Session 5:

Flexible Budgets and

Performance Analysis
 Learning Objectives
1. Prepare a flexible budget
2. Use the flexible budget for performance
reporting
 Characteristics of Flexible Budgets
Hmm! Comparing
static planning budgets
Planning budgets
with actual costs
are prepared for is like comparing
a single, planned apples and oranges.
level of activity.
Performance
evaluation is difficult
when actual activity
differs from the
planned level of
activity.
 Deficiencies of the Static Planning Budget

Larry’s Lawn Service provides lawn care in a planned

community where all lawns are approximately the same size.
At the end of May, Larry prepared his June budget based on
mowing 500 lawns. Since all of the lawns are similar in size,
Larry felt that the number of lawns mowed in a month would
be the best way to measure overall activity for his business.

Larry’s Budget
Deficiencies of the Static Planning Budget
Larry’s Planning Budget
Deficiencies of the Static Planning Budget
Larry’s Actual Results
 Deficiencies of the Static Planning Budget
Larry’s Actual Results Compared with the Planning Budget
 Deficiencies of the Static Planning Budget

▪ The relevant question is . . .

“How much of the cost variances is due to higher
activity, and how much is due to cost control?”

▪ To answer the question,

we must
the budget to the
actual level of activity.
 How a Flexible Budget Works

To a budget we need to know that:

►Total variable costs change
in direct proportion to
changes in activity.
►Total fixed costs remain
unchanged within the
relevant range. Fixed
Preparing a Flexible Budget
Larry’s Flexible Budget
 Activity Variances

Planning Flexible
budget revenues budget revenues
and expenses and expenses

The differences between

the budget amounts are
called activity variances.
 Activity Variances
Larry’s Flexible Budget Compared with the Planning Budget
 Activity Variances
Larry’s Flexible Budget Compared with the Planning Budget
Activity and revenue increase by 10 percent, but net operating income
increases by more than 10 percent due to the presence of fixed costs.
 Revenue and Spending Variances
Flexible budget revenue Actual revenue

The difference is a revenue variance.

Flexible budget cost Actual cost

The difference is a spending variance.

 Revenue and Spending Variances
Larry’s Flexible Budget Compared with the Actual Results
$1,750 favorable
revenue variance
 Revenue and Spending Variances
Larry’s Flexible Budget Compared with the Actual Results
Spending
variances
A Performance Report Combining Activity and
Revenue and Spending Variances
 Session 6
Standard Costs and Variances
 Learning Objectives
1. Explain how direct materials and labor
standards are set
2. Compute the direct materials, labor and
manufacturing overhead variances.
 Standard Costs
Standards are benchmarks or “norms” for
measuring performance. In managerial accounting,
two types of standards are commonly used.

Quantity standards Price standards

specify how much of an specify how much
input should be used to should be paid for
make a product or each unit of the
provide a service. input.
 Variance Analysis Cycle
Take
Identify Receive corrective
questions explanations actions

Conduct next
Analyze period’s
variances operations

Prepare standard
Begin
cost performance
report
 Setting Standard Costs
Accountants, engineers, purchasing
agents, and production managers
combine efforts to set standards that encourage
efficient future operations.
Setting Direct Material Standards
Price Quantity
Standards Standards

Final, delivered Summarized in

cost of materials, a Bill of Materials.
net of discounts.
 Setting Direct Labor Standards
Rate Time
Standards Standards

Often a single Use time and

rate is used that reflects motion studies for
the mix of wages earned. each labor operation.
Setting Variable Manufacturing Overhead
Standards
Rate Quantity
Standards Standards

The rate is the The quantity is

variable portion of the the activity in the allocation
predetermined overhead base for predetermined
rate. overhead.
 Standard Cost Card – Variable
Production Cost
A standard cost card for one unit of
product might look like this:
A B AxB
Standard Standard Standard
Quantity Price Cost
Inputs or Hours or Rate per Unit
Direct materials 3.0 lbs. $ 4.00 per lb. $ 12.00
Direct labor 2.5 hours 14.00 per hour 35.00
Variable mfg. overhead 2.5 hours 3.00 per hour 7.50
Total standard unit cost $ 54.50
 Price and Quantity Standards
Price and quantity standards are determined
separately for two reasons:

 The purchasing manager is responsible for raw

material purchase prices and the production manager
is responsible for the quantity of raw material used.

