Flexible Budgets and

Overhead Analysis

Chapter Eleven

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Static Budgets and Performance Reports

Hmm! Comparing
static budgets with
Static budgets actual costs is like
are prepared for comparing apples
a single, planned and oranges.
level of activity.
Performance
evaluation is difficult
when actual activity
differs from the
planned level of
activity.
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 Flexible Budgets

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.

Improve performance evaluation.

Let’s look at CheeseCo.

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Static Budgets and Performance Reports

CheeseCo

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Static Budgets and Performance Reports

CheeseCo

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Static Budgets and Performance Reports

CheeseCo

U = Unfavorable variance
CheeseCo was unable to achieve
the budgeted level of activity.

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Static Budgets and Performance Reports

CheeseCo

F = Favorable variance that occurs when

actual costs are less than budgeted costs.

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Static Budgets and Performance Reports

CheeseCo

Since cost variances are favorable, have

we done a good job controlling costs?

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Static Budgets and Performance Reports

I don’t think I
can answer the Actual activity is below
question using budgeted activity.
a static budget. So, shouldn’t variable costs
be lower if actual activity
is lower?

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Static Budgets and Performance Reports

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.

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 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. Fixed

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 Preparing a Flexible Budget

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 Preparing a Flexible Budget

CheeseCo
Cost Total Flexible Budgets
Formula Fixed 8,000 10,000 12,000
per Hour Cost Hours Hours Hours
Machine hours 8,000 10,000 12,000
Variable costs Variable costs are expressed as
Indirect labor $ 4.00 a constant amount per hour.
Indirect material 3.00
Power 0.50 $40,000 ÷ 10,000 hours is
Total variable cost $ 7.50 $4.00 per hour.
Fixed costs Fixed costs are
Depreciation $ 12,000
Insurance 2,000
expressed as a
Total fixed cost total amount.
Total overhead costs
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 Preparing a Flexible Budget

CheeseCo
Cost Total Flexible Budgets
Formula Fixed 8,000 10,000 12,000
per Hour Cost Hours Hours Hours
Machine hours 8,000 10,000 12,000
Variable costs
Indirect labor $ 4.00 $ 32,000
Indirect material 3.00 24,000
Power 0.50 4,000
Total variable cost $ 7.50 $ 60,000

Fixed costs $4.00 per hour × 8,000 hours = $32,000

Depreciation $ 12,000
Insurance 2,000
Total fixed cost
Total overhead costs
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 Preparing a Flexible Budget

CheeseCo
Cost Total Flexible Budgets
Formula Fixed 8,000 10,000 12,000
per Hour Cost Hours Hours Hours
Machine hours 8,000 10,000 12,000
Variable costs
Indirect labor $ 4.00 $ 32,000
Indirect material 3.00 24,000
Power 0.50 4,000
Total variable cost $ 7.50 $ 60,000

Fixed costs
Depreciation $ 12,000 $ 12,000
Insurance 2,000 2,000
Total fixed cost $ 14,000
Total overhead costs $ 74,000
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 Preparing a Flexible Budget

CheeseCo
Cost Total Flexible Budgets
Formula Fixed 8,000 10,000 12,000
per Hour Cost Hours Hours Hours
Machine hours 8,000 10,000 12,000
Variable costs
Indirect labor $ 4.00 $ 32,000 $ 40,000
Indirect material 3.00 fixed costs
Total 24,000 30,000
Power 0.50
do not change in4,000 5,000
Total variable cost $ 7.50 $ 60,000 $ 75,000
the relevant range.
Fixed costs
Depreciation $ 12,000 $ 12,000 $ 12,000
Insurance 2,000 2,000 2,000
Total fixed cost $ 14,000 $ 14,000
Total overhead costs $ 74,000 $ 89,000 ?
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 Preparing a Flexible Budget

Cost Total Flexible Budgets

Formula Fixed 8,000 10,000 12,000
per Hour Cost Hours Hours Hours
Machine hours 8,000 10,000 12,000
Variable costs
Indirect labor $ 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
Depreciation $ 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
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 Flexible Budget Performance Report

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 Flexible Budget Performance Report
CheeseCo
Flexible budget Cost
is Total
prepared for the
Formula Fixed Flexible Actual
same activity level
per Hour Cost Budget Results Variances
(8,000
Machine hours) as
hours 8,000 8,000 0
actually achieved.
Variable costs
Indirect labor $ 4.00 $ 34,000
Indirect material 3.00 25,500
Power 0.50 3,800
Total variable cost $ 7.50 $ 63,300

