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Flexible Budgets, Variances, and Management Control:II

Flexible Budgets, Variances, and Management Control:II. Session 8. Learning Objectives. Explain similarities and differences in the planning of variable overhead costs and the planning of fixed overhead costs Identify the key features of a standard costing system

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Flexible Budgets, Variances, and Management Control:II

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  1. Flexible Budgets, Variances, and Management Control:II Session 8

  2. Learning Objectives • Explain similarities and differences in the planning of variable overhead costs and the planning of fixed overhead costs • Identify the key features of a standard costing system • Compute variable overhead spending and efficiency variances • Compute the budgeted fixed overhead rate • Explain two caveats to consider when interpreting the production-volume variance as a measure of the economic cost of unused capacity • Show how the 4-Variance Analysis approach reconciles the actual overhead incurred with the overhead amounts allocated during the period • Illustrate how the flexible-budget variance approach can be used in activity-based costing

  3. Learning Objective 1 Explain similarities and differences in the planning of variable overhead costs and the planning of fixed overhead costs

  4. Planning of Variable and Fixed Overhead Costs • Rockville Co. manufactures a dress suit that is then sold to distributors. • Variable overhead costs include: • Energy • Machine maintenance • Indirect materials • Indirect labor • Fixed manufacturing overhead costs include: • Plant leasing costs • Some administrative costs (plant manager’s salary) • Depreciation

  5. Planning of Variable and Fixed Overhead Costs • Effective planning of variable overhead costs involves undertaking only those variable overhead activities that add value for customers using the product or service. • Rockville’s customers perceive sewing to be an essential activity, therefore, maintenance activities for sewing machines included in variable overhead costs are also essential. • Effective planning of fixed overhead costs involves planning to undertake only essential activities and then planning to be efficient in that undertaking.

  6. Planning of Variable and Fixed Overhead Costs • The key challenge with planning fixed overhead is choosing the appropriate level of capacity or investment that will benefit the company over an extended time period. • Most of the key decisions that determine the level of fixed overhead costs to be incurred are made at the start of a budget period. • Day-to-day, ongoing operating decisions play a large role in determining the level of variable overhead costs incurred in the budget period.

  7. Learning Objective 2 Identify the key features of a standard costing system

  8. Standard Costing • Standard costing is a costing method that traces direct costs to a cost object by multiplying the standard price(s) or rate(s) times the standard inputs allowed for actual outputs produced. • Costs of every product or service planned to be worked on during the period can be computed at the start of that period. • Once standards have been set, the costs of operating a standard costing system can be low relative to an actual or normal costing system.

  9. Developing Budgeted Variable Overhead Allocation Rates • Variable overhead cost allocation rates can be developed with a four step approach. • Step 1: Choose the time period used to compute the budget. • Rockville uses a twelve-month budget period.

  10. Developing Budgeted Variable Overhead Allocation Rates • Variable overhead cost allocation rates can be developed with a four step approach. • Step 1: Choose the time period used to compute the budget. • Step 2: Select the cost-allocation bases to use in allocating variable overhead-costs to the cost object(s). • Rockville selects standard labor-hours as the cost allocation base. • Rockville budgets 26,000 labor hours for a budgeted output of 13,000 suits in year 2001.

  11. Developing Budgeted Variable Overhead Allocation Rates • Variable overhead cost allocation rates can be developed with a four step approach. • Step 1: Choose the time period used to compute the budget. • Step 2: Select the cost-allocation bases to use in allocating variable overhead-costs to the cost object(s). • Step 3: Identify the variable overhead costs associated with each cost-allocation base. • Rockville groups all its variable manufacturing overhead costs (energy, machine maintenance, engineering support, indirect materials, indirect labor) into a single cost pool. • Rockville’s budgeted variable manufacturing costs for 2001 are $312,000.

