Accounting for Decision Making &

Control #2

Ngo Bich Van, MBA

September, 2012

Flexible Budgets, Variances, and Management Control

Static and Flexible Budgets

Static Budget

Based on

Planned level of output at start of the budget period

Flexible Budget

Based on

Budgeted revenues and cost based on actual level of output

Static Budget Example

Assume that Pasadena Co. 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

Static Budget Example

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. The static budget for year 2004 is based on selling 13,000 suits. What is the static-budget operating income?

Static Budget Example

Revenues (13,000 $155) Less Expenses: Variable (13,000 $115) Fixed Budgeted operating income $2,015,000 1,495,000 286,000 234,000

Assume that Pasadena Co. produced and sold 10,000 suits at $160 each with actual variable costs of $120 per suit and fixed manufacturing costs of $300,000.

Static Budget Example

What was the actual operating income?

Revenues (10,000 $160) Less Expenses: Variable (10,000 $120) Fixed Actual operating income

$1,600,000
1,200,000 300,000 $100,000

Static-Budget Variance Example

What is the static-budget variance of operating income? Actual operating income Budgeted operating income Static-budget variance of operating income $100,000 234,000 $134,000 U

This is a Level 0 variance analysis.

Static-Budget Variance Example

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

Suits Revenue Variable costs Contribution margin Fixed costs Operating income

Static Budget Actual 13 10 $2,015 $1,600 1,495 1,200 $ 520 $ 400 286 300 $ 234 $ 100

Variance 3U $415 U 296 F $120 U 14 U $134 U

Steps in Developing Flexible Budgets

Step 1:

Determine budgeted selling price, variable cost per unit, and budgeted fixed cost.

Budgeted selling price is $155, variable cost is $115 per suit, and the budgeted fixed cost is $286,000.

Steps in Developing Flexible Budgets

Step 2: Determine the actual quantity of output. In the year 2004, 10,000 suits were produced and sold.

Step 3: Determine the flexible budget for revenues. $155 10,000 = $1,550,000

Steps in Developing Flexible Budgets

Step 4:
Determine the flexible budget for costs.

Variable costs: 10,000 $115 = $1,150,000 Fixed costs 286,000 Total costs $1,436,000

Variances

Level 2 analysis provides information on the two components of the static-budget variance. 1. Flexible-budget variance 2. Sales-volume variance

Flexible-Budget Variance

Flexible-Budget Variance (Level 2) in (000) Flexible Budget 10 $1,550 1,150 $ 400 286 $ 114 Actual Variance 10 0 $1,600 $ 50 F 1,200 50 U $ 400 $ 0 300 14 U $ 100 $ 14 U

Suits Revenue Variable costs Contribution margin Fixed costs Operating income

Flexible-Budget Variance

Actual quantity sold: 10,000 suits Actual results operating income $100,000

Flexible-budget variance $14,000 U

Flexible-budget operating income $114,000

Flexible-Budget Variance
Total flexible-budget variance Total actual results Total flexible budget for actual sales level

Selling price Variable cost Contribution margin

Actual Amount $160 120 $40

Budgeted Amount $155 115 $ 40

Flexible-Budget Variance
Why is the flexible-budget variance $14,000 U?
Selling-price variance Actual variable costs exceeded flexible budget variable costs Actual fixed costs exceeded flexible budget fixed costs $50,000 F 50,000 U

14,000 U

Total flexible-budget variance

$14,000 U

Sales-Volume Variance
Sales-Volume Variance (Level 2) in (000)

Suits Revenue Variable costs Contr. margin Fixed costs Operating income

Flexible Budget 10 $1,550 1,150 $ 400 286 $ 114

Static Budget 13 $2,015 1,495 $ 520 286 $ 234

Sales-Volume Variance 3U $465 U 295 F $120 U 0 $120 U

Sales-Volume Variance

Actual quantity sold: 10,000 suits Flexible-budget operating income $114,000

Sales-volume variance $120,000 U

Static-budget operating income $234,000

Sales-Volume Variance
Actual sales unit Master budgeted sales units 13,000 10,000 = 3,000

Budgeted contribution margin per unit $40 = Total sales-volume variance $120,000 U

Budget Variances

Level 1

Static-budget variance $134,000 U

Level 2

Flexible-budget variance $14,000 U

Sales-volume variance $120,000 U

Standards

Pasadenas budgeted cost for each variable direct cost item is computed as follows:

Standard input allowed for one output unit

Standard cost per input unit

Standards
4.00 square yards allowed per output unit at $16.25 standard cost per square yard. Standard cost per output unit: 4.00 $16.25 = $65.00

2.00 manufacturing labor-hours of input allowed per output unit at $13.00 standard cost per hour.

