TM 11-1

AGENDA: FLEXIBLE BUDGETS AND OVERHEAD ANALYSIS

A. Flexible budgets and performance reports

1. Static budgets
2. Flexible budgets
3. Flexible budget overhead performance report
B. Further analysis of variable overhead
1. The choice of activity measure
2. Variable overhead spending variance
3. Variable overhead efficiency variance
C. Overhead application in a standard cost system
1. Predetermined overhead rate
2. Applying overhead
D. Fixed overhead variances
1. Budget variance
2. Volume variance
E. Overhead under- and overapplied and standard cost variances

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TM 11-2

STATIC BUDGETS

The budgets in Chapter 9 were “static.” A static budget is created at the

beginning of the budgeting period and is valid only for the budgeted level
of activity.
EXAMPLE: Larch Company, which makes a single product, bases its
budgets for manufacturing overhead on the following data:

Standard
Variable overhead cost category Cost Per Unit
Maintenance............................... $0.60
Indirect materials........................ 1.40
Utilities....................................... 1.00
Total variable overhead cost........ $3.00

Budgeted
Fixed overhead cost category Annual Cost
Depreciation............................... $ 40,000
Supervision................................. 50,000
Insurance................................... 10,000
Total fixed overhead cost............ $100,000

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TM 11-3

STATIC BUDGETS (continued)

Larch Company originally planned to produce and sell 10,000 units

during the year, but actual activity was only 8,000 units. A report based on
the static (i.e., original) budget from the beginning of the year follows:

Larch Company
Comparison of Actual Overhead Costs
to Budgeted Overhead Costs
Original
Actual Budget Variance
Units produced and sold..... 8,000 10,000 2,000 U

Variable overhead costs:

Maintenance.................... $ 4,500 $ 6,000 $1,500 F
Indirect materials............. 12,000 14,000 2,000 F
Utilities............................ 9,500 10,000 500 F
Total variable overhead...... 26,000 30,000 4,000 F
Fixed overhead costs:
Depreciation.................... 40,000 40,000 0
Supervision..................... 49,000 50,000 1,000 F
Insurance........................ 10,000 10,000 0
Total fixed overhead........... 99,000 100,000 1,000 F
Total overhead cost............ $125,000 $130,000 $5,000 F
Does the above report, which is based on the original static budget,
indicate whether overhead spending was under control?

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TM 11-4

FLEXIBLE BUDGETS

• A flexible budget is geared toward all levels of activity within a relevant

range, rather than toward only one level of activity.
• A flexible budget is dynamic rather than static; it can be tailored for any
level of activity within the relevant range.
EXAMPLE: Refer to the data for Larch Company. A flexible budget for
manufacturing overhead is provided below for three different levels of
activity ranging from 5,000 to 15,000 units.

Larch Company
Flexible Budget for Overhead
Cost
Formul
a Units
Per
Unit 5,000 10,000 15,000
Variable overhead costs:
Maintenance.................. $0.60 $ 3,000 $ 6,000 $ 9,000
Indirect materials........... 1.40 7,000 14,000 21,000
Utilities.......................... 1.00 5,000 10,000 15,000
Total variable overhead.... $3.00 15,000 30,000 45,000
Fixed overhead costs:
Depreciation.................. 40,000 40,000 40,000
Supervision.................... 50,000 50,000 50,000
Insurance...................... 10,000 10,000 10,000
Total fixed overhead......... 100,000 100,000 100,000
Total overhead cost.......... $115,000 $130,000 $145,000

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TM 11-5

OVERHEAD PERFORMANCE REPORT

In a performance report focused on cost control, actual costs should be

compared to the flexible budget for the actual level of activity—not the
budget for the planned level of activity.

EXAMPLE: Because Larch Company produced and sold only 8,000 units
instead of the 10,000 units that had been planned, we would expect
spending on variable overhead items to be less than had been planned.

