CHAPTER FLEXIBLE BUDGETS, VARIANCES, AND MANAGEMENT CONTROL: I LEARNING OBJECTIVES Distinguish a static budget from a flexible budget Develop a flexible budget and compute flexible-budget variances and sales-volume variances Explain why standard costs are often used in variance analysis Compute price variances and efficiency variances for direct-cost categories Explain why purchasing performance measures should focus on more factors than just price variances Integrate continuous improvement into variance analysis Perform variance analysis in activity-based costing systems Describe benchmarking and how it can be used in cost management CHAPTER OVERVIEW Chapter illustrates specific tools used by accountants for providing managers information for improved decision making The tool developed from the assumptions and use of cost behavior in relation to volume found in cost-volume-profit analysis is that of the flexible budget Having the ability to compare what actually happened with what “should have” happened furnishes the accountant with another helpful tool, variance analysis As illustrated in the chapter, the calculation of a variance is the process of closely examining the details of the static budget, that one point ideal or bull’s eye, with the point of actual impact (dart thrown at the bull’s eye) by use of multiple flexible budgets acting as concentric rings emanating from the ideal By increasing the level of detail, more opportunity exists for comparison and more levels of variance calculation In the previous chapter, the emphasis was on the planning aspect of budgeting This chapter incorporates the control aspect of the study of budgeting Control, as defined in Chapter 1, “comprises (a) taking actions that implement the planning decisions, and (b) deciding how to evaluate performance and what feedback to provide that will help future decision making.” Thus the action taken with actual results are compared to planned or budgeted amounts for control purposes Of special interest is the use of flexible budgets and variance analysis in performance measurement and evaluation as an aspect of control Caution is always necessary when evaluating the performance of individuals In keeping with the key management accounting guideline of behavior consideration, the authors highlight that the important task is to understand why variances arise and to use that knowledge to promote learning and continuous improvement Flexible Budgets, Variances, and Management Control: I 87 CHAPTER OUTLINE I Budgets—aiding managers in their control functions [Chapter Budgets—assisting managers in their planning function] A Variances: differences between amount based on actual result and amount supposed to be according to budget amount Management by exception: practice of concentrating on areas not operating as expected and giving less attention to areas operating as expected Performance evaluation use Strategy changes possible Learning Objective 1: Distinguish a static budget from a flexible budget B Static budgets and flexible budgets Static budget: budget for a single planned output level at the start of the budget period Flexible budget: adjusted (flexed) to recognize actual output level of budget period and help managers gain more insight into causes of variances than available from static budgets C Static budget variances: difference between actual result and corresponding amount in static budget [Exhibits 7-1and 7-4] Various levels of detail reported [Levels – in this chapter with as least detail] a Level – Static-budget variance: static budget to actual results–operating income only b Level – Static-budget variance: static budget to actual results by line items Variance designations in reference to operating income a Favorable variance: effect of increasing operating income relative to budgeted amount b Unfavorable variance: effect of decreasing operating income relative to budgeted amount Do multiple choice Assign Exercise 7-16 Learning Objective 2: Develop a flexible budget and compute flexible-budget variances and sales-volume variances II Steps in developing a flexible budget 88 Chapter A Assumption: all costs either variable with respect to output unit produced or fixed B Three-step procedure [Exhibit 7-2] Identify the actual quantity of output Calculate the flexible budget for revenues based on budgeted selling price and actual quantity of output Calculate the flexible budget for costs based on budgeted variable costs per output unit, actual quantity of output, and the budgeted fixed costs C Level 2—Variances [Exhibit 7-4] Difference due to inaccurate forecasting of output units sold a Sales-volume variance: difference caused solely by difference in volume sold and volume expected to be sold in static budget—hence the name b Variance calculated because budget developed based on volume sold—flexible budget c Response to variance influenced by presumed cause of variance Difference due to company’s performance a Flexible-budget variance: difference between actual results and flexible-budget amounts b Selling-price variance: solely pertains to revenues (selling price—actual to budgeted) c Variance analysis: provides suggestions for further investigation not evidence of good or bad performance Do multiple choice and Assign Exercises 7-17, 7-23, and 7-24 D Level 3—Variances for direct cost inputs Sources of information for budgeted input prices and quantities a Actual input data from past periods b Data from other companies that have similar processes Learning Objective 3: Explain why standard costs are often used in variance analysis c Standards developed by company [Surveys of Company Practice] i Standard: carefully predetermined price, cost, or quantity based on efficient operations and usually expressed on a per unit basis Flexible Budgets, Variances, and Management Control: I 89 ii Standard input: carefully predetermined quantity of inputs required for one unit of output iii Standard price: carefully determined price expected to pay for a unit of input iv Standard cost: carefully predetermined cost of a unit of output d Standard can be used to obtain budgeted amounts but budget is broader term e Standards can be set as attainable through efficient operations or as ideal or theoretical Do multiple choice [See next section for assignment using standards.] Learning Objective 4: Compute price variances and efficiency variances for direct-cost categories TEACHING TIP: See note at end of this Outline section before Chapter Quiz Solutions Price variance [Exhibits 7-3 and 7-4] a Difference between the actual price and the budgeted price multiplied by actual quantity of input b Also known as input-price variance or rate variance c Response to variance influenced by presumed cause of variance [Concepts in Action] Efficiency variance [Exhibits 7-3 and 7-4] a Difference between actual quantity of input used and budgeted quantity of input that should have been used to produce the actual output, multiplied by the budgeted price b Also known as usage variance c Response to variance influenced by presumed cause of variance [Concepts in Action] Impact of inventories on calculation of variances a Variance analysis concepts apply whether quantities are purchased and used within the same period or quantities purchased differ from those used within the same period b Computation and interpretation of variances may differ if quantities purchased differ from quantities used within the same time period [Exhibit 7-6] Do multiple choice and Assign Exercises 7-19 and 7-20 and Problems 7-36, 7-37, 7-39, 7-40 Learning Objective 5: Explain why purchasing performance measures should focus on more factors than just price variances III Managerial uses of variances 90 Chapter A Performance measurement using variances Two attributes of performance commonly measured a Effectiveness: the degree to which a predetermined objective or target is met b Efficiency: the relative amount of inputs used to achieve a given level of output Caution: Understand the cause(s) of a variance before using it as a performance measure a Focus should be on reducing the total costs of the company as a whole b Excessive emphasis on a single performance measure may conflict with achievement of overall company goals B Multiple causes of variances and organizational learning Always consider possible interdependencies among variances; not interpret them in isolation of each other Use broad perspective of actions taken in the supply chain of organizations (supply chain: flow of goods, services, and information from purchase of materials to delivery of products to consumers regardless of whether those activities occur in same organizations or other organizations) Focus on understanding why variances arise and how to use that understanding to learn and improve performance –most important task in variance analysis C Delicately balance two uses of variances: performance evaluation and organization learning Use cost-benefit test to decide when and which variances should be investigated Realize that the standard is a range of possible acceptable outcomes Do multiple choice Assign Problem 7-34 Learning Objective 6: Integrate continuous improvement into variance analysis Continuous improvement a Use of continuous improvement budgeted cost: cost that is progressively reduced over succeeding time periods b Use of varied rates for products that have just started to those in production for several years Financial and nonfinancial performance measures IV Standard costing Flexible Budgets, Variances, and Management Control: I 91 A Journal entries for use with standard costs Unfavorable cost variances always debits (reduce operating income) and favorable cost variances always credits (increase operating income) Simplified product costing as actual costs not have to be tracked Variances isolated at earliest possible time Variances