Chapter Fourteen

The Flexible Budget:

Factory Overhead
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Learning Objectives

• Distinguish between the product-costing and

control purposes of standard costs for factory
overhead
• Calculate and properly interpret standard cost
variances for factory overhead using traditional
approaches
• Record factory overhead costs and associated
standard cost variances
• Apply standard costs to service organizations
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Learning Objectives
(continued)

• Analyze overhead variances in an activity-based

cost (ABC) system
• Understand decision rules that can be used to
guide the variance-investigation decision

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Factory Overhead Costs:

Examples

Fixed
Variable Overhead
Overhead

 Factory managers’
salaries
 Energy costs  Plant and equipment
 Indirect materials depreciation
 Indirect labor  Plant security guards
 Equipment repair  Insurance and property
and maintenance taxes for factory
building and equipment
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Standard Variable Overhead

Costs: Product Costing vs. Control
Variable
Overhead
Cost

Product Costing &

Control (SQ x SP)

Activity Variable
(e.g., DL Hrs.)
SQ = Standard allowed DLHs for units produced
SP = Standard variable overhead rate/DLH
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Variable Overhead Variance

Analysis
Variable
Overhead
Cost Product Costing &
Control (SQ x SP)

SQ x SP
Efficiency
Variance Total
AQ x SP Variance
Spending
AQ x AP Variance
Activity Variable
(e.g., DL Hrs.)
AQ SQ
SQ = Standard allowed DLHs for units produced; AQ = Actual DLHs worked;
overhead rate/DLH; SP = Standard variable overhead rate/DLH; AP = Actual variable
overhead rate/DLH
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Variable Overhead Variance Analysis:

Equation Approach

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Variable Overhead Variance Analysis:

Equation Approach (continued)

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Variable Overhead Variance Analysis:

Example Calculations

Hanson, Inc. applies variable factory overhead on

the basis of DLHs. Hanson has the following
variable factory overhead standard to
manufacture one unit of product:
1.5 standard DLHs per unit @ a variable overhead
rate of $3.00 per DLH

Last month, 1,550 hours were worked to make

1,000 units, and $5,115 was spent for variable
factory overhead
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Variable Overhead Variance Analysis:

Example Calculations (continued)

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Variable Overhead Variance Analysis:

Alternative Solution Format
Total Variable Overhead Variance = Actual Variable
Overhead – Flexible Budget for Variable Overhead
= $5,115 - $4,500 = $615 U
Variable Overhead Spending Variance = AQ x (AP – SP)
= 1,550 DLHs x ($3.30 - $3.00)/DLH
= $465 U
Variable Overhead Efficiency Variance = SP x (AQ – SQ)
= $3.00/DLH x (1,550 – 1,500) DLHs
= $150 U
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Interpretation of Variable Overhead

Variances
Spending Variance Efficiency Variance

Results from spending Reflects efficiency or

more or less than inefficiency in the
expected for overhead
use of the selected
items such as
activity measure;
does not reflect
supplies and utilities.
overhead control.

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Standard Fixed Overhead Cost:

Planning vs. Control
Fixed
Overhead Product Costing:
Cost Standard Fixed OH
Applied = SQ x SP

Control Budget
(Lump Sum)

Activity Variable
(e.g., DL Hrs.)
SQ = Standard allowed DLHs for units produced
SP = Standard fixed overhead rate/DLH
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Product Costing: Determining the Standard

Fixed Factory Overhead Rate

 Determine the total budgeted fixed factory

overhead for level of operation.
 Select an activity driver (or drivers) for applying
fixed factory overhead.
 Choose a denominator volume for the selected
activity driver (e.g., “practical capacity”).
 Divide the amount in Step 1 by the amount in
Step 3 to determine the standard fixed factory
overhead application rate for product costing
purposes.
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Fixed Overhead Variance Analysis

Fixed
Overhead Product Costing: Standard
Cost Fixed OH Applied = SQ x SP
Actual FOH Spending
Variance (U) Total
Budgeted FOH
Volume
Variance
Variance (U) (U)
Applied FOH

Activity Variable
SQ Den. Vol. (e.g., DL Hrs.)
SQ = Standard allowed DLHs for units produced
SP = Standard fixed overhead rate/DLH
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Calculating Fixed Overhead Variances

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Example: Calculating Fixed Overhead

Variances
Hanson Inc.’s budgeted fixed overhead is $9,000 for
the month. The budgeted activity measure for the
month is 3,000 units.
Actual production is 3,200 units and actual fixed
overhead is $8,450 for the month.
Compute the fixed overhead spending and
volume variances.

$9,000 budgeted fixed overhead

FR = = $3.00 per unit
3,000 budgeted units

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Example: Calculating Fixed Overhead

Variances (continued)

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Fixed Overhead Variance Analysis:

Alternative Solution Format

Total Fixed Overhead Variance = Actual Fixed Overhead –

Fixed Overhead Applied to Production
= $8,450 - $9,600 = $1,150 F (also called
Overapplied fixed overhead)
Fixed Overhead Spending (Budget) Variance
= Actual Fixed Overhead – Budgeted Fixed Overhead
= $8,450 - $9,000 = $550 F
Fixed Overhead Production Volume Variance
= Budgeted Fixed Overhead – Applied Fixed Overhead
= $9,000 - $9,600 = $600 F
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Fixed Overhead Production Volume

Variance: Alternative Calculation

Fixed Overhead Production Volume Variance

= Standard Fixed Overhead Application Rate x
(Actual Units Produced – Denominator
Volume)
= $3.00/unit x (3,200 – 3,000) units
= $600 F (i.e., overapplied fixed overhead)

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Interpretation of Fixed Overhead
Variances
Spending (Budget)
Variance
Results from spending
more or less than
expected for individual
fixed overhead items.
That is, spending on
individual fixed
overhead items was
different than planned.
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Production Volume
Variance
Results from operating
at a level other than the
denominator volume
level. Arises because of
the product-costing
purpose of fixed
overhead. Not of direct
interest for control
purposes
©The McGraw-Hill Companies
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Causes of Fixed Overhead Variances

• Spending (Budget) Variance:

– Ineffective budget procedures
– Inadequate control of costs
– Misclassification of cost items

• Production Volume Variance:

– Management decisions
– Unexpected changes in market demand
– Unforeseen problems in manufacturing operations

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Three-Way Breakdown of Total Overhead

Variance

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Hanson, Inc.: Three-Way vs. Four-Way Analysis

of Total Factory Overhead Variance

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Two-Way Analysis of Total Factory

Overhead Variance

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Hanson, Inc.: Two-Way Analysis of Total

Factory Overhead Variance

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Disposition of Standard Manufacturing Cost

Variances
Hanson Inc
Manufacturing Cost Variances
For the Month Ending June 30, 2008
From Chapter 13
Material price variance $ 170 F
Material usage variance 800 U
Labor rate variance 310 U
Labor efficiency variance 600 U
From Chapter 14
Variable factory overhead spending variance 465 U
Variable factory overhead efficiency variance 150 U
Fixed factory overhead spending variance 550 F
Fixed factory overhead volume variance 600 F
Total manufacturing cost variance $ 1,005 U
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2008
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Alternative 1: Close Net Manufacturing Cost

Variance to CGS
Dr. CGS (net variance) $1,005
Dr. DM Price Variance 170
Dr. FOH Spending Variance 550
Dr. FOH Volume Variance 600
Cr. DM Usage Variance $ 800
Cr. DL Rate Variance 310
Cr. DL Efficiency Variance 600
Cr. VOH Spending Variance 465
Cr. VOH Efficiency Variance 150
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Income Statement after Disposition of Net

Manufacturing Cost Variance
Hanson Inc
Income statement
For the Month Ended June 30, 2008

Sales $ 100,000
Add: Favorable selling price variance 7,000
Net sales $ 107,000
Cost of goods sold (at standard) $ 60,000
Add: Unfavorable manufacturing cost variances 1,005
Total cost of goods sold 61,005
Gross margin $ 45,995
Selling and administrative expenses 41,000
Operating income $ 4,995

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Alternative 2: Prorate (Allocate) Net

Manufacturing Cost Variance

End-of-period account balances are used to allocate

the net manufacturing cost variance, as follows:

Proration of Manufacturing Cost Variances

Cost at Percent Proration of Adjusted

Accounts Standard of Total Variance Total cost
Ending WIP $ 20,000 20% 20% of $1,005 =$ 201 $ 20,201
Ending Fin. Goods 20,000 20% 20% of $1,005 = 201 20,201
CGS 60,000 60% 60% of $1,005 = 603 60,603
Total $ 100,000 100% $ 1,005 $ 101,005

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Alternative 2: Prorate Net Manufacturing

Cost Variance
Dr. CGS (net variance) $ 603
Dr. WIP Inventory 201
Dr. Finished Good Inventory 201
Dr. DM Price Variance 170
Dr. FOH Spending Variance 550
Dr. FOH Volume Variance 600
Cr. DM Usage Variance $ 800
Cr. DL Rate Variance 310
Cr. DL Efficiency Variance 600
Cr. VOH Spending Variance 465
Cr. VOH Efficiency Variance 150
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Traditional vs. ABC Approach to Overhead

Cost Analysis

Traditional Approach to Product Costing:

Cost Item Variable Per Fixed

Direct materials $20 Unit
Direct labor 30 DLH
Indirect materials 2 DLH
Repair and Maintenance 5 DLH
Receiving $5,000
Engineering Support 30,000
Setup 75,000

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Traditional Performance Report

Actual Flexible
Cost Item Cost Budget Variance
Direct materials $50,000 $40,000 $10,000 U
Direct labor 36,000 30,000 6,000 U
Indirect materials 3,000 2,000 1,000 U
Repair and Maintenance 6,500 5,000 1,500 U
Receiving 3,000 5,000 2,000 F
Engineering Support 30,000 30,000 30,000
Setup 50,000 75,000 25,000 F
Total $178,500 $187,000 $8,500 F

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Flexible Budget Using ABC

Flexible
Cost Item Budget
Direct materials $40,000 (2,000 x $20)
Direct labor 30,000 (2,000 x 0.5 x $30)
Indirect materials 2,000 (1,000 x $2)
Repair and Maintenance 6,000 (300,000 X $0.01 +$3,000)
Receiving 3,500 (2 x $1,500 + $500)
Engineering Support 30,000 ($30,000 per period)
Setup 50,000 (2 x $25,000)
Total $161,500

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Performance Report Using ABC

Actual Flexible
Cost Item Cost Budget Variance
Direct materials $50,000 $40,000 $10,000 U
Direct labor 36,000 30,000 6,000 U
Indirect materials 3,000 2,000 1,000 U
Repair and Maintenance 6,500 6,000 500 U
Receiving 3,000 3,500 500 F
Engineering Support 30,000 30,000
Setup 50,000 50,000
Total $178,500 $161,500 $17,000 U

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Standard Costing Applied to

Service Contexts

• Jobs with repetitive tasks lend themselves

to efficiency measures

• Computing non-manufacturing efficiency

variances requires some assumed
relationship between input and output activity

Examples

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Service Applications (continued)

Department Input Output

Mailing Labor hours Number of pieces mailed
Personnel Labor hours Number of personnel changes processed

Food service Labor hours Number of meals served

Consulting Billable hours Customer revenues
Nursing Labor hours Number of patients and/or procedures

Check Processing Computer hours Number of checks processed

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The Variance Investigation Decision

Larger variances, in
How do I know which dollar amount or as
variances to a percentage of the
investigate? standard, are
investigated first.
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The Variance Investigation Decision

(continued)

Uncontrollable:
– Random Error
Controllable (Systematic):
– Prediction error
– Modeling error
– Measurement error
– Implementation error
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Control Charts

Control
Charts

Display variations in a Distinguish between

process and help to random variations
analyze the variations and variations that
over time should be investigated

Provide a warning signal when variations

are beyond a specified level
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Control Charts (continued)

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Control Charts (continued)

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Appendix: Variance Investigation Decisions

—Using Payoff Tables
States of Nature
Action Random Nonrandom
Investigate I I+C
Do not investigate none L
Where: I = cost of an investigation
C = the cost to correct a variance
L = present value of losses by not
correcting the variance
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Appendix: Variance Investigation Decisions

—Indifference Probability

E(Investigate) = [(I + (1 - p)] + [(I + C) x p]

E(Do not investigate) = L x p

Set the above two equations equal, solve for

p, the indifference probability:
p = I/(L –C)

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Chapter Summary

We distinguished between the product-costing and

control purposes of standard costs for factory
overhead

– For variable overhead costs, we saw that these two

purposes are the same (see Exhibit 14.1)
– For fixed overhead costs, these purposes are different
(see Exhibit 14.3)

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2008
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Chapter Summary
(continued)

For product-costing purposes, we defined the total

overhead variance for the period as the difference
between the actual overhead costs incurred and the
overhead costs applied to production using the
overhead application rate

– We saw that this total variance is also referred to as

the “total over- or under-applied” overhead for the
period

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2008
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Chapter Summary (continued)

The total overhead variance for the period can be
decomposed using a four-way, three-way, or two- way
analysis:
– Four-way analysis = variable overhead spending variance
+ variable overhead efficiency variance + fixed overhead
spending (budget) variance + fixed overhead production
volume variance
– Three-way analysis = total overhead spending variance +
variable overhead efficiency variance + fixed overhead
production volume variance
– Two-way analysis = flexible (controllable) budget variance
+ fixed overhead production volume variance
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Chapter Summary (continued)

• We discussed how to record standard overhead costs

in the accounting records and how any standard cost
variances for product-costing purposes are disposed of
at the end of the accounting period

• We learned how traditional and ABC approaches to

overhead cost analysis differ in terms of insights
provided to management

• We learned how to apply standard costs to service

organizations

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Chapter Summary
(continued)

• We discussed indicated managerial actions

associated with particular types of errors

• We covered the use of control charts, including

statistical control charts, for monitoring activities and
ensuring financial control

• Finally, we presented in the Appendix a formal

decision approach to the variance-investigation
decision under uncertainty; this decision model
involved the use of “pay-off” tables
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2008