Overhead Budgets

Most companies use flexible budgets to
control overhead costs.
– A flexible budget is not based on only one level of
activity but is valid for the firm’s relevant range of
activity.
– The flexible budget provides the correct basis for
comparison between actual and expected costs.
– The flexible overhead budget is based on a
standard input measure (e.g. machine hours)
Flexible Budget Formula

The relationship between activity and
total budgeted overhead is given by:
Total budgeted
monthly
overhead cost
=
Budgeted
Total activity
variableunits
overhead cost *
per activity unit
+
Budgeted fixedoverhead cost
per month
Standard Costing System

In a standard costing system, overhead
application is based on standard hours
allowed, given actual output.
– The Manufacturing Overhead account is
credited and the Work-In-Process
Inventory is debited by the following
amount:
• Standard allowed hours X Predetermined (Standard) rate
Variable-Overhead Spending Variance

Variable-overhead spending variance =
• Actual variable overhead - (AH x SVR)
or
• (AH x AVR) - (AH x SVR)
• AH x (AVR - SVR)
Notation:
AH = actual machine hours
AVR = actual variable-overhead rate
= actual variable overhead  AH
SVR = standard variable-overhead rate
Variable-Overhead Efficiency Variance

Variable-Overhead Efficiency Variance =
• (AH x SVR) - (SH x SVR)
• SVR x (AH - SH)
Notation:
AH = actual machine hours
SH = standard machine hours
SVR = standard variable-overhead rate
Variance Analysis for Managerial Control
Variable Overhead
Actual Costs Incurred
(a)
Flexible Budget based
on Actual Output (b)
AQ * AR
Expected Costs based
on Actual Output (c)
AQ * SR
SQA * SR
Variable-Overhead
Spending Variance (b-a)
Variable-Overhead
Efficiency Variance (c-b)
AQ(SR - AR)
SR(SQA - AQ)
Variable-Overhead Budget Variance (c-a)
(SQA * SR) - (AQ * AR)
Interpreting Variable Variance

The variable-overhead efficiency variance simply
reflects an adjustment in the managerial accountant’s
expectation about variable overhead cost.
– It does not indicate inefficient use of variable-overhead.

An unfavorable variable-overhead spending variance
simply means that the total actual cost of variable
overhead is greater than expected.
– The spending variance is the real control variance for
variable overhead. The spending variance can alert
managers if variable overhead costs are exceeding
expectations.
Fixed-Overhead Variances

Fixed-Overhead Budget Variance =
• Actual fixed overhead - Budgeted fixed overhead
• The budget variance is the real control variance for fixed
overhead, because it compares actual expenditures with
budgeted fixed-overhead costs.

Fixed-Overhead Volume Variance =
• Budgeted fixed overhead - Applied fixed overhead
• Applied fixed overhead = Predetermined fixed overhead rate x Standard allowed hours
• A faulty interpretation of a positive volume variance is that it
measures the cost of under-utilizing productive capacity. Perhaps
under-utilizing capacity and reducing inventory may be the
appropriate response to the current demand.
Variance Analysis for Managerial Control
Fixed Overhead
Actual Costs Incurred
(a)
Flexible Budget based
on Actual Output (b)
AQ * AR
AQ * SR
Expected Costs based
on Actual Output (c)
SQA * SR
Fixed-Overhead
Spending Variance (b-a)
Fixed-Overhead
Efficiency Variance (c-b)
AQ(SR - AR)
SR(SQA - AQ)
Fixed-Overhead Budget Variance (c-a)
(SQA * SR) - (AQ * AR)
Disposition of Variances

Variances are temporary accounts and
most companies close them directly into
Cost of Goods Sold at the end of each
accounting period.
– Debit: Cost of Goods Sold
Credit: Manufacturing Overhead