7 - 1 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Flexible Budgets, Variances, and Management Control: I Budgeting Lecture 2

7 - 2 Distinguish a static budget from a flexible budget. Learning Objective 1

7 - 3 Static and Flexible Budgets Static Budget Planned level of output at start of the budget period Based on Flexible Budget Budgeted revenues and cost based on actual level of output Based on

7 - 4 Static Budget Example Assume that Pasadena Co. manufactures and sells dress suits. Budgeted variable costs per suit are as follows: Direct materials cost$ 65 Direct manufacturing labor 26 Variable manufacturing overhead 24 Total variable costs$115

7 - 5 Static Budget Example Budgeted selling price is $155 per suit. Fixed manufacturing costs are expected to be $286,000 within a relevant range between 9,000 and 13,500 suits. Variable and fixed period costs are ignored. The static budget for year 2004 is based on selling 13,000 suits. What is the static-budget operating income?

7 - 6 Static Budget Example Revenues (13,000 × $155) $2,015,000 Less Expenses: Variable (13,000 × $115) 1,495,000 Fixed 286,000 Budgeted operating income $ 234,000 Assume that Pasadena Co. produced and sold 10,000 suits at $160 each with actual variable costs of $120 per suit and fixed manufacturing costs of $300,000.

7 - 7 Static Budget Example Revenues (10,000 × $160)$1,600,000 Less Expenses: Variable (10,000 × $120) 1,200,000 Fixed 300,000 Actual operating income$ 100,000 What was the actual operating income?

7 - 8 Static-Budget Variance Example What is the static-budget variance of operating income? Actual operating income$100,000 Budgeted operating income 234,000 Static-budget variance of operating income$134,000 U This is a Level 0 variance analysis.

7 - 9 Static-Budget Variance Example Static-Budget Based Variance Analysis (Level 1) in (000) Static Budget Actual Variance Suits U Revenue$2,015$1,600$415 U Variable costs 1,495 1, F Contribution margin$ 520$ 400$120 U Fixed costs U Operating income$ 234$ 100$134 U

Learning Objective 2 Develop a flexible budget and compute flexible-budget variances and sales-volume variances.

Steps in Developing Flexible Budgets Step 1: Determine budgeted selling price, variable cost per unit, and budgeted fixed cost. Budgeted selling price is $155, variable cost is $115 per suit, and the budgeted fixed cost is $286,000.

Steps in Developing Flexible Budgets Step 2: Determine the actual quantity of output. In the year 2004, 10,000 suits were produced and sold. Step 3: Determine the flexible budget for revenues. $155 × 10,000 = $1,550,000

Steps in Developing Flexible Budgets Step 4: Determine the flexible budget for costs. Variable costs: 10,000 × $115 = $1,150,000 Fixed costs 286,000 Total costs $1,436,000

Variances Level 2 analysis provides information on the two components of the static-budget variance. 1. Flexible-budget variance 2. Sales-volume variance

Flexible-Budget Variance (Level 2) in (000) Flexible BudgetActual Variance Suits Revenue$1,550$1,600$ 50 F Variable costs 1,150 1, U Contribution margin$ 400$ 400$ 0 Fixed costs U Operating income$ 114$ 100$ 14 U

Flexible-Budget Variance Actual quantity sold: 10,000 suits Flexible-budget variance $14,000 U Actual results operating income $100,000 Flexible-budget operating income $114,000

Flexible-Budget Variance Total flexible-budget variance = Total actual results – Total flexible budget for actual sales level

Flexible-Budget Variance Actual Budgeted Amount Amount Selling price$160$155 Variable cost Contribution margin$ 40$ 40

Flexible-Budget Variance Why is the flexible-budget variance $14,000 U? Selling-price variance$50,000 F Actual variable costs exceeded flexible budget variable costs 50,000 U Actual fixed costs exceeded flexible budget fixed costs 14,000 U Total flexible-budget variance$14,000 U

Sales-Volume Variance (Level 2) in (000) Flexible StaticSales-Volume BudgetBudgetVariance Suits U Revenue$1,550$2,015$465 U Variable costs 1,150 1, F Contr. margin$ 400$ 520$120 U Fixed costs Operating income$ 114$ 234$120 U

Sales-Volume Variance Actual quantity sold: 10,000 suits Sales-volume variance $120,000 U Flexible-budget operating income $114,000 Static-budget operating income $234,000

Sales-Volume Variance Total sales-volume variance $120,000 U = Actual sales unit – Master budgeted sales units 13,000 – 10,000 = 3,000 × Budgeted contribution margin per unit $40

Budget Variances Static-budget variance $134,000 U Flexible-budget variance $14,000 U Level 1 Sales-volume variance $120,000 U Level 2

Learning Objective 3 Explain why standard costs are often used in variance analysis.

Standards Pasadena’s budgeted cost for each variable direct cost item is computed as follows: Standard input allowed for one output unit Standard cost per input unit ×

Standards 4.00 square yards allowed per output unit at $16.25 standard cost per square yard. Standard cost per output unit 4.00 × $16.25 = $65.00

Standards 2.00 manufacturing labor-hours of input allowed per output unit at $13.00 standard cost per hour. Standard cost per output unit 2.00 × $13.00 = $26.00

Learning Objective 4 Compute price variances and efficiency variances for direct-cost categories.

