CHAPTER THREE

FLEXIBLE BUDGETS AND STANDARDS

A standard is a Flexible budgets and variances help managers gain insights into why the actual results differ
from the planned performance. This chapter focuses on the difference of static and flexible budgets and how
budgets –specifically flexible budgets – can be used to evaluate feedback on variances and aid managers in
their control function.

3.1. Use of Standard Costing Systems for Control

Any control system has three basic parts:

1. A predetermined or standard performance level

 First, a predetermined, or standard cost is set. In essence, a standard cost is a budget for the
production of one unit of product or service.
 It is the cost chosen by the cost-management analyst to serve as the benchmark in the budgetary
control system. When the firm produces many units, the cost management analyst uses standard
unit cost to determine the total standard or budgeted cost of production.
 For example, suppose that the standard direct material cost for one unit is $96. and the firm
manufactures 1,000 units. The total standard or budgeted direct material cost, given actual output of
1,000 units, is $96,000 ($96 x 1,000).
2. A measure of actual performance, and
 Second, the cost management analyst measures the actual cost incurred in the production process.
3. A comparison of standard and actual performances
 Third, the cost management analyst compares the actual cost with the budgeted, or standard, cost.
Any difference between the actual cost and the standard cost is called a cost variance. Cost
management analysts then use these cost variances to control costs.
 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.
 All variances would not be investigated because of the assumption called Management by
exception - is the practice of concentrating on areas not operating as expected and giving less
attention to areas operating as expected.

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3.2. Static vs. Flexible Budgets
A static budget is a budget prepared for only one level of activity. It is based on the level of output planned at
the start of the budget period. The master budget is an example of a static budget because the budget for the
period is developed around a single (static) planned output level.
A flexible budget is developed using budgeted revenues or cost amounts based on the level of output actually
achieved in the budget period. It is a budget that could be flexed or adjusted to any level of output. It is
prepared based on standards. It is calculated at the end of the period when the actual output is known.
A key difference between a flexible budget and a static budget is the use of the actual output level in the
flexible budget.
Static-Budget Variance

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 of increasing operating income relative to the budgeted
amount. That is, actual revenue is higher than budgeted revenue, or actual cost is lower than budgeted cost.
An Unfavorable variance - denoted U, has the effect of decreasing operating income relative to the budgeted
amount. i.e., actual revenue is lower than budgeted revenue, or actual cost is higher than budgeted cost.

Illustration: Assume that LSY manufactures and sells dress suits.

 Budgeted variable costs per suit are as follows:

Direct materials cost €65
Direct manufacturing labor 26
Variable manufacturing overhead 24
Total variable costs €115
 Budgeted selling price is €155 per suit.
 Fixed manufacturing costs are expected to be €286,000 within a relevant range between 9,000 and 13,500
suits.
 Variable and fixed period costs are ignored in this example.
 The static budget for the year 2000 is based on selling 13,000 suits. What is the static-budget operating
profit?

Revenues (13,000 × €155) €2,015,000

Less Costs:
Variable (13,000 × €115) 1,495,000

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 Fixed 286,000
Budgeted operating profit €234,000

Assume that LSY produced and sold 10,000 suits at €160 each with actual variable costs of €120 per suit and
fixed manufacturing costs of €300,000. What was the actual operating profit?

Revenues (10,000 × €160) €1,600,000

Less Costs:
Variable (10,000 × €120) 1,200,000
Fixed 300,000
Actual operating profit €100,000

What is the static-budget variance of operating profit?

Actual operating profit €100,000

Budgeted operating profit 234,000
Static-budget variance of operating profit €134,000 U This is a Level 0 variance analysis.

Level 0 Analysis:

 It gives the least detailed comparison of the actual and budgeted operating income.
 It compares actual operating profit with budgeted operating profit.
 It is the least detailed variance analysis.

Static Budget Based Variance Analysis (Level 1) in (000)

Static Actual
Budget Results Variance
Suits 13 10 3U
Revenue €2,015 €1,600 €415 U
Variable costs 1,495 1,200 296 F
Contribution margin €520 €400 €120 U
Fixed costs 286 300 14 U
Operating profit €234 €100 €134 U
€134 U
Static-budget variance
Level 1 Analysis:

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  It provides more detailed information on the operating profit static-budget variance.

