ACCT 302 Ch7

Ch. 7: Flexible Budgets, Direct Costs and Management Control

Variances: Difference between an actual and an expected (budgeted) amount.

+ By studying variances, managers can focus on where specific performances have fallen

short and make corrective adjustments to achieve significant savings for their

companies.

+ Variances bring together the planning and control functions of management and facilitate

management by exception.

+ Variances can also be used to evaluate performance and motivate managers.

Favorable Variance: has the effect, when considered in isolation, of increasing operating income relative to the budgeted (expected) amount.

Unfavorable Variance: Has the effect, when viewed in isolation, to decrease operating income relative to the budgeted (expected) amount.

Management by Exception: Practice of focusing attention on areas not operating as expected (budgeted) and less closely on areas that are. It focuses on both favorable and unfavorable variances.

Static (Master) Budget: Based on the output planned at the start of the budget period.

Level 1 Analysis: Static Budget Variance

Static Budget Variance: Level 1 Variance. The difference between the actual amount and the static budget amount.

+ Levels 1,2 and 3 analyses examine Level 0 variance, but it breaks it down into more detailed levels of analysis.

Deficiencies of the Static Budget: Static budgets are prepared for a single, planned level of activity. Performance evaluation is difficult when actual activity differs from the planned level of activity. Comparing static and actual costs are like comparing apples and oranges.

+ The relevant question is: How much of the cost variances are due to higher activity, and how much are due to control costs?

Flexible Budget: Calculates budgeted revenues and costs based on the actual output.

+ Prepared at the end of the period, after managers know the actual output.

+ The hypothetical budget that would have been prepared at the start of the budgeted

period if the company had correctly forecasted the actual output we sold.

+ Shows revenues and costs that would have happened at the actual level of activity,

enabling “apples to apples” comparisons.

+ The only difference between the static and flexible budget is the level of activity. Static

uses our planned (expected) activity. Flexible uses actual level of activity. Level 2 Analysis: Sales-Volume Variance and Flexible Budget Variances

Sales-Volume Variance: Compares static and flexible budgets. Why would we incur an unfavorable sales-volume variance?

+ Failure to execute the sales plan → They didn’t sell as much units as anticipated by their sales plan.

+ Weaker than anticipated demand → Not enough demand to meet our expected sales units.

+ Aggressive competitors taking market share → Competitors taking away our customers, resulting in fewer sales.

+ Unanticipated market preference away from the product → Again, not a lot of people were interested in buying our product. Resulting in fewer sales.

+ Quality problems → Product had a defect, not as many sales sold as anticipated.

Comparing actual budget to the flexible-budget.

Targets or standards are established for direct material and direct labor.

The standard costs are recorded in the accounting system. Actual price and usage amounts are compared to the standard and variances are recorded.

+ A company will subdivide the flexible budget variances for its direct-cost inputs into two more detailed variances – Price and efficiency variance.

Level 3 Analysis: Breaks down Flexible-Budget Variance into Price and Efficiency Variance

Flexible-Budget Variance:

Standard Costing:

Price Variance: The difference between an actual input price and a budgeted input price multiplied by the actual input quantity.

+ We are comparing actual and budgeted prices because flexible-budget variances compare the flexible and actual budgets. Remember, a flexible budget uses the budgeted selling prices and the actual amount.

Price variance = Actual Quantity of input x (Actual price - Budgeted price). → Favorable if the actual price is less than we anticipated (budgeted).

→ Unfavorable if the actual price is more than we anticipated (budgeted).

+ Marketing managers are in the best position to understand and explain the reason for a selling price difference.

+ Was the difference due to better quality?

+ Or, was the difference due to an overall increase in market prices?

Difference between the actual input of quantity and budgeted input quantity for actual output multiplied by the budgeted price.

Efficiency Variance = Budgeted/Standard rate x (Actual Quantity - Standard Quantity Allowed for actual output)

+ Managers have more control over efficiency variances than price variances because the quantity of inputs used is primarily affected by factors inside the company (like the efficiency which operations are performed).

Management’s Use of Variances:

+ Price and efficiency variances provide feedback to initiate corrective actions.

+ Managers use variance analysis to evaluate performance after decisions are

implemented.

+ Standards are used to control costs and guide managers to appropriate investigations of

variances.

+ Understand why variances arise, learn, and improve future performance.

Direct Materials Variances

Price Variance = AQ purchased (AP - SP)

+ The price variance is computed on the entire quantity purchased.

if the actual price of the materials purchased is less than the budgeted price. →Unfavorable if the actual price is higher than the standard price because that means we paid more for materials than anticipated.

Favorable Materials Variances Causes:

+ Webb’s purchasing manager skillfully negotiated lower direct materials prices.

+ The purchasing manager switched to a lower-priced supplier.

+ The purchasing manager obtained quantity discounts by ordering larger

quantities.

+ Direct materials prices decreased unexpectedly due to an oversupply of

materials.

+ The budgeted purchase prices of direct materials were set too high because

managers did not carefully analyze market conditions.

+ The purchasing manager negotiated favorable prices because he was willing to

accept unfavorable terms on factors other than prices (such as agreeing to lower- quality material).

Efficiency Variance:

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Efficiency Variance = SP x (AQ used - SQA) + The efficiency variance is computed only on the quantity used.

if it uses a larger quantity than budgeted quantity allowed. → Favorable if actual quantity used is less than budgeted quantity allowed.

Unfavorable Efficiency Variances Causes:

+ Workers working more slowly or making poor-quality jackets that require

reworking.

+ The personnel manager hiring underskilled workers.

+ Inefficient production scheduling resulting in idle and lost time.

+ Improper maintenance leading to equipment failures.

+ Inaccurately evaluating the skill levels of employees and the environment in

which they operate and consequently setting standards that are too tight.

Responsibility for Materials Variances:

Materials Price Variance: Purchasing manager Materials Efficiency Variance: Production manager.

+ Standard price is used to compute the efficiency variance so that the production manager is not held responsible for the purchasing manager’s performance.

Labor Variances Summary

Price Variance = Actual Hours (AR - SR) Efficiency Variance = SR x (AH - SHA)

Responsibility for Labor Variances:

Production managers are held accountable for labor variances because they can influence the:

+ Mix of skill levels assigned to work tasks.

+ Level of employee motivation.

+ Quality of production supervision.

+ Quality of training provided to employees.