analyzing financial performance

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Analyzing Financial Performance Reports

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Topics

• Post-budget control

• The need for computing variances

• Variance as a control measure

• The different types of variances

• Using variances to evaluate performance

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Need for comparing actual to budgeted

• Even the best run organization cannot make perfect

forecasts.

• Forecasts always contain errors – random and non-random.

• How should we assess the performance of a responsibility

center manager when the budgeted performance does not

match actual performance.

• Through variance analysis, a control mechanism.

• Variance analysis would reveal what caused the deviations

and what should be done in future.

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Variances

• Traditionally, variances or deviation of actual

from budgeted numbers is done at periodic

intervals

• Is this adequate?

• Recent approach: do such analysis on a routine

basis or as a continuous improvement

approach

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Variances

• Computing variances is simple; it should be

extended from top to the lowest levels of

management to develop a true understanding

of the causes.

• The variance should be broken into its different

elements – revenue, expenses, etc.

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Before we proceed, let us briefly go over a few basic cost/managerial concepts

• The following costs:

• Standard cost

• Fixed cost

• Variable cost

• Are standard cost same as budgets?

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Standard Costs

• Standards are benchmarks.

• In the context of manufacturing or services, standard

costs represent each major input (e.g. raw materials,

labor time) that a product or service must use.

• Cost standards refer to how much you should pay for

an item or service.

• It is a management by exception concept.

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•Budget for a single unit•Each unit has standards for:

Standard Costs

Copyright (c) 2009 Prentice Hall. All rights reserved. 8

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Fixed costs

• A cost that remains constant, in total,

regardless of changes in the level of activity.

• Examples: rent, investment in machinery,

building

• Consequently, more the level of activity,

smaller the fixed cost per unit of activity or vice

versa.

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Variable Costs

• Variable cost is cost that varies, in total, in direct

proportion to changes in the level of activity.

• Example: as units produced increases, raw

material usage, direct labor costs will go up

proportionately.

• Total costs rises and falls with the level of

activity.

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Price Standards


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Quantity Standards


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Price Standard Quantity Standard

Direct Materials

Responsibility: Production managers

Responsibility: Production managers & engineers

Factors: Purchase price, discounts, delivery, credit policy

Factors: Product specifications, spoilage, production scheduling

Direct Labor Responsibility: Human resource managers

Responsibility: Production managers & engineers

Factors: Wage rate, payroll taxes, fringe benefits

Factors: Time requirements

Manufacturing Overhead

Responsibility: Production managers Factors: Nature and amount of resources needed for support activities

Summary of Standard Setting Issues


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Helps managers:

• In budget preparation

• Target levels of performance

• Identify performance standards

• Set sales prices

• Decrease accounting costs

Benefits of Standard Costs


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Cost behavior

• Remember: Costs – both fixed and variable

work only within a relevant range.

• For example, whether you produce 10 units or

100,000 units, will the variable cost per unit

remain the same? No.

• Many costs might also have a fixed and

variable components. E.g. Telephone bill

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Basic Variance Analysis

• Analyzing the factors that caused the actual

and budgeted (costs, revenues, production

units, etc.) is called variance analysis.

• Usually, variance analysis is separated into two

categories – quantity and price.

• This is because the same individual may not be

responsible for both quantity and price.

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A basic variance model – Price and Quantity variances

Actual Quantity Actual Quantity Standard Quantityof inputs of inputs allowed for outputat Actual Price at Standard Price at Standard Price

(AQ x AP) (AQ X SP) (SQ x SP) (1) (2) (3)

Price Variance1-2

Materials PriceVarianceLabor rate varianceVariable overhead spending variance

Quantity Variance2 -3Materials Quantity VarianceLabor efficiency varianceVariable overhead efficiencyvariance

Total Variance

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Let us use the following data from Colonial Pewter Co.

Std. Qty Std. Price Std. Cost

Inputs or Hours or Rate

(1) (2) (1) x (2)

Direct materials 3 pound $ 4.00 $12.00

Direct Labor 2.5 hours 14.00 35.00

Variable Mfg. overhead 2.5 hours 3.00 7.50

Total std. cost per unit $54.50

Standard cost of direct materials per unit of product = 3 lbs x $4 per lb = $12 per unit.Purchasing records show that in June, 6,500 lbs. of pewter were purchased at a cost of $3.80 per pound. The cost included freight and handling. All of the materials purchased was used during June to manufacture 2,000 lbs of pewter bookends. Using the data, let us computer price and quantity variances.

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Price and Quantity variances for Colonial Pewter

Actual Quantity Actual Quantity Standard Quantity

of inputs of inputs allowed for output

at Actual Price at Standard Price at Standard Price

(AQ x AP) (AQ X SP) (SQ x SP) (1) (2) (3)

6,500 pounds x $3.80 6,500 lbs. x $4.00 6,000 lbs. x per lb. = $24,700 = $26,000 $4.00 = $24,000

Total Variance = $700 U

Price variance = $1,300 F Quantity Variance = $2,000 U

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Interpretation

• First, $24,700 refers to the actual total cost of the pewter that was

purchased during June.

• Second, $26,000 refers to what the pewter would have cost if it had

been purchased in the standard price of $4.00 a pound rather than

the actual price of $3.80 per pound.

• Difference between first and second, $1,300 is the price variance.

• Third, $24,000 represents cost of Pewter if it were purchased at

standard price and if standard quantity had been used.

• The difference between second and third is the quantity variance.

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In the previous example, the quantity of pewter purchased was 6,500 lbs. and the Quantity used in production was also 6,500 lbs. But, such occurrences are rare. More common is, the quantity purchased will be greater than quantity used and the excess quantity will be carried out as ending inventory to the next period. How would you compute variances under such conditions?

Let us look at the next slide. Out of 6,500 lbs. purchased, only 5,000 lbs. were used (Standard lbs. allowed for the production is 4,800 lbs = 1,600 units x 3 lbs. per unit). Usually, price variance is computed as soon as purchases are made while quantity variance may overlap into more than one period.

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Price and Quantity variances when quantity purchased and used differ

Actual Quantity Actual Quantity Standard Quantity

of inputs of inputs allowed for output

at Actual Price at Standard Price at Standard Price

(AQ x AP) (AQ X SP) (SQ x SP) (1) (2) (3)6,500 pounds x $3.80 6,500 lbs. x $4.00 4,800 lbs.

x per lb. = $24,700 = $26,000 $4.00 = $19,200

Price variance = $1,300 F

Quantity Variance = $800 U

5,000 lbs. x 4.00 per pound = $20,000

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Revenue variances

• Unlike cost variances, revenue variances focus

on

• selling prices and how

• Volume of sales and

• Mix (of various products)

Impact revenue and profitability

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Selling Price Variance

• What causes selling price variance?

• Difference between the price you set (budgeted

price) and the actual price at which you sell

(using actual volume of sales).

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Sales Price Variance

• Three products – A, B, and C

• The budgeted prices are $1.00, 2.00, and 3.00

respectively

• Actual selling price was $0.90, 2.05, and 2.50

respectively.

• Actual volume of sales in units – 100, 200, and 150

respectively.

• Sales price variance is = [100 (1.00 -0.90) + 200 (2.00 –

2.05) + 150 (3.00 – 2.50)] = 75

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Mix and Volume Variance

• The firm sells several products (mix) and the volume of

sales for each is different.

• If we do not separate the mix and volume into separate

components (to get a general overview), then the

equation to compute a combined mix/volume variance is

• Mix/Vol. variance = [Actual Vol. – Bud. Volume] *

Budgeted contribution

• Contribution = Selling price – variable costs only

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Combined Mix and Volume Variance

Product 1

Actual Volume

2

Bud. Volume

3

Difference 4

(2-3)

Unit contribution

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Variance 6

(4-5)A 100 100 0 -- --B 200 100 100 $0.90 $90.00C 150 100 50 1.2 $60.00

Total 450 300 150

The$150 variance is favorable in this example because the actual sales volume for the three products combined was more than what was budgeted

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Now, if you want to separate the mix and volume variances by each product -

• We can find this by using the following equation:

Mix variance = [(Act. Vol. of sales) – (total act vol of sales * budgeted proportion)] *

Budgeted unit contribution

Volume variance is easy to compute; We already computed the

combined variance. From this, subtract the mix variance to be

computed using above equation

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Mix Variance

Product 1

Bud. Proportion

2

Bud. Mix at Actual Volume

(3)Actual Sales

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Difference 5

(4-3)

Unit contribution

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Variance 7

(5) * (6)A 1/3 150 100 -50 0.2 -10B 1/3 150 200 50 $0.90 45C 1/3 150 150 0

Total 0 450 450 0 1.1 35

• See Column 3 and 4 – A higher proportion of B was sold while a lower proportion A was sold to A.• Since the contribution margin for B is higher (0.90) compared to A (0.20), the mix variance is favorable (35)

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Volume variance separated from mix variance

• We already computed the combined mix/volume

variance (three slides earlier). It is 150.

