Lecture 3

Flexed Budgets & Interpreting variances

and controllability principle
Reading
Essential:
Drury : Management & Cost Accounting 10th Ed Chapters 16, 17 &
18.
Recommended:
Seal, Rohde, Garrison & Noreen : Management Accounting 6th Ed Chapter
13 (ebook)

Part one – Flexed Budgets

Part Two – Interpreting variances & controllability principle

This unit assumes understanding of unit 8 in ACC1115

Objectives
By the end of the lecture you should be able to :
 
Flex the budgeted results to match actual.

 Calculate labour, material, overhead and sales

margin variances and reconcile actual profit with
budgeted profit;

 Identify the causes of labour, material, overhead

and sales margin variances;
L3 Part One

Flexed Budgets

Drury Chapter 16
Reasons for Variances
It is important to understand the possible reasons for cost
variances.
Cupcakes Ltd makes a standard pack of 4 cupcakes with the following
cost information for direct materials, actual production is 100 packs of
cupcakes.
Standard Cost information:
Direct material 0.5kg @ £2 per kg = £1 per unit
Actual Cost data:
Direct material 0.55kg @ £1.80 per kg = £0.99 per unit

Think!
Cupcake Ltd has used more kgs than planned to What could have
produce the pack of cupcakes and has paid less caused these
per kg of direct material than planned. variances?
Controllable variances &
uncontrollable variances
There are many reasons why variances can occur.
Some are common sense such as wastage of materials by having
more substandard raw materials or increases in price causing the
actual to be more expensive than predicted. In the real world
having calculated all of the variances withoutinvestigating the
reasons would be apointless exercise as the variances are used
to control operations and know when activities are diverging from
budget. If this investigation showed that the original budget was
unrealistic then it would be normal practice to reforecast the
results for the year.
Why would we do this? To get a meaningful standard to
compare to
Flexed Budgets and Budgetary
Control
A budget is set at for a single level of activity – e.g. 10,000 units of
output. If the actual levels differ from budget, then comparing the actual
results with the original budget is not going to give meaningful
variances.
 
The standard unit costs will give the expected variable costs per unit
from which the contribution or standard gross margin can be calculated.
By knowing the budgeted unit selling price and predicted sales volume
the sales variances can also be calculated.

Fixed budget is set prior to the control period and not subsequently
changed in response to changes in activity, costs or revenues.
Effect of Volume on variable costs

If you consider a simple example of catering for 50

people with budgeted food costs of £4 per meal and 40
hours of labour at £6 per hour then the total expected
costs will be :

Direct materials 50 x £4 = £200.

Direct labour 40 x £6 = £240
Total £440
Unit cost = £440/50 = £8.80

But what if 60 attend and the costs total £475 have we

done better or worse than expected????
Flexible Budgets

How can we get over this problem?

This can only be resolved by flexing the original

budget to equal the actual activity achieved and
then comparing the differences with actual to
calculate the variances. Consider this example:
Example 1
Columbus Ltd produce a single product and have
the following results for May 20X0
Total All variances
  Budget Actual   are adverse!
Variance
Production Units 4,000 6,000   
Direct Materials 12,000 17,000 5,000 (A)
Direct Labour 8,000 9,000 1,000 (A)
Variable Overhead 7,200 10,000 2,800 (A)
Fixed Overheads 7,000 7,600 600 (A)
Total Costs 34,200 43,600 9,400 (A)
Costs 34,200 43,600 9,400 (A)
Example 1
Flex the budget to obtain meaningful comparisons to the
Actual results
Budget Flexed Budget Actual Variance
Production Units 4,000 6,000 6,000
£ £ £
Direct Materials 12,000 18,000 17,000 1,000 (F)
Direct Labour 8,000 12,000 9,000 3,000 (F)
Variable Overhead 7,200 10,800 10,000 800 (F)
Fixed Overheads 7,000 7,000 7,600 600 (A)
Total Costs 34,200 47,800 43,600 4,200 (F)

Costs 34,200 47,800 43,600 4,200 (F)

Direct Materials = £12,000 / 4,000 x 6,000 = £18,000

Direct Materials = £18,000 - £17,000 = 1,000
Example 1

You can now see that the differences with the

flexed budget generate completely different
figures to the original budget and that for Direct
Materials and Direct Labour the variances are
both now Favourable rather than Adverse.
So without flexing, completely the wrong
conclusions could be drawn in comparing the
actual results to the original budget numbers.
The need for flexible budgets

Think!
High proportion of fixed
costs in modern
companies, these do
not vary with output

High proportion of fixed costs:

 Depreciation on plant and machinery, rent / leasehold
 Wage costs are often fixed in short to medium term
 Service industries have high wage costs often fixed in short term and fixed
costs but low direct materials costs.
Flexible budgets are still used extensively in industry for control purposes to
overcome these issues non-financial performance targets are used
Example 2
Remember that sales variances explain the difference in
contribution / gross margin between the original budget and
the actual results (unlike overhead variances which use the
flexed budget to compare similar levels of activity)

Jade plc operates a standard marginal costing system

producing a single product. Details of the standard product
unit cost data are :-
£
Direct material 6kg at £4 per kg 24
Direct Labour 1 hour at £7 per hour 7
Variable production overhead 3
34
Example 2

Jade plc budgets to sell 40,000 units per month for £50 per unit.

