Chapter Four

Standard Cost System & Flexible Budgets

Master Budget Vs Flexible Budget
All master budgets discussed in the previous chapter are static or inflexible because they assume fixed
level of activity. A master budget or static budget is prepared for only one activity level (for example one
volume of sales activity). This chapter introduces flexible budgets, which are budgets designed to direct
management to areas of actual financial performance that desire attention. Managers can apply this same
basic process to control important areas of performance such as quality or customer service.
Example (1): Evergreen Company prepares a budget based on detailed expectation for the forthcoming
month. Evergreen Company’s plan tailored to a single sales level, i.e., 9,000 units. However, sales
volume units turned out to be only 7, 000 units instead of the original 9, 000 units. Compute the master
budget variance for each item given below. Exhibit 2-1 Evergreen Company Performance Report
Master Budget
Particulars Actual Master Budget
Variances
Units 7,000 units 9,000 units 2,000 units U
Sales Br. 217,000 Br. 279,000 Br. 62,000 U
Variable Expenses
* Manufacturing Br. 151,270 Br. 189,000 Br. 37,730 F
* Selling 5,000 5,400 400 F
* Administrative 2,000 1,800 200 U
Total Variable Expense Br. 158,270 Br. 196,200 Br. 37,930 F
Contribution Margin Br. 58,730 Br. 82,800 Br. 24,070 U
Fixed Expenses
* Manufacturing Br. 37,300 Br. 37,000 300 U
*Selling & Administrative 33,000 33,000 ---
Total Fixed Expenses Br. 70,300 Br. 70,000 300 U
Operating Income (Loss) Br. (11,570) Br. 12,800 Br. 24,370 U
N.B. Master budget variance (static budget variance) is the variance of actual result from the master budget. It
is customary to label variances favorable (F) or unfavorable (U). The label indicates whether the target or
the actual figure is larger. The way in which labels are applied depends on the item for which a variance
is computed. If the item for which the variance is computed is a revenue or profit item, favorable
variances are those for which actual is greater than the target; unfavorable variances are those for which
actual is less than the target (or the budget). If the item for which the variance is computed is a cost or
expense item, favorable variances are those for which actual is less than the target. Therefore, if actual
cost is greater than target cost, the variance will be labeled unfavorable.
Flexible Budget (Dynamic Budget)
Actual activity may differ significantly from budgeted activity because of an unexpected labor strike,
cancellation of an order, an unexpected large new production contract, and other factors. When actual
results differ considerably from plans, a fixed or static budget may not be particularly effective in
supporting managers. In such cases several budgets prepared for a variety of activity levels may be more
useful. In contrast to the performance report based only on comparing the master budget to the actual
results, a more useful benchmark for analysis is the flexible budget. A flexible budget (sometimes called a

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variable budget) is budget that can easily be adjusted for differences in the level of activity. It provides
managers more useful information for planning and better basis for comparing performance than, a static
or fixed budget. In performance evaluation, a master budget is kept fixed or static to serve as a benchmark
for evaluating performance. It shows revenues and costs at only the originally planned levels of activity.
However, a flexible budget will be prepared at the actual activity level.
The flexible budget is identical to the master budget in format, but managers may prepare it for any level
of activity.
Distinguishing Features of Flexible Budget
Flexible budgets have several desirable characteristics. They:
i. Cover a range of activity
ii. Are dynamic
iii. Facilitate performance measurement.
Flexible Budget Cover a Range of Activity. Accurate predictions of activity levels are sometimes hard
to make, and many managers find they make more effective decisions with the aid of flexible budgets. In
developing a flexible budget one activity level at each extreme of the relevant range is selected, with one
or more in between.
Flexible Budget Are Dynamic. Flexible budgets allow managers to adjust plans easily when activity
level differs from the expected level. Such budgets address “what is” rather than “what was” or “what
was expected”. This dynamic nature of flexible budget makes them a very useful decision making tool for
management.
Flexible Budget Facilitate Performance Measurement. Measuring efficiency is an important role of
performance report. Fixed budgets are useful for measuring effectiveness, i.e., achievement of goal. In
some cases, however, fixed budgets do not identify the question, “what should the result be, given the
actual level of activity”. In other words, the flexible-budget approach says, “Give me any activity level
you choose, and I’ll provide a budget tailored to that particular level.” To summarize, whenever actual
and budgeted activity are significantly different, a flexible budget variance report provides a better
measure of efficiency than a report based on a fixed budget.
4.2.2 Flexible Budgeting Process
The following steps are needed to develop a flexible budget.
i. Determine the range of activity the budget should cover (because cost behavior patterns
may be different in different ranges of activity)
ii. Determine the cost behavior pattern for each cost included in the budget.
iii. Select the activity levels for which budgets will be prepared.
iv. Prepared a flexible budget using the cost behavior data and the selected activity level.
Example (2): Evergreen Company is planning to use a flexible budgeting system to plan and control its
operations. Evergreen made the following cost estimates for budgeting purposes:

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 Budget Formula Per Unit
Sales Br. 31.00
Variable Costs
* Manufacturing Br. 21.00
* Selling 0.60
* Administrative 0.20
Total Variable Costs Br. 21.80
Contribution Margin Br. 9.20
Budget Formula Per Month
Fixed Costs
* Manufacturing Br. 37,000

