Unit 4

Budgeting
Standard costing and
variance analysis
Session 6
6.1 Standard costing
A standard cost is a carefully pre-determined and realistic
target cost that should be incurred during normal efficient
operating conditions. Therefore, if the normal operating
conditions change over time, the standard costs applied to
products and services have to be changed accordingly.

Standard costs are used as the basis for a comparison with

actual costs incurred and have the following advantages.
- The organisation calculates actual costs only for control
purposes, not for individual job or batch pricing purposes.
- By comparing standard costs with the actual costs, the
organisation has a way of judging performance. Differences
between actual and standard costs are known as variances.

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6.1 Standard costing (Cont’d)
The principal purposes of standard costing are to:
- provide management with performance benchmarks
- call attention to areas of the firm’s activities which do not fulfil
the original plans
- provide cost information for use in future planning.

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6.1.1 Types of standard
There are four main interpretations:
- basic standard, ideal standard, attainable standard & current
standard.

Basic standards
These are standards that could remain unchanged over a long
period, perhaps even years.

Ideal standards
These standards take no account of wastage, breakdowns,
natural breaks or idle time. They are based on optimal
operating conditions and are therefore highly unlikely ever to
be achieved in practice. This makes them unsuitable for use in
control systems.
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6.1.1 Types of standard (Cont’d)
Attainable standards
These standards are usually used within standard costing
systems. They should be attainable in that they are realistic,
but they should also be challenging and stimulating. They
assume efficient levels of operation and include allowance for
normal loss, waste and machine down-time. In this session,
you will be referring to attainable standards.
Current standards
A current standard is a standard which is normally determined
for use over a current period of time and is related to current
operations. It reflects the performance that should be achieved
during the current period. In the event that there is any change
in price or manufacturing conditions, the standards are also
revised. Most organisations use attainable standards as a
yardstick for measurement and control.
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6.2 Variance analysis
The variances are calculated by comparing actual costs (or
revenue) with the standard costs (or revenue) that should have
resulted if everything had gone according to plan. When
something goes better than planned, there will be a favourable
variance. When something goes worse than planned, there will
be an adverse variance.

Variances represent differences between actual performance

and planned performance. They may be fruitful items for
management to look at when trying to improve performance or
when trying to pinpoint why poor or better than expected
performance has occurred.

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6.2 Variance analysis (Cont’d)
You should always refer to variances in terms of whether they
are favourable or adverse rather than positive or negative.

So, variance analysis is not concerned only with comparison of

actual results with budgeted results: its principal aim is to
determine the extent of the differences and the reasons why
they occurred.

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6.2 Variance analysis (Cont’d)
The major causes of variances are as follows:
- inefficiency in operation, for example, failure to obtain a
reasonable standard in the prevailing circumstances, through
inability in one form or another, such as wastage of materials,
idle time, or through a lack of motivation,
- originally incorrect plans and standards, or originally correct
plans and standards that have been invalidated by
environmental changes
- poor communication of standards and budgetary goals
- random fluctuations around standards and goals which are
like l to be average performance targets
- the interdependence of departments, if not taken into account
in the budgeting process, such that action taken by one
department may cause variances elsewhere within the firm.

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6.2 Variance analysis (Cont’d)
Variance calculations fall into two groups, as set out below.
1 - Material, labour and variable overheads.
These are all variable costs. The budgeted costs should be
adjusted, or flexed, for the actual production in order to make a
worthwhile comparison.

2 - Fixed overheads and sales

Fixed costs are independent of the level of production.
Therefore, actual fixed costs can be compared with the original
budget. Sales are also compared with the original budget. You
will want to see whether sales revenues and volumes are
better or worse than were expected (i.e., favourable or
adverse).

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6.3 Calculating variances

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6.3 Calculating variances (Cont’d)

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6.3.1 Flexing the budget

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6.3.1 Flexing the budget (Cont’d)
Management should examine the reasons why variances have arisen.
The more the causes can be identified, the more appropriate the
corrective action that can be taken. There are usually two main
causes of variances that may arise:
- differences in price (e.g., having to pay more for materials or
wages)
- differences in usage of resources (e.g., it may take longer than
anticipated to complete a job or more materials are used than
planned).

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6.4 Materials cost variances
Material costs arise from the combination of price and quantity, so
that any difference between standard and actual costs can arise
because of price variances, usage variances or both.

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6.4.1 Price variance
To find the variance due to price alone, you need to compare the
actual cost of materials with what they would have cost if an
organisation had been able to buy the same (i.e., actual) quantity at
the standard price. Figure 11 depicts the price variance.

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6.4.2 Usage variance
To find the variance due solely to the difference in the quantity of
materials actually used compared with the standard amount, you
need to compare how much the materials should have cost (i.e., the
flexed budget) with how much they would have cost if an organisation
had been able to buy the actual quantity at the standard price.

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6.4.2 Usage variance (Cont’d)

This has arisen because the actual quantity is more than the
standard quantity and is therefore an adverse variance. At this point,
you need to consider what may have arisen that resulted in this
increase in usage of materials against standard.

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6.5 Labour variances

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6.5.1 Labour rate variance

At this point, you need to consider what may have arisen that resulted in
this increase in the average hourly rate over budget.

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6.5.2 Labour efficiency variance

At this point, you need to consider what may have arisen that resulted in
this decrease in number of labour hours compared with the flexed
budget.
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6.6 Variable overhead variances
The variable overhead variance is the difference between the actual
variable overhead incurred and the standard variable overheads
charged to production. The concept of volume is critical to all
measurement of overhead. Volume should be described in terms of
output, for example, the number of units of product produced, or the
number of standard labour hours used.

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6.6.1 Variable overhead expenditure
variance

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6.6.1 Variable overhead expenditure
variance (Cont’d)
The variable overhead expenditure variance is not very meaningful
on its own, as all that you can tell from this is that expenditure is
£2,400 more than was planned. It is not known which items of
variable overheads have caused this. Any meaningful analysis
requires a comparison of actual expenditure for each individual item
of variable overhead expenditure against the budget to find out which
variable expenses cost more or less than anticipated.

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6.6.2 Variable overhead efficiency
variance

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6.6.2 Variable overhead efficiency
variance (Cont’d)
Under marginal costing (the approach used here), it is assumed
that fixed production overheads should not vary with volume, so the
only fixed overhead variance is an expenditure variance reflecting the
difference between budgeted and actual cost.

The fixed overhead expenditure variance is not very meaningful on

its own, as all that you can tell from this is that expenditure is £250
more than was planned. It is not known which items of fixed
overheads have caused this. Any meaningful analysis requires a
comparison of actual expenditure for each individual item of fixed
overhead expenditure against the budget to find out which expenses
cost more or less than anticipated. The nature of these costs means
that they are not susceptible to short-term control by management.
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6.8 Sales variances
6.8.1 Sales price variance
This measures the effect on budgeted contribution of a different
selling price from the standard selling price. It calculates the
difference between what the sales revenue should have been for the
actual quantity sold and what it was:

From this you can deduce that a favourable variance has arisen
because of an unplanned price increase. (Obviously, this rise in price
may have contributed to the fall in sales volume below the budgeted
level.)

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6.8 Sales variances
6.8.2 Sales volume variance
This variance indicates the effect on budgeted contribution of sales
volume being higher or lower than originally budgeted:
Standard contribution can be derived from Table 15 as
£20,832/8,333 units
= £2.50 per unit.

The adverse variance appears to have arisen because Widget was

unable to sell as many units as planned, possibly owing to a fall in
demand. There could be a link between increased selling price, as
shown by the sales price variance, and a fall in demand.

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6.10 Reconciling budgeted profit and
actual profit
Management will be interested in reasons why actual profit is
different from budgeted profit. Variances can be used to explain this
difference.

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6.11 Investigating variances
6.11.1 Management by exception
As management time is a scarce resource, it is important to
investigate only significant variances. If an individual variance is
small, things in general are going according to plan, and little
management attention is needed. If an individual variance is
significant, management should spend time investigating it.
However, managers need not necessarily be concerned with only the
absolute amount of any variance. They should also be concerned with
the relationship between the various variances identified.
A very important point about management by exception is that significant
favourable variances should be investigated as diligently as adverse
ones.

