Financial and Non-Financial Measures of Operating Efficiency Chapter 8 Financial and Non-Financial Measures of Operating Efficiency

Profit Variance Analysis Compare budgeted and actual results to isolate the impact of individual input and output factors Used to Revise plan assumptions Evaluate employee performance LO1: Understand how companies use budgets for control.

The Master Budget Benchmark for computing variances As you know, the master budget specifies in detail Sales volumes and prices Input quantities and costs Planned efficiencies and prices Capacity costs Also termed overhead cost The master budget is like picking a point on the profit line in the CVP graph LO1: Understand how companies use budgets for control.

Cindy’s Master Budget LO1: Understand how companies use budgets for control.

Actual Results Differ LO1: Understand how companies use budgets for control.

Many Possible Sources Variance could be due to Variance analysis Output quantities and/or prices Input efficiencies and/or prices Errors in estimated overhead costs Variance analysis Linear decomposition of overall profit variance into above factors Turns “one dial” at a time LO1: Understand how companies use budgets for control.

$20.95 1 $14.30 2 $6.65 3 $19,950 $14,000 4 1 $3,75 in materials + $10.00* in labor + $0.55 in variable overhead *($10.00 = $20 per hour x 0.50 hours per cake) 2 $20.95 - $14.30 3 $3,000 x $6.65 4 $19,950 - $14,000

Variance Conventions LO2: Perform variance analysis. 8

Conceptual Approach Master budget Flexible Budget Flexible budget (actual price) Flexible budget (act. efficiency) Actual results Output Quantity Budget Actual Output Price Input Efficiency Input Price LO2: Perform variance analysis.

Structure of Variances LO2: Perform variance analysis.

$58,660 $79,610 $40,040 $45,760 $21,280 $25,270 $14,000 $14,000

Sales Volume Variance Difference between income / contribution in master and flexible budgets  units × Budgeted UCM = revenue × Budgeted CMR Flexible budget is at actual output quantity Sales volume is only change in plan assumption  Profit difference is due to change in sales volume Focus on change in CM / income & not revenue Change in volume changes revenues and variable costs Fixed costs do not change if volume changes LO2: Perform variance analysis.

Budgeted and Actual Results Volume of Activity Profit or Loss ($) Actual Profit Budgeted Profit Profit Variance Budgeted volume Actual volume (Fixed Cost) Profit Line (per CVP model) LO2: Perform variance analysis.

Flexible Budget Profit Sales Volume Variance B C A Volume of Activity Profit ($) Actual Profit Master Budget Profit Budgeted volume Actual volume (Fixed Costs) Profit Line (per CVP relation) Flexible Budget Profit Sales Volume Variance + Flexible Budget Variance = Total Profit Variance Profit ($) Volume of Activity LO2: Perform variance analysis.

Sales Volume Variance - Concept Total Profit Variance Flexible Budget Variance Sales Volume Variance Master budget profit Actual profit Profit in flexible budget Sales volume variance Flexible budget variance Total profit variance LO2: Perform variance analysis. 15

Tabular Format F F U LO2: Perform variance analysis. 16

1 300 $8.15 2 $2,445 1 3,800 cakes – 3,500 cakes 2 300 x $8.15

Flexible Budget Variance LO2: Perform variance analysis.

Cost Variances Cost in flexible budget is the right benchmark Activity volume the same in flexible budget and actual operations Can compare line items Materials Labor Overhead costs LO2: Perform variance analysis.

Look Back to the Previous Step F F U LO2: Perform variance analysis. 20

Flexible Budget Variances LO2: Perform variance analysis.

Cost Variances - Concept Variable Cost Variance Quantity Variances Price Variances Cost item in flexible budget Cost item in actual results “as if” cost item Quantity variance Price variance Flexible budget variance for given cost LO2: Perform variance analysis.

Tabular Format LO2: Perform variance analysis.

Variances are Linear Actual Cost Budgeted Cost LO2: Perform variance analysis.

Profit Reconciliation LO2: Perform variance analysis.

Test Your Knowledge! For what purpose is a flexible budget used? To provide various possible outcomes for management to consider To adjust input prices so that future variances are eliminated To insure that profit does not drop below a predetermined level To identify the sources of variances A flexible budget helps identify what caused any differences between the budgeted amount allowed at the actual level of sales and the actual amounts incurred.

$75,810 actual revenue / 3,800 cakes actually sold $19.95 $20.95 3,800 2 1 $75,810 actual revenue / 3,800 cakes actually sold 2 ($19.95 - $20.95) x 3,800 = $3,800 U

Interpreting Variances Investigate all significant variances Large variance shows poor plan / execution Examine trends Consistent sign may be related to plan assumptions Consider the total picture Variances ignore interactions Price-quantity, input substitution LO3: Interpret variances to determine possible corrective actions.

5 eggs per cake x 3,800 cakes $372 U = [($0.12 - $0.14) x 18,600] 19,000 1 2 3 1 5 eggs per cake x 3,800 cakes 2 $372 U = [($0.12 - $0.14) x 18,600] 3 $48 F = [(19,000 – 18,600) x $0.12]

Non-financial Controls Non financial measures better on Timeliness Specificity Non-financial measures used for Process control Provide localized feedback for immediate action Agency control (Chapter 12 & 13) LO4: Explain how nonfinancial measures complement variance analysis.

