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Budgeting and Variances
Uses of budgets
Production variances
Agenda
• Discussion of budgeting
• Discussion of variances
– Materials
– Labor
– Overhead
• Demonstration problems
• Thursday’s class
• Group work
Master Budget
• Budget = quantitative expression of a
firm’s strategic plan of action
• Master budget = prepared before the
accounting period begins
– Also static budget
– Standard costs
Preparing the budget
• Project sales
• Plan production activity level
– Sales prediction
– Current finished goods inventory
– Desired ending finished goods inventory
• Plan purchases, employment
• Estimate fixed costs
• Prepare estimated income statements and
balance sheets
Uses of budgets
• Planning
– Operational plans (short-term)
– Capital budgets (long-term)
– Company strategy
• Performance evaluation
– Variances
– Responsibility centers
• Control
Behavioral aspects of budgeting:
• Participative budgeting
– Better information
– Better cooperation
– Budgetary slack
• Dysfunctional responses
– Compulsion to spend all discretionary funds
– Short-run emphasis on budget only
– Questionable actions designed only to balance
the budget
Flexible budget:
• Flexible budget = the master budget you
would have prepared if you had known
before the accounting period started how
much you would actually produce during
the period.
• Flexible budget = “standard cost allowed
for good output achieved”
Flexible budgets and
performance evaluation:
Actual
Activity
AP input
x
AQ output
Flexible
Budget
BP input
x
AQ output
"flexible budget
variance"
Also called
production
variance
Master
Budget
BP input
x
BQ output
"activity
variance"
Variances
• “unfavorable variance” = NI is reduced
from the budgeted expectation
• “favorable variance” = NI is increased from
budgeted expectation
• Note: Do not interpret directly as “bad” or
“good” behavior on the part of
management.
Variances
Actual:
Actual
Costs,
Actual
Production
Activity,
Actual
Input
Usage
Standard
Input:
Budgeted
Costs
Actual
Production
Activity,
Actual
Input
Usage
Price Variance
Flexible
Budget:
Budgeted
Costs, Actual
Production
Activity,
Budgeted
Input Usage
Efficiency
Variance
Master
Budget:
Budgeted
Costs,
Budgeted
Production
Activity,
Budgeted
Input
Usage
Activity
Variance
Variable cost variances
• Direct materials
– price variance: usage price variance
purchase price variance
(actual price - std. price) x actual usage
(actual price - std. price) x actual purchases
– quantity variance: based on usage
(actual usage - std. usage) x std. price
actual usage = total actual materials used
standard usage = std. allowed per unit x actual
units
Variable cost variances
• Direct labor
– rate variance:
(actual price - std. price) x actual usage
– efficiency variance:
(actual usage - std. usage) x std. price
actual usage = total actual labor hrs. used
standard usage = std. allowed per unit x
actual units
Example: Chemical, Inc.
Chemical, Inc., has set up the following standards for
materials and direct labor:
Materials: 10 lbs. @ $3
$30 per batch
Direct labor: .5 hrs. @ $20/hr.
$10 per batch
The number of finished units budgeted for the period
was 10,000. The number of actual batches produced
was 9,810. During the month, purchases amounted to
100,000 lbs. at a total cost of $310,000. The actual price
paid for labor was $21 per hour. Price variances are
isolated upon purchase. Actual inputs used were: 98,073
lbs. of material and 4,900 hours of labor.
Direct material price variances
What might cause a direct material price variance?
Price change in market
Purchase discounts
Transportation costs
Grade of materials
Therefore, purchasing department
Direct material quantity variance
What could cause a direct material efficiency variance?
Defect in material
Inexperienced workers
Poor supervision
Poor scheduling
Therefore, production department
DM variance computations
Direct material purchase price variance:
$310,000 - ($3 x 100,000) = $10,000
U
Or: ($3.10 - $3.00) x 100,000 = $10,000
Direct material quantity variance:
[98,073 - (10 lbs. x 9,810 batches)]x $3 = $81 F
Or: (9.9972 - 10) x 9,810 batches x $3 = $82
DM activity variance
(actual output - budgeted output)
x standard price per unit of direct material
x standard quantity of direct material per unit of output
(9,810 batches - 10,000 batches)
x $3 x 10 lbs. = $5,700
F?????
Direct labor variances
What would cause a direct labor rate variance?
The actual rate = approximately average wage
paid, including fringes
Experience of workers
Union contract
Overtime
Change in fringes
Therefore, human resources or management
Direct labor variances
What would cause a direct labor efficiency variance?
Skill
Motivation
Supervision/scheduling
Quality of materials
Late time
Therefore, production, human resources, purchasing
Labor variance computations
Rate variance:
($21 - $20) x 4,900 hours = $4,900 U
Efficiency variance:
(4,900 hours - (9,810/2)) hours) x $20 = $100 F
Activity variance:
(9,810 batches - 10,000 batches) x $20 x .5 = $1,900 F
Overhead variances
1. By definition, fixed overhead does not vary with the
level of planned production.
Flexible budget FOH = Master budget FOH
2. By definition, fixed overhead is incurred as a lump
sum expenditure and there are no partial input-output
relationships.
Therefore, the “Std. Input” column is undefined.
