Chapter
11
Flexible Budgets and
Overhead Analysis
11-2
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
1. Prepare a flexible budget and explain the
advantages of the flexible budget approach
over the static budget approach.
2. Prepare a performance report for both variable
and fixed overhead costs using the flexible
budget approach.
3. Use the flexible budget to prepare a variable
overhead performance report containing only
a spending variance.
© McGraw-Hill Ryerson Limited., 2001
11-3
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
4. Use the flexible budget to prepare a variable
overhead performance report containing both a
spending and an efficiency variance.
5. Explain the significance of the denominator
activity figure in determining the standard cost
of a unit of product.
6. Apply overhead cost to units of product in a
standard cost system.
7. Compute and interpret the fixed overhead
budget and volume variances.
© McGraw-Hill Ryerson Limited., 2001
11-4
Static Budgets and Performance
Reports
Hmm! Comparing
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.
static budgets with
actual costs is like
comparing apples
and oranges.
Let’s look at CheeseCo.
© McGraw-Hill Ryerson Limited., 2001
11-5
Static Budgets and Performance
Reports
CheeseCo
Static
Budget
Machine hours
Variable costs
Indirect labour
Indirect materials
Power
Fixed costs
Amortization
Insurance
Total overhead costs
Actual
Results
10,000
8,000
$ 40,000
30,000
5,000
$ 34,000
25,500
3,800
12,000
2,000
12,000
2,050
$ 89,000
$ 77,350
Variances
© McGraw-Hill Ryerson Limited., 2001
11-6
Static Budgets and Performance
Reports
CheeseCo
Static
Static
Budget
Budget
Machine
hours
Machine hours
10,000
10,000
Actual
Actual
Results
Results
Variances
Variances
8,000
8,000
2,000
U
2,000 U
Variable
costs
Variable costs
U = Unfavourable
Indirectlabour
labor
$ 40,000
$ 34,000
Indirect
40,000 variance
34,000
unable to achieve
IndirectCheeseCo
materials was30,000
25,500
Indirect
materials
30,000
25,500
level of activity.
Power the budgeted 5,000
5,000
3,800
Power
3,800
Fixed
costs
Fixed costs
Depreciation
Amortization
Insurance
Insurance
Total
overheadcosts
costs
Total overhead
$6,000
F
$6,000 F
4,500
F
4,500 F
1,200
F
1,200 F
12,000
12,000
2,000
2,000
12,000
12,000
2,050
2,050
00
50 U
U
$ 89,000
89,000
$ 77,350
77,350
$11,650
F
$11,650 F
© McGraw-Hill Ryerson Limited., 2001
11-7
Static Budgets and Performance
Reports
CheeseCo
Static
Static
Budget
Budget
Machine
hours
Machine hours
Variable
costs
Variable costs
Indirectlabour
labor
Indirect
Indirectmaterials
materials
Indirect
Power
Power
Actual
Actual
Results
Results
Variances
Variances
10,000
10,000
8,000
8,000
2,000
U
2,000 U
$ 40,000
40,000
30,000
30,000
5,000
5,000
$ 34,000
34,000
25,500
25,500
3,800
3,800
$6,000
F
$6,000 F
4,500
F
4,500 F
1,200
F
1,200 F
F = Favourable
variance that occurs when
Fixed
costs
Fixed
costs
Depreciation
12,000
actual
costs are less than
budgeted12,000
costs.
Amortization
12,000
12,000
Insurance
2,000
2,050
Insurance
2,000
2,050
Total
overheadcosts
costs
Total overhead
$ 89,000
89,000
$ 77,350
77,350
00
50 U
U
$11,650
F
$11,650 F
© McGraw-Hill Ryerson Limited., 2001
11-8
Static Budgets and Performance
Reports
CheeseCo
Static
Static
Budget
Budget
Machine
hours
Machine hours
Variable
costs
Variable costs
Indirectlabour
labor
Indirect
Indirectmaterials
materials
Indirect
Power
Power
Actual
Actual
Results
Results
Variances
Variances
10,000
10,000
8,000
8,000
2,000
U
2,000 U
$ 40,000
40,000
30,000
30,000
5,000
5,000
$ 34,000
34,000
25,500
25,500
3,800
3,800
$6,000
F
$6,000 F
4,500
F
4,500 F
1,200
F
1,200 F
Since
cost variances are favourable, have
Fixed
costs
Fixed costs
Depreciation
12,000
12,000
we
done a good job controlling
costs?
