Chapter 11 - Flexible Budgeting and the Management of Overhead and Support Activity Costs

CHAPTER 11

FLEXIBLE BUDGETING AND THE MANAGEMENT OF

OVERHEAD AND SUPPORT ACTIVITY COSTS

Learning Objectives

1. Distinguish between static and flexible budgets, and explain the

advantages of a flexible overhead budget.

2. Prepare a flexible overhead budget, using both a formula and a

columnar format.

3. Explain how overhead is applied to Work-in-Process Inventory under

standard costing.

4. Explain some important issues in choosing an activity measure for

overhead budgeting and application.

5. Compute and interpret the variable-overhead spending and efficiency

variances and the fixed-overhead budget and volume variances.

6. Prepare an overhead cost performance report.

7. Explain how an activity-based flexible budget differs from a

conventional flexible budget.

8. Prepare journal entries to record manufacturing overhead under

standard costing (Appendix A).

9. Compute and interpret the sales-price and sales-volume variances

(Appendix B).

Chapter Overview

I. Flexible Budgets
A. Flexible budgets vs. static budgets
B. Advantages
C. The activity measure
D. Flexible budget formula

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Chapter 11 - Flexible Budgeting and the Management of Overhead and Support Activity Costs

II. Overhead Application in a Standard-Costing System

A. Standard costing vs. normal costing
B. Choice of an activity measure

III. Cost Management Using Overhead Cost Variances

A. Analysis of variable overhead
1. Spending and efficiency variances
2. Interpretation of results
B. Analysis of fixed overhead
1. Budget and volume variances
2. Interpretation of results

IV. Activity-Based Flexible Budgets

V. Appendix A: Standard Costs and Product Costing

VI. Appendix B: Sales Variances

Key Lecture Concepts

1. FLEXIBLE BUDGETS

A flexible budget is a detailed plan for controlling overhead

and other costs. Most important, the flexible budget is prepared
for different levels of activity within a firm's relevant range.

In contrast, a static budget (such as the master budget

in Chapter 9) sets forth a plan for only one level of activity.

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.

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Chapter 11 - Flexible Budgeting and the Management of Overhead and Support Activity Costs

As mentioned in previous chapters, when applying or budgeting

overhead, the activity base must be chosen carefully. It is
typically an input measure, namely, the standard hours allowed
for the actual production.

The flexible budget may be expressed as a formula:

Total budgeted overhead = (Budgeted variable cost per

activity unit x Number of activity units) + Budgeted
fixed overhead cost

The formula allows quick calculation of overhead amounts at any

volume level within the relevant range.

2. OVERHEAD APPLICATION IN A STANDARD-COSTING SYSTEM

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.

Normal costing:
Overhead applied = Actual hours x Predetermined
rate

Standard costing:
Overhead applied = Standard hours x Predetermined
rate (i.e., S x S)
Predetermined overhead rates are calculated by dividing the
overhead dollars shown in the flexible budget by the most likely
level of activity.

The activity measure selected should be a cost driver for

variable overhead, with both of these items moving together as
activity changes.

More companies are switching to machine hours and

process time to reflect the increased importance of

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Chapter 11 - Flexible Budgeting and the Management of Overhead and Support Activity Costs

computer-integrated manufacturing at their firms.

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Chapter 11 - Flexible Budgeting and the Management of Overhead and Support Activity Costs

3. COST MANAGEMENT USING OVERHEAD COST VARIANCES

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.

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**)

* Actual hours ** Standard variable-overhead rate ***

Standard hours

The result of taking (SH x SVR) is the amount of variable

overhead applied to production.

The VOH spending variance is the result of comparing the

amount that was spent on variable overhead items at the
actual level of activity against the amount that should
have been spent at that level.

The spending variance can arise from paying

higher/lower prices than expected and consuming
larger/smaller quantities than expected (e.g.,
energy, supplies), so it is not a "pure" price/rate
variance.

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 associated with the application
base (e.g., machine hours, process hours, and so on).

Fixed overhead variances are calculated as follows:

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Chapter 11 - Flexible Budgeting and the Management of Overhead and Support Activity Costs

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Chapter 11 - Flexible Budgeting and the Management of Overhead and Support Activity Costs

FOH budget variance = Actual fixed overhead -

Budgeted fixed overhead
FOH volume variance = Budgeted fixed overhead -
Applied fixed overhead

The FOH budget variance is the result of comparing total

actual fixed-overhead expenditures with lump-sum,
budgeted fixed overhead costs.

Although it is often difficult to change certain fixed

cost expenditures in the short run, unfavorable fixed
overhead items should be carefully monitored and
the information used when preparing future budgets.

The volume variance occurs whenever the planned level of

activity and the standard level of activity differ.

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 activity levels is in response to an
unexpected decrease in demand.

