CHAPTER THREE

FLEXIBLE BUDGET AND

STANDARDS
 LEARNING OBJECTIVES
 Describe the difference between a static budget and a
flexible budget
 Develop a flexible budget and compute flexible-budget
variances and sales-volume variances
 Compute the price and efficiency variances for direct-cost
categories
 Explain why standard costs are often used in variance
analysis
 Explain similarities and differences in the planning of
variable overhead costs and the planning of fixed overhead
costs
 Compute variable overhead spending and efficiency
variances
 Introduction
• Budgets are planning tools that are usually prepared prior to the start
of the period being budgeted.
• The comparison of the budget to actual results provides valuable
information about performance.
• Budgets are both planning tools and performance evaluation tools.
• In this unit, therefore the discussion focuses on how budget are used
to evaluate feedback and variances aid managers in their control
function.
• In evaluating performance
 The budgeted performance are compared with actual operational
results and
 The resulting variance will be examined so as to identify the
causes for variance on the bases of which performance can
be rewarded for favorable variance or corrective actions will
be taken to avoid unfavorable variance on the coming
operational periods.
 Standard Cost Systems
• Standard costs are predetermined costs that are
usually expressed on per unit basis.
• In other word, standard cost is a predetermined
calculation of how much costs should be
incurred under specified working condition.
• It is built up from an assessment of the value of
direct material, direct labor and overhead items.
• Standard costing is the establishment of cost
standards for activities and their periodic analysis
to determine the reasons for any variances.
• Standard costing is a tool that helps management
account in controlling costs.
• For example, at the beginning of a year a company estimates
that labor costs should be $2 per unit.
• Such standards are established either by historical trend
analysis of the cost or by an estimation by any engineer or
management scientist.
• After a period, say one month, the company compares the
actual cost incurred per unit, say $2.05 to the standard cost
and determines whether it has succeeded in controlling cost
or not.
• This comparison of actual costs with standard costs is called
variance analysis and it is vital for controlling costs and
identifying ways for improving efficiency and profitability.
 If actual cost exceeds the standard costs, it is an
unfavorable variance.
 On the other hand, if actual cost is less than the standard
 Why Standard Cost Systems Are Used
• A standard cost system has three basic functions:
collecting the actual costs of a manufacturing
operation, determining the achievement of that
manufacturing operation, and evaluating
performance through the reporting of variances
from standard.
• These basic functions result in six distinct
benefits of standard cost systems.
1. Clerical Efficiency
• A company using standard costs usually discovers that less
clerical time and effort are required than in an actual cost
system.
• In an actual cost system, the accountant must continuously
recalculate changing actual unit costs.
2. Motivation
• Standards are a way to communicate management’s
expectations to workers.
• When standards are achievable and when workers are
informed of rewards for standards attainment, those workers
are likely to be motivated to strive for accomplishment.
• The standards used must require a reasonable amount of effort
on the workers’ part.
3. Planning
• Planning generally requires estimates about the future.
• Managers can use current standards to estimate future quantities and
costs.
• These estimates should help in the determination of purchasing
needs for material, staffing needs for labor, and capacity needs
related to overhead that, in turn, will aid in planning for company
cash flows.
4. Controlling
• The control process begins with the establishment of standards that
provide a basis against which actual costs can be measured and
variances calculated.
• Variance analysis is the process of categorizing the nature (favorable
or unfavorable) of the differences between actual and standard costs
and seeking explanations for those differences.
• An early measurement and reporting system allows managers to
monitor operations, take corrective action if necessary, evaluate
performance, and motivate workers to achieve standard production.
5. Decision Making
• Standard cost information facilitates decision making.
• For example, managers can compare a standard cost with a quoted price
to determine whether an item should be manufactured in-house or
instead be purchased.
• Use of actual cost information in such a decision could be inappropriate
because the actual cost may fluctuate from period to period.
6. Performance Evaluation
• When top management receives summary variance reports
highlighting the operating performance of subordinate managers, these
reports are analyzed for both positive and negative information.
• Top management needs to know when costs were and were not
controlled and by which managers.
• Such information allows top management to provide essential feedback to
subordinates, investigate areas of concern, and make performance
evaluations about who needs additional supervision, who should be
replaced, and who should be promoted.
• For proper performance evaluations to be made, the responsibility for
variances must be traced to specific managers.
 Budgetary Control vs Standard Costing
• Budgetary control and standard costing are
comparable system of cost accounting in that they
are both predetermined of forward – looking.
