By: Mengistu

By: MengistuN.N. MU, CBE , DCS

Msc in
Msc inAccounting &
Acc...& Fin...
Finance Chapter 3: FLEXIBLE BUDGETS AND VARIANCE ANALYSIS

Chapter objectives:

3.1 Meaning of Flexible and static Budget, Variance and Variance Analysis

3.2 Steps for Developing Flexible Budgets

3.3 Flexible Budget Variance

3.3.1 Sales Volume Variance

3.3.2 Flexible Budget Variance

3.3.3 Efficiency and Price Variance for Inputs

3.4 Reasons for Variance

A variance is defined the difference between actual results and expected performance.

Variance analysis- is the process of computing the differences between actual results and
expected performance and identifying the causes of those differences.

Static Budgets and Static-Budget Variances

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 for Webb Company for
April 2011 that was prepared at the end of 2010. For each line item in the income statement, data
for the actual April results are presented bellow. For example, actual revenues are $1,250,000,
and the actual selling price is $1,250,000 ÷ 10,000 jackets = $125 per jacket—compared with the
budgeted selling price of $120 per jacket. Similarly, actual direct material costs are $621,600,
and the direct material cost per jacket is $621,600 ÷ 10,000 = $62.16 per jacket— compared with
the budgeted direct material cost per jacket of $60.
The static-budget variance is the difference between the actual result and the corresponding
budgeted amount in the static budget. A favorable variance—denoted F—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

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By: Mengistu N. MU, CBE , DCS

Msc in Acc...& Fin...

actual costs are less than budgeted costs. An unfavorable variance—denoted U— 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.
Illustration: Consider Webb Company, a firm that manufactures and sells jackets.
Webb has three variable-cost categories. The budgeted variable cost per jacket for each category
is as follows:

Budgeted and actual data for April 2011 follow:

Static-Budget-Based Variance Analysis for Webb Company for April 2011 is presented below
which is prepared based on the above data and actual fixed cost of $285,000 static budgeted
fixed cost of $ 276,000.

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By: Mengistu N. MU, CBE , DCS

Msc in Acc...& Fin...

The unfavorable static-budget variance for operating income of $93,100 is calculated by

subtracting static-budget operating income of $108,000 from actual operating income of
$14,900.
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 (April 2011), after the
actual output of 10,000 jackets is known. 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 10,000 jackets.
Steps to develop a flexible budget
There are three steps;
Step 1: Identify the Actual Quantity of Output. In April 2011, Webb produced and sold 10,000
jackets.
Step 2: Calculate the Flexible Budget for Revenues Based on Budgeted Selling Price and Actual
Quantity of Output.

Step 3: Calculate the Flexible Budget for Costs Based on Budgeted Variable Cost per

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By: Mengistu N. MU, CBE , DCS

Msc in Acc...& Fin...

Output Unit, Actual Quantity of Output, and Budgeted Fixed Costs.

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.

Sales-Volume Variances

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By: Mengistu N. MU, CBE , DCS

Msc in Acc...& Fin...

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.

The sales-volume variance in operating income for Webb measures the change in budgeted
contribution margin because Webb sold only 10,000 jackets rather than the budgeted 12,000.

What do you think about the reasons for this unfavorable variance (reading ass.?)
Flexible-Budget Variances

The operating income in the flexible-budget variance is $29,100 U ($14,900 – $44,000). The
$29,100 U arises because actual selling price, actual variable cost per unit and actual fixed costs
differ from their budgeted amounts. The actual results and budgeted amounts for the selling price
and variable cost per unit are as follows:

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:
What do you think about the reasons for this favorable variance (reading ass.?)

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By: Mengistu N. MU, CBE , DCS

Msc in Acc...& Fin...

Market-Share and Market-Size Variances

You have learnt about sales-volume variance, the difference between a flexible-budget amount
and the corresponding static-budget amount. The sales-volume variances for operating income
and contribution margin are the same. In the Webb example, this amount equals 64,000 U,
because Webb had a sales shortfall of 2,000 units (10,000 units sold compared to the budgeted
12,000 units), at a budgeted contribution margin of $32 (64, 000 / 12, 000) per jacket. Webb’s
managers can gain more insight into the sales-volume variance by subdividing it.
The sales-volume variance is also called the sales-quantity variance. Sales depend on overall
demand for jackets, as well as Webb’s share of the market.
Assume that Webb derived its total unit sales budget for April 2011 from a management estimate
of a 20% market share and a budgeted industry market size of 60,000 units (0.20* 60,000 units =
12,000 units). For April 2011, actual market size was 62,500 units and actual market share was
16% (10,000 units / 62,500 units = 0.16 or 16%). Exhibit 7-7 shows the columnar presentation of
how Webb’s sales-quantity variance can be decomposed into market-share and market-size
variances.

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By: Mengistu N. MU, CBE , DCS

Msc in Acc...& Fin...

Market-Share Variance
The market-share variance is the difference in budgeted contribution margin for actual market
size in units caused solely by actual market share being different from budgeted market share.
The formula for computing the market share variance is as follows:

Webb lost 4.0 market-share percentage points—from the 20% budgeted share to the actual share
of 16%. The $80,000 U market-share variance is the decline in contribution margin as a result of
those lost sales.
Market-Size Variance
The market-size variance is the difference in budgeted contribution margin at budgeted market
share caused solely by actual market size in units being different from budgeted market size in
units. The formula for computing the market size variance is as follows:

The market-size variance is favorable because actual market size increased 4.17% [(62,500 –
60,000) ÷ 60,000 = 0.417, or 4.17%] compared to budgeted market size.

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.

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By: Mengistu N. MU, CBE , DCS

Msc in Acc...& Fin...

Obtaining Budgeted Input Prices and Budgeted Input Quantities

To calculate price and efficiency variances, Webb needs to obtain budgeted input prices and
budgeted input quantities. Webb’s three main sources for this information are:
1. Actual input data from past periods.
2. Data from other companies that have similar processes.
3. Standards developed by Webb.
The term “standard” refers to many different things. Always clarify its meaning and how it is
being used. A standard input is a carefully determined quantity of input—such as square yards
of cloth or direct manufacturing labor-hours—required for one unit of output, such as a jacket. A
standard price is a carefully determined price that a company expects to pay for a unit of input.
In the Webb example, the standard wage rate that Webb expects to pay its operators is an
example of a standard price of a direct manufacturing labor-hour. A standard cost is a carefully
determined cost of a unit of output—for example, the standard direct manufacturing labor cost of
a jacket at Webb.

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 manufacturing labor cost per jacket: 0.8 manufacturing labor-hour of input
allowed per output unit manufactured, at $20 standard price per hour

How are the words “budget” and “standard” related? Budget is the broader term. To clarify,
budgeted input prices, input quantities, and costs need not be based on standards.
As we saw previously, they could be based on past data or competitive benchmarks, for example.
However, when standards are used to obtain budgeted input quantities and prices, the terms
“standard” and “budget” are used interchangeably. The standard cost of each input required for
one unit of output is determined by the standard quantity of the input required for one unit of
output and the standard price per input unit.

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By: Mengistu N. MU, CBE , DCS

Msc in Acc...& Fin...

Data for Calculating Webb’s Price Variances and Efficiency Variances

Illustration: 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:

Price variance

The formula for computing the price variance is as follows:

Price variances for Webb’s two direct-cost categories are as follows

Always consider a broad range of possible causes for a price variance. For example,
Webb’s favorable direct materials price variance could be due to one or more of the following:
_ Webb’s purchasing manager negotiated the direct materials prices more skillfully than was
planned for in the budget.
_ The purchasing manager changed to a lower-price supplier.
_ Webb’s purchasing manager ordered larger quantities than the quantities budgeted, thereby
obtaining quantity discounts.
_ Direct material prices decreased unexpectedly because of, say, industry oversupply.
_ Budgeted purchase prices of direct materials were set too high without careful analysis of
market conditions.
_ The purchasing manager received favorable prices because he was willing to accept
unfavorable terms on factors other than prices (such as lower-quality material).

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By: Mengistu N. MU, CBE , DCS

Msc in Acc...& Fin...

Efficiency Variance
For any actual level of output, the efficiency variance is the difference between actual quantity of
input used and the budgeted quantity of input allowed for that output level, multiplied by the
budgeted input price:

The efficiency variances for each of Webb’s direct-cost categories are as follows:

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By: Mengistu N. MU, CBE , DCS

Msc in Acc...& Fin...

