Introduction to Management Accounting

Introduction to Budgets & Introduction to Budgets & Variance Analysis Variance Analysis

Introduction to Budgets & Introduction to Budgets & Variance Analysis Variance Analysis

Chapter 8Chapter 8

Budgets and the Organization

BudgetsBudgetsBudgetsBudgets Goals and Goals and objectivesobjectivesGoals and Goals and objectivesobjectives

A budget provides a comprehensive financial A budget provides a comprehensive financial overview of planned company operations.overview of planned company operations.

A budget provides a comprehensive financial A budget provides a comprehensive financial overview of planned company operations.overview of planned company operations.

Benefits of Budgets

Provide an opportunity to Provide an opportunity to reevaluate existing activitiesreevaluate existing activities

and evaluate new ones.and evaluate new ones.

Provide an opportunity to Provide an opportunity to reevaluate existing activitiesreevaluate existing activities

and evaluate new ones.and evaluate new ones.

Aid managers in communicating Aid managers in communicating objectives and coordinating actions objectives and coordinating actions

across the organization. across the organization.

Aid managers in communicating Aid managers in communicating objectives and coordinating actions objectives and coordinating actions

across the organization. across the organization.

CompelCompelmanagersmanagers

to thinkto thinkaheadahead

CompelCompelmanagersmanagers

to thinkto thinkaheadahead

Types of Budgets

Strategic planStrategic planStrategic planStrategic plan Long-range planningLong-range planningLong-range planningLong-range planning

Capital budgetCapital budgetCapital budgetCapital budget

Master budgetMaster budgetMaster budgetMaster budget

Continuous budget Continuous budget Continuous budget Continuous budget

Strategic Plan

The most forward-looking budget is theThe most forward-looking budget is thestrategic plan, which sets the overallstrategic plan, which sets the overall

goals and objectives of the organization.goals and objectives of the organization.

The most forward-looking budget is theThe most forward-looking budget is thestrategic plan, which sets the overallstrategic plan, which sets the overall

goals and objectives of the organization.goals and objectives of the organization.

The strategic plan leads to long-rangeThe strategic plan leads to long-rangeplanning, which producesplanning, which produces

forecasted financial statementsforecasted financial statementsfor five- to ten-year periods.for five- to ten-year periods.

The strategic plan leads to long-rangeThe strategic plan leads to long-rangeplanning, which producesplanning, which produces

forecasted financial statementsforecasted financial statementsfor five- to ten-year periods.for five- to ten-year periods.

Master Budget

SalesSalesSalesSales

ProductionProductionProductionProduction

DistributionDistributionDistributionDistribution

FinanceFinanceFinanceFinance

The master budgetThe master budget

is a detailed and is a detailed and

comprehensive analysis comprehensive analysis

of the first year of theof the first year of the

long-range plan. long-range plan.

It summarizes theIt summarizes the

planned activitiesplanned activities

of all subunits ofof all subunits of

an organizatioan organization.n.

The master budgetThe master budget

is a detailed and is a detailed and

comprehensive analysis comprehensive analysis

of the first year of theof the first year of the

long-range plan. long-range plan.

It summarizes theIt summarizes the

planned activitiesplanned activities

of all subunits ofof all subunits of

an organizatioan organization.n.

Continuous Budget

Rolling budgets...Rolling budgets...Rolling budgets...Rolling budgets...are a common form ofare a common form ofmaster budgets that master budgets that add a month in the add a month in the future as the month future as the month

just ended is dropped.just ended is dropped.

are a common form ofare a common form ofmaster budgets that master budgets that add a month in the add a month in the future as the month future as the month

just ended is dropped.just ended is dropped.

Operating budgetOperating budget(Profit plan). . .(Profit plan). . .

Financial budget. Financial budget. . .. .

Master Budget

Focuses on the Focuses on the Income Statement Income Statement

and supporting and supporting schedules or schedules or

budgeted budgeted expenses.expenses.

Focuses on the Focuses on the effects that the effects that the

operating budget operating budget and other plans will and other plans will

have on cash have on cash balances.balances.

Steps in Preparing the Master Budget

1. Basic data1. Basic data1. Basic data1. Basic data

2. Operating budget2. Operating budget2. Operating budget2. Operating budget

3. Financial budget3. Financial budget3. Financial budget3. Financial budget

Steps in Preparing the Master Budget

1. Basic data1. Basic dataa.a. Sales budgetSales budgetb.b. Cash collections from customersCash collections from customersc.c. Purchases and cost-of-goods sold budgetPurchases and cost-of-goods sold budgetd.d. Cash disbursements for purchasesCash disbursements for purchasese.e. Operating expense budgetOperating expense budgetf.f. Cash disbursements for operating expensesCash disbursements for operating expenses

1. Basic data1. Basic dataa.a. Sales budgetSales budgetb.b. Cash collections from customersCash collections from customersc.c. Purchases and cost-of-goods sold budgetPurchases and cost-of-goods sold budgetd.d. Cash disbursements for purchasesCash disbursements for purchasese.e. Operating expense budgetOperating expense budgetf.f. Cash disbursements for operating expensesCash disbursements for operating expenses

The principal steps in preparingThe principal steps in preparingthe master budget:the master budget:

The principal steps in preparingThe principal steps in preparingthe master budget:the master budget:

Steps in Preparing the Master Budget

Financial BudgetFinancial Budget3.3. Prepare forecasted financial statements:Prepare forecasted financial statements:

b.b. Capital budgetCapital budgetc.c. Cash budgetCash budgetd.d. Budgeted Balance sheetBudgeted Balance sheet

Financial BudgetFinancial Budget3.3. Prepare forecasted financial statements:Prepare forecasted financial statements:

b.b. Capital budgetCapital budgetc.c. Cash budgetCash budgetd.d. Budgeted Balance sheetBudgeted Balance sheet

Operating BudgetOperating Budget2. Prepare budgeted income statement using basic data in step 1.2. Prepare budgeted income statement using basic data in step 1.

Operating BudgetOperating Budget2. Prepare budgeted income statement using basic data in step 1.2. Prepare budgeted income statement using basic data in step 1.

Human Relations Problems

1. Low levels of participation in the 1. Low levels of participation in the budget process andbudget process and

Lack of acceptance of responsibility for Lack of acceptance of responsibility for the final budget.the final budget.

2. Incentives to lie and cheat in the 2. Incentives to lie and cheat in the budget process.budget process.

3. Difficulties in obtaining accurate 3. Difficulties in obtaining accurate sales forecasts.sales forecasts.

1. Low levels of participation in the 1. Low levels of participation in the budget process andbudget process and

Lack of acceptance of responsibility for Lack of acceptance of responsibility for the final budget.the final budget.

2. Incentives to lie and cheat in the 2. Incentives to lie and cheat in the budget process.budget process.

3. Difficulties in obtaining accurate 3. Difficulties in obtaining accurate sales forecasts.sales forecasts.

Competitors’

Competitors’

actionsactions

Past patterns

Past patterns

of sales

of sales

Estimates made

Estimates made

By sales force

By sales forceGen

eral

Gener

al

econ

omic

econ

omic

conditi

ons

conditi

ons

Factors to Consider When Forecasting Sales

Changes in the

Changes in the

firm’s prices

firm’s pricesChanges in

Changes in

product mix

product mix

Market Market

research research

studiesstudies

Advertisin

g

Advertisin

g

and sales

and sales

promotion plans

promotion plans

Favorable and Unfavorable Variances

ProfitProfit Revenue CostsRevenue CostsActual > Expected Actual > Expected F F F F U UActual < ExpectedActual < Expected U U U U F F

Favorable (F) versus Unfavorable (U) Favorable (F) versus Unfavorable (U) VariancesVariances

Case 1

budget actual

Units sold 10,000,000 9,000,000

Cost(strictly variable cost)

1,000,000 940,000

Static and Flexible Budgets

A static budget is prepared for only one levelA static budget is prepared for only one levelof a given type of activity. Differences between of a given type of activity. Differences between

actual results and the static budget for level actual results and the static budget for level of output achieved are static-budget variances.of output achieved are static-budget variances.

A flexible budget (variable budget) adjustsA flexible budget (variable budget) adjustsfor different levels of activities. Differences for different levels of activities. Differences

between actual results and the flexible between actual results and the flexible budget are flexible-budget variances.budget are flexible-budget variances.

Evaluation of Financial Performance

2) revenue or variable costs per unit of activity and2) revenue or variable costs per unit of activity andfixed costs per period were not as expected.fixed costs per period were not as expected.

Actual results may differ fromActual results may differ fromthe master budget because...the master budget because...

1) sales and other cost-driver activities were1) sales and other cost-driver activities werenot the same as originally forecasted, ornot the same as originally forecasted, or

Evaluation of Financial Performance

UnitsUnits 7,000 7,000 – – 7,000 2,000U 9,000 7,000 2,000U 9,000 SalesSales $217,000$217,000 – – $217,000 $217,000 $62,000 U $279,000 $62,000 U $279,000Variable costsVariable costs 158,200 158,200 5,6705,670 U U 152,600 43,600 152,600 43,600 F F 196,200 196,200Contribution marginContribution margin $ 58,730 $ 5,670 U $ 58,730 $ 5,670 U $ 64,400 $ 64,400 $18,400 U $ 82,800 $18,400 U $ 82,800Fixed costsFixed costs 70,300 300 70,300 300 U U 70,000 70,000 – – 70,00070,000Operating incomeOperating income $ (11,570) $5,970 U $ (11,570) $5,970 U $(5,600) $(5,600) $18,400 U $ 12,800 $18,400 U $ 12,800

ActuaActual l

resulresults at ts at actuaactua

l l activiactivi

ty ty levellevel

(1)(1)

Flexible-Flexible-budget budget

variancevariances s

(2) = (2) = (1)-(3)(1)-(3)

FlexibFlexible le

budgebudget for t for

actual actual sales sales activitactivit

yy

(3)(3)

Sales-Sales-Activity Activity VarianceVariance

(4) = (4) = (3)–(5)(3)–(5)

StatiStatic c

BudgBudgetet

(5)(5)

Isolating the Causes of Variances

Managers use comparisons amongManagers use comparisons among actual results, master budgets,actual results, master budgets,and flexible budgets to evaluateand flexible budgets to evaluate

organizational performance.organizational performance.

Isolating the Causes of Variances

Effectiveness is the degree to whichEffectiveness is the degree to whicha goal, objective, or target is met.a goal, objective, or target is met.

Performance may be effective,Performance may be effective,efficient, both, or neither.efficient, both, or neither.

Efficiency is the degree to which inputs areEfficiency is the degree to which inputs areused in relation to a given level of outputs.used in relation to a given level of outputs.

Flexible-Budget Variances

Total flexible-budget varianceTotal flexible-budget variance= Total actual results= Total actual results–– Total flexible-budget planned resultsTotal flexible-budget planned results

Flexible-budget variances Flexible-budget variances Flexible-budget variances Flexible-budget variances

ActualActualresultsresults

$(11,570)$(11,570)

ActualActualresultsresults

$(11,570)$(11,570)

FlexibleFlexiblebudgetbudget

$(5,600)$(5,600)

FlexibleFlexiblebudgetbudget

$(5,600)$(5,600)$$5,970 Unfavorable5,970 Unfavorable$$5,970 Unfavorable5,970 Unfavorable

Sales-Activity Variances

Total sales - activity varianceTotal sales - activity variance==Actual sales unit – Master budgeted sales unitsActual sales unit – Master budgeted sales units

××Budgeted contribution margin per unitBudgeted contribution margin per unit

Activity-level variancesActivity-level variances

(7,000 – 9,000) × $9.20 (7,000 – 9,000) × $9.20

$18,400 Unfavorable$18,400 Unfavorable

FlexiFlexible ble budgbudgetet

MasteMaster r budgbudgetet==

Trade-Offs Among Variances

Improvements in one area could lead toImprovements in one area could lead toimprovements in others and vice versa.improvements in others and vice versa.

Likewise, substandard performanceLikewise, substandard performancein one area may be balanced byin one area may be balanced bysuperior performance in others.superior performance in others.

When to Investigate Variances

When should managementWhen should managementinvestigate a variance?investigate a variance?

Many organizations have developedMany organizations have developedsuch rules of thumb as “investigatesuch rules of thumb as “investigate

all variances exceeding $5,000 or 25%all variances exceeding $5,000 or 25%of expected cost, whichever is lower.”of expected cost, whichever is lower.”

Flexible-Budget Variance in DetailStandard per unit of output:Standard per unit of output:

Std. inputs Std. inputs Flexible Flexible expected expected Budget Amount Budget Amount

DirectDirect Material Material 5 pounds5 pounds $ 2 /pound $ 2 /pound $10 $10Direct LaborDirect Labor ½ hour ½ hour $16/hour $16/hour $ 8 $ 8

Std. price Std. price expected expected

Actual results for 7,000 units produced:Actual results for 7,000 units produced:

Direct materialDirect materialPounds purchasedPounds purchasedand used: 36,800and used: 36,800

Price/pound: $1.90Price/pound: $1.90Total actual cost:Total actual cost:

$69,920$69,920

Direct laborDirect laborHours used: 3,750Hours used: 3,750

Actual price (rate): $16.40Actual price (rate): $16.40Total actual cost:Total actual cost:

$61,500$61,500

Variances from Material and Labor Standards

Units of good output achievedUnits of good output achieved

Input allowed per unit of outputInput allowed per unit of output

Standard unit price of inputStandard unit price of input

××

××

==Flexible Budget or Total Standard Cost AllowedFlexible Budget or Total Standard Cost Allowed

