1. Flexible Budgets and Overhead Analysis
Chapter11
Flexible Budgets and Overhead Analysis

2. Static Budgets and Performance Reports
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 is difficult when actual activity differs from the planned level of activity.
Let’s look at CheeseCo.

3. Static Budgets and Performance Reports
CheeseCo
Static
Actual
Budget
Results
Variances
Machine hours
10,000
8,000
Variable costs
Ind
irect labor
40,000 $
34,000
Indirect materials
30,000
25,500
Power
5,000
3,800
Fixed costs
Depreciation
12,000
Insurance
2,000
2,050
Total overhead costs
89,000
77,350

4. Static Budgets and Performance Reports
CheeseCo
Static
Actual
Budget
Results
Variances
Machine hours
10,000
8,000
2,000 U
Variable costs
Ind
irect labor
40,000 $
34,000
$6,000 F
Indirect materials
30,000
25,500
4,500
Power
5,000
3,800
1,200
Fixed costs
Depreciation
12,000
Insurance
2,050 50
Total overhead costs
89,000
77,350
$11,650
U = Unfavorable variance CheeseCo was unable to achieve the budgeted level of activity.

5. Static Budgets and Performance Reports
CheeseCo
Static
Actual
Budget
Results
Variances
Machine hours
10,000
8,000
2,000 U
Variable costs
Ind
irect labor
40,000 $
34,000
$6,000 F
Indirect materials
30,000
25,500
4,500
Power
5,000
3,800
1,200
Fixed costs
Depreciation
12,000
Insurance
2,050 50
Total overhead costs
89,000
77,350
$11,650
F = Favorable variance that occurs when actual costs are less than budgeted costs.

6. Static Budgets and Performance Reports
CheeseCo
Static
Actual
Budget
Results
Variances
Machine hours
10,000
8,000
2,000 U
Variable costs
Ind
irect labor
40,000 $
34,000
$6,000 F
Indirect materials
30,000
25,500
4,500
Power
5,000
3,800
1,200
Fixed costs
Depreciation
12,000
Insurance
2,050 50
Total overhead costs
89,000
77,350
$11,650
Since cost variances are favorable, have we done a good job controlling costs?

7. Static Budgets and Performance Reports
Actual activity is below budgeted activity which is unfavorable.
So, shouldn’t variable costs be lower if actual activity is lower?
I don’t think I can answer the question using a static budget.

8. 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.

9. 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.
Improve performance evaluation.

10. 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.

11. Preparing a Flexible Budget
To a budget we need to know that:
Total variable costs change in direct proportion to changes in activity.
Total fixed costs remain unchanged within the relevant range.
Variable
Fixed

12. Preparing a Flexible Budget
Let’s prepare budgets for CheeseCo.

13. Preparing a Flexible Budget
CheeseCo
Cost
Total
Flexible Budgets
Formula
Fixed
8,000
10,000
12,000
Per Hour
Cost
Hours
Hours
Hours
Machine hours
8,000
10,000
12,000
Variable costs are expressed as a constant amount per hour.
$40,000 ÷ 10,000 hours is $4.00 per hour.
Variable costs
Indirect labor
4.00 $
32,000
Indirect material
3.00
24,000
Power
0.50
4,000
Total variable cost $
7.50 $
60,000
Fixed costs
Fixed costs are expressed as a total amount.
Depreciation $
12,000
Insurance
2,000
Total fixed cost
Total overhead costs

14. Preparing a Flexible Budget
CheeseCo
Cost
Total
Flexible Budgets
Formula
Fixed
8,000
10,000
12,000
Per Hour
Hours
Machine hours
Variable costs
Indirect labor
4.00
32,000 $
Indirect material
3.00
24,000
Power
0.50
4,000
Total variable cost
7.50
60,000
Fixed costs
Depreciation
Insurance
2,000
Total fixed cost
Total overhead costs
$4.00 per hour × 8,000 hours = $32,000

15. Preparing a Flexible Budget
CheeseCo
Cost
Total
Flexible Budgets
Formula
Fixed
8,000
10,000
12,000
Per Hour
Hours
Machine hours
Variable costs
Indirect labor
4.00
32,000 $
40,000
48,000
Indirect material
3.00
24,000
30,000
36,000
Power
0.50
4,000
5,000
6,000
Total variable cost
7.50
60,000
75,000
90,000
Fixed costs
Depreciation
Insurance
2,000
Total fixed cost
14,000
Total overhead costs
74,000
89,000
104,000

16. Preparing a Flexible Budget
CheeseCo
Cost
Total
Flexible Budgets
Formula
Fixed
8,000
10,000
12,000
Per Hour
Hours
Machine hours
Variable costs
Indirect labor
4.00
32,000 $
40,000
48,000
Indirect material
3.00
24,000
30,000
36,000
Power
0.50
4,000
5,000
6,000
Total variable cost
7.50
60,000
75,000
90,000
Fixed costs
Depreciation
Insurance
2,000
Total fixed cost
14,000
Total overhead costs
74,000
89,000
104,000
Total fixed costs do not change in the relevant range.

