Chapter 14 – Operational Performance Measurement: Sales, Direct-Cost Variances, and the Role of Nonfinancial
Performance Measures
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CHAPTER 14: OPERATIONAL PERFORMANCE MEASUREMENT:
SALES, DIRECT-COST VARIANCES, AND THE ROLE OF
NONFINANCIAL PERFORMANCE MEASURES
QUESTIONS
14-1 A master budget represents forecasted operating profit based on a single output
level (“planned sales”) for an upcoming period. As such, this budget is also
referred to as a static budget.
Pro-forma budgets represent budgeted operating income for various output
levels (production or sales). Pro-forma budgets can be prepared for any output
level within the relevant range.
flexible-budget variance. For this reason, some accountants refer to this budget
as a “control budget.”
14-2 Standard costs (and selling prices), and their use in the construction of flexible
budgets (prepared after the current operating period is over), establish targets or
unit, and total fixed costs.
14–3 Management time is scarce. According to the philosophy of management by
exception, managers give primary attention to things (operations, sales
promotions, production, revenue growth, productivity gains, etc.) that are not
going according to plan, or at least are departing materially from plan. The
part of managers is needed. On the other hand, when a variance is consider
“abnormal” (i.e., an “exception”) it may trigger the need for an investigation to
Chapter 14 – Operational Performance Measurement: Sales, Direct-Cost Variances, and the Role of Nonfinancial
Performance Measures
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uncover the underlying cause, which in turn may lead to some type of
intervention or change.
14-4 The performance of a division should not be considered as less than satisfactory
simply because all variances are “unfavorable.” For example, a company
expects unfavorable variances if it uses an ideal performance standard. As long
as there is making satisfactory progress toward the standard, unfavorable
and every operation.
14-5 Direct material price variances can be caused by any of the following factors:
purchasing material of a different quality than that envisioned in the standard
material cost; inapplicability of the standard cost per unit of raw material (i.e.,
outdated standards—the market price may have changed); purchasing was done
through a new supplier; delivery terms for purchases were different (and
therefore either more or less costly) than the terms envisioned when the standard
material costs were set; skill (or lack thereof) of the purchasing manager in
Direct materials usage variances can be caused by: poorly supervised
employees; inadequately maintained machinery and equipment; inappropriate
standard (e.g., standard is out–of-date, or the standard was set incorrectly); or,
the use of non-standard raw materials. Normally, the Production Manager is in
the best position to influence the direct materials usage (quantity) variance. Note,
however, that this variance might also be affected by decisions made by the
Chapter 14 – Operational Performance Measurement: Sales, Direct-Cost Variances, and the Role of Nonfinancial
Performance Measures
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14-6 Direct labor rate (price) variances could be caused by: highly skilled (and paid)
labor used in place of lower-skilled labor; standard is out of date (e.g., new labor
contract); or, overtime work that is included in direct labor cost (rather than
manufacturing overhead). In some cases, the Production Manager is in the best
position to influence the direct labor rate (price) variance because this individual
relates to how labor is deployed in the organization (e.g., skilled workers who are
paid more may be assigned to do tasks meant for lower-paid workers). In other
labor usage (efficiency) variance. However, this variance (as noted in 14–5
above) may be assigned to the Purchasing Manager if the purchase of inferior
materials caused excess labor-hour consumption.
One particularly interesting situation that students should be aware of is the
potential for overemphasizing labor efficiency variances when labor is essentially
a short-term fixed cost. In this case, the labor efficiency variance can be largely
attributable to lack of orders (i.e., lack of sales demand), not worker efficiency.
For this reason, some writers suggest that when labor is essentially a short-term
14–7 The answer depends on how overtime premium is treated by the accounting
system. If overtime premium is included as part of factory overhead, then the
higher wages paid due to overtime premium should not affect any direct labor
variances. However, for firms that include overtime premium in the total wages,
prospects of the firm. In short, the labels “favorable” and “unfavorable” are
defined solely on the basis of the impact of the variance (positive or negative) on
Chapter 14 – Operational Performance Measurement: Sales, Direct-Cost Variances, and the Role of Nonfinancial
Performance Measures
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short-term operating profit. It is a value judgment as to whether such variances
are positive or negative.
