Flexible Budgets and Variances

1. Flexible Budgets and Variances Identifying Problems and Opportunities

2. Flexible Budgets • Standard Inputs required to get actual outputs. • The Budget figure we would have used if we had known actual output in advance. • The flexible budget adjusts, after the fact, to give an expectation of what costs should have been for the actual output that we got.

3. Flexible Budget for Labor • Suppose that we normally use 3 labor hours for every unit that we produce and that we pay $10 per hour for labor. • If we plan on producing 100 units, our budget would be for 300 hours @ $10 per hour. • If we actually produced 80 units, our Flexible budget would be for 240 hours at $10 per hour

4. Flexible Budgets • In order to calculate the Flexible budget, it is necessary to know what actual output was. • It can only be calculated after we have completed the production for the year. • The flexible budget allows us to evaluate how efficiently we have used our inputs to produce our outputs.

5. Efficiency • Efficiency relates inputs to outputs. • We are more efficient if we get more output from a given amount of inputs or if we use less inputs for a given amount of output. • Effectiveness relates to the ability to accomplish a task or achieve a goal.

6. Variances • Variances compare actual results to budgeted results. • Variances highlight performance that is not in accordance with the budget and may require managerial attention. • Variances are either “favorable” or “unfavorable”. • Favorable variances generally result in income being higher than planned. • Unfavorable variances result in income being lower than planned.

8. Labor Price Variance • The Price or Rate Variance is caused by the actual wage being different from the standard wage. (P) • Price Variance = P * Qa • The “” term gives the variance its name. • Dollars per unit * Units = Dollars. • The quantity is the actual quantity.

9. Labor Efficiency Variance • The Efficiency or Quantity Variance is caused by the actual quantity of inputs being different from the standard quantity of inputs. (Q) • Quantity Variance = Q * Ps • Again, the“” term gives the variance its name. • Units * dollars per unit = dollars • The price is the standard price

10. Labor Variances - Example • Morgan Company generally uses 6 labor hours per unit at $12 per hour. They had planned to produce 5,000 units in October. • Morgan actually produced 6,000 units and used 38,000 hours paying $10 per hour.

11. Identification of Variables • Ps = $12 • Pa = $10 • Qa = 38,000 hours • Qs = 6 * 6,000 = 36,000 hours • Qs = standard inputs for actual outputs.

12. Calculation of Variances • Price Variance = P * Qa • = (12 - 10) * 38,000 • = $76,000 Favorable • Its favorable because it cost us less than standard. • Efficiency Variance = Q * Ps • =(38,000 - 36,000) * (12) • = $24,000 Unfavorable • Its unfavorable because we used more than we had planned for the output that we got.

13. Materials • What changes if we consider materials instead of labor? • Can we still get a price variance and an efficiency variance? • The only difference relates to Qa. • Is Qa the actual quantity purchased, or the actual quantity used in production?

14. Qa • The best Qa depends upon the variance we are calculating. • For the price variance, Qa is the quantity purchased, for the efficiency variance, Qa is the quantity used in production. • Other than this, the variances are calculated in the same way as for labor.

15. Materials Variances - Example • Morgan Company uses 8 pounds of materials for each unit they produce. They pay $6 per pound. They plan on producing 1,000 units in October. • During October, they actually produced 1,200 units. They used 10,000 pounds of materials. They purchased 9,000 pounds at $5 a pound.

16. Identification of Variables • Ps = $6 • Pa = $5 • Qused = 10,000 pounds • Qpurchased = 9,000 pounds • Qs = 8 * 1,200 = 9,600 pounds • Qs = standard inputs for actual outputs.

17. Calculation of Variances • Price Variance = P * Qpurchased • = (6-5) * 9,000 • = $9,000 Favorable • It is favorable because it cost less than expected • Efficiency Variance = Q * Ps • =(10,000 - 9,600) * (6) • = $2,400 Unfavorable • Its unfavorable because we used more than we had planned for the output that we got.

18. Overhead Variances • Overhead is separated into fixed and variable components before variances are computed. • There are two variable overhead variances and two fixed overhead variances.

19. Variable Overhead Variances • We use the same approach to variable overhead as we do for labor and materials. • We still calculate a price variance and an efficiency variance. • Sometimes the price variance is easier with a slightly different form of the equation.

20. Variable Overhead Price Variance • Price Variance = P * Qa • = (Ps- Pa) * Qa • = (Ps * Qa)- (Pa * Qa) • = (Ps * Qa)- VOHa • Ps is the variable overhead application rate

21. Observations of VOH Variances • If variable overhead is applied based upon labor hours, the Q’s for variable overhead will be the same as those for labor. • If variable overhead is applied based upon labor hours, the efficiency variances for labor and VOH will either both be favorable or both be unfavorable. • In any case, the Q for VOH is measured in terms of the allocation base or cost driver for VOH.

22. VOH Variances - Example • Morgan Company applies VOH based upon Direct labor hours. They generally use 6 labor hours per unit at $12 per hour and apply VOH at $6 per hour. • Morgan actually produced 6,000 units and used 38,000 hours. • Actual VOH was $247,000.

23. Identification of Variables • Ps = $6 • Qa = 38,000 hours • Qs = 6 * 6,000 = 36,000 hours • VOHa = 247,000 • Qs = standard inputs for actual outputs.

24. Calculation of Variances • Price Variance = (Ps * Qa)- VOHa • = (6 * 38,000) - 247,000 • = $19,000 Unfavorable • It is unfavorable because it cost more per hour than expected • Efficiency Variance = Q * Ps • =(38,000 - 36,000) * (6) • = $12,000 Unfavorable • Its unfavorable because we used more than we had planned for the output that we got.

25. Fixed Overhead Variances • There are 2 variances for fixed overhead, the spending variance and the volume variance. • The spending variance is similar to a price variance • The volume variance is similar to an efficiency variance.

26. Spending Variance • The spending variance is calculated by comparing the Actual Fixed overhead with the Budgeted Fixed Overhead. • If Actual is greater than Budgeted, it is Unfavorable. • If Actual is less than Budgeted, it is Favorable.

27. Volume Variance • The volume variance is calculated by comparing the fixed overhead applied to the fixed overhead budgeted. • It the applied is greater than the budgeted, it is favorable. (we got more output from a fixed input than we had expected) • It the applied is less than the budgeted, it is unfavorable. (we got less output from a fixed input than we had expected)

28. Fixed Overhead Variances - Example • Morgan Company estimates that they will produce 5,000 units during October and that their fixed overhead will be $90,000. • Morgan actually produced 6,000 units and had fixed overhead of $110,000. • Fixed Overhead is applied based upon labor hours, at 6 hours per unit.

29. Identification of Variables • Budgeted Fixed Overhead $90,000 • Actual Fixed Overhead $110,000 • Applied Fixed Overhead $108,000 • Applied = Qa * Std Hours per Unit * Application Rate • Applied = 6,000 * 6 * 3 • Application Rate = 90,000 / (5,000 * 6) = $3 per hour

30. Calculation of Variances • Spending Variance = Actual - Budget • = 110,000 - 90,000 • = $20,000 Unfavorable • Its unfavorable because it cost us more than standard. • Volume Variance = Budgeted - Applied • 90,000 - 108,000 • = $18,000 Favorable • Its favorable because we got more output than we had planned.