Budget and variance analysis differ between sales and manufacturing due to the unique nature of each function within a business.
Here are some key points of the differences:
- Nature of operations
- Sales primarily deal with external market conditions, customer demand, and pricing strategies. Sales budgets are typically focused on revenue targets, unit sales, and market share, which are influenced by factors like market trends, customer behaviour, and competitive actions.
- Manufacturing focuses on the internal processes of producing goods. Manufacturing budgets are more concerned with production costs, efficiency, and output levels. Key factors include raw material costs, labour, overhead, and production schedules.
- Components of the budget
- Sales budget: Includes projected sales volume, sales revenue, pricing strategies, discounts, and possibly commissions. The budget is often influenced by market research, historical sales data, and marketing initiatives.
- Manufacturing budget: Comprises direct material costs, direct labour costs, manufacturing overhead, and production volumes. It often involves detailed planning around production capacity, inventory levels, and supply chain management.
- Sources of variance
- Sales variance:
- Price variance: Difference between actual selling price and budgeted selling price.
- Volume variance: Difference between actual units sold and budgeted units.
- Market share variance: Changes in a company’s market position compared to budget expectations.
- Manufacturing variance:
- Material variance: Differences in the cost or usage of materials compared to the budget.
- Labour variance: Differences in labour costs, often split into rate and efficiency variances.
- Overhead variance: Variances in fixed and variable manufacturing overhead costs.
- Sales variance:
- Responsiveness to external factors
- Sales performance is highly sensitive to external factors like economic conditions, customer preferences, and competition. Variance analysis in sales often involves examining why customer demand differed from expectations, which can be challenging to control directly.
- Manufacturing variances are more influenced by internal factors, such as production efficiency, cost management, and resource utilization. These are more directly controllable by management through operational improvements and cost controls.
- Timing and frequency
- Sales performance is often reviewed on a shorter-term basis (monthly, quarterly) due to its dynamic nature and the need for quick adjustments to strategies.
- Manufacturing budgets and variances are typically reviewed less frequently (quarterly, annually), focusing on long-term efficiency improvements and cost management.
- Impact on financial performance
- Sales variance directly affects the top line (revenue) and can have an immediate impact on profitability. Poor sales performance can signal broader strategic issues.
- Manufacturing variances impact the cost of goods sold (COGS) and gross margin. Over time, persistent manufacturing variances can affect the bottom line by increasing costs or reducing production efficiency.
In summary, while both sales and manufacturing budget and variance analysis are critical for overall business performance, they differ significantly in focus, methodology, and the factors influencing them. Sales is outward-facing, dealing with market dynamics, while manufacturing is inward-facing, focused on process efficiency and cost control.
In this topic, we are going to explore the features of manufacturing budgeting.
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.
Reading
You can read more about responsibility accounting here.
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.
Reading
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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:
+ Forecasted unit sales
+ Desired finished goods ending balance
= Total production required
- Beginning finished goods
= Products to be manufactured
Production budget for 202X | |
---|---|
Forecast unit sales | 1,500 |
Add desired ending inventory | 900 |
Less beginning finished goods | -800 |
Units to be manufactured | 1,600 |
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:
+ Raw materials required for production
+ Desired ending materials balance
= Total raw materials required
- Beginning raw materials
= Raw materials to be purchased (quantity)
X Costs per Raw material unit
= total Raw materials costs to purchase (value)
Direct material budget for 202X | |
---|---|
Units to be manufactured for Product A | 1,600 |
Resin per unit (kg) | 2 |
Total resin needed (kg) | 3,200 |
Add desired ending materials (kg) | 2,000 |
Total resin required (kg) | 5,200 |
Less beginning materials (kg) | 1,600 |
Total resin to be purchased (kg) | 3,600 |
Resin cost per kilogram | $0.50 |
Total resin costs to purchase | $1,800 |
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.
Direct labour budget for 202X | |
---|---|
Units to be manufactured for Product A | 1,600 |
Direct labour hours per unit | 1.5 |
Total hours required (1,600*1.5) | 2,400 |
Labour rate per hour | $34.00 |
Total labour costs (2,400 hours * $34) | $ 81,600 |
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.
Manufacturing overhead budget for 202X | |
---|---|
Indirect materials such as sandpaper | $ 16,000 |
Indirect labour (such as Supervisor’s salary) | $ 68,000 |
Indirect labour (such as cleaning costs) | $ 29,000 |
Depreciation on factory machinery | $ 14,000 |
Factory rent | $ 56,000 |
Factory insurance | $1,500 |
Other Factory running costs | $ 32,800 |
Total manufacturing overhead | $ 217,300 |
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.
Example
A factory’s annual rent is $100,000, over which time 10,000 units are produced. Even though the factory manufactures 20,000 units, the rent will stay at $100,000.
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.
Example
Raw materials are budgeted at $20,000 to produce 5,000 units. If 10,000 units are produced, these costs will escalate to $40,000. Note, however, that the cost of the unit remains the same, e.g. $20,000/5,000 = $4; $40,000/10,000 = $4. Minor changes may occur where large volumes of raw materials can be purchased at a discount.
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:
Example
Total costs = Fixed costs + (variable costs per activity unit × total activity units)
Variable cost per activity = (Total variable costs of production) / (Number of units of production)
Example
Fixed costs of production are $80,000; the number of units produced is 10,000; and variable costs are $6.50 per unit:
Total costs: $80,000+($6.50×10,000) = $145,000
The same equation can be used to include manufacturing costs.
Fixed costs are $80,000; direct materials = $20; direct labour = $15; manufacturing variable overhead costs are $6.50 per unit; number of units produced is 10,000:
Total costs: $80,000+($20x10,000 + $15×10,000 + $6.5x10,000) = $495,000
Since direct materials and direct labour costs are variable costs, total variable costs = direct material + direct labour + variable manufacturing overhead costs = $20 +$15 +$6.5 = $41.5 per unit.
If 15,000 units were produced:
Total costs: $80,000+($41.50×15,000) = $702,500
This will result in an increase of $207,500. This amount represents the total variable costs for producing the extra 5,000 units, e.g.: 5,000×$41.50 = $207,500.
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
1. Materials, labour and variable overhead variances | 2. Fixed overhead variance | 3. Budget variances |
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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.
Example
Happy Manufacturing Pty Ltd set a December 202X purchases budget as 20,000 units at $2 per unit.
Actual results for December 202X:
The business purchased 22,000 units at $2.2 for each unit.
However, Happy Manufacturing Pty Ltd cannot expect that December purchases will be fixed at 20,000 units. The number of units can be increased due to demand or special orders, etc. Therefore, Happy Manufacturing should flexibly adopt 22,000 actual units purchase quantity into $2 budgeted cots. In this case, the difference between the actual result and the flexible budget is only from price differences ($2.2 actual cost, but the budgeted cost was $2).
The same quantity of 22,000 units was applied to both. As the business had to pay a higher rate than its budgeted rate, the price variance would be unfavourable.
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:
Rule of thumb
The amount increases when it shifts to the right, then it will result in Favourable (F). Conversely, if the amount decreases, then it will result in Unfavourable (UF). This applies to all variance analyses except for sales.
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:
Sales Information | Product A | Product B |
---|---|---|
Actual selling price | $5.80 | $8.40 |
Budgeted selling price | $5.00 | $9.00 |
Actual units sold | 10,000 | 24,000 |
Budgeted quantity | 12,000 | 19,000 |
Sales price variance = (Actual selling price - Budgeted selling price) x Actual units sold | F or UF | |
---|---|---|
Product A $58,000-50,000 | $8,000.00 | Favourable |
Product B $201,600-216,000 | ($14,400.00) | Unfavourable |
Sales price variance for A & B | $6,400.00 | Unfavourable |
Sales volume variance = (Actual quantity - Budgeted quantity) x Budgeted selling price | F or UF | |
---|---|---|
Product A $50,000-60,000 | ($10,000.00) | Unfavourable |
Product B $21,6000-171,000 | $45,000.00 | Unfavourable |
Sales volume variance | $35,000.00 | Favourable |
Total Sales Variance (product A + B) | $28,600.00 | Favourable |
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.
Standard quantity | 25,000 |
Standard price | $7.00 |
Actual quantity | 20,000 |
Actual price | $9.50 |
Total materials variance | F or UF | |
---|---|---|
Standard quantity x Standard price | $175,000.00 | |
Actual quantity x Actual price | $190,000.00 | |
Total variance | ($15,000.00) | Unfavourable |
Material price per unit variance | $2.50 |
Purchase price variance | F or UF | |
---|---|---|
(Actual price - Standard price) x Actual quantity | ($50,000.00) | Unfavourable |
Material volume variance | F or UF | |
---|---|---|
(Actual quantity - Standard quantity) x Standard price | $35,000.00 | Favourable |
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.
Standard quantity | 30,000 |
Standard price | $10.00 |
Actual quantity | 43,000 |
Actual price | $9.50 |
Total labour variance | F or UF | |
---|---|---|
Standard quantity x Standard price | $300,000.00 | |
Actual quantity x Actual price | $408,500.00 | |
Total labour variance | ($108,500.00) | Unfavourable |
Labour price per unit variance | $1.00 |
Labour spending (price) variance | F or UF | |
---|---|---|
(Standard price - Actual price) x Actual quantity | $21,500.00 | Favourable |
Labour volume variance | F or UF | |
---|---|---|
(Actual quantity - Standard quantity) x Standard price | ($130,000.00) | Unfavourable |
Variable Overheads Variances
Let’s assume that Happy Manufacturing Pty Ltd's variable overhead information is as follows:
Actual variable overhead | $30,000 |
Actual hours | 3,100 |
Variable overhead rate (Standard) | $5.00 |
Standard hours | 3,700 |
Variable overhead price variance | F or UF | |
---|---|---|
Actual variable overhead | $30,000.00 | |
Budgeted adjusted actual hours | $15,500.00 | |
Price variance | $14,500.00 | Unfavourable |
Variable overhead efficiency variance | F or UF | |
---|---|---|
Budgeted adjusted actual hours (Actual unit usage - standard unit usage) | $15,500.00 | |
Budgeted adjusted to standard hours | $18,500.00 | |
Efficiency variance | ($3,000.00) | Favourable |
Total Variable Overhead Variance | ($11,500.00) | Unfavourable |
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.
