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We have seven Learning Objectives in our chapter on flexible budgets. The first four are shown here:
Understand static budgets and static-budget variances
Examine the concept of a flexible budget and learn how to develop one
Calculate flexible-budget variances and sales-volume variances
Explain why standard costs are often used in variance analysis
The final three Learning Objectives for Chapter 7 are:
Compute price variances and efficiency variances for direct-cost categories.
Understand how managers use variances
Describe benchmarking and explain its role in cost management
A variance is the difference between actual results and expected performance. The expected performance is also called budgeted performance.
Management by exception is a practice whereby managers focus more closely on areas that are not operating as expected and less closely on areas that are.
The static budget is another name for the master budget. It is based on the level of output planned at the start of the budget period. It is called a static budget because the budget for the period is developed around a single (static) planned output level.
The static-budget variance is the difference between the actual result and the corresponding budgeted amount in the static budget.
For revenue items, F means actual revenues exceed budgeted revenues. For cost items, F means actual costs are less than budgeted costs.
For revenue items, U means actual revenues are less than budgeted revenues. For cost items, U means actual costs exceed budgeted costs.
Variances can be calculated at multiple levels and those levels are identified with level numbers. The broadest variance is a level 0 and is a very macro-view showing the difference between actual and static-budget operating income.
Further analysis breaks down the Level 0 variance into progressively smaller and smaller components, attempting to answer questions such as:
How much were we off?
Where were we off?
Why were we off?
A level 1 analysis, illustrated here, takes the static-budget variance (level 0) and breaks it down by line item. As a result, in addition to knowing that we fell short in operating income, we now know how we got there. Column 1 presents the actual results, column 3 the static budget, and in column 2 are the level 1 variances: the difference between the static budget and the actual results. Variance analysis levels 2 and 3 answer the question WHY were we off? With level 2 and 3 variances, we can get quite specific about what went wrong in our operations that caused the shortfall in operating income.
Exhibit 7.1.
Long Description:
The static budget variances, which are the difference of actual results and static budget, are classified as favorable or unfavorable effect on operation system denoted by “F” and “U” respectively. The details of the level 1 analysis are as follows.
Actual results:
Units sold: 10,000
Revenues: dollar 1,250,000
Variable costs
Direct materials: 621,600
Direct manufacturing labor: 198,000
Variable manufacturing overhead: 130,500
Total variable costs: 950,100
Contribution margin: 299,900
Fixed costs: 285,000
Operating income: dollar 14,900
Static budget variances
Units sold: 2,000 U
Revenues: dollar 190,000 U
Variable costs
Direct materials: 98,400 F
Direct manufacturing labor: 6,000 U
Variable manufacturing overhead: 13,500 F
Total variable costs: 105,900 F
Contribution margin: 84,100 U
Fixed costs: 9,000 U
Operating income: dollar 93,100 U
Static budget
Units sold: 12,000
Revenues: dollar 1,440,000
Variable costs
Direct materials: 720,000
Direct manufacturing labor: 192,000
Variable manufacturing overhead: 144,000
Total variable costs: 1,056,000
Contribution margin: 384,000
Fixed costs: 276,000
Operating income: dollar 108,000
A flexible budget calculates budgeted revenues and budgeted costs based on the actual output in the budget period.
The flexible budget is prepared at the end of the period, after managers know the actual output.
The flexible budget is the hypothetical budget that would have been prepared at the start of the budget period if the company had correctly forecast the actual output for the period.
In a flexible budget, the selling price is the same as the static budget, the budgeted unit variable cost is the same, and, within the relevant range, total fixed costs are the same.
These three steps enable a company to prepare a flexible budget. The flexible budget allows for a more detailed analysis of a static-budget variance for operating income.
Here is an example of a Level 2 analysis. In the first column, the actual results are reported. The third column reports the FLEXIBLE BUDGET and the 5th column reports the STATIC BUDGET.
The second column provides the variances between our actual results and the flexible budget. These variances are the flexible-budget variances. They help us to understand what results we should have had for the level of volume compared to what was actually obtained.
The fourth column provides the difference between the static and the flexible budget. This is called the sales-volume variance because it tells us how much we gained or lost as a result of a volume difference between what was originally anticipated and what we actually achieved.
The flexible budget uses budgeted per unit data applied to ACTUAL units. It represents what our budget would have been had we budgeted correctly for volume.
Exhibit 7.2.
Long Description:
The flexible budget variances, which are the difference of actual results and flexible budget, are classified as favorable or unfavorable effect on operation system denoted by “F” and “U” respectively.
Actual results (1)
Units sold: 10,000
Revenues: dollar 1,250,000
Variable costs
Direct materials: 621,600
Direct manufacturing labor: 198,000
Variable manufacturing overhead: 130,500
Total variable costs: 950,100
Contribution margin: 299,900
Fixed manufacturing costs: 285,000
Operating income: dollar 14,900
Flexible-budget variances (2) equals (1) minus (3)
Units sold: 0
Revenues: dollar 50,000 F
Variable costs
Direct materials: 21,600 U
Direct manufacturing labor: 38,000 U
Variable manufacturing overhead: 10,500 U
Total variable costs: 70,100 U
Contribution margin: 20,100 U
Fixed manufacturing costs: 9,000 U
Operating income: dollar 29,100 U
Flexible budget (3)
Units sold: 10,000
Revenues: dollar 1,200,000
Variable costs
Direct materials: 600,000
Direct manufacturing labor: 160,000
Variable manufacturing overhead: 120,000
Total variable costs: 880,000
Contribution margin: 320,000
Fixed manufacturing costs: 276,000
Operating income: dollar 44,000
Sales-Volume Variances (4) equals (3) minus (5)
Units sold: 2,000 U
Revenues: dollar 240,000 U
Variable costs
Direct materials: 120,000 F
Direct manufacturing labor: 32,000 F
Variable manufacturing overhead: 24,000 F
Total variable costs: 176,000 F
Contribution margin: 64,000 U
Fixed manufacturing costs: 0
Operating income: dollar 64,000U
Static budget
Units sold: 12,000
Revenues: dollar 1,440,000
Variable costs
Direct materials: 720,000
Direct manufacturing labor: 192,000
Variable manufacturing overhead: 144,000
Total variable costs: 1,056,000
Contribution margin: 384,000
Fixed manufacturing costs: 276,000
Operating income: dollar 108,000
Level 2:
Flexible-budget variance: dollar 29,100 U
Sales-volume variance: dollar 64,000 U
Level 1:
Static-budget variance: dollar 93,100 U
The sales-volume variance is the difference between a flexible-budget amount and the corresponding static-budget amount. The flexible-budget variance is the difference between an actual result and the corresponding flexible-budget amount.
Let’s first take a closer look at the Sales-Volume Variance.
Here are some reasons why an unfavorable sales-volume variance might occur. (Actual sales are less than budgeted sales.)
How a company responds to an unfavorable sales-volume variance will depend on what its managers believe caused the variance. If, for example, the underlying cause is the market (items 1 through 4), the sales manager is most likely to be able to explain the cause. If, on the other hand, there are quality problems, the production manager would be in the best position to explain the cause.
The sales-volume variance is the difference between a flexible-budget amount and the corresponding static-budget amount. The flexible-budget variance is the difference between an actual result and the corresponding flexible-budget amount.
Now let’s take a closer look at Flexible Budget Variances.
If a company has, for example, an unfavorable material cost variance, we can find out if that was due to the company using greater quantities of inputs vs. the budgeted quantities of those inputs and/or having to pay higher prices per unit for the inputs than the budgeted price per unit of input.
On this slide, we see the formulas to calculate the level three variances.
The formulas to calculate the price and efficiency variances are shown here. These formulas work equally well for direct material and direct labor but will not work for overhead.
The formula for PRICE VARIANCE is: (Actual Price – Budgeted Price) X Actual Quantity
The formula for EFFICIENCY VARIANCE is: (Actual Quantity – Budgeted Quantity) X Budgeted Price
The Actual Quantity of Input used can be yards or pounds of material or direct labor or machine hours.
The Budgeted Quantity of Input Allowed for Actual Output means that we’ll take the quantity expected to be used per output (4 lbs of steel per item) X the actual quantity.
As an example, if we made 10 units and each required 4.4 lbs of plastic, we would expect to have used 44 lbs of plastic. If we ACTUALLY used 48 lbs of plastic, that element of the formula would be (48 – 44).
If we made 10 units and each required 5 hours of direct labor, we would expect to have used 50 hours of labor. If we ACTUALLY used 55 hours of labor, that element of the formula would be (55 – 50).
Level 3 analysis looks at the flexible budget variances (the variance between the flexible budget and the actual results) and explains it in more detail.
We know, for example, from our Level 2 Analysis that Webb Company’s (the company used in our textbook) had an unfavorable direct materials variance of $21,600. That means that we spent $21,600 more for the materials than we should have.
This Level 3 analysis tells us how much of that amount was based on price (we paid more or less for the material than we expected to) and how much of the amount was based on usage or efficiency. You can see that the situation is even worse than it appears. We spent $66,000 more than we expected to on usage which was offset quite a bit by the $44,400 favorable purchase price variance.
These variances provide infinitely important information to management to help them improve operations in the future.
Exhibit 7.3.
Long Description:
The details of the table are as follows:
Direct material
1. Actual Costs Incurred (actual inputs quantity times the actual price: dollar 621,600 (which is 22,200 square yards times dollar 28 per square yard)
2. Actual input quantity times budgeted price: dollar 666,000 (which is 22,200 square yards times dollar 30 per square yard)
3. Flexible budget (budgeted input quantity allowed for actual output times the budgeted price): dollar 600,000 (which is 10,000 units times 2 square yards per unit times dollar 30 per square yard)
Level 3
Price variance: dollar 44,400 that has favorable effect on operating income, is the difference between the above 1 and 2
Efficiency variance: dollar 66,000 that has unfavorable effect on operating income, is the difference between the above 2 and 3
Level 2
Flexible-budget variance: dollar 21,600 that has unfavorable effect on operating income, is the difference between the above 1 and 3
Direct manufacturing labor
1. Actual Costs Incurred (actual inputs quantity times the actual price): dollar 198,000 (which is 9,000 hours times dollar 22 per hour)
2. Actual input quantity times budgeted price: dollar 180,000 (which is 9,000 hours times dollar 20 per hour)
3. Flexible budget (budgeted input quantity allowed for actual output times the budgeted price): dollar 160,000 (which is 10,000 units times 0.8 hour per unit times dollar 20 per hour)
Level 3
Price variance: dollar 18,000 that has unfavorable effect on operating income, is the difference between the above 1 and 2
Efficiency variance: dollar 20,000 that has unfavorable effect on operating income, is the difference between the above 2 and 3
Level 2
Flexible-budget variance: dollar 38,000 that has unfavorable effect on operating income, is the difference between the above 1 and 3
The slide almost looks like an organization chart, but it isn’t. It is a summary of the variances we’ve just discussed; Levels 1 thru 3.. At the top is the static-budget variance for operating income, which is level 1.
Level 2 identifies the variances between the flexible budget and actual operating income by line item and in total.
Level 3 variances target one of the Level 2 line item variances and break it down into more detail.
Exhibit 7.4.
Long Description:
The details of the flowchart are as follows:
Level 1: Static-budget variance for operating income dollar 93,100 unfavorable effect on operating income.
Level 2 is Level 1 split into two below mentioned
Flexible-budget variance for operating income of dollar 29,100 unfavorable effect on operating income.
Sales-volume variance for operating income of dollar 64,000 unfavorable effect on operating income.
Flexible-budget variance splits into its individual line items mentioned below
Selling price variance of dollar 50,000 favorable effect on operating income.
Direct materials variance of dollar 21,600 unfavorable effect on operating income.
Direct manufacturing labor variance of dollar 38,000 unfavorable effect on operating income.
Variable manufacturing overhead variance of dollar 10,500 unfavorable effect on operating income.
Fixed manufacturing overhead variance of dollar 9,000 unfavorable effect on operating income.
Level 3:
Direct material variance splits into the two below mentioned variances.
Direct materials price variance of dollar 44,400 favorable effect on operating income.
Direct materials efficiency variance of dollar 66,000 unfavorable effect on operating income.
Direct manufacturing labor variance splits into the two below mentioned variances.
Direct manufacturing labor price variance of dollar 18,000 unfavorable effect on operating income.
Direct manufacturing labor efficiency variance of dollar 20,000 unfavorable effect on operating income.
Budgeted input prices and budgeted input quantities can be obtained from a number of sources including actual input data from past periods, data from other companies that have similar processes and standards developed by the firm itself.
A standard is a carefully determined price, cost, or quantity that is used as a benchmark for judging performance.
Of course each of these has its own advantages and disadvantages.
Sometimes the terms budget and standard are confused. Budget is the broader term but when standards are used to obtain budgeted input quantities and prices, the terms are used interchangeably.
Variances are journalized into individual variance accounts. Favorable variances are credits (they increase operating income) and unfavorable variances are debits (they decrease operating income).
If immaterial, variance are closed into cost of goods sold at the end of the period.
In Chapter 4, we looked at journal entries when normal costing is used.
When standard costing is used, variances are recorded a bit differently. As an example, since the purchased material will be recorded at STANDARD, the price variance will be recorded upon purchase rather than when used.
Managers and management accountants use variances to evaluate performance after decisions are implemented, to trigger organization learning and to make continuous improvements. Variances serve as an early warning system to alert managers to existing problems or to prospective opportunities.
