Chapter 16 Outline

Chapter Outline LO 16-1 Use budgets for performance evaluation. USING BUDGETS FOR PERFORMANCE EVALUATION • The development of the master budget is the first step in the budgetary planning and control cycle. o The budgeting process provides a means to coordinate activities among units of the organization, to communicate the organization’s goals to individual units, and to ensure that adequate resources are available to carry out the planned activities. o In the control and evaluation activity, the performance of units and managers is evaluated and actions are taken in an attempt to improve performance. o The budget serves as the benchmark for units of the firm or for organizations that do not routinely prepare public reports. o The budget is management’s plan for financial performance. • The master budget includes: o Operating budgets (such as the budgeted income statement, production budget, budgeted cost of goods sold, and supporting budgets) o Financial budgets (budgets of financial resources—for example, the cash budget and the budgeted balance sheet) •  When management uses the master budget for control purposes, it focuses on the key items that must be controlled to ensure the company’s success.  The income statement is the most important financial statement that managers use to control operations. Variance is the difference between planned result and actual outcome. That is: Variance = Actual result – Budgeted performance. o Variance analysis is used to:  Evaluate the performance of individuals and business units.  Identify possible sources of deviations between budgeted and actual performance. PROFIT VARIANCE • The simplest measure of performance is the variance between actual income and budgeted income. o A favorable variance is the variance that, taken alone, results in an addition to operating profit.  When discussing revenue, income, or contribution margin, a favorable variance means the actual result is better than the budgeted result.  When discussing costs, a favorable variance indicates that actual costs are less than budgeted costs. o An unfavorable variance is the variance that, taken alone, reduces operating profit. o The labels “favorable” and “unfavorable” should not be considered as evaluations of performance without additional investigation. (See Business Application box “When a Favorable Variance Might Not Mean “Good” News.”) •  Although a simple comparison of planned and actual profit suggests that performance was better (or worse) than planned, the additional data (such as those in Exhibit 16.2) provide information on the impact on profit performance from each of the revenue and cost line items.  The additional information is useful for two reasons: • It allows the manager to investigate more efficiently the causes of off-budget performance, and • It allows the manager to evaluate subordinate managers responsible for various aspects of the firm’s operations. Why are Actual and Budgeted Results Different? o An important part of variance analysis is to understand:  What might cause a difference between actual and budgeted results.  What portion of the total profit variance is due to each cause. o The following table summarizes the variance analysis between actual results and the master budget for line items comprising the operating profit: Units (1) Actual xxx (3) = (1) – (2) Variancea xxx F or U (2) Master Budget xxx Sales revenue Less: Variable costsb Contribution margin Less: Fixed costsc Operating profit $ xxx (xxx) $xxx (xxx) $ xxx $xxx F or U (xxx) F or U $xxx F or U (xxx) F or U $xxx F or U $ xxx (xxx) $xxx (xxx) $ xxx a For revenue, income, or contribution margin, a favorable (F) variance results when (3) > 0. For cost items, a favorable (F) variance results when (3) < 0. b Including variable manufacturing costs and variable selling and administrative costs. c Including fixed manufacturing overhead and fixed selling and administrative costs. See Demonstration Problem 1 LO 16-2 Develop and use flexible budgets. FLEXIBLE BUDGETING • One obvious reason that actual results might differ from budgeted results is that the actual activity itself differed from the budgeted or expected activity. o A static budget is developed in detail for one level of anticipated activity, such as a master budget. o A flexible budget indicates budgeted revenues, costs, and profits for virtually all feasible levels of activities.  Because variable costs and revenues change with changes in activity levels, these amounts are budgeted to be different at each activity level in the flexible budget.  Flexible budget line is the expected costs at different output levels and can be represented by the following formula: Total Budgeted Costs • = Budgeted Fixed Cost + Budgeted Unit Variable Cost × Activity Level (Units Produced and Sold) The flexible budget line (see Exhibit 16.3) is an estimated cost-volume line because it shows the budgeted costs allowed for each level of activity. o The master budget is based on an ex ante (before-the-fact) prediction of the activity level. o The flexible budget is based on ex post (after-the-fact) knowledge of the actual activity level. LO 16-3 Compute and interpret the sales activity variance. COMPARING BUDGETS AND RESULTS • A comparison of the master budget with the flexible budget and with actual results is the basis for analyzing differences between plans and actual performance. • Sales Activity Variance o Sales activity variance (also known as sales volume variance) is the difference between operating profit in the master budget and operating profit in flexible budget that arises because the actual number of units sold is different from the budgeted number.  