Flexible Budgets, Variances, and Management Control: II Chapter 16 Flexible Budgets, Variances, and Management Control: II

Introduction Overhead costs are a major cost area for many organisations. Planning and control of overhead costs is an ongoing challenge to managers. This chapter emphasises the overhead categories of variable and fixed manufacturing overhead.

Learning Objectives Explain differences in the planning of variable- overhead costs and the planning of fixed- overhead costs Explain the computation and meaning of spending and efficiency variances for variable overhead Illustrate how to compute the budgeted fixed-overhead rate Give two reasons why the production-volume variance may not be a good measure of the opportunity cost of unused capacity Explain how a 4-variance analysis can provide an integrated overview of overhead cost variances Explain the differing roles of cost allocation bases for fixed manufacturing overhead when (a) planning and controlling, and (b) valuing stock Prepare journal entries for variable- and fixed- overhead variances Explain how the flexible-budget variance approach can be used in activity-based costing and why managers frequently use both financial and non-financial variables to plan and control overhead costs

Learning Objective 1 Explain differences in the planning of variable-overhead costs and the planning of fixed-overhead costs

Learning Objective 1(continued) Planning of Variable and Fixed Overhead Costs LSY Co manufactures a dress suit that is then sold to distributors. Variable overhead costs include: Energy Machine maintenance Indirect materials Indirect labour Fixed manufacturing overhead costs include: Plant leasing costs Some administrative costs (plant manager’s salary) Depreciation

Learning Objective 1(continued) Effective planning of variable overhead costs involves undertaking only those variable overhead activities that add value for customers using the product or service. LSY’s customers perceive sewing to be an essential activity, therefore, maintenance activities for sewing machines included in variable overhead costs are also essential. Effective planning of fixed overhead costs involves planning to undertake only essential activities and then planning to be efficient in that undertaking. The key challenge with planning fixed overhead is choosing the appropriate level of capacity or investment that will benefit the company over an extended time period. Most of the key decisions that determine the level of fixed overhead costs to be incurred are made at the start of a budget period. Day-to-day, ongoing operating decisions play a large role in determining the level of variable overhead costs incurred in the budget period.

Learning Objective 2 Explain the computation and meaning of spending and efficiency variances for variable overhead

Learning Objective 2(continued) Variable Overhead Cost Variances The following data are for 2002 when LSY Co produced and sold 10,000 suits: Output units: 10,000 Labour-hours: Actual results: 21,500 Flexible-budget amount: 20,000 Labour-hours per output unit: Actual results: 21,500 ÷ 10,000 = 2.15 Flexible-budget amount: 20,000 ÷ 10,000 = 2.00

Learning Objective 2(continued) Variable manufacturing overhead costs: Actual results: €244,775 Flexible-budget amount: €240,000 Variable manufacturing overhead cost per labour hour: Actual results: €244,775 ÷ 21,500 = €11.3849 Flexible-budget amount: €240,000 ÷ 20,000 = €12.00 Variable manufacturing overhead cost per output unit: Actual results: €244,775 ÷ 10,000 = €24.4775 Flexible-budget amount: €240,000 ÷ 10,000 = €24.00

Learning Objective 2(continued) Flexible-Budget Analysis The variable overhead flexible-budget variance measures the difference between the actual variable overhead costs and the flexible-budget variable overhead costs. Actual results: €244,775 – Flexible-budget amount €240,000 = €4,775 U

Learning Objective 2(continued) Actual Budgeted Inputs Costs Allowed for Actual Incurred Outputs at Budgeted Rate 21,500 × €11.3849 20,000 × €12.00 = €244,775 = €240,000 €4,775 U Flexible-budget variance

Learning Objective 2(continued) Variable Overhead Efficiency Variance The variable overhead efficiency variance measures the efficiency with which the cost-allocation base is used. (Actual units of variable overhead cost-allocation base used for actual output Budgeted units of variable overhead cost-allocation base allowed for actual output) Budgeted variable overhead rate (21,500 – 20,000) × €12 = €18,000 U This unfavourable variance means that actual labour-hours were higher than the budgeted labour-hours allowed.

