1. © 2012 Pearson Prentice Hall. All rights reserved. Using Budgets for Planning and Coordination Chapter 10

2. © 2012 Pearson Prentice Hall. All rights reserved. What-If Analysis Structure and information required to prepare the master budget can be used to easily provide the basis for what-if analysis – Evaluating Decision-Making Alternatives – Sensitivity Analysis The process of selectively varying a plan’s or budget’s key estimates for the purpose of identifying over what range a decision option is preferred

3. © 2012 Pearson Prentice Hall. All rights reserved. Variance Analysis Variance analysis – comparison of planned (or budgeted) results with actual results Variance—difference between planned and actual results – Should be investigated to determine: What caused the variance What should be done to correct that variance

4. © 2012 Pearson Prentice Hall. All rights reserved. Variance Analysis Budgeted or planned costs can come from three sources: – Standards established by industrial engineers – Previous period’s performance – A benchmark—the best in class results achieved by a competitor

5. © 2012 Pearson Prentice Hall. All rights reserved. Variance Analysis The financial numbers are the product of a price and a quantity component: – Budgeted amount = standard price per unit * budgeted quantity – Actual amount = actual price per unit * actual quantity Variance analysis explains the difference between planned and actual costs by evaluating: – Differences between planned and actual prices – Differences between planned and actual quantities

6. © 2012 Pearson Prentice Hall. All rights reserved. Variance Analysis Managers focus separately on prices and quantities because in most organizations: – One department or division is responsible for the acquisition of a resource and determining the actual price – A different department uses the resource and determines the quantity A variance is a signal that is part of a control system for monitoring results

7. © 2012 Pearson Prentice Hall. All rights reserved. Basic Variance Analysis If managers learn that specific actions they took helped lower the actual costs, then they can obtain further cost savings by repeating those actions on similar jobs in the future If the factors causing actual costs to be higher than expected can be identified, then actions may be taken to prevent those factors from recurring in the future If cost changes are likely to be permanent, cost information can be updated for future jobs

8. © 2012 Pearson Prentice Hall. All rights reserved. First-Level Variances The first-level variance for a cost item is the difference between the actual costs and the master budget costs for that cost item Variances are favorable (F) if the actual costs are less than estimated master budget costs Unfavorable (U) variances arise when actual costs exceed estimated master budget costs

9. © 2012 Pearson Prentice Hall. All rights reserved. Decomposing the Variances A flexible budget adjusts the forecast in the master budget for the difference between planned volume and actual volume Cost differences between the master and the flexible budget are called planning variances – Reflect the difference between planned output and actual output – Arise entirely because the planned volume of activity was not realized

10. © 2012 Pearson Prentice Hall. All rights reserved. Planning and Flexible Budget Variances Flexible budget variances are the differences between the flexible budget and the actual results Flexible budget variances reflect: – Quantity variances—the difference between the planned and the actual use rates per unit of output – Cost variances—the difference between the planned and the actual price or cost per unit of the various cost items

11. Static and Flexible Budgets Static Budget Master budget Carefully forecasted sales and operating targets Actual Budget Variances Units 7,0009,000 Sales$217,000$279,000 Variable costs: Manufacturing$151,270$189,000 Shipping. 5,0005,400 Administrative 2,000 1,800 Total variable$158,270$196,200 Contr’n margin $58,730 $82,800 Fixed costs: Manufacturing$37,300$37,000 Sell & Admin33,00033,000 Total fixed costs$70,300$70,000 Op income (loss)$(11,570)$12,800 2,000 U 62,000 U 37,730 F 400 F 200 U $37,930 F $24,070 F 300 U UNCH 300 U $24,370 U

12. Evaluation of Financial Performance Subdivision of total difference between master or static budget and actual results to evaluate performance FlexibleSales Actual BudgetFlexibleActivityMaster ResultsVariancesBudgetVariancesBudget Units7,0007,0002,000 U9,000 Sales$217,000$217,000$62,000 U$279,000 Variable costs158,2705,670 U152,60043,600 F196,200 Contribution Margin58,7305,670 U64,40018,400 U82,800 Fixed costs70,300 300 U70,000 70,000 Operating income$(11,570)$5,970 U$(5,600)$18,400 U$12,800

13. © 2012 Pearson Prentice Hall. All rights reserved. Second and Third-Level Variances The second-level variances are the planning variance and the flexible budget variance The direct material flexible budget variances and direct labor flexible budget variances can be decomposed further into third-level variances: – Efficiency variances – Price variances

14. Copyright  2010 Pearson Education Canada Price and Efficiency Variances Static-Budget Variance Flexible-Budget VarianceSales-Volume ( Planning ) Variance Price VarianceEfficiency Variance

15. A General Model for Variance Analysis AQ x (AP – SP) (AQ – SQ) x SP AQ = Actual Quantity SP = Standard Price AP = Actual Price SQ = Standard Quantity Price VarianceQuantity Variance Actual Quantity Actual Quantity Standard Quantity × × × Actual Price Standard Price Standard Price

16. © 2012 Pearson Prentice Hall. All rights reserved. Direct Material Variances Quantity variance = (AQ - SQ) x SP Where: AQ = actual quantity of materials used SQ = standard quantity of materials allowed SP = standard price of materials

17. © 2012 Pearson Prentice Hall. All rights reserved. Direct Material Variances Price variance = (AP - SP) x AQ Where: AP = actual price of materials SP = standard price of materials AQ = actual quantity of materials used – The price variance may be calculated using the quantity purchased rather than the quantity used

18. © 2012 Pearson Prentice Hall. All rights reserved. Direct Labor Variances Efficiency variance = (AH - SH) x SR Rate variance = (AR - SR) x AH Where: AH = actual number of direct labor hours AR = actual wage rate SR = standard rate SH = standard number of direct labor hours allowed The sum of the rate variance and the efficiency variance equals the total flexible budget direct labor variance

19. © 2012 Pearson Prentice Hall. All rights reserved. Support Activity Cost Variances Support costs can reflect either flexible or fixed costs The quantity of fixed costs may not change from period to period, but the spending on them may fluctuate Monitoring spending variances on fixed costs is possible and desirable

20. © 2012 Pearson Prentice Hall. All rights reserved. Support Activity Cost Variances Flexible support costs reflect behind-the-scenes operations that are proportional to the volume of activity but are not directly a part of the product or service provided to the customer Flexible support costs consist of a quantity (or usage) component and a price component Flexible support cost variances may be analyzed in a manner similar to direct material or direct labor variances

21. Sales Variances Sales volume effects – Sales mix variance – Sales quantity variance © 2012 Pearson Prentice Hall. All rights reserved. Actual totalActualPlannedPlanned = units of allx sales – sales xrevenue products soldmix %mix %per unit Actual totalPlanned totalPlannedPlanned =units of all–units of allxsales xrevenue products soldproductsmix %per unit

22. Copyright  2010 Pearson Education Canada Profitability Variances Static-Budget Variance Flexible-Budget VarianceSales-Volume (Planning) Variance Sales-Volume Variance = (Actual unit sales – Budgeted unit sales) x Budgeted contribution margin per unit Sales-Mix Variance Sales-Quantity Variance Level 1 Level 2 Level 3

23. Sales Variances Sales price effects – Sales price variance Actual number of units sold x (Actual price per unit – Planned price per unit) © 2012 Pearson Prentice Hall. All rights reserved. Actual numberActualPlanned of unitsx price per – price soldunitper unit