| Flexible Budgets and Variances |
Creating Budgetary Numbers
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Variances
Occur when actual results are different from budget expectations. The simple difference between a budget and actual performance can be caused by numerous reasons, therefore we break down variances into smaller and smaller subsets until the cause of the variance can be identified. As we break down variances, we may find that positive and negative factors were being netted together to result in a difference which did not truly emphasize what was truly going on.
As more and more variances are identified, we have to track whether they are beneficial – Favorable or not beneficial – Unfavorable to the company. We identify favorable variances as increasing operating income and unfavorable variances decreasing operating income when all else is held constant
Variances are often used to evaluate a company’s efficiency with resources (acquiring inputs – price efficiency and the processing of inputs – production efficiency) and effectiveness (the ability to achieve budgets/quotas/goals) Investigation of Variances
Variance analysis follows the cost-benefit concept. Therefore ranges are normally set for budgetary numbers and only variances outside of the range by a certain percentage or dollar amount. Focusing on these variances is also called management by exception
There are three main levels that we can break variance analysis into. The first level is the basic difference between the budget and actual amounts.
The Master Budget or Static-Budget Variance Recall that the master budget, also referred to as a static budget, is created at the beginning of a period to estimate future activity.
Quantity and efficiency variances are included in the Static-Budget Variance; the second level separates the variances due to quantity from the other efficiency variances. This is done by creating a Flexible Budget.
The flexible budget is the restatement on the master budget if the actual quantities were known. This will affect revenues and variable costs, but not the fixed costs which should be unaffected by quantity differences. This is a better measurement of performance since we now have an apples to apples comparison We now have broken the Static Budget Variance into two variances:
The Sales-Volume Variance
This is the difference between the static budget and the flexible budget. Any fixed cost should have a variance of $0 for this component. Formula: Flexible Budget – Static Budget Formula: Budgeted Price * (Actual Quantity – Static Budget Quantity)
Flexible-Budget Variances
The Flexible-Budget Variance highlights favorable and unfavorable variances between a budget and actual figures without quantity discrepancies. Formula: Actual Results – Flexible Budget Amount Formula: Actual Quantity * (Actual Price – Budgeted Price)
The favorable or unfavorable classification depend on whether we are examining revenue, cost or operating income variances
If you want a generalization – if the variance is a revenue or income figure and negative, it is an unfavorable variance If the variance is a cost and negative, it is a favorable variance
For the Third Level - The Flexible-Budget Variance can be further subdivided into two variances due to different price and input usage between the actual results and flexible budget.
The Flexible Budget uses actual unit quantity, but budgetary pricing and budgetary quantity allowance for the creation of each actual unit. Since there will enviably be a difference between budgetary quantity allowance and actual quantity used, we need to further refine our variances. We can create a column for budgetary analysis between actual results and the flexible budget which will show actual input quantity * budgeted price (this should look familiar – it was the same concept we used to create the flexible budget in the first place).
Variances can be further improved by incorporating activity-based costing. The focus on specific activities and cost hierarchies will produce more informative variances.
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Journal Entries for Variances
Favorable variances increase operating income, so they are a credit Unfavorable variances decrease operating income, so they are a debit The variances are recognized as journal entries immediately.
For example, when recording the purchase of inputs, the Materials Control account uses the budgeted price, while payment is obviously made at the actual amount. The difference is recorded in a variance account – e.g. Raw Materials Price Variance. Each variance has its own account
There are accounts for price and usage variances for both Material and Labor. At the end of the year, the variance accounts are analyzed and written off to cost of goods sold or are allocated between inventory accounts and cost of goods sold.
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