Admas University Cost II CH 5

Chapter 4

Flexible Budgets and Management Control

4.1. Introduction
In the previous chapter, we have seen how budgets assist managers in their planning functions.
We now turn our attention to how budge- specifically flexible budget- can be used to evaluate
feedback on variance and aid managers in their control function. Feedback enables managers to
compare actual results with planned performance and take corrective action.

Static budget is a budget designed to remain unchanged regardless of changes in volume of

output. It is prepared based on single level of out put and is not adjusted or altered after it is set.
Best example is a master budget, which is based on a single level of output, 500,000 units. Thus
a static budget is based on the level of output planned at the start of the budget period. Static
budget has two major characteristics:
a) It is geared towards only one level of activity.
b) Actual results are always compared against budgeted costs at the original budget activity
level.
Flexible budget is a budget that is developed using budgeted revenue or cost amounts and is
adjusted (flexed) to changes in activity level during the budget period. It is a fixed budget
adjusted for changes in assumptions or variations in the level of operation and provides
detailed information about budgeted expenses and revenues at various level of out put. Because
of this, flexible budget is called Variable budget. Flexible budgets and variances help managers
gain insights into why the actual results differ from the planned performance. The key
difference between a flexible budget and a static budget is the use of the actual output level in
the flexible budget; whereas the static budget uses the out put level planned at the start of the
budget period. In sum, the characteristics of a flexible budget are:

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a) It is geared towards all level of activity within the relevant range, rather than only one
level of activity. It is dynamic in nature rather than static. It can be tailored for any level of
activity within the relevant range, even after the period is over. That is, a manager can look
at what activity level was attained during a period and then turn to the flexible budget to
determine what costs should have been at that activity level.
b) Actual results do not have to be compared against budgeted costs at the original budget
activity level. Since the flexible budget covers a range of activity, if actual costs are
incurred at a different activity level from what was originally planned, then the manager is
able to construct a new budget, as needed, to compare against actual results.

4.2. The Use of Variances

Variance: - is the amount by which actual amount differs from budget amount. Each variance
we compute is the difference between an actual results and a budget amount. The budgeted
amount is a benchmark, a point of reference from which comparisons may be made.
Organizations differ widely in how they compute and label their budgeted amounts. Some
organizations rely heavily on past results when developing budgeted amounts; others rely on
detailed engineering studies. Variances assist managers in their planning and control decisions.
Management by exception is the practice of concentrating on areas not operating as anticipated
and giving less attention to areas operating as anticipated. Managers use information from
variances when planning how to allocate their efforts. Areas with sizable variances receive more
attention by managers on an ongoing basis than do areas with minimal variances. Variances
also guide managers to ensure that future operations have less scrap and rework. Variances are
also used in performance evolution.

Cost variance is the difference between budgeted cost and comparable actual cost incurred
during a period.

Revenue variance is the difference between actual revenue and budgeted revenue

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Favorable variance (F) is a variance that increases operating income relative to budgeted
amount.

Unfavorable variance (U) is a variance that decreases operating income relative to
budgeted amount.

For revenue items, ‘F’ means actual revenues exceed budgeted revenues. For costs, ‘F’
means actual costs are less than budgeted costs. The reverse is unfavorable (U) in both
cases.

4.3. Variance Analysis

It means sub-dividing total variances in to small parts and analyzing each part to identify the
person responsible for the performance. Variance analysis helps to take corrective action,
control costs, and helps to pinpoint responsibilities to managers. It can be analyzed at different
levels.

4.3.1. Static Budget Variances

If variances are computed from a static budget at the end of the period, no adjustment is made
to the budgeted amounts irrespective of the actual level of output in the budget period. A static
budget variance is the difference between an actual result and a budgeted amount in the static
budget. Static budget based variance analysis provides level-0 and level-1 analysis:

A. Level-0 analysis

It is made comparing the budgeted operating income of static budget and actual operating
income. It is called static budget variance. No detailed explanation exists and hence does not
tell us what the factors caused the variances. If actual operating income is grater than budgeted,
the variance is favorable other wise, it is unfavorable.
Static budget variance = Actual operating income – Static budgeted operating income

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B. Level -1 analysis

It provides mangers with more detailed information on the operating income static budget
variance which level zero failed. Accordingly, it compares actual results with static budget line
by line for variable costs, revenues, contribution margin, and fixed costs and operating income
to identify the many factors contributed for the change in operating income. It can be done as
follows:

Actual Static budget Static budget

results Amount Variances
Units sold XX XX XX
Revenues XX XX XX
Variable costs XX XX XX
Contribution Margin XX XX XX
Fixed costs XX XX XX
Operating income XX XX XX

Illustration on Variance Analysis

Funny Family PLC is an Ethiopian based manufacturing business engaged in producing and
exporting hand tools to West African Countries. The following data is abstracted from its
accounting records for the year ended Dec.31, 2007. Assume the entity planned to produce and
sell 20,000 units but actually produced only 18,000 units. The following is data related to actual
and budget results.

Budgeted Actual
Units sold ------- 20,000 18,000
Sales revenue ----- 2,000,000 1,710,000
Variable costs ------- (1,248,000) 1,146,400
Fixed stat ------------- (370,000) (390,000)
Operating income ------ $ 382,000 $173,600
Instruction: Determine level-0 & 1 variances

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a) Level -0 analysis

Static budget variance = Actual operating income – budgeted operating income
= $173,600 - $382,00U
= $208,400U

Level - 0 analyses indicates that there is unfavorable operating income. No detailed
explanation exists and hence is not sufficient to identify the cause of variance.
b) Level -1 analysis
Actual Master Static Budget
Results (static) Variance
Units sold 18,000 20,000
Sales 1,710,000 2,000,000 $ 290,000U
Less: variable costs 1,146,400 1,248,000 101,600F
Contribution margin $ 563,600 $ 752,000 $ 188,400U
Les: Fixed costs 390,000 370,000 20,000U
Operating income $ 173,600 $ 382,000 $ 208,400U

Level 1:– analysis indicates the factors that contributed to unfavorable operating
income which level zero failed. It indicates the factors that contributed to
unfavorable operating income of $208,400. Accordingly, actual sales are less by $
290,000, which is unfavorable; actual variable cost is less than budgeted by $
101,600, which is favorable; actual fixed cost is greater than budgeted by $20,000,
which is unfavorable.

4 .3.2 Flexible Budget Variances

Level 0 and level 1 analysis both are based on static budget because they simply compare actual
results with the static budget. While level 1 analysis contains more information than level 0,
additional insights in to causes of variances can be gained by incorporating a flexible budget in
to the computation of variances. It includes:
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A. Level - 2 analyses

It is meant to provide additional information, which level 0 and level 1 failed to provide by
using flexible budget, which provides explanations for deviations between actual results and
static budget. Flexible budget variances and sales volume variances are level -2 analyses.

Static Budget Variance

Flexible Budget Sales Volume

Variance
Variance

Performance Evaluation using Flexible Budget

Managers usually use variance analysis to evaluate performance. When evaluating
performance, it is useful to distinguish between effectiveness and efficiency. Effectiveness – the
degree to which a predetermined objective or target is met. It means doing the right thing.
Efficiency – achieving a given target or level of out put with minimum inputs, measures the
amount of input used to achieve a given level of out put.

Sales volume variance is a measure of effectiveness. It represents the difference
caused solely by the difference in the quantities of units sold from that in the static
budget. It is the difference between the flexible budget amount and the static budget
amount & can be determined as:
SV Variance = Static Budget Amount – Flexible Budget Amount
Amount

Flexible budget variance is a measure of efficiency. It is the difference between the
actual results and the flexible-budget amount based on the level of out put actually
achieved in the budget period & determined as:
FB Variance = Actual results – Flexible budget
budget amount

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The flexible budget variance pertaining to revenue is often called selling price
variance because it arises solely from differences between the actual selling price
and the budgeted selling price.
Selling price variance = (Actual SP–Budgeted) Actual units sold

The computation involves:

Static budget:

• Budget Revenue = Budgeted Sales Quantity * Budgeted Selling Price unit

• Budgeted VC = Budgeted Quantity of Output * Budgeted Variable Cost/unit

• Budgeted Fixed Cost

Flexible budget:

• Budgeted Revenue = Actual Sales Quantity * Budgeted Selling Price per unit

• Budgeted Variable Cost = Actual Quantity of Output* Budgeted Variable Cost per unit

• Budgeted Fixed Cost

Actual results:

• Actual Revenue = Actual Sales Quantity X Actual Price per unit

• Actual Cost = Actual Quantity of Output* Actual Variable Cost per unit

• Actual fixed cost

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Instruction: Determine level-2 variances for the Funny Family PLC in the ex-illustration.