That is: Sales Activity Variance  Flexible Budget (Based on Actual Activity) - Master Budget (Based on Planned Activity). For Sales Revenue: Budgeted Unit Price × Actual Units - Budgeted Unit Price × Budgeted Units For Variable Costs: Budgeted Unit Cost × Actual Units - Budgeted Unit Cost × Budgeted Units = The budgeted unit price and budgeted unit cost are used in the flexible budget instead of the actual unit price and actual unit cost in order to isolate the effects of volume alone. o The sales activity variance, as shown in Exhibit 16.4, is useful for management because:  It isolates the change in operating profits caused by the actual activity being different from the master budget level.  The resulting flexible budget shows budgeted sales, costs, and operating profits after considering the activity change but before considering differences in unit selling prices, variable costs, and fixed costs from the master budget. o Interpreting Variances  LO 16-4 Holding everything else constant, a decrease in sales creates an unfavorable sales activity variance as shown in Exhibit 16.4. Does this indicate poor performance? • Perhaps it does not. Economic conditions could have been worse than planned, decreasing the volume demanded by the market. Hence, perhaps, the 20,000 unit decrease in sales volume could have been even greater, taking everything into account. • Note that both variable cost variances are labeled favorable, but this doesn’t mean that they are good for the company. Variable costs are expected to decrease when volume is lower than planned. Prepare and use a profit variance analysis. PROFIT VARIANCE ANALYSIS AS A KEY TOOL FOR MANAGERS • Profit variance analysis shows the causes of differences between budgeted profits and the actual profits earned. o The actual results can be compared with both the flexible budget and the master budget in a profit variance analysis, as shown in Exhibit 16.5. (1) Sales revenue Less: Variable costs Variable manufacturing cost Variable marketing and administrative cost Contribution margin Less: Fixed costs Fixed manufacturing cost Fixed marketing and administrative cost Operating profit Actual (Based on Actual Activity) $xxx (xxx) (2) (3) Manufacturing Variances Marketing And Administrative Variance (4) Sales Price Variance $xx U or F (5) Flexible Budget (Based on Actual Activity) $xxx Sales Activity Variance $xxx U or F (7) Master Budget (Based on Planned Activity) $xxx (xxx) (xxx) U or F (xxx) (xxx) $xxx (xxx) U or F $xxx U or F (xxx) $xxx (xxx) 0 (xxx) (xxx) $xxx 0 $xxx U or F (xxx) $xxx $xxx U or F (xxx) $xxx $xxx U or F (xxx) xxx U or F (xxx) $xxx $xxx U or F xxx U or F $xxx U or F $xxx U or F Total variance from flexible budget Total variance from master budget    Column (1) is the reported income statement based on the actual sales. Column (2) summarizes production variances. Column (3) shows marketing and administrative variances. (6) o Cost variances result from deviations in costs and efficiencies in operating the company. They are important for measuring productivity and for helping to control costs. •  Variable cost variances in Columns (2) and (3) are input variances  Variable cost variances in Column (6) are part of the sales activity variance. Sales Price Variance o Column (4) shows the sales price variance as derived from the difference between the actual revenue and budgeted selling price multiplied by the actual number of units sold.  That is: Sales Price Variance • = Actual Revenue - Budgeted Selling Price × Actual Units Sold = Budgeted Selling Price) × Actual Units Sold (Actual Selling Price - Variable Production Cost Variances o Variable costs in Column (5) represent what should have been spent given the actual sales volume. • Fixed Production Cost Variance o The fixed production cost variance is the difference between actual and budgeted costs because the flexible budget’s fixed costs equal the master budget’s fixed costs. • Marketing and Administrative Variances o Marketing and administrative costs are treated like production costs.  Variable costs are expected to change as activity changes.  Fixed marketing and administrative costs do not change as volume changes. See Demonstration Problem 2 PERFORMANCE MEASUREMENT AND CONTROL IN A COST CENTER • For cost centers whose production managers typically do not control what they are asked to produce, the actual unit production (not sales) should be used as a baseline. • Variable Production Costs o For any unit variable cost (such as direct materials), the variable cost in the budget is determined by multiplying the budgeted amount of the direct material in each unit of output by the expected price of each unit of direct material.  The standard cost sheet is a form that provides standard quantities of inputs (direct material, direct labor, and variable production overhead) required to produce a unit of output and the standard (budgeted) unit prices for the inputs. See Exhibit 16.6 for an example.  