Chapter-3

Flexible Budgets and Standards

3.1. Static vs. Flexible budgets
3.1.1. Flexible budget
• A flexible budget is one that is allowed to adjust
based on a change in the assumptions used to
create the budget during management's planning
process.
• A flexible budget is a budget that adjusts or
flexes for changes in the volume of activity.
• To compute the value of the flexible budget,
multiply the variable cost per unit by the actual
production volume.
 Cont….
3.1.2. Static Budget
• A static budget remains the same even if
there are significant changes from the
assumptions made during planning.
• To calculate a static budget variance, simply
subtract the actual spend from the planned
budget for each line item over the given time
period. Divide by the original budget to
calculate the percentage variance
Cont….
 Cont…
3.2. Standards for material and labor
• Performance measure serves a critical role in
attaining goals.
• It provides a feedback concerning what works
and what does not work and it help motivate
people to sustain their effort.
• A standard is a benchmark for measuring
performance.
• They are used widely in managerial accounting
relating to quantity and cost (acquisition price) of
inputs used in manufacturing goods or providing
services.
 Cont…
• Quantity standards specify how much of an
input should be used to make a product or
provide service.
• Price standards specify how much should be
paid for each input.
• Actual quantities and prices are compared
with these standards and if variance exists,
managers investigate the cause of the
problem.
 Cont…..
• Any type of business organization uses a
standard cost.
• Manufacturing companies have highly
developed standard costing system in which
standards for direct materials, direct labor and
overhead are created for each product.
• They have a standard cost cards showing the
standard quantities and costs of inputs
required to produce a unit of s specific
product.
 Cont……
3.2.1 Setting standard cost
• To set price and quantity standards requires
the expertise of those who are responsible for
purchasing and using the inputs.
• This may include accountants, purchasing
managers, engineers; production supervisor
etc… past records of purchase prices and input
usage can be helpful in setting standards.
 Cont….
Standards fall into two categories as ideal and
practical standards.
• Ideal standards: can be attained only under
the best circumstances.
• They do not allow for machine breakdown or
other work interruptions.
• They require for level of effort that can be
attained only by the most skilled and efficient
employees working at peak effort of 100% all
the time.
 Cont…..
Practical standards: are standards that are
“tight” but attainable.
• They allow for machine downtime and
employee rest periods and can be attained
through reasonable but efficient efforts by
workers.
• Variances form these standards need
management attention because they
represent deviation that fall outside of normal
operating conditions.
3.2.1.1.Setting direct materials standard
• The first step in setting this standard is to
prepare price and quantity standards for raw
materials.
• The standard price per unit should reflect
final, delivery cost of materials net of any
discounts taken.
Purchase price xxx
Freight xxx
Less purchase discounts (xxx)
Standard price per kg xxx
• The standard quantity per unit for direct
materials should reflect the amount of
material required for each unit of finished
product as well as an allowance for
unavoidable waste.
• Materials required for one unit xxx
• Allowance for waste and spoilage xxx
• Allowance for rejections xxx
• Standard quantity per unit xxx
3.2.1.2Setting direct labor standards
• Direct labor price and quantity standards are
expressed in terms of a labor rate and labor
hours.
• The standard rate per hour for direct labor
includes wages, employment taxes and fringe
benefits.
• Basic wage rate per hour xxx
• Employment taxes xxx
• Fringe benefits xxx
• Standard rate per direct labor hour xxx
 cont
• Many companies prepare a single standard
rate per hour for all employees in a
department which reflects mix of workers
even thought actually wage rates may vary
according to skills and seniority.
• The standard hour per unit is the most
difficult standard to compete.
• The standard time should include allowances for
breaks, personal needs of employees, cleanup and
machine down time.
• Basic labor time per unit, in hour’s xxx
• Allowance for breaks and personal needs xxx
• Allowance for cleanup and machine downtime xxx
• Allowance for rejections xxx
• Standard direct labor hours per unit of product xxx
• Once the rate and time standards have been set, the
standard direct labor cost per unit of product is
computed as:
= direct labor hour per unit * direct labor hour rate
3.2.1.3.Setting variable manufacturing
overhead standards
• As with direct labor, the price and quantity
standards for variable manufacturing
overhead are expressed in terms of rate and
hours.
• The rate represent the variable portion of the
predetermined overhead rate where as the
hours relate to the activity base that is used to
apply overhead to units of product usually
machine-hour or labor-time.
• Therefore, standard variable manufacturing
overhead cost per units is
= direct labor hour per unit * variable overhead
rate
• The reason for separating price and quantity
standards is because these two represent the
responsibility of two managers.
• One is responsible for buying and the other is
responsible for using inputs.
• Therefore, it is important to distinguish between
deviations from price standards and deviation
from quantity standards.
 Cont…
• Inputs standard Qty/hrs standard price/rate standard cost
Direct material xx xx xx
Direct labor xx xx xx
Variable MOH xx xx xx
Total standard cost per unit xx
 3.3. Understanding Variance analysis

• The primary objective of variance analysis is to exercise

cost control and cost reduction.
• Under standard costing system, the management by
exception principle is applied through variance analysis.
• The variances are related to efficiency.
• The showing of efficiency leads to favorable variance.
• In this case, the responsible persons are rewarded.
• On the other hand, the showing of in efficiency leads to
unfavorable variance.
• In this case, the responsible persons are enquired and find
the root causes for such unfavorable variances.
• This type of findings is used for taking remedial action.
 Cont….
Meaning of Variance
• A variance is the deviation of actual from
standard or is the difference between actual and
standard.
Definition of Variance analysis
• Variance analysis is the resolution into
constituent parts and explanation of variances”.
• Variance analysis is the measurement of
variances, location of their root causes,
measuring their effect and their disposition”.
• Thus, variance analysis can be defined as the
segregation of total cost variances into
different elements in such a way as to indicate
or locate clearly the cause for such variances
and persons held responsible for them.
Types of Variances
• There is a need of knowing types of variances
before measuring the variances.
• Generally, the variances are classified on the
following basis.
A. On the basis of Elements of Cost.
• Material Cost Variance.
• Labour Cost Variance.
• Overhead Variance.
B. On the basis of Controllability
• Controllable Variance.
• Uncontrollable Variance
C. On the basis of Impact
• Favorable Variance.
• Unfavorable Variance
D. On the basis of Nature
• Basic Variance.
• Sub-variance.
• A brief explanation of the above mentioned variances are
presented below
• Material Cost Variance: It is the difference between actual
cost of materials used and the standard cost for the actual
output.
• Labour Cost Variance: It is the difference between the
actual direct wages paid and the direct labour cost allowed
for the actual output to be achieved.
• Overhead Variance: Overhead variance is the difference
between the standard cost of overhead allowed for actual
output (in terms of production units or labour hours) and
the actual overhead cost incurred.
• Controllable Variance: A variance is controllable whenever
an individual or a department or section or division may be
held responsible for that variance.
Uncontrollable Variance: External factors are responsible for
uncontrollable variances. The management has no power or is
unable to control the external factors. Variances for which a
particular person or a specific department or section or division
cannot be held responsible are known as uncontrollable variances.
• Favourable Variances: Whenever the actual costs are lower than
the standard costs at per-determined level of activity, such
variances termed as favorable variances. The management is
concentrating to get actual results at costs lower than the standard
costs. It shows the efficiency of business operation.
• Unfavorable Variances: Whenever the actual costs are more than
the standard costs at predetermined level of activity, such variances
termed as unfavorable variances. These variances indicate the
inefficiency of business operation and need deeper analysis of
these variances.
Basic Variances: Basic variances are those variances which arise on account of
monetary rates (i.e. price of raw materials or labour rate) and also on
account of non-monetary factors (such as physical units in quantity or
time). Basic variances due to monetary factors are material price variance,
labour rate variance and expenditure variance. Similarly, basic variances
due to non-monetary factors are material quantity variance, labour
efficiency variance and volume variance.
Sub Variance: Basic variances arising due to non-monetary factors are further
analyzed and classified into sub-variances taking into account the factors
responsible for them. Such sub variances are material usage variance and
material mix variance of material quantity variance. Likewise, labour
efficiency variance is subdivided into labour mix variance and labour yield
variance. At the same time, variable overhead variance is sub-divided
into variable overhead efficiency variance and variable overhead
expenditure variance.
Advantages of Variance analysis
• The following are the merits of variance analysis.
1. The reasons for the overall variances can be
easily find out for taking remedial action.
2. The sub-division of variance analysis discloses the
relationship prevailing between different
variances.
3. It is highly useful for fixing responsibility of an
individual or department or section for each
variance separately.
4. It highlights all inefficient performances and the
extent of inefficiency.
5. It is used for cost control.
6. The top management can follow the principle of
management by exception. Only unfavorable variances
are reporting to management.
7. Sometimes, the variances can be classified as
controllable and uncontrollable variances. In this case,
controllable variances are taken into consideration for
further action.
8. Profit planning work can be properly carried on by the
top management.
9. The results of managerial action can be a cost
reduction.
10. It creates cost consciousness in the minds of the every
employee of business organization.
3.3.1. Direct material
• Using formulas to calculate direct materials variances
• The total direct materials variance is comprised of two
components: the direct materials price variance and
the direct materials quantity variance.
• To compute the direct materials price variance, take
the difference between the standard price (SP) and the
actual price (AP), and then multiply that result by the
actual quantity (AQ):
• Direct materials price variance = (SP – AP) x AQ
 Cont…
• To get the direct materials quantity variance,
multiply the standard price by the difference
between the standard quantity (SQ) and the
actual quantity:
• Direct materials quantity variance = SP x (SQ –
AQ)
• The total direct materials variance equals the
difference between total actual cost of materials
(AP x AQ) and the budgeted cost of materials,
based on standard costs (SP x SQ):
• Total direct materials variance = (SP x SQ) – (AP x
AQ)
 Cont….
• For example, Band Book’s standard price is $10.35 per
pound.
• The standard quantity per unit is 28 pounds of paper per
case.
• This year, Band Book made 1,000 cases of books, so the
company should have used 28,000 pounds of paper, the
total standard quantity (1,000 cases x 28 pounds per case).
• However, the company purchased 30,000 pounds of paper
(the actual quantity), paying $9.90 per case (the actual
price).
• Based on the given formula, the direct materials price
variance comes to a positive $13,500, a favorable variance:
• Direct materials price variance = (SP – AP) x AQ = ($10.35 –
$9.90) x 30,000 = $13,500 favorable
• This variance means that savings in direct
materials prices cut the company’s costs by
$13,500.
• The direct materials quantity variance focuses on
the difference between the standard quantity
and the actual quantity, arriving at a negative
$20,700, an unfavorable variance:
• Direct materials quantity variance = SP x (SQ –
AQ) = $10.35 x (28,000 – 30,000) = –$20,700
unfavorable
• This result means that the 2,000 additional
pounds of paper used by the company increased
total costs $20,700. Now, you can plug both parts
in to find the total direct materials variance.
Compute the total direct materials variance as
follows:
• Total direct materials variance = (SP x SQ) – (AP x
AQ) = ($10.35 x 28,000) – ($9.90 x 30,000) =
$289,800 – $297,000 = –7,200 unfavorable
• 3.3.2. Direct labor
• The difference between actual time incurred
to manufacture a certain number of units and
the time allowed by standards to manufacture
that number of units multiplied by standard
direct labor rate is called direct labor
efficiency variance or direct labor quantity
variance.
• Favorable and unfavorable variance:
 Cont….
• Like direct labor rate variance, this variance may
be favorable or unfavorable.
• If workers manufacture a certain number of units
in an amount of time that is less than the amount
of time allowed by standards for that number of
units, the variance is known as favorable direct
labor efficiency variance.
• On the other hand, if workers take an amount of
time that is more than the amount of time
allowed by standards, the variance is known as
unfavorable direct labor efficiency variance.
 Cont…
• The direct labor efficiency variance may be
computed either in hours or in dollars.
• Suppose, for example, the standard time to
manufacture a product is one hour but the
product is completed in 1.15 hours, the
variance is 0.15 hours – unfavorable.
• If the labor cost is $6.00 per hour the variance
in dollars would be $0.90 (0.15 hours × $6.00).
• For proper financial measurement the
variance is normally expressed in dollars.
 The following formula is used to calculate this
variance:
• Rate variance = (Actual rate * Actual hours ) - (standard rate * actual hours)
• Efficiency varance = (standard hrs allowed * standard rate ) - (AH * SR)
for actual ouput
• Total direct labor cost variance= (SR*SH) –(AR*AH)
OR
• Total direct labor cost variance= Rate variance + Efficiency variance.
 Cont…..
Example
• Nice furniture manufacturing company presents
the following data for the month of March 2013.
• Standard direct labor rate per hour$6.50
• Actual direct labor rate per hour$6.75
• Standard time to produce on unit of product3
hours
• Production during the month of March 2013,600
units
• Hours worked during the month of March,1850
hours
Required:
• Compute direct labor efficiency variance.
• Indicate whether the variance is favorable or
unfavorable.
• Solution
Direct labor efficiency variance = (AH × SR) – (SH × SR )
• = (1850 hours × $6.50) – (1,800 hours × $6.50)
• = $12,025 – $11,700
• = $325 unfavorable
• The variance is unfavorable because labor worked 50
hours more than what was allowed by standard.
 3.3.3.Variable manufacturing overhead variances
• Example:
• the standard variable overhead cost for
company “x” is br.7.50 per unit of product [2.5
hrs/unit * br.3/hrs].
• Actual variable MOH cost for the period was
br.15,390.
• The actual direct labor hour was 5400 hrs.
• The actual output produced is 2000 units.
• Rate variance = [AH * AR] – [AH * SR] AR = actual variable MOH cost
= [5400 * br.2.85] - [5400 * br.3] actual DL hour
= br.15,390 – br.16,200 = br.15,390 =br.2.85
=br.810 (favorable) 5400 hrs
• Efficiency variance =(AHs allowed for A.out put* SR ) - (AH * SR)

= [5000 * 3] – [5400 * 3]
=15,000 – 16,200
=br. 1,200 (unfavorable)
• N.B. standard hrs allowed for actual output = actual output * SH
 Cont…..
 Causes of unfavorable variance:
 There are a lot of reasons of unfavorable variance.
Some common reasons are as follows:
 Inexperienced workers
 Poorly motivated workers
 Old or faulty equipment
 Purchase of low quality or unsuitable direct materials
 Poor supervision
 Insufficient demand for company’s product
 Frequent breakdowns
 Shortage of raw materials
 CHAPER-4
Measuring Mix and Yield Variances
• Sales variance is the difference between
actual sales and budget sales.
• It is used to measure the performance of a
sales function, and/or analyze business results
to better understand market conditions.
• When calculating sales variances as part of
variance analysis, one issue that arises is when
a company sells more than one product.
• Two possible scenarios can occur:
 Cont…..
• If customers are unlikely to buy one product
instead of another from the same company,
then separate sales volume variances can be
calculated
• If, on the other hand, customers might
substitute one product for another, then the
concept of sales mix is important and separate
sales volume variances can be replaced by
a combined sales mix variance.
(1) Sales price variances are calculated by comparing the
actual selling price per unit and the budgeted selling
price per unit; each price variance is multiplied by the
number of units for each type of product.
(2) A sales volume variance is the difference between
the actual number of units sold, and the budgeted
number.
• Each difference is multiplied by the budgeted profit per
unit.
• Sales volume in turns splits into a sales mix variance
and a sales quantity variance.
(3) A sales mix variance indicates the effect on profit of
changing the mix of actual sales from the standard mix.
A Sales Mix variance can be calculated in one
of two ways :
(a) The difference between the actual total
quantity sold in the standard mix and the
actual quantities sold, valued at the standard
profit per unit;
(b) The difference between the actual sales and
budgeted sales, valued at the standard profit
per unit less the budgeted weighted average
profit per unit
(4) A sales quantity variance indicates the effect
on profit of selling a different total quantity
from the budgeted total quantity. Like the mix
variance, it can be calculated in one of two
ways :
(a) The difference between actual sales volume
in the standard mix and budgeted sales valued
at the standard profit per unit.
(b) The difference between actual sales volume
and budgeted sales valued at the weighted
average profit per unit.