Chapter 24

Flexible Budgets and Standard Costs

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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
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Analytical Learning Objectives

A1: Compare fixed and flexible budgets A2: Analyze changes in sales from expected amounts

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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
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P1

Budgetary Control and Reporting

Develop the budget
from planned objectives.

Revise
objectives and prepare a new budget.

Management uses budgets to monitor and control operations.

Compare
actual with budget and analyze any differences.

Take corrective and

strategic actions.
McGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2007

A2

Fixed Budget Performance Report

Fixed budgets are prepared for a single, predicted level of activity.
Performance evaluation is difficult when actual activity differs from the predicted level of activity.
Hmm! Comparing fixed budgets with actual costs is like comparing apples with oranges.

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A2

Fixed Budget Performance Report

Consider the following condensed example from the Optel Company . . .

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Hmm! Comparing fixed budgets with actual costs is like comparing apples with oranges.

The McGraw-Hill Companies, Inc., 2007

A2

Fixed Budget Performance Report

Optel Fixed Budget Performance Report For the Month Ended January 31, 2008 Fixed Budget 10,000 $ 100,000 $ 49,000 13,000 26,000 $ 88,000 $ 12,000 Actual Results 12,000 $ 125,000 $ 58,100 15,100 26,400 $ 99,600 $ 25,400 Variances $ 25,000 F $ 9,100 2,100 400 $ 11,600 $ 13,400 U U U U F

Sales: In units In dollars Cost of goods sold Selling expenses Gen. & admin. expenses Total expenses Income from operations
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A2

Fixed Budget Performance Report

Exh. 21-2

Optel U = Unfavorable variance Actual cost Fixed Budget Performance Report is greater than budgeted cost. For the Month Ended January 31, 2008 Fixed Budget 10,000 $ 100,000 $ 49,000 13,000 26,000 $ 88,000 $ 12,000 Actual Results 12,000 $ 125,000 $ 58,100 15,100 26,400 $ 99,600 $ 25,400 Variances $ 25,000 F $ 9,100 2,100 400 $ 11,600 $ 13,400 U U U U F

Sales: In units In dollars Cost of goods sold Selling expenses Gen. & admin. expenses Total expenses Income from operations
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A2

Fixed Budget Performance Report

Optel Fixed Budget Performance Report For the Month Ended January 31, 2008 Fixed Budget 10,000 $ 100,000 Actual Results 12,000 $ 125,000

Exh. 21-2

Variances $ 25,000 F $ 9,100 2,100 400 $ 11,600 $ 13,400 U U U U F

Sales: In units In dollars

F= Cost of goods sold Favorable 49,000 $ variance $ 58,100 Actual revenue and income are greater Selling expenses 13,000 15,100 Gen. &than budgeted revenue and income. admin. expenses 26,000 26,400 Total expenses $ 88,000 $ 99,600 Income from operations $ 12,000 $ 25,400
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A2

Fixed Budget Performance Report

Fixed Budget Performance Report For the Month Ended January 31, 2005 Fixed Budget 10,000 $ 100,000 $ 49,000 13,000 26,000 $ 88,000 $ 12,000 Actual Results 12,000 $ 125,000 $ 58,100 15,100 26,400 $ 99,600 $ 25,400

Exh. 21-2

Optel If unit sales are higher, should we expect costs to be higher?

How much of the higher costs are because of higher unit sales?

Variances $ 25,000 F $ 9,100 2,100 400 $ 11,600 $ 13,400 U U U U F

Sales: In units In dollars Cost of goods sold Selling expenses Gen. & admin. expenses Total expenses Income from operations
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A2

Fixed Budget Performance Report

How much of the unfavorable cost variance is due to higher activity, and how much is due to poor cost control?

I dont think I can answer the question using a fixed budget.

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A2

Fixed Budget Performance Report

How much of the unfavorable cost variance is due to higher activity, and how much is due to poor cost control?

I dont think I can answer the question using a fixed budget.

To answer the questions, we must the budget to the actual level of activity.
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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.

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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.

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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 unchanged within the relevant range.
Fixed

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P1

Preparing Flexible Budgets

Lets prepare

budgets for Optel.

