Chapter Four Cost & Management Accounting

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FLEXIBLE BUDGET AND VARIANCE ANALYSIS

A budget is a plan for the future. Hence, budgets are planning tools, and they are usually
prepared prior to the start of the period being budgeted. However, the comparison of the
budget to actual results provides valuable information about performance. Therefore,
budgets are both planning tools and performance evaluation tools.
Usually, the single most important input in the budget is some measure of anticipated
output. For a factory, this measure of output is the number of units of each product
produced. For a retailer, it might be the number of units of each product sold. For a
hospital, it is the number of patient days (the number of patient admissions multiplied by
the average length of stay).

3.1 STATIC AND FLEXIBLE BUDGET

The static budget is the budget that is based on this projected level of output, prior to
the start of the period. In other words, the static budget is the “original” budget. The
static budget variance is the difference between any line-item in this original budget
and the corresponding line-item from the statement of actual results. Often, the line-item
of most interest is the “bottom line”: total cost of production for the factory and other cost
centers; net income for profit centers.
Budgeted Revenue = Budgeted Sales Budgeted Price per unit
in quantity X
Budgeted Cost = Budgeted VC + Budgeted FC
Budgeted VC = Budgeted Out put Budgeted Variable Cost
in quantity X per unit

Level refers to the detailed expression of the variance.

Static Budget Variance = Actual Budget - Static Budget

Favorable Variance:
For Revenue: Actual Revenue > Budgeted Revenue
For Cost: Actual Cost < Budgeted Cost
Unfavorable Variance:
For Revenue: Actual Revenue > Budgeted Revenue
For Cost: Actual Cost > Budgeted Cost

Illustrative examples
Item Actual Results Static Budget
Units Sold 10,000 12,000
Revenue $1,850,000 $2,160,000
Variable Cost $1,120,000 $1,188,000
Fixed Cost $705,000 $710,000
Operating Income $25,000 $262,000
Budgeted cost for five items

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DM – 2 square yard of cloth inputs per out put at $30 per square yard.
Direct Manufacturing Labour: 0.8 mfg labour hour per out put at $20 per hour.
Direct Marketing Labour: 0.25 labour hour per out put at $24 per hour.
Variable Manufacturing Over head: allocated on the basis of 1.20 machine hours per
out put units manufactured at $10 Standard Cost per machine hours.
Variable Marketing Over head: allocated on the basis of 0.125 direct marketing labour
hours out put sold at $40 Standard Cost per machine hours.
Actual cost for five items
DM – 22,200 square yards of cloths at $31 each.
Direct Manufacturing Labour: 9,000 mfg labour hours at $22 each.
Direct Marketing Labour: 2,304 Direct Marketing Labour at $25 each.
Variable Manufacturing Over head: $130,500
Variable Marketing Over head: $45,700

The flexible budget is a performance evaluation tool. It cannot be prepared before the
end of the period. A flexible budget adjusts the static budget for the actual level of output.
The flexible budget asks the question: “If I had known at the beginning of the period what
my output volume (units produced or units sold) would be, what would my budget have
looked like?” The motivation for the flexible budget is to compare apples to apples. If the
factory actually produced 10,000 units, then management should compare actual factory
costs for 10,000 units to what the factory should have spent to make 10,000 units, not to
what the factory should have spent to make 9,000 units or 11,000 units or any other
production level.

The flexible budget variance is the difference between any line-item in the flexible
budget and the corresponding line-item from the statement of actual results.
Budgeted Revenue = Actual Sales Budgeted Price per unit
in quantity X
Budgeted Cost = Budgeted VC + Budgeted FC
Budgeted VC = Actual Out put Budgeted Variable Cost
in quantity X per unit
The following steps are used to prepare a flexible budget:
1. Determine the budgeted variable cost per unit of output. Also determine the
budgeted sales price per unit of output, if the entity to which the budget applies
generates revenue (e.g., the retailer or the hospital).
2. Determine the budgeted level of fixed costs.
3. Determine the actual volume of output achieved (e.g., units produced for a
factory, units sold for a retailer, patient days for a hospital).
4. Build the flexible budget based on the budgeted cost information from steps 1
and 2, and the actual volume of output from step 3.
Flexible budgets are prepared at the end of the period, when actual output is known.
However, the same steps described above for creating the flexible budget can be used
prior to the start of the period to anticipate costs and revenues for any projected level of
output, where the projected level of output is incorporated at step 3. If these steps are

