This document discusses flexible budgets and their advantages over static budgets. It provides an example of how to prepare a flexible budget for variable and fixed overhead costs using different activity levels. The flexible budget allows for "apples to apples" cost comparisons by showing costs that should have been incurred at the actual activity level. This improves performance evaluation by revealing variances related to cost control and separating variances due to activity from those due to cost control.

1. Chapter 9
© The McGraw-Hill Companies, Inc., 2007McGraw-Hill /Irwin
Flexible Budgets and
Overhead Analysis

2. 9-2
Learning Objective
To prepare a flexible budget and
explain the advantages of
the flexible budget approach
over the static budget
approach
LO1

3. 9-3
Static Budgets and Performance Reports
Static budgets
are prepared for
a single, planned
level of activity.
Performance evaluation is
difficult when actual activity
differs from the planned level
of activity.
Hmm! Comparing
static budgets with
actual costs is like
comparing apples
and oranges.

4. 9-4
Flexible Budgets
Let’s look at a Specific Example.
May be prepared for any activity
level within the relevant range.
Show costs that should have been
incurred at the actual level of
activity, enabling “apples to apples”
cost comparisons.
Reveal variances related to
cost control.
Improve performance evaluation.

5. 9-5
CheeseCo
Static Budgets and Performance Reports

6. 9-6
CheeseCo
Static Budgets and Performance Reports

7. 9-7
U = Unfavorable variance
CheeseCo was unable to achieve
the budgeted level of activity.
CheeseCo
Static Budgets and Performance Reports

8. 9-8
CheeseCo
F = Favorable variance that occurs when
actual costs are less than budgeted costs.
Static Budgets and Performance Reports

9. 9-9
Since cost variances are favorable, have
we done a good job controlling costs?
CheeseCo
Static Budgets and Performance Reports

10. 9-10
I don’t think I
can answer the
question using
a static budget.
Actual activity is below
budgeted activity.
So, shouldn’t variable costs
be lower if actual activity
is lower?
Static Budgets and Performance Reports

11. 9-11
Static Budgets and Performance Reports
The relevant question is . . .
“How much of the favorable cost
variance is due to lower activity, and
how much is due to good cost control?”
To answer the question,
we must
the budget to the
actual level of activity.

12. 9-12
Learning Objective
To prepare a performance report
for both variable and fixed
overhead costs using the
flexible budget approach
LO2

13. 9-13
Preparing a Flexible Budget
To a budget we need to know that:
 Total variable costs change
in direct proportion to
changes in activity.
 Total fixed costs remain
unchanged within the
relevant range.
Fixed

14. 9-14
Preparing a Flexible Budget

15. 9-15
Cost Total
Formula Fixed 8,000 10,000 12,000
per Hour Cost Hours Hours Hours
Machine hours 8,000 10,000 12,000
Variable costs
Indirect labor 4.00$
Indirect materials 3.00
Power 0.50
Total variable cost 7.50$
Fixed costs
Depreciation 12,000$
Insurance 2,000
Total fixed cost
Total overhead costs
Flexible Budgets
Preparing a Flexible Budget
Fixed costs are
expressed as a
total amount.
Variable costs are expressed as
a constant amount per hour.
$40,000 ÷ 10,000 hours is
$4.00 per hour.
CheeseCo

16. 9-16
Cost Total
Formula Fixed 8,000 10,000 12,000
per Hour Cost Hours Hours Hours
Machine hours 8,000 10,000 12,000
Variable costs
Indirect labor 4.00$ 32,000$
Indirect materials 3.00 24,000
Power 0.50 4,000
Total variable cost 7.50$ 60,000$
Fixed costs
Depreciation 12,000$
Insurance 2,000
Total fixed cost
Total overhead costs
Flexible Budgets
Preparing a Flexible Budget
$4.00 per hour × 8,000 hours = $32,000
CheeseCo

17. 9-17
Preparing a Flexible Budget
CheeseCo
Cost Total
Formula Fixed 8,000 10,000 12,000
per Hour Cost Hours Hours Hours
Machine hours 8,000 10,000 12,000
Variable costs
Indirect labor 4.00$ 32,000$
Indirect materials 3.00 24,000
Power 0.50 4,000
Total variable cost 7.50$ 60,000$
Fixed costs
Depreciation 12,000$ 12,000$
Insurance 2,000 2,000
Total fixed cost 14,000$
Total overhead costs 74,000$
Flexible Budgets

18. 9-18
Cost Total
Formula Fixed 8,000 10,000 12,000
per Hour Cost Hours Hours Hours
Machine hours 8,000 10,000 12,000
Variable costs
Indirect labor 4.00$ 32,000$ 40,000$
Indirect materials 3.00 24,000 30,000
Power 0.50 4,000 5,000
Total variable cost 7.50$ 60,000$ 75,000$
Fixed costs
Depreciation 12,000$ 12,000$ 12,000$
Insurance 2,000 2,000 2,000
Total fixed cost 14,000$ 14,000$
Total overhead costs 74,000$ 89,000$ ?
Flexible Budgets
Preparing a Flexible Budget
Total fixed costs
do not change in
the relevant range.
CheeseCo

19. 9-19
Quick Check 
What should be the total overhead costs for
the Flexible Budget at 12,000 hours?
a. $92,500.
b. $89,000.
c. $106,800.
d. $104,000.

20. 9-20
What should be the total overhead costs for
the Flexible Budget at 12,000 hours?
a. $92,500.
b. $89,000.
c. $106,800.
d. $104,000.
Quick Check 
Total overhead cost
= $14,000 + $7.50 per hour  12,000 hours
= $14,000 + $90,000 = $104,000

21. 9-21
Preparing a Flexible Budget
Cost Total
Formula Fixed 8,000 10,000 12,000
per Hour Cost Hours Hours Hours
Machine hours 8,000 10,000 12,000
Variable costs
Indirect labor 4.00$ 32,000$ 40,000$ 48,000$
Indirect materials 3.00 24,000 30,000 36,000
Power 0.50 4,000 5,000 6,000
Total variable cost 7.50$ 60,000$ 75,000$ 90,000$
Fixed costs
Depreciation 12,000$ 12,000$ 12,000$ 12,000$
Insurance 2,000 2,000 2,000 2,000
Total fixed cost 14,000$ 14,000$ 14,000$
Total overhead costs 74,000$ 89,000$ 104,000$
Flexible Budgets

22. 9-22
Flexible Budget Performance Report

23. 9-23
Cost Total
Formula Fixed Flexible Actual
per Hour Cost Budget Results Variances
Machine hours 8,000 8,000 0
Variable costs
Indirect labor 4.00$ 34,000$
Indirect materials 3.00 25,500
Power 0.50 3,800
Total variable cost 7.50$ 63,300$
Fixed costs
Depreciation 12,000$ 12,000$
Insurance 2,000 2,050
Total fixed cost 14,050$
Total overhead costs 77,350$
CheeseCo
A flexible budget is
prepared for the
same activity level
(8,000 hours) as
actually achieved.
Flexible Budget Performance Report

24. 9-24
Quick Check 
What is the variance for indirect labor when
the flexible budget for 8,000 hours is
compared to the actual results?
a. $2,000 U
b. $2,000 F
c. $6,000 U
d. $6,000 F

25. 9-25
What is the variance for indirect labor when
the flexible budget for 8,000 hours is
compared to the actual results?
a. $2,000 U
b. $2,000 F
c. $6,000 U
d. $6,000 F
Quick Check 

26. 9-26
Cost Total
Formula Fixed Flexible Actual
per Hour Cost Budget Results Variances
Machine hours 8,000 8,000 0
Variable costs
Indirect labor 4.00$ 32,000$ 34,000$ $ 2,000 U
Indirect materials 3.00 25,500
Power 0.50 3,800
Total variable cost 7.50$ 63,300$
Fixed costs
Depreciation 12,000$ 12,000$
Insurance 2,000 2,050
Total fixed cost 14,050$
Total overhead costs 77,350$
CheeseCo
Flexible Budget Performance Report

