Chapter 8 Flexible Budgets, standard costs, and variance analysis Notes PDF

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Paige O'Shaughnessy, Principles of Managerial Accounting ...

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Chapter 8 Flexible Budgets, Standard Costs, and Variance Analysis The Variance Analysis Cycle  The variance analysis cycle is used by companies to compare budgets to actual results for the purposes of solving problems and evaluating performance. Emphasis should be on highlighting problems, finding their root causes, and then taking corrective action, rather than seeking to assign blame.  Managers use the concept of management by exception in conjunction with the variance analysis cycle. Management by exception is a management system that compares actual results to a budget so that significant deviations can be flagged as exceptions and investigated further. Enables managers to focus on the most important variances while bypassing trivial discrepancies between the budget and actual results. Flexible Budgets  Characteristics of a Flexible Budget o A flexible budget is an estimate of what revenues and costs should have been, given the actual level of activity for the period.  Take into account how changes in activity affect costs.  When used in performance evaluation, actual costs are compared to what the costs should have been for the actual level of activity during the period rather than the static planning budget.  If adjustments for the level of activity are not made, it is very difficult to interpret discrepancies between budgeted and actual costs.  Deficiencies of the Static Planning Budget (key term here is Static) o Prepared for a single planned level of activity making performance valuations very difficult when the actual level of activity differs for the planned level. o An increase in the sales level results in an increase in revenue (favorable variance) and also an increase in expenses which we would expect, but the variance would be considered unfavorable since the expenses are higher than we had budgeted. (Remember our variable costs!)  How a flexible budget Works o Shows what the revenues and costs should have been given the actual level of activity. o For each budget item we would use our formula Y = a + bX. Note that some items may be made up of fixed and variable costs, or only one type of cost, but the formula still holds. Flexible Budget Variances  The flexible budget gives us what should have happened at the actual level of activity  Compare what should have happened with what actually happened  Revenue Variances o A revenue variance is the difference between what the total revenue should have been, given the actual level of activity for the period, and the actual total revenue.  Actual greater than budgeted then favorable variance ( AR > BR – F)  Actual less than budgeted then unfavorable variance (AR < BR – U)

o The revenue variance is favorable if the average selling price is greater than expected; it is unfavorable if the average selling price is less than expected.  Reasons: change in selling price, a different mix of products sold, a change in the amount of discounts given, poor accounting controls, etc.  Spending variances o A spending variance is the difference between how much a cost should have been, given the actual level of activity, and the actual amount of the cost.  Actual greater than budgeted then unfavorable variance ( AS > BS – F)  Actual less than budgeted then favorable variance (AS < BS – U) o The spending variance is favorable if the actual cost is less than what the cost should have been; it is unfavorable if the actual cost is greater than what the cost should have been.  Reason: paying a higher price for inputs than should have been paid, using too many inputs for the actual level of activity, a change in technology, etc. Flexible Budgets with Multiple Cost Drivers  A cost driver is a factor, such as machine-hours, beds occupied, computer time, or flighthours, which causes overhead costs.  Using multiple cost drivers is more accurate than the cost formulas based on just one cost driver and the variances will be more accurate.  Using multiple cost drivers with improve the budgeting and performance analysis process.  A company can also decompose its spending variances into two parts – a part that measures how well resources were used and a part that measures how well the acquisition prices of those resources were controlled. Standard Costs – Setting the Stage o Standard cost systems can be sued to decompose spending variances into two parts:  measure how well resources were used (quantity)  measure how well the acquisition prices of those resources were controlled (cost) o A standard is a benchmark for measuring performance. o A quantity standard specifies how much of an input should be used to make a product or provide a service. o A price standard specifies how much should be paid for each unit of the input.  Setting direct materials standards o Standard price per unit for direct materials should reflect the final, delivered cost of the materials. o The standard quantity per unit for direct materials should reflect the amount of material required for each unit of finished product as well as an allowance for waste.  Setting direct labor standards o Direct labor price and quantity standards are usually expressed in terms of a labor rate and labor-hours.

o The standard rate per hour for direct labor should include hourly wages, employment taxes, and fringe benefits.  Reflects the expected “mix” of workers, even though the actual wage rates may vary somewhat from individual to individual due to differing skills or seniority. o The standard hours per unit is the amount of direct labor time that should be required to complete a unit of product, including allowances for breaks, machine downtime, cleanup, rejects, and other normal inefficiencies.  Setting variable manufacturing overhead standards o Usually expressed in terms of rate and hours  The rate represents the variable portion of the predetermined overhead rate  The hours relate to the activity base that is used to apply overhead to units of product (usually machine-hours or direct labor-hours) o The standard quantity allowed per unit of the output is multiplied by the standard price  Using standards in flexible budgets o Use the actual results and the standard cost (standard quantity or hours multiplied by standard price or rate) data to compute the spending variances A General Model for Standard Cost Variance Analysis  Standard cost variance analysis breaks down spending variances from the flexible budget into two elements o Variance resulting from the amount of the input that is used o Variance resulting from the price paid for the input  A quantity variance is the difference between how much of an input was actually used and how much should have been used and is stated in dollar terms using the standard price of the input.  A price variance is the difference between the actual price of an input and its standard price, multiplied by the actual amount of the input purchased.  Standards are separated in two categories because the variances usually have different causes o Different managers are usually responsible for buying and for using inputs  A general model for standard cost variance analysis – variable manufacturing costs

