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What-If Analysis

The costvolumeprofit analysis discussed in Chapter 3 provided insights into how revenues,
costs, and profits respond to changes in the quantity of product made and sold. However, that
analysis assumed a constant product mix.

Spreadsheet softwares make it possible to consider product mixes (and much more) so that
managers can evaluate alternative strategies. Managers can explore the effects of alternative
marketing, production, and selling strategies. Such alternative proposals can be evaluated in a
what-if analysis

The structure and information required to prepare the master budget can be used easily to
provide the basis for what-if analysis.

Evaluating Decision-Making Alternatives


Sensitivity Analysis

Sensitivity analysis is the process of selectively varying a plans or a budgets key estimates
for the purpose of identifying over what range a decision option is preferred.

Planners test planning models by varying the model estimates, to see how it affects the plan.

If small forecasting errors of an estimate used in the production plan change the plan, we say
that the model is sensitive to that estimate. If the performance consequences (for example,
profits) from a bad estimate are severe, planners may want to invest time and resources to
improve the accuracy of their estimates.

Both what-if and sensitivity analyses use the same model to evaluate future alternatives.
However, the approaches differ in their purposes. What-if-analysis is a process that uses a model
to predict the results of varying that models key parameters or estimates. Sensitivity analysis is
the process of selectively varying key estimates of a plan or a budget to identify over what range
a decision option is preferred. In this way, sensitivity analysis enables planners to identify
estimates critical to the decision under consideration. What-if-analysis relies on that model
tested via sensitivity analysis

Exercise 10-42
Jeren Company is considering replacing its existing cutting machine with a new
machine that will help reduce its defect rate.
Relevant information for the two machines includes the following:

Cost item Existing Machine New Machine


Monthly fixed cost $32,000 $40,000
Variable cost per unit $44 $40
Sales price per unit $55 $55

(a) Determine the sales level, in number of units, at which the costs are the same for both
machines.
(b) Determine the sales level in dollars at which the use of the new machine results in a 10%
profit on sales (profit/sales) ratio.

a. Let Q sales level in units at which the costs are the same with both machines.

Total cost for existing machine = Total cost of new machine


($44 Q) + $32,000 = ($40 Q) + $40,000
$4Q = 8,000
Q = 2,000 units

b. Let R sales level in dollars at which the use of the new machine results in a 10% profit on
sales ratio.

Let Q be the corresponding number of units, so that R $55 Q

Q = FC/ [CM per unit (10% x SP)]


Q = $40,000 / [15 (.10 x 55)]
Q = $40,000/ 9.5 = 4,211 units
R= $55 x 4,211 = $231,605

Variance Analysis
Variance analysis comparison of planned (or budgeted) results with actual results

Variancedifference between planned and actual results.

Should be investigated to determine:


- What caused the variance
- What should be done to correct that variance
New slide
Budgeted or planned costs can come from three sources:
Standards established by industrial engineers
Previous periods performance
A benchmarkthe best in class results achieved by a competitor

New slide
The financial numbers are the product of a price and a quantity component:
Planned or Budgeted amount = standard price per unit * budgeted quantity
Actual amount = actual price per unit * actual quantity

Variance analysis explains the difference between planned and actual costs by evaluating:
Differences between planned and actual prices
Differences between planned and actual quantities

New slide
Managers focus separately on prices and quantities because in most organizations:
One department or division is responsible for the acquisition of a resource and
determining the actual price
A different department uses the resource and determines the quantity

A variance is a signal that is part of a control system for monitoring results and thus
variances provide a signal that operations did not go as planned.

Basic Variance Analysis


Variance analysis helps managers understand the source of the differences
If managers learn that specific actions they took helped lower the actual costs, then they
can obtain further cost savings by repeating those actions on similar jobs in the future
If the factors causing actual costs to be higher than expected can be identified, then
actions may be taken to prevent those factors from recurring in the future
If cost changes are likely to be permanent, cost information can be updated for future jobs

The document summarizing costsvariously referred to as budgeted costs, estimated costs, projected
costs, target costs, or forecasted costs, but all identify the same costsis called the master budget.

