2 TECHNICAL
Budgets, standards and
simple variances
David Cornes is a Senior Lecturer at Bournemouth University
T
here is often understandable confu-
sion regarding the relationship be-
tween budgets and budgetary control
on the one hand and standards and standard
costing on the other. Furthermore, variances
seem to pop up indiscriminately — sometimes
when you least expect them!
A good starting point to resolve the confusion
is the CIMA Terminology of Management
Accounting which defines a budget as:
“A plan expressed in money. It is prepared and
approved prior to the budget period and may
show income, expenditure, and the capital to
be employed...”
The definition then goes on to outline how the
budget is prepared. Putting aside the question
of whether a budget is only concerned with
money, for example a production budget could
be more meaningful to production personnel
expressed in units rather than cost, the key
feature is that a budget is a future plan.
Budgetary control is defined thus in the Ter-
minology:
“The establishment of budgets relating the
responsibilities of executives to the require-
ments of a policy, and the continuous compari-
son of actual with budgeted results, either to
secure by individual action the objectives of
that policy or to provide a basis for its revi-
sion.”
This implies the use of the budgets to imple-
ment responsibility accounting, the Sales Man-
ager for example is responsible for the achieve-
ment of the sales that are budgeted to be made;
the comparison of actual sales achieved with
the budget indicating what action must be
taken to achieve the budget, or, if the budget
can no longer be achieved then the opportunity
arises to decide the best course of action in the
light of circumstances that were not envisaged
when the budget was prepared.
What about standards then? The Terminology
defines a standard as:
“A predetermined measurable quantity set in
defined conditions.”
Standard cost is defined as:
“A standard expressed in money. It is built up
from an assessment of the value of cost ele-
ments...”
The standard then goes on to define the uses of
standards in measuring performance and in
valuing stock and providing control informa-
tion. So is there a link here with budgetary
control? The Terminology definition of stand-
ard costing helps to clarify this:
“A control technique which compares stand-
ard costs and revenues with actual results to
obtain variances which are used to stimulate
improved performance.”
So, yes there is a link, both standard costing
and budgetary control are concerned with
comparing something with actual results
achieved in order to influence future perform-
ance. The easiest way to consider them is to
regard the techniques as very closely related
with substantial overlaps, however budgets
and budgetary control are concerned with the
comparison of the expected (budgeted) results
with the actual results of the company as a
whole at a particular (budgeted) level of activ-
ity, broken down to individual managers’ level
(i.e. departmental); and standards are prepared
at unit level i.e. individual products etc., aggre-
gated to individual managers or departments
as required. Of course, the standards are used
in the preparation of budgets; and, as will be
demonstrated shortly, the budgeted level of
production is used to determine the standard
fixed cost per unit. You can have budgetary
Figure 1— Standard cost specification
Direct material
160 x kg mat @ £/kg
Direct labour
25 hrs @ £/hr
Variable production overhead
25 hrs @ £/hr
Total standard variable cost
Fixed production overhead
Budgeted units/month 200
Total production standard cost
Standard gross profit
Standard selling price
control without standard costing, but standard
costing without the additional management
information provided by budgetary control is
unlikely.The factor which links the topics
irrevocably together is the fact that they are
both concerned with the calculation of
variances.
Variances
Returning to the CIMA Terminology let us see
what the definition is for a variance:
“Difference between planned, budgeted or
standard cost and actual cost; and similarly for
revenue.”
So, a variance is the difference between what
a cost (or revenue) ought to have been under
standard circumstances, and what it actually
was. If we are looking at the variance concern-
ing a single item, then this is a variance against
standard; and a variance for a department or
the company as a whole is a variance against
budget; but when we come down to the com-
putations the distinction becomes academic.
