Chapter 3

Flexible budgets and standards

Introduction
A standard is a benchmark or “norm” for measuring performance. Standards are found
everywhere. You doctor evaluates your weight using standards that have set for individuals of
your age, height, and gender. Standards are also widely used in managerial accounting, where
they relate to the quantity and cost of inputs used in manufacturing goods or providing services.
Managers-often assisted by engineers and accountants-set quantity and cost standards for each
major input such as raw materials and labor time. Quantity standards indicate how much of an
input should be used in manufacturing a unit of product or in providing a unit of service.
If either the quantity or the cost of inputs deports significantly from the standards, managers
investigate the discrepancy. The purpose is to find the cause of the problem and then eliminate it
so that it does not recur. This process is called Management by exception.
Management by exception is a technique in which managers set upper and lower limits of
tolerance for deviations and investigate only deviations that fall outside those tolerance ranges.
Variances large enough to fall outside the ranges of acceptability are usually indicative of
trouble, and the variances themselves do not reveal the cause of the trouble or the person or
group responsible. Mangers must investigate problems through observation, inspection, and
inquiry to determine the causes of variances. In addition, it may be useful to randomly select a
small percentage of variances to ensure that cost controls remain adequate. It is also important to
investigate both favorable and unfavorable variances. A favorable variance for a particular item
may be unfavorable to the firm overall. For example, using less material than required creates a
favorable quantity variance, but might make the product unsafe and lead to legal problems.
Types of Standards
Ideal Standard: - standard that allows for no machine breakdown or other work interruptions
and that requires peak efficiency at all time. It represents perfect operating conditions and
therefore can be hard to achieve. It assumes no material wastage, the workers always measured
perfectly, and the machines never get to of adjustment. Ideal standards have no slack- that is, no
allowance for waste breaks. The use of ideal standards creates unfavorable variances which can
have a negative impact on employee morale even when attained. Ideal standards can cause a high
level of tension in the organization. It is for this reason that many researchers argue that some
slack in standards is functional. An ideal standard is sometimes called theoretical standard.
Practical standard: Standard that allow for normal machine downtime and other work
interruption and that can be attained though reasonable, although highly efficient, efforts by the
average workers. It deliberate Ideal standards have no slack- that is, no allowance for waste
breaks. The use of ideal standards creates unfavorable variances which can have a negative
impact on employee morale even when attained. Ideal standards can cause a high level of tension
in the organization. It is for this reason that many researchers argue that some slack in standards
is functional. An ideal standard is sometimes called theoretical standard.
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ly builds slack into the standard. It represents estimated cost under tight, but achievable
conditions. Practical standards make allowances for normal breakdowns in machinery and for
rest periods of workers. Ideal standards, however, assume that operations are 100% efficient
throughout the entire production processes. Practical standards are considered to be more
realistic than ideal standards. Practical standard can be reached with reasonable effort under
existing operating conditions.
In general, standards:

 Can be defined as a benchmark for measuring performance.

 Here the standards relate to the cost and quantity of inputs used in the manufacturing of
goods or provision of services.
 The budgeted amount is a benchmark, i.e. it is a point of reference from which
comparison may be made.
 Variances are computed by obtaining the difference between actual results and a
budgeted amount.

Static Budgets and Static-Budget Variances

A variance is the difference between actual results and expected performance. The expected
performance is also called budgeted performance, which is a point of reference for making
comparisons.
The static budget is based on the level of output planned at the start of the budget period. The
master budget is called a static budget because the budget for the period is developed around a
single (static) planned output level. It is static in the sense that the budget is developed for a
single planned output level. When variances are computed from a static budget at the end of the
period, adjustments are not made to the budgeted amounts for the actual output level for the
budget period.
The static-budget variance is the difference between the actual result and the corresponding
budgeted amount in the static budget.
A favorable variance—denoted F —has the effect, when considered in isolation, of increasing
operating income relative to the budgeted amount. For revenue items, F means actual revenues
exceed budgeted revenues. For cost items, F means actual costs are less than budgeted costs. An
unfavorable variance—denoted U—has the effect, when viewed in isolation, of decreasing
operating income relative to the budgeted amount. Unfavorable variances are also called adverse
variances.
Consider ABC Company produce product X. Budgeted data for the company is as follows:
Budgeted selling price Br. 31
Budgeted Variable cost per unit Br. 21.8
Budgeted production and sales 9,000 units
Budgeted Fixed costs Br. 70,000

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The actual result income statement is as follows:
ABC Company
Income Statement
For the year ended …
Units 7,000
Revenues Br. 217,000
Variable costs 158,270
Contribution margin 58,730
Fixed costs 70,300
Operating income (11,570)
Compute the static budget variance.
ABC Company
Income Statement
For the year ended …
Actual Result Static Budget Variance Static Budget
Units 7,000 Static2,000 U 9,000
Revenues Br. 217,000 Budge
Br. 62,000 U Br. 279,000
Variable costs 158,270 t 37,930 F 196,200
Contribution margin 58,730 24,070 U
varian 82,800
Fixed costs 70,300 ce 300 U 70,000
Operating income (11,570) =Br.24,370 U 12,800
24,370
U
The unfavorable static-budget variance for operating income of Br. 24,370 in the above table is
calculated by subtracting static-budget operating income of Br. 12,800 from actual operating loss
of Br. 11,570:
SBV for operating income= Actualresult −static Budget amount
SBV for operating income=(11,570 )−12,800
SBV for operating income=24,370 U
The analysis in table provides managers with additional information on the static budget variance
for operating income of Br. 24,370 U. The more detailed breakdown indicates how the line items
that comprise operating income—revenues, variable costs, and fixed costs—add up to the static-
budget variance of Br. 24,370 U.
Remember, ABC Company produced and sold only 7,000 units, although managers anticipated
an output of 9,000 units in the static budget. Managers want to know how much of the static-
budget variance is because of inaccurate forecasting of output units sold and how much is due to
company’s performance in manufacturing and selling 7,000 units. Managers, therefore, create a
flexible budget, which enables a more in-depth understanding of deviations from the static
budget.

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Flexible Budgets
A flexible budget calculates budgeted revenues and budgeted costs based on the actual output in
the budget period. The flexible budget is prepared at the end of the period after the actual output
is known. The flexible budget is the hypothetical budget that would have prepared at the start of
the budget period if it had correctly forecast the actual output. In other words, the flexible budget
is not the plan initially had in mind. Rather, it is the budget that would have put together for the
year if we knew in advance that the output for the year would be different. In preparing the
flexible budget, note that:
 The budgeted selling price is the same used in preparing the static budget.
 The budgeted unit variable cost is the same used in the static budget.
 The budgeted total fixed costs are the same static-budget.
The only difference between the static budget and the flexible budget is that the static budget is
prepared for the planned output, whereas the flexible budget is based on the actual output. The
static budget is being “flexed,” or adjusted for actual output. The flexible budget for actual
output assumes that all costs are either completely variable or completely fixed with respect to
the number of output produced.
Flexible budget can be prepared in three steps
1. Identify the Actual Quantity of Output
2. Calculate the Flexible Budget for Revenues Based on Budgeted Selling Price and Actual
Quantity of Output.
3. Calculate the Flexible Budget for Costs Based on Budgeted Variable Cost per Output
Unit, Actual Quantity of Output, and Budgeted Fixed Costs.
Flexible-Budget Variances and Sales-Volume Variances
The flexible-budget-based variance analysis for ABC Company, which subdivides the Br. 24,370
unfavorable static-budget variance for operating income into two parts: a flexible-budget
variance of 5,970 U and a sales-volume variance of 18,400 U. The sales-volume variance is the
difference between a flexible-budget amount and the corresponding static-budget amount. The
flexible-budget variance is the difference between an actual result and the corresponding
flexible-budget amount.
ABC Company
Income Statement

