MCS UNS MCS UNS chapter 6 :Variance chapter 6 :Variance

Analysis Analysis

28.03.0528.03.05

Internal ControlsChp 13

Business Strategy

Core Values

Chps 13

Belief Systems

Chps 12 & 13

Boundary Systems

StrategicUncertainties

Interactive Control Systems

Chp 10

Diagnostic Control Systems

Chp 10

Core ValuesRisks to be

Avoided

Critical PerfVariables

Chp 2 Chp 14

Course Map – Where are we? Organizing for Performance

Chp 3

Designing Employee Goals and Incentives

Chp 11

What to ControlChp 4

Building and Evaluating Budgets

Chps 5, 6, 7

Measuring PerformanceChps 8 & 9

4 LEVERS OF

CONTROL

Today’s Topic

Chp 6 - Evaluating Strategic Chp 6 - Evaluating Strategic Profit PerformanceProfit Performance

► IntroductionIntroduction

►Variance Analysis Overview – Theory Variance Analysis Overview – Theory behind ‘Crunching the Numbers’behind ‘Crunching the Numbers’

►Disadvantages and Advantages of Disadvantages and Advantages of Variance AnalysisVariance Analysis

Monitoring the Business Monitoring the Business StrategyStrategy

►Diagnostic FunctionDiagnostic Function►Used to evaluate:Used to evaluate:

Effectiveness – extent to which we met Effectiveness – extent to which we met our desired goals; compare actual to our desired goals; compare actual to expectedexpected

Efficiency – level of resources used to Efficiency – level of resources used to achieve specific outputsachieve specific outputs

Two Components of Two Components of Strategic Profitability (or Strategic Profitability (or

Value Creation)Value Creation)►Strategic ProfitabilityStrategic Profitability = =

Profit (loss) from competitive Profit (loss) from competitive effectivenesseffectiveness

(revenue variance)(revenue variance)

+ Profit (loss) from competitive efficiency+ Profit (loss) from competitive efficiency(cost variance)(cost variance)

Variance AnalysisVariance Analysis

►Variance – difference between actual Variance – difference between actual and expected (budgeted) performanceand expected (budgeted) performance

►Favorable variance – actual profit is Favorable variance – actual profit is higher than plannedhigher than planned

►Unfavorable variance – actual profit is Unfavorable variance – actual profit is lower than plannedlower than planned

Three Conditions necessary Three Conditions necessary in order to Evaluatein order to Evaluate

►There must be an way to measure There must be an way to measure outputs.outputs.

►A predetermined standard of A predetermined standard of performance must exist.performance must exist.

►There must be an ability to use There must be an ability to use variance information as feedback to variance information as feedback to make corrections and improvements.make corrections and improvements.

Variance Analysis CycleVariance Analysis Cycle

Strategic Profitability Strategic Profitability AnalysisAnalysis

►A tool used to evaluate the success of A tool used to evaluate the success of a business in generating profit from a business in generating profit from the implementation of its strategythe implementation of its strategy

►Composed of:Composed of: Analysis of competitive effectivenessAnalysis of competitive effectiveness Analysis of operating efficienciesAnalysis of operating efficiencies

Strategic Profitability Strategic Profitability AnalysisAnalysis

Strategic Variance Strategic Variance AnalysisAnalysis

Total Variance

REVENUE COST

Competitive Effectivenes

s

Competitive

Efficiency

Market Size

Market Share

Sales Price

Product Mix

Production Efficiency

Nonvariable Spending

Production Spending

Pros & Cons of Strategic Pros & Cons of Strategic AnalysisAnalysis

AdvantagesAdvantages DisadvantagesDisadvantages

Competitive EffectivenessCompetitive Effectiveness

►Must be able to set and implement Must be able to set and implement market strategymarket strategy

►Used for profit centers and stand alone Used for profit centers and stand alone businessesbusinesses

►Measured by two output indicators:Measured by two output indicators: Market share growthMarket share growth Price premiumPrice premium

Market Share VariancesMarket Share Variances

►Change in profits due to our Change in profits due to our market market shareshare:: Tells us how much of our change in profits is Tells us how much of our change in profits is

due to increases or decreases in due to increases or decreases in our hold on our hold on the marketthe market

►Change in market share due to Change in market share due to industry industry volumevolume:: Tells us how much of our increased Tells us how much of our increased

(decreased) sales is due to a (decreased) sales is due to a bigger (smaller) bigger (smaller) overall market for our productsoverall market for our products

Revenue VariancesRevenue Variances

► Increase in profit due to changes in Increase in profit due to changes in selling pricesselling prices Result of this variance lets management know how Result of this variance lets management know how

successful their price strategy wassuccessful their price strategy was Did they have to lower their price to sell products? Or were Did they have to lower their price to sell products? Or were

customers willing to pay a price premium?customers willing to pay a price premium?► Increase in profit due to changes in Increase in profit due to changes in product mixproduct mix

Results from selling a different proportion of products than Results from selling a different proportion of products than plannedplanned

Must evaluate why customers chose one product over Must evaluate why customers chose one product over anotheranother

► Increase in profit due to changes in Increase in profit due to changes in volumevolume This variance tells us whether we sold more units than This variance tells us whether we sold more units than

planned.planned.

Operating EfficienciesOperating Efficiencies

►How many resources were consumed to How many resources were consumed to achieve the actual outputs?achieve the actual outputs?

► This analysis can be used for any type of This analysis can be used for any type of business unit; including cost centers.business unit; including cost centers.

► Revenue variances tell us about Revenue variances tell us about performance in the market, and spending performance in the market, and spending and efficiency variances inform us about and efficiency variances inform us about how well managers used their internal how well managers used their internal capabilities of the business.capabilities of the business.

►Good to benchmarkGood to benchmark

Flexible BudgetFlexible Budget

► Flexible budget – budget made out for many Flexible budget – budget made out for many levels of activitieslevels of activities

► To calculate operating efficiencies, we must To calculate operating efficiencies, we must use the budget for our actual level of use the budget for our actual level of activity, not the static budget (if different activity, not the static budget (if different from actual)from actual)

► Static – 100,000 units, actual – 102,000 Static – 100,000 units, actual – 102,000 unitsunits

►Must make out a new budget for 102,000 Must make out a new budget for 102,000 units to compare actual to budgetunits to compare actual to budget

Variable CostsVariable Costs

►Materials and labor can often be Materials and labor can often be broken down into price and quantity broken down into price and quantity variances. Texts also call these variances. Texts also call these spending and efficiency variances.spending and efficiency variances.

►Materials Spending varianceMaterials Spending variance - Tells if - Tells if you spent more or less than standard you spent more or less than standard price per unit of materialprice per unit of material

►Causes and responsibility for varianceCauses and responsibility for variance

Variable CostsVariable Costs

► Materials Efficiency varianceMaterials Efficiency variance –tells whether you –tells whether you used more or less materials than the standard used more or less materials than the standard called forcalled for

► Causes and responsibility for varianceCauses and responsibility for variance► Labor Spending varianceLabor Spending variance -tells if you spent more or -tells if you spent more or

less than standard price per unit on laborless than standard price per unit on labor► Causes and responsibility for varianceCauses and responsibility for variance► Labor Efficiency variance Labor Efficiency variance –tells whether you used –tells whether you used

more or less labor hours than the standard called more or less labor hours than the standard called forfor

► Causes and responsibility for varianceCauses and responsibility for variance

Nonvariable costsNonvariable costs

► Spending variance: Planned cost – Actual costSpending variance: Planned cost – Actual cost► Committed fixed costsCommitted fixed costs►Discretionary fixed costsDiscretionary fixed costs► Activity-Based costsActivity-Based costs

Volume varianceVolume variance - Impact on profits due to changes - Impact on profits due to changes in cost-driver activityin cost-driver activity

Efficiency varianceEfficiency variance – Impact on profits due to – Impact on profits due to changes in efficiencychanges in efficiency

Spending varianceSpending variance – Impact on profits due to – Impact on profits due to changes in cost of resourceschanges in cost of resources

Cost Center and Discretionary Cost Center and Discretionary Cost CenterCost Center

►The hallmark of two centers should be The hallmark of two centers should be understood in terms of the following understood in terms of the following factors:factors:

Budget preparationBudget preparation

Type controlType control

Performance measurementPerformance measurement

Uses of Variance AnalysisUses of Variance Analysis

► Calculation of variances do not explain causesCalculation of variances do not explain causes► Variances should be investigatedVariances should be investigated

Often reasons for variances are explained beside Often reasons for variances are explained beside the calculated variancethe calculated variance

► Favorable variances are not always goodFavorable variances are not always good► Unfavorable variances are not always badUnfavorable variances are not always bad► It is not good to net variancesIt is not good to net variances

Netting of variances may cancel out large favorable Netting of variances may cancel out large favorable variances against large unfavorable variancesvariances against large unfavorable variances

Uses of Variance AnalysisUses of Variance Analysis

►Management by exception – allows Management by exception – allows managers to focus only on those variances managers to focus only on those variances which are truly out of the ordinarywhich are truly out of the ordinary Management by exception allows managers to Management by exception allows managers to

focus on certain areasfocus on certain areas Maximizes return on managementMaximizes return on management

► Variance analysis should be performed often Variance analysis should be performed often in order to make corrections in order to make corrections as early as as early as possiblepossible – at least every month if possible – at least every month if possible

► Any variance is only as good as the Any variance is only as good as the standards or planned activity to which standards or planned activity to which actual is compared!!!!!!actual is compared!!!!!!

Evaluation StandardsEvaluation Standards

► Predetermined standards – carefully determined Predetermined standards – carefully determined standards can be established using ideal standards can be established using ideal circumstances, practical circumstances, or some circumstances, practical circumstances, or some other basis.other basis. Ideal standards will show a lot of unfavorable variances.Ideal standards will show a lot of unfavorable variances.

► Historical standards – often past inefficiencies Historical standards – often past inefficiencies passed onpassed on

► External standards – benchmarks External standards – benchmarks Comparison to other companies in industryComparison to other companies in industry Can be obtained from private sources for a feeCan be obtained from private sources for a fee Some library sourcesSome library sources

Strategic Variance Analysis Strategic Variance Analysis ExerciseExercise

You are the new controller for a firm and are You are the new controller for a firm and are asked to analyze these nonvariable cost asked to analyze these nonvariable cost variances:variances:

1.1. Advertising shows an unfavorable Advertising shows an unfavorable variancevariance

Are you concerned?Are you concerned?

2.2. R&D spending is far below budgetR&D spending is far below budget Should you reward the R&D manager?Should you reward the R&D manager?

3.3. Employee training has a large negative Employee training has a large negative variancevariance

Should you fire the HR Manager?Should you fire the HR Manager?

Summary - Summary - Strategic Variance Analysis Strategic Variance Analysis

► It is an imperfect control toolIt is an imperfect control tool

► In reality, it is not important if the In reality, it is not important if the variance is variance is UU (unfavorable) or (unfavorable) or FF (favorable) (favorable)

►What is What is keykey is that managers are is that managers are asking the right questions and then asking the right questions and then pursuing appropriate actionpursuing appropriate action