Performance Evaluation Chapter Twenty-Two Performance Evaluation In Chapter Twenty-two, we are going to examine performance evaluation. We’ll begin by looking at flexible budgeting, then rapidly move on to standard costing. This chapter is packed with information, so it may be a good idea to go through the presentation at least twice or until you feel you have a thorough understanding of the material.

Learning Objective 1 Distinguish between flexible and static budgets. Learning Objective One: Distinguish between flexible and static budgets.

Preparing Flexible Budgets The master budget, sometimes called a static budget, is based solely on the planned volume of activity. Flexible budgets differ from static budgets in that they show expected revenues and costs at a variety of volume levels. The master budget that we previously prepared is really a static budget because it is only applicable to one plan and level of activity. On the other hand, a flexible budget can be prepared for any level of activity including the actual level of activity. Flexible budgeting is much more helpful in the management decision process. Flexible

Learning Objective 2 Use spreadsheet software to prepare flexible budgets. Learning Objective Two: Use spreadsheet software to prepare flexible budgets.

Preparing Flexible Budgets Melrose Manufacturing, a producer of small high-quality trophies, plans to make and sell 18,000 trophies during 2006. Melrose uses a standard cost system as outlined below: Melrose Manufacturing provided us with some information about its proposed sales for the coming year. The company plans to sell eighteen thousand trophies. We have detailed information about the expected selling price, the standard cost of materials, labor, and overhead. In addition, the company has calculated the variable standard general selling and administrative costs as well as information about its fixed costs.

Preparing Flexible Budgets From the standard cost information, Melrose prepares the following static and flexible budgets. 18,000 × $80 = $1,440,000 Part One This Excel spreadsheet shows a static budget for the plan and level of activity of eighteen thousand trophies sold. We can calculate revenue and all of our variable expenses by multiplying the number of units sold times the unit cost. Part Two For example, our anticipated sales revenue is one million four hundred forty thousand dollars, that is, eighteen thousand units times eighty dollars per unit. In addition to the static budget, we prepared our flexible budget at various levels of activity between sixteen thousand and twenty thousand units sold. It would be a good idea to take a few minutes and make sure you can calculate the amount shown in the flexible budget.

Preparing Flexible Budgets With very little effort, the accountant can provide management with a flexible budget for both budgeted and actual levels of activity. The flexible budget is a critical tool in effective performance evaluation. With the help of electronic spreadsheets, accountants can provide managers with flexible budgets for both planned and actual levels of activity. The flexible budget is an effective way for managers to determine whether their subordinates are effectively controlling revenues and expenses.

Learning Objective 3 Compute revenue and cost variances and interpret whether the variances signal favorable or unfavorable performance. Learning Objective Three: Compute revenue and cost variances and interpret whether the variances signal favorable or unfavorable performance.

Determining Variances for Performance Evaluation The differences between standard and actual amounts are called variances. A variance may be favorable or unfavorable. When actual sales are less than expected sales, an unfavorable sales variance exists. When actual costs are more than standard costs, an unfavorable cost variance exists. In accounting, the difference between a standard amount and an actual amount is called a variance. The variance can be favorable or unfavorable. A favorable variance means you spent less than budgeted or used fewer materials than we thought were required. An unfavorable variance means you spent more than budgeted or used more materials or resources than planned.

Learning Objective 4 Compute sales volume variances (differences between static and flexible budgets) and explain how volume variances affect fixed and variable costs. Learning Objective Four: Compute sales volume variances (differences between static and flexible budgets) and explain how volume variances affect fixed and variable costs.

Sales Volume Variances The difference between the static budget sales amount and the flexible budget sales amount is a measure of the sales volume variance. This Excel spreadsheet shows one of the problems managers face when there’s a difference between a static budget and the flexible budget. As we can see, we are comparing a static budget based on sales of eighteen thousand units, to a flexible budget with sales of nineteen thousand units. The company actually sold nineteen thousand trophies during the year. It exceeded its planned number of units sold of eighteen thousand. Can we compare the actual sales of nineteen thousand units to the planned sales of eighteen thousand units and arrive at any meaningful conclusions? We have a favorable volume variance because we sold more units than planned. All our variable expenses show an unfavorable variance because it is logical that we would spend more at a higher level of activity. It doesn’t appear that comparing these two budgeted amounts is likely to yield meaningful results. Let’s see how we might solve the problem.

