Flexible Budgets,

Direct-Cost Variances,
and
Management Control

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Basic Concepts
Variance difference between an actual and
an expected (budgeted) amount. The
expected performance is also called
budgeted performance, which is a point of
reference for making various comparisons.
Management by Exception the practice of
focusing attention on areas not operating as
expected (budgeted).

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 Management by Exception
Managers focus on quantities and costs
that exceed standards, a practice known as
management by exception.

Standard
Amount

Direct
Material
Direct
Labor

Type of Product Cost

Basic Concepts
Static (Master) Budget is based on the output
planned at the start of the budget period
Static-Budget Variance (Level 0) the difference
between the actual result and the corresponding
static budget amount
Favorable Variance (F) has the effect of
increasing operating income relative to the
budget amount
Unfavorable Variance (U) has the effect of
decreasing operating income relative to the
budget amount
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Variances
Lie at the point where the planning and control
functions of management come together.
Assist managers in implementing their strategies
by enabling management by exception.
Are also used in performance evaluation and to
motivate managers. For example, XYZ company
may have quarterly efficiency incentives linked to
achieving a budgeted amount of cost.
May suggest that the company should consider a
change in strategy. For example, large negative
variances caused by excessive defects rates for a
new product may suggest a flawed product design.

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Variances
Variances may start out at the top with a
Level 1 analysis.
This is the highest level of analysis, a super-
macro view of operating results.
The Level 0 analysis is nothing more than the
difference between actual and static-budget
operating income

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Variances
Further analysis decomposes (breaks down)
the Level 0 analysis down into progressively
smaller and smaller components
Answers: How much were we off?
Levels 1, 2, and 3 examine the Level 0
variance into progressively more-detailed
levels of analysis
Answers: Where and why were we off?

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Variances
First, variance analysis is not simple. In order
to fully understand variance analysis, one
needs to understand the terminology.
Second, variance analysis is very valuable in
that it can provide much useful information
about how the company is operating.
Third, the variances illustrated in this chapter
(and others) are only the beginning of variance
analysis. Anytime there are budgeted and
actual amounts, a variance can be calculated.

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Level 1 Analysis, Illustrated
Cost Category Variable Cost per Jacket
Direct material costs* $60
Direct manufacturing labor costs* 16
Variable manufacturing overhead costs* 12
*The number of units manufactured is the cost
driver ___________________________________________
Budgeted fixed cost within relevant range 276,000
Budgeted selling price per jacket 120
Budgeted production and sales (jackets) 12,000
Actual production and sales (jackets) 10,000

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Level 1 Analysis, Illustrated

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Evaluation
Level 1 tells the user very little other than
how much Contribution Margin was off from
budget.
Level 1 answers the question: How much were we
off in total?
Level 2 gives the user a little more
information: it shows which line-items led to
the total Level 1 variance.
Level 2 answers the question: Where were we off?

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Flexible Budget
A flexible budget calculates budgeted
revenues and budgeted costs based on the
actual level of output in the budget period.
Thus a flexible budget is adjusted for changes
in the activity level that differ from the master
budget amount

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Flexible Budget versus Static
Budget
The key difference is the output level used to

set the budget. A static budget is based on the
level of output planned at the start of the
budget period. A flexible budget is developed
using budgeted revenues or cost amounts
based on the actual output level in the budget
period. The actual level of output is not known
until the end of the budget period.

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Flexible Budget
Flexible Budget shifts budgeted revenues
and costs up and down based actual operating
results (activities)
Represents a blending of actual activities and
budgeted dollar amounts
Will allow for preparation of Level 2 and 3
variances
Answers the question: Why were we off?

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Flexible Budget
The three-step process for developing the flexible
budget is as follows:
Identify the actual output quantity.
Calculate flexible budget revenues (budgeted
selling price actual quantity).
Calculate flexible budget costs (budgeted per-
unit variable cost actual quantity plus fixed
costs).

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Flexible Budget
The sales-volume variance is the difference
between actual output from the flexible budget
(at actual output) and the original static budget
output level.
The flexible-budget variance is the
difference between actual revenues or costs
and the corresponding flexible budget amounts.
The flexible-budget variance for revenues is
called the selling-price variance as it arises
only from the difference between the actual
selling price and the budgeted selling price.
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Level 2 Analysis, Illustrated

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Possible reasons for
Unfavorable Sales-Volume
The overall demand for jackets is not growing
variance.
at the rate that was anticipated.
Competitors are taking away market share
from Webb.
Webb did not adapt quickly to changes in
customer preferences and tastes.
Budgeted sales targets were set without
careful analysis of the market conditions.
Quality problems developed that led to
customer dissatisfaction with Webbs jackets.
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Possible reasons for
Unfavorable Flexible-Budget
Selling price variance is favorable due to a
variance.
general increase in prices.
Webb used greater quantities of inputs (such
as direct manufacturing labor hours compared
to the budgeted quantities of inputs.
Webb incurred higher prices per unit for the
inputs (such as wage rate per direct
manufacturing labor-hour) compared to the
budgeted prices per unit of the inputs.

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 Managing Costs
Standard Actual
cost cost

Comparison between
standard and actual
performance
level

Cost
variance
Standard
A standard can be thought of as a budget for
one unit of product.
Standards, as used in variance analysis, have
two advantages:
They seek to exclude past inefficiencies
They take into account changes expected to
occur in the budget period.
Standards also simplify product costing,
enabling the company to cost a product
immediately upon its completion.
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 Setting Standards

Cost
Standards

Analysis of Task
Historical Data Analysis
SETTING STANDARDS
Managers set standards by analyzing historical data.
However, past data must be adjusted for expected
changes in technology, the production process,
inflation, and other similar factors.
In using task analysis, the emphasis shifts from
what the product did cost in the past to what it
should cost in the future. The managerial
accountant typically works with engineers to
conduct studies in an effort to determine exactly
how much direct material should be required, how
machinery should be used in the production process,
and how many direct labor hours are required(e.g.,
time and motion studies) .
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 Participation in
Setting Standards
Standards should not be determined by the managerial
accountant alone. People generally will be more committed to
meeting standards if they are allowed to participate in setting
them. For example, production supervisors should have a role
in setting production cost standards, and sales managers
should be involved in setting targets for sales prices and
volume.
Knowledgeable people such as engineers, purchasing agents,
production supervisors, and accountants should be brought
into the standard-setting process. Cross-functional teams are
very useful here.

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 Perfection versus Practical
Standards: A Behavioral Issue
Practical standards
should be set at levels
that are currently
attainable with
Should we use reasonable and
practical standards
or perfection efficient effort.
standards?
 Perfection versus Practical
Standards: A Behavioral Issue
I agree. Perfection
standards are
unattainable and
therefore discouraging
to most employees.
 Use of Standards by
Service Organizations

Standard cost
analysis may be used
in any organization
with repetitive tasks.
A relationship
between tasks and
output measures
must be established.
Standard
A standard is a carefully determined, price, cost,
or quantity that is used as a benchmark for judging
performance. It is usually expressed on a per-unit
basis.
a)A standard input is a quantity of input such as 2
pounds of raw material for each completed unit.
b)A standard price is the price a company expects
to pay for a unit of input, such as $10 per direct
labor hour.
c)A standard cost is the cost the company expects
a unit of finished product to cost the company.

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Standard
Four reasons for using standard costs are:
(i) cost management,
(ii) pricing decisions,
(iii) budgetary planning and control, and
(iv) financial statement preparation.

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Level 3 Variances
All Product Costs can have Level 3 Variances.
Direct Materials and Direct Labor will be
handled next. Overhead Variances are
discussed in detail in a later chapter
Both Direct Materials and Direct Labor have
both Price and Efficiency Variances, and their
formulae are the same

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 Cost Variance Analysis
Standard Cost Variances

Price Variance Quantity Variance

The difference between The difference between

the actual price and the the actual quantity and
standard price the standard quantity

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Price & Efficiency
Variance
Sometimes these variances go by other names.
The direct material variances may be called price
and usage variances. The direct labor variances
may be called rate and efficiency variances.
The price variance (or input-price variance)
reflects the difference between an actual input
price and a budgeted input price. When referring
to direct labor, this is sometimes called the rate
variance.
The efficiency variance reflects the difference
between an actual input quantity and a budgeted
input quantity. For direct materials, this is
sometimes referred to as the usage variance.
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Actual Quantity Actual Quantity Standard Quantity

Actual Price Standard Price Standard Price

Price Variance Quantity Variance

AQ(AP
Materials price- SP)
variance SP(AQ
Materials - SQ)
quantity variance
Labor rate variance Labor efficiency variance
AQ =Variable
Actual overhead
Quantity SP = Standard
Variable Price
overhead
AP = spending
Actual Price
variance SQ = Standard
efficiency Quantity
variance
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Actual Quantity Actual Quantity Standard Quantity

Actual Price Standard Price Standard Price

Price Variance Quantity Variance

Standard price is the amount that should

have been paid for the resources acquired.

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Actual Quantity Actual Quantity Standard Quantity

Actual Price Standard Price Standard Price

Price Variance Quantity Variance

Standard quantity is the quantity that should

have been used.

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Level 3 Variances
Price Variance formula:

Efficiency Variance formula:

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 Data for Calculating Price
and Efficiency Variances
Standard direct material cost
per jacket = 2 square yards
* $30 = $60
Standard direct manufacturing labor cost
per jacket =0.8 labor-hour
* $20 = $16
o Actual units purchased = 10,000

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 Data for Calculating Price
and Efficiency Variances
Direct materials purchased and used
Square yards of cloth 22,200
Actual price per square yard $28
Direct material costs (22,200 *$28) $621,600
o Direct manufacturing labor
Direct manufacturing labor-hours 9,000
Actual price per direct manufacturing
Labor-hour $22
Direct manufacturing labor Costs
(9,000*$22) $198,000
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Level 3 Analysis, Illustrated

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 Causes of Favorable Direct
Material Price Variance
purchasing officer negotiated more skillfully
than was planned in the budget,
purchasing manager bought in larger lot sizes
than budgeted, thus obtaining quantity
discounts,
materials prices decreased unexpectedly due to,
say, industry oversupply,
budgeted purchase prices were set without
careful analysis of the market, and
purchasing manager received unfavorable terms
on nonpurchase price factors (such as lower
quality materials).
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Causes of Unfavorable Direct
manufacturing labor
efficiency variance
are the hiring and use of underskilled workers;
inefficient scheduling of work so that the
workforce was not optimally occupied;
poor maintenance of machines resulting in a
high proportion of non-value-added labor;
unrealistic time standards.

