Flexible Budgeting Chapter 07, 08 Chapter 9: Flexible Budgets and Performance Analysis This chapter explores how budgets can be adjusted so that meaningful comparisons to actual costs can be made.

Performance evaluation Performance evaluation by comparing actual results with budgeted numbers. Actual Budget Larry’s Lawn Service provides lawn care in a planned community where all lawns are approximately the same size. At the end of May, Larry prepared his June budget based on mowing 500 lawns. Since all of the lawns are similar in size, Larry felt that the number of lawns mowed in a month would be the best way to measure overall activity for his business.

Deficiencies of the Static Budget Larry’s Static Budget Larry identified 7 major expenses for his business. In addition, Larry estimated a cost formula for revenue and for each expense in terms of the number of lawns mowed. Revenue, along with each of the 7 major expense categories, and their relationship to the number of lawns (Q) is as follows: Revenue, $75 per lawn (Q) Wages and salaries, $5,000 + $30 per lawn (Q) Gasoline and supplies, $9Q Equipment maintenance, $3Q Some expenses are not directly related to the number of lawns mowed. They are the fixed costs: office and shop utilities, $1,000; office and shop rent, $2,000; equipment depreciation, $2,500; and insurance, $1,000. Larry’s static planning budget is based on an activity level of 500 lawns.

Deficiencies of the Static Budget Larry’s Actual Results Assume that Larry’s actual results for the month of June are as shown. Notice that Larry actually mowed 550 lawns.

Deficiencies of the Static Budget Larry’s Actual Results Compared with the Static Budget If Larry wanted to, he could compare his actual results to the planning budget as shown on the slide. Notice that a variance is computed for revenue and each expense item. The planning budget column and actual results column have apple and orange icons to emphasize that the amounts in both columns are based on different levels of activity (500 vs. 550 lawns). Since these variances are unfavorable, has Larry done a poor job controlling costs? Since these variances are favorable, has Larry done a good job controlling costs?

Static Budgets and Performance Reports Hmm! Comparing static budgets with actual costs is like comparing apples and oranges. Static budgets are prepared for a single, planned level of activity. Performance evaluation is difficult when actual activity differs from the planned level of activity.

Deficiencies of the Static Budget The relevant question is . . . “How much of the cost variances are due to higher activity and how much is due to cost control?” To answer the question, we must the budget to the actual level of activity. This raises an additional question, namely – How much of the cost variances are due to higher activity and how much are due to cost control? To answer this question, we must “flex” the budget.

Characteristics of Flexible Budgets May be prepared for any activity level in the relevant range. Show costs that should have been incurred at the actual level of activity, enabling “apples to apples” cost comparisons. Help managers control costs. Improve performance evaluation. A flexible budget provides estimates of what revenues and costs should be for any level of activity, within a specified range. When used for performance evaluation purposes, actual costs are compared to what the costs should have been for the actual level of activity during the period. This enables “apples-to-apples” cost comparisons. Let’s look at Larry’s Law Consultancy

Preparing a Flexible Budget Larry’s Flexible Budget Larry’s flexible budget for an activity level of 550 lawns mowed is as shown on this slide. The key to preparing a flexible budget is to state each variable cost as a function of activity. For example, gasoline and supplies are equal to $9 per lawn, and the variable portion of wages and salaries is $30 per lawn. While variable costs are expressed per unit of activity, fixed costs are not. The fixed costs are not sensitive to changes in the activity level. Notice, the “Q” in all revenue and cost formulas is 550 lawns mowed. So, for example: Revenue of $41,250 is computed by multiplying $75 × 550. Wages and salaries of $21,500 is computed by multiplying $30 × 550 plus $5,000 in fixed salaries. Can you compute the flexible budget amount for wages and salaries at a different level of activity? The question on the following screen will ask you to do that.

