Agenda: Flexible Budgets and Overhead Analysis

TM 11-1

AGENDA: FLEXIBLE BUDGETS AND OVERHEAD ANALYSIS

A.Flexible budgets and performance reports

1.Static budgets

2.Flexible budgets

3.Flexible budget overhead performance report

B.Further analysis of variable overhead

1.The choice of activity measure

2.Variable overhead spending variance

3.Variable overhead efficiency variance

C.Overhead application in a standard cost system

1.Predetermined overhead rate

2.Applying overhead

D.Fixed overhead variances

1.Budget variance

2.Volume variance

E.Overhead under- and overapplied and standard cost variances

STATIC BUDGETS

The budgets in Chapter 9 were “static.” A static budget is created at the beginning of the budgeting period and is valid only for the budgeted level of activity.

EXAMPLE: Larch Company, which makes a single product, bases its budgets for manufacturing overhead on the following data:

Variable overhead cost category / Standard Cost Per Unit
Maintenance...... / $0.60
Indirect materials...... / 1.40
Utilities...... / 1.00
Total variable overhead cost.... / $3.00
Fixed overhead cost category / Budgeted Annual Cost
Depreciation...... / $40,000
Supervision...... / 50,000
Insurance...... / 10,000
Total fixed overhead cost...... / $100,000

STATIC BUDGETS (continued)

Larch Company originally planned to produce and sell 10,000 units during the year, but actual activity was only 8,000 units. A report based on the static (i.e., original) budget from the beginning of the year follows:

Larch Company
Comparison of Actual Overhead Costs
to Budgeted Overhead Costs
Original
Actual / Budget / Variance
Units produced and sold.. / 8,000 / 10,000 / 2,000 / U
Variable overhead costs:
Maintenance...... / $4,500 / $6,000 / $1,500 / F
Indirect materials...... / 12,000 / 14,000 / 2,000 / F
Utilities...... / 9,500 / 10,000 / 500 / F
Total variable overhead... / 26,000 / 30,000 / 4,000 / F
Fixed overhead costs:
Depreciation...... / 40,000 / 40,000 / 0
Supervision...... / 49,000 / 50,000 / 1,000 / F
Insurance...... / 10,000 / 10,000 / 0
Total fixed overhead..... / 99,000 / 100,000 / 1,000 / F
Total overhead cost...... / $125,000 / $130,000 / $5,000 / F

Does the above report, which is based on the original static budget, indicate whether overhead spending was under control?

FLEXIBLE BUDGETS

•A flexible budget is geared toward all levels of activity within a relevant range, rather than toward only one level of activity.

•A flexible budget is dynamic rather than static; it can be tailored for any level of activity within the relevant range.

EXAMPLE: Refer to the data for Larch Company. A flexible budget for manufacturing overhead is provided below for three different levels of activity ranging from 5,000 to 15,000 units.

Larch Company
Flexible Budget for Overhead
Cost
Formula / Units
Per Unit / 5,000 / 10,000 / 15,000
Variable overhead costs:
Maintenance...... / $0.60 / $3,000 / $6,000 / $9,000
Indirect materials..... / 1.40 / 7,000 / 14,000 / 21,000
Utilities...... / 1.00 / 5,000 / 10,000 / 15,000
Total variable overhead.. / $3.00 / 15,000 / 30,000 / 45,000
Fixed overhead costs:
Depreciation...... / 40,000 / 40,000 / 40,000
Supervision...... / 50,000 / 50,000 / 50,000
Insurance...... / 10,000 / 10,000 / 10,000
Total fixed overhead.... / 100,000 / 100,000 / 100,000
Total overhead cost..... / $115,000 / $130,000 / $145,000

OVERHEAD PERFORMANCE REPORT

In a performance report focused on cost control, actual costs should be compared to the flexible budget for the actual level of activity—not the budget for the planned level of activity.

EXAMPLE: Because Larch Company produced and sold only 8,000 units instead of the 10,000 units that had been planned, we would expect spending on variable overhead items to be less than had been planned.

Larch Company
Overhead Performance Report
Actual / Flexible
Costs / Budget
Cost / Incurred / Based on / Spending
Formula / 8,000 / 8,000 / & Budget
Per Unit / Units / Units / Variances
Variable overhead costs:
Maintenance...... / $0.60 / $4,500 / $4,800 / $300 / F
Indirect materials..... / 1.40 / 12,000 / 11,200 / 800 / U
Utilities...... / 1.00 / 9,500 / 8,000 / 1,500 / U
Total variable overhead.. / $3.00 / 26,000 / 24,000 / 2,000 / U
Fixed overhead costs:
Depreciation...... / 40,000 / 40,000 / 0
Supervision...... / 49,000 / 50,000 / 1,000 / F
Insurance...... / 10,000 / 10,000 / 0
Total fixed overhead.... / 99,000 / 100,000 / 1,000 / F
Total overhead cost..... / $125,000 / $124,000 / $1,000 / U

THE MEASURE OF ACTIVITY

•Most companies use a measure of activity such as labor-hours or machine-hours as the activity base for manufacturing overhead. This is particularly true in multi-product companies where hours often serve as a common denominator for diverse products.

•Should actual hours or standard hours allowed for the actual output be used in constructing budget allowances for the performance report? There are two approaches:

1.The budget allowance is based solely on the actual hours. Then only a spending variance for variable overhead is computed. (See Exhibit 11-6 in the text for an example.)

2.Budget allowances are based on both the actual hours and the standard hours allowed for the actual output. Then both spending and efficiency variances are computed for variable overhead. (See Exhibit 11-7 in the text for an example.)

TM 11-1

Variable Overhead Performance Report:
Budget Allowances Based on Actual Hours

Variable Overhead Performance Report:
Budget Allowances Based on Actual Hours
and Standard Hours Allowed

TM 11-1

OVERHEAD VARIANCE ANALYSIS

The flexible budget for manufacturing overhead provides information to:

•Compute predetermined overhead rates.

•Complete the standard cost card.

•Apply overhead cost to products.

•Prepare overhead variance reports.

EXAMPLE: Swift Company manufactures a single product. Standard cost data for the product follow:

(1) / (2)
Standard / Standard / Standard
Quantity / Price / Cost
or Hours / or Rate / (1) × (2)
Direct materials.. / 3.5 feet / $12 per foot / $42
Direct labor..... / 2.0 hours / $16 per hour / $32

Overhead is assigned to the product on the basis of standard direct labor-hours. Swift Company’s flexible budget for overhead (in condensed form) is given below:

Cost / Direct Labor-Hours
Per DLH / 10,000 / 15,000 / 20,000
Variable costs / $5 / $50,000 / $75,000 / $100,000
Fixed costs... / 300,000 / 300,000 / 300,000
Total cost... / $350,000 / $375,000 / $400,000

PREDETERMINED OVERHEAD RATE

In a standard cost system, the predetermined overhead rate is computed as follows:

EXAMPLE: The predetermined overhead rate at Swift Company is computed below for two levels of activity:

Denominator activity: 10,000 DLHs

Variable element: ($50,000 ÷ 10,000 DLHs). / $5 per DLH
Fixed element: ($300,000 ÷ 10,000 DLHs).. / 30 per DLH
Predetermined overhead rate...... / $35 per DLH

Denominator activity: 15,000 DLHs

Variable element: ($75,000 ÷ 15,000 DLHs). / $5 per DLH
Fixed element: ($300,000 ÷ 15,000 DLHs).. / 20 per DLH
Predetermined overhead rate...... / $25 per DLH

Note that the difference between the predetermined overhead rates at the two levels of activity is entirely due to fixed overhead being spread over different amounts of activity.

APPLYING OVERHEAD IN A STANDARD COST SYSTEM

Assume that the denominator level of activity at Swift Company is 15,000 DLHs. The following data apply to the current year’s operations.

