Slide 1

A short note on budgets and variance analysis

What is a budget?Why do we need budgets?PlanningCommunication and coordinationAllocating resourcesPerformance evaluation and incentives.Different types of budgets:Bottom up (participative) vs. top down.Zero-based vs. incremental.Detailed vs. aggregate.Short run vs. long run.Static vs. flexible.

Budgeted Income StatementCash BudgetSales of Services or GoodsEndingInventoryBudgetWork in Processand FinishedGoodsProductionBudgetDirectMaterialsBudgetSelling andAdministrativeBudgetDirectLaborBudgetOverheadBudgetEndingInventoryBudgetDirect MaterialsBudgeted Balance SheetBudgeted Statement of Cash FlowsThe master budget comprises many separate budgets, or schedules, that are interdependent. Based on the sales budget, a company develops a set of operational budgets that specify how its operations will be carried out to meet the demand for its goods or services. A manufacturing company develops a production budget, which shows the number of product units to be manufactured and ending inventory budgets. From the production budget, a manufacturer develops budgets for the direct materials, direct labor, and overhead that will be required in the production process. A budget for selling and administrative expenses also is prepared. The operational portion of the master budget is similar in a merchandising firm, but instead of a production budget for goods, a merchandiser develops a budget for merchandise purchases. A merchandising firm will not have a budget for direct materials. Based on the sales budget for its services, a service industry firm develops a set of budgets that show how the demand for those services will be met. Every business prepares a cash budget. This budget shows expected cash receipts, as a result of selling goods or services, and planned cash disbursements, to pay the bills incurred by the firm. The final portion of the master budget includes a budgeted income statement, a budgeted balance sheet, and a budgeted statement of cash flows. (LO2)

Activity-Based Costing versus Activity-Based BudgetingResourcesCost objects:products and servicesproduced, andcustomers served.ActivitiesResourcesForecast of productsand services to beproduced andcustomers served.ActivitiesActivity-BasedCosting (ABC)Activity-BasedBudgeting (ABB)Applying ABC concepts to the budgeting process yields activity-based budgeting or ABB. Under ABB, the first step is to specify the products or services to be produced and the customers to be served. Then the activities that are necessary to produce these products and services are determined. Finally, the resources necessary to perform the specified activities are quantified. Conceptually, ABB takes the ABC model and reverses the flow of the analysis. ABC assigns resource costs to activities, and then it assigns activity costs to products and services produced and customers served. ABB, on the other hand, begins by forecasting the demand for products and services as well as the customers to be served. These forecasts then are used to plan the activities for the budget period and budget the resources necessary to carry out the activities. (LO3)Static versus Flexible Budgets

Master/Static budgetex-ante analysis of what management expects to happen in the future, consisting of:sales projectionsoperating and financial budgetspro-forma financial statementsFlexible budgetadjusts for changes in volume ONLYapplies estimate of variable costs to new volume levelsfixed costs do NOT change, since they do not fluctuate with changes in volume (within the relevant range)often prepared for purposes of performance evaluation

An exampleStandards: P = $10/unit; VC = $5/unit; FC = $3,000/period; Sales volume = 3,000 units; Actual sales = 2,000 units.Master/StaticActual Variance# Units3,0002,000Sales$30,000 $22,500 V. Costs$15,000 $11,000 CM$15,000 $11,500 FC$3,000 $4,000 Profit$12,000 $7,500 An exampleStandards: P = $10/unit; VC = $5/unit; FC = $3,000/period; Sales volume = 3,000 units; Actual sales = 2,000 units.

Master/StaticActual Flexible Variance# Units3,0002,000Sales$ 30,000$ 22,500V. Costs$ 15,000$ 11,000CM$ 15,000$ 11,500FC$ 3,000$ 4,000Profit$ 12,000$ 7,500

VARIANCE ANALYSISVariance = difference between actual results and budgeted static budget variance = difference between actual results and static budget (formulated at beginning of periodvolume variancemarket share variance / Mix variancemarket volume varianceflexible budget variance = difference between actual and flexible budget (adjusted for realized production/sales)price varianceefficiency variance(Effectiveness: Doing right things; Efficiency: Doing things right)Total Variance Flexible Budget Variance Volume Variance Price Efficiency Mkt. Share/Mix Mkt. Volume Variance Variance Variance VarianceSTANDARD COST PRODUCTION VARIANCESA.Variable Manufacturing Inputs (DM, DL, VOH)Incurred Costs Flexible Budget Static Budget

AP x AQI SP x SQIAO SP x SQISO(Actual Costs of (Std. Costs given (Std. Costs based onInputs) Actual Output) Std. Output)SP X AQI (Std. Costs given Actual Inputs)

Price (Spending Variance Efficiency Variance Volume Variance= (AP-SP) X AQI = (AQI SQIAO) X SP = (SQIAO SQISO) X SP

Flexible Budget Variance = AP X AQI SP X SQIAONotation:AP = actual price paid for the input/resourceAQI = actual quantity of input usedSP = standard price of input/resourceSQIAO = Standard quantity of Input allowed given the Actual quantity of Output produced/soldSQISO = Standard quantity of Input allowed given the Standard quantity of Output produced/sold#ISB Sri S. Sridharan11Variable Cost VariancesPrice/Spending Variance

Efficiency Variance

Results from paying moreor less than expected forinputs.Results from using moreor less than expectedamounts of inputs. #ISB Sri S. SridharanAn unfavorable spending variance simply means that the total actual cost of variable overhead is greater than expected, after adjusting for the actual quantity of process hours used. An unfavorable spending variance could result from paying a higher-than-expected price per unit for variable-overhead items. Or the variance could result from using more of the variable-overhead items than expected. The variable overhead efficiency variance is a function of the cost driver selected. It does not reflect overhead control. Therefore, the spending variance is the real control variance for variable overhead. Managers can use the spending variance to alert them if variable-overhead costs are out of line with expectations. (LO5)

STANDARD COST PRODUCTION VARIANCESA.Variable Manufacturing Inputs (DM, DL, VOH)Incurred Costs Flexible Budget Static Budget

AP x AQI SP x SQIAO SP x SQISO(Actual Costs of (Std. Costs given (Std. Costs based onInputs) Actual Output) Std. Output)SP X AQI (Std. Costs given Actual Inputs)

Price (Spending Variance Efficiency Variance Volume Variance= (AP-SP) X AQI = (AQI SQIAO) X SP = (SQIAO SQISO) X SP

Flexible Budget Variance = AP X AQI SP X SQIAONotation:AP = actual price paid for the input/resourceAQI = actual quantity of input usedSP = standard price of input/resourceSQIAO = Standard quantity of Input allowed given the Actual quantity of Output produced/soldSQISO = Standard quantity of Input allowed given the Standard quantity of Output produced/sold#ISB Sri S. Sridharan13INTERPRETATION OF OVERHEAD VARIANCES Variable OH Variances:price variance = (AP SP ) x AQI efficiency variance = (AQI SQIAO) x SP volume variance =( SQIAO SQISO ) x SP Fixed OH Variances:budgeted variance in FOH = FOHact - FOHbudproduction volume variance = FOHbud - FOHappIied

DMDLVOHStd. # units of input allowed to produce one unit of good output211Actual # units purchased and used 3,0002,500?Actual cost per unit of input $ 1.50.82Std. cost per unit of input $ 112#ISB Sri S. Sridharan14