New CMA Part 1 Section B

8/10/2019 New CMA Part 1 Section B

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2010 CMA Part 1 Section BPerformance Management 3

Introduction to Variance Analysis and

Standard Costs


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Variance Analysis

Variance analysis is the comparison between theactual results for the period and the budgetedresults.

Variance analysis is an attempt to determine why

the actual results were different from the budgetedresults.

Either the quantity sold (or purchased), or the pricereceived (or paid), was different than expected, or both.

Variances enable management to focus itsattention on areas where something was wrong.


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Standard Costs

A standard cost is an estimate of the cost thecompany expects to incur in the productionprocess. It is the standard against which tomeasure the actual performance.

Standard costs are calculated at the beginning ofeach year and are based on the estimated costsand the expected level of activity or production.

Standard costs are determined through the use of

accounting and production estimates.

Standard costs are used to control costs. A largevariance between actual cost and standard cost is

an alert to management.


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Standard Costs Contd

A standard cost is not the same thing as a standardcost system.

A standard cost prescribes expected performance interms of cost.

A standard cost system is an accounting system thatuses standard costs and standard cost variances in theformal accounting system.

There are other types of accounting systems, and

standard costs can be used with those accountingsystems as well. In these other systems thestandard costs are used for control purposesoutside the formal accounting system.


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A standard cost system can be used with either ajob order costing system or a process costingsystem.

A process costing system is used to assign costs toindividual products when the products are all relativelysimilar and are mass-produced, as on an assembly line.

A job-order costing system is a method in which all of thecosts associated with a specific job (or client) areaccumulated and charged to that job (or client).


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Standard costs are used with a flexible budgetingsystem.

A flexible budget enables the company to identifydifferences from the budget that are not simply due

to the actual quantity sold or produced beingdifferent from the budgeted or standard quantity tobe sold or produced.

A flexible budget is a budget prepared using standard

per-unit amounts and the actual level of activity.


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Determining the Level of Activity

Costs are the result of activities that createproducts or render services. Standards should beestablished for the cost drivers underlying thecosts.

An expected, or budgeted, level of activityforproduction must be determined in order to calculatestandard costs.

It is important to use the correct level of activity

when developing standards.


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Determining the Level of Activity Contd

Choices of levels of activity to use:

Ideal, perfect, or theoreticallevel of outputassumesno breakdowns, no waste and no time lost and thatworkers are working at maximum efficiency.

Practical, or currently attainable, level of outputthe

level achieved given the normal amount of time lost,waste, and a normal learning curve for employees.

Attainable, but difficult to attain.

Normal level of outputan average expected level of

production within a period of several years, giveneffective and efficient production and customer demand.

Master budget capacitythe planned output for the nextbudget period.


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Reviewing the Established Standard Cost

The established standard costs need to be

reviewed periodically, because costs of the inputsinto the manufacturing process will change overtime.


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Sources of Standards

Standards can be set using several sources:

Activity analysis: Identifying, delineating or outlining, and evaluating all the

activities necessary to complete a job, a project or an operation

Considers everything required to complete the task efficiently and

involves personnel from several areas including engineers,management accountants and production workers

Time consuming and expensive.

If properly executed, it is the most precise way to determinestandard costs.

Use of historical data less costly way since historical data for a similar product can be a

good source if reliable information is available.

Advantage: using historical data is that it is based on the way the

particular firm has operated in the past.


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Sources of Standards Contd


Benchmarking: based on current practices of similar operations in other firms.

Associations of manufacturers often collect industry informationand have data available. The firm can use this data as guidelines

By using benchmarking to set standard costs, a firm can haveaccess to the best performance anywhere and this can helpsustain its competitive edge.

A disadvantage of using benchmark data is that it might not becompletely applicable to the firms own situation.


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Sources of Standards Contd


Use of target costing: Use of target costing to set standard costs puts the focus on the

market and on the price the product can be sold for

A target price is the price the firm can sell its product for, and the

target cost is the cost that must be attained for the firm to realizeits desired profit margin for the product.

Once the target cost has been determined, detailed standardsare then set to attain the desired cost.

Strategic decisions: Strategic decisions may affect a products standard cost. For

instance, a decision to replace an obsolete machine with a new,computer-controlled machine would require an adjustment to thestandard cost for the process.


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Management by Exception

Variance reporting enables management by

exceptionwhich permits management to focus onareas where there are problems, as identified bythe variance from the standard.

Disadvantages of management by exception: Negative trends may be overlooked at earlier stages,

before they show up as variances.

If too many deviations from the standards occur, it

becomes a very confusing and involved process becausemanagement is trying to fix all of the problems at once.


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Variance Analysis Concepts


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Variance Analysis Concepts

Variances are a comparison between the actual

results and the budgeted, or standard, results.

More detailed levels of variance analysis determinethe cause for the difference:

whether the actual quantity was different or whether the actual price per unit was different, or

whether both quantity and price differences caused thevariance.


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Static Budget Vs Flexible Budget Variances Variances can be looked at from a variety of levels

and perspectives. The total static budget variance is the difference

between the actual results and the static (ormaster) budget.

This is the broadest variance, and not very usefulbecause much of it may be explained by the fact thatactual sales were different than expected.

This variance may be broken down into two sub-

variances:1. The flexible budget variance is the differencebetween actual results and the flexible budget amount.

2. The sales volume variance is the difference betweenthe flexible budget and the static budget amount.


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Variances: Favorable or Unfavorable When calculating variances for incomes or

expenses, always subtract the Budget amountfrom the Actual amount.

Actual Budget = Variance

A positivevariance for an incomeitem is aFavorablevariance

A negativevariance for an incomeitem is anUnfavorable variance

A positivevariance for an expenseitem is anUnfavorablevariance

A negativevariance for an expenseitem is a

Favorable variance


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Types of Variances Manufacturing Input Variances

Direct Materials Variances Price Variance

Quantity or Efficiency Variance

Mix Variance

Yield Variance

Direct Labor Variances

Rate (Price) Variance

Efficiency (Quantity) Variance

Mix Variance

Yield Variance


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Types of Variances Contd

Factory Overhead Variances

Total Variable Overhead Variance

Variable Overhead Spending Variance

Variable Overhead Efficiency Variance

Total Fixed Overhead Variance Fixed Overhead Spending or Budget Variance

Fixed Overhead Production-Volume Variance

Sales Variances

Sales Price Variance

Sales Volume Variance

Quantity Variance

Mix Variance


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Variance Abbreviations

The formulas for the different variances all have

common elements to them. The followingabbreviations are used:

AQActual Quantity

SQStandard Quantity for the actu al level of ou tpu t APActual Price

SPStandard Price

WASPAMThe weighted average standardprice of the

actual mix WASPSMThe weighted average standardprice of the

standard mix


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Manufacturing Input Variances

Concerned with inputs to the manufacturing process

Whether the amount of inputs used per unitmanufactured was over or under the standard

Whether the costof inputs used per unit manufacturedwas over or under the standard

Standard (expected, budgeted) costs are determinedusing an estimated cost and estimated level of usage.

If the company either pays a different price per unit of

the input purchased than planned or uses a differentamount of inputs than planned, the actual cost will bedifferent from the budgeted cost.


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Manufacturing Input Variances Contd

Input cost variances are subdivided into

A price variancereflecting the difference between actualand budgeted input prices, and

A quantity variance, also called an efficiency variance,reflecting the difference between actual and budgeted

input quantities.

Variance analysis enables management to identifythe specific reasons for variances and then to focus

its efforts on the variances that are unfavorable.


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Intro to Direct Materials Variances

The total materials variance is the difference

between the actual direct material costs and theexpected direct material costs in the flexiblebudget.

Note that these variances are not caused bymanufacturing more units than were planned.

Variances are caused by either using more inputs perunit manufactured than the standard per unit, or bypaying more per unit used than the standard per unit,or both.

These differences need to be further examined toidentify what caused the difference.


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Direct Materials Variances

The total materials variance may be broken down

into two smaller variances:1. The quantity variance, and

2. The price variance.


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The Quantity Variance The quantity variance is also called the efficiency

variance, or the usage variance. It measures the effect on the total variance that wascaused by the actual quantity used being differentfrom the expected quantity to be used for the actuallevel of output that was produced.

The formula for the quantity variance is:

(AQSQ) SP

If the result is positive,actual cost was greater

than planned because the company used moreinputs per unit manufactured than it had planned.Since this is a cost, the variance is Unfavorable.

If the result is negative, actual cost was lowerthanplanned, and the variance is Favorable.


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The Price Variance The price variance measures the effect on the total

variance that was caused by the actual price beingdifferent from the expected price.

The formula for the price variance is:

(APSP) AQ

If the result is positive, actual cost was greaterthan planned because the he company paid morethan it expected to for each unit that was

purchased. Since this is a cost, the variance isUnfavorable.

If the result is negative,actual cost was lowerthanplanned, and the variance is Favorable.


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The Variance Formulas and Using Them

In addition to being able to solve for the amount of

the variance, you also need to be able to use theseformulas to solve for any of the variables.

In a question, it is possible that you will be given what thevariance is and will need to calculate what the standardprice, or the actual quantity, or another variable was.

This is not difficult as it is simply an algebraic equation inwhich you need to solve for the missing variable. This iseasy after you have identified the equation that must be

used.

You also need to be able to understand what maycause a variance or a combination of variances.


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Accounting for Direct Materials Variances

Standard costing systems use actual variance

accounts to record the variances from the standardcosts as they occur.

The following accounting is performed at the time of

purchase: Purchases of direct materials are recorded as debits to

the materials inventory account at their standard cost

If the company recognizes price variances at the time of

purchase, any difference in price from the standard isrecorded in a direct materials purchase price varianceaccount (a debit if the price is higher than the standardand a credit if the price is lower than the standard)

The credit is booked to accounts payable


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Accounting for Direct Materials Variances Contd


material requisition to production: When direct materials are requisitioned from the

materials inventory for use in production, the debit toWork-in-Process inventory is for the standard quantity

of materials that should have been used formanufacturing the units manufactured at their standardcost.

The credit to the materials inventory account is for the

total amount of the material actually used at theirstandard cost

The difference is the direct materials quantity variance,and it is recorded in the direct materials quantity variance

account


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Accounting for Direct Materials Variances Contd

These entries isolate the variances in special

accounts so they can be analyzed. It also maintainsstandard costs in the Work-in-Process inventoryaccounts during the production process.

