CHAPTER FOUR: FLEXIBLE BUDGET AND STANDARD COSTING

Dear students, when you have finished studying this chapter, you should be able to:

 Describe the difference between a static budget and a flexible budget

 . Develop a flexible budget and compute flexible-budget variances and sales-volume variances

 Compute the price and efficiency variances for direct-cost categories

 Explain why standard costs are often used in variance analysis

 Explain similarities and differences in the planning of variable overhead costs and the planning of
fixed overhead costs

 Compute variable overhead spending and efficiency variances

 Explain how the efficiency variance for a variable indirect-cost item differs from the efficiency
variance for a direct-cost item

 Compute the budgeted fixed overhead rate

 Explain two caveats to consider when interpreting the production-volume variance as a measure of
the economic cost of unused capacity

3.1. Introduction

Dear learners in the previous unit you have studied the benefit of budget as a planning tool. Hence,
budgets are planning tools that are usually prepared prior to the start of the period being budgeted.
However, the comparison of the budget to actual results provides valuable information about
performance. Therefore, budgets are both planning tools and performance evaluation tools. In this unit,
therefore the discussion focuses on how budget are used to evaluate feedback and variances aid
managers in their control function. In evaluating performance the budgeted performance are compared
with actual operational results and the resulting variance will be examined so as to identify the causes
for variance on the bases of which performance can be rewarded for favorable variance or corrective
actions will be taken to avoid unfavorable variance on the coming operational periods.

The unit highlights the importance of variance analysis and show how the budget initially prepared at
planning stage creates problem while comparing actual results with the budget. In this unit you are also
introduced with the advantage of flexible budget over the static budget, steps in the preparation of
flexible budget and evaluating performance using flexible budget.
3.2. Standard Cost Systems

3.2.1. Meaning of Standard Costing

Standard costs are predetermined costs that are usually expressed on per unit basis. In other word,
standard cost is a predetermined calculation of how much costs should be incurred under specified
working condition. It is built up from an assessment of the value of direct material, direct labor and
overhead items.

3.2.2. Why Standard Cost Systems Are Used

A standard cost system has three basic functions: collecting the actual costs of a manufacturing
operation, determining the achievement of that manufacturing operation, and evaluating performance
through the reporting of variances from standard. These basic functions result in six distinct benefits of
standard cost systems.

Clerical Efficiency
A company using standard costs usually discovers that less clerical time and effort are required than in
an actual cost system. In an actual cost system, the accountant must continuously recalculate changing
actual unit costs. In a standard cost system, unit costs are held constant for some period. Costs can be
assigned to inventory and cost of goods sold accounts at predetermined amounts per unit regardless of
actual conditions.

Motivation
Standards are a way to communicate management’s expectations to workers. When standards are
achievable and when workers are informed of rewards for standards attainment, those workers are likely
to be motivated to strive for accomplishment. The standards used must require a reasonable amount of
effort on the workers’ part.
Planning
Planning generally requires estimates about the future. Managers can use current standards to estimate
future quantities and costs. These estimates should help in the determination of purchasing needs for
material, staffing needs for labor, and capacity needs related to overhead that, in turn, will aid in
planning for company cash flows. In addition, budget preparation is simplified because a standard is, in
fact, a budget for one unit of product or service. Standards are also used to provide the cost basis needed
to analyze relationships among costs, sales volume, and profit levels of the organization.
Controlling
The control process begins with the establishment of standards that provide a basis against which actual
costs can be measured and variances calculated. Variance analysis is the process of categorizing the
nature (favorable or unfavorable) of the differences between actual and standard costs and seeking
explanations for those differences. A well-designed variance analysis system captures variances as early
as possible, subject to cost-benefit assessments. The system should help managers determine who or
what is responsible for each variance and who is best able to explain it. An early measurement and
reporting system allows managers to monitor operations, take corrective action if necessary, evaluate
performance, and motivate workers to achieve standard production.

Decision Making
Standard cost information facilitates decision making. For example, managers can compare a standard
cost with a quoted price to determine whether an item should be manufactured in-house or instead be
purchased. Use of actual cost information in such a decision could be inappropriate because the actual
cost may fluctuate from period to period. Also, in making a decision on a special price offering to
purchasers, managers can use standard product cost to determine the lower limit of the price to offer. In
a similar manner, if a company is bidding on contracts, it must have some idea of estimated product
costs. Bidding too low and receiving the contract could cause substantial operating income (and,
possibly, cash flow) problems; bidding too high might be uncompetitive and cause the contract to be
awarded to another company.

Performance Evaluation
When top management receives summary variance reports highlighting the operating performance of
subordinate managers, these reports are analyzed for both positive and negative information. Top
management needs to know when costs were and were not controlled and by which managers. Such
information allows top management to provide essential feedback to subordinates, investigate areas of
concern, and make performance evaluations about who needs additional supervision, who should be
replaced, and who should be promoted. For proper performance evaluations to be made, the
responsibility for variances must be traced to specific managers.

3.2.3. Budgetary Control vs. Standard Costing

Budgetary control and standard costing are comparable system of cost accounting in that they are both
predetermined of forward – looking. The common objective is of controlling business operations by
establishing predetermined targets. However, there are a few differences between these two systems are
which given below:
Budgetary control system Standard costing system
1. Budgetary control is related to all types 1. Standard costing is related to production
of items of revenue and expenditure, and production costs. Hence, it is more
whether they belong to the product or rigorous and intensive.
not, i.e. to all types of business 2. Standard is established on the basis of
activities. Hence, it is more extensive. technical estimates. It is the projection
2. Budget is based on past experience and of accounts.
in most cases a projection of financial 3. Standard are very rigid and ‘ought to be’
accounts. estimates. They fix targets.
3. Budgets are comparatively less rigid 4. Standard costing system cannot operate
and
well without a budgetary control
‘should be’ estimates. They fix limits.
system. Also, it is not possible to
4. Budgetary control can be operated
operate the system in parts
without a standard costing system. It
5. Variance analysis is a subject of special
can be adopted in part.
study of standard costing.
5. The study of variances is not a subject
of special study as in the case of
standard costing

3.2.4. Advantages and Limitations of Standard Costing

Advantages of standard costing

1. The weakness of the traditional costing system can be estimated by compiling standard costs
more carefully.
2. Standard costs can be used as a yardstick against which actual costs can be compared. It is an
effective tool for planning production costs. Hence, cost control is greatly facilitated.
3. Variance analysis helps management to have regular as well as better checks over costs incurred.
It makes the application of the principle of management by exception more easy. That is, the
management can concentrate its attention on variances only, leaving the other aspects of cost
control to be taken care of at the lower level.
4. It is a valuable guide to management in the formulation of production and price policies in
advance with certainty. It also assists management in the areas of profit – planning, product –
pricing, and inventory pricing, etc.
 5. Standard costing makes the reporting of operating data more meaningful and also fast. This
makes the interpretation of management reports easy.
6. As the emphasis of the standard costing system is more on cost variations, it makes the entire
organization cost conscious. It makes the employees recognize the importance of efficient
operations so that costs can be reduced by joint efforts.
7. Labor, materials and machines can be effectively used, and economies can be affected in addition
to increase productivity. Standards may also be used as the basis for introducing incentive
schemes.

Limitations of standard costing

1. Setting of standards is a very difficult task. It requires a lot of scientific studies such as time –
study, motion study, etc., and therefore it is very costly. Small firms may find it very difficult to
operate such a system.
2. Standards are very rigid estimates and once set, are not changed for a considerable time. This
makes the standards highly unrealistic in certain industries which face fluctuations in prices of
products due to frequent changes.
3. The utility of variance analysis depends much more on the standard set. While a loosely set
standard may be ridicule the standards which are set very high may create frustration in the
minds of the workers. At the same time setting of correct standards is also, it is difficult to apply
this system when production takes more than one accounting period.

3.2.5. DEVELOPMENT OF A STANDARD COST SYSTEM

Although standard cost systems were initiated by manufacturing companies, these systems can also be
used by service and not-for-profit organizations. In a standard cost system, both standard and actual
costs are recorded in the accounting records. This dual recording provides an essential element of cost
control: having norms against which actual operations can be compared. Standard cost systems make
use of standard costs, which are the budgeted costs to manufacture a single unit of product or perform a
single service. Developing a standard cost involves judgment and practicality in identifying the material
and labor types, quantities, and prices as well as understanding the kinds and behaviors of organizational
overhead.

A primary objective in manufacturing a product is to minimize unit cost while achieving certain quality
specifications. Almost all products can be manufactured with a variety of inputs that would generate the
same basic output and output quality. The input choices that are made affect the standards that are set.
Some possible input resource combinations are not necessarily practical or efficient.
Once management has established the desired output quality and determined the input resources needed
to achieve that quality at a reasonable cost, quantity and price standards can be developed. Experts from
cost accounting, industrial engineering, personnel, data processing, purchasing, and management are
assembled to develop standards. To ensure credibility of the standards and to motivate people to operate
as close to the standards as possible, involvement of managers and workers whose performance will be
compared to the standards is vital.

Material Standards
The first step in developing material standards is to identify and list the specific direct materials used to
manufacture the product. This list is often available on the product specification documents prepared by
the engineering department prior to initial production. In the absence of such documentation, material
specifications can be determined by observing the production area, querying of production personnel,
inspecting material requisitions, and reviewing the cost accounts related to the product. Three things
must be known about the material inputs: types of inputs, quantity of inputs used, and quality of inputs
used.
In making quality decisions, managers should seek the advice of materials experts, engineers, cost
accountants, marketing personnel, and suppliers. In most cases, as the material grade rises, so does cost;
decisions about material inputs usually attempt to balance the relationships of cost, quality, and
projected selling prices with company objectives. The resulting trade-offs affect material mix, material
yield, finished product quality and quantity, overall product cost, and product salability. Thus, quantity
and cost estimates become direct functions of quality decisions.

Given the quality selected for each component, physical quantity estimates of weight, size, volume, or
some other measure can be made. These estimates can be based on results of engineering tests, opinions
of managers and workers using the material, past material requisitions, and review of the cost accounts.
Specifications for materials, including quality and quantity, are compiled on a bill of materials. Even
companies without formal standard cost systems develop bills of materials for products simply as guides
for production activity. When converting quantities on the bill of materials into costs, allowances are
often made for normal waste of components. After the standard quantities are developed, prices for
each component must be determined. Prices should reflect desired quality, quantity discounts
allowed, and freight and receiving costs. Although not always able to control prices, purchasing agents
can influence prices. These individuals are aware of alternative suppliers and attempt to choose suppliers
providing the most appropriate material in the most reasonable time at the most reasonable cost. The
purchasing agent also is most likely to have expertise about the company’s purchasing habits.
Incorporating this information in price standards should allow a more thorough analysis by the
purchasing agent at a later time as to the causes of any significant differences between actual and
standard prices.
When all quantity and price information is available, component quantities are multiplied by unit prices
to obtain the total cost of each component. (Remember, the price paid for the material becomes the cost
of the material.) These totals are summed to determine the total standard material cost of one unit of
product.

Labor Standards
Development of labor standards requires the same basic procedures as those used for material. Each
production operation performed by either workers (such as bending, reaching, lifting, moving material,
and packing) or machinery (such as drilling, cooking, and attaching parts) should be identified. In
specifying operations and movements, activities such as cleanup, setup, and rework are considered. All
unnecessary movements by workers and of material should be disregarded when time standards are set.
To develop usable standards, quantitative information for each production operation must be obtained.
Time and motion studies may be performed by the company; alternatively, times developed from
industrial engineering studies for various movements can be used. A third way to set a time standard is
to use the average time needed to manufacture a product during the past year. Such information can
be calculated from employees’ past time sheets. A problem with this method is that historical data
may include inefficiencies. To compensate, management and supervisory personnel normally make
subjective adjustments to the available data.

After all labor tasks are analyzed, an operations flow document can be prepared that lists all operations
necessary to make one unit of product (or perform a specific service). When products are manufactured
individually, the operations flow document shows the time necessary to produce one unit. In a flow
process that produces goods in batches; individual times cannot be specified accurately.

Labor rate standards should reflect the employee wages and the related employer costs for fringe
benefits, FICA (Social Security), and unemployment taxes. In the simplest situation, all departmental
personnel would be paid the same wage rate as, for example, when wages are job specific or tied to a
labor contract. If employees performing the same or similar tasks are paid different wage rates, a
weighted average rate (total wage cost per hour divided by the number of workers) must be computed
and used as the standard. Differing rates could be caused by employment length or skill level.

Overhead Standards
To provide the most appropriate costing information, overhead should be assigned to separate cost pools
based on the cost drivers, and allocations to products should be made using different activity drivers.
After the bill of materials, operations flow document, and predetermined overhead rates per activity
measure have been developed, a standard cost card is prepared. This document summarizes the standard
quantities and costs needed to complete one product or service unit.

Data from the standard cost card are then used to assign costs to inventory accounts. Both actual and
standard costs are recorded in a standard cost system, although it is the standard (rather than actual) costs
of production that are debited to Work in Process Inventory. Any difference between an actual and a
standard cost is called a variance.

3.2.6. Considerations in Establishing Standards

When standards are established, appropriateness and attainability should be considered.
Appropriateness, in relation to a standard, refers to the basis on which the standards are developed and
how long they will be expected to last. Attainability refers to management’s belief about the degree of
difficulty or rigor that should be incurred in achieving the standard.

Appropriateness
Although standards are developed from past and current information, they should reflect relevant
technical and environmental factors expected during the time in which the standards are to be applied.
Consideration should be given to factors such as material quality, normal material ordering quantities,
expected employee wage rates, degree of plant automation, facility layout, and mix of employee skills.
Management should not think that, once standards are set, they will remain useful forever. Current
operating performance is not comparable to out-of-date standards. Standards must evolve over the
organization’s life to reflect its changing methods and processes. Out-of-date standards produce
variances that do not provide logical bases for planning, controlling, decision making, or evaluating
performance.

Attainability
Standards provide a target level of performance and can be set at various levels of rigor. The level of
rigor affects motivation, and one reason for using standards is to motivate employees. Standards can be
classified as expected, practical, and ideal. Depending on the type of standard in effect, the acceptable
ranges used to apply the management by exception principle will differ. This difference is especially
notable on the unfavorable side.
Self test 3.1.
1. Differentiate between standards and Budgets
2. Distinguish between standard input, standard price and standard cost.
3.3. Classification of Budgets

3.3.1. Fixed or Static Budget

The static budget is the budget that is based on this projected level of output, prior to the start of the
period. In other words, the static budget is the “original” budget. The static budget variance is the
difference between any line-item in this original budget and the corresponding line-item from the
statement of actual results. Often, the line-item of most interest is the “bottom line”: total cost of
production for the factory and other cost centers; net income for profit centers.

Static budget is a budget that is based on one level of activity.

Evaluating performance based upon the master budget which fixed and prepared at s ingle level of
activity may not provide accurate picture of performance. This because usually the planned and actual
output or activities levels may not be equal, as a result the comparison is performed at two different
level of activity which hides the variance attribute to the actual performance units as well as overall
organization. For example, if a company budgeted to produce and sell 12,000 units, but the actual
performance showed only
10,000 units, the comparison of revenue, cost and profit at the budget and actual level of output do
revels only the variance resulted from the difference in the level of output. Therefore unless the analysis
is re done by adjusting the budgeted level of output towards the actual units produced and sold, the
variance is not helpful to the management as performance evaluation tool.
Static Budget Variance [SBV] is the difference between an actual result and the
corresponding budgeted amount in a static budget.

3.3.2. Flexible Budget

The flexible budget is a performance evaluation tool. It cannot be prepared before the end of the period.
A flexible budget adjusts the static budget for the actual level of output so as to avoid the inherent
limitation of using static budget for performance evaluation. The flexible budget asks the question: “If I
had known at the beginning of the period what my output volume (units produced or units sold) would
be, what would my budget have looked like?” The motivation for the flexible budget is to compare
apples to apples. If the factory actually produced 10,000 units, then management should compare actual
factory costs for 10,000 units to what the factory should have spent to make 10,000 units, not to what the
factory should have spent to make 9,000 units or 12,000 units or any other production level.

3.4. Variance Analysis

The main advantage of the standard costing system is variance analysis. The principle of “management
by exception” is practiced easily with the help of variances. Variance may be defined as the difference
between standard and actual for each element of cost and sometimes for sales. And ‘variance analyses’
may be defined as the process of analyzing variance by sub –dividing the total variance in such a way
that management can assign responsibility for off –standard performance. When the actual results are
better than expected, a ‘favorable’ variance arises; where they are not up to the standard, an ‘adverse
variance’ occurs.

Variances help to fix the responsibilities so that management can ascertain the person responsible for the
poor results. For example, an adverse material usage variance would indicate that excess material cost
was due to inefficient use of materials. This would enable management to fix the responsibility on the
supervisor in charge of a particular operation in which the inefficiency occurred. It may be discovered
that the variance was caused by (say) inefficient handling, purchase of poor quality materials or
employment of trainees. The important point is that the reason for the variance must be found, explained
and wherever necessary, corrective measures taken.

Self test 3.2.

1. Explain the differences between static budget and flexible budget

2. Define the term variance

3.4.1. Flexible and static budget variances

The flexible budget variance is the difference between any line-item in the flexible budget and the
corresponding line-item from the statement of actual results.
To have a better understanding of causes for variance managers usually require variance calculated at
different level. Variance according to the degree of detailed feedback on performance can be classified
as:
 Level 0 variance analysis
 Level 1 variance analysis
 Level 2 variance analysis
 Level 3 variance analysis
 Level 4 variance analysis

In this unit the focus is on level 0, 1, and 2 variances, and the reaming will be discussed in length on the
next unit.

Now let see the preparation of flexible budget as well as analysis of variance using the following:
Illustration 3.1: Kombolcha Garment Co. manufactures and sells a jacket. Sales are made to
distributors who sell to independent clothing stores Kombolcha Garment’s only costs are
manufacturing costs. All units manufactured in April 2003 are sold in April 2003. There is no
beginning or ending inventory. Kombolcha Garment has variable cost categories. The budgeted data for
April 2003 are:
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 Cost category Variable cost / jacket.
DM costs………………………………… Br. 60
DL costs…………………………………. 16
Variable MOH costs…………………… 12
Total variable costs ……………… Br. 88

The number of units manufactured is the cost driver for all variable-manufacturing costs. The relevant
range for the cost driver is from 0 to 12,000 jackets. Budgeted manufacturing fixed costs are Br. 276,000
for production between 0 & 12,000 jackets. Budgeted selling price is Br.120/jacket. The static budget for
April 2003 is based on selling 12,000 jackets.
The actual data for April 2003 are as follows:
Units sold ………………… 10,000 jackets
Revenues …………………. Br. 1,250,000
Variable costs:
DM …………………….. 621,600
DL……………………… 198,000
Variable MOH……….. 130,500
Fixed costs …………….. 285,000

1. Level 0 or Static Budget Variance for operating income

Level zero variance analysis the least detail analysis which simply compares the operating income at
static budget income statement with the operating income at the actual income statement. The level zero
variance for Kombolcha Garment from the above given data is determined as,
Actual operating income………………… Br. 14,900
Budgeted operating income……………… 108,000
SBV for operating income………………. Br. 93,100 U

The analysis revealed unfavorable variance as the actual operating income is lower than the budgeted
operating income by Birr 93,100. The result here couldn’t provide the management useful information
as it couldn’t show the contribution revenue and each cost element to operating income variance.
2. Static Budget Variance (SBV)
Level one variance can offer management a better insight about their organizational performance than
level zero analysis. At this level, operating income variance will be decomposed into revenue and cost
component as a result the management will identify the responsibility center that demands attention.

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Static Budget Variance
Actual Static Budget Static Budget
Results (1) Variance(SBV) Result (3)
Items (2) = (1) – (3)
Unit sales 10,000 2,000U 12,000 .

Revenues Br.1,250,000 Br. 190,000U 1,440,000

Variable costs:

DM 621,600 98,400F 720,000

DL 198,000 6,000U 192,000
MOH 130,500 13,500F 144,000

Total variable 950,100 105,900F 1,056,000

costs
Contribution 299,900 84,100U 384,000
Margin
Fixed Costs 285,000 9,000U 276,000

Br. 14,900 Br. 93,100U Br. 108,000

Operating Income

Br. 93,100U SBV

The static budget variance shows an unfavorable variance for revenue, fixed costs whereas favorable
variance of total variable cost. These variances are due primarily to the fact that the static budget was
built on an output level of 12,000 units, while the company actually made and sold 10,000 units. The
revenue variance might also be due to an average unit sales price that differed from budget. The variable
cost variances might also be due to input prices that differed from budget (e.g., the price of fabric), or
input quantities that differed from the per-unit budgeted amounts (e.g., yards of fabric per jackets) that
may be identified at the later stages of the variance analysis.

Level 2-variance analysis [Flexible Budget Variance (FBV) & Sales-Volume Variance (SVV)]

To identify the amount of variance attributed the difference in the level of output as well as to real
performance of the company, at this level the static budget variance will be decomposed into the flexible
budget variance and sales volume variance.
Flexible Budget Variance (FBV) is a better measure of operating performance because they compare
actual revenues to budgeted revenues and actual costs to budgeted costs for the same output level.

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Sales-Volume Variance (SVV) is the difference between the flexible budget amounts and static budget
amounts. It represents the variance caused solely by the difference in the actual output volume and
budgeted quantity of output expected to be produced and sold in the static budget.

To determine the flexible budget variance and sales volume variance, first you need to develop a flexible
budget. The flexible budget, for the example given above is prepared at the end of the period after the
actual output level of 10,000 jackets is known. The flexible budget is that Kombolcha Garment would
have prepared at the start of the budget period had it correctly forecasted the actual level of 10,000
jackets.

In preparing the flexible budget,

(1) The budgeted selling price is the same Br. 120/ jacket.
(2) The budgeted variable costs per unit are the same Br. 88/ jacket.
(3) The budgeted fixed costs are the same Br. 276, 000, are used.

