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Flexible Budgets
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Direct-Cost Variances
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and Management control
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Flexible Budgets and BASIC CONCEPTS

Chapter 7 Direct-Cost Variances
 Variance—difference between an actual and an
Learning Objectives: expected (budgeted) amount.
After studying this chapter, you should be able to:  Management by exception—the practice of focusing
attention on areas not operating as expected
1. Understand static budgets and static-budget variances (budgeted).
2. Examine the concept of a flexible budget and learn how to develop it  Static (master) budget is based on the output planned
3. Calculate flexible-budget variances and sales-volume variances at the star t of the budget period.
4. Explain why standard costs are often used in variance analysis
5. Compute price variances and efficiency variances for direct-cost
categories
6. Understand how managers use variances

BASIC CONCEPTS VARIANCES

 Static-budget variance (Level 0)—the difference  Variances may star t out “at the top” with a Level 0
between the actual result and the corresponding analysis.
static budget amount  This is the highest level of analysis, a super-macro
 Favorable variance (F)—has the effect of increasing view of operating results.
operating income relative to the budget amount  The Level 0 analysis is nothing more than the
 Unfavorable variance (U)—has the effect of decreasing difference between actual and static-budget
operating income relative to the budget amount operating income.

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 VARIANCES LEVEL 1 ANALYSIS, ILLUSTRATED

 Fur ther 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?”

EVALUATION FLEXIBLE BUDGET

 Level 0 tells the user very little other than how  Flexible budget—shifts budgeted revenues and costs
up and down based on actual operating results
much contribution margin was off from budget.
(activities)
 Level 0 answers the question: “How much were we off in
 Represents a blending of actual activities and
total?”
budgeted dollar amounts
 Level 1 gives the user a little more information:  Will allow for preparation of Level 2 and 3 variances
it shows which line-items led to the total Level 0  Answers the question: “Why were we off?”
variance.
 Level 1 answers the question: “Where were we off?”

LEVEL 3 ANALYSIS, ILLUSTRATED

LEVEL 2 ANALYSIS, ILLUSTRATED

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 LEVEL 3 VARIANCES VARIANCE SUMMARY

 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.
 Both direct materials and direct labor have both price
and efficiency variances, and their formulae are the
same.

LEVEL 3 VARIANCES LECTURE EXAMPLE

 Price variance formula: Brabham Enterprises manufactures tires for the Formula I motor
racing circuit. For August 2017, 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 2017 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
 Efficiency variance formula: were $50,000.
Re quired:
1. Prepare a per formance repor t that uses a flexible budget and
a static budget.
2. Comment on the results in requirement 1.

VARIANCES AND JOURNAL ENTRIES STANDARD COSTING

 Each variance may be journalized.  Targets or standards are established for direct
 Each variance has its own account. material and direct labor.
 Favorable variances are credits; unfavorable  The standard costs are recorded in the accounting
variances are debits. system.
 Variance accounts are generally closed into cost of  Actual price and usage amounts are compared to the
goods sold at the end of the period, if immaterial. standard and variances are recorded.

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STANDARD COSTS CAN BE A USEFUL TOOL BENCHMARKING AND VARIANCES

 Price and efficiency variances provide feedback to  Benchmarking is the continuous process of comparing
initiate corrective actions. the levels of per formance in producing products and
 Standards are used to control costs. services against the best levels of per formance in
 Managers use variance analysis to evaluate competing companies.
per formance after decisions are implemented.  Variances can be extended to include comparison to
 Par t of a continuous improvement program. other entities.