CHAPTER 14

STANDARD COSTS AND OPERATING PERFORMANCE MEASURES

Rationale of Standard Costs

Proper control of costs requires a comparison of actual cost results with some
base data. Management is interested to know what costs are but also whether
they represent an efficient level of productive operations. Comparing actual
costs with those incurred in a previous period is one way to evaluate costs. To
properly interpret and control costs, we can compare actual costs with
standard costs so we can study any difference or variance. Thus, standards are
yardsticks that measure achievement or lack of achievement.

Standard costs represent what costs should be incurred under attainable,

acceptable performance. They do not represent what the cost would be if
perfection in performance had actually been attained. Standards establish
desirable minimum costs. When actual operations exceed standard, the
variances are generally investigated.

The standards relate to the quantity and cost of inputs used in manufacturing
goods or providing services.Quantity standards indicate how much of a cost
element such as labor, time or raw materials, should be used in manufacturing a
unit of product or in providing a unit of service. Cost standards indicate what the
cost of the time or the materials should be.

Actual quantities and actual costs of inputs are compared against these
standards to whether operations are proceeding within the limits that
management has set. If either the quantity or the cost of inputs exceeds the
limits that. management directs its attention to the difference and uses its efforts
where they will do the most 8ood. This process is known as management by
exception.
Users of Standard Costs

Manufacturing, service, food, not-for-profit organizations and even financial

institutions all make use of standards (in terms of either costs or quantities) to
some extent.

Auto service centers offer set labor time standards for the completion of certain
work tasks and then measure actual performance against these standards. Fast-
food outlets such as Jollibee, McDonalds have exacting standards as to the
quantity of meat going into a sandwich, as well as standard for the cost of the
meat. Hospitals have standard costs for laboratory tests, for food, laundry and
other items for each occupied bed.

In short, the business student is likely to run into standard costs, concepts in
almost any line of business that she or he may enter.

Benefits of Standard Costs

When standard costs are set carefully and used widely, they provide benefits to
an organization such as:

1. Managers and employees become cost conscious because variances

between standard costs and actual costs are reported, studied and their causes
determined. Thus, these standards provide a measuring device calling attention
to cost variations. In turn, these standards serve as a compass that guide
managers toward improvement.

2. They aid management planning by providing the unit amount for budgeting.
Also in the process of setting standards, managers thoroughly study all factors
affecting costs and oftentimes discover how operations can be improved.

3. Standard cost systems integrate managerial, accounting and engineering

functions. Coordination is encouraged because all elements of the organization
are striving for the same goal.
4. Although initially, standard cost systems might appear to be costly to use
because of the start-up investment, using standards can save data processing
costs.

Limitations of Standard Cost

Although the advantages of using standard costs are significant, certain

difficulties can also be encountered by the manager. The following are some of
the problems or potential problems in using standard costs:

1. Difficulty may be encountered in determining which variances are material or

significant in amount to warrant investigation.

2. Other useful information such as trends may not be noticed at an early stage
since attention is focused only on variances above a certain level.

3. Subordinates may be tempted to cover up unfavorable exceptions or not

report them at all. particularly when they do not receive reinforcement or
commendation for the positive things they do. This is a possible consequence of
applying the principle of management by exception.

4. The management by exception technique may also affect supervisory

employees in an unsatisfactory manner because they may feel that they are
not getting a complete review of operations as they are always just keying it in
on problems. Also, supervisors may feel they are being constantly critical of their
subordinates and this may have a negative impact on their morale.

These possible problems and difficulty suggest that extreme care must be
exercised by the manager in adopting a standard cost system. It is particularly
important that managers go out of their way to focus on the positive rather than
on the negative, and to be aware of possible unintended consequences.

How Standards are Set

The setting of standard costs is more an art than a science because it requires
the combined thinking and expertise of all persons who have responsibility over
prices and quantities of inputs. In non-manufacturing companies (service and
trading firms), this standard-setting activity would involve the controller or
managerial accountant, purchasing agent, segment managers, sales personnel
Such as salesmen or service providers themselves. In a manufacturing setting.
This group of persons would include the managerial accountant, purchasing
agent, industrial engineer, production supervisors, line managers and the
production workers.

1he managerial accountant provides great help at the beginning point in

setting standard costs by preparing data on the cost characteristics of prior
years activities at various levels of operation. However, a standard for the future
must be more than simply a projection of the past. Data must be adjusted for
changing economic patterns, changing demand and supply characteristics
and changing technolOgy.

Generally, standards are set on a less demanding level. Normal, and expected
actual standards are standards that are "light but attainable." Also known as
practical standards, they allow for normal machine breakdown, normal material
loss, expected lost time, employee rest periods and can be attained through
reasonable though nighy efficient, efforts by the average worker at a task
Variances from such a standard are very useful to management in that they
represent deviation that fall at outside or normal, recurring inefficiencies than
ma standards however, make no Chapter, the use of practical rather than the
ideal standard is assumed.

Setting Direct Material Standards

Standard Quantity

Industrial engineers develop specifications for the kinds and quantities of

material used in producing the goods budgeted. Operation schedules list the
materials and quantities required to the expected volume of production.
Traditionally quantity standards contained an allowance for waste or shrinkage.
Nowaday the popular zero defect philosophy does not include an allowance
for wa Production standards no longer reflect planned scrap, lost materia
inefficiencies in the production Process. instead, companies improve con
charging resources lost due to waste directly to the supervisor whose group
caused the error.