Steps in Developing Flexible Budgets

Step 1: Determine budgeted selling price, budgeted variable cost per unit and budgeted fixed cost.
The budgeted selling price is €155, the budgeted variable cost is €115 per suit and the
budgeted fixed cost is €286,000
Step 2: Determine the actual quantity of output.
10,000 suits were produced and sold in the year 2000.
Step 3: Determine the flexible budget for revenues based on budgeted selling price and actual
quantity of output.
€155 × 10,000 = €1,550,000
Step 4: Determine the flexible budget for costs based on budgeted variable costs per output unit,
actual quantity of output and the budgeted fixed costs.
Flexible budget:
Variable costs (10,000 × €115) €1,150,000
Fixed costs 286,000
Total costs €1,436,000
Level 2 analysis provides information on the two components of the static-budget variance.
1. Flexible-budget variance
2. Sales-volume variance

Flexible-Budget-Based Variance Analysis (Level 2) in (000)

Actual Flexible-Budget Flexible Sales-Volume Static
Results(1) Variances (2)=(1)-(3) Budget (3) Variances (4)=(3)-(5) Budget(5)
Suits 10 0U 10 3U 13
Revenue €1,600 €50 F €1,550 €465 U €2,015
Variable costs 1,200 50 U 1,150 €295 F 1,495
Contribution margin €400 €0 U €400 €120 U €520
Fixed costs 300 14 U 286 0 286
Operating profit €100 €14 U €114 €120 U €234

Level 2 €14 U €120 U

Flexible-budget variance Sales-volume variance
Level 1 €134 U
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 Static-budget variance
Flexible-Budget Variance
 The flexible-budget variance is the difference between an actual result and the corresponding flexible-
budget amount.
 The flexible-budget variance arises because the actual selling price, variable costs per unit, quantities and
fixed costs differ from the budgeted amount.
 These flexible-budget variances are a better measure of operating performance than static-budget
variances because they compare actual revenues to budgeted revenues and actual costs to budgeted costs
for the same 10,000 suits of output.

( Flexible ) = {( )}
Result ) (
budget Actual − Flexible budget
variance amount
for operating income = €100,000 - €114,000
= €14,000 U - arises because actual selling price, actual variable cost per
unit, and actual fixed costs differ from their budgeted amounts.
 The actual results and budgeted amounts for the selling price and variable cost per unit are as follows:
Actual Amount Budgeted Amount
Selling price €160 (1,600,000/10,0000) €155
Variable Cost €120 (1,200,000/10,000) €115
 The flexible-budget variance for revenues is often called a selling-price variance because it arises solely
from the difference between the actual selling price and the budgeted selling price:

( Selling
variance ) ( selling price selling price ) ( units sold )
− price = Actual− Budgeted x Actual

= (€160 per suit - €155 per suit) x (10,000 suits)

= €50,000 F
 LSY has a favorable selling-price variance because the €160 actual selling price exceeds the $155 budgeted
amount, which increases operating income. Marketing managers are generally in the best position to
understand and explain the reason for this selling price difference. For example, the difference might be
due to better quality or due to an overall increase in market prices.
 The flexible-budget variance for total variable costs is unfavorable (€50,000 U) for the actual output of
10,000 suits. It’s unfavorable because of one or both of the following:
 LSY used greater quantities of inputs (such as direct manufacturing labor-hours) compared to the
budgeted quantities of inputs.

