Manufacturing budget and variance analysis

Responsibility accounting entails the separate reporting of revenues and expenses for each responsibility centre within a business, thereby enhancing operational management. For instance, the cost of rent can be allocated to the individual who negotiates and signs the lease, while the cost of an employee's salary falls under the purview of that person's direct manager. This concept also applies to product costs, as each component part has a standard cost listed in the item master and bill of materials, which the purchasing manager is responsible for procuring at the correct price. Similarly, scrap costs incurred at a machine are the responsibility of the shift manager.

Responsibility Centers

A responsibility centre is a functional entity within a business that has its own goals and objectives, dedicated staff, policies and procedures, and financial reports. It is used to give managers specific responsibility for revenues generated, expenses incurred, and/or funds invested. This allows the senior managers of a company to trace all financial activities and results of a business back to specific employees. Doing so preserves accountability and may also be used to calculate bonus payments for employees.

There may be many responsibility centres in a business, but never less than one such centre. Thus, a responsibility centre is usually a subset of a business. These centres are usually stated on a firm’s organisation chart. The use of multiple responsibility centres requires a certain amount of corporate infrastructure to develop each centre, track its results, and manage expectations with the various managers.

Cost Centre

A cost centre is specifically accountable for incurring certain costs. An example of a cost centre is the janitorial department, where the manager aims to minimize expenses while maintaining a required level of service.

Revenue Centre

A revenue centre is exclusively responsible for generating sales. A typical example is the sales department, where the primary focus of the sales manager is to increase sales.

Profit Centre

A profit centre is accountable for both revenues and expenses, which ultimately affect profits and losses. A common example of a profit centre is a product line managed by a product manager.

Investment Centre

An investment centre, on the other hand, is responsible not only for generating profits but also for the return on invested capital within the group's operations. A typical investment centre is a subsidiary overseen by the subsidiary's president.

Sales Budget

Any business needs some structure to its sales planning, which calls for a sales budget.

A sales budget is focused on selling specific unit quantities at targeted price points; this information can be used to estimate the expenditures needed to achieve these goals. With a budget in hand, you can plan for sales expenditures and compensation changes - all with the goal of maximising your revenue over the planning period.

Production Budget

The production budget determines the number of units that need to be manufactured.

It is based on a combination of the sales forecast and the desired level of finished goods inventory, which often includes safety stock to accommodate unexpected demand increases. The production budget includes a direct material budget, direct labour budget and factory/manufacturing overhead budget.

Calculation of the Production Budget

The production budget is typically presented in either a monthly or quarterly format. The basic calculation used by the production budget is:

Direct Materials Budget

The direct materials budget determines the quantity of materials that need to be purchased within each time period to meet the production budget's requirements. It is usually presented on a monthly or quarterly basis within the annual budget. In a business focused on selling products, this budget often represents a significant portion of the company's total costs and should be prepared with great precision.

Inaccurate budgeting could lead to misleading figures regarding the cash needed for material purchases.

How do we calculate the direct/raw materials budget?

The basic calculation used by the direct materials budget is as follows:

Units to be manufactured for product:

X Costs per Raw material unit

Direct Labour Budget

The direct labour budget estimates the number of labour hours required to produce the units specified in the production budget. A more detailed direct labour budget will not only calculate the total hours needed but also break this information down by labour category. This budget is useful for forecasting the number of employees needed in the manufacturing area during the budget period, helping management plan for hiring, schedule overtime, and anticipate layoffs. Although it provides aggregate information, it is not typically used for making specific hiring and layoff decisions.

Manufacturing/Factory Overhead Budget

The manufacturing overhead budget encompasses all manufacturing costs except for direct materials and direct labour. The total costs in this budget are converted into a per-unit overhead allocation, which is used to determine the cost of ending finished goods inventory and is subsequently reflected on the budgeted balance sheet. This budget is crucial among the departmental budget models, as it may represent a substantial portion of a company's overall expenditures.

A flexible budget adapts to variations in actual revenue levels. After the completion of an accounting period, actual revenues or other activity measures are input into the flexible budget, which then produces a budget tailored to these inputs. This adjusted budget is subsequently compared to actual expenses for control and analysis.

A flexible budget adapts to the changing needs of a company.

How to construct a flexible budget?

To construct a flexible budget, follow these steps:

Click on the steps to read more about each.

Fixed and Variable Costs

In order to prepare flexible budgets, fixed, variable and semi-variable costs must be categorised. Fixed costs will stay constant in total during the budget period even if the level of activity changes. These expenses include building insurance, rent and depreciation. Variable costs will change in accordance with changes in activity levels, e.g. production, sales, commission and raw materials.

Fixed Costs

Fixed costs are those that remain constant during the budget period and are independent of activity changes, particularly in the short term.

Variable Costs

Variable costs are those costs that change in accordance with changes in activity levels, such as sales or production. Variable costs include raw materials, direct labour and commission.

Semi-variable costs are those that include a fixed component and a variable component. An example of a semi-variable cost is telephone costs, e.g. the fixed charge for the phone connection or line rental remains the same, but the total cost for calls will vary.