Level -2 analysis
Actual Flexible B Flexible Sales Volume Static
Results Variance Budget Variance Budget
(1) 2= (1)-(3) (3) 4= (3)-(5) (5)
Units sold 18000 __ 18000 __ 20,000
Sales 1,710,000 90,000 U 1,800,000 200,000 2,000,000
Less: VCs 1,146, 400 23,200 U 1,123,200 124,800 F 1,248,000
Cont. margin 563,600 113, 200 U $ 676,800 75,200U 752,000
Less: Fix costs 390,000 20,000 U 370,000 __ 370,000
Oper. Income $173,600 133,200U 306,800 75,200U 382,000

Flexible Budget Variance Sales Volume Variance

Static budget variance = FBV + SVV= 133,200 U + 75,200 U = 208,400 U
Actual operating income – budgeted operating income = 173600- 382000 = 208,400

B. Level -3 analyses
It provides additional detailed subdivisions of level 2 analysis. Its information helps managers
better understand past performance and better plan for future performance. It involves the
determination of standard costs Standard costs are a carefully predetermined measure of what
a cost should be under stated condition. They are predetermined costs stated or usually
expressed on a per unit basis. Standard costs are the results of: (1) Effective engineering studies,
(2) Time and motion studies, (3) Study of general economic condition, which affect cost of
purchase, (4) good or best level of performance. The main purposes of standard cost are: to
provide basis for control through variance accounting, for valuing inventories, for fixing selling
prices.

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Static Budget Variance

Flexible Budget Sales volume

Variance Variance

Price variance Efficiency variance

Classification of Standards
1) Ideal (Theoretical Standards) are standards that are set on the basis of theoretical capacity
and reflect maximum efficiency. They are developed with the assumption that the company
will operate at full capacity and full speed without any interruption (even the normal ones
as machine breakdowns). Such standards are attained only under most favorable conditions
without providing allowance for shrinkage, spoilage, or machine breakdowns, and
employee rest time etc. Although theoretically possible, such standards are extremely
unlikely to occur. The disadvantage of such standards is that employees may be discouraged
because of unattainably. Such standards also result in a large unfavorable variance
2) Currently attainable (Practical Standards) are standards more realistic than theoretical and
makes allowance for unavoidable delays such as: machine break down, employee rest time,
normal spoilage, etc.
Standard Cost Determination
1) Standard costs for materials: In determining standard material costs, two factors should be
considered: (1)standard usage (quantity standard), the allowed quantity of raw materials
required for one unit of out put given a good or best level of performance. It is based on
engineering and technical specifications, consideration of expected wastage, the quantity of
each type of material to be used in production, (2) standard purchase price, the standard
price for a unit of raw material. It is determined by purchasing department and involves the

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purchase price paid to the supplier (adjusted for quantity discount) and incidental costs
(such as transportation charges, receiving and testing costs insurance

Standard cost for material = Material usage standard x standard purchase price for Material

2) Standard costs for labor: The standard cost for labor constitutes two factors: (1) standard
time for each operation (i.e. Standard labor hours). A detailed time and motion study of
operations is carried out by the engineering department to establish the basic time required
for each operation. The standard time is established by adjusting the basic time for an
acceptable level of waste motion, idle time and other inefficiencies, (2) standard wage rate
per hour, a forecasted wage rate which takes in to consideration the wage agreement
between labor unions and management, labor conditions within the firm and in local,
national and international labor markets.

Standard cost for labor = standard time x standard wage rate

4.3.2.1. Direct Manufacturing Costs (DM & DL) Variance Analysis

a) Price variance is the difference between actual unit price and budgeted unit prices
multiplied by the actual quantity of goods used.
Direct material price variance = (actual price – standard price) actual quantity purchased
Direct labor price (rate) variance = (actual rate – standard rate) actual hours used

DM- price variance – variance arising from paying more per unit of input or less per
unit of input than budgeted,

DL – rate variance- caused by paying more or less wage per hour than budgeted,
b) Efficiency (usage variance) is the difference between the quantity of input used and the
quantity of inputs that should have been used multiplied by budgeted price or rate.

