Management 122
Fall 2001
Handout 3
Budgeting and Variances
Introduction
In the previous portion of the course, we looked forward. The objective was to determine
where the company should go in the future. In this portion of the course, we will look
backward. The objective will be to determine whether things happened the way we
wanted/expected them to in the past.
There are several benefits of understanding what happened in the past. First, we can take
actions to prevent undesirable past events from occurring again in the future. Second, we
can improve our forecasts of future events by determining why our previous forecasts
were wrong. Third, by rewarding (punishing) people for past successes (failures), we
provide an incentive for them to do their jobs well.
Before we can determine whether things happened as they should have, we must establish
a baseline for comparison that reflects our expectations. This baseline can be compared to
the actual accounting numbers to determine what occurred that we didn’t expect.
One example of a baseline is a standard. A standard is the company’s estimate of how
much a cost or aspect of a cost should be. For example, a desk uses wood as a direct
material. The standard for the price of the wood might be $1.20 per board foot while the
standard for the usage of wood might be 50 board feet per desk. The standard for the
wood materials cost per desk would be $1.20x50 = $60. The company would expect to
spend $60 on wood for every desk produced. If it actually spent $80 per desk for wood,
there might be a problem. It is certain in that case that something unexpected happened.
Another example of a baseline is a budget which is a plan for all activities of the firm, its
revenues and costs, investments, and cash flows. Budgets are discussed in the textbook,
and as noted therein, budgets have many uses. For purposes of this section, the benefit of
budgets that is of interest is its usefulness as a baseline for comparison to actual results,
particularly the operating budget.
An important issue is how should the operating budget be developed. A good approach
for most manufacturing companies works as follows. Note that specific firm
circumstances might warrant some changes to this approach, and some of the steps might
be inapplicable to service firms.
1. Estimate/choose revenue This step should be done by the marketing department. It
involves forecasting both sales volume and sales price. Forecasting sales volume
might involve predicting total industry sales and multiplying it by the company’s
expected market share.
2. Estimate/choose production volume This decision clearly depends on the forecasted
sales volume as well as actual and desired inventory levels and capacity. For a service
company or a JIT firm (just in time), production volume will equal sales volume.
3. Budget direct labor and materials cost This requires multiplying the estimated sales
volume by the standard cost per unit of output. In the desk example above, if
estimated volume is 1000 desks, the budgeted wood materials cost is 1000x$60 =
$60,000.
4. Estimate/choose activity levels To budget overhead costs, the levels of the cost
drivers must be estimated. That is easiest in an ABC system. The estimated activity
levels will depend on forecasted production/sales volume.
5. Budget overhead cost In an ABC system, this involves multiplying the forecasted cost
driver by the standard overhead per cost driver unit. In a “traditional” cost allocation
system, this involves identifying fixed and variable costs. Fixed costs are budgeted at
whatever level seems reasonable. Variable costs are budgeted at the forecasted
production volume times the standard overhead per unit.
The above method is an example of zero-based budgeting. While probably ideal, zerobased budgeting can be costly and time consuming. Therefore, firms frequently set
budgets by tweaking past budgets or past actual results. This second approach is typically
less innovative and less accurate.
Part 1: Flexible Budget and Basic Variances
Variances are deviations of actual results from expected results, typically reflected in
standards or budgets. Variances are always expressed in dollar terms. In other words,
variances measure whether costs or revenues were too high or too low relative to
expectation. If a cost is too high (or a revenue too low), the variance is classified as
unfavorable. If a cost is too low (or a revenue too high), the variance is classified as
favorable. Hence, favorableness of a variance depends on its effect on profit.
Variances are useful in identifying possible problem areas. If variances are large, and
particularly if they are unfavorable, that can indicate that something needs to change. This
should lead to an analysis of the potential causes of the variance, and if warranted, an
investigation of the situation. The key issues in deciding whether to expend resources on
the investigation of variance is the controllability of the variance (is the company likely to
be able to do anything about it?), magnitude/materiality (would it really matter if the
company could do something about it?), and prescriptive ambiguity (is the company likely
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to discover the cause and solution for the variance?). You should focus attention on
controllable, large, and prescriptively unambiguous variances.
The budget prepared before the period is based on estimated sales/production volume.
Actual volume will typically differ from the forecast. To enhance the usefulness of the
budget as a baseline for comparison, it is usually desirable to adjust it to reflect actual
volume. A problem with using the original “static” budget is illustrated in the following
example. Our budget is based on producing and selling 1000 desks with a wood materials
cost of $60,000. Actual volume is 500 desks, and actual wood cost is $40,000. Should
this be a favorable variance? The actual cost is less than the budgeted cost. However,
since volume is lower than expected, it is hardly worthy of celebration. If we produce
fewer desks, we should spend less on wood.
A budget that reflects revenues and costs that would have been expected if actual volume
had been known in advance is called a flexible budget. In the example in the preceding
paragraph, had we known that we would only make 500 desks, we would have only
budgeted (500/1000)x$60,000 = $30,000 for wood materials. That is the amount that
would be reflected in the flexible budget.
Once we construct a flexible budget, we can calculate some useful variances. The first
that we need to consider is the sales volume variance. The sales volume variance is the
difference between actual and budgeted profit that is due to the actual sales volume
differing from the budgeted sales volume. There are two ways to calculate it. Both
formulas will yield the same answer.