At the end of the period, the variances are closedout to cost of goods sold or, if material, proratedamong cost of goods sold, Work-In-Processinventory, and Finished Goods inventory.


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Intro to Direct Labor Variances

The direct labor variances are almost exactly the

same as the direct material variances.

The formulas are the same, but the names given tothe variances are a little bit different.

The total labor variance is the difference betweenthe actual labor costs and the expected labor costsin the flexible budget.

Variances result either by using more direct labor per

unit manufactured than the standard per unit, or bypaying more per unit used than the standard per unit,or both.

This difference needs to be further examined to identify

what caused the difference.


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The Direct Labor Variances

The total labor variance may be broken down into

two smaller variances:1.The labor rate (or price) variance, and

2.The labor efficiency (or quantity) variance.


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The Labor Efficiency Variance The efficiency variance measures the effect on the

total variance that was caused by the actualquantity used being different from the expectedquantity to be used for the actual level of output thatwas produced.

The formula for the labor efficiency variance is:(AQSQ) SP

If the result is positive, the variance is Unfavorablebecause the company used more labor than itexpected to for the level of output actuallyproduced.

If the result is negative,the variance is Favorable.


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Accounting for Direct Labor Variances

Standard costing systems use actual variance

accounts to record the variances from the standardcosts as they occur.


production for direct labor: The production payroll is recorded by debiting Work-in-Process inventory for the total number of standardhours for the units manufacturedat the standardhourly rate.

The credit is accrued payroll at the total number ofhours actually spentand at the actual rate.

The difference is recorded in the direct labor varianceaccounts depending upon the type of variance.


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Accounting for Direct Labor Variances Contd

At the end of the period, the variances are closed

out to cost of goods sold or, if material, proratedamong cost of goods sold, Work-In-Processinventory, and Finished Goods inventory.

Note: the company must also choose how the costsof employee related costs such as employeebenefits and payroll taxes are treated. They may beincluded in the cost of direct labor or treated as an

overhead and allocated to the units produced. Insome cases they may be treated as a period cost.


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More than One Material or Labor Input The variances already discussed are used when

there is only one type (or class) of labor or material. When there is more than one input (either labor or

material), the total price (or rate) variance, iscalculated as follows:

1. The price (or rate) variance is calculated for eachindividual input separately, and

2. These individual variances are added together.

When there is more than one input, the totalquantity (or efficiency) variance is calculated inthe same manner as the total price (or rate)variance.


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The Yield Variance (Materials or Labor)

The yield variance results from a difference

between the total quantity of the inputs that wereactually used to produce the actual output and thetotal standard quantity that should have been usedto produce the actual output.

Needed (calculate):

Weighted Average StandardPrice of the StandardMix(WASPSM)

The formula for the yield variance is:(AQ SQ) WASPSM


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Factory Overhead Variances

In addition to calculating variances for materials

and labor, variances may also be calculated formanufacturing (factory) overhead. These variancesare:

Total Variable Overhead Variance Variable Overhead Spending Variance

Variable Overhead Efficiency Variance

Total Fixed Overhead Variance

Fixed Overhead Spending (or Budget) Variance



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Total Variable Overhead Variance

This is also called the flexible budget variance.

It is equal to the difference between the actualvariable overhead incurred and the standardvariable overhead applied, based on the standardusage of the allocation base.

The total variable overhead variance is calculatedas:

Actual Total Variable Overhead Incurred

Flexible Budget Amount of Variable Overhead

= Total Variable Overhead Variance

The total variable overhead variance can bebroken down into spending and efficiency

variances.


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Variable Overhead Spending Variance This is essentially the same as a price variance and

determines how much of the total variance wascaused by the actual variable overhead cost perunit of the allocation base actually used beingdifferent from the standard overhead application

rate per unit of the allocation base actually used. The formula is:

(APSP) AQ

Remember that it is not a price in this case, butrather the overhead application rate. We have leftthe variables the same to indicate how similar thisis to the materials and labor variances.


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Variable Overhead Efficiency Variance This is essentially the same as the quantity

variance and determines how much of the totalvariance was caused by the actual number of theallocation base (direct labor hours, number ofparts) used being different than the expectednumber of the allocation base to be used.

The formula is:

(SQAQ) SP

Again, remember that it is not a price in this case,but rather the overhead application rate. We haveleft the variables the same to indicate how similarthis is to the materials and labor variances.


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Example: Variable Overhead Variances

Variable overhead is applied based on machine

hours. Total budgeted production: 200,000 units

Standard quantity of machine hours allowed per

unit: 2. Standard variable overhead cost per machine hour:

$1.50.

Actual production: 180,000 units

Actual machine hours used: 450,000 hours

Actual variable overhead incurred: $603,000


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E l 1 VOH S di V i


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Example 1: VOH Spending Variance

The Variable Overhead Spending Variance is:

1

F

1450,000 machine hours actually used $1.50/hr. = $675,000

Actual Variable Overhead Incurred $603,000

Less: Standard Amount of VOH $Allowed for the Actual Quantity of the

VOH Allocation Base Used for theActual Output 675,000

Total Variable Overhead Variance $ (72,000)


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E l VOH Effi i V i


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Example: VOH Efficiency Variance

The Variable Overhead Efficiency Variance, using

the variance formula (AQ SQ) SP is:

(450,000 360,0001) $1.50 = $135,000 U

12.0 machine hrs. standard/unit 180,000 unitsproduced = standard quantity of 360,000 MH

The Variable OH Efficiency Variance was $135,000

Unfavorable because instead of the 2.0 machine hoursplanned to be used for each unit produced, 2.5 machine hourswere used (450,000 total actual hours used 180,000 unitsproduced).

