PM - Budgeting and control

Contents
Standard Costing .....................................................................................................................2
STANDARD COST: .................................................................................................................2
FLEXED BUDGET: ..................................................................................................................3
CONTROLLABILITY: ...............................................................................................................4
Expected Value ........................................................................................................................5
High / low Analysis ..................................................................................................................6
Learning Curve.........................................................................................................................8
Linear Regression Analysis .....................................................................................................11
Correlation and The Correlation Coefficient...........................................................................14
GRAPHICAL PRESENTATION: ..............................................................................................14
STATISTICAL TECHNIQUE: ...................................................................................................15
Time Series Analysis...............................................................................................................18
Material Mix and Yield Variances ...........................................................................................21
Sales Mix and Quantity Variances ..........................................................................................22
Planning and Operational Variances ......................................................................................23
DEFINITION: .......................................................................................................................23
REVISED BUDGET: ..............................................................................................................23
PLANNING AND OPERATIONAL VARIANCES: .......................................................................23

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Standard Costing
STANDARD COST:

A standard cost for a product or service is a predetermined unit cost set under specified
working conditions.

A standard cost can have the following uses:

1) Budget preparation. Standard costs and standard sales prices are necessary for the
preparation of budgets;

2) Motivation. A standard cost can motivate those working within the cost centre to
ensure that the standard is achieved;

3) Control. By comparing a standard cost to an actual cost differences are highlighted and
can be investigated;

4) Performance measurement. Differences between the standard cost and the actual cost
can form the basis for assessing the performance of cost centre managers;

5) Inventory valuation. Standard costs can be used for the measurement of inventory to
be included in the organisation’s SFP and P&L.

There are four main types of standard:

1) Basic Standards. The assumption is that nothing has changed since the standard was
first set.

 Used for trend analysis to illustrate how costs have changed over time;

 They become outdated so they cannot be used to highlight efficiency levels or as a

basis of performance assessment;

 They demotivate employees as an outdated standard can become either too easy or
too difficult to achieve;

 Performance assessment would be difficult given a demotivated employee.

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 2) Current Standards. They are based on current working conditions and assume current
efficiency and cost levels will be maintained.

 Staff may become demotivated as they are not encouraged or expected to improve
on what they are currently doing;

 Productivity levels could suffer and fair assessment of performance would be difficult
to achieve.

3) Ideal Standards. They are based on perfect working conditions and assume an optimal
level of efficiency and cost.

 It may not be possible to achieve the standard, which can have a negative impact on
employee motivation and productivity;

 Fair performance appraisal would be difficult to achieve.

4) Attainable Standards. It assumes there will be some improvements in current efficiency

and cost levels.

 Employees should feel that attainable standards are challenging yet realistic and
achievable;

 Employees should be motivated to meet the standard.

FLEXED BUDGET:

A flexed budget is prepared at the end of the period by applying standard costs and standard
revenues to the actual number of units produced & sold in that period.

Flexed budget variance = Actual cost - Flexed cost

Flexed cost = Standard cost x Actual units produced

Note: The variances should be analysed into its component parts (e.g. material, labour,
overhead). They should form the basis of performance assessment and future cost control.

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CONTROLLABILITY:

A positive or adverse variance does not necessarily mean that the budget holder has performed
well or performed badly. A budget holder should only be assessed based on what they can
control.

A controllable cost is a cost which is influenced by the budget holder.

An uncontrollable cost is a cost that cannot be changed by the budget holder.

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Expected Value
Expected value is a weighted average of all possible outcomes. It calculates the average return
that will be made if a decision is repeated over and again.

EV = Σxp

X - value of each possible outcome;

P - the probability of that outcome arising.

Calculation pro forma:

Estimated result (x), $ Probability (p), % xp

Outcome 1 X P XP
Outcome 2 X P XP
Outcome n X P XP
Expected value = Total

Advantages
- EV takes uncertainty into
consideration as the probability of
each possible outcome is considered
and then used to calculate an expected
value;
- The expected value calculation is
relatively straightforward;
- The actual EV is a single number
meaning decision making is facilitated.
Disadvantages
- It calculates the long term weighted average
value. Expected values should
not therefore be applied to one-off decisions;
- The EV may not equal any of the possible
outcomes;
- The probabilities applied to the EV calculation
can be subjective;
- EV can be seen to ignore the risk as the range
of possible profit outcomes is not considered.

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High / low Analysis
High / low analysis - method of analysis of semi-variable or mixed costs into its fixed and
variable elements based on analysis of costs incurred on various levels of activity and used to
forecast total cost for specific activity level.

4 Step approach:

Using the difference between activity levels, determine variable cost per unit:

Cost at high activity level - Cost at low activity level

Variable cost per unit =
High activity level units - Low activity level units

Find fixed cost by substitution at either high or low activity level:

Fixed cost = Total cost - Variable cost

Use variable and fixed cost to forecast total cost for specific level of activity.

