Chapter 08 Flexible Budgets, Standard Costs, and Variance Analysis
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Chapter 8
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. It also describes how standards are used to
compute material, labor, and overhead 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. Actions are taken to improve performance.
vi. Next period’s operations are carried out and the
process is repeated.
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II. Flexible budgets
Learning Objective 8-1: 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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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 this
slide. Notice:
1. A variance is computed for revenue and
each expense item.
2. The actual results and planning budget
columns 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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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 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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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
Learning Objective 8-2: Prepare a report showing
revenue and spending variances.
D. Computing revenue and spending variances
i. A revenue variance is the difference between what
the total revenue should have been, given the actual
level of activity for the period, and the actual total
revenue.
ii. A spending variance is the difference between
how much a cost should have been, given the actual
level of activity, and the actual amount of the cost.
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E. Larry’s Lawn Service: Computing revenue and
spending variances
i. The revenue and spending variances for Larry’s
Lawn Service would be computed as shown on this
slide. Notice:
1. The apple icons on the slide indicate that the
actual results and flexible budget columns
are both based on 550 lawns mowed.
2. The $1,750 favorable revenue variance
indicates that actual revenue exceeded the
budgeted amount that would be expected for
an activity level of 550 lawns mowed.
3. The $1,950 unfavorable spending variance
indicates that total expenses were $1,950
greater than would be expected for an
activity level of 550 lawns mowed.
4. Overall, net operating income was $200
less than would be expected for an activity
level of 550 lawns mowed.
III. Flexible budgets with multiple cost drivers
Learning Objective 8-3: Prepare a flexible budget with
more than one cost driver.
A. Key concepts
i. More than one cost driver may be needed to
adequately explain all of the costs in an
organization.
ii. The cost formulas used to prepare a flexible budget
can be adjusted to recognize multiple cost drivers.
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I. Larry’s Lawn Service: Multiple cost drivers
i. Let’s assume that Larry determined that wages
and salaries were driven by the number of lawns
mowed and the number of hours required for
additional edging and trimming.
ii. Larry’s flexible budget could easily be adjusted to
accommodate the second cost driver. Notice:
1. The number of hours (H) is designated as
the second cost driver.
2. Larry’s flexible budget is based on 100
hours of edging and trimming.
3. The cost formula for wages and salaries has
been adjusted to include $25 per hour of
edging and trimming.
4. Larry also adjusted the revenue formula to
include $30 per hour of edging and
trimming.
IV. Standard costs – setting the stage
A. Basic definitions/concepts
1. A standard is a benchmark for measuring
performance. In managerial accounting, two types
of standards are commonly used by
manufacturing, service, food, and not-for-profit
organizations to further analyze their spending
variances:
a. Quantity standards specify how much of
an input should be used to make a product or
provide a service. For example:
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a. Auto service centers like Firestone
and Sears set labor time standards for
the completion of work tasks.
b. Fast-food outlets such as
McDonald’s have exacting standards
for the quantity of meat going into a
sandwich.
b. Price standards specify how much should
be paid for each unit of the input. For
example:
a. Hospitals have standard costs for
food, laundry, and other items.
b. Home construction companies have
standard labor costs that they apply to
sub-contractors such as framers,
roofers, and electricians.
c. Manufacturing companies often
have highly developed standard
costing systems that establish
quantity and price standards for each
separate product’s material, labor,
and overhead inputs.
B. Setting direct materials standards
i. 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, spoilage,
and other normal inefficiencies.
ii. The standard price per unit for direct materials
should reflect the final, delivered cost of the
materials.
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C. Setting direct labor standards
i. The standard hours per unit reflects the labor
hours required to complete one unit of product.
1. Standards can be determined by using
available references that estimate the time
needed to perform a given task, or by
relying on time and motion studies.
ii. The standard rate per hour for direct labor
includes not only wages earned but also fringe
benefits and other labor costs.
1. Many companies prepare a single rate for
all employees within a department that
reflects the “mix” of wage rates earned.
