Overhead Budgets

Flexible Budgets
The tool used by most companies to control overhead costs is called a flexible budget. A flexible
budget resembles the budgets we studied in Chapter 9, with one important difference: A flexible
budget is not based on only one level of activity. Instead, when used as a planning tool, the flexible
budget covers a range of activity within which the firm may operate. A flexible overhead budget is
defined as a detailed plan for controlling overhead costs that is valid in the firm’s relevant range of
activity. In contrast, a static budget is based on a particular planned level of activity.
Moreover, a flexible budget can tell us, after the fact, what it should have cost to produce a particular
level of output. This turns out to be a key control concept for analyzing cost variances, because it
allows us to split the variance in spending into different, more easily explained pieces. In this chapter,
we will apply this concept to overhead costs. But remember the standard quantity allowed for direct
material in the prior chapter? That was the basis for calculating the flexible budget amount, after the
fact, for controlling direct material (what it should have cost for direct material to make the actual
output). The standard hours allowed filled the same role for direct labor. So the concept is not entirely
new to us.

Advantages of Flexible Budgets

A manager using the static budget makes the following comparison.
Budgeted Electricity Cost
(static budget)
Actual Electricity Cost Cost Variance
$3,200 $3,750 $550 Favorable
This comparison suggests that operating personnel maintained excellent control over electricity costs
during September, generating a favorable variance of $550. Is this a valid analysis and conclusion?
The fault with this analysis is that the manager is comparing the electricity cost incurred at
the actual activity level, 2,000 multilayer fancy cakes, with the budgeted electricity cost at
the planned activity level, 2,500 multilayer fancy cakes. Since these activity levels are different, we
should expect the electricity cost to be different.
A more sensible approach is to compare the actual electricity cost incurred with the cost that should
be incurred when 2,000 multilayer fancy cakes are produced. At this production level, 6,000 process
hours should be used (3 per cake). The flexible budget in Exhibit 11–1 shows that the manager should
expect $3,000 of electricity cost at the 6,000 process-hour level of activity. Therefore, an analysis
based on the flexible budget gives the following comparison.
Budgeted Electricity Cost
Actual Electricity Cost (flexible budget) Cost Variance
$3,200 $3,000 $200 Unfavorable
Now the manager’s conclusion is different; the revised analysis indicates an unfavorable variance.
Electricity cost was greater than it should have been, given the actual level of output. The flexible
budget provides the correct basis for comparison between actual and expected costs, given actual
activity.

The Activity Measure

Notice that the flexible budget for electricity cost in Exhibit 11–1 is based on hours of process time,
which is an input in the production process. The process-hour activity levels shown in the flexible
budget are the standard allowed process hours given various levels of output. If 2,000 multilayer
fancy cakes are produced, and the standard allowance per cake is 3 process hours, then the standard
allowed number of process hours is 6,000.
Why are the activity levels in the flexible budget based on process hours, an input measure, instead of
the number of multilayer fancy cakes produced, an output measure? When only a single product is
produced, it makes no difference whether the flexible budget is based on input or output. In our
illustration, either of the flexible budgets shown in Exhibit 11–2 could be used.

Recall that the controller estimates electricity cost at $.50 per process hour. Thus, the flexible-budget
cost of electricity during August is computed as follows:
Standard allowed process hours given August output 9,600
Electricity cost per process hour × $.50
Flexible budget for electricity cost $4,800
The important point is that units of output usually is not a meaningful measure in a multiproduct firm,
because it would require us to add numbers of unlike products. To avoid this problem, output is
measured in terms of the standard allowed input, given actual output. The flexible overhead budget is
then based on this standard input measure.

Flexible Overhead Budget Illustrated

DCdesserts.com’s monthly flexible overhead budget is shown in the Excel spreadsheet in Exhibit 11–
3. The overhead costs on the flexible budget are divided into variable and fixed costs. The total
budgeted variable-overhead cost increases proportionately with increases in the activity. Thus, when
the number of process hours increases by 50 percent, from 6,000 hours to 9,000 hours, the total
budgeted variable-overhead cost also increases by 50 percent, from $30,000 to $45,000. In contrast,
the total budgeted fixed overhead does not change with increases in activity; it remains constant at
$15,000 per month.
Exhibit 11–3 Flexible Overhead Budget

