CHAPTER FIVE

FLEXIBLE BUDGETS AND STANDARDS

LEARNING OBJECTIVES:
Upon the completion of this chapter, you will be able to:
 distinguish between flexible budgets and master (static) budget
 understand the performance evaluation relationship between master (static)
budgets and flexible budgets
 compute flexible-budget variance and sales activity variance.
 compute price and usage variance for direct materials and direct labor
 compute both variable and fixed overhead variances

5.1 MASTER BUDGET vs FLEXIBLE BUDGET

All master budgets discussed in the previous chapter are static or inflexible because
they assume fixed level of activity. A master budget or static budget is prepared for
only one activity level (for example one volume of sales activity) and such budget is
prepared by a business prior to the start of the budget period.

This chapter introduces flexible budgets, which are budgets designed to direct
management to areas of actual financial performance that desire attention. A flexible
budget is a budget prepared by a business after the budget period has ended, as part
of the variance analysis process. A flexible budget uses the same underlying fixed cost
and per-unit cost and revenue assumptions as the original static budget. Managers can
apply this same basic process to control important areas of performance such as quality
or customer service.

The only difference between a static budget and a flexible budget is that the flexible
budget uses actual output levels instead of budgeted output levels.

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EXAMPLE 1: Evergreen Company prepares a budget based on detailed expectation for
the forthcoming month. Evergreen Company’s plan tailored to a single sales level, i.e.,
9,000 units. However, sales volume units turned out to be only 7, 000 units instead of
the original 9, 000 units. Compute the master budget variance for each item given
below.
Exhibit 5-1 Evergreen Company’s Performance Report

Master Master Budget

Particulars Actual
Budget Variances
Units 7,000 units 9,000 units 2,000 units U
Sales Br. 217,000 Br. 279,000 Br. 62,000 U
Variable Expenses
* Manufacturing Br. 151,270 Br. 189,000 Br. 37,730 F
* Selling 5,000 5,400 400 F
* Administrative 2,000 1,800 200 U
Total Variable Expense Br. 158,270 Br. 196,200 Br. 37,930 F
Contribution Margin Br. 58,730 Br. 82,800 Br. 24,070 U
Fixed Expenses
* Manufacturing Br. 37,300 Br. 37,000 300 U
*Selling & Administrative 33,000 33,000 ---
Total Fixed Expenses Br. 70,300 Br. 70,000 300 U
Operating Income (Loss) Br. (11,570) Br. 12,800 Br. 24,370 U

N.B. Master budget variance (static budget variance) is the variance of actual result
from the master budget.

It is customary to label variances favorable (F) or unfavorable (U). The label indicates
whether the target or the actual figure is larger. The way in which labels are applied
depends on the item for which a variance is computed. If the item for which the
variance is computed is a revenue or profit item, favorable variances are those for
which actual is greater than the target; unfavorable variances are those for which
actual is less than the target (or the budget).

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If the item for which the variance is computed is a cost or expense item, favorable
variances are those for which actual is less than the target. Therefore, if actual cost is
greater than target cost, the variance will be labeled unfavorable.

5.2 FLEXIBLE BUDGETS (DYNAMIC BUDGETS)

Actual activity may differ significantly from budgeted activity because of an unexpected
labor strike, cancellation of an order, an unexpected large new production contract, and
other factors. When actual results differ considerably from plans, a fixed or static
budget may not be particularly effective in supporting managers. In such cases several
budgets prepared for a variety of activity levels may be more useful.

In contrast to the performance report based only on comparing the master budget to
the actual results, a more useful benchmark for analysis is the flexible budget. A flexible
budget (sometimes called a variable budget) is budget that can easily be adjusted for
differences in the level of activity. It provides managers more useful information for
planning and better basis for comparing performance than, a static or fixed budget.

In performance evaluation, a master budget is kept fixed or static to serve as a

benchmark for evaluating performance. It shows revenues and costs at only the
originally planned levels of activity. However, a flexible budget will be prepared at the
actual activity level.

The flexible budget is identical to the master budget in format, but managers may
prepare it for any level of activity.
Flexible budgets have several desirable characteristics. They:
i. Cover a range of activity
ii. Are dynamic
iii. Facilitate performance measurement.

