Flexible Budgets, Variances, and Management Control: I

Static and Flexible Budgets
Based on Planned level of output at start of the budget period Budgeted revenues and cost based on actual level of output

Static Budget

Flexible Budget

Based on

Static Budget Example
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

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 2004 is based on selling 13,000 suits. What is the static-budget operating income?

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.

Static Budget Example
What was the actual operating income? Revenues (10,000 × $160) Less Expenses: Variable (10,000 × $120) Fixed Actual operating income $1,600,000 1,200,000 300,000 $ 100,000

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 This is a Level 0 variance analysis.

Static-Budget Variance Example
Static-Budget Based Variance Analysis (Level 1) 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

Steps in Developing Flexible Budgets
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.

Steps in Developing Flexible Budgets
Step 2: Determine the actual quantity of output. In the year 2004, 10,000 suits were produced and sold. Step 3: Determine the flexible budget for revenues. $155 × 10,000 = $1,550,000

Steps in Developing Flexible Budgets
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

Variances
Level 2 analysis provides information on the two components of the static-budget variance. 1. Flexible-budget variance 2. Sales-volume variance

Flexible-Budget Variance
Flexible-Budget Variance (Level 2) in (000)
Suits Revenue Variable costs Contribution margin Fixed costs Operating income Flexible Budget 10 $1,550 1,150 $ 400 286 $ 114 Actual 10 $1,600 1,200 $ 400 300 $ 100 Variance 0 $ 50 F 50 U $ 0 14 U $ 14 U

Flexible-Budget Variance
Actual quantity sold: 10,000 suits Actual results operating income $100,000 Flexible-budget operating income $114,000

Flexible-budget variance $14,000 U

Flexible-Budget Variance

Total flexible-budget variance = Total actual results – Total flexible budget for actual sales level

Flexible-Budget Variance

Selling price Variable cost Contribution margin

Actual Amount $160 120 $ 40

Budgeted Amount $155 115 $ 40

Flexible-Budget Variance
Why is the flexible-budget variance $14,000 U? Selling-price variance Actual variable costs exceeded flexible budget variable costs Actual fixed costs exceeded flexible budget fixed costs Total flexible-budget variance $50,000 F 50,000 U 14,000 U $14,000 U

Sales-Volume Variance
Sales-Volume Variance (Level 2) in (000)
Suits Revenue Variable costs Contr. margin Fixed costs Operating income Flexible Budget 10 $1,550 1,150 $ 400 286 $ 114 Static Sales-Volume Budget Variance 13 3U $2,015 $465 U 1,495 295 F $ 520 $120 U 286 0 $ 234 $120 U

Sales-Volume Variance
Actual quantity sold: 10,000 suits Flexible-budget operating income $114,000 Static-budget operating income $234,000

Sales-volume variance $120,000 U

Sales-Volume Variance
Actual sales unit – Master budgeted sales units 13,000 – 10,000 = 3,000 Budgeted contribution

=
Total sales-volume variance $120,000 U

×
margin per unit $40

Budget Variances
Static-budget variance $134,000 U

Level 1

Level 2

Flexible-budget variance $14,000 U

Sales-volume variance $120,000 U

Standards
Pasadena’s budgeted cost for each variable direct cost item is computed as follows:

×

Standard input allowed for one output unit

Standard cost per input unit

Standards
4.00 square yards allowed per output unit at $16.25 standard cost per square yard. Standard cost per output unit 4.00 × $16.25 = $65.00

Standards
2.00 manufacturing labor-hours of input allowed per output unit at $13.00 standard cost per hour. Standard cost per output unit 2.00 × $13.00 = $26.00

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

Price Variance Example
Direct-material price variance

= =

Actual price – Budgeted price

×

Actual quantity

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

Price Variance Example
Direct-labor price variance

= =

Actual price – Budgeted price

×

Actual quantity

($12.90 – $13.00) × 21,500 = $2,150 F

Price Variance Example
What is the journal entry when the materials price variance is isolated at the time of purchase? Materials Control 690,625 Direct-Materials Price Variance 12,750 Accounts Payable Control 677,875 To record direct materials purchased

Efficiency Variance Example
Direct-material efficiency variance

= =

Actual quantity – Standard quantity

×

Standard price

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

Efficiency Variance Example
Direct-labor efficiency variance

= =

Actual quantity – Standard quantity

×

Standard price

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

Efficiency Variance
What is the journal entry to record materials used? Work in Process Control 650,000 Direct-Materials Efficiency Variance 40,625 Materials Control 690,625 To record direct materials used

Price and Efficiency Variance
What is the journal entry for direct manufacturing labor?

