Chapter Three: Flexible Budgets and Standards

3.1. Fixed Budgets

A budget is a formal plan of action expressed in monetary terms. A budget that is based on a single
estimate of expected sales and production is called a “static budget”. The yearly master budget which is
developed around a single (static) planned output level explained in the preceding chapter in a static
budget. In short, static or master budget is prepared based on the level of output planned at the start of
the budget period. All static budgets have the following common points:-
1. They are geared towards only one level of activity
2. They are static in nature in that comparison of actual result is always made against
budgeted costs at the original budget activity level.
“A fixed budget is a budget which is designed to remain unchanged irrespective of the level of activity
actually attained.” Thus, a budget prepared based on a standard or fixed level of activity is known as a
fixed budget. It does not change with the change in the level of activity. Therefore, it becomes an
unrealistic yardstick in case the level of activity actually attained does not confirm to the one assumed
for budgeting purposes.

  Fixed budget is useful when there is no significant variation between the budgeted output and the
actual output.  It does not consider variances due to changes in the volume. 

In the industries where the pattern of demand is stable, a fixed budget may be adequate, especially
where the budget period is comparatively short. 

3.1.1. Static budget variances

A variance is the difference between actual price and quantity and standard budgeted price and
quantity. The budgeted performance is the expected performance, which is a point of reference for
making comparisons. When we come to static budget variance, it is simply mean the difference
between the actual result and the corresponding budgeted amount in the static budget.
Static budget variance=Actual result-Static budget amount
Variance we compute at last may be favorable or unfavorable variance.
 Favorable variance (denoted by F):- has the effect of increasing operating income relative to
the budgeted amount. For revenue items, favorable means actual revenues exceed budgeted revenues
and the reverse is true for unfavorable variance.
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 For cost items, favorable means actual cost less than budgeted costs.
 An unfavorable variances (denoted by u):- has the effect of decreasing operating income
relative to the budgeted amount when viewed the following instruction shows how to compute the
actual result, static budget and static budget variance. We can also identify each static budget variance
trainable (F) or unfavorable (U) based on their effect on operating income.

Structure of variance

Level 1
Static budget
1.

Flexible budget variance Sales volume variance

Level 2

Sale quantity Sale mix

Level 3 Price Efficiency variance variance
variance

Example: 3.1: ABC Company manufactures and sells jackets. The jackets require tailoring and many
hand operations. The company incurred only manufacturing costs. ABC Company has three variable
cost categories. The budgeted variable cost per jacket for each category is:-
Cost category Variable cost per jacket
Direct material costs $ 60
Direct manufactory labor costs $16
Variable manufacturing overhead costs 12
Total variable costs $88
The number of units manufactured is the cost driver for direct materials, direct manufacturing labor,
and variable manufacturing overhead. The relevant range for the cost driver is from 0 to 12,000
jackets. Budgeted and Actual data for April 2008 follow:-

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 Budgeted fixed cost under the relevant range………….. $276,000
Budgeted selling price ……………………………………. $120 per jackets
Budgeted production and sales ……………………….. 12,000 jackets
Actual fixed cost under the relevant rage……………. $285,000
Actual selling price ……………………………………….. $125 per jackets
Actual production and sales …………………………….. 10,000 jackets

Cost category Variable cost per jacket

Direct material costs…………………………… $62.16
Direct manufacturing labor costs ……………. 19.8
Variable manufacturing over head costs …… 13.05
Total variable cost ……………………………….. 95.01

Required
Compute Actual operating income, static budget operating income and static budget variance for
operating income.
Additional information
All direct materials are purchased and used in the same budget period and there is no direct material
inventory at either the beginning or the end of the period. No work-in-process or finished goods
inventories exist at either the beginning or the end of the period.
Solution
(1) (2)=(1)-(3) (3)
Level 1 analysis Actual Static budget Static budge
Result Variances
Unit sold 10,000 2000U 12,000
Revenues $1,2250,000 $190,000U$1,440,000
Variable costs
Direct material 621,600 98,000F 720,000
Direct manufactory labor 198,000 6,000U 192,000
Variable manufactory overhead 130,500 13,500F 144,000
Total variable costs 950,100 105,900F 1,056,000
Contribution margin 299,900 84,100 U 384,000
Fixed costs 285,000 9,000 u 276,000
Operating income $14,900 $93,100U $108, 000