* Selling and administrative 33,000

Total fixed costs Br. 70,000
Instruction: Prepared a flexible budget for the next month using 7,000, 8,000, and 9,000 units as activity
level. Evergreen Company’s cost functions or flexible budget formulas are believed to be
valid within the range of 7,000 to 9,000 units. At what level of activity does the company
breakeven?
Exhibit 2.2 Evergreen Co. Flexible Budget
Flexible Budgets For Various Activity Levels
7,000 units 8,000 units 9,000 units
Sales Br. 217,000 Br. 248,000 Br. 279,000
Variable Costs
* Manufacturing Br. 147,000 Br. 168,000 Br. 189,000
* Selling 4,200 4,800 5,400
* Administrative 1,400 1,600 1,800
Total Variable Costs Br. 152,600 Br. 174,400 Br. 196,200
Contribution margin Br. 64,400 Br. 73,600 Br. 82,800
Fixed costs
* Manufacturing Br. 37,000 Br. 37,000 Br. 37,000
* Selling and administrative 33,000 33,000 33,000
Total fixed costs Br. 70,000 Br. 70,000 Br. 70,000
Operating income (loss) Br. (5,600) Br. 3,600 B. 12,800
BEP (in units) = Total fixed costs = Br.70, 000
Unit Contribution Margin 31-21.8
= 7609 units(approximation)
BEP (in birrs) = Total fixed costs =Br.70, 000 =Br.235,873(approximation)
CM-ratio 9.2/31
Comparing the flexible budget to actual results accomplishes an important performance evaluation
purpose. There are basically two reasons why actual results might not have conformed to the master
budget:
i. Sales and other cost-driver activities were not the same as originally forecasted.
ii. Revenues or variable costs per unit and fixed costs per period were not as expected.
Flexible Budget Variances: Any variances between the flexible budget and actual results can not b due
to activity levels. These variances between the flexible budget and actual results are called flexible budget
variances and must be due to departure of actual costs or revenues from flexible-budget formula amounts.
Activity level variances: Any differences or variances between the master budget and the flexible budget
are due to activity levels. These differences are called activity-level variances.
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 The sum of the activity level variances and the flexible budget variances equal the total of the master
budget variances.
Example (3): Refer the data given in example (1) and (2). Prepare a condensed table showing the static
(master) budget variance, the sales activity variance, and the flexible-budget variance.
Exhibit 2.3 Evergreen Co. Summary of Performance
Flexible
Flexible Sales Activity
Actual Results Master Budget Budget
Budget Variances
Variance
Units 7,000 7,000 9,000 - 2,000 U
Sales Br. 17,000 Br. 17,000 Br.279,000 - Br62,000 U
Variable costs 158,270 152,600 196,200 Br 5,670 U 43,600 F
Contribution margin Br. 58,730 Br. 64,400 Br. 82,800 Br.5,670 U Br18,400 U
Fixed Costs 70,300 70,000 70,000 300 U -
Operating Income (loss) Br. (11,570) Br. (5,600) Br. 12,800 Br. 5,970 U Br. 18,400 U
*U or F indicates whether the variances are unfavorable or favorable, respectively.
Total master budget variance (TMBV) = ALF + FBV
where TMBV = Total Master Budget Variance
ALF = Activity Level Variance
FBV = Flexible Budget Variance
Thus, the total master budget variance for Evergreen Co. amounts to Br. 24,370 unfavorable (Br. 5970 U
+ Br. 18400 U). The sum of the activity-level variances here equals sales-activity variances because sales
are the only activity used as a cost driver. Managers use comparisons between actual results, master
budgets, and flexible budgets to evaluate organizational performance. When evaluating performance, it is
useful to distinguish between effectiveness-the degrees to which a goal, objective, or target is met- and
efficiency-the degree to which inputs are used in relation to a given level of outputs.
Performance may be effective, efficient, both, or neither. For example, Evergreen Co. set a master budget
objective of manufacturing and selling 9,000 units. Only 7,000 units were actually made and sold,
however. Performance, as measured by sales-activity variances, was ineffective because the sales
objective was not met. Was Evergreen’s performance efficient? Managers judge the degree of efficiency
by comparing actual outputs achieved (7,000 units) with actual inputs (such as the cost of direct materials
and direct labor). The less input used to produce a given output, the more efficient the operation.
Evergreen was in efficient in its use of a number of inputs. Later in this Chapter, direct material, direct
labor and variable and fixed overhead flexible-budget variances will be discussed in detail. Flexible-
budget variances measure the efficiency of operations at the actual level of activity. The flexible-budget
variances shown in column (4) of Exhibit 2.3 total Br. 5,970 unfavorable. The total flexible-budget
variance arises from sales prices received and the variable and fixed costs incurred. Evergreen Co. had no
difference between actual sales price and the flexible-budgeted sales price, so the focus is on the
differences between actual costs and flexible-budgeted costs at actual 7,000-unit level of activity. Sales-
activity variances measure how effective managers have been in meeting the planned sales objective. In
Evergreen Co., sales activity fell 2,000 units short of the planned level. The sales-activity variances
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(totaling Br. 18,400 U) are unaffected by any changes in unit prices or variable costs. Why? Because the
same budgeted unit prices and variable costs are used in constructing both the flexible and master
budgets. Therefore, all unit prices and variable costs are held constant in columns (2) and (3) of Exhibit
2.3
Standard Costing System
Standard cost systems is accounting system that value products according to standard costs only. A
standard cost is a carefully determined cost per unit that should be attained. A standard cost is a
predetermined measure of what a cost should be under stated conditions. A standard is more than just an
estimate; it is a goal. Achieving this goal represents a reasonable level of performance predetermined
costs; they are target costs that should be incurred under efficient operating conditions. Standard cost is
planned, generally established well before production begins, and provides management with goals to
attain (planning) & a basis for comparison with actual results (control).
Standard costs are not the same as budgeted costs. A budget relates to an entire activity or operation; a
standard presents the same information on a per unit basis. A standard therefore provides cost
expectations per unit of activity and a budget provides the cost expectation for the total activity. If the
budget output for a product is for 10 000 units and the standard cost is Br 3 per unit, budgeted cost will be
Br 30,000. We shall see that establishing standard costs for each unit produced enables a detailed analysis
to be made of the difference between the budgeted cost and the actual cost so that costs can be controlled
more effectively. Standard costs are also known as planned costs, predicted costs and scheduled costs.
The purpose of standard costing is to assist the management of an organization to plan and control their
operations
Types of Standards
Standards can be classified by their degree of rigor and, thus, their motivational value from easy to
difficult, which parallels the lax, expected, practical, and ideal levels of capacity.
Ideal standard represents perfect operating conditions and therefore can be hard to achieve. It assumes
no material wastage, the worker always measures perfectly, and the machines never get out of adjustment.
Ideal standards have no slack – that is, no allowance for waste, breaks, or stress reduction. The use of
ideal standards creates unfavorable variances, which can have a negative impact on employee morale.
Even when attained, ideal standards can cause a high level of tension in the organization. It is for this
reason that many researchers argue that some slack in standards is functional. An ideal standard is
sometimes called theoretical standard.
A practical standard deliberately builds slack into the standard. It represents estimated cost under tight,
but achievable conditions. Practical standards make allowances for normal breakdowns in machinery and
for rest periods for workers. Ideal standards, however, assume that operations are 100% efficient
throughout the entire production process. Practical standards are considered to be more realistic than ideal
standards. Practical standards can be reached with reasonable effort under existing operating conditions. It

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may be useful for firms to use both ideal and practical standards for cost management. The former
focuses and challenges the organization to continually move the actual results closer to the ideal. The
latter ensures that standards do not create unnecessary tension or lower employee morale. Practical
standard is sometimes called attainable standard.
Expected Standard: are standards that reflect what is actually expected to occur in a future period
Lax standard: refers to standard that can be achieved with little effort.
Most companies presently use attainable standards but a new manufacturing environment, like just in time
(JIT), is developing that emphasizes ideal standards.
Standard Costing Steps
There are five major steps in standard costing. Careful application of these steps helps maximize the value
of the SCS as a cost management tool and supports its supplemental objectives of inventory valuation and
simplifying bookkeeping. The five steps are:
Step 1: Develop standards Step 4: Investigate variances
Step 2: Accumulate actual information Step5: Take corrective action
Step 3: Compute variances
STEP 1: DEVELOP STANDARDS
A standard cost represents the predetermined amount of resources necessary to produce a unit of output of
a product or service. Therefore, standard costing begins with a good understanding of the input-output
relationships in a process. To set standards, we must also decide how difficult they must be, what data to
use as a basis for setting standards and who participates in setting standards.
a. Understanding Input-Output Relationships
An analysis of the work activities in the production process is the first step in setting standards.
Knowledge of the production process can be translated into the quantity of material, labor, and other
resources required for producing a product. When this information is combined with knowledge of market
prices, accountants can set standard product costs for the materials, labor and other short-term
consumable resources.
b. Data Used for Setting Standards
Setting standards requires data. This data may come from engineering studies, external benchmarks, or
past historical experience. Engineering studies done by production engineers may help to determine the
input-output relationships in a process. This data may be used to define ideal and attainable standards.
External benchmarking of firms in the same industry or firms in a different industry but with a similar
process can also provide data for standards. Such external comparisons have the added advantage of
keeping a firm aware of what their competition is doing and help the firm stay competitive. Past
historical data can be used for standard setting. There are two dangers in using past data. We can
institutionalize past inefficiency in the standards, and the past may not be a good guide to the future
because of design changes in the product and/or the process.

