1. Flexible Budgets, Standard Costs, and Variance Analysis
Chapter 08
Chapter 8: Flexible Budgets, Standard Costs, and Variance Analysis
This chapter explores how to prepare flexible budgets and how to compare them to actual results for the purposes of computing revenue and spending variances. It also describes how standards are used to compute material, labor, and overhead variances.

2. Variance Analysis Cycle
Take
corrective
actions
Identify
questions
Receive
explanations
Conduct next
period’s
operations
Analyze variances
Prepare standard
cost performance report
Begin

3. Characteristics of Flexible Budgets
Hmm! Comparing static planning budgets with actual costs is like comparing apples and oranges.
Planning budgets are prepared for a single, planned level of activity.
Performance evaluation is difficult when actual activity differs from the planned level of activity.
A planning budget is prepared before the period begins and is valid for only the planned level of activity. If the actual level of activity differs from what was planned, it would be misleading to evaluate performance by comparing actual costs to the static, unchanged planning budget.

4. 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 Lawn Service.

5. Deficiencies of the Static Planning Budget
I don’t think I can answer the questions using a static budget.
Actual activity is above planned activity.
So, shouldn’t the variable costs be higher if actual activity is higher?
The answer is unclear because the actual activity level (550 lawns) does not equal the planned activity level (500 lawns).

6. Deficiencies of the Static Planning Budget
The relevant question is . . .
“How much of the cost variances are due to higher activity and how much are 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.

7. How a Flexible Budget Works
To a budget, we need to know that:
Total variable costs change in direct proportion to changes in activity.
Total fixed costs remain unchanged within the relevant range.
Variable
Flexing a budget involves two key assumptions about cost behavior. First, total variable costs change in direct proportion to changes in activity; and second, total fixed costs remain unchanged within a specified activity range.
Fixed

8. Revenue and Spending Variances
Flexible budget revenue
Actual revenue
The difference is a revenue variance.
A revenue variance is the difference between what the total revenue should have been, given the actual level of activity for the period, and the actual total revenue.  
A spending variance is the difference between how much a cost should have been, given the actual level of activity, and the actual amount of the cost.
Flexible budget cost
Actual cost
The difference is a spending variance.

9. Deficiencies of the Static Planning Budget
Larry’s Actual Results Compared with the Planning Budget
F = Favorable variance that occurs when actual revenue is greater than budgeted revenue.
U = Unfavorable variance that occurs when actual costs are greater than budgeted costs.
Revenue variances are labeled favorable when actual revenues exceed budgeted revenues, and they are labeled unfavorable when actual revenues are less than budgeted revenues. Expense variances are labeled favorable when actual expenses are less than budgeted expenses, and they are labeled unfavorable when actual expenses exceed budgeted expenses.
F = Favorable variance that occurs when actual costs are less than budgeted costs.

10. Revenue and Spending Variances
Now, let’s use budgeting
concepts to compute revenue and spending variances for Larry’s Lawn Service.
We have seen the impact that a change in activity has on revenues, costs, and profits, but we haven’t yet answered the question “How well did Larry control his revenues, costs, and profits?” We will answer that question by computing revenue and spending variances.

11. Revenue and Spending Variances
Larry’s Flexible Budget Compared with the Actual Results
$1,750 favorable revenue variance
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.

12. Flexible Budgets with Multiple Cost Drivers
More than one cost driver may be needed to adequately explain all of the costs in an organization.
The cost formulas used to prepare a flexible budget can be adjusted to recognize multiple cost drivers.
It is unlikely that all variable costs within a company are driven by a single factor such as the number of units produced, labor-hours, or machine-hours (or lawns mowed in Larry’s Lawn Service). More than one cost driver may be needed to adequately explain all of the costs in an organization. The cost formulas used to prepare a flexible budget can be adjusted to recognize multiple cost drivers.

13. Standard Costs
Standards are benchmarks or “norms” for measuring performance. In managerial accounting,
two types of standards are commonly used.
Quantity standards specify how much of an input should be used to make a product or provide a service.
Price standards specify how much should be paid for each unit of the input.
A standard is a benchmark or “norm” for measuring performance. In managerial accounting, two types of standards are commonly used by manufacturing, service, food, and not-for-profit organizations:
Quantity standards specify how much of an input should be used to make a product or provide a service. For example:
Auto service centers like Firestone and Sears set labor time standards for the completion of work tasks.
Fast-food outlets such as McDonald’s have exacting standards for the quantity of meat going into a sandwich.
Price standards specify how much should be paid for each unit of the input. For example:
Hospitals have standard costs for food, laundry, and other items.
Home construction companies have standard labor costs that they apply to sub-contractors such as framers, roofers, and electricians.
Manufacturing companies often have highly developed standard costing systems that establish quantity and price standards for each separate product’s material, labor, and overhead inputs. These standards are listed on a standard cost card.
Examples: Firestone, Sears, McDonald’s, hospitals,
construction, and manufacturing companies.

14. Setting Direct Materials Standards
Standard Price per Unit
Standard Quantity per Unit
Summarized in a Bill of Materials.
Final, delivered cost of materials, net of discounts.
The standard price per unit for direct materials should reflect the final, delivered cost of the materials, net of any discounts taken.
The standard quantity per unit for direct materials should reflect the amount of material required for each unit of finished product, as well as an allowance for unavoidable waste, spoilage, and other normal inefficiencies.
A bill of materials is a list that shows the quantity of each type of material in a unit of finished product.

15. Setting Direct Labor Standards
Often a single rate is used that reflects the mix of wages earned.
Standard Rate per Hour
Use time and motion studies for each labor operation.
Standard Hours per Unit
The standard rate per hour for direct labor includes not only wages earned but also fringe benefits and other labor costs. Many companies prepare a single rate for all employees within a department that reflects the “mix” of wage rates earned.
The standard hours per unit reflects the labor-hours required to complete one unit of product. Standards can be determined by using available references that estimate the time needed to perform a given task, or by relying on time and motion studies.

16. Setting Variable Manufacturing Overhead Standards
The rate is the variable portion of the predetermined overhead rate.
Price Standard
The quantity is the activity in the allocation base for predetermined overhead.
Quantity Standard
The price standard for variable manufacturing overhead comes from the variable portion of the predetermined overhead rate.
The quantity standard for variable manufacturing overhead is expressed in either direct labor-hours or machine-hours depending on which is used as the allocation base in the predetermined overhead rate.

17. Using Standards in Flexible Budgets
Standard costs per unit for direct materials, direct labor, and variable manufacturing overhead can be used to compute activity and spending variances.
Spending variances become more useful by breaking them down into quantity and price variances.
Standard costs per unit for direct materials, direct labor, and variable manufacturing overhead can be used to compute activity and spending variances as described in the previous chapter.
Spending variances become more useful by breaking them down into quantity and price variances. This is our focus in this chapter.

18. A General Model for Variance Analysis
Quantity Variance
Difference between actual quantity and standard quantity
Price Variance
Difference between actual price and standard price
Differences between standard prices and actual prices and standard quantities and actual quantities are called variances. The act of computing and interpreting variances is called variance analysis.
A quantity variance is the difference between how much of an input was actually used and how much should have been used and is stated in dollar terms using the standard price of the input.
A price variance is the difference between the actual price of an input and its standard price, multiplied by the actual amount of the input purchased.

19. Quantity and Price Standards
Quantity and price standards are determined separately for two reasons:
The purchasing manager is responsible for raw material purchase prices and the production manager is responsible for the quantity of raw material used.
Quantity and Price standards are determined separately for two reasons:
Different managers are usually responsible for buying and for using inputs. For example: The purchasing manager is responsible for raw material purchase prices and the production manager is responsible for the quantity of raw material used.
The buying and using activities occur at different points in time. For example: raw material purchases may be held in inventory for a period of time before being used in production.
The buying and using activities occur at different times. Raw material purchases may be held in inventory for a period of time before being used in production.

