Chapter 11 Flexible Budgeting and the Management of Overhead and Support Activity Costs Chapter 11: Flexible Budgeting and the Management of Overhead and Support Activity Costs McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Learning Objective 1 Learning Objective 1. Distinguish between static and flexible budgets and explain the advantages of a flexible overhead budget. 11-2

Static budgets are prepared for a single, planned level of activity. Flexible Budgets Hmm! Comparing static budgets with actual costs is like comparing apples and oranges. Static budgets are prepared for a single, planned level of activity. Performance evaluation for overhead is difficult when actual activity differs from the planned level of activity. Static budgets are prepared for a single, planned level of activity. Performance evaluation for overhead is difficult when actual activity differs from the planned level of activity. Since direct material and direct labor are traceable to products, it is straightforward to determine standard costs for these inputs. But to compare overhead costs at the budgeted level of activity to actual overhead costs at some other level of activity, is like comparing apples and oranges. (LO1) 11-3

Consider the following example from the Cheese Company . . . Flexible Budgets Hmm! Comparing static budgets with actual costs is like comparing apples and oranges. Consider the following example from the Cheese Company . . . Consider the Cheese Company. (LO1) 11-4

Static Budgets and Performance Reports U = Unfavorable variance Cheese Company was unable to achieve the budgeted level of activity. Cheese Company was unable to produce at the budgeted level of activity. There were only 8,000 machine hours actually used as opposed to the 10,000 hours budgeted. Therefore, there was a 2,000 hour unfavorable variance. (LO1) 11-5

Static Budgets and Performance Reports F = Favorable variance since actual costs are less than budgeted costs. Because there was less production, the variable overhead costs were less. This caused a favorable variance. But does a favorable cost variance indicate that Cheese Company has done a good job controlling costs? (LO1) Since cost variances are favorable, have we done a good job controlling costs? 11-6

Static Budgets and Performance Reports I do know that actual activity is below budgeted activity which is unfavorable. But shouldn’t variable costs be lower if actual activity is below budgeted activity? I don’t think I can answer this question using a static budget. Cheese Company cannot determine how well overhead costs have been controlled using a static budget. When actual activity is different from the budgeted activity, variable costs should also be different. This is because variable costs vary with the level of activity. If static budgets do not provide the answer to controlling overhead, what does? (LO1) 11-7

Static Budgets and Performance Reports The relevant question is . . . “How much of the favorable cost variance is due to lower activity, and how much is due to good cost control?” To answer the question, we must the budget to the actual level of activity. A company must be able to determine how much of the variance is caused by the activity level and how much of the variance is a result of good cost control. The tool used by most companies to control overhead costs is called a flexible budget. A flexible budget flexes a static budget to cover a range of activity within which the firm may operate. (LO1) 11-8

Flexible Budgets Central Concept If you can tell me what your activity was for the period, I will tell you what your costs and revenue should have been. The central concept of a static budget is to determine what costs and revenue should have been for a particular level of activity. (LO1) 11-9

Advantages of Flexible Budgets Show revenues and expenses that should have occurred at the actual level of activity. May be prepared for any activity level in the relevant range. Reveal variances due to good cost control or lack of cost control. There are several advantages of flexible budgets. Revenues and expenses are what they should have been at the actual level of activity. Flexible budgets can be prepared for any level of activity within the relevant range. These budgets make it possible to distinguish if variances are caused by good cost control or lack of cost control. The variances can be analyzed to help improve performance evaluation. (LO1) Improve performance evaluation. 11-10

Learning Objective 2 Learning Objective 2. Prepare a flexible overhead budget, using both a formula and a columnar format. 11-11

Preparing a Flexible Budget Let’s prepare budgets for the Cheese Company. Let’s prepare flexible budgets for the Cheese Company. (LO2) 11-12

Preparing a Flexible Budget The Cheese Company uses machine hours as the activity units. The flexible budget is prepared at three levels of activity: 8,000 hours, 10,000 hours and 12,000 hours, which are all within the relevant range. (LO2) 11-13

Preparing a Flexible Budget Variable costs are expressed as a constant amount per hour. Fixed costs are expressed as a total amount that does not change within the relevant range of activity. The static budget amounts for each of the variable costs of overhead are expressed as a constant amount per machine hours. For example, the static budget for indirect labor was $40,000 at 10,000 machine hours, which is $4.00 per machine hour. The static budget for indirect materials was $30,000 which is $3.00 per machine hour. And for power, the static budget cost was $5,000 which is $0.50 per machine hour. Fixed costs are expressed as a total amount. This is due to the nature of fixed costs. Total fixed costs do not change within the relevant range of activity. (LO2) (LO2) 11-14

Preparing a Flexible Budget The flexible budget at the 8,000 machine hour level of activity can be completed. Each of the variable costs per hour is multiplied by 8,000. Total variable costs at the 8,000 machine hour level is $60,000. Total fixed costs is $14,000. The total overhead costs is the sum of the total variable costs and the total fixed costs, which is $74,000. (LO2) 11-15

Preparing a Flexible Budget The flexible budget at the remaining two levels of activity is completed in the same manner. (LO2) 11-16

Preparing a Flexible Budget Note: There is no flex in the fixed costs. Notice that there is no “flex” in the fixed costs. They remain the same at all three levels of activity. (LO2) 11-17

Preparing a Flexible Budget Total budgeted overhead cost = Budgeted variable Total overhead cost per activity activity unit units × + Budgeted fixed overhead cost The total overhead cost can be expressed as the formula total budgeted overhead costs equals budgeted variable overhead cost per activity unit times the total activity units. Then add budgeted fixed overhead costs. (LO2) 11-18

Flexible Budget Performance Report Now let’s prepare a budget performance report at 8,000 actual machine hours for the Cheese Co. A flexible budget performance report can now be prepared at 8,000 machine hours. 8,000 machine hours is the actual machine hours for the period. (LO2) 11-19

Flexible Budget Performance Report Their variable cost per hour and the total fixed costs are in the two left-most columns of the flexible budget performance report. The fourth column is for the actual results during the period. (LO2) 11-20

Flexible Budget Performance Report Flexible budget is prepared for the same activity level (8,000 hours) as actually achieved. Now the third column, the flexible budget column, is prepared for the same level of activity at the actual level, which is 8,000 hours. (LO2) 11-21

Flexible Budget Performance Report We are no longer comparing apples and oranges. The flexible budget column can be completed at the 8,000 hour level. (LO2) 11-22

Flexible Budget Performance Report Indirect labor and indirect material have unfavorable variances because actual costs are more than the flexible budget costs. Indirect material costs should have been $32,000, but were actually $34,000. This is an unfavorable variance of $2,000. Indirect labor should have been $24,000, but were actually $25,500, which is an unfavorable variance of $1,500. (LO2) 11-23

Flexible Budget Performance Report Power has a favorable variance because the actual cost is less than the flexible budget cost. Power costs should have been $4,000 but were actually $3,800 which is a favorable variance of $200. (LO2) 11-24

Learning Objective 3 Learning Objective 3. Explain how overhead is applied to Work-in-Process Inventory under standard costing. 11-25

Overhead Application in a Standard Costing System Recall that overhead application refers to the addition of overhead cost to the Work-in-Process Inventory account as a product cost. In the normal-costing system, overhead application is based on actual hours. In a standard-costing system, overhead application is based on standard hours allowed, given actual output. The difference between normal costing and standard costing, insofar as overhead is concerned, lies in the quantity of hours used. Both normal- and standard-costing systems use a predetermined overhead rate. In a standard-costing system, the predetermined overhead rate also is referred to as the standard overhead rate. (LO3) 11-26

