Chapter 1

Capital budgeting decisions

Objective (1): Overview of Capital Budgeting: Basic
Terminology
Capital budgeting: is the process of evaluating and selecting long-
term investments that are consistent with the firm’s goal of maximizing
owner wealth.
A capital expenditure is an outlay of funds by the firm that is
expected to produce benefits over a period of time greater than 1 year.
An operating expenditure is an outlay of funds by the firm
resulting in benefits received within 1 year.
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 The capital budgeting process consists of five steps:
1. Proposal generation. Proposals for new investment projects are made at all
levels within a business organization and are reviewed by finance personnel.
2. Review and analysis. Financial managers perform formal review and analysis to
assess the merits of investment proposals
3. Decision-making. Firms typically delegate capital expenditure decision making
on the basis of dollar limits.
4. Implementation. Following approval, expenditures are made and projects
implemented. Expenditures for a large project often occur in phases.
5. Follow-up. Results are monitored and actual costs and benefits are compared
with those that were expected. Action may be required if actual outcomes differ
from projected ones.
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 Typical Capital Budgeting Decisions:

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Objective (2): Understanding some basic concepts.
 Variance: difference between an actual and an expected (budgeted) amount
 Management by Exception: the practice of focusing attention on areas not
operating as expected (budgeted)
 Static (Master) Budget: is based on the output planned at the start of the
budget period

Example:

 Variances assist managers in implementing their strategies by enabling

management by exception.
 Management by exception—the practice of focusing attention on areas
not operating as expected (budgeted).
 Enable managers to focus their efforts on the most critical areas.
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Objective (3): Explain the types of variance.
Varience anaylsis

Varience

Level 0 Level 1 Level 2 Level 3

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 “Level” the amount of detail shown by a variance analysis
 Level 0 Or 1 reports the least detail; level 2 offers more information; and so on
 Favorable Variance (F) – has the effect of increasing operating income relative
to the budget amount
 Unfavorable Variance (U) – has the effect of decreasing operating income
relative to the budget amount

Causes of Varience:

Varience

Cost per unit &

Number of units
Selling price per
sold
unit
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Example (Variance analysis):
Consider Webb Company, a firm that manufactures and sells jackets. Webb has
three variable-cost categories. The budgeted variable cost per jacket for each
category is as follows
Category (units Sold 12,000) Cost
Direct material costs (2 square yard @ $30/yard) $60
Direct manufacturing labor costs (0.8 hour @ $20/labor hour) 16
Variable manufacturing overhead costs 12
Total variable costs $88

The number of units manufactured is the cost driver for direct materials, direct
manufacturing labor, and variable manufacturing overhead. Budgeted and actual
data for April 2011 follow

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 Actual revenues (10,000 unit x $125) $1,250,000
Actual direct material costs (10,000 unit x $62.16) $621,600
Actual direct labor costs (10,000 unit x $19.8) $198,000
Actual variable OH costs $130,500
Actual Fixed costs $285,000
Additional information:
1- Actual material used 2.22 square yard @ $28/yard
2- Actual labor hours 0.9 hour @ $22/labor hour
Required:
1-Prepare static budget
2-Prepare flexible budget
Answer
Level 0 & 1:

Evaluation:
 Level 0 tells the user very little other than how much Contribution Margin was off
from budget.
 Level 0 answers the question: “How much were we off in total?”
 Level 1 gives the user a little more information: it shows which line items led to the
total Level 0 variance.
 Level 1 answers the question: “Where were we off?”
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Level 2 variance:
 Flexible Budgets calculates budgeted revenues and budgeted costs based on the
actual output in the budget period.

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  The flexible budget is prepared at the end of the period (April 2011), after the
actual output of 10,000 jackets is known.
 Very important notes:
 In preparing the flexible budget, note that
 The budgeted selling price is the same $120 per jacket used in preparing the static
budget.
 The budgeted unit variable cost is the same $88 per jacket used in the static
budget.
 The budgeted total fixed costs are the same static-budget amount of $276,000.
Why?
 Because the 10,000 jackets produced falls within the relevant range of 0 to
12,000 jackets.
 The only difference between the static budget and the flexible budget is that the
static budget is prepared for the planned output of 12,000 jackets, whereas the
flexible budget is based on the actual output of 10,000 jackets

 Steps in calculating flexible budget:
 Step 1: Identify the Actual Quantity of Out-put. In April 2011, Webb produced and
sold 10,000 jackets
 Step 2: Calculate the Flexible Budget for Revenues Based on Budgeted Selling
Price and Actual Quantity of Output.

 Step 3: Calculate the Flexible Budget for Costs Based on Budgeted Variable Cost
per Output Unit, Actual Quantity of Output, and Budgeted Fixed Costs.

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  Sales-volume variance:
 The sales-volume variance is the difference between the static budget for the
number of units expected to be sold and the flexible budget for the number
of units that were actually sold.
 it arises solely from the difference between the 10,000 actual quantity (or
volume) of jackets sold and the 12,000 quantity of jackets expected to be sold
in the static budget.

 Managers determine that the unfavorable sales-volume variance in operating income could be
because of one or more of the following reasons:
1. The overall demand for jackets is not growing at the rate that was anticipated.
2. Competitors are taking away market share from Webb.
3. Webb did not adapt quickly to changes in customer preferences and tastes.
4. Budgeted sales targets were set without careful analysis of market conditions.
5. Quality problems developed that led to customer dissatisfaction with Webb’s jacket

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 Flexible-Budget Variances: arises because actual selling price, actual variable
cost per unit, and actual fixed costs differ from their budgeted amounts ($29,100)

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 The flexible-budget variance for revenues is called the selling-price
variance because it arises solely from the difference between the actual selling
price and the budgeted selling price
 Webb has a favorable selling-price variance because the $125 actual selling price
exceeds the $120 budgeted amount, which increases operating income.

 Was the difference due to better quality? Or was it due to an overall

increase in market prices?
 The flexible-budget variance for total variable costs is unfavorable
($70,100 U) for the actual output of 10,000 jackets:
o Webb used greater quantities of inputs (such as direct manufacturing labor-hours)
compared to the budgeted quantities of inputs.
o Webb incurred higher prices per unit for the inputs (such as the wage rate per direct
manufacturing labor-hour) compared to the budgeted prices per unit of the inputs

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Level 3: (Variance Cost Per unit)
 Any product has the following costs:
Total cost = DM + DL + OH
 What are the causes that make any company pay more costs?

Reasons

efficiency
Price
(Usage/quantity)

 A price variance: is the difference between actual price and budgeted price,
multiplied by actual input quantity, such as direct materials purchased or used.

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 An efficiency variance is the difference between actual input quantity used—
such as square yards of cloth of direct materials—and budgeted input quantity
allowed for actual output, multiplied by budgeted price
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Direct Material variance
 Columnar Presentation method of Variance Analysis

 Equation method of Variance Analysis

1-Price Variances
 Price varience =
(Actual price of input X Actual quantity) – (standard (budget) price X Actual quantity)

OR
 Price varience =
(Actual price - standard (budget) price) X Actual quantity)

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2-Efficiency (quantity) varience
 The efficiency variance: is the difference between actual quantity of input used
and the budgeted quantity of input allowed for that output level, multiplied by the
budgeted input price.
 efficiency varience =
(budgeted price of input X Actual quantity) – (budgeted price of input X Standard quantity)

OR
 efficiency varience =

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 variances—direct materials efficiency variance is unfavorable because
more input was used than was budgeted for the actual output,
resulting in a decrease in operating income
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Direct labor variance

Reasons

Price Quantity
(Rate) (Hours)
 Columnar Presentation method of Variance Analysis

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 Equation method of Variance Analysis

1-Price Variances
 Price varience =
(Actual rate of input X Actual hours) – (standard (budget) rate X Actual hours)

OR
 Price varience =
(Actual rate - standard (budget) rate) X Actual hours)

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2-Efficiency (hours) varience
 efficiency varience =
(Budgeted rate of input X Actual hours) – (budgeted rate of input X Standard hours)

OR
 efficiency varience =

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Price and Efficiency Variances

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Summary

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