• The mix variance we just computed is 35.

• Therefore, volume variance =

150 - 35 = 115

• Formula for volume variance =

• [(Total Act Vol of Sales) * (Budgeted Proportion) –

Budgeted Sales] * Budgeted Unit contribution

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Isolation of Variances

• At what point should variances be isolated and

brought to the attention of the management?

• Earlier the better.

• What should management do?

• Variances should be viewed as ‘red flags.”

• Seek explanations for the reasons behind

variances and then decide, responsibility, course

of action.

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Other relevant issues of Variance Analysis –Time period comparison

Is comparison of annual budgets with annual

performance reports better than,

• Quarterly budgets with quarterly performance

comparisons?

• Or, shorter period comparisons?

• It depends on the objectives of the decision

maker.

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Other relevant issues of Variance Analysis –selling price or gross margin?

• We computed revenue variances based on

selling prices. Is this realistic?

• Does selling price remain constant throughout

the year?

• And, if not, a better approach would be to focus

on gross margin (selling price- cost per unit)

than on sales prices to compute variances.

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Who is generally responsible for monitoring and taking action on variances?

• One who can control the variance.

• Example:

• Purchase manager for purchase price

variance and

• Production manager for quantity variance.

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Flexible-Budget Variance in Detail

Standard per unit of output:Standard per unit of output:

DirectDirect Direct Direct MaterialMaterial LabourLabour

Std. inputs expectedStd. inputs expected 5 kg5 kg ½ hour½ hourStd. price expectedStd. price expected $ 2$ 2 $16$16Std. cost expectedStd. cost expected $10$10 $ 8$ 8

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Variances from Material and Labour Standards

Actual results for 7,000 units produced:Actual results for 7,000 units produced:

Direct materialDirect materialKgs purchasedKgs purchased

and used: 36,800and used: 36,800Price/kg: $1.90Price/kg: $1.90

Total actual cost:Total actual cost:$69,920$69,920

Direct labourDirect labourHours used: 3,750Hours used: 3,750

Actual price (rate): $16.40Actual price (rate): $16.40Total actual cost:Total actual cost:

$61,500$61,500

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Flexible budget or totalFlexible budget or totalstandard cost allowed: $70,000standard cost allowed: $70,000

Units of good output achieved: 7,000Units of good output achieved: 7,000

Input allowed per unit of output: 5 kgsInput allowed per unit of output: 5 kgs

Standard unit price of input: $2/kgStandard unit price of input: $2/kg

××

××

==

Standard Direct-Materials Cost Allowed:Standard Direct-Materials Cost Allowed:

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Direct material flexible-budget varianceDirect material flexible-budget variance

ActualActualcostcost

$69,920$69,920

FlexibleFlexiblebudgetbudget$70,000$70,000

$80 Favourable$80 Favourable

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Flexible budget or totalFlexible budget or totalstandard cost allowed: $56,000standard cost allowed: $56,000

Units of good output achieved: 7,000Units of good output achieved: 7,000

Input allowed per unit of output: ½ hourInput allowed per unit of output: ½ hour

Standard unit price of input: $16/hourStandard unit price of input: $16/hour

××

××

==

Standard Direct-Labour Cost Allowed:Standard Direct-Labour Cost Allowed:

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Direct labour flexible-budget varianceDirect labour flexible-budget variance


$61,500$61,500


$5,500 Unfavorable$5,500 Unfavorable

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Price and Usage Variances

(Actual quantity – (Actual quantity – StandardStandard quantity) quantity)× × StandardStandard price price

(Actual price – (Actual price – StandardStandard Price) Price)× Actual quantity × Actual quantity

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Price Variance Computations

($16.40 – $16.00) per hour($16.40 – $16.00) per hour× 3,750 hours = $1,500 U× 3,750 hours = $1,500 U

($1.90 – $2.00) per kg($1.90 – $2.00) per kg× 36,800 kg = $3,680 F× 36,800 kg = $3,680 F

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Usage Variance Computations

[3,750 – (7,000 × ½)] hours[3,750 – (7,000 × ½)] hours× $16 per hour = $4,000 U× $16 per hour = $4,000 U

[36,800 – (7,000 × 5)] kg[36,800 – (7,000 × 5)] kg× $2 per kg = $3,600 U× $2 per kg = $3,600 U

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Favourable or Unfavourable Variance?