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c. Who Participates In Setting Standards
Standards may be imposed from the top-management or they may be set through a participative process
of consultation with employees who are affected by the standard.
An imposed standard, which is set with little or no input from those responsible for meeting the
standard, is used when it is desirable to ensure that all actions lead to a uniform strategic target. However,
imposed standards do not create a sense of ownership of the part of employees. Motivating employees to
achieve these standards, therefore, may be more difficult.
Participative standards use inputs from employee either affected by a standard or who have the best
understanding of the process. Participation does not mean those responsible for meeting the standard get
to set the standard. It does mean that employees have input in the standard setting process. Normally
standards are developed by a group composed of representatives from the following areas: management
accounting, product design, industrial engineering, personnel, data processing, purchasing, and
production management
Key Point: To set standards we must understand the input-output relationships in a process decide how
much slack to allow in standards, select the data to use as a basis for setting standards and determine who
should participate in setting standards.
d. Development of Standards
Standards are conventionally established for each component (materials, labor, and overhead) of product
cost. A standard cost is an estimated cost to manufacture a single unit of product or perform a single
service. The development of a standard cost involves judgment and practicality in identifying the types of
material and labor to be used and their related quantities and prices. The development of standards for
overhead requires that costs are appropriately classified by cost behavior, valid allocation bases have been
chosen, and a reasonable level of activity has been specified.
i. MATERIAL STANDARDS
The first step in developing material standards is to identify and list the specific direct material
components used to manufacture the product or to perform the service. Three things must be known about
the materials:
a. what inputs are needed,
b. what the quality of those inputs must be, and
c. What quantities of inputs of the specified quality are needed?
Physical quantity estimates can be made in terms of weight, size, volume, or other measures – given the
level of quality chosen for each essential component. The estimates should be based on the results of
engineering tests, opinions of people using the materials, or historical data. A bill of materials is a
document that contains information about product material components, their specifications (including
quality), and the quantities needed for production.
The main information sources of standard setting for the amount of material could be:

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 • Product specifications (the ‘recipe’ for the • Estimates of wastage
product being made) • Quality of material
• Technical data from the material supplier • Production equipment & machinery
(e.g. recommended usage) available, and its performance
• Historical data on quantities used in the
past
• Observation of manufacture
The main information sources of standard setting for the cost of material could be:
• Data from suppliers • Production schedules and bulk buying
• Records of previous prices paid policy (in conjunction with availability of
• anticipated cost inflation (measured by bulk discounts)
general or specific price indices) • Seasonality of prices
• anticipated demand for scarce supplies • anticipated currency exchange rates
ii. LABOR STANDARDS
The development of labor standards requires procedures that are similar to those used for materials. An
analysis of labor tasks is completed, then an operations flow document can be prepared which lists all
tasks necessary to make a unit of product or perform a service and the corresponding time allowed for
each operation. The main information sources of standard setting for the amount of labor time could be:
• Data on previous output and efficiency levels
• Results of formal observations (work study or ‘time & motion’ study)
• Anticipated changes in working practices or productivity levels
• The level of training of employees to be used
The main information sources of standard setting for the cost of labor could be:
• Current pay rates
• Anticipated pay rises
• The expected effects of bonus schemes
• Equivalent pay rates of other employers in the locality
• Changes in legislation (e.g. minimum wage rates)
• Grade of labor (or sub contractors) to be used
iii. OVERHEAD STANDARDS
FOH cost pool includes IM, IL, factory rent, factory depreciation, factory insurance, etc. To prepare the
standard usually involves input from many department & managers. The development of standards for
overhead requires that costs are appropriately classified by cost behavior, valid allocation bases have been
chosen, and a reasonable level of activity has been specified. Budgets are commonly used in controlling
factory overhead costs. Fixed budgets show anticipated costs at one level of activity. Flexible budgets
show anticipated costs at different levels of activities. A standard cost card is a document that summarizes

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the direct material and direct labor standard quantities and the prices needed to complete one unit of
product as well as the overhead allocation bases and rates.
e. Considerations in Establishing Standards
Appropriateness and attainability need to be considered when standards are established.
! Appropriateness, in relation to a standard, refers to the basis on which the standards are developed
and how long they are expected to last. Standards are developed from past and current information,
and they should reflect technical and environmental factors expected for the period in which the
standards are to be applied. Factors such as materials quality, normal ordering quantities, employee
wage rates, degree of plant automation, facility layout, and mix of employee skills should be
considered. Standards must evolve over the organization’s life to reflect its changing methods and
processes.
Attainability refers to management’s belief about the degree of difficulty or rigor that should be incurred
in achieving the standard. Standards can be classified by their degree of rigor and, thus, their motivational
value from easy to difficult, which parallels the lax, expected, practical, and ideal levels of capacity. Lax
standard refers to standard that can be achieved with little effort. Expected standards are standards that
reflect what is actually expected to occur in a future period. Practical standards are a standard that allows
for normal, unavoidable time problems or delays, such as machine downtime and worker breaks; can be
reached or slightly exceeded approximately sixty to seventy percent of the time with reasonable effort by
workers. Ideal standard is a standard that allows for no inefficiency of any type and, therefore, is
sometimes also called perfection or an ideal standard.
STEP 2: ACCUMULATE ACTUAL INFORMATION
Standard cost systems compare actual and standard costs to make sure costs are under control. This means
that actual cost information must be collected and reported using the same categories as those used for
setting standards. Managers use standards to manage costs by taking corrective actions when the process
is out of control. For standard costing to be an effective cost management tool, the data on actual cost
performance must be captured and reported in a timely fashion.
The frequency of reporting depends upon how fast corrective action should and can be taken. If reporting
is too late and the time for corrective action is over, standard cost and variance reports are not useful for
cost management. Critical information that operating personnel need to actively manage operations is
often captured and reporting using other tools. This allows problems to be identified and solved before the
standard cost variances are even reported. For example, observation, a control chart, or an hourly quality
report may show that more products than normal are flawed. This information leads to immediate
corrective action.
Key Point: Actual information for computing and analyzing variances must be collected and reported in
the same categories as the standards and the information should be reported in a timely manner for

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corrective action to be taken quickly. When this is not possible, we must supplement standard costing
with other real time tools such as hourly display boards or control charts.
STEP 3: COMPUTE VARIANCES
A. VARIANCE ANALYSIS
A variance is a deviation from a predetermined standard cost. Since the cost of any item is the sum of the
unit price multiplied by the total quantity purchased, mathematically a variance is the result of a deviation
in the price paid, the quantity purchased, or both. In a typical organization, the responsibility for
purchasing inputs and using those inputs is usually separate. For example, the procurement department
negotiates and orders materials while the plant supervisors usually control usage of that material. In a
responsibility accounting system, therefore, variances are used to assign responsibility to appropriate
people who have control over that element of the cost and to draw their attention to the need for
corrective action. Based on this mathematical and organizational logic, most standard cost systems
compute and report three major variances. They are material variance, labor variance, and overhead
variances.
A. Material Variances
The standard material cost for any product consists of a standard price of materials times the standard
quantity for those materials. Total actual costs may differ from standard because of either a difference in
the price paid for those materials and/or the amount of materials used. Hence, we can isolate two
variances for materials: materials price variance and materials usage variance. There are two good reasons
for breaking the materials variance into these two components: (1) different individuals or departments
may be responsible for each component (purchasing manager for price and production manager for
quantity), and (2) materials may be purchased in one period and used in another. It would probably be of
little use for management to learn that an unfavorable price variance exists some time after the purchase
was made.
A) The materials price variance: It measures how much is paid for material consumed and how much
should have been paid. If actual price is higher than standard, an unfavorable variance exists. If the
reverse were true, a favorable variance would exist. MPV is computed using the following formula:
MPV = (AP-SP) X AQ, where AP= Actual Price per Unit
SP= Standard Price per Unit
AQ= Actual Material Consumption
B) The materials quantity (or usage) variance: It measures how much material is consumed and how
much should have been consumed. An unfavorable variance results when the actual quantity used exceeds
the standard quantity allowed. A favorable variance results when the reverse is true.
MQV is computed as follows:
MQV = (AQ - SQ) X SP, where AQ= Actual Total Material Used
SQ= Standard Total Material Used

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 SP= Standard Price per Unit
Total Material Variance= MPV+ MQV
B. Labor Variance
The standard labor cost of a product consists of the standard hours allowed to produce the product times
the standard rate. It follows that total labor costs may differ from standard for two reasons: a deviation
from standard pay rates and/or from standard hours. We can therefore isolate two variances for labor: the
labor rate variance and the labor efficiency variance. The labor rate variance indicates what portion of the
total difference between actual and standard labor cost is due to a variation in pay rates. The labor
efficiency variance shows what portion of the total difference between actual and standard labor cost is
due to a deviation in the number of hours worked. It is similar to the usage variance computed for
materials.
A) The labor rate variance: It measures how much is paid and hoe much should have been paid. If the
actual rate is higher than the standard rate, an unfavorable variance exists. If the actual rate is less than the
standard rate, a favorable variance exists. LRV is computed as follows:
LRV = (AR - SR) X AH, where AR= Actual Labor Rate per Hour
SR= Standard Labor Rate per Hour
AH= Actual Total Labor Hour Worked
b) The labor efficiency variance: It measures how much time is used and how much should have been
used. If more hours are used to produce a given number of products than are allowed under standard, an
unfavorable variance exists. If actual hours are less than standard, a favorable variance exists. LEV is
computed as follows:
LEV = (AH - SH) x SR, where SR= Standard Labor Rate per Hour
SH= Standard Total Labor Hour Allowed
AH= Actual Total Labor Hour Worked
Exercise
Budget Standards per unit Actual
Production 50 units 30 units
DM usage 4 lbs. @ Br 0.50 per lb. 140 lbs @ Br 1 per lb.
DL usage 2 hrs. @ Br1 per hour 72 hours @ Br 0.75 per hr.

Compute: -
a) Material Price Variance d) Labor Rate Variance
b) Material Quantity Variance e) Labor Efficiency Variance
c) Total Material Variance h) Total Labor Variance
C. Factory Overhead variances
In a standard cost system, overhead is assigned to production via a predetermined overhead rate just as is
done in an actual cost system. This predetermined rate is often based on a flexible overhead budget. The
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flexible overhead budget shows the amount of overhead that is expected to be incurred at various levels of
activity. Overhead will differ (and therefore overhead rates will differ) at various levels due to the
variable nature of some overhead costs and the fixed nature of others. Total fixed overhead is the same at
various levels of output, which will result in a different rate per unit for the different levels of output. On
the other hand, total variable overhead varies according to the activity level chosen since it is a constant
amount per unit. Once an expected volume has been chosen (the standard volume of output), the
predetermined overhead rate can be set on estimated overhead for that level. The standard volume of
output may be expressed as percent of capacity, number of units or direct labor hours. Overhead is then
applied to production based on this predetermined rate. The amount of over- and under-applied overhead
resulting from using this rate can be investigated using the two-variance approach, which results in the
computation of the overhead budget variance and the overhead volume variance. The overhead budget
variance shows the efficiency of operations and may be considered a combination of the price and usage
variance for total overhead. The overhead volume variance results from two factors: (1) the fixed nature
of some overhead costs, and (2) operating at a level of output different from that expected. In effect, this
variance shows whether the level chosen was appropriate.
Budgeted variable and fixed overhead rates are developed following the following steps:
Developing variable overhead rate
1. Identify the costs to include in the variable overhead cost pool and fixed overhead cost
pool
2. Select the cost allocation base for variable FOH and fixed FOH. The cost allocation base
may be output, direct labor hour, machine hour, etc.
3. Estimate the budgeted quantity of the selected allocation base(s)
4. Compute the budgeted variable FOH and fixed FOH rate, which are computed by dividing
the budgeted overhead cost by estimated allocation base
The overhead variance is computed as the difference between total actual overhead costs and budgeted
total overhead for the actual output attained. If the budgeted overhead costs exceed the actual overhead, a
favorable variance exists. Conversely, if actual overhead costs exceed budgeted overhead, an unfavorable
variance exists. At the end of the period, actual overhead costs are compared against amounts shown in
the flexible budget. The difference, or variance, is subdivided into two components for variable overhead
and two for fixed overhead.
Remember: For the sake of simplicity in the variance formula “budgeted overhead rate” refers to
‘budgeted overhead rate per unit of selected cost allocation base” and “Actual overhead rate” refers to
‘Actual overhead rate per unit of selected cost allocation base”.
Variable Overhead Variance (VFOH)
Variable-overhead variances are conceptually similar to variances for direct material and direct labor.
The variances may be divided into spending and efficiency variance.

