A fixed budget performance report not only compares results, but also indicates if the variances are

Budget reports compare budgeted results to actual results.

A master budget is based on a predicted level of activity, such as sales volume, for the budget period. In preparing a master budget, two alternative approaches can be used: fixed budgeting or flexible budgeting.

A fixed budget, also called a static budget, is based on one predicted amount of sales or other activity measure.

A flexible budget, also called a variable budget, is based on more than one amount of sales or other activity measure.

Exhibit 21.2 shows a fixed budget performance report, a report that compares actual results with the results expected under a fixed budget. January’s fixed budget for the guitar maker is based on 100 units, but 140 units were actually sold. The far-right column shows the variances between the budgeted and actual dollar amounts for each budget item. We use the letters F and U to identify variances.

A fixed budget report is limited because it is not an apples-to-apples comparison based on similar levels of activity. In Exhibit 21.2, the budgeted amounts use 100 units of activity, but 140 units were actually sold.

Favorable variance (F): when actual income is higher than budgeted income. It is also when actual revenue is higher than budgeted revenue or when actual cost is lower than budgeted cost.

Unfavorable variance (U): when actual income is lower than budgeted income. It is also when actual revenue is lower than budgeted revenue, or when actual cost is higher than budgeted cost.

A flexible budget prepared after the period ends helps evaluate performance. It is an apples-to-apples comparison because budgeted activity level equals actual activity level. Comparisons of actual results with budgeted performance at the same activity level are more likely to reveal the real causes of any variances. Managers then focus attention on problems resulting in unfavorable variances and opportunities resulting in favorable variances.

Flexible Budgeted Equation for Total Budgeted Costs: flexible budgets can be prepared at any activity level using the following formula:

Total Budgeted Costs = Total Fixed Costs + (Total Variable Cost Per Unit x Units of Activity).

Let’s see how flexible budgeting works by preparing flexible budgets for 10,000 units, 12,000 units, and 14,000 units for SolCel. Notice that SolCel’s costs have been classified by behavior, either variable or fixed, in the flexible budget. The flexible budget follows a contribution margin format beginning with sales followed by variable costs and then fixed costs.

For SolCel, the flexible budget is based on 12,000 units produced and sold for January.
Management often focuses on large variances. Exhibit 21.4 shows a $5,000 favorable variance in dollar sales. Because actual and budgeted sales volumes are both 12,000 units, the $5,000 favorable sales variance must have resulted from a higher-than-expected selling price. Management would like to determine if the conditions that resulted in higher selling prices will continue.

Both the direct materials ($1,000 U) and direct labor ($2,000 U) variances are relatively large and unfavorable. On the other hand, a relatively large favorable variance is observed for sales commissions ($900 F). Management will try to determine the causes for these variances, both favorable and unfavorable, and make changes to operations if needed.

Standard costs are preset costs for delivering a product or service under normal conditions. We can think of standard costs as budgeting on a per unit basis. We expect to operate within the standard cost allowances under normal conditions. Production managers and engineers often determine the production requirements for one unit of product, and accountants put those requirements into dollars.

When actual costs vary from standard costs, management follows up to identify potential problems and take corrective actions. Management by exception means that managers focus attention on the most significant differences between actual costs and standard costs.

Budgets are prepared using standard costs.

Standard costs can also help control nonmanufacturing costs. Companies providing services instead of products can also benefit from the use of standard costs. For example, while quality medical service is crucial, efficiency in providing that service is also important in controlling medical costs. The use of budgeting and standard costing is effective in controlling costs, especially overhead.

The standard direct labor rate should include allowances for employee breaks, cleanup, and machine downtime. Most companies use practical rather than ideal standards.

Standards for direct labor are set by time and motion studies that show the direct labor hours required under normal operations.

Standards for direct materials are set by studying the quantity, grade, and cost of each material used.

Overhead standards are set by studying the resources needed to support production activities.

Standards should be challenging but attainable and should acknowledge machine breakdowns, material waste, and idle time.

Direct labor Two hours of direct labor are required to manufacture a bat. The direct labor rate is $15 per hour. This rate includes wages, taxes, and direct benefits.

Overhead ProBat applies overhead at the rate of $5 per direct labor hour (DLH).

The standard costs of direct materials, direct labor, and overhead for one bat, manufactured by ProBat, are shown on this slide. This is called a standard cost card.

If actual costs are less than standard costs, variance is favorable (F).
If actual costs are greater than standard cost, variance is unfavorable (U).

