1. Financial and Managerial Accounting
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Wild, Shaw, and Chiappetta
Fifth Edition
McGraw-Hill/Irwin
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. 1

2. Flexible Budgets and Standard Costing
Chapter 21
Flexible Budgets and Standard Costing
This chapter describes flexible budgets, variance analysis, and standard costs. It explains how each is used for purposes of better controlling and monitoring of business activities.

3. Conceptual Learning Objectives
C1: Define standard costs and explain how standard cost information is useful for management by exception.
C2: Describe variances and what they reveal about performance.
Conceptual Learning Objectives:
C1: Define standard costs and explain how standard cost information is useful for management by exception.
C2: Describe variances and what they reveal about performance.
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4. Analytical Learning Objectives
A1: Analyze changes in sales from
expected amounts.
Analytical Learning Objectives:
A1: Analyze changes in sales from expected amounts.
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5. Procedural Learning Objectives
P1: Prepare a flexible budget and interpret a flexible budget performance report.
P2: Compute materials and labor variances.
P3: Compute overhead variances.
P4A: Prepare journal entries for standard costs and account for price and quantity variances.
Procedural Learning Objectives:
P1: Prepare a flexible budget and interpret a flexible budget performance report.
P2: Compute materials and labor variances.
P3: Compute overhead variances.
P4A: (Appendix) Prepare journal entries for standard costs and account for price and quantity variances.
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6. Budgetary Control and Reporting
Develop the budget from planned objectives.
Revise objectives and prepare a new budget.
Compare actual with budget and analyze any differences.
Management uses budgets to monitor and control operations.
Budgets are an important cost control tool. Actual results are compared with budgets and differences are investigated and analyzed. This process may result in corrective action to restore progress toward budgeted objectives. If the operating environment has changed the investigation and analysis may lead to budget revisions.
Take corrective and strategic actions.
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7. Fixed Budget Performance Report
One of the major problems with fixed budgets is that they’re prepared for a single planned level of activity. Performance valuations can be very difficult when the actual level of activity differs from the planned level.
To illustrate the difficulty involved with performance evaluation when comparing actual results at one activity with a fixed budget at another activity, let’s look at an example. Optel’s fixed budget was prepared for January at an expected sales level of 10,000 units. However, Optel actually sold 12,000 units during the month. All of the expense variances are unfavorable because actual expenses are greater than budgeted expenses.
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8. Fixed Budget Performance Report
If unit sales are higher, should we expect costs to be higher?
How much of the higher costs are because of higher unit sales?
Note that the variances for sales and income are favorable.
Since the cost variances are unfavorable, has Optel done a poor job controlling costs?
What if sales volume is greater than expected, shouldn’t we expect Optel’s costs to be higher? If so, what portion of the higher costs is due to activity and what portion is due to poor cost control? These are questions that can be answered by a variance analysis.
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9. Purpose of Flexible Budgets
Show revenues and expenses that should have occurred at the actual level of activity.
May be prepared for any activity level in the relevant range.
Reveal variances due to good cost control or lack of cost control.
One of the ways we can answer the question about the effectiveness of cost control is to use flexible budgeting. We will prepare a budget at the actual level of activity. In other words, we will flex Optel’s fixed budget up to the actual level of sales.
A flexible budget shows us the revenue and expenses that should have been incurred at the actual level of activity rather than just the budgeted level of activity. One of the real strengths of flexible budgeting is that it helps us get a firm grasp on cost control. In addition, performance evaluation is improved using flexible budgeting.
Improve performance evaluation.
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10. Preparing Flexible Budgets
To a budget for different activity levels, we must know how costs behave with changes in activity levels.
Total variable costs change in direct proportion to changes in activity.
Total fixed costs remain unchanged within the relevant range.
Fixed
Variable
In order to prepare an effective flexible budget, we have to know that total variable costs change directly and proportionately with the level of activity, and that total fixed costs remain unchanged as long as we stay within the relevant range of activity. Recall that in a previous chapter, we studied fixed and variable costs along with methods to determine the fixed and variable components of mixed costs.
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11. Preparing Flexible Budgets
We are now ready to prepare flexible budgets for Optel. We will prepare flexible budgets at three levels of activity to illustrate the process.
Let’s see how flexible budgeting works by preparing budgets for 10,000 units, 12,000 units, and 14,000 units. Notice that Optel’s costs have been classified by behavior, either variable or fixed in the flexible budget. The first thing we do is express the variable costs in per unit amounts. For example, we divide the 48,000 variable costs by 10,000 units to obtain a unit variable cost of $ Optel’s $40,000 fixed cost will remain the same at all three levels of budgeted activity.
Variable costs are expressed as a constant amount per unit.
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12. Preparing Flexible Budgets
Next we multiply the $4.80 unit variable cost times each of the budgeted levels of activity to get the total variable costs at each activity level. For example, at 14,000 units of activity, the budgeted variable cost of $67,200 is computed by multiplying $4.80 per unit times 14,000 units.
Total variable cost = $4.80 per unit × budget level in units
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13. Preparing Flexible Budgets
Total fixed costs remain unchanged in the budgeting process as long as we operate within the relevant range of activity.
Fixed costs are expressed as a total amount that does not change within the relevant range of activity.
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14. Flexible Budget Performance Report
Now let’s compare the flexible budget for 12,000 units with the actual costs at 12,000 units.
At 12,000 units, we would expect sales revenue to be $120,000. Since the actual sales revenue was $125,000, we conclude that Optel’s average selling price was greater than $10. Now we can begin to analyze cost control.
Favorable sales variance indicates that the average selling price was greater than $10.00.
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15. Flexible Budget Performance Report
Comparing actual costs at 12,000 units with a flexible budget prepared at 12,000 units reveals that Optel has unfavorable cost variances. These variances are due to cost control issues because we have removed the activity differences by flexing the fixed budget from 10,000 units up to the actual activity of 12,000 units.
Unfavorable cost variances indicate costs that are greater than expected.
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16. Flexible Budget Performance Report
The favorable variances for contribution margin and income indicate that the favorable sales variance is larger than the unfavorable cost variances.
Favorable variances because favorable sales variance overcomes unfavorable cost variances.
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17. Standard Costs Based on carefully predetermined amounts.
Standard Costs are
Used for planning labor, material and overhead requirements.
The expected level of performance.
Let’s turn our attention to standard costs. Standard costs are preset costs for making a product or delivering a service. We can think of standard costs as budgeting on a per unit basis. We expect to operate within the standard cost allowances under normal conditions. When actual costs vary from standard costs, management follows up to identify potential problems and take corrective actions.
Benchmarks for measuring performance.
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18. Setting Standard Costs
Practical standards should be set at levels that are currently attainable with reasonable and
efficient effort.
Should we use practical standards or ideal standards?
When the standard cost team gets together, perhaps the first question they have to answer is, do they want to develop a practical standard or an ideal standard. An ideal standard is based upon perfection. It is the quantity of material required if the process is 100% efficient without any loss or waste. Reality suggests that some loss of material usually occurs with any process. Most members of the team would argue that the standards should be practical; they should be attainable with a reasonable amount of efficient effort.
Production Manager
Managerial Accountant
Engineer
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19. Setting Direct Material Standards
Price Standards
Quantity Standards
Use product design specifications.
Use competitive bids for the quality and quantity desired.
When we think of direct materials standards, we think of price standards that represent the final delivered cost, net of any applicable discounts. Standard quantities are amounts needed to meet the production designs.
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20. Setting Direct Material Standards
The standard material cost for one unit of product is:
Standard quantity Standard price for of material one unit of material required for one unit of product ×
We can combine the price standard and the quantity standard to get the standard material cost for one unit of product. The standard material cost for a unit of product is the standard price for one unit of material multiplied by the standard quantity of material required for each unit of product.
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21. Setting Direct Labor Standards
Time Standards
Rate Standards
Use time and motion studies for each labor operation.
Use wage surveys and labor contracts.
Instead of the terms price and quantity used for material, we use rate and time when we apply standard cost concepts to direct labor. Labor rates can be determined by wage surveys of rates paid in comparable companies or by labor contracts. We can use time and motion studies to determine how to best manufacture the product using our direct labor.
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22. Setting Direct Labor Standards
The standard labor cost for one unit of product is:
Standard number Standard wage rate of labor hours for one hour for one unit of product ×
We can combine the labor rate standard and the labor time standard to get the standard labor cost for one unit of product. The standard labor cost for a unit of product is the standard rate for one hour of direct labor multiplied by the standard time required for each unit of product.
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23. Setting Variable Overhead StandardsC1
Activity Standards
Rate Standards
The activity is the cost driver used to calculate the predetermined overhead.
The rate is the variable portion of the predetermined overhead rate.
For variable manufacturing overhead, we use a rate standard which is the variable portion of the predetermined overhead rate. The activity standard is the units of activity in the base used to apply our predetermined overhead. Examples of the activity base might be standard direct labor hours or standard machine hours.
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24. Setting Variable Overhead StandardsC1
The standard variable overhead cost for one unit of product is:
Standard variable Standard number overhead rate for of activity units one unit of for one unit of activity product ×
As with material and labor, we can combine the standard variable overhead rate and the standard number of activity units for variable overhead to get the standard variable overhead for one unit of product. The standard variable overhead cost for one unit of product is the standard variable overhead rate for one unit of activity multiplied by the standard number of activity units for each unit of product ×
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25. A standard cost card might look like this:
A standard cost card might look like the one shown on the screen. First, we see a standard quantity. In this case, direct materials is expressed in terms of kilograms, direct labor in hours, and manufacturing overhead in hours. Second, we have a standard price or standard rate, and finally, we have a standard cost per unit. In this case, one unit should cost a total of $85.00.
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26. Manufacturing Overhead
Variances C2
A standard cost variance is the amount by which an actual cost differs from the standard cost.
Direct Material
Variance
Standard cost
Variance
Amount
Direct Labor
You can see from this diagram that direct labor cost is equal to the standard cost for labor, while direct material cost is above standard and manufacturing overhead cost is below standard. The difference between actual cost and standard cost is called a standard cost variance.
Manufacturing Overhead
Type of Product Cost
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27. Variance Analysis Begin Take corrective actions Identify questions
Receive explanations
Conduct next period’s operations
Analyze variances
Variance analysis involves comparing actual costs with standard costs. If variances exist, we investigate by asking appropriate managers for explanations and possible causes for the variances. Our objective is to correct problems that caused unfavorable variances and to possibly adopt and reward the practices that resulted in favorable variances.
Prepare standard cost performance report
Begin
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28. Computing Variances Standard Cost Variances Quantity Variance
Price Variance
The difference between the actual price and the standard price
The difference between the actual quantity and the standard quantity
Price variances result when we pay an actual price for a resource that differs from the standard price that should have been paid. Quantity variances are caused by using an actual amount of a resource that differs from the standard amount that should have been used.
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29. Computing Variances Price Variance Quantity Variance
Actual quantity Actual quantity Standard quantity × × × Actual price Standard price Standard price
Price Variance
Quantity Variance
Standard price is the amount that should have been paid for the resources acquired.
Here’s a general model for computing standard cost variances. We multiply the actual quantity times the actual price and compare that to the actual quantity times the standard price. The difference is the price variance. Then we compare the actual quantity times the standard price to the standard quantity at the standard price. The difference is the quantity variance. Standard price is the amount we should pay for the resources acquired.
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30. Computing Variances Price Variance Quantity Variance
Actual quantity Actual quantity Standard quantity × × × Actual price Standard price Standard price
Price Variance
Quantity Variance
The standard quantity is the standard quantity for one unit multiplied times the number of units produced. It is the amount of a resource that should have been used given the actual output achieved.
Standard quantity is the quantity that should have been used for the actual good output.
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31. Computing Variances Price Variance Quantity Variance
Actual quantity Actual quantity Standard quantity × × × Actual price Standard price Standard price
Price Variance
Quantity Variance
We can reduce these relationships to mathematical equations. For example, we can determine the material price variance by multiplying the actual quantity times the difference between the actual price and the standard price, and we can determine the material quantity variance by multiplying the standard price times the difference between the actual quantity and the standard quantity.
AQ(AP - SP) SP(AQ - SQ)
AQ = Actual quantity SP = Standard price AP = Actual price SQ = Standard quantity
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32. Labor Variances Rate Variance Efficiency VarianceP2
Actual hours Actual hours Standard hours × × × Actual rate Standard rate Standard rate
Rate Variance
Efficiency Variance
Now that we have computed material variances, we can apply the same concepts to labor.
Instead of price and quantity, for direct labor we use the terms rate and hours. Also, instead of price and quantity variances, for labor, we use the terms rate and efficiency variances. The underlying concepts are the same as we saw for material. The standard rate is the amount we should pay per hour for the work performed. Standard hours are the hours that should have been worked for the actual output achieved. Just as with material, we can reduce these relationships to mathematical equations. For example, we can determine the labor rate variance by multiplying actual hours times the difference between the actual rate and the standard rate, and we can determine the labor efficiency variance by multiplying the standard rate times the difference between actual hours and standard hours.
Quantity is the standard quantity for one unit multiplied times the number of units produced. It is the amount of a resource that should have been used.
Materials price variance Materials quantity variance Labor rate variance Labor efficiency variance Variable overhead Variable overhead spending variance efficiency variance
AH(AR - SR) SR(AH - SH)
AH = Actual hours SR = Standard rate AR = Actual rate SH = Standard hours
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33. Labor Cost Variances Unfavorable Efficiency VarianceP2
Poorly trained workers
Poor supervision of workers
Poor quality materials
Poorly maintained equipment
Unfavorable Efficiency Variance
A number of factors can cause an unfavorable efficiency variance. All too often an unfavorable efficiency variance is blamed on inefficient workers. The reasons listed on this slide may also be likely causes for unfavorable labor efficiency variances.
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34. Overhead Standards and VariancesP3
Recall that overhead costs are assigned to products and services using a predetermined overhead rate (POHR):
Assigned overhead = POHR × Standard activity
Now that we have mastered material and labor variances, we can apply the same concepts to overhead.
Recall from our work in previous chapters that the predetermined overhead rate is calculated by dividing estimated overhead costs for the operating period by the estimated activity for the operating period. We then use the predetermined overhead rate to assign overhead costs to products as they are manufactured.
Estimated total overhead costs Estimated activity
POHR =
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35. Setting Overhead StandardsP3
Contains a fixed overhead rate which declines as activity level increases.
Contains a variable unit rate which stays constant at all levels of activity.
Overhead Rate
The predetermined overhead rate contains both fixed and variable components of overhead. The variable costs per unit remain constant, but fixed costs per unit decline with increases in volume. This means the average total overhead cost per unit declines with increases in volume.
Function of activity level chosen to determine rate.
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36. Total Overhead Cost Variance (Exhibit 21.14)P3
Total Overhead Variance
Actual total overhead incurred – Standard total overhead applied
Controllable Variance
Actual total overhead incurred – Budgeted total overhead
Volume Variance
Budgeted fixed overhead – Applied fixed overhead
When standard costs are used, the cost accounting system applies overhead to the good units produced using the predetermined standard overhead rate. At period-end, the difference between the total overhead cost applied to products and the total overhead cost actually incurred is called an overhead cost variance or total overhead variance. The total overhead cost variance is the difference between actual total overhead incurred – standard total overhead applied. To help identify factors causing the overhead cost variance, managers analyze this variance separately, for controllable and volume variances.
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37. Controllable VarianceP3
Actual total overhead incurred – Budgeted total overhead
Actual total overhead $ 7,650
Applied total overhead (from flexible budget) ,500
Controllable variance (unfavorable) $
The controllable variance is the difference between actual overhead costs incurred and the budgeted overhead costs based on a flexible budget. The controllable variance is so named because it refers to activities usually under management control. Let’s examine the cost information on this slide. A company had actual total overhead costs of $7,650 but only applied $7,500 of overhead because this was the amount budgeted at that level of production for that month. The controllable variance is the difference of $150. This is considered an unfavorable variance because the actual costs were greater than the budgeted amount.
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38. Budgeted fixed overhead – Applied fixed overhead
Volume Variance P3
Budgeted fixed overhead – Applied fixed overhead
The same regardless of the volume of production
Based on the standard rate allowed for the actual volume of production, using the flexible budget.
The volume variance occurs when there is a difference between the actual volume of production and the standard volume of production. The budgeted fixed overhead amount is the same regardless of the volume of production (within the relevant range). The applied fixed overhead is based, however, on the standard rate allowed for the actual volume of production, using the flexible budget. When a company operates at a capacity different from what it expected, the volume variance will differ from zero. Let’s examine the cost information on this slide. At a certain level of production, 4,000 units, this company had budgeted $4,000 of fixed overhead. However, after applying $3,500 of overhead based on its actual level of production using the standard overhead rate, the company can compute its volume variance as equaling $500. This is considered an unfavorable variance because the company did not reach its predicted operating level.
Budgeted fixed overhead (standard rate at predicted capacity of 4000 units) $ 4,000
Applied fixed overhead (standard rate at actual volume of 3500 units) ,500
Volume variance (unfavorable) $
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39. Analyzing Overhead VariancesP3
Controllable Variance
Volume Variance
To help management isolate the reasons for a controllable variance, an overhead variance report can be prepared.
The report will reveal specific costs that were higher or lower than expected
The main purpose of the volume variance is to identify what portion of the total overhead variance is caused by failing to meet the expected production level.
A company needs to investigate favorable and unfavorable overhead variances. Management can help isolate the reasons for a controllable variance by preparing an overhead variance report. A complete overhead variance report provides managers information about specific overhead costs and how they differ from budgeted amounts. The volume variance means that the company did not meet the expected production level. They either produced more or less than planned. The reasons for not meeting expected production levels could be due to factors that are beyond employees’ control, for example, customer demands.
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40. Analyze Changes in Sales from Expected Amounts
Sales Volume Variance
The sales volume variance is caused by a difference in the actual sales in units vs. the budgeted sales in units.
Sales Price Variance
A sales price variance is caused by a difference between the budgeted sales price and the actual sales price.
In previous slides, we looked at how to compute and analyze various cost variances. A similar variance analysis can be applied to sales. Managers use sales variances for planning and control purposes. Sales variances can be separated out into the sales price variance and the sales volume variance. A sales price variance is caused by a difference between the budgeted sales price and the actual sales price. The sales volume variance is caused by a difference in the actual sales in units vs. the budgeted sales in units. Furthermore, when multiple products are involved, the sales volume variance can be separated into a sales mix variance and a sales quantity variance.
Let’s calculate these sales price and volume variances for an example company on the next two slides.
When multiple products are involved, the sales volume variance can be separated into a sales mix variance and a sales quantity variance.
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41. Sales Price Variance Formula:
A sales price variance is caused by a difference between the budgeted sales price and the actual sales price.
Budgeted Actual Sales of golf balls (units) ,000 units 1,100 units
Sales price per golf ball $10/ball $10.50/ball
Formula:
(Actual sales x Actual price) – (Actual sales x Budgeted price)
A sales price variance is caused by a difference between the budgeted sales price and the actual sales price. In this slide the actual selling price was greater than the budgeted selling price by .50/per unit. This caused a favorable sales price variance of $550.
(1,100 x $10.50) – (1,100 x $10.00) $11,550 – $11,000 = $550 Favorable variance
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42. Sales Volume Variance Formula:
The sales volume variance is caused by a difference in the actual sales in units vs. the budgeted sales in units.
Budgeted Actual Sales of golf balls (units) ,000 units 1,100 units
Sales price per golf ball $10/ball $10.50/ball
Formula:
The sales volume variance is caused by a difference in the actual sales in units vs. the budgeted sales in units. In this slide, we see that the company actually sold 100 more units than was previously budgeted, and this caused a $1,000 favorable sales volume variance. This company experienced favorable sales variances this month. Nevertheless, management will still want to study the sales variance information to maintain its avoidance of any variances that may prove unfavorable in future periods.
(Actual sales x Budgeted price) – (Budgeted sales x Budgeted price)
(1,100 x $10.00) – (1,000 x $10.00) $11,000 – $10,000 = $1,000 Favorable variance
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43. End of Chapter 21
You have now been exposed to some of the basic concepts and principles of managerial accounting in the form of flexible budgets and standard costing. These concepts will help us in other topics that are just ahead.
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