E l T t l V i bl OH V i


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Example: Total Variable OH Variance

Here are the individual variable overhead variances

combined, and their total is the Total VariableOverhead Variance:

F

U

U

Variable Overhead Spending Variance $(72,000)

Variable Overhead Efficiency Variance 135,000

Total Variable Overhead Variance $ 63,000

E l I t t ti f V i bl OH V i


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Example: Interpretation of Variable OH Variances

Calculating variances is only the beginning. The

next step is to interpret them. The Total Variable Overhead Variance was

$63,000 Unfavorable, because the actual amount

of variable overhead incurred was $63,000 greaterthan the flexible budget amount. Why?

Investigation should be performed into why moremachine hours were used per unit than planned

and why the actual variable overhead incurred permachine hour was lower than the expected amount.

Th Fi d O h d V i


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The Fixed Overhead Variances

The fixed overhead variances are different from all

of the previous variances we have looked at. This isbecause fixed factory overhead (rent, for example)is not dependent on quantity produced, or sales, oranything.

Also, because of the nature of these expenses,much less control can be maintained or effectedover these costs. If the production is less than

expected, there will be an unfavorable variance, butthere is little that can be done to change, or control,the fixed overhead costs.

T t l Fi d O h d V i


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Total Fixed Overhead Variance The total fixed overhead variance analysis is the

difference between the actual fixed overheadincurred and the amount that was applied using thestandard rate and the standard usage for the actuallevel of output.

Actual Fixed Overhead Incurred Applied Fixed Overheads1

= Total Fixed Overhead Variance

1Standard rate per unit of application base Standard amt.of application base for actual output

Note that this amount is the same as the over- orunder-applied fixed factory overhead.

Fi d O h d S di (B d t) V i


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Fixed Overhead Spending (Budget) Variance

The Fixed Overhead Spending (also called the

Fixed Overhead Budget) Variance is simply thedifference between the actual fixed overhead costsand the budgeted fixed overhead amount.

Actual Fixed Overhead Incurred

Budgeted Fixed Overhead (Static Budget Amt.)

= Fixed Overhead Budget/Spending Variance

Fi d O h d P d ti V l V i


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The Fixed Overhead Production-Volume Variance is the

difference between the budgeted amount of fixed over-head and the amount of fixed overhead applied. It iscaused by the actual production level being differentfrom the production level used to calculate the

budgeted fixed overhead rate.Budgeted Fixed Overhead (Static Budget Amt.)

Applied Fixed Overheads1

= Fixed overhead production-volume variance1Standard rate per unit of application base Standard amt. ofapplication base for actual output

E l Fi d O h d V i


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Example: Fixed Overhead Variances

Fixed overhead is applied based on machine hours.

Total budgeted fixed overhead: $1,000,000

Total budgeted production: 200,000 units

Standard quantity of machine hours allowed per unit:

2. Standard fixed overhead cost per machine hour:

$1,000,000 200,000 units 2 MH/unit =$2.50/MH. (Also, $5 per unit)

Actual production: 180,000 units

Actual machine hours used: 450,000 hours

Actual fixed overhead incurred: $1,200,000


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Example: FOH Production Volume Variance


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Example: FOH Production-Volume Variance

The Fixed Overhead Production-Volume Variance

is:

1

U

1$2.50/MH 2 MH/unit 180,000 units produced

The variance is Unfavorable because the actual output waslower than planned. The facilities were under-used, and so lessoverhead was applied to units produced than anticipated.

Static Budget Fixed Overhead $1,000,000

Less: Fixed Overhead Applied 900,000


$ 100,000

Example: Total FOH Variance


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Example: Total FOH Variance

Here are the individual fixed overhead variances

combined, and their total is the Total FixedOverhead Variance:

U

U

U

Fixed Overhead Spending Variance $200,000


100,000

Total Fixed Overhead Variance $300,000

Example: Interpreting the FOH Variances


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Example: Interpreting the FOH Variances The $200,000 Unfavorable Fixed Overhead

Spending Variance needs to be investigated to findout why fixed costs were higher than planned, toidentify the source of the variance.

The $100,000 Unfavorable Fixed Overhead

Production-Volume Variance measures the amountof excess fixed costs that the company incurred forfixed manufacturing capacity that it planned to usebut did not use. By their very nature, fixed costs donot decrease if usage is lower than anticipated.

The interpretation of this variance depends upon thereason for the lower production, which should beinvestigated.


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2 3 and 4 way OH Variance Summary


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2, 3 and 4-way OH Variance SummaryIn table format, this is the presentation of 2-way, 3-way and 4-way variance analysis, with our variances:

Variable Overhead Variances Fixed Overhead Variances

EfficiencyVariance

$135,000 U

SpendingVariance

($72,000) F

SpendingVariance

$200,000 U

Prod.-VolumeVariance

$100,000 UEfficiencyVariance

$135,000 U

Spending Variance (Var &Fixed)

$128,000 U


$100,000 U

Controllable Variance

$263,000 U


$100,000 U

OH Variance Summary C td


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OH Variance Summary ContdThe Controllable Variance of $263,000 is equal to

the difference between the total actual overheadincurred (variable and fixed) and the total flexiblebudget overhead (variable and fixed).1

1Note: For fixed overhead, the flexible budget and the static budgetamounts are the same, because fixed overhead does not change withchanging activity levels.