Standard cost per output unit: 2.00 $13.00 = $26.00

Actual Data

Direct materials purchased and used: 42,500 square yards at $15.95

Cost of direct materials = $677,875 Labor hours: 21,500 at $12.90 Cost of direct manufacturing labor = $277,350

Price Variance Example

Direct-material price variance = = Actual price Budgeted price Actual quantity

($15.95 $16.25) 42,500 = $12,750 F

Direct-labor price variance = = Actual price Budgeted price Actual quantity

($12.90 $13.00) 21,500 = $2,150 F

Price Variance Example

What is the journal entry when the materials price variance is isolated at the time of purchase? Materials Control Direct-Materials Price Variance Accounts Payable Control To record direct materials purchased 690,625 12,750 677,875

Efficiency Variance Example

Direct-material efficiency variance = = Actual quantity Standard quantity Standard price

(42,500 40,000) $16.25 = $40,625 U

Direct-labor efficiency variance = = Actual quantity Standard quantity Standard price

(21,500 20,000) $13.00 = $19,500 U

Efficiency Variance

What is the journal entry to record materials used?

Work in Process Control Direct-Materials Efficiency Variance Materials Control To record direct materials used 650,000 40,625 690,625

Price and Efficiency Variance

What is the journal entry for direct manufacturing labor? Work in Process Control 260,000 Direct Manufacturing Labor Efficiency Variance 19,500 Direct-Manufacturing Labor Price Variance 2,150 Wages Payable 277,350 To record liability for direct manufacturing labor

Flexible Budget Material Variance Example

Actual Cost $677,875 $12,750 F

AQ BP 42,500 $16.25 $690,625

BQ BP 40,000 $16.25 $650,000 $40,625 U

$27,875 U

Flexible Budget Labor Variance Example

Actual Cost $277,350 $2,150 F

AQ BP 21,500 $13.00 $279,500

BQ BP 20,000 $13.00 $260,000 $ 19,500 U

$17,350 U

Variance Analysis
Level 1 Static-budget variance Materials $167,125 F Labor 60,650 F Total $227,775 F Level 2 Flexible-budget variance Materials $27,875 U Labor 17,350 U Total $45,225 U Level 2 Sales-volume variance Materials $195,000 F Labor 78,000 F Total $273,000 F

Variance Analysis
Level 2 Flexible-budget variance Materials $27,875 U Labor 17,350 U Total $45,225 U Level 3 Price variance Materials $12,750 F Labor 2,150 F Total $14,900 F Level 3 Efficiency variance Materials $40,625 U Labor 19,500 U Total $60,125 U

Performance Measurement Using Variances

Effectiveness is the degree to which a predetermined objective or target is met. Efficiency is the relative amount of inputs used to achieve a given level of output.

Variances should not solely be used to evaluate performance.

When to Investigate Variances

When should variances be investigated? Subjective judgments

Rules of thumb as investigate all variances exceeding $10,000 or 25% of expected cost, whichever is lower.

Continuous Improvement

Assume that the budgeted direct materials cost for each suit that Pasadena Co. manufactures is $65.
Pasadena Co. wants to implement continuous improvement budgets based on a target 1% materials cost reduction each period. What should the budgeted cost be for the next 3 subsequent periods?

Continuous Improvement
Prior Period Budgeted Amount This Period: Period 1: $65.00 Period 2: $64.35 Period 3: $63.71 Reduction in Budget $0.650 $0.644 $0.637 Revised Budgeted Amount $65.00 $64.35 $63.71 $63.07

Flexible Budgeting & Activity-Based Costing

Materials costs and direct manufacturing labor costs are examples of output-unit level costs. Batch-level costs are resources sacrificed on activities that are related to a group of units of product(s) or service(s) rather than to each individual unit of product or service.

Flexible Budgeting & Activity-Based Costing

Denver Co. produces metal planters (MP).

Assume that material-handling labor costs vary with the number of batches produced rather than the number of units in a batch. Material-handling labor costs are direct batch level costs that vary with the number of batches.

Flexible Budgeting & Activity-Based Costing

Units produced and sold Batch size Number of batches Material-handling labor-hours per batch

Static Budget 18,000 180 100

5.00

Actual Amounts 15,660 174 90

5.20

Flexible Budgeting & Activity-Based Costing

Static Budget 500 $14.00 $7,000 Actual Amounts 468 $14.50 $6,786

Total labor-hours Cost per material-handling labor-hour Total material-handling labor cost

Flexible Budgeting & Activity-Based Costing

How many batches should have been employed to produce the actual output units? 15,660 units 180 units per batch = 87 batches How many material-handling hours should have been used? 87 batches 5 hours/batch = 435 hours

Flexible Budgeting & Activity-Based Costing

What is the flexible budget for material-handling labor-hours?

435 hours $14.00/labor-hour = $6,090

Flexible-budget costs Actual costs Flexible-budget variance

$6,090 6,786 $696 U

Price and Efficiency Variances

Price variance = ($14.50 $14.00) 468

= $234 U

Efficiency variance = (468 435) $14.00 = $462 U

Total variance

= $696 U

Benchmarking

It refers to the continuous process of measuring products, services, and activities against the best levels of performance.