BUDGETING AND BUDGETARY

CONTROL
Learning objectives:
After this lesson, students should be able to understand and explain:
1. What is a budget and budgetary control
2. The types of budgets
3. The purposes of budgets
4. How to prepare all types of budgets
5. Behavioural aspect of budgeting and
6. Advantages and disadvantages of budgeting.

Let’s begin with some basic definitions:

a. A budget: may be fined as “a plan quantified in monetary terms prepared and

approved to a defined period of time; usually showing planned income to be
generated and/or expenditure to be incurred during that period and the capital to
be employed to attain a given objective”.

b. Basic budget: According to CIMA, it may be defined as “a budget based on a long-

term plan and used as a basis for developing current budget. A basic budget is
usually much broader in scope and less detailed than a current budget”.

c. Current budget: I s defined as “a budget which is established for use over a short
period of time usually one year but sometimes less, and related to current
conditions likely to prevail during the budget period”- CIMA

d. Fixed budget: This is a traditional type of budget. It is a budget designed to remain

unchanged irrespective of the actual activity. It is simply to prepare but if there is
deviation from the target, the information on the budget becomes meaningless.

e. Flexible budget: Is a budget which take into account the difference between fixed
and variable cost and is designed to change with the level of activity actually
attained.
f. Budgeting: It is the process of preparing budgets. Thus, it is the ways and means of
preparing budget which applies to all aspects of business operation.
PURPOSES OF BUDGETING
This is a very important aspect of our entire studies in this topic. This is because, whatever we
want to achieve and whichever type of budget we would want to prepare, we must return to
the purpose and make our choice. Budgeting is all about PCCCMA: I guess you are asking
“……..what is the meaning of that……………?
Let’s look at it in details.
1. PLANNING: This involves making choices between alternatives and is primarily a
decision making activity. A plan is a course of action to undertake a certain activity. The
plan sets the target for the organization and without a plan; an organization will fail
because it wouldn’t know where it is going. It means that, budgeting helps management
to plan into the future as to what they want to achieve as a corporate entity.

2. CONTROLLING: Since every organization has a plan, this plan facilitates the duty of
controlling all activities to align with the PLAN. Plans set the targets. But control involves
two things: (i) Measurement of actual results against plan and (ii) Take actions to adjust
actual performance to achieve the plan or to change the plan altogether. Control is
therefore impossible without planning.

3. COMMUNICATION: Budgeting serves as the channel to communicate the plan of the

entire organization among the departmental heads and their subordinates. It allows the
senior managers to communicate with the junior managers and visa visa.

4. CO-ORDINATION: Budgeting helps the organization to bring together all parts or

department of the organization to work towards the same goal. That is to say, the
quantity of goods that is likely to be sold by the sales and marketing department will
inform the production how many quantity of output to produce and how many
resources it will need which intend to inform the purchasing department about how
many raw materials they should buy and the human resource department how many
labour hours will be required. This ensures that all activities are synchronized in a
manner against the objective of the entire organization.

5. EVALUATION: To enable an organization to check on management concerning how

good or badly they are carrying out their duties, budgeting can serve as an evaluation
tool against which management performance is measured.
 6. MOTIVATION: This is what makes people to behave in the way they do. Since budgeting
can be used as the benchmark for evaluating management performance, both junior
and senior managers are motivate to perform their duties diligently to achieve the
budget.

7. AUTHORISATION TOOL: The budget tells people what to do in a given situation. That’s
the budget authorizes them what they can and cannot do. Without the sales budget, the
production manager may decide to produce any quantity of goods that he feels to
produce and this will course the purchasing and human resources department to
purchase and employ labour respectively which may or may not be needed by the
entity. The budget therefore officially authorizes managers to act within a given scope
of business operation.

BUDGETING PROCESS- GENERAL

One thing you must understand is that, budgeting is a human process or exercise and
hence must be considered with utmost care as possible. The process of budgeting can
be in various ways depending on the entity but the process below is the generalized
steps that an entity can follow to prepare budgets:

1. BUDGET COMMITTEE MEETS: “The budget committee constitutes high-level

management who represent the major departments of the organization. Its major
responsibility is to ensure that budgets are realistically established and that they are
coordinated satisfactorily”. The purpose of the committee is to understand the overall
aim of where the organization wants to be. They answer the question “WHERE DO WE
WANT TO BE?” and the strategic plan is drawn. There are three key activities they
undertake:
i. Budget Aims: this is where they look at issues like market shares, units to be
sold, either to introduce a new product or rebrand an existing product. However,
the critical aim is the PROFIT.
ii. Underlying assumptions: Every manager will prepare their budget and if this is
the case, there must be a framework (benchmark) within which each individual
manager prepares his or her budget. The committee take do SWOT ANALYSIS (
where are we now?, they carry out ‘a position audit’ or strategic analysis which
involves looking both inward and outward), the state of the economy(inflation;
prices of raw materials, oil prices, wage rise, etc., interest rate and exchange
rate; if the organization is a multinational organization). This is critical because
everybody must use the same assumption.
 iii. Documentation: the committee also standardizes the system of the collection of
budgets as well as the type of budgets to be prepared.

2. IDENTIFY PRINCIPAL BUDGET FACTOR: This refers to the limiting factor of the
organization. The organization can set any target but all the targets are subject to the
resources available for the organization and the demand of the product(s). The
organization can be limited in labour hours, machine hours or raw materials available.
However, the key limiting factor of a profit making entity is SALES DEMAND while for a
non-profit making is FUNDING.

3. PREPARE SALES BUDGET: This is a very difficult art because; whatever must be done in
the organization depends solely on the outcome from the ales budget. In order to get it
right, all key functions of the organization must be consulted to help the entity make
good estimate. The marketing and sales department specifically consulted to make
some forecast of the volume of sales that is likely to be sold and the price.