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P1

Preparing Flexible Budgets

Optel Flexible Budgets For the Month Ended January 31, 2008 Variable Amount per Unit $ 10.00 4.80 $ 5.20 Total Fixed Cost Budget for 10,000 Units $ 100,000 48,000 $ 52,000 40,000 $ 12,000 Budget for 12,000 Units $ 120,000 57,600 $ 62,400 40,000 $ 22,400

Exh. 21-3

Sales: Total variable costs Contribution margin Total fixed costs Income from operations

$ 40,000

Budget for 14,000 Units $ 140,000 67,200 $ 72,800 40,000 $ 32,800

Variable costs are expressed as a constant amount per unit.

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

P1

Preparing Flexible Budgets

Optel Flexible Budgets For the Month Ended January 31, 2008 Variable Amount per Unit $ 10.00 4.80 $ 5.20 Total Fixed Cost Budget for 10,000 Units $ 100,000 48,000 $ 52,000 40,000 $ 12,000 Budget for 12,000 Units $ 120,000 57,600 $ 62,400 40,000 $ 22,400

Exh. 21-3

Sales: Total variable costs Contribution margin Total fixed costs Income from operations

$ 40,000

Budget for 14,000 Units $ 140,000 67,200 $ 72,800 40,000 $ 32,800

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

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

P1

Preparing Flexible Budgets

Optel Flexible Budgets For the Month Ended January 31, 2008 Variable Amount per Unit $ 10.00 4.80 $ 5.20 Total Fixed Cost Budget for 10,000 Units $ 100,000 48,000 $ 52,000 40,000 $ 12,000 Budget for 12,000 Units $ 120,000 57,600 $ 62,400 40,000 $ 22,400

Exh. 21-3

Sales: Total variable costs Contribution margin Total fixed costs Income from operations

$ 40,000

Budget for 14,000 Units $ 140,000 67,200 $ 72,800 40,000 $ 32,800

Fixed costs are expressed as a total amount that does not change within the relevant range of activity.
McGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2007

P1

Flexible Budget Performance Report

Now lets prepare a budget performance report at 12,000 actual units for Optel.
McGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2007

P1

Flexible Budget Performance Report

Optel Flexible Budget Performance Report For the Month Ended January 31, 2008 Variable Amount per Unit $ 10.00 4.80 $ 5.20 Total Fixed Cost Budget for 12,000 Units $ 120,000 57,600 $ 62,400 40,000 $ 22,400 Actual for 12,000 Units $ 125,000 59,400 $ 65,600 40,200 $ 25,400

Exh. 21-4

Sales (12,000 units) Total variable costs Contribution margin Total fixed costs Income from operations

$ 40,000

Variances $ 5,000 1,800 $ 3,200 200 $ 3,000

F U F U F

Favorable sales variance indicates that the average selling price was greater than $10.00.
McGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2007

P1

Flexible Budget Performance Report

Optel Flexible Budget Performance Report For the Month Ended January 31, 2008 Variable Amount per Unit $ 10.00 4.80 $ 5.20 Total Fixed Cost Budget for 12,000 Units $ 120,000 57,600 $ 62,400 40,000 $ 22,400 Actual for 12,000 Units $ 125,000 59,400 $ 65,600 40,200 $ 25,400

Exh. 21-4

Sales (12,000 units) Total variable costs Contribution margin Total fixed costs Income from operations

$ 40,000

Variances $ 5,000 1,800 $ 3,200 200 $ 3,000

F U F U F

Unfavorable cost variances indicate costs that are greater than expected.
McGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2007

P1

Flexible Budget Performance Report

Optel Flexible Budget Performance Report For the Month Ended January 31, 2008 Variable Amount per Unit $ 10.00 4.80 $ 5.20 Total Fixed Cost Budget for 12,000 Units $ 120,000 57,600 $ 62,400 40,000 $ 22,400 Actual for 12,000 Units $ 125,000 59,400 $ 65,600 40,200 $ 25,400

Exh. 21-4

Sales (12,000 units) Total variable costs Contribution margin Total fixed costs Income from operations

$ 40,000

Variances $ 5,000 1,800 $ 3,200 200 $ 3,000

F U F U F

Favorable variances because favorable sales variance overcomes unfavorable cost variances.
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C1

Standard Costs

Lets change topics.

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C1

Standard Costs
Based on carefully predetermined amounts.
Used for planning labor, material and overhead requirements. The expected level of performance. Benchmarks for measuring performance.

Standard Costs are

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C1

Setting Standard Costs

Should we use practical standards or ideal standards? Practical standards should be set at levels that are currently attainable with reasonable and efficient effort.

Production Manager Engineer

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Managerial Accountant
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C1

Setting Standard Costs

I agree. Ideal standards, that are based on perfection, are unattainable and therefore discouraging to most employees.

Human Resources Manager

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C1

Setting Direct Material Standards

Price Standards Quantity Standards

Use competitive bids for the quality and quantity desired.

Use product design specifications.

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C1

Setting Direct Material Standards

The standard material cost for one unit of product is:
standard price for one unit of material standard quantity of material required for one unit of product

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C1

Setting Direct Labor Standards

Rate Standards Time Standards

Use wage surveys and labor contracts.

Use time and motion studies for each labor operation.

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C1

Setting Direct Labor Standards

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

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C1

Setting Variable Overhead Standards

Rate Standards Activity Standards

The rate is the variable portion of the predetermined overhead rate.

The activity is the cost driver used to calculate the predetermined overhead.

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C1

Setting Variable Overhead Standards

The standard variable overhead cost for one unit of product is: standard variable overhead rate for one unit of activity

standard number of activity units for one unit of product

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

C1

Standard Cost Card

Exh. 21-5

A standard cost card might look like this:

Standard Quantity or Hours
1 kg. 2 hours 2 hours $ $ $

Cost factor
Direct materials Direct labor Variable mfg. overhead Total standard unit cost

Standard Price or Rate

Standard Cost
25.00 40.00 20.00 85.00

25 per kg. $ 20 per hour 10 per hour $

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P2

Variances
A standard cost variance is the amount by which an actual cost differs from the standard cost.
Amount Standard cost Direct Material

Direct Labor

Manufacturing Overhead

Type of Product Cost

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P2

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

Direct Labor

Manufacturing Overhead

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P2

Variance Analysis
Identify questions Receive explanations Take corrective actions

Analyze variances

Conduct next periods operations Prepare standard cost performance report

The McGraw-Hill Companies, Inc., 2007

Begin

McGraw-Hill/Irwin

P2

Computing Variances
Standard Cost Variances

Price Variance

Quantity Variance

The difference between the actual price and the standard price
McGraw-Hill/Irwin

The difference between the actual quantity and the standard quantity
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P2

Computing Variances
Actual Quantity Actual Price Actual Quantity Standard Price Standard Quantity Standard Price

Price Variance

Quantity Variance

Standard price is the amount that should have been paid for the resources acquired.

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P2

Computing Variances
Actual Quantity Actual Price Actual Quantity Standard Price Standard Quantity Standard Price

Price Variance

Quantity Variance

Standard quantity is the quantity that should have been used for the actual good output.

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P2

Computing Variances
Actual Quantity Actual Price Actual Quantity Standard Price Standard Quantity Standard Price

Price Variance
AQ(AP - SP) AQ = Actual Quantity AP = Actual Price
McGraw-Hill/Irwin

Quantity Variance
SP(AQ - SQ) SP = Standard Price SQ = Standard Quantity
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P2

Computing Material and Labor Variances

G-Max Company makes golf clubheads with the following standard cost information:

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

$ 1.00 8.00 $ 9.00

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P2

Material Variances
During May, G-Max produced 3,500 clubheads using 3,600 pounds of material. G-Max paid $1.05 per pound for the material. Compute the material price and quantity variances.
Direct materials (1 lb. per unit at $1 per lb.) Direct labor (1 hr. per unit at $8 per hr.) Total standard direct cost per unit $ 1.00 8.00 $ 9.00

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P2

Material Variances
SQ = 3,500 units 1 lb. per unit = 3,500 lbs. Actual Quantity Actual Price 3,600 lb. $1.05 per lb. $3,780 Actual Quantity Standard Price 3,600 lbs. $1.00 per lb. $3,600 Standard Quantity Standard Price 3,500 lbs. $1.00 per lb. $3,500

Price variance $180 unfavorable

McGraw-Hill/Irwin

Quantity variance $100 unfavorable

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P2

Responsibility for Material Variances

You used too much material because of poorly trained workers and poorly maintained equipment.

