1. 7 - 1 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Flexible Budgets, Variances, and Management Control: I Chapter 7 2/14/05

2. 7 - 2 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Use of Variances l A Variance is the difference between actual performance and budgeted performance l Management by exception puts focus on large, significant variances only l Variances can be either positive or negative, and both types must be analyzed l Variances can be used in performance evaluation l Variances can indicate flawed designs or processes

3. 7 - 3 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Distinguish a static budget from a flexible budget. Learning Objective 1

4. 7 - 4 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Static and Flexible Budgets Static Budget Planned level of output at start of the budget period Based on Flexible Budget Budgeted revenues and cost based on actual level of output Based on

5. 7 - 5 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Static Budget Example Assume that Pasadena Co. manufactures and sells dress suits. Budgeted variable costs per suit are as follows: Direct materials cost$ 65 Direct manufacturing labor 26 Variable manufacturing overhead 24 Total variable costs$115

6. 7 - 6 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Static Budget Example Budgeted selling price is $155 per suit. Fixed manufacturing costs are expected to be $286,000 within a relevant range between 9,000 and 13,500 suits. The static budget for year 2004 is based on selling 13,000 suits. What is the static-budget operating income?

7. 7 - 7 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Static Budget Example Revenues (13,000 × $155) $2,015,000 Less Expenses: Variable (13,000 × $115) 1,495,000 Fixed 286,000 Budgeted operating income $ 234,000 Assume that Pasadena Co. produced and sold 10,000 suits at $160 each with actual variable costs of $120 per suit and fixed manufacturing costs of $300,000.

8. 7 - 8 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Static Budget Example Revenues (10,000 × $160)$1,600,000 Less Expenses: Variable (10,000 × $120) 1,200,000 Fixed 300,000 Actual operating income$ 100,000 What was the actual operating income?

9. 7 - 9 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Static-Budget Variance Example What is the static-budget variance of operating income? Actual operating income$100,000 Budgeted operating income 234,000 Static-budget variance of operating income$134,000 U

10. 7 - 10 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Static-Budget Variance Example Static-Budget Based Variance Analysis (Level 1) in (000) Static Budget Actual Variance Suits 13 10 3 U Revenue$2,015$1,600$415 U Variable costs 1,495 1,200 296 F Contribution margin$ 520$ 400$120 U Fixed costs 286 300 14 U Operating income$ 234$ 100$134 U

11. 7 - 11 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Static Budget Variance Analysis l What this variance report doesn’t tell you is how much of the variance is due to spending and how much is due to a different level of activity l One would assume lower spending levels due to lower sales volume; 10,000 vs 13,000 dress suits l How much of the variance is actually due to performance?

12. 7 - 12 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Learning Objective 2 Develop a flexible budget and compute flexible-budget variances and sales-volume variances.

13. 7 - 13 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Steps in Developing Flexible Budgets Step 1: Determine budgeted selling price, variable cost per unit, and budgeted fixed cost. Budgeted selling price is $155, variable cost is $115 per suit, and the budgeted fixed cost is $286,000.

14. 7 - 14 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Steps in Developing Flexible Budgets Step 2: Determine the actual quantity of output. In the year 2004, 10,000 suits were produced and sold. Step 3: Determine the flexible budget for revenues. $155 × 10,000 = $1,550,000

15. 7 - 15 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Steps in Developing Flexible Budgets Step 4: Determine the flexible budget for costs. Variable costs: 10,000 × $115 = $1,150,000 Fixed costs 286,000 Total costs $1,436,000

16. 7 - 16 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Variances Level 2 analysis provides information on the two components of the static-budget variance. 1. Flexible-budget price/cost variance 2. Sales-volume related variance

17. 7 - 17 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Flexible-Budget Variance Flexible-Budget Price/Cost Variance (Level 2) in (000) Flexible BudgetActual Variance Suits 10 10 0 Revenue$1,550$1,600$ 50 F Variable costs 1,150 1,200 50 U Contribution margin$ 400$ 400$ 0 Fixed costs 286 300 14 U Operating income$ 114$ 100$ 14 U

18. 7 - 18 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Flexible-Budget Variance Total flexible-budget price/cost variance = Total actual results – Total flexible budget for actual sales level

19. 7 - 19 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Flexible-Budget Variance Actual quantity sold: 10,000 suits Flexible-budget oper. income variance $14,000 U Actual results operating income $100,000 Flexible-budget operating income $114,000

20. 7 - 20 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Flexible-Budget Price/Cost Variance Why is the flexible-budget variance $14,000 U? Selling-price variance$50,000 F Actual variable costs exceeded flexible budget variable costs 50,000 U Actual fixed costs exceeded flexible budget fixed costs 14,000 U Total flexible-budget variance$14,000 U

21. 7 - 21 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Sales-Volume Variance Sales-Volume Related Variance (Level 2) in (000) Flexible StaticSales-Volume BudgetBudgetVariance Suits1013 3 U Revenue$1,550$2,015$465 U Variable costs 1,150 1,495 295 F Contr. margin$ 400$ 520$120 U Fixed costs 286 286 0 Operating income$ 114$ 234$120 U

22. 7 - 22 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Sales-Volume Variance Actual quantity sold: 10,000 suits Sales-volume related contr. margin variance $120,000 U Flexible-budget operating income $114,000 Static-budget operating income $234,000

23. 7 - 23 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Sales-Volume Variance Total sales-volume variance $120,000 U = Actual sales unit – Master budgeted sales units 13,000 – 10,000 = 3,000 × Budgeted contribution margin per unit $40

24. 7 - 24 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Budget Variances Static-budget variance $134,000 U Flexible-budget spending variance $14,000 U Level 1 Sales-volume variance $120,000 U Level 2

25. 7 - 25 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Learning Objective 3 Explain why standard costs are often used in variance analysis.

