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15 Budgetary Control In this chapter, we describe the budgetary control that takes place in organizations through the techniques of flexible budgets and variance analysis. However, we caution against variance analysis in circumstances where this could conflict with more broadly based improvement strategies within the business. The chapter also considers how cost control can be exercised in practice. What is budgetary control? Budgetary control is concerned with ensuring that actual financial results are in line with targets. An important part of this feedback process (see Chapter 4) is investigating variations between actual results and budgeted results and taking appropriate corrective action. Budgetary control provides a yardstick for comparison and isolates problems by focusing on variances, which provide an early warning to managers. Buckley and McKenna (1972) argued: The sinews of the budgeting process . . . are the influencing of management behaviour by setting agreed performance standards, the evaluation of results and feedback to management in anticipation of corrective action where necessary. (p. 137) Budgetary control is typically exercised at the level of each responsibility centre. Management reports show, for each line item, the budget expenditure, usually for both the current accounting period and the year to date. The report will also show the actual income and expenditure and a variance. A typical actual versus budget financial report is shown in Table 15.1. There are two types of variance: ž ž A favourable variance occurs where income exceeds budget and/or expenses are lower than budget. An adverse variance occurs where income is less than budget and/or expenses are greater than budget. It is important to look both at the current period, which in the above example shows an underspend of £6,500 (budget of £80,000 less actual spending of £73,500), 226 ACCOUNTING FOR MANAGERS Table 15.1 Actual v. budget financial report Budget for this period Actual for this period Budget for the year to date Actual for the year to date Variance Materials Labour Energy Other costs 40,000 21,000 9,000 10,000 45,000 19,000 7,000 2,500 100,000 30,000 40,000 50,000 96,000 32,000 38,000 55,000 4,000 Fav 2,000 Adv 2,000 Fav 5,000 Adv Total 80,000 73,500 220,000 221,000 1,000 Adv and the year to date, which shows an overspend of £1,000. The weakness of traditional management reports for budgetary control is that the business may not be comparing like with like. For example, if the business volume is lower than budgeted, then it follows that any variable costs should (in total) be lower than budgeted. Conversely, if business volume is higher than budget, variable costs should (in total) be higher than budget. In many management reports, the distinction between variable and fixed costs (see Chapter 8) is not made and it becomes very difficult to compare costs incurred at one level of activity with budgeted costs at a different level of activity and to make judgements about managerial performance. Flexible budgeting Flexible budgets provide a better basis for investigating variances than the original budget, because the volume of production may differ from that planned. If the actual activity level is different to that budgeted, comparing revenue and/or costs at different (actual and budget) levels of activity will produce meaningless figures. A flexible budget is a budget that is flexed, that is standard costs per unit are applied to the actual level of business activity. It makes little sense to compare the budgeted costs of producing (say) 40,000 units with the costs incurred in producing 35,000 units. Variance analysis is then carried out between the flexed budget costs and actual costs. Flexible budgets take into account variations in the volume of activity. Using the above example, costs are budgeted at £2 per unit for 40,000 units but actual costs are £2.10 for 35,000 units. A standard actual versus budget report will show: Budget £80,000 40,000 @ £2 Actual £73,500 35,000 @ £2.10 Variance £6,500 Favourable The favourable variance disguises the fact that fewer units were produced. A flexible budget adjusts the original budget to the actual level of activity. The BUDGETARY CONTROL 227 variance under a flexed budget would then show: Original budget £80,000 40,000 @ £2 Flexed budget £70,000 35,000 @ £2 Actual £73,500 35,000 @ £2.10 Variance £3,500 Adverse This is a more meaningful comparison, because the manager responsible for cost control has spent more per unit and should not have this responsibility negated by the effect of a reduced volume, which may have been outside that manager’s control. Separately, the adverse effect of the volume variance – the difference between the original and flexed budgets – is shown as 5,000 units @ £2 or £10,000. This may be controllable by a different manager. As can be seen by comparing the two styles of presentation, there is still a £6,500 favourable variance, but the flexed budget identifies the two separate components of this variance: ž ž £10,000 favourable variance (in terms of cost) because of the reduction in volume from 40,000 to 35,000 units at £2 each. This is offset by £3,500 adverse variance because the 35,000 units produced each cost 10p more than the standard cost. Variance analysis An important part of the feedback process (see Chapter 4) is variance analysis. Variance analysis involves comparing actual performance against plan, investigating the causes of the variance and taking corrective action to ensure that targets are achieved. Variance analysis needs to be carried out for each responsibility centre, product/service and for each line item. The steps involved in variance analysis are: 1 Ascertain the budget and phasing (see Chapter 14) for each period. 2 Report the actual spending. 3 Determine the variance between budget and actual (and determine whether it is either favourable or adverse). 4 Investigate why the variance occurred. 5 Take corrective action. Not only adverse variances need to be investigated. Favourable variances provide a learning opportunity that can be repeated. The questions that need to be asked as part of variance analysis are: ž ž ž ž ž Is the variance significant? Is it early or late in the year? Is it likely to be repeated? Can it be explained (and understood)? Is it controllable? 228 ACCOUNTING FOR MANAGERS Only significant variations need to be investigated. However, what is significant can be interpreted differently by different people. Which is more significant, for example, a 5% variation on £10,000 (£500) or a 25% variation on £1,000 (£250)? The significance of the variation may be either an absolute amount or a percentage. A variance later in the year will be more difficult to correct, so variances should be detected for corrective action as soon as they occur. Similarly, a one-off variance requires a single corrective action, but a variance that will continue requires more drastic action. A variance that can be understood can be corrected, but if the causes of the variance are not understood or are outside the manager’s control, it may be difficult to correct and control in the future. Explanations need to be sought in relation to different types of variance: ž ž ž ž sales variances: price and quantity of product/services sold; material variances: price and quantity of materials used; labour variances: wage rate and efficiency; overhead variances: spending and efficiency. The following case study provides an example of variance analysis. Variance analysis example: Wood’s Furniture Co. Wood’s Furniture has produced a budget versus actual report, which is shown in Table 15.2. The difference between budget and actual is an adverse variance of £15,200. However, the firm’s accountant has produced a flexed budget to assist in carrying out a more meaningful variance analysis. This is shown in Table 15.3. The flexed budget shows a favourable variance of £3,300 compared to the flexed budget. In order to undertake a detailed variance analysis, we need some additional information, which the accountant has produced in Table 15.4. Sales variance The sales variance is used to evaluate the performance of the sales team. There are two sales variances for which the sales department is responsible: ž ž The sales price variance is the difference between the actual price and the standard price for the actual quantity sold. The sales quantity variance is the difference between the budget and actual quantity at the standard margin (i.e. the difference between the budget price and the standard variable costs), because it would be inappropriate to hold sales managers accountable for production efficiencies and inefficiencies. The sales price variance is the difference between the flexed budget and the actual sales revenue, i.e. £45,000. This is calculated in Table 15.5. The variance is favourable because the business has sold 9,000 units at an additional £5 each. The sales quantity variance is the difference between the original budget profit of £70,000 and the flexed budget profit of £50,500 – an unfavourable variance of BUDGETARY CONTROL Table 15.2 Budget v. actual report Budget Sales units Selling price Revenue Variance 10,000 9,000 1,700,000 1,575,000 125,000 30,000 20,000 30,000 26,600 20,000 26,600 3,400 0 3,400 900,000 225,000 300,000 838,750 195,000 283,250 61,250 30,000 16,750 1,505,000 1,390,200 114,800 195,000 125,000 184,800 130,000 10,200 −5,000 70,000 54,800 15,200 Variable costs Materials Plastic Metal Wood Labour Skilled Semi-skilled Variable overhead Total variable costs Actual Contribution Fixed costs Net profit Table 15.3 Flexible budget Original budget Sales units Selling price Revenue Variable costs Materials Plastic Metal Wood Labour Skilled Semi-skilled Variable overhead Total variable costs Contribution Fixed costs Net profit Flexed budget Actual Variance 10,000 9,000 9,000 1,700,000 1,530,000 1,575,000 −45,000 30,000 20,000 30,000 27,000 18,000 27,000 26,600 21,000 26,600 400 −3,000 400 900,000 225,000 300,000 810,000 202,500 270,000 838,750 195,000 283,250 −28,750 7,500 −13,250 1,505,000 1,354,500 1,391,200 −36,700 195,000 125,000 175,500 125,000 183,800 130,000 −8,300 −5,000 70,000 50,500 53,800 −3,300 229 £150.50 £19.50 Total variable costs Contribution Fixed costs Net profit 900,000 225,000 300,000 6 @ £15 3 @ £7.50 6 @ £5 70,000 195,000 125,000 1,505,000 30,000 20,000 30,000 £1,700,000 10,000 2 @ £1.50 1 @ £2 4 @ £0.75 £170 Original budget Variable costs Materials Plastic Metal Wood Labour Skilled Semi-skilled Variable overhead Revenue Sales units Selling price Std cost per unit Table 15.4 Variance report £19.50 £150.50 6 @ £15 3 @ £7.50 6 @ £5 2 @ £1.50 1 @ £2 4 @ £0.75 £170 Std cost per unit 50,500 175,500 125,000 1,354,500 810,000 202,500 270,000 27,000 18,000 27,000 £1,530,000 9,000 Flexed budget 55,000 26,000 55,000 19,000 10,000 38,000 Usage qty £20.42 £154.58 £15.25 £7.50 £5.15 £1.40 £2.10 £0.70 £175 Act cost per unit 53,800 183,800 130,000 1,391,200 838,750 195,000 283,250 26,600 21,000 26,600 £1,575,000 9,000 Actual −3,300 −8,300 −5,000 −36,700 −28,750 7,500 −13,250 400 −3,000 400 −£45,000 Variance BUDGETARY CONTROL 231 Table 15.5 Sales price variance Actual quantity @ actual price 9,000 £175 £1,575,000 Actual quantity @ standard price 9,000 £170 £1,530,000 Favourable price variance £45,000 Table 15.6 Sales quantity variance Budget quantity –Actual quantity 10,000 9,000 @ standard margin Unfavourable quantity variance £19.50 1,000 £19,500 £19,500. This is calculated in Table 15.6. The variance is unfavourable because 1,000 units budgeted have not been sold and the standard margin for each of those units was £19.50 (selling price of £170 less variable costs of £150.50), resulting in a lost contribution of £19,500. It is important to note that the sales mix can affect the quantity and price variances significantly. Therefore, a sales variance analysis should reflect the budget and actual sales mix. We have now accounted for the variance between the original budget and the flexed budget (i.e. due to volume of units sold) and between the revenue in the flexed budget and the actual (i.e. due to the difference in selling price). We now have to look at the variances between the costs in the flexed budget and the actual costs incurred. Cost variances Each cost variance – for materials, labour and overhead – can be split into two types, a price variance and a usage variance. This is because each type of variance may be the responsibility of a different manager. Price variances occur because the cost per unit of resources is higher or lower than the standard cost. Usage variances occur because the actual quantity of labour or materials used is higher or lower than the routing or bill of materials (these concepts were covered in Chapter 9). The relationship between price and usage variances is shown in Figure 15.1. Materials