4. PREPARE ALL FUNCTIONAL (DEPARTMENTAL BUDGETS): immediately the sale budget is

prepared, then all other department’s budgets can follow. Starting with the production
department, purchasing and human resource department, and all other departments in
the organization. This is normally done in a PARTICIPATORY (BOTTOM UP) manner. This
means, instead of preparing the budget at head office and imposing it on functional
managers, the organization allows each manager to prepare a budget for his/her
department.
WHY IS THIS IMPORTANT? - REASONS

i. They have the local knowledge and hence can prepare accurate budget.
ii. We wish to promote OWNERSHIP. If managers prepare their own budgets, they
would be inclined and work to achieve it rather than imposing something which
they didn’t do themselves. This enhances motivation.
PROBLEM: “WOULD THE MANAGER PREPARE A BUDGET THAT REFLECTS TRULY WHAT
THEY WANT TO ACHIEVE?
5. NEGOTIATION PROCESS (SENIOR AND JUNIOR MANAGERS): Since we allow each
manager to prepare his/her own budget and we are not sure whether the prepared
budgets reflect truly what we want to achieve, the junior managers after preparing their
respective budgets hand them over to senior managers to go through each cost element
to make sure they conform with the budget assumption. What this stage of the process
do it that, we want an efficient budget but we also don’t want to lose the idea of
ownership, hence it must end with an agreement of all parties.
 6. REVIEW- PREPARES MASTER BUDGET: Once the negotiation process is over, the master
budget is prepared. This is the budget for the entire organization. We must understand
each budget is:
i. Feasible: Do all the functional budgets work when brought together? Is each
budget connecting with each other?
ii. Acceptable: when we bring all the budgets together, does it achieve our budget
aim (PROFIT)?

7. FORMAL ACCEPTANCE: This is the final stage in the budgeting process. It is when the
Master Budget is accepted for the whole organization and becomes the key
authorization tool.

BUDGETING TYPES

The budgeting types of an organization will depend on a lot of factors, which may
include the size of the organization, the state of the economy, the type of environment
the organization operates (service or production), and the type of product the entity
produces and sells, the level of knowledge or skills of its employees, among others.
However, there are six (6) types of budgeting systems that an organization can use.
These are:

1. INCREMENTAL BUDGETS: This is a very simple budget and does not require much
work. The incremental budgeting system involves changing the present budget by
taking into account the key factors that may change next year (period). It means,
managers look at the current budget and consider how inflation, interest rates,
changes in sales, redraw/introduce new product(s).

2. ZERO-BASED BUDGETING (ZBB): Involves preparing a budget for each cost centre
from a zero base. Every item of expenditure has then been justified in its entirety to
be included in the next year’s budget. It means there is no expectation and we
prepare the budget from nothing.
IMPLEMENTING ZERO BASED BUDGETS:
There is a three- step approach to ZBB. These are; define decision units, evaluate
and rank packages and allocate resources.
a. Identify All Decision Packages: the organization defines all the decision packages.
This involves comprehensive description of all the activities the organization will
undertake and the cost and benefit associated with each activity to be
undertaken with each budget.
b. Evaluate and rank each decision package in order of preference: Even though the
organization wants to undertake a lot of activities, it may not be capable of
undertaking all of the decision it want to undertake because of limited supply of
resources. Hence, the organization prepares a scale of preference and ranks all
the decision packages in order of importance/ priority.
c. Identify resources and allocate (Funding): After the entity has ranked all its
decision packages, it must then identify the sources of resource or funding and
allocate the resources according to how the activities have been ranked.
NB: ZBB is a considered allocation of resources (funds) to the best effect (in the
best efficient manner).
ADVANTAGES OF ZBB (as opposed to Incremental budget)
1. Emphasis is placed on the future not on past actions
2. It enhances the elimination of past errors that may be perpetuated in an incremental
budget
3. A positive disincentive for management to introduce slack into their budget
4. It ensures a considered allocation of resources
5. It encourages cost reduction.

DISADVANTAGES
1. ZBB can be very costly and time consuming
2. It may lead to increase stress for management
3. It may ‘re-invent’ the wheel each year. That is we go through the whole process
4. It may lead to loss of continuity of actions and short term planning
5. The ranking of decision packages may be very difficult.

3. PERIODIC BUDGETING: This is a budget prepared for a specific period which is not
linked to either previous year or future events. This system is normally used when
the environment is likely not to change (STABLE ENVIRONMENT). Here, the entity
doesn’t expect things to change. Hence it prepares budget for each period
separately.
 4. CONTINUOUS BUDGET: This is where we continuously update the budgets due to
changes in the environment. This approach to budgeting is implemented when the
entity expects things to change within its environment (DYNAMIC ENVIRONMENT).
With this approach, the entity prepares budget for the four quarters in a period (the
first quarter is prepared in details and the rest in outline). After the first quarter, we
obtain actual results and use that to update the remaining three quarters and add
the first quarter in the next period continuously. It is also referred to as rolling
budget. This approach enhances accuracy.

WHY IS THIS APPROACH ACCURATE?

a. There is accurate date for planning

b. Better control is enhanced
c. Effective evaluation is enhanced
d. It serves as a better motivator

ADVANTAGES (AS OPPOSED TO PERIODIC BUDGET)

1. The budgeting process is more accurate

2. There is much better information upon which to appraise the performance of
management
3. The budget will be more relevant by the end of the traditional budgeting period
4. It forces management to take the budgeting process seriously.

DISADVANTAGES

1. It is more costly and time consuming

2. An increase in budgeting work may lead to less control of the actual results

5. NON-PARTICIPATORY BUDGETING: Some organization may not require junior managers

to participate in the budgetary process. This may be because of security or more likely
due to centralized nature of the company.

REASONS FOR NON-PARTICIPATORY BUDGET

1. Centralized control system of the company

 2. Confidentiality: The head office may want to keep some information confidentially
at the head office to prevent a lot of people having knowledge of it. An example can
be the introduction or lunching of a new product.
3. Dilution of plan: The head office would want a certain plan to be implemented.
However, the junior managers may have their own perception of the budget and this
may change the plan of the top level management and hence the entire
organization.