17. Flexible Budget Performance Report
Let’s prepare a budget performance report for CheeseCo.

18. Flexible Budget Performance Report
CheeseCo
Flexible budget is prepared for the same activity level (8,000 hours) as actually achieved.
Cost
Total
Formula
Fixed
Flexible
Actual
Per Hour
Costs
Budget
Results
Variances
Machine hours
8,000
8,000
Variable costs
Indirect labor $
4.00 $
32,000 $
34,000
Indirect material
3.00
24,000
25,500
Power
0.50
4,000
3,800
Total variable costs $
7.50 $
60,000 $
63,300
Fixed Expenses
Depreciation $
12,000 $
12,000 $
12,000
Insurance
2,000
2,000
2,050
Total fixed costs $
14,000 $
14,050
Total overhead costs $
74,000 $
77,350

19. Flexible Budget Performance Report
CheeseCo
Cost
Total
Formula
Fixed
Flexible
Actual
Per Hour
Costs
Budget
Results
Variances
Machine hours
8,000
Variable costs
Indirect labor
4.00 $
32,000
34,000
$ 2,000 U
Indirect material
3.00
24,000
25,500
1,500 U
Power
0.50
4,000
3,800
200 F
Total variable costs
7.50
60,000
63,300
$ 3,300 U
Fixed Expenses
Depreciation
12,000
Insurance
2,000
2,050
50 U
Total fixed costs
14,000
14,050
Total overhead costs
74,000
77,350
$ 3,350 U

20. Flexible Budget Performance Report
Remember the question: “How much of the total variance is due to activity and how much is due to cost control?”

21. Static Budgets and Performance
How much of the $11,650 is due to activity and how much is due to cost control?
Static
Actual
Budget
Results
Variances
Machine hours
10,000
8,000
2,000 U
Variable costs
Ind
irect labor
40,000 $
34,000
$6,000 F
Indirect materials
30,000
25,500
4,500
Power
5,000
3,800
1,200
Fixed costs
Depreciation
12,000
Insurance
2,050 50
Total overhead costs
89,000
77,350
$11,650

22. Flexible Budget Performance Report
Overhead Variance Analysis
Let’s place the flexible budget for 8,000 hours here.
Difference between original static budget and actual overhead = $11,650 F.

23. Flexible Budget Performance Report
Overhead Variance Analysis
Activity
Cost control
This $15,000F variance is due to lower activity.
This $3,350U flexible budget variance is due to poor cost control.

24. Flexible Budget Performance Report
There are two primary reasons for unfavorable variable overhead variances:
1. Spending too much for resources.
2. Using the resources inefficiently.
What causes the cost control variance?

25. Overhead Rates and Overhead Analysis
Recall that overhead costs are assigned to products and services using a predetermined overhead rate (POHR):
Assigned Overhead = POHR × Standard Activity
Overhead from the flexible budget for the denominator level of activity
POHR =
Denominator level of activity

26. Overhead Rates and Overhead Analysis – Example
Let’s look at overhead rates in a budget for ColaCo.

27. Overhead Rates and Overhead Analysis – Example
ColaCo prepared this budget for overhead:
Total
Variable
Total
Fixed
Machine
Variable
Overhead
Fixed
Overhead
Hours
Overhead
Rate
Overhead
Rate
2,000 $
4,000 ? $
9,000 ?
4,000
8,000 ?
9,000 ?
Let’s calculate overhead rates.
ColaCo applies overhead based on machine hour activity.

28. Overhead Rates and Overhead Analysis – Example
ColaCo prepared this budget for overhead:
Total
Variable
Fixed
Machine
Overhead
Hours
Rate
2,000
4,000 $
2.00
9,000 ?
8,000
Rate = Total Variable Overhead ÷ Machine Hours
This rate is constant at all levels of activity.