Actual sales in the month for the 37,000 units were £1,924,000

Variable production overhead varies with units produced

Budgeted fixed production overhead £200,000 per month

Budgeted production 40,000 units per month

Budgeted Admin Overheads £45,000 per month

Example 2

Actual production and costs for the month were as follows :-

Units produced 37,000 and sold

Direct Material 227,000 kg at a cost of £885,300

Direct Labour 35,600 hours which cost £259,880
Variable production overhead £117,600
Fixed Production overhead £210,000
Fixed Admin overhead £50,000

Prepare a statement in columnar form showing

a) Original Budget
b) Flexed budget
c) Actual
d) Total variances
 Example 2
Budget Flexed Budget Actual Variance
Production Units 40,000 37,000 37,000
£ £ £
Sales 2,000,000 1,924,000
Direct Materials 960,000 888,000 885,300 2,700 (F)
Direct Labour 280,000 259,000 259,880 880 (A)
Variable Overhead 120,000 111,000 117,600 6,600 (A)
Fixed Prodn Ovrhs 200,000 200,000 210,000 10,000 (A)
Fixed Admin Ovrhs 45,000 45,000 50,000 5,000 (A)
Total Costs 1,605,000 1,503,000 1,522,780 19,780 (A)
Profit 395,000 401,220
Difference in Profit 395,000 401,220 6,220 (F)
Direct Materials = £960,000 / 40,000 x 37,000 = £888,000
Direct Materials = £888,000 - £885,300 = 2,700
Variable / Marginal Costing System

Drury p441

Use with Management and Cost Accounting 10e

by Colin Drury ISBN 9781473748873
© 2018 Colin Drury
Sales MarginVariances -
Fixed Overhead Variances – Absorption costing
Marginal Costing

Sales Margin Variance

(ASR – SCOS) - BC

Sales margin Price variance Sales margin volume variance

(ASP – SSP) x AV (AV – BV) x SM
Example 2

SALES VARIANCES
These variances explain the difference between theORIGINAL BUDGET and the Actual
results achieved.

Sales Volume contribution variance = (AV – BV) x SM

(Flexed sales volume - Original Budget sales volume) x standard contribution per unit

-3,000 units (37,000 -40,000) x £16 per unit(£50 SSP - £34 VC)= 48,000 (A)

Sales price variance = (ASP – SSP) x AV

Difference between what the sales revenue should have been for the Flexed Budget
Quantity sold and actual revenue.
Actual Revenue (ASP x AV) 1,924,000
37,000 units should achieve a unit price of£50 per unit(SSP x AV) 1,850,000
74,000 (F )

26,000 (F )
Example 2

Materials
Usage Variance
Flexed Budget Quantity at Budgeted Price 37,000x6kg @ £4.00 888,000
Actual Quantity at Budgeted Price 227,000 kg @ £4.00 908,000
20,000 (A)
Price
Actual Volume at Budgeted Price 227,000kg @ £4.00 908,000
Actual Volume at Actual Price 227,000kg @ £3.90 885,300
22,700 (F) 2,700(F)
Labour
Efficiency
Flexed Budget Hours @ Budgeted Rate 37,000 hrs @ £7.00 259,000
Actual Hours @ Budgeted Rate 35,600 hrs @£7.00 249,200
9,800 (F)
Rate
Actual Hours @ Budgeted Rate 35,600 hrs @£7.00 249,200
Actual Hours @ Actual Rate 35,600 hrs @£7.30 259,880
10,680 (A) 880(A)
Example 2
Variable Overhead
Efficiency
Flexed Budget Hours @ Budgeted Rate 37,000 hrs@ £3 111,000
Actual Hours @ Budgeted Rate 35,600 hrs @£3 106,800
4,200 (F)
Rate
Actual Hours @ Budgeted Rate 35,600 hrs @£3 106,800
Actual Hours @ Actual Rate 35,600 hrs @£3.303 117,600
10,800(A) 6,600(A)
Fixed Overhead
Expenditure Variance Production
Overheads
Flexed Budgeted Cost ( = Original Budget Fixed OHD) 200,000
Actual Cost 210,000
10,000 (A)
Expenditure Variance Admin Overheads
Flexed Budgeted Cost ( = Original Budget Fixed OHD) 45,000
Actual Cost 50,000
5,000 (A) 15,000(A)

TOTAL OVERHEAD VARIANCES 19,780(A)

Example 2

SUMMARY OF VARIANCES

Favourable Adverse Total

Sales Volume 48,000 26,000 (F)

Sales Price 74,000

Direct Material Usage 20,000

Direct Material Price 22,700

Direct Labour Efficiency 9,800

Direct Labour Rate 10,680 19,780 (A)

Variable Overhead Efficiency 4,200

Variable Overhead Expenditure 10,800

Fixed Overhead Expenditure 15,000

110,700 104,480 6,220 (F)

L3 Part Two

Interpreting variances and controllability principle

Drury Chapter 16, 17 & 18

Example 2
Remember that sales variances explain the difference in
contribution / gross margin between the original budget and
the actual results (unlike overhead variances which use the
flexed budget to compare similar levels of activity)

Jade plc operates a standard marginal costing system

producing a single product. Details of the standard product
unit cost data are :-
£
Direct material 6kg at £4 per kg 24
Direct Labour 1 hour at £7 per hour 7
Variable production overhead 3
34
Example 2

Jade plc budgets to sell 40,000 units per month for £50 per unit.

Actual sales in the month for the 37,000 units were £1,924,000

Variable production overhead varies with units produced

Budgeted fixed production overhead £200,000 per month

Budgeted production 40,000 units per month

Budgeted Admin Overheads £45,000 per month

Example 2

Actual production and costs for the month were as follows :-

Units produced 37,000 and sold

Direct Material 227,000 kg at a cost of £885,300

Direct Labour 35,600 hours which cost £259,880
Variable production overhead £117,600
Fixed Production overhead £210,000
Fixed Admin overhead £50,000

Investigate reasons for variances

 Example 2 – investigate reasons
for variances
Budget Flexed Budget Actual Variance
Production Units 40,000 37,000 37,000
£ £ £
Sales 2,000,000 1,924,000
Direct Materials 960,000 888,000 885,300 2,700 (F)
Direct Labour 280,000 259,000 259,880 880 (A)
Variable Overhead 120,000 111,000 117,600 6,600 (A)
Fixed Prodn Ovrhs 200,000 200,000 210,000 10,000 (A)
Fixed Admin Ovrhs 45,000 45,000 50,000 5,000 (A)
Total Costs 1,605,000 1,503,000 1,522,780 19,780 (A)
Profit 395,000 401,220
Difference in Profit 395,000 401,220 6,220 (F)
Direct Materials = £960,000 / 40,000 x 37,000 = £888,000
Direct Materials = £888,000 - £885,300 = 2,700
Direct Materials
Direct Material Variance = SC – AC

 Standard Cost = SP * SQ

 Actual Cost = AP * AQ

 Price Variance = (SP – AP) * AQ

 Usage Variance = (SQ – AQ) * SP

Direct Materials Price Variance

Direct Materials Price Variance = (SP – AP) x AQ

= (£4 – (£885,300 / 227,000)) x 227,000
= £4 - £3.90) x 227,000
= £22,700 (F)

Suggest reasons for direct

materials price variance

Favourable price variance Paid less per kg than expected

a. Materials maybe lower quality than expected

b. Purchasing department may have negotiated a better discount
c. Direct materials prices have fallen
Actual price is used
Which of these reasons is
which is not controlled by
under control of production
the production manager.
manager?
Direct Materials Usage Variance

Direct Materials Usage Variance = (SQ – AQ) * SP

= (6kg x 37,000) - 227,000) x £4
= (222,000 - 227,000) x £4
= - £20,000 (A)

Suggest reasons for direct

materials usage variance

Adverse usage variance Used more kg than expected

a. Materials maybe lower quality than expected leading to more waste
b. Careless handling of materials and processing errors leading to waste spoilage
c. Changes in quality control requirements
Standard price is used
Which of these reasons is and all these factors
under control of production are under control of
manager? production manager
Labour Rate and Efficiency
Variances
Direct Labour Variance = SC – AC

 Standard Cost = SR * SH

 Actual Cost = AR * AH

 Rate Variance = (SR – AR) * AH

 Efficiency Variance = (SH – AH) * SR

Direct Labour Rate Variance

Direct Labour Rate Variance = (SR – AR) * AH

= (£7 – (£259,880 / 35,600)) x 35,600
= £7 - £7.30) x 35,600
= - £10,680 (A)
Suggest reasons for direct
labour rate variance

Adverse rate variance Paid more per hour worked than expected

a. Used more highly skilled labour than planned, paid higher rate per hour
b. Negotiated pay rates / bonuses higher than expected
c. Unexpected overtime to meet order deadlines
Labour rates are often not
Which of these reasons is controlled by the production
under control of production manager and are affected by
manager? general pay conditions and
economic factors.
Direct Labour Efficiency Variance

Direct Labour Efficiency Variance = (SH – AH) * SR

= (37,000 – 35,600) x £7
= £9,800 (F)
Suggest reasons for direct
labour efficiency variance

Favourable efficiency variance Labour worked less hours than expected

a. Used more highly skilled labour than planned, worked more efficiently
b. Machines well maintained with few stoppages
c. Change in quality standards
The production manager may
Which of these reasons is choose grade of labour used,
under control of production maintenance is controlled.
manager? Changes in quality standards
maybe external factor
Interdependence of variances

Direct materials price & usage variances

Favourable Price variance
Materials maybe lower quality than expected
Adverse Usage variance
Materials maybe lower quality than expected leading to more waste

Direct labour rate & efficiency variance

Adverse rate variance
Used more highly skilled labour than planned, paid higher rate per hour

Favourable efficiency variance

Used more highly skilled labour than planned, worked more efficiently

Variances cannot be looked at in isolation they are often interrelated.

Whether to investigate
variances
 Materiality
Small variations are likely to occur and investigation is unlikely to yield
helpful information. Cost of additional information should be less than
value obtained from information.
 Controllability
If factors are outside control of managers then the plan should be
reviewed rather than assign variances and responsibility to
individuals.
 Variance Trend
If always an adverse variance then may be standard is unattainable.
 Interrelationship of variances
Variances cannot be looked at in isolation, especially if two or more
managers share responsibility
Summary of reasons for
Variances

It is important to understand the possible

reasons for cost variances. Some of
these have been summarised below see
if you can choose the correct options
below :
 Variance Favourable Adverse
Material Usage More / less effective use of materials Unpredicted waste

Worse / better quality material used Defective material

More /less careful handling of material Theft

Material Price Adverse / favorable prices achieved Decrease / increase in material
costs
Labour Output produced less / more quickly Good / poor training
Efficiency than expected because of incentive
Above standard / Substandard
schemes, new machinery, etc. materials used
Time gained / lost in excess of
standard.

Labour Rate Higher / lower grade labour employed. Wage decreases / increases
Use of more / less skilled labour.

Overhead Variances should be traced to individual cost centres

Sparse / excessive use of
Expenditure Increase / reduction in costs such as
Services.
power
Activity levels higher / lower than
Overhead Production at higher / lower level than
Budgeted, assumed related to
Volume predicted.
direct labour hours .
.
Controllability Principle

Managers should be held responsible for costs over which they exercise
control

Joint variance should be reported to each manager jointly responsible

Consider, a company with the following direct materials variances:

Standard unit 6kg @ £2 per kg
Actual output was 100 units for the period
Actual materials used 640kg @£2.30 per kg

Direct Materials Price Variance = (SP – AP) x AQ

Direct Materials Price Variance
= (£2 – £2.30 x 640
= - £192 (A)
= (SQ – AQ) * SP
= (6kg x 100) - 640) x £2
= (600 - 640) x £2
= - £80 (A)
Controllability Principle

The production manager controls most factors affecting usage variance.

The purchasing manager has more control over the price paid per kg.

Each variance should be reported to the separate managers

If supply is restricted in short

If the production manager had term may mean higher price
only used 600kgs would the paid due to more needed
price per kg remained at £2?

The excess purchase price of excess materials could have been

avoided by either purchasing manager or production manager
Would need to investigate to find actual explanation!
Guideline to applying the
controllability principle

Uncontrollable factors make designing accounting control

systems very complex!
Guidelines:
 If a manager can control the quantity and price paid for a service/ product
then the manager is responsible for all components of the expense incurred.
Usage and price or rate variance

 If manager can only control the quantity but not the price/ rate paid, then can
only be held responsible for usage
Usage variance

 If manager cannot control either price or quantity then the expenditure is

uncontrollable
Points to remember

• It is necessary to flex overhead budgets before comparing them to

actuals. If you are given the unit standard data or original budget,
this is the basis to calculate the flexed budget to compare to
overheads.
• Sales variances explain the variance between the original
budgeted sales and actual sales both in terms of prices and
volume changes.
• Any variance analysis should include the summary of variances
detailing the total net movement in the results showing all
favourable and adverse variances

• Interpreting variances should bear in mind responsibility and

control of costs, interrelationships of variances and performance
standards set.
Weekly Lecture Assignment LA3

You need to do your lecture assignment LA3 to gain

your weekly mark.

Look on unihub in unit 3 – LA3