6. ACTIVITY BASED BUDGETING (ABB): This involves defining that the activities that
underlie the financial figures in each function and using the level of activity to decide
how much resources should be allocated, how well it is being managed and to explain
variances from budget.
Preparation and analysis – Functional budgets
Functional budgets take the anticipated sales level as their point of reference
Preparing sales and resource budgets
Process

 Determining the key budget factor: As we have already discussed, determination of the
key budget factor is critical to the preparation of budgets. It is assumed that the key
budget factor is sale (even though some other factors such as machine, labour or
material may be a limiting factor), and this determines the sales forecast from which the
resource budget flow.
 Preparing the activity plans in the case of each production resource which fit with sales
forecast. E.g. determining qualities of material required, labour hours or machine hours
necessary, taking account of inventory levels, wastage, available labour and production
capacity hours.
 Taking these activity plans and creating financial plans i.e. converting the physical
quantities into costs, consistent with the organisation’s costing system and reflecting
standard costs; this gives specific resource budgets
 Combining all resource budgets, and sales (income) budgets, along with capital and cash
budgets to create a master budget for the organisation.
Let’s now take the Functional budgets one after the other.
1. Sales budget
This is the first budget to be prepared assuming that the key budget factor is sales which shows
the anticipated sales in both units and value.
2. Production budget
A Production budget (finished goods units) is a budget for the number of units of production.
From the sales budget, the production budget will be prepared taking into account planned
changes in inventory levels for finished goods and the anticipated level of defective finished
goods.

Format
Units
Sales quantity xxx
Less opening inventories of finished goods (xxx)
Add closing inventories of finished goods xxx
Production units xxx
Defective output
In many production processes it will be accepted that there will be a certain level of NORMAL
LOSS or faulty production. This normal loss is the percentage of finished goods that it is
anticipated will not be saleable, due to some defect from the production process.
Assuming that the defective output is 5% of finished goods, the Production budget format
will be as follow:
Format
Units
Sales quantity xxx
Less opening inventories of finished goods (xxx)
Add closing inventories of finished goods xxx
Quantity required meeting sales demand (95%) xxx

Add anticipated defective units ( quantity reuired) xxx

Production quantity xxx

3. Material Usage budget

The Material usage budget (units of materials) is the budget for the quantity of materials to be
used in the production process. It is based upon the production for the period but must take
account of material wastage during the production process.
To illustrate this budget, let’s look at this scenario:
Junilove Ltd. prepared their production budget showing a unit of 10205 units to be produced.
From the standard cost card, it is determined that each unit of production requires 2 kg of
material Z. however; the production process has a normal loss of 20% of the materials input
into the process.
Prepare the Material usage budget for the period.
Explanation with solution
From the above scenario, although each unit of product requires 2 kg of material Z, this
represents only 80% of the actual amount required; this is due to the normal loss of 20%. For
this reason, the amount of material Z required for each unit is therefore:

2 kg = 2.5 kg

The amount of normal loss can separately be calculated as:

2 kg = 0.5 kg

The materials usage budget can now be prepared:

Material Usage Budget
Quantity of Production 10205
Material usage (Quantity 2.5 kg) 25513 kg
 4. Material Purchasing budget
The Material purchasing budget (units and $) is the budget for the quantity and value of
materials purchases required.
This is based upon the material usage budget but with adjustment for planned changes in
inventories of materials; once the quantities of purchases are known, then they can be valued
by applying the anticipated purchase price per unit.

Format
Material usage xxx
Less opening inventory of materials (xxx)
Add closing inventory of materials xxx
Quantity to be purchased xxx
Cost of purchases (Quantity to be purchased price per unit)

5. Labour Usage Budget (hours)

The Labour usage budget (hours) is the budget for the number of labour hours required for the
planned level of production.
This is based upon the production budget and the standard hours for each unit – however, any
idle time or labour efficiency must also be built into the number of hours required to complete
the planned production. Once the hours have been determined, the labour cost budget can be
calculated using the hourly rates of labour, taking account of any overtime hours required.
Idle time is non – productive hours that are worked and paid for.
Therefore, if there is to be idle time built into the budget, a greater number of hours will need
to be paid than the standard time, in order to produce the required units.
Illustration:
Continuing Junilove Ltd. question, the standard time for production of one unit is 1 hour.
However, due to necessary break times only 80% of the time paid is productive, so there is 20%
idle time.
From the above scenario, although each unit of product requires 1 hour, this represents only
80% of the actual productive time, this is due to the necessary break time of 20%. For this
reason, the total number of hours that must be paid in total for each unit is therefore:
1 hour = 1.25 hours

The idle time per product can separately be calculated as:

1 hour = 0.25 hours

Labour usage budget

Quantity of production xxx units
Labour usage hours (quantity of production 1.25 hours) xxx hours
Labour cost budget = (labour usage hours rate per hour)

Labour efficiency
It is possible that for a situation to arise where the standard hours for labour are taken from the
standard cost card shows that the work force is known how to work efficiently than these
standard hours. Therefore there will be fewer hours required for production than indicated by
the standard cost card. This is referred to as the Learning curve
Illustration:
Let us suppose that a business is to produce 100000 units of its product in a period and the
standard cost card shows that each unit requires four labour hours. However, it is known that
due to their skill level the work force is producing at 110% efficiency. Therefore the number of
hours of labour required to produce the 100 000 units will be calculated as follows:

6. Overheads budget
This refers to the budget for indirect expenses of the business.
In a manufacturing context, the main budgeting effort will be spent determining the budget for
sales revenue, production, materials and labour. However, budgets must also be set for the
overheads and production facilities related to costs, which include for example, factory rent
and cost of running machinery. Overheads will also include depreciation charges.
Preparing and Analysis – Master budget
The master budget is a summary budget comprising a budgeted operating statement, budgeted
statement of financial position and a cash budget.
A budgeted operating statement is a summary of the detailed budgets for the period, which
provides managers with an overview of expected performance. The overview provided by a
budgeted operating statement allows the organisation’s managers to assess whether the
expected performance is acceptable in terms of the organisation’s overall objectives. If this is
not the case, then they can plan to make adjustments to various areas of activity in order to try
to meet their objectives.
The format is as follows
GHS GHS
Revenue xxx
Less cost of sales:
Materials xxx
Labour xxx
Overheads xxx
(xxx)
Gross profit xxx

Capital budget
A capital budget is a budget for the cost of non – current assets, i.e. for the purchase of non –
current assets.