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  LSY 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.
 The actual fixed costs of €300,000 are €14,000 more than the flexible budget fixed costs (budgeted
amount) of €286,000. This unfavorable flexible-budget variance reflects unexpected increases in the cost of
fixed indirect resources, such as factory rent or supervisory salaries.
 Why is the flexible-budget variance of €14,000 unfavorable?
Selling-price variance €50,000 F
Actual VCs exceeded flexible budget VCs €50,000 U
Actual FCs exceeded flexible budget FCs €14,000 U
Total flexible-budget variance €14,000 U
Sales-Volume Variances
 Keep in mind that the flexible-budget amounts and the static-budget amounts are both computed using
budgeted selling prices, budgeted variable cost per suit, 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 10,000 actual quantity (or volume) of suits sold and the 13,000
quantity of suits expected to be sold in the static budget.

for operating income ) {(

( Sales ) ( amount )}
volume variance Flexible budget − Static budget
=
amount
= €114,000 - €234,000
= €120,000 U - reflects the effects of inaccurate forecasting of output units sold.
 The sales-volume variance in operating income for LSY measures the change in budgeted contribution
margin because LSY sold only 10,000 suits rather than the budgeted 13,000.

for operating income ) {( margin per unit

( Sales ) ( sold units sold )}
volume variance Budgeted contribution x Actualunits − Static budget
=

for operating income ) {(

( Sales ) ( sold units sold )}
volume variance Bdged selling− Bdged variable x Actual units − Static budget
=
price cost per unit
= (€155 per suit - €115 per suit) x (10,000 suits - 13,000 suits)
= €40 per suit x (-3,000 suits)
= €120,000 U
 This unfavorable sales-volume variance in operating income could be because of the following reasons:
 The overall demand for suits is not growing at the rate that was anticipated.
 Competitors are taking away market share from LSY.
 LSY did not adapt quickly to changes in customer preferences and tastes.

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  Budgeted sales targets were set without careful analysis of market conditions.
 Quality problems developed that led to customer dissatisfaction with LSY’s suits.
 How LSY responds to the unfavorable sales-volume variance will be influenced by what management
believes to be the cause of the variance. For example,
 LSY’s managers believe the unfavorable sales-volume variance was caused by market-related
reasons (the first four reasons mentioned above), 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 (the last reason mentioned above), 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.
3.3. Price-Variances and Efficiency-Variances for Direct-Cost Inputs
 The flexible-budget variance for direct-cost inputs is subdivided into two more-detailed variances:
1. A price-variance - that reflects the difference between an actual input price and a budgeted input
price
2. An efficiency-variance - that reflects the difference between an actual input quantity and a budgeted
input quantity
 The information available from these variances, which is said to be level 3 variances, helps managers to
better understand past performance and take corrective actions to implement superior strategies in the
future.
 Managers generally have more control over efficiency variances than price variances because the quantity
of inputs used is primarily affected by factors inside the company (such as the efficiency with which
operations are performed), while changes in the price of materials or in wage rates may be largely dictated
by market forces outside the company.
 There are three main sources for obtaining budgeted input prices and budgeted input quantities. These are:
1. Actual input data from past periods.
 These historical data could be analyzed for trends or patterns to obtain estimates of budgeted prices
and quantities.
 Advantages of past data: represent real quantities and prices, serve as benchmark for continuous
improvement, and available at low cost.
 Limitations to using past data: Include inefficiencies such as wastage of direct materials, and don't
incorporate any changes expected for the budget period.

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 2. Data from other companies that have similar processes.
 The benefit of using data from peer firms is that the budget numbers represent competitive
benchmarks from other companies.
 The main difficulty of using this source is that input price and input quantity data from other
companies are often not available or may not be comparable to a particular company’s situation.
3. Standards developed
 A standard is a carefully determined price, cost, or quantity that is used as a benchmark for judging
performance. Standards are usually expressed on a per-unit basis.
 LSY conducts engineering studies to obtain a detailed breakdown of the steps required to make a suit.
Each step is assigned a standard time based on work performed by a skilled worker using equipment
operating in an efficient manner.
 There are two advantages of using standard times: (i) They aim to exclude past inefficiencies and (ii)
they aim to take into account changes expected to occur in the budget period.
 A standard input is a carefully determined quantity of input—such as square yards of cloth or direct
manufacturing labor-hours—required for one unit of output, such as a suit.
 A standard price is a carefully determined price that a company expects to pay for a unit of input.
 A standard cost is a carefully determined cost of a unit of output - for example, the standard direct
manufacturing labor cost of a suit at LSY.