Work in Process Control 260,000 Direct Manufacturing Labor Efficiency Variance 19,500 Direct-Manufacturing Labor Price Variance 2,150 Wages Payable 277,350 To record liability for direct manufacturing labor

Flexible Budget Material Variance Example
Actual Cost $677,875 AQ × BP 42,500 × $16.25 $690,625 BQ × BP 40,000 × $16.25 $650,000

$12,750 F $27,875 U

$40,625 U

Flexible Budget Labor Variance Example
Actual Cost $277,350 AQ × BP 21,500 × $13.00 $279,500 BQ × BP 20,000 × $13.00 $260,000

$2,150 F $17,350 U

$ 19,500 U

Variance Analysis
Level 1 Static-budget variance Materials $167,125 F Labor 60,650 F Total $227,775 F Level 2 Flexible-budget variance Materials $27,875 U Labor 17,350 U Total $45,225 U Level 2 Sales-volume variance Materials $195,000 F Labor 78,000 F Total $273,000 F

Variance Analysis
Level 2 Flexible-budget variance Materials $27,875 U Labor 17,350 U Total $45,225 U Level 3 Price variance Materials $12,750 F Labor 2,150 F Total $14,900 F Level 3 Efficiency variance Materials $40,625 U Labor 19,500 U Total $60,125 U

Performance Measurement Using Variances
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 level of output. Variances should not solely be used to evaluate performance.

When to Investigate Variances
When should variances be investigated? Subjective judgments Rules of thumb as “investigate all variances exceeding $10,000 or 25% of expected cost, whichever is lower.”

Continuous Improvement
Assume that the budgeted direct materials cost for each suit that Pasadena Co. manufactures is $65. Pasadena Co. wants to implement continuous improvement budgets based on a target 1% materials cost reduction each period. What should the budgeted cost be for the next 3 subsequent periods?

Continuous Improvement
Prior Period Budgeted Budgeted Amount This Period: – Period 1: $65.00 Period 2: $64.35 Period 3: $63.71 Reduction Revised in Budget – $0.650 $0.644 $0.637 Amount $65.00 $64.35 $63.71 $63.07

Flexible Budgeting and Activity-Based Costing
Materials costs and direct manufacturing labor costs are examples of output-unit level costs. Batch-level costs are resources sacrificed on activities that are related to a group of units of product(s) or service(s) rather than to each individual unit of product or service.

Flexible Budgeting and Activity-Based Costing
Denver Co. produces metal planters (MP). Assume that material-handling labor costs vary with the number of batches produced rather than the number of units in a batch. Material-handling labor costs are direct batch level costs that vary with the number of batches.

Flexible Budgeting and Activity-Based Costing
Static Budget 18,000 180 100 5.00 Actual Amounts 15,660 174 90 5.20

Units prod.and sold Batch size Number of batches Material-handling labor-hours per batch

Flexible Budgeting and Activity-Based Costing
Static Budget Actual 468 $14.50 $6,786

Amounts Total labor-hours 500 Cost per material-handling labor-hour $14.00 Total material-handling labor cost $7,000

Flexible Budgeting and Activity-Based Costing
How many batches should have been employed to produce the actual output units? 15,660 units ÷ 180 units per batch = 87 batches How many material-handling hours should have been used? 87 batches × 5 hours/batch = 435 hours

Flexible Budgeting and Activity-Based Costing
What is the flexible budget for material-handling labor-hours? 435 hours × $14.00/labor-hour = $6,090 Flexible-budget costs Actual costs Flexible-budget variance $6,090 6,786 $ 696 U

Price and Efficiency Variances
Price variance = ($14.50 – $14.00) × 468 Total variance = $234 U $696 U

Efficiency variance = (468 – 435) × $14.00 = $462 U

Benchmarking
It refers to the continuous process of measuring products, services, and activities against the best levels of performance.