CHAPTER THREE

Flexible Budgets and Standards

3.1. Static vs. Flexible budgets

Static Budgets and Static-Budget Variances

We will take a closer look at variances by examining one company’s accounting system. Note as
you study the exhibits in this chapter that “level” followed by a number denotes the amount of
detail shown by a variance analysis. Level 1 reports the least detail; level 2 offers more
information; and so on. Consider Webb Company, a firm that manufactures and sells jackets.
The jackets require tailoring and many other hand operations. Webb sells exclusively to
distributors, who in turn sell to independent clothing stores and retail chains. For simplicity, we
assume that Webb’s only costs are in the manufacturing function; Webb incurs no costs in other
value-chain functions, such as marketing and distribution. We also assume that all units
manufactured in April 2011 are sold in April 2011. Therefore, all direct materials are purchased
and used in the same budget period, and there is no direct materials 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. Webb has three variable-cost categories. The
budgeted variable cost per jacket for each category is as follows:

Cost Category Variable Cost per Jacket

Direct material costs $60
Direct manufacturing 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 2011 follow:
Budgeted fixed costs for production between 0 and 12,000 jackets $276,000
Budgeted selling price $ 120 per jacket
Budgeted production and sales 12,000 jackets
Actual production and sales 10,000 jackets

The static budget, or master budget, is based on the level of output planned at the start of the
budget period. The master budget is called a static budget because the budget for the period is
developed around a single (static) planned output level. Table 1, column 3, presents the static
budget for Webb Company for April 2011 that was prepared at the end of 2010. For each line
item in the income statement, Table 1, column 1, displays data for the actual April results. For
example, actual revenues are $1,250,000, and the actual selling price is $1,250,000 ÷ 10,000
jackets = $125 per jacket—compared with the budgeted selling price of $120 per jacket.

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Similarly, actual direct material costs are $621,600, and the direct material cost per jacket is
$621,600 ÷ 10,000 = $62.16 per jacket— compared with the budgeted direct material cost per
jacket of $60. The static-budget variance is the difference between the actual result and the
corresponding budgeted amount in the static budget. A favorable variance—denoted F in this
book—has the effect, when considered in isolation, of increasing operating income relative to the
budgeted amount. For revenue items, F means actual revenues exceed budgeted revenues. For
cost items, F means actual costs are less than budgeted costs. An unfavorable variance—
denoted U in this book— has the effect, when viewed in isolation, of decreasing operating
income relative to the budgeted amount.

Table 1. Static-Budget-Based Variance Analysis for Webb Company for April 2011

The unfavorable static-budget variance for operating income of $93,100 in Table 1is calculated
by subtracting static-budget operating income of $108,000 from actual operating income of
$14,900:
Static-budget variance for operating income = Actual result Static - budget amount
= $14,900 - $108,000
= $93,100 U.
The analysis in Table 1 provides managers with additional information on the static budget
variance for operating income of $93,100 U. The more detailed breakdown indicates how the
line items that comprise operating income, revenues, individual variable costs, and fixed costs
add up to the static-budget variance of $93,100. Remember, Webb produced and sold only
10,000 jackets, although managers anticipated an output of 12,000 jackets in the static budget.
Managers want to know how much of the static-budget variance is because of inaccurate
forecasting of output units sold and how much is due to Webb’s performance in manufacturing
and selling 10,000 jackets. Managers, therefore, create a flexible budget, which enables a more
in-depth understanding of deviations from the static budget.

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Flexible Budgets
A flexible budget calculates budgeted revenues and budgeted costs based on the actual output in
the budget period. The flexible budget is prepared at the end of the period (April 2011), after the
actual output of 10,000 jackets is known. The flexible budget is the hypothetical budget that
Webb would have prepared at the start of the budget period if it had correctly forecast the actual
output of 10,000 jackets. Note that:

The budgeted selling price is the same $120 per jacket used in preparing the static budget.

The budgeted unit variable cost is the same $88 per jacket used in the static budget.

The budgeted total fixed costs are the same static-budget amount of $276,000. Why?

Because the 10,000 jackets produced falls within the relevant range of 0 to 12,000 jackets.
Therefore, Webb would have budgeted the same amount of fixed costs, $276,000, whether it
anticipated making 10,000 or 12,000 jackets. The only difference between the static budget and
the flexible budget is that the static budget is prepared for the planned output of 12,000 jackets,
whereas the flexible budget is based on the actual output of 10,000 jackets. The static budget is
being “flexed,” or adjusted, from 12,000 jackets to 10,000 jackets. Webb develops its flexible
budget in three steps.

Step 1: Identify the Actual Quantity of Output. In April 2011, Webb produced and sold
10,000 jackets.

Step 2: Calculate the Flexible Budget for Revenues Based on Budgeted Selling Price and
Actual Quantity of Output.

