Budgeting and standard costing

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1 The budgetary process

The budgetary process is an essential part of planning. Indeed, a budget can be defined as a ‘quantified plan’.

Budgets have the following important roles:

Planning – a budget is a quantified plan: money, units, people, market share.
Forecasting – forecasting is a necessary step in establishing any plan.
Coordination – all departments in the organisation should be co-ordinated and be in line with the limiting factor (principal budget factor).
Communication – the budget is an effective way of informing departments and people what is expected of them.
Control – a budget is a way of directing and controlling expenditure.
Authorisation – a budget figure (for example for advertising) authorises expenditure up to the budget amount.
Motivation – budgets provide people with targets to aim for.
Evaluation – comparing budget to actual is the first step in evaluating performance. Sometimes performance might need to be improved; sometimes the budget might need to be changed.

2 Care in budget setting

Some care is needed when setting and using budgets for evaluation.

If the budget is too easy, performance will probably be pulled down.

If the budget is too difficult, employees can become demotivated.

If the budget is applied too strictly with no allowance for other important factors, data might be mis-reported and staff will be demotivated.

3 Standard costing

Standard costs are predetermined costs per unit of output that should be incurred under normal operating conditions.

Even if the use of standard costs does not progress to variance analysis, ‘standards’ are needed for budgeting. It is essential to know how much material and how many hours it will take to produce planned output and what these resources will cost.

Probably the best standards to use are ‘currently attainable standards’. These should be achievable under normal operating conditions without being too easy.

4 Variance analysis

Variance analysis is a common way to try to find reasons for discrepancies between actual and budgeted performance.

You will have to know how to interpret them and to suggest their causes.

Above all, it is important not to jump to conclusions when stating what caused a variance or who was responsible for them. Just because a production department used more material than might have been expected does not mean that that the operations in the production department was at fault. The purchasing department might have bought poor material, machines might be old and unreliable thus wasting some material, cheaper and worse staff might have been forced on the department and these people make errors.

5 Material variances

The variances	Potential causes
Material price variance: Quantity of material actually used at actual price compared to what that quantity of material would cost if bought at standard price/unit.	Wrong standard cost/unit of material Poor/excellent buying Price changes since the standard was set Exchange rate movements altering the price of imported material
Material usage variance: The physical amount of material actually used compared to the standard amount that should be used for the actual output achieved, evaluated at the standard cost per unit.	Wrong standard usage/unit of production Poor/excellent use of material Material of different quality Poor machine maintenance Poor staff training

6 Labour variances

The variances	Potential causes
Labour rate variance: The actual coast of labour paid for compared to what that amount labour should have cost if paid at the standard hourly rate.	Wrong standard rate/hour Wage inflation A different mix of labour eg better, more expensive people
Labour efficiency variance: Number of hours actually worked compared to the standard number of hours that should be worked for the actual output achieved, evaluated at the standard rate per hour.	Wrong standard hours per unit A different mix of labour Better or worse training than expected Good/poor supervision
Labour idle time variance: Hours actually worked compared to hours paid for, evaluated at the standard rate per hour	Poor supervision Machine breakdown Lack of material Poor job scheduling

7 Variable overhead variances

The variances	Potential causes
Variable overhead rate variance: Amount of variable overhead actually paid, compared to what those hours of variable overhead should have cost if bought at standard hourly rate.	Wrong standard rate/hour Different machines being used Unexpected inflation relating to machine running.
Variable overhead efficiency variance: Number of hours actually worked compared to the standard number of hours for the actual output achieved, evaluated at the standard rate per hour.	Wrong standard hours per unit Machines of a different efficiency than expected. Good/poor supervision Good/poor machine maintenance .

8 Fixed overhead variances

The variances	Potential causes
Fixed overhead expenditure variance: Total amount of budgeted fixed overheads compared to total actual fixed overheads	Wrong budget Unexpected level of expenditure
Fixed overhead volume variance: Actual output in units compared to budgeted output (units), evaluated at the fixed overhead absorption rate per unit	Wrong budget Different output to what was expected.

9 Sales variances

The variances	Potential causes
Sales price variance: Actual volume sold times difference between actual and budgeted selling price	Wrong budget Different selling price to what was expected.
Sales volume variance: Actual volume sold compared to budget volume, evaluated at budgeted contribution per unit or at budgeted profit per unit.	Wrong budget Different selling price to what was expected (affects demand) Change in marketing Economic changes

10 Operating statement

Once variances have been calculated they can be conveniently displayed on an operating statement. Typically this reconciles budgeted profits or contribution to actual profit.

	*Favourable* *variances*	*Adverse* *variances*	$000
Budgeted profit			x
Sales price variance		x
Sales volume variance	x
	x	x	x
			x
Material price variance		x
Material usage variance	x

Labour rate variance	x
Labour efficiency variance	x
Labour idle time variance		x

Variable overhead rate variance		x
Variable overhead efficiency variance	x
	x	x
Fixed overhead expenditure variance		x
Fixed overhead volume variance	x
	x	x	x
Actual profit			x

A company buys and sells goods and has a sales budget of 10,000 units selling at $100 each. The standard purchase price of a unit is $70, and fixed costs (which include all costs except the purchase price of goods) are budgeted at $200,000.

Actual results for the period show that 12,000 units were sold at a selling price of $98. Fixed costs were $220,000 which includes an additional $10,000 spent on advertising.

The operating statement is therefore:

	$	$
Budgeted contribution 10,000 x (100 – 70)		300,000
Sales price variance (A) 12,000 x (98 – 100)		(24,000)
Sales volume contribution variance (F) 2,000 x (100 – 70)		60,000
		336,000
Budgeted fixed costs	200,000
Fixed overhead expenditure variance (A)	20,000
		(220,000)
Actual profit		116,000

Note: budgeted profit was $100,000 ($300,000 contribution - $200,000 fixed costs)

Required

Outline what might have caused the three variances and include comments about the potential interdependencies of variances and what the strategies the company might therefore adopt to improve profits in the future.

Adverse sales price variance

This could simply be caused by market forces such as competitors dropping their selling prices, or a poor economy forcing companies to maintain or increase sales volumes by decreasing prices.

Alternatively it could be part of a more deliberate strategy to gain market share, to put pressure on competitors and to make the market less attractive to new entrants.

Potential interdependencies with other variances are discussed below.

Favourable sales volume variance

This could simply be caused by increased demand for the company’s products. For example, a better economy, a competitor withdrawing or an increase in advertising.

Fixed overhead variance

It is assumed that the $10,000 increase in advertising was deliberate, either to make a play for a higher market share or to defend the company’s current position if a competitor had become more aggressive.

Interdependencies

There is probably a connection between the favourable volume variance, the unfavourable price variance and the unfavourable $10,000 additional advertising spend. It is not possible to separate out the causes and effects using the data provided and this is something that the company should investigate further.

The most favourable outcome of the investigation would be that the company deliberately spent $10,000 more on advertising, reduced its price as part of the campaign, and that these changes boosted demand by 2,000 units.

That was clearly a worthwhile effort because contribution increased by $36,000 and after the additional advertising profits would have increased by $26,000. As part of future strategies, the company should try to predict the effect of reducing selling costs further and of increasing advertising as it might be worthwhile pursuing those polices even further.

There is, of course, a danger that competitors will retaliate and that a price war begins.