Overhead Application in a Standard Costing System Both normal- and standard-costing systems use a predetermined overhead rate. In a standard-costing system, the predetermined overhead rate also is referred to as the standard overhead rate. The Cheese Company calculates its predetermined or standard overhead rate annually. The rate for the current year is based on planned activity of 8,000 machine hours per month. Notice that the predetermined overhead rate is broken into a variable rate and a fixed rate. (LO3) 11-27

Learning Objective 4 Learning Objective 4. Explain some important issues in choosing an activity measure for overhead budgeting and application. 11-28

Choice of Activity Measure Variable overhead and the activity measure should vary in a similar pattern. Identify variable overhead cost drivers. Examples: machine hours, labor hours, process time. Dollar measures should be avoided as they are subject to price-level changes. Choosing the appropriate activity measure for the flexible overhead budget is important, because the flexible budget is the chief tool for managing overhead costs. The activity measure should be one that varies in a similar pattern to the way that variable overhead varies. As productive activity shifts, both variable-overhead cost and the activity measure should shift in roughly the same proportion and in the same direction. Cost drivers are identified as the most significant factors affecting overhead costs. Variable overhead cost drivers, such as machine hours, labor hours, or process time, should be identified. Dollar measures, such as raw material costs, should be avoided because they are subject to price-level changes. (LO4) 11-29

Learning Objective 5 Learning Objective 5. Compute and interpret the variable-overhead spending and efficiency variances and the fixed-overhead budget and volume variances. 11-30

Cost Management Using Overhead Cost Variances Let’s turn our attention to the computation of overhead cost variances. We will begin with variable overhead. We will now turn our attention to overhead cost variances. We will start with variable overhead. (LO5) 11-31

Variable Overhead Variances Actual Flexible Budget Flexible Budget Variable for Variable for Variable Overhead Overhead at Overhead at Incurred Actual Hours Standard Hours AH × AR AH × SVR SH × SVR Spending Variance Efficiency Variance The spending variance for variable overhead is calculated using two components: actual hours times actual rate and actual hours times the standard variable rate. The spending variance is the difference between these two components. The efficiency variance for variable overhead is calculated using two components: actual hours times the standard variable rate and standard hours times the standard variable rate. The efficiency variance is the difference between these two components. (LO5) AH = Actual Hours of Activity AR = Actual Variable Overhead Rate SVR = Standard Variable Overhead Rate SH = Standard Hours Allowed 11-32

Variable Overhead Variances Actual Flexible Budget Flexible Budget Variable for Variable for Variable Overhead Overhead at Overhead at Incurred Actual Hours Standard Hours AH × AR AH × SVR SH × SVR Spending Variance Efficiency Variance The spending variance can be restated as the actual rate less the standard variable rate. This difference is then multiplied times the actual hours. The efficiency variance for variable overhead can be restated as the actual hours less the standard hours. The difference is then multiplied times the standard variable rate. (LO5) Spending variance = AH(AR - SVR) Efficiency variance = SVR(AH - SH) 11-33

Variable Overhead Variances – Example ColaCo’s actual production for the period required 3,200 standard machine hours. Actual variable overhead incurred for the period was $6,740. Actual machine hours worked were 3,300. Compute the variable overhead spending and efficiency variances. Let’s look at an example. The standard hours required for ColaCo’s actual production was 3,200 machine hours. The actual variable overhead costs incurred for the period was $6,740. There were 3,300 actual machine hours used. (LO5) 11-34

Variable Overhead Variances – Example ColaCo prepared this budget for overhead: Total budgeted overhead cost = Budgeted variable Total overhead cost per x activity activity unit units + Budgeted fixed overhead cost ColaCo prepared a flexible budget for overhead. The total budgeted overhead costs formula is total variable overheads costs plus fixed overhead costs. For ColaCo, this is $2.00 per machine hour times the total machine hours used. Then add the budgeted fixed overhead cost of $9,000. (LO5) Total budgeted overhead cost = $2.00 per machine hour × Total machine hours + $9,000 11-35