27. 9-27
Quick Check 
What is the variance for indirect materials
when the flexible budget for 8,000 hours is
compared to the actual results?
a. $1,500 U
b. $1,500 F
c. $4,500 U
d. $4,500 F

28. 9-28
What is the variance for indirect materials
when the flexible budget for 8,000 hours is
compared to the actual results?
a. $1,500 U
b. $1,500 F
c. $4,500 U
d. $4,500 F
Quick Check 

29. 9-29
Cost Total
Formula Fixed Flexible Actual
per Hour Cost Budget Results Variances
Machine hours 8,000 8,000 0
Variable costs
Indirect labor 4.00$ 32,000$ 34,000$ $ 2,000 U
Indirect materials 3.00 24,000 25,500 1,500 U
Power 0.50 4,000 3,800 200 F
Total variable cost 7.50$ 60,000$ 63,300$ $ 3,300 U
Fixed costs
Depreciation 12,000$ 12,000$ 12,000$ $ 0
Insurance 2,000 2,000 2,050 50 U
Total fixed cost 14,000$ 14,050$ 50 U
Total overhead costs 74,000$ 77,350$ $ 3,350 U
CheeseCo
Flexible Budget Performance Report

30. 9-30
Flexible Budget Performance Report

31. 9-31
Static Budgets and Performance
How much of the $11,650 favorable variance is due to
lower activity and how much is due to cost control?

32. 9-32
Difference between original static budget
and actual overhead = $11,650 F.
Overhead Variance Analysis
Static Actual
Overhead Overhead
Budget at at
10,000 Hours 8,000 Hours
89,000$ 77,350$
Let’s insert
the flexible
budget for
8,000 hours
here.
Flexible Budget Performance Report

33. 9-33
Overhead Variance Analysis
This $15,000F variance is
due to lower activity.
Activity
This $3,350U
variance is due
to poor cost control.
Cost control
Static Flexible Actual
Overhead Overhead Overhead
Budget at Budget at at
10,000 Hours 8,000 Hours 8,000 Hours
89,000$ 74,000$ 77,350$
Flexible Budget Performance Report

34. 9-34
The Measure of Activity– A Critical Choice
Three important
factors in selecting an
activity base for an overhead
flexible budget
Activity base and
variable overhead
should be
causally related.
Activity base should
not be expressed
in dollars or
other currency.
Activity base should
be simple and
easily understood.

35. 9-35
Learning Objective
LO3
To use a flexible budget to
prepare a variable overhead
performance report containing
only a spending variance

36. 9-36
Variable Overhead Variances –
A Closer Look
If flexible budget
is based on
actual hours
If flexible budget
is based on
standard hours
Only a spending
variance can be
computed.
Both spending
and efficiency
variances can be
computed.

37. 9-37
Variable Overhead Variances – Example
ColaCo’s actual production for the period
required 3,200 standard machine hours. Actual
variable overhead incurred for the period was
$6,740. Actual machine hours worked were
3,300. The standard variable overhead cost per
machine hour is $2.00.
Compute the variable overhead spending
variance first using actual hours. Then use
standard hours allowed to calculate the variable
overhead efficiency variance.

38. 9-38
Actual Flexible Budget
Variable for Variable
Overhead Overhead at
Incurred Actual Hours
AH × SRAH × AR
Spending
Variance
Spending variance = AH(AR – SR)
Variable Overhead Variances
AH = Actual hours
AR = Actual variable
overhead rate
SR = Standard variable
overhead rate

39. 9-39
Actual Flexible Budget
Variable for Variable
Overhead Overhead at
Incurred Actual Hours
3,300 hours
×
$2.00 per hour
= $6,600$6,740
Spending Variance
= $140 unfavorable
Variable Overhead Variances – Example

40. 9-40
Variable Overhead Variances –
A Closer Look
Spending Variance
Results from paying more
or less than expected for
overhead items and from
excessive usage of
overhead items.
Now, let’s use the
standard hours
allowed, along with
the actual hours, to
compute the
efficiency variance.

