Budget Control (Week 10) Topics + Flexible budget * Conducting variance analysis + Standard costs + Under/over applied overhead The Flexible Budget ‘A good way to understand the flexible budget concept isto define static budget first. A static budget is designed for only the planned level of activity, which is what we did last week, However, a flexible budget has the ability to analyze revenues and costs for a range of activity levels. This is quite useful i the sales levels end up varying from the expectations. This, in turn, would impact production, purchase of raw materials, direct labour usage, etc Recall that the UCW Bookstore has a strict policy of not committing to fixed manufacturing overhead costs (all expenses are incurred on hourly usage). However, this might change in future if volume goes Up. Let's look at a flexible budget income statement for the UCW Bookstore at the 400, 450, and 500 sales levels: UCW Bookstore | Flexible Budget | For the Year Ended August 31, 2023 Sales in Units Budgeted Amount Per Unit 400 450 500 Sales $100 $40,000 $45,000 $50,000 “Less variable expenses Direct materials (sce 3,200 3,600 4,000 Direct labour 30 12,000 13,500 15,000 Variable manufacturing overhead | 450 1800-20252, 250 Variable selling and administrative Siete 2,000 2250 2/500 Total variable expenses 47.50 19,000 21,375 | Contribution margin 52.50 21,000 23,625.24, 250 Less fixed expenses Fixed manufacturing overhead |__Fixed selling and administrative _ Total fixed expenses Operating income 15,000 15,000 15,000 15,000 $8625 _ $1250]Having a flexible budget income statement gives us an opportunity to evaluate performance versus actual results (see next page). The difference between the flexible budget and actual numbers s known as flexible budget variance. Sometimes a variance is to our benefit (favourable, marked with an “f") and sometimes a variance is to our detriment (unfavourable, marked with a “u”). The best way to remember this concept isto realize that higher revenues are good (favourable) while higher expenses are bad (unfavourable). in the bookstore's flexible budget performance report below, we see that the flexible budget variance ends up being unfavourable by $2,025. UCW Bookstore Flexible Budget Performance Report For the Year Ended August 31, 2023 Flexible Flexible Budgeted Amount Actual Budget Budget Per Unit __—(S00units) (500 units)_Variance_ Sales ie $100 $47,500 $50,000 $2,500 u Less variable expenses Direct materials 8 4200 _4,000 800 u Direct labour 30 14,500 15,000 500 f Variable manufacturing - |_ overhead fr Neteeetesiesaaeaeaae 777 2,250 2se| | Variable seling and administrative 5 2,750 2,500 250 Total variable expenses if 47.50 24,275 23,750 525 w | Contribution margin 52.50 23,225 26,250 G02 w Less fixed expenses acu — Fixed manufacturing overhead 0 oO oO Fixed selling and administrative 34,000 15,000 1,000 F Total fixed expenses 14,000 15,000 1000 F ‘Operating Income 9,225 11,250 82,024! We can do the same analysis between the actual numbers and the static budget. Recall that the static budget has a set expected activity level so static budget variances can not only arise from improved/worse efficiency but also differences in activity levels. The bookstore ends up with a favourable static budget variance of $600 (see Static Budget Performance Report below). Finally, we can show both the sales volume variance, flexible budget variance, and static budget variance (along with the static, flexible budget, and actual numbers) in one performance report (see Comprehensive Performance Report further below).UCW Bookstore Static Budget Performance Report For the Year Ended August 31, 2023, Static Budgeted Amount Actual Budget _ Static Budget - Per Unit (500 units) (450 units) _Variance Sales $100 $47,500 $45,000 $ 2, 500 F Less variable expenses Direct materials ‘ii 3,600 1/200 Direct labour 30 13,500 L000 w Variable manufacturing s a : overhead ee) 2,025 200 w Variable selling and administrative 5 2,750 2,250 Soo w Total variable expenses 47.50 24,275 21375 Z,400_w Contribution margin. 52.50 23,225 23,625 Yoo w | Less fixed expenses a | Fixed manufacturing overhead 0 mane o Fixed selling and administrative 14,000 15,000 1000 € Total fixed expenses 14,000 15,000 Looof [Operating Income = 9, 8,625 $ho0€ ; = - 2 a LUCW Bookstore ‘Comprehensive Performance Report For the Year Ended August 31, 2023 Actual Flexible Flexible sales Static (500 Budget Budget Volume Budget | i Units) Variance (500 units) __Variance __(450 Units) Sales $47,500 2/500" $50,000 Soo f__$45,000 Less variable expenses | Direct materials 4,800 FIOn 4,000 Yoow 3,600 Direct labour 14,500 ook 15,000 soo 13,500 Variable manufacturing overhead 2,225 Zoe 2,250 22s uM 2,025 | Variable selling and | administrative 2,750 250% __2,500 2So w __2250| Total variable expenses 24275 F 25 A 23,750__Z,375 A 21375 Contribution margin 23,225 3,025 vw 26250 2,625 € 23,625 Less fixed expenses z Fixed manufacturing overhead 