As with price variances, there is a broad range of possible causes for these efficiency variances.
For example, Webb’s unfavorable efficiency variance for direct manufacturing labor could be
because of one or more of the following:
_ Webb’s personnel manager hired under skilled workers.
_ Webb’s production scheduler inefficiently scheduled work, resulting in more manufacturing
labor time than budgeted being used per jacket.
_ Webb’s maintenance department did not properly maintain machines, resulting in more
manufacturing labor time than budgeted being used per jacket.
_ Budgeted time standards were set too tight without careful analysis of the operating conditions
and the employees’ skills.
Variable Overhead Cost Variances
We now illustrate how the budgeted variable overhead rate is used in computing Webb’s variable
overhead cost variances. The following data are for April 2011, when Webb produced and sold
10,000 jackets:

As we have seen earlier, the flexible budget enables Webb to highlight the differences between
actual costs and actual quantities versus budgeted costs and budgeted quantities for the actual
output level of 10,000 jackets.
Flexible-Budget Analysis-The variable overhead flexible-budget variance measures the
difference between actual variable overhead costs incurred and flexible-budget variable overhead
amounts.

This $10,500 unfavorable flexible-budget variance means Webb’s actual variable overhead
exceeded the flexible-budget amount by $10,500 for the 10,000 jackets actually produced and

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By: Mengistu N. MU, CBE , DCS

Msc in Acc...& Fin...

sold. Webb’s managers would want to know why actual costs exceeded the flexible-budget
amount. Webb’s managers can get further insight into the reason for the $10,500 unfavorable
variance by subdividing it into the efficiency variance and spending variance.
Variable Overhead Efficiency Variance
The variable overhead efficiency variance is the difference between actual quantity of the cost-
allocation base used and budgeted quantity of the cost-allocation base that should have been used
to produce actual output, multiplied by budgeted variable overhead cost per unit of the cost-
allocation base.

Variable Overhead Spending Variance

The variable overhead spending variance is the difference between actual variable overhead cost
per unit of the cost-allocation base and budgeted variable overhead cost per unit of the cost-
allocation base, multiplied by the actual quantity of variable overhead cost-allocation base used
for actual output.

Reading assignment (part of your exam)

Refer any cost and management accounting book and read about fixed overhead variances
Direct Materials Mix and Direct Materials Yield Variances

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By: Mengistu N. MU, CBE , DCS

Msc in Acc...& Fin...

Managers sometimes have discretion to substitute one material for another. The manager of
Delpino’s ketchup plant has some leeway in combining Latoms, Caltoms, and Flotoms without
affecting the ketchup’s quality. We will assume that to maintain quality, mix percentages of each
type of tomato can only vary up to 5% from standard mix. For example, the percentage of
Caltoms in the mix can vary between 25% and 35% (30% } 5%). When inputs are
substitutable, direct materials efficiency improvement relative to budgeted costs can come from
two sources: (1) using a cheaper mix to produce a given quantity of output, measured by the
direct materials mix variance, and (2) using less input to achieve a given quantity of output,
measured by the direct materials yield variance.
Holding actual total quantity of all direct materials inputs used constant, the total direct
materials mix variance is the difference between (1) budgeted costs for actual mix of actual
total quantity of direct materials used and (2) budgeted cost of budgeted mix of actual total
quantity of direct materials used. Holding budgeted input mix constant, the direct materials
yield variance is the difference between (1) budgeted cost of direct materials based on actual
total quantity of direct materials used and (2) flexible-budget cost of direct materials based on
budgeted total quantity of direct materials allowed for actual output produced. Direct Materials
Mix Variance
The total direct materials mix variance is the sum of the direct materials mix variances for each
input:

The direct materials mix variances are as follows:

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By: Mengistu N. MU, CBE , DCS

Msc in Acc...& Fin...

The total direct materials mix variance is favorable because relative to the budgeted mix,
Delpino substitutes 5% of the cheaper Caltoms for 5% of the more-expensive Flotoms.
Direct Materials Yield Variance
The direct materials yield variance is the sum of the direct materials yield variances for each
input:

The direct materials yield variances are as follows:

The total direct materials yield variance is unfavorable because Delpino used 6,500 tons of
tomatoes rather than the 6,400 tons that it should have used to produce 4,000 tons of ketchup.

Reading assignment (which will be part of your exam)

Refer any cost and management accounting book and read direct labor mix and yield variances

Sales-Mix Variance

The sales-mix variance is the difference between (1) budgeted contribution margin for the actual
sales mix and (2) budgeted contribution margin for the budgeted sales mix. The formula and
computations (using data from p. 519) are as follows:

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By: Mengistu N. MU, CBE , DCS

Msc in Acc...& Fin...

Exercise; the Payne Company manufactures two types of vinyl flooring. Budgeted and actual
operating data for 2012 are as follows:

Required: Compute the sales-mix variance

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By: Mengistu N. MU, CBE , DCS

Msc in Acc...& Fin...

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