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Review of Key Concepts

  1. Distinguish between flexible budgets and master (static) budgets.
    1. Master budgets are static; that is, they assume fixed levels of activity. Therefore the master budgets do not change even if the underlying sales and other cost-driver activities do change.
      1. One of the major roles of the master budget is to provide a benchmark for evaluating actual performance.
        1. Recall from Chapter 1 the common form of the performance report: Actual result - Expected result = Variance
        2. When the "expected result" is a component of the master budget, say, the budgeted income statement, the performance report variance is called the master budget variance.
      2. When actual revenue exceeds master budget revenue, the master budget variance is "favourable" (and vice versa).
      3. When an actual cost or expense exceeds master budget cost or expense, the master budget variance is "unfavourable" (and vice versa).
      4. See textbook Exhibit 12-1.
      5. The shortcoming of the master-budget variance is that the variance is the net result of at least two underlying causes:
        1. Differences in underlying sales volume and other cost driver activity that cause total costs and revenue to differ from the master budget.
        2. Differences in either revenue or variable costs per unit of activity and fixed costs per period that cause costs and revenue in total to differ from the master budget.
        3. From the master-budget variance alone, managers cannot determine why actual results differed from the master budget. Since each cause has different control implications, it would be useful to separate their effects.
        4. The flexible budget (variable budget) is used to attribute one part of the master budget to different activity levels and the other part to differences in revenue and costs per unit of activity.
      Before going on to the next section, be sure that you understand that we have re-introduced the concept of a variance from Chapter 1 and have applied it to the master budget from Chapter 11. Can you explain two possible causes of a master budget variance?
    2. The flexible budget is part or all of a master budget that is prepared for the actual (or any) levels of sales and other cost driver activities.
      1. Contrast with a master budget, which is tied to a single level of underlying activities.
      2. Obviously, use of a computerized financial planning model makes preparation of flexible budgets relatively easy because the model contains the quantitative relationships between activity levels and revenues or expenses, but flexible budgets can be prepared manually, too.
  2. Use flexible-budget formulas to construct a flexible budget based on the volume of sales.
    1. The relationships among activities and costs and revenues can be called flexible-budget formulas, but they are just the revenue and cost functions developed and used in previous chapters.
      1. Recall for strictly variable costs, this formula is the cost per unit of cost driver activity, as shown in the upper part of Exhibit 13-2.
      2. See textbook Exhibit 12-2.
      3. For fixed and step costs, the flexible-budget formula is simply the total budgeted amounts per budget period, as illustrated in the lower part of Exhibit 13-2.
      4. The relationship between these two formulas is identical to the relationships discussed in
        Chapters 2 and 3.
      See textbook Exhibit 12-3.
      Before going on to the next section be sure you understand that by introducing the flexible budget we are combining concepts of CVP relationships, cost behaviour, and the master budget. All the elements of the flexible budget should already be familiar to you.
    2. An activity-based flexible budget is based on budgeted costs for each activity centre and related cost driver. Within each activity centre, costs depend on an appropriate cost driver.
    3. The key difference between an activity-based flexible budget and a traditional flexible budget is that in an activity-based flexible budget costs that are fixed with respect to units but vary with respect to more appropriate cost drivers (e.g., setups) will be correctly identified as variable costs.
    4. Activity-based flexible budgets are appropriate for companies, which have a substantial proportion of costs that vary with cost drivers other than unit of output.
    5. See textbook Exhibit 12-4.
  3. Understand the performance evaluation relationship between master (static) budgets and flexible budgets.
    1. The master budget variance can be split into two variances by "inserting the flexible budget between the master budget and actual results."
      1. This is an important result because each variance can be attributed to differences in either activity levels or per unit revenues and variable costs and fixed costs per period.
        1. For simplicity, the textbook chapter and this study guide chapter assume that the only relevant activity level is sales activity.
        2. In practice, multiple activity levels can be used for different portions of the master budget and flexible budget.
        3. Flexible budget or efficiency variances are the variances between actual results and flexible budget expectations.
        4. Activity-level variance causes variance between the master budget and the flexible budget.
        5. The sum of the activity-level variance and the flexible-budget variance is the total variance between the actual result and the master budget expectations.
        6. Note how the flexible budget is "inserted" between the master budget and actual results for a model income statement:
        7. See textbook Exhibit 12-5.
        8. Another explanation follows:
        9. Master budget - Actual result = Master-budget variance (Master budget - Flexible budget) - (Actual result - Flexible budget) = Master-budget variance Sales-activity variance + Flexible-budget variance = Master-budget variance
        10. Distinguishing between effectiveness (did we meet the target?) and efficiency (did we use the least inputs to achieve a specific quality and quantity of outputs?) is important information provided through a careful variance analysis.
  4. Compute flexible-budget variances and sales-volume variances.
    1. The sales-activity variance is an analysis of effectiveness. It is the difference between actual sales minus the master-budget, and the result is multiplied by the budgeted unit contribution margin.
      1. The underlying cause of the sales-activity variance is that actual sales activity was different than expected in the master budget.
      2. The sales-activity variance is the portion of the master-budget variance attributed to sales activity.
      3. The sales-activity variance comprises both the market share and the market size variance, the formulas for which can be found in the text.
  5. Distinguish between standard costs and standard cost systems.
    1. Master budgets and flexible budgets are constructed using expected costs or standard costs:
      1. Expectations are standard costs per unit that should be attained. They are benchmarks to be attained.
      2. A standard cost system is an inventory valuation and control system that values inventories at standard costs only.
        1. Differences between standard costs and actual costs are charged to income.
        2. Using standard costs for budgeting does not require using a standard cost for inventories.
        3. In practice, some companies use multiple cost systems for multiple purposes. This is because a single cost system that would support all decision making and financial reporting would be too expensive — an application of the cost-benefit criterion.
      3. Standard costing is not linked to having a standard cost system.
      4. Perfection standards, also called ideal standards, are expressions of the absolutely minimum unit costs possible under the best conceivable conditions, using current specifications and facilities.
        1. These are not widely used for budgeting or performance evaluation.
        2. Perfection standards are thought to have adverse motivational effects since they can never be attained and always result in unfavourable cost variances.
        3. Perfection standards do direct attention to inefficiencies in the organization.
      5. Currently attainable standards represent costs that can be achieved by realistic levels of effort
        1. These are widely used for budgeting and evaluation.
        2. These standards do make allowances for normal shrinkage, spoilage, lost time, and equipment breakdowns.
        3. Currently attainable standards usually have a desirable motivational effect on employees because, although difficult to reach, they are reasonable goals.
      6. Managers may trade off variances.
        1. For example, a manager may consider reducing material costs by buying lower quality materials even though this might cause higher labour costs due to more required rework of defective products.
        2. Trading off variances can be beneficial, but it is a dangerous practice since the trade-off may be unfavourable.
        3. If standards or expectations are set carefully, they take into account the most favourable trade-offs of various costs. Usually managers should try to change the standards rather than trying to informally change the trade-offs.
      7. Decisions to investigate variances balance the costs of investigating versus the costs of not investigating.
        1. Costs of investigating include managers' and other employees' time and downtime for equipment and processes.
        2. Costs of not investigating include allowing costs to be uncontrolled in the future.
        3. As discussed in Chapter 9, standard cost variances tend to not be very useful for control of operations where quick feedback is necessary - more timely and relevant measures are available (e.g., defects, yields).
        4. Standard cost variances are more useful for periodic performance evaluations. Explanations of large variances serve to inform higher-level managers about the quality of lower-level managers - how problems were resolved.
        Can you explain the different types of standards, their advantages and disadvantages? Which are the most widely used for budgeting and performance evaluation? Why?
  6. Compute and interpret price and usage variances for material, labour, and overhead inputs.
    1. Flexible-budget cost variances can be split into these effects: price of inputs and usage of inputs.
      1. Price variances for direct materials, direct labour, and variable overhead items like supplies are computed as:
      2. Price variance = (Actual price - Expected price) × (Actual quantity of input)
        This is the portion of the flexible budget variance due to spending a different amount per unit for inputs than expected.
      3. We define usage variances for inputs as:
      4. Usage variance = (Actual quantity - Expected quantity) × (Expected or standard price)
        1. This is the portion of the flexible budget variance due to using an amount of input different than expected.
        2. The "expected input" in the above formula is more formally known as the standard input allowed for the output achieved.
        3. Usage variances are also known as efficiency variances, but efficiency includes both spending and usage, so the term "efficiency variance" is misleading.
        See textbook Exhibit 12-7.
      5. Flexible-budget variable overhead variances can be split similarly.
      6. Another approach to computing price and usage variances is to split the flexible-budget variance into two complementary effects in much the same way as we split the master-budget variance.
        1. We can split the flexible-budget variance by inserting a flexible budget based on actual inputs at expected prices, between the previous flexible budget (which uses expected inputs for the outputs achieved and expected prices) and actual results (which uses actual cost multiplied by actual price).