For any level of out put, the efficiency variance is the difference b/n the input that was
actually used and the input that should have been used to achieve the actual out put
holding the price constant at the budgeted level. An organization is efficient or
inefficient if it uses more or less in puts than budgeted for the actual out put achieved.
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DM- usage variance – variance caused by using more or less material than budgeted

DL- efficiency variance - caused by using more or less hours than budgeted for
production.
Direct material usage variance = (actual quantity – allowed quantity) standard price
Direct labor efficiency variance = (actual hours – allowed hours) standard rate

Allowed quantity is the quantity of input that should have been used & computed as:

Allowed quantity = Standard quantity of input x Actual units produced

Generally,
DM-cost variance = DM Flexible Budget Variance = DM price variance + DM usage variance
DL-cost variance = DL Flexible Budget Variance = DL rate variance + DL efficiency variance

Illustration on Direct Manufacturing Price & Efficiency Variance Analysis

ABC company is operating in a textile industry where the products are jackets, shirts etc. To
manufacture one jacket the entity has set 6kg cotton as standard. One kg of cotton is expected to
be purchased on average at $20/ kg. During the period, ABC has actually produced 14,000 good
jackets using 8kg of cotton per jacket. The total quantities of materials purchased were 120,000
kgs at $18/kg. Standard labor time set to produce one jacket is 4hrs at $ 30/hr. The entity
actually paid $1,176,000 for using 42,000 hrs of direct labor.
Required:
1) Identity standard Quantity & Price of DM and DL
2) Compute standard cost for material and labor.
3) Compute total allowed quantities Direct Material and Labor.
4) Compute total actual DM and DL hours to produce actual out put
5) Compute price variance and rate variance
6) Compute efficiency variance for both DM&DL
7) Compute flexible budget variance for DM and DL

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General Leger Entries to record DM and DL Cost Variances
1. Journal Entry to record the Purchase of Materials. This entry isolates the direct
material price variance at the time of purchase by debiting materials inventory
at/material control at standard price of actual quantity of material purchased (AQSP),
and credits accounts payable at actual debt owed (AQAP). Direct material price variance
will be debited if unfavorable or credited if favorable. Note: unfavorable variances are
debits in variance accounts, because they add to the cost incurred, which are record as
debits. Favorable variances are shown as credits because they are reductions in costs.
Thus, favorable variances are recorded in variance accounts as credits. The entry to
isolate the direct material price variance of our illustrations looks like the following
Raw Materials -------------------------------- ------------------------- 2,400,000
DMPV ------------------------------------------------------------------------------240,000
A/P -------------------------------------------------------------------------------2,160,000
2. Journal Entry to record the use of Materials: Direct material efficiency variance is
usually isolated at the time of usage of direct material by debiting work in process at
amount equal to allowed quantity multiplied by standard price (All. QSP) & RM (AQ
used SP).
WIP--------------------------------------------------------------------------- 1,680,000
DM- Efficiency Variance -------------------------------------------------- 560,000
Raw Material--------------------------------------------------------------------2,240,000
3. Journal entry to charge DL cost to WIP- inventory: The direct labor efficiency
and rate variances are both isolated at the time of usage by debiting WIP-inventory at
amount equal to standard quantity allowed for actual O/P achieved times standard
price. Any unfavorable variance related to direct labor will be debited. Wages payable at
actual amount (AHAR) and any favorable variances are credited
WIP ------------------------------------------------------------------------1,680,000
DLRV--------------------------------------------------------------------------------84,000
DLEV -------------------------------------------------------------------------------420,000
Wages payable------------------------------------------------------------------1,176,000

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Summary on DM & DL Variances
Note:

Rate variance is the same as price variance one is a substitute for the other. But rate
variance is popular term with respect to direct labor.

Efficiency variance, quantity variance and usage variance are substitute terms.

The production department is responsible for efficiency variance

Price variance is the responsibility of purchasing dept.

Standard cost is used with flexible budget. The concept of flexible budget, there fore is a
key to analysis of variance in standard cost system.
Possible Causes for Favorable Direct Material Price Variance

Good price negotiation by purchasing manger

Purchased larger lot sizes than budgeted, thus obtaining quaintly discount.

Materials price decreased unexpectedly due to say industry oversupply

Standard wrongly (unrealistically set)

The purchasing manger received unfavorable terms on non-purchase price factors
(Such as lower quality materials or minimal inspections by the supplier)
Possible Causes for Unfavorable Direct Material Price Variance

Standard wrongly (unrealistically) set

Poor price negotiation

Purchase of higher quality materials

Materials price unexpectedly increased due to external shocks.

