Accounting: The Language of Business - Vol. 1 (Part 135)

Life is expensive when you do not know accounting.

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Performance Evaluation Using Variances from Standard Costs (Part B)

by

Charles Lamson

Budgetary Performance Evaluation

As we discussed in part 131, the master budget assists a company in planning, directing, and controlling performance. In the next several posts, we will discuss using the master budget for control purposes. The control function, or budgetary performance evaluation, compares the actual performance against the budget.

We illustrate budget performance evaluation using Western Rider Inc., a manufacturer of blue jeans. Western Rider Inc. uses standard manufacturing costs in its budgets. The standards for direct materials [Direct material is the physical items built into a product. For example, the direct materials for a baker include flour, eggs, yeast, sugar, oil, and water. The direct materials concept is used in cost accounting, where this cost is separately classified in several types of financial analysis (accountingtools.com).]direct labor (labor involved in production rather than administration, maintenance, and other support services), and factory overhead (costs incurred during the manufacturing process, not including the costs of direct labor and direct materials) are separated into two components: (1) a price standard and (2) a quantity standard. Multiplying these two elements together is the standard cost per unit for a given manufacturing cost category, as shown for style XL jeans in Exhibit 1.

The standard price and quantity are separated because the means of controlling them are normally different. For example, the direct materials price per square yard is controlled by the Purchasing Department, and the direct materials quantity per pair is controlled by the Production Department.

The budgeted costs at planned volumes are included in the master budget at the beginning of the period. The standard amount budgeted for materials purchases, direct labor, and factory overhead are determined by multiplying the standard costs per unit by the planned level of production. At the end of the month, the standard costs per unit are multiplied by the actual production and compared to the actual costs. To illustrate, assume that Western Rider produced and sold 5,000 pairs of XL jeans. It incurred direct materials cost of $40,150, direct labor costs of $38,500, and factory overhead costs of $22,400. The budget performance report shown in Exhibit 2 summarizes the actual costs, the standard amounts for the actual level of production achieved, and the differences between the two amounts. These differences are called cost variances. A favorable cost variance occurs when the actual cost is less than the standard cost (at actual volumes). An unfavorable variance occurs when the actual cost exceeds the standard cost (at actual volumes).

EXHIBIT 2 Budget Performance Report

Based on the information in the budget performance report, management can investigate major differences and take corrective action. In Exhibit 2, for example, the direct materials cost variance is an unfavorable $2,650. There are two possible explanations for this variance: (1) the amount of blue denim used per pair of blue jeans was different than expected, and/or (2) the purchase price of blue denim was different than expected. In the next several posts, we will illustrate how to separate the price and quantity variances for direct materials, the rate and time variations for direct labor, and the controllable and volume variances for factory overhead.

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 919-921*

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