Flexible Budgets and

Overhead Analysis

Chapter
7
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Static Budgets and Performance
Reports
Hmm! Comparing
static budgets with
actual costs is 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.
Lets look at CheeseCo.
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Static Actual
Budget Results Variances
Machine hours 10,000 8,000
Variable costs
Ind irect labor 40,000 $ 34,000 $
Indirect materials 30,000 25,500
Power 5,000 3,800
Fixed costs
Depreciation 12,000 12,000
Insurance 2,000 2,050
Total overhead costs 89,000 $ 77,350 $
Static Budgets and Performance
Reports
CheeseCo
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Static Actual
Budget Results Variances
Machine hours 10,000 8,000 2,000 U
Variable costs
Ind irect 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 2,050 50 U
Total overhead costs 89,000 $ 77,350 $
$11,650 F
Static Budgets and Performance
Reports
U = Unfavorable variance
CheeseCo was unable to achieve
the budgeted level of activity.
CheeseCo
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Static Actual
Budget Results Variances
Machine hours 10,000 8,000 2,000 U
Variable costs
Ind irect 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 2,050 50 U
Total overhead costs 89,000 $ 77,350 $
$11,650 F
Static Budgets and Performance
Reports
F = Favorable variance that occurs when
actual costs are less than budgeted costs.
CheeseCo
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Static Actual
Budget Results Variances
Machine hours 10,000 8,000 2,000 U
Variable costs
Ind irect 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 2,050 50 U
Total overhead costs 89,000 $ 77,350 $
$11,650 F
Static Budgets and Performance
Reports
Since cost variances are favorable, have
we done a good job controlling costs?
CheeseCo
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Static Budgets and Performance
Reports
I dont think I
can answer the
question using
a static budget.
Actual activity is below
budgeted activity which
is unfavorable.
So, shouldnt variable costs
be lower if actual activity
is lower?
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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 must
the budget to the
actual level of activity.
Static Budgets and Performance
Reports
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Flexible Budgets
Improve performance evaluation.
May be prepared for any activity
level in the relevant range.
Show revenues and expenses
that should have occurred at the
actual level of activity.
Reveal variances due to good cost
control or lack of cost control.
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Flexible Budgets
Central Concept
If you can tell me what your activity was
for 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 we need to know that:
Total variable costs change
in direct proportion to
changes in activity.
Total fixed costs remain
unchanged within the
relevant range.
Fixed
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Preparing a Flexible Budget
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Cost Total Flexible Budgets
Formula 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 32,000 $
Indirect material 3.00 24,000
Power 0.50 4,000
Total variable cost 7.50 $ 60,000 $
Fixed costs
Depreciation 12,000 $
Insurance 2,000
Total fixed cost
Total overhead costs
Preparing a Flexible Budget
Fixed costs are
expressed as a
total amount.
Variable costs are expressed as
a constant amount per hour.
$40,000 10,000 hours is
$4.00 per hour.
CheeseCo
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Cost Total Flexible Budgets
Formula 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 32,000 $
Indirect material 3.00 24,000
Power 0.50 4,000
Total variable cost 7.50 $ 60,000 $
Fixed costs
Depreciation 12,000 $
Insurance 2,000
Total fixed cost
Total overhead costs
Preparing a Flexible Budget
$4.00 per hour 8,000 hours = $32,000
CheeseCo
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Preparing a Flexible Budget
Cost Total Flexible Budgets
Formula 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 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 $
CheeseCo
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Preparing a Flexible Budget
Cost Total Flexible Budgets
Formula 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 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 $
Total fixed costs
do not change in
the relevant range.
CheeseCo
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Flexible Budget
Performance Report
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Cost Total
Formula Fixed Flexible Actual
Per Hour Costs Budget Results Variances
Machine hours 8,000 8,000 0
Variable costs
Indirect labor 4.00 $ 32,000 $ 34,000 $
Indirect material 3.00 24,000 25,500
Power 0.50 4,000 3,800
Total variable costs 7.50 $ 60,000 $ 63,300 $
Fixed Expenses
Depreciation 12,000 $ 12,000 $ 12,000 $
