Analyzing Financial Performance Reports

Need for comparing actual to budgeted

 Even the best run organization cannot make perfect
forecasts.
 Forecasts always contain errors – random and non-
random.
 How should we assess the performance of a
responsibility center manager when the budgeted
performance does not match actual performance.
 Through variance analysis, a control mechanism.
 Variance analysis would reveal what caused the
deviations and what should be done in future.
 In this chapter, we will discuss:

• Post-budget control.
• The need for computing variances
• Variance as a control measure
• The different types of variances
• Using variances to evaluate performance
 Variances
 Traditionally, variances or deviation of
actual from budgeted numbers is done at
periodic intervals.
 Is this adequate?

 Recent approach: do such analysis on a

routine basis or as a continuous
improvement approach.
 Variances
 Computing variances is simple; it should
be extended from top to the lowest levels
of management to develop a true
understanding of the causes.
 The variance should be broken into its
different elements – revenue, expenses,
etc.
Before we proceed, let us briefly go over a
few basic cost/managerial concepts

 The following costs:

• Standard cost
• Fixed cost
• Variable cost
• Are standard cost same as budgets?
 Standard Costs
 Standards are benchmarks.
 In the context of manufacturing or
services, standard costs represent each
major input (e.g. raw materials, labor
time) that a product or service must use.
 Cost standards refer to how much you
should pay for an item or service.
 It is a management by exception concept.
 Fixed costs
 A cost that remains constant, in total,
regardless of changes in the level of
activity.
 Examples: rent, investment in machinery,
building
 Consequently, more the level of activity,
smaller the fixed cost per unit of activity
or vice versa.
 Variable Costs
 Variable cost is cost that varies, in total, in
direct proportion to changes in the level
of activity.
 Example: as units produced increases, raw
material usage, direct labor costs will go
up proportionately.
 Total costs rises and falls with the level of
activity.
 Cost behavior
 Remember: Costs – both fixed and
variable work only within a relevant
range.
 For example, whether you produce 10
units or 100,000 units, will the variable
cost per unit remain the same? No.
 Many costs might also have a fixed and
variable components. E.g. Telephone bill
 Basic Variance Analysis
 Analyzing the factors that caused the
actual and budgeted (costs, revenues,
production units, etc.) is called variance
analysis.
 Usually, variance analysis is separated
into two categories – quantity and price.
 This is because the same individual may
not be responsible for both quantity and
price.
 A basic variance model –
Price and Quantity variances
Actual Quantity Actual Quantity Standard Quantity
of inputs of inputs allowed for output
at Actual Price at Standard Price at Standard Price
(AQ x AP) (AQ X SP) (SQ x SP)
(1) (2) (3)

Price Variance Quantity Variance

1-2 2 -3
Materials Price Materials Quantity Variance
Variance Labor efficiency variance
Labor rate variance Variable overhead efficiency
Variable overhead variance
spending variance

Total Variance
 Let us use the following data from
Colonial Pewter Co.
Std. Qty Std. Price Std. Cost
Inputs or Hours or Rate
(1) (2) (1) x (2)
Direct materials 3 pound $ 4.00 $12.00
Direct Labor 2.5 hours 14.00 35.00
Variable Mfg. overhead 2.5 hours 3.00 7.50
Total std. cost per unit $54.50

Standard cost of direct materials per unit of product = 3 lbs x $4 per lb = $12 per unit.
Purchasing records show that in June, 6,500 lbs. of pewter were purchased at a cost
of $3.80 per pound. The cost included freight and handling. All of the materials
purchased was used during June to manufacture 2,000 lbs of pewter bookends.
Using the data, let us computer price and quantity variances.
Price and Quantity variances for Colonial Pewter
Actual Quantity Actual Quantity Standard Quantity
of inputs of inputs allowed for output
at Actual Price at Standard Price at Standard Price
(AQ x AP) (AQ X SP) (SQ x SP)
(1) (2) (3)

6,500 pounds x $3.80 6,500 lbs. x $4.00 6,000 lbs. x

per lb. = $24,700 = $26,000 $4.00 = $24,000

Price variance = $1,300 F Quantity Variance

= $2,000 U

Total Variance = $700 U

 Interpretation
 First, $24,700 refers to the actual total cost of the pewter
that was purchased during June.
 Second, $26,000 refers to what the pewter would have cost if
it had been purchased in the standard price of $4.00 a
pound rather than the actual price of $3.80 per pound.
 Difference between first and second, $1,300 is the price
variance.
 Third, $24,000 represents cost of Pewter if it were
purchased at standard price and if standard quantity had
been used.
 The difference between second and third is the quantity
variance.
In the previous example, the quantity of pewter
purchased was 6,500 lbs. and the
Quantity used in production was also 6,500 lbs. But,
such occurrences are rare. More common is, the
quantity purchased will be greater than quantity used
and the excess quantity will be carried out as ending
inventory to the next period. How would you compute
variances under such conditions?

Let us look at the next slide. Out of 6,500 lbs.

purchased, only 5,000 lbs. were used (Standard lbs.
allowed for the production is 4,800 lbs = 1,600 units x
3 lbs. per unit). Usually, price variance is computed as
soon as purchases are made while quantity variance
may overlap into more than one period.
 Price and Quantity variances when quantity
purchased and used differ
Actual Quantity Actual Quantity Standard Quantity
of inputs of inputs allowed for output
at Actual Price at Standard Price at Standard Price
(AQ x AP) (AQ X SP) (SQ x SP)
(1) (2) (3)

6,500 pounds x $3.80 6,500 lbs. x $4.00 4,800 lbs. x

per lb. = $24,700 = $26,000 $4.00 = $19,200

Price variance = $1,300 F

5,000 lbs. x 4.00 per pound = $20,000

Quantity Variance
= $800 U
 Revenue variances
 Unlike cost variances, revenue variances
focus on
• selling prices and how
• Volume of sales and
• Mix (of various products)
 Impact revenue and profitability
 Selling Price Variance
 We will use the data from chapter 10 –
exhibit 10.3 and 10.4
 What causes selling price variance?

 Difference between the price you set

(budgeted price) and the actual price at
which you sell (using actual volume of
sales).
 Exhibit 10.4 – Sales Price Variance
 Three products – A, B, and C
 The budgeted prices are $1.00, 2.00, and
3.00 respectively
 Actual selling price was $0.90, 2.05, and
2.50 respectively.
 Actual volume of sales in units – 100, 200,
and 150 respectively.
 Sales price variance is = [100 (1.00 -0.90) +
200 (2.00 – 2.05) + 150 (3.00 – 2.50)] = 75
 Mix and Volume Variance
 The firm sells several products (mix) and the
volume of sales for each is different.
 If we do not separate the mix and volume into
separate components (to get a general overview),
then the equation to compute a combined
mix/volume variance is
 Mix/Vol. variance = [Actual Vol. – Bud.
Volume] * Budgeted contribution
 Contribution = Selling price – variable costs only
 Exhibit 10.5 –
Combined Mix and Volume Variance

Actual Bud. Difference Unit Variance

Product Volume Volume 4 contribution 6
1 2 3 (2-3) 5 (4-5)
A 100 100 0 -- --
B 200 100 100 $0.90 $90.00
C 150 100 50 1.2 $60.00

Total 450 300 150

The$150 variance is favorable in this example because the actual sales

volume for the three products combined was more than what was budgeted
Now, if you want to separate the mix and volume
variances by each product -
 We can find this by using the following equation:
Mix variance =
[(Total act. Vol. of sales * Bud. Proportion) –
(Act. Vol. of sales) * (Bud. Unit contribution)]

Volume variance = is easy to compute; We already

computed the combined variance. From this, subtract the mix
variance to be computed using above equation = Volume variance

Let us look at exhibit 10.6 from the textbook

 Mix Variance
Bud. Mix
Bud. at Actual Difference Unit Variance
Product Proportion Volume Actual Sales 5 contribution 7
1 2 (3) 4 (4-3) 6 (5) * (6)
A 1/3 150 100 -50 0.2 -10
B 1/3 150 200 50 $0.90 45
C 1/3 150 150 0

Total 0 450 450 0 1.1 35

• See Column 3 and 4 – A higher proportion of B was sold while a lower

proportion A was sold to A.
• Since the contribution margin for B is higher (0.90) compared to A (0.20),
the mix variance is favorable (35)
 Volume variance separated from mix variance
Exhibit 10. 6

 We already computed the combined

mix/volume variance (three slides earlier).
It is 150.
 The mix variance we just computed is 35.

 Therefore, volume variance =

150 - 35 = 115
 Isolation of Variances
 At what point should variances be isolated
and brought to the attention of the
management?
 Earlier the better.
 What should management do?
 Variances should be viewed as ‘red flags.”
 Seek explanations for the reasons behind
variances and then decide, responsibility,
course of action.
 Other relevant issues of Variance Analysis –
Time period comparison

Is comparison of annual budgets with

annual performance reports better than,
 Quarterly budgets with quarterly
performance comparisons?
 Or, shorter period comparisons?

 It depends on the objectives of the decision

maker.
 Other relevant issues of Variance Analysis –
selling price or gross margin?

 We computed revenue variances based on

selling prices. Is this realistic?
 Does selling price remain constant
throughout the year?
 And, if not, a better approach would be to
focus on gross margin (selling price- cost
per unit) than on sales prices to compute
variances.
Who is generally responsible for monitoring and
taking action on variances?
 One who can control the variance.
 Example:

• Purchase manager for purchase price variance

and
• Production manager for quantity variance.