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CHAPTER 8 FLEXIBLE BUDGETS, OVERHEAD COST VARIANCES, AND MANAGEMENT CONTROL 8-1

How do managers plan for variable overhead costs?

Effective planning of variable overhead costs involves: 1. Planning to undertake only those variable overhead activities that add value for customers using the product or service, and 2. Planning to use the drivers of costs in those activities in the most efficient way. 8-2 How does the planning of fixed overhead costs differ from the planning of variable overhead costs? At the start of an accounting period, a larger percentage of fixed overhead costs are locked-in than is the case with variable overhead costs. When planning fixed overhead costs, a company must choose the appropriate level of capacity or investment that will benefit the company over a long time. This is a strategic decision. 8-3

How does standard costing differ from actual costing?

The key differences are how direct costs are traced to a cost object and how indirect costs are allocated to a cost object:

Direct costs Indirect costs

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Actual Costing Actual prices × Actual inputs used Actual indirect rate × Actual inputs used

Standard Costing Standard prices × Standard inputs allowed for actual output Standard indirect cost-allocation rate × Standard quantity of cost-allocation base allowed for actual output

What are the steps in developing a budgeted variable overhead cost-allocation rate?

Steps in developing a budgeted variable-overhead cost rate are: 1. Choose the period to be used for the budget, 2. Select the cost-allocation bases to use in allocating variable overhead costs to the output produced, 3. Identify the variable overhead costs associated with each cost-allocation base, and 4. Compute the rate per unit of each cost-allocation base used to allocate variable overhead costs to output produced. 8-5 What are the factors that affect the spending variance for variable manufacturing overhead? Two factors affecting the spending variance for variable manufacturing overhead are: a. Price changes of individual inputs (such as energy and indirect materials) included in variable overhead relative to budgeted prices.

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b. Percentage change in the actual quantity used of individual items included in variable overhead cost pool, relative to the percentage change in the quantity of the cost driver of the variable overhead cost pool. 8-6 Assume variable manufacturing overhead is allocated using machine-hours. Give three possible reasons for a favorable variable overhead efficiency variance. Possible reasons for a favorable variable-overhead efficiency variance are:  Workers more skillful in using machines than budgeted,  Production scheduler was able to schedule jobs better than budgeted, resulting in lower-than-budgeted machine-hours,  Machines operated with fewer slowdowns than budgeted, and  Machine time standards were overly lenient. 8-7 Describe the difference between a direct materials efficiency variance and a variable manufacturing overhead efficiency variance. A direct materials efficiency variance indicates whether more or less direct materials were used than was budgeted for the actual output achieved. A variable manufacturing overhead efficiency variance indicates whether more or less of the chosen allocation base was used than was budgeted for the actual output achieved. 8-8

What are the steps in developing a budgeted fixed overhead rate?

Steps in developing a budgeted fixed-overhead rate are 1. Choose the period to use for the budget, 2. Select the cost-allocation base to use in allocating fixed overhead costs to output produced, 3. Identify the fixed-overhead costs associated with each cost-allocation base, and 4. Compute the rate per unit of each cost-allocation base used to allocate fixed overhead costs to output produced. 8-9 Why is the flexible-budget variance the same amount as the spending variance for fixed manufacturing overhead? The relationship for fixed-manufacturing overhead variances is: Flexible-budget variance

Efficiency variance (never a variance)

Spending variance

There is never an efficiency variance for fixed overhead because managers cannot be more or less efficient in dealing with an amount that is fixed regardless of the output level. The result is that the flexible-budget variance amount is the same as the spending variance for fixedmanufacturing overhead.

