OROMIA STATE UNIVERSITY

Project Management-Program
Course Title: Project Cost Management
Course Code: MAPMS 631
Credit Hours: 3

READING ASSIGNMENT

CHAPTER SIX: BUDGET & BUDGETARY CONTROL

Instructor: Dr. Abdela Y. (Assistant Professor)

 READING ASSIGNMENT
6.1 Concepts, essentials and characteristics of
budget
6.2 Participatory Budgets versus Imposed Budgets
6.3. Master budget
6.4. Some other types of Budget –Zero-Base
Budgeting, incremental budgeting, static vs
Flexible Budget, Cash Budget,
 FLEXIBLE BUDGET AND VARIANCE ANALYSIS
THE USE OF VARIANCES
• Variance represents the difference between an amount
based on an actual result and the corresponding
budgeted amount.
• Each variance we compute is the difference between
an actual result and the corresponding budgeted
amount.
• The budgeted amount is a benchmark, a point of
reference from which comparisons may be made.
• Variances assist managers in their planning and control
decisions.
• In other words, variances are where the planning and
control functions come together to assist managers in
implementing their strategies.
 Cont’d…
• Management by exception is the practice of
concentrating on areas not operating as
anticipated or expected (such as a cost
overrun on a defense project or a large
shortfall in sales of a product) and giving less
attention to areas operating as anticipated or
expected.
Cont’d…
• Managers use information from variances
when planning how to allocate their efforts.
• Areas with sizable variances receive more
attention by managers on an ongoing basis
than do areas with minimal variances.
• Variances are also used in performance
evaluation and to motivate managers.
Sometimes variances suggest a change in
strategy.
 Static Budget and Flexible Budgets
Static Budget
• The master budget or static budget is based
on the level of output planned at the start
of the budget period.
• In other words, the static budget is the
“original” budget.
• It’s static in the sense that the budget is
developed for a single (static) planned
output level.
Cont’d…
• A static budget is prepared at the beginning
of the budgeting period and is valid for only
the planned level of activity.
• It is suitable for planning, but it is
inadequate for evaluating how well costs are
controlled because the actual level of activity
is unlikely to equal the planned level of
activity, thus resulting in “apples-to-oranges”
cost comparisons.
Cont’d…
• When variances are computed from a static
budget at the end of the period,
adjustments are not made to the budgeted
amounts for the actual output level in the
budget period.
Flexible Budget
• A flexible budget (variable budget):
calculates budgeted revenues and budgeted
costs based on the actual output level in the
budget period.
• A flexible budget is calculated at the end of
the period when the actual output is known;
a static budget is developed at the start of
the budget period based on the planned
output level for the period.
Cont’d…
• A flexible budget is dynamic rather than
static; it can be tailored for any level of
activity within the relevant range.
• A relevant range is the band of normal
activity level or volume in which there is a
specific relationship between the level of
activity or volume and the cost in question.
 Cont’d…
• A flexible budget provides estimates of what
costs should be for any level of activity
within a specified range.
• A flexible budget is a performance evaluation
tool.
• When used for performance evaluation
purposes, actual cost are compared to what
the costs should have been for the actual
level of activity during the period. This
enables “apples-to-apples” cost comparisons.
Cont’d…
• A flexible budget can be prepared for
various levels of output whereas a static
budget is based on one specific level of
output.
• A flexible budget adjusts the static budget
for the actual level of output.
• It cannot be prepared before the end of the
period.
Cont’d…
• Budgets, both static and flexible, can differ
in the level of detail they report.
• Companies present budgets with broad
summary figures that can then be broken
down into progressively more detailed
figures via computer software programs.
 Cont’d…
The level of detail increases in the number of
line items examined in the income statement
and the number of variances computed.
Level ‘0’ Analysis gives the least detailed
comparison of the actual and budgeted
operating income.
• It compares the actual operating income with
the budgeted operating income.
 Cont’d…
• Level ‘1’ Analysis: Provides managers with
more detailed information on the operating
income.
• It also compares actual operating income
items with line (each) operating income
items.
 Static Budget Variances
• The static budget variance is the difference
between the actual result and the
corresponding budgeted amount in the static
budget.
• A Favorable Variance (denoted by F) has
the effect of increasing operating income relative
to the budgeted amount.
For revenue items, ‘F’ means actual
revenue exceeds budgeted revenues.
For cost items, ‘F’ means actual costs are
less than budgeted costs.
 Cont’d…
• An Unfavorable Variance (denoted by U)-has
the effect of decreasing operating income
relative to the budgeted amount.
• Unfavorable variances are also called adverse
variances in some countries, example, in UK.
Favorable Vs Unfavorable Variances

Profit Revenue Costs

Actual > Expected F F U
Actual < Expected U U F

• Static Budget Variances = Actual Results – Static Budget

Amount
 Steps in Developing Flexible Budget
• The following steps are used to prepare a
flexible budget:
Step1:Identify the actual quantity of output.
Step2: Calculate the flexible budget for
revenues based on budgeted selling price
and actual quantity of output.
Step3: Calculate the flexible budget for
costs based on budgeted variable cost per
output unit, actual quantity of output, and
budgeted fixed costs.
Cont’d…
• The only difference between the static
budget and the flexible budget is that the
static budget is prepared for the planned
output level, where as the flexible budget is
based on the actual output level.
 Cont’d…
Static-budget variance can be classified
into two:
Flexible-budget /cost /total variance
Sales-volume variance
Flexible-Budget Variances: The flexible
budget variance is the difference between
the actual results and the flexible-budget
amount based on the level of output actually
achieved in the budget period.
 Cont’d…
Flexible Budget Variance = Actual Results -
Flexible Budget Amounts Or
Flexible Budget Variance = Price Variance +
Efficiency Variance
• The flexible–budget variance pertaining to
revenues is often called a selling-price
variance because it arises solely from
differences between the actual selling price
and the budgeted selling price.
 Cont’d…
• Flexible-budget variance can be
classified into two:
Price (or rate) variance
Efficiency (or usage) variance
 Sales-Volume Variances
• The sales-volume variance is the difference
between a flexible-budget amount and the
corresponding static-budget amount.
• It’s called the sales-volume variance because
it represents the difference caused solely by
the actual quantity of units sold and the
quantity of units expected to be sold in the
static budget.
Sales-Volume Variance=Flexible-Budget Amount
(–) Static-Budget Amount
 Cont’d…
• The sales-volume variances arises solely
from the differences between the budgeted
output level used to develop the static
budget and the actual output level used to
develop the flexible budget.
• Note particularly that any budgeted selling
prices or unit variable costs are always held
constant when sales-volume variances are
computed.
 Cont’d…
Sales-volume variance = (Budgeted selling
price (-) Budgeted variable cost per unit) x
(Actual units sold (–) Static budget units sold)
Sales-volume variance = Budgeted
contribution margin per unit x (Actual units
sold (-) Static- budget units sold)
 Cont’d…
Static-budget variance= Flexible-budget
variance + Sales-volume variance
• If the flexible-budget variance is unfavorable,
it is because of one or both of the following:
If the company used greater quantities of
inputs (such as direct manufacturing labor-
hours) relative to the budgeted quantities of
inputs.
 Cont’d…
• If the company incurred higher price per unit
for the inputs (such as the wage rate per
direct manufacturing labor-hour) relative to
the budgeted prices per unit of the inputs.
• Higher input quantities relative to the budget
and/or higher input prices relative to the
budget could be the result of the company
deciding to produce a better product than
what was planned in the budget or the result
of inefficiencies in Company’s manufacturing
and purchasing, or both.
Unfavorable sales-volume variance
• Company`s managers determine that the
unfavorable sales-volume variance could be
because of one or more of the following
reasons:
The overall demand for jackets is not growing
at the rate that was anticipated
Competitors are taking away market share
from Webb
Company do not adapt quickly to changes in
customer preferences and tastes
Cont’d…
Budgeted sales targets were set without
careful analysis of market conditions
Quality problems developed that led to
customer dissatisfaction with Company’s
product.
Application of Standard Costing in
Variance Analysis
• Every organization wants to minimize the
cost of production and maximize the profits.
Standard costing is such a system which
seeks to control the cost of each unit or
batch or product through price determination
beforehand of what should be the cost and
then its comparison with actual cost.
 Definition of Standard Costing
• Standard costing is a system of cost
accounting which is designed to show in
detail how much each product should cost to
produce and sell when a business is
operating at a stated level of efficiency and
for a given volume of output (J. Batty).
• A standard cost system is a method of cost
accounting in which standard costs are used
in recording certain transactions and the
actual costs are compared with the standard
costs to learn the amount and reason for any
variations from the standard (Lawrence).
 Application of Standard Costing
• The application of standard costing requires
the following conditions to be fulfilled:
1. A sufficient volume of standard products or
components should be produced.
2. Methods, procedures and materials should
be capable of being standardized.
3. A sufficient number of costs should be
capable of being controlled.
 Advantages of Standard Costing
1. Simplification of cost bookkeeping: it is
very simple in comparison to historical costing.
2. Basis for measuring operating
performance: standards work as yardsticks
for measuring the operating efficiency or
inefficiency.
3. Cost reduction and control: standard
costing is very useful in cost reduction and
control by eliminating or limiting lost time, idle
time, spoilage, material wastage and lost
machine hours.
 Cont’d…
4. Management by exception: Variance
analysis brings the inefficient operations in light
and management can focus its attention
towards those matters only.
5. Formulation of production and price
policies: Standard costs represent long-term
estimates, cost and prices. It helps the
management in the formulation of ideal
production policy.
6.Implementing incentive schemes: standard
costing promotes the implementation of
incentive schemes in the organization because
every incentive scheme is based on certain
standards which are determined under this
system.
 Cont’d…
7. Facilitates comparison: Cost comparison
between different products and department
can be done under standard costing. It also
makes possible the comparison of costs of
one period with another.
8. Promotes cost consciousness and
efficiency: It also promotes cost
consciousness as the employees know that
their performance shall be in assessing
manufacturing inefficiencies and fixing
responsibilities.
Limitations of Standard Costing
Not appropriate for small concerns: it is
not appropriate for small concerns as the
installation of standard costing requires high
degree of skill and the small concerns may
not have expert staff for handling or
operating the system.
Not suitable for certain industries: this
system is not suitable for industries which
produce non-standardized products and for
job works which change according to
customers` requirements.
Cont’d…
Why standard costs are often used in variance
analysis?
Because, standard costs exclude past
inefficiencies and take into account future
changes.
• A standard is a carefully predetermined
price, cost or quantity amount. It is usually
expressed on a per unit basis. The
advantages of using standard amounts for
variance analysis are:
– They can exclude past inefficiencies
– They can take into account changes
expected to occur in the budgeted period
 Cont’d…
• Company has developed standard inputs and
standard costs for each of its variable cost
items.
• A standard input is a carefully predetermined
quantity of inputs (such as pounds of
materials or manufacturing labor-hours)
required for one unit of output.
• A standard price is a carefully determined
price that a company expects to pay for a
unit of input. A standard cost is a carefully
predetermined cost. Standard costs can
relate to units of inputs or units of outputs.
 Price Variance
• A price variance is the difference between the
actual price and the budgeted price
multiplied by the actual quantity of input in
question (such as DM purchased or used).
• A price variance is sometimes called input-
price variance or rate variance, especially
when referring to a price variance for direct
labor.
Formula for price variance:
Price Variance = (Actual Price of Input –
Budgeted Price of Input) x Actual Quantity of
Input
 Cont’d…
• The direct materials price variance is
favorable because actual price of cloth is less
than the budgeted price, resulting in an
increase in operating income.
• The direct manufacturing labor price variance
is unfavorable because actual wage rate paid
to labor is more than the budgeted rate,
resulting in a decrease in operating income.
 Cont’d…
If the company`s favorable direct materials price
variance could be because of one or more of the
following:
 Company’s purchasing officer/manager
negotiated the direct materials prices more
skillfully than was planned for in the budget
 The purchasing manager changed to a lower-
price supplier
 The purchasing manager bought in larger lot
sizes than budgeted, thus obtaining quantity
discounts (i.e., Company’s purchasing manager
ordered larger quantities than the quantities
budgeted, thereby obtaining quantity discounts).
 Cont’d…
Materials prices decreased unexpectedly due
to, say, industry oversupply
Budgeted purchase prices were set without
careful analysis of the market, and
Purchasing manager received unfavorable
terms on non purchase price factors (such as
lower quality materials)
 Efficiency Variance/ Usage Variance
• An efficiency variance is the difference
between the actual quantity of input used
(such as yards of cloth of the direct
materials) and the budgeted quantity of input
that should have been used, multiplied by the
budgeted price.
• Computation of an efficiency variance
requires measurement of inputs for a given
level of output. For any level of output, the
efficiency variance is:
Efficiency Variance = (Actual quantity of input
used − Budgeted quantity of input allowed
for actual output) x Budgeted Price of Input
 Cont’d…
• The idea here is that an organization is
inefficient if it uses more inputs than
budgeted for the actual output units
achieved, and it is efficient if it uses fewer
inputs than budgeted for the actual output
units achieved.
 Cont’d…
• The two manufacturing efficiency variances
are direct materials efficiency variance and
direct manufacturing labor efficiency
variance are each unfavorable because more
input was used than was budgeted, resulting
in a decrease in operating income.
 Cont’d…
• As with price variances, there is a broad
range of possible causes for these efficiency
variances. unfavorable efficiency variance for
direct manufacturing labor could be because
of one or more of the following:
Company’s personnel manager hired under-
skilled workers
Company’s production scheduler inefficiently
scheduled work, resulting in more
manufacturing labor time than budgeted
being used per product.
 Cont’d…
Company’s maintenance department did not
properly maintain machines, resulting in
more manufacturing labor time than
budgeted being used per product.
Budgeted time standards were set too tight
without careful analysis of the operating
conditions and the employee`s skills.
 Cont’d…
• Note that managers generally have more
control over efficiency variances than price
variances.
• That`s because the quantity of inputs used is
primarily affected by factors inside the
company, but price changes are primarily due
to market forces outside the company.
THE END