Flexible Budgets and Variance Analysis Management Cycle Standard

Flexible Budgets and Variance Analysis

Management Cycle, Standard Costing and Variance Analysis Use standard costs to prepare budgets and establish goals for product costing. Use standard costs to account for operations and managers’ performance. Calculate variances between standard and actual costs, determine their causes, identify inefficient operations, and take corrective action. Use variances to evaluate managers’ performance. Apply dollar, time, and quantity standards to work. 2

3 Standard Costs A standard cost (predetermined cost) indicates what it should cost to provide an activity or produce one batch or unit of product under planned and efficient operating conditions. Flexible budgets are based on standard costs.

4 Standard Costs • To determine the unit standard cost for a particular input, 2 decisions must be made: § The amount of input that should be used per unit of output (quantity standard) § The amount that should be placed for the quantity of the input to be used (pricing standard) Unit Standard cost = Quantity Standard x Price Standard

5 Standard Costs • How standards are developed § Historical experience § Engineering studies § Input from operating personnel • Types of standards § Ideal standards § Demand maximum efficiency and can be achieved only if everything operates perfectly § Currently attainable standards § Can be achieved under efficient operating conditions, with allowance for normal breakdowns, interruptions, etc.

6 Standard Costs • Why standard cost systems are adopted § Planning and Control – Unit standards are a fundamental requirement for a flexible budgeting system – Budgetary control systems compare actual costs with budgeted costs by comparing variances – By developing unit price standards and quantity standards, an overall variance can be decomposed into a price variance/spending variance and a usage variance/efficiency variance

7 Standard Costs • Why standard cost systems are adopted § Product Costing – Comparison of costing systems

8 Standard Costs – Advantages of standard costing üGreater capacity for control over product cost üProvide readily available unit cost information that can be used for pricing decisions üIf a process costing system uses standard costing, there is no need to compute a unit cost for each equivalent unit of DM, DL and MOH

9 Standard Costs Product cost (to illustrate use of standard cost in process costing): Input Required Cost Inputs Direct materials $2. 00/lb. 20 Direct labor $5. 00/dlh. 3 Fixed MOH $2. 00/dmh. 3 Variable MOH $3. 00/dmh. 3 Total unit cost. . . . Cost per ‘X’ $40. 00 15. 00 6. 00 9. 00 $70. 00

10 Standard Costs Example of DM standards calculation Standard price of corn = $0. 006 per ounce Standard usage of per bag = 18 ounces Standard cost per bag = $0. 108 If the budgeted number of bags is 800 bags: • Standard quantity for 800 bags = 14, 400 ounces • Standard cost for budgeted level of activity (a. k. a static budget) = 0. 006 x 14, 400 = $86. 40 If the actual number of bags produced is 1, 000 bags: • Standard quantity allowed for 1, 000 bags = 18, 000 ounces • Standard cost for actual level of activity (a. k. a flexible budget) = 0. 006 x 18, 000 = $108

11 Manufacturing Budget Mc. Millan Company Manufacturing Budget for the Month of July Manufacturing costs: Unit level: Direct materials (10, 000 x 2 pounds X $5) Assembly (10, 000 x 0. 25 hours x $24) Waterproofing and Inspection (10, 000 x $8) Batch level: Setup (10 batches x $400) Test run (10 batches x $100) Product level Facility level Total $100, 000 60, 000 80, 000 4, 000 1, 000 20, 000 32, 000 $297, 000

12 Static Budget Mc. Millan Company Production Department Performance Report for the Month of July Actual Original Budget Static Budget Variance Volume 11, 000 10, 000 Unit level: Direct materials $108, 000 $100, 000 $ 8, 000 U Assembly 70, 000 60, 000 10, 000 U Waterproofing and Inspection 81, 000 80, 000 1, 000 U Batch costs: Setup 4, 000 Test runs 1, 000 Continued on next slide

13 Static Budget Mc. Millan Company Production Department Performance Report for the Month of July Volume Batch costs: Total Fixed overhead: Product Facility Totals Actual Original Budget 11, 000 10, 000 5, 600 5, 000 Static Budget Variance 600 U 22, 000 20, 000 2, 000 U 31, 000 32, 000 1, 000 F $317, 600 $297, 000 $20, 600 U