Flexible-budget revenues = $120 per jacket * 10,000 jackets

= $1,200,000
Step 3: Calculate the Flexible Budget for Costs Based on Budgeted Variable Cost per
Output Unit, Actual Quantity of Output, and Budgeted Fixed Costs.

Flexible-budget variable costs

Direct materials, $60 per jacket × 10,000 jackets $ 600,000
Direct manufacturing labor, $16 per jacket × 10,000 jackets 160,000
Variable manufacturing overhead, $12 per jacket × 10,000 jackets 120,000
Total flexible-budget variable costs 880,000
Flexible-budget fixed costs 276,000
Flexible-budget total costs $1,156,000

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These three steps enable Webb to prepare a flexible budget, as shown in Table 2, column 3. The
flexible budget allows for a more detailed analysis of the $93,100 unfavorable static-budget
variance for operating income.

Flexible-Budget Variances

The flexible-budget variance is the difference between an actual result and the corresponding
flexible-budget amount. The flexible-budget-based variance analysis for Webb, which
subdivides the $93,100 unfavorable static-budget variance for operating income into two parts: a
flexible-budget variance of $29,100 U and a sales-volume variance of $64,000 U.

Table 2. Level 2 Flexible-Budget-Based Variance Analysis for Webb Co. for April 2011

Level 2 Analysis
Actual Flexible-Budget Sales-Volume
Results Variances Flexible Budget Variances Static Budget
(1) (2) = (1) − (3) (3) (4) = (3) − (5) (5)
Units sold 10,000 0 10,000 2,000 U 12,000
Revenues $ 1,250,000 $50,000 F $1,200,000 $240,000 U $1,440,000
Variable costs
Direct materials 621,600 21,600 U 600,000 120,000 F 720,000
Direct manuf. labor 198,000 38,000 U 160,000 32,000 F 192,000
Variable manuf. overhead 130,500 10,500 U 120,000 24,000 F 144,000
Total variable costs 950,100 70,100 U 880,000 176,000 F 1,056,000
Contribution margin 299,900 20,100 U 320,000 64,000 U 384,000
Fixed manuf. costs 285,000 9,000 U 276,000 0 276,000
Operating income $ 14,900 $29,100 U $ 44,000 $ 64,000 U $ 108,000

Level 2 $29,100 U $ 64,000 U

Flexible-budget variance Sales-volume variance

Level 1 $93,100 U
Static-budget variance

F = favorable effect on operating income; U = unfavorable effect on operating income

3.2. Standards for material and labor

a. Direct materials

The direct materials price standard is the cost per unit of direct materials that should be
incurred. This standard should be based on the purchasing department’s best estimate of the cost
of raw materials. This cost is frequently based on current purchase prices. The price standard
also includes an amount for related costs such as receiving, storing, and handling. The materials
price standard per pound of material for Xonic’s weed killer is:

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 Item Price
Purchase price, net of discounts $ 2.70
Freight 0.20
Receiving and handling 0.10
Standard direct materials price per pound $3.00

The direct materials quantity standard is the quantity of direct materials that should be used
per unit of finished goods. This standard is expressed as a physical measure, such as pounds,
barrels, or board feet. In setting the standard, management considers both the quality and
quantity of materials required to manufacture the product. The standard includes allowances for
unavoidable waste and normal spoilage. The standard quantity per unit for Xonic, Inc. is as
follows.

Quantity
Item (Pounds)
Required materials 3.5
Allowance for waste 0.4
Allowance for spoilage 0.1
Standard direct materials quantity per unit 4.0

The standard direct materials cost per unit is the standard direct materials price times the
standard direct materials quantity. For Xonic, Inc., the standard direct materials cost per gallon of
Weed-O is $12.00 ($3.00 × 4.0 pounds).

b. Direct labor

The direct labor price standard is the rate per hour that should be incurred for direct labor.
This standard is based on current wage rates, adjusted for anticipated changes such as cost of
living adjustments (COLAs). The price standard also generally includes employer payroll taxes
and fringe benefits, such as paid holidays and vacations. For Xonic, Inc., the direct labor price
standard is as follows.

Item Price
Hourly wage rate $ 7.50
COLA 0.25
Payroll taxes 0.75
Fringe benefits 1.50
Standard direct labor rate per hour $10.00

The direct labor quantity standard is the time that should be required to make one unit of the
product. This standard is especially critical in labor-intensive companies. Allowances should be
made in this standard for rest periods, cleanup, machine setup, and machine downtime. For
Xonic, Inc., the direct labor quantity standard is as follows.

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 Quantity
Item (Pounds)
Actual production time 1.5
Rest periods and cleanup 0.2
Setup and downtime 0.3
Standard direct labor hours per unit 2.0

The standard direct labor cost per unit is the standard direct labor rate times the standard direct
labor hours. For Xonic, Inc., the standard direct labor cost per gallon of Weed-O is $20 ($10.00 ×
2.0 hours).

c. Manufacturing overhead

For manufacturing overhead, companies use a standard predetermined overhead rate in

setting the standard. This overhead rate is determined by dividing budgeted overhead costs by an
expected standard activity index. For example, the index may be standard direct labor hours or
standard machine hours.

Xonic, Inc. uses standard direct labor hours as the activity index. The company expects to
produce 13,200 gallons of Weed-O during the year at normal capacity. Normal capacity is the
average activity output that a company should experience in the long run. Since it takes 2 direct
labor hours for each gallon, total standard direct labor hours are 26,400 (13,200 gallons ×2
hours). At normal capacity of 26,400 direct labor hours, overhead costs are expected to be
$132,000. Of that amount, $79,200 is variable and $52,800 is fixed.

Budgeted Standard Overhead Rate

Overhead Direct per Direct
Costs Amount ÷ Labor Hours = Labor Hour
Variable $ 79,200 26,400 $3.00
Fixed 52,800 26,400 2.00
Total $132,000 26,400 $5.00

The standard manufacturing overhead rate per unit is the predetermined overhead rate times the
activity index quantity standard. For Xonic, Inc., which uses direct labor hours as its activity
index, the standard manufacturing overhead rate per gallon of Weed-O is $10 ($5 × 2 hours).

d. Total standard cost per unit

After a company has established the standard quantity and price per unit of product, it can
determine the total standard cost. The total standard cost per unit is the sum of the standard costs
of direct materials, direct labor, and manufacturing overhead. For Xonic, Inc., the total standard
cost per gallon of Weed-O is $42, as shown on the following standard cost card.

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 Product: Weed-O Unit Measure: Gallon
Manufacturing Standard Standard Standard
Cost Elements Quantity × Price = Cost
Direct materials 4 pounds $ 3.00 $ 12.00
Direct labor 2 hours $ 10.00 $ 20.00
Manufacturing overhead 2 hours $ 5.00 $10.00
$ 42.00

The company prepares a standard cost card for each product. This card provides the basis for
determining variances from standards.

3.3. Controllability and variance analysis

One of the major management uses of standard costs is to identify variances from standards.
Variances are the differences between total actual costs and total standard costs. To illustrate,
we will assume that in producing 1,000 gallons of Weed-O in the month of June, Xonic, Inc.
incurred the following costs.

Direct materials $13,020

Direct labor 20,580
Variable overhead 6,500
Fixed overhead 4,400
Total actual costs $44,500

Companies determine total standard costs by multiplying the units produced by the standard cost
per unit. The total standard cost of Weed-O is $42,000 (1,000 gallons× $42). Thus, the total
variance is $2,500, as shown below.

Actual costs $44,500

Less: Standard costs 42,000
Total variance $ 2,500

Note that the variance is expressed in total dollars, and not on a per unit basis. When actual costs
exceed standard costs, the variance is unfavorable. The $2,500 variance in June for Weed-O is
unfavorable. An unfavorable variance has a negative connotation. It suggests that the company
paid too much for one or more of the manufacturing cost elements or that it used the elements
inefficiently. If actual costs are less than standard costs, the variance is favorable. A favorable
variance has a positive connotation. It suggests efficiencies in incurring manufacturing costs and
in using direct materials, direct labor, and manufacturing overhead. However, be careful: A
favorable variance could be obtained by using inferior materials. In printing wedding invitations,
for example, a favorable variance could result from using an inferior grade of paper. Or, a
favorable variance might be achieved in installing tires on an automobile assembly line by

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tightening only half of the lug bolts. A variance is not favorable if the company has sacrificed
quality control standards.

3.3.1. Direct material

In completing the order for 1,000 gallons of Weed-O, Xonic used 4,200 pounds of direct
materials. These were purchased at a cost of $3.10 per unit. The total materials variance is
computed from the following formula.

(Actual Quty ×Actual Price) - (Stand. Quty × Stand. Price) =Total Materials Variance
(AQ) × (AP) - (SQ) × (SP) = (TMV)

For Xonic, Inc., the total materials variance is $1,020 ($13,020 - $12,000) unfavorable, as shown
below.
(4,200 × $3.10) - (4,000 × $3.00) = $1,020 U

Next, the company analyzes the total variance to determine the amount attributable to price
(costs) and to quantity (use). The materials price variance is computed from the following
formula.
(Actual Quty ×Actual Price) - (Actual Quty × Stand. Price) = Materials Price Variance
(AQ) × (AP) - (AQ) × (SP) = (MPV)

For Xonic, Inc., the materials price variance is $420 ($13,020 - $12,600) unfavorable, as shown
below.
(4,200 × $3.10) - (4,200× $3.00) = $420 U

