Difficulty: Intermediate | Prerequisites: Familiarity with basic financial statements, cost behaviour (fixed vs variable costs), and contribution margin.
Budgeting and variance analysis sit at the heart of managerial accounting. Budgets translate a company's operational plans into financial targets, while variance analysis compares those targets against what actually happened and asks why the gap exists. Together, they give managers a feedback loop: plan, execute, measure, adjust. If you can work a flexible budget and decompose a variance into price and quantity components, you have the toolkit for most of the control-oriented questions in this course.
Budgets set financial expectations for a period. A static budget uses the originally planned volume; a flexible budget recalculates costs at the volume that actually occurred. Variance analysis splits any budget-to-actual gap into a price (rate) component and a quantity (efficiency) component, so managers know whether the problem was paying too much or using too much. Cash budgets layer in the timing of when money actually moves.
Static budget
The budget prepared at the beginning of the period based on the planned level of output. It does not change when actual volume turns out to be different.
In simple terms, this is the "original plan" budget.
Flexible budget
A budget that adjusts the original cost estimates to reflect the actual quantity of output achieved, while keeping the budgeted prices and rates the same.
Think of it as asking: "What should we have spent, given how much we actually produced?"
"As-if" budget (input budget)
The budgeted cost calculated by multiplying the actual quantity of input used by the standard (budgeted) price per unit of input.
In simple terms, this is what we would have spent if we had paid the budgeted rate for the inputs we actually consumed.
Price variance (rate variance / spending variance)
The difference between the as-if budget and actual results. It isolates the effect of paying a different price per unit of input than was budgeted.
Formula: (Standard price per unit of input x Actual quantity of input) minus Actual cost.
Quantity variance (efficiency variance / usage variance)
The difference between the flexible budget and the as-if budget. It isolates the effect of using more or fewer units of input than the standard allows for the output achieved.
Formula: (Standard price x Standard quantity allowed for actual output) minus (Standard price x Actual quantity of input).
Favourable variance (F)
A variance where actual costs are lower than budgeted, or actual revenues are higher. Labelled "F."
Unfavourable variance (U)
A variance where actual costs are higher than budgeted, or actual revenues are lower. Labelled "U."
Purchases budget
The number of units a retailer needs to buy in a period. Calculated as: budgeted sales + target ending inventory - beginning inventory.
Cash budget
A schedule showing expected cash inflows and outflows over a period, used to predict the ending cash balance and identify potential shortfalls.
Purchase price variance (materials)
The portion of the total materials variance caused by paying a different price per unit of material than budgeted. Responsibility typically sits with the purchasing manager.
A retailer does not manufacture goods, so the budget question is how many units to buy. The formula is straightforward:
Units to purchase = Budgeted sales + Desired ending inventory - Beginning inventory
Worked example (David Company):
Budgeted sales: 8,000 units
Target ending inventory: 1,000 units
Beginning inventory: 300 units
Units to purchase: 8,000 + 1,000 - 300 = 8,700 units
The logic: you need enough to cover what you plan to sell, plus what you want left over at the end, minus what you already have on hand.
The static budget is locked to the originally planned volume. The flexible budget re-states costs at whatever volume actually occurred. This distinction matters because comparing actual results against the wrong volume creates misleading variances.
Worked example (Garcia Company, setup costs):
Planned production: 12,000 units requiring 40 setups
Setup cost structure: $18,000 fixed + $500 per setup
Static budget for setups: $18,000 + (40 x $500) = $38,000
The static budget uses the planned number of setups (40), regardless of what actually happened. A common mistake is to use the actual number of setups (15) in the static budget calculation; that would give a flexible budget figure instead.
Labour variances decompose the gap between budgeted and actual labour costs into two pieces: one caused by the wage rate paid, the other by the hours worked per unit of output.
The three reference points, left to right:
Flexible budget = Actual output x Standard hours per unit x Standard wage rate
As-if budget = Actual hours worked x Standard wage rate
Actual = Actual hours worked x Actual wage rate (i.e. what was actually paid)
Quantity (efficiency) variance = Flexible budget - As-if budget
Price (rate) variance = As-if budget - Actual
If the flexible budget is less than the as-if budget, the firm used more hours than the standard allows for the output achieved, and the quantity variance is unfavourable.
If the as-if budget is greater than actual, the firm paid a lower wage rate than budgeted, and the price variance is favourable.
Worked example (QuickyLube):
Standard: 0.5 hours per car at $12.50 per hour
Actual output: 210 cars serviced
Actual hours: 140 hours
Actual labour cost: $1,470
Flexible Budget | Quantity Variance | As-If Budget | Price Variance | Actual | |
|---|---|---|---|---|---|
Labour cost | $1,312.50 | $437.50 U | $1,750.00 | $280.00 F | $1,470.00 |
Calculation detail:
Flexible budget: 210 cars x 0.5 hrs x $12.50 = $1,312.50
As-if budget: 140 hrs x $12.50 = $1,750.00
Quantity variance: $1,312.50 - $1,750.00 = ($437.50) U (technicians used more hours per car than the standard)
Price variance: $1,750.00 - $1,470.00 = $280.00 F (actual wage rate of $10.50/hr was below the $12.50 standard)
Interpreting the pattern: QuickyLube put trainees on the job during a slow week. Trainees earn less (favourable price variance) but take longer per car: 140 / 210 = 0.67 hours per car instead of the budgeted 0.50 hours (unfavourable quantity variance). The two variances are linked; investigating one without the other gives an incomplete picture.
The purchasing manager is typically held accountable for direct materials price variances, because that role controls supplier selection, negotiation, and order quantities.
Production supervisors are more likely held accountable for quantity (usage) variances, since they oversee how efficiently materials and labour are used on the shop floor.
A cash budget tracks when money enters and leaves the business, not when revenue is earned or expenses are incurred. The key structure:
Beginning cash balance + Cash inflows - Cash outflows = Ending cash balance
The timing of collections is critical. If a firm collects 70% of revenue in the month of sale and 30% in the following month, November's cash inflow includes 70% of November's revenue plus 30% of October's revenue.
Worked example (Oliver Ortega, Kachina dolls):
Revenue: Oct $40,000, Nov $50,000, Dec $60,000
COGS: 60% of revenue (paid in month of sale, consignment model)
Marketing and admin: Oct $4,000, Nov $6,000, Dec $5,000
Collections: 70% in month of sale, 30% next month
Beginning cash (1 Nov): $16,000
November | December | |
|---|---|---|
Beginning balance | $16,000 | $27,000 |
+ Current month collections (70%) | $35,000 | $42,000 |
+ Prior month collections (30%) | $12,000 | $15,000 |
= Total available | $63,000 | $84,000 |
- COGS (60% of current revenue) | $30,000 | $36,000 |
- Marketing and admin | $6,000 | $5,000 |
Ending balance | $27,000 | $43,000 |
The November prior-month collection ($12,000) is 30% of October's $40,000 revenue. The December prior-month collection ($15,000) is 30% of November's $50,000 revenue.
Purchases budget (retailer):
Units to purchase = Budgeted sales + Desired ending inventory - Beginning inventory
Variance analysis (three-column framework):
Flexible budget = Actual output x Standard input per unit x Standard price per input
As-if budget = Actual input quantity x Standard price per input
Quantity variance = Flexible budget - As-if budget
Price variance = As-if budget - Actual cost
Static budget (mixed costs):
Static budget = Fixed component + (Planned activity level x Variable rate per unit of activity)
Cash budget:
Ending cash = Beginning cash + Cash receipts - Cash disbursements
Variance analysis is how service businesses (auto shops, restaurants, hospitals) track whether their labour is being used efficiently. A restaurant chain, for instance, sets a standard prep time per cover and a standard hourly wage; the weekly labour report decomposes any overspend into rate and efficiency components, exactly as the QuickyLube example does.
Cash budgets are essential for seasonal businesses. A retailer selling holiday items may generate 60% of annual revenue in two months but must pay rent and wages year-round. The cash budget shows when a line of credit will be needed and when it can be repaid.
Students often confuse the static budget with the flexible budget. The static budget uses the planned volume; the flexible budget uses actual volume. If a question says "static budget," use the originally planned activity level, not the actual one.
A favourable variance is not always good news. A favourable materials price variance might mean the purchasing manager bought cheaper, lower-quality inputs, which could lead to an unfavourable quantity variance downstream.
Students sometimes calculate the price variance by comparing budgeted price to actual price and multiplying by budgeted quantity. The correct multiplier for the price variance is the actual quantity of input used.
In cash budgets, students frequently forget that collections from credit sales span multiple months. Revenue recognised in October may not be collected until November. The cash budget tracks cash movement, not accrual revenue.
⚠️ Know the three-column variance framework cold: Flexible Budget | Quantity Variance | As-If Budget | Price Variance | Actual. This layout appears in nearly every variance problem.
⚠️ Be ready to explain why a variance occurred, not just calculate it. The QuickyLube problem asks for both the numbers and the managerial story behind them.
⚠️ Static budget questions test whether you use the planned volume, not the actual volume. Read the question stem carefully.
⚠️ Cash budget questions test timing of collections. Map out which month's revenue feeds which month's cash inflow before touching a calculator.
⚠️ Responsibility assignment: purchasing manager owns price variances for materials; production supervisor owns quantity/efficiency variances.
True or False: The static budget adjusts for the actual level of output achieved. (False. That describes the flexible budget.)
Fill in the blank: Units to purchase = Budgeted sales + ________ - Beginning inventory. (Desired ending inventory)
True or False: A favourable price variance means the firm used fewer inputs than budgeted. (False. A favourable price variance means the firm paid a lower price per unit of input than budgeted. Using fewer inputs produces a favourable quantity variance.)
Fill in the blank: The ________ manager is most likely held accountable for direct materials price variances. (Purchasing)
True or False: In a cash budget, revenue earned this month is always collected this month. (False. Collections depend on the firm's collection pattern, which often spans multiple months.)
Q: A company budgeted to produce 5,000 units requiring 2 hours of labour each at $15 per hour. Actual production was 4,500 units, actual hours were 9,500, and actual labour cost was $133,000. What are the labour price and quantity variances?
A: Flexible budget = 4,500 x 2 x $15 = $135,000. As-if budget = 9,500 x $15 = $142,500. Quantity variance = $135,000 - $142,500 = $7,500 U. Price variance = $142,500 - $133,000 = $9,500 F.
Q: A retailer budgets sales of 6,000 units, wants ending inventory of 800 units, and has beginning inventory of 500 units. How many units should be purchased?
A: 6,000 + 800 - 500 = 6,300 units.
Q: A firm's setup costs are $10,000 fixed plus $200 per setup. The static budget planned for 30 setups. What is the static budget amount for setup costs?
A: $10,000 + (30 x $200) = $16,000.
Q: A business collects 60% of revenue in the month of sale and 40% the following month. October revenue is $80,000, November revenue is $100,000. What are total cash collections in November?
A: (60% x $100,000) + (40% x $80,000) = $60,000 + $32,000 = $92,000.
Q: Why might a favourable labour price variance and an unfavourable labour quantity variance occur in the same period?
A: The firm may have used less experienced (and therefore cheaper) workers, who took longer to complete each unit of output. The lower wage rate produces the favourable price variance; the extra time per unit produces the unfavourable quantity variance.
Variance analysis connects directly to activity-based costing (ABC). Where traditional variance analysis uses a single cost driver (labour hours, machine hours), ABC-informed variance analysis can decompose variances by activity (setups, inspections, order processing), giving a more granular picture of where costs diverge from plan.
Cash budgets are the operational bridge between accrual-based income statements and the firm's actual liquidity. This connects to the broader topic of absorption vs variable costing, where the timing of cost recognition differs between methods.
The concept of responsibility for variances ties into the performance evaluation topics (balanced scorecard, decentralisation), where the question is always: who controls this outcome, and what metric should they be judged on?
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