Budgeting and standard costing

Commerce (General / Accounting and Finance / Banking and Insurance) (B.Com) · Cost and management accounting · free study notes for exams, placements and interviews

In short

Budgeting is the process of expressing a firm's plans for a future period in quantitative and monetary terms, and budgetary control is the use of those budgets to compare actual results, isolate differences and fix responsibility. Standard costing goes one level deeper: it sets a predetermined cost per unit of output and analyses the difference between standard and actual cost into named variances (price, usage, rate, efficiency, volume) so that the cause and the responsible manager can be identified. The two are the core "control" half of management accounting — planning in advance and explaining the gap afterwards. In B.Com and M.Com papers this is usually the heaviest-scoring chapter (cash budget, flexible budget and full variance sets), and it recurs in CA/CMA Inter, UGC-NET Commerce and placement tests for FP&A, costing, internal audit and shared-service roles at firms such as ITC, Asian Paints, Tata Steel, Hindustan Unilever, Maruti Suzuki, Genpact, Deloitte and the Big 4 GCCs.

Explained

Budget, budgetary control and the framework

Budget (CIMA): a quantitative statement, for a defined period, of planned revenues, expenses, assets, liabilities and cash flows. A forecast is only a prediction of what will happen; a budget is a *commitment* to achieve, approved by management.
Budgetary control: establishing budgets by responsibility centre, continuously comparing actual with budget, reporting variances, and taking corrective action or revising the budget.
Budget centre: a section of the organisation (department, process, cost centre) for which a separate budget is prepared — the basis of responsibility accounting.
Budget committee: cross-functional team (sales, production, purchase, personnel, finance) headed usually by the CEO/MD, with the Budget Officer / Cost Accountant as convenor; it co-ordinates, reviews and recommends budgets for approval.
Budget manual: a written document stating objectives, procedures, formats, responsibilities, timetable and reporting lines for budgeting — ensures the system survives staff changes.
Budget period: long-term (3–10 years, capital expenditure), short-term (one year, matched with the financial year 1 April–31 March in India) and control periods (month, quarter).
Principal budget factor / key factor / limiting factor: the resource that limits activity — usually sales demand, but can be material availability, skilled labour, machine hours, power, cash or a licence/quota. The budget for the key factor is prepared first; all others follow from it.
Steps: define objectives → identify key factor → prepare functional budgets → consolidate into master budget → obtain approval → communicate → record actuals → report variances → act.
Goal congruence and behavioural aspect: budgets should be participative ("bottom-up") to secure acceptance, but participation lets managers build in budgetary slack (padding costs, understating sales); imposed top-down budgets curb slack yet invite rejection and dysfunctional behaviour.

Functional budgets and the master budget

Sales budget: quantity × selling price by product, territory and period; built from past trends, market research, sales-force estimates and order book. Normally the starting point.
Production budget (units): Budgeted sales + Closing finished stock − Opening finished stock.
Material purchase budget (quantity): Material needed for production + Closing material stock − Opening material stock; value it at expected purchase price.
Labour / personnel budget: standard hours per unit × output, split by grade, costed at expected wage rates including statutory costs (PF, ESI, bonus, gratuity).
Overhead budgets: factory, administration, selling and distribution; each split into fixed, variable and semi-variable.
Plant utilisation / machine-hour budget: matches output to available capacity, reveals bottlenecks and the need for overtime or subcontracting.
Capital expenditure budget: long-lived assets; evaluated by NPV/IRR/payback before inclusion.
Research and development budget; cost of production and cost of sales budgets.
Cash budget: month-wise receipts and payments showing opening balance, surplus or deficit and closing balance — prepared by the receipts and payments method (most common in exams), the adjusted profit and loss method, or the projected balance sheet method. It excludes non-cash items (depreciation, provisions) and includes capital items, tax, dividend, GST payments and loan repayments.
Master budget: the summary budget — budgeted Profit and Loss Account and budgeted Balance Sheet with the cash budget — placed before the Board for approval.

Fixed, flexible and modern techniques

Fixed (static) budget: drawn for one assumed level of activity and not changed. Useful only when activity is stable; useless for control if actual volume differs.
Flexible (variable) budget: prepared for several activity levels (e.g. 60%, 75%, 90%, 100%) by separating fixed, variable and semi-variable costs; the budget is then "flexed" to actual output before comparison. This isolates genuine cost control from volume effects. Semi-variable costs are split by the high-low method or least squares.
Zero-base budgeting (ZBB): every activity starts from a zero base and must be justified afresh each year through decision packages ranked by priority; no automatic incremental increase. Developed by Peter Pyhrr; used in government departments, PSUs and overhead-heavy service functions. Merits: eliminates obsolete spending, links spend to output. Demerits: time-consuming, paper-heavy, resisted by managers.
Performance budgeting / outcome budgeting: budget is framed around functions, programmes and activities with physical targets and performance indicators rather than line-item objects of expenditure; used extensively in Government of India ministries and state budgets (Outcome Budget documents) and in PSUs through MoUs with the administrative ministry.
Programme (PPBS), activity-based and Kaizen budgeting; rolling / continuous budget: as one month or quarter ends another is added, keeping a constant horizon ahead — common in FMCG and IT services with volatile demand.
Functional versus activity classification: functional budgets follow departments; activity-based budgets drive costs from activity cost drivers.

Standard costing: standards and the standard hour

Standard cost: a scientifically predetermined cost of a unit of product or service under specified conditions of efficiency, price and volume. Standard costing is the system of using standard costs, comparing them with actuals and analysing variances.
Standard cost card / sheet: per-unit statement of standard quantity and price of each material, standard hours and rate of each labour grade, and standard variable and fixed overhead absorption rates.
Types of standards: (i) ideal / theoretical — assumes perfect conditions, demotivating; (ii) expected / attainable — allows normal spoilage, idle time and breakdowns; the recommended basis; (iii) basic — fixed for long periods as an index for trends; (iv) normal — average over a trade cycle; (v) current — for the immediate short period.
Setting standards: quantity standards from engineering studies, bills of material and test runs; price standards from purchase contracts, market trend and expected inflation; labour standards from time and motion study; overhead rates from budgeted overhead ÷ normal capacity (CAS-2, Capacity Determination, defines installed, practical and normal capacity).
Standard hour: the quantity of output achievable in one hour under standard conditions — the common denominator that lets dissimilar products be added up (e.g. 400 standard hours of output across three products).
Revision of standards: necessary when there is a permanent change in design, technology, wage settlement or statutory levy; temporary price spikes are better reported as variances than built into the standard.
Variance: the difference between standard and actual. Favourable (F) when actual cost is less or actual revenue is more; adverse / unfavourable (A) otherwise. Variances are controllable (usage, efficiency — a manager's responsibility) or uncontrollable (market price rise, statutory wage hike). Management acts on exceptions only — management by exception.

Variance analysis — material, labour and overhead

Material cost variance = price variance + usage variance; usage splits further into mix variance (proportions departed from standard) and yield / sub-usage variance (output obtained from a given input differed from standard).
Price variance is normally the purchase manager's responsibility; usage/yield the production manager's. If material is priced into stores at standard price, the price variance is isolated at purchase.
Labour cost variance = rate variance + idle time variance + efficiency variance; efficiency splits into gang/mix composition and labour yield where several grades work together. Idle time variance is always adverse (abnormal idle time is charged to Costing P&L, not to product cost).
Rate variance is computed on hours paid; efficiency variance on hours actually worked.
Variable overhead cost variance = expenditure (spending) variance + efficiency variance — variable overhead varies with activity, so there is no volume variance.
Fixed overhead cost variance = expenditure variance + volume variance. Volume variance arises purely from under- or over-absorption of fixed overhead and splits into efficiency, capacity and calendar variances.
Calendar variance appears only when the actual number of working days differs from budgeted days (festival holidays, strike, extra Sundays).
Two-way, three-way and four-way analysis: the examiner's "two-way" is expenditure + volume; "four-way" adds the efficiency/capacity/calendar split.
Disposal of variances: written off to Costing Profit and Loss Account (common, for abnormal variances), or transferred to a Reserve, or prorated over work-in-progress, finished goods and cost of sales. Ind AS 2 / AS 2 permit the standard cost technique for inventory valuation only if it approximates actual cost and is reviewed regularly; abnormal variances cannot be carried in inventory. CAS-4 (cost for captive consumption/related-party transfers, certified in the CAS-4 certificate) is built on actual cost, with abnormal variances excluded.

Sales variances, profit reconciliation and control ratios

Sales value (turnover) method: total sales variance = price variance + volume variance; volume = mix + quantity (sub-volume) variance. Shows the effect on revenue.
Sales margin (profit) method: variances computed on contribution or profit per unit; preferred because it shows the effect on profit, which is what reconciliation needs.
Operating statement / profit reconciliation: Budgeted profit ± sales variances ± material, labour, variable overhead and fixed overhead variances = Actual profit. This is the standard "reconcile budgeted and actual profit" question.
Control ratios: Efficiency ratio, Capacity utilisation ratio and Activity (volume) ratio; Activity ratio = Capacity ratio × Efficiency ratio. Above 100% is favourable.
Advantages (both systems): cost consciousness, co-ordination between functions, delegation with measurable accountability, fixing of quotations and transfer prices, basis for incentive schemes, early warning on cash, and inventory valuation.
Limitations: depend on the quality of forecasts; costly for small firms; standards become stale with inflation, technology change and short product life cycles; may encourage slack, short-termism and gaming (buying cheap poor-quality material to earn a favourable price variance); unsuitable where output is non-standard (job and contract work) or quality- and innovation-driven; ignores non-financial measures — hence beyond budgeting and balanced-scorecard criticisms.

Basis	Budgetary control	Standard costing
Scope	Whole organisation, all functions including capital and cash	Mainly manufacturing/operating cost per unit
Unit of measure	Total amounts for a department or period	Cost per unit of product or service
Based on	Expected (attainable) performance	Predetermined scientific standards
Variance detail	Broad, by cost head	Detailed, split into price/usage/rate/efficiency
Needs the other?	Can exist without standard costing	Works best with budgets; needs cost standards
Intensity of use	Projection and policy tool	Day-to-day operating control tool

Key points

Budget - a quantified, approved plan for a future period; a forecast is only an estimate with no commitment.
Budgetary control - setting budgets, comparing actuals, reporting variances and acting, by responsibility centre.
Principal budget factor - the limiting resource (usually sales); its budget is prepared first.
Budget manual - written rules, formats and timetable; budget committee co-ordinates and approves.
Production budget - sales + closing stock − opening stock, in units; purchases budget adds material stock adjustment.
Cash budget - receipts and payments only; excludes depreciation, includes capital expenditure, tax and GST.
Master budget - budgeted P&L, balance sheet and cash budget consolidated for Board approval.
Flexible budget - costs restated for the actual activity level by splitting fixed, variable and semi-variable.
ZBB - every activity justified from zero through ranked decision packages; no incremental creep.
Performance budgeting - budget tied to functions, programmes and physical targets; used by Government of India.
Standard cost - predetermined cost per unit at specified efficiency; standard hour is output per hour, the common denominator.
Expected/attainable standard - the recommended basis; ideal standards demotivate, basic standards go stale.
Material usage variance - splits into mix (proportions) and yield (output per unit of input).
Idle time variance - always adverse; rate variance uses hours paid, efficiency variance uses hours worked.
Fixed overhead volume variance - under/over absorption; splits into efficiency, capacity and calendar.
Variable overhead - has expenditure and efficiency variances only, no volume variance.
Control ratios - Activity = Capacity × Efficiency; over 100% is favourable.
Disposal of variances - abnormal variances to Costing P&L; Ind AS 2 allows standard cost for inventory only if it approximates actual cost.

Formulas and examples

Production budget (units) = Budgeted sales + Closing finished stock − Opening finished stock
Purchase budget (qty) = Material for production + Closing material stock − Opening material stock
Flexible budget cost at X units = Fixed cost + (Variable cost per unit × X); semi-variable split by high-low: variable rate = (Cost at high − Cost at low) ÷ (Units high − Units low)
Closing cash = Opening cash + Receipts − Payments (₹)
Material cost variance MCV = (SQ × SP) − (AQ × AP) [SQ = standard qty for *actual output*]
Material price variance = AQ × (SP − AP); Material usage variance = SP × (SQ − AQ)
Material mix variance = SP × (RAQ − AQ), where RAQ = total actual input in standard proportion
Material yield variance = Std cost per unit of output × (Actual output − Standard output from actual input)
Labour cost variance = (SH × SR) − (AH paid × AR); Rate variance = AH paid × (SR − AR)
Idle time variance = Idle hours × SR (always adverse); Efficiency variance = SR × (SH − AH worked)
Variable OH cost variance = (SH × Std VOH rate) − Actual VOH; Expenditure = (AH × Std rate) − Actual VOH; Efficiency = Std rate × (SH − AH)
Fixed OH cost variance = (SH × Std FOH rate) − Actual FOH; Expenditure = Budgeted FOH − Actual FOH
Fixed OH volume variance = (SH × Std rate) − Budgeted FOH; Efficiency = Std rate × (SH − AH); Capacity = Std rate × (AH − Revised budgeted hours); Calendar = Std rate per day × (Actual days − Budgeted days)
Sales price variance = AQ × (AP − SP); Sales volume variance = SP × (AQ − BQ)
Sales margin price variance = AQ × (Actual margin − Std margin); Sales margin volume variance = Std margin × (AQ − BQ)
Efficiency ratio = (Std hours for actual output ÷ Actual hours worked) × 100
Capacity ratio = (Actual hours worked ÷ Budgeted hours) × 100
Activity ratio = (Std hours for actual output ÷ Budgeted hours) × 100 = Capacity × Efficiency

Symbols: S = standard, A = actual, B = budgeted, Q = quantity, P = price, H = hours, R = rate; quantities in kg or units, hours in labour/machine hours, money in ₹.

Example 1 — Material variances with mix and yield. Standard for 100 kg of output: A 60 kg @ ₹20 = ₹1,200; B 50 kg @ ₹10 = ₹500; input 110 kg, standard cost ₹1,700 per 100 kg output (₹17 per kg of output). Actual output 1,000 kg from A 640 kg @ ₹22 and B 540 kg @ ₹9.

Standard quantity for actual output: A 600 kg, B 500 kg → standard cost = 10 × 1,700 = ₹17,000. Actual cost = 14,080 + 4,860 = ₹18,940.
MCV = 17,000 − 18,940 = ₹1,940 (A).
Price: A 640(20−22) = 1,280 A; B 540(10−9) = 540 F → ₹740 (A).
Usage: A 20(600−640) = 800 A; B 10(500−540) = 400 A → ₹1,200 (A). Check: 740 + 1,200 = 1,940 ✓.
Mix: RAQ on 1,180 kg input = A 1,180 × 60/110 = 643.64 kg, B 536.36 kg. Mix = 20(643.64−640) + 10(536.36−540) = 72.73 F − 36.36 A = ₹36.36 (F).
Yield: standard output from 1,180 kg = 1,180 × 100/110 = 1,072.73 kg; variance = 17 × (1,000 − 1,072.73) = ₹1,236.36 (A). Check: 1,236.36 A + 36.36 F = 1,200 A ✓.

Example 2 — Labour variances and control ratios. Standard 5 hours @ ₹40 = ₹200 per unit; budget 1,100 units (5,500 hours). Actual output 1,000 units; hours paid 5,400 including 150 idle hours; wages ₹2,32,200 (actual rate ₹43).

Standard cost for actual output = 1,000 × 200 = ₹2,00,000 → LCV = 2,00,000 − 2,32,200 = ₹32,200 (A).
Rate = 5,400(40 − 43) = ₹16,200 (A). Idle time = 150 × 40 = ₹6,000 (A).
Efficiency = 40(5,000 − 5,250) = ₹10,000 (A). Total 16,200 + 6,000 + 10,000 = 32,200 ✓.
Efficiency ratio = 5,000/5,250 = 95.24%; Capacity ratio = 5,250/5,500 = 95.45%; Activity ratio = 5,000/5,500 = 90.91% (= 0.9524 × 0.9545 ✓).

Example 3 — Overhead variances (four-way). Budget: 2,000 units, 10,000 hours, 25 working days, fixed OH ₹2,00,000 (₹20/hour, ₹8,000/day), variable OH ₹1,00,000 (₹10/hour). Actual: 1,900 units, 9,300 hours, 24 days, fixed OH ₹2,06,000, variable OH ₹96,000. Standard hours for actual output = 9,500.

Fixed: absorbed = 9,500 × 20 = ₹1,90,000. Cost variance ₹16,000 (A); Expenditure = 2,00,000 − 2,06,000 = ₹6,000 (A); Volume = 1,90,000 − 2,00,000 = ₹10,000 (A).
Volume split: Efficiency = 20(9,500 − 9,300) = ₹4,000 (F); Calendar = 8,000 × (24 − 25) = ₹8,000 (A); Capacity = 20(9,300 − 9,600) = ₹6,000 (A). Sum = 10,000 A ✓.
Variable: absorbed = 9,500 × 10 = ₹95,000 → Cost variance ₹1,000 (A); Expenditure = 93,000 − 96,000 = ₹3,000 (A); Efficiency = 10(9,500 − 9,300) = ₹2,000 (F) ✓.

Example 4 — Flexible budget. 100% capacity = 10,000 units. Material ₹60/unit, labour ₹40/unit, variable OH ₹20/unit; semi-variable OH ₹1,50,000 at 100% (60% fixed → ₹90,000 fixed, ₹6/unit variable); fixed OH ₹2,00,000.

Item (₹)	70% – 7,000 u	85% – 8,500 u	100% – 10,000 u
Direct material	4,20,000	5,10,000	6,00,000
Direct labour	2,80,000	3,40,000	4,00,000
Variable overhead	1,40,000	1,70,000	2,00,000
Semi-variable (90,000 + ₹6/u)	1,32,000	1,41,000	1,50,000
Fixed overhead	2,00,000	2,00,000	2,00,000
Total cost	11,72,000	13,61,000	15,50,000
Cost per unit	167.43	160.12	155.00

Example 5 — Cash budget (March and April). Sales: Feb ₹5,00,000, Mar ₹6,00,000, Apr ₹5,50,000. Collections 40% in the month of sale, 60% next month. Purchases = 60% of next month's sales, paid one month after purchase. Wages ₹50,000 paid in the same month; overheads ₹30,000 paid in the following month. Opening cash 1 March ₹80,000; machine bought in March for ₹2,00,000.

March receipts = 40% × 6,00,000 + 60% × 5,00,000 = 2,40,000 + 3,00,000 = ₹5,40,000. Payments = purchases of Feb (60% × 6,00,000 = 3,60,000) + wages 50,000 + Feb overheads 30,000 + machine 2,00,000 = ₹6,40,000.
Closing March = 80,000 + 5,40,000 − 6,40,000 = (₹20,000) → an overdraft of ₹20,000 must be arranged.
April receipts = 40% × 5,50,000 + 60% × 6,00,000 = 2,20,000 + 3,60,000 = ₹5,80,000. Payments = March purchases (60% × 5,50,000 = 3,30,000) + 50,000 + 30,000 = ₹4,10,000.
Closing April = (20,000) + 5,80,000 − 4,10,000 = ₹1,50,000 (surplus).

Where it is used

Manufacturing: standard costing is standard practice in auto and auto-component plants (Maruti Suzuki, Bosch, Tata Motors vendors), cement, steel, paints and pharma, where bills of material and routings feed SAP/Oracle standard cost runs and monthly variance reviews.
FMCG and consumer durables: annual operating plan (AOP), rolling forecasts, trade-spend and advertising budgets by brand; yield and mix variances in food and beverage processing.
Services and outsourcing: IT/BPO and GCC firms budget by headcount, billable hours and utilisation; efficiency and capacity ratios become utilisation and realisation metrics.
Government and PSUs: Union and State budgets, outcome/performance budgeting, zero-based reviews of schemes, and MoU targets for central PSUs; municipal and university budgets follow the same structure.
Banking, insurance and NBFC: branch-level business budgets, cost-to-income targets, and cash/liquidity budgeting for treasury.
Job roles: cost accountant, FP&A and business-finance analyst, plant finance controller, internal auditor, management trainee (finance) — all expected to build a flexible budget, a cash budget and a variance reconciliation. Cost records maintained in Form CRA-1 under the Companies (Cost Records and Audit) Rules, 2014 require variance treatment to be disclosed.

Interview questions

Q: What is the difference between a budget, a forecast and a standard? A: A forecast predicts likely outcomes, a budget is an approved plan and target for a period, and a standard is a predetermined cost per unit used to measure actual performance.
Q: What is the principal budget factor and why does it matter? A: It is the resource that limits activity, usually sales demand; the budget for that factor is prepared first because every other budget must fit within it.
Q: Why is a flexible budget better than a fixed budget for control? A: It restates budgeted costs at the actual activity level, so the comparison measures real cost control instead of mixing in the effect of volume change.
Q: Which items are excluded from a cash budget? A: Non-cash charges such as depreciation, provisions, write-offs and accrued but unpaid items — only actual receipts and payments, including capital expenditure and taxes, are shown.
Q: Why is the labour rate variance computed on hours paid but efficiency on hours worked? A: Wages are paid for all hours including idle hours, so rate deviation applies to hours paid; efficiency measures productivity, which can only relate to hours actually worked.
Q: A favourable material price variance with an adverse usage variance — what does it suggest? A: Cheaper, poorer-quality material was bought, causing higher wastage; the two are linked and the purchase decision may have cost more than it saved.
Q: What causes a fixed overhead volume variance? A: Actual output differs from the budgeted output used to set the absorption rate, so fixed overhead is under- or over-absorbed; it splits into efficiency, capacity and calendar variances.
Q: Why does variable overhead have no volume variance? A: Variable overhead is absorbed at a rate per hour or unit, so total absorbed moves with activity automatically and no under/over absorption on volume arises.
Q: When would a calendar variance appear? A: Only when the actual number of working days differs from the budgeted days — holidays, strikes or an extra working day in the month.
Q: How are variances disposed of in the accounts? A: Abnormal variances are written off to the Costing Profit and Loss Account; normal ones may be prorated over inventories and cost of sales. Ind AS 2 allows standard cost for inventory only if it closely approximates actual cost.
Q: What is zero-base budgeting and where is it suitable? A: Every activity is justified afresh through ranked decision packages with no incremental base; it suits discretionary overheads, support functions and government schemes rather than routine production costs.
Q: Give one serious criticism of standard costing today. A: With short product life cycles, high automation and customised output, standards go stale quickly and direct-labour-based variances control a small and shrinking part of total cost; non-financial and ABC-based measures supplement them.

Common mistakes

Using budgeted quantity instead of the standard quantity for actual output when computing usage, efficiency and absorption — the single commonest error.
Comparing actual cost at actual volume with a fixed budget at a different volume and calling the whole gap a cost overrun.
Mixing up mix and yield: mix uses total actual input re-proportioned (RAQ), yield compares actual output with the standard output from that input.
Treating idle time variance as part of efficiency, or showing it as favourable; it is separated and is always adverse.
Putting depreciation, provisions or credit sales/purchases into a cash budget, or forgetting the lag on collections and payments.
Getting the sign convention wrong — writing "₹5,000" without stating (F) or (A) — and then failing the cross-check that the sub-variances must add back to the cost variance.
Reconciling to actual profit without the sales variances, or using sales value variances where margin variances are needed for a profit reconciliation.