Cost Accounting

Sixteenth Edition, Global Edition

Chapter 7
Flexible Budgets,
Direct-Cost Variances,
and
Management Control

Copyright © 2015 Pearson Education

 Chapter 7 learning objectives
7.1 Understand static budgets and static-budget
variances
7.2 Examine the concept of a flexible budget and
learn how to develop it
7.3 Calculate flexible-budget variances and sales-
volume variances
7.4 Explain why standard costs are often used in
variance analysis.
7.5 Compute price variances and efficiency variances
for direct-cost categories.
7.6 Understand how managers use variances
7.7 Describe benchmarking and explain its role in
cost management
Copyright © 2015 Pearson Education 7-2
Basic Concepts

• Variance—difference between actual results and

expected (budgeted) performance.
• Management by exception—the practice of
focusing attention on areas not operating as
expected (budgeted).
• Static (master) budget is based on the output
planned at the start of the budget period.

Copyright © 2015 Pearson Education 7-3

 Basic Concepts
• Static-budget variance—the difference between
the actual result and the corresponding static
budget amount
• Favorable variance (F)—has the effect of increasing
operating income relative to the budget amount
(actual revenues >budgeted revenues
actual costs < budgeted costs )
• Unfavorable variance (U)—has the effect of
decreasing operating income relative to the budget
amount
(actual revenues < budgeted revenues
actual costs > budgeted costs )

Copyright © 2015 Pearson Education 7-4

Copyright © 2015 Pearson Education 7-5
 Assume that Pasadena Co. manufactures
and sells dress suits.

Budgeted variable costs per suit are as follows:

Direct materials cost $ 65
Direct manufacturing labor 26
Variable manufacturing overhead 24
Total variable costs $115

Copyright © 2015 Pearson Education 7-6

Static Budget Example

Budgeted selling price is $155 per suit.

Fixed manufacturing costs are expected
to be $286,000 within a relevant range
between 9,000 and 13,500 suits.

Variable and fixed period costs are ignored.

The static budget for year 2018 is based

on selling 13,000 suits.

What is the static-budget operating income?

Copyright © 2015 Pearson Education 7-7

Static Budget Example

Revenues (13,000 × $155) $2,015,000

Less Expenses:
Variable (13,000 × $115) 1,495,000
Fixed 286,000
Budgeted operating income $ 234,000

Assume that Pasadena Co. produced and sold

10,000 suits at $160 each with actual variable
costs of $120 per suit and fixed manufacturing
costs of $300,000.

Copyright © 2015 Pearson Education 7-8

Static Budget Example

What was the actual operating income?

Revenues (10,000 × $160) $1,600,000

Less Expenses:
Variable (10,000 × $120) 1,200,000
Fixed 300,000
Actual operating income $ 100,000

Copyright © 2015 Pearson Education 7-9

Static-Budget Variance Example

What is the static-budget variance of

operating income?

Actual operating income $100,000

Budgeted operating income 234,000
Static-budget variance of
operating income $134,000 U

Copyright © 2015 Pearson Education 7-10

Static-Budget Variance Example
Static-Budget Based Variance Analysis in (000)

Static Budget Actual

Suits 13 10
Revenue $2,015 $1,600
Variable costs 1,495 1,200

Contribution margin $520 $400

Fixed costs 286 300

Operating income $234 $ 100
Copyright © 2015 Pearson Education 7-11
 Static-Budget Variance Example

Static-Budget Based Variance Analysis in (000)

Static Budget Actual Variance

Suits 13 10 3U
Revenue $2,015 $1,600 $415 U
Variable costs 1,495 1,200 296 F
Contribution margin $ 520 $ 400 $120 U
Fixed costs 286 300 14 U
Operating income $ 234 $ 100 $134 U

Copyright © 2015 Pearson Education 7-12

Static Budgets and Performance Reports

• The relevant question is . . .

“How much of the favourable cost variance
is due to lower activity, and how much is
due to good cost control?”
• To answer the question,
we must
the budget to the actual level of activity.

Copyright © 2015 Pearson Education 7-13

Flexible Budgets
Show revenues and expenses
that should have occurred at the
actual level of activity.

May be prepared for any

activity level in the relevant
range.
Reveal variances due to good
cost control or lack of cost
control.
Improve performance evaluation.
Copyright © 2015 Pearson Education 7-14
 Flexible Budgets

Central Concept
If you can tell me what your activity was
for the period, I will tell you what your costs and revenue
should have been.

Copyright © 2015 Pearson Education 7-15

 Step 1:
Determine budgeted selling price,
variable cost per unit, and budgeted fixed cost.

Budgeted selling price is $155,

variable cost is $115 per suit, and
the budgeted fixed cost is $286,000.

Copyright © 2015 Pearson Education 7-16

 Step 2:
Determine the actual quantity of output.
In the year 2018:
10,000 suits were produced and sold.

