Cornerstones of Managerial Accounting, 5e

Chapter 11: Flexible Budgets and Overhead Analysis Cornerstones of Managerial Accounting, 5e

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. LO-1 3

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). LO-1 4

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. How well did the manager control costs for the actual level of production? LO-1 5

Flexible Budget Variance (cont.) 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. LO-1 6

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. LO-2 7

Variable Overhead Analysis (cont.) 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 LO-2 8

Total Variable Overhead Variance The total variable overhead variance is 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 are calculated by using either the three-pronged (columnar) approach or formulas. LO-2 9

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: LO-2 10

Variable Overhead Spending Variance Variable overhead spending variance measures the aggregate effect of differences between the actual variable overhead rate (AVOR) and the standard variable overhead rate (SVOR). Actual variable overhead rate is computed as follows: LO-2 11

Variable Overhead Efficiency Variance VOH is assumed to vary in proportion to changes in the direct labor hours used. 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: LO-2 12

Variable Overhead Spending Variance vs Variable Overhead Spending Variance vs. Price Variances of Materials &Labor While the variable overhead spending variance is similar to the price variances of materials and labor, there are 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. LO-2 13

Variable Overhead Spending Variance vs Variable Overhead Spending Variance vs. Price Variances of Materials &Labor (cont.) 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. LO-2 14

Variable Overhead Spending Variance vs Variable Overhead Spending Variance vs. Price Variances of Materials &Labor (cont.) 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. LO-2 15

Responsibility for the Variable Overhead Spending Variance Variable overhead items may be affected by several responsibility centers. If consumption of VOH can be traced to a responsibility center, it can be assigned. Controllability is a prerequisite for assigning responsibility. LO-2 16

Responsibility for the Variable Overhead Spending Variance (cont.) Price changes of variable overhead items are beyond the control of supervisors. If small, then the spending variance is a matter of the efficient use of overhead in production. Responsibility for the variable overhead spending variance is generally assigned to production departments. LO-2 17

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 change in proportion to changes in direct labor hours 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. LO-2 18

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 use practical capacity to determine the number of direct labor hours in the denominator of the fixed overhead rate. LO-3 19

Total Fixed Overhead Variances 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). LO-3 20

Total Fixed Overhead Variances (cont.) The total fixed overhead variance is the difference between the actual fixed overhead and the applied fixed overhead: LO-3 21

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): LO-3 22

Fixed Overhead Volume Variance The fixed overhead volume variance is the difference between budgeted fixed overhead (BFOH) and applied fixed overhead: LO-3 23

Fixed Overhead Volume Variance (cont.) 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. LO-3 24

Responsibility for the Fixed Overhead Spending Variance Many fixed overhead items—long-run investments can be changed in the short run. Fixed overhead costs are often beyond the immediate control of management. Many fixed overhead costs are affected primarily by long-run decisions, and not by changes in production levels, the budget variance is usually small. LO-3 25

Analysis of the Fixed Overhead Spending Variance 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. LO-3 26

Responsibility for the Fixed Overhead Volume Variance Volume variance measures capacity utilization which implies that the general responsibility for this variance should be assigned to the production department. A significant volume variance may be due to factors beyond the control of production. LO-3 27

Analysis of the Volume Variance Notice that the volume variance occurs because fixed overhead is treated as if it were a variable cost. Fixed costs do not change as activity changes, as a predetermined fixed overhead rate allows. LO-3 28

Analysis of the Volume Variance LO-3 29

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 LO-4 30

Activity-Based Budgeting (cont.) Companies that have implemented an activity-based costing (ABC) system may 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 LO-4 31

Activity Flexible Budgeting Understanding the relationship between changes in activity costs and changes in activity drivers allows managers to 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 helps to improve traditional budgetary performance reporting, and enhances the ability to manage activities. LO-4 32

Activity Flexible Budgeting (cont.) If 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. LO-4 33