Static budget
variance for = actual result – static budget
operating income $14,900 - $ 108,000 = $93,100 U

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3.2. Flexible budgets : level 2 analysis

Flexible Budgets –are budgets that “flex” or change with varying levels of activity. Most of the
time flexible budgets correspond to actual levels of output. They help management evaluate
performance.
Flexible budget, also known as variable or sliding sale budget, is a budget, which is designed to
furnish budgeted costs for any level of activity actually attained. Flexible budgeting technique may
be employed to adjust other budgets according to current conditions arising out of seasonal
variations or changes in the length of the working period etc.
“a flexible budget is a budget designed to change in accordance with the level of activity actually
attained.”

A flexible budget is more realistic, useful and practical. The likely changes in the actual
circumstances are taken into account while preparing a flexible budget. The technique is highly
useful for control purposes.   Actual performance of an executive may be compared with what he
should have achieved in the actual circumstances and not with what he should have achieved under
quite different circumstances.

3.2.1. Developing flexible budget

The only difference between static budget and flexible budget is that static budget is prepared for the
planned output; whereas flexible budget is based on the actual output.
Steps in developing a flexible budget
Step1, Identify the actual quantity of output
Step2, Calculate flexible budget for revenues based on budgeted selling Price and actual quantity of
output.
Step 3, Calculate flexible budget for costs based on budgeted variable cost per output Unit,
Actual quantity of output and budgeted fixed cost.

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 Example: 3.2 using example 3.1 develop flexible budget.
Solution:
Step1 Identify the actual quantity of output
In April 2003 ABC produced and sold 10,000 jackets
Step2 Flexible budget for revenues
Flexible budget revenue=budgeted selling price x actual quantity of output.
= $120 per jacket x 10,000 jackets.
= $1,200,000
Step 3 flexible budgets for cost
Flexible budget variable costs
Direct materials, $60 per jacket x 10,000 jackets ………………….. $600,000
Direct manufacturing labor, $16 per jacket x10, 000 jackets…………. 160,000
Variable manufacturing overhead, $12 per jacket x10, 000 jak...........120,000
Total flexible-budget variable costs………………………………..…… 880,000
Flexible budget fixed costs 276,000
Flexible budget total costs $1,156,000

3.2.2. Flexible budget variances

Once the flexible budget in prepared, the manager is ready to compare actual results for a period
against the comparable budgeted level anywhere within the relevant range. The difference between
an actual result and the corresponding flexible budget amount based on the actual output level in the
budget period is called flexible budget variance.
Flexible budget variance =Actual result-flexible budget amount
Example 3.3 using data presented in example 3.1 compute flexible budget variances.

Actual Flexible-budget Flexible sales volume static

Results variance budget variance budget
1 2=1-2 3 4=3-5 5
Units sold 10,000 0 10,000 2000U 12,000
Revenues $1,250,000 50,000F $1,200,000 240,000U 1,440,000
Variable costs
Direct material variance 621,600 21,600U 600,000 120,000 F 720,000
-Direct manufactory labor 198,000 38,000U 160,000 32,000F 192,000
Variable manufactory overhead 130,500 10,500U 120,000 24,000F 144,000

Total variable cost 950,100 70,100U 880,000 176,000U 1,056,000

Contribution margin 299,900 20,100U 320,000 64,000U 384,000
Fixed cost 285,000 9,000U 276,000 0 276,000
Operating income $14,900$ 29,100U $44,000 64,000U 108,000

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The operating income in example 3.3 shows the flexible budget variance is $29,100U ($14,900-
$44,000).
The $29,100 unfavorable variance arises because actual selling price, variable cost per unit and fixed
costs differ from their budgeted amount. The flexible-budget variance for revenues is called the
selling-price variance because it arises solely from the difference between the actual selling price and
the budgeted selling price:

Selling-price ¿ ( sellingActual−Budgeted
priced selling price )
x Actual units sold
Variance
= ( $ 125 per jacket −$ 120 per jacket ) x 10,000 jackets
= $50,000F
3.3. Standards for Materials and Labor
The pre-set standards require managers to plan in advance the amount and price of each resource
that will be used in providing a service or manufacturing a product. These pre-set standards, for
selling prices and sales volumes as well as for costs, provide a basis for planning, a target for
achievement and a benchmark against which the actual costs and revenues can be compared. The
actual costs and revenues recorded after the event are then compared with the preset standards and
the differences are recorded as variances.
If resource price or usage is above standard, or if sales volume or selling price is below standard,
an adverse variance will result. If resource price or usage is below standard or if sales volume or
selling price is above standard, a favorable variance will result.
Careful analysis of the variances and their presentation to management can help to direct
managers’ attention to areas of the business that are performing below or above expectation.
A standard cost is a carefully predetermined unit cost that is prepared for each cost unit. It
contains details of the standard amount and price of each resource that will be utilized in
providing the service or manufacturing the product.
In order to be able to apply standard costing it must be possible to identify a measurable cost unit.
This can be a unit of product or service but it must be capable of standardizing, for example,
standardized tasks must be involved in its creation. The cost units themselves do not necessarily
have to be identical.

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For example, standard costing can be applied in situations such as costing plumbing jobs for
customers where every cost unit is unique. However, the plumbing jobs must include standardized
tasks for which a standard time and cost can be determined for monitoring purposes.
The standard cost of product 12345 is set out below on a standard cost card.

Standard Cost Card

Product: the Splodget, No 12345
Cost Requirement
Direct materials $ $
A $2.00 per kg 6 kgs 12.00
B $3.00 per kg 2 kgs 6.00
C $4.00 per liter 1 liter 4.00
Others 2.00
24.00
Direct labour
Grade I $4.00 per hour 3 hrs 12.00
Grade II $5.40 per hour 5 hrs27.00
39.00
Variable production overheads $1.00 per hour 8 hrs 8.00
Fixed production overheads $3.00 per hour 8 hrs24.00
Standard full cost of production 95.00
Notice how it is built up from standards for each cost element: standard quantities of
materials at standard prices, standard quantities of labor time at standard rates and so on. It is
therefore determined by management's estimates of the following.
• The expected prices of materials labor and expenses
• Efficiency levels in the use of materials and labor
• Budgeted overhead costs and budgeted volumes of activity
3.3. Controllability and Variance Analysis
3.3.1. Direct Material Variances
It includes both the direct material price Variance and the standard direct material quantity
Variance
Direct Material Price Variance is the difference between the actual cost of direct material and the
standard cost of quantity purchased or consumed.

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 A. Direct Material Price Variance:
=   Actual Quantity x Actual Price - Actual Quantity x Standard Price 
=     Actual Cost - Standard Cost of Actual Quantity 
Where:

 Actual Quantity is the quantity purchased during a period if the variance is calculated at
the time of material purchase

 Actual Quantity is the quantity consumed during a period if the variance is calculated at
the time of material consumption
Example
Cement PLC manufactured 10,000 bags of cement during the month of January. Following raw
materials were purchased and consumed by Cement PLC during the period:
Material Quantity Actual Price Standard Price
Limestone 100 tons $75/ton $70/ton
Clay 150 tons $20/ton $24/ton
Sand 250 tons $10/ton $12/ton
Material Price Variance will be calculated as follows:
Step 1: Calculate Actual Cost
Actual Cost = Actual Quantity x Actual Price
Limestone: 100 tons x $75 = $7,500
Clay: 150 tons x $20 = $3,000
Sand: 250 tons x $10 = $2,500
Step 2: Find the Standard Cost of Actual Quantity
Standard Cost = Actual Quantity x Standard Price
Limestone: 100 tons x $70 = $7,000
Clay: 150 tons x $24 = $3,600
Sand: 250 tons x $12 = $3,000
Step 3: Calculate the Variance
Material Price Variance = Actual Cost (Step 1) - Standard Cost (Step 2)
Limestone: $7,500 - $7,000 = $500 Unfavorable
Clay: $3,000 - $3,600 = ($600) Favorable
Sand: $2,500 - $3,000 = ($500) Favorable
Total Price Variance ($100) Favorable
Analysis
A favorable material price variance suggests cost effective procurement by the company.
Reasons for a favorable material price variance may include:

 An overall decrease in the market price level

 Purchase of materials of lower quality than the standard (this will be reflected in adverse
material usage variance)
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  Better price negotiation by the procurement staff

 Implementation of better procurement practices (e.g. invitation of price quotations from

multiple suppliers)

 Purchase discounts on larger orders

Unfavorable material price variance indicates higher purchase costs incurred during the period
compared with the standard.
Reasons for unfavorable material price variance include:

 An overall hike in the market price of materials

 Purchase of materials of higher quality than the standard (this will be reflected in favorable
material usage variance)

 Increase in bargaining power of suppliers

 Loss of purchase discounts due to smaller order sizes

 Inefficient buying by the procurement staff

B. Direct Material Usage Variance
Definition-Direct Material Usage Variance is the measure of difference between the actual
quantity of material utilized during a period and the standard consumption of material for the
level of output achieved.
Formula
Direct Material Usage Variance:
 =Actual Quantity x Standard Price - Standard Quantity x Standard Price 
= Standard Cost of Actual Quantity  - Standard Cost of Standard Quantity 
= (Actual Quantity - Standard Quantity) x Standard Price
Example: Cement PLC manufactured 10,000 bags of cement during the month of January.
Consumption of raw materials during the period was as follows:

Material Quantity Standard Usage Per Bag Actual Price Standard Price
Used
Limestone 100 tons 11 KG $75/ton $70/ton
Clay 150 tons 14 KG $21/ton $20/ton
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 Sand 250 tons 26 KG $11/ton $10/ton
Material Usage Variance will be calculated as follows:
Step 1: Calculate Standard Quantity
Limestone: 10,000 units x 11 / 1000 = 110 tons
Clay: 10,000 units x 14 / 1000 = 140 tons
Sand: 10,000 units x 26 / 1000 = 260 tons
Step 2: Calculate the Variance
Material Usage Variance = [Actual Quantity - Standard Cost (Step 2)] x Standard
Price

Limestone: (100 - 110) x $70 = ($700) Favorable

Clay: (150 - 140) x $20 = $200 Unfavorable
Sand: (250 - 260) x $10 = ($100) Favorable
Total Usage Variance ($600) Favorable
.Analysis
A favorable material usage variance suggests efficient utilization of materials.
Reasons for a favorable material usage variance may include:

 Purchase of materials of higher quality than the standard (this will be reflected in adverse material
price variance)

 Greater use of skilled labor

 Training and development of workforce to improve productivity

 Use and improvement of automated manufacturing tools and processes

An adverse material usage variance indicates higher consumption of material during the period as
compared with the standard usage.
Reasons for adverse material usage variance include:

 Purchase of materials of lower quality than the standard (this will be reflected in a favorable
material price variance)

 Use of unskilled labor

 Increase in material wastage due to depreciation of plant and equipment

3.3.2. Direct LaborVariances
A. Direct Labor Rate Variance- DefinitionDirect Labor Rate Variance is the measure of difference
between the actual cost of direct labor and the standard cost of direct labor utilized during a period.

