Chapter Outline - Chapter 16 - Fundamentals of Variance Analysis
Chapter Outline - Chapter 16 - Fundamentals of Variance Analysis MBAD 6213
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CHAPTER 16 FUNDAMENTALS OF VARIANCE ANALYSIS Using Budget for Performance Evaluation When evaluating a firm s performance it is common to select other firms in the same industry as benchmarks Financial performance as reported in publicly available accounting records is one measure of performance For units of the firm or for organizations that don t routinely prepare public reports for example government organizations and notforprofit firms these benchmarks are much more difficult to collect One obvious alternative is the budget this is management s plan for financial performance Master Budget 1 Operating Budget Budgeted income statement production budget budgeted costs of goods sold and supporting budgets 2 Financial Budget Budgets of financial resources for example the cash budget and the budgeted balance sheet When management uses the master budget for control purposes it focuses on the key items that must be controlled to ensure the company s success Most of these items are in the operating budgets although some also appear in the financial budgets Chapter focus is on income statement as it is the most important financial statement that managers use to control operations Variance Difference between planned result and actual outcome Variance analysis uses the difference between actual performance and budgeted performance to 1 evaluate the performance of individuals and business units and 2 identify possible sources of deviations between budgeted and actual performance Basic ldea Calculate the difference between a planned budgeted number and actual performance and attempt to explain the causes of the difference Profit Variance Simplest measure of performance is the variance or difference between actual income and budgeted income Favorable Variance Variance that taken alone results in addition to operating profit Unfavorable Variance Variance that taken alone reduces operating profit When discussing revenue income or contribution margin a favorable variance means that the actual result is greater than the budgeted result When discussing costs a favorable variance indicates that actual costs are less than budgeted costs A favorable variance is not necessarily good and unfavorable variance is not necessarily bad This information can be useful for two reasons 1 It allows the managers to investigate more efficiently the cause of offbudget performance Manager can analyze those areas with a relatively large variance and if the investigation identifies the problem and it can be corrected the organization will be more likely to improve its performance in the following period 2 The information allows the manager to evaluate subordinate managers responsible for various aspects of the firm s operations for example marketing and production CHAPTER 16 FUNDAMENTALS OF VARIANCE ANALYSIS Why Are Actual and Budgeted Results Different An important part of variance analysis is understanding first what might cause a difference between actual and budgeted results and second what portion of the total profit variance is due to each cause Flexible Budgeting One obvious reason that actual results might differ from budgeted results is that the actual activity itself sometimes differs from the budgeted or expected activity Static Budget Budget for a single activity level usually the master budget Flexible Budget Budget that indicates revenues costs and profits for different levels of activity including the ex post actual activity level Because variable costs and revenues change with changes in activity levels these amounts are budgeted to be different at each activity level in the flexible budget Flexible Budget Line Expected monthly costs at different output levels Comparing Budgets and Results A comparison of the master budget with the flexible budget and with actual results is the basis for analyzing differences between plans and actual performance The flexible budget is based on actual activity Sales Activity Variance Difference between operating profit in the master budget and operating profit in the flexible budget that arises because the actual number of units sold is different from the budgeted number also known as sales volume variance Flexible and Master Budget Comparison Useful for management 1 It isolates the decrease in operating profits caused by the decrease in activity from the master budget 2 The resulting flexible budget shows budgeted sales costs and operating profits after considering the activity decrease but before considering differences in unit selling prices variable costs and fixed costs from the master budget Exhibit 164 Flexible and Master Budget 200000 difference between the master budget sales and flexible budget sales is based on the 20000unit decrease in sales volume multiplied by the budgeted 10 unit sales price Use the budgeted unit sales price instead of the actual price because we want to isolate the impact of the activity decrease from changes in the sales price We want to focus on the effects of volume alone Thus the sales amount in the flexible budget is not the actual revenue actual price times actual volume but the budgeted unit sales price times the actual number of units sold Interpreting Variances Holding everything else constant the 20000unit decrease in sales creates an unfavorable sales activity vanance Does this indicate poor performance Perhaps not CHAPTER 16 FUNDAMENTALS OF VARIANCE ANALYSIS Economic conditions could have been worse than planned decreasing the volume demanded by the market Hence perhaps the decrease in sales volume could have been even greater taking everything into account Note that both variable cost variances are labeled favorable but this doesn t mean that they are good for the company Variable costs are expected to decrease when volume is lower than planned Profit Variance Analysis as a Key Tool for Managers Profit Variance Analysis Analysis of the causes of differences between budgeted profits and the actual profits earned The profit variance analysis shows additional detail about the differences between budgeted profits and actual profits earned The actual results can be compared with both the flexible budget and the master budget in a profit variance analysis Cost variances result from deviations in input prices and efficiencies in operating the company They are important for measuring productivity and helping to control costs Sales Price Variance Sales Price Variance Difference between the actual revenue and actual units sold multiplied by the budgeted selling price Measurement and Control in a Cost Center We now change the focus of the analysis to a cost center level and consider using costs budgeted or planned versus actual as a basis for performance evaluation Because we are focusing on cost centers whose production managers typically do not control what they are asked to product we will use actual unit production not sales as a baseline Variable Production Costs For any variable resource eg direct materials the unit variable cost in the budget is determined by multiplying the expected budgeted amount of the resource used in each unit of output by the expected price of each unit of the resource Standard Cost Sheet Form providing standard quantities of inputs used to product a unit of output and the standard prices for the inputs Exhibit 166 Standard Cost Sheet Variable Manufacturing Costs Notice that overhead quantity is expressed in terms of direct laborhours because that is what is being used to apply the overhead Thus the standard cost per unit of input for overhead is really the standard laborbased burden rate Direct Materials Purchasing manager estimates that the cost of metal with the correct specifications and quality should be 055 per pound The 055 is the standard price for input not output The standard materials cost for a unit of output a frame is 220 4 pounds x 055 per pound CHAPTER 16 FUNDAMENTALS OF VARIANCE ANALYSIS Direct Labor Direct labor standards are based on a standard labor rate for the work performed and the standard number of laborhours required The standard labor rate includes wages earned as well as fringe benefits such as medical insurance and pension plan contributions and employerpaid taxes Most companies develop one standard for each labor category Variable Production Overhead Management reviewed prior period activities and costs estimated how costs will change in the future and performed a regression analysis in which overheard cost was the dependent variable and laborhours the independent variable Determined that best estimate was 1200 per standard laborhour as the variable overhead production rate Variable Cost Variance Analysis General Model Cost Variance Analysis Comparison of actual input amounts and prices with standard input amounts and pnces Both the actual and standard input quantities are for the actual output attained Price Variance Difference between actual costs and budgeted costs arising from the changes in the cost of inputs to a production process or other activity Efficiency Variance Difference between budgeted an actual results arising from differences between the inputs that were budgeted per unit of output and the inputs actually used Total Cost Variance Differences between budgeted and actual results equal to the sum of the price and efficiency variances Managers who are responsible for price variances would not be held responsible for efficiency variances and vice versa Example Purchasing department managers are usually held responsible for direct materials price variances and manufacturing department managers are usually held responsible for using the direct materials efficiently Price Variance AP x AQ SP x A0 AP SP x AQ Efficiency Variance SP x AQ SP x SQ SP x AQ SQ AP Actual Price AQ Actual Quantity SP Standard Price SQ Standard Quantity of Input Allowed for Actual Good Output Produced As the General Model for Variable Cost Variance Analysis is applied to each variable cost incursed a mre comprehensive variable analysis results CHAPTER 16 FUNDAMENTALS OF VARIANCE ANALYSIS In variance analysis a few basic methods can be applied with minor modifications to numerous business and nonbusiness situations Flexible Budget Production Standard input price times standard quantity of input allowed for actual good input The flexible budget concept can be applied to production as well as sales Flexible budget in Exhibit 165 was based on actual sales volume that is number of frames sold The flexible budget in 168 is based on actual production volume that is number of frames produced In this case the number of frames sold is equal to the number of frames produced Discussion of cases in which production and sales differ is in Chapter 17 Responsibility for Direct Materials Variances Direct Materials Price Variance Responsibility for this variance is usually assigned to the purchasing department Reports to management include an explanation of the variance for example failure to take purchase discounts higher transportation costs than expected different grade of direct materials purchased or changes in the market price of direct materials Direct Materials Efficiency Variance Responsibility for this variance is usually assigned to the production department In setting standards an allowance is usually made for defects in direct materials inexperience workers poor supervision and the like If actual material usage is less that these standards a favorable variance occurs lf usage exceeds standards an unfavorable variance occurs Direct Labor Direct Labor Price Variance Explanation given for favorable price variance is that company hired less experience employees in August they were paid a lower than standard wage thus reducing the average wage rate for all workers Wage rates for many companies are set by union contract If the wage rates used in setting standards are the same as those in the union contract labor price variances will not occur Labor Efficiency Variance The labor efficiency variance is a measure of labor productivity It is one of the most closely watched variances because production managers usually can control it Unfavorable labor efficiency variances have many causes including the employees themselves Sometimes poor materials or faulty equipment can cause productivity problems Poor supervision and scheduling can lead to unnecessary idle time Production department managers are usually responsible for direct labor efficiency variances Scheduling problems can stem from other production departments that have delayed production Example Personnel Department hires wrong type of worker Note that one event such as hiring inexperienced employees can affect more than one variance Variable Production Overhead Variable Production Overhead Price Variances CHAPTER 16 FUNDAMENTALS OF VARIANCE ANALYSIS Variable overhead standard rate was derived from a twostage estimation of 1 costs at various levels of activity and 2 the relationship between those estimated costs and the basis which is direct laborhours at company Price variance could have occurred because 1 actual costs for example machine power materials handling supplies some indirect labor were different from those expected and 2 the relationship between variable production overhead costs and direct labor hours is not perfect The variable overhead price actually contains some efficiency items as well as price items Example Utility rates are higher than expected or kilowatthours kwh per laborhour are higher than expected Some companies separate these components of variable overhead price variance this is done for energy costs in heavy manufacturing companies for example Variable Overhead Efficiency Variance The variable overhead efficiency variance must be interpreted carefully It is not related to the use or efficiency of variable overhead It is related to efficiency in using the base on which variable overhead is applied Example Company applies variable overhead on the basis of direct laborhours Thus if there is an unfavorable direct labor efficiency variance because actual direct laorOhours were higher than the standard allowed there will be a corresponding unfavorable variable overhead efficiency variance Variable overhead is assumed to vary directly with direct laborhours which is the base on which variable overhead is applied Thus inefficiency in using the base example direct laborhours machinehours units of output is assumed to case an increase in variable overhead This emphasizes the importance of selecting the proper base for applying variable overhead Managers who are responsible for controlling the base will probability be responsible for the variable overhead efficiency variance as well Fixed Cost Variances Because fixed costs are unchanged when volume changes at least within the relevant range the amount budgeted for fixed overhead is the same in both the master and flexible budgets This is consistent with the variable costs method of product costing in which fixed production overhead is treated as a period cost Fixed Cost Variances with Variable Costing Income statements prepared using variable costing there is no absorption of the fixed costs by units of production All the fixed manufacturing overhead is charged to income in the periods incurred Fixed overhead has no inputoutput relationships and thus no efficiency variance The difference between the flexible budget and the actual fixed overhead is entirely due to changes in the costs that make up fixed overhead example insurance premiums on the factory are higher than expected Hence the variance falls under the category of a price variance Spending Budget Variance Price variance for fixed overhead For fixed costs there is no difference between the flexible and master or static budget within the relevant range CHAPTER 16 FUNDAMENTALS OF VARIANCE ANALYSIS No calculation of the efficiency with which inputs are used Absorption Costing The Production Volume Variance lf fixed manufacturing costs are unitized and treated as product costs another variance is computed This occurs when companies use full absorption standard costing Developing the Standard Unit Cost for Fixed Production Costs Like other standard costs the fixed manufacturing standard cost is determined before the start of the production period Unlike standard variable manufacturing costs fixed costs are period costs by nature To convert them to product costs requires estimating both that period costs and the production volume for the period Standard or predetermined Fixed Production Overhead Cost Budgeted Fixed Manufacturing Costs Budgeted Activity Level Production Volume Variance Variances that arises because the volume used to apply fixed overhead differs from the estimated volume used to estimate fixed costs per unit A variance occurs if the number of units actually produced differs from the number of units used to estimate the fixed cost per unit Again this variance is commonly referred to as a production volume variance also called a capacity variance an idle capacity variance or a denominator variance The production volume variance applies only to fixed costs it occurs because we are allocating a fixed period cost to units on a predetermined basis It does not represent resources spent or saved This is unique to full absorption costing Compare with the Fixed Production Cost Price Variance The fixed production cost price variance is the difference between actual and budgeted fixed production costs Unlike the production volume variance the price variance commonly is sued for control purposes because it is a measure of differences between actual and budgeted period costs Standard Costing An accounting method that assigns costs to cost objects at predetermined amounts In process costing units transferred between departments are valued at standard cost In job costing standard costs are used to charge the job for its components
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