Sales-Volume Variances Larry’s Flexible Budget Compared with the Static Budget The activity variances for Larry’s Lawn Service would be computed as shown on this slide. Notice: The level of activity in the flexible budget (550 lawns) is 10% higher than the level of activity in the planning budget (500 lawns). The planning budget shows revenue and cost amounts at the original planned level of activity while the flexible budget shows revenue and cost amounts at the actual level of activity. The differences (variances) between the planning budget for 500 lawns and the flexible budget for 550 lawns are due solely to the activity increase. Revenue in the flexible budget is 10% higher than the planning budget because revenue varies proportionally to changes in the activity level. The higher activity level results in a favorable activity variance for revenue. The variable costs in the flexible budget (gasoline and supplies and equipment maintenance) are 10% higher than the planning budget because variable costs vary proportionally to changes the activity level. The mixed cost (wages and salaries) in the flexible budget is less than 10% higher than the planning budget because the fixed cost component of the mixed cost does not change when the activity level changes. The higher activity level results in unfavorable activity variances for these costs. The fixed costs in the flexible budget are the same as the planning budget because they do not change in response to changes in the activity level within the relevant range.

Flexible-Budget Variances Larry’s Flexible Budget Compared with the Actual Results The revenue and spending variances for Larry’s Lawn Service would be computed as shown on this slide. Notice: The apple icons on the slide indicate that the flexible budget and actual results columns are both based on 550 lawns mowed. The $1,750 favorable revenue variance indicates that actual revenue exceeded the budgeted amount that would be expected for an activity level of 550 lawns mowed. This could happen for a number of reasons including an increase in the amount charged for each lawn or a change in lawn services. In Larry’s case, several homeowners requested some additional edging and trimming, beyond the customary monthly services, that resulted in increased revenue. The $1,950 unfavorable spending variance indicates that total expenses were $1,950 greater than would be expected for an activity level of 550 lawns mowed. Larry explained the individual spending variances that make up the total $1,950 unfavorable spending variance as follows: The $1,500 unfavorable wages and salaries spending variance occurred because of extra hours required for the additional trimming. The $150 unfavorable gasoline and supplies spending variance was primarily the result of rising gasoline prices. The $350 favorable equipment maintenance spending variance occurred because maintenance was postponed in order to get the extra edging and trimming work completed. Fixed cost variances are not the result of increased activity. The utility bill was less because the weather was milder than normal for June, while insurance was higher because of an unexpected premium increase. Overall, net operating income was $200 less than would be expected for an activity level of 550 lawns mowed.

Performance report If Larry wanted to, he could compare his actual results to the planning budget as shown on the slide. Notice that a variance is computed for revenue and each expense item. The planning budget column and actual results column have apple and orange icons to emphasize that the amounts in both columns are based on different levels of activity (500 vs. 550 lawns). Since these variances are unfavorable, has Larry done a poor job controlling costs? Since these variances are favorable, has Larry done a good job controlling costs?

Variance Analysis Standard Cost Variances Price Variance The difference between the actual price and the standard price Efficiency Variance The difference between the actual quantity and the standard quantity

A General Model for Variance Analysis Actual Quantity Actual Quantity Standard Quantity × × × Actual Price Standard Price Standard Price Price Variance Efficiency Variance Standard price is the amount that should have been paid for the resources acquired.

A General Model for Variance Analysis Actual Quantity Actual Quantity Standard Quantity × × × Actual Price Standard Price Standard Price Standard quantity is the quantity allowed for the actual good output. Standard input per unit of output times amount of good output. Price Variance Efficiency Variance

A General Model for Variance Analysis Actual Quantity Actual Quantity Standard Quantity × × × Actual Price Standard Price Standard Price Price Variance Efficiency Variance AQ(AP - SP) SP(AQ - SQ) AQ = Actual Quantity SP = Standard Price AP = Actual Price SQ = Standard Quantity

Material Variances Example Zippy Material Variances Example Hanson Inc. has the following direct material standard to manufacture one Zippy: 1.5 pounds per Zippy at $4.00 per pound Last week 1,700 pounds of material were purchased and used to make 1,000 Zippies. The material cost a total of $6,630.

Zippy Quick Check  What is the actual price per pound paid for the material? a. $4.00 per pound. b. $4.10 per pound. c. $3.90 per pound. d. $6.63 per pound.