• The common objective is of controlling
business operations by establishing
predetermined targets.
• However, there are a few differences between
these two systems are which given below:
 Advantages and Limitations of Standard
• Costing
Advantages of standard costing
1. The weakness of the traditional costing system can be
estimated by compiling standard costs more carefully.
2. Standard costs can be used as a yardstick against which actual
costs can be compared. It is an effective tool for planning
production costs. Hence, cost control is greatly facilitated.
3. Variance analysis helps management to have regular as well as
better checks over costs incurred. It makes the application of
the principle of management by exception more easy. That
is, the management can concentrate its attention on
variances only, leaving the other aspects of cost control to
be taken care of at the lower level.
4. It is a valuable guide to management in the formulation of
production and price policies in advance with certainty. It also
assists management in the areas of profit – planning, product –
pricing, and inventory pricing, etc.
5. Standard costing makes the reporting of operating data more meaningful and
also fast. This makes the interpretation of management reports easy.
6. As the emphasis of the standard costing system is more on cost variations, it
makes the entire organization cost conscious. It makes the employees
recognize the importance of efficient operations so that costs can be reduced
by joint efforts.
7. Labor, materials and machines can be effectively used, and economies can be
affected in addition to increase productivity. Standards may also be used
as the basis for introducing incentive schemes.
• Limitations of standard costing
1. Setting of standards is a very difficult task. It requires a lot of scientific studies
such as time – study, motion study, etc., and therefore it is very costly. Small
firms may find it very difficult to operate such a system.
2. Standards are very rigid estimates and once set, are not changed for a
considerable time. This makes the standards highly unrealistic in certain
industries which face fluctuations in prices of products due to frequent
changes.
3. The utility of variance analysis depends much more on the standard set.
While a loosely set standard may be ridicule the standards which are set very
high may create frustration in the minds of the workers. At the same time
 DEVELOPMENT OF A STANDARD COST SYSTEM
• Standard cost systems make use of standard costs, which
are the budgeted costs to manufacture a single unit of
product or perform a single service.
• Developing a standard cost involves judgment and
practicality in identifying the material and labor types,
quantities, and prices as well as understanding the
kinds and behaviors of organizational overhead.
• A primary objective in manufacturing a product is to
minimize unit cost while achieving certain quality
specifications.
• Almost all products can be manufactured with a variety of
inputs that would generate the same basic output and
output quality.
• The input choices that are made affect the standards that
• Once management has established the desired
output quality and determined the input resources
needed to achieve that quality at a reasonable cost,
quantity and price standards can be developed.
• Experts from cost accounting, industrial
engineering, personnel, data processing,
purchasing, and management are assembled to
develop standards.
• To ensure credibility of the standards and to
motivate people to operate as close to the
standards as possible, involvement of managers
and workers whose performance will be compared
Material Standards
• The first step in developing material standards is to identify
and list the specific direct materials used to manufacture
the product.
• This list is often available on the product specification
documents prepared by the engineering department prior to
initial production.
• In the absence of such documentation, material
specifications can be determined by observing the
production area, querying of production personnel,
inspecting material requisitions, and reviewing the cost
accounts related to the product.
• Three things must be known about the material inputs: types
of inputs, quantity of inputs used, and quality of inputs
Labor Standards
• Development of labor standards requires the same
basic procedures as those used for material.
• Each production operation performed by either workers
(such as bending, reaching, lifting, moving material,
and packing) or machinery (such as drilling,
cooking, and attaching parts) should be identified.
• In specifying operations and movements, activities such
as cleanup, setup, and rework are considered.
• All unnecessary movements by workers and of material
should be disregarded when time standards are set.
Overhead Standards
• To provide the most appropriate costing information,
overhead should be assigned to separate cost pools
based on the cost drivers, and allocations to products
should be made using different activity drivers.
• After the bill of materials, operations flow
document, and predetermined overhead rates per
activity measure have been developed, a standard cost
card is prepared.
• This document summarizes the standard quantities and
costs needed to complete one product or service unit.
• Data from the standard cost card are then used to
assign costs to inventory accounts.
 Classification of Budgets
1. Fixed or Static Budget
• The static budget, or master budget, is based on the level of
output planned at the start of the budget period.
• The master budget is called a static budget because the budget
for the period is developed around a single (static) planned
output level.
• The static-budget variance is the difference between the
actual result and the corresponding budgeted amount in
the static budget.
2. Flexible Budgets
• A flexible budget calculates budgeted revenues and budgeted
costs based on the actual output in the budget period.
• The flexible budget is prepared at the end of the period after
the actual output is known.
 Variance Analysis
• Variance may be defined as the difference between standard and
actual for each element of cost and sometimes for sales.
• When the actual results are better than expected, a ‘favorable’
variance arises; where they are not up to the standard, an ‘adverse
variance’ occurs.
• Variances help to fix the responsibilities so that management can
ascertain the person responsible for the poor results.
• For example, an adverse material usage variance would indicate that
excess material cost was due to inefficient use of materials.
• This would enable management to fix the responsibility on the
supervisor in charge of a particular operation in which the
inefficiency occurred.
• It may be discovered that the variance was caused by (say) inefficient
handling, purchase of poor quality materials or employment of
trainees.
• The important point is that the reason for the variance must be found,
• A favorable variance—denoted F and has the effect,
when considered in isolation, of increasing operating
income relative to the budgeted amount.
 For revenue items, F means actual revenues
exceed budgeted revenues.
 For cost items, F means actual costs are less than
budgeted costs.
• An unfavorable variance—denoted U and has the
effect, when viewed in isolation, of decreasing
operating income relative to the budgeted amount.
• Unfavorable variances are also called adverse
variances in some countries, such as the United
Kingdom.
• To have a better understanding of causes for
variance managers usually require variance
calculated at different level.
• Variance according to the degree of detailed
feedback on performance can be classified as:
Level 0 variance analysis
Level 1 variance analysis
Level 2 variance analysis
Level 3 variance analysis
Level 4 variance analysis
 Illustration
• Consider Webb Company, a firm that manufactures and sells
jackets. The jackets require tailoring and many other hand
operations. Webb sells exclusively to distributors, who in turn
sell to independent clothing stores and retail chains. For
simplicity, we assume that Webb’s only costs are in the
manufacturing function; Webb incurs no costs in other
value-chain functions, such as marketing and distribution.
We also assume that all units manufactured in April 2011
are sold in April 2011. Therefore, all direct materials are
purchased and used in the same budget period, and there is no
direct materials inventory at either the beginning or the
end of the period. No work-in-process or finished goods
inventories exist at either the beginning or the end of the
period. Webb has three variable-cost categories. The budgeted
variable cost per jacket for each category is as follows:
Cost Category Variable Cost per Jacket
Direct material costs………………………$60
Direct manufacturing labor costs……………16
Variable manufacturing overhead costs………12
Total variable costs…………………………$88
• The number of units manufactured is the cost driver for
direct materials, direct manufacturing labor, and variable
manufacturing overhead. The relevant range for the cost
driver is from 0 to 12,000 jackets. Budgeted and actual
data for April 2011 follow:
Budgeted fixed costs for production between 0 and 12,000
jackets………………………………………….$276,000
Budgeted selling price……………………………$ 120 per
jacket
Budgeted production and sales……………………12,000 jackets
• Remember, Webb produced and sold only 10,000 jackets, although
managers anticipated an output of 12,000 jackets in the static budget.
• Managers want to know how much of the static budget variance is
because of inaccurate forecasting of output units sold and how much
is due to Webb’s performance in manufacturing and selling 10,000
jackets.
• Managers, therefore, create a flexible budget, which enables a
more in-depth understanding of deviations from the static budget.
• A flexible budget calculates budgeted revenues and budgeted costs
based on the actual output in the budget period.
• The flexible budget is prepared at the end of the period (April 2011),
after the actual output of 10,000 jackets is known.
• The flexible budget is the hypothetical budget that Webb would
have prepared at the start of the budget period if it had correctly
forecast the actual output of 10,000 jackets.
• The only difference between the static budget and the flexible budget is
that the static budget is prepared for the planned output of 12,000
jackets, whereas the flexible budget is based on the actual output of
• Webb develops its flexible budget in three steps.
1. Identify the Actual Quantity of Output. In April 2011, Webb
produced and sold 10,000 jackets.
2. Calculate the Flexible Budget for Revenues Based on Budgeted
Selling Price and Actual Quantity of Output.
Flexible-budget revenues = $120 /jacket * 10,000 jackets =
$1,200,000
3. Calculate the Flexible Budget for Costs Based on Budgeted
Variable Cost per Output Unit, Actual Quantity of Output, and
Budgeted Fixed Costs.
Flexible-budget variable costs
Direct materials, $60/jacket * 10,000 jackets……….……..$
600,000
Direct manufacturing labor, $16/jacket * 10,000
jackets……..160,000
Variable manufacturing overhead, $12/jacket * 10,000
Flexible-Budget Variances and Sales-Volume
Variances
• The sales-volume variance is the difference
between a flexible-budget amount and the
corresponding static-budget amount.
• The flexible-budget variance is the difference
between an actual result and the corresponding
flexible-budget amount.
• The flexible-budget-based variance analysis for
Webb, which subdivides the $93,100 unfavorable
static-budget variance for operating income into
two parts: a flexible-budget variance of $29,100 U
and a sales-volume variance of $64,000 U.
 Sales-Volume Variances
• The difference between the static-budget and the flexible-budget
amounts is called the sales volume variance because it arises solely
from the difference between the 10,000 actual quantity (volume) of
jackets sold and the 12,000 quantity of jackets expected to be sold
in the static budget.
Sales-volume variance for operating income = Flexible budget amount -
Static budget amount
= $44,000 - $108,000 = $64,000 U
Sales-volume variance for operating income =
(Budgeted contribution margin per unit) * (Actual units sold – Static budget
units sold)
= (Budgeted selling price - Budgeted variable cost per unit) * (Actual
units sold- Static-budget units sold)
= ($120 per jacket - $88 per jacket) * (10,000 jackets - 12,000 jackets)
= $32 per jacket * (-2,000 jackets)
= $64,000 U
• Webb’s managers determine that the unfavorable sales-volume
variance in operating income could be because of one or more of
the following reasons:
 The overall demand for jackets is not growing at the rate that was
anticipated.
 Competitors are taking away market share from Webb.
 Webb did not adapt quickly to changes in customer preferences and
tastes.
 Budgeted sales targets were set without careful analysis of market
conditions.
 Quality problems developed that led to customer dissatisfaction
with Webb’s jackets.
• Flexible-budget variances are a better measure of operating
performance than static-budget variances because they
compare actual revenues to budgeted revenues and actual
costs to budgeted costs for the same 10,000 jackets of output.
• The flexible-budget variance for revenues is called
the selling-price variance because it arises
solely from the difference between the actual
selling price and the budgeted selling price:
Selling price variance = (Actual selling price –
Budgeted selling price) * Actual units sold
= ($125 per jacket - $120 per jacket) * 10,000
jackets
= $50,000 F
Price Variances and Efficiency Variances for Direct-
Cost Inputs
• To gain further insight, almost all companies subdivide the flexible-
budget variance for direct cost inputs into two more-detailed
variances:
1. A price variance that reflects the difference between an actual input
price and a budgeted input price.
2. An efficiency variance that reflects the difference between an actual
input quantity and a budgeted input quantity
• The information available from these variances (which we call level 3
variances) helps managers to better understand past performance and
take corrective actions to implement superior strategies in the
future.
• Managers generally have more control over efficiency variances
than price variances because the quantity of inputs used is
primarily affected by factors inside the company (such as the
efficiency with which operations are performed), while changes in
the price of materials or in wage rates may be largely dictated by
 Obtaining Budgeted Input Prices and Budgeted
Input Quantities
• Three main sources for this information are past data, data from
similar companies, and standards.
• Webb’s standard cost includes
• Standard cost per output unit for each variable direct-cost input =
Standard input allowed for one output unit * Standard price per
input unit
• Standard direct material cost per jacket: 2 square yards of cloth input
allowed per output unit (jacket) manufactured, at $30 standard price
per square yard
• Standard direct material cost per jacket = 2 square yards * $30 per
square yard = $60
• Standard direct manufacturing labor cost per jacket: 0.8
manufacturing labor-hour of input allowed per output unit
manufactured, at $20 standard price per hour
• Standard direct manufacturing labor cost per jacket = 0.8 labor-hour
 Data for Calculating Webb’s Price Variances and Efficiency
Variances
• Consider Webb’s two direct-cost categories. The actual cost for
each of these categories for the 10,000 jackets manufactured and
sold in April 2011 is as follows:
• Direct Materials Purchased and Used
1. Square yards of cloth input purchased and used…………………
22,200
2. Actual price incurred per square yard……………………………$
28
3. Direct material costs (22,200 * $28) …………………………
$621,600
• Direct Manufacturing Labor
1. Direct manufacturing labor-hours………………………………
9,000
2. Actual price incurred per direct manufacturing labor-hour ………$
 A price variance or input-price variance or rate variance is the
difference between actual price and budgeted price, multiplied by actual
input quantity
• Price variance= (Actual price of input - Budgeted price of input) *
Actual quantity of input
 Direct materials…… ($28 per sq. yard – $30 per sq. yard) * 22,200
square yards = $44,400 F
 Direct manufacturing labor………. ($22 per hour – $20 per hour) *
9,000 hours = $18,000 U
 An efficiency variance or usage variance is the difference between
actual input quantity used.
