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Understanding Variances: Actual vs. Budgeted Performance in Business - Prof. Stubing, Study notes of Management Accounting

George Mason University (GMU)Management Accounting

Prof. David Stubing

An in-depth analysis of variances, the difference between actual results and expected performance in business. It covers the use of variances, static budgets, flexible budgets, flexible-budget variances, sales-volume variances, and the importance of past data and standards in budgeting. It also discusses the relationship between budgets and standards, and the calculation of price and efficiency variances.

Typology: Study notes

2021/2022

Uploaded on 06/13/2022

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● Variances

○ A variance is the difference between actual results and expected performance

■ Expected performance is also called budgeted performance, which is a

point of reference for making comparisons

○ The Use of Variances

■ Bring together the planning and control functions of management and

facilitate management by exception.

● Practice whereby managers focus more closely on areas that are

not operating as expected and less closely on areas that are.

■ Also used for evaluating performance and to motivate managers.

■ Sometimes variances suggest that the company should consider a

change in strategy.

■ Help managers make more informed predictions about the future and

thereby improve the quality of the 5 step decision-making process

● Static Budgets

○ Static budget, or master budget, is based on the level of output planned at the

start of the budget period.

■ Master budget is called the static budget because the budget for the

period is developed around a single (static) planned output level

○ Static budget variances is the difference between the actual result and the

corresponding budgeted amount in the static budget

■ A favorable variance (denoted F) has the effect, when considered in

isolation, of increasing operating income relative to the budgeted amount.

● For revenue items, F means actual revenues exceed budgeted

revenues.

● For cost items, F means actual costs are less than budgeted costs

■ An unfavorable variance (denoted U) has the effect, when viewed in

isolation, of decreasing operating income relative to the budgeted

amount.

● Also called adverse variances

■ Managers want to know how much of the static budget variance is due to

inaccurate forecasting what it expected to produce and sell and how

much is due to how it actually performed manufacturing and selling

products.

● Create a flexible budget, which enables a more in-depth

understanding of deviations from the static budget.

● Flexible Budgets

○ Calculates budgeted revenues and budgeted costs based on the actual output in

the budget period.

○ Prepared at the end of the period, after managers know the actual output

○ The hypothetical budget that the company would have prepared at the start of the

budget period if it had correctly forecasted output

○ Steps to prepare the flexible budget

■ Identify the actual quantity of output

Discover Study notes of Management Accounting George Mason University (GMU)

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● Variances ○ A variance is the difference between actual results and expected performance ■ Expected performance is also called budgeted performance, which is a point of reference for making comparisons ○ The Use of Variances ■ Bring together the planning and control functions of management and facilitate management by exception. ● Practice whereby managers focus more closely on areas that are not operating as expected and less closely on areas that are. ■ Also used for evaluating performance and to motivate managers. ■ Sometimes variances suggest that the company should consider a change in strategy. ■ Help managers make more informed predictions about the future and thereby improve the quality of the 5 step decision-making process ● Static Budgets ○ Static budget, or master budget, is based on the level of output planned at the start of the budget period. ■ Master budget is called the static budget because the budget for the period is developed around a single (static) planned output level ○ Static budget variances is the difference between the actual result and the corresponding budgeted amount in the static budget ■ A favorable variance (denoted F) has the effect, when considered in isolation, of increasing operating income relative to the budgeted amount. ● For revenue items, F means actual revenues exceed budgeted revenues. ● For cost items, F means actual costs are less than budgeted costs ■ An unfavorable variance (denoted U) has the effect, when viewed in isolation, of decreasing operating income relative to the budgeted amount. ● Also called adverse variances ■ Managers want to know how much of the static budget variance is due to inaccurate forecasting what it expected to produce and sell and how much is due to how it actually performed manufacturing and selