07: Budget Variances

Minjae Koo
 Table of Contents

• What are Variances?

• What is Static Budget Variance?
• Decomposition of Static Budget Variance
• What is Flexible Budget Variance?
• What is Sales Volume Variance?
• Decomposition of Flexible Budget Variance
• What is Selling-Price Variance?
• What are Price and Efficiency Variances?
• Price Variance
• Efficiency Variance
• How to Record Price and Efficiency Variance in the Journal Entry?
What are Variances?
■ Variances: measure how actual amount differs from budgeted amount.
o Sales variance = actual sales – budgeted sales
o Cost variance = actual cost – budgeted cost
■ Favorable and Unfavorable Variance
□ Favorable Variance: Variance that increases operating income.
□ Unfavorable Variance (or adverse variance): Variance that decreases
operating income.
o Example:
– If actual sales is greater than budgeted sales, favorable sales variance.
– If actual cost is greater than budgeted cost, unfavorable cost variance.
What are Variances?

Income
Scenario Actual Budget Act. – Bud. (Increasing / Variance
Decreasing?)
Revenue Revenue
1 +2000 Increasing $2000F
= $12,000 = $10,000
Revenue Revenue
2 -2000 Decreasing 2000U
= 10,000 = 12,000
Variable costs Variable costs
3 -1000 Increasing 1000F
= 5,000 = 6,000
Variable costs Variable costs
4 +1000 Decreasing 1000U
= 6,000 = 5,000
What is Static Budget Variance?
■ Static Budget: Budgets based on the level of budgeted output
o Prepared at the beginning of a fiscal year
■ Static Budget Variance: Difference between actual amount and budgeted amount in the
static budget.
□ Also referred to as “Level 1” analysis
o Example: Webb company produces jackets.

o How to compute static budget variances?

What is Static Budget Variance?
Static-Budget
Budgets Actual Static Budget
Variance

Units Sold 12,000 10,000 12,000 2000 U

Revenues $120 per output $1,250,000 $120 * 12,000 = 1,440,000 190,000 U
Variable Costs
DM $60 per output $621,600 $60 * 12,000 = $720,000 98,400 F
DL $16 per output $198,000 $16 * 12,000 = $192,000 6,000 U
Variable MOH $12 per output $130,500 $12 * 12,000 = $144,000 13,500 F
Total Variable Costs $88 per unit $950,100 $88 * 12,000 = $1,056,000 105,900 F
CM $120 – $88 = $32 $299,900 $32 * 12,000 = $384,000 84,100 U
Fixed MOH $276,000 for 12,000 units $285,000 $276,000 9,000 U
Operating Income $14,900 $108,000 93,100 U
Decomposition of Static Budget Variance
■ Why is the budgeted operating income different from the actual operating income?
o Operating Income = TR – TC = (P – UC) * Q
o P = selling price
o UC = unit cost
o Q = output quantity
o Any difference between budgeted and actual amount in P, UC, and Q can result in static-budget
variance for operating income
□ If we want to understand how (P – UC) contributes to operating income variance, we need to hold Q
constant and vary (P – UC)
o This will lead to a measure called Flexible-Budget Variance
□ Also, if we want to understand how Q contributes to operating income variance, we need to hold (P – UC)
constant and vary Q
o This will lead to a measure called Sales-Volume Variance
What is Flexible Budget Variance?
■ Flexible Budget: Hypothetical budget that the firm would have prepared at the start of the budget
period if it had correctly forecasted the actual output quantity
■ Flexible Budget Variance: Difference between actual amount and budgeted amount in the flexible
budget.
o Better measure of sales price and cost performance than static budget variances.
o Back to Webb company case.
o The flexible-budget output quantity (Q) = The actual output quantity = 10,000 units
o Budgeted price = $120 (same as static-budget, different from the actual)
o Budgeted variable cost per unit = $88 (same as static-budget, different from the actual)
o TR = Stat. Budgeted Price * Actual Output Quantity = $120 * 10,000 = $120,000
o VC = Stat. Budgeted VC per Unit * Actual Output Quantity = $88 * 10,000 = $88,000

o How about the flexible-budget fixed cost?

