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Chapter 8
Flexible Budgets and Variance Analysis
LEARNING OBJECTIVES:
When your students have finished studying this chapter, they should be able to:
1. Identify variances and label them favorable or unfavorable.
2. Distinguish between flexible budgets and static budgets.
3. Use flexible-budget formulas to construct a flexible budget.
4. Compute and interpret static-budget variances, flexible-budget variances and sales
activity budgets.
5. Understand how the setting of standards affects the computation and interpretation of
variances.
https://www.sodocs.net/doc/ca14984709.html,pute and interpret price and quantity variances for materials and labor.
https://www.sodocs.net/doc/ca14984709.html,pute variable overhead spending and efficiency variances.
8. Compute the fixed-overhead spending variance.
CHAPTER 8: ASSIGNMENTS
CRITICAL THINKING EXERCISES
19. Interpretation of Favorable and Unfavorable Variances
20.Marketing Responsibility for Sales-Activity Variances
21.Production Responsibility for Flexible-Budget Variances
22.Responsibility of Purchasing Manager
23.Variable Overhead Efficiency Variance
EXERCISES
24.Flexible Budget
25.Basic Flexible Budget
26.Flexible Budget
27.Basic Flexible Budget
28.Activity-Level Variances
29.Direct-Material Variances
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31.Quantity Variances
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33.Material and Labor Variances
PROBLEMS
34.National Park Service
35.Flexible and Static Budgets
36.Summary Explanation
37.Explanation of Variance in Income
38.Activity and Flexible-Budget Variances at KFC
39.Summary of Airline Performance
40.Hospital Costs and Explanation of Variances
41.Flexible Budgeting
42.Activity-Based Flexible Budget
43.Straightforward Variance Analysis
44.Variance Analysis
45.Similarity of Direct-Labor and Variable-Overhead Variances
46.Material, Labor, and Overhead Variances
47.Automation and Direct Labor as Overhead
48.Standard Material Allowances
49.Role of Defective Units and Nonproductive Time in Setting Standards
50.Review of Major Points in This Chapter
51.Review Problem on Standards and Flexible Budgets; Answers Are
Provided
CASES
52.Activity and Flexible-Budget Variances—Hospital
53.Activity-Based Costing and Flexible Budgeting
54.Analyzing Performance
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56.Nike 10k Problem: Performance Standards EXCEL APPLICATION EXERCISE
57. Flexible-Budget and Sales-Activity Variances COLLABORATIVE LEARNING EXERCISE
58. Setting Standards
INTERNET EXERCISE
59. Flexible Budgets at Hershey Food Corporation
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CHAPTER 8: OUTLINE
I. Using Budgets to Evaluate Actual Results {L. O. 1}
A. Favorable and Unfavorable Variances
Favorable Cost Variance—actual costs are less than budgeted costs.
Favorable (F) versus Unfavorable (U) Variances
Profits Revenues Costs
Actual > Expected F F U
Actual < Expected U U F
Unfavorable Cost Variance—actual costs exceed budgeted costs.
Static Budget Variances (i.e., variances from master budget amounts) may not
be very useful in helping management assess whether costs are being controlled
adequately when the actual activity level differs considerably from the static
budget activity level.
B. Static Budgets Versus Flexible Budgets {L. 0. 2}
All the master budgets discussed in Chapter 7 are static or inflexible, because
even though they may be easily revised, the accepted budgets assume fixed levels
of future activity. A static budget is prepared for only one level of activity (for
example, volume of sales activity). Differences between actual results and the
static budget are static-budget variances.
Actual results could be compared with the original plan, even though a different
activity level was reached than was used in constructing the static budget. See
EXHIBIT 8-1 for an illustration of this in the performance report. A
performance report is a generic term that usually means a comparison of actual
results with some budget. Variances shown on the performance report direct
management’s attention to significant deviations from expected results, allowing
management by exception.
Flexible Budget (or Variable Budget)—a budget that adjusts for changes in sales
volume and other cost-driver activities. It is identical to the static budget in format,
but it can be prepared for any levels of activity. For performance evaluation, the
flexible budget would be prepared for the actual levels of activity achieved.
Differences between actual results and a flexible budget are flexible-budget
variances. In contrast, the static budget is kept fixed at only the originally planned levels of activity.
C. Limitations of Static-Budget Variances
D. Flexible-Budget Formulas {L. O. 3}
The cost functions or formulas that were discussed in Chapters 2 and 3 are used in constructing flexible budgets within the relevant range of activity. See EXHIBIT 8-2for an illustration of the use of a budget formula for the Dominion Company to create budgets for 7,000, 8,000, and 9,000 units of sales.
The fixed costs/expenses are the same, in total, at each volume level. The variable costs/expenses increase by the budgeted amount for each unit increase in the activity level. Cost drivers other than units sold or produced must be considered in creating flexible budgets. See EXHIBIT 8-3 for a graph of flexible budget of costs.
E. Activity-Based Flexible Budgets
Organizations are increasingly adopting activity-based costing (ABC) systems that have multiple cost drivers. Activity-Based Flexible Budget—based on budgeted costs for each activity center and related cost driver. ABC systems focus on activities as the primary cost objects. Costs of activity centers are then assigned to final cost objects such as products or customer classes using cost drivers.
Companies that use ABC systems develop a flexible budget for each activity center. See EXHIBIT 8-4for an illustration of Dominion Company’s activity-based flexible budget.
F. Static-Budget Variance and Flexible-budget Variances
{L. O. 4}
There are two types of reasons why actual performance might not have conformed to the master budget. First, sales and cost-driver activity may be different than that forecasted (Activity-Level Variances). Second, revenues or variable costs per unit of activity and fixed costs per period may not be as expected (Flexible-Budget Variances). See EXHIBIT 8-6 for an illustration of these two types of variances. The sum of the flexible-budget variances and the activity-level variances is the master budget variance.
II. Revenue and Cost Variances {L. O. 5}
Managers use comparisons between actual results, master budgets, and flexible budgets to evaluate organizational performance. In evaluating performance, it is useful to distinguish Effectiveness (i.e., the degree to which a goal, objective, or target is met) and Efficiency (i.e., the degree to which inputs are used in relation to a given level of outputs).
Effectiveness may be measured by determining whether the master budget goal has been met. Efficiency can be measured by comparing actual results to the flexible budget.
A. Sales-Activity Variances
These variances measure how effective managers have been in meeting the
planned level of sales. The final three columns in EXHIBIT 8-6 for Dominion
Company show the sales-activity variances. All unit prices and variable costs are
held constant in constructing the master budget and the flexible budget. The
differences between the amounts are due to the level of sales activity. The
sales-activity variance indicates to managers the effect of not selling the budgeted
sales level. Marketing managers are typically in the best position to explain why
actual sales activities differed from plans.
B. Flexible-Budget Variances
Flexible-budget variances measure the efficiency of operations at the actual level
of activity. The differences between columns 1 and 3 in EXHIBIT 8-6for
Dominion Company are flexible-budget variances. The total flexible-budget
variance is the difference between the actual income achieved and the flexible
budget income for the achieved activity level. The total flexible-budget variance
arises from sales prices received, and the variable and fixed costs incurred.
Flexible-budget variances may serve as the basis for periodic performance
evaluation. Operations managers are in the best position to explain these
variances. The variances should not be used to fix blame. Managers being
evaluated may resort to cheating to beat the system.
See EXHIBIT 8-7 for an expanded, line-by-line computation of flexible-budget
variances for Dominion Company. The variances should be interpreted as
signals that actual operations have not occurred exactly as anticipated when the
flexible-budget formulas were set, rather than as being good or bad. Any cost
differing significantly (materially) from the flexible budget must be explained.
A. Setting Standards
Expected Cost—the cost that is most likely to be attained. Standard Cost—a
carefully developed cost per unit that should be obtained. Standard Cost Systems—value products according to only standard costs and are used for inventory valuation purposes. For planning and control purposes, expected future costs and expected future activity levels are used to set budgets and prepare performance reports. The standard costs from the standard cost system are not necessarily used because they may differ from the expected future costs.
Companies use different cost systems for inventory valuation, product costing for decision-making, and for performance evaluation.
What standard of expected performance should be used? Perfection Standards (or Ideal Standards)—expressions of the most efficient performance possible under the best conceivable conditions, using existing specifications and equipment. No provision is made for spoilage, waste, machine breakdowns, and so on. These standards are not frequently used because of the adverse effect on employee motivation resulting from their use. The unfavorable variances resulting from the use of these standards indicate the improvement that is possible through continuous improvement efforts.
Currently Attainable Standards—levels of performance that can be achieved by realistic levels of effort. They are set just tightly enough so that employees regard their attainment as highly probable if normal diligence and effort are exercised.
These standards allow for normal defectives, waste, spoilage, and nonproductive time. Variances from these standards should be random and negligible.
Another interpretation is that they are set tightly and employees regard their fulfillment as possible, though unlikely. They can only be achieved under very efficient operations. With this interpretation, variances tend to be unfavorable while employees view them as being tough but reasonable goals. Advantages are that they can be used for financial budgeting, inventory valuation, and departmental performance evaluation. They also have a desirable motivational impact on employees.
D. Trade-offs Among Variances
Because the operations of organizations are linked, the level of performance in one area of operations will affect performance in other areas. Paying higher than standard costs for materials results in an unfavorable materials price variance.
However, if the higher price is due to a better-than-standard quality of material being purchased, less scrap and rework than normal may be possible, resulting in
a favorable materials usage variance. The labels ―favorable‖ and ―unfavorable‖
are attention directors, not problem solvers. Faulty expectations may be the cause of variances rather than the execution of plans by managers. The validity of expectations must be questioned whenever variances exist.
E. When to Investigate Variances
If the variance is a result of random fluctuations, investigation is not needed.
Managers expect a range of ―normal‖ variances: this range may be based on
economic (how large a dollar amount) or statistical (number of standard
deviations from the expected mean) criteria. A typical investigation rule of thumb
is to investigate all variances exceeding a certain dollar amount or percentage of
expected cost, whichever is lower. The goal is to investigate those variances for
which corrective action creates savings larger than the cost of investigation (i.e.,
benefits are greater than the costs).
F. Comparisons with Prior Period’s Results
Some organizations compare the most recent budget period’s actual results with
last year’s results for the same period or last month’s results rather than use the
flexible budget’s benchmarks. Unless the activities undertaken in the current
period are nearly the same as those for the year ago period or prior month, this
comparison does not reveal much meaningful information.
III. Analysis of Flexible-Budget Variances in Detail {L. O. 6} Materials, labor, and overhead variances may be subdivided into price, usage, and spending components. If direct-labor costs are small in relation to total costs, they may be treated as overhead. Therefore, separate labor variances are not computed.
A. Variances from Material and Labor Standards
Variances from material and labor standards are found by comparing the flexible
budget at the actual output level with the actual costs for these items. The
flexible-budget amounts are those that would have been spent for the actual
output with expected efficiency. They are often labeled total standard costs
allowed, computed as follows:
flexible budget or = units of good output achieved
standard costs x input allowed per unit of output
allowed x standard unit price of input
B. Price and Quantity Variances
Flexible-budget variances measure the relative efficiency of achieving the actual
output. The price and usage variances subdivide the flexible-budget variance.
Price Variance—the difference between actual input prices and standard input
prices multiplied by the actual quantity of inputs used. Quantity Variance—the difference between the quantity of inputs actually used and the quantity of inputs that should have been used to achieve the actual quantity of output. Rate Variance—the difference between actual labor rates and standard labor rates multiplied by the actual quantity of labor used.
The variances should be separated into those that are subject to a manager’s direct influence and those that are not. Prices are typically less controllable than usage factors. The variances, once computed, should be used to raise questions, provide clues, and direct attention rather than to explain why budgeted operating income was not achieved. The effects of trade-offs between prices and usage should be analyzed. Was the purchase of substandard, lower-price materials a good idea?
The objective is to hold either price or usage constant so that the effect of the other can be isolated (see EXHIBITS 8-9 and 8-10).
Direct-Material Price Variance =
(actual price – standard price) x actual quantity
Direct-Labor Price (Rate) Variance =
(actual price – standard price) x actual quantity
Direct-Materials Quantity Variance =
(actual quantity used – standard quantity) x standard price
Direct-Labor Quantity (Efficiency or Usage) Variance =
(actual quantity used – standard quantity) x standard price
C.Summary of Materials and Labor Variances
Exhibit 8-10 presents the analysis of direct material and direct labor in a format that deserves close study.
D. Interpretation of Price and Quantity Variances
If the actual price is less than standard or the actual quantity used is less than the standard quantity allowed, the variance is favorable. The opposite relationships imply unfavorable variances. See EXHIBIT 8-10 for a graphical representation
of the variances.
When production does not equal sales, the sales-activity variance is the
difference between the static budget and the flexible budget for the number of
units sold. In contrast, the flexible-budget cost variances compare actual costs
with flexible-budgeted costs for the number of units produced. Therefore, two
flexible budgets must be prepared.
When the number of units of raw materials differs from the amount used in
production, the price variance should be computed based on the actual amount
purchased. The usage variance should still be based on the actual usage of
materials as compared to the quantity allowed for the production level achieved. IV. Overhead Variances
A. Variable Overhead Variances {L. O. 7}
The flexible-budget variance for variable overhead is subdivided into the
variable-overhead efficiency variance and the variable overhead spending
variance, computed as follows:
Variable-Overhead Efficiency Variance =
(actual quantity of – standard quantity) x standard variable-overhead rate
cost-driver unit of cost driver allowed per cost-driver
Variable-Overhead Spending Variance =
actual variable overhead – (standard variable overhead x actual cost-driver)
rate per unit of cost-driver activity used
The efficiency variance is controlled by regulating the cost-driver activity and the
spending variance through the price paid for variable-overhead items.
See EXHIBIT8-11 for illustrations of the general approach for subdividing the
flexible-budget variances into the direct-materials price and usage variances,
direct-labor price and usage variances, and variable-overhead spending and
usage variances. Actual costs are in the left-most column (A). A flexible budget
based on actual inputs with expected prices is the center column (B). Finally, the
right-most column contains a flexible-budget amount based on expected inputs
for the actual outputs achieved at the expected prices (C). Differences between
(A) and (B) are due to prices and differences between (B) and (C) are due to
usage.
B. Fixed Overhead Variances {L. O. 8}
The flexible budget in Column B based on actual inputs and the flexible budget in Column C based on standard inputs allowed are always the same. Fixed overhead is not expected to vary with the level of output (nor with the level of inputs). The entire fixed overhead flexible-budget variance shown in Exhibit 8-11 arises due to the difference between columns A and B because there is, by definition, no difference between columns B and C. This difference between the actual fixed overhead cost in column A and the budgeted cost in column B is the fixed overhead spending variance.
CHAPTER 8: Quiz/Demonstration Exercises
Learning Objective 1
1. _____ budgets provide expected revenues and costs for several levels of activity.
a. flexible
b. continuous
c. master
d. static
2. _____ are budgets for a single activity level.
a. flexible budgets
b. master budgets
c. both A and B
d. static budget
Learning Objective 2
3. The Tiger Company has the following budgeted costs for the production of its only
product, exercise machines:
Variable manufacturing costs $ 200.00 per unit
Selling expenses $ 30.00 per unit
Administrative $ 20.00 per unit
Fixed manufacturing costs $ 300,000 per month
Fixed selling and admin. costs $ 150,000 per month
What are High Tech’s expected costs for 10,000 units of product to be produced and sold in March?
a. $ 2,300,000
b. $ 2,950,000
c. $ 450,000
d. $ 2,500,000
4.The flexible budget is based on the same assumptions of revenue and cost behavior
(within the relevant range), as is the _____.
a.master budget
b.static budget
c.neither A nor B
d.both A and B
Learning Objective 3
5.Which of the following is descriptive of an activity-based flexible budget?
a.based on actual costs for each activity center and related cost driver
b.based on budgeted costs for each activity center and related cost driver
c.is limited to no more than ten activity centers
d. A and C
6. The key differences between the traditional flexible budget and the activity-based
flexible budget are _____.
a.the traditional should be used when a significant portion of the costs vary with
cost drivers other than units of production
b.traditional flexible budgeting is dramatically increasing in popularity
c.some manufacturing costs that are fixed with respect to unit are variable with
respect to cost drivers, and other than units, used for an activity-based flexible
budget
d.the larger the company, the more likely the activity-based flexible budget will not
be used
Learning Objective 4
7. When revenues or variable costs per unit of activity and fixed costs per period may not
be as expected, this is called _____.
a. flexible-level variance
b. activity-budget variance
c. static-budget variance
d. master-budget variance
8.The flexible budget is prepared using the _____.
a.estimated levels of activity of the closest competitor
b.historical levels of activity
c.most conservative levels of activity
d.actual levels of activity
Learning Objective 5
9. _____variances measure how effective managers have been in meeting the planned
level of sales.
a. continuous-budget
b. flexible-budget
c. sales-activity
d. master-budget
10. _____ variances measure the efficiency of operations at the actual level of activity.
a. zero-based budget
b. master-budget
c. flexible-budget
d. sales-activity
Learning Objective 6
Use the following information for questions 11 through 14.
The Victor Company has developed the following standards for one of their products.
Direct materials: 10 pounds x $4 per pound
Direct labor: 5 hours x $10 per hour
Variable overhead: 5 hours x $2 per hour
The following activity occurred during the month of July:
Materials purchased: 1,000,000 pounds at $4.10 per pound
Material used: 800,000 pounds
Units Produced: 20,000 units
Direct labor: 110,000 hours at $7.50 per hour
Actual variable OH: $250,000
The company records the materials price variance at the time of purchase.
11. The materials price variance is _____.
a. $80,000 favorable
b. $80,000 unfavorable
c. $100,000 unfavorable
d. $100,000 favorable
12. The labor usage variance is _____.
a. $70,000 favorable
b. $70,000 unfavorable
c. $100,000 unfavorable
d. $100,000 favorable
Learning Objective 7
13. The variable overhead spending variance is _____.
a. $50,000 unfavorable
b. $50,000 favorable
c. $100,000 favorable
d. $100,000 unfavorable
14.The variable overhead efficiency variance is _____.
a.$20,000 unfavorable
b.$20,000 favorable
c.$10,000 favorable
d.$10,000 unfavorable
CHAPTER 8: Solutions to Quiz/Demonstration Exercises
1. [a]
2. [c]
3. [b]From the information provided, Tiger’s flexible-budget cost formula is $450,000
+ $250.00 X, where X is the number of units produced. Inserting 10,000 for X
gives $450,000 + ($250.00 x 10,000) which equals $2,950,000.
4. [d]
5. [b]
6. [c]
7. [a]
8. [d]
9. [c]
10. [c]
11. [c]A s stated, the company determines the price variance based on the material purchased.
Therefore, the price variance is ($4.10 – $4.00) x 1,000,000 pounds, which is
$100,000. The variance is unfavorable because the actual price paid ($4.10)
exceeds the standard price ($4.00).
12. [c]T he labor usage variance is found by multiplying the standard labor rate ($10) by the
difference between the actual hours worked (110,000) and the number of hours
that should have been taken to produce 20,000 units of 100,000 = 20,000 x 5
hrs./unit. The resulting variance is $100,000 ((110,000-100,000) x $10), which is
unfavorable because more hours were worked than should have been for the
production level achieved.
13. [a]T he spending variance is the difference between the flexible-budget variance and the
actual variable-overhead costs. In this case, the flexible budget for variable
overhead would be $200,000 (20,000 x 5 hours) x unit x $2/hr. This yields a
flexible budget variance of $50,000 unfavorable because actual
variable-overhead costs are $250,000.
14. [a]T he efficiency variance is the difference between the actual quantity of the cost-driver
activity and the standard quantity allowed, which is then multiplied by the
standard rate. The actual quantity of 110,000 hours is more than the standard
allowed of 100,000 hours. The 10,000 hours difference is multiplied by the
standard rate of $2 to arrive at a $20,000 unfavorable variance.