Reconciliation of budgeted and actual profit - Reconciliatio...

Learning Outcomes

After reading this article, you will be able to explain why the profit calculated from a budget may differ from the actual profit earned, describe the reconciliation process under standard absorption costing, identify key variances affecting profit, and prepare an operating statement reconciling budgeted and actual profit. You will also recognise common causes of variance, how to interpret reconciliation statements, and understand their importance in management control and performance reporting.

ACCA Management Accounting (MA) Syllabus

For ACCA Management Accounting (MA), you are required to understand how actual and budgeted profit are reconciled in organisations using absorption costing. This article focuses on:

• The use and impact of standard absorption costing in profit reporting
• Calculation and interpretation of standard cost variances, especially fixed overhead variances
• Preparation and interpretation of reconciliation statements between budgeted and actual profit
• The influence of under- or over-absorbed overheads on reported profit
• The main steps in preparing an operating statement to explain the difference between actual and budgeted profit

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. What is under- or over-absorbed overhead? How does it impact the reconciliation of actual and budgeted profit under absorption costing?
2. Which three main variances need to be considered when reconciling budgeted profit with actual profit under standard absorption costing?
3. True or false? Sales price variances do not affect the reconciliation of profit under standard absorption costing.
4. Briefly outline the steps you would follow to prepare an operating statement that reconciles budgeted profit to actual profit.

Introduction

Organisations regularly compare actual profits with budgeted profits to evaluate performance. In absorption costing systems, profit differences arise not just from variations in sales and costs, but also from how overheads are absorbed into product costs. Reconciling these profits involves explaining the impact of sales, cost, and overhead variances. A clear reconciliation highlights areas requiring management attention and ensures meaningful performance reporting.

Key Term: standard absorption costing
A costing system where products are costed using standard rates for each element, including both variable and fixed production overheads, absorbed to units produced.

THE PURPOSE OF PROFIT RECONCILIATION

Reconciliation of profit under standard absorption costing enables managers to understand why the actual profit differs from the budgeted profit. The main purposes are:

• To quantify the influence of sales, cost, and overhead variances
• To show the combined effect of favourable and adverse variances
• To support accountability through responsibility accounting
• To guide corrective actions for future planning and control

Key Term: variance
The difference between an actual result and the budgeted or standard amount for the same item, calculated for sales, costs, or overheads.

WHY DO BUDGETED AND ACTUAL PROFIT DIFFER?

Under standard absorption costing, there are three main sources of difference between budgeted profit and actual profit:

1. Profit impact of selling more or fewer units than planned
2. Profit impact of selling at higher or lower prices than planned
3. The effect of under- or over-absorbed fixed production overheads caused by actual output differing from budgeted output or by actual overhead costs differing from budget

Key Term: operating statement
A report that reconciles budgeted profit with actual profit, analysing the effect of individual variances for sales, costs, and overheads.

THE STRUCTURE OF THE OPERATING STATEMENT

A typical reconciliation operating statement in standard absorption costing will follow this structure:

1. Start with budgeted profit (from the original or flexed budget)
2. Add favourable variances (which increase profit)
3. Subtract adverse variances (which decrease profit)
4. Arrive at actual profit

The statement typically includes:

• Sales price variance
• Sales volume profit (or margin) variance
• Direct material and direct labour total, price, and usage/efficiency variances
• Variable and fixed overhead variances (with fixed overhead variances often split into expenditure, volume, capacity, and efficiency)
• Other relevant variances (where necessary)

Worked Example 1.1

A company budgets to sell 2,000 units, earning a budgeted profit of $10,000. Actual profit for the period was $8,000. Key variances calculated:

• Sales price variance: $2,000 adverse
• Sales volume profit variance: $500 adverse
• Materials variance (total): $700 favourable
• Labour variance (total): $200 adverse
• Fixed overhead expenditure variance: $400 adverse
• Fixed overhead volume variance: $500 favourable

Prepare a profit reconciliation.

Answer:

Budgeted profit	$10,000
Sales price variance	$(2,000)
Sales volume profit var.	$(500)
Materials variance	$700
Labour variance	$(200)
Fixed overhead expenditure var.	$(400)
Fixed overhead volume var.	$500
Actual profit	$8,000

FIXED OVERHEAD VARIANCES AND PROFIT RECONCILIATION

Fixed production overhead is absorbed into product cost based on a predetermined absorption rate. At period-end, if the absorbed overhead does not match the actual overhead incurred, the difference (under- or over-absorbed overhead) must be accounted for in the profit reconciliation.

• Under-absorbed overhead: Actual overhead incurred exceeds the amount absorbed; this reduces actual profit compared to budget.
• Over-absorbed overhead: Absorbed overhead exceeds actual overhead incurred; this increases actual profit.

Worked Example 1.2

Budgeted production overhead: $50,000, based on producing 10,000 units ($5 per unit). Actual production: 9,000 units, actual overhead incurred: $48,000.

Calculate the fixed overhead variances and their effect on profit.

Answer:

• Overhead absorbed: 9,000 units × $5 = $45,000
• Expenditure variance: Actual – Budgeted = $48,000 – $50,000 = $2,000 favourable
• Volume variance: Absorbed – Budgeted = $45,000 – $50,000 = $5,000 adverse
• Under-absorption for the period: $3,000
• Net effect: The under-absorbed overhead reduces actual profit in the reconciliation by $3,000.

PREPARING AN OPERATING STATEMENT: STEP-BY-STEP

To prepare a reconciliation operating statement under absorption costing:

1. Calculate budgeted profit (flex if actual activity level differs from budgeted level).
2. Calculate sales variances:
   • Sales price variance = (actual price – budget price) × actual quantity sold
   • Sales volume profit variance = (actual quantity sold – budget quantity) × standard profit per unit
3. Calculate cost variances for each input (materials and labour):
   • Total variance, broken down into price/rate and usage/efficiency elements
4. Calculate variable and fixed overhead variances:
   • Fixed overhead should be split into expenditure and volume variances (which can be further analysed into efficiency and capacity if overhead is absorbed by hours)
5. Adjust budgeted profit: Add favourable and subtract adverse variances stepwise to arrive at actual profit.
6. Present the statement clearly (see Worked Examples above).

Worked Example 1.3

A company’s budgeted profit (absorption costing) = $12,000.

Calculated variances for the period:

• Sales price: $800 favourable
• Sales volume profit: $400 adverse
• Materials total: $300 adverse
• Labour total: $200 favourable
• Fixed overhead expenditure: $100 adverse
• Fixed overhead volume: $400 favourable

Prepare a reconciliation statement.

Answer:

Budgeted profit	$12,000
Sales price variance	$800 F
Sales volume profit variance	$400 A
Materials total variance	$300 A
Labour total variance	$200 F
Fixed overhead expenditure var.	$100 A
Fixed overhead volume var.	$400 F
Actual profit	$12,600

ANALYSING RECONCILIATION VARIANCES

Each variance in the operating statement provides information about the reason for the profit difference:

• Sales price variance: Indicates if actual selling prices were higher or lower than planned.
• Sales volume profit variance: Measures effect of selling more or fewer units than budgeted.
• Materials and labour variances: Show the impact of paying different prices or using more/fewer resources than standard allows.
• Overhead variances: Explain the combined impact of actual overheads versus amounts absorbed.

Key Term: under- or over-absorbed overhead
The difference between actual overhead costs incurred and the amount absorbed to products via the standard overhead absorption rate. Under-absorption signals insufficient overhead has been included in product cost; over-absorption means too much overhead has been included.

INTERPRETING RECONCILIATION AND MANAGEMENT ACTION

Clear reconciliation and variance analysis help managers make informed decisions:

• Investigate large/frequent adverse variances
• Identify areas for cost saving or process improvement
• Revise standards or budgets if planning errors are identified
• Hold relevant managers accountable for controllable variances

Revision Tip

Always check which basis the company uses (absorption or marginal costing), as the approach to profit reconciliation and variance calculation will differ. Practise preparing operating statements until the steps become automatic.

Summary

Reconciling budgeted to actual profit under standard absorption costing involves systematically explaining how and why variances—especially sales, cost, and overhead variances—cause actual profit to differ from budget. The key focus is the operating statement, which presents each variance’s effect, helping to trace and explain the full difference. Understanding this process is essential for reporting, control, and effective management decision-making.

Key Point Checklist

This article has covered the following key knowledge points:

• Explain why actual profit and budgeted profit differ under absorption costing
• Identify and calculate the main variances affecting profit reconciliation
• Describe how fixed overheads are absorbed and result in under- or over-absorption
• Prepare an operating statement reconciling budgeted and actual profit
• Interpret what individual variances indicate about business performance

Key Terms and Concepts

• standard absorption costing
• variance
• operating statement
• under- or over-absorbed overhead