CH 8

CHAPTER 8
Flexible Budgets,
Overhead Cost Variances,
and
Management Control
Learning Objective 1
Explain the similarities and

differences in planning
variable and fixed
overhead costs.
To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright 2006 by Pearson Education. All rights reserved.
8-2
Planning of Variable and

Fixed Overhead Costs
OH costs are more difficult to manage than
direct costs: the relationship between

production volume and OH costs is not easy
to determine.
Separating OH into variable and fixed OH.
8-3

Variable OH: energy, machine maintenance,
engineering support, and indirect materials

Fixed OH: plant leasing costs, depreciation
on plant equipment, and salaries of the plant
managers.
8-4

Variable OH cost planning:
1. Effective planning of variable overhead costs
involves undertaking only those variable overhead
activities that add value for customers using the
product or service.
2. Examining how each item of variable overhead
relates to delivering a superior product or service is
part of this process.
8-5

Fixed OH cost planning:
1. Focusing on eliminating the non-value added costs
2. Choosing the appropriate level of capacity or
investment that will benefit the company over an
extended time period since fixed costs are
predetermined well before the budget period begins.
8-6
Standard Costing
Standard costing is a costing system that
utilized predetermined quantities and cost of

inputs into the manufacturing process.
Traces direct costs to output by multiplying the
standard prices or rate by the standard
quantities of inputs allowed for actual outputs
produced
Allocates overhead costs on the basis of the
standard overhead-cost rates time the standard
quantities of the allocation bases allowed for the
actual outputs produced
8-7
Developing Budgeted Variable
Overhead Allocation Rates.
8-8

Overhead Allocation Rates
Step 1: Choose the period to be used for the budget.
Pasadena Co. uses a 12-month budget period.
Step 2: Select the cost-allocation base.
Pasadena budgets select labor-hours as the cost
allocation base. 26,000 labor-hours for a budgeted
output of 13,000 suits in year 2004.
8-9

Step 3: Identify the variable overhead costs
associated with each cost-allocation base.
Pasadenas budgeted variable OH costs for
2004 are $312,000.
Step 4: Compute the rate per unit of each
cost-allocation base.
Budgeted variable cost rate per base
$312,000 26,000 hours = $12/hour
8-10

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 base
= $24 per suit (output unit)
8-11
Compute the variable overhead

efficiency variance and
spending variance.
8-12
Variable Overhead
Cost Variances
The following data are for 2004 when
Pasadena produced and sold 10,000 suits:
Output units:
10,000
Labor-hours:
Actual results:
Flexible-budget amount:
21,500
20,000
8-13
Variable Overhead
Cost Variances
Labor-hours per 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
$240,000
8-14
Variable Overhead
Cost Variances
Variable manufacturing overhead
cost per labor-hour:
Actual results:
$244,775 21,500 = $11.3849
$240,000 20,000 = $12.00
8-15
Variable Overhead
Cost Variances
cost per output unit:
Actual results:
$244,775 10,000 = $24.4775
$240,000 10,000 = $24.00
8-16
Flexible-Budget Analysis
The variable overhead flexible-budget variance
measures the difference between the actual
variable overhead costs and the flexible-budget
variable overhead costs.
Actual results: $244,775

Flexible-budget amount $240,000 = $4,775 U
8-17
Actual
Costs Incurred
$244,775
Budgeted Inputs
Allowed for Actual
Outputs at Budgeted Rate
20,000 $12.00
= $240,000
$4,775 U
Flexible-budget variance
8-18
The Details:
Variable OH Variances
Variable Overhead Efficiency Variance is the
difference between actual quantity of the costallocation base used and budgeted quantity of the
cost-allocation base, times budgeted OH rate.
8-19
Actual Quantity
of Inputs at
Budgeted Rate
21,500 $12.00
= $258,000
Budgeted Inputs
Allowed for Actual
Outputs at Budgeted Rate
20,000 $12.00
= $240,000
$18,000 U
Variable overhead efficiency variance
8-20
Interpretation of Efficiency Variance

Direct cost efficiency variance: whether more or
fewer direct materials or direct labor hours are
used per output than budgeted.
OH cost efficiency: whether more or fewer cost
allocation bases are used than budgeted.
The key cause for Pasadenas unfavorable
efficiency variance is the higher-than-budgeted
labor-hours used.
8-21
Interpretation of Efficiency Variance

Possible causes:
1. Less skilled workers
2. Production schedule inefficiency
3. Poor machine maintenance
4. A rush delivery
5. Standards too tight
8-22
The Details:
Variable OH Variances
Variable Overhead Spending Variance is the
difference between actual and budgeted variable

overhead cost rate, multiplied by actual quantity of
variable overhead cost-allocation base used
8-23
Actual Costs Incurred

$244,775
Actual Quantity
of Inputs at
Budgeted Rate
21,500 $12.00
= $258,000
$13,225 F
Variable overhead spending variance
8-24
Variable Overhead Variances

Flexible-budget variance
$4,775 U
Efficiency variance
$18,000 U
Spending variance
$13,225 F
8-25
Interpretation Spending Variance

Actual variable OH cost rate is lower than budgeted.
In the Pasadena Co.s example, the 21,500 actual direct
manufacturing labor-hours are 7.5% greater than the
flexible-budget amount of 20,000 direct manufacturing
labor-hours.
(21,500 20,000) 20,000 = 7.5%
Actual variable overhead costs of $244,775 are only 2%
greater than the flexible-budget amount of $240,000.
8-26
Interpretation Spending Variance

Possible causes:
1. Actual prices of individual inputs are lower
than budgeted.
2. The percentage increase in actual quantity
usage of individual items is less than
percentage increase in labor hours.
8-27
Journal Entries for Variable Overhead

Costs and Variances
What is the journal entry to record variable
manufacturing overhead?
Variable Manufacturing
Overhead Control
244,775
Accounts Payable (and other)
244,775
To record actual variable manufacturing overhead
costs incurred
8-28

Costs and Variances
What is the journal entry to allocate variable
Work in Process Control
240,000
Overhead Allocated
240,000
To record variable manufacturing overhead cost
allocated: (2.00 10,000 $12)
What is the journal entry to isolate variances?
8-29

Costs and Variances
Overhead Allocated
240,000
Variable Overhead
Efficiency Variance
18,000
Overhead Control
244,775
Variable Overhead
Spending Variance
13,225
To isolate variances for the accounting period
8-30
Compute a budgeted
fixed overhead cost rate.
8-31
Developing Budgeted Fixed

Fixed overhead costs are, by definition, a lump sum
of costs that remain unchanged in total for a given
period despite wide changes in the level of activity.
These costs are fixed in the sense that they do not
automatically increase or decrease with the level of
activity within the relevant range.
Fixed costs are expressed on a per-unit basis to
facilitate assigning a unit cost to the product or
service.
8-32

Step 1: Choose the period used for the budget.
The budget period is typically twelve months.
Step 2: Select the cost-allocation base.
Pasadena budgets 26,000 labor-hours for a budgeted
output of 13,000 suits in year 2004.
8-33

Step 3: Identify the fixed overhead costs.
Pasadenas fixed manufacturing budget for
2004 is $286,000.
Step 4: Compute the rate per unit of each
cost-allocation base.
$286,000 26,000 = $11
8-34

What is the budgeted fixed overhead cost rate
per output unit (dress suit)?
2 hours allowed per output unit
$11 budgeted fixed overhead cost rate per base
$22 per suit (output unit)

