Flexible Budgets and Overhead Analysis Chapter 7

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Static Budgets and Performance Reports 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 is difficult when actual activity differs from the planned level of activity. Let’s look at CheeseCo.

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Static Budgets and Performance Reports CheeseCo

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Static Budgets and Performance Reports U = Unfavorable variance CheeseCo was unable to achieve the budgeted level of activity. CheeseCo

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Static Budgets and Performance Reports F = Favorable variance that occurs when actual costs are less than budgeted costs. CheeseCo

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Static Budgets and Performance Reports Since cost variances are favorable, have we done a good job controlling costs? CheeseCo

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Static Budgets and Performance Reports I don’t think I can answer the question using a static budget. Actual activity is below budgeted activity which is unfavorable. So, shouldn’t variable costs be lower if actual activity is lower?

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill 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. Static Budgets and Performance Reports

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Flexible Budgets Improve performance evaluation. May be prepared for any activity level in the relevant range. Show revenues and expenses that should have occurred at the actual level of activity. Reveal variances due to good cost control or lack of cost control.

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill 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.

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill 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

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Preparing a Flexible Budget Let’s prepare budgets for CheeseCo.

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill CostTotal Flexible Budgets FormulaFixed8,00010,00012,000 Per HourCostHours Machine hours8,000 10,000 12,000 Variable costs Indirect labor ,000$ Indirect material ,000 Power0.50 4,000 Total variable cost7.50$ 60,000$ Fixed costs Depreciation12,000$ Insurance2,000 Total fixed cost Total overhead costs Preparing a Flexible Budget Fixed costs are expressed as a total amount. Variable costs are expressed as a constant amount per hour. $40,000 ÷ 10,000 hours is $4.00 per hour. CheeseCo

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Preparing a Flexible Budget $4.00 per hour × 8,000 hours = $32,000 CheeseCo

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Preparing a Flexible Budget CostTotal Flexible Budgets FormulaFixed8,00010,00012,000 Per HourCostHours Machine hours8,000 10,000 12,000 Variable costs Indirect labor ,000$ 40,000$ 48,000$ Indirect material ,000 30,000 36,000 Power0.50 4,000 5,000 6,000 Total variable cost7.50$ 60,000$ 75,000$ 90,000$ Fixed costs Depreciation12,000$ $ $ $ Insurance2,000 Total fixed cost14,000$ $ $ Total overhead costs74,000$ 89,000$ 104,000$ CheeseCo

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Preparing a Flexible Budget CostTotal Flexible Budgets FormulaFixed8,00010,00012,000 Per HourCostHours Machine hours8,000 10,000 12,000 Variable costs Indirect labor ,000$ 40,000$ 48,000$ Indirect material ,000 30,000 36,000 Power0.50 4,000 5,000 6,000 Total variable cost7.50$ 60,000$ 75,000$ 90,000$ Fixed costs Depreciation12,000$ $ $ $ Insurance2,000 Total fixed cost14,000$ $ $ Total overhead costs74,000$ 89,000$ 104,000$ Total fixed costs do not change in the relevant range. CheeseCo

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Let’s prepare a budget performance report for CheeseCo. Flexible Budget Performance Report

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill CostTotal FormulaFixedFlexibleActual Per HourCostsBudgetResultsVariances Machine hours8,000 0 Variable costs Indirect labor4.00$ 32,000$ 34,000$ Indirect material ,000 25,500 Power0.50 4,000 3,800 Total variable costs7.50$ 60,000$ 63,300$ Fixed Expenses Depreciation12,000$ $ $ Insurance2,000 2,050 Total fixed costs14,000$ 14,050$ Total overhead costs74,000$ 77,350$ Flexible Budget Performance Report Flexible budget is prepared for the same activity level (8,000 hours) as actually achieved. CheeseCo

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Flexible Budget Performance Report CheeseCo

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Remember the question: “How much of the total variance is due to activity and how much is due to cost control?” Flexible Budget Performance Report

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Static Budgets and Performance How much of the $11,650 is due to activity and how much is due to cost control?

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Flexible Budget Performance Report Difference between original static budget and actual overhead = $11,650 F. Overhead Variance Analysis Let’s place the flexible budget for 8,000 hours here.

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Flexible Budget Performance Report This $15,000F variance is due to lower activity. Overhead Variance Analysis Activity This $3,350U flexible budget variance is due to poor cost control. Cost control

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Flexible Budget Performance Report What causes the cost control variance? There are two primary reasons for unfavorable variable overhead variances: 1. Spending too much for resources. 2. Using the resources inefficiently.

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Overhead Rates and Overhead Analysis Overhead from the flexible budget for the denominator level of activity POHR = Recall that overhead costs are assigned to products and services using a predetermined overhead rate (POHR): Assigned Overhead = POHR × Standard Activity Denominator level of activity

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Overhead Rates and Overhead Analysis – Example Let’s look at overhead rates in a budget for ColaCo.

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill ColaCo prepared this budget for overhead: Overhead Rates and Overhead Analysis – Example TotalVariableTotalFixed MachineVariableOverheadFixedOverhead HoursOverheadRateOverheadRate 2,000 4,000$ ?9,000$ ? 4,000 8,000 ?9,000 ? ColaCo applies overhead based on machine hour activity. Let’s calculate overhead rates.