Interpreting the Volume Variances In a standard cost system, marketing managers are usually responsible for the volume variance. Because sales volume drives production, production managers have little control over volume variance. In the case of Melrose, the marketing manager exceeded planned sales volume by 1,000 units, resulting in an $80,000 favorable revenue variance ($80 × 1,000). The unfavorable cost variances are somewhat misleading. Melrose incurred higher costs because it manufactured and sold more units than planned. In a standard cost system, the marketing department is usually responsible for any volume variance. The production Department has little or no control over the volume of units sold. Once again, in the case of Melrose, we had a favorable volume variance of one thousand units.

Interpreting the Volume Variances Because actual volume is not known until the end of the period, the selling price must be based on planned volume. At the planned volume of 18,000 units, Melrose’s fixed cost per unit is expected to be as follows: The volume variance also impacts the fixed cost per unit. The fixed costs developed for the static budget were based on sales of eighteen thousand units. Fixed costs represented sixteen dollars and twenty cents per unit. However, actual sales volume is nineteen thousand units, so our fixed cost per unit drops to fifteen dollars and thirty-five cents. Based on actual volume, fixed cost per unit would be $15.35 ($291,600 ÷ 19,000).

Learning Objective 5 Compute and interpret flexible budget variances (differences between flexible budget and actual results). Learning Objective Five: Compute and interpret flexible budget variances (differences between flexible budget and actual results).

Flexible Budget Variances For effective performance evaluation, management must compare the actual results achieved to the flexible budget based on the actual volume of activity. Here is a comparison of the standard cost and actual cost per unit for the current period. Here is some information gathered from Melrose at the end of the accounting period. We can see the standard amounts developed at the start of the year, and the actual amounts achieved as we move through the year.

Flexible Budget Variances Now we are comparing actual results achieved with the results that should have been achieved at the activity level. $78 × 19,000 = $1,482,000 Part One On this screen we have prepared a flexible budget for nineteen thousand units sold, using our standard cost. We will compare the flexible budget to the actual results achieved. Notice that the volume variance is zero. Both the budget and actual amounts are based on unit sales of nineteen thousand. We determine the flexible budget amounts by multiplying the nineteen thousand units times the various per-unit amounts at standard. Part Two We determine the actual amounts by multiplying the nineteen thousand units times the actual amounts achieved during the period. For example, our revenue was determined by multiplying nineteen thousand units times seventy-eight dollars per unit. We carried out similar calculations for the other variable costs. We are now in a position to determine the variances and seek explanations for major unfavorable or favorable variances. We see that we have an unfavorable thirty-eight thousand dollar sales revenue variance. This is because the actual selling price of seventy-eight dollars per unit is less than the planned selling price of eighty dollars per unit. As a supervisor, I want to know why the unit sales price was lower than anticipated.

Calculating Sales Price Variance or Part One We can isolate the sales price variances as shown on the screen. Our actual sales were one million four hundred eighty-two thousand dollars while our expected sales were one million four hundred forty thousand dollars. In effect, we had a forty-two thousand dollar favorable sales price variance. Part Two We can calculate this amount differently. We can take the favorable volume variance of eighty thousand dollars and subtract from that the unfavorable sales price variance of thirty-eight thousand dollars to arrive at an overall favorable total sales variance of forty-two thousand dollars.

Learning Objective 6 Explain how practical standards can motivate employee performance without negative consequences such as lowballing (the human element). Learning Objective Six: Explain how practical standards can motivate employee performance without negative consequences such as lowballing (the human element).

Establishing Standards A standard represents the amount a price, cost, or quantity should be, based on certain anticipated circumstances. Accountants, engineers, purchasing agents, and production managers combine efforts to set standards that encourage efficient future production. Establishing standard costs within an organization is really a team effort. To be successful, we need representatives from the accounting, engineering, purchasing, production, and marketing departments. Once standard costs have been established, they must be continually revised and updated in light of changing economic consequences in the industry.

Establishing Standards I recommend using practical standards that an average worker performing diligently would be able to achieve. Should we use ideal standards that represent what costs should be under the best circumstances? Managerial Accountant Part One Ideal standards can only be attained under the best circumstances. They allow for no work interruptions and they require employees to continually work at one hundred percent peak efficiency. Part Two Practical standards are tight but attainable. They allow for normal machine downtime and employee rest periods, and can be attained through reasonable, highly efficient efforts of the average worker. Practical standards can also be used for forecasting cash flows and planning inventory. Engineer

Need for Standard Costs Standard costs help managers plan and establish benchmarks against which actual performance can be judged. Management by exception focuses on material differences between actual and expected results. Standard cost systems help managers benchmark actual performance. Management by exception is the process of focusing on material differences between actual and expected results.

Learning Objective 7 Identify which variances are the most appropriate to investigate. Learning Objective Seven: Identify which variances are the most appropriate to investigate.

Selecting Variances to Investigate Management by exception tells us to consider: The materiality of a variance, How frequently it occurs, The capacity to control the variance, and The characteristics of the items behind the variance. A good manager will consider four variables when investigating variances. The first is the material nature of the variances. The higher the dollar amount of the variance, the more significant the impact. Second, a manager must look at how frequently the variance occurs. If the variance occurs monthly, corrective action is required. The third variable is how likely it is that we can control the variance. If it is extremely difficult to control the variance, we may not want to waste our time investigating it. Finally, a good manager will always look at the characteristics of the items behind the variance. We really want to know what is causing the variance.

Learning Objective 8 Calculate price and usage variances and identify the parties most likely responsible for them. Learning Objective Eight: Calculate price and usage variances and identify the parties most likely responsible for them.

Manufacturing Cost Variances We will use the following information provided by Melrose Manufacturing in 2006 to calculate manufacturing variances. Part One Melrose Manufacturing has provided standard and actual manufacturing costs for 2006. Take a moment to review the information on the table. Part Two Additionally, Melrose has provided the total quantity of materials used at standard and actual. Each unit produced should require a standard six point two pounds of raw material. During the year the company was able to produce its nineteen thousand units using only six pounds of raw materials per unit.

Materials Price and Usage Variances Actual Cost Column Variance Dividing Column Standard Cost Column Actual Quantity Used × Actual Price Per Pound Actual Quantity Used × Standard Price Per Pound Standard Quantity × Standard Price Per Pound 117,800 × $1.90 $223,820 117,800 × $2.00 $235,600 114,000 × $2.00 $228,000 Part One: Here is a general model for isolating material price and usage variances. The left column is referred to as the actual cost column, the middle column is the variance dividing column, and the column on the right is referred to as the standard cost column. You can see the amounts that we multiplied together in each of the three columns. Part Two: First, we calculate the material price variance of a favorable eleven thousand seven hundred eighty dollars. We multiply the actual quantity used times the actual price per pound to get two hundred twenty-three thousand eight hundred twenty dollars. Then, we multiply the actual quantity used times the standard price per pound to get two hundred thirty-five thousand six hundred dollars. Now, we arrive at the material price variance by taking the difference between these two amounts (two hundred twenty-three thousand eight hundred twenty dollars minus two hundred thirty-five thousand six hundred dollars). Part Three: Next, we calculate the material usage variance of an unfavorable seven thousand six hundred dollars. We multiply the actual quantity used times the standard price per pound to get two hundred thirty-five thousand six hundred dollars. Then, we multiply the standard quantity times the standard price per pound to get two hundred twenty-eight thousand dollars. Now, we arrive at the material usage variance by taking the difference between these two amounts (two hundred thirty-five thousand six hundred dollars minus two hundred twenty-eight thousand dollars). Part Four: Finally, we combine the two variances for a total variance of four thousand one hundred eighty dollars, favorable. Materials Price Variance $11,780 Favorable Materials Usage Variance $7,600 Unfavorable Total Variance $4,180 Favorable