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Flexible Budget Cover a Range of Activity. Accurate predictions of activity levels
are sometimes hard to make, and many managers find they make more effective
decisions with the aid of flexible budgets. In developing a flexible budget one activity
level at each extreme of the relevant range is selected, with one or more in between.

Flexible Budget Are Dynamic. Flexible budgets allow managers to adjust plans
easily when activity level differs from the expected level. Such budgets address “what
is” rather than “what was” or “what was expected”. This dynamic nature of flexible
budget makes them a very useful decision making tool for management.

Flexible Budget Facilitate Performance Measurement. Measuring efficiency is an

important role of performance report. Fixed budgets are useful for measuring
effectiveness, i.e., achievement of goal. In some cases, however, fixed budgets do not
identify the question, “what should the result be, given the actual level of activity”. In
other words, the flexible-budget approach says, “Give me any activity level you choose,
and I’ll provide a budget tailored to that particular level.” To summarize, whenever
actual and budgeted activity are significantly different, a flexible budget variance report
provides a better measure of efficiency than a report based on a fixed budget.

5.3 FLEXIBLE BUDGETING PROCESS

The following steps are needed to develop a flexible budget.
1. Determine the range of activity the budget should cover (because cost behavior patterns
may be different in different ranges of activity)
2. Determine the cost behavior pattern for each cost included in the budget.
3. Select the activity levels for which budgets will be prepared.
4. Prepared a flexible budget using the cost behavior data and the selected activity level.

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Example (2): Evergreen Company is planning to use a flexible budgeting system to
plan and control its operations. Evergreen made the following cost estimates for
budgeting purposes:
Budget Formula Per Unit
Sales Br. 31.00
Variable Costs
* Manufacturing Br. 21.00
* Selling 0.60
* Administrative 0.20
Total Variable Costs Br. 21.80
Contribution Margin Br. 9.20
Budget Formula per Month
Fixed Costs
* Manufacturing Br. 37,000
* Selling and administrative 33,000
Total fixed costs Br. 70,000

Required: Prepared a flexible budget for the next month using 7,000, 8,000, and
9,000 units as activity level. Evergreen Company’s cost functions or flexible budget
formulas are believed to be valid within the range of 7,000 to 9,000 units.
Exhibit 5.2 Evergreen Company’s Flexible Budget
Flexible Budgets for Various Activity Levels
7,000 units 8,000 units 9,000 units
Sales Br. 217,000 Br. 248,000 Br. 279,000
Variable Costs
* Manufacturing Br. 147,000 Br. 168,000 Br. 189,000
* Selling 4,200 4,800 5,400
* Administrative 1,400 1,600 1,800
Total Variable Costs Br. 152,600 Br. 174,400 Br. 196,200
Contribution margin Br. 64,400 Br. 73,600 Br. 82,800
Fixed costs
* Manufacturing Br. 37,000 Br. 37,000 Br. 37,000
* Selling and administrative 33,000 33,000 33,000
Total fixed costs Br. 70,000 Br. 70,000 Br. 70,000
Operating income (loss) Br. (5,600) Br. 3,600 B. 12,800

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Comparing the flexible budget to actual results accomplishes an important performance
evaluation purpose. There are basically two reasons why actual results might not have
conformed to the master budget:
 Sales and other cost-driver activities were not the same as originally forecasted.
 Revenues or variable costs per unit and fixed costs per period were not as
expected.

Flexible Budget Variances: Any variances between the flexible budget and actual
results cannot be due to activity levels. These variances between the flexible budget
and actual results are called flexible budget variances and must be due to departure of
actual costs or revenues from flexible-budget formula amounts.

Activity level variances: Any differences or variances between the master budget
and the flexible budget are due to activity levels. These differences are called activity-
level variances.
The sum of the activity level variances and the flexible budget variances equal the total
of the master budget variances.
Example (3): Refer the data given in example (1) and (2). Prepare a condensed table
showing the static (master) budget variance, the sales activity variance, and the
flexible-budget variance.

