Chapter 4: Flexible Budgets and Standards

Learning Objectives
After studying this chapter, you should be able to:
1. Evaluate the usefulness of static budget reports.
2. Explain the development of flexible budgets and the usefulness of flexible budget reports.
3. Distinguish between a standard and a budget.
4. Identify the advantages of standard costs.
5. Describe how companies set standards.
6. State the formulas for determining direct materials and direct labor variances.
7. State the formula for determining the total manufacturing overhead variance.
8. Discuss the reporting of variances.
9. Prepare an income statement for management under a standard costing system.

4.1 Introduction
The activity of management in modern business is complex and is a difficult task. In general the
activity is confined in the areas of planning, implementing and evaluating performances.
Managers do plan in every phase of business operation in advance and must insure, by means of
carefully developed control procedures that the plans are carried out. One of the control
procedures is the preparation of performance reports periodically so as to get the feed-back on
the operation of the firm. Usually, managers accomplish the planning and control function by
assigning different persons the responsibility for specific segments of business operations. For
each segment identified as responsibility center, information must be provided to exercise the
control activity. The important part of the information is provided through an accounting system.
The accounting system provides the quantified plans (budgets) during the planning activity, data
accumulation system during the implementation process, and different types of evaluation
reports during the control activity.

Evaluation reports are prepared by comparing the actual results of implementation and the
budgeted data for specific period of time. For each type of activity the firm undertakes, budget is
prepared and control over operations is accomplished by comparing the budget with actual
operating results and by taking corrective action whenever necessary. The following is the
simplest form of performance evaluation reports:
Performance Reports
Budgeted Data Actual Results Deviation
Material Costs Xxx xxx Xx
Labor Costs Xxx xxx Xx
Overhead Costs Xxx xxx Xx
Total Xxx xxx Xx

From this simple performance report, we can make a number of analyses particularly on the
deviation column. The deviation is the difference between actual results and budgeted data. The
difference between budget data and actual result is termed as variance. Variances can be
favorable or unfavorable. If the actual result is better than the budgeted one, the variance is
favorable, otherwise, it is unfavorable. The budget is used to identify variances. There are two
types of budgets depending upon the activity level the budget covers.

4.2.Static vs. Flexible Budgets

Static Budget: A static budget is a budget prepared for only single level of activity. For
example, if sales volume is used as a basis to develop cost of goods sold budget and operating
expense budgets, a single level of sales volume could be used. A typical example of static budget
is master budget. A static budget is not helpful for control purpose because the actual volume of
activity may differ from the budgeted one. For example, a firm may incur a cost of $300 for
selling expenses on budgeted sales volume of $3,000 as compared to budgeted $400. Comparing
$300 with $400 cannot be sufficient to say the firm had performed better on selling expenses. To
have meaningful comparison, it is necessary to know the actual volume of sales for which selling
expenses amounting $300 is incurred. If the actual sales volume is exactly $3,000 as budgeted
the comparison of $300 with $400 is meaningful and it can be said that there is $100 favorable
variance for the firm. On the other hand, $300 selling expenses might be incurred for actual sales
volume of $2,000. In this case it is not appropriate to say that the firm enjoyed a favorable
variance because the budgeted cost could be less than $300 had it was tailored for this level of
sales. Therefore, it is required to prepare another type of budget, which can accommodate this
problem. The variances gathered from the performance report must be identified with their
causes. A better budget for performance evaluation and variance analysis is a flexible budget.

Flexible Budget: Flexible budget is a budget prepared for a range of volume of activity. It can
be adapted for any level of activity. Flexible budget is affected by volume of activity level and
also can be prepared after actual results are obtained and hence sometimes termed as ex-post
budgets. To prepare flexible budget, the behavior of costs in relation to the volume of activity
must be known. The flexible budget is compiled after obtaining a detailed analysis of how each
cost element is affected by change in volume of activity level. For example, a firm may develop
budgets for sales volume at $70,000, $80,000, $ 90,000 and so on for a particular budget period.
Thus, the flexible budget is more helpful for comparing the actual results with budgeted data
since it provides a dynamic basis of evaluation. Flexible budgets are also helpful before the
budget period in question. It is possible to use the flexible budgets to choose among various
ranges of activity for planning purposes in addition to the use of flexible budgets at the end of the
period when managers try to analyze actual results which is a control activity of management.
The following can be a simple illustration of flexible budgets for manufacturing costs at three
different volumes of production levels for Fox manufacturing firm.
 Fox Manufacturing Firm
Flexible Budgets for Manufacturing Costs
For the budget period ended June 30, 2014
Total Units of production 8,000 units 9,000 units 10,000 units
Manufacturing cost budgets for:
Direct materials $ 18,800 $ 21,150 $ 23,500
Direct labor 64,000 72,000 80,000
Variable MOH 12,000 13,500 15,000
Fixed MOH 20,000 20,000 20,000
Totals $ 114,800 $ 126,650 $ 138,500

From this illustration one can see that the budgeted manufacturing cost is affected by the change
in volume of production. Note that the effect on the cost elements due to change in volume is
selective. Only the variable costs are affected by the change in volume of production level. The
fixed manufacturing overhead cost is the same for all levels of production. Therefore, it is very
important to identify the cost behavior so that one can prepare flexible budgets. If the actual
volume of production coincides with one of the three budgeted volumes, comparing the actual
with the budgeted data will be made easily by taking that budget as a basis of reference.
Sometimes it is possible to have an actual volume of production for which budget was not
prepared. In such cases, a flexible budget for the actual level of production can be prepared since
the behavior of costs is known in advance.
Suppose Fox Manufacturing produced 8,500 units during the budget period, the flexible budget
at this level of production volume is prepared as follows.
Fox Manufacturing Firm
Flexible Budgets (Ex-Post)
For the budget period ended June 30, 2014
Physical Units of production 8,500 units
Manufacturing cost budgets:
Direct materials ($2.35x8,500 units)* $ 19,975
Direct labor ($8x8,500 units)* 68,000
Variable MOH ($1.5x8,500 units)* 12,750
Fixed MOH 20,000
Totals $ 120,725
*The unit costs are computed by dividing the total budgeted costs by total units for each variable
manufacturing cost. That is;
- Direct materials: ($18,800/8,000; or $21,150/9,000; or $23,500/10,000) =$2.35
- Direct labor: ($64,000/8,000; or $72,000/9,000; or $80,000/10,000) =$8.00
- Variable manufacturing overheads: ($12,000/8000; or $13,500/9,000; or $15,000/10,000) =$1.50
Before, we go to further discussions on variance analysis; we need to recall once again the
differences between static budgets and flexible budgets. The summary of the comparison
between the two types of budgets is presented below in a form of a table.
 (a) Static Budget (Ex-Ante) (b) Flexible Budgets (Ex-Post)
 Not affected by charge in activity level  Affected by the volume of an activity level.
 Prepared for a single volume of activity  Prepared for ranges of volume of activity
level levels sometimes referred as relevant range.
 Prepared before actual operation  Can be prepared before or after actual
operations.
 Less helpful for performance evaluation  Provides a dynamic basis for performance
purpose. evaluation purpose.

4.3.Variance Analysis
Variance is the difference between actual results and budgeted data. Variance can be favorable
or unfavorable. Favorable variances are considered as better achievement and unfavorable
variances are considered as indicators of problem in general. However, such general conclusion
cannot be always true. Management without further analysis should not welcome having a huge
amount of favorable variance. Variances are highly interrelated. For example, a favorable
variance for raw-materials purchases could results by purchasing inferior items at very low price.
This does result too much wastage in the production process and be a cause for unfavorable
production variances. Therefore, both favorable and unfavorable variances must be analyzed in
detail before taking any action.
At the beginning, variances can be grouped into two major categories. Different terms are used
in the literature to represent these variances. But in general, we can use output variances and
input variances. The output variances refer to effectiveness - whether the set objective is
achieved or not and the input variances refer to efficiency - a measure of the means by which an
objective is achieved.
The Output variance includes:
Sales volume variances -Variances that arise from failure to achieve the targeted volume of
sales for the budget period.
Selling price variances - Variances which arise from, change in unit selling prices from the
budgeted ones.
Production volume variances-Variances which arise from failure to achieve targeted volume
of production during the budget period.
The input variance may include.
Price variance -Variances which arise from change in input prices from the expected prices
(budgeted prices).
Efficiency variance -Variances, which arise from use of input quantities.

The price and efficiency variances together are sometimes referred as flexible budget variances.
The output variance is the difference between flexible budget and the static budget, which is
usually the master budget. All variances - favorable or unfavorable - ultimately affect the
operating income of the firm. Variances can be computed in different approach. Among others;
the equation or formula approach, the general approach, and the graphical approach are
commonly used. In the coming paragraphs, we shall see the application of each approach in
determining amounts of variances. Consider the following simple example to illustrate the
introductory part of variance analysis. Assume that Fox manufacturer has the following master
budget data (static budget) and actual results.
Master Budget Actual Results
Physical units 9,000 units 7,000 units
Sales $ 94,500 $ 73,500
Variable costs 63,000 52,500
Fixed costs 20,000 20,900

The first level of variance analysis is to compute the deviation between the budgeted operating
income and the actual operating income. This level of variance analysis is usually termed as level
zero variance analysis. According to the example the budgeted operating income is $11,500
($94,500 - $63,000 -$20,000) and the actual operating income is birr 100 ($73,500 - $52, 500 -
$20, 900). The variance on operating income is $11,400 unfavorable because the actual operating
income in less than the budgeted one. The cause for this gross unfavorable variance must be
explained and corrective actions, if necessary, must be taken. Using the static budget data the
following performance report can be prepared as follows:
Fox Manufacturer Firm
Performance Report
For the budget Period Ended June 30, 2014
Master Budget Actual Results Variance to be Explained*

Physical units 9,000 7,000 2,000 U

Sales $ 94,500 $ 73,500 $ 21,000 U

Variable costs 63,000 52,500 10,500 F
Contribution margin $ 31,500 $ 21,000 $ 10,500 U
Fixed costs 20,000 20,900 900 U
Operating income $ 11,500 $ 100 $ 11,400 U
*U - Unfavorable variance
*F - Favorable variance

The causes of each variance must be explained. The first step in variance analysis is to identify
the basic two variance groups - output variance and input variance. To identify these variances it
is important to prepare a performance report using flexible budget. In the above performance
report, the output variance is the sales volume variance and the input variance is the cost
variances. The following performance report is more meaningful than the above one.
Cost and Management Accounting II

Fox Manufacturer Firm

Performance Report
For the budget Period Ended June 30, 2014
(A) (A - B) (B) (B - C) (C)
Actual Flexible Budget Flexible Sales Volume Master
Results Variance Budget Variance Budget
Physical units 7,000 -0- 7,000 2,000 U 9,000

Sales $ 73,500 $ -0- $ 73,500 $ 21,000 $94,500

Variable costs 52,500 3,500 U 49,000 14,000 F 63,000
Contr. Margin $ 21,000 $ 3,500 U $ 24,500 $ 7,000 U $ 31,500
Fixed costs 20,900 900 U 20,000 -0- 20,000
Operating income $ 100 $ 4,400U $ 4,500 $ 7,000 U $ 11,500
U = Unfavorable
F = Favorable

The total unfavorable variance on the operating income is divided into two major groups. The
above performance report shows that $7,000 unfavorable variances are caused due to failure to
achieve targeted level of sales 9,000 units or $94,500. The remaining unfavorable variance of
$4,400 on the operating income is an input variance, which could be caused by inefficient use of
inputs or by change in prices of inputs. The formula approach can also be used to determine the
two major categories of variances. The following formula can be used to compute them.

Formula:
Sales volume variance = Budgeted unit contribution margin times difference between the master budget (static
budget) sales in units and the actual units of sales during the period.

The total budgeted sale in units.................................. 9,000units

Less: The total actual sales in units........................... 7,000units
The total variance in units.......................................... 2,000 units(unfavorable)
Times The unit contribution margin ......................... $ 3.50*
Sales volume variance on operating income……..... $7,000 Unfavorable
* $10.50 - $7.50 = $3.50

Flexible budget variance = Actual results at actual prices - flexible budgets for actual outputs achieved.
Actual Costs incurred:
Variable costs........................................ ………. $52,500
Fixed costs............................................ ………. 20,900
Total Actual Costs.................................$73,400
Flexible budget for actual outputs:
Variable costs (Br. 7.00x7, 000).......... $ 49,000
Fixed costs........................................... 20,000
Total flexible budgets........................... $69,000
Flexible budget variance.................................. . $4,400 U
Cost and Management Accounting II

4.4.Standards, Controllability and Variances

In exercising control over any activity there is usually some basis for comparison. When one
states that a job was exceptionally well done, it means that the performance was better than usual
or better than some standard established as acceptable. For example, in a particular athletics race,
the athletes should achieve the minimum speed to participate in the race. In some examinations,
a pass mark is set at 50%. These are standards.

Distinguishing between Standards and Budgets

Both standards and budgets are predetermined costs, and both contribute to management
planning and control. There is a difference, however, in the way the terms are expressed. A
standard is a unit amount. A budget is a total amount. Thus, it is customary to state that the
standard cost of direct labor for a unit of product is, say, $10. If the company produces 5,000
units of the product, the $50,000 of direct labor is the budgeted labor cost. A standard is the
budgeted cost per unit of product. A standard is therefore concerned with each individual cost
component that makes up the entire budget.

There are important accounting differences between budgets and standards. Except in the
application of manufacturing overhead to jobs and processes, budget data are not journalized in
cost accounting systems. In contrast, standard costs may be incorporated into cost accounting
systems. Also, a company may report its inventories at standard cost in its financial statements,
but it would not report inventories at budgeted costs.

Standards Costing: Standards for Inputs

Standards are carefully determined activity levels that are established before the fact and used as
a basis for comparison with actual activity levels. Standards are used as a basis for measuring
performances or achievements. In business situations, standards provide much of the framed
work necessary for detailed and timely performance reporting which is so important in
monitoring and controlling daily business activities. Control over costs can be exercised by
comparing actual performances and costs with standards. The variations from the standards, if
there are any, are bases for either tighter control over the operation or a revision of the standards.
In the process of control, efforts should be made to protect the firm from waste or loss and
determine the most economical way to acquire and use goods and services.

Standard for Direct Materials and Direct Labor

Standard costs are carefully determined costs that management establishes and uses as bases for
comparison with actual costs. Like all standards, standard costs are measures of achievement. A
standard cost is often expressed on a unit basis. There is a standard price for a unit of material
and a standard quantity of material to be used for a unit of product, and there is a standard
labor rate and a standard length of time to perform a certain amount of work. The standards are
budgetsforaunitofactivitytobeperformed.Theydifferfrombudgetsbecausebudgetsare
Cost and Management Accounting II

prepared in terms of totals. Conceptually, there is no difference between standards and budgets.
The standard remains unchanged as long as there is no change in the method of operation or in
the unit prices of materials or services.

Setting Material Quantity Standards

In setting the material standard, the year-to-date totals of material quantity should be studied and
used as guides in setting the physical quantity of materials needed in the production process. The
physical quantity needed is usually provided by engineering and design department which will
develop specifications for the kinds and quantities of materials to be used in the production of
goods specified and budgeted on the operating forecast. Obviously, the standard specification
will be determined only after a study of factory operations has been conducted.

However, it is not sufficient to base material quantity standards on engineering specifications.

The management accountant may need assistance from a manufacturing supervisor who is
closely familiar with the raw materials used in the process of manufacturing finished goods.
Sometimes it may be possible to conduct production tests under controlled conditions. A quantity
of material is put into process and the results are carefully analyzed. But there may be a tendency
for the workers to produce with less wastage of materials under these set conditions, and the
management accountant must watch for any artificial element because, if it is not considered, the
material quantity standard may be understated or overstated.

The physical standards set should include factors for scrap, shrinkage and other normal spoilages
that are unavoidable. After the quantity standard is set the accountant should determine the total
quantity of materials required for the period and forward it to the purchasing department.

Setting Material Price Standards

Usually the purchasing agent or department is responsible for the material price variance and
hence should help the management accountant in setting material price standards. The
purchasing department is more familiar to the material purchase prices. In arriving at the material
price standard the purchasing department must predict the probable changes in price that are
expected to occur. Moreover, the entire operation associated with acquiring materials should be
considered. Such operations are like the bargaining policy of the firm, selection of suppliers, etc.
In practice, the existing economic situation is an important input in setting material prices. For
example, the price standard should reflect the most economic order size if attention is given to it.
Other inputs in price standard setting are the cash available and the cash discount policy of the
firm. In setting the material price standards, it is necessary to provide allowances for unexpected
market fluctuations and seasonal trends.
Cost and Management Accounting II

Setting Labor Standards

One of the basic inputs in the production process is labor. Since labor refers to human beings, it
is more difficult to set standards for labor than to establish standards for materials. There are
many factors, which cause a variance in labor productivity. Among others, the attitudes of
workers towards their jobs, their superiors along with the relationship among them affect labor
efficiency. These facts together with age, skill, seniority, experience must be considered in
establishing the standard labor. In establishing the labor standards, labor is first classified as
direct or indirect labor. Direct labor is treated as a separate item of cost in standard cost systems,
and provision for indirect labor is made in manufacturing overhead costs.

