COST ACCOUNTING

Sixteenth Edition

Chapter 7
Flexible Budgets,
Direct-Cost Variances,
and
Management Control

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Basic Concepts (1 of 2)
Variance—the difference between actual results and
expected (budgeted) performance.
Management by Exception—the practice of focusing
attention on areas not operating as expected (budgeted).
A Static (master) budget is based on the level of output
planned at the start of the budget period.
A Static budget variance is the difference between the actual
result and the corresponding static budget amount.

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Basic Concepts (2 of 2)
A Favorable variance (F) has the effect, when considered in
isolation, of increasing operating income relative to the
budget amount.
An Unfavorable variance (U) has the effect, when viewed in
isolation, of decreasing operating income relative to the
budget amount.

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Variances
Variances may start out “at the top” with a Level 0 analysis.
This is the highest level of analysis and is nothing more than
the difference between actual and static-budget operating
income.
Levels 1, 2, and 3 examine the Level 0 variance, breaking it
down into progressively more detailed levels of analysis.

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Level 1 Analysis, Illustrated

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Flexible Budget
• A 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,
after managers know the actual output.
• The flexible budget is the hypothetical budget that would
have been prepared at the start of the budget period if the
company had correctly forecast the actual output for the
period.
• In a flexible budget, the selling price is the same as the
static budget, the budgeted unit variable cost is the same,
and, within the relevant range, total fixed costs are the
same.

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Develop the Flexible Budget in Three
Steps:
1. Identify the Actual Quantity of Output
2. Calculate the Flexible Budget for Revenues Based on
the Budgeted Selling Price and Actual Quantity of Output
3. Calculate the Flexible Budget for Costs Based on the
Budgeted Variable Cost per Output Unit, Actual Quantity
of Output, and Budgeted Fixed Costs

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Level 2 Analysis, Illustrated

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Sales-Volume Variances (1 of 2)
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
actual volume and the budgeted volume (from the static
budget).

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Sales-Volume Variances (2 of 2)
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

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Flexible Budget Variances (1 of 2)
Level 3 variances provide even more information than we
get from level 2.
All product costs can have Level 3 variances. Direct
materials and direct labor will be discussed next. Overhead
variances are discussed in detail in a later chapter.

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Flexible Budget Variances (2 of 2)
Level 3 variances provide details of our level 2 flexible
budget variances. Instead of simply identifying the
difference between actual Material costs and (flexible)
budgeted costs, we can break that variance down into a
price variance component and an efficiency component.

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Flexible Budget Variances—
Formulas (Materials & Direct Labor)
Price variance formula =

{Actual Price of Budgeted Price X Actual Quantity

Efficiency variance formula =

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Variance Summary

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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.

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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.

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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.

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Management’s Use of Variances
• Price and efficiency variances provide feedback to initiate
corrective actions.
• Standards are used to control costs and guide manager’s
to appropriate investigations of variances.
• Managers use variance analysis to evaluate performance
after decisions are implemented.
• Understand why variances arise, learn, and improve future
performance.

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Benchmarking and Variances
Benchmarking is the continuous process of comparing your
firm’s performance levels against the best levels of
performance in competing companies or in companies
having similar processes.
Let’s take a look at a common unit of measurement used to
compare the efficiency of airlines: Cost per Available Seat
Mile.

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Benchmarking Airlines:
Cost Per Seat Mile
EXHIBIT 7.5 Available Seat Mile (ASM) Benchmark Comparison of United Airlines with Six
Other Airlines

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