For each input: Standard Cost per Unit of Output = Standard Input Price or Rate per Unit of Input × Standard Quantity of Input per Unit of Output o Direct Materials  The purchasing manager estimates the cost of direct materials with the correct specification and quality. o Direct Labor  The standard labor rate includes wages earned as well as fringe benefits. Most companies develop one standard for each labor category. o Variable Production Overhead  The overhead “quantity” is expressed in terms of the units of the cost driver chosen (such as direct labor hours) because that is what is being used to apply the overhead. • To determine the variable production overhead rate:  Management reviews prior period activities and costs,  Estimates how costs will change in the future, and  Performs a regression analysis in which overhead cost is the dependent variable and certain cost driver (such as direct labor hours) the independent variable. LO 16-5 Compute and use variable cost variances. VARIABLE COST VARIANCE ANALYSIS • General Model o Comparing the budget (based on standard costing) to actual results identifies production cost variances.  Cost variance analysis uses a conceptual model that compares actual input amounts and prices with standard input amounts and prices. o Both the actual and standard input quantities are for the actual output attained.  A price variance is the difference between actual costs and budgeted costs arising from changes in the cost of inputs to a production process or other activity. •  Price variance = (AP × AQ) – (SP × AQ) = (AP – SP) × AQ. An efficiency variance is the difference between budgeted and actual results arising from differences between the inputs that were budgeted per unit of output and the inputs actually used. • Efficiency variance = (SP × AQ) – (SP × SQ) = SP × (AQ – SQ). o Managers who are responsible for price variances would not be held responsible for efficiency variances and vice versa.  The total cost variance is the difference between budgeted and actual results (equal to the sum of the price and efficiency variances). • Total cost variance = (AP × AQ) – (SP × SQ). o The general model is applied to each variable cost incurred and is outlined in Exhibit 16.7.  That is, Actual Costs = Actual Input Quantity at Actual Input Price (AP X AQ) Flexible Production Budget = Standard Input Quantity Allowed For Actual Output at Standard Input Price (SP X SQ) Actual Input Quantity at Standard Input Price (SP X AQ) Price (Rate, or Spending) Variance Quantity (Usage, or Efficiency) Variance (AP – SP) × AQ SP × (AQ – SQ) Total Cost Variance (AP × AQ) – (SP × SQ)  • The comprehensive cost variance analysis will ultimately explain, in detail, the variable manufacturing cost variance calculated earlier. Direct Materials o A flexible production budget is calculated as standard input price times standard quantity of input allowed for actual good output. It is based on actual production volume.  An alternative way to view these variances graphically is shown below. Quantities are presented on the horizontal axis and prices on the vertical axis. The three areas are standard cost (SP × SQ), price variance ((AP – SP) × AQ), and efficiency variance (SP × (AQ - SQ)), respectively. Prices AP Price Variance = (AP – SP) × AQ SP Standard Cost = SP × SQ Efficiency Variance = SP × (AQ – SQ) SQ AQ Quantities  Exhibit 16.8 applies the general model to direct materials variances. o Responsibility for Direct Materials Variances  Responsibility for the direct materials price variance is usually assigned to the purchasing department. •  Explanations for a materials price variance include failure to take purchase discounts, higher transportation costs than expected, different grade of direct materials purchased, or changes in the market price of direct materials. Direct materials efficiency variances are typically the responsibility of production departments. • Explanations for a materials efficiency variance include defects in direct materials, inexperienced workers, poor supervision, and so on. See Demonstration Problem 3 • Direct Labor o Exhibit 16.9 applies the general model to direct labor variances. o Direct Labor Price Variance  The direct labor price variance may be caused by hiring less experienced employees. • If the wage rates used in setting standards are the same as those in the union contract, labor price variances will not occur. o Labor Efficiency Variance  The labor efficiency variance is a measure of labor productivity and is usually controlled by production managers. • Unfavorable labor efficiency variances may be due to poorly motivated or trained workers, poor materials or faulty equipment, poor supervision and scheduling problems. o One event, such as hiring inexperienced employees, can affect more than one variance. See Demonstration Problem 4 • Variable Production Overhead o Exhibit 16.10 applies the general model to variable overhead variances. The variable overhead standard rate is derived from a two-stage estimation of:  Costs at various levels of activity, and  The relationship between those estimated costs and the basis. o Variable Production Overhead Price Variance  The variable overhead price variance could have occurred because • Actual costs are different from those expected, and • The relationship between variable production overhead costs and the basis chosen is not perfect. o Variable Overhead Efficiency Variance  The variable overhead price variance actually contains some efficiency items as well as price items. Some companies separate those components.  