To illustrate the effect of standards and budg-
ets on the calculation of variances let us take a
straightforward example. We are examining
the performance of a company which has a
single product, the standard cost specification
for which is shown in Figure 1. The standard
cost specification for the variable cost ele-
ments (direct material, direct labour and vari-
able production overhead) are specified as the
Total Std £
£7.50 1,200
£6.00 150
£10.00 250
1,600
400
2,000
500
2,500

Figure 2 — Budget
Sales 200
Production 200 Units
Direct materials 200
Direct labour 200
Variable production overhead 200
Fixed production overhead 200
Gross profit
Figure 3 — Actuals
Sales were
Sales revenue
Production was
Direct materials purchased & issued
Direct labour worked
Variable production overhead
Fixed production overhead
Gross profit
Selling and administration
Net profit
standard quantity of the resource required (e.g.
160 kg of material) multiplied by the standard
cost per unit of that resource (i.e. £7.50 per kg).
The sum of the three variable cost elements is
the total standard variable cost.
Fixed production overhead is of course differ-
ent. Fixed overhead in total is regarded as
constant, it should not be altered by changes in
the level of production, at least not over the
normal range of activity. Therefore, as fixed
production overhead per unit is calculated by:
total fixed overhead –: number of units, it will
be a factor of the number of units chosen. In the
example in Figure 1 it can be seen that the
fixed overhead of £400 per unit has been based
on the budgeted production per month of 200
units, so the budgeted amount of fixed produc-
tion overhead per month must have been 200
x £400 = £80,000. Also included in the stand-
ard cost specification is the standard selling
price and therefore the standard gross profit
per unit that the company expects to achieve.
Given the budget of 200 units per month and
the standard cost specification per unit we can
calculate the budget per month. This is shown
in Figure 2. This tells us what the revenue and
costs per month should be. If we now look at
the actual results for a period in Figure 3 a
number of queries arise. First, the budget was
to sell 200 units and we actually produced and
sold 220. Secondly, we have the actual usage
of the direct material and labour in kilograms
and hours as well as the values and, thirdly,
there is another category of expense, selling
and administration, to be deducted from gross
profit to finally arrive at net profit. Taking the
last of these problems first, it is not unusual in
variance analysis questions to find we are
given the standard gross profit and the actual
net profit after charging non-production ex-
TECHNICAL 5
cost behaviour patterns, is designed to change
as volume of output changes.”
@ £2,500 £500,000 Well, the volume of output has changed, from
the budgeted 200 units to the actual 220.
@ £1,200 £240,000 What’s this about cost behaviour patterns?
@ £150 £30,000 The analysis of costs according to behaviour
@ £250 £50,000 gives us a distinction between variable and
@ £400 £80,000 fixed costs. As can be seen in Figure 4 in the
flexed budget the variable items, direct mate-
£100,000
rial, direct labour and variable production
overhead have changed from the original fixed
budget (Figure 2), whereas fixed overhead
remains unaltered from the original budget
220 units @ £2,450 per unit because fixed costs by definition should not
£539,000 change. That is, the budget has been flexed to
220 units the actual level of 220 units, evaluated at the
35,000 kgs £266,700 standard per-unit costs and selling price. You
6,000 hours £33,000 should notice in this example that the produc-
£53,000 tion and sales units are the same so there are no
£79,300 complications due to stock increases or de-
creases, in other words the cost of production
£107,000
and cost of sales are identical.
£32,000
£75,000 Comparing the flexed budget with the actual
performance results in the variances. When
we consider these differences there is not only
penses like selling and administration. Unless
the amount of the variance to be established
the question asks you to reconcile budgeted
but also the sign of the variances. Variances
gross profit with actual net profit you can
can be either favourable or adverse according
ignore this, if you are asked for such a recon-
to their effect on profit. Take sales, with a
ciliation then the actual non-production cost
flexed budget of £550,000 compared with an
given is the final item on your reconciliation.
