Chapter

7
Flexible Budgets and
Overhead Analysis
 Static Budgets and Performance
Reports Hmm! Comparing
static budgets with
actual costs is like
Static budgets are comparing apples
prepared for a single, and oranges.
planned level of
activity.
Performance
evaluation is difficult
when actual activity
differs from the
planned level of
activity.
Let’s look at CheeseCo.
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 Static Budgets and Performance
Reports
CheeseCo
Static Actual
Budget Results Variances
Machine hours 10,000 8,000
Variable costs
Ind irect labor $ 40,000 $ 34,000
Indirect materials 30,000 25,500
Power 5,000 3,800
Fixed costs
Depreciation 12,000 12,000
Insurance 2,000 2,050
Total overhead costs $ 89,000 $ 77,350

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 Static Budgets and Performance
Reports
CheeseCo
Static Actual
Budget Results Variances
Machine hours 10,000 8,000 2,000 U
Variable costs
U = Unfavorable
Ind irect labor $ 40,000
variance
$ 34,000 $6,000 F
IndirectCheeseCo
materials was30,000
unable to achieve
25,500 4,500 F
Power the budgeted level5,000 of activity.
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

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 Static Budgets and Performance
Reports
CheeseCo
Static Actual
Budget Results Variances
Machine hours 10,000 8,000 2,000 U
Variable costs
Ind irect 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
F = Favorable variance that occurs when
Fixed costs
actual costs are less than
Depreciation budgeted12,000
12,000 costs. 0
Insurance 2,000 2,050 50 U
Total overhead costs $ 89,000 $ 77,350 $11,650 F

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 Static Budgets and Performance
Reports
CheeseCo
Static Actual
Budget Results Variances
Machine hours 10,000 8,000 2,000 U
Variable costs
Ind irect 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
Since cost variances are favorable, have
Fixed costs
we done a good job controlling
Depreciation 12,000 costs?
12,000 0
Insurance 2,000 2,050 50 U
Total overhead costs $ 89,000 $ 77,350 $11,650 F

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 Static Budgets and Performance
Reports
I don’t think I Actual activity is below
can answer the budgeted activity which
question using is unfavorable.
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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 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.

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 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.

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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 ble
ar ia
unchanged within the V
relevant range. Fixed

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 Preparing a Flexible Budget

Let’s prepare
budgets
for CheeseCo.

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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
$ 32,000 amount per hour.
Indirect material 3.00 24,000
Power 0.50 $40,000
4,000÷ 10,000 hours is
Total variable cost $ 7.50 $4.00 per hour.
$ 60,000

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
Depreciation $4.00 per hour × 8,000 hours = $32,000
$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 $ 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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 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 laborfixed costs
Total 4.00 $ 32,000 $ 40,000 $ 48,000
Indirect material 3.00 24,000 30,000 36,000
Power
do not change in
0.50 4,000 5,000 6,000
the relevant
Total variable cost $range.
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

Let’s prepare a
budget performance
report
for CheeseCo.

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 Flexible Budget
Performance Report
CheeseCo
Cost Total
Flexible Formula
budget isFixed Flexible Actual
prepared
Per for
HourtheCosts Budget Results Variances
Machine hours
same activity level 8,000 8,000 0
(8,000 hours) as
Variable costs
actually $achieved.
Indirect labor 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
Depreciation $ 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

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 Flexible Budget
Performance Report
CheeseCo
Cost Total
Formula Fixed Flexible Actual
Per Hour Costs 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 costs $ 7.50 $ 60,000 $ 63,300 $ 3,300 U
Fixed Expenses
Depreciation $ 12,000 $ 12,000 $ 12,000 0
Insurance 2,000 2,000 2,050 50 U
Total fixed costs $ 14,000 $ 14,050 50 U
Total overhead costs $ 74,000 $ 77,350 $ 3,350 U

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 Flexible Budget
Performance Report
Remember the ques
tion:
“How much of the to
tal
variance is due to ac
tivity
and how much is due
to
cost control?”