20. A General Model for Variance Analysis
Quantity Variance
Price Variance
Quantity and price variances can be computed for all three variable cost elements – direct materials, direct labor, and variable manufacturing overhead – even though the variances have different names as shown.
Materials quantity variance
Labor efficiency variance
VOH efficiency variance
Materials price variance Labor rate variance VOH rate variance

21. Responsibility for Materials Variances
Your poor scheduling sometimes requires me to rush order materials at a higher price, causing unfavorable price variances.
I am not responsible for this unfavorable materials quantity variance.
You purchased cheap material, so my people had to use more of it.
The materials variances are not always entirely controllable by one person or department. For example, the production manager may schedule production in such a way that it requires express delivery of raw materials resulting in an unfavorable materials price variance. The purchasing manager may purchase lower quality raw materials resulting in an unfavorable materials quantity variance for the production manager.
Production Manager
Purchasing Manager

22. Labor Variances – An Example
Glacier Peak Outfitters has the following direct labor standard for its mountain parka.
1.2 standard hours per parka at $10.00 per hour
Last month, employees actually worked 2,500 hours at a total labor cost of $26,250 to make 2,000 parkas.
Now let’s turn our attention back to Glacier Peak Outfitters to illustrate the computation of labor rate and efficiency variances.

23. Labor Variances Summary
Standard Hours Actual Hours Actual Hours × × × Standard Rate Standard Rate Actual Rate
2,400 hours ,500 hours ,500 hours × × × $10.00 per hour $10.00 per hour $10.50 per hour
= $24, = $25, = $26,250
The labor efficiency variance, defined as the difference between the actual quantity of labor hours and the quantity allowed according to the standard, is $1,000 unfavorable. The efficiency variance is labeled unfavorable because the actual quantity of hours exceeds the standard quantity allowed by 100 hours.
The labor rate variance, defined as the difference between the actual average hourly wage paid and the standard hourly wage, is $1,250 unfavorable. The rate variance is labeled unfavorable because the actual average wage rate was more than the standard wage rate by $0.50 per hour.
Efficiency variance $1,000 unfavorable
Rate variance $1,250 unfavorable

24. Labor Variances Summary
Standard Hours Actual Hours Actual Hours × × × Standard Rate Standard Rate Actual Rate
2,400 hours ,500 hours ,500 hours × × × $10.00 per hour $10.00 per hour $10.50 per hour
= $24, = $25, = $26,250
1.2 hours per parka  2,000 parkas = 2,400 hours
The standard quantity of 2,400 hours is computed by multiplying the standard hours for one parka times the number of parkas made.
Efficiency variance $1,000 unfavorable
Rate variance $1,250 unfavorable

25. Labor Variances Summary
Standard Hours Actual Hours Actual Hours × × × Standard Rate Standard Rate Actual Rate
2,400 hours ,500 hours ,500 hours × × × $10.00 per hour $10.00 per hour $10.50 per hour
= $24, = $25, = $26,250
$26,250  2,500 hours = $10.50 per hour
The actual price (or rate) of $10.50 per hour is computed by dividing the actual total cost for labor by the actual number of hours worked.
Efficiency variance $1,000 unfavorable
Rate variance $1,250 unfavorable

26. Labor Variances: Using the Factored Equations
Labor efficiency variance
LEV = (AH × SR) – (SH × SR)
= SR (AH – SH)
= $10.00 per hour (2,500 hours – 2,400 hours)
= $10.00 per hour (100 hours)
= $1,000 unfavorable
Labor rate variance
LRV = (AH × AR) – (AH × SR)
= AH (AR – SR)
= 2,500 hours ($10.50 per hour – $10.00 per hour)
= 2,500 hours ($0.50 per hour)
= $1,250 unfavorable
Factored equations can also be used to compute the rate and efficiency variances.

27. Responsibility for Labor Variances
Production managers are usually held accountable for labor variances because they can influence the:
Mix of skill levels assigned to work tasks.
Level of employee motivation.
Quality of training provided to employees.
Quality of production supervision.
Production Manager
Labor variances are partially controllable by employees within the Production Department. For example, production managers/supervisors can influence:
The deployment of highly skilled workers and less skilled workers on tasks consistent with their skill levels.
The level of employee motivation within the department.
The quality of production supervision.
The quality of the training provided to the employees.