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applied to various anticipated levels of output, the analysis is called pro forma analysis.
Pro forma analysis is useful for planning purposes. For example, if next year’s sales are
double this year’s sales, what will be the company’s cash, materials, and labor
requirements in order to meet production needs?

The difference between static Budget and flexible budget is known as Sales Volume
Variance (SVV).
The difference between Flexible Budget and Actual budget is known as Flexible Budget
Variance (FBV).
FBV + SVV = Static Budget Variance
Actual Results:
Actual Revenue = Actual Sales Actual Price per unit
in quantity X
Actual Cost = Actual VC + Actual FC
Actual VC = Actual Out put Actual Variable Cost
in quantity X per unit

PERFORMANCE EVALUATION USING FLEXIBLE BUDGET

There are basically two reasons why actual results may differ from master budget. These
are:
 Sales and other cost driver activities were not the same as originally forecasted.
 Revenue or Variable cost per units of activity and Fixed Costs per period were not as
expected.
The variance that is obtained between flexible budget and actual result tells us the reason
why the changes exist.

The difference between fixed cost in flexible budget and static budget is Zero. When
evaluating performance, it is useful to distinguish between:
 Effectiveness: the degree to which the target is met.
 Efficiency: the degree to which inputs are used in relation to a given level of out put.
Flexible budget variance measure efficiency of operations at actual level of out put in the
activity.

3.2 COST VARIANCES FOR DIRECT MATERIALS AND LABOR

Introduction:
In the previous part, we saw that the static budget variance measures the difference
between budgeted costs and actual costs (or budgeted revenues and actual revenues).
We also saw that when the actual volume of output (sales or production) differs from the
budgeted volume of output, this difference contributes to the static budget variance. We
saw that a flexible budget adjusts the static budget to reflect what the budget would
have looked like, if the actual output volume could have been known in advance. The
flexible budget variance measures the difference between the flexible budget and
actual results.

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As stated in the previous part, there can be only two explanations for the flexible budget
variance for variable costs. First, there can be a difference between budgeted input prices
and actual input prices: the company paid more per yard of fabric, or less per pound of
steel, than planned. Second, there can be an efficiency piece: the company used more
fabric per pair of pants, or fewer pounds of steel per widget, than planned. In this chapter,
we separate the flexible budget variance for direct materials into these two pieces: the
“price” piece, and the “efficiency” piece. At the end of the chapter, we extend the
discussion to other variable costs: direct labor and variable overhead.

Notation:
The following concepts and abbreviations are used:
Inputs are the materials used in the production process (fabric or steel).
Outputs are the units of finished product (pairs of pants, or widgets).

Abbreviatio Definition Explanation

n
Q Quantity The total quantity of inputs used in
production
(the inputs for all output units, not the
P Price inputs for one unit of output)
AP Actual Price The price per unit of input
SP Standard Price The actual price paid per unit of input
AQ Actual The budgeted price paid per unit of
SQ Quantity input
Standard The actual quantity of inputs used in
Quantity production
The quantity of inputs that “should
have been used” for the actual output
produced
Sometimes Q refers to the total quantity of inputs purchased, not used in production. We
will return to this possibility later in this chapter, but for now, Q refers to the quantity used
in production.
The most important concept identified above is the Standard Quantity (SQ). SQ is a
flexible budget concept: it is the quantity of inputs that would have been budgeted had
the budget correctly anticipated the actual volume of output.
Derivation of the Direct Materials Variances:
Given these definitions, the flexible budget can be expressed as
SQ x SP;
and the flexible budget variance can be expressed as
(AQ x AP) – (SQ x SP) (1)
By introducing the following expression, we can separate the flexible budget variance into
two pieces.
AQ x SP

