Budgeting and Variances Uses of budgets Production variances

Agenda Discussion of budgeting Discussion of variances Materials Labor Overhead Demonstration problems Thursday’s class Group work

Master Budget Budget = quantitative expression of a firm’s strategic plan of action Master budget = prepared before the accounting period begins Also static budget Standard costs

Preparing the budget Project sales Plan production activity level Sales prediction Current finished goods inventory Desired ending finished goods inventory Plan purchases, employment Estimate fixed costs Prepare estimated income statements and balance sheets

Uses of budgets Planning Performance evaluation Control Operational plans (short-term) Capital budgets (long-term) Company strategy Performance evaluation Variances Responsibility centers Control

Behavioral aspects of budgeting: Participative budgeting Better information Better cooperation Budgetary slack Dysfunctional responses Compulsion to spend all discretionary funds Short-run emphasis on budget only Questionable actions designed only to balance the budget

Flexible budget: Flexible budget = the master budget you would have prepared if you had known before the accounting period started how much you would actually produce during the period. Flexible budget = “standard cost allowed for good output achieved”

Flexible budgets and performance evaluation:

Variances “unfavorable variance” = NI is reduced from the budgeted expectation “favorable variance” = NI is increased from budgeted expectation Note: Do not interpret directly as “bad” or “good” behavior on the part of management.

Variances

Variable cost variances Direct materials price variance: usage price variance purchase price variance (actual price - std. price) x actual usage (actual price - std. price) x actual purchases quantity variance: based on usage (actual usage - std. usage) x std. price actual usage = total actual materials used standard usage = std. allowed per unit x actual units

Variable cost variances Direct labor rate variance: (actual price - std. price) x actual usage efficiency variance: (actual usage - std. usage) x std. price actual usage = total actual labor hrs. used standard usage = std. allowed per unit x actual units

Example: Chemical, Inc. Chemical, Inc., has set up the following standards for materials and direct labor: Materials: 10 lbs. @ $3 $30 per batch Direct labor: .5 hrs. @ $20/hr. $10 per batch The number of finished units budgeted for the period was 10,000. The number of actual batches produced was 9,810. During the month, purchases amounted to 100,000 lbs. at a total cost of $310,000. The actual price paid for labor was $21 per hour. Price variances are isolated upon purchase. Actual inputs used were: 98,073 lbs. of material and 4,900 hours of labor.

Direct material price variances What might cause a direct material price variance? Price change in market Purchase discounts Transportation costs Grade of materials Therefore, purchasing department

Direct material quantity variance What could cause a direct material efficiency variance? Defect in material Inexperienced workers Poor supervision Poor scheduling Therefore, production department

DM variance computations Direct material purchase price variance: U $310,000 - ($3 x 100,000) = $10,000 Or: ($3.10 - $3.00) x 100,000 = $10,000 Direct material quantity variance: [98,073 - (10 lbs. x 9,810 batches)]x $3 = $81 F Or: (9.9972 - 10) x 9,810 batches x $3 = $82

(9,810 batches - 10,000 batches) x $3 x 10 lbs. = $5,700 DM activity variance (actual output - budgeted output) x standard price per unit of direct material x standard quantity of direct material per unit of output (9,810 batches - 10,000 batches) x $3 x 10 lbs. = $5,700 F?????

Direct labor variances What would cause a direct labor rate variance? The actual rate = approximately average wage paid, including fringes Experience of workers Union contract Overtime Change in fringes Therefore, human resources or management

Direct labor variances What would cause a direct labor efficiency variance? Skill Motivation Supervision/scheduling Quality of materials Late time Therefore, production, human resources, purchasing

Labor variance computations Rate variance: ($21 - $20) x 4,900 hours = $4,900 U Efficiency variance: (4,900 hours - (9,810/2)) hours) x $20 = $100 F Activity variance: (9,810 batches - 10,000 batches) x $20 x .5 = $1,900 F

Overhead variances 1. By definition, fixed overhead does not vary with the level of planned production. Flexible budget FOH = Master budget FOH 2. By definition, fixed overhead is incurred as a lump sum expenditure and there are no partial input-output relationships. Therefore, the “Std. Input” column is undefined.