Amortization
12,000
12,000
Insurance
Insurance
Total
overheadcosts
costs
Total overhead
2,000
2,000
2,050
2,050
00
50 U
U
$ 89,000
89,000
$ 77,350
77,350
$11,650
F
$11,650 F
© McGraw-Hill Ryerson Limited., 2001
11-9
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 unfavourable.
So, shouldn’t variable costs
be lower if actual activity
is lower?
© McGraw-Hill Ryerson Limited., 2001
11-10
Static Budgets and Performance
Reports
! The relevant question is . . .
“How much of the favourable 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.
© McGraw-Hill Ryerson Limited., 2001
11-11
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.
© McGraw-Hill Ryerson Limited., 2001
11-12
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.
© 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 to
changes in activity.
"Total fixed costs remain
unchanged within the
relevant range.
le
b
ria
a
V
Fixed
© McGraw-Hill Ryerson Limited., 2001
11-14
Preparing a Flexible Budget
Let’s prepare
budgets
for CheeseCo.
© McGraw-Hill Ryerson Limited., 2001
11-15
Preparing a Flexible Budget
CheeseCo
Cost
Formula
Per Hour
Total
Fixed
Cost
Flexible Budgets
8,000
10,000
Hours
Hours
Machine hours
Variable costs
Indirect labour
Indirect material
Power
Total variable cost
Fixed costs
Amortization
Insurance
Total fixed cost
Total overhead costs
8,000
$
4.00
3.00
0.50
7.50
12,000
Hours
10,000
12,000
Variable costs are expressed as
$ 32,000 amount per hour.
a constant
24,000
$40,000
4,000 ÷ 10,000 hours
$ 60,000
$4.00 per hour.
$12,000
2,000
is
Fixed costs are
expressed as a
total amount.
© McGraw-Hill Ryerson Limited., 2001
11-16
Preparing a Flexible Budget
CheeseCo
Cost
Formula
Per Hour
Total
Fixed
Cost
Machine hours
Variable costs
Indirect labour
Indirect material
Power
Total variable cost
Flexible Budgets
8,000
10,000
Hours
Hours
8,000
$
Fixed costs
Amortization $4.00
Insurance
Total fixed cost
Total overhead costs
4.00
3.00
0.50
7.50
10,000
12,000
Hours
12,000
$ 32,000
24,000
4,000
$ 60,000
per hour
× 8,000 hours = $32,000
$12,000
2,000
© McGraw-Hill Ryerson Limited., 2001
11-17
Preparing a Flexible Budget
CheeseCo
Cost
Formula
Per Hour
Machine hours
Variable costs
Indirect labour
Indirect material
Power
Total variable cost
Fixed costs
Amortization
Insurance
Total fixed cost
Total overhead costs
$
4.00
3.00
0.50
7.50
Total
Fixed
Cost
Flexible Budgets
8,000
10,000
Hours
Hours
12,000
Hours
8,000
10,000
12,000
$ 32,000
24,000
4,000
$ 60,000
$ 40,000
30,000
5,000
$ 75,000
$ 48,000
36,000
6,000
$ 90,000
$12,000 $ 12,000
2,000
2,000
$ 14,000
$ 74,000
$ 12,000
2,000
$ 14,000
$ 89,000
$ 12,000
2,000
$ 14,000
$ 104,000
© McGraw-Hill Ryerson Limited., 2001
11-18
Preparing a Flexible Budget
CheeseCo
Cost
Formula
Per Hour
Machine hours
Variable costs
Indirect
labourfixed costs
4.00
Total
Indirect material
3.00
do not change0.50
in
Power
the relevant
Total variable
cost
$ range.
7.50
Fixed costs
Amortization
Insurance
Total fixed cost
Total overhead costs
Total
Fixed
Cost
Flexible Budgets
8,000
10,000
Hours
Hours
12,000
Hours
8,000
10,000
12,000
$ 32,000
24,000
4,000
$ 60,000
$ 40,000
30,000
5,000
$ 75,000
$ 48,000
36,000
6,000
$ 90,000
$12,000 $ 12,000
2,000
2,000
$ 14,000
$ 74,000
$ 12,000
2,000
$ 14,000
$ 89,000
$ 12,000
2,000
$ 14,000
$ 104,000
© McGraw-Hill Ryerson Limited., 2001
11-19
Flexible Budget
Performance Report
Let’s prepare a
budget performance
repor t
for CheeseCo.