28. Responsibility for Labor Variances
I think it took more time to process the materials because the Maintenance Department has poorly maintained your equipment.
I am not responsible for the unfavorable labor efficiency variance!
You purchased cheap material, so it took more time to process it.
However, labor variances are not entirely controllable by one person or department. For example:
The Maintenance Department may do a poor job of maintaining production equipment. This may increase the processing time required per unit, thereby causing an unfavorable labor efficiency variance.
The purchasing manager may purchase lower-quality raw materials resulting in an unfavorable labor efficiency variance for the production manager.

29. Materials Variances―An Important Subtlety
The quantity variance is computed only on the quantity used.
The price variance is computed on the entire quantity purchased.
When the quantity of materials purchased differs from the quantity used in production, the quantity variance is based on the quantity used in production and the price variance is based on the quantity purchased.

30. Variance Analysis and Management by Exception
Larger variances, in dollar amount or as a percentage of the standard, are investigated first.
All variances are not worth investigating. Methods for highlighting a subset of variances as exceptions include:
Looking at the size of the variance.
Looking at the size of the variance relative to the amount of spending.
How do I know which variances to investigate?

31. Advantages of Standard Costs
Management by exception
Promotes economy and efficiency
Advantages
Research has shown that a substantial portion of companies in the United Kingdom, Canada, Japan, and the United States use standard cost systems. This is because standard cost systems offer many advantages including:
Standard costs are a key element of the management by exception approach which helps managers focus their attention on the most important issues.
Standards that are viewed as reasonable by employees can serve as benchmarks that promote economy and efficiency.
Standard costs can greatly simplify bookkeeping.
Standard costs fit naturally into a responsibility accounting system.
Enhances responsibility accounting
Simplified bookkeeping

32. Potential Problems with Standard Costs
Emphasizing standards may exclude other important objectives.
Favorable variances may be misinterpreted.
Potential Problems
Standard cost reports may not be timely.
Emphasis on negative may impact morale.
The use of standard costs can also present a number of problems. For example:
Standard cost variance reports are usually prepared on a monthly basis and are often released days or weeks after the end of the month; hence, the information can be outdated.
If variances are misused as a club to negatively reinforce employees, morale may suffer, and employees may make dysfunctional decisions.
Labor variances make two important assumptions. First, they assume that the production process is labor-paced; if labor works faster, output will go up. Second, the computations assume that labor is a variable cost. These assumptions are often invalid in today’s automated manufacturing environment where employees are essentially a fixed cost.
In some cases, a “favorable” variance can be as bad or worse than an unfavorable variance.
Excessive emphasis on meeting the standards may overshadow other important objectives such as maintaining and improving quality, on-time delivery, and customer satisfaction.
Just meeting standards may not be sufficient; continual improvement using techniques such as Six Sigma may be necessary to survive in a competitive environment.
Invalid assumptions about the relationship between labor cost and output.
Continuous improvement may be more important than meeting standards.

33. PREDETERMINED Overhead Rates and Overhead analysis in a standard costing system
Appendix 8A
Appendix 8A: Predetermined Overhead Rates and Overhead Analysis in a Standard Costing System

34. Computing Fixed Overhead Variances
ColaCo’s production and machine-hour data is shown on your screen.

35. Computing Fixed Overhead Variances
ColaCo’s overhead production costs are presented here.

36. Predetermined Overhead Rates
Estimated total manufacturing overhead cost Estimated total amount of the allocation base =
Predetermined overhead rate
$360,000 90,000 Machine-hours =
The predetermined overhead rate is equal to the estimated total manufacturing overhead cost divided by the estimated total amount of the allocation base.
ColaCo’s predetermined overhead rate is $4.00 per machine-hour.
Predetermined overhead rate
= $4.00 per machine-hour

37. End of Chapter 08
End of Chapter 8.