The first level of variance analysis for a cost item focuses on the differences between actual
and estimated (master budget) costs for the item. The second level of variance analysis
decomposes the first-level variances into a flexible budget variance and a planning variance. The
flexible budget variance is the difference between actual costs and flexible budget costs, which
reflect the volume level achieved, rather than planned. The planning variance is the
difference between flexible budget costs and master budget costs. For variable costs, the third
level of variance analysis decomposes the flexible budget component of the second level
variance into efficiency (use) and price (rate) variances.

First-Level Variances
The first-level variance for a cost item is the difference between the actual costs and
the master budget costs for that cost item
Variances are favorable (F) if the actual costs are less than estimated master budget
costs
Unfavorable (U) variances arise when actual costs exceed estimated master budget
costs
Decomposing the Variances
A flexible budget adjusts the forecast in the master budget for the difference between
planned volume and actual volume
Cost differences between the master and the flexible budget are called planning
variances
Reflect the difference between planned output and actual output
Arise entirely because the planned volume of activity was not realized

Planning and Flexible Budget Variances


Flexible budget variances are the differences between the flexible budget and the
actual results
Flexible budget variances reflect:
Quantity variancesthe difference between the planned and the actual use rates
per unit of output
Cost variancesthe difference between the planned and the actual price or cost
per unit of the various cost items

Second and Third-Level Variances


The second-level variances are the planning variance and the flexible budget
variance
The direct material flexible budget variances and direct labor flexible budget variances can
be decomposed further into third-level variances:
Efficiency variances
Price variances
By classifying flexible budget variances into rate (price) and efficiency (quantity)
variances, managers can better understand the factors causing those variances and
correct the standards or institute changes that help reduce expenses

Direct Material Variances


Quantity variance = (AQ - SQ) x SP
Where:
AQ = actual quantity of materials used
SQ = standard quantity of materials allowed
SP = standard price of materials

New slide
Price variance = (AP - SP) x AQ
Where:
AP = actual price of materials
SP = standard price of materials
AQ = actual quantity of materials used
The price variance may be calculated using the quantity purchased rather than the
quantity used

When the amount of raw material used is different from the amount of raw material purchased,
we define one more variable PQ (the actual quantity of raw material purchased)
Total Cost: The actual cost of the acquired raw materials = purchased quantity (PQ) x actual price (AP).
Price Adjusted Cost: The cost of acquired materials using the standard price = purchased quantity (PQ) x
standard price (SP).
Price Adjusted Quantity: The cost of materials used using the standard price = quantity used (AQ) x
standard price (SP).
Flexible Budget Cost: The cost of the standard quantity of materials = standard quantity (SQ) x standard
price (SP).

Direct Labor Variances

Efficiency variance = (AH - SH) x SR


Rate variance = (AR - SR) x AH
Where:
AH = actual number of direct labor hours
AR = actual wage rate
SR = standard rate
SH = standard number of direct labor hours allowed

The sum of the rate variance and the efficiency variance equals the total flexible
budget direct labor variance

10-45 The following information is available for Mandalay Company:

Actual Unit cost Standard Unit cost


(budgeted)
Material 15,000 pounds $6/ pound 30 pound/ unit 7$/ pound
purchased
DL 2,000h $10/h 4h/ unit $11/h
Units produced 500
Material used 12,500 pounds
(PQ)

Required
(a) Determine the material price variance based on the quantity of materials purchased.
(b) Determine the material quantity variance.
(c) Determine the direct labor rate variance.
(d) Determine the direct labor efficiency variance.