      See textbook Exhibit 12-8.
    2. When actual cost-driver activity differs from the standard amount allowed for the actual output achieved, a variable overhead efficiency variance occurs. Variable overhead efficiency variance is calculated by subtracting the expected cost from the actual cost.
      1. The cause is identical to that for an activity efficiency variance.
    3. A variable overhead spending variance is the difference between actual variable overhead and budgeted variable overhead.
    4. Stop and Review See textbook Exhibit 12-9.
      Before going on, be sure that you understand how the flexible budget variance is split into price and usage effects. There are several ways to perform this analysis. Use the approach that makes the most sense to you; they are equivalent.
  7. Compute the production-volume variance.
    1. To obtain an absorption product cost for pricing and inventory uses, one must select an expected level of activity as the basis for applying fixed overhead. In Chapter 4 the production-volume variance was calculated as:
    2. (Actual volume – Expected volume) × (Fixed overhead rate)

      1. A budgeted rate for applying fixed factory overhead is then predetermined for a given year:
      2. Fixed overhead rate = Budgeted fixed overhead ÷ Expected activity level

      3. A production-volume variance arises whenever the actual production volume deviates from the expected or practical-capacity level used to calculate the fixed overhead rate.
        1. When actual production volume is less than the expected volume, the fixed overhead production-volume variance is unfavourable because fixed overhead expected is greater than applied (or fixed overhead is underapplied).
        2. When actual production volume is greater than the expected volume, the volume variance is favourable because fixed overhead applied is greater than expected (or fixed overhead is overapplied).
        3. There is no production-volume variance for variable overhead.
      4. Selecting the appropriate denominator to calculate the fixed overhead rate is a matter of judgment.
        1. Some managers favour using budgeted annual volume.
        2. Some managers favour using a longer-run amount representing normal activity.
        3. Some accountants argue that the best fixed overhead allocation base is practical capacity, which is the level of production activity that would utilize facilities optimally. When expected or actual production is less than optimal, the production-volume variance is an indication of the cost of excess capacity - excess fixed cost that is incurred because production is lower than the facility was designed for.
  8. Identify the differences between the three alternative cost bases of an absorption-costing system: actual, normal, and standard.
    1. There are three basic ways for applying costs to products by the absorption-costing approach: actual costing, normal costing, and standard costing.
      1. Actual costing uses the actual production level to allocate fixed overhead. Therefore, the volume variance is always zero. Prime costs are applied as they are actually incurred.
      2. Normal costing uses the standard or expected production volume to apply overhead, so a volume variance may exist. Prime costs (direct materials and direct labour) use actual costs.
      3. Standard costing applies all costs at standard rates multiplied by the inputs allowed for actual outputs achieved.
      Can you explain how to determine the fixed overhead rate? Can you also explain the meaning and derivation of the production-volume variance?
    2. Flexible-budget variances arise for both variable and fixed overhead. There is a relationship between the production-volume variance and the fixed-overhead flexible-budget variance.
    3. See textbook Exhibit 12-10.
    4. One can reconcile the difference in the operating incomes measured by the variable-costing and absorption-costing approaches for a given year by adjusting for changes in inventory levels.
      1. Recall from the discussion above that the reason the two income measures may differ is that in absorption costing, fixed overhead first flows through inventory accounts before being expensed.
        1. When actual production volume equals actual sales volume, then usually (inventory accounting methods can complicate this) the period's fixed overhead is expensed, just as in variable costing, so there is no difference in income measures.
        2. When actual production volume does not equal actual sales volume, the income measures can differ because the amount of fixed overhead recognized as expense by the two methods differs.
      2. There are several straightforward methods for reconciling the income differences between the two methods (the first is probably easier):
        1. Multiply the budgeted rate of fixed manufacturing overhead by the increase or decrease in inventory units for the year.
        See textbook Exhibit 12-11.
        Before going on to the next section, be sure that you understand how to reconcile income reported under both variable and absorption costing under conditions of: no change in inventory, increase in inventory, decrease in inventory.
  9. Identify the two methods for disposing of the standard cost variances at the end of a year and give the rationale for each.
    1. Variances that arise in a standard costing system can be dealt with in two ways.
      1. They can be prorated, assigned to the inventories and costs of goods sold related to the production during the period the variances arose, to cost of goods and ending inventories.
        1. This adjusts inventories and cost of goods sold to actual costs.
      2. More often, variances are treated as an adjustment to the current income.
      3. These variances are usually treated as expired costs of the period and charged to current income.

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