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7- 1CHAPTER 7FLEXIBLE BUDGETS, DIRECT-COST VARIANCES,AND MANAGEMENT CONTROL7-1 What are the main uses of variances analysis in organization?Variances can help to identify deviations from planned performance and be used for evaluating performance and to motivate managers. Variances can help managers ...

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CHAPTER 7 FLEXIBLE BUDGETS, DIRECT-COST VARIANCES, AND MANAGEMENT CONTROL What are the main uses of variances analysis in organization?

Variances can help to identify deviations from planned performance and be used for evaluating performance and to motivate managers. Variances can help managers with their planning and control functions as well with their strategy settings. For example, sometimes large variances can suggest that the company should consider a change in strategy or a change in standard setting and control. 7-2 When using standard costing, what are the two main components of variances for materials in a flexible budget? The two main components of variances for materials are price and efficiency (or quantity) variances. 7-3

What are the impacts of variances on an operating income?

All variances can have either a favorable or an unfavorable impact on operating incomes. Favorable variances have a positive impact on operating income and increase it (relative to the budgeted amount), while unfavorable variances have a negative impact on the operating income and decrease it. 7-4 Why should the performance of variance analyses be based on flexible budgets rather than static budgets? The performance of variance analysis should not be based on a static budget as it ignores actual levels of output. It compares the budgeted costs/revenues for a planned level of output versus actual costs/revenues for an actual level of output. The actual level of output may differ from the planned level, and may necessitate different levels of costs. Thus, the results could be misleading. For example, a favorable cost variance based on a flexible budget can be changed to an unfavorable cost variance based on a static budget and, therefore, lead to wrong decision/s. This is why performance of variance analyses should be based on flexible budgets. 7-5

What is the main component of sales variance if a flexible-sales budget is used?

Price and volume are the two main components of sale variances when we compare actual sale versus static/budgeted sale. However, if we use a flexible-sales budget and compare it with actual sale, the only component left would be the price as a flexible budget is already taking care of volume. 7-6

When is a flexible budget similar to a static budget? Why?

A flexible budget can be similar to a static budget if the actual outputs are equal to the planned outputs. This is because the only difference between a static budget and a flexible budget is that

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the static budget is prepared for the planned output, whereas the flexible budget is based on the actual output. 7-7

What is the main advantage of standard costs versus past costs?

Standard costs take into consideration issues related to the past costs such as past inefficiencies and take into account expected future changes. 7-8

How are the main components of materials variances interrelated in a flexible-budget?

There could be a link between all the components of variances (including materials) and therefore, the manager should not investigate the variances in isolation. For example, buying low quality materials at a lower price can lead to a favorable price variance for materials. However, at the same time it may lead to the use more materials for the same outputs and this, in turn, could lead to unfavorable quantity variances, or vice versa. 7-9

List three causes of a favorable direct materials price variance.

Possible causes of a favorable direct materials price variance are:  purchasing officer negotiated more skillfully than was planned in the budget,  purchasing manager bought in larger lot sizes than budgeted, thus obtaining quantity discounts,  materials prices decreased unexpectedly due to, say, industry oversupply,  budgeted purchase prices were set without careful analysis of the market, and  purchasing manager received unfavorable terms on nonpurchase price factors (such as lower quality materials). 7-10

Describe three reasons for an unfavorable direct manufacturing labor efficiency variance.

Some possible reasons for an unfavorable direct manufacturing labor efficiency variance are the hiring and use of underskilled workers; inefficient scheduling of work so that the workforce was not optimally occupied; poor maintenance of machines resulting in a high proportion of nonvalue-added labor; unrealistic time standards. Each of these factors would result in actual direct manufacturing labor-hours being higher than indicated by the standard work rate. 7-11

How does variance analysis help in continuous improvement?

Variance analysis, by providing information about actual performance relative to standards, can form the basis of continuous operational improvement. The underlying causes of unfavorable variances are identified and corrective action taken where possible. Favorable variances can also provide information if the organization can identify why a favorable variance occurred. Steps can often be taken to replicate those conditions more often. As the easier changes are made, and perhaps some standards tightened, the harder issues will be revealed for the organization to act on—this is continuous improvement. 7-12 Why might an analyst examining variances in the production area look beyond that business function for explanations of those variances?