Standard Price

The purchasing department receives the operation schedule and bills of

material established jointly by the engineering department, the manufacturing
supervisor and the accountant. This information becomes the basis for the
material price standard.

Because the purchasing agents arc responsible for price variances, they should
help set the price standards which should reflect the study of market condition
vendors quoted prices and the optimum size of a purchase order. The just-in
time (JT management philosophy which many companies adopt. minimizes
inventories, keeping on hand only the amount needed in production until the
next order arrives. In so doing. the inventory carrying cost is minimized. In
addition, the entire operation associated with acquiring goods including any
exhaustive bargaining for the lowest material price should be studied.

The account should also consider cash discounts, material handling costs
(freight, purchasing, receiving and other costs) in the standard price to be
established. Lastly, the purchasing department should be made accountable
not only for the price of purchased components but also for the specified
quality. Otherwise, the purchasing's motivation is just to find inexpensive vendors
without concern for meeting the material quality specifications. While this may
lead to a favorable material price variance, unfavorable materials quantity
variance and unfavorable labor efficiency variance may also result because of
poor quality of materials and substantial manufacturing rework time.

Setting Labor Standards

Standard Time
Examination of past payroll and production records can reveal the worker-hours
used on various jobs and can help determine standard performance. Time
reports from the workers for a limited period will be a good basis for the
standard. If possible, time and motion study should be the basis for setting time
standards. The time study seeks to develop time standards and piece rates
which he average operator can meet daily, A time study breaks up the
operating cycle into distinct elements. Managers who should have expert
knowledge and skill, place the rating of the operation and the employees skill
and effort in tie study sheets.

Standard Labor Rate

Labor rates should be determined by considering the current rates as well as

the competitive markets. The company may use any of the following methods in
determining the labor rate standards:

1. A company may establish a standard rate for the job; regardless of who
performs the job, the rate stays the same, or
2. A company may establish a rate for an individual worker and the worker
receives this rate regardless of the work performed.

If labor contracts exist, the wage is relatively fixed and can be used as standard.
Labor costs in an automated manufacturing system are largely fixed even
though wages are expressed on an hourly basis. Accountants can derive an
average salary figure from a schedule showing the number of salaried people
and their individual salaries. The average plant salary figure should also include
payroll taxes and such employees' benefits as vacation pay, insurance, and
pensions.

Setting Overhead Standards

Factory overhead cost standards provide a means of allocating factory

overhead to cost inventories for pricing decisions and controlling expenses. A
standard cost system uses budgeted rates based on standard hours or other
cost drivers allowed for actual production. In a cost system not employing
standards, there are no standard hours-actual hours or another cost driver is the
only means for applying overhead. A standard cost system applies overhead to
Work in Process Inventory based on standard hours.

A capacity level is selected as the volume basis or denominator capacity s

previously mentioned, theoretical capacity is rarely chosen because it does not
represent it an attainable level of performance. Standards set on practical
capacity are more likely to be attainable and are more realistic than theoretical
standards. Either normal capacity or expected actual capacity is the basis for
current standards.

After selecting the capacity level, costs are allocated on a volume related o
non-volume related base. Commonly used volume-related bases include
machine hours direct labor hours direct labor costs, direct materials costs and
units of production. An activity-based costing system uses nonvalue related
activities such as number of scheduled production runs or inspections. After
expressing volume based on machine hours, the number of inspection, or
another basis, the factory overhead incurred at this level is estimated.

Operating Performance Evaluation

Analysis of Variances

Basically, the variance or difference between actual costs and standard costs
can be separated and analyzed into two components: a price variance and an
efficiency variance. These may be computed as follows:

Direct Materials Variance Analysis

The difference between actual cost and standard cost of materials used is
called a material cost variance. This variance is made up of a price variance
and a usage or quantity or efficiency variance. These variances may be
computed as follows:

When the manufacturing process uses several different direct materials that are
supposed to be combined in a standard proportion, the materials quantity
variance may be broken down into:

a) Materials Mix variance and

b) Materials Yield variance
The possible causes of materials price variance are as follows:

1. Fluctuations in market prices of materials.

2. Purchasing from distant suppliers, which results in additional transportation
costs.
3. Failure to take cash discounts available.
4. Purchasing materials of substandard quality or in uneconomical lots.
5. Unfavorable purchase contract terms

Responsibility: The Purchasing Department is usually responsible for material

price variances. However, the Production Planning Department could be
responsible for unfavorable price variance occurring (l) because of a request for
rush order due to poor scheduling or (2) when they specify certain brand-name
materials or materials of certain grade or quality other than those initially
included in the bill of materials.

The possible causes of materials quantity or usage variance are as follows:

1. Waste and loss of material in handling and processing

2. Substitution of defective or nonstandard materials.
3. Spoilage o production of excess scrap because of inexperienced workers
or poor supervision
4. Lack of proper tools or machines
5. Variation in yields from materials.