29. Overhead Rates and Overhead Analysis – Example
ColaCo prepared this budget for overhead:
Total
Variable
Fixed
Machine
Overhead
Hours
Rate
2,000
4,000 $
2.00
9,000
4.50
8,000
2.25
Rate = Total Fixed Overhead ÷ Machine Hours
This rate decreases when activity increases.

30. Overhead Rates and Overhead Analysis – Example
ColaCo prepared this budget for overhead:
Total
Variable
Fixed
Machine
Overhead
Hours
Rate
2,000
4,000 $
2.00
9,000
4.50
8,000
2.25
The total POHR is the sum of the fixed and variable rates for a given activity level.

31. Overhead Variances
Let’s use the overhead rates, to determine variable and fixed overhead variances.

32. 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.

33. 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 × SR
SH × SR
Spending Variance
Efficiency Variance
Spending variance = AH(AR - SR)
Efficiency variance = SR(AH - SH)

34. 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 ,200 hours × × $2.00 per hour $2.00 per hour
$6,740
$6,600
$6,400
Spending variance $140 unfavorable
Efficiency variance $200 unfavorable
$340 unfavorable flexible budget total variance

35. 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.
Controlled by managing the overhead cost driver.

36. Now let’s turn our attention to fixed overhead.
Overhead Variances
Now let’s turn our attention to fixed overhead.

37. Overhead Rates and Overhead Analysis – Example
ColaCo prepared this budget for overhead:
Total
Variable
Fixed
Machine
Overhead
Hours
Rate
2,000
4,000 $
2.00
9,000
4.50
8,000
2.25
What is ColaCo’s fixed overhead rate for an estimated activity of 3,000 machine hours?

38. Overhead Rates and Overhead Analysis – Example
ColaCo prepared this budget for overhead:
Total
Variable
Fixed
Machine
Overhead
Hours
Rate
2,000
4,000 $
2.00
9,000
4.50
8,000
2.25
What is ColaCo’s fixed overhead rate for an estimated activity of 3,000 machine hours?
Fixed Overhead Rate FR = $9,000 ÷ 3,000 machine hours FR = $3.00 per machine hour

39. 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.

40. Fixed Overhead Variances
Actual Fixed Fixed Fixed Overhead Overhead Overhead Incurred Budget Applied
SH × FR
Budget Variance
Volume Variance
FR = Standard Fixed Overhead Rate SH = Standard Hours Allowed

41. Fixed Overhead Variances – Example
Actual Fixed Fixed Fixed Overhead Overhead Overhead Incurred Budget Applied
SH × FR
3,200 hours × $3.00 per hour
$8,450
$9,000
$9,600
Budget variance $550 favorable
Volume variance $600 favorable

42. Fixed Overhead Variances – A Closer Look
Budget Variance
Volume Variance
Results from paying more or less than expected for overhead items.
Results from operating at an activity level different from the denominator activity.

43. Overhead Variances
Let’s look at a graph showing fixed overhead variances. We will use ColaCo’s numbers from the previous example.

44. Fixed Overhead Variances
Cost
Fixed overhead
applied to products
Volume
3,000 Hours Expected Activity
3,200 Standard Hours

45. Fixed Overhead Variances
3,200 machine hours × $3.00 fixed overhead rate
Cost
$9,600 applied fixed OH
$9,000 budgeted fixed OH
$8,450 actual fixed OH
Fixed overhead
applied to products
Volume
3,000 Hours Expected Activity
3,200 Standard Hours

46. Fixed Overhead Variances
3,200 machine hours × $3.00 fixed overhead rate
Cost
$600 Favorable Volume Variance
$9,600 applied fixed OH { {
$9,000 budgeted fixed OH {
$8,450 actual fixed OH
$8,450 actual fixed OH
$550 Favorable Budget Variance
Fixed overhead
applied to products
Volume
3,000 Hours Expected Activity
3,200 Standard Hours

47. Volume Variance – A Closer Look
Results when standard hours allowed for actual output differs from the denominator activity.
Unfavorable when standard hours < denominator hours
Favorable when standard hours > denominator hours

48. Volume Variance – A Closer Look
Does not measure over- or under spending
Explainable by and controllable only through activity
Volume Variance
Results when standard hours allowed for actual output differs from the denominator activity.
Unfavorable when standard hours < denominator hours
Favorable when standard hours > denominator hours

49. Overhead Variances and Under- or Overapplied Overhead Cost
In a standard cost system:
Unfavorable variances are equivalent to underapplied overhead.
Favorable variances are equivalent to overapplied overhead.
The sum of the overhead variances equals the under- or overapplied overhead cost for a period.

50. 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?