o Stat. Budget Unit Fixed Cost = $276,000 / 12,000 = $23 per output
o Is flexible-budget fixed cost equal to $23 * 10,000 = $230,000?
– No. Because $276,000 is FC for up to 12,000 outputs. Within 12,000 outputs, the budgeted
FC should always be $276,000.
What is Flexible Budget Variance?
Budgeted outputs = 12,000 units per month Actual outputs = 10,000 units in the month

Budget Actual Flexible-Budget Flexible-Budget Variance

Units Sold 12,000 outputs 10,000 10,000 0

Revenues $120 per output $1,250,000 $120 * 10,000 = 1,200,000 50,000 F
Variable Costs
DM $60 per output $621,600 $60 * 10,000 = 600,000 21,600 U
DL $16 per output $198,000 $16 * 10,000 = 160,000 38,000 U
VMOH $12 per output $130,500 $12 * 10,000 = 120,000 10,500 U
Total Variable Costs $950,100 $88 * 10,000 = 880,000 70,100 U
CM $299,900 ($120 - $88) * 10,000 = $320,000 20,100 U
Fixed MOH $23 per unit $285,000 $23 * 12,000 = $276,000 9,000 U
Operating Income $44,000 29,100 U
What is Sales Volume Variance?
■ Sales Volume Variance: Difference between flexible budget and static budget
o Variance arises solely from the difference between the actual output quantity (used in flexible-
budget) and the budgeted output quantity (used in static budget)
Budget Static Budget Flexible Budget Sales-Volume Variance
Units Sold 12,000 outputs 12,000 10,000 2,000 U
Revenues $120 per output $1,440,000 $1,200,000 $120 * 2000 = $240,000 U
Variable Costs
DM $60 per output $720,000 $600,000 $60 * 2000 = $120,000 F
DL $16 per output $192,000 $160,000 $16 * 2000 = $32,000 F
VMOH $12 per output $144,000 $120,000 $12 * 2000 = $24,000 F
Total Variable Costs $1,056,000 $880,000 $176,000 F
CM $384,000 $320,000 $64,000 U
Fixed Costs $23 per unit $276,000 $276,000 0
Operating Income $108,000 $44,000 $64,000 U
Decomposition of Static Budget Variance
■ Static-budget variance of any item equals to the sum of flexible-budget variance of the item plus
the sales-volume variance of the item.
■ Flexible Budget Variance and Sales Volume Variance are Level 2 analysis.

Static-Budget OI Variance
= Actual – Static Budget
= $93,100 U

Flex-Budget OI Variance Sales-Volume OI Variance

= Actual – Flex-Budget = Flex-Budget – Static-Budget
= $29,100 U = $64,000 U

Static-Budget OI Variance = FB OI Variance + Sales-Volume OI Variance

$93,100 U = $29,100 U + $64,000 U
Decomposition of Flexible Budget Variance
■ Flexible Budget Variance for Operating Income = (AP – AUC) * AQ – (BP – BUC) * AQ
= ((AP – AUC) – (BP – BUC)) * AQ
= ((AP – BP) – (AUC – BUC)) * AQ
(where AP=actual price, AQ=actual output quantity, AUC=actual unit cost,
BP=budgeted price, BQ=budgeted output quantity, BUC= budgeted unit cost)

□ (AP – BP) * AQ: Flexible budget variance for revenues.

o P affects this item → Selling-price variance
o How much of the actual and budgeted selling price differences contribute to the flexible-budget
variances.
□ (AUC – BUC) * AQ: Flexible budget variance for direct variable costs.
o Unit Cost affects this item, but Unit Cost = Input Price * Input Quantity
o Input price can affect this item → Price Variance
o Input quantity affect this item → Efficiency Variance (or Usage Variance)
✓ Note that selling-price variance is not equal to price variance
 What is Selling Price Variance?
■ Selling-Price Variance: (AP – BP) * AQ
o It arises solely from the difference between the actual selling price and the budgeted selling price
o Flexible budget variance for revenues.
o Sales managers are generally in the best position to understand and explain the reason for a selling
price difference.
o Example: Revisit Webb company case. Actual price is $125 while budgeted price is $120. They sell
10,000 units of jackets, while they budgeted 12,000 units.
o Selling-Price Variance = ($125 – $120) * 10,000 = 50,000 F
Level 1 Static-budget variance for operating income ($93,100 U)
Flexible-budget variance ($29,100 U) Sales-volume
Level 2 variance
($64,000 U)
Selling price Direct Direct Variable Fixed
variance materials manufacturing manufacturing manufacturing
($50,000 F) variance labor variance overhead variance overhead variance
(Next slides) (Next slides) (Ch. 8) (Ch. 8)
What are Price and Efficiency Variances?
■ Why do we have DM and DL flexible-budget variances? Actual Budget

□ Actual DM Cost = $28 * 2.22 * 10,000 = $621,600 Price of DM $28 $30

Price of DL $22 $20
□ Flex-Budget Cost of DM = $30 * 2 * 10,000 = $600,000 DM per output 2.22 2

o Again, only “flex” the output DL per output 0.9 0.8

Output 10,000 12,000
□ Actual DL Cost = $22 * 0.9 * 10,000 = $198,000
□ Flex-Budget Cost of DL = $20 * 0.8 * 10,000 = $160,000
o Again, only “flex” the output
□ Reasons:
o Price per input can be different
o Quantity per unit output can be different
□ Before investigating differences, how do we set these DM and DL budgets to begin
with?
What are Price and Efficiency Variances?
■ Standard Price and Standard Quantity
□ In order to determine whether firm paid too much on input costs or used too many
inputs, the firm needs a benchmark, against which they can compare the differences.
□ Firm managers use a standard costing system
□ Managers set a standard on how much they should pay for one unit of input, and how
many inputs they should use for output (considering operating efficiency)
□ Using Webb example:
■ Standard input quantity (SQ): budgeted quantity of input for one unit of output
o SQ of DM = 2 SQ of DL = 0.8
■ Standard input price (SP): budgeted price a firm expects to pay for a unit of input
o SP of DM = $30 SP of DL = $20 Actual Budget

■ Standard cost per output (SC): Budgeted cost of a unit of output Price of DM $28 $30

o SC of DM = 2 * $30 = $60 SC of DL = 0.8 * $20 = $16 Price of DL $22 $20

DM per output 2.22 2

DL per output 0.9 0.8

Output 10,000 12,000

What are Price and Efficiency Variances?
■ Standard Costing System Actual Budget
Price of DM $28 $30
□ Record both direct costs and indirect costs that “should have been Price of DL $22 $20
paid”
DM per output 2.22 units 2 units
□ How much they should have paid? This is based on “standards” DL per output 0.9 DLH 0.8 DLH
(budgets) set my managers Output 10,000 12,000

□ Question: How much money should have been paid for DM if the actual production is 10,000 units based on
the standard costing?
o For one unit of output, the manager set a standard for DM cost of___________________________
2 units per output * $30 per unit = $60 per output

10,000
o The actual production of _____________________ outputs
o Thus, the DM should have been paid for the actual production is ____________________________
$60 per output * 10,000 outputs = $600,000

o But the firm actually paid for the DM is ___________________________________________

22,200 * $28 = $621,600

Actual usage of DM = 2.22 * 10,000 = 22,200 units

Each unit has the actual cost $28
What are Price and Efficiency Variances?
■ A company further investigates the flexible-budget variances for its direct-cost inputs
□ Direct Cost Variance = Price Variance + Efficiency Variance

■ Price Variance: Reflect the difference between an actual input price and a standard
(budgeted) input price
o Do firms pay more or less than they “should have paid” to acquire the inputs they need?
o If a firm actually pays more to acquire direct inputs than “they should have paid” →
Purchasing price is too high
■ Efficiency Variance: Reflect the difference between actual input quantity and a standard
(budgeted) input quantity
o Do firms use more or fewer direct inputs than they “should have used” for the actual
output quantity?
o If a firm “actually” uses more direct inputs than “they should have used” for actual
production → Inefficient in production
Price Variance
■ Price Variance Formula = (Actual Price of Input – Standard Price of Input) * Actual Quantity of
Input = (AP-SP)*AQ
Actual Budget
o Price Variance of DM = ($28 – $30) * 22,200 = $44,400 F
Price of DM $28 $30
o Price Variance of DL = ($22 – $20) * 9,000 = 18,000 U Price of DL $22 $20

