Flexible Budgets and

Variance Analysis

Chapter 8

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 8-1
With over 28,000 locations, how does McDonald’s maintain cost and
quality control?
It uses standards, budgets and variance analysis
The material standard for a hamburger is the same in every location
Material variances are computed for every ingredient by comparing
what was actually used with what should have been used for the
number of hamburgers sold each day
What are these standards?
It also has nonfinancial standards such as average drive-through
time
Knowing what went wrong and what went right helps managers
plan
 Learning Objective 1

Distinguish between flexible

budgets and master
(static) budgets.
 Static Budgets

A static budget is prepared for only

one level of a given type of activity.

All actual results are compared with the

original budgeted amounts, even if sales
volume is more or less than originally planned.
Master Budget Variance: Sales

The variances of actual results

from the master budget are called
master (static) budget variances.

Actual Budget Variance

$217,000 $279,000 $62,000 U
Master Budget Variance:
Expenses

Actual expenses that exceed

budgeted expenses result in
unfavorable expense variances.

Actual expenses that are less than

budgeted expenses result in
favorable expense variances.
 Objective 2

Use flexible-budget formulas

to construct a flexible budget
based on the volume of sales.
 Flexible Budget

A flexible budget (variable budget) is a

budget that adjusts for changes in sales
volume and other cost-driver activities.
 Flexible Budget Formulas

To develop a flexible budget, managers

determine revenue and cost behavior
(within the relevant range) with
respect to cost drivers.
Objective 3

Prepare an activity-based
flexible budget.
Activity-Based Flexible Budget

An activity-based flexible budget

is based on budgeted costs for
each activity and related cost driver.

Within each activity center, costs

depend on an appropriate cost driver.
 Objective 4

Explain the performance

evaluation relationship
between master (static)
budgets and flexible budgets.
 Evaluation of Financial
Performance

Comparing the
flexible budget
to actual results
accomplishes an
important
performance
evaluation purpose.
 Evaluation of Financial
Performance
Actual results may differ from
the master budget because...

1) sales and other cost-driver activities were

not the same as originally forecasted, or

2) revenue or variable costs per unit of activity and

fixed costs per period were not as expected.
Evaluation of Financial
Performance

Flexible-budget variances

Activity-level variances
 Evaluation of Financial
Performance
Actual Flexible
results budget
at actual for actual Flexible-
activity sales budget
level activity variances

Units 7,000 7,000 –

Sales $217,000 $217,000 –
Variable costs 158,200 152,600 5,670 U
Contribution margin $ 58,730 $ 64,400 $5,670 U
Fixed costs 70,300 70,000 300 U
Operating income $ (11,570) $ (5,600) $5,970 U
 Evaluation of Financial
Performance
Flexible
budget
for actual Sales-
sales Master activity
activity budget variances

Units 7,000 9,000 2,000 U

Sales $217,000 $279,000 $62,000 U
Variable costs 152,600 196,200 43,600 F
Contribution margin $ 64,400 $ 82,800 $18,400 U
Fixed costs 70,000 70,000 –
Operating income $ (5,600) $ 12,800 $18,400 U
Total master budget variances = $11,570 + $12,800 = $24,370
Objective 5

Compute flexible-budget
variances and
sales-activity variances.
Isolating the Causes of Variances

Managers use comparisons among

actual results, master budgets,
and flexible budgets to evaluate
organizational performance.
 Isolating the Causes of Variances

Effectiveness is the degree to which

a goal, objective, or target is met.

Efficiency is the degree to which inputs are

used in relation to a given level of outputs.

Performance may be effective,

efficient, both, or neither.
 Flexible-Budget Variances

Total flexible-budget variance

= Total actual results
– Total flexible-budget planned results

Actual Flexible
results budget
$(11,570) $(5,600)
$5,970 Unfavorable
Flexible-budget variances
 Sales-Activity Variances

Total sales-activity variance

=
Actual sales unit – Master budgeted sales units
×
Budgeted contribution margin per unit
 Sales-Activity Variances

Flexible Master
budget budget

$18,400 Unfavorable
Activity-level variances
(9,000 – 7,000) × $9.20
 Objective 6

Compute and interpret price

and usage variances for inputs
based on cost-driver activity.
Setting Standards

An expected cost is the cost that

is most likely to be attained.

A standard cost is a carefully

developed cost per unit
that should be attained.
 Perfection Standards...

or ideal standards, are expressions of the

most efficient performance possible
under the best conceivable conditions,
using existing specifications and equipment.

No provision is made for waste, spoilage,

machine breakdowns, and the like.
Currently Attainable Standards...

are levels of performance that

managers can achieve by
realistic levels of effort.

They make allowances for normal

defects, spoilage, waste,
and nonproductive time.
 Trade-Offs Among Variances

Improvements in one area could lead to

improvements in others and vice versa.

Likewise, substandard performance

in one area may be balanced by
superior performance in others.
When to Investigate Variances

When should management

investigate a variance?

Many organizations have developed

such rules of thumb as “investigate
all variances exceeding $5,000 or 25%
of expected cost, whichever is lower.”
 Comparison with Prior Periods

Some organizations compare the most

recent budget period’s actual results with
last year’s results for the same period.
 Flexible-Budget Variance in Detail

Standard per unit of output:

Direct Direct
Material Labor
Std. inputs expected 5 pounds ½ hour
Std. price expected $ 2 $16
Std. cost expected $10 $ 8
 Variances from Material and
Labor Standards

Actual results for 7,000 units produced:

Direct material
Direct labor
Pounds purchased
Hours used: 3,750
and used: 36,800
Actual price (rate): $16.40
Price/pound: $1.90
Total actual cost:
Total actual cost:
$61,500
$69,920
 Variances from Material and
Labor Standards
Standard Direct-Materials Cost Allowed:
Units of good output achieved
×
Input allowed per unit of output
×
Standard unit price of input
=
Flexible budget or total
standard cost allowed
 Variances from Material and
Labor Standards

Actual Flexible
cost budget
$69,920 $70,000
$80 Favorable
Direct material flexible-budget variance
 Variances from Material and
Labor Standards
Standard Direct-Labor Cost Allowed:
Units of good output achieved: 7,000
×
Input allowed per unit of output: ½ hour
×
Standard unit price of input: $16/hour
=
Flexible budget or total
standard cost allowed: $56,000
 Variances from Material and
Labor Standards

Actual Flexible
cost budget
$61,500 $56,000
$5,500 Unfavorable
Direct labor flexible-budget variance
Price and Usage Variances

(Actual price – Standard Price)

× Actual quantity

(Actual quantity – Standard quantity)

× Standard price
Price Variance Computations

($1.90 – $2.00) per pound

× 36,800 pounds = $3,680 F

($16.40 – $16.00) per hour

× 3,750 hours = $1,500 U
Usage Variance Computations

[36,800 – (7,000 × 5)] pounds

× $2 per pound = $3,600 U

[3,750 – (7,000 × ½)] hours

× $16 per hour = $4,000 U
 Favorable or Unfavorable
Variance?

To determine whether
a variance is favorable
or unfavorable, use
logic rather than
memorizing a formula.
 Direct Materials Flexible
Budget Variance

Actual AQ × SP Flexible
cost = budget
$69,920 $73,600 $70,000
$3,680 F $3,600 U
Direct material flexible-budget variance
$80 F
 Direct Labor Flexible
Budget Variance

Actual AH × SP Flexible
cost = budget
$61,500 $60,000 $56,000
$1,500 U $4,000 U
Direct labor flexible-budget variance
$5,500 U
Interpretation of Price and Usage
Variances

Price and usage variances are helpful

because they provide feedback
to those responsible for inputs.

Managers should not use these

variances alone for decision
making, control, or evaluation.
 Objective 7

Compute variable overhead

spending and efficiency
variances.
 Variable-Overhead
Efficiency Variance

When actual cost-driver activity differs from

the standard amount allowed for the actual
output achieved, a variable-overhead
efficiency variance will occur.
 Variable-Overhead
Spending Variance

This is the difference between the actual

variable overhead and the amount
of variable overhead budgeted for the
actual level of cost-driver activity.
 Variable Overhead Example

Suppose that Dominion Company’s cost

of supplies, a variable-overhead cost,
is driven by direct labor hours.

The variable-overhead cost rate of

$.60 per unit is equivalent to $1.20
per direct labor hour because each
unit of output requires ½ hour of labor
Variable Overhead Example

Actual variable overhead = $4,700

Variable overhead allowed

= $.60 × 7,000 units = $4,200

$500 unfavorable variance

 Variable Overhead Example

(3,750 act. hours – 3,500 std. hours allowed)

× $1.20 per hour = $300 U

($4,700 – ($1.20 × 3,750 actual hours used)

= $200 U

Do P 8-43
 End of Chapter 8

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 8 - 50