CHAPTER 8
FLEXIBLE BUDGETS, VARIANCES,
AND MANAGEMENT CONTROL: II
LEARNING OBJECTIVES
1. Explain in what ways the planning of variable overhead costs and fixed overhead costs are similar and in what ways they differ
2. Identify the features of a standard-costing system
3. Compute the variable overhead efficiency variance and the variable overhead spending variance
4. Explain how the efficiency variance for a variable indirect-cost item differs from the efficiency variance for a direct-cost item
5. Compute the budgeted fixed overhead cost rate
6. Explain two concerns when interpreting the production-volume variance as a measure of the economic cost of unused capacity
7. Show how the 4-variance analysis approach reconciles the actual overhead incurred with the overhead amounts allocated during the period
8. Illustrate how the flexible-budget variance approach can be used in activity-based costing
CHAPTER OVERVIEW
Chapter 8 extends the budgeting process to the indirect manufacturing costs, both variable and fixed. The planning for these costs focuses on undertaking only essential activities and then being efficient in that undertaking with emphasis on satisfying customers. The control aspect of the budgeting process is described and illustrated through the use of standard costing and variance analysis.
Variance analysis for indirect costs demands careful interpretation of the variances primarily because of the manner in which the costs are assigned to the cost object. Indirect costs are allocated on the basis of a cost driver or cost-allocation base. In calculating the efficiency variance for variable overhead costs one is actually calculating the difference in the use of the cost-allocation base not the use of the overhead items. For direct variable costs, a price variance could be calculated but not for indirect variable costs. The difference in price from actual to budgeted is a part of the difference in quantity of variable overhead items used and is labeled as a spending variance to incorporate both differences.
Fixed overhead variances add another dimension to variance analysis because of the use of a cost-allocation base: behavior of the cost in relation to changes in level of activity. Fixed costs are budgeted as a total cost or lump sum. However, when fixed costs are used in a standard costing system and allocated on a per unit basis, they take on the “look” of a variable cost. The resulting production-volume variance, calculated as a difference between a lump sum amount and an allocation of a per unit cost, must be carefully examined for meaning.
CHAPTER OUTLINE
I. Budgeting indirect manufacturing cost categories [Refer to Chapter 7 for emphasis on direct manufacturing cost categories]
A. Overhead costs as big part of costs of many companies
1. Flexible-budget/variance-analysis approach helps managers plan and control overhead costs
2. Careful interpretation of overhead variances developed primarily for financial reporting purposes
Learning Objective 1:
Explain in what ways the planning of variable overhead costs and fixed overhead costs are similar and in what ways they differ
B. Planning of variable and fixed overhead costs
1. Similarities of variable and fixed overhead costs
a. Undertake only essential activities that add value for customers
b. Be efficient/cost effective in that undertaking
2. Differences between variable and fixed overhead costs
a. Variable-cost planning: ongoing decisions during budget period play larger role
b. Fixed-cost planning: most decisions must occur before start of period
Do multiple choice 1. Assignments start with L.O. 4.
Learning Objective 2:
Identify the features of a standard-costing system
II. Standard costing
A. Features of costing a cost object--output
1. Traces direct costs to output produced by multiplying the standard prices (SP) or rates by the standard quantities of inputs allowed (SQ) for actual outputs produced (flexible budget)
2. Allocates indirect costs on the basis of the standard indirect rates (SP) times the standard quantities of the allocation bases (SQ) allowed for actual output produced (flexible budget)
B. Features of the recording system
1. Costs of every product or service planned to be worked on during period can be computed at the start of that period
2. Individual records need not be kept of actual costs of items used or of the actual quantity of the cost-allocation based used on individual products or services worked on during the period
3. Costs of operating standard-costing system can be low relative to the costs of operating an actual or normal costing system
Do multiple choice 2. Assignments start with L.O. 4.