Overhead variances: FOH
FOH budget variance = Actual FOH - Budgeted FOH
FOH efficiency variance = Is undefined
FOH applied = (Predetermined rate/unit) x actual units
Production volume variance = Applied FOH - Budgeted FOH
Overhead variances: VOH
VOH spending variance = Actual VOH - “Std. Input” col.
VOH efficiency variance = “Std. Input” - Flexible Budget
VOH activity variance = Flexible Budget - Master Budget
Or: VOH applied - Master Budget
Overhead variances
Over- or underapplied overhead =
Actual overhead spending - Overhead applied
Or
The net of all the variances computed
Example: Murray Manufacturers
VOH Rate = $3 per DL hour
FOH Rate = $4 per DL hour
One unit requires 2 hours of labor
Denominator volume is 1,000 units of output
Actual production was only 800 units.
Actual costs were $5,800 for variable overhead and
$8,130 for fixed overhead; 1,590 DL hrs. were worked.
Example: Murray Manufacturers
VOH spending variance =
$5,800 - ($3 x 1,590 hrs.)
$1,030
U
VOH efficiency variance = (1,590 hr. - (2x800)hrs)
x $3 = $30
F
VOH activity variance = (800 units - 1000 units)
x 2 hrs. x $3 = $1,200
F
Example: Murray Manufacturers
FOH budget variance = $8,130 - $8,000 = $130 U
FOH production volume variance =
(800 units x 2 hrs. x $4) - $8,000
= $1,600
U
Example: The Vanguard
Company
The Vanguard Company manufactures one product. Its
standard cost system incorporates flexible budgets and
assigns indirect costs on the basis of standard DL hrs.
At denominator activity, the standard cost per unit is:
Direct materials, 3 lbs. @ $5.00
$15.00
Direct labor, .4 hr. @ $20.00
8.00
Variable indirect costs, .4 hr. @ $6.00
Fixed indirect costs, .4 hr. @ $4.00
Total
2.40
1.60
$27.00
Example: The Vanguard
Company
DM
Actual Standard Total
Price
Eff.
Price
Costs
Var.
Var.
Var.
$134,400 $135,000 $600
$5,600 F $5,000 U
DL
77,900
72,000
5,900
VOH
VOH
21,500
21,600
FOH
15,800
14,400
PVV
---
1,900 U 4,000 U
---
100
1,300
---
1,400
200
$249,600 $243,000 $6,600
$5,200
1,200 U
--
$1,600 U
$10,200 U $1,600 U
Example: The Vanguard
Company
Direct materials were quoted at $5.50 per pound throughout September and October to all suppliers. There was no
purchase-price variance for materials in October; the
price variance shown relates solely to the materials used
during October.
Wage standards were set in accordance with an annual
union contract, but a shortage of workers in the local
areas has resulted in rates higher than standard.
There were no beginning or ending inventories of work
in process.
Example: The Vanguard
Company
1. How many units were produced?
Use the standard cost column.
All the units manufactured cost $243,000
One unit at standard costs $27.00
Units produced = $243,000 / $27.00 = 9,000 units
Example: The Vanguard
Company
2. What were the actual number of direct labor hours
used?
Efficiency variance = (actual hrs./unit - std. hrs./unit)
x actual units x std. price
= [actual DL hrs. - (.4 x 9,000)]
x $20
$4,000 = actual DL hrs. x $20 - $72,000
$76,000 = actual DL hrs. x $20
3,800 = actual DL hrs.
Example: The Vanguard
Company
3. What was the actual wage rate?
Labor price variance = (actual rate - std. rate) x
actual labor hours
$1,900 = (actual wage rate - $20.00) x 3,800 hrs.
$1,900 = actual wage rate x 3,800 hrs - $76,000
$77,900 = actual wage rate x 3,800 hrs
$20.50 = actual wage rate
Example: The Vanguard
Company
4. What was the budget for fixed indirect costs.
FOH budget variance = Budgeted FOH - Actual FOH
$200 = Budgeted FOH - $15,800
Actual FOH < Budgeted FOH
$16,000 = Budgeted FOH
Example: The Vanguard
Company
5. Denominator activity expressed in direct labor hours.
Budgeted FOH
x std.hrs. x actual output  $14,400
Denominato r Volume
Budgeted FOH
x .4 hrs. x 9,000  $14,400
Denominato r Volume
$16,000
x .4 hrs. x 9,000  $14,400
Denominato r Volume
Denominator Volume = 4,000 DL hrs.
Example: The Vanguard
Company
6. How many pounds of direct materials were used?
DM quantity variance = (actual quantity used std. quantity for output) x
standard price
$5,000 = (actual quantity used - (3 lbs. x 9,000) x $5.00
$5,000 = actual quantity used x $5.00 - $135,000
$140,000 = actual quantity used x $5.00
28,000 lbs. = actual quantity used
Thursday
• Review overhead variances
• Compute sales revenue variances
– sales price
– sales activity (measured via contribution margin)
• sales mix
• sales volume
– market size
– market share
• Variance reconciliation
Group exercise
• Use example company: Look at the
numbers and determine what they all mean.
• Compute
– Direct material price, quantity and activity
variances
– Direct labor rate, quantity and activity
variances
– Overhead variances: spending/budget,
efficiency (if applicable), and PVV