Budgeting and Variances

Uses of budgets

Production variances

Agenda

• Discussion of budgeting• Discussion of variances

– Materials– Labor– Overhead

• Demonstration problems• Thursday’s class

• Group work

Master Budget

• Budget = quantitative expression of a firm’s strategic plan of action

• Master budget = prepared before the accounting period begins– Also static budget– Standard costs

Preparing the budget

• Project sales• Plan production activity level

– Sales prediction– Current finished goods inventory– Desired ending finished goods inventory

• Plan purchases, employment• Estimate fixed costs• Prepare estimated income statements and

balance sheets

Uses of budgets

• Planning– Operational plans (short-term)– Capital budgets (long-term)– Company strategy

• Performance evaluation– Variances– Responsibility centers

• Control

Behavioral aspects of budgeting:

• Participative budgeting– Better information– Better cooperation– Budgetary slack

• Dysfunctional responses– Compulsion to spend all discretionary funds– Short-run emphasis on budget only– Questionable actions designed only to balance

the budget

Flexible budget:

• Flexible budget = the master budget you would have prepared if you had known before the accounting period started how much you would actually produce during the period.

• Flexible budget = “standard cost allowed for good output achieved”

Flexible budgets and performance evaluation:

ActualActivity

MasterBudget

AP inputx

AQ output

BP inputx

BQ output

FlexibleBudget

BP inputx

AQ output

"flexible budgetvariance"

Also calledproductionvariance

"activity variance"

Variances

• “unfavorable variance” = NI is reduced from the budgeted expectation

• “favorable variance” = NI is increased from budgeted expectation

• Note: Do not interpret directly as “bad” or “good” behavior on the part of management.

Variances

Actual:ActualCosts,Actual

ProductionActivity,ActualInputUsage

FlexibleBudget:Budgeted

Costs, ActualProductionActivity,Budgeted

Input Usage

MasterBudget:

BudgetedCosts,

BudgetedProductionActivity,Budgeted

InputUsage

StandardInput:

BudgetedCostsActual

ProductionActivity,ActualInputUsage

Price Variance EfficiencyVariance

ActivityVariance

Variable cost variances

• Direct materials– price variance: usage price variance

purchase price variance(actual price - std. price) x actual usage(actual price - std. price) x actual purchases

– quantity variance: based on usage(actual usage - std. usage) x std. price

actual usage = total actual materials usedstandard usage = std. allowed per unit x actual

units

Variable cost variances

• Direct labor– rate variance:

(actual price - std. price) x actual usage– efficiency variance:

(actual usage - std. usage) x std. priceactual usage = total actual labor hrs. usedstandard usage = std. allowed per unit x

actual units

Example: Chemical, Inc.

Chemical, Inc., has set up the following standards formaterials and direct labor:

Materials: 10 lbs. @ $3 $30 per batchDirect labor: .5 hrs. @ $20/hr. $10 per batch

The number of finished units budgeted for the periodwas 10,000. The number of actual batches produced was 9,810. During the month, purchases amounted to100,000 lbs. at a total cost of $310,000. The actual pricepaid for labor was $21 per hour. Price variances areisolated upon purchase. Actual inputs used were: 98,073lbs. of material and 4,900 hours of labor.

Direct material price variances

What might cause a direct material price variance?

Price change in market

Purchase discounts

Transportation costs

Grade of materials

Therefore, purchasing department

Direct material quantity variance

What could cause a direct material efficiency variance?

Defect in material

Inexperienced workers

Poor supervision

Poor scheduling

Therefore, production department

DM variance computations

Direct material purchase price variance:

$310,000 - ($3 x 100,000) = $10,000

Or: ($3.10 - $3.00) x 100,000 = $10,000

U

Direct material quantity variance:

[98,073 - (10 lbs. x 9,810 batches)]x $3 = $81 F

Or: (9.9972 - 10) x 9,810 batches x $3 = $82

DM activity variance

(actual output - budgeted output) x standard price per unit of direct material

x standard quantity of direct material per unit of output

(9,810 batches - 10,000 batches)x $3 x 10 lbs. = $5,700

F?????

Direct labor variances

What would cause a direct labor rate variance?

The actual rate = approximately average wage paid, including fringes

Experience of workers

Union contract

OvertimeChange in fringes

Therefore, human resources or management

Direct labor variances

What would cause a direct labor efficiency variance?

Skill

Motivation

Supervision/scheduling

Quality of materials

Late time

Therefore, production, human resources, purchasing

Labor variance computations

Rate variance:

($21 - $20) x 4,900 hours = $4,900 U

Efficiency variance:

(4,900 hours - (9,810/2)) hours) x $20 = $100 F

Activity variance:

(9,810 batches - 10,000 batches) x $20 x .5 = $1,900 F

Overhead variances

1. By definition, fixed overhead does not vary with thelevel of planned production.

Flexible budget FOH = Master budget FOH

2. By definition, fixed overhead is incurred as a lumpsum expenditure and there are no partial input-outputrelationships.

Therefore, the “Std. Input” column is undefined.

