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Advance Cost & Management Accounting Page 1

Basic Concepts

Variance

Difference between an actual and an expected (budgeted) amount

Management by Exception

The practice of focusing attention on areas not operating as expected (budgeted)

Static budget

A budget prepared for only one level of activity.

It is based on the level of output planned at the start of the budget period.

The master budget is an example of a static budget.

Flexible budget

Revenues or costs considered justified by the actual output level of the budget period.

A key difference between a flexible budget and a static budget is the use of the actual output level in

the flexible budget.

In general, flexible budgets can also be conditioned on actual levels of other external influences

Serve to implement responsibility accounting.

Static-Budget Variance (Level 0)

The difference between the actual result and the corresponding static budget amount.

Flexible-Budget Variances (Level 1)

Static budget variance decomposed according to categories.

Favorable Variance (F)

Has the effect of increasing operating income relative to the budget amount.

Unfavorable Variance (U)

Has the effect of decreasing operating income relative to the budget amount

Variances

Variances may start out “at the top” with a Level 0 variance the difference between actual and static-

budget operating income.

Answers: “How much were we off?”

Levels 1, 2, and 3 examine the Level 0 variance into progressively more-detailed levels of analysis.

Answers: “Where and why were we off?”

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Advance Cost & Management Accounting Page 2

Simple Example

Flexible Budget

Shifts budgeted revenues and costs up and down based on actual operating results (activities). Represents a blending of actual activities and budgeted dollar amounts.

Will allow for preparation of Levels 2 and 3 variances Answers the question: “Why were we off?”

Sales-Volume Variance Difference between the static budget for the number of units expected to be sold and the flexible

budget for the number of units that were actually sold. The only difference between the static budget and the flexible budget is the output level upon which the budget is based.

Level 2 analysis Provides information on the two components of the static-budget variance.

Level 1

Analysis

900

Level 0

Analysis

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Flexible-budget variance:

(Actual – budgeted contribution margin/unit)×actual sales mix × actual units sold

Sales-volume variance: (Actual units sold × actual sales mix – budgeted units sold × budgeted sales mix) × budgeted

contribution margin/unit

A Flexible-Budget Example

Level 3 Variances

All Product Costs can have Level 3 Variances. Direct Materials and Direct Labor will be handled

next.

Both Direct Materials and Direct Labor have both Price and Efficiency Variances, and their formulae

are the same.

Price Variance = {Actual Price of Input - Budgeted Price of Input } × Actual Quantity

of Input

Efficiency Variance = {Actual Quantity of Input Used - Budgeted Quantity of Input Allowed

for Actual Output of Input} × Budgeted Price

Actual Data

Direct materials purchased and used = 42,500 square yards at $15.95

Cost of direct materials = $677,875

Labor hours: 21,500 at $12.90

Cost of direct manufacturing labor = $277,350

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Price variance for direct materials= ($15.95 – $16.25) × 42,500 = $12,750 F Œ

Price variance for direct manufacturing labor = ($12.90 – $13.00) × 21,500 = $2,150 F

Efficiency variance for direct materials = (42,500 – 40,000) × $16.25 = $40,625 U Œ

Efficiency variance for direct manufacturing labor = (21,500 – 20,000) × $13.00 = $19,500

Production Volume Variance

The production volume variance is associated with a standard costing system used by some

manufacturers.

Production Volume Variance =

Budgeted fixed overhead – Fixed overhead allocated for actual output units produced

To illustrate the production volume variance, let's assume that a manufacturer had budgeted $300,000

of fixed manufacturing overhead (supervisors' compensation, depreciation, etc.) for the upcoming

year. During that period it expected to have 30,000 machines hours of good output. Based on this

plan the manufacturer established a fixed manufacturing overhead rate of $10 per standard machine

hour. If the company actually produces 29,000 standard machine hours of good output, the products

will be assigned (or will have absorbed) $290,000 of the fixed manufacturing overhead.

Production Volume Variance = 300,000 – 290,000 = $10,000

This will cause an unfavorable production volume variance of $10,000

Managerial Uses of Variances

To understand underlying causes of variances

Recognition of inter-relatedness of variances

Performance Measurement

Managers ability to be Effective

Managers ability to be Efficient

Effectiveness is the degree to which a predetermined objective or target is met.

Efficiency is the relative amount of inputs used to achieve a given level of output.

Performance evaluation should not be based on Variances alone

If any single performance measure, such as a labor efficiency variance, receives excessive

emphasis, managers tend to make decisions that maximize their own reported performance in

terms of that single performance measure “what you measure is what you get”.