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# 5.

## THE FACTORY OVERHEAD BUDGET

The factory overhead budget is based on a flexible budget calculation as described in Exhibit 9-3. More
specifically, the calculation is as follows:
a. Budgeted Factory Overhead Costs = Budgeted Fixed Overhead + (Budgeted Variable Overhead
Rate)(D.L. Hours needed for Production from 4a)
This is a cumulative equation that combines the equations for the company's various types of indirect
resources. This same idea was illustrated in Chapter 4 when introducing predetermined overhead rates.
The predetermined overhead rates developed in Chapter 4 and the budgeted overhead rates discussed in
this chapter are conceptually the same.
A plant wide rate based on direct labor hours is used as the overhead allocation basis in this chapter and
subsequent chapters mainly to simplify the illustrations. Keep in mind however, that although many
companies are still using a single production volume based measurement for overhead allocations, most
companies use departmental rates and many companies are now using activity based rates.
The calculation for cash payments reflects one of the differences between cash flows and accrual
accounting. Since some costs, like depreciation, do not involve cash payments in the current period,
these costs must be subtracted from the total overhead costs to determine the appropriate amount.
b. Cash Payments for Overhead = Budgeted Factory Overhead Cost - Depreciation and other costs that
do not require cash payments
Alternative Calculation for Budgeted Factory Overhead Costs
Although budgeted factory overhead costs can be calculated in the manner presented above, there is an
alternative approach that illustrates the difference between budgeted and standard costs. Budgeted
factory overhead costs can be calculated by determining the standard factory overhead costs and then
adjusting for the planned production volume variance. The planned production volume variance is
similar to the capacity (or idle capacity) variance illustrated in Chapter 4. It is the difference between
the denominator inputs used to calculate the overhead rates, i.e., direct labor hours in our example, and
the budgeted direct labor hours needed for production, multiplied by the budgeted fixed overhead rate.
The alternative calculation for factory overhead costs is:
Budgeted factory overhead costs = (Total budgeted overhead rate per hour)(D.L. hours needed for
production from 4a)
+ Unfavorable planned production volume variance or - Favorable planned production volume variance
Multiplying the total overhead rate by the number of direct labor hours needed for production provides
the standard or applied overhead costs. However, if the number of direct labor hours needed for
planned production (i.e., budgeted hours) is not equal to the number of hours used to calculate the
overhead rates (i.e., denominator hours), then standard fixed overhead costs will not be equal to
budgeted fixed overhead costs. The difference is the planned production volume variance. This is
illustrated graphically in Figure 9-1.
Since the difference is caused by the way fixed overhead costs are treated, it can be illustrated by
comparing standard fixed overhead costs with budgeted fixed overhead costs. Figure 9-1 shows that if
planned or budgeted hours (BH1) are less than denominator hours (DH), the planned production
volume variance (PPVV) is unfavorable and represents underapplied fixed overhead. However, if
planned or budgeted hours (BH2) are greater than denominator hours (DH), then the planned
production volume variance (PPVV) is favorable and represents overapplied fixed overhead.
The difference between budgeted and standard total factory overhead costs can be illustrated by simply
adding variable overhead costs to the graph. Since budgeted and standard variable overhead costs are
always equal at any level of production, the difference between standard and budgeted total overhead
costs is the same as the difference between standard and budgeted fixed overhead costs. The difference
is the planned production volume variance. This is illustrated in Figure 9-2
Summary of the PPVV Concept
At any particular level of production, e.g., 1,000 hours, budgeted and standard variable overhead costs
are always equal. However, budgeted and standard fixed overhead costs are only equal when the
budgeted hours planned for the month are equal to the denominator hours used to calculate the
overhead rates. The difference between the budgeted hours planned and the denominator hours,
multiplied by the fixed overhead rate is the difference between budgeted and standard fixed overhead
costs as well as the difference between budgeted and standard total overhead costs. When working with
a budget this difference is referred to as the planned production volume variance.