• Efficiency Variance = (Actual quantity of Input used - Budgeted
quantity of input allowed for actual output) * Budgeted price of input
 Direct materials [22,200 sq. yds. – (10,000 units * 2 sq. yds./unit)] *
$30 per sq. yard = (22,200 sq. yds. – 20,000 sq. yds.) * $30 per sq. yard
= $66,000 U
 Direct manufacturing Labor [9,000 hours – (10,000 units * 0.8
hour/unit)] * $20 per hour = (9,000 hours – 8,000 hours) * $20 per
Overhead Cost Variances
• Overhead variances arise when the actual overhead
costs incurred differ from the expected amounts.
• When standard costs are used, the cost accounting
system applies overhead to the good units produced
using the predetermined standard overhead rate.
• At period-end, the difference between the total
overhead cost applied to products and the total
overhead cost actually incurred is called an overhead
cost variance (total overhead variance)
• To help identify factors causing the overhead cost
variance, managers analyze this variance separately
for variable and fixed overhead
a. Variable overhead cost variance (VOHV)
• This is the difference between standard variable overheads
for actual production and the actual variable overheads.
• It can be sub–divided into Variable overhead expenditure
variance, and Variable overhead efficiency variance.
A spending variance occurs when management pays an
amount different than the standard price to acquire an item.
• For instance, the actual wage rate paid to indirect labor
might be higher than the standard rate.
• Similarly, actual supervisory salaries might be different
than expected.
• Spending variances such as these cause management to
investigate the reasons that the amount paid differs from the
standard.
• VOH expenditure variance is the difference between the
standard variable overheads for the actual hours worked,
and the actual variable overheads incurred.
• The formula for computing it is as follows:
VOH Exp. Variance = AVOH –SVOH.
= Actual hours worked x (Actual overhead rate - standard
overhead rate)
 VOH efficiency variance arises when the actual output
produced differs from the standard output for actual hours
worked.
• It is a measure of extra overhead (for saving) incurred solely
because of the efficiency shown during the actual hours
worked.
• The formula to compute it is as follows:
VOH efficiency variance = Standard overhead rate x (Actual
• Example: From the following information, calculate VOH cost
variances assuming labor hours as cost driver for variable
manufacturing overhead.
Budget output 5000 units
Budgeted hours 10,000
Budgeted variable overheads Br. 2,000
Actual variable overheads Br. 3,000
Actual output 4,000 units
Actual hours 12,000 hours
VOH expenditure variance = AVOH –SVOH for actual hours
worked = Br.3000 - (12000x0.20*) =Br. 600 (U)
VOH efficiency variance =SVOH for actual Hrs - SVOH for
actual output =Br. 2400 – Br. 1600**=Br. 800 (U)
*SVOH pre hours = Br.2000/10,000 = Br.0.20 per hour
**SVOH per unit of output –Br.2000/5000 = Br.0.40 per unit x
b. Fixed overheads cost variance (FOHV)
• This is the difference between the standard fixed overheads
for actual output and actual fixed overheads.
• The major sub –divisions of FOHV are FOH expenditure
variance and FOH volume variance.
FOH expenditure variance (FOHEV)
• This is the difference between Actual fixed overhead costs
and Budgeted fixed overhead
FOHEV= AFOH –BFOH
FOH volume Variance (FOHVV)
• This is the difference between the budgeted fixed
overheads and the standard fixed overheads absorbed on
actual production. The formula is as follows:
• Example : From the following data calculate FOH
cost variance.
• Budgeted hours: 10,000 hours; Budgeted output:
5,000 units, Budgeted FOH: Br.3,000Actual hours:
12,000 hours; Actual output:4,800 units; Actual FOH:
Br.3,600
FOHEV=AHOH –BFOH
• = Br.3600 – Br.3000=.Br.600 (U)
FOHVV =BFOH –SFOH on actual output
• = Br.3000-(0.60x4800)
• = Br.3000 – 2880 * =.Br.120 (U)
*SFOH per unit = Br. 3000/5000= Br.0.60 per unit x 4,
End of chapter