Learning Objective 3:
Compute the variable overhead efficiency variance and the variable overhead spending variance
C. Development of budgeted variable overhead cost-allocation rates in standard costing system
1. Four-step approach for variable overhead cost-allocation rates
a. Step 1: Choose the time period used to compute the budget
b. Step 2: Select the cost-allocation bases to use in allocating variable overhead costs to output produced
c. Step 3: Identify the variable overhead costs associated with each cost-allocation base
d. Step 4: Compute the rate per unit of each cost-allocation base used to allocate variable overhead costs to outputs produced—budgeted rate per output unit
2. Budgeted variable overhead cost rate per output unit
a. Used in static budget (planning)
b. Used in performance evaluation and reports (controlling)
D. Computation of variable manufacturing overhead cost variances [Exhibits 8-1 and 8-7]
1. Overall variance: Variable overhead flexible-budget variance: difference between actual variable overhead costs and flexible-budget variable overhead costs
2. Subdivisions of variable overhead flexible-budget variance
a. Variable overhead efficiency variance: evaluates the difference actual quantity of the cost-allocation base used relative to the budgeted quantity (what should have been used) of the cost-allocation base [(AQ – SQ) X SP]
TEACHING TIP: A comparison can be made of costing systems (actual, normal, and standard) by the calculation of the variable indirect manufacturing costs. Exercise 4-23 and problem 4-33 illustrate normal costing with the use of the calculated budgeted manufacturing overhead cost per unit of cost-allocation base (BP) multiplied by the actual quantity of the cost-allocation base (AQ) in computing the allocation of manufacturing overhead. Standard costing introduces the quantity of the cost-allocation base that should have been used (SQ) to produce the actual output, a feature of the flexible budget. Actual costing would use an actual rate and actual quantity used without the capability of variance calculations.
The flexible-budget variance used in standard costing is the same as underallocated or overallocated overhead used in normal costing for variable indirect manufacturing costs. Students can be asked how exercise 4-23/problem 4-33 would differ in the calculation of underallocated or overallocated overhead (flexible-budget variance) if the company used a standard-costing system rather than normal costing.
Learning Objective 4:
Explain how the efficiency variance for a variable indirect-cost item differs from the efficiency variance for a direct-cost item
i. Efficiency variance for direct cost measures whether more or less of direct cost item is used than was budgeted for actual output achieved
ii. Efficiency variance for indirect variable cost evaluates relative use of actual quantity to budgeted quantity of cost-allocation base (efficiency with which cost-allocation base is used)
b. Variable overhead spending variance: evaluates the actual cost per unit of the cost-allocation base relative to the budgeted cost per unit of the cost-allocation base [(AP –SP) X AQ]
i. Includes differences between actual prices of individual inputs and budgeted prices of those inputs
ii. Includes differences in percentage change in actual quantity usage of individual items in variable overhead-cost pool from percentage change in quantity usage of cost-allocation base used for the individual items
Do multiple choice 3 and 4. Assign Exercises 8-16 and 8-18.
Learning Objective 5:
Compute a budgeted fixed overhead rate
E. Development of budgeted fixed overhead cost allocation rates for use in standard costing system [Exhibits 8-2, 8-6, and 8-7]
1. By definition fixed overhead costs are a lump sum of costs that remain unchanged in total for a given period despite wide changes in the level of total activity or volume related to those overhead costs—same total amount in flexible budgets within relevant range
2. To develop a standard rate per output unit for fixed costs: four-step approach
a. Step 1: Choose the time period to be used for the budget
b. Step 2: Select the cost-allocation base to use in allocating fixed overhead costs to output produced—the denominator level
c. Step 3: Identify the fixed overhead costs associated with each cost-allocation base
d. Step 4: Compute the rate per unit of each cost-allocation base used to allocate fixed overhead costs to output produced
F. Computation of fixed manufacturing overhead cost variances [Exhibits 8-2, 8-6, and 8-7]
1. Fixed overhead flexible-budget variance (same as fixed overhead spending variance because no efficiency variance for fixed costs as a given lump sum unaffected by how efficiently cost-allocation base is used to produce output in given budget period)
2. Production-volume variance (denominator variance and output-level variance)
a. Exists because fixed costs allocated on a units-of-output basis (“unitized”) for inventory costing and some types of contracts but budgeted as a lump sum
b. Arises whenever the actual level of denominator differs from level used to calculate the budgeted fixed overhead rate
Learning Objective 6:
Explain two concerns when interpreting the production-volume variance as a measure of the economic cost of unused capacity
c. Needs careful interpretation, especially when using as a measure of the economic cost of unused capacity [Concepts in Action]
i. One caution—management may have maintained some extra capacity to meet uncertain demand surges that are important to satisfy
ii. Other caution—the production-volume variance focuses only on fixed overhead costs and does not take into account any decreases in price of output necessary to spur extra demand that might make use of any idle capacity
d. Always explore why of a variance before concluding that label of unfavorable or favorable necessarily indicates poor or good management performance
Do multiple choice 5, 6, and 7. Assign Exercises 8-17 and 8-19 and Problem 8-36.
