 Flexible Budgets and Standard Costs

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Flexible Budgets and Standard Costs
Chapter 22 Chapter 22 explains flexible budgets and standard costs.

Prepare a flexible budget for the income statement
Learning Objective 1 Prepare a flexible budget for the income statement The first learning objective is to prepare a flexible budget for the income statement.

Static vs. Flexible Budgets
Static Budget Flexible Budget Prepared for only one level of sales volume Prepared for several different volume levels within a relevant range Separates fixed and variable costs Variance = difference between actual and budget The master budget is a static budget, which means that it is prepared for only one level of sales volume. The static budget does not change after it is developed. A variance is the difference between an actual amount and the budgeted amount. The variances are classified as either: • Favorable (F) if an actual amount increases operating income, OR • Unfavorable (U) if an actual amount decreases operating income. A flexible budget summarizes costs and revenues for several different volume levels within a relevant range. Flexible budgets separate variable costs from fixed costs; it is the variable costs that put the “flex” in the flexible budget. To create a flexible budget, you need to know: • Budgeted selling price per unit • Variable cost per unit • Total fixed costs • Different volume levels within the relevant range Favorable – actual amount increases income Unfavorable – actual amount decreases income Copyright (c) 2009 Prentice Hall. All rights reserved.

Prepare an income statement performance report
Learning Objective 2 Prepare an income statement performance report The second learning objective is to prepare an income statement performance report.

Static Budget Variances
Flexible Budget based on actual number of outputs Static Budget based on expected number of outputs Actual Results Flexible Budget Variance Sales Volume Variance It is not enough to know that a variance occurred. Managers must know why a variance occurred—to pinpoint problems and take corrective action. If sales are less than budgeted, a static budget will underestimate both sales and total costs. If sales are more than budgeted, the static budget will overestimate. These variances are called static budget variances because actual activity differed from what was expected in the static budget. To develop more useful information, managers divide the static budget variance into two broad categories: • Sales volume variance—arises because the number of units actually sold differed from the number of units on which the static budget was based. • Flexible budget variance—arises because the company had more or less revenue, or more or less cost, than expected for the actual level of output. Static Budget Variance Copyright (c) 2009 Prentice Hall. All rights reserved.

Budget Variances Sales Volume Variance Flexible Budget Variance
Master Budget (for the expected number of units to be sold) Flexible Budget (for the number of units actually sold) Flexible Budget Variance The formulas for computing the variances are shown here. The sales volume variance is based on two different sales levels: expected sales and actual sales. The flexible budget variance, however, is based on the actual sales level only. Flexible Budget (for the number of units actually sold) Actual results (for the actual number of units to be sold) Copyright (c) 2009 Prentice Hall. All rights reserved.

Exercise 22-16 Exercise requires the completion of an income statement performance report. The missing amounts are those of the flexible budget variances and the static budget amounts. To compute the flexible budget variances, the difference between the actual results are compared to the flexible budget amounts. There was no difference in sales revenue. However, both actual variable and actual fixed costs were higher than the flexible budget. This results in unfavorable variances. To compute the static budget, the sales volume variances are subtracted from the flexible budget. Since the variance for sales for output was favorable, this means more units were sold than expected. This is also why sales revenue has a positive volume variance. The sales volume variance for variable costs was unfavorable. This means the flexible budget amount was greater than the static budget. The favorable variance for sales and the unfavorable variance for costs are netted together to produce an overall \$10,000 favorable sales volume variance in operating income. Given the increase in sales revenue, the sales department should be commended. However, the unfavorable variances in costs should be explored. Copyright (c) 2009 Prentice Hall. All rights reserved.

Identify the benefits of standard costs and learn how to set standards
Learning Objective 3 Identify the benefits of standard costs and learn how to set standards The third learning objective is to identify the benefits of standard costs and learn how to set standards.

Standard Costs Budget for a single unit Each unit has standards for:
Quantity Price Most companies use standard costs to develop their flexible budgets. Think of a standard cost as a budget for a single unit. In a standard cost system, each input has both a quantity standard and a price standard. Copyright (c) 2009 Prentice Hall. All rights reserved.