actual of £539,000, there is a difference of
The second query, the fact that we are given
£11,000 less, so had the budgeted sales been
the actual quantities of the resources used is in
achieved the profit would have been £11,000
fact required information when we come to
more, the variance is obviously adverse;
sub-divide the variances but can be ignored for
whereas direct materials have cost £2,700
the moment. The principal problem is that the
more than budget, the effect on profit is again
number of units produced and sold is different
adverse. Note also the convention that has
from the budget. This means that we cannot
been adopted in this example to express whether
directly compare the budget figures in Figure
the variances are favourable or adverse. This is
2 with the actual results in Figure 3. If we do
stated at the head of the variances column and
and, say, tell the Production Manager that he
tells us that the variances are in £ with favour-
has overspent by (£266,700 – £240,000)
able variances in plain figures and adverse
£26,700 on direct materials, his answer will be
variances within brackets. There are other
along the lines of “Well of course I have, I
conventions, for example the letters (F), (U) or
made twenty extra units”, but probably not
(A) standing for favourable, unfavourable or
expressed so politely! What we have to estab-
adverse; or favourable variances may be pre-
lish first is what the results should have been
sented in one column and unfavourable ones
given that 220 units were produced and sold.
in another. It does not matter what convention
So, for our last dip into the CIMA Terminol-
you adopt so long as you state what convention
ogy, let us see what the definition is for a
you are using, and stick to it! If you are
flexible budget:
presented with a question containing variances
“A budget which, by recognising different with some in brackets and some without where
Figure 4 — Flexible budget
Flexed Actual Variances
budget £Fav/(Adv)
Sales 220 @ £2,500 £550,000 £539,000 (11,000)
Production 220 Units
Direct materials 220 @ £1,200 £264,000 £266,700 (2,700)
Direct labour 220 @ £150 £33,000 £33,000 0
Variable production overhead 220 @ £250 £55,000 £53,000 2,000
Fixed production overhead £80,000 £79,300 700
Gross profit £118,000 £107,000 (11,000)
4 TECHNICAL
the convention is not stated do not assume that
the bracketed figures are necessarily adverse,
in at least one question under the old 2.4
syllabus the reverse was the case.
What do these variances tell us? Well we can
see that on the actual sales of 220 units the
profit should have been £118,000 and it was
only £107,000, a total adverse variance of
£11,000. Of this total, £11,000 adverse is the
responsibility of sales and a net nil variance
arose in production. This does not mean that
the cost of production corresponded in detail
to the budget, but that there are compensating
variances with £2,700 adverse due in some
way to differences on direct materials, £2,000
being gained on variable production overhead
and £700 underspend on fixed production
overhead. However although this analysis tells
us where the variances have arisen it gives
little help in establishing why. The purpose of
variance analysis is to give more information
to managers to enable them to understand and
control their operations. To find out more we
will have to analyse the variances further.
Variance analysis
For the moment I am going to consider only
the cost variances arising in the variable cost
elements; that is direct material, direct labour
and variable production overhead. There are
several methods of performing the variance
calculations. They fall into two groups involv-
ing either the memorising of formulae as ad-
vocated in Drury and also in the Students’
Newsletter articles by Duncan Williamson
and Mark Lee Inman, or the logical examina-
tion of what each variance is trying to measure
by comparing what it should cost to what it did
cost in the context of the factor in question. It
is the latter method that I will attempt to
describe.
If you examine the direct material variances in
Figure 5 you will note that the total direct
material variance is of course the direct mate-
rial variance that we obtained by comparing
the flexible budget with the actual results in
Figure 4. It is obtained by asking the same
Figure 5 —Total direct material variance
Total direct material variance
Production should cost 220 @ £1,200
Production did cost
Direct material price variance
Material should cost 35,000 @ £7.50 £262,500
Material did cost £266,700
Direct material usage variance
Production should use 220 @ 160
Production did use
Material variance in units
Total direct material variance
question, what should it have cost in direct
material to produce the 220 units that were
produced, and what did it cost? Each unit
should have cost the standard direct material
cost of £1,200, so 220 units should have cost
£264,000, they did cost £266,700 so they cost
£2,700 too much — the variance is adverse.
Unless specifically asked for in the question it
is not necessary to calculate the total variance,
simply to go straight to the sub-variances.
However until you feel competent with vari-
ance calculations I suggest that you do calcu-
late the total variance first, it gives you the total
that the sub-variances should sum to and thus
gives you a check on your calculations.
