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Flexible Budgets, Variances, and Management Control: I

Flexible Budgets, Variances, and Management Control: I. Session 7. Learning Objectives. Describe the difference between a static budget and a flexible budget Develop a flexible budget and compute flexible-budget variances and sales-volume variances

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Flexible Budgets, Variances, and Management Control: I

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  1. Flexible Budgets, Variances, and Management Control: I Session 7

  2. Learning Objectives • Describe the difference between a static budget and a flexible budget • Develop a flexible budget and compute flexible-budget variances and sales-volume variances • Explain why standard costs are often used in variance analysis • Compute the price and efficiency variances for direct cost categories • Explain why purchasing performance measures should focus on more factors than just price variances

  3. Learning Objective 1 Describe the difference between a static budget and a flexible budget

  4. Static and Flexible Budgets • A static budget is a budget prepared for only one level of activity. • It is based on the level of output planned at the start of the budget period. • The master budget is an example of a static budget. • A flexible budget is developed using budgeted revenues or cost amounts based on the level of output actually achieved in the budget period. • A key difference between a flexible budget and a static budgetis the use of the actual output level in the flexible budget.

  5. Static Budget Assume that Rockville Co. manufactures and sells dress suits. • Budgeted variable costs per suit are as follows: Direct materials cost $ 65 Direct manufacturing labor 26 Variable manufacturing overhead 24Total variable costs $115 • Budgeted selling price is $155 per suit. • Fixed manufacturing costs are expected to be $286,000 within a relevant range between 9,000 and 13,500 suits. • The static budget for year 2001 is based on selling 13,000 suits. What is the static-budget operating income? • Revenues (13,000 × $155) $2,015,000 Variable Expenses (13,000 × $115) - 1,495,000 Fixed Expenses - 286,000Budgeted operating income $ 234,000

  6. Static Budget • Assume that Rockville Co. produced and sold 10,000 suits at $160 each with actual variable costs of $120 per suit and fixed manufacturing costs of $300,000. • What was the actual operating income? • Revenues (10,000 × $160) $1,600,000 Less Expenses: Variable (10,000 × $120) 1,200,000 Fixed 300,000Actual operating income $ 100,000

  7. Static-Budget Variance • A static-budget variance is the difference between an actual result and a budgeted amount in the static budget. • A favorable variance is a variance that increases operating income relative to the budgeted amount. • An unfavorable variance is a variance that decreases operating income relative to the budgeted amount. • Level 0 analysis compares actual operating income with budgeted operating income. • Actual operating income $100,000 Budgeted operating income 234,000Static-budget variance of operating income $134,000 U

  8. Static-Budget Variance • Level 1 analysis provides more detailed information on the operating income static- budget variance. Static Budget Based Variance Analysis (Level 1) in (000) Static Actual Budget ResultsVariance Suits 13 10 3 U Revenue $2,015 $1,600 $415 U Variable costs 1,495 1,200 296 F Contribution margin $ 520 $ 400 $120 U Fixed costs 286 30014 U Operating income $ 234 $ 100 $134 U

  9. Learning Objective 2 Develop a flexible budget and compute flexible-budget variances and sales-volume variances

  10. Steps in Developing Flexible Budgets • Step 1: Determine budgeted selling price, budgeted variable cost per unit, and budgeted fixed cost. • The budgeted selling price is $155, the budgeted variable cost is $115 per suit, and the budgeted fixed cost is $286,000.

  11. Steps in Developing Flexible Budgets • Step 1: Determine budgeted selling price, budgeted variable cost per unit, and budgeted fixed cost. • Step 2: Determine the actual quantity of output. • In the year 2001, 10,000 suits were produced and sold.

  12. Steps in Developing Flexible Budgets • Step 1: Determine budgeted selling price, budgeted variable cost per unit, and budgeted fixed cost. • Step 2: Determine the actual quantity of output. • Step 3: Determine the flexible budget for revenues based on budgeted selling price and actual quantity of output. • $155 × 10,000 = $1,550,000

  13. Steps in Developing Flexible Budgets • Step 1: Determine budgeted selling price, budgeted variable cost per unit, and budgeted fixed cost. • Step 2: Determine the actual quantity of output. • Step 3: Determine the flexible budget for revenues based on budgeted selling price and actual quantity of output. • Step 4: Determine the flexible budget for costs based on budgeted variable costs per output unit, actual quantity of output, and the budgeted fixed costs. • Flexible budget: Variable costs 10,000 × $115 $1,150,000 Fixed costs 286,000 Total costs $1,436,000