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An individual business function, such as production, is interdependent with other business functions. Factors outside of production can explain why variances arise in the production area. For example:  poor design of products or processes can lead to a sizable number of defects,  marketing personnel making promises for delivery times that require a large number of rush orders can create production-scheduling difficulties, and  purchase of poor-quality materials by the purchasing manager can result in defects and waste. 7-13 Comment on the following statement made by a management accountant: ―The plant manager has little knowledge of the individual impacts of the purchase department, the sales department, and the production department on the total unfavorable variance in our operating income.‖ The management accountant might be correct in stating the above if the plant manager is unaware of the cause and effect relationships which exist among most components of variances. For example, a low quality product made by the production department or a low quality material provided by purchase department could lead to lower sales and result in unfavorable operating income variance. 7-14 When inputs are substitutable, how can the direct materials efficiency variance be decomposed further to obtain useful information? The direct materials efficiency variance can be decomposed into two parts: a direct materials mix variance that reflects the impact of using a cheaper mix of inputs to produce a given quantity of output, and the direct materials yield variance, which captures the impact of using less input to achieve a given quantity of output. 7-15 ―Benchmarking is about comparing your firm’s performance against the best levels of performance in the market and has nothing to do with variance analyses.‖ Do you agree? It is true that benchmarking is the continuous process of comparing your firm’s performance against the best levels of performance in competing companies or companies with similar processes. However, variance analysis is part of the process and can be considered as a tool for assessing the firm’s performance especially in terms of production costs. 7-16 Metal Shelf Company’s standard cost for raw materials is $4.00 per pound and it is expected that each metal shelf uses two pounds of material. During October Year 2, 25,000 pounds of materials are purchased from a new supplier for $97,000 and 13,000 shelves are produced using 27,000 pounds of materials. Which statement is a possible explanation concerning the direct materials variances? a. The production department had to use more materials since the quality of the materials was inferior. b. The purchasing manager paid more than expected for materials. c. Production workers were more efficient than anticipated. d. The overall materials variance is positive; no further analysis is necessary.

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SOLUTION Choice "a" is correct. The materials price variance is $3,000 favorable since 25,000 pounds of materials were purchased for $97,000. The materials efficiency variance is $4,000 unfavorable since it took 27,000 pounds of material to produce 13,000 shelves ($4.00 × 1,000 additional pounds). It is possible that the materials which were purchased from a new supplier at a lower price were of a lesser quality and caused more material to be used in the production process. Choice "b" is incorrect. The purchasing manager paid less than expected for materials. The materials price variance is $3,000 favorable since 25,000 pounds of materials were purchased for $97,000. Choice "c" is incorrect. Production workers used more materials than expected. The materials efficiency variance is $4,000 unfavorable since it took 27,000 pounds of material to produce 13,000 shelves ($4.00 × 1,000 additional pounds). Choice "d" is incorrect. The overall material variance is unfavorable. Even if the overall variance were favorable, the components of the variance are analyzed to identify the details on why the variance is favorable and whether there are areas for further improvement. Also, consistent favorable or unfavorable variances may indicate that the standards are not properly set. 7-17 All of the following statements regarding standards are accurate except: a. Standards allow management to budget at a per-unit level. b. Ideal standards account for a minimal amount of normal spoilage. c. Participative standards usually take longer to implement than authoritative standards. d. Currently attainable standards take into account the level of training available to employees. SOLUTION Choice "b" is correct. Ideal standards do not make any provisions for normal spoilage or downtime. They assume perfect efficiency and effectiveness, which is helpful as an initial benchmark but is often unrealistic and unattainable. The other three choices are incorrect as they are factually true. Choice "a" is incorrect. Standards are thought of as per unit budgets. Choice "c" is incorrect. Because they involve managers and their employees, participative standards take longer to implement than authoritative standards which are set solely by management. Choice "d" is incorrect. Currently attainable standards assume an appropriate level of training for the employees who are to be held accountable in achieving those standards. 7-18 Amalgamated Manipulation Manufacturing’s (AMM) standards anticipate that there will be 3 pounds of raw material used for every unit of finished goods produced. AMM began the 7-4

month of May with 5,000 pounds of raw material, purchased 15,000 pounds for $19,500 and ended the month with 4,000 pounds on hand. The company produced 5,000 units of finished goods. The company estimates standard costs at $1.50 per pound. The materials price and efficiency variances for the month of May were: Price Variance

Efficiency Variance

1. $3,000 U

$1,500 F

2. $3,000 F

$

3. $3,000 F

$1,500 U

4. $3,200 F

$1,500 U

0

SOLUTION Choice "3" is correct. Actual Quantity Purchased = 15,000 pounds (given) Actual Quantity Used = Beginning Inventory 5,000 + Purchases 15,000 - Ending Inventory 4,000 = 16,000 pounds Standard Quantity Allowed = 5,000 finished units x 3 pounds per unit = 15,000 pounds Actual Price = $19,500 ÷ 15,000 = $1.30 Standard Price = $1.50 (given) Price variance = Actual Quantity Purchased x (Standard Price - Actual Price) = 15,000 × ($1.50 − $1.30) = $3,000 F

Efficiency variance

= Standard Price x (Standard Quantity Allowed – Actual Quantity Used) = $1.50 × (15,000 − 16,000) = $1,500 U

Choice "1" is incorrect. Computation makes an incorrect determination with regard to whether the variance is favorable or unfavorable. Choice "2" is incorrect. Computation inappropriately uses actual quantity purchased in the quantity variance. Choice "4" is incorrect. Computation inappropriately uses the quantity used in the price variance. 7-19 Atlantic Company has a manufacturing facility in Brooklyn that manufactures robotic equipment for the auto industry. For Year 1, Atlantic collected the following information from its main production line: Actual quantity purchased

200 units

Actual quantity used

110 units

Units standard quantity

100 units

Actual price paid

$ 8 per unit

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Standard price

$ 10 per unit

Atlantic isolates price variances at the time of purchase. What is the materials price variance for Year 1? 1. $400 favorable. 2. $400 unfavorable. 3. $220 favorable. 4. $220 unfavorable. SOLUTION Choice "1" is correct. The question asks for the materials price variance for a production line. Materials price variances are isolated at the time of purchase. The actual price was $8 per unit, and the standard price was $10 per unit. The materials price variance has got to be favorable. The variance formula for the materials price variance can be stated as the actual units purchased of 200 units times the difference between the actual and standard price of $2 ($10 − $12), or $400 (favorable). 7-20 Basix Inc. calculates direct manufacturing labor variances and has the following information: Actual hours worked: 200 Standard hours: 250 Actual rate per hour: $12 Standard rate per hour: $10 Given the information above, which of the following is correct regarding direct manufacturing labor variances? a. The price and efficiency variances are favorable. b. The price and efficiency variances are unfavorable. c. The price variance is favorable, while the efficiency variance is unfavorable. d. The price variance is unfavorable, while the efficiency variance is favorable. SOLUTION Choice "d" is correct. The direct labor variance is an expense variance. Therefore, when the actual hours worked are less (greater) than the standard hours worked, this is favorable (unfavorable). Also, when the actual rate per hour is less (greater) than the standard hours worked, this is favorable (unfavorable). This question can be solved without actually calculating the variances. All that is needed is a comparison between the actual and standard hours worked for the efficiency variance and a 7-6

comparison between the actual and standard rate per hour for the price variance. Here, the actual rate per hour is higher than the standard rate, meaning the price variance is unfavorable. The actual hours worked are less than the standard hours worked, meaning the efficiency variance is favorable. Choice "a" is incorrect. The efficiency variance is favorable, but because the actual rate per hour is greater than the standard rate, the price variance is unfavorable. Choice "b" is incorrect. The price variance is unfavorable, but the efficiency variance is favorable because fewer hours were worked than budgeted. Choice "c" is incorrect. The price variance is unfavorable, while the efficiency variance is favorable. 7-21 Flexible budget. Brabham Enterprises manufactures tires for the Formula I motor racing circuit. For August 2017, it budgeted to manufacture and sell 3,000 tires at a variable cost of $74 per tire and total fixed costs of $54,000. The budgeted selling price was $110 per tire. Actual results in August 2017 were 2,800 tires manufactured and sold at a selling price of $112 per tire. The actual total variable costs were $229,600, and the actual total fixed costs were $50,000. Required: 1. Prepare a performance report (akin to Exhibit 7-2, page 274) that uses a flexible budget and a static budget. 2. Comment on the results in requirement 1. SOLUTION (20–30 min.)