6. ENDING INVENTORY BUDGET
The dollar amount for the ending inventory of finished goods is needed below to determine cost of
goods sold. The dollar amounts for ending direct materials and finished goods are needed for the
balance sheet.
a. Ending Direct Materials = (Desired Ending Materials from 3b)(Budgeted Prices)
b. Budgeted or Standard Unit Cost = (Quantity of D.M. required per Unit)(Budgeted Prices) + (D.L.
Hours required per Unit)(Budgeted Rate)
+ (Total Overhead Rate)(D.L. Hours required per Unit)
The budgeted or standard unit cost can be calculated at any time after the budgeted quantities per unit
and input prices are obtained. The calculation is placed here because it is needed for 6c.
c. Ending Finished Goods = (Desired Ending Finished Goods from 2)(Budgeted Unit Cost)
7. COST OF GOODS SOLD BUDGET
Cost of goods sold is needed for the income statement. One method of determining budgeted COGS
involves accumulating the amounts from the previous sub-budgets as follows.
a. Budgeted Total Manufacturing Cost = Cost of Direct Material Used (from 3d.) + Cost of Direct
Labor Used (from 4b.)
+ Total Factory Overhead Costs (from 5a.)
b. Budgeted Cost of Goods Sold = Budgeted Total Manufacturing Cost (from 7a.) + Beginning
Finished Goods (from previous ending or calculate from 2 and 6b) - Ending Finished Goods (from 6c
or calculate from 2 and 6b)
This is the same approach used in Chapter 2 to determine cost of goods sold, but when developing a
budget we typically assume no change in Work in Process. Therefore, budgeted cost of goods
manufactured is equal to budgeted cost of goods sold.
Alternative Calculation for Budgeted Cost of Goods Sold
Budgeted cost of goods sold can also be calculated by determining standard cost of goods sold, and
then adjusting for the planned production volume variance. The alternative calculation for cost of
goods sold is:
Budgeted Cost of Goods Sold = (Budgeted unit sales)(Budgeted unit cost)
+ Unfavorable planned production volume variance
or - Favorable planned production volume variance
Although budgeted unit cost equals standard unit cost, budgeted cost of goods sold is not equal to
standard cost of goods sold. Again, the difference between standard and budgeted costs is the
production volume variance. There are two reasons to become familiar with this alternative. First, it
helps strengthen your understanding an important concept that appears again in subsequent chapters,
e.g., Chapters 10 and 12. A second reason is that the alternative approach provides a much faster way to
calculate budgeted cost of goods sold. Therefore it can be used as a stand alone method, or as a way to
check the accuracy of your calculations in 7a and b.
You may wonder why a company would plan a production volume variance in the budget. This occurs
because the denominator activity for a particular month is normally the average monthly production
based on one twelfth of the planned production for the entire year. The denominator may also be an
average based on normal, practical, or theoretical maximum capacity for the year. When the planned
production for a particular month is higher or lower than the monthly average, a planned production
volume variance results. Actual production volume variances also occur as we shall see in the next
chapter.
8. SELLING & ADMINISTRATIVE EXPENSE BUDGET
The preparation of the selling and administrative expense budgets is very similar to the approach used
for factory overhead.
a. Budgeted Selling and Administrative Expenses = Budgeted Fixed Selling & Administrative Expenses
+ (Bud Variable Rate as a Proportion of Sales \$)(Budgeted Sales \$)
b. Cash Payments for Selling & Administrative Expenses = Budgeted Selling & Administrative
Expenses - Depreciation and other cost which do not require cash payments
Although we will place less emphasis on this part of the master budget, (mainly to simplify the
illustrations) these costs are usually significant. Also remember that many appropriation budgets
(treated as fixed costs) may be included, particularly for certain administrative costs. In addition, as
pointed out earlier in the text, a more precise traceable costing approach might be used for management
purposes where some selling and administrative costs are allocated (i.e., traced to products) in
determining a more precise product cost. Remember however, that selling and administrative costs are
treated as expenses (period costs) in the conventional inventory valuation methods.