  14. Variances • Level 2 analysis provides information on the two components of the static-budget variance. • Flexible-budget variance • Sales-volume variance

  15. Flexible-Budget Variance Flexible-Budget Variance (Level 2) in (000) Flexible Actual BudgetResultsVariance Suits 10 10 0 Revenue $1,550 $1,600 $ 50 F Variable costs 1,150 1,200 50 U Contribution margin $ 400 $ 400 $ 0 U Fixed costs 286 300 14 U Operating income $ 114 $ 100 $ 14 U

  16. Flexible-Budget Variance • The flexible-budget variance pertaining to revenues is often called a selling-price variancebecause it arises solely from differences between the actual selling price and the budgeted selling price: • Selling-price variance = ($160 – $155) x 10,000 = $50,000 F • Actual selling price exceeds the budgeted amount by $5. • What does this tell you? • Suppose Rockville Co had started an advertising campaign that led to the increase in the selling price. • If the campaign had costed more than $50,000 it was unprofitable • If the campaign had costed less than $50,000 it was a profitable one

  17. Sales-Volume Variance • The sales-volume variance is the difference between the static budget for the number of units expected to be sold and the flexible budget for the number of units that were actually sold. • The only difference between the static budget and the flexible budget is the output level upon which the budget is based.

  18. Sales-Volume Variance Sales-Volume Variance (Level 2) in (000) Flexible Static Sales-Volume BudgetBudgetVariance Suits 10 13 3 U Revenue $1,550 $2,015 $465 U Variable costs 1,150 1,495 345 F Contr. margin $ 400 $ 520 $120 U Fixed costs 286286 0 Operating income $ 114 $ 234 $120 U

  19. Sales-Volume Variance Actual quantity sold 10,000 suits: Flexible-budget operating income $114,000 Sales-volume variance $120,000 U Static-budget operating income $234,000

  20. Budget Variances Static-budget variance $134,000 U Level 1 Flexible-budget variance $14,000 U Sales-volume variance $120,000 U Level 2

  21. Flexible budget variance Zero Sales volume variance Remark • The above split-up has been derived by introducing the flexible budget as an intermediate step: static budget variance (level 1) = budgeted # of pieces * budgeted $ per piece- actual # of pieces * budgeted $ per piece+ actual # of pieces * budgeted $ per piece- actual # of pieces * actual $ per piece • Formally, a similar split-up could have been derived by developing a „flexible budget 2“ as follows static budget variance (level 1) = budgeted # of pieces * budgeted $ per piece- budgeted # of pieces * actual $ per piece+ budgeted # of pieces * actual $ per piece- actual # of pieces * actual $ per piece

  22. Learning Objective 3 Use standard costs in variance analysis

  23. Sources of Information • The two main sources of information about budgeted input prices and budgeted input quantities are: • Actual input data from past periods • Standards developed

  24. Standards • A standard inputis a carefully predetermined quantity of inputs (such as pounds of materials or manufacturing labor-hours) required for one unit of output. • A standard costis a carefully predetermined cost that is based on a norm of efficiency. • Standard costs can relate to units of inputs or units of outputs.

  25. Standards Rockville’s budgeted cost for each variable direct cost item is computed as follows: × Standard input allowed for one output unit Standard cost per input unit

  26. Standards • The following standards were developed for Rockville Company: • Direct materials: • 4.00 square yards of cloth input allowed per output unit (suit) purchased at $16.25 standard cost per square yard. • Standard cost per output unit manufactured = 4.00 × $16.25 = $65.00 • Direct manufacturing labor: • 2.00 manufacturing labor-hours of input allowed per output unit (suit) manufactured at $13.00 standard cost per hour. • Standard cost per output unit manufactured = 2.00 × $13.00 = $26.00

  27. Learning Objective 4 Compute the price and efficiency variances for direct cost categories

  28. Price and Efficiency Variances • Level 3 analysis separates the flexible-budget variance into price and efficiency variances. The following relates to Rockville Company: • Direct materials purchased and used: 42,500 square yards • Actual price paid per yard: $15.95 • Actual direct manufacturing labor hours: 21,500 • Actual price paid per hour: $12.90 What is the actual cost of direct materials? • 42,500 × $15.95 = $677,875 What is the actual cost of direct manufacturing labor? • 21,500 × $12.90 = $277,350