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Advantages:
- Simple technique;
- Splits total costs into fixed and
variable;
- Easy to understand and apply.
Disadvantages:
- Assumes only activity level drives the production
costs;
- Two pairs of past data is considered;
- Other data is ignored;
- Historical costs may not predict future costs;
- Not always possible to split total costs into
variable and fixed.
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Learning Curve
When the workforce starts making a new product, the rate of production can be fairly slow, but
as they make more of the items they will become faster and therefore the average time taken
to make each unit will decrease and the labour cost per unit will drop.

This decrease in time taken is called the learning curve effect and it can be demonstrated in a
following graphical form:

As the volume produced increases the time taken per unit or batch drops and then slowing as
the effect of the learning curve effect starts to diminish.

Note: When producing budgets we need to consider these changes in the labour cost to ensure
the budgets are as accurate as possible given the information available to us.

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This learning curve effect won’t work for all production scenarios. It works best when the
following factors are in place:

 A motivated workforce who are keen to work at a fast pace and are keen to learn;

 A low turnover of workers, so that each of the workers have time to learn the process and
then speed up;

 Repetitive production process, so a learning effect can be massively saved;

 Labour-intensive production process, because if machines are being used for the majority
of the process they will work at the same pace with large or small volumes and at both the
start of a new production process and some time after the process has been in place;

 New production process to the business, because if the same production process has been
used for some time there will be little learning effect seen.

In order to calculate learning curve effect, we need to consider the percentage decrease in the
cumulative amount of time it takes each time the output doubles. For example:

1) We need Y hours in order to produce X units of products;

2) If the learning curve effect works we would expect that for the production of 2X units
we will need less than 2Y hours. Let’s assume that production of 2X units takes 1.8Y
hours.

3) Learning curve effect (learning rate) is 80% because the time to produce the second
batch of products drops by 20% as compared to the first one.

In order to estimate how the learning curve effect would work as production volumes increase
we can use following formulas:

logLR
y = axb b=
log2
where y - cumulative average time taken to make x units;

x - cumulative number of units made;

a - time taken to produce the first unit;

b - learning factor;

LR - learning rate as a decimal.

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Steady state effect is reached once the learning curve effect has more or less disappeared.
Usually it happens when:

 Machines become efficient and restrict improvements;

 Machines reach the limit of safe running speeds;

 The labour force has reached maximum working speed.

Once the steady state has been reached the average time taken to produce a single unit or
batch can then be used for all future budgeting, costing and pricing purposes.

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Linear Regression Analysis
Linear regression analysis is a statistical technique used to establish the equation of a straight
line, or a linear function.

The equation of a straight line can be written as follows:

𝑦 = 𝑎 + 𝑏𝑥

y - dependent variable;

x - independent variable;

a - point at which the straight line crosses the y axis;

b - gradient of a straight line.

Once a set of data is plotted on a graph, and a line of best fit is drawn through the points on the
scatter diagram, then the equation of this straight line can be established using the following
equations:

𝛴𝑦 𝛴𝑥 𝑛𝛴𝑥𝑦 − 𝛴𝑥𝛴𝑦
𝑎 = −𝑏 𝑏 =
𝑛 𝑛 𝑛𝛴𝑥 2 − (𝛴𝑥)2

Note: 𝛴(sigma) is a sign used to mean ‘the sum of’.

Once a and b are determined, it is possible to forecast future costs and revenues by establishing
the linear function. We can use this equation in order to determine a value of dependent
variable (y), when a value of independent variable (x) is given (estimated or budgeted).

Note: Under this method the value of a forecasted dependent variable is the same as the value
that is calculated by extrapolating a scatter diagram of the same data.

Example 1:

The following information relates to the number of electricity units consumed by a business
and the total electricity charge:

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 Month Electricity units used Total electricity charge ($)

x y

1 120 14.00

2 140 15.00

3 90 12.50

4 110 13.50

Establish the equation of the linear function.

