Chapter 8

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall

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Chapter 8

Flexible Budgets andVariance Analysis


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Chapter 8 Learning Objectives

When you have finished studying this chapter, you should be able to:

1.Identify variances and label them as 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 variances.


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5. Understand how the setting of standards affects the computation and interpretation of variances.

6. Compute and interpret price and quantity variances for materials and labor.

7. Compute variable overhead spending and efficiency variances.

8. Compute the fixed-overhead spending variance.


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Favorable and Unfavorable Variances

Profits Revenue CostsActual > Expected F F UActual < Expected U U F

Favorable variances arise when actual results exceed budgeted.

Unfavorable variances arise when actual results fall below budgeted.

Favorable (F) versus Unfavorable (U) Variances

Learning Objective 1


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Types of Favorable and Unfavorable Variances

Favorable profit variances arise when actual profits exceed budgeted profits. Unfavorable profit variance occurs when actual profit falls below budgeted profit.

Actual revenues that exceed budgeted revenues result in favorable revenue variances, and actual revenues that fall short of budgeted revenues result in unfavorable revenue variances.


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Types of Favorable and Unfavorable Variances

When actual costs exceed budgeted costs, we have unfavorable cost variances; when actual costs are less than budgeted costs, we have favorable cost variances.

The favorable and unfavorable labels indicate only the directional relationships summarized in the charts—they do not indicate that the explanation for the variance is necessarily good or bad.


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Favorable or Unfavorable Variance?

To determine whether a variance is favorable or unfavorable,

use logic rather than memorizing a formula.

A price variance is favorable if the actual

price is less than the standard.

A quantity variance is favorable if the actual quantity

used is less than the standard

quantity allowed.


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Static and Flexible Budgets

A static budget is prepared for only one expected level of activity.

LearningObjective 2

A budget that adjusts to different levels of activity is a flexible budget

(sometimes called a variable budget).


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Flexible Budget Formulas

To develop a flexible budget, managersdetermine revenue and cost behavior

(within the relevant range) withrespect to cost drivers.

LearningObjective 3

Note that the static budget is just the flexible budget for a single

assumed level of activity.


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Activity-Based Flexible Budget

An activity-based flexible budgetis based on budgeted costs for

each activity and related cost driver.

For each activity, costsdepend on a different cost driver.


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Activity-Based Flexible Budget


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Static-Budget Variances and Flexible-Budget Variances

Flexible budget variances reflect how actualresults deviate from what was expected, given the achieved activity level.

Differences between actual results and the static budget for the original planned levelof output are static-budget variances.

Differences between actual results and the flexible budget for the actual level of output achieved are flexible-budget variances.

LearningObjective 4


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Static-Budget Variances and Flexible-Budget Variances

revenue or variable costs per unit of activity and fixed costs per period were not as expected.

Actual results may differ fromthe master budget because...

sales and other cost-driver activities werenot the same as originally forecasted


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Evaluation of Financial Performance

Units 7,000 – 7,000 2,000U 9,000 Sales $217,000 – $217,000 $62,000 U $279,000Variable costs 158,200 5,670 U 152,600 43,600 F 196,200Contribution margin $ 58,730 $ 5,670 U $ 64,400 $18,400 U $ 82,800Fixed costs 70,300 300 U 70,000 – 70,000Operating income $ (11,570) $5,970 U $(5,600) $18,400 U $ 12,800

Actual results

at actual activity level*

(1)

Flexible-budget

variances

(2) = (1)-(3)

Flexible budget

for actual sales

activity

(3)

Sales -Activity Variance

(4) = (3)–(5)

Static Budget

(5)


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Flexible-Budget Variances

Flexible-budget variance= Actual results – Flexible-budget


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Sales-Activity Variances

Sales – activity income

variance

(9,000 – 7,000) $9.20

$18,400 Unfavorable

Falling short of the sales target by 2,000 units explains $18,400 of the shortfall of income relative to the amount initially budgeted.

Actual unit -Static budget units

Contribution margin per unit


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Role of Standards in Determining Variances

LearningObjective 5

Static-budget variances and flexible-budget variances depend on the costs used in the budget formulas. Budget formula costs are standard costs—costs that should be achieved. Standard costs are defined in different ways by different companies. The level at which standards are set will affect the variances generated and the incentives created.


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Setting Standards

An expected cost is the cost that is most likely

to be attained.

A standard cost is a carefully developed cost per unit that should be attained.

Perfection (ideal) standards are expressions of the Most efficient performance possible under the best conceivable conditions, using existing specifications and equipment. No provision is made for waste, spoilage, machine breakdowns, and the like.


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Currently Attainable Standards

are levels of performance thatmanagers can achieve byrealistic levels of effort.

They make allowances for normaldefects, spoilage, waste,and nonproductive time.

Currently Attainable Standards . . .


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Trade-Offs Among Variances

Improvements in one area could lead toimprovements in others and vice versa.

Likewise, substandard performancein one area may be balanced bysuperior performance in others.


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When to Investigate Variances

When should managementinvestigate a variance?

Many organizations have developedsuch rules of thumb as “investigate

all variances exceeding either $5,000 or 15% of expected cost.”


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Isolating the Causes of Variances

Effectiveness is the degree to whicha goal, objective, or target is met.

Performance may be effective,efficient, both, or neither.

Efficiency is the degree to which inputs are used in relation to

a given level of outputs.


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Comparison with Prior Periods

Some organizations compare the mostrecent budget period’s actual results with

last year’s results for the same period.

Even comparisons with the prior month’s actual results may not be as useful as comparisons with an up-to-date flexible budget.


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Flexible-Budget Variance in Detail

Standard per unit of output:

Std. inputs Flexible expected Budget Amount

Direct Material 5 pounds $ 2 /pound $10Direct Labor ½ hour $16/hour $ 8

Std. price expected

Flexible-budget amounts based on $10 per unit of output for direct materials and $8 per unit for direct labor.


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Variances for Material and Labor Standards

Standard Costs Allowed:

Direct materialCost allowed7,000 units X

5 pounds X $2.00 per pound =$70,000

Direct laborCost allowed

7,000 units X 1/2 hour X $16.00 per hour =

$56,000


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Actual results for 7,000 units produced:

Direct materialPounds purchasedand used: 36,800

Price/pound X $1.90 = Total actual cost

$69,920

Direct laborHours used: 3,750 XActual price (rate)

X $16.40 = Total actual cost

$61,500


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Units of good output achieved

Input allowed per unit of output

Standard unit price of input

×

×

=

Flexible Budget or Total Standard Cost Allowed



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(1) (2) (3)Flexible

Actual Flexible Budget Costs Budget Variance

Direct Materials $69,920 *$70,000 $ 80 FDirect Labor 61,500 **$56,000 $5,500 U

Flexible-budget cost is the standard quantity allowed for the actual level of activity multiplied by the standard price per unit.

Flexible-budget variances for direct material and direct labor: $80 F and $5,500 U, respectively.


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Price and Quantity Variances

(Actual quantity used – standard quantity allowedfor actual output) × Standard price

(Actual price – Standard Price) × Actual quantity used

LearningObjective 6


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Quantity (Usage) Variance Computations

[3,750 – (7,000 × ½)] hours× $16 per hour = $4,000 U

[36,800 – (7,000 × 5)] pounds× $2 per pound = $3,600 U


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Price Variance Computations

($16.40 – $16.00) per hour× 3,750 hours = $1,500 U

($1.90 – $2.00) per pound× 36,800 pounds = $3,680 F


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Direct Materials Flexible Budget Variance

Direct-Labor Flexible-budget variance:

$1,500 unfavorable

+ $4,000 unfavorable

= $5,500 unfavorable

Direct-Materials Flexible-budget variance:

$3,680 favorable

+ $3,600 unfavorable

= $80 favorable

The sum of the direct-labor price and quantity variances equals the direct-labor flexible-budget variance. Similarly, the sum of the direct-materials price and quantity variances equals the total direct-materials flexible-budget variance.


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Interpretation of Price and Quantity Variances

Price and quantity variances are helpfulbecause they provide feedback to

those responsible for managing inputs.

Managers should not use thesevariances alone for decision

making, control, or evaluation.

By dividing flexible-budget variances into price and quantity variances, managers can be better

evaluated on variances that they can control.

By dividing flexible-budget variances into price and quantity variances, managers can be better

evaluated on variances that they can control.


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Variable-Overhead Spending and Efficiency Variances

A variable-overhead efficiency variance occurs whenactual cost-driver activity differs from the standard

amount allowed for the actual output achieved.

A variable-overhead spending variance occurs when the difference between the actual variable overhead

and the amount of variable overhead budgeted for the actual level of cost-driver activity.

LearningObjective 7


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variable- actual standard standardoverhead cost-driver cost-driver variable-overhead efficiency activity activity rate pervariance allowed cost-driver unit

X= -

variable- actual standardactual overhead variable variable-overhead cost-driverspending overhead rate per unit activityvariance of cost-driver used

= X-

Variable-Overhead Variances


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Fixed Overhead Spending Variance

The difference between actual fixed overhead and budgeted fixed overhead

is the fixed overhead spending variance.

LearningObjective 8

The flexible budget based on actual use of the cost driver and the flexible budget based on standard use of the cost driver are always the same because fixed overhead does not vary with the level of use of the cost driver.

Therefore . . .


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