Chapter 8- Budgets and variance analysis

What does standard costing provide and why is it used?

- It provides detailed information to management as to why actual performance differs from expected performance

- Standard costing systems are widely used because they provide cost data which can be used for many different purposes

Name 5 purposes of standard costing

1. To assist in budget setting and evaluating performance

2. To act as a control device by highlighting those activities that do not conform to plan and thus alerting managers to those situations which may be 'out of control' and hence in need of corrective action

3. To provide a prediction of future costs to be used in decision making

4. To simplify the task of tracing costs to products for inventory valuation

5. To provide a challenging target that individuals are motivated to achieve

What does an effective standard costing system rely on?

It relies on standard cost reports, with variances clearly identified, presented in an intelligible form to management as part of the overall cost reporting cycle

Define a standard cost

• A standard cost is the planned unit cost of a product or service

• It is an indication of what a unit of product or service should cost

• Standard costs represent 'target' costs and they are therefore useful for planning, control and motivation

• They are also commonly used to simplify inventory valuation

What are the four main types of cost standards?

1. Basic standards

2. Ideal standards

3. Attainable standards

4. Current standards

Tell me more about basic standards as a type of cost standard

• Basic standards are long-term standards which remain unchanged over a period of years

• Their sole use is to show trends over time for items such as material prices, labour rates and labour efficiency

• They are also used to show the effect of using different methods over time

• Basic standards are the least used and the least useful type of standard

Tell me more about ideal standards as a type of cost standard

• Ideal standards are based upon perfect operating conditions

• Perfect operating conditions include: no wastage; no scrap; no breakdowns; no stoppages; no idle time

• In search for perfect quality, companies can use ideal standards for pinpointing areas where close examination may result in large cost savings

• Ideal standards may have an adverse (bad) motivational impact because they are unlikely to be achieved

Tell me more about attainable standards as a type of cost standard

• Attainable standards are the most frequently encountered type of standard

• They are based on efficient (but not perfect) operating conditions

• These standards include allowances for the following: normal or expected material losses; fatigue; machine breakdowns

• Attainable standards must be based on a high performance level so that with a certain amount of hard work they are achievable (unlike ideal standards)

Tell me more about current standards as a type of cost standard

• Current standards are based on current levels of efficiency in terms of allowances for breakdowns, wastage, losses and so on

• The main disadvantage of using current standards is that they do not provide any incentive to improve on the current level of performance

Name 3 key facts about standard costing

1. A standard cost may be based on either marginal costing or absorption costing

2. Standard costs also provide an easier method of accounting since it enabled simplified records to be kept

3. Once estimated, standard costs are usually collected on a standard cost card

Name 5 reasons why a budget may be used?

1. To forecast future activity levels

2. To communicate goals and objectives

3. To plan for the use of resources- materials, labour, money

4. To control the different departments

5. To motivate by setting achievable targets

These are mostly the same as the aims of management accounting

What is a rolling budget?

• A rollig budget is a budget (usually annual) kept continously up to date by adding another accounting period (e.g. month or quarter) when the earliest accounting period has expired

• The remaining budget is re-forecaast, as well as the new period being added

When would rolling budgets be suitable?

- Rolling budgets are suitable if accurate forecasts cannot be made for example, in a fast moving environment, or for any area of business that needs tight control

What is the typical way a rolling budget might be prepared?

1. A budget is prepared for the coming year, broken down into suitable, say quarterly, control periods

2. At the end of the first control period a comparison is made of that period's results against the budget. The conclusions drawn from this analysis are used to update the budgets for the remaining control period and to add a budget for a further three months, so that the company once again has budgets available for the coming year

3. The planning process is repeated at the end of each three month control period

Name some advantages of rolling budgets

• Planning and control will be based on a more accurate budget

• Rolling budgets reduce the element of uncertainty in budgeting since they concentrate on the short term when the degree of uncertainty is much smaller

• There is always a budget that extends into the future

• It forces management to reassess the budget regularly and to produce budgets which are more up to date

Name some disadvantages of rolling budgets

• Rolling budgets are costilier and time consuming than some other budgets as they are constantly being updated