8-35
The Details:
Fixed OH Variances
Fixed Overhead Flexible-Budget Variance is the
difference between actual fixed overhead costs and

fixed overhead costs in the flexible budget
This is the same amount for the Fixed Overhead
Spending Variance
8-36
Flexible-Budget Variance
Actual Costs
Incurred
$300,000
Flexible Budget:
Budgeted
Fixed Overhead
$286,000
$14,000 U
Fixed overhead spending variance
Fixed overhead flexible-budget variance
8-37
The Details:
Fixed OH Variances
Production-Volume Variance is the difference between
budgeted fixed overhead and fixed overhead allocated

on the basis of actual output produced
This variance is also known as the Denominator-Level
Variance or the Output-Level Overhead Variance
8-38
Production-Volume Variance
Flexible Budget:
Budgeted
Fixed Overhead
$286,000
Fixed Overhead Allocated Using

Budgeted Input Allowed for
Actual Output Units Produced
$220,000
$66,000 U
Production-volume variance
10,000 2.00 $11 = $220,000
8-39
Fixed Overhead Variances

Fixed overhead variance (Difference between
actual and allocated fixed OH)
$80,000 U
Production-volume variance
$66,000 U
Spending variance
$14,000 U
8-40
Journal Entries for Fixed Overhead Costs

and Variances
What is the journal entry to record fixed
Fixed Manufacturing
Overhead Control
300,000
Accumulated
Depreciation, etc.
300,000
To record actual fixed manufacturing
overhead costs incurred
8-41

and Variances
What is the journal entry to allocate fixed
Work in Process Control
220,000
Fixed Manufacturing
Overhead Allocated
220,000
To record fixed manufacturing overhead cost
allocated: (2.00 10,000 $11)
What is the journal entry to isolate variances?
8-42

and Variances
Fixed Manufacturing
Overhead Allocated
220,000
Fixed Overhead
Spending Variance
14,000
Fixed Overhead
Volume Variance
66,000
Fixed Manufacturing
Overhead Control
300,000
To isolate variances for the accounting period
8-43
Interpreting the
production-volume variance
8-44
The production volume variance is an
indicator of the use of capacity. If the

company exceeded planned capacity, the
variance is favorable. If the company fell
short of planned capacity, the variance is
unfavorable, as there was unused capacity.
8-45
Interpreting the ProductionVolume Variance

Should unfavorable production volume variance be
interpreted as a measure of the economic cost of
unused capacity?
Management
Management may
may have
have maintained
maintained some
some
extra
extra capacity
capacity to
to accommodate
accommodate unexpected
unexpected
surges
surges in
in demand.
demand.
Production
Production volume
volume variance
variance focuses
focuses
only
only on
on costs.
costs.
8-46
Another way to view the production-volume
variance is that a favorable variance indicates

that overhead was over-allocated; if
unfavorable, overhead is under-allocated.
8-47
Possible causes of production-volume
variance:
1. Weak demand
2. Quality problem
3. Strategic mistake
8-48
Show how the 4-variance

analysis approach reconciles
the actual overhead incurred
with the overhead amounts
allocated during the period.
8-49
A Roadmap: Variable Overhead
8-50
A Roadmap: Fixed Overhead
8-51
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.
8-52
Integrated Analysis
Actual manufacturing overhead incurred:
Fixed manufacturing overhead
Total
Overhead allocated:
Fixed manufacturing overhead
Total
Amount underallocated
$244,775
300,000
$544,775
$240,000
220,000
$460,000
$ 84,775
8-53
Integrated Analysis
4-Variance Analysis:
Spending V
Variable OH: $13,225 F
Fixed OH:
14,000 U
Efficiency V
18,000 U
Never
Volume V
Never
66,000 U
8-54
Integrated Analysis
Total OH:
Spending V
$ 775 U
Efficiency V
18,000 U
Volume V
66,000 U
8-55
Integrated Analysis
Total OH:
Flexible V
18,775 U
Production-Volume V
66,000 U
8-56
Production-Volume Variance and SalesVolume Variance