( Standard
each variable direct −cost input ) ( for one output unit ) ( per input unit )
cost per output unit for = Standard input allowed x Standard price

Data for Calculate LSY's Price Variances and Efficiency Variances

Standards
input/unit cost/input unit cost/unit
Direct material 4 sq meters €16.25 €65
Direct mfg labor 2 hrs €13 €26

Direct Materials Purchased and Used

DMs purchased and used ................................................................ 42,500 sq meters
Actual price paid per sq meter......................................................... €15.95
Direct material costs (42,500 x 15.95) ................................................ €677,875
Direct Manufacturing Labor

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Actual direct manufacturing labor hours........................................21,500 hours
Actual price paid per hour................................................................ €12.90
Direct manufacturing labor cost (21,500 x 12.90) ............................ €277,350
Price Variances
 A price variance is the difference between actual price and budgeted price multiplied by actual input
quantity, such as direct materials purchased or used.
 A price variance is sometimes called an input-price variance or rate variance, especially when
referring to a price variance for direct manufacturing labor.

( variance
Price
)= ( Actual of inputs ) ( of inputs )
price − Budgeted price x Actual quantity
of inputs
 Price variance for direct materials:

DM PriceVariance = ( Actual
price price ) ( purc ℎ ases )
− Budgeted x Direct material

= (€15.95 - €16.25) x 42,500

= €12,750 F
 Rate variance for direct manufacturing labor:

DL Price Variance = ( paid per ℎ our ) ( ℎours )

Actual price − Budgeted price x Actual DL
per ℎ r .
= (€12.90 - €13.00) x 21,500
= €2,150 F
LSY’s favorable direct materials and direct labor price variances could be due to one or more of the
following:
 Purchasing manager negotiated the prices more skillfully than was planned (i.e., high bargaining
power).
 The purchasing manager changed to a lower-price supplier.
 Obtained quantity discount for making bulky order.
 Direct material prices decreased unexpectedly because of, say, industry oversupply.
 Budgeted purchase prices of direct materials were set too high without careful analysis of market
conditions.
 Labor prices were set without careful analysis of the market.
Efficiency Variance
 The efficiency variance is the difference between actual quantity of input used and the budgeted
quantity of input allowed multiplied by the budgeted input price.

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 ( Efficiency
variance ) ( of inputsused
=
of inputs allowed ) ( of inputs )
Actual quantity − Budgeted quantity x Budgeted price

 A company is inefficient if it uses a larger quantity of input than the budgeted quantity for its actual
level of output.
 The company is efficient if it uses a smaller quantity of input than was budgeted for that output level.
 Efficiency variance for direct materials:

( DMvariance
Efficiency
)= ( Actual
usage usage ) ( price )
− Budgeted x Budgeted

= (42,500 - (10,000 units x 4 sq m/unit)) x (€16.25)

= (42,500 - 40,000) x 16.25 = €40,625 U
 Efficiency variance for direct manufacturing labor:

( DLvariance
Efficiency
)= (labor ℎrs labor ℎ rs ) ( price )
Actual − Budgeted x Budgeted

= (21,500 hrs - (10,000 units x 2hrs)) x (€13)

= (21,500 hrs - 20,000hrs) x 13 = €19,500 U
LSY’s unfavorable direct materials and direct labor efficiency variances could be due to one or more of the
following:
 LSY's purchasing manager received lower quality of materials.
 The personnel manager hired under-skilled workers or problem in motivation of employees.
 The maintenance department did not properly maintain machines.
 Poor design of products or processes.
 Problem with the budget.
 Poor work on the production line.
 Inappropriate assignment of labor or machines to specific jobs.
3.4. Overhead Variance Analysis
Overhead variances have a somewhat different meaning than direct materials and direct labor variances for
two reasons:
 overhead is an indirect cost whereas materials and labor are direct costs
 overhead includes both variable and fixed costs
For overhead variance analysis the standard or pre-determined overhead rate based on total overhead costs is
divided into variable and fixed rates, which are calculated by dividing budgeted variable or budgeted fixed
overhead by the budgeted allocation base.
Developing Budgeted Variable Overhead Rates

