1. Flexible Budgets and Variance Analysis

2. Management Cycle, Standard Costing and Variance Analysis
Use standard costs to prepare budgets and establish goals for product costing.
Use standard costs to account for operations and managers’ performance.
Calculate variances between standard and actual costs, determine their causes, identify inefficient operations, and take corrective action.
Use variances to evaluate managers’ performance.
Apply dollar, time, and
quantity standards to work.

3. Flexible budgets are based on standard costs.
A standard cost (predetermined cost) indicates what it should cost to provide an activity or produce one batch or unit of product under planned and efficient operating conditions.
Flexible budgets are based on standard costs.

4. Standard Costs
To determine the unit standard cost for a particular input, 2 decisions must be made:
The amount of input that should be used per unit of output (quantity standard)
The amount that should be placed for the quantity of the input to be used (pricing standard)
Unit Standard cost =
Quantity Standard x Price Standard

5. Standard Costs How standards are developed Types of standards
Historical experience
Engineering studies
Input from operating personnel
Types of standards
Ideal standards
Demand maximum efficiency and can be achieved only if everything operates perfectly
Currently attainable standards
Can be achieved under efficient operating conditions, with allowance for normal breakdowns, interruptions, etc.

6. Standard Costs Why standard cost systems are adopted
Planning and Control
Unit standards are a fundamental requirement for a flexible budgeting system
Budgetary control systems compare actual costs with budgeted costs by comparing variances
By developing unit price standards and quantity standards, an overall variance can be decomposed into a price variance/spending variance and a usage variance/efficiency variance

7. Standard Costs Why standard cost systems are adopted Product Costing
Comparison of costing systems

8. Standard Costs Advantages of standard costing
Greater capacity for control over product cost
Provide readily available unit cost information that can be used for pricing decisions
If a process costing system uses standard costing, there is no need to compute a unit cost for each equivalent unit of DM, DL and MOH

9. Standard Costs
Product cost (to illustrate use of standard cost in process costing):
Input Required Cost
Cost Inputs per ‘X’
Direct materials $2.00/lb $40.00
Direct labor $5.00/dlh
Fixed MOH $2.00/dmh
Variable MOH $3.00/dmh
Total unit cost $70.00

10. Standard Costs Example of DM standards calculation
Standard price of corn = $0.006 per ounce
Standard usage of per bag = 18 ounces
Standard cost per bag = $0.108
If the budgeted number of bags is 800 bags:
Standard quantity for 800 bags = 14,400 ounces
Standard cost for budgeted level of activity (a.k.a static budget)
= x 14,400 = $86.40
If the actual number of bags produced is 1,000 bags:
Standard quantity allowed for 1,000 bags = 18,000 ounces
Standard cost for actual level of activity (a.k.a flexible budget)
= x 18,000 = $108

11. Manufacturing Budget McMillan Company Manufacturing Budget
for the Month of July
Manufacturing costs:
Unit level:
Direct materials (10,000 x 2 pounds X $5) $100,000
Assembly (10,000 x 0.25 hours x $24) 60,000
Waterproofing and Inspection (10,000 x $8) 80,000
Batch level:
Setup (10 batches x $400) 4,000
Test run (10 batches x $100) 1,000
Product level 20,000
Facility level 32,000
Total $297,000

12. Continued on next slide
Static Budget
McMillan Company
Production Department Performance Report
for the Month of July
Original Static Budget
Actual Budget Variance
Volume , ,000
Unit level:
Direct materials $108,000 $100,000 $ 8,000 U
Assembly 70,000 60,000 10,000 U
Waterproofing and Inspection 81,000 80,000 1,000 U
Batch costs:
Setup 4,000
Test runs 1,000
Continued on next slide

13. Static Budget Original Static Budget Volume 11,000 10,000 Batch costs:
McMillan Company
Production Department Performance Report
for the Month of July
Original Static Budget
Actual Budget Variance
Volume , ,000
Batch costs:
Total 5, , U
Fixed overhead:
Product 22,000 20,000 2,000 U
Facility 31, , ,000 F
Totals $317,600 $297,000 $20,600 U

14. Continued on next slide
Flexible Budget
McMillan Company
Production Department Performance Report
for the Month of July
Flexible Flexible Budget
Actual Budget Variance
Volume , ,000
Unit level:
Direct materials $108,000 $110,000 $ 2,000 F
Assembly 70,000 66,000 4,000 U
Waterproofing and Inspection 81,000 88,000 7,000 F
Batch costs:
Setup 4,400
Test runs 1,100
Continued on next slide

15. Flexible Budget Flexible Flexible Budget Volume 11,000 11,000
McMillan Company
Production Department Performance Report
for the Month of July
Flexible Flexible Budget
Actual Budget Variance
Volume , ,000
Batch costs:
Total 5, , U
Fixed overhead*:
Product 22,000 20,000 2,000 U
Facility 31, , ,000 F
Totals $317,600 $321,500 $3,900 F
* For fixed overheads, there is no difference between static budget and flexible budget because fixed overheads do not vary with output.

21. Variance Analysis
A flexible budget can be used to identify the costs that should have been incurred for the actual level of activity.
Flexible budget is tailored after the fact to actual production levels.
Flexible budget variance =
Actual costs – Flexible budget cost

22. Variance Analysis Flexible budget variance
= Actual costs – Flexible budget cost
Dichotomizing flexible budget variance
Total flexible budget variance
= (AP x AQ) – (SP x SQ)
= (AP x AQ) – (SP x AQ) + (SP x AQ) – (SQ x SP)
= (AP – SP)AQ + (AQ – SQ)SP
= Price Variance + Efficiency variance

23. Variance Analysis Variance analysis
Identifies the general causes for the total flexible budget variance by breaking it down into separate price and quantity variances for each production resource
2 possible reasons why actual cost may differ from flexible budget cost for a given amount of output produced:
Difference between actual price and standard price
Difference between actual quantity and standard quantity

24. Variance Analysis Unfavorable and favorable variances
Unfavorable variances occur whenever the actual prices or usage of inputs are greater than standard prices or usages (variances are + ve)
AP > SP, AQ > SQ
Favorable variances occur whenever the actual prices or usage of inputs are less than standard prices or usages (variances are – ve)
AP < SP, AQ < SQ
Favorable and unfavorable variances are not equivalent to good or bad variances. Must investigate underlying reasons for variances.

25. Variance Analysis
Why separate total variances into price and quantity variances?
Separate variances that are subjected to a manager’s direct influence from those that are not
Excessive focus on variances can lead to dysfunctional behavior
Decision to investigate
Rarely will actual performance exactly meet established standards

26. Variance Analysis
Management should develop an acceptable range of performance.
When variances are within this range, they are assumed to be caused by random factors.
When variances are outside this range, they are assumed to be caused by nonrandom factors and these variances should be investigated.
Controllable: Corrective actions/Affirmative actions
Uncontrollable: Revise standards
Management should also consider costs and benefits of investigating variances.

27. Input at Standard Price Input at Standard Price
Variance Analysis: DM
Actual Quantity of
Input at Actual Price
AQ x AP
Actual Quantity of
Input at Standard Price
AQ x SP
Standard Quantity of
Input at Standard Price
SQ x SP
Price
Variance
AQ x (AP - SP)
Usage
Variance
SP x (AQ - SQ)
Budget
Variance
(AQ x AP) - (SQ x SP)

28. Variance Analysis: DM Possible causes for DM Price Variance
Inaccurate or outdated price standards
Quality of DM
Quantity discounts
Market price fluctuations
Possible causes for DM Usage Variance
Inaccurate or outdated usage standards
Level of scrap, waste or rework

29. Variance Analysis: DL Actual Hours of Input at Actual Rate AH x AR
Input at Standard Rate
AH x SR
Standard Hours of
Input at Standard Rate
SH x SR
Labor Rate
Variance
AH x (AR - SR)
Labor Efficiency
Variance
SR x (AH - SH)
Budget
Variance
(AH x AR) - (SH x SR)

30. Variance Analysis: DL Possible causes for DL Rate Variance
Inaccurate or outdated labor rate standards
Increase or decrease in the pay of workers
Use of highly or lowly skilled workers in the production
Possible causes for DL Efficiency Variance
Inaccurate or outdated quantity standards
Training of employees
Quality of machinery
Quality of materials
Level of supervision

31. Variance Analysis: VMOH
Actual Hours of Input x
Actual Variable OH Rate
AH x AVOH rate
Actual Hours of Input x
Std Variable OH Rate
AH x SVOH rate
Std Hours of Input x
Std Variable OH Rate
SH x SVOH rate
Spending
Variance
AH x (AVOR – SVOR)
Efficiency
Variance
SVOR x (AH - SH)
Total Variance
(AVOR x AH) – (SVOR x SH)

