1. Chapter 11 Standard costs for control: flexible budgets and manufacturing overhead
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2. 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
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3. 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
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5. 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
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6. 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
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8. 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
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9. 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
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10. 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.)
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11. 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
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13. 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
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14. 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
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16. 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
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18. 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
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19. 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.)
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20. 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.)
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21. 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
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22. 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.)
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23. 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
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24. 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.)
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27. 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.)
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28. 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
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29. 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
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