CHAPTER FLEXIBLE BUDGETS, VARIANCES, AND MANAGEMENT CONTROL: II LEARNING OBJECTIVES Explain in what ways the planning of variable overhead costs and fixed overhead costs are similar and in what ways they differ Identify the features of a standard-costing system Compute the variable overhead efficiency variance and the variable overhead spending variance Explain how the efficiency variance for a variable indirect-cost item differs from the efficiency variance for a direct-cost item Compute the budgeted fixed overhead cost rate Explain two concerns when interpreting the production-volume variance as a measure of the economic cost of unused capacity Show how the 4-variance analysis approach reconciles the actual overhead incurred with the overhead amounts allocated during the period Illustrate how the flexible-budget variance approach can be used in activity-based costing CHAPTER OVERVIEW Chapter extends the budgeting process to the indirect manufacturing costs, both variable and fixed The planning for these costs focuses on undertaking only essential activities and then being efficient in that undertaking with emphasis on satisfying customers The control aspect of the budgeting process is described and illustrated through the use of standard costing and variance analysis Variance analysis for indirect costs demands careful interpretation of the variances primarily because of the manner in which the costs are assigned to the cost object Indirect costs are allocated on the basis of a cost driver or cost-allocation base In calculating the efficiency variance for variable overhead costs one is actually calculating the difference in the use of the cost-allocation base not the use of the overhead items For direct variable costs, a price variance could be calculated but not for indirect variable costs The difference in price from actual to budgeted is a part of the difference in quantity of variable overhead items used and is labeled as a spending variance to incorporate both differences Fixed overhead variances add another dimension to variance analysis because of the use of a costallocation base: behavior of the cost in relation to changes in level of activity Fixed costs are budgeted as a total cost or lump sum However, when fixed costs are used in a standard costing system and allocated on a per unit basis, they take on the “look” of a variable cost The resulting production-volume variance, calculated as a difference between a lump sum amount and an allocation of a per unit cost, must be carefully examined for meaning CHAPTER OUTLINE I Budgeting indirect manufacturing cost categories [Refer to Chapter for emphasis on direct manufacturing cost categories] A Overhead costs as big part of costs of many companies Flexible-budget/variance-analysis approach helps managers plan and control overhead costs Careful interpretation of overhead variances developed primarily for financial reporting purposes Learning Objective 1: Explain in what ways the planning of variable overhead costs and fixed overhead costs are similar and in what ways they differ B Planning of variable and fixed overhead costs Similarities of variable and fixed overhead costs a Undertake only essential activities that add value for customers b Be efficient/cost effective in that undertaking Differences between variable and fixed overhead costs a Variable-cost planning: ongoing decisions during budget period play larger role b Fixed-cost planning: most decisions must occur before start of period Do multiple choice Assignments start with L.O Learning Objective 2: Identify the features of a standard-costing system II Standard costing A Features of costing a cost object output Traces direct costs to output produced by multiplying the standard prices (SP) or rates by the standard quantities of inputs allowed (SQ) for actual outputs produced (flexible budget) Allocates indirect costs on the basis of the standard indirect rates (SP) times the standard quantities of the allocation bases (SQ) allowed for actual output produced (flexible budget) B Features of the recording system Costs of every product or service planned to be worked on during period can be computed at the start of that period 102 Chapter Individual records need not be kept of actual costs of items used or of the actual quantity of the cost-allocation based used on individual products or services worked on during the period Costs of operating standard-costing system can be low relative to the costs of operating an actual or normal costing system Do multiple choice Assignments start with L.O Learning Objective 3: Compute the variable overhead efficiency variance and the variable overhead spending variance C Development of budgeted variable overhead cost-allocation rates in standard costing system Four-step approach for variable overhead cost-allocation rates a Step 1: Choose the time period used to compute the budget b Step 2: Select the cost-allocation bases to use in allocating variable overhead costs to output produced c Step 3: Identify the variable overhead costs associated with each cost-allocation base d Step 4: Compute the rate per unit of each cost-allocation base used to allocate variable overhead costs to outputs produced—budgeted rate per output unit Budgeted variable overhead cost rate per output unit a Used in static budget (planning) b Used in performance evaluation and reports (controlling) D Computation of variable manufacturing overhead cost variances [Exhibits 8-1 and 8-7] Overall variance: Variable overhead flexible-budget variance: difference between actual variable overhead costs and flexible-budget variable overhead costs Subdivisions of variable overhead flexible-budget variance a Variable overhead efficiency variance: evaluates the difference actual quantity of the cost-allocation base used relative to the budgeted quantity (what should have been used) of the cost-allocation base [(AQ – SQ) X SP] TEACHING TIP: A comparison can be made of costing systems (actual, normal, and standard) by the calculation of the variable indirect manufacturing costs Exercise 4-23 and problem 4-33 illustrate normal costing with the use of the calculated budgeted manufacturing overhead cost per unit of cost-allocation base (BP) multiplied by the actual quantity of the cost-allocation base (AQ) in computing the allocation of manufacturing overhead Standard costing introduces the quantity of the cost-allocation base that should have been used (SQ) to produce the actual output, a feature of the flexible budget Actual costing would use an actual rate and actual quantity used without the capability of variance calculations The flexible-budget variance used in standard costing is the same as underallocated or overallocated overhead used in normal costing for variable indirect manufacturing costs Students can be asked how exercise 4-23/problem 4-33 would differ in the calculation of underallocated or overallocated overhead (flexible-budget variance) if the company used a standard-costing system rather than normal costing Flexible Budgets, Variances, and Management Control: II 103 Learning Objective 4: Explain how the efficiency variance for a variable indirect-cost item differs from the efficiency variance for a direct-cost item i Efficiency variance for direct cost measures whether more or less of direct cost item is used than was budgeted for actual output achieved ii Efficiency variance for indirect variable cost evaluates relative use of actual quantity to budgeted quantity of cost-allocation base (efficiency with which cost-allocation base is used) b Variable overhead spending variance: evaluates the actual cost per unit of the costallocation base relative to the budgeted cost per unit of the cost-allocation base [(AP – SP) X AQ] i Includes differences between actual prices of individual inputs and budgeted prices of those inputs ii Includes differences in percentage change in actual quantity usage of individual items in variable overhead-cost pool from percentage change in quantity usage of costallocation base used for the individual items Do multiple choice and Assign Exercises 8-16 and 8-18 Learning Objective 5: Compute a budgeted fixed overhead rate E Development of budgeted fixed overhead cost allocation rates for use in standard costing system [Exhibits 8-2, 8-6, and 8-7] By definition fixed overhead costs are a lump sum of costs that remain unchanged in total for a given period despite wide changes in the level of total activity or volume related to those overhead costs—same total amount in flexible budgets within relevant range To develop a standard rate per output unit for fixed costs: four-step approach a Step 1: Choose the time period to be used for the budget b Step 2: Select the cost-allocation base to use in allocating fixed overhead costs to output produced—the denominator level c Step 3: Identify the fixed overhead costs associated with each cost-allocation base d Step 4: Compute the rate per unit of each cost-allocation base used to allocate fixed overhead costs to output produced F Computation of fixed manufacturing overhead cost variances [Exhibits 8-2, 8-6, and 8-7] Fixed overhead flexible-budget variance (same as fixed overhead spending variance because no efficiency variance for fixed costs as a given lump sum unaffected by how efficiently cost-allocation base is used to produce output in given budget period) 104 Chapter Production-volume variance (denominator variance and output-level variance) a Exists because fixed costs allocated on a units-of-output basis (“unitized”) for inventory costing and some types of contracts but budgeted as a lump sum b Arises whenever the actual level of denominator differs from level used to calculate the budgeted fixed overhead rate Learning Objective 6: Explain two concerns when interpreting the production-volume variance as a measure of the economic cost of unused capacity c Needs careful interpretation, especially when using as a measure of the economic cost of unused capacity [Concepts in Action] i One caution—management may have maintained some extra capacity to meet uncertain demand surges that are important to satisfy ii Other caution—the production-volume variance focuses only on fixed overhead costs and does not take into account any decreases in price of output necessary to spur extra demand that might make use of any idle capacity d Always explore why of a variance before concluding that label of unfavorable or favorable necessarily indicates poor or good management performance Do multiple choice 5, 6, and Assign Exercises 8-17 and 8-19 and Problem 8-36 Learning Objective 7: Show how the 4-variance analysis approach reconciles the actual overhead incurred with the overhead amounts allocated during the period G Presentation of integrated analysis of overhead cost variances: 4-variance analysis [Exhibit 8-3] Two variable overhead variances (spending and efficiency) and two fixed overhead variances (spending and production-volume) Combinations of variances possible a 3-variance analysis or combined variance analysis uses total manufacturing overhead, combining variable and fixed spending variances as one, and presenting efficiency (variable) and production-volume (fixed)—loses some information but simplifies accounting b 2-variance analysis combines spending and efficiency variances into flexible-budget variance plus production-volume variance c 1-variance analysis combines all overhead variances into a total overhead variance: difference between total actual manufacturing overhead incurred and manufacturing overhead allocated to actual output produced (underallocated or overallocated concept from normal costing) Variances are interrelated Do multiple choice and 8-40 Assign Exercises 8-21, 22, 23, 27, and 28 and Problems 8-39 and Flexible Budgets, Variances, and Management Control: II 105 H Different purposes of manufacturing overhead cost analysis [Surveys of Company Practice] Planning and control purposes [Exhibit 8-4] Assign Problem 8-31 a Variable overhead costs vary in proportion to number of output units produced b Fixed overhead costs remain fixed in total over given range of output units Inventory costing for financial reporting purpose a Variable overhead costs vary in proportion to number of output units produced b Fixed overhead costs allocated on per unit basis an inventoriable cost (unitized) based on level of output units produced and will not necessarily remain fixed in total but change I Journal entries for overhead costs and variances Assign Problems 8-29 and 8-30 III Other considerations of overhead variance analysis A Financial and nonfinancial performance measures: signals to direct managers’ attention to problems B Overhead cost variances in nonmanufacturing and service settings Manufacturing and nonmanufacturing variable cost often used in decisions about pricing and which products to push or de-emphasize Nonmanufacturing fixed costs used when reimbursed on basis of full actual costs plus a percentage of those costs and in capacity planning and utilization decisions as well as management of those costs Assign Exercises 8-24, 8-25, and 8-26 Learning Objective 8: Illustrate how the flexible-budget variance approach can be used in activity-based costing C Activity-based costing and variance analysis Basic principles and concepts for variable and fixed manufacturing overhead costs can be applied to ABC systems Illustration of batch-level variance analysis [Exhibit 8-5] Do multiple choice 10 Assign Problems 8-37 and 8-38 CHAPTER QUIZ SOLUTIONS: 106 Chapter 1.d 2.b 3.a 4.d 5.c 6.a 7.a 8.b 9.d 10.c CHAPTER QUIZ Which of the following pertains primarily to the planning of fixed overhead costs? a b c d A standard rate per output unit is developed Only essential activities are to be undertaken Activities are to be undertaken in most efficient method Key decisions are made at the start of the budget period determining the level of costs A feature of a standard-costing system is that the costs of every product or service planned to be worked on during the period can be computed at the start of that period This feature of standard costing makes it possible to a b c d maintain actual costs as an integral part of the costing system use a simple recording system eliminate routine reports justify eliminating the budgeting process The following data apply to questions 3–9 Sebastian Company, which manufactures electrical switches, uses a standard cost system and carries all inventories at standard The standard manufacturing overhead costs per switch are based on direct labor hours and are shown below: Variable overhead (5 hours @ $12 per direct manufacturing labor hour) Fixed overhead (5 hours @ $15* per direct manufacturing labor hour) Total overhead per switch *Based on capacity of 200,000 direct manufacturing labor hours per month $ 60 75 $135 The following information is available for the month of December: • 46,000 switches were produced although 40,000 switches were scheduled to be produced • 225,000 direct manufacturing labor hours were worked at a total cost of $5,625,000 • Variable manufacturing overhead costs were $2,750,000 • Fixed manufacturing overhead costs were $3,050,000 [CMA Adapted] The variable overhead spending variance for December was a $50,000 U d $60,000 F b $350,000 U c $10,000 F d $60,000 F [CMA Adapted] The fixed manufacturing overhead spending variance for December was a $450,000 F c $10,000 F [CMA Adapted] The