4.0BUDGETARY CONTROLAND VARIANCE ANALYSIS
Budgetary control:
Definition
This is a technique of Managerial control through budgets. It is a system of controlling costs and includes the preparation of budgets, co-ordinating the activities departments and establishing responsibilities, comparing actual performance with budgeted performance and acting upon results to achieve maximum profitability.
Thus, the term budgetary control is designed to evaluate the performance in terms of goals planned(budgets) through budget reports.
The above definition of budgetary control can be analysed to mean:
(i)Planning – Being a formal expression of policies, plans, objectives and goals laid down in advance by the top management for the undertaking as whole and for every sub-division.
(ii)Co-ordination - As the integration and co-ordination of the various departmental plans and budgets. It is achieved through the preparation of a master budget that integrates both the operating and financial budgets for the whole undertaking.
(iii)Recording - Recording of all the actual performance using the operating accounting system which is then used for comparison with the budgeted standards.
(iv)Control -Comparison of actual data with those of the standard, this is an essential feature of any control system to determine deviations from the budgets and place the responsibility for failure or success in achieving the budgeted figures to a responsibility centre.
(v)Appraisal and Follow-up - After identifying the probable reasons for deviations, a follow-up action is taken. It involves the necessary steps to be taken in order to improve the situation and prevent further deviations.
Organisation of a Budgetary Control System:
The process of budgetary control can reasonably be divided into two distinct activities:
-Preparation of the budgets; and
-Implementation of the budget program.
From the management point of view, the budgeting process is closely associated with the operations of the business and its organisational structure. The effectiveness of a budgeting system to a large extent depends up on the organisation efficiency. In a large-sized organisation, an effective budgetary control system can be organised on the following lines:
a)Creation of budget centres.
b)Provision of adequate and reliable Accounting Records.
c)Setting the guidelines for budget staff for the preparation of the budget.
d)Preparation of Organisational chart; an organisational chart should be prepared which must define the functional responsibilities of each member of the management team.
e)Establishment of a budget committee:
In small organisations, budgets may be prepared by one executive and he is made in charge ofall budgetary arrangements, this means budgeting in small organizations are less formal. In large organisations, a budget committee may be created under the charge of a budget officer or the Director of Finance.
Standard Costing and Budgetary Control
Budgetary control and standard costing systems are essentially concerned with encouraging individuals within an organisation to alter their behaviour so that the overall aims of the organisation are effectively attained.
A standard costing is a very important system of cost control. It seeks to control the cost of each unit or batch by determining before hand what should be the cost under desirable conditions and then compares it with the actual costs attained.
Definition:
A standard cost system is method of cost accounting in which standard costs are used in recording certain transactions and the actual costs are compared with the standard costs to learn the amount and reason for any variations from the standards”.
Distinctions between Budgetary Control and Standard Costing
Budgetary control system is an integrated and co-ordinated plan of action in respect of all functions of an enterprise. On the other hand, standard costing is limited to the business operating level.
The Budgets embrace revenues as well as costs and all functions and activities – sales, purchases, finance, capital expenditure, personnel etc. in additional to production, whereas the coverage of standard costing is limited to costs only.
Budgets are projection of final accounts while standard costs are projection of only the cost accounts.
Thus, standard costing and budgetary control systems are two different aspects of the process of the managerial control. These systems are complementary to each other and should be used simultaneously in order to achieve maximum efficiency and economy. When standard costs have been determined, it becomes relatively easier to compute budgets for production costs and sales.
STANDARD COSTS:
Definition:
They are pre-determined costs of manufacturing a single unit or a number of product units (batch) during a specified period in the immediate future.
“A standard cost, as usually employed, is predetermined operation costs, computed to reflect specified quantities, prices and level of operations per unit of output”.
Cecil Gillespie
-Standard costs are the basis of a system of standard costing.
-Thus standard costs represent the costs that should have been incurred under the expected circumstances. In a standard costing system, each unit of product has a standard material cost, a standard labour cost, and a standards overhead cost for each product centre. The total standard cost (budget) of the period under consideration is obtained by multiplying these standard unit costs by the number of units flowing through the cost centre in the period.
Purposes of standard costs:
Standard costs are very useful for managerial control and planning. They provide a yardstick for the measurement of operational efficiency of an enterprise.
Standard costs are used for:-
- Establishing budgets
- Controlling costs, motivating employees, and measuring efficiency.
- Promoting possible cost reduction.
- Simplifying costing procedures and expediting cost reports.
- Assigning/allocating costs to materials, work-in-progress and finished goods inventories.
- Forming the basis for establishing bids and contracts as well as for setting selling prices.
Setting of standards:
A standard is an ideal which is anticipated and can be attained over a future period of time, normally in the next accounting year. The cost accountant, departmental heads, foremen and technical experts should work together in setting standards. Just like a budget committee, a committee should be formed to set standards.
TYPES OF STANDARDS
Broadly the standards can be divided into three categories:
(i)Current standards;
(ii)Basic standard; and
(iii)Normal standard
Current Standards:
Fixed on the basis of current conditions and remain in operation for a limited period in the sense that they are revised at regular intervals. Current standards are of two types:
(a)Ideal standards:
This standard reflects the level of attainment on the basis of maximum possible level ofefficiency which may never be achieved.
(b)Expected (or Attainable) standards.
Reflects a level of attainment based on a high level of efficiency which is capable of being achieved. It is best suited for control point of view because this standard reveals real variances from the attainable performance levels.
Basic standard:
The standard is established and operated without revision for a number of years to help forward planning. It is not suitable for cost control purposes.
Normal standard
This standard is meant to smooth out fluctuations caused by seasonal and cyclical changes. It is difficult to follow such standards in practice because it is not possible to forecast performance with adequate accuracy for a long period of time. As such, normal standards have little relevance for planning and cost control.
Budgetary Control And Variance Analysis
A distinctive feature of a standard costing system is in variance analysis. The term variance means the variation or deviation of the actual from the “standard”. In standard costing, variance means the difference between the actual cost and standard cost and shows the extent to which standards set have been so achieved.
-If properly recorded and analysed, these variances become very useful and important tools for managerial control.
-Variances by themselves are not an end. They are computed to know and show the reasons and fix responsibility for deviations of actual performance against pre-determined targets so that measures can be taken to correct them in future.
Variance Analysis
Definition:The process of analysis variances by sub-dividing the total variance in such a way that management can assign responsibility for off-standard performance.
Interpretation of Variances:
Each variance is interpreted accordingly and by “interpretation” we mean making a decision whether the variance is favourably or unfavorable and attaching responsibility.
-When actual cost is less than the standard cost, the difference is considered “FAVOURABLE” or CREDIT VARIANCE.
-On the other hand when the actual cost exceeds the standard cost, the difference is termed as UNFAVOURABLE or a DEBIT VARIANCE.
-Ordinarily, a favourable variance is a sign of efficiency of the organisation whereas an unfavourable variance is a sign of inefficiency.
Controllable Vs. Uncontrollable Variances:
-A variance is controllable if it can be identified as a primary responsibility of a specified person or of a department. If the variance is caused by factors beyond the control of the concerned person (or department), it is said to be uncontrollable.
-It is the controllable variance that attracts the attention of the management because it is here that corrective action is required.
CLASSIFICATION OF VARIANCES:
-Variances may broadly be classified into two groups:
(i)Cost Variances, and
(ii)Sales Variances.
TOTAL ORGANISATION VARIANCE
CostSales
MaterialLaborOverhead
SalesSales
ValueMargin
COST VARIANCES:
In the manufacturing function, cost variances are classified on the basis of the elements of cost viz. material, labor and expense variances.
In cost analysis the standard cost of each element of cost is reconciled with actual cost and difference is called cost variance or total variance. The cost variance has two components:
(i)Price Variance; and
(ii)Volume variance.
Classification of Cost Variances:
(i)Material Variance:
Price
varianceMix variance
Cost Variance
Usage/volume
varianceYield variance
(ii)Labour Variances:
Rate variance
Mix Variances
Efficiency variance
Cost Variance
Idle time varianceYield variance
Calendar variance
(iii)Overhead Variances
A: VariableExpenditure variance
Overhead variance
Efficiency/volume variance
B: Fixed Overhead Variance
Expenditure variance
Cost VarianceEfficiency variance
Volume varianceCapacity variance
Calendar variances
DIRECT MATERIAL VARIANCES
Illustration:
(i)From the following particular, calculate material variances
Standard Mix$Actual Mix$
A: 55kgs at $2.0011060kgs at $2.25135
B: 45kgs at $4.0018040kgs at $3.50140
100 kgs290100 kgs275
(ii)Using the information as in (i) and further assuming that the standard output and actual output are 90 units and 81 units respectively, calculate the material variances.