Manufacturing overhead budget | Overhead
budget
Manufacturing Overhead Budget Definition
The manufacturing overhead budget contains all manufacturing costs other than the costs of direct
materials and direct labor (which are itemized separately in the direct materials budget and the direct
labor budget). The information in the manufacturing overhead budget becomes part of the cost of goods
sold line item in the master budget.
Also, the total of all costs in this overhead budget are converted into a per-unit overhead allocation,
which is used to derive the cost of ending finished goods inventory, and which in turn is listed on the
budgeted balance sheet. The information in this budget is among the most important of the various
departmental budget models, since it may contain a large proportion of the total amount of a company's
expenditures.
This budget is typically presented in either a monthly or quarterly format.
Example of the Manufacturing Overhead Budget
Delphi Furniture produces Greek-style furniture. It budgets the wood raw materials and cost of its
artisans in the direct materials budget and direct labor budget, respectively. Its manufacturing overhead
costs are outlined as follows:
Delphi Furniture
Manufacturing Overhead Budget
For the Year Ended December 31, 20XX

## Quarter 1 Quarter 2 Quarter 3 Quarter 4

Administrative salaries \$142,000 \$143,000 \$144,000 \$145,000
Administrative payroll taxes 10,000 10,000 11,000 11,000
Depreciation 27,000 27,000 29,000 29,000
Freight in and out 8,000 7,000 10,000 9,000
Rent 32,000 32,000 32,000 34,000
Supplies 6,000 5,000 7,000 6,000
Travel and entertainment 3,000 3,000 3,000 3,000
Utilities 10,000 10,000 10,000 12,000
Total manufacturing overhead \$238,000 \$237,000 \$236,000 \$237,000
The administrative salaries line item contains the wages paid to manufacturing supervisors, the
purchasing staff, production clerks, and logistics planning staff, and gradually increases over time to
reflect changes in pay rates. The depreciation expense is relatively fixed, though there is an increase in
the third quarter that reflects the purchase of new equipment. Both the freight and supplies expenses are
closely linked to actual production volume, and so their amounts fluctuate in conjunction with planned
production levels. The rent expense is a fixed cost, but does increase in the fourth quarter to reflect a
scheduled rent increase.
The budget could also include a calculation of the overhead rate. For example, direct labor hours could
be included at the bottom of the budget, which are divided into the total manufacturing overhead cost
per quarter to arrive at the allocation rate per direct labor hour.
Much of the information in this budget can be estimated from historical results, if the types of products
manufactured and production volumes do not vary significantly from prior periods.
Other Manufacturing Overhead Budget Issues
A less-common format for the overhead budget is to group the line items into fixed and variable
expense classifications. It can be difficult to determine the fixed or variable status of a cost, in which
case you can add a third cost grouping for mixed costs that contain both fixed and variable cost
characteristics. Separate treatment of variable expenses is useful if you want to create a flexible budget,
where the budgeted amount of variable costs change to match the amount of actual revenues earned.
In a simplified budgeting environment, the overhead budget may be as simple as an overhead rate that
is multiplied by some form of activity, such as direct labor hours or machine time used. This approach
is generally not recommended, since it does not reveal the precise nature of the various types of
expenses incorporated into the overhead rate, and could even be used by a less ethical manager to
increase his manufacturing budget without making it visible to the rest of the management team.
Given the considerable size of the expenditures in this budget, one must guard against the inclusion of
an incorrect figure, since the result could be a seriously incorrect overall budget. One way to spot
incorrect numbers is to match the budgeted totals by period against the actual amounts incurred for the
same periods in the immediately preceding year, for reasonableness.
It is not customary to include a cash requirements calculation as part of the manufacturing overhead
budget. Instead, the cash requirements are calculated for all of the revenues and expenditures of a
business as a whole, and are then summarized on a separate page of the budget.
Similar Terms
The manufacturing overhead budget is also known as the manufacturing budget, the factory overhead
budget, and the overhead budget.