COST ANALYSIS FOR CONTROL CHAPTER 15 COST ANALYSIS FOR CONTROL McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Learning Objectives Why are all costs controllable by someone at some time, but in the short run some costs may be classified as noncontrollable? How does performance reporting facilitate the management-by-exception process? How can the operating results of segments of an organization be reported most meaningfully? McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Learning Objectives What is a flexible budget, and how is it used? How and why are the two components of a standard cost variance calculated? What are the specific names assigned to variances for different product inputs? McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Learning Objectives How do the control and analysis of fixed overhead variances and variable cost variances differ? What are the alternative methods of accounting for variances? McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Learning Objective 1 Why are all costs controllable by someone at some time, but in the short run some costs may be classified as noncontrollable? McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Performance Reporting Involves the comparison of actual results with planned results The objective is highlighting those activities where planned and actual results differ Appropriate actions may be taken to address the causes of the favorable or unfavorable variances McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Planning and Control Cycle Strategic, Operational, and Financial Planning Planning and Control Cycle Performance Analysis: Plans vs. Actual Results (Controlling) Executing Operational Activities (Managing) Revisit Plans Implement Plans Data Collection and Performance Feedback McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Relationship of Total Costs to Volume of Activity +/- Any differences between achieved and planned performances should be evaluated As the level of activity changes from the planned activity, total variable costs should change The total amount of fixed costs should not change with changes in levels of activity McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Cost Classification According to a Time-Frame Perspective A noncontrollable cost is one which the manager can do nothing to influence the amount of the cost Noncontrollable costs occur in the short run In the long run every cost is controllable by someone in the organization McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Learning Objective 2 How does performance reporting facilitate the management-by-exception process? McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Characteristics of the Performance Report A performance report compares actual results to budgeted amounts It is an integral part of the control process The general format is as follows: Budget Actual Activity Amount Amount Variance Explanation McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Variances +/- Variances are usually described as either favorable or unfavorable A favorable variance occurs when results exceed planned activities in a positive manner – revenues are larger than expected An unfavorable variance occurs when results exceed planned activities in a negative manner – expenses are larger than expected McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Responsibility Reporting The explanation column in the performance report is to communicate to upper-level management the causes of variances In responsibility reporting, higher levels of management receive less details regarding lower levels in the chain of command Managers want to eliminate unfavorable variances and retain favorable variances McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Management by Exception Managers concentrate their efforts only on those activities that are not performing according to the plan To aid in this effort, variances are often expressed in percentages Only those variances that exceed a predetermined percentage are investigated McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Frequency of Performance Reports Performance reports should be issued soon after the period in which the activity takes place If later, actions are forgotten or confused A question regarding performance reports is whether noncontrollable expenses should be reported May want managers to be aware of all costs, or may want managers to deal only with controllable costs McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Learning Objective 3 How can the operating results of segments of an organization be reported most meaningfully? McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Reporting for Segments of an Organization A segment is a division, product line, or other organizational unit Using the contribution margin format, sales, variable expenses, contribution margin, fixed expenses, and operating income are calculated for each segment Fixed expenses should be divided into direct fixed expenses and common fixed expenses McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Segment Fixed Expenses Direct fixed expenses would be eliminated if the segment were eliminated Common fixed expenses are an allocated portion of the organization’s fixed expenses Common fixed expenses would not be eliminated if the segment were eliminated McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Types of Segments A responsibility center is an element of the organization over which a manager has responsibility and authority Cost center – does not generate revenue for the organization Profit center – generates revenue for the organization Investment center – generates revenue and controls assets of the organization McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Evaluating Segments Cost centers are evaluated by comparing actual costs incurred to budgeted costs Profit centers are evaluated by comparing actual segment margin to budgeted segment margin Investment centers are evaluated by comparing actual and budgeted return on investment based on segment margin and assets controlled by the segment McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Learning Objective 4 What is a flexible budget, and how is it used? McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Flexible Budget A flexible budget is one that reflects budgeted amounts for actual activity Flexible budgeting does not affect the predetermined overhead application rate Therefore, fixed overhead will be overapplied or underapplied McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Learning Objective 5 How and why are the two components of a standard cost variance calculated? McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Analysis of Variable Cost Variances The total variance for a cost component is called the budget variance The budget variance is caused by two factors: The difference between the standard and actual quantity The difference between the standard and actual unit cost McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Variance Terminology Different variances are the responsibility of different managers Must separate total variances so that each manager can take appropriate action Quantity variances often called usage or efficiency variances Cost per unit of input variances often called price, rate, or spending variances McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Direct Labor Variances Direct labor efficiency variance is the quantity variance for direct labor The direct labor efficiency variance is the difference between standard hours allowed and actual hours worked Direct labor rate variance is the cost per unit of input variance The direct labor rate variance is the difference between actual and standard hourly pay rates McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Learning Objective 6 What are the specific names assigned to variances for different product inputs? McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Variance Names Cost per unit Input Quantity of Input Raw materials Usage Price Direct labor Efficiency Rate Variable overhead Efficiency Spending McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

General Variance Model Quantity variance = Standard Actual Standard quantity - quantity X cost per allowed used unit Cost per unit of input variance = Standard Actual Standard quantity - quantity X cost per allowed used unit McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Graphical Representation Actual quantity used Actual quantity used Standard quantity allowed X X X Actual cost per unit Standard cost per unit Standard cost per unit Cost per unit of Input variance Quantity variance McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Variance Analysis Objectives Objective is to highlight deviations from planned results Want to eliminate unfavorable variances and capture favorable variances Need to analyze variances for each standard Usually raw materials usage variances and direct labor efficiency variances are reported frequently McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Raw Materials Purchase Variance Many firms calculate and report raw materials price variances at the time the materials are purchased rather than when they are used Modified purchase price variance: Standard Actual Actual cost per - cost per X quantity unit unit purchased McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Learning Objective 7 How do the control and analysis of fixed overhead variances and variable cost variances differ? McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Analysis of Fixed Overhead Analyzed differently from variable cost variances The focus is on the difference budgeted fixed overhead and actual fixed overhead expenditures This difference is divided into a budget variance and a volume variance McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Fixed Overhead Volume Variance Volume variance is the difference between the amount of fixed overhead applied to production and that planned to be applied It is not appropriate to make per unit fixed overhead variance calculations because fixed costs do not behave on a per unit basis McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Fixed Overhead Budget Variance The budget variance is the difference between budgeted fixed overhead for the period and the actual fixed overhead for the period Fixed overhead is difficult to control on a short-term basis But is a significant cost, so it receives management’s attention McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Learning Objective 8 What are the alternative methods of accounting for variances? McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Accounting for Variances If the total of all of the variance is not significant, it is included with cost of goods sold in the income statement Standard costs also are released to cost of goods sold Therefore, cost of goods sold reports the actual cost of the items If variances are large, the variances are allocated between inventory and cost of goods sold McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002