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6.11 Investigating variances
6.11.2 Feedback provisions
Timely and regular feedback is vital to the success of any control
system. An efficient feedback loop procedure will ensure that
managers obtain regular and up to date information on significant
deviation from budget in order to take effective action to correct such
deviations, as well as to adjust future plans in line with changed
forecasts and market conditions.

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6.12 Advantages and disadvantages of variance
analysis
The main reasons for undertaking standard costing and detailed
variance analysis are:
- to help identify potential problem areas in order to improve control
- to identify managerial responsibility, that is, by splitting overall
variances into their components to obtain some insight as to who
or which department is responsible for a variance.

There is a cost to adopting any planning and control system.

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6.12.1 Drawbacks of using standard costing and
variance analysis

Keeping standards updated

Standard costing systems can be costly to introduce and will require

considerable time, cost and effort to maintain in line with changing
prices and product specifications. Detailed standards must also be
maintained for each labour and material input (standard price and
quantities). Rapid technological and continuous improvement
initiatives, for example, Total Quality Management (TQM), mean that
standards quickly become outdated. TQM is a customer-focused
approach to continuous performance improvement which is
established on a principle of continuous improvement by the
organisation. The use of TQM is considered as the key to improving
profitability because there is a cost associated with failing to meet
quality standards of products.

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6.12.1 Drawbacks of using standard costing and
variance analysis (Cont’d)

Difficulty in specifying standards

It is particularly difficult to establish
labour efficiency standards where products are customised to
individual customer requirements.

Over-simplifying results
We have already suggested that variances are indicative not
conclusive. There is, however, a danger that a simple-minded
approach may be taken. For example, it may be judged that adverse
variances are ‘a bad thing’ while favourable variances are ‘a good
thing’.

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6.12.1 Drawbacks of using standard costing and
variance analysis (Cont’d)

Responsibility and inter-relationships between variances

There is a further risk in over-emphasising the responsibility aspect
of variance analysis. There may be inter-relationships between the
variances, such as a possible decision by the purchasing manager to
purchase substandard materials, producing a favourable variance but
resulting in problems for the production manager.

A cost-cutting mentality
Standard costs and detailed variances may concentrate management
attention on responding to relatively unimportant internal details at
the expense of more strategic (but long-term and external) issues.

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6.12.1 Drawbacks of using standard costing and
variance analysis (Cont’d)
Standard costing systems were developed when the business
environment was more stable and less prone to change. The current
business environment is more dynamic and it is not possible to
assume stable conditions. Nevertheless, while some organisations
might be abandoning their detailed standard costing systems, they
often retain some standard costs. These companies still use standard
costs for planning and control purposes.

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Behavioural aspects of
budgeting
Session 7
7.1 Budgets and people
Traditionally, accountants and managers tended to look on
organisations from a technical viewpoint and ignore the human
aspects of budgeting. This led to some very Draconian budgets being
imposed (such as setting production levels that could only be achieved
if people were to work far more hours than they ought to) and in
budgets being prepared without consulting those people who would
be affected by them.

Performance management is often linked to budgeting, with budgets

being used as targets with associated rewards for achievement. When
an organisation focuses on this aspect, management may be tempted
to make the budgets less than realistic, aiming a bit higher than it is
possible to achieve. This can be very counter-productive.

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7.1 Budgets and people (Cont’d)
Thankfully, over the past few years, accountants and managers have
become increasingly aware of the fact that accounting reports, in all
their forms, shapes and sizes, play a major role in influencing the
actions that managers take and that the budget set will impact
significantly on all those responsible for achieving it. Accountants
and managers have moved towards involving everyone affected by
budgets in the budget setting process and in educating budget
holders in what is expected of them in achieving the targets set by
their budgets.

Clearly, accounting, and budgeting in particular, influence behaviour.

If behaviour is influenced for the better, then improved actions
may result, bringing greater rewards for the organisation. What has
gone before takes on particular relevance since budgeting is
concerned with:
- assessing how effectively managers have carried out their responsibilities
- identifying those areas that require corrective action
- motivating managers towards goals.
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7.2 Behavioural approaches and their limits
The starting point is to acknowledge that there are behavioural
issues – concerning trust, risk, openness and relationships – and that
they have to be approached in those terms (rather than, say, by
refining the accounting methods or procedures).

