Question

A flexible budget provides estimates of what revenues and costs “should be”. If we are trying to compare actual costs to “budgeted” costs, why is comparing actual costs to the flexible budget better than comparing them to the static/planning budget?

2)Explain why a business could have a favorable material price variance but an unfavorable material quantity variance. Don’t just explain the math. Provide a real world scenario.

3Simply looking at overall spending variances tells us what’s different. Why is it important for a business to go deeper and examine specific variances like material quantity and prices variances or labor rate and efficiency variances?

Answer 1

1) A flexible budget is a variation of static budget for actual level of activity. A Flexible budget is more meaningful comparison of actual results with budget since the same level of activity as actual level of activity is used in budgeting. It helps in like to like comparison and reasons for variances can be investigated for better control and taking corrective actions. A comparison of actual results to static budget accounts for volume variance and hence this variance does not help management much in analysing the price and efficiency component of variance. A flexible budget is a right kind of tool for cost management that helps in cost control and cost reduction.

2) A favorable material price variance is due to better actual price of material compared to standard price of material. An unfavorable quantity variance is due to higher actual usage of quantity of input compared to standard quantity of input allowed for actual production. A favorable material price variance can result in lower quality of material being purchased and hence it will compromise on usage since lower quality material can lead to production losses, quality issues, more defects in output, etc. For example: a new supplier introduced can supply material at lower prices by supplying inferior material and when that material is used in production it can lead to unfavorable material quantity variance.

3) An overall variance gives the total cost variance that is difference between standard cost for actual output and actual cost incurred. A total cost variance can be segregated into price or rate and quantity or efficiency component. It helps in understanding which department can be fixed responsibility and take right corrective action in bringing the cost under control. It helps in process improvement and doing investigation of variance based on management by exception rule. In Management by exception rule variances are investigated based on certain threshold so that benefits exceed the cost of investigation.