Actual fixed overhead | 560,000 |
Fixed overhead rate | $22.00 |
Budgeted production hours (2 locations) | 11,000 |
Standard production hours (2 locations) | 9,900 |
Actual production hours (2 locations) | 12,100 |
Fixed overhead budget variance | F or UF | |
---|---|---|
Actual fixed overhead | $560,000.00 | |
Budgeted fixed overhead | $435,600.00 | |
Budget variance | $124,400.00 | Unfavourable |
Volume variance | F or UF | |
---|---|---|
Budgeted fixed overhead | $484,000.00 | |
Standard fixed overhead | $435,600.00 | |
Volume variance | $48,400.00 | Unfavourable |
Fixed overhead efficiency variance at actual to standard capacity | F or UF | |
---|---|---|
(Standard hours vs Actual hours) x Standard fixed overhead rate (9,900 – 12,100) x 2 locations x $22 |
($88,000.00) | Unfavourable |
Fixed overhead efficiency variance at actual to budget capacity | F or UF | |
---|---|---|
(Actual hours - Budgeted hours) x Standard fixed overhead rate (12,100 – 11,000) x 2 locations x $22 |
$44,000.00 | Unfavourable |
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:
- Prepare Sales budget and spending, volume variance and total sales variance.
- Prepare Material budget and spending, volume variance and total material variance.
- Prepare Labour budget and spending, volume variance and total labour variance.
- Prepare Variable overhead budget and spending, efficiency variance and total variable overhead variance.
- Prepare Fixed overhead budget and spending, volume variance and total fixed overhead variance.
Sales Information | Computers |
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Actual selling price | $520 |
Budgeted selling price | $500 |
Actual units sold | 7,000 |
Budgeted quantity | 7,600 |
Material Information | |
---|---|
Standard quantity | 45,000 |
Standard price | $25.00 |
Actual quantity | 37,000 |
Actual price | $26.50 |
Labour Information | |
---|---|
Standard quantity | 80,000 |
Standard price | $38.00 |
Actual quantity | 73,000 |
Actual price | $40.00 |
Variable Overhead Information | |
---|---|
Actual variable overhead | $78,000 |
Actual hours | 13,000 |
Variable overhead rate (Standard) | $4.00 |
Standard hours | 11,900 |
Fixed Overhead Information | |
---|---|
Actual fixed overhead | $90,000 |
Fixed overhead rate | $12.00 |
Budgeted production hours | 7,400 |
Actual production hours | 8,200 |
- Sales Variance:
Sales price variance = (Actual selling price - Budgeted selling price) x Actual units sold F or UF Sales price variance $140,000.00 Favourable Sales volume variance = (Actual quantity - Budgeted quantity) x Budgeted selling price F or UF Sales volume variance ($300,000.00) Unfavourable Total Sales Variance (Price + Volume) ($160,000.00) Unfavourable -
Materials variance
Purchase price variance F or UF (Actual price - Standard price) x Actual quantity ($55,500.00) Unfavourable Material quantity (volume) variance F or UF (Actual quantity - Standard quantity) x Standard price $200,000.00 Favourable Total materials variance F or UF Standard quantity x Standard price $1,125,000.00 N/A Actual quantity x Actual price $980,500.00 N/A Total variance $144,500.00 Favourable -
Labour Variance
Labour price variance F or UF (Standard price - Actual price) x Actual quantity ($146,000.00) Unfavourable Labour quantity/volume variance F or UF (Actual quantity - Standard quantity) x Standard price $266,000.00 Unfavourable Total labour variance F or UF Standard quantity x Standard price $3,040,000.00 N/A Actual quantity x Actual price $2,920,000.00 N/A Total variance $120,000.00 Favourable -
Variable Overhead Variance
Variable overhead price variance F or UF Actual variable overhead $78,000.00 N/A Budgeted adjusted actual hours $52,000.00 N/A Price variance ($26,000.00) Unfavourable Variable overhead efficiency variance F or UF Budgeted adjusted actual hours (Actual unit usage - standard unit usage) $52,000.00 N/A Budgeted adjusted to standard hours $47,600.00 N/A Efficiency variance ($4,400.00) Unfavourable Total Variance ($30,400.00) Unfavourable -
Fixed Overhead Variance
Fixed overhead spending variance F or UF Actual fixed overhead $90,000.00 N/A Budgeted fixed overhead $98,400.00 N/A Spending/price variance $8,400.00 Favourable Fixed overhead efficiency variance (Volume variance) F or UF Budgeted fixed overhead to actual hours $98,400.00 N/A Standard fixed overhead $88,800.00 N/A Volume variance ($9,600.00) Unfavourable Total variance ($1,200.00) Unfavourable