Overhead variances: FOH FOH budget variance = Actual FOH - Budgeted FOH FOH efficiency variance = Is undefined FOH applied = (Predetermined rate/unit) x actual units Production volume variance = Applied FOH - Budgeted FOH

Overhead variances: VOH VOH spending variance = Actual VOH - “Std. Input” col. VOH efficiency variance = “Std. Input” - Flexible Budget VOH activity variance = Flexible Budget - Master Budget Or: VOH applied - Master Budget

Overhead variances Over- or underapplied overhead = Actual overhead spending - Overhead applied Or The net of all the variances computed

Example: Murray Manufacturers VOH Rate = $3 per DL hour FOH Rate = $4 per DL hour One unit requires 2 hours of labor Denominator volume is 1,000 units of output Actual production was only 800 units. Actual costs were $5,800 for variable overhead and $8,130 for fixed overhead; 1,590 DL hrs. were worked.

Example: Murray Manufacturers $5,800 - ($3 x 1,590 hrs.) VOH spending variance = U $1,030 VOH efficiency variance = (1,590 hr. - (2x800)hrs) x $3 = $30 F VOH activity variance = (800 units - 1000 units) x 2 hrs. x $3 = $1,200 F

Example: Murray Manufacturers FOH budget variance = $8,130 - $8,000 = $130 U FOH production volume variance = (800 units x 2 hrs. x $4) - $8,000 = $1,600 U

Example: The Vanguard Company The Vanguard Company manufactures one product. Its standard cost system incorporates flexible budgets and assigns indirect costs on the basis of standard DL hrs. At denominator activity, the standard cost per unit is: Direct materials, 3 lbs. @ $5.00 $15.00 Direct labor, .4 hr. @ $20.00 8.00 Variable indirect costs, .4 hr. @ $6.00 2.40 Fixed indirect costs, .4 hr. @ $4.00 1.60 Total $27.00

Example: The Vanguard Company DM DL VOH FOH

Example: The Vanguard Company Direct materials were quoted at $5.50 per pound through- out September and October to all suppliers. There was no purchase-price variance for materials in October; the price variance shown relates solely to the materials used during October. Wage standards were set in accordance with an annual union contract, but a shortage of workers in the local areas has resulted in rates higher than standard. There were no beginning or ending inventories of work in process.

Example: The Vanguard Company 1. How many units were produced? Use the standard cost column. All the units manufactured cost $243,000 One unit at standard costs $27.00 Units produced = $243,000 / $27.00 = 9,000 units

Example: The Vanguard Company 2. What were the actual number of direct labor hours used? Efficiency variance = (actual hrs./unit - std. hrs./unit) x actual units x std. price = [actual DL hrs. - (.4 x 9,000)] x $20 $4,000 = actual DL hrs. x $20 - $72,000 $76,000 = actual DL hrs. x $20 3,800 = actual DL hrs.

Example: The Vanguard Company 3. What was the actual wage rate? Labor price variance = (actual rate - std. rate) x actual labor hours $1,900 = (actual wage rate - $20.00) x 3,800 hrs. $1,900 = actual wage rate x 3,800 hrs - $76,000 $77,900 = actual wage rate x 3,800 hrs $20.50 = actual wage rate

Example: The Vanguard Company 4. What was the budget for fixed indirect costs. FOH budget variance = Budgeted FOH - Actual FOH $200 = Budgeted FOH - $15,800 Actual FOH < Budgeted FOH $16,000 = Budgeted FOH

Example: The Vanguard Company 5. Denominator activity expressed in direct labor hours. Denominator Volume = 4,000 DL hrs.

Example: The Vanguard Company 6. How many pounds of direct materials were used? DM quantity variance = (actual quantity used - std. quantity for output) x standard price $5,000 = (actual quantity used - (3 lbs. x 9,000) x $5.00 $5,000 = actual quantity used x $5.00 - $135,000 $140,000 = actual quantity used x $5.00 28,000 lbs. = actual quantity used

Thursday Review overhead variances Compute sales revenue variances sales price sales activity (measured via contribution margin) sales mix sales volume market size market share Variance reconciliation

Group exercise Use example company: Look at the numbers and determine what they all mean. Compute Direct material price, quantity and activity variances Direct labor rate, quantity and activity variances Overhead variances: spending/budget, efficiency (if applicable), and PVV