1. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Chapter 11: Flexible Budgets and Overhead Analysis Cornerstones of Managerial Accounting, 4e

2. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Learning Objectives 1.Prepare a flexible budget, and use it for performance reporting. 2.Calculate the variable overhead variances, and explain their meaning. 3.Calculate the fixed overhead variances, and explain their meaning. 4.Prepare an activity-based flexible budget.

3. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Using Budgets for Performance Evaluation ► Budgets are useful for both planning and control, where they are used as benchmarks for performance evaluation. ► Determining how budgeted amounts should be compared with actual results is a major consideration that must be addressed. 1

4. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Static Budgets versus Flexible Budgets ► A performance report compares actual costs with budgeted costs. There are two ways to make this comparison: ► Compare actual costs with the budgeted costs for the budgeted level of activity (static budget). ► Compare actual costs with the actual level of activity (flexible budget). 1

5. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Relationship between Static and Flexible Budget Variances for the Actual Quantity Produced 1

6. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Static Budget ► A static budget is a budget created in advance that is based on a particular level of activity. ► Master budgets are generally created for a particular level of activity. ► Thus, one way to prepare a performance report is to compare the actual costs with the budgeted costs from the master budget. 1

7. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 1 Cornerstone 11-1 Preparing a Performance Report Based on a Static Budget (Using Budgeted Production)

8. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 1 Cornerstone 11-1 Preparing a Performance Report Based on a Static Budget (Using Budgeted Production) (continued)

9. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Flexible Budget ► A flexible budget enables a firm to compute expected costs for a range of activity levels. ► The key to flexible budgeting is knowledge of fixed and variable costs. ► The two types of flexible budgets are: ► Before-the-fact, in which the budget gives expected outcomes for a range of activity levels ► After-the-fact, in which a budget is based on the actual level of activity 1

10. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 1 Cornerstone 11-2 Preparing a Before-the-Fact Flexible Production Budget

11. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 1 Cornerstone 11-2 Preparing a Before-the-Fact Flexible Production Budget (continued)

12. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 1 Cornerstone 11-3 Preparing a Performance Report Using a Flexible Budget

13. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 1 Cornerstone 11-3 Preparing a Performance Report Using a Flexible Budget (continued)

14. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Flexible Budget Variance ► A difference between the actual amount and the flexible budget amount is the flexible budget variance. ► The flexible budget provides a measure of the efficiency of a manager. ► That is, how well did the manager control costs for the actual level of production? ► To measure whether or not a manager accomplishes his or her goals, the static budget is used. ► The static budget represents certain goals that the firm wants to achieve. ► A manager is effective if the goals described by the static budget are achieved or exceeded. 1

15. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 1 You Decide Flexible Budgeting for Entertainment

16. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Variable Overhead Analysis ► In a standard cost system, the total overhead variance, or the difference between applied and actual overhead, is also broken down into component variances. ► There are several methods of overhead variance analysis; the four-variance method is described in this chapter. ► First, overhead is divided into fixed and variable categories. Next, two variances are calculated for each category. ► Variable overhead variances ► Variable overhead spending variance ► Variable overhead efficiency variance ► Fixed overhead variances ► Fixed overhead spending variance ► Fixed overhead volume variance 2

17. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Total Variable Overhead Variance ► The total variable overhead variance is simply the difference between the actual variable overhead and applied variable overhead. ► VOH is applied by using hours allowed in a standard cost system. ► The total variable overhead variance can be divided into spending and efficiency variances. ► Variable overhead spending and efficiency variances can be calculated by using either the three-pronged (columnar) approach or formulas. 2

18. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Variance Abbreviations ► Because the equations for variable overhead variances can be long if expressed in words, abbreviations are often used. ► Here are some common abbreviations: 2

19. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 2 Cornerstone 11-4 Calculating the Total Variable Overhead Variance

20. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Variable Overhead Spending Variance ► The variable overhead spending variance measures the aggregate effect of differences between the actual variable overhead rate (AVOR) and the standard variable overhead rate (SVOR). ► The actual variable overhead rate is computed as follows: 2

21. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Variable Overhead Efficiency Variance ► VOH is assumed to vary in proportion to changes in the direct labor hours used. ► The variable overhead efficiency variance measures the change in the actual variable overhead cost (VOH) that occurs because of efficient (or inefficient) use of direct labor. ► The variable overhead efficiency variance is computed by using the following formula: 2

22. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 2 Cornerstone 11-5 Calculating Variable Overhead Spending and Efficiency Variances: Columnar & Formula Approaches

23. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 2 Cornerstone 11-5 Calculating Variable Overhead Spending and Efficiency Variances: Columnar & Formula Approaches (continued)

24. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 2 Cornerstone 11-5 Calculating Variable Overhead Spending and Efficiency Variances: Columnar & Formula Approaches (continued)

25. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Comparison of the Variable Overhead Spending Variance with the Price Variances of Materials and Labor ► While the variable overhead spending variance is similar to the price variances of materials and labor, there are some conceptual differences. ► VOH is not a single input—it is made up of a large number of individual items. ► The standard variable overhead rate represents the weighted cost per direct labor hour that should be incurred for all variable overhead items. ► The difference between what should have been spent per hour and what actually was spent per hour is a type of price variance. ► One reason that a variable overhead spending variance can arise is that prices for individual variable overhead items have increased or decreased. ► The second reason for a variable overhead spending variance is the use of the items that comprise variable overhead. Waste or inefficiency in the use of VOH increases the actual variable overhead cost. ► The variable overhead spending variance is the result of both price and efficiency. 2

26. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Responsibility for the Variable Overhead Spending Variance ► Variable overhead items may be affected by several responsibility centers. To the extent that consumption of VOH can be traced to a responsibility center, responsibility can be assigned. ► Controllability is a prerequisite for assigning responsibility. ► Price changes of variable overhead items are essentially beyond the control of supervisors. If price changes are small, then the spending variance is primarily a matter of the efficient use of overhead in production. ► Responsibility for the variable overhead spending variance is generally assigned to production departments. 2

27. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Responsibility for the Variable Overhead Efficiency Variance ► The variable overhead efficiency variance is directly related to the direct labor efficiency or usage variance. ► If variable overhead costs really change in proportion to changes in direct labor hours, then responsibility for the variable overhead efficiency variance should be assigned to the individual who has responsibility for the use of direct labor: the production manager. 2

28. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. A Performance Report for the Variable Overhead Spending and Efficiency Variances ► Recall that Cornerstone 11-5 showed a favorable $45 variable overhead spending variance and an unfavorable $30 variable overhead efficiency variance. ► The $45 F spending variance means that less was spent than expected on variable overhead. ► The reasons for the $30 U variable overhead efficiency variance are the same as those offered for an unfavorable labor usage variance. ► Control of VOH requires line-by-line analysis for each item. 2

29. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 2 Cornerstone 11-6 Preparing a Performance Report for the Variable Overhead Variances

30. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 2 Cornerstone 11-6 Preparing a Performance Report for the Variable Overhead Variances (continued) Solution:

31. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Fixed Overhead Analysis ► Fixed overhead costs are capacity costs acquired in advance of usage. ► The fixed overhead rate changes as the underlying production level changes. ► To keep a stable fixed overhead rate throughout the year, companies typically use practical capacity to determine the number of direct labor hours in the denominator of the fixed overhead rate. 3

32. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Total Fixed Overhead Variances ► The total fixed overhead variance is the difference between actual fixed overhead and applied fixed overhead, when applied fixed overhead is obtained by multiplying the standard fixed overhead rate (SFOR) times the standard hours allowed for the actual output (SH). ► The total fixed overhead variance is the difference between the actual fixed overhead and the applied fixed overhead: 3

33. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 3 Cornerstone 11-7 Calculating the Total Fixed Overhead Variance

34. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Fixed Overhead Spending Variance ► The fixed overhead spending variance is defined as the difference between the actual fixed overhead (AFOH) and the budgeted fixed overhead (BFOH): 3

35. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Fixed Overhead Volume Variance ► The fixed overhead volume variance is the difference between budgeted fixed overhead (BFOH) and applied fixed overhead: ► The volume variance measures the effect of the actual output differing from the output used at the beginning of the year to compute the predetermined standard fixed overhead rate. ► If you think of the output used to calculate the fixed overhead rate as the capacity acquired (practical capacity) and the actual output as the capacity used, then the volume variance is the cost of unused capacity. 3

36. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 3 Cornerstone 11-8 Calculating Fixed Overhead Variances: Columnar and Formula Approaches

37. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 3 Cornerstone 11-8 Calculating Fixed Overhead Variances: Columnar and Formula Approaches (continued)

38. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 3 Cornerstone 11-8 Calculating Fixed Overhead Variances: Columnar and Formula Approaches (continued)

39. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Responsibility for the Fixed Overhead Spending Variance ► Many fixed overhead items—long-run investments be changed in the short run. Consequently, fixed overhead costs are often beyond the immediate control of management. ► Since many fixed overhead costs are affected primarily by long-run decisions, and not by changes in production levels, the budget variance is usually small. 3

40. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Analysis of the Fixed Overhead Spending Variance ► Because FOH is made up of many individual items, a line-by-line comparison of budgeted costs with actual costs provides more information concerning the causes of the spending variance. ► An investigation might reveal that these are due to issues beyond management control like the weather. 3

41. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Responsibility for the Fixed Overhead Volume Variance ► Assuming that volume variance measures capacity utilization implies that the general responsibility for this variance should be assigned to the production department. ► At times, however, a significant volume variance may be due to factors beyond the control of production. 3

42. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Analysis of the Volume Variance ► Notice that the volume variance occurs because fixed overhead is treated as if it were a variable cost. ► In reality, fixed costs do not change as activity changes, as a predetermined fixed overhead rate allows. 3

43. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Activity-Based Budgeting ► The traditional approach to budgeting emphasizes: ► estimation of revenues and costs by organizational units (e.g., departments, plants) ► use of a single unit-based driver such as direct labor hours ► Companies that have implemented an activity-based costing (ABC) system may also wish to install an activity-based budgeting system. ► An activity-based budgeting (ABB) system focuses on: ► estimation of the costs of activities rather than the costs of departments and plants ► use of multiple drivers, both unit-based and nonunit-based 4

44. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Static Activity Budgets ► Assuming that activity-based costing (ABC) has been implemented, the major emphasis for ABB is estimating the workload (demand) for each activity and then determining the resources required for this workload. ► ABB begins with sales and production budgets. Direct materials and direct labor budgets are also compatible with an activity-based costing framework because these inputs can be directly traced to the individual products. ► The major differences between traditional and ABB are found in the overhead and selling and administration categories. ► In a traditional-based approach, budgets within these categories are typically detailed by cost categories. Furthermore, traditional budgets are usually constructed by budgeting for a cost item within a department and then rolling these items up into the master overhead budget. ► ABB, on the other hand, identifies the overhead, selling, and administrative activities and then builds a budget for each activity, based on the resources needed to provide the required output levels. Costs are classified as variable or fixed with respect to the activity output measure or driver. 4

45. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 4 Cornerstone 11-9 Preparing a Static Budget for an Activity

46. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Activity Flexible Budgeting ► Understanding the relationship between changes in activity costs and changes in activity drivers allows managers to more carefully plan and monitor activity improvements. ► Activity flexible budgeting is the prediction of what activity costs will be as related output changes. ► Variance analysis within an activity framework makes it possible to improve traditional budgetary performance reporting, and enhances the ability to manage activities. ► If, however, costs vary with respect to more than one driver, and the drivers are not highly correlated with direct labor hours, then the predicted costs can be misleading. ► The solution is to build flexible budget formulas for more than one driver. ► Cost estimation procedures (high-low method, the method of least squares, and so on) can be used to estimate cost formulas for each activity. 4

47. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 4 Cornerstone 11-10 Preparing an Activity Flexible Budget

48. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 4 Cornerstone 11-10 Preparing an Activity Flexible Budget (continued)

49. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 4 Cornerstone 11-11 Preparing an Activity-Based Performance Report

50. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 4 Cornerstone 11-11 Preparing an Activity-Based Performance Report (continued)

51. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 4 You Decide Activity Flexible Budgeting for Museums Museums do much more than simply present art to the public. Today’s art museums put on shows, provide access to the public to view the collections, sell art-related merchandise in the museum store and online, and may put on special events and performances. The annual budget for a museum can easily run into millions of dollars, so cost understanding and control are crucial. As an accountant for a large metropolitan museum, you would be responsible for budgeting and controlling costs. Splitting costs into fixed and variable components would be a first step in budgeting. However, what driver would you use? Number of patrons going through the museum? That would be a good driver for a few costs, especially those related to printing tickets and explanatory materials (such as maps of the museum to help people navigate through the collections). However, the vast majority of costs would be fixed with respect to the number of people going through the museum. ABC and budgeting would give a much richer view of the costs of running the various activities of the museum. What type of information would you need to create activity-based budgets?

52. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 4 You Decide Activity Flexible Budgeting for Museums (continued) Your first step would be to determine the various activities of the museum. These might include: providing access to the public, selling merchandise through the museum store, putting on special events (e.g., concerts, lectures, benefits), acquiring and cataloging pieces of art, and so on. For example, the activity of cataloguing new art pieces would include the salaries of staff who catalog the pieces, or clean and restore them, insurance on the art, and so on. Many of these costs vary with the number of newly donated or purchased pieces. The activity of selling merchandise would have costs of staff to run the store, cost of the items purchased for sale, advertising, and so on. Those costs might vary with the number of items sold or with the revenue earned. Putting on special events would have a different set of costs attached and those might vary with the number of events and the number of attendees. Recognizing the different activities associated with the museum and relating the costs to specific activity drivers will give you a much better idea of what costs to expect. This understanding can help the museum director exercise good stewardship of the funds donated and provide important services to the public.