written off or dealt with as described in Chapter B Standard costing and information technology: facilitates usage C Wide applicability of standard costing systems with other systems by use for control of costs Do multiple choice Assign Exercises 7-27, 7-28, 7-29, 7-30, and 7-31 Learning Objective 7: Perform variance analysis in activity-based costing V Flexible budgeting and activity-based costing A Focus on individual activities as the fundamental cost objects B Classification of costs into cost hierarchy Output-unit level costs: direct costs of materials and manufacturing labor Batch-level costs: illustrated with material-handling costs a Step 1: Using the budgeted batch size, calculate the number of batches in which the actual output units should have been produced b Step 2: Using the budgeted material-handling labor-hours per batch, calculate the number of material-handling labor-hours that should have been used c Step 3: Using the budgeted cost per material-handling labor-hour, calculate the flexiblebudget amount for material-handling labor-hours d Examine price and efficiency components of flexible-budget variance Product-sustaining costs: focus flexible-budget on costs at that level Facility-sustaining costs: focus flexible-budget on costs at that level Do multiple choice Assign Problems 7-41 and 7-42 Learning Objective 8: Describe benchmarking and how it can be used in cost management 92 Chapter VI Benchmarking and variance analysis [Exhibit 7-5] A Benchmarking: continuous process of comparing the level of performance in producing products and services and doing activities against the best levels of performance B Problem of ensuring comparability between organization and chosen benchmark Problems of ensuring benchmark numbers are comparable Problems of nonfinancial comparisons and need to consider differences C Value of management accountants in providing insight into why costs or revenues differ across companies or plants as opposed to simply reporting magnitude of such differences Do multiple choice 10 Assign Exercises 7-25 and 7-26 TEACHING TIP: The columnar approach to variance analysis seems easier for most students to understand because it is so easy to “see” or visualize As one works from actual results to planned amounts based on actual level of output, one works with one change at a time The item that changes from one column to the next is the name of the variance in most cases For example, using Level variances of price and efficiency, the columns are headed – AIQ x AP AIQ x BP Price variance SIQ (allowed for actual output) x BP Efficiency variance If the price varies from AP (actual price) to BP (budgeted price that may be the standard price if budgeting was done using standard prices), then the input quantity must stay the same, AIQ The same holds true for the change of input quantity in which the price must stay the same (BP) Students will often be confused by the “two actual quantities” of which one is an input actual quantity of direct materials purchased/used or direct manufacturing labor hours The other actual quantity is an output quantity used for the allowed quantity of input The difference in an item of direct material and an item of finished goods – the start and end of the conversion process Flexible budgets can be developed “after the fact” and therefore use actual output quantity as a basis Sometimes it is helpful to incorporate the journal entries (illustrated in the chapter) with the variance analysis The amounts for the journal entries can be noted as AIQ x BP for purchases of direct materials, debited to Direct Materials Inventory with a corresponding credit to Accounts Payable of AIQ x AP Also note the purchase-price variance for direct materials used in the Self-Study Problem for the chapter The middle column if simply labeled “Actual Input x Budgeted Price” because actual input can be either actual input quantity purchased or actual input quantity used (Exhibit 7-6) CHAPTER QUIZ SOLUTIONS: 1.b 2.c 3.a 4.b 5.c 6.d 7.a 8.c 9.a 10.d Flexible Budgets, Variances, and Management Control: I 93 CHAPTER QUIZ [CMA Adapted] Flexible budgets a b c d accommodate changes in the inflation rate accommodate changes in activity levels are used to evaluate capacity utilization are static budgets that have been revised for changes in prices [CMA Adapted} The following information is available for the Gabriel Products Company for the month of July: Static Budget Units 5,000 Sales revenue $60,000 Variable manufacturing costs $15,000 Fixed manufacturing costs $18,000 Variable marketing and administrative expense $10,000 Fixed marketing and administrative expense $12,000 Actual 5,100 $58,650 $16,320 $17,000 $10,500 $11,000 The total sales-volume variance for the month of July would be a $2,550 unfavorable b $1,350 unfavorable c $2,030 unfavorable d $2,030 favorable Which of the following is not an advantage for using standard costs for variance analysis? a