Flexible Budgets and Standard Costing

Budgetary Control and Responsibility Accounting

In Lesson 22, we saw how a master budget can be used for planning purposes. This lesson provides another aspect of the budgeting process—that of budgetary control. You set your budget for next year, and then next year comes along and you hope your actual costs are consistent with your budget plan. The basic idea is that after a budget is developed, a company must compare its actual operating results with the budget on a continuous basis. Any material deviations between actual and budgeted amounts should be investigated, in order for the company to accomplish its goals. Over a long period, the practice of managing a budget should result in better predictions, and a habit of staying within the budget.

Implicit in this process of planning and control, the company must keep two issues in mind: effectiveness, (accomplishing the company's goals), and efficiency (using minimum resources). By comparing budgeted and actual revenues and costs, a company can modify its plans and strategies in advance of its next budget-setting period.

Management by Exception

A key question you should be asking is: "what action should management take if favorable or unfavorable variances are found?" The variances (deviations from what was predicted) provide evidence that our prediction did not come true. The seriousness of the investigation of a variance will depend upon whether the variance was material (significant) and whether the item is controllable. By analyzing deviations between budgeted and actual costs, management can become aware of situations that may jeopardize its plans. This management technique is called management by exception. Implicit in this technique is the idea that, if our performance is at standard (no variances), then no attention is necessary. If exceptions occur (measured by favorable or unfavorable variances), then management's attention or intervention is required.

Performance Evaluation Through Standard Costing

Lesson 23 presents a methodology used for evaluating how well resources are used in a manufacturing company. The starting point in this process is to set standards for various manufacturing costs. As soon as actual results are obtained, they are compared with the standards in order to measure variances. As you might expect, the variances may be favorable or unfavorable. Either type of variance may be investigated, if significant, to determine its cause. Additionally, managers within an organization may be held accountable for explaining why a cost was above or below the standard.

A standard costing system may provide many advantages. A major element in standard costing is to increase the efficiency of the manufacturing company, by focusing upon how much each resource should cost. The resources under scrutiny are direct materials, direct labor, and manufacturing overhead. Variances are calculated for each of these resources, based upon how much each one costs per unit (a price standard), and how much of each resource was used (a quantity standard).

But how are standards set? A systematic study of production costs could be undertaken by examining job cost sheets or departmental reports; the production processes themselves could be observed; various cost components could be analyzed to determine cost formulas. In practice, a combination of activities would be initiated to arrive at a rigorous, but attainable standard.

Variance Calculations--Price and Efficiency

The chapter explores standard costing using a comprehensive case study. You should begin your work by becoming familiar with the textbook example. 

Our overall goal is to determined if Western Rider stayed within budget regarding three items: direct materials, direct labor, and manufacturing overhead. Moreover, we would like to pinpoint why our budget predictions didn't come true, and determine which of the company's departments is responsible. Our analysis involves the calculation of six variances--two variances for direct material, two for direct labor, and two for manufacturing overhead.

For direct material and direct labor, we will calculate a price variance and a quantity variance. A price variance occurs when the price of direct material or direct labor is not what we expected. For example, if direct material is budgeted to cost $5.00 per pound, but actually costs $6 per pound, we would experience an unfavorable price variance of $1 per pound. The purchasing department would be asked why this variance happened. Perhaps our regular supplier was short on the type of material we usually purchase; perhaps raw materials prices have increased; perhaps the shipping cost of materials is more costly.

A quantity variance occurs when we use more of a resource than we planned to use. For example, if our product requires one pound of material per unit, but we actually consume 1.25 pounds for each unit produced, we will have an unfavorable direct material efficiency variance. The production department would be asked why this variance occurred. Perhaps the raw materials were of poor quality or our machines are out of adjustment.

Analogously, for direct labor we calculate a rate variance and a time variance. The rate variance is similar to the price variance for materials; the rate variance is the cost per hour of labor. The time variance is similar to the quantity variance for direct material; the labor time used is the quantity of labor we use.

The Chapter Problem

Your text demonstrates the calculation of all variances. We start with the standard costs and standard quantities required to produce one pair of jeans:

Costs Standard Price Standard Qty Per Pair Standard Cost Per Pair
Direct Materials $5.00 per sq. yd. 1.5 sq. yd. $7.50
Direct Labor $9.00 per hour .8 hour $7.20
Factory Overhead $6.00 per hour .8 hour $4.80
Standard Cost Per Pair     $19.50 per pair

The actual costs experienced to produce 5,000 pairs of jeans were as follows:

Costs Price Actual Quantity Used Total Actual Costs
Direct Materials $5.50 per sq. yd. 7,300 sq. yd. $40,150
Direct Labor $10.00 per hour 3,850 hours $38,500
Variable Overhead $10,400   $10,400
Fixed Overhead $12,000   $12,000
Total Costs     $101,050

Using the above table, we calculate two variances for direct materials.

Direct Materials Variances

Actual Q* Actual P


Actual Q * Std. P.


Std. Q*Std. Price





















$3650 U


$1,000 F

DM Variance  
2,650 U

The Direct Materials Price Variance (DMPV): Look at the leftmost column of the table. We multiply the actual cost per unit times the number of material units. So, 7,300 yards of material times $5.50 means that we purchased $40,150 of material. In the middle column, we use the same 7,300 yards times the standard price of $5.00 per yard. Did we pay more than standard or less than standard in this case? We spend .50 per yard too much, leading to an unfavorable variance (Direct Materials Price Variance or DMPV) of $3,650.