The only difference between the static budget and the flexible budget is that the static budget is prepared
for the planned output level of 12,000 jackets, whereas the flexible budget is based on the actual output
of 10,000jackets.
The following stapes are used to prepare a flexible budget:
Step [Link] the Actual Quantity of Output produced and sold.
10,000jackets.
Step 2. Calculate the flexible budget for revenues based on Budgeted Selling Price and
Actual Quantity of Output.
Flexible B for Revenues = Br. 120 /jacket X 10,000jacket
= Br. 1,200,000
Step 3. Calculate the Flexible Budget for Costs based on Budgeted Variable Costs per
Unit, Actual Quantity of Output and Fixed Costs.
Flexible Budget for Variable Costs:
DM: Br. 60/j X 10,000j Br. 600,000
DL: Br. 16/j X 10,000j 160,000
MOH: Br. 12/j X 10,000j 120,000
FB for TVC Br. 880,000
FB for FC 276,000
FB for Costs Br .
1,156,000
Step 4: Building the flexible budget based on the information from steps 1 and 2, and step 3 results a
flexible budget presented on column 3 of the following table.
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After the flexible budget is developed it is possible to determine the flexible budget variance by
comparing the flexible budget and the actual operational results, and sales volume variance by
comparing the flexible
budget results and the static budget as shown on the following table.
PARTICULARS AR (1) FBV (2) = 1-3 FB(3) SVV (4) SB (5)
Units sold 10000 0 10,000 2,000 12,000
Revenues 1,250,000 50,000 F 1,200,000 240,000 U 1,440,000
Direct material 621,600 21,6000 U 600,0000 120,000 F 720,000
Direct manfg. labor 198,000 38,000 U 160,0000 32,000 F 192,000
Variable manuf. 130,500 10,500 U 120,0000 24,000 F 144,000
Overhead
Total Variable costs 950,100 70,100 U 880,0000 176,000 F 1,056,000
Contribution margin 299,900 20,100 U 320,000 64,000 U 384,000
Fixed costs 285,000 9,0000 U 276,0000 0 276,000
Operating income 14,900 29,100 U 44,0000 64, 0000 U 108,000

From this table, Kombolcha Garment sees that after adjusting for sales volume, revenue was higher
than
would have been expected. The favorable Birr 50,000 variance must be due entirely to an average sales
price that was higher than planned which was Bir125 per jacket compared to the original budget of
Birr120 per jacket.
Materials costs were higher than would have been expected for a sales volume of 2,000 units. This
unfavorable variance is due to higher material prices, or to inefficient utilization of fabric (more waste
than expected), or a combination of these two factors. Labor and overhead were higher than expected,
even after adjusting for the sales volume of 2,000 units. This unfavorable flexible budget variance
implies that either wage rates were higher than planned, or labor was not as efficient as planned, or both.
Similarly, the components of variable overhead were either more expensive than budgeted, or were used
more intensively than budgeted. For example, electric rates might have been higher than planned, or
more electricity was used than planned per unit of output.

The fixed cost variances are identical in this table to the previous table. In other words, the flexible
budget and flexible budget variance provide no additional information about fixed costs beyond what
can be learned from the static budget variance.

[Link].Direct Material and Labor Variances

How are material, labor, and overhead variances calculated? How materials and labor cost variance
computed when there are is only one type (classes) of material (labor) input used in the production?
What about if there are more than one type (classes) of material (labor) input used in the production?
A. Direct material cost variances:

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To completely and meaningfully analyze the flexible budget variance for material, it should be analyzed
in terms of the materials price standard and the materials quantity standard. This level of analysis
resulted

65
in: (i) material price variance that identifies the effect of differences in prices paid for materials.
(ii)Material quantity (usage) variance that identifies the effect of difference in the quantities of materials
used.
i) Material Price Variance(MPV)
A material price variance is the difference between the actual price of material/unit and the standard
price of material per unit multiplied by the actual quantity of material purchased. In other words, the
material price variance(MPV) indicates whether the amount paid for material was below or above the
standard price. Material price variance can be calculated as:

MPV = (SP – AP) AQ

where: SP is the standard price of material per unit

AP is actual price of material per
unit AQ is the actual quantity
of material purchased and consumed

If the actual price is larger than the standard price, this variance is unfavorable (U); if the standards are
larger than the actual; the variance is favorable (F)

ii) Materials Quantity (usage) Variance(MQV)

The material quantity variance(MQV) indicates whether the actual quantity used was below or above
the standard quantity allowed for the actual output. This difference is multiplied by the standard price
per unit of material. i.e. A material quantity (usage) variance is the difference between the actual
quantity of materials used and the standard quantity of materials that should have been used to produce
the actual output, multiplied by the standard price of materials per unit. It can be calculated as:

MQV = (SQ-AQ) x SP

where: SP is the standard price of material per unit

SQ is the actual quantity of material used
for units produced
AQ═ the actual quantity of material used

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If the actual quantity amounts are larger than the standard quantity amounts, this variance is unfavorable
(U); if the standards are larger than the actual; the variance is favorable (F)
Example In August 2001, East Publishing Company’s costs and quantities of paper consumed in
manufacturing its 2002 Executive Planner and Calendar were as follow:
Actual unit purchase price Br 0.16 per page
Standard quantity allowed for good production 195,800 pages
Actual quantity purchased during August 230,000 pages
Actual quantity used in August 200,000 pages
Standard unit price Br 0.15 per page
Required:
a) Calculate the total cost of purchases for August.
b) Compute the material price variance on the bases of purchase
c) Calculate the material quantity variance.
d) Total FBV
Solution:
a) Total cost of purchases for August would be:
Actual unit purchase price (a) -------------------------------- Br 0.16 per page
Actual quantity purchased during August (b) ---------------- 230,000 pages
Total cost (a x b) ------------------------------------ Br.31, 220
b) MPV = (SP – AP) AQ
= (Br 0.15 per page - Br 0.16 per page) 230,000 pages= Br. 2,300 (U)
c) MQV = (SQ-AQ) x SP
= (195,800 pages - 200,000 pages) Br 0.15 per page= Br. 630(U)
d) Total FBV═ Br 2,300U + Br. 630U═ Br.2,930 U
B. Labor cost variances:

Just like we have done for material inputs, we will do the same meaningful analysis for labor inputs.
Hence, the variance investigation to flexible budget variance for labor resulted in: (i) labor rate variance
that identifies the effect of differences in the rates paid to workers, and (ii) labor efficiently or usage
variance that identifies the effect of differences in the quantities of labor used.
i) Labor Rate Variance(LRV)
The labor rate variance(LRV) shows the difference between the actual wages paid to labor for the
period and the standard wages for all hours worked. Thus, Labor rate variance is the difference between
the actual rate of labor per hour and the standard rate of labor per hour, multiplied by the actual hours of
labor worked.

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 LRV= (SR-AR) x AH
Where: SR is standard rate of labor per hour
AR is actual rate of labor per hour, AH is a total actual hour of labor worked

ii) Labor Efficiency Variance (LEV)

A labor efficiency variance is the difference between the actual labor hours worked and the standard
labor hours that should have been worked to produce the actual output, multiplied by the standard rate of
labor per hour. Thus, multiplying the standard labor rate by the difference between the actual minutes
worked and the standard minutes for the production achieved results in the labor efficiency
variance(LEV)

LEV = (SH – AH) x SR

Where: SH is standard hours of labor for the actual unit produced
AH is actual labor hours used for the unit produced
SR is standard rate of labor per hour

Example Sagittarius Corp. has established the following standards for the prime costs of one of its
chief product, dart boards.
Standard Qtystandard Price (Rate)Total Standard cost
Direct material 8.5 pounds Br.1.80/poundBr.15.30
Direct labor 0.25 hour 8.00/hour 2.00
Br.17.30
During May, Sagittarius purchased 160,000 pounds of direct material at a total cost of Br.304, 000. The
total wages for May were Br.42, 000, 90% of which were for DL. Sagittarius manufactured 19,000 dart
boards during May; using 142,500 pounds of direct material & 5,000 direct laborhours.
Required: Compute the following variances for May.
a) Direct material price variances
b) Direct materialusage variance
c) Direct material cost variance
d) Direct labor rate variance
e) Direct labor efficiency variance
f) Direct labor cost variance
Solution
Material Variances
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i). SQ = Standard Quantity ofDirect material for Actual Output would be:
1 dart board = 8.5 poundsDirect material
19,000 dart boards =?
So, SQ = 8.5 pounds Direct material x 19,000 = 161,500 pounds
ii). SP = Standard price of Direct material = Br. 1.80/pounds.
iii). AP = Actual Price of Direct material = Total cost of Direct material purchased
Total units of direct material purchased
= Br. 304,000 = Br.1.90/ pounds
160,000 pounds
iv). AQ=Actual Quantity of Direct material purchased or used = 142,500 pounds
a) MPV= (SP – AP) AQ
= (Br.1.80/pds - Br.1.90/ pds) 142,500 pounds = Br. 14,250(U)
b) MQV = (SQ-AQ) x SP
= (161,500 pounds - 142,500 pounds) Br. 1.80/pounds= Br. 34,200(F)
c) Material cost variance = MPV + MQV
= Br. 14,250 (U) + Br. 34,200 (F) = Br. 19,950 (F)
Labor Variances
i) SR= Standard Rate of DL per hour= Br.8.00/Hr
ii) SH=Standard Hours of DL for Actual Output would be:
0.25Hrs=1dart board
? = 19,000 dart boards
SH = 0.25x19, 000=4,750Hrs
iii) AH=Actual hrs of DL used = 5,000 hrs
iv) AR= 0.9 x 42,000 = 37,800 = Br.7.56/Hr
5,000 5,000
d) LRV= (SR-AR) x AH
= (Br.8.00/Hr - Br.7.56/Hr) 5,000 hrs = Br. 2,200 (F)
e) LEV = (SH – AH) x SR
= (4,750Hrs - 5,000 hrs) Br.8.00/Hr = Br.2, 000(U)
f) labor cost variance = LRV + LEV= Br. 2,200 (F) + Br.2, 000(U) = Br. 200 (F)

[Link].Overhead Cost Variances

In developing overhead application rates, a company must specify an operating level or capacity.
Capacity refers to the level of activity. Alternative activity measures include theoretical, practical,
normal, and expected capacity. Because total variable overhead changes in direct relationship with
changes in activity and fixed overhead per unit changes inversely with changes in activity, a specific
activity level must be chosen to determine budgeted overhead costs.

A flexible budget is a planning document that presents expected overhead costs at different activity
levels. In a flexible budget, all costs are treated as either variable or fixed; thus, mixed costs must be
separated into their variable and fixed elements. The activity levels shown on a flexible budget usually

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cover the contemplated range of activity for the upcoming period. If all activity levels are within the
relevant range,

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costs at each successive level should equal the previous level plus a uniform monetary increment for
each variable cost factor. The increment is equal to variable cost per unit of activity times the quantity
of additional activity.

The use of separate variable and fixed overhead application rates and accounts allows separate price and
usage variances to be computed for each type of overhead.

a. Variable overhead cost variance (VOHV)

This is the difference between standard variable overheads for actual production and the actual variable
overheads.

Symbolically,
VOHV =SC-AC
Where: SC= standard variable overheads for actual production
AC= actual variable overheads

It can be sub –divided intoVariable overhead expenditure variance, and Variable overhead efficiency
variance.

i) VOH expenditure variance is the difference between the standard variable overheads for the
actual hours worked, and the actual variable overheads incurred. The formula for computing it is
as follows:

VOH Exp. Variance = AVOH –SVOH.

Where: AVOH is actual variable overheads incurred
SVOH is standard variable overheads for the actual hours worked,

ii) VOH efficiency variance arises when the actual output produced differs from the standard
output for actual hours worked. It is a measure of extra overhead (for saving) incurred solely
because of the efficiency shown during the actual hours worked. The formula to compute it is as
follows:
VOH efficiency variance = (SHOV for actual hours worked)- (SHOV for actual output)

Example From the following information, calculate VOH cost variances assuming labor hours as
cost driver for variable manufacturing overhead.

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Budget output 5000 units
Budgeted hours 10,000
Budgeted variable overheads Br. 2,000
Actual variable overheads Br. 3,000
Actual output 4,000 units
Actual hours 12,000 hours
Solution
i) VOH cost variance =AVOH –SVOH for actual production
= Br.3, 000 - (4000xBr 0.40*)
= Br...3,000- Br. 1600= Br.1400 (U)
ii) VOH expenditure variance = AVOH –SVOH for actual hours worked
= Br.3000 - (12000x0.20**) =Br. 600 (U)
iii) VOH efficiency variance =SVOH for actualHrs- SVOH for actual output
=Br. 2400 – Br. 1600=Br. 800 (U)
Workings:
*SVOH per unit of output –Br.2000/5000 = Br.0.40 per unit
** SVOH pre hours = Br.2000/10,000 = Br.0.20 per hour

b. Fixed overheads cost varinance (FOHV)

This is the difference between the standard fixed overheads for actual output and actual fixed overheads.
The reasons for the variance are over absorption or under –absorption of overheads for the actual
production the budgeted production may be different form the actual production for the actual overheads
incurred. The major sub –divisions of FOHV are FOH expenditure variance and FOH volume variance.
The formula for FOHV is as follows:
FOHV =AFOH –SFOH
Where: AFOH = actual fixed overheads.
SFOH = standard fixed overheads for actual output

Note that, if the AFOH is less than the SFOH, the variance is favorable (F), and vice versa. This variance
can be classified into two.
i) FOH expenditure variance (FOHEV)
This is the difference between Actual fixed overhead costs and Budgeted fixed overhead
(Symbolically, FOHEV= AFOH –BFOH)
If the actual is greater than the budgeted, this variance is adverse (U), and vice versa

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 ii) FOH volume
Variance (FOHVV)
This is the difference between the budgeted fixed overheads and the standard fixed
overheads absorbed on actual production. The formula is as follows:
FOHVV =BFOH –SFOH on actual production.
If the BFOH is greater than the SFOH on actual production, the variance is adverse (U) and
vice versa.
Example : From the following data calculate FOH cost variance.
Budgeted hours: 10,000 hours; Budgeted output: 5,000 units, Budgeted FOH:
Br.3,000Actual hours:
12,000hours; Actual output:4,800 units; Actual FOH: Br.3,600
Solution:
a. FOHV =AFOH –SFOH on actual output
= Br.3600-(0.60* x4800)
= Br. 3600-Br. 2880=.Br.720 (U)
b. FOHEV=AHOH –BFOH
= Br.3600 – Br.3000=.Br.600 (U)
c. FOHVV =BFOH –SFOH on actual output
= Br.3000-(0.60x4800)
= Br.3000 – 2880 =.Br.120 (U)
Workings:
*SFOH per unit = Br. 3000/5000=
Br.0.60 per unit

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