Question

Discuss why the amount actually spent on direct labor could differ from that was budgeted in the planning budget?

What assumption is implicitly made about cost behavior when all of the items in a budget are adjusted in proportion to a change in activity?

Explain in detail why the spending variance takes the difference between the Flexible budget and Actual results instead of Planning budget and Actual results.

Answer 1

. 1. The amount actually spent on direct labor could differ from that was budgeted in the planning budget:

The difference can be because of following reasons:

• The activity level or total production is different than budgeted
• The actual labor rate is different than budgeted
• The actual labor hour used is different than the budgeted due to higher or lower labor efficiency

. 2. assumption implicitly made about cost behavior when all of the items in a budget are adjusted in proportion to a change in activity:

The assumptionimplcitely made is that there is no fixed cost. All costs are variable and varies directly with the level of activity.

. 3. why the spending variance takes the difference between the Flexible budget and Actual results instead of Planning budget and Actual results:

The variable costs like materials , direct labor etc vary directly with the level of activity. If the actual level of activity is higher than the planning budgeted level of activity, the actual variable costs will be higher, even though budgeted standards of material price and quantity or labor rate and efficiencies are achieved. But the variances when compared to planning budget will show unfavourable variance.

Similarly if the level of activity is lower than the planning budget, the variance will be favourable without any improvement in labor efficiency or rate and without favourable material price or quantity.

Thus, if spending variances are reported based on difference between actual and planning budget, the variance report will not give correct information .

Hence a flexible budget is prepared based on actual level of activity and the spending variances are reported based on difference between actual cost and flexible budget.

For example:

Material cost as per planning budget =$10,000

Activity level as per planning budget =1000 units of production

Budgeted material cost per unit=10000/1000=$10

If the actual activity level or production is 1200 unit

Actual material cost=$11,400

If we report variances based on planning budget, it will show (11400-10000)=$1,400 Unfavourable variance since the actual cost is higher than the planning budget.

But the actual material cost per unit was $(11400/1200)= $       9.50

Hence , the correct variance should be favourable

The correct information can be obtained if the actual cost is compared with the cost as per flexible budget.

Material cost per unit as per planning budget=$10

Material cost as per flexible budget =$10*1200=$12000

Actual cost =$11400

Material cost variance=(12000-11400)=$600 (Favourable)