Flexible Budgets and Overhead Analysis

Chapter 11




Earlier in the course when we discussed budgeting, we studied only static budgets—budgets prepared for one and only one level of activity.  On Page 493 there is another example of a static budget.   Observe that the budget for Rick’s Hairstyling is set for an activity level of 5,000 client visits.  If actual client visits total say 6,000 client visits, one would expect all variable cost variances to be unfavorable as actual client visits greatly exceeded budgeted client visits.


A static budget performance report appears on Page 494.  Note that actual client visits amounted to 5,200.  Based on the actual client visits of 5,200 versus planned client visits of 5,000 we should not surprised to see that every variable overhead cost variance is unfavorable.  As you can see, the static budget is of little use when actual activity level  is different than planned.


This basic flaw with a static budget is remedied by the use of a flexible budget.  A flexible budget is a plan which provides estimates of what costs should be for any level of activity within a specified range.  By using a flexible budget the manager can compare actual costs to what costs should have been for that actual level of activity. 


Exhibit 11-3, Page 495, is an example of a flexible budget for Rick’s Hairstyling.  Using the data in this flexible budget we can easily prepare a performance report based on 5,200 client visits.  A flexible performance report for the activity level of 5,200 client visits is shown on Page 496..  Note the differences in variable variances between the static budget performance report (Page 494) and the flexible budget performance report (Page 496).


In Chapter 10 we calculated variances for variable overhead.  Beginning on page 498 the authors provide an extended analysis of both variable and fixed overhead variances.  Data relating to MicroDrive Corporation is presented on page 499.  Note that budgeted production was 25,000 motors but actual production amounted to just 20,000 motors.  Also note that the cost driver is machine hours and that the established standard is 2MH per motor produced. 


When computing the spending variance the managerial accountant compares actual variable overhead costs with actual machine hours expended (42,000) times the standard rate.   Spending variance analysis is presented on page 499.  However, when calculating the efficiency variance the accountant uses standard machine hours (2 MH times 20,000 units).  On page 501 the variable overhead performance report shows spending, efficiency, and total variable overhead variances for MicroDrive Corporation.


Fixed overhead analysis is discussed beginning on page 502.  Note that during the year as units are produced they are charged with a pro rata cost for fixed overhead as if fixed overhead were a variable cost.  Since the company intended to produce 25,000 units and each unit requires 2 machine hours at standard, the total expected number of machine hours to be expended is 50,000 for the 25,000 unit volume.  Based on this information, a pro rata cost is calculated using the predetermined fixed overhead rate ($300,000/50,000MH) and it amounts to $6 per machine hour.  As motors are completed they can be costed based on a standard cost rate which includes 2 machine hours times $6 or a total of $12 for fixed overhead for each motor.


On page 506 fixed overhead variances are computed including the budget variance, the volume variance, and the total fixed overhead variance.  The budget variance is calculated by comparing actual fixed overhead with budgeted fixed overhead.   Actual fixed overhead was $308,000 and budgeted overhead was $300,000 giving rise to an unfavorable budget variance of $8000.


The volume variance is calculated by comparing the fixed overhead budgeted amount with the fixed overhead applied to work in process.  This latter figure is found by multiplying standard hours for the production realized by the fixed overhead rate of $6 per machine hour.  The unfavorable variance arose because the company produced only 20,000 motors not 25,000 motors. Thus only $240,000 ($6 times 20,000) of fixed overhead was applied to the motors.  Subtracting the fixed overhead applied ($240,000) from the fixed overhead budgeted ($300,000) gives rise to a $60,000 unfavorable variance. 


Who is responsible for the $60,000 unfavorable fixed overhead volume variance?  It may not be the production department as the volume variance is a measure of utilization of plant facilities.  It may be that some other organization unit was responsible for failing to sell the planned 25,000 motor total.


On page 509 the authors present a summary of the calculations of the variable and fixed overhead variances for MicroDrive  Corp.  An excellent review problem and solution appear on Pages 510-512.  Please study this problem carefully as it will give you further insight into calculating overhead variances.