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

1. 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.

2. 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

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

4. 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

5. 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.

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

7. 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, Flexible-budget amount: 20,000
Labour-hours per output unit: Actual results: 21,500 ÷ 10,000 = Flexible-budget amount: 20,000 ÷ 10,000 = 2.00

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

9. 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

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

11. 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.

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

13. 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.

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

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

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

17. 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.

18. 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.

19. 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

20. 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)

21. 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.

22. 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.

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

24. 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

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

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

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

28. 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.

29. 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.

30. 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.

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

32. 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.

33. 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

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

35. 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

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

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

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

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

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

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

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

43. 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.

44. 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.

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

46. 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 , Accounts Payable , To record actual variable manufacturing overhead costs incurred

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

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

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

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

51. Learning Objective 7(continued)
Fixed Manufacturing Overhead Allocated 220, Fixed Overhead Spending Variance , Fixed Overhead Volume Variance , Fixed Manufacturing Overhead Control , To isolate variances for the accounting period

52. 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

53. 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.

54. 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.