14-8 Of the three, for motivation and control purposes, standards based on the
average of recent historical performance are the least desirable. Many firms
prefer to use standards based on attainable performance in their standard cost
14-9 Establishing a standard cost system and identifying variances from the standard
are steps in gaining a better understanding of the operations and improving
operations. The focus of a standard cost system should be on influencing
excessive pressure, inflexibility, uneven reward systems, or excessive emphasis
on short-term financial results (profits) can all compromise the benefits of a
standard cost system.
14–10 Organizations engage in a variety of processes in order to deliver the stated
value proposition to its targeted customers and in order to achieve its stated
financial objectives. These processes, for expository purposes, might be grouped
materials from supplier firms; producing finished goods and services; and,
distributing the finished product to customers.
Chapter 14 – Operational Performance Measurement: Sales, Direct-Cost Variances, and the Role of Nonfinancial
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14–11 A JIT system is very different from a conventional manufacturing system. In a JIT
system, a good or service is produced or delivered only when a customer
requires it. Some describe this as “demand pull” rather than “push.”
JIT production requires a product layout with a continuous flow once
production starts. Underlying the JIT system is a continuous improvement
philosophy of eliminating or reducing delay, error, and waste, such as materials
goods. All types of inventories are kept on hand in case unforeseen events
occur. Little attention is given to studying efficient and inefficient activities, and
materials movement, storage, rework, and waiting time are part of the
conventional work environment.
Financial benefits resulting from a shift to cellular manufacturing, just–in–time
production, or continuous quality improvements may include the following:
1. Increased sales because the short production cycle time enables a
company to win customers by cutting the delivery time.
5. Reduced clerical costs for keeping inventory records.
6. Reduced financing costs of inventories
The adoption of a JIT philosophy affects the organization’s management
accounting and control system in two primary ways:
1. To support the move to JIT, the accounting system needs to monitor
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14–12 We might define total customer response time as the amount of time between
the time a customer places an order and the time when that order is received by
the customer. Manufacturing (production) cycle time can be defined as the
time-lapse between when the manufacturing department receives the order and
when the order is completed (i.e., when finished goods are created). (Note:
PCE = processing time ÷ total manufacturing time
PCE = processing time ÷ (processing time + moving time + storage
time + inspection time)
Alternatively, we can view PCE as the ratio of “value–added time” to the sum of
“value–added time” + “non-value-added time.” These terms are defined, and
Chapter 14 – Operational Performance Measurement: Sales, Direct-Cost Variances, and the Role of Nonfinancial
Performance Measures
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BRIEF EXERCISES
14–13 Budgeted (Pro-forma) Operating Profit = (cm/unit × #units) − FC
14–14 Total static (master) budget variance = actual operating income − static (master)
budget operating income
14–15 Sales volume variance = budgeted cm/unit × (actual sales volume − master budget
sales volume)
14–16 Sales price variance = actual sales volume × (actual − budgeted) selling price/unit
= AQ × (AP − SP)
14–17 Total static (master) budget variance in operating profit = actual operating profit −
static (master) budget operating profit
Sales volume variance in operating income = flexible-budget operating income −
master budget operating income
Flexible-budget variance = actual operating income − flexible-budget operating
income
= $30,000 − $35,000 = $5,000U
Chapter 14 – Operational Performance Measurement: Sales, Direct-Cost Variances, and the Role of Nonfinancial
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14–18 Direct materials usage (quantity) variance for PVC = Standard price/lb. × (actual lbs.
used – standard quantity of lbs. that should have been used, given the actual
output for the period)
14–19 Purchase price variance for PVC = actual pounds purchased × (actual – standard)
price/lb.
14–20 Flexible-budget variance for PVC = actual PVC cost for units produced – FB cost
= (actual price/lb. × actual lbs. used) – (actual output × standard #lbs./unit of
output × standard price/lb.)
14–21 Direct labor efficiency variance = standard wage rate/hr. × (actual – standard) direct
labor hours= SP × (AQ − SQ)
14–22 Direct labor rate (price) variance = actual hours worked × (actual – standard) wage
rate/hr.
Chapter 14 – Operational Performance Measurement: Sales, Direct-Cost Variances, and the Role of Nonfinancial
Performance Measures
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EXERCISES
14-23 Financial versus Operational Control; Behavioral Considerations in the
Standard-Setting Process (20 minutes)
As indicated in the text, we use the term “management accounting and control
system” to refer to the entire set of procedures and systems used by an organization
to monitor activities and guide actions in support of the overall goals and objectives
of the organization. As such, a comprehensive management accounting and control
While terminology may differ across textbooks and organizations, one useful way to
conceptualize feedback/performance evaluation systems is to view such systems as
consisting of two primary components: a financial control system and an operational
control system. The goal of the former system is to monitor financial results to
determine whether the organization is on-track in terms of its specified financial
One dimension of a financial control system is the use of flexible-budgets, standard
costs, and variance analysis—covered in Chapters 14, 15, and 16 of the text. In
essence, such procedures assess both effectiveness (e.g., did we attain budgeted
operating profits or budgeted sales volume for the period) and efficiency aspects of
financial performance (e.g., whether the purchasing department secured a favorable
price for materials purchased for production, or whether the organization used labor
No management accounting and control system is good or bad per se. Each is
judged, at least conceptually, by comparing costs and benefits. Among the more
important considerations are behavioral considerations. For example, one
consideration relates to the standard-setting process. Should standards be imposed
(authoritative), should employees whose performance will be judged develop the
standards (participative), or should the organization use a consultative process in
developing such standards?
Chapter 14 – Operational Performance Measurement: Sales, Direct-Cost Variances, and the Role of Nonfinancial
Performance Measures
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14–24 Financial versus Nonfinancial Performance Indicators for Operational Control
(15 minutes)
Repetitive operations, such as consumption of power (or direct materials) in an
automated manufacturing facility, require constant feedback and data to ensure that
the underlying process is “in control.” That is, the managers of such operations
cannot wait for financial reports in order to correct (put back into control) a
malfunctioning process. In this context, real-time nonfinancial performance
operating personnel are familiar with.
On the other hand, managers are likely to be more interested in financial operating
results, for several reasons. One, the performance of managers is often judged on
the basis of financial results. Two, financial metrics provide decision-makers with a
common unit that can be used to evaluate the economic effects of different courses
of action (e.g., changes in sources of supply, product mix, etc.). Operating
personnel might also be interested in financial performance indicators. For
example, such measures communicate to such individuals the “bottom–line” impact
of their decisions and operating efficiencies.
Chapter 14 – Operational Performance Measurement: Sales, Direct-Cost Variances, and the Role of Nonfinancial
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14–25 Behavioral Considerations (40- minutes)
1. Managerial time can be considered a scare resource. Time spent in terms of
securing operational control detracts from time spent dealing with issues of a more
strategic (or long-term) nature. For this reason, many managers embrace a
managerial philosophy known as “management by exception.” When variances
(e.g., labor cost variances) are considered immaterial, no intervention on the part
of management is required: the underlying system is considered to be “in control.”
When the variances are considered “large” or “material,” some kind of intervention
operating problems. Assuming standards are “internalized,” they may properly
motivate employees to work more efficiently, an important element of “control.”
2. A standard cost system can have a negative impact on worker motivation if the
standards are too “loose” (i.e., too easily attainable) or too “tight” (i.e., too difficult
to attain). In the former case, the standards tend to reduce productivity; in the latter
case, in the extreme, employees simply ignore the standards—that is, they do not
“internalize” the standards as legitimate goals. Some research in management
should not, as in the case of Chen, Inc., be used to assign “blame.” Rather, they
should be used positively to motivate continual operating improvements.
3. The purpose of this question is to get students to think about the strategic role of
standard costs and flexible budgets in a comprehensive management accounting
and control system. In this regard, students should think about both the costs and
benefits of using these elements of a traditional financial control mechanism.
Finally, the question should expose students to some of the current controversies
surrounding the use of standard costs and flexible budgets in “the new
manufacturing environment.” As such, students (particularly undergraduate
Criticisms/Limitations of Conventional Standard Cost Variance Analysis
1. Variances are too aggregated and concentrate on consequences rather than
the causes of problems. This criticism, in fact, gets to the heart of the issue:
whether traditional standard cost variance analysis provides useful information
for operational control purposes.
