Strategic Cost Management
ACCT 90009
Flexible Budgets II :
Overhead costs
Lecture 10
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Learning Objectives
1. Analyse differences between actual and budgeted variable and fixed overhead costs.
• Calculate spending and efficiency variances for variable overhead, and interpret the meaning of these
variances
• Calculate spending and production-volume variances for fixed overhead and interpret the meaning of
these variances
2. Explain why the production–volume variance may not be a good measure of the economic cost of
unused capacity.
3. Develop an integrated 4-variance analysis of overhead variances.
4. Apply the different roles of cost allocation bases for manufacturing overhead when (a) planning and
controlling, and (b) valuing stock.
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Study Tasks
Textbook
Bhimani, Horngren, Datar, Tajan (2019) Management and Cost Accounting.
Seventh Edition. Pearson.
• Read chapter 16.
• Do review questions 16.2, 16.5, 16.6, 16.7.
• Do exercises 16.3, 16.19, 16.22.
3
Introduction
We have talked a lot about the challenges associated with allocating overheads to products. Planning and
control of overhead costs are also important and challenging.
One mechanism of overhead cost control is variance analysis (as we did last seminar for materials and
labour), i.e. assessing, and drilling down into, the difference between budgeted and actual overheads.
The notion of a flexible budget is important for overheads as well as direct costs.
4
Dr Chung Yu Hung (2022) lecture slides.
From last seminar …
Variance analysis for Lewis Pty Ltd - 2019
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Lewis Pty Ltd (Lewis) manufactures and sells men's suits.
The budget estimates for 2019 are:
• Direct material cost is 4 metres cloth per suit at $16.25 per metre.
• Direct manufacturing labour costs are 2 labour-hours per suit at $13 per labour-hour.
• Variable manufacturing overhead is $24 per suit.
• Fixed manufacturing costs are $286,000
Lewis planned to produce and sell 13,000 suits in 2019 at $155 per suit.
The budget estimates of variable and fixed cost are based on a relevant range of 9,000 to 13,500 suits per
year.
In 2019, Lewis produced and sold 10,000 suits at $160 each with actual variable costs of $120 per suit and
fixed manufacturing costs of $300,000.
Conduct a variance analysis for Lewis for the 2019 reporting period.
Variance analysis for Lewis Pty Ltd - 2019
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In 2019, Lewis produced and sold 10,000 suits.
• Direct material purchased and used was 42,500 metres at an average price of $15.95 per metre.
• Direct labour used was 21,500 labour-hours at an average rate of $12.90 per hour.
Calculate the efficiency variances and the input price variances
Lewis applies variable manufacturing overheads costs at a rate of $12 per direct labour-hour (DLH).$24 2 = $12
Additional information …
Dr Chung Yu Hung (2022) lecture slides.
Lewis Pty Ltd
2019 Variable Manufacturing Costs
Budget
Sales volume 13,000 suits
Qty used rate ($ per unit) cost ($'000) cost per suit ($)
Direct material 4.00 metres 52,000 metres @ 16.25 845,000 65.00
Direct labour 2.00 labour-hours 26,000 labour-hours @ 13.00 338,000 26.00
Variable Overhead 2.00 labour-hours 26,000 labour-hours @ 12.00 312,000 24.00
1,495,000 115.00
Actual
Sales volume 10,000 suits
Qty used rate ($ per unit) cost ($'000) cost per suit ($)
Total variable cost 1,200,000 120.00
LESS
Direct material 42,500 metres @ (15.95) (677,875) (67.79)
Direct labour 21,500 labour-hours @ (12.90) (277,350) (27.74)
Variable Overhead 244,775 18.83
Qty used per suit
We are given the actual total variable cost and the
actual direct costs, so we can calculate the actual
variable overhead cost.