Solution:

0 Electricity units used Total electricity charge ($) xy x2

x Y

1 120 14.00 1,680 14,400

2 140 15.00 2,100 19,600

3 90 12.50 1,125 8,100

4 110 13.50 1,485 12,100

Total 460 55.00 6,390 54,200

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𝛴𝑦= $55

𝛴𝑥= 460

𝛴𝑥𝑦= 6,390

𝛴𝑥2 = 54,200

𝑛𝛴𝑥𝑦 − 𝛴𝑥𝛴𝑦
𝑏 =
𝑛𝛴𝑥 2 − (𝛴𝑥)2

4 ✕ 6,390 − 55 ✕ 460
𝑏 =
4 ✕ 54,200 − (460)2

𝑏 = $0.05

𝛴𝑦 𝛴𝑥
𝑎 = −𝑏
𝑛 𝑛
$55 460
𝑎 = − 0.05
4 4
𝑎 = $8

y = $8 + 0.05x

BENEFITS AND LIMITATIONS

Benefits
Helps determine which variables are most
important for the business
Shows how the variables are interrelated and
impact on each other
Powerful statistical tool that helps with
forecasts and predictions
Limitations
It is assumed that the cause and effect
relationship between the variables remains
unchanged
It involves very lengthy and complicated
calculations
It cannot be used very effectively for
qualitative factors

13
Correlation and The Correlation Coefficient
GRAPHICAL PRESENTATION:

Correlation is an indication of how the two variables are related. We can measure the degree of
correlation between THE two variables by calculating a correlation coefficient.

There are various types of scatter diagramS which represent different degrees of correlation:

Positive correlation. When a scatter diagram shows an upward sloping line, it means that as
the value of one variable increases, the value of the other variable tends to increase as well.

Depende
Depende

Perfect positive correlation Partial positive correlation

Note: When there is no exact relationship between the points plotted on a scatter diagram and
we can’t join all of the points up to make a straight line, we can draw a line of best fit through
the points that we have plotted by estimating the general direction of the data.

Negative correlation. When a scatter diagram shows a downward sloping line, it means that as
the value of one variable increases, the value of the other one decreases.

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 Depende

Depende
Perfect negative correlation Partial negative correlation

No correlation. This is when we can’t see any possible relationship between the points plotted.
Depende

No correlation

STATISTICAL TECHNIQUE:

The correlation coefficient (r) measures the degree of correlation between variables and is
calculated using the following formula:

𝑛𝛴𝑥𝑦 − 𝛴𝑥𝛴𝑦
𝑟=
√(𝑛𝛴𝑥 2 − (𝛴𝑥)2 )(𝑛𝛴𝑦 2 − (𝛴𝑦)2 )

When r =1, there is perfect positive correlation and the variables are strongly related to each
other;

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r = -1, data is perfectly negatively correlated;

0 < r < 1, there is partial positive correlation;

-1 < r < 0, two variables have partial negative correlation;

r = 0, there is no correlation.

The coefficient of determination is a measure of how much the variation in one variable can be
explained by the variation in another variable. The coefficient of determination is simply the
correlation coefficient (r) squared.

For example, when the coefficient of determination is equal to 1, it means that 100 percent of
the variations in the dependent variable can be explained by the variation in the independent
variable.

EXAMPLE:

The following information relates to the number of electricity units used and the total
electricity charge of a business:

Month Electricity units used Total electricity charge ($) xy x2 y2

x y

1 120 14.00 1,680 14,400 196

2 140 15.00 2,100 19,600 225

3 90 12.50 1,125 8,100 156.25

4 110 13.50 1,485 12,100 182.25

460 55.00 6,390 54,200 759.50

Calculate the correlation coefficient.

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Solution:

𝛴𝑥 = 460

𝛴𝑦 = 55.00

𝛴𝑥𝑦 = 6,390

𝛴𝑥2 = 54,200

𝛴𝑦2 = 759.50

4 𝑥 6,390 − 460 𝑥 55
𝑟=
√(4 𝑥 54,200 − (460)2 ) (4 𝑥 759.50 − (55)2 )

𝑟=1

BENEFITS AND LIMITATIONS OF CORRELATION

Benefits
Same as regression analysis, helps determine
which variables are most important for the
business
Same as regression analysis, shows how the
variables are interrelated and impact on each
other
Helps in developing analytical understanding
of the business
Limitations
Same as regression analysis , it is assumed
that the cause and effect relationship
between the variables remains unchanged
Same as regression analysis, it involves very
lengthy and complicated calculations
Same as regression analysis, it cannot be
used very effectively for qualitative factors
Assumes that past trend can be used to
predict future behaviour as well

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 Time Series Analysis
A time series is a series of data which is recorded over a period of time.

In a business situation, you are more likely to come across time series which are concerned with
the sales revenue or expenditure of an organisation over a number of months, quarters, or
years.

The following example shows the sales revenue figures of the company for quarters 1 to 12:

Quarter Actual sales revenue $000s

1 220
2 310 Maximum
Revenue for quarter 1-12

3 230
4 240
5 260
6 350 Maximum
7 270
8 280
9 300
10 390 Maximum
11 310
12 320

Note: The table shows that there is a peak in sales revenue once every four quarters, in
Quarters 2, 6, and 10.

We can plot the data on a time series graph and draw a line of best fit (or a trend line) which
shows the general trend of the company’s sales revenue. The graph appears as follows:

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The line of best fit represents the general trend of the data and is known as the trend line on
the time series graph.

