CHAPTER 8

Budgetary Control and Variance Analysis

Learning Objectives

After studying this chapter, you will be able to:

  1. Understand how companies use budgets for control.
  2. Perform variance analysis.
  3. Interpret variances to determine possible corrective actions.
  4. Explain how nonfinancial measures complement variance analysis.

Overview

As we know, it is not enough just to make plans.We need to check periodically to see whether everythingis going according to plan and whether anycorrective actions are necessary. For example, wemight review a day’s activities. Did we accomplishwhat we set out to do? Do we need to change ourschedule for the next day? Similarly, large organizationscompare actual revenues, costs, and profitswith budgeted amounts to determine whether theyneed to make changes to their products, marketingpolicies, production processes, or purchasingprocedures.In this chapter, we focus on short-term measuresof control. We begin by discussing the roleof budgets in the control process. We then presentthe mechanics of variance analysis, a techniquefirms use to determine why actual revenues, costs,and profit differ from their budgeted amounts.Variance analysis helps organizations determinewhether their people and processes are performingas expected. It also helps organizations motivatetheir employees and improve future planning decisions. Finally, we discuss how organizations can use nonfinancial measures, in addition to variance analysis, to help control operations.

Learning Objective 1

Understand how companies use budgets for control.

Budgets As the Basis for Control

  1. As you learned in Chapter 7, a good plan is the foundation for effective control.
  2. Without a well-conceived plan against which to compare actual performance, it isdifficult to determine how we are doing or what we could do to improve.
  3. Cindy makes assumptionsfor the following items to estimate costs:
  4. Raw Materials Quantities
  5. Raw Materials Prices
  6. Labor Requirements
  7. Wage Rate
  8. Variable Overhead
  9. Fixed Costs
  10. The information determined is used to prepare the master budget.
  11. The master budget is a plan that presents the expected revenues, costs, and profit corresponding to the expected sales volume as of the beginning of that period.

Learning Objective 2

Perform variance analysis.

How to Calculate Variances

  1. A variance is the difference between an actual result and a budgeted amount.
  2. Weclassify a variance as favorable or unfavorable based on their effect on current profit.
  3. A favorable (F) variance means that performance exceeded expectations—actual revenue exceeded budgeted revenue or actual cost was less than budgeted cost.
  4. An unfavorable (U) variance means that performance fell shortof expectations—actual revenue was less than budgeted revenue or actual costexceededbudgeted cost.
  5. We denote favorable variances with positive numbers and unfavorable variances with negative numbers.
  6. Thus, we calculate sales, contribution margin, and profit variances asthe actual result less the budgeted amount (e.g., actual profit - budgeted profit).
  7. In contrast, because costs represent outflows, we calculate cost variances as the budgetedamount less the actual result (e.g., budgeted labor cost 2 actual labor cost).
  8. The total profit variance formula is shown below:

Total Profit Variance = Actual Profit - Master Budget Profit

  1. Variances are often related in the movement of amounts. For instance, if actual sales exceed budgeted sales, costs will increase as well.
  2. Example: Increased sales give rise to increased labor costs.
  3. Despite the seemingly simple relationship noted above, there are other factors to consider. (e.g., wage rates, unit amount fluctuations, etc.)

Breaking Down the Total Profit Variance

  1. As Exhibit 8.6 shows, in a series of steps, we can break down the total profit varianceinto several components.
  2. Each component informs us about how a certain aspect ofoperations, such as a change in sales volume or a change in the selling price, affectsprofit.

Flexible Budget

  1. Let us begin by breaking down the total profit variance into the sales volume variance and the flexible budget variance.
  2. Exhibit 8.6A reproduces the relevant portion of Exhibit 8.6 to help you place this step in context.
  3. Using the assumptions in the master budget, companies can develop a CVP relation that projects the profit for any sales level (Called “flexing” the budget).
  4. Flexing the master budget changes total budgeted revenues and total budgeted costs to correspond to any sales level.
  5. In variance analysis, we are particularly interested in the budget at the actual level of sales, or the flexible budget because profit differences are driven by the difference between budgeted and actual sales.

Sales Volume Variance

  1. Because the flexible and master budgets only differ in sales volume, we refer to thedifference in profit between the two budgets as the sales volume variance.
  2. Wecompute it by subtracting master budget profit from flexible budget profit.
  3. Because identical assumptions are made about sales price and variable costs, the budgeted unit contribution margin is thesame for both the master and the flexible budgets.
  4. Therefore, changing the volumeof sales proportionatelychanges profit by the budgeted unit contributionmargin, as follows:

Sales Volume Variance = Flexible Budget Profit - Master Budget Profit

= (Actual Sales Quantity - Budgeted Sales Quantity)

x Budgeted Unit Contribution Margin

  1. The variances for each line item simply represent changes in revenue and costs that are strictly proportional to the change in sales volume (not individual revenue or cost components).
  2. Thus, the net profit effect, which also equals the difference in contribution margins, is all we should interpret.
  3. In Appendix B, we discuss how firms can split the sales volume variance into two pieces.

Flexible Budget Variance

  1. The difference in profit between the actual results and the flexible budget is theflexible budget variance.

Flexible Budget Variance = Actual Profit - Flexible Budget Profit

  1. Before we move to the component variances, let us first look at the sales volume variance and the flexible budget variance graphically.
  2. Exhibit 8.8 shows how variances isolate the effect of one factor while controlling for other factors.
  3. Once we know the actual volume of activity, we use the flexible budget to calculate what the expected profit is—the budgeted profit given theactual volume.
  4. On the graph, the difference between points A and C on the y-axis, the profit orloss in dollars, is the total profit variance.
  5. This variance is the difference betweenthe master budget and the actual results and is made up of two components.
  6. Thefirst, the difference between points A and B, between the master budget and theflexible budget, is the sales volume variance.
  7. The second, the difference betweenpoints B and C, between the flexible budget and the actual results, is the flexiblebudget variance.

Components of the Flexible Budget Variance

  1. In the next step of variance analysis (see Exhibit 8.6B), we split the flexible budget variance into three components: the sales price variance, fixed cost variances, andvariable cost variances.
  2. We calculate these individual variances bycomparing the lines for revenue and each kind of cost between the flexible budgetand actual results.

Sales Price Variance

  1. In reference to the text example, recall that the flexible budget provides the expected revenue for the actual numberof cakes sold.
  2. However, because the actual price per cake was lower than the budgeted price, actual revenue differed from expected revenue.
  3. We compute the sales price variance between actual revenues and flexible budgetrevenues, as follows:

Sales Price Variance = Actual Revenue - Flexible Budget Revenue

= (Actual Sales Price x Actual Sales Quantity)

- (Budgeted Sales Price x Actual Sales Quantity)

= (Actual Sales Price - Budgeted Sales Price)

x Actual Sales Quantity

Fixed Cost Variance

  1. We refer to any difference between budgeted andactual fixed costs as a spending variance.

Fixed Cost Spending Variance = Budgeted Fixed Costs - Actual Fixed Costs

  1. Recall from Chapter 5 that the CVP relation assumes that fixed costs should be the same for all sales levels within the relevant range.
  2. However, even in the short term a firm’s actual expenditure on fixed costs could differ from the budgeted amount.

Variable Cost Variances

  1. These variances are the differences betweenthebudgeted costs (from the flexible budget) and the actual costs.
  2. Cindy should notattributethese variances to the increased sales volume.
  3. Why? The reason is that thecosts in the flexible budget—the benchmark for this variance—are already adjustedfor the actual volume of operations.

Input Quantity and Price Variances

  1. The final step is to calculate input quantity and price variances corresponding tovariable costs.
  2. A variable cost variance equals the amount in theflexible budget less the actual cost.
  3. To calculate the flexible budget cost, we multiply the budgeted input perunit of sales by the actual sales quantity.
  4. The product is the flexible budget quantity ofthe input.
  5. Then, multiply this quantity by the budgeted cost per unit of the inputto find the flexible budget cost.
  6. The actual total cost of any input is the actual cost per unit of the input times theactual quantity of the input used.
  7. In sum, the amounts in the flexible budget represent budgeted prices andbudgetedquantities for the actual sales.
  8. Meanwhile, actual quantities and actualprices dictate actual results. The differences in the amounts are the variances forvariable costs.
  9. For each of the line items, the input price variance is the difference between the “as if” budget and actual results.
  10. The input quantity variance is the difference between the amounts in the flexiblebudget and the “as if” budget.
  11. The text provides a summary of variance calculations associated withvariable costs.

Learning Objective 3

Interpret variances to determine possible corrective actions.

Interpreting and Using Variances

  1. Companies generally prepare a budget reconciliation report that provides managementwith a summary that bridges actual and expected performance.
  2. The reporthelps pinpoint which areas to investigate in order to take appropriate correctiveactions and also highlights areas of exceptional performance.
  3. Variances can arise:
  4. during the normal course of operations.
  5. because of a more permanent change in the firm’s operating environment.
  6. because budgets or standards are either too tight or too loose.

General Rules for Analyzing Variances

  1. There are three general rules to follow in a variance investigation:
  2. Investigate all significant variances, whether favorable or unfavorable.
  3. Examine trends.
  4. Consider the total picture.

Investigate All Large Variances

  1. Large variances could signal a permanent change in the operating environment.
  2. It is important to understand certain changes that result in long term implications.

Trends in Variances

  1. Trends in variances often point to inherent problems.
  2. Trends in variances also could arise because of biases that influence the settingof standards.
  3. Marketing personnel can intentionally “underestimate” market demand.
  4. Production personnel can “overstate” costs to give an artificial “cushion” to not exceed them.

Linking Variances—The Big Picture

  1. It is important to step back and see how thevariances are connected to each other.
  2. For instance, unfavorable sales pricevariancescould lead to favorable sales volume variances.
  3. An excessivefocus on generating favorable input price variances provides the purchasingmanagerwith a natural incentive to look for “good” deals by sacrificing quality,purchasingin bulk quantities, or agreeing to flexible delivery schedules.
  4. Suchpracticescould lead to unfavorable variances elsewhere in the organization.
  5. Also, revenue and cost variances sometimes have the same underlying cause.

Making Control Decisions inResponse to Variances

  1. Firms should use all of the variances toinvestigatethe validity of underlying budget assumptions and targets.
  2. They thenneed to collect additional information to choose among alternate explanations.
  3. Only then should companies decide on suitable corrective actions.

Learning Objective 4

Explain how nonfinancial measures complement variance analysis.

Nonfinancial Controls

  1. Variance analysis has some limitations.
  2. These limitations apply whenever controls are based on financial data from a firm’s accounting system.
  3. The primary limitations of variance analysis pertain to timeliness and specificity.
  4. The lack oftimeliness and specificity in financial variances force organizations to use other,primarily nonfinancial controls to ensure that they are meeting organizationalobjectives.

Nonfinancial Measures andProcess Control

  1. Nonfinancial measures can provide immediate and specific feedback to employees about the status of the environment and the outcomes of their decisions.
  2. We all need feedback, or control, information to perform our jobs effectively.
  3. In all cases, there is an expected or budgeted value for each measure.

Nonfinancial Measures andAligning Goals

  1. In addition to helping firms identify problems with their processes, nonfinancialmeasures also help align goals.
  2. This dual role for nonfinancial measures is similar tothat for financial measures.
  3. In general, financial controls are more useful for evaluating managers at higherlevels in an organizational hierarchy, whereas nonfinancial controls are more usefulfor monitoring and evaluating employees at lower levels, engaged in day-to-dayoperations.
  4. Problems that are not fixed in a timely manner when and where theyarise will give rise to unfavorable financial variances at the end of the week or themonth, and it becomes a manager’s responsibility to take corrective actions nexttime around.

CHAPTER 8 REVIEW QUESTIONS

TRUE/FALSE

1. A budget is the benchmark for evaluating actual performance.

2. An unfavorable variance means that actual revenue exceeds budgeted revenue or actual cost was less than budgeted cost.

3. We use a master budget to decompose the total profit variance into two major components: the sales volume variance and the flexible budget variance.