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1. The VFOH spending variance
It is the result of comparing the amount that was spent on variable overhead items at the actual level of
activity with the amount that should have been spent at that level. The variance may be expressed
algebraically as follows:
VFOH Actual quantity of VFOH Actual Budgeted
spending = allocation base for actual X VFOH rate - VFOH rate
variance output
The spending variance can arise from paying higher/lower prices than expected and consuming
larger/smaller quantities than expected (e.g., energy, supplies), so it is not a “pure” price/rate variance.
2. The VFOH efficiency variance
It is not a direct measure of how efficiently the quantity of overhead was used but instead is a measure of
efficiency with the application base (e.g., machine hours, process hours, and so on). The variance may be
expressed algebraically as follows:
VFOH Budgeted Actual quantity of Budgeted quantity of
Efficiency = VFOH X VFOH allocation base - VFOH allocation base
variance rate for actual output Allowed for actual output
Fixed Overhead Variances (FFOH)
Fixed overhead variances are divided into spending and volume variances.
1. FFOH spending variance, also called budget variance
It is the result of comparing total actual fixed-overhead expenditures with lump-sum, budgeted fixed
overhead costs. It is calculated as follows:
FFOH Spending variance = Actual fixed overhead - Budgeted fixed overhead
If the budgeted FFOH costs exceed the actual overhead, a favorable variance exists. Conversely, if actual
overhead costs exceed budgeted overhead, an unfavorable variance exists. Although it is often difficult to
change certain fixed cost expenditures (such as property taxes) in the short run, unfavorable fixed
overhead items should be carefully monitored and the information used when making future budgets.
2. Production-Volume variance
The volume variance occurs whenever the actual production differs from the budgeted level used to
calculate the budgeted FFOH rate. The production –volume variance is the difference between budgeted
FFOH and the FFOH allocated. The FFOH is allocated based on the budgeted FFOH rate times the
budgeted quantity of the FFOH allocation base for the actual output units achieved. Production-volume
variance sometimes termed as output-level overhead variance and denominator-level variance. It is
calculated as follows:
Production-volume variance = Budgeted FFOH - Applied FFOH
Applied FFOH= Standard quantity of FFOH allocation base for Actual Output X Budgeted
FFOH Rate
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If the applied overhead exceeds the budgeted overhead, a favorable variance exists because a level of
production higher than expected was achieved. Conversely, if budgeted overhead exceeds applied
overhead, an unfavorable variance exists. The overhead volume variance can also be calculated by
subtracting the budgeted hours from the standard hours allowed for actual production and multiplying this
figure by the fixed overhead rate. A common interpretation of a positive volume variance is that a
company has underutilized its facility. However, this interpretation is faulty when a reduction in activity
levels is in response to an unexpected decrease in demand. In such a situation, the volume variance is a
demand prediction error and not the fault of the production manager.
Note: Total FOH Spending Variance = VFOH Spending Variance + FFOH Spending Variance
Total FOH Flexible-Budget Variance = Total FOH Spending Variance + Production-volume Variance
Example
Addis Manufacturing uses a standard costing system and its fiscal year ends on Hamle 30. Variable
overhead for Hamle 1997 was budgeted at Br 4 per machine hour. Budgeted fixed overhead in Hamle
1997 was Br 240,000. Addis has budgeted 200,000 units of output for Hamle 1997. Machine hour is the
allocation base for variable and fixed overhead costs. Machine hour is budgeted to be 0.50 hours per unit
of output. The actual number of units produced for the month is 192,000 with a total machine hours of
57,600. The actual variable and fixed overhead costs for the month are Br 120,000 and Br 256,800,
respectively.
Required: Compute
1. VFOH Efficiency Variance 3. FFOH Spending Variance
2. VFOH Spending Variance 4. Production-Volume Variance
B. VARIANCE REPORTS
All of the variances computed are to be typically summarized in a variance report to management and
first level supervisors. The report may provide comparisons at any level of detail. For example, a firm
might compare actual or expected labor costs on an overall basis, for each facility, for each department,
for each work classification, and for each product. The SCS should provide variance reports customized
to the level of detail needed to maintain control of costs.
Top management typically receives summary financial information on major variances by product,
process, or cost factors in a quarterly report. Plant, product, or division managers receive monthly
variance reports that summarize significant financial variances in major categories such as labor or
material use or price. Operating managers and supervisors receive detailed analysis of price and quantity
variances for each material, labor, or variable overhead item that has a standard. These reports typically
cover a week’s activity. While birr variances are useful to gauge the financial impact of deviating from
plans, they may be too late to take corrective actions. Critical variables, such as quantity produced, are
often monitored and reported daily, by shift, hourly, or even continually. Activities that are monitored
more frequently are measured in operational and not financial terms.

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STEP 4: INVESTIGATE VARIANCES
The primary purpose of investigating reported variances is to manage costs. This requires identifying the
root causes of variances and assigning responsibility for variances so corrective action may be taken.
However, it takes employee time and other costs to investigate variances. The benefits of investigating a
variance, therefore, should be greater than the cost of doing the analysis. Only those variances deemed
significant should be investigated.
a. Deciding Which Variances to Investigate
Given that investigation is costly, most firms use a management by exception system that focuses on
variances that are large in size or show a negative trend. Management by exception is a technique in
which managers set upper and lower limits of tolerance for deviations and investigate only deviations that
fall outside those tolerance ranges. Variances large enough to fall outside the ranges of acceptability are
usually indicative of trouble, and the variances themselves do not reveal the cause of the trouble or the
person or group responsible. Mangers must investigate problems through observation, inspection, and
inquiry to determine the causes of variances. In addition, it may be useful to randomly select a small
percentage of variances to investigate to ensure that cost controls remain adequate. It is also important to
investigate both favorable and unfavorable variances. A favorable variance for a particular item may be
unfavorable to the firm overall. For example, using less material than required creates a favorable
quantity variance, but might make the product unsafe and lead to legal problems.
Size: The absolute or relative size of a variance is an important factor in the investigation decision. Often
absolute size or percentage difference criteria are set and all variances that exceed these criteria are
investigated.
Trend: If a variance shows a trend, that is, it is getting larger period by period or is always negative or
positive, further investigation may be warranted. Even though the size of the variance remains below
preset size criteria, the trend may be a warning that a particular part of a process may be deteriorating and
may fail if corrective action is not taken.
Key Point: It is important to investigate both favorable and unfavorable variances if they are large,
exceed a certain percent of budget or seem to have trend.
b. Identifying Root Causes of Variances
Once accountants identify that a variance needs investigation, operating personnel must apply a
systematic process to find out what causes these variances. Many firms use a tool called root cause
analysis. Root cause analysis is a method of linking a variance to the underlying cause of the variance.
This technique requires that investigators ask “why” until they find the underlying cause of the variance.
Root Cause Analysis Using the 5-Why Method
Most firms find it takes four or five levels of analysis to identify root causes. For one company, root cause
analysis simply may take the form of asking “five whys”- that is, they recommend asking "why" at least
five times to determine the root cause of a problem or a variance.

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Assume that Girum Company has a persistent problem with an unfavorable labor quantity variance. The
following five levels of analysis provide a possible root cause analysis for why the company has this
unfavorable variance.
Labor Quantity Variance
Why?
More hours used than allowed in the standard
Why?
Less experienced labor used in the labor pool
Why?
Not enough experienced workers available
Why?
Experienced workers hired by competitors
Why?
No career opportunity for growth
Note that at the first level the answer is more labor hours than budget were used. This is not only obvious;
it is also not very helpful. The second question asks why we used more hours. The answer, there were lots
of inexperienced labor in the pool, is a little more helpful. The next why asks why inexperienced labor
was used? The answer is that experienced labor was unavailable. The fourth why tells us that the reason
little experienced labor was unavailable was because competitors are hiring this labor away. The fifth and
last why tells us that the reason experienced workers leave is that they do not have career growth
opportunities. Note that root cause analysis shows that labor quantity variance, a problem normally
associated with manufacturing, is actually the result of the human resource policies of the firm. It reveals
the process linkages that show how decisions in one area can adversely affect other areas. By
understanding the root cause, we can attack the real source of the problem rather than simply putting
pressure on the production supervisor- the normal outcome without root cause analysis.
Key Point: Root cause analysis, which requires asking why several times, allows managers to understand
and address the source of variances rather than their symptoms.
STEP 5: TAKE CORRECTIVE ACTION
The final step in the standard costing process is to use the information derived from the root cause
investigation to take corrective action. However, to select the appropriate corrective action, we must array
the root causes by source – that is, where in the organization a root cause originates. A root cause can
originate within a unit, from another unit, or from the external environment.
Assume that Girum Company has done a complete root cause analysis of all variances and that this
analysis shows the following six root causes for the variances:
! Poor safety training for workers ! New hires poorly trained and
! Improper storage of molds inexperienced
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 ! Incentives to accept the lowest bidder for ! Demand fluctuations making prediction
materials difficult
! Early retirement package to layoff
workers
The following analysis places these causes in the three different cells depending on where these causes
originate -- within unit, inter-unit or external environment.
Classifying Root Causes by Source and Frequency
Source Root Cause of Variances
Poor safety training for workers
Within Unit
Improper storage of materials

