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TECHNICAL

**Budgets, standards and simple variances
**

David Cornes is a Senior Lecturer at Bournemouth University

T

here is often understandable confusion regarding the relationship between budgets and budgetary control on the one hand and standards and standard costing on the other. Furthermore, variances seem to pop up indiscriminately — sometimes when you least expect them! A good starting point to resolve the confusion is the CIMA Terminology of Management Accounting which defines a budget as: “A plan expressed in money. It is prepared and approved prior to the budget period and may show income, expenditure, and the capital to be employed...” The definition then goes on to outline how the budget is prepared. Putting aside the question of whether a budget is only concerned with money, for example a production budget could be more meaningful to production personnel expressed in units rather than cost, the key feature is that a budget is a future plan. Budgetary control is defined thus in the Terminology: “The establishment of budgets relating the responsibilities of executives to the requirements of a policy, and the continuous comparison of actual with budgeted results, either to secure by individual action the objectives of that policy or to provide a basis for its revision.” This implies the use of the budgets to implement responsibility accounting, the Sales Manager for example is responsible for the achievement of the sales that are budgeted to be made; the comparison of actual sales achieved with the budget indicating what action must be taken to achieve the budget, or, if the budget can no longer be achieved then the opportunity arises to decide the best course of action in the light of circumstances that were not envisaged when the budget was prepared. What about standards then? The Terminology defines a standard as: “A predetermined measurable quantity set in defined conditions.” Standard cost is defined as: “A standard expressed in money. It is built up

from an assessment of the value of cost elements...” The standard then goes on to define the uses of standards in measuring performance and in valuing stock and providing control information. So is there a link here with budgetary control? The Terminology definition of standard costing helps to clarify this: “A control technique which compares standard costs and revenues with actual results to obtain variances which are used to stimulate improved performance.” So, yes there is a link, both standard costing and budgetary control are concerned with comparing something with actual results achieved in order to influence future performance. The easiest way to consider them is to regard the techniques as very closely related with substantial overlaps, however budgets and budgetary control are concerned with the comparison of the expected (budgeted) results with the actual results of the company as a whole at a particular (budgeted) level of activity, broken down to individual managers’ level (i.e. departmental); and standards are prepared at unit level i.e. individual products etc., aggregated to individual managers or departments as required. Of course, the standards are used in the preparation of budgets; and, as will be demonstrated shortly, the budgeted level of production is used to determine the standard fixed cost per unit. You can have budgetary

control without standard costing, but standard costing without the additional management information provided by budgetary control is unlikely.The factor which links the topics irrevocably together is the fact that they are both concerned with the calculation of variances.

Variances

Returning to the CIMA Terminology let us see what the definition is for a variance: “Difference between planned, budgeted or standard cost and actual cost; and similarly for revenue.” So, a variance is the difference between what a cost (or revenue) ought to have been under standard circumstances, and what it actually was. If we are looking at the variance concerning a single item, then this is a variance against standard; and a variance for a department or the company as a whole is a variance against budget; but when we come down to the computations the distinction becomes academic. To illustrate the effect of standards and budgets on the calculation of variances let us take a straightforward example. We are examining the performance of a company which has a single product, the standard cost specification for which is shown in Figure 1. The standard cost specification for the variable cost elements (direct material, direct labour and variable production overhead) are specified as the

**Figure 1— Standard cost specification
**

Direct material 160 x kg mat @ £/kg Direct labour 25 hrs @ £/hr Variable production overhead 25 hrs @ £/hr Total standard variable cost Fixed production overhead Budgeted units/month 200 Total production standard cost Standard gross profit Standard selling price £10.00 250 1,600 400 2,000 500 2,500 £6.00 150 £7.50 Total Std £ 1,200

700 on direct materials. for example the letters (F).500 £1.000 700 (11. It does not matter what convention you adopt so long as you state what convention you are using.500 220 Units 220 @ £1.000 compared with an actual of £539. That is.TECHNICAL 5 Figure 2 — Budget Sales Production Direct materials Direct labour Variable production overhead Fixed production overhead Gross profit 200 @ 200 Units 200 @ 200 @ 200 @ 200 @ £2. the volume of output has changed. direct labour and variable production overhead have changed from the original fixed budget (Figure 2).000 £50. Therefore.000 £53.000 cost behaviour patterns.200 220 @ £150 220 @ £250 . I made twenty extra units”. it should not be altered by changes in the level of production.300 £107. There are other conventions.000 £240. the budget was to sell 200 units and we actually produced and sold 220. so the budgeted amount of fixed production overhead per month must have been 200 x £400 = £80. Take sales.000 £55.200 £150 £250 £400 £500. as fixed production overhead per unit is calculated by: total fixed overhead – number of units. at least not over the normal range of activity.000 kgs 6. with a flexed budget of £550.700 £33. so had the budgeted sales been achieved the profit would have been £11.000 (11.000 220 units 35.000 £80. So.000 £100. This is shown in Figure 2. Comparing the flexed budget with the actual performance results in the variances.700 £33. This tells us what the revenue and costs per month should be.000 £33.000 £264. £7. if you are asked for such a reconciliation then the actual non-production cost given is the final item on your reconciliation. is designed to change as volume of output changes.700 more than budget.50 per kg).000 hours £266. whereas direct materials have cost £2. This means that we cannot directly compare the budget figures in Figure 2 with the actual results in Figure 3. for our last dip into the CIMA Terminology.000. whereas fixed overhead remains unaltered from the original budget because fixed costs by definition should not change.000 less. direct material. it is not unusual in variance analysis questions to find we are given the standard gross profit and the actual net profit after charging non-production ex220 units @ £2. or favourable variances may be presented in one column and unfavourable ones in another.000 £53. Variances can be either favourable or adverse according to their effect on profit. The principal problem is that the number of units produced and sold is different from the budget. This is stated at the head of the variances column and tells us that the variances are in £ with favourable variances in plain figures and adverse variances within brackets. Also included in the standard cost specification is the standard selling price and therefore the standard gross profit per unit that the company expects to achieve. Unless the question asks you to reconcile budgeted gross profit with actual net profit you can ignore this. Note also the convention that has been adopted in this example to express whether the variances are favourable or adverse. let us see what the definition is for a flexible budget: “A budget which. the variance is obviously adverse.000 more. in other words the cost of production and cost of sales are identical. there is another category of expense. there is a difference of £11.300 £107. unfavourable or adverse. Fixed overhead in total is regarded as constant. it will : be a factor of the number of units chosen.700 – £240. the fact that we are given the actual quantities of the resources used is in fact required information when we come to sub-divide the variances but can be ignored for the moment. evaluated at the standard per-unit costs and selling price.450 per unit £539. but probably not expressed so politely! What we have to establish first is what the results should have been given that 220 units were produced and sold. Given the budget of 200 units per month and the standard cost specification per unit we can calculate the budget per month. 160 kg of material) multiplied by the standard cost per unit of that resource (i.000 Actual Variances £Fav/(Adv) £539.000.e.700) 0 2. by recognising different Figure 4 — Flexible budget Flexed budget £550. the effect on profit is again adverse.000 penses like selling and administration. Fixed production overhead is of course different. (U) or (A) standing for favourable. selling and administration.000) £266. the budget has been flexed to the actual level of 220 units.000 (2.000 £30. we have the actual usage of the direct material and labour in kilograms and hours as well as the values and.000 £118.g.000 £75. tell the Production Manager that he has overspent by (£266. and stick to it! If you are presented with a question containing variances with some in brackets and some without where Figure 3 — Actuals Sales were Sales revenue Production was Direct materials purchased & issued Direct labour worked Variable production overhead Fixed production overhead Gross profit Selling and administration Net profit standard quantity of the resource required (e.000) £26. What’s this about cost behaviour patterns? The analysis of costs according to behaviour gives us a distinction between variable and fixed costs.000 £79. say. You should notice in this example that the production and sales units are the same so there are no complications due to stock increases or decreases. In the example in Figure 1 it can be seen that the fixed overhead of £400 per unit has been based on the budgeted production per month of 200 units.000) Sales Production Direct materials Direct labour Variable production overhead Fixed production overhead Gross profit 220 @ £2. The sum of the three variable cost elements is the total standard variable cost. The second query. If we do and.000 £79. As can be seen in Figure 4 in the flexed budget the variable items. If we now look at the actual results for a period in Figure 3 a number of queries arise. Taking the last of these problems first. his answer will be along the lines of “Well of course I have. Secondly. When we consider these differences there is not only the amount of the variance to be established but also the sign of the variances. thirdly. to be deducted from gross profit to finally arrive at net profit.” Well.000 £32. First.000 £80. from the budgeted 200 units to the actual 220.