A cost variance is further defined by its components. Actual quantity (AQ) is the actual amount of direct material or direct labor used to manufacture the actual quantity of output. Standard quantity (SQ) is the standard input expected for the actual quantity of output. Actual price (AP) is the actual amount paid to acquire the actual direct material or direct labor used for the period, and standard price (SP) is the standard price of direct material or direct labor.

Price variances result when we pay an actual price for a resource that differs from the standard price that should have been paid. Quantity variances are caused by using an actual amount of a resource that differs from the standard amount that should have been used.

Managers sometimes find it useful to use alternative formulas for price and quantity variances, as in Exhibit 21.9. Results from applying the formulas in Exhibits 21.8 and 21.9 are identical.

Its materials standard shows that it should have used 1,750 pounds of direct materials to produce 3,500 units (0 .5 lb. per unit). Using the standard cost of $20 per pound, we get the standard cost of $35,000 for 3,500 units. Its direct materials variance is $2,800 Unfavorable.

To identify the causes of this $2,800 unfavorable (U) variance, the materials price and quantity variances are analyzed in Exhibit 21.10. The $1,800 unfavorable price variance results from paying $1 more per pound than the standard price, then multiplied by the 1,800 actual pounds purchased and used. The $1,000 unfavorable quantity variance results from using 50 pounds more of material than the standard quantity, then multiplied by the $20 per pound standard cost.

The production department is responsible for the quantity of direct material used. The production department might have used more than the standard amount of material because low quality material caused excessive waste. In this case, the purchasing manager must explain why inferior materials were acquired. However, if that waste was due to inefficiencies, not poor-quality materials, the production manager must explain why. In sum, variance analysis along with corrective action can improve future performance.

G-Max should have used 1,750 direct labor hours to produce 3,500 units (0.5 DLH per unit). Using the standard cost of $32 per DLH, we get the standard cost of $56,000 for 3,500 units; see second row in table. Its direct labor variance is $100 U.

Actual direct labor cost is $100 over the standard, which might suggest no concern. A closer look reveals a problem. The direct labor variance can be divided into price and quantity variances, called rate and efficiency variances. Exhibit 21.11 shows the $100 total unfavorable labor variance results from a $1,600 favorable efficiency variance and a $1,700 unfavorable rate variance.

The production manager should explain how direct labor hours were reduced. If this efficiency can be repeated and transferred to other departments, more savings are possible.

The $1,700 U rate variance results from paying a rate that is $1 per hour higher than the standard ($33 actual rate - $32 standard rate). Each of the 1,700 actual direct labor hours used costs $1 more, resulting in the $1,700 unfavorable rate variance. Human resources or the production manager needs to explain why the wage rate is higher than the standard.

We begin by showing how to use standard costs to develop flexible overhead budgets. The left two number columns of Exhibit 21.12 show the budgeted variable costs per unit and fixed costs for May. With these variable and fixed overhead costs, G-Max can prepare flexible overhead budgets at different capacity levels (see rightmost number columns). At its maximum capacity of 100%, G-Max can produce 5,000 clubheads. At 70% of capacity, G-Max can produce 3,500 clubheads (5,000 × 70%). At 100% capacity, total variable overhead costs are budgeted at $10,000 (5,000 × $2). At 70% capacity, total variable overhead costs are budgeted at $7,000 (3,500 × $2). At all capacity levels within the relevant range, fixed overhead costs are budgeted at $12,000 per month.

Step 1: Determine an Allocation Base – The allocation base is a measure of input related to overhead costs. Examples include direct labor hours or machine hours. G-Max uses direct labor hours as an allocation base and it has a standard of 0.5 direct labor hour per unit.

Step 2: Predict an Activity Level - The predicted activity level is not set at 100% of capacity. Difficulties in scheduling work, equipment breakdowns, and low product demand typically cause the activity level to be less than full capacity. G-Max managers predicted an 80% activity level for May, or a production volume of 4,000 clubheads. We assume all units produced are sold.

Step 3: Compute the Standard Overhead Rate -- At the predicted activity level of 4,000 units, the flexible budget in Exhibit 21.12 shows total overhead of $20,000. To make 4,000 units, the standard direct labor hours required are 2,000 DLH computed as 4,000 units × 0.5 DLH per unit. The standard overhead rate is used to compute overhead cost variances. Standard overhead rate depends on the predicted activity level.

We can separate the overhead rate into two rates: one for variable overhead (VOH) and one for fixed overhead (FOH). Both rates are computed using numbers in the 80% column from Exhibit 21.12.