2. Traditional standard cost variance reports are too late to be useful. In order to
Chapter 14 – Operational Performance Measurement: Sales, Direct-Cost Variances, and the Role of Nonfinancial
Performance Measures
14–12
take prompt managerial action, accounting information should be timely. Due to
the use of modern scanning technologies, manufacturers can now monitor in
14–25 (Continued-1)
real time the consumption of resources (e.g., labor and materials). Traditional
3. Standard costing systems tend to focus too heavily on cost minimization. For
companies competing on the basis of cost (i.e., those pursuing a cost–
4. Standard costing systems take a departmental perspective rather than a
process perspective. The point here is that traditional standard costing systems
are not “integrated.” As such, each department or cost center tends to focus on
can be viewed either as one of goal congruency or of local vs. global
optimization.
5. Too much emphasis is placed on the cost and efficiency of direct labor.
Traditional systems focus on the analysis of labor and material cost variances,
6. JIT Manufacturing: JIT is a strategy that requires continuous working to improve
quality and reduce costs. Some question whether traditional standard cost
7. Standard costs become out-dated quickly due to shorter product life cycles.
8. Some critics maintain that the use of standard costs and variances (via flexible
budgets) is misplaced in terms of securing operational control. These critics
maintain that operating personnel perform or participate in one or more
Chapter 14 – Operational Performance Measurement: Sales, Direct-Cost Variances, and the Role of Nonfinancial
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Benefits/Advantages of Using a Standard Cost System
1. Provides a good basis for cost comparisons. To the extent that “cost” is a
critical variable on which the organization competes, a standard cost system
14–25 (Continued-2)
2. Enables managers to use management by exception. As noted above, a
standard cost system can be viewed as a “diagnostic control system,” which
monitors itself and therefore frees management to attend to more strategic
issues confronting the organization.
3. Provides a basis for performance evaluation and determining bonuses. Again,
the key here is that managers who decide to use standard costs and variances
5. Standard costs can be used for external reporting purposes (as long as such
standards do not deviate significantly from actual costs).
Chapter 14 – Operational Performance Measurement: Sales, Direct-Cost Variances, and the Role of Nonfinancial
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14–26 Flexible Budgets and Operating Income Variance Analysis; Spreadsheet
Application (45 minutes)
1. Flexible- Sales
Budget Flexible Volume Master
Actual Variance Budget Variance Budget
Units 3,800 – 0 – 3,800 200U 4,000
Sales $53,200 $3,800U $57,000 1 $3,000U $60,000
Variable costs:
Manufacturing $19,000 $3,800U $15,200 2 $800F $16,000
Selling & Admin. 7,700 100U 7,600 3 400F 8,000
Total variable costs $26,700 $3,900U $22,800 1,200F $24,000
Contribution margin $26,500 $7,700U $34,200 $1,800U $36,000
1 Budgeted selling price per unit × number of units sold
= ($60,000 ÷ 4,000) × 3,800 units
2 Standard variable manufacturing cost per unit × number of units sold
= ($16,000 ÷ 4,000) × 3,800 units
= $4 variable manufacturing cost per unit × 3,800 units = $15,200
3 Standard variable selling and administrative expense per unit x number of units
Sales volume variances
In terms of contribution margin: $34,200 − $36,000 = $1,800U
In terms of operating income: $10,200 − $12,000 = $1,800U
Flexible-budget variances
Chapter 14 – Operational Performance Measurement: Sales, Direct-Cost Variances, and the Role of Nonfinancial
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14–26 (continued)
2. The company reduced its selling price (from $15 per unit to $14 per unit) to compete
in the market, suggesting the pursuit of a cost-leadership, not a differentiation,
competitive strategy for the product. However, the company failed to exercise proper
control of its operating costs, as indicated by unfavorable variances for
The company has unfavorable selling price and sales-volume variances. Even
though the company reduced its selling price, it failed to attain the budgeted sales
volume. The strategy of competing through reduced selling prices to gain sales has
apparently failed.
3.
Note: An Excel spreadsheet solution file is embedded below. You can open this
“object” by doing the following:
Flexible Flexible Master
Budget Budget Budget
Units 3,750 4,150 4,000
Sales $56,250 $62,250 $60,000
Variable costs:
Manufacturing $15,000 $16,600 $16,000
Selling and Admin. $7,500 $8,300 $8,000
Total variable costs $22,500 $24,900 $24,000
Contribution margin $33,750 $37,350 $36,000