Sales volume variance = (budgeted contribution margin per unit)
x(actual volume - budgeted volume).
Sales volume variance = flexible budget profit - static budget profit.
The sales volume variance frequently indicates the benefit (harm) to the company of
unexpectedly strong (weak) demand. It can often be used as an indicator of good (bad)
marketing.
The next variance of interest is the sales price variance which is the difference between
actual and expected profit due to the actual average sales price differing from the
budgeted sales price. It is calculated as follows:
Sales price variance = actual revenue - flexible budget revenue.
Like the sales volume variance, the sales price variance frequently indicates the benefit
(harm) to the company of unexpectedly strong (weak) demand. It can also be used as an
indicator of good (bad) marketing, but is usually less good at this role than the sales
volume variance.
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Basic cost variances can also be computed given the flexible budget. There will be one
variance for each cost:
Basic cost variance = flexible budget cost - actual cost.
Unfavorable basic cost variances can indicate problems/waste in the production process.
Costs with large unfavorable variances should be carefully analyzed to determine whether
that is the case.
If sales and production volume are equal, then the following identity will hold. It is very
useful as a check that the variances have been calculated properly.
Actual profit - budgeted profit
=
sales volume variance +
sales price variance +
sum of all basic cost variances.
Consider the following example:
The Williams Citrus Co. operates a small orange farm in West Los Angeles, CA. The
company had the following budget for 2001:
Revenue (5000 lbs. x $0.80/pound)
4000
Materials (bags)
Labor
Land rent
Citrus tax (charged by the pound)
300
1200
2000
200
Total cost
3700
Profit
300
Actual results were:
Revenue (6000 lbs. x $0.75/pound)
4500
Materials (bags)
Labor
Land rent
Citrus tax
400
1300
2400
300
Total cost
4400
Profit
100
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Actual volume exceeded budgeted volume by 20% (6000 lbs. vs. 5000 lbs.). Therefore
the flexible budget should adjust both the budgeted revenue and budgeted variable costs
(materials, labor, and citrus tax) by 20%. Land rent is fixed, so the flexible budget amount
should be the same as the static budget amount. The flexible budget is:
Revenue (6000 lbs. x $0.80/pound)
4800
Materials (bags)
Labor
Land rent
Citrus tax
360
1440
2000
240
Total cost
4040
Profit
760
The sales volume variance is 760 - 300 = 460 F (favorable).
The sales price variance is 4,500 - 4,800 = 300 U (unfavorable).
The materials cost variance is 360 - 400 = 40 U.
The labor cost variance is 1,440 - 1,300 = 140 F.
The land rent variance is 2,000 - 2,400 = 400 U.
The citrus tax variance is 240 - 300 = 60 U.
The sum of these variances is 200 U, which corresponds to the actual shortfall in profit
from the budgeted amount.
Part 2: Production Variances
When actual costs differ from budgeted costs, there are three basic explanations that are
possible:
1. The costs are variable and actual volume differs from budgeted volume.
2. In the case of costs that involve units of an input, actual usage (units of inputs per unit
of output) differs from budgeted usage.
3. Again, in the case of costs that involve units of an input (such as direct labor which
involves usage of labor hours), the actual price of the input (such as the wage in the
case of direct labor) differs from the budgeted price.
Given these three possible effects, how do we know what actually happened? To
distinguish between these effects, we need to decompose the difference between actual
and budgeted cost into three variances: volume, efficiency, and price.
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The following approach to computing these three variance only works for variable costs
that have measurable input units, such as direct materials, direct labor, and some overhead
items such as electricity. The decomposition would be meaningless for other types of
costs. This approach requires knowledge of six pieces of data:
Actual
Va
Ua
Pa
Volume of production output
Usage of input per unit of output
Price per unit of input
Budgeted (standard)
Vb
Ub
Pb
The actual cost is Va x Ua x Pa while the budgeted cost is Vb x Ub x Pb.
The three variances of interest are:
Volume variance = (Vb - Va) x Ub x Pb.
The volume variance is generally not of interest.
Efficiency variance = Va x (Ub - Ua) x Pb.
The efficiency variance indicates how much waste is occurring in the production process.
An unfavorable variance is likely to be controllable and therefore a good candidate for
investigation if large and unfavorable.
Price (or rate) variance = Va x Ua x (Pb - Pa).
The price variance indicates whether input prices were above or below standard levels.
This is usually a function of exogenous market conditions and therefore not controllable.
A nice feature of this decomposition is the fact that the sum of the three variances equals
the difference between budgeted and actual cost. Also the sum of the efficiency and price
variances is the basic cost variance discussed in Part 1.
Finally, consider the following example involving wood materials cost in desk production:
Volume of production output
(# of desks)
Usage of input per unit of output
(board feet of wood per desk)
Price per unit of input (price per
board foot of wood)
Actual
500
Budgeted (standard)
1000
64
50
$1.25
$1.20
Actual cost of wood is 500x64x$1.25 = $40,000.
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Budgeted cost of wood is 1000x50x$1.20 = $60,000.
Wood volume variance = (1000-500)x50x$1.20 = $30,000 F.
Wood efficiency variance = 500x(50-64)x$1.20 = $8,400 U.
Wood price variance = 500x64x($1.20-$1.25) = $1,600 U.
Sum of the three variances = 30,000-8,400-1,600 = 20,000 = 60,000 - 40,000
= budgeted - actual cost.
Part 3: Marketing Variances
When analyzing the performance of the marketing department, the sales volume variance
is a useful tool. However, there are multiple potential explanations for an unfavorable
sales volume variance. Therefore, decompositions can be desirable to discover the actual
causes. Two decompositions will be considered, one that distinguishes between industry
volume and market share, and one that distinguishes between sales quantity and sales mix.
Sales volume for a single company equals the total industry sales volume (Ia) multiplied by
the company’s market share (Sa) in that industry. If the budgeted sales volume had been
based on forecasted industry volume (Ib) and market share (Sb), the sales volume variance
can be divided into two pieces. If Cb is the budgeted contribution margin per unit:
Industry volume variance = (Ia - Ib) x Sb x Cb.
Market share variance = Ia x (Sa - Sb) x Cb.
The market share variance is far more likely to be controllable than the industry volume
variance, unless the firm has huge market share. An unfavorable market share variance
might indicate a failure on the part of the marketing department.
If a firm produces multiple products, the sales volume variance might also depend on
which of the products are being sold. Assuming that the company’s products are demand
substitutes, of comparable size, and have different contribution margins per unit, the
following decomposition is sensible. The most common situation in which this applies is a
firm offering multiple quality levels of the same product (such as Powerful and Super
Powerful cleaning agent). The key to the decomposition is the calculation of “expected”
volume of each product given the actual total volume of all the products. This expected
volume is budgeted volume of each product multiplied by the ratio of actual total volume
to budgeted total volume. Given expected volume for each product, the sales volume
variance can be split into these two parts (summations are taken over all the products):
Sales quantity variance = Σ [(expected volume - budgeted volume) x
budget contribution margin per unit].
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Sales mix variance = Σ [(actual volume - expected volume) x
budget contribution margin per unit].
The sales quantity variance identifies the effect on profit of unexpected high (low) volume
overall. An unfavorable sales mix variance indicates the substitution of low margin for
high margin products, suggesting that the marketing people might be focusing on the low
margin products to boost sales figures at the expense of the company’s profit.
Part 4: Variance Investigation
Variances can only suggest that problems might exist and where they might be. They
cannot tell you with certainty what the problem is (or even whether one exists) or how to
fix the problem. Detailed investigation of the circumstances leading to the variances are
needed to get specific answers.
Accounting departments have limited resources. They cannot thoroughly investigate
every variance in the company. Instead, they must choose the variances that are most
promising, that is those variances that are likely to lead to beneficial results if investigated
and are the least costly to investigate.
The decision of whether to investigate a variance is ultimately a tradeoff of costs and
benefits. What are some of the costs of performing an investigation and what are some of
the benefits? We will discuss them in class.
There are three possible conclusions that an investigation could lead to, regarding the
causes of a variance:
1. Information system variance: the accounting system is flawed and either the actual
amount was incorrectly recorded or the standard/budgeted amount was poorly
estimated.
2. Random variance: the variance is due to unpredictable and uncontrollable
circumstances, such as a hurricane that disrupts production for several days leading to
unfavorable cost variances.
3. Controllable operating variance: the operations are inefficient and can be improved
through identifiable measures. For example, an unfavorable materials efficiency
variance might be due to a defective machine destroying materials. By repairing the
machine, materials efficiency can be improved.
As noted in part 1, there are three principal qualities of variances that make them good
investigation candidates:
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1. Controllable: there is a high probability that the variance is of type 3 and controllable.
If you can’t do anything about the situation, why expend resources to discover the
problem? Efficiency and market share variances are often controllable. For example,
a direct labor efficiency variance might be controllable by eliminating lazy or
incompetent workers, training workers better, or improving scheduling. Price
variances for cost items are rarely controllable. For example, there is rarely much that
can be done regarding labor wage variances since wages are determined by market
forces or union contracts.
2. Large/material: the variance is big enough to lead to a significant benefit from fixing
the underlying problem.
3. Prescriptively unambiguous: the least concrete of the criteria. A variance with this
quality is easy to investigate, and the underlying problem and solution are likely to be
found. If you need to check 10,000 machines in a plant by hand to find the defective
one, and even then you can’t be certain how to correct it, then it is unlikely to be
worth the effort.
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Section 4 Exercises
Exercise H3(E1): Troposphere Budget
This exercise is the first in a series involving a Las Vegas casino, the Troposphere, a very
tall structure with a tropical theme. The Troposphere measures its volume of activity in
terms of gambler-hours. It has the following anticipated costs, either fixed, variable, or
mixed:
Advertising
Security
Rent
Electricity
Corporate Expenses
Gaming Equipment
Dealers
Drinks
Cocktail Waitresses
Fixed
400,000
1,500,000
800,000
700,000
600,000
1,000,000
Per G-H
0.25
0.50
0.75
0.50
The casino predicts that it will serve 4,000,000 gambler-hours with net revenue (difference
between the amounts that the casino wins and loses on bets) of $4.50 per gambler-hour.
Construct a budget for the casino.
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Exercise H3(E2): Basic Variances at Troposphere
At the end of the year, the Troposphere is disappointed to discover that actual gamblerhours are only 3,200,000. Construct a flexible budget based on that volume.
Even more disappointing for the casino is its income statement, which appears below.
Management is very upset, and is looking for someone to fire, starting with the
accountants, whose budget was obviously way off.
Net Revenue
Advertising
Security
Rent
Electricity
Corporate Expenses
Gaming Equipment
Dealers
Drinks
Cocktail Waitresses
Total Expenses
Net Income (Loss)
12,400,000
300,000
1,800,000
800,000
600,000
700,000
2,000,000
1,800,000
3,000,000
1,500,000
12,500,000
(100,000)
Compute the sales volume variance, sales price variance, and variances for each cost.
Based on these variances, write a report to management explaining why actual income
differed from budgeted income, and suggesting what the source(s) of the problems is (are)
and what can be done about it (them).
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Exercise H3(E3): Labor Variances
The following table displays direct labor costs at two factories producing different types of
widgets. Fill in the missing information (a through n).
FACTORY X
FACTORY Y
Budget
Direct labor cost
Direct labor hours
Average wage ($/hour)
Widgets produced
Labor hours / widget
(a)
12,000
6.50
4,000
(b)
35,000
7,000
(h)
(i)
(j)
Actual
Direct labor cost
Direct labor hours
Average wage ($/hour)
Widgets produced
Labor hours / widget
91,800
(c)
(d)
5,000
2.7
(k)
9,000
4.80
3,000
(l)
(e)
(f)
(g)
(m)
3,000 U
(n)
Labor cost variance
Labor efficiency variance
Labor wage (price) variance
What observations do you have about the relative performance of the two factories? The
personnel managers at both factories are being considered for a promotion to V.P. for
human resources for the company. Who should get the job?
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Exercise H3(E4): More Detailed Variances at Troposphere
Lets return to the casino.
Troposphere's standard cost for dealers and cocktail waitresses is $4.00 per labor hour.
Standard quantity of drinks per gambler-hour is 0.8. These standards were used in the
casino's budget development.
Things have turned out differently than the casino anticipated (they always do). The
actual cost per labor hour for dealers is $4.20. The actual quantity of cocktail waitress
labor hours is 380,000. The actual cost per drink is $0.85.
Compute the price and efficiency variances for dealer, drink, and waitress costs.
What information do these more detailed variances provide beyond what you already
knew based on the variances calculated in exercise 2?
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Exercise H3(E5): Marketing Variances at the Troposphere
The Nevada Gaming Commission reports that gambler-hours for the entire state is 2.2
billion. The Troposphere had expected 2.5 billion when developing its budget.
Compute the industry volume and market share variances.
The casino has two games: blackjack and craps. The following data apply to the two:
Net revenue per gambler-hour
Variable cost per gambler-hour
Allocated fixed cost
Budgeted gambler-hours
Actual gambler-hours
Blackjack
$4.80
$2.10
$4,000,000
3,000,000
2,300,000
Compute the sales quantity and sales mix variances.
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Craps
$3.60
$1.70
$1,000,000
1,000,000
900,000
Exercise H3(E6): Investigating Variances at the Troposphere
You have computed a variety of variances for the Troposphere. The accounting
department has limited resources for conducting variance investigations. Which one or
two variances do you think warrant(s) further investigation and why? You must make a
compelling argument that your choice(s) is (are) worth the cost.
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Section 4 Exercise Solutions
Exercise H3(E1)
Net Revenue
Advertising
Security
Rent
Electricity
Corporate Expenses
Gaming Equipment
Dealers
Drinks
Cocktail Waitresses
Total Expenses
Net Income (Loss)
15
18,000,000
400,000
1,500,000
800,000
700,000
600,000
2,000,000
2,000,000
3,000,000
2,000,000
13,000,000
5,000,000
Exercise H3(E2)
Net Revenue
Advertising
Security
Rent
Electricity
Corporate Expenses
Gaming Equipment
Dealers
Drinks
Cocktail Waitresses
Total Expenses
Net Income (Loss)
Actual
Flexible Budget
Difference
12,400,000
300,000
1,800,000
800,000
600,000
700,000
2,000,000
1,800,000
3,000,000
1,500,000
12,500,000
(100,000)
14,400,000
400,000
1,500,000
800,000
700,000
600,000
1,800,000
1,600,000
2,400,000
1,600,000
11,400,000
3,000,000
(2,000,000)
(100,000)
300,000
0
(100,000)
100,000
200,000
200,000
600,000
(100,000)
1,100,000
(3,100,000)
Sales volume variance = 2,000,000 U
(3,000,000 - 5,000,000, flexible - static budgeted income)
Sale price variance = 2,000,000 U
(12,400,000 - 14,400,000, actual - flexible budget revenue)
Cost variances (flexible budget - actual costs):
Advertising variance = 100,000 F
Security variance = 300,000 U
Rent variance = 0
Electricity variance = 100,000 F
Corporate expenses variance = 100,000 U
Gaming equipment variance = 200,000 U
Dealers variance = 200,000 U
Drinks variance = 600,000 U
Cocktail waitresses variance = 100,000 F
Note that the sum of all the above variances is 5,100,000 U, which is the difference
between static budget net income and actual net income. That is a good way to check that
you've done the calculations properly.
Your report to management should focus on the large unfavorable variances: sales
volume, sales price, and drinks. These variances give you some idea of the problems at
the casino: lack of traffic flow, low-betting customers, and excessive drink costs (for some
reason which at this stage is unclear). Since this is a report to management, not an
accountant, don’t write things like “the sales volume variance is $2,000,000 unfavorable;”
use plain English, for example, “profits were off $2 million due to a shortfall in the number
of gamblers visiting the casino.”
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Exercise H3(E3)
(a)
(b)
(c)
(d)
(e)
(f)
12,000 x 6.50 = 78,000.
12,000 / 4,000 = 3.0.
5,000 x 2.7 = 13,500.
91,800 / 13,500 = 6.80.
78,000 x (5,000 / 4,000) - 91,800 = 5,700 F. (flexible budget cost - actual cost)
5,000 x (3.0 - 2.7) x 6.50 = 9,750 F. (actual volume x difference in usage x budgeted
price)
(g) 5,000 x 2.7 x (6.50 - 6.80) = 4,050 U. (actual volume x actual usage x difference in
price)
(h) 35,000 / 7,000 = 5.00.
(i) see below.
(j) see below.
(k) 9,000 x 4.80 = 43,200.
(l) 9,000 / 3,000 = 3.0.
(m) 3,000 U + 1,800 F = 1,200 U. (add the efficiency and wage variances; the wage
variance is calculated below)
(n) 3,000 x 3.0 x (5.00 - 4.80) = 1800 F. (actual volume x actual usage x difference in
price)
(i) and (j) can be solved given that we know the efficiency variance is 3,000 U.
The efficiency variance formula is
actual volume x difference in usage x budgeted price =
3,000 x (Ub - 3.0) x 5.00 = 3,000 U.
Ub = 2.8 which is (j).
(i) 7,000 / 2.8 = 2,500.
Factory X has superior labor efficiency to factory Y. That suggests that X’s personnel
manager has done a better job. However, before handing that person a promotion based
on one statistic, the company should consider whether the inefficiency at Y might be due
to special circumstances, and should weigh other relevant factors, such as long-term
performance and employee morale (which could create long-term costs if very low).
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Exercise H3(E4)
The following table provides the budgeted and actual output volume (gambler-hours),
usage of input per unit of output, and price per unit of input for dealers, waitresses, and
drinks. These are the numbers given in the exercise.
Actual
Volume (Va)
Usage (Ua)
Price (Pa)
Budget
Volume (Vb)
Usage (Ub)
Price (Pb)
Dealers
Waitresses
Drinks
3,200,000
3,200,000
380,000 / 3,200,000
3,200,000
4.20
0.85
4,000,000
4,000,000
4.00
4.00
4,000,000
0.80
The empty spaces in the table can be filled given the fact that budgeted cost =
Vb x Ub x Pb and actual cost = Va x Ua x Pa. These costs are in the budget and actual
income statement. Hence, the table becomes:
Actual
Volume (Va)
Usage (Ua)
Price (Pa)
Budget
Volume (Vb)
Usage (Ub)
Price (Pb)
Dealers
Waitresses
Drinks
3,200,000
0.1339
4.20
3,200,000
0.1188
3.947
3,200,000
1.103
0.85
4,000,000
0.125
4.00
4,000,000
0.125
4.00
4,000,000
0.80
0.9375
Variance calculations are now straightforward:
Dealers
Waitresses
Drinks
Price variance
Va x Ua x (Pb - Pa)
85,714 U
20,000 F
308,824 F
Efficiency variance
Va x (Ub - Ua) x Pb
114,286 U
80,000 F
908,824 U
The most important new piece of information provided by this analysis is that the large
drinks variance is even worse than previously suspected. It isn’t due to a rise in drink
prices, but rather to a massive increase in consumption, which suggests theft.
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Exercise H3(E5)
The sales volume variance of 2,000,000 U needs to be decomposed into two pieces. The
sales volume variance is the product of the budgeted contribution margin per gamblerhour (g-h) and the shortfall of actual g-h from budgeted g-h. The master budget assumes
$4.50 in revenue and $2.00 in variable cost per g-h for a contribution margin of $2.50 per
g-h. The shortfall is 800,000 g-h (4,000,000 - 3,200,000).
Part of the shortfall is explained by the low industry volume relative to forecast. Indeed,
industry volume is off 12 percent (0.3 billion / 2.5 billion). So we should expect our
volume to be off by 480,000 (12 percent of 4,000,000). The remaining 320,000
(800,000 - 480,000) is due to a loss in market share. Converting the lost volume to lost
profit requires multiplying by the budgeted contribution margin of $2.50 per g-h. That
gives us the variances:
Industry volume variance = 1,200,000 U (480,000 x 2.50)
Market share variance = 800,000 U (320,000 x 2.50)
The sales quantity and sales mix variances distinguish between the effects on income of
changes in volume of both games and the change in the percentage of volume attributable
to each game.
The key to computing both variances is calculation of the contribution margin per g-h for
each game and the expected g-h for each game given the total g-h of 3,200,000
(2,300,000 + 900,000). The contribution margins per g-h are $2.70 (4.80-2.10) for
blackjack and $1.90 (3.60-1.70) for craps. Expected g-h are 2,400,000
(3,000,000 / 4,000,000 x 3,200,000) for blackjack and 800,000
(1,000,000 / 4,000,000 x 3,200,000) for craps.
The sales quantity variance has the following formula:
(expected g-h for blackjack - budgeted g-h for blackjack) x cm / g-h for blackjack
+ (expected g-h for craps - budgeted g-h for craps) x cm / g-h for craps =
(2,400,000 - 3,000,000) x 2.70 + (800,000 - 1,000,000) x 1.90 = 2,000,000 U.
The sales mix variance has the following formula:
(actual g-h for blackjack - expected g-h for blackjack) x cm / g-h for blackjack +
(actual g-h for craps - expected g-h for craps) x cm / g-h for craps =
(2,300,000 - 2,400,000) x 2.70 + (900,000 - 800,000) x 1.90 = 80,000 U.
19
Exercise H3(E6)
Discuss in class. Think about which variances are large and controllable. Then think
about what an investigation of each variance would entail, what insights the investigations
would likely provide, and how much they would cost to conduct.
20
Previous Exam Questions and Solutions
I - Budgeting and Variances) You're the controller at X Corp. Your accounting staff
has just provided you with a list of variance calculations that you requested.
Unfortunately, they forgot to calculate some variances that you wanted, and even worse,
they neglected to provide you with the original budget data that you also requested. It's 8
PM, and everyone has gone home already. You have an actual income statement and have
scrounged your desk to find some information on standards that the company used in
developing the budget. You need to prepare a presentation for tomorrow morning and
don't want to admit that you can't find your own budget. You resolve to reconstruct it.
Variances
Market share variance
Industry volume variance
Sales price variance
Materials efficiency variance
Direct labor rate variance
Maintenance variance
Supervision variance
Income Statement
8,000 U
15,000 U
10,000 U
6,000 F
7,000 F
6,000 U
8,000 F
Standards
Materials price
Direct labor usage
$3 / lb.
90 seconds /
unit produced
Revenue
(100,000 units sold)
$455,000
Materials
(30,000 lbs.)
Direct labor
(3,500 hours)
Maintenance
Supervision
Depreciation
120,000
Total expenses
Net income
380,000
75,000
70,000
90,000
40,000
60,000
Depreciation and supervision are fixed costs; the others are variable. Depreciation was
known with certainty at the time of budgeting.
a) Reconstruct the original budgeted income statement.
b) The purpose of tomorrow's meeting is to discuss your strategy for variance
investigation. Your staff is small, and you can only adequately investigate two variances.
Which two will you pick, and why? Note that you are in no way constrained by the
selection of variances provided above by your staff. You can choose any variance to
investigate, after you have calculated it.
21
Solution - I)
This exercise is very difficult. The key is to determine the budgeted volume (Vb). That
requires several steps. First, the budgeted sales price can be determined using the sales
price variance of 10,000 U = actual revenue - (actual volume x budgeted sales price).
Hence, the budgeted sales price is $4.65.
Next, the budgeted materials usage (Ub) is needed. Note that actual usage is 30,000 lbs. /
100,000 units = 0.3. The materials efficiency variance of 6,000 F = 100,000 x (Ub - 0.3) x
3.00. Hence, budgeted materials usage is 0.32. Budgeted materials cost per unit is
Ub x Pb = 0.32 x 3 = 0.96.
Next, the budgeted labor wage (Pb) and usage is needed. Note that the actual price is
$70,000 / 3,500 = $20/hour. Budgeted usage is 0.025 hours / unit (90 seconds / 3600
seconds per hour). The labor rate variance of 7,000 F = 100,000 x 0.035 x (Pb - 20).
Hence, the budgeted wage = $22/hour. Budgeted direct labor cost per unit is
Ub x Pb = 0.025 x 22 = 0.55.
The last item needed to determine the budgeted volume is the budgeted maintenance cost
per unit of output. The maintenance variance of 6,000 U = flexible budget maintenance actual maintenance = (100,000 x budgeted maintenance per unit) - 90,000. Hence,
budgeted maintenance per unit is 0.84.
Taken together, the above calculations imply that the budgeted contribution margin per
unit is budgeted sales price - budgeted materials per unit - budgeted labor per unit budgeted maintenance per unit = 4.65 - 0.96 - 0.55 - 0.84 = $2.30.
The sales volume variance equals the sum of the market share and industry volume
variances = 8,000 U + 15,000 U = 23,000 U which must equal
(actual - budgeted volume) x budgeted contribution margin per unit. Since actual volume
is 100,000 and budgeted contribution margin per unit is $2.30, the budgeted volume is
100,000 + 23,000/2.3 = 110,000 units.
This budgeted volume can be multiplied by the budgeted sales price and budgeted variable
costs per unit to derive the budgeted revenue and variable costs. In addition, budgeted
supervision is actual supervision + supervision variance = 40,000 + 8,000 = 48,000.
Lastly, depreciation was budgeted at the actual amount, 60,000.
The budgeted income statement is:
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Revenue
$511,500
Materials
Direct labor
Maintenance
Supervision
Depreciation
105,600
60,500
92,400
48,000
60,000
Total expenses
366,500
Net income
145,000
b) Five variances seem the most plausible (1and 2 are particularly good candidates for
investigation). In descending order, they are:
1.
2.
3.
4.
5.
Direct labor efficiency variance of 22,000 U.
Market share variance of 8,000 U.
Maintenance variance of 6,000 U.
Sales price variance of 10,000 U.