Purchased in smaller lot sizes than budgeted and didn’t get quantity discount.

Change in supplier when lower priced supplier went out of business.

Purchasing from suppliers other than those offering the most favorable terms

Purchasing from unfavorably located suppliers, which result in additional
transportation costs.

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Possible Causes for Favorable Direct Material Efficiency Variance

Workers did more extensive planning and scheduling for materials.

Standard wrongly (unrealistically) set.

Increased skills of workers.

Use of more automated machinery.

Economics of scale in production.
Possible Causes for Unfavorable Direct Material Efficiency Variance

Wastage and loss of materials in handling and processing

Spoilage or production of excess scrap

Change in production specifications that have not been incorporated in standards

Substitutions of non-standard materials

Variation in yields from materials
Possible Causes for DL-rate variance (unfavorable)

Unfavorable change in labor rate that has not been incorporated in standard rate.

Using greater number higher paid employees in the group than anticipated.

Standard wrongly (unrealistically) set

Use of higher skill mix than budgeted

Poor negotiations with labor

Unexpected labor shortage due to external factors

Personnel manger hired under skilled workers
Possible Causes for Unfavorable Direct labor Efficiency Variance

Hiring unskilled worker.

Labor may be less efficient at higher out put levels due to tiredness

Standard wrongly (unrealistically) set

In efficient equipment used, resulting in larger labor hour than budgeted

Machine break downs, and usage of non-standard material

Inefficient scheduling of work, resulting in longer labor time than budgeted

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Failure of maintenance department to maintain the machine in good condition,
resulting in longer labor time per unit.

Lower quality materials purchased requiring more labor input to finish out puts.

Production scheduler inefficiently scheduled work, resulting in more manufacturing
labor time being used per out put.

Maintenance department didn’t properly maintain machines, resulting in more
manufacturing labor time being used per out put.

4.3.2.2. Factory Overhead Variance Analysis

A. Variable Factory Overhead Variances

By definition, VFOH varies in direct proportion to fluctuations in activity level whish is usually
indicated by the production volume. However, a closer look at variable overhead shows that it
varies with the hours worked because overheads tend to be time based cost. There fore, time
worked is a better indication of activity level of that output achieved for variable factory
overhead.

Effective planning of variable overhead costs involves undertaking only value added
variable overhead activities and managing the cost driver of those activities in the most
efficient way.

Flexible budget amount of variable factory overhead indicates the amount applied to
product. The reason why there is no production volume variance for variable overhead
is the amount of variable overhead allocated is always the same as the flexible budget
amount.

Variable overhead cost allocation rates can be developed and budgeted variable
overhead rate per output can be determined as follows:
Budgeted costs = Budgeted VFOH
Per Input unit Budgeted Cost Driver

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Budgeted VFOH Budgeted in puts × Budgeted cost
Rate per Output = allowed per out put per input unit

Types of Variances for VFOH

Variable Factory Overhead Flexible Budget Variance measures the difference between
the actual variable overhead costs and the flexible budget variable overhead costs.

It represents under applied or over applied variable factory overhead

It can be classified as efficiency variance and spending variance. & can be determined as:
VFOH-FBV = Actual VFOH Cost – FB-VFOH Cost

If the VFOH-FBV is favorable, the variance amount is over applied.

If the VFOH-FBV unfavorable, the variance amount is under applied.
1) Spending variance - is the difference between the actual amount of variable overhead
incurred and the budgeted amount allowed for the actual quantity of the variable overhead
allocation base used for the actual output units produced. It can be determined as
VFOHSV = AVFOH cost _ BVFOH cost for actual out put
Or
VFOHSV= (AVFOH rate – BVFOH rate) AQCD.

The two main reasons for VOHSP are:

The actual price of individual items included in the VFOH differ from budgeted
prices

The actual usage of individual items included in the VFOH differ from the budgeted
usage

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3) Efficiency variance
It measures the efficiency with which the cost allocation base is used. It can be determined as:

VFOHEV = (Standard input allowed for actual out put __ Actual Input) Budgeted VFOH

rate.
VFOHEV= (AQCD- BQCD allowed) BVFOH rate, where
AQCD = actual quantity of cost driver
BQCD = budgeted/allowed quantity of cost driver

The main reasons for VOHEP are:

The difference in skill of workers in use of machine than expected

Variation in product scheduling than budgeted

The impact of Machines maintenance.