Learning Objective 7:
Show how the 4-variance analysis approach reconciles the actual overhead incurred with the overhead amounts allocated during the period
G. Presentation of integrated analysis of overhead cost variances: 4-variance analysis [Exhibit 8-3]
1. Two variable overhead variances (spending and efficiency) and two fixed overhead variances (spending and production-volume)
2. Combinations of variances possible
a. 3-variance analysis or combined variance analysis uses total manufacturing overhead, combining variable and fixed spending variances as one, and presenting efficiency (variable) and production-volume (fixed)—loses some information but simplifies accounting
b. 2-variance analysis combines spending and efficiency variances into flexible-budget variance plus production-volume variance
c. 1-variance analysis combines all overhead variances into a total overhead variance: difference between total actual manufacturing overhead incurred and manufacturing overhead allocated to actual output produced (underallocated or overallocated concept from normal costing)
3. Variances are interrelated
Do multiple choice 8 and 9. Assign Exercises 8-21, 22, 23, 27, and 28 and Problems 8-39 and
8-40.
H. Different purposes of manufacturing overhead cost analysis [Surveys of Company Practice]
1. Planning and control purposes [Exhibit 8-4] Assign Problem 8-31.
a. Variable overhead costs vary in proportion to number of output units produced
b. Fixed overhead costs remain fixed in total over given range of output units
2. Inventory costing for financial reporting purpose
a. Variable overhead costs vary in proportion to number of output units produced
b. Fixed overhead costs allocated on per unit basis an inventoriable cost (unitized) based on level of output units produced and will not necessarily remain fixed in total but change
I. Journal entries for overhead costs and variances Assign Problems 8-29 and 8-30.
III. Other considerations of overhead variance analysis
A. Financial and nonfinancial performance measures: signals to direct managers’ attention to problems
B. Overhead cost variances in nonmanufacturing and service settings
1. Manufacturing and nonmanufacturing variable cost often used in decisions about pricing and which products to push or de-emphasize
2. Nonmanufacturing fixed costs used when reimbursed on basis of full actual costs plus a percentage of those costs and in capacity planning and utilization decisions as well as management of those costs
Assign Exercises 8-24, 8-25, and 8-26.
Learning Objective 8:
Illustrate how the flexible-budget variance approach can be used in activity-based costing
C. Activity-based costing and variance analysis
1. Basic principles and concepts for variable and fixed manufacturing overhead costs can be applied to ABC systems
2. Illustration of batch-level variance analysis [Exhibit 8-5]
Do multiple choice 10. Assign Problems 8-37 and 8-38
CHAPTER QUIZ SOLUTIONS: 1.d 2.b 3.a 4.d 5.c 6.a 7.a 8.b 9.d 10.c
CHAPTER QUIZ
1. Which of the following pertains primarily to the planning of fixed overhead costs?
a. A standard rate per output unit is developed.
b. Only essential activities are to be undertaken.
c. Activities are to be undertaken in most efficient method.
d. Key decisions are made at the start of the budget period determining the level of costs.
2. A feature of a standard-costing system is that the costs of every product or service planned to be worked on during the period can be computed at the start of that period. This feature of standard costing makes it possible to
a. maintain actual costs as an integral part of the costing system.
b. use a simple recording system.
c. eliminate routine reports.
d. justify eliminating the budgeting process.
The following data apply to questions 3–9.
Sebastian Company, which manufactures electrical switches, uses a standard cost system and carries all inventories at standard. The standard manufacturing overhead costs per switch are based on direct labor hours and are shown below:
Variable overhead (5 hours @ $12 per direct manufacturing labor hour) $ 60
Fixed overhead (5 hours @ $15* per direct manufacturing labor hour) 75
Total overhead per switch $135
*Based on capacity of 200,000 direct manufacturing labor hours per month.
The following information is available for the month of December: