chapter 9

When a flexible budget is used in performance evaluation

actual costs are compared to what the costs should have been for the actual level of activity during the period rather than to the static planning budget.

A flexible budget report shows

combines the activity variances with the revenue and spending variances

spending variance

is the difference between the actual amount of the cost and how much a cost should have been, given the actual level of activity. If the actual cost is greater than what the cost should have been, the variance is labeled as UNFAVORABLE If the actual cost is less than what the cost should have been at the actual level of activity, the variance is labeled as FAVORABLE

revenue variance

is the difference between the actual total revenue and what the total revenue should have been, given the actual level of activity for the period. If actual revenue exceeds what the revenue should have been, the variance is labeled FAVORABLE. If actual revenue is less than what the revenue should have been, the variance is labeled UNFAVORABLE.

Revenue and spending variances

Subtract flexible budget from actual budget help managers explain why actual net income differs what it should have been at the actual level of activity

new performance report

The emphasis should be on highlighting superior and unsatisfactory results, finding the root causes of these outcomes, and then replicating the sources of superior achievement and eliminating the sources of unsatisfactory performance.

Static planning budget

Unchanged planning budget is suitable for planning but is inappropriate for evaluating how well costs are controlled.

Management by exception

is a management system that compares actual results to a budget so that significant deviations can be flagged as exceptions and investigated further. This approach enables managers to focus on the most important variances while bypassing trivial discrepancies between the budget and actual results. Another clue is the size of the variance relative to the amount of spending. In addition to watching for unusually large variances, the pattern of the variances should be monitored.

flexible budget

is an estimate of what revenues and costs should have been, given the ACTUAL level of activity for the period. Adjusts to show what costs should be for the actual level of activity.

variance analysis cycle

to evaluate and improve performance The cycle begins with the preparation of performance reports in the accounting department. The significant variances are investigated so that their root causes can be either replicated or eliminated. Then, next period's operations are carried out and the cycle begins again with the preparation of a new performance report for the latest period.

Favorable variance

Actual revenue is MORE than budgeted revenue

leverage effect

Because of the existence of fixed costs, net operating income does not change in proportion to changes in the level of activity. The percentage changes in net operating income are ordinarily larger than the percentage increases in activity.

TRUE

Fixed costs are often more controllable than variable costs

term revenue is used in the planning budget rather than sales because

some organizations have sources of revenue other than sales. For example, donations, as well as sales, are counted as revenue in nonprofit organizations.

activity variance

subtract planning budget from flexible budget The difference between a revenue or cost item in the planning budget and the same time in the flexible budget at the actual activity level Favorable variance:increase number of clients

numerous reasons why its actual results may differ from expectations

(1) changes in the supply and cost of raw materials; (2) changes in the availability and cost of electricity and natural gas; (3) changes in the market demand for products;

Options to generate a favorable revenue and spending variance include

1. PROTECT the selling price 2.REDUCE the prices of inputs 3.INCREASE operating efficiency

common errors in preparing performance reports

1. implicitly assume that all costs are fixed 2. to implicitly assume that all costs are variable. These erroneous assumptions lead to inaccurate benchmarks and incorrect variances.

A flexible budget shows

1. what costs should be for the actual level of activity 2. what the revenues and costs should have been given the actual level of activity 3.what the fixed costs should have been given the actual level of activity

numerous reasons why its actual results may differ from expectations

4) fluctuations in currency conversion rates; (5) significant changes in laws or government regulations; and (6) the cyclical nature of the industry.

Unfavorable variance

Actual revenue is LESS than budgeted revenue May NOT indicate bad performance because increased activity should result in HIGHER variable costs

cost centers

managers in these departments are responsible for costs, but not revenues.Performance reports are often prepared for organizations that do not have any source of outside revenue.

an organization's actual expenses will rarely equal its budgeted expenses as estimated at the beginning of the period.

the actual level of activity (such as unit sales) will rarely be the same as the budgeted activity; therefore, many actual expenses and revenues will naturally differ from what was budgeted.

nonprofit organizations

usually receive a significant amount of funding from sources other than sales. This means that, like costs, the revenue in these organizations may consist of both fixed and variable elements.

multiple cost drivers

variances are more accurate cost formulas based on more than one cost driver are more accurate than the cost formulas based on just one cost driver, the variances will also be more accurate.