Chapter 11

Standard costs for control:

flexible budgets and
manufacturing overhead

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 Outline
• Flexible budgets
• Input and output measures
• Overhead application in a standard
costing system
• Overhead cost variances
• Standard costs for product costing
• Standard costing systems
• Activity-based budgeting
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 Flexible budgets
• A detailed budget prepared for a range of
levels of activity
• Often restricted to flexing overhead costs
to various levels of activity
• Allows the selection of the most
appropriate benchmark for cost control
• Provides a valid basis for comparing
actual and expected costs to budget, for
the actual level of activity
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 Static and flexible budgets for
moleskins, R.M. Williams

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 Input measures and output
measures
• Units of output as a measure of the level
of activity in a multi-product firm
• Output can be measured as the standard
quantity of input allowed, given actual
output
• Choice between input and output
measures becomes important when
multiple products are manufactured

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 Flexible overhead budget
• Flexible overhead budget shows
overhead costs at various levels of
activity using the following formula:

(cont.)

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 Flexible manufacturing overhead
budget, R.M. Williams

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 Overhead application in a
standard costing system
• Overhead application is the method of
allocating overhead cost to products
− Recorded in the WIP inventory account
• Overhead is applied to inventory
using the standard overhead rate
• The activity chosen for the standard
overhead rate should be a cost driver

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 Calculating overhead cost
variances
• The flexible budget provides a tool for
controlling manufacturing overhead costs
• Can be used to calculate the amount of
overhead cost that should have been
incurred given the actual level of activity
• Four different overhead variances can be
calculated to compare the actual
overhead cost with the flexible budget
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Calculating variable overhead
cost variances
• Variable overhead spending variance
– A measure of the difference between the
actual variable overhead and the
standard variable overhead rate
multiplied by actual activity
= Actual variable overhead – (AH × SVR)
where AH = actual direct labour hours
SVR = standard variable
overhead rate (cont.)

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 Calculating variable overhead
cost variances (cont.)
• Variable overhead efficiency variance
– A measure of the difference between the
actual activity and the standard activity
allowed, given the actual output multiplied by
the standard variable overhead rate
= SVR(AH – SH)
Where SH = standard direct labour hours
allowed for actual output
AH = actual direct labour hours
SVR = standard variable overhead rate
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 Variable overhead spending and
efficiency variances, R.M. Williams

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 Interpreting variable overhead
variances
• Spending variance
– Variance result after adjusting for the
actual quantity of cost driver used
• Efficiency variance
– The cost effect of excessive or minimal
use of the particular activity (cost driver)
• The spending variance provides the
‘real’ control information for variable
overhead
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 Calculating fixed overhead
variances
• Fixed overhead budget variance
– The difference between actual fixed overhead
and budgeted fixed overhead
= actual fixed overhead – budgeted fixed overhead
• Fixed overhead volume variance
– The difference between budgeted fixed overhead
and fixed overhead applied to production
= budgeted fixed overhead – applied fixed overhead

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 Fixed overhead budget and volume
variances, R.M. Williams

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 Interpreting fixed overhead
variances
• Fixed overhead budget variance
– Used for cost control
– Assumes fixed overhead will not change
• Fixed overhead volume variance
– Standard cost driver allowed for actual
output is more/less than planned
– Reconciles the two purposes of costing
systems: product costing and cost
control
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 Four-way, three-way and two-way
overhead variance analysis,
R.M. Williams

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 Standard costs for product
costing
• Costs of direct material, direct labour
and manufacturing overhead are
charged to inventory at standard costs,
not actual costs
• Variances are closed off at end of the
accounting period
– To Cost of Goods Sold expense
– Prorate between WIP, FG and COGS
inventory if the amount is large
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 Criticisms of standard
costing systems
• Variances are too aggregated and
concentrate on consequences rather
than the causes of problems
• Variance reports too late to be useful
− Monthly reporting may be too late to
correct problems
• Standard costing systems tend to focus
too heavily on cost minimisation
(cont.)
− can adversely affect other areas
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 Criticisms of standard
costing systems (cont.)
• Standard costing systems take a
departmental perspective rather than a
process perspective
– Can lead to missing opportunities for cost
control
– Controlling one department’s costs may
increase costs in other departments
• Too much emphasis is placed on the
cost and efficiency of direct labour (cont.)
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 Criticisms of standard
costing systems (cont.)
• Overhead variances give limited cost
control information
• Standard costs do not explicitly
encourage continuous improvement
• Standard costs become outdated
quickly due to short product life cycles
• Do not capture the full costs of materials
– Ordering and paying for materials,
storage, handling, rework
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 Advantages of standard
costing
• Provide a good basis for cost
comparisons
• Enable managers to use ‘management
by exception’
• Provide a basis for managerial
performance evaluation and
determining bonuses
(cont.)

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 Advantages of standard
costing (cont.)
• Participation in setting standards and
assigning responsibility for certain
variances can motivate employees
• May lead to more stable product
costs compared to using actual costs
• Can be used for external financial
reporting

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 Activity-based budgeting
• A process of building up budgets from
the major activities of the business
• Uses principles of ABC to estimate a
firm’s future demand for resources
• ABB works in reverse to ABC
• ABB may be complex and costly to
implement
(cont.)

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 Activity-based costing versus
activity-based budgeting

Source: adapted from Cooper & Slagmulder (2000a)

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Activity-based budget, R.M. Williams

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 Activity-based budgeting (cont.)
• Activity-based flexible budgets
– Under ABB it is not practical to formulate
a series of flexible budgets, prior to the
commencement of the year.
– ABB flexible budgets may be used as a
benchmark at the end of a period to
compare against actual costs.
– Such flexible budgets may provide more
accurate benchmarks than conventional
flexible budgets
(cont.)

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 Activity-based budgeting (cont.)
• Inaccuracies in ABB Systems
– Spending versus consumption of
resources
– Estimates of non-manufacturing activities
may be distorted
– Shared resources may not be accounted
for accurately
– Information requirements for ABB are high
compared to traditional budgeting systems

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 Summary
• A flexible budget can be used to
control manufacturing costs
• Cost variances can be calculated for
variable and fixed overheads, but
their usefulness can be questioned
• Standard costing systems have been
criticised in the light of more modern
methods
• Activity-based budgeting may provide
more accurate benchmarks
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