For the year ended …

Actual Flexible Budget Flexible Sales Volume Static
Variance Budget Variance Budget
Units 7,000 0 7,000 2,000 U 9,000
Revenues Br. 217,000 0 Br. 217,000 Br. 62,000 U Br. 279,000
Variable costs 158,270 Flexible
5,670 U 152,600 Sales F
43,600 196,200
Contribution margin 58,730 Budget5,670 U 64,400 volum U
18,400 82,800
Fixed costs 70,300 varianc300 U 70,000 e 0 70,000
Operating income (11,570) e =Br.
5,970 U (5,600) 18,400
varian U 12,800
5,970 ce
U =Br.
Sales-Volume Variances 18,400
U
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Keep in mind that the flexible-budget amounts in column 3 of the above table and the static-
budget amounts in column 5 are both computed using budgeted selling prices, budgeted variable
cost per unit, and budgeted fixed costs. The difference between the static-budget and the flexible-
budget amounts is called the sales-volume variance because it arises solely from the difference
between the 7,000 actual quantity (or volume) of products sold and the 9,000 quantity of product
expected to be sold in the static budget.
SVV for operating income=Flexible budget amount−static Budget amount
SVV for operating income=(5,600)−12,800
SVV for operating income=18,400 U
The sales-volume variance in operating income for ABC Company measures the change in
budgeted contribution margin because ABC Company sold only 7,000 units rather than the
budgeted
9,000.
SVV for operating income=Budget CM per unit x( Actual units sold−Static Budget units sold)
SVV for operating income=(Budget Selling Price−Budget VC per unit )x ( Actualunits sold−Static Budget units s
SVV for operating income=(31−21.8) x (7,000−9,000)
SVV for operating income=Br .9 .2 x (7,000−9,000)
SVV for operating income=18,400 U
In the above table, column 4 shows the components of this overall variance by identifying the
sales-volume variance for each of the line items in the income statement. ABC Company’s
managers determine that the unfavorable sales-volume variance in operating income could be
because of one or more of the following reasons:
 The overall demand for the products is not growing at the rate that was anticipated.
 Competitors are taking away market share from the company.
 The company did not adapt quickly to changes in customer preferences and tastes.
 Budgeted sales targets were set without careful analysis of market conditions.
 Quality problems developed that led to customer dissatisfaction with the company’s
products.
How the company responds to the unfavorable sales-volume variance will be influenced by what
management believes to be the cause of the variance. For example, if the managers believe the
unfavorable sales-volume variance was caused by market-related reasons (reasons 1, 2, 3, or 4),
the sales manager would be in the best position to explain what happened and to suggest
corrective actions that may be needed, such as sales promotions or market studies. If, however,
managers believe the unfavorable sales-volume variance was caused by quality problems (reason
5), the production manager would be in the best position to analyze the causes and to suggest
strategies for improvement, such as changes in the manufacturing process or investments in new
machines.
The static-budget variances compared actual revenues and costs for 7,000 units against budgeted
revenues and costs for 9,000 units. A portion of this difference, the sales-volume variance,
reflects the effects of inaccurate forecasting of output units sold. By removing this component
from the static-budget variance, managers can compare actual revenues earned and costs
incurred for the budget period against the flexible budget—the revenues and costs the company
would have budgeted for the 7,000 units actually produced and sold. These flexible-budget
variances are a better measure of operating performance than static-budget variances because

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they compare actual revenues to budgeted revenues and actual costs to budgeted costs for the
same 7,000 units of output.

Flexible-Budget Variances
The first three columns of the above table compare actual results with flexible-budget amounts.
Flexible-budget variances are in column 2 for each line item in the income statement:
F BV for operating income= Actual result−Flexible Budget amount
The operating income line in the above table shows the flexible-budget variance is 5,970 U
{(11,570) – (5,600)}. The 5,970 U arises because actual variable cost per unit and actual fixed
costs differ from their budgeted amounts.
The flexible-budget variance for total variable costs is unfavorable (5,670 U) for the actual
output of 7,000 units. It’s unfavorable because of one or both of the following:
 The company used greater quantities of inputs (such as direct manufacturing labor-hours)
compared to the budgeted quantities of inputs.
 The company incurred higher prices per unit for the inputs (such as the wage rate per
direct manufacturing labor-hour) compared to the budgeted prices per unit of the inputs.
Higher input quantities and/or higher input prices relative to the budgeted amounts could be the
result of ABC Company deciding to produce a better product than what was planned or the result
of inefficiencies in the company’s manufacturing and purchasing, or both. You should always
think of variance analysis as providing suggestions for further investigation rather than as
establishing conclusive evidence of good or bad performance.
The actual fixed costs of 70,300 are 300 more than the budgeted amount of 70,000. This
unfavorable flexible-budget variance reflects unexpected increases in the cost of fixed indirect
resources, such as factory rent or supervisory salaries.
Price variances and Efficiency variances
When evaluating performance, some managers like to distinguish between effectiveness and
efficiency.
Effectiveness represents the degree to which a predetermined objective or target is met.
Efficiency represents the degree to which inputs are used in relation to a given level of outputs.
Performance may be both efficient and effective, but either condition can occur without the
other.

