Contents: 7 sections
Syllabus points
- Compare actual results with the budget and calculate variances.
- Prepare a flexed budget and explain why flexing is necessary.
- Explain favourable and adverse variances and suggest causes.
- Explain the behavioural effects of budgetary control.
What control means
Budgetary control is the comparison of actual results with the budget, the investigation of the differences, and action taken as a result. The comparison is worthless without the last part: a variance report nobody acts on is an expense with no benefit.
A variance is the difference between budget and actual.
- Favourable (F) means profit is higher than budgeted: revenue above budget, or a cost below it.
- Adverse (A), sometimes called unfavourable, means profit is lower.
The words describe the effect on profit, not the direction of the number. A cost above budget is adverse; revenue above budget is favourable. Both are numbers that went up.
Flexing the budget
Comparing an actual result at 11 000 units against a budget set for 10 000 units compares two different things. The variable costs should have been higher, because more was made. A flexed budget restates the original budget at the activity level actually achieved, so that only genuine differences remain.
Flexing follows cost behaviour: variable costs are scaled to the actual activity, fixed costs are not.
Budget for 10 000 units: materials $60 000, labour $40 000, variable overheads $20 000, fixed overheads $50 000. Actual output was 11 000 units, costing materials $67 500, labour $43 000, variable overheads $22 500 and fixed overheads $51 000.
| Original budget, 10 000 | Flexed budget, 11 000 | Actual, 11 000 | Variance | |
|---|---|---|---|---|
| Materials | 60 000 | 66 000 | 67 500 | 1 500 A |
| Labour | 40 000 | 44 000 | 43 000 | 1 000 F |
| Variable overheads | 20 000 | 22 000 | 22 500 | 500 A |
| Fixed overheads | 50 000 | 50 000 | 51 000 | 1 000 A |
| Total | 170 000 | 182 000 | 184 000 | 2 000 A |
Against the original budget the total looks $14 000 adverse, which would be a misleading and demoralising report. Against the flexed budget the real overspend is $2 000, and the labour variance turns out to be favourable, which the unflexed comparison hid completely.
Note the fixed overhead row: it stays at $50 000 in the flexed column. Scaling fixed costs up with output is the most common flexing error, and it makes every cost look controlled when it is not.
Reading the variances
Suggest causes that fit the variance, and prefer causes that connect two variances together.
Materials adverse may come from a price rise, a change of supplier, buying in smaller quantities and losing discounts, or waste and poor-quality material.
Labour favourable may come from a lower grade of worker, an unfilled vacancy, or better efficiency.
Put those two together and a single explanation covers both: cheaper, lower-grade material was harder to work with, so more was wasted, while cheaper labour was used. That is a much stronger answer than two unrelated guesses, and it is what the examiner is looking for.
Interdependence is the general point. Variances are rarely independent, and a favourable one is often bought with an adverse one somewhere else. A favourable purchase price variance obtained by buying inferior material shows up as adverse usage, adverse labour efficiency and, eventually, lost customers.
Which variances to investigate
Investigating everything is not worth the cost. Businesses use management by exception: investigate only variances that are significant.
Judge significance by size in money, by percentage of the budget, by whether the variance is persistent rather than a one-off, and by whether it is controllable by anyone. A large adverse variance caused by a worldwide rise in a commodity price is worth knowing about and not worth investigating, because no manager could have prevented it.
Behavioural effects
This carries as many marks as the arithmetic, and it is answered less well.
- A budget set too tight is dismissed as unachievable, and managers stop trying.
- A budget set too loose wastes capacity, and managers may spend up to it to protect next year's allowance.
- Participation in setting the budget improves commitment, but it invites budgetary slack, where managers build in easy targets to be sure of meeting them.
- Holding a manager responsible for uncontrollable costs is resented and damages motivation.
- Budgets can encourage short-term thinking, cutting training or maintenance to meet a figure this year at next year's expense.
- Departmental conflict arises when one department's favourable variance is another's adverse one.
The practical conclusion is that a budget should be demanding but attainable, set with the participation of those responsible, and used to hold managers to account only for what they can actually control.
Common mistakes
- Comparing actual results with the original budget when output differed.
- Flexing the fixed costs.
- Labelling a cost above budget as favourable because the number rose.
- Giving a cause that does not fit the direction of the variance.
- Treating each variance in isolation when two of them clearly share a cause.
- Recommending that every variance be investigated.
- Answering a behavioural question with more arithmetic.