Price Standards Direct materials Consider early-pay discounts, freight-in, and receiving costs Managers look for ways to cut costs Direct labor Consider pay rates, payroll taxes, and fringe benefits Accountants work with human resource managers Manufacturing overhead Accountants work with production managers Appropriate allocation base chosen The price standard for direct materials starts with the base purchase cost of each unit of inventory. Accountants help managers set a price standard for materials after considering early-pay discounts, freight-in, and receiving costs. World-class businesses demand continuous reductions in costs. This can be achieved several ways, such as working with suppliers to cut their costs, using the Internet to solicit price quotes from suppliers around the world, and sharing information. For direct labor, accountants work with human resource managers to determine standard labor rates. They must consider basic pay rates, payroll taxes, and fringe benefits. Job descriptions reveal the level of experience needed for each task. Accountants work with production managers to estimate manufacturing overhead costs. Production managers identify an appropriate allocation base, such as direct labor hours or direct labor cost. Accountants then compute the standard overhead rates. Copyright (c) 2009 Prentice Hall. All rights reserved.

Quantity Standards Direct materials Consider product specifications, spoilage Direct labor Consider time requirements Use of time-and-motion studies and benchmarking Manufacturing overhead Based on overhead application rate Production managers and engineers set direct material and direct labor quantity standards. To set its labor standards, a company may analyze its plant operations. Some companies conduct time-and-motion studies to streamline various tasks. Many companies set quantity standards based on “best practices.” This is often called benchmarking. The best practice may be an internal benchmark from other plants or divisions within the company or it may be an external benchmark from other companies. Internal benchmarks are easy to obtain, but managers can also purchase external benchmark data. Copyright (c) 2009 Prentice Hall. All rights reserved.

Summary of Standard Setting Issues
Price Standard Quantity Standard Direct Materials Responsibility: Production managers Responsibility: Production managers & engineers Factors: Purchase price, discounts, delivery, credit policy Factors: Product specifications, spoilage, production scheduling Direct Labor Responsibility: Human resource managers Factors: Wage rate, payroll taxes, fringe benefits Factors: Time requirements Manufacturing Overhead Factors: Nature and amount of resources needed for support activities This table summarizes who is responsible for setting standards for each of the cost elements and what factors come into play when setting the standards. Copyright (c) 2009 Prentice Hall. All rights reserved.

Benefits of Standard Costs
Helps managers: In budget preparation Target levels of performance Identify performance standards Set sales prices Decrease accounting costs U.S. surveys show that more than 80% of responding companies use standard costing. Over half of responding companies in the United Kingdom, Ireland, Sweden, and Japan use standard costing. Why? Standard costing helps managers: • Prepare the budget • Set target levels of performance • Identify performance standards • Set sales prices of products and services • Decrease accounting costs Copyright (c) 2009 Prentice Hall. All rights reserved.

Variances Price Variance Efficiency Variance Total Cost Variance
Actual Price X Actual Quantity Standard Price X Actual Quantity Standard Price X Standard Quantity Price Variance Efficiency Variance This diagram shows how price and efficiency variances are computed. Total Cost Variance Copyright (c) 2009 Prentice Hall. All rights reserved.

Price Variance (AP – SP) x AQ OR
Measures how well the business keeps unit costs within standards (Actual Price x Actual Quantity) (Standard Price x Actual Quantity) OR A price variance measures how well the business keeps unit prices of material and labor inputs within standards. As the name suggests, the price variance is the difference in prices (actual price per unit – standard price per unit) of an input, multiplied by the actual quantity of the input. Actual Quantity (Actual Price – Standard Price) (AP – SP) x AQ Copyright (c) 2009 Prentice Hall. All rights reserved.

Efficiency (Quantity) Variance
Measures how well the business keeps unit costs within standards (Standard Price x Actual Quantity) (Standard Price x Standard Quantity) OR An efficiency or quantity variance measures how well the business uses its materials or human resources. The efficiency variance is the difference in quantities (actual quantity of input used – standard quantity of input allowed for the actual number of outputs) multiplied by the standard price per unit of the input. Standard Price (Actual Quantity – Standard Quantity) (AQ – SQ) x SP Copyright (c) 2009 Prentice Hall. All rights reserved.

Variances Static Budget Variance Flexible Budget based on actual
number of outputs Static Budget based on expected number of outputs Actual Results Price Variance Efficiency Variance This table illustrates these variances and emphasizes two points. • First, the price and efficiency variances add up to the flexible budget variance. • Second, static budgets play no role in the price and efficiency variances. The static budget is used only to compute the sales volume variance—never to compute the flexible budget variance or the price and efficiency variances for materials and labor. Flexible Budget Variance Sales Volume Variance Static Budget Variance Copyright (c) 2009 Prentice Hall. All rights reserved.