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  Price variance: difference between actual input prices and standard input prices
multiplied by the actual quantity of inputs used. PV = (AP – SP) AQ
Price Variance=(Actual Price of Inputs - Budgeted Price of Inputs) X Actual Q of Input

 Efficiency variance: difference between the quantity of inputs actually used and the
quantity of inputs that should have been used to achieve the quantity of output multiplied
by the expected price of the input. EV = (AQ – SQ) SP
Efficiency Variance=(Actual Q of Inputs - Budgeted Q of Input allowed for actual output )
X Budgeted Price of Input

When feasible, you should separate the variances that are subject to manager’s direct influence
from those that are not. The usual approach is to separate price factors from usage factors. Price
factors are less subject to immediate control than are usage factors, principally because prices are
influenced by external factors. Isolating these two factors help managers to focus on the efficient
use of inputs.

Illustration
Consider the following data:

Direct materials Direct labor

Actual price per unit of inputs Br. 16 Br. 12
Standard price per unit of inputs 14 13
Standard inputs allowed per unit of output 5 kg 2 hours
Actual units of input 56,000 kg 30,000 hours
Actual units of output 14,400 14,4000
Required: - Determine

a. Price variance for direct materials and direct labor

b. Efficiency variance for direct materials and direct labor
c. Flexible budget variance for direct materials and direct labor

Solution

a. Price variance for DM = (AP – SP) AQ

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 = (16 – 14) 56,000
= Br. 112,000 U
Price variance for DL = (AP – SP) AQ
= (12 – 13) 30,000
= 30,000 F

b. Efficiency variance for DM = (AQ – SQ) SP

= [56,000 – (14,400 x 5)] 14

= (56,000 – 72,000) 14
= Br. 224,000 F

Efficiency variance for DL = (AQ – SQ) SP

= [30,000-(2 x 14,400)]x13
= (30,000-28,800)x 13
= Br. 15,600U
c. Flexible budget variance for DM = PV + EV

= Br. 112,000 U + Br. 224,000 F

= Br. 112,000 F
Flexible budget variance for DL = PV + EV
= Br. 30,000 F + Br. 15600U
= Br. 44,400F

OR: Flexible budget variance DM = Actual result – Flexible budget amount

= (56,000 x 16) – (14,400 x 14 x 5)
= 896,000 – 1,008,000
= Br. 112,000 F
Flexible budget variance DL = Actual result – Flexible budget amount
=(30,000x13) – (14,400x12x2)
=390,000 – 345,600
= Br. 44,400 F
Exercise 1
The following standards were developed for product Z.

Direct materials Direct labor

standard inputs expected for each unit of output 10 kg 5 hours
standard price per unit of input Br. 5 per kg Br. 25 per hour

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During the month of April, 550 units were scheduled for production. However, only 525 were
actually produced. Direct materials purchased and used amounted to 5,500 kg at a unit price of
Br.4.25 per kg. Direct labor actually paid was Br. 26 per hour, and 2,850 hours were used.

Required

a. Compute:
 Price variance for direct materials and direct labor
 Efficiency variance for direct materials and direct labor
 Flexible budget variance for direct materials and direct labor

Exercise 2
Consider the following standards for ABC Company to produce product X.
Direct materials = 4 kg of inputs allowed @ Br. 5 = Br. 20 per unit of output
Direct labor = 2 hours of input allowed @ Br. 8 = Br. 16 per unit of output
In addition, the following data pertain to the actual results:

Units produced 10,000 units

Direct materials cost Br. 270,000
Kg of inputs purchased and used 50,000kg
Price per kg Br. 5.4
Direct labor costs Br. 171,600
Hour of direct labor used 22,000 hours
Labor price per hour Br. 7.8
Required: - Compute:

a. Price variance for direct materials and

b. Efficiency variance for direct materials and direct labor
c. Flexible budget variance for direct materials and direct labor

Exercise 3
XYZ Company produces a special perfume. The direct materials and direct labor standards for a
bottle of perfume are given below

Standard Quantity Standard price

Direct materials 7.2 grams Br. 2.5 per gram
Direct labor 0.4 hour Br. 10 per hour
During the previous month, the following activities were recorded:

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  20,000 grams of materials were purchased at a cost of Br. 2.40 per gram.
 All of the materials were used to produce 2,500 bottles of perfume.
 900 hours of direct labor time were recorded at a total labor cost of Br. 10,800.

Required: - Determine:

a. Price variance for direct materials and direct labor

b. Efficiency variance for direct materials and direct labor
c. Flexible budget variance for direct materials and direct labor

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