Chapter 8

Flexible Budgets and Variance Analysis

LEARNING OBJECTIVES:
When your students have finished studying this chapter, they should be able to:

1. Distinguish between flexible budgets and master (static) budgets.

2. Use flexible-budget formulas to construct a flexible budget based on the volume of

sales.

3. Prepare an activity-based flexible budget.

4. Understand the performance evaluation relationship between master (static) budgets

and flexible budgets.

5. Compute flexible-budget variances and sales-activity variances.

6. Compute and interpret price and usage variances for inputs based on cost-driver
activity.

7. Compute variable overhead spending and efficiency variances.

8. Understand how management uses flexible budgets to evaluate the company’s

financial performance.

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CHAPTER 8: OVERVIEW

The topic of this chapter is flexible budgets and their use as standards for control.

Section One: Distinguishes between flexible budgets and the master budget, which was
the topic of Chapter 7. The creation of flexible budgets using flexible-
budget formulas is explained and the use of performance reports for
evaluating performance is presented.

Section Two: Demonstrates the subdivision of the difference between actual results and
the master budget into flexible-budget variances and sales-activity
variances. Effectiveness is contrasted with efficiency. Differences
between expectations, standards, and standard cost systems are explained.
The selection of perfection versus current attainable standards is
addressed. A discussion is presented of the possible trade-off among
variances, as are discussions of when variances should be investigated and
the proper comparison data for actual results.

Section Three: Contains a presentation of the details of the flexible-budget variances.

Direct-material and direct-labor variances are explained, discussed, and
computed. The role of these variances in controlling operations is
mentioned.

Section Four: Contains a discussion of and computation of variable-overhead variances.

Section Five: Presents a general approach for variance analysis. The use of columns for
actual costs, flexible budgets based on inputs, and flexible budgets based
on the standard input allowed for the actual output achieved is offered as a
means of organizing flexible-budget variance analyses.

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CHAPTER 8: ASSIGNMENTS
COGNITIVE EXERCISES

20 Marketing Responsibility for Sales-Activity Variances

21 Production Responsibility for Flexible-Budget Variances
22 Responsibility of Purchasing Manager
23 Variable Overhead Efficiency Variance

EXERCISES

24 Flexible Budget
25 Basic Flexible Budget
26 Flexible Budget
27 Basic Flexible Budget
28 Activity-Level Variances
29 Direct-Material Variances
30 Labor Variances
31 Usage Variances
32 Labor and Material Variances
33 Material and Labor Variances

PROBLEMS

34 National Park Service

35 Flexible and Static Budgets
36 Summary Explanation
37 Explanation of Variance in Income
38 Activity and Flexible-Budget Variances at Burger King
39 Summary of Airline Performance
40 University Flexible Budgeting
41 Activity-Based Flexible Budget
42 Straightforward Variance Analysis
43 Variance Analysis
44 Similarity of Direct-Labor and Variable-Overhead Variances
45 Material, Labor, and Overhead Variances
46 Automation and Direct Labor as Overhead
47 Standard Material Allowances
48 Role of Defective Units and Nonproductive Time in Setting
Standards
49 Review of Major Points in This Chapter
50 Review Problem on Standards and Flexible Budgets: Answers Are
Provided

3
CASES

51 Hospital Costs and Explanation of Variances

52 Activity-Based Costing and Flexible Budgeting
53 Analyzing Performance

COLLABORATIVE EXERCISE

54 Setting Standards

4
CHAPTER 8: OUTLINE
I. Flexible Budgets: Bridge Between Static Budgets and Actual Results

A. Static Budgets

All the master budgets discussed in Chapter 7 are static or inflexible,

because even though they may be easily revised, the accepted budgets assume
fixed levels of future activity. A master budget is prepared for only one level
of activity (for example, volume of sales activity). Master budget and static
budget are usually regarded as synonyms.

Actual results could be compared with the original plan, even though a
different activity level was reached than was used in constructing the static,
master budget. See EXHIBIT 8-1 for an illustration of this in the
performance report. A performance report is a generic term that usually
means a comparison of actual results with some budget. Variances shown on
the performance report direct management's attention to significant deviations
from expected results, allowing management by exception.

Master (Static) Budget Variances (i.e., variances from master budget

amounts) may not be very useful in helping management assess whether costs
are being controlled adequately when the actual activity level differs
considerably from the master budget activity level. Unfavorable Expense
Variance - actual expenses exceed budgeted expenses. Favorable Expense
Variance - actual expenses are less than budgeted expenses.