Standard wrongly (unrealistically) set
Illustration on Variable Factory Overhead Variances
Funny Family PLC is an Ethiopian based manufacturing business engaged in producing and
exporting hand tools to West African Countries. The following data is abstracted from its
accounting records for the year ended Dec.31, 2007.
Actual Budgeted
Out put unit 10,000 units 12,000 units
Direct labor hours 4,500 4,800
VMOH cost $130,500 $144,000
Variable factory over head is applied to products on the basis of direct labor hrs.

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Required: Determine:
1. VFOH per input and out put unit for budged results.
2. VFOH per input and out put unit for actual results.
3. FB amount of O/P, direct labor hrs & VFOH.
4. VFOH-SBV & VFOH-SVV,VFOH-FBV,VFOHSV & VFOHEV
5. Journalize the necessary entries
Solution
AVOH cost Actual input Flexible Budget Static
Incurred X BUD. Rate BIAFAO/P X BR Budget
4500 X 29 4500 X 30 4000 X 30 4800 X 30
= $ 130,500 =$ 135000 = $ 120,000 = $ 144000

4500F 15000U 24000F

VFOHSV VFOHEV VFOH-SVV
10,500U 24000F
VFOH -FBV VFOH –SVV
13,500 F
VFOH – SBV

General ledger Entries for VFOH

a. Entry to record VFMOH allocated /applied/ flexible budget.

It applies manufacturing overhead to work in process at the rate of $ 30/standard
direct labor hours.
Work in prices ----------------------------------------- 120,000
VMOH –allocated --------------------------------------------- 120,000
b. Entry to record AVFOH –incurred

It records the actual manufacturing overhead costs incurred during the period
AVFOH –Control -------------------------------- -------130,500
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A/P and other accounts ------------------------------------------130,500
c. Entry to close overhead accounts and to isolate variances for the accounting period

It reduces the VFOH account balance to zero and set up the two variances calculated
for over head, these two variances reveal the cause of the under applied VOH for the
period
VMOH –Allocated --------------------------------------- 120,000
VMOHEV---------- ------------------------------------------- 15,000
VFOHSV ----------------------------------------------------------- 4,500
VFOH –incurred ------------------------------------------------130,500

B. Fixed Factory Overhead Variances

Fixed costs do not change with change in activity level. These costs include supervision costs,
depreciation, insurance, property taxes, and rentals. Fixed factory overhead is applied to
production on the basis of predetermined application rate, which is calculated as follows:
Fixed factory overhead rate = Budgeted Fixed Factory Overhead cost
Budgeted Denominator Volume

Denominator volume is the pre-selected level of the application base used to set a budgeted
fixed factory overhead. Effective planning of fixed overhead costs includes undertaking only
value added fixed overhead activities and then determining the appropriate level for those
activities.

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

Types of Variances for VFOH

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There are two fixed overhead variances. They include:
1) Fixed Factory Overhead Spending Variance- Note that there is no efficiency variance
for fixed factory overhead because short run fixed overhead is not affected by efficiency. As a
result, spending variance for fixed factory overhead is equal to flexible budget variance and
static budget variance. The fixed overhead flexible budget variance is the difference between
actual fixed overhead costs and the fixed overhead costs in the flexible or static budget. It can be
determined as:
FFOHSV = FFOH-FBV = FFOH-SBV=Actual FFOH – Budgeted FFOH

There is also no sales volume variance to FFOH because within a given period, fixed cost
remains constant. In the short run, a decision that is made on fixed costs is reversible. So,
the efficiency of management is not measured by fixed costs in the short run. Therefore,
there is no sales volume variance and efficiency variance for fixed cost. A lump-sum
amount of fixed costs will be unaffected by the degree of operating efficiency in a given
budget period.
2) Production Volume Variance: Production volume variance is also called Capacity
variance or Activity variance or Denominator variance.is the difference between budgeted fixed
overhead and the fixed overhead allocated on the basis of the budgeted quantity of the fixed
overhead allocation base allowed for the actual output produced. Thus, the production volume
variance arises whenever the actual level of the denominator differs from the level used to
calculate the budget fixed overhead rate. It results from “unitizing” of fixed costs.
PVV = Budgeted FFOH – Applied FFOH
Or
PVV = (Denominator level of out put – Actual out put) Budgeted FFOH/out put unit
Or
PVV = (Denominator input – Input allowed for actual out put) budgeted FFOH /input
unit

Applied FFOH = Budgeted FFOH rate x Actual Production

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If BFFOH is greater than Applied FFOH, the PVV is unfavorable; i.e. if the actual volume
achieved is less than the denominator volume..

