Chapter 11 Standard costs for control: flexible budgets and manufacturing overhead Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Outline Flexible budgets Input measures and output measures Overhead application in a standard costing system Calculating and interpreting overhead cost variances Standard costs for product costing An appraisal of standard costing systems Criticisms and advantages Activity-based budgeting Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Flexible budgets A detailed budget prepared for a range of levels of activities Compared to a static budget which relates to one specific planned level of activity Often restricted to flexing overhead costs to various levels of activity Allow us to select the most appropriate benchmark for cost control Provide a valid basis for comparing actual and expected costs, for the actual level of activity Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Input measures and output measures Units of output are not usually a meaningful measure of the level of activity in a multi-product firm Output can be measured as the standard quantity of input allowed, given actual output Machine hours Direct labour hours The choice between input or output measures becomes important when multiple products are being manufactured Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Flexible overhead budget Flexible budget report: shows flexible overhead budgets at various levels of activity Formula flexible budget: allows us to calculate total overhead at various levels of activity using a formula Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Overhead application in a standard costing system Overhead application is the method of allocating overhead cost to products Recorded in the WIP inventory account Overhead is applied to inventory using the standard overhead rate Based on the standard quantity of input allowed, given actual output The activity chosen for the standard overhead rate should be a cost driver Any activity or factor that causes costs to be incurred Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Calculating overhead cost variances The flexible budget provides a tool for controlling manufacturing overhead costs At the end of an accounting period, the flexible budget can be used to calculate the amount of overhead cost that should have been incurred, given the actual level of activity Four different overhead variances can be calculated to compare the actual overhead cost incurred with the flexible budget Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Calculating variable overhead cost variances Variable overhead spending variance A measure of the difference between the actual variable overhead and the standard variable overhead rate multiplied by actual activity = Actual variable overhead – (AH × SVR) Where AH = actual direct labour hours SVR = standard variable overhead rate (cont.) Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Calculating variable overhead cost variances (cont.) Variable overhead efficiency variance A measure of the difference between the actual activity and the standard activity allowed, given the actual output multiplied by the standard variable overhead rate = SVR(AH – SH) Where SH = standard direct labour hours allowed for actual output AH = actual direct labour hours SVR = standard variable overhead rate Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Interpreting variable overhead variances Spending variance Actual cost of variable overhead is greater/less than expected, after adjusting for the actual quantity of cost driver that is used Used to control variable overhead cost Efficiency variance The cost effects of excessive or minimal use of the particular activity (cost driver) The spending variance is the real control variance for variable overhead Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Calculating fixed overhead variances Fixed overhead budget variance The difference between actual fixed overhead and budgeted fixed overhead = actual fixed overhead – budgeted fixed overhead Fixed overhead volume variance The difference between budgeted fixed overhead and fixed overhead applied to production = budgeted fixed overhead – applied fixed overhead Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Interpreting fixed overhead variances Fixed overhead budget variance Used for control Assumes fixed overhead will not change as activity varies Fixed overhead volume variance Standard cost driver allowed for actual output is more/less than the planned level of production Reconciles the two purposes of costing systems: product costing and cost control Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Standard costs for product costing Costs of direct material, direct labour and manufacturing overhead are all charged to inventory at standard costs, not actual costs Variances are closed off at end of the accounting period To cost of goods sold expense Prorate between WIP, FG and COGS inventory if the amount is large Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Criticisms of standard costing systems Variances are too aggregated and concentrate on consequences rather than the causes of problems Variance reports are too late to be useful Monthly reporting may be too late to correct problems Standard costing systems tend to focus too heavily on cost minimisation May encourage cost reduction which can adversely affect other areas of strategic importance (cont.) Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Criticisms of standard costing systems (cont.) Standard costing systems take a departmental perspective rather than a process perspective Miss opportunities for cost control Controlling one department’s costs may increase costs in other departments Too much emphasis is placed on the cost and efficiency of direct labour This is of decreasing importance in the face of increasing automation Overhead variances give limited cost control information (cont.) Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Criticisms of standard costing systems (cont.) Variance analysis does not explicitly encourage continuous improvement Due to 12-month standards Standard costs become outdated quickly due to shorter product life cycles Standard costing systems do not capture the full costs of materials The full cost of ownership includes cost of ordering and paying for materials, storage, handling, rework Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Advantages of standard costing Provides a good basis for cost comparisons Particularly with the use of flexible budgets Enables managers to use management by exception Focus only on those variances that are significant and save management time Provides a basis for managerial performance evaluation and determining bonuses (cont.) Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Advantages of standard costing (cont.) Participation in setting standards and assigning responsibility can have motivational effects on employees May lead to more stable product costs compared to using actual costs Useful for pricing and setting product mix Can be used for external financial reporting Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Activity-based budgeting A process of building up budgets from the major activities of the business Uses principles of ABC to estimate a firm’s future demand for resources ABB works in reverse to ABC Start with analysis of the market, estimate sales demand, estimate production activities, required level of production and resources (cont.) Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Activity-based budgeting (cont.) Inaccuracies in ABB may include the following: Spending versus consumption of resources The cost of unused resources are not included in ABC product costs Estimates of non-manufacturing activities may be distorted Shared resources may not be accounted for accurately Information requirements for ABB are high compared to traditional budgeting systems (cont.) Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Activity-based budgeting (cont.) Performance evaluation under ABB Need to compare actual activity costs to budgeted costs Budgeted costs should be based on flexible budgets which show the budgeted cost of activities as various cost drivers change Complexity would make it difficult to prepare an information report Such flexible budgets have the potential to be very complex and costly to design and maintain, with difficulties relating to data collection Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Summary A flexible budget can be used to control manufacturing costs, based on a range of different levels of activity Cost variances can be calculated for variable and fixed overheads, but their usefulness for controlling overhead costs can be questioned Standard costing systems have been criticised in the light of more modern methods for controlling costs and evaluating performance Activity-based budgeting may provide more accurate benchmarks than a flexible budget, but may be complex and costly to implement Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith