Budgets, standard costs and variances: planning and checking results
A budget says what a business expects to happen, and a standard says what each unit should cost. Comparing them with what actually happened is the main way managers control costs, but only if the comparison is made fairly. This lesson builds a budget for a fictional bicycle maker, shows why a flexible budget is the right yardstick when volume differs from plan, and splits the cost difference into price and usage variances. Apple's and Microsoft's costs are then tested against a simple proportional benchmark.
- Level
- Beginner
- Reading time
- About 26 minutes
- Know this first
- Relevant costs and decisions
By the end you will be able to:
- describe how an operating budget is built from the sales forecast
- explain the difference between a static budget and a flexible budget, and why the flexible budget is the fair comparison
- calculate price and quantity variances for materials and rate and efficiency variances for labour
- say who a variance should be reported to and why the parts of a variance should be read separately
From a plan to a check on the plan
The earlier lessons in this module used cost information to understand a business and to make one-off decisions. This one is about running it through the year. A budget is a quantitative plan: it estimates how much money and other resources will come in, and when and how they will be used. Managers use budgets to communicate plans to the people who must carry them out, to plan, to coordinate departments, to control by watching results against the plan, and to evaluate performance against a stated benchmark.
The running example is the fictional bicycle maker once more, now with a budget for 8,000 bicycles and standards for what each bicycle should cost. Apple and Microsoft appear near the end. Their internal budgets and standards are not published, so the lesson tests their reported costs against a simple benchmark of its own instead.
How an operating budget is built
The master budget is a set of linked budgets. The operating budgets start with sales, because everything else depends on how much can be sold. The sales budget feeds the production budget, which in turn drives the budgets for direct materials, direct labour and factory overhead, and a separate budget covers selling and administrative costs. Together they produce the budgeted income statement. The financial budgets follow, such as the capital spending plan and the cash budget, and the budgeted balance sheet comes last.
There are two ways to prepare a budget. In a top-down approach senior management sets the goals and the allowed spending, which ties the budget to strategy but may be set by people who do not know the details of the operation. In a participative or bottom-up approach the managers who will run the budget help set it, which tends to make the numbers more realistic but can drift from the company's plan. A known risk is budgetary slack, expenses padded or targets set artificially low so that they are easy to hit.
| Operating budget, 8,000 bicycles | Amount |
|---|---|
| Sales budget: 8,000 bicycles at $200 | $1,600,000 |
| Production budget: 8,000 bicycles, no change in stock | 8,000 bicycles |
| Materials budget: 24,000 kg at $30 | $720,000 |
| Labour budget: 16,000 hours at $15 | $240,000 |
| Factory overhead budget | $150,000 |
| Selling budget: commission at $5 a bicycle | $40,000 |
| Administration and advertising budget | $90,000 |
| Budgeted operating income | $360,000 |
The budget produces a profit of $360,000, the same figure as the bicycle maker's earlier lessons, because the standards come from the same costs.
Standard costs
A standard cost is an expected cost, usually set at the start of the year, built from a standard price and a standard quantity for each input. The standard cost card for one bicycle is below.
| Standard cost of one bicycle | Quantity | Price | Standard cost |
|---|---|---|---|
| Frame tubing and components | 3.0 kg | $30.00 a kg | $90.00 |
| Assembly labour | 2.0 hours | $15.00 an hour | $30.00 |
| Standard variable cost of production | $120.00 |
The level at which standards are set matters. An ideal standard assumes everything goes perfectly, and tends to be a poor motivator because people see it as out of reach. A standard that is too easy gives no reason to improve. The usual aim is an attainable standard, one that people can reach with reasonable effort. Standards also feed the budget, help in setting selling prices, and give a target to measure efficiency against.
Static and flexible budgets
A static budget is prepared for one level of activity and does not change when the activity does. A flexible budget adjusts the variable costs to the level of activity actually reached, so that results are compared with what the budget would have allowed for that volume. The fixed costs stay as budgeted.
The difference matters whenever actual volume is not the budgeted volume, which is nearly always. Suppose the bicycle maker sells and makes 9,000 bicycles, 1,000 more than budgeted. The tubing and labour bills will naturally be higher than a budget for 8,000 bicycles allowed. A report that compares actual costs with the static budget labels that increase as overspending, though nobody has overspent. Only the flexible budget for 9,000 bicycles says whether the costs were reasonable for the work done.
Price and quantity variances
A variance is the difference between an actual result and the standard or budget. Each input cost has two parts, the price paid and the quantity used, and the difference from the flexible budget splits into one variance for each. The convention in the table and calculator below shows each variance as its effect on profit: a favourable variance, spending less than the standard, appears as a positive amount, and an unfavourable one, spending more, as a negative amount in brackets.
The standard quantity is what the inputs should have been for the units actually made, which is the flexible budget quantity. For simplicity the calculator treats all the tubing bought as used. The price variance is, strictly, measured when the material is bought, so that management hears about it early, and the quantity variance when it is used.
Measure the variances
Set the number of bicycles made and the actual prices and quantities. The standards are 3.0 kg of tubing at $30 a kilogram and 2.0 hours of labour at $15 an hour for each bicycle, and the static budget is for 8,000 bicycles. The left page works through tubing and the right page through labour.
At 9,000 bicycles the flexible budget allows $810,000 for tubing and $270,000 for labour. Tubing cost $806,400, which is $3,600 favourable against the flexible budget: price $57,600 favourable and usage $54,000 unfavourable. Labour cost $265,050, which is $4,950 favourable: rate $8,550 unfavourable and efficiency $13,500 favourable. Against the static budget for 8,000 bicycles the same costs look $111,450 unfavourable, but $120,000 of that is only the cost of making more bicycles than budgeted.
Four experiments. First, the starting settings make 9,000 bicycles. The flexible budget allows $810,000 for tubing, and the actual cost is $806,400, which is $3,600 favourable. Look at the parts: tubing was bought for $28 against the standard $30, a favourable price variance of $57,600, but 3.2 kg was used per bicycle against the standard 3.0, an unfavourable quantity variance of $54,000. The two nearly cancel, and a report showing only the total would call the tubing almost on budget. Labour shows the same pattern in reverse: a wage of $15.50 against $15 cost $8,550 more, and 1.9 hours against 2.0 saved $13,500, a net $4,950 favourable. Second, set the price to $30, the tubing to 3.0, the wage to $15 and the hours to 2.0: every variance is nil. The costs are exactly as standard, and still $120,000 above the static budget, only because 1,000 more bicycles were made. Third, return to the starting settings and raise the tubing used to 3.4 kg. The price variance is $61,200 favourable, the quantity variance $108,000 unfavourable, and tubing is $46,800 over the flexible budget, which is a problem even though the price looks good. Fourth, set the wage to $17: the labour rate variance becomes $34,200 unfavourable and, with the efficiency gain of $13,500, labour finishes $20,700 over the flexible budget.
The comparison in numbers, at the starting settings:
| Costs, 9,000 bicycles made | Static budget (8,000) | Flexible budget (9,000) | Actual | Against static | Against flexible |
|---|---|---|---|---|---|
| Tubing | $720,000 | $810,000 | $806,400 | $86,400 over | $3,600 under |
| Labour | $240,000 | $270,000 | $265,050 | $25,050 over | $4,950 under |
| Materials and labour | $960,000 | $1,080,000 | $1,071,450 | $111,450 over | $8,550 under |
Against the static budget, tubing and labour together look $111,450 over budget. Of that, $120,000 is only the cost of making 1,000 more bicycles. Against the flexible budget, the costs are $8,550 under what the actual volume allowed. The static comparison suggests a problem where there is none, and a flexible one shows the real picture.
Reading a variance
A variance is a question and not an answer. The key is to find out why it occurred, since the same figure can come from different causes. Price variances may come from changes in supply and demand, supplier price increases or new technology, or from a purchasing decision such as switching to a cheaper material. Quantity variances may come from the efficiency of production, carelessness, or a standard that was set badly. Buying cheaper tubing of poorer quality can produce a favourable price variance and an unfavourable usage variance together, which is the pattern in the first experiment.
Components can offset each other, so the parts should be reviewed separately. A small total may hide two large variances. And a favourable variance is not always good news: it can be a sign of a standard set too easily, or of quality cut to save cost.
Who is responsible: responsibility centres
Variances are most useful when reported to the person who can influence them. Responsibility accounting organises a business into centres, each with a manager who has both the responsibility for results and the authority to act. A cost centre manager is held responsible only for costs, such as a factory department. A revenue centre manager is accountable only for revenues. A profit centre manager is responsible for both revenues and costs, and an investment centre manager is also accountable for the capital the segment uses.
Investment centres are judged on return on investment, which is the segment's profit divided by its investment base, or on residual income, which is segment income less the investment multiplied by the cost of capital. Return on investment can discourage a manager from accepting a project that benefits the company but lowers the segment's own return. Residual income sets a dollar minimum that every investment must beat. Whatever the measure, a manager should be judged on what the manager can control. A rise in the world price of steel is not the fault of the person buying it, though how the purchase was timed may be.
Testing Apple and Microsoft against a benchmark
Companies publish their results, not their budgets or standards. An outsider can still ask the flexible budget question with a rough benchmark. Take each company's total costs for fiscal 2024, revenue less operating income, and suppose they had grown exactly in step with revenue, as if every cost were variable. That is the flexible budget of an extremely simple model. It is the author's benchmark, not either company's budget, and it carries no authority beyond showing the method.
| Fiscal 2025, $ million | Apple | Microsoft |
|---|---|---|
| Total costs, fiscal 2024 (revenue less operating income) | 267,819 | 135,689 |
| Revenue growth, fiscal 2024 to 2025 | 6.4% | 14.9% |
| Benchmark: fiscal 2024 costs grown with revenue | 285,028 | 155,950 |
| Actual total costs, fiscal 2025 | 283,111 | 153,196 |
| Actual costs below the benchmark | 1,917 | 2,754 |
Apple's revenue grew 6.4% and Microsoft's 14.9%. On this benchmark Apple's costs would have been $285.0 billion and Microsoft's $156.0 billion in fiscal 2025. Both came in below it, Apple by $1.9 billion and Microsoft by $2.8 billion. A favourable variance against a fully variable benchmark is what operating leverage predicts for a business that has a fixed part to its costs: when revenue grows, total costs grow by less. The previous lessons used this as evidence of fixed cost. It is also a reminder that a variance has no meaning without a stated benchmark. Choose a different benchmark, such as last year's costs unchanged, and both companies would show unfavourable variances.
What budgets and variances cannot tell you
- They are only as good as the standards. A standard that is out of date or too loose produces variances that mean little.
- They report the past. A variance tells managers what happened, and the cause still has to be found and acted on.
- They can encourage the wrong behaviour. A manager rewarded for a favourable price variance may buy poor material, and one rewarded for meeting a budget may pad it with slack.
- They need a fair benchmark. A static budget compared with a different volume misleads, as the calculator shows.
- Not everything is measurable. Quality, customer goodwill and employee morale do not appear in a price or quantity variance.
Common mistakes
Comparing actual costs with a static budget at a different volume
The result mixes the effect of volume with the effect of performance. Use a flexible budget.
Reading only the total variance
A price variance and a quantity variance in opposite directions can cancel, and each may need action.
Mixing up the signs
Whether a positive number means favourable depends on the convention. State it, as this lesson does, and check it before drawing conclusions.
Using the actual quantity for the quantity variance
The quantity variance compares the quantity used with the standard quantity for the actual output. Using the budgeted output instead gives a figure that mixes in volume.
Blaming a manager for what the manager cannot control
Judge people on the items they can influence, and report the rest separately.
Try it yourself
1. The standard for a material is $4 a kilogram. A factory bought and used 5,000 kg at $4.20. The standard quantity for the output was 4,800 kg. Find the price and quantity variances.
Show the working
Price variance = (4.00 − 4.20) × 5,000 = −$1,000, unfavourable. Quantity variance = (4,800 − 5,000) × 4.00 = −$800, unfavourable. Total = −$1,800. Check: standard cost 4,800 × 4 = $19,200; actual cost 5,000 × 4.20 = $21,000; the difference is $1,800.
2. The standard for a unit is 2 hours of labour at $12. The factory made 1,000 units and used 1,900 hours, paying $12.50 an hour. Find the rate and efficiency variances.
Show the working
Rate variance = (12.00 − 12.50) × 1,900 = −$950, unfavourable. Efficiency variance = (2,000 − 1,900) × 12 = +$1,200, favourable. Net = +$250 favourable. A report showing only the net would hide a wage problem.
3. A static budget for 10,000 units has variable costs of $8 a unit and fixed costs of $40,000. What does the flexible budget allow at 12,000 units?
Show the working
Variable costs = 8 × 12,000 = $96,000. Fixed costs stay at $40,000. The flexible budget allows $136,000, against the $120,000 in the static budget, and the extra $16,000 is the cost of the extra 2,000 units.
4. A plant has a favourable materials price variance of $5,000 and an unfavourable quantity variance of $5,000. The total is nil. Should anyone look into it?
Show the working
Yes. A nil total hides two large variances that may be linked: for example, cheaper material may be wasting more in production. Each variance should be investigated for its cause.
5. Why is a flexible budget the fairer standard for judging a department that made more than planned?
Show the working
Producing more units naturally requires more materials and labour. The flexible budget gives the cost allowed for the units actually made, so the comparison isolates price and efficiency from the effect of a change in volume.
Where this is used
- A finance team builds the annual budget from a sales forecast and reviews it monthly against a flexible budget.
- A purchasing manager is reviewed on price variances, and a production manager on usage and efficiency variances.
- A plant that reports a large unfavourable usage variance investigates wastage, training and the quality of the material.
- A group sets targets for a division as a profit centre or investment centre and judges the manager on the measures that apply.
Key terms
- Budget
- A quantitative plan for how resources will be received and used.
- Master budget
- The set of linked operating and financial budgets, starting from the sales budget.
- Static budget
- A budget prepared for one level of activity.
- Flexible budget
- A budget whose variable costs are adjusted to the level of activity actually reached.
- Standard cost
- An expected cost, built from a standard price and a standard quantity for each input.
- Variance
- The difference between an actual result and the standard or budgeted amount.
- Favourable and unfavourable variances
- Variances where actual cost is below, or above, the standard.
- Budgetary slack
- Padding in a budget so that targets are easy to meet.
- Responsibility centre
- A segment whose manager is responsible for its costs, revenues, profit or investment.
- Residual income
- Segment income less the invested capital multiplied by the cost of capital.
Questions people ask
Is a favourable variance always good?
No. It can come from a standard that was too easy, from cheaper material that raises waste, or from cuts in quality or maintenance. Check the cause first.
Why not just compare with last year's actual costs?
Last year's volume and prices were different. A budget or standard adjusted for this year's volume is a more reliable yardstick, although last year is useful as another view.
How often are budgets updated?
Practice varies. Many businesses prepare an annual budget and review it monthly. Some update it during the year with rolling forecasts.
Do public companies publish their variances?
Not in their financial statements. Budgets and standards are internal management tools, so the published accounts show only the actual results.
Sources and review
- Apple Inc., Form 8-K, Exhibit 99.1: fourth quarter and full-year fiscal 2025 results, filed with the US Securities and Exchange Commission. Source of Apple's statements.
- Microsoft Corporation, Form 8-K, Exhibit 99.1: fourth quarter and fiscal year 2025 results, filed with the US Securities and Exchange Commission. Source of Microsoft's statements.
- OpenStax, Principles of Accounting, Volume 2: Managerial Accounting, section 7.1: Describe how and why managers use budgets, for the purposes of budgets, the master budget, top-down and participative budgeting, and static and flexible budgets.
- OpenStax, Principles of Accounting, Volume 2: Managerial Accounting, section 8.1: Explain how and why a standard cost is developed, for standard costs and ideal and attainable standards.
- OpenStax, Principles of Accounting, Volume 2: Managerial Accounting, section 8.2: Compute and evaluate materials variances, for the price and quantity variance formulas and the way the two can offset each other.
- OpenStax, Principles of Accounting, Volume 2: Managerial Accounting, chapter 8 summary, for the labour rate and time variances and the favourable and unfavourable convention.
- OpenStax, Principles of Accounting, Volume 2: Managerial Accounting, section 9.3: Describe the types of responsibility centers, for responsibility accounting, return on investment and residual income.
How the numbers were checked: every budget, flexible budget and variance in the lesson was recomputed in plain code, the price and quantity parts were checked to add up to the total difference from the flexible budget, and the calculator, which runs separately, was compared with that code across a grid of inputs. The cost figures for Apple and Microsoft come from the filed income statements, and the benchmark is the author's own and is labelled as such.