Flexible Budgets and Overhead Analysis

Static Budget versus Flexible Budget

Performance reports compare actual costs with budgeted costs. This is done in two ways. The first is to compare the actual costs with budgeted costs for the budgeted level of activity. This is based on a static budget. The second is to compare actual costs with the actual level of activity. This is based on a flexible budget.

A static budget is a budget for one particular level of activity. The performance report will compare direct materials, direct labor, and overhead costs budgeted for the planned level of activity with actual costs for the actual level of activity. When the actual production exceeds the planned level, this results in an unfavorable variance. To create a meaningful performance report actual costs and expected costs must be compared at the same level of activity.

A flexible budget enables a firm to compute expected costs for a range of activity levels. The two types of flexible budgets are:

1. Before-the-fact: This type allows managers to see the expected outcomes for a range of activity levels. This is used to generate financial results for a number of plausible scenarios.

2. After-the-fact: This type is created for the actual level of activity. It is used to compute what costs should have been for the actual level of activity. Expected costs are then compared with the actual costs in order to assess performance.

Variable Overhead Analysis

Total overhead variance is the difference between applied and actual overhead. It is broken down into two sections. The first is total variable overhead, which is broken down further into variable overhead spending variance and variable overhead efficiency variance. The second is total fixed overhead variance, which is broken down further into fixed overhead spending variance and overhead volume variance.

Variable overhead spending variance measures the aggregate effect of the difference between actual variable overhead rate (AVOR) and standard variable overhead rate (SVOR). There are two ways to calculate this variance. The first is a three-pronged columnar approach. The second is a formula approach. The formula is (AVOR-SVOR) times AH. Yes, more algebra.

Variable overhead efficiency variance measures the change in variable overhead consumption that occurs because of efficient (or inefficient) use of direct labor. There are two ways to calculate this variance. The first is a three-pronged columnar approach. The second is a formula approach. The formula is (AH-SH) times SVOR.

Fixed overhead spending variance is the difference between actual fixed overhead rate (AFOH) and budgeted fixed overhead rate (BFOH). There are two ways to calculate this variance. The first is a three-pronged columnar approach. The second is a formula approach. The formula is AFOH minus SFOH.

Fixed overhead volume variance is the difference between budgeted fixed overhead (BFOH) and applied fixed overhead (ApFOH). There are two ways to calculate this variance. The first is a three-pronged columnar approach. The second is a formula approach. The formula is (SHp minus SH) times SFOR.

Activity Based Budgeting

Activity based budgeting is a powerful planning and control tool. It can be used to emphasize cost reduction through the elimination of wasteful activities and improving efficiency of necessary activities. There are two types: static activity budgets and activity-based flexible budgets.