0 o 0 0 0 Fixed selling and administrative 14,000 1,00 £ __ 15,000 oO 15,000 Total fixed expenses 14,000 1,000 £ 15,000 O 15,000 | Operating Income $9,225 201s $11,250 Bez $8,625) t Total Static-Budget Variance =$ Coo F t“The point of doing all of this analysis is to derive conclusions and make recommendations on how operations can be improved. In the bookstore’s case, there are plenty of areas we can look into and possibly improve. We should note that there is a significant flexible-budget variance. Looking into the individual items a bit more closely, we see that there is some difference in the sales revenue that should have been generated at the 500-units sold level and what was actually generated. We should question the bookstore salespeople about why the sales revenue total was lower than expected. It could be a result of something like sales promotions, but it could also be error or fraud. Higher than expected expenses also contributed to the unfavourable flexible budget variance. We should analyze why expenses were consistently higher than expected. This information will help us determine if there is an unfavourable trend which we should account for in future budgeting or if this is just inefficiency which must be improved on. We should also look into how the bookstore spent less on direct labour than expected and if this savings method is sustainable for future budgeting purposes. Our sales-volume variance is favourable largely as a result of higher units sold than expected. This is undoubtedly something that the bookstore should be happy with, but it failed to generate significantly higher profits as a result of it. Standard Costs A standard is a benchmark for measuring performance. It can be viewed as a budget for a single unit. Quantity standard- how much of an input should be used to make a unit of product or provide a unit of servi Cost (price) standard how much should be paid for each unit of the input. We can set certain standards for specific activities then compare actual results to them. Significant differences are labelled as “exceptions” and managers can investigate further or address the issues which cause them. This is called management by exception. To set price and quantity standards, we should rely on expertise of everyone who Is responsible for purchasing and using inputs. A standard cost report is a detailed listing of the standard amounts of materials, labour, and overhead that should go into one unit of product, multiplied by the standard price or rate that has been set for each cost element. Ideal standards: Standards which allow for no machine breakdowns or other work interruptions and that require peak efficiency at all times. Practical standards: Standards which allow for normal machine downtime and other work interruptions. ‘These standards can be attained through reasonable but highly efficient efforts by the average employee.Direct materials standards The standard price per unit should reflect the final, delivered cost of the materials including shipping, receiving, and other costs, net of any discounts taken. Let's use the UCW Library producing fancy bookends (which are used in the library and also sold for profit) as an example: Purchase price, top-grade pewter $3.60 Freight, by truck, from supplier's warehouse 0.44 Receiving and handling 0.05 Less purchase discount (0.09) Standard price per kilogram st.00 The standard quantity per unit should reflect the amount of material required for each unit of finished product as well as an allowance for unavoidable waste, spoilage, and other normal inefficiencies. Here's an example: Materials requirements as specified in the bill of materials for a pair of bookends, in kilograms 27 ‘Allowance for waste and spoilage, in kllograms 02 Allowance for rejects, in kilograms o1 Standard quantity per pair of bookends, in kilograms 42 Once we have these two breakdowns, we can compute the standard cost of our finished product (a pair of bookends): Standard price per kilogram x standard quantity per unit $4.00 per kilogram x 3.0 kilograms per unit=$ !2.00 per uni Direct labour standards The standard rate per hour for direct labour includes wages earned, employee benefits, and other labour costs. Here's an example: Basic average wage rate per hour $15.00 Employment taxes at 10% of the basic rate 1.50 Employment benefits at 30% of the basic rate Standard price per direct labour-hourMany companies prepare a single standard rate for all employees in a department. This reflects an expected “mix” even though the actual wage rates may vary. In our case, the UCW Library might have two high-cost employees (ex. Engineers) who have a standard price per direct-labour hour of $30, two low-cost employees (ex. Janitors) who have a standard price per direct-labour hour of $12, and five assembly-line workers who have a standard price per direct-labour hour of $21 (exactly as shown above). Because the average standard price per direct labour hour for the employees is $21, we can broadly use the rate for our calculations. The standard hours per unit refers to how long it takes to produce a single unit of product. Here’s an example: Basic labour time per unit, in hours iy Allowance for breaks and personal needs O01 Allowance for cleanup and machine downtime 03 Allowance for rejects 0.2 Standard labour-hours per unit of product as ‘As with direct materials standards, we can compute the standard labour cost per unit of finished product: Standard price per direct labour-hour x Standard labour-hours per unit of product = $21.00 per direct labour-hour x 2.5 Standard labour-hours per unit of product =$ $2.50 per unit Variable manufacturing overhead standards This rate represents the variable portion of predetermined overhead rate and is also calculated based ‘on rates and hours (like direct labour standards). The hours relate to whatever acti base is used (typically direct labour or machine hours) to apply overhead to units of product. Let's assume UCW Library's variable manufacturing overhead cost is $3.00 per direct labour-hour. (Our standard variable manufacturing overhead cost per unit is: Standard price per direct labour/machine hour x Standard labour/machine hours per unit of product = $3.00 per direct labour-hour x 2.5 Standard labour-hours per unit of product=$ SO per unit With the direct materials, direct labour and variable manufacturing overhead standards set, we can now calculate the standard variable cost per unit: Inputs Standard quantity or hours Standard price or rate Standard cost, Direct Materials 3.0 kilograms $4.00 $i2.00 Direct Labour 2.5 hours $21.00 $8b.49, Variable manufacturing overhead 2.5 hours $3.00 $250 Total standard variable cost per unit $72.09neral Model for Variance Analysis (1) (2) @) Actual Quantity of ‘Actual Quantity of Standard Quantity allowed for inputs at Actual Price inputs at Standard Price Actual Output at Standard Price (AQx AP) {aQx SP) (saxsP) ‘Quantity Variance (2)-(3) a ’ + Price Variance (2)-(2) | Materials price variance, ‘Materials quantity variance, | Labour rate variance, Labour efficiency variance, Variable overhead spending variance Variable overhead efficiency variance Total flexible budget variance ‘The last exhibit can be considered a general model for variance analysis. A few points to note about this: 1) Aprice variance and quantity variance can be computed for all three cost elements (direct, materials, direct labour, and variable manufacturing overhead), but with different names. 2). Even though price variances have different names under different cost elements, they are computed in the same manner. This is also true with quantity variance. 3) The inputs represent the actual quantities of direct materials, direct labour, or variable manufacturing overhead used. The output represents the good production of the period, ‘expressed in terms of the standard quantity (or standard hours) allowed for the actual output. 4) The third column (SP x SQ) represents the flexible budget for the period. Materials Variances Let’s continue on with our example. Assume 2,000 units were produced this quarter. Therefore, $24,000 {S12 x 2,000 units) is expected to be used on direct materials for this level of production. However, the UCW Library ended up using 6,500 kilograms of input purchased at $3.80 per kilogram. We can easily determine the price and quantity variances by filing in the diagram below: Actual Quantity of ‘Actual Quantity of Standard Quantity allowed for inputs at Actual Price inputs at Standard Price ‘Actual Output at Standard Price (AQx AP) (AQx SP) (saxsP) 6,500 kg x $3.80 per kg = 6,500 kg x $4 per ke 6,000 kg x $4 per kg = $24,700 $24,000 $ 24,000 4 4 4 | BooF Quantity Variance Price Variance 2,000 Total flexible budget variance=$ TOO‘Some observations from the diagram: a) The price of the input used was lower than the standard by $0.20 per unit, which resulted in a favourable price variance. b)_ The quantity of the input used was greater than the standard by 500 kg. This resulted in an unfavourable quantity variance. Since the quantity variance was larger than the price variance, we ended up with an unfavourable total flexible budget variance. Here are a couple of formulas to make life easier: ‘Materials price variance = AQ(AP-SP) Materials quantity variance= SP(AQ-SQ) Direct Labour Variances Let’s assume that the UCW Library used 5,400 direct-labour hours at an average of $20 per hour. Recall that our standard was 2.5 DLHs per pair of bookends (5,000 DLHs needed for 2,000 units) at a rate of ‘$21 per DLH. Once again, we get to use an analytical model- this time for direct labour variances: Actual Hours of Actual Hours of Standard Hours allowed for input at Actual Rate inputs at Standard Rate Actual Output at Standard Rate (AHxAR) (AH x SR) (SH x SR) 5,400 hours x $20 per hour = 5,400 hours x $21 per hour = 5,000 hours x $21 per hour = $10/000 $113,400 $ los7000 ‘ ‘ i | Rate variance =$ 5, oo £ Efficiency Variance =$ $4.00 Total flexible budget variance=$ % OOo w Since we all love shortcuts, here are the two formulas for direct labour variances: Labour rate variance = AH(AR-SR) Labour efficiency variance = SR(AH-SH)Variable manufacturing overhead variances Finally, let’s look at variable manufacturing overhead. Assume that the actual variable manufacturing overhead cost was $15,200. We can fill out our variance analysis table with information from before: Actual Hours of Actual Hours of Standard Hours allowed for input at Actual Rate inputs at Standard Rate Actual Output at Standard Rate {AH x AR) (AH x SR} (SH x SR) 51¢200 5,400 hours x $3 per hour = 5,000 hours x $3 per hour = ‘4 7 $16,200 Fiso00 Spending Variance =$|,000 Efficiency Variance =$ 1 200 Total flexible budget varianc $ Zoo w You can observe clear ies between this diagram and the direct labour variances one preceding it. This is a result of both analyses being based on direct labour-hours. Finally, here are the two formulas for variable manufacturing overhead variances (identical to direct labour, but we need to ensure we are Using the right rates for each equation): Variable overhead spending variance = AH(AR-SR) Variable overhead efficiency variance = SR(AH-SH) Fixed overhead analysis Recall the Predetermined Overhead Rate formula: Predetermined overhead rate = Estimated total manufacturing overhead cost ‘Estimated total units in the base (MH, DLH, etc) ‘The estimated total units in the base of the formula is called denominator activity. Note that we now also have flexible budget as a tool we can use. We can now rewrite our formula as: | Predetermined overhead rate = Overhead from the flexible budget at the denominator level of activity Denominator level of activity Once again, let’s use our example to demonstrate this concept. Have a look at the flexible budget below and calculate the predetermined overhead rate for the median level of activityUCW Library Flexible Budgets at Various Levels of Activity Annual activity Overhead Costs Cost Formula in direct labour hours) Variable overhead costs 40,000 50,000 60,000 Indirect labour $1.50 60,000 | 75,000 90,000 Lubricants $1.00 40,000 50,000 | __60,000 Power 0.50 20,000 25,000 30,000 Total variable overhead cost |___ $3.00 320000 | _150,000 180,000 Fixed overhead costs db etranagegesge | SESE | Depreciation 120,000 | _ 120,000 Supervisory salaries 144,000 | __ 144,000 Insurance 36,000 36,000 | | Total fixed overhead cost __| 300,000 | __ 300,000 Total overhead cost $450,000 | __ $480,000 Predetermined overhead rate=$__4 50,000 =$ 7 per direct labour-hour %,000 Direct labour-hours We can break down the predetermined overhead rate into variable and fixed elements: Variable element: $150,000 =$ 7 per direct labour-hour 50,000 DLH Fixed element: $300,000 =$ 4 _ per direct labour-hour 50,000 DLH Let's add fixed costs to our variable costing table and make it an absorption cost breakdown for each unit of production: Inputs Standard quantity orhours Standard price orrate Standard cost Direct Materials 3.0 kilograms $4.00 gle Direct Labour 25 hours $21.00 een Variable manufacturing overhead 2.5 hours $3.00 SCO: Fixed manufacturing overhead 2.5 hours $6.00 gl%o0 Total standard absorption cost per unit S%200 Budget and volume variance Let's have a look at the data we used for calculating the predetermined overhead rate again: Denominator atvity in direct labour-hours 50,000 Budgeted annual fixed overhead costs $300,000 Fixed portion of the predetermined overhead rate $6Now here are the actual operating results recorded for the month: ‘Actual direct labour hours I 5,400 ‘Standard direct labour-hours allowed I 5,000 ‘Actual fixed overhead costs | Depreciation un $10,000 | Supervisory salaries 14,000 Insurance 2 3,500 | Total actual cost Budget variance = Actual fixed overhead cost ~ Flexible budget fixed overhead cost, Volume variance= Fixed portion ofthe x _—_ (Denominator hours ~ Standard hours allowed) predetermined overhead rate Actual Fixed Overhead Cost Flexible Budget Fixed Overhead Cost Fixed Overhead Cost $27,500 $25,000" Applied to Work in Process * + 5,000 standard hours x $6 per hour = $30,000 Budget Variance =$2,500 % Volume Variance=$s7000 £ Total flexible budget variance =$ 2, S00 F * Assume the monthly budget is the annual budget of $300,000 divided by 12 Overhead variance and under- or over-applied overhead cost Let’s summarize the four variances for overhead costs in our example: Variable overhead spending variance $ too. Variable overhead efficiency variance N200 Fixed overhead budget variance aes & Fixed overhead volume variance woes Total overhead variance S300 The sum of the overhead variance equals the under- or over-applied overhead cost for the period. A favourable total overhead variance (as above) means that overhead was over-applied, while an unfavourable total overhead variance means that overhead was under-applied.