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Variance Summary

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Variances & Journal Entries
Each variance may be journalized
Each variance has its own account
Favorable variances are credits; Unfavorable
variances are debits
Variance accounts are generally closed into
Cost of Goods Sold at the end of the period, if
immaterial

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Variances & Journal Entries
Direct Material Control 666,000
(22,200 Sq. yards * $30 per Sq. yard)
Direct Materials Price Variance
(22,200 Sq. yards * $2 per Sq. yard)
44,400
Accounts Payable Control
(22,200 Sq. yards *$28 per Sq. yard)
621,600

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Variances & Journal Entries
Work-in-Process Control
(10,000 jackets *2 yards per jacket *$30 per sq.
yard) 600,000
Direct Materials Efficiency Variance
(2,200 Sq. yards *$30 per Sq. yard) 66,000
Direct Materials Control
(22,200 Sq. yards *$30 per Sq. yard)
666,000

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Variances & Journal Entries
Work-in-Process Control
(10,000 jackets * 0.80 hour per jacket * $20 per
hour) 160,000
Direct Manufacturing Labor price Variance
18,000
Direct Manufacturing Labor Efficiency Variance
20,000
Wages Payable Control
(9,000 hours * $22 per hour) 198,000

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Variances & Journal Entries
Cost of Goods Sold 59,600
Direct Materials Price Variance 44,400
Direct Materials Efficiency Variance
66,000
Direct Manufacturing Labor price Variance
18,000
Direct Manufacturing Labor Efficiency Variance

20,000

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Standard Costing
Budgeted amounts and rates are actually
booked into the accounting system
These budgeted amounts contrast with actual
activity and give rise to Variance Accounts.

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Standard Costing
Reasons for implementation:
Improved software systems
Wide usefulness of variance information

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Management Uses of
Variances
Managers use variances in three ways:
To evaluate performance after decisions are
implemented
To trigger organizational learning
To make continuous improvements

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Management Uses of
To understand underlying causes of variances.
Variances
Recognition of inter-relatedness of variances.
For example, a favorable materials price variance
may give rise to an unfavorable efficiency
variance if the cheaper material is of lower quality.
This may also result in an unfavorable labor
efficiency variance as the workers find the lower-
quality material more difficult to work with.
Also, a favorable direct materials efficiency
variance may be due to an experienced workforce.
However, experienced workers are paid more and
there may be an unfavorable direct labor price
variance as a result. The opposite can be true with
inexperienced workers.
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Management Uses of
Variances
Performance Measurement
Managers ability to be Effective
Managers ability to be Efficient
The second use of variances is organizational
learning. Managers need to understand why
variances arise, learn from them, and improve
future performance.
Finally, variances are used to create a cycle of
continuous improvement by identifying causes of
the variances, initiating corrective actions, and
evaluating the results of those actions.
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Activity-Based Costing and
Variances
ABC easily lends its to budgeting and variance
analysis.
Budgeting is not conducted on the
departmental-wide basis (or other macro
approaches)
Instead, budgets are built from the bottom-up
with activities serving as the building blocks of
the process

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 Data for Variance Analysis
Using Activity-Based Costing
Static Actual
1.Units of Elegance produced and sold 180,000 151,200
2. Batch Size (units per batch) 150 140
3. Number of batches 1,200 1,080
4.Material-handling labor hrs per batch 5 5.25
5.Total material handling labor hours 6,000 5,670
6.Cost per material-handling labor hour $14 $14.50
7.Tota materials-handling labor costs $84,000 $82,215

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Level 3 Variances
Price Variance formula:

= ($14.50 - $14) *5,670 hours = $2,835 U

Efficiency Variance formula:
= (5,670-5,040)* $14 = $8,820U

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 Variance Analysis when
materials purchased differ
from material used
Units produced 2,000
Materials purchased 5,000 kilograms
Standard input allowed for one output unit2 kilograms
Direct materials used 4,400 kilograms
Standard price per kilograms $15
Actual price per kilograms $16.50
Actual direct labor hour 3,250 at a total cost $66,300
Standard labor hour 1.5
Standard direct labor cost $20 per hr.

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Benchmarking and Variances
Benchmarking is the continuous process of
comparing the levels of performance in
producing products & services against the
best levels of performance in competing
companies
Variances can be extended to include
comparison to other entities

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Benchmarking Example:
Airlines

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