copyright © 2006. the mcgraw-hill companies, inc.mcgraw-hill/irwincopyright © 2006, the...

Copyright © 2006. The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

Flexible Budgets and Control of Overhead Costs

Week 7: Lecture 7

1

Copyright © 2006. The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

Learning Outcomes

• What are the overhead costs?• What is a flexible budget?• What is a static budget?• What are the variances?• Prepare a flexible budget and a budgetary

control statement.

2


Overhead costs• Controlling overhead costs is a major concern of

managers in business, in government and in non-profit organizations.

• In business, overhead costs refers to an ongoing expense of operating a business: expenses that are necessary to the continued functioning of the business but cannot be immediately associated with the products or services being offered. Overhead expenses are all costs on the income statement except for direct labour, direct materials, and direct expenses. Overhead expenses include accounting fees, advertising, depreciation, insurance, interests, legal fees, rent, repairs, supplies, taxes, telephone bills, travel expenditures, salaries of employees e.t.c.

3


• Overhead costs can include everything from the disposable coffee cup in the visitor’s waiting area to the president’s salary. Overhead is made up of many separate costs many of which may be small and some overhead costs are variable, some fixed and some mixture of fixed and variable. The nature of overhead costs makes it difficult to control them and for that reason we use the flexible budgets instead of the static budgets that we studied in previous lecture.

4


Characteristics of a flexible budget• A static budget is prepared for only one level of activity.

This budget approach is proper for planning purposes but is not enough for estimating how well costs are control. It works well for evaluating performance when the planned level of activity is the same as the actual level of activity. But, if actual level of activity in a given month or quarter is different from the planned amount, it is difficult to ensure if costs were controlled.

• Flexible budgets are one way companies deal with different levels of activity. A flexible budget provides budgeted data for different levels of activity. Another way of thinking of a flexible budget is a number of static budgets. For example, a restaurant may serve 100, 150, or 300 customers an evening. If a budget is prepared assuming 100 customers will be served, how will the managers be evaluated if 300 customers are served? 5


Characteristics of a flexible budget

• Flexible budgets take into account changes in costs that might take place as a result of changes in activity. A flexible budget give calculations of what costs should be for any level of activity within a specified range. Using this approach of budget actual costs are compared to what the costs should have been for this level-the actual level- instead of comparing them to the budgeted costs from the static budget. If we were using the static budget we would compare costs of one level of activity to costs of a different level of activity.

6


Variances

• Budget reports shows variances. The budget report is used by management to identify the sales or expenses whose amounts are not what were expected so management can find out why the variances occurred. By understanding the variances, management can decide whether any action is needed. Favourable variances are usually positive amounts, and unfavourable variances are usually negative amounts. Some textbooks show budget reports with “F” for favourable and “U” for unfavourable next to the variances to highlight in this way the type of variance being reported.

7


Static Budgets and Performance Reports

Static budgetsare prepared fora single, plannedlevel of activity.

Performance evaluation is difficult when actual activity

differs from the planned level of

activity.

Hmm! Comparingstatic budgets withactual costs is likecomparing apples

and oranges.


Flexible Budgets

Improve performance evaluation.

May be prepared for any activity level within a specified level range.

Show costs that should have beenincurred at the actual level ofactivity, enabling “apples to apples”cost comparisons.

Make known variances related tocost control.

Let’s look at CheeseCo.9


CheeseCo


10


CheeseCo


11


U = Unfavorable variance CheeseCo was unable to achieve

the budgeted level of activity.

CheeseCo


12


CheeseCo

F = Favorable variance that occurs when actual costs are less than budgeted costs.


13


Since cost variances are favorable, havewe done a good job controlling costs?

CheeseCo


14


I don’t think Ican answer thequestion usinga static budget.

Actual activity is belowbudgeted activity.

So, shouldn’t variable costsbe lower if actual activity

is lower?


15



The relevant question is . . .“How much of the favorable cost variance is due to lower activity, and how much is due to good cost control?”

To answer the question,we mustthe budget to theactual level of activity.

16


Preparing a Flexible Budget

To a budget we need to know that:– Total variable costs change

in direct proportion to changes in activity.

– Total fixed costs remainunchanged within therelevant range. Fixed

Variable

17



Let’s prepare budgets for CheeseCo.

18


Cost Total Formula Fixed 8,000 10,000 12,000per unit Cost Units Units Units

Units Sold 8,000 10,000 12,000

Variable costs Indirect labor 4.00$ Indirect material 3.00 Power 0.50 Total variable cost 7.50$

Fixed costs Depreciation 12,000$ Insurance 2,000 Total fixed costTotal overhead costs

Flexible Budgets


Fixed costs areexpressed as atotal amount.

Variable costs are expressed as a constant amount per unit.

