2. Copyright © 2006. The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin 11 th Edition Chapter 11

3. Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Flexible Budgets and Overhead Analysis Chapter Eleven

4. 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. 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. 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.

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

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

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

8. 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

9. 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

10. 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

11. 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

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

13. Copyright © 2006. The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Preparing a Flexible Budget To a budget we need to know that: 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

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

15. 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 hour. $40,000 ÷ 10,000 hours is $4.00 per hour. CheeseCo

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

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

18. 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

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

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

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

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

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

24. Copyright © 2006. The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Remember the question: “How much of the total variance is due to lower activity and how much is due to cost control?” Flexible Budget Performance Report

25. Copyright © 2006. The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Static Budgets and Performance How much of the $11,650 favorable variance is due to lower activity and how much is due to cost control?

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

27. Copyright © 2006. The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Overhead Variance Analysis This $15,000F variance is due to lower activity. Activity This $3,350U variance is due to poor cost control. Cost control Flexible Budget Performance Report

28. Copyright © 2006. The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin The Measure of Activity– A Critical Choice Three important factors in selecting an activity base for an overhead flexible budget Activity base and variable overhead should be causally related. Activity base should not be expressed in dollars or other currency. Activity base should be simple and easily understood.

29. Copyright © 2006. The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Variable Overhead Variances – A Closer Look If flexible budget is based on actual hours If flexible budget is based on standard hours Only a spending variance can be computed. Both spending and efficiency variances can be computed.

30. Copyright © 2006. The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin 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. The standard variable overhead cost per machine hour is $2.00. 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. The standard variable overhead cost per machine hour is $2.00. Compute the variable overhead spending variance first using actual hours. Then use standard hours allowed to calculate the variable overhead efficiency variance. Compute the variable overhead spending variance first using actual hours. Then use standard hours allowed to calculate the variable overhead efficiency variance. Variable Overhead Variances – Example

31. Copyright © 2006. The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Actual Flexible Budget Variable for Variable Overhead Overhead at Incurred Actual Hours AH × SRAH × AR Spending Variance Spending variance = AH(AR – SR) Variable Overhead Variances AH = Actual hours AR = Actual variable overhead rate SR = Standard variable overhead rate

32. Copyright © 2006. The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Actual Flexible Budget Variable for Variable Overhead Overhead at Incurred Actual Hours 3,300 hours × $2.00 per hour = $6,600 $6,740 Spending Variance = $140 unfavorable Variable Overhead Variances – Example

33. Copyright © 2006. The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Variable Overhead Variances – A Closer Look Spending Variance Results from paying more or less than expected for overhead items and from excessive usage of overhead items. Now, let’s use the standard hours allowed, along with the actual hours, to compute the efficiency variance.

34. Copyright © 2006. The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin 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 Variable Overhead Variances

35. Copyright © 2006. The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin 3,300 hours 3,200 hours × × $2.00 per hour $2.00 per hour Variable Overhead Variances – Example $6,740$6,600$6,400 Spending variance $140 unfavorable Efficiency variance $200 unfavorable $340 unfavorable flexible budget total variance Actual Flexible Budget Flexible Budget Variable for Variable for Variable Overhead Overhead at Overhead at Incurred Actual Hours Standard Hours

36. Copyright © 2006. The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Efficiency Variance Controlled by managing the overhead cost driver. Variable Overhead Variances – A Closer Look

37. Copyright © 2006. The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Activity-based Costing and the Flexible Budget It is unlikely that all variable overhead will be driven by a single activity. Activity-based costing can be used when multiple activity bases drive variable overhead costs.

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

39. Copyright © 2006. The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin The predetermined overhead rate can be broken down into fixed and variable components. The variable component is useful for preparing and analyzing variable overhead variances. The fixed component is useful for preparing and analyzing fixed overhead variances. Overhead Rates and Overhead Analysis

40. Copyright © 2006. The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Normal versus Standard Cost Systems In a normal cost system, overhead is applied to work in process based on the actual number of hours worked in the period. In a standard cost system, overhead is applied to work in process based on the standard hours allowed for the output of the period.

41. Copyright © 2006. The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Budget Variance Volume Variance FR = Standard Fixed Overhead Rate SH = Standard Hours Allowed DH = Denominator Hours SH × FR Actual Fixed Fixed Fixed Overhead Overhead Overhead Incurred Budget Applied Fixed Overhead Variances DH × FR

42. Copyright © 2006. The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin ColaCo prepared this budget for overhead: ColaCo prepared this budget for overhead: Overhead Rates and Overhead Analysis – Example TotalVariableTotalFixed MachineVariableOverheadFixedOverhead HoursOverheadRateOverheadRate 3,0006,000$?9,000$? 4,0008,000?9,000? ColaCo applies overhead based on machine-hour activity. Let’s calculate overhead rates.