• May demotivate employees if they feel that they spend a large proportion of their time budgeting or if they feel that the budgetary targets are constantly changing

• There is a danger that the budget may become the last budget 'plus or minus a bit'

• An increase in budgeting work may lead to less control of the actual results

• Issues with version control, as each month the full year numbers will change

• Confusion in meetings as to each numbers the business is working towards; this can distract from the key issues, as managers discuss which numbers to achieve

Define a fixed budget

A fixed budget is a budget produced for a single activity level

Tell me more about a fixed budget

• A fixed budget is produced at the beginning of the period and is used to provide information as to the aims and objectives that the organisation is working towards in that particular period

• The simplest form of a budget report compares the original budget against actual results

Define a flexed budget

A flexed or flexible budget is one which, by recognising cost behaviour patterns, is designed to change as volume of activity changes

What cost behaviour and nature principles does a flexed budget use?

• Variable costs

• Direct costs

• Fixed costs

• Stepped costs

• Semi-variable costs

• Sales revenue-→> assumed to have a variable behaviour unless stated otherwise

Define a functional budget

A functional budget is a budget of revenue and/or expenditure which applies to a particular function of the business

What are the main functional budgets?

• Sales

• Production

• Raw material usage

• Raw material purchases

• Labour

• Variable and fixed overheads

• Non-manufacturing overheads

What is the difference between the budget and actual results called?

Variance

Define an adverse variance

An adverse variance occurs when the actual costs exceed the budgeted costs or when the actual revenue is less than the budgeted revenue

Define a favourable variance

A favourable variance occurs when the actual cost is less than the budgeted cost or when the actual revenue exceeds the budgeted revenue

What is one of the big concerns when using variances as a control process and how do you overcome this?

• One of the major concerns here is to ensure that the budgeted and actual figures reflect the same activity level

• To overcome this issue budgets are flexed to match the actual production level

How is variance analysis done using flexed budgets?

• When completing a budgetary control report using flexed budgets the flexed budget is prepared based on the actual activity level i.e. the number of units produced

• Any variances identified will be due to the price charged or the amount used per unit of product

What are some examples of potential variances using flexed budgets?

• If a material variance was discovered it would be due to the number of kg used per unit or the price paid per kg

• If a labour variance was discovered it would be due to the number of hours

worked per unit or the rate per hour

If actual revenue is adverse what might this mean?

- We must have been selling at a lower price as we are now comparing using the same volume of sales

If actual labour costs favourable what might this mean?

- The efficiency of the staff or the rate paid per hour was better than budgeted

If actual fixed overheads were adverse what might this mean?

- Since they should not change when activity levels change this must be due to an inaccurate budgeted or an unexpected expense occurring

If overall profit is adverse what might this mean?

- This is because we have kept better control of the material and labour costs than planned

How do you reconcile the actual with budget?

Once the variances have been calculated it should be possible to reconcile the actual profit with the budgeted profit:

1. An adverse variance will decrease the budgeted profit so this is subtracted from budgeted profit

2. A favourable variance will increase the budgeted profit so this is added to the budgeted profit

To be able to control aspects of the business, management will need to investigate why the variances have happened? To decide which variances to investigate management will consider:

• The size of the variance--> is it significant compared to the cost incurred?

• The cost of investigating the variance-→ will it cost less to investigate and put it right than the variance itself?

• Whether it is adverse or favourable-→ some companies will only investigate the adverse variances

• Ability to correct the variance--> is the variance controllable in house (hours worked by staff) or uncontrollable (price changed by suppliers)

Why might a sales variance occur?

There are two main reasons

1. Price changes--> selling the product at a higher or lower price. This could happen if discounts are offered to the customer or discounts are removed or reduced, a price drop is required to remain competitive and/or an enforced price change due to legislation

2. Volume changes--> higher or lower volumes are sold than expected. This could be due to a successful or unsuccessful advertising campaign; changes in buyers' habits; a problem with production may reduce availability and/or changes in market conditions

When comparing a flexed budget with actual results the volume changes are already accounted for by changing the volume in the budget to match the sales volume

Tell me more about material variances?

