Standard costing and fixed and flexed budgets
| by Barrie Mitchinson 01 Jul 2000 Diploma in Financial Management Relevant to Paper D2 |
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In this article Barrie Mitchinson MBA ACMA PGCEd, Certified Diploma Course Leader at the University of Northumbria at Newcastle provides an integrated illustration of the use of basic standards and fixed and flexible budgets. The article identifies the impact of overhead under recovery and the importance of cost classification to support the planning and control framework.
Standard costing involves the development of a product or service
cost using estimates of both the resources consumed and the prices
of those resources. The standard cost may then be increased by
an estimated profit margin to produce a standard selling price.
These estimates of cost and revenue then provide a foundation
for further planning and control.
Figure 1 relates to the street sweeping service of the Blue City Council. We can assume that the Street Sweeping Department has a contract with the city’s Highways Department to provide the service at a contract price of £86.90 per mile swept. As the name implies this is a service and not the manufacturing environment we might have expected for such an example. While traditionally standard costing has been associated with manufacturing it can be applied to the service sector. CS Jones for instance has written on its use within planning and control for hospital treatment in the National Health Service.1 Essentially, all we need to adopt the standard costing method is a task which is repeated many times. Repeated so many times in fact that we can estimate the nature of how it will be performed in the future. Such tasks may range from car assembly to sweeping streets, or the treatment of broken legs within hospitals accident and emergency departments!
| FIGURE 1 |
| Blue City Council | ||
| Standard information per mile cleaned: Street Sweeping | ||
| Revenue | £86.90 | |
| Costs | ||
| Labour | 4 hours @ £5.00 | £20.00 |
| Materials | 6 litres @ £4.00 | £24.00 |
| Variable overheads | 4 hours @ £0.75 | £3.00 |
| Fixed overheads | 4 hours @ £8.00 | £32.00 |
| Standard cost per mile swept | £79.00 |
| Standard profit margin | £7.90 |
| The fixed overhead recovery rate is based on the following calculation. | |
| £16,000 per month of departmental fixed costs on rent, rates etc / | |
| Planned activity 2,000 hours per 4 week period (sweeping 500 road miles) | |
This produces an hourly fixed overhead recovery rate of £8 per direct labour hour.
Used simply for planning we could use this information to predict the income and expense for any period given the planned number of miles for that period. Knowing the miles to be swept we could establish which costs and revenues change in relation to the miles swept and which do not. You may recognise this approach as the classification of costs and revenues by behaviour. Knowing how costs and revenues change in relation to output, in this case miles swept, has many uses in planning. See Figure 2.
| FIGURE 2 |
| Flexed Budget for Month X | |
| Budgeted costs for 100 miles swept | |
| Revenue | £8,690 |
| Costs | |
| Labour | £2,000 |
| Materials | £2,400 |
| Variable overheads | £300 |
| Fixed overheads | £3,200 |
| Profit | £790 |
.The costs and revenue per mile established in the standard in Figure 1 have been multiplied by the planned output for the period. Constructing a budget in this way, to reflect the variable and fixed nature of costs and revenues within the budget is an example of flexible budgeting.
You may recall that we calculated the fixed overhead recovery rate on the basis of spending £16,000 and sweeping 500 miles per month. Organisations typically need to establish such overhead recovery rates in advance to support price setting or in manufacturing environments for stock valuation. They therefore represent the organisation’s best estimates of activity level and costs at the time they are set. They remain estimates, however, and may prove to be wrong. The low level of activity of 100 miles swept in the period shown in Figure 2 may be the result of, say, a strike which lasted much of the period. You should now attempt to write a budget based on 500 miles being swept in a period before proceeding further (visit this link for the solution to this task).
The budget you have produced is consistent with the organisation’s original planned level of activity of 500 miles per period. If we predicted this level of income and expenditure to apply to each period we would be using a fixed budget approach to our planning.
Assume now that the actual costs and revenues for Period X shown in Figure 2 are as follows, 100 miles of street having been swept -
| Revenue | £9,000 |
| Labour (400 hours worked) | £1,800 |
| Materials (500 litres consumed) | £2,600 |
| Variable overheads | £400 |
| Fixed overheads | £15,000 |
| Loss | £10,800 |
With this actual information, which can only be collected after
the end of the period, we can review the organisation’s performance.
It would be unrealistic to compare the actual cost of sweeping
100 miles of street with the fixed budget. The fixed budget is
based on 500 miles and such a comparison would ignore the impact
of the difference in miles swept and its significance to output
related costs. While we may use a fixed budget as our best estimate
of the future for planning when exercising control, we need a
flexible budget to make valid comparisons.
A flexed budget analysis is shown, see figure
3 based on 100 miles swept.
| FIGURE 3 |
| Flexed budget analysis | ||||
| 100 miles swept - bases on 100 miles swept | ||||
| Budget | Actual | Variance | ||
| Revenue | £8,690 | £9,000 | £310 | Favourable |
| Costs | ||||
| Labour | £2,000 | £1,800 | £310 | Favourable |
| Materials | £2,400 | £2,600 | £200 | Adverse |
| Variable overheads | £300 | £400 | £200 | Adverse |
| Fixed overheads | £3,200 | £15,000 | £11,800 | Adverse |
| Profit (loss) | £790 | (£10,800) | £11,590 | Adverse |
In this context a favourable variance causes an increase in profits while an adverse variance would cause a reduction in profits. This flexed budget analysis gives management an insight into the cause of the variation between the planned level of cost and revenue at this level of output and the actual cost. Looking at the revenue information we know the output for both budget and actual figures is 100 miles. The difference in revenue must be due to the amount of income received, therefore. In the case of labour and the other variable costs, however, we do not know if the variance was due to using more or less of the actual resource or due to paying a different price per unit of resource.
Much more useful information could be produced through the use of standard costing variance analysis and it is this we turn to next.
Standard Costing Variance Analysis
It will help to consider the variances as forming three distinct types. Those to do with sales, those to do with variable costs and those to do with fixed costs. In all cases one variance highlights variances in profit caused by price or cost, while its ‘partner’ variance evaluates the variance in profits caused by differences in quantity.
| FIGURE 4 - What's in a Name |
| Variances in relation to | Variance caused by price or cost being different to standard | Variance caused by amount being different to standard |
| Sales | Price | Volume |
| Variable costs | ||
| Labour | Rate | Efficiency |
| Materials | Price | Usage |
Variable overheads |
Expenditure | Efficiency |
| Fixed costs | ||
| Fixed overheads | Expenditure | Volume |
The Full Extent of the Differences
There are three key figures revealed by the budgetary analysis so far -
A fixed budget profit (500 miles @ £7.90/mile: See Figure 1) of £3,950 per month was planned. You should be able to prove this by looking at the fixed budget you created earlier. For Period X, however, a flexed budget result of £790 profit was established while the actual result achieved in Period X was £10,800 loss.
We will now use standard costing to provide a comprehensive analysis and reconciliation of these figures.
The Sales Variances
Turning first to sales, we planned sales volume (miles swept) in our fixed budget to be 500 miles yet during Period X we swept only 100 miles. We swept 400 miles less than planned with each mile under budget accounting for £7.90 in lost profit. Thus, the variance caused by sales volume difference is therefore 400 x £7.90/mile = £3,160 adverse. If the 100 miles we did sweep brought in the standard income per mile we would have accumulated 100 x £86.90 = £8,690. We actually received £9,000 for sweeping 100 miles. As the number of miles is the same in both cases the variance must be due to the sales price received. This is the sales price variance of £310 favourable.
The Variable Cost Variances
The variable costs are made up of labour, materials and variable overheads. In each case looking at the standard in Figure 1 you will see that the quantity of each resource per unit of output has been defined as well as the price per unit of each of the resources input.
This common structure of these variable costs within the standard helps in calculating the required variances. In each case we can establish the effect on profits of the actual price being different to standard. We can also establish the effect on profits of the amount of the resource consumed being different to standard.
By convention the ‘price’ variance for labour is called the labour rate variance, for materials it is called the material price variance and for variable overheads it is called the overhead expenditure variance. In each case the method of calculation is the same as is shown below for labour. For the variance dealing with the amount of input resources used these are referred to by convention as the labour efficiency variance, the material usage variance and the variable overhead efficiency variance.
For each of the ‘price’ variances you need to establish -
- How much did you expect to spend for the actual quantity of the resource consumed?
- How much did you actually spend for the actual quantity of the resource consumed?
The difference between these two figures is the ‘price’ variance.
Example Using Labour
Labour ‘Rate’ Variance -
Expected to spend £5/hour for 400 hours worked =£2,000
Actually spent working 400 hours = £1,800
Labour rate variance = £200 favourable
Remember in this part of the calculation to use the actual quantity of the resource consumed for the actual quantity of output achieved.
Labour Efficiency Variance
100 units output should use at 4 hours/mile = 400 hours
did use = 400 hours
labour efficiency variance = 0 hour and £
You can see that these two labour variances added together are the same as the variance revealed by the flexed budget shown in Figure 3. This will be the case for all of the variable costs. You should now attempt to calculate the variances for materials and variable overheads using the same logic as shown for labour above (click here for the solution to this task).
The Fixed Cost Variances
The remaining variances relate to the fixed overheads. Again there is a variance that relates to the cost, which because it is an overhead is conventionally referred to as the fixed overhead expenditure variance, its partner variance being the fixed overhead volume variance. Thinking back to cost behaviour you will recall that fixed costs are referred to as such because they do not change due to changes in output. The planned level of fixed costs, therefore, cannot be affected by short- term changes in output volumes.
Using the standard information in Figure 1 we can see that the department intended to spend £16,000 on fixed overheads. The actual information given reveals a spend of £15,000. This difference can only be due to the price of the fixed overheads as the difference in volume cannot affect the quantity of fixed overheads consumed by definition. The fixed overhead expenditure variance must therefore be £1,000 favourable. The remaining variance is the fixed overhead volume variance. In this case the volume relates to the volume of overheads absorbed by production.
You will recall that the original standard anticipated £32.00
of fixed overhead being absorbed for each mile of road swept,
and that given an output of 500 miles per period the full £16,000
of overhead would be absorbed. In the period we are considering
only 100 miles of street were swept and therefore only £3,200
of fixed overheads absorbed. This difference between overhead
absorbed and budgeted is equal to the variation between actual
volume of output and planned volume of output multiplied by the
fixed overhead recovery rate per unit of output (in our case 100
-500 x £32 = £12,800 adverse). This is under recovery
of overheads and will result in a corresponding charge to profit
and loss account. You can also see that the sum of the fixed overhead
variances (expenditure £1,000 favourable, volume £12,800
adverse = £11,800 adverse ) is the same as the total fixed
overhead variance revealed by the flexed budget in Figure
3.
Finally we need to bring all of this information together in a Standard Costing Operating Statement which will summarise the causes of variation between the original fixed budget planned profit and the eventual actual outcome. This document conveniently summarises the nature and extent of each variance for senior management. A common format is shown across. It provides a starting point for their further investigation of the causes of the variances. You should attempt to complete the form across before referring to the answer.
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