Flexible Budgets and Overhead Analysis

CORNERSTONES
of Managerial Accounting, 5e
CHAPTER 11:
FLEXIBLE BUDGETS AND
OVERHEAD ANALYSIS
Cornerstones of Managerial
Accounting, 5e
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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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
Fixed Overhead Volume Variance
▪ The fixed overhead volume variance is the
difference between budgeted fixed overhead
(BFOH) and applied fixed overhead:
LO-3
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
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
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
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
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
Analysis of the Volume Variance
LO-3
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
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
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
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

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CORNERSTONES

▪ Actual variable overhead rate is computed as

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