Fixed costs
Depreciation $ 12,000 $ 12,000
Insurance 2,000 2,050
Total fixed cost $ 14,050
Total overhead costs $ 77,350
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 Flexible Budget Performance Report
CheeseCo
Cost Total
Formula Fixed Flexible Actual
per Hour Cost Budget Results Variances
Machine hours 8,000 8,000 0
Variable costs
Indirect labor $ 4.00 $ 32,000 $ 34,000 $ 2,000 U
Indirect material 3.00 25,500
Power 0.50 3,800
Total variable cost $ 7.50 $ 63,300

Fixed costs
Depreciation $ 12,000 $ 12,000
Insurance 2,000 2,050
Total fixed cost $ 14,050
Total overhead costs $ 77,350
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 Quick Check 

What is the variance for indirect material when the

flexible budget for 8,000 hours is compared to the
actual results?
a. $1,500 U
b. $1,500 F
c. $4,500 U
d. $4,500 F

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 Flexible Budget Performance Report
CheeseCo
Cost Total
Formula Fixed Flexible Actual
per Hour Cost Budget Results Variances
Machine hours 8,000 8,000 0
Variable costs
Indirect labor $ 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 F
Total variable cost $ 7.50 $ 60,000 $ 63,300 $ 3,300 U

Fixed costs
Depreciation $ 12,000 $ 12,000 $ 12,000 $ 0
Insurance 2,000 2,000 2,050 50 U
Total fixed cost $ 14,000 $ 14,050 50 U
Total overhead costs $ 74,000 $ 77,350 $ 3,350 U
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 Flexible Budget Performance Report

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 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?

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 Flexible Budget Performance Report

Overhead Variance Analysis

Static Let’s place Actual
Overhead the flexible Overhead
Budget at budget for at
10,000 Hours 8,000 Hours
8,000 hours
$ 89,000 here. $ 77,350

Difference between original static budget

and actual overhead = $11,650 F.

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 Flexible Budget Performance Report

Overhead Variance Analysis

Static Flexible Actual
Overhead Overhead Overhead
Budget at Budget at at
10,000 Hours 8,000 Hours 8,000 Hours
$ 89,000 $ 74,000 $ 77,350

Activity Cost control

This $15,000F variance is This $3,350U

due to lower activity. variance is due
to poor cost control.

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The Measure of Activity– A Critical Choice

Three important
factors in selecting an
activity base for an overhead
flexible budget
Activity base and
Activity base should
variable overhead
be simple and
should be
easily understood.
causally related.
Activity base should
not be expressed
in dollars or
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 Variable Overhead Variances –
A Closer Look

If flexible budget If flexible budget

is based on is based on
actual hours standard hours

Both spending
Only a spending
and efficiency
variance can be
variances can be
computed.
computed.

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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. 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.
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 Variable Overhead Variances

Actual Flexible Budget

Variable for Variable
Overhead Overhead at
Incurred Actual Hours
AH × AR AH × SR
AH = Actual hours
AR = Actual variable
Spending overhead rate
Variance SR = Standard variable
overhead rate

Spending variance = AH(AR – SR)

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Variable Overhead Variances – Example

Actual Flexible Budget

Variable for Variable
Overhead Overhead at
Incurred Actual Hours
3,300 hours
×
$2.00 per hour
$6,740 = $6,600

Spending Variance
= $140 unfavorable

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 Variable Overhead Variances –
A Closer Look

Spending Variance
Results from paying more
or less than expected for
overhead items and from Now, let’s use the
excessive usage of standard hours allowed,
overhead items. along with the actual
hours, to compute the
efficiency variance.

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 Variable Overhead Variances

Actual Flexible Budget Flexible Budget

Variable for Variable for Variable
Overhead Overhead at Overhead at
Incurred Actual Hours Standard Hours
AH × AR AH × SR SH × SR

Spending Efficiency
Variance Variance
Spending variance = AH(AR - SR)
Efficiency variance = SR(AH - SH)

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Variable Overhead Variances – Example

Actual Flexible Budget Flexible Budget

Variable for Variable for Variable
Overhead Overhead at Overhead at
Incurred Actual Hours Standard Hours
3,300 hours 3,200 hours
× ×
$2.00 per hour $2.00 per hour
$6,740 $6,600 $6,400

Spending variance Efficiency variance

$140 unfavorable $200 unfavorable
$340 unfavorable flexible budget total variance
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 Variable Overhead Variances –
A Closer Look

Efficiency Variance

Controlled by
managing the
overhead cost driver.

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 Quick Check Summary

Actual Flexible Budget Flexible Budget

Variable for Variable for Variable
Overhead Overhead at Overhead at
Incurred Actual Hours Standard Hours
2,050 hours 2,100 hours
× ×
$5 per hour $5 per hour
$10,950 $10,250 $10,500

Spending variance Efficiency variance

$700 unfavorable $250 favorable
$450 unfavorable flexible budget total variance
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 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.