Step 3:
Determine the flexible budget for revenues.
$155 × 10,000 = $1,550,000

Copyright © 2015 Pearson Education 7-17

 Step 4:
Determine the flexible budget for costs.
Variable costs: 10,000 × $115 = $1,150,000
Fixed costs 286,000
Total costs $1,436,000

Copyright © 2015 Pearson Education 7-18

 Flexible-Budget Variance
in (000)

Flexible
Budget Actual
Suits 10 10
Revenue $1,550 $1,600
Variable cost 1,150 1,200
Contribution margin $ 400 $ 400
Fixed costs 286 300
Operating income $ 114 $ 100

Copyright © 2015 Pearson Education 7-19

 Flexible-Budget Variance
in (000)

Flexible
Budget Actual Variance
Suits 10 10 0
Revenue $1,550 $1,600 $ 50 F
Variable costs 1,150 1,200 50 U
Contribution margin $ 400 $ 400 $ 0
Fixed costs 286 300 14 U
Operating income $ 114 $ 100 $ 14 U

Copyright © 2015 Pearson Education 7-20

Flexible Budget Variance

There are two primary

reasons for unfavorable
What causes variable cost variance
the variable cost 1. Spending too much for
variance? resources.
2. Using the resources
inefficiently.

Copyright © 2015 Pearson Education 7-21

 Sales-Volume Variance in (000)

Flexible Static Sales-Volume

Budget Budget Variance
Suits 10 13 3U
Revenue $1,550 $2,015 $465 U
Variable costs 1,150 1,495 295 F
Contr. margin $ 400 $ 520 $120 U
Fixed costs 286 286 0
Operating income $ 114 $ 234 $120 U

Copyright © 2015 Pearson Education 7-22

VARIANCES, ANALYSIS

Some possible reasons we might incur an

unfavorable Sales-Volume Variance include:
1. Failure to execute the sales plan
2. Weaker than anticipated demand
3. Aggressive competitors taking market share
4. Unanticipated market preference away from the
product
5. Quality problems

Copyright © 2015 Pearson Education 7-23

 Price and Efficiency variances
• Direct materials and direct labor both have
price and efficiency variances, and their
formulae are the same.

Copyright © 2015 Pearson Education 7-24

Variances

• Price variance formula:

Price
Variance = { Actual Price
Of Input -
Budgeted Price
Of Input } X Actual Quantity
Of Input

• Efficiency variance formula:

Efficiency
Variance = { Actual Quantity
Of Input Used -
Budgeted Quantity of Input
Allowed for Actual Output }X Budgeted Price
Of Input

7-25
Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall.
Actual Data

Direct materials purchased and used:

42,500 square yards at $15.95

Cost of direct materials = $677,875

Labor hours: 21,500 at $12.90

Cost of direct manufacturing labor = $277,350

26
Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall.
Budgeted Data

Direct materials purchase and use:

40,000 square yards at $16.25

Cost of direct materials = $650, 000

Labor hours: 20,000 at $13.00

Cost of direct manufacturing labor = $260,000

27
Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall.
 Price Variance Example

Direct-material price variance

= Actual price – × Actual

Budgeted price quantity

=
($15.95 – $16.25) × 42,500 = $12,750 F

28
Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall.
 Price Variance Example

Direct-labor price variance

= Actual price – × Actual

Budgeted price quantity

=
($12.90 – $13.00) × 21,500 = $2,150 F

29
Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall.
 Efficiency Variance Example

Direct-material efficiency variance

= Actual quantity – × Budgeted

budgeted quantity price

=
(42,500 – 40,000) × $16.25 = $40,625 U

30
Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall.
Efficiency Variance Example

Direct-labor efficiency variance

= Actual quantity – × Budgeted

Budgeted quantity price

=
(21,500 – 20,000) × $13.00 = $19,500 U

31
Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall.
 Obtaining budgeted input prices and input
quantities
Budgeted input prices and budgeted input
quantities can be obtained from a number of
sources including actual input data from past
periods, data from other companies that have
similar processes and standards developed by
the firm itself.
A standard is a carefully determined price, cost
or quantity that is used as a benchmark for
judging performance.

Copyright © 2015 Pearson Education 7-32

Standard Costing

• Targets or standards are established for direct

material and direct labor.
• The standard costs are recorded in the accounting
system.
• Actual price and usage amounts are compared to
the standard and variances are recorded.

Copyright © 2015 Pearson Education 7-33

Standard Costs can be a Useful Tool

• Price and efficiency variances provide feedback to

initiate corrective actions.
• Standards are used to control costs.
• Managers use variance analysis to evaluate
performance after decisions are implemented.
• Part of a continuous improvement program.

Copyright © 2015 Pearson Education 7-34

Benchmarking and Variances

Benchmarking refers to the continuous process of

measuring products, services, and activities
against the best levels of performance.

Variances can be extended to include

comparison to other entities

Copyright © 2015 Pearson Education 7-35

36