B. Flexible Budgets {L. O. 1}

Flexible Budget (or Variable Budget) - a budget that adjusts for changes in
sales volume and other cost-driver activities. It is identical to the master
budget in format, but it can be prepared for any levels of activity. For
performance evaluation, the flexible budget would be prepared for the actual
levels of activity achieved. In contrast, the master budget is kept fixed or
static at only the originally planned levels of activity.

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 C. Flexible-Budget Formulas {L. O. 2}
The cost functions or formulas that were discussed in Chapters 2 and 3 are
used in constructing flexible budgets within the relevant range of activity.
See EXHIBIT 8-2 for an illustration of the use of a budget formula for the
Dominion Company to create budgets for 7,000, 8,000, and 9,000 units of
sales. The fixed costs/expenses are the same, in total, at each volume level.
The variable costs/expenses increase by the budgeted amount for each unit
increase in the activity level. Cost drivers other than units sold or produced
must be considered in creating flexible budgets. See EXHIBIT 8-3 for a
graph of flexible budget of costs.

D. Activity-Based Flexible Budgets {L. O. 3}

Organizations are increasingly adopting activity-based costing (ABC) systems
that have multiple cost drivers. Activity-Based Flexible Budget - based on
budgeted costs for each activity center and related cost driver. ABC systems
focus on activities as the primary cost objects. Costs of activity centers are
then assigned to final cost objects such as products or customer classes using
cost drivers. Companies that use ABC systems develop a flexible budget for
each activity center. See EXHIBIT 8-4 for an illustration of Dominion
Company’s activity-based flexible budget.

E. Evaluation of Financial Performance Using Flexible Budget {L. O.

4}
There are two types of reasons why actual performance might not have
conformed to the master budget. First, sales and cost-driver activity may be
different than that forecasted (Activity-Level Variances). Second, revenues
or variable costs per unit of activity and fixed costs per period may not be as
expected (Flexible-Budget Variances). See EXHIBIT 8-5 for an illustration
of these two types of variances. The sum of the flexible-budget variances and
the activity-level variances is the master budget variance.

II. Isolating The Causes of Variances {L. O. 5}

Managers use comparisons between actual results, master budgets, and flexible
budgets to evaluate organizational performance. In evaluating performance, it is
useful to distinguish Effectiveness (i.e., the degree to which a goal, objective, or
target is met) and Efficiency (i.e., the degree to which inputs are used in relation to a
given level of outputs). Effectiveness may be measured by determining whether the
master budget goal has been met. Efficiency can be measured by comparing actual
6
results to the flexible budget.

7
A. Flexible-Budget Variances

Flexible-budget variances measure the efficiency of operations at the actual

level of activity. The differences between columns 1 and 3 in EXHIBIT 8-5
for Dominion Company are flexible budget variances. The total flexible-
budget variance is the difference between the actual income achieved and the
flexible budget income for the achieved activity level. The total flexible-
budget variance arises from sales prices received, and the variable and fixed
costs incurred. Flexible-budget variances may serve as the basis for periodic
performance evaluation. Operations managers are in the best position to
explain these variances. The variances should not be used to fix blame.
Managers being evaluated may resort to cheating to beat the system.

See EXHIBIT 8-6 for an expanded, line-by-line computation of flexible-

budget variances for Dominion Company. The variances should be
interpreted as signals that actual operations have not occurred exactly as
anticipated when the flexible-budget formulas were set, rather than as being
good or bad. Any cost differing significantly (materially) from the flexible
budget must be explained.

B. Sales-Activity Variances

These variances measure how effective managers have been in meeting the
planned level of sales. The final three columns in EXHIBIT 8-5 for
Dominion Company show the sales-activity variances. All unit prices and
variable costs are held constant in constructing the master budget and the
flexible budget. The differences between the amounts are due to the level of
sales activity. The sales-activity variance indicates to managers the effect of
not selling the budgeted sales level. Marketing managers are typically in the
best position to explain why actual sales activities differed from plans.

C. Setting Standards

Expected Cost - the cost that is most likely to be attained. Standard Cost - a
carefully developed cost per unit that should be obtained. Standard Cost
Systems - value products according to only standard costs and are used for
inventory valuation purposes. For planning and control purposes, expected
future costs and expected future activity levels are used to set budgets and
prepare performance reports. The standard costs from the standard cost
system are not necessarily used because they may differ from the expected
future costs. Companies, such as Caterpillar, Inc., use different cost systems
for inventory valuation, product costing for decision making, and for
performance evaluation.

8
What standard of expected performance should be used? Perfection Standards (or Ideal
Standards) - expressions of the most efficient performance possible under
the best conceivable conditions, using existing specifications and equipment.
No provision is made for spoilage, waste, machine breakdowns, etc. These
standards are not frequently used because of the adverse effect on employee
motivation resulting from their use. The unfavorable variances resulting from
the use of these standards indicate the improvement that is possible through
continuous improvement efforts.

Current Attainable Standards - levels of performance that can be achieved

by realistic levels of effort. They are set just tightly enough so that employees
regard their attainment as highly probable if normal diligence and effort are
exercised. These standards allow for normal defectives, waste, spoilage, and
nonproductive time. Variances from these standards should be random and
negligible.

Another interpretation is that they are set tightly and employees regard their
fulfillment as possible, though unlikely. They can only be achieved under
very efficient operations. With this interpretation, variances tend to be
unfavorable while employees view them as being tough but not unreasonable
goals. Advantages are that they can be used for financial budgeting,
inventory valuation, and departmental performance evaluation. They also
have a desirable motivational impact on employees.

D. Trade-offs Among Variances.

Because the operations of organizations are linked, the level of performance

in one area of operations will affect performance in other areas. Paying
higher than standard costs for materials results in an unfavorable materials
price variance. However, if the higher price is due to a better-than-standard
quality of material being purchased, less scrap and rework than normal may
be possible, resulting in a favorable materials usage variance. The labels
"favorable" and "unfavorable" are attention directors, not problem solvers.
Faulty expectations may be the cause of variances rather than the execution of
plans by managers. The validity of expectations must be questioned
whenever variances exist.

TEACHING TIP: Performance Measurement and Benchmarking –

http://www.aicpa.org/cefm/ma/index.htm
(Administrative Accountability and Control)
http://www.aicpa.org/cefm/bench/index.htm

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 E. When to Investigate Variances

If the variance is a result of random fluctuations, investigation is not needed.

Managers expect a range of "normal" variances: this range may be based on
economic (how large a dollar amount) or statistical (number of standard
deviations from the expected mean) criteria. A typical investigation rule of
thumb is to investigate all variances exceeding a certain dollar amount or
percentage of expected cost, whichever is lower. The goal is to investigate
those variances for which corrective action creates savings larger than the cost
of investigation (i.e., benefits are greater than the costs).

F. Comparisons with Prior Period's Results

Some organizations compare the most recent budget period's actual results
with last year's results for the same period or last month's results rather than
use the flexible budget's benchmarks. Unless the activities undertaken in the
current period are nearly the same as those for the year ago period or prior
month, this comparison does not reveal much meaningful information.

III. Flexible-Budget Variances In Detail {L. O. 6}

Materials, labor, and overhead variances may be subdivided into price, usage, and
spending components. If direct-labor costs are small in relation to total costs, they
may be treated as an overhead. Therefore, separate labor variances are not
computed.

A. Variances from Material and Labor Standards

Variances from material and labor standards are found by comparing the
flexible budget at the actual output level with the actual costs for these items.
The flexible-budget amounts are those that would have been spent for the
actual output with expected efficiency. They are often labeled total standard
costs allowed, computed as follows:

flexible budget or standard costs allowed

= units of good output achieved
x input allowed per unit of output
x standard unit price of input

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B. Price and Usage Variances

Flexible-budget variances measure the relative efficiency of achieving the

actual output. The price and usage variances subdivide the flexible-budget
variance. Price Variance - the difference between actual input prices and
standard input prices multiplied by the actual quantity of inputs used. Usage
Variance (Quantity or Efficiency Variance) - the difference between the
quantity of inputs actually used and the quantity of inputs that should have
been used to achieve the actual quantity of output.

The variances should be separated into those that are subject to a manager's
direct influence and those that are not. Prices are typically less controllable
than usage factors. The variances, once computed, should be used to raise
questions, provide clues, and direct attention rather than to explain why
budgeted operating income was not achieved. The effects of trade-offs
between prices and usage should be analyzed. Was the purchase of
substandard, lower-price materials a good idea?

