Performance Evaluation Chapter 8

Preparing Flexible Budgets Hmm! Comparing static budgets with actual costs is like comparing apples and oranges. Static budgets are prepared for a single, planned level of activity. Performance evaluation is difficult when actual activity differs from the planned level of activity. Let’s look at Melrose Co.

Preparing Flexible Budgets F = Favourable variance Actual sales exceeded budgeted level of sales.

Preparing Flexible Budgets

Preparing Flexible Budgets Would you expect these variances to be favourable or unfavourable given the favourable sales variance?

Preparing Flexible Budgets I don’t think I can answer the question using a static budget. Actual activity is below budgeted activity which is unfavorable. So, shouldn’t variable costs be lower if actual activity is lower?

Preparing Flexible Budgets The relevant question is . . . “What portion of the variances is due to activity and price changes, and what portion is due to cost control?” To answer the question, we must the budget for the actual activity.

Preparing Flexible Budgets Show revenues and expenses that should have occurred at the actual activity. May be prepared for any activity level in the relevant range. Reveal variances due to good cost control or lack of cost control. Improve performance evaluation.

Preparing Flexible Budgets Central Concept If you can tell me what your activity was for the period, I will tell you what your costs and revenue should have been.

Preparing Flexible Budgets To a budget for different activity levels, we must know how costs behave with changes in activity levels. Total variable costs change in direct proportion to changes in activity. Total fixed costs remain unchanged within the relevant range. Variable Fixed

Preparing Flexible Budgets Let’s prepare budgets for the Melrose Co.

Preparing Flexible Budgets 18,000 units × $12.00 per unit = $216,000

Preparing Flexible Budgets

Preparing Flexible Budgets “What portion of the variances is due to activity and price changes, and what portion is due to cost control?”

Sales and Cost Variances Sales price variance 19,000 units × ($80 per unit – $78 per unit) Variances due to activity change

Sales and Cost Variances Variances due to cost control

Standard Costs We will use standard costs analysis to determine the causes for manufacturing cost variances.

Establishing Standards Based on carefully predetermined amounts. Used for planning labor, material, and overhead requirements. Standard Costs are The expected level of performance. Benchmarks for measuring performance.

Establishing Standards Accountants, engineers, personnel administrators, and production managers combine efforts to set standards based on experience and expectations.

Establishing Standards Practical standards should be set at levels that are currently attainable with reasonable and efficient effort. Should we use practical standards or ideal standards? Managerial Accountant Engineer

Establishing Standards I agree. Ideal standards, based on perfection, are unattainable and discourage most employees. Lax standards create motivational problems. Production manager Human Resources Manager

Manufacturing Overhead Need for Standards Managers focus on quantities and costs that exceed standards, a practice known as management by exception.. Standard Amount Direct Material Direct Labour Manufacturing Overhead Type of Product Cost

Selecting Variances to Investigate Materiality, frequency, capacity to control, and characteristics of the cost are items to consider. How do I know which variances to investigate?

Manufacturing Cost Variances A standard cost variance is the amount by which an actual cost differs from the standard cost. This variance is unfavourable because the actual cost exceeds the standard cost. Standard Product Cost

Manufacturing Cost Variances First, they point to causes of problems and directions for improvement. Second, they trigger investigations in departments having responsibility for incurring the costs. I see that there is an unfavourable variance. But why are variances important to me?

Manufacturing Cost Variances Take corrective actions Identify questions Receive explanations Conduct next period’s operations Analyze variances Prepare standard cost performance report Begin

Price and Usage Variances Standard Cost Variances Price Variance Usage Variance The difference between the actual quantity and the standard quantity The difference between the actual price and the standard price

Price and Usage Variances Actual Quantity Actual Quantity Standard Quantity × × × Actual Price Standard Price Standard Price Price Variance Usage Variance Standard price is the amount that should have been paid for the resources acquired.

Price and Usage Variances Actual Quantity Actual Quantity Standard Quantity × × × Actual Price Standard Price Standard Price Price Variance Usage Variance Standard quantity is the quantity that should have been used for the output achieved.

Price and Usage Variances Actual Quantity Actual Quantity Standard Quantity × × × Actual Price Standard Price Standard Price Price Variance Usage Variance AQ(AP - SP) SP(AQ - SQ) AQ = Actual Quantity SP = Standard Price AP = Actual Price SQ = Standard Quantity

Calculating the Materials Price and Usage Variances Let’s apply what we have learned calculate standard cost variances, starting with material.

