Variance Analysis

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Agenda Motivate the need for variance analysis Describe the organizational use of variances Discuss the mechanics of variance analysis Example: Ross Parts Takeaway

Management Accounting Systems Variance Analysis Cost Accounting Systems Budgeting Systems Transfer Pricing Performance Measurement Systems

Variance Analysis Organizations that have a budget typically compare the actual results to the budget at the end of the period. Variance: Difference between actual and budgeted results: Actual Budget Variance Revenue: $1,150 $1,000 $150F Direct Material: $450 $400 $50U Direct Labor: $425 $25F Overheard: $100 $0 Profit $175 $50 $125F

Labeling Convention Variance that implies a higher profit: favorable (F) Actual revenue is higher than budgeted Actual costs are lower than budgeted Variance that implies a lower profit: unfavorable (U) Actual revenue is lower than budgeted Actual costs are higher than budgeted

Goal of Variance Analysis Quantify the impact of the individual factors on the total variances Actual Budget Variance Possible reasons for the variance Sales: $1,150 $1,000 $150F Sales volume, sales price Direct Material: $450 $400 $50U Sales volume, material costs, material usage Direct Labor: $425 $25F Sales volume, labor costs, labor usage Overheard: $100 $0 Sales volume, resource costs, resource usage Profit $175 $50 $125F - All of the above -

Purpose of Variance Analysis Performance evaluation: Who is responsible for the overall results? How well did our sales/ marketing people do? How efficiently did our production dept. use the resources? How well did our sourcing dept. negotiate with suppliers? Planning: Should we change our product mix? Should we change our suppliers?

Mechanics of Variance Analysis We can quantify the impact of the individual factors by decomposing the variances: The decomposition uses a common unit of measure, namely $ It is difficult to compare #units, kg, $/unit, etc., across products

Variance Analysis - Mechanics We can quantify the impact of the individual factors by decomposing the variances: Sales variance: Cost variances: Actual Sales (AV x AP) Flexible Budget (AV x EP) (Master) Budget (EV x EP) Output Price Variance Sales Volume Variance Actual Costs (AO x AI x AP) Flexible Budget (AO x EI x EP) (Master) Budget (EO x EI x EP) (AO x AI x EP) Input Price Variance Efficiency Variance Production Volume Variance

Example: Ross Parts Ross Parts produces the RP-24 Budget for 2011: Per Unit Total: 100,000 Units Sales: $20 $2,000,000 Costs: Direct materials: 2kg @ $3 = $6 $ 600,000 Direct labor: 0.2 hrs. @ $25 = $5 $500,000 Overhead : $300,000 Profit: $600,000 *Print this out.

Example: Ross Parts Actual results for 2011: Total Sales: 100,000 units @ $20.50 $2,050,000 Costs: Direct materials: 194,000 kg @ $3.50/kg $ 679,000 Direct labor: 21,000 hrs. @ $23/hr. $483,000 Overhead : $300,000 Profit: $588,000 Actual Direct Material usage per unit: 194,000 kg/ 100,000 units = 1.94kg/ unit Actual Direct Labor usage per unit: 21,000 hrs./ 100,000 units = 0.21 hrs.

Example: Ross Parts Sales variance (Volume is Sales Volume): 100,000 x $20.50 100,000 x $20 100,000 x $20 = $2,050,000 = $2,000,000 = $2,000,000 Actual Sales (AV x AP) Flexible Budget (AV x EP) (Master) Budget (EV x EP) Price Variance Volume Variance Output Price Variance: $50,000 F Volume Variance: $0

Cost variances (Volume is Production Volume): Direct Material 100,000 x 1.94 x $3.50 100,000 x 1.94 x $3 100,000 x 2 x $3 100,000 x 2 x $3 = $679,000 = $582,000 = $600,000 = $600,000 $97,000 U $18,000 F 0 Direct Labor 100,000 x 0.21 x $23 100,000 x 0.21 x $25 100,000 x 0.2 x $25 100,000 x 0.2 x $25 = $483,000 = $525,000 = $500,000 = $500,000 $42,000 F $25,000 U 0 Overhead $300,000 $300,000 Actual Costs (AO x AI x AP) Flexible Budget (AO x EI x EP) (Master) Budget (EO x EI x EP) (AO x AI x EP) Input Price Variance Efficiency Variance Volume Variance “Spending Variance”

Variance Decomposition Summary Sales variances Price variance $50,000 F Volume variance $0 Direct material variances 97,000 U Efficiency variance 18,000 F 79,000 U Direct labor variances 42,000 F 25,000 U 17,000 F Overhead Variance Profit Variance $12,000 U Q: Why is this summary useful to management?

Takeaway Variance: Difference between actual results and budget. Variance Analysis: Quantitative decomposition of total variances into individual components (volume variance, price variance, cost variance, efficiency variance). Purpose of variance analysis: Performance evaluation: Who is responsible for the overall results? Planning

Variance Analysis - Worksheet We can quantify the impact of the individual factors by decomposing the variances: Sales variance: Cost variances: Actual Sales (AV x AP) Flexible Budget (AV x EP) (Master) Budget (EV x EP) Output Price Variance Sales Volume Variance Actual Costs (AO x AI x AP) Flexible Budget (AO x EI x EP) (Master) Budget (EO x EI x EP) (AO x AI x EP) Input Price Variance Efficiency Variance Production Volume Variance