Running head ACQUISITION STRATEGY PIEZOELECTRIC EMBEDDED TRA.docx

Running head: ACQUISITION STRATEGY: PIEZOELECTRIC
EMBEDDED TRANSDUCERS UNDER WALL
GEOSTRUCTURE PROGRAM
4
ACQUISITION STRATEGY: PIEZOELECTRIC EMBEDDED
TRANSDUCERS UNDER WALL GEOSTRUCTURE
PROGRAM
Acquisition Strategy: Piezoelectric Embedded Transducers
(PET)
Under the WALL Geostructure Program
XXXXXX
ASCM 628 Section 9040 2172
University of Maryland University College
March 11, 2017
This strategic plan will specify the details relating to the
acquisition of Piezoelectric Embedded Transducers (PET) to be
utilized to provide enhanced surveillance capabilities for the
new Wide Alignment Limited Loading (WALL) Geostructure
Program. As referenced by Kim, Roberts & Brown (2016),

United States federal policy and regulatory guidance encourage
the use of fixed-price contracts in an effort to secure best value
for purchasing groups; therefore, the form of contract that shall
be utilized shall be a Fixed Price Economic Price Adjustment
(FPEPA) contract to account for the uncertainties of future
economic conditions that may cause fluctuations in the future
costs of supplies and equipment that the contractor might be
required to provide under contract and would not at this time be
predictable. Contract
Type
Pursuant to 41 USC 253 and 10 USC 2305, competition
will be full and open and the contract shall be both severable
and non-severable. For the procurement of 1,000 Piezoelectric
Embedded Transducers, the contract shall be non-severable;
however, any elements relating to their maintenance and non-
developmental support and data to be reported shall be
considered non-severable. Additionally, given the complexity
and technical nature of this service, price alone is not sufficient
to determine the award and therefore, the contract will be
awarded based on a contracting by negotiation bidding process.
Furthermore, it is assumed that the U.S. Immigrations and
Customs Enforcement (ICE) Acquisitions Division wishes to
hold discussions regarding the contract to ensure that its needs
are clearly communicated and met to its satisfaction. To allow
ICE to have maximum flexibility in awarding the contract, the
trade-off process shall also be initiated.
Planning Fundamentals
The subsequent planning fundamentals shall also be
incorporated within this strategic plan as they are essential for
the PET sourcing and future negotiations: (1) Contractor
Performance Requirements, (2) Deliverables, and (3)
Assumptions.
Contractor Performance Requirements and Deliverables
The contractor shall be responsible for providing substantial

value to ICE in the form of required hardware to ensure the
enhancement of the surveillance capability for the WALL
program, software to certify the technical monitoring and
successful operation of the hardware, and the non-
developmental support and data which will be utilized to
analyze the stabilization and sustainability of the geostructures.
The contractor’s performance requirements shall begin on the
date specified within the contract and continue over a multi-
year period with submissions of progress and status reports, at
the request of ICE. The schedule and individual timeframes of
each phase may be determined by the contractor; as will the
assembly of a project team who will be responsible for the
installation, operation and implementation of the system that
will allow ICE to monitor the structural health and damage
detection to ensure the reliability of the structure which is
essential both for safety and economic purposes. Visual
inspections or destructive tests which are the most widely used
methods are costly and hardly efﬁcient since they are
necessarily intermittent.
Gao, Dai, Liu, & Tian (2016) state that, “One of the
main targets of structural health monitoring is the online
damage detection, which not only reduces costs by minimizing
maintenance and inspection cycles, but also prevents
catastrophic failures at earlier stage. This is particularly useful
for developing self-monitoring structures, into which “smart”
materials are
Integrated.” As a nondestructive evaluation method,
electromagnetic testing for damage detection is being employed,
which applies the elements of piezoelectric materials as
noninvasive means for monitoring structural health online.
Assumptions
Project Plan Development: the contractor shall develop a
project plan with specific time frames that detail each phase of
the system process, including hardware installation, software
configuration, and non-developmental support and data that

reflects testing and system monitoring.
Testing: the servers, machines, and other equipment used for
testing shall be furnished by the contractor and installation and
configuration of the systems, and its software. ICE
representatives will assess and identify any errors, deficiencies
or discrepancies and report them in writing to the contractor.
Contractor Expenses: ICE shall not be responsible for
contractor expenses that might be incurred as a result of the
project.
Acceptance of the Project: the final acceptance will occur over
a multi-year period, when all discrepancies, errors or software
irregularities identified by ICE have been resolved.
Payment: contract payment is due once the hardware has been
installed and the new system has been tested and is fully
operational. The amount due to the contractor shall be the
amount agreed upon during the negotiation process, not to
exceed the budgeted $20-$30M.
References
Gao, S., Dai, X., Liu, Z., & Tian, G. (2016). High-Performance
Wireless Piezoelectric Sensor
Network for Distributed Structural Health Monitoring.
International Journal Of
Distributed Sensor Networks, 1-16.
Doi:10.1155/2016/3846804
Kim, Y. W., Roberts, A., & Brown, T. (2016). Impact of
Product Characteristics and Market
Conditions on Contract Type: Use of Fixed Price Versus
Cost-Reimbursement Contracts
in the U.S. Department of Defense. Public Performance
and Management Review, 39(4),
783. doi:10.1080/15309576.2015.1137765
Office of Law Revision Counsel, United States Code, 41 USC §
253 (2012). Retrieved from

http://uscode.house.gov/view.xhtml?req=granuleid:USC-1999-
title41- section253&num=0&edition=1999
Office of Law Revision Counsel, United States Code, 10 USC §
2305 (2012). Retrieved from
http://uscode.house.gov/view.xhtml?hl=false&edition=prelim&r
eq=granuleid%3AUSC-prelim-title10-
section2305&num=0&saved=%7CKHRpdGxlOjEwIHNlY3Rpb2
46MjMwNWEgZWRpdGlvbjpwcmVsaW0p%7C%7C%7C0%7Cf
alse%7Cprelim
ASCM 628 9040 2172 Paper #1
Name:
Stephanie Watson
Date: 3/12/2017
Content and Development
Rating
Score
THREE (3) distinct acquisition planning fundamentals relevant
to the PET acquisition process.
Substantially Met
4.625
Rationale and explanation for why the selected acquisition
planning fundamentals are essential for the contemplated PET
Sourcing and future negotiations.
Substantially Met
4.750
Selection of a Contract type for the major deliverable items 1,
2, and 3 in the given Scenario for the PET.
Substantially Met
4.625
Explanation for how the selected Contract type will contribute
to meeting the factors and performance standards contribute

explicitly to the PET acquisition objectives.
Substantially Met
4.750
Content and Development Total
18.75
Organization and Mechanics
Paper length
Substantially Met
1.250
4 References
Substantially Met
2.500
General writing mechanics - Organization, Headings,
Formatting, Correctness
Substantially Met
2.500
Organization and Mechanics Total
6.25
Assignment Total
25.00
Your Paper addresses at least 3 relevant acquisition planning
fundamentals. It highlights a good explanation and rationale
that may be tied to the acquisition process for future
negotiations. It includes a well-written summary of the
processes to identify, evaluate, and selection of a good
alternative for proceeding with the negotiation of the resultant
PET Contract.
You synthesized the deliverables for the given scenario well and
demonstrated a significant understanding of the concepts by
considering specific factors and applying them to your selection

of Contract Type. Your points on Contract Type selection are
well supported with other examples, which demonstrate a
deeper understanding for planning and preparations for
negotiations of the PET Contract.
The page length is satisfactory and of good quality and shows
skillful use of, at least 4 relevant sources important for
benchmarking critical thought appropriate for the discipline and
theme of the Assignment scenario. The Paper is well organized
and formatted and your writing is well done with no errors
which impede the reader’s understanding.
chapter 6
Budgeting
Learning Objectives
• Understand the need for, nature of, and benefits associated
with budgeting.
• Know about organizational behavior dimensions of the
budgeting process.
• Know the components of a master budget.
• Be familiar with alternative types of budget cycles.
• Understand the concepts and methods associated with
flexible budgeting and how
technology can enhance budgeting and planning.

istockphoto
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142
CHAPTER 6Section 6.1 Purpose of Budgeting
Chapter Outline
6.1 Purpose of Budgeting
6.2 Benefits of Budgeting
Responsibility Accounting
Budgets Drive Efficiency
Human Behavior
6.3 Budgeting Drawbacks
Quality Estimates
The Comprehensive Budget
Sales and Cash Collections Budgets
6.4 Production Budget
Purchases and Payments for Materials
Direct Labor Budget
Factory Overhead Budget
SG&A Budget
Budgeted Income Statement
Cash Budget
Distribution of Budgets
Budget Cycles
6.5 Flexible Budgets
Using Flexible Budgets in Business Management

Considering Per-Unit Costs and Profit Impacts
Extending Flexible Budgeting
6.6 Benefits of Technology in Budgeting
6.1 Purpose of Budgeting
If you have worked in a medium to large-sized organization,
you have probably had some level of involvement with a budget
and the budget process. Although many may
not see the need for a budget, and often question the value of
the entire exercise, by the
end of this chapter it is hoped that you will appreciate the
importance of budgeting. The
substantial positive benefits of budgeting usually offset and
justify the time and effort.
Budgets are detailed financial plans that quantify future
expectations and actions. These
expectations and actions relate to numerous facets of business,
including planned sales,
staffing needs, acquisition of materials to support production,
financing, and expendi-
tures for plant assets. Budgets are important in proper control of
all facets of business
operation. They provide benchmarks against which to compare
actual results, establish
guidelines for expenditures, and may be used to establish
forward-looking guidance to
persuade investors and creditors to invest or lend to a business.
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143

