Flexible Budgets and Variance Analysis

Management Cycle, Standard Costing and Variance Analysis Use standard costs to prepare budgets and establish goals for product costing. Use standard costs to account for operations and managers’ performance. Calculate variances between standard and actual costs, determine their causes, identify inefficient operations, and take corrective action. Use variances to evaluate managers’ performance. Apply dollar, time, and quantity standards to work.

Flexible budgets are based on standard costs. A standard cost (predetermined cost) indicates what it should cost to provide an activity or produce one batch or unit of product under planned and efficient operating conditions. Flexible budgets are based on standard costs.

Standard Costs To determine the unit standard cost for a particular input, 2 decisions must be made: The amount of input that should be used per unit of output (quantity standard) The amount that should be placed for the quantity of the input to be used (pricing standard) Unit Standard cost = Quantity Standard x Price Standard

Standard Costs How standards are developed Types of standards Historical experience Engineering studies Input from operating personnel Types of standards Ideal standards Demand maximum efficiency and can be achieved only if everything operates perfectly Currently attainable standards Can be achieved under efficient operating conditions, with allowance for normal breakdowns, interruptions, etc.

Standard Costs Why standard cost systems are adopted Planning and Control Unit standards are a fundamental requirement for a flexible budgeting system Budgetary control systems compare actual costs with budgeted costs by comparing variances By developing unit price standards and quantity standards, an overall variance can be decomposed into a price variance/spending variance and a usage variance/efficiency variance

Standard Costs Why standard cost systems are adopted Product Costing Comparison of costing systems

Standard Costs Advantages of standard costing Greater capacity for control over product cost Provide readily available unit cost information that can be used for pricing decisions If a process costing system uses standard costing, there is no need to compute a unit cost for each equivalent unit of DM, DL and MOH

Standard Costs Product cost (to illustrate use of standard cost in process costing): Input Required Cost Cost Inputs per ‘X’ Direct materials $2.00/lb. 20 $40.00 Direct labor $5.00/dlh. 3 15.00 Fixed MOH $2.00/dmh. 3 6.00 Variable MOH $3.00/dmh. 3 9.00 Total unit cost. . . . . . . . . . . . . . . . $70.00

Standard Costs Example of DM standards calculation Standard price of corn = $0.006 per ounce Standard usage of per bag = 18 ounces Standard cost per bag = $0.108 If the budgeted number of bags is 800 bags: Standard quantity for 800 bags = 14,400 ounces Standard cost for budgeted level of activity (a.k.a static budget) = 0.006 x 14,400 = $86.40 If the actual number of bags produced is 1,000 bags: Standard quantity allowed for 1,000 bags = 18,000 ounces Standard cost for actual level of activity (a.k.a flexible budget) = 0.006 x 18,000 = $108

Manufacturing Budget McMillan Company Manufacturing Budget for the Month of July Manufacturing costs: Unit level: Direct materials (10,000 x 2 pounds X $5) $100,000 Assembly (10,000 x 0.25 hours x $24) 60,000 Waterproofing and Inspection (10,000 x $8) 80,000 Batch level: Setup (10 batches x $400) 4,000 Test run (10 batches x $100) 1,000 Product level 20,000 Facility level 32,000 Total $297,000

Continued on next slide Static Budget McMillan Company Production Department Performance Report for the Month of July Original Static Budget Actual Budget Variance Volume 11,000 10,000 Unit level: Direct materials $108,000 $100,000 $ 8,000 U Assembly 70,000 60,000 10,000 U Waterproofing and Inspection 81,000 80,000 1,000 U Batch costs: Setup 4,000 Test runs 1,000 Continued on next slide

Static Budget Original Static Budget Volume 11,000 10,000 Batch costs: McMillan Company Production Department Performance Report for the Month of July Original Static Budget Actual Budget Variance Volume 11,000 10,000 Batch costs: Total 5,600 5,000 600 U Fixed overhead: Product 22,000 20,000 2,000 U Facility 31,000 32,000 1,000 F Totals $317,600 $297,000 $20,600 U