43. Copyright © 2006. The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Rate = Total Variable Overhead ÷ Machine Hours This rate is constant at all levels of activity. TotalVariableTotalFixed MachineVariableOverheadFixedOverhead HoursOverheadRateOverheadRate 3,000 6,000$ 2.00$ 9,000$ ? 4,000 8,000 2.00 9,000 ? ColaCo prepared this budget for overhead: ColaCo prepared this budget for overhead: Overhead Rates and Overhead Analysis – Example

44. Copyright © 2006. The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin TotalVariableTotalFixed MachineVariableOverheadFixedOverhead HoursOverheadRateOverheadRate 3,000 6,000$ 2.00$ 9,000$ 3.00$ 4,000 8,000 2.00 9,000 2.25 Rate = Total Fixed Overhead ÷ Machine Hours This rate decreases when activity increases. ColaCo prepared this budget for overhead: ColaCo prepared this budget for overhead: Overhead Rates and Overhead Analysis – Example

45. Copyright © 2006. The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin TotalVariableTotalFixed MachineVariableOverheadFixedOverhead HoursOverheadRateOverheadRate 3,000 6,000$ 2.00$ 9,000$ 3.00$ 4,000 8,000 2.00 9,000 2.25 The total POHR is the sum of the fixed and variable rates for a given activity level. ColaCo prepared this budget for overhead: ColaCo prepared this budget for overhead: Overhead Rates and Overhead Analysis – Example

46. Copyright © 2006. The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin ColaCo’s actual production required 3,200 standard machine hours. Actual fixed overhead was $8,450. The predetermined overhead rate is based on 3,000 machine hours. ColaCo’s actual production required 3,200 standard machine hours. Actual fixed overhead was $8,450. The predetermined overhead rate is based on 3,000 machine hours. Fixed Overhead Variances – Example

47. Copyright © 2006. The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Overhead Variances Now let’s turn our attention to calculating fixed overhead variances.

48. Copyright © 2006. The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Fixed Overhead Variances – Example Budget variance $550 favorable $8,450$9,000 Actual Fixed Fixed Fixed Overhead Overhead Overhead Incurred Budget Applied

49. Copyright © 2006. The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Fixed Overhead Variances – A Closer Look Budget Variance Results from spending more or less than expected for fixed overhead items. Now, let’s use the standard hours allowed to compute the fixed overhead volume variance.

50. Copyright © 2006. The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin 3,200 hours × $3.00 per hour Budget variance $550 favorable Fixed Overhead Variances – Example $8,450$9,000$9,600 Volume variance $600 favorable SH × FR Actual Fixed Fixed Fixed Overhead Overhead Overhead Incurred Budget Applied

51. Copyright © 2006. The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Volume Variance – A Closer Look Volume Variance Results when standard hours allowed for actual output differs from the denominator activity. Unfavorable when standard hours < denominator hours Favorable when standard hours > denominator hours

52. Copyright © 2006. The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Volume Variance – A Closer Look Volume Variance Results when standard hours allowed for actual output differs from the denominator activity. Unfavorable when standard hours < denominator hours Favorable when standard hours > denominator hours Does not measure over- or under spending It results from treating fixed overhead as if it were a variable cost.

53. Copyright © 2006. The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Quick Check Quick Check Yoder Enterprises’ actual production for the period required 2,100 standard direct labor hours. Actual fixed overhead for the period was $14,800. The budgeted fixed overhead was $14,450. The predetermined fixed overhead rate was $7 per direct labor hour. What was the budget variance? Yoder Enterprises’ actual production for the period required 2,100 standard direct labor hours. Actual fixed overhead for the period was $14,800. The budgeted fixed overhead was $14,450. The predetermined fixed overhead rate was $7 per direct labor hour. What was the budget variance? a. $350 U b. $350 F c. $100 F d. $100 U Yoder Enterprises’ actual production for the period required 2,100 standard direct labor hours. Actual fixed overhead for the period was $14,800. The budgeted fixed overhead was $14,450. The predetermined fixed overhead rate was $7 per direct labor hour. What was the budget variance? Yoder Enterprises’ actual production for the period required 2,100 standard direct labor hours. Actual fixed overhead for the period was $14,800. The budgeted fixed overhead was $14,450. The predetermined fixed overhead rate was $7 per direct labor hour. What was the budget variance? a. $350 U b. $350 F c. $100 F d. $100 U

54. Copyright © 2006. The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Yoder Enterprises’ actual production for the period required 2,100 standard direct labor hours. Actual fixed overhead for the period was $14,800. The budgeted fixed overhead was $14,450. The predetermined fixed overhead rate was $7 per direct labor hour. What was the budget variance? Yoder Enterprises’ actual production for the period required 2,100 standard direct labor hours. Actual fixed overhead for the period was $14,800. The budgeted fixed overhead was $14,450. The predetermined fixed overhead rate was $7 per direct labor hour. What was the budget variance? a. $350 U b. $350 F c. $100 F d. $100 U Yoder Enterprises’ actual production for the period required 2,100 standard direct labor hours. Actual fixed overhead for the period was $14,800. The budgeted fixed overhead was $14,450. The predetermined fixed overhead rate was $7 per direct labor hour. What was the budget variance? Yoder Enterprises’ actual production for the period required 2,100 standard direct labor hours. Actual fixed overhead for the period was $14,800. The budgeted fixed overhead was $14,450. The predetermined fixed overhead rate was $7 per direct labor hour. What was the budget variance? a. $350 U b. $350 F c. $100 F d. $100 U Quick Check Quick Check Budget variance = Actual fixed overhead – Budgeted fixed overhead = $14,800 – $14,450 = $350 U

55. Copyright © 2006. The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Quick Check Quick Check Yoder Enterprises’ actual production for the period required 2,100 standard direct labor hours. Actual fixed overhead for the period was $14,800. The budgeted fixed overhead was $14,450. The predetermined fixed overhead rate was $7 per direct labor hour. What was the volume variance? Yoder Enterprises’ actual production for the period required 2,100 standard direct labor hours. Actual fixed overhead for the period was $14,800. The budgeted fixed overhead was $14,450. The predetermined fixed overhead rate was $7 per direct labor hour. What was the volume variance? a. $250 U b. $250 F c. $100 F d. $100 U Yoder Enterprises’ actual production for the period required 2,100 standard direct labor hours. Actual fixed overhead for the period was $14,800. The budgeted fixed overhead was $14,450. The predetermined fixed overhead rate was $7 per direct labor hour. What was the volume variance? Yoder Enterprises’ actual production for the period required 2,100 standard direct labor hours. Actual fixed overhead for the period was $14,800. The budgeted fixed overhead was $14,450. The predetermined fixed overhead rate was $7 per direct labor hour. What was the volume variance? a. $250 U b. $250 F c. $100 F d. $100 U

56. Copyright © 2006. The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Yoder Enterprises’ actual production for the period required 2,100 standard direct labor hours. Actual fixed overhead for the period was $14,800. The budgeted fixed overhead was $14,450. The predetermined fixed overhead rate was $7 per direct labor hour. What was the volume variance? Yoder Enterprises’ actual production for the period required 2,100 standard direct labor hours. Actual fixed overhead for the period was $14,800. The budgeted fixed overhead was $14,450. The predetermined fixed overhead rate was $7 per direct labor hour. What was the volume variance? a. $250 U b. $250 F c. $100 F d. $100 U Yoder Enterprises’ actual production for the period required 2,100 standard direct labor hours. Actual fixed overhead for the period was $14,800. The budgeted fixed overhead was $14,450. The predetermined fixed overhead rate was $7 per direct labor hour. What was the volume variance? Yoder Enterprises’ actual production for the period required 2,100 standard direct labor hours. Actual fixed overhead for the period was $14,800. The budgeted fixed overhead was $14,450. The predetermined fixed overhead rate was $7 per direct labor hour. What was the volume variance? a. $250 U b. $250 F c. $100 F d. $100 U Quick Check Quick Check Volume variance = Budgeted fixed overhead – (SH  FR) = $14,450 – (2,100 hours  $7 per hour) = $14,450 – $14,700 = $250 F

57. Copyright © 2006. The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin 2,100 hours × $7.00 per hour Budget variance $350 unfavorable $14,800$14,450 $14,700 Actual Fixed Fixed Fixed Overhead Overhead Overhead Incurred Budget Applied Volume variance $250 favorable SH × FR Quick Check Summary

58. Copyright © 2006. The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Overhead Variances Let’s look at a graph showing fixed overhead variances. We will use ColaCo’s numbers from the previous example.

59. Copyright © 2006. The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Fixed Overhead Variances Activity Cost 3,000 Hours Expected Activity $9,000 budgeted fixed OH Fixed overhead applied to products

60. Copyright © 2006. The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Fixed Overhead Variances $8,450 actual fixed OH Activity Cost 3,000 Hours Expected Activity $9,000 budgeted fixed OH Fixed overhead applied to products $8,450 actual fixed OH $550 Favorable Budget Variance {

61. Copyright © 2006. The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin { Fixed Overhead Variances $8,450 actual fixed OH 3,200 machine hours × $3.00 fixed overhead rate $600 Favorable Volume Variance $9,600 applied fixed OH 3,200 Standard Hours Activity Cost 3,000 Hours Expected Activity $9,000 budgeted fixed OH Fixed overhead applied to products $550 Favorable Budget Variance { $8,450 actual fixed OH

62. Copyright © 2006. The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Overhead Variances and Under- or Overapplied Overhead Cost In a standard cost system: Unfavorable variances are equivalent to underapplied overhead. Favorable variances are equivalent to overapplied overhead. The sum of the overhead variances equals the under- or overapplied overhead cost for a period.