CHAPTER 6Section 6.2 Benefits of Budgeting
6.2 Benefits of Budgeting
A large organization is complex. There are many people and
parts that must be coordi-nated to work together in a cohesive
manner. As such, the budget becomes a vital tool
for both communicating expected outcomes and coordinating
the actions of all factors of
production. Only through a budget can abstract and general
plans be converted into spe-
cific goals and objectives. Satisfaction of the budgetary
guidelines is expected to result in
fulfillment of the identified goals and objectives. When things
do not go as planned, the
budget is the tool that provides a mechanism for identifying and
focusing on departures
from the plan. The budget provides the benchmarks against
which to judge success or
failure, and it facilitates timely corrective measures.
Responsibility Accounting
Responsibility accounting is a term meaning that units and their
managers are held
accountable for transactions and events under their direct
influence and control. Budgets
should be aligned with units of responsibility. This results in a
push down of budgeted
revenues and expenses to lower levels within the organization.
It becomes difficult to
avoid accountability for outcomes when budgeted results are not
met. Each unit must
assume responsibility for meeting its plan. This forces managers
to pay attention to sales
results, cost controls, and organization efficiency. Deviations

are not always suggestive of
the need for corrective actions, but they do require unit
managers to explain outcomes.
Very few businesses have unlimited resources. Indeed, most
businesses face constraints.
There are more opportunities than available capital permits
pursuing. Thus, it is common
for unit managers to compete for budgetary allocations from
within the available resource
pool. For example, each business unit may have employees
desiring a pay raise, equip-
ment in need of updating, new projects that require startup
funding, and so forth. The
sum of the resource demands can easily exceed the anticipated
level of access to funds.
A successful manager is one who can make a strong case for his
or her resource needs,
understand the needs of other units, and ultimately adopt a
strategy that meshes his or her
unit’s plan with the greater needs of the overall organization.
Once the business plan is
agreed upon, a successful manager will support the plan and
work for the organization’s
ultimate success. Many managers have difficulty with these
concepts, and they respond
by working divisively by constantly fighting against the adopted
business plan. The bud-
get reflects the adopted business plan quantitatively. Only by
having all team members
support the plan can organizational effectiveness be maximized.
Budgets Drive Efficiency
An organization is made more efficient by improved rates of
throughput in the procure-

ment, production, and customer delivery process. You have
probably witnessed a pro-
duction bottleneck. Maybe you have been frustrated at a fast-
food restaurant when a
particular food item was not ready to meet customer demand.
The entire operation can
bog down over one missing ingredient. You probably concluded
that the business was
rapidly losing current and future business because of the
situation. Most business opera-
tions are subject to these types of constraints. Interestingly, the
budget process plays a
major role in avoiding these problems. As you will soon see, the
comprehensive budget
attempts to include planning considerations to ensure that all
factors of production are
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CHAPTER 6Section 6.2 Benefits of Budgeting
available when needed. Budgets allow managers to learn in
advance of potential bottle-
necks; advance knowledge is a key to solving and avoiding
business constraints.
Without a well-thought-out budget, an organization will suffer
from inefficiencies. The
budget serves a vital role in planning for success. This is true in
personal affairs as well
as in running a business. It is also true for other types of
entities, such as municipalities,

state governments, churches, not-for-profit hospitals, and
countless other organizations.
Accordingly, the budget process should be taken quite
seriously. Unfortunately, such is
not always the case. As you will see in the ensuing discussion,
human behavior traits
can at times interfere with an optimal budget process. One
needs to be aware of these
attributes and contemplate their effects. You see, managerial
accounting is more than just
number crunching.
Human Behavior
A large business may form a budget committee with senior
representatives from each
business unit. These individuals should possess knowledge
about all phases of business
operations. They should be able to provide insight into sales and
production. Their role
also includes being an advocate to make the case for resources
needed by their business
unit. Their initial charge may be to formulate budget guidelines
and gather data necessary
to formulate the preparation of a comprehensive budget.
However, many organizations
extend the committee’s work to include a monitoring role. In
this context, the committee
will meet regularly throughout the period to monitor progress
against the budget, and it
will make suggestions for budgetary and operational revisions.
Be aware that the budget
committee’s recommendations are strikingly influential to the
fate of an organization.
The work of the budget committee includes a significant

communication component. In
some organizations, the budget information will flow from
senior management down
through the organization. Other organizations attempt to pull
information up from
within. These different approaches have earned the alternative
monikers of top–down or
bottom–up budgeting.
The top–down approach to budgeting begins with upper level
management establish-
ing guidelines that the budget committee is intended to instill in
the organization. These
guidelines cover topics such as anticipated sales, acceptable
expenditure levels and rates,
and policies for compensation adjustments. Mid- and lower
level personnel have almost
no input in goal setting. Their role in constructing the budget
consists mainly of compil-
ing numerical data in support of the given corporate goals. The
top–down approach can
foster resentment because the budget is viewed as dictatorial.
Such budgets can also intro-
duce ethical challenges when lower level managers feel forced
to meet unrealistic targets
given to their units. However, an advantage is that the top–
down approach serves to give
the organization a clear picture of expectations at the top, which
then translates its way
down into the entire organization. Top–down budgets can set
the tone for the organiza-
tion and signal expected sales and production activity that the
organization is supposed to
reach. All parties should be in a position to know top
managements’ overall goals and, it
is hoped, understand the parameters that are put in place for

achievement of those goals.
The bottom–up approach is highly participative. Top
management initiates the budget
process by providing general guidelines, but it is the lower level
employees who are pri-
marily responsible for developing the budget. Individual
budgets from lower levels are
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CHAPTER 6Section 6.3 Budgeting Drawbacks
compiled to form divisional budgets, which are in turn
regrouped at successfully higher
levels within the organization. Top management’s budget
committee eventually receives
the overall plan. The committee reviews this document and
identifies areas in need of
coordination and revision. As you would suspect, it often
becomes necessary to engage in
several iterations of asking specific units within the
organization to fine-tune their indi-
vidual budgets. Because this type of budget is prepared by those
with the best knowledge
of their units, it can provide for a more realistic and accurate
plan. Performance evalua-
tion is enhanced because it removes the excuse that the original
budget was unrealisti-
cally imposed from higher up. Proponents of the bottom–up
approach claim a number
of benefits leading to positive effects on employee performance.

A primary benefit is that
the budget is at least partially self-imposed, generating
improved morale and results. Cer-
tainly, the approach is more in keeping with contemporary
team-based theories about
optimization of an organization.
6.3 Budgeting Drawbacks
You should be aware of certain drawbacks with budgeting. A
bottom–up approach to the budget preparation process can be
very time-consuming. This entails added cost.
Employees can become frustrated with planning tasks,
especially when they are addition-
ally under pressure to continue to produce products and meet
customer needs. Managers
may use a bottom–up approach to try to pad their budgets.
Human behavior suggests
that participants in the budget process will attempt to create a
cushion in their budget by
underestimating expected sales and overestimating anticipated
costs. In other words, they
try to leave room in the budget to ensure that they will meet
their goals. This phenomenon
can be particularly acute when bonuses are tied to actual versus
budgeted results. Padding
does little to advance organizational efficiency. In addition,
padding of planned expenses
may induce wasteful overspending. Managers may fear a future
loss of funding if they
do not spend all budget amounts. This problem seems to be
amplified in governmental
entities that lack a revenue/profit motive. The managerial
accountant’s engagement with
budgeting entails considerable skill and judgment to maximize
benefits to the entity.

At the opposite end of the spectrum, a top–down approach can
introduce unattainable
guidelines for revenues and expenses. When employees believe
that they have no chance
of achieving a budget, they may feel frustrated and capitulate to
an attitude of certain
failure. They may cease to try and may even engage in wasteful
activities. This is akin to
fielding a team for the second half of a game when the first half
went so badly that there is
no chance to win. Performance typically suffers. You probably
never thought of budgeting
as an exercise in organizational psychology, but that is certainly
the case.
Quality Estimates
Budgets require significant speculation about future conditions.
Thus, a certain amount
of error is unavoidable. That the future is unknowable can result
in the budget team
becoming cavalier about its prognostications. This trap is to be
avoided. Although many
things about the future cannot be known with certainty, there is
ample past information
on which to build forward-looking models. Such models should
be based on reason and
logic, not haphazard guesswork. Careful study, statistical
analysis, macroeconomic data
and forecasts, and similar tools all provide a strong foundation
on which to formulate and
evaluate budgets.
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146
Often, the starting point for constructing a budget is the prior
year’s budget. One assumes
previous budgets have been constructed with great diligence.
Adjustments to prior bud-
gets are made based on observed prior variances and new
information about future expec-
tations. This results in a new budget that is equivalent to an old
budget, plus or minus
indicated changes. This overall budgeting framework is termed
incremental budgeting.
An entirely different approach is known as zero-based
budgeting. With the zero-based
approach, no planned expenditure is protected by the status quo.
Each budget item must
be justified during each budget cycle. This is a time-consuming
and expensive way to
develop a budget, and many will question whether cost savings
that can be identified
via the process are justified by the effort. Thus, business
managers should view such a
method as useful but perhaps one that should be used on a
selective basis. Consider that
this approach can be deployed on a rolling basis that only
periodically causes the complete
reexamination of budgets within specific business units or
related to specific product lines.
The Comprehensive Budget
A comprehensive budget (or master budget) is the cornerstone

documentation revealing
a business’s anticipated sales, expenses, financial needs, and so
forth. The comprehen-
sive budget is actually a compilation of a number of individual
budgets. The lynchpin is
the sales budget. Once anticipated sales are factored in, you
have a benchmark for logi-
cally planning production and selling, general, and
administrative components. In turn,
production data are central to determining the need for materials
and labor, as well as
establishing the benchmark for the application of factory
overhead. You can think of the
comprehensive budget as a compilation of numerous individual
interlocking blocks, as
shown in Exhibit 6.1:
Exhibit 6.1
SALES BUDGET
PRODUCTION
BUDGET
SG&A
BUDGET
FACTORY
OVERHEAD
BUDGET
MATERIALS
BUDGET
LABOR

