CHAPTER 7FLEXIBLE BUDGETS, VARIANCES, AND MANAGEMENT CONTROL: I7-1Management by exception is the practice of concentrating on areas not operating as anticipated and giving less attention to areas operating as anticipated. Variance analysis helps managers identify areas not operating as anticipated. The larger the variance, the more likely an area is not operating as anticipated.7-2 Sources of information about budgeted amounts include (a) past amounts, and (b) detailed engineering studies.7-3 A favorable variance-denoted F- is a variance that increases operating income relative to the budgeted amount. An unfavorable variance-denoted U-is a variance that decreases operating income relative to the budgeted amount.7-4 The key difference is the output level used to set the budget. A static budget is based on the level of output planned at the start of the budget period. A flexible budget is developed using budgeted revenues or cost amounts based on the level of output actually achieved in the budget period. The actual level of output is not known until the end of the budget period.7-5A Level 2 flexible-budget analysis enables a manager to distinguish how much of the difference between an actual result and a budgeted amount is due to (a) differences between actual and budgeted output levels, and (b) differences between actual and budgeted selling prices, variable costs, and fixed costs.7-6The steps in developing a flexible budget are:Step 1: Determine budgeted selling price, budgeted variable costs per unit, and budgeted fixed costs.Step 2: Determine the actual quantity of output.Step 3: Determine the flexible budget for revenues based on budgeted selling price and actual quantity of output.Step 4: Determine the flexible budget for costs based on budgeted variable costs per output unit, actual quantity of output, and budgeted fixed costs.7-7 Four reasons for using standard costs are:(i)cost management,(ii)pricing decisions,(iii)budgetary planning and control, and(iv)financial statement preparation.7-8A manager should decompose the flexible-budget variance for direct materials into a price variance and an efficiency variance. The individual causes of these variances can then be investigated, recognizing possible interdependencies across these individual causes.7-9Possible causes of a favorable materials price variance are:purchasing officer negotiated more skillfully than was planned in the budget,purchasing manager bought in larger lot sizes than budgeted, thus obtaining quantity discounts,materials prices decreased unexpectedly due to, say, industry oversupply,budgeted purchase prices set without careful analysis of the market, andpurchasing manager received unfavorable terms on nonpurchase price factors (such as lower quality materials).7-10 Direct materials price variances are often computed at the time of purchase, while direct materials efficiency variances are often computed at the time of usage. Purchasing managers are typically responsible for price variances, while production managers are typically responsible for usage variances.7-11 Budgeted costs can be successively reduced over consecutive time periods to incorporate continuous improvement. The chapter uses the phrase continuous improvement budgeted costs to describe this approach.7-12 An individual business function, such as production, is interdependent with other business functions. Factors outside of production can explain why variances arise in the production area. For example:poor design of products or processes can lead to a sizable number of defects, andmarketing personnel making promises for delivery times that require a large number of rush orders can create production-scheduling difficulties.7-13 The plant supervisor likely has good grounds for complaint if the plant accountant puts excessive emphasis on using variances to pin blame. The key value of variances is to help understand why actual results differ from budgeted amounts and then to use that knowledge to promote learning and continuous improvement.7-14 Variances can be calculated at the activity level as well as at the company level. For example, a price variance and an efficiency variance can be computed for an activity area.7-15 Evidence on the costs of other companies is one input managers can use in setting the performance measure for next year. However, caution should be taken before choosing such an amount as next years performance measure. It is important to understand why cost differences across companies exist and whether these differences can be eliminated. It is also important to examine when planned changes (in, say, technology) next year make even the current low-cost producer not a demanding enough hurdle.7-16 (20-30 min.)Flexible budget.ActualResults(1)Flexible-Budget Variances(2) = (1) (3)