Responsibility: Production line supervisors should be held responsible for

materials under their control.
Direct Labor Variance Analysis

Labor cost variance is the difference between actual labor cost and standard
labor cost. This variance may be analyzed into two components, namely, the
labor rate variance and the labor usage or efficiency variance. These variances
are computed as follows:

Labor Efficiency or Time Variance

Actual hours Pxx

Less: Standard hours xx

Unfavorable (Favorable) Pxx

Multiplied by: Standard labor rate xx

Unfavorable (Favorable) Pxx

If several different materials are used in the manufacturing process, the labor
usage variance may further be analyzed into:

a) Labor efficiency variance

b) Labor yield variance

These variances are computed as follows:

Labor Efficiency Variance

Actual hours x Standard labor rate Pxx

Less: Standard hours based on actual input

(SHAD) x Standard labor rate xx

Unfavorable (Favorable) Pxx

Labor Yield Variance

SHAI × Standard labor rate Pxx

Less: Standard hours based on actual output

(SHAO) x Standard labor rate xx

Unfavorable (Favorable) Pxx

The possible causes of labor rate variance are as follows:

1. Inexperienced workers hired.

2. Change in labor rate particularly peak season that has not been
incorporated in the standard rate.

3. Use of an employee having a wage classification other than that assumed

when the standard for a job was set.

4. Use of a greater number of higher-paid employees in the group than

anticipated.

Responsibility: If production line supervisors have the authority to match workers

and machines to task by hiring the proper grade of labor, line supervisors should
be responsible. They will also be responsible if they control the wage rate of their
labor force. If they do not, the Personnel Department may be responsible.

The possible causes of labor efficiency variance are as follows:

1. Good or poor training of workers

2. Poor materials or faulty equipment

3. Good or poor supervision and scheduling of work

4. Experience or lack of experience on the job

5. Inefficient equipment

6. Machine breakdown

7. Nonstandard materials being used

Responsibility: Production line supervisors should be held responsible for labor

under their control. The Production Planning Department or the Purchasing
Department should be held responsible for any labor efficiency variance that
results from the use of nonstandard material.

Factory Overhead Variance Analysis

Variable Manufacturing Overhead

Total variable manufacturing overhead variance is the difference between

actual variable overhead and standard variable overhead allowed on actual
output. This may be broken down into:

a) Variable overhead spending variance

b) Variable overhead efficiency variance

These variances are computed as follows:

AH = actual hours

Std VOR = standard variable overhead rate

SH = standard hours
Alternative presentation:

Variable Overhead Spending Variance

Actual Variable OH Pxx

Less: Actual Hours x Standard variable overhead rate xx

Unfavorable (Favorable) Pxx

Variable Overhead Efficiency Variance

Actual hours Pxx

Less: Standard hours xx

Unfavorable (Favorable) Pxx

Multiplied by: Std. VOR xx

Unfavorable (Favorable) Pxx

The possible causes of variable overhead spending or price / controllable

variance are as follows:

Actual costs, for example, machine power, materials handling, supplies were
different from those expected because of fluctuations in market prices or rates.

2. Increase in energy costs.

3. Waste in using supplies.

4. Avoidable machine breakdowns.

5. Wrong grade of indirect material and indirect labor.

6. Lack of operators or tools.

Responsibility: Supervisors of cost centers are responsible because they have
some degree of control over these budget or expense factors.

The possible causes of variable overhead efficiency variance are as follows: This
is attributable to efficiency in using the base on which variable overhead is
applied. So that if the basis of the variable overhead application is direct labor
hours, the causes of the labor efficiency variance will also be the causes of the
variable overhead efficiency variance.

Responsibility: Production line supervisors are responsible for this variance. This
variance shows how much of the factory's capacity has been consumed or
released by off-standard labor performance. If machine-hours are the basis for
applying factory overhead, the variance measures the efficiency of machine
usage.

Fixed Manufacturing Overhead Variance Analysis

In variance analysis, fixed manufacturing costs are treated differently from

variable manufacturing costs. It is usually assumed that fixed costs are
unchanged when volume changes, so the amount budgeted for fixed
overhead is the same in both the master and flexible budgets. This is consistent
with the variable costing method of product costing. There are no input-output-
relationships for fixed overhead: The difference between the actual fixed
overhead and the budgeted fixed overhead at normal capacity falls under the
category of a price variance (also called spending or budget variance). While
the difference between the budgeted fixed overhead and applied fixed
overhead represents the volume or capacity variance.

The possible causes of capacity or volume variance are as follows:

1. Poor production scheduling.

2. Unusual machine breakdowns.

3. Storms or strikes.

4. Fluctuations over time.

5. Decrease in customer demand.

6. Excess plant capacity.

7. Shortage of skilled workers.

Responsibility: Line supervisors can control fixed overhead when the costs are
discretionary rather than committed. Top sales executives may be held
responsible if budgeted volume is matched with anticipated long-run sales.
Responsibility usually rests with top management, for the volume variance
represents under -or overutilization of plant and equipment.