• When comparing a flexed budget with actual results we are looking at the material cost per unit of product

• This can be broken down into the quantity of raw material that is used per unit and the price paid for the raw material

• Flexed vs actual comparisons remove the effect on cost that is due to the number of units manufactured

Why might a material variance occur when considering the raw material used to produce the product? There are four main reasons

1. Price changes--> an increase or decrease in the price per unit of material purchased. This could be due to suppliers changing prices, loss or introduction of a bulk discount, higher delivery changes and/or a change in the quality of the material

2. Usage changes--> an increase or decrease in the amount of material used. This could be due to more efficient or less efficient working conditions and/ or a change in the quality of the materials purchased

3. Quality--> if production uses a higher quality material then it will cost more to purchase. If a lower quality material is sued it will be cheaper to purchase

4. Combination of quality and quantity--

> Higher quality costs more but may well lead to less wastage so use less. Lower quality costs less but may lead to more wastage so use more

Tell me more about labour variances

• When comparing a flexed budget with actual results we are looking at the labour cost per unit of product

• This can be broken down into the hours of labour worked and the rate paid per hour

• Flexed vs actual

comparisons remove the effect on cost that is due to the number of units manufactured

Why might a labour variance occur?

There are 3 main reasons

1. Rate changes--> a) higher or lower hourly rate is paid to the emoloyees than expected.

If a higher grade of labour is used then they will require higher wages. If a lower grade of labour is used they will require lower wages.

b) There could be an increase in the basic rate of pay (minimum wage) or a bonus may have been paid

1. Efficiency of staff or the hours worked to produce output--› If the actual time taken is longer than budgeted then this will cost more but if actual time taken is shorter than budgeted then it will cost less. This could be due to change in the grade of labour as the more experience the staff the more efficient they are assumed to be

2. Overtime--> If there is extra time needed to complete the production then this may have to lead to pay some staff overtime. This is often paid at a higher rate than normal hours.

This will increase the labour costs due to both increased hours and increased rates of pay

What might it mean if there is a fixed overheads variance?

Fixed overheads should not change when activity levels change so the cause of any variance when comparing the flexed and actual figures is due to the budgeted expenditure being different from actual expenditure

In many cases the explanation for one variance might also explain why other variances occur. Give 3 examples

1. Using cheaper materials would result in a drop in the price paid for materials (favourable variance for purchasing department) but using cheaper materials in production might increase the wastage rate (adverse variance for the production department)

2. An increase in wastage due to using cheaper material may reduce the productivity of the labour force leading to increased working hours to meet production demands (adverse labour variance)

3. Employees trying to improve productivity (work fewer hours) in order to win a bonus (increase in cost) might use materials wastefully in order to save time (adverse material variance)

Variances can be sub-divided to provide more detail so how can sales variance be sub-divided?

Sales variances can be sub-divided into the variance due to the quantity sold (volume variance) and the variance due to the sales prices changed (price variance)

Variances can be sub-divided to provide more detail so how can material variance be sub-divided?

Material variances can be sub-divided into the variance due to quantity of the materials used (usage variance) and the variance due to the price paid for the materials (price variance)

Variances can be sub-divided to provide more detail so how can labour variance be sub-divided?

Labour variance can be sub-divided into the variance due to the hours worked (efficiency variance) and the variance due to the rate paid per hour (rate variance)

What should you do before coming up with a solution for a variance?

Each variance should be considered in turn and any interdependence should be considered before solutions can be arrived at

Name 9 possible solutions for variances that arise:

1. Lower the price of the finished goods to increase volumes of sales

2. Increase advertising to improve volume of sales without impacting the price

3. A change of supplier may be an option for improving prices for materials

4. Negotiation of bulk or trade discounts for materials purchased

5. Updating machinery may make the usage of materials better and may also improve the efficiency of the labour force

6. Better quality control over the materials that are used in production may reduce wastage

7. Better supervision of staff may reduce idle time and errors in production

8. Increased training may reduce errors and make the staff more efficient

9. Closer monitoring of budgets may make the budgets more accurate

If you are working out a standard cost card and are asked to work out the standard cost for fixed overheads if they are absorbed on a labour rate basis, how would you do this?