Variance analysis for Lewis Pty Ltd - 2019
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2019 Flexed Budget Manufacturing Variances
static budget
volume
variance
flexed
budget
flexed
variance actual variance
Sales volume (suits) 13,000 10,000 10,000 (3,000)
$'000 $'000 $'000 $'000 $'000 $'000
Sales revenue 2,015 (465) 1,550 50 1,600 (415)
LESS variable costs
Direct material (845) 195 (650) (28) (678) 167
Direct labour (338) 78 (260) (17) (277) 61
Variable overhead (312) 72 (240) (5) (245) 67
Contribution 520 (120) 400 0 400 (120)
LESS Fixed manufacturing cost (286) 0 (286) (14) (300) (14)
Operating profit before non-manufacturing costs 234 (120) 114 (14) 100 (134)
In this seminar we will focus on the variable and fixed overhead costs.
Variance analysis for Lewis Pty Ltd - 2019
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The fixed overhead variance is simple. It does not change with output volume.
= − = 300 000 − 286 000= 14 000 unfavourable
The fixed overhead cost was $14,000 more than budgeted for 2019.
Variance analysis for Lewis Pty Ltd - 2019
10
The favourable $72,000 variable overhead volume variance arises because the actual sales
volume was 3,000 suits less than planned.
=
−
×
= 10 000 − 13 000 × 24= (−3 000) × 24= −72 000 Does this favourable
variance indicate good
performance?
favourable
Variance analysis for Lewis Pty Ltd - 2019
11
The unfavourable $4,775 flexed variable overhead variance arises because the actual
variable overhead rate was $0.48 more than planned.
= × −
= 10 000 × 24.4775 − 24.0000= 10 000 × 0.4775= $ 4 775 unfavourable
= 10 000 × 244 77510 000 − 24.0000
12
=
×
×
EfficiencyVolume Spending
Efficiency Variances & Spending Variances
Flexed variable manufacturing overhead variance
Variable overhead efficiency variance Variable overhead spending variance
An efficiency variance arises when the overhead
resource usage rate
(input units used per output unit produced)
differs from what was planned.
A spending variance arises when the cost per
overhead resource unit ($ per input unit)
differs from what was planned.
Now we can breakdown each flexed manufacturing variable overhead cost variances into two components
– the variable overhead efficiency variance & the variable overhead spending variance.
Efficiency Variances & Spending Variances
14
=
×
×
−
=
×
−
×
Note: Allocation rate is the variable overhead cost per unit of allocation base used.
Variance analysis for Lewis Pty Ltd - 2019
Standard allocation rate is 2 DLH per suit @ $12 per DLH. In 2019, Lewis actual produced 10,000 suits.
The actual direct labour used was 21,500 DLH.
• Lewis’ profit in 2019 was $18,000 lower than it otherwise would have been, because on
average, Lewis used 0.15 direct labour hours per suit (7.5%) more than planned.
• To the extent that the amount of variable overhead resources used is ‘driven’ by direct
labour hours, this reduced profit by $18,000 relative to what was planned.
= 10 000 × 21 50010 000 − 2.00 × 12= 10 000 × 2.15 − 2.00 × 12= 18 000 unfavourable
=
×
−
×
Variance analysis for Lewis Pty Ltd - 2019
Variable overhead spending variance
In 2019, Lewis actually used 21,500 DLH. The standard allocation rate was $12 per DLH.
Lewis’ operating profit was $13,225 higher than it otherwise would have been because the
actual variable overhead cost was $0.615 per direct labour hour (5%) lower than planned.
= 10 000 × 2.15 × 11.385 − 12.000= −13 225 favourable
=
×
×
−
= 10 000 × 2.15 × $ 244 77521 500 − 12.000
Variance analysis for Lewis Pty Ltd - 2019
Flexed variable manufacturing overhead
$4 775
Variable overhead efficiency variance
$18 000
Variable overhead spending variance
$(13 225)
Lewis Pty Ltd
2019 Variance Analysis - revenue and manufacturing cost
Planned operating profit before non-manufacturing costs 234,000
volume variance (120,000)
Less flexed variance
selling price variance 50,000
variable direct material variance (27,875)
variable direct labour variance (17,350)
flexed variable direct cost variance (45,225)
variable overhead efficiency variance (18,000)
variable overhead spending variance 13,225
flexed variable overhead cost variance (4,775)
fixed manufacturing cost variance (14,000)
flexed variance (14,000)
total variance (134,000)
Actual operating profit before non-manufacturing costs 100,000
$
Why no efficiency variance on fixed overheads?