14 Flexible Budget Mc. Millan Company Production Department Performance Report for the Month of July Actual Flexible Budget Volume 11, 000 Unit level: Direct materials $108, 000 $110, 000 Assembly 70, 000 66, 000 Waterproofing and Inspection 81, 000 88, 000 Batch costs: Setup 4, 400 Test runs 1, 100 Continued on next slide Flexible Budget Variance $ 2, 000 F 4, 000 U 7, 000 F

15 Flexible Budget Mc. Millan Company Production Department Performance Report for the Month of July Volume Batch costs: Total Fixed overhead*: Product Facility Totals Actual Flexible Budget 11, 000 5, 600 Flexible Budget Variance 5, 500 100 U 22, 000 20, 000 31, 000 32, 000 $317, 600 $321, 500 2, 000 U 1, 000 F $3, 900 F * For fixed overheads, there is no difference between static budget and flexible budget because fixed overheads do not vary with output.

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21 Variance Analysis • A flexible budget can be used to identify the costs that should have been incurred for the actual level of activity. • Flexible budget is tailored after the fact to actual production levels. • Flexible budget variance = Actual costs – Flexible budget cost

22 Variance Analysis • Flexible budget variance = Actual costs – Flexible budget cost • Dichotomizing flexible budget variance § Total flexible budget variance = (AP x AQ) – (SP x SQ) = (AP x AQ) – (SP x AQ) + (SP x AQ) – (SQ x SP) = (AP – SP)AQ + (AQ – SQ)SP = Price Variance + Efficiency variance

23 Variance Analysis • Variance analysis § Identifies the general causes for the total flexible budget variance by breaking it down into separate price and quantity variances for each production resource § 2 possible reasons why actual cost may differ from flexible budget cost for a given amount of output produced: – Difference between actual price and standard price – Difference between actual quantity and standard quantity

24 Variance Analysis • Unfavorable and favorable variances § Unfavorable variances occur whenever the actual prices or usage of inputs are greater than standard prices or usages (variances are + ve) AP > SP, AQ > SQ § Favorable variances occur whenever the actual prices or usage of inputs are less than standard prices or usages (variances are – ve) AP < SP, AQ < SQ § Favorable and unfavorable variances are not equivalent to good or bad variances. Must investigate underlying reasons for variances.

25 Variance Analysis • Why separate total variances into price and quantity variances? § Separate variances that are subjected to a manager’s direct influence from those that are not • Excessive focus on variances can lead to dysfunctional behavior • Decision to investigate § Rarely will actual performance exactly meet established standards

26 Variance Analysis § Management should develop an acceptable range of performance. – When variances are within this range, they are assumed to be caused by random factors. – When variances are outside this range, they are assumed to be caused by nonrandom factors and these variances should be investigated. üControllable: Corrective actions/Affirmative actions üUncontrollable: Revise standards § Management should also consider costs and benefits of investigating variances.

27 Variance Analysis: DM Actual Quantity of Input at Actual Price AQ x AP Actual Quantity of Input at Standard Price AQ x SP Price Variance AQ x (AP - SP) Standard Quantity of Input at Standard Price SQ x SP Usage Variance SP x (AQ - SQ) Budget Variance (AQ x AP) - (SQ x SP)

28 Variance Analysis: DM • Possible causes for DM Price Variance § Inaccurate or outdated price standards § Quality of DM § Quantity discounts § Market price fluctuations • Possible causes for DM Usage Variance § Inaccurate or outdated usage standards § Quality of DM § Level of scrap, waste or rework

29 Variance Analysis: DL Actual Hours of Input at Actual Rate AH x AR Actual Hours of Input at Standard Rate AH x SR Labor Rate Variance AH x (AR - SR) Standard Hours of Input at Standard Rate SH x SR Labor Efficiency Variance SR x (AH - SH) Budget Variance (AH x AR) - (SH x SR)

30 Variance Analysis: DL • Possible causes for DL Rate Variance § Inaccurate or outdated labor rate standards § Increase or decrease in the pay of workers § Use of highly or lowly skilled workers in the production • Possible causes for DL Efficiency Variance § Inaccurate or outdated quantity standards § Training of employees § Quality of machinery § Quality of materials § Level of supervision

31 Variance Analysis: VMOH Actual Hours of Input x Actual Variable OH Rate AH x AVOH rate Actual Hours of Input x Std Variable OH Rate AH x SVOH rate Spending Variance AH x (AVOR – SVOR) Std Hours of Input x Std Variable OH Rate SH x SVOH rate Efficiency Variance SVOR x (AH - SH) Total Variance (AVOR x AH) – (SVOR x SH)

32 Variance Analysis: VMOH • Possible causes for VMOH Spending Variance § Inaccurate or outdated VMOH rate standards § Changes in the price of the variable overhead items Efficiency in the use (in terms of quantity) of the variable overhead items • Possible causes for VMOH Efficiency Variance § Inaccurate or outdated quantity standards for allocation base § Efficiency in the use of the cost allocation base – If the cost allocation base is direct labor hours, the reasons for direct labor efficiency variance will be the reason for VMOH efficiency variance

33 Variance Analysis: FMOH Impt: Note that budgeted hours is used instead of actual hours because FMOH does not vary with the number of units Actual Fixed OH AH x AFOR rate Budgeted Fixed OH BH x SFOR Spending Variance Applied Fixed OH SH x SFOR for actual work done Volume Variance Total Variance [Note: Variance formulas for DM, DL and VMOH are not applicable for computing spending variance and volume variance of FMOH]

34 Variance Analysis: FMOH • Spending variance = Actual FMOH cost – Static FMOH budget [Note: Spending variance = Flexible budget variance = Static budget variance] • Volume variance = Static FMOH budget – “Flexible” FMOH budget • “Flexible” FMOH budget = Static FMOH budget + Static FMOH budget x % change in number of units sold • In fact, the volume variance is just (negative of) Static FMOH budget x % change in number of units sold

35 Variance Analysis: FMOH • Possible causes for FMOH Spending Variance § Inaccurate or outdated budgets for FMOH § Changes in the price and quantity of the FMOH items § Note: Many FMOH items are not subject to change in the short run, consequently fixed overhead costs are often beyond the immediate control of management • Cause for FMOH Volume Variance § Changes in the level of output

36 Variance Analysis: TR Actual Price x Actual Volume AP x AQ Budgeted Price x Actual Volume BP x AQ Sales Price Variance AQ x (AP - BP) Budgeted Price x Budgeted Volume BP x BQ Sales Volume Variance BP x (AQ - BQ) Revenue Variance (AP x AQ) - (BP x BQ)

37 Variance Analysis: TR Flexible budget variance = Actual revenue – Flexible budget revenue Example FAS budget 2001 ticket sales at $70, 000 per home game, which represent the sale of an estimated 10, 000 tickets at a selling price of $7. In July’s first game, actual gate ticket revenue was $66, 000, creating a total unfavorable revenue variance of $4, 000. The actual sales consisted of 12, 000 tickets at $5. 50.

38 Variance Analysis: TR Actual Price x Actual Volume 12, 000 x 5. 50 Budgeted Price x Actual Volume 7 x 12, 000 Sales Price Variance 12, 000 x (5. 50 - 7) 18, 000 U Budgeted Price x Budgeted Volume 7 x 10, 000 Sales Volume Variance 7 x (12, 000 – 10, 000) 14, 000 F Revenue Variance (66, 000) - (70, 000) 4, 000 U

39 Variance Analysis: TR • Possible causes for TR Price Variance § Inaccurate or outdated price standards § Changes in the market price of the product • Possible causes for TR Volume Variance § Inaccurate or outdated quantity standards § Changes in the level of demand for the product • Note: For TR variance only, variance favorable if AP > SP, AQ > SQ (In contrast with cost variances)

40 Summary of Variance Analysis • Variance analysis in general § Deviation of an actual amount from the expected (standard) or budgeted amount. § “Unfavorable” or “Favorable” means nothing § Provide clues to the causes of performance i. e. attention directors, not problem solvers § Requires a drill down into the organization to have a better understanding of the variances

41 Summary of Variance Analysis • Benefits of variance analysis § Useful for control purposes. For example, when the figures in the master budgets are not achieved, investigations and appropriate actions can be undertaken. § Communicates information to management. – Highlights possible organizational difficulties – management cannot fix what they do not know about. – Affects the actions of organization management.

42 Summary of Variance Analysis • Trade-Offs Among Variances § As the operations of organizations are linked, the level of performance in one area of operations will affect performance in another. § Improvements in one area could lead to improvements in others and vice versa. § Substandard performance in one area may be balanced by superior performance in others.