variable manufacturing overhead efficiency variance for December was a $50,000 U b $350,000 U b $400,000 F c $50,000 U d $775,000 F The fixed overhead production volume variance for December was a $450,000 F b $400,000 F c $50,000 U d $775,000 F Flexible Budgets, Variances, and Management Control: II 107 What amount should be credited to the allocated manufacturing overhead control account for the month of December? a $6,210,000 c $5,760,000 d $5,700,000 Under the 2-variance method, the flexible budget variance for December was a $10,000 F b $5,800,000 b $40,000 U c $50,000 U d $100,000 U Under the 3-variance method, the spending variance for December was a $10,000 F b $40,000 U c $50,000 U d $100,000 U 10 Which of the following statements is true about overhead cost variance analysis using activity-based costing? a b c d 108 Overhead cost variances are calculated for output-unit level costs only Overhead cost variances are calculated for variable manufacturing overhead costs only A 4-variance analysis can be conducted Activity-based costing uses input measures for all activities resulting in the inability to flexible budgets needed for variance analysis Chapter WRITING/DISCUSSION EXERCISES Explain in what ways the planning of variable overhead costs and fixed overhead costs are similar and in what ways they differ As noted in the text, “Management will have made most of the decisions that determine the level of fixed overhead costs to be incurred at the start of a budget period.” This key strategic decision for the company’s long-range benefit is the choosing of an appropriate level of capacity or investment to meet that level of volume or activity anticipated What are some other types of costs that would need to be determined at the start of the budget period? {Prelude to Chapter 12 and the concept of locked-in costs compared to incurred costs.} The design of a product or a process can cause certain costs to have to be incurred These costs would be incurred regardless of the level of activity or volume because they would be caused by the choice of a particular type of activity rather than its volume level Consider Webb Company and the jackets that they produce used as illustration in Chapters and If Webb has planned to sell jackets with zipper closures rather than cape-style jackets, they have set in motion types of equipment to use in production of their product The type of material used in the jackets or the way that decorations are affixed (sewn or imprinted or tacked on) are other examples of design decisions that would be made at the beginning of the budget period These decisions affect the costs to be incurred but are not costs tied to level of activity or volume (fixed costs) Identify the features of a standard-costing system “No record need be kept of the actual costs of items used or of the actual quantity of the cost-allocation base used on individual products or services worked on during the period.” If no record is kept as to actual costs, won’t the financial statements prepared using standard costing be dishonest about what actually happened during the time period? A key word in the sentence is individual Actual costs and actual quantities are recorded in any system The variances that are calculated between standard and actual are incorporated into the financial statements through proration or other method of adjustment at the end of the period The financial statements then reflect actual costs or approximate actual costs Compute the variable overhead efficiency variance and the variable overhead spending variance The variable manufacturing overhead spending variance incorporates both a difference in price and difference in usage of the overhead items Could a variance be designed to calculate a price variance only? Any variance can be calculated if the actual cost of the item is collected and a budgeted amount for that item is available The cost of preparing budgeted numbers and collecting the actual costs for the various items of overhead might not be cost/beneficial for the organization An accounting system should be designed to provide the information that improves the decisions of managers, keeping in mind that accounting systems have a cost Flexible Budgets, Variances, and Management Control: II 109 Explain how the efficiency variance for a variable indirect-cost item differs from the efficiency variance for a direct-cost item Should the variable overhead efficiency variance be renamed to more accurately reflect its nature of measuring the difference in usage of the cost-allocation base? With the use of activity-based costing, a renaming should be considered to more accurately reflect the use of the particular cost-allocation base or cost driver The “spending variance” is a change from the use of the term “price variance” when considering the differences in price as well as the differences in usage of the variable overhead item(s) Compute a budgeted fixed overhead cost rate What factors should be considered in selecting the denominator level for computing the budgeted fixed overhead rate? Fixed costs are so named because of their behavior in relation to