To determine whethera variance is favourable

or unfavourable, uselogic rather than

memorizing a formula.

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Direct Materials Variances

• Price Variance—the cost difference

attributable to the difference between the

standard price of one unit of material and the

actual price of one unit of material.

• Quantity Variance—the cost difference

attributable to the difference between the

standard amount and the actual amount in

one unit of the product during the period.

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Direct Materials Flexible Budget Variance

Direct material flexible-budget varianceDirect material flexible-budget variance


$69,920$69,920


$80 F$80 F

AQ × SPAQ × SP==

$73,600$73,600

$3,680 F

(Price variance)$3,600 U

(Usage variance)

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Direct Labor Variances

•The standard is based on current wage

rates, adjusted for anticipated changes

such as cost of living adjustments.

•The rate standard also generally includes

employer payroll taxes, and fringe benefits

such as paid holidays and vacations.

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Direct Labor Variance

AH X AR = X1

AH x SR = X2

SH x SR = X3

Where:

AH = actual hoursAR = actual rateSH = standard hoursSR = standard rate

Note: This is essentially the same formula as for materials, exceptwe substitute hours for quantity, and rate for price.

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Direct Labour Flexible Budget Variance

Direct labour flexible-budget varianceDirect labour flexible-budget variance


$61,500$61,500


$5,500 U$5,500 U

AH × SPAH × SP==

$60,000$60,000

$1,500 U

(Price variance)$4,000 U

(Usage variance)

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Interpretation of Price and Usage Variances

Price and usage variances are helpfulPrice and usage variances are helpfulbecause they provide feedbackbecause they provide feedbackto those responsible for inputs.to those responsible for inputs.

Managers should not use theseManagers should not use thesevariances alone for decisionvariances alone for decision

making, control, or evaluation making, control, or evaluation possibility of trade-offspossibility of trade-offs

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Overhead Variance

• The total overhead variance can be broken into a

controllable variance and a overhead volume

variance.

• The formula is:

• Actual OH – Budgeted OH = Controllable variance

• Fixed OH rate x (Normal capacity hours – standard

hours allowed) = overhead volume variance

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Three Kinds of Overhead

• Budgeted overhead—number we came up with at

the beginning of the year.

• Use for one thing—to calculate rate for the year

(actually we use it for calculating variance)

• Actual overhead—this is what we actually spent,

this number comes from the general ledger).

• Overhead applied—budgeted overhead rate x

base.

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Overhead Variance

• The controllable variance tells whether spending

on individual overhead items was controlled or

not.

• The volume variance relates to whether overhead

was over or under applied due to differences in

budgeted base and actual base.

• i.e. did we us too many overhead hours (if it is

the base) or fewer than we estimated?

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Variable-Overhead Efficiency Variance

When actual cost-driver activity differs fromWhen actual cost-driver activity differs fromthe standard amount allowed for the actualthe standard amount allowed for the actual

output achieved, a output achieved, a variable-overheadvariable-overheadefficiency varianceefficiency variance will occur. will occur.

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Variable-Overhead Spending Variance

This is the difference between the actualvariable overhead and the amount

of variable overhead budgeted for theactual level of cost-driver activity.

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Variable Overhead Example

The variable-overhead cost rate of$.60 per unit is equivalent to $1.20per direct labour hour because each

unit of output requires ½ hour of labour

Suppose that Dominion Company’s costof supplies, a variable-overhead cost,

is driven by direct labour hours.

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Actual variable overhead = $4,700

Variable overhead allowed= $.60 × 7,000 units = $4,200

$500 unfavourable variance

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($4,700 – ($1.20 × 3,750 actual hours used)= $200 U

(3,750 act. hours – 3,500 std. hours allowed)× $1.20 per hour = $300 U

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Who is Responsible?

• Materials price variance—usually the purchasing

agent

• Materials quantity variance—usually the

production supervisor

• Labor rate variance—usually the personnel

director

• Labor efficiency variance—usually the production

supervisor

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Who is Responsible?

• Overhead variances

• Over or under spending on specific overhead items

• Use of more or less of the base than anticipated.

For example if the base is direct labor hours, then

additional hours used incur additional fringe benefit

costs, one component of the overhead pool.

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Reporting Variances

• Report variances to appropriate levels of

management as soon as possible.

• The form, content, and frequency of variance

reports varies considerably among companies.

• In income statements prepared for management,

cost of goods sold is stated at standard costs and

the variances are disclosed separately.

analyzing financial performance

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