Flexible Budgeting and the Management of Overhead and Support Activity Costs

CHAPTER 11

Flexible Budgeting and the Management of Overhead and Support Activity Costs

ANSWERS to Review Questions

11-1The advantage of a flexible budget is that it is responsive to changes in the activity level. It enables a comparison between actual costs incurred at the actual level of activity and the standard allowed costs that should have been incurred at the actual level of activity.

11-2A static budget is based on only one level of activity. A flexible budget allows for several different levels of activity.

11-3Flexible overhead budgets are based on an input activity measure, such as process time, in order to provide a meaningful measure of production activity. An output measure, such as the number of units produced, could be used effectively only in a single-product enterprise. If multiple, heterogeneous products are produced, it would not be meaningful to base the flexible budget on an output measure aggregated across highly different types of products.

11-4A columnar flexible budget has several columns listing the budgeted levels of cost at different levels of activity. Each column is based on a different activity level. A formula flexible budget is an equation expressed as follows: total cost equals fixed cost plus the product of the activity measure and the variable cost per unit of activity. The formula flexible budget allows for any level of activity, rather than only the activity levels for the various columns used in the columnar flexible budget.

11-5Manufacturing overhead is added to Work-in-Process Inventory under standard costing as shown in the following T-accounts:

Work-in-Process Inventory / Manufacturing Overhead
X * / X *
*The amount of X is the following:

X =

11-6Computer-integrated manufacturing systems have resulted in a shift from variable toward fixed costs. In addition, as automation increases, more and more firms are switching to such measures of activity as machine hours or process time for their flexible overhead budgets. Machine hours and process time are linked more closely than direct-labor hours to the robotic technology and computer-integrated manufacturing systems becoming common in today's manufacturing environment.

11-7The interpretation of the variable-overhead spending variance is that a different total amount was spent on variable overhead than should have been spent in accordance with the variable-overhead rate, given the actual level of the cost driver upon which the variable-overhead budget is based. For example, if direct labor hours are used to budget variable overhead, an unfavorable spending variance means that a greater total amount was spent on variable overhead than should have been spent, after adjusting for how much actual direct-labor time was used. The spending variance is the control variance for variable overhead.

11-8An unfavorable variable-overhead spending variance does not imply that the company paid more than the anticipated rate per kilowatt-hour for electricity. An unfavorable spending variance could result from spending more per kilowatt-hour for electricity or from using more electricity than anticipated, or some combination of these two causes.

11-9The interpretation of the variable-overhead efficiency variance is related to the efficiency in using the activity upon which variable overhead is budgeted. For example, if the basis for the variable-overhead budget is direct-labor hours, an unfavorable variable-overhead efficiency variance will result when the actual direct-labor hours exceed the standard allowed direct-labor hours. Thus, the variable-overhead efficiency variance will disclose no information about the efficiency with which variable-overhead items are used. Rather, it results from inefficiency or efficiency, relative to the standards, in the usage of the cost driver (such as direct-labor hours).

11-10The interpretations of the direct-labor and variable-overhead efficiency variances are very different. The direct-labor efficiency variance does convey information about the efficiency with which direct labor was used, relative to the standards. In contrast, the variable-overhead efficiency variance conveys no information about the efficiency with which variable-overhead items were used.

11-11The fixed overhead budget variance is defined as the difference between actual fixed overhead and budgeted fixed overhead. It is the control variance for fixed overhead.

11-12The fixed-overhead volume variance is the difference between budgeted fixed overhead and applied fixed overhead. The best interpretation for this variance is a means of reconciling two disparate purposes of the standard-costing system: the control purpose and the product-costing purpose. For the control purpose, budgeted fixed overhead recognizes the fixed nature of this cost. Budgeted fixed overhead does not change as activity changes. For product-costing purposes, budgeted fixed overhead is divided by a denominator activity measure and applied to products on the basis of a fixed-overhead rate. The result of this dual purpose for the standard-costing system is that budgeted fixed overhead and applied fixed overhead will differ whenever the actual production activity differs from the budgeted production activity.

11-13A common but misleading interpretation of the fixed-overhead volume variance is that it is a measure of the cost of underutilizing or overutilizing production capacity. For example, when budgeted fixed overhead exceeds applied fixed overhead, the fixed-overhead volume variance is positive. Some people interpret this positive variance to be unfavorable and claim that it is a measure of the cost of not having utilized production capacity to the level that was anticipated. However, this interpretation is misleading, because the real cost of underutilizing capacity lies in the forgone contribution margins from the products that were not produced and sold.

11-14The following graph depicts budgeted and applied fixed overhead and displays a positive volume variance.

11-15All kinds of organizations use flexible budgets, including manufacturing firms, retail firms, service-industry firms, and nonprofit organizations. For example, a hospital's flexible overhead budget might be based on different levels of activity expressed in terms of patient-days.

11-16The conceptual problem in applying fixed manufacturing overhead as a product cost is that this procedure treats fixed overhead as though it were a variable cost. Fixed overhead is applied as a product cost by multiplying the fixed overhead rate by the standard allowed amount of the cost driver used to apply fixed overhead. For example, fixed overhead might be applied to Work-in-Process Inventory by multiplying the fixed-overhead rate by the standard allowed machine hours. As the number of standard allowed machine hours increases, the amount of fixed overhead applied increases proportionately. This situation is conceptually unappealing, because fixed overhead, although it is a fixed cost, appears variable in the way that it is applied to work in process.

11-17The control purpose of a standard-costing system is to provide benchmarks against which to compare actual costs. Then management by exception is used to follow up on significant variances and take corrective action. The product-costing purpose of the standard-costing system is to determine the cost of producing goods and services. Product costs are needed for a variety of purposes in both managerial and financial accounting.

11-18Fixed-overhead costs sometimes are called capacity-producing costs because they are the costs incurred in order to generate a place and environment in which production can take place. For example, a common fixed-overhead cost is depreciation, which is the cost of acquiring plant and equipment, allocated across time periods. Thus, depreciation is part of the cost of acquiring and maintaining a place in which production can occur.

11-19The following graph depicts budgeted and applied variable overhead. Budgeted and applied variable overhead are represented by the same line because variable overhead is a variable cost. Both budgeted and applied variable overhead increase proportionately as production activity increases.

11-20Plausible activity bases for a variety of organizations to use in flexible budgeting are as follows:

(a)Insurance company: Insurance policies processed or insurance claims processed.

(b)Express delivery service: Number of items of express mail or weight of express mail processed.

(c)Restaurant: Number of customers served.

(d)State tax-collection agency: Number of tax returns processed.

11-21Conventional flexible budgets typically are based on a single cost driver, such as direct-labor hours or machine hours. Costs are categorized as variable or fixed. The fixed costs do not vary with respect to the single cost driver on which the flexible budget is based. An activity-based flexible budget is based on multiple cost drivers. Cost drivers are selected on the basis of how well they explain the behavior of the costs in the flexible budget. Costs that are treated as fixed in a conventional flexible budget may vary with respect to an appropriate cost driver in an activity-based flexible budget.

Solutions to exercises

Exercise 11-22 (20 minutes)

1. / Variable-overhead spending variance / = / actual variable overhead – (AH  SVR)
= / $320,000 – (50,000  $6.00)
= / $20,000 U
2. / Variable-overhead efficiency variance / = / SVR(AH – SH)
= / $6.00(50,000 – 40,000*)
= / $60,000 U
*SH = 40,000 hrs. = 20,000 units  2 hrs. per unit
3. / Fixed-overhead budget variance / = / actual fixed overhead – budgeted fixed overhead
= / $97,000 – $100,000
= / $3,000 F
4. / Fixed-overhead volume variance / = / budgeted fixed overhead – applied fixed overhead
= / $100,000 – $80,000†
= / $20,000 (positive sign**)
†Applied fixed overhead / = /
= /  (20,000  2)
= / $80,000
**Consistent with the discussion in the text, we choose not to interpret the volume variance as either favorable or unfavorable. Some accountants would designate a positive volume variance as "unfavorable" and a negative volume variance as "favorable."

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Managerial Accounting, 5/e 11-1

EXERCISE 11-23 (40 MINUTES)

1. / Variable overhead variances:

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Exercise 11-23 (Continued)

2. / Fixed-overhead variances:
Fixed-Overhead Budget and Volume Variances
/ (1)
Actual
Fixed
Overhead / (2)
Budgeted
Fixed
Overhead / (3)
Fixed Overhead
Applied To
Work in process
Standard
Standard / Fixed-
Allowed /  / Overhead
Hours / Rate
40,000
hours /  / $2.00 per
hour*
$97,000 / $100,000 / $80,000
$3,000 Favorable / $20,000 (Positive)†
Fixed-overhead
budget variance / Fixed-overhead
volume variance
*Fixed overhead rate = $2.00 per hour =
†Consistent with the discussion in the text, we choose not to interpret the volume variance as either favorable or unfavorable. Some accountants would designate a positive volume variance as "unfavorable" and a negative volume variance as "favorable."

Exercise 11-24 (35 minutes)

(a)Graphical analysis of variable-overhead variances*:

*The graph is not drawn to scale, in order to make it easier to visualize the overhead variances.

Exercise 11-24 (Continued)

(b) Graphical analysis of budgeted versus applied fixed overhead:

EXERCISE 11-25 (30 MINUTES)

1. Answers will vary widely, depending on the governmental unit selected and the budget items selected by the student. For example, fire fighting costs might be budgeted based on cost drivers such as the number of structure fires, severity of the structure fires (e.g., one or two alarm, etc.), the number of car fires, and so forth.

1. Again, the cost drivers would depend on the governmental unit and budget items selected.

Exercise 11-26 (20 minutes)

1. / Variable-overhead spending variance / = / actual variable overhead – (AH  SVR)
= / $405,000 – (40,500  $9.00)
= / $40,500 U
2. / Variable-overhead efficiency variance / = / SVR(AH – SH)
= / $9.00(40,500 – 36,000*)
= / $40,500 U
*SH = 36,000 hrs. = 9,000 cases  4 hours per case
3. / Fixed-overhead budget variance / = / actual fixed overhead – budgeted fixed overhead
= / $122,000 – $120,000
= / $2,000 U
4. / Fixed-overhead volume variance / = / budgeted fixed overhead – applied fixed overhead
= / $120,000 – $108,000†
= / $12,000 (positive)**
†Applied fixed overhead / = /
= /
= / $108,000
**Consistent with the discussion in the text, we choose not to interpret the volume variance as either favorable or unfavorable. Some accountants would designate a positive volume variance as "unfavorable" and a negative volume variance as "favorable."

Exercise 11-27 (10 minutes)

1.
Product / Standard Hours per Unit / Number of Units / Total Standard Hours
Field ...... / 3 / 200 / 600
Professional ...... / 5 / 300 / 1,500
Total ...... / 2,100
The total standard allowed direct-labor hours in May is 2,100 hours.
2. / Basing the flexible budget on the number of binoculars produced would not be meaningful. Production of 500 binoculars could mean 100 fields and 400 professionals, or 200 fields and 300 professionals, and so forth. Depending on the composition of the 500 units, in terms of production type, different amounts of direct labor would be expected. More to the point, different amounts of variable-overhead costs would be expected.

Exercise 11-28 (15 minutes)

1. / Formula flexible budget:
Total budgeted monthly electricity cost = (3DM* number of patient days) + 1,000DM
*3DM per patient day = 30 kwh per patient day  .10DM per kwh,
where DM denotes deutsch mark, the German national currency.
2. / Columnar flexible budget:
Patient Days
30,000 / 40,000 / 50,000
Variable electricity cost...... / 90,000DM / 120,000DM / 150,000DM
Fixed electricity cost...... / 1,000DM / 1,000DM / 1,000DM
Total electricity cost...... / 91,000DM / 121,000DM / 151,000DM

Exercise 11-29 (15 minutes)

Memorandum
Date: / Today
To: / I. Makit, Production Supervisor
From: / I. M. Student, Controller
Subject: / Variable-overhead efficiency variance
The variable-overhead efficiency variance has a misleading name. This variance does not convey any information about the efficiency with which variable overhead items are used, such as electricity, manufacturing supplies, and indirect labor. An unfavorable variable-overhead efficiency variance occurs when there is inefficient usage of the cost driver (or activity base) upon which variable overhead is budgeted. For example, when direct-labor time is the cost driver, the variable-overhead efficiency variance is defined as SR(AH – SH). Thus, the difference between actual direct-labor hours (AH) and standard allowed direct-labor hours (SH) causes the variance.

Exercise 11-30 (45 minutes)

Standard machine hours per unit of output...... / 4 hours
Standard variable-overhead rate per machine hour...... / $8.00
Actual variable-overhead rate per machine hour...... / $9.00b
Actual machine hours per unit of output...... / 3d
Budgeted fixed overhead...... / $50,000
Actual fixed overhead ...... / $65,000a
Budgeted production in units...... / 25,000
Actual production in units ...... / 24,000c
Variable-overhead spending variance ...... / $72,000U
Variable-overhead efficiency variance...... / $192,000F
Fixed-overhead budget variance...... / $15,000U
Fixed-overhead volume variance...... / $2,000g(positive)
Total actual overhead...... / $713,000
Total budgeted overhead (flexible budget)...... / $818,000e
Total budgeted overhead (static budget)...... / $850,000f
Total applied overhead...... / $816,000

Exercise 11-30 (continued)

Explanatory Notes:
a. / Fixed-overhead budget variance / = / actual fixed overhead – budgeted fixed overhead
$15,000 U / = / X – $50,000
X / = / $65,000 = actual fixed overhead
b. / Total actual overhead / = / actual variable overhead + actual fixed overhead
$713,000 / = / X + $65,000
X / = / $648,000 = actual variable overhead
Variable-overhead spending variance / = / actual variable overhead – (AH  SR)
$72,000 U / = / $648,000 – (AH $8)
$8AH / = / $576,000
AH / = / 72,000
Actual variable-overhead
rate per machine hour / = /
= /

Exercise 11-30 (continued)

c. / Fixed-overhead rate / = /
= /
= / $.50 per hr.
Total standard
overhead rate / = / standard variable overhead rate + fixed-overhead rate
$8.50 / = / $8.00 + $.50
Total applied overhead / = / total standard hours  total standard overhead rate
$816,000 / = / X  $8.50
X / = / 96,000 = total standard hrs.
Actual production / = /
= /
d. / Actual machine hrs. per unit of output / = /
= /
e. / Total budgeted overhead (flexible budget)
= / budgeted fixed overhead + (SVR  SH)
= / $50,000 + ($8.00  24,000 units  4 hrs. per unit)
= / $818,000

exercise 11-30 (continued)

f. / Total budgeted overhead (static budget)
= /
= / ($8.50)(25,000)(4)
= / $850,000
g. / Fixed overhead volume variance
= / budgeted fixed overhead – applied fixed overhead
= / $50,000 – ($.50)(24,000  4)
= / $2,000 (positive)*
*Consistent with the discussion in the text, we choose not to interpret the volume variance as either favorable or unfavorable. Some accountants would designate a positive volume variance as "unfavorable" and a negative volume variance as "favorable."

Exercise 11-31 (10 minutes)

1. / Flexible budgeted amounts, using activity-based flexible budget:
a. / Indirect material: $27,500 ($15,000 + $2,500 + $2,500 + $7,500)
b. / Utilities: $5,000 ($3,750 + $1,250)
c. / Inspection: $4,400
d. / Engineering: $1,800
e. / Material handling: $4,000
f. / Total overhead cost: $60,300 ($37,500 + $10,400 + $1,800 + $4,000 + $6,600)
2. / Variance for setup cost:
a. / Using the activity-based flexible budget: $3,000 F (actual cost minus flexible budget = $3,000 – $6,000)
b. / Using the conventional flexible budget: zero (actual cost minus flexible budget = $3,000 – $3,000)

Exercise 11-32 (15 minutes)

Variable-overhead spending variance / = / actual variable overhead – (AH  SVR)
= / $2,340,000 – (275,000  $8.00)
= / $140,000 U
Variable-overhead efficiency variance / = / SVR (AH – SH)
= / $8.00 (275,000 – 280,000*)
= / $40,000 F
*SH = 56,000 units  5 hours per unit
Fixed-overhead budget variance / = / actual fixed overhead – budgeted fixed overhead
= / $3,750,000 – $3,600,000*
= / $150,000 U
*Budgeted fixed overhead = 300,000 hours  $12 per hour
Fixed-overhead volume variance / = / budgeted fixed overhead – applied fixed overhead
= / $3,600,000 – $3,360,000*
= / $240,000 (positive)†
*Applied fixed overhead = $12 per hour  5 hours per unit  56,000 units
†Consistent with the discussion in the text, we choose not to interpret the volume variance as either favorable or unfavorable. Some accountants would designate a positive volume variance as “unfavorable” and a negative volume variance as “favorable.”

Exercise 11-33 (15 minutes)

Manufacturing Overhead...... / 417,000*
Various Accounts...... / 417,000
To record actual overhead costs.
*$417,000 = $320,000 + $97,000
Work-in-Process Inventory...... / 320,000†
Manufacturing Overhead...... / 320,000
To record applied manufacturing overhead.
†$320,000 = $240,000 + $80,000
Cost of Goods Sold...... / 97,000**
Manufacturing Overhead...... / 97,000
To close underapplied overhead into Cost of Goods Sold:
**$97,000 = $417,000 – $320,000 (Also, $97,000 = sum of the four overhead variances.)

Exercise 11-34 (10 minutes)

/ actual sales
volume
($11.50* – $12.00†)  9,000 = $4,500 Unfavorable
/ budgeted unit
contribution margin
=(9,000 – 10,000)  $7.00** = $7,000 Unfavorable
*$11.50 = $103,500  9,000
†$12.00 = $120,000 ÷ 10,000
**$7.00 = ($120,000 – $40,000 – $10,000) ÷ 10,000

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Managerial Accounting, 5/e 11-1

solutions to Problems

Problem 11-35 (45 minutes)

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Problem 11-35 (Continued)

Fixed-Overhead Budget and Volume Variances
/ (1)
Actual
Fixed
Overhead / (2)
Budgeted
Fixed
Overhead / (3)
Fixed Overhead
Applied To
Work in process
Standard
Standard / Fixed-
Allowed /  / Overhead
Hours / Rate
160,000
hours /  / $5.00 per
hour
$860,000 / $900,000* / $800,000
$40,000 Favorable / $100,000 (Positive)†
Fixed-overhead
budget variance / Fixed-overhead
volume variance
*Budgeted fixed overhead = 180,000 hrs.  $5 per hour.
†Consistent with the discussion in the text, we choose not to interpret the volume variance as either favorable or unfavorable. Some accountants would designate a positive volume variance as "unfavorable" and a negative volume variance as "favorable."

Problem 11-36 (20 minutes)

1.
Policy
Type / Standard Hours per Application / Actual Activity / Standard Hours Allowed
Automobile...... / 1 / 250 / 250
Renter's ...... / 1 / 200 / 200
Homeowner's ...... / 2 / 100 / 200
Health...... / 2 / 400 / 800
Life...... / 5 / 200 / 1,000
Total...... / 2,450
2. / The different types of applications require different amounts of clerical time, and variable overhead cost is related to the use of clerical time. Therefore, basing the flexible budget on the number of applications would give a misleading estimate of overhead costs. For example, processing 100 life insurance applications will entail much more overhead cost than processing 100 automobile insurance applications.
3. / Formula flexible budget:
Total budgeted
monthly overhead
cost / = / / + / budgeted fixed-
overhead cost
per month
Total budgeted monthly overhead cost = ($4.00 X) + $2,000
where X denotes total clerical time in hours.
4. / Budgeted overhead cost for July / = / ($4.00  2,450) + $2,000
= / $11,800

Problem 11-37 (30 minutes)