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Flexible Budgets andOverhead Analysis
Chapter
11
© McGraw-Hill Ryerson Limited., 2001
11-2
LEARNING OBJECTIVES
1. Prepare a flexible budget and explain theadvantages of the flexible budget approachover the static budget approach.
2. Prepare a performance report for both variableand fixed overhead costs using the flexiblebudget approach.
3. Use the flexible budget to prepare a variableoverhead performance report containing onlya spending variance.
After studying this chapter, you should be able to:
© McGraw-Hill Ryerson Limited., 2001
11-3
LEARNING OBJECTIVES
4. Use the flexible budget to prepare a variableoverhead performance report containing both aspending and an efficiency variance.
5. Explain the significance of the denominatoractivity figure in determining the standard costof a unit of product.
6. Apply overhead cost to units of product in astandard cost system.
7. Compute and interpret the fixed overheadbudget and volume variances.
After studying this chapter, you should be able to:
© McGraw-Hill Ryerson Limited., 2001
11-4
Static Budgets and PerformanceReports
Hmm! Comparingstatic budgets withactual costs is likecomparing apples
and oranges.
Static budgets areprepared for a single,
planned level ofactivity.
Performanceevaluation is difficultwhen actual activity
differs from theplanned level of
activity.Let’s look at CheeseCo.
© McGraw-Hill Ryerson Limited., 2001
11-5
Static ActualBudget Results Variances
Machine hours 10,000 8,000
Variable costs Indirect labour 40,000$ 34,000$ Indirect materials 30,000 25,500 Power 5,000 3,800
Fixed costs Amortization 12,000 12,000 Insurance 2,000 2,050
Total overhead costs 89,000$ 77,350$
Static Budgets and PerformanceReports
CheeseCo
© McGraw-Hill Ryerson Limited., 2001
11-6
Static ActualBudget Results Variances
Machine hours 10,000 8,000 2,000 U
Variable costs Indirect labor 40,000$ 34,000$ $6,000 F Indirect materials 30,000 25,500 4,500 F Power 5,000 3,800 1,200 F
Fixed costs Depreciation 12,000 12,000 0 Insurance 2,000 2,050 50 U
Total overhead costs 89,000$ 77,350$ $11,650 F
Static ActualBudget Results Variances
Machine hours 10,000 8,000 2,000 U
Variable costs Indirect labour 40,000$ 34,000$ $6,000 F Indirect materials 30,000 25,500 4,500 F Power 5,000 3,800 1,200 F
Fixed costs Amortization 12,000 12,000 0 Insurance 2,000 2,050 50 U
Total overhead costs 89,000$ 77,350$ $11,650 F
Static Budgets and PerformanceReports
U = Unfavourable varianceCheeseCo was unable to achieve
the budgeted level of activity.
CheeseCo
© McGraw-Hill Ryerson Limited., 2001
11-7
Static ActualBudget Results Variances
Machine hours 10,000 8,000 2,000 U
Variable costs Indirect labor 40,000$ 34,000$ $6,000 F Indirect materials 30,000 25,500 4,500 F Power 5,000 3,800 1,200 F
Fixed costs Depreciation 12,000 12,000 0 Insurance 2,000 2,050 50 U
Total overhead costs 89,000$ 77,350$ $11,650 F
Static ActualBudget Results Variances
Machine hours 10,000 8,000 2,000 U
Variable costs Indirect labour 40,000$ 34,000$ $6,000 F Indirect materials 30,000 25,500 4,500 F Power 5,000 3,800 1,200 F
Fixed costs Amortization 12,000 12,000 0 Insurance 2,000 2,050 50 U
Total overhead costs 89,000$ 77,350$ $11,650 F
Static Budgets and PerformanceReports
F = Favourable variance that occurs whenactual costs are less than budgeted costs.
CheeseCo
© McGraw-Hill Ryerson Limited., 2001
11-8
Static ActualBudget Results Variances
Machine hours 10,000 8,000 2,000 U
Variable costs Indirect labor 40,000$ 34,000$ $6,000 F Indirect materials 30,000 25,500 4,500 F Power 5,000 3,800 1,200 F
Fixed costs Depreciation 12,000 12,000 0 Insurance 2,000 2,050 50 U
Total overhead costs 89,000$ 77,350$ $11,650 F
Static ActualBudget Results Variances
Machine hours 10,000 8,000 2,000 U
Variable costs Indirect labour 40,000$ 34,000$ $6,000 F Indirect materials 30,000 25,500 4,500 F Power 5,000 3,800 1,200 F
Fixed costs Amortization 12,000 12,000 0 Insurance 2,000 2,050 50 U
Total overhead costs 89,000$ 77,350$ $11,650 F
Static Budgets and PerformanceReports
Since cost variances are favourable, havewe done a good job controlling costs?
CheeseCo
© McGraw-Hill Ryerson Limited., 2001
11-9
Static Budgets and PerformanceReports
I don’t think Ican answer thequestion usinga static budget.
Actual activity is belowbudgeted activity which
is unfavourable.
So, shouldn’t variable costsbe lower if actual activity
is lower?
© McGraw-Hill Ryerson Limited., 2001
11-10
!The relevant question is . . .
“How much of the favourable cost varianceis due to lower activity, and how much is dueto good cost control?”
!To answer the question,we mustthe budget to theactual level of activity.
Static Budgets and PerformanceReports
© McGraw-Hill Ryerson Limited., 2001
11-11
Flexible Budgets
Improve performance evaluation.
May be prepared for any activity level in the relevant range.
Show revenues and expensesthat should have occurred at theactual level of activity.
Reveal variances due to good costcontrol or lack of cost control.
© McGraw-Hill Ryerson Limited., 2001
11-12
Flexible Budgets
Central Concept
If you can tell me what your activity wasfor the period, I will tell you what your costs
and revenue should have been.
© McGraw-Hill Ryerson Limited., 2001
11-13
Preparing a Flexible Budget
To a budget we need to know that:"Total variable costs change
in direct proportion tochanges in activity.
"Total fixed costs remainunchanged within therelevant range. Fixed
Variable
© McGraw-Hill Ryerson Limited., 2001
11-14
Preparing a Flexible Budget
Let’s prepare budgets for CheeseCo.
© McGraw-Hill Ryerson Limited., 2001
11-15
Cost Total Flexible BudgetsFormula Fixed 8,000 10,000 12,000Per Hour Cost Hours Hours Hours
Machine hours 8,000 10,000 12,000
Variable costs Indirect labour 4.00 32,000$ Indirect material 3.00 24,000 Power 0.50 4,000 Total variable cost 7.50$ 60,000$
Fixed costs Amortization 12,000$ Insurance 2,000 Total fixed costTotal overhead costs
Preparing a Flexible Budget
Fixed costs areexpressed as atotal amount.
Variable costs are expressed asa constant amount per hour.
$40,000 ÷ 10,000 hours is$4.00 per hour.
CheeseCo
© McGraw-Hill Ryerson Limited., 2001
11-16
Cost Total Flexible BudgetsFormula Fixed 8,000 10,000 12,000Per Hour Cost Hours Hours Hours
Machine hours 8,000 10,000 12,000
Variable costs Indirect labour 4.00 32,000$ Indirect material 3.00 24,000 Power 0.50 4,000 Total variable cost 7.50$ 60,000$
Fixed costs Amortization 12,000$ Insurance 2,000 Total fixed costTotal overhead costs
Preparing a Flexible Budget
$4.00 per hour × 8,000 hours = $32,000
CheeseCo
© McGraw-Hill Ryerson Limited., 2001
11-17
Preparing a Flexible Budget
Cost Total Flexible BudgetsFormula Fixed 8,000 10,000 12,000Per Hour Cost Hours Hours Hours
Machine hours 8,000 10,000 12,000
Variable costs Indirect labour 4.00 32,000$ 40,000$ 48,000$ Indirect material 3.00 24,000 30,000 36,000 Power 0.50 4,000 5,000 6,000 Total variable cost 7.50$ 60,000$ 75,000$ 90,000$
Fixed costs Amortization 12,000$ 12,000$ 12,000$ 12,000$ Insurance 2,000 2,000 2,000 2,000 Total fixed cost 14,000$ 14,000$ 14,000$ Total overhead costs 74,000$ 89,000$ 104,000$
CheeseCo
© McGraw-Hill Ryerson Limited., 2001
11-18
Preparing a Flexible Budget
Cost Total Flexible BudgetsFormula Fixed 8,000 10,000 12,000Per Hour Cost Hours Hours Hours
Machine hours 8,000 10,000 12,000
Variable costs Indirect labour 4.00 32,000$ 40,000$ 48,000$ Indirect material 3.00 24,000 30,000 36,000 Power 0.50 4,000 5,000 6,000 Total variable cost 7.50$ 60,000$ 75,000$ 90,000$
Fixed costs Amortization 12,000$ 12,000$ 12,000$ 12,000$ Insurance 2,000 2,000 2,000 2,000 Total fixed cost 14,000$ 14,000$ 14,000$ Total overhead costs 74,000$ 89,000$ 104,000$
Total fixed costsdo not change in
the relevant range.
CheeseCo
© McGraw-Hill Ryerson Limited., 2001
11-19
Let’s prepare a budget performance report for CheeseCo.
Flexible BudgetPerformance Report
© McGraw-Hill Ryerson Limited., 2001
11-20
Cost TotalFormula Fixed Flexible ActualPer Hour Costs Budget Results Variances
Machine hours 8,000 8,000 0
Variable costs Indirect labour 4.00$ 32,000$ 34,000$ Indirect material 3.00 24,000 25,500 Power 0.50 4,000 3,800 Total variable costs 7.50$ 60,000$ 63,300$ Fixed Expenses Amortization 12,000$ 12,000$ 12,000$ Insurance 2,000 2,000 2,050 Total fixed costs 14,000$ 14,050$ Total overhead costs 74,000$ 77,350$
Flexible BudgetPerformance Report
Flexible budget isprepared for the
same activity level(8,000 hours) as
actually achieved.
CheeseCo
© McGraw-Hill Ryerson Limited., 2001
11-21
Cost TotalFormula Fixed Flexible ActualPer Hour Costs Budget Results Variances
Machine hours 8,000 8,000 0
Variable costs Indirect labour 4.00$ 32,000$ 34,000$ $ 2,000 U Indirect material 3.00 24,000 25,500 1,500 U Power 0.50 4,000 3,800 200 FTotal variable costs 7.50$ 60,000$ 63,300$ $ 3,300 UFixed Expenses Amortization 12,000$ 12,000$ 12,000$ 0 Insurance 2,000 2,000 2,050 50 UTotal fixed costs 14,000$ 14,050$ 50 UTotal overhead costs 74,000$ 77,350$ $ 3,350 U
Flexible BudgetPerformance Report
CheeseCo
© McGraw-Hill Ryerson Limited., 2001
11-22
Remember the question:“How much of the totalvariance is due to activityand how much is due tocost control?”
Flexible BudgetPerformance Report
© McGraw-Hill Ryerson Limited., 2001
11-23
Static ActualBudget Results Variances
Machine hours 10,000 8,000 2,000 U
Variable costs Indirect labour 40,000$ 34,000$ $6,000 F Indirect materials 30,000 25,500 4,500 F Power 5,000 3,800 1,200 F
Fixed costs Amortization 12,000 12,000 0 Insurance 2,000 2,050 50 U
Total overhead costs 89,000$ 77,350$ $11,650 F
Static Budgets and Performance How much of the $11,650 is due to activity
and how much is due to cost control?
© McGraw-Hill Ryerson Limited., 2001
11-24
Flexible BudgetPerformance Report
Difference between original static budgetand actual overhead = $11,650 F.
Overhead Variance Analysis
Static ActualOverhead OverheadBudget at at
10,000 Hours 8,000 Hours
89,000$ 77,350$
Let’s placethe flexiblebudget for
8,000 hourshere.
© McGraw-Hill Ryerson Limited., 2001
11-25
Flexible BudgetPerformance Report
This $15,000F variance isdue to lower activity.
Overhead Variance Analysis
Activity
This $3,350U flexiblebudget variance is dueto poor cost control.
Cost control
Static Flexible ActualOverhead Overhead OverheadBudget at Budget at at
10,000 Hours 8,000 Hours 8,000 Hours
89,000$ 74,000$ 77,350$
© McGraw-Hill Ryerson Limited., 2001
11-26
Flexible BudgetPerformance Report
What causesthe cost
control variance?
There are two primaryreasons for unfavourablevariable overhead variances:
1. Spending too much for resources.
2. Using the resources inefficiently.
© McGraw-Hill Ryerson Limited., 2001
11-27
Overhead Rates and OverheadAnalysis
Overhead from theflexible budget for the
denominator level of activityPOHR =
Recall that overhead costs are assigned toproducts and services using a
predetermined overhead rate (POHR):
Assigned Overhead = POHR × Standard Activity
Denominator level of activity
© McGraw-Hill Ryerson Limited., 2001
11-28
Overhead Rates and OverheadAnalysis – Example
Let’s look at overhead
rates in a
budget for ColaCo.
© McGraw-Hill Ryerson Limited., 2001
11-29
ColaCo prepared this budget for overhead:
Overhead Rates and OverheadAnalysis – Example
Total Variable Total FixedMachine Variable Overhead Fixed Overhead
Hours Overhead Rate Overhead Rate
2,000 4,000$ ? 9,000$ ?
4,000 8,000 ? 9,000 ?
ColaCo applies overhead basedon machine hour activity.
ColaCo applies overhead basedon machine hour activity.
Let’s calculate overhead rates.
© McGraw-Hill Ryerson Limited., 2001
11-30
Overhead Rates and OverheadAnalysis – Example
Rate = Total Variable Overhead ÷ Machine Hours
ColaCo prepared this budget for overhead:
This rate is constant at all levels of activity.
Total Variable Total FixedMachine Variable Overhead Fixed Overhead
Hours Overhead Rate Overhead Rate
2,000 4,000$ 2.00$ 9,000$ ?
4,000 8,000 2.00 9,000 ?
© McGraw-Hill Ryerson Limited., 2001
11-31
Total Variable Total FixedMachine Variable Overhead Fixed Overhead
Hours Overhead Rate Overhead Rate
2,000 4,000$ 2.00$ 9,000$ 4.50$
4,000 8,000 2.00 9,000 2.25
Overhead Rates and OverheadAnalysis – Example
Rate = Total Fixed Overhead ÷ Machine Hours
ColaCo prepared this budget for overhead:
This rate decreases when activity increases.
© McGraw-Hill Ryerson Limited., 2001
11-32
Total Variable Total FixedMachine Variable Overhead Fixed Overhead
Hours Overhead Rate Overhead Rate
2,000 4,000$ 2.00$ 9,000$ 4.50$
4,000 8,000 2.00 9,000 2.25
Overhead Rates and OverheadAnalysis – Example
The total POHR is the sum ofthe fixed and variable rates
for a given activity level.
ColaCo prepared this budget for overhead:
© McGraw-Hill Ryerson Limited., 2001
11-33
Overhead Variances
Let’s use theoverhead rates, todetermine variableand fixed overhead
variances.
© McGraw-Hill Ryerson Limited., 2001
11-34
ColaCo’s actual production for the period required3,200 standard machine hours. Actual variableoverhead incurred for the period was $6,740.
Actual machine hours worked were 3,300.
Compute the variable overhead spending andefficiency variances.
Variable Overhead Variances –Example
© McGraw-Hill Ryerson Limited., 2001
11-35
Variable Overhead Variances
AH × SR AH × AR
Spending variance = AH(AR - SR)
Efficiency variance = SR(AH - SH)
SH × SR
SpendingVariance
EfficiencyVariance
Actual Flexible Budget Flexible Budget Variable for Variable for Variable Overhead Overhead at Overhead at Incurred Actual Hours Standard Hours
© McGraw-Hill Ryerson Limited., 2001
11-36
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 unfavourable
Efficiency variance$200 unfavourable
$340 unfavourable flexible budget total variance$340 unfavourable flexible budget total variance
© McGraw-Hill Ryerson Limited., 2001
11-37
Variable Overhead Variances – ACloser Look
Spending Variance Efficiency Variance
Results from paying moreor less than expected foroverhead items and from
excessive usage ofoverhead items.
Controlled bymanaging the
overhead cost driver.
© McGraw-Hill Ryerson Limited., 2001
11-38
Overhead Variances
Now let’s turnour attention
to fixedoverhead.
© McGraw-Hill Ryerson Limited., 2001
11-39
Overhead Rates and OverheadAnalysis – Example
ColaCo prepared this budget for overhead:
What is ColaCo’s fixed overhead rate for an estimated activity of 3,000 machine hours?
Total Variable Total FixedMachine Variable Overhead Fixed Overhead
Hours Overhead Rate Overhead Rate
2,000 4,000$ 2.00$ 9,000$ 4.50$
4,000 8,000 2.00 9,000 2.25
© McGraw-Hill Ryerson Limited., 2001
11-40
Overhead Rates and OverheadAnalysis – 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 = $3.00 per machine hour
Total Variable Total FixedMachine Variable Overhead Fixed Overhead
Hours Overhead Rate Overhead Rate
2,000 4,000$ 2.00$ 9,000$ 4.50$
4,000 8,000 2.00 9,000 2.25
© McGraw-Hill Ryerson Limited., 2001
11-41
ColaCo’s actual production required3,200 standard machine hours. Actual
fixed overhead was $8,450.
Compute the fixed overhead budget andvolume variances.
Fixed Overhead Variances –Example
© McGraw-Hill Ryerson Limited., 2001
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Fixed Overhead Variances
BudgetVariance
VolumeVariance
FR = Standard Fixed Overhead RateSH = Standard Hours Allowed
SH × FR
Actual Fixed Fixed Fixed Overhead Overhead Overhead Incurred Budget Applied
© McGraw-Hill Ryerson Limited., 2001
11-43
3,200 hours × $3.00 per hour
Budget variance$550 favourable
Fixed Overhead Variances –Example
$8,450 $9,000 $9,600
Actual Fixed Fixed Fixed Overhead Overhead Overhead Incurred Budget Applied
Volume variance$600 favourable
SH × FR
© McGraw-Hill Ryerson Limited., 2001
11-44
Fixed Overhead Variances –A Closer Look
Budget Variance Volume Variance
Results from paying moreor less than expected for
overhead items.
Results from operatingat an activity leveldifferent from the
denominator activity.
© McGraw-Hill Ryerson Limited., 2001
11-45
Overhead Variances
Let’s look at agraph showingfixed overhead
variances. We willuse ColaCo’s
numbers from theprevious example.
© McGraw-Hill Ryerson Limited., 2001
11-46
Volume
Cost
3,200Standard
Hours
3,000 HoursExpectedActivity
Fixed Overhead Variances
Fixed overhead
applied to products
© McGraw-Hill Ryerson Limited., 2001
11-47
Fixed Overhead Variances
$8,450 actual fixed OH
Volume
Cost
$9,600 applied fixed OH
$9,000 budgeted fixed OH
3,200Standard
Hours
3,000 HoursExpectedActivity
Fixed overhead
applied to products
3,200 machine hours × $3.00 fixed overhead rate
© McGraw-Hill Ryerson Limited., 2001
11-48
{$600
FavourableVolumeVariance
Fixed Overhead Variances
{$550Favourable
BudgetVariance
$8,450 actual fixed OH$8,450 actual fixed OH
Volume
Cost
$9,600 applied fixed OH
$9,000 budgeted fixed OH
3,200Standard
Hours
3,000 HoursExpectedActivity
Fixed overhead
applied to products
3,200 machine hours × $3.00 fixed overhead rate
{
© McGraw-Hill Ryerson Limited., 2001
11-49
Results when standard hoursallowed for actual output differsfrom the denominator activity.
Volume Variance – A Closer Look
VolumeVariance
Favourablewhen standard hours> denominator hours
Unfavourablewhen standard hours< denominator hours
© McGraw-Hill Ryerson Limited., 2001
11-50
Results when standard hoursallowed for actual output differsfrom the denominator activity.
Volume Variance – A Closer Look
VolumeVariance
Favorablewhen standard hours> denominator hours
Unfavorablewhen standard hours< denominator hours
Does not measure over- or under spending
Explainable by and controllable only through
activity
© McGraw-Hill Ryerson Limited., 2001
11-51
Overhead Variances and Under- orOverapplied Overhead Cost
The sum of the overhead variancesequals the under- or overapplied
overhead cost for a period.
Favourablevariances are equivalentto overapplied overhead.
Unfavourablevariances are equivalent
to underapplied overhead.
In a standardcost system:
© McGraw-Hill Ryerson Limited., 2001
11-52
End of Chapter 11
I’m here to yourbudget. Are you ready to
ante up?
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