If instead we are given the actual price paid per kg (in this example it is £7. Turning now to the other ‘variable cost elements’ of direct labour and variable production overhead the pattern of variances is identical to those for direct material that we have already examined. having extracted the price variance on all the material actually used. in at least one question under the old 2. the efficiency variance evaluates the difference between the hours allowed for 220 units and the actual hours taken. This is why I suggested that the price variance should always be calculated first. As the actual amount paid is more than the standard amount the variance is obviously adverse. However although this analysis tells us where the variances have arisen it gives little help in establishing why. £2.000 x £0. what should it have cost in direct material to produce the 220 units that were produced.12 = £4. question.000 kg should have cost at the standard price of £7. or too much material was used — a usage variance. However this does not mean that we do not have to calculate the sub-variances. Remembering that we are using flexible budgeting the question to ask is how much material should 220 units use if each one is allowed 160 kgs.4 syllabus the reverse was the case. that is direct material.000 kg 200 kg @ £7.000 adverse is the responsibility of sales and a net nil variance arose in production. It is not however the answer.000 kg to obtain the price variance (35. and what did it cost? Each unit should have cost the standard direct material cost of £1. we have evaluated the 200 kg favourable usage variance at the standard price of £7.000. that part of the total variance caused by the price of the resource being different from standard. The total variance can still be analysed into two elements. 200 kg saved at the standard price of £7. it gives you the total that the sub-variances should sum to and thus gives you a check on your calculations. This does not mean that the cost of production corresponded in detail to the budget. £11. For reasons I shall return to later always calculate the price variance first! The price variance calculates the effect of any difference from the standard price per unit on all the material actually used.700) Direct material price variance Material should cost 35.50 when we know that we actually paid £7.000 and it was only £107. The purpose of variance analysis is to give more information to managers to enable them to understand and control their operations.500 Material did cost £266. Variance calculations are always performed this way ‘by convention’. the question is basically the same as for the total material variance.200) £1. given that production was 220 units. of course. with how much 35. However until you feel competent with variance calculations I suggest that you do calculate the total variance first. The adverse price variance of £4.62) we can find the difference in price per kg and multiply by 35.500 (£2. Taking the total direct labour variance first.500. it feels more ‘comfortable’ to evaluate the usage variance at standard price. the usage variance now addresses the question of whether 35. There are two possible causes: either the material we used cost too much per kilogram — a price variance. simply to go straight to the sub-variances.200 combined with the favourable usage variance of £1. Unless specifically asked for in the question it is not necessary to calculate the total variance. a total adverse variance of £11.200 £264. The calculations for these variances are identical in concept to those for direct material. called now either a rate or expenditure variance.50 gives a favourable usage variance of £1.700) .000.524? For the moment the answer has to be that as we have evaluated the price variance on all the material that was actually used then arithmetically the usage variance must be evaluated at the standard price.700 Direct material usage variance Production should use 220 @ 160 Production did use Material variance in units Total direct material variance 35. There are several methods of performing the variance calculations. Or. It is obtained by asking the same Figure 5 —Total direct material variance Total direct material variance Production should cost Production did cost 220 @ £1.000 @ £7.500 agrees with the total direct material variance of £2. The rate variance evaluates the difference between the standard cost of the actual hours worked and the actual cost.50 £262.000 £266.000 kg did cost. If you examine the direct material variances in Figure 5 you will note that the total direct material variance is of course the direct material variance that we obtained by comparing the flexible budget with the actual results in Figure 4. The answer of 35. Note Variance analysis For the moment I am going to consider only the cost variances arising in the variable cost elements.50 per kg. Of this total. As can be seen there are compensating variances for direct labour rate and direct labour efficiency. and that part of the total variance caused by the quantity of the resource differing from the standard allowance.700 too much — the variance is adverse. What do these variances tell us? Well we can see that on the actual sales of 220 units the profit should have been £118. To find out more we will have to analyse the variances further.000 kg should have been used. direct labour and variable production overhead. Only the names of the variances are different as shown in Figure 6. there is no arithmetical reason for doing so but. they did cost £266.200 kg compared with the actual usage of 35.000. They fall into two groups involving either the memorising of formulae as advocated in Drury and also in the Students’ Newsletter articles by Duncan Williamson and Mark Lee Inman. so 220 units should have cost £264. how much should the direct labour cost be at the standard of £150 per unit? This is identical to the actual direct labour cost so the total direct labour variance is nil.700 adverse due in some way to differences on direct materials.700 Variances £Fav/(Adv) (£2.200). This gives a favourable usage variance of 200 kg. Having calculated the price variance on the actual quantity used.50 (£4. You may be feeling slightly uneasy about one thing.000 kg means that 200 kg have been saved.4 TECHNICAL the convention is not stated do not assume that the bracketed figures are necessarily adverse. In the example in Figure 5 35. called now an efficiency variance.700 more than it should but we do not yet know the reasons why this is so. but that there are compensating variances with £2.200 kg 35. Has not the saving really been £1.700 so they cost £2. We need to calculate the usage variance as a monetary value.000 kg were used so we compare how much 35. again calculate the rate variance first. and it is a common mistake in variance questions for students to stop right there and say the usage variance is 200 favourable.200. or the logical examination of what each variance is trying to measure by comparing what it should cost to what it did cost in the context of the factor in question. It is the latter method that I will attempt to describe. some combination of both price and usage variances.700 adverse that we calculated to begin with.000 being gained on variable production overhead and £700 underspend on fixed production overhead. So what are these sub-variances? We know that direct material has cost £2.62.