  12. Developing Budgeted Variable Overhead Allocation Rates • Variable overhead cost allocation rates can be developed with a four step approach. • Step 1: Choose the time period used to compute the budget. • Step 2: Select the cost-allocation bases to use in allocating variable overhead-costs to the cost object(s). • Step 3: Identify the variable overhead costs associated with each cost-allocation base. • Step 4: Compute the rate per unit of each cost-allocation base used to allocate variable overhead costs to the cost object(s). • Rockville estimates a rate of $12/labor hour for its variable manufacturing overhead costs. • $312,000 ÷ 26,000 hours = $12/hour

  13. Developing Budgeted Variable Overhead Allocation Rates • What is the budgeted variable overhead cost rate per output unit (dress suit)? • 2.00 hours allowed per output unit × $12 budgeted variable overhead cost rate per input unit = $24 per suit (output unit)

  14. Learning Objective 3 Compute variable overhead spending and efficiency variances

  15. Variable Overhead Cost Variances • The following data are for 2001 when Rockville Co. produced and sold 10,000 suits: • Output units: 10,000 • Labor-hours: Actual results: 21,500 Flexible-budget amount: 20,000 • Labor-hours/output unit: Actual results: 21,500 ÷ 10,000 = 2.15 Flexible-budget amount: 20,000 ÷ 10,000 = 2.00 • Variable manufacturing overhead costs: Actual results: $244,775 Flexible-budget amount: $240,000 • Variable manufacturing overhead cost per labor hour: Actual results: $244,775 ÷ 21,500 = $11.3849 Flexible-budget amount: $240,000 ÷ 20,000 = $12.00 • Variable manufacturing overhead cost per output unit: Actual results: $244,775 ÷ 10,000 = $24.4775 Flexible-budget amount: $240,000 ÷ 10,000 = $24.00

  16. Actual Budgeted Inputs Costs Allowed for Actual Incurred Outputs at Budgeted Rate 21,500 × $11.3849 20,000 × $12.00 = $244,775 = $240,000 $4,775 U Flexible-budget variance Flexible-Budget Analysis • The variable overhead flexible-budgetvariance measures the difference between the actual variable overhead costs and the flexible-budget variable overhead costs.

  17. Variable Overhead Efficiency Variance • The variable overhead efficiency variance measures the efficiency with which the cost-allocation base is used. • (Actual units of variable overhead cost-allocation base used for actual output - Budgeted units of variable overhead cost-allocation base allowed for actual output) x Budgeted variable overhead rate = (21,500 – 20,000) × $12 = $18,000 U • This unfavorable variance means that actual labor-hours were higher than the budgeted labor-hours allowed. Actual Quantity of Inputs at Budgeted Inputs Allowed for Actual Budgeted RateOutputs at Budgeted Rate 21,500 × $12.00 20,000 × $12.00 = $258,000 = $240,000 $18,000 U Variable overhead efficiency variance

  18. Actual Actual Quantity Costs of Inputs at IncurredBudgeted Rate 21,500 × $11.3849 21,500 × $12.00 = $244,775 = $258,000 $13,225 F Variable overhead spending variance Variable Overhead Spending Variance • The variable overhead spending variance is the difference between the actual amount of variable overhead incurred and the budgeted amount allowed for the actual quantity of the variable overhead allocation base used for the actual output units produced.

  19. Variable Overhead Variances Flexible-budget variance $4,775 U Efficiency variance $18,000 U Spending variance $13,225 F

  20. Learning Objective 4 Compute the budgeted fixed overhead rate

  21. Developing Budgeted Fixed Overhead Allocation Rates • Fixed overhead costs are a lump sum that remains unchanged in total for a given time period despite wide changes in the related total activity or output level. • While total fixed costs are frequently included in flexible budgets, they remain the same total amount within the relevant range regardless of the output level chosen.

  22. Developing Budgeted Fixed Overhead Allocation Rates • 4 steps in developing the budgeted fixed overhead rate: • Step 1: Choose the time period used to compute the budget. • The budget period is typically twelve months.

  23. Developing Budgeted Fixed Overhead Allocation Rates • 4 steps in developing the budgeted fixed overhead rate: • Step 1: Choose the time period used to compute the budget. • Step 2: Select the cost-allocation base to use in allocating fixed overhead costs to the cost object(s). • Rockville uses standard labor hours as the cost allocation base for fixed manufacturing overhead costs. • This is the denominator of the budgeted fixed overhead rate computation. • It is called the denominator levelorproduction-denominator level. • In year 2001, Rockville budgets 26,000 labor hours for a budgeted output of 13,000 suits.

  24. Developing Budgeted Fixed Overhead Allocation Rates • 4 steps in developing the budgeted fixed overhead rate: • Step 1: Choose the time period used to compute the budget. • Step 2: Select the cost-allocation base to use in allocating fixed overhead costs to the cost object(s). • Step 3: Identify the fixed overhead costs associated with each cost-allocation base. • Rockville groups all its fixed manufacturing overhead costs (depreciation, leasing costs, plant manager’s salary) in a single cost pool. • Rockville’s fixed manufacturing budget for 2001 is $286,000.

  25. Developing Budgeted Fixed Overhead Allocation Rates • 4 steps in developing the budgeted fixed overhead rate: • Step 1: Choose the time period used to compute the budget. • Step 2: Select the cost-allocation base to use in allocating fixed overhead costs to the cost object(s). • Step 3: Identify the fixed overhead costs associated with each cost-allocation base. • Step 4: Compute the rate per unit of each cost-allocation base used to allocate fixed overhead costs to the cost object(s). • Rockville estimates a rate of $11/labor-hour for its fixed manufacturing overhead costs. • $286,000 ÷ 26,000 = $11

  26. Developing Budgeted Fixed Overhead Allocation Rates • What is the budgeted fixed overhead cost rate per output unit (dress suit)? 2.00 hours allowed per output unit • $11 budgeted fixed overhead cost rate per input unit • $22 per suit (output unit)

  27. Fixed Overhead Cost Variances • The flexible budget amount for a fixed cost item is the amount included in the static budget prepared at the start of the period. • No adjustment is required for differences between the actual output and the budgeted output for fixed costs. • Fixed costs are unaffected by changes in the level of output.

  28. Flexible-Budget Variance • The fixed overhead flexible-budget variance (spending variance) is the difference between actual fixed overhead costs and the fixed overhead costs in the flexible budget. • Assume that Rockville’s actual total fixed overhead is $300,000. • Actual costs incurred $300,000 – Flexible-budget amount $286,000 = $14,000 U • The variable overhead flexible-budget variance was subdivided into a spending variance and an efficiency variance. • For fixed overhead there is not an efficiency variance. Why? • Because a lump sum of fixed costs will be unaffected by the degree of operating efficiency in a given budget period.

  29. Flexible Budget: Fixed Overhead Budgeted Allocated Using Budgeted Input Fixed Overhead Allowed for Actual Output Units Produced $286,000 $220,000 $66,000 U Production-volume variance 10,000 × 2.00 × $11 = $220,000 Production-Volume Variance • The production-volume variance is the difference between budgeted fixed overhead and the fixed overhead allocated on the basis of the budgeted quantity of the fixed overhead allocation base allowed for the actual output produced. • Denominator-level variance • Output-level overhead variance

  30. Fixed Overhead Variances Fixed overhead variance $80,000 U Volume variance $66,000 U Spending variance $14,000 U

  31. Fixed overhead variances Actual Cost Function Cost Budgeted Cost Function 66 300 14 286 Labor hours 20 26

  32. Learning Objective 5 Explain two caveats to consider when interpreting the production-volume variance as a measure of the economic cost of unused capacity

  33. Interpreting the Production-Volume Variance • Caution is appropriate before interpreting the production-volume variance as a measure of the economic cost of unused capacity. • One caveat is that management may have maintained some extra capacity to meet uncertain demand surges that are important to satisfy customer demands. • A second caveat is that the production-volume variance focuses only on costs.It does not take into account any price changes necessary to spur extra demand that would in turn make use of any idle capacity.

  34. Interpreting the Production-Volume Variance • Lump-sum fixed costs represent resources sacrificed in acquiring capacity. • Plant • Equipment leases • These costs cannot be decreased if the resources needed are less than the resources acquired.

  35. Interpreting the Production-Volume Variance • The unfavorable $66,000 production-volume variance measures the amount of extra fixed costs that Rockville incurred for manufacturing capacity it planned to use but did not. • Had Rockville manufactured 13,000 suits instead of 10,000, allocated fixed overhead would have been 13,000 × 2.00 × $11 = $286,000. • No production-volume variance would have occurred.

  36. Interpreting the Production-Volume Variance • Assume that in year 2001, Rockville’s denominator level is exactly the capacity used for that budget period, but actual demand and production turns out to be 8% below the denominator level. • Rockville would report an unfavorable production-volume variance.

  37. Learning Objective 6 Show how the 4-Variance Analysis approach reconciles the actual overhead incurred with the overhead amounts allocated during the period

  38. Integrated Analysis • A 4-Variance Analysis presents • spending and • efficiency variances for variable overhead costs • and spending and • production-volume variances for fixed overhead costs. • Managers can reconcile the actual overhead costs with the overhead amounts allocated during the period.

  39. Integrated Analysis Actual manufacturing overhead incurred:Variable manufacturing overhead $244,775 Fixed manufacturing overhead 300,000 Total $544,775 Overhead allocated:Variable manufacturing overhead $240,000 Fixed manufacturing overhead 220,000 Total $460,000 Amount underallocated $ 84,775

  40. Integrated Analysis 4-Variance AnalysisVariable manufacturing overhead:Spending variance $13,225 F Efficiency variance 18,000 U Fixed manufacturing overhead:Spending variance 14,000 U Volume variance 66,000 U Total $84,775 U

  41. Integrated Analysis 3-Variance AnalysisVariable and fixed manufacturing overhead:Spending variance $13,225 F + $14,000 U = $ 775 U Variable manufacturing overhead:Efficiency variance 18,000 U Fixed manufacturing overhead:Volume variance 66,000 U Total $84,775 U

  42. Integrated Analysis 2-Variance AnalysisVariable and fixed manufacturing overhead: Spending variance $ 775 U Variable manufacturing overhead:Efficiency variance 18,000 U Flexible-budget variance: $18,775 U Fixed manufacturing overhead Volume variance: 66,000 U Total $84,775 U

  43. Different Purposes of Overhead Cost Analysis • Variable manufacturing overhead costs are variable with respect to output units (suits) for both planning and control purposes and inventory costing purpose. • The greater the number of output units manufactured, the higher the budgeted total variable manufacturing overhead costs and the higher the total variable manufacturing overhead costs allocated to output units

  44. Different Purposes of Overhead Cost Analysis • Fixed overhead costs do not change within the relevant range. • Management can do little to change the lump-sum fixed cost. • Under generally accepted accounting principles, fixed manufacturing costs are allocated as an inventoriable cost based on the level of output units produced.

  45. Different Purposes of Overhead Cost Analysis • Every output unit that Rockville manufactures will increase the fixed overhead allocated to products by $22. • Managers should not use this unitization of fixed manufacturing overhead costs for planning and control.

  46. Financial and Nonfinancial Performance • Overhead variances are examples of financial performance measures. • Managers also find that nonfinancial measures provide useful information. Examples are: • actual labor time per suit, relative to budgeted labor time per suit, and... • actual indirect materials usage per labor-hour, relative to budgeted indirect materials usage per labor-hour. • Nonfinancial performance measures are best viewed as attention directors, not as problem solvers.

  47. Learning Objective 7 Illustrate how the flexible-budget variance approach can be used in activity-based costing

  48. Activity-Based Costing and Variance Analysis • ABC systems classify costs of various activities into a cost hierarchy (output-unit level, batch level, product sustaining, and facility sustaining). • The basic principles and concepts for variable and fixed manufacturing overhead costs can be extended to ABC systems. • Flexible budgeting in activity-based costing systems enables insight into why actual activity costs differ from those budgeted. • With well-defined output and input measures for an activity, a 4-variance analysis can be conducted.

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