changes in the level of their cost driver(s) A fixed cost remains unchanged in total for a given time period despite wide changes in the related level of total activity or volume and is budgeted as a lump sum or fixed amount A denominator indicates division and an averaging or “unitizing” process for developing a rate Using a fixed overhead rate is artificial in that the fixed cost is treated as if it were a variable cost by changing in total as the level of activity varied The choice of a denominator level should be chosen with care to minimize the interpretation of any variance computed from using the budgeted fixed overhead rate The time period to be used is one consideration Should a typical budget period of twelve months be used or some longer time frame? Capacity issues are another consideration Should the maximum capacity available be used to obtain the lowest rate? Should the standard level of activity of the cost-allocation base for the anticipated sales/production for the budget period be used? Should only those who prepare financial statements for external parties make these calculations? Other considerations could include pricing and performance evaluation issues from use of a “unit cost” rather than a lump sum amount Explain two concerns when interpreting the production-volume variance as a measure of the economic cost of unused capacity Whose responsibility is it to use caution in interpreting the production-volume variance as a measure of the economic cost of unused capacity? Accountants understand how numbers are developed in response to managers’ need for information They are ethically responsible for reporting the numbers in a manner consistent with the appropriate interpretation of those numbers As indicated in earlier chapters of the text the focus is on information and knowledge when considering variances and responsibility The accountants can help managers first focus on whom they should ask to obtain information while the accountants themselves can refrain from making uninformed judgments Refer to the “Standards of Ethical Conduct for Management Accountants” developed by the Institute of Management Accounting, Exhibit 1-7 in Chapter 110 Chapter Show how the 4-variance analysis approach reconciles the actual overhead incurred with the overhead amounts allocated during the period If one were to develop a complete analysis of differences in revenue, costs, and operating income using flexible budgets for the various inputs from the static budget to actual amounts, how would the production-volume variance for fixed manufacturing overhead be depicted? One could progress from actual through the flexible budgets to the static budget going left to right, changing one item at a time to develop a fairly comprehensive analysis of changes and interrelationships Revenues vary with the level of volume, as variable costs, allowing for individual changes in price, quantity (efficiency), and sales volume (similar to Exhibit 7-4 in Chapter 7) Variable manufacturing overhead variances can be added in similar fashion with spending and efficiency variance paralleling the (variable) direct manufacturing costs with consideration of the role of the costallocation base But how fixed manufacturing overhead variances fit? Fixed costs are lump sums for reporting the actual costs, each of the flexible budgets, and the static budget Using the total fixed costs allows for the reporting of the spending variance or flexible-budget variance but not the productionvolume variance The analysis will not flow in a two-dimensional plane from actual amounts through the flexible budgets to the static budget if fixed costs are unitized, especially if the static budget level is not the denominator level Some variation must be made to include the changing of the fixed costs from a total concept to a unit concept for allocation purposes Perhaps a third dimension could be imposed (See Chapter of this manual for an overview of the variances.) Illustrate how the flexible-budget variance approach can be used in activity-based costing Activity-based costing is an approach to refining a costing system and is especially useful in the allocation of indirect costs Explain what is meant by “well-defined output and input measures for an activity” in the development of a 4-variance analysis The text defines and illustrates through Chapters 5, 6, 7, and the activity-based costing approach to refining a costing system An activity-based costing system requires explicit definition of activities and numerous calculations Budgets must then be developed according to the costing system, activity-based If the organization has budgets that align with actual data collection, variances will be meaningful The outputs generated by the inputs can be compared to the standards developed and/or budgets if prepared on a consistent basis If an activity-based costing system is to be used, then it must be used throughout the accounting process from planning to control The increase in the number of calculations and detail makes ABC expensive to implement and maintain but it should provide the manager with improved information for making