o Three things to note from exhibit  A quantity variance and a price variance can be computed for each of the three variable cost elements (direct materials, direct labor, and variable manufacturing overhead) even though they have different names  The quantity and price variances are computed in exactly the same way regardless of whether one is dealing with direct materials, direct labor, or variable manufacturing overhead.  The input is the actual quantity of direct materials or direct labor purchased; the output is the amount of finished goods produced during the period.  The standard quantity allowed for actual output means the amount of an input that should have been used to produce the actual output of the period. Using Standard Costs – Direct Materials Variances o Variances are computed by comparing standard costs to actual costs o The standard quantity allowed for actual output, at standard price (1 in exhibit) is what should have been spent o The actual quantity of input, at actual price (3 in exhibit) is the actual amount spent.  The materials quantity variance o The materials quantity variance measures the difference between the actual quantity of materials used in production and the standard quantity allowed for the actual output, multiplied by the standard price per unit of materials.  F (favorable) quantity used less than what was budgeted to be used  U (unfavorable) quantity used greater than what was budgeted to be used  The materials price variance o The materials price variance measures the difference between the actual price per unit of an input and its standard price, multiplied by the actual quantity purchased.

 F (favorable) actual purchase price was less than the standard purchase price  U (unfavorable) actual purchase price was greater than the standard purchase price o The purchasing manager is generally responsible for the materials price variance as he has control over the price paid for goods. o Factors influencing the prices paid for goods include how many units are ordered, how the order is delivered, whether the order is a rush order, and the quality of materials purchased.  Direct Materials Variances Equations o Materials Quantity Variance  (AQ – SQ)SP o Materials Price Variance Equation  AQ(AP - SP) o AQ = Actual quantity of XXX purchased and used in production SQ = Standard quantity of XXX allowed for the actual output AP = Actual price per unit of the input SP – Standard price per unit of the output Using Standard Costs – Direct Labor Variances  The labor efficiency variance o The labor efficiency variance measures the difference between the actual hours taken to complete a task and the standard hours allowed for the actual output, multiplied by the standard hourly rate.  F (favorable) hours used less than what was budgeted to be used  U (unfavorable) hours used greater than what was budgeted to be used o The managers in charge of production would usually be responsible for control of the labor efficiency variance. o Factors causing unfavorable labor efficiency variance include poorly trained or motivated workers; poor quality materials, requiring more labor time; faulty equipment, causing breakdowns and work interruptions; poor supervision of workers; and inaccurate standards. Insufficient demand for the company’s product is another cause of an unfavorable labor efficiency variance.  The labor rate variance o The labor rate variance measures the difference between the actual hourly rate and the standard rate, multiplied by the actual number of hours worked during the period.  F (favorable) actual hourly rate was less than the standard hourly rate  U (unfavorable) actual hourly rate was greater than the standard hourly rate o Rate variances can arise based on how production supervisors use their direct labor workers. Overtime work at premium rates will result in an unfavorable rate variance if the overtime premium is charged to the direct labor account  Direct Labor Variances equations o Labor efficiency variance  (AH – SH)SR

o Labor Rate Variance  AH(AR – SR) o AH = Actual quantity of hours used in production SH – Standard quantity of hours allowed for the actual output AR = Actual rate per direct labor hour SR = Standard rater per direct labor hour Using Standard Costs – Variable Manufacturing Overhead Variances  The variable manufacturing overhead efficiency and rate variances o The variable overhead efficiency variance measures the difference between the actual level of activity and the standard activity allowed, multiplied by the variable part of the predetermined overhead rate.  F (favorable) hours used less than what was budgeted to be used  U (unfavorable) hours used greater than what was budgeted to be used o The variable overhead rate variance measures the difference between the actual variable overhead cost incurred during a period and the standard cost that should have been incurred based on the actual activity of the period. o Interpretation of the variable overhead variances is not as clear as the direct materials and direct labor variances o The variable overhead efficiency variance really doesn’t tell us anything about how efficiently overhead resources were used. It depends solely on how efficiently direct labor was used (if direct labor is used as the base.)  Variable manufacturing overhead variances o Variable overhead efficiency variance  (AH – SH)SR o Variable overhead rate variance  AH(AR – SR) o AH = Actual quantity of hours used in production SH – Standard quantity of hours allowed for the actual output AR = Actual rate per direct labor hour SR = Standard rater per direct labor hour An Important Subtlety in the Materials Variances  TO BE COMPLETED...