Formula
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Direct Labor Rate Variance:
 =   Actual Quantity x Actual Rate  - Actual Quantity x Standard Rate
= Actual cost - Standard Cost of Actual Hours
Example:DM is a denim brand specializing in the manufacture and sale of hand-stitched jeans
trousers.
DM manufactured and sold 10,000 pairs of jeans during a period.
Information relating to the direct labor cost and production time per unit is as follows:

Actual Hours Standard Hours Actual Rate Standard Rate

Per Unit Per Unit Per Hour Per Hour
Direct 0.50 0.60 $12 $10
Labor
Labor rate variance shall be calculated as follows:
Step 1: Calculate Actual hours
Actual Hours = 10,000 units x Actual hours per unit
= 5,000 hours.
Step 2: Calculate the actual cost
Actual Cost = Actual Hours x Actual Rate
= 5,000 hours (Step 1) x $12 per hour
= $60,000.
Step 3: Calculate the standard cost of actual number of hours
Standard Cost of actual hours = Actual Hours x Standard Rate
= 5,000 hours (Step 1) x $10 per hour
= $50,000.
Step 4: Calculate the variance
Labor Rate Variance = Actual Cost - Standard Cost of the Actual Hours
= $60,000 (Step 2) - $50,000 (Step 3)
= $10,000 unfavorable
Analysis
A favorable labor rate variance suggests cost efficient employment of direct labor by the
organization.
Reasons for a favorable labor rate variance may include:
 Hiring of more un-skilled or semi-skilled labor (this may adversely impact labor efficiency
variance)
 Decrease in the overall wage rates in the market due to an increase in the supply of labor
which may be caused, for example, due to the influx of immigrants as a result of the
relaxation of immigration policy
 Inappropriately high setting of the standard cost of direct labor which may, in the
hindsight, be attributed to inaccurate planning
An adverse labor rate variance indicates higher labor costs incurred during a period compared
with the standard.
Causes for adverse labor rate variance may include:
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  Increase in the national minimum wage rate
 Hiring of more skilled labor than anticipated in the standard (this should be reflected in a
favorable labor efficiency variance)
 Inefficient hiring by the HR department
 Effective negotiations by labor unions

B. Direct Labor Efficiency Variance- Definition- Direct Labor Efficiency Variance is the measure
of difference between the standard cost of actual number of direct labor hours utilized during a
period and the standard hours of direct labor for the level of output achieved.

Formula
Direct Labor Efficiency Variance:
=   Actual Hours x Standard Rate  - Standard Hours x Standard Rate 
Standard Cost of Actual Hours   - Standard Cost   
Example
DM is a denim brand specializing in the manufacture and sale of hand-stitched jeans trousers.
DM manufactured and sold 10,000 pairs of jeans during a period.
Information relating to the direct labor cost and production time per unit is as follows:
Actual Hours Standard Hours Actual Rate Standard Rate
Per Unit Per Unit Per Hour Per Hour
Direct 0.50 0.60 $12 $10
Labor
Labor rate variance shall be calculated as follows:
Step 1: Calculate Actual hours
Actual Hours = 10,000 units x 0.5 hours per unit
= 5,000 hours.
Step 2: Calculate the standard cost of actual number of hours
Standard Cost of Actual Hours = Actual Hours x Standard Rate
= 5,000 hours (Step 1) x $10 per hour
= $50,000.
Step 3: Calculate the standard hours
Standard hours = 10,000 units x 0.60 hours per unit
= $6,000.
Step 4: Calculate the standard cost
Standard Cost = Standard Hours x Standard Rate
= 6,000 hours (Step 3) x $10 per hour
= $60,000.

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Step 5: Calculate the variance
Labor Efficiency Variance = Standard Cost of Actual Hours - Standard Cost
= $50,000 (Step 2) - $60,000 (Step 4)
= $10,000 Favorable.
Analysis
A favorable labor efficiency variance indicates better productivity of direct labor during a period.
Causes for favorable labor efficiency variance may include:
 Hiring of more higher skilled labor (this may adversely impact labor rate variance)
 Training of work force in improved production techniques and methodologies
 Use of better quality raw materials which are easier to handle
 Higher learning curve than anticipated in the standard
An adverse labor efficiency variance suggests lower productivity of direct labor during a period
compared with the standard.
Reasons for adverse labor efficiency variances may include:
 Hiring of lower skilled labor than the standard (this should be reflected in a
favorable labor rate variance)
 Lower learning curve achieved during the period than anticipated in the standard
 Decrease in staff morale and motivation
 Idle time incurred during a period caused by disruption or stoppage of activities (idle time
variance may be calculated separately from the labor efficiency variance to reflect the
underlying increase or decrease in labor productivity during a period)
3.4. Overheads variances
3.4.1. Variable Overhead Spending Variance
The variable overhead spending variance is the difference between actual variable overhead
cost per unit of the cost-allocation base and budgeted variable overhead cost per unit of the cost-
allocation base, multiplied by the actual quantity of variable overhead cost-allocation base used
for actual output.
Formula
Variable actual variable budgeted variable
Overhead overhead cost _ overhead actual quantity of
spending = per unit cost per unit variable overhead
variance

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3.4.2. Variable Manufacturing Overhead Efficiency Variance:
The variable overhead efficiency variance is the difference between actual quantity of the cost-
allocation base used and budgeted quantity of the cost-allocation base that should have been used
to produce actual output, multiplied by budgeted variable overhead cost per unit of the cost-
allocation base.

Variable actual quantity variable budgeted quantity budgeted

Overhead overhead cost _ variable overhead variable overhead
Efficiency = per unit cost per unit cost per unit
Variance
The following data are for April 2003, when webb company produced and sold 10,000 jackets.

Item actual flexible budget

result amount

1. Output unit (jackets) 10,000 10,000

2. Machine hours 4,500 4000
3. Machine hour per output (2÷1) 0.45 0.4
4. V.mfg overhead cost $ 130,500 $120,000
5. V.mfg overhead cost per machine hour (4÷2) $29 $30
6. V.mfg overhead cost per output unit (4÷1) $13.05 $12

Required: find the following

1. Variable overhead flexible budget variance
2. Variable overhead efficiency variance
3. Variable overhead spending variance

Variable overhead = actual cost _ flexible budget amount

flexible budget variance incurred

130,500 - 120,000

= $10,500 U

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This $10,500 unfavorable flexible-budget variance means Webb’s actual variable overhead
exceeded the flexible-budget amount by $10,500 for the 10,000 jackets actually produced and
sold.

Variable overhead = ( actual overhead budgeted overhead ) budgeted

efficiency variance quantity - for actual output overhead price

(4500hrs -0.4hr./unit x10,000units) x $30 per hrs

(4500hrs -4000hrs) x $30 per hrs
$15,000 U

unfavorable variable overhead efficiency variance of $15,000 means that the actual machine-
hours (the cost-allocation base) of 4,500 hours turned out to be higher than the budgeted
machine-hours of 4,000 hours allowed to manufacture 10,000 jackets.

Analysis
An adverse variable manufacturing overhead spending variance suggests that the company
incurred a higher cost than the standard expense.
Potential causes for an adverse variance include:

 A decrease in the level of activity not fully offset by a decrease in overheads (e.g. electricity
consumption of machines during set up is usually same even if a smaller batch of output is
required to be produced)

 In efficient cost control (e.g. not optimizing the batch production quantities leading to
higher set up costs)

 Planning error (e.g. failing to take into account the increase in unit rates of electricity
applicable for the level of activity budgeted during a period)

Variable overhead = ( actual price - budgeted price ) actual quantity

spending variance per overhead per overhead of overhead

= ($29 per machine-hour - $30 per machine-hour) * 4,500 machine-hours

= (- $1 per machine-hour) * 4,500 machine-hours
= $4,500 F
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Favorable, why because actual variable overhead cost per unit of the cost-allocation base ($29
per machine-hour) is lower than the budgeted variable overhead cost per unit of the cost
allocation base ($30 per machine-hour).

Analysis
Favorable variable manufacturing overhead spending variance indicates that the company
incurred a lower expense than the standard cost.
Possible reasons for favorable variance include:

 Economies of scale (e.g. increase in order size of indirect material leading to bulk discounts
on purchase)

 A decrease in the general price level of indirect supplies

 More efficient cost control (e.g. optimizing electricity consumption through the installation
of energy efficient equipment)

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