Insurance 2,000 2,000 2,050
Total fixed costs 14,000 $ 14,050 $
Total overhead costs 74,000 $ 77,350 $
Flexible Budget
Performance Report
Flexible budget is
prepared for the
same activity level
(8,000 hours) as
actually achieved.
CheeseCo
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Cost Total
Formula Fixed Flexible Actual
Per Hour Costs Budget Results Variances
Machine hours 8,000 8,000 0
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 F
Total variable costs 7.50 $ 60,000 $ 63,300 $ $ 3,300 U
Fixed Expenses
Depreciation 12,000 $ 12,000 $ 12,000 $ 0
Insurance 2,000 2,000 2,050 50 U
Total fixed costs 14,000 $ 14,050 $ 50 U
Total overhead costs 74,000 $ 77,350 $ $ 3,350 U
Flexible Budget
Performance Report
CheeseCo
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Flexible Budget
Performance Report
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Static Actual
Budget Results Variances
Machine hours 10,000 8,000 2,000 U
Variable costs
Ind irect 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 2,050 50 U
Total overhead costs 89,000 $ 77,350 $
$11,650 F
Static Budgets and Performance
How much of the $11,650 is due to activity
and how much is due to cost control?
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Flexible Budget
Performance Report
Difference between original static budget
and actual overhead = $11,650 F.
Overhead Variance Analysis
Static Actual
Overhead Overhead
Budget at at
10,000 Hours 8,000 Hours
89,000 $ 77,350 $
Lets place
the flexible
budget for
8,000 hours
here.
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Flexible Budget
Performance Report
This $15,000F variance is
due to lower activity.
Overhead Variance Analysis
Activity
This $3,350U flexible
budget variance is due
to poor cost control.
Cost control
Static Flexible Actual
Overhead Overhead Overhead
Budget at Budget at at
10,000 Hours 8,000 Hours 8,000 Hours
89,000 $ 74,000 $ 77,350 $
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Flexible Budget
Performance Report
What causes
the cost
control variance?
There are two primary
reasons for unfavorable
variable overhead variances:
1. Spending too much for
resources.
2. Using the resources
inefficiently.
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Overhead Rates and Overhead
Analysis
Overhead from the
flexible budget for the
denominator level of activity
POHR =
Recall that overhead costs are assigned to
products and services using a
predetermined overhead rate (POHR):
Assigned Overhead = POHR Standard Activity
Denominator level of activity
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Overhead Rates and Overhead
Analysis Example
Lets look at overhead
rates in a
budget for ColaCo.
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ColaCo prepared this budget for overhead:
Overhead Rates and Overhead
Analysis Example
Total Variable Total Fixed
Machine Variable Overhead Fixed Overhead
Hours Overhead Rate Overhead Rate
2,000 4,000 $ ? 9,000 $ ?
4,000 8,000 ? 9,000 ?
ColaCo applies overhead based
on machine hour activity.
Lets calculate overhead rates.
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Overhead Rates and Overhead
Analysis Example
Rate = Total Variable Overhead Machine Hours
ColaCo prepared this budget for overhead:
This rate is constant at all levels of activity.
Total Variable Total Fixed
Machine Variable Overhead Fixed Overhead
Hours Overhead Rate Overhead Rate
2,000 4,000 $ 2.00 $ 9,000 $ ?
4,000 8,000 2.00 9,000 ?
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Total Variable Total Fixed
Machine Variable Overhead Fixed Overhead
Hours Overhead Rate Overhead Rate
2,000 4,000 $ 2.00 $ 9,000 $ 4.50 $
4,000 8,000 2.00 9,000 2.25
Overhead Rates and Overhead
Analysis Example
Rate = Total Fixed Overhead Machine Hours
ColaCo prepared this budget for overhead:
This rate decreases when activity increases.
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Total Variable Total Fixed
Machine Variable Overhead Fixed Overhead
Hours Overhead Rate Overhead Rate
2,000 4,000 $ 2.00 $ 9,000 $ 4.50 $
4,000 8,000 2.00 9,000 2.25
Overhead Rates and Overhead
Analysis Example
The total POHR is the sum of
the fixed and variable rates
for a given activity level.
ColaCo prepared this budget for overhead:
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Overhead Variances
Lets use the
overhead rates, to
determine variable
and fixed overhead
variances.
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ColaCos 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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Variable Overhead Variances
AH
SR
AH AR
Spending variance = AH(AR - SR)
Efficiency variance = SR(AH - SH)
SH
SR
Spending
Variance
Efficiency
Variance
Actual Flexible Budget Flexible Budget
Variable for Variable for Variable
Overhead Overhead at Overhead at
Incurred Actual Hours Standard Hours
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3,300 hours 3,200 hours

$2.00 per hour $2.00 per hour
Variable Overhead Variances
Example
Actual Flexible Budget Flexible Budget
Variable for Variable for Variable
Overhead Overhead at Overhead at
Incurred Actual Hours Standard Hours
$6,740 $6,600 $6,400
Spending variance
$140 unfavorable
Efficiency variance
$200 unfavorable
$340 unfavorable flexible budget total variance
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Variable Overhead Variances A
Closer Look
Spending Variance

Efficiency Variance

Results from paying more
or less than expected for
overhead items and from
excessive usage of
overhead items.
Controlled by
managing the
overhead cost driver.
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Overhead Variances
Now lets turn
our attention
to fixed
overhead.
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Overhead Rates and Overhead
Analysis Example
ColaCo prepared this budget for overhead:
What is ColaCos fixed overhead rate for an
estimated activity of 3,000 machine hours?
Total Variable Total Fixed
Machine Variable Overhead Fixed Overhead
Hours Overhead Rate Overhead Rate
2,000 4,000 $ 2.00 $ 9,000 $ 4.50 $
4,000 8,000 2.00 9,000 2.25
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Overhead Rates and Overhead
Analysis Example
ColaCo prepared this budget for overhead:
What is ColaCos fixed overhead rate for an
estimated activity of 3,000 machine hours?
Fixed Overhead Rate
FR = $9,000 3,000 machine hours
FR = $3.00 per machine hour
Total Variable Total Fixed
Machine Variable Overhead Fixed Overhead
Hours Overhead Rate Overhead Rate
2,000 4,000 $ 2.00 $ 9,000 $ 4.50 $
4,000 8,000 2.00 9,000 2.25
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ColaCos actual production required 3,200
standard machine hours. Actual fixed overhead
was $8,450.

Compute the fixed overhead budget and volume
variances.
Fixed Overhead Variances
Example
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Fixed Overhead Variances
Budget
Variance
Volume
Variance
FR = Standard Fixed Overhead Rate
SH = Standard Hours Allowed
SH FR

Actual Fixed Fixed Fixed
Overhead Overhead Overhead
Incurred Budget Applied
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3,200 hours

$3.00 per hour
Budget variance
$550 favorable
Fixed Overhead Variances
Example
$8,450 $9,000 $9,600

Actual Fixed Fixed Fixed
Overhead Overhead Overhead
Incurred Budget Applied
Volume variance
$600 favorable
SH FR
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Fixed Overhead Variances
A Closer Look
Budget Variance

Volume Variance

Results from paying more
or less than expected for
overhead items.
Results from operating
at an activity level
different from the
denominator activity.
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Overhead Variances
Lets look at a
graph showing
fixed overhead
variances. We will
use ColaCos
numbers from the
previous example.
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Volume
Cost
3,200
Standard
Hours
3,000 Hours
Expected
Activity
Fixed Overhead Variances
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Fixed Overhead Variances
$8,450 actual fixed OH
Volume
Cost
$9,600 applied fixed OH
$9,000 budgeted fixed OH
3,200
Standard
Hours
3,000 Hours
Expected
Activity
3,200 machine hours $3.00 fixed overhead rate
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{
$600
Favorable
Volume
Variance
Fixed Overhead Variances
{ $550
Favorable
Budget
Variance
$8,450 actual fixed OH $8,450 actual fixed OH
Volume
Cost
$9,600 applied fixed OH
$9,000 budgeted fixed OH
3,200
Standard
Hours
3,000 Hours
Expected
Activity
3,200 machine hours $3.00 fixed overhead rate
{
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Results when standard hours
allowed for actual output differs
from the denominator activity.
Volume Variance A Closer Look
Volume
Variance
Favorable
when standard hours
> denominator hours
Unfavorable
when standard hours
< denominator hours
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Results when standard hours
allowed for actual output differs
from the denominator activity.
Volume Variance A Closer Look
Volume
Variance
Favorable
when standard hours
> denominator hours
Unfavorable
when standard hours
< denominator hours
Does not measure over-
or under spending
Explainable by and
controllable only through
activity
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Overhead Variances and Under- or
Overapplied Overhead Cost
The sum of the overhead variances
equals the under- or overapplied
overhead cost for a period.
Favorable
variances are equivalent
to overapplied overhead.
Unfavorable
variances are equivalent
to underapplied overhead.
In a standard
cost system:
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End of Chapter 11
Im here to your
budget. Are you ready to
ante up?