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This expression measures what the company “should have spent” for the actual quantity
of inputs used. We insert this expression into Equation (1) for the flexible budget variance:
(AQ x AP) – (AQ x SP) – (SQ x SP) (2)
The first difference in Equation (2) can be rewritten as follows:
(AQ x AP) – (AQ x SP) = AQ x (AP – SP)
This expression is the price variance. It is the actual inputs used in production (AQ)
multiplied by the difference between the budgeted price (SP) and the actual price (AP)
paid per unit of input. The price variance is abbreviated PV. Hence:
PV = AQ x (AP – SP)
If the term in parenthesis is positive, the factory paid more per unit of input than
budgeted, and the price variance is unfavorable. If the term in parenthesis is negative, the
factory paid less per unit of input than budgeted, and the price variance is favorable. In
either case, the price variance can be interpreted as answering the following question:
What was the total impact on the cost of production caused by the fact that the actual
price per unit of input differed from the budgeted price.
The second difference in Equation (2) can be rewritten as follows:
(AQ x SP) – (SQ x SP) = SP x (AQ – SQ)
This expression is the quantity variance (also called the usage variance). It is the
budgeted price per unit of input (SP) multiplied by the difference between the quantity of
inputs that should have been used for the output units produced (SQ) and the quantity of
inputs actually used (AQ). The quantity variance is abbreviated QV. Hence:
QV = SP x (AQ – SQ)
If the term in parenthesis is positive, the factory used more inputs than it should have
used for the amount of output units produced, and the quantity variance is unfavorable. If
the term in parenthesis is negative, the factory used fewer inputs than it should have used
for the amount of output units produced, and the quantity variance is favorable. In either
case, the quantity variance can be interpreted as answering the following question: What
was the total impact on the cost of production caused by the fact that the quantity of
inputs used to make each unit of output differed from budget.

Timing of Recognition of the Price Variance:

Some firms recognize the price variance for direct materials when the raw materials are
purchased, rather than waiting until the raw materials are put into production. In this case,
the AQ in the price variance will generally differ from the AQ in the quantity variance,
which is denoted in the following expressions for these variances:
PV = AQ Purchased x (AP – SP)
QV = SP x (AQ Used – SQ)
Where usually, AQ Purchased  AQ Used

Recognizing the price variance when raw materials are purchased provides more timely
information to management about the cost of direct materials and the performance of the
purchasing department. Hence, this method for calculating the price variance has much to
commend it. However, in this situation, the sum of the price variance and quantity

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variance will not equal the flexible budget variance, except by coincidence or when
beginning and ending quantities of raw materials are zero.

Cost Variances and External Reporting:

Cost variances are not reported separately in the external financial statements of a firm,
but are implicitly incorporated in one or more line-items on the balance sheet and income
statement, such as Cost of Goods Sold and ending Finished Goods Inventory. However, for
internal reporting, cost variances are frequently reported as separate line-items on
divisional income statements and product-specific profit statements.

Cost Variances for Direct Labor:

The formulas for splitting the flexible budget variance into a “price” variance and
“quantity” variance are the same for direct labor as direct materials. However, the
terminology differs slightly. What is called the price variance for direct materials is called
the rate variance or wage rate variance for direct labor. However, we retain the same
abbreviations:
PV = AQ x (AP – SP)

Where AQ is the actual labor hours used in production, AP is the actual wage rate, and SP
is the budgeted wage rate.

What is called the quantity or usage variance for direct materials is called the efficiency
variance for direct labor. We abbreviate this variance as EV:
EV = SP x (AQ – SQ)

Where SP and AQ are the same as above and SQ is the flexible budget quantity of labor
hours (the labor hours the factory should have used for the volume of output units
produced).
The issue discussed earlier in this chapter regarding the timing of the recognition of the
price variance for direct materials does not arise for direct labor. Consequently, for direct
labor, the sum of the wage rate variance and efficiency variance always equals the flexible
budget variance.
Example:
The Blue Moose Restaurant makes and sells sandwiches. The Restaurant makes and sells
a lot of sandwiches. Following is the restaurant’s budget for making a peanut butter and
jelly sandwich:
Direct Materials:
Bread:
Quantity: 2 slices of bread (you probably knew this)
Price: Birr 0.10 per slice of bread
Peanut butter:
Quantity: 3 tablespoons
Price: Birr 0.05 per tablespoon

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Jelly:
Quantity: 4 tablespoons
Price: Birr 0.03 per tablespoon
Direct labor:
Quantity: two minutes of labor
Wage rate: Birr 12 per hour (Birr 0.20 per minute)
The static budget for May indicated a production and sales level of 1,100 peanut butter
and jelly sandwiches. In fact, the restaurant made and sold 1,000 peanut butter and jelly
sandwiches. The total cost in direct materials and labor to make these 1,000 sandwiches
was Birr 520 for ingredients and Birr 450 for labor.
Required:
1. What is the budgeted cost per unit for making a peanut butter and jelly sandwich?
2. What would the static budget show, in total, for the cost of production for all peanut
butter and jelly sandwiches?
3. What would the flexible budget show, in total, for the cost of production for all peanut
butter and jelly sandwiches? Show materials separately from labor.
4. What is the flexible budget variance? Show this variance separately for materials and
labor. Is the flexible budget variance favorable or unfavorable?
5. Each loaf of bread contains 20 slices of bread. 105 loafs of bread were used to make all
of the peanut butter and jelly sandwiches. The actual price paid per loaf was Birr 2.20.
Calculate the quantity (usage) variance for bread. Provide a possible explanation for
this variance.
6. What is the price variance for bread? Is it favorable or unfavorable?
7. 30 labor hours were spent making peanut butter and jelly sandwiches, at an average
wage rate of Birr 15 per hour. What is the efficiency variance for labor?
8. What is the wage rate variance?

3.3. Overhead Variance

The flexible overhead budget is the managerial accountant’s primary tool for the control of
manufacturing overhead costs. At the end of each accounting period, the managerial
accountant uses the flexible overhead budget to determine the level of overhead cost that
should have been incurred, given the actual level of activity. Then the accountant
compares the overhead cost in the flexible budget with the actual overhead cost incurred.
The marginal accountant, given the necessary data computes four separate overhead
variances, each of which conveys information useful in controlling overhead costs.

Examp. 1.To illustrate overhead variance analysis, we will continue the illustration of the XYZ
Carpenters Share Company. During the month of January, the company produced 2,500 tables. Since
production standards allow 4 machines–hours per table, the total standard allowed number of machine
hours for the actual output is computed as follows:
Actual Production Output 2,500 Tables
Standard Allowed Machine Hours Per X4
Table

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Total Standard Allowed Machine Hours 10,000 Machines
Hours

Thus, 10,000 machines–hours represent the standard machine-hours allowed for the actual production of
2,500 tables. This means, according to the standard, only 10,000 hours of machine time should have
been used to manufacture the 2,500 tables actually produced in January. From the 10,000 machine-hours
column in the columnar flexible budget prepared earlier, the budgeted overhead cost for January is
follows:
Budgeted Overhead Cost For January
Variable Overhead Birr 65,000
Fixed Overhead 42,000
From the cost-accounting records of the company, the controller determined that the following overhead
costs were actually incurred during January to produce the 2,500 tables:
Actual Costs For January
Variable Overhead Birr 71,400
Fixed Overhead 43,800
Total Overhead Birr 115,200
The production supervisor’s records of the company indicate that the actual machine-
hours used during January to produce the 2,500 tables were 10,500 hours. Notice that the
actual number of machine-hours used (10,500 hours exceeds the standard allowed
number of machine hours 10,000 hours), given the actual production output 2,500 tables.
Now all of the information necessary to compute XYZ Carpenters Share company’s
overhead variances for January is assembled. Therefore, in the discussions that follow in
this section, you will study how overhead cost variances are computed and interpreted.

The company’s total variable-overhead variance fo r January is computed below:

Actual Variable Overhead Birr 71,400
Budgeted Variable Overhead 65,000
Total Variable–Overhead Variance Birr 6,400 U

Variable Overhead Variance

What caused the company to spend Birr 6,400 more than the budgeted amount on
variable overhead? To discover the reasons behind this performance, the managerial
accountant computes the following variable overhead variances variable–overhead
spending variance, and variable–overhead efficiency variance.

Before we move in to the computation of these variances, carefully note the following
symbols:
AH = Actual hours (machine-hours in our case)
AR = Actual variable-overhand rate
SR = Standard variable-overhand rate
SH = Standard hours (machine hours in our case) allowed for actual output

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1.Variable Overhead Spending Variance

The spending variance addresses the question, “How much should have been spent on
overhead, given the actual input?” It is a comparison of actual overhead with a flexible
budget based on actual hours.
To compute this variance, we use the formula given below:
Variable  OH Spending Variance Actual Variable OH  AH x SR 

Because actual variable overhead is equal to actual hours (AH) times the actual
variable overhead rate (AR), the above formula could be rewritten as follows:

Notice that the actual variable–overhead rate (AR) is computed using the formula giving
below.

The AR for the XYZ Carpenters Share Company is Birr 6.80 per machine hair as computed
below:

Using the information at hand, let us now compute the variable-overheard spending
variance for the company.

You can also apply the other formula given above to compute variable-overheard spending
variance for the company as indicated below:

The variable-overhead spending variance is unfavorable because the actual variable-

overhead cost exceeded the expected amount, after adjusting that expectation for the
actual number of machine hours used or worked. Notice that the Birr 6.50 standard
variable overhead rate was calculated in our previous discussions under the topic “Flexible
overhead budget”

2.Variable–Overhead Efficiency Variance

The efficiency variance measures the amount of overhead variance attributable to using
more or less inputs than allowed by the standards, given the amount of production. If
actual hours worked are fewer than standard hours, the efficiency variance is favorable.
An unfavorable variance occurs when actual hours exceed standard hours. To compute
this variance, we use the formula given below:

XYZ Carpenter Share Company’s variable- overhead efficient variance for January is
computed as follows:

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The above formula can be simplified by expressing it in factored from as follows:

The variable-overhead efficiency variance is unfavorable because actual machine hours

(10,500 hours) exceeded the standard allowed machine hours (10,000 hours) for the
actual output (2,500 tables) manufactured in January. Now carefully observe that, as
shown below, the total variable –overhead variance is the sum of the variable – overhead
spending and efficiency variances:

Variable–Overhead Spending Variance Birr 3,150 U

Variable–Overhead Efficiency Variance 3,250 U
Total Variable–Overhead Variance Birr 6,400 U

The variable–overhead spending variance measures the aggregate effect of differences

between the actual variable–overhead rate and the standard efficiency variance, in
contrast, measures the aggregate effect of differences between the actual activity base
and the standard activity base allowed for the actual out put achieved. Recall that the
activity base in the XYZ Carpenters Share Company problem is machine hours. A
summary of variable variances is presented in the table that follows. Notice, in this table,
that “hours” represent machine hours and rates per “hour” stand to indicate rates per
machine hour.