Compute standard cost variances for direct materials and direct labor
Learning Objective 4 Compute standard cost variances for direct materials and direct labor The fourth learning objective is to compute standard cost variances for direct materials and direct labor.

Computing Variances Gather necessary data:
Identify fixed and variable costs Compare actual results with flexible budget Prepare flexible budget based on standard costs Compute actual quantities and prices of materials and labor The first step in identifying the causes of the cost variance is to identify the variable and fixed costs and prepare a comparison of actual results with the flexible budget. Next, a flexible budget based on standard costs is prepared. Last, actual quantities and costs are computed. Copyright (c) 2009 Prentice Hall. All rights reserved.

(Actual Price – Standard Price)
Exercise 22-18 Direct materials price variance Actual Quantity (Actual Price – Standard Price) 2900 yards (\$1.15 – \$1.10) Exercise requires the computation of the direct materials price variance, direct materials efficiency variance, direct labor price variance, and the direct labor efficiency variance. Quality, Inc., produced 1,000 units of the company’s product in The standard quantity of materials was three yards of cloth per unit at a standard price of \$1.10 per yard. The accounting records showed that 2,900 yards of cloth were used and the company paid \$1.15 per yard. To compute the direct materials price variance, the difference between actual price and standard price is multiplied by the actual number of yards of fabric actually used. Since the actual price exceeded the standard price, the variance is unfavorable. \$145 U Copyright (c) 2009 Prentice Hall. All rights reserved.

Exercise 22-18 (continued)
Direct materials efficiency variance Standard Price (Actual Quantity – Standard Quantity) 2900 yards – (1000 units x 3 yards) \$1.10 To compute the direct materials efficiency variance, the difference between the actual number of yards used and the standard is multiplied by the standard price. The standard quantity was given for one unit as 3 yards of fabric. To determine the standard quantity for the 1000 units, multiply three yards by Since less yards of material was used, the efficiency variance is favorable. \$110 F Copyright (c) 2009 Prentice Hall. All rights reserved.

Exercise 22-18 (continued)
Actual price x Actual quantity Standard price x Actual quantity Standard price x Standard quantity \$1.15 x 2900 = \$3,335 \$1.10 x 2900 = \$3,190 \$1.10 x 3000 = \$3,300 Price variance Efficiency variance \$145 U \$110 F To summarize the materials variances, this diagram shows each materials variance and the total materials variance. Total materials variance \$35 U Copyright (c) 2009 Prentice Hall. All rights reserved.

Exercise 22-18 (continued)
Direct labor price variance Actual Hours (Actual Price – Standard Price) 650 hours (\$9.50 – \$10.00) Standard time was one direct labor hour per unit at a standard rate of \$10 per direct labor hour. Employees worked 650 hours and were paid \$9.50 per hour. To compute the direct labor price variance, the actual hourly pay is subtracted from the standard and multiplied by the actual hours worked. Since the actual labor rate is \$0.50 less per hour than standard, the variance is favorable. \$325 F Copyright (c) 2009 Prentice Hall. All rights reserved.

Exercise 22-18 (continued)
Direct labor efficiency variance Standard Price (Actual Hours – Standard Hours) 650 hours – (1,000 units x 1 hour/unit) \$10.00 To compute the direct labor efficiency variance, standard hours are subtracted from actual hours. Since the standard is one hour per unit and 1,000 units were produced, the standard hours equal 1,000. The difference is then multiplied by the standard labor rate. Since the employees worked 350 hours less than standard, this labor variance is also favorable. \$3,500 F Copyright (c) 2009 Prentice Hall. All rights reserved.

Exercise 22-18 (continued)
Actual price x Actual hours Standard price x Actual hours Standard price x Standard hours \$9.50 x 650 = \$6,175 \$10.00 x 650 = \$6,500 \$10.00 x 1,000 = \$10,000 Price variance Efficiency variance \$325 F \$3,500 F This diagram shows the individual labor variances and the total labor variance. Total labor variance \$3,825 F Copyright (c) 2009 Prentice Hall. All rights reserved.

Analyze manufacturing overhead in a standard cost system
Learning Objective 5 Analyze manufacturing overhead in a standard cost system The fifth learning objective is to analyze manufacturing overhead in a standard cost system.

Actual overhead cost minus The total overhead variance is the difference between actual overhead cost and standard overhead allocated to production. Standard overhead allocated to production Copyright (c) 2009 Prentice Hall. All rights reserved.

Allocating Overhead in a Standard Cost System
Overhead allocated to production Standard (predetermined) overhead rate Standard quantity of the allocation base allowed for actual output The overhead allocated to production is computed by multiplying the standard overhead rate by the standard quantity of the allocation base allowed for actual output. For example, if the overhead rate is based on direct labor hours, the standard hours for the production level achieved would be used. Copyright (c) 2009 Prentice Hall. All rights reserved.

Overhead Flexible Budget Variance

Overhead Production Volume Variance
Occurs when actual production differs from expected production Flexible budget overhead for actual output Standard overhead allocated to actual production The second component of the total overhead variance is the overhead production volume variance. This variance arises when actual production differs from expected production. Copyright (c) 2009 Prentice Hall. All rights reserved.

Learning Objective 6 Record transactions at standard cost and prepare a standard cost income statement The sixth learning objective is to record transactions at standard cost and prepare a standard cost income statement.

Standard Cost Accounting Systems
Materials inventory and Manufacturing wages are recorded at standard prices Unfavorable variances are recorded as debits; favorable variances are recorded as credits Work in process inventory is recorded at standard quantities and standard prices To be alerted of variances quickly, companies can adopt standard costing for recording journal entries. The Materials inventory, Manufacturing wages, and Work in process accounts are debited at standard costs. Each variance has a separate account, with unfavorable variances debited and favorable ones credited. Copyright (c) 2009 Prentice Hall. All rights reserved.

Standard Cost Entries: Direct materials price variance
GENERAL JOURNAL DATE DESCRIPTION REF DEBIT CREDIT Materials inventory Direct materials price variance Accounts payable To record purchase of direct materials standard price) (if U-debit, if F-credit) actual price) The entry to record purchases of materials requires a debit to Materials inventory at the standard price of materials purchased. Accounts payable is credited at the actual price. If the materials price variance is unfavorable (actual price is greater than standard), the Materials price variance account is debited. If the price variance is favorable, the Materials price variance is credited. Copyright (c) 2009 Prentice Hall. All rights reserved.

Standard Cost Entries: Direct materials efficiency variance
GENERAL JOURNAL DATE DESCRIPTION REF DEBIT CREDIT Work in process inventory Direct materials efficiency variance Materials inventory To record use of direct materials standard price & quantity) (If U-debit, if F-credit) standard price & actual quantity) The entry to record the use of direct materials in production includes a debit to Work in process for the standard price multiplied by the standard quantity. Materials inventory is credited for the standard price multiplied by the actual quantity. If the materials quantity variance is favorable (actual materials used is less than standard), the variance account is credited. If it is unfavorable, it is debited. Copyright (c) 2009 Prentice Hall. All rights reserved.

Standard Cost Entries: Direct labor price (rate) variance
GENERAL JOURNAL DATE DESCRIPTION REF DEBIT CREDIT Manufacturing wages Direct labor price(rate) variance Wages payable To record labor costs standard rate) (If U-debit, if F-credit) actual rate) To record labor costs, Manufacturing wages is debited at the standard labor rate for the hours worked. Wages payable is credited at the actual amount of wages. If the labor rate variance is unfavorable (actual labor rate is greater than the standard), the variance account is debited. If it is favorable, it is credited. Copyright (c) 2009 Prentice Hall. All rights reserved.

Standard Cost Entries: Direct labor efficiency variance
GENERAL JOURNAL DATE DESCRIPTION REF DEBIT CREDIT Work in process inventory Direct labor efficiency variance Manufacturing wages To allocate direct labor to production standard rate & hours) (If U-debit, if F-credit standard rate & actual hours) The entry to record the use of direct labor in production includes a debit to Work in process for the standard rate multiplied by the standard hours. Manufacturing wages is credited for the standard rate multiplied by the actual hours. If the labor efficiency variance is unfavorable (actual hours worked is more than standard), the variance account is debited. If it is favorable, it is credited. Copyright (c) 2009 Prentice Hall. All rights reserved.

Standard Cost Entries: Actual and allocated overhead

Standard Cost Entries: Completing production and COGS
GENERAL JOURNAL DATE DESCRIPTION REF DEBIT CREDIT Finished goods inventory Work in process inventory To record completion of goods at standard cost Cost of goods sold To record the cost of goods sold at standard cost The entries to record the completion and sale of goods are the same as we learned in an earlier chapter. The amounts are at standard cost. Copyright (c) 2009 Prentice Hall. All rights reserved.

Standard Cost Entries Overhead flexible budget variance