CHAPTER 7
Flexible Budgets,
Direct-Cost Variances,
and
Management Control
Basic Concepts
 Variance – difference between an actual and
an expected (budgeted) amount
 Management by Exception – the practice of
focusing attention on areas not operating as
expected (budgeted)
 Static (Master) Budget – is based on the
output planned at the start of the budget
period
To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved.
7-2
Basic Concepts
 Static-Budget Variance (Level 0) – the difference
between the actual result and the corresponding
static budget amount
 Favorable Variance (F) – has the effect of increasing
operating income relative to the budget amount
 Unfavorable Variance (U) – has the effect of
decreasing operating income relative to the budget
amount
To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved.
7-3
Variances
 Variances may start out “at the top” with a
Level 0 analysis
 This is the highest level of analysis, a supermacro view of operating results
 The Level 0 analysis is nothing more than the
difference between actual and static-budget
operating income
To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved.
7-4
Variances
 Further analysis decomposes (breaks down)
the Level 0 analysis into progressively
smaller and smaller components

Answers: “How much were we off?”
 Levels 1, 2, and 3 examine the Level 0
variance into progressively more-detailed
levels of analysis

Answers: “Where and why were we off?”
To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved.
7-5
A Simple Example
 Operating Indicators:
Indicator
Actual
Results
Units Sold
Selling Price
Static
Budget
100
90
$
35 $
30
Direct Material Cost per Unit
$
Direct Labor Cost per Unit
$
Variable Manufacturing Overhead per Unit $
7 $
10 $
5 $
6
10
6
600 $
700
Fixed Costs
$
To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved.
7-6
A Simple Example
Actual Results
Units Sold
100
Static-Budget
Variances
Static Budget
10 F
90
Revenues
$
Variable Costs:
Direct Materials
Direct Labor
Variable Factory Overhead
3,500 $
800 F
700
1,000
500
160 U
100 U
(40) F
540
900
540
Contribution Margin
1,300
580 F
720
600
(100) F
700
700 $
680 F
Fixed Costs
Operating Income
$
$
$
Level 1
Analysis
2,700
20
Level 0 Analysis
To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved.
7-7
Evaluation
 Level 0 tells the user very little other than how much
Contribution Margin was off from budget: a $680 F
variance in this case

Level 0 answers the question: “How much were we off
in total?”
 Level 1 gives the user a little more information: it
shows which line-items led to the total Level 0
variance

Level 1 answers the question: “Where were we off?”
To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved.
7-8
Flexible Budget
 Flexible Budget – shifts budgeted revenues
and costs up and down based on actual
operating results (activities)
 Represents a blending of actual activities and
budgeted dollar amounts
 Will allow for preparation of Levels 2 and 3
variances

Answers the question: “Why were we off?”
To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved.
7-9
A Flexible-Budget Example
Actual Results
Units Sold
Flexible-Budget
Variances
100
-
N/A
Revenues
$
Variable Costs:
Direct Materials
Direct Labor
Variable Factory Overhead
3,500 $
500 F
700
1,000
500
100 U
N/A
(100) F
Contribution Margin
1,300
Fixed Costs
Operating Income
Level 3
Variances will
explore these
figures in detail
$
Flexible Budget
Sales-Volume
Variances
100
10 F
90
3,000 $
300 F
600
1,000
600
60 U
100 U
60 U
540
900
540
500 F
800
80 F
720
600
(100) F
700
-
700
700 $
600 F
100 $
80 F
Level 2 Variances:
Flexible-Budget
$
Static Budget
$
$
2,700
N/A
$
20
Level 2 Variances:
Sales-Volume
Level 1 Variance:
Static-Budget
To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved.
7-10
Level 3 Variances
 All Product Costs can have Level 3
Variances. Direct Materials and Direct Labor
will be handled next. Overhead Variances
are discussed in detail in a later chapter
 Both Direct Materials and Direct Labor have
both Price and Efficiency Variances, and their
formulae are the same
To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved.
7-11
Level 3 Variances
 Price Variance formula:
Price
Variance
=
{
Actual Price
Of Input
-
Budgeted Price
Of Input
}X
Actual Quantity
Of Input
 Efficiency Variance formula:
Efficiency
Variance
=
{
Actual Quantity
Of Input Used
-
Budgeted Quantity of Input
Allowed for Actual Output
}X
Budgeted Price
Of Input
To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved.
7-12
Variances and Journal Entries
 Each variance may be journalized
 Each variance has its own account
 Favorable variances are credits; Unfavorable
variances are debits
 Variance accounts are generally closed into
Cost of Goods Sold at the end of the period, if
immaterial
To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved.
7-13
Standard Costing
 Budgeted amounts and rates are actually
booked into the accounting system
 These budgeted amounts contrast with actual
activity and give rise to Variance accounts
To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved.
7-14
Standard Costing
 Reasons for implementation:


Improved software systems
Wide usefulness of variance information
To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved.
7-15
Management Uses of Variances
 To understand underlying causes of
variances
 Recognition of inter-relatedness of variances
 Performance Measurement


Managers ability to be Effective
Managers ability to be Efficient
To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved.
7-16
Activity-Based Costing and Variances
 ABC easily lends itself to budgeting and
variance analysis
 Budgeting is not conducted on the
departmental-wide basis (or other macro
approaches)
 Instead, budgets are built from the bottom-up
with activities serving as the building blocks of
the process
To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved.
7-17
Benchmarking and Variances
 Benchmarking is the continuous process of
comparing the levels of performance in
producing products and services against the
best levels of performance in competing
companies
 Variances can be extended to include
comparison to other entities
To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved.
7-18