000 100 units did use 100 x 11 kg = 1. or expenditure) variance is the effect of the difference between standard and actual price per unit on all the units actually used. Figure 6 —Total direct labour variance Total direct labour variance Production should cost Production did cost Direct labour rate variance Actual hrs should cost Actual hrs did cost 220 @ £150. Suppose that the direct labour variances show the effect of a deliberate decision by management to employ a lower grade of labour at £5.50 per hour actually paid and the standard of £6. ACCA Students’ Newsletter.000) £2.00 per hour.00 Variances £Fav/(Adv) £0 6.00 Actual hrs did cost Variable overhead efficiency variance Variance in hours Total variable overhead variance £2. Total cost is a factor of both price and quantity.000 £33.B. A future article will discuss fixed overhead variances. standard price and quantity for total standard cost.000 £53. ‘Management Accounting. To calculate the variable production overhead variances the assumption is made that the overhead is actually incurred in proportion to the direct labour hours worked.000 @ £10. You might at first suppose that the decision had broken even as the favourable rate variance is exactly compensated by the adverse efficiency variance. The price (or rate. If asked to suggest causes for variances always look for inter-relationships between them. Chapman and Hall.000) £0 £55. Colin Drury.100 kg x (£5 per kg – £6 per kg) Usage variance 100 units x (10 kg –11 kg) = 100 kg at £5 per kg £(1.600) . Duncan Williamson.000 Figure 7 — Variable cost variances Standard Price. 1994.000 of variable overhead that would not otherwise have been incurred. Chartered Institute of Management Accountants: 1991. Thus the expenditure variance ‘should cost’ value is calculated on the actual 6. and actual price and quantity for total actual cost. The usage (or efficiency) variance is the effect of the difference between total actual usage and total standard allowance evaluated at standard price.000 £60. ‘Standard costing made simple’.00 Production did cost Variable overhead expenditure variance Actual hrs should cost 6.000 5.100) £(500) £(1.TECHNICAL 5 again that the rate variance can be calculated by multiplying the difference between the £5. or efficiency variance £6 per kg Qty 10 kg per unit Total std cost < Total variance 11 kg per unit Total actual cost > Variable cost variances (Direct material.000 direct labour hours worked.000 Direct labour efficiency variance Production should take 220 @ 25 Production did take Variance in hours Total direct labour variance Total variable overhead variance Production should cost 220 @ £250. the efficiency variance is calculated first in units (hours in this case) and then evaluated at standard rate per hour. January 1990. The fact that the same variance in hours applies both to the direct labour and variable overhead variances emphasises the inter-relationship between variances.000 £7. revenue (sales) variances and the further analysis of variances together with some more theoretical aspects concerning joint variances and the timing of the extraction of the material price variance.00 £33. direct labour. Official Terminology’.100 kg each costing £6 per kg = £6. like the usage variance. Mark Lee Inman.00 (£3.000 hrs (500) hrs@ £6. Costing: an introduction —3rd Edition.000 @ £6.00 per hour and as a result the labour force took 500 extra hours to complete the work. Budget is ‘flexed’ so unit quantity and price are multiplied by actual quantity produced = 100 units 100 units should use 100 x 10 kg = 1. References ‘Beyond traditional variance analysis’.000 (500) hrs @ £10.or rate or expenditure variance Actual Price £5 per kg Usage.000 (£5. and.500 hrs 6.00 £3. variable production overhead) N. direct labour and variable overhead are illustrated in Figure 7. This is not the case as the extra 500 hours have also incurred an extra £5. for example a cheap material purchased may give a favourable price variance but cause not only an adverse material usage variance but also adverse labour efficiency and variable overhead efficiency variances. and we do not need to recalculate the efficiency variance in hours because this is the same as the direct labour efficiency variance of 500 hours adverse but evaluated now at £10.00 per hour by the actual hours worked.000 £33.50 per hour instead of the standard £6.600 Total direct material variance Price variance 1. ACCA Students’ Newsletter.000 £53.000 £36.000 kg each costing £5 per kg = £5. The total variance is the difference between total actual cost and total standard cost. The relationships between the sub-variances for the variable cost elements of direct material. August 1993.600) £(1.

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