Examination of past payroll records and production records help much in determining the labor
hours used up in the previous production period. However, past performances may include
inefficiencies and hence should not be extended for the budget period. Historical records should
never be accepted until they are revised in light of the existing conditions. Time and motion
study, whenever possible, is the basis for setting labor quantity standards. Often, the operating
cycle is broken down into many distinct elements and on each operating element; representative
employees are selected to work on. The composition of the employees should be studied very
carefully. They should not be too slow or too fast in their performance. They should be from the
average group. The behavior of the selected employees, i.e., their character and honesty play an
important role. After the time used up by the sample employees in their performance is
determined, some adjustments are made for normal idle time and others.

Labor Rate Standards

It is common for labor rates to be set by the central government or by union contracts. After
time standards (labor quantity standards are determined), labor rates are applied to obtain the
total labor cost standard for an output. Reference to the previous period rates can be the basis for
the rate to prevail in the budget period. However, using the previous period rates as standard
rates is incorrect. In some economic situations, the competitive market in which supply and
demand are active and constantly changing may determine labor rate. When labor rates are fixed,
it is easy to establish the labor rate standard because the fixed wage can be taken as a standard.
In some operating situations, the labor rate may differ from one operation to the other. In such
cases, different labor rates are used for each operating center in establishing standard labor cost.

Material Standards and Control

Standards are one of the control mechanisms for materials used during the production process.
Standards are established for the cost of obtaining materials and for the quantities to be used in
the production. At the end of the period, it is customary to compare these standards with actual
results for evaluation purpose. When actual costs are compared with the standard cost, the
variances are determined which is one step for performance evaluation.
Cost and Management Accounting II

Basically, there are two types of variances for materials. These are: (1) price variance; and (2)
quantity variance (efficiency variance). Many other variances may be determined for specific
purposes, but they can always be classified as being variations in the price of materials, the
quantities used, or a combination of price and quantity. If the actual cost is less than the standard
cost the variance is favorable; if the actual cost is greater than the standard cost, the variance is
unfavorable.

4.4.1. Material Price Variance

The material price variance measures the amount of variance from the standard that occurs
because of the price paid for raw materials is different from the standard cost. It measures the
difference between the prices at which materials were purchased and the prices at which they
should have been obtained according to the established standards. In other words, material price
variance is caused by change in prices of materials. If the actual material cost is greater than
standard, there is an unfavorable variance and if the actual material cost is less than the standard,
there is a favorable standard.

A factory may be operated efficiently, but if materials are not purchased at reasonable price,
potential profits will be lost before the actual manufacturing operation begins. Usually it is the
responsibility of the purchasing department or unit to bear material price variances. For each
class of materials to be purchased, price is set. If the purchasing function is carried out properly,
the standard price should be attainable. Lower prices are favorable and higher prices are
unfavorable. However, the favorable or unfavorable price variances should not be taken as they
are computed to fix responsibility to the purchasing department. Further analysis of the variance
is very important. The detailed cause of a specific material price variance must be identified. The
following are few examples for material price variances.

1. Purchasing of inferior raw materials could yield favorable price variance. At first glance,
favorable variances are welcome. However, in such cases the favorable price variance could
cause a huge lose to the firm because the outputs produced will be inferior quality and hence
low sales volume.
2. The purchasing department may negotiate with suppliers less skillfully than assumed in the
standard (budget). In such cases unfavorable martial price variance could result and
appropriate action should be taken. Probably, the purchasing officer is a newly hired one
who needs some more time to learn.
3. The quantity ordered might be below the optimal quantity (less than the economic order
quantity) where quantity discounts are available for larger lot size.
4. Unexpected material price changes due to external factors such as draughts, flood, and other
weather conditions. These factors are uncontrollable label and no one is responsible for
unfavorable price variances caused by such factors.
Cost and Management Accounting II

5. Rush orders from customer and accepted by production department. In such circumstances
the purchasing unit does not have sufficient time to select appropriate price from prospective
suppliers and will be forced to purchase at higher price. The facts should be considered from
the overall benefit of the firm.
6. The standard material price being set without careful analysis of the market for the firm. If
there is such a fact, the standards can’t be used for performance evaluation.

There are also other more causes depending upon a specific firm’s activity and the economy in
which the firm is operating. Periodically, reports are prepared to show the actual prices compared
with the standard prices for various types of materials purchased. The material price variance is
better identified at the time of purchases than to wait until the material is used in the production
process. The total cost effect is equal to the difference between actual unit price and the standard
unit price multiplied by total units of materials purchased. Expressed algebraically;

VP = AQ x (AP -SP)
Where,
VP = total material price variance,
AP = actual price per unit of the material purchased,
SP = standard price for the material purchased, and
AQ = total units (quantity) of materials purchased.

The variance could be computed using a general approach and graphical approach. The general
approach of computing variances eases the computation process - particularly when all types of
variances are computed together. For example, to compute materials price variance, the
following is the format in the approach.

