Exam 3

Budget Variance

A budget variance is the difference between an actual amount and a budgeted amount. This chapter shows how managers use variances to control business activities. It is important to know why actual amounts differ from the budget. This enables managers to identify problems and decide what action to take.

Cost Variance Formula

A cost variance measures how well the business keeps unit costs of material and labor inputs within standards. As the name suggests, the cost variance is the difference in costs, or actual cost per unit less the standard cost per unit, of an input, multiplied by the actual quantity used of the input. Cost Variance = (Actual Cost × Actual Quantity - (Standard Cost × Actual Quantity) = (Actual Cost − Standard Cost) × Actual Quantity = (AC − SC) × AQ

Flexible Budget

A flexible budget is a budget prepared for various levels of sales volume. This type of budget is useful for what if analysis. Smart Touch Learning may expect to sell 2,000 tablet computers, but a flexible budget showing results for selling 1,600 tablets, 1,800 tablets, 2,000 tablets, 2,200 tablets, and 2,400 tablets allows managers to plan for various sales levels.

Information needed to Create a Flexible Budget

A flexible budget summarizes revenues and expenses for various levels of sales volume within a relevant range. Flexible budgets separate variable costs from fixed costs—the variable costs put the flex in the flexible budget. To create a flexible budget, you need to know the following: budgeted selling price per unit; the variable cost per unit which includes the product costs of direct materials, direct labor, and variable manufacturing overhead; and the variable selling and administrative expenses. You also need to know the total fixed costs, which consist of fixed manufacturing overhead and fixed selling and administrative expenses. Finally, you need to know the different volume levels within the relevant range.

Static Budget

A static budget is a budget prepared for only one level of sales volume. For example, Smart Touch Learning, the fictitious company we have used to illustrate accounting concepts throughout the textbook, may prepare a budget based on annual sales of 2,000 touch screen tablet computers. All revenue and expense calculations would be based on sales of 2,000 tablets.

Strategic Budget

A strategic budget is a long-term financial plan used to coordinate the activities needed to achieve the long-term goals of the company. Strategic budgets often span 3 to 10 years. Because of their longevity, they often are not as detailed as budgets for shorter periods.

Efficiency Variance Formula

An efficiency variance measures how well the business uses its materials or human resources. The efficiency variance measures the difference in quantities, or actual quantity of input used less the standard quantity of input allowed for the actual number of units produced, multiplied by the standard cost per unit of the input. Efficiency Variance = (Standard Cost × Actual Quantity) − (Standard Cost × Standard Quantity) = (Actual Quantity − Standard Quantity) × Standard Cost = (AQ − SQ) × SC

Spend it or Lose it

Another budgetary game is referred to as spend it or lose it. In many companies, if a business segment has a budgeted expense item and does not spend as much as expected for the item, there is a fear the budgeted item will have a lower amount in future budget periods. For example, if the Accounts Payable Department budget allows for $5,000 in Supplies Expense and the department only spends $3,000, then there is a fear the amount will be reduced to $3,000 in the next budget. The employees are then motivated to purchase unneeded supplies, which reduces the operating income for the company.

Operational Budget

Are Short-term budgets that are most often one year in length, but may also span only a week, a month, or a quarter

Practice Questions: Friedman Company manufactures and sells bicycles. A popular model is the XC. The company expects to sell 1,500 XCs in 2014 and 1,800 XCs in 2015. At the beginning of 2014, Friedman has 350 XCs in Finished Goods Inventory and desires to have 10% of the next year's sales available at the end of the year. How many XCs will Friedman need to produce in 2014?

Budgeted XCs to be sold 1,500 Plus: Desired XCs in ending inventory + 180 Total XCs needed = 1,680 Less: XCs in beginning inventory - 350 Budgeted XCs to be produced = 1,330

Calculation of Amount of Material to be Purchased Example

Budgeted tablets to be produced × Direct materials cost per unit = Direct materials needed for production + Desired direct materials in ending inventory = Total direct materials needed − Direct materials in beginning inventory = Budgeted purchases of direct materials

Calculation of Tablets to be produced Example

Budgeted tablets to be sold + Desired tablets in ending inventory = Total tablets needed − Tablets in beginning inventory = Budgeted tablets to be produced

Standard Cost System/Efficiency(Amount) Standard

Cheerful Colors uses a standard cost system, which is an accounting system that uses standards for product costs—direct materials, direct labor, and manufacturing overhead. Each input has both a cost standard and an efficiency standard. For example, Cheerful Colors has a standard for the cost it pays per pound of paraffin wax. This determines the cost standard. The company also has a standard for the amount of wax it uses for making the crayons. This determines the efficiency standard.

Variance Relationships

Exhibit 23-9 shows the relationship among variances and how to separate total flexible budget variances for materials and labor into cost and efficiency variances. Exhibit 23-9 emphasizes two points. First, the cost and efficiency variances add up to the flexible budget variance. Second, static budgets play no role in the cost and efficiency variances. The static budget is used only to compute the sales volume variance, the variance caused because the company sold a different quantity than it thought it would sell when it created the budget. It is never used to compute the flexible budget variance or the cost and efficiency variances for materials and labor.

Favorable versus Unfavorable Variances

Favorable (F) if an actual amount increases operating income Actual revenue > Budgeted revenue Actual expense < Budgeted expense Unfavorable (U) if an actual amount decreases operating income Actual revenue < Budgeted revenue Actual expense > Budgeted expense

Calculations for desired Ending Inventory Example

First Quarter: Second quarter's sales × 20% = Desired ending inventory Second Quarter: Third quarter's sales × 20% = Desired ending inventory Third Quarter: Fourth quarter's sales × 20% = Desired ending inventory Fourth Quarter: First quarter's sales (2018) × 20% = Desired ending inventory

Practice Questions: Kendall Company projects 2015 first quarter sales to be $10,000 and increase by 5% per quarter. Determine the projected sales for 2015 by quarter and in total. Round answers to the nearest dollar.

First quarter: = $10,000 Second quarter: $10,000 × 1.05 = 10,500 Third quarter: $10,500 × 1.05 = 11,025 Fourth quarter: $11,025 × 1.05 = 11,576 Total: = $ 43,101

Static Budget

Includes only one level of sales volume

Operating Budget

Includes sales, production, and cost of goods sold budgets

Financial Budget

Includes the budgeted financial statements

Flexible Budget

Includes various levels of sales of volume

Budget Variances

It is not enough to know that a variance occurred. Managers must know why a variance occurred in order to pinpoint problems and take corrective action. In example if The static budget underestimated both sales and variable costs. These differences are caused by two primary factors: there is a difference in prices or costs, and/or there is a difference in volume. To develop more useful information, managers divide the static budget variance into two broad categories: the flexible budget variance and the sales volume variance.

Strategic Budget

Long-term budgets often span 3 to 10 years.

Planning

Managers are required to think about future business activities.

Controlling

Managers use feedback to identify corrective action.

Benchmarking

Managers use results to evaluate employees' performance.

Coordinating and Communicating

Managers work with managers in other divisions.

Budgetary Slack

Managers' performance is also evaluated by comparing actual results to the budget. When they develop the company's budget, they may be tempted to participate in budgetary "gaming" and build in budgetary slack. Budgetary slack occurs when managers intentionally understate expected revenues or overstate expected expenses. This increases the chance that actual performance will be better than the budget and that they will receive a good evaluation. But adding slack into the budget makes it less accurate and less useful for planning and control.

Cost Variance

Measures how well the business keeps unit costs of material and labor inputs within standards

Efficiency Variance

Measures how well the business uses its materials or human resources.

Setting Standards

Most companies use standards to develop budgets. A standard is the price, cost, or quantity that is expected under normal conditions. For example, based on Exhibit 23-5, Cheerful Colors expects the direct materials to cost $1.75 per batch of 100 crayons. Therefore, the standard cost for direct materials is $1.75, and that was the amount used to develop both the static and flexible budgets. The terms "standard" and "budget" are sometimes used interchangeably. However, a budget amount generally indicates a total amount, whereas a standard amount is a per unit amount. In the case of direct materials, the standard is $1.75 per batch and the budgeted amount for 52,000 batches is $91,000 ($1.75 per batch multiplied by 52,000 batches).

Cost and Efficiency Variances

Once standards are established, managers can use the standards to assign costs to production. At least once per year, managers will compare the actual production costs to the standard costs to locate variances. Exhibit 23-8 shows the formulas for computing the cost and efficiency variances.

Benefits of Budgeting

One benefit of budgeting is that is requires managers to plan for the company's future. Decisions are then based on this formalized plan, which helps prevent haphazard decision making. Keep in mind, however, that budgets are plans for future activities and may need to be modified. Another benefit is that the budget coordinates a company's activities. Forcing managers to work together to make a single, unified, comprehensive plan for the business. A third benefit is that budgets provide a benchmark that motivates employees and helps managers evaluate performance. In most companies, part of the manager's performance evaluation depends on how actual results compare to the budget. This can be done through a performance report

Predetermined Overhead Allocation Rate

Predetermined Overhead Allocation Rate = Total estimated overhead costs / Total estimated quantity of the overhead allocation base

budgeting objectives

Previously, you learned how managers use budgets for planning and controlling business activities. The master budget focuses on the planning step. In this chapter, we focus on the controlling step as we look at the decisions managers make during and after the budgeting period, based on the actual results. Managers may ask: Did my division meet its sales goals? Have costs increased? Sales have dropped, so how do we need to adjust spending?