b c d d $100 favorable [CMA Adapted] Bartholomew Corporation’s master budget calls for the production of 6,000 units of product monthly The master budget includes indirect labor of $396,000 annually; Bartholomew considers indirect labor to be a variable cost During the month of September, 5,600 units of product were produced, and indirect labor costs of $30,970 were incurred A performance report utilizing flexible budgeting would report a flexible budget variance for indirect labor of a $170 unfavorable b $170 favorable c $700 favorable Standards simplify product costing Standards are developed using past costs and are available at a relatively low cost Standards are usually expressed on a per unit basis Standards can take into account expected changes planned to occur in the budgeted period Information on Pruitt Company’s direct-material costs for the month of July 2003 was as follows: Actual quantity purchased 30,000 units Actual unit purchase price $2.75 Materials purchase-price variance —unfavorable (based on purchases) $1,500 Standard quantity allowed for actual production 24,000 units Actual quantity used 22,000 units [CPA Adapted] For July 2003 there was a favorable direct-materials efficiency variance of a $7,950 94 Chapter b $5,500 c $5,400 d $5,600 6 Information for Garner Company’s direct-labor costs for the month of September 2003 is as follows: Actual direct-labor hours Standard direct-labor hours Total direct-labor payroll Direct-labor efficiency variance—favorable 34,500 hours 35,000 hours $241,500 $ 3,200 [CPA Adapted] What is Garner’s direct-labor price (or rate) variance? a $21,000 favorable b $21,000 unfavorable c $17,250 unfavorable d $20,700 unfavorable Performance evaluation using variance analysis should guard against a b c d emphasis on a single performance measure emphasis on total company objectives basing effect of a manager’s action on total costs of the company as a whole highlighting individual aspects of performance Which of the following statements does not describe continuous improvement? a Continuous improvement can be readily incorporated into budgets b A product may have higher budgeted improvement rates during initial production than the budgeted improvement rates for products that have been manufactured for longer periods c A company using continuous improvement is signaling that it is in trouble because of its costs d Variances and flexible budgets can be used to measure performance such as continuous improvement The basic principles and concepts of variance analysis can be applied to activity-based costing a b c d by application as to the levels of cost hierarchy through careful classification of costs as direct and indirect as applied to the product or job with use of standard costing systems only only through those activities related to individual units of product or service 10 Benchmarking is a b c d relatively easy to with the amount of available financial information about companies best done with the best in their field regardless of type of company simply reporting the magnitude of differences in costs or revenues across companies making comparisons to direct attention to why differences in costs exist across companies Flexible Budgets, Variances, and Management Control: I 95 WRITING/DISCUSSION EXERCISES Distinguish a static budget from a flexible budget How is the preparation of a flexible budget like a parent or coach instructing a child? Flexible budgets are usually prepared “after the fact” or when the actual results are known In this way, the preparation of a flexible budget is based upon the “oughts” and “shoulds” of how something could have happened Many times one instructs another person by comparing what did happen with what could have happened by using the phrase “You ought to have ” or “You should have ” done such-andsuch The static budget is the plan that is used to develop a flexible budget so the actual results are appropriately compared to a budget based upon the same level of performance When a student or child has done something (actual behavior), then the coach or parent can specifically instruct for the situation in point (desired behavior) Develop a flexible budget and compute flexible-budget variances and sales-volume variances What is the “flex” in a flexible budget? The budgeted selling price and budgeted variable costs that stay the same per unit (within the relevant range) are used to configure the flexible budget The fixed costs stay the same in total in each flexible budget as they are in the static budget (relevant range) The assumptions and concepts of cost-volume-profit analysis are used in the developing of budgets at any given level of output or sales—within the relevant range The use of the cost behavior based upon variable and fixed in relation to volume has enabled accountants to provide managers with useful information for controlling as well as planning Explain why standard costs are often