Total actual costs Flexible budget for actual

Price Variance

Reports on price variances may be made monthly to the purchasing agent and to the executive
who is responsible for the purchasing function. The reports reveal which materials are
responsible for the large part of any total price variations and can help the purchasing department
in its search for more economical sources of supply. Standard costs are not always incorporated
in the accounting records. If a firm follows a standard cost system, the variance computed should
be reflected in the general ledger. For materials purchased, the firm is liable for the actual cost,
but it would record the materials inventory at standard cost. (Standard price multiplied by
quantity purchased). The difference is accounted for in the “Materials Price Variance” account.

To illustrate, assume that the purchasing department bought 10,000 units of a certain material at
a price of 90 cents each on account for which the standard price was 95 cents each. The journal
entry to record this transaction is as follows:
Cost and Management Accounting II

Materials Inventory……………………… 9,500

Materials Price Variance… 500
Accounts payable ………… 9,000
Computation:
Actual cost incurred to purchase the 10,000 units of Materials (AP x AQ) (0.90 x 10,000)......................... $ 9,000
Less: Budgeted cost to purchase the 10,000 units of Materials (SP x AQ) (0.95 x 10,000)............................ 9,500
Materials price variance – favorable................................................................................................................ $ 500 F

On the journal entry, the “Materials Price Variance” account is credited because the variance is
favorable. Had the actual cost per unit being greater than the standard cost, this account would
have been debited for the total material price variance. At the end of a fiscal period the account
balance of the “Materials Price Variance” account would be added or deducted from the gross
profit at standard. It would be added if it had a credit balance and would be deducted if it had a
debit balance. The credit balance shows that during the fiscal period the price variance was
favorable on average and the debit balance shows there was an unfavorable variance.

4.4.2. Materials QuantityVariance

Materials are withdrawn and used in production. However, the units of materials withdrawn and
used in the production process may not be equal to the standard quantity. More or less materials
may be used than the specified quantity by the standards. The variation between the actual
materials usage and the standard materials is called materials quantity or materials usage or
efficiency variance. The materials usage variance measures the amount of variance caused by
using more or less materials than the standard, which is the allowed usage for actual units of
outputs. The variance could be favorable or unfavorable. If fewer materials are used than the
standard, the difference is favorable variance and if the actual usage is greater than the allowed
(standard), the difference is unfavorable variance. The computation of materials usage variance
is quite simple. It is the difference between actual quantity and standard quantity multiplied by
standard price. Algebraically, the computation is as follows.

MQV = SP x (AQ -SQ)

Where,
MQV = Materials Quantity Variance
AQ = Total actual quantity used in the production.
SQ = Total standard quantity allowed for the production of actual outputs.(Flexible budget)
SP = Standard price of materials.
Like other variances, materials quantity variance should be isolated and recorded as soon as
possible. If this variance is identifiable at the time materials are issued to production, it should be
recorded on that date. The journal entry to record the issuance of materials will be, therefore, to
debit the work-in-process inventory account and credit the materials control account and if there
is any variance it will be debited (if unfavorable) or credited (if favorable) to “Materials Quantity
Variance”.
Cost and Management Accounting II

For example, suppose a particular firm set a standard for materials as 10 pounds per unit of
output at standard price of $2 per pound. During the year 5,000 pounds were actually used to
produce 495 units of outputs. The variance computation and the journal entry will be as follows.
Total actual quantity used in the production (AQ)................................................................................ 5,000 pounds
Less: Total standard quantity allowed producing 495 units Output (SQ) (495 x 10 pounds)............... 4,950 pounds
Total materials quantity variance in pounds.................................................................................. ......... 50 pounds
Multiplied by the standard material’s price.................................................................................. ......... x $2/pound
Total materials quantity variance............................................................................................................. 100 U*
* U = Unfavorable

The materials quantity variance is unfavorable because the total pounds of materials allowed to produce
495 units of output are 4950 pounds which is less than the actual pounds of materials, used. The journal
entry to record the issuance of materials to production and the materials quantity variance would be:
Work-in-process.............................................. 9,900
Materials quantity variance............................ 100
Materials Inventory......................... 10,000
Note: In the above example, it is implicitly assumed that there is no materials price variance.
That is, the price per pound is $2 for the actual materialspurchased.

Sometimes it is not possible to identify material quantity variances at the time that materials are
issued to production. Materials quantity variance can be calculated only when the total
production output for the period could be measured. In such circumstances, it may not be
possible until the end of the period to compute quantity variance. The journal entry at the time of
issuance of materials would be, therefore, only to debit the work-in-process and credit the
materials inventory account for the actual quantity. The materials quantity variance will be
determined and recorded at the end of a period when the actual production output isknown.

Labor Standards and Control

In the above discussions, we have seen the preliminary variance analysis for direct materials. The
same applies to direct labor. Standards are established for direct labor and the variances from the
standards are measured and further analysis of direct labor variances will be made. Following the
same general principle used for materials, there are two types of direct labor variances. These
are: (1) price variance and (2) quantity variance. Usually in working with direct labor, the price
variance is termed as rate variance and the quantity variance is termed as efficiency variance.

(1) Labor Rate Variance

The labor rate variance measures the difference between the budgeted labor rate and actual labor
rate paid to employees. It isolates the portion of the total labor variance that is caused by the
actual labor rate being different from the expected (standard) labor rate. The computation of
labor rate variance is in the way as the computation of material price variance. It is the difference
between the rates (actual and standard) multiplied by the actual hours used up in the production
process. The formula to compute the labor rate variance is:
Cost and Management Accounting II

DLRv = AH x (AR -SR)

Where,
DLRv = direct labor rate variance
AH = actual total direct labor hours used,
AR = actual direct labor rate, and
SR = the standard direct labor rate.

Suppose the amount of labor used in a particular production process during a month is 3,900 hours and
the actual labor cost incurred per hour is $3 while the standard labor rate is $3.05. The labor rate variance
is computed as follows.
DLRv = AH x (AR -SR)
= 3,900 hours x ($3 -$3.05)
= 3,900 x 0.05
= $195F

During the month, therefore, the firm enjoyed a favorable labor rate variance of $195 because the
actual rate paid is less than the budgeted one. If the actual rate were higher than the budgeted rate
the result would have been unfavorable labor rate variance. The unfavorable rate variances could
be caused by different reasons. Among others; transferring workers with high pay rates to jobs
that call for low standard rates, authorizing overtime work at premium pay, employing
overqualified employees at high rates than the standard and unexpected labor rate change in the
market are the major causes. These labor cost differences are all caused by rate differences rather
than by changes in performance. The management should pay attention on such causes on labor
rate variance and take appropriate action. The labor rate variance is accounted through the
account called “Labor Rate Variance”. The labor rate variance account is debited for all
unfavorable labor rate variances and is credited for all favorable labor rate variances computed
during the period. At the end of the fiscal period the account balance of this account is added to
or deducted from the gross profit computed at standard cost. If the account balance is debit, it is
a deduction from the gross profit at standard and if the account balance is credit, it is an addition
to the gross profit at standard. In the above example, the journal entry is made as follows:

Work-in-process....................................................... 11,895*
Labor rate variance................................ 195
Payroll...................................................... 11,700

*Here we have assumed that there is no labor efficiency variance. When there is labor efficiency variance the debit
to work-in-process account will be different, as we will see it in the following paragraphs.
(2) Labor Efficiency Variance
The labor efficiency variance measures the amount of the total labor variance caused by using
more or less labor than the standard quantity. It is directly related to the productivity of
employees involved in the production process. When labor is used more efficiently, the labor
cost per unit of product is lowered and sometimes the variable overhead cost per unit of product
willalsobelowered.Insuchcircumstances-whentheoverheadvarieswithlaborhourusage-
Cost and Management Accounting II

there can be a double advantage by improving labor efficiency. Labor efficiency is affected by
the method of operation and types of equipment used in the production process.

As to computation, the labor efficiency variance is the difference between the actual labor hours
used and the standard labor hours required for production multiplied by the standard labor rate.
The formula to compute labor efficiency variance is, therefore,

DLEv = SR x (AH -SH)

Where;
DLEv = direct labor efficiency variance,
SR = the standard labor rate,
SH = the standard labor hours required for the production, and
AH = the actual labor hours used in the production.
Suppose that 24,500 direct labor hours were used to complete a work that should have been completed in
25,000 direct labor hours as per the standard and the standard labor rate was $3.05. The labor efficiency
variance is computed as follows:
DLEv = SR x (SH -AH)
= $3.05 x (25,000hrs -24,500hrs)
= $3.05 x500hrs
= $1,525F

The variance is favorable because less actual labor hours were used than the expected one. It can be said
that the employees are more productive (efficient) than expected.
The “Labor Efficiency Variance” account will be maintained to account for labor efficiency
variance. This account will be debited for all unfavorable labor efficiency variances and credited
for all favorable labor efficiency variances. By the end of the fiscal period, the account balance
of labor efficiency variance account will be added to or deducted from the gross profit computed
at standard cost. If the account balance is debit, it will be deducted from the gross profit at
standard and if the account balance is credit it will be added to the gross profit at standard. The
journal entry to record the above example in the general journal form wouldbe:

Work-in-process........................................................ 76,250
Labor Efficiency Variance...................... 1,525
Payroll..................................................... 74,725

Note: Here it is assumed that there is no labor rate variance. If there were labor rate variance, the debit to
work-in-process account and the credit to payroll account would be different than the figure shown above.
Manufacturing Overhead Cost Control
Manufacturing overhead costs are major components of the total costs in most manufacturing
firms. Hence, it is very important to discuss about the planning and control of these costs.
Making use of information developed through standard cost accounting systems controls the
manufacturingoverheadcosts.Theoverheadcostsareaccumulatedbydepartmentsorother
Cost and Management Accounting II

identifiable cost object as incurred and the actual costs are compared with the budgets developed
for various levels of output. The comparison shows whether the costs incurred are less or more
than the budgets for each element of the overhead costs. In normal costing system overhead costs
are applied to the output using the predetermined overhead rate. The use of predetermined
overhead rate allocates overhead costs to production based on actual activity (allocation) base
selected which can be direct labor hour, machine hour, direct material costs, direct labor cost,
etc. It should be recalled that in selecting the allocation (application) base, managers should
select the one that has the strongest cause-and-effect relationship with overhead cost behavior.
For example, in a labor-intensive firm or department, the application base better be the direct
labor, and in a machine intensive firm or department, the base better be the machine-hours.
Using the predetermined overhead rate, it is possible to develop standard overhead cost - cost per
unit of production. The standard overhead cost is the product of the predetermined overhead rate
and the standard quantity of the application base. For example, if the standard quantity of direct
labor is 0.25 hours and the predetermined overhead rate is $2 per direct labor hours, the standard
overhead cost per unit of output will be $0.50 (0.25 x $2). However, it is very important to
isolate the variable overhead costs from the fixed overhead costs because these two costs behave
differently with regard to the volume of outputs.
Variable Overhead Costs and Variance Analysis
So as to exercise an effective control over variable overhead costs, all elements of variable costs
should be identified and the cost driver should be selected on the cause-and-effect relationship
basis. After all variable costs are known and the cost driver is selected, the next step is to develop
the predetermined variable overhead rate. The predetermined variable overhead rate is computed
by dividing the total budgeted variable overhead costs for the period by the total volume of
activity level selected as a cost driver.
Suppose ABC Manufacturing firm had budgeted a total variable overhead cost for a period
amounts $20,000 and the cost driver chosen is machine hours with a budgeted machine hours of
40,000 during the period. Then, the predetermined variable overhead would be $0.50 per
machine hour ($20,000/40,000 machine hours). The predetermined rate is used to develop the
standard variable overhead cost. Continuing with the example, let us assume that to produce a
unit of output 0.50 machine hours are required. Given this additional information the standard
variable overhead cost is computed as follows:
Standard variable overhead cost = Predetermined Rate x the standard quantity of the cost driver.
= $0.50 per machine hour x 0.50 machine hours.
= $0.25/unit of output
Therefore, to produce one unit of output the allowed cost to be incurred is $0.25. Once an appropriate
activity (cost driver) has been determined, variable overhead price and efficiency variances are simple to
calculate.
Cost and Management Accounting II

