Chapter 7

Flexible Budgets, Direct-Cost Variances, and Management Control

2009 Pearson Prentice Hall. All rights reserved.

Key Terms
Flexible Budget
Static Budget Standard Costs

Favorable Variance Unfavorable Variance Management by Exception Efficiency Variance

2009 Pearson Prentice Hall. All rights reserved.

Basic Concepts
Variance is the difference between an actual and an

expected (budgeted) amount. Management by Exception the practice of focusing management attention on areas not operating as expected and devoting less time to areas operating as expected
Static (Master) Budget is based on the output

planned at the start of the budget period. The master budget is called a static budget because the budget for the period is developed around a single (static) planned output level
2009 Pearson Prentice Hall. All rights reserved.

Basic Concepts
Static-Budget Variance the difference between the

actual result and the corresponding static budget amount Favorable Variance (F) has the effect of increasing operating income relative to the budget amount Unfavorable Variance (U) has the effect of decreasing operating income relative to the budget amount

2009 Pearson Prentice Hall. All rights reserved.

Example
Webb company, a firm that manufactures and sells jacket. For simplicity,

we assume that webbs only costs are in the manufacturing function, webb incurs no costs in other value chain, such as marketing and distribution. No inventories exist at either the beginning or the end in April 2011. Cost Category Variable Cost per Jacket
Direct material costs
Direct labor costs Variable overhead costs Total variable costs

$60
16 12 $88 $276,000 $120 per jacket 12,000 jackets 10,000 jackets

Budgeted fixed costs for production between 0 and 12,000 jackets Budgeted selling price Budgeted production and sales Actual production andsales 2009 Pearson Prentice Hall. All rights reserved.

Level 1 Analysis, Illustrated

2009 Pearson Prentice Hall. All rights reserved.

Flexible Budgets
Managers, therefore, create a flexible budget, which

enables a more in-depth understanding of deviation from the static budget. Flexible budget calculates budgeted revenues and budgeted costs based on the actual output in the budget period. (the flexible budget is prepared at the end of the period April 2011)

2009 Pearson Prentice Hall. All rights reserved.

Level 2 Analysis, Illustrated

2009 Pearson Prentice Hall. All rights reserved.

Sales-Volume Variances
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 of jackets sold and 12,000 quantity of jackets expected to be sold in the static budget. Flexible-budget operating income =
(Budgeted selling price-Budgeted variable cost)*Actual units sold-Fixed costs

Static-budget operating income =

(Budgeted selling price-Budgeted variable cost)*Static-budget units sold-Fixed costs So,

Sales-volume variance for operating income=

(Budgeted selling price-Budgeted variable cost)*(Actual units sold- Static-budget units sold)
2009 Pearson Prentice Hall. All rights reserved.

Sales-Volume Variances
One or more of the Following reasons:

The overall demand for jackets is not growing at the

rate that was anticipated Competitors are taking away market share from Webb Webb did not adapt quickly to changes in customer preferences and tastes Budgeted sales targets were set without careful analysis of market conditions Quality problems developed that led to customer dissatisfaction with Webbs jackets
2009 Pearson Prentice Hall. All rights reserved.

Flexible-Budget Variances
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 jackets of output. Flexible-budget variance = Actual result Flexible-budget amount The flexible-budget variance for revenues is called the sellingprice variance: Selling-price variance= (Actual selling price-budgeted selling price)*Actual units sold
2009 Pearson Prentice Hall. All rights reserved.

Flexible-Budget Variances
One or more of the following:
Webb used greater quantities of input (such as direct

manufacturing labor-hour) compared to the budgeted quantities of inputs An overall increase in market prices Webb incurred higher prices per unit for the input (such as the wage rat per direct manufacturing laborhour) compared to the budgeted prices per units of the inputs Webb sold better quality of jackets
2009 Pearson Prentice Hall. All rights reserved.

Price Variances and Efficiency Variances for Direct-Cost Inputs

A price-variance that reflects the difference between an

actual input price and a budgeted input price An efficiency variance that reflects the difference between an actual input quantity and a budgeted input quantity. Managers generally have more control over efficiency variances than price variances.( that because the quantity of inputs
is primarily affected by factors inside the company, but price changes are primarily due to market forces outside the company)

2009 Pearson Prentice Hall. All rights reserved.

Example
Direct materials purchased and used 1.Square yards of cloth input purchased and used 2.Actual price incurred per square yard 3.Direct material costs(22,200*28) 22,200 $28 $621,600

Direct manufacturing labor 1.Direct manufacturing labor-hours 2.Actual price incurred per direct manufacturing laborhour 3.Direct manufacturing labor costs(9,000*22)
2009 Pearson Prentice Hall. All rights reserved.

9,000 $22 $198,000

Example
Direct materials standard cost 1.Square yards of cloth input per jacket 2.Budgeted price incurred per square yard 3.Actual output 2sq.yds $30 10,000

Direct manufacturing labor standard cost 1.Direct manufacturing labor-hours per jacket 2.Budget price incurred per direct manufacturing laborhour 3.Actual output
2009 Pearson Prentice Hall. All rights reserved.

0.8hr/unit $20/hr 10,000

Level 3 Analysis, Illustrated

2009 Pearson Prentice Hall. All rights reserved.

Level 3 Variances
Price Variance formula:
Price Variance

Actual Price Of Input

Budgeted Price Of Input

} X

Actual Quantity Of Input

Efficiency Variance formula:

Efficiency Variance

Actual Quantity Of Input Used

Budgeted Quantity of Input Allowed for Actual Output

}X

Budgeted Price Of Input

2009 Pearson Prentice Hall. All rights reserved.

Price Variances and Efficiency Variances

One or more following: Webbs purchasing manager changed to a lower-price

supplier Webbs purchasing manager negotiated the direct materials price more skillfully than was planned for in the budget Direct material prices decreased unexpectedly because of, say, industry oversupply. Webbs personnel manager hired underskilled workers Budgeted time standards were set too tight without careful analysis of the operating conditions and the employees skills. 2009 Pearson Prentice Hall. All rights reserved.

Variance Summary

2009 Pearson Prentice Hall. All rights reserved.

Exercise
Flexible-budget preparation and analysis Bank Management Printers, Inc., produces luxury checkbooks with three checks and stubs per page. Each checkbook is designed for an individual customer and is ordered through the customers bank.

2009 Pearson Prentice Hall. All rights reserved.

The companys operating budget for September 2009 included these data:

Number of checkbooks 15,000 Selling price per book $ 20 Variable cost per book $8 Fixed costs for the month $145,000 The actual results for September 2009 were: Number of checkbooks 12,000 Selling price per book $ 21 Variable cost per book $7 Fixed costs for the month $150,000 1. Prepare a static-budget-based variance analysis of the September performance 2.Prepare a flexible-budget-based variance analysis of the September performance 3. Why might Bank Management find the flexible-budget-based variance analysis more informative than the static-budget-based variance analysis? 2009 Pearson Prentice Hall. All rights reserved.

1. Prepare a static-budget-based variance analysis of the September performance

Variance Analysis for Bank Management Printers for September 2009

2009 Pearson Prentice Hall. All rights reserved.

2. Prepare a flexible-budget-based variance analysis of the September performance

Reminder: the sales volume variance is the difference between actual and budged output times budgeted contribution margin or (3,000 x 12)

2009 Pearson Prentice Hall. All rights reserved.

3. Why might Bank Management find the flexible-budget-based variance analysis more informative than the static-budget-based variance analysis?
Level 2 analysis breaks down the static-budget variance into a flexible-budget variance and a salesvolume variance. The primary reason for the static-budget variance being unfavorable ($17,000 U) is the reduction in unit volume from the budgeted 15,000 to an actual 12,000.

2009 Pearson Prentice Hall. All rights reserved.

Morro Bay Surfboards manufactures fiberglass surfboards. The standard cost of direct materials and direct manufacturing labor is $100 per board. This includes 20 pounds of direct materials, at the budgeted price of $2 per pound, and five hours of direct manufacturing labor, at the budgeted rate of $12 per hour.
Following are additional data for the month of July: Units completed 6,000 units Direct material purchases 150,000 pounds Cost of direct material purchases $292,500 Actual direct manufacturing labor-hours 32,000 Actual direct-labor cost $368,000 Direct materials efficiency variance $12,500 U There were no beginning inventories. 1.Compute direct manufacturing labor variances for July 2.Compute the actual pounds of direct materials used in production in July 3.Calculate the actual price per pound of direct materials purchased
2009 Pearson Prentice Hall. All rights reserved.

1. Compute direct manufacturing labor variances for July

2009 Pearson Prentice Hall. All rights reserved.

2. Compute the actual pounds of direct materials used in production in July

Budgeted pounds allowed for the output achieved: 6,000 20 = 120,000 pounds Actual pounds of direct materials used: 120,000 + 6,250 = 126,250 pounds Unfavorable direct materials efficiency variance of $12,500 indicates that more pounds of direct materials were actually used than the budgeted quantity allowed for actual output. $12,500 efficiency variance $2 per pound budgeted price

The 6,250 excess units can also be computed by dividing the efficiency variance by the standard price

2009 Pearson Prentice Hall. All rights reserved.

3. Calculate the actual price per pound of direct materials purchased

2009 Pearson Prentice Hall. All rights reserved.

Standard Costing
Targets or standards are established for direct material

and direct labor. The standard costs are recorded in the accounting system. Actual price and usage amounts are compared to the standard and variances are recorded.

2009 Pearson Prentice Hall. All rights reserved.

Variances & Journal Entries

Each variance may be journalized

Each variance has its own account

Favorable variances are credits; Unfavorable

variances are debits Variance accounts are generally closed into Cost of Goods Sold at the end of the period, if immaterial

2009 Pearson Prentice Hall. All rights reserved.

Management Uses of Variances

Multiple Cause of Variances
The causes of variances in one part of the value chain can be the result of decisions made in another part of the value chain. Whenever possible, manager must attempt to understand the root causes of the variances.

When to Investigate Variance

A variance within an acceptable range is considered to be an in control occurrence and calls for no investigation or action by managers. Frequently, managers investigate variances based on subject judgments or rules of thumb.

Performance Measurement Using Variances

Two attributes of performance are commonly evaluated: Effectiveness and Efficiency
2009 Pearson Prentice Hall. All rights reserved.

Management Uses of Variances

Organization Learning
the goal of variance analysis is for managers to understand why variances arise, to learn, and to improve future performance

Financial and Nonfinancial Performance Measures

Almost all companies use a combination of financial and nonfinancial performance measures for planning and control rather than relying exclusively on either type of measure. Timely nonfinancial performance measures are frequently used for control a production process

2009 Pearson Prentice Hall. All rights reserved.

Benchmarking and Variances

Benchmarking is the continuous process of comparing

the levels of performance in producing products and services against the best levels of performance in competing companies. Variances can be extended to include comparison to other entities.

2009 Pearson Prentice Hall. All rights reserved.

Benchmarking Example: Airlines

2009 Pearson Prentice Hall. All rights reserved.

Thank you!

2009 Pearson Prentice Hall. All rights reserved.