Question

The Watch and Timepiece Division of Geraldo Jewelers had significant problems in 2018. Sales and production were down by almost 35 percent as compared with the budget. Manufacturing was plagued by quality problems and had frequent customer complaints. Timothy Atlee, the division’s manager, recently received a report comparing his division’s actual costs with the costs in the master budget prepared at the start of 2018. Surprisingly, actual costs were less than budgeted, indicating favorable variances.

Timothy was upbeat when told that the president had scheduled a meeting with him to discuss the Watch and Timepiece Division’s performance. Although sales were down, at least he could point to a large number of favorable cost variances.

Briefly explain why the variances are positive, and discuss what John should know about flexible budgets. Assuming that the president understands flexible budgets, will the president be impressed by the favorable cost variances?

Answer 1

Briefly explain why the variances are positive, and discuss what John should know about flexible budgets.

The cost projections in the budget are for the level of activity planned. As against this, the actual costs are for the activity level achieved, which is less by 35% of the planned activity. Hence, the cost projections would be higher than the actual costs resulting in favorable cost variances.

Before comparing actual costs with the budgeted costs, the budgeted costs should be recast to related it to the actual level of activity. In other words a budget should be prepared as if the actual activity level is the budgeted activity level. Total fixed costs (if the activity levels are within the relevant range) would be the same, but total variable costs would vary with the actual activity level achieved. Such a modified budget is called the 'Flexible budget'.

Cost comparisons and variance computations should be made with the flexible budget.

John should understand that there is a budget allowance for each cost item, depending on the activity level achieved, against which comparisons of actual costs are to be made.

Assuming that the president understands flexible budgets, will the president be impressed by the favorable cost variances?

No, the President will not be impressed by the cost variances computed with reference to the planned budget. He will ask for the cost variances to be computed in relation to the flexed budget.