Variable Fixed Total

Total Actual Overhead $603,000 $1,200,000 $1,803,000

Less: Total FlexibleBudget Overhead

540,000 1,000,000 1,540,000

Total Variances $ 63,000 $ 200,000 $ 263,000


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Sales Variances

Sales Variances


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Sales Variances

Variance analysis can be used to assess the selling

department as well as the production department. Sales variances are used to explain the differencesbetween actual and budgeted amounts of revenue,variable costs, and contribution margin caused

by differences between actual sales results andplanned or budgeted sales results.

These variances can be caused by differences insales prices charged, differences in sales volume,

differences in variable cost per unit, and bydifferences in the mix of products sold.

They are called Sales Variances to differentiatethem from manufacturing input variances.

Sales Price Variance for a Single Product Firm


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Sales Price Variance for a Single Product Firm

The Sales Price Variance is the same as the

Flexible Budget Variance. Since the Flexible Budget is adjusted to the actual

sales volume, the only cause for a variancebetween the actual and the flexible budget amountsis sales price charged (for revenue) or variablecosts of sales (for costs)i.e., price variances.

The Sales Price Variance for a single product firm

is calculated as:(AP SP) AQ

Sales Volume Variance for a Single Product Firm


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Sales Volume Variance for a Single Product Firm

The Sales Volume Variances measures the impact

of the difference in sales volume between theactual results and the STATIC budget.

The Sales Volume Variance for a single productfirm is calculated as:

(AQSQ) SP

If only a Flexible Budget is used to make

comparisons to actual results, the Sales VolumeVariance will be zero, because the actual quantitysold will be the same as the budgeted (i.e.,standard) quantity.

Single Product Firm Variances Contd


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Single Product Firm Variances Cont d

The Sales Price Variance and the Sales Volume

Variance can be calculated for the Revenue,Variable Costs, and Contribution Margin lines.

For Revenue and Contribution Margin, a positivevariance amount is Favorable (revenue orcontribution margin were higher than planned); anda negative variance amount is Unfavorable (theywere less than planned).

For Variable Costs, a positive variance amount isUnfavorable (costs were higher than planned); anda negative variance amount is Favorable (theywere less than planned).

Summary of Single Product Variances


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Summary of Single Product Variances

For a single product firm, Flexible Budget Variances are

due to differences in prices, and Sales VolumeVariances are due to differences in quantity.

When comparing actual resultsto the stat icbudget,the Flexible Budget Variances are due to price while

the Sales Volume Variances are due to quantity. When comparing actual resultsto the f lexiblebudget,

there will be no Sales Volume/Quantity Variance (i.e.,the variance will be zero). This is because the quantity

in the flexible budget is the same as the actual quantity.

The Flexible Budget Variance plus the Sales VolumeVariance equals the Static Budget Variance.

Sales Variances When More Than One Product Is Sold


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Sales Variances When More Than One Product Is Sold

When more than one product is sold, the Sales PriceVariance is calculated differently from the way it iscalculated for a single product firm.

The Sales Volume Variance (or Sales QuantityVariance) is also calculated differently, although it is

also true that when the actual results are comparedwith the Flexible Budget, the Sales Volume Variancewill be zero.

The Sales Volume Variance is subdivided into a

Sales Mix Variance and a Sales Quantity Variance. This breakdown of the Sales Volume Variance is similar

to the way manufacturing quantity variances aresubdivided when there is more than one input.

Sales Price Variance for a Multi-Product Firm


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Sales Price Variance for a Multi-Product Firm

This is also the Flexible Budget Variance.

Calculate each products individual sales pricevariance and sum the variances:

The Sales Price Variance for a multi-product firm is:

(AP SP) AQ

This variance can be calculated for revenue,variable costs, or contribution margin.

It is the portion of the total variance caused by thefact that the sales prices received for the units soldwere different from the budgeted sales prices.


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Sales Mix Variance for a Multi-Product Firm


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Sales Mix Variance for a Multi Product Firm

The Sales Mix Variance incorporates the impact of

the differences between the actual product mix soldand the budgeted product mix and its effect onwhichever line is being analyzed (revenue, variablecost, or contribution margin).

It works in much the same manner as the mixvariance for labor or material, using the weightedaverage standard price for the actual mixWASPAM) and the weighted average standard

price for the standard mix (WASPSM).

The formula is:

(WASPAMWASPSM) AQ


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Market Variances

Market Variances


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Market Variances

The Sales Quantity Variance can also be analyzed

as to why it occurred. The difference between actual and expected sales

units may be connected to two potential areasrelated to the market.

1. The actual market was bigger or smaller than wasexpected,

2. The companys market share was bigger or smallerthan expected.

The market variances measure how much of thedifference was a result of these two potentialfactors.

Market Size Variance


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Market Size Variance

This measures how much of the Sales Quantity

Variance for the contribution margin was caused bythe market itself being bigger or smaller than wasexpected.

The formula for the Market Size Variance is:

(Actual Market Size inUnitsExpected Market

Size in Units) ExpectedMarket Share %

Standard Weighted

Average ContributionMargin per Unit


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Variance Analysis for a Service Company


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Variance Analysis for a Service Company A service companys product is the service it

provides. An example of a pure service company isa public accounting firm. The public accounting firmhas no cost of goods sold because its sole productis the service it provides.

Service companies can have the followingvariances: price, volume (quantity), mix (related tothe services they provide) and overhead

If a service company provides service only, then it can

calculate price, quantity and mix variances for therevenue line.

Variance Analysis for a Service Company Contd


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Variance Analysis for a Service Company Cont d

If the company provides both a service and a

product such as replacement parts, the companyshould segregate its service revenue from its partsrevenue in its accounting system.

It can then analyze its service revenue in isolation while

analyzing the parts sales variances the same way areseller would analyze its sales variances: revenue,variable costs, and contribution margin.

Variance Analysis for a Service Company Contd


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Variance Analysis for a Service CompanyCont d Variance analysis can also be done by any

company on its selling, and general andadministrative overhead costs.

Variable overhead can be a large component of a servicecompanys costs, and it needs to be used in

A service organization may have high fixedoverhead costs. If revenue declines, the fixedoverhead costs remain, and the company canquickly find itself in financial trouble.

Fixed overhead variance reporting can detect this earlyand may enable the company to make changes in itsfixed cost structure to respond to the decreased sales.


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Responsibility Centers and Reporting

Segments^^

Responsibility Centers


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p y A responsibility center is any part of an organiza-

tion. It may be a product line, a geographical area,or any other meaningful unit.

The main classifications of centers, from the mostfundamental (basic) to the least fundamental, are:

A cost center is responsible only for the incurrence ofcosts (any revenue it may earn is immaterial).

Cost centers are measured on their efficiency (obtainingthe most with the least use of resources).

Training and maintenance are examples of cost centers. A service center is a type of cost center that provides

services to other departments.

Responsibility Centers Contd


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p y

Classifications of responsibility centers continued:

A revenue center is responsible only for generatingrevenues and is not measured by its expenses.

A sales department is a revenue center.

It is measured on its effectiveness (how much did it sell).

A profit center is responsible for both the incurrence ofcosts and generating revenue.

It is measured in respect to both efficiency andeffectiveness.

An example is a department within a larger store, such aslinens.

Responsibility Centers Contd


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p y

An investment center is responsible not only for the

incurrence of costs and generating revenues, but also forproviding a return on an investment.

An investment center is most like a complete business inand of itself. However, it is part of the larger organization.

A branch office in a different location would be an example.

It is measured using return-on-investment.

Return on investment emphasizes that the departmentmust provide a return to the larger company.

A company wants to have as many of its units be

investment centers as possible.

Evaluating Managers and Departments


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g g p

Whenever an evaluation of a manager is made, it is

important that the manager be evaluated only onthings that they are able to control.

For example, a line manager may be evaluated based onthe cost of production as they have control over that, but

should not be evaluated by the effectiveness of themarketing campaign as they have no control over that.

Similarly, departments should not be evaluated onthings that they cannot control.

Local departments cannot control the amount of centralcosts that are charged to them, so these costs shouldgenerally not be included when evaluating thedepartment.


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Systems for Cost Allocation


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y Cost allocations can be done based on various

systems: Cause and effect: activities that cause resources to beconsumed are identified, and cost allocations are basedupon each responsibility centers usage of the resources

Benefits received: based upon the benefit received byeach responsibility center

Fairness or equity: allocation should be reasonable orfair. It is a matter of judgment. This approach is often a

requirement for government contracts when a price to thegovernment is based on costs and cost allocations.

Ability to bear: costs are allocated based upon theability of the responsibility center to bear the cost

Systems for Allocating Common Costs Contd


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y g

An alternative: allocate some percentage of each

departments contribution to covering the commoncosts, rather than actually allocating common coststo each department.

This will enable managers to see themselves as

contributing to the overall success of the company ratherthan paying for a central administration cost that theymay not perceive as adding value to their operations.

Ways of Allocating Common Costs


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y g

There are two main ways in which common costs

may be allocated: Stand alone cost allocation, and

Incremental cost allocation.

Stand-Alone Cost Allocation


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Thestand-alone cost allocation method allocatescosts proportionately among all users on somebasis that relates to each users proportion of theentire organization.

This could be based on each responsibility centersother costs as a proportion of the companys totalcosts; or it could be the proportion of eachresponsibility centers sales in relation to total salesof the entire company.

The cost allocation methods discussed in Section Cof this text (i.e., direct method, step method,reciprocal method) are all stand-alone cost allocationmethods.

Incremental Cost Allocation


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The incremental cost-allocation methodranksusers of a cost object according to their total usage or

on some other basis. The first-ranked user of the activity is called the

primaryuser. The primary user is charged for costsup to what its cost would be if it were the only user.

Then, the next-ranked user(s) are called theincrementalusers and are allocated the additionalcost, proportionately if there is more than one

incremental user. This is advantageous for a new responsibility centers suchas a new branch office just building its business, if it can becharged as an incremental user ,as its costs can be lower.

The Contribution Income Statement


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One way to be able to more easily identify the

performance of different managers or departmentsin the organization is to use a contribution incomestatement.

