Chapter Four

Standard Costing, Flexible Budgeting and Variance Analysis

The Use of Variances
• Variance represents the difference between an amount based on an actual
result and the corresponding budgeted amount.
• The budgeted amount is a benchmark, a point of reference from which
comparisons may be made.
• Variances assist managers in their planning and control decisions
• Management by exception is the practice of concentrating on areas not
operating as anticipated or expected (such as a cost overrun on a
defense project or a large shortfall in sales of a product) and giving less
attention to areas operating as anticipated or expected. In other words,
managers usually pay more attention to areas with large variances.
Static Budget and Flexible Budgets
• The master budget or static budget is based on the level of output planned
at the start of the budget period.

• Static budget is the “original” budget. It’s static in the sense that the budget
is developed for a single (static) planned output level.
• A static budget is prepared at the beginning of the budgeting period and is
valid for only the planned level of activity.
• It is suitable for planning, but it is inadequate for evaluating how well
costs are controlled because the actual level of activity
• It results in “apples-to-oranges” cost comparisons
Static Budgets and Performance Reports
Static Budgets and Performance Reports

U = Unfavorable variance the company

was unable to achieve the budgeted
level of activity.
Static Budgets and Performance Reports

F = Favorable variance that occurs when actual

costs are less than budgeted costs.
Static Budgets and Performance Reports

Since cost variances are favorable, have

we done a good job controlling costs?
Favorable & Unfavorable Variance
• A Favorable Variance (denoted by F) has the effect of
increasing operating income relative to the budgeted amount.
 For revenue items, F means actual revenue exceeds budgeted revenues.
 For cost items, F means actual costs are less than budgeted costs.
• An Unfavorable Variance (denoted by U) – has the effect of decreasing
operating income relative to the budgeted amount. Unfavorable variances
are also called adverse variances in some countries, for example, the
United Kingdom
Levels of Variance Analysis
• Companies present budgets with broad summary figures that can then be
broken down into progressively more detailed figures via computer software
programs.
• The level of detail increases in the number of line items examined in the
income statement and the number of variances computed.
• “Level” followed by a number denotes the amount of detail shown by a
variance analysis.
• Level 0 reports the least detail.
• Level 1 offers more information, and so on.
A Flexible budget (variable budget)

• A flexible budget (variable budget) calculates budgeted revenues and

budgeted costs based on the actual output level in the budget period
• A flexible budget is calculated at the end of the period when the actual output
is known; a static budget is developed at the start of the budget period based
on the planned output level for the period.
• A flexible budget is dynamic rather than static; it can be tailored for any
level of activity within the relevant range.
• A flexible budget is a performance evaluation tool.
• It enables “apples-to-apples” cost comparisons.
Steps to Develop Flexible budget
The following steps are used to prepare a flexible budget:
Step 1. Identify the actual quantity of output.

Step 2. Calculate the flexible budget for revenues based on budgeted

selling price and actual quantity of output.

Step 3. Calculate the flexible budget for costs based on budgeted

variable cost per output unit, actual quantity of output, and budgeted
fixed costs.
Flexible Budget Example
Maedot e-learning is preparing a budget for 2024. The budgeted
selling price per unit is $10, and total fixed costs for 2024 are
estimated to be $5,000. Variable costs are budgeted at $3/unit.
Prepare a flexible budget for the volume levels 1,000, 1,100, and 1,200
units.
Volume Levels
Volume Levels
Sales in units 1,000 1,100 1,200
Sales in units 1,000 1,100 1,200
Revenues $10,000 $11,000 $12,000
Revenues $10,000 $11,000 $12,000
Variable costs $3,000 $3,300 $3,600
Variable costs $3,000 $3,300 $3,600
Contribution margin $7,000 $7,700 $8,400
Contribution margin $7,000 $7,700 $8,400
Fixed costs $5,000 $5,000 $5,000
Fixed costs $5,000 $5,000 $5,000
Operating income $2,000 $2,700 $3,400
Operating income $2,000 $2,700 $3,400

Slide # 14
Static Budget Variances Example

Suppose that Tina’s 2024 static budget was for 1,100 units of sales.
The actual results are given below. Compute the static budget
variances for each row and discuss.

Static
Static
Static
Static Actual Budget
Actual Budget
Budget
Budget Results Variance
Results Variance
in units
SalesSales in units 1,100
1,100 980
980 120 Unfavorable
Revenues
Revenues $11,000
$11,000 $9,604 $1,396
$9,604 $1,396 Unfavorable
Unfavorable
Variable costs
Variable costs $3,300
$3,300 $2,989
$2,989 $311
$311 Favorable
Favorable
Contribution
Contribution margin $7,700
margin $7,700 $6,615 $1,085
$6,615 $1,085 Unfavorable
Unfavorable
costs
FixedFixed costs $5,000
$5,000 $4,520
$4,520 $480
$480 Favorable
Favorable
Operating
Operating income $2,700
income $2,700 $2,095
$2,095 $605
$605 Unfavorable
Unfavorable
11-16

Preparing a Flexible Budget

Cost Total Flexible Budgets

Formula Fixed 8,000 10,000 12,000
per Hour Cost Hours Hours Hours
Machine hours 8,000 10,000 12,000
Variable costs Variable costs are expressed as
Indirect labor $ 4.00 a constant amount per hour.
Indirect material 3.00
Power 0.50 $40,000 ÷ 10,000 hours is
Total variable cost $ 7.50 $4.00 per hour.
Fixed costs Fixed costs are
Depreciation $ 12,000
Insurance 2,000
expressed as a
Total fixed cost total amount.
Total overhead costs
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11-17

Preparing a Flexible Budget

Cost Total Flexible Budgets

Formula Fixed 8,000 10,000 12,000
per Hour Cost Hours Hours Hours
Machine hours 8,000 10,000 12,000
Variable costs
Indirect labor $ 4.00 $ 32,000
Indirect material 3.00 24,000
Power 0.50 4,000
Total variable cost $ 7.50 $ 60,000

Fixed costs $4.00 per hour × 8,000 hours = $32,000

Depreciation $ 12,000
Insurance 2,000
Total fixed cost
Total overhead costs
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11-18

Preparing a Flexible Budget

Cost Total Flexible Budgets

Formula Fixed 8,000 10,000 12,000
per Hour Cost Hours Hours Hours
Machine hours 8,000 10,000 12,000
Variable costs
Indirect labor $ 4.00 $ 32,000
Indirect material 3.00 24,000
Power 0.50 4,000
Total variable cost $ 7.50 $ 60,000

Fixed costs
Depreciation $ 12,000 $ 12,000
Insurance 2,000 2,000
Total fixed cost $ 14,000
Total overhead costs $ 74,000
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11-19

Preparing a Flexible Budget

Cost Total Flexible Budgets

Formula Fixed 8,000 10,000 12,000
per Hour Cost Hours Hours Hours
Machine hours 8,000 10,000 12,000
Variable costs
Indirect labor $ 4.00 $ 32,000 $ 40,000
Indirect material 3.00 fixed costs
Total 24,000 30,000
Power 0.50
do not change in4,000 5,000
Total variable cost $ 7.50 $ 60,000 $ 75,000
the relevant range.
Fixed costs
Depreciation $ 12,000 $ 12,000 $ 12,000
Insurance 2,000 2,000 2,000
Total fixed cost $ 14,000 $ 14,000
Total overhead costs $ 74,000 $ 89,000 ?
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11-20

Preparing a Flexible Budget

Cost Total Flexible Budgets

Formula Fixed 8,000 10,000 12,000
per Hour Cost Hours Hours Hours
Machine hours 8,000 10,000 12,000
Variable costs
Indirect labor $ 4.00 $ 32,000 $ 40,000 $ 48,000
Indirect material 3.00 24,000 30,000 36,000
Power 0.50 4,000 5,000 6,000
Total variable cost $ 7.50 $ 60,000 $ 75,000 $ 90,000

Fixed costs
Depreciation $ 12,000 $ 12,000 $ 12,000 $ 12,000
Insurance 2,000 2,000 2,000 2,000
Total fixed cost $ 14,000 $ 14,000 $ 14,000
Total overhead costs $ 74,000 $ 89,000 $ 104,000
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11-21

Flexible Budget Performance Report

Cost Total
Formula Fixed Flexible Actual
per Hour Cost Budget Results Variances
Machine hours 8,000 8,000 0
Variable costs
Indirect labor $ 4.00 $ 32,000 $ 34,000 $ 2,000 U
Indirect material 3.00 24,000 25,500 1,500 U
Power 0.50 4,000 3,800 200 F
Total variable cost $ 7.50 $ 60,000 $ 63,300 $ 3,300 U

Fixed costs
Depreciation $ 12,000 $ 12,000 $ 12,000 $ 0
Insurance 2,000 2,000 2,050 50 U
Total fixed cost $ 14,000 $ 14,050 50 U
Total overhead costs $ 74,000 $ 77,350 $ 3,350 U
McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc.
Example The budgeted variable cost per jacket for each category is:

• The relevant range for the cost driver is from 0 to 12,000 jackets. The budgeted
fixed manufacturing costs are Br 276,000 for production between 0 and 12,000
jackets. The budgeted selling price is Br 120 per jacket. This selling price is the
same for all distributors. The static budget for April 2006 is based on selling 12,000
jackets. Actual sales for April 2006 were 10,000 jacket
Level – 0 Analysis
Static Budget Variances = Actual Results – Static Budget Amount

• Level 0 Analysis gives the least detailed comparison of the actual and budgeted
operating income. It compares the actual operating income with the budgeted
operating income
Exercises
• Addis Tires Enterprises manufactures tires for the
Formula I motor racing circuit. For August 2014, it
budgeted to manufacture and sell 3,000 tires at a
variable cost of $74 per tire and total fixed costs of
$54,000. The budgeted selling price was $110 per tire.
Actual results in August 2014 were 2,800 tires
manufactured and sold at a selling price of $112 per
tire. The actual total variable costs were $229,600,
and the actual total fixed costs were $50,000.
Required
Prepare a performance report that uses a flexible
budget and a static budget.
Static Budget Variance – Level 2
• Static-budget variance can be classified into two:
 Flexible-budget variance
 Sales-volume variance
• Flexible-Budget Variances
• The flexible budget variance is the difference between the actual results and the
flexible- budget amount based on the level of output actually achieved in the budget
period.
Flexible Budget Variance = Actual Results - Flexible Budget Amounts
• Sales-Volume Variances
• The sales-volume variance is the difference between a flexible-budget amount and the
corresponding static-budget amount.
Sales-Volume Variance = Flexible-Budget Amount – Static Budget Amount
Sales-Volume Variances
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
 Flexible-Budget Variance – Level 3

Standard Costs and Variance Analysis

 Standard Costing System
 Standard Costing System
Standard cost systems is accounting system that value products according to
standard costs only.
Standard cost
It is a carefully determined cost per unit that should be attained.
It is a predetermined measure of what a cost should be under stated
conditions.
they are target costs that should be incurred under efficient operating
conditions.
provides management with goals to attain (planning) & a basis for comparison
with actual results (control).
Standard Costs Vs Budgeted Costs
Standard costs Vs budgeted costs
Standard costs are not the same as budgeted costs.
A budget relates to an entire activity or operation. But a standard presents
the same information on a per unit basis
a budget provides the cost expectation for the total activity but a standard
therefore provides cost expectations per unit of activity
Standard costs are also known as planned costs, predicted costs and
scheduled costs.
The purpose of standard costing is to assist the management of an organization
to plan and control their operations
Types of Standards
 Ideal standard/theoretical standard
 represents perfect operating conditions and therefore can be hard to achieve.
 It assumes no material wastage, the worker always measures perfectly, and the
machines never get out of adjustment.
 A practical standard (Attainable Standards)
 It represents estimated cost under tight, but achievable conditions.
 make allowances for normal breakdowns in machinery and for rest periods for
workers.
 considered to be more realistic than ideal standards.
 Expected Standard:
 are standards that reflect what is actually expected to occur in a future period
 Lax standard:
 refers to standard that can be achieved with little effort.
 Setting Direct Material Standards

Price Quantity
Standards Standards

Final, delivered Summarized in

cost of materials, a Bill of Materials.
net of discounts.

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 Setting Direct Labor Standards

Rate Time
Standards Standards

Often a single Use time and

rate is used that reflects motion studies for
the mix of wages earned. each labor operation.

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 Setting Variable Overhead Standards

Rate Activity
Standards Standards

The rate is the The activity is the

variable portion of the base used to calculate
predetermined overhead the predetermined
rate. overhead.

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 A General Model for Variance Analysis

Variance Analysis

Price Variance Quantity Variance

Materials price variance Materials quantity variance

Labor rate variance Labor efficiency variance
VOH spending variance VOH efficiency variance

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 A General Model for Variance Analysis

Actual Quantity Actual Quantity Standard Quantity

× × ×
Actual Price Standard Price Standard Price

Price Variance Quantity Variance

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 A General Model for Variance Analysis

Actual Quantity Actual Quantity Standard Quantity

× × ×
Actual Price Standard Price Standard Price

Price Variance Quantity Variance

Actual quantity is the amount of direct

materials, direct labor, and variable
manufacturing overhead actually used.

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 A General Model for Variance Analysis

Actual Quantity Actual Quantity Standard Quantity

× × ×
Actual Price Standard Price Standard Price

Price Variance Quantity Variance

Standard quantity is the standard quantity

allowed for the actual output for the period.

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 A General Model for Variance Analysis

Actual Quantity Actual Quantity Standard Quantity

× × ×
Actual Price Standard Price Standard Price

Price Variance Quantity Variance

Actual price is the amount actually

paid for the for the input used.

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 A General Model for Variance Analysis

Actual Quantity Actual Quantity Standard Quantity

× × ×
Actual Price Standard Price Standard Price

Price Variance Quantity Variance

Standard price is the amount that should

have been paid for the input used.

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 A General Model for Variance Analysis

Actual Quantity Actual Quantity Standard Quantity

× × ×
Actual Price Standard Price Standard Price

Price Variance Quantity Variance

(AQ × AP) – (AQ × SP) (AQ × SP) – (SQ × SP)

AQ = Actual Quantity SP = Standard Price
AP = Actual Price SQ = Standard Quantity

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Material Price Variance (MPV)

MPV = (AP – SP) AQ

AP > SP Unfavorable
Decision Rule:
AP < SP Favorable

Raw Materials (AQ x SP) XXX

Journal Entry Materials Price Variance [(AP-SP)AQ] XXX or XXX
(Recorded at Time of Purchase)
Accounts Payable (AQ x AP) XXX
 Material Quantity Variance (MQV)

MQV = (AQ – SQ) SP

AQ > SQ Unfavorable
Decision Rule:
AQ < SQ Favorable

Journal Entry Work in Process (SQ x SP) XXX

(Recorded when materials are put into Materials Quantity Variance [(AQ-SQ)SP] XXX or XXX
production) Raw Materials (AQ x SP) XXX
 Labor Rate Variance (LRV) Labor Efficiency Variance (LEV)

LRV = (AR – SR) AH LEV = (AH – SH) SR

AR > SR Unfavorable AH > SH Unfavorable

Decision Rule:
AR < SR Favorable AH < SH Favorable

Work in Process (SH x SR) XXX

Labor Rate Variance [(AR-SR)AH] XXX or XXX
Labor Efficiency Variance [(AH-SH)SR] XXX or XXX
Wages Payable (AH x AR) XXX
Exercises
G-Max Company makes golf club heads with the following standard cost information:
Direct materials (0.5 lb. per unit at $20 per lb.) $10.00
Direct labor (1 hr. per unit at $16 per hr.) 16.00
Total standard direct cost per unit $ 26.00

During May, G-Max produced 3,500 club heads using 1,800 pounds of material.
G-Max paid $21.00 per pound for the material.
Compute the material price and quantity variances.
 Cost
Actual  Standard
  Cost
 
Actual Quantity Actual Quantity Actual Quantity Standard Quantity
   
Actual Price Standard Price Standard Price Standard Price
1,800 lbs. 1,800 lbs. 1,800 lbs. 1,750 lbs.
   
$21.00 per lb. $20.00 per lb. $20.00 per lb. $20.00 per lb.
$37,800 $36,000 $36,000 $35,000
     
Price Variance Quantity Variance
$1,800 Unfavorable
$1,000 Unfavorable

  

$2,800 Total Direct Materials Variance (U)

SQ = 3,500 units × 0.5 per unit = 1,750 lbs.

During May, G-Max produced 3,500 club heads working 3,400 hours. G-Max paid
an average of $16.50 per hour for the hours worked.
Compute the labor rate and efficiency variances.
Direct materials (0.5 lb. per unit at $20 lb.) $10.00
Direct labor 1 hr. per unit at $16 per hr.) 16.00
Total standard direct cost per unit $26.00

Use this information to compute the labor rate and efficiency

variances before you go to the next slide.
 Actual
Cost

 Standard
  Cost

Actual Hours Actual Hours Actual Hours Standard Hours
   
Actual Rate Standard Rate Standard Rate Standard Rate
3,400 hours 3,400 hours 3,400 hours 3,500 hours
   
$16.50 per hr. $16.00 per hr. $16.00 per hr. $16.00 per hr.
$56,100 $54,400 $54,400 $56,000
       
Rate Variance Efficiency Variance
$1,700 Unfavorable
$1,600 Favorable
 

$100 Total Cost Variance (U)

SQ = 3,500 units × 1.0 hour per unit = 3,500 hours.

 Is this
Favorable or
Unfavorable
?