Learning Objective 2(continued) Actual Quantity Budgeted Inputs of Inputs at Allowed for Actual Budgeted Rate Outputs at Budgeted Rate 21,500 × €12.00 20,000 × €12.00 = €258,000 = €240,000 €18,000 U Variable overhead efficiency variance

Learning Objective 2(continued) Variable Overhead Spending Variance The variable overhead spending variance is the difference between the actual amount of variable overhead incurred and the budgeted amount allowed for the actual quantity of the variable overhead allocation base used for the actual output units produced.

Learning Objective 2(continued) Actual Actual Quantity Costs of Inputs at Incurred Budgeted Rate 21,500 × €11.3849 21,500 × €12.00 = €244,775 = €258,000 €13,225 F Variable overhead spending variance

Learning Objective 2(continued) Variable Overhead Variances Flexible-budget variance €4,775 U Efficiency variance €18,000 U Spending variance €13,225 F

Learning Objective 3 Illustrate how to compute the budgeted fixed-overhead rate

Learning Objective 3(continued) Developing Budgeted Fixed Overhead Allocation Rates Fixed overhead costs are a lump sum that remains unchanged in total for a given time period despite wide changes in the related total activity or output level. While total fixed costs are frequently included in flexible budgets, they remain the same total amount within the relevant range regardless of the output level chosen.

Learning Objective 3(continued) The steps in developing the budgeted fixed overhead rate are: Step 1: Choose the time period used to compute the budget The budget period is typically twelve months. Step 2: Select the cost-allocation base to use in allocating fixed overhead costs to the cost object(s) LSY uses standard labour-hours as the cost allocation base for fixed manufacturing overhead costs. This is the denominator of the budgeted fixed overhead rate computation. It is called the denominator level or production-denominator level. In year 2002, LSY budgets 26,000 labour- hours for a budgeted output of 13,000 suits.

Learning Objective 3(continued) Step 3: Identify the fixed overhead costs associated with each cost-allocation base LSY groups all its fixed manufacturing overhead costs (depreciation, leasing costs, plant manager’s salary) in a single cost pool. LSY’s fixed manufacturing budget for 2002 is €286,000. Step 4: Compute the rate per unit of each cost-allocation base used to allocate fixed overhead costs to the cost object(s) LSY estimates a rate of €11/labour-hour for its fixed manufacturing overhead costs. €286,000 ÷ 26,000 = €11

Learning Objective 3(continued) What is the budgeted fixed overhead cost rate per output unit (dress suit)? 2.00 hours allowed per output unit €11 budgeted fixed overhead cost rate per input unit €22 per suit (output unit)

Learning Objective 3(continued) Fixed Overhead Cost Variances The flexible budget amount for a fixed cost item is the amount included in the static budget prepared at the start of the period. No adjustment is required for differences between the actual output and the budgeted output for fixed costs. Fixed costs are unaffected by changes in the level of output.

Learning Objective 3(continued) Flexible-Budget Variance The fixed overhead flexible-budget variance (spending variance) is the difference between actual fixed overhead costs and the fixed overhead costs in the flexible budget. Assume that LSY’s actual total fixed overhead is €300,000 for 2002. Actual costs incurred €300,000 – Flexible-budget amount €286,000 = €14,000 U The variable overhead flexible-budget variance was subdivided into a spending variance and an efficiency variance. For fixed overhead there is not an efficiency variance. Why? Because a lump sum of fixed costs will be unaffected by the degree of operating efficiency in a given budget period.

Learning Objective 3(continued) Actual Costs Flexible Budget: Incurred Budgeted Fixed Overhead €300,000 €286,000 €14,000 U Fixed overhead spending variance Fixed overhead flexible-budget variance

Learning Objective 3(continued) Production-Volume Variance The production-volume variance is the difference between budgeted fixed overhead and the fixed overhead allocated on the basis of the budgeted quantity of the fixed overhead allocation base allowed for the actual output produced. Denominator-level variance Output-level overhead variance

Learning Objective 3(continued) Flexible Budget: Fixed Overhead Budgeted Allocated Using Fixed Overhead Budgeted Input Allowed for Actual Output Units Produced €286,000 €220,000 €66,000 U Production-volume variance 10,000 × 2.00 × €11 = €220,000

Learning Objective 3(continued) Fixed Overhead Variances Fixed overhead variance €80,000 U Volume variance €66,000 U Spending variance €14,000 U

Learning Objective 4 Give two reasons why the production-volume variance may not be a good measure of the opportunity cost of unused capacity

Learning Objective 4(continued) Interpreting the Production-Volume Variance Caution is appropriate before interpreting the production-volume variance as a measure of the economic cost of unused capacity. One caveat is that management may have maintained some extra capacity to meet uncertain demand surges that are important to satisfy customer demands. A second caveat is that the production-volume variance focuses only on costs. It does not take into account any price changes necessary to spur extra demand that would in turn make use of any idle capacity.

Learning Objective 4(continued) The production-volume variance arises whenever the actual level of the denominator differs from the level used to calculate the budgeted fixed overhead rate. The production-volume variance results from ‘unitising’ fixed costs. Lump-sum fixed costs represent resources sacrificed in acquiring capacity. Plant Equipment leases These costs cannot be decreased if the resources needed are less than the resources acquired.

Learning Objective 4(continued) The unfavourable €66,000 production-volume variance measures the amount of extra fixed costs that LSY incurred for manufacturing capacity it planned to use but did not. Had LSY manufactured 13,000 suits instead of 10,000, allocated fixed overhead would have been 13,000 × 2.00 × €11 = €286,000. No production-volume variance would have occurred. Assume that in year 2001, LSY’s denominator level is exactly the capacity used for that budget period, but actual demand and production turns out to be 8% below the denominator level. LSY would report an unfavourable production-volume variance.

Learning Objective 5 Explain how a 4-variance analysis can provide an integrated overview of overhead cost variances

Learning Objective 5(continued) Integrated Analysis A 4-Variance Analysis presents spending and efficiency variances for variable overhead costs and spending and production-volume variances for fixed overhead costs. Managers can reconcile the actual overhead costs with the overhead amounts allocated during the period.

Learning Objective 5(continued) Actual variable overhead costs incurred €244,775 Flexible budget: budgeted inputs allowed × budgeted rate €240,000 Flexible-budget variance €4,775 U Under-allocated variable overhead

Learning Objective 5(continued) Actual variable overhead costs incurred €244,775 Actual inputs × budgeted rate €258,000 Variable overhead spending variance €13,225 F

Learning Objective 5(continued) Actual inputs × budgeted rate €258,000 Flexible budget: budgeted inputs allowed × budgeted rate €240,000 Variable overhead efficiency variance €18,000 U

Learning Objective 5(continued) Actual fixed overhead costs incurred €300,000 Budgeted fixed overhead costs €286,000 Fixed overhead spending variance €14,000 U

Learning Objective 5(continued) Budgeted fixed overhead costs €286,000 Budgeted inputs allowed × budgeted rate €220,000 Volume variance €66,000 U

Learning Objective 5(continued) Actual manufacturing overhead incurred: Variable manufacturing overhead €244,775 Fixed manufacturing overhead 300,000 Total €544,775 Overhead allocated: Variable manufacturing overhead €240,000 Fixed manufacturing overhead 220,000 Total €460,000 Amount under-allocated € 84,775

Learning Objective 5(continued) 4-Variance Analysis Variable manufacturing overhead: Spending variance €13,225 F Efficiency variance 18,000 U Fixed manufacturing overhead: Spending variance 14,000 U Volume variance 66,000 U Total €84,775 U

Learning Objective 5(continued) 3-Variance Analysis Variable and fixed manufacturing overhead: Spending variance €13,225 F + €14,000 U = € 775 U Variable manufacturing overhead: Efficiency variance 18,000 U Fixed manufacturing overhead: Volume variance 66,000 U Total €84,775 U

Learning Objective 5(continued) 2-Variance Analysis Variable and fixed manufacturing overhead: Spending variance € 775 U Variable manufacturing overhead: Efficiency variance 18,000 U Flexible-budget variance: €18,775 U Fixed manufacturing overhead Volume variance: 66,000 U Total €84,775 U

Learning Objective 6 Explain the differing roles of cost allocation bases for fixed manufacturing overhead when (a) planning and controlling, and (b) valuing stock

Learning Objective 6(continued) Different Purposes of Overhead Cost Analysis Variable manufacturing overhead costs are variable with respect to output units (suits) for both planning and control purposes and stock costing purposes. The greater the number of output units manufactured, the higher the budgeted total variable manufacturing overhead costs and the higher the total variable manufacturing overhead costs allocated to output units. Fixed overhead costs do not change within the relevant range.

Learning Objective 6(continued) Management can do little to change the lump-sum fixed cost. Under generally accepted accounting principles, fixed manufacturing costs are allocated as a stock cost based on the level of output units produced. Every output unit that LSY manufactures will increase the fixed overhead allocated to products by €22. Managers should not use this unitisation of fixed manufacturing overhead costs for planning and control.

Learning Objective 7 Prepare journal entries for variable- and fixed-overhead variances

Learning Objective 7(continued) Journal Entries for variable- and fixed-overhead variances What is the journal entry to record variable manufacturing overhead? Variable Manufacturing Overhead Control 244,775 Accounts Payable 244,775 To record actual variable manufacturing overhead costs incurred

Learning Objective 7(continued) What is the journal entry to allocate variable manufacturing overhead? Work-in-Progress Control 240,000 Variable Manufacturing Overhead Allocated 240,000 To record variable manufacturing overhead cost allocated: (2.00 × 10,000 × €12) What is the journal entry to isolate variances?

Learning Objective 7(continued) Variable Manufacturing Overhead Allocated 240,000 Variable Overhead Efficiency Variance 18,000 Variable Manufacturing Overhead Control 244,775 Variable Overhead Spending Variance 13,225 To isolate variances for the accounting period

Journal Entries for variable- and fixed-overhead variances What is the journal entry to record fixed manufacturing overhead? Fixed Manufacturing Overhead Control 300,000 Accumulated Depreciation, etc. 300,000 To record actual fixed manufacturing overhead costs incurred

Learning Objective 7(continued) What is the journal entry to allocate fixed manufacturing overhead? Work-in-Progress Control 220,000 Fixed Manufacturing Overhead Allocated 220,000 To record fixed manufacturing overhead cost allocated: (2.00 × 10,000 × €11) What is the journal entry to isolate variances?

Learning Objective 7(continued) Fixed Manufacturing Overhead Allocated 220,000 Fixed Overhead Spending Variance 14,000 Fixed Overhead Volume Variance 66,000 Fixed Manufacturing Overhead Control 300,000 To isolate variances for the accounting period

Learning Objective 8 Explain how the flexible-budget variance approach can be used in activity-based costing and why managers frequently use both financial and non-financial variables to plan and control overhead costs

Learning Objective 8(continued) Activity-Based Costing and Variance Analysis ABC systems classify costs of various activities into a cost hierarchy (output-unit level, batch level, product sustaining, and facility sustaining). The basic principles and concepts for variable and fixed manufacturing overhead costs can be extended to ABC systems. Flexible budgeting in activity-based costing systems enables insight into why actual activity costs differ from those budgeted. With well-defined output and input measures for an activity, a 4-variance analysis can be conducted.

Learning Objective 8(continued) Financial and Non-financial Performance Overhead variances are examples of financial performance measures. Managers also find that non-financial measures provide useful information. Examples are: Actual labour time per suit, relative to budgeted labour time per suit, and ... Actual indirect materials usage per labour-hour, relative to budgeted indirect materials usage per labour-hour. Non-financial performance measures are best viewed as attention directors, not as problem solvers.