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CHAPTER 21
FLEXIBLE BUDGETS AND STANDARD COSTS
Related Assignment Materials
Student Learning Objectives
Discussion
Questions
Quick
Studies*
Exercises*
Problems*
Beyond the
Numbers
Conceptual objectives:
C1. Define standard costs and
explain how standard cost
information is useful for
management by exception
8,13
21-5, 21-7
21-5, 21-6
21-6
21-1, 21-3,
21-5, 21-6,
21-8
C2. Describe variances and what
they reveal about performance.
5, 6, 7, 11, 14
21-6
21-7, 21-8
21-3
21-4, 21-6,
21-7
Analytical objectives:
A1. Analyze changes in sales from
expected amounts.
21-20, 21-21
21-23
21-2
21-2, 21-9
Procedural objectives:
P1. Prepare a flexible budget and
interpret a flexible budget
performance report.
1, 2, 3, 4
21-1, 21-2,
21-3, 21-4
21-1, 21-2,
21-3, 21-4
21-1, 21-2,
21-3
P2. Compute materials and labor
variances.
21-8, 21-9,
21-10, 21-11,
21-12
21-9, 21-10,
21-11, 21-12,
21-13, 21-15,
21-16
21-2, 21-3
21-4
P3. Compute overhead controllable
and volume variances.
9, 10, 12, 13,
15, 16
21-13, 21-14,
21-15, 21-16,
21-18
21-17, 21-19,
21-20, 21-21,
21-22
21-3, 21-4
P4 Compute overhead spending and
efficiency variances.
(Appendix 21A)
21-19
21-18
21-5
P5. Prepare journal entries for
standard costs and account for
price and quantity variances.
(Appendix 21A)
21-17
21-14
21-6
21-4
*See additional information on next page that pertains to these quick studies, exercises and problems.
Additional Information on Related Assignment Material
Connect (Available on the instructor’s course-specific website) repeats all numerical Quick Studies, all
Exercises and Problems Set A. Connect provides new numbers each time the Quick Study, Exercise or
Problem is worked. It allows instructors to monitor, promote, and assess student learning. It can be used
in practice, homework, or exam mode.
Corresponding problems in set B also relate to learning objectives identified in grid on previous page.
Problems 21-2A and 21-4A can be completed using EXCEL. The Serial Problem for Success Systems
starts in this chapter and continues throughout many chapters of the text.
Synopsis of Chapter Revision
Niner Bikes—New opener and entrepreneurial assignment.
Added learning objective for overhead spending and efficiency variances
Revised discussion of fixed budget performance report
Revised discussion of flexible budget performance report
Reorganized section on flexible budgeting
Revised several flexible budget exhibits
Revised discussion of standard cost systems
Revised discussion of setting standard costs
Revised discussion of computing and analyzing cost variances
Revised exhibits on computing direct materials and direct labor variances
Revised sections on analyzing materials, labor, and overhead variances
Simplified discussion of setting overhead standards
Revised discussion of computing the predetermined overhead rate
Revised exhibits on overhead variances and overhead variance report
Added Sustainability section using BMW
Revised discussion of sales variances
Added discussion, with an exhibit, on the standard costing income statement
Added several end of chapter assignments
Chapter Outline
Section 1Flexible Budgets
I. Budgetary Process
A. Budgetary Control and Reporting
1. Budgetary controlmanagement’s use of budgets to see that planned
objectives are met.
2. Budget reports
a. Contain relevant information that compares actual results to
planned activities.
b. Sometimes viewed as progress reports (or report cards) on
management’s performance in achieving planned objectives.
c. Common periods for budget reports are for a month, a quarter and
for a year.
3. Budgetary control process involves at least four steps.
a. Develop budget from planned objectives.
b. Compare actual results to budgeted amounts and analyze
differences.
c. Take corrective and strategic actions.
d. Establish new planned objectives and prepare new budget.
4. Two alternative approaches: fixed budgeting and flexible budgeting.
a. Fixed budgeting: a fixed budget (also called a static budget) is
based on a single product amount of sales or other activity
measure.
b. Flexible budgeting: a flexible budget (also called a variable
budget) is based on several different amounts of sales or activity
levels.
c. A flexible budget is more useful when actual results are different
from predicted.
B. Fixed Budget Performance Report
1. A fixed budget performance report compares actual results with results
expected under the fixed budget (that predicted a certain sales volume
or other activity level). (Exhibit 21.2)
2. Differences between budgeted and actual results are designated as
variances.
a. Favorable variance (F)actual revenue is greater than budgeted
revenue, or actual cost is lower than budgeted cost.
b. Unfavorable variance (U)Actual revenue is lower than budgeted
revenue, or actual cost is greater than budgeted cost.
C. Budget Reports for Evaluation
1. Primary use of budget reports is to help management monitor and
control operations.
2. Fixed budget reports show variances from budget, but manager
doesn’t know if a change in sales volume (or other activity level) is
cause for variances, or if other factors have influenced the amounts.
3. Major limitation of fixed budget performance report is inability of
fixed budget reports to adjust for changes in activity levels.
Notes
Chapter Outline
II. Flexible Budget Reports –Superior alternative to fixed budget reports.
A. Purpose of Flexible Budgets
1. Flexible budget (also called variable budget) is based on predicted
amounts of revenues and expenses corresponding to actual level of
output.
2. Useful both before and after the period’s activities are complete
3. Flexible budgets prepared before the period are based on several levels
of activities. Include both best case and worst case scenarios
4. Flexible budgets prepared after the period help managers evaluate past
performance.
5. Especially useful because it reflects the different levels of activities in
different amounts of revenues and costs.
a. Comparisons of actual results with budgeted performance are
more likely to identify reasons for any differences.
b. Helps managers to focus attention on problem areas and to
implement corrective actions.
B. Preparation of Flexible Budgets
1. Designed to reveal effects of volume of activity on revenue and costs.
2. Must classify costs as variable and fixed within a relevant range.
a. Variable cost per unit of activity remains constant; total amount of
variable cost changes in direct proportion to a change in level of
activity.
b. Total amount of fixed cost remains unchanged regardless of
changes in level of activity within relevant (normal) operating
range.
3. When numbers making up a flexible budget are created:
a. Each variable cost is expressed as either a constant amount per
unit of sales or as a percent of sales dollar.
b. Budgeted amount of fixed cost is expressed as the total amount
expected to occur at any sales volume within the relevant range.
4. Layout follows a contribution margin format (Exhibit 21.3)
a. Sales are followed by variable costs, and then by fixed
costsdifference between sales and variable costs equals
contribution margin.
b. First column shows flexible budget amounts of variable costs per
unit, and second column shows fixed costs for any volume of sales
in relevant range.
c. Third, fourth, and fifth columns show flexible budget amounts
computed for specified sales volumes (three different sales
volumes used in this example).
Notes
Chapter Outline
C. Flexible Budget Performance Report
1. Lists differences between actual performance and budgeted
performance based on actual sales volume (or other level of activity).
2. Helps direct management’s attention to those costs or revenues that
differ substantially from budgeted amounts; areas where corrective
actions may help management control operations.
3. Used for variance analysis.
a. Actual and budgeted sales volumes are the same; as such, any
variance in total dollar sales must have resulted from a selling
price that was different than expected.
b. Difference between actual price per unit of input and budgeted
price per unit of input can be described as a price variance.
c. Difference between actual quantity of input used and budgeted
quantity can be described as a quantity variance.
Section 2Standard Costs
I. Standard CostsActual costs are amounts paid in past transactions; a
measure of comparison is usually needed to decide whether actual cost
amounts are reasonable or excessive, and standard costs offer one basis for
comparison.
A. Standard costs are preset costs for delivering a product or service expected
under normal conditions.
1. Used by management to assess the reasonableness of actual costs
incurred for producing the product or service.