Materials Price and Usage Variances Price Variance = Actual Quantity × Actual Price Standard Price – = $11,780 Favorable = × – ($1.90 $2.00) 117,800 Usage Variance = Standard Price × Actual Quantity Standard Quantity – Part One We can calculate the materials price and usage variance using the equations. The materials price variance is the difference between the actual price and the standard price times the actual quantity used. Part Two In our equation we have one dollar and ninety cents less two dollars times one hundred seventeen thousand eight hundred pounds. This yields a favorable price variance of eleven thousand seven hundred eighty dollars. We know that the price variance is favorable because we paid less than standard for the materials we purchased. Part Three For the material usage variance, we take the difference between the actual quantity and the standard quantity, and multiply that amount by the standard price. Part Four In our example we have an unfavorable variance of seven thousand six hundred dollars. We know the variance is unfavorable because we used more material than the standard called for. = $7,600 Unfavorable = × – (117,800 114,000) $2.00

Materials Quantity Variance Materials Price Variance Responsibility for Materials Variances Materials Quantity Variance Materials Price Variance Production Manager Purchasing Manager The purchasing manager and production manager are usually held responsible for the materials price variance and materials quantity variance, respectively. The standard price is used to compute the quantity variance so that the production manager is not held responsible for the performance of the purchasing manager. The standard price is used to compute the quantity variance so that the production manager is not held responsible for the purchasing manager’s performance.

Responsibility for Materials Variances I am not responsible for this unfavorable material quantity variance. You purchased inferior material, so my people had to use more of it. Production Manager Your poor scheduling sometimes requires me to rush order material at a higher price, causing unfavorable price variances. Part One Here we have a good example of the “blame game.” The production manager claims not to be responsible for the unfavorable materials quantity variance because the purchasing agent acquired inferior goods. Part Two In response, the purchasing managers says that because the production manager did a poor job of scheduling, she had to place rush orders and pay higher prices than normal for the raw materials. Purchasing Manager

Calculating Labor Variances Melrose has provided the following information about labor cost and usage during the period. Now let’s change the subject and look at labor variances. Melrose has provided information about actual pay rates and actual number of hours used to produce one unit of good output. We can now compare this information to the standard. We also have information about the total number of hours required to manufacture the nineteen thousand trophies.

Labor Price and Usage Variances Actual Cost Column Variance Dividing Column Standard Cost Column Actual Hours Used × Actual Price Per Hour Actual Hours Used × Standard Price Per Hour Standard Hours × Standard Price Per Hour 28,500 × $11.50 $327,750 28,500 × $12.00 $342,000 26,600 × $12.00 $319,200 Part One Once again we use the three-column approach. Take a few seconds and make sure you understand the values that we’re multiplying together. Part Two First, calculate the labor price variance. The variance is a favorable fourteen thousand two hundred fifty dollars. We know the variance will be favorable because our hourly pay rate was less than the standard. Part Three Next, we’ll calculate the labor usage variance, which turns out to be an unfavorable twenty-two thousand eight hundred dollars. The variance is unfavorable because we used one thousand nine hundred more hours than we were permitted by this standard. Part Four Finally, we combine the labor price variance and the labor usage variance and get a total unfavorable variance of eight thousand five hundred fifty dollars. Labor Price Variance $14,250 Favorable Labor Usage Variance $22,800 Unfavorable Total Variance $8,550 Unfavorable

Labor Price and Usage Variances Actual Price Standard Price – Price Variance Actual Hours = × = $14,250 Favorable = × – ($11.50 $12.00) 28,500 Usage Variance = Standard Price × Actual Hours Standard Hours – Part One Once again we can calculate the price and usage variance using equations. Let’s start with the price variance. To calculate the price variance, we find the difference between the actual price and the standard price and multiply that amount times the actual hours. Part Two Our calculations show us the favorable fourteen thousand two hundred fifty dollar price variance. Part Three We calculate the usage variance by finding the difference between the actual hours and the standard hours, then multiplying this amount times the standard wage rate. Part Four Just like using the column approach, we get a twenty-two thousand eight hundred dollar unfavorable usage variance. = $22,800 Unfavorable = × – (28,500 26,600) $12.00

