A short note on budgets and

variance analysis

What is a budget?

Why do we need budgets?

Planning
Communication and coordination
Allocating resources
Performance evaluation and incentives.

Different types of budgets:

Bottom up (participative) vs. top down.

Zero-based vs. incremental.
Detailed vs. aggregate.
Short run vs. long run.
Static vs. flexible.

Sales
Sales of
of Services
Services or
or Goods
Goods
Ending
Ending
Inventory
Inventory
Budget
Budget

Production
Production
Budget
Budget

Work
Work in
in Process
Process
and
and Finished
Finished
Goods
Goods

Ending
Ending
Inventory
Inventory
Budget
Budget

Direct
Direct Materials
Materials

Direct
Direct
Materials
Materials
Budget
Budget

Direct
Direct
Labor
Labor
Budget
Budget

Overhead
Overhead
Budget
Budget

Cash
Cash Budget

Budgeted
Statement of Cash
Flows

Budgeted
Balance Sheet

Selling
Selling and
and
Administrative
Administrative
Budget
Budget

Budgeted
Income
Statement

Activity-Based Costing versus Activity-Based

Budgeting

Resources
Resources

Resources
Resources

Activity-Based
Activity-Based
Costing
Costing (ABC)
(ABC)
Activities
Activities

Cost
Cost objects:
objects:
products
productsand
and services
services
produced,
produced, and
and
customers
customersserved.
served.

Activities
Activities

Activity-Based
Activity-Based
Budgeting
Budgeting (ABB)
(ABB)

Forecast
Forecast of
of products
products
and
and services
servicesto
tobe
be
produced
producedand
and
customers
customersserved.
served.

Static versus Flexible Budgets

Master/Static budget
ex-ante analysis of what management expects to
happen in the future, consisting of:
sales projections
operating and financial budgets
pro-forma financial statements

Flexible budget
adjusts for changes in volume ONLY
applies estimate of variable costs to new volume levels
fixed costs do NOT change, since they do not fluctuate
with changes in volume (within the relevant range)
often prepared for purposes of performance evaluation

An example
Standards: P = $10/unit; VC = $5/unit; FC =
$3,000/period; Sales volume = 3,000 units;
Actual sales = 2,000 units.

Master/Static

Actual

Variance

3,000

2,000

Sales

$30,000

$22,500

V. Costs

$15,000

$11,000

CM

$15,000

$11,500

FC

$3,000

$4,000

$12,000

$7,500

# Units

Profit

An example
Standards: P = $10/unit; VC = $5/unit; FC =
$3,000/period; Sales volume = 3,000 units;
Actual sales = 2,000 units.
Master/Sta
tic
# Units

Actual

3,000

2,000

Sales

$ 30,000

$ 22,500

V. Costs

$ 15,000

$ 11,000

CM

$ 15,000

$ 11,500

$ 3,000

$ 4,000

$ 12,000

$ 7,500

FC
Profit

Flexible

Variance

VARIANCE ANALYSIS
Variance = difference between actual results and budgeted

static budget variance = difference between actual results and static budget
(formulated at
beginning of period

volume variance
market share variance / Mix variance
market volume variance

flexible budget variance = difference between actual and flexible

budget (adjusted for realized
production/sales)
price variance
efficiency variance

(Effectiveness: Doing right things; Efficiency: Doing things right)

Total Variance

Variance

Share/Mix

Flexible Budget Variance

Price

Mkt. Volume

Efficiency

Volume

Mkt.

STANDARD COST PRODUCTION VARIANCES

A.

Variable Manufacturing Inputs (DM, DL, VOH)

Incurred Costs

Flexible Budget

AP x AQI

SP x SQIAO

(Actual Costs of

Static Budget

SP x SQISO

(Std. Costs given

Inputs)

(Std. Costs based on

Actual Output)

Std. Output)

SP X AQI
(Std. Costs given
Actual Inputs)

Price (Spending Variance

Efficiency Variance

= (AP-SP) X AQI

Volume Variance

= (AQI SQIAO) X SP

= (SQIAO SQISO) X SP

Flexible Budget Variance

= AP X AQI SP X SQIAO

Notation:
AP = actual price paid for the input/resource
AQI = actual quantity of input used
SP = standard price of input/resource
SQIAO = Standard quantity of Input allowed given the Actual quantity of Output produced/sold11
SQISO = Standard quantity of Input allowed given the Standard quantity of Output produced/sold

ISB
Sri S. Sridharan

Variable Cost Variances

Price/Spending Variance

Efficiency Variance

Results from paying more

or less than expected for
inputs.

Results from using more

or less than expected
amounts of inputs.

12

ISB
Sri S. Sridharan

STANDARD COST PRODUCTION VARIANCES

A.

Variable Manufacturing Inputs (DM, DL, VOH)

Incurred Costs

Flexible Budget

AP x AQI

SP x SQIAO

(Actual Costs of

Static Budget

SP x SQISO

(Std. Costs given

Inputs)

(Std. Costs based on

Actual Output)

Std. Output)

SP X AQI
(Std. Costs given
Actual Inputs)

Price (Spending Variance

Efficiency Variance

= (AP-SP) X AQI

Volume Variance

= (AQI SQI AO) X SP

= (SQI AO SQISO) X SP

Flexible Budget Variance

= AP X AQI SP X SQIAO
Notation:
AP = actual price paid for the input/resource

13

ISB
Sri S. Sridharan

INTERPRETATION OF OVERHEAD VARIANCES

DM

DL

VOH

3,000

2,500

1.5

0.8

Std. # units of input allowed to produce one unit of good

output
Actual # units purchased and used
Actual cost per unit of input $
Std. cost per unit of input $

Variable OH Variances:

price variance = (AP SP ) x AQI

efficiency variance = (AQI SQI AO) x SP

volume variance =( SQIAO SQISO ) x SP

Fixed OH Variances:

budgeted variance in FOH = FOHact - FOHbud

production volume variance = FOHbud - FOHappIied

14

ISB
Sri S. Sridharan