Continued on next slide Flexible Budget McMillan Company Production Department Performance Report for the Month of July Flexible Flexible Budget Actual Budget Variance Volume 11,000 11,000 Unit level: Direct materials $108,000 $110,000 $ 2,000 F Assembly 70,000 66,000 4,000 U Waterproofing and Inspection 81,000 88,000 7,000 F Batch costs: Setup 4,400 Test runs 1,100 Continued on next slide

Flexible Budget Flexible Flexible Budget Volume 11,000 11,000 McMillan Company Production Department Performance Report for the Month of July Flexible Flexible Budget Actual Budget Variance Volume 11,000 11,000 Batch costs: Total 5,600 5,500 100 U Fixed overhead*: Product 22,000 20,000 2,000 U Facility 31,000 32,000 1,000 F Totals $317,600 $321,500 $3,900 F * For fixed overheads, there is no difference between static budget and flexible budget because fixed overheads do not vary with output.

Variance Analysis A flexible budget can be used to identify the costs that should have been incurred for the actual level of activity. Flexible budget is tailored after the fact to actual production levels. Flexible budget variance = Actual costs – Flexible budget cost

Variance Analysis Flexible budget variance = Actual costs – Flexible budget cost Dichotomizing flexible budget variance Total flexible budget variance = (AP x AQ) – (SP x SQ) = (AP x AQ) – (SP x AQ) + (SP x AQ) – (SQ x SP) = (AP – SP)AQ + (AQ – SQ)SP = Price Variance + Efficiency variance

Variance Analysis Variance analysis Identifies the general causes for the total flexible budget variance by breaking it down into separate price and quantity variances for each production resource 2 possible reasons why actual cost may differ from flexible budget cost for a given amount of output produced: Difference between actual price and standard price Difference between actual quantity and standard quantity

Variance Analysis Unfavorable and favorable variances Unfavorable variances occur whenever the actual prices or usage of inputs are greater than standard prices or usages (variances are + ve) AP > SP, AQ > SQ Favorable variances occur whenever the actual prices or usage of inputs are less than standard prices or usages (variances are – ve) AP < SP, AQ < SQ Favorable and unfavorable variances are not equivalent to good or bad variances. Must investigate underlying reasons for variances.

Variance Analysis Why separate total variances into price and quantity variances? Separate variances that are subjected to a manager’s direct influence from those that are not Excessive focus on variances can lead to dysfunctional behavior Decision to investigate Rarely will actual performance exactly meet established standards

Variance Analysis Management should develop an acceptable range of performance. When variances are within this range, they are assumed to be caused by random factors. When variances are outside this range, they are assumed to be caused by nonrandom factors and these variances should be investigated. Controllable: Corrective actions/Affirmative actions Uncontrollable: Revise standards Management should also consider costs and benefits of investigating variances.

Input at Standard Price Input at Standard Price Variance Analysis: DM Actual Quantity of Input at Actual Price AQ x AP Actual Quantity of Input at Standard Price AQ x SP Standard Quantity of Input at Standard Price SQ x SP Price Variance AQ x (AP - SP) Usage Variance SP x (AQ - SQ) Budget Variance (AQ x AP) - (SQ x SP)

Variance Analysis: DM Possible causes for DM Price Variance Inaccurate or outdated price standards Quality of DM Quantity discounts Market price fluctuations Possible causes for DM Usage Variance Inaccurate or outdated usage standards Level of scrap, waste or rework

Variance Analysis: DL Actual Hours of Input at Actual Rate AH x AR Input at Standard Rate AH x SR Standard Hours of Input at Standard Rate SH x SR Labor Rate Variance AH x (AR - SR) Labor Efficiency Variance SR x (AH - SH) Budget Variance (AH x AR) - (SH x SR)

Variance Analysis: DL Possible causes for DL Rate Variance Inaccurate or outdated labor rate standards Increase or decrease in the pay of workers Use of highly or lowly skilled workers in the production Possible causes for DL Efficiency Variance Inaccurate or outdated quantity standards Training of employees Quality of machinery Quality of materials Level of supervision