Cash budget (Cash flow forecast) is a method of determining the expected net cash flow for a
future period and the expected cash or overdraft balance at the end of that future period.

Cash budgets are probably the most important tool in practice for the management of any
company’s cash position. They are vital to identifying in advance a likely deficit or surplus in
order that appropriate action can be taken to avoid any problem or profit from any
opportunity.
Cash budgets
Proforma
Period 1 2 3 4 5
$ $ $ $ $
Receipts
Cash sales x x x x x
Receipts from credit
customers x x x x x
Other income x x
x x x x x
Payments
Cash purchases x x x x x
Payments for credit
Purchases x x x x x
Rent and rates x x
Wages x x x x x
Light and heat x x
Salaries x x x x x
Telephone x x
Insurance x
x x x x x
Surplus/ (deficit) (x) (x) x x x
Balance b/f – (x) (x) (x) x x
Balance c/f (x) (x) (x) x x
Question – functional Budgets preparation

The XYZ company produces three products, X, Y, and Z. For the coming accounting period
budgets are to be prepared using the following information:

Budgeted sales

Product X 2000 units at $100 each

Product Y 4000 units at $130 each

Product Z 3000 units at $150 each

Standard usage of raw material
Wood Varnish (litres per unit)
(Kg per unit)
Product X 5 2
Product Y 3 2
Product Z 2 1
Standard cost of raw material $8 $4

Inventories of finished goods

X Y Z
Opening 500u 800u 700u
Closing 600u 1000u 800u

Inventories of raw materials

Wood Varnish
Opening 21,000 10,000
Closing 18,000 9,000

Labour
X Y Z
Standard hours per unit 4 6 8

Labour is paid at the rate of $3 per hour

Prepare the following budgets:

(a) Sales budget (quantity and value)

(b) Production budget (units)
(c) Material usage budget (quantities)
(d) Material purchases budget (quantities and value)
(e) Labour budget (hours and value)

Solution
(a) Sales budget
$
X 2,000u × $100 = 200,000
Y 4,000u × $130 = 520,000
Z 3,000u × $150 = 450,000
$1,170,000

(b) Production budget

X Y Z
Sales 2,000 4,000 3,000
Opening inventory (500) (800) (700)
Closing inventory 600 1,000 800
Production 2,100 u 4,200u 3,100u

(c) Material usage budget

Wood Varnish
X 2,100u × 5 = 10,500 ×2 4,200
Y 4,200u × 3 = 12,600 ×2 8,400
Z 3,100u × 2 = 6,200 ×1 3,100
29,300 kg 15,700 litres
(d) Materials purchases budget
Wood Varnish
Usage 29,300 15,700
Opening inventory (21,000) (10,000)
Closing inventory 18,000 9,000
26,300 kg 14,700 litres
× $8 × $4
$210,400 $58,800

(e) Labour budget

hours
X 2,100u × 4 = 8,400
Y 4,200u × 6 = 25,200
Z 3,100u × 8 = 24,800
58,400 hours
×$3
$175,200

Fixed and flexible budgets

Fixed budgets remain unchanged regardless of the level of activity; flexible budgets are
designed to flex with the level of activity.

A fixed budget is a budget which is designed to remain unchanged regardless of the volume of
output or sales achieved.

A flexible budget is a budget which, by recognising different cost behaviour patterns, is

designed to change as volumes of output change.

Question

A company has prepared the following fixed budget for the coming year.

Sales 10,000 units

Production 10,000 units
$
Direct materials 50,000
Direct labour 25,000
Variable overheads 12,500
Fixed overheads 10,000
$97,500
Budgeted selling price $10 per unit.
At the end of the year, the following costs had been incurred for the actual production of
12,000 units.
$
Direct materials 60,000
Direct labour 28,500
Variable overheads 15,000
Fixed overheads 11,000
$114,500
The actual sales were 12,000 units for $122,000

(a) Prepare a flexed budget for the actual activity for the year

(b) Calculate the variances between actual and flexed budget, and summarise in a form
suitable for management. (Use a marginal costing approach)

Solution

Flexed Actual Variances

Sales 12,000u 12,000 u

Production 12,000u 12,000 u

Sales 120,000 122,000 2,000 (F)

Materials 60,000 60,000 –
Labour 30,000 28,500 1,500 (F)
Variable o/h 15,000 15,000 –
105,000 103,500
Contribution 15,000 18,500
Fixed o/h 10,000 11,000 1,000 (A)
Profit $5,000 $7,500 $2,500 (F)
Statement
$
Original budget contribution (10,000u × $1.25) 12,500
Sales volume variance (2,000 × $1.25) 2,500 (F)
15,000
Sales price variance 2,000 (F)
Labour variance 1,500 (F)
Actual contribution 18,500
Fixed overheads
Budget 10,000
Variance 1,000 (A) 11,000
Actual profit $7,500

Activity based budgeting

Activity based budgeting involves defining the activities that underlie the financial figures in
each function and using the level of activity to decide how much resource should be allocated,
how well it is being managed and to explain variances from budget.

Principles of ABB

ABB involves defining the activities that underlie the financial figures in each function and using
the level of activity to decide how much resource should be allocated, how well it is being
managed and to explain variances from budget.

ABB is therefore based on the following principles.

(a) It is activities which drive costs and the aim is to control the causes (drivers) of costs rather
than the costs themselves, with the result that in the long term, costs will be better managed
and better understood.

(b) Not all activities are value adding and so activities must be examined and split up according
to their ability to add value.

(c) Most departmental activities are driven by demands and decisions beyond the immediate
control of the manager responsible for the department's budget.
(d) Traditional financial measures of performance are unable to fulfil the objective of
continuous improvement. Additional measures which focus on drivers of costs, the quality of
activities undertaken, the responsiveness to change and so on are needed.

