Managerial Accounting Wild and Shaw 2010 Edition McGraw-Hill/Irwin Copyright 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 8Flexible Budgets and Standard Costing

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Conceptual Learning ObjectivesC1: Define standard costs and explain their computation and uses.C2: Describe variances and what they reveal about performance.C3: Explain how standard cost information is useful for management by exception.

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Analytical Learning ObjectivesA1: Compare fixed and flexible budgets. A2: Analyze changes in sales from expected amounts.

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Procedural Learning ObjectivesP1: Prepare a flexible budget and interpret a flexible budget performance report.P2: Compute materials and labor variances.P3: Compute overhead variances.P4: Prepare journal entries for standard costs and account for price and quantity variances.

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Budgetary Control and ReportingManagement uses budgets to monitor and control operations. Develop the budget from planned objectives. Compare actual with budget and analyze any differences. Take corrective and strategic actions. Revise objectives and prepare a new budget.P1

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Fixed Budget Performance ReportA2

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Fixed Budget Performance ReportIf unit sales are higher, should we expect costs to be higher? How much of the higher costs are because of higher unit sales?A2

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Purpose of Flexible BudgetsImprove performance evaluation.May be prepared for any activity level in the relevant range.Show revenues and expenses that should have occurred at the actual level of activity. Reveal variances due to good costcontrol or lack of cost control.A1

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Preparing Flexible Budgets To a budget for different activity levels, we must know how costs behave with changes in activity levels.Total variable costs change in direct proportion to changes in activity.Total fixed costs remain unchanged within the relevant range. P1

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Preparing Flexible BudgetsVariable costs are expressed as a constant amount per unit.P1

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Preparing Flexible BudgetsTotal variable cost = $4.80 per unit budget level in unitsP1

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Preparing Flexible BudgetsFixed costs are expressed as a total amount that does not change within the relevant range of activity. P1

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Flexible Budget Performance ReportFavorable sales variance indicates that the average selling price was greater than $10.00.P1

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Flexible Budget Performance ReportUnfavorable cost variances indicate costs that are greater than expected. P1

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Flexible Budget Performance ReportFavorable variances because favorable sales variance overcomes unfavorable cost variances.P1

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Standard CostsBenchmarks for measuring performance.The expected level of performance.Based on carefully predetermined amounts.Used for planning labor, material and overhead requirements.C 1

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Setting Standard CostsEngineerManagerial AccountantProduction ManagerC 1

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Setting Direct Material StandardsC 1

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Setting Direct Material Standards The standard material cost for one unit of product is: standard quantity standard price for of material one unit of material required for one unit of product C 1

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Setting Direct Labor StandardsC 1

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Setting Direct Labor Standards The standard labor cost for one unit of product is: standard number standard wage rate of labor hours for one hour for one unit of product C 1

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Setting Variable Overhead StandardsC 1

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Setting Variable Overhead StandardsThe standard variable overhead cost for one unit of product is: standard variable standard number overhead rate for of activity units one unit of for one unit of activity productC 1

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Standard Cost Card A standard cost card might look like this:C 1

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VariancesType of Product CostAmountManufacturing OverheadA standard cost variance is the amount by which an actual cost differs from the standard cost.P2

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Variance AnalysisPrepare standard cost performance reportConduct next periods operations Analyze variances Identify questions Receive explanationsTake corrective actionsBeginP2

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Computing VariancesP2

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Computing VariancesP2

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Computing VariancesStandard quantity is the quantity that should have been used for the actual good output. P2

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Computing Variances AQ(AP - SP) SP(AQ - SQ) AQ = Actual Quantity SP = Standard Price AP = Actual Price SQ = Standard Quantity P2

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Labor Variances Actual Hours Actual Hours Standard Hours Actual Rate Standard Rate Standard RateRate VarianceEfficiency Variance Materials price variance Materials quantity variance Labor rate variance Labor efficiency variance Variable overhead Variable overhead spending variance efficiency variance AH(AR - SR) SR(AH - SH) AH = Actual Hours SR = Standard Rate AR = Actual Rate SH = Standard Hours P2

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Labor VariancesUnfavorable Efficiency VarianceP2