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Overhead Rates and Overhead Analysis – Example Rate = Total Variable Overhead ÷ Machine Hours ColaCo prepared this budget for overhead: This rate is constant at all levels of activity. TotalVariableTotalFixed MachineVariableOverheadFixedOverhead HoursOverheadRateOverheadRate 2,000 4,000$ 2.00$ 9,000$ ? 4,000 8, ,000 ?

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill TotalVariableTotalFixed MachineVariableOverheadFixedOverhead HoursOverheadRateOverheadRate 2,000 4,000$ 2.00$ 9,000$ 4.50$ 4,000 8, , Overhead Rates and Overhead Analysis – Example Rate = Total Fixed Overhead ÷ Machine Hours ColaCo prepared this budget for overhead: This rate decreases when activity increases.

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill TotalVariableTotalFixed MachineVariableOverheadFixedOverhead HoursOverheadRateOverheadRate 2,000 4,000$ 2.00$ 9,000$ 4.50$ 4,000 8, , Overhead Rates and Overhead Analysis – Example The total POHR is the sum of the fixed and variable rates for a given activity level. ColaCo prepared this budget for overhead:

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Overhead Variances Let’s use the overhead rates, to determine variable and fixed overhead variances.

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill 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

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Variable Overhead Variances AH × SR AH × AR Spending variance = AH(AR - SR) Efficiency variance = SR(AH - SH) SH × SR Spending Variance Efficiency Variance Actual Flexible Budget Flexible Budget Variable for Variable for Variable Overhead Overhead at Overhead at Incurred Actual Hours Standard Hours

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill 3,300 hours 3,200 hours × × $2.00 per hour $2.00 per hour Variable Overhead Variances – Example Actual Flexible Budget Flexible Budget Variable for Variable for Variable Overhead Overhead at Overhead at Incurred Actual Hours Standard Hours $6,740$6,600$6,400 Spending variance $140 unfavorable Efficiency variance $200 unfavorable $340 unfavorable flexible budget total variance

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill 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. Controlled by managing the overhead cost driver.

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Overhead Variances Now let’s turn our attention to fixed overhead.

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Overhead Rates and Overhead Analysis – Example ColaCo prepared this budget for overhead: What is ColaCo’s fixed overhead rate for an estimated activity of 3,000 machine hours? TotalVariableTotalFixed MachineVariableOverheadFixedOverhead HoursOverheadRateOverheadRate 2,000 4,000$ 2.00$ 9,000$ 4.50$ 4,000 8, ,

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Overhead Rates and Overhead Analysis – Example ColaCo prepared this budget for overhead: What is ColaCo’s fixed overhead rate for an estimated activity of 3,000 machine hours? Fixed Overhead Rate FR = $9,000 ÷ 3,000 machine hours FR = $3.00 per machine hour TotalVariableTotalFixed MachineVariableOverheadFixedOverhead HoursOverheadRateOverheadRate 2,000 4,000$ 2.00$ 9,000$ 4.50$ 4,000 8, ,

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill 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

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Fixed Overhead Variances Budget Variance Volume Variance FR = Standard Fixed Overhead Rate SH = Standard Hours Allowed SH × FR Actual Fixed Fixed Fixed Overhead Overhead Overhead Incurred Budget Applied

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill 3,200 hours × $3.00 per hour Budget variance $550 favorable Fixed Overhead Variances – Example $8,450$9,000$9,600 Actual Fixed Fixed Fixed Overhead Overhead Overhead Incurred Budget Applied Volume variance $600 favorable SH × FR

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Fixed Overhead Variances – A Closer Look Budget Variance Volume Variance Results from paying more or less than expected for overhead items. Results from operating at an activity level different from the denominator activity.

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Overhead Variances Let’s look at a graph showing fixed overhead variances. We will use ColaCo’s numbers from the previous example.

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Volume Cost 3,200 Standard Hours 3,000 Hours Expected Activity Fixed Overhead Variances Fixed overhead applied to products

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Fixed Overhead Variances $8,450 actual fixed OH Volume Cost $9,600 applied fixed OH $9,000 budgeted fixed OH 3,200 Standard Hours 3,000 Hours Expected Activity Fixed overhead applied to products 3,200 machine hours × $3.00 fixed overhead rate

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill { $600 Favorable Volume Variance Fixed Overhead Variances { $550 Favorable Budget Variance $8,450 actual fixed OH Volume Cost $9,600 applied fixed OH $9,000 budgeted fixed OH 3,200 Standard Hours 3,000 Hours Expected Activity Fixed overhead applied to products 3,200 machine hours × $3.00 fixed overhead rate {

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Results when standard hours allowed for actual output differs from the denominator activity. Volume Variance – A Closer Look Volume Variance Favorable when standard hours > denominator hours Unfavorable when standard hours < denominator hours

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Results when standard hours allowed for actual output differs from the denominator activity. Volume Variance – A Closer Look Volume Variance Favorable when standard hours > denominator hours Unfavorable when standard hours < denominator hours Does not measure over- or under spending Explainable by and controllable only through activity

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Overhead Variances and Under- or Overapplied Overhead Cost The sum of the overhead variances equals the under- or overapplied overhead cost for a period. Favorable variances are equivalent to overapplied overhead. Unfavorable variances are equivalent to underapplied overhead. In a standard cost system:

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill End of Chapter 11 I’m here to your budget. Are you ready to ante up?