The importance of organisations recognising the behavioural aspects

of control systems cannot be overstated and should never be taken
lightly. If the behavioural aspect is taken into consideration,
managers’ efforts will contribute in a more effective manner towards
the attainment of organisational goals.

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7.2 Behavioural approaches and their limits
(Cont’d)
The general drive of behavioural approaches is to stress the
importance of setting budgets through open discussion and agreement,
rather than posturing or imposition. The benefits of this are twofold.

1 - Mutual understanding: frank negotiation involves an exchange

not only of more information but also of more reliable information
than occurs in the context of distrust and manoeuvring.
Consequently, senior managers appreciate better the constraints,
outlooks and concerns of their staff, and vice versa.

2- Increased commitment: whereas imposed targets are alienating,

agreed targets are a stimulant, a fair challenge and an
opportunity for achievement. In short, psychological ownership of
the budget motivates better performance.

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7.2 Behavioural approaches and their limits
(Cont’d)
Management by objectives (MBO)

The management process that MBO recommended involved:

- reviewing both long- and short-term organisational objectives
- reviewing and, where appropriate, revising the structure of the
organisation
- establishing a clear picture of the hierarchy of delegation
- obtaining a consensus between senior management and managers
in the process of setting standards
- stressing that budgetary control systems should not be seen as
constraints, but rather as guidelines and resource providers, which will help
managers to achieve recognised goals
- implementing a participative measurement process, which
involves joint discussions with managers
- having regular periodic reviews of the factors affecting the
organisation, its structure and its management systems.

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7.3 The reality of budgeting
By involving managers in budget preparation a communication
channel can be created, and managers at all levels are more likely to
understand the justification for any changes in operations. In such
cases, instead of complaining, they might well become more
constructive, and even innovative, in their responses.

7.3.1 Incremental budgeting

The incremental approach to budgeting used to be fairly widespread
but, fortunately, is now dying out in many organisations. It is a logical
approach to planning for the next year in that it starts with the current
or latest year. The approach bases the next year’s budget on the
previous year’s actual (sometimes budgeted) figures, plus an allowance
for, say, inflation, and/or a percentage deduction to encourage cost
reductions. It adds or subtracts on an incremental basis.
The incremental approach has the advantage of being relatively
simple and therefore cheap to implement. This is useful in
organisations where activity, resourcing levels and external
environment do not change much.
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7.3.2 Budget games
Faced with the need to anticipate spending requirements in an
uncertain future, it is unsurprising that most people want to ‘play
safe’. Research has shown that building some ‘slack’ into budgets is
widespread. However, what makes good sense for the individual
budget holder may be damaging for the organisation as a whole. If all
budget holders are building in a hidden contingency of, say, ten per
cent, and it turns out in the event that only a quarter or a third of
them really need to use this slack, then the organisation has
committed six to seven per cent more resources than it need have.
Does it matter very much if the funds are unused at the end of the
year, with most budget holders coming in ahead of target? In fact, this
rarely happens. Instead, expenditure rises to take advantage of the
budget available, and finance departments observe the upturned
version of the ‘hockey stick’ effect, as illustrated in the spending
graph in Figure 15.

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7.3.2 Budget games (Cont’d)

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7.3.2 Budget games (Cont’d)
The curve on the hockey stick may go either way. You can imagine a
budget holder not spending wisely and having to curtail expenditure
towards the end of the year. It may even be that resources have been
used wisely but circumstances have changed.

The obvious solution to this problem – senior management being

tougher in negotiating budgets, cutting back the bids they receive by
five or ten per cent – has equally obvious consequences: the draft
budgets are further inflated in the expectation that some of this slack
will be eliminated during the negotiations.

It is precisely to discourage such political concerns and manoeuvring

that some managers give great weight to budgets as performance
indicators. The intention is to provide budget holders with a powerful
incentive to make company priorities their own, to seek out and
deliver economies, driving down costs while maintaining or boosting
performance.

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7.3.2 Budget games (Cont’d)
Such budget games can easily generate conflict and a sense of
injustice when, for example, budget holders feel that they are being
punished for outcomes over which they had only limited control, or for
failing to achieve unrealistic targets.