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Overhead Standards and VariancesRecall that overhead costs are assigned to products and services using a predetermined overhead rate (POHR):Estimated total overhead costs Estimated activity POHR =Assigned Overhead = POHR Standard ActivityP3

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Setting Overhead StandardsOverhead RateContains a variable unit rate which stays constant at all levels of activity.Contains a fixed overhead rate which declines as activity level increases.Function of activity level chosen to determine rate.P3

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Spending VarianceEfficiency VarianceAH SVR AH AVRAH= Actual Hours of Activity AVR= Actual Variable Overhead Rate SVR= Standard Variable Overhead Rate SH= Standard Hours AllowedSH SVR Actual Flexible Budget Applied Variable for Variable Variable Overhead Overhead at Overhead at Incurred Actual Hours Standard Hours P3Computing Overhead Variances

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Spending VarianceVolume VarianceSFR= Standard Fixed Overhead Rate SH= Standard Hours AllowedSH SFR Actual Fixed Fixed Fixed Overhead Overhead Overhead Incurred Budget Applied P3Computing Overhead Variances

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Overhead Variance AnalysisTotal Overhead VarianceVariable OverheadFixed OverheadEfficiency VarianceSpending VarianceVolume VarianceSpending VarianceP3

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Variable Overhead VariancesSpending Variance

Efficiency Variance

Results from paying more or less than expected for overhead items and from excessive usage of overhead items.A function of the selected cost driver.It does not reflect overhead control. P3

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Fixed Overhead VariancesSpending Variance

Volume Variance

Results from paying more or less than expected for fixed overhead items.Results from the inability to operate at the activity planned for the period.Has no significance for cost control.P3

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Standard Costs for ControlType of Product CostAmountManufacturing OverheadManagers focus on quantities and costs that differ from standards, a practice known as management by exception. C 3

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End of Chapter 8

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This chapter describes flexible budgets, variance analysis, and standard costs. It explains how each is used for purposes of better controlling and monitoring business activities.In this chapter, you will learn the following conceptual objectives:C1: Define standard costs and explain their computation and uses.C2: Describe variances and what they reveal about performance.C3: Explain how standard cost information is useful for management by exception.

In this chapter, you will learn the following analytical objectives:A1: Compare fixed and flexible budgets.A2: Analyze changes in sales from expected amounts.

In this chapter, you will learn the following procedural objectives:P1: Prepare a flexible budget and interpret a flexible budget performance report.P2: Compute materials and labor variances.P3: Compute overhead variances.P4: Prepare journal entries for standard costs and account for price and quantity variances.

Budgets are an important cost control tool. Actual results are compared with budgets and differences are investigated and analyzed. This process may result in corrective action to restore progress toward budgeted objectives. If the operating environment has changed the investigation and analysis may lead to budget revisions. One of the major problems with fixed budgets is that theyre prepared for a single planned level of activity. Performance valuations can be very difficult when the actual level of activity differs from the planned level.To illustrate the difficulty involved with performance evaluation when comparing actual results at one activity with a fixed budget at another activity, lets look at an example. Optels fixed budget was prepared for January at an expected sales level of ten thousand units. However, Optel actually sold twelve thousand units during the month. All of the expense variances are unfavorable because actual expenses are greater than budgeted expenses.

Note that the variances for sales and income are favorable.Since the cost variances are unfavorable, has Optel done a poor job controlling costs? What if sales volume is greater than expected, shouldnt we expect Optels costs to be higher? If so, what portion of the higher costs is due to activity and what portion is due to poor cost control? These are questions that can be answered by a variance analysis.

One of the ways we can answer the question about the effectiveness of cost control is to use flexible budgeting. We will prepare a budget at the actual level of activity. In other words, we will flex Optels fixed budget up to the actual level of sales.A flexible budget shows us the revenue and expenses that should have been incurred at the actual level of activity rather than just the budgeted level of activity. One of the real strengths of flexible budgeting is that it helps us get a firm grasp on cost control. In addition, performance evaluation is improved using flexible budgeting.

In order to prepare an effective flexible budget, we have to know that total variable costs change directly and proportionately with the level of activity, and that total fixed costs remain unchanged as long as we stay within the relevant range of activity. Recall that in Chapter 7, we studied fixed and variable costs along with methods to determine the fixed and variable components of mixed costs.

We are now ready to prepare flexible budgets for Optel. We will prepare flexible budgets at three levels of activity to illustrate the process.Lets see how flexible budgeting works by preparing budgets for ten thousand units, twelve thousand units, and fourteen thousand units. Notice that Optels costs have been classified by behavior, either variable or fixed in the flexible budget. The first thing we do is express the variable costs in per unit amounts. For example, we divide the forty eight thousand variable costs by ten thousand units to obtain a unit variable cost of four dollars and eighty cents. Optels forty thousand dollars fixed cost will remain the same at all three levels of budgeted activity.

Next we multiply the four dollars and eighty cents unit variable cost times each of the budgeted levels of activity to get the total variable costs at each activity level. For example, at fourteen thousand units of activity, the budgeted variable cost of sixty seven thousand, two hundred dollars is computed by multiplying four dollars and eighty cents per unit times fourteen thousand units.

Total fixed costs remain unchanged in the budgeting process as long as we operate within the relevant range of activity.Now lets compare the flexible budget for twelve thousand units with the actual costs at twelve thousand units.At twelve thousand units, we would expect sales revenue to be one hundred twenty thousand dollars. Since the actual sales revenue was one hundred twenty five thousand dollars, we conclude that Optels average selling price was greater than ten dollars. Now we can begin to analyze cost control.

Comparing actual costs at twelve thousand units with a flexible budget prepared at twelve thousand units reveals that Optel has unfavorable cost variances. These variances are due to cost control issues because we have removed the activity differences by flexing the fixed budget from ten thousand units up to the actual activity of twelve thousand units. The favorable variances for contribution margin and income indicate that the favorable sales variance is larger than the unfavorable cost variances.Lets turn our attention to standard costs. Standard costs are preset costs for making a product or delivering a service. We can think of standard costs as budgeting on a per unit basis. We expect to operate within the standard cost allowances under normal conditions. When the standard cost team gets together, perhaps the first question they have to answer is, do they want to develop a practical standard or an ideal standard. Most members of the team would argue that the standards should be practical; they should be attainable with a reasonable amount of efficient effort.

There are also ideal standards. An ideal standard is based upon perfection, and is thus unattainable. This can have the effect of discouraging and demoralizing employees. Using ideal standards is not wise in most circumstances.

When we think of direct materials standards, we think of price standards that represent the final delivered cost, net of any applicable discounts. Standard quantities are amounts needed to meet the production designs.

We can combine the price standard and the quantity standard to get the standard material cost for one unit of product. The standard material cost for a unit of product is the standard price for one unit of material multiplied by the standard quantity of material required for each unit of product.Instead of the terms price and quantity used for material, we use rate and time when we apply standard cost concepts to direct labor. Labor rates can be determined by wage surveys of rates paid in comparable companies or by labor contracts. We can use time and motion studies to determine how to best manufacture the product using our direct labor.

We can combine the labor rate standard and the labor time standard to get the standard labor cost for one unit of product. The standard labor cost for a unit of product is the standard rate for one hour of direct labor multiplied by the standard time required for each unit of product.

For variable manufacturing overhead, we use a rate standard which is the variable portion of the predetermined overhead rate. The activity standard is the units of activity in the base used to apply our predetermined overhead. Examples of the activity base might be direct labor hours or machine hours.As with material and labor, we can combine the standard variable overhead rate and the standard number of activity units for variable overhead to get the standard variable overhead for one unit of product. The standard variable overhead cost for a unit of product is the standard variable overhead rate labor multiplied by the standard number of activity units for each unit of productA standard cost card might look like the one shown on the screen. First, we see a standard quantity. In this case, direct materials is expressed in terms of pounds, direct labor in hours, and variable manufacturing overhead in hours. Second, we have a standard price or standard rate, and finally, we have a standard cost per unit. In this case, one unit should cost a total of $85.00.