Benefits of ABB

Some writers treat ABB as a complete philosophy in itself and attribute to it all the good
features of strategic management accounting, zero base budgeting, total quality management,
and other ideas. For example, the following claims have been made.

(a) Different activity levels will provide a foundation for the 'base' package and incremental
packages of ZBB.

(b) It will ensure that the organisation's overall strategy and any actual or likely changes in that
strategy will be taken into account, because it attempts to manage the business as the sum of
its interrelated parts.

(c) Critical success factors will be identified and performance measures devised to monitor
progress towards them. (A critical success factor is an activity in which a business must perform
well if it is to succeed).

(d) Because concentration is focused on the whole of an activity, not just its separate parts,
there is more likelihood of getting it right first time. For example what is the use of being able
to produce goods in time for their despatch date if the budget provides insufficient resources
for the distribution manager who has to deliver them?
 STANDARD COSTING & VARIANCE ANALYSIS

1.1. Introduction

Standard costing involves the establishment of predetermined estimates of the costs of

products or services, the collection of actual costs and the comparison of the actual costs with
the predetermined estimates. The predetermined costs are known as standard costs and the
difference between standard and actual cost is known as a variance. The process by which the
total difference between standard and actual results is analysed in known as variance analysis.

What are the possible advantages for the control function of an organisation of having a
standard costing system?

(a) Carefully planned standards are an aid to more accurate budgeting.

(b) Standard costs provide a yardstick against which actual costs can be measured.
(c) The setting of standards involves determining the best materials and methods which may
lead to economies.
(d) A target of efficiency is set for employees to reach and cost-consciousness is stimulated.

Standard costing is most suited to mass production and repetitive assembly work.

1.2. Objectives of Standard Costing

The objectives include the following

1. Provide a basis for cost control. That is it indicates what is attainable and what is being
attained.
2. Expose operations or areas of a business where efficiency or inefficiency is being
attained.
3. Assist in the evaluation of performance variations or deviations for the purpose of
revising estimates or standards.
4. Enable corrective action to be taken on time.
5. Provide a basis for stack valuation.
6. Provide a basis for the preparation of budgets
7. Assist in the establishment of selling prices.
8. Encourage participation of all employees in setting standards and establishing budgets.
Advantages of Standard Costing
1. It serves as a basis for budgeting and planning.
2. It promotes management by exception. That is management can focus on only activities
which are not proceeding significantly according to plan.
3. Variance analysis may result in cost reduction techniques being proposed and followed
up. That is, it stimulates cost consciousness.
4. It provides basis for product pricing and stock valuation.
5. Standard cost provides a yard stick against which actual cost or performance can be
measured.
6. Full participation of all employees and the setting of realistic standards will lead to
motivation of staff.

Disadvantages of Standard Costing

1. It may be time consuming and expensive to operate.
2. It may concentrate on only aspects of a business which can be quantified in monetary
terms.
3. It may stifle initiative.
4. Standards set will be rendered out of date in volatile conditions i.e., where prices,
production methods, etc. are changing rapidly.
5. The system may be so complex that it will be difficult to understand by line managers.
6. It does not allow for flexibility.
7. It is difficult to use where non-standardised products or operations are involved.

1.3. Key Terminologies

 When actual results are better than expected results, we have a

favourable variance (F). If actual results are worse than expected results,
we have an adverse variance (A).
 The selling price variance measures the effect on expected profit of a
selling price different to the standard selling price. It is calculated as the
difference between what the sales revenue should have been for the
actual quantity sold, and what it was.
 The sales volume variance measures the increase or decrease in expected
profit as a result of the sales volume being higher or lower than budgeted.
It is calculated as the difference between the budgeted sales volume and
the actual sales volume multiplied by the standard profit per unit.
 The material total variance is the difference between what the output
actually cost and what it should have cost, in terms of material. It can be
divided into the following two sub-variances.
 The material price variance is the difference between what the material
did cost and what it should have cost.
 The material usage variance is the difference between the standard cost of
the material that should have been used and the standard cost of the
material that was used.
 The labour total variance is the difference between what the output
should have cost and what it did cost, in terms of labour. It can be divided
into two sub-variances.
 The labour rate variance is the difference between what the labour did
cost and what it should have cost.
 The labour efficiency variance is the difference between the standard cost
of the hours that should have been worked and the standard cost of the
hours that were worked.
 The variable production overhead total variance is the difference
between what the output should have cost and what it did cost, in terms of
variable production overhead. It can be divided into two sub-variances.
 The variable production overhead expenditure variance is the difference
between the amount of variable production overhead that should have
been incurred in the actual hours actively worked, and the actual amount
of variable production overhead incurred.
 The variable production overhead efficiency variance is the difference
between the standard cost of the hours that should have been worked for
the number of units actually produced, and the standard cost of the actual
number of hours worked.
 Fixed production overhead total variance is the difference between fixed
production overhead incurred and fixed production overhead absorbed. In
other words, it is the under– or over absorbed fixed production overhead.
 Fixed production overhead expenditure variance is the difference
between the budgeted fixed production overhead expenditure and actual
fixed production overhead expenditure.
 Fixed production overhead volume variance is the difference between
actual and budgeted production/volume multiplied by the standard
absorption rate per unit.
 When actual results are better than expected results, we have a
favourable variance (F). If actual results are worse than expected results,
we have an adverse variance (A).
 The selling price variance measures the effect on expected profit of a
selling price different to the standard selling price. It is calculated as the
difference between what the sales revenue should have been for the
actual quantity sold, and what it was.
 The sales volume variance measures the increase or decrease in expected
profit as a result of the sales volume being higher or lower than budgeted.
It is calculated as the difference between the budgeted sales volume and
the actual sales volume multiplied by the standard profit per unit.
 The material total variance is the difference between what the output
actually cost and what it should have cost, in terms of material. It can be
divided into the following two sub-variances.
 The material price variance is the difference between what the material
did cost and what it should have cost.
 The material usage variance is the difference between the standard cost of
the material that should have been used and the standard cost of the
material that was used.
 The labour total variance is the difference between what the output
should have cost and what it did cost, in terms of labour. It can be divided
into two sub-variances.
 The labour rate variance is the difference between what the labour did
cost and what it should have cost.
 The labour efficiency variance is the difference between the standard cost
of the hours that should have been worked and the standard cost of the
hours that were worked.
 The variable production overhead total variance is the difference
between what the output should have cost and what it did cost, in terms of
variable production overhead. It can be divided into two sub-variances.
 The variable production overhead expenditure variance is the difference
between the amount of variable production overhead that should have
been incurred in the actual hours actively worked, and the actual amount
of variable production overhead incurred.
 The variable production overhead efficiency variance is the difference
between the standard cost of the hours that should have been worked for
the number of units actually produced, and the standard cost of the actual
number of hours worked.
  Fixed production overhead total variance is the difference between fixed
production overhead incurred and fixed production overhead absorbed. In
other words, it is the under– or overabsorbed fixed production overhead.
 Fixed production overhead expenditure variance is the difference
between the budgeted fixed production overhead expenditure and actual
fixed production overhead expenditure.
 Fixed production overhead volume variance is the difference between
actual and budgeted production/volume multiplied by the standard
absorption rate per unit.
 Fixed production overhead volume efficiency variance is the difference
between the number of hours that actual production should have taken,
and the number of hours actually taken (that is, worked) multiplied by the
standard absorption rate per hour.
 Fixed production overhead volume capacity variance is the difference
between budgeted hours of work and the actual hours worked, multiplied
by the standard absorption rate per hour.

Processes Involved in Standard Costing

The following steps must be followed when operating a Standard Costing System:
1. Establishment of standard costs for each element of cost.
2. Measurement or recording of actual results.
3. Comparison of actual results with standard costs to measure any variances which have
occurred.
4. Analysis of variances (i.e., into price, usage, efficiency, etc. variances).

Investigation of variances and the taking of remedial or corrective actions.

1.4. Deriving standards

The responsibility for deriving standard costs should be shared between managers able to
provide the necessary information about levels of expected efficiency, prices and overhead
costs.

1.4.1. Setting standards for materials costs

Direct materials costs per unit of raw material will be estimated by the purchasing department
from their knowledge of the following.

 Purchase contracts already agreed

 Pricing discussions with regular suppliers
  The forecast movement of prices in the market
 The availability of bulk purchase discounts
 The quality of material required by the production departments

1.4.2. Setting standards for labour costs

Direct labour rates per hour will be set by reference to the payroll and to any agreements on
pay rises with trade union representatives of the employees. A separate hourly rate or weekly
wage will be set for each different labour grade/type of employee and an average hourly rate
will be applied for each grade (even though individual rates of pay may vary according to age
and experience).

Similar problems to those which arise when setting material standards in times of high inflation
can be met when setting labour standards.

1.4.3. Setting standards for material usage and labour efficiency

To estimate the materials required making each product (material usage) and also the labour
hours required (labour efficiency), technical specifications must be prepared for each product
by production experts (either in the production department or the work study department).

1.4.4. Setting standards for overheads

When standard costs are fully absorbed costs (standard costs can be used in both marginal and
absorption costing systems), the absorption rate of fixed production overheads will be
predetermined and based on budgeted fixed production overhead and planned production
volume.

Production volume will depend on two factors.

(a) Production capacity (or 'volume capacity') measured perhaps in standard hours of output (a
standard hour being the amount of work achievable at standard efficiency levels in an hour),
which in turn reflects direct production labour hours.

(b) Efficiency of working, by labour or machines, allowing for rest time and contingency
allowances.
Suppose that a department has a work force of ten men, each of whom works a 36 hour week
to make standard units, and each unit has a standard time of two hours to make. The expected
efficiency of the work-force is 125%.

(a) Budgeted capacity, in direct labour hours, would be 10 36 = 360 production hours per
week.

(b) Budgeted efficiency is 125% so that the work-force should take only 1 hour of actual
production time to produce 1.25 standard hours of output.

1.4.5. Setting standards for sales price and margin

The standard selling price will depend on a number of factors including the following.

 Anticipated market demand

 Manufacturing costs
 Competing products
 Inflation estimates

The standard sales margin is the difference between the standard cost and the standard selling
price.

1.5. Types of standard

There are four types of standard: ideal, attainable, current and basic. These can have an
impact on employee motivation.

An ideal standard is a standard which can be attained under perfect operating conditions: no
wastage, no inefficiencies, no idle time, and no breakdowns

An attainable standard is a standard which can be attained if production is carried out

efficiently, machines are properly operated and/or materials are properly used. Some
allowance is made for wastage and inefficiencies

A current standard is standard based on current working conditions (current wastage, current
inefficiencies)

A basic standard is a long-term standard which remains unchanged over the years and is used
to show trends
The different types of standard have a number of advantages and disadvantages.

(a) Ideal standards can be seen as long-term targets but are not very useful for day-to-day
control purposes.

(b) Ideal standards cannot be achieved. If such standards are used for budgeting, an allowance
will have to be included to make the budget realistic and attainable.

(c) Attainable standards can be used for product costing, cost control, inventory valuation,
estimating and as a basis for budgeting.

(d) Current standards or attainable standards provide the best basis for budgeting, because
they represent an achievable level of productivity.

(e) Current standards do not attempt to improve on current levels of efficiency.

(f) Current standards are useful during periods when inflation is high. They can be set on a
month by month basis.

(g) Basic standards are used to show changes in efficiency or performance over a long period
of time. They are perhaps the least useful and least common type of standard in use.

1.6. Budgets and standards compared

You will recall from previous chapters that a budget is a quantified monetary plan for a future
period, which managers will try to achieve. Its major function lies in communicating plans and
coordinating activities within an organisation.

On the other hand, a standard is a carefully predetermined quantity target which can be
achieved in certain conditions.

Budgets and standards are similar in the following ways.

