April 23, 2010

1. April 23, 2010 Flexible Budgets and Overhead Analysis

2. What is a Flexible Budget Flexible versus Static Budget Shortcomings of Static Budgets Advantages of Flexible Budgets Building a Flexible Budget Variance Analysis Today’s Agenda

3. May be prepared for any activity level within the relevant range. Show costs that should have beenincurred at the actual level ofactivity, enabling “apples to apples”cost comparisons. Reveal variances related tocost control. Improve performance evaluation. Flexible Budgets Flexible Budget

4. Variable Budgets • Budgeting in this Brewer chapter focuses on overhead • Note that the same concepts can be applied to direct costs as well • Eg, materials cost can vary over volume as price breaks are achieved • Start with a Static Budget - Steps: • 1. Select an activity base that scales with volume – eg, Manufacturing Hours • 2. Divide forecast costs into variable costs and fixed costs • 3. Arrive at total forecast overhead costs • 4. Compare to actual results • 5. Identify Favourable and Unfavourable items • 6. Determine what actions need to be taken

5. Activity base andvariable overheadshould becausally related. Activity base shouldbe simple andeasily understood. Activity base shouldnot be expressedin dollars orother currency. The Measure of Activity– A Critical Choice Three importantfactors in selecting anactivity base for an overheadflexible budget

6. Static Budgets and Performance Reports • Remember, we’re focusing on MOH at this point • Static Budgets provide meaningful information if activity does not change • We will want to look at what variances are attributable to activity changes, and performance changes

7. Static Budgets and Performance Reports • Certain variances could be perfectly acceptable because of activity changes • When actual results come in, it is difficult to see what variances are really favourable or unfavourable

8. Static Budgets and Performance Reports • Machine Hours are below budget • Unfavourable • Variable Costs are at or below budget • Neutral to Unfavourable? • Fixed Costs are neutral to over budget • Unfavourable? • Overall • Favourable?

9. Static Budgets and Performance Reports • How much of the variance is due to: • Volume? • Efficiency? • Prices? • A Flexible Budget can help answer these questions • Variable costs will flex with volume • Fixed costs will be static

10. Building a Flexible Budget • Flexible Budgets require Cost Formulas for Variable Costs

11. Building a Flexible Budget • Cost Formula is applied to variable costs at differing activity rates

12. Flexible Budget – Performance Report • Develop a Performance Report for Actual Activity – 25,000 Machine Hours

13. Flexible Budget – Performance Report • Using the Flexible Budget, we see that the variances are unfavourable

14. Variance Analysis • Calculate the variance between the initial budget (static budget) and the actual results

15. Variance Analysis • Static Analysis • Activity variance is negative • Cost variance is positive • Flexible Analysis • Calculate the variances after including the flexible budget for the actual volume

16. Variance Analysis • After inserting the appropriate Flexible Budget numbers for the actual activity level, more accurate variances are produced • Lower activity resulted in $15,000 less of costs than initially budgeted (favourable) • However, the company spent $7,500 more than it should have based on the activity level • Variance from the Flexible Budget is $7,500 Unfavourable versus from the Static Budget which is $7,500 Favourable

17. Variable Overhead Variances Actual Flexible Budget Variable for Variable Overhead Overhead at Incurred Actual Hours AH × AR AH × SR AH = Actual hoursAR = Actual variable overhead rateSR = Standard variable overhead rate Spending Variance Spending variance = AH(AR – SR)

18. Variable Overhead Variances – Example Actual Flexible Budget Variable for Variable Overhead Overhead at Incurred Actual Hours 25,000 hours×$3.00 per hour= $75,000 $82,000 Spending Variance= $7,000unfavorable

19. Variable Overhead Variances Actual Flexible Budget Flexible Budget Variable for Variable for Variable Overhead Overhead at Overhead at Incurred Actual Hours Standard Hours AH × AR AH × SR SH × SR Spending Variance EfficiencyVariance Spending variance = AH(AR - SR) Efficiency variance = SR(AH - SH)

20. Variable Overhead Variances – Example • Assume Standard Hours for the Output Volume were 27,000 Actual Flexible Budget Flexible Budget Variable for Variable for Variable Overhead Overhead at Overhead at Incurred Actual Hours Standard Hours 25,000 hours 27,000 hours × × $3.00 per hour $3.00 per hour $82,000 $75,000 $81,000 Spending variance$7,000 unfavourable Efficiency variance$6,000favourable $1,000 unfavourable flexible budget total variance

21. Recall that overhead costs are assigned to products and services using a predetermined overhead rate (POHR): Computing Overhead Rates Assigned Overhead = POHR × Standard Activity Overhead from theflexible budget for thedenominator level of activity POHR = Denominator level of activity

22. Fixed Cost OH Variance & Adjustment • If fixed overhead costs have been applied on a per unit basis, a POHR would have been established • Estimated Total Fixed Overhead / Estimated Total Basis (MHs) for the given production volume • The OH is applied only to machine hours logged • Fixed costs, in this example have been under-applied by $4,352 • $500 is due to spending over budget • $3,852 is due to the difference between actual and standard machine hours

23. What is a Flexible Budget Flexible versus Static Budget Shortcomings of Static Budgets Advantages of Flexible Budgets Building a Flexible Budget Variance Analysis Review

24. Tutorial