New hires poorly trained and inexperienced

Inter-unit
Incentives to accept the lowest bidder for materials
Early retirement package to layoff workers
External environment Demand fluctuations making prediction difficult

Within unit causes are properly addressed by unit managers and first line supervisors. They have the
primary responsibility for analyzing, investigating, and taking corrective action on such causes. If
improper storage of molds is causing warping in products, this is something that should be addressed by
the molding department supervisor. When variances result from actions that originate from other units, a
cross functional team is better suited to take care of this problem. This is because corrective action
requires cooperation and coordination among these mangers. If procurement is causing variances from
poor purchasing policies, they need to be part of the production team to understand the consequences of
their actions. Finally, top management is best suited to handle causes that originate outside an
organization from its environment. For example, fluctuations in demand cause production schedules to go
off. Stabilizing demand is not something the production managers can do even if the variances are in
production costs.
Key Point: The source of a root cause determines whether the unit manager, a cross-functional team or
upper management can best handle it.
Dealing with Variances
Variances assist managers in their planning and control decisions. Management by exception is the
practice of concentrating on areas not operating as expected (such as a shortfall in sales of a product) and
giving less attention to areas operating as expected. Managers use information from variances in deciding
how to allocate their energies. Areas with sizable variances receive more of their attention than do areas
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with minimal variances. Variances also are used in performance evaluation. For example, production-line
managers may have quarterly efficiency incentives linked to achieving a budgeted amount of operating
costs. Managers consider many possible causes for price variances and efficiency variances. Here are
some examples.
! A favourable materials-price variance occurs if the purchasing manager bought in larger lot sizes
than budgeted, thereby obtaining quantity discounts.
! An unfavourable labor-price variance occurs because wage rates for highly skilled workers
unexpectedly increase.
! An unfavourable materials-efficiency variance results from inadequate training of the labour
force.
! A favourable labour-efficiency variance occurs because budgeted time standards for highly
skilled workers are not set tight enough.
The most important task in variance analysis is to identify the causes of variances and use this knowledge
to promote continuous improvement. Often the causes of variances are interrelated. For example, an
unfavourable materials efficiency variance is likely to be related to a favourable materials price variance
when the purchasing manager buys lower-priced, lower-quality materials. It is always best to consider
possible interdependencies among variances rather than to interpret them in isolation of each other. In
some cases, the causes of variances are in different parts of the company's value chain or in other
companies in the supply chain. For example, an unfavourable labour-efficiency variance could be caused
by the marketing manager obtaining a large number of rush orders that disrupts the normal flow of
production. If rush orders caused the variance, top management could establish a policy limiting the
number of rush orders or could increase the selling price for these orders.
Managers use variance analysis in performance evaluation. Effectiveness and efficiency are two common
attributes of performance. Effectiveness is the degree to which a predetermined objective or target is met.
Efficiency is the relative amount of inputs used to achieve a given output level Performance can be both
effective and efficient, but either condition can exist without the other. For example, assume a company's
static budget calls for production and sales of 12,000 units. If the company produces and sells 15,000
units, performance is effective. Given the 25% increase in output, performance would be inefficient,
however, if the usage of direct materials and direct manufacturing labour inputs exceeds the static-budget
amounts by more than25%. Favorable and unfavorable are not synonymous with good and bad results.
Variances must be investigated before an accurate assessment can be made. Although variances are
isolated, they may not be independent. Managers must decide when to investigate variances. They often
use rules of thumb such as "investigate all variances exceeding Br 5,000 or 5% of budgeted cost,
whichever is lower." This approach recognizes that the budget represents a range of possible acceptable
outcomes rather than a single acceptable outcome. Variances within this range are due to random chance
and hence do not require investigation. A continuous improvement budgeted cost is progressively reduced

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over succeeding periods. For example, budgeted direct material costs of a product could be reduced by
1% per month. Continuous improvement budgeted costs signal to managers and employees the
importance of constantly seeking ways to reduce total costs. Products in the initial months of their
production often have higher budgeted improvement rates than those that have been manufactured for
longer periods.

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 CHAPTER FIVE

Mix and Yield Variances

There are a variety of possible extensions to the basic variance analysis presented in previous chapter.
Although it is not practical to include all possible variations of variance analysis, one or two additional
types of analysis will provide you with a feel for the variations of variance analysis found in practice.
Material mix and yield variances provide a variance analysis extension that some firms have found useful.
Most products are a combination of different materials and several types of labor. For such products,
particularly those that require precise recipes the mix of materials and labor should not vary. Bottling
plant managers at MOHA are not allowed to tamper with the formula used to make Pepsi. Dairies mix
precise amounts of chocolate and milk to produce chocolate flavored milk. Some production
environments, however, offer some flexibility. Different types of materials or classes of labor may be
substituted in a product. For example, orange juice manufacturers can mix Jimma and Harar oranges in
slightly different proportions. A fried chicken franchise may mix experienced higher paid cooks with low
paid helpers in their breading operation.
When materials or labor varies from their predetermined proportion, a mix variance results. A mix
variance is the cost that results from the difference between an actual mix and a standard mix. Often mix
changes can also impact the total output that is produced from a given amount of input. For example,
substituting cooks for helpers may result in higher quantity of breaded chicken pieces because the cooks
are faster and more experienced. A yield variance is the extra cost from the loss in quantity that results
when there is a change in the mix material or labor.
Material Mix and Yield Variance
When different types of materials may be used as substitutes for each other, a standard mix is usually
determined to insure a quality product at the lowest possible cost. If the actual material mix varies from
the standard mix, both quality and cost may be affected. The effect on cost can be determined by
separating the material quantity variance into two variances referred to as material mix and material yield
variances. In addition to the substitutability requirement, the unit of measure for the various materials
needs to be the same. Materials may be measured in gallons or pounds or board feet, or some other
measure, but the unit of measure must be the same for each ingredient. If these two prerequisites are
satisfied, material mix and yield variances can be calculated.
As said earlier, mix and yield variances for materials may be used when the materials are substitutable for
each other. When inputs are substitutable, direct materials efficiency improvement relative to budgeted
costs can come from two sources:
(1) Using less input to achieve a given output, and
(2) Using a cheaper mix to produce a given output.
The total material variance is the sum of material price variance and material quantity variance. The
material quantity variance is the difference between a flexible budget based on the actual quantity used
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and a flexible budget based on the standard quantity allowed. The material quantity variance is further
separated into mix and yield variances. Material mix and yield variances are computed as follows.
Direct Material Actual DM Budgeted Actual Qty Budgeted
Mix Variance = Mix - DM mix x of All DM x Price of
Percentage Percentage used DM input

