Chapter 09 – Lecture Notes
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Chapter 9
Lecture Notes
Chapter theme: This chapter explains how to prepare
flexible budgets and how to compare them to actual results
for the purposes of computing revenue and spending
variances.
I. The variance analysis cycle
A. The steps of the cycle
i. The cycle begins with the preparation of
performance reports in the accounting
department.
ii. These reports highlight variances which are
differences between actual results and what should
have occurred according to the budget.
iii. The variances raise questions such as:
1. Why did this variance occur?
2. Why is this variance larger than it was last
period?
iv. The significant variances are investigated to
discover their root causes.
v. Corrective actions are taken.
vi. Next period’s operations are carried out and the
process is repeated.
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Chapter 09 – Lecture Notes
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II. Flexible budgets
Learning Objective 1: Prepare a flexible budget.
A. Characteristics of a flexible budget
i. A planning budget is prepared before the period
begins and is valid for only the planned level of
activity.
1. If the actual level of activity differs from
what was planned, it would be misleading
to evaluate performance by comparing
actual costs to the static, unchanged
planning budget.
ii. A flexible budget is an estimate of what revenues
and costs should have been, given the actual level
of activity for the period. Flexible budgets:
1. May be prepared for any activity level in the
relevant range.
2. Enable “apples to apples” cost comparisons.
3. Help managers control costs.
4. Help evaluate managerial performance.
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Chapter 09 – Lecture Notes
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B. Larry’s Lawn Service: Illustrating the deficiencies
of the static planning budget
i. Assume the following facts with respect to Larry’s
Lawn Service. Notice that Larry expects to mow
500 lawns during June.
ii. Assume that Larry prepared the planning budget
for June as shown. Notice that the budget includes:
1. Two variable costs—gasoline and supplies
and equipment maintenance.
2. Four fixed costs—office and shop utilities,
office and shop rent, equipment
depreciation, and insurance.
3. One mixed cost—wages and salaries.
iii. Assume that Larry’s actual results for the month
of June are as shown. Notice:
1. Larry actually mowed 550 lawns.
iv. If Larry wanted to, he could compare his actual
results to the planning budget as shown on the
slide. Notice:
1. A variance is computed for revenue and
each expense item.
2. The actual results column and planning
budget column have apple and orange icons
to emphasize that the amounts in both
columns are based on different levels of
activity (500 vs. 550 lawns).
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Chapter 09 – Lecture Notes
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3. A favorable (unfavorable) revenue variance
occurs when actual revenue is greater than
(less than) the planning budget.
4. A favorable (unfavorable) expense variance
occurs when actual expenses are less than
(greater than) the planning budget.
5. The important question for us to consider is:
—do these expense variances indicate
whether Larry has done a good job
controlling his costs?
6. At this point, we cannot answer this question
because the actual level of activity is
greater than the planned level of activity.
Therefore, actual variable costs are likely to
be higher than planned variable costs
regardless of Larry’s managerial efficiency.
7. To intelligently evaluate Larry’s
performance, we need to determine how
much of the cost variances are due to higher
activity levels and how much are due to
Larry’s ability to control costs. In other
words, we need to flex the planning
budget to accommodate the actual level of
activity.
C. How a flexible budget works
i. Keys to understanding a flexible budget
1. Variable costs change in direct proportion to
changes in activity.
2. Total fixed costs remain unchanged within
the relevant range.
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Chapter 09 – Lecture Notes
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ii. Larry’s Lawn Service: preparing a flexible
budget
1. Larry’s flexible budget for an activity level
of 550 lawns mowed is as shown on this
slide. Notice, the “Q” in all revenue and
cost formulas is 550 lawns mowed. So, for
example:
a. Revenue of $41,250 is computed by
multiplying $75 × 550.
b. Wages and salaries expense of
$21,500 is computed by multiplying
$30 × 550 plus $5,000 in fixed
salaries.
2. The fixed costs in Larry’s flexible budget
are not sensitive to changes in the activity
level.
Quick check – preparing a flexible budget
III. Flexible budget variances
Learning Objective 2: Prepare a report showing
activity variances.
A. Key terminology
i. An activity variance arises solely due to the
difference in the actual level of activity and the
level of activity included in the planning budget.
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Chapter 09 – Lecture Notes
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B. Larry’s Lawn Service: Computing activity
variances
i. The activity variances for Larry’s Lawn Service
would be computed as shown on this slide. Notice:
1. The level of activity in the flexible budget
(550 lawns) is 10% higher than the level of
activity in the planning budget (500 lawns).
2. The revenue in the flexible budget is 10%
higher than the planning budget because
revenue varies proportionally to changes in
the activity level.
3. The variable costs in the flexible budget
(gasoline and supplies and equipment
maintenance) are 10% higher than the
planning budget because variable costs vary
proportionally to changes in the activity
level.
4. The mixed cost (wages and salaries) in the
flexible budget is less than 10% higher
than the planning budget because the fixed
cost component of the mixed cost does not
change when the activity level changes.
5. The fixed costs in the flexible budget are the
same as the planning budget because they
do not change in response to changes in the
activity level within the relevant range.
6. The net operating income in the flexible
budget is more than 10% higher than the
planning budget due to the presence of fixed
costs.
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