Chapter Three Cost & Management Accounting-II Handout

FLEXIBLE BUDGET AND VARIANCE ANALYSIS

A budget is a plan for the future. Hence, budgets are planning tools, and they are usually
prepared prior to the start of the period being budgeted. However, the comparison of the
budget to actual results provides valuable information about performance. Therefore,
budgets are both planning tools and performance evaluation tools.
Usually, the single most important input in the budget is some measure of anticipated
output. For a factory, this measure of output is the number of units of each product
produced. For a retailer, it might be the number of units of each product sold. For a
hospital, it is the number of patient days (the number of patient admissions multiplied by
the average length of stay).

3.1 STATIC AND FLEXIBLE BUDGET

The static budget is the budget that is based on this projected level of output, prior to
the start of the period. In other words, the static budget is the “original” budget. The
static budget variance is the difference between any line-item in this original budget
and the corresponding line-item from the statement of actual results. Often, the line-item
of most interest is the “bottom line”: total cost of production for the factory and other cost
centers; net income for profit centers.
Budgeted Revenue = Budgeted Sales Budgeted Price per unit
in quantity X
Budgeted Cost = Budgeted VC + Budgeted FC
Budgeted VC = Budgeted Out put Budgeted Variable Cost
in quantity X per unit

Level refers to the detailed expression of the variance.

Static Budget Variance = Actual Result - Static Budget

Favorable Variance:
For Revenue: Actual Revenue > Budgeted Revenue
For Cost: Actual Cost < Budgeted Cost
Unfavorable Variance:
For Revenue: Actual Revenue > Budgeted Revenue
For Cost: Actual Cost > Budgeted Cost

Illustrative examples
Item Actual Results Static Budget
Units Sold 10,000 12,000
Revenue $1,850,000 $2,160,000
Variable Cost $1,120,000 $1,188,000
Fixed Cost $705,000 $710,000
Operating Income $25,000 $262,000

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Budgeted cost for five items

DM – 2 square yard of cloth inputs per out put at $30 per square yard.
Direct Manufacturing Labour: 0.8 mfg labour hour per out put at $20 per hour.
Direct Marketing Labour: 0.25 labour hour per out put at $24 per hour.
Variable Manufacturing Over head: allocated on the basis of 1.20 machine hours per
out put units manufactured at $10 Standard Cost per machine hours.
Variable Marketing Over head: allocated on the basis of 0.125 direct marketing labour
hours out put sold at $40 Standard Cost per direct marketing labor hours.
Actual cost for five items
DM – 22,200 square yards of cloths at $31 each.
Direct Manufacturing Labour: 9,000 mfg labour hours at $22 each.
Direct Marketing Labour: 2,304 Direct Marketing Labor hours at $25 each.
Variable Manufacturing Over head: $130,500
Variable Marketing Over head: $45,700
Required: make level 0 and level 1 variance analysis (static budget variances)

The flexible budget is a performance evaluation tool. It cannot be prepared before the
end of the period. A flexible budget adjusts the static budget for the actual level of output.
The flexible budget asks the question: “If I had known at the beginning of the period what
my output volume (units produced or units sold) would be, what would my budget have
looked like?” The motivation for the flexible budget is to compare apples to apples. If the
factory actually produced 10,000 units, then management should compare actual factory
costs for 10,000 units to what the factory should have spent to make 10,000 units, not to
what the factory should have spent to make 9,000 units or 11,000 units or any other
production level.

The flexible budget variance is the difference between any line-item in the flexible
budget and the corresponding line-item from the statement of actual results.
Budgeted Revenue = Actual Sales Budgeted Price per unit
in quantity X
Budgeted Cost = Budgeted VC + Budgeted FC
Budgeted VC = Actual Out put Budgeted Variable Cost
in quantity X per unit
The following steps are used to prepare a flexible budget:
1. Determine the budgeted variable cost per unit of output. Also determine the
budgeted sales price per unit of output, if the entity to which the budget applies
generates revenue (e.g., the retailer or the hospital).
2. Determine the budgeted level of fixed costs.
3. Determine the actual volume of output achieved (e.g., units produced for a
factory, units sold for a retailer, patient days for a hospital).
4. Build the flexible budget based on the budgeted cost information from steps 1
and 2, and the actual volume of output from step 3.
Flexible budgets are prepared at the end of the period, when actual output is known.
However, the same steps described above for creating the flexible budget can be used

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prior to the start of the period to anticipate costs and revenues for any projected level of
output, where the projected level of output is incorporated at step 3. If these steps are
applied to various anticipated levels of output, the analysis is called pro forma analysis.
Pro forma analysis is useful for planning purposes. For example, if next year’s sales are
double this year’s sales, what will be the company’s cash, materials, and labor
requirements in order to meet production needs?

The difference between static Budget and flexible budget is known as Sales Volume
Variance (SVV).
The difference between Flexible Budget and Actual budget is known as Flexible Budget
Variance (FBV).
FBV + SVV = Static Budget Variance
Actual Results:
Actual Revenue = Actual Sales Actual Price per unit
in quantity X
Actual Cost = Actual VC + Actual FC
Actual VC = Actual Out put Actual Variable Cost
in quantity X per unit

PERFORMANCE EVALUATION USING FLEXIBLE BUDGET

There are basically two reasons why actual results may differ from master budget. These
are:
 Sales and other cost driver activities were not the same as originally forecasted.
 Revenue or Variable cost per units of activity and Fixed Costs per period were not as
expected.
The variance that is obtained between flexible budget and actual result tells us the reason
why the changes exist.

The difference between fixed cost in flexible budget and static budget is Zero. When
evaluating performance, it is useful to distinguish between:
 Effectiveness: the degree to which the target is met.
 Efficiency: the degree to which inputs are used in relation to a given level of out put.
Flexible budget variance measure efficiency of operations at actual level of out put in the
activity.

3.2 COST VARIANCES FOR DIRECT MATERIALS AND LABOR

Introduction:
In the previous part, we saw that the static budget variance measures the difference
between budgeted costs and actual costs (or budgeted revenues and actual revenues).
We also saw that when the actual volume of output (sales or production) differs from the
budgeted volume of output, this difference contributes to the static budget variance. We
saw that a flexible budget adjusts the static budget to reflect what the budget would
have looked like, if the actual output volume could have been known in advance. The

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flexible budget variance measures the difference between the flexible budget and
actual results.

As stated in the previous part, there can be only two explanations for the flexible budget
variance for variable costs. First, there can be a difference between budgeted input prices
and actual input prices: the company paid more per yard of fabric, or less per pound of
steel, than planned. Second, there can be an efficiency piece: the company used more
fabric per pair of pants, or fewer pounds of steel per widget, than planned. In this chapter,
we separate the flexible budget variance for direct materials into these two pieces: the
“price” piece, and the “efficiency” piece. At the end of the chapter, we extend the
discussion to other variable costs: direct labor and variable overhead.

Notation:
The following concepts and abbreviations are used:
Inputs are the materials used in the production process (fabric or steel).
Outputs are the units of finished product (pairs of pants, or widgets).

Abbreviatio Definition Explanation

n
Q Quantity The total quantity of inputs used in
production
(the inputs for all output units, not the
inputs for one unit of output)
P Price The price per unit of input
AP Actual Price The actual price paid per unit of input
SP Standard Price The budgeted price paid per unit of
AQ Actual input
Quantity The actual quantity of inputs used in
SQ production
Standard The quantity of inputs that “should
Quantity have been used” for the actual output
produced
Sometimes Q refers to the total quantity of inputs purchased, not used in production. We
will return to this possibility later in this chapter, but for now, Q refers to the quantity used
in production.
The most important concept identified above is the Standard Quantity (SQ). SQ is a
flexible budget concept: it is the quantity of inputs that would have been budgeted had
the budget correctly anticipated the actual volume of output.
Derivation of the Direct Materials Variances:
Given these definitions, the flexible budget can be expressed as
SQ x SP;
and the flexible budget variance can be expressed as
(AQ x AP) – (SQ x SP) (1)

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By introducing the following expression, we can separate the flexible budget variance into
two pieces.
AQ x SP
This expression measures what the company “should have spent” for the actual quantity
of inputs used. We insert this expression into Equation (1) for the flexible budget variance:
(AQ x AP) – (AQ x SP) – (SQ x SP) (2)
The first difference in Equation (2) can be rewritten as follows:
(AQ x AP) – (AQ x SP) = AQ x (AP – SP)
This expression is the price variance. It is the actual inputs used in production (AQ)
multiplied by the difference between the budgeted price (SP) and the actual price (AP)
paid per unit of input. The price variance is abbreviated PV. Hence:
PV = AQ x (AP – SP)
If the term in parenthesis is positive, the factory paid more per unit of input than
budgeted, and the price variance is unfavorable. If the term in parenthesis is negative, the
factory paid less per unit of input than budgeted, and the price variance is favorable. In
either case, the price variance can be interpreted as answering the following question:
What was the total impact on the cost of production caused by the fact that the actual
price per unit of input differed from the budgeted price.
The second difference in Equation (2) can be rewritten as follows:
(AQ x SP) – (SQ x SP) = SP x (AQ – SQ)
This expression is the quantity variance (also called the usage variance). It is the
budgeted price per unit of input (SP) multiplied by the difference between the quantity of
inputs that should have been used for the output units produced (SQ) and the quantity of
inputs actually used (AQ). The quantity variance is abbreviated QV. Hence:
QV = SP x (AQ – SQ)
If the term in parenthesis is positive, the factory used more inputs than it should have
used for the amount of output units produced, and the quantity variance is unfavorable. If
the term in parenthesis is negative, the factory used fewer inputs than it should have used
for the amount of output units produced, and the quantity variance is favorable. In either
case, the quantity variance can be interpreted as answering the following question: What
was the total impact on the cost of production caused by the fact that the quantity of
inputs used to make each unit of output differed from budget.

Timing of Recognition of the Price Variance:

Some firms recognize the price variance for direct materials when the raw materials are
purchased, rather than waiting until the raw materials are put into production. In this case,
the AQ in the price variance will generally differ from the AQ in the quantity variance,
which is denoted in the following expressions for these variances:
PV = AQ Purchased x (AP – SP)
QV = SP x (AQ Used – SQ)
Where usually, AQ Purchased  AQ Used

Recognizing the price variance when raw materials are purchased provides more timely
information to management about the cost of direct materials and the performance of the

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purchasing department. Hence, this method for calculating the price variance has much to
commend it. However, in this situation, the sum of the price variance and quantity
variance will not equal the flexible budget variance, except by coincidence or when
beginning and ending quantities of raw materials are zero.

Cost Variances and External Reporting:

Cost variances are not reported separately in the external financial statements of a firm,
but are implicitly incorporated in one or more line-items on the balance sheet and income
statement, such as Cost of Goods Sold and ending Finished Goods Inventory. However, for
internal reporting, cost variances are frequently reported as separate line-items on
divisional income statements and product-specific profit statements.

Cost Variances for Direct Labor:

The formulas for splitting the flexible budget variance into a “price” variance and
“quantity” variance are the same for direct labor as direct materials. However, the
terminology differs slightly. What is called the price variance for direct materials is called
the rate variance or wage rate variance for direct labor. However, we retain the same
abbreviations:
PV = AQ x (AP – SP)
Where AQ is the actual labor hours used in production, AP is the actual wage rate, and SP
is the budgeted wage rate.
What is called the quantity or usage variance for direct materials is called the efficiency
variance for direct labor. We abbreviate this variance as EV:
EV = SP x (AQ – SQ)
Where SP and AQ are the same as above and SQ is the flexible budget quantity of labor
hours (the labor hours the factory should have used for the volume of output units
produced).
The issue discussed earlier in this chapter regarding the timing of the recognition of the
price variance for direct materials does not arise for direct labor. Consequently, for direct
labor, the sum of the wage rate variance and efficiency variance always equals the flexible
budget variance.

Example:
The Blue Moose Restaurant makes and sells sandwiches. The Restaurant makes and sells
a lot of sandwiches. Following is the restaurant’s budget for making a peanut butter and
jelly sandwich:
Direct Materials:
Bread:
Quantity: 2 slices of bread (you probably knew this)
Price: Birr 0.10 per slice of bread
Peanut butter:
Quantity: 3 tablespoons
Price: Birr 0.05 per tablespoon

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Jelly:
Quantity: 4 tablespoons
Price: Birr 0.03 per tablespoon

Direct labor:
Quantity: two minutes of labor
Wage rate: Birr 12 per hour (Birr 0.20 per minute)
The static budget for May indicated a production and sales level of 1,100 peanut butter
and jelly sandwiches. In fact, the restaurant made and sold 1,000 peanut butter and jelly
sandwiches. The total cost in direct materials and labor to make these 1,000 sandwiches
was Birr 520 for ingredients and Birr 450 for labor.
Required:
1. What is the budgeted cost per unit for making a peanut butter and jelly sandwich?
2. What would the static budget show, in total, for the cost of production for all peanut
butter and jelly sandwiches?
3. What would the flexible budget show, in total, for the cost of production for all peanut
butter and jelly sandwiches? Show materials separately from labor.
4. What is the flexible budget variance? Show this variance separately for materials and
labor. Is the flexible budget variance favorable or unfavorable?
5. Each loaf of bread contains 20 slices of bread. 105 loafs of bread were used to make all
of the peanut butter and jelly sandwiches. The actual price paid per loaf was Birr 2.20.
Calculate the quantity (usage) variance for bread. Provide a possible explanation for
this variance.
6. What is the price variance for bread? Is it favorable or unfavorable?
7. 30 labor hours were spent making peanut butter and jelly sandwiches, at an average
wage rate of Birr 15 per hour. What is the efficiency variance for labor?
8. What is the wage rate variance?
Solutions:
[Link] is the budgeted cost per unit for making a peanut butter and jelly sandwich?

Bread Birr 0.20

Peanut butter Birr 0.15
Jelly Birr 0.12
Labor Birr 0.40
Birr 0.87

[Link] would the static budget show, in total, for the cost of production for all peanut
butter and jelly sandwiches?

Birr 0.87 per sandwich x 1,100 sandwiches = Birr 957.

[Link] would the flexible budget show, in total, for the cost of production for all peanut
butter and jelly sandwiches? Show materials separately from labor.

Ingredients Birr 0.47 x 1,000 = Birr 470

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Labor Birr 0.40 x 1,000 = Birr 400

Total Birr 870

[Link] is the flexible budget variance? Show this variance separately for materials and
labor. Is the flexible budget variance favorable or unfavorable?

Ingredient Birr 520 actual  Birr 470 budgeted Birr 50 unfavorable

s = Birr 50 unfavorable
Labor Birr 450 actual  Birr 400 budgeted Birr 100 unfavorable
Total =
5. Each loaf of bread contains 2.0 slices of bread. 105 loafs of bread were used to make all
of the peanut butter and jelly sandwiches. The actual price paid per loaf was Birr 2.20.
Calculate the quantity (usage) variance for bread. Provide a possible explanation for this
variance.

SP x (AQ – SQ)
= Birr 0.10 per slice x (2,100 actual slices – 2,000 flexible budget slices)
= Birr 10 unfavorable

Possible reasons for the unfavorable usage variance for bread include the following:
1. Some of the bread was stale.
2. Some bread was dropped on the floor and not used
3. The 20 slices per loaf includes the heels, which are not used.

6. What is the price variance for bread? Is it favorable or unfavorable?

AQ x (AP – SP)
= 2,100 slices of bread x (Birr 0.11 per slice  Birr 0.10 per slice) =
Birr 21 unfavorable
7. 30 labor hours were spent making peanut butter and jelly sandwiches, at an average
wage rate of Birr 15 per hour. What is the efficiency variance for labor?
SP x (AQ – SQ)
= Birr 12 per hour x (30.00 actual hours – 33.33 flexible budget hours)
= Birr 40 favorable
8. What is the wage rate variance?
AQ x (AP – SP)
= 30 actual hours x (Birr 15 actual wage rate – Birr 12 budgeted wage rate)
= Birr 90 unfavorable

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