The payback period is the time required for the amount invested in an asset to be repaid by the
net cash outflow generated by the asset. It is a simple way to evaluate the risk associated with a
proposed project.
The payback period is expressed in years and fractions of years. For example, if a company
invests $300,000 in a new production line, and the production line then produces cash flow of
$100,000 per year, then the payback period is 3.0 years ($300,000 initial investment / $100,000
annual payback). An investment with a shorter payback period is considered to be better, since
the investor's initial outlay is at risk for a shorter period of time. The calculation used to derive
the payback period is called the payback method.
The formula for the payback method is simplistic: Divide the cash outlay (which is assumed to
occur entirely at the beginning of the project) by the amount of net cash flow generated by the
project per year (which is assumed to be the same in every year).
Payback Period Example
Alaskan Lumber is considering the purchase of a band saw that costs $50,000 and which will
generate $10,000 per year of net cash flow. The payback period for this capital investment is 5.0
years. Alaskan is also considering the purchase of a conveyor system for $36,000, which will
reduce saw mill transport costs by $12,000 per year. The payback period for this capital
investment is 3.0 years. If Alaskan only has sufficient funds to invest in one of these projects,
and if it were only using the payback method as the basis for its investment decision, it would
buy the conveyor system, since it has a shorter payback period.
Payback Method Advantages and Disadvantages
The payback period is useful from a risk analysis perspective, since it gives a quick picture of the
amount of time that the initial investment will be at risk. If you were to analyze a prospective
investment using the payback method, you would tend to accept those investments having rapid
payback periods, and reject those having longer ones. It tends to be more useful in industries
where investments become obsolete very quickly, and where a full return of the initial
investment is therefore a serious concern. Though the payback method is widely used due to its
simplicity, it suffers from the following problems:
1. Asset life span. If an assets useful life expires immediately after it pays back the initial
investment, then there is no opportunity to generate additional cash flows. The payback
method does not incorporate any assumption regarding asset life span.
2. Additional cash flows. The concept does not consider the presence of any additional cash
flows that may arise from an investment in the periods after full payback has been
achieved.
3. Cash flow complexity. The formula is too simplistic to account for the multitude of cash
flows that actually arise with a capital investment. For example, cash investments may be
required at several stages, such as cash outlays for periodic upgrades. Also, cash outflows
may change significantly over time, varying with customer demand and the amount of
competition.
4. Profitability. The payback method focuses solely upon the time required to pay back the
initial investment; it does not track the ultimate profitability of a project at all. Thus, the
method may indicate that a project having a short payback but with no overall
profitability is a better investment than a project requiring a longterm payback but
having substantial longterm profitability.
5. Time value of money. The method does not take into account the time value of money,
where cash generated in later periods is work less than cash earned in the current period.
A variation on the payback period formula, known as the discounted payback formula,
eliminates this concern by incorporating the time value of money into the calculation.
6. Individual asset orientation. Many fixed asset purchases are designed to improve the
flows from the project over several years  but if the forecasted cash flows are mostly in
the part of the forecast furthest in the future, the calculation will incorrectly yield a
payback period that is too soon. The following example illustrates the problem.
Payback Method Example #2
ABC International has received a proposal from a manager, asking to spend $1,500,000 on
equipment that will result in cash inflows in accordance with the following table:
Year
1
2
3
4
5
Cash Flow
+$150,000
+150,000
+200,000
+600,000
+900,000
The total cash flows over the fiveyear period are projected to be $2,000,000, which is an
average of $400,000 per year. When divided into the $1,500,000 original investment, this results
in a payback period of 3.75 years. However, the briefest perusal of the projected cash flows
reveals that the flows are heavily weighted toward the far end of the time period, so the results of
this calculation cannot be correct.
Instead, the company's financial analyst runs the calculation year by year, deducting the cash
flows in each successive year from the remaining investment. The results of this calculation are:
Year
Cash Flow
+$150,000
1,350,000
+150,000
1,200,000
+200,000
1,000,000
+600,000
400,000
+900,000
The table indicates that the real payback period is located somewhere between Year 4 and Year 5.
There is $400,000 of investment yet to be paid back at the end of Year 4, and there is $900,000 of
cash flow projected for Year 5. The analyst assumes the same monthly amount of cash flow in
Year 5, which means that he can estimate final payback as being just short of 4.5 years.
Summary
The payback method should not be used as the sole criterion for approval of a capital investment.
Instead, consider using the net present value or internal rate of return methods to incorporate the
time value of money and more complex cash flows, and use throughput analysis to see if the
investment will actually boost overall corporate profitability. There are also other considerations
in a capital investment decision, such as whether the same asset model should be purchased in
volume to reduce maintenance costs, and whether lowercost and lowercapacity units would
make more sense than an expensive "monument" asset.
Similar Terms
The payback period formula is also known as the payback method.
Home > Managerial Accounting > Capital Budgeting > Payback Period
Payback Period
Payback period is the time in which the initial cash outflow of an investment is expected to be
recovered from the cash inflows generated by the investment. It is one of the simplest investment
appraisal techniques.
Formula
The formula to calculate payback period of a project depends on whether the cash flow per
period from the project is even or uneven. In case they are even, the formula to calculate payback
period is:
Payback
Period =
Initial Investment
Cash Inflow per
Period
When cash inflows are uneven, we need to calculate the cumulative net cash flow for each period
and then use the following formula for payback period:
Payback Period
=A+
B
C
Decision Rule
Accept the project only if its payback period is LESS than the target payback period.
Examples
Example 1: Even Cash Flows
Company C is planning to undertake a project requiring initial investment of $105 million. The
project is expected to generate $25 million per year for 7 years. Calculate the payback period of
the project.
Solution
Payback Period = Initial Investment Annual Cash Flow = $105M $25M = 4.2 years
Example 2: Uneven Cash Flows
Company C is planning to undertake another project requiring initial investment of $50 million
and is expected to generate $10 million in Year 1, $13 million in Year 2, $16 million in year 3,
$19 million in Year 4 and $22 million in Year 5. Calculate the payback value of the project.
Solution
(cash flows in
millions)
Year Cash Flow
Cumulati
ve
Cash
Flow
(50)
(50)
10
(40)
13
(27)
16
(11)
19
22
30
Payback Period
= 3 + ($11M $19M)
= 3 + ($11M $19M)
3 + 0.58
3.58 years
The Payback Period represents the amount of time that it takes for a Capital Budgeting project to
recover its initial cost. The use of the Payback Period as a Capital Budgeting decision rule
specifies that all independent projects with a Payback Period less than a specified number of
years should be accepted. When choosing among mutually exclusive projects, the project with the
quickest payback is preferred.
The calculation of the Payback Period is best illustrated with an example. Consider Capital
Budgeting project A which yields the following cash flows over its five year life.
Year
Cash
Flow
1000
500
400
200
200
100
To begin the calculation of the Payback Period for project A let's add an additional column to the
above table which represents the Net Cash Flow (NCF) for the project in each year.
Year
Cash
Flow
Net Cash
Flow
1000
1000
500
500
400
100
200
100
200
300
100
400
Notice that after two years the Net Cash Flow is negative (1000 + 500 + 400 = 100) while after
three years the Net Cash Flow is positive (1000 + 500 + 400 + 200 = 100). Thus the Payback
Period, or breakeven point, occurs sometime during the third year. If we assume that the cash
flows occur regularly over the course of the year, the Payback Period can be computed using the
following equation:
Thus, the project will recoup its initial investment in 2.5 years.
As a decision rule, the Payback Period suffers from several flaws. For instance, it ignores the
Time Value of Money, does not consider all of the project's cash flows, and the accept/reject
criterion is arbitrary.
Example Problems
Find the Payback Period for the project with the
following cash flows.
Year
Cash Flow
1000
500
400
300
200
100
Payback:
years
where
The example below illustrates the calculation of Net Present Value. Consider Capital Budgeting
projects A and B which yield the following cash flows over their five year lives. The cost of
capital for the project is 10%.
Project A Project B
Year
Cash
Flow
Cash
Flow
$1000
$1000
500
100
400
200
200
200
200
400
100
700
Project B:
Thus, if Projects A and B are independent projects then both projects should be accepted. On the
other hand, if they are mutually exclusive projects then Project A should be chosen since it has
the larger NPV.
Example Problems
Find the NPV for the following Capital Budgeting project.
Year
Cash Flow
1000
500
400
300
200
100
Cost of Capital:
NPV:
10
2002  2015 by
where
The determination of the IRR for a project, generally, involves trial and error or a numerical
technique. Fortunately, financial calculators greatly simplify this process.
The example below illustrates the determination of IRR. Consider Capital Budgeting projects A
and B which yield the following cash flows over their five year lives. The cost of capital for both
projects is 10%.
Project A Project B
Year
Cash
Flow
Cash
Flow
$1000
$1000
500
100
400
200
200
200
200
400
100
700
Project B:
Thus, if Projects A snd B are independent projects then both projects should be accepted since
their IRRs are greater than the cost of capital. On the other hand, if they are mutually exclusive
projects then Project A should be chosen since it has the higher IRR.
Example Problems
Find the IRR for the following Capital Budgeting project.
Year
Cash Flow
1000
500
400
300
200
100
IRR:
Investment Appraisal
Purpose
All businesses require capital equipment (fixed assets) such as machinery, premises and vehicles.
The purchase of such assets is known as capital investment and is undertaken for the
following reasons:
1. To replace existing equipment which is outofdate or obsolete
2. To expand the productive capacity of the business
3. To reduce the production costs per unit (i.e. to achieve economies of scale)
4. To produce new products and, therefore, break into new markets
Capital investment, like all other business activities, involves an element of uncertainty, because
expenditure is incurred today in order to produce some benefit in the future. Investment appraisal
techniques are designed to aid decisionmaking regarding such investment projects.
There are 3 methods which can be used to appraise any investment project:
1. The Payback method
2. The Average Rate of Return (A.R.R) method
3. The Net Present Value (N.P.V) method.
Payback Method
This is the simplest method of investment appraisal and is usually preferred by small businesses
because of its simplicity. Larger businesses may use it as a screening process before embarking
on one of the more complicated techniques.
The payback period is the time taken for the equipment, (machinery etc.), to generate sufficient
net cash flow to pay for itself.
For example:
A manufacturing firm is considering investing 500,000 in new machinery. The equipment is
expected increase the firm's cashflow by 150,000 per year. How long is the payback period ?
After 1 year, the cashflow will be 150,000.
After 2 years, the cashflow will be 300,000.
After 3 years, the cashflow will be 450,000.
The firm will need 50,000 (or one third) of the cashflow from year 4 in order to reach the
payback point.
Therefore, the payback period is 3 1/3 years (or 3 years, 4 months).
Firms can use this technique in one of two ways:
Firstly, a firm could set an upper limit on the time allowed for payback, and any project
which is not expected to payback within this period is rejected.
Secondly, when faced with a choice of projects, the payback method can be used to rank
projects according to the speed at which they payback.
However, the payback method ignores the following two important factors:
1. The total return on the investment project (i.e. the earnings after payback).
2. The timing of the return prior to payback.
The payback method clearly discriminates against projects which produce a slow but substantial
return, resulting in the danger that highly profitable projects will be rejected because of the delay
in producing a return (yield).
Example:
Each of the three alternative projects below involve an initial cost of 1 million, and produce net
cash flow as shown:
0m
0m 0m
0.5m 0.5m 0.5m
0m 0m
1m 1m
0.5m
Project A pays back in 3 years ( 0 in year 1 + 0.5m in year 2 + 0.5m in year 3).
