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Managerial Accounting Flexible Budget

Characteristics of a Flexible Budget The budgets that we studied in Chapter 9 were
static budgets.Astatic budgetis prepared at the beginning of the budgeting period
and is valid for only the planned level of activity. Astatic budget approach is suitable
for planning, but it is inadequate for evaluating how well costs are controlled. If the
actual level of activity during a period differs from what was planned, it would be
misleading to simply compare actual costs to the static budget. If activity is higher
than expected, variable costs should be higher than expected; and if activity is
lower than expected, variable costs should be lower than expected. Flexible budgets
take into account changes in costs that should occur as a consequence of changes
in activity. Aflexible budget provides estimates of what costs should be for any level
of activity within a specified range. When a flexible budget is used in performance
evaluation, actual costs are compared to what the costs should have been for the
actual level of activity during the period rather than to the budgeted costs from the
original budget. This is a very important distinctionparticularly for variable costs.
If adjustments for the level of activity are not made, it is very difficult to interpret
discrepancies between budgeted and actual costs.

Overhead Rates and Fixed Overhead Analysis

Fixed overhead variances are different from variable overhead variances because of
the difference in the nature of the costs. To provide a background for our discussion,
we will first briefly review the need for, and computation of, predetermined
overhead rates. This review will be helpful, since the predetermined overhead rate
plays a major role in fixed overhead analysis. We will then show how fixed overhead
variances are computed and make some observations about their usefulness to
Flexible Budgets and Overhead Rates Fixed costs come in large, indivisible pieces
that by definition do not vary with changes in the level of activity within the
relevant range. This creates a problem in product costing, since the average fixed
cost per unit will vary with the level of activity.

Overhead Application in a Standard Cost System

To understand fixed overhead variances, it is necessary first to understand how
overhead is applied to work in process in a standard cost system. Recall that in
Chapter 3 we applied overhead to work in process on the basis of actual hours of
activity (multiplied by the predetermined overhead rate). This procedure was
correct, since at the time we were dealing with a normal cost system.1 However, we
are now dealing with a standard cost system. In such a system, overhead is applied
to work in process on the basis of the standard hours allowed for the output of the
period rather than on the basis of the actual number of hours worked. This point is

illustrated in Exhibit 119. In a standard cost system, every unit of product is

charged with the same amount of overhead cost, regardless of how much time the
unit actually requires for processing.

The Volume Variance

A Closer Look The volume variance is a measure of utilization of facilities. The
variance arises whenever the standard hours allowed for the output of a period are
different from the denominator activity level that was planned when the period
began. It can be computed as shown in Exhibit 1110 or by using the following

Cautions in Fixed Overhead Analysis

A volume variance for fixed overhead arises because when applying the costs to
work in process, we act as if the fixed costs were variable and depended on activity.
This point can be seen from the graph in Exhibit 1112. Notice from the graph that
the fixed overhead costs are applied to work in process at a rate of $6 per hour as if
they were variable. Treating these costs as if they were variable is necessary for
product costing purposes, but some real dangers lurk here. Managers can easily be
misled into thinking that fixed costs are in fact variable. Keep clearly in mind that
fixed overhead costs come in large, indivisible pieces. Expressing fixed costs on a
unit or per hour basis, though necessary for product costing for external reports, is
artificial. Increases or decreases in activity in fact have no effect on total fixed costs
within the relevant range of activity. Even though fixed costs are expressed on a
unit or per hour basis, they are not proportional to activity. In a sense, the volume
variance is the error that occurs as a result of treating fixed costs as variable costs
in the costing system.