This document discusses flexible budgets and standards. It begins by describing the difference between static and flexible budgets. It then discusses how standard costs are established and why standard cost systems are used, including for planning, controlling costs, motivating workers, and evaluating performance. The document outlines the development of a standard cost system, including setting standards for materials, labor, and overhead. It also covers variances and variance analysis in standard costing.
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Chapter Three
This document discusses flexible budgets and standards. It begins by describing the difference between static and flexible budgets. It then discusses how standard costs are established and why standard cost systems are used, including for planning, controlling costs, motivating workers, and evaluating performance. The document outlines the development of a standard cost system, including setting standards for materials, labor, and overhead. It also covers variances and variance analysis in standard costing.
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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
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