Variable Overhead Variances – Example Actual Flexible Budget Flexible Budget Variable for Variable for Variable Overhead Overhead at Overhead at Incurred Actual Hours Standard Hours 3,300 hours 3,200 hours × × $2.00 per hour $2.00 per hour $6,740 $6,600 $6,400 The spending variance for ColaCo is determined by first calculating the flexible budget for variable overhead at the actual hours. This is the actual machine hours of 3,300 times the standard variable overhead rate of $2.00 per machine hour. This amount, $6,600, is compared to the actual overhead incurred, $6,740. The difference is $140. Because the actual variable overhead incurred was greater than the flexible budget for variable overhead at the actual hours, the difference is unfavorable. To determine the efficiency variance, we must first determine the flexible budget amount for variable overhead at the standard hours allowed. This is the standard hours allowed of 3,200 times the standard variable overhead rate of $2.00 per machine hour. The result is $6,400. This amount is then compared to the flexible budget amount for variable overhead at the actual hours which we calculated earlier as $6,600. The difference is $200. Because the flexible budget amount for variable overhead at the standard hours allowed was greater than the flexible budget for variable overhead at the actual hours, the difference is unfavorable. (LO5) Spending variance $140 unfavorable Efficiency variance $200 unfavorable 11-36

Variable Overhead Variances – Example Actual Flexible Budget Flexible Budget Variable for Variable for Variable Overhead Overhead at Overhead at Incurred Actual Hours Standard Hours 3,300 hours 3,200 hours × × $2.00 per hour $2.00 per hour $6,740 $6,600 $6,400 The $140 unfavorable spending variance and the $200 unfavorable efficiency variance result in a $340 unfavorable flexible budget variance. (LO5) The $140 unfavorable spending variance and the $200 unfavorable efficiency variance result in a $340 unfavorable flexible budget variance. 11-37

Variable Overhead Variances – A Closer Look Spending Variance Efficiency Variance Results from paying more or less than expected for overhead items and from excessive usage of overhead items. A function of the selected cost driver. It does not reflect overhead control. An unfavorable spending variance simply means that the total actual cost of variable overhead is greater than expected, after adjusting for the actual quantity of process hours used. An unfavorable spending variance could result from paying a higher-than-expected price per unit for variable-overhead items. Or the variance could result from using more of the variable-overhead items than expected. The variable overhead efficiency variance is a function of the cost driver selected. It does not reflect overhead control. Therefore, the spending variance is the real control variance for variable overhead. Managers can use the spending variance to alert them if variable-overhead costs are out of line with expectations. (LO5) 11-38

Now let’s turn our attention to fixed overhead. Now we will look at fixed overhead. (LO5) 11-39

Fixed Overhead Variances Actual Fixed Fixed Fixed Overhead Overhead Overhead Incurred Budget Applied SH × PFOHR Budget Variance Volume Variance To analyze fixed overhead costs, managerial accountants calculate two fixed-overhead variances: The fixed overhead budget variance and the fixed overhead volume variance. The budget variance is the difference between the actual fixed overhead costs incurred and the budgeted fixed overhead. The volume variance is the difference between the budgeted fixed overhead and the applied fixed overhead. Applied fixed overhead is the standard hours allowed for the actual level of activity times the predetermined fixed overhead rate. (LO5) PFOHR = Predetermined Fixed Overhead Rate SH = Standard Hours Allowed 11-40

Budgeted Fixed Overhead Planned Activity in Hours Recall that fixed overhead costs are applied to products and services using a predetermined fixed overhead rate (PFOHR): Applied Fixed Overhead = PFOHR × Standard Hours Remember that fixed overhead costs are applied to products and services using a predetermined overhead rate times the standard hours allowed. That predetermined overhead rate is established by dividing the budgeted fixed overhead by the planned activity in hours. (LO5) Budgeted Fixed Overhead Planned Activity in Hours PFOHR = 11-41