variance The total materials variance is £2,200 unfavourable, as shown in Table 15.7. However, we need to consider the price and usage variances for each type of material, because the reasons for the variance and the corrective action may be different for each. 232 ACCOUNTING FOR MANAGERS Standard quantity × Standard price Actual quantity × Standard price Actual quantity × Actual price Price variance Usage variance Total variance Figure 15.1 Price and usage variances Table 15.7 Materials variance Std cost per unit Original budget Flexed budget Usage qty Act cost per unit Actual Variance 27,000 18,000 19,000 10,000 1.4 2.1 26,600 21,000 400 −3,000 30,000 27,000 38,000 0.7 26,600 400 80,000 72,000 74,200 −2,200 2 @ £1.50 Plastic Metal Wood 1 @ £2 4 @ £0.75 Std cost per unit 2 @ £1.50 30,000 20,000 1 @ £2 4 @ £0.75 Materials usage variance Using the above formula we can calculate the usage variance for each of the three materials. This is shown in Table 15.8. In each case, while holding the (standard) price constant, there has been a higher than expected usage of materials. This is an efficiency variance, which may be the result of: ž ž ž poor productivity; out-of-date bill of materials; poor quality materials. Materials price variance Using the formula, the price variance for each of the three materials is shown in Table 15.9. While holding the (actual) quantity constant, we can see the effect of price fluctuations. Both plastic and wood have been bought below the standard price, while metal has cost more than standard. These variances may be the result of: ž ž changes in supplier prices not yet reflected in the bill of materials; poor purchasing. In total, the materials variance is £2,200. We can see that of the three materials, metal contributes the greatest variance – an adverse £3,000 (£2,000 usage and BUDGETARY CONTROL 233 Table 15.8 Materials usage variance Standard quantity Standard price Actual quantity Standard price Plastic 9,000 × 2 @ £1.50 27,000 19,000 @ £1.50 28,500 −1,500 Adverse variance Standard quantity Standard price Actual quantity Standard price Metal 9,000 × 1 @ £2.00 18,000 10,000 @ £2.00 20,000 −2,000 Adverse variance Standard quantity Standard price Actual quantity Standard price Adverse variance Total usage variance – adverse Wood 9,000 × 4 @ £0.75 27,000 38,000 @ £0.75 28,500 −1,500 −5,000 £1,000 price), which needs to be investigated as a matter of priority – while there may be a trade-off between the price and usage variances for plastic and wood, as sometimes quality and price can conflict with each other. The total materials variance is shown in Table 15.10. Similarly, we need to analyse the usage and price variances for both skilled and semi-skilled labour. Labour variance The total labour variance is an unfavourable £21,250, as shown in Table 15.11. Similarly, we need to look at the usage variance (which is a productivity or efficiency measure) and the price variance (which is a wage rate variance) for each of the two types of labour. Labour efficiency variance Using the same formula, the efficiency variance for labour is shown in Table 15.12. The adverse variance is a result of 1,000 additional hours being worked for skilled labour and 1,000 hours less being worked by unskilled labour. This may have been the result of: 234 ACCOUNTING FOR MANAGERS Table 15.9 Materials price variance Actual quantity Standard price Plastic 19,000 @ £1.50 28,500 Actual quantity Actual price 19,000 @ £1.40 26,600 Favourable variance 1,900 Actual quantity Standard price Metal 10,000 @ £2.00 20,000 Actual quantity Actual price 10,000 @ £2.10 21,000 −1,000 Adverse variance Actual quantity Standard price Wood 38,000 @ £0.75 28,500 Actual quantity Actual price 38,000 @ £0.70 26,600 Favourable variance Total price variance – favourable 1,900 2,800 Table 15.10 Total materials variance Usage – adverse Price – favourable −5,000 2,800 Total – adverse −2,200 Plastic Metal Wood 400 −3,000 400 −2,200 ž ž ž poor-quality material that required greater skill to work; the lack of unskilled labour that was replaced by skilled labour; poor production planning. Labour rate variance The labour rate variance is shown in Table 15.13. Skilled labour costs an additional 25p for each hour worked, while unskilled labour was paid the standard rate. This may be the result of: