1. Flexible Budgets, Direct-Cost Variances, and Management Control
CHAPTER 7
Flexible Budgets,
Direct-Cost Variances,
and
Management Control
We learned in Chapter 6 how budgets help managers with their planning function. In Chapter 7, we’ll take a look at flexible budgets and variances.

2. Chapter 7 learning objectives
Understand static budgets and static- budget variances
Examine the concept of a flexible budget and learn how to develop it
Calculate flexible-budget variances and sales-volume variances
Explain why standard costs are often used in variance analysis
We have 7 learning objectives in our chapter on flexible budgets. The first 4 are shown here:
Understand static budgets and static-budget variances
Examine the concept of a flexible budget and learn how to develop it
Calculate flexible-budget variances and sales-volume variances
Explain why standard costs are often used in variance analysis
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3. Chapter 7 learning objectives, concluded
Compute price variances and efficiency variances for direct-cost categories.
Understand how managers use variances
Describe benchmarking and explain its role in cost management
The final 3 learning objectives for chapter 7 are:
Compute price variances and efficiency variances for direct-cost categories.
Understand how managers use variances
Describe benchmarking and explain its role in cost management
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4. Basic Concepts
Variance—difference between actual results and expected (budgeted) performance.
Management by exception—the practice of focusing attention on areas not operating as expected (budgeted).
Static (master) budget is based on the output planned at the start of the budget period.
A variance is the difference between actual results and expected performance. The expected performance is also called budgeted performance.
Management by exception is a practice whereby managers focus more closely on areas that are not operating as expected and less closely on areas that are.
The static budget is another name for the master budget. It is based on the level of output planned at the start of the budget period. It is called a static budget because the budget for the period is developed around a single (static) planned output level.
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5. Basic Concepts
Static-budget variance—the difference between the actual result and the corresponding static budget amount
Favorable variance (F)—has the effect of increasing operating income relative to the budget amount
Unfavorable variance (U)—has the effect of decreasing operating income relative to the budget amount
The static-budget variance is the difference between the actual result and the corresponding budgeted amount in the static budget.
Favorable variances are denoted with an F. Variances are favorable when actual revenues exceed budgeted revenues and when actual costs are less than budgeted costs.
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6. Variances
Variances may start out “at the top” with a Level 0 analysis.
This is the highest level of analysis, a super- macro view of operating results.
The Level 0 analysis is nothing more than the difference between actual and static-budget operating income.
Variances can be calculated at multiple levels and those levels are identified with level numbers. The most broad variance is a level 0 and is a very macro-view showing the difference between actual and static-budget operating income.
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7. Variances
Further analysis decomposes (breaks down) the Level 0 analysis into progressively smaller and smaller components.
Answers: “How much were we off?”
Levels 1, 2, and 3 examine the Level 0 variance into progressively more-detailed levels of analysis.
Answers: “Where and why were we off?”
Variances are broken down further into smaller and smaller components to help managers understand more and more about what happened in the business.
Further analysis decomposes (breaks down) the Level 0 analysis into progressively smaller and smaller components.
Answers: “How much were we off?”
Levels 1, 2, and 3 examine the Level 0 variance into progressively more-detailed levels of analysis.
Answers: “Where and why were we off?”
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8. Evaluation
Level 0 tells the user very little other than how much operating income was off from budget.
Level 0 answers the question: “How much were we off in total?”
Level 1 gives the user a little more information: it shows which line-items led to the total Level 0 variance.
Level 1 answers the question: “Where were we off?”
As previously stated, level 1 can provide information on WHERE we were off from target instead of just HOW MUCH we were off, which is what level 0 provides.
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9. Level 1 Analysis, Illustrated
A level 1 analysis, illustrated here, takes the static-budget variance (level 0) and breaks it down by line item. As a result, in addition to knowing that we fell short in operating income, we now know how we got there. Column 1 presents the actual results, column 3 the static budget and in column 2 are the level 1 variances: the difference between the static budget and the actual results. Exhibit 7-1 page 251
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10. Flexible Budget
Flexible budget—shifts budgeted revenues and costs up and down based on actual operating results (activities)
Represents a blending of actual activities and budgeted dollar amounts
Will allow for preparation of Level 2 and 3 variances
Answers the question: “Why were we off?”
Variance analysis levels 2 and 3 answer the question WHY were we off? With level 2 and 3 variances, we can get quite specific about what went wrong in our operations that caused the shortfall in operating income.
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11. Level 2 Analysis, Illustrated
Here is an example of a Level 2 analysis. In the first column, the actual results are reported. The third column reports the FLEXIBLE BUDGET and the 5th column reports the STATIC BUDGET.
The second column provides the variances between our actual results and the flexible budget. These variances are the flexible-budget variances. They help us to understand what results we should have had for the level of volume compared to what was actually obtained.
The fourth column provides the difference between the static and the flexible budget. This is called the sales-volume variance because it tells us how much we gained or lost as a result of a volume difference between what was originally anticipated and what we actually achieved.
The flexible budget uses budgeted per unit data applied to ACTUAL units. It represents what our budget would have been had we budgeted correctly for volume. Exhibit 7-2 page 253
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12. LEVEL 2 VARIANCES, ANALYSIS
Some possible reasons we might incur an unfavorable Sales-Volume Variance include:
Failure to execute the sales plan
Weaker than anticipated demand
Aggressive competitors taking market share
Unanticipated market preference away from the product
Quality problems
Some reasons we may incur unfavorable sales-volume variances include:
Failure to meet the sales plan
Weaker than anticipated demand
Aggressive competitors taking market share
Unanticipated market preference away from the product
Quality problems
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13. Level 3 Variances
All product costs can have Level 3 variances. Direct materials and direct labor will be handled next. Overhead variances are discussed in detail in a later chapter.
Direct materials and direct labor both have price and efficiency variances, and their formulae are the same.
The level 2 variances are great – they certainly break down our successes and shortfalls in more detail than level 1. However, as you’ll see, level 3 variances are even better because they separate what we call Price and Efficiency variances.
Direct materials and direct labor both have price and efficiency variances, and their formulae are the same.
Let’s take a look:
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14. Level 3 Variances Price variance formula: Efficiency variance formula:
The formulas to calculate the price and efficiency variances are shown here. These formulas work equally well for direct material and direct labor but will not work for overhead.
The formula for PRICE VARIANCE is: (Actual Price – Budgeted Price) X Actual Quantity
The formula for EFFICIENCY VARIANCE is: (Actual Quantity – Budgeted Quantity) X Budgeted Price
The Actual Quantity of Input used can be yards or pounds of material or direct labor or machine hours.
The Budgeted Quantity of Input Allowed for Actual Output means that we’ll take the quantity expected to be used per output (4 lbs of steel per item) X the actual quantity.
As an example, if we made 10 units and each required 4.4 lbs of plastic, we would expect to have used 44 lbs of plastic. If we ACTUALLY used 48 lbs of plastic, that element of the formula would be (48 – 44).

15. Level 3 Analysis, Illustrated
Level 3 analysis looks at the flexible budget variances (the variance between the flexible budget and the actual results) and explains it in more detail.
For example, on a previous slide, we saw that direct materials was unfavorable by $21,600. That means that we spent $21,600 more for the materials than we should have.
This level 3 analysis tells us how much of that amount was based on price (we paid more or less for the material than we expected to) and how much of the amount was based on usage or efficiency. You can see that the situation is even worse than it appears. We spent $66,000 more than we expected to on usage which was offset quite a bit by the $44,400 favorable purchase price variance.
These variances provide infinitely important information to management to help them improve operations in the future. Exhibit 7-3 page 260
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16. Variance Summary
The slide almost looks like an organization chart, but it isn’t. It is a summary of the variances we’ve just discussed. At the top is our level 1 variance (remember, level 0 is the static-budget variance for operating income and level 1 is that variance broken down by line item).
Level two identifies the variances between the flexible budget and actual operating income by line item and in total. Exhibit 7-4 page 261
Level three variances target one of the level 2 line item variances and breaks it down into more detail.
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17. Obtaining budgeted input prices and input quantities
Budgeted input prices and budgeted input quantities can be obtained from a number of sources including actual input data from past periods, data from other companies that have similar processes and standards developed by the firm itself. A standard is a carefully determined price, cost or quantity that is used as a benchmark for judging performance.
Budgeted input prices and budgeted input quantities can be obtained from a number of sources including actual input data from past periods, data from other companies that have similar processes and standards developed by the firm itself.
A standard is a carefully determined price, cost or quantity that is used as a benchmark for judging performance.
Of course each of these has its own advantages and disadvantages.
Sometimes the terms budget and standard are confused. Budget is the broader term but when standards are used to obtain budgeted input quantities and prices, the terms are used interchangeably.
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18. Variances and Journal Entries
Each variance may be journalized.
Each variance has its own account.
Favorable variances are credits; unfavorable variances are debits.
Variance accounts are generally closed into cost of goods sold at the end of the period, if immaterial.
Variances are journalized into individual variance accounts. Favorable variances are credits and unfavorable variances are debits.
If immaterial, variances are closed into cost of goods sold at the end of the period.
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19. Standard Costing
Targets or standards are established for direct material and direct labor.
The standard costs are recorded in the accounting system.
Actual price and usage amounts are compared to the standard and variances are recorded.
In Chapter 4, we looked at journal entries when normal costing is used.
When standard costing is used, variances are recorded a bit differently. As an example, since the purchased material will be recorded at STANDARD, the price variance will be recorded upon purchase rather than when used.
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20. Standard Costs can be a Useful Tool
Price and efficiency variances provide feedback to initiate corrective actions.
Standards are used to control costs.
Managers use variance analysis to evaluate performance after decisions are implemented.
Part of a continuous improvement program.
Standard costing provides valuable information that is used for the management and control of materials, labor and other activities related to production.
Managers must not interpret variances in isolation of each other; when used correctly, variance analysis provides information helpful for future improvement.
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21. Benchmarking and Variances
Benchmarking is the continuous process of comparing the levels of performance in producing products and services against the best levels of performance in competing companies.
Variances can be extended to include comparison to other entities.
Management accountants are more valuable to managers when they use benchmarking data to provide insight into WHY costs or revenues differ across companies or within plants of the same company, as distinguished from simply reporting the magnitude of the differences.
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22. Benchmarking airlines
In this chart, we can see various measures between United and other airlines. Airlines use Available Seat Miles (ASM) to answer questions such as how plane size and type affect the cost per ASM. Exhibit 7-5 page 268
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23. terms to learn Terms to Learn Page Number Reference Benchmarking
Budgeted performance
Page 249
Direct materials mix variance
Page 272
Direct materials yield variance
Effectiveness
Page 265
Efficiency
Efficiency variance
Page 258
Favorable variance
Page 251
Flexible budget
Page 252
Flexible-budget variance
Page 253
Management by exception
Price variance
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24. terms to learn, cont’d Terms to Learn Page Number Reference
Rate variance
Page 258
Sales-volume variance
Page 253
Selling-price variance
Page 255
Standard
Page 257
Standard cost
Standard input
Standard price
Static budget
Page 251
Static-budget variance
Unfavorable variance
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25. terms to learn, concluded
Page Number Reference
Usage variance
Page 258
Variance
Page 249
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