Chapter 7:
Flexible Budgets, Variances, and
Management Control: I
The use of Planning for Control
1
Basic Concepts



Variance – difference between an actual and an expected
(budgeted) amount
Management by Exception – the practice of focusing attention
on areas not operating as expected (budgeted)
Static budget – a budget prepared for only one level of activity

It is based on the level of output planned at the start of the budget
period.
 The master budget is an example of a static budget.

Flexible budget – revenues or costs considered justified by the
actual output level of the budget period

A key difference between a flexible budget and a static budget is
the use of the actual output level in the flexible budget.
 In general, flexible budgets can also be conditioned on actual
levels of other external influences
 serve to implement responsibility accounting
2
Basic Concepts



Static-Budget Variance (Level 0) – 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
3
Variances

Variances may start out “at the top” with a Level 0
variance



the difference between actual and static-budget operating
income
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?”
4
A Simple Example

Operating Indicators:
Indicator
Actual
Results
Units Sold
Selling Price
Static
Budget
100
90
$
35 $
30
Direct Material Cost per Unit
$
Direct Labor Cost per Unit
$
Variable Manufacturing Overhead per Unit $
7 $
10 $
5 $
6
10
6
600 $
700
Fixed Costs
$
5
A Simple Example
Actual Results
Units Sold
100
Static-Budget
Variances
Static Budget
10 F
90
Revenues
$
Variable Costs:
Direct Materials
Direct Labor
Variable Factory Overhead
3,500 $
800 F
700
1,000
500
160 U
100 U
(40) F
540
900
540
Contribution Margin
1,300
580 F
720
600
(100) F
700
700 $
680 F
Fixed Costs
Operating Income
$
$
$
2,700
Level 1
Analysis
Level 0
Analysis
20
6
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 Levels 2 and 3 variances

Answers the question: “Why were we off?”
7
A Flexible-Budget Example
Flexible-Budget
Variances
Actual Results
Units Sold
100
-
N/A
Revenues
$
Variable Costs:
Direct Materials
Direct Labor
Variable Factory Overhead
3,500 $
500 F
700
1,000
500
100 U
N/A
(100) F
Contribution Margin
1,300
Fixed Costs
Operating Income
Level 3
Variances will
explore these
figures in detail
$
Sales-Volume
Variances
Flexible Budget
100
$
Static Budget
10 F
90
3,000 $
300 F
600
1,000
600
60 U
100 U
60 U
540
900
540
500 F
800
80 F
720
600
(100) F
700
-
700
700 $
600 F
100 $
80 F
$
Level 2 Variances:
Flexible-Budget
$
2,700
N/A
$
20
Level 2 Variances:
Sales-Volume
Level 1 Variance:
Static-Budget
8
Level 2 analysis

provides information on the two components of the
static-budget variance.
1 Flexible-budget variance:
(Actual – budgeted contribution margin/unit)
× actual sales mix
× actual units sold
2
Sales-volume variance:
(Actual units sold × actual sales mix
– budgeted units sold × budgeted sales mix) ×
× budgeted contribution margin/unit
9
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
Both Direct Materials and Direct Labor have both Price and
Efficiency Variances, and their formulae are the same
Price
Variance
Efficiency
Variance
=
=
{
{
Actual Price
Of Input
Actual Quantity
Of Input Used
-
-
Budgeted Price
Of Input
} 
Budgeted Quantity of Input
Allowed for Actual Output
Actual Quantity
Of Input
}
Budgeted Price
Of Input
10
Remark
The above split-up has been derived by introducing the flexible budget
between static budget and actual values:
160 Flex. Budg. Variance F
155
static budget variance (level 1)
= budgeted # of units * budgeted $ per unit
– actual # of units * budgeted $ per unit
+ actual # of units * budgeted $ per unit
– actual # of units * actual $ per unit
10
Sales volume
variance U

Flexible budget variance
Sales volume variance
Formally, a similar split-up could have been derived by developing a
„flexible budget 2“ as follows
160
Flex. Budg. Variance F
static budget variance (level 1)
155
= budgeted # of units * budgeted $ per unit
– budgeted # of units * actual $ per unit
+ budgeted # of units * actual $ per unit
– actual # of units * actual $ per unit
Sales volume
variance U

13
10
13
11
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
12
Sources of Information

1.
Main sources of information about budgeted input
prices and budgeted input quantities:
Actual input data from past periods

2.
averages adapted according to expected inflation and/or cost
reductions due to improvement actions
Standards developed

A standard input is a carefully predetermined quantity of
inputs (such as pounds of materials or manufacturing laborhours) required for one unit of output.
 A standard cost is a carefully predetermined cost that is
based on a norm of efficiency.
 Standard costs can relate to units of inputs or units of outputs
Standard input
allowed for
one output unit
×
Standard cost
per input unit
13
Cost budgeting, procedure...
• Choose normal capacity xP
• Determine static budget (master budget) KP at normal capacity
• determine budgeted “fixed” cost
• flexible budget as a linear
approximation of the cost
function which is non-linear
in general
KP
K(x), x near xP
KF
xP
x
14
Cost absorption
• charge rate = tg a = KP /xP,
contains costs of used part
of capacity
KP
K(x), x near xP
KF
a
xP
x
15
Standard Costing



Budgeted amounts and rates are actually booked
into the accounting system
These budgeted amounts contrast with actual
activity and give rise to Variance accounts
Reasons for implementation:


Improved software systems
Wide usefulness of variance information
16
Management Uses of Variances



To understand underlying causes of variances
Recognition of inter-relatedness of variances
Performance Measurement

Managers ability to be Effective
 Managers ability to be Efficient



Effectiveness is the degree to which a predetermined objective
or target is met.
Efficiency is the relative amount of inputs used to achieve a
given level of output.
Performance evaluation should not be based on Variances
alone


If any single performance measure, such as a labor efficiency
variance, receives excessive emphasis, managers tend to make
decisions that maximize their own reported performance in terms
of that single performance measure
“what you measure is what you get”.
17
Efficiency Variance, graphical
• Determine actual usage xA
• the cost budget consists of
- the cost of idle capacity
- the absorbed cost
KP
• determine actual cost
at budgeted prices and
charge rates
underabsorbed
KF
• excess of actual cost over
budget:
Efficiency variance
a
xA
xP
x
18
Cost budgeting and control, Formulas

Flexible budget:
KS(x)
KF +
=
= KP –
absorbed cost:
A
x
KP· P
x

cost of idle capacity:
KF·(1

efficiency variance:
KA – KS(xA)

A
x
– P
x
(KP–
KF)
KP– KF
xP
x
xP
( xP – x)
)
19
Possible Causes of unfavorable Efficiency
Variances




Purchasing manager received lower quality of
materials.
Personnel manager hired underskilled workers
Maintenance department did not properly maintain
machines.
Poor organization of production process



Shortage of material due to untimely delivery
Patterns or models missing
Fluctuations in motivation or working conditions...
20
Flexible-budget variance for direct materials
= Materials-price
variance
42,500 × ($15.95 – $16.25)
Input price
= $12,750 F
Price variance F
Efficiency variance U
+ Materials-efficiency
variance
$16.25
15.95
(42,500 – 40,000) × $16.25
= $40,625 U
$27,875 U
40
42.5
Quantity
of input
÷ 1000
21
Flexible-budget variance for direct
manufacturing labor?
= Labor-price variance
21,500 × ($12.90 – $13.00)
= $2,150 F
Input price
Price variance F
$13
12.90
Efficiency variance U
+ Labor- efficiency
variance
(21,500 – 20,000) × $13.00
= $19,500 U
$17,350 U
20
21.5
Quantity
of input
÷ 1000
22
Separating price and quantity components
Budget = budgeted price  budgeted quantity
Price variance = (actual price - budgeted price) 
actual quantity
Quantity variance = Budgeted price
(actual quantity - budgeted quantity)
2nd order
variance
pA
pP
Price variance
Budget
Quantity
variance
A standard cost center in a
production factory usually
has no discretion on purchasing.
Then its budget should be
independent of price fluctuation
xP
xA
23
Activity-Based Costing and Variances

ABC easily lends itself to budgeting and variance
analysis
 Budgeting is not conducted on the departmentalwide basis (or other macro approaches)
 Instead, budgets are built from the bottom-up with
activities serving as the building blocks of the
process
24
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
25
Possible Causes of unfavorable Efficiency
Variances




Purchasing manager received lower quality of
materials.
Personnel manager hired underskilled workers
Maintenance department did not properly maintain
machines.
Poor organization of production process



Shortage of material due to untimely delivery
Patterns or models missing
Fluctuations in motivation or working conditions...
26
Multiple Causes of Variances





Often the causes of variances are interrelated.
A favorable price variance might be due to lower
quality materials.
It is best to always consider possible
interdependencies among variances and to not
interpret variances in isolation of each other...
Almost all organizations use a combination of
financial and nonfinancial performance measures
rather than relying exclusively on either type.
Control may be exercised by observation of workers.
27
Quiz
60000  15000  10000
 5100  5000  700
5000
1. Flexible budgets
a.
accommodate changes in the inflation rate.
b.
accommodate changes in activity levels.
c.
are used to evaluate capacity utilization.
d.
are static budgets that have been revised for changes in prices.
2. The following information is available for the Gabriel Products Company for the month of July:
Units
Sales revenue
Variable manufacturing costs
Fixed manufacturing costs
Variable marketing and administrative expense
Fixed marketing and administrative expense
Static Budget
5,000
$60,000
$15,000
$18,000
$10,000
$12,000
Actual
5,100
$58,650
$16,320
$17,000
$10,500
$11,000
The total sales-volume variance of operating income for the month of July would be
a. $2,550 unfavorable. b. $1,350 unfavorable. c. $700 favorable. d. $100 favorable.
28
30970 
3.
Bartholomew Corporation’s master budget calls for the production of 6,000 units
of product monthly. The master budget includes indirect labor of $396,000
annually; Bartholomew considers indirect labor to be a variable cost. During the
month of September, 5,600 units of product were produced, and indirect labor
costs of $30,970 were incurred. A performance report utilizing flexible budgeting
would report a flexible budget variance for indirect labor of
a. $170 U.
4.
396000
 5600  170U
12  6000
b. $170 F.
c. $2,030 U.
d. $2,030 F.
Which of the following is not an advantage for using standard costs for variance
analysis?
a.
Standards simplify product costing.
b.
Standards are developed using past costs and are available at a relatively
low cost.
c.
Standards are usually expressed on a per unit basis.
d.
Standards can take into account expected changes planned to occur in the
budgeted period.
29
1500 

