Chapter 16 – Fundamentals of Variance Analysis
16-1
Chapter 16
Fundamentals of Variance Analysis
Learning Objectives
1. Use budgets for performance evaluation.
2. Develop and use flexible budgets.
3. Compute and interpret the sales activity variance.
4. Prepare and use a profit variance analysis.
5. Compute and use variable cost variances.
6. Compute and use fixed cost variances.
7. (Appendix) Understand how to record costs in a standard costing system.
Chapter Outline
I. USING BUDGETS FOR PERFORMANCE EVALUATION
II. PROFIT VARIANCE
♦ Why are actual and budgeted results different?
III. FLEXIBLE BUDGETING
IV. COMPARING BUDGETS AND RESULTS
♦ Sales activity variance
V. PROFIT VARIANCE ANALYSIS AS A KEY TOOL FOR MANAGERS
A. Sales price variance
B. Variable production cost variances
C. Fixed production cost variance
D. Marketing and administrative variances
VI. PERFORMANCE MEASUREMENT AND CONTROL IN A COST CENTER
♦ Variable production costs
1. Direct materials
2. Direct labor
3. Variable production overhead
VII. VARIABLE COST VARIANCE ANALYSIS
A. General model
B. Direct materials
• Responsibility for direct materials variances
C. Direct labor
Chapter 16 – Fundamentals of Variance Analysis
16-2
1. Direct labor price variance
2. Labor efficiency variance
D. Variable production overhead
1. Variable production overhead price variance
2. Variable overhead efficiency variance
E. Variable cost variances summarized in graphic form
VIII. FIXED COST VARIANCES
A. Fixed cost variances with variable costing
B. Absorption costing: The production volume variance
1. Developing the standard unit cost for fixed production costs
2. Compare with the fixed production cost price variance
IX. SUMMARY OF OVERHEAD VARIANCES
♦ Key points
X. SUMMARY
XI. APPENDIX: RECORDING COSTS IN A STANDARD COST SYSTEM
A. Direct materials
B. Direct labor
C. Variable manufacturing overhead
D. Fixed manufacturing overhead
E. Transfer to finished goods inventory and to cost of goods sold
F. Close out variance accounts to cost of goods sold
Key Concepts
LO 16-1 Use budgets for performance evaluation.
♦ The development of the master budget is the first step in the budgetary planning and control
cycle.
• The budgeting process provides a means to coordinate activities among units of the
organization, to communicate the organization’s goals to individual units, and to ensure
that adequate resources are available to carry out the planned activities.
• In the control and evaluation activity, the performance of units and managers is
evaluated and actions are taken in an attempt to improve performance.
• The budget serves as the benchmark for units of the firm or for organizations that do not
routinely prepare public reports.
• The budget is management’s plan for financial performance.
Chapter 16 – Fundamentals of Variance Analysis
16-3
♦ The master budget includes operating budgets (such as the budgeted income statement,
production budget, budgeted cost of goods sold, and supporting budgets) and financial budgets
(budgets of financial resources, including the cash budget and the budgeted balance sheet).
• When management uses the master budget for control purposes, it focuses on the key
items that must be controlled to ensure the company’s success.
• The income statement is the most important financial statement that managers use to
control operations.
• Variance is the difference between planned result and actual outcome. That is,
Variance = Actual result – Budgeted performance.
• Variance analysis is used to
(1) evaluate the performance of individuals and business units, and
(2) identify possible sources of deviations between budgeted and actual performance.
• The simplest measure of performance is the variance between actual income and
budgeted income.
• A favorable variance is the variance that, taken alone, results in an addition to
operating profit. An unfavorable variance is the variance that, taken alone, reduces
operating profit.
• When discussing revenue, income, or contribution margin, a favorable variance means
the actual result is better than the budgeted result. When discussing costs, a favorable
variance indicates that actual costs are less than budgeted costs.
• The labels “favorable” and “unfavorable” should not be considered as evaluations of
performance without additional investigation.
• Although a simple comparison of planned and actual profit suggests that performance
was better (or worse) than planned, the additional data (such as those in Exhibit 16.2)
provide information on the impact on profit performance from each of the revenue and
cost line items.
• The additional information is useful for two reasons.
(1) It allows the manager to investigate more efficiently the causes of off-budget
performance, and
Chapter 16 – Fundamentals of Variance Analysis
16-4
(2) It allows the manager to evaluate subordinate managers responsible for various
aspects of the firm’s operations.
• An important part of variance analysis is to understand
(1) what might cause a difference between actual and budgeted results, and
(2) what portion of the total profit variance is due to each cause.
• The following table summarizes the variance analysis between actual results and the
master budget for line items comprising the operating profit
Actual
(1)
Variancea
(3) = (1) – (2)
Master Budget
(2)
Units
xx
xx F or U
xx
Sales revenue
$xx
$xx F or U
$xx
Less: Variable costsb
(xx)
(xx) F or U
(xx)
Contribution margin
$xx
$xx F or U
$xx
Less: Fixed costsc
(xx)
(xx) F or U
(xx)
Operating profit
$xx
$xx F or U
$xx
a For revenue, income, or contribution margin, (F)avorable variance results when
(3) > 0. For cost items, (F)avorable variance results when (3) < 0.
b Including variable manufacturing costs and variable selling and administrative costs.
c Including fixed manufacturing overhead and fixed selling and administrative costs.
======================
Demonstration Problem 1
The accountant at EZ Toys, Inc. is analyzing the production and cost data for its Trucks Division.
For October, the actual results and the master budget data are presented below.
Actual results
Budget data
10,000 trucks produced and sold
12,000 trucks planned
Unit selling price
$15
Unit selling price
Variable costs:
Unit variable cost:
Direct materials
$52,800
Direct materials
Direct labor
51,000
Direct labor
Variable overhead
23,000
Variable overhead
Total variable costs
$126,800
Total unit variable costs
Fixed overhead
$9,000
Fixed overhead
Chapter 16 – Fundamentals of Variance Analysis
16-5
Required:
Prepare a variance analysis to compare actual results and the master budget.
Solution:
Actual
(1)
Variance
(3) = (1) – (2)
Master Budget
(2)
Units
10,000
2,000 U
12,000
Sales revenue
$150,000
$18,000 U
$168,000a
Less: Costs
Variable costs
Direct materials
$52,800
$7,200 F
$60,000b
Direct labor
51,000
3,000 U
48,000c
Variable overhead
23,000
1,000 F
24,000d
Total variable costs
$126,800
$5,200 F
$132,000
Contribution margin
$23,200
$12,800 U
$36,000
Fixed overhead
9,000
600 F
9,600
Operating profit
$14,200
$12,200 U
$26,400
F = Favorable variance.
U = Unfavorable variance.
a 12,000 units @ $14.
b 12,000 units @ $5.
c 12,000 units @ $4.
d 12,000 units @ $2.
======================
LO 16-2 Develop and use flexible budgets.
♦ One obvious reason that actual results might differ from budgeted results is that the actual
activity itself differed from the budgeted or expected activity.
• A static budget is developed in detail for one level of anticipated activity, such as a
master budget.
• A flexible budget indicates budgeted revenues, costs, and profits for virtually all
feasible levels of activities.
• Because variable costs and revenues change with changes in activity levels, these
amounts are budgeted to be different at each activity level in the flexible budget.
Chapter 16 – Fundamentals of Variance Analysis
16-6
• Flexible budget line is the expected costs at different output levels and can be
represented by the following formula:
Total budgeted
costs
=
Budgeted
fixed cost
+
Budgeted unit
variable cost
×
Activity level
(Units produced and sold).
• The flexible budget line (see Exhibit 16.3) is an estimated cost-volume line because it
shows the budgeted costs allowed for each level of activity.
• The master budget is based on an ex ante (before-the-fact) prediction of the activity
level. The flexible budget is based on ex post (after-the-fact) knowledge of the actual
activity level.
LO 16-3 Compute and interpret the sales activity variance.
♦ A comparison of the master budget with the flexible budget and with actual results is the basis
for analyzing differences between plans and actual performance.
♦ Sales activity variance (also known as sales volume variance) is the difference between
operating profit in the master budget and operating profit in flexible budget that arises because
the actual number of units sold is different from the budgeted number. That is,
Sales activity
variance
=
Flexible budget
(based on actual activity)
–
Master budget
(based on planned activity).
For sales
revenue:
Budgeted unit price ×
Actual units
–
Budgeted unit price ×
Budgeted units
For variable
costs:
Budgeted unit cost ×
Actual units
–
Budgeted unit cost ×
Budgeted units
• The budgeted unit price and budgeted unit cost are used in the flexible budget instead of
the actual unit price and actual unit cost in order to isolate the effects of volume alone.
• Sales activity variance, as shown in Exhibit 16.4, is useful for management because
(1) It isolates the change in operating profits caused by the actual activity being different
from the master budget level.
Chapter 16 – Fundamentals of Variance Analysis
16-7
(2) The resulting flexible budget shows budgeted sales, costs, and operating profits after
considering the activity change but before considering differences in unit selling
prices, variable costs, and fixed costs from the master budget.
• Variable costs are expected to decrease when volume is lower than planned, resulting in
favorable variances.
LO 16-4 Prepare and use a profit variance analysis.
♦ Profit variance analysis shows the causes of differences between budgeted profits and the
actual profits earned.
• The actual results can be compared with both the flexible budget and the master budget
in a profit variance analysis, as shown in Exhibit 16.5.
