Chapters 10 & 11 Notes
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Companies prepare cost budgets as part of their
These budgets assume a
given level of activity (e.g., financial statements
assume that 10,000 units will be produced and
Budgets that are tied to a specific level of
activity are referred to as Static Budgets.
Firms will compare their budgeted costs to their
actual costs in order to control costs, evaluate
employee performance, and evaluate the budgeting process. This comparison is done
by computing Budget Variances. A variance is the dollar difference between a budgeted
cost and the actual cost.
Unfortunately, the actual activity level is very likely to be
different from the budgeted activity level (e.g., firm actually produced 9,000 units).
When dealing with Variable Costs, in order to have
a meaningful comparison, the budgeted and actual
costs must relate to the same activity level (e.g.,
produce 9,000 units to your labor cost budget (that
is based on 10,000 units)].
Consider the following
analogous situation, assume that your employer
asks you to: (i) produce a spectacular commercial,
and (ii) reserve a 30-second spot during the Super
Bowl in which you will showcase the commercial.
You are given a $10 million budget for this project. Instead of producing and running the
commercial, you contract with PBS to take over the sponsorship of Masterpiece Theatre
from Exxon Mobil for $9 million.
Coming $1 million under budget is not very impressive,
when the activity that you did (Masterpiece Theatre) is significantly different than the
activity assumed in the budget (Super Bowl).
In order to have a valid comparison for Variable Costs, we use Flexible Budgets when
computing Budget Variances. A Flexible Budget is a cost function that produces a
different budgeted cost for different activity levels (e.g., Flexible Budget says that your
labor cost is equal to $30 for each unit produced).
Using a Flexible Budget, you can
compare: (i) the actual cost, with (ii) a budgeted cost for the work that you actually did
(actual activity level
Budgets and Variances
As noted above, Budget Variances are important tools used in evaluating your
When comparing actual results to a Flexible Budget, there can be two
different reasons for a Budget Variance. For example, if your Direct Labor Costs on a
particular project exceeded the amount budgeted for that project, it can be due to: (i)