Variance Analysis: VMOH Actual Hours of Input x Actual Variable OH Rate AH x AVOH rate Actual Hours of Input x Std Variable OH Rate AH x SVOH rate Std Hours of Input x Std Variable OH Rate SH x SVOH rate Spending Variance AH x (AVOR – SVOR) Efficiency Variance SVOR x (AH - SH) Total Variance (AVOR x AH) – (SVOR x SH)

Variance Analysis: VMOH Possible causes for VMOH Spending Variance Inaccurate or outdated VMOH rate standards Changes in the price of the variable overhead items Efficiency in the use (in terms of quantity) of the variable overhead items Possible causes for VMOH Efficiency Variance Inaccurate or outdated quantity standards for allocation base Efficiency in the use of the cost allocation base If the cost allocation base is direct labor hours, the reasons for direct labor efficiency variance will be the reason for VMOH efficiency variance

Variance Analysis: FMOH Impt: Note that budgeted hours is used instead of actual hours because FMOH does not vary with the number of units Actual Fixed OH AH x AFOR rate Budgeted Fixed OH BH x SFOR Applied Fixed OH SH x SFOR for actual work done Spending Variance Volume Variance Total Variance [Note: Variance formulas for DM, DL and VMOH are not applicable for computing spending variance and volume variance of FMOH]

Variance Analysis: FMOH Spending variance = Actual FMOH cost – Static FMOH budget [Note: Spending variance = Flexible budget variance = Static budget variance] Volume variance = Static FMOH budget – “Flexible” FMOH budget “Flexible” FMOH budget = Static FMOH budget + Static FMOH budget x % change in number of units sold In fact, the volume variance is just (negative of) Static FMOH budget x % change in number of units sold

Variance Analysis: FMOH Possible causes for FMOH Spending Variance Inaccurate or outdated budgets for FMOH Changes in the price and quantity of the FMOH items Note: Many FMOH items are not subject to change in the short run, consequently fixed overhead costs are often beyond the immediate control of management Cause for FMOH Volume Variance Changes in the level of output

Variance Analysis: TR Actual Price x Actual Volume AP x AQ Budgeted Price x Actual Volume BP x AQ Budgeted Price x Budgeted Volume BP x BQ Sales Price Variance AQ x (AP - BP) Sales Volume Variance BP x (AQ - BQ) Revenue Variance (AP x AQ) - (BP x BQ)

Variance Analysis: TR Flexible budget variance = Actual revenue – Flexible budget revenue Example FAS budget 2001 ticket sales at $70,000 per home game, which represent the sale of an estimated 10,000 tickets at a selling price of $7. In July’s first game, actual gate ticket revenue was $66,000, creating a total unfavorable revenue variance of $4,000. The actual sales consisted of 12,000 tickets at $5.50.

Variance Analysis: TR Actual Price x Actual Volume 12,000 x 5.50 Budgeted Price x Actual Volume 7 x 12,000 Budgeted Price x Budgeted Volume 7 x 10,000 Sales Price Variance 12,000 x (5.50 - 7) 18,000U Sales Volume Variance 7 x (12,000 – 10,000) 14,000F Revenue Variance (66,000) - (70,000) 4,000U

Variance Analysis: TR Possible causes for TR Price Variance Inaccurate or outdated price standards Changes in the market price of the product Possible causes for TR Volume Variance Inaccurate or outdated quantity standards Changes in the level of demand for the product Note: For TR variance only, variance favorable if AP > SP, AQ > SQ (In contrast with cost variances)

Summary of Variance Analysis Variance analysis in general Deviation of an actual amount from the expected (standard) or budgeted amount. “Unfavorable” or “Favorable” means nothing Provide clues to the causes of performance i.e. attention directors, not problem solvers Requires a drill down into the organization to have a better understanding of the variances

Summary of Variance Analysis Benefits of variance analysis Useful for control purposes. For example, when the figures in the master budgets are not achieved, investigations and appropriate actions can be undertaken. Communicates information to management. Highlights possible organizational difficulties – management cannot fix what they do not know about. Affects the actions of organization management.

Summary of Variance Analysis Trade-Offs Among Variances As the operations of organizations are linked, the level of performance in one area of operations will affect performance in another. Improvements in one area could lead to improvements in others and vice versa. Substandard performance in one area may be balanced by superior performance in others.