Quick Check  Hanson’s material price variance (MPV) for the week was: Zippy Quick Check  Hanson’s material price variance (MPV) for the week was: a. $170 unfavorable. b. $170 favorable. c. $800 unfavorable. d. $800 favorable.

Zippy Quick Check  The standard quantity of material that should have been used to produce 1,000 Zippies is: a. 1,700 pounds. b. 1,500 pounds. c. 2,550 pounds. d. 2,000 pounds.

Zippy Quick Check  Hanson’s material efficiency variance (MEV) for the week was: a. $170 unfavorable. b. $170 favorable. c. $800 unfavorable. d. $800 favorable.

Material Variances Summary Zippy Material Variances Summary Actual Quantity Actual Quantity Standard Quantity × × × Actual Price Standard Price Standard Price 1,700 lbs. 1,700 lbs. 1,500 lbs. × × × $3.90 per lb. $4.00 per lb. $4.00 per lb. = $6,630 = $ 6,800 = $6,000 Hanson purchased and used 1,700 pounds. How are the variances computed if the amount purchased differs from the amount used? The price variance is computed on the entire quantity purchased. The quantity variance is computed only on the quantity used. I need the price variance sooner so that I can better identify purchasing problems. You accountants just don’t understand the problems that purchasing managers have. I’ll start computing the price variance when material is purchased rather than when it’s used. I am not responsible for this unfavorable material quantity variance. You purchased cheap material, so my people had to use more of it. You used too much material because of poorly trained workers and poorly maintained equipment. Also, your poor scheduling sometimes requires me to rush order material at a higher price, causing unfavorable price variances. Price variance $170 favorable Efficiency variance $800 unfavorable

Labor Variances Example Zippy Labor Variances Example Hanson Inc. has the following direct labor standard to manufacture one Zippy: 1.5 standard hours per Zippy at $12.00 per direct labor hour Last week 1,550 direct labor hours were worked at a total labor cost of $18,910 to make 1,000 Zippies.

Zippy Quick Check  What was Hanson’s actual rate (AR) for labor for the week? a. $12.20 per hour. b. $12.00 per hour. c. $11.80 per hour. d. $11.60 per hour.

Quick Check  Hanson’s labor price variance (LPV) for the week was: Zippy Quick Check  Hanson’s labor price variance (LPV) for the week was: a. $310 unfavorable. b. $310 favorable. c. $300 unfavorable. d. $300 favorable.

Zippy Quick Check  The standard hours (SH) of labor that should have been worked to produce 1,000 Zippies is: a. 1,550 hours. b. 1,500 hours. c. 1,700 hours. d. 1,800 hours.

Zippy Quick Check  Hanson’s labor efficiency variance (LEV) for the week was: a. $590 unfavorable. b. $590 favorable. c. $600 unfavorable. d. $600 favorable.

Labor Variances Summary Zippy Labor Variances Summary Actual Hours Actual Hours Standard Hours × × × Actual Rate Standard Rate Standard Rate 1,550 hours 1,550 hours 1,500 hours × × × $12.20 per hour $12.00 per hour $12.00 per hour = $18,910 = $18,600 = $18,000 Using highly paid skilled workers to perform unskilled tasks results in an unfavorable rate variance. Production managers who make work assignments are generally responsible for rate variances. Reasons for unfavourable efficiency var: poorly trained workers, insufficient demand, poor quality materials, poorly maintained equipments, poor supervision of workers. I am not responsible for the unfavorable labor efficiency variance! You purchased cheap material, so it took more time to process it. You used too much time because of poorly trained workers and poor supervision. Maybe I can attribute the labor and material variances to personnel for hiring the wrong people and training them poorly. Price variance $310 unfavorable Efficiency variance $600 unfavorable

Variable Manufacturing Overhead Variances Example Zippy Variable Manufacturing Overhead Variances Example Hanson Inc. has the following variable manufacturing overhead standard to manufacture one Zippy: 1.5 standard hours per Zippy at $3.00 per direct labor hour Last week 1,550 hours were worked to make 1,000 Zippies, and $5,115 was spent for variable manufacturing overhead.

Zippy Quick Check  What was Hanson’s actual rate (AR) for variable manufacturing overhead rate for the week? a. $3.00 per hour. b. $3.19 per hour. c. $3.30 per hour. d. $4.50 per hour.