SOLUTION:
Calculation of Input Variances:
A.1.Cost Variance = Actual cost - Standard cost
=$275 – 290=$15F
2.Price Variance=Actual Qty. (Actual Price – Standard Price)
=A: 60 (2.25 – 2.00) = $15 (A)
=B: 40 (3.50 – 4.00) = $20 (F)
5 (F)
3.Usage Variance=Std. Price (Actual Qty. – Std. Qty.)
=A: 2.00 (60 – 55) = $10 (A)
B: 4.00 (40 – 45) = $ 20 (F)
10 (F)
- Material Mix
Variance=Std. Price (Actual Qty. – Revised Std. Qty)
=A: 2.00 (60 – 55*x 100) = $10 (A)
100
=B: 4.00 (40 – 45 x 100) = $20 (F)
100 10 (F)
*Revised Standard Qty.Std. Qty usedxTotal in actual mix
for actual output= Total Qty in Std. Mix
Verification:
Cost Variance =Price Variance + Use Variance
=Price variance + Mix variance + Yield Variance
15=5+10+0
=15
B:SOLUTION
Calculation of Output variances:
1.Cost variance=Actual cost of output – Standard cost of output
=$(275 – 81* x 290) = $14
90
*Actual outputx Total Qty in std. mix
Std. output
2.Price Variance=Actual Qty. (Actual price – standard price)
=A: 60 (2.25 – 2.00)=$15 (A)
B: 40 (3.50 – 4.00)=$20 (F)
5 (F
3.Usage Variance =Std. Price (Actual Qty – Revised standard Qty)
=A; $2 (60 – 49.5) = $21 (A)
B: $4(40 – 40.5) = $2 (F)
19 (A)
Workings:RSQ =Std. Qty forxActual output achieved.
each MaterialStd. Output from Std. mix
A:=55 x 81 = 49.5 units
90
B:=45 x 81 = 40.5 units
90
4.Mix Variance=Std. Price (Actual Qty – Revised Std. Qty)
=A: $2 (60 – 55) = $10 (A)
B: $4 (40 – 45) = $20 (F)
10 (F)
Workings:RSQ is the actual mix’s total in terms of standard mix proportion x Actual Quantity in actual Mix.
5.Yield Variance=Std. rate per unit of put x (AY – SY)
=290 (81-90)=$29 (A)
90
DIRECT LABOUR VARIENCES
Illustration
In the manufacture of a product, 200 employees are engaged at a rate of $.50 per hour. A five-day week of 40 hours is worked and the standard performance is set at 250 units per hour. During the first week in January, six employees were paid at $.45 an hour and four at $ .56 an hour, the remaining were paid at the standard rate. The factory stopped production for one hour due to power failure. Calculate labour variances.
SOLUTION
1. Cost Variance= Actual Cost – Standard Cost
=$ 3 997.60 – 4000= $2.40 (F)
Workings:
SC= Std. Hours x Std. Rate per hour
=200 x 40 x 50
= $4 000
AC(i)=190 employees for 40 hours at $.50
=$3 800
(ii)=6 employees for 40 hours at $.45
= $ 108
(iii)=4 employees for 40 hours at $.56
=$89.60
Total Actual Cost = $ 3 997.60
2. Rate Variance
=Actual Hours Paid (Actual Rate – Std. rate)
(i) =190 employees x 40 Hrs (.50 - .50)=0
(ii)=6 employees x 40 Hrs (.45 - .50)=$12 (F)
(iii)=4 employees x 40 Hrs (.56 - .50)=$9.60 (A)
Total$2.40 (F)
- Efficiency Variance
=Std. rate (Actual Hours worked – Std. Hours)
=.50 (7 800 – 8 000) = $100 (F)
Workings: AH – worked = 200 x 39 = 7 800 Hours
4.Idle Time variance =Idle hours x Std. rate per hour
=200 x 1 hours x .50 = $100 (A)
Verification:
CV=R.V + Eff. V + ITV
=2.4 (F) + 100 (F) + 100 (A)
=2.40 F
OVERHEAD VARIANCE
Variable costs are constant per unit because they vary in a direct proportion to the level of business activity while fixed costs variable per unit but constant for a given range. This attribute of fixed costs hampers the establishment of a standard fixed overheads rate when the level of activity differs from month to month within the relevant range.Overhead absorption rates are usually based on budgeted level of output and linked (driven) to products through labor hours, or machine hours or as a percentage of direct labor costs.
VARIABLE OVERHEAD VARIANCES:
Overheads absorption rates (tariffs) are usually based on direct labour hours or machine hours, or are expressed as a percentage of the direct labour costs.
Illustration:
The following are the budgeted results at normal capacity of A Ltd, a manufacturing enterprise for the month of February, 2000.