BUDGET
Budget Building Blocks
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147
The budget blocks shown in Exhibit 6.1 can also be linked to
their income statement and
cash (financial) impacts, as will be shown in the following
illustrations. Budgeted financial
statements are often seen as the culmination of the budgeting
process. Quite obviously, a
business must have a pathway to successful future performance
as reflected in a thought-
ful budget. In addition to the operating budget components,
businesses may extend their
budgets to plan for major capital expenditures. Decisions
related to capital budgeting are
discussed in a later chapter.
Considerable effort is needed to coordinate the construction of a
comprehensive bud-
get. It guides actions over the entire budget period and all
phases of activity, including
purchasing, staffing, and most other resource procurement and
deployment actions. For
most organizations, the comprehensive budget begins with an
assessment of anticipated
sales. The expected level of sales defines production activities
as well as the expected

selling, general, and administrative expenditures. Production
activities are broad. They
encompass purchasing of materials, deployment of labor, and
allocation of overhead. In
addition, consideration must be given to the beginning and
ending inventory levels of
materials and finished goods. All plans must be dovetailed to
match the cash flow of the
organization as well as expected financial statement outcomes.
As you will soon see, the
comprehensive budget is composed of a series of individual
budgets, all of which dovetail
together in a cohesive manner.
Sales and Cash Collections Budgets
As noted previously, the comprehensive budget begins with a
projection of sales. Antici-
pated activity is incorporated into a sales budget. The
determination of anticipated vol-
ume should be based on prior sales patterns, economic
conditions, competitive actions,
and so forth. Where a company has multiple products,
consideration must be given to
each. You will soon see how projected sales drive the budgets
for all other factors of pro-
duction; in this regard, it can become quite important to know
the exact product mix that
is contemplated within the sales budget.
By now, you clearly understand that sales do not necessarily
equal cash collections. There
are often delays between the date of sale (on account) and
conversion of the transaction
to cash (i.e., collection). A company needs knowledge of both.
Whereas sales drive pro-

duction levels, cash flow is necessary to support production.
Thus, the comprehensive
budget process requires mapping of both sales and collections.
How this occurs is best
demonstrated with an example. Exhibit 6.2 is the sales and cash
collections budget for
Wheat Treat. Wheat Treat produces a very large specialized
bread roll for use at banquets
and weddings. The company is experiencing significant growth.
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148
CHAPTER 6Section 6.4 Production Budget
Exhibit 6.2
Notice that the upper portion of Exhibit 6.2 begins with
expected sales, in units. Each unit
is anticipated to sell for $7.50. Thus, the determination of
quarterly sales is not particularly
difficult. The anticipated cash collections require a bit more
explanation. Assume that cus-
tomers are given credit terms, and the normal result is that 60%
of sales in each quarter
are collected within the quarter. The remaining 40% are
presumed to be collected in the
following quarter. Looking closely at the second quarter, note
that total sales are forecast at
$450,000. Sixty percent of $450,000 is $270,000, which is
shown as cash collections from the
second quarter’s sales. The other 40% of $450,000, or $180,000,
is shown as collected in the

third quarter. This allocation of sales to cash collections is
repeated for each quarter (collec-
tions in the first quarter would relate to sales from the last
quarter of the prior year, which
are not shown here). Wheat Treat’s sales and cash collections
are fairly straightforward. You
can well imagine that the complexity could increase if
collection activities spanned longer
periods of time, including the possibility of uncollectibles.
Also, note that the quarterly
effects are compiled into an annual total within the final
column. Although this exhibit is
informative, it is only the point of beginning in the budget
construction process.
6.4 Production Budget
The sales, in units, are carried forward from the sales budget
into the production bud-get. It should be obvious why sales are
a key driver in the decision about how many
units to produce. However, beginning and ending inventory are
also important to con-
sider. Budgeted unit production level is reflective of units sold,
plus desired ending fin-
ished goods inventory, minus beginning finished goods
inventory. Very simply, in units,
the following formula applies:
Planned Production 5 Sales 1 Desired Ending Inventory 2
Beginning Inventory
50,000
$ 7.50
$ 375,000

$ 225,000
140,000
$ 365,000
SALES:
Units
X Sales price per unit
Estimated sales
COLLECTIONS:
From current quarter sales
From prior quarter sales
Cash collections
1st Quarter
WHEAT TREAT
Sales and Cash Collections Budget
For the Year Ending December 31, 20X4
60,000
$ 7.50
$ 450,000

$ 270,000
150,000
$ 420,000
2nd Quarter
65,000
$ 7.50
$ 487,500
$ 292,500
180,000
$ 472,500
3rd Quarter
80,000
$ 7.50
$ 600,000
$ 360,000
195,000
$ 555,000
4th Quarter

255,000
$ 7.50
$ 1,912,500
$ 1,812,500
Annual Recap
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149
Exhibit 6.3 shows the production budget for Wheat Treat. The
planned ending finished
goods inventory for each quarter may appear as a random
amount. However, careful
inspection for Wheat Treat reveals that it plans to end each
quarter with an inventory of
20% of the next quarter’s anticipated sales (e.g., third quarter
sales of 65,000 units 3 20%
5 13,000 ending inventory for the second quarter). Thus, a
systematic process can be fol-
lowed to arrive at the various inventory levels. Test your
understanding of this concept by
looking at the fourth quarter. What can you infer about the
company’s planned sales for
the first quarter of 20X5? The answer is 100,000 units
(20,000/20%).
Exhibit 6.3

Purchases and Payments for Materials
Purchases of materials are driven by the level of production.
Continuing the Wheat Treat
example, the next budget component appears to be a bit more
intimidating, but only
because it involves more computations. The concepts are
straightforward. To begin, each
quarter’s scheduled production is carried forward from the
preceding budget. An addi-
tional fact is that each finished unit requires 10 pounds of raw
materials. Thus, you can
understand how the total raw material needs are to be
calculated. Of course, raw material
that is needed for production is not synonymous with purchases
of raw materials. One
must take into account beginning and ending raw materials.
Here, it is assumed that each
quarter begins with raw materials sufficient to produce 10% of
the quarter’s needs. Look at
Exhibit 6.4, and carefully note how materials needed, plus the
desired ending stock, minus
the beginning stock, results in an amount equal to anticipated
purchases for the period.
50,000
12,000
62,000
(10,000)
52,000

Quarterly sales in units
Planned ending finished goods
Units needed
Less: Beginning finished goods
Production level
1st Quarter
WHEAT TREAT
Production Budget
60,000
13,000
73,000
(12,000)
61,000
2nd Quarter
65,000
16,000
81,000
(13,000)

68,000
3rd Quarter
80,000
20,000
100,000
(16,000)
84,000
4th Quarter
255,000
20,000
(10,000)
265,000
Annual Recap
waL80281_06_c06_141-168.indd 9 9/25/12 1:03 PM
150
Exhibit 6.4

The raw materials purchases must be multiplied by the price per
unit to arrive at the
expected cost of raw material purchases. Last, it is again
important to consider the cash
flows necessary for the direct material purchases. This
illustration presumes that cash
payments required will be 75% of those purchases made within
the quarter of purchase
(e.g., second quarter purchases of $92,550 3 75% 5 $69,413)
and 25% in the next follow-
ing quarter (e.g., second quarter purchases of $92,550 3 25% 5
$23,138). The cash pay-
ments in the first quarter, related to the prior quarters
purchases, are simply assumed
in this illustration.
Direct Labor Budget
The direct labor budget calculations are relatively simple.
Potential complications might
relate to developing staffing plans to meet the needs identified
within the direct labor
budget. This could expand to include the human resources
department as it relates to
plans for additional hiring or reductions in force. Exhibit 6.5
reveals that each unit of
production requires one-quarter hour of direct labor, and direct
labor costs $11 per hour.
There are no “beginning” and “ending” direct labor hours that
can be stored up. And, as
is typically the case, labor is generally paid as incurred
(weekly, biweekly, or monthly).
Thus, it is assumed that cash paid for direct labor is equivalent
to the direct labor cost for
each quarter, and thus the cash flow needs are equal to the cost

of direct labor.
52,000
10
520,000
61,000
581,000
(52,000)
529,000
$ 0.15
$ 79,350
PURCHASES:
Scheduled production
X Raw materials per unit (lbs.)
Total raw material needs (lbs.)
Plus: Target ending raw material
Total units needed (lbs.)
Less: Target beg. raw material
Raw material purchases (lbs.)

X Estimated cost per pound
Cost of raw material purchases
1st Quarter
WHEAT TREAT
Direct Materials Budget
61,000
10
610,000
68,000
678,000
(61,000)
617,000
$ 0.15
$ 92,550
2nd Quarter
68,000
10
680,000

84,000
764,000
(68,000)
696,000
$ 0.15
$ 104,400
3rd Quarter
84,000
10
840,000
89,000
929,000
(84,000)
845,000
$ 0.15
$ 126,750
4th Quarter
265,000

10
2,650,000
89,000
2,739,000
(52,000)
2,687,000
n/a
$ 403,050
Annual Recap
1st Quarter 2nd Quarter 3rd Quarter 4th Quarter Annual Recap
For current quarter purchases
For prior quarter purchases
Cash payments for materials
PAYMENTS:
$ 59,513
15,000
$ 74,513
$ 69,413

19,838
$ 89,251
$ 78,300
23,138
$ 101,438
$ 95,063
26,100
$ 121,163 $
386,365
waL80281_06_c06_141-168.indd 10 9/25/12 1:03 PM
151
Exhibit 6.5
Wheat Treat’s factory overhead budget is presented in Exhibit
6.6. The company’s over-
head consists of both variable and fixed components. The
variable overhead is expected
to be $0.80 per direct labor hour. The fixed factory overhead is

expected to be $19,875 per
quarter. All of this would be determined based on a careful
analysis of the company’s
cost structure.
Exhibit 6.6
In Exhibit 6.6, notice that the variable overhead driver was
considered to be direct labor
hours. The direct labor hours were derived by reference to the
direct labor budget. Also,
notice that $2,500 of the amount incurred for overhead was
related to depreciation. Because
depreciation does not consume cash, it is subtracted from each
quarter’s total overhead to
arrive at the amount of cash that is needed to support overhead
costs each period.
52,000
0.25
13,000
$ 11.00
$ 143,000
Scheduled production
X Direct labor hours per unit
Total direct labor hours
X Cost per direct labor hour

Cost of direct labor
1st Quarter
WHEAT TREAT
Direct Labor Budget
61,000
0.25
15,250
$ 11.00
$ 167,750
2nd Quarter
68,000
0.25
17,000
$ 11.00
$ 187,000
3rd Quarter
84,000
0.25

21,000
$ 11.00
$ 231,000
4th Quarter
265,000
0.25
66,250
$ 11.00
$ 728,750
Annual Recap
13,000
$ 0.80
$ 10,400
19,875
$ 30,275
(2,500)
$ 27,775
Direct labor hours

X Variable factory overhead rate
Total variable factory overhead
Fixed factory overhead
Total factory overhead
Less: Depreciation
Cash paid for factory overhead
1st Quarter
WHEAT TREAT
15,250
$ 0.80
$ 12,200
19,875
$ 32,075
(2,500)
$ 29,575
2nd Quarter

17,000
$ 0.80
$ 13,600
19,875
$ 33,475
(2,500)
$ 30,975
3rd Quarter
21,000
$ 0.80
$ 16,800
19,875
$ 36,675
(2,500)
$ 34,175
4th Quarter
66,250
$ 0.80

$ 53,000
79,500
$ 132,500
(10,000)
$ 122,500
Annual Recap
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152
In a later chapter, you will learn about applying factory
overhead in determining a prod-
uct’s full cost, so this is an excellent point to begin to introduce
this concept. Notice that
Wheat Treat is anticipating $132,500 of total overhead. If, as is
often the case, overhead is
applied based on direct labor hours, then the total overhead
application rate would be $2
per hour ($132,500 divided by 66,250 hours). This $2 is
included in the schedule shown in
Exhibit 6.7, which shows the calculation of per-unit cost at
$4.75. The per-unit amounts for
direct materials and direct labor were derived in prior
schedules. Likewise, we previously
noted that the company plans to end the year with 20,000 units
in inventory. Thus, one is

able to project the dollar cost of ending inventory.
Exhibit 6.7
SG&A Budget
Wheat Treat will also need to develop a selling, general, and
administrative expenses
(SG&A) budget. SG&A usually contains both variable and fixed
components. Variable
components can include shipping costs, sales commissions, and
other costs that tend to
vary based on sales volume or other potential measures of
activity. Wheat Treat’s bud-
get is based on the assumption that each unit sold triggers an
additional $1.25 in cost
(Exhibit 6.8). The fixed SG&A components tend to include
management and clerical sala-
ries, planned advertising campaigns, the costs associated with
office space, insurance, and
similar unavoidable costs that are not a function of business
volume (over the relevant
planned range of operations). Wheat Treat is planning for
$30,000 per quarter, divided
between salaries, office, and other costs. The budget is based on
an assumption that all
SG&A costs are all funded in cash as incurred.
10 lbs.
0.25 hours
0.25 hours
Cost Component

Direct material
Direct labor
Applied factory overhead
X Units in ending finished goods inventory
Ending finished goods inventory
Units
WHEAT TREAT
Ending Finished Goods Inventory
$ 0.15
$ 11.00
$ 2.00
Per Unit Cost
$ 1.50
2.75
0.50
$ 4.75
20,000
$ 95,000

Per Unit Total
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153
Exhibit 6.8
At this juncture, there are numerous individual budgets.
Although they are interesting
and perhaps useful at lower levels of operation and
management, we are lacking an over-
all picture of company-wide expectations. For instance, is the
company expected to be
profitable? To answer important “macrolevel” questions
requires drawing together the
individual budgeting building blocks into a comprehensive
picture. Exhibit 6.9 is the bud-
geted income statement for Wheat Treat for 20X4.
Exhibit 6.9
50,000
$ 1.25
$ 62,500
$ 20,000

8,000
2,000
$ 30,000
$ 92,500
Estimated units sold
X Per unit variable SG&A
Total variable SG&A
Fixed SG&A
Salaries
Office
Other
Total fixed SG&A
Total budgeted SG&A
1st Quarter
WHEAT TREAT
Selling, General, and Administrative Budget
60,000

$ 1.25
$ 75,000
$ 20,000
8,000
2,000
$ 30,000
$ 105,000
2nd Quarter
65,000
$ 1.25
$ 81,250
$ 20,000
8,000
2,000
$ 30,000
$ 111,250
3rd Quarter
80,000

$ 1.25
$ 100,000
$ 20,000
8,000
2,000
$ 30,000
$ 130,000
4th Quarter
255,000
$ 1.25
$ 318,750
$ 80,000
32,000
8,000
$ 120,000
$ 438,750
Annual Recap
Sales

Cost of goods sold
Beginning finished goods
Cost of goods manufactured
Goods available for sale
Less: Ending finished goods inventory
Cost of goods sold
Gross profit
SG&A
Income before interest and taxes
Interest
Income before taxes
Income taxes
Net income
$ 47,500
1,258,750
$1,306,250
$ 95,000
$1,912,500

1,211,250
$ 701,250
438,750
$ 262,500
2,000
$ 260,500
60,500
$ 200,000
WHEAT TREAT
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154
The information in the income statement was derived from
various portions of the previ-
ous budgets, along with a few added assumptions. To help you
understand the income
statement amounts, please refer to the notes in Table 6.1.
Table 6.1: Additional assumptions

Sales Annual recap within sales budget
Beginningfinished goods Last year’s ending
finished goods (assumed)
Cost of goods manufactured Production budget quantity
times per-unit cost from
inventory schedule (265,000 3 $4.75)
Goods available for sale Subtotal
Ending inventory Inventory schedule
Cost of goods sold Subtotal
Gross profit Subtotal
SG&A Annual recap within SG&A budget
Income before interest and taxes Subtotal
Interest Assumed amount
Income before taxes Subtotal
Income taxes Assumed provided by tax department
Net income Subtotal
The budgeted income statement is essential for allowing
management to know the
expected outcome for the period. With this information,
management knows whether
operational adjustments are necessary to ensure satisfactory
performance for the year.

Furthermore, as deviations from budget take place, management
is keenly positioned to
know what the effect will be on the overall performance of the
enterprise. Imagine trying
to anticipate future outcomes without a comprehensive budget.
Perhaps you can begin to
appreciate why the budget process is indeed so important to
business success.
Cash Budget
Another macrolevel view of the enterprise’s expectations can be
derived by reference to
the cash budget. Although we now know that Wheat Treat is
looking forward to a $200,000
profit, we do not yet know much about its cash flows. You
might be surprised to find that
Wheat Treat will actually run out of cash unless the company
makes plans for additional
borrowings! How can this be? Begin by looking at the cash
budget shown in Exhibit 6.10.
waL80281_06_c06_141-168.indd 14 9/25/12 1:03 PM
155
Exhibit 6.10
Without an adequate supply of cash, a business’s plans cannot
be realized. Even success-
ful businesses can occasionally find themselves squeezed.
Causes include delays in col-

lecting receivables and capital expenditure decisions. Wheat
Treat is expecting both. You
have already seen the reconciliation of sales to cash receipts in
a prior schedule. Also notice
that the second quarter of the year involves a land purchase for
$150,000. Given these fac-
tors, the company expects a second quarter cash shortage of
$66,363. By knowing this in
advance, and being able to explain why it is not a systemic
problem, the company should
be able to arrange for borrowings to bridge over the anticipated
shortfall. This planned bor-
rowing is reflected in the lower portion of the schedule. By the
fourth quarter, operations
have generated sufficient cash to repay half of the loan and all
of the accrued interest.
It is perhaps obvious at this point, but each value (e.g., cash
receipts) is taken from one of
the prior budgets. The only exceptions relate to the assumed
values for beginning cash,
the land purchase, and the schedule borrowings/repayments.
Take time to relate the val-
ues to previous schedules.
Distribution of Budgets
Budgets are normally prepared for internal use only.
Nevertheless, external financial
statement users may have a keen interest in knowing what they
reveal. Investors and
lenders surely would prefer to know what management is
thinking about the future, as
reflected in budgets. Businesses would not normally choose to
make such information
broadly available. However, in special circumstances, such as a

condition of a loan, a
business may conclude that its best interests are served by
revealing its internal projec-
tions. When this occurs, professional standards include fairly
complex disclosure rules,
including language noting that the company is not vouching for
the achievability of
$ 50,000
365,000
$ 415,000
$ 74,513
143,000
27,775
92,500
10,000
–
$ 347,788
$ 67,213
–
–
–
$ 67,213
Beginning cash balance
Plus: Customer receipts
Available cash
Less: Disbursements
Direct materials
Direct labor
Factory overhead

SG&A
Taxes
Land purchase
Total Disbursements
Cash surplus/(deficit)
Financing:
Planned borrowing
Planned repayment
Interest on repayment
Ending cash balance
1st Quarter
WHEAT TREAT
Cash Budget
$ 67,213
420,000
$ 487,213
$ 89,251
167,750
29,575
105,000
12,000
150,000
$ 553,576
$ (66,363)
100,000
–

–
$ 33,638
2nd Quarter
$ 33,638
472,500
$ 506,138
$ 101,438
187,000
30,975
111,250
18,000
–
$ 448,663
$ 57,475
–
–
–
$ 57,475
3rd Quarter
$ 57,475
555,000
$ 612,475
$ 121,163

231,000
34,175
130,000
20,500
–
$ 536,838
$ 75,638
–
(50,000)
(2,000)
$ 23,638
4th Quarter
$ 50,000
1,812,500
$ 1,862,500
$ 386,365
728,750
122,500
438,750
60,500
150,000
$ 1,886,865
$ (24,365)
100,000
(50,000)

(2,000)
$ 23,635
Annual Recap
waL80281_06_c06_141-168.indd 15 9/25/12 1:03 PM
156
CHAPTER 6Section 6.5 Flexible Budgets
the results. Notwithstanding that assertion, the involved
accountant nevertheless has a
duty to prepare the reports carefully and to possess a reasonable
basis for the assump-
tions utilized in preparing the information. Public companies
will sometimes provide
forward-looking guidance to their shareholders, but it is
invariably accompanied by
additional cautionary language.
Budget Cycles
You will normally see budgets that are prepared for specific
time intervals. These budgets
may relate to a month, quarter, year, or other clearly
identifiable time period. Sometimes,
the budget may relate to a natural business cycle. For example,
a wheat farmer’s crop does
not follow a calendar year. What use could one make of a
calendar year budget in this
case? The budget would clearly need to relate to the time period
extending from at least

planting through harvest. In other business environments, a
budget may be continuous in
nature. Such budgets are constantly being updated to reflect the
addition of future months
or quarters. With the completion of one period, another period
is pulled into the budget.
This rolling approach allows management better insight into
business adaptations that
are needed for changing economic conditions.
6.5 Flexible Budgets
The comprehensive budget illustration you just studied
presumed a static budget. In other words, the budget was
developed for a single level of activity. A shortcoming
of this approach is that it is insensitive to volume fluctuations.
This presents special chal-
lenges for managing a business and for performance evaluation.
As actual output varies
from the anticipated level, significant deviations in revenues
and expenses will naturally
occur. These variances can produce quite misleading signals.
For example, if a company
produces and sells more products than anticipated, you would
also expect an increase in
selected variable expenses. This will appear as a cost overrun
when actual results are com-
pared to the static budget. Although the natural response to a
cost overrun is to assume
that this is a bad thing, it may well be that the growth signifies
great success. The opposite
effects can also be true. Adjusting budgets and budget models
for the effects of volume
fluctuations is the goal of flexible budgeting.
A flexible budget can best be explained with a simple example.