Standard overhead applied = Actual x Standard amount of x Standard overhead rate
production allocation base (at predicted activity level)

  Standard overhead applied = 3,500 units x 0.5 Direct labor hour per unit x $10 per DLH = $17,500

  Actual total overhead often differs from the standard overhead applied. The difference between the actual total overhead and the standard amount of overhead applied is the overhead variance shown on this slide.

Overhead variance = Actual total overhead minus Standard overhead applied

Overhead variance = $18,150 - $17,500 = $650 Unfavorable

The variance is unfavorable because actual overhead is higher than the standard.

A volume variance is the difference between budgeted overhead and the standard overhead applied at the actual units produced. It occurs when the company operates at a different capacity level than was predicted. G-Max expected to manufacture 4,000 units, but it only manufactured 3,500 units. The volume variance is usually considered outside the control of the production manager, which is why it is also titled noncontrollable variance. Volume variance is computed as shown in Exhibit 21.15.

G-Max’s budgeted overhead is $19,000 at 3,500 units as shown in Exhibit 21.12. Standard overhead applied is $17,500. This results in the following $1,500 volume variance. The volume variance is unfavorable because G-Max made 500 fewer units than predicted.

Controllable variance = Actual total overhead − Budgeted (flexible) total overhead at actual units produced

= $18,150 - $19,000 = $850 (favorable)

The controllable variance is a part of the overhead variance under the production manager’s control. Actual total overhead is $18,150 (given). Flexible budget total overhead at 3,500 units is $19,000 as shown in Exhibit 21.12. Controllable variance is as shown on this slide.

The listing of individual overhead costs reveals the following sources of the $850 unfavorable controllable variance: (1) Actual costs for indirect materials, indirect labor, and maintenance were lower than budgeted. (2) Actual costs for power and lights were higher than budgeted. (3) Fixed supervisory salaries were lower than budgeted. Management uses the overhead variance report to identify controllable overhead costs to investigate.

The $1,500 unfavorable volume variance means the company did not reach its predicted activity level. While 80% of manufacturing capacity was budgeted, only 70% was used.

Management needs to know why the actual level of production differs from the predicted level. The reasons for failing to meet the predicted production level are often due to factors, such as customer demand that are beyond the production manager’s control.

Managers use sales variances for planning and control. G-Max sold 90 combined total units (both balls and drivers) more than budgeted, yet its total sales price and sales volume variances are unfavorable. The unfavorable sales price variance is due mainly to a decrease in the selling price of Big Bert drivers by $10 per unit. Management must assess whether this price decrease should continue. The unfavorable sales volume variance is due to G-Max selling fewer Big Bert drivers (140) than were budgeted (150). Management must assess whether this decreased demand for Big Bert drivers will persist.

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.

An efficiency variance occurs when standard direct labor hours (the allocation base) expected for actual production differ from the actual direct labor hours used.

With this information, we compute overhead variances for both variable and fixed overhead as follows. To help better isolate the causes of these variances, more detailed overhead variances can be used, as we show next.

G-Max reports actual variable overhead of $6,350, or $450 less than budgeted. This means G-Max has a favorable variable overhead spending variance of $450 ($6,800 − $6,350). G-Max also used 50 fewer direct labor hours than budgeted to make 3,500 units. Thus, G-Max has a favorable variable overhead efficiency variance of $200 ($7,000 − $6,800).

We showed how to compute the $1,500 unfavorable volume variance in the chapter and its calculation is repeated in Exhibit 21A.4.

The first entry records standard direct materials cost of $35,000 in the Work in Process Inventory account. This entry credits Raw Materials Inventory for the actual cost of direct materials used of $37,800. The difference between standard and actual direct materials costs is recorded with debits to two separate direct materials variance accounts (recall Exhibit 21.10). Both direct materials price and quantity variances are recorded as debits because they reflect additional costs higher than the standard cost (if actual costs are less than the standard, they are recorded as credits).

The balances of these different variance accounts accumulate until the end of the accounting period. As a result, the unfavorable variances of some months can offset the favorable variances of other months.

These ending variance account balances, which reflect results of the period’s various transactions and events, are closed at period-end. If the amounts are immaterial, they are added to or subtracted from the balance of the Cost of Goods Sold account. This process is similar to that shown in the job order costing chapter for eliminating an underapplied or overapplied balance in the Factory Overhead account.

In addition to budget reports, management can use a standard costing income statement to summarize company performance for a period. This income statement reports sales and cost of goods sold at their standard amounts, and then lists individual sales and cost variances to compute gross profit at actual cost. Unfavorable cost variances are added to cost of goods sold at standard cost; favorable cost variances are subtracted from cost of goods sold at standard cost.