Direct Actual Qty Budgeted Qty of Budgeted Budgeted

Material = of All DM - All DM Allowed x DM mix x Price of
Yield Used for Actual Output Percentage DM input
Variance

Total Material
Variance

Material Price Material Quantity

Variance Variance

Material Mix Material Yield

Variance Variance

EXAMPLE

Assume Bole Burger combines three ingredients in the production of the firm's popular hamburger. The
standard quantities and input prices of these materials are provided below for a normal production batch
of 2,000 pounds of hamburger.
Material Standard Mix Standard Inputs Standard Price
per pound
A 10% 200 Br1.00
C 50% 1,000 2.00
B 40% 800 3.00
2,000 lbs
The following data are provided for a recent production period in which 20,500 pounds of materials were
used to produce 20,000 pounds of hamburger.
Material Actual Quantities Used
A 2,460
C 9,225
B 8,815
20,500
The requirements are simply to calculate the materials quantity, mix and yield variances for this situation.
The standard quantities of inputs allowed for actual output are:
A = (200/2,000) x 20,000 = 2,000
B = (1,000/2,000) x 20,000 = 10,000
C = (800/2,000) x 20,000 = 8,000
The variances are calculated in the following manner:
Material Quantity Variance = (AQ - SQ)(SP)
A = (2,460 - 2,000) (1.00) = Br 460 U

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 B = (10,000 – 9,225) (2.00) = 1,550 F
C = (8,000 - 8,815) (3.00) = 2,445 U
Br 1,355U
Material Mix Variance = (AM- SM) (ATM)(SP)
A (0.12-0.10) x 20,500x 1.00 = Br 410 U
B (0.45– 0.50) x20,500 x 2.00 = 2,050 F
C (0.43 -0.40) x 20,500 x 3.00 = 1,845U
Br 205U
Material Yield Variance = (ATM - STM) (SM)(SP)
A (20,500-20,000)x 0.10x 1.00 = Br 50 U
B (20,500-20,000)x 0.50x 2.00 = 500 U
C (20,500-20,000)x 0.40x 3.00 = 600 U
Br 1150 U

The sum of the mix and yield variances must be equal to the material quantity variance. The status of the
material quantity variance is determined in the usual way, i.e., it is unfavorable if the actual quantity used
exceeds the standard quantity allowed. The mix variance is unfavorable if Actual Mix > Standard Mix,
i.e., the actual quantity exceeds the quantity called for by the standard mix. This is unfavorable because it
increases the cost of the product. The material yield variances represent a measure of what the material
quantity variances would have been if the actual mix proportions were equal to the standard mix
proportions. The yield variances are unfavorable when Actual Total Material Used >Standard Total
Materials allowed for Actual Output.
Labor Mix and Yield Variances
The idea of labor mix and yield variance is the same as material mix and yield variance. To illustrate mix
and yield variances, consider Birhanu Electric Works – an electrical contractor who does new
construction wiring. The typical crew consists of one experienced electrician and two apprentice
electricians. An experienced electrician can wire 10 fixtures per hour while an apprentice can wire only 5
fixtures per hour. The standard and actual data is summarized as follows.
Birhanu Electric: Standard Cost Sheet for Ginbot

Labor Standard Standard Standard Standard Standard

Rate per Crew Mix Hours Labor Cost Output in
Hour Fixtures
Apprentice Br 15 2 (67%) 320 Br 4,800 1,600
Electricians
Master Br 40 1 (33%) 160 6,400 1,600
Electricians
Total 480 Br 11,200 3,200

During Ginbot, Birhanu Electric wired 3,600 fixtures at a total labor cost of Br 15,000. The detailed
breakdown of the actual hours is shown as follows:

Labor Standard Rate Actual Actual Output

per Hour Hours in Fixtures
Apprentice Electricians Br 15 240 1,440
Master Electricians Br 40 240 2,160
Total 480 3,600

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Labor Quantity Variance
To understand labor mix and yield variances, we will begin by computing the quantity variance for the
two types of labor, apprentice and master. The first table shows the standard wage rates and the budgeted
hours (480) for a budgeted output of 3,200 fixtures. Since the actual output is 3,600 fixtures (see the
second table), the standard total hours for the actual output is 540 hours [(3,600/3,200) x 480)]. Ignoring
the mix, we can compute a quantity variance as simply the difference between actual hours and the
flexible budget for the standard hours earned on the basis of the output of 3,600 fixtures. The labor
quantity variance for Ginbot is:
LQV (Apprentices) = (AQ – SQ) x SP
= (240 – 360) x Br 15
= Br 1,800 F
LQV (Master) = (AQ – SQ) x SP
= (240 – 180) x Br 40
= Br 2,400 U
LQV (Combined) = Br 1,800 F + Br 2,400 U
= Br 600 U

Labor Mix Variance

Let us now consider the impact of a crew mix. For Ginbot, there is a mix variance because the actual
labor mix used differed from the standard labor mix. The third column of the second table above shows
that the actual apprentice labor was 50 percent rather than the expected 67 percent and that the master
electrician was 50 percent rather than 33 percent. The mix variance measures the monetary effect of using
a different mix. In our example, it is the higher than expected percentage of master electrician hours. The
mix variance uses the actual hours, but assumes that they are distributed in the budgeted mix. This is
because we want to isolate the effect of a change in mix without adding the effect of a change in output as
well. The formula for computing the mix variance is as follows:

Direct Labor Actual DL Budgeted DL Actual Qty Standard

Mix Variance = Mix - Mix x of All DL x Rate per
Percentage Percentage Hours Used Hour

The electrician crew mix variance for Ginbot is computed as follows:

DLMV (Apprentice) = (.50 – .67) x 480 x Br15 = Br 1,200 F
DLMV (Master) = (.50 – .33) x 480x Br 40 = Br 3,200 U
Total Labor Mix Variance Br 2,000 U
The decrease in the percentage of apprentice labor used results in a favorable variance while the increase
in the use of master labor results in an unfavorable mix variance. The net effect of the mix change is an
unfavorable crew mix variance of Br 2,000. Because the total mix must equal 100 percent, there is always
at least one favorable and one unfavorable mix variance if there is any change in mix.