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8-10 Explain how the analysis of fixed manufacturing overhead costs differs for (a) planning and control and (b) inventory costing for financial reporting. For planning and control purposes, fixed overhead costs are a lump sum amount that is not controlled on a per-unit basis. In contrast, for inventory costing purposes, fixed overhead costs are allocated to products on a per-unit basis. 8-11 Provide one caveat that will affect whether a production-volume variance is a good measure of the economic cost of unused capacity. An important caveat is what change in selling price might have been necessary to attain the level of sales assumed in the denominator of the fixed manufacturing overhead rate. For example, the entry of a new low-price competitor may have reduced demand below the denominator level if the budgeted selling price was maintained. An unfavorable production-volume variance may be small relative to the selling-price variance had prices been dropped to attain the denominator level of unit sales. 8-12 “The production-volume variance should always be written off to Cost of Goods Sold.” Do you agree? Explain. A strong case can be made for writing off an unfavorable production-volume variance to cost of goods sold. The alternative is prorating it among inventories and cost of goods sold, but this would “penalize” the units produced (and in inventory) for the cost of unused capacity, i.e., for the units not produced. But, if we take the view that the denominator level is a “soft” number— i.e., it is only an estimate, and it is never expected to be reached exactly, then it makes more sense to prorate the production volume variance—whether favorable or not—among the inventory stock and cost of goods sold. Prorating a favorable variance is also more conservative: it results in a lower operating income than if the favorable variance had all been written off to cost of goods sold. Finally, prorating also dampens the efficacy of any steps taken by company management to manage operating income through manipulation of the production volume variance. In sum, a production-volume variance need not always be written off to cost of goods sold. 8-13

What are the variances in a 4-variance analysis?

The four variances are:  Variable manufacturing overhead costs  spending variance  efficiency variance  Fixed manufacturing overhead costs  spending variance  production-volume variance 8-14 “Overhead variances should be viewed as interdependent rather than independent.” Give an example.

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Interdependencies among the variances could arise for the spending and efficiency variances. For example, if the chosen allocation base for the variable overhead efficiency variance is only one of several cost drivers, the variable overhead spending variance will include the effect of the other cost drivers. As a second example, interdependencies can be induced when there are misclassifications of costs as fixed when they are variable, and vice versa. 8-15 Describe how flexible-budget variance analysis can be used in the control of costs of activity areas. Flexible-budget variance analysis can be used in the control of costs in an activity area by isolating spending and efficiency variances at different levels in the cost hierarchy. For example, an analysis of batch costs can show the price and efficiency variances from being able to use longer production runs in each batch relative to the batch size assumed in the flexible budget.

8-16 Each of the following statements is correct regarding overhead variances except: a. Actual overhead greater than applied overhead is unfavorable. b. The efficiency overhead variance ignores the standard variable overhead rate. c. Variable overhead rates are not a factor in the production-volume variance calculation. d. Favorable spending and efficiency variances imply that the flexible budget variance must be favorable. SOLUTION Choice "b" is the right answer, as that statement is incorrect. The efficiency variance multiplies the standard variable overhead rate by the difference between actual and standard direct labor hours. The other choices are incorrect as the statements contained in them are accurate. The statement in "a" is accurate, as actual overhead greater than applied overhead will result in an overall unfavorable variance. The statement in "c" is accurate, as fixed (rather than variable) overhead rates are factored into the production-volume variance calculation. The statement in "d" is accurate, as the flexible-budget variance is a combination of the spending and efficiency variances. If both the spending and efficiency variances are favorable, then the flexible-budget variance must be favorable. 8-17 Steed Co. budgets production of 150,000 units in the next year. Steed’s CFO expects that each unit will take 8 hours to produce at an hourly wage rate of $10 per hour. If factory overhead

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is applied on the basis of direct labor hours at $6 per hour, the budget for factory overhead will total: a. $7,200,000. b. $9,000,000. c. $12,000,000. d. $19,200,000. SOLUTION Choice "a" is correct. 150,000 units at 8 hours per unit is equal to 1,200,000 hours budgeted. Factory overhead is applied at $6 per direct labor hour, so at 1,200,000 hours, factory overhead will be equal to $7,200,000. Choice "b" is incorrect. This choice incorrectly substitutes the hourly wage rate of $10 for the number of hours to produce a unit. Choice "c" is incorrect. This answer choice represents the direct labor budget. 150,000 units at 8 hours per unit is equal to 1,200,000 hours budgeted. At an hourly wage rate of $10 per hour, the direct labor budget will be equal to $12,000,000. Choice "d" is incorrect. This answer choice combines the direct labor and factory overhead budgets. 8-18 As part of her annual review of her company’s budgets versus actuals, Mary Gerard isolates unfavorable variances with the hope of getting a better understanding of what caused them and how to avoid them next year. The variable overhead efficiency variance was the most unfavorable over the previous year, which Gerard will specifically be able to trace to: a. Actual overhead costs below applied overhead costs. b. Actual production units below budgeted production units. c. Standard direct labor hours below actual direct labor hours. d. The standard variable overhead rate below the actual variable overhead rate. SOLUTION Choice "c" is correct. The variable overhead efficiency variance is calculated as the difference between actual direct labor hours used versus standard (budgeted) direct labor hours allowed, multiplied by the standard variable overhead rate. If standard hours are below actual hours, this would mean more hours were used than expected and would therefore cause an unfavorable variance. Choice "a" is incorrect. Overall overhead variance is calculated as actual costs versus applied costs, and this situation would be favorable because applied is above actual. Choice "b" is incorrect. The volume variance focuses on actual versus budgeted units of production. Choice "d" is incorrect. The actual variable overhead rate does not factor into the variable overhead efficiency variance calculation. 8-

8-19 Culpepper Corporation had the following inventories at the beginning and end of the month of January:

Finished goods Work-in-process Direct materials

January 1 $125,000 235,000 134,000

January 31 $117,000 251,000 124,000

The following additional manufacturing data was available for the month of January. Direct materials purchased Transportation in Direct labor Actual factory overhead

$189,000 3,000 400,000 175,000

Culpepper Corporation applies factory overhead at a rate of 40% of direct labor cost, and any overapplied or underapplied factory overhead is deferred until the end of the year. Culpepper’s balance in its factory overhead control account at the end of January was: 1. 2. 3. 4.

$15,000 overapplied. $15,000 underapplied. $5,000 underapplied. $5,000 overapplied.

SOLUTION Choice "2" is correct. The question asks for the amount of overapplied or underapplied overhead at the end of a month. For Culpepper, factory overhead is applied based on 40 percent of direct labor cost. Direct labor cost is $400,000, and factory overhead applied would be $160,000. Actual overhead is $175,000. Factory overhead is therefore underapplied by $15,000. 8-20 Fordham Corporation produces a single product. The standard costs for one unit of its Concourse product are as follows: Direct materials (6 pounds at $0.50 per pound)

$ 3

Direct labor (2 hours at $10 per hour)

20

Variable manufacturing overhead (2 hours at $5 per hour)

10

Total

33

During November Year 2, 4,000 units of Concourse were produced. The costs associated with November operations were as follows:

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Material purchased (36,000 pounds at $0.60 per pound)

$21,600

Material used in production (28,000 pounds) Direct labor (8,200 hours at $9.75 per hour)

79,950

Variable manufacturing overhead incurred

41,820

What is the variable overhead efficiency variance for Concourse for November Year 2? 1. $2,000 favorable. 2. $1,000 favorable. 3. $2,000 unfavorable. 4. $1,000 unfavorable. SOLUTION Choice "4" is correct. The question asks for the variable overhead efficiency variance for a product. The actual hours used to produce the 4,000 units of Concourse were 8,200 hours, and the standard hours to produce 4,000 units were 8,000 hours. Variable overhead is based on labor hours. Because the actual hours were more than the standard hours, the variable overhead efficiency variance has to be unfavorable. The variance formula for the variable overhead efficiency variance can be stated as the standard rate of $5 per hour times the difference between the actual and standard hours used of 200 (8,200 8,000), or $1,000 Unfavorable. 8-21 Variable manufacturing overhead, variance analysis. Esquire Clothing is a manufacturer of designer suits. The cost of each suit is the sum of three variable costs (direct material costs, direct manufacturing labor costs, and manufacturing overhead costs) and one fixed-cost category (manufacturing overhead costs). Variable manufacturing overhead cost is allocated to each suit on the basis of budgeted direct manufacturing labor-hours per suit. For June 2017, each suit is budgeted to take 4 labor-hours. Budgeted variable manufacturing overhead cost per labor-hour is $12. The budgeted number of suits to be manufactured in June 2017 is 1,040. Actual variable manufacturing costs in June 2017 were $52,164 for 1,080 suits started and completed. There were no beginning or ending inventories of suits. Actual direct manufacturing labor-hours for June were 4,536. Required: 1. Compute the flexible-budget variance, the spending variance, and the efficiency variance for variable manufacturing overhead. 2. Comment on the results. SOLUTION (20 min.) Variable manufacturing overhead, variance analysis.

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1.

Variable Manufacturing Overhead Variance Analysis for Esquire Clothing for June 2017

Actual Costs Incurred Actual Input Qty. × Actual Rate (1) (4,536 × $11.50) $52,164

Actual Input Qty. × Budgeted Rate (2) (4,536 × $12) $54,432

$2,268 F Spending variance

Flexible Budget: Budgeted Input Qty. Allowed for Actual Output × Budgeted Rate (3) (4 × 1,080 × $12) $51,840

$2,592 U Efficiency variance

$324 U Flexible-budget variance

Allocated: Budgeted Input Qty. Allowed for Actual Output × Budgeted Rate (4) (4 × 1,080 × $12) $51,840

Never a variance

Never a variance

2. Esquire had a favorable spending variance of $2,268 because the actual variable overhead rate was $11.50 per direct manufacturing labor-hour versus $12 budgeted. It had an unfavorable efficiency variance of $2,592 U because each suit averaged 4.2 labor-hours (4,536 hours ÷ 1,080 suits) versus 4.0 budgeted labor-hours. 8-22 Fixed manufacturing overhead, variance analysis (continuation of 8-21). Esquire Clothing allocates fixed manufacturing overhead to each suit using budgeted direct manufacturing labor-hours per suit. Data pertaining to fixed manufacturing overhead costs for June 2017 are budgeted, $62,400, and actual, $63,916. Required: 1. Compute the spending variance for fixed manufacturing overhead. Comment on the results. 2. Compute the production-volume variance for June 2017. What inferences can Esquire Clothing draw from this variance? SOLUTION (20 min.) Fixed-manufacturing overhead, variance analysis (continuation of 8-21).

1 & 2.

Budgeted fixed overhead rate per unit of allocation base

=

$62,400 1,040 × 4 $62,400 4,160

= = $15 per hour Fixed Manufacturing Overhead Variance Analysis for Esquire Clothing for June 2017

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Actual Costs Incurred (1)

Same Budgeted Lump Sum (as in Static Budget) Regardless of Output Level (2)

Flexible Budget: Same Budgeted Lump Sum (as in Static Budget) Regardless of Output Level (3)

$63,916

$62,400

$62,400

$1,516 U Spending variance

Never a variance

$1,516 U Flexible-budget variance

Allocated: Budgeted Input Qty. Allowed for Actual Output × Budgeted Rate (4) (4 × 1,080 × $15) $64,800

$2,400 F Production-volume variance $2,400 F Production-volume variance

The fixed manufacturing overhead spending variance and the fixed manufacturing flexible budget variance are the same––$1,516 U. Esquire spent $1,516 above the $62,400 budgeted amount for June 2017. The production-volume variance is $2,400 F. This arises because Esquire utilized its capacity more intensively than budgeted (the actual production of 1,080 suits exceeds the budgeted 1,040 suits). This results in overallocated fixed manufacturing overhead of $2,400 (4 × 40 × $15). Esquire would want to understand the reasons for a favorable production-volume variance. Is the market growing? Is Esquire gaining market share? Will Esquire need to add capacity? 8-23 Variable manufacturing overhead variance analysis. The Sourdough Bread Company bakes baguettes for distribution to upscale grocery stores. The company has two direct-cost categories: direct materials and direct manufacturing labor. Variable manufacturing overhead is allocated to products on the basis of standard direct manufacturing labor-hours. Following is some budget data for the Sourdough Bread Company: Direct manufacturing labor use Variable manufacturing overhead

0.02 hours per baguette $10.00 per direct manufacturing labor-hour

The Sourdough Bread Company provides the following additional data for the year ended December 31, 2017: Planned (budgeted) output

3,100,000 baguettes

Actual production

2,600,000 baguettes

Direct manufacturing labor

46,800 hours

Actual variable manufacturing overhead

$617,760

Required: 1. What is the denominator level used for allocating variable manufacturing overhead? (That is, 8-

for how many direct manufacturing labor-hours is Sourdough Bread budgeting?) 2. Prepare a variance analysis of variable manufacturing overhead. Use Exhibit 8-4 (page 304) for referen...