(1)
(2)
(3)
(4)
(5)
(7)
Actual
(based on
actual
activity)
Manufacturing
variances
Marketing and
Administrative
variance
Sales price
variance
Flexible
budget
(based on
actual
activity)
Master
budget
(based on
planned
activity)
Sales revenue
$xx
$xx U or F
$xx
$xx
Less:
Variable costs
Variable manufacturing cost
(xx)
$xx U or F
(xx)
(xx)
Variable marketing and
administrative cost
(xx)
$xx U or F
(xx)
(xx)
Contribution margin
$xx
$xx
$xx
Less:
Fixed costs
Fixed manufacturing cost
(xx)
xx U or F
(xx)
(xx)
Fixed marketing and
administrative cost
(xx)
xx U or F
(xx)
(xx)
Operating profit
$xx
$xx U or F
$xx U or F
$xx U or F
$xx
$xx
Total variance from flexible budget
Total variance from master budget
• Column (1) is the reported income statement based on the actual sales. Column (2)
summarizes production variances. Column (3) shows marketing and administrative
variances.
• Cost variances result from deviations in costs and efficiencies in operating the company.
They are important for measuring productivity and for helping to control costs.
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16-8
• Variable cost variances in Columns (2) and (3) are input variances; variable cost
variances in Column (6) are part of the sales activity variance.
• Column (4) shows the sales price variance as derived from the difference between the
actual revenue and budgeted selling price multiplied by the actual number of units sold.
That is,
Sales price
variance
=
Actual
revenue
–
Budgeted
selling price
×
Actual
units sold
=
(Actual
selling price
–
Budgeted
selling price)
×
Actual
units sold.
• Variable costs in Column (5) represent what should have been spent given the actual
sales volume.
• The fixed production cost variance is the difference between actual and budgeted costs
because the flexible budget’s fixed costs equal the master budget’s fixed costs.
• Marketing and administrative costs are treated like production costs. Variable costs are
expected to change as activity changes. Fixed marketing and administrative costs do not
change as volume changes.
======================
Demonstration Problem 2
(Continued from Demonstration Problem 1)
Required:
Prepare a profit variance analysis.
Chapter 16 – Fundamentals of Variance Analysis
16-9
Solution:
Actual
(based on
actual
activity of
10,000 units
sold)
Manufacturing
variances
Sales price
variance
Flexible
budget
(based on
actual
activity of
10,000 units
sold)
Sales
activity
variance
Master
budget
(based on
12,000
units
planned)
Sales revenue
$150,000
$10,000 F
$140,000a
$28,000 U
$168,000
Less: Costs
Variable costs
Direct materials
$52,800
$2,800 U
$50,000b
$10,000 F
$60,000
Direct labor
51,000
11,000 U
40,000c
8,000 F
48,000
Variable overhead
23,000
3,000 U
20,000d
4,000 F
24,000
Total variable costs
$126,800
$110,000
$22,000 F
$132,000
Contribution margin
$23,200
$30,000
$6,000 U
$36,000
Fixed overhead
9,000
600 F
9,600
0
9,600
Operating profit
$14,200
$16,200 U
$10,000 F
$20,400
$6,000 U
$26,400
F = Favorable variance.
U = Unfavorable variance.
a 10,000 units @ $14.
b 10,000 units @ $5.
c 10,000 units @ $4.
d 10,000 units @ $2.
======================
♦ For cost centers whose production managers typically do not control what they are asked to
produce, the actual unit production (not sales) should be used as a baseline.
• For any unit variable cost (such as direct materials), the variable cost in the budget is
determined by multiplying the budgeted amount of the direct material in each unit of
output by the expected price of each unit of direct material.
• The standard cost sheet is a form that provides standard quantities of inputs (direct
material, direct labor, and variable production overhead) required to produce a unit of
output and the standard (budgeted) unit prices for the inputs. See Exhibit 16.6 for an
example.
Chapter 16 – Fundamentals of Variance Analysis
16–10
• For each input,
Standard cost
per unit of output
=
Standard input
price or rate
per unit of input
×
Standard quantity
of input
per unit of output.
• The purchasing manager estimates the cost of direct materials with the correct
specification and quality.
• The standard labor rate includes wages earned as well as fringe benefits. Most
companies develop one standard for each labor category.
• The overhead “quantity” is expressed in terms of the units of the cost driver chosen
(such as direct labor hours) because that is what is being used to apply the overhead.
• To determine the variable production overhead rate, management reviews prior period
activities and costs, estimates how costs will change in the future, and performs a
regression analysis in which overhead cost is the dependent variable and certain cost
driver (such as direct labor hours) the independent variable.
LO 16-5 Compute and use variable cost variances.
♦ Comparing the budget (based on standard costing) to actual results identifies production cost
variances.
• Cost variance analysis uses a conceptual model that compares actual input amounts
and prices with standard input amounts and prices.
• Both the actual and standard input quantities are for the actual output attained.
• A price variance is the difference between actual costs and budgeted costs arising from
changes in the cost of inputs to a production process or other activity.
Price variance = (AP × AQ) – (SP × AQ) = (AP – SP) × AQ.
• An efficiency variance is the difference between budgeted and actual results arising
from differences between the inputs that were budgeted per unit of output and the inputs
actually used.
Efficiency variance = (SP × AQ) – (SP × SQ) = SP × (AQ – SQ).