If Applied FFOH exceeds BFFOH, the variance is favorable. In other words, when the
production volume exceeds denominator volume, the production volume variance is
favorable. This is due to the fact that managers regard the variance as a benefit of better than
expected utilization.

PVV arise from utilizing fixed costs. Be careful not to attribute much economic significance
to this variance. The most common misinterpretation is to assume this variance means the
economic cost of producing and selling actual units rather than budgeted unit.

If Actual FFOH is greater than Applied FFOH, the varaiance is unfavorable and it is called
under applied FFOH.

If Applied FFOH is greater than Actual FFOH, the variance is favorable and it is called over
applied FFOH.
Illustration on Fixed Factory Overhead Variances
Funny Family PLC is an Ethiopian based manufacturing business engaged in producing and
exporting hand tools to West African Countries. The following data is abstracted from its
accounting records for the year ended Dec.31, 2007.
Actual Budgeted
Fixed Factory Overhead (FFOH) $163,000 $160,000
Out put (Actual, Denominator) 22,000 units 20,000 units
Direct labor hours (Actual, Denominator) 14,500 hours 16,000 hours
Standard direct labor hours allowed 17,600 hours
Required: Determine;
1) Budgeted FFOH rate per input and out put unit.
2) FFOH static budget variance.
3) FFOHSV and FFOH-PVV.
4) Under/Over applied overhead.

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Exercises on Variance Analysis
Exercise1

Assume that the following information pertains to hypothetical textile factory.

Items Actual results Static budget

Units sold 10,000 12,000
Revenue 1,850,000 2,160,000
Variable costs:

Direct material 688,200 720,000

Direct manufacturing labor 198,000 192,000

Direct marketing labor 57,600 72,000

Variable manufacturing OH 130,500 144,000

Variable marketing OH 45,700 60,000
Fixed costs 705,000 710,000

Budgeted cost for three items

Direct material = 2 square yards of cloth input per out put at $ 30 per square yard

Direct manufacturing labor = 0.8 manufacturing labor hours per out put at $20 per hour

Direct marketing labor = 0.25 labor hours per out put at $24 per hour.
Actual Cost for three items

Direct material = 22,200 square yards of clothe at $ 31 each

Direct manufacturing labor = 9000 manufacturing labor hours at $22 each

Direct marketing labor = 2,304 direct marketing labor hours at $25 each
Required:
a) Determine level-0, level-1, level-2, level-3 variances where Level-3 analysis is applied only to
direct input costs i.e., (DM, DML & DMktgL).

By: Taddsse K. 2016 22

 Admas University Cost II CH 5
Exercise2
Journalize the following transactions.
a) Purchased 25,000 square yards of materials at $31 per square yard on account.
b) 22,200 yards are used in production of 10,000 outputs
c) 9,000 manufacturing labor hours are used at $22 per hour in production of 10,000
outputs.
Exercise-3
Variable marketing overhead is allocated to products using direct marketing labor hours per
output. Fixed market overhead is allocated to products on a per output basis.
Budgeted amount for the period
i) Direct market labor hours = 0.25 hours per output
ii) Variable marketing overhead rate = $20 per direct marketing labor hours
iii) Fixed market overhead = $434,000
iv) Output which is used as denominator level of output = 12,000 output units
Actual results for the period
v) Variable marketing overhead = $45,700
vi) Fixed marketing overhead = $420,000
vii) Direct marketing labor hour = 2,304 hours
viii) Actual output: 10,000 units
Required:
a. Compute variable marketing overhead variances (FBV, SVV,PVV, EV & SV)
a. Compute fixed marketing overhead variance (FBV, SVV, PVV, SV,& EV)
b. Record the necessary journal entries to both variable and fixed costs that:
i. Applies FFOH to Work In Process
ii. Recognizes Actual FFOH incurred during the period

iii. Closes the FFOH account balance to zero and set up the variances.

By: Taddsse K. 2016 23