Cost and Management Accounting II compiled by Amenut B.

Unit 4 4

Chapter 4
4.1. FLEXIBLE BUDGET AND VARIANCE ANALYSIS
4.2. Budget and Variance analyses
The use of budget as performance evaluation tool focuses on determining the discrepancies between
the planned and actual performance at the end of the operating cycle. Variance is the difference
between an amount on an actual result and the corresponding budgeted amount i.e., the actual
amount of something and the amount it was supposed to be according to the budget. The budgeted
amount is a point of reference from which comparison may be made. The difference between budget and
actual result can be favorable or unfavorable based upon the impact of the discrepancy on the overall
profitability of the firm. If the variance has an increasing effect on the operating income as compared to
the budgeted amount, it is said to be favorable variance. On the other hand, unfavorable or adverse
variance occurs when the variance has a decreasing effect on the operating income relative to the
budgeted amount.

Variances assist managers in their planning and control decisions. It enables to exercise
Management by Exception (MBE), which is the practice of concentrating attention on areas not operating
as expected and giving less attention to areas operating as expected. Managers regularly
pay attention to areas with large variances. Variances are also used in performance evaluation. For
example, Production line managers in a manufacturing company may have quarterly
efficiency incentives linked to achieving a budgeted amount of operating costs.
4.3. Fixed or Static (master) Budget
The static budget is the budget that is based on the 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 single level of
activity may not provide accurate picture of performance. This is 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 12,000units, 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 reveals 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.
4.4. 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

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 Cost and Management Accounting II compiled by Amenut B. Unit 4 4

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 9,000units or 12,000 units or any other production level. 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.
Level of variance analysis:
 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 only.

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
isBr.120/jacket. The static budget for April 2003 is based on selling 12,000 jackets.
The actual data for April 2003 are as follows:

1. Level 0 or Static Budget Variance for operating income

Level zero variance analysis is 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 Bonga Garment from the above given data is determined as,

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 useful information to the
management as it couldn’t show the contribution, revenue and each cost element to operating
income variance.
2. Level 1 Static Budget Variance (SBV)

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 Cost and Management Accounting II compiled by Amenut B. Unit 4 4

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.

The static budget variance shows an unfavorable variance for revenue, and 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.
3. Level 2-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

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 Cost and Management Accounting II compiled by Amenut B. Unit 4 4

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.
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 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 Bonga Garment would have prepared at
the start of the budget period. It correctly forecasted the actual level of 10,000 jackets.
In preparing the flexible budget:
 The budgeted selling price is the same Br. 120/ jacket
 The budgeted variable costs per unit are the same Br. 88/ jacket.
 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 steps are used to prepare a flexible budget:
 Step 1. Identify the Actual Quantity of Output produced and sold. 10,000 jackets.
 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.
1,200,000Step
 Step3. Calculate the Flexible Budget for Costs based on Budgeted Variable Costs per Unit,
Actual Quantity of Output and Fixed Costs.

 Step 4: Building the flexible budget based on the information from steps 1 and 2, and step
3results a flexible budget presented on column 3 of the following table.
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.

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 Cost and Management Accounting II compiled by Amenut B. Unit 4 4

SBV
From this table, Bonga 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 notes 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

Class work 1 (static budget)

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 Cost and Management Accounting II compiled by Amenut B. Unit 4 4

Class work 2
Particulars Flexible budget Actual result Flexible budget variance
Units sold 20,000 20,000
Revenue
DM costs
DL costs
MOH Costs
Total variable costs
Contribution margin
Total fixed costs
Operating income
Hint: Budgeted unit selling price Br. 125, unit direct material cost 60, unit direct labor cost Br. 50,
manufacturing overhead cost 45 and unit fixed cost 13
Hint: Actual unit selling price Br. 120, unit direct material cost 55, unit direct labor cost Br. 40,
manufacturing overhead cost 40 and unit fixed cost 15

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