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Budgeted variable overhead cost-allocation rates can be developed in four steps.
Step 1: Choose the Period to Be Used for the Budget.
 uses a 12-month budget period because it saves management the time it would need 12 times during
the year if budget rates had to be set monthly.
Step 2: Select the Cost-Allocation Bases to Use in Allocating Variable Overhead Costs to Output Produced.
(i.e., Total budgeted level of allocation bases)
 LSY’s operating managers select machine-hours as the cost-allocation base because they believe that
machine-hours is the only cost driver of variable overhead.
Step 3: Identify the Variable Overhead Costs Associated with Each Cost-Allocation Base. (i.e., Total budgeted
variable overhead costs)
 LSY groups all of its variable overhead costs, including costs of energy, machine maintenance,
engineering support, indirect materials, and indirect manufacturing labor in a single cost pool.
Step 4: Compute the Rate per Unit of Each Cost-Allocation Base Used to Allocate Variable Overhead Costs
to Output Produced. (i.e., Predetermined variable overhead rate)
Total budgeted VOH Costs
Predetermined VOH rate =
Total budgeted level of allocation bases
In standard costing, the variable overhead rate per unit of the cost-allocation base is generally expressed as a
standard rate per output unit.

( Budgeted ) ( per output unit ) ( per input unit )

VOH cost rate = Budgeted input allowed x Budgeted VOH cost rate
per output unit

LCY Co.'s data related to overhead cost as follows:

 Machine hour is selected as cost-allocation base. Because it is believed that it is the only cost-driver of
variable overhead.
 Based on an engineering study, LSY estimates it will take 0.5 of a machine-hour per actual output unit.
Total budgeted level of allocation base is 6,500 (0.5 x 13,000 suits) machine hours.
 LSY's total budgeted variable overhead costs are €180,000.
Total budgeted VOH Costs
Predetermined VOH rate =
Total budgeted level of allocation bases
= 180,000/6,500 = €27.7 per machine hour

( Budgeted ) ( per output unit ) ( per input unit )

VOH cost rate = Budgeted input allowed x Budgeted VOH cost rate
per output unit
= 0.50 machine hour per suit x €27.7 per machine hour
= €13.85 per suit

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Variable Overhead Cost Variances
The following data for calculate LSY's variable overhead cost variance are, when LSY produced and sold
10,000 suits:
Actual Result Flexible-Budget Amount
1. Output units (Suits) 10,000 10,000
2. Machine hours per unit 0.55 0.50
3. Machine hours (1 x 2) 5,500 5,000
4. Variable overhead costs 148,500 138,500
5. VOH costs per m. hr. (4÷3) € 27 €27.7
6. VOH costs per unit (4÷1) €14.9 €13.85
Flexible-Budget Variance (Level 2)
The variable overhead flexible-budget variance measures the difference between actual variable overhead
costs incurred and flexible-budget variable overhead amounts.

(budget variance ) ( incurred ) (

VOH flexible − = Actual costs − Flexible − budget
amount )
= €148,500 - €138,500
= €10,000 U
Reasons:
 LSY used more machine-hours than planned to produce the 10,000 suits.
 Workers were less skilled than expected in using machines.
 LSY spent more on variable overhead costs, such as maintenance.
To get further insight into the reason for the €10,000 unfavorable variance, VOH flexible-budget variance is
divided into the spending variance and efficiency variance.
VOH Spending Variance
The variable overhead spending variance is the difference between actual variable overhead cost per unit of
the cost-allocation base and budgeted variable overhead cost per unit of the cost-allocation base, multiplied by
the actual quantity of variable overhead cost-allocation base used for actual output.

(VOHvariance ) ( unitActualVOH
Spending = per − Budgeted VOH per
of allocation base unit of allocation base ) x ( Actual level of t ℎ e )
allocationbase
= (€27 - €27.7) x 5,500 machine hours
= €3,850 F
Reasons
 Decline in the price of items included in variable overhead costs.
 Usage of materials per allocation base have been less than the budget.
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VOH Efficiency Variance
The variable overhead efficiency variance is the difference between actual quantity of the cost-allocation base
used and budgeted quantity of the cost-allocation base that should have been used to produce actual output,
multiplied by budgeted variable overhead cost per unit of the cost-allocation base.
It is due to using more or less of the allocation base. In other words, these variances are based on the
efficiency with which the cost allocation base is used.

