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Flexible Budgeting and the Management of Overhead and Support Activity Costs

11ChapterEleven

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Flexible BudgetsHmm! Comparing

static budgetswith actual costsis like comparing

apples and oranges.

Static budgets are prepared for a single,

planned level of activity.

Performance evaluation is difficult when actual activity

differs from the planned level of

activity.

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Considerthe following example from the Cheese

Company . . .

Hmm! Comparingstatic budgets

with actual costsis like comparing

apples and oranges.

Flexible Budgets

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Static ActualBudget Results Variances

Machine hours 10,000 8,000 2,000 U

Variable costs Indirect labor 40,000$ Indirect materials 30,000 Power 5,000

Fixed costs Depreciation 12,000 Insurance 2,000

Total overhead costs 89,000$

Static Budgets andPerformance Reports

U = Unfavorable varianceCheese Company wasunable to achieve the

budgeted level of activity.

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Machine hours 10,000 8,000 2,000 U

Variable costs Indirect 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 2,000 0

Total overhead costs 89,000$ 77,300$ $11,700 F


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Machine hours 10,000 8,000 2,000 U




F = Favorable variance since actual costsare less than budgeted costs.


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Machine hours 10,000 8,000 2,000 U




Since cost variances are favorable, havewe done a good job controlling costs?


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I don’t think I cananswer this question

using a static budget.

I do know thatactual activity is belowbudgeted activity which

is unfavorable. But shouldn’t variable costs

be lower if actual activityis below budgeted activity?


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☯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 mustthe budget to theactual level of activity.


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Flexible Budgets

Central Concept

If you can tell me what your activity wasfor 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 for different activity levels, we must know how costs behave with changes in activity levels.

Total variable costs changein direct proportion to changes in activity.Total fixed costs remainunchanged within therelevant range.

FixedVariable

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Advantages of Flexible Budgets

Improve performance evaluation.

May be prepared for any activity level in the relevant range.

Show revenues and expensesthat should have occurred at theactual level of activity.

Reveal variances due to good costcontrol or lack of cost control.

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Let’s preparebudgets for the

Cheese Company.

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Variable Total Flexible BudgetsCost 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 Indirect material 3.00 Power 0.50 Total variable cost 7.50$

Fixed costs Depreciation 12,000$ Insurance 2,000 Total fixed costTotal overhead costs


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Machine hours 8,000 10,000 12,000

Variable costs Indirect labor 4.00 Indirect material 3.00 Power 0.50 Total variable cost 7.50$


Preparing a Flexible BudgetUsing an input activity measure

as units of output may not bemeaningful in a multiproduct firm.

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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$



Variable costs are expressed as a constant amount per hour.

In the original static budget, indirect labor was $40,000 for

10,000 hours resulting in a rate of $4.00 per hour.

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Machine hours 8,000 10,000 12,000




Fixed costs are expressed as a total amount that does not change within the relevant

range of activity.

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Preparing a Flexible BudgetVariable Total Flexible Budgets

Cost Fixed 8,000 10,000 12,000Per Hour Cost Hours Hours Hours

Machine hours 8,000 10,000 12,000


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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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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Machine hours 8,000 10,000 12,000



Note: There is no flexin the fixed costs.

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Machine hours 8,000 10,000 12,000



Budgeted variable Total overhead cost per activity

activity unit units × + Budgeted fixed

overhead cost

Total budgetedoverhead cost =

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11-22Flexible BudgetPerformance Report

Now let’s prepare a budget performance reportat 8,000 actual machinehours for the Cheese Co.

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Variable TotalCost Fixed Flexible Actual

Per Hour Costs Budget Results Variances

Machine hours 8,000 0

Variable costs Indirect labor 4.00$ 34,000$ Indirect material 3.00 25,500 Power 0.50 3,800 Total variable costs 7.50$ 63,300$Fixed Expenses Depreciation 12,000$ 12,000$ Insurance 2,000 2,000 Total fixed costs 14,000$Total overhead costs 77,300$

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Machine hours 8,000 0


Original actual results for Cheese Company that we saw

earlier.

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Machine hours 8,000 8,000 0


Flexible budget is prepared for the

same activity level (8,000 hours) as

actually achieved.