□ Under which circumstances would the DM price variance be favorable?DM per output 2.22 2

o Negotiating better prices with suppliers DL per output 0.9 0.8

o Finding alternative lower-cost materials Output 10,000 12,000

o Bulk purchasing discounts

o Budgeted purchase prices of direct materials were set too high.
□ Does favorable variance mean ‘favorable’ performance? Not always.
˗ The purchasing manager may have secured a discount by placing larger orders,
leading to higher inventory costs.
˗ The manager may have accepted a bid from a low-priced supplier by sacrificing
quality → higher defect rates and inspection costs.
Efficiency Variance
■ Efficiency Variance Formula = (Actual Quantity of Input – Budgeted Quantity of Input for Actual
Output) * Budgeted Input Price = (AQ-SQ)*SP

□ Actual Quantity of Input = Actual Quantity of Inputs per Output * Actual Quantity of Output
o The total number of inputs actually used for the total outputs
o Actual quantity of touchscreens used for the actual production of 10,000 iPhones is 10,100

□ Standard Quantity of Input for Actual Output = Standard Quantity of Input per Output * Actual
Output
o This is the flexible-budget quantity of total inputs
o Managers make a budget for the number of inputs per output
o But “flex” the output from budgeted output to actual output

□ Budgeted Input Price

o How much the firm plans to pay to acquire one unit of input
Efficiency Variance
■ Efficiency Variance = (Actual Quantity of Input – Budgeted Quantity of Input for Actual Output) *
Budgeted Input Price= (AQ-SQ)*SP
o Efficiency Variance of DM = (22,200 – 20,000) * 30 = 66,000 U
o Efficiency Variance of DL = (9,000 – 8,000) * $20 = 20,000 U

□ Under which circumstances would the DL efficiency variance be unfavorable?

o Slow and underskilled workers → requires reworking
o Inefficient production scheduling Actual Budget
o Improper maintenance → equipment failures Price of DM $28 $30
o Standards were set too tight. Price of DL $22 $20
o Question: DM per output 2.22 2

An unfavorable flexible-budget variance for variable costs may be the result of ________. DL per output 0.9 0.8

A) using more input quantities than were budgeted Output 10,000 12,000

B) paying lower prices for inputs than were budgeted

C) selling output at a higher selling price than budgeted
D) selling less quantity compared to the budgeted
Price and Efficiency Variance
■ The flexible-budget variance for total variable costs: (Actual input cost per output– budgeted input per
output) * Actual output quantity = (Actual input price*Actual input quantity per output - Standard input
price*Standard input quantity per output)*Actual output quantity = Actual input price*Total actual input
quantity (AP*AQ) - Standard input price*Total standard input quantity (SP*SQ)

Actual Quantity Actual Quantity at Standard Quantity Allowed for

at Actual Price Standard Price Actual Outputs at Standard Price
AP*AQ SP*AQ SP*SQ

Price Variance Efficiency Variance

(AP – SP)*AQ (AQ – SQ) * SP

Total Flexible-Budget Variance

AP * AQ – SP * SQ
 Price and Efficiency Variance

Level 1 Static-budget variance for operating income ($93,100 U)

Flexible-budget variance ($29,100 U) Sales-volume
Level 2 variance
($64,000 U)
Selling price Direct Direct Variable Fixed
variance materials manufacturing manufacturing manufacturing
($50,000 F) variance labor variance overhead variance overhead variance
(Next slides) (Next slides) (Ch. 8) (Ch. 8)

Level 3

Direct Material FB Variance ? 21,600 U = 44,400 F + 66,600 U

Direct Labor FB Variance ? 38,000 U = 18,000 U + 20,000 U
How to Record Price and Efficiency Variance in the Journal Entry?
□ Some general rules of the journal entries of standard costing
o Record the costs using “standards”

■ Rule 1: Unfavorable cost variances are always debits

o Firms spend more than they “should have spent”
o Actual spending is income decreasing → debit (increasing) cost

■ Rule 2: Favorable cost variances are always credits

o Firms spend less than they “should have spent”
o Actual spending is income increasing → credit (decreasing) cost
How to Record Price and Efficiency Variance in the Journal Entry?
□ DM Purchase
Actual Budget

Price of DM $28 $30

o Since we assume that Webb company does not have DM inventory Price of DL $22 $20