used in variance analysis The text notes that “standards” are developed using “engineering studies based on work performed by a skilled operator using equipment operating in an efficient manner.” What is some of the history of these engineering studies? With the greater use of machines for manufacturing in the late 1800s, some industrialists searched for the best way to a job Much of the work was repetitive and could be learned by most people The idea of using a “best way” to most jobs became the basis of standards in manufacturing Frederick W Taylor was perhaps the most well-known of the promoters of scientific management during the last of the nineteenth century and into the twentieth century A humorous account of a couple known as “efficiency experts,” Frank and Lillian Gilbreth, industrial engineers who performed time-and-motion studies for large corporations, is in the book, Cheaper by the Dozen, written by two of their twelve children Stories of how their father used his ideas of the most efficient method of accomplishing a task are quite entertaining as well as providing insight into the times when companies were looking to science, specifically engineering, to lead the way in production techniques 96 Chapter Compute price variances and efficiency variances for direct cost-categories Why use the actual input quantity for calculating the price variance? Some could argue that the use of the actual input quantity rather than the quantity allowed for actual output for calculating the price variance does include an element of efficiency as well as price difference The following graph may be used to explain a combined price-efficiency variance The following standards exist: $5.00 per pound of material and 40,000 pounds allowed for actual output produced The actual amounts were $5.40 per pound paid and 50,000 pounds of material used [The calculation of the purchase-price variance for materials eliminates this combined variance for materials A purchase-price variance, of course, cannot be calculated for direct manufacturing labor because the purchase and use of labor cannot be separated.] Total price variance: $16,000 + $4,000 = $20,000 U Pure price variance ($0.40 x 40,000 = $16,000 U) Combined price-efficiency variance ($0.40 x 10,000 = $4,000 U) $5.40 $5.00 Price per pound Efficiency variance (10,000 x $5 = $50,000 U) 40,000 50,000 Quantity in pounds Explain why purchasing performance measures should focus on more factors than just price variances Explain the benefit of using the value-chain concept when using variance analysis as a basis for performance evaluations Production is an integral part of a larger operation as characterized by the value-chain concept The understanding that the whole of the company is greater than the sum of its parts is necessary for realizing that any decision made about one aspect of the company’s operations will impact another aspect of the company The explanation is given in the text to support the idea that sometimes increasing costs in one aspect of operations will reduce overall costs in the other parts of the company The opposite can also be true—reducing costs in one area can increase costs in several other areas To achieve the overall best for the company, these interactions must be considered Top management must take the lead in emphasizing achievement of total organizational objectives rather than a piecemeal approach Flexible Budgets, Variances, and Management Control: I 97 Integrate continuous improvement into variance analysis What other variances can be used (other than those described in the text) in the quest for continuous improvement? Variances can be calculated for any aspect of a job or task in which some preplanning or forward thinking has been done Variances can be financial or nonfinancial Variances measure a difference As an organization seeks continuous improvement, they may wish to examine ways to develop more comparisons by subjecting activities to predetermined levels of achievement Areas for further investigation, and therefore improvement, could be in “orders shipped” by comparing jobs produced and shipped to jobs produced and not shipped An interesting article about the use of standard costs is “Redesigning Cost Systems: Is Standard Costing Obsolete?” by Carole B Cheatham and Leo R Cheatham, Accounting Horizons, (December 1996) pp 23-31 Perform variance analysis in activity-based costing systems Using the three steps illustrated for developing a flexible budget for batch-level costs, describe developing a flexible budget for either product-sustaining costs or facilitysustaining costs Some possible candidates of each type are given in Chapter in the Plastim example For product-sustaining costs in the Plastim example, design costs are noted The design costs are dependent upon the time spent by designers on designing and modifying the product, mold, and process Aspects of the design and modification process are