The Direct Materials Quantity Variance (DMQV): Now we compare the middle column with the right hand column. Did we use an appropriate amount of material? Compare Actual Quantity used (7,300 yards) with the amount we should have used. Note that if we produced 5,000 pairs of jeans, and the standard says that we should use 1.5 yards of materials at a standard cost of $5.00 per yard, the amount that 5,000 pairs of jeans should have cost is 5,000*1.5*$5.00=$37,500. Comparing $37,500 with the actual cost of $36,500 suggests that material usage was under standard; in other words, a $1,000 favorable variance.

Note that the two variances can be combined into a Direct Material Variance: $3650 U + $1,000 F equals 2650 U.

Direct Labor Variances

Actual Hrs* Actual Rate


Actual Hrs *Std Rate


Std Hrs*Std Rate






3850 * $10











 $3850 U

$1350 F 


DL Variance  
$2,500 U

Using the standards table and the actual costs table, we can determine the direct labor variances.

Direct Labor Rate Variance (DLRV): For the DLRV use the left column and the middle column. We used 3,850 hours of labor at a rate of $10 per hour. The standard is $9.00 per hour. Therefore, for each hour we used, we spent $1.00 too much. Therefore, the DLRV is $3,850 unfavorable.

Direct Labor Time Variance (TLTV): Now we compare the middle and right columns. The actual hours times standard rate is 3850*$9= $34,650. But how many hours should we have used to produce 5,000 pairs of jeans? At .8 hours per pair, it would be 5,000*.8*$9.00=$36,000. It actually is the case that we used 3850 hours, but the standard is 4,000 hours, so we had a favorable variance of $1,350.

Direct Labor Cost Variance would be the difference between $3850 U and $1,350 F, or $2,500 U.

Factory Overhead

At the beginning of the period, the company must determine how to allocate factory overhead. It turns out that overhead can be either variable or fixed. If the company budgets overhead for the most likely scenario--100% of capacity, the budget says that variable overhead should be $18,000 and fixed overhead should be $12,000. These figures are summarized in the Factory Overhead Flexible Budget. At 100% of capacity, the company expects to produce 6,250 pairs of jeans. At .8 hours per pair, this would say that the capacity would be .8*6250=5,000 direct labor hours.

We break down the factory overhead of $30,000 into two rates--one for variable overhead and one for fixed overhead:

  Budgeted Cost Budgeted DLH Rate
Variable Overhead $18,000 5,000 DLH $3.60/DLH
Fixed Overhead $12,000 5,000 DLH $2.40/DLH
Factory Overhead Rate     $6.00/DLH

The actual overhead costs were $10,400 for variable overhead and $12,000 for fixed overhead.

Variable Factory Overhead Controllable Variance is equal to:

Actual Variable Overhead - (Standard Hours for Actual Units Produced) * Variable Overhead Rate

=$10,400 minus (5,000 pairs * .8 hour per pair) * $3.60 = $10,400 minus $14,400 = $4,000 F

Fixed Overhead Volume Variance is equal to :

(Standard Hours for 100% capacity - Standard Hours for Units Produced) * Fixed Overhead Rate =

(5,000 hours - 5,000 pairs * .8 hours) times $2.40 = 1,000*$2.40=$2400 U

The Total Overhead Variance is the sum of $4,000 F and $2,400 U = $1600 F

The Manufacturing Overhead Account

One other detail. Think back to an earlier chapter in which we calculated the over- or underapplied factory overhead. In this exercise, we could diagram the actual and applied overhead as follows:

Factory Overhead
Actual Applied
$22,400 4,000hrs * $6.00 = $24,000
  Balance = $1,600 overapplied

Note that the Total Overhead Variance computed as $1,600 Favorable, reconciles with the $1,600 of overapplied factory overhead.

The Standard Costing System

When a standard costing system is implemented, the journal entries are handled in a slightly different way than you learned earlier. Variances, when they occur, are placed in separate accounts, so that they will become visible to management. The movement of inventory cost from Work in Process to Finished Goods to Cost of Goods Sold, however, is at standard cost. The point of recording journal entries at standard is that it causes management to focus on the problem areas--that will be highlighted by the variance entries.

In the final section of Chapter 22, the journal entries for a standard costing system are illustrated, using the information from the variance analysis. The strategy is to record direct materials, work in process, finished goods, and cost of goods sold at standard cost. The variances will be placed in separate accounts, causing them to catch the attention of management.

Let us examine a few entries to get the idea. First, look at the Direct Materials variances shown earlier. The purchase of raw materials would be recorded as follows:


Raw Materials Inventory (7300*$5.00)



....Direct Materials Price Variance




....Accounts Payable





To record the purchase of raw materials at standard cost,


with the unfavorable price variance of $3,650.


Note that the Raw Materials is debited for what it should have cost (not the actual cost), and the difference is debited to a DMPV account. A debit balance always denotes an unfavorable variance.

When the raw materials are requisitioned to work in process, the following entry is made:


Work in Process (7500 yd *$5.00)



....Direct Materials Quantity Variance




....Raw Materials Inventory (7300 yd $5.00)





To record the usage of raw materials at standard cost,


with a favorable efficiency variance of $1,000.


This second entry is also from the direct material variance analysis, and represents the usage of the direct materials. Because the efficiency variance is favorable, the DMQV shows up as a credit balance, indicating that it is we used less material than standard.

The direct labor variances are entered into the accounts in similar fashion.

The actual MO is recorded at actual cost. However, applying the MO is at standard cost, based on direct labor hours used, at the rate of $6.00 per DLH.

Your textbook presents an income statement containing all variances. Note that the unfavorable variances are treated as if they are extra costs, reducing gross profit. The favorable variances, conversely, increase gross profit. This type of income statement would never be published for outside parties—it is strictly for internal management purposes.