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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

Overhead from the

flexible budget for the
denominator level of activity
POHR =
Denominator level of activity

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Overhead Rates and Overhead Analysis

The predetermined overhead rate

can be broken down into fixed
and variable components.

The variable The fixed

component is useful component is useful
for preparing and analyzing for preparing and analyzing
variable overhead fixed overhead
variances. variances.

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 Normal versus Standard Cost Systems

In a normal cost In a standard cost

system, overhead is system, overhead is
applied to work in applied to work in
process based on process based on
the actual number the standard hours
of hours worked allowed for the output
in the period. of the period.

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 Fixed Overhead Variances

Actual Fixed Fixed Fixed

Overhead Overhead Overhead
Incurred Budget Applied
DH × FR SH × FR

Budget Volume
Variance Variance

FR = Standard Fixed Overhead Rate

SH = Standard Hours Allowed
DH = Denominator Hours
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 Overhead Rates and Overhead
Analysis – Example

ColaCo prepared this budget for overhead:

Total Variable Total Fixed

Machine Variable Overhead Fixed Overhead
Hours Overhead Rate Overhead Rate
3,000 $ 6,000 ? $ 9,000 ?
4,000 8,000 ? 9,000 ?

Let’s calculate overhead rates.

ColaCo applies overhead based

on machine-hour activity.
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 Overhead Rates and Overhead
Analysis – Example

ColaCo prepared this budget for overhead:

Total Variable Total Fixed

Machine Variable Overhead Fixed Overhead
Hours Overhead Rate Overhead Rate
3,000 $ 6,000 $ 2.00 $ 9,000 ?
4,000 8,000 2.00 9,000 ?

Rate = Total Variable Overhead ÷ Machine Hours

This rate is constant at all levels of activity.

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 Overhead Rates and Overhead
Analysis – Example

ColaCo prepared this budget for overhead:

Total Variable Total Fixed

Machine Variable Overhead Fixed Overhead
Hours Overhead Rate Overhead Rate
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.

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 Overhead Rates and Overhead
Analysis – Example

ColaCo prepared this budget for overhead:

Total Variable Total Fixed

Machine Variable Overhead Fixed Overhead
Hours Overhead Rate Overhead Rate
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.
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 Fixed Overhead Variances – Example

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.

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 Overhead Variances

Now let’s turn

our attention
to calculating
fixed overhead
variances.

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 Fixed Overhead Variances – Example

Actual Fixed Fixed Fixed

Overhead Overhead Overhead
Incurred Budget Applied

$8,450 $9,000

Budget variance
$550 favorable
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 Fixed Overhead Variances –
A Closer Look

Budget Variance

Results from spending

more or less than
Now, let’s use the
expected for fixed
standard hours allowed
overhead items.
to compute the fixed
overhead volume
variance.

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 Fixed Overhead Variances – Example

Actual Fixed Fixed Fixed

Overhead Overhead Overhead
Incurred Budget Applied
SH × FR
3,200 hours
×
$3.00 per hour
$8,450 $9,000 $9,600

Budget variance Volume variance

$550 favorable $600 favorable
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 Volume Variance – A Closer Look

Volume
Variance

Results when standard hours

allowed for actual output differs
from the denominator activity.

Unfavorable Favorable
when standard hours when standard hours
< denominator hours > denominator hours
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 Volume Variance – A Closer Look

Volume
Variance
Does not measure over-
or under spending
Results when standard hours
Itallowed
resultsforfrom
actualtreating fixed
output differs
from the denominator
overhead activity.
as if it were a
variable cost.
Unfavorable Favorable
when standard hours when standard hours
< denominator hours > denominator hours
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 Overhead Variances

Let’s look at a
graph showing
fixed overhead
variances. We will
use ColaCo’s
numbers from the
previous example.
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 Fixed Overhead Variances

Cost

$9,000 budgeted fixed OH

Activity
3,000 Hours
Expected
Activity
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 Fixed Overhead Variances

Cost

$9,000 budgeted fixed OH

$550
Favorable
{ $8,450 actual fixed OH
Budget
Variance

Activity
3,000 Hours
Expected
Activity
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 Fixed Overhead Variances

3,200 machine hours × $3.00 fixed overhead rate

Cost
$600
Favorable $9,600 applied fixed OH
Volume
Variance { $9,000 budgeted fixed OH
$550 { $8,450 actual fixed OH
Favorable
Budget
Variance

Activity
3,000 Hours 3,200
Expected Standard
Activity Hours
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 Overhead Variances and Under- or
Overapplied Overhead Cost

In a standard
cost system:

Unfavorable Favorable
variances are equivalent variances are equivalent
to underapplied overhead. to overapplied overhead.

The sum of the overhead variances

equals the under- or overapplied
overhead cost for a period.
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 End of Chapter 11

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