2. When actual costs vary from standard costs, management follows up
to identify potential problems and take corrective action.
3. Management by exception: managers focus attention on most
significant differences and give less attention where performance is
reasonably close to standard.
4. Often used in preparing budgets because they are the anticipated costs
incurred under normal conditions.
5. Can also help control nonmanufacturing costs.
II. Materials and Labor Standards
A. Identifying Standard Costs
1. Managerial accountants, engineers, personnel administrators, and other
managers help set standard costs.
a. To set direct labor costs - conduct time and motion studies for
each labor operation in the process of providing product or
service; sets standard labor time required for each operation under
normal conditions.
b. To set direct material costs – study quantity, grade, and cost of
each material used.
Notes
Chapter Outline
2. Regardless, actual costs frequently differ from standard costs;
differences often due to more than one factor.
a. Actual quantity used (of direct labor hours or direct materials) may
differ from standard.
b. Actual price paid per unit (of direct labor or direct materials) may
differ from standard.
B. Setting Standard Costs
1. Due to inefficiencies and waste, materials may be lost as part of
process.
a. An ideal standard is the quantity of material required if process
was 100% efficient without any loss or waste.
b. A practical standard is the quantity of material required under
normal application of process; allowance for loss included in
standard.
c. Most companies use practical standards.
2. A standard cost card shows the standard costs of direct materials,
direct labor, and overhead for one unit of product or service.
.
III. Cost VariancesCost variance (or simply variance) is difference between
actual and standard costs; can be favorable (if actual cost is less than standard
cost) or unfavorable (if actual cost is more than standard cost). Note that short-
term favorable variances can lead to long-term unfavorable variances.
A. Cost Variance Analysis
1. Variances are commonly identified in performance reports.
2. Management examines circumstances to determine factors causing the
variance; analysis, evaluation, and explanation involved.
3. Results of efforts should allow assignment of responsibility for the
variance; actions can then be taken to correct problems.
4. Four steps involved in proper management of variance analysis.
a. Preparation of standard cost performance report.
b. Computation and analysis of variances.
c. Identification of questions and their explanations.
d. Corrective and strategic action.
B. Cost Variance ComputationCost variance (CV) equals difference
between actual cost (AC) and standard cost (SC).
1. Actual quantity (AQ ) Standard quantity (SQ)
x Actual price (AP) x Standard price (SP)
Actual Cost (AC) Standard Cost (SC)
2. Actual quantity is input (material or labor) used in manufacturing the
quantity of output, and Standard Quantity is the input expected for the
quantity of output.
3. Actual Price is amount paid for acquiring the input (material or labor),
and Standard Price is the expected price.
Notes
Chapter Outline
4. Two main factors cause a cost variance
a. Price variance caused by difference between actual price paid and
standard price.
b. Quantity (or usage or efficiency) variance caused by difference
between the actual quantities of materials or hours used and the
standard quantity.
5. Price variance and quantity variance can be determined by formulas.
Actual Cost Standard
AQ x AP AQ x SP SQ x SP
Price variance Quantity variance
(AQ x AP) – (AQ x SP) (AQ x AP) – (AQ x SP)
Cost variance
2. Alternative price variance and quantity variance formulas can also be
used.
a. Price variance = (Actual price – Standard price) x Actual quantity.
PV = (AP – SP) x AQ.
b. Quantity variance = (Actual quantity - Standard quantity) x
Standard price.
QV = (AQ – SQ) x SP.
C. Computing Materials and Labor Variances
1. Material cost variances may be due to price and/or quantity factors.
a. A materials price variance results when company pays different
amount per unit than standard price; purchasing department
usually responsible.
b. A material quantity or usage variance results when company uses
a quantity that differs from the standard quantity allowed to
produce the actual amount of output; production department
usually responsible. Can also be fault of purchasing department if
the purchase of inferior materials caused excess use of materials.
