MA Lecture Week 16 - Variance Analysis (2)

8/12/2019 MA Lecture Week 16 - Variance Analysis (2)

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www.bradford.ac.uk/management

Variance Analysis (2)

Week 16
http://www.bradford.ac.uk/managementhttp://www.bradford.ac.uk/management


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Learning Outcomes

At the end of the session, you should be able to:

Identify the issues surrounding variance analysis foroverheads

Reconcile budgeted to actual profit

Calculate yield and mix variances for process accountingAppreciate the criticisms of traditional budgeting

Illustrate the differences in the process of preparing rollingforecasts, kaizen budgets, zero-based budgets and activity-based budgets


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Recap - Overhead Costs

Some forms have overheads of between 3050% oftheir total costs

Analysing these costs becomes as important as analysingthe variable cost or marginal cost of one unit of

production Traditionally an allocation base is neededthis could be

direct labour hours or machine hours

BUT most of the time actual overhead costs are onlyknown at the end of the processin most cases acompany would use standard costs to measureperformance...


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Example

A firm has budgeted units of production of 12,000

for period 1 The variable overheads are estimated at 30,000 and

fixed overhead is estimated at 25,000. Theallocation base is direct labour hours, which are

budgeted at 4,800 hours Actual output at the end of the period was 10,000

units, with a fixed overhead spend of 24,000, and avariable overhead of 28,700, with direct labour

hours of 4,100

Analyse the variable OH variance


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Solution

Firstly, draw the chartbudget information on the left, actual

information on the right, and a gap in the middle, to show the flexed

budget to reflect actual economic activity

Calculate the flexed budget using an appropriate OH rate

In this case, use DL hours to work out a variable OH rate(30,000 / 4,800 hrs) = 6.25

Use this rate to work out the flexed variable OH rate

(12,000 / 4,800 hrs) x 10,000 = 25,000

And the total number of hours that should be used to make 10,000

units: 25,000/6.25 = 4000

Fill in the flexed Budget figures, and then calculate the price and

volume variance


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Reconciling Budget to

Actual ProfitFixed Actual Flexible Variances

Sales volume 75,000 82,000 82,000

Sales 750000 650667 820000 -169333

Less variable costs

Food costs 300000 270500 328000 57500

Other variable costs 90000 85000 98400 13400

Contribution 360000 295167 393600 33600

Less fixed costsLabour costs 158000 165000 158000 -7000

Overheads 78000 65000 78000 13000

Net profit 124000 65167 157600


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Statement Reconciling Budget Net Profit withActual Net Profit

Budgeted net profit 124,000

Sales price variance -169,333Sales margin variance(contribution) 33,600

Food costs variance 57,500

Other variable costs variance 13,400

Labour costs variance -7,000

Overhead costs variance

13,000

-58,833

Actual net profit 65,166


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Mix variance

1. A mix variance arises when the actual mix differs from the pre-determined standard mix.

Example

Standard mix to produce 9 litres of output:

5 litres of X at 7 per litre = 35

3 litres of Y at 5 per litre = 152 litres of Z at 2 per litre = 4

54

Standard loss =10% of input. Actual output = 92 700 litres

Actual inputs:

53 000 litres of X at 7 = 371 000

28 000 litres of Y at 5.30 = 148 400

19 000 litres of Z at 2.20 = 41 800

100 000 561 200


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2. Mix variance = (SQ x SP) - (AQ SP)

How much should have been used How much was actually used

SQ SP AQ SP

X =100 000 5/10 7 350 000 53 000 7 371 000

Y =100 000 3/10 5 150 000 28 000 5 140 000Z =100 000 2/10 2 40 000 19 000 2 38 000

540 000 549 000

Mix variance = 9 000 A

So a greater proportion of inferior material has been used.

Standard prices are used to calculate the variances to remove the effect of

price on variance. Price effects can be misleading an unfavourable variance

can be caused by substituting higher quality material for cheaper ones this

maybe in best interests of company but an adverse variance will not reflect

this.


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Yield variance

Yield variance is the difference between the standard output for a given

level of inputs and the actual output:

= (Actual yield Standard yield from actual input)

SC per unit of output

= (92 700 90 000 ) 54 / 9 = 16 200 F

If Adverse variable:

Failure to follow standard proceduresInferior quality material


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Sales mix and quantity variances

1. Where a company sells several different products that have

different profit margins, it is possible to divide the sales volume varianceinto a quantity and mix variance.

Example

Budgeted sales

X = 8 000 units at 20 contribution = 160 000Y = 7 000 units at 12 contribution = 84 000

Z = 5 000 units at 9 contribution = 45 000

20 000 289 000

Actual sales

X = 6 000 units at 20 contribution = 120 000

Y = 7 000 units at 12 contribution = 84 000

Z = 9 000 units at 9 contribution = 81 000

22 000 285 000


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Sold more than we expected (22000 instead

of 20000)

However Contribution was less than expected

(4000A Total sales margin variance).

Probably because

sold more of product Z which provides less

contribution per unit.

Sold less of product X which provides greatestcontribution per unit.


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Sales Mix variance = (AQ SQ in budgeted proportions) Standard margin

SQ in budgeted proportions:X = 40% (8/20) of 22000 = 8800

Y = 35% (7/20) of 22000 = 7700

Z = 25% (5/20) of 22000 = 5500

AQ SQ in budgeted proportions x Standard margin

X 6 000

8 800 20 = 56 000 AY 7 000 7 700 12 = 8 400 A

Z 9 000 5 500 9 = 31 500 F

22 000 32 900 A


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Adverse sale mix variance suggests that a higher proportion of the low marginproducts were sold during the period than expected in the budget.

Demand for the more profitable products being lower than anticipated

Decrease in the production of the high margin products due to supply sidelimiting factors (e.g. shortage of raw materials or labor)

Sales team not focusing on selling products with higher margins due to forexample lack of awareness or misaligned performance incentives (e.g.uniform sales commission on the entire product range may not motivate salesstaff to compete for high margin sales)

Increase in demand or supply of the less profitable products

Favorable sales mix variance suggests that a higher proportion of more profitableproducts were sold during the period than was anticipated in the budget.

Concentration of sales and marketing efforts towards selling the moreprofitable products Increase in the demand for the higher margin products(where demand is a limiting factor)

Increase in the supply of the more profitable products due to for exampleaddition to the production capacity (where supply is a limiting factor)

Decrease in the demand or supply of the less profitable products


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Sales quanti ty var iances

3. Quantity variance = (AQ in budgeted proportions

BQ) Actual SM

X = (8 800 8 000) 20 = 16 000 F

Y = (7 700 7 000) 12 = 8 400 F

Z = (5 500 5 000) 9 = 4 500 F

28 900 F

4. If planned mix had been achieved the sales volume variance would

have been 28 900 F.

Splitting variances in this way allows us to see how promoting overall

sales volume is not as beneficial as promoting the most desirableproducts.


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Favorable sales quantity variance suggests that thecompany was able to sell a higher number of products in

aggregate as compared to the total number of unitsbudgeted to be sold during a period. Improved marketing of company products

Installation of a new production plant

More efficient production

Adverse sales quantity variance indicates that the companysold lesser number of goods on aggregate basis ascompared to the total number of units budgeted to be soldduring a period.

A reduction in the overall demand in industry (e.g. due to theintroduction of a better or cheaper substitute in the market)

Unavailability of a critical manufacturing component or rawmaterial

Decline in the productivity of the workforce


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Criticisms of traditional budgeting

Traditional budgeting uses a detailed line approach which issubject to an incremental change in forthcoming years.

There are alternative systems which can be used within thebudgeting process.

There are also management philosophies that argue budgeting shouldnot be used in any form.

The CIMA 2009 survey clearly demonstrates that traditionalbudgeting is still the most popular form of budgeting.

However, traditional budgeting is renowned for its limitations.

The biggest concern with traditional budgeting is the inability torespond to a fast-changing environment.

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Traditional budgeting

Reeves and Deimler (2011) argue that: Traditional budgeting assumes the world is predictable

and relatively stable!

In order to remain competitive, companies need to be able

to respond and learn fast, which will impact the budget.

Frow et al (2010) argue that: Organizations are facing economic uncertainty through

new technologies, business models and shorter product

life cycles All of which need to be constantly updated within the

budgets

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Alternative budgeting systems

There are many alternative budgeting

systems:

Rolling forecasts

Zero-based budgeting

Kaizen budgeting

Activity-based budgeting

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Rolling Forecasts

An approach to budgeting that uses a continuous updating

approach to forecasting, the time period of the budget

remains constant

In the majority of cases they will have 6-8 rolling quarterly

forecasts

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Zero-based budgeting

An approach to budgeting that starts with a

blank piece of paper every accounting period.

Resources are allocated on needs rather than

past budgeted information.

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Zero based budgeting

1. All activities within the organization are identified. Report

generated to analyse costs of each activity, justify thereason for the activity to go ahead and to present allalternatives. Targets should be identified as a performancetool. These activity reports are commonly referred to asdecisionpackages.

2. Every activity report will then be given due considerationand they will be ranked in order of what is required for thatup and coming budget period.

3. The final stage is the allocation of resources which isdetermined by the ranking performed in stage two.

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Zero based budgeting

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Kaizen Budgeting

Budgeting based on a continuous improvement philosophy.

Seeking small improvements in the operating processes which

are recorded within the budget statement.

Although it is about cost reduction it is a cultural mindset.

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Budgeting based on activities rather than units, products, or

departments. An extension of ABC.

CIMA (2009) reports that nearly 50% of the respondents used

ABB.

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Process:

1. Analyse products and customers to be able to predict

the production and sales demand.

2. Use the information from the ABC system to estimatethe resources required to perform organizational

activities.

3. With demand predicted, estimate the quantity of each

resource that will be needed to meet the demand.

4. Allocate resources based on these predictions for each

activity.

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Beyond budgeting

A philosophy which seeks the abandonment of budgets.

Using relative target measure this approach seeks

innovation and value added activities to measure the

success of a department, under a devolved process.

Traditional budgeting was deemed to have many

problems.

Hope and Fraser (2003) brought the discussion of the

beyond budgeting philosophy to the wider audience.

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Beyond budgeting

Moving away from fixed targets, by using relative targets through benchmarking, will encourage employees to improve their own performance.

Using relative targets will encourage employees to be innovative andprovide the confidence to take (positive) risks they would not have donebefore.

By continuously readdressing plans employees are encouraged to thinkabout value creation rather than achieving set numbers within thebudget.

By using on demand allocation of resources rather than allocating for the

year ahead reduces costs.

Using decentralization and passing the decision making to small localteams means market feedback is used within the process.

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Beyond budgeting

So why isnt everyone using this philosophy?

It is very difficult to move away from the

traditional budgeting process, cultural mindset.

It is difficult to generate relative benchmarks for

lower level managers

Some of the principles need more detailedexplanation

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MA Lecture Week 16 - Variance Analysis (2)

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