- You would do:

Fixed overhead cost/ total labour hours expected x actual hours

How would you work out the standard quantity of labour per unit in minutes?

Total budgeted direct labour hours/ total budgeted

production units x 60 (to convert to minutes)

How would you work out the standard quantity of material required to produce 100,500 for example?

Total budgeted direct materials usage/ total budgeted production units x 100,500 (required number of units)

How do you work out the standard labour hours to produce 90,000 units?

Total budgeted direct labour hours/ total budgeted production units x 90,000 (required number of units)

How do you work out the standard labour cost to produce 100,500 units?

Total budgeted direct labour cost/ total budgeted production units x 100,500 (required number of units

If you are given a table to fill out with the actual filled in and asked to work out the budgeted columns and the variances. How would you do it?

1. Put the actual volume sold into the budgeted volume sold

2. Now to work out the budgeted column, you need to get the budgeted figure from the question, divide it by the budgeted volume sold (in question but not the table) and then multiply it by the actual volume sold

3. Then to work out the variance, find the difference between them

4. If any actual costs are higher than budgeted then this is adverse, and if any are lower then this is favourable

5. Of course if actual sales revenue and profit is higher then budgeted this is favourable or adverse if it is the other way round

When you are working with semi-variable costs in this context such as a question stating "There is a semi-variable cost which when activity is at 7,000 units incurs a cost of £20,600", how would you work out the variable and fixed elements?

1. Variable element cost=

(20600 - maximum units in question)/ 7000 - (lowest units from question)= variable element cost per unit

2. Fixed element cost=

Maximum units from question - (minimum units from questions x variable element cost)= fixed element cost

When you are working out a table with budgeted and actual figures but have more than one budgeted unit information, what do you do to work out that column?

1. So you've already added the actual volume into the budgeted volume row

2. Work out the price per unit for the actual, this is just for interest

3. Look back at the previous table and find the unit that is closest to the actual volume, find out the price per unit and then multiply it by the actual unit

When you are filling out a table of actual and budgeted, how do you deal with the semi-variable

information using the information from the question or from the table above?

1. Variable element cost x actual units + fixed costs from the budgeted table beforehand or question

The last line on the variance value column is the variance between actual and budgeted operating profit, not the total of the variance value column

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If you are given a table and asked to explain what caused some of the variances, give a reason for all unless stated otherwise

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What can cause adverse material variance could be caused by which of the following?

Cheap material and poorly maintained machinery may lead to increased material usage andtherefore an adverse material usage variance.

Why might a business investigate a variance report during a particular month in the middle of the financial year and what is the least likely reason not to investigate a variance reported?

not to investigate a variance reported during a particular month in the middle of the financial year?

1. The size of the variance is relevant. Small variances are unlikely to be worth investigating.Some organisations use a reporting by exception system whereby only unusually large results are flagged for management's attention.

2. To see whether the variance is controllable, the likelihood of a variance being controllable by the manager is relevant. If a variance is likely to be outside the manager's control, there will be no point in spending time and efforti nvestigating it.

3. Looking at variance trends throught the year to the month can also be significant. If a variance is getting larger each month, instead of being favourable in one month and adverse in another month, the need for control action might be more urgent.

4. The factor that should be least likely to affect an investigation is whether the variance is favourable or adverse. If a variance is large and favourable, management might be able to make sure that the favourable variance continues in future months by taking appropriate measures.

A company has a higher than expected staff turnover and as a result staff are less experienced than expected. As an indirect result of this, are the labour rate variances and material variances likely to be adverse or favourable and why?

• Less experienced staff are likely to be paid at a lower rate and therefore the labour rate variance will be favourable.

• Usage of materials is likely to be adverse as the staff are less experienced, thus there will be more wastage and a higher level of rejects.

A company is obliged to buy sub-standard materials at lower than standard price because nothing else is available.As an indirect result of this purchase, are the materials usage variance and labour efficiency variance likely to be adverse or favourable and why?

• Usage of materials is likely to be adverse as the materials are sub-standard, thus there will be more wastage and a higher level of rejects.

• Time spent by the labour force on rejected items that will not become output leads to higher than standard time being spent per unit of output,therefore efficiency will decline