© McGraw-Hill Ryerson Limited., 2001
11-20
Flexible Budget
Performance Report
CheeseCo
Cost
Total
FlexibleFormula
budget is
Fixed
prepared
for theCosts
Per Hour
same activity level
Machine hours
(8,000 hours) as
Variable costs
actually$achieved.
Indirect labour
4.00
Indirect material
Power
Total variable costs
Fixed Expenses
Amortization
Insurance
Total fixed costs
Total overhead costs
$
3.00
0.50
7.50
$ 12,000
2,000
Flexible
Budget
Actual
Results
8,000
8,000
$ 32,000
24,000
4,000
$ 60,000
$ 34,000
25,500
3,800
$ 63,300
$ 12,000
2,000
$ 14,000
$ 74,000
$ 12,000
2,050
$ 14,050
$ 77,350
Variances
0
© McGraw-Hill Ryerson Limited., 2001
11-21
Flexible Budget
Performance Report
CheeseCo
Cost
Formula
Per Hour
Total
Fixed
Costs
Machine hours
Variable costs
Indirect labour
Indirect material
Power
Total variable costs
Fixed Expenses
Amortization
Insurance
Total fixed costs
Total overhead costs
$
$
4.00
3.00
0.50
7.50
$ 12,000
2,000
Flexible
Budget
Actual
Results
8,000
8,000
$ 32,000
24,000
4,000
$ 60,000
$ 34,000
25,500
3,800
$ 63,300
$ 2,000 U
1,500 U
200 F
$ 3,300 U
$ 12,000
2,000
$ 14,000
$ 74,000
$ 12,000
2,050
$ 14,050
$ 77,350
0
50 U
50 U
$ 3,350 U
Variances
0
© McGraw-Hill Ryerson Limited., 2001
11-22
Flexible Budget
Performance Report
Remember the ques
tio
“How much of the to n:
ta
variance is due to ac l
tivity
and how much is du
e to
cost control?”
© McGraw-Hill Ryerson Limited., 2001
11-23
Static Budgets and Performance
How much of the $11,650 is due to activity
and how much is due to cost control?
Static
Budget
Machine hours
Variable costs
Indirect labour
Indirect materials
Power
Fixed costs
Amortization
Insurance
Total overhead costs
Actual
Results
Variances
10,000
8,000
2,000 U
$ 40,000
30,000
5,000
$ 34,000
25,500
3,800
$6,000 F
4,500 F
1,200 F
12,000
2,000
12,000
2,050
0
50 U
$ 89,000
$ 77,350
$11,650 F
© McGraw-Hill Ryerson Limited., 2001
11-24
Flexible Budget
Performance Report
Overhead Variance Analysis
Static
Overhead
Budget at
10,000 Hours
$
89,000
Let’s place
the flexible
budget for
8,000 hours
here.
Actual
Overhead
at
8,000 Hours
$
77,350
Difference between original static budget
and actual overhead = $11,650 F.
© McGraw-Hill Ryerson Limited., 2001
11-25
Flexible Budget
Performance Report
Overhead Variance Analysis
Static
Overhead
Budget at
10,000 Hours
$
89,000
Flexible
Overhead
Budget at
8,000 Hours
$
Activity
This $15,000F variance is
due to lower activity.
74,000
Actual
Overhead
at
8,000 Hours
$
77,350
Cost control
This $3,350U flexible
budget variance is due
to poor cost control.
© McGraw-Hill Ryerson Limited., 2001
11-26
Flexible Budget
Performance Report
There are two primary
reasons for unfavourable
variable overhead variances:
What causes
the cost
control variance?
1. Spending too much for
resources.
2. Using the resources
inefficiently.
© McGraw-Hill Ryerson Limited., 2001
11-27
Overhead Rates and Overhead
Analysis
Recall that overhead costs are assigned to
products and services using a
predetermined overhead rate (POHR):
Assigned Overhead = POHR × Standard Activity
POHR
=
Overhead from the
flexible budget for the
denominator level of activity
Denominator level of activity
© McGraw-Hill Ryerson Limited., 2001
11-28
Overhead Rates and Overhead
Analysis – Example
Let’s look at overhead
rates in a
budget for ColaCo.
© McGraw-Hill Ryerson Limited., 2001
11-29
Overhead Rates and Overhead
Analysis – Example
ColaCo prepared this
Machine
Hours
2,000
4,000
Total
Variable
Overhead
$
budget for overhead:
Variable
Overhead
Rate
4,000
?
8,000
?
Total
Fixed
Overhead
$
Fixed
Overhead
Rate
9,000
?
9,000
?
Let’s calculate overhead rates.
ColaCo
ColaCo applies
appliesoverhead
overheadbased
based
on
onmachine
machinehour
houractivity.
activity.
© McGraw-Hill Ryerson Limited., 2001
11-30
Overhead Rates and Overhead
Analysis – Example
ColaCo prepared this
Machine
Hours
2,000
4,000
budget for overhead:
Total
Variable
Overhead
Variable
Overhead
Rate
Total
Fixed
Overhead
$
$
$
4,000
8,000
2.00
2.00
Fixed
Overhead
Rate
9,000
?
9,000
?
Rate = Total Variable Overhead ÷ Machine Hours
This rate is constant at all levels of activity.
© McGraw-Hill Ryerson Limited., 2001
11-31
Overhead Rates and Overhead
Analysis – Example
ColaCo prepared this
Machine
Hours
2,000
4,000
budget for overhead:
Total
Variable
Overhead
Variable
Overhead
Rate
Total
Fixed
Overhead
Fixed
Overhead
Rate
$
$
$
$
4,000
8,000
2.00
2.00
9,000
9,000
4.50
2.25
Rate = Total Fixed Overhead ÷ Machine Hours
This rate decreases when activity increases.
© McGraw-Hill Ryerson Limited., 2001
11-32
Overhead Rates and Overhead
Analysis – Example
ColaCo prepared this
Machine
Hours
2,000
4,000
budget for overhead:
Total
Variable
Overhead
Variable
Overhead
Rate
Total
Fixed
Overhead
Fixed
Overhead
Rate
$
$
$
$
4,000
8,000
2.00
2.00
9,000
9,000
4.50
2.25
The total POHR is the sum of
the fixed and variable rates
for a given activity level.
© McGraw-Hill Ryerson Limited., 2001
11-33
Overhead Variances
Let’s use the
overhead rates, to
determine variable
and fixed overhead
variances.
© McGraw-Hill Ryerson Limited., 2001
11-34
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.
© McGraw-Hill Ryerson Limited., 2001
11-35
Variable Overhead Variances
Actual
Variable
Overhead
Incurred
Flexible Budget
for Variable
Overhead at
Actual Hours
AH × AR
AH × SR
Spending
Variance
Flexible Budget
for Variable
Overhead at
Standard Hours
SH × SR
Efficiency
Variance
Spending variance = AH(AR - SR)
Efficiency variance = SR(AH - SH)
© McGraw-Hill Ryerson Limited., 2001
11-36
Variable Overhead Variances –
Example
Actual
Variable
Overhead
Incurred
Flexible Budget
for Variable
Overhead at
Actual Hours
3,300 hours
×
$2.00 per hour
$6,740
Spending variance
$140 unfavourable
$6,600
Flexible Budget
for Variable
Overhead at
Standard Hours
3,200 hours
×
$2.00 per hour
$6,400
Efficiency variance
$200 unfavourable
$340
$340unfavourable
unfavourableflexible
flexiblebudget
budgettotal
totalvariance
variance
© McGraw-Hill Ryerson Limited., 2001
11-37
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.
Efficiency Variance
Controlled by
managing the
overhead cost driver.
© McGraw-Hill Ryerson Limited., 2001
11-38
Overhead Variances
Now let’s turn
our attention
to fixed
overhead.
© McGraw-Hill Ryerson Limited., 2001
11-39
Overhead Rates and Overhead
Analysis – Example
ColaCo prepared this
Machine
Hours
2,000
4,000
budget for overhead:
Total
Variable
Overhead
Variable
Overhead
Rate
Total
Fixed
Overhead
Fixed
Overhead
Rate
$
$
$
$
4,000
8,000
2.00
2.00
9,000
9,000
4.50
2.25
What is ColaCo’s fixed overhead rate for an
estimated activity of 3,000 machine hours?
