This document provides an overview of flexible budgets and overhead analysis in managerial accounting. It defines static and flexible budgets, and explains how to prepare flexible budgets before and after the fact. It also describes how to calculate variances for variable and fixed overhead, including spending, efficiency, and volume variances. The goals are to help managers evaluate performance using flexible budgets and understand the meaning of overhead variances.

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Chapter 11:
Flexible Budgets and Overhead
Analysis
Cornerstones of Managerial Accounting, 4e

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Learning Objectives
1. Prepare a flexible budget, and use it for performance
reporting.
2. Calculate the variable overhead variances, and explain their
meaning.
3. Calculate the fixed overhead variances, and explain their
meaning.
4. Prepare an activity-based flexible budget.

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Using Budgets
for Performance Evaluation
►Budgets are useful for both planning and
control, where they are used as benchmarks for
performance evaluation.
►Determining how budgeted amounts should be
compared with actual results is a major
consideration that must be addressed.
1

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Static Budgets versus
Flexible Budgets
►A performance report compares actual costs
with budgeted costs. There are two ways to
make this comparison:
►Compare actual costs with the budgeted costs for
the budgeted level of activity (static budget).
►Compare actual costs with the actual level of activity
(flexible budget).
1

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The Relationship between Static and Flexible Budget
Variances for the Actual Quantity Produced
1

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Static Budget
►A static budget is a budget created in advance
that is based on a particular level of activity.
►Master budgets are generally created for a
particular level of activity.
►Thus, one way to prepare a performance report
is to compare the actual costs with the budgeted
costs from the master budget.
1

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1
Cornerstone 11-1
Preparing a Performance Report Based on a
Static Budget (Using Budgeted Production)

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1
Cornerstone 11-1
Preparing a Performance Report Based on a
Static Budget (Using Budgeted Production)
(continued)

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Flexible Budget
►A flexible budget enables a firm to compute
expected costs for a range of activity levels.
►The key to flexible budgeting is knowledge of
fixed and variable costs.
►The two types of flexible budgets are:
►Before-the-fact, in which the budget gives expected
outcomes for a range of activity levels
►After-the-fact, in which a budget is based on the
actual level of activity
1

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1
Cornerstone 11-2
Preparing a Before-the-Fact
Flexible Production Budget

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1
Cornerstone 11-2
Preparing a Before-the-Fact
Flexible Production Budget (continued)

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1
Cornerstone 11-3
Preparing a Performance Report
Using a Flexible Budget

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1
Cornerstone 11-3
Preparing a Performance Report
Using a Flexible Budget (continued)

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Flexible Budget Variance
►A difference between the actual amount and the flexible budget
amount is the flexible budget variance.
►The flexible budget provides a measure of the efficiency of a
manager.
►That is, how well did the manager control costs for the actual
level of production?
►To measure whether or not a manager accomplishes his or her
goals, the static budget is used.
►The static budget represents certain goals that the firm wants to
achieve.
►A manager is effective if the goals described by the static budget
are achieved or exceeded.
1

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1 You Decide
Flexible Budgeting for Entertainment

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Variable Overhead Analysis
►In a standard cost system, the total overhead variance, or the
difference between applied and actual overhead, is also broken
down into component variances.
►There are several methods of overhead variance analysis; the
four-variance method is described in this chapter.
►First, overhead is divided into fixed and variable categories. Next,
two variances are calculated for each category.
►Variable overhead variances
►Variable overhead spending variance
►Variable overhead efficiency variance
►Fixed overhead variances
►Fixed overhead spending variance
►Fixed overhead volume variance
2

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Total Variable Overhead Variance
►The total variable overhead variance is simply the
difference between the actual variable overhead and
applied variable overhead.
►VOH is applied by using hours allowed in a standard cost
system.
►The total variable overhead variance can be divided into
spending and efficiency variances.
►Variable overhead spending and efficiency variances can
be calculated by using either the three-pronged
(columnar) approach or formulas.
2

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Variance Abbreviations
►Because the equations for variable overhead variances
can be long if expressed in words, abbreviations are
often used.
►Here are some common abbreviations:
2

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2
Cornerstone 11-4
Calculating the
Total Variable Overhead Variance

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Variable Overhead
Spending Variance
►The variable overhead spending variance measures the
aggregate effect of differences between the actual
variable overhead rate (AVOR) and the standard
variable overhead rate (SVOR).
►The actual variable overhead rate is computed as
follows:
2

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Variable Overhead
Efficiency Variance
►VOH is assumed to vary in proportion to changes in the
direct labor hours used.
►The variable overhead efficiency variance measures the
change in the actual variable overhead cost (VOH) that
occurs because of efficient (or inefficient) use of direct
labor.
►The variable overhead efficiency variance is computed
by using the following formula:
2

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2
Cornerstone 11-5
Calculating Variable Overhead Spending
and Efficiency Variances:
Columnar & Formula Approaches

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2
Cornerstone 11-5
Calculating Variable Overhead Spending
and Efficiency Variances: Columnar &
Formula Approaches (continued)

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2
Cornerstone 11-5
Calculating Variable Overhead Spending
and Efficiency Variances:
Columnar & Formula Approaches (continued)

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Comparison of the Variable Overhead
Spending Variance with the
Price Variances of Materials and Labor
► While the variable overhead spending variance is similar to the price variances
of materials and labor, there are some conceptual differences.
► VOH is not a single input—it is made up of a large number of individual items.
► The standard variable overhead rate represents the weighted cost per direct
labor hour that should be incurred for all variable overhead items.
► The difference between what should have been spent per hour and what
actually was spent per hour is a type of price variance.
► One reason that a variable overhead spending variance can arise is that prices
for individual variable overhead items have increased or decreased.
► The second reason for a variable overhead spending variance is the use of the
items that comprise variable overhead. Waste or inefficiency in the use of VOH
increases the actual variable overhead cost.
► The variable overhead spending variance is the result of both price and
efficiency.
2

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Responsibility for the Variable
Overhead Spending Variance
►Variable overhead items may be affected by several responsibility
centers. To the extent that consumption of VOH can be traced to
a responsibility center, responsibility can be assigned.
►Controllability is a prerequisite for assigning responsibility.
►Price changes of variable overhead items are essentially beyond
the control of supervisors. If price changes are small, then the
spending variance is primarily a matter of the efficient use of
overhead in production.
►Responsibility for the variable overhead spending variance is
generally assigned to production departments.
2

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Responsibility for the Variable
Overhead Efficiency Variance
►The variable overhead efficiency variance is
directly related to the direct labor efficiency or
usage variance.
►If variable overhead costs really change in
proportion to changes in direct labor hours, then
responsibility for the variable overhead
efficiency variance should be assigned to the
individual who has responsibility for the use of
direct labor: the production manager.
2

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A Performance Report for the Variable
Overhead Spending and Efficiency Variances
►Recall that Cornerstone 11-5 showed a favorable $45
variable overhead spending variance and an
unfavorable $30 variable overhead efficiency variance.
►The $45 F spending variance means that less was spent
than expected on variable overhead.
►The reasons for the $30 U variable overhead efficiency
variance are the same as those offered for an
unfavorable labor usage variance.
►Control of VOH requires line-by-line analysis for each
item.
2

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2
Cornerstone 11-6
Preparing a Performance Report for the
Variable Overhead Variances

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2
Cornerstone 11-6
Preparing a Performance Report for the
Variable Overhead Variances (continued)
Solution:

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Fixed Overhead Analysis
►Fixed overhead costs are capacity costs acquired in
advance of usage.
►The fixed overhead rate changes as the underlying
production level changes.
►To keep a stable fixed overhead rate throughout the
year, companies typically use practical capacity to
determine the number of direct labor hours in the
denominator of the fixed overhead rate.
3

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Total Fixed Overhead Variances
►The total fixed overhead variance is the difference
between actual fixed overhead and applied fixed
overhead, when applied fixed overhead is obtained by
multiplying the standard fixed overhead rate (SFOR)
times the standard hours allowed for the actual output
(SH).
►The total fixed overhead variance is the difference
between the actual fixed overhead and the applied
fixed overhead:
3

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3
Cornerstone 11-7
Calculating the Total Fixed Overhead
Variance

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Fixed Overhead Spending Variance
►The fixed overhead spending variance is defined
as the difference between the actual fixed
overhead (AFOH) and the budgeted fixed
overhead (BFOH):
3

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Fixed Overhead Volume Variance
►The fixed overhead volume variance is the difference between
budgeted fixed overhead (BFOH) and applied fixed overhead:
►The volume variance measures the effect of the actual output
differing from the output used at the beginning of the year to
compute the predetermined standard fixed overhead rate.
►If you think of the output used to calculate the fixed overhead
rate as the capacity acquired (practical capacity) and the actual
output as the capacity used, then the volume variance is the cost
of unused capacity.
3

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3
Cornerstone 11-8
Calculating Fixed Overhead Variances:
Columnar and Formula Approaches

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3
Cornerstone 11-8
Calculating Fixed Overhead Variances:
Columnar and Formula Approaches
(continued)

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3
Cornerstone 11-8
Calculating Fixed Overhead Variances:
Columnar and Formula Approaches
(continued)

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Responsibility for the Fixed
Overhead Spending Variance
►Many fixed overhead items—long-run
investments be changed in the short run.
Consequently, fixed overhead costs are often
beyond the immediate control of management.
►Since many fixed overhead costs are affected
primarily by long-run decisions, and not by
changes in production levels, the budget
variance is usually small.
3

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Analysis of the Fixed Overhead
Spending Variance
►Because FOH is made up of many individual
items, a line-by-line comparison of budgeted
costs with actual costs provides more
information concerning the causes of the
spending variance.
►An investigation might reveal that these are due
to issues beyond management control like the
weather.
3