A more general format for expressing a flexible budget is called a formula flexible budget. In this
format, we express the relationship between activity and total budgeted overhead cost by the
following formula:
Total budgeted monthly overhead cost
=Budgeted variable-overhead cost per activity unit × Total activity units + Budgeted fixed-overhead cost per month

Overhead Application in a Standard-Costing

System
Recall that overhead application refers to the addition of overhead cost to the Work-in-Process
Inventory account as a product cost. In a normal-costing system, described in Chapter 3, overhead is
applied based on the actual quantity of the cost driver, as shown in the top panel of Exhibit 11–4.
Continuing the example from the prior section, overhead application would be based
on actual hours. In a standard-costing system, overhead application is based on the standard amount
of the cost driver allowed, given the amount of actual output. This system is depicted in the bottom
panel of Exhibit 11–4for our example, where the application is based on standard hours allowed.
Notice that the difference between normal costing and standard costing, insofar as overhead is
concerned, lies in the quantity of the cost driver used.
Exhibit 11–4 Overhead Application

Both normal- and standard-costing systems use a predetermined overhead rate. In a standard-costing
system, the predetermined overhead rate also is referred to as the standard overhead rate.
DCdesserts.com calculates its predetermined or standard overhead rate annually. The rate for the
current year, computed in Exhibit 11–5, is based on planned activity of 7,500 process hours per
month. Notice that DCdesserts.com breaks its predetermined overhead rate into a variable rate and a
fixed rate. We will discuss further the use of standard costs for product costing in Appendix A at the
end of this chapter.

Choice of Activity Measure

Criteria for Choosing the Activity Measure
How should a manager select the activity measure for the flexible budget? The activity measure
should be one that varies in a similar pattern to the way that variable overhead varies. This means
that, in practice, the activity measure for the flexible budget is the same as the cost driver in the
company’s costing system. As productive activity increases, both variable-overhead cost and the
activity measure should increase in roughly the same proportion. As productive activity declines, both
variable-overhead cost and the activity measure should decline in roughly the same proportion. In
short, variable-overhead cost and the activity measure should move together as overall productive
activity changes.

Changing Manufacturing Technology

Direct-labor time has traditionally been a popular activity measure in manufacturing firms. However,
as automation increases, more and more firms are switching to such measures as machine hours or
process time for their flexible overhead budgets. Machine hours and process time are linked more
closely than direct-labor hours to the robotic technology and computer-integrated manufacturing
(CIM) systems common in today’s manufacturing environment.

Cost Drivers
As we discussed in Chapter 5, some companies have refined their cost management systems even
further. Cost drivers are identified as the most significant factors affecting overhead costs. Then
multiple overhead rates based on these cost drivers are used to compute product costs and control
overhead expenditures. A relentless search for non-value-added costs is an integral part of such a cost
management system. We will discuss the role of activity-based costing in flexible budgeting later in the
chapter.

Beware of Dollar Measures

Dollar measures, such as direct-labor or raw-material costs, often are used as the basis for flexible
overhead budgeting. However, such measures have significant drawbacks, and they should be
avoided. Dollar measures are subject to price-level changes and fluctuate more than physical
measures. For example, the direct-labor hours required to produce a fancy dessert will be relatively
stable over time. However, the direct-labor cost will vary as wage levels and fringe-benefit costs
change with inflation and conditions in the labor market.

Cost Management Using Overhead Cost

Variances
The flexible overhead budget is one of a company’s primary tools for the control of production-
overhead costs. At the end of each accounting period, the company’s managerial accountants use the
flexible overhead budget to determine the level of overhead cost that should have been incurred, given
the actual level of activity. They then compare the overhead cost in the flexible budget with the actual
overhead cost incurred.With this information, the accountants can report to managers four separate
overhead variances, each of which conveys information useful in controlling overhead costs.
Flexible Budget
DCdesserts.com’s monthly flexible overhead budget, displayed in Exhibit 11–3, shows budgeted
variable and fixed production-overhead costs at three levels of production output. During September,
DCdesserts.com produced 2,000 multilayer fancy cakes. Since production standards allow three
process hours per cake, the total standard allowed number of process hours is 6,000 hours.
Notice that the actual number of process hours used (6,300) exceeds the standard allowed number of
process hours, given actual production output (6,000).
We now have assembled all of the information necessary to compute DCdesserts.com’s overhead
variances for September.
Variable Overhead

*Actual variable-overhead rate (AVR)

=Actual variable-overhead costActual process hours
=$34,6506,300=$5.50

Variable-Overhead Spending Variance

Multiplying the actual quantity of the activity measure by the standard variable-overhead rate (AQ ×
SVR) gives a revised estimate of expected spending on variable overhead, given that we now know the
actual quantity of the activity measure. This figure, which we designate the projected variable
overhead, provides a benchmark against which the actual spending on variable overhead can be
assessed. Any difference between the actual and projected variable-overhead cost is called
the variable-overhead spending variance.
Two equivalent formulas for the variable-overhead spending variance are shown below.

These two formulas are equivalent because actual variable overhead is equal to the actual activity level
times the actual variable overhead rate (AQ × AVR).
DCdesserts.com’s variable-overhead spending variance for September is computed as follows (using
formula 1):
Variable-overhead spending variance
=Actual variable overhead−(AQ×SVR)
= $34,650−(6,300×$5.00)=$3,150Unfavorable

This variance is unfavorable because the actual variable-overhead cost exceeded the expected amount,
after adjusting that expectation for the actual number of process hours used.

Variable-Overhead Efficiency Variance

As Exhibit 11–6 shows, the following formula defines the variable-overhead efficiency variance.
Variable-overhead efficiency variance = (AQ × SVR) − (SQ × SVR)

where
SQ denotes standard allowed activity level (standard quantity of the activity measure)
Variable-overhead efficiency variance = SVR(AQ − SQ)

DCdesserts.com’s variable-overhead efficiency variance for September is computed as follows:

Variable-overhead efficiency variance
=SVR(AQ − SQ)=$5.00(6,300 − 6,000)=$1,500 Unfavorable

This variance is unfavorable because actual process hours exceeded standard allowed process hours,
given actual output.
Product Costing versus Cost Management
Columns (1), (2), and (3) in Exhibit 11–6 are used to compute the variances for cost management
purposes. Column (4) in the exhibit shows the variable overhead applied to work in process for
the product-costing purpose. Notice that the variable-overhead cost on the flexible budget, $30,000, is
the same as the amount applied to work in process.
Graphing Variable-Overhead Variances
Managerial Interpretation of Variable-Overhead Variances

Efficiency Variance
Recall that an unfavorable direct-labor efficiency variance results when more direct labor is used than
the standard allowed quantity. Thus, direct labor has been used inefficiently, relative to the standard.
However, that is not the proper interpretation of an unfavorable variable-overhead efficiency
variance. DCdesserts.com’s variable-overhead efficiency variance did not result from using more of
the variable-overhead items, such as electricity and indirect material, than the standard allowed
amount. Instead, this variance resulted when the division used more process hours than the standard
quantity, given actual output. Recall that the company’s director of cost management chose process
hours as the activity measure for overhead because variable-overhead costs vary in a pattern similar
to that with which process hours vary. Since 300 more process hours were used than the standard
quantity, the division’s management should expect that variable-overhead costs will be greater. Thus,
the variable-overhead efficiency variance has nothing to do with efficient or inefficient usage of
electricity, indirect material, and other variable-overhead items. This variance simply reflects an
adjustment in the company’s expectation about variable-overhead costs, because the division used
more than the standard quantity of process hours.
What is the important difference between direct labor and variable overhead that causes this different
interpretation of the efficiency variance? Direct labor is a traceable cost and is budgeted on the basis
of direct-labor hours. Variable overhead, on the other hand, is a pool of indirectcosts that are budgeted
on the basis of an activity measure, process hours. The indirect nature of variable-overhead costs
causes the different interpretation.
Spending Variance
An unfavorable spending variance simply means that the total actual cost of variable overhead is
greater than expected, after adjusting for the actual quantity of process hours used. An unfavorable
spending variance could result from paying a higher-than-expected price per unit for variable-
overhead items. Or the variance could result from using more of the variable-overhead items than
expected.
Suppose, for example, that electricity were the only variable-overhead cost item. An unfavorable
variable-overhead spending variance could result from paying a higher-than-expected price per
kilowatt-hour for electricity, from using more than the expected amount of electricity, or from both.
Management of Variable-Overhead Costs
Since the variable-overhead efficiency variance says nothing about efficient or inefficient usage of
variable overhead, the spending variance is the real control variance for variable overhead. Managers
can use the spending variance to alert them if variable-overhead costs are out of line with
expectations.
Fixed Overhead
Fixed-Overhead Budget Variance
The variance used by managers to control fixed overhead is called the fixed-overhead budget
variance. It is defined as follows:
Fixed-overheadbudget variance
= Actual fixed overhead−Budgeted fixed overhead

DCdesserts.com’s fixed-overhead budget variance for September is as follows:

Fixed-overhead budget variance
 =Actual fixed overhead−Budgeted fixed overhead
= $16,100−$15,000*=$1,100 Unfavorable
*From the flexible budget (Exhibit 11–3).

The fixed-overhead budget variance is unfavorable, because the company spent more than the
budgeted amount on fixed overhead. Notice that we need not specify an activity level to determine
budgeted fixed overhead because, by definition, a fixed overhead cost is the same at every activity
level. All three columns in the flexible budget (Exhibit 11–3) specify $15,000 as budgeted fixed
overhead.
Fixed-Overhead Volume Variance
The fixed-overhead volume variance is defined as follows:
Fixed-overhead volume variance= Budgeted fixed overhead − Applied fixed overhead

DCdesserts.com’s applied fixed overhead for September is $12,000:

Applied fixed overhead

=Predetermined fixedoverhead rate× Standard allowed activity level (quantity of the activity measure)
=$2.00 per process hour×6,000 process hours=$12,000

The $2.00 predetermined fixed-overhead rate was calculated in Exhibit 11–5. The 6,000 standard
allowed process hours is based on actual September production of 2,000 multilayer fancy cakes, each
with a standard allowance of three process hours.

Fixed overhead volume variance

=Budgeted fixed overhead−Applied fixed overhead

= $15,000−$12,000=$3,000 Unfavorable

Managerial Interpretation of Fixed-Overhead Variances

Exhibit 11–8 shows DCdesserts.com’s two fixed-overhead variances for September. The budget
variance is the real control variance for fixed overhead, because it compares actual expenditures with
budgeted fixed-overhead costs.
Exhibit 11–8 Fixed-Overhead Budget and Volume Variances
 *Consistent with our
discussion of the fixed-overhead volume variance, some financial planning and analysis systems would designate a positive variance as
“unfavorable.”

The volume variance provides a way of reconciling two different purposes of the standard-costing
system. For the control purpose, the system recognizes that fixed overhead does not change as
production activity varies. Hence, budgeted fixed overhead is the same at all activity levels in the
flexible budget. (Review Exhibit 11–3 to verify this.) Budgeted fixed overhead is the basis for
controlling fixed overhead, because it provides the benchmark against which actual expenditures are
compared.
For the product-costing purpose of the system, budgeted fixed overhead is divided by planned activity
to obtain a predetermined (or standard) fixed-overhead rate. For DCdesserts.com, this rate is $2.00
per process hour (budgeted fixed overhead of $15,000 divided by planned activity of 7,500 process
hours). This predetermined rate is then used to apply fixed overhead to Work-in-Process Inventory.
During any period in which the standard allowed number of process hours, given actual output,
differs from the planned level of process hours, the budgeted fixed overhead differs from applied fixed
overhead.
Exhibit 11–9 illustrates this point graphically. Budgeted fixed overhead is constant at $15,000 for all
levels of activity. However, applied fixed overhead increases with activity, since fixed overhead is
applied to Work-in-Process Inventory at the rate of $2.00 per standard allowed process hour. Notice
that budgeted and applied fixed overhead are equal only if the number of standard allowed hours
equals the planned activity level of 7,500 process hours. When this happens, there is no fixed-
overhead volume variance. DCdesserts.com has a $3,000 volume variance in September because the
standard allowed hours and planned hours are different.
Exhibit 11–9 Budgeted versus Applied Fixed Overhead

