Flexible Budgets DirectCost Variances and Management Control Copyright

CHAPTER 7 LEARNING OBJECTIVES 1. 2. 3. 4. Understand static budgets and staticbudget variances Examine the concept of a flexible budget and learn how to develop it Calculate flexible-budget variances and sales-volume variances Explain why standard costs are often used in variance analysis Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall 7 -2

CHAPTER 7 LEARNING OBJECTIVES, CONCLUDED 5. 6. 7. Compute price variances and efficiency variances for direct-cost categories. Understand how managers use variances Describe benchmarking and explain its role in cost management Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall 7 -3

BASIC CONCEPTS Variance—difference between actual results and expected (budgeted) performance. Management by exception—the practice of focusing attention on areas not operating as expected (budgeted). Static (master) budget is based on the output planned at the start of the budget period. Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall 7 -4

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 Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall 7 -5

VARIANCES Variances may start out “at the top” with a Level 0 analysis. This is the highest level of analysis, a supermacro view of operating results. The Level 0 analysis is nothing more than the difference between actual and static-budget operating income. Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall 7 -6

VARIANCES Further analysis decomposes (breaks down) the Level 0 analysis into progressively smaller and smaller components. Answers: “How much were we off? ” Levels 1, 2, and 3 examine the Level 0 variance into progressively more-detailed levels of analysis. Answers: “Where and why were we off? ” Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall 7 -7

EVALUATION Level 0 tells the user very little other than how much operating income was off from budget. Level 0 answers the question: “How much were we off in total? ” Level 1 gives the user a little more information: it shows which line-items led to the total Level 0 variance. Level 1 answers the question: “Where we off? ” Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall 7 -8

LEVEL 1 ANALYSIS, ILLUSTRATED Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall

FLEXIBLE BUDGET Flexible budget—shifts budgeted revenues and costs up and down based on actual operating results (activities) Represents a blending of actual activities and budgeted dollar amounts Will allow for preparation of Level 2 and 3 variances Answers the question: “Why were we off? ” Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall 7 -10

LEVEL 2 ANALYSIS, ILLUSTRATED Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall

LEVEL 2 VARIANCES, ANALYSIS Some possible reasons we might incur an unfavorable Sales-Volume Variance include: 1. Failure to execute the sales plan 2. Weaker than anticipated demand 3. Aggressive competitors taking market share 4. Unanticipated market preference away from the product 5. Quality problems Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall 7 -12

LEVEL 3 VARIANCES All product costs can have Level 3 variances. Direct materials and direct labor will be handled next. Overhead variances are discussed in detail in a later chapter. Direct materials and direct labor both have price and efficiency variances, and their formulae are the same. Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall 7 -13

LEVEL 3 VARIANCES Price variance formula: Efficiency variance formula: Copyright © 2015 Pearson Education,

LEVEL 3 ANALYSIS, ILLUSTRATED Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall

VARIANCE SUMMARY Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall 7 -16

OBTAINING BUDGETED INPUT PRICES AND INPUT QUANTITIES Budgeted input prices and budgeted input quantities can be obtained from a number of sources including actual input data from past periods, data from other companies that have similar processes and standards developed by the firm itself. A standard is a carefully determined price, cost or quantity that is used as a benchmark for judging performance. Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall 7 -17

VARIANCES AND 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. Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall 7 -18

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. Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall 7 -19

STANDARD COSTS CAN BE A USEFUL TOOL Price and efficiency variances provide feedback to initiate corrective actions. Standards are used to control costs. Managers use variance analysis to evaluate performance after decisions are implemented. Part of a continuous improvement program. Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall 7 -20

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. Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall 7 -21

BENCHMARKING AIRLINES Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall 7 -22

TERMS TO LEARN Terms to Learn Page Number Reference Benchmarking Page 267 Budgeted performance Page 249 Direct materials mix variance Page 272 Direct materials yield variance Page 272 Effectiveness Page 265 Efficiency variance Page 258 Favorable variance Page 251 Flexible budget Page 252 Flexible-budget variance Page 253 Management by exception Page 249 Price variance Page 258 Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall 7 -23

TERMS TO LEARN, CONT’D Terms to Learn Page Number Reference Rate variance Page 258 Sales-volume variance Page 253 Selling-price variance Page 255 Standard Page 257 Standard cost Page 257 Standard input Page 257 Standard price Page 257 Static budget Page 251 Static-budget variance Page 251 Unfavorable variance Page 251 Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall 7 -24

TERMS TO LEARN, CONCLUDED Terms to Learn Page Number Reference Usage variance Page 258

26