The objective is to hold either price or usage constant so that the effect of the
other can be isolated.

Direct-Material Price Variance =

(actual price - standard price) x actual quantity

Direct-Labor Price (Rate) Variance =

(actual price (rate) - standard price (rate)) x actual quantity

Direct-Material Usage Variance =

(actual quantity used - standard quantity allowed) x standard price

Direct-Labor Usage (Efficiency) Variance =

(actual quantity used - standard quantity allowed) x standard price

C. Interpretation of Price and Usage Variances

If the actual price is less than standard or the actual quantity used is
less than the standard quantity allowed, the variance is favorable. The
opposite relationships imply unfavorable variances. See EXHIBIT 8-7 for a
graphical representation of the variances.

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 D. Effects of Inventories

When production does not equal sales, the sales-activity variance is the
difference between the static budget and the flexible budget for the number of
units sold. In contrast, the flexible-budget cost variances compare actual
costs with flexible-budgeted costs for the number of units produced.
Therefore, two flexible budgets must be prepared.

When the number of units of raw materials differs from the amount
used in production, the price variance should be computed based on the actual
amount purchased. The usage variance should still be based on the actual
usage of materials as compared to the quantity allowed for the production
level achieved.

IV. Overhead Variances {L. O. 7}

The flexible-budget variance for variable overhead is subdivided into the variable-
overhead usage or efficiency variance and the variable overhead spending variance,
computed as follows:

Variable-Overhead Usage (Efficiency) Variance =

(actual quantity of - standard quantity x standard rate cost-driver activity allowed)

Variable-Overhead Spending Variance =

(flexible budget variance - variable-overhead usage variance)

The usage (efficiency) variance is controlled by regulating the cost-driver activity

and the spending variance through the price paid for variable-overhead items.

V. General Approach

See EXHIBIT 8-8 and EXHIBIT 8-9 for illustrations of the general approach for
subdividing the flexible-budget variances into the direct-materials price and usage
variances, direct-labor price and usage variances, and variable-overhead spending
and usage variances. Actual costs are in the left-most column (A). A flexible budget
based on actual inputs with expected prices is the center column (B). Finally, the
right-most column contains a flexible-budget amount based on expected inputs for
the actual outputs achieved at the expected prices (C). Differences between (A) and
(B) are due to prices and differences between (B) and (C) are due to usage.

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CHAPTER 8: TRANSPARENCY MASTERS
The following exhibits are reproduced as transparency master at the end of this manual:

Exhibit 8-1 Dominion Company’s Performance Report Using Master Budget For
the Month Ended June 30, 20X1

Exhibit 8-2 Dominion Company’s Flexible Budgets

Exhibit 8-4 Dominion Company’s Activity-Based Flexible Budget for the Month
Ended June 30, 20X1

Exhibit 8-5 Dominion Company’s Summary of Performance for the Month Ended
June 30, 20X1

Exhibit 8-6 Dominion Company’s Cost-Control Performance Report for the

Month Ended June 30, 20X1

Exhibit 8-7 Graphical Representation of Price and Usage Variances for Labor

Exhibit 8-8 General Approach to Analysis of Direct-Labor and Direct-Material

Variances

Exhibit 8-9 General Approach to Analysis of Overhead Variances

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CHAPTER 8: Quiz/Demonstration Exercises
Learning Objective 1

1. provide expected revenues and costs for several levels of activity.

a. Continuous budgets
b. Flexible budgets
c. Master budgets
d. Static budgets

2. are budgets for a single activity level.

a. Flexible budgets
b. Master budgets
c. Static budgets
d. Both b and c are correct.

Learning Objective 2

3. The Zachary Fitness Company has the following budgeted costs for the production
of its only product, exercise machines:

Variable manufacturing costs $20.00 per unit

Shipping expenses (selling) $ 3.00 per unit
Administrative $ 1.00 per unit
Fixed manufacturing costs $30,000 per month
Fixed selling and admin. costs $15,000 per month

What are Zachary's expected costs for 1,000 units of product to be produced and sold
in March?

a. $24,000 b. $54,000 c. $69,000 d. $45,000.

4. The flexible budget is based on the same assumptions of revenue and cost behavior
(within the relevant range) as is the:

a. master budget
b. static budget
c. both a. and b.
d. neither a. nor b.

