Chapter 11 Flexible Budgeting and the Management of Overhead and Support Activity Costs

Learning Objective 1

Static budgets are prepared for a single, planned level of activity. Flexible Budgets Hmm! Comparing static budgets with actual costs is like comparing apples and oranges. Static budgets are prepared for a single, planned level of activity. Performance evaluation for overhead is difficult when actual activity differs from the planned level of activity.

Consider the following example from the Cheese Company . . . Flexible Budgets Hmm! Comparing static budgets with actual costs is like comparing apples and oranges. Consider the following example from the Cheese Company . . .

Static Budgets and Performance Reports U = Unfavorable variance Cheese Company was unable to achieve the budgeted level of activity.

Static Budgets and Performance Reports F = Favorable variance since actual costs are less than budgeted costs. Since cost variances are favorable, have we done a good job controlling costs?

Static Budgets and Performance Reports I do know that actual activity is below budgeted activity which is unfavorable. But shouldn’t variable costs be lower if actual activity is below budgeted activity? I don’t think I can answer this question using a static budget.

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.

Flexible Budgets Central Concept If you can tell me what your activity was for the period, I will tell you what your costs and revenue should have been.

Advantages of Flexible Budgets Show revenues and expenses that should have occurred at the actual level of activity. May be prepared for any activity level in the relevant range. Reveal variances due to good cost control or lack of cost control. Improve performance evaluation.

Learning Objective 2

Preparing a Flexible Budget Let’s prepare budgets for the Cheese Company.

Preparing a Flexible Budget

Preparing a Flexible Budget Variable costs are expressed as a constant amount per hour. Fixed costs are expressed as a total amount that does not change within the relevant range of activity.

Preparing a Flexible Budget

Preparing a Flexible Budget

Preparing a Flexible Budget Note: There is no flex in the fixed costs.

Preparing a Flexible Budget Total budgeted overhead cost = Budgeted variable Total overhead cost per activity activity unit units × + Budgeted fixed overhead cost

Flexible Budget Performance Report Now let’s prepare a budget performance report at 8,000 actual machine hours for the Cheese Co.

Flexible Budget Performance Report

Flexible Budget Performance Report Flexible budget is prepared for the same activity level (8,000 hours) as actually achieved.

Flexible Budget Performance Report

Flexible Budget Performance Report Indirect labor and indirect material have unfavorable variances because actual costs are more than the flexible budget costs.

Flexible Budget Performance Report Power has a favorable variance because the actual cost is less than the flexible budget cost.

Learning Objective 3

Overhead Application in a Standard Costing System

Overhead Application in a Standard Costing System

Learning Objective 4

Choice of Activity Measure Variable overhead and the activity measure should vary in a similar pattern. Identify variable overhead cost drivers. Examples: machine hours, labor hours, process time. Dollar measures should be avoided as they are subject to price-level changes.

Learning Objective 5

Cost Management Using Overhead Cost Variances Let’s turn our attention to the computation of overhead cost variances. We will begin with variable overhead.

Variable Overhead Variances Actual Flexible Budget Flexible Budget Variable for Variable for Variable Overhead Overhead at Overhead at Incurred Actual Hours Standard Hours AH × AR AH × SVR SH × SVR Spending Variance Efficiency Variance AH = Actual Hours of Activity AR = Actual Variable Overhead Rate SVR = Standard Variable Overhead Rate SH = Standard Hours Allowed

Variable Overhead Variances Actual Flexible Budget Flexible Budget Variable for Variable for Variable Overhead Overhead at Overhead at Incurred Actual Hours Standard Hours AH × AR AH × SVR SH × SVR Spending Variance Efficiency Variance Spending variance = AH(AR - SVR) Efficiency variance = SVR(AH - SH)

Variable Overhead Variances – Example ColaCo’s actual production for the period required 3,200 standard machine hours. Actual variable overhead incurred for the period was $6,740. Actual machine hours worked were 3,300. Compute the variable overhead spending and efficiency variances.