So what are these sub-variances? We know
that direct material has cost £2,700 more than
it should but we do not yet know the reasons
why this is so. There are two possible causes:
either the material we used cost too much per
kilogram — a price variance; or too much
material was used — a usage variance. Or, of
course, some combination of both price and
usage variances. For reasons I shall return to
later always calculate the price variance first!
The price variance calculates the effect of any
difference from the standard price per unit on
all the material actually used. In the example
in Figure 5 35,000 kg were used so we com-
pare how much 35,000 kg should have cost at
the standard price of £7.50 per kg, with how
much 35,000 kg did cost. If instead we are
given the actual price paid per kg (in this
example it is £7.62) we can find the difference
in price per kg and multiply by 35,000 kg to
obtain the price variance (35,000 x £0.12 =
£4,200). As the actual amount paid is more
than the standard amount the variance is obvi-
ously adverse.
Having calculated the price variance on the
actual quantity used, the usage variance now
addresses the question of whether 35,000 kg
should have been used. Remembering that we
are using flexible budgeting the question to
ask is how much material should 220 units use
if each one is allowed 160 kgs. The answer of
35,200 kg compared with the actual usage of
Variances
£Fav/(Adv)
£264,000
£266,700 (£2,700)
(£4,200)
35,200 kg
35,000 kg
200 kg @ £7.50 £1,500
(£2,700)
35,000 kg means that 200 kg have been saved.
This gives a favourable usage variance of 200
kg, and it is a common mistake in variance
questions for students to stop right there and
say the usage variance is 200 favourable. It is
not however the answer. We need to calculate
the usage variance as a monetary value. 200 kg
saved at the standard price of £7.50 gives a
favourable usage variance of £1,500.
The adverse price variance of £4,200 com-
bined with the favourable usage variance of
£1,500 agrees with the total direct material
variance of £2,700 adverse that we calculated
to begin with.
You may be feeling slightly uneasy about one
thing, we have evaluated the 200 kg favour-
able usage variance at the standard price of
£7.50 when we know that we actually paid
£7.62. Has not the saving really been £1,524?
For the moment the answer has to be that as we
have evaluated the price variance on all the
material that was actually used then arithmeti-
cally the usage variance must be evaluated at
the standard price. This is why I suggested that
the price variance should always be calculated
first, there is no arithmetical reason for doing
so but, having extracted the price variance on
all the material actually used, it feels more
‘comfortable’ to evaluate the usage variance at
standard price. Variance calculations are al-
ways performed this way ‘by convention’.
Turning now to the other ‘variable cost ele-
ments’ of direct labour and variable produc-
tion overhead the pattern of variances is iden-
tical to those for direct material that we have
already examined. Only the names of the
variances are different as shown in Figure 6.
The total variance can still be analysed into
two elements, that part of the total variance
caused by the price of the resource being
different from standard, called now either a
rate or expenditure variance; and that part of
the total variance caused by the quantity of the
resource differing from the standard allow-
ance, called now an efficiency variance.
Taking the total direct labour variance first, the
question is basically the same as for the total
material variance, given that production was
220 units, how much should the direct labour
cost be at the standard of £150 per unit? This
is identical to the actual direct labour cost so
the total direct labour variance is nil. However
this does not mean that we do not have to
calculate the sub-variances. As can be seen
there are compensating variances for direct
labour rate and direct labour efficiency. The
calculations for these variances are identical in
concept to those for direct material, again
calculate the rate variance first. The rate vari-
ance evaluates the difference between the stand-
ard cost of the actual hours worked and the
actual cost, the efficiency variance evaluates
the difference between the hours allowed for
220 units and the actual hours taken. Note
 TECHNICAL 5

again that the rate variance can be calculated References ‘Management Accounting; Official Termi-
by multiplying the difference between the ‘Beyond traditional variance analysis’, Mark nology’, Chartered Institute of Management
£5.50 per hour actually paid and the standard Lee Inman, ACCA Students’ Newsletter, Au- Accountants: 1991.
of £6.00 per hour by the actual hours worked, gust 1993. ‘Standard costing made simple’, Duncan
and, like the usage variance, the efficiency
Costing: an introduction —3rd Edition, Colin Williamson, ACCA Students’ Newsletter,
variance is calculated first in units (hours in
Drury, Chapman and Hall, 1994. January 1990.
this case) and then evaluated at standard rate
per hour.