26. 7 - 26 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Standard Costs l A standard is a carefully determined price, cost or quantity that represents the desired expectation of what these values should be. l Standards are determined by various methods including engineering studies, accounting analyses, l Standards are normally expressed on a per unit basis l Standards try to exclude past inefficiencies and take into account future changes

27. 7 - 27 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Standards Pasadena’s budgeted cost for each variable direct cost item is computed as follows: Standard input allowed for one output unit Standard cost per input unit ×

28. 7 - 28 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Standards – Direct Material 4.00* square yards allowed per output unit at $16.25* standard cost per square yard. Standard material cost per output unit 4.00 × $16.25 = $65.00 * These amounts are fully loaded. Material usage might include allowances for waste, unskilled workers, mistakes. Material cost includes purchase price, shipping costs, taxes, discounts, etc.

29. 7 - 29 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Standards – Direct labor 2.00* manufacturing labor-hours of input allowed per output unit at $13.00* standard fully absorbed cost per hour. Standard labor cost per output unit 2.00 × $13.00 = $26.00 * Labor hours could include manufacturing time, breaks, and allowances for rework and broken product. The labor rate would include pay rate, payroll taxes, and benefits.

30. 7 - 30 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Learning Objective 4 Compute price variances and efficiency variances for direct-cost categories.

31. 7 - 31 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Actual Data (10,000 Units) Direct materials purchased and used: 42,500 square yards at $15.95 Labor hours: 21,500 at $12.90 Cost of direct materials = $677,875 Cost of direct manufacturing labor = $277,350

32. 7 - 32 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Price Variance Example Direct-material price variance Actual price – standard price × Actual quantity Material Price Var. = AQ(AP – SP) ($15.95 – $16.25) × 42,500 = -$12,750 F (A negative amount indicates a favorable variance and a positive amount would indicate an unfavorable variance) = =

33. 7 - 33 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Price Variance Example Direct-labor rate variance Actual rate – Budgeted rate × Actual Quantity (hours) Labor rate variance = AH(AR – SR) ($12.90 – $13.00) × 21,500 = -$2,150 F = =

34. 7 - 34 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Efficiency Variance Example Direct-material efficiency variance Actual quantity – Standard quantity × Standard price Material efficiency var. = SP(AQ – SQ) (42,500 – 40,000) × $16.25 = $40,625 U = =

35. 7 - 35 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Efficiency Variance Example Direct-labor efficiency variance Actual Hours – Standard Hours × Standard Rate Labor efficiency var. = SR(AH – SH) (21,500 – 20,000) × $13.00 = $19,500 U = =

36. 7 - 36 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Flexible Budget Material Variance Example AQ x AP 42,500 x 15.95 $677,875 SQ × SP 40,000 × $16.25 $650,000 AQ × SP 42,500 × $16.25 $690,625 $12,750 F$40,625 U $27,875 U

37. 7 - 37 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Material Cost Variance Causes Price Variances l Changed to a lower-price vendor l Bought larger than normal quantity l Standards are outdated, poorly set l Bought lower quality material Quantity variances Poorly trained workers Lower quality material Poorly maintained equipment

38. 7 - 38 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Flexible Budget Labor Variance Example AH x AR 21,500 x 12.90 $277,350 SH × SR 20,000 × $13.00 $260,000 AH × SR 21,500 × $13.00 $279,500 $2,150 F$ 19,500 U $17,350 U

39. 7 - 39 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Labor variance causes l Labor rate Labor rates went up (union agreement) Fired/Hired low rate employees Used high rate employees on low skill jobs l Labor quantity (hours) Use low quality materials (lots of rework) Poor training, supervision

40. 7 - 40 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Static-budget variance Materials$167,125 F Labor 60,650 F Total$227,775 F Flexible-budget variance Materials$27,875 U Labor 17,350 U Total$45,225 U Sales-volume variance Materials$195,000 F Labor 78,000 F Total$273,000 F Level 1 Level 2 Variance Analysis (Using flexible along with static budget) Level 2

41. 7 - 41 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Flexible-budget variance Materials$27,875 U Labor 17,350 U Total$45,225 U Price/Rate variance Materials$12,750 F Labor 2,150 F Total$14,900 F Efficiency variance Materials$40,625 U Labor 19,500 U Total$60,125 U Level 2 Level 3 Variance Analysis (Breaking variances down into price and efficiency components ) Level 3

42. 7 - 42 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Learning Objective 5 Explain why purchasing performance measures should focus on more factors than just price variances.

43. 7 - 43 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Management Uses of Variances l The focus of variance analysis is to understand why variances arise and how to use that information to learn and to improve performance l You must evaluate possible operational causes and take corrective action l Use management by exception

44. 7 - 44 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Performance Measurement Using Variances Do not automatically interpret a favorable variance as “good news”. (McDonalds) Do not interpret variances in isolation of each other; i.e. poor design can cause material and labor inefficiencies Variances should not be used solely to evaluate performance; wrong incentives

45. 7 - 45 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster When to Investigate Variances When should variances be investigated? Subjective judgments, rules of thumb Rules of thumb as “investigate all variances exceeding $5,000 or 25% of expected cost, whichever is lower.”

46. 7 - 46 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Learning Objective 8 Describe benchmarking and how it is used in cost management.

47. 7 - 47 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Benchmarking It refers to the continuous process of measuring products, services, and activities against the best levels of performance.

48. 7 - 48 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Benchmarking l Firms must insure that benchmark companies are comparable l Variances should be calculated on benchmarked items that are most relevant to your company l Must determine why observed costs or revenue differences exist across companies

49. 7 - 49 ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster End of Chapter 7