decisions Over time, the costs of implementation have declined Flexible Budgets, Variances, and Management Control: II 111 SUGGESTED READINGS Beischel, M and Smith, K., “Linking the Shop Floor to the Top Floor,” Management Accounting (October 1991) p.25 [5p] Carman-Stone, M., “Unabsorbed Overhead: What to Do When Contracts Are Canceled,” Management Accounting (April 1987) p.55 [3p] Cornick, M., Cooper, W and Wilson, S., “How Do Companies Analyze Overhead?” Management Accounting (June 1988) p.41 [3p] Crawford, D and Henry, E., “Budgeting and Performance Evaluation at the Berkshire Toy Company,” Issues in Accounting Education (May 2000) p.283 [27p] Datar, S and Gupta, M., “Aggregation, Specification and Measurement Errors in Product Costing,” The Accounting Review (October 1994) p.567 [25p] MacArthur, J and Stranahan, H., “Cost Driver Analysis in Hospitals: A Simultaneous Equations Approach,” Journal of Management Accounting Research (1998) p.279 [34p] Martin, J and Laughlin, E., “A Graphic Approach to Variance Analysis Emphasizes Concepts Rather than Mechanics,” Issues in Accounting Education (Fall 1988) p.351 [14p] Novin, A., “Applying Overhead: How to Find the Right Bases and Rates,” Management Accounting (March 1992) p.40 [4p] Shank, J and Govindarajan, V., “The Perils of Cost Allocation Based on Production Volumes,” Accounting Horizons (December 1988) p.71 [10p] Wang, X H and Yang, B., “Fixed and Sunk Cost Revisited,” Journal of Economic Education (Spring 2001) p.178 [8p] 112 Chapter [...]... Floor,” Management Accounting (October 1991) p.25 [5p] Carman-Stone, M., “Unabsorbed Overhead: What to Do When Contracts Are Canceled,” Management Accounting (April 1987) p.55 [3p] Cornick, M., Cooper, W and Wilson, S., “How Do Companies Analyze Overhead?” Management Accounting (June 1988) p.41 [3p] Crawford, D and Henry, E., “Budgeting and Performance Evaluation at the Berkshire Toy Company,” Issues in Accounting. .. be used, then it must be used throughout the accounting process from planning to control The increase in the number of calculations and detail makes ABC expensive to implement and maintain but it should provide the manager with improved information for making decisions Over time, the costs of implementation have declined Flexible Budgets, Variances, and Management Control: II 111 SUGGESTED READINGS... Measurement Errors in Product Costing,” The Accounting Review (October 1994) p.567 [25p] MacArthur, J and Stranahan, H., “Cost Driver Analysis in Hospitals: A Simultaneous Equations Approach,” Journal of Management Accounting Research (1998) p.279 [34p] Martin, J and Laughlin, E., “A Graphic Approach to Variance Analysis Emphasizes Concepts Rather than Mechanics,” Issues in Accounting Education (Fall 1988) p.351... Overhead: How to Find the Right Bases and Rates,” Management Accounting (March 1992) p.40 [4p] Shank, J and Govindarajan, V., “The Perils of Cost Allocation Based on Production Volumes,” Accounting Horizons (December 1988) p.71 [10p] Wang, X H and Yang, B., “Fixed and Sunk Cost Revisited,” Journal of Economic Education (Spring 2001) p.178 [8p] 112 Chapter 8 ... to Exhibit 7-4 in Chapter 7) Variable manufacturing overhead variances can be added in similar fashion with spending and efficiency variance paralleling the (variable) direct manufacturing costs with consideration of the role of the costallocation base But how do fixed manufacturing overhead variances fit? Fixed costs are lump sums for reporting the actual costs, each of the flexible budgets, and the... of the flexible budgets, and the static budget Using the total fixed costs allows for the reporting of the spending variance or flexible- budget variance but not the productionvolume variance The analysis will not flow in a two-dimensional plane from actual amounts through the flexible budgets to the static budget if fixed costs are unitized, especially if the static budget level is not the denominator... be made to include the changing of the fixed costs from a total concept to a unit concept for allocation purposes Perhaps a third dimension could be imposed (See Chapter 7 of this manual for an overview of the variances.) 8 Illustrate how the flexible- budget variance approach can be used in activity-based costing Activity-based costing is an approach to refining a costing system and is especially useful... were to develop a complete analysis of differences in revenue, costs, and operating income using flexible budgets for the various inputs from the static budget to actual amounts, how would the production-volume variance for fixed manufacturing overhead be depicted? One could progress from actual through the flexible budgets to the static budget going left to right, changing one item at a time to develop... the allocation of indirect costs Explain what is meant by “well-defined output and input measures for an activity” in the development of a 4-variance analysis The text defines and illustrates through Chapters 5, 6, 7, and 8 the activity-based costing approach to refining a costing system An activity-based costing system requires explicit definition of activities and numerous calculations Budgets must