$40,000 ÷ 10,000 units is$4.00 per unit.

CheeseCo

19



Units Sold 8,000 10,000 12,000

Variable costs Indirect labor 4.00$ 32,000$ Indirect material 3.00 24,000 Power 0.50 4,000 Total variable cost 7.50$ 60,000$

Fixed costs Depreciation 12,000$ Insurance 2,000 Total fixed costTotal overhead costs

Flexible Budgets


$4.00 per unit × 8,000 units = $32,000

CheeseCo

20


Preparing a Flexible BudgetCheeseCo


Units sold 8,000 10,000 12,000


Fixed costs Depreciation 12,000$ 12,000$ Insurance 2,000 2,000 Total fixed cost 14,000$ Total overhead costs 74,000$

Flexible Budgets

21



Units sold 8,000 10,000 12,000

Variable costs Indirect labor 4.00$ 32,000$ 40,000$ Indirect material 3.00 24,000 30,000 Power 0.50 4,000 5,000 Total variable cost 7.50$ 60,000$ 75,000$

Fixed costs Depreciation 12,000$ 12,000$ 12,000$ Insurance 2,000 2,000 2,000 Total fixed cost 14,000$ 14,000$ Total overhead costs 74,000$ 89,000$ ?

Flexible Budgets


Total fixed costsdo not change in

the relevant range.

CheeseCo

22


Quick Check

What should be the total overhead costs for the Flexible Budget at 12,000 units?a. $92,500.b. $89,000.c. $106,800.d. $104,000.

23


Quick Check

What should be the total overhead costs for the Flexible Budget at 12,000 units?a. $92,500.b. $89,000.c. $106,800.d. $104,000.

Total overhead cost

= $14,000 + $7.50 per unit 12,000 units

= $14,000 + $90,000 = $104,00024




Units sold 8,000 10,000 12,000

Variable costs Indirect labor 4.00$ 32,000$ 40,000$ 48,000$ Indirect material 3.00 24,000 30,000 36,000 Power 0.50 4,000 5,000 6,000 Total variable cost 7.50$ 60,000$ 75,000$ 90,000$

Fixed costs Depreciation 12,000$ 12,000$ 12,000$ 12,000$ Insurance 2,000 2,000 2,000 2,000 Total fixed cost 14,000$ 14,000$ 14,000$ Total overhead costs 74,000$ 89,000$ 104,000$

Flexible Budgets

25


Let’s prepare a budget performance report for CheeseCo.

Flexible Budget Performance Report

26


Cost Total Formula Fixed Flexible Actualper unit Cost Units Units Variances

Units sold 8,000 8,000 0



CheeseCoFlexible budget is prepared for the

same activity level (8,000 units) as

actually achieved.


27


Quick Check

What is the variance for indirect labor when the flexible budget for 8,000 units is compared to the actual results?a. $2,000 Ub. $2,000 Fc. $6,000 Ud. $6,000 F

28


Quick Check

What is the variance for indirect labor when the flexible budget for 8,000 units is compared to the actual results?a. $2,000 Ub. $2,000 Fc. $6,000 Ud. $6,000 F

29


Cost Total Formula Fixed Flexible Actualper unit Cost Budget Results Variances

Units sold 8,000 8,000 0

Variable costs Indirect labor 4.00$ 32,000$ 34,000$ $ 2,000 U Indirect material 3.00 25,500 Power 0.50 3,800 Total variable cost 7.50$ 63,300$


CheeseCoFlexible Budget Performance Report

30


Quick Check

What is the variance for indirect material when the flexible budget for 8,000 units is compared to the actual results?a. $1,500 Ub. $1,500 Fc. $4,500 Ud. $4,500 F

31


Quick Check

What is the variance for indirect material when the flexible budget for 8,000 units is compared to the actual results?a. $1,500 Ub. $1,500 Fc. $4,500 Ud. $4,500 F

32


Cost Total Formula Fixed Flexible Actualper unit Cost Budget Results Variances

Units Sold 8,000 8,000 0

Variable costs Indirect labor 4.00$ 32,000$ 34,000$ $ 2,000 U Indirect material 3.00 24,000 25,500 1,500 U Power 0.50 4,000 3,800 200 FTotal variable cost 7.50$ 60,000$ 63,300$ $ 3,300 U

Fixed costs Depreciation 12,000$ 12,000$ 12,000$ $ 0 Insurance 2,000 2,000 2,050 50 UTotal fixed cost 14,000$ 14,050$ 50 UTotal overhead costs 74,000$ 77,350$ $ 3,350 U

CheeseCo


33


End of Lecture

34

copyright © 2006. the mcgraw-hill companies, inc.mcgraw-hill/irwincopyright © 2006, the...

Documents