14
Learning Objective 3

5. Which of the following is descriptive of an activity-based flexible budget:

a. based on budgeted costs for each activity center and related cost driver
b. based on actual costs for each activity center and related cost driver
c. is limited to no more than ten activity centers
d. a and c

6. The key differences between the traditional flexible budget and the activity-based
flexible budget is:

a. the traditional should be used when a significant portion of the costs vary with
cost drivers other than units of production
b. some manufacturing costs that are fixed with respect to units are variable with
respect to cost drivers, other than units, used for an activity-based flexible
budget
c. traditional flexible budgeting is dramatically increasing in popularity
d. the larger the company, the more likely the activity-based flexible budget will
not be used

Learning Objective 4

7. Flexible budgets allow for financial performance evaluation because actual results
can be compared with

a. the expected prices and variable costs per unit and fixed cost for the period.
b. the continuous budget for the period.
c. the static budget for the period.
d. the master budget for the period.

8. The flexible budget is prepared using the:

a. estimated levels of activity of the closest competitor

b. historical levels of activity
c. actual levels of activity
d. most conservative levels of activity

15
Learning Objective 5

9. measure how effective managers have been in meeting the planned

level of sales.

a. Continuous-budget variances
b. Flexible-budget variances
c. Master-budget variances
d. Sales-activity variances

10. measure the efficiency of operations at the actual level of activity.

a. Zero-based budget variances

b. Flexible-budget variances
c. Master-budget variances
d. Sales-activity variances

Learning Objective 6

Use the following information for questions 11 through 14.

The Vernon Company has developed the following standards for one of their products.

Direct materials: 20 pounds x $3 per pound

Direct labor: 15 hours x $8 per hour
Variable overhead: 15 hours x $2 per hour

The following activity occurred during the month of November:

Materials purchased: 600,000 pounds at $3.20 per pound

Material used: 560,000 pounds
Units Produced: 10,000 units
Direct labor: 140,000 hours at $7.50 per hour
Actual variable OH: $290,000

The company records the materials price variance at the time of purchase.

11. The materials price variance is

a. $92,000 favorable.
b. $92,000 unfavorable.
c. $120,000 unfavorable.
d. $120,000 favorable.

16
12. The labor usage variance is

a. $70,000 favorable.
b. $70,000 unfavorable.
c. $80,000 favorable.
d. $80,000 unfavorable.

Learning Objective 7

13. The variable overhead spending variance is

a. $5,000 favorable.
b. $5,000 unfavorable.
c. $10,000 favorable.
d. $10,000 unfavorable.

14. The variable overhead efficiency variance is

a. $20,000 favorable
b. $20,000 unfavorable
c. $10,000 favorable
d. $10,000 unfavorable

17
CHAPTER 8: Solutions to Quiz/Demonstration Exercises

1. [b] 2. [d]

3. [c] From the information provided, Zachary's flexible-budget cost formula

is $45,000 + $24.00 X, where X is the number of units produced. Inserting
1,000 for X gives $45,000 + ($24.00 x 1,000) which equals $69,000.

4. [c] 5. [a] 6. [b] 7. [a] 8. [c]

9. [d] 10. [b]

11. [c] As stated, the company determines the price variance based on the material
purchased. Therefore, the price variance is ($3.20 - $3.00) x 600,000 pounds
which is $120,000. The variance is unfavorable since the actual price paid
($3.20) exceeds the standard price ($3.00).

12. [c] The labor usage variance is found by multiplying the standard labor rate ($8)
by the difference between the actual hours worked (140,000) and the number
of hours that should have been taken to produce 10,000 units (150,000 =
10,000 x 105hrs./unit). The resulting variance is $80,000, which is favorable
because fewer hours were worked than should have been for the production
level achieved.

13. [c] The spending variance is the difference between the flexible-budget variance
and the actual variable-overhead costs. In this case the flexible budget for
variable overhead would be $300,000 (10,000 x 15 hours / unit x $2/hr.).
This yields a flexible budget variance of $10,000 favorable since actual
variable-overhead costs are $290,000.

14. [a] The efficiency variance is the difference between the actual quantity of the
cost-driver activity and the standard quantity allowed, which is then
multiplied by the standard rate. The actual quantity of 140,000 hours is less
than the standard allowed of 150,000 hours. The 10,000 hours difference is
multiplied by the standard rate of $2 to arrive at a $20,000 favorable variance.

18
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