• Fixed overheads are incurred as a lump sum.
• They do not actually vary with volume.
• So as the volume of activity rises and falls (within the relevant range) fixed overheads do not vary.
For example: rent normally stays the same depending on the rental agreement.
• So the only relevant variance for control purposes for fixed overhead is the spending variance.
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BUT …
• We apply fixed overheads at a pre-determined standard rate.
• We don’t know what the actual rate is until after the end of the reporting period.
• The applied fixed overhead cost may differ from the budgeted fixed overhead cost, giving rise to a
fixed overhead volume variance.
• The fixed overhead cost may be over-applied or under-applied. A residual variance.
Dr Chung Yu Hung (2022) lecture slides.
Fixed overhead volume variance
The fixed overhead volume variance is the budgeted fixed overhead cost less the applied fixed overhead
cost.
A positive value is favourable. It indicates that the fixed overhead cost has been over-applied. The excess
amount needs to be reversed, leading to a higher profit.
A negative value is unfavourable. It indicated that the fixed overhead cost is under-applied. An additional
cost needs to be applied, leading to a lower profit.
=
−
= − ×
Variance analysis for Lewis Pty Ltd - 2019
In 2019, Lewis’ manufacturing fixed overhead costs are applied to product at the standard rate
of $11 per DLH and 2 DLH per suit. The rate is set during the budgeting process.
The budgeted fixed overhead costs was $286,000.
= −3 000 × $22 = −$66 000 under-applied
= 10 000 − 13 000 × $286 00013 000
An additional $66 000 needs to applied to the fixed overhead cost to reflect the budgeted fixed
manufacturing cost.
= − ×
Reminder: At this stage, we are assuming that the actual fixed overhead cost per suit is equal to the budgeted rate.
Fixed Overhead Volume Variance
The fixed overhead volume variance does not appear on the flexible budget.
It arises only because of the way we apply fixed overhead costs to product.
It is not meaningful for control purposes.
It does not reflect either a genuine expectation in relation to fixed overheads, nor does it represent actual
costs incurred.
But it does reconcile the budgeted overhead cost to the applied overhead cost.
22
Dr Chung Yu Hung (2022) lecture slides.
Production-volume Variance & Capacity
= −
Dr Chung Yu Hung (2022) lecture slides.
=
−
Source: Bhimani, Horngren, Datar, Tajan (2019) Management and Cost Accounting. Seventh Edition. Pearson. Chapter 16, p 516, Summary.
Production-volume Variance & Capacity
Caution is appropriate before interpreting the production volume variance as a measure of the economic
cost of unused capacity.
• The planned production volume may be based on market demand, and may be less than the firm’s
production capacity.
• Demand may be seasonal. Recovery of overhead costs may be “normalised”.
For example: overhead costs may be under-applied in some months and over-applied in other
months.
• The fixed overhead volume variance only measures the extent to which fixed overhead is over-
absorbed or under-absorbed (in inventory and COGS).
• The sales-volume variance in the flexible budget is the better diagnostic measure of the bottom line
impact of volume changes.
Dr Chung Yu Hung (2022) lecture slides.
Source: Bhimani, Horngren, Datar, Tajan (2019) Management and Cost Accounting. Seventh Edition. Pearson. Chapter 16, p 516, Summary.
Actual, Normal, & Standard Costing
Actual costing Normal Costing
Direct costs
×
×
Indirect costs
×
×
Source: Bhimani, Horngren, Datar, Tajan (2019) Management and Cost Accounting. Seventh Edition. Pearson. Chapter 16, Exhibit 16.6.
The amount of allocation base is known as it is consumed during the reporting period.
The actual allocation rate is not known until the end of the reporting period.
Actual, Normal, & Standard Costing
Source: Bhimani, Horngren, Datar, Tajan (2019) Management and Cost Accounting. Seventh Edition. Pearson. Chapter 16, Exhibit 16.6.
Standard Costing
Direct costs
×
×
Indirect costs
×
×
The focus is on standards.
Flexed variances represent departure from standards.
Choice of Allocation Base
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• The allocation of costs differs depending on the resources selected as an allocation base.
For example: the allocation base could be direct labour-hours, machine-hours, etc.
• Costs may be broken-down into components. Each component may have it own allocation base. The
variance analysis would need to be conducted for each component and then aggregated.
o If the allocation base is direct labour-hours (DLH), then the efficiency variance will reflect the
efficiency of human resources (DLH per unit output), and the spending variance will reflect the cost
per DLH (hourly rate).
o If the allocation base is direct machine-hours (MH), then the efficiency variance will reflect machine
efficiency (MH per unit output), and the spending variance will reflect the cost of operating the
machine per hour (hourly rate).
• The actual fixed overhead cost is independent of allocation base.
Dr Chung Yu Hung (2022) lecture slides.
Spending and Efficiency Overhead Variances
Illustration: Danskmat AS
Danskmat AS (Danskmat) operates a home meal delivery service. It has agreements with 20 restaurants to
pick up and deliver meals to customers who phone or fax in orders. Danskmat is currently examining its
overhead costs for May 2018.
Variable-overhead costs for May 2018 were budgeted at DKK 20 per hour of home delivery time. Fixed-
overhead costs were budgeted at DKK 240 000. The budgeted number of home deliveries in May 2018 was
8000. Delivery time, the allocation base for variable and fixed overhead costs, is budgeted to be 0.80 hour
per delivery.
Actual results for May 2018 were:
Source: Bhimani, Horngren, Datar, Tajan (2019) Management and Cost Accounting. Seventh Edition. Pearson. Chapter 16, Assessment Material, Task 16.20, p 522
Variable overhead DKK 141 740
Fixed overhead DKK 276 000
Number of home deliveries 7 460
Hours of delivery time 5 595
Customers are charged DKK 120 per delivery. The delivery driver is paid DKK 70 per delivery. Danskmat
receives a 10% commission on the amount that the restaurants charge the customers who use Danskmat.
“DKK denotes ‘Danish Krone’.
Spending and Efficiency Overhead Variances
Illustration: Danskmat AS
Required
1. Calculate spending and efficiency variances for Danskmat’s variable and fixed overhead in May 2018. Comment on
the results.
2. How might Danskmat manage its variable-overhead costs differently from the way it manages its fixed-overhead
costs?
29Source: Bhimani, Horngren, Datar, Tajan (2019) Management and Cost Accounting. Seventh Edition. Pearson. Chapter 16, Assessment Material, Task 16.20, p 522
“DKK denotes ‘Danish Krone’.
Variable overhead DKK 20 per hour-delivery-time
Fixed overhead DKK 240 000
Number of home deliveries 8000 deliveries
Hours of delivery time DKK 0.8 hours per delivery
Danskmat’s budget estimates for May 2018:
Spending and Efficiency Overhead Variances
Illustration: Danskmat AS
“DKK denotes ‘Danish Krone’.
Variable Overhead Efficiency Variance
=
×
−
×
= 5 595 − 0.8 × 8 000 × 20
Variable Overhead Efficiency Variance is a favourable DKK 16 100, because the Danskmat
used 805 delivery hours less than planned.
= − ×
= 5 595 − 6 400 × 20= −805 × 20= −16 100 favourable
Spending and Efficiency Overhead Variances
Illustration: Danskmat AS
31“DKK denotes ‘Danish Krone’.
Variable Overhead Spending Variance
= 5 595 × 141 7405 595 − 20
= 5 595 delivery hours × DKK 5.3333 per delivery hour= 29 840
Variable Overhead Spending Variance is a unfavourable DKK 29 821, because the variable cost per
delivery hour was DKK 5.33 higher than planned.
unfavourable
=
×
−
= 5 595 × 25.33 − 20.00
Spending and Efficiency Overhead Variances
Illustration: Danskmat AS
32“DKK denotes ‘Danish Krone’.
Reconciliation
Variable Overhead Variance is an unfavourable DKK 13 740.
=
−
= 141 740 − 20 × 0.8 × 8 000= 141 740 − 128 000= 13 740
DKK
Efficiency variance (16 100)
Spending variance 29 840.
Variable overhead variance 13 740.
Spending and Efficiency Overhead Variances
Illustration: Danskmat AS
33Source: Bhimani, Horngren, Datar, Tajan (2019) Management and Cost Accounting. Seventh Edition. Pearson. Chapter 16, Assessment Material, Task 16.20, p 522
“DKK denotes ‘Danish Krone’.
Fixed Overhead Variance
Fixed Overhead Variance is a unfavourable DKK 36 000.
unfavourable
= − = 276 000 − 240 000= 36 000
Spending and Efficiency Overhead Variances
Illustration: Danskmat AS
34Source: Bhimani, Horngren, Datar, Tajan (2019) Management and Cost Accounting. Seventh Edition. Pearson. Chapter 16, Assessment Material, Task 16.20, p 522
“DKK denotes ‘Danish Krone’.
Alternatively, we could use a flexed budget, based on delivery time.
Danksmat AS
May 2018
Delivery time (hours) 6,400 5,595
budget
Efficiency
Variance flexed
Spending
Variance actual variance
Variable overhead costs (DKK) 128,000 (16,100) 111,900 29,840 141,740 13,740
Fixed overhead costs (DKK) 276,000 276,000 (36,000) 240,000 (36,000)
0.8 hours per delivery x 8000 deliveries
DKK 20 per hour x 0.8 hours per delivery x 8000 deliveries
Spending and Efficiency Overhead Variances
Illustration: Danskmat AS
35
= − ×
Fixed Overhead Production-volume Variance
= 7 460 − 8 000 × 0.8 × 20= −540 × 16= −8 640
The fixed overhead cost is under-applied. Danksmat needs to apply an additional DKK 8 640.
under-applied
= − ×
What if the firm used ABC?
… but there is still a problem:
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• Cost pools under ABC include both fixed and variable costs.
• So the estimated cost driver (for example: number of setups) multiplied by the expected cost per unit
of driver (i.e. $x per setup) includes both fixed and variable set-up costs.
• To set up a flexible budget amount for costs driven by number of setups we would need to
disentangle fixed and variable costs within the cost pool……
Dr Chung Yu Hung (2022) lecture slides.
We need to conduct a variance analysis for each activity
(volume variance, efficiency variance, and spending variance)
and then aggregate the variances.
What if the firm used ABC?
There may be many cost pools, each needing to be budgeted separately, and each
needing fixed and variable costs to be disentangled.
It can be done using sophisticated software and extensive costing databases.
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Distinguishing variable costs from fixed costs is very important for planning and control
purposes.
Activity based costing is useful for capturing the way products (and customer, etc)
consume resources in the long-run.
Dr Chung Yu Hung (2022) lecture slides.
Workshop
• Read the case narrative.
• Do the workshop tasks before the
seminar.
• Make sure you take good notes.
• Be prepared to participate in class-
discussion during the seminar.
• Attend the seminar. Ask questions.
Listen and respond to other people’s
views, try to resolve any difficulties.
• Revisit your work after the seminar.
Reflect and not improvements.
• Outline your insights in writing.
The End