Budgets and Variance Analysis

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Budgets and Variance Analysis
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Advantages of Budgets

• Formalisation of planning
• forces management to think ahead
• requires to set objectives and to establish
  policies
• budgets are road maps
• Framework for judging performance
• budgets are a better basis for judging than past
  performance
• changes in economic conditions can be
  incorporated
• Communication and coordination
• budgets communicate what is expected and what is
  achievable
• top down and bottom up communication
• visualisation of interdependencies

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Types of Budgets

• Strategic plans
• most forward looking budget
• overall aims and objectives
• Long range plans
• financial statements for 5 to 10 years
• decisions on product lines, designs, locations
• Capital budgets
• detailed plan of expenditures
• applied to investments and long term commitments

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Master Budgets

• Summary of the planned activities of all subunits
• sales
• production
• Quantification of targets for sales, costs,
  activity levels, income and cash position
• Periodic business plan with detailed operating
  schedules and financial statements
• Time horizon
• fixed pre-defined period, e.g. fiscal
  year/planning period (pro forma statement)
• continuous rolling budgets over different time
  periods with same duration

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Components of a Master Budget

• Operating budget
• sales (and other cost-driver budgets)
• purchases
• COGS
• operating expenses
• budgeted income statement
• Financial budget
• capital
• cash
• balance sheet

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Preparing an Operating BudgetSales Budget

• Sales budgets are the starting point
• Sales levels determine other activities

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Preparing an Operating BudgetCash Collections

• Easiest to determine sales, cash sales and flows
  from previous sales
• Needed for cash budget

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Preparing an Operating BudgetPurchases Budget

• Purchases Desired End Inventory COGS
  Beginning Inventory
• COGS Sales Sales margin

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Preparing an Operating BudgetDisbursements for
Purchases

• Combines purchasing and payment pattern
• Needed for the cash budget

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Preparing an Operating BudgetOperating Expense
Budget

• High amount of fixed costs
• Details rent, wages,

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Preparing an Operating BudgetDisbursements for
Operating Expenses

• Combines use of resource with payment pattern
• Needed for the cash budget

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Preparing A Cash Budget

• Combination of cash receipts, disbursements for
  purchases, operating expenses and Capital
  expenses
• Determines whether funds are borrowed or paid off

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Example for A Cash Budget
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Preparing the Budgeted Income Statement

• Combines previously determined amounts
• Interest payment from cash budget if necessary

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Constructing the Balance Sheet

• Balance sheet results from all planning
  activities
• Check on adequate structures and returns

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Evaluation Using Master Budgets

• Master budgets are static budgets
• no updating
• static budgets and master budgets are synonyms
• Actual results can be used to compare with the
  budgets
• performance reports
• variances show deviations from results
• Master (Static) budget variances
• not very useful to measure whether costs were
  controlled
• unfavourable expense variance expenses above
  budget
• favourable expense variance expenses below
  budget
• no explanation why
• economic condition
• management (cost control) skills

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Flexible (Variable) Budgets

• Adjustments for changes in sales volume and cost
  driver activities
• Budgets prepared for the actual activity levels
  and planned prices
• Static budgets do not adjust for activity levels

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Flexible Budget Formulas

• Cost functions determine the flexible budget
  formula
• Fixed costs remain the same, variable costs are
  adjusted
• Cost drivers play an important role

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Exercise 8 - 25

• The superintendent of police of the city of
  Daytona is attempting to predict the costs of
  operating a fleet of police cars. Among the items
  of concern are fuel, .15 per mile, and
  depreciation, 5,500 per car per year.
• The manager is preparing a flexible budget for
  the coming year. What are the flexible budget
  amounts for fuel and depreciation for each car at
  a level of 30,000, 40,000 and 50,000 miles,
  respectively?

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Example for an Activity-Based Flexed Budget
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Example for an Activity-Based Flexed Budget
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Combining Budget Variances

• Master budget variance is a combination of
• activity level variance (explained by higher or
  lower than planned)
• flexible budget variance (not explained by
  activity variation)

Exhibit 8-5
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Exercise 8 - 38

• Suppose a chain of KFC franchises in Beijing had
  budgeted sales for 2005 of 7.3 million yuan
  (1,000 CNY 100 EUR). Cost of goods sold and
  other variable costs were expected to be 70 of
  sales. Budgeted annual fixed costs were 1.8
  million. A thriving Chinese economy caused actual
  2005 sales to sour to to 9.2 million yuan and
  actual profits to increase to 570,000 yuan. Fixed
  costs in 2005 were as budgeted.
• The franchise was pleased with this profit. Can
  variance analysis support this view?

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Setting Standards

• Standards determine the split between activity
  and flexible budget variances
• Types of flexible budget costs
• expected costs a level that is most likely to be
  attained
• standard costs a carefully established level
  that should be attained
• Standard levels
• perfection standard the level of highest
  efficiency possible (no waste, spoilage,
  breakdowns)
• currently attainable standards a level that can
  currently be achieved by realistic levels of
  effort

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What does Variance signal?

• Level of performance in one area typically links
  into the level in another
• Favourable and unfavourable are accounting
  (budgeting) terms and not an expression of
  managerial assessment
• Variances are attention directors, not problem
  solvers
• Causes for variance
• faulty expectations
• random fluctuations
• Investigate variances that exceed whichever is
  lower
• a certain dollar amount
• a certain percentage of expected cost
• goal cost of investigation smaller than gains
  from correction

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Computation of Flexible-Budget Variance

• Flexible budget is the amount that should have
  been spent
• if expectations on activity levels had been
  correct
• if expectations on usage had materialised
• if expectations of prices had been met
• Alternative term standard costs allowed
• Computation
• Flexible Budget or units of good output
  achieved
• Standard Costs x input allowed per unit of
  output
• allowed x standard unit price of input

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Direct Cost Variance
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Interpretation of Price and Usage Variance

• Favourable variance if actual price is less than
  standard or actual quantity is less than allowed
• When production does not equal sales the sales
  activity variance (master vs. flexible budget) is
  based on units sold.
• Flexible budget variances are based on units
  produced.

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Overhead Variances
Master Budget (Absorbed) Costs
Actual Spend
Spending Variance (Overspend)
Total Standard (Allowed) Cost
Activity Variance (Underproduction)
Fixed Cost
Planned Output
Actual Output