Academic journal article Management International Review

Flexible Budgets and the Analysis of Overhead Variances

Academic journal article Management International Review

Flexible Budgets and the Analysis of Overhead Variances

Article excerpt

Standard costing has become so generally accepted as a useful accounting technique in industry that is unusual to find any of its methods called in question. Yet, while the analysis of variances between actual and standard direct costs--direct materials and direct labor--has given rise to no important differences of theory or practice among writers and practitioners, the same cannot be said of the analysis of overhead variances. Indeed, an examination of the literature of the subject over the last thirty years shows an extraordinary variety of treatments.(1) It would surely be in the best interests of management if some agreement could be reached about the most effective method of analysing overhead variances for general application.

In this paper I shall set myself three objectives. The first is to compare the two principal systems of overhead variance analysis in common use. I shall attempt to do this by the use of a diagrammatic method of representing variances which I have written about previously.(2) From the comparison of the two-variance and three-variance systems, an assessment of what an effective system should achieve is then made. Finally a suggestion is made for an improvement in the flexible budget, leading to a corresponding improvement in the analysis of overhead variances.

The conventional analysis of overhead variances

The conventional analysis of overhead variances is illustrated in diagram I.(3) Diagram I (a) shows the analysis of variance into two parts, a controllable variance, as it is usually called, and a volume variance. In the situation illustrated, the actual man-hours worked fell seriously short of the man-hours budgetted, and the actual efficiency of the work done was also substantially below 100%, so that the output produced (expressed in standard hours) was less than it should have been in the man-hours actually worked. These three quantities, budgetted hours, actual hours and achieved standard hours (i. e. actual output) are represented by the three vertical lines. Budgetted fixed overheads are represented by the horizontal line B.F.O. and on top of this the variable expenses budgetted for varying levels of output are superimposed, to give the line B.T.O. representing budgetted total overheads. This line stands for the flexible budget, and shows at each level of activity the total overhead expenditure allowed by the budget. While this line is shown as a straight line in the diagram, the analysis would in no way be jeopardized, and would almost certainly gain in realism, if the budget line were shown as curved instead of straight, or even as rising in discontinuous jumps.

The standard overhead rate is computed by dividing the total overhead budget allowance appropriate to the budgetted level of activity by the number of man-hours to be worked. This gives the standard hourly rate of overheads, and is represented by a straight line joining the point S (the point where the budget expense line B.T.O. cuts the "budget hours" vertical) to the origin. This line cannot be anything but straight, since the standard rate, once fixed, cannot vary during the period, whatever fluctuations of output or expenditure may occur. Only when there is a revision of standards will the standard overhead rate change.

It is important to make a clear distinction between the budgetary data in the diagram and the information about actual results. To enable this distinction to be kept in mind, budget data is represented by broken lines and "actual" data by unbroken lines. The actual expenditure on overheads during the period under examination is shown by the horizontal line passing through the point A.

With the two-variance system, the flexible budget allowance is regarded as being set by the level of output achieved, and in diagram I (a) it is represented by the point B', allowed expense, the point at which the vertical for actual output cuts the flexible budget line. The excess of actual expense over allowed expense, represented by the vertical distance AB', is the controllable variance, the excess expenditure (in this case) for which the departmental officials and foreman can be held responsible. …

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