(a) They both involve looking to the future and forecasting what is likely to happen given a
certain set of circumstances.
(b) They are both used for control purposes. A budget aids control by setting financial targets
or limits for a forthcoming period. Actual achievements or expenditures are then compared
with the budgets and action is taken to correct any variances where necessary. A standard also
achieves control by comparison of actual results against a predetermined target.

As well as being similar, budgets and standards are interrelated. For example, a standard unit
production cost can act as the basis for a production cost budget. The unit cost is multiplied by
the budgeted activity level to arrive at the budgeted expenditure on production costs.

1.7. Variance analysis is a key element of performance management and is the process by
which the total difference between flexed standard and actual results is analysed.
A number of basic variances can be calculated. If the results are better than expected, the
variance is favourable (F). If the results are worse than expected, the variance is adverse (A).

It is important to be able to:

 calculate a variance
 explain the meaning of the variance calculated
 identify possible causes for each variance.

Once the variances have been calculated, an operating statement can be prepared reconciling
actual profit to budgeted profit, under marginal costing or under absorption costing principles.

Basic variances can be calculated for sales, material, labour, variable overheads and fixed
overheads.

Note: 'Margin' = contribution per unit (marginal costing) or profit per unit (absorption costing).

Note: The material price variance and the material usage variance may be linked. For example,
the purchase of poorer quality materials may result in a favourable price variance but an
adverse usage variance.

. Profit Statement

 Marginal costing system

With a marginal costing profit and loss, no overheads are absorbed, the amount spent is simply
written off to the income statement.
So with marginal costing the only fixed overhead variance is the difference between what was
budgeted to be spent and what was actually spent, i.e. the fixed overhead expenditure
variance.

 Absorption costing system

Under absorption costing we use an overhead absorption rate to absorb overheads. Variances
will occur if this absorption rate is incorrect (just as we will get over/under-absorption).

So with absorption costing we calculate the fixed overhead expenditure variance and the fixed
overhead volume variance (this can be split into a capacity and efficiency variance).

Operating statement under absorption costing

The purpose of calculating variances is to identify the different effects of each item of
cost/income on profit compared to the expected profit. These variances are summarised in a
reconciliation statement or operating statement.

OPERATING STATEMENT FOR JANUARY – ABSORPTION COSTING

$ $ $
Budgeted profit xxx
Sales variances: price xxx
volume xxx
xxx
Actual sales minus the standard cost of sales xxx
Cost variances
(F) (A)
$ $ $
Material price xxx
Material usage xxx
Labour rate xxx
Labour efficiency xxx
Labour idle time xxx
Variable overhead expenditure xxx
Variable overhead efficiency xxx
Fixed overhead expenditure xxx
Fixed overhead volume xxx
Xxx xxx xxx
Actual profit for January xxx

Check
$ $
Sales xxx
Materials xxx
Labour xxx
Variable overhead xxx
Fixed overhead xxx
xxx
Actual profit xxx

Operating statement under marginal costing

The operating statement under marginal costing is the same as that under absorption costing
except;

 a sales volume contribution variance is included instead of a sales volume profit

variance
 the only fixed overhead variance is the expenditure variances
 the reconciliation is from budgeted to actual contribution then fixed overheads are
deducted to arrive at a profit.
 OPERATING STATEMENT FOR JANUARY – MARGINAL COSTING

$ $ $
Budgeted profit xxx
Budgeted fixed production costs xxx
Budgeted contribution xxx
Sales variances: volume xxx
price xxx
xxx
Actual sales ($95,600) minus the standard
variable cost of sales (4,850 $6.60) xxx

(F) (A)
Variable cost variances $ $ $
Material price xxx
Material usage xxx
Labour rate xxx
Labour efficiency xxx
Labour idle time xxx
Variable overhead expenditure xxx
Variable overhead efficiency xxx
xxx xxx
xxx
Actual contribution xxx
Budgeted fixed production overhead xxx
Expenditure variance xxx
Actual fixed production overhead xxx
Actual profit xxx

Question 1:

A company produces and sells one product only, the Thing, the standard cost for one unit being
as follows.
$
Direct material A – 10 kilograms at $20 per kg 200
Direct material B – 5 litres at $6 per litre 30
Direct wages – 5 hours at $6 per hour 30
Fixed production overhead 50
Total standard cost 310

The fixed overhead included in the standard cost is based on an expected monthly output of
900 units.
Fixed production overhead is absorbed on the basis of direct labour hours.
During April the actual results were as follows.
Production 800 units
Material A 7,800 kg used, costing $159,900
Material B 4,300 litres used, costing $23,650
Direct wages 4,200 hours worked for $24,150
Fixed production overhead $47,000

Required
(a) Calculate price and usage variances for each material.
(b) Calculate labour rate and efficiency variances.
(c) Calculate fixed production overhead expenditure and volume variances and then subdivide
the volume variance.

Solution

(a) Price variance – A

$
7,800 kgs should have cost ( $20) 156,000
but did cost 159,900
Price variance 3,900

Usage variance – A
800 units should have used ( 10 kgs) 8,000 kgs
but did use 7,800 kgs
Usage variance in kgs 200 kgs (F)
standard cost per kilogram $20
Usage variance in $ $4,000 (F)

Price variance – B
$
4,300 litres should have cost ( $6) 25,800
but did cost 23,650
Price variance 2,150 (F)

Usage variance – B
 $
800 units should have used ( 5) 4,000
but did use 4,300
Usage variance in litres 300 (A)
standard cost per litre × $6
Usage variance in $ $1,800 (A)

Labour rate variance

$
4,200 hours should have cost ( $6) 25,200
but did cost 24,150
Rate variance 1,050 (F)

Labour efficiency variance

800 units should have taken ( 5 hrs.) 4,000 hrs.

but did take 4,200 hrs.
Efficiency variance in hours 200 hrs. (A)
standard rate per hour × $6
Efficiency variance in $ $1,200 (A)

Fixed overhead expenditure variance

$
Budgeted expenditure ($50 900) 45,000
Actual expenditure 47,000
Expenditure variance 2,000 (A)

Fixed overhead volume variance

$
Budgeted production at standard rate (900 $50) 45,000
Actual production at standard rate (800 $50) 40,000
Volume variance 5,000 (A)

Fixed overhead volume efficiency variance

$
800 units should have taken ( 5 hrs.) 4,000 hrs.
but did take 4,200 hrs.
Volume efficiency variance in hours 200 hrs.
 standard absorption rate per hour $10
Volume efficiency variance $2,000 (A)

Fixed overhead volume capacity variance

Budgeted hours 4,500 hrs.
Actual hours 4,200 hrs.
Volume capacity variance in hours 300 hrs. (A)
standard absorption rate per hour ($50 ÷ 5) $10
$3,000 (A)

Question 2:

A company manufactures one product, and the entire product is sold as soon as it is produced.
There is no opening or closing inventories and work in progress is negligible. The company
operates a standard costing system and analysis of variances is made every month. The
standard cost card for the product, a widget, is as follows.

STANDARD COST CARD – WIDGET

$
Direct materials 0.5 kilos at $4 per kilo 2.00
Direct wages 2 hours at $2.00 per hour 4.00
Variable overheads 2 hours at $0.30 per hour 0.60
Fixed overhead 2 hours at $3.70 per hour 7.40
Standard cost 14.00
Standard profit 6.00
Standing selling price 20.00

Budgeted output for January was 5,100 units. Actual results for January were as follows.
Production of 4,850 units was sold for $95,600
Materials consumed in production amounted to 2,300 kilos at a total cost of $9,800
Labour hours paid for amounted to 8,500 hours at a cost of $16,800
Actual operating hours amounted to 8,000 hours
Variable overheads amounted to $2,600
Fixed overheads amounted to $42,300

Required
Calculate all variances and prepare an operating statement for January.
Solution

(a) 2,300 kg of material should cost ( $4) 9,200

but did cost 9,800
Material price variance 600 (A)

(b) 4,850 Widgets should use ( 0.5 kgs) 2,425 kg

but did use 2,300 kg
Material usage variance in kgs 125 kg (F)
standard cost per kg × $4
Material usage variance in $ $ 500 (F)

(c) 8,500 hours of labour should cost ( $2) 17,000

but did cost 16,800
Labour rate variance 200 (F)

(d) 4,850 Widgets should take ( 2 hrs) 9,700 hrs

but did take (active hours) 8,000 hrs
Labour efficiency variance in hours 1,700 hrs. (F)
standard cost per hour × $2
Labour efficiency variance in $ $3,400 (F)

(e) Idle time variance 500 hours (A) $2 $1,000 (A)

(f) 8,000 hours incurring variable o/hd expenditure should cost ( $0.30) 2,400
but did cost 2,600
Variable overhead expenditure variance 200 (A)

(g) Variable overhead efficiency variance is the same as the

labour efficiency variance:
1,700 hours (F) $0.30 per hour $ 510 (F)

(h) Budgeted fixed overhead (5,100 units 2 hrs. $3.70) 37,740

Actual fixed overhead 42,300
Fixed overhead expenditure variance 4,560 (A)

(i) Actual production at standard rate (4,850 units $7.40) 35,890

Budgeted production at standard rate (5,100 units $7.40) 37,740
Fixed overhead volume variance 1,850 (A)

(j) 4,850 Widgets should have sold for ( $20) 97,000

but did sell for 95,600
Selling price variance 1,400 (A)

(k) Budgeted sales volume 5,100 units

Actual sales volume 4,850 units
Sales volume variance in units 250 units
standard profit per unit × $6 (A)
Sales volume variance in $ $1,500

$ $
Budgeted profit (5,100 units $6 profit) 30,600
Selling price variance 1,400 (A)
Sales volume variance 1,500 (A)
2,900 (A)
Actual sales ($95,600) less the standard cost of sales (4,850 $14) 27,700

OPERATING STATEMENT FOR JANUARY

$ $ $
Budgeted profit 30,600
Sales variances: price 1,400 (A)
volume 1,500 (A)
2,900 (A)
Actual sales minus the standard cost of sales 27,700

Cost variances
(F) (A)
$ $ $
Material price 600
Material usage 500
Labour rate 200
Labour efficiency 3,400
Labour idle time 1,000
Variable overhead expenditure 200
Variable overhead efficiency 510
Fixed overhead expenditure 4,560
Fixed overhead volume 1,850
 4,610 8,210 3,600 (A)
Actual profit for January 24,100

Check
$ $
Sales 95,600
Materials 9,800
Labour 16,800
Variable overhead 2,600
Fixed overhead 42,300
71,500
Actual profit 24,100

Operating statements in a marginal cost environment

Question 3:

Returning to the question above, now assume that the company operates a marginal costing
system.
Required
Recalculate any variances necessary and produce an operating statement.

Answer

(a) There is no fixed overhead volume variance.

(b) The standard contribution per unit is $(20 – 6.60) = $13.40, therefore the sales volume
variance of
250 units (A) is valued at ( $13.40) = $3,350 (A).

The other variances are unchanged; therefore an operating statement might appear as follows.

OPERATING STATEMENT FOR JANUARY

$ $ $
Budgeted profit 30,600
Budgeted fixed production costs 37,740
Budgeted contribution 68,340
Sales variances: volume 3,350 (A)
price 1,400 (A)
4,750 (A)
Actual sales ($95,600) minus the standard
variable cost of sales (4,850 $6.60) 63,590

(F) (A)
Variable cost variances $ $ $
Material price 600
Material usage 500
Labour rate 200
Labour efficiency 3,400
Labour idle time 1,000
Variable overhead expenditure 200
Variable overhead efficiency 510
4,610 1,800
2,810 (F)
Actual contribution 66,400
Budgeted fixed production overhead 37,740
Expenditure variance 4,560 (A)
Actual fixed production overhead 42,300
Actual profit 24,100

Note: The profit here is the same on the profit calculated by standard absorption costing
because there were no changes in inventory levels. Absorption costing and marginal costing
do not always produce an identical profit figure.