1. 1 Introduction This discussion focuses on financial performance measures

2. 2 Calculating Variances Most companies make a monthly analysis of the differences between actual and budgeted revenues and expenses for each business unit and for the whole organization.Most companies make a monthly analysis of the differences between actual and budgeted revenues and expenses for each business unit and for the whole organization. A more thorough analysis identifies the causes of the variances and the organization unit responsible.A more thorough analysis identifies the causes of the variances and the organization unit responsible. Effective systems identify variances down to the lowest level of managementEffective systems identify variances down to the lowest level of management Therefore, it is possible to identify each variance with with the individual manager who is responsible for it.Therefore, it is possible to identify each variance with with the individual manager who is responsible for it. Most companies make a monthly analysis of the differences between actual and budgeted revenues and expenses for each business unit and for the whole organization.Most companies make a monthly analysis of the differences between actual and budgeted revenues and expenses for each business unit and for the whole organization. A more thorough analysis identifies the causes of the variances and the organization unit responsible.A more thorough analysis identifies the causes of the variances and the organization unit responsible. Effective systems identify variances down to the lowest level of managementEffective systems identify variances down to the lowest level of management Therefore, it is possible to identify each variance with with the individual manager who is responsible for it.Therefore, it is possible to identify each variance with with the individual manager who is responsible for it.

3. 3 Calculating Variances The analytical framework use to conduct variance analysis incorporates the following ideas : Identify the key causal factors that affects profitsIdentify the key causal factors that affects profits Break down the overall profit variances by these key causal factorsBreak down the overall profit variances by these key causal factors Focus on the profit impact of variation in each causal factorsFocus on the profit impact of variation in each causal factors The analytical framework use to conduct variance analysis incorporates the following ideas : Identify the key causal factors that affects profitsIdentify the key causal factors that affects profits Break down the overall profit variances by these key causal factorsBreak down the overall profit variances by these key causal factors Focus on the profit impact of variation in each causal factorsFocus on the profit impact of variation in each causal factors

4. 4 Calculating Variances Try to calculate the specific, separable impact of each causal factor by varying only that factor while holding all other factors constantTry to calculate the specific, separable impact of each causal factor by varying only that factor while holding all other factors constant Add complexity sequentially, one layer at a time, beginning at a very basic “commonsense” level (“peel the onion”).Add complexity sequentially, one layer at a time, beginning at a very basic “commonsense” level (“peel the onion”). Stop the process when the added complexity at a newly created level is not justified by added useful insights into the casual factors underlying the overall profit varianceStop the process when the added complexity at a newly created level is not justified by added useful insights into the casual factors underlying the overall profit variance Try to calculate the specific, separable impact of each causal factor by varying only that factor while holding all other factors constantTry to calculate the specific, separable impact of each causal factor by varying only that factor while holding all other factors constant Add complexity sequentially, one layer at a time, beginning at a very basic “commonsense” level (“peel the onion”).Add complexity sequentially, one layer at a time, beginning at a very basic “commonsense” level (“peel the onion”). Stop the process when the added complexity at a newly created level is not justified by added useful insights into the casual factors underlying the overall profit varianceStop the process when the added complexity at a newly created level is not justified by added useful insights into the casual factors underlying the overall profit variance

5. 5 Calculating Variances Revenue Variances The calculation is made for each product line, and the product line results are then aggregated to calculate the total variance.The calculation is made for each product line, and the product line results are then aggregated to calculate the total variance. Revenue Variances The calculation is made for each product line, and the product line results are then aggregated to calculate the total variance.The calculation is made for each product line, and the product line results are then aggregated to calculate the total variance.

6. 6 Variations in Practice Time Period of the Comparison Some companies use performance for the year to date as the basis for comparison. For period ended June 30, they would use budgeted and actual amounts for the six months ending on June, rather than the amounts for June.Some companies use performance for the year to date as the basis for comparison. For period ended June 30, they would use budgeted and actual amounts for the six months ending on June, rather than the amounts for June. A comparison for the year to date is not as much influenced by temporary aberrations that may be peculiar to the current month.A comparison for the year to date is not as much influenced by temporary aberrations that may be peculiar to the current month. Time Period of the Comparison Some companies use performance for the year to date as the basis for comparison. For period ended June 30, they would use budgeted and actual amounts for the six months ending on June, rather than the amounts for June.Some companies use performance for the year to date as the basis for comparison. For period ended June 30, they would use budgeted and actual amounts for the six months ending on June, rather than the amounts for June. A comparison for the year to date is not as much influenced by temporary aberrations that may be peculiar to the current month.A comparison for the year to date is not as much influenced by temporary aberrations that may be peculiar to the current month.

