HBSP Product Number TCG318

THE CRIMSON PRESS CURRICULUM CENTER

THE CRIMSON GROUP, INC.
Note on Flexible Budgeting and Variance Analysis
Among other things, managers are paid to make decisions. Ordinarily, an informed decision is
better than an uninformed one. The difference, of course, is information. For this reason, the meas-
urement and reporting phase of the management control process is a critical aspect of the design
effort. In many respects, it is in this phase that managers’ needs and accountants’ skills merge.
Managers must be able to communicate their information needs to the accounting staff. Otherwise,
the accounting staff will not be able to design a measurement system that captures the appropriate
information.
This note discuss some important aspects of the measurement phase: (1) the importance of
aligning responsibility with control, (2) flexible budgeting, and (3) variance analysis.
Aligning Responsibility with Control
Most costs in an organization are controllable by someone. As a consequence, the management
control system must be designed so that different managers are held responsible for controlling
different costs. Ideally, the system is designed so that each manager is held responsible only for
those costs over which he or she exercises a reasonable degree of control.
In part, this alignment between responsibility and control is attained via the choice of responsi-
bility centers.1 In addition, however, the management control system must attempt to assign only
controllable costs (and sometimes revenues) to each responsibility center. This can be quite diffi-
cult, frequently requiring that the organization’s costs be measured in ways that differ from those
used for other types of cost calculations.
In addition, if managers are to be asked to control costs, they must receive the information per-
taining to their responsibility centers on reports that are both useful and timely. This may mean
augmenting the cost-collection process, or it may simply mean that data already being collected for
full cost or other purposes must be restructured for management control purposes. In all cases, the
way information is presented on the reports sent to a responsibility center manager is an important
aspect of the management control system.
In the context of measuring controllable costs, two techniques stand out as particularly relevant
and important: flexible budgeting and variance analysis. Both techniques have been used exten-
sively in many organizations, and can be quite useful to managers at all decision-making levels.
FLEXIBLE BUDGETING
The concept of flexible budgeting is derived from the distinction between controllable and non-
controllable costs. In standard expense centers, individual department managers typically exert a
great deal of control over both their department’s fixed costs and the variable costs per unit of ac-
tivity, but almost no control over the total units of activity. As a result, they exercise little control
over total variable costs. The management control solution to this problem is a budget that is ad-
justed for volume changes prior to measuring a manager’s performance. This adjusted budget is
known as the flexible budget.
A flexible budget contrasts with a fixed budget, which is a budget with no variable expense
component. A fixed budget typically is used in a discretionary expense center. In a discretionary
expense center, the manager is held responsible for spending no more than the originally budgeted
amount each month (or other reporting period). This is usually the case unless there are compelling
reasons to change the budget, such as a labor strike, a fire in the plant, or some other similarly cata-
strophic event.
1
For a discussion of responsibility centers, see the Note on Responsibility Accounting, HBSP Product 304.
_____________________________________________________________________________________________
This background note was prepared by Professor David W. Young. It is intended to assist with case analyses, and not
to illustrate either effective or ineffective handling of administrative situations.
Copyright © 2013 by The Crimson Group, Inc. To order copies or request permission to reproduce this document,
contact Harvard Business Publications (http://hbsp.harvard.edu/). Under provisions of United States and interna-
tional copyright laws, no part of this document may be reproduced, stored, or transmitted in any form or by any
means without written permission from The Crimson Group (www.thecrimsongroup.org)
TCG318 • Note on Flexible Budgeting and Variance Analysis 2 of 10
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A flexible budget is developed by classifying a responsibility center’s expenses into their fixed
and variable elements. Rather than being a fixed amount, a flexible budget is expressed as a cost
formula using agreed-upon fixed expenses and agreed-upon variable expenses per unit. An ex-
pected level of volume is specified to make sure the fixed expenses are within their relevant ranges.
This gives rise to the original budget. The original budget is then “flexed” each month (or other
reporting period) by applying the actual volume of activity to the cost formula. The result is the
budget against which the responsibility center manager’s performance is measured (because of this
it sometimes is called a performance budget).
Example: The manager of Tanglewood Dentistry, Inc., a large dental group practice, estimated that 2,000
patients would need exams and cleanings each month. She estimated that each exam and cleaning would take
approximately a half hour of a dental hygienist’s time, at an hourly rate of $20. Other costs associated with
an exam and cleaning were supplies, electricity, and water; these totaled about $2 per cleaning. The monthly
fixed costs associated with the exam and cleaning activity were $8,000. The result was the following budget:

