Chapter 7: Flexible Budgets, Direct-Cost Variances, & Management Control

Flexible budget

-a flexible budget calculates budgeted revenues and costs based on the actual output in the budget period -the flexible budget is created at the end of the period after managers know the actual output and is the hypothetical budget that would've been prepared at the start of the budget period if the budget had correctly forecasted the actual output -the only difference between the static and flexible budget is the level of output, the sales price, variable cost per unit, and total fixed costs stay the same (if within the relevant range) -you should always think of variance analysis as providing suggestions to further investigation rather than as establishing conclusive evidence of good or bad performance -steps to develop the flexible budget: 1. Identify the actual quantity of output 2. Calculate the flexible budget for revenues based on the budgeted selling price and actual quantity of output 3. Calculate the flexible budget for costs based on the budgeted variable cost per output unit, actual quantity of output, and budgeted fixed costs

Price variances

-a price variance is the difference between an actual input price and a budgeted input price multiplied by the actual input quantity -this is sometimes called a rate variance when related to DL -price variance = (actual price of input - budgeted price of input) x actual quantity of input

Obtaining information from standards developed by the firm itself

-a standard is a carefully determined price, cost, or quantity that is used as a benchmark for judging performance and is usually expressed on a per-unit basis -advantages: standards (1) aim to exclude past inefficiencies, and (2) take into account changes expected to occur in the budget period -disadvantages: because they're not based on actual realized benchmarks, they might not be achievable and workers could get discouraged trying to meet them

The use of variances

-a variance is the difference between actual results and expected performance: the expected performance is also called a budgeted performance, which is a point of reference for making comparisons -variances bring together the planning and control functions of management and facilitate management by exception: a practice where managers focus more closely areas that are not operating as expected and less closely on areas that are -variances are also used for evaluating performance and to motivate managers -sometimes variances suggest that the company should consider a change in strategy and help managers make more informed predictions about the future, thereby improving the quality of the 5-step decision making process

Efficiency variances

-an efficiency variance is the difference between actual input quantity used and budgeted input quantity allowed for the actual output, multiplied by the budgeted input price -this is sometimes called a usage variance -efficiency variance = (actual quantity of input used - budgeted quantity of input allowed for actual output) x budgeted input price -the idea here is that at a certain level, a company is inefficient if it uses a larger quantity of input than budgeted (& vice versa) -managers generally have more control over efficiency variances than price variances because the quantity of inputs used is primarily affected by factors inside the company (such as operations efficiency), whereas changes in the price of materials or in wage rates may be largely dictated by market forces outside the company

When to investigate variances

-because a standard is not a single measure but rather a range of acceptable input quantities, costs, or prices, we should expect small variances to arise -a variance within an acceptable range is called an "in-control occurrence" and calls for no investigation -frequently managers investigate variances based off of subjective judgements or rules of thumb and is subject to the same cost-benefit test

Benchmarking and variance analysis

-benchmarking is the continuous process of comparing your firms performance levels against the best levels or performance in competing or similar companies -when benchmarks are used as standards, we know that the company will be competitive in the marketplace if it can meet or beat those standard -companies develop benchmarks and calculate variances on items most important to their business

Obtaining information from data from other companies that have similar processes

-data from peer companies or those with similar processes can serve as a benchmark -advantages: can provide a firm useful information about how its performing relative to competitors -disadvantages: this data often isn't available or may not be comparable to a particular company's situation

Management's use of variances

-managers use variances to evaluate performance after decisions are implemented, to trigger organization learning, and to make continuous improvements

Obtaining information from actual input data from past periods

-most companies have past data on actual input prices and quantities which can be analyzed for trends or patterns to obtain estimates of budgeted prices and quantities -advantages: past data represents real quantities and prices rather than hypothetical so they can be very useful benchmarks for measuring improvements in performance and is relatively easy to collect at a low cost -disadvantages: a firm's inefficiencies are incorporated into past data so it doesn't represent ideal performance... only the performance achieved in the past, it also does not incorporate any changes expected for the budgeting period (such as improvements from new investments in technology)

Continuous improvement

-repeatedly identifying causes of variances, taking corrective actions, and evaluating the results

Flexible budget variance

-the flexible budget variance is the difference between an actual result and the corresponding flexible budget amount -flexible budget variances are a better measurement of sales price and cost performance than static budget variances because they compare revenues and costs for the actual, same units of output -flexible budget variance for revenues is called the selling-price variances and the flexible budget variance for direct cost inputs can be divided into price variances and efficiency variances

Selling-price variance

-the flexible budget variances for revenues is called the selling-price variance because it arises solely from the difference between the actual selling price and the budgeted selling price -selling-price variance = (actual selling price - budgeted selling price) x actual units sold

Organization learning

-the goal of variance analysis is for managers to understand why variances arise, to learn, and to improve future performance -should not be used to "play the blame game" but to help managers learn how to improve -companies need to strike a balance between using variances for performance evaluation and organization learning

Static budget variance

-the static budget variance is the difference between the actual result and the corresponding budgeted amount in the static budget, and is called the static-budget variance at level 1 -the static variance for operating income is called the static budget variance at income level, or level 0, and answers the question "how much were we off in total?" -a favorable variance, F, has the effect, when considered in isolation, of increasing operating income relative to the budgeted revenues: for revenue items F means actual revenues exceeded budgeted revenues, for cost items F means actual costs are less than budgeted costs -an unfavorable variance, U, has the effect, when viewing in isolation, of decreasing operating income relative to the budgeted amount -managers want to know how much of the static-budget variance is due to inaccurate forecasting of what was expected to be produced and sold, and how much is due to what was actually performed manufacturing and selling the number of units produced and sold: managers then therefore create a flexible budget, which enables a more depth understating of deviations from the static budget

Static budget

-the static budget, or master budget, is based on the level of output planned at the start of the budget period -the master budget is called a static budget because the master budget for the period is planned around a single, static planned output level

Standards

-the term 'standard' refers to many different things: a standard input is a carefully determined quantity of input (DM, DL) required for one unit of output, a standard price is a carefully determined price a company expected to pay for a unit of input, a standard cost is a carefully determined cost of a unit of output -standard cost per output unit for each variable direct cost input = standard input allowed for one output unit x standard price per input unit -How are the terms 'budget' and 'standard' related? Budget is the broader term and budgeted input prices, quantities, and costs dont need to be based on standards, however when they are used the terms are used interchangeably

Obtaining budgeted input prices and input quantities

-theres 3 main sources for obtaining needed price and quantity inputs: actual past data, data from similar companies, and standards

Multiple causes of variances

-to interpret variances correctly and make appropriate decisions based off them, managers need to recognize that they can have multiple causes and must not interpret them in isolation of each other

Using variances for performance measurement

-two attributes of performance are commonly evaluated: 1. Effectiveness: the degree to which a predetermined target or objective is met 2. Efficiency: the relative amount of inputs used to achieve a given output level -note that managers should not automatically interpret a favorable variances as good news or assume it mean subordinates performed well

Our objective in this chapter:

-variance analysis is used as a starting point for performance evaluation, it helps answer the following questions: -By how much were we off in total income? -Which line items on the I/S led to the variance in total income? -Why were we off at each line item? (i.e. was the difference between budgeted and actual because of output sold, input/output prices, quantity of input used, etc.)