Chapter 21:
Flexible Budgets and Overhead
Analysis
Financial and Managerial Accounting:
The Cornerstones of Business Decisions, 2e
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1
Using Budgets
for Performance Evaluation
►Budgets are useful for both planning and
control, where they are used as benchmarks for
performance evaluation.
►Determining how budgeted amounts should be
compared with actual results is a major
consideration that must be addressed.
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1
Static Budgets versus
Flexible Budgets
►A performance report compares actual costs
with budgeted costs. There are two ways to
make this comparison:
►Compare actual costs with the budgeted costs for
the budgeted level of activity (static budget).
►Compare actual costs with the actual level of activity
(flexible budget).
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1
Flexible Budget Variance
► A difference between the actual amount and the flexible budget
amount is the flexible budget variance.
► The flexible budget provides a measure of the efficiency of a
manager.
► That is, how well did the manager control costs for the actual
level of production?
► To measure whether or not a manager accomplishes his or her
goals, the static budget is used.
► The static budget represents certain goals that the firm wants to
achieve.
► A manager is effective if the goals described by the static budget
are achieved or exceeded.
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2
Variable Overhead Analysis
► In a standard cost system, the total overhead variance, or the
difference between applied and actual overhead, is also broken
down into component variances.
► There are several methods of overhead variance analysis; the
four-variance method is described in this chapter.
► First, overhead is divided into fixed and variable categories. Next,
two variances are calculated for each category.
► Variable overhead variances
►Variable overhead spending variance
►Variable overhead efficiency variance
► Fixed overhead variances
►Fixed overhead spending variance
►Fixed overhead volume variance
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2
Total Variable Overhead Variance
►The total variable overhead variance is simply the
difference between the actual variable overhead and
applied variable overhead.
►VOH is applied by using hours allowed in a standard cost
system.
►The total variable overhead variance can be divided into
spending and efficiency variances.
►Variable overhead spending and efficiency variances can
be calculated by using either the three-pronged
(columnar) approach or formulas.
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2
Variance Abbreviations
►Because the equations for variable overhead variances
can be long if expressed in words, abbreviations are
often used.
►Here are some common abbreviations:
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2
Variable Overhead
Spending Variance
►The variable overhead spending variance measures the
aggregate effect of differences between the actual
variable overhead rate (AVOR) and the standard
variable overhead rate (SVOR).
►The actual variable overhead rate is computed as
follows:
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Variable Overhead
Efficiency Variance
►VOH is assumed to vary in proportion to changes in the
direct labor hours used.
►The variable overhead efficiency variance measures the
change in the actual variable overhead cost (VOH) that
occurs because of efficient (or inefficient) use of direct
labor.
►The variable overhead efficiency variance is computed
by using the following formula:
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Comparison of the Variable Overhead
Spending Variance with the
Price Variances of Materials and Labor
► While the variable overhead spending variance is similar to the price variances
of materials and labor, there are some conceptual differences.
► VOH is not a single input—it is made up of a large number of individual items.
► The standard variable overhead rate represents the weighted cost per direct
labor hour that should be incurred for all variable overhead items.
► The difference between what should have been spent per hour and what
actually was spent per hour is a type of price variance.
► One reason that a variable overhead spending variance can arise is that prices
for individual variable overhead items have increased or decreased.
► The second reason for a variable overhead spending variance is the use of the
items that comprise variable overhead. Waste or inefficiency in the use of VOH
increases the actual variable overhead cost.
► The variable overhead spending variance is the result of both price and
efficiency.
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Responsibility for the Variable
Overhead Spending Variance
► Variable overhead items may be affected by several responsibility
centers. To the extent that consumption of VOH can be traced to
a responsibility center, responsibility can be assigned.
► Controllability is a prerequisite for assigning responsibility.
► Price changes of variable overhead items are essentially beyond
the control of supervisors. If price changes are small, then the
spending variance is primarily a matter of the efficient use of
overhead in production.
► Responsibility for the variable overhead spending variance is
generally assigned to production departments.
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Responsibility for the Variable
Overhead Efficiency Variance
►The variable overhead efficiency variance is
directly related to the direct labor efficiency or
usage variance.
►If variable overhead costs really change in
proportion to changes in direct labor hours, then
responsibility for the variable overhead
efficiency variance should be assigned to the
individual who has responsibility for the use of
direct labor: the production manager.
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3
Fixed Overhead Analysis
►Fixed overhead costs are capacity costs acquired in
advance of usage.
►The fixed overhead rate changes as the underlying
production level changes.
►To keep a stable fixed overhead rate throughout the
year, companies typically use practical capacity to
determine the number of direct labor hours in the
denominator of the fixed overhead rate.
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Total Fixed Overhead Variances
►The total fixed overhead variance is the difference
between actual fixed overhead and applied fixed
overhead, when applied fixed overhead is obtained by
multiplying the standard fixed overhead rate (SFOR)
times the standard hours allowed for the actual output
(SH).
►The total fixed overhead variance is the difference
between the actual fixed overhead and the applied
fixed overhead:
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Fixed Overhead Spending Variance
►The fixed overhead spending variance is defined
as the difference between the actual fixed
overhead (AFOH) and the budgeted fixed
overhead (BFOH):
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Fixed Overhead Volume Variance
► The fixed overhead volume variance is the difference between
budgeted fixed overhead (BFOH) and applied fixed overhead:
► The volume variance measures the effect of the actual output
differing from the output used at the beginning of the year to
compute the predetermined standard fixed overhead rate.
► If you think of the output used to calculate the fixed overhead
rate as the capacity acquired (practical capacity) and the actual
output as the capacity used, then the volume variance is the cost
of unused capacity.
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3
Responsibility for the Fixed
Overhead Spending Variance
►Many fixed overhead items—long-run
investments be changed in the short run.
Consequently, fixed overhead costs are often
beyond the immediate control of management.
►Since many fixed overhead costs are affected
primarily by long-run decisions, and not by
changes in production levels, the budget
variance is usually small.
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Analysis of the Fixed Overhead
Spending Variance
►Because FOH is made up of many individual
items, a line-by-line comparison of budgeted
costs with actual costs provides more
information concerning the causes of the
spending variance.
►An investigation might reveal that these are due
to issues beyond management control like the
weather.
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Responsibility for the Fixed
Overhead Volume Variance
►Assuming that volume variance measures
capacity utilization implies that the general
responsibility for this variance should be
assigned to the production department.
►At times, however, a significant volume variance
may be due to factors beyond the control of
production.
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Analysis of the Volume Variance
►Notice that the volume variance occurs because fixed
overhead is treated as if it were a variable cost.
►In reality, fixed costs do not change as activity changes,
as a predetermined fixed overhead rate allows.
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4
Activity-Based Budgeting
► The traditional approach to budgeting emphasizes:
► estimation of revenues and costs by organizational units (e.g.,
departments, plants)
► use of a single unit-based driver such as direct labor hours
► Companies that have implemented an activity-based costing
(ABC) system may also wish to install an activity-based budgeting
system.
► An activity-based budgeting (ABB) system focuses on:
► estimation of the costs of activities rather than the costs of departments
and plants
► use of multiple drivers, both unit-based and nonunit-based
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4
Activity Flexible Budgeting
► Understanding the relationship between changes in activity costs and changes
in activity drivers allows managers to more carefully plan and monitor activity
improvements.
► Activity flexible budgeting is the prediction of what activity costs will be as
related output changes.
► Variance analysis within an activity framework makes it possible to improve
traditional budgetary performance reporting, and enhances the ability to
manage activities.
► If, however, costs vary with respect to more than one driver, and the drivers
are not highly correlated with direct labor hours, then the predicted costs can
be misleading.
► The solution is to build flexible budget formulas for more than one driver.
► Cost estimation procedures (high-low method, the method of least squares,
and so on) can be used to estimate cost formulas for each activity.
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