DM per output 2.22 2

DL per output 0.9 0.8

→ DM usage = DM purchase Output 10,000 12,000

2.22 * 10,000 = 22,200

o Webb company actually purchases DM = _________________________ units

o These DM are in DM inventory before changing into WIP goods and then FG
goods
How to Record Price and Efficiency Variance in the Journal Entry?
□ DM Purchase Actual Budget

o Record the DM Price Variance (44,400 F) at the time of purchase Price of DM $28 $30

o This is the earliest time possible to record this variance for control DM per output 2.22 2

Output 10,000 12,000

o The actual units of DM is 22,200
o Record the costs (value) of these 22,200 units of DM under standard costing
o Record the payment for these 22,200 units of DM

DR CR

22,200 * $30
DM
= $666,000 The cost (value) of 22,200 units
of DM under the standard costing
system
DM Price Variance $44,400

Cash 22,200 * $28 = $621,600

Actual payment in cash

Credit Favorable Variance

How to Record Price and Efficiency Variance in the Journal Entry?
□ DM Usage
Actual Budget
o Isolate the DM Efficiency Variance (66,000 U) at the time the direct Price of DM $28 $30
materials are used DM per output 2.22 2

o This is the earliest time possible to identify DM Efficiency Variance Output 10,000 12,000

DR CR

Each output uses (2 * $30 = $60) DM under SC, and

WIP total output is 10,00 units
→ Debit WIP by 10,000 * $60 = $600,000

DM Efficiency Variance $66,000

Actual use 22,200 units, and each unit has a

DM cost of $30 under SC
→ 22,200 * $30 = $666,000
How to Record Price and Efficiency Variance in the Journal Entry?
□ DL Usage and Purchase Actual Budget
Price of DL $22 $20
o Isolate the DL Price Variance (18,000 U) and Efficiency Variances
DL per output 0.9 0.8
(20,000 U) at the time labor is used Output 10,000 12,000

o This is the earliest time possible to identify the DL Price and Efficiency Variances

DR CR

Each output uses (0.8 * $20) = $16 DL under SC, and the
WIP total output is 10,000.
→ Debit WIP by $16 * 10,000 = $160,000

DL Price Variance $18,000

DL Efficiency Variance $20,000

(0.9 * $22) * 10,000

Cash = $198,000
How to Record Price and Efficiency Variance in the Journal Entry?
□ End of year adjustments – Write-off to COGS Approach
o Close all temporary variance accounts
o Debit the temporary accounts that have credits before
o Credit the temporary accounts that have debits before
o The difference between total debits and credits are allocated to the COGS account
o Direct Variance Account:
DM Price Variance = 44,400 F DL Price Variance = 18,000 U
DM Efficiency Variance = 66,000 U DL Efficiency Variance = 20,000 U

DR CR

DM Price Variance 44,400

DM Efficiency Variance 66,000

DL Price Variance 18,000 Total CR

= 104,000
DL Efficiency Variance 20,000

COGS 104,000 – 44,000 = 59,600

How to Record Price and Efficiency Variance in the Journal Entry?
o From the perspective of control, variances are isolated (recorded) at the earliest possible time
˗ DM Price Variance is calculated at the time materials are purchased
˗ DM Efficiency Variance is calculated at the time materials are used
˗ DL Price Variance and Efficiency Variance are calculated at the time direct labor is
used

o Managers take corrective actions as soon as when a variance is known

˗ Know Unfavorable DM Price Variance – Negotiating cost reductions from current
suppliers or obtaining price quotes from new suppliers
˗ Know Unfavorable DM or DL Efficiency Variance – Checking with the production line
managers to see how to improve production efficiency
Chapter Summary
□ Variance measures how actual amount differs from budgeted amount. Favorable variance increases operating
income while unfavorable variance decreases operating income.

□ Static budget variance is a difference between actual amount and budgeted amount in the static budget. It can be
decomposed into flexible budget variance and sales volume variance.

□ Flexible budget variance is difference between actual amount and budgeted amount in the static budget.

□ Sales volume variance is difference between flexible budget and actual amount. Flexible budget variance is
decomposed into flexible budget for revenues (or selling price variance) and flexible budget for direct variable
costs.

□ Flexible budget for direct variable cost is further decomposed into price variance and efficiency variance.

□ Students need to know how to calculate each variance and record variance in the journal entry.