Materials price variance of 30,000 U.
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II - Decentralization) Platypus Corp. sets standards for a variety of costs in its
accounting system. Variances for each department are calculated, and the department
managers are held responsible for them. One such variance is the cost of rejected
units. An inspection occurs at the end of the Machining Department. The inspectors
attempt to identify the cause of the rejection to assign its cost to the appropriate
department (which could be any of the departments that had worked on the units).
Not all errors can be easily identified with a specific department. Costs of unidentified
errors are assigned to departments in proportion to the number of identified errors.
Hence each department's variance is a combination of errors it caused and a fraction of
unidentified errors.
Jane Smith was recently appointed manager of the Machining Department of the
company. She has complained that this system is biased against her department.
a) Does Jane have a valid complaint? Explain.
b) How do you suggest the company solve its problem with Jane?
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Solution - II)
a) Maybe. The system for assigning unidentified flaws assumes that the same percentage
of flaws are identified regardless of which department is at fault. However, some
departments might tend to make obvious flaws, while others’ mistakes result in more
subtle flaws that are difficult to trace. In that case, Platypus’ method is biased against
somebody. Of course, just because machining is the last stage, doesn’t necessarily mean
that it is the victim of that bias.
b) Jane’s problem could be resolved by estimating the probability that a flaw produced by
each department can be traced to that department, either through engineering analysis or
carefully monitored test runs (a lot of them). Then different weights for the departments
could be used to allocate the unidentified flaws, eliminating the bias. Of course, it might
not be worth the trouble.
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III - Variances) Another year has passed, and the Troposphere's problems continue.
Despite cracking down on theft of its drink inventories and developing a new advertising
campaign that seems to have brought additional customers into the casino, the casino has
suffered another loss. Consider the following budget and actual results:
Net revenue
Advertising
Security
Rent
Electricity
Corporate expenses
Gaming equipment
Dealers
Drinks
Cocktail waitresses
Total expenses
Net income (loss)
Budget
Actual
17,100,000
500,000
1,750,000
800,000
800,000
720,000
2,640,000
1,980,000
2,520,000
1,980,000
13,690,000
3,410,000
17,100,000
1,300,000
1,900,000
800,000
950,000
780,000
3,180,000
2,140,000
3,630,000
2,990,000
17,670,000
(570,000)
The first five expenses are fixed costs, while the last three (dealers, drinks, and waitresses)
are variable costs. Gaming equipment is a mixed cost, with $1,200,000 of the amount
being fixed. Recall that the casino measures its output in terms of gambler-hours. It had
budgeted for 3.6 million gambler-hours, but it actually had 4.5 million gambler-hours.
The casino has the following standards:
Labor wage
(dealers and waitresses)
Drinks usage
$4.40 / hour
Market share
0.15 percent
0.8 drinks / gambler-hour
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Some actuals results were:
Labor wage
(dealers and waitresses)
Drinks cost
Industry volume
$4.75 /hour
95 cents / drink
2.5 billion gambler-hours
a) What were the following variances?
Sales price variance
Advertising variance
Security variance
Rent variance
Electricity variance
Corporate expenses variance
Gaming equipment variance
Dealers price variance
Dealers efficiency variance
Drinks price variance
Drinks efficiency variance
Cocktail waitresses price variance
Cocktail waitresses efficiency variance
Market share variance
Industry volume variance
b) The CEO of the casino is really upset. You must persuade him that the fault here lies
not in the budgeting, but in the actual performance, or else you will lose your job. To do
that, you will need to investigate some of the variances listed above to accertain why the
budget was off. However, you have to meet with the CEO when he returns from vacation
next week, so you only have time to investigate two variances. Which two variances will
you investigate and why? Also, what likely causes do you hypothesize could explain the
variances you want to investigate (you need some idea of what the cause could be to
know how to conduct the investigation)?
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Solution - III)
a) The variances are as follows:
Sales price variance
Advertising variance
Security variance
Rent variance
Electricity variance
Corporate expenses variance
Gaming equipment variance
Dealers price variance
Dealers efficiency variance
Drinks price variance
Drinks efficiency variance
Cocktail waitresses price variance
Cocktail waitresses efficiency variance
Market share variance
Industry volume variance
4,275,000 U
800,000 U
150,000 U
0
150,000 U
60,000 U
180,000 U
157,684 U
492,684 F
286,579 U
193,421 U
220,316 U
294,684 U
1,912,500 F
382,500 F
b) Look for large, controllable, unfavorable variances. The obvious choice is the sales
price variance, which is enormous. Two other choices are advertising and waitress
efficiency. The advertising overrun was deliberate, part of a new marketing strategy, so
its investigation should focus on whether the additional advertising was successful. The
large favorable market share variance suggests yes, but the sales price variance suggests
maybe not. The new advertising might be attracting the “wrong” crowd, low-budget
gamblers or, even worse, non-gambling gawkers (I know many people who only go to
Vegas to see the place, not to gamble). Thus, the two largest unfavorable variances might
be connected (variances often are). The huge sales price variance might also be due to
gambling fraud. An investigation of internal controls might be warranted.