Estimated number of procedures 2,000

Hygienist cost (1/2 hour at $20/hr.) $10
Other variable costs 2
Total variable costs per procedure $12
Variable-cost budget $24,000
Fixed costs 8,000
Total budget $32,000

During the reporting period, a total of 2,500 patients had an exam and cleaning, and the total costs of the de-
partment were $40,000. The flexible budget for Tanglewood would look as follows:

Actual number of procedures 2,500

Variable costs per procedure $ 12
Variable-cost budget $30,000
Fixed-cost budget 8,000
Flexed (performance) budget $38,000
Less actual expenditures 40,000
Spending variance $ (2,000)

Note that, although it would appear initially there was a budget overrun of $8,000 ($32,000 - $40,000), in
fact only $2,000 was a “spending” overrun. The remaining $6,000 can be attributed to the volume change,
which the manager could not control.

Factors Other than Volume. Although the flexible budget is a partial answer to the problem
of aligning responsibility with control, it does not answer all the important questions. Returning to
the above example, we might still have some questions about the negative $2,000 spending variance.
Among the possible explanations are: (1) a higher hygienist wage rate, (2) higher per-unit supply
costs, (3) more hygienist time per procedure, (4) more supply usage per procedure, (5) usage of
different kinds of supplies, and (6) higher fixed costs.
Since the answer most likely is contained in one or more of the above factors, we might wish to
explore the issue even further. If, for example, more hygienist time than budgeted were used, we
might wish to know why. Were there new hygienists on the job who required training and thus
were slower than anticipated in exams and cleanings? Or were there some patients for whom exams
and cleanings were more complex than others, resulting in more time needed to complete the proce-
dures? Or perhaps patients arrived late, and scheduling was disrupted, slowing the hygienists
down? And so on. While accounting techniques cannot answer all the above questions, the tech-
nique of variance analysis permits us to look into some of the possibilities.
VARIANCE ANALYSIS
Variance analysis is an accounting technique that permits a close examination of the difference
between budgeted and actual information. The technique allows us to break the difference into cate-
gories that are potentially meaningful for managerial action. In most organizations, the difference,
or variance, between budgeted and actual performance can be explained by five factors:
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1. Volume (number of units of activity (products or services)
2. Mix of units of activity
3. Revenue per unit of activity (selling price)
4. Rates paid for inputs (such as labor wages and cost per unit of raw materials)
5. Usage and efficiency of inputs (usage of raw materials and efficiency of labor)
Variance analysis can be used to determine the amount of the total change between budget and
actual that is associated with changes in each of these factors. Ordinarily, the variance for each fac-
tor is considered separately. There are three reasons for the separation: (1) each variance typically
has a different cause, (2) different variances usually involve different responsibility center manag-
ers, and (3) different variances require different types of corrective action. Thus, if responsibility for
different factors has been assigned to a different responsibility center managers, variance analysis
helps senior management to work with each responsibility center manager to determine the reasons
for the variance and the kinds of corrective action that might be taken.
Basic techniques for calculating these variances are shown below; more complex techniques are
described in cost accounting textbooks. In many situations, computer programs are available, or can
be developed easily on spreadsheet software, to perform the actual calculations.
A Graphic Illustration. The concept of variance analysis can be illustrated graphically. Con-
sider the example of labor costs. Total labor costs for a given employee or category of employees
can be calculated using the number of hours worked and the wage rate per hour. Assume that our
labor budget is $4,000, resulting from an estimate of 100 hours of work at $40 per hour. Graphi-
cally, this can be represented by a rectangle, with the vertical axis indicating the wage rate and the
horizontal axis the number of hours, as follows:

$/hour

$40

$4,000

100 hours
Assume now that our actual labor costs for the period in question were $6,000. A typical
budget report might indicate the variance as follows:
Item Budget Actual Variance
Labor cost $4,000 $6,000 $(2,000)
Although the report indicates a $2,000 negative variance, i.e., actual expenses greater than
budget, it does not indicate why the variance occurred. More specifically, in this instance, it does not
tell us whether the cause was a higher wage rate than anticipated, more hours than anticipated, or
some combination of the two.
If the variance were solely the result of a higher wage rate, it could be viewed as follows:

$/hour
$60
$2,000
$40

100 hours
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If, on the other hand, it were a result solely of more hours than budgeted, it could be viewed as
follows:

$/hour

$40

$2,000

100 150 hours

Finally, if it were a result of a combination of both a higher wage rate and more hours, the vari-
ance could be depicted by several wage/hour combinations; one example is shown below:

$/hour
$50
$1,000 $200
$40
$800

100 120 hours

Note that there is a problem in this last instance: the small rectangle shown on the upper right
portion of the graph that results from a combination of the labor (or wage) rate variance and the
hour (or use) variance. This combination variance sometimes is referred to as the “gray area,” in
that it cannot be assigned to either the higher rate or the higher use, but rather to the combined effect
of the two. In this instance, $1,000 of the total variance can be attributed to the higher wage rate,
$800 to the higher number of hours, and $200 to the combined effect.
For ease of calculation, the combined effect ordinarily is included in the rate variance (here the
labor wage rate variance). Not only does this approach simplify the calculation and presentation of
information, it also seems reasonable. Specifically, whoever is responsible for the rate variance is
responsible for it over as many units as actually were used. This means that the $200 combination
effect described above would be added to the $1,000 to give a $1,200 labor rate variance.
Given this approach, the budget report might look as follows:
Item Budget Actual Variance
Labor costs $4,000 $6,000 $(2,000)
Labor rate (wage) variance (1,200)
Use variance (800)
The managerial utility of this report comes directly from the fact that, in most organizations, dif-
ferent managers are responsible for different elements of a total variance. In line with the need to
align responsibility with control, it is important to designate the portion of the total variance that is
attributable to each individual manager. It then becomes possible to discuss the reasons for the vari-
ances with the managers who are involved.
In this context, it is important to emphasize that a negative variance is not designed to be used as
a “club.” Rather, it is the first step in diagnosing the reasons why costs diverged from budget, and
for exploring these reasons with the appropriate managers so that, where possible, corrective actions
can be taken to bring costs back in line. Similarly, as we will see below, a positive variance is not
necessarily a cause for celebration. It does suggest, however, that some improvement in operations
have been achieved that could be examined for possible transfer to other operating units.
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Calculating Variances
The accounting technique used to calculate a variance follows two relatively simple rules with
slight differences depending on whether a revenue or expense variance is desired:
Expense Variances. With expense variances, when actual expenses exceed budgeted ex-
penses, the organization’s financial condition is worsened, i.e., its income is reduced from what it
otherwise would have been. Similarly, when actual expenses are below budgeted expenses, the or-
ganization’s financial condition is improved. Since we wish a negative variance to be a negative
number and a positive variance to be a positive number, we use the following rules:

1. For an expense variance related to use, subtract the actual use from the budgeted use and multiply the result
by budgeted rate. If actual use exceeds budgeted use, the result will be a negative number; if actual use is be-
low budgeted use, the result will be positive.
2. For an expense variance related to rate, subtract the actual rate from the budgeted rate and multiply the result
by actual use. If the actual rate exceeds the budgeted rate, the result will be a negative number; if the actual
rate is below the budgeted rate, the result will be positive.

We can express these rules with formulas:

1. Use: (Ub - Ua) * Rb
2. Rate: (Rb - Ra) * Ua
Where ’U’ stands for use, ’R’ stands for rate, and the subscripts ’a’ and ’b’ stand for actual and
budget.
Revenue Variances. With revenue variances, when actual revenue exceeds budgeted revenue,
the organization’s financial condition has improved, i.e., its income is greater than it otherwise
would have been. Therefore:

1. For a revenue variance related to volume, subtract budgeted volume from actual volume and multiply the
result by budgeted selling price. If actual volume exceeds budgeted volume, the result is a positive number;
if actual volume is below budgeted volume, the result is negative.
2. For a revenue variance related to selling price, subtract budgeted selling price from actual selling price and
multiply the result by actual volume. If the actual selling price exceeds the budgeted selling price, the result
is a positive number; if the actual selling price is below the budgeted selling price, the result is negative.

We also can express these rules with formulas:

1. Volume: (Va - Vb) * Pb
2. Selling Price: (Pa - Pb) * Va

Where ‘V’ stands for volume, ’P’ stands for selling price, and the subscripts ’a’ and ’b’ stand for
actual and budget.
Making the Computations. Let’s return now to the example illustrated above and perform
the calculations according to the above rules and formulas. Since there are no revenue variances, we
need not concern ourselves with them; we just need to calculate the expense variances. The compu-
tations are as follows:
Use (Budgeted - (Actual * (Budgeted
variance hours) hours) wage rate)
(Ub - Ua) * Rb
(100 - 120) * $40.00 = (800)
Rate (Wage) (Budgeted- (Actual * (Actual
variance wage rate) wage rate) hours)
(Rb - Ra) * Ua
($40.00 - $50.00) * 120 =($1,200)
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Graphically, the calculations look as follows:

Rate Variance

(Rb-Ra) * Ua
($40 - $50) * 120 = $1,200

$/hour Use Variance

$50 (Ub-Ua) * Rb
$1,200 (100 - 120) * 40 = $800
$40
$800

100 120 hours

Multiple Variances. Note that this technique was performed in a situation where only two
items were involved. It also could be performed where several items have a variance. When volume
is involved, for example, a flexible budget can be prepared first, and the remaining variances can be
calculated using the actual level of volume. Let’s look at this more complicated situation with an-
other example, this time using materials instead of labor.

Example: The Haskell Manufacturing Company’s budgeted and actual material use for one department is as
follows:
Number of Material Direct Material
Units of Output per Unit Cost/Unit Total Cost
Budget 7,000 10 sq. feet $.20/sq. foot $14,000
Actual 6,000 12 sq. feet $.25/sq. foot $18,000
The factory manager is interested in obtaining a better understanding of the reasons behind the budget over-
run. To do so, we begin by preparing a flexible budget for the department—changing the volume from its
budgeted to its actual level while holding everything else constant at budgeted levels. We then can determine
what the budget would have been if we had known volume in advance. This budget then can be compared to
actual results, as follows:

Number of Material Direct Material

Units of Output per Unit Cost/Unit Total Cost Variances
Original Budget 7,000 10 sq. feet $.20/sq. foot $14,000
Flexible Budget 6,000 10 sq. feet $.20/sq. foot $12,000 $2,000
Actual 6,000 12 sq. feet $.25/sq. foot $18,000 ($6,000)
Total ($4,000)

Note that the volume variance (original budget - flexible budget) is a favorable $2,000 ($14,000
- $12,000). That is, if we had known our volume in advance, we would have budgeted $12,000
rather than $14,000. Since, to calculate the flexible budget, we held all other factors at the levels in
the original budget (10 sq. feet per unit and $.20 per sq. foot), this $2,000 positive variance is due
exclusively to the lower volume. It is favorable since it reduces expenses which, other things equal,
improves our income. (Of course, we have excluded revenue variances from the analysis. Assuming
we are paid on a per-unit basis, the fall in volume would have led to a negative revenue variance, in-
dicating a reduction in our income.)
In this example, as in many variance calculations, an unfavorable variance (i.e., one that lowers
the income of the organization) is shown in parentheses; it is sometimes called a negative variance.
A favorable (positive) variance does not have parentheses. Sometimes, unfavorable variances are
designated as “UF” and favorable variances are designated as “F”).
The spending variance (flexible budget - actual) is an unfavorable $6,000 ($12,000 - $18,000),
caused, as we can see from the data, by using two additional sq. feet per unit and paying $.05 more
per sq. foot. The combined result of the volume and spending variances is a total unfavorable vari-
ance of $4,000.
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We now can calculate the reasons for the spending variance. As indicated, above, a portion of
this variance is due to higher use (12 sq. feet vs. 10 sq. feet), and a portion is due to higher rate
($.25 per sq. foot vs. $.20 per sq. foot). Thus, the expense variances can be calculated as follows:
Use = (Ub - Ua)*Rb = (10 - 12)*($0.20) = ($0.40)
Rate = (Rb - Ra)*Ua = ($.20 - $.25)*12 = ($.60)
Note that these are variances per unit of output. To obtain the total variance, we need to multiply
these unit variances by the actual volume of output, i.e., the volume used in calculating the flexible
budget, as follows:
Variance per Unit * Actual Volume = Total
of Output of Output Variance
Use Variance ($.40) * 6,000 = ($2,400)
Rate Variance ($.60) * 6,000 = ($3,600)
Total ($6,000)
Alternatively, the calculations could be made in one step, as follows:
Variance (Budget - Actual ) * Other* * Actual Volume = Total Variance
Rate ($/sq. foot) (.20 - .25) * 12 * 6,000 = ($3,600)
Use (sq. feet) (10 - 12) * .20 * 6,000 = ($2,400)
Total ($6,000)
* “Other” in the case of the rate variance is the actual use of square feet per unit; in the case of the use
variance, it is the budgeted rate per square foot.
As this example demonstrates, variance analysis can help explain the reasons why actual ex-
penses deviated from budget. In the case of Haskell Manufacturing, we now can see that we saved
$2,000 in expenses as a result of producing fewer units, but our expenses increased by $3,600 be-
cause of higher prices for our raw materials and $2,400 because of a greater use of raw materials
per unit of output.
Mix Variances. The volume variance computed in the above problem assumed that every unit
of volume had the same variable expense associated with it. In many organizations, different types
of products and services have different unit variable expense amounts. When this is the case, the
volume variances are calculated using weighted averages of the variable expense amounts. If there is
a change in the budgeted proportions of the different product or service types, an output mix vari-
ance develops.
Input mix variances also arise with items such as raw materials and labor. This can happen if,
for example, a responsibility center manager uses a different mix of raw materials than budgeted, or
if the actual skill mix of labor differs from budget. Techniques for calculating input mix variances
are shown in most cost accounting textbooks.
Many organizations do not calculate mix variances. In these organizations, the output mix vari-
ance is automatically a part of the volume variance and the input mix variance typically is a part of
the rate variance (assuming the different types of raw materials or different skill levels for labor
have different rates).

Example: In a hospital, an output mix variance results from a change in the hospital’s case types (e.g., rela-
tively more coronary artery bypass surgery cases than influenza cases). An input mix variance comes about
when there is a change in the mix of services used to treat a given case type (e.g., more or different radio-
logical procedures ordered for each patient undergoing coronary artery bypass surgery). A second type of in-
put mix variance also could take place if the manager of, say, the radiology department used a mix of techni-
cians to take the x-rays that was different from the budget.

Managerial Uses of Variances. An important feature of variance analysis is the ability it gives
senior management to link managerial responsibility to changes in revenues and expenses. By way
of summary, Exhibit 1 lists each variance, and identifies in a general sense the department or re-
sponsibility center manager who controls it.
TCG318 • Note on Flexible Budgeting and Variance Analysis 8 of 10
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Exhibit 1. TYPES OF VARIANCES AND CONTROLLING AGENTS

Variance
Volume Variance
Output Mix Variances
Selling Price Variances
Raw Material Price Variances
Wage Rate Variances
Raw Material Usage Variances
Labor Efficiency Variances
Controlling Agent
Marketing department/senior management/the
environment (depending on the organization)
Same as above
Senior management/marketing
department/responsibility center managers
(depending on who in the organization sets prices)
Purchasing department/responsibility center
managers
Senior management (who negotiate union contracts;
responsibility center managers (who make job
offers)
Responsibility center managers
Responsibility center managers

Input Mix Variances Responsibility center managers

As this exhibit suggests, operating managers ordinarily do not control the volume or mix of
services supplied, nor do they usually set wage rates for employees or control the rates paid for raw
materials and other items of expense. Consequently, variance analysis permits management to focus
attention on each individual item and the managers who control it.
Simply identifying the separate variances is not enough, however. Senior management needs to
know why a large efficiency variance arose, for example. It also needs to know what steps are under
way to correct unfavorable variances. Thus, by separating a total variance between budgeted and
actual performance into its individual components, senior management is in a better position to
discuss these steps with the appropriate responsibility center managers.
Limitations of Variance Analysis. It is important to remember that while variance analysis
can highlight the reasons for a deviation between budgeted and actual performance, and can do so
in terms of volume, rate, use, and mix, it cannot explain why a particular organizational unit was
more or less efficient than budgeted, or why volume was higher or lower than anticipated. As a
result, variance analysis can be a useful tool to assist managers in asking the right questions and in
identifying lower-level managers to whom those questions might be addressed. As with many other
accounting techniques, however, it should be considered only as a means to assist managers to learn
more about the activities of their organizations.
In using variance analysis for managerial action, it is important to recognize that few variances
can be interpreted independently from all other variances. A negative material use variance in the
factory, for example, may have arisen because the purchasing department bought some raw
materials of lower-than-anticipated quality. Thus, what appears as a positive rate variance for the
purchasing department, may have negative “downstream” consequences in the production effort.
In sum, used properly, a negative expense variance (rate or use) can be extremely valuable: it
can help to identify areas where operating improvements can take place and can allow managers to
see the financial consequences of their corrective actions. Used in a club-like way, however, it can
be quite threatening, and may even lead to unproductive conflict or reduced cooperation between
managers and their subordinates.
TCG318 • Note on Flexible Budgeting and Variance Analysis 9 of 10
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PRACTICE CASE. OAK STREET INN
The Oak Street Inn was a small bed and breakfast located in a resort town. The inn charged a
nominal fee for a night’s stay. The following budgeted and actual figures for 1997 were available:

Actual Budget
Person-nights 10,000 12,000
Revenue $750,000 $720,000
Expenses 735,000 684,000
Income $ 15,000 $ 36,000
Questions
1. Reconcile the $30,000 increase in revenue using appropriate revenue variances.
2. Prepare a flexible budget for the Inn’s expenses. Use it and the revenue variances to
reconcile the change in income between budget and actual.

3. What additional information would you like to have to explain the difference between
the budgeted and actual income figures?

SOLUTION
Question 1
To reconcile the budgeted and actual revenue, we begin with a calculation of unit rates:
Actual Budget
Revenue $750,000 $720,000
Person-nights _10,000 _12,000
Rate per night $75.00 $60.00

We now can calculate the price variance and the sales volume variance, as follows:
Price variance [($75-$60) x 10,000] = $150,000 F
Volume variance [(10,000 - 12,000) x $60] = $120,000 UF
To reconcile the $30,000 increase, we begin with budgeted sales revenue, and use the variances to
convert it to actual sales revenue. The calculations are as follows:

Budgeted revenue $720,000

Plus: favorable price variance 150,000
Less: unfavorable volume variance (120,000)
Actual sales revenue $750,000
Alternatively, you could have calculated a flexible budget, as follows:
Original Flexible Actual
Budget Budget Results
Person nights 12,000 10,000 10,000
Fee $60 $60 $75
Revenue $720,000 $600,000 $750,000
|_____________| |____________|
Volume variance ($120,000)
Price variance $150,000
Total variance $30,000
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Question 2
The flexible budget for expenses can follow the same format:
Original Flexible Actual
Budget Budget Results
Person nights 12,000 10,000 10,000
Expense per night $57.00 $57.00 $73.50
Total expense $684,000 $570,000 735,000
|_______________||_____________|
Volume variance $114,000
Spending variance ($165,000)
Total variance ($51,000)
To reconcile the change in income, we can make the following calculations:
Budgeted income $36,000
Plus favorable revenue variance 30,000
Less unfavorable spending variance (51,000)
Actual income $15,000

Question 3
We have a good idea of the reasons underlying the revenue variance, principally a decline in
number of nights, but this was coupled with an increase in the price per night. We need more infor-
mation about the reasons for the increase in expense per night from $57.00 to $73.50. Among the
items of information we might like to have are:

• the breakdown between fixed and variable costs

• the labor and material breakdown of the two figures

• wage and efficiency information for labor
• price and usage information for materials