MCS UNS chapter 6 :Variance Analysis 28.03.05

Course Map – Where are we? Organizing for Performance Chp 3 Chps 12 & 13 Boundary Systems Chps 13 Belief Systems What to Control Chp 4 Risks to be Avoided Core Values Core Values Building and Evaluating Budgets Chps 5, 6, 7 Today’s Topic Business Strategy Chp 2 Chp 14 Measuring Performance Chps 8 & 9 Strategic Uncertainties Critical Perf Variables Internal Controls Chp 13 Interactive Control Systems Chp 10 Diagnostic Control Systems Chp 10 Designing Employee Goals and Incentives Chp 11 4 LEVERS OF CONTROL

Chp 6 - Evaluating Strategic Profit Performance Introduction Variance Analysis Overview – Theory behind ‘Crunching the Numbers’ Disadvantages and Advantages of Variance Analysis

Monitoring the Business Strategy Diagnostic Function Used to evaluate: Effectiveness – extent to which we met our desired goals; compare actual to expected Efficiency – level of resources used to achieve specific outputs

Two Components of Strategic Profitability (or Value Creation) Profit (loss) from competitive effectiveness (revenue variance) + Profit (loss) from competitive efficiency (cost variance)

Variance Analysis Variance – difference between actual and expected (budgeted) performance Favorable variance – actual profit is higher than planned Unfavorable variance – actual profit is lower than planned

Three Conditions necessary in order to Evaluate There must be an way to measure outputs. A predetermined standard of performance must exist. There must be an ability to use variance information as feedback to make corrections and improvements.

Variance Analysis Cycle

Strategic Profitability Analysis A tool used to evaluate the success of a business in generating profit from the implementation of its strategy Composed of: Analysis of competitive effectiveness Analysis of operating efficiencies

Strategic Profitability Analysis

Strategic Variance Analysis Total Variance Competitive Effectiveness Competitive Efficiency REVENUE COST Sales Price Market Size Production Efficiency Nonvariable Spending Market Share Product Mix Production Spending

Pros & Cons of Strategic Analysis Advantages Disadvantages

Competitive Effectiveness Must be able to set and implement market strategy Used for profit centers and stand alone businesses Measured by two output indicators: Market share growth Price premium

Market Share Variances Change in profits due to our market share: Tells us how much of our change in profits is due to increases or decreases in our hold on the market Change in market share due to industry volume: Tells us how much of our increased (decreased) sales is due to a bigger (smaller) overall market for our products

Revenue Variances Increase in profit due to changes in selling prices Result of this variance lets management know how successful their price strategy was Did they have to lower their price to sell products? Or were customers willing to pay a price premium? Increase in profit due to changes in product mix Results from selling a different proportion of products than planned Must evaluate why customers chose one product over another Increase in profit due to changes in volume This variance tells us whether we sold more units than planned.

Operating Efficiencies How many resources were consumed to achieve the actual outputs? This analysis can be used for any type of business unit; including cost centers. Revenue variances tell us about performance in the market, and spending and efficiency variances inform us about how well managers used their internal capabilities of the business. Good to benchmark

Flexible Budget Flexible budget – budget made out for many levels of activities To calculate operating efficiencies, we must use the budget for our actual level of activity, not the static budget (if different from actual) Static – 100,000 units, actual – 102,000 units Must make out a new budget for 102,000 units to compare actual to budget

Variable Costs Materials and labor can often be broken down into price and quantity variances. Texts also call these spending and efficiency variances. Materials Spending variance - Tells if you spent more or less than standard price per unit of material Causes and responsibility for variance

Variable Costs Materials Efficiency variance –tells whether you used more or less materials than the standard called for Causes and responsibility for variance Labor Spending variance -tells if you spent more or less than standard price per unit on labor Labor Efficiency variance –tells whether you used more or less labor hours than the standard called for

Nonvariable costs Spending variance: Planned cost – Actual cost Committed fixed costs Discretionary fixed costs Activity-Based costs Volume variance - Impact on profits due to changes in cost-driver activity Efficiency variance – Impact on profits due to changes in efficiency Spending variance – Impact on profits due to changes in cost of resources

Cost Center and Discretionary Cost Center The hallmark of two centers should be understood in terms of the following factors: Budget preparation Type control Performance measurement

Uses of Variance Analysis Calculation of variances do not explain causes Variances should be investigated Often reasons for variances are explained beside the calculated variance Favorable variances are not always good Unfavorable variances are not always bad It is not good to net variances Netting of variances may cancel out large favorable variances against large unfavorable variances

Uses of Variance Analysis Management by exception – allows managers to focus only on those variances which are truly out of the ordinary Management by exception allows managers to focus on certain areas Maximizes return on management Variance analysis should be performed often in order to make corrections as early as possible – at least every month if possible Any variance is only as good as the standards or planned activity to which actual is compared!!!!!!

Evaluation Standards Predetermined standards – carefully determined standards can be established using ideal circumstances, practical circumstances, or some other basis. Ideal standards will show a lot of unfavorable variances. Historical standards – often past inefficiencies passed on External standards – benchmarks Comparison to other companies in industry Can be obtained from private sources for a fee Some library sources

Strategic Variance Analysis Exercise You are the new controller for a firm and are asked to analyze these nonvariable cost variances: Advertising shows an unfavorable variance Are you concerned? R&D spending is far below budget Should you reward the R&D manager? Employee training has a large negative variance Should you fire the HR Manager?

Summary - Strategic Variance Analysis It is an imperfect control tool In reality, it is not important if the variance is U (unfavorable) or F (favorable) What is key is that managers are asking the right questions and then pursuing appropriate action