Units
Rev.
VC
FC
OI
Flexible
Operating income
budget (1) based on allocated FC(2)
Actual (x)
Actual (x)
Bgtd SP*x Bgtd SP*x
Bgtd/unit*x Bgtd/unit*x
Bgtd
Allocated
Flexible OI Allocated OI
Static
Budget(3)
Bgtd (y)
Bgtd SP*y
Bgtd/unit*y
Bgtd
Static OI
For OI:
Difference between column 1 and 2: production-volume
variance.
Difference between column 2 and 3: operating income
volume variance
8-57
Production-Volume Variance and SalesVolume Variance

Sales-volume variance
Production-volume
variance
Operating income
volume variance
8-58
Financial and Nonfinancial

Performance
Overhead variances are examples of financial
performance measures.
What are examples of nonfinancial measures?
Actual labor time, relative to budgeted time
Actual indirect materials usage per labor-hour,
relative to budgeted indirect materials usage
8-59
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.
8-61
Activity-Based Costing and Variance

Analysis
1.Units produced and sold
2.Batch size
3.Number of batches
4.Material-handling
labor-hours per batch
5.Total labor-hours
6.Variable OH cost per
material-handling labor-hour
7. Variable handling OH costs
8.Fixed material-handling
OH cost
Static
Budget
180,000
150
1,200
Actual
Amounts
151,200
140
1,080
6
7,200
6.25
6,750
$20
144,000
$21
141,750
$216,000
$220,000
8-62

Variance Analysis
Flexible budget variance for variable handling OH
=(Actual costs Flexible budget costs)
=141,750 (151,200/150)*6*20
=20,790 U
Variable handling OH efficiency variance:
(Actual Q of allocation base used- Budgeted Q of
allocation base allowed)*budgeted variable OH per base
=(6,750 6,048)*20
=14,040 U
8-63

Variance Analysis
Variable handling OH spending variance:
(Actual variable OH per base - Budgeted variable OH
per base)* Actual Q of allocation base used
=(21 20)*6,750
=6, 750 U
8-64

Variance Analysis
Flexible budget variance for fixed handling OH (Spending
variance)=4,000 U
Budgeted fixed handling OH cost per unit of allocation base
=Budgeted total fixed OH/ Budgeted total Q of base)

=216,000/7,200 = 30
Production-volume variance for fixed handling OH:
=Budgeted fixed handling OH Fixed handling OH
allocated
=216,000 (151,200/150)*6*30
=34,560 U
8-65

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CHAPTER 8

Explain the similarities and

Planning of Variable and

direct costs: the relationship between

Planning of Variable and

engineering support, and indirect materials

Planning of Variable and

Planning of Variable and

utilized predetermined quantities and cost of

Developing Budgeted Variable

Developing Budgeted Variable

Developing Budgeted Variable

Compute the variable overhead

Actual results: $244,775

Interpretation of Efficiency Variance

Interpretation of Efficiency Variance

difference between actual and budgeted variable

Actual Costs Incurred

Variable Overhead Variances

Interpretation Spending Variance

Interpretation Spending Variance

Journal Entries for Variable Overhead

Journal Entries for Variable Overhead

Journal Entries for Variable Overhead

Developing Budgeted Fixed

Developing Budgeted Fixed

Developing Budgeted Fixed

Developing Budgeted Fixed

$11 budgeted fixed overhead cost rate per base

$22 per suit (output unit)

difference between actual fixed overhead costs and

budgeted fixed overhead and fixed overhead allocated

Fixed Overhead Allocated Using

Fixed Overhead Variances

Journal Entries for Fixed Overhead Costs

Journal Entries for Fixed Overhead Costs

Journal Entries for Fixed Overhead Costs

indicator of the use of capacity. If the

Interpreting the ProductionVolume Variance

variance is that a favorable variance indicates

Show how the 4-variance

A Roadmap: Variable Overhead

A Roadmap: Fixed Overhead

Production-Volume Variance and SalesVolume Variance

Production-Volume Variance and SalesVolume Variance

Financial and Nonfinancial

Activity-Based Costing and

Activity-Based Costing and Variance

Activity-Based Costing and

Activity-Based Costing and

Activity-Based Costing and

=Budgeted total fixed OH/ Budgeted total Q of base)

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