We can see the occurrence of peaks at A, B, and C which represent maximum sales revenue and
occur at regular intervals. They are known as seasonal variations on the time series graph.

In addition to the trend and seasonal variations, there are two other elements of a time series:

Cyclical variations: These are irregular variations which occur in the medium to long term. For
example, you may have heard of the boom/bust cycle which commonly occurs in the economic
environment.

Random variations: They are not as predictable as seasonal and cyclical variations. Such
variations might occur when a successful advertising campaign is launched and brings about an
increase in sales.

The trend and seasonal variations are two of the main elements of a time series. They can be
predicted and used in forecasting future costs and revenues. We can estimate the trend of data
by drawing the line of best fit and extending it to make forecasts of future data.

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Another method that is commonly used in forecasting future costs and revenues is the use of
linear regression analysis in order to establish the equation of the line of best fit.

There is also another method that is sometimes used to predict future costs and revenues and
this is known as the moving averages method. A moving average is established by calculating a
series of averages in order to estimate the trend of a series of data.

BENEFITS AND LIMITATIONS

Benefits
The actual past behaviour of the same
variable is used to predict its future
behaviour
This analysis helps identify patterns that can
used to forecasting
Limitations
Same as regression analysis, it cannot be
used very effectively for qualitative factors
It is not necessary that the past behvaiour
will be followed in the future as well
Random variations might occur, that cannot
be predicted

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Material Mix and Yield Variances
There are different types of material variances that can be calculated:

a) Material price variance. This variance tells us whether we have spent more or less than
planned on the material we have bought and used within the production process;

b) Material usage variance. This variance tells us whether we have used more or less than
planned.

The material usage variance can be split into a material mix and a material yield variance:

1) The material mix variance will give us more information on the financial impact of the
cost of using different proportions (or mixes) of materials. It is calculated using the
following formula:

(Actual quantity x Actual mix - Actual quantity x Standard mix) x Standard cost

Note: We need to perform this calculation for each material in the mix and then total them
together to find the total material mix variance.

2) The yield variance measures the impact of the different materials on the output (or
yield) from using those materials. It is calculated using the following formula:

(Actual quantity x Standard mix - Standard quantity x Standard mix) x Standard cost

or

(Used per std mix - Should have used) x Std cost

Note: Cost and quality are key considerations and need to be balanced when determining the
mix of materials to use. The variances, therefore, provide management with useful information
that will help them determine the best mix for the production process and for the business.

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Sales Mix and Quantity Variances
The sales volume variance can be split into the sales mix and quantity variances.

The sales mix variance looks at the proportions of each product actually sold compared to the
proportions we expected to sell when setting our budgets. It is calculated using the following
formula:

(Actual quantity x Actual mix - Actual quantity x Standard mix) x Standard contribution /
profit

Note: Alternatively, we could state this calculation as what we did sell compared to what we
thought sales of each product would be using the standard mix, multiplied by the standard
contribution or profit per unit.

The sales quantity variance looks at the difference in the contribution or profit generated by a
change in the sales volume of each product compared to budgeted sales of those products. It is
calculated using the following formula:

(Actual quantity x Standard mix - Standard quantity x Standard mix)

x Standard contribution / profit

22
Planning and Operational Variances
DEFINITION:

Planning and operational variances can be used to further break down the sales, material, or
labour variances to explore why our actual costs and revenues differ from those originally
budgeted.

REVISED BUDGET:

A budget should be revised when there are factors outside of the business’s control that impact
the original budgeted figures. The factors resulting in us revising the budget include:

 Problems with the supplier;

 An unexpected increase in material prices;

 Workers going on strike;

 The government setting a new, unexpected minimum wage;

 A new competitor coming to market, meaning that we had to reduce our selling price.

PLANNING AND OPERATIONAL VARIANCES:

When revising the budget for direct costs, we flex the budgeted costs the budgeted costs for
the actual volume of units produced.

Planning variance is the difference between flexed figures and the original budgeted figures. It
is calculated as follows:

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 (Budgeted standard cost - Revised standard cost) x Actual
Material planning price variance =
usage

(Budgeted usage - Revised usage)

Material planning usage variance =
x Budgeted standard cost

Labour planning variance = Budgeted labour cost - Revised labour cost

(Budgeted sales volume - Expected sales volume)

Sales planning variance =
x Standard contribution

Operational variance is the difference between flexed budget and actual costs. It is deemed to
be controlled by management and calculated as follows:

(Revised standard cost - Actual standard cost) x

Material operational price variance =
Actual usage

(Revised usage - Actual usage)

Material operational usage variance =
x Budgeted standard cost

Labour operational variance = Revised labour cost - Actual labour cost

(Expected sales volume - Actual sales volume) x Standard

Sales operational variance =
contribution

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