FIXED AND FLEXIBLE BUDGETS & VARIANCE

ANALYSIS

DR. WEKESA
What is a budget?

• A budget is a quantified plan of action for a forthcoming

accounting period.
• A budget is a plan of what the organisation is aiming to
achieve and what it has set as a target whereas a forecast is
an estimate of what is likely to occur in the future.
• The budget is 'a quantitative statement for a defined period
of time, which may include planned revenues, expenses,
assets, liabilities and cash flows.
• A budget facilitates planning'.
Objectives of a budgeting

• To ensure the achievement of the organisation's

objectives
• To compel planning
• To communicate ideas and plans
• To co-ordinate activities
• To provide a framework for responsibility accounting
• To establish a system of control
• To motivate employees to improve their performance
Types of budget in accounting

 Financial budget
 Cash Budget.
 Operating budget
 Labor budget.
 Sales Budget:
 Master budget.
 Operating budget.
Responsibility centres

• Responsibility accounting is a system of accounting

that segregates revenue and costs into areas of
personal responsibility in order to monitor and assess
the performance of each part of an organisation.
• A responsibility centre is a function or department
of an organisation that is headed by a manager who
has direct responsibility for its performance.
• The centres can be divided into three types.
– Cost centres
– Profit centres
– Investment centres
Cost centres

• A cost centre acts as a collecting place for certain costs before they
are analysed further.
• May include:
– A department
– A machine or group of machines
– A project
– A new product
• Information about cost centres might be collected in terms of:
– total actual costs,
– total budgeted costs and
– total cost variances
Profit centres

• A profit centre is any unit of an organisation (for

example, division of a company) to which both
revenues and costs are assigned, so that the
profitability of the unit may be measured.
• They differ from cost centres in that they account
for both costs and revenues and the key
performance measure of a profit centre is
therefore profit
Investment centres

• An investment centre is a profit centre whose

performance is measured by its return on capital
employed.
• The investment centre manager has some say in
investment policy in their area of operations as
well as being responsible for costs and revenues.
Controllable costs

• A controllable cost is 'a cost that can be controlled,

typically by a cost, profit or investment centre
manager'.
• Variable costs within a department are thought to be
controllable in the short term because managers can
influence the efficiency with which resources are used.
• Some costs are non-controllable, such as increases in
expenditure items due to inflation.
• Committed fixed costs (costs that support the long-term
needs of the business) for example depreciation, rent,
administration, salaries are largely non-controllable in
the short term.
• Discretionary fixed costs, such as advertising, sales
promotion, research and development, training costs and
consultancy fees, are costs which are incurred as a result
of a top management decision, but which could be raised
or lowered at fairly short notice.
Controllability and apportioned costs

• Managers should only be held accountable for

costs over which they have some influence.
• Apportioned overhead costs (for example, share
of maintenance department): the manager should
not be held accountable for such costs.
Fixed & Flexible budgets

Managers use budgets to control operations and see that

planned objectives are met.
 A master budget based on a predicted level of activity for
the budget period.
 Two alternative approaches: fixed or flexible budgeting.
 A fixed budget, or static budget, based on a single
predicted amount of sales or other activity measure.
 A flexible budget, or variable budget, based on several
different amounts of sales.
• The master budget prepared before the beginning of the budget
period is known as the fixed budget.
• The term 'fixed' has the following meaning:
– The budget is prepared on the basis of an estimated volume of
production and an estimated volume of sales, but no plans are made
for the event that actual volumes of production and sales may differ
from budgeted volumes.
– When actual volumes of production and sales during a control period
(month or four weeks or quarter) are achieved, a fixed budget is not
adjusted (in retrospect) to the new levels of activity
Fixed Budget Performance Report
A fixed budget is based on a single predicted amount of
sales
Purpose of Flexible Budgets
• Flexible Budgets
– Show revenues and expenses that should
have occurred at the actual level of activity.
– May be prepared for several activity levels in
the relevant range.
– Reveal variances due to good cost control or
lack of cost control.
– Improve performance evaluation and helps
managers focus on problem areas.
Preparation of Flexible Budgets

• To flex a budget for different activity levels, we

must know how costs behave with changes in
activity levels.
– Total variable costs change in direct
proportion to changes in activity.
– Total fixed costs remain unchanged within the
relevant range.
• Variable costs are a constant amount per unit.
• Total variable cost = $4.80 per unit × budget level
in units
• Total Fixed costs do not change within the relevant
range.
• A flexible budget performance report
compares actual performance and budgeted
performance based on actual sales. In SolCel’s
case, January’s sales are 12,000 units.
Prepare a flexible budget and interpret
a flexible budget performance report
• Favorable sales variance indicates that the
average selling price was greater than $10.00
per unit.
• Favorable variance because favorable sales
variance is greater than unfavorable cost
variances.
A manufacturing company reports the fixed
budget and actual results for the year as shown
below. The company’s fixed budget assumes a
selling price of $40 per unit. The fixed budget is
based on 20,000 units of sales, and the actual
results are based on 24,000 units of sales.
Prepare a flexible budget performance report for
the year. Label variances as favorable (F) or
unfavorable (U).
 Budget assumptions:
Selling price per unit $40.00 ($800,000 divided by 20,000 units)
Variable cost per unit $8.00 ($160,000 divided by 20,000 units)

Budget Assumptions Flexible Budget (24,000 units)

Sales $40.00 × 24,000 units = $960,000
Variable costs $8.00 × 24,000 units = 192,000
Fixed costs 500,000
FLEXIBLE BUDGET PERFORMANCE REPORT
Standard Costs

Standard costs can be used in a flexible budgeting

system to enable management to better
understand the reasons for variances
• Standard costs are
– Based on carefully predetermined amounts.
– Used for planning materials, labor, and overhead
requirements.
– The expected level of performance.
– Benchmarks for measuring performance.
Setting Standard Costs

• Direct Materials
– Price Standards
– Quantity Standards
• Direct Labor
– Rate Standards
– Time Standards
• Variable Overhead
– Rate Standards
– Activity Standards
Setting Standard Costs
 standard cost card.
 These standard cost amounts are then used to prepare manufacturing budgets for
a budgeted level of production.
cost variances and what they reveal
about performance.
• Cost variance difference between actual and
standard cost.
• if actual cost > standard cost Variance is
unfavorable (U).
• If actual cost < standard cost Variance is
favorable (F).
Cost Variance Analysis

• Prepare Reports  Analyze Variances  Questions and

Answers  Take Action
• The process is repeated again.
• Variance analysis involves preparing a standard cost
performance report and comparing actual costs with
standard costs.
• We then investigate variances by asking for explanations
and possible causes for the variances.
• We should correct problems that caused unfavorable
variances and possibly adopt and reward the practices
that resulted in favorable variances.
Cost Variance Computation

Management needs information about the factors

causing a cost variance, but first it must properly
compute the variance. In its most simple form, a cost
variance (CV) is computed as:
• Cost Variance (CV) = Actual Cost (AC) - Standard
Cost (SC)
• Actual Cost (AC) = Actual Quantity (AQ) × Actual
Price (AP)
• Standard Cost (SC) = Standard Quantity (SQ) ×
Standard Price (SP
Cost Variance Computation

• Actual quantity (AQ) is the actual amount of

material or labor used to manufacture the actual
quantity of output.
• Standard quantity (SQ) is the standard amount of
input for the actual quantity of output.
• Actual price (AP) is the actual amount paid to
acquire the actual direct material or direct labor
used during the period.
• Standard price (SP) is the standard price.
General Model of Price and Quantity
Variances
Two main factors cause a cost variance:
• Cost Variance
– Price Variance (AQ × AP) – (AQ × SP)
 Difference between the actual price and
standard price
– Quantity Variance (AQ × SP) – (SQ × SP)
 Difference between actual quantity and
standard quantity
Isolating these price and quantity factors in a
cost variance lead to these formulas.
Cost Variance Computation
• Standard quantity: Standard quantity is the quantity
that should have been used for the actual good
output.
• Price Variance
– Actual Quantity × Actual Price
– Actual Quantity × Standard Price
• Quantity Variance
– Actual Quantity × Standard Price
– Standard Quantity × Standard Price

• Standard Price: Standard price is the amount that

should have been paid for the resources acquired.
Cost Variance Computation

 Actual
   Cost
   Standard
    Cost
  
Actual Quantity Actual Quantity Actual Quantity Standard Quantity
   
Actual Price Standard Price Standard Price Standard Price
                                  
Price Variance Quantity Variance

(AP - SP) × AQ (AQ - SQ) × SP

AQ = Actual Quantity SP = Standard Price
AP = Actual Price SQ = Standard Quantity
Compute materials and labor variances

G-Max Company makes golf club heads with the

following standard cost information:
 Materials Cost Variances

Direct materials (0.5 lb. per unit at $20 per lb.) $10.00

Direct labor (1 hr. per unit at $16 per hr.) 16.00

Total standard direct cost per unit $ 26.00

 Compute materials and labor variances

 Actual
   Cost
    Standard
     Cost
 
Actual Quantity Actual Quantity Actual Quantity Standard Quantity
   
Actual Price Standard Price Standard Price Standard Price
1,800 lbs. 1,800 lbs. 1,800 lbs. 1,750 lbs.
   
$21.00 per lb. $20.00 per lb. $20.00 per lb. $20.00 per lb.

  $37,800
       $36,000
      $36,000
       $35,000
    
Price Variance Quantity Variance
$1,800 Unfavorable $1,000 Unfavorable
                            

$2,800 Total Direct Materials Variance (U)

SQ = 3,500 units × 0.5 per unit = 1,750 lbs.

Evaluating Materials Variances
Who is responsible for material cost variances??
• I am not responsible for this unfavorable material
quantity variance.
• You purchased cheap material, so my people
had to use more of it.
• You used too much material because of poorly
trained workers and poorly maintained equipment.
• Also, your poor scheduling requires me to rush
order material at a higher price, causing
unfavorable price variances.
Compute materials and labor variances.

A manufacturing company reports the following for

one of its products. Compute the direct materials (a)
price variance and (b) quantity variance and indicate
whether they are favorable or unfavorable.
• Direct materials standard - 8 pounds @ $6.00 per
pound
• Actual direct materials used - 83,000 pounds @
$5.80 per pound
• Actual finished units produced - 10,000
Compute materials and labor variances.
 Actual Cost Standard Cost
AQ  SP AQ  SP
AQ  AP SQ  SP
83,000  $6.00 83,000  $6.00
83,000  $5.80 10,000  8  $6.00
$498,000 $498,000
$481,400 $480,000
                            
$16,600 Favorable $18,000 Unfavorabl e
Materials Price Variance Materials Quantity Variance
                            
$1,400 Unfavorabl e
Total Direct Materials Variance
Compute materials and labor variances.

Instead of price and quantity, for direct labor we use

the terms rate and hours.

Actual
   Cost
 Standard
     Cost
 
Actual Hours Actual Hours Actual Hours Standard Hours
   
Actual Rate Standard Rate Standard Rate Standard Rate
                              
*
NEW *Efficiency Variance
  *Rate Variance

AH(AR - SR) SR(AH – SH)

AH = Actual Hours SR = Standard Rate
AR = Actual Rate SH = Standard Hours
 Labor Cost Variances

Direct materials (0.5 lb. per unit at $20 lb.) $10.00

Direct labor 1 hr. per unit at $16 per hr.) 16.00
Total standard direct cost per unit $26.00

Use this information to compute the labor rate and

efficiency variances before you go to the next slide.
 Labor Cost Variances

 Actual
   Cost
  Standard
    Cost

Actual Hours Actual Hours Actual Hours Standard Hours
   
Actual Rate Standard Rate Standard Rate Standard Rate
3,400 hours 3,400 hours 3,400 hours 3,500 hours
   
$16.50 per hr. $16.00 per hr. $16.00 per hr. $16.00 per hr.

 $56,100
      $54,400
     $54,400
      $56,000
   
Rate Variance Efficiency Variance
$1,700 Unfavorable
                $1,600
   Favorable
     

$100 Total Cost Variance (U)

SQ = 3,500 units × 1.0 hour per unit = 3,500 hours.

 Evaluating Labor Variances

• Evaluating Labor Cost Variances

– One possible explanation of G-Max’s labor rate
and efficiency variances is the use of workers with
different skill levels.
• High skill, high rate  Low skill, low rate
– Using highly paid skilled workers to perform
unskilled tasks results in an unfavorable rate
variance.
– However, fewer labor hours might be required for
the work resulting in a favorable efficiency
variance.
Labor Cost Variances

Who is responsible for material cost variances??

Production managers who make work assignments are
generally responsible for labor cost variances.
• I am not responsible for the unfavorable labor
efficiency variance.
• You purchased cheap material, so it took more time
to process it.
• You used too much time because of poorly trained
workers and poor supervision