(VOHvariance ) (t ℎ Actuallevel
Efficiency =
e allocationbase t ℎ e allocationbase ) ( unit of allocation base )
of − Budgeted level of x Budgeted VOH per

= (5,500 hrs. - (0.5 hr per unit x 10,000 units )) x €27.7 per hr

= (5,500 hrs - 5,000 hrs) x €27.7 per hr
= €13,850 U
Reasons:
 Workers were less skilled or problems in motivation, Problem with budgeting.
 Poor scheduling of jobs, resulting in more machine hours used, Poor quality materials.
 Machines were not maintained in good operation condition.
Fixed Overhead Cost Variances
Fixed overhead costs are a lump sum of costs that remains unchanged in total for a given period. Fixed costs
are included in flexible budgets, but they remain the same total amount within the relevant range of activity
regardless of the output level.
Do not assume that fixed overhead costs can never be changed. Managers can reduce fixed overhead costs by
selling equipment or by laying off employees. But they are fixed in the sense that, unlike variable costs such
as direct material costs, fixed costs do not automatically increase or decrease with the level of activity within
the relevant range.
Fixed overhead costs are assigned to products through allocation. They are not so important for cost control
purpose because FOH costs are assumed to be constant.
¿
FOH Allocation Rate ¿ Budgeted ¿ Costs Budgeted Activity level

Example: LSY Company's budgeted fixed costs is €286,000. The allocation base is machine hour.
LSY estimates machine hour per unit. It is 0.5.
Budgeted Machine hours = 13,000 units x 0.5 hr = 6,500 machine hours.
Actual Fixed Costs = €300,000
¿ € 286,000
FOH Allocation Rate ¿ Budgeted ¿ Costs Budgeted Activity level = = €44 per machine hr.
6,500 ℎ rs
LSY can now calculate the budgeted fixed overhead cost per output unit as follows:

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 ( Budgeted
per output unit ) (base allowed per output unit ) ( per unit of alloc . base )
FOH cost = Budgeted Qty of Allocation x Budgeted FOH cost

= 0.5 hrs. x €44 per hr. = €22 per suit

The flexible-budget amount for a fixed-cost item is also the amount included in the static budget prepared at
the start of the period. No adjustment is required for differences between actual output and budgeted output
for fixed costs, because fixed costs are unaffected by changes in the output level within the relevant range.
The fixed overhead flexible-budget variance is the difference between actual fixed overhead costs and fixed
overhead costs in the flexible budget:

(budget variance ) ( incurred ) (

FOH flexible = Actual costs − Flexible budget
amount )
= €300,000 - €286,000 = €14,000 U
There is not an efficiency variance for fixed overhead costs. That’s because a given lump sum of fixed
overhead costs will be unaffected by how efficiently machine-hours are used to produce output in a given
budget period.
FOH Spending Variance
The fixed overhead spending variance is the same amount as the fixed overhead flexible budget variance:

( FOHvariance ) ( incurred ) ( amount )

spending = Actual costs − Flexible budget

= €300,000 - €286,000
= €14,000 U
Reasons for the unfavorable spending variance
 Higher plant leasing costs, Higher depreciation on plant and equipment
 Higher administrative costs, such as higher salaries paid to the plant manager or supervisory.
Production Volume Variance
The production-volume variance, also referred to as the denominator-level variance, is the difference between
budgeted fixed overhead and fixed overhead allocated on the basis of actual output produced.

The allocated fixed overhead can be expressed in terms of allocation base units (machine-hours for LSY) or in
terms of the budgeted fixed cost per unit:

( volume ) (
Production = Budgeted −
variance FOH costs ) ( actual output units produced )
FOH allocated for

FOH costs ) [ ( ) ( for actual outputs )]

=(
Budgeted − FOH allocation x Allocation base amount
rate
= €286,000 - (44 per hr. x (10,000 units x 0.5 hrs. per unit))

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 = €286,000 - €220,000 = €66,000 U

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