 2.75 
  2000  5400
30000 

5. Information on Pruitt Company’s direct-material costs for the month
of July 2005 was as follows:
Actual quantity purchased
Actual unit purchase price
Materials purchase-price variance
—unfavorable (based on purchases)
Standard quantity allowed for actual production
Actual quantity used
30,000 units
$2.75
$1,500
24,000 units
22,000 units
For July 2005 there was a favorable direct-materials efficiency variance
of
a. $7,950. b. $5,500. c. $5,400.
d. $5,600.
30
 3200
 241500



  34500  20700
 34500 34500  35000 
6. Information for Garner Company’s direct-labor costs for the month of
September 2005 is as follows:
Actual direct-labor hours
Standard direct-labor hours
Total direct-labor payroll
Direct-labor efficiency variance—favorable
34,500 hours
35,000 hours
$241,500
$ 3,200
What is Garner’s direct-labor price (or rate) variance?
a. $21,000 F b. $21,000 U c. $17,250 U d. $20,700 U
31
Problems

7-17 (=11)(5%),
 7-23 (=11.7-21)(8%),
 7-21 (7%),
 7-37 (=11)(8%),
 7-39 (6%)
 7-41 (6%) to be presented using Excel®
 7-43 (=11.7-41)(8%)
32
7-17
Actual
costs
Static
budget
Variance
Direct materials
$364 000 $400 000 $36 000 F
Direct manufact. labor
78 000
80 000
2,000 F
Direct distribution labor
110 000
120 000 10 000 F

Budgeted
resource
prices per
case
$40
8
12
Actual output: 8 800 cases
Revised performance report based on a flexible budget?
33
7-23






Budgeted sales: 7.8 million minutes
Actual sales:
7.5 million
10% more minutes have to be purchased than are
sold
Budgeted price: 4.5 cents per minute purchased
Actual average: 5.0 cents
Direct labor:
1 hr. per 5000 minutes sold


Actual usage 1 600 hrs.

1.
2.
Budgeted wage rate: $60 per hr.
Actual average price: $62 per hr.
Flexible budget variance for direct materials and
direct labor?
Price and efficiency variances
34
7-21




1.
2.
3.
Budgeted production: 60 000 scones
Budgeted purchases of pumpkin: 15 000 lb. @$0.89
Actual usage: 16 000 lbs @$0.82
Actual output: 60 800 scones.
Flexible budget variance?
Price and efficiency variances?
Comment on results.
35
7-37

Standard direct costs per board:



Data for July:







1.
2.
3.
4.
20 lbs of directs materials @ $2
5 hrs. of direct manuf. Labor @ $12
Units completed
Direct material purchases
Cost of DM purchases
Actual direct manuf. Labor
Actual direct labor cost
Direct materials efficiency variance:
No beginning inventories
6 000
150 000 lbs
$292 500
32 000 hrs
$368 000
$ 12 500 U
Direct manufacturing labor variances July?
Direct material quantity usedin July?
Actual price per lb. purchased?
Direct materials price variance
36
7-39

Direct material



Direct manufacturing labor:





Production volume: 10000 cases
Labor cost: $78 000 for 6 500 hrs.
Materail consumed: 71 000 lbs @ $1.80/lb.
For direct materials and direct nabufacturing labor:

2.
Standard price: $14 /hr.
Standard quantity ½ hr./case
Actual data of May:

1.
standard price $2/lb.
Standard quantity: 6 lb/case of product
price variance, efficiency variance
Discussion of responsibility for variances
37
7-41
Variable Cos
Per Unit Variable Costs
Direct materials
Direct manufacturing labor
Other variable costs
S tandard
2,2 lbs at $5,70 per lb
0,5 hrs at
$12 per hr
First-Quarter 2007
Resul
$12,54 2,3 lbs at
$6,00 0,52 hrs at
$10,00
$28,54
38
7-43
Static Budget Actual amounts
Units produced and sold
Batch size (units/batch)
Cleaning hrs / batch
Cleaning labor cost / hr
1.
2.
30 000
250
3
$14
22 500
225
3.5
$12.50
Flexible Budget variance
Price and efficiency variances for total cleanung
labor cost. Comment!
39