41. 9-41
Learning Objective
LO4
To use a flexible budget to
prepare a variable overhead
performance report containing
both a spending and an
efficiency variance

42. 9-42
AH × SRAH × AR
Spending variance = AH(AR - SR)
Efficiency variance = SR(AH - SH)
SH × SR
Spending
Variance
Efficiency
Variance
Actual Flexible Budget Flexible Budget
Variable for Variable for Variable
Overhead Overhead at Overhead at
Incurred Actual Hours Standard Hours
Variable Overhead Variances

43. 9-43
3,300 hours 3,200 hours
× ×
$2.00 per hour $2.00 per hour
Variable Overhead Variances – Example
$6,740 $6,600 $6,400
Spending variance
$140 unfavorable
Efficiency variance
$200 unfavorable
$340 unfavorable flexible budget total variance
Actual Flexible Budget Flexible Budget
Variable for Variable for Variable
Overhead Overhead at Overhead at
Incurred Actual Hours Standard Hours

44. 9-44
Efficiency Variance
Controlled by
managing the
overhead cost driver.
Variable Overhead Variances –
A Closer Look

45. 9-45
Quick Check 
Yoder Enterprises’ actual production for the period
required 2,100 standard direct labor hours. Actual
variable overhead for the period was $10,950.
Actual direct labor hours worked were 2,050. The
predetermined variable overhead rate is $5 per
direct labor hour. What was the spending
variance?
a. $450 U
b. $450 F
c. $700 F
d. $700 U

46. 9-46
Yoder Enterprises’ actual production for the
period required 2,100 standard direct labor hours.
Actual variable overhead for the period was
$10,950. Actual direct labor hours worked were
2,050. The predetermined variable overhead rate
is $5 per direct labor hour. What was the spending
variance?
a. $450 U
b. $450 F
c. $700 F
d. $700 U
Quick Check 
Spending variance = AH (AR - SR)
= Actual variable overhead incurred – (AH  SR)
= $10,950 – (2,050 hours  $5 per hour)
= $10,950 – $10,250
= $700 U

47. 9-47
Quick Check 
Yoder Enterprises’ actual production for the period
required 2,100 standard direct labor hours. Actual
variable overhead for the period was $10,950.
Actual direct labor hours worked were 2,050. The
predetermined variable overhead rate is $5 per
direct labor hour. What was the efficiency
variance?
a. $450 U
b. $450 F
c. $250 F
d. $250 U

48. 9-48
Yoder Enterprises’ actual production for the
period required 2,100 standard direct labor hours.
Actual variable overhead for the period was
$10,950. Actual direct labor hours worked were
2,050. The predetermined variable overhead rate
is $5 per direct labor hour. What was the
efficiency variance?
a. $450 U
b. $450 F
c. $250 F
d. $250 U
Quick Check 
Efficiency variance = SR (AH – SH)
= $5 per hour (2,050 hours – 2,100 hours)
= $250 F

49. 9-49
2,050 hours 2,100 hours
× ×
$5 per hour $5 per hour
Quick Check Summary
Actual Flexible Budget Flexible Budget
Variable for Variable for Variable
Overhead Overhead at Overhead at
Incurred Actual Hours Standard Hours
$10,950 $10,250 $10,500
Spending variance
$700 unfavorable
Efficiency variance
$250 favorable
$450 unfavorable flexible budget total variance

50. 9-50
Activity-based Costing
and the Flexible Budget
It is unlikely that all
variable overhead will be
driven by a single activity.
Activity-based costing
can be used when multiple
activity bases drive
variable overhead costs.