4. In variance analysis, we are particularly interested in the budget at the actual level of sales, or the flexible budget.

5. Variance could arise because budgets or standards are either too tight or too loose.

6. Relevance and Specificity are the two primary reasons organization use nonfinancial measure as well as financial measures for control measures.

MULTIPLE CHOICE

1. Total profit variance equals:

  1. Forecasted profit less master budget profit.
  2. Master budget profit less forecasted profit
  3. Actual profit less master budget profit.
  4. Actual profit less forecast.

2. Suppose actual profit before taxes is $9,900 and master budget profit before taxes is $8,000, what is the total profit variance:

  1. $1,800 Favorable.
  2. $1,800 Unfavorable.
  3. $1,900 Unfavorable.
  4. $1,900 Favorable.

3. Using a flexible budget, we break down total profit variance into two major components:

  1. The sales volume variance and the flexible budget variance.
  2. The master budget variance and the flexible budget variance.
  3. The static budget variance and the sales volume variance.
  4. The master budget variance and the sales volume variance.

4. Which is not a main reason why variances could arise?

  1. Variances could occur during the normal course of operations.
  2. Variance could arise due to a more temporary change in the firm's operating environment.
  3. Variances could occur because budgets or standards are either too tight or too loose.
  4. Variance could occur due to more permanent change in the firm's operating environment.

5. (Actual Sales Price X Actual Sales Quantity) - (Budgeted Sales Price X Actual Sales Quantity) =

  1. Sales Volume Variance.
  2. Flexible Budget Variance.
  3. Sales Price Variance.
  4. Input Price Variance.

6. What is not a characteristic of a budget reconciliation report?

  1. The report helps pinpoint which areas to investigate in order to take appropriate corrective actions.
  2. It provides management with a summary that bridges actual and expected performance.
  3. The report highlights areas of exceptional performance thus organizations can learn from "success" stories.
  4. The report begins with fixed spending variance.

7. Firms use budgets for control for which of the following reasons:

  1. A good plan is the foundation of effective control.
  2. It is difficult to evaluate the performance of the firm without comparing a well-conceived plan with actual performance.
  3. It is the benchmark for evaluating actual performance.
  4. All of the above.

8. Smith's Tool Company manufactures tools for multiple uses. For the month of May, Smith budgeted to manufacture and sell 10,000 tools at a price of $52. Smith's management estimated the unit variable cost at $32 and budgeted fixed costs of $50,000 for the month. During May, Smith actually sold 9,200 tools, earning $470,000 in revenue. In addition, Smith's actual total variable and fixed costs amounted to $282,000 and $46,000. What is the sales price variance?

  1. $50,000 Favorable.
  2. $8,400 Favorable.
  3. $8,400 Unfavorable.
  4. $50,000 Unfavorable.

9. Smith's Tool Company manufactures tools for multiple uses. For the month of May, Smith budgeted to manufacture and sell 10,000 tools at a price of $52. Smith's management estimated the unit variable cost at $32 and budgeted fixed costs of $50,000 for the month. During May, Smith actually sold 9,200 tools, earning $470,000 in revenue. In addition, Smith's actual total variable and fixed costs amounted to $282,000 and $46,000. What is the variable cost variance?

  1. $38,000 Favorable.
  2. $12,400 Favorable.
  3. $38,000 Unfavorable.
  4. $12,400 Unfavorable.

10. Smith's Tool Company manufactures tools for multiple uses. For the month of May, Smith budgeted to manufacture and sell 10,000 tools at a price of $52. Smith's management estimated the unit variable cost at $32 and budgeted fixed costs of $50,000 for the month. During May, Smith actually sold 9,200 tools, earning $470,000 in revenue. In addition, Smith's actual total variable and fixed costs amounted to $282,000 and $46,000. What is the fixed cost variance?

  1. $4,000 Favorable.
  2. $6,000 Favorable.
  3. $6,000 Unfavorable.
  4. $4,000 Unfavorable.

MATCHING

1.Match the items below by entering the appropriate code letter in the space provided.

A.Sales Price Variance F. Budget Reconciliation Report