7. 7 Variations in Practice Focus on Gross Margin Gross margin = Selling prices – Manufacturing costGross margin = Selling prices – Manufacturing cost Focus on Gross Margin Gross margin = Selling prices – Manufacturing costGross margin = Selling prices – Manufacturing cost

8. 8 Variations in Practice Focus on Gross Margin EvaluationEvaluation The formal standards used in the evaluation of reports on actual activities are : 1.Predetermined standards If carefully prepared and coordinated, these are excellent standards If carefully prepared and coordinated, these are excellent standards 2. Historical standards These are records of past actual performance. Results for the current month may be compared with the results for last month, or with results for the same month a year ago. These are records of past actual performance. Results for the current month may be compared with the results for last month, or with results for the same month a year ago. 3. External standards These are standards derived from the performance of other responsibility centers or of other companies in the same industry. These are standards derived from the performance of other responsibility centers or of other companies in the same industry. Focus on Gross Margin EvaluationEvaluation The formal standards used in the evaluation of reports on actual activities are : 1.Predetermined standards If carefully prepared and coordinated, these are excellent standards If carefully prepared and coordinated, these are excellent standards 2. Historical standards These are records of past actual performance. Results for the current month may be compared with the results for last month, or with results for the same month a year ago. These are records of past actual performance. Results for the current month may be compared with the results for last month, or with results for the same month a year ago. 3. External standards These are standards derived from the performance of other responsibility centers or of other companies in the same industry. These are standards derived from the performance of other responsibility centers or of other companies in the same industry.

9. 9 Variations in Practice Full Cost Systems If the company has a full cost system, both variable and fixed overhead costs are included in the inventory at the standard cost per unitIf the company has a full cost system, both variable and fixed overhead costs are included in the inventory at the standard cost per unit Variance = Budgeted fixed production cost at the actual volume – Standard fixed production costs at that volumeVariance = Budgeted fixed production cost at the actual volume – Standard fixed production costs at that volume The important point is that production variances should be associated with production volume, not sales volumeThe important point is that production variances should be associated with production volume, not sales volume Full Cost Systems If the company has a full cost system, both variable and fixed overhead costs are included in the inventory at the standard cost per unitIf the company has a full cost system, both variable and fixed overhead costs are included in the inventory at the standard cost per unit Variance = Budgeted fixed production cost at the actual volume – Standard fixed production costs at that volumeVariance = Budgeted fixed production cost at the actual volume – Standard fixed production costs at that volume The important point is that production variances should be associated with production volume, not sales volumeThe important point is that production variances should be associated with production volume, not sales volume

10. 10 Variations in Practice Amount of Detail We analyzed revenue variances at several levels : 1.In total 2.By volume, mix and price 3.By analyzing the volume and mix variance 4.By industry volume and market share At each of these levels, we analyzed the variances by individual products. The process of going from one level to another is often referred to as “peeling the onion “. Amount of Detail We analyzed revenue variances at several levels : 1.In total 2.By volume, mix and price 3.By analyzing the volume and mix variance 4.By industry volume and market share At each of these levels, we analyzed the variances by individual products. The process of going from one level to another is often referred to as “peeling the onion “.

11. 11 Variations in Practice Engineered and Discretionary Costs A favorable variance in engineered costs is usually an indication of good performance, that is the lower the cost, the better the performanceA favorable variance in engineered costs is usually an indication of good performance, that is the lower the cost, the better the performance By contrast, the performance of a discretionary expense center is usually judged to be satisfactory if actual expenses are about equal to the budgeted amount, neither higher or lower.By contrast, the performance of a discretionary expense center is usually judged to be satisfactory if actual expenses are about equal to the budgeted amount, neither higher or lower. Engineered and Discretionary Costs A favorable variance in engineered costs is usually an indication of good performance, that is the lower the cost, the better the performanceA favorable variance in engineered costs is usually an indication of good performance, that is the lower the cost, the better the performance By contrast, the performance of a discretionary expense center is usually judged to be satisfactory if actual expenses are about equal to the budgeted amount, neither higher or lower.By contrast, the performance of a discretionary expense center is usually judged to be satisfactory if actual expenses are about equal to the budgeted amount, neither higher or lower.

12. 12 Limitations of Variance Analysis 1.Although it identifies where a variance occurs, it does not tell why the variance occurred or what is being done about it. 2.To decide whether a variance is significant 3.The performance reports become more highly aggregated, offsetting variances might mislead the reader. Finally, the reports show only what was happened. They do not show the future effects of actions that manager has taken. 1.Although it identifies where a variance occurs, it does not tell why the variance occurred or what is being done about it. 2.To decide whether a variance is significant 3.The performance reports become more highly aggregated, offsetting variances might mislead the reader. Finally, the reports show only what was happened. They do not show the future effects of actions that manager has taken.

13. 13 Limitations of Variance Analysis Management Action There is one cardinal principle in analyzing formal financial reports. The monthly profit report should contain no major surprises.There is one cardinal principle in analyzing formal financial reports. The monthly profit report should contain no major surprises. One of the most important benefits of formal reporting is that is provides the desirable pressure on the subordinate managers to take corrective actions on their own initiativeOne of the most important benefits of formal reporting is that is provides the desirable pressure on the subordinate managers to take corrective actions on their own initiative Profit reports are worthless unless they lead to actionProfit reports are worthless unless they lead to action Management Action There is one cardinal principle in analyzing formal financial reports. The monthly profit report should contain no major surprises.There is one cardinal principle in analyzing formal financial reports. The monthly profit report should contain no major surprises. One of the most important benefits of formal reporting is that is provides the desirable pressure on the subordinate managers to take corrective actions on their own initiativeOne of the most important benefits of formal reporting is that is provides the desirable pressure on the subordinate managers to take corrective actions on their own initiative Profit reports are worthless unless they lead to actionProfit reports are worthless unless they lead to action