© McGraw-Hill Ryerson Limited., 2001
11-40
Overhead Rates and Overhead
Analysis – Example
ColaCo prepared this
Machine
Hours
2,000
4,000
budget for overhead:
Total
Variable
Overhead
Variable
Overhead
Rate
Total
Fixed
Overhead
Fixed
Overhead
Rate
$
$
$
$
4,000
8,000
2.00
2.00
9,000
9,000
4.50
2.25
What is ColaCo’s
overhead
Fixedfixed
Overhead
Rate rate for an
estimated
3,000
machine
hours?
FR = activity
$9,000 ÷of
3,000
machine
hours
FR = $3.00 per machine hour
© McGraw-Hill Ryerson Limited., 2001
11-41
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.
© McGraw-Hill Ryerson Limited., 2001
11-42
Fixed Overhead Variances
Actual Fixed
Overhead
Incurred
Budget
Variance
Fixed
Overhead
Budget
Fixed
Overhead
Applied
SH × FR
Volume
Variance
FR = Standard Fixed Overhead Rate
SH = Standard Hours Allowed
© McGraw-Hill Ryerson Limited., 2001
11-43
Fixed Overhead Variances –
Example
Actual Fixed
Overhead
Incurred
Fixed
Overhead
Budget
Fixed
Overhead
Applied
SH × FR
3,200 hours
×
$3.00 per hour
$8,450
$9,000
$9,600
Budget variance
$550 favourable
Volume variance
$600 favourable
© McGraw-Hill Ryerson Limited., 2001
11-44
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.
© McGraw-Hill Ryerson Limited., 2001
11-45
Overhead Variances
Let’s look at a
graph showing
fixed overhead
variances. We will
use ColaCo’s
numbers from the
previous example.
© McGraw-Hill Ryerson Limited., 2001
11-46
Fixed Overhead Variances
Cost
ad
e
rh ucts
e
v
d
o
o
r
d
p
e
x
o
i
t
F
ed
i
l
p
p
a
3,000 Hours
Expected
Activity
Volume
3,200
Standard
Hours
© McGraw-Hill Ryerson Limited., 2001
11-47
Fixed Overhead Variances
Cost
3,200 machine hours × $3.00 fixed overhead rate
$9,600 applied fixed OH
$9,000 budgeted fixed OH
$8,450 actual fixed OH
ad
e
rh ucts
e
v
d
o
o
r
d
p
e
x
o
i
t
F
ed
i
l
p
p
a
3,000 Hours
Expected
Activity
Volume
3,200
Standard
Hours
© McGraw-Hill Ryerson Limited., 2001
11-48
Fixed Overhead Variances
Cost
$600
Favourable
Volume
Variance
{
$550 {
Favourable
Budget
Variance
3,200 machine hours × $3.00 fixed overhead rate
$9,600 applied fixed OH
$9,000 budgeted fixed OH
$8,450 actual fixed OH
ad
e
rh ucts
e
v
d
o
o
r
d
p
e
x
o
i
t
F
ed
i
l
p
p
a
3,000 Hours
Expected
Activity
Volume
3,200
Standard
Hours
© McGraw-Hill Ryerson Limited., 2001
11-49
Volume Variance – A Closer Look
Volume
Variance
Results when standard hours
allowed for actual output differs
from the denominator activity.
Unfavourable
when standard hours
< denominator hours
Favourable
when standard hours
> denominator hours
© McGraw-Hill Ryerson Limited., 2001
11-50
Volume Variance – A Closer Look
Volume
Variance
Does not
measure overor under spending
Results when standard hours
allowed
for actual output
differs
Explainable
by and
from the denominator activity.
controllable only through
activity
Unfavorable
when standard hours
< denominator hours
Favorable
when standard hours
> denominator hours
© McGraw-Hill Ryerson Limited., 2001
11-51
Overhead Variances and Under- or
Overapplied Overhead Cost
In a standard
cost system:
Unfavourable
variances are equivalent
to underapplied overhead.
Favourable
variances are equivalent
to overapplied overhead.
The sum of the overhead variances
equals the under- or overapplied
overhead cost for a period.
© McGraw-Hill Ryerson Limited., 2001
11-52
End of Chapter 11
I’m here to
your
budget. Are you ready to
ante up?
© McGraw-Hill Ryerson Limited., 2001