In short, this classifies costs according to whocontrols them.

We will look at the different lines of the contributionincome statement.


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Contribution Margin


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Manufacturing contribution margin

Variable nonmanufacturing costs= Contribution margin

This is the amount that is available to cover fixed

costs after all variable costs are covered, and leavesome for profit.

Controllable Margin


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This is also called short-term segment managerperformance.

Contribution margin

Controllable fixed costs

= Controllable margin

Controllable fixed costs are the costs the segmentmanager can control. This is important because it is a measurement of all the

revenues and expenses (variable and fixed) that arecontrollable by the individual managers on a short-term(less than one year) basis.

The controllable margin is a good measure of amanagers short-term performance.

Segment Margin


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This is also called contribution by strategic businessunit.

Controllable margin

Noncontrollable, traceable fixed costs

= Segment Margin

Noncontrollable, traceable fixed costs are costs thesegment manager cannot control over the short term,such as depreciation, but they can be traced to thatdepartment.

The segment margin is a measure of the performance ofeach business unit. It may also be used as a measure ofthe long-termperformance of the manager, ifthemanager can control the noncontrollable traceable fixedcosts over a long-term period.

Net Income


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Segment margin

Noncontrollable, untraceable fixed costs= Net income

Noncontrollable, untraceable fixed costs are thecosts that are incurred at the company level and

would continue even if the individual segment werediscontinued. Because they would continue if any individual segment

was discontinued, these costs should not be allocated

to the individual departmentsor segments. Rather, they are subtracted from the sumof the

segment margins to calculate the companys net

income.

Transfer Pricing


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The transfer price is the price charged by one unit ofthe company to another unit of the same companyfor the services or goods produced by the first unitand sold to the second unit.

Profit and investment centers use transfer pricing

to calculate the costs of services received fromservice departments and revenues when selling a

product that has an outside market to anotherdepartment.

Transfer pricing is most common in firms that arevertically integrated, i.e., they are engaged in severaldifferent value-creating operations for a product.

Goals of a Transfer Pricing System


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A transfer system must accomplish the following:

It must give senior management the information it needsto evaluate the performance of the profit centers

It must motivate the profit center managers to pursuetheir own profit goals while also working towards the

success of the company as a whole It must encourage the cost center managers efficiency

while maintaining their autonomy as managers of profitcenters

It must be equitable, permitting each unit of a company toearn a fair profit for the functions it performs

It must meet legal and external reporting requirements

It should be easy to apply

Transfer Pricing Decisions


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Ultimately, the method used to calculate thetransfer price is determined by top management.

They must identify a method that will motivate managersto make the best decisions for the entire company.

The methods used for transfer pricing include:

Market price (this is often the best method) Cost of production plus opportunity cost

Variable cost

Full cost

Cost plus Negotiation

Arbitrary pricing

Dual-Rate pricing


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Transfer Pricing Methods Contd


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Variable costthe variable costs of the sellingdivision only. Advantage: Works well when the seller has excess

capacity and when the objective is just to satisfy theinternal demand for goods.

Disadvantage: Not appropriate if the seller is a profit or

investment center because it decreases their profitability. Full costthe full cost of production including all

materials, labor, and a full allocation of overhead. Advantages: Well understood and cost information is

easily available. No need to eliminate intracompanyprofits in consolidated statements; easy comparisonbetween actual and budgeted costs.

Disadvantage: Because it includes fixed costs, it can bemisleading and cause poor decision-making.


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Negotiationthe selling and buying departmentsagree on a price.

Each department must have the ability to determine theamount of materials it buys or the amount of its output itsells.

Enables both parties to operate as if they were dealing

with an unrelated party and can lead to good long-termdecisions.

Most useful when the products in the market are rapidlychanging and companies need to react quickly to the

changes. Also helpful when the units are having a conflict and

negotiation can bring about a resolution.

It can negatively impact the units autonomy.



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Arbitrary Pricingcentral management decides

on a price to achieve some overall objective suchas tax minimization

Advantage of this approach is that it achieves theobjectives that central management considers most

important Disadvantages far outweigh the advantages because it

defeats the goal of making divisional managers profitconscious. It hampers their autonomy as well as theirprofit incentive



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Dual-Rate pricingthe selling and purchasing

departments each record the transaction atdifferent prices.

Advantage of this method is that the selling division hasan incentive to expand sales and production; while, at the

same time, the buying division gets to book the productat its actual cost to the firm. No artificial profit exists forthe selling division. Variable cost is used for decisionmaking but market price is used for evaluation

Disadvantage of this method is the complexity becausedivisional profits are determined using different bases.

Transfer Pricing Contd


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Any cost-based method does not provide anymotivation for the producing department to control

costs.

However, cost-based transfer pricing is perhaps thebest method if the buying department is not

required to buy from another internal department. If the buying department is unable to choose its supplier,

the manager of the supplying department will not bemotivated to control costs.

In deciding which method to use, managementconsiders: The goals of the company

The capacity of the producing department

Transfer Pricing and Capacity


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If the producing department has excess capacityand can produce what is required by the otherdepartment, the minimum price that they will chargeis the variable cost of production.

Any transfer price between the variable cost of

production and the market price will be beneficial to bothdepartments.

If the producing department does not have excesscapacity, they will need to charge a transfer price

that: Covers the variable costs of production, and

Recovers any lost contribution from the units that theyare not able to produce because of this order.


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Performance Measures


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Performance needs to be measured and rewardedin a way that motivates managers to achieve thecompanys strategic objectives and operationalgoals.

Goal congruenceIndividuals and organization

segments are all working toward achieving theorganizationsgoals. Managers should be evaluated ontheir achievement of goals that benefit the company, noton their achievement of goals that benefit their owndepartment or division.

Short-term versus long-term focusEmphasis onshort-term profits endangers long-term success becausemanagers will eliminate or postpone activities that arevital for the firms long-term success.


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Performance Measurement


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In addition to the contribution income statement,

there are other tools for financial and performancemeasurement that you need to be familiar with:

Return on Investment (ROI), and

Residual Income (RI).

Return on Investment


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ROI is the key performance measure for an

investment center. It provides the measure of the percentage of return

that was provided on the dollar amount of theinvestment (i.e., assets).

The formula is:Net income of the Investment Center

Average Total Assets (Investment Base) of the Investment Center

Several different measurements of investment areused.


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Residual Income


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Residual Income provides a $ based measure

instead of a % measure. It measures the amount ofincome the company achieved in excess of adetermined target income.

Two terms that are involved in RI are:

The targeted amount of return is usually somepercentage of the total assets of the division or theinvested capital in the division, and

The percentage used in the calculation is the target

rate that management has set.


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Residual Income Contd


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Because it measures a dollar amount, RI is not

useful in comparing projects or departments ofdifferent sizes.

RI is useful when different projects (ordepartments) have different risks or operating

environments, because a different target rate canbe used for each segment to take these intoaccount.

RI is useful for evaluating managers, because itmotivates them to maximize an absolute amount(dollars) instead of a percentage.

Accounting Methods and Performance Measurement


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2010 CMA Part 1 Section BPerformance Management

127

When items such as inventory and fixed assets are

used in calculating performance measures, theirvalues are influenced by the chosen accountingmethods.

When comparing two business units, both units should

use the same inventory valuation, depreciation, revenuerecognition and expense recognition methods in order tobe comparable.

Performance Measurement in Multinationals

Wh t i diff t t i it


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128

When a company operates in different countries, itcreates additional difficulties in comparingperformance of its operating divisions.

Government controls on selling prices

Varying tax rates

Tariffs and customs duties Availability and costs of labor, materials and

infrastructure vary

Economic, legal, political, social and cultural

environments vary Different currencies, exchange rate fluctuations and

differences in inflation rates

Expropriation risk

Performance Measurement in Multinationals Contd


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129

Foreign currency calculation of ROI used to

compare two divisions: Both divisions incomes should be restated into U.S.

dollars at the average exchange ratein effect during theyear.

Both divisions assets should be restated into U.S. dollarsat the exchange rate that was in effect when theassets were acquired.

The Balanced Scorecard More companies are using a more encompassing


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130

More companies are using a more encompassingmethod of evaluation that includes financial and

nonfinancial measures - called a balancedscorecard.

The common categories (perspectives) measured are

Financial perspective - profitability

Customer perspective - identifying the marketsegment(s) to target and then measuring success inthose segments.

Internal business process perspective - products andservices, operations and customer service/support

Innovation and learninga culture that supportsemployee innovation, growth and development

Balanced Scorecard Contd


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131

The scorecard used by an individual business

should depend upon its strategy. The business should select just a few measures

critical success factorsthat are most relevantto its business strategy and track those measures

rigorously.

Managements attention needs to be focused on

these few key measures and not be distracted by

measures that are not critical.

Balanced Scorecard ContdA strateg map links the fo r perspecti es


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132

A strategy maplinks the four perspectivestogether and provides a way for all employees tosee how their work is linked to the corporations

goals.

Beginning at the bottom, innovation and learningcontributes to the goals of the internal business processperspective.

Operational improvements made in operations support(business process perspective) contribute to thecompanys ability to fulfill the goals of customer

satisfaction (customer perspective).

Customer satisfaction brings about increased business,increased profits and improved financial performance(financial perspective).

The Balanced Scorecard Contd The balanced scorecard is a tremendous evaluation


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133

The balanced scorecard is a tremendous evaluationtool when it is used correctly.

However, there are several problems with using thebalanced scorecard approach to performanceevaluation:

It is difficult to use scorecards to make comparisonsacross business units, because each business unit hasits own scorecard.

In order to implement balanced scorecard performancemeasurement, it is necessary for a firm to have extensive

enterprise resource planningsystems to capture thedetailed information required.

Nonfinancial data is not subject to control or audit andthus its reliability could be questionable.

Customer Profitability Analysis


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134

80% of profits usually come from the top 20% of a

firms customers. To maintain competitive advantage, a firm needs to

work to attract and keep profitable customers whilediscouraging unprofitable customers from dragging

down profits. Customer profitability analysis can be used to

determine the profitability of individual customers or

groups of customers. Profitability information can be used for targeted

marketing, as well.

Product Profitability Analysis


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Product profitability analysis can identify products

and services that are unprofitable so thoseproducts and services can be either repriced ordiscontinued.

Accurate allocations of common costs are critical

when customers and products are being evaluatedfor their profitability.

Documents

New CMA Part 1 Section B