I am not responsible for this unfavorable material quantity variance. You purchased cheap material, so my people had to use more of it.

Also, your poor scheduling requires me to rush order material at a higher price, causing unfavorable price variances.

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P2

Labor Variances

Lets turn our attention to labor variances.

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P2

Labor Variances
Actual Hours Actual Rate Actual Hours Standard Rate Standard Hours Standard Rate

Rate Variance
Materials price SR) AH(AR - variance Labor rate variance AH = Actual Hours Variable overhead AR = Actual Rate spending variance
McGraw-Hill/Irwin

Efficiency Variance
Materials quantity variance SR(AH - SH) Labor efficiency variance SR = Standard Rate Variable overhead SH = Standard Hours efficiency variance
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P2

Labor Variances
During May, G-Max produced 3,500 clubheads working 3,400 hours. G-Max paid an average of $8.30 per hour for the hours worked. Compute the labor rate and efficiency variances.
Direct materials (1 lb. per unit at $1 per lb.) Direct labor (1 hr. per unit at $8 per hr.) Total standard direct cost per unit $ 1.00 8.00 $ 9.00

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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 $8.30 per hour 3,400 hours $8.00 per hour 3,500 hours $8.00 per hour

$28,220

$27,200

$28,000

Rate variance $1,020 unfavorable

McGraw-Hill/Irwin

Efficiency variance $800 favorable

The McGraw-Hill Companies, Inc., 2007

P2

Labor Variances
Using highly paid skilled workers to perform unskilled tasks results in an unfavorable rate variance.

High skill, high rate

Low skill, low rate

Production managers who make work assignments are generally responsible for rate variances.
McGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2007

P2

Labor Variances
Poorly trained workers Poor quality materials

Unfavorable Efficiency Variance

Poor supervision of workers
McGraw-Hill/Irwin

Poorly maintained equipment

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P2

Responsibility for Labor Variances

I am not responsible for the unfavorable labor efficiency variance! You purchased cheap material, so it took more time to process it. You used too much time because of poorly trained workers and poor supervision.

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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.

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P3

Overhead Standards and Variances

Lets change topics again.

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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

POHR

Estimated total overhead costs Estimated activity

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P3

Setting Overhead Standards

Contains a fixed overhead rate which declines as activity level increases. Contains a variable unit rate which stays constant at all levels of activity.

Overhead Rate

Function of activity level chosen to determine rate.

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P3

Setting Overhead Standards

Flexible budgets, showing budgeted amount of overhead for various levels of activity, are used to analyze overhead costs.
G-Maxs flexible budget for overhead

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P3

Flexible Overhead Budget

G-Max Overhead Costs Scenarios For the Month Ended May 31, 2008 Variable Amount per Unit Production in units Total variable costs $ Total fixed costs Total factory overhead Standard direct labor hours POHR per direct labor hour 1.00 $ 4,000 Total Fixed Cost

Exh. 21-12

Different Production Levels (Percent of Monthly Capacity) 70% 80% 90% 100% 3,500 4,000 4,500 5,000 $ 3,500 $ 4,000 $ 4,500 $ 5,000 4,000 4,000 4,000 4,000 $ 7,500 $ 8,000 $ 8,500 $ 9,000 3,500 4,000 4,500 5,000 $ 2.14 $ 2.00 $ 1.89 $ 1.80

$7,500 3,500 hours = $2.14 per hour

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

P3

Flexible Overhead Budget

G-Max Overhead Costs Scenarios For the Month Ended May 31, 2008 Variable Amount per Unit Production in units Total variable costs $ Total fixed costs Total factory overhead Standard direct labor hours POHR per direct labor hour 1.00 $ 4,000 Total Fixed Cost

Exh. 21-12

Different Production Levels (Percent of Monthly Capacity) 70% 80% 90% 100% 3,500 4,000 4,500 5,000 $ 3,500 $ 4,000 $ 4,500 $ 5,000 4,000 4,000 4,000 4,000 $ 7,500 $ 8,000 $ 8,500 $ 9,000 3,500 4,000 4,500 5,000 $ 2.14 $ 2.00 $ 1.89 $ 1.80

G-Max predicted an 80 percent activity level

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P3

Computing Overhead Variances

Now that we can compute the overhead rates, lets use them to determine variable and fixed overhead variances.
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P3

Computing Overhead Variances

Actual Variable Overhead Incurred AH AVR Flexible Budget for Variable Overhead at Actual Hours AH SVR Applied Variable Overhead at Standard Hours SH SVR

Spending Variance
AH AVR SVR SH
McGraw-Hill/Irwin

Efficiency Variance

= = = =

Actual Hours of Activity Actual Variable Overhead Rate Standard Variable Overhead Rate Standard Hours Allowed
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P3

Computing Overhead Variances

Actual Fixed Overhead Incurred Fixed Overhead Budget

Exh. 21-14

Fixed Overhead Applied SH SFR

Spending Variance

Volume Variance

SFR = Standard Fixed Overhead Rate SH = Standard Hours Allowed

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P3

Overhead Variance Analysis

Total Overhead Variance Variable Overhead Fixed Overhead

Spending Variance

Efficiency Variance

Spending Variance

Volume Variance

McGraw-Hill/Irwin

Controllable Variance

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P3

Computing Overhead Variances

During May, G-Max produced 3,500 clubheads working 3,400 hours. G-Max budgeted for 4,000 units (80%). Actual variable overhead was $3,650 and actual fixed overhead was $4,000. Compute the variable overhead spending and efficiency variances and the fixed overhead spending and volume variances.

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P3

Computing Variable Overhead Variances

Actual Variable Overhead Incurred Flexible Budget for Variable Overhead at Actual Hours 3,400 hours $1.00 per hour

Exh. 21-16

Applied Variable Overhead at Standard Hours 3,500 hours $1.00 per hour

$3,650

$3,400

$3,500

Spending variance $250 unfavorable

McGraw-Hill/Irwin

Efficiency variance $100 favorable

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P3

Variable Overhead Variances

Spending Variance
Results from paying more or less than expected for overhead items and from excessive usage of overhead items.

Efficiency Variance
A function of the selected cost driver. It does not reflect overhead control.

McGraw-Hill/Irwin

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P3

Computing Fixed Overhead Variances

Actual Fixed Overhead Incurred Fixed Overhead Budget

Exh. 21-17

Fixed Overhead Applied 3,500 hours $1.00 per hour

$4,000

$4,000

$3,500

Spending variance $0
McGraw-Hill/Irwin

Volume variance $500 unfavorable

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P3

Fixed Overhead Variances

Spending Variance
Results from paying more or less than expected for fixed overhead items.

Volume Variance
Results from the inability to operate at the activity planned for the period.

Has no significance for cost control.

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P3

Volume Variance
Cost $500 $4,000 expected fixed OH Volume Variance $3,500 applied fixed OH unfavorable

Exh. 21-18

3,500 units $1.00 fixed overhead rate

3,500 Actual Units

McGraw-Hill/Irwin

Volume 4,000 Expected Units

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C3

Standard Costs for Control

Managers focus on quantities and costs that differ from standards, a practice known as management by exception.

Amount

Standard cost Direct Material

Direct Labor

Manufacturing Overhead

Type of Product Cost

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A2

Sales Variances
A similar analysis can be applied to sales variances. We will use two additional G-Max products, golf balls and drivers, to illustrate.
Budgeted 1,000 $ 10.00 150 $ 200.00 Actual 1,100 $ 10.50 140 $ 190.00

Sales of golf balls (units) Sales price per golf ball Sales of driver (units) Sales price per driver

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A2

$550 F Price Variance

$1,000 F Volume Variance

$1,400 U Price Variance

McGraw-Hill/Irwin

$2,000 U Volume Variance

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End of Chapter 24

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