Denominator level of activity...... / 15,000 / DLHs
Number of units completed...... / 8,000 / units
Actual direct labor-hours...... / 18,000 / DLHs
Actual manufacturing overhead cost:
Variable...... / $81,000
Fixed...... / 305,000
Total...... / $386,000

In a standard cost system, overhead is applied on the basis of the standard hours allowed for the actual output rather than on the basis of the actual hours. This results in a simpler system in which the overhead applied to units is always the same. In this example, the overhead cost is always $50 per unit (2.0 DLHs per unit × $25 per DLH)

Using the above data, the company’s manufacturing overhead account would appear as follows:

Manufacturing Overhead
Actual overhead cost / 386,000 / Applied overhead cost / 400,000*
Overapplied overhead / 14,000

*8,000 units × 2.0 DLHs per unit = 16,000 DLHs;
16,000 DLHs × $25 per DLH = $400,000.

VARIABLE OVERHEAD VARIANCES

Swift Company’s $14,000 overapplied overhead can be explained by four variances: the variable overhead spending and efficiency variances and the fixed overhead budget and volume variances. The variable overhead variances are computed below:

Actual Hours of Input, at the
Actual Rate / Actual Hours of Input, at the Standard Rate / Standard Hours Allowed for Output, at the Standard Rate
(AH × AR) / (AH × SR) / (SH × SR)
18,000 DLHs ×
$5 per DLH / 16,000 DLHs ×
$5 per DLH
$81,000 / = $90,000 / = $80,000
 /  / 
Spending Variance,
$9,000 F / Efficiency Variance,
$10,000 U

Spending variance: The variable overhead spending variance contains differences between actual and standard prices and between actual and standard quantities.

Efficiency variance: The variable overhead efficiency variance is not a measure of how efficiently overhead resources were used. It is a measure of the efficiency with which the base underlying the flexible budget was used.

FIXED OVERHEAD VARIANCES

Data concerning Swift Company are presented below:

Denominator activity (direct labor-hours)...... / 15,000 / DLHs
Actual direct labor-hours worked...... / 18,000 / DLHs
Standard direct labor-hours allowed for output... / 16,000 / DLHs
Number of units produced...... / 8,000 / units
Budgeted fixed overhead cost...... / $300,000
Actual fixed overhead cost incurred...... / $305,000
Fixed element of the predetermined overhead rate / $20

Using these data, an analysis of the company’s fixed overhead variances follows:

Actual Fixed Overhead Cost /
Budgeted Fixed Overhead Cost / Fixed Overhead Cost Applied to
Work in Process
16,000 DLHs ×
$20 per DLH
$305,000 / $300,000 / = $320,000
 /  / 
Budget Variance,
$5,000 U / Volume Variance,
$20,000 F

FIXED OVERHEAD VARIANCES (continued)

The fixed overhead variances can also be computed as follows:

•The volume variance is not a measure of spending; it is affected only by the level of activity.

Standard hours allowed for the actual activity > Denominator level of activity / Favorable
Standard hours allowed for the actual activity < Denominator level of activity / Unfavorable

GRAPHIC ANALYSIS OF VOLUME VARIANCE

SUMMARY OF VARIANCES

•In a standard costing system, under or overapplied overhead equals the sum of:

•Variable overhead spending variance

•Variable overhead efficiency variance

•Fixed overhead budget variance

•Fixed overhead volume variance

•Underapplied overhead is equivalent to a net unfavorable variance.

•Overapplied overhead is equivalent to a net favorable variance.

Thus, Swift Company’s $14,000 overapplied overhead can be explained as follows:

Variable overhead:
Spending variance...... / $9,000 / F
Efficiency variance...... / 10,000 / U
Fixed overhead:
Budget variance...... / 5,000 / U
Volume variance...... / 20,000 / F
Overapplied overhead...... / $14,000 / F