Labor Yield Variance

The change in mix required more of the expensive master electricians. While this increased the total
wages paid, master electricians work faster and the yield from the same 480 labor hours has gone up.
Instead of the budgeted 3,200 fixtures we have 3,600 fixtures. In effect, the 480 hours at the new mix has
yielded 540 labor hours worth of output. This impact can be captured in the yield variance, which shows
us the productivity impact of the new mix. Again, to isolate the effect of a change in the yield, we will
hold the mix constant and assume that the earned hours and the actual hours were both at the standard
mix. The formula for computing the mix variance is as follows:
Direct Actual Budgeted Total Budgeted Standard
Labor Yield = Total - Labor Hours x DL mix x Rate per
Variance Labor Allowed for Percentage Hour
Hours Used Actual Output

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The crew yield variance for Ginbot is computed as follows:
DLYV (Apprentice) = (480 – 540) x 0.67 x Br 15 = Br 600 F
DLYV (Master) = (480 – 540) x 0.33 x Br 40 = Br 800 F
Total Labor Yield Variance = Br 1,400 F
Note that the mix and yield variances together give additional information about the causes of a quantity
variance. When mix and yield variances are combined, they equal the quantity variance. In our example,
the mix and yield equal the combined quantity variance of Br 600 Unfavorable.
Total mix variance = Br 2,000 U
Total yield variance = Br1,400 F
Total Quantity variance = Br 600 U
We can see that despite the increased productivity of the master electricians, the decision to substitute the
higher paid labor has resulted in an overall unfavorable variance of Br 600. This was because unfavorable
mix variance was larger than the favorable yield variance. Birhanu is better off sticking to its standard
crew mix and avoiding the type of tradeoff between using cheaper labor it did in Ginbot.
SALES VARIANCES
The idea of variance analysis can be extended to areas other than production. For example, an analysis
can be made on why actual revenue differed from budgeted revenue. If, for example, a company budgeted
to sell 10,000 units at Br 50 each but because of market forces had to reduce the price to Br 48 and even
so they were only able to sell 9,000 at this price, a variance occurs. Then:
Actual Sales Revenue = 9,000 x Br 48 = Br 432,000
Budgeted Sales Revenue = 10,000 x Br 50 = Br 500,000
Sales Variance = Br 432,000 – Br 500,000 = -Br 68,000 = Br 68,000 U
This variance is negative which means that less revenue was obtained than expected and is therefore
unfavorable and marked with U. This variance is made up of two elements: the reduction in volume of
1,000 units and the reduction in selling price of Br 2 per unit. From the above example it can be seen that
two items will contribute to sales variance: the sales-price variance (SPV) and the sales-volume
variance (SVV). The sales-price variance arises because a company increased or decreased its sales price
when compared with the budgeted sales price. The sales-volume variance arises from an increase or
decrease in units sold. Generally speaking, sales variances can be analyzed by splitting the total variance
into six variance as shown below.

Static-Budget
Variance

Flexible-Budget Sales-Volume
Variance Variance

Sales-Mix Sales-Quantity
Variance Variance

Market-Size Market-Share
Variance Variance

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Example
Agere ltd sales three products in the Dembel City centre. The Company Budgeted to sell 10,000 units.
The budgeted 10,000 units represent 50% market share. The details for the budgeted and actual data for
the year 1996 fiscal year are as follows:

Budgeted Data Actual Data

Produc Selling Quantity Sales Total Selling Unit Sales Total
t Price per Mix Revenu Price Volume Mix Reven
Unit e per Unit ue
A 12 1,000 10% 12,000 10 1,800 15%
18,000
B 20 3,000 30 60,000 25 4,800 40 120,00
0
C 15 6,000 60 90,000 15 5,400 45
81,000
10,000 162,000 12,000 219,00
0

Static-budget variance: is the difference between an actual result and a budgeted amount in the static
budget.

Static-Budget Variance= Actual Result- budgeted Amount

The Static-budget variance for Agere Ltd is computed as follows:
A= 18,000-12,000 = 6,000F
B= 120,000-60,000 =60,000F
C= 81,000-90,000 = 9,000U
Total SBV =57,000F
A. Static-Budget variance can be further split into Flexible-Budget and Sales-Volume variance.
1. Flexible-budget variance: Is the difference between the actual revenues and the flexible-budget
amount for the actual unit volume of sales. It is computed as: -
FBV=Actual Result- Flexible-budget Amount
The Static-budget variance for Agere Ltd is computed as follows:
FBV A=18,000- (12x 1,800) = 3,600U
B=120,000-(20x 4,800) =24,000F
C=81,000-(15 x 5,400) = 0 Total..............................20,400F
2. Sales-volume variance: shows the effect of the difference between the actual and budgeted quantity
of variable used to flex the flexible budget. The sales-volume variance, which arises from an increase
or decrease in units sold, is calculated as:
SVV = (Actual Sales Quantity - Budgeted Sales Quantity) x Budgeted Selling Price per Unit
The Sales-volume variance for Agere Ltd is computed as follows:
SVV-A= (1,800-1,000) x 12= $9,600F
B= (4,800-3,000) x 20=$36,000F
C= (5,400-6,000) x 15= $9,000U
Total SVV=$36,600F
B. Subdivisions of sales-volume variance
1. Sales-mix variance: difference between (1) budgeted amount for the actual sales mix, and (2) the
budgeted amount if the budgeted sales mix had been changed. The formula for computing the sales-
mix variance in terms of revenue and the amount for Agere Ltd is:-

Actual Budgeted Actual Units Budgeted

SMV = Sales Mix - Sales Mix x Of All x Selling Price
Percentage percentage Products Sold Per Unit

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 SMV-A= (0.15-0.10) x 12,000 x 12=$7,200F
B= (0.40-0.30) x 12,000 x 20=$2,400F
C= (0.45-0.60) x 12,000 x 15=$27,000U
TSMV= $17,400U
2. Sales-quantity variance: is the difference between two amounts: (1) the budgeted amount based
on actual quantities sold of all products and the budgeted mix, and (2) the amount in the static
budget (which is based on the budgeted quantities to be sold of all products and the budgeted mix).
The formula for computing the sales-quantity variance in terms of revenue and the amount for
Agere Ltd is:-
Actual Units Budgeted Budgeted Sales Budgeted
SQV = Of All - Units Of All x Mix x Selling Price
Products Sold Products Sold percentage Per Unit

SQV-A = (12,000 -10,000) x 0.10x 12=

B = (12,000 -10,000) x 0.30x 20=
C = (12,000 -10,000) x 0.60x 15=
Market Share and Market Size Variance
Sales depend on overall market demand as well as the firm’s ability to maintain its share of the market.
The following table summarizes the budgeted and actual sales units for the industry.
Budgeted Industry Actual Industry
Quantity Quantity
Product A 1,800 2,200
Product B 6,200 8,000
Product C 12,000 14,800
Total 20,000 25,000

Agere Ltd can use the industry information to get further insight into the sales quantity variance by
dividing this variance into a market-size and market-share variance.
Market- size variance is the difference between two amounts (1) the budgeted amount based on the actual
market size in units and the budgeted market share, and (2) the static budget amount based on the
budgeted market-size in units and the budgeted market share. The formula and the amount for Agere Ltd
are: -
MSV= (Actual MSZ - Budgeted MSZ) x Budgeted MSR x Budgeted ASP
Where, MSV= Market Share Variance MSR= Market Share in Units
MSZ= Market Size in Units ASP= Average Selling Price per Unit
MSV for Agere Ltd is computed as follows:-
MSV= (25,000-20,000) x 0.50x 16.20
= Br 40,500F
Market –share variance is the difference between two amounts: (1) the budgeted amount at budgeted mix
based on actual market size in units and the actual market share, and (2) the budgeted amount at budgeted
mix based on actual market size in units and the budgeted market share. The formula and the amount for
Agere Ltd are: -
Mkt-share Variance= (Actual MSR- Budgeted MSR)x Actual MSZ x Budgeted ASP
MSV for Agere Ltd is computed as follows:-
Mkt-share Variance= (0.48- 0.50) x 25,000x 16.20
=Br 8,100 U

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