Overall Framework
Corporate Strategy
Decision Making (Unit 2)
Performance Evaluation (Unit 3)
-CVP
-Special Orders
-Make or Buy
-Capital Investments
-Budgets and other benchmarks
-Variance analysis
-Performance Measures and Control
Cost Accumulation Systems (Unit 1)
Organizational
Culture and Controls
Budgeting and Variance Analysis
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Terminology (today)
Standards (today)
Master Budgets (today)
Flexible Budgets (today and Thursday)
Variances (Thursday and beyond)
– Production Variances
– Sales Variances
Some Critical Terms
• Standards
– An expected, or planned, amount of something
• The standard price for a raw material is what we expect to pay
our suppliers per unit of the material
• The standard rate for direct labor is what we expect to pay our
workers on an hourly basis
• The standard machine time per unit is how long we expect
each part to take on a given machine
• The standard market share is the percent of the market that we
expect our products to capture
• We eventually “dollarize” most standards into an amount per
unit of our product
Some Critical Terms
• Master Budget
– An aggregate representation of the firm’s
expected activity over some future time period
• Calculated at one activity level (the most likely) for
sales and production
• Assumes all activity occurs at standard expectations
(selling, producing, capital spending, cash
collecting, etc.)
Some Critical Terms
• Flexible Budget
– Imagine a master budget set for production of
1,000 units.
– Imagine that actual production was 1,100 units
because of high demand
– Imagine comparing master budgeted materials
costs to actual materials costs
– Would the manager look good?
Some Critical Terms
• Flexible Budget
– The flexible budget adapts the master budget
based on actual activity levels (in sales and
production)
– The flexible budget depicts what the master
budget would have looked like had we
accurately estimated activity levels.
– The flexible budget is still based on standards
Some Critical Terms
• Variance Analysis
– The comparison of actual activity and resource
consumption to expected amounts
– VERY FEW such calculations are appropriately
done using master budget information
– ALMOST ALL such calculations are
appropriately done using FLEXIBLE budget
information
Determination of Standards
• Standards are (per unit) expected levels of
resource consumption
• “Ideal” standards assume 100% utilization
and perfect implementation
• “Currently attainable” standards set at
achievable work pace
– include breaks, “normal” mistakes
Sources of Standards
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Activity analysis
Historical data
Benchmarking
Market information
– quality expectations
– target costs
• Can be mandated or negotiated
Types of Standards
• Direct Materials
– Usage: units of RM per unit of product
– Price: cost of RM per unit of product
• Direct Labor
– Usage: labor hours per unit of product
– Rate: labor cost per unit of product
• Mix of materials inputs
• Mix of labor inputs
Types of Standards
• Variable Overhead
– Usage: Amount of VOH charged per unit of
product
– Rate: VOH PDOR
– Some VOH items, like electricity, may be more
traceable than others
• Budgeted Fixed Overhead
• Fixed Overhead PDOR
Types of Standards
• Standards also exist for the selling side of
the business
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Prices and volumes
Sales mix
Market share
Market size
Standard Cost Card
Resource
Quantity
Unit Cost
Direct Materials
X
4 lb
$25/lb
Y
1 lb
40/lb
Direct Labor
5 DLH
$40/hr
VOH
5 DLH
$12/DLH
FOH
5 DLH
$24/DLH
Subtotal
Total
Why Budget?
• Planning
– Helps identify resource requirements
• Coordinating
– Communication tool across company units
• Motivation
– Targets for performance
• Evaluation
– Compare actual to expected performance
Strategic Planning
External Scan
Internal Scan
Threats and
Opportunities
Strengths and
Weaknesses
Best
Opportunities
Strategy
Overall Budget Framework
Strategic Goals
Long Term Objectives
Long Term Plan
Capital Budget
Short Term Objectives
Master Budget
Operations
Internal Controls
Budget Process Timeline
Ongoing
Negotiations
June
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Year Being Budgeted
Nov
Jan
Guidelines from top management
Initial proposal: bottom or top?
Factors: volume changes, new products
Review, revise, review, approve (iterative)
Dec
Master Budget Framework
Strategic Objectives
(Short- and Long-Term
Cash
Collections
Capital
Budget
Sales Forecasts
Sales Budget
Production Budget
Direct
Labor
Direct
Mats.
Mfg.
OH
Administrative Budgets
Sales &
Mktg.
Cash Budget
Res. &
Dev.
Corp.
OH
Purposes of Specific Budgets
• Capital Budget
– Ensure funding for long-term projects
– Ensure capacity requirements met
• Production Budget
– Ensure demand and inventory goals met
• Materials
– Ensure required materials available
– Allow planning for purchasing contracts
Purposes of Specific Budgets
• Labor Budget
– Ensure labor capacity adequate
– Allow for informed choices among alternatives
(e.g., overtime versus new hires)
• Cash Budget
– Ensure enough cash for all activities
– Avoid emergency borrowing
– Plan investment of excess cash
Approaches to Budgeting
• Incremental
– Ratchet up (or down) from previous year
• Zero-based
– Budget as if current operation did not exist
• Activity-based
– Budget based on activity transactions
Approaches to Budgeting
• Unilateral
– Top management sets budget
• Top-Down
– Top management makes initial proposal,
negotiation occurs
• Bottom-Up
– Operations-level employees make initial
proposal, negotiation occurs
Budget Target Level
• Assume you are a worker and you can
comfortably complete 100 units per day. At
what level would you like your daily budget
to be set?
– 60
90
110
• Goal congruence
150
Budget Shenanigans
• Budgetary Slack
– Expect 100, budget for 125 (expenses)
– Expect 125, budget for 100 (sales)
• “Spending” the Budget
– Budget for 125, spend 110, 15 left
– Spend it or lose it (?)
Flexible Budgets
• Master Budget Process is “Static”
– One level of activity
– Can show how well firm is meeting production
goals
• Flexible budgets are “dynamic”
– “Flex” with level of activity
– Can help show how well the firm is controlling
its costs
Flexible Budget Preparation
• Determine relevant activity range
• Separate costs by behavior pattern
• Prepare Master Budget at expected activity level
• Prepare Flexible Budget at actual activity level
– What MB would have looked like had the expected
level been the actual level
Example Flexible Budget
• Master Budget at 8,000 units
Revenues
@ $21
$168,000
Materials
@ 1.6
12,800
Labor
@7
56,000
VOH
@ 3.15
25,200
@ 11.75
94,000
@ 9.25
$74,000
Total VC
CM
Example Flexible Budget
• What if we actually sell 7,000?
Actual Sales
Revenues @ $21
Materials @ 1.6
Labor @ 7
VOH @ 3.15
Total VC @ 11.75
CM @ 9.25
7,000
What About Fixed Costs?
• Not expected to change across activity
levels
• Reasons for inclusion:
– Overall performance evaluation
– Product costing
– Profit planning (must remember to cover FC)
• Use amount of allocation base at most likely
activity level to determine PDORs