Note: Some managerial accountants do not attach a

favorable or unfavorable label to this variance.

4. ACTIVITY-BASED FLEXIBLE BUDGETS

The basic difference between a conventional flexible budget and

an activity-based flexible budget is the use of additional cost
pools and additional cost drivers.

The end-result of this process is a more accurate prediction

and benchmark of overhead costs.

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Chapter 11 - Flexible Budgeting and the Management of Overhead and Support Activity Costs

5. APPENDIX A: STANDARD COSTS AND PRODUCT COSTING

Journal entries are made to record overhead expenditures

throughout the period. Actual overhead amounts are recorded
in the Manufacturing Overhead account, whereas applied
overhead amounts (S x S) are recorded in Work-in-Process
Inventory.

The difference between actual and applied overhead, 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.

6. APPENDIX B: SALES VARIANCES

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.

If unit variable costs do not change, two items will contribute to

this variance: the sales-price variance (SPV) and the sales-
volume variance (SVV).

The sales-price variance (SPV) arises because a

company increased or decreased its sales price when
compared with the budgeted sales price. The variance is
computed as follows:

SPV = (Actual sales price - Budgeted sales price) x

Actual sales volume

The sales-volume variance (SVV), which arises from an

increase or decrease in units sold, is calculated as:

SVV = (Actual sales volume - Budgeted sales volume) x

Budgeted sales price

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Chapter 11 - Flexible Budgeting and the Management of Overhead and Support Activity Costs

Teaching Overview

The two main concepts in Chapter 11 are (1) the construction and use of a
flexible budget and (2) the analysis of overhead variances. The construction
of a flexible budget presents little difficulty for students; however, overhead
variance analysis is more troublesome.

Be prepared to spend extra time in the area of variance computation. If this

is the first time that you have taught the course, you may be surprised at
how easily students calculate and interpret direct material and direct labor
variances, and the great difficulty they have in doing the same for overhead.

Fixed overhead is especially troublesome. I recommend emphasizing that

fixed cost items and variable cost items cannot be analyzed by using the
same model. Even students who remember this fact seem to experience
"interference" from the variable cost model and use an erroneous
combination of the two.

A teaching hint: Show why the (AH x SVR) calculation that is used for
variable overhead cannot be used for fixed overhead because no matter
what the activity level, this calculation (the amount that the AH should have
cost) must remain the same (i.e., fixed). Thus, the middle term of the model
cannot fluctuate and, instead, is budgeted fixed overhead.

Quite frankly, when teaching this chapter, I tend to focus on flexible

budgets. Students have already received a heavy exposure to variances via
the material presented in Chapter 10. In addition, accounting majors will
see the overhead variance topic again when they take a full course in cost
accounting/management.
Possible lecture/demonstration material includes Problem 11-40 (flexible
budgets and performance evaluation), Exercise 11-22 (straightforward
example of overhead variances), and Problem 11-39 (variance calculation
and interpretation).

Links to the Text

Homework Grid CHAPTER 11

Learnin Completi Special

Item No. g on Feature
Objectiv Time s*
es (min.)
Exercises:

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Chapter 11 - Flexible Budgeting and the Management of Overhead and Support Activity Costs

11-22 5 20

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Chapter 11 - Flexible Budgeting and the Management of Overhead and Support Activity Costs

11-32 5 15
11-27 1, 2 10
11-26 5 20
11-23 5 40
11-24 5 35
11-29 5 15 C
11-25 4, 7 30 W
11-31 7 10
11-30 2, 5 45
11-28 1, 2 15
11-33 8 15
11-34 9 10
Problems:
11-35 5 45
11-37 1, 2, 3 30 C
11-38 5 40
11-36 1, 2, 4 20
11-41 5 25
11-39 1, 6 30
11-40 1, 2, 5 30
11-43 1, 2, 5 40 C
11-45 1, 2, 6 55 E, C
11-42 1, 6 40 C
11-44 1, 5 45
11-46 5 20 C
11-48 1, 2, 5 60 G
11-47 1, 6 40 C
11-49 5 35
Learnin Completi Special
Item No. g on Feature
Objectiv Time s*
es (min.)
11-50 5, 8 30 I
11-51 2, 5, 8 60 C, G
11-52 9 20
11-53 9 45
Cases:
11-54 1, 3, 5 50 G
11-55 4, 5, 7 50 G
* C = Business communication E = Ethics G = Group work I = International
W = Web-based application

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Chapter 11 - Flexible Budgeting and the Management of Overhead and Support Activity Costs

Links to the Ancillaries

Video Programs

McGraw-Hill has produced various videos that are relevant to the instruction
of managerial/cost accounting. Information about these videos (including a
description of those applicable to this chapter) appears in Appendix A.

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