Fixed Overhead Variances – Example ColaCo used the following predetermined fixed overhead rate: PFOHR = Budgeted Fixed Overhead Planned Activity in Hours $9,000 3,000 machine hours PFOHR = $3.00 per machine hour ColaCo established their predetermined overhead rate by dividing the budgeted fixed overhead of $9,000 by the planned activity in hours of 3,000 machine hours. The result was $3.00 per machine hour. (LO5) 11-42

Fixed Overhead Variances – Example ColaCo’s actual production required 3,200 standard machine hours. Actual fixed overhead was $8,450. Compute the fixed overhead budget and volume variances. ColaCo’s actual production allowed for 3,200 machine hours. The actual fixed overhead was $8,450. Let’s calculate the fixed overhead budget and volume variances. (LO5) 11-43

Fixed Overhead Variances – Example Actual Fixed Fixed Fixed Overhead Overhead Overhead Incurred Budget Applied 3,200 hours × $3.00 per hour $8,450 $9,000 $9,600 The actual fixed overhead costs incurred of $8,450 is less than the budgeted fixed overhead of $9,000. The difference is $550 favorable variance. The variance is favorable because the actual amount spent was less than the budgeted amount. The fixed overhead applied is $3.00 per machine hours times 3,200 standard machine hours allowed which is $9,600. This is compared to the budgeted fixed overhead of $9,000 to arrive at a $600 volume variance. Many managerial accountants choose not to designate the volume variance as either favorable or unfavorable, but merely as a way of reconciling the two purposes of the cost management system. (LO5) Budget variance $550 favorable Volume variance $600 (neither favorable nor unfavorable) 11-44

Fixed Overhead Variances Let’s look at a graph showing fixed overhead variances. We will use ColaCo’s numbers from the previous example. ColaCo’s fixed overhead variances can be illustrated graphically. (LO5) 11-45

Fixed Overhead Variances – A Closer Look Budget Variance Volume Variance Results from paying more or less than expected for overhead items. Results from the inability to operate at the activity level planned for the period. Has no significance for cost control. The budget variance is the real control variance for fixed overhead, because it compares actual expenditures with budgeted fixed-overhead costs. The volume variance provides a way of reconciling two different purposes of the cost management system. For the control purpose, the system recognizes that fixed overhead does not change as production activity varies. Hence, budgeted fixed overhead is the same at all activity levels in the flexible budget. (Review Exhibit 11–3 to verify this.) Budgeted fixed overhead is the basis for controlling fixed overhead, because it provides the benchmark against which actual expenditures are compared. (LO5) 11-46

Fixed Overhead Variances 3,200 machine hours × $3.00 fixed overhead rate Cost $9,600 applied fixed OH $600 Volume Variance { $9,000 budgeted fixed OH { $550 Favorable Budget Variance $8,450 actual fixed OH Fixed overhead applied to products The applied fixed overhead for the period was $9,600 because there were 3,200 machine hours allowed and the predetermined fixed overhead rate was $3.00 per machine hour. Budgeted fixed overhead is $9,000 for all levels of activity. The difference between these two resulted in a $600 volume variance. The actual fixed overhead costs were $8,450, which, when compared to the $9,000 budgeted fixed overhead, resulted in a $550 favorable budget variance. (LO5) Volume 3,000 Hours Planned Activity 3,200 Standard Hours 11-47

Learning Objective 6 Learning Objective 6. Prepare an overhead and cost performance report. 11-48

Overhead Cost Performance Report The variable-overhead spending and efficiency variances and the fixed-overhead budget variance can be computed for each overhead cost item in the flexible budget. When these itemized variances are presented along with actual and budgeted costs for each overhead item, the result is an overhead cost performance report. The overhead cost performance report will include only spending and efficiency variances for the variable items, and only a budget variance for the fixed items. (LO6) 11-49

Learning Objective 7 Learning Objective 7. Explain how an activity-based flexible budget differs from a conventional flexible budget. 11-50

