How Do Managers Evaluate Performance Using Cost Variance Analysis? Module
- Understand how flexible budgets are used to evaluate performance.
Question: The master budget in Chapter 9 "How Are Operating Budgets Created?" was prepared for only one level of activity (activity was measured by the number of units sold, which was budgeted at 200,000 units). Although this works well in the planning phase of budgeting, it is not appropriate for the control phase. Actual sales rarely match budgeted sales. When actual sales differ from budgeted sales, it is inappropriate and perhaps unfair to evaluate employee performance by comparing actual results to the master budget. If actual sales volume is higher than the master budget, variable costs should be higher than the master budget. The opposite is true as well. How do organizations modify the master budget to adjust for actual sales?
Answer: Organizations use a modified budget called a flexible budget. A flexible budgetA revised master budget based on the actual activity level. is simply a revised master budget based on the actual activity level. It represents what costs should be given a certain level of activity. The master budget at Jerry’s Ice Cream was based on sales of 200,000 units and production of 200,400 units. Because actual sales totaled 210,000 units, the flexible budget should be based on 210,000 units of activity. (It should be noted that in Chapter 9 "How Are Operating Budgets Created?", we presented an example with budgeted sales of 200,000 units and budgeted production of 200,400 units resulting from differing beginning and ending finished goods inventory amounts. In this chapter, we assume beginning and ending finished goods inventory are the same, and therefore units produced and sold will be the same. Thus we assume actual sales and actual production total 210,000 units.)
Question: Imagine being the production manager at Jerry’s Ice Cream, and you are evaluated based on the quantity of direct materials used in production. Would it be fair to compare the materials used to produce 210,000 units with the master budget showing the materials that should have been used to produce 200,400 units?
Answer: Probably not. The budget should be adjusted upward to reflect the actual number of units produced before a comparison is made, thus the term flexible budget. As we develop the process of cost variance analysis, we will use flexible budget information. That is, we will revise the master budget for direct materials, direct labor, and variable manufacturing overhead to reflect actual sales volume of 210,000 units. However, we must first describe the concept of standard cost.
- A flexible budget is a revised master budget that represents expected costs given actual sales. Costs in the flexible budget are compared to actual costs to evaluate performance.
Review Problem 10.1
What is a flexible budget, and why do companies use a flexible budget to evaluate production managers?
Solution to Review Problem 10.1
A flexible budget is a revised master budget based on the actual activity level achieved for a period. The master budget is established before the period begins for planning purposes, and the flexible budget is established after the period ends for control and evaluation purposes. Production managers are evaluated using the flexible budget because the usage of direct materials, direct labor, and manufacturing overhead will depend on the actual number of units produced.
- Chapter Introduction
- Flexible Budgets
- Standard Costs
- Direct Materials Variance Analysis
- Direct Labor Variance Analysis
- Variable Manufacturing Overhead Variance Analysis
- Determining Which Cost Variances to Investigate
- Using Variance Analysis with Activity-Based Costing
- Fixed Manufacturing Overhead Variance Analysis
- Appendix: Recording Standard Costs and Variances