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Chapter 11 Outline

Flexible Budgeting and Overhead Cost Control


  1. Flexible Budgets
    1. Detailed plan for control: A flexible budget is a detailed plan for controlling overhead and other costs.
    1. Flexible prepared for different levels: Most important, the flexible budget is prepared for different levels of activity within the firm’s relevant range.
    2. Static restricted to one level: In comparison, a static budget (such as a master budget—from Chapter 9) sets forth a plan for only one level of activity.
    1. Improved performance evaluations: The flexible budget results in improved performance evaluations. Actual results at one activity level are compared against what should have happened (i.e., budgeted costs) at the same level of output. With static budgets, actual results are compared against anticipated results at what might be two different volume levels.
    2. Choose activity base carefully: As previously mentioned, when apply or budgeting overhead, the activity base must be chosen carefully. It is typically an input measure, namely, the standard hours for the actual production.
    3. Formula:

Tot. budgeted o.h. cost = (budgeted var. cost per base unit X # of units)

+ budgeted fixed overhead cost

  1. Overhead Application in a Standard-Costing System
    1. Overhead application similar: Overhead application to Work-in-Process Inventory in a standard-costing system is similar to the method demonstrated in Chapter 3 for normal costing, with one important difference.
    1. Normal costing:
    2. Overhead applied = Actual hours X Predetermined rate

    3. Standard costing:

Overhead applied = Standard hours X Predetermined rate (i.e., S X S)

    1. Divide by most likely level of activity: Predetermined overhead rates are calculated by dividing the overhead dollars shown in the flexible budget by the most likely level of activity.
    2. Variable overhead cost driver: The activity measure selected should be a cost driver for variable overhead, with both of these items moving together as production activity changes.
    1. More companies now use machine hours and process time: More companies are switching to machine hours and process time to reflect the increased importance of computer-integrated manufacturing firms.
  1. Overhead Variances
    1. Compare actual with budgeted: At the end of the period, actual overhead costs are compared against amounts shown in the flexible budget. The difference, or variance, is subdivided into two components for variable overhead and two for fixed overhead.
    2. Variable-overhead variances similar to labor and material: Variable-overhead variances are conceptually similar to variances for direct material and direct labor. The variances may be expressed algebraically as follows:

VOH Spending Variance = Actual VOH — (AH X SVR)

VOH Efficiency Variance = (AH X SVR) — (SH X SVR)

    1. Variable overhead applied to production: The result of taking (SH X SHR) is the amount of variable overhead applied to production.
    1. Compares actual amount spent with budgeted amount: The VOH spending variance is the result of comparing the amount that was spent on variable overhead items at the actual level of activity with the amount that should have been spent at that level. The spending variance can arise from paying higher prices than expected and consuming larger quantities than expected (e.g., supplies), so it is not a "pure" price/rate variance.
    2. Efficiency variance not an exact measure: The VOH efficiency variance is not a direct measure of how efficiently the quantity of overhead was used but instead is a measure of efficiency with the application base (e.g., machine hours, labor hours, and so on). To illustrate, machine hours may be correlated with some items in the cost pool (such as power); however, it may be correlated with others (e.g., indirect labor). It would be misleading to say that an inefficient use of machine hours also means an inefficient use of all items in the pool. Therefore, the efficiency variance is not as useful for cost control as the spending variance.
    3. Fixed overhead variances formula:
    4. FOH Budget Variance = Actual fixed o.h. — budgeted fixed o.h.

      FOH Vol. Variance = Budgeted fixed o.h. — standard applied fixed o.h.

    5. FOH results from comparison: The FOH budget variance is the result of comparing total actual fixed-overhead expenditures with lump-sum, budgeted fixed overhead costs. While it is often difficult to change certain fixed cost expenditures (such as property taxes) in the short run, unfavorable fixed overhead items should be carefully monitored and the information used when making future budgets.
    6. Variance occurs when planned and standard differ: The volume variance occurs whenever the planned level of activity does not equal the standard level of activity. A common interpretation of a positive volume variance is that a company has underutilized its facility. However, this interpretation is faulty when a reduction in production levels is in response to an unexpected decrease in demand. In such a situation, the volume variance is a demand prediction error and not the fault of the production manager. The volume varaince indicates a deviation from plans, but great care must be exercised in determining where the responsibility lies. Note: This variance is not labeled favorable or unfavorable.
  1. Standard Costs and Product Costing: Actual overhead amounts are recorded in Manufacturing Overhead account, whereas applied overhead are recorded in Work-in-Process Inventory. The difference between these two figures, formerly called under- or overapplied overhead, is now composed of variances, which are recorded on the books and then closed to Cost of Goods Sold at year-end.
  2. Activity-based Flexible Budgets
    1. Activity-based and flexible budget compatible: Companies that use activity-based costing can also use flexible budgets. The basic difference between a conventional flexible budget and an activity-based flexible budget is the use of more cost pools and more cost drivers, which provides a more accurate prediction and benchmark of overhead costs.
  1. Sales Variances
    1. Extended to other areas: The idea of variance analysis can be extended to areas other than production, for example, an analysis of why actual contribution margin differed from budgeted contribution margin.
    2. Two contributors to variance when unit variables remain constant: If unit variable costs do not change, two items contribute to this variance: (1) the sales-price variance (SPV) and the sales-volume variance (SVV).
    3. Sales prices fluctuations cause variance: The sales-price variances arises because a company increased or decreased its sales price when compared with the budgeted sales price. The variance is computed as follows:
    4. SPV = (Act. Sale Price – Exp. Sale Price) X Act. Sales Volume

    5. Volume fluctuations cause variance: The sales-volume variance, which arises from an increase or decrease in units sold. The formula is:

SVV = (Act. Sales Vol. – Bud. Sale Vol.) X Unit Contribution Margin

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