Lecture 8: Budgetary Control and Variance Analysis

In the last module, we had learnt that managers quantify their plans in the form of
budgets. In this module, we will discuss how budgets can play a key role in management
control. At the beginning of the course, we discussed about the four types of managerial
activities planning, decision making, directing and control activities. In control
activities, managers essentially compare the actual results with a pre-established
benchmark and provide feedback to themselves and others in the organization. Budget
performances can conveniently be employed as the pre-established benchmark against
which the actual performance can be compared. Variance analysis can help managers to
gain insight into why the actual results differ from the planned performance.
In budgetary control, we focus on the difference between an actual result and a
budgeted amount. In this sense, the budgeted amount is a benchmark or a point of
reference from which comparisons can be made. Companies choose various types of
benchmarks. A benchmark can be a financial variable that is already reported in the
accounting system. For example, it could be the budgeted customer service cost for
AT&T. Companies can also use financial variables that are not reported in the accounting
system for benchmarking purposes. For example, it could be cost of production for a
competitor. Benchmarks can even be a non-financial variable such as the time to fill an
order from a key customer or percentage defective in the production process, etc. What
we are going to discuss now is the first one in the list, namely benchmarks based on
financial variables typically reported in the accounting system. Generally speaking there
are two types of benchmarks in budgetary control. The first one is an absolute
benchmark. This is based on one particular level of operations that was forecasted in the
master budget. Comparison of actual results with this absolute benchmark will give
feedback to managers regarding whether they were effective in achieving their budgeted
goals. Suppose the actual results were different from the budgeted benchmarks in the
sense the firm overachieved or under-achieved its goals. In such a case, comparison of
actual results cant tell anything about how efficient they were in their operations,
given that they did or did not achieve their goals. For this purpose, we need a relative
benchmark, relative to the actual level of activity. We will discuss how to construct these
two types of benchmarks. We have a special term for the difference or deviation of actual
results from the budgeted results. We call this as a variance.
Let us first understand a convention that we will use. There are two types of
variances favorable and unfavorable. A favorable variance is a variance that is
equivalent to increasing the operating income relative to the budgeted amount and is
denoted by the letter F. An unfavorable variance denoted by the letter U is a
variance that has the impact of decreasing the operating income relative to the budgeted
amount. Your textbook uses the convention of representing the favorable variances by
positive numbers and unfavorable variances by negative numbers. Therefore, when you
compute cost variances, subtract the actual cost from the budgeted cost so that a positive
number will correspond to favorable variance. For non cost items (i.e. for profit or
revenue items), subtract budgeted amount from the actual revenue or profit so that a
positive number will correspond to favorable variance.

A static budget is a budget that is based on one level of output. It is not adjusted
or altered after it is set, regardless of ensuing changes in actual output (i.e. actual revenue
or cost drivers). Master budget is an example of a static budget. Before we construct a
master budget, we need to establish standards. For example, the price at which we
budget to sell the goods is the standard price and the quantity of direct materials that we
expect to consume on a per unit of production is the materials quantity standards. Master
budget is constructed based on the specified standards and the assumed sales activity
level. The operating income budgeted in the master budget is like picking one point on
the profit line in CVP graph. The difference between the actual profit and the budgeted
profit in master budget is the total profit variance. The total profit variance can be broken
into a number of components. For example, we can compare the actual revenue and the
master budget revenue to get the sales variance; or compare the actual variable costs with
master budget variable costs to get the variable cost variances. In fact, we can compute a
variance for every line item in the budgeted income statement of the master budget. The
total profit variance is the sum of all such individual variances. These variances are not
informative about the efficiency of operations since they are not controlled for the size
of operations. For example, actual costs may differ from the budgeted costs if the firm
sells less than the budgeted sales units. Therefore, we cant decide, based on comparison
of master budget benchmarks and actual results, whether operations were efficient. We
need to compare the actual results to a benchmark that takes into account the deviation of
actual results from the budgeted results. Such benchmarks are obtained from the flexible
budget. A flexible budget is a budget that is adjusted in accordance with ensuing changes
in actual output. A flexible budget enables managers to compute a richer set of variances
than does a static budget.
This slide presents an overview of the variance analysis. The total profit variance
is decomposed into sales volume variance and flexible budget variances. Flexible budget
variance can be further decomposed into sales price variance, fixed cost variance and
variable cost variances. We will consider three categories of variable costs direct
material, direct labor and variable overhead. Each one of them will be decomposed into
quantity variance and price variance. Also, the sales volume variance can be decomposed
into sales mix variance and market size and share variances.
The need for flexible budget is illustrated in this diagram. A is the level of
operations specified in the master budget. However, the firm achieved a sales volume
corresponding to B. Notice that while the sales activity is higher than the budgeted sales
activity, the actual profit is less than the budgeted profit. Since the profit performance is
less than the expected profit performance, this is a case of unfavorable variance. PB- PA is
called the static budget variance or the total profit variance. This does not tell the whole
story. In some sense, the comparison of profits corresponding to points A and B (i.e. PA
and PB) is like comparing apples and oranges. Why?
Notice that given that the volume of sales activity was B, according to the CVP
graph, we should expect a profit of PC and not PB. So the flexible budget for profits,
given the actual sales performance is PC. The difference between PC and PA is called

