CHAPTER 8 Performance Evaluation

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 8-2 Learning Objective LO1 To describe flexible and static budgets

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 8-3 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 McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 8-4 Preparing Flexible Budgets Melrose Manufacturing, a producer of small high-quality trophies, plans to make and sell 18,000 trophies during Melrose uses a standard cost system as outlined below:

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 8-5 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.

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 8-6 Preparing Flexible Budgets From the standard cost information, Melrose prepares the following static and flexible budgets. 18,000 × $80 = $1,440,000

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 8-7 Learning Objective LO2 To classify variances as being favorable or unfavorable

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 8-8 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, an unfavorable sales variance exists. When actual sales revenue is greater than expected revenue, a company has a favorable sales variance.

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 8-9 Learning Objective LO3 To compute and interpret sales volume variances

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 8-10 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.

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 8-11 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.

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 8-12 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: Based on actual volume, fixed cost per unit would be $15.35 ($291,600 ÷ 19,000).

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 8-13 Learning Objective LO4 To compute and interpret flexible budget variances

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 8-14 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 amount and actual amount per unit for the current period.

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 8-15 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

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 8-16 Calculating Sales Price Varianceor

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 8-17 Learning Objective LO5 To explain standard cost systems

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 8-18 Standard Cost Systems 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.

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 8-19 Establishing Standards ideal standards Should we use ideal standards that represent what costs should be under the best circumstances? Engineer Managerial Accountant practical standards I recommend using practical standards that an average worker performing diligently would be able to achieve.

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 8-20 Need for Standard Costs Management by exception 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.

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 8-21 Selecting Variances to Investigate Management by exception tells us to consider: 1.The materiality of a variance, 2.How frequently it occurs, 3.The capacity to control the variance, and 4.The characteristics of the items behind the variance. Management by exception tells us to consider: 1.The materiality of a variance, 2.How frequently it occurs, 3.The capacity to control the variance, and 4.The characteristics of the items behind the variance.

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 8-22 Manufacturing Cost Variances We will use the following information provided by Melrose Manufacturing in 2006 to calculate manufacturing variances.

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 8-23 Learning Objective LO6 To calculate price and usage variances

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 8-24 Materials Price and Usage Variances 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, ,800 × $2.00 $235,600 $11,780 Favorable Materials Price Variance $11,780 Favorable 114,000 × $2.00 $228,000 $7,600 Unfavorable Materials Usage Variance $7,600 Unfavorable $4,180 Favorable Total Variance $4,180 Favorable Actual Cost Column Variance Dividing Column Standard Cost Column

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 8-25 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 – = $7,600 Unfavorable = ×– (117, ,000)$2.00

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 8-26 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. 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. Purchasing Manager

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 8-27 Calculating Labor Variances Melrose has provided the following information about labor cost and usage during the period.

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 8-28 Labor Price and Usage Variances 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 $14,250 Favorable Labor Price Variance $14,250 Favorable 26,600 × $12.00 $319,200 $22,800 Unfavorable Labor Usage Variance $22,800 Unfavorable $8,550 Unfavorable Total Variance $8,550 Unfavorable Actual Cost Column Variance Dividing Column Standard Cost Column

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 8-29 Labor Price and Usage Variances Price Variance = Actual Hours × Actual Price Standard Price – = $14,250 Favorable = ×–($11.50 $12.00) 28,500 Usage Variance = Standard Price × Actual Hours Standard Hours – = $22,800 Unfavorable = ×–(28,500 26,600) $12.00

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 8-30 Responsibility for Labor Variances Production Manager 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.

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 8-31 Responsibility for Labor Variances I am not responsible for the unfavorable labor efficiency variance! You purchased cheap material, so it took more time to process. You purchased cheap material, so it took more time to process. I think it took more time to process the materials because the Maintenance Department has poorly maintained your equipment. Production Manager Purchasing Manager

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 8-32 Variable Overhead Variances Variable Overhead Variance = Actual Units × Actual Cost Standard Cost – Unfavorable = $2,850 Unfavorable = ×– ($5.75 $5.60)19,000 For Melrose’s Flexible Budget

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 8-33 Fixed Overhead Variances Variable costs can have both price and usage variances. Fixed overhead costs can have a price variance. The difference between the actual fixed overhead cost and the budgeted fixed overhead cost is called the spending variance. At Melrose, the spending variance was: ($210,000 actual - $201,600 budgeted) = $8,400 Unfavorable

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 8-34 Fixed Overhead Variances Overhead Volume Variance ($201,600 budgeted – $212,800 applied) = $11,200 Favorable

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 8-35 Fixed Overhead Variances Actual Fixed Cost Budgeted Fixed Cost $210,000 $201,600 Unfavorable Spending Variance $8,400 Unfavorable Applied Fixed Cost $212,800 Favorable Volume Variance $11,200 Favorable

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 8-36 General, Selling & Administrative 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 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.

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 8-37 End of Chapter 8