Variances from Material and Labor Standards

(1)(1) (2) (2) (3) (3)FlexibleFlexible

Actual Actual Flexible Flexible Budget Budget CostsCosts Budget Budget VarianceVariance

DirectDirect Materials Materials $69,920 $69,920 *$70,000 *$70,000 $ 80 F $ 80 FDirect LaborDirect Labor 61,500 61,500 **$56,000 **$56,000 $5,500 U $5,500 U

Standard Direct-Labor Cost Allowed:Standard Direct-Labor Cost Allowed:7,000 units X 1/2 hour X $16 per hour = $56,000**7,000 units X 1/2 hour X $16 per hour = $56,000**

Standard Direct-Materials Cost Allowed:Standard Direct-Materials Cost Allowed:7,000 units X 5 pounds X $2.00 per pound = $70,000*7,000 units X 5 pounds X $2.00 per pound = $70,000*

Price and Quantity Variances

(Actual quantity used – standard quantity allowed(Actual quantity used – standard quantity allowedfor actual output) × Standard pricefor actual output) × Standard price

(Actual price – Standard Price) × Actual quantity used (Actual price – Standard Price) × Actual quantity used

Price Variance Computations

($16.40 – $16.00) per hour($16.40 – $16.00) per hour× 3,750 hours = $1,500 U× 3,750 hours = $1,500 U

($1.90 – $2.00) per pound($1.90 – $2.00) per pound× 36,800 pounds = $3,680 F× 36,800 pounds = $3,680 F

Quantity (Usage) Variance Computations

[3,750 – (7,000 × ½)] hours[3,750 – (7,000 × ½)] hours× $16 per hour = $4,000 U× $16 per hour = $4,000 U

[36,800 – (7,000 × 5)] pounds[36,800 – (7,000 × 5)] pounds× $2 per pound = $3,600 U× $2 per pound = $3,600 U

Direct Materials Flexible Budget Variance

Direct-Labor Flexible-budget variance:Direct-Labor Flexible-budget variance:$1,500 unfavorable $1,500 unfavorable

+ $4,000 unfavorable + $4,000 unfavorable

= $5,500 unfavorable= $5,500 unfavorable

Direct-Materials Flexible-budget variance: Direct-Materials Flexible-budget variance: $3,680 favorable $3,680 favorable

+ $3,600 unfavorable + $3,600 unfavorable

= $80 favorable= $80 favorable

Interpretation of Price and Usage Variances

Price and usage variances are helpfulPrice and usage variances are helpfulbecause they provide feedback tobecause they provide feedback to

those responsible for managing inputs.those responsible for managing inputs.

Managers should not use theseManagers should not use thesevariances alone for decisionvariances alone for decision

making, control, or evaluation.making, control, or evaluation.

Setting Standards

An expected cost is the cost thatAn expected cost is the cost thatis most likely to be attained.is most likely to be attained.

A standard cost is a carefullyA standard cost is a carefullydeveloped cost per unitdeveloped cost per unitthat should be attained.that should be attained.

Perfection (ideal) standards are expressions of the most Perfection (ideal) standards are expressions of the most efficient performance possible under the best conceivableefficient performance possible under the best conceivableconditions, using existing specifications and equipment.conditions, using existing specifications and equipment.

No provision is made for waste, spoilage,No provision is made for waste, spoilage,machine breakdowns, and the like.machine breakdowns, and the like.

Currently Attainable Standards...

are levels of performance thatare levels of performance thatmanagers can achieve bymanagers can achieve byrealistic levels of effort.realistic levels of effort.

They make allowances for normalThey make allowances for normaldefects, spoilage, waste,defects, spoilage, waste,and nonproductive time.and nonproductive time.

Variable-Overhead Spending and Efficiency Variances

A variable-overhead efficiency variance occurs whenactual cost-driver activity differs from the standard

amount allowed for the actual output achieved.

A variable-overhead spending variance occurs when the difference between the actual variable overhead

and the amount of variable overhead budgeted for the actual level of cost-driver activity.

Variable-Overhead Variances

variable- variable- actual actual standard standard standard standardoverhead overhead cost-driver cost-driver variable-overhead cost-driver cost-driver variable-overhead efficiency efficiency activity activity activity activity rate per rate pervariance variance allowed allowed cost-driver unit cost-driver unit

XX== -

variable- variable- actual actual standard standard actual actual overhead overhead variable variable-overhead cost-driver variable variable-overhead cost-driverspendingspending overhead overhead rate per unit rate per unit activityactivityvariance variance of cost-driver of cost-driver usedused

== XX-

Fixed Overhead Spending Variance

The difference between actual fixed overhead and budgeted fixed overhead

Is the fixed overhead spending variance.