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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 FTotal variable costs 7.50$ 60,000$ 63,300$ $ 3,300 UFixed Expenses Depreciation 12,000$ 12,000$ 12,000$ 0 Insurance 2,000 2,000 2,000 0Total fixed costs 14,000$ 14,000$ 0Total overhead costs 74,000$ 77,300$ $ 3,300 U

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Indirect labor and indirect material have unfavorable variances because actual costs

are more than the flexible budget costs.

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Power has a favorable variance because the

actual cost is less than the flexible budget cost.

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11-29Cost Management Using Overhead Cost Variances

Let’s turn our attentionto the computation of

overhead cost variances. We will begin withvariable overhead.

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Spending Variance

EfficiencyVariance

AH × SVR AH × AR

AH = Actual Hours of Activity AR = Actual Variable Overhead RateSVR = Standard Variable Overhead RateSH = Standard Hours Allowed

SH × SVR

Actual Flexible Budget Flexible BudgetVariable for Variable for VariableOverhead Overhead at Overhead at Incurred Actual Hours Standard Hours

Variable Overhead Variances

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AH × AR

Spending variance = AH(AR - SVR)Efficiency variance = SVR(AH - SH)

Spending Variance

EfficiencyVariance


AH × SVR SH × SVR

Variable Overhead Variances

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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.

Variable Overhead Variances –Example

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ColaCo prepared this budget for overhead:


Budgeted variable Total overhead cost per activity

activity unit units × + Budgeted fixed

overhead cost



$2.00 permachine

hour×

Totalmachine

hours+ $9,000

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3,300 hours 3,200 hours× ×

$2.00 per hour $2.00 per hour

Spending variance$140 unfavorable

Efficiency variance$200 unfavorable


$6,740 $6,600 $6,400


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3,300 hours 3,200 hours× ×

$2.00 per hour $2.00 per hour

The $140 unfavorable spending variance and the $200 unfavorable efficiency variance result in a $340

unfavorable flexible budget variance.


$6,740 $6,600 $6,400


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11-36Variable Overhead Variances – A Closer Look

Spending Variance Efficiency VarianceResults from paying moreor less than expected foroverhead items and from

excessive usage ofoverhead items.

A function of theselected cost driver.

It does not reflectoverhead control.

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Fixed Overhead

Now let’s turn our attention to fixed overhead.

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Budget Variance

VolumeVariance

PFOHR = Predetermined Fixed Overhead RateSH = Standard Hours Allowed

SH × PFOHR

Actual Fixed Fixed FixedOverhead Overhead Overhead Incurred Budget Applied

Fixed Overhead Variances

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PFOHR =

Applied Fixed Overhead = PFOHR × Standard Hours

Budgeted Fixed OverheadPlanned Activity in Hours

Recall that fixed overhead costs are applied to products and services using a predetermined

fixed overhead rate (PFOHR):

Fixed Overhead

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ColaCo used the following predeterminedfixed overhead rate:

PFOHR =Budgeted Fixed OverheadPlanned Activity in Hours

PFOHR =$9,000

3,000 machine hours

PFOHR = $3.00 per machine hour

Fixed Overhead Variances –Example

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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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3,200 hours×

$3.00 per hour


Actual Fixed Fixed FixedOverhead Overhead Overhead Incurred Budget Applied

$8,450 $9,000 $9,600

Budget variance$550 favorable

Volume variance$600 (neither favorable nor

unfavorable)

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11-43Fixed Overhead Variances –A Closer Look

Budget Variance Volume Variance

Results from paying moreor less than expected for

overhead items.

Results from the inabilityto operate at the activity

level planned for the period.

Has no significance forcost control.

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Let’s look at a graph showing fixed

overhead variances. We will use ColaCo’s

numbers from the previous example.

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Volume

Cost

$9,600 applied fixed OH$9,000 budgeted fixed OH

3,200 machine hours × $3.00 fixed overhead rate

Fixed overhead

applied to products


{$600

Volume Variance

{$550Favorable

Budget Variance

$8,450 actual fixed OH

3,200 Standard

Hours

3,000 Hours PlannedActivity

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Activity-Based Flexible BudgetVariable Total Flexible Budgets


Machine hours 8,000 10,000 12,000



The Cheese Co. flexiblebudget is based on a singlecost driver, machine hours

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Activity-Based Flexible BudgetVariable Total Flexible Budgets


Machine hours 8,000 10,000 12,000



If different cost drivers are identified for thedifferent variable costs, an activity-based flexible

budget should be prepared with different costformulas based on the different drivers.

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End of Chapter 11

I’m here to your budget. Are you ready to

ante up?

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