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 Exhibit 5.3 Evergreen Company Summary of Performance
Master Flexible Sales
Actual Flexible Master
Budget Budget Activity
Results Budget Budget
Variance Variance Variances
Units 7,000 units 7,000 units 9,000 units 2,000 U - 2,000 U

Sales Br. 217,000 Br. 217,000 Br. 279,000 Br. 62,000 U - Br. 62,000 U

Variable costs
* Manufacturing Br. 151,270 Br. 147,000 Br.189,000 Br37,730F Br4,270 U 42,000 F

* Selling 5,000 4,200 5,400 400 F 800 U 1,200 F

* Administrative 2,000 1,400 1,800 200 U 600U 400 F

Total variable costs Br. 158,270 Br. 152,600 196,200 Br. 37,930 F Br. 5,670 U 43,600 F

Contribution margin Br. 58,730 Br. 64,400 Br. 82,800 Br. 24,070 U Br. 5,670 U Br. 18,400 U

Fixed costs
* Manufacturing Br. 37,300 Br. 37,000 Br. 37,000 Br 300 U Br 300 U -

* Selling & Admin 33,000 33,000 33,000 - - -

Fixed Costs Br. 70,300 Br. 70,000 Br. 70,000 300 U 300 U -

Income (loss) Br. (11,570) Br. (5,600) Br. 12,800 Br. 24,370 U Br. 5,970 U Br. 18,400 U

*U or F indicates whether the variances are unfavorable or favorable, respectively.

Total master budget variance (TMBV) = ALF + FBV
where TMBV = Total Master Budget Variance
ALF = Activity Level Variance
FBV = Flexible Budget Variance
Thus, the total master budget variance for Evergreen Company amounts to Br. 24,370
unfavorable (Br. 5970 U + Br. 18400 U). The sum of the activity-level variances here
equals sales-activity variances because sales are the only activity used as a cost driver.

Managers use comparisons between actual results, master budgets, and flexible
budgets to evaluate organizational performance. When evaluating performance, it is
useful to distinguish between effectiveness-the degrees to which a goal, objective, or
target is met- and efficiency-the degree to which inputs are used in relation to a given
level of outputs.

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Performance may be effective, efficient, both, or neither. For example, Evergreen
Company set a master budget objective of manufacturing and selling 9,000 units. Only
7,000 units were actually made and sold, however. Performance, as measured by sales-
activity variances, was ineffective because the sales objective was not met.

Was Evergreen’s performance efficient?

Flexible-budget variances measure the efficiency of operations at the actual level of

activity. The flexible-budget variances shown in column (4) of Exhibit 5.3 total Br. 5,970
unfavorable. The total flexible-budget variance arises from sales prices received and
the variable and fixed costs incurred. Evergreen Company had no difference between
actual sales price and the flexible-budgeted sales price, so the focus is on the
differences between actual costs and flexible-budgeted costs at actual 7,000-unit level
of activity.

Sales-activity variances measure how effective managers have been in meeting the
planned sales objective. In Evergreen Company, sales activity fell 2,000 units short of
the planned level. The sales-activity variances (totaling Br. 18,400 U) are unaffected by
any changes in unit prices or variable costs. Why? Because the same budgeted unit
prices and variable costs are used in constructing both the flexible and master budgets.
Therefore, all unit prices and variable costs are held constant in columns (2) and (3) of
Exhibit 5.3

The section that follows will discuss direct material, direct labor and variable and fixed
overhead flexible-budget variances in detail.

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5.4 STANDARD COST VARIANCE ANALYSIS

5.4.1 Standard Costs Defined

Many companies for planning and controlling operations use standard cost accounting
systems. Standards are useful in detailed planning, cost control, performance
measurement, and pricing decisions.