Variable Overhead Variances – Example ColaCo prepared this budget for overhead: Total budgeted overhead cost = Budgeted variable Total overhead cost per x activity activity unit units + Budgeted fixed overhead cost Total budgeted overhead cost = $2.00 per machine hour × Total machine hours + $9,000

Variable Overhead Variances – Example Actual Flexible Budget Flexible Budget Variable for Variable for Variable Overhead Overhead at Overhead at Incurred Actual Hours Standard Hours 3,300 hours 3,200 hours × × $2.00 per hour $2.00 per hour $6,740 $6,600 $6,400 Spending variance $140 unfavorable Efficiency variance $200 unfavorable

Variable Overhead Variances – Example Actual Flexible Budget Flexible Budget Variable for Variable for Variable Overhead Overhead at Overhead at Incurred Actual Hours Standard Hours 3,300 hours 3,200 hours × × $2.00 per hour $2.00 per hour $6,740 $6,600 $6,400 The $140 unfavorable spending variance and the $200 unfavorable efficiency variance result in a $340 unfavorable flexible budget variance.

Variable Overhead Variances – A Closer Look Spending Variance Efficiency Variance Results from paying more or less than expected for overhead items and from excessive usage of overhead items. A function of the selected cost driver. It does not reflect overhead control.

Now let’s turn our attention to fixed overhead.

Fixed Overhead Variances Actual Fixed Fixed Fixed Overhead Overhead Overhead Incurred Budget Applied SH × PFOHR Budget Variance Volume Variance PFOHR = Predetermined Fixed Overhead Rate SH = Standard Hours Allowed

Budgeted Fixed Overhead Planned Activity in Hours Recall that fixed overhead costs are applied to products and services using a predetermined fixed overhead rate (PFOHR): Applied Fixed Overhead = PFOHR × Standard Hours Budgeted Fixed Overhead Planned Activity in Hours PFOHR =

Fixed Overhead Variances – Example ColaCo used the following predetermined fixed overhead rate: PFOHR = Budgeted Fixed Overhead Planned Activity in Hours $9,000 3,000 machine hours PFOHR = $3.00 per machine hour

Fixed Overhead Variances – Example ColaCo’s actual production required 3,200 standard machine hours. Actual fixed overhead was $8,450. Compute the fixed overhead budget and volume variances.

Fixed Overhead Variances – Example Actual Fixed Fixed Fixed Overhead Overhead Overhead Incurred Budget Applied 3,200 hours × $3.00 per hour $8,450 $9,000 $9,600 Budget variance $550 favorable Volume variance $600 (neither favorable nor unfavorable)

Fixed Overhead Variances Let’s look at a graph showing fixed overhead variances. We will use ColaCo’s numbers from the previous example.

Fixed Overhead Variances – A Closer Look Budget Variance Volume Variance Results from paying more or less than expected for overhead items. Results from the inability to operate at the activity level planned for the period. Has no significance for cost control.

Fixed Overhead Variances 3,200 machine hours × $3.00 fixed overhead rate Cost $9,600 applied fixed OH $600 Volume Variance { $9,000 budgeted fixed OH { $550 Favorable Budget Variance $8,450 actual fixed OH Fixed overhead applied to products Volume 3,000 Hours Planned Activity 3,200 Standard Hours

Learning Objective 6

Overhead Cost Performance Report

Learning Objective 7

Activity-Based Flexible Budget The Cheese Co. flexible budget is based on a single cost driver, machine hours

Activity-Based Flexible Budget If different cost drivers are identified for the different variable costs, an activity-based flexible budget should be prepared with different cost formulas based on the different drivers.

Learning Objective 8

Standard Costs and Product Costing

Standard Costs and Product Costing

Learning Objective 9

A General Model for Variance Analysis Actual Quantity Actual Quantity Standard Quantity × × × Actual Price Standard Price Standard Price Price Variance Quantity Variance Materials price variance Materials quantity variance Labor rate variance Labor efficiency variance Variable overhead Variable overhead spending variance efficiency variance AQ(AP - SP) SP(AQ - SQ) AQ = Actual Quantity SP = Standard Price AP = Actual Price SQ = Standard Quantity

A General Model for Variance Analysis Actual Sales Volume Actual Sales Volume Budgeted Sales Volume × × × Actual Sales Price Budgeted Sales Price Budgeted Sales Price Sales Price Variance Sales Volume Variance ASV(ASP - BSP) BSP(ASV - BSV) ASV = Actual Sales Volume BSP = Budgeted Sales Price ASP = Actual Sales Price BSV = Budgeted Sales Volume

I’m here to your budget. Are you ready to ante up? End of Chapter 11 I’m here to your budget. Are you ready to ante up?