COST AND MANAGEMENT

UNIT 3 SECTION 3 FLEXIBLE BUDGETS AND VARIANCE ANALYSIS

ACCOUNTING Unit 3, section 3: Flexible budget and variance analysis

We saw in the earlier sessions that budgets are tools for evaluating
performance. In using budgets as control mechanism, standards are set and
actual performances are regularly compared with the standards or budget.
While the master budget is static or fixed to one level of activity, a flexible
budget is tailored to different levels of activity. The differences between the
actual and the budgeted are called Variances. Variances are either classified
as favourable (F) or unfavourable (U) depending on its effect on profit.

In this session we will look at the nature of flexible budgets and variance
analysis.

By the end of the session, you should be able to

 explain flexible budgets
 state and apply the flexible budget formula
 explain variances analysis
 state the classification of variances.

Now Read on…

Nature of Flexible Budget

A budget as it has been stated, is a financial statement indicating the result
that will be achieved in future if the variables underlying the budget
preparation follow the assumptions made in respect of them or where
compensating differences exist for any variations. For example, a budgeted
profit may be based on a certain level of sales. The achievement of the
budgeted profit will depend on either attaining both the volume of sales and
unit sales price or failure to attain the volume of sales by recording lower
sales volume but with a compensating increase in unit sales price or vice
versa. It is, of course assumed that all things are equal and that the actual
results of other variables follow the budget.

However, it is very unlikely that the result achieved will follow the level of
activity budgeted for. Therefore for a meaningful decision, planning and
control, budgets should be prepared for different levels of activity. While
the master budget is static or fixed, i.e. tailored to one level of activity, a
flexible budget is tailored to different levels of activity. A flex is build into
the budget preparation to allow meaningful comparison to be made no
matter the level of activity actually attained. A flexible budget is a budget
which may be prepared to any level of activity. It recognises the difference
in behaviour pattern between fixed and variable costs in relation to
fluctuations in output, turnover or other variable factors such as member of
employees or machines.

To prepare a flexible budget, cost behaviour patterns must be carefully

studied. This will enable a budget to be prepared to fit various levels of
activity. The basic idea behind a flexible budget is to enable correct

96 UEW/IEDE
 COST AND MANAGEMENT
Unit 3, section 3: Flexible budget and variance analysis ACCOUNTING

determination of costs for different levels of activity so that meaningful

comparisons can be made between the budget and the actual results attained.

The end result is that, the actual cost associated with a particular number of
units of output is compared with the flexed budget cost associated with that
number of units instead of a budgeted cost associated with a fixed budget
output of a different units. For example, the actual cost associated with
8,500 units of output is compared with the flexed budget cost associated
with 8,500 units instead of a budgeted cost associated with a fixed budget
output of 11,000 units. This type of comparison brings into focus all
compensatory differences and allows meaningful decisions to be taken on
the real causes of variances.

Flexible Budget Formula

In developing a flexible budget, the patterns of cost behaviour, as they are
affected by changes in the level of activity, should be accurately analysed.
All cost should be analysed into variable and fixed. Once all the costs are
completely analysed into variable and fixed, a formula can be used to
prepare a flexible budget to fit any relevant range of activity. The formula is
as follows:
Budgeted Cost = (unit variable cost x quantity) + fixed costs

Example 3.1
Ameen Sangari produced 1000 units of soaps. The unit variable cost of
production was GHC8.50 and fixed costs was GHC7,500. What will be the
budgeted cost?

Solution:
(GHC8.50 X 1000) + 7,500 = GHC16,000

Example 3.2:
From Example 3.1, assume that Ameen Sangari produced 900 units, 1000
units and 1,100 units for three levels of activity. The unit variable cost of
production was GHC8.50 and fixed costs was GHC7,500. What will be the
budgeted cost for each level of activity?

Solution: Level of activity

900 units 1000 units 1,100 units
Variable cost GHC7,650 GHC8,500 GHC9,350
Fixed cost GHC7,500 GHC7,500 GHC7,500
Budgeted cost GHC15,150 GHC16,000 GHC16,850

The items making up the variable cost and fixed cost will be analysed
individually. They might include cost of material, labour and other
expenses. For example

UEW/IEDE 97
COST AND MANAGEMENT
ACCOUNTING Unit 3, section 3: Flexible budget and variance analysis

Variance Analysis
Variances are the differences obtained as the result of comparing actual
results with budgeted results. Variances by themselves only raise questions
for which appropriate answers must be provided if company objectives and
managerial policies are to be achieved. Variances are analysed so that
attention can be directed to those areas which need to be investigated.