Responsibility for Labor Variances Production managers are usually held accountable for labor variances because they can influence the: Mix of skill levels assigned to work tasks. Level of employee motivation. Quality of production supervision. Quality of training provided to employees. Labor variances are partially controllable by employees within the production department. For example, production managers/supervisors can influence the: Deployment of highly skilled workers and less skilled workers on tasks consistent with their skill levels. Level of employee motivation within the department.   Quality of production supervision. Quality of the training provided to the employees. Production Manager

Responsibility for Labor Variances I think it took more time to process the materials because the Maintenance Department has poorly maintained your equipment. Purchasing Manager I am not responsible for the unfavorable labor efficiency variance! You purchased cheap material, so it took more time to process. Production Manager Labor variances are not entirely controllable by one person or department. For example: The Maintenance Department may do a poor job of maintaining production equipment. This may increase the processing time required per unit, thereby causing an unfavorable labor efficiency variance. The purchasing manager may purchase lower quality raw materials resulting in an unfavorable labor efficiency variance for the production manager.

Variable Overhead Variances For Melrose’s Flexible Budget Variable Overhead Variance = Actual Units × Actual Cost Standard Cost – = $2,850 Unfavorable = × – ($5.75 $5.60) 19,000 Part One To calculate the variable overhead variance, we take the difference between the actual cost and the standard cost and multiply this amount times the actual units produced. Part Two For Melrose, the variable overhead variance is an unfavorable two thousand eight hundred fifty dollars. Part Three Variable costs can have both price and usage variances. Variable costs can have both price and usage variances.

Fixed Overhead Variances Fixed overhead costs can have a price variance. The difference between the actual fixed overhead costs and the budgeted fixed overhead costs is called the spending variance. At Melrose, the spending variance was: Fixed overhead costs can have a spending variance. The spending variance is the difference between the actual fixed overhead cost and the budgeted fixed overhead cost. Note that Melrose had an unfavorable fixed spending overhead variance of eight thousand four hundred dollars. ($201,600 budgeted – $210,000 actual) = $8,400 Unfavorable

Fixed Overhead Variances Overhead Volume Variance is the difference between budgeted fixed cost and applied fixed cost. Part One We can also calculate the overhead volume variance for fixed overhead. For Melrose, the predetermined fixed overhead rate is eleven dollars and twenty cents. Part Two There were nineteen thousand trophies produced so the company applied two hundred twelve thousand eight hundred dollars of overhead to its product. Part Three The volume variance is the difference between the budgeted fixed overhead and the applied overhead. For Melrose the volume variance was eleven thousand two hundred dollars, favorable. ($201,600 budgeted – $212,800 applied) = $11,200 Favorable

Fixed Overhead Variances Actual Fixed Cost Budgeted Fixed Cost $210,000 $201,600 Spending Variance $8,400 Unfavorable Applied Fixed Cost $212,800 Volume Variance $11,200 Favorable Part One Here is a summary of our fixed overhead variances. You can see the spending variance is an unfavorable eight thousand four hundred dollars. Part Two The volume variance is a favorable eleven thousand two hundred dollars. Remember, the volume variance is the difference between the budgeted fixed cost and the applied fixed cost.

GS&A Cost Variances Variable general, selling, and administrative (GS&A) costs can have price and usage variances. Fixed GS&A costs are also subject to variance analysis. We know that the flexible budget for 19,000 units sold shows GS&A expenses of $90,000. The actual GS&A expenses incurred during the period were $85,000. There was a $5,000 ($90,000 – $85,000) favorable fixed GS&S variance. Variable GS and A costs can have a price and usage variance. Fixed GS and A costs are also subject to variance analysis. The flexible budget for nineteen thousand units allowed ninety thousand dollars of GS and A expenses, but the company spent only eighty-five thousand dollars during the period. Therefore, there was a five thousand dollar favorable fixed GS and A variance.

End of Chapter Twenty-Two We have covered a lot of material in this chapter. Before your next exam, make sure you can easily calculate the material, labor, and overhead variances.