51. 9-51
Learning Objective
LO5
To compute the
predetermined overhead rate
and apply overhead to
products in a standard cost
system

52. 9-52
Overhead Rates and Overhead Analysis
Overhead from the
flexible budget for the
denominator level of activity
POHR =
Recall that overhead costs are assigned
to products and services using a
predetermined overhead rate (POHR):
Assigned Overhead = POHR × Standard Activity
Denominator level of activity

53. 9-53
The predetermined overhead rate
can be broken down into fixed
and variable components.
The variable
component is useful
for preparing and analyzing
variable overhead
variances.
The fixed
component is useful
for preparing and analyzing
fixed overhead
variances.
Overhead Rates and Overhead Analysis

54. 9-54
Normal versus Standard Cost Systems
In a normal cost
system, overhead is
applied to work in
process based on
the actual number
of hours worked
in the period.
In a standard cost
system, overhead is
applied to work in
process based on
the standard hours
allowed for the output
of the period.

55. 9-55
Budget
Variance
Volume
Variance
FR = Standard Fixed Overhead Rate
SH = Standard Hours Allowed
DH = Denominator Hours
SH × FR
Actual Fixed Fixed Fixed
Overhead Overhead Overhead
Incurred Budget Applied
Fixed Overhead Variances
DH × FR
The General Model

56. 9-56
Overhead Rates and Overhead
Analysis – Example
ColaCo prepared this budget for overhead:
Total Variable Total Fixed
Machine Variable Overhead Fixed Overhead
Hours Overhead Rate Overhead Rate
3,000 6,000$ ? 9,000$ ?
4,000 8,000 ? 9,000 ?
ColaCo applies overhead based
on machine-hour activity.
Let’s calculate overhead rates.

57. 9-57
Rate = Total Variable Overhead ÷ Machine Hours
This rate is constant at all levels of activity.
Total Variable Total Fixed
Machine Variable Overhead Fixed Overhead
Hours Overhead Rate Overhead Rate
3,000 6,000$ 2.00$ 9,000$ ?
4,000 8,000 2.00 9,000 ?
Overhead Rates and Overhead
Analysis – Example
ColaCo prepared this budget for overhead:

58. 9-58
Total Variable Total Fixed
Machine Variable Overhead Fixed Overhead
Hours Overhead Rate Overhead Rate
3,000 6,000$ 2.00$ 9,000$ 3.00$
4,000 8,000 2.00 9,000 2.25
Rate = Total Fixed Overhead ÷ Machine Hours
This rate decreases when activity increases.
Overhead Rates and Overhead
Analysis – Example
ColaCo prepared this budget for overhead:

59. 9-59
Total Variable Total Fixed
Machine Variable Overhead Fixed Overhead
Hours Overhead Rate Overhead Rate
3,000 6,000$ 2.00$ 9,000$ 3.00$
4,000 8,000 2.00 9,000 2.25
The total POHR is the sum of
the fixed and variable rates
for a given activity level.
Overhead Rates and Overhead
Analysis – Example
ColaCo prepared this budget for overhead:

60. 9-60
Fixed Overhead Variances – Example
ColaCo’s actual production required 3,200
standard machine hours. Actual fixed
overhead was $8,450. The predetermined
overhead rate is based on 3,000 machine
hours.

61. 9-61
Learning Objective
LO6
To compute and interpret the
fixed overhead budget and
volume variances

62. 9-62
Overhead Variances
Now let’s turn our
attention to calculating
fixed overhead
variances

63. 9-63
Fixed Overhead Variances – Example
Budget variance
$550 favorable
$8,450 $9,000
Actual Fixed Fixed Fixed
Overhead Overhead Overhead
Incurred Budget Applied

64. 9-64
Fixed Overhead Variances –
A Closer Look
Budget Variance
Results from spending
more or less than
expected for fixed
overhead items.
Now, let’s use the
standard hours
allowed to
compute the fixed
overhead volume
variance.