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Static Budgets and Performance
How much of the $11,650 is due to activity
and how much is due to cost control?
Static Actual
Budget Results Variances
Machine hours 10,000 8,000 2,000 U
Variable costs
Ind irect 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

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 Flexible Budget
Performance Report
Overhead Variance Analysis
Static Let’s place Actual
Overhead the flexible Overhead
Budget at at
budget for
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 flexible

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

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 Flexible Budget
Performance Report
There are two primary
reasons for unfavorable
variable overhead variances:
What causes 1. Spending too much for
the cost resources.
control variance?
2. Using the resources
inefficiently.

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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 – Example

Let’s look at overhead

rates in a
budget for ColaCo.

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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
2,000 $ 4,000 ? $ 9,000 ?
4,000 8,000 ? 9,000 ?

Let’s calculate overhead rates.

ColaCo
ColaCoapplies
appliesoverhead
overheadbased
based
on
onmachine
machinehour
houractivity.
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
2,000 $ 4,000 $ 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
2,000 $ 4,000 $ 2.00 $ 9,000 $ 4.50
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
2,000 $ 4,000 $ 2.00 $ 9,000 $ 4.50
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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 Overhead Variances

Let’s use the

overhead rates, to
determine variable
and fixed overhead
variances.

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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.

Compute the variable overhead spending and

efficiency variances.

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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
$340unfavorable
unfavorableflexible
flexiblebudget
budget total
totalvariance
variance
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 Variable Overhead Variances – A
Closer Look
Spending Variance Efficiency Variance
Results from paying more
Controlled by
or less than expected for
managing the
overhead items and from
overhead cost driver.
excessive usage of
overhead items.

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 Overhead Variances

Now let’s turn

our attention
to fixed
overhead.

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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
2,000 $ 4,000 $ 2.00 $ 9,000 $ 4.50
4,000 8,000 2.00 9,000 2.25

What is ColaCo’s fixed overhead rate for an

estimated activity of 3,000 machine 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
2,000 $ 4,000 $ 2.00 $ 9,000 $ 4.50
4,000 8,000 2.00 9,000 2.25

What is ColaCo’s
Fixedfixed overhead
Overhead Rate rate for an
estimated
FR = activity
$9,000 ÷of 3,000
3,000 machine
machine hours?
hours
FR = $3.00 per machine hour

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 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.

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 Fixed Overhead Variances
Actual Fixed Fixed Fixed
Overhead Overhead Overhead
Incurred Budget Applied
SH × FR

Budget Volume
Variance Variance
FR = Standard Fixed Overhead Rate
SH = Standard Hours Allowed

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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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 Fixed Overhead Variances –
A Closer Look
Budget Variance Volume Variance

Results from paying more Results from operating

or less than expected for at an activity level
overhead items. different from the
denominator activity.

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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

e ad
e rh ucts
o v d
d pr o
ix e o
F t
li ed
p p
a Volume
3,000 Hours 3,200
Expected Standard
Activity Hours
Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2000
 Fixed Overhead Variances
3,200 machine hours × $3.00 fixed overhead rate
Cost
$9,600 applied fixed OH
$9,000 budgeted fixed OH
$8,450 actual fixed OH

e ad
e rh ucts
o v d
d pr o
ix e o
F t
li ed
p p
a Volume
3,000 Hours 3,200
Expected Standard
Activity Hours
Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2000
 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 ad
Variance e
rh ucts
ve
o r o d
e d p
Fix t o
li ed
p p
a Volume
3,000 Hours 3,200
Expected Standard
Activity Hours
Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2000
 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
allowed for actual output
Explainable by anddiffers
from the denominator activity.
controllable only through
activity
Unfavorable Favorable
when standard hours when standard hours
< denominator hours > denominator 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

I’m here to your

budget. Are you ready to
ante up?

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2000