 The buying and using activities occur at different times.

Raw material purchases may be held in inventory for a
period of time before being used in production.
 A General Model for Variance
Analysis

Variance Analysis

Price Variance Quantity Variance

Difference between Difference between

actual price and actual quantity and
standard price standard quantity
 A General Model for Variance Analysis

Variance Analysis

Price Variance Quantity Variance

Materials price variance Materials quantity variance

Labor rate variance Labor efficiency variance
VOH rate variance VOH efficiency variance
 A General Model for Variance Analysis

Actual Quantity Actual Quantity Standard Quantity

× × ×
Actual Price Standard Price Standard Price

Price Variance Quantity Variance

(AQ × AP) – (AQ × SP) (AQ × SP) – (SQ × SP)

AQ = Actual Quantity SP = Standard Price
AP = Actual Price SQ = Standard Quantity
 Material Variances – An Example

Glacier Peak Outfitters has the following direct material

standard for the fiberfill in its mountain parka.
0.1 kg. of fiberfill per parka at $5.00 per kg.
Last month 210 kgs. of fiberfill were purchased and used
to make 2,000 parkas. The material cost a total of
$1,029.
 Material Variances Summary
Actual Quantity Actual Quantity Standard Quantity
× × ×
Actual Price Standard Price Standard Price
210 kgs. 210 kgs. 200 kgs.
× × ×
$4.90 per kg. $5.00 per kg. $5.00 per kg.
= $1,029 = $1,050 = $1,000

Price variance Quantity variance

$21 favorable $50 unfavorable
 Material Variances:
Using the Factored Equations
Materials price variance
MPV = AQ (AP - SP)
= 210 kgs ($4.90/kg - $5.00/kg)
= 210 kgs (-$0.10/kg)
= $21 F
Materials quantity variance
MQV = SP (AQ - SQ)
= $5.00/kg (210 kgs-(0.1 kg/parka  2,000 parkas))
= $5.00/kg (210 kgs - 200 kgs)
= $5.00/kg (10 kgs)
= $50 U
 Material Variances – An Example

Glacier Peak Outfitters has the following direct material

standard for the fiberfill in its mountain parka.
0.1 kg. of fiberfill per parka at $5.00 per kg.
Last month 300 kgs. of fiberfill were purchased and 210
kgs were used to make 2,000 parkas. The purchased
material cost a total of $1,500.
 Isolation of Material Variances
I need the price variance I’ll start computing
sooner so that I can better the price variance
identify purchasing problems. when material is
You accountants just don’t purchased rather
understand the problems that than when it’s used.
purchasing managers have.
 Material Variances

The price variance is

Hanson purchased and
computed on the entire
used 1,700 pounds. How
quantity purchased.
are the variances computed
if the amount purchased The quantity variance is
differs from the amount computed only on the
used? quantity used.
 Responsibility for Material Variances

Materials Quantity Variance Materials Price Variance

Production Manager Purchasing Manager

The standard price is used to compute the quantity variance

so that the production manager is not held responsible for
the purchasing manager’s performance.
 Responsibility for Material Variances
Your poor scheduling
I am not responsible for sometimes requires me to rush
this unfavorable material order material at a higher price,
quantity variance. causing unfavorable price
You purchased cheap variances.
material, so my people
had to use more of it.
 Labor Variances – An Example

Glacier Peak Outfitters has the following direct labor

standard for its mountain parka.
1.2 standard hours per parka at $10.00 per hour
Last month, employees actually worked 2,500 hours at a
total labor cost of $26,250 to make 2,000 parkas.
 Labor Variances Summary
Actual Hours Actual Hours Standard Hours
× × ×
Actual Rate Standard Rate Standard Rate
2,500 hours 2,500 hours 2,400 hours
× × ×
$10.50 per hour $10.00 per hour. $10.00 per hour
= $26,250 = $25,000 = $24,000