The price variance can also be computed by multiplying the actual quantity purchased by the
difference between the actual and standard price per unit. The computation in this case is 4,200 ×
($3.10 - $3.00) = $420 U. The materials quantity variance is determined from the following
formula.
(Actual Quty ×Actual Price) - (Stand. Quty × Stand. Price) = Materials Quty Variance
(AQ) × (AP) - (SQ) × (SP) = (MQV)

For Xonic, Inc., the materials quantity variance is $600 ($12,600 - $12,000) unfavorable, as
shown below.
(4,200× $3.00) - (4,000× $3.00) = $600 U

The price variance can also be computed by applying the standard price to the difference
between actual and standard quantities used. The computation in this example is $3.00× (4,200 -
4,000) = $600 U. The total materials variance of $1,020 U, therefore, consists of the following.

Materials price variance $ 420 U

Materials quantity variance 600 U
Total materials variance $1,020 U

Companies sometimes use a matrix to analyze a variance. When the matrix is used, a company
computes the formulas for each cost element first and then computes the variances.

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3.3.2. Direct Labor Variances

The process of determining direct labor variances is the same as for determining the direct
materials variances. In completing the Weed-O order, Xonic, Inc. incurred 2,100 direct labor
hours at an average hourly rate of $9.80. The standard hours allowed for the units produced were
2,000 hours (1,000 gallons × 2 hours). The standard labor rate was $10 per hour. The total labor
variance is computed from the following formula.

(Actual Hours ×Actual Rate) – (Standard Hours ×Standard Rate) = Total Labor Variance
(AH × AR) (SH × SR) = (TLV)

The total labor variance is $580 ($20,580 - $20,000) unfavorable, as shown below.

(2,100 × $9.80) - (2,000 × $10.00) = $580 U. Formula for the labor price variance is as follows.

(Actual Hours ×Actual Rate) – (Actual Hours ×Standard Rate) = Labor Price Variance
(AH × AR) (AH × SR) = (LPV)

For Xonic, Inc., the labor price variance is $420 ($20,580 - $21,000) favorable, as
shown below.
(2,100× $9.80) - (2,100 × $10.00) = $420 F.

The labor price variance can also be computed by multiplying actual hours worked by the
difference between the actual pay rate and the standard pay rate. The computation in this
example is 2,100 × ($10.00 - $9.80) = $420 F. The labor quantity variance is derived from the
following formula.

(Actual Hours × Stand. Rate) – (Stand. Hours ×Standard Rate) = Labor Quty Variance
(AH × SR) (SH × SR) = LQV

For Xonic, Inc., the labor quantity variance is $1,000 ($21,000- $20,000) unfavorable:

(2,100 × $10.00) - (2,000× $10.00) = $1,000 U

The same result can be obtained by multiplying the standard rate by the difference between
actual hours worked and standard hours allowed. In this case the computation is $10.00 × (2,100
- 2,000) = $1,000 U. The total direct labor variance of $580 U, therefore, consists of:

Labor price variance $ 420 F

Labor quantity variance 1,000 U
Total direct labor variance $ 580 U

3.3. 3. Manufacturing Overhead Variance

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The total overhead variance is the difference between the actual overhead costs and overhead
costs applied based on standard hours allowed. Xonic incurred overhead costs of $10,900
($6,500+ $4,400) to produce 1,000 gallons of Weed-O in June. The computation of the actual
overhead is comprised of a variable and a fixed component.

Variable overhead $ 6,500

Fixed overhead 4,400
Total actual overhead $10,900

We then determine the overhead costs applied based on standard hours allowed times the
predetermined overhead rate. Standard hours allowed are the hours that should have been
worked for the units produced. Because it takes two hours of direct labor to produce one gallon
of Weed-O, for the 1,000-gallon Weed-O order, the standard hours allowed are 2,000 hours
(1,000 gallons × 2 hours). We then apply the predetermined overhead rate to the 2,000 standard
hoursallowed.

The predetermined rate for Weed-O is $5, comprised of a variable overhead rate of $3 and a
fixed rate of $2. The amount of budgeted overhead costs at normal capacity of $132,000 was
divided by normal capacity of 26,400 direct labor hours, to arrive at a predetermined overhead
rate of $5 ($132,000 ÷26,400). The predetermined rate of $5 is then multiplied by the 2,000
standard hours allowed, to determine the overhead costs applied.

Actual Overhead - Overhead Applied* = Total Overhead Variance

$10,900 - $10,000 = $900 U
($6,500 + $4,400) - ($5 × 2,000 hours)

*Based on standard hours allowed.

Thus, for Xonic, Inc. the total overhead variance is $900 unfavorable. The overhead variance is
generally analyzed through a price and quantity variance. The name usually given to the price
variance is the overhead controllable variance; the quantity variance is referred to as the
overhead volume variance.

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