Overhead variances: FOH

FOH budget variance = Actual FOH - Budgeted FOH

FOH efficiency variance = Is undefined

FOH applied = (Predetermined rate/unit) x actual units

Production volume variance = Applied FOH - Budgeted FOH

Overhead variances: VOH

VOH spending variance = Actual VOH - “Std. Input” col.

VOH efficiency variance = “Std. Input” - Flexible Budget

VOH activity variance = Flexible Budget - Master Budget

Or: VOH applied - Master Budget

Overhead variances

Over- or underapplied overhead =

Actual overhead spending - Overhead applied

Or

The net of all the variances computed

Example: Murray Manufacturers

VOH Rate = $3 per DL hour

FOH Rate = $4 per DL hour

One unit requires 2 hours of labor

Denominator volume is 1,000 units of output

Actual production was only 800 units.

Actual costs were $5,800 for variable overhead and$8,130 for fixed overhead; 1,590 DL hrs. were worked.

Example: Murray Manufacturers

VOH spending variance = $5,800 - ($3 x 1,590 hrs.)

$1,030 U

VOH efficiency variance = (1,590 hr. - (2x800)hrs)

x $3 = $30 F

VOH activity variance = (800 units - 1000 units)

x 2 hrs. x $3 = $1,200 F

Example: Murray Manufacturers

FOH budget variance = $8,130 - $8,000 = $130 U

FOH production volume variance =

(800 units x 2 hrs. x $4) - $8,000

= $1,600 U

Example: The Vanguard Company

The Vanguard Company manufactures one product. Itsstandard cost system incorporates flexible budgets andassigns indirect costs on the basis of standard DL hrs.

At denominator activity, the standard cost per unit is:Direct materials, 3 lbs. @ $5.00 $15.00Direct labor, .4 hr. @ $20.00 8.00

Variable indirect costs, .4 hr. @ $6.00 2.40

Fixed indirect costs, .4 hr. @ $4.00 1.60

Total $27.00

Example: The Vanguard Company

ActualPrice

StandardCosts

TotalVar.

PriceVar.

Eff.Var. PVV

$134,400 $135,000 $600 $5,600 F $5,000 U ---

77,900 72,000 5,900 1,900 U 4,000 U ---

VOH 21,500 21,600 100 1,300 1,200 U ---

15,800 14,400 1,400 200 -- $1,600 U

$249,600 $243,000 $6,600 $5,200 $10,200 U $1,600 U

DM

DL

VOH

FOH

Example: The Vanguard Company

Direct materials were quoted at $5.50 per pound through-out September and October to all suppliers. There was nopurchase-price variance for materials in October; theprice variance shown relates solely to the materials usedduring October.

Wage standards were set in accordance with an annualunion contract, but a shortage of workers in the localareas has resulted in rates higher than standard.

There were no beginning or ending inventories of workin process.

Example: The Vanguard Company

1. How many units were produced?

Use the standard cost column.

All the units manufactured cost $243,000

One unit at standard costs $27.00

Units produced = $243,000 / $27.00 = 9,000 units

Example: The Vanguard Company

2. What were the actual number of direct labor hoursused?

Efficiency variance = (actual hrs./unit - std. hrs./unit) x actual units x std. price

= [actual DL hrs. - (.4 x 9,000)] x $20

$4,000 = actual DL hrs. x $20 - $72,000

$76,000 = actual DL hrs. x $20

3,800 = actual DL hrs.

Example: The Vanguard Company

3. What was the actual wage rate?

Labor price variance = (actual rate - std. rate) x actual labor hours

$1,900 = (actual wage rate - $20.00) x 3,800 hrs.

$1,900 = actual wage rate x 3,800 hrs - $76,000

$77,900 = actual wage rate x 3,800 hrs

$20.50 = actual wage rate

Example: The Vanguard Company

4. What was the budget for fixed indirect costs.

FOH budget variance = Budgeted FOH - Actual FOH

$200 = Budgeted FOH - $15,800

Actual FOH < Budgeted FOH

$16,000 = Budgeted FOH

Example: The Vanguard Company

5. Denominator activity expressed in direct labor hours.

$14,400 output actualxhrs.std.xVolumer Denominato

FOH Budgeted

$14,400 9xhrs..xVolumer Denominato

FOH Budgeted000,4

$14,400 9xhrs..xVolumer Denominato

$16,000000,4

Denominator Volume = 4,000 DL hrs.

Example: The Vanguard Company

6. How many pounds of direct materials were used?

DM quantity variance = (actual quantity used -std. quantity for output) xstandard price

$5,000 = (actual quantity used - (3 lbs. x 9,000) x $5.00

$5,000 = actual quantity used x $5.00 - $135,000

$140,000 = actual quantity used x $5.00

28,000 lbs. = actual quantity used

Thursday

• Review overhead variances• Compute sales revenue variances

– sales price– sales activity (measured via contribution margin)

• sales mix• sales volume

– market size– market share

• Variance reconciliation

Group exercise

• Use example company: Look at the numbers and determine what they all mean.

• Compute– Direct material price, quantity and activity

variances

– Direct labor rate, quantity and activity variances

– Overhead variances: spending/budget, efficiency (if applicable), and PVV