Combined Manufacturing Overhead (Variable and Fixed) Variance

Analysis:

If the company is using a flexible budget, the total overhead variance may be
analyzed as follows:

Standard Hours = Equivalent Production or Allowed hours based on actual

production × Standard hours per unit.
Fixed Efficiency or Effectiveness Variance
Standard hours P xx
Less: Actual hours xx
Unfavorable (favorable) P xx
Multiplied by: Fixed Overhead rate xx
(Favorable) Unfavorable P xx

Idle Capacity Variance

Normal capacity hours P xx
Less: Actual hours xx
Unfavorable (Favorable) P xx
Multiplied by: Fixed Overhead rate xx
Unfavorable (Favorable) P xx
Total overhead variance P xx

Figure 14.1
Manufacturing Overhead (Fixed And Variable) Variance Analysis (Flexible Budget In
Use)
**Budget allowed based on Actual Hours: [Fixed overhead + (AH x Std. VOR)]
** Budget allowed based on Standard Hours: [Fixed overhead + (SH x Std.
VOR)]

*** May also be analyzed using the following presentation:

Spending Variance (1-2)

Actual Overhead Costs P xx
Less: Budget allowed based on Actual hours xx
Unfavorable (Favorable) P xx

Capacity Variance (2-4)

Budget allowed based on Actual hours P xx
Less: Actual hours x SOR xx
Unfavorable (Favorable) P xx

Efficiency (Fixed and Variable) (4-5)

Actual hours x SOR P xx
Less: Standard hours x SOR xx
Unfavorable (Favorable) P xx

Net Unfavorable (Favorable) variance P xx

B. If the company uses a fixed or static budget, variance analysis may be done as
follows:

I. Under the Two-Variance Method:

Budget Variance (1-2)
Actual Manufacturing Overhead P xx
Less: Budgeted Overhead (at normal capacity) xx
Unfavorable (Favorable) P xx

Capacity Variance (2-4)

Budgeted Overhead P xx
Less: Standard or Applied Overhead
(Standard hours x Standard Overhead Rate) xx
Unfavorable (Favorable) P xx
 II. Under the Three-Variance Method
Budget Variance (1-2)
Actual Manufacturing Overhead P xx
Less: Budgeted Overhead xx
Unfavorable (Favorable) P xx

Capacity Variance (2-3)

Budgeted hours x Standard Overhead rate P xx
Less: Actual hours x SOR xx
Unfavorable (Favorable) P xx

Efficiency Variance (3-4)

Actual hours x Standard Overhead rate P xx
Less: Standard hours x SOR. xx
Total Unfavorable (Favorable) P xx

Net Unfavorable (Favorable) Variance P xx

The above computational procedures are summarized in Figure 14.2.

Figure 14.2
Manufacturing Overhead (Fixed And Variable) Variance Analysis (Fixed Budget In
Use)

Treatment of Variances

a) If the variances are relatively small, they may be closed to Cost of Goods
Sold.

b) Although inventory may be valued at standard cost for internal reporting

purposes, the standard costs must be adjusted to actual costs for financial
reporting purposes. This will require prorating the variances to each and every
account that has been charged or credited with specific standard cost that is
now being adjusted to actual. These accounts may be Cost of Goods Sold,
Raw Materials Inventory, Work in Process Inventory and Finished Goods
Inventory.
Illustrative Problem 14.1. Variance Analysis (Standard Variable Costing System in
use)

The following events took place at Certified Containers, Inc. During the month of
December:

1. Produced and sold 50,000 plastic water containers at a sales price of P10
each. (Budgeted sales were 45,000 units at P10.15).

2. Standard variable cost per unit:

Direct materials: 2 lbs. At P1 P2.00
Direct labor: 0.10 hours at P15 1.50
Variable manufacturing overhead: 0.10 hours at P5 0.50
Total P4.00/unit

3. Fixed manufacturing overhead cost:

Monthly budget P80,000

4. Actual production costs:

Direct materials purchased (200,000 pounds at P1.20) P240,000
Direct materials used (110,000 pounds at P1.20) 132,000
Direct labor (6,000 hours at P14) 84,000
Variable overhead 28,000
Fixed overhead 83,000

REQUIRED:

1. Compute the direct materials, labor and variable manufacturing overhead

price and efficiency variances.

2. Compute the fixed manufacturing overhead price (spending) variance.

Solution: Certified Containers, Inc.

1. a. Direct materials price variance:
Actual materials purchased P240,000
Less: Actual Quantity at Standard price
(200,000 x P1) 200,000
Unfavorable P 40,000

b. Direct materials efficiency variance:

Actual quantity used at standard price
(110,000 x P1) P110,000
Less: Standard quantity at standard price
(100,000 × P1) 100,000
Unfavorable P 10,000
c. Direct labor rate variance:
Actual labor cost P 84,000
Less: Actual hours at standard rate
(6,000 × P15) 90,000
Favorable P (6,000)

d. Direct labor efficiency variance:

Actual hours at standard rate P 90,000
Less: Standard hours at standard rate
[(50,000 x 0.10) x P15] 75,000
Unfavorable P 15,000

e. Variable overhead spending variance:

Actual variable overhead P 28,000
Less: Actual hours at standard variable
overhead rate (6,000 x P5) 30,000
Favorable P (2,000)

f. Variable overhead efficiency variance:

Actual hours 6,000
Less: Standard hours 5,000
Unfavorable 1,000
Multiplied by: Std. VOR P 5
Unfavorable P 5,000
 CHAPTER 15
FUNCTIONAL AND ACTIVITY-BASED BUDGETING

Repeated references to budget allowances have been made throughout previous chapters and we
have seen how closely accounting and budgeting are related and how one depends on the other.
Accounting draws some of its data from planned performances established in the budget; in turn,
recorded historical data provide a basis for determining budget estimates.

Budget Defined
A budget is a financial plan of the resources needed to carry out tasks and meet financial goals. It is
also a quantitative expression of the goals the organization wishes to achieve and the cost of attaining
these goals.

The act of preparing a budget is called budgeting. The use of budgets to control a firm's activities is
known as budgetary control.

The overall or master budget (also known as planning budget or budget plan) indicates the sales
levels, production and cost levels, income and cash flows that are anticipated for the coming year.

The master budget is a summary of all phases of a company's plans and goals for the future. In
short, it represents a comprehensive expression of management's plans for the future and how these
plans are to be accomplished.

Difference between Planning and Control

Planning and control are two quite distinct concepts. Planning involves developing objectives and
preparing various budgets to achieve these objectives.

Control involves the steps taken by management to ensure that the objectives set down at the
planning stage are attained and to ensure that all parts of the organization function in a manner
consistent with organizational policies.

An effective budgeting system must provide for both planning and control. Good planning without
effective control is time wasted. On the other hand, unless plans are presented or known in advance,
there are no objectives toward which control can be directed.

Functions of Budgeting
Properly conceived, budgeting can mean the difference between a general drift that may or may not
lead to a desired goal and a carefully plotted course toward a predetermined objective that holds drift
to a minimum. Budgets make the decision-making process more effective by helping managers meet
uncertainties. The objective of budgeting is to substitute deliberate, well-conceived business
judgment for accidental success in enterprise management. Budgets should not be expressions of
wishful thinking but rather descriptions of attainable objectives.

The Purposes of the Budget

A budget is a description in quantitative - usually monetary - terms of a desired future result. The
process of preparing the budget requires management at all levels to focus on the future of the
business entity. The benefits that may be realized from a budgeting program are
1. Defining broad objectives and goals and formulating strategies to achieve such objectives;
2. Coordinating the activities of the organization by integrating the plans of the various parts thereby
pulling every one in the same direction;
3. Allocating resources to those parts of the organization where they can be used most effectively;
4. Communicating management's approved plans throughout the organization;
5. Uncovering and preparing for potential bottleneck in the operations before they occur.
6. Motivating managers to achieve the desired results; and
7. Setting a standard or benchmark for evaluating actual performance.

Discussion of the Purposes of Budget

1. Planning Function
The first step in a company's planning process is the establishment of its broad goals or objectives.
After the objectives have been defined, strategies to achieve these desired objectives must be
formulated, and tentative budgetary schedules must be developed. Each time a budget is prepared,
there is a period of critical self-appraisal during which policies and procedures come up for review.
When planning is done well in advance, many problems are anticipated long before they arise, and
solutions can be sought through deliberative study. Planning ideally should occur at three levels,
namely

a) Strategic planning which focuses on long-range horizon and is performed by the highest level of
management.

b) Programming or intermediate-range planning which involves identification of broad programs in

the functional areas such as marketing plan, a finance plan, and a production plan. This is performed
by higher and middle management, and

c) Short-term budget which a quantitative detailed plan covering typically one year established by all
managers at all levels. Logically, the budget is an expression of the strategic planning and
programming also being conducted.

2. Coordination and Allocating Resources function for Goal Congruence

The budget serves as a tool through which the actions of different parts of an organization can be
welded into a harmonious unit working toward a common objective. Goal congruence is the term used
to refer to a firm's striving to achieve a common set of objectives. It is also an ideal that can be
attained only to the extent that individuals can be convinced that what is best for the company is also
best for them and that their own welfare is congruous or aligned with the welfare of the organization.
Individuals when left to themselves may go in different directions believing that he or she is acting in
the best interests of the enterprise as a whole. Budgeting will reconcile the differences between the
sales, manufacturing, purchasing, finance and personnel departments for the common good of an
organizational system. Limited resources will also be properly allocated for optimum returns.

3. Communication function
If an organization is to operate as an efficient unit, there must be definite lines of communication, so
that the employees in the various departments can be kept fully informed of objectives, policies, plans
and achievements. Each employee should have a clear understanding of the company's goals and
the part that he or she is expected to play in their attainment. To a certain extent the employees can
gain understanding of how they can positively contribute toward accomplishing organizational goals.
This is achieved through their participation in the budgeting process. Furthermore, everyone who has
responsibility under the budget should be informed on how his/her actual performance compares with
budget plans. Budgeting also facilitates decentralized decision making It serves as authorization for
a manager to act since it delineates available resources and goals. Decentralized decision making
means that higher management is freed from such burdens and has more time to focus on programs
and strategic planning.
4. Motivation function
Budgeting can be a force for good and evil. A budgeting approach in which managers prepare their
own budget estimates called a self- imposed budget or participative budget is generally considered
to be the most effective method of budget preparation. If a firm's employees have actively participated
in budget preparation and if they are convinced that their own personal interests are closely allied
with the firm's success, budgets provide motivation in the form of goals to be attained. Most people
like to face up to a challenge and take satisfaction in operating efficiently and effectively under a
budget they participated in planning. On the other hand, if the budget is dictated from above by top
management and poses a threat rather than a challenge to the employees, then it becomes
something to be resisted rather than accepted and it can do more harm than good from the viewpoint
of organizational operating performance.

5. Control function
Budgets represent management's formal commitment to take positive actions to make actual events
correspond to the formal plan. Profit plans also contain explicit statements concerning implementation
of management objectives for a period of time; managers communicate these to all parties with
control responsibility. Comparison of actual results with the profit plan forms the basis for
management control, motivation, and performance evaluation. Many problems occur when managers
are evaluated on their ability to achieve the budget. The most serious consequences occur when the
budget is the sole or overriding criterion of performance. In such situations, managers may reach the
budget by devious or shortsighted means. To alleviate the problems of employing budgets to evaluate
performance, the following should be considered.

1) Flexibility which means that the budget is viewed as a plan, not set in concrete. A variance
(difference between actual and budget) should merely raise a question as to why we are off the plan
and managers should feel that they have the freedom to deviate from the plan when necessary;

2) Focus on controllable costs. Managers should be evaluated only on

controllable costs over which they have significant influence." Holding a manager responsible for
noncontrollable costs or costs which he did not authorize, causes frustration and mistrust and is
demotivating; and

3) Nonpunitive approach. The focus of analysis should not be solely on unfavorable variances as a
punitive device to make sure that managers do not go over budget. Rather, any significant variance
(whether over or under budget) should be investigated. Examining variances may reveal situations in
which a manager should be praised for strong performance a motivating event. Large variances in
either direction require analysis to either alter the plan or take appropriate actions, not to find fault
with managers.

6. Standards in evaluating performance

Management must keep clearly in mind that rather than being used as a pressure device, the budget
should be used as a positive instrument to assist in establishing goals, in measuring operating results,
and in isolating areas that are in need of extra effort or attention. The ultimate objective must be to
develop the realization that the budget is designed to be a positive aid in achieving both individual
and company goals.

Advantages and Limitations of Budgets

The advantages of budgeting include:
(1) It forces planning and exposes situations in which plans of subcomponents are inadequate to
attain the total organization's objectives.
(2) It allows a reiterative process to bring the goals of the organization and the subcomponents into
agreement.
(3) It provides a means of communicating organization goals down through the organization and sub-
unit operational limitations up though the organization.
(4) It provides a basis for financial planning, sub-unit coordination, resource acquisition, inventory
policy, scheduling and output distribution.
(5) It provides a basis by which activity can be monitored, with actual results being compared to the
planned results.

The limitations of budgeting are:

(1) Budgets tend to oversimplify the real situation and fail to allow for variations in external factors.
They do not reflect qualitative variables.
(2) It is difficult to prepare a detailed budget for an organization that has never existed or for a new
division, product, or department of an existing firm.
(3) There may be lack of higher and lower management commitment because of lack of
understanding of the fundamentals of budget preparation and utilization.
(4). The budget is only a representation of future plans or a means to the goal of profitable activity
and not an end in itself. It may interfere with the supervisor's style of leadership and can therefore
stifle initiative.
(5) Budget reports usually emphasize results, not reasons.

Types of Budgets
The types of budgets or the major composition of the master budget are:
1) The Operating budget
2) The Financial budget
3) The Capital budget

The following is a simplified subclassification of the above-mentioned types of

budget for a manufacturing firm:
1. Operating Budget
A. Budgeted Income Statement
I. Sales budget
II. Production budget
i. Materials cost budget
ii. Direct labor cost budget
iii. Factory overhead budget
iv. Inventory levels
B. Cost of Sales budget
C. Selling and Administrative expenses budget
D. Financial expense budget
2. Financial Budget
A. Budgeted Statement of Financial Position
B. Cash budget
3. Capital Investment Budget

Budgeting Terminologies Defined

Budgeted Income Statement

refers to projection of revenue, expenses, and results of operations for a definite period of time.

Cash budget
a period-by-period statement of cash at the start of a budget period, expected cash receipts
classified by source; expected cash disbursements, classified by function, responsibility, and
form; and the resulting cash balance at the end of the budget period.
Financial Budget
refers to the budget of the financial resources as reflected in the budgeted statement of
financial position and cash budget.

Fixed budget
projection of cost at a particular or one level of production (usually at normal capacity) for a
definite time period.

Flexible (variable) budget

projection of cost at different levels of production for a definite period of time.

Participative budget
budget prepared using employees at all levels in the organization.

Physical budget
budget that is expressed in units of materials, number of employees, or number of man-hours
or service units rather than in pesos.

Planning budget (static.budget)

another term for master budget.

Production budget
production plan of resources needed to meet current sales demand and ensure adequate
inventory levels.

Program budget
budget for the major programs or projects that the company plans to undertake.

Operating budget
refers to the plans for the conduct of business for the planning period; it includes the budgeted
income statement and all its supporting budgets.

Responsibility budget
budget for a responsibility center.

Rolling (continuous, progressive) budget

budget which is prepared throughout the year, that is, as one month elapses, a budget is
prepared for one more month in the future.

Sales-budget
budget that shows the quantity of each product and the revenueexpected to be sold.

Traditional budgeting
a system of budgeting which concentrates on the incremental change from the previous year
assuming that the previous year's activities are essential and must be continued.

Zero-based budgeting
a system of establishing financial plans. beginning with an assumption of no activity and
justifying each program or activity level.
The Management Process of Preparing the Master Budget
Organization for Budget Preparation
It is essential that the manager of an entity assigns the most qualified personnel to the preparation of
the budget. A budget committee with representation from the different functional areas (marketing,
production, finance, and administration) is generally considered an effective body to oversee
preparation and administration of the budget. The controller may be selected to serve as head of the
committee for two major reasons:

(1) Controller's position is independent from the operating parts of the organization.
(2) He has the skills and experiences in coping with the intricacies of setting up a budget.

The controller acts as a coordinator in the budgeting operation. He recommends how budgets should
be prepared, assembles the budgets, prepares periodic reports showing variances of the actual
results from the budgeted results, interprets variances and offers suggestions for improvement
whenever possible.

The budget committee decides how budgets shall be prepared, passes on the final budget, and
settles disputes in one segment of the business and another when differences of opinion arise. The
committee also receives budget reports and makes policy decisions with respect to budget revisions
and other problems of budget administration.

The Budget Period

As a general rule, the period covered by a budget should be long enough to show the effect of
managerial policies but short enough so that estimates can be made with reasonable accuracy. This
suggests that different types of budgets should be made for different time spans.

A master budget is an overall financial and operating plan for a coming fiscal period and the
coordinated program for achieving the plan. It is usually prepared on a quarterly or an annual basis.
Long range budgets called capital budgets, which incorporate plans for major expenditures for plant
and equipment or the addition of product lines, might be prepared to cover plans for as long as 5 to
10 years. Responsibility budgets which are segments of the master budget relating to the aspect of
the business that is the responsibility of a particular manager are often prepared monthly. Cash
budgets may be prepared on a day-to-day or monthly basis. Some companies follow a continuous
budgeting plan whereby budgets are constantly reviewed and updated. The updating is
accomplished, for example, by extending the annual budget one additional month at the end of each
month. A review of the budget may also suggest that the budget be changed as a result of changing
business and operating conditions.
Budget Cycle of a Manufacturing Firm
Managerial plans are implemented through budgets that are developed for the various departments
of a company. These budgets should be based on the lines of authority and responsibility fixed by
the organization chart. An overview of the budget cycle is shown in Figure 14.1 which also depicts
the sequence and. types of budgets commonly found.

Figure 14.1
The Master Budget Interrelationships

Steps in Developing a Master Budget

The major steps in developing a master budget may be outlined as follows:
1. Establish basic goals and long-range plans for the company. These will serve as guidelines in
the preparation of budget estimates.
2. Prepare a sales forecast for the budget period.
3. Estimate the cost of goods sold and operating expenses.
4. Determine the effect of budgeted operating results on assets, liabilities and ownership equity
accounts. The cash budget is the largest part of this step, since changes in many asset and
liability accounts will depend upon the cash flow forecast.
5. Summarize the estimated data in the form of a projected income statement for the budget
period and the projected statement of financial position as of the end of the budget period.

Comprehensive Budget Illustrated

Gilbert Manufacturing Company manufactures a special line tools. As of December 31, 2018, the
Statement of Financial Position of the firm is as follows:
Sales Budget
The sales budget showing what products will be sold in what quantities at what prices, is the
foundation on which all other short-term budgets are built. The sales budget triggers a chain reaction
that leads to the development of many other budget figures in an organization. The sales budget
provides the revenue predictions from which cash receipts from customers can be estimated and
supplies the basic data for constructing budgets for production costs and selling and administrative
expenses. In short, the sales forecast is the keystone of the budget structure. The accuracy and
reasonableness of the sales data will affect the whole budget. The sales forecast is made after
consideration of the following factors.
1. Past sales volume
2. General economic and industry conditions
3. Relationship of sales to economic indicators
4. Relative product profitability
5. Market research studies and competition
6. Pricing, advertising and other promotion policies
7. Production capacity
8. Quality of sales force
9. Seasonal variations
10. Long-term sales trends for various products

For Gilbert Company, the Sales Budget is presented as follows:

Schedule 1

Sales Budget
For 2019

Units Price per Unit Total Sales Revenue

Estimated sales 6,400 800 P5,120,000

Production Budget
After the sales budget has been set, a decision can be made on the level of production that will be
needed for the period to support sales and the production budget can be set as well. The production
budget becomes a key factor in the determination of other budgets, including the direct materials
budget, the direct labor budget and the manufacturing overhead budget. These budgets in turn are
needed to assist in formulating a cash budget.

Using the data from the previously prepared sales budget as well as the inventory summary
information, the following production budget is developed.

Schedule 2

Production Budget
For 2019

Units to be sold 6400

Add: Desired ending inventory 1000
Total 7400
Less: Beginning inventory 900
Units to be produced 6500
Raw Materials Budget
After determining the number of units to be produced, the raw materials purchases can now be
prepared, as follows:

Schedule 3

Raw Materials Purchases

For 2019

Digital Labor Budget

The preliminary data show that the budgeted direct labor cost per unit produced is P146. This must
have been arrived at after considering such factors as skills, level of the workers, labor rate per hour,
time requirement, conditions of union contracts, etc.

The direct labor is therefore budgeted as follows:

Schedule 4

Number of units to be produced 6,500

Multiply by: Direct labor cost per unit 146
Total budgeted direct labor costs 949,000

Overhead Costs Budget

Study of past records will show how cost reacts to changes in volume or in relation to actors. Some
overhead items may be projected on the basis of direct labor hours or on material costs or on machine
hours.

The overhead costs budget for 2019 is illustrated below using the basic information from the
preliminary data previously established.

Schedule 5

Budgeted Manufacturing Overhead

For 2019

Variable overhead: units needed to produce 6500 units

Indirect materials and supplies (@P5.85) P 38,000
Materials handling (@P9.07) 59,000
Other indirect labor (P5.07) 53,000
Total 130,000
Fixed manufacturing overhead
Supervisor labor 175,000
Maintenance & repairs 85,000
Plant administration 173,000
Utilities 87,000
Depreciation 280,000
Insurance 43,000
Property taxes 117,000
Others 41,000
Total 1,001,000
Total manufacturing overhead 1,131,000

Budgeted Cost of Sales

The Budgeted Cost of Sales Statement can now be developed using the data from the following:

Production Budget Schedule 2

Raw Materials Budget Schedule 3
Direct Labor Budget Schedule 4
Overhead Cost Budget Schedule 5
Budgeted Statement of Cost of Sales Schedule 6

Schedule 6

Budgeted Statement of Cost of Sales

For 2019

Marketing and Administrative Expense Budget

As with overhead costs, marketing and administrative expenses are also made up of fixed and
marketing variable components. The marketing and administrative expense budget for 2019 is shown
on the next page. Previously provided data are used.
Schedule 7

Budgeted Marketing and Administrative Costs

For 2019

Cash Budget
Cash Receipts
Normally, the bulk of a firm’s cash receipts comes from the customers. The possibility of cash from
other sources (such as additional investments, sales of assets, borrowings) should likewise be
considered when cash receipts are being budgeted.

Cash Disbursements
Data converted from individual budgets previously illustrated supply the basic information for the cash
disbursements budget. However, various adjustments and additions will have to be made when
preparing the budget for prepayments, accruals as well extraneous items (such as the purchase of
new equipment, dividend payment) that do not show up in any of the individual budgets already
prepared. If the financial policy of the company requires that a minimum cash balance be maintained
at all times, the cash budget must be altered to accommodate back loans and their repayment.

Using the collected in the various budgets and the information that has been previously provided, the
following Cash Budget Statement is developed.
Schedule 8

Gilbert Manufacturing Company

Cash Budget
For the Budget Year Ending December 31, 2019

Budgeted Income Statement

After the cash budget has been completed, Gilbert Company prepares the budgeted income
statement showing the net income that is to be expected during the budget period. The information
needed to prepare the budgeted income statement comes from the previously provided preliminary
data as well as from the company’s other budgets.

Schedule 9

Gilbert Manufacturing Company

Budgeted Income Statement
For the Budget Year Ending December 31, 2019

Budgeted Statement of Financial Position

The budgeted statement of financial position is developed by beginning with the current statement of
financial position and adjusting it for the data contained in the other budgets. Gilbert Company’s
budgeted statement of financial position is presented below:
Schedule 10

Gilbert Manufacturing Company

Budgeted Statement of Financial Position
December 31, 2019

FLEXIBLE BUDGETING
The budgets that have been presented in the first part of this Chapter were essentially static in nature.
A static budget has two characteristics.
1. It is geared toward only one level of activity.
2. Actual results are always compared against budgeted costs as the original budget activity level.

Fixed budgeting is appropriate only if a company can estimate its operating: volume within close limits
and if the costs are behaving predictably. Few companies are fortunate enough to fall into this group.
As a result of these factors, a fixed or static budget is generally not adequate.

A flexible budget is an alternative to the fixed budget. A flexible budget adjusts revenues, costs, and
expenses to the actual volume experienced and compares these amounts to actual results. Flexible
budgets incorporate changes in volume to provide a valid basis of comparison with actual costs.

The basis steps in preparing a flexible budget are as follows:

1. Determine the relevant range over which activity is expected to fluctuate during the coming period.
2. Analyze the costs that will be incurred over the relevant range in order to determine cost behavior
patterns (variable, fixed, or mixed).
3. Separate the costs by behavior, and determine the formula for variable and mixed costs, as
discussed in Chapter 11.
4. Using the formula for the variable portion of the costs, prepare a budget showing what costs will
be incurred at various points throughout the relevant range.
Fixed and Flexible Budget Variances Compared
Assume that RON Company's sales budget calls for the production of 10,000 shirts during January.
The variable overhead budget that has been set for this level of activity is shown in Figure 14.2.

Figure 14.2
RON Company
Static Budget
For the month Ending January 31

Budget production of shirts (in units) 10,000

Budgeted variable overhead costs:

Indirect materials P4,000
Lubricants 1,000
Power 3,000
Total P8,000

Assume further that the production goal of 10,000 shirts is not met and the company is able to produce
only 9,400 shirts during the month.

If the static budget approach is used, the performance report for the month will appear as shown in
Figure 14.3.

Figure 14.3
RON Company
Static Budget Performance Report
For the month ended January 31

* These costs variances are misleading and useless since they have been derived by comparing
actual costs at one level of activity against budgeted costs at a different level of activity.

The main deficiency with the static budget is that it fails completely to distinguish between the
production control and the cost control dimensions of a manager's performance.

Under the flexible budget approach, the performance report would appear as shown in Figure 14.4.
Figure 14.4
RON Company
Flexible Budget Performance Report
For the month ended January 31

Budgeted production of shirts (in units) 20,000

Actual production of Shirts (in units) 18,800

In contrast to the performance report prepared earlier under the static budget approach, this
performance report prepared under the flexible budget approach distinguishes clearly between
production control and cost control. The production data at the top of the report indicate whether the
production goal was met. The cost data at the bottom of the report tell how well costs were controlled
for the 18,800 shirts that were actually produced.

It will be observed that all the cost variances in Figure 14.4 are unfavorable, as contrasted to the
favorable cost variances on the performance report prepared earlier under the static budget
approach. The reason for the change in variances is that by means of the flexible budget approach
we are able to compare budgeted and actual costs at the same activity level (18,800 shirts produced).
The result shows up in more usable variances.