Flexible budget. Variance Analysis for Brabham Enterprises for August 2017

Units (tires) sold

Revenues Variable costs Contribution margin Fixed costs

Actual Results (1) 2,800g

FlexibleBudget Flexible Variances (2) = (1) – Budget (3) (3) 0 2,800 $308,000

a

$ 5,600 F

229,600d

22,400 U

207,200e

84,000 50,000g

16,800 U 4,000 F

100,800

$313,600

SalesVolume Static Variances (4) = (3) – Budget (5) (5) 200 U 3,000g

b

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$22,000 U

$330,000c

14,800 F

222,000f

7,200 U 0

108,000 54,000g

54,000g Operating income

$ 34,000

$12,800 U $ 46,800 $ 7,200 U $ 54,000 $12,800 U $ 7,200 U

Total flexible-budget variance Total sales-volume variance $20,000 U Total static-budget variance $112 × 2,800 = $313,600 b $110 × 2,800 = $308,000 c $110 × 3,000 = $330,000 d Given. Unit variable cost = $229,600 ÷ 2,800 = $82 per tire e $74 × 2,800 = $207,200 f $74 × 3,000 = $222,000 g Given a

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The key information items are: Units Unit selling price Unit variable cost Fixed costs

Actual 2,800 $ 112 $ 82 $50,000

Budgeted 3,000 $ 110 $ 74 $54,000

The total static-budget variance in operating income is $20,000 U. There is both an unfavorable total flexible-budget variance ($12,800) and an unfavorable sales-volume variance ($7,200). The unfavorable sales-volume variance arises solely because actual units manufactured and sold were 200 less than the budgeted 3,000 units. The unfavorable flexible-budget variance of $12,800 in operating income is due primarily to the $8 increase in unit variable costs. This increase in unit variable costs is only partially offset by the $2 increase in unit selling price and the $4,000 decrease in fixed costs. 7-22 Flexible budget. Beta Company’s budgeted prices for direct materials, direct manufacturing labor, and direct marketing (distribution) labor per luxury wallet are $41, $5, and $11, respectively. The president is pleased with the following performance report: Direct materials Direct manufacturing labor Direct marketing (distribution) labor

Actual Costs Static Budget Variance $373,500 $410,000 $36,500 F 48,600 50,000 1,400 F 103,500 110,000 6,500 F

Required: 1. Actual output was 9,000 luxury wallets. Assume all three direct-cost items shown are variable costs. 2. Is the president’s pleasure justified? Prepare a revised performance report that uses a flexible

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budget and a static budget. SOLUTION (15 min.) Flexible budget. The existing performance report is a Level 1 analysis, based on a static budget. It makes no adjustment for changes in output levels. The budgeted output level is 10,000 units––direct materials of $410,000 in the static budget ÷ budgeted direct materials cost per luxury wallet of $41. The following is a Level 2 analysis that presents a flexible-budget variance and a salesvolume variance of each direct cost category.

Variance Analysis for Beta Company

Output units Direct materials Direct manufacturing labor Direct marketing labor Total direct costs

Actual Results (1)

FlexibleBudget Variances (2) = (1) – (3)

9,000 $373,500 48,600 103,500 $525,600

0 $4,500 U 3,600 U 4,500 U $12,600 U

SalesFlexible Volume Budget Variances (3) (4) = (3) – (5)

Static Budget (5)

9,000 $369000 45000 99000 $513000

10,000 $410,000 50,000 110,000 $570,000

1,000 U $41,000 F 5,000 F 11,000 F $57,000 F

$12,600 U $57,000 F Flexible-budget variance Sales-volume variance $44,400 F Static-budget variance The Level 1 analysis shows total direct costs have a $44,400 favorable varianc...