Standard costs are carefully predetermined costs created by management and used as
a basis for comparison with actual costs. Like all standards, standard costs are
measure of achievement. Consequently, managers must use care to ensure that the
standards are appropriate measures of performance that encourage attainment of
organizational goals.
Types of Standards. Different firms may fix different standards and the same firm
may adopt different standards at different points of time. This difference in standards
arises due to the variation in circumstances or conditions under which standards are
fixed. On the basis of circumstances, the standards may be classified as under:

 Ideal standard: A standard is said to be an ideal if it is based on ideal

conditions of work. It reflects the most optimistic expectations of management.
Ideal standards (also called perfection standards) can be achieved only with
perfect operating conditions. It pre-supposes most favorable conditions of work
and rules out any possibility of loss arising out of abnormal conditions such as
break-down of machines, failure of power, employee error, labor strikes, changes
in government policy, defective raw material, inventory shortage, etc. In brief, it
assumes no production problems of any sort.

 Basic standard: It is a fixed standard that provide a framework for comparing

performance over a period of years. They are sometimes called long-range
standards because once created, they are used for several years or longer.
Since a basic standard remains unchanged, it does not suggest, “What the cost
for the year ought to be?” Therefore, it cannot be used for valid comparisons as

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 rapidly rising resource costs and charging production technology often make
basic standards difficult to use. As a result, not many firms use basic standards.

 Normal standard: Normal standards can also be termed as historical

standards as it is based on the average performance in the past years. It can be
fairly a satisfactory standard if the performance in the past has been fairly stable.
In case of constantly improving efficiency or erratic performance, the normal
standards will fail to serve the purpose. It suffers from all the defects of an
arithmetic average based on a series of items that include few extreme items.

 Attainable standard: It is one that can be attained under the conditions and
circumstances prevailing within the organization. Currently attainable standards
are the most commonly used standards. They represent benchmarks for
efficient production in the current environment. Currently attainable standards
are not as stringent as ideal standards because they allow for normal production
problems, such as equipment maintenance, downtime, random employee errors,
and occasional inventory shortages. Still, currently attainable standards
represent desirable information. Currently attainable standards are also called
practical standards.

Are Standards the Same as Budgets?

Standards and budgets are very similar. The major distinction between the two terms
is that a standard is a unit amount, whereas a budget is a total amount. Suppose that
the standard cost for materials is Br. 12 per unit and 1,000 units are to be
manufactured during a budget period, then the budgeted cost of materials would be Br.
12,000 (Br. 12 x 1,000). In effect, a standard can be viewed as the budgeted cost for
one unit of product.

5.4.2 Purpose of Standard Costs

Cost information may be used for many different purposes. It should be noted that
cost information that serves one purpose might not be appropriate for another.
Therefore, the purpose for which cost information is to be used should be clearly

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defined before procedures are developed to accumulate cost data. Standard costs may
be used for the following purposes:

 Cost control: The most important objective of standard cost is to help the
management in cost control. It can be used as a yardstick against which actual
costs can be compared to measure efficiency. The management can make
comparison of actual costs with the standard costs at periodic intervals and take
corrective action to maintain control over costs.

 Product pricing: The selling price of a unit and the cost per unit are usually
closely related. The cost data are readily available under standard costing
system and the price can be quoted on the basis of standard costs without fear
of under or over pricing. Standard cost is the predetermined normal cost of
normal output and as such forms basis for price fixation.

 Estimating budgets: Standard costs and budgets are similar, because they
both represent planned costs for a specific period. Standard costs are very
useful when developing a budget, since they form the building blocks of a total
cost goal (or budget). Budgets, in effect, are standard costs multiplied by the
volume or activity level expected.

 Performance appraisal: Employee performance evaluation is a difficult task

involving many different variables, some of which are subjective and therefore
difficult to use in comparing employees. When standards are established for
performance evaluation, they provide tangible measures that can be applied
uniformly to all personnel. For example, the standard labor time for performing
various production activities may be used to evaluate the efficiency of
employees. Similarly, production department supervisors may be evaluated on
how close their department came to achieving standards. Standards can be
effective in performance evaluation if employees have a clear understanding of
the standards and the way they are used. In addition, employees must be given

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 timely reports evaluating their performance. The timely reports are possible
because the standards are readily available for quick comparison and reporting.

 Simplify performance reports. The performance reports presented in the

form of variance analysis are simple to understand as they clearly distinguish
between favorable and unfavorable variances. The busy top management can
concentrate on significance variances and take appropriate action in the matter.

