The budgeting process may be approached differently in various firms. Top-down b

Question

The budgeting process may be approached differently in various firms. Top-down budgeting has its inception with directives from senior management who prepare the budget for staff and assess performance based on objectives established at higher levels. Any additional compensation received occurs as a result of achieving budgetary targets imposed by others. In contrast, bottom-up budgeting reflects the predictions of cost, revenue, profit, and investment center managers—proposed and approved by senior managers. Incentives are negotiated by managers proposing the budget rather than imposed by higher level executives. In a well-written paper demonstrating CSU-Global standards, answer the following questions:

1. What are the potential benefits of monitoring direct cost variances?

Explanation / Answer

As you may recall direct costs (i.e. direct materials and direct labor) have two major components:

As the result, direct costs have two major types of variance: price variance and efficiency variance. It is important to note that variances for factory overhead are different, which is why we will talk about them later. Price variance is the difference between actual and standard prices paid for resources used in production.

We encounter price variances on a daily basis. For instance, if you usually pay $2.00 per loaf of bread and then buy the same bread for $2.20 at a different store, the 20 cents difference ($2.00 – 2.20) is a price variance. In this example, it is also an unfavorable variance ($2.00 – 2.20 = - $0.20) because you had to pay a higher than standard (normal) price for the product. On the other hand, if you purchase two loafs of bread for $2.50, you essentially paid $1.25 per loaf of bread. In this case, you have a favorable price variance of 75 cents (per loaf of bread: $2.00 – $1.25).

The latter scenario is also applicable for businesses because they often try to take advantage of bargain purchases. Bargain purchases might affect the quality of the material, usage requirements (e.g., need to use more material of a lower quality), storage space, and cash flows. Unfortunately, a price variance does not tell how bargain purchases affect production efficiency. In such a case, we use efficiency variances.

Efficiency variance tells how economically and efficiently direct materials and direct labor are used in production.

We encounter efficiency variances on a daily basis as well. For instance, if it usually takes you 30 minutes to get to work by car, and then one day you get to work in 20 minutes, you have a favorable efficiency variance of 10 minutes (i.e., which can be transferred into a dollar value; for example, $15).

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