When all costs are categorised into fixed and variable, a formula can be used to determine the total costs and variable costs per unit, as follows:

Variance analysis, as already mentioned in Topic 2, involves examining the differences between planned and actual figures. The total of all variances provides insight into overall performance, indicating whether a company has exceeded or fallen short of expectations for a given reporting period. Companies evaluate performance by comparing actual costs to industry-standard costs for each item.

For instance, if the actual cost of raw materials is lower than the standard cost, assuming the same volume of materials, this results in a favourable price variance (indicating cost savings). Conversely, if the standard quantity was 10,000 pieces of material but 15,000 pieces were used in production, this represents an unfavourable quantity variance due to the higher usage of materials than originally anticipated.

Types of Variances

Price Variance (also known as Spending Variance)

The price variance is from the actual price received (Sales) or paid (Purchases) against the budgeted/standard price (sales revenue or costs). The presence of a variance tells management when to investigate situations where purchase prices appear to be too high. This is a key cost management tool.

When it comes to purchases, to calculate price variance, subtract the standard cost of a purchased item from its actual purchase price, then multiply by the number of units purchased. The formula for price variance is:

A favourable price variance occurs if the actual cost is lower than the standard cost. Conversely, an unfavourable price variance occurs if the actual cost is higher than the standard cost.

A flexible budget can now be integrated. A flexible budget adapts to changes in a business’s activity or volume levels, adjusting continuously with variations in costs. In this context, it is unrealistic to assume that the business will consistently purchase 10,000 units. Therefore, instead of keeping the $2 budgeted rate fixed, we will adjust only the purchase level. The variance in purchases arises from changes in both price and volume. It is necessary to separate this variance into distinct components for price and volume.

Quantity Variance

A quantity variance refers to the difference between the actual usage of a resource and its expected usage. For instance, if the standard requirement to construct a widget is 10 kilograms of iron, but 11 kilograms are used, there is a quantity variance of one kilogram. This variance typically pertains to direct materials in product manufacturing but can also apply to machine hours, square footage, and other resources.

Example

Now, compare the flexible budget with budgeted data. In this case, the difference between flexible budget and standard data is only from volume differences (22,000 units and 20,000 units). The same budget rate of $2 is applied to each. As the business had to purchase more units than its budgeted units, it would be unfavourable.

Now, let’s combine price and volume variances:

For example:

$48400 Actual results - $44,000 flexible budget: the amount has been decreased when shifts to the right =; therefore, the result is Unfavourable (UF).

The above rule of thumb applies to all expense variance analyses (not Sales).

Sales Variances

Let’s assume that Happy Manufacturing Pty Ltd sells two (2) types of products. Sales information is as follows:

When calculating variances, you may encounter both negative and positive amounts, depending on the direction of the subtraction. For instance, if you subtract the actual amount of $58,000 from the flexible budget amount of $50,000, you will obtain a negative variance. However, this negative amount does not necessarily indicate an unfavourable outcome. In this scenario, it is considered favourable, as the actual revenue (sales) exceeds the budgeted amount. Therefore, the determination of whether a variance is favourable (F) or unfavourable (UF) should not be based solely on the negative or positive outcome of the calculation.

Materials Variances

Let’s assume that Happy Manufacturing Pty Ltd's material information is as follows. The following information is only for product A. Calculate material variance for product A only.

Labour Variances

Let’s assume that Happy Manufacturing Pty Ltd's labour information is as follows. The following information is only for product A. Please calculate labour variance for product A only.

Variable Overheads Variances

Let’s assume that Happy Manufacturing Pty Ltd's variable overhead information is as follows:

Fixed Overhead Variances

Let’s assume that Happy Manufacturing Pty Ltd's fixed overhead information is as follows. The difference between budgeted production hours and standard production hours is that in the year the business made the budget, all capacity was based on 11,000 hours (perhaps due to special orders from customers), but normally, standard production hours are 9,900 hours.

Cause of Variances

The purpose of calculating variances and presenting performance reports is a control function of the budgeting process and is performed to identify and investigate any deviations. Actual figures should be checked initially to ensure there are no accounting errors.

Variances in the following variables' costs can be linked to the purchasing, production and human resource departments. A materials price variance is the responsibility of the purchasing manager.

We have already talked about the possible causes of variances in Topic 4. The context may be different, but with professional communication skills, you may ease its impact on the business and its stakeholders.

Calculate the following variances related to the scenario provided:

• spending/price variance
• volume/quantity variance
• efficiency variance

Delightful Pty Ltd manufactures computers and has provided you with the following information:

1. Prepare Sales budget and spending, volume variance and total sales variance.
2. Prepare Material budget and spending, volume variance and total material variance.
3. Prepare Labour budget and spending, volume variance and total labour variance.
4. Prepare Variable overhead budget and spending, efficiency variance and total variable overhead variance.
5. Prepare Fixed overhead budget and spending, volume variance and total fixed overhead variance.