Flexible Budgets and Standard Costs: © The Mcgraw-Hill Companies, Inc., 2007 Mcgraw-Hill/Irwin

Chapter 24
Flexible Budgets and

Standard Costs
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

Conceptual Learning
Objectives
C1: Define standard costs and explain

their computation and uses
C2: Describe variances and what they
reveal about performance
C3: Explain how standard cost
information is useful for management
by exception

Analytical Learning Objectives
A1: Compare fixed and flexible budgets

A2: Analyze changes in sales from
expected amounts

Procedural Learning
Objectives
P1: Prepare a flexible budget and

interpret a flexible budget performance
report
P2: Compute materials and labor
variances
P3: Compute overhead variances
P4: Prepare journal entries for standard
costs and account for price and
quantity variances
P1 Budgetary Control and
Reporting
 Develop the budget
from planned objectives.
 Revise Management uses

 Compare
objectives actual with
budgets to monitor
and prepare budget and
and control
a new analyze any
operations.
budget. differences.
 Take corrective and

strategic actions.

A2 Fixed Budget Performance
Report
Hmm! Comparing
Fixed budgets are fixed budgets
prepared for a single, with actual costs
predicted level of is like comparing
activity. apples with oranges.
Performance evaluation
is difficult when actual
activity differs from the
predicted level of
activity.
Report
Hmm! Comparing
fixed budgets
Consider with actual costs
is like comparing
the following apples with oranges.
condensed
example from the
Optel
Company . . .

Report
Optel
Fixed Budget Performance Report
For the Month Ended January 31, 2008
Fixed Actual
Budget Results Variances
Sales: In units 10,000 12,000
In dollars $ 100,000 $ 125,000 $ 25,000 F
Cost of goods sold $ 49,000 $ 58,100 $ 9,100 U
Selling expenses 13,000 15,100 2,100 U
Gen. & admin. expenses 26,000 26,400 400 U
Total expenses $ 88,000 $ 99,600 $ 11,600 U
Income from operations $ 12,000 $ 25,400 $ 13,400 F

Exh.
Report 21-2
Optel U = Unfavorable variance

Actual
Fixed Budget Performance cost is greater
Report
than31,
For the Month Ended January budgeted
2008 cost.
Fixed Actual
In dollars $ 100,000 $ 125,000 $ 25,000 F
Total expenses $ 88,000 $ 99,600 $ 11,600 U

Exh.
Report 21-2
Optel
Fixed Actual
In dollars $ 100,000 $ 125,000 $ 25,000 F
F = Favorable
Cost of goods sold variance $ 58,100
$ 49,000 $ 9,100 U
Actual
Selling revenue and income
expenses 13,000 are greater
15,100 2,100 U
Gen. &than budgeted
admin. revenue
expenses and income.
26,000 26,400 400 U
Total expenses $ 88,000 $ 99,600 $ 11,600 U

Exh.
Report 21-2
Optel
If unit sales are higher, should we expect costs to be higher?
How much ofFor
thethe
higher costs are because of higher unit sales?
Month Ended January 31, 2005
Fixed Actual
In dollars $ 100,000 $ 125,000 $ 25,000 F
Total expenses $ 88,000 $ 99,600 $ 11,600 U

Report
How much of
the unfavorable cost I don’t think I can
variance is due to higher answer the question
activity, and how much is due using a fixed budget.
to poor cost control?

Report
How much of
the unfavorable cost I don’t think I can
variance is due to higher answer the question
activity, and how much is due using a fixed budget.
to poor cost control?
To answer the questions, we must

the budget to the actual level of activity.
A1
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.

A1
Purpose of 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.

P1
Preparing Flexible Budgets

To a budget for different activity
levels, we must know how costs
behave with changes in activity levels.
 Total variable costs change
in direct proportion to
changes in activity.
 Total fixed costs remain
ble
unchanged within the r ia
Va
relevant range.
Fixed

P1
Preparing Flexible Budgets
Let’s prepare
budgets for Optel.

P1
Exh.
Preparing Flexible Budgets 21-3
Optel
Flexible Budgets
Budget Budget Budget
Variable Total for for for
Amount Fixed 10,000 12,000 14,000
per Unit Cost Units Units Units
Sales: $ 10.00 $ 100,000 $ 120,000 $ 140,000
Total variable costs 4.80 48,000 57,600 67,200
Contribution margin $ 5.20 $ 52,000 $ 62,400 $ 72,800
Total fixed costs $ 40,000 40,000 40,000 40,000
Income from operations $ 12,000 $ 22,400 $ 32,800
Variable costs are expressed as

a constant amount per unit.
P1
Exh.
Optel
Flexible Budgets
Amount Fixed 10,000 12,000 14,000
Sales: $ 10.00 $ 100,000 $ 120,000 $ 140,000
Total variable cost = $4.80 per unit × budget level in units

P1
Exh.
Optel
Flexible Budgets
Amount Fixed 10,000 12,000 14,000
Sales: $ 10.00 $ 100,000 $ 120,000 $ 140,000
Fixed costs are expressed as a total amount that does

not change within the relevant range of activity.
P1 Flexible Budget Performance
Report
Now let’s prepare a
budget
performance report
at 12,000 actual
units for Optel.
Report Exh.
21-4
Optel
Flexible Budget Performance Report
Budget Actual
Variable Total for for
Amount Fixed 12,000 12,000
per Unit Cost Units Units Variances
Sales (12,000 units) $ 10.00 $ 120,000 $ 125,000 $ 5,000 F
Total variable costs 4.80 57,600 59,400 1,800 U
Contribution margin $ 5.20 $ 62,400 $ 65,600 $ 3,200 F
Total fixed costs $ 40,000 40,000 40,200 200 U
Favorable sales variance indicates that the

average selling price was greater than $10.00.
Report Exh.
21-4
Optel
Budget Actual
Sales (12,000 units) $ 10.00 $ 120,000 $ 125,000 $ 5,000 F
Unfavorable cost variances indicate

costs that are greater than expected.
Report Exh.
21-4
Optel
Budget Actual
Sales (12,000 units) $ 10.00 $ 120,000 $ 125,000 $ 5,000 F
Favorable variances because favorable sales

variance overcomes unfavorable cost variances.
C1
Standard Costs
Let’s
change
topics.

C1
Standard Costs
Based on carefully
predetermined amounts.
Used for planning labor, material

Standard and overhead requirements.
Costs are
The expected level
of performance.
Benchmarks for
measuring performance.

C1
Setting Standard Costs

Should we use Practical standards should be
practical standards set at levels that are currently
or ideal standards? attainable with reasonable and
efficient effort.
Production Managerial
Engineer Manager Accountant
C1
Setting Standard Costs

I agree. Ideal standards, that are
based on perfection, are
unattainable and therefore
discouraging to most employees.
Human
Resources
Manager
C1 Setting Direct Material
Standards
Price Quantity
Standards Standards
Use competitive Use product

bids for the quality design specifications.
and quantity desired.

C1 Setting Direct Material
Standards
The standard material cost for one unit of product is:
standard quantity
standard price for of material
one unit of material × required for one
unit of product

C1
Setting Direct Labor Standards

Rate Time
Standards Standards
Use wage Use time and

surveys and motion studies for
labor contracts. each labor operation.

C1
Setting Direct Labor Standards

The standard labor cost for one unit of product is:
standard number
standard wage rate of labor hours
for one hour × for one unit
of product

C1 Setting Variable Overhead
Standards
Rate Activity
Standards Standards
The rate is the The activity is the

variable portion of the cost driver used to
predetermined overhead calculate the
rate. predetermined overhead.

C1 Setting Variable Overhead
Standards
The standard variable overhead cost for one unit of
product is:
standard variable standard number
overhead rate for of activity units
one unit of × for one unit of
activity product
×
C1
Exh.
Standard Cost Card 21-5
A standard cost card might look like this:
Standard Standard
Quantity Price Standard
Cost factor or Hours or Rate Cost
Direct materials 1 kg. $ 25 per kg. $ 25.00
Direct labor 2 hours $ 20 per hour 40.00
Variable mfg. overhead 2 hours $ 10 per hour 20.00
Total standard unit cost $ 85.00

P2
Variances
A standard cost variance
is the amount by which
an actual cost differs from
the standard cost.
Standard cost
Amount
Direct
Material
Direct Manufacturing
Labor Overhead
Type of Product Cost