Project B pays back in 2 years ( 0.5m in year 1 + 0.5m in year 2).
Project C pays back in 3 1/2 years ( 0 in year 1 + 0 in year 2 + 0.5m in year 3 + half of
the 1m in year 4).
Using 'The Payback Method' to decide between these projects, project B would be selected.
But if you looked at the total revenue over the full life of each project, project C actually brings
more cash into the business and would be the better project to select.
Average Rate of Return (A.R.R.) Method
This method takes the total return (yield) over the whole life of the asset into account and
therefore overcomes one of the defects of the payback method.
In order to understand the arithmetic, consider an item of capital (e.g. a machine) which will cost
1 million to purchase, is expected to last 5 years, and will produce an annual net cash flow of
0.5 million.
The total return (yield) is: 5 x 0.5 million = 2.5 million
If we now deduct the initial cost of investment ( 1 million) we are left with a total return (yield),
net of the initial capital outlay, of 1.5 million.
Annually, this works out at:
When we express this annual figure as a percentage of the original capital outlay we get the
Average Rate of Return for the project:
0
100,000 20,000
50,000 140,000
Project A:
Total forecasted net cash flow = 150,000
Total forecasted net cash flow  capital outlay = 50,000
16.67%.
Project B:
Total forecasted net cash flow = 120,000
Total forecasted net cash flow  capital outlay = 20,000
6.67%
Project C:
Total forecasted net cash flow = 190,000
Total forecasted net cash flow  capital outlay = 90,000
30%
The great defect of the A.R.R. method of investment appraisal is that it attaches no importance to
the timing of the inflows of cash. A.R.R treats all money as of equal value, irrespective of when
it is received.
Hence, a project may be favoured even though it only produces a return over a long period of
time.
The more sophisticated methods of investment appraisal take the timing of the cash inflows
into account, as well as the size of the inflows.
A sum of money in one year's time is worth less than that same sum of money now (i.e. inflation
will erode the real value of that sum of money over the year). This is where the notion of present
value is used.
Net Present Value (N.P.V.) Method
The return on an investment comes in the form of a stream of earnings in the future. The N.P.V.
method of investment appraisal takes into account the size of the cash inflows over the life of the
equipment, but also makes adjustment for the timing of the money. A greater weighting (or
importance) is given to the inflows of cash in the earlier years.
In examinations you will usually be given the discount factor, so that you do not have to work it
out!
The present value of each year's cash inflow are then aggregated (this is called the discounted
cashflow, or D.C.F) and this figure is compared with the initial capital outlay. If the sum of
present values (minus the capital cost) is positive, then it is worthwhile proceeding with the
project. If the resulting figure is negative, then the project should not be undertaken.
Example:
In appraising a 300,000 investment project, a firm uses a discount rate of 5%. The equipment
will produce a cash inflow (net of operating costs) of 75,000 per year, over a five year period.
At the end of the five years, the firm expects to sell the equipment for 10,000. What is the Net
Present Value of the project?
Yea cashflo
r
w
Present
Value

 300,000
300,000
+
75,000
+
71,428.57
+
75,000
+
68,027.21
3 +
75,000
64,787.82
+
75,000
+
61,702.69
+
85,000
+
66,599.72
Year 0 is the present day (i.e. when the initial capital outlay is spent).
The cashflow of 75,000 in year 1 has a present value of:
71,428.57
The cashflow of 75,000 in year 2 has a present value of:
68,027.21
The process continues for the remaining years.
The discounted cashflow is the sum of the present values for the 5 cash inflows (i.e. from year 1
to year 5).
This figure is 332,546.01
The net present value is found by deducting the initial capital outlay from the discounted
cashflow. In other words:
332,546.01  300,000 = 32,546.01
Since this result is positive, then it is advisable for the firm to go ahead with the investment
project. If the result had been negative, then the investment project should not be undertaken.
Other Influencing Factors
There are many other factors that a business will need to take into consideration when appraising
an investment project, other than the financial (quantitative) factors.
Qualitative factors such as the objectives of the business must be considered at all times, as
well as the effect upon the employees of new machinery, new working practices and changes to
their working conditions.
The external environment needs to be considered before any decision can be taken regarding a
proposed investment project.
These factors include the state of the economy (e.g. it may be dangerous to attempt to expand
during a recession, because demand for products may be falling), pressure group activity, the
level of technological progress in the industry (e.g. competitors may already be using the new
machinery), and any legislation (e.g. restricting the use of certain materials, components).
The effects of the actions of the business on the environment must also be taken into
consideration, since any external costs (e.g. pollution) will have a detrimental effect on the image
and reputation of the business.
Finally, as with any investment decision, the business will also need to consider the amount of
finance that is available for expansion, and the effect that any borrowing to raise extra finance
will have on the gearing ratio.
How it works/Example:
Let's say John Doe opens a lemonade stand. He invests $500 in the venture, and the lemonade
stand makes about $10 a day, or about $3,000 a year (he takes some days off).
In its simplest form, John Doe's rate of return in one year is simply the profits as a percentage of
the investment, or $3,000/$500 = 600%.
There is one fundamental relationship you should be aware of when thinking about rates of
return: the riskier the venture, the higher the expected rate of return.
For example, investing in a restaurant is much riskier than investing in Treasury bills. One is
backed by the full faith and credit of the United States government; the other is backed by your
cousin's sofa. Accordingly, the risk that you'll lose your money is much higher in the restaurant
scenario, and to induce and reward you to make the investment, the anticipated returns have to be
much higher than the 1% that the Treasury bill would pay. Inversely, the safer the investment, the
lower the expected rate of return should be.
Why it Matters:
If only it were that simple. Rates of return often involve incorporating other factors, including
the bites that inflation and taxes take out of profits, the length of time involved, and any
additional capital an investor makes in the venture. If the investment is foreign, then changes in
exchange rates will also affect the rate of return.
Compounded annual growth rate (CAGR) is a common rate of return measure that represents the
annual growth rate of an investment for a specific period of time.
The formula for CAGR is:
CAGR = (EV/BV)1/n  1
where:
EV = The investment's ending value
BV = The investment's beginning value
n = Years
For example, let's assume you invest $1,000 in the Company XYZ mutual fund, and over the
next five years, the portfolio looks like this:
End of Year Ending Value
1
$750
2
$1,000
3
$3,000
4
$4,000
5
$5,000
Using this information and the formula above, we can calculate that the CAGR for the
investment is:
CAGR = ($5,000/$1,000)1/5  1 = .37972 = 37.97%
AccountingExplained
Financial Accounting
Managerial Accounting
Miscellaneous
Home > Managerial Accounting > Capital Budgeting > Accounting Rate of Return
Formula
Accounting Rate of Return is calculated using the following formula:
ARR
=
Average Accounting
Profit
Average Investment
Average accounting profit is the arithmetic mean of accounting income expected to be earned
during each year of the project's life time. Average investment may be calculated as the sum of
the beginning and ending book value of the project divided by 2. Another variation of ARR
formula uses initial investment instead of average investment.
Decision Rule
Accept the project only if its ARR is equal to or greater than the required accounting rate of
return. In case of mutually exclusive projects, accept the one with highest ARR.
Examples
Example 1: An initial investment of $130,000 is expected to generate annual cash inflow of
$32,000 for 6 years. Depreciation is allowed on the straight line basis. It is estimated that the
project will generate scrap value of $10,500 at end of the 6th year. Calculate its accounting rate
of return assuming that there are no other expenses on the project.
Solution
Annual Depreciation = (Initial Investment Scrap Value) Useful Life in Years
Annual Depreciation = ($130,000 $10,500) 6 $19,917
Average Accounting Income = $32,000 $19,917 = $12,083
Accounting Rate of Return = $12,083 $130,000 9.3%
Example 2: Compare the following two mutually exclusive projects on the basis of ARR. Cash
flows and salvage values are in thousands of dollars. Use the straight line depreciation method.
Project A:
Year
Cash Outflow
91
130
105
220
Cash Inflow
Salvage Value
10
Project B:
Year
Cash Outflow
87
110
84
198
Cash Inflow
Salvage Value
18
Solution
Project A:
Step 1: Annual Depreciation = ( 220 10 ) / 3 = 70
Step 2: Year
Cash Inflow
91
130
105
Salvage Value
Depreciation*
Accounting Income
10
70
70
70
21
60
45
= 42
Step 4: Accounting Rate of Return = 42 / 220 = 19.1%
Project B:
Step 1: Annual Depreciation = ( 198 18 ) / 3 = 60
Step 2: Year
Cash Inflow
87
110
84
Salvage Value
Depreciation*
Accounting Income
18
60
60
60
27
50
42
Since the ARR of the project B is higher, it is more favorable than the project A.
Disadvantages
1. It ignores time value of money. Suppose, if we use ARR to compare two
projects having equal initial investments. The project which has higher annual
income in the latter years of its useful life may rank higher than the one
having higher annual income in the beginning years, even if the present
value of the income generated by the latter project is higher.
It can be calculated in different ways. Thus there is problem of consistency.
2. It uses accounting income rather than cash flow information. Thus it is not
suitable for projects which having high maintenance costs because their
viability also depends upon timely cash inflows.
Buyers of dividend paying stocks too often look only at the dividend and
ignore the potential for capital loss/gain.
Before investing in foreign countries consider the capital losses that may be
caused by changing Foreign Exchange (FX) rates.
Detailed instructions for measuring your own portfolio's rate of return are on the page Keep
Track.
Are quoted rates of return comparable between investments? NO !
Each of the asset types in the box below has its returns normally calculated in a different way.
For most uses the results are 'good enough' for comparisons. But for any finetuning of a
decision take the time to translate the 'normally' calculated return into a 'true' economic rate of
return. The IIAC (investment industry selfregulating body) has produced this document of
measurement conventions for fixed income products. Conventions may differ between
Method of Calculation
Bond yield
Bond coupons
Stock index
Stock dividend
Cdn mortgage
US monthly mortgage
US weekly mortgage
Real estate
Government TBills
The 'true' rate of return is what most people's understanding of it would be. People refer to it as
the Compound Annual Growth rate (CAGR), Effective Annual rate, Annual Equivalent rate,
Internal Rate of Return (IRR), discount rate, geometric mean, or Annualized Compound rate..
Essentially these all refer to the same concept. Different terms are used in different contexts.
E.g. if $100 invested at the beginning of the year grows to $112 by the end of the year, then
the rate of return was 12%. To be more specific;
Any income paid early is reinvested to earn its own income for the
remaining portion of the year, or considered to have done so.
TOTAL return
ACCRUED interest
TO COMPOUND (verb)
subtracted from the nominal rate. Much analysis of historical stock returns
uses real returns because all investors demand at least the rate of inflation
in order to justify deferring consumption, so it is premium above inflation
that matters.
E.g. Longbond yields have historically been equal to 2% plus inflation. The
'2%' is the real yield. It represents the risk premium for term risk  ignoring
the compensation for inflation.
E.g. GDP is the yearly production of a country measured using the market
value of items. Its yeartoyear change is heavily influenced by the inflation
increases of the transactions. So the percent change in GDP is usually
reported with the rate of inflation (GDP deflator) removed.
Instead of simple subtraction, you sometimes see the calculation of the real return as:
((1+return) / (1+inflation))  1.
E.g. ((1+5%) / (1+3%))  1 = 1.9% real return (not 2%).
This is the technically correct math but the simple subtraction is good enough.
See also the discussion below on "Nominal vs. Effective rates".