noted as a “measure of the number of parts in the mold multiplied by the square feet area over which the molten plastic must flow.” Using predetermined number of parts and/or square feet compared to actual results would be a basis for calculation of a variance Price and quantity are two common elements in most measures Describe benchmarking and how it can be used in cost management What is the origin of the term “benchmark”? The term “bench mark” is used in the work of surveying A mark with known precision as to elevation, latitude, and longitude is made by a surveyor on a permanent landmark to serve as a reference point in making maps or determining other altitudes in the surrounding area 98 Chapter Excel spreadsheet for variance analysis-insert here Flexible Budgets, Variances, and Management Control: I 99 SUGGESTED READINGS Anderson, “Industrial Benchmarking for Competitive Advantage,” Human Systems Management (1999) p.287 [10p] Cheatham, C and Cheatham, L., “Redesigning Cost Systems: Is Standard Costing Obsolete?” Accounting Horizons (December 1996) p.23 [7p] Dervitsiotis, K., “Benchmarking and Business Paradigm Shifts,” Total Quality Management (July 2000) p.S641 [6p] Johnson, D and Sopariwala, P., “Standard Costing Is Alive and Well at Parker Brass,” Management Accounting Quarterly (Winter 2000) p.12 [9p] Lapide, L., “New Developments in Business Forecasting,” Journal of Business Forecasting Methods and Systems (Summer 2001) p.13 [3p] Palmer, R & Green, L., “ITT Automotive North America: A Case Study Requiring Use of Benchmarking, Activity/Process Analysis,” Issues in Accounting Education (August 1999) p.465 [32p] Sen, P., “Another Look at Cost Variance Investigation,” Issues in Accounting Education (February 1998) p.127 [8p] Stammerjohn, W., “Better Information through the Marriage of ABC and Traditional Standard Costing Techniques,” Management Accounting Quarterly (Fall 2001) p.15 [7p] Wing, K., “Using Enhanced Cost Models in Variance Analysis for Better Control and Decision Making,” Management Accounting Quarterly (Winter 2000) p.27 [9p] Yarrow, D., Mitchell, E & Robson, A., “The Hidden Factory: The Naked Truth about Excellence in the Real World,” Total Quality Management (July 2000) p.S439 [9p] 100 Chapter [...]... increase costs in several other areas To achieve the overall best for the company, these interactions must be considered Top management must take the lead in emphasizing achievement of total organizational objectives rather than a piecemeal approach Flexible Budgets, Variances, and Management Control: I 97 6 Integrate continuous improvement into variance analysis What other variances can be used (other... Flexible Budgets, Variances, and Management Control: I 99 SUGGESTED READINGS Anderson, “Industrial Benchmarking for Competitive Advantage,” Human Systems Management (1999) p.287 [10p] Cheatham, C and Cheatham, L., “Redesigning Cost Systems: Is Standard Costing Obsolete?” Accounting Horizons (December 1996) p.23 [7p] Dervitsiotis, K., “Benchmarking and Business Paradigm Shifts,” Total Quality Management (July... Cost Variance Investigation,” Issues in Accounting Education (February 1998) p.127 [8p] Stammerjohn, W., “Better Information through the Marriage of ABC and Traditional Standard Costing Techniques,” Management Accounting Quarterly (Fall 2001) p.15 [7p] Wing, K., “Using Enhanced Cost Models in Variance Analysis for Better Control and Decision Making,” Management Accounting Quarterly (Winter 2000) p.27... Cheatham and Leo R Cheatham, Accounting Horizons, (December 1996) pp 23-31 7 Perform variance analysis in activity-based costing systems Using the three steps illustrated for developing a flexible budget for batch-level costs, describe developing a flexible budget for either product-sustaining costs or facilitysustaining costs Some possible candidates of each type are given in Chapter 5 in the Plastim... cost management What is the origin of the term “benchmark”? The term “bench mark” is used in the work of surveying A mark with known precision as to elevation, latitude, and longitude is made by a surveyor on a permanent landmark to serve as a reference point in making maps or determining other altitudes in the surrounding area 98 Chapter 7 Excel spreadsheet for variance analysis-insert here Flexible Budgets,. .. Costing Is Alive and Well at Parker Brass,” Management Accounting Quarterly (Winter 2000) p.12 [9p] Lapide, L., “New Developments in Business Forecasting,” Journal of Business Forecasting Methods and Systems (Summer 2001) p.13 [3p] Palmer, R & Green, L., “ITT Automotive North America: A Case Study Requiring Use of Benchmarking, Activity/Process Analysis,” Issues in Accounting Education (August 1999) p.465... Management Accounting Quarterly (Winter 2000) p.27 [9p] Yarrow, D., Mitchell, E & Robson, A., “The Hidden Factory: The Naked Truth about Excellence in the Real World,” Total Quality Management (July 2000) p.S439 [9p] 100 Chapter 7