(a) (b) (c) (d)

Actual variable Flexible Budget Based Flexible Budget Based on Variable OH Applied to
overhead- on Actual Hours Standard Hours Work-In-Process
(AH) x (AR) (AH) x (SR) (SH) x (SR) (SH) x (SR)
10,500 x Birr6.80 10,500 x Birr6.50 10,000 x Birr 6.50 10,000 x Birr6.50
Hours x per hour = Birr 68,250 = Birr 65,000 = Birr 65,000
Birr 71,400

Birr 3,150 U Birr 3,250U

No Difference
Variable OH
Variable OH Efficiency Variance
Spending Variance

Birr 6,400 U
Total Variable OH Variance

Columns (a), (b), and (c) in the above table are used to compute the variances for cost-
control purposes. Column (d), in contrast, is not used to compute the variances. This last

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column is included to point out that the flexible–budget amount for variable overhead (Birr
65,000) is the amount that will be applied to work in process inventory for product-
costing purposes. In brief, column (d) shows the variable overhead applied to work in
process for the product costing purpose.

What do the variable–overhead variances mean? What information do they convey

to management? Let us see the interpretations of the variable-overhead spending
variance and that of the variable–overhead efficiency variance in the discussion that
follows.

3.Interpreting Variable-Overhead Spending variance

The variable overhead spending variance is useful only if the cost driver for variable
overhead really is the actual hours worked. Then the flexible budget based on the actual
hours worked is a valid benchmark that tells us how much should have been spent in total
on variable overhead items during the period. The actual overhead costs would be larger
than this benchmark, resulting in an unfavorable variance, if either:
(a)The variable overhead items cost more to purchase than the standards allow, or
(b)More variable overhead items were used than the standards allow.

So the spending variance includes both price and quantity variances. In principle, these
variances could be separately reported, but this is seldom done. Ordinary, the price
element in this variance may be small, so the variance will mainly be influenced by how
efficiently variable overhead resources such as production supplies are used.

In brief, an unfavorable spending variance simply means that the total actual cost of
variable overhead is greater than expected, after adjusting for the actual quantity of
machine hours used. An unfavorable spending variance could result from paying a higher
than expected price per unit for variable-overhead items, or the variance could result from
using more of the variable-overhead items than expected. Suppose for example, that
electricity were the only variable-overhead cost item. An unfavorable variable-overhead
spending variance could result from paying a higher than expected price per kilowatt-hour
for electricity, from using more than the expected amount of electricity, or from both.

4.Interpreting Variable-Overhead Efficiency Variance

Like the variable-overhead spending variance, the variable-overhead efficiency variance is
useful only if the cost driver for variable overhead really is the actual hours worked.
Then any increase in hours actually worked should result in additional variable overhead
costs. Consequently, if too many hours were used to produce the actual output, this is
likely to result in an increase in variable overhead. The variable-overhead efficiency
variance is an estimate of the effect on variable overhead costs of inefficiency in the use
of the base (i.e., hours). In a sense, the term variable-overhead efficiency variance is
a misnomer. It seems to suggest that it measures the efficiency with which variable
overhead resources were used while it does not. It is rather an estimate of the indirect
effect on variable overhead cost of inefficiency in the use of the activity base (machine

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hours in our case). Notice from the discussions made earlier that the variable–-overhead
efficiency variance is a function of the difference between the actual hours worked and the
hours that should have been worked to produce the period’s actual output. If more hours
are worked than are allowed at standard, then the overhead efficiency variance will be
unfavorable. However, as discussed above, the efficiency is not in the use of overhead
but rather in the use of the base itself.

Exercise.1. In the XYZ Carpenters Share Company example, 500 more machine hours
(10,500 actual hours less 10,000 stand and hours) were used during January than should
have been used to produce the January’s actual output (2,500 tables). Each of these 500
more hours presumably required the incurrence of Birr 6.50 of variable overhead cost,
resulting in an unfavorable variance of Birr 3,250 (500 hours x Birr 6.50 = Birr 3,250).
Although this Birr 3,250 variance is called an overhead efficiency variance it could better
be called a machine-hours efficiency variance, since it results from using too many
machine–hours rather than from inefficient use of overhead resources.
Example
Item Actual Results Flexible Budget Amount
Out Put Units 10,000 10,000
Machine Hours 4,500 4,000
Machine Hour Per Out 0.45 0.40
Put
VMOH Cost $130,500 $120,000
VMOH Cost/machine $29 $30
hours
VMOH Cost/Out Put 13.05 12
Required: Compute the following VMOH Variance
 VMOH Flexible Budget Variance
 VMOH Efficiency Variance
 VMOH Spending Variance
Fixed Overhead Variances
The process of analyzing the difference between standard and actual costs, called
variance analysis, can be applied to overhead costs just as we applied it to direct
materials and direct labor in the preceding parts. Direct materials and direct labor are
variable costs only; they contain no fixed component. On the other hand, overhead
includes relatively large amounts of fixed costs as well as some variable costs, making the
analysis of overhead variances somewhat more complicated. Without flexible budgets it is
difficult to assess the impact on overhead costs of activity levels that differ from the
budgeted level. The purpose of overhead variance analysis is the same as that of other
types of variance analysis: to determine how much actual results differ from expected
outcomes and why the variance occurred.
Examp. 2.To analyze performance with regard to fixed overhead, the managerial accountant
calculates fixed-overhead variances. The company’s total fixed-overhead variance for January is
computed below:

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Actual Fixed Overhead Birr 43,800

Fixed Overhead Applied to Work-In–Process* 35,000
Total Fixed Overhead Variance Birr 8,800 U
*Applied Fixed OH = Predetermined Fixed OH Rate X Standard Allowed
hours
= Birr 3.50 X 10,000 machine hours = Birr 35,000

Notice that overhead has been applied to work in process on the basis of 10,000 standard
machine hours allowed for the actual output of January (2,500 tables) rather than on the
basis of 10,500 actual hours worked. This keeps unit costs from being affected by any
variations in efficiency. What caused the company to spend Birr 8,800 more than the fixed
overhead applied to work-in-process based on standard machine hours allowed for actual
output? To find out the reasons behind this performance, the management accountant
computes the following two variances for fixed overhead:
(a)A fixed–overhead budget variance, and
(b)A fixed–overhead volume variance.

1. Fixed-Overhead Budget Variance

The budget variance is the difference between the actual fixed overhead costs incurred
during the period and the budgeted fixed overhead costs as contained in the flexible
overhead budget. This variance, used by managers to control fixed overhead costs, and
that is computed by using the following formula:

XYZ Carpenters Share Company’s fixed-overhead budget variance for January is, applying
the formula given about, computed as follows:

2. Fixed-Overhead Volume Variance

The volume variance is a measure of utilization of plant facilities. The variance arises
whenever the standard hours allowed for the actual output of a period are different from
the dominator activity level that was planned when the period began. This variance can
be commuted using any one of the following two formulas:

Let’s now compute the fixed –overhead volume variance for the XYZ Carpenters Share
Company’s problem, using the above two formulas.

Notice that, to compute the predetermined overhead rate for XYZ Carpenters Share
Company, 12,000 machine-hours per month was taken as planned activity when the

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period began. Using this base, recall that, the predetermined fixed overhead rate was
computed to be Birr 3.50 per machine hour as follows:

The budgeted activity level for the moth (12,000 machine hours) is used as the
denominator activity in the formula for the predetermined overhead rate. These 12,000
machine hours are what we called denominator hours in the formula for volume
variance. In general, the estimated total units in the base (machine hours, direct-labor
hours, etc.) in the formula for the predetermined overhead rate are the denominator
activity. Once an estimated activity level (denominator activity) has been chosen, it
remains unchanged throughout the year even if the actual activity turns out to be different
from what was estimated. The reason for not changing the denominator is to maintain
stability in the amount of overhead applied to each unit of product regardless of when it is
produced during the year.
Recall that 10,000 machine hours represent the standard hours allowed for actual output
of January (2,500 tables) at 4 standard machine hours per table. You can as well arrive at
the same result of fixed overhead volume variance applying the second formula as shown
below:

Now carefully observe that, as shown blow, the total fixed-overhead variance is the sum of the fixed-
overhead budget and volume variances:
Fixed-Overhead Budget Birr 1,800
Variance U
Fixed–Overhead Volume 4,000
Variance U
Total Fixed Overhead Variance Birr 8,800
U

A summary of fixed–overhead variance is presented in the table that follows.

