1. Chapter 10 The Use of Budgets for Cost Control and Performance Evaluation

2. Topics to be Discussed Introduction Standard Costing Ideal Versus Practical Standards Use of Standards by Nonmanufacturing Organizations Application in Business

3. Introduction Key Concept The purpose of the control function in management is to make sure that the goals of the organization are being attained.

4. Introduction Variance Analysis At the end of the an accounting period, managers use the budget as a control tool by comparing budgeted sales, budgeted production and budgeted manufacturing costs with actual sales, production and manufacturing costs. Variance analysis allows managers to see whether sales, production and manufacturing costs are higher or lower than planned, and WHY actual sales, production and costs differ from those budgeted.

5. Introduction Management by Exception: Managers choose deviations to investigate by focusing on material or significant differences.

6. Standard Costing Standard Price: the Budgeted Price of the material, labor or overhead for each unit. Standard Quantity: the Budgeted Quantity of the material, labor or overhead for each unit.

7. Standard Costing Task Analysis: examines the production process in detail with an emphasis on determining what it should cost to produce a product, not what it cost last year.

8. Ideal vs Practical Standards Ideal Standards: One that is attained only when near perfect conditions are present. Assumes that every aspect of the production process, from purchasing through shipment, is at peak efficiency.

9. Ideal vs Practical Standards Practical Standards: Should be attained under normal, efficient operating conditions. Take into consideration that machines break down occasionally, that employees are not always perfect, that waste in materials does occur.

10. Ideal vs Practical Standards Pause and Reflect How do you think you would react to being evaluated using ideal standards? Only A’s or F’s for a grade? What about practical standards?

11. Use of Standards by Nonmanufacturing Organizations Auto dealership: How much should it cost to sell a car? City: How much should it cost to provide garbage pickup? State University: How much should it cost to provide an education per student? CPA firm: How much time is needed to prepare certain types of tax forms or returns?

12. Use of Standards by Nonmanufacturing Organizations Pause and Reflect The estimated cost of providing an education to a student at a typical state university has been estimated to exceed $30,000 per year. However, in-state tuition at most public universities rarely exceeds $3,000 to $5,000 per year. Who is paying the rest of the cost?

13. Application in Business Some managed health care companies have a standard amount of time for doctors seeing patients for particular ailments. Initial visit: 20 minutes Full physical: 45 minutes

14. Standard Costing Topics Flexible Budgeting with Standard Costs Sales Volume Variance Variable Manufacturing Cost Variances A Model Variance Analysis Direct Material Variances Direct Labor Variances Variable Overhead Variances Fixed Overhead Variances

15. Flexible Budgeting with Standard Costs Standard Costs for Corinne’s Country Rocker Direct Material Direct Labor Variable OH Standard Quantity 20 linear ft of oak 5 labor hours Standard Price $2 per foot $12 per hour $ 3 per hour Standard Cost $40 $60 $15 $115 Total Variable Production Costs

16. Flexible Budgeting with Standard Costs Comparison of Budget to Actual Units sold Units produced Sales revenue Variable manuf. Costs Variable S & A Contribution margin Static Budget 1,500 $375,000 172,500 37,500 $165,000 Flexible Budget 1,600 $400,000 184,000 40,000 $176,000 Actual Results 1,600 $396,800 189,200 40,800 $166,800

17. Flexible Budgeting with Standard Costs Comparison of Budget to Actual, cont. Contribution margin Fixed manuf. Costs Fixed S & A Operating Income Static Budget $165,000 15,000 18,000 $132,000 Flexible Budget $176,000 15,000 18,000 $143,000 Actual Results $166,800 16,000 $134800

18. Flexible Budgeting with Standard Costs Why is the difference between the static budget and flexible budget contribution margin the same as the difference between the static budget and flexible budget operating income?

19. Sales Volume Variance Sales Volume Variance = (Actual – Budgeted Sales Volume) X (Budgeted Contribution Margin Per Unit) For Corrine’s: $11,000 = (1,600 – 1,500) x $110

20. Sales Volume Variance Units sold Units produced Sales revenue Variable manuf. Costs (-) Variable S & A (-) Contribution margin Fixed manuf. Costs (-) Fixed S & A (-) Operating Income Static Budget 1,500 375,000 172,000 37,500 165,000 15,000 18,000 132,000 Sales Vol Var 25,000 11,500 2,500 11,000 Flexible Budget 1,600 400,000 184,000 40,000 176,000 15,000 18,000 143,000

21. Flexible Budget Variance The difference between the flexible budget operating income and actual operating income is called the flexible budget variance. The flexible budget removes any differences due to volume.

22. Flexible Budget Variance Units sold Avg. sales price per unit Sales revenue Variable manuf. Costs (-) Variable S & A (-) Contribution Margin Fixed manuf. Costs (-) Fixed S & A (-) Operating Income Flexible Budget 1,600 $250 400,000 184,000 40,000 176,000 15,000 18,000 143,000 Flexible Budget Variance (3,200) 5,200 800 (9.200) 1,000 (2,000) (8,200) Actual Results 1,600 $248 398,800 189,200 40,800 166,800 16,000 134,800

23. Flexible Budget Variance Key Concept The flexible budgeting process removes any differences or variances due only to variations in volume.