Calculating the Materials Price and Usage Variances Zippy Hanson Inc. has the following material standards to manufacture one Zippy: 1.5 kilograms per Zippy at $4.00 per kilogram Last week 1,700 kilograms of material were purchased and used to make 1,000 Zippies. The material cost a total of $6,630.

Calculating the Materials Price and Usage Variances Zippy What is the actual price per kilogram paid for the material? a. $4.00 per kilogram. b. $4.10 per kilogram. c. $3.90 per kilogram. d. $6.63 per kilogram.

Calculating the Materials Price and Usage Variances Zippy What is the actual price per kilogram paid for the material? a. $4.00 per kilogram. b. $4.10 per kilogram. c. $3.90 per kilogram. d. $6.63 per kilogram. AP = $6,630 ÷ 1,700 kgs AP = $3.90 per kg

Calculating the Materials Price and Usage Variances Zippy Hanson’s material price variance (MPV) for the week was: a. $170 unfavourable. b. $170 favourable. c. $800 unfavourable. d. $800 favourable.

Calculating the Materials Price and Usage Variances Zippy Hanson’s material price variance (MPV) for the week was: a. $170 unfavourable. b. $170 favourable. c. $800 unfavourable. d. $800 favourable. MPV = AQ(AP - SP) MPV = 1,700kgs. × ($3.90 - 4.00) MPV = $170 Favourable

Calculating the Materials Price and Usage Variances Zippy The standard quantity of material that should have been used to produce 1,000 Zippies is: a. 1,700 kilograms. b. 1,500 kilograms. c. 2,550 kilograms. d. 2,000 kilograms.

Calculating the Materials Price and Usage Variances Zippy The standard quantity of material that should have been used to produce 1,000 Zippies is: a. 1,700 kilograms. b. 1,500 kilograms. c. 2,550 kilograms. d. 2,000 kilograms. SQ = 1,000 units × 1.5 kgs per unit SQ = 1,500 kgs.

Calculating the Materials Price and Usage Variances Zippy Hanson’s material usage variance (MUV) for the week was: a. $170 unfavourable. b. $170 favourable. c. $800 unfavourable. d. $800 favourable.

Calculating the Materials Price and Usage Variances Zippy Hanson’s material usage variance (MUV) for the week was: a. $170 unfavourable. b. $170 favourable. c. $800 unfavourable. d. $800 favourable. MUV = SP(AQ - SQ) MUV = $4.00(1,700 kgs - 1,500 kgs) MUV = $800 unfavourable

Material Variances Summary Actual Quantity Actual Quantity Standard Quantity × × × Actual Price Standard Price Standard Price 1,700 kgs. 1,700 kgs. 1,500 kgs. × × × $3.90 per kg. $4.00 per kg. $4.00 per kg. = $6,630 = $ 6,800 = $6,000 Price variance $170 favorable Usage variance $800 unfavorable

Responsibility for Materials Variances I need the price variance sooner so that I can better identify purchasing problems. You accountants just don’t understand the problems that purchasing managers have. I’ll start computing the price variance as soon as the information is available.

Responsibility for Materials Variances You used too much material because of poorly trained workers and poorly maintained equipment. Also, your poor scheduling sometimes requires me to rush order material at a higher price, causing unfavourable price variances. I am not responsible for this unfavourable material usage variance. You purchased cheap material, so my people had to use more of it.

Now let’s calculate standard cost variances for labour. Labour Variances Now let’s calculate standard cost variances for labour.

1.5 standard hours per Zippy at $6.00 per direct labour hour Labour Variances Zippy Hanson Inc. has the following direct labour standard to manufacture one Zippy: 1.5 standard hours per Zippy at $6.00 per direct labour hour Last week 1,550 direct labour hours were worked at a total labor cost of $9,610 to make 1,000 Zippies.

Labour Variances Zippy What was Hanson’s actual price (AP) for labor for the week? a. $6.20 per hour. b. $6.00 per hour. c. $5.80 per hour. d. $5.60 per hour.

Labour Variances Zippy What was Hanson’s actual price (AP) for labour for the week? a. $6.20 per hour. b. $6.00 per hour. c. $5.80 per hour. d. $5.60 per hour. AP = $9,610 ÷ 1,550 hours AP = $6.20 per hour

Labour Variances Zippy Hanson’s labour price variance (LPV) for the week was: a. $310 unfavourable. b. $310 favourable. c. $300 unfavourable. d. $300 favourable.

Labour Variances Zippy Hanson’s labour price variance (LPV) for the week was: a. $310 unfavourable. b. $310 favourable. c. $300 unfavourable. d. $300 favourable. LPV = AH(AP - SP) LPV = 1,550 hrs($6.20 - $6.00) LPV = $310 unfavourable

Labour Variances Zippy The standard hours (SH) of labour that should have been worked to produce 1,000 Zippies is: a. 1,550 hours. b. 1,500 hours. c. 1,700 hours. d. 1,800 hours.

Labour Variances Zippy The standard hours (SH) of labour that should have been worked to produce 1,000 Zippies is: a. 1,550 hours. b. 1,500 hours. c. 1,700 hours. d. 1,800 hours. SH = 1,000 units × 1.5 hours per unit SH = 1,500 hours

Labour Variances Zippy Hanson’s labour usage variance (LUV) for the week was: a. $290 unfavourable. b. $290 favourable. c. $300 unfavourable. d. $300 favourable.

Labour Variances Zippy Hanson’s labour usage variance (LUV) for the week was: a. $290 unfavourable. b. $290 favourable. c. $300 unfavourable. d. $300 favourable. LUV = SP(AH - SH) LUV = $6.00(1,550 hrs - 1,500 hrs) LUV = $300 unfavourable

Labour Variances Zippy Actual Hours Actual Hours Standard Hours × × × Actual Price Standard Price Standard Price Price variance $310 unfavourable Usage variance $300 unfavourable 1,550 hours 1,550 hours 1,500 hours × × × $6.20 per hour $6.00 per hour $6.00 per hour = $9,610 = $9,300 = $9,000

Responsibility for Labour Variances Using highly paid skilled workers to perform unskilled tasks results in an unfavourable rate variance. High skill, high rate Low skill, low rate Production managers who make work assignments are generally responsible for rate variances.

Responsibility for Labour Variances Poorly trained workers Poor quality materials Unfavourable Usage Variance Poor supervision of workers Poorly maintained equipment

Responsibility for Labour Variances You used too much time because of poorly trained workers and poor supervision. I am not responsible for the unfavourable labor usage variance! You purchased cheap material, so it took more time to process it.

Responsibility for Labour Variances Maybe I can attribute the labor and material variances to personnel for hiring the wrong people and training them poorly.

Variable Overhead Variances Many companies do not calculate price and usage variances for variable overhead. Flexible budget variances are used to evaluate variable overhead cost control.

Fixed Overhead Variances Now let’s turn our attention to fixed overhead.

Fixed Overhead Variances Overhead costs are assigned to products and services using a predetermined overhead rate (POHR): Assigned Overhead = POHR × Standard Activity Fixed Overhead Budget POHR = Static Budget Activity

Fixed Overhead Variances Spending Variance Volume Variance POHR = Fixed Overhead Rate SH = Standard Hours Allowed SH × POHR Actual Fixed Fixed Fixed Overhead Overhead Overhead Incurred Budget Applied

Fixed Overhead Variances Zippy Hanson Inc. has the following budgeted and actual fixed overhead information: Calculate the fixed overhead spending and volume variances.

Fixed Overhead Variances Zippy 1,500 hours × $3.00 per hour Spending variance $150 favourable $5,250 $5,400 $4,500 Volume variance $900 unfavourable SH × POHR Actual Fixed Fixed Fixed Overhead Overhead Overhead Incurred Budget Applied

Fixed Overhead Variances Spending Variance Volume Variance Results from paying more or less than expected for overhead items. Results from operating at an activity level different from the planned activity.

Volume Variance - A Closer Look Results when standard hours allowed for actual output differs from the budgeted activity. Unfavourable when standard hours < budgeted hours Favourable when standard hours > budgeted hours

Volume Variance - A Closer Look Results when standard hours allowed for actual output differs from the budgeted activity. Volume Variance Favorable when standard hours > budgeted hours Unfavorable when standard hours < budgeted hours Does not measure over- or under spending Explainable by and controllable only through activity

End of Chapter 8 We made it!