Overhead Budgets

1
Overhead Budgets

• Most companies use flexible budgets to control
  overhead costs.
• A flexible budget is not based on only one level
  of activity but is valid for the firms relevant
  range of activity.
• The flexible budget provides the correct basis
  for comparison between actual and expected costs.
• The flexible overhead budget is based on a
  standard input measure (e.g. machine hours)

2
Flexible Budget Formula

• The relationship between activity and total
  budgeted overhead is given by

Budgeted variable-overhead cost per activity unit
Budgeted fixed-overhead cost per month
Total budgeted monthly overhead cost
Total activity units



3
Standard Costing System

• In a standard costing system, overhead
  application is based on standard hours allowed,
  given actual output.
• The Manufacturing Overhead account is credited
  and the Work-In-Process Inventory is debited by
  the following amount
• Standard allowed hours X Predetermined (Standard)
  rate

4
Variable-Overhead Spending Variance

• Variable-overhead spending variance
• Actual variable overhead - (AH x SVR)
• or
• (AH x AVR) - (AH x SVR)
• AH x (AVR - SVR)

Notation AH actual machine hours AVR actual
variable-overhead rate actual variable
overhead ? AH SVR standard variable-overhead
rate
5
Variable-Overhead Efficiency Variance

• Variable-Overhead Efficiency Variance
• (AH x SVR) - (SH x SVR)
• SVR x (AH - SH)

Notation AH actual machine hours SH standard
machine hours SVR standard variable-overhead
rate
6
Variance Analysis for Managerial ControlVariable
Overhead
Actual Costs Incurred (a)
Flexible Budget based on Actual Output (b)
Expected Costs based on Actual Output (c)
AQ AR
AQ SR
SQA SR
Variable-Overhead Spending Variance (b-a)
Variable-Overhead Efficiency Variance (c-b)
AQ(SR - AR)
SR(SQA - AQ)
Variable-Overhead Budget Variance (c-a)
(SQA SR) - (AQ AR)
7
Interpreting Variable Variance

• The variable-overhead efficiency variance simply
  reflects an adjustment in the managerial
  accountants expectation about variable overhead
  cost.
• It does not indicate inefficient use of
  variable-overhead.
• An unfavorable variable-overhead spending
  variance simply means that the total actual cost
  of variable overhead is greater than expected.
• The spending variance is the real control
  variance for variable overhead. The spending
  variance can alert managers if variable overhead
  costs are exceeding expectations.

8
Fixed-Overhead Variances

• Fixed-Overhead Budget Variance
• Actual fixed overhead - Budgeted fixed overhead
• The budget variance is the real control variance
  for fixed overhead, because it compares actual
  expenditures with budgeted fixed-overhead costs.
• Fixed-Overhead Volume Variance
• Budgeted fixed overhead - Applied fixed overhead
• Applied fixed overhead Predetermined fixed
  overhead rate x Standard allowed hours
• A faulty interpretation of a positive volume
  variance is that it measures the cost of
  under-utilizing productive capacity. Perhaps
  under-utilizing capacity and reducing inventory
  may be the appropriate response to the current
  demand.

9
Variance Analysis for Managerial ControlFixed
Overhead
Actual Costs Incurred (a)
Flexible Budget based on Actual Output (b)
Expected Costs based on Actual Output (c)
AQ AR
AQ SR
SQA SR
Fixed-Overhead Spending Variance (b-a)
Fixed-Overhead Efficiency Variance (c-b)
AQ(SR - AR)
SR(SQA - AQ)
Fixed-Overhead Budget Variance (c-a)
(SQA SR) - (AQ AR)
10
Disposition of Variances

• Variances are temporary accounts and most
  companies close them directly into Cost of Goods
  Sold at the end of each accounting period.
• Debit Cost of Goods Sold
• Credit Manufacturing Overhead