Activity-Based Flexible Budget The flexible budget for Cheese Company, used for our variance analysis, is based on a single cost driver. Overhead costs that vary with respect to machine hours are categorized as variable; all other overhead costs are treated as fixed. This approach is consistent with traditional, volume-based product-costing systems. (LO7) The Cheese Co. flexible budget is based on a single cost driver, machine hours 11-51

Activity-Based Flexible Budget Under the more accurate product-costing method called activity-based costing, several cost drivers are identified. Costs that may appear fixed with respect to a single volume-based cost driver, such as machine hours, may be variable with respect to some other cost driver. The activity-based costing approach also can be used as the basis for a flexible budget for planning and cost management purposes. An activity-based flexible budget should be prepared with different cost formulas based on the different cost drivers. (LO7) If different cost drivers are identified for the different variable costs, an activity-based flexible budget should be prepared with different cost formulas based on the different drivers. 11-52

Learning Objective 8 Learning Objective 8. Prepare journal entries to record manufacturing overhead under standard costing (Appendix A). 11-53

Standard Costs and Product Costing Under standard costing, actual manufacturing overhead costs are debited to the manufacturing overhead account and credited accounts such as wages payable, utilities payable, prepaid insurance, indirect material inventory, etc for the actual amounts. When manufacturing overhead is applied in a standard costing system, work-in-process inventory is debited and manufacturing overhead is credited for the standard allowed hours times the predetermined overhead rate. The predetermined overhead rate is the sum of the variable overhead and fixed overhead predetermined rates. (LO8) 11-54

Standard Costs and Product Costing Variances are closed directly to the cost of goods sold account. When actual overhead is greater than applied overhead, a debit balance remains in manufacturing overhead. That balance is closed by crediting manufacturing overhead and debiting cost of goods sold. When applied overhead is greater than actual overhead, a credit balance remains in manufacturing overhead. That balance is closed by debiting manufacturing overhead and crediting cost of goods sold. (LO8) 11-55

Learning Objective 9 Learning Objective 9. Compute and interpret the sales-price and sales-volume variances (Appendix B). 11-56

A General Model for Variance Analysis Actual Quantity Actual Quantity Standard Quantity × × × Actual Price Standard Price Standard Price Price Variance Quantity Variance Materials price variance Materials quantity variance Labor rate variance Labor efficiency variance Variable overhead Variable overhead spending variance efficiency variance The general model for variance analysis can also be used to calculate the sales price variance and the sales volume variance. Let’s change it slightly for these sales variances. (LO9) AQ(AP - SP) SP(AQ - SQ) AQ = Actual Quantity SP = Standard Price AP = Actual Price SQ = Standard Quantity 11-57

A General Model for Variance Analysis Actual Sales Volume Actual Sales Volume Budgeted Sales Volume × × × Actual Sales Price Budgeted Sales Price Budgeted Sales Price Sales Price Variance Sales Volume Variance To calculate the sales price variance, start by subtracting the budgeted sales price from the actual sales price. This difference is then multiplied by the actual sales volume. If the amount is negative, the variance is unfavorable because the budgeted sales price was greater than the actual sales price. If the amount is positive, the variance is favorable because the actual sales price was greater than the budgeted sales price. To calculate the sales volume variance, start by subtracting the budgeted sales volume from the actual sales volume. This difference is then multiplied by the budgeted sales price. If the amount is negative, the variance is unfavorable because the budgeted sales volume was greater than the actual sales volume. If the amount is positive, the variance is favorable because the actual sales volume was greater than the budgeted sales volume. Together, the sales-price and sales-volume variances explain the variance between actual and budgeted sales revenue. (LO9) ASV(ASP - BSP) BSP(ASV - BSV) ASV = Actual Sales Volume BSP = Budgeted Sales Price ASP = Actual Sales Price BSV = Budgeted Sales Volume 11-58

I’m here to your budget. Are you ready to ante up? End of Chapter 11 I’m here to your budget. Are you ready to ante up? 11-59