P2
Variances
This variance is unfavorable This variance is
because the actual cost favorable because
exceeds the standard cost. the actual cost
is less than the
standard cost.
Standard cost
Direct
Material
Labor Overhead

P2
Variance Analysis
Take
Identify Receive
corrective
questions explanations
actions
Conduct next
Analyze
period’s
variances
operations
Prepare standard
Begin
cost performance
report
P2
Computing Variances
Standard Cost Variances
Price Variance Quantity Variance
The difference between The difference between

the actual price and the the actual quantity and
standard price the standard quantity

P2
Computing Variances
Actual Quantity Actual Quantity Standard Quantity
× × ×
Actual Price Standard Price Standard Price
Standard price is the amount that should

have been paid for the resources acquired.

P2
Computing Variances
× × ×
Standard quantity is the quantity that should

have been used for the actual good output.

P2
Computing Variances
× × ×
AQ(AP - SP) SP(AQ - SQ)

AQ = Actual Quantity SP = Standard Price
AP = Actual Price SQ = Standard Quantity

P2 Computing Material
and Labor Variances
G-Max
G-Max Company
Company makes
makes golf
golf clubheads
clubheads with
with
the
the following
following standard
standard cost
cost information:
information:
Direct materials (1 lb. per unit at $1 per lb.) $ 1.00

Direct labor (1 hr. per unit at $8 per hr.) 8.00
Total standard direct cost per unit $ 9.00

P2
Material Variances
During
DuringMay,
May, G-Max
G-Maxproduced
produced 3,500
3,500 clubheads
clubheadsusing
using
3,600
3,600 pounds
poundsof ofmaterial.
material. G-Max
G-Maxpaid
paid$1.05
$1.05per
per
pound
poundfor
forthe
thematerial.
material.
Compute
Computethe
thematerial
material price
price and
and quantity
quantityvariances.
variances.


P2
Material Variances
SQ = 3,500 units × 1 lb. per unit = 3,500 lbs.

× × ×
3,600 lb. 3,600 lbs. 3,500 lbs.
× × ×
$1.05 per lb. $1.00 per lb. $1.00 per lb.
$3,780 $3,600 $3,500
Price variance Quantity variance

$180 unfavorable $100 unfavorable
P2 Responsibility for Material
Variances
You used too much material
because of poorly trained workers
I am not responsible for and poorly maintained equipment.
this unfavorable material
quantity variance. Also, your poor scheduling
requires me to rush order material
You purchased cheap at a higher price, causing
material, so my people unfavorable price variances.
had to use more of it.

P2
Labor Variances
Let’s turn
our attention
to labor
variances.

P2
Labor Variances
Actual Hours Actual Hours Standard Hours
× × ×
Actual Rate Standard Rate Standard Rate
Rate Variance Efficiency Variance
AH(AR
Materials price- SR)
variance SR(AH
Materials - SH)
quantity variance
Labor rate variance Labor efficiency variance
AH = Actual
Variable Hours
overhead SRVariable
= Standard Rate
overhead
AR = Actual
spending Rate
variance SHefficiency
= Standard Hours
variance

P2
Labor Variances
During
During May,
May,G-Max
G-Max produced
produced 3,500
3,500clubheads
clubheadsworking
working
3,400
3,400hours.
hours. G-Max
G-Maxpaidpaidan
anaverage
averageof
of$8.30
$8.30per
per
hour
hour for
for the
thehours
hours worked.
worked.
Compute
Computethe
thelabor
laborrate
rateand
andefficiency
efficiencyvariances.
variances.


P2
Labor Variances Exh.

21-11
SH = 3,500 units × 1 hour per unit = 3,500 hours

Actual Hours Actual Hours Standard Hours
× × ×
Actual Rate Standard Rate Standard Rate
3,400 hours 3,400 hours 3,500 hours
× × ×
$8.30 per hour $8.00 per hour $8.00 per hour
$28,220 $27,200 $28,000
Rate variance Efficiency variance

$1,020 unfavorable $800 favorable
P2
Labor Variances
Using highly paid skilled workers to
perform unskilled tasks results in an
unfavorable rate variance.
High skill, Low skill,

high rate low rate
Production
Production managers
managers who
who make
make workwork assignments
assignments
are
are generally
generally responsible
responsible for
for rate
rate variances.
variances.

P2
Labor Variances
Poorly Poor
trained quality
workers materials
Unfavorable
Efficiency
Variance
Poor Poorly
supervision maintained
of workers equipment
P2 Responsibility for Labor
Variances
I am not responsible for

the unfavorable labor You used too much
efficiency variance! time because of
poorly trained
You purchased cheap workers and poor
material, so it took more supervision.
time to process it.

P2 Responsibility for Labor
Variances
Maybe I can attribute the labor
and material variances to personnel
for hiring the wrong people
and training them poorly.

P3 Overhead Standards and
Variances
Let’s change
topics
again.

P3 Overhead Standards and
Variances
Recall that overhead costs are assigned
to products and services using a
predetermined overhead rate (POHR):
Assigned Overhead = POHR × Standard Activity
Estimated total overhead costs

POHR =
Estimated activity

P3
Setting Overhead Standards
Contains a fixed Contains a variable

overhead rate which unit rate which stays
declines as activity constant at all levels
level increases. of activity.
Overhead Rate
Function of activity level

chosen to determine rate.

P3
Setting Overhead Standards
Flexible budgets, showing

budgeted amount of overhead for
various levels of activity, are
used to analyze overhead costs.
G-Max’s flexible
budget for overhead

P3
Exh.
Flexible Overhead Budget 21-12
G-Max
Overhead Costs Scenarios
For the Month Ended May 31, 2008
Variable Total Different Production Levels
Amount Fixed (Percent of Monthly Capacity)
per Unit Cost 70% 80% 90% 100%
Production in units 3,500 4,000 4,500 5,000
Total variable costs $ 1.00 $ 3,500 $ 4,000 $ 4,500 $ 5,000
Total fixed costs $ 4,000 4,000 4,000 4,000 4,000
Total factory overhead $ 7,500 $ 8,000 $ 8,500 $ 9,000
Standard direct labor hours 3,500 4,000 4,500 5,000
POHR per direct labor hour $ 2.14 $ 2.00 $ 1.89 $ 1.80
$7,500 ÷ 3,500 hours = $2.14 per hour

P3
Flexible Overhead Budget Exh.

21-12
G-Max
Overhead Costs Scenarios
For the Month Ended May 31, 2008
Variable Total Different Production Levels
Amount Fixed (Percent of Monthly Capacity)
per Unit Cost 70% 80% 90% 100%
Production in units 3,500 4,000 4,500 5,000
Total variable costs $ 1.00 $ 3,500 $ 4,000 $ 4,500 $ 5,000
Total fixed costs $ 4,000 4,000 4,000 4,000 4,000
Total factory overhead $ 7,500 $ 8,000 $ 8,500 $ 9,000
Standard direct labor hours 3,500 4,000 4,500 5,000
POHR per direct labor hour $ 2.14 $ 2.00 $ 1.89 $ 1.80
G-Max predicted an 80 percent activity level

P3 Computing Overhead
Variances
Now that we can

compute the
overhead rates,
let’s use them to
determine variable
and fixed overhead
variances.
Variances
Actual Flexible Budget Applied
Variable for Variable Variable
Overhead Overhead at Overhead at
Incurred
AH × AVR Actual Hours
AH × SVR Standard
SH × SVRHours
Spending Efficiency
Variance Variance
AH = Actual Hours of Activity
AVR = Actual Variable Overhead Rate
SVR = Standard Variable Overhead Rate
SH = Standard Hours Allowed
Variances Exh.
21-14
Actual Fixed Fixed Fixed

Overhead Overhead Overhead
Incurred Budget Applied
SH × SFR
Spending Volume
Variance Variance
SFR = Standard Fixed Overhead Rate
SH = Standard Hours Allowed

P3
Overhead Variance Analysis

Total
Overhead
Variance
Variable Fixed
Overhead Overhead
Spending Efficiency Spending Volume

Variance Variance Variance Variance
Controllable
Variance © The McGraw-Hill Companies, Inc., 2007
McGraw-Hill/Irwin
Variances
During
During May,
May,G-Max
G-Max produced
produced 3,500
3,500clubheads
clubheadsworking
working
3,400
3,400hours.
hours. G-Max
G-Maxbudgeted
budgetedforfor4,000
4,000units
units(80%).
(80%).
Actual
Actualvariable
variableoverhead
overheadwaswas$3,650
$3,650and
and
actual
actual fixed
fixedoverhead
overheadwaswas$4,000.
$4,000.
Compute
Computethe thevariable
variableoverhead
overheadspending
spendingand
and
efficiency
efficiency variances
variances and
and the
thefixed
fixed overhead
overhead
spending
spendingandandvolume
volumevariances.
variances.

P3 Computing Variable Overhead
Variances Exh.
21-16
Actual Flexible Budget Applied

Variable for Variable Variable
Overhead Overhead at Overhead at
Incurred Actual Hours Standard Hours
3,400 hours 3,500 hours
× ×
$1.00 per hour $1.00 per hour
$3,650 $3,400 $3,500
Spending variance Efficiency variance

$250 unfavorable $100 favorable

P3
Variable Overhead Variances

Spending Variance Efficiency Variance
Results from paying more A function of the
or less than expected for selected cost driver.
overhead items and from
It does not reflect
excessive usage of
overhead control.
overhead items.

P3 Computing Fixed Overhead
Variances Exh.
21-17
Actual Fixed Fixed Fixed

Overhead Overhead Overhead
Incurred Budget Applied
3,500 hours
×
$1.00 per hour
$4,000 $4,000 $3,500
Spending variance Volume variance

$0 $500 unfavorable

P3
Fixed Overhead Variances

Spending Variance Volume Variance
Results from paying more Results from the inability

or less than expected for to operate at the activity
fixed overhead items. planned for the period.
Has no significance for
cost control.

P3
Volume Variance Exh.

21-18
3,500 units × $1.00 fixed overhead rate

Cost
$500 $4,000 expected fixed OH
Volume
Variance {
$3,500 applied fixed OH
unfavorabl
e
ad
rh e ts
ve u c
o ro d
e d p
Fix d to
p lie
ap Volume
3,500 4,000
Actual Expected
Units Units
C3
Standard Costs for Control

Managers focus on quantities and costs
that differ from standards, a practice known as
management by exception.
Standard cost
Amount
Direct
Material
Labor Overhead
Type of Product Cost

A2
Sales Variances
AA similar
similar analysis
analysis can
can be
be applied
applied to to sales
sales
variances.
variances. WeWe will
will use
use two
two additional
additional G-Max
G-Max
products,
products, golf
golf balls
balls and
and drivers,
drivers, to
to illustrate.
illustrate.
Budgeted Actual
Sales of golf balls (units) 1,000 1,100
Sales price per golf ball $ 10.00 $ 10.50
Sales of driver (units) 150 140

Sales price per driver $ 200.00 $ 190.00

A2
$550 F $1,000 F
Price Volume
Variance Variance
$1,400 U $2,000 U
Price Volume
Variance Variance

End of Chapter 24

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Chapter 24

Flexible Budgets and

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

C1: Define standard costs and explain

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

A1: Compare fixed and flexible budgets

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

P1: Prepare a flexible budget and

 Revise Management uses

 Take corrective and

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

Optel U = Unfavorable variance

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

To answer the questions, we must

If you can tell me what your activity was

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

Purpose of Flexible Budgets

May be prepared for any activity

Reveal variances due to good cost

Improve performance evaluation.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

Preparing Flexible Budgets

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

Preparing Flexible Budgets

budgets for Optel.

Preparing Flexible Budgets 21-3

Variable costs are expressed as

Preparing Flexible Budgets 21-3

Total variable cost = $4.80 per unit × budget level in units

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

Preparing Flexible Budgets 21-3

Fixed costs are expressed as a total amount that does

Now let’s prepare a

Favorable sales variance indicates that the

Unfavorable cost variances indicate

Favorable variances because favorable sales

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

Used for planning labor, material

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

Setting Standard Costs

Setting Standard Costs

Use competitive Use product

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

Setting Direct Labor Standards

Use wage Use time and

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

Setting Direct Labor Standards

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

The rate is the The activity is the

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

Standard Cost Card 21-5

A standard cost card might look like this:

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Type of Product Cost

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

Price Variance Quantity Variance

The difference between The difference between