The variable overhead efficiency variance is not related to the use (or efficiency) of variable overhead. Instead, it is related to efficiency in using the base on which variable overhead is applied.  Managers who are responsible for controlling the base will probably be held responsible for the variable overhead efficiency variance as well. See Demonstration Problem 5 • Variable Cost Variances Summarized in Graphic Form o Exhibit 16.11 summarizes the variable production cost variances.  A summary of this nature is useful for reporting variances to high-level managers. It provides both an overview of variances and their sources. • Management could want more detailed information about some of the variances by extending each variance branch to show variances by product line, department, or other categories. LO 16-6 Compute and use fixed cost variances. FIXED COST VARIANCES • It is usually assumed that fixed costs are unchanged when volume changes within the relevant range, so the amount budgeted for fixed overhead is the same in both the master and flexible budgets. o Fixed costs are period costs by nature. • Fixed Cost Variances with Variable Costing o When the income statement is prepared using variable costing, there is no absorption of the fixed costs by units of production. All the fixed manufacturing overhead is charged to income in the period incurred.  Fixed overhead has no input-output relationships and, therefo0re, no efficiency variance.  A spending (or budget) variance, the price variance for fixed overhead, is the difference between the flexible budget and the actual fixed overhead and is entirely due to changes in the costs that make up fixed overhead. o Exhibit 16.12 shows a variance analysis for fixed overhead.  That is: Flexible Production Budget Actual Price (Spending) Variance (Efficiency Variance is not Applicable) • Absorption Costing: The Production Volume Variance o When companies use full-absorption, standard costing, fixed production costs are unitized and treated as product costs. o Developing the Standard Unit Cost for Fixed Production Costs  The fixed manufacturing standard cost is determined before the start of the production period using the following formula from Chapter 7: Standard (or Predetermined) Fixed Production Overhead Cost  Budgeted Fixed Manufacturing Overhead Budgeted Activity Level = A production volume variance (also called capacity variance, idle capacity variance, or denominator variance) is the difference between the applied fixed overhead and the budgeted fixed overhead. • Production volume variances arise because the volume used to apply fixed overhead differs from the estimated volume used to calculate fixed overhead per unit. o Compare with the Fixed Production Cost Price Variance  Exhibit 16.13 demonstrates the variance analysis for fixed overhead under costing. • That is: Actual Budgeted Price (Spending) Variance  absorption Applied Production Volume Variance An alternative way to present fixed overhead variances graphically is shown below (see also Exhibit 16-14). Application line Budget Actual Budget line Price (spending) variance Production volume variance Applied Actual volume Budgeted volume  • Since fixed overhead is unitized through the calculation of predetermined fixed overhead rate, fixed overhead is applied as if it were variable cost, as seen in the application line. • At the budgeted volume, the applied fixed overhead coincides with budgeted fixed overhead, as seen in the budget line. • Since actual volume is less than the budgeted volume in this graph, the applied fixed overhead is less than the budgeted fixed overhead; the difference between the two represents the production volume variance. • The difference between actual and budgeted fixed overhead becomes the price (or spending) variance. The production volume variance applies only to fixed costs as a result of allocating a fixed period cost to units on a predetermined basis. It does not represent resources spent or saved, and is unique to full-absorption costing. •  The benefits of calculating the production volume variance for control purposes are questionable. The price (spending) variance is used for control purposes because it is a measure of difference between actual and budgeted period costs. See Demonstration Problem 6 SUMMARY OF OVERHEAD VARIANCES • The method of computing overhead variances described is known as the four-way analysis of overhead variances because it computes the following four variances: o Price and efficiency for variable overhead o Price and production volume for fixed overhead. • Key Points o Exhibit 16.15 summarizes the four-way analysis of variable and fixed overhead variances.  The variable overhead efficiency variance measures the efficiency in using the allocation base.  The production volume variance occurs only when fixed production cost is unitized. The budgeted fixed overhead might not equal the amount applied to units produced.  There is no efficiency variance for fixed production costs.  Managers evaluated by variances that include production volume variance do have an incentive to overproduce. (See Business Application box “Does Standard Costing Lead to Waste?”)