Budgeted Results:$
Fixed Overheads27 000
Variable Overheads22 500
Labour Hours15 000
According to the standard, it takes 7.5 hours to manufacture one product.
Actual Results:$
Fixed Overheads27 200
Variable Overheads22 400
Labour hours worked16 000
Units manufactured 2 100
Required:
Calculate the following variances in respect of variable manufacturing overheads:
(i)Efficiency Variance
(ii)Expenditure Variance
(iii)Total variable overheads
(i)Efficiency Variance =Std. rate (Actual Hrs worked – Std. Hrs required)
=22 500 x (16 000 – 2 100 X 7.5)
15 000
=1.5 x (16 000 – 15 750)
=$375 (A)
This variance shows the effect / impact of a change in labor efficiency on variable overhead recovery.
(ii)Expenditure Variance
=(AR – SR) AT
=(22 400 – 22 500) X 16 000
16 000 15 000
=$1 600 (F)
The difference shows what the standard variable overheads should have been on the hours worked and the actual variable overheads paid.
(iii)Total variance:=Actual Amount paid – Standard Amount
=$(22 400 – 15 750 x 1.5)
=$1 225 (F)
PROOF:TVOV=E.V + EX. V ~1225 (F) = 375 (A) + 1600 (F)
FIXED OVERHEAD VARIANCES
Total Fixed
Overhead Variance
ExpenditureVolume
VarianceVariance
Efficiency
Variance
Capacity
Variance
Revised CapacityCalendar
VarianceVariance
Fixed Overhead
- Expenditure Variance:
This is the difference between the budgeted fixed overheads and the actual fixed overheads incurred during a particular period.This variance arises due to excessive or reduced spending as compared to what was laid out in the budget for the period.
Expenditure Variance = Actual cost – Budgeted cost
- Fixed Overhead:
Volume Variance
This variance measures under/over-recovery of overheads because output differs from budgeted output. This variance measures the over-recovery / under-recovery of fixed overheads due to deviation of:i.e. more output / less output than was anticipated.
Arises due to actual output level differing from the pre-determined output level, thus affecting overhead recovery as based on the Standard fixed Overhead rate.
Volume variance = Std. Fixed overheadRate (Actual output – Budgeted output)
= Standard cost – Budgeted cost
ANALYSIS OF VOLUME VARIANCE:
In order to show the cause of over – recovery and under – recovery of overheads, the volume variance has to be analyzed into its various components viz. efficiency, capacity and calendar variances.
(a)Efficiency Variance:
This variance shows over or under recovery of fixed overheads due toincreased or reduced labor efficiency.It is seen as the difference between the actual time worked and the standard time allowed for that level of output all at the total standard rate.
Efficiency variance = Standard overhead rate (Actual Hours – Standard Hours)
= Standard Overheads allowed – Budgeted Overheads
(b)Capacity Variance:
It is defined as thatpart or portion of volume variance which is due to working at a higher or lower capacity than budgeted and shows over or under recovery of fixed overheads due to over or under utilisation of plant and equipment capacity.
Capacity variance = Standard overhead rate (Budgeted Hours – Actual Hours)
(c)Calendar Variance:
This variance arises because the actual number of working days in the budget period differs from the budgeted number of working days in a normal month. It is therefore a ratio of the actual number of work days in a given period to normal budgeted number of days.
Calendar variance = Standard Daily rate (Actual Days – Budgeted days)
Standard daily rate = Budgeted Overheads Budgeted Days
If calendar variance exists, the capacity variance will be calculated by applying the following formula:
Capacity variance = Standard o rate (Revised budgeted output – Standard output)
Illustration
The budgeted output of a product is 500 000 units per annum. Fixed overheads for the same period are $225 000. Each year the factory closes for two weeks’ annual holidays. During the first week in January, the output was 10 250 units while the actual expenditure was $4 750. Standard performance is 250 units per hour on a 40 hour week basis this works to 50 budgeted weeks. One hour per week is normally lost due to abnormal idle time.
Calculate the various fixed overhead variances based on the units of output.
SOLUTION
Fixed Overhead Variances, Unit of Output basis
1.Cost Variance=Actual Cost – Standard Cost
=$ 4750 -4 612.50 = $137.50 (A)
SC=Actual output x Standard Fixed Overhead Rate
=10 250 x $.45 = $4 612.50
SR=Budgeted fixed overheads p.a. Budgeted output per annum
=$225 000 500 000 = $.45
2.Expenditure Variance =Budgeted cost – actual Cost