Larch Company
Overhead Performance Report
Actual Flexible
Costs Budget
Cost Incurred Based on Spending
Formul
a 8,000 8,000 & Budget
Per Variance
Unit Units Units s
Variable overhead costs:
Maintenance.................. $0.60 $ 4,500 $ 4,800 $ 300 F
Indirect materials.......... 1.40 12,000 11,200 800 U
Utilities......................... 1.00 9,500 8,000 1,500 U
Total variable overhead.... $3.00 26,000 24,000 2,000 U
Fixed overhead costs:
Depreciation.................. 40,000 40,000 0
Supervision................... 49,000 50,000 1,000 F
Insurance...................... 10,000 10,000 0
Total fixed overhead......... 99,000 100,000 1,000 F
Total overhead cost.......... $125,000 $124,000 $1,000 U

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TM 11-6

THE MEASURE OF ACTIVITY

• Most companies use a measure of activity such as labor-hours or

machine-hours as the activity base for manufacturing overhead. This is
particularly true in multi-product companies where hours often serve as
a common denominator for diverse products.
• Should actual hours or standard hours allowed for the actual output be
used in constructing budget allowances for the performance report?
There are two approaches:
1. The budget allowance is based solely on the actual hours. Then
only a spending variance for variable overhead is computed. (See
Exhibit 11-6 in the text for an example.)
2. Budget allowances are based on both the actual hours and the
standard hours allowed for the actual output. Then both spending
and efficiency variances are computed for variable overhead. (See
Exhibit 11-7 in the text for an example.)

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TM 11-7

Variable Overhead Performance Report:

Budget Allowances Based on Actual Hours

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TM 11-8

Variable Overhead Performance Report:

Budget Allowances Based on Actual Hours
and Standard Hours Allowed

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TM 11-9

OVERHEAD VARIANCE ANALYSIS

The flexible budget for manufacturing overhead provides information

to:
• Compute predetermined overhead rates.
• Complete the standard cost card.
• Apply overhead cost to products.
• Prepare overhead variance reports.

EXAMPLE: Swift Company manufactures a single product. Standard

cost data for the product follow:

(1) (2)
Standard Standard Standard
Quantity Price Cost
or Hours or Rate (1) × (2)
Direct materials..... 3.5 feet $12 per foot $42
Direct labor........... 2.0 hours $16 per hour $32
Overhead is assigned to the product on the basis of standard direct
labor-hours. Swift Company’s flexible budget for overhead (in
condensed form) is given below:

Cost Direct Labor-Hours

Per DLH 10,000 15,000 20,000
Variable costs.. $5 $ 50,000 $ 75,000 $100,000
Fixed costs...... 300,000 300,000 300,000
Total cost....... $350,000 $375,000 $400,000

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TM 11-10

PREDETERMINED OVERHEAD RATE

In a standard cost system, the predetermined overhead rate is

computed as follows:
Overhead from the flexible budget
Predetermined = at the denominator level of activity
overhead rate Denominator level of activity

EXAMPLE: The predetermined overhead rate at Swift Company is

computed below for two levels of activity:

Denominator activity: 10,000 DLHs

Variable element: ($50,000 ÷ 10,000 DLHs). . $ 5 per DLH
Fixed element: ($300,000 ÷ 10,000 DLHs).... 30 per DLH
Predetermined overhead rate........................ $35 per DLH

Denominator activity: 15,000 DLHs

Variable element: ($75,000 ÷ 15,000 DLHs). . $ 5 per DLH
Fixed element: ($300,000 ÷ 15,000 DLHs).... 20 per DLH
Predetermined overhead rate........................ $25 per DLH
Note that the difference between the predetermined overhead rates
at the two levels of activity is entirely due to fixed overhead being
spread over different amounts of activity.

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TM 11-11

APPLYING OVERHEAD IN A STANDARD COST SYSTEM

Assume that the denominator level of activity at Swift Company is

15,000 DLHs. The following data apply to the current year’s
operations.