Actual Fixed Flexible Budget Fixed OH Cost Applied to Work-

OH Cost Fixed OH Cost In-Process 10,000 standard hours
Birr 43,800 Birr 42,000 X Birr 3.50 per hours
= Birr 35,000

Birr 1,800 Unfavorable Birr 7,000

Fixed–OH Unfavorable
Budget variance Fixed– OH
Volume variance
Birr 8,800 unfavorable
Total Fixed–OH variance U Page 14 of 16
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The fixed–Overhead variances convey useful information to management. Let’s see, in the
discussion that follows, at the interpretation of these variances.

3. Interpreting Fixed–Overhead Budget Variance

The budget variance is the real control variance for fixed overhead, because it compares
actual expenditures with budgeted fixed – overhead costs. The budget variances for fixed
overhead can be very useful, since they represent the difference between how much
should have been spent (according to the flexible overhead budget) and how much was
actually spent. An unfavorable fixed – overhead budget variance calls for an explanation of
why it happened. If, for instance, the production supervisor’s salary shows an unfavorable
budget variance, it could be due to many reasons. The reasons could be an increase in
salaries, overtime work, or another supervisor could have been hired. Proper explanation
should be given as to why another supervisor was hired, if this was not included in the
budget when activity for the period was planned. In brief, the fixed – overhead budget
variance for XYZ Carpenters Share Company’s problem is unfavorable, because the
company spent more than the budgeted amount of fixed overhead. Notice that an
activity level to determine budgeted fixed overhead needs no specification. This is so
because all the three columns in the columnar flexible budget prepared earlier specify Birr
42,000 as budgeted fixed overhead per month.

4. Interpreting Fixed–Overhead Volume Variance

It has been stated earlier that the volume variance is a measure of utilization of available
plant facilities. An unfavorable variance, as you have seen in our computations, means
that the company operated at an activity level below that planned for the period. A
favorable variance would, on the other head, mean that the company operated at an
activity level greater than that planned for the period. It is important to note that the
volume variance does not measure over–or under–spending. Accompany would
normally incur the same Birr amount of fixed overhead cost regardless of whether the
period’s activity was above or below the planned (denominator) level of activity. In short,
the volume variance is an activity–related variance. It is explainable only by activity and is
controllable only thought activity. The following three points could summarize the fixed–
overhead volume variances:
(a)If the denominator activity (12,000 machine hours in our case) and the standard
hours allowed for the actual output of the period are the same, then there is no
volume variance.
(b)If the denominator activity is greater than the standard hours allowed for actual
output of the period, then the volume variance is unfavorable. This indicates an
underutilization of available facilities.

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(c) If the denominator activity is less than the standard hours allowed for the actual
output of the period, then the volume variance is favorable. This indicates a
higher utilization of available faculties than was planned.
Example
1. VMOH is allocated products using direct marketing labour hours per out put.
FMOH is allocated to product on a per out put basis.
2. budgeted amount for the period are
(a)Direct marketing labour hours 0.25 hours per out put.
(b)Variable marketing over head rate $20 per direct marketing labour hours.
(c) Fixed marketing Over Head: $434,000
(d)Out put which is used as denominator level is equal to 12,000 out put (Budgeted
Out Put)
3. Actual Results for the period are:
(a)Fixed Marketing Over Head: $420,000
(b)Variable Marketing Over Head: $47,700
(c) Direct Marketing Labour Hours:2,304
(d)Actual Out Put: 10,000 units

Required: Compute the following VMOH Variance

 Variable Marketing Over Head Variance
 Fixed Marketing Over Head Variance
 Prepare the necessary journal entries

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