The document discusses key concepts in variance analysis including static budgets, flexible budgets, favorable and unfavorable variances, and levels of variance analysis. It provides examples of variances including sales volume variance, price and efficiency variances for direct materials and labor, and production volume variance. Variance analysis is used for performance measurement and evaluation of manager effectiveness and efficiency.

1. University Of Central Punjab F14
Advance Cost & Management Accounting Page 1
Basic Concepts
Variance
Difference between an actual and an expected (budgeted) amount
Management by Exception
The practice of focusing attention on areas not operating as expected (budgeted)
Static budget
A budget prepared for only one level of activity.
It is based on the level of output planned at the start of the budget period.
The master budget is an example of a static budget.
Flexible budget
Revenues or costs considered justified by the actual output level of the budget period.
A key difference between a flexible budget and a static budget is the use of the actual output level in
the flexible budget.
In general, flexible budgets can also be conditioned on actual levels of other external influences
Serve to implement responsibility accounting.
Static-Budget Variance (Level 0)
The difference between the actual result and the corresponding static budget amount.
Flexible-Budget Variances (Level 1)
Static budget variance decomposed according to categories.
Favorable Variance (F)
Has the effect of increasing operating income relative to the budget amount.
Unfavorable Variance (U)
Has the effect of decreasing operating income relative to the budget amount
Variances
Variances may start out “at the top” with a Level 0 variance the difference between actual and static-
budget operating income.
Answers: “How much were we off?”
Levels 1, 2, and 3 examine the Level 0 variance into progressively more-detailed levels of analysis.
Answers: “Where and why were we off?”

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Advance Cost & Management Accounting Page 2
Simple Example
Flexible Budget
Shifts budgeted revenues and costs up and down based on actual operating results (activities).
Represents a blending of actual activities and budgeted dollar amounts.
Will allow for preparation of Levels 2 and 3 variances
Answers the question: “Why were we off?”
Sales-Volume Variance
Difference between the static budget for the number of units expected to be sold and the flexible
budget for the number of units that were actually sold.
The only difference between the static budget and the flexible budget is the output level upon which
the budget is based.
Level 2 analysis
Provides information on the two components of the static-budget variance.
Level 1
Analysis
900
Level 0
Analysis

3. University Of Central Punjab F14
Advance Cost & Management Accounting Page 3
Flexible-budget variance:
(Actual – budgeted contribution margin/unit)×actual sales mix × actual units sold
Sales-volume variance:
(Actual units sold × actual sales mix – budgeted units sold × budgeted sales mix) × budgeted
contribution margin/unit
A Flexible-Budget Example
Level 3 Variances
All Product Costs can have Level 3 Variances. Direct Materials and Direct Labor will be handled
next.
Both Direct Materials and Direct Labor have both Price and Efficiency Variances, and their formulae
are the same.
Price Variance = {Actual Price of Input - Budgeted Price of Input } × Actual Quantity
of Input
Efficiency Variance = {Actual Quantity of Input Used - Budgeted Quantity of Input Allowed
for Actual Output of Input} × Budgeted Price
Actual Data
Direct materials purchased and used = 42,500 square yards at $15.95
Cost of direct materials = $677,875
Labor hours: 21,500 at $12.90
Cost of direct manufacturing labor = $277,350

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Advance Cost & Management Accounting Page 4
Price variance for direct materials= ($15.95 – $16.25) × 42,500 = $12,750 F Œ
Price variance for direct manufacturing labor = ($12.90 – $13.00) × 21,500 = $2,150 F
Efficiency variance for direct materials = (42,500 – 40,000) × $16.25 = $40,625 U Œ
Efficiency variance for direct manufacturing labor = (21,500 – 20,000) × $13.00 = $19,500
Production Volume Variance
The production volume variance is associated with a standard costing system used by some
manufacturers.
Production Volume Variance =
Budgeted fixed overhead – Fixed overhead allocated for actual output units produced
To illustrate the production volume variance, let's assume that a manufacturer had budgeted $300,000
of fixed manufacturing overhead (supervisors' compensation, depreciation, etc.) for the upcoming
year. During that period it expected to have 30,000 machines hours of good output. Based on this
plan the manufacturer established a fixed manufacturing overhead rate of $10 per standard machine
hour. If the company actually produces 29,000 standard machine hours of good output, the products
will be assigned (or will have absorbed) $290,000 of the fixed manufacturing overhead.
Production Volume Variance = 300,000 – 290,000 = $10,000
This will cause an unfavorable production volume variance of $10,000
Managerial Uses of Variances
 To understand underlying causes of variances
 Recognition of inter-relatedness of variances
 Performance Measurement
 Managers ability to be Effective
 Managers ability to be Efficient
 Effectiveness is the degree to which a predetermined objective or target is met.
 Efficiency is the relative amount of inputs used to achieve a given level of output.
 Performance evaluation should not be based on Variances alone
 If any single performance measure, such as a labor efficiency variance, receives excessive
emphasis, managers tend to make decisions that maximize their own reported performance in
terms of that single performance measure “what you measure is what you get”.