Denominator level of activity................. 15,000 DLHs

Number of units completed................... 8,000 units
Actual direct labor-hours....................... 18,000 DLHs
Actual manufacturing overhead cost:
Variable............................................. $ 81,000
Fixed................................................. 305,000
Total.................................................... $386,000
In a standard cost system, overhead is applied on the basis of the
standard hours allowed for the actual output rather than on the basis
of the actual hours. This results in a simpler system in which the
overhead applied to units is always the same. In this example, the
overhead cost is always $50 per unit (2.0 DLHs per unit × $25 per
DLH)
Using the above data, the company’s manufacturing overhead
account would appear as follows:

Manufacturing Overhead
Actual overhead cost 386,000 Applied overhead cost 400,000*
Overapplied overhead 14,000
* 8,000 units × 2.0 DLHs per unit = 16,000 DLHs;
16,000 DLHs × $25 per DLH = $400,000.

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TM 11-12

VARIABLE OVERHEAD VARIANCES

Swift Company’s $14,000 overapplied overhead can be explained

by four variances: the variable overhead spending and efficiency
variances and the fixed overhead budget and volume variances. The
variable overhead variances are computed below:

Actual Hours of Actual Hours of Standard Hours

Input, at the Input, at the Allowed for Output,
Actual Rate Standard Rate at the Standard Rate
(AH × AR) (AH × SR) (SH × SR)
18,000 DLHs × 16,000 DLHs ×
$5 per DLH $5 per DLH
$81,000 = $90,000 = $80,000
  
Spending Variance, Efficiency Variance,
$9,000 F $10,000 U

Spending variance: The variable overhead spending variance

contains differences between actual and standard prices and between
actual and standard quantities.
Efficiency variance: The variable overhead efficiency variance is
not a measure of how efficiently overhead resources were used. It is
a measure of the efficiency with which the base underlying the
flexible budget was used.

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TM 11-13

FIXED OVERHEAD VARIANCES

Data concerning Swift Company are presented below:

Denominator activity (direct labor-hours)............... 15,000 DLHs

Actual direct labor-hours worked........................... 18,000 DLHs
Standard direct labor-hours allowed for output....... 16,000 DLHs
Number of units produced..................................... 8,000 units
Budgeted fixed overhead cost................................ $300,000
Actual fixed overhead cost incurred........................ $305,000
Fixed element of the predetermined overhead rate. $20
Using these data, an analysis of the company’s fixed overhead
variances follows:

Fixed Overhead Cost

Actual Fixed Budgeted Fixed Applied to
Overhead Cost Overhead Cost Work in Process
16,000 DLHs ×
$20 per DLH
$305,000 $300,000 = $320,000

Budget Variance, Volume Variance,

$5,000 U $20,000 F

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TM 11-14

FIXED OVERHEAD VARIANCES (continued)

The fixed overhead variances can also be computed as follows:

Budget = Actual fixed - Budgeted fixed

variance overhead cost overhead cost

= $305,000 - $300,000

= $5,000 U

Fixed component of � Standard�

Volume = the predetermined Denominator - hours �
�
� �
variance � hours �
�
overhead rate �
�
� allowed �
�

= $20 per DLH × (15,000 DLHs - 16,000 DLHs)

= $20,000 F

• The volume variance is not a measure of spending; it is affected

only by the level of activity.

Standard hours allowed for the actual activity > Favorable

Denominator level of activity
Standard hours allowed for the actual activity < Unfavorable
Denominator level of activity

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TM 11-15

GRAPHIC ANALYSIS OF VOLUME VARIANCE

Fixed overhead cost

Applied applied at $20 per
fixed standard hour
overhead

320,000
Volume variance
20,000 F
300,000

Budgeted
fixed
overhead

Denominator Standard
hours hours
allowed

13 14 15 16 17 18
Standard direct labor hours (000)

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TM 11-16

SUMMARY OF VARIANCES

• In a standard costing system, under or overapplied overhead

equals the sum of:
• Variable overhead spending variance
• Variable overhead efficiency variance
• Fixed overhead budget variance
• Fixed overhead volume variance
• Underapplied overhead is equivalent to a net unfavorable variance.
• Overapplied overhead is equivalent to a net favorable variance.

Thus, Swift Company’s $14,000 overapplied overhead can be

explained as follows:
Variable overhead:
Spending variance................. $ 9,000 F
Efficiency variance................. 10,000 U
Fixed overhead:
Budget variance.................... 5,000 U
Volume variance.................... 20,000 F
Overapplied overhead.............. $14,000 F

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