BUS105: Managerial Accounting

Rarely will the assumptions of the master budget be completely accurate. As a result, organizations use a modified budget called a flexible budget. A flexible budget is a revised master budget based on the actual activity levels. The flexible budget represents what costs should be – based on the actual levels of sales/activity. In this unit, the text assumes beginning and ending finished goods inventory are the same and, therefore, the number of units produced and sold will be the same. Read the Chapter 10 Introduction, and then click "Next Section" to read Section 10.1. As you read, follow along with how Jerry's Ice Cream handles a doubling of expected sales – sweet news!

In this section, you will see what happens when the master budget plan deviates significantly from the assumptions used to develop it. When a deviation from the master budget becomes apparent, one of the possible causes is that actual costs were not known when the master budget was developed and standard costs were used. Standard costs are those costs that management expects to incur to provide a good or service and are typically stated as a cost per unit. Standard cost is based on the combination of price (or rate) and quantity (or hours). They serve as the "standard" by which performance will be evaluated and are used to produce the master budget.

Follow along and document how Jerry's Ice Cream used standard costs to develop a master budget and how that contributes to variance from the actual results. You should note that a standard cost is a per-unit cost, while a master budget cost is the total cost at a given standard level of activity/standard quantity of units.

Jerry’s Ice Cream is concerned about cost overruns of direct materials. This section examines the "causation" of direct materials variance. The master budget amount allocated to direct materials is made up of two estimated parts, the quantity (Q) of materials included and the price (P) of those materials. Any variance in this cost category from the master budget can be accounted for by an increase or decrease in P and/or Q. Attribution of the variance to its cause(s) is critical to management decisions.

Jerry's Ice Cream wants to know why there are cost overruns for direct labor. This section considers another significant factor of variance: direct labor. Like direct material variance, direct labor variance has two possible causes: labor rate variance and labor efficiency variance. As with materials, any variance in this cost category from the master budget can be accounted for. Attribution of the variance to its cause(s) is critical to management decisions.

The final piece of the puzzle for Jerry's Ice Cream is variable manufacturing overhead variance. Variable manufacturing overhead variance has two distinct variances. When you calculate both variances, one is favorable and the other is not. The two variances are the spending variance and efficiency variance. The variable overhead spending variance is the difference between actual costs for variable overhead and budgeted costs based on the standards.

At Jerry's Ice Cream or any other company, each budget line item could have an associated variance. The question becomes which variances should be investigated. As a decision-maker, you have limited resources, and you should allocate them to their most productive use. Every investigation consumes resources and has a direct expense associated with it. All managers must be judicious in selecting and investigating variances. Let's return to Jerry's Ice Cream to determine which variance you would track and examine.

If a company uses ABC (activity-based costing), like Jerry's Ice Cream, it cannot establish one standard variable overhead rate and standard quantity based on one cost driver. ABC companies must establish several standard variable overhead rates and quantities, each having its own cost driver. Regardless of whether a company uses the traditional costing approach or an activity-based costing approach, the process of performing variance analysis is consistent. Suppose Jerry's Ice Cream identified three significant activities. Let's see how ABC can be used with variance analysis!

Fixed overhead in the master budget is the same as fixed overhead in the flexible budget because fixed costs do not change with changes in units produced. Fixed manufacturing overhead variance analysis involves two separate variances, the spending variance and the production volume variance. This unit applies this management measure to Jerry's Ice Cream. Calculating the two variances informs management if they are applying enough overhead to the operation.