Analyzing Financial Performance Reports Chapter 10 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 Quantity of inputs of inputs allowed for output at Actual Price at Standard Price at Standard Price (AQ x AP) (AQ X SP) (SQ x SP) (1) (2) (3) Price Variance 1-2 Materials Price Variance Labor rate variance Variable overhead spending variance Quantity Variance 2 -3 Materials Quantity Variance Labor efficiency variance Variable overhead efficiency variance A price variance and quantity variance can be computer for all three variable components – direct materials, direct labor, and variable overhead. However, the variance is not called by the same name in all cases. For example, a price variance is called a materials price variance in the case of direct materials, but labor rate variance in the case of direct labor and an overhead spending variance in the case of variable manufacturing overhead. 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 3.00 7.50 Total std. cost per unit $54.50 Standard 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 Quantity of inputs of inputs allowed for output at 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 A price variance and quantity variance can be computer for all three variable components – direct materials, direct labor, and variable overhead. However, the variance is not called by the same name in all cases. For example, a price variance is called a materials price variance in the case of direct materials, but labor rate variance in the case of direct labor and an overhead spending variance in the case of variable manufacturing overhead. Quantity Variance = $2,000 U Price variance = $1,300 F Total Variance = $700 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.

In the previous example, the quantity of pewter purchased was 6,500 lbs. and the Quantity used in production was also 6,500 lbs. But, such occurrences are rare. More common is, the quantity purchased will be greater than quantity used and the excess quantity will be carried out as ending inventory to the next period. How would you compute variances under such conditions? Let us look at the next slide. Out of 6,500 lbs. purchased, only 5,000 lbs. were used (Standard lbs. allowed for the production is 4,800 lbs = 1,600 units x 3 lbs. per unit). Usually, price variance is computed as soon as purchases are made while quantity variance may overlap into more than one period.

Price and Quantity variances when quantity purchased and used differ Actual Quantity Actual Quantity Standard Quantity of inputs of inputs allowed for output at 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 A price variance and quantity variance can be computer for all three variable components – direct materials, direct labor, and variable overhead. However, the variance is not called by the same name in all cases. For example, a price variance is called a materials price variance in the case of direct materials, but labor rate variance in the case of direct labor and an overhead spending variance in the case of variable manufacturing overhead. Price variance = $1,300 F 5,000 lbs. x 4.00 per pound = $20,000 Quantity Variance = $800 U

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 We will use the data from chapter 10 – exhibit 10.3 and 10.4 What causes selling price variance? Difference between the price you set (budgeted price) and the actual price at which you sell (using actual volume of sales).

Exhibit 10.4 – 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

Exhibit 10.5 – Combined Mix and Volume Variance The$150 variance is favorable in this example because the actual sales volume for the three products combined was more than what was budgeted

Now, if you want to separate the mix and volume variances by each product - We can find this by using the following equation: Mix variance = [(Total act. Vol. of sales * Bud. Proportion) – (Act. Vol. of sales) * (Bud. Unit contribution)] Volume variance = is easy to compute; We already computed the combined variance. From this, subtract the mix variance to be computed using above equation = Volume variance Let us look at exhibit 10.6 from the textbook

Mix Variance 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 Exhibit 10. 6 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.

Does selling price remain constant throughout the year? 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.

One who can control the variance. Example: 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.