You can see from this diagram that direct labor cost is equal to the standard cost for labor, while direct material cost is above standard and manufacturing overhead cost is below standard. The difference between actual cost and standard cost is called a standard cost variance. Variance analysis involves comparing actual costs with standard costs. If variances exist, we investigate by asking appropriate managers for explanations and possible causes for the variances. Our objective is to correct problems that caused unfavorable variances and to possibly adopt and reward the practices that resulted in favorable variances. Price variances result when we pay an actual price for a resource that differs from the standard price that should have been paid. Quantity variances are caused by using an actual amount of a resource that differs from the standard amount that should have been used. Heres a general model for computing standard cost variances. We multiply the actual quantity times the actual price and compare that to the actual quantity times the standard price. The difference is the price variance. Then we compare the actual quantity times the standard price to the standard quantity at the standard price. The difference is the quantity variance. Standard price is the amount we should pay for the resource acquired.

The standard quantity is the standard quantity for one unit multiplied times the number of good units produced. It is the amount of a resource that should have been used given the actual good output achieved.

We can reduce these relationships to mathematical equations. For example, we can determine the material price variance by multiplying the actual quantity times the difference between the actual price and the standard price, and we can determine the material quantity variance by multiplying the standard price times the difference between the actual quantity and the standard quantity. Now that we have computed material variances, we can apply the same concepts to labor.Instead of price and quantity, for direct labor we use the terms rate and hours. Also, instead of price and quantity variances, for labor, we use the terms rate and efficiency variances. The underlying concepts are the same as we saw for material. The standard rate is the amount we should pay per hour for the work performed. Standard hours are the hours that should have been worked for the actual good output achieved. Just as with material, we can reduce these relationships to mathematical equations. For example, we can determine the labor rate variance by multiplying actual hours times the difference between the actual rate and the standard rate, and we can determine the labor efficiency variance by multiplying the standard rate times the difference between actual hours and standard hours. -Quantity is the standard quantity for one unit multiplied times the number of good units produced. It is the amount of a resource that should have been used.A number of factors can cause an unfavorable efficiency variance. All too often an unfavorable efficiency variance is blamed on inefficient workers. The reasons listed on your screen are much more likely to be the causes for unfavorable labor efficiency variances.Now that we have mastered material and labor variances, we can apply the same concepts to overhead.Recall from our work in previous chapters that the predetermined overhead rate is calculated by dividing estimated overhead costs for the operating period by the estimated activity for the operating period. We then use the predetermined overhead rate to assign overhead costs to products as they are manufactured.The predetermined overhead rate contains both fixed and variable components of overhead. The variable overhead rate will be the same for all levels of activity. However, the fixed portion of the overhead rate will differ depending on the activity level used in the denominator of the predetermined overhead rate computation. Flexible budgets for overhead will help us see these relationships.We now have the fixed and variable overhead rates for G-Max. Next, we can use these overhead rates in a standard cost system to calculate variable and fixed overhead variances.When we compare actual hours times actual variable overhead rate to actual hours times the standard variable overhead rate, we get the spending variance for variable overhead. When we compare actual hours times the standard variable overhead rate to standard hours at the standard variable overhead rate, we get the efficiency variance for variable overhead. The budget variance for fixed overhead is determined by comparing the fixed overhead actually incurred to the budgeted fixed overhead. The volume variance for fixed overhead is determined by comparing the budgeted fixed overhead to the fixed overhead applied. The applied fixed overhead is the product of the fixed overhead rate times standard hours.

The variable overhead spending and efficiency variances and the fixed overhead budget variances are often combined and referred to as the controllable overhead variance.The spending variance results from paying more or less than expected for variable overhead items, or from the excessive use of those variable overhead items. The efficiency variance is controlled through proper management of the overhead cost driver activity level.The budget variance results from paying more or less than expected for fixed overhead items. The volume variance results from operating at an activity level different from the activity level used to compute the predetermined overhead rate.

Standard cost analysis enables managers to focus on problems that need their attention. As long as operations are functioning without variances, managers are free to deal with other issues. In those instances when variances do occur, manager redirect their efforts to correcting the problems causing the variances. This process is referred to as management by exception.You have now been exposed to some of the basic concepts and principles of managerial accounting in the form of flexible budgets and standard costing. These concepts will help us in other topics that are just ahead.