a. Because the quantity purchased differs from the quantity used, the material price variance
uses the purchased quantity (PQ) instead of the quantity used (AQ).
Material price variance = (AP SP) PQ
Material price variance = ($6 $7) 15,000 = (15,000)
b. Material quantity variance = (AQ - SQ) x SP
Material quantity variance = (12,500 (500x30)) x $7 = (17,500)

c. Direct labor rate variance = (AR - SR) x AH


= ($10- $11) x 2,000 = (2,000)

d. Direct efficiency variance = (AH - SH) x SR


= (2,000 (500x4)) x $11 = 0

10-46

Pharout Company uses a standard cost system. Job 007 is for the manufacturing of 1000 units of the
product X. The companys standards for one unit of product X are as follows:

Quantity Price
DM 10 ounces $5/ ounce
DL 5 hours $10/ h

The job required 9,800 ounces of raw material costing $58,800. A favorable labor rate variance of $2,250
and an unfavorable labor efficiency variance of $1,000 also were determined for this job.

(a) Determine the direct material price variance for job 007 based on the actual quantity of
materials used.
(b) Determine the direct material quantity variance for job 007 based on the actual quantity of
materials used.
(c) Determine the actual quantity of direct labor hours used on job 007.
(d) Determine the actual labor costs incurred for job 007.

a. Material price variance = (AP SP) AQ


= [(58,800/9,800) 5] x 9,800
= (6 - 5) x 9,800 = 9,800

b. Material quantity variance = (AQ - SQ) x SP


= (9,800 (10x1,000))x 5
= (1000)

c. To get AH
Direct efficiency variance = (AH - SH) x SR
1000 = (AH- (5x1000)) x 10
100 = AH 5,000
5,100 = AH
AH = 5,100

d. Direct labor rate variance = (AR - SR) x AH


(2,250) = (AR 10) x 5,100
AR = 9.55

Actual direct labor cost = AR x AH = 9.55 x 5100 = $48750

10-47 Each unit of Product B has standard requirements of 8 pounds of raw material at a price of $25 per
pound and 1 hour of direct labor at $12 per hour. To produce 20,000 units of this product, product B
actually required 18, 000 pounds of the raw material costing $27 per pound. The job used a total of 18,000
direct labor hours costing a total of $198,000.

Required
(a) Determine the material price variance for product B.
(b) Determine the material quantity variance for product B.
c) Assume that the materials used on this job were purchased from a new supplier. Would you
recommend continuing with this new supplier? Why or why not?
(d) Determine the direct labor rate variance for product B.
(e) Determine the direct labor efficiency variance for product B.

a. Material price variance = (AP SP) AQ


= (27 25) x 180,000 = 360,000

b. Material quantity variance = (AQ - SQ) x SP


= (180,000 (20,000 x 8)) = 20,000

c. unfavorable variances, No.


d. Direct labor rate variance = (AR - SR) x AH
= (11 12) x 18,000
= (18,000) F

e. Direct efficiency variance = (AH - SH) x SR


= ( 18,000 - 20,000) x 12
= (24,000) F
10-48 Assembly of product P13 requires two unit of component X, one units of component Y, and two units
of component Z. Job J372 produced 220 units of P13. The following information pertains to material
variances for this job, analyzed by component:

Components
X Y Z
Price variance 1000 U 750 F 450 U
Quantity Variance 2500 U 1000 U 800 F

The actual material prices were $2 more, $3 less, and $1.5 more per unit for components X, Y, and Z,
respectively, than their standard material prices per unit.

Required
(a) Determine the number of materials units consumed of each type of component.
(b) Determine the standard materials price per unit of each type of component.

a. Material price variance = (AP SP) AQ


AQ for X = 1000/ 2 = 500
AQ for Y = -750 / -3 = 250
AQ for Z = 450 / 1.5 = 300

b. Material quantity variance = (AQ - SQ) x SP

SP for X = (500- (2x200)) /2500 = $0.04


SP for Y = (250 (1x200)) / 1000 = $0.05
SP for Z = (300 - (2x200)) / -800 = $0.125