D. Setting variable manufacturing overhead standards
i. The quantity standard for variable manufacturing
overhead is expressed in either direct labor hours or
machine hours depending on which is used as the
allocation base in the predetermined overhead rate.
ii. The price standard for variable manufacturing
overhead comes from the variable portion of the
predetermined overhead rate.
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E. The standard cost card
i. The standard cost card is a detailed listing of the
standard amounts of direct materials, direct
labor, and variable overhead inputs that should
go into a unit of product, multiplied by the standard
price or rate that has been set for each input.
V. Using standards in flexible budgets
A. Breaking down spending variances
i. Standard costs per unit for direct materials, direct
labor, and variable manufacturing overhead can be
used to compute spending variances as previously
described in the Larry’s Lawn Service example.
ii. However, spending variances become more useful
by breaking them down into price and quantity
variances. Standard costs can be used to decompose
a spending variance into its price and quantity
components.
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VI. A general model for standard cost variance analysis
A. Price and quantity variances
i. A price variance is the difference between the
actual price of an input and its standard price,
multiplied by the actual amount of the input
purchased.
ii. A quantity variance is the difference between how
much of an input was actually used and how much
should have been used and is stated in dollar terms
using the standard price of the input.
B. Price and quantity standards
i. Price and quantity standards are determined
separately because price and quantity variances
usually have different causes. In addition:
1. Different managers are usually
responsible for buying and for using
inputs. For example:
a. The purchasing manager is
responsible for raw material purchase
prices and the production manager is
responsible for the quantity of raw
material used.
2. The buying and using activities occur at
different points in time. For example:
a. Raw material purchases may be held
in inventory for a period of time
before being used in production.
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C. The general model—an overview
i. Price and quantity variances can be computed for
all three variable cost elements – direct materials,
direct labor, and variable manufacturing
overhead – even though the variances have
different names as shown.
ii. Although price and quantity variances are known
by different names, they are computed exactly the
same way (as shown on this slide) for direct
materials, direct labor, and variable manufacturing
overhead.
1. The actual quantity represents the actual
amount of direct materials, direct labor, and
variable manufacturing overhead used.
Helpful Hint: Emphasize that the quantities in this
model pertain to inputs not outputs. So, in the case of
direct materials, the quantities will be stated in terms
such as pounds, ounces, etc., not the number of units of
finished goods produced.
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2. The standard quantity represents the
standard quantity allowed for the actual
output of the period.
Helpful Hint: Mention that the “SQ” portion of the
model is the most common stumbling block for students
when it comes to variance analysis. Emphasize that
“SQ” refers to the standard quantity of inputs allowed
for the actual level of output achieved. For example, if
5,000 drapes were produced and each requires 2 yards
of fabric, the standard quantity allowed would be
10,000 yards. Any other amount of fabric used would
result in a variance.
3. The actual price represents the actual
amount paid for the input used.
4. The standard price represents the amount
that should have been paid for the input
used.
VII. Using standard costs—direct materials variances
Learning Objective 8-4: Compute the direct materials
price and quantity variances and explain their
significance.
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A. Glacier Peak Outfitters – an example
i. The materials price variance, defined as the
difference between what is paid for a quantity of
materials and what should have been paid
according to the standard, is $21 favorable.
1. The price variance is labeled favorable
because the actual price was less than the
standard price by $0.10 per kilogram.
ii. The materials quantity variance, defined as the
difference between the quantity of materials used in
production and the quantity that should have been
used according to the standard, is $50 unfavorable.
1. The quantity variance is labeled
unfavorable because the actual quantity
exceeds the standard quantity allowed by 10
kilograms.
Helpful Hint: Remind students that a favorable price
variance might not always be a good thing. If it arose
from receiving inferior or obsolete goods at a reduced
price, the total costs of making the company’s products
might be higher.
iii. Supporting/additional computations
1. The standard quantity of 200 kilograms was
computed as shown.
2. The actual price of $4.90 per kilogram was
computed as shown.
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3. The equations that we have been using thus
far can be factored as shown and used to
compute quantity and price variances.