Rate variance Efficiency variance

$1,250 unfavorable $1,000 unfavorable
 Labor Variances:
Using the Factored Equations
Labor rate variance
LRV = AH (AR - SR)
= 2,500 hours ($10.50 per hour – $10.00 per hour)
= 2,500 hours ($0.50 per hour)
= $1,250 unfavorable
Labor efficiency variance
LEV = SR (AH - SH)
= $10.00 per hour (2,500 hours – 2,400 hours)
= $10.00 per hour (100 hours)
= $1,000 unfavorable
 Responsibility for Labor Variances
Production managers are Mix of skill levels
usually held accountable assigned to work tasks.
for labor variances
because they can
Level of employee
influence the:
motivation.

Quality of production
supervision.

Quality of training
provided to employees.
Production Manager
Responsibility for Labor Variances
I think it took more time
to process the materials
I am not responsible for because the
the unfavorable labor Maintenance
efficiency variance! Department has poorly
maintained your
You purchased cheap equipment.
material, so it took more
time to process it.
 Variable Manufacturing Overhead
Variances – An Example
Glacier Peak Outfitters has the following direct
variable manufacturing overhead labor standard
for its mountain parka.
1.2 standard hours per parka at $4.00 per hour
Last month, employees actually worked 2,500
hours to make 2,000 parkas. Actual variable
manufacturing overhead for the month was
$10,500.
 Variable Manufacturing Overhead
Variances Summary
Actual Hours Actual Hours Standard Hours
× × ×
Actual Rate Standard Rate Standard Rate
2,500 hours 2,500 hours 2,400 hours
× × ×
$4.20 per hour $4.00 per hour $4.00 per hour
= $10,500 = $10,000 = $9,600

Rate variance Efficiency variance

$500 unfavorable $400 unfavorable
 Variable Manufacturing Overhead
Variances: Using Factored Equations
Variable manufacturing overhead rate variance
VMRV = AH (AR - SR)
= 2,500 hours ($4.20 per hour – $4.00 per hour)
= 2,500 hours ($0.20 per hour)
= $500 unfavorable
Variable manufacturing overhead efficiency
variance
VMEV = SR (AH - SH)
= $4.00 per hour (2,500 hours – 2,400 hours)
= $4.00 per hour (100 hours)
= $400 unfavorable
Variance Analysis and Management
by Exception

Larger variances, in
How do I know dollar amount or as
which variances to a percentage of the
investigate? standard, are
investigated first.
 A Statistical Control Chart
Warning signals for investigation

Favorable Limit
• •
• • •
Desired Value
• •
Unfavorable Limit •
•
1 2 3 4 5 6 7 8 9
Variance Measurements
 Advantages of Standard Costs
Management by Promotes economy
exception and efficiency

Advantages
Enhances
Simplified responsibility
bookkeeping accounting
Potential Problems with Standard Costs
Emphasizing standards Favorable
may exclude other variances may
important objectives. be misinterpreted.
Potential
Problems
Standard cost Emphasis on
reports may negative may
not be timely. impact morale.

Invalid assumptions Continuous

about the relationship improvement may
between labor be more important
cost and output. than meeting standards.
 Fixed Overhead Budget Variance
Actual Budgeted Fixed
Fixed Fixed Overhead
Overhead Overhead Applied

Budget
variance

Actual Budgeted
Budget
= fixed – fixed
variance
overhead overhead
Fixed Overhead Volume Variance
Actual Budgeted Fixed
Fixed Fixed Overhead
Overhead Overhead Applied

Volume
variance

Budgeted Fixed
Volume overhead
= fixed –
variance applied
overhead
 Fixed Overhead Volume Variance
Actual Budgeted Fixed
Fixed Fixed Overhead
Overhead Overhead Applied
DH × FR SH × FR

