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.

Flexible Budgets, Variances, and Management Control: II 101

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

102 Chapter 8
 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 producedbudgeted 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.

Flexible Budgets, Variances, and Management Control: II 103

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 costssame 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
producedthe 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)

104 Chapter 8
 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 cautionmanagement may have maintained some extra capacity to meet
uncertain demand surges that are important to satisfy
ii. Other cautionthe 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.

Flexible Budgets, Variances, and Management Control: II 105

 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

106 Chapter 8
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 39.

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:

46,000 switches were produced although 40,000 switches were scheduled to be produced.

225,000 direct manufacturing labor hours were worked at a total cost of $5,625,000.

Variable manufacturing overhead costs were $2,750,000.

Fixed manufacturing overhead costs were $3,050,000.

3. [CMA Adapted] The variable overhead spending variance for December was

a. $50,000 U. b. $350,000 U. c. $10,000 F. d. $60,000 F.

4. [CMA Adapted] The variable manufacturing overhead efficiency variance for December was

a. $50,000 U. b. $350,000 U. c. $10,000 F. d. $60,000 F.

5. [CMA Adapted] The fixed manufacturing overhead spending variance for December was

a. $450,000 F. b. $400,000 F. c. $50,000 U. d. $775,000 F.

6. The fixed overhead production volume variance for December was

Flexible Budgets, Variances, and Management Control: II 107

 a. $450,000 F. b. $400,000 F. c. $50,000 U. d. $775,000 F.
7. What amount should be credited to the allocated manufacturing overhead control account for the
month of December?

a. $6,210,000 b. $5,800,000 c. $5,760,000 d. $5,700,000

8. Under the 2-variance method, the flexible budget variance for December was

a. $10,000 F. b. $40,000 U. c. $50,000 U. d. $100,000 U.

9. Under the 3-variance method, the spending variance for December was

a. $10,000 F. b. $40,000 U. c. $50,000 U. d. $100,000 U.

10. Which of the following statements is true about overhead cost variance analysis using activity-based
costing?

a. Overhead cost variances are calculated for output-unit level costs only.
b. Overhead cost variances are calculated for variable manufacturing overhead costs only.
c. A 4-variance analysis can be conducted.
d. Activity-based costing uses input measures for all activities resulting in the inability to do flexible
budgets needed for variance analysis.

108 Chapter 8
WRITING/DISCUSSION EXERCISES
1. Explain in what ways the planning of variable overhead costs and fixed overhead costs are
similar and in what ways they differ

As noted in the text, Management will have made most of the decisions that determine
the level of fixed overhead costs to be incurred at the start of a budget period. This key
strategic decision for the companys long-range benefit is the choosing of an appropriate
level of capacity or investment to meet that level of volume or activity anticipated. What
are some other types of costs that would need to be determined at the start of the budget
period? {Prelude to Chapter 12 and the concept of locked-in costs compared to incurred
costs.} The design of a product or a process can cause certain costs to have to be incurred. These costs
would be incurred regardless of the level of activity or volume because they would be caused by the
choice of a particular type of activity rather than its volume level. Consider Webb Company and the
jackets that they produce used as illustration in Chapters 7 and 8. If Webb has planned to sell jackets with
zipper closures rather than cape-style jackets, they have set in motion types of equipment to use in
production of their product. The type of material used in the jackets or the way that decorations are
affixed (sewn or imprinted or tacked on) are other examples of design decisions that would be made at the
beginning of the budget period. These decisions affect the costs to be incurred but are not costs tied to
level of activity or volume (fixed costs).

2. Identify the features of a standard-costing system

No record need be kept of the actual costs of items used or of the actual quantity of the
cost-allocation base used on individual products or services worked on during the
period. If no record is kept as to actual costs, wont the financial statements prepared
using standard costing be dishonest about what actually happened during the time
period? A key word in the sentence is individual. Actual costs and actual quantities are recorded in any
system. The variances that are calculated between standard and actual are incorporated into the financial
statements through proration or other method of adjustment at the end of the period. The financial
statements then reflect actual costs or approximate actual costs.

3. Compute the variable overhead efficiency variance and the variable overhead spending
variance

The variable manufacturing overhead spending variance incorporates both a difference

in price and difference in usage of the overhead items. Could a variance be designed to
calculate a price variance only? Any variance can be calculated if the actual cost of the item is
collected and a budgeted amount for that item is available. The cost of preparing budgeted numbers and
collecting the actual costs for the various items of overhead might not be cost/beneficial for the
organization. An accounting system should be designed to provide the information that improves the
decisions of managers, keeping in mind that accounting systems have a cost.

Flexible Budgets, Variances, and Management Control: II 109

4. Explain how the efficiency variance for a variable indirect-cost item differs from the efficiency
variance for a direct-cost item

Should the variable overhead efficiency variance be renamed to more accurately reflect
its nature of measuring the difference in usage of the cost-allocation base? With the use of
activity-based costing, a renaming should be considered to more accurately reflect the use of the
particular cost-allocation base or cost driver. The spending variance is a change from the use of the
term price variance when considering the differences in price as well as the differences in usage of the
variable overhead item(s).

5. Compute a budgeted fixed overhead cost rate

What factors should be considered in selecting the denominator level for computing the
budgeted fixed overhead rate? Fixed costs are so named because of their behavior in relation to
changes in the level of their cost driver(s). A fixed cost remains unchanged in total for a given time
period despite wide changes in the related level of total activity or volume and is budgeted as a lump sum
or fixed amount. A denominator indicates division and an averaging or unitizing process for
developing a rate. Using a fixed overhead rate is artificial in that the fixed cost is treated as if it were a
variable cost by changing in total as the level of activity varied. The choice of a denominator level should
be chosen with care to minimize the interpretation of any variance computed from using the budgeted
fixed overhead rate.