Actual Data Direct materials purchased and used: 42,500 square yards at $15.95 Labor hours: 21,500 at $12.90 Cost of direct materials = $677,875 Cost of direct manufacturing labor = $277,350

Price Variance Example Direct-material price variance Actual price – Budgeted price × Actual quantity ($15.95 – $16.25) × 42,500 = $12,750 F = =

Price Variance Example Direct-labor price variance Actual price – Budgeted price × Actual quantity ($12.90 – $13.00) × 21,500 = $2,150 F = =

Price Variance Example What is the journal entry when the materials price variance is isolated at the time of purchase? Materials Control 690,625 Direct-Materials Price Variance 12,750 Accounts Payable Control 677,875 To record direct materials purchased

Efficiency Variance Example Direct-material efficiency variance Actual quantity – Standard quantity × Standard price (42,500 – 40,000) × $16.25 = $40,625 U = =

Efficiency Variance Example Direct-labor efficiency variance Actual quantity – Standard quantity × Standard price (21,500 – 20,000) × $13.00 = $19,500 U = =

Efficiency Variance What is the journal entry to record materials used? Work in Process Control650,000 Direct-Materials Efficiency Variance 40,625 Materials Control 690,625 To record direct materials used

Price and Efficiency Variance What is the journal entry for direct manufacturing labor? Work in Process Control260,000 Direct Manufacturing Labor Efficiency Variance 19,500 Direct-Manufacturing Labor Price Variance 2,150 Wages Payable277,350 To record liability for direct manufacturing labor

Flexible Budget Material Variance Example Actual Cost $677,875 BQ × BP 40,000 × $16.25 $650,000 AQ × BP 42,500 × $16.25 $690,625 $12,750 F$40,625 U $27,875 U

Flexible Budget Labor Variance Example Actual Cost $277,350 BQ × BP 20,000 × $13.00 $260,000 AQ × BP 21,500 × $13.00 $279,500 $2,150 F$ 19,500 U $17,350 U

Static-budget variance Materials$167,125 F Labor 60,650 F Total$227,775 F Flexible-budget variance Materials$27,875 U Labor 17,350 U Total$45,225 U Sales-volume variance Materials$195,000 F Labor 78,000 F Total$273,000 F Level 1 Level 2 Variance Analysis Level 2

Flexible-budget variance Materials$27,875 U Labor 17,350 U Total$45,225 U Price variance Materials$12,750 F Labor 2,150 F Total$14,900 F Efficiency variance Materials$40,625 U Labor 19,500 U Total$60,125 U Level 2 Level 3 Variance Analysis Level 3

Learning Objective 5 Explain why purchasing performance measures should focus on more factors than just price variances.

Performance Measurement Using Variances Effectiveness is the degree to which a predetermined objective or target is met. Efficiency is the relative amount of inputs used to achieve a given level of output. Variances should not solely be used to evaluate performance.

When to Investigate Variances When should variances be investigated? Subjective judgments Rules of thumb as “investigate all variances exceeding $10,000 or 25% of expected cost, whichever is lower.”

Learning Objective 6 Integrate continuous improvement into variance analysis.

Continuous Improvement Assume that the budgeted direct materials cost for each suit that Pasadena Co. manufactures is $65. Pasadena Co. wants to implement continuous improvement budgets based on a target 1% materials cost reduction each period. What should the budgeted cost be for the next 3 subsequent periods?

Continuous Improvement Prior Period Reduction Revised Budgeted in Budgeted Amount Budget Amount This Period: – – $65.00 Period 1: $65.00 $0.650 $64.35 Period 2: $64.35 $0.644 $63.71 Period 3: $63.71 $0.637 $63.07

Learning Objective 7 Perform variance analysis in activity-based costing systems.

Flexible Budgeting and Activity-Based Costing Materials costs and direct manufacturing labor costs are examples of output-unit level costs. Batch-level costs are resources sacrificed on activities that are related to a group of units of product(s) or service(s) rather than to each individual unit of product or service.

Flexible Budgeting and Activity-Based Costing Denver Co. produces metal planters (MP). Assume that material-handling labor costs vary with the number of batches produced rather than the number of units in a batch. Material-handling labor costs are direct batch level costs that vary with the number of batches.

Flexible Budgeting and Activity-Based Costing StaticActual Budget Amounts Units produced and sold18,00015,660 Batch size Number of batches Material-handling labor-hours per batch

Flexible Budgeting and Activity-Based Costing StaticActual Budget Amounts Total labor-hours Cost per material-handling labor-hour$14.00$14.50 Total material-handling labor cost$7,000$6,786

Flexible Budgeting and Activity-Based Costing How many batches should have been employed to produce the actual output units? 15,660 units ÷ 180 units per batch = 87 batches How many material-handling hours should have been used? 87 batches × 5 hours/batch = 435 hours

Flexible Budgeting and Activity-Based Costing What is the flexible budget for material-handling labor-hours? 435 hours × $14.00/labor-hour =$6,090 Flexible-budget costs$6,090 Actual costs 6,786 Flexible-budget variance$ 696 U

Price and Efficiency Variances Price variance = ($14.50 – $14.00) × 468 = $234 U Efficiency variance = (468 – 435) × $14.00 = $462 U Total variance $696 U

Learning Objective 8 Describe benchmarking and how it is used in cost management.

Benchmarking It refers to the continuous process of measuring products, services, and activities against the best levels of performance.