ANNUAL vs. CUMULATIVE return (also called HOLDING PERIOD return) :
Cumulative returns measure the total increase in the value of an
investment over a number of years, not just one year. For example: if you
bought your home for $100,000 and sold it 10 years later for $150,000, you
had a 50% cumulative return.
Sometimes this measurement is the simplest, and perfectly valid, when comparing
investments with the same time frame. But most times it is used to impress you
because it produces a large number. You may not be told explicitly that it is cumulative
 hoping you will think it is the annual rate earned each year of the investment. Even if
they tell you, they count on you not being able to quickly convert it into a yearly return
(only 4.1% in that example).
Most everyone thinks of rates of return in the context of a one year period. That
percentage is 'meaningful' to people. They have certain benchmarks in their mind for
comparison. They know the yearly rate for term deposits or for their bank's Line Of
Credit. They know the yearly inflation rate. When comparing investments, yearly rates
are the most logical, because investment terms may differ.
You may hear the cumulative return referred to as a Total Return.
TOTAL return :
You hear the term Total Return used most often to clarify that both the
capital gains plus all dividend and interest income is being measured in
total. E.g. Stock indexes measure only the price changes of their
component companies. But some indexes publish their Total Return variant
that includes dividends paid and the income earned by the reinvestment of
those dividends. It is the Total Return Indexes that would be used to
benchmark your own portfolio returns.
The term 'total return' is also used when referring to what is called 'cumulative return'
above.
AVERAGE returns (arithmetic vs geometric) :
You know how to calculate an arithmetic average. But the question is: "Do
investors WANT to find an average return of a multiyear period?" Consider
the example
The arithmetic average return of the two years would be (100  50) / 2 = 25%. But over
the whole period there was a 0% true return ("geometric mean"). Using arithmetic
averages means that any losses will be undervalued because they are calculated on the
higher amount at the year's start. The arithmetic mean will always be larger than the
geometric mean.
The greater the volatility of individual year's returns, the greater the difference between
the arithmetic and geometric means. The difference can be estimated by the equation:
Difference = 1/2 Variance = 1/2 StandardDeviationSquared
E.g. US equities historically had a 20% standard deviation with a 10% average
(geometric) return. The expected difference would be 1/2 * 0.2 * 0.2 = 2%. The
expected arithmetic mean would be 10% + 2% = 12%.
Fortunately, when you hear the term 'average' used by mutual funds or others in the
finance industry, it almost always refers to the geometric mean that you DO want to
use to compare investments. They use the term 'average' because that is the concept
everyone understands.
REALIZED profits vs. PAPER profits :
Realized profits have been converted to cash by a transaction. E.g.
dividend dollars have been received, or an asset has been sold. Paper
profits have had no transaction to prove their value. E.g. increases in
market value have been calculated but the assets not yet sold. This
distinction does not affect the method chosen to measure the rate of
return.
Many investors have a preference for high dividend stocks because they feel this cash
is more 'real' than paper profits. But in the accumulation phase, those realized profits
must be reinvested back into paper assets, leaving the investor no more sure of his
wealth gains.
ACCRUED interest :
Accrued interest is acknowledged as payable, eventually, but not yet
booked (posted to your account). For example with credit cards, the
interest expense for each day is calculated individually. Only at month end
are they added together and posted to your account. The total accrued up
to any midmonth date does not affect the calculation of interest for
subsequent days. I.e. it has only accrued, not compounded.
Bank accounts and credit cards post all the daily accruals for the month, at the month
end. Only then does it compound. With bonds, the accruals keep adding up for 6months, until they equal the interest payment due. When buying a bond or debenture,
you pay the transaction price plus the portion of the next interest payment that has
accrued since the bond's last payment.
TO COMPOUND (verb) :
Some investments have interest that compounds. E.g. a mortgage's
interest compounds. It means that any unpaid interest that is due, but not
paid, is added to the balance of the principal ... so the subsequent interest
is calculated on the nowbigger balance. Of course if the mortgage
payment is received, nothing compounds.
Compounding reflects an activity that is factual (true or not). For example: Preferred
shares have their attributes defined by the prospectus. The prospectus will state (e.g.)
that the dividends are cumulative (accrue if unpaid), but none say that unpaid
dividends compound (unpaid dividends never earn interest to compensate for their
being paid late).
The frequency of compounding will always be at least as often as the scheduled cash
flows. E.g. A monthlypay mortgage will compound monthly and a weeklypay
mortgage will compound weekly. If it were not to compound, there would be no
incentive to make the required payment  the eventual payment would be the same
whether paid on time, or late. It is the compounding that creates the incentive to pay on
time.
The more frequent the compounding the greater the true rate of return. This is because
the income is put to work quicker, earning more of its own income.
If the investment compounded monthly, then there would be twelve repeats of (1 + i%)
in a year. The interest rate i% is not the yearly rate. It is the rate for only the
compounding period  in this example the monthly rate. The 'true' yearly rate would be
calculated from the the resulting (Principal at end) / (Principal at beginning)  1 ...
as if the interest compounding each month does not get paid.
REGULAR vs. COMPOUND interest (adjective) :
These terms are usually used to describe term deposits, GICs and CDs.
They are meant to distinguish between
products that pay out the interest earned when it becomes payable
(regular), and
products that retain the interest and reinvest it (compound).
When a product is described as "x% compounded monthly" (or weekly, etc) you know
the rate is measured using simple interest methodology because none of that
clarification is necessary when measuring with compound interest methodology.
The following two sections describe each in more detail.
SIMPLE INTEREST (methodology) :
To calculate the rate of return using simple interest methodology, add all
the interest paid in a year is added together. NO income earned on reinvested income is included. Divided that by the investment $$ at the
beginning of the year. Simple interest methodology ignores the timevalueofmoney (TVM means a dollar today is worth more than a dollar tomorrow).
If a $100 investment pays $1 interest each month, simple interest
methodology treats all the year's $12 as if paid at the year end. It would
make no difference if all the $12 was paid after the second day. The return
would still be measured as $12/$100 = 12%.
Bonds pay interest twice yearly. If they are quoted to pay 12%, then
6% is paid each 6 months.
GICs and US mortgages may be paid every month. If their quoted
rate is 12%, then 1% is paid/charged each month.
Stocks' dividend yields are quoted as the total of all (normally 4)
payments in the year, divided by the current stock price.
compound interest.
A)
This time line shows the equality of cash at different times. There are no cash flows during the
intervening time. Your calculator may call this function "interest", or something else. The
variables for input are PV, FV, n and i%. Common uses for this timeline are
Convert a quoted rate that uses simple interest to the true rate.
Find the interest rate of a paydayloan.
Find the capital gains you realized from owning real estate over many
years.
Examples
B)
This time line shows a lumpsum investment (or loan) at the start, followed immediately be a
series of equal payments that continue for a set period of time. This diagram shows the
Payments happening at the end of the period. Alternately, the first payment may happen at t=0.
Your calculator may call this function "loan", or something else. The variables for input are
PV, Pmts, n and i%. Common uses for this timeline are
Examples
C)
This time line shows a series of equal payments that continue for a set period of time, until a
lumpsum cash flow at the end. This diagram shows the Payments happening at the beginning
of the period. Alternately, the first payment may happen at t=1. Your calculator may call this
function "saving", or something else. The variables for input are FV, Pmts, n and i%. Common
uses for this timeline are
Determine how much must be saved every year in order to have $$ when
retire.
Find the rate of return implicit in the cost of life insurance.
Examples
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Chapter One
Chapter Two
Chapter Three
Chapter Four
Chapter Five
Where:
PV = present value
CFi = cash flow in year i
k = discount rate
TCF = the terminal year cash flow
g = growth rate assumption in perpetuity beyond terminal year
n = the number of periods in the valuation model including the terminal year
There are many variations when it comes to what you can use for your cash flows and discount
rate in a DCF analysis. For example, free cash flows can be calculated as operating profit +
depreciation + amortization of goodwill  capital expenditures  cash taxes  change in working
capital. Although the calculations are complex, the purpose of DCF analysis is simply to estimate
the money you'd receive from an investment and to adjust for the time value of money.
Discounted cash flow models are powerful, but they do have shortcomings. DCF is merely a
mechanical valuation tool, which makes it subject to the axiom "garbage in, garbage out." Small
changes in inputs can result in large changes in the value of a company. Instead of trying to
project the cash flows to infinity, terminal value techniques are often used. A simple annuity is
used to estimate the terminal value past 10 years, for example. This is done because it is harder
to come to a realistic estimate of the cash flows as time goes on.
At a time when financial statements are under close scrutiny, the choice of what metric to use for
making company valuations has become increasingly important. Wall Street analysts are
emphasizing cash flowbased analysis for making judgments about company performance.
DCF analysis is a key valuation tool at analysts' disposal. Analysts use DCF to determine a
company's current value according to its estimated future cash flows. For investors keen on
gaining insights on what drives share value, few tools can rival DCF analysis.
Accounting scandals and inappropriate calculation of revenues and capital expenses give DCF
new importance. With heightened concerns over the quality of earnings and reliability of
standard valuation metrics like P/E ratios, more investors are turning to free cash flow, which
offers a more transparent metric for gauging performance than earnings. It is harder to fool the
cash register. Developing a DCF model demands a lot more work than simply dividing the share
price by earnings or sales. But in return for the effort, investors get a good picture of the key
drivers of share value: expected growth in operating earnings, capital efficiency, balance sheet
capital structure, cost of equity and debt, and expected duration of growth. An added bonus is
that DCF is less likely to be manipulated by aggressive accounting practices.
DCF analysis shows that changes in longterm growth rates have the greatest impact on share
valuation. Interest rate changes also make a big difference. Consider the numbers generated by a
DCF model offered by Bloomberg Financial Markets. Sun Microsystems, which in 2012 traded
on the market at $3.25, is valued at almost $5.50, which makes its price of $3.25 a steal. The
model assumes a longterm growth rate of 13%. If we cut the growth rate assumption by 25%,
Sun's share valuation falls to $3.20. If we raise the growth rate variable by 25%, the shares go up
to $7.50. Similarly, raising interest rates by one percentage point pushes the share value to $3.55;
a 1% fall in interest rates boosts the value to about $7.70.
Investors can also use the DCF model as a reality check. Instead of trying to come up with a
target share price, they can plug in the current share price and, working backwards, calculate
how fast the company would need to grow to justify the valuation. The lower the implied growth
rate, the better  less growth has therefore already been "priced into" the stock.
Best of all, unlike comparative metrics like P/Es and pricetosales ratios, DCF produces a bona
fide stock value. Because it does not weigh all the inputs included in a DCF model, ratiobased
valuation acts more like a beauty contest: stocks are compared to each other rather than judged
on intrinsic value. If the companies used as comparisons are all overpriced, the investor can end
up holding a stock with a share price ready for a fall. A welldesigned DCF model should, by
contrast, keep investors out of stocks that look cheap only against expensive peers.
DCF models are powerful, but they do have shortcomings. Small changes in inputs can result in
large changes in the value of a company. Investors must constantly secondguess valuations; the
inputs that produce these valuations are always changing and are susceptible to error.
Meaningful valuations depend on the user's ability to make solid cash flow projections. While
forecasting cash flows more than a few years into the future is difficult, crafting results into
eternity (which is a necessary input) is near impossible. A single, unexpected event can
immediately make a DCF model obsolete. By guessing at what a decade of cash flow is worth
today, most analysts limit their outlook to 10 years. Investors should watch out for DCF models
that project to ridiculous lengths of time. Also, the DCF model focuses on longrange investing;
it isn't suited for shortterm investments.
Investors shouldn't base a decision to buy a stock solely on discounted cash flow analysis  it is a
moving target, full of challenges. If the company fails to meet financial performance
expectations, if one of its big customers jumps to a competitor, or if interest rates take an
unexpected turn, the model's numbers have to be rerun. Any time expectations change, the DCFgenerated value is going to change.
While many finance courses espouse the gospel of DCF analysis as the preferred valuation
methodology for all cash flow generating assets, in practice, DCF can be difficult to apply in the
valuation of stocks. Even if one believes the gospel of DCF, other valuation approaches are
useful to help generate a complete valuation picture of a stock.
Alternative Methodologies
Even if one believes that DCF is the final word in assessing the value of an equity investment, it
is very useful to supplement the approach with multiplebased target price approaches. If you are
going to project income and cash flows, it is easy to use the supplementary approaches. It is
important to assess which trading multiples (P/E, price/cash flow, etc.) are applicable based on
the company's history and its sector. Choosing a target multiple range is where it gets tricky.
While this is analogous to arbitrary discount rate selection, by using a trailing earnings number
two years out and an appropriate P/E multiple to calculate a target price, this will entail far fewer
assumptions to "value" the stock than under the DCF scenario. This improves the reliability of
the conclusion relative to the DCF approach. Because we know what a company's P/E or
price/cash flow multiple is after every trade, we have a lot of historical data from which to assess
the future multiple possibilities. In contrast, the DCF model discount rate is always theoretical,
and we do not really have any historical data to draw from when calculating it.
For more insight, read Discounted Cash Flow Analysis, Top 3 Pitfalls Of Discounted Cash Flow
Analysis and our DCF Analysis Tutorial.
Annuities And The Future Value And Present Value Of Multiple Cash Flows
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Dictionary
Investing
Trading
Markets
Personal
Finance
Wealth
Management
Financial
Advisors
Exam Prep
Continuing Education
FAQs
Tutorials
Video
Stock
Simulator
Chapter One
Chapter Two
Chapter Three
Chapter Four
Chapter Five
Where:
PV = present value
CFi = cash flow in year i
k = discount rate
TCF = the terminal year cash flow
g = growth rate assumption in perpetuity beyond terminal year
n = the number of periods in the valuation model including the terminal year
There are many variations when it comes to what you can use for your cash flows and discount
rate in a DCF analysis. For example, free cash flows can be calculated as operating profit +
depreciation + amortization of goodwill  capital expenditures  cash taxes  change in working
capital. Although the calculations are complex, the purpose of DCF analysis is simply to estimate
the money you'd receive from an investment and to adjust for the time value of money.
Discounted cash flow models are powerful, but they do have shortcomings. DCF is merely a
mechanical valuation tool, which makes it subject to the axiom "garbage in, garbage out." Small
changes in inputs can result in large changes in the value of a company. Instead of trying to
project the cash flows to infinity, terminal value techniques are often used. A simple annuity is
used to estimate the terminal value past 10 years, for example. This is done because it is harder
to come to a realistic estimate of the cash flows as time goes on.
At a time when financial statements are under close scrutiny, the choice of what metric to use for
making company valuations has become increasingly important. Wall Street analysts are
emphasizing cash flowbased analysis for making judgments about company performance.
DCF analysis is a key valuation tool at analysts' disposal. Analysts use DCF to determine a
company's current value according to its estimated future cash flows. For investors keen on
gaining insights on what drives share value, few tools can rival DCF analysis.
Accounting scandals and inappropriate calculation of revenues and capital expenses give DCF
new importance. With heightened concerns over the quality of earnings and reliability of
standard valuation metrics like P/E ratios, more investors are turning to free cash flow, which
offers a more transparent metric for gauging performance than earnings. It is harder to fool the
cash register. Developing a DCF model demands a lot more work than simply dividing the share
price by earnings or sales. But in return for the effort, investors get a good picture of the key
drivers of share value: expected growth in operating earnings, capital efficiency, balance sheet
capital structure, cost of equity and debt, and expected duration of growth. An added bonus is
that DCF is less likely to be manipulated by aggressive accounting practices.
DCF analysis shows that changes in longterm growth rates have the greatest impact on share
valuation. Interest rate changes also make a big difference. Consider the numbers generated by a
DCF model offered by Bloomberg Financial Markets. Sun Microsystems, which in 2012 traded
on the market at $3.25, is valued at almost $5.50, which makes its price of $3.25 a steal. The
model assumes a longterm growth rate of 13%. If we cut the growth rate assumption by 25%,
Sun's share valuation falls to $3.20. If we raise the growth rate variable by 25%, the shares go up
to $7.50. Similarly, raising interest rates by one percentage point pushes the share value to $3.55;
a 1% fall in interest rates boosts the value to about $7.70.
Investors can also use the DCF model as a reality check. Instead of trying to come up with a
target share price, they can plug in the current share price and, working backwards, calculate
how fast the company would need to grow to justify the valuation. The lower the implied growth
rate, the better  less growth has therefore already been "priced into" the stock.
Best of all, unlike comparative metrics like P/Es and pricetosales ratios, DCF produces a bona
fide stock value. Because it does not weigh all the inputs included in a DCF model, ratiobased
valuation acts more like a beauty contest: stocks are compared to each other rather than judged
on intrinsic value. If the companies used as comparisons are all overpriced, the investor can end
up holding a stock with a share price ready for a fall. A welldesigned DCF model should, by
contrast, keep investors out of stocks that look cheap only against expensive peers.
DCF models are powerful, but they do have shortcomings. Small changes in inputs can result in
large changes in the value of a company. Investors must constantly secondguess valuations; the
inputs that produce these valuations are always changing and are susceptible to error.
Meaningful valuations depend on the user's ability to make solid cash flow projections. While
forecasting cash flows more than a few years into the future is difficult, crafting results into
eternity (which is a necessary input) is near impossible. A single, unexpected event can
immediately make a DCF model obsolete. By guessing at what a decade of cash flow is worth
today, most analysts limit their outlook to 10 years. Investors should watch out for DCF models
that project to ridiculous lengths of time. Also, the DCF model focuses on longrange investing;
it isn't suited for shortterm investments.
Investors shouldn't base a decision to buy a stock solely on discounted cash flow analysis  it is a
moving target, full of challenges. If the company fails to meet financial performance
expectations, if one of its big customers jumps to a competitor, or if interest rates take an
unexpected turn, the model's numbers have to be rerun. Any time expectations change, the DCFgenerated value is going to change.
While many finance courses espouse the gospel of DCF analysis as the preferred valuation
methodology for all cash flow generating assets, in practice, DCF can be difficult to apply in the
valuation of stocks. Even if one believes the gospel of DCF, other valuation approaches are
useful to help generate a complete valuation picture of a stock.
Alternative Methodologies
Even if one believes that DCF is the final word in assessing the value of an equity investment, it
is very useful to supplement the approach with multiplebased target price approaches. If you are
going to project income and cash flows, it is easy to use the supplementary approaches. It is
important to assess which trading multiples (P/E, price/cash flow, etc.) are applicable based on
the company's history and its sector. Choosing a target multiple range is where it gets tricky.
While this is analogous to arbitrary discount rate selection, by using a trailing earnings number
two years out and an appropriate P/E multiple to calculate a target price, this will entail far fewer
assumptions to "value" the stock than under the DCF scenario. This improves the reliability of
the conclusion relative to the DCF approach. Because we know what a company's P/E or
price/cash flow multiple is after every trade, we have a lot of historical data from which to assess
the future multiple possibilities. In contrast, the DCF model discount rate is always theoretical,
and we do not really have any historical data to draw from when calculating it.
For more insight, read Discounted Cash Flow Analysis, Top 3 Pitfalls Of Discounted Cash Flow
Analysis and our DCF Analysis Tutorial.
Variance Analysis
Definition
Variance Analysis, in managerial accounting, refers to the investigation of deviations in financial
performance from the standards defined in organizational budgets.
Topic Contents:
1. Definition
2. Explanation
3. Types of variances
4. Basis of calculation
5. Functions & Importance
Explanation
Variance analysis typically involves the isolation of different causes for the variation in income
and expenses over a given period from the budgeted standards.
So for example, if direct wages had been budgeted to cost $100,000 actually cost $200,000
during a period, variance analysis shall aim to identify how much of the increase in direct wages
is attributable to:
More wages incurred due to higher production than the budget (favorable
sales volume variance).
Types of Variances
Main types of variances are as follows:
Click on variances listed above to view their explanations, formulas, calculations &
examples
Basis of Calculation
Variance analysis highlights the causes of the variation in income and expenses during a period
compared to the budget.
In order to make variances meaningful, the concept of 'flexed budget' is used when calculating
variances. Flexed budget acts as a bridge between the original budget (fixed budget) and the
actual results.
Flexed budget is prepared in retrospect based on the actual output. Sales volume variance
accounts for the difference between budgeted profit and the profit under a flexed budget. All
remaining variances are calculated as the difference between actual results and the flexed budget.
Following is a graphical illustration of how variances are calculated using the flexed budget
approach:
Output
Budget
(Original)
Budget
(Flexed)
Actual
Result
(10,000 units)
(15,000 units)
(15,000 units)
The difference of
$300,000 represents
Sales Price Variance
Sales
$1,000,000
$1,500,000
$1,800,000
The difference of
$50,000 represents
Direct Material Total Variance
Direct
Materials ($100,000)
($150,000)
($200,000)
The difference of
$50,000 represents
Direct Labor Total Variance
Direct
Labor
($200,000)
($300,000)
($350,000)
Variable
($300,000)
The difference of
$50,000 represents
Variable Overhead Total Variance
Overhead
s
($450,000)
($500,000)
The difference of
$25,000 represents
Fixed Overhead Total Variance
Fixed
Overhead
s
($75,000)
($75,000)
($50,000)
Total
$325,000
$525,000
$700,000
As you may have noticed, all variances other than the sales volume variance are basically
calculated as the difference between actual and flexed income & expenses. The difference
between flexed budget profit and the fixed budget profit is accounted for separately in a single
variance, i.e. sales volume variance.
This approach to calculating variances facilitates comparison of like with like. Hence, we can
compare the actual expenditure incurred during a period with the standard expenditure that
'should have been incurred' for the level of actual production. Similarly, actual sales revenue can
be compared with the standard revenue that 'should have been earned' for the level of actual sales
during a period in order to determine the effect of
Control Mechanism
Variance analysis facilitates 'management by exception' by highlighting deviations from
standards which are affecting the financial performance of an organization. If variance analysis is
not performed on a regular basis, such exceptions may 'slip through' causing a delay in
management action necessary in the situation.
Responsibility Accounting
Variance analysis facilitates performance measurement and control at the level of responsibility
centers (e.g. a department, division, designation, etc). For example, procurement department
shall be answerable in case of a substantial increase in the purchasing cost of raw materials (i.e.
adverse material price variance) whereas the production department shall be held responsible
with respect to an increase in the usage of raw materials (i.e. adverse material usage variance).
Therefore, the performance of each responsibility centre is measured and evaluated against
budgetary standards with respect to only those areas which are within their direct control
Formula
Sales Volume Variance (where absorption costing is used):
(Actual Unit Sold  Budgeted Unit Sales) x = Standard Profit Per Unit
Explanation
Sales Volume Variance quantifies the effect of a change in the level of sales on the profit or
contribution over the period.
Sales volume variance differs from other volume based variances such as material usage variance
and labor efficiency variance in that it calculates not just the variance in sales revenue as a result
of the change in activity but it quantifies the overall change in the profit or contribution.
The nature of the sales volume variance helps in forming a more meaningful analysis of other
variances in the preparation of the operating statement. For example, the material usage variance
needs to take into account only the difference between the actual consumption of material and
the standard consumption of material for the actual number of units sold since the sales volume
variance already takes into account the variation in material cost caused by the difference
between budgeted and actual sales volume.
Sales volume variance should be calculated using the standard profit per unit in case of
absorption costing whereas in case of marginal costing system, standard contribution per unit is
to be applied.
Example
Wrangler Plc is a manufacturer of jeans trousers and jackets.
Information relating to Wrangler Plc's sales during the last period is as follows:
Trous Jacke
ers
ts
Units Units
Budget
12,000 5,000
ed
Actual
10,000 8,000
Standard costs and revenues per unit of trouser and jacket are as follows:
Trous Jacke
ers
ts
$
$
Revenue
20
50
Direct labor
10
Direct Material
15
Variable
Overheads
10
Fixed
Overheads
Revenue
20
50
Direct labor
(5)
(10)
Direct Material
(6)
(15)
Variable Overheads
(4)
(10)
15
Standard contribution
per unit
Step 2: Calculate the difference between actual units sold and budgeted sales
Trous Jacke
ers
ts
Units Units
Actual
10,000 8,000
Differe (2,000
3,000
nce
)
Trousers
Jackets
$5
$15
Variance
$10,000
Adverse
$45,000
Favorable
Note: If Wrangler Plc used absorption costing, sales volume variance would be calculated based
on the standard profit per unit (i.e. fixed costs per unit of output will need to be deducted from
the standard contribution calculated in Step 1).
Analysis
Favorable sales volume variance suggests a higher standard profit or contribution than the
budgeted profit or contribution.
Favorable sales quantity variance (i.e. higher total number of units sold than
budgeted)
Favorable sales mix variance> (i.e. higher proportion of the more profitable
products sold than planned in the budget)
Adverse sales volume variance indicated a lower standard profit or contribution than the
budgeted profit or contribution.
Causes for an adverse sales volume variance include:
Adverse sales quantity variance (i.e. lower total number of units sold than
budgeted)
Adverse sales mix variance (i.e. higher proportion of the less profitable
products sold than anticipated in the budget)
Favorable sales volume variance can be achieved in case of a favorable sales mix variance even
if the total number of units of all products sold during the period are lower than the total
budgeted units (and vice versa).
It is therefore important to investigate the sales volume variance by analyzing it further into sales
quantity and sales mix variances in case where an organization sells more than one product.
 See more at: http://accountingsimplified.com/management/varianceanalysis/sales/volume.html#sthash.U1s5m7jU.dpuf
4. Example
5. Analysis
Formula
Sales Mix Variance (where standard costing is used):
= (Actual Unit Sold  Unit Sales at Standard Mix) x Standard Profit Per Unit
Explanation
Sales Mix Variance is one of the two subvariances of sales volume variance (the other being
sales quantity variance). Sales mix variance quantifies the effect of the variation in the
proportion of different products sold during a period from the standard mix determined in the
budgetsetting process.
Sales mix variance, as with sales volume variance, should be calculated using the standard
profit per unit in case of absorption costing and standard contribution per unit in case of
marginal costing system.
Example
Aliengear Inc. is a small company that specializes in the manufacture and sale of gaming
computers. Currently, the company offers two models of gaming PCs:
Aliengear budgeted sales of 1,600 units of Turbox and 2,400 units of Speedo in the last year. The
standard variable costs of a single unit of Turbox and Speedo were set at $1,500 and $750
respectively.
The sales team at Aliengear managed to sell 1,300 units of Turbox and 3,700 units of Speedo
during the last year.
Step 3: Calculate the difference between actual sales quantities and the sales quantities in
standard mix
Turbox
Units
Speedo
Units
1,300
3,700
(2000)
(3000)
(700)
Adverse
700
Favorable
Difference
Revenue
2,500 1,000
Variable cost
(1,50
(750)
0)
250
Speedo
$1,000
$250
x (700 units)
x 700 units
$700,000
Adverse
$175,000
Favorable
Variance
Analysis
Sales mix variance is only a relative measure of the variation in performance of an organization
and should be interpreted with care. For instance, an adverse sales mix variance may be perfectly
fine where a company is able to earn extra revenue through sale of lower margin products if such
sales are in addition to high sales of the products with higher margins.
Favorable sales mix variance suggests that a higher proportion of more profitable products
were sold during the period than was anticipated in the budget.
Reasons for favorable sales mix variance may include:
Increase in the supply of the more profitable products due to for example
addition to the production capacity (where supply is a limiting factor)
Adverse sale mix variance suggests that a higher proportion of the low margin products were
sold during the period than expected in the budget.
Reasons for adverse sales mix variance may include:
Demand for the more profitable products being lower than anticipated
Decrease in the production of the high margin products due to supply side
limiting factors (e.g. shortage of raw materials or labor)
Sales team not focusing on selling products with higher margins due to for
example lack of awareness or misaligned performance incentives (e.g.
uniform sales commission on the entire product range may not motivate
sales staff to compete for high margin sales)
Formula
Sales Quantity Variance may be calculated as follows:
Sales Quantity Variance:
= (Budgeted sales  Unit Sales at Standard Mix) x Standard Contribution*
*Where marginal costing is used
Explanation
Sales quantity variance is an extension of the sales volume variance which demonstrates the
impact of a higher or lower sales quantity as compared to budget.
The difference between sales volume variance and sales quantity variance is that the former is
calculated using the actual sales volume whereas the latter is calculated using the sales volume of
products in the proportion of standard mix (see example below).
Since sales quantity variance is calculated using the standard mix, any difference between the
standard and actual mix of products is to be ignored (since the difference is accounted for
separately under the sales mix variance).
Example
Aliengear Inc. is a small company that specializes in the manufacture and sale of gaming
computers. Currently, the company offers two models of gaming PCs:
Aliengear budgeted sales of 1,600 units of Turbox and 2,400 units of Speedo in the last year. The
standard variable costs of a single unit of Turbox and Speedo were set at $1,500 and $750
respectively.
The sales team at Aliengear managed to sell 1,300 units of Turbox and 3,700 units of Speedo
during the last year.
Step 3: Calculate the difference between actual sales quantities and the sales quantities in
standard mix
Turbox
Units
Speedo
Units
1,600
2,400
(2000)
(3000)
400
600
Favorable Favorable
Difference
Revenue
2,500 1,000
Variable cost
(1,50
(750)
0)
250
Speedo
$1,000
$250
x 400
units
x 600 units
$400,000 $150,000
Fav
Fav
Variance
550,00 Favorabl
0
e
(525,00
Adverse
0)
Total
25,000
Favora
ble
Turbox Speedo
Actual Sales
1,300
Budgeted Sales
Difference (Units)
Standard
Contribution ($)
Sales Volume
Variance
Total
3,700
(1,600) (2,400)
(300)
1,300
x 1,000
x 250
($300,00 $325,0
0)
00
$25,000
Favorable
Analysis
Favorable sales quantity variance suggests that the company was able to sell a higher number of
products in aggregate as compared to the total number of units budgeted to be sold during a
period.
Favorable sales quantity variance may be achieved through:
Adverse sales quantity variance indicates that the company sold lesser number of goods on
aggregate basis as compared to the total number of units budgeted to be sold during a period.
Adverse sales quantity variance may be caused by the following:
Decline in demand side factors where demand is the limiting factor such as
by:
o A reduction in the overall demand in industry (e.g. due to the
introduction of a better or cheaper substitute in the market, etc)
Decrease in the quantity and quality of supply side factors where excess
demand exists in the market for example due to:
o
1. Definition
2. Formula
3. Explanation
4. Example
5. Analysis
Formula
Sales Price Variance:
Actual Units Sold x (Actual Price  Standard Price) =
Standard Price x Actual Units Sold  Actual Price x Actual Units Sold =
Explanation
Sales Price Variance can be calculated in a number of ways as illustrated in the formulas given
above. The calculation of the variance is in fact very simple if you just remember the objective of
finding the variance, i.e. how much change in sales revenue is attributable to the change in
selling price from the standard?
Example
ABC PLC is a fertilizer producer which specializes in the manufacture of NHKII (a chemical
fertilizer) and ORGI (a types of organic fertilizer).
Following information relates to the sale of fertilizers by ABC PLC during the period:
Standard
Price
NHKII
200
tons
$380/ton
$400/ton
ORGI
300
tons
$660/ton
$600/ton
NHK
380
Standa
Unit Sold
rd
ab
(d)
Price
=c
(tons)
(b)
400
20
200
cxd
4,000
II
Adverse
ORGI
660
600
60
300
18,000
Favorabl
e
14,000
Favora
ble
Total
Analysis
Favorable sales price variance suggests higher selling price realized during the period than
anticipated in the standard. Reasons for favorable sales price variance may include:
Adverse sales price variance indicates that sales were made at a lower average price than the
standard. Causes for adverse sales price variance may include:
1. Definition
2. Formula
3. Example
4. Analysis
5. MCQ
Formula
Direct Material Price Variance:
Actual Quantity x Standard Price  Actual Quantity x Actual Price =
Example
Cement PLC manufactured 10,000 bags of cement during the month of January. Following raw
materials were purchased and consumed by Cement PLC during the period:
Standard
Price
Limesto
ne
100
tons
$75/ton
$70/ton
Clay
150
tons
$20/ton
$24/ton
Sand
250
tons
$10/ton
$12/ton
Sand:
Limestone:
Clay:
Sand:
Limestone:
Adverse
Clay:
Favorable
Sand:
Favorable
$600
Favorable
Analysis
A favorable material price variance suggests cost effective procurement by the company.
Reasons for a favorable material price variance may include:
An adverse material price variance indicates higher purchase costs incurred during the period
compared with the standard.
Reasons for adverse material price variance include:
MCQ
$4500 Adverse
$5,000 Adverse
1. Definition
2. Formula
3. Example
4. Analysis
5. MCQ
Formula
Direct Material Usage Variance:
Standard Quantity x Standard Price  Actual Quantity x Standard Price =
Example
Cement PLC manufactured 10,000 bags of cement during the month of January. Consumption of
raw materials during the period was as follows:
Materia Quantity
l
Used
Standard Usage
Per Bag
Actual
Price
Standard
Price
Limesto
ne
100 tons
11 KG
$75/ton
$70/ton
Clay
150 tons
14 KG
$21/ton
$20/ton
Sand
250 tons
26 KG
$11/ton
$10/ton
10,000
11 /
110
x
=
units
1000
tons
Clay:
10,000
14 /
140
x
=
units
1000
tons
Sand:
10,000
26 /
260
x
=
units
1000
tons
Limestone:
(100  110)
$70
($700)
Favora
ble
Clay:
(150  140)
$20
$200
Advers
e
Sand:
(250  260)
$10
($100)
Favora
ble
($600)
Favora
ble
Note: Actual price paid for the acquisition of materials shall be ignored since the variation
between standard price is already accounted for in the material price variance.
Analysis
A favorable material usage variance suggests efficient utilization of materials.
An adverse material usage variance indicates higher consumption of material during the period
as compared with the standard usage.
Reasons for adverse material usage variance include:
Purchase of materials of lower quality than the standard (this will be reflected
in a favorable material price variance)
Use of unskilled labor
MCQ
Zero
$1,500 Favorable
$1,500 Adverse
$2,000 Adverse
1. Definition
2. Formula
3. Example
4. Explanation
5. Analysis
Formula
Direct Material Mix Variance:
Standard Mix Quantity x Standard Price  Actual Quantity x Standard Price =
Example
Cement PLC manufactured 10,000 bags of cement during the month of January. Consumption of
raw materials during the period was as follows:
Materia Quantity
l
Used
Standard Mix
Per Bag
Actual
Price
Standard
Price
Limesto
ne
100 tons
11 KG
$75/ton
$70/ton
Clay
150 tons
14 KG
$21/ton
$20/ton
Sand
250 tons
26 KG
$11/ton
$10/ton
Limeston
e:
500 tons
11 /
108
x
=
units
51*
tons
Clay:
500 tons
14 /
137
x
=
units
51*
tons
Sand:
500 tons
26 /
255
x
=
units
51*
tons
Limestone:
(100  108)
$70
($560)
Favora
ble
Clay:
(150  137)
$20
$260
Advers
e
Sand:
(250  255)
$10
($50)
Favora
ble
($350)
Favora
ble
Note: Actual price paid for the acquisition of materials shall be ignored since any variation
between standard price is already accounted for in the material price variance..
Explanation
Material Mix Variance quantifies the effect of a variation in the proportion of raw materials used
in a production process over a period.
Material mix variance is a subdivision of material usage variance. While material usage
variance illustrates the overall efficiency of raw material consumption during a period (in terms
of the difference between the amount of materials which should have been used and the actual
usage), material mix variance focuses on the aspect of proportion of raw materials used in the
production process.
Material mix variance is only suitable for performance measurement and control where the
proportion of inputs to the production process can be altered without reducing the effectiveness
of the final product. It may not therefore be used in industries that require a high degree of
precision in the input variables such as in the pharmaceuticals sector.
Analysis
A favorable material mix variance suggests the use of a cheaper mix of raw materials than the
standard. Conversely, an adverse material mix variance suggests that a more costly combination
of materials have been used than the standard mix.
A change in the material mix must also be analyzed in the context of other organization wide
implications that may follow. Some of the effects a change in direct material mix include:
Change in material mix may affect the workability of materials which may in
turn affect labor efficiency
Definition
Direct Material Yield Variance is a measure of cost differential between output that should have
been produced for the given level of input and the level of output actually achieved during a
period.
Contents:
1. Definition
2. Formula
3. Example
4. Explanation
5. Analysis
Formula
Direct Material Yield Variance:
= (Actual Yield  Standard Yield) x Standard Material Cost Per Unit
Example
Cement PLC manufactured 10,000 bags of cement during the month of January. Consumption of
raw materials during the period was as follows:
Materia Quantity
l
Used
Standard Mix
Per Bag
Actual
Price
Standard
Price
Limesto
ne
100 tons
11 KG
$75/KG
$70/KG
Clay
150 tons
14 KG
$21/KG
$20/KG
Sand
250 tons
26 KG
$11/KG
$10/KG
Step 1: Calculate the Standard Yield for the total materials input
500 tons of materials should have yielded 9,804 bags
Standard Yield = 500 tons x 1000 / 51 KG = 9,804 bags
$770
Clay:
14
$2
x
=
KG
0
$280
Sand:
26
$1
x
=
KG
0
$260
Total
$1,310 per
bag
Actual material price should be ignored since the variance between actual and standard price is
accounted for in the material price variance.
Materials
:
Limeston
e:
196 bags
$770
= $150,920
Clay:
196 bags
$280
= $54,880
Sand:
196 bags
$260
= $50,960
$256,760
Note that sum of individual material yield variances equals the total yield variance calculated
in step 3.
Explanation
Material Yield Variance measures the effect on material cost of a change in the production yield
from the standard.
Material yield variance is used in conjunction with material mix variance in order to provide
additional analysis of the material usage variance.
The difference between material usage and material yield variance is that the former focuses on
the utilization of input at the start of production process whereas latter focuses on the efficiency
in terms of the output yield during a period.
Analysis
A favorable material yield variance indicates better productivity than the standard yield resulting
in lower material cost.
Conversely, an adverse material yield variance suggests lower production achieved during a
period for the given level of input resulting in higher material cost.
 See more at: http://accountingsimplified.com/management/varianceanalysis/material/yield.html#sthash.f8tBg3ho.dpuf
1. Definition
2. Formula
3. Example
4. Analysis
Formula
Direct Labor Rate Variance:
Actual Quantity x Standard Rate  Actual Quantity x Actual Rate =
Example
DM is a denim brand specializing in the manufacture and sale of handstitched jeans trousers.
DM manufactured and sold 10,000 pairs of jeans during a period.
Information relating to the direct labor cost and production time per unit is as follows:
Actual
Hours
Per Unit
Standard
Hours
Per Unit
Actual
Rate
Per Hour
Standard
Rate
Per Hour
0.50
0.60
$12
$10
Direct
Labor
= $60,000.
Analysis
A favorable labor rate variance suggests cost efficient employment of direct labor by the
organization.
Reasons for a favorable labor rate variance may include:
An adverse labor rate variance indicates higher labor costs incurred during a period compared
with the standard.
Causes for adverse labor rate variance may include:
1. Definition
2. Formula
3. Example
4. Analysis
Formula
Direct Labor Effciency Variance:
Standard Hours x Standard Rate  Actual Hours x Standard Rate =
Example
DM is a denim brand specializing in the manufacture and sale of handstitched jeans trousers.
DM manufactured and sold 10,000 pairs of jeans during a period.
Information relating to the direct labor cost and production time per unit is as follows:
Direct
Labor
Actual
Hours
Per Unit
Standard
Hours
Per Unit
Actual
Rate
Per Hour
Standard
Rate
Per Hour
0.50
0.60
$12
$10
= 5,000 hours.
Analysis
A favorable labor efficiency variance indicates better productivity of direct labor during a period.
Causes for favorable labor efficiency variance may include:
Hiring of more higher skilled labor (this may adversely impact labor rate
variance)
Training of work force in improved production techniques and methodologies
An adverse labor efficiency variance suggests lower productivity of direct labor during a period
compared with the standard.
Reasons for adverse labor efficiency variances may include:
Hiring of lower skilled labor than the standard (this should be reflected in a
favorable labor rate variance)
Lower learning curve achieved during the period than anticipated in the
standard
Definition
Labor Idle Time Variance is the cost of the standby time of direct labor which could not be
utilized in the production due to reasons including mechanical failure of equipment, industrial
disputes and lack of orders.
1. Definition
2. Formula
3. Explanation
4. Example
5. Analysis
Formula
Standard labor rate x Number of idle hours = Idle Time Variance:
Explanation
Idle time variance illustrates the adverse impact on the profitability of an organization as a result
of having paid for the labor time which did not result in any production. Idle time variance is
therefore always described as an 'adverse' variance.
The separate calculation of idle time variance ensures a more meaningful analysis of the
underlying productivity of the workforce demonstrated in the labor efficiency variance as
illustrated in the example below.
As with the labor efficiency variance, the calculation of idle time variance is based on the
standard rate since the variance between actual and standard labor rate is separately accounted
for in the labor rate variance.
Example
DM is a denim brand specializing in the manufacture and sale of handstitched jeans trousers.
Direct
Labor
Actual
Hours
Per Unit
Standard
Hours
Per Unit
Actual
Rate
Per Hour
Standard
Rate
Per Hour
0.65
0.60
$12
$10
During the period, 800 hours of idle time was incurred. In order to motivate and retain
experienced workers, DM has devised a policy of paying workers the full hourly rate in case of
any idle time.
Note: 0.65 hours per unit of actual time includes the idle time.
Calculation of idle time variance and labor efficiency variance will be as follows:
(a) Idle Time Variance:
Idle time variance = number of idle hours x standard rate
= 800 hours x $10
= $8,000 Adverse.
= 5,700 hours.
The sum of idle time variance and labor efficiency variance calculated above should equal the
labor efficiency variance ignoring idle time.
Sum of variances = Idle time variance + Labor efficiency variance
= $8,000 Adverse + ($3,000 Favorable)
= $5,000 Adverse
Labor efficiency variance = Standard Cost of Actual Hours  Standard Cost
(without idle time variance)
= 6,500 Hours (Step 1) x $10  $60,000 (Step 5)
= $5,000 Adverse
Comment
Without considering the impact of idle time, it would appear that the productivity of workforce
(1.53 units per hour*) had been lower than the standard (1.67 units per hour**) due to inefficient
workflow and production process. However, taking into consideration the unavoidable
production time lost (idle time), we can conclude that the underlying efficiency of the workforce
improved (1.75 units per hour***) compared with the standard.
* 10,000 units / 6,500 hours (total)
** 10,000 units / 6,000 hours (standard)
*** 10,000 units / 5,700 hours (active)
Analysis
Reasons for idle time may include:
Industrial disputes
Formula
Variable Overhead Spending Variance:
Actual Hours is the number of machine hours or labor hours during a period.
Explanation
Variable Overhead Spending Variance is essentially the difference between what the variable
production overheads did cost and what they should have cost given the level of activity during
a period.
Standard variable overhead rate may be expressed in terms of the number of machine hours or
labor hours. So for example, in case of a labor intensive manufacturing business, standard
variable overhead rate may be expressed in terms of the number of labor hours whereas in case
of predominantly automated production processes, a standard rate based on the number of
machine hours may be more appropriate. Very often however, companies have a combination of
manual and automated business processes which may necessitate the use of both basis of variable
overhead absorption.
Example
AAA Sports LTD is a small manufacturing company specializing in the production of cricket
bats. AAA Sports LTD currently manufactures 2 types of bats:
AAA Plus  a handcrafted English Willow bat designed for professional use
AAA Gold  a machinemanufactured cheaper bat designed for casual cricket
Following is a breakup of standard variable manufacturing overhead cost:
Number of
Hours
AAA Plus
AAA Gold
2 direct labor
hours
1 machine hour
Overheads:
Indirect Labor
$10
Polish
$5
$1
Sand paper
$1
Glue
$1
$0.5
Machine
lubricants
$0.5
Electricity
$3
$10
Total
$20
$12
($10 per direct labor ($12 per machine
hour)
hour)
$175,0
00
10,000
Machine Hours
5,000
175,00
0
Less:
Actual Hours
10,00
5,000
0
x $10 x $12
Standard Overhead
Expense
15,000
Adver
se
Analysis
Favorable variable manufacturing overhead spending variance indicates that the company
incurred a lower expense than the standard cost.
Possible reasons for favorable variance include:
Planning error (e.g. failing to take into account the learning curve effect which
could have reasonably be expected to result in a more efficient use of indirect
materials in the upcoming period)
An adverse variable manufacturing overhead spending variance suggests that the company
incurred a higher cost than the standard expense.
Potential causes for an adverse variance include:
A rise in the national minimum wage rate leading to a higher cost of indirect
labor
A decrease in the level of activity not fully offset by a decrease in overheads
(e.g. electricity consumption of machines during set up is usually same even
if a smaller batch of output is required to be produced)
In efficient cost control (e.g. not optimizing the batch production quantities
leading to higher set up costs)
Planning error (e.g. failing to take into account the increase in unit rates of
electricity applicable for the level of activity budgeted during a period)
Limitations
Variable production overheads by their nature include costs that cannot be directly attributed to a
specific unit of output unlike direct material and direct labor which vary directly with output.
Variable overheads do however vary with a change in another variable. Traditional management
accounting often define blanket variables such as machine hours or labor hours which seldom
provides a meaningful basis of cost control. The use of activity based costing to calculate
overhead variances can significantly enhance the usefulness of such variances.
 See more at: http://accountingsimplified.com/management/varianceanalysis/variableoverhead/spending.html#sthash.ubMDKvSq.dpuf
Formula
Variable Overhead Spending Variance:
Standard Variable Overhead Rate per hour x = Standard hours
Less
Standard Variable Overhead Rate per hour x Actual hours
where:
Hours refers to the number of machine hours or labor hours incurred in the
production of output during a period.
Explanation
Variable Overhead Efficiency Variance is calculated to quantify the effect of a change in
manufacturing efficiency on variable production overheads. As in the case of variable overhead
spending variance, the overhead rate may be expressed in terms of labor hours or machine hours
(or both) depending on the degree of automation of production processes.
Example
AAA Sports LTD is a small manufacturing company specializing in the production of cricket
bats. AAA Sports LTD currently manufactures 2 types of bats:
AAA Plus  a handcrafted English Willow bat designed for professional use
AAA Gold  a machinemanufactured cheaper bat designed for casual cricket
Following is a breakup of the standard variable manufacturing overhead costs:
AAA Plus
AAA Gold
2 direct labor
hours
1 machine hour
Indirect Labor
$10
Polish
$5
$1
Sand paper
$1
Glue
$1
$0.5
Machine
lubricants
$0.5
Electricity
$3
$10
Number of
Hours
Overheads:
Total
$20
$12
($10 per direct labor ($12 per machine
hour)
hour)
$175,0
00
10,000
Machine Hours
5,000
4,500
5,200
9,000 5,200
x $10 x $12
90,00 62,40 152,4
0
0
00
Less:
Actual Hours
10,00
5,000
0
x $10 x $12
100,0 60,00 152,4
00
0
00
7,600
Adver
se
Proof check:
Adding variable overhead spending and efficiency variances to the standard cost should equal to
actual variable overheads during the period.
Standard Cost (Standard hours x
Standard rate)
$152,4
(see above)
00
$15,00 A (see
0 solution)
Actual Overheads
A (see
above)
$175,0
00
$175,0 (from
00 question)
Analysis
Favorable variable overhead efficiency variance indicates that fewer manufacturing hours were
expended during the period than the standard hours required for the level of actual output.
Reasons for a favorable variance may include:
Use of a raw material which is easier to work with (this should be evident in a
favorable material usage variance and possibly an adverse material price
variance)
Planning error (e.g. ignoring or under estimating the impact of learning curve
effect on productivity)
An adverse variable overhead efficiency variance suggests that more manufacturing hours were
expended during the period than the standard hours required for the level of actual production.
Possible causes for adverse variance include:
Use of a cheaper raw material which is harder to work with (this should be
corroborated with an adverse material usage variance and a favorable a
href="/management/varianceanalysis/material/price.html">material price
variance)
Inefficient production caused by the employment of lower skilled labor (this
shall be evident in an adverse direct labor efficiency variance and probably a
favorable labor rate variance)
Planning error (e.g. over calculating the impact of learning curve effect on the
manufacturing efficiency)
Limitations
Variable Overhead Efficiency Variance is traditionally calculated on the assumption that the
overheads could be expected to vary in proportion to the number of manufacturing hours. While
there is usually correlation between manufacturing hours and variable overheads when
considered on aggregate basis, the number of manufacturing hours may not be the factor that
drives the cost of many types of variable overheads (e.g. setup costs vary with the number of
setups). Using Activity based costing in the calculation of variable overhead variances might
therefore provide more relevant information for management control purposes.
Also, in case where variable overhead rate is based on labor hours, the variable overhead
efficiency variance does not offer any additional information than provided by the labor
efficiency variance.
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Formula
Fixed Overhead Expenditure Variance:
= Actual Fixed Overheads  Budgeted Fixed Overheads
Example
Motors PLC is a manufacturing company specializing in the production of automobiles.
Information relating to its fixed manufacturing overhead expense of last period is as follows:
Millio
n
$
Actual fixed
overheads
A 526
Budgeted fixed
overheads
B 500
Fixed Overhead
Expenditure Variance
A  2 Adver
B 6 se
The variance is adverse since actual expense is higher than the budgeted expense.
Explanation
Fixed Overhead Spending Variance is calculated to illustrate the deviation in fixed production
costs during a period from the budget. The variance is calculated the same way in case of both
marginal and absorption costing systems. As under marginal costing fixed overheads are not
absorbed in the standard cost of a unit of output, fixed overhead expenditure variance is the only
variance relating to fixed overheads calculated under marginal costing (i.e. fixed overhead
expenditure variance is equal to fixed overhead total variance under marginal costing system).
Analysis
Favorable fixed overhead expenditure variance suggests that actual fixed costs incurred during
the period have been lower than budgeted cost.
Reasons for a favorable variance may include:
Adverse fixed overhead expenditure variance indicates that higher fixed costs were incurred
during the period than planned in the budget.
An adverse variance may be caused by the following:
Expansion of business undertaken during the period, which was not taken
into consideration in the budget setting process, causing a stepped increase
in fixed overheads.
Planning errors (e.g. increase in insurance premium being higher than budget
due to changes in the risk profile of business).
4. Explanation
5. Fixed Overhead Capacity Variance
6. Fixed Overhead Efficiency Variance
7. Example 2
8. Limitations
Definition
Fixed Manufacturing Overhead Volume Variance quantifies the difference between budgeted and
absorbed fixed production overheads.
Formula
Fixed Overhead Volume
Variance
Absorbed Fixed
=
overheads
Budgeted Fixed
Overheads
Actual Output x
=
FOAR*
Budgeted Output x
FOAR*
Example
Motors PLC is a manufacturing company specializing in the production of automobiles.
Information from its last budget period is as follows:
Actual Production
275,000
units
Budgeted Production
250,000
units
$2,000 per
Absorption Rate
unit
(275,000 x
$2,000)
$550
m
Budgeted Fixed
Overheads
(250,000 x
$2,000)
($500
m)
$50 m
Favora
ble
Note:
It may appear strange to you that even though the absorbed fixed overheads are higher than the
budgeted overheads, the variance is described as being 'favorable' which is usually not how cost
variances are interpreted. In short, this variance is used as a balancing exercise when fixed
overhead expenditure variance is calculated. For more detail on this, see the explanation below.
Explanation
Fixed Overhead Volume Variance is the difference between the fixed production cost budgeted
and the fixed production cost absorbed during the period. The variance arises due to a change in
the level of output attained in a period compared to the budget.
The variance can be analyzed further into two subvariances:
The sum of the above two variances should equal to the volume variance.
Fixed overhead volume variance helps to 'balance the books' when preparing an operating
statement under absorption costing.
Sales Quantity Variance already takes into account the change in budgeted fixed production
overheads as a result of increase or decrease in sales quantity along with other expenses.
At the same time, fixed overhead expenditure variance accounts for the difference between actual
and budgeted expense rather than the flexed expense unlike other expenditure variances.
This implies that the difference between budgeted and flexed fixed cost is included twice in the
operating statement. Sales volume variance removes the effect of such duplication.
As fixed costs are not absorbed under marginal costing system, fixed overhead volume variance
(and its subvariances) are to be calculated only when absorption costing is applied.
Example
Continuing the Motors PLC example above, we have the following data from its last period:
Actual Production
275,000
units
Budgeted Production
250,000
units
$2,000 per
unit
Additional information:
Standard machine hours per unit 10 hours
Actual number of machine hours
3,000,000
Calculate the fixed overhead capacity and fixed overhead efficiency variance.
2,500,000
(3,000,00
0)
500,000
x 200
100,000, Favora
000 ble
The variance is favorable because Motors PLC managed to operate more manufacturing
hours than anticipated in the budget.
2,750,00
0
(3,000,0
00)
250,000
Fixed Overhead Absorption Rate / unit of hour
($2,000 / 10)
50,000, Adver
000 se
Variance
x 200
The variance is adverse because Motors PLC utilized more manufacturing hours in the
production of 275,000 units than the standard.
Proof Check
Fixed Overhead Capacity
Variance
$100,000, Favorab
000 le
$50,000,0 Advers
00 e
Total
$50,000,0 Favorab
00 le
$50,000,0 Favorab
00 le
Limitations
Fixed Overhead Volume Variance is necessary in the preparation of operating statement under
absorption costing as it removes the arithmetic duplication as discussed earlier. However, besides
its role as a balancing agent, the variance offers little information in its own right over and above
what can be ascertained from other variances (e.g. sales quantity variance already illustrates the
effect of an increase in sales quantity on the overall profitability).
The traditional calculation of subvariances (i.e. fixed overhead capacity and efficiency
variances) does not provide a meaningful analysis of fixed production overheads. For instance, if
the workforce utilized fewer manufacturing hours during a period than the standard (the effect of
which is more adequately reflected in labor efficiency variance), it is hard to imagine a
significant benefit of calculating a favorable fixed overhead efficiency variance.
Definition
Fixed Overhead Total Variance is the difference between actual and absorbed fixed production
overheads during a period.
Formula
Fixed Overhead Total Variance = Actual Fixed Overheads  Absorbed Fixed Overheads
Example
Motors PLC is a manufacturing company involved in the production of automobiles.
Information from its last budget period is as follows:
Actual Production
275,000
units
Budgeted Production
250,000
units
$526,000,0
00
$500,000,0
00
In order to calculate the required variance, we first need to find out the standard absorption rate:
Fixed Overhead
Absorption Rate
budgeted fixed
overheads
budgeted output
$50,000,000
=
$2,000 per
unit
250,000 units
Now we can apply the formula to calculate the fixed overhead total variance as follows:
=
Actual Fixed
Overheads
Absorbed Fixed
Overheads
$526,000,000
275,000 x $2,000
$526,000,000
$550,000,000
$24,000,000
Favorable
The variance is favorable because the actual expense is lower than the fixed overheads absorbed
during the period.
Explanation
Fixed Overhead Total Variance is the difference between the actual fixed production overheads
incurred during a period and the 'flexed' cost (i.e. fixed overheads absorbed).
In case of absorption costing, the fixed overhead total variance comprises the following subvariances:
Under marginal costing system, fixed production overheads are not absorbed in the cost of
output. Fixed overhead total variance in such instance will therefore equal to the fixed overhead
expenditure variance because the budgeted and flexed overhead cost shall be the same.
Example
Continuing the Motors PLC example above, we have the following information:
Actual Production
275,000
units
Budgeted Production
250,000
units
$526,000,0
00
$500,000,0
Overheads
00
Calculate the fixed overhead volume variance and fixed overhead expenditure variance.
$500,000,
000
$26,000,0 Adver
00 se
The variance is adverse because Motors PLC incurred greater expense than provided for
in the budget.
$500,000,
000
$550,000,
000
Variance
$50,000,0 Favora
00 ble
The variance is favorable because Motors PLC yielded a higher output than anticipated
in the budget.
Proof Check
The sum of fixed overhead expenditure and volume variances should equal to the
fixed overhead total variance as calculated in above Example :
$
Fixed Overhead Expenditure
26,000,00 Adverse
Variance
0
Fixed Overhead Volume
Variance
$
Favorab
50,000,00
le
0
Total
$
Advers
24,000,0
e
00
$
Advers
24,000,0
e
00
The variance is favorable because Motors PLC yielded a higher output than
anticipated in the budget.
The following diagram summarizes the breakup of the total variance into its subcomponents:
 See more at: http://accountingsimplified.com/management/varianceanalysis/fixedoverhead/total.html#sthash.EPQBhjjO.dpuf
MARGINAL COST
The increase or decrease in the total cost of a production run for making one additional unit of an
item. It is computed in situations where the breakeven point has been reached: the fixed costs
have already been absorbed by the already produced items and only the direct (variable) costs
have to be accounted for.
Marginal costs are variable costs consisting of labor and material costs, plus an estimated portion
of fixed costs (such as administration overheads and selling expenses). In companies where
average costs are fairly constant, marginal cost is usually equal to average cost. However, in
industries that require heavy capital investment (automobile plants, airlines, mines) and have
high average costs, it is comparatively very low. The concept of marginal cost is critically
important in resource allocation because, for optimum results, management must concentrate its
resources where the excess of marginal revenue over the marginal cost is maximum. Also called
choice cost, differential cost, or incremental cost.
Read more: http://www.businessdictionary.com/definition/marginalcost.html#ixzz3moDrXtkp
Learning Objectives
under
both
marginal
costing
and
MARGINAL
COST =
VARIABLE
LABOUR
COST
DIRECT
+
DIRECT MATERIAL
+
DIRECT EXPENSE
+
VARIABLE OVERHEADS
fixed and only the aggregate of the remainder will tend to rise
proportionately with an increase in output. Conversely, a decrease in
the volume of output will normally be accompanied by less than
proportionate fall in the aggregate cost.
The theory of marginal costing may, therefore, by understood in the
following two steps:
1.
$
45 =
$2.25
20
For any given period of time, fixed costs will be the same, for any
volume of sales and production (provided that the level of activity is
within the relevant range). Therefore, by selling an extra item of
product or service the following will happen.
b. Similarly, if the volume of sales falls by one item, the profit will fall
by the amount of contribution earned from the item.
c.
d.
main features of
Cost
Classification
The marginal costing technique makes a sharp distinction between
variable costs and fixed costs. It is the variable cost on the basis of
which production and sales policies are designed by a firm following
the marginal costing technique.
2.
Stock/Inventory
Valuation
Under marginal costing, inventory/stock for profit measurement is
Marginal
Contribution
Marginal costing technique makes use of marginal contribution for
marking various decisions. Marginal contribution is the difference
between sales and marginal cost. It forms the basis for judging the
profitability of different products or departments.
Disadvantages
1.
2.
3.
4.
xxxx
x
Sales Revenue
Less Marginal Cost of Sales
Opening Stock (Valued @ marginal xxx
cost)
x
Add Production
marginal cost)
Cost
(Valued
xxx
x
Stock
@ xxx
x
(Valued
@ (xxx
)
xxx
x
(xxx
x)
Contribution
xxxx
x
(xxx
x)
xxxx
x
xxxx
x
Sales Revenue
Less Absorption Cost of Sales
Opening Stock (Valued @ absorption
xxxx
cost)
Add Production
absorption cost)
Cost
(Valued
xxxx
xxxx
(Valued
(xxx)
xxxx
(xxx
x)
UnAdjusted Profit
xxxx
x
xxxx
(xxx
x)
(Under)/Over Absorption
xxxx
x
Adjusted Profit
xxxx
x
Reconciliation
Statement
Absorption Costing Profit
for
Marginal
Costing
and
opening
x
x
x
x
x
x
Overheads
In absorption costing, fixed overheads can never be absorbed
exactly because of difficulty in forecasting costs and volume of
output. If these balances of under or over absorbed/recovery are not
written off to costing profit and loss account, the actual amount
incurred is not shown in it. In marginal costing, however, the actual
b.
c.
When closing stock is more than opening stock, the profit under
absorption costing will be higher as comparatively a greater portion
of fixed cost is included in closing stock and carried over to next
period.
d.
When closing stock is less than opening stock, the profit under
absorption costing will be less as comparatively a higher amount of
fixed cost contained in opening stock is debited during the current
period.
The features
costing from
follows.
a.
c.
d.
ii.
sales
volume;
is not easily seen, because behaviour is not analysed and
incremental costs are not used in the calculation of actual profit.
following are
2.
Learning Objectives
IntroductionIn
the output and sales level at which there would neither profit
nor loss (breakeven point)
the amount by which actual sales can fall below the budgeted
sales level, without a loss being incurred (the margin of safety)
MARGINAL
COSTS,
CONTRIBUTION
PROFITA marginal cost is another term for a variable
AND
cost. The
term marginal cost is usually applied to the variable cost of a unit
of product or service, whereas the term variable cost is more
commonly applied to resource costs, such as the cost of materials
and labour hours.
b. fixed costs, which should be the same for a given period of time,
regardless of the level of activity in the period.
Suppose that a firm makes and sells a single product that has a
marginal cost of 5 per unit and that sells for 9 per unit. For every
additional unit of the product that is made and sold, the firm will
incur an extra cost of 5 and receive income of 9. The net gain will
be 4 per additional unit. This net gain per unit, the difference
between the sales price per unit and the marginal cost per unit, is
called contribution.
Contribution is a term meaning making a contribution towards
covering fixed costs and making a profit. Before a firm can make a
profit in any period, it must first of all cover its fixed costs.
Breakeven is where total sales revenue for a period just covers fixed
costs, leaving neither profit nor loss. For every unit sold in excess of
the breakeven point, profit will increase by the amount of the
contribution per unit.
CVP analysis is broadly known as costvolumeprofit analysis.
Specifically speaking, we all are concerned with indepth analysis
and application of CVP in practical world of industry management.
Volume of production
Product mix
Size of batches
Size of plant
3.
4.
Profit graph
4.
Assumptions and
TerminologyFollowing
are
the
The changes in the level of various revenue and costs arise only
because of the changes in the number of product (or service) units
produced and sold, e.g., the number of television sets produced and
sold by Sigma Corporation. The number of output (units) to be sold
is the only revenue and cost driver. Just as a cost driver is any factor
that affects costs, a revenue driver is any factor that affects
revenue.
Direct materials
Direct labor
Administration overheads
5.
The unit selling price, unit variable costs and fixed costs are
constant.
8. All revenue and cost can be added and compared without taking
into account the time value of money.
9.
of CostVolume
Profit Analysis
The CVP analysis is generally made under certain limitations and
with certain assumed conditions, some of which may not occur in
practice. Following are the main limitations and assumptions in the
costvolumeprofit analysis:
1.
The analysis will be correct only if input price and selling price
remain fairly constant which in reality is difficulty to find. Thus, if a
cost reduction program is undertaken or selling price is changed, the
relationship between cost and profit will not be accurately depicted.
b.
Example
Following is the spreadsheet of ABC Ltd.,
1,000
1,500
2,000
2,000 100
4,000
6,000
7,000
8,000
120
5,000
7,500
8,750
10,000
140
6,667
2,500 100
5,000
7,000
8,000
120
6,250
8,750
10,000 11,250
140
8,333
3,000 100
6,000
8,000
120
7,500
140
9,000
9,000
10,000
From the above example, one can immediately see the revenue that
needs to be generated to reach a particular operating income level,
given alternative levels of fixed costs and variable costs per unit. For
example, revenue of $. 6,000 (30 units @ $. 200 each) is required to
earn an operating income of $. 1,000 if fixed cost is $. 2,000 and
variable cost per unit is $. 100. You can also use exhibit 34 to
assess what revenue the company needs to breakeven (earn
operating income of Re. 0) if, for example, one of the following
changes takes place:
Marginal
Analysis
Cost
Equations
and
Breakeven
From the marginal cost statements, one might have observed the
following:
Sales Marginal cost = Contribution ......(1)Fixed cost + Profit =
Contribution ......(2)
By combining these two equations, we get the fundamental
marginal cost equation as follows:
Sales Marginal cost = Fixed cost + Profit ......(3)
This fundamental marginal cost equation plays a vital role in profit
projection and has a wider application in managerial decisionmaking problems.The sales and marginal costs vary directly with the
number of units sold or produced. So, the difference between sales
and marginal cost, i.e. contribution, will bear a relation to sales and
(or
C/S Contribution
(c)
Sales (s)
......
(4)
Or,
Contributi
Sales = on
P/V ratio
......
(6)
in
in
Breakeven point
Profit at any volume of sales
Profitability of products
Processes or departments
Sales
BEP =
Contribution
S BEP
P/ V ratio
at Fixed
cost
=
P/
ratio
= $. 1000
Breakeven
point =
Fixed cost
= 100 units or $.
Contribution per 1000
unit
Profit at
Margin of safety = Sales at selected activity activity
Sales at BEP =
P/V ratio
selected
c.
d.
e.
Margin
safety =
of
Profit
P/V
ratio
Contribution
P/V ratio 100
=
Sales
Problem 2
A company producing a single article sells it at $. 10 each. The
marginal cost of production is $. 6 each and fixed cost is $. 400 per
annum. You are required to calculate the following:
Profits for annual sales of 1 unit, 50 units, 100 units and 400
units
P/V ratio
Breakeven sales
Amount
Amount
Amount
Amount
Units produced
50
100
400
10
500
1000
4000
Variable cost
300
600
2400
Contribution (sales4
VC)
200
400
1600
Fixed cost
400
400
400
400
Profit
FC)
396
200
1200
(Contribution
$.
Sales at BEP = Fixed cost/PV 400 =
$.
ratio =
1,200
1/3
Plot fixed cost on vertical axis and draw fixed cost line passing
through this point parallel to horizontal axis.
3. Plot variable costs for some activity levels starting from the fixed
cost line and join these points. This will give total cost line.
Alternatively, obtain total cost at different levels, plot the points
starting from horizontal axis and draw total cost line.
4. Plot the maximum or any other sales volume and draw sales line by
joining zero and the point so obtained.
Uses of Breakeven ChartA breakeven chart can be used to show
the effect of changes in any of the following profit factors:
Volume of sales
Variable expenses
Fixed expenses
Selling price
Breakeven point
Margin of safety at sale of $. 1,500
Angle of incidence
40
80
120
200
$.
$.
$.
$.
400
800
1,200
2,000
400
400
400
Sales
Variable
cost
240
480
400
720
880
1,120
1,600
Fixed cost line, total cost line and sales line are drawn one after
another following the usual procedure described herein:
This chart clearly shows the breakeven point, margin of safety and
angle of incidence.
a.
d. At 80 units, total cost (from the table) = $. 880. Hence, selling price
for breakeven at 80 units = $. 880/80 = $. 11 per unit. Increase in
selling price is Re. 1 or 10% over the original selling price of $. 10
per unit.
Limitations and Uses of Breakeven ChartsA simple breakeven
chart gives correct result as long as variable cost per unit, total fixed
cost and sales price remain constant. In practice, all these facto$
may change and the original breakeven chart may give misleading
results.
But then, if a company sells different products having different
percentages of profit to turnover, the original combined breakeven
chart fails to give a clear picture when the sales mix changes. In this
Breakeven
point
(inFixed costs
units) =
Fixed cost
B.E.
point
revenue) =
(in
Weighted average P/V
ratio
Ambience
Percentage
33 1/3
Luxury
41 2/3
Comfort
16 2/3
Lavish
8 1/3
100
Luxury
Comfort
Lavish
b. It has been proposed to change the sales mix as follows, with the
sales per month remaining at $. 6,00,000:
Brand Name
Percentage
Ambience
25
Luxury
40
Comfort
30
Lavish
05
100
a.
5.