Flexible Budgets,

Overhead Cost Variances,

and
Management Control

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Basic Concepts
 Managing overhead costs is challenging. Managers must
understand the behavior of overhead costs, plan for
them, perform variance analysis, and act upon the
results.
 In planning variable overhead costs, managers seek to
eliminate activities that do not add value to the product
or service.
 Examining how each item of variable overhead relates to
delivering a superior product or service is part of this
process.

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Basic Concepts
 Effective planning for fixed overhead costs is similar to
planning for variable overhead costs—focusing on
eliminating the non-value added costs.
 An additional strategic issue for managers in fixed costs
is choosing the appropriate level of capacity that will
benefit the company in the long run.
 Timing is an important issue in this planning. By the
beginning of the budget period most decisions
regarding fixed costs will have been made. With variable
costs, day-to-day operating decisions affect the level of
variable costs incurred in the period.
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Planning and Overhead
 Variable Overhead: as efficiently as possible, plan only
essential activities
 Fixed Overhead: as efficiently as possible, plan only
essential activities, especially since fixed costs are
predetermined well before the budget period begins

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Standard Costing
 Standard costing is a costing system that utilized
predetermined quantities and cost of inputs into the
manufacturing process
 Traces direct costs to output by multiplying the
standard prices or rate by the standard quantities of
inputs allowed for actual outputs produced
 Allocates overhead costs on the basis of the standard
overhead-cost rates time the standard quantities of the
allocation bases allowed for the actual outputs
produced
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Overhead Variances
 Overhead is the most difficult cost to manage, and is
the least understood
 Overhead variances involve taking differences between
equations as the analysis moves back and forth
between actual results and budgeted amounts

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Developing Budgeted Variable Overhead
Cost Rates
1. Choose the period to be used for the budget
2. Select the cost-allocation bases to use in allocating
variable overhead costs to output produced
3. Identify the variable overhead costs associated
with each cost-allocation base
4. Compute the rate per unit of each cost-allocation
base used to allocate variable overhead costs to
output produced

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 Developing budgeted variable
overhead cost-allocation rates
 Step 1: Choose the Period to Be Used for the
Budget. Normally companies will use a 12-month
period for budgeting, but a shorter time frame may be
appropriate in given situations.
 Step 2: Select the Cost-Allocation Bases to Use
in Allocating Variable Overhead Costs to Output
Produced. In selecting the cost-allocation bases,
management is seeking a cause-and-effect relationship
between the cost and the base, or cost driver. Webb’s
operating manager selected machine-hours as cost
allocation base for variable and fixed overhead.
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 Developing budgeted variable
overhead cost-allocation rates
 Based on engineering study, Webb estimates it will
take 0.40 of machine-hour per actual output unit. For
its budgeted output of 144,000 jackets in 2008, Webb
budgets 57,600 (0.40 * 144,000) machine hours.
 Step 3: Identify the Variable Overhead Costs
Associated with Each Cost-Allocation Base. Webb
groups all of its variable overhead costs in a single cost
pool. Webb’s total budgeted variable overhead costs
for 2008 are $1,728,000.

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 Developing budgeted variable
overhead cost-allocation rates
 Step 4: Compute the Rate per Unit of Each
Cost-Allocation Base Used to Allocate Variable
Overhead Costs to Output Produced. Dividing the
amount in step 3 ($1,728,000) by the amount in step 2
(57,600), Webb estimated a rate of $30 per standard
machine-hour for allocating its variable overhead
costs. Webb calculates the budgeted overhead cost rate
per unit by multiplying Budgeted input allowed per
output (0.40) with Budgeted variable overhead cost
rate per input unit ($30).

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 Data for Variable Overhead Cost
Variances
 Actual Flexible
 Output Units (Jackets) 10,000 10.000
 Machine-hours per output unit 0.45 0.40
 Machine-hours (1*2) 4,500 4,000
 Variable overhead costs $130,500 $120,000
 Variable overhead costs per
machine-hour $29.00 $30.00
 Variable overhead costs per output unit $13.05 $12.00

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The Details: Variable OH Variances
 Variable Overhead Flexible-Budget Variance
measures the difference between actual variable
overhead costs incurred and flexible-budget
variable overhead amounts :
 = $130,500 - $120,000
 = $10,500 U

Variable Overhead Actual Costs Flexible-budget

flexible-budget variance = Incurred - amount

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 The Details: Variable OH Variances
 Variable Overhead Efficiency Variance is the
difference between actual quantity of the cost-
allocation base used and budgeted quantity of the
cost per unit of the cost-allocation base:
 = (4,500 hours – 0.40hr/unit *10,000) *$30 per hr
 = (4,500-4,000) *$30 per hr = $15,000 U

{ }X
Variable Actual quantity of Budgeted quantity of Budgeted variable
Overhead variable overhead variable overhead cost- overhead cost
Efficiency = cost-allocation base - allocation based allowed per unit of
Variance used for actual output for actual output cost-allocation base

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The Details: Variable OH Variances
 Variable Overhead Spending Variance is the
difference between actual and budgeted variable
overhead cost per unit of the cost-allocation base,
multiplied by actual quantity of variable overhead
cost-allocation base used for actual output:
=($29 per machine hr - $30 per machine hr)* 4,500
machine hr= (-$1 per machine hr) * 4,500 machine
hr= $4,500 F