Zippy Quick Check  Hanson’s spending variance (VOSV) for variable manufacturing overhead for the week was: a. $465 unfavorable. b. $400 favorable. c. $335 unfavorable. d. $300 favorable.

Zippy Quick Check  Hanson’s efficiency variance (VOEV) for variable manufacturing overhead for the week was: a. $435 unfavorable. b. $435 favorable. c. $150 unfavorable. d. $150 favorable.

Variable Manufacturing Overhead Variances Zippy Variable Manufacturing Overhead Variances Actual Hours Actual Hours Standard Hours × × × Actual Rate Standard Rate Standard Rate 1,550 hours 1,550 hours 1,500 hours × × × $3.30 per hour $3.00 per hour $3.00 per hour = $5,115 = $4,650 = $4,500 Spending var:Results from paying more or less than expected for overhead items and from excessive usage of overhead items. Effi. Var. Controlled by managing the overhead cost driver. Spending variance $465 unfavorable Efficiency variance $150 unfavorable

Fixed Overhead Variances – Example Zippy Fixed Overhead Variances – Example Zippy’s actual production required 3,200 standard machine hours. Actual fixed overhead was $8,450. The budgeted fixed overhead was $9,000. The allocation fixed overhead rate was $3 per machine hour. Compute the fixed overhead spending and production- volume variances.

Production - Volume Variance Fixed Overhead Variances Actual Fixed Fixed Fixed Overhead Overhead Overhead Incurred Budget Allocated SH × FR Spending Variance Production - Volume Variance FR = Standard Fixed Overhead Rate SH = Standard Hours Allowed

Fixed Overhead Variances – Example Zippy Fixed Overhead Variances – Example Actual Fixed Fixed Fixed Overhead Overhead Overhead Incurred Budget Applied SH × FR 3,200 hours × $3.00 per hour Spending var. Results from paying more or less than expected for overhead items. Volume var. Results from operating at an activity level different from the denominator activity. $8,450 $9,000 $9,600 Spending variance $550 favorable Production - Volume variance $600 favorable

Fixed Overhead Variances Zippy Fixed Overhead Variances Volume Cost 3,000 Hours Expected Activity $9,000 budgeted fixed OH Fixed overhead applied to products

Fixed Overhead Variances Zippy Fixed Overhead Variances Volume Cost 3,000 Hours Expected Activity $9,000 budgeted fixed OH Fixed overhead applied to products { $8,450 actual fixed OH $8,450 actual fixed OH $550 Favorable Budget Variance

Fixed Overhead Variances Zippy Fixed Overhead Variances 3,200 machine hours × $3.00 fixed overhead rate Volume Cost 3,000 Hours Expected Activity $9,000 budgeted fixed OH Fixed overhead applied to products $600 Favorable Volume Variance $9,600 applied fixed OH { { { $8,450 actual fixed OH $8,450 actual fixed OH $550 Favorable Budget Variance 3,200 Standard Hours

Sales variances x - x - Selling price variance = Actual selling price Budgeted selling price - x Actual units sold Sales volume variance = Actual units sold Budgeted units sold - x Budgeted margin per unit

Example - Leather Ltd One of the departments of Leather Ltd manufactures leather briefcases. The standard cost schedule applicable for April is set out below. Standard cost schedule per briefcase (assuming monthly production of 640 items) £ Leather 0.7 m2 at £30 per m2 21.00 Labor 2 hours at £16 per hour 32.00 Variable OH 2 hours at £2 per hour 4.00 Fixed OH 2 hours at £6 per hour 12.00 Total standard cost 69.00 Margin 23.50 Selling price 92.50  OH are allocated on the basis of standard labor hours.

The actual figures for April are set out below The actual figures for April are set out below. There were no changes in stock levels. £ £ Sales: 700 briefcases 63,000 Less expenses Leather: 525 m2 16,800 Labor: 1,350 hrs 22,275 Variable OH 2,600 Fixed OH 8,000 49,675 Profit for April 13,325

End of Chapter 07&08 End of Chapter 9.