Test Your Knowledge! The controller for Navia, Inc. created a budget prior to the current period. At the end of the period, the controller compared the budget with the actual results. For what purpose is the controller using budgets? Coordination Control Variances Planning Having a good plan alone is not sufficient. The budget must be compared to actual performance, with any significant differences investigated and changes made as necessary.

PURCHASE PRICE VARIANCE (Appendix A) PURCHASE PRICE VARIANCE Appendix A

Rationale We calculated materials price variance based on quantity of materials used This can differ from quantity purchased Firms want to know a variance sooner than later Thus, many calculate the materials price variance on the quantity of materials purchased. Which approach is better? “Quantity purchased” is the pure approach and is consistent with a traditional accounting view We continue to employ “quantity used” Helps with profit reconciliation Appendix A

(Appendix B and C) MARKETING VARIANCES

Appendix B: Market Size and Share This is a drill down of sales volume variance Similar in principle to breaking down labor variance into labor rate and labor quantity variances. Volume (in units or $) = Size × Share Sales Volume Variance turns both dials The decomposition turns one dial at a time Appendix B and C

Decomposition: Graphical Market size variance Sales volume variance Actual market size x Planned market share x Planned UCM x Actual market share Flexible budget profit Planned market size Static budget profit Market share variance Appendix B and C

Example Sales volume variance 17,500 cakes x 20% share x $6,65/cake = $28,525 Static budget profit (3,500 cakes) 20,000 cakes x 20% share x $6.65/cake = $32,600 20,000 x 19% share x $6.65/cake = $30,970 Flexible budget profit (3,800 cakes) Market size variance Market share variance $3,325 F $1,330 U Sales volume variance $1,995 F Appendix B and C

Appendix C: Multiple Products Thus, far we have considered a 1- product case Budget was budgeted quantity and UCM. Flexible budget based on actual quantity and budgeted UCM. Thus. Sales volume variance = (Actual quantity – budgeted quantity) * budgeted UCM With Multi-product case Budget at budgeted quantity and budgeted UCM for each product Flexible budget at actual quantity and budgeted UCM for each product We can perform analysis in two ways Analyze each product separately Appropriate when products are independent Consider each product as a (total quantity * % share of product) Useful when products are substitutes / complements Appendix B and C

Multi-product Variance Analysis Focus on second type of analysis Recall that in CVP, when we considered multiple products, we used sales mix (% sales of each kind) to calculate Weighted Average Contribution Margin (WACM). Identical concept used here Use budgeted total sales (in units) and budgeted WACM to compute master budget Use actual total sales (in units) and actual WACM in flexible budget But, this turns two dials – total sales and WACM Can decompose into a mix effect and a quantity (mix-adjusted total sales) effect Introduce a “as if” column between master and flexible budget Appendix B and C

Mix and Quantity Variances Sales quantity variance Sales volume variance Actual total sales x Planned mix x Planned UCM x Actual mix Profit in flexible budget Planned total sales Static budget profit Sales mix variance Appendix B and C

Pacific Telephones Appendix B and C

Sales Volume Variance Sales volume variance Sales quantity variance 201,000 Actual units x $25.075 Plan WACM x $24.841 WACM in flexible budget Profit in flexible budget 200,000 plan units x $25.075 plan WACM Static budget profit Sales mix variance $25,075 F $47,125 U $22,050 U Appendix B and C

Exercise 8.34 Calculating materials and labor price and quantity variances (LO2). The Glass Vessel Company has established the following budget for producing one of its hand-blown vases: In March of the most recent year, Glass Vessel produced 300 vases using 650 pounds of materials. Glass Vessel purchased the 650 pounds of materials for $845. Labor costs for March were $7,200 for 480 hours worked. Required: What were Glass Vessel’s materials price and materials quantity variances for March? What were Glass Vessel’s labor price and labor quantity variances for March?

Exercise 8.34 (Continued) What were Glass Vessel’s materials price and materials quantity variances for March? To calculate the materials price and quantity variances, we need to know: (1) the flexible budget for materials; (2) the “as if” budget for materials with actual efficiencies; and (3) the actual results. The table below provides the required computations and accompanying variances.

Exercise 8.34 (Continued) What were Glass Vessel’s materials price and materials quantity variances for March? 1 $750 = 300 vases actually produced × 2 pounds of materials budgeted per vase × $1.25 budgeted cost per pound. 2 $812.50 = 650 pounds of materials actually used × $1.25 budgeted cost per pound. 3 Given. Thus, Glass Vessel’s materials price and quantity variances were $32.50 U and $62.50U, respectively, for March.

Exercise 8.34 (Continued) What were Glass Vessel’s labor price and labor quantity variances for March? As in part [a], to calculate the labor price and quantity variances, we need to know: (1) the flexible budget for labor; (2) the “as if” budget; and (3) the actual results. The table below provides the required computations and accompanying variances.

Exercise 8.34 (Continued) What were Glass Vessel’s labor price and labor quantity variances for March? 1 $6,750 = 300 vases actually produced × 1.5 hours of labor budgeted per vase × $15.00 budgeted cost per labor hour. 2 $7,200 = 480 hours actually worked × $15 budgeted cost per labor hour. 3 Given. Thus, Glass Vessel’s labor price and quantity variances were $0 and $450 U, respectively, for March.