{ }X
Variable Actual variable Budgeted variable Actual quantity of
Overhead overhead cost overhead cost variable overhead
Spending = per unit of - per unit of cost-allocation base
Variance cost-allocation base cost-allocation base used for actual output

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 Journal Entries for Variable
Overhead Costs and Variances
 1. Variable Overhead Control 130,500
 Accounts Payable & other accounts 130,500
 2. Work-in-Process Control 120,000
 Variable Overhead Allocated 120,000
 3. Variable Overhead Allocated 120,000
 Variable Overhead Efficiency
 Variance 15,000
 Variable Overhead Control 130,500
 Variable Overhead Spending Variance 4,500
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A Roadmap: Variable Overhead
Flexible Budget: Allocated:
Actual Costs
Budgeted Input Budgeted
Incurred: Actual Inputs
Allowed for Input Allowed for
Actual Input X
Actual Output Actual Output
X Budgeted Rate
X X
Actual Rate
Budgeted Rate Budgeted Rate

Spending Efficiency Never a

Variance Variance Variance

Flexible-Budget Never a
Variance Variance

Total Variable Overhead Variance

Over/Under Allocated Variable Overhead

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Variable Overhead
Variance Analysis Illustrated

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Possible Reasons For Favorable
Spending Variance
 Actual prices of individual inputs included in variable
overhead costs, such as the price of energy, indirect
materials, or indirect labor, are lower than budgeted
prices of the inputs.
 The favorable spending variance can be partially or
completely traced to the efficient use of energy and
other variable overhead items.

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Possible Causes of Exceeding
Budget
 Workers were less skilled than expected in using
machines.
 Production scheduler inefficiently scheduled jobs,
resulting in more machine hours used than budgeted.
 Machines were not maintained in good operating
conditions.
 Webb’s sales staff promised a distributor a rush
delivery, which resulted in more machine-hours used
than budgeted.
 Budgeted machine time standards were set too tight.
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Developing Budgeted Fixed Overhead Cost
Rates
1. Choose the period to be used for the budget
2. Select the cost-allocation bases to use in allocating
fixed overhead costs to output produced. For
simplicity we assume Webb expects to operate at
capacity in fiscal year 2008– with a budgeted usage
of 57,600 machine hours for budgeted output of
144,ooo jackets.

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Developing Budgeted Fixed Overhead Cost
Rates
3. Identify the fixed overhead costs associated with
each cost-allocation base. Webb’s fixed overhead
budget for 2008 is $3,312,000.
4. Compute the rate per unit of each cost-allocation
base used to allocate fixed overhead costs to
output produced. Dividing the $3,312,000 from
step 3 by the machine hour from step 2, Webb
estimates a fixed overhead rate of $57.50 per
machine-hour.

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The Details: Fixed OH Variances
 Fixed Overhead Flexible-Budget Variance is the
difference between actual fixed overhead costs
($285,000)and fixed overhead costs in the flexible
budget ($276,000).
 This is the same amount for the Fixed Overhead
Spending Variance:
 = $285,000 – 276,000
 = $9,000 U
Fixed Overhead Actual Costs Flexible-budget
flexible-budget variance = Incurred - amount

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The Details: Fixed OH Variances
 Production-Volume Variance is the difference
between budgeted fixed overhead ($276,000) and
fixed overhead allocated on the basis of actual output
produced (0.40*10,000 units $57.50) =$230,000.
 This variance is also known as the Denominator-Level
Variance or the Output-Level Overhead Variance:
 = $276,000 - $230,000
 = $46,000 U
Production-Volume Budgeted Fixed Overhead allocated using
Variance = Fixed Overhead - budgeted input allowed for
actual output units produced

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Production-Volume Variance
 Interpretation of this variance is difficult due to the nature
of the costs involved and how they are budgeted
 Fixed costs are by definition somewhat inflexible. While
market conditions may cause production to flex up or
down, the associated fixed costs remain the same
 Fixed costs may be set years in advance, and may be
difficult to change quickly
 Contradiction: Despite this, examination of the fixed
overhead budget formulae reveals that it is budgeted
similar to a variable cost

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Journal Entries for Fixed Overhead
Costs and Variances
 . Fixed Overhead Control 285,000
 Salaries Payable & other accounts 285,000
 2. Work-in-Process Control 230,000
 Fixed Overhead Allocated 230,000
 3. Fixed Overhead Allocated 230,000
 Fixed Overhead Spending Variance 9,000
 Fixed Overhead Production Volume
 Variance 46,000
 Fixed Overhead Control 285,000
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A Roadmap: Fixed Overhead
Same Budgeted Flexible Budget: Allocated:
Lump Sum Same Budgeted Budgeted
Actual Costs (as in Static Lump Sum (as in Input Allowed for
Incurred Budget) Static Budget) Actual Output
Regardless of Regardless of X
Output Level Output Level Budgeted Rate
Production-
Spending Never a Volume
Variance Variance Variance

Production-
Flexible-Budget
Volume
Variance
Variance

Total Fixed Overhead Variance

Over/Under Allocated Fixed Overhead

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Fixed Overhead
Variance Analysis Illustrated

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Fixed Overhead Behavior

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Integrated
Variance
Analysis
Illustrated

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© 2009 Pearson Prentice Hall. All rights reserved.