The time period to be used is one consideration. Should a typical budget period of twelve months be used
or some longer time frame? Capacity issues are another consideration. Should the maximum capacity
available be used to obtain the lowest rate? Should the standard level of activity of the cost-allocation
base for the anticipated sales/production for the budget period be used? Should only those who prepare
financial statements for external parties make these calculations? Other considerations could include
pricing and performance evaluation issues from use of a unit cost rather than a lump sum amount.

6. Explain two concerns when interpreting the production-volume variance as a measure of the
economic cost of unused capacity

Whose responsibility is it to use caution in interpreting the production-volume variance

as a measure of the economic cost of unused capacity? Accountants understand how numbers
are developed in response to managers need for information. They are ethically responsible for reporting
the numbers in a manner consistent with the appropriate interpretation of those numbers. As indicated in
earlier chapters of the text the focus is on information and knowledge when considering variances and
responsibility. The accountants can help managers first focus on whom they should ask to obtain
information while the accountants themselves can refrain from making uninformed judgments. Refer to
the Standards of Ethical Conduct for Management Accountants developed by the Institute of
Management Accounting, Exhibit 1-7 in Chapter 1.

110 Chapter 8
 7. Show how the 4-variance analysis approach reconciles the actual overhead incurred with
the overhead amounts allocated during the period

If one were to develop a complete analysis of differences in revenue, costs, and

operating income using flexible budgets for the various inputs from the static budget to
actual amounts, how would the production-volume variance for fixed manufacturing
overhead be depicted? One could progress from actual through the flexible budgets to the static
budget going left to right, changing one item at a time to develop a fairly comprehensive analysis of
changes and interrelationships. Revenues vary with the level of volume, as do variable costs, allowing for
individual changes in price, quantity (efficiency), and sales volume (similar to Exhibit 7-4 in Chapter 7).
Variable manufacturing overhead variances can be added in similar fashion with spending and efficiency
variance paralleling the (variable) direct manufacturing costs with consideration of the role of the cost-
allocation base. But how do fixed manufacturing overhead variances fit? Fixed costs are lump sums for
reporting the actual costs, each of the flexible budgets, and the static budget. Using the total fixed costs
allows for the reporting of the spending variance or flexible-budget variance but not the production-
volume variance. The analysis will not flow in a two-dimensional plane from actual amounts through the
flexible budgets to the static budget if fixed costs are unitized, especially if the static budget level is not
the denominator level. Some variation must be made to include the changing of the fixed costs from a
total concept to a unit concept for allocation purposes. Perhaps a third dimension could be imposed.
(See Chapter 7 of this manual for an overview of the variances.)

8. Illustrate how the flexible-budget variance approach can be used in activity-based costing

Activity-based costing is an approach to refining a costing system and is especially

useful in the allocation of indirect costs. Explain what is meant by well-defined output
and input measures for an activity in the development of a 4-variance analysis. The text
defines and illustrates through Chapters 5, 6, 7, and 8 the activity-based costing approach to refining a
costing system. An activity-based costing system requires explicit definition of activities and numerous
calculations. Budgets must then be developed according to the costing system, activity-based. If the
organization has budgets that align with actual data collection, variances will be meaningful. The outputs
generated by the inputs can be compared to the standards developed and/or budgets if prepared on a
consistent basis. If an activity-based costing system is to be used, then it must be used throughout the
accounting process from planning to control. The increase in the number of calculations and detail makes
ABC expensive to implement and maintain but it should provide the manager with improved information
for making decisions. Over time, the costs of implementation have declined.

Flexible Budgets, Variances, and Management Control: II 111

SUGGESTED READINGS
Beischel, M. and Smith, K., Linking the Shop Floor to the Top Floor, Management Accounting
(October 1991) p.25 [5p].

Carman-Stone, M., Unabsorbed Overhead: What to Do When Contracts Are Canceled, Management
Accounting (April 1987) p.55 [3p].

Cornick, M., Cooper, W. and Wilson, S., How Do Companies Analyze Overhead? Management
Accounting (June 1988) p.41 [3p].

Crawford, D. and Henry, E., Budgeting and Performance Evaluation at the Berkshire Toy Company,
Issues in Accounting Education (May 2000) p.283 [27p].

Datar, S. and Gupta, M., Aggregation, Specification and Measurement Errors in Product Costing, The
Accounting Review (October 1994) p.567 [25p].

MacArthur, J. and Stranahan, H., Cost Driver Analysis in Hospitals: A Simultaneous Equations
Approach, Journal of Management Accounting Research (1998) p.279 [34p].

Martin, J. and Laughlin, E., A Graphic Approach to Variance Analysis Emphasizes Concepts Rather than
Mechanics, Issues in Accounting Education (Fall 1988) p.351 [14p].

Novin, A., Applying Overhead: How to Find the Right Bases and Rates, Management Accounting
(March 1992) p.40 [4p].

Shank, J. and Govindarajan, V., The Perils of Cost Allocation Based on Production Volumes,
Accounting Horizons (December 1988) p.71 [10p].

Wang, X. H. and Yang, B., Fixed and Sunk Cost Revisited, Journal of Economic Education (Spring
2001) p.178 [8p].

112 Chapter 8