Chapter 11

Standard costs for control:

flexible budgets and
manufacturing overhead

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 Outline
Flexible budgets
Input and output measures
Overhead application in a standard
costing system
Overhead cost variances
Standard costs for product costing
Standard costing systems
Activity-based budgeting
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 Flexible budgets
A detailed budget prepared for a range of
levels of activity
Often restricted to flexing overhead costs
to various levels of activity
Allows the selection of the most
appropriate benchmark for cost control
Provides a valid basis for comparing
actual and expected costs to budget, for
the actual level of activity
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 Static and flexible budgets for
moleskins, R.M. Williams

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Exe 11.21

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Exe 11.21
1 Formula flexible budget:

Total budgeted monthly electricity cost = ($18*

number of patient days) + $15 000
* 18.00 per patient day = 0.60 kwh per patient day
$30 per kwh

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Exe 11.21
1 Formula flexible budget:

Total budgeted monthly electricity cost = ($18*

number of patient days) + $15 000
* 18.00 per patient day = 0.60 kwh per patient day
$30 per kwh

2 Flexible budget in report form:

Patient days
20 000 30 000 40 000
Variable electricity cost $360 000 $540 000 $720 000
Fixed electricity cost $15 000 $15 000 $15 000
Total electricity cost $375 000 $555 000 $735 000

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 Input measures and output
measures
Units of output as a measure of the level
of activity in a multi-product firm
Output can be measured as the standard
quantity of input allowed, given actual
output
Choice between input and output
measures becomes important when
multiple products are manufactured

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 Flexible overhead budget
Flexible overhead budget shows
overhead costs at various levels of
activity using the following formula:

(cont.)

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Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e 11-9
 Flexible manufacturing overhead
budget, R.M. Williams

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Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e 11-10
 Overhead application in a
standard costing system
Overhead application is the method of
allocating overhead cost to products
Recorded in the WIP inventory account
Overhead is applied to inventory
using the standard overhead rate
The activity chosen for the standard
overhead rate should be a cost driver

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 Calculating overhead cost
variances
The flexible budget provides a tool for
controlling manufacturing overhead costs
Can be used to calculate the amount of
overhead cost that should have been
incurred given the actual level of activity
Four different overhead variances can be
calculated to compare the actual
overhead cost with the flexible budget
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Calculating variable overhead
cost variances
Variable overhead spending variance
A measure of the difference between the
actual variable overhead and the
standard variable overhead rate
multiplied by actual activity
= Actual variable overhead (AH SVR)
where AH = actual direct labour hours
SVR = standard variable overhead
rate (cont.)

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 Calculating variable overhead
cost variances (cont.)
Variable overhead efficiency variance
A measure of the difference between the
actual activity and the standard activity
allowed, given the actual output multiplied by
the standard variable overhead rate
= SVR(AH SH)
Where SH = standard direct labour hours
allowed for actual output
AH = actual direct labour hours
SVR = standard variable overhead rate
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 Variable overhead spending and
efficiency variances, R.M. Williams

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 Interpreting variable overhead
variances
Spending variance
Variance result after adjusting for the
actual quantity of cost driver used
Efficiency variance
The cost effect of excessive or minimal
use of the particular activity (cost driver)
The spending variance provides the
real control information for variable
overhead
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 Calculating fixed overhead
variances
Fixed overhead budget variance
The difference between actual fixed overhead
and budgeted fixed overhead
= actual fixed overhead budgeted fixed overhead
Fixed overhead volume variance
The difference between budgeted fixed overhead
and fixed overhead applied to production
= budgeted fixed overhead applied fixed overhead

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Fixed overhead budget and volume
variances, R.M. Williams

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Exe 11.22

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Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e 11-19
Exe 11.22

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Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e 11-20
 Interpreting fixed overhead
variances
Fixed overhead budget variance
Used for cost control
Assumes fixed overhead will not change
Fixed overhead volume variance
Standard cost driver allowed for actual
output is more/less than planned
Reconciles the two purposes of costing
systems: product costing and cost
control
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 Four-way, three-way and two-way
overhead variance analysis,
R.M. Williams

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 Standard costs for product
costing
Costs of direct material, direct labour
and manufacturing overhead are
charged to inventory at standard costs,
not actual costs
Variances are closed off at end of the
accounting period
To Cost of Goods Sold expense
Prorate between WIP, FG and COGS
inventory if the amount is large
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 Criticisms of standard
costing systems
Variances are too aggregated and
concentrate on consequences rather
than the causes of problems
Variance reports too late to be useful
Monthly reporting may be too late to correct
problems
Standard costing systems tend to focus
too heavily on cost minimisation
(cont.)
can adversely affect other areas
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 Criticisms of standard
costing systems (cont.)
Standard costing systems take a
departmental perspective rather than a
process perspective
Can lead to missing opportunities for cost
control
Controlling one departments costs may
increase costs in other departments
Too much emphasis is placed on the
cost and efficiency of direct labour (cont.)
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 Criticisms of standard
costing systems (cont.)
Overhead variances give limited cost
control information
Standard costs do not explicitly
encourage continuous improvement
Standard costs become outdated
quickly due to short product life cycles
Do not capture the full costs of materials
Ordering and paying for materials,
storage, handling, rework
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 Advantages of standard
costing
Provide a good basis for cost
comparisons
Enable managers to use management
by exception
Provide a basis for managerial
performance evaluation and
determining bonuses
(cont.)

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 Advantages of standard
costing (cont.)
Participation in setting standards and
assigning responsibility for certain
variances can motivate employees
May lead to more stable product
costs compared to using actual costs
Can be used for external financial
reporting

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 Activity-based budgeting
A process of building up budgets
from the major activities of the
business
Uses principles of ABC to estimate a
firms future demand for resources
ABB works in reverse to ABC
ABB may be complex and costly to
implement (cont.)

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 Activity-based costing versus
activity-based budgeting

Source: adapted from Cooper & Slagmulder (2000a)

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Activity-based budget, R.M. Williams

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 Activity-based budgeting (cont.)
Activity-based flexible budgets
Under ABB it is not practical to formulate
a series of flexible budgets, prior to the
commencement of the year.
ABB flexible budgets may be used as a
benchmark at the end of a period to
compare against actual costs.
Such flexible budgets may provide more
accurate benchmarks than conventional
flexible budgets (cont.)

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 Activity-based budgeting (cont.)
Inaccuracies in ABB Systems
Spending versus consumption of
resources
Estimates of non-manufacturing activities
may be distorted
Shared resources may not be accounted
for accurately
Information requirements for ABB are high
compared to traditional budgeting systems

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 Summary
A flexible budget can be used to
control manufacturing costs
Cost variances can be calculated for
variable and fixed overheads, but their
usefulness can be questioned
Standard costing systems have been
criticised in the light of more modern
methods
Activity-based budgeting may provide
more accurate benchmarks
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