Developing Budgeted Fixed Overhead Rates

Fixed overhead costs are, by definition, a lump sum of costs that remains unchanged for a given period, despite wide changes in a firm’s level of activity or output. Fixed costs are included in flexible budgets, but they remain the same within the relevant range of activity regardless of the output level chosen to “flex” the variable costs and revenues. Recall from Exhibit 7-2 and the steps in developing a flexible budget that Webb’s monthly fixed overhead costs of $276,000 are the same in the static budget as they are in the flexible budget. Do not assume, however, that these costs can never be changed. Managers can reduce them by selling equipment or laying off employees, for example. But the costs are fixed in the sense that, unlike variable costs such as direct material costs, fixed costs do not automatically increase or decrease with the level of activity within the relevant range.

The process of developing the budgeted fixed overhead rate is the same as the one for calculating the budgeted variable overhead rate. The steps are as follows:

1. Step 1: CHOOSE THE PERIOD TO USE FOR THE BUDGET. As with variable overhead costs, the budget period for fixed overhead costs is typically 1 year, to help smooth out seasonal effects.
2. Step 2: SELECT THE COST-ALLOCATION BASES TO USE IN ALLOCATING THE FIXED OVERHEAD COSTS TO THE OUTPUT PRODUCED. Webb uses machine-hours as the only cost-allocation base for the firm’s fixed overhead costs. Why? Because Webb’s managers believe that, in the long run, the company’s fixed overhead costs will increase or decrease to the levels needed to support the amount of machine-hours. Therefore, in the long run, the number of machine-hours used is the only cost driver of fixed overhead costs. The number of machine-hours is the denominator in the budgeted fixed overhead rate computation and is called the denominator level. For simplicity, we assume Webb expects to operate at capacity in fiscal year 2020, with a budgeted usage of 57,600 machine-hours for a budgeted output of 144,000 jackets.^*
3. Step 3: IDENTIFY THE FIXED OVERHEAD COSTS ASSOCIATED WITH EACH COST-ALLOCATION BASE. Because Webb identifies a single cost-allocation base—machine-hours—to allocate fixed overhead costs, it groups all such costs into a single cost pool. Costs in this pool include depreciation on plant and equipment, plant and equipment leasing costs, and the plant manager’s salary. Webb’s fixed overhead budget for 2020 is $3,312,000.
4. Step 4: COMPUTE THE RATE PER UNIT OF EACH COST-ALLOCATION BASE USED TO ALLOCATE FIXED OVERHEAD COSTS TO THE OUTPUT PRODUCED. By dividing the $3,312,000 from Step 3 by the 57,600 machine-hours from Step 2, Webb estimates a fixed overhead cost rate of $57.50 per machine-hour:

1. Under standard costing, the $57.50 fixed overhead cost per machine-hour is usually expressed as a standard cost per output unit. Recall that Webb’s engineering study estimates that it will take 0.40 machine-hour per output unit. Webb can now calculate the budgeted fixed overhead cost per output unit as follows:

When preparing monthly budgets for 2020, Webb divides the $3,312,000 annual total fixed costs into 12 equal monthly amounts of $276,000. If Webb had multiple cost-allocation bases and corresponding fixed overhead cost pools, Webb would repeat Steps 1 to 4 for each cost pool.