1. Flexible Budgets, Variance Analysis & Standard Costs
November 23, 2015
Flexible Budgets, Variance Analysis & Standard Costs
Chapter 9: Flexible Budgets and Overhead Analysis.
This chapter expands the study of overhead variances that was started in Chapter 8. It also explains how flexible budgets can be used to control variable and fixed overhead costs.

2. Today’s Agenda Variance Analysis What is a Flexible Budget
Flexible versus Static Budget
Shortcomings of Static Budgets
Advantages of Flexible Budgets
Building a Flexible Budget
Standard Costs

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

4. Characteristics of Flexible Budgets
Planning budgets are prepared for a single, planned level of activity.
Evaluation is difficult when actual activity varies from planned activity.
Flexible Budgets are prepared to provide an accurate budget for differing levels of output.
When comparing actual performance to budgeted performance at the actual level of output, we can better identify and isolate problem areas and areas which over performed
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.

5. Flexible Budgets
May be prepared for any activity level within the relevant range.
Show costs that should have been incurred at the actual level of activity, enabling “apples to apples” cost comparisons.
Flexible Budget
Improve performance evaluation.
Reveal variances related to cost control.
Flexible budgets provide estimates of what costs should be at any level of activity within the relevant range. When used for performance evaluation, actual costs are compared to the costs that should have been incurred at the actual level of activity, thereby enabling “apples to apples” cost comparisons.

6. Deficiencies of the Static Planning Budget
Leung’s Actual Results Compared with the Planning Budget
Has Leong done a poor job controlling those costs with unfavorable variances? Has he done a good job controlling the costs with favorable variances?

7. Creating a Flexible Budget
Establish the “relevant range” of activity
Range in which fixed costs remain in place; i.e., no requirement for stepped up investment (or step down)
Develop a cost function (mathematical equation) as to has each cost line item should behave based on differing activity levels
Calculate the budget for forecast activity

8. Preparing a Flexible Budget
Leong’s Flexible Budget
Leong’s flexible budget for an activity level of 600 pools cleaned is as shown on this slide.

9. 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.

10. Revenue and Spending Variances
Leong’s Flexible Budget Compared with the Actual Results
Spending variances
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 $2,000 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.

11. Standard Costs – Setting Cost Formulas for Flexible Budgets
To build a flexible budget, we need to establish a “standard” for costs
What is Standard Cost and what is its purpose?
How are they set?
Direct Material Standard
Direct Labour Standard
Variable Overhead Standard
Standard Cost versus Actual Cost
Variance Analysis
Benefits and Problems with Standard Cost

12. 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.

13. Standard Cost
Standard Costs are benchmark costs that management believes are appropriate for measuring performance
Quantity Standards
How many units of an input should be used to produce a unit of output
E.g., it should take 20 minutes of Direct Labour to produce one cell phone
Price Standards
What is the appropriate price of a unit
E.g., an hour of labour should cost $5
In this case, the Direct Labour Standard is .33 * 5, or $1.67 per unit

14. Standard Cost Standard Cost information is used for several purposes:
Budgeting
Build up of expected appropriate costs are input into budgets
Monitoring costs
Budgets are tracked on a regular basis
Controlling costs
With budgeted inputs in place, managers are incentivized to work to and exceed targets
Isolating problems
When compared to actual costs, it is helpful in identifying problem areas and isolating the source

15. Variance Deviations from Standard Cost are called “Variances”
Variances can be “Favourable” or “Unfavourable”
In the case of the cell phone manufacturer, any Direct Labour cost per unit which is
above the Standard Cost of $1.67 would be described as an Unfavourable Variance
Below the Standard Cost of $1.67 would be described as a Favourable Variance
Managers can focus in particular on Unfavourable Variances
There could be a problem in the production process
There could be a problem with the application of the methodology

16. Who Sets Standard Costs
Setting appropriate Standard Costs requires the input of several people
Purchasing Managers
Pricing of Direct Materials
Production Managers
Quantity of Direct Materials
Required Labour
Engineers
Optimizing processes and determining impact on Standard Cost
Accountants
Verification
Calculation and monitoring
Exception reporting
As managers will be held to account for Variances, therefore Standard Costs should be “reasonable” and achievable (remember “Participating Budgeting Process”)
Additional incentive can be provided for reducing costs, designing out high value parts and processes, etc.

17. Product Costing, revisited
Product Costs
Direct Labour
Direct Materials
Manufacturing Overhead
Variable
Fixed
Flexible budgets require all variable costs to be separated from fixed costs
Recall “Absorption Costing” - included fixed and variable Manufacturing Overhead
Recall “Variable Costing” – included only Variable Overhead

18. Standard Costs – Direct Materials & Labour
Quantity Standard
Quantity or each component required
Lead times – impacts inventory financing costs (as apposed to standard cost)
Price Standard
Price of the components at the volume required
Net of discounts, shipping etc. – “landed cost”
Direct Labour
Time Standard
Time required from Direct Labour to “Convert” the Direct Materials into a Finished Product
Rate Standard

19. Setting Direct Materials Standards
Standard Quantity per Unit
Standard Price per Unit
Final, delivered cost of materials, net of discounts.
Summarized in a Bill of Materials.
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.
What costs are included in “final, delivered” materials, net of discounts?
What is a “Bill of Materials”?

20. 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.