 Record Keeping: Detailed record keeping may be reduced when standard

costs are used in conjunction with actual costs. For example, when materials are
kept at standard cost, the materials ledgers need only keep track of quantities.

 Cost awareness: Accountants and financial managers are aware of the costs
associated with the activities of the business, because they deal with them daily.
Many other employees, however, have little or no awareness of costs. They may
be concerned with increasing daily production, improving employee morale, and
improving production efficiency, all of which have an impact on costs, but many
employees do not understand the cost consequences of these activities.
Standard costs and standard cost performance reports inform employees about
the cost implications of their actions. Such cost awareness may result in better
employee efforts at cost control.
There are three fundamental activities in a standard cost system. These are
 Standard setting.
 Accumulation of actual costs.
 Variance analysis.

Standard setting: The first step in a standard cost system is the creation of the
standards to be used as a basis for measuring performance. Standard setting is an
important activity because poorly conceived standards result in inappropriate measures
of performance. Standard setting is not a one – time activity. As resource costs and
production methods change, revision of the standard is necessary. In many firms
standards are evaluated on a regular basis, such as annually or every 6 months.

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Management accountants typically use two methods for setting standards: analysis of
historical data and task analysis.

 Historical data: Often the immediate past is the best indicator of the near
future. Firms that have been producing the same product using the same
production technology for a number of years may base their standards on their
historical experience. They may use various cost estimation techniques to
determine the past relationship between input usage and output produced or
between input purchases and input prices. The past relationships and prices are
then used as standards. However, the management accountant often will need
to adjust these predictions to reflect movements in price levels or technological
changes in the production process.

 Task analysis: Another way to set cost standards is to analyze the process of
manufacturing a product to determine what it should cost. The emphasis shifts
from what the product did cost in the past to what it should cost in the future.
In using task analysis, the management accountant typically works with
engineers who are intimately familiar with the production process. Together
they conduct studies to determine how much direct material should be required
and how machinery should be used in the production process. Time and motion
studies are conducted to determine how long each step performed by direct
laborers should take.

Accumulation of actual costs: A standard cost system does not eliminate the need
for accumulating actual production costs. Actual costs are compared with standard
costs to determine variances. In manufacturing, actual costs are accumulated in a job
order or a process costing system. With nonmanufacturing activities, actual costs are
also accumulated and compared with standards established for nonmanufacturing
activities.

Variance analysis: A variance occurs when actual costs differ from standard costs.
Variances are expressed in total birr amounts and separated into specific classifications

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to facilitate cost analysis and control. Variance analysis is a systematic process of
identifying variances and reporting them to management.

5.5 VARIANCE ANALYSIS

Variances can be computed for all three of the basic cost elements – direct materials,
direct labor, and manufacturing overhead. The computation for materials and labor is
quite similar. Manufacturing overhead variances require different and somewhat more
complex situations.

5.5.1 DIRECT MATERIAL VARIANCES

Direct materials variances may be divided into:

1. Quantity (usage or efficiency) variance
2. Price variance.

MATERIAL PRICE AND QUANTITY VARIANCES

Material Quantity Variance: The material quantity variance measures the amount of
variance caused by using more or less materials than standard. Direct materials
quantity variance is favorable when the actual quantity used is less than the standard
quantity allowed and is unfavorable when more materials are used than standard. The
formula for the variance can be expressed as follows:
MQV = (AQ – SQ) x SP
Where MQV = direct materials quantity variance
AQ = actual quantity used
SQ = standard quantity allowed
SP = standard unit price

Standard quantity allowed is the amount of direct materials that should have been used
to produce the actual unit output of the period. And it is equal to the predetermined
quantity of direct materials that should go into one finished unit multiplied by the
number of units produced.
Standard quantity of = Actual output x materials allowed
materials allowed Achieved per unit of out put

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Material quantity variance highlights deviations between the quantity of material
actually used and the standard quantity allowed. Thus, it makes sense to compute this
variance at the time the material is used in production.

The production department or cost center that controls the input of direct materials into
the production process is usually assigned the responsibility for this variance.

Material Price Variance: The material price variance measures the amount of
variances from standard that occurs because the price paid for raw materials is different
from the standard cost. If the actual materials cost is greater than standard, the price
variance is unfavorable. A favorable variance occurs if the cost of materials is less than
standard. The equation of the material price variance is
MPV = (AP – SP) x AQ
Where MPV = direct materials price variance
AP = actual price or unit cost
SP = standard price
AQ = actual quantity
The sum of the direct material usage and price variances equals the material cost
variance (MCV).

MCV =MQV + MPV

Or computed alternatively,
MCV = Actual costs – Standard Cost
= (AQ x AP)-(SQ x SP)

EXAMPLE 1. West Tool Company uses a standard cost system and has developed the
following standard:
Direct materials 10 pound per unit @ Br 0.25 per pound Br 2.50
Direct labor: 2 hours per unit @ Br 3.00 per hour 6.00
Variable Overhead: Br 1.50 per direct labor hour 3.00
Standard variable cost per unit of output Br 11.50

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During March, 10,000 units were produced. To manufacture these units, the company
purchased and used 110,000 pounds of direct materials for Br22,000. Direct labor costs
amounted to Br64, 900 for 22,000 hours.
REQUIRED: For materials used in the production, compute
a. Material cost variance
b. Material price variance
c. Material quantity variance
Solution:

a Computation of material cost variance (MCV)

MCV =Actual costs – Standard costs
=(AQ x AP) –(SQ x SP)
=(110,000 x 0.20) – (100,000 x0.25)
=Br 22,000 – Br 25,000
=Br 3,000 F
b Material quantity variances
Standard materials allowed (SQ) = Actual output x Materials allowed per unit
= 10,000 x 10
= 100,000 pounds
MQV = (AQ – SQ) x SP
= (110,000 – 100,000) x 0.25
= Br.2,500 U. The unfavorable variance indicates that direct materials
quantity used was more than the standard quantity allowed.
c Materials price variance
MPV = (AP – SP) x AQ
= (0.20 – 0.25) x 110,000
= Br. 5,500 F. A favorable direct materials price variance resulted because
the actual unit cost was less than the standard unit cost.
The material cost variance (MCV)
MCV = MQV + MPV
= Br. 2,500U + Br. 5,500 F
= Br. 3,000 F
The total material cost variance is also called material flexible budget variance.

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5.5.2 DIRECT LABOR VARIANCES

The computation of direct labor variances is very similar to that of direct materials
variances. However, there are some differences between labor and materials in setting
variances, in the controllability of the variances, and in the timing of the variance
reports. Consequently, labor and materials variances are treated separately.

Direct labor variances may be divided into

i. Efficiency variance.
ii. Rate variance.

LABOR USAGE AND RATE VARIANCES

Labor Efficiency Variance: The labor efficiency (usage) variance identifies the
amount of total labor variance caused by using more or less than the standard quantity.
The term efficiency expresses the idea that the labor is used favorably if fewer hours
than standard are used to make a product. Conversely, labor is used inefficiently if
more labor hours than standard are used. The equation for the direct labor efficiency is
LEV = (AH – SH) x SR
Where LEV = direct labor efficiency variance
AH = actual hours worked
SH = standard hours allowed
SR = standard wage rate.
Standard hours allowed is equal to the number of direct labor hours that should be
worked in the production of one finished unit multiplied by the number of units
production.

The supervisor of the department or cost center in which the work performed is usually
held responsible for direct labor efficiency variances if procedures and conditions remain
constant (for example, if no new procedures or equipment were introduced).

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Labor Rate Variance: It isolates the portion of the total labor variance that is caused
by the actual labor rate’s being different from the expected (standard) labor rate. It is
computed in the same way as the material price variance. The formula is:
LRV = (AR – SR) x AH
Where LRV = direct labor rate variances
AR = actual wage rate
SR = standard wage rate
AH = actual hours worked

As in the case of the direct materials price variances, management has very little
control over rate variances. However, some companies hold the supervisor of the
department or cost center where the work is performed responsible if, for example,
workers with a high rate were used in a particular process and as a result, the greatest
worker loss efficiency was achieved.

Note that the sum of the direct labor usage and rate variances equals the labor cost
variance (LCV).

LCV =LEV + LRV

Or computed alternatively,
LCV = Actual costs – Standard Cost
= (AH x AR)-(SH x SR)
EXAMPLE 2. Refer example (1) above and compute the following variances for direct
labor employed in production:
a. Labor cost variance
b. Labor rate variance
c. Labor efficiency variance

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Solution:
a. Computations of labor cost variance
LCV = Actual costs – Standard Cost
= (AH x AR)-(SH x SR)
= (22,000 x 2.95)-(20,000 x 3.00)
=Br 64, 900 – Br 60,000
=Br 4,900 U
b. Labor rate variances
LRV = (AR – SR) x AH
= (2.95 – 3.00) x 22,000
= Br. 1,100 F
c. Labor efficiency variances
SH = Actual output x standard hours allowed per unit of output
= 10,000 x 2
= 20,000 hours
LEV = (AH – SH) x SR
= (22,000 – 20,000) x 3.00
= Br. 6,000 U
Thus, the labor cost variance (LCV) equals
LCV = LRV + LEV
= 1,100 F + 6,000 U
= Br. 4,900 U
The total labor cost variance is also called labor flexible budget variance.

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5.5.3 MANUFACTURING OVERHEAD VARIANCES

Overhead costs include indirect materials, indirect labor and other indirect
manufacturing costs. Cost and management accountants compute different overhead
variances each of which conveys information useful in controlling overhead costs.

Overhead variances may be separately computed for fixed overheads and variable
overheads. As part of this chapter, four separate variances are to be discussed. These
are variable overhead spending, variable overhead efficiency, fixed overhead budget,
and fixed overhead volume variances.

VARIABLE OVERHEAD VARIANCES

Variable Overhead Cost Variance. It is defined as the difference between actual
variable overhead and standard variable overhead for the actual output. Its formula is

Variable Overhead Cost Variance = Actual VOH -Absorbed or recovered VOH

= Actual VOH – (SH x Standard VOH rate)

Where: VOH= Variable overhead

SH= Standard hours allowed for the actual output

Variable Overhead Efficiency Variance. This variance arises due to the difference
between standard hours allowed for actual output and actual hours. The reasons for
this variance are the same which give rise to labor efficiency variance. Its formula is as
follows:

VOH Efficiency Variance = (AH-SH) x Standard variable OH rate

Where: AH = Actual hours

SH= Standard hours allowed for the actual output

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Variable Overhead Spending Variance. This is also known as expenditure or
budget variance. This variance arises due to the difference between standard variable
overhead allowed and actual variable overhead incurred. Its formula is:

VOH Spending Variance = Actual VOH-(AH x Standard variable OH rate)

Note that the variable overhead cost variance equals the total of VOH efficiency and
VOH spending variance.
Variable Overhead Cost Variance= VOH Efficiency Variance +VOH Spending Variance

EXAMPLE 1. The following data are the actual results for Marvelous Company for the
Month of March 2009:
Actual output 9,500 units
Actual variable overhead Br 405, 000
Actual fixed overhead Br 122,000
Actual labor hour 40,500 hours
Standard cost and budget information for Marvelous Company follows:
Budgeted variable overhead Br 360,000
Standard quantity of labor hour 4 hours per unit
Budgeted fixed overhead Br 120,000 per month
Budgeted output 10,000 units
Required: Compute the following variances
a. Variable overhead cost variance
b. Variable overhead efficiency variance
c. Variable overhead spending variance
Solution:
a. Variable overhead cost variance
Variable overhead cost variance
= Actual variable overhead – (SH x Standard VOH rate**)
= Br 405, 000 – (38,000 x 9.00)
=Br 63,000 U

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 **Standard variable overhead rate = Budgeted VOH
Budgeted labor hour
= Br 360,000 =Br 9.00 per LHR
10,000 x4 hrs
b. Variable overhead efficiency variance
Variable overhead efficiency variance = (AH-SH) x Standard VOH rate
= (40,500-38,000) x 9.00
=Br 22,500 U
c. Variable overhead spending variance
Variable overhead spending variance
= Actual variable overhead -(AH x Standard VOH rate)
= Br 405, 000 – (40,500 x 9.00)
=Br 40,500 U
Check: VOH Cost Variance = VOH Efficiency variance + VOH Spending Variance
=Br 22,500 U + Br 40,500 U
=Br 63,000 U

FIXED OVERHEAD VARIANCES

Fixed Overhead Cost Variances. It is the difference between actual fixed overhead
and absorbed overhead. The formula follows
Fixed overhead cost variances
= Actual fixed overhead -Absorbed overhead
= Actual fixed overhead – (SH x Standard fixed OH rate)
Note that SH refers to the standard hours allowed for the actual output

Fixed Overhead Spending Variances. This is also known as expenditure or

budget variance. It arises due to the difference between the budgeted fixed overhead
and actual fixed overhead. Its formula is
Fixed OH Expenditure Variance
= Actual fixed overhead – Budgeted fixed overhead
Fixed Overhead Volume Variance. This variance arises due to the difference
between actual output and standard output. It is defined as that portion of overhead
variance which arises due to the difference between standard cost of overhead

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absorbed by actual production and the standard allowance for that output. In simple
words, this variance is the result of under or over absorption of overheads. Its formula
is
Fixed OH Volume Variance
= Absorbed Overhead – Budgeted Overhead
= (SH – Budgeted hours) x Standard Fixed OH rate
Note that SH refers to the standard hours allowed for the actual output
EXAMPLE 1. Blue Glassware Company has the following standards flexible budget
data:
Standard variable overhead rate Br 6.00 per direct labor hour
Budgeted variable overhead Br 300,000
Budgeted fixed overhead Br 120,000 per month
Budgeted output 25,000 units
The following data are the actual results for Marvelous Company for the Month of
March 2009:
Actual output 22,000 units
Actual variable overhead Br 320, 000
Actual fixed overhead Br 108,000
Actual direct labor hour 48,000 hours
Required:
i. Compute the following variances
a. Variable overhead cost variance
b. Variable overhead efficiency variance
c. Variable overhead spending variance
ii. Compute the following variances
a. Fixed overhead cost variance
b. Fixed overhead budget variance
c. Fixed overhead volume variance
Standard variable overhead rate= Budgeted VOH
Budgeted DL Hours
Budgeted DL Hours = Budgeted VOH = Br 300,000 =50,000 hours
Standard variable overhead rate Br 6.00 per LHR

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 SH per unit of output = Budgeted LHR =50,000 hours = 2 hours per unit
Budgeted output 25,000 units
Standard fixed overhead rate= Budgeted fixed OH = Br 120,000 =Br 2.40 per LHR
Budgeted DL Hours 50,000 hours
Solution:
i. Computations of overhead variances
a. Variable overhead cost variance
Variable overhead cost variance
= Actual variable overhead – (SH x Standard VOH rate**)
= Br 320, 000 – (44,000 x 6.00)
=Br 56,000 U
b. Variable overhead efficiency variance
Variable overhead efficiency variance = (48,000-44,000) x 6.00
=Br 24,000 U
c. Variable overhead spending variance
Variable overhead spending variance
= Actual variable overhead -(AH x Standard VOH rate)
= Br 320, 000 – (48,000 x 6.00)
=Br 32,000 U
Check: VOH Cost Variance = VOH Efficiency variance + VOH Spending Variance
=Br 24,000 U + Br 32,000 U
=Br 56,000 U
ii. Computations of overhead variances
a. Fixed Overhead Cost Variance
= Actual overhead –Absorbed overhead
= Br108, 000 – (SH x Std Fixed OH rate)
=Br 108,000 – (44,000 x 2.40)
=Br 2,400 U
b. Fixed overhead budget variance(FOHBV)
= Actual overhead –Budgeted overhead
= Br108, 000 – Br 120,000
= Br 12,000 F

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c. Fixed overhead volume variance(FOHVV)
= (SH-Budgeted Hrs) x Standard fixed OH rate
= (44,000-50,000) x Br 2.40
= Br 14,400 U
Check :
Fixed OH Cost Variance = Fixed OH Budget variance + Fixed OH Volume Variance
= Br 12,000 F + Br 14,400 U
= Br 2,400 U

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