Variance analysis is the analysis and comparison of the factors which have
caused the differences between predetermined standards and actual results,
with a view to eliminating inefficiencies. For every element of cost and/or
revenue, a total variance can be extracted. The total variance can then be
further analysed so that proper accountability can be assigned to responsible
managers.

Variance analysis is only a means to an end and not an end in itself. It is one
of the many management tools for evaluating performance and assessing
areas of weakness and strength. By means of variance analysis,
management’s attention is directed to areas where control action needs to be
taken. The control action takes many forms, among which are:
 identifying the causes for the variances.
 Reporting to managers responsible for the variances
 Improving the implementation of the decisions taken to achieve the
budget objectives
 Revisiting the budgets to suit prevailing conditions.

It must be noted that variance analysis is a historical exercise. It looks into

the past to find out what went wrong or right so that prompt decisions and
actions can be taken to guide future courses of action.

Variance analysis helps management to control a business. Thus

 As variances indicate deviations, management by exception can be
enhanced and thus save the valuable time of managers.
 It helps in the implementation of responsibility accounting as the
accountability of managers can be isolated.
 Areas needing action are easily localised and highlighted.
 Variances arising from previous periods can provide important
information towards the preparation of the next period’s budget.
 Generally, variances can lead to greater efficiency in managers.

Classification of Variances
Variances arise because of either internal or external factors. While
management has little control of external factors, internal factors should be
the subject of control by individual managers. A basic step in proper
accountability starts with variance classification into its component parts
and further subdivision into controllable and uncontrollable variance.

98 UEW/IEDE
 COST AND MANAGEMENT
Unit 3, section 3: Flexible budget and variance analysis ACCOUNTING

For the purpose of analysis, variances are classified as follows:

 Materials cost variance
a. Purchase price variance
b. Usage variance
i. Mix variance
ii. Yield variance
 Labour cost variance
a. Rate variance
b. Idle time variance
c. Efficiency variance
 Variable production overhead cost variance
a. Expenditure or spending variance
b. Efficiency variance
 Fixed production overhead cost variance
a. Expenditure or spending variance
b. Volume variance
i. Capacity variance
ii. Efficiency variance
 Marketing cost variance
 Administration cost variance
 Sales margin variance
a. Selling price variance
b. Sales volume profit variance
i. Sales mix variance
ii. Sales quantity variance
iii.
For the purpose of our study for this level, we will restrict ourselves to price
and efficiency variances, overhead cost variances, mix and yield variances.
It must however be noted that variances are either designated favourable (F)
or unfavourable (U), also referred to as Adverse (A).

Example 3.3
The following is a master budget for planned production and sales figure of
5,000 units for the year 2013 and the actual results achieved for the same
period by Windy Enterprise.

Windy Enterprise
Income Statement for the period ending 31 December, 2013
Budget Actual
Production and sales (units) 5,000 6,000

GHC GHC GHC GHC

Sales 50,000 59,000
Variable costs
Direct materials 20,000 21,200
Direct labour 15,000 19,700

UEW/IEDE 99
COST AND MANAGEMENT
ACCOUNTING Unit 3, section 3: Flexible budget and variance analysis

Variable production o/h

10,000 (45,000) 12,100 (53,000)
Contribution 5,000 6,000
Fixed costs (2,000) (2,500)
Profit 3,000 3,500

You are required to prepare a flexible budget based on the fixed budget and
compare the flexible budget figures with the actual results.

Solution 3.3
Fixed Flexible Actual Variance
budget budget results (D)= (C) –
(A) (B) (C) (B)
Production and sales 5,000 6,000 6,000
(units)
GHC GHC GHC GHC
Sales 50,000 60,000 59,000 1,000U
Variable costs:
Direct materials 20,000 24,000 21,200 2,800F
Direct labour 15,000 18,000 19,700 1,700U
Variable production 10,000 12,000 12,100 100U
overhead 2,000 2,000 2,500 500U
Fixed costs 47,000 56,000 55,500 500F
Total Costs 3,000 4,000 3,500 500U
Profit

100 UEW/IEDE
 COST AND MANAGEMENT
Unit 3, section 3: Flexible
This page
budget
is leftand
blank
variance
for your
analysis
notes ACCOUNTING

UEW/IEDE 101