Capacity Utilization
A common, but faulty, interpretation of a positive volume variance is that it measures the cost of
underutilizing productive capacity. Some firms even designate a positive volume variance as
unfavorable. The reasoning behind this view is that the planned activity level used to compute the
predetermined fixed-overhead rate is a measure of normal capacity utilization. Moreover, fixed-
overhead costs, such as depreciation and property taxes, are costs incurred to create productive
capacity. Therefore, the predetermined fixed-overhead rate measures the cost of providing an hour of
productive capacity. If 7,500 process hours are planned, but output is such that only 6,000 standard
process hours are allowed, then capacity has been underutilized by 1,500 hours. Since each hour costs
$2.00 (DCdesserts.com’s predetermined fixed-overhead rate), the cost of underutilization is $3,000
(1,500 × $2.00), which is DCdesserts.com’s volume variance.
The fault with this interpretation of the volume variance is that it ignores the real cost of
underutilizing productive capacity. The real cost is due to the lost contribution margins of the
products that are not produced when capacity is underutilized. Moreover, this interpretation fails to
recognize that underutilizing capacity and reducing inventory may be a wise managerial response to
slackening demand.
For this reason, many managers interpret the volume variance merely as a way of reconciling the two
purposes of the standard-costing system. Moreover, these managers would choose not to designate
the volume variance as either favorable or unfavorable. However, some designate a positive volume
variance as unfavorable. Their reasoning is that when the volume variance is closed into Cost of Goods
Sold expense at the end of the accounting period (as explained in Appendix A), the effect is to increase
Cost of Goods Sold, which in turn has an unfavorableeffect on income. In contrast, other accountants
argue that no sign (favorable or unfavorable) should be assigned to the fixed-overhead volume
variance.

Overhead Cost Performance Report

The variable-overhead spending and efficiency variances and the fixed-overhead budget variance can
be computed for each overhead cost item in the flexible budget. When these itemized variances are
presented along with actual and budgeted costs for each overhead item, the result is an overhead cost
performance report. DCdesserts.com’s performance report is displayed in Exhibit 11–10. This
report would be used by management to exercise control over each of the division’s overhead costs.
Notice that the performance report includes spending and efficiency variances for the variable items, and only
a budget variance for the fixed items. Upon receiving this report, a manager might investigate the relatively
large variances for indirect maintenance labor, electricity, and production supervisory labor.

Activity-Based Flexible Budget

Under the more accurate product-costing method called activity-based costing, several cost drivers are
identified.1 Costs that may appear fixed with respect to a single volume-based cost driver, such as process
hours, may be variable with respect to some other cost driver. The activity-based costing approach also can be
used as the basis for a flexible budget for planning and cost management purposes. Exhibit 11–11displays
an activity-based flexible budget for DCdesserts.com, using the same data as Exhibit 11–3.

The budgeted electricity cost is the same on both budgets, because both use the same cost driver (process
hours). Insurance and property taxes are also the same, because both budgets recognize these as facility-level
fixed costs. However, the other overhead costs are budgeted at different levels, because the conventional and
activity-based flexible budgets use different cost drivers for these items. While the conventional budget treats
inspection, setup, test kitchen, and material-handling costs as fixed, the activity-based flexible budget shows
that they are all variable with respect to the appropriate cost driver.

Flexible Budgeting in the Service Industry

All kinds of organizations benefit from the concept of a flexible budget. Like manufacturing firms,
service-industry organizations incur overhead costs that vary with appropriately chosen cost drivers.
At Cornell University, for example, the cost of operating the admissions department depends in part
on the number of applicants. At GEICO Insurance Company, the cost of administering the claims
department depends in part on the number of claims. At the Mayo Clinic, the cost of operating the
patient records department depends in part on the number of patients.
Review Problem on Flexible Budgeting and
Analysis of Overhead Costs
In November, DCdesserts.com produced 3,000 multilayer fancy cakes, used 9,100 hours of process
time, and incurred the following production-overhead costs.

Variable overhead $45,955

Fixed overhead $15,800
DCdesserts.com’s monthly flexible overhead budget for November is the same as that given in Exhibit
11–3.

Compute DCdesserts.com’s variable-overhead variances using the format shown in Exhibit 11–6.
Compute the company’s fixed-overhead variances using the format shown in Exhibit 11–8.
Solution to Review Problem

The solution to the review problem is given in Exhibits 11–13 and 11–14.
Exhibit 11–13 Variable-Overhead Spending and Efficiency Variances: Review Problem

†Column (4) is not used to compute the variances. It is included to point out that the flexible-budget amount for variable overhead, $45,000,
is the amount that will be applied to Work-in-Process Inventory for product-costing purposes.

Exhibit 11–14 Fixed-Overhead Budget and Volume Variances: Review Problem

*Some financial planning and analysis systems would designate a negative fixed-overhead volume variance as “favorable.”