Chapter 14: The Flexible Budget: Factory Overhead

Summary

Establishing standard variable overhead application rates requires selection of appropriate activity measures. These rates can be determined using relatively simple procedures (e.g., a single, volume-related activity measure) or more sophisticated procedures, such as ABC. The resulting standard-cost data can be used both for product-costing purposes and, through their inclusion in flexible budgets, control purposes.

For control purposes, actual overhead costs (both variable and fixed) are compared to flexible budget costs. A summary of the overhead cost variances realized by the Schmidt Machinery Company for October 2007 is presented in Exhibit 14.18 . This exhibit is a variant of the model presented earlier in Exhibit 14.7 . Both exhibits are general in nature and therefore can be used in a four-variance, a three-variance, and a two-variance approach to decomposing the total overhead variance for the period. Feel free to use whichever of the two models you find more appealing.

Exhibit 14.18 also indicates a total fixed overhead variance for the period of \$37,050U. This variance, which is also called the total over- or underapplied fixed overhead for the period , can be decomposed into a fixed overhead spending variance (\$10,650U) and a production volume variance (\$26,400U). The former variance is defined as the difference between the actual fixed overhead costs and the budgeted (lump-sum) fixed overhead costs for the period. If management desires, this total variance can be broken down on a line-item basis.

The production volume variance exists only because of the product-costing need to assign a share of fixed overhead costs to each unit produced. To do this, the accountant develops a fixed overhead allocation rate, which is defined as budgeted fixed overhead costs divided by an assumed level of activity, called the denominator volume . If the denominator volume is defined as practical capacity , then the resulting production volume variance can be thought of as a measure of the cost of unused capacity.

You should remember that, in practice, different terms are used to describe the same overhead variance. Thus, you are advised in constructing any performance reports to clearly define the meaning of each variance contained in the report.

A firm can dispose of variances in the income statement of the period in which the variance occurs by charging them to the cost of goods sold. Alternatively, the firm can prorate the variances among the cost of goods sold, ending work-in-process inventory, and ending finished goods inventory. For materials price variances, the proration should include the materials ending inventory and materials usage variance.

Uses of standard cost systems are not limited to manufacturing operations; service firms and other organizations also can benefit from using them. Because operating characteristics of service firms often differ from those of manufacturing firms, modifications might be needed and emphases could be different when using standard costs in a service organization. Among operating characteristics that differ between manufacturing and service organizations are the absence of output inventory, labor-intensive operations, the predominance of fixed costs, and the ambiguity of output measures in service organizations.

Changes in manufacturing environments in recent years have motivated changes in cost systems. Increasingly, companies are using systems with multiple activity measures, both volume-based and non-volume-based. Flexible budgets based on ABC systems provide more accurate data for cost-control purposes.

Whether to investigate variances depends on the type of standard the firm uses, the expectations of the firm, the magnitude and impact of variances, and the causes and controllability of variances. Causes of variances can be random or systematic. Control charts can be used by managers to isolate random versus non-random variances.