32. Variance Analysis: VMOH
Possible causes for VMOH Spending Variance
Inaccurate or outdated VMOH rate standards
Changes in the price of the variable overhead items Efficiency in the use (in terms of quantity) of the variable overhead items
Possible causes for VMOH Efficiency Variance
Inaccurate or outdated quantity standards for allocation base
Efficiency in the use of the cost allocation base
If the cost allocation base is direct labor hours, the reasons for direct labor efficiency variance will be the reason for VMOH efficiency variance

33. Variance Analysis: FMOH
Impt: Note that budgeted hours is used instead of actual hours because FMOH does not vary with the number of units
Actual Fixed OH
AH x AFOR rate
Budgeted Fixed OH
BH x SFOR
Applied Fixed OH
SH x SFOR for
actual work done
Spending Variance
Volume Variance
Total Variance
[Note: Variance formulas for DM, DL and VMOH are not applicable for computing spending variance and volume variance of FMOH]

34. Variance Analysis: FMOH
Spending variance = Actual FMOH cost – Static FMOH budget
[Note: Spending variance = Flexible budget variance = Static budget variance]
Volume variance = Static FMOH budget – “Flexible” FMOH budget
“Flexible” FMOH budget =
Static FMOH budget +
Static FMOH budget x % change in number of units sold
In fact, the volume variance is just (negative of) Static FMOH budget x % change in number of units sold

35. Variance Analysis: FMOH
Possible causes for FMOH Spending Variance
Inaccurate or outdated budgets for FMOH
Changes in the price and quantity of the FMOH items
Note: Many FMOH items are not subject to change in the short run, consequently fixed overhead costs are often beyond the immediate control of management
Cause for FMOH Volume Variance
Changes in the level of output

36. Variance Analysis: TR Actual Price x Actual Volume AP x AQ
Budgeted Price x
Actual Volume
BP x AQ
Budgeted Price x
Budgeted Volume
BP x BQ
Sales Price
Variance
AQ x (AP - BP)
Sales Volume
Variance
BP x (AQ - BQ)
Revenue
Variance
(AP x AQ) - (BP x BQ)

37. Variance Analysis: TR Flexible budget variance
= Actual revenue – Flexible budget revenue
Example
FAS budget 2001 ticket sales at $70,000 per home game, which represent the sale of an estimated 10,000 tickets at a selling price of $7. In July’s first game, actual gate ticket revenue was $66,000, creating a total unfavorable revenue variance of $4,000. The actual sales consisted of 12,000 tickets at $5.50.

38. Variance Analysis: TR Actual Price x Actual Volume 12,000 x 5.50
Budgeted Price x
Actual Volume
7 x 12,000
Budgeted Price x
Budgeted Volume
7 x 10,000
Sales Price
Variance
12,000 x ( )
18,000U
Sales Volume
Variance
7 x (12,000 – 10,000)
14,000F
Revenue
Variance
(66,000) - (70,000)
4,000U

39. Variance Analysis: TR Possible causes for TR Price Variance
Inaccurate or outdated price standards
Changes in the market price of the product
Possible causes for TR Volume Variance
Inaccurate or outdated quantity standards
Changes in the level of demand for the product
Note: For TR variance only, variance favorable if AP > SP, AQ > SQ
(In contrast with cost variances)

40. Summary of Variance Analysis
Variance analysis in general
Deviation of an actual amount from the expected (standard) or budgeted amount.
“Unfavorable” or “Favorable” means nothing
Provide clues to the causes of performance i.e. attention directors, not problem solvers
Requires a drill down into the organization to have a better understanding of the variances

41. Summary of Variance Analysis
Benefits of variance analysis
Useful for control purposes. For example, when the figures in the master budgets are not achieved, investigations and appropriate actions can be undertaken.
Communicates information to management.
Highlights possible organizational difficulties – management cannot fix what they do not know about.
Affects the actions of organization management.

42. Summary of Variance Analysis
Trade-Offs Among Variances
As the operations of organizations are linked, the level of performance in one area of operations will affect performance in another.
Improvements in one area could lead to improvements in others and vice versa.
Substandard performance in one area may be balanced by superior performance in others.