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IV - Transfer Pricing) Division S, located in Texas, of your company produces product
X, which it sells to division P, located in California. Division P uses X as an input in the
production of Z. Division S does not sell X to other companies, but it does sell a slightly
more sophisticated version, Y, to other firms at a price of $250 per unit. S's costs are as
follows:
Variable cost per unit
Allocated fixed cost per unit
X
70
120
Y
80
120
P incurs an additional variable cost of $150 per unit to produce Z, as well as allocated
fixed costs of $200 per unit. The selling price for Z is $700. If P doesn't buy from S, it can
acquire X from an outside supplier for $200 per unit, inclusive of shipping. If P buys from
S, it must pay the transfer price as well as $10 per unit to ship X from Texas to California.
What transfer price should be set for X? Note that the answer should depend on a variety
of assumptions. Specify every possible set of assumptions, and state what the transfer
price should be in each case.
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Solution - IV) If division S is at capacity, then the transfer price should ideally be the
market price (the opportunity cost). But the market price of what? S’s opportunity cost
would come from lost sales of Y, since it doesn’t sell X. Assuming a one-to-one tradeoff
(one more unit of X leads to one less unit of Y being produced), that opportunity cost is
the market price of Y, $250, less the differential cost reduction from producing X instead
of Y, ($80-$70), resulting in a transfer price of $240. The transfer price could also be
based on the opportunity benefit of division P from receiving the transfer, specifically the
market price of X, $200, less the shipping cost of $10, resulting in a transfer price of
$190. Either way, one or the other of the two parties will not be interested in making the
transfer (which in this case is best for the company, P should buy X from outside the firm).
If division S is below capacity and the fixed cost allocated to X is unavoidable, then the
transfer price should be the variable cost of X, $70. Some amount of profit could be
added to that to provide S with an incentive to transfer.
If division S is below capacity and part of the fixed cost is avoidable if P buys X from an
outside vendor (which is plausible since S doesn’t produce X for any other reason), then
the transfer price should be the variable cost, $70, plus the avoidable fixed cost, which
could be more or less than the $120 allocated fixed cost.
All the analysis above assumes that taxes are not an issue. If the tax rate in California is
higher than in Texas (which it is) and the transfer price shifts taxable income from
California to Texas (which it technically doesn’t due to the odd way that California’s
franchise tax system is designed, but we will ignore that), then the firm has an incentive to
maximize the transfer price, within the bounds of plausibility. That suggests designating
the market price-based measure ($240) as the transfer price.
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V - Budgeting and Performance Evaluation) A large consumer products company has
thirteen divisions responsible for various lines of business (tobacco, beer, coffee, cheese,
chocolate, ice cream, etc.). These businesses are very profitable, but some are highly
cyclical in nature (sales vary with economic conditions) or are sensitive to weather
patterns (in both production locations, such as Columbia in the case of coffee, and in
consumer locations, mainly the U.S., as in the case of beer and ice cream).
Each division is organized as a profit center and is responsible for both costs and revenue.
Headquarters feels that the individual divisions are in the best position to make cost
cutting and sales enhancing decisions, so it provides them with enormous discretion.
Nevertheless, their results are closely monitored on a monthly basis, and large unfavorable
variances lead to quick criticism. Also, bonuses and promotions of division managers are
closely tied to the difference between actual and budgeted profit. A similar story holds for
sub-division managers in charge of marketing, production, and support services. In those
cases, appropriate variances (such as sales volume variances and cost variances) are the
basis for setting bonuses and awarding promotions.
The CFO is proud of his company's participative budgeting process, in which division level
marketing people forecast sales, production line managers estimate costs, and division
managers coordinate. The corporate CFO oversees the process, but generally defers to
division judgments since they are the experts on their own areas. The Board of Directors
must approve the company's budget, but that is mostly a rubber stamp on all but the most
broad strategic issues, such as developing new business lines or building new plants.
What is your opinion of this company's budgeting and performance evaluation system?
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Solution - V) The variety of points that can be made on this question is extensive. The
variety of points that should be made in a single essay (particularly under the time pressure
of an exam) is probably less extensive. I would suggest reading the passage once, then the
question, then carefully rereading the passage while thinking about the question. Then,
organize a short list of relevant points (think carefully to be sure that the points are
relevant to the issue and that you understand them clearly), form an opinion based on that
list, then discard the points that are unnecessary or tangential to the opinion that you wish
to express (including extraneous material will both waste your time in writing the essay
and suggest to me that your thinking is muddled). Now you can write the essay,
expressing your overall opinion and then presenting the evidence point by point that
supports that opinion, making the links clear. The essay should be lean and express a
coherent stream of thought. Regardless of the specific content of an essay question, this is
a good strategy. While you might think that such a structured approach will be too time
consuming for an exam, you should realize that the ideal essay is roughly ten lines long,
and the structured approach allows you to include all the important information in such a
short space.
Example:
The combination of the grassroots budgeting system and myopic, budget-driven evaluation
system in this company can, and probably will, lead to serious behavioral distortions. The
most severe problem is that variances from the budget are the basis for evaluating midlevel management, yet these are precisely the people entrusted to develop the budget in
the first place. With little oversight from top-level management, the irresistible temptation
to lower sales estimates and raise cost estimates in the budget will probably get out of
control, threatening both the integrity of the performance evaluation system and the firm’s
planning capabilities. This problem is made all the worse by the monthly frequency with
which performance is reviewed and critiqued, which makes budget padding a necessity to
avoid occasional failure when dealing in volatile markets.
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