B. Direct materials variances—points of clarification:
i. The purchasing manager and production
manager are usually held responsible for the
materials price variance, and materials quantity
variance, respectively.
1. The standard price is used to compute the
quantity variance so that the production
manager is not held responsible for the
performance of the purchasing manager.
ii. The materials variances are not always entirely
controllable by one person or department. For
example:
1. The production manager may schedule
production in such a way that it requires
express delivery of raw materials resulting
in an unfavorable materials price variance.
2. The purchasing manager may purchase
lower quality raw materials resulting in an
unfavorable materials quantity variance for
the production manager.
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Quick Check – direct materials variance calculations
VIII. Using standard costs—direct labor variances
Learning Objective 8-5: Compute the direct labor rate
and efficiency variances and explain their significance.
A. Glacier Peak Outfitters – continued (assume the
information as shown)
i. The labor rate variance, defined as the difference
between the actual average hourly wage paid and
the standard hourly wage, is $1,250 unfavorable.
1. The rate variance is labeled unfavorable
because the actual average wage rate was
more than the standard wage rate by $0.50
per hour.
ii. The labor efficiency variance, defined as the
difference between the actual quantity of labor
hours and the quantity allowed according to the
standard, is $1,000 unfavorable.
1. The efficiency variance is labeled
unfavorable because the actual quantity of
hours exceeds the standard quantity allowed
by 100 hours.
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iii. Supporting/additional computations
1. The standard quantity of 2,400 hours was
computed as shown.
2. The actual price (or rate) of $10.50 per
hour was computed as shown.
3. Factored equations can also be used to
compute the efficiency and rate variances.
B. Direct labor variances—points of clarification:
i. Labor variances are partially controllable by
employees within the Production Department. For
example, production managers/supervisors can
influence:
1. The deployment of highly skilled workers
and less skilled workers on tasks consistent
with their skill levels.
2. The level of employee motivation within the
department.
3. The quality of production supervision.
4. The quality of the training provided to the
employees.
ii. However, labor variances are not entirely
controllable by one person or department. For
example:
1. The Maintenance Department may do a
poor job of maintaining production
equipment. This may increase the
processing time required per unit, thereby
causing an unfavorable labor efficiency
variance.
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2. The purchasing manager may purchase
lower quality raw materials resulting in an
unfavorable labor efficiency variance for the
production manager.
Quick Check – direct labor variance calculations
IX. Using standard costs—variable manufacturing
overhead variances
Learning Objective 8-6: Compute the variable
manufacturing overhead rate and efficiency variances
and explain their significance.
A. Glacier Peak Outfitters – continued
i. The variable overhead rate variance, defined as
the difference between the actual variable overhead
costs incurred during the period and the standard
cost that should have been incurred based on the
actual activity of the period, is $500 unfavorable.
1. The rate variance is labeled unfavorable
because the actual variable overhead rate
was more than the standard variable
overhead rate by $0.20 per hour.
ii. The variable overhead efficiency variance,
defined as the difference between the actual activity
of a period and the standard activity allowed,
multiplied by the variable part of the predetermined
overhead rate, is $400 unfavorable.
1. The efficiency variance is labeled
unfavorable because the actual quantity of
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the activity (hours) exceeds the standard
quantity of the activity allowed by 100
hours.
iii. Supporting/additional computations
1. The standard quantity of 2,400 hours was
computed as shown.
2. The actual price of $4.20 per hour was
computed as shown.
3. Factored equations can be used to compute
the efficiency and rate variances.
Quick Check – variable overhead variance calculations
X. Materials variances—an important subtlety
A. When the quantity of materials purchased differs
from the quantity used in production, the quantity
variance is based on the quantity used in production
and the price variance is based on the quantity
purchased.
B. Glacier Peak Outfitters—revisited
i. The materials quantity variance is computed
using the actual quantity used in production (200
kgs.); therefore, the materials quantity variance is
$0.
ii. The materials price variance is computed using
the actual quantity purchased (210 kgs.); therefore,
the materials price variance is $21 favorable.
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