Standard Setting Issues and Problems

Setting standards can be the most difficult part of using a standard cost system. Setting standards requires coordination and communication among different divisions and functions. For example, the cost standard for direct materials starts with the base purchase cost of each unit of raw materials inventory. Accountants help managers set a cost standard for materials after considering purchase discounts, freight in, and receiving costs. Companies can work with reliable vendors to build relationships that ensure quality and on-time delivery of materials at an affordable cost. For direct labor, accountants work with human resource managers to determine the cost standard for direct labor. They must consider basic pay rates, payroll taxes, and fringe benefits. Job descriptions reveal the level of experience needed for each task. A big part of this process is ensuring that employees receive training for the job and are paid fairly for the job. 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, or they allocate overhead using activity-based costing. Accountants then compute the standard overhead allocation rates.

Projected Supplies Expense Example

Supplies Expense = Sales Revenue for each quarter X 1%

Benefits of Standard Cost Systems

Surveys show that the use of standard cost systems is widespread in manufacturing companies in the United States and around the world. Standard costing helps managers: prepare the master budget, set target levels of performance for flexible budgets, identify performance standards, set sales prices of products and services, and decrease accounting costs. Standard cost systems might appear to be expensive. Indeed, the company must invest up front to develop the standards, and standards must be updated on a regular basis—at least once per year. But standards can save accounting costs. When integrated with the company's Enterprise Resource Planning, or ERP, system, businesses can easily keep track of inventory costs, determine cost and efficiency variances, and make real-time decisions.

Budgeting Procedures

The budgeting process varies from company to company. For a small company, the process may be relatively simple and somewhat informal. In larger companies, however, the process can be very complex, with a budget committee coordinating the process. To achieve the benefit of motivating employees, the budget should include input from all levels. This requires significant coordination among the company's various business segments. Therefore, the budgeting process usually begins several months before the beginning of the budget period.

Flexible Budget Variance

The difference between actual results and the expected results in the flexible budget for the actual units sold.

Static Budget Variance

The difference between actual results and the expected results in the static budget.

Sales Volume Variance

The difference between the expected results in the flexible budget for the actual units sold and the static budget.

Flexible Budget Variance

The flexible budget variance tells us the difference between actual results and the expected results in the flexible budget for the actual units sold. The variance arises because the company had different revenues and/or costs than expected for the actual units sold. The flexible budget variance occurs because sales price per unit, variable cost per unit, and/or total fixed cost was different than planned on in the budget. Flexible Budget Variance = Actual Results - Flexible Budget

Master Budget

The master budget, is the set of budgeted financial statements and supporting schedules for the entire organization. Budgeted financial statements are financial statements based on budgeted amounts rather than actual amounts. The master budget is operational and static.

Motivate employees to follow the Budget's Goals

The most important part of a budgeting system is getting managers and employees to accept the budget so the company can reap the planning, coordination, and control benefits illustrated in Exhibit 22-1. Few people enjoy having their work monitored and evaluated. If managers use the budget as a benchmark to evaluate employees' performance, managers must first motivate employees to accept the budget's goals. Here is how they can do it: • Managers must support the budget themselves, or no one else will. • Managers must show employees how budgets can help them achieve better results. • Managers must have employees participate in developing the budget so that employees feel the goals are realistic and achievable.

Master Budget Components Part 1

The operating budget is the set of budgets that projects sales revenue, cost of goods sold, and selling and administrative expenses, all of which feed into the budgeted income statement that projects operating income for the period. The first component of the operating budget is the sales budget, the cornerstone of the master budget. Why? Because sales affect most other components of the master budget. The company will not produce products it does not expect to sell. Additionally, variable production and period costs are projected based on sales and production levels. Therefore, the sales budget is the first step in developing the master budget. The second type of budget is the capital expenditures budget. This budget presents the company's plan for purchasing property, plant, equipment, and other long-term assets.

Sales Volume Variance

The sales volume variance is the difference between expected results in the flexible budget for the actual units sold and the static budget. This variance arises because the actual number of units sold differed from the number of units on which the static budget was based. Sales volume variance is the volume difference between actual sales and budgeted sales. Sales Volume Variance = Flexible Budget − Static Budget

Operational Budget

The term "operational" generally indicates a short-term goal. After the company develops strategies and creates a strategic budget, the next step is to plan for shorter periods. An operational budget is a short-term financial plan used to coordinate the activities needed to achieve the short-term goals of the company. Operational budgets are most often one year in length, but may also span only a week, a month, or a quarter, depending on the company's needs. Operational budgets are generally much more detailed than strategic budgets.

Master Budgets Components Part 2 Continued

The third type of budget is the financial budget. The financial budget includes the cash budget and the budgeted financial statements. Prior components of the master budget provide information for the first element of the financial budget: the cash budget. The cash budget details how the business expects to go from the beginning cash balance to the desired ending cash balance and feeds into the budgeted balance sheet and the budgeted statement of cash flows. These budgeted financial statements look exactly like ordinary financial statements. The only difference is that they list budgeted, or projected, amounts rather than actual amounts.