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7.3.3 The underlying issues
There are occasions when the latter line of action is
justified, but, equally, most senior managers for most of the time
rightly judge that there comes a point when they simply have to
believe what their managers are telling them. Thus, perhaps
reluctantly, they have to trust them: they do not have the information
to do otherwise. It is these underlying issues of trust, information and
uncertainty that need to be addressed and which mean that budget
games cannot simply be stamped out. The problems of budgetary
games and hockey stick curves, while they will never disappear, have
been curtailed by the application of different approaches to the
management of budgeting systems. These will now be considered.

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7.3.4 Zero-base budgeting
Zero-base budgeting (ZBB) is an approach that tackles head on
the relationships between targets, inputs, outputs and activities.
At the budget holder level, managers are instructed to forget about
last year and the past and to concentrate on next year. They are
asked to identify their targets and to establish the level of resourcing
now required.

This does away with the idea of incremental budgeting, as next year
may not be the same as last, because of changed targets, external
events, inflation, etc. Managers are usually asked to prepare budgets
for a number of levels of activity, starting at a minimum level of
production/service, then detailing extra resourcing required for
increments in levels of production/service. With every budget holder
doing this, senior management can then produce a mix of activities
reflecting available resources and prioritised targets.

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7.3.4 Zero-base budgeting (Cont’d)
One problem with budget setting, however it is done, is that changes
may take place elsewhere that affect the activity area budgeted for.
Ideally, flexibility should be built into the budgeting system to deal
with any changes arising. One way of doing this is through what are
known as rolling budgets. Rolling budgets stem from the idea that
‘day to day’ management is just what it says it is – management from
one day to the next.

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Budgeting in transition
Many areas of management accounting, including budgeting, are
subject to on-going debate and change. Critics have found fault with
the traditional budgeting process described in this unit. These critics
argue that the traditional budgeting process tends to reflect a topdown
approach to budgeting that is inconsistent with the need to be flexible and
adapt to often rapidly changing organisational circumstances. Traditionally,
budgeting focuses on meeting the budget targets rather than on helping the
organisation to achieve its strategic objectives.

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Budgeting in transition (Cont’d)
As an alternative to abandoning budgets altogether, the critics have
made a number of proposals relating to improving traditional
budgeting systems (Hope and Fraser, 2003), as follows.
l Link budgeting explicitly to strategy by tying budgeting to
strategic initiatives by including provisions for strategic
expenditure, such as new product development, employee training
and process improvement in budgets.
l Use activity based budgeting to guide areas for cost reduction.
Activity based budgeting focuses on the costs of activities
necessary to produce and sell products and services. It is
inherently linked to activity based costing, but differs in its
emphasis on future costs and future usage of activity areas.

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Budgeting in transition (Cont’d)
Practise variance analysis to identify the need for process
improvement, for example, quality improvements by adopting a cross-
functional approach where interdependencies across
business function areas of the value chain are recognised.

- Balance financial aspects with non-financial (such as quality and

time) aspects.

- Inform employees about the need for continuous improvement of

performance (such as revenue enhancement and cost reduction).

- Use multi-dimensional measures to measure the performance of

individuals or units based on their contribution to the
organisation’s ability to achieve strategic results, such as quality
improvements, reduced costs, and improved customer service.

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Budgeting in transition (Cont’d)
Practise variance analysis to identify the need for process
improvement, for example, quality improvements by adopting a cross-
functional approach where interdependencies across
business function areas of the value chain are recognised.

- Balance financial aspects with non-financial (such as quality and

time) aspects.

- Inform employees about the need for continuous improvement of

performance (such as revenue enhancement and cost reduction).

- Use multi-dimensional measures to measure the performance of

individuals or units based on their contribution to the
organisation’s ability to achieve strategic results, such as quality
improvements, reduced costs, and improved customer service.

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Budgeting in transition (Cont’d)

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Budgeting in transition (Cont’d)
Figure 16b reflects the beyond budgeting model which comprises a
comprehensive set of decentralised processes that support continuous
planning, dynamic cross-company coordination, and a range of multilevel
controls. Performance responsibility is relocated from the senior
management to lower level business units. The ownership and
commitment that come from involving people in setting goals and
actions provides the driving force for continuous improvement.

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