Volume
variance
Volume variance = FPOHR × (DH – SH)

FPOHR = Fixed portion of the predetermined overhead rate

DH = Denominator hours
SH = Standard hours allowed for actual output
 Session 7
Performance Measurement in
Decentralized Organizations
 Learning Objectives
1. Describe a decentralized organizational
structure.
2. Understand an organizational view of
responsibility centers.
3. Compute return on investment (ROI),
residual income and understand their
strengths and weaknesses.
Decentralization in Organizations

Benefits of Top management

Decentralization freed to concentrate
on strategy.
Lower-level managers
gain experience in
decision-making. Decision-making
authority leads to
job satisfaction.
Lower-level decisions
often based on
better information.
Lower level managers
can respond quickly to
customers.
 Decentralization in Organizations
May be a lack of
coordination among
autonomous
Lower-level managers managers.
may make decisions
without seeing the
“big picture.” Disadvantages of
Decentralization
Lower-level manager’s
objectives may not
be those of the May be difficult to
organization. spread innovative ideas
in the organization.
 Cost, Profit, and Investments Centers

Cost Profit Investment

Center Center Center

Cost, profit,
and investment
centers are all
known as Responsibility
Center
responsibility
centers.
 Responsibility Centers
Investment
Centers Superior Foods Corporation
Corporate Headquarters
President and CEO

Operations Finance Legal Personnel

Vice President Chief FInancial Officer General Counsel Vice President

Salty Snacks Beverages Confections

Product Manger Product Manager Product Manager

Bottling Plant Warehouse Distribution

Cost
Manager Manager Manager
Centers
Superior Foods Corporation provides an example of the
various kinds of responsibility centers that exist in an
organization.
 Responsibility Centers
Superior Foods Corporation
Corporate Headquarters
President and CEO

Operations Finance Legal Personnel

Vice President Chief FInancial Officer General Counsel Vice President

Salty Snacks Beverages Confections

Product Manger Product Manager Product Manager

Bottling Plant Warehouse Distribution

Profit
Manager Manager Manager
Centers
Superior Foods Corporation provides an example of the
various kinds of responsibility centers that exist in an
organization.
 Responsibility Centers
Superior Foods Corporation
Corporate Headquarters
President and CEO

Operations Finance Legal Personnel

Vice President Chief FInancial Officer General Counsel Vice President

Salty Snacks Beverages Confections

Product Manger Product Manager Product Manager

Bottling Plant Warehouse Distribution

Cost
Manager Manager Manager
Centers
Superior Foods Corporation provides an example of the
various kinds of responsibility centers that exist in an
organization.
Return on Investment (ROI) Formula
Income before interest
and taxes (EBIT)

Net operating income

ROI =
Average operating assets

Cash, accounts receivable, inventory,

plant and equipment, and other
productive assets.
 Understanding ROI
Net operating income
ROI =
Average operating assets
Net operating income
Margin =
Sales
Sales
Turnover =
Average operating assets

ROI = Margin  Turnover

 Increasing ROI
There are three ways to increase ROI . . .
Reduce
Increase Expenses Reduce
Sales Assets
 Criticisms of ROI
In the absence of the balanced
scorecard, management may
not know how to increase ROI.

Managers often inherit many

committed costs over which
they have no control.

Managers evaluated on ROI

may reject profitable
investment opportunities.
Residual Income - Another Measure of
Performance

Net operating income

above some minimum
return on operating
assets
 Calculating Residual Income

Residual
income
=
Net
operating -
income
(
Average
operating
assets

Minimum
)
required rate of
return

This computation differs from ROI.

ROI measures net operating income earned relative to the
investment in average operating assets.
Residual income measures net operating income earned less
the minimum required return on average operating assets.
Motivation and Residual Income
Residual income encourages managers to
make profitable investments that would
be rejected by managers using ROI.
Divisional Comparisons and Residual
Income
The residual
income approach
has one major
disadvantage.
It cannot be used
to compare the
performance of
divisions of
different sizes.