The Flexible Budget and Standard Costing: Direct Materials and Direct Labor

1
The Flexible Budget and Standard Costing
Direct Materials and Direct Labor
Chapter Thirteen
2
Learning Objectives

• Explain the essence of control systems in general
  and operational control systems in particular
• Distinguish between effectiveness and efficiency
  aspects of operational performance
• Develop standard costs for product costing,
  performance evaluation, and control
• Develop and apply flexible budgets for evaluating
  short-term financial performance

3
Learning Objectives (continued)

• Recognize behavioral considerations in
  implementing a standard cost system
• (Appendix) Record manufacturing cost flows and
  associated variances in a standard cost system

4
Management Accounting Control Systems

• Control set of procedures, tools, and systems
  organizations use to monitor activities and guide
  managerial actions
• Management accounting control system core
  performance-measurement system of the
  organization, including both planning and
  feedback components
• Management Control Systems
• Operational Control Systems

5
Evaluation Operating Performance

• Components of an Operational Control System
• Effectiveness
• Has the organization accomplished its specified
  goals?
• Efficiency
• Did the organization use resources efficiently?
  (Comparison of inputs to outputsproductivity)
• Financial Performance Measures
• Standard Cost (and Revenue) Variance Analysis
• Nonfinancial Performance Indicators
• These measures can be leading indicators
  (predictors) of future financial performance

6
Standard Costs

• Standard Costs vs. a Standard Cost System?
• Standard Costs costs that should be incurred
  under efficient operating conditions
• Standard Cost System standard costs recorded in
  the formal accounting records
• Regardless of whether a standard cost system is
  used, standard costs can be useful at the end of
  the period for financial control purposes (i.e.,
  conducting variance analysis)

7
Standard Costs

• Types of Standards
• Ideal (Perfection) Standards
• Currently Attainable Standards
• Standard-Setting Procedures
• Authoritative Standards
• Participative Standards
• Standard Cost Sheet
• Contains both price and quantity components of
  each cost
• See text Exhibits 13.2 and 13.3

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Budget Preparation

• Master Budget
• Prepared before the start of the period
• Contains the following items
• Budgeted sales volume
• Budgeted sales price per unit
• Budgeted variable cost per unit
• Budgeted total fixed costs
• Flexible (Control) Budget
• Prepared at the end of the period (after actual
  activity is known)
• Actual sales volume is used, but with budgeted
  selling price per unit, budgeted variable cost
  per unit, and budgeted total fixed costs
• Key to performing variance analysis at the end of
  the period

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Master Budget Example
10
Actual Operating Profit Generated
During the period the company actual produced and
sold 8,000 units (not 10,000 as was originally
planned). The actual operating income is 12,400,
as follows
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Total Operating Income (Master Budget) Variance
for the Period (12,600 U)
12
Flexible Budget Example
At the end of the period, we prepare a flexible
(control) budget based on the 8,000 unit level,
as follows
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Explaining the Total Operating Income Variance

• The total operating income variance should be
  traceable to a combination of the following four
  factors
• Actual sales volume was different than planned
• Actual variable cost per unit was different than
  planned
• Actual total fixed costs were different than
  planned
• Actual selling price per unit was different than
  planned
• The flexible budget allows us to breakdown the
  total operating income variance into components
  related to the above four factors

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Decomposing the Total Operating Income Variance
(5,300 U)
(1) (2)
(3)
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Breakdown of Total Operating Income Variance
(5,300 U)

• The difference between actual results and the
  flexible budget results 4,700 F
• This difference is called the total flexible
  (controllable) budget variance
• This variance captures the net effect of
• Actual selling prices per unit being different
  than planned
• Actual variable cost per unit was different than
  planned
• Actual total fixed costs were different than
  planned

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Breakdown of Total Operating Income Variance
(continued)

• The difference between the flexible budget
  results and the master budget results 10,000
  U
• This difference is called the sales volume
  variance
• Everything else other than volume is being held
  constant in calculating this variance hence,
  the difference in operating income between the
  two budget columns is due entirely to sales
  volume being different than planned
• The sales volume variance can also be
  calculated as budgeted cm per unit x (actual
  budgeted) units
• In the example 5/unit x 2,000 units 10,000
  U

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Breakdown of Total Operating Income Variance
Summary

• Total Operating Income Variance Actual
  Operating Income Master Budgeted Operating
  Income
• 19,700 - 25,000 5,300 U
• Flexible (Controllable) Budget Variance
  Actual Operating Income Flexible Budget
  Operating Income
• 19,700 - 15,000 4,700 F

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Breakdown of Total Operating Income Variance
(continued)

• Sales Volume Variance Flexible Budget
  Operating Income Master Budget Operating
  Income
• 15,000 - 25,000 10,000 U
• Total Operating Income Variance Flexible
  Budget Variance Sales Volume Variance
• 4,700F 10,000U 5,300 U

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Breakdown of Total Flexible (Controllable) Budget
Variance (4,700 F)
Sales Price Variance Actual Sales -
Flexible Budget Sales 88,000 - 80,000
8,000 F Or, AQ x (AP SP) 8,000 units x
(11 - 10)/unit 8,000 F
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Breakdown of Total Flexible (Controllable) Budget
Variance (4,700 F) (continued)

• Total Fixed Cost Variance Actual Fixed Costs
  Flexible Budget Fixed Cost
• 25,700 - 25,000 700 U
• Note that this budget (spending) variance on
  fixed costs can be further broken down
• First, by functional categories (e.g.,
  Marketing)
• Second, by individual costs within categories
  (e.g., Sales Manager Salaries)

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Breakdown of Total Flexible (Controllable) Budget
Variance (4,700F) (continued)

• Total Variable Cost Variance Actual Variable
  Costs Flexible Budget Variable Costs
• 42,600 - 40,000 2,600 U
• or, AQ x (AP SP)
• 8,000 units x (5.325 - 5.00)/unit 2,600
  U
• This total variance can be further broken down
• First, by functional categories (e.g.,
  Manufacturing)
• Second, by individual costs within categories
  (e.g., Direct Materials Cost)

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General Model Decomposing Variable Cost Flexible
Budget Variances into Price and Quantity
Components
(1)
(2)
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Decomposing Variable Cost Variances into Price
and Quantity Components Variable Notation
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Formulas for Decomposing Variable Cost Flexible
Budget Variances into Price and Quantity
Components

• Variable Cost Variance Actual Variable Costs
  Flexible Budget Variable Costs
• (AQ x AP) x (SQ x SP)
• Breakdown of total variance
• Price (Rate) Variance AQ x (AP SP)
• Quantity (Efficiency) Variance SP x (AQ
  SQ)

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Formulas for Decomposing Variable Cost Flexible
Budget Variances into Price and Quantity
Components (continued)

• Notes
• For DM AQ in the Price Variance formula
  represents actual quantity purchased
• SQ standard quantity of resource input (e.g.,
  DL) for the output of the period
• In a standard cost system, these variances are
  recorded in the formal accounting records (i.e.,
  each in a descriptive account, such as Direct
  Labor Rate Variance)

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Example Direct Materials (DM) Variance
Decomposition
Hanson Inc. has the following direct material
standard to manufacture one unit of Jerf 1.5
pounds per Jerf at 4.00 per pound Last month
1,700 pounds of material were purchased and used
to make 1,000 Jerfs. The material cost a total of
6,630.
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Direct Materials (DM) VarianceQuestion 1
What is the actual price per pound (AP) paid for
the material? a. 4.00 per pound. b. 4.10
per pound. c. 3.90 per pound. d. 6.63 per
pound.
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Answer Question 1
What is the actual price per pound(AP) paid for
the material? a. 4.00 per pound. b. 4.10
per pound. c. 3.90 per pound. d. 6.63 per
pound.
AP 6,630 1,700 lbs.AP 3.90 per lb.
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Direct Materials (DM) VarianceQuestion 2
Hansons materials price variance (MPV) forthe
month was a. 170 unfavorable. b. 170
favorable. c. 800 unfavorable. d. 800
favorable.
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Answer Question 2
Hansons materials price variance (MPV) forthe
month was a. 170 unfavorable. b. 170
favorable. c. 800 unfavorable. d. 800
favorable.
MPV AQ x (AP - SP) MPV 1,700 lbs. (3.90
- 4.00) MPV 170 Favorable
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Direct Materials (DM) VarianceQuestion 3
The standard quantity (SQ) of material
thatshould have been used to produce 1,000
Jerfs is a. 1,700 pounds. b. 1,500
pounds. c. 2,550 pounds. d. 2,000 pounds.
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Answer Question 3
The standard quantity of material (SQ)
thatshould have been used to produce 1,000
Jerfs is a. 1,700 pounds. b. 1,500
pounds. c. 2,550 pounds. d. 2,000 pounds.
SQ 1,000 units 1.5 lbs per unit SQ 1,500
lbs
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Direct Materials (DM) VarianceQuestion 4
Hansons material usage variance (MUV) for the
month was a. 170 unfavorable. b. 170
favorable. c. 800 unfavorable. d. 800
favorable.
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Answer Question 4
Hansons material usage variance(MUV) for the
month was a. 170 unfavorable. b. 170
favorable. c. 800 unfavorable. d. 800
favorable.
MUV SP x (AQ - SQ) MUV 4.00 x (1,700 -
1,500) lbs. MUV 800 unfavorable
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Direct Materials (DM) Variances Summary
Total Flexible Budget Variance 6,630 - 6,000
630U
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Causes of DM Variances

• Price Variances
• Purchase of materials of different grade
• Quantity discounts
• Freight/delivery expediting cost (rush orders)
• Quantity Variances
• Purchase of non-standard quality materials
• Poorly trained or poorly supervised workers
• Poorly maintained machinery (not calibrated
  properly)

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Causes of DL Variances

• Price (Rate) Variances
• Labor substitution
• Out-of-date standards (e.g., new labor contract)
• Quantity (Efficiency) Variances
• Poorly trained workers
• Poor quality raw materials used in production
• Poorly maintained equipment
• Poor supervision of workers
• Out-of-date standards

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Behavioral/Implementation Issues

• A standard cost system provides guidelines for
  operations and criteria or benchmarks for
  evaluating performance.
• Companies should use variances strictly as
  inputs to gain a better understanding of and to
  improve operations
• Variances should not be used to place blame
  (i.e., avoid scapegoating)
• Research shows the importance of linking
  incentives to performance

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Appendix Recording Standard Costs
Recording DM Purchases
Materials Inventory (AQ X SP)
6,800 Materials Purchase Price Variance
170 Accounts Payable (AQ x
AP) 6,630

Recording DM Usage
Work-in-process Inventory (SQ X SP)
6,000 Materials Usage Variance
800 Materials Inventory (AQ x SP)
6,800
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Chapter Summary

• We defined the terms control systems, management
  accounting control systems, and operational
  control systems
• We distinguished between effectiveness and
  efficiency aspects of operational performance
• We discussed the development of standard costs
  for product costing, performance evaluation, and
  control
• We distinguished between flexible budgets and
  master budgets the former are key for evaluating
  short-term financial performance (i.e., for
  financial control purposes)

41
Chapter Summary (continued)

• The difference between actual operating income
  and master budgeted operating income total
  operating income variance
• Also called total master (static) budget
  variance
• Through the introduction of a flexible budget
  based on output, the total operating income
  variance is broken down into
• A total flexible budget variance, and
• A sales volume variance budgeted cm/unit x
  (actual budgeted) sales in units

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Chapter Summary (continued)

• The total flexible (controllable) budget variance
  is then broken down into component variances,
  e.g.,
• Total variable manufacturing cost variance
• Total variable selling administrative cost
  variance
• Total fixed manufacturing cost variance
• Total fixed selling administrative cost
  variance
• Further breakdown of the total variable
  manufacturing cost variance
• Total DM variance
• Total DL variance
• Total variable overhead variance (Chapter 14)

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Chapter Summary (continued)

• Breakdown (decomposition) of total DM variance
• DM Purchase Price Variance
• AQ x (AP SP)
• DM Quantity Variance
• SP x (AQ SQ)
• Breakdown (decomposition) of total DL variance
• DL Price (Rate) Variance
• AQ x (AP SP)
• DL Quantity (Efficiency) Variance
• SP x (AQ SQ)

44
Chapter Summary (continued)

• We discussed various behavioral considerations in
  implementing a standard cost system
• (Appendix) We discussed how to record
  manufacturing cost flows and associated variances
  in a standard cost system
• Standard cost variance analysis for overhead
  costs is covered in Chapter 14
• The end-of-period disposition of standard cost
  variance accounts is covered in Chapter 14