21. Standard Costs – Variable Manufacturing Overhead
Price Standards
Quantity Standards
The 3rd and final cost to address for Flexible Budgeting is Variable Manufacturing Overhead
Think back to the POHR (Predetermined Overhead Rate) in Product Costing
We selected a basis for allocating Manufacturing Overhead
Eg, Overhead/Labour hour; or Overhead/Machine hours; etc.
The “Activity Base”
We will do something similar here, but applied only to Variable Overhead
It is only the Variable portion of overhead that will “Flex” with volume/output

22. 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.

23. The Measure of Activity– A Critical Choice
Three important factors in selecting an activity base for an overhead flexible budget
Activity base and variable overhead should be causally related.
Activity base should not be expressed in dollars or other currency.
Activity base should be simple and easily understood.
At least three factors are important in selecting an activity base for an overhead flexible budget:
The activity base and variable overhead should be causally related;
The activity base should not be expressed in dollars or other currency. Direct labor cost is usually a poor choice
for an activity base because changes in wage rates do not result in proportionate changes in overhead; and
The activity base should be simple and easily understood.

24. Standard Cost Card – Variable Production Cost
A Standard Cost Card is produced for each SKU
The standard cost card is a detailed listing of the standard amounts of direct materials, direct labor, and variable overhead inputs that should go into a unit of product, multiplied by the standard price or rate that has been set for each input.

25. A General Model for Variance Analysis
Price Variance
Difference between actual price and standard price
Quantity Variance
Difference between actual quantity and standard quantity
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.

26. A General Model for Variance Analysis
Price Variance
Quantity Variance
Actual Quantity Actual Quantity Standard Quantity × × × Actual Price Standard Price Standard Price
Although price and quantity variances are known by different names, they are computed exactly the same way (as shown on this slide) for direct materials, direct labor, and variable manufacturing overhead.
(AQ × AP) – (AQ × SP) (AQ × SP) – (SQ × SP)
AQ = Actual Quantity SP = Standard Price AP = Actual Price SQ = Standard Quantity

27. General Variance Analysis Applied
Assumptions:
Standard Rate = $104
Standard Quantity = 1,000
Actual Quantity = 900
Actual Cost = $100,080
What is the Price and quantity Variance?

28. General Variance Analysis Applied
Actual Rate = 900 units / $100,080 = $111.20
Price Variance = 93,600 – 100,080 = -$6,480 (unfavourable)
Quantity Variance = 104,000 – 93,600 = $10,400 (favourable)
NOTE: Less quantity isn’t exactly “favourable” for the business, but it removes the difference due to volume and highlights the inefficiencies relative to budget

29. Detailed Variance Analysis
General Variance Analysis exposed unfavourable performance relative to budget
Applying the same analysis to the three components can isolate particular problems, which can then be addressed
The same formulas were applied for General Variance are applied to:
Direct Materials
Direct Labour
Variable Manufacturing Overhead

30. Actual Costs
On completion of the accounting period, we can obtain actual costs
Actual costs are compared to Standard Costs to analyze and identify problem areas

31. Detailed Variance Analysis Applied – Direct Materials
Variance Analysis is applied in the same way for detailed accounts as it is in general
Direct Materials, Direct Labour, Variable Overhead
If need be, we can “drill down” line by line into the Bill of Materials
Both Price and Quantity Variance are Unfavourable
Too many scrapped pieces?
Poor purchasing? Or supply shortage?

32. 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

33. Detailed Variance Analysis Applied – Direct Labour
Production manager upgraded to more costly, skilled labour which could work faster
Labour quantity came down to 2 hours per unit from 3 hours per unit
Quantity variance is hugely favourable
While price variance was unfavourable, the cost increase was justified by the decrease in quantity

34. Responsibility for Labour 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 production supervision.
Quality of training provided to employees.
How would you rate this production manager’s performance?
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.

35. Possible Conflicts - Labour 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.

36. Detailed Variance Analysis Applied – Variable Manufacturing Overhead
Quantity variance is “favourable” only due to the reduced output
Price variance is unfavourable, the cause of which needs to be investigated

37. Summary of Variances
The sum of the variances for each product cost equals the total variance
Recall that in many accounting systems, it is Standard Costs which are charged to Inventory and COGS accounts as products are produced
In these companies, Variance from Standard Costs will require adjustments to accounts
Fixed Costs – the same principles apply
Inevitably, even within the relevant range, there will be variances in fixed costs
In an Absorption Costing system, fixed costs may have been over or under applied and need to be cleared

38. Cost Flows in a Standard Cost System
Inventories are recorded at standard cost.
Variances are recorded as follows:
Favorable variances are credits, representing savings in production costs.
Unfavorable variances are debits, representing excess production costs.
Standard cost variances are usually closed out to cost of goods sold.
Unfavorable variances increase cost of goods sold.
Favorable variances decrease cost of goods sold.
The entries into the various accounts are made at standard cost – not actual cost. The differences between actual and standard costs are entered into special accounts that accumulate the various standard cost variances. The standard cost variance accounts are usually closed out to Cost of Goods Sold at the end of the period. Unfavorable variances increase Cost of Goods Sold, and favorable variances decrease Cost of Goods Sold.

39. 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?

40. 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

41. 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.

42. Review Variance Analysis What is a Flexible Budget
Flexible versus Static Budget
Shortcomings of Static Budgets
Advantages of Flexible Budgets
Building a Flexible Budget
Standard Costs