Lecture 8

Budgetary Control and

Variance Analysis

Control use of budgets

For effective control, one needs wellestablished benchmarks. Budgets
provide the benchmarks.
Two types of benchmarks
Absolute benchmark
Relative benchmark

The difference between the actual

result and a budgeted amount (i.e.
benchmark) is called a variance.

Types of variances
When actual performance exceeds expectations
(i.e. benchmark), we have favorable variance
(denoted as F in parentheses).
When performance is below the expectations
(i.e. benchmark), we have unfavorable variance
(denoted as U in parentheses).
In the case of cost items, actual cost is
subtracted from the benchmark cost. In the
case of revenue items or profits, benchmark
revenue or profit is subtracted from actual
revenue or profit.

Flexible budget
A static budget is prepared for only one
particular level of sales volume.
Variances obtained by comparing actual
results to benchmarks are called Static
budget variances.
Static budget variances have limited use. Not
useful in assessing efficiency of operations.
A Flexible budget is a budget that adjusts for
changes in sales volume and other cost-driver
activities.

Structure of Variances

LO2: Perform variance analysis.

Budgeted and Actual

Results
Profit Variance

Profit or Loss ($)

Profit Line (per

CVP model)

PA
PB
0

Budgeted Profit

Actual Profit

Volume of Activity
Budgeted Actual
volume volume

(Fixed Cost)

Sales Volume Variance

Profit ($)

Profit ($)
Sales
Volume
Variance
+
Flexible
Budget
Variance
=
Total
Profit
Variance

Flexible
Budget
Profit

Master
Budget
Profit

Actual
Profit

Profit Line (per

CVP relation)

PC

PA
PB
A

B
Volume of
Activity

Budgeted
volume

(Fixed Costs)

Volume of Activity

Actual
volume

Sales Volume Variance ConceptTotal Profit Variance

Sales Volume
Variance

Master budget
profit

Flexible Budget
Variance

Profit in flexible
budget

Sales volume variance

Actual
profit

Flexible budget variance

Total profit variance

Two different types of

variances
Sales Volume variance
Difference in profit between the static and flexible
budgets is called sales volume variance of profits

Flexible budget variance

Difference in profit between actual results and the
flexible budget is called flexible budget variance
of profits

The sum of these two variances should give

the total profit variance (i.e. the difference
between static budget profit and the actual
profit).

Components of flexible budget

variance
Sales price variance
This is the difference between actual
revenues and flexible budget revenues.

Fixed cost variance

Also called as spending variance. This
is the difference between budgeted
fixed costs and the actual fixed costs.

Variable cost variances

Cost Variances - Concept

Variable Cost
Variance

Quantity
Variances

Cost item in
flexible budget
Quantity variance

Price
Variances

as if
cost item

Cost item in
actual results

Price variance

Flexible budget variance for given cost

Variable cost variances

Input quantity and price variances
With respect to materials
With respect to labor
With respect to variable overhead

Quantity variances are also called

efficiency or usage variances
Direct labor price variance is also
called direct labor rate variance.

Interpreting and using

variances
Budget reconciliation report is the starting
point.
This report reconciles the actual profit with the
planned profit in master budget.

Variances can arise in the normal course of

operations or due to change in operating
conditions or due to excessively tight/loose
standards.
Investigate all variances. Examine trends
in variances. Dont take a narrow view.
Focus on the big picture.

Nonfinancial controls
Variance analysis is subject to the
limitations of
Timeliness
Not being specific

Nonfinancial performance measures are

often more timely and can provide more
specific feedback to managers.
Nonfinancial performance measures are
used for both performance evaluation and
aligning goals.
Nonfinancial measures are especially
useful at evaluating lower level managers.

More on variances
Purchase price variance is different from price
variance for materials used.
The actual quantity of materials used in operations is
often different from the purchase quantity.

Sales volume variance can be decomposed into

market size variance and market share variance.
Is it due to a change in the market as a whole or change
in firms share of the market?

Sales volume variance can also be decomposed

into sales mix variance and sales quantity
variance.
Is the variance due to change in sales mix or is it due to
change in sales quantity?