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Responsibility for the Fixed
Overhead Volume Variance
►Assuming that volume variance measures
capacity utilization implies that the general
responsibility for this variance should be
assigned to the production department.
►At times, however, a significant volume variance
may be due to factors beyond the control of
production.
3

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Analysis of the Volume Variance
►Notice that the volume variance occurs because fixed
overhead is treated as if it were a variable cost.
►In reality, fixed costs do not change as activity changes,
as a predetermined fixed overhead rate allows.
3

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Activity-Based Budgeting
►The traditional approach to budgeting emphasizes:
►estimation of revenues and costs by organizational units (e.g.,
departments, plants)
►use of a single unit-based driver such as direct labor hours
►Companies that have implemented an activity-based costing
(ABC) system may also wish to install an activity-based budgeting
system.
►An activity-based budgeting (ABB) system focuses on:
►estimation of the costs of activities rather than the costs of departments
and plants
►use of multiple drivers, both unit-based and nonunit-based
4

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Static Activity Budgets
► Assuming that activity-based costing (ABC) has been implemented, the major
emphasis for ABB is estimating the workload (demand) for each activity and
then determining the resources required for this workload.
► ABB begins with sales and production budgets. Direct materials and direct labor
budgets are also compatible with an activity-based costing framework because
these inputs can be directly traced to the individual products.
► The major differences between traditional and ABB are found in the overhead
and selling and administration categories.
► In a traditional-based approach, budgets within these categories are typically
detailed by cost categories. Furthermore, traditional budgets are usually
constructed by budgeting for a cost item within a department and then rolling
these items up into the master overhead budget.
► ABB, on the other hand, identifies the overhead, selling, and administrative
activities and then builds a budget for each activity, based on the resources
needed to provide the required output levels. Costs are classified as variable or
fixed with respect to the activity output measure or driver.
4

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4
Cornerstone 11-9
Preparing a Static Budget for an Activity

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Activity Flexible Budgeting
► Understanding the relationship between changes in activity costs and changes
in activity drivers allows managers to more carefully plan and monitor activity
improvements.
► Activity flexible budgeting is the prediction of what activity costs will be as
related output changes.
► Variance analysis within an activity framework makes it possible to improve
traditional budgetary performance reporting, and enhances the ability to
manage activities.
► If, however, costs vary with respect to more than one driver, and the drivers
are not highly correlated with direct labor hours, then the predicted costs can
be misleading.
► The solution is to build flexible budget formulas for more than one driver.
► Cost estimation procedures (high-low method, the method of least squares,
and so on) can be used to estimate cost formulas for each activity.
4

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4
Cornerstone 11-10
Preparing an Activity Flexible Budget

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4
Cornerstone 11-10
Preparing an Activity Flexible Budget (continued)

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4
Cornerstone 11-11
Preparing an Activity-Based
Performance Report

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4
Cornerstone 11-11
Preparing an Activity-Based
Performance Report (continued)

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4 You Decide
Activity Flexible Budgeting for Museums
Museums do much more than simply present art to the public. Today’s art
museums put on shows, provide access to the public to view the collections, sell
art-related merchandise in the museum store and online, and may put on special
events and performances. The annual budget for a museum can easily run into
millions of dollars, so cost understanding and control are crucial. As an
accountant for a large metropolitan museum, you would be responsible for
budgeting and controlling costs. Splitting costs into fixed and variable
components would be a first step in budgeting. However, what driver would you
use? Number of patrons going through the museum? That would be a good driver
for a few costs, especially those related to printing tickets and explanatory
materials (such as maps of the museum to help people navigate through the
collections). However, the vast majority of costs would be fixed with respect to the
number of people going through the museum. ABC and budgeting would give a
much richer view of the costs of running the various activities of the museum.
What type of information would you need to create activity-based budgets?

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4
You Decide
Activity Flexible Budgeting for Museums
(continued)
Your first step would be to determine the various activities of the museum. These
might include: providing access to the public, selling merchandise through the
museum store, putting on special events (e.g., concerts, lectures, benefits),
acquiring and cataloging pieces of art, and so on. For example, the activity of
cataloguing new art pieces would include the salaries of staff who catalog the
pieces, or clean and restore them, insurance on the art, and so on. Many of these
costs vary with the number of newly donated or purchased pieces. The activity of
selling merchandise would have costs of staff to run the store, cost of the items
purchased for sale, advertising, and so on. Those costs might vary with the
number of items sold or with the revenue earned. Putting on special events would
have a different set of costs attached and those might vary with the number of
events and the number of attendees.
Recognizing the different activities associated with the museum and
relating the costs to specific activity drivers will give you a much better idea
of what costs to expect. This understanding can help the museum director
exercise good stewardship of the funds donated and provide important
services to the public.