(1) Variable Overhead Spending Variance

Variable overhead spending variance is the term to mean variable overhead price variance. It is
the difference between the actual amount of variable overhead incurred and the budgeted amount
allowed for actual outputs achieved. The variable overhead spending variance is computed based
on units of the activity base selected (cost driver). The formula to compute the variable overhead
(VOH) spending variance is:
VOHSP = AQVOH x (AVOH -BVOH)
Where,
VOHSP = Variable Overhead spending variance,
AVOH = Actual Variable Overhead costs per unit of cost driver,
BVOH = Budgeted Variable Overhead costs per unit of cost driver, and
AQVOH = Actual Quantity of Variable Overhead Cost driver for actual units of output achieved.
To illustrate let us continue with ABC manufacturing firm. Its variable overhead standard cost was
computed as $0.25 per unit of output. Suppose during the period ABC incurred a total of $22,000 for
variable overhead items and operated exactly 40,000 machine hours. The price (spending) variance
computed as follows:
VOHSP = AQVOH x (AVOH - BVOH)
= 40,000 machine hours x ($0.55 - $0.50)
= 40,000 machine hours x $0.05
= $2,000 U
Note that the variable overhead spending variance is computed in the same way as the price (rate)
variance for direct costs (direct labor and direct materials). However, do not assume that the cause for
these variances is the same.
The variable overhead price variance is explained by two main reasons:
1. The price of individual variable overhead items differed from the budgetedone,
2. The actual usage of individual variable overhead items differed from the budgetedusage.
In the above example, probably the unit price of all items in the variable overhead was the same
as the budgeted price. The $2,000U variance could be caused, thus, by the usage of more
overhead quantity than the budgeted. Therefore, before making any conclusion it is necessary to
further investigate the real cause of the variance. Moreover, for overhead variance analysis, the
standard overhead cost per unit of output is not used to compute variances. This is because
overhead costs are applied to products based on selected cost driver. Therefore, the overhead
rates (predetermined) are used in the computation of overhead variances. In our example, the
variable overhead standard cost ($0.25) is irrelevant in computing the spending variance. The
variance computed could be a misleading figure if the selected cost driver is less associated with
overhead costs. It is important to have the highest possible cause-and-effect relationship between
overhead costs and the selected activity base (cost driver).
(2) Variable Overhead Efficiency Variance
The variable overhead efficiency variance reveals the difference between actual and budgeted
variable overhead costs as a result of using more or less quantity of cost driver than budgeted
quantity of overhead items for the manufacture of the outputs. Efficiency variance, thus, does not
Cost and Management Accounting II

result from the saving or improper use of overhead items or favorable or unfavorable overhead
prices. Instead, it measures the difference in variable overhead costs which arise by efficient or
inefficient use of the factor used in applying overhead costs to the products. The variable
overhead efficiency variance is computed in a similar way as the efficiently variance for direct
costs - direct labor and direct material - are computed. The formula for computing variable
overhead efficiency variance is:

VOHe = BVOHR x (AQVOH -BQVOH)

Where:
VOHe = Variable overhead efficiencyvariance,
AQVOH = Actual quantity of cost driver for actual outputachieved,
BQVOH = Budgeted quantity of cost driver allowed for actual outputachieved,and
BVOHR = Budgeted variable overhead cost allocationrate.

To illustrate the variable overhead efficiency variance, consider the following simple example. A firm
developed a predetermined variable overhead rate based on machine hour to be $2. The firm also
established a standard machine hours to produce a unit of output to be 0.50 machine hours. During the
year, the firm produced 50,000 units of output by using 26,000 machine hours. Using this data we can
compute the variable overhead efficiency variance.
VOHe = BVOHR x (AQVOH - BQVOH)
= $2 x (26,000 machine hours - 25,000 machine hours)
= 1,000 machine hours x $2
= $2,000U

The allowed machine hours to produce 50,000 units of output are 25,000 (0.50 x 50,000). The
variance is unfavorable because 1,000 excess machine hours are operated than the budget. Here,
the efficiency variances for variable overhead costs reflect the efficiency with which the cost
driver is used not the efficiency of individual overhead items usage.

Note: The interpretation of spending and efficiency variances for variable manufacturing overheads is
not synonymous with those of the direct costs (direct material and direct labor) variances. The real cause
for these variances is not solely the price change of overhead items for spending variance and efficient or
inefficient use of overhead items. It is also related how efficiently the quantity of the cost driver isused.
Fixed Overhead Costs and Variance Analysis
Fixed overhead costs are lump sum costs, which do not change in total despite change in volume
of production. Fixed overhead costs are applied to production based on selected cost driver
(application base). The cost driver obviously changes with volume of production. The fixed
overhead costs in total are not affected by the change in a cost driver. The flexible budget
amount for fixed overhead costs is same with the static budget amount. Therefore, the analysis of
fixed overhead variances differs substantially from the analysis of variable overhead variances.
The basic difference lies on the behavior of costs and the cause-and-effect relationship between
costs and the application base. For variable costs, it is expected that, there is a cause-and-effect
relationship between the application base and the incurrence of costs. But for fixed costs, thereis
Cost and Management Accounting II

no such relationship between the application base and the incurrence of costs. Fixed costs are
constant within the relevant range regardless of how many units of the cost driver used (machine
hours or labor hour worked, direct labor cost incurred, etc.). Yet, the fixed costs are applied to
production at a fixed amount per unit of the cost driver. Thus, in a sense, fixed costs are treated
as variable costs when they are applied to production. But they must be analyzed differently. To
properly understand the fixed overhead variance analysis, it is important to recall how the
predetermined fixed overhead rate is computed and how the fixed overhead cost is applied to
production. The predetermined rate is computed as follows:

Fixed overhead Total budget fixed overhead amount

=
Predetermined rate Total budgeted amount of cost driver

Using the predetermined rate, we can compute the standard fixed overhead cost per unit of
output. The standard fixed overhead cost is the product of the predetermined rate and the
standard amount of the cost driver. For example, if a firm developed a fixed overhead
predetermined rate based on machine-hours to be $3 per machine hour and the standard machine
hour to produce a unit of output is 0.50 machine hours, then, the standard fixed overhead cost is
$1.50 per unit of output. The standard fixed overhead cost per unit of output can be computed in
another method. This method is to use the total budgeted units of output as a denominator. In
this method, the standard rate is computed as:

Fixed overhead Budgeted fixed overhead costs

=
Rate per output unit Budgeted units of output

The fixed overhead rate therefore, can be computed based on denominator level measured in
units of inputs (the cost driver) and denominator level measured in unit of outputs (production
level). The former is the standard fixed overhead for inputs and the later is the standard fixed
overhead cost of output.
The fixed overhead rate is affected by the denominator level chosen. The denominator level is
the preselected level of cost application base used to set a budgeted fixed overhead rate for
allocating fixed overhead costs to a cost object. As the denominator level changes, the fixed
overhead rate also changes. The relationship is inverse, that is, the higher the denominator level,
the lower the rate would be and vice versa.
Fixed Overhead Cost Variances
The analysis of fixed overhead costs generates a new variance not previously discussed. This
variance is termed as an output level overhead variance. In manufacturing firms it is usually
termed as denominator volume variance. When this term is used it should be understood that the
denominator volume is measured in units of output. In addition to the output level variance, a
spending variance is also computed for fixed overhead costs. Unlike the variable overheadcosts,
Cost and Management Accounting II

efficiency variance for fixed overhead cost is always zero because managers cannot be more or
less efficient in dealing with fixed amount. Thus, the total flexible budget variance is equal to the
spending variance.

(1) Spending Variance

The formula to compute the fixed overhead spending variance is the same as the formula used to
compute variable overhead spending variance. It is the difference between the actual fixed
overhead cost incurred and the budgeted amount (the static and flexible budget amount is the
same). Since the static budget and the flexible budget amount is the same for fixed overhead
costs, the total spending variance, the total flexible budget variance, and the total static budget
variance is the same amount.

To demonstrate the analysis of fixed overhead variance, let us assume ABC Manufacturing uses
a total of 20,000 machines hours to compute its predetermined fixed overhead rate and the total
budgeted fixed overhead $172,000. The standard machine hours required to produce a unit of
output is 0.40 machine hours. During the period, ABC actually operated 22,000 machine hours
and produced 48,000 units of output, and incurred $178,500 for fixed overhead. Using this data,
let us compute the spendingvariance.

It was stated that the spending variance is the difference between the budgeted fixed overhead
cost and the actual fixed overhead cost incurred. Thus:

Fixed Overhead Spending Variance = (Actual Cost) - (Budgeted Cost)

= $178,500 - $172,000
= $6,500 U

The flexible budget variance is also the same amount $6,500U. The variance is unfavorable because ABC
incurred $6,500 more than the budget amount for its fixed overhead.

(2) Output Level (Denominator Volume) OverheadVariance

The output level (denominator volume) variance is the difference between the budgeted fixed
overhead amount and the fixed overhead applied to actual volume of output achieved. The
formula to compute the output level (denominator volume) variance expressed in terms of a rate
per output (standard fixed overhead cost per output) is:

Output level fixed (Denominator level (Actual (Standard fixed overhead

= - x
overhead variance in output units) output units) per output unit)

Or, the formula for an output level overhead variance expressed in terms of input units (machine hours,
etc.) is:
Output level fixed (Budgeted Fixed (Fixed overhead allocated using budgeted input
= -
overhead variance Overhead) allowed for actual output units achieved)
Cost and Management Accounting II

To demonstrate how denominator volume variance is computed using the above formula, let us
continue with ABC manufacturing. ABC actually produced 48,000 units of output. However, the
denominator level in output units is 50,000 units (20,000 machine hours divided by 0.40 machine
hours). The standard fixed overhead rate per unit of output is $3.44 computed as follows:

Standard fixed overhead Predetermined fixed overhead rate Standard input of the cost
= x
rate per unit of output expressed in terms of input units driver per unit of output

= $172,000 x 0.40 machine hour

20,000 machine hours
= $8.60 per machine hour x 0.40 machine hour
= $3.44 per output unit

Therefore, the output level variance is computed as:

Output level fixed (Denominator level (Actual (Standard fixed overhead
= - x
overhead variance in output units) output units) per output unit)

= (50,000 units - 48,000 units) x $3.44 per unit

= $6,800U

Or,
Output level fixed (Budgeted Fixed (Fixed overhead allocated using budgeted input
= -
overhead variance Overhead) allowed for actual output units achieved)
= $172,000 - ($8.60 x 0.40 Mhrs x 48,000units)
= $172, 000 -$165,120
= $6,880U