2. Labor cost variances may be due to rate (price) and/or efficiency
(quantity) factors.
a. Labor rate (price) variance results when wage rate paid to
employees differs from standard rate; personnel administrator or
production manager need to explain why the actual rate is higher
or lower than standard
b. Labor efficiency (quantity) variances results when labor hours
used differ from the standard quantity of hours allowed to produce
the actual amount of output; production manager needs to explain
why the actual hours were different from standard.
c. Labor rate and efficiency variances may be due to use of workers
with different skill levels.
Notes
Chapter Outline
IV. Overhead Standards and VariancesA predetermined overhead rate is used
to assign standard overhead costs to products or services produced;
predetermined rate is often based on relation between standard overhead and
standard labor cost, standard labor hours, standard machine hours, or another
measure of production.
A. Setting Overhead Standards
1. Standard overhead costs are amounts expected to occur at a certain
level of activity.
2. Overhead includes both variable and fixed costs; as such, average
overhead cost per unit changes as the predicted volume changes.
3. Standard overhead costs are average per unit costs based on predicted
level of activity.
4. To establish standard overhead cost rate, use same cost structure as
that used to construct flexible budget at end of a period.
a. Management selects a level of activity (volume) and predicts total
overhead costs.
b. Many factors affect predicted activity level.
i. Level of 100% of capacity rarely used.
ii. Factors that cause activity level to be less than full capacity
include difficulties in scheduling work, equipment under
repair or maintenance, and insufficient product demand.
iii. Total overhead costs predicted are divided by allocation base
to get standard rate.
B. Total Overhead Cost Variance
1. Cost accounting system applies overhead using predetermined
overhead rate when standard costs are used.
2. At end of period, the difference between total overhead cost applied to
products and total overhead cost actually incurred is called the
overhead cost variance
3. Actual overhead costs incurred (AOI)
- Standard overhead applied (SOA)
Overhead Cost Variance (OCV)
4. The standard overhead applied is based on the predetermined overhead
rate and the standard number of hours that should have been used,
based on the actual production output.
Total Overhead Variance
Actual total Overhead – Standard total overhead applied
Actual Overhead Incurred Budgeted Fixed Overhead
- Budgeted total Overhead - Applied Fixed Overhead
Controllable Variance Volume Variance
Notes
Chapter Outline
5. To help identify factors causing the overhead cost variance managers
will analyze the variance separately for controllable and volume
variances.
a. The controllable variance is the difference between the actual
overhead costs incurred and the budgeted overhead costs based on
a flexible budget; named because it refers to activities usually
under management control.
b. The volume variance is the difference between the budged fixed
overhead (at predicted capacity) and the applied fixed overhead).
i. Occurs when there is a difference between the actual volume
of production and the standard volume of production
ii. The budgeted fixed overhead is the same value regardless of
the volume of production.
iii. The applied overhead is based on the standard direct labor
hours allowed for the actual volume of production.
iv. When a company operates at a capacity different from what is
expected, the volume variance will differ from zero
6. Analyzing controllable and volume variances
a. An unfavorable volume means the company did not reach its
expected operating level – a favorable variance means the
company operated at a greater than expected operating level
b. Main purpose of the volume variance to identify what portion of
the total overhead variance is cause by failing to meet the expected
production level.
c. Often the reasons the failing to meet expected operating levels are
due to factors (e.g. customer demand) beyond employees’ control.
7. Overhead Variance Reports
a. Help managers isolate the reasons for a controllable variance.
b. Provides information about specific overhead costs and how they
differ from budgeted amounts
V. Decision AnalysisSales VariancesSimilar to computation and analysis of
cost variances.
A. Sales price variance and sales volume variance can be computed.
B. Managers use sales variances for planning and control purposes.
1. Used to plan future actions to avoid unfavorable variances
2. Question why sales were higher/lower than expected.
3. Evaluate and reward salespeople.
C. When multiple products sold:
1. Sales mix variance is difference between actual and budgeted sales
mix of products.
2. Sales quantity variance is difference between total actual and total
budgeted quantity of units sold.
Notes