24. Sales Price Variance Sales Price Variance = (Actual - Expected Sales Price) x Actual volume -$3,200 = ($248-$250) x 1,600 Why?

25. Variance Analysis AQ x AP Actual Cost AQ (AP-SP) Price Variance SQ x SP Flexible Budget Amount SP (AQ - SQ) Usage Variance Basic Variance Analysis Model AQ x SP

26. Variance Analysis SQ = Actual number of units produced multiplied by the standard (budgeted) quantity of material or hours of labor per unit X = Standard (budgeted) quantity of material or number of hours budgeted per unit

27. Direct Material Variances AQ x AP 33,600 x $1.90 = $63,840 AQ x SP 33,600 x $2.00 =$67,200 SQ x SP 32,000 x $2.00 =$64,000 33,600 ($1.90 - 2.00) $3,360 F Price Var. $2.00 (33,600 - 32,000) $3,200 U Usage Var Total Variance = $3,360 F + $3,200 U = $160 F SQ = 20 ft./unit x 1,600 chairs

28. Direct Material Variances What are some possible reasons for a favorable direct material price variance and an unfavorable material usage variance?

29. Direct Material Variances When the actual amount of material purchased is different from the amount of material used, the direct material variance model must be modified. For example, let’s assume that Corinne’s purchased 35,000 feet of lumber but only used 33,600 feet in production.

30. Direct Material Variances AQ X AP AQ X SP AQ X SP SQ X SP 35,000 X $1.90 35,000 X $2.00 33,600 X $2.00 32,000 X $2.00 = $66,500 = $70,000 = $67,200 = $64,000 $3,500 F $3,200 Price Var Usage Var The model above is when quantities purchased are not the same as quantities used.

31. Direct Labor Variances AH X AR AH X SR SH X SR 8,400 X $12.10 8,400 X $12.00 8,000 X $12.00 = $101,640 = $100,800 = $96,000 $840 U $4,800 U Rate Var Efficiency Var Total Direct Labor Variance = $840 U + $4,800 U = $5,640 U SH = 1,600 chairs X 5 hrs/chair

32. Direct Labor Variances What are some possible reasons for unfavorable direct labor rate and efficiency variances?

33. Variable Overhead Variances Actual Variable AH X SVR SH X SVR Overhead Expense 8,400 X $3.00 8,000 X $3.00 = $23,720 =$25,200 = $24,000 $1,480 F $1,200 U Spending Variance Efficiency Variance Total Variable Overhead Variance = $1,480 F +$1,200 U = $280 F

34. Variable Overhead Variances Key Concept The variable overhead efficiency variance does not measure the efficient use of overhead but rather the efficient use of the cost driver or overhead allocation base used in the flexible budget.

35. Fixed Overhead Variances Budget Variance: the difference between the amount of fixed overhead actually incurred and the flexible budget amount. Volume Variance: the difference between the flexible budget amount and the amount of fixed overhead applied to products.

36. Fixed Overhead Variances Actual Fixed Budgeted Applied Overhead Expense Fixed Overhead Fixed Overhead = $16,000 = $15,000 = $16,000 $1,000 U $1,000 F Spending Variance Volume Variance

37. Overhead Variances Key Concept Total over- or underapplied overhead is the sum of the four overhead variances (two variable overhead variances and the two fixed overhead variances).

38. Overhead Variances Key Concept The fixed overhead volume variance should not be interpreted as favorable or unfavorable, or as a measure of the efficient utilization of facilities.

39. More Topics ABC and Variance Analysis Selling and Administrative Expense Variance Interpreting and Using Variance Analysis Behavioral Considerations

40. Selling and Administrative Expense Variance A price standard can be developed for the time spent to process each mail-order sales by telephone, which includes the salary costs incurred by the sales representatives handling the call and the direct costs of the toll-free line. Then the actual costs incurred can be compared to the the flexible budget and the price and usage variances can be calculated.

41. Selling and Administrative Expense Variance Drawbacks on Variances The information from VA is likely to be too aggregated for operating managers to use. The information from VA is not timely enough to be useful to managers.

42. Selling and Administrative Expense Variance Drawbacks on Variances Traditional VA of variable and fixed overhead provides little useful information for managers. Traditional VA focuses on cost control instead of product quality, customer service, delivery time, and other nonfinancial measures of performance.

43. Interpreting and Using Variance Analysis Use the decision model: Define the problem Identify objectives Identify and analyze available options Select the best option

44. Interpreting and Using Variance Analysis An unfavorable direct material usage variance generally points to a problem in production. However, further analysis might reveal that usage was high because of an unusual number of defective parts and the large number of defective parts was a result of the purchasing manager buying materials of inferior quality.

45. Interpreting and Using Variance Analysis Pause and Reflect Even though the purchasing manager caused the “problem,” the material price variance would be favorable. As discussed earlier, favorable variances are not necessarily “good.”

46. Behavioral Considerations Standards Costs and Variance Analysis can provide very useful control and performance evaluations, or they can cause dysfunctional behavior among employees and management.

47. End of Chapter 10 What variances do you need for your business?