  29. Price Variances • A price varianceis the difference between the actual price and the budgeted price of inputs multiplied by the actual quantity of inputs. • Input-price variance • Rate variance • Price variance = (Actual price of inputs – Budgeted price of inputs) × Actual quantity of inputs • What is the price variance for direct materials? • ($15.95 – $16.25) × 42,500 = $12,750 F What is the price variance for direct manufacturing labor? • ($12.90 – $13.00) × 21,500 = $2,150 F

  30. Price Variances Actual Quantity Actual Quantity of Inputs at of Inputs at Actual Price Budgeted Price 42,500 × $15.95 42,500 × $16.25 = $677,875 = $690,625 $12,750 F Materials price variance

  31. Price Variances Actual Quantity Actual Quantity of Inputs at of Inputs at Actual PriceBudgeted Price 21,500 × $12.90 21,500 × $13.00 = $277,350 = $279,500 $2,150 F Labor price variance

  32. Price Variances • What may be some of the possible causes for Rockville’s favorable price variances? • Rockville’s purchasing manager negotiated more skillfully than was planned. • Labor prices were set without careful analysis of the market.

  33. Efficiency Variances • The efficiency varianceis the difference between the actual and budgeted quantity of inputs used multiplied by the budgeted price of input. • Efficiency variance = (Actual quantity of inputs used – Budgeted quantity of inputs allowed for actual output) × Budgeted price of inputs What is the efficiency variance for direct materials? • (42,500 – 40,000) × $16.25 = $40,625 U What is the efficiency variance for direct manufacturing labor? • (21,500 – 20,000) × $13.00 = $19,500 U

  34. Efficiency Variances Actual Quantity Budgeted Quantity of Inputs at Allowed for Actual Budgeted PriceOutputs at Budgeted Price 42,500 × $16.25 40,000 × $16.25 = $690,625 = $650,000 $40,625 U Materials efficiency variance

  35. Efficiency Variances Actual Quantity Budgeted Quantity of Inputs at Allowed for Actual Budgeted Price Outputs at Budgeted Price 21,500 × $13.00 20,000 × $13.00 = $279,500 = $260,000 $19,500 U Labor efficiency variance

  36. Efficiency Variances • What may be some of the causes for Rockville’s unfavorable efficiency variances? • Rockville’s purchasing manager received lower quality of materials. • The personnel manager hired underskilled workers. • The maintenance department did not properly maintain machines.

  37. Price and Efficiency Variances • What is the flexible-budget variance for direct materials? Materials-price variance $12,750 F + Materials-efficiency variance $40,625 U = $27,875 U quantity of input Efficiency variance:$40,625U 42.5 40 price variance: $12,750F Priceof input 15.95 16.25

  38. Efficiency variance:$19,500U Flexible budget variance: $2,150F Price and Efficiency Variances Direct labor • What is the flexible-budget variance for direct manufacturing labor? Labor-price variance $2,150 F + Labor- efficiency variance $19,500 U = $17,350 U Quantity of input 21,5 20 12.9 13 Price of input

  39. Variance Analysis Level 1 Static-budget variance Materials $167,125 F Labor 60,650 F Total $227,775 F Level 2 Flexible-budget variance Materials $27,875 U Labor 17,350 U Total $45,225 U Sales-volume variance Materials $195,000 F Labor 78,000 F Total $273,000 F

  40. Variance Analysis Flexible-budget variance Materials $27,875 U Labor 17,350 U Total $45,225 U Level 2 Level 3 Price variance Materials $12,750 F Labor 2,150 F Total $14,900 F Efficiency variance Materials $40,625 U Labor 19,500 U Total $60,125 U

  41. Learning Objective 5 Explain why purchasing performance measures should focus on more factors than just price variances

  42. Performance Measurement Using Variances • A key use of variance analysis is in performance evaluation. • Two attributes of performance are commonly measured: • Effectiveness • Efficiency • Effectiveness is the degree to which a predetermined objective or target is met. • Efficiency is the relative amount of inputs used to achieve a given level of output. • Variances should not solely be used to evaluate performance.

  43. Performance Measurement Using Variances • If any single performance measure, such as a labor efficiency variance, receives excessive emphasis, managers tend to make decisions that maximize their own reported performance in terms of that single performance measure • “what you measure is what you get”.

  44. Multiple Causes of Variances • Often the causes of variances are interrelated. • A favorable price variance might be due to lower quality materials. • It is best to always consider possible interdependencies among variances and to not interpret variances in isolation of each other... • Almost all organizations use a combination of financial and nonfinancial performance measures rather than relying exclusively on either type. • Control may be exercised by observation of workers.

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