65. 9-65
3,200 hours
×
$3.00 per hour
Budget variance
$550 favorable
Fixed Overhead Variances – Example
$8,450 $9,000 $9,600
Volume variance
$600 favorable
SH × FR
Actual Fixed Fixed Fixed
Overhead Overhead Overhead
Incurred Budget Applied

66. 9-66
Volume Variance – A Closer Look
Volume
Variance
Results when standard hours
allowed for actual output differs
from the denominator activity.
Unfavorable
when standard hours
< denominator hours
Favorable
when standard hours
> denominator hours

67. 9-67
Volume Variance – A Closer Look
Volume
Variance
Results when standard hours
allowed for actual output differs
from the denominator activity.
Unfavorable
when standard hours
< denominator hours
Favorable
when standard hours
> denominator hours
Does not measure over-
or under spending
It results from treating fixed
overhead as if it were a
variable cost.

68. 9-68
Quick Check 
Yoder Enterprises’ actual production for the
period required 2,100 standard direct labor
hours. Actual fixed overhead for the period was
$14,800. The budgeted fixed overhead was
$14,450. The predetermined fixed overhead
rate was $7 per direct labor hour. What was the
budget variance?
a. $350 U
b. $350 F
c. $100 F
d. $100 U

69. 9-69
Yoder Enterprises’ actual production for the
period required 2,100 standard direct labor
hours. Actual fixed overhead for the period
was $14,800. The budgeted fixed overhead
was $14,450. The predetermined fixed
overhead rate was $7 per direct labor hour.
What was the budget variance?
a. $350 U
b. $350 F
c. $100 F
d. $100 U
Quick Check 
Budget variance
= Actual fixed overhead – Budgeted fixed overhead
= $14,800 – $14,450
= $350 U

70. 9-70
Quick Check 
Yoder Enterprises’ actual production for the
period required 2,100 standard direct labor
hours. Actual fixed overhead for the period was
$14,800. The budgeted fixed overhead was
$14,450. The predetermined fixed overhead
rate was $7 per direct labor hour. What was the
volume variance?
a. $250 U
b. $250 F
c. $100 F
d. $100 U

71. 9-71
Yoder Enterprises’ actual production for the
period required 2,100 standard direct labor
hours. Actual fixed overhead for the period
was $14,800. The budgeted fixed overhead
was $14,450. The predetermined fixed
overhead rate was $7 per direct labor hour.
What was the volume variance?
a. $250 U
b. $250 F
c. $100 F
d. $100 U
Quick Check 
Volume variance
= Budgeted fixed overhead – (SH  FR)
= $14,450 – (2,100 hours  $7 per hour)
= $14,450 – $14,700
= $250 F

72. 9-72
2,100 hours
×
$7.00 per hour
Budget variance
$350 unfavorable
$14,800 $14,450 $14,700
Actual Fixed Fixed Fixed
Overhead Overhead Overhead
Incurred Budget Applied
Volume variance
$250 favorable
SH × FR
Quick Check Summary

73. 9-73
Overhead Variances
Let’s look at a
graph showing
fixed overhead
variances. We will
use ColaCo’s
numbers from the
previous example.

74. 9-74
Fixed Overhead Variances
Activity
Cost
3,000 Hours
Expected
Activity
$9,000 budgeted fixed OH

75. 9-75
Fixed Overhead Variances
$8,450 actual fixed OH
Cost
3,000 Hours
Expected
Activity
$9,000 budgeted fixed OH
$8,450 actual fixed OH$550
Favorable
Budget
Variance
{
Activity

76. 9-76
{
Fixed Overhead Variances
$8,450 actual fixed OH
3,200 machine hours × $3.00 fixed overhead rate
$600
Favorable
Volume
Variance
$9,600 applied fixed OH
3,200
Standard
Hours
Cost
3,000 Hours
Expected
Activity
$9,000 budgeted fixed OH
$550
Favorable
Budget
Variance
{ $8,450 actual fixed OH
Activity

77. 9-77
Overhead Variances and Under- or
Overapplied Overhead Cost
In a standard
cost system:
Unfavorable
variances are equivalent
to underapplied overhead.
Favorable
variances are equivalent
to overapplied overhead.
The sum of the overhead variances
equals the under- or over applied
overhead cost for a period.

78. 9-78
End of Chapter 9