flexible budget variance of profits. Unlike the static budget profit variance, the flexible
budget variance is a good measure of cost efficiency since we are comparing actual
profits with a benchmark that takes into account the change in sales volume activity. PBPC is called the flexible budget variance. PC (flexible budget profit) is the benchmark for
PB(actual profits) in this comparison. Unlike the benchmark of PA, the benchmark of PC,
controls for the level of revenues. PC-PA is called sales volume variance. In this
comparison, PA is the bench mark and PC is being compared with that. This gives the
impact of the deviation in sales volume from the budgeted sales volume on the profits.
Therefore, by construction, this is positive if the actual sales volume exceeded the
budgeted volume and negative otherwise. Notice that the sum of sales volume variance
and flexible budget variance = (PC-PA) + (PB- PC) = PB- PA = total profit variance.
Let us look at the concept in the form of a picture. Total profit variance is
decomposed into Sales volume variance and Flexible budget variance. The former is
computed as the difference between flexible budget profit and the master budget profit.
The latter is computed as the difference between the actual profit and the flexible budget
profit.
For the computation of sales volume variance, the master budget profit is the
benchmark and the flexible budget profit is being compared against it. This variance,
therefore, captures the effect of the actual sales volume deviating from the volume of
sales specified in the master budget. For the computation of flexible budget variance, the
actual profit is compared with the benchmark of flexible budget profit and this variance
captures how efficiently the inputs, such as material, labor and other production and nonproduction resources are used and/or procured in the organization. The sum of these two
variances, by definition, captures the combine effect of cost efficiency and the effect of
sales volume deviation on the profit which we call as the total profit variance.
Now, let us break down the flexible budget variance into different components.
The first component captures the effect of the actual price charged being different than
the standard price specified in the master budget. This is called sales price variance and
is equal to the sales quantity multiplied by the difference between actual price and the
standard price. The second component of flexible budget variance is fixed cost variance
and it equals the master budgeted fixed cost minus the actual fixed cost. This variance
captures how well the fixed costs are controlled in the organization. The last component
is variable cost variances and is typically broken into three components.
Each variable cost variance is decomposed into a quantity variance component
and a price variance component. In order to do this decomposition, we need to calculate
a budget for the actual quantity of that particular input that was consumed and estimate
its value based on the price standards for that input. This is called as if budget for that
particular input. The difference between the as if budget and the actual cost gives the
price variance. Price variance captures the efficiency of the procurement process for the
input concerned. Based on the actual output achieved and the quantity standards and
price standards, we can estimate the cost item in flexible budget. The difference between
the cost item in the flexible budget and the as if budget gives the quantity variance and

captures how efficiently the input is being used. The sum of these two variances gives
the flexible budget variance for the variable cost item.