Assume that Old Time
Dominoes manufactures simulated ivory dominoes. Direct
materials are budgeted to cost
$1 per set, direct labor is budgeted at $0.50 per set, and variable
factory overhead is antici-
pated to run $0.70 per set. The company plans for fixed factory
overhead of $12,000 per
month. The middle column of Exhibit 6.11 reveals the details of
the $34,000 monthly bud-
get, based on the usual anticipated production run of 10,000
sets.
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157
Exhibit 6.11
During May, Old Time Dominoes received a large order from a
company that wanted to
award sets of dominoes to employees as a thank-you gift. The
company was pleased with
the added business but disturbed by the unfavorable budget
variances. For most expense
categories, the company seems to have spent more than was
budgeted, producing several
unfavorable indicators.
Because of the added volume, the company actually produced
11,000 sets of dominoes.
This is not apparent in the preceding report. The company
actually needs to prepare a

flexible budget to understand better the effectiveness of its cost
control. A flexible budget
will reveal the amount of expenses that are anticipated for the
given level of production.
The following example shows that variable costs are “budgeted”
at a higher overall level.
Because production was 10% greater than normal, so are the
budgeted variable expense
components within the middle column in Exhibit 6.12.
Exhibit 6.12
The flexible budget outcomes paint an entirely different
conclusion. There were only slight
deviations from budget, as revealed by the variances related to
selected expense catego-
ries. This information is probably far more useful for
performance evaluation purposes.
$ 11,000
5,100
7,900
$ 24,000
11,500
$ 35,500
Variable expenses:
Direct materials
Direct labor

Variable factory overhead
Total variable expenses
Total manufacturing costs
Actual
OLD TIME DOMINOES
Expense Budget
For the Month Ending May 31, 20XX
$ 10,000
5,000
7,000
$ 22,000
12,000
$ 34,000
Budget
$ (1,000)
(100)
(900)

$ (2,000)
500
$ (1,500)
Variance
$ 11,000
5,100
7,900
$ 24,000
11,500
$ 35,500
Variable expenses:
Direct materials
Direct labor
Actual
(11,000 sets)

OLD TIME DOMINOES
Flexible Expense Budget
$ 11,000
5,500
7,700
$ 24,200
12,000
$ 36,200
Budget
(11,000 sets)
$ –
400
(200)
$ 200
500
$ 700
Variance
waL80281_06_c06_141-168.indd 17 9/25/12 1:03 PM

158
Using Flexible Budgets in Business Management
A flexible budget can be prepared either before or after actual
production is known. Pre-
paring a flexible budget “after the fact” may help explain
variances and aid in performance
evaluation, but it does little to facilitate corporate planning. For
planning purposes, it is
better to prepare the flexible budget (or a financial model of the
anticipated outcomes) in
advance. By anticipating fluctuations in volume, a business is
empowered to anticipate
needed adjustments to materials and labor. Exhibit 6.13 is an
example of a flexible budget
that contemplates outcomes based on four different possible
outcomes.
Exhibit 6.13
Considering Per-Unit Costs and Profit Impacts
The preceding perspective on flexible budgeting focused on
total costs. These data can be
modified for analysis purposes. One modification is to calculate
per-unit costs, as shown
in Exhibit 6.14.
Exhibit 6.14

In Exhibit 6.14, the total manufacturing costs were divided by
the total units, yielding a
calculation of per-unit cost. It is immediately apparent that per-
unit cost declines as vol-
ume increases. This occurs because the fixed cost pool is spread
across more units. This
$ 9,000
4,500
6,300
$ 19,800
12,000
$ 31,800
Variable expenses:
Direct materials
Direct labor
Budget
(9,000 sets)
OLD TIME DOMINOES
Flexible Expense Budget/Alternative Scenarios
$ 10,000
5,000
7,000

$ 22,000
12,000
$ 34,000
Budget
(10,000 sets)
$ 11,000
5,500
7,700
$ 24,200
12,000
$ 36,200
Budget
(11,000 sets)
$ 12,000
6,000
8,400
$ 26,400
12,000
$ 38,400
Budget
(12,000 sets)
$ 9,000
4,500
6,300

$ 19,800
12,000
$ 31,800
$ 3.53
Variable expenses:
Direct materials
Direct labor
Total manufacturing costs per
unit (total cost divided by units)
OLD TIME DOMINOES
Flexible Expense Budget/Per Unit Cost Assessment
$ 10,000
5,000
7,000
$ 22,000
12,000
$ 34,000
$ 3.40
$ 11,000
5,500

7,700
$ 24,200
12,000
$ 36,200
$ 3.29
$ 12,000
6,000
8,400
$ 26,400
12,000
$ 38,400
$ 3.20
Budget
(9,000 sets)
Budget
(10,000 sets)
Budget
(11,000 sets)
Budget
(12,000 sets)
waL80281_06_c06_141-168.indd 18 9/25/12 1:03 PM

159
extended analysis enables a better understanding of the need to
fully utilize fixed capacity
to generate maximum efficiency. Furthermore, the tool can
facilitate logical pricing deci-
sions. You have probably heard how giant retailers such as Wal-
Mart drive tough business
deals to get low prices from their suppliers. One reason
suppliers are willing to respond is
because the orders tend to be quite large, enabling them to
squeeze maximum efficiency
out of their existing cost structure.
Another advantage of flexible budgeting is that it aids overall
profitability analysis. Con-
sider Exhibit 6.15, which is based on an assumed selling price
of $10 per set.
Exhibit 6.15
This report adds information to the flexible budget about sales
in dollars. The net of the
total sales and total manufacturing costs reflects the amount of
income that will be avail-
able to cover anticipated SG&A costs and provide for a profit
margin. The managers of
the manufacturing operation may not be provided with
information about SG&A, and
their flexible budget may stop at the point shown in the
preceding budget. However, at
higher levels with the organization, more may be known about
(including responsibility
for) SG&A costs, and the flexible budget could be expanded to

include information about
these costs.
Extending Flexible Budgeting
For simplicity, the flexible budget illustration in this chapter
reveals aggregated amounts.
In actuality, a flexible budget would usually resemble the
comprehensive budget. The
comprehensive flexible budget would permit a drill down to the
smallest levels of oper-
ational detail. This information would allow management to
pinpoint exactly where
operational efficiencies and inefficiencies are occurring,
thereby providing an excellent tool
for performance evaluation. When performance evaluation is
only based on a static bud-
get, there is a reduction in incentive to drive sales increases.
This occurs because increases
in volume tend to produce greater costs that may appear as
unfavorable variances.
$ 90,000
$ 9,000
4,500
6,300
$ 19,800
12,000
$ 31,800

$ 58,200
Total Sales
Variable expenses:
Direct materials
Direct labor
Income available to cover SG&A
OLD TIME DOMINOES
Income to Cover SG&A
$ 100,000
$ 10,000
5,000
7,000
$ 22,000
12,000

$ 34,000
$ 66,000
$ 110,000
$ 11,000
5,500
7,700
$ 24,200
12,000
$ 36,200
$ 73,800
$ 120,000
$ 12,000
6,000
8,400
$ 26,400
12,000
$ 38,400
$ 81,600

Budget
(9,000 sets)
Budget
(10,000 sets)
Budget
(11,000 sets)
Budget
(12,000 sets)
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160
CHAPTER 6Section 6.6 Benefits of Technology in Budgeting
6.6 Benefits of Technology in Budgeting
By now, it has surely occurred to you that computers are most
helpful in preparing budget information, especially as it relates
to flexing the budget for constant changes
in volume and cost. The budget preparation is not nearly as
tedious and costly as it once
was. In the past, building a budget required a number of
iterative rounds of information
sharing such that each level within an organization found it
necessary to do and redo
its financial plans based on new information and directives.
Today’s electronic tools and
budgeting models provide embedded links such that the slightest
tweak by one unit is

transferred into the budget models deployed by other units.
Modern business information systems are often highly
sophisticated. Budget data,
although not central to a traditional general ledger system, are
nonetheless incorporated
into a sophisticated modern database of accounting information.
These systems include
real-time feedback on budget versus actual performance, often
in graphical form. Further-
more, budgeted expenditures can be reflected as authorization
“tags,” thereby expediting
execution of approved business purchases (i.e., approved
expenditures have a shortened
purchasing cycle requiring less management action for final
approval).
Indeed, electronic data interchange between companies and their
suppliers and custom-
ers facilitates an interlocking of selected budgeting data. As
product demand increases
or decreases, computerized flexible budgets can be adjusted on
a real-time basis to send
signals throughout the modern organization (including
electronic data interchange with
suppliers). The net result is that the supply chain is immediately
adjusted to match raw
material orders to anticipated production levels, thereby
eliminating significant waste.
The presence of a sophisticated supply chain management
system is a hallmark feature
of today’s successful business. For example, inventory
investment is minimized in an
optimal manner. Furthermore, obsolescence is greatly reduced.
Computer systems are
designed to adjust purchases automatically based on real-time

flow of goods all the way
through to an end customer. Surely you have noticed the
proliferation of chain stores such
as Best Buy, Lowes, Bed Bath and Beyond, and Kohl’s. One
feature they all have in com-
mon is a robust information system in support of their supply
chain management. Despite
their gigantic size, they probably have a better pulse on their
business volume and prod-
uct flow than any “mom-and-pop” one-location retailer. It is
fair to say that the growth
of these retail giants would not have occurred without modern
technology in support of
their business processes. You can easily think of their
information technology as the “ulti-
mate” in perfecting business performance via a real-time
flexible budget.
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161
CHAPTER 6Concept Check
Concept Check
The five questions that follow relate to several issues raised in
the chapter. Test
your knowledge of the issues by selecting the best answer. (The
correct answers can
be found at the end of your text.)
1. Preparing the comprehensive budget begins with
consideration of

a. direct labor budget.
b. ending inventory levels.
c. cash disbursements.
d. anticipated sales.
2. Calculating fixed unit manufacturing costs results in
a. constant unit costs as production increases.
b. constant unit costs as production decreases.
c. increasing unit costs as production increases.
d. increasing unit costs as production decreases.
3. Which of the following will result in a direct materials
efficiency variance that is
not favorable?
a. The actual unit cost of direct materials exceeds the standard
cost of direct materials.
b. The actual cost per unit of direct materials was less than
the standard cost of
direct materials.
c. The actual quantity of direct materials used per unit
exceeds the standard quan-
tity of direct materials allowed per unit.
d. The actual quantity of direct materials used per unit is less
than the standard
quantity of direct materials allowed per unit.
4. Parno Fitters has beginning inventory of 15,000 units. Sales
are expected to be
41,000 units. The anticipated ending inventory is 12,500 units.
How many units
must be produced?

a. 41,500
b. 46,000
c. 38,500
d. 43,500
5. Preparation of the cash budget takes all but which of the
following items into con-
sideration?
a. Depreciation expense
b. Cash received from customers
c. Inventory payments
d. Payments to suppliers
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CHAPTER 6
budget committee An entity within a
company that can be made up of senior
representatives from each business unit.
Their role includes being an advocate to
make the case for resources needed by
their business unit.
budgets Detailed financial plans that
quantify future expectations and actions.
comprehensive budget The cornerstone
documentation revealing a business’s
anticipated sales, expenses, financial
needs, and so forth. It is sometimes

referred to as the master budget.
flexible budgeting Adjusting budgets and
budget models for the effects of volume
fluctuations.
incremental budgeting Overall budgeting
framework in which the previous year’s
budget is used as a starting point.
responsibility accounting A term mean-
ing that units and their managers are held
accountable for transactions and events
under their direct influence and control.
zero-based budgeting An approach in
which no planned expenditure is protected
by the status quo. Each budget item must
be justified during each budget cycle.
Critical Thinking Questions
Key Terms
Critical Thinking Questions
1. Briefly discuss the advantages of budgeting.
2. Is a budget a planning tool, a control tool, or both? Explain.
3. When evaluating performance, many organizations compare
current results with
the actual results of previous accounting periods. Is an
organization that follows
this approach likely to encounter any problems? Explain.
4. Explain how a budget assists in coordinating the plans of an

organization’s various
subunits (divisions, departments, and so forth).
5. Define and fully explain the top–down approach to
budgeting.
6. Briefly discuss the concept of slack as it pertains to
budgeting.
7. Calabro Corporation, a manufacturer with annual sales
approaching $75 million, is
beginning the budget process for the upcoming year. Should
Calabro use long-term
budgets, yearly budgets, or monthly budgets? Explain your
answer.
8. Why is an accurate sales forecast so important in the
preparation of a master budget?
9. Why is it necessary to carefully budget direct labor
requirements for an upcoming
period?
10. Explain how a cash budget leads to effective management
of an organization’s cash
balances.
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163
CHAPTER 6Exercises
Exercises

1. Overview of the budgeting process
Evaluate the comments that follow as being true or false. If the
comment is false,
briefly explain why.
a. When assessing current performance, a comparison of
actual results against a
predetermined budget is generally preferred over a comparison
of the current
period’s actual results with those of the preceding period.
b. Lower level managers are inclined to work harder to
achieve budgeted targets if
the top–down (rather than the bottom–up) budget approach is
used.
c. Virtually all budgets are 1 year in duration.
d. Land & Sea plans to sell 36,700 units of its single product
during the coming year.
If the beginning and ending finished goods inventories are
15,900 and 17,700
units, respectively, the company’s production budget will reveal
that 38,500 units
should be manufactured.
e. The last step in the construction of a master budget is the
preparation of a cash
budget.
2. Schedule of cash collections
Sugarland Company sells a single product and anticipates
opening a new facility in
Charlotte on May 1 of the current year. Expected sales during
the first 3 months of
activity are as follows: May, $60,000; June, $80,000; and July,

$85,000.
Thirty percent of all sales are for cash; the remaining 70% are
on account. Credit
sales have the following collection pattern:
Collected in the month of sale 60%
Collected in the month following sale 35
Uncollectible 5
a. Prepare a schedule of cash collections for May through July.
b. Compute the expected balance in Accounts Receivable as of
July 31.
3. Direct material purchases budget
Bass Corporation manufactures a home video recorder that
requires four No. S1326
circuit boards. Anticipated production of recorders for the
upcoming year follows:
Quarter Production (units)
First 8,000
Second 10,000
Third 12,000
Fourth 16,000
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164
CHAPTER 6Exercises
Bass wants to stock enough circuit boards to meet 30% of the
following quarter’s
production needs. Circuit boards cost $2.50 each; the cost has
been fairly stable dur-
ing the past 6 months.
Assuming a beginning circuit board inventory of $23,750,
prepare a direct material
purchases budget for the first three quarters of the year.
4. Production and cash-outlay computations
RPR Inc. anticipates that 120,000 units of product K will be
sold during May. Each
unit of product K requires four units of raw material A. Actual
inventories as of
May 1 and budgeted inventories as of May 31 follow:
May 1 May 31
Product K (units) 55,000 60,000
Raw material A (units) 40,000 37,000
Each unit of raw material A costs $8; RPR pays for all
purchases in the month of
acquisition. Invoices that account for 80% of the cost of
materials acquired will be
paid within 10 days of receipt, entitling the company to a 2%
cash discount.
a. Determine the number of units of product K to be
manufactured in May.

b. Compute the May cash outlay for purchases of raw material
A.
5. Abbreviated cash budget; financing emphasis
An abbreviated cash budget for Big Chuck Enterprises follows:
July August September
Beginning cash balance $ 10,000 $ ? $ ?
Add: Cash receipts 50,000 63,000 71,000
Deduct: Cash payments (64,000) (58,000) (64,000)
Cash excess (deficiency)
before financing
$ (4,000) $ ? $ ?
Financing
Borrowing to maintain
minimum balance
? ? ?
Principal repayment ? ? ?
Interest payment ? ?
?
Ending cash balance $ ? $ ? $ ?
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165
CHAPTER 6Problems
Big Chuck wants to maintain a $10,000 minimum cash balance
at all times. Additional
financing is available (and retired) in $1,000 multiples at a 12%
interest rate. Assume
that borrowings take place at the beginning of the month;
retirements, in contrast,
occur at the end of the month. Interest is paid at the time of
repaying principal and
computed on the portion of principal repaid.
a. Find the unknowns in Big Chuck’s abbreviated cash budget.
b. Determine the outstanding loan balance as of September
30, after any repay-
ments have been made.
Problems
1. Production and purchases budgets; purchasing policy
Mason Inc. manufactures and distributes various parts for lawn
mowers. The com-
pany’s main product, a bilateral assembly, requires five units of
direct material at
a cost of $0.60 per unit. To keep production moving smoothly,
the firm must main-
tain a direct materials inventory equal to 70% of the following
month’s production
needs. Sales projections in units for the past 6 months of 20X6
follow:
Month Estimated sales

July 9,000
August 12,000
September 16,000
October 22,000
November 29,000
December 26,000
Management wants to carry a finished goods inventory equal to
40% of the follow-
ing month’s sales. On June 30, 20X6, the finished goods
inventory totaled 3,200
assemblies. On the same date, 30,000 units of direct material
were in the warehouse.
Instructions
a. Prepare a production budget for July through September.
b. Prepare a direct material purchases budget for July through
September.
c. List several factors that could cause a change in the
company’s present direct
material inventory policy.
2. Cash budget for service enterprise; analysis of operations
The Eastside Tennis Club frequently experiences cash flow
difficulties, with its
checking account often below a desired minimum balance of
$12,000. The follow-
ing information pertains to club operations for the upcoming
year (20X2):

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166
CHAPTER 6Problems
1) The directors anticipate that 400 memberships will be sold.
Family
memberships ($150) will comprise 60% of this total; the
remainder are
individual memberships ($50).
2) Members are assessed hourly fees for court time; the rate
depends on whether
usage occurs during “prime” time or “regular” time. The
following hours and
rates are expected:
3)
Prime time Regular time
Rate per hour $ 10 $ 7
Hours of use 4,300 6,500
4) With the exception of accounts that total $2,500, all billings
for memberships
and court fees are expected to be collected during the year.
5) John Connors, club pro, is paid a salary of $20,000 plus
20% of all court fee
revenues. Connors gives private lessons and expects to earn an
additional

$3,500. Lesson fees are paid directly to Connors by the
participating members.
6) Expenses incurred during 20X1 were as follows:
maintenance, $34,000;
utilities, $13,500; and taxes, $6,200. Maintenance and utilities
are expected to
increase by 10% during 20X2; taxes should amount to $6,800.
All expenses will
be paid when incurred.
7) An examination of the club’s records revealed outstanding
accounts payable
of $1,000 on January 1, 20X2. These amounts will be paid by
the end of
February.
8) The addition of one new court and improved lighting will
cost $45,000. The
club will pay $20,000 down, with the remaining balance
financed by a short-
term note. Interest and principal payments during 20X2 will
amount to $3,600.
9) The cash balance on January 1, 20X2, amounts to $5,000.
Instructions
a. Prepare a cash budget for 20X2 for the Eastside Tennis
Club. Disregard financing
(except for that noted in item 7) to meet minimum balance
requirements.
b. Assume that the budget revealed an ending cash balance of
$4,400. In light of the
club’s target minimum of $12,000, what actions could the

directors take to improve
the ending cash position?
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167
CHAPTER 6Problems
3. Comprehensive budgeting
The balance sheet of Watson Company as of December 31,
20X1, follows:
WATSON COMPANY
Balance Sheet
December 31, 20X1
Assets
Cash $ 4,595
Accounts receivable 10,000
Finished goods (575 units 3 $7.00) 4,025
Direct materials (2,760 units 3 $0.50) 1,380
Plant & equipment $50,000
Less: Accumulated depreciation 10,000 40,000
Total assets $ 60,000

Liabilities & Stockholders’ Equity
Accounts payable to suppliers $ 14,000
Common stock $25,000
Retained earnings 21,000 46,000
Total liabilities & Stockholders’ equity $ 60,000
The following information has been extracted from the firm’s
accounting records:
1) All sales are made on account at $20 per unit. Sixty percent
of the sales
are collected in the month of sale; the remaining 40% are
collected in the
following month. Forecasted sales for the first 5 months of
20X2 are as follows:
January, 1,500 units; February, 1,600 units; March, 1,800 units;
April, 2,000
units; and May, 2,100 units.
2) Management wants to maintain the finished goods inventory
at 30% of the
following month’s sales.
3) Watson uses four units of direct material in each finished
unit. The direct
material price has been stable and is expected to remain so over
the next
6 months. Management wants to maintain the ending direct
materials
inventory at 60% of the following month’s production needs.
4) Seventy percent of all purchases are paid in the month of

purchase; the
remaining 30% are paid in the subsequent month.
5) Watson’s product requires 30 minutes of direct labor time.
Each hour of direct
labor costs $7.
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168
CHAPTER 6Problems
Instructions
a. Rounding computations to the nearest dollar, prepare the
following for January
through March:
1) Sales budget
2) Schedule of cash collections
3) Production budget
4) Direct material purchases budget
5) Schedule of cash disbursements for material purchases
6) Direct labor budget
b. Determine the balances in the following accounts as of
March 31:
1) Accounts Receivable
2) Direct Materials
3) Accounts Payable
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chapter 7
Standard Costs and Variances
Learning Objectives
• Understand the concepts of standards and standard costs.
• Know how to calculate direct materials price and quantity
variances, and understand
their implications in assessing material cost and waste.
• Know how to calculate direct labor rate and time
variances, and understand their
implications in assessing labor cost and utilization.
• Know how to calculate factory overhead volume and
controllable variances, and
understand their implications in assessing overhead spending
and efficiency.
istockphoto
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170
CHAPTER 7Section 7.1 What Are Standards?
Chapter Outline

7.1 What Are Standards?
Controlling Via Standards
Establishing Standards
Comparing Actual to Standard
7.2 General Variance Model
Variances Relating to Direct Material
Impact on the Ledger
Variances Relating to Direct Labor
Variances Related to Factory Overhead
7.3 Concluding Discussion on Variances
In the previous chapter, you studied budgets and general
variances. Recall that a variance is just a departure from the
expected outcome. You learned many important concepts,
including the idea that budget variances are sometimes
explainable by volume fluctua-
tions. To the extent that a budget variance is only due to a
volume fluctuation, it may not be
an indication of a lack of cost control or inefficiency. Thus,
some variances do not require a
response. On the other hand, some unfavorable variances may
suggest the need for swift
corrective actions. How is a manager to discern the nature of a
budget variance?
One method for sorting out the nature of budget variances is the
flexible budget. This
concept was also introduced in the previous chapter, and it
provides an excellent point
of beginning. However, it is only a point of beginning. For
example, if a company spent

more on direct material than expected, it could be explained by
higher than anticipated
levels of production, but it could also be due to waste and/or
paying more per unit for
raw material inputs. Only through a detailed analysis can a
manager fully understand the
nature of expenditures, and through those understandings begin
to look for opportunities
for improvement. This is where standards and variance analysis
come into play.
7.1 What Are Standards?
Standards are the predetermined expectations about the inputs
that will be required to achieve anticipated output. For a
manufacturer, inputs generally relate to the factors of
production, namely materials, labor, and overhead. Output is
usually (but not always) the
product or service that is to be delivered to a customer.
Standard costs express a measure
of what the factors of production should cost.
Standards serve multiple purposes. They are essential to
business planning. Standards
were implicit in the budget process in the prior chapter. You
might recall how Wheat
Treat anticipated 10 pounds of direct material for each unit.
That scenario represented a
straightforward example of a standard that was used in the
planning process. Standards
were also implicit to cost–volume–profit (CVP) analysis. Recall
how CVP techniques were
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171
CHAPTER 7Section 7.1 What Are Standards?
used to study many facets of business operations, such as the
determination of the sales
level necessary to achieve profitability. Standards are also very
useful in pricing and bill-
ing. Have you ever had your car repaired? Look closely at the
bill and you will probably
see that labor was charged not on actual time or wages but,
rather, on a standard amount
of time for the designated task. It may have taken the mechanic
more or less time to per-
form the task, but the work was billed for standard hours and at
a standard wage rate.
Standards are also used in control applications, which is the
primary focus for this chapter.
Controlling Via Standards
Controlling a business requires constant comparison of achieved
results to planned or
predetermined standards. In this context, standards are the
established benchmarks of
efficiency and cost incurrence. You have likely been involved
with standards in some job
you have performed. For example, many people have been
employed in fast-food restau-
rants. You are probably aware that these businesses have very
specific expectations about
customer wait times, food temperatures, cleanliness guidelines,
and so forth. These stan-
dards are clearly intended to keep the business operating at peak
performance. Most busi-

nesses will create their own unique standards. As noted
previously, manufacturers tend
to focus on the key factors of production in setting standards.
Thus, a finished unit can be
analyzed from the perspective of its raw material, direct labor,
and factory overhead. By
the time you complete this chapter, you will be quite familiar
with standards and variance
calculations related to each. In addition, keep in mind that other
nonfinancial standards
could relate to product quality, delivery schedule, and so forth;
thus, standards apply to
both manufacturing and nonmanufacturing environments.
Without standards, tasks tend
to expand in a costly manner.
Establishing Standards
Establishing standards is far more complex than you might
think. If you were going to tile
a floor, you know that you would likely use more square feet of
tile than is the size of the
room. The nooks and crannies of the room might require some
complex cuts with atten-
dant scrap, and the overall dimensions of the room will
probably require some wasted
end cuts. Then, mistakes are also made. Tiles might be broken,
set crooked and have to
be chipped up and redone, and so forth. In calculating the
quantity of tile to buy, you will
probably estimate liberally and then buy a few more for
unplanned problems. The last
thing you would want to happen is to run out of tiles with the
room 95% complete. What if
you could not then procure enough additional matching tiles to
finish? On the other hand,

you certainly would not want to have an enormous quantity of
unused tiles, especially if
you could not return the unused quantity to the supplier.
Calculating the quantity of tiles
is very similar to the challenge faced in a manufacturing
environment. The managerial
accountant would need to study the production environment,
taking into consideration
waste and spoilage. The problems faced in estimating material
also relate to labor. How
long should it take to tile the room? No doubt you probably find
that your own projects
take longer than you expect, especially when unanticipated
problems arise. There is also a
learning curve. If you were to tile two equally shaped rooms,
the second one would prob-
ably go much quicker than the first. Again, business standard
setters face the same issues.
Managerial accountants may be helpful in performing studies
and building models that
are foundational to establishing standards. For instance, a
managerial accountant may be
one of the few persons with access to overall information.
Overall information is needed
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CHAPTER 7Section 7.2 General Variance Model
in setting standards because standards are often based on
averages; total estimated costs

must be divided by total estimated output or activity. This is
especially true for overhead
where the standard variable overhead is sometimes determined
by dividing estimated
variable overhead by the estimated activity level. In similar
fashion, fixed standard per-
unit overhead reflects the total estimated fixed overhead divided
by the estimated activity.
Notwithstanding the need to engage the managerial accountants
in setting standards, it
is also imperative to involve personnel who best understand the
operational processes.
These frontline persons will have the best understanding of the
specific amounts of time
and materials that are necessary to achieve desired outcomes.
Their realistic assessments
are invaluable in providing insight needed to understand what is
truly necessary to get a
job done and thereby set standards.
Comparing Actual to Standard
In the previous chapter, you saw how a budget could be
compared to actual results. The
mathematical differences were simply referred to as variances.
When actual cost is more
than planned, an unfavorable variance is produced, and vice
versa. This is quite logical. It
is the hallmark of variance analysis. The foundation for
variance analysis is the setting of
standards; without standards, you would have no basis for
comparison.
Variance analysis is the examination of the deviations between
actual and standard costs.

More important, its objective is to identify areas for
improvement. This is an important
role for management. Although comparing total actual costs to
total standard costs is
interesting, it provides little useful information for identifying
specific problems that can
be corrected. A more penetrating analysis into the detailed
variances relating to each fac-
tor of production is needed. Developing these analytical tools is
the goal for the remainder
of this chapter.
7.2 General Variance Model
The point of beginning is to set a general frame of reference and
some attendant nomen-clature. Let’s establish the following
generalities:
When Actual Cost (AC) . Standard Cost (SC), the result is an
Unfavorable
Variance (UV)
and
When SC . AC, the result is a Favorable Variance (FV)
Furthermore,
AC 5 Actual Quantity (AQ) 3 Actual Price (AP) per unit
and
SC 5 Standard Quantity (SQ) 3 Standard Price (SP) per unit
These general formulations are foundational to the variance
analysis techniques that

follow.
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173
Variances Relating to Direct Material
There are two primary variances that relate to direct materials.
Simply, when a company
pays more or less than the standard price per unit, the result is
an unfavorable or favor-
able price variance. The other type of variance relates to usage.
When a company uses
more or less than the standard quantity, the result is an
unfavorable or favorable usage
variance. The combination of both variances results in the total
materials variance, reflect-
ing a combination of effects related to both pricing and usage.
The total variance for direct
materials is the overall difference between actual direct
material cost and standard
direct material cost. Although the total variance is important,
the individual variances
provide the greatest insight and opportunity for control. Thus,
your focus should be on
the individual variances.
The materials price variance reveals the difference between the
standard price for mate-
rials purchased and the amount actually paid for those
materials. Thus, the following

formula applies:
Materials Price Variance 5 (SP 2 AP) 3 AQ
In applying the preceding formula, we shall assume that the
quantity purchased and the
quantity used are identical; additional fine-tuning of the
formulas would be necessary if
such were not the case.
The materials quantity variance reveals the difference between
the standard cost of the
standard quantity of materials that should have been used and
the standard cost of
the actual quantity of materials used. Thus, consider the
following formula:
Materials Quantity Variance 5 (SQ 2 AQ) 3 SP
In applying either of the preceding formulas, a negative result
suggests an unfavorable
variance, and vice versa. In other words, negative values
produced by these formulations
suggest that actual prices/quantities exceed standard
prices/quantities. It is important
for you to grasp more than just the formulas. It is good for you
to also think in terms of
favorable and unfavorable conditions by asking the following
question: Does this vari-
ance create a favorable or unfavorable situation for the
company? If there is an unfa-
vorable price variance (actual . standard) and an unfavorable
labor efficiency variance
(actual . standard / budgeted), the total variance would also be
unfavorable. In other
words, a company does not want to pay more than standard cost

for materials (price vari-
ance) or use more than the standard requirement for materials.
The preceding formulas are reinforced with an example. Assume
that Bamboo Mat Com-
pany produces a flat wooden panel that can be used as a serving
tray or laptop desk. The
only raw material that is needed for production—other than
glues, sand paper, and stains
that are treated as indirect materials—is strips of bamboo that
are acquired from a dealer.
In ideal circumstances, each panel requires 20 strips of bamboo
that are aligned and glued
together. There is normally some spoilage and wasted materials
due to imperfections, cut-
ting errors, and so forth. Based on a careful analysis of the
entire production process, the
company believes that the standard amount of material per panel
should be 23 strips of
bamboo. Bamboo normally costs $0.25 per strip. During the
month of February, Bamboo
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174
Mat Company produced 5,000 mats. The company purchased
and used 112,000 strips of
bamboo, paying an average of $0.26 per strip.
Table 7.1 reveals calculations of total actual and total standard
costs for materials.

Table 7.1: Total actual and total standard costs for materials
Actual cost Standard cost
Strips purchased/used 112,000 Strips that should have been used
(5,000 3 23)
115,000
Per-unit price 3 0.26 Per-unit price 3 0.25
Total actual cost $29,120 $28,750
The difference between actual cost of $29,120 and standard cost
of $28,750 suggests
an unfavorable overall variance of $370 ($28,750 2 $29,120). A
casual inspection of the
infor-mation suggests that the price per strip was higher than
planned ($.026 actual vs.
$0.25 standard), whereas less was used (112,000 strips actual
vs. 115,000 strips
standard) than anticipated. Thus, logic suggests an unfavorable
material price
variance and a positive materials quantity variance. Let’s look
closely at the actual
calculations of each variance:
Materials Price Variance 5 (SP 2 AP) 3 AQ 5 ($0.25 2 $0.26) 3
112,000
5 ,$1,120. unfavorable
Materials Quantity Variance 5 (SQ 2 AQ) 3 SP 5 (115,000 2
112,000) 3 $0.25
5 $750 favorable

Notice that these two specific variances net (,$1,120. 1 $750) to
the overall $370 unfa-
vorable outcome. Although management might be concerned
about having overspent by
$370, that number provides little information for control. This
explains the necessity of
splitting the overall variance into its specific subcomponents.
The individual variances
clearly identify that material usage rates are not a problem. The
problem was with pric-
ing; Bamboo Mat Company paid more than standard cost for
each strip of material. This
type of analysis allows management to focus on areas for
improvement, which should be
directed at attempting to improve the purchase price of raw
material.
One aspect that should always be considered is the possible
interplay between price and
quantity variances. It is possible that the higher priced material
was of better quality,
contributing to less spoilage and waste. This would contribute
to offsetting variances.
Whatever the specific cause, management needs to explore
variances and take corrective
action as necessary.
Your understanding of variances should not stop with the basic
calculations. It is also
important to grasp their impact on the accounting system. Never
lose sight of the fact that
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175
Bamboo Mat Company spent exactly $29,120 on materials. This
is the amount that must
be accounted for. However, under a standard cost system,
inventory is recorded at its
standard cost, as follows:
2-28-XX Raw Materials Inventory 28,000
Materials Price Variance 1,120
Accounts Payable 29,120
To record purchase of raw materials at standard price
This entry records the raw materials at $28,000 (112,000 actual
units purchased 3 $0.25
each), with the difference between that amount and the actual
price being shown as a
debit (unfavorable) to the Materials Price Variance account. If
the company had purchased
at less than standard price, a credit (favorable variance) would
be needed to balance the
entry. The clear intention is to record the raw materials
inventory at the standard price,
regardless of the actual price.
Continuing, as the raw materials are put into process, the Work
in Process account is deb-
ited for the standard cost of the standard quantity that should be
used, regardless of actual

use. Differences between standard and actual usage are debited
(unfavorable) or credited
(favorable) to the Materials Quantity Variance account:
2-28-XX Work in Process Inventory 28,750
Raw Materials Inventory 28,000
Materials Quantity Variance 750
To transfer raw materials to production at standard
In the preceding entry, it is important to note that Work in
Process is debited for the stan-
dard amount of material that was used, calculated at the
standard price. Thus, the inven-
tory accounts reflect measurements based on standards. The
difference between actual
and standard is reflected in variance accounts. The Materials
Price Variances and Materi-
als Quantity Variances are typically disposed of by reporting
them as decreases in income
(if unfavorable) or increases in income (if favorable). Other
methods for closing out vari-
ance accounts are possible, and these are usually covered in
advanced accounting courses.
Variances Relating to Direct Labor
Direct labor variances are strikingly similar to direct materials
variances. The overall dif-
ference between actual direct labor cost and standard direct
labor cost can reflect combi-
nations of paying laborers more or less than standard wage rates
and/or using more or
less direct labor hours than anticipated. Thus, we can separate

labor variances into rate
and time components.
waL80281_07_c07_169-188.indd 7 9/25/12 1:03 PM
176
The labor rate variance reveals the difference between the
standard rate and actual rate
for the actual labor hours worked. The following formula
applies:
Labor Rate Variance 5 (SR 2 AR) 3 AH
In this formula, SR is the standard labor rate per hour, AR is the
actual labor rate per hour,
and AH is the actual hours worked.
The labor time variance compares the standard hours of direct
labor that should have
been used to the actual hours worked:
Labor Time Variance 5 (SH 2 AH) 3 SR
As with the materials variances, negative results for labor
variances suggest unfavorable
variances, and vice versa. In other words, negative values mean
that actual wage rates
and/or hours exceeded standard rates/hours.
Let’s continue with our illustration for Bamboo Mat Company.
The bamboo strips must

be glued together, sanded, and stained. Each mat is anticipated
to require 45 minutes of
labor by employees who are paid $12 per hour. Recall that
5,000 mats were produced dur-
ing February. The standard number of hours of labor required
for this level of production
is 3,750 hours (5,000 mats 3 3/4 of an hour per mat). At $12 per
hour, the standard cost of
labor for the month was $45,000 (3,750 hours 3 $12 per hour).
Bamboo Mat’s direct labor
actually cost $42,350, resulting in an overall favorable variance
of $2,650 ($45,000 standard
vs. $42,350 actual). What the overall variance does not reveal is
the cause of the favorable
outcome. Was the result due to lower hourly wage rates, better
employee efficiency, or a
combination of factors? The rate and time variances will reveal
the answers:
Labor Rate Variance 5 (SR 2 AR) 3 AH 5 ($12 2 $11) 3 3,850 5
$3,850
Labor Time Variance 5 (SH 2 AH) 3 SR 5 (3,750 2 3,850) 3 $12
5 ,$1,200.
The rate variance is favorable by $3,850. This reflects that
Bamboo Mat Company hired
less skilled employees at only $11 per hour rather than $12.
This benefit was slightly off-
set by an unfavorable time variance. The less skilled laborers
took longer to complete the
necessary tasks, as revealed by the actual hours of 3,850.
Generalizing, labor variances should be examined as to their
root causes. For example,
suppose a unionized company hired inexperienced workers

during a strike. Although
the direct labor rate variance might be favorable (by hiring
employees below the union
pay scale), it is also highly likely that the labor time variance
will reflect poorly (assuming
inexperienced employees cannot work as fast). Unfavorable
labor time variances may also
be due to poorly motivated or trained workers, poor materials or
faulty equipment, poor
supervision, and scheduling problems. Management should be
held accountable for this
outcome because many of the root causes are traced to the
degree of supervision, plan-
ning, and training that go into production management.
An issue that these variances will not reveal is the quality of
workmanship. If a favorable
labor variance is the product of working faster and cheaper,
quality can suffer. A company
waL80281_07_c07_169-188.indd 8 9/25/12 1:03 PM
177
must clearly assess all aspects of business performance.
Nonetheless, the labor variances
are vitally important in measuring and monitoring costs
associated with direct labor.
Bamboo Mat Company can also record its labor variances in the

accounting system. The
entry for labor variances is actually simpler than that for
inventory. Labor costs flow
directly to Work in Process Inventory at standard cost (there is
no account equivalent
to the Raw Materials Inventory as was needed to track
materials). The following entry
reflects the standard labor cost, the actual labor obligation, and
the differences being
charged (when unfavorable) or credited (when favorable) to the
labor variance accounts:
2-28-XX Work in Process Inventory 45,000
Labor Time Variance 1,200
Labor Rate Variance 3,850
Wages Payable 42,350
To charge Work in Process for the standard direct labor cost,
and record both labor
variances
As with materials variances, the labor variances typically cause
an increase (favorable)
or decrease (unfavorable) in a company’s income during the
period in which they occur.
Variances Related to Factory Overhead
In addition to direct material and direct labor, production
processes also require indirect
material, indirect labor, and all of the other costs associated
with the production facilities.
As you know, this last category is described as factory

overhead. Control of factory over-
head cost is also important and the subject of additional
standards and variance analy-
sis. Advanced managerial accounting courses may introduce you
to alternative theories
about how to calculate and interpret overhead variances. There
are two-, three-, and four-
variance approaches. The reason for this topic’s complexity
relates to the comingling of
the application base (e.g., applying overhead based on labor
hours) with the overhead
cost pool. The following discussion introduces a frame of
reference for considering fac-
tory overhead variances, but detailed coverage is best deferred
to advanced accounting
courses, which are likely to devote considerable coverage to
this complex topic.
Variable overhead consists of items such as indirect material,
indirect labor, and factory
supplies. Fixed factory overhead typically relates to
expenditures such as rent, deprecia-
tion, insurance, and maintenance. Like any other expense
category, a company may spend
more or less on these items than planned. This is especially true
if a business finds that it
is producing more or less than budgeted. The goal of the
overhead variances is to sort out
and explain the reasons for deviations from standard costs.
Let’s continue with our example for Bamboo Mat Company.
Prior to the beginning of the
month of February, the company prepared a static budget for its
overhead expenditures
(Table 7.2).

waL80281_07_c07_169-188.indd 9 9/25/12 1:03 PM
178
Table 7.2: Static budget for overhead expenditures
Budgeted overhead
Variable factory overhead $22,500
Fixed factory overhead 9,000
Total factory overhead $31,500
This budget was based on an assumed production level of 4,500
units. These units should
require 3,375 hours of direct labor hours, using the previously
discussed rate of 3/4 hours
per unit. Bamboo Mat Company applies overhead to production
based on direct labor
hours. This means that the variable overhead application rate is
$6.67 per direct labor hour
($22,500 / 3,375), and the fixed overhead application rate is
$2.67 per direct labor hour.
The primary purpose of the overhead budget is deriving these
overhead application rates.
Because 5,000 units were actually produced, the company would
apply the amounts of
overhead in Table 7.3 to production.
Table 7.3: Amounts of overhead applied to production

Applied overhead for 5,000 units
Variable factory overhead (5,000 units 3 3/4 hours per unit 3
$6.67 per hour) $25,012.50
Fixed factory overhead (5,000 units 3 3/4 hours 3 2.67)
10,012.50
Total applied factory overhead $35,025
The applied overhead is debited to Work in Process. The
difference between the amount
applied and the amount actually spent constitutes the overall
overhead variance. Assume
that actual overhead expenses for the month of February were as
stated in Table 7.4.
Table 7.4: Actual overhead: February
Actual factory overhead
Variable factory overhead $24,500
Fixed factory overhead 9,800
Total factory overhead $34,300
The difference between actual factory overhead ($34,300) and
applied overhead
($35,025) reflects an overall favorable variance of $725. Of
course, a significant factor here
is related to the increase in volume. The standard amount of
applied fixed overhead
is $10,012.50 (3,750 standard hours 3 $2.67 per hour fixed
overhead application rate),

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