Chapter 9

Analyzing Financial Performance Reports

Need for comparing actual to budgeted

Even the best run organization cannot make perfect forecasts.

Forecasts always contain errors – random and non-random.

How should we assess the performance of a responsibility center manager when the budgeted performance does not match actual performance.

Through variance analysis, a control mechanism. Variance analysis would reveal what caused the

deviations and what should be done in future.

In this chapter, we will discuss: Post-budget control. The need for computing variances Variance as a control measure The different types of variances Using variances to evaluate performance

Variances

Traditionally, variances or deviation of actual from budgeted numbers is done at periodic intervals.

Is this adequate? Recent approach: do such analysis on a

routine basis or as a continuous improvement approach.

Variances

Computing variances is simple; it should be extended from top to the lowest levels of management to develop a true understanding of the causes.

The variance should be broken into its different elements – revenue, expenses, etc.

Before we proceed, let us briefly go over a few basic cost/managerial concepts

The following costs: Standard cost Fixed cost Variable cost Are standard cost same as budgets?

Standard Costs

Standards are benchmarks. In the context of manufacturing or

services, standard costs represent each major input (e.g. raw materials, labor time) that a product or service must use.

Cost standards refer to how much you should pay for an item or service.

It is a management by exception concept.

Fixed costs

A cost that remains constant, in total, regardless of changes in the level of activity.

Examples: rent, investment in machinery, building

Consequently, more the level of activity, smaller the fixed cost per unit of activity or vice versa.

Variable Costs

Variable cost is cost that varies, in total, in direct proportion to changes in the level of activity.

Example: as units produced increases, raw material usage, direct labor costs will go up proportionately.

Total costs rises and falls with the level of activity.

Cost behavior

Remember: Costs – both fixed and variable work only within a relevant range.

For example, whether you produce 10 units or 100,000 units, will the variable cost per unit remain the same? No.

Many costs might also have a fixed and variable components. E.g. Telephone bill

Basic Variance Analysis

Analyzing the factors that caused the actual and budgeted (costs, revenues, production units, etc.) is called variance analysis.

Usually, variance analysis is separated into two categories – quantity and price.

This is because the same individual may not be responsible for both quantity and price.

A basic variance model – Price and Quantity variances

Actual Quantity Actual Quantity Standard Quantityof inputs of inputs allowed for outputat Actual Price at Standard Price at Standard Price

(AQ x AP) (AQ X SP) (SQ x SP) (1) (2) (3)

Price Variance1-2

Materials PriceVariance

Labor rate varianceVariable overhead spending variance

Quantity Variance2 -3

Materials Quantity VarianceLabor efficiency variance

Variable overhead efficiencyvariance

Total Variance

Let us use the following data from Colonial Pewter Co.

Std. Qty Std. Price Std. Cost

Inputs or Hours or Rate

(1) (2) (1) x (2)

Direct materials 3 pound $ 4.00 $12.00

Direct Labor 2.5 hours 14.00 35.00

Variable Mfg. overhead 2.5 hours 3.00 7.50

Total std. cost per unit $54.50Standard cost of direct materials per unit of product = 3 lbs x $4 per lb = $12 per unit.Purchasing records show that in June, 6,500 lbs. of pewter were purchased at a cost of $3.80 per pound. The cost included freight and handling. All of the materials purchased was used during June to manufacture 2,000 lbs of pewter bookends. Using the data, let us computer price and quantity variances.

Price and Quantity variances for Colonial Pewter

Actual Quantity Actual Quantity Standard Quantityof inputs of inputs allowed for outputat Actual Price at Standard Price at Standard Price

(AQ x AP) (AQ X SP) (SQ x SP) (1) (2) (3)

6,500 pounds x $3.80 6,500 lbs. x $4.00 6,000 lbs. x per lb. = $24,700 = $26,000 $4.00 = $24,000

Total Variance = $700 U

Price variance = $1,300 F Quantity Variance = $2,000 U

Interpretation

First, $24,700 refers to the actual total cost of the pewter that was purchased during June.

Second, $26,000 refers to what the pewter would have cost if it had been purchased in the standard price of $4.00 a pound rather than the actual price of $3.80 per pound.

Difference between first and second, $1,300 is the price variance.

Third, $24,000 represents cost of Pewter if it were purchased at standard price and if standard quantity had been used.

The difference between second and third is the quantity variance.

Price and Quantity variances when quantity purchased and used differ

Actual Quantity Actual Quantity Standard Quantityof inputs of inputs allowed for outputat Actual Price at Standard Price at Standard Price

(AQ x AP) (AQ X SP) (SQ x SP) (1) (2) (3)

6,500 pounds x $3.80 6,500 lbs. x $4.00 4,800 lbs. x per lb. = $24,700 = $26,000 $4.00 = $19,200

Price variance = $1,300 F

Quantity Variance = $800 U

5,000 lbs. x 4.00 per pound = $20,000

Revenue variances

Unlike cost variances, revenue variances focus on selling prices and how Volume of sales and Mix (of various products)

Impact revenue and profitability

Selling Price Variance

Difference between the price you set (budgeted price) and the actual price at which you sell (using actual volume of sales).

Sales Price Variance

Three products – A, B, and C The budgeted prices are $1.00, 2.00, and 3.00

respectively Actual selling price was $0.90, 2.05, and 2.50

respectively. Actual volume of sales in units – 100, 200, and

150 respectively. Sales price variance is = [100 (1.00 -0.90) + 200

(2.00 – 2.05) + 150 (3.00 – 2.50)] = 75

Mix and Volume Variance

The firm sells several products (mix) and the volume of sales for each is different.

If we do not separate the mix and volume into separate components (to get a general overview), then the equation to compute a combined mix/volume variance is

Mix/Vol. variance = [Actual Vol. – Bud. Volume] * Budgeted contribution

Contribution = Selling price – variable costs only

Combined Mix and Volume Variance

Product 1

Actual Volume

2

Bud. Volume

3

Difference 4

(2-3)

Unit contribution

5

Variance 6

(4-5)A 100 100 0 -- --B 200 100 100 $0.90 $90.00C 150 100 50 1.2 $60.00

Total 450 300 150

The$150 variance is favorable in this example because the actual sales volume for the three products combined was more than what was budgeted

Mix Variance

Product 1

Bud. Proportion

2

Bud. Mix at Actual Volume

(3)Actual Sales

4

Difference 5

(4-3)

Unit contribution

6

Variance 7

(5) * (6)A 1/3 150 100 -50 0.2 -10B 1/3 150 200 50 $0.90 45C 1/3 150 150 0

Total 0 450 450 0 1.1 35

• See Column 3 and 4 – A higher proportion of B was sold while a lower proportion A was sold to A.• Since the contribution margin for B is higher (0.90) compared to A (0.20), the mix variance is favorable (35)

Volume variance separated from mix variance

We already computed the combined mix/volume variance (three slides earlier). It is 150.

The mix variance we just computed is 35. Therefore, volume variance =

150 - 35 = 115

Isolation of Variances

At what point should variances be isolated and brought to the attention of the management?

Earlier the better. What should management do? Variances should be viewed as ‘red flags.” Seek explanations for the reasons behind

variances and then decide, responsibility, course of action.

Other relevant issues of Variance Analysis –Time period comparison

Is comparison of annual budgets with annual performance reports better than,

Quarterly budgets with quarterly performance comparisons?

Or, shorter period comparisons? It depends on the objectives of the

decision maker.

Other relevant issues of Variance Analysis –selling price or gross margin?

We computed revenue variances based on selling prices. Is this realistic?

Does selling price remain constant throughout the year?

And, if not, a better approach would be to focus on gross margin (selling price- cost per unit) than on sales prices to compute variances.

Who is generally responsible for monitoring and taking action on variances?

One who can control the variance. Example:

Purchase manager for purchase price variance and

Production manager for quantity variance.

Thank You