1. Copyright © 2006. The McGraw-Hill Companies, Inc.McGraw-Hill/IrwinCopyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Flexible Budgets and Control of Overhead Costs Week 7: Lecture 7 1

2. Copyright © 2006. The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Learning Outcomes What are the overhead costs? What is a flexible budget? What is a static budget? What are the variances? Prepare a flexible budget and a budgetary control statement. 2

3. Copyright © 2006. The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Overhead costs Controlling overhead costs is a major concern of managers in business, in government and in non-profit organizations. In business, overhead costs refers to an ongoing expense of operating a business: expenses that are necessary to the continued functioning of the business but cannot be immediately associated with the products or services being offered. Overhead expenses are all costs on the income statement except for direct labour, direct materials, and direct expenses. Overhead expenses include accounting fees, advertising, depreciation, insurance, interests, legal fees, rent, repairs, supplies, taxes, telephone bills, travel expenditures, salaries of employees e.t.c. 3

4. Copyright © 2006. The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Overhead costs can include everything from the disposable coffee cup in the visitor’s waiting area to the president’s salary. Overhead is made up of many separate costs many of which may be small and some overhead costs are variable, some fixed and some mixture of fixed and variable. The nature of overhead costs makes it difficult to control them and for that reason we use the flexible budgets instead of the static budgets that we studied in previous lecture. 4

5. Copyright © 2006. The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Characteristics of a flexible budget A static budget is prepared for only one level of activity. This budget approach is proper for planning purposes but is not enough for estimating how well costs are control. It works well for evaluating performance when the planned level of activity is the same as the actual level of activity. But, if actual level of activity in a given month or quarter is different from the planned amount, it is difficult to ensure if costs were controlled. Flexible budgets are one way companies deal with different levels of activity. A flexible budget provides budgeted data for different levels of activity. Another way of thinking of a flexible budget is a number of static budgets. For example, a restaurant may serve 100, 150, or 300 customers an evening. If a budget is prepared assuming 100 customers will be served, how will the managers be evaluated if 300 customers are served? 5

6. Copyright © 2006. The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Characteristics of a flexible budget Flexible budgets take into account changes in costs that might take place as a result of changes in activity. A flexible budget give calculations of what costs should be for any level of activity within a specified range. Using this approach of budget actual costs are compared to what the costs should have been for this level-the actual level- instead of comparing them to the budgeted costs from the static budget. If we were using the static budget we would compare costs of one level of activity to costs of a different level of activity. 6

7. Copyright © 2006. The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Variances Budget reports shows variances. The budget report is used by management to identify the sales or expenses whose amounts are not what were expected so management can find out why the variances occurred. By understanding the variances, management can decide whether any action is needed. Favourable variances are usually positive amounts, and unfavourable variances are usually negative amounts. Some textbooks show budget reports with “F” for favourable and “U” for unfavourable next to the variances to highlight in this way the type of variance being reported. 7

8. Copyright © 2006. The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Static Budgets and Performance Reports 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. Hmm! Comparing static budgets with actual costs is like comparing apples and oranges.

9. Copyright © 2006. The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Flexible Budgets Improve performance evaluation. May be prepared for any activity level within a specified level range. Show costs that should have been incurred at the actual level of activity, enabling “apples to apples” cost comparisons. Make known variances related to cost control. Let’s look at CheeseCo. 9

10. Copyright © 2006. The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin CheeseCo Static Budgets and Performance Reports 10

11. Copyright © 2006. The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin CheeseCo Static Budgets and Performance Reports 11

12. Copyright © 2006. The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin U = Unfavorable variance CheeseCo was unable to achieve the budgeted level of activity. CheeseCo Static Budgets and Performance Reports 12

13. Copyright © 2006. The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin CheeseCo F = Favorable variance that occurs when actual costs are less than budgeted costs. Static Budgets and Performance Reports 13

14. Copyright © 2006. The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Since cost variances are favorable, have we done a good job controlling costs? CheeseCo Static Budgets and Performance Reports 14

15. Copyright © 2006. The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin I don’t think I can answer the question using a static budget. Actual activity is below budgeted activity. So, shouldn’t variable costs be lower if actual activity is lower? Static Budgets and Performance Reports 15

16. Copyright © 2006. The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin 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. 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. 16

17. Copyright © 2006. The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin 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. Fixed Variable 17

18. Copyright © 2006. The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Preparing a Flexible Budget Let’s prepare budgets for CheeseCo. 18

19. Copyright © 2006. The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Preparing a Flexible Budget Fixed costs are expressed as a total amount. Variable costs are expressed as a constant amount per unit. $40,000 ÷ 10,000 units is $4.00 per unit. CheeseCo 19

20. Copyright © 2006. The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Preparing a Flexible Budget $4.00 per unit × 8,000 units = $32,000 CheeseCo 20

21. Copyright © 2006. The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Preparing a Flexible Budget CheeseCo 21

22. Copyright © 2006. The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Preparing a Flexible Budget Total fixed costs do not change in the relevant range. CheeseCo 22

23. Copyright © 2006. The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Quick Check What should be the total overhead costs for the Flexible Budget at 12,000 units? a. $92,500. b. $89,000. c. $106,800. d. $104,000. What should be the total overhead costs for the Flexible Budget at 12,000 units? a. $92,500. b. $89,000. c. $106,800. d. $104,000. 23

24. Copyright © 2006. The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Quick Check What should be the total overhead costs for the Flexible Budget at 12,000 units? a. $92,500. b. $89,000. c. $106,800. d. $104,000. What should be the total overhead costs for the Flexible Budget at 12,000 units? a. $92,500. b. $89,000. c. $106,800. d. $104,000. Total overhead cost = $14,000 + $7.50 per unit  12,000 units = $14,000 + $90,000 = $104,000 24

25. Copyright © 2006. The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Preparing a Flexible Budget 25

26. Copyright © 2006. The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Let’s prepare a budget performance report for CheeseCo. Flexible Budget Performance Report 26

27. Copyright © 2006. The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin CheeseCo Flexible budget is prepared for the same activity level (8,000 units) as actually achieved. Flexible Budget Performance Report 27

28. Copyright © 2006. The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Quick Check What is the variance for indirect labor when the flexible budget for 8,000 units is compared to the actual results? a. $2,000 U b. $2,000 F c. $6,000 U d. $6,000 F What is the variance for indirect labor when the flexible budget for 8,000 units is compared to the actual results? a. $2,000 U b. $2,000 F c. $6,000 U d. $6,000 F 28

29. Copyright © 2006. The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Quick Check What is the variance for indirect labor when the flexible budget for 8,000 units is compared to the actual results? a. $2,000 U b. $2,000 F c. $6,000 U d. $6,000 F What is the variance for indirect labor when the flexible budget for 8,000 units is compared to the actual results? a. $2,000 U b. $2,000 F c. $6,000 U d. $6,000 F 29

30. Copyright © 2006. The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin CheeseCo Flexible Budget Performance Report 30

31. Copyright © 2006. The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Quick Check What is the variance for indirect material when the flexible budget for 8,000 units is compared to the actual results? a. $1,500 U b. $1,500 F c. $4,500 U d. $4,500 F What is the variance for indirect material when the flexible budget for 8,000 units is compared to the actual results? a. $1,500 U b. $1,500 F c. $4,500 U d. $4,500 F 31

32. Copyright © 2006. The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Quick Check What is the variance for indirect material when the flexible budget for 8,000 units is compared to the actual results? a. $1,500 U b. $1,500 F c. $4,500 U d. $4,500 F What is the variance for indirect material when the flexible budget for 8,000 units is compared to the actual results? a. $1,500 U b. $1,500 F c. $4,500 U d. $4,500 F 32

33. Copyright © 2006. The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin CheeseCo Flexible Budget Performance Report 33

34. Copyright © 2006. The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin End of Lecture 34