To calculate the variable production overhead Figure 6 —Total direct labour variance
variances the assumption is made that the
overhead is actually incurred in proportion to Total direct labour variance Variances
the direct labour hours worked. Thus the ex- £Fav/(Adv)
penditure variance ‘should cost’ value is cal- Production should cost 220 @ £150.00 £33,000
culated on the actual 6,000 direct labour hours Production did cost £33,000 £0
worked, and we do not need to recalculate the
Direct labour rate variance
efficiency variance in hours because this is the
Actual hrs should cost 6,000 @ £6.00 £36,000
same as the direct labour efficiency variance
Actual hrs did cost £33,000 £3,000
of 500 hours adverse but evaluated now at
£10.00 per hour. Direct labour efficiency variance
Production should take 220 @ 25 5,500 hrs
The fact that the same variance in hours ap- Production did take 6,000 hrs
plies both to the direct labour and variable
Variance in hours (500) hrs@ £6.00 (£3,000)
overhead variances emphasises the inter-rela-
tionship between variances. Suppose that the Total direct labour variance £0
direct labour variances show the effect of a Total variable overhead variance
deliberate decision by management to employ Production should cost 220 @ £250.00 £55,000
a lower grade of labour at £5.50 per hour Production did cost £53,000 £2,000
instead of the standard £6.00 per hour and as a
result the labour force took 500 extra hours to Variable overhead expenditure variance
complete the work. You might at first suppose Actual hrs should cost 6,000 @ £10.00 £60,000
that the decision had broken even as the fa- Actual hrs did cost £53,000 £7,000
vourable rate variance is exactly compensated Variable overhead efficiency variance
by the adverse efficiency variance. This is not Variance in hours (500) hrs @ £10.00 (£5,000)
the case as the extra 500 hours have also Total variable overhead variance £2,000
incurred an extra £5,000 of variable overhead
that would not otherwise have been incurred.
If asked to suggest causes for variances always
look for inter-relationships between them, for
example a cheap material purchased may give Figure 7 — Variable cost variances
a favourable price variance but cause not only Standard Actual
an adverse material usage variance but also
adverse labour efficiency and variable over- Price,or
head efficiency variances. Price £5 per kg rate or £6 per kg
The relationships between the sub-variances expenditure
for the variable cost elements of direct mate- Usage, or variance
rial, direct labour and variable overhead are efficiency
illustrated in Figure 7. Total cost is a factor of variance
both price and quantity; standard price and
quantity for total standard cost, and actual Qty 10 kg per unit 11 kg per unit
price and quantity for total actual cost. The Total Total
total variance is the difference between total std actual
actual cost and total standard cost. The price cost cost
(or rate, or expenditure) variance is the effect < Total variance >
of the difference between standard and actual Variable cost variances
price per unit on all the units actually used. The (Direct material, direct labour, variable production overhead)
usage (or efficiency) variance is the effect of
the difference between total actual usage and N.B. Budget is ‘flexed’ so unit quantity and price are multiplied by actual
total standard allowance evaluated at stand- quantity produced = 100 units
ard price. 100 units should use 100 x 10 kg = 1,000 kg each costing £5 per kg = £5,000
100 units did use 100 x 11 kg = 1,100 kg each costing £6 per kg = £6,600
A future article will discuss fixed overhead
variances, revenue (sales) variances and the Total direct material variance £(1,600)
further analysis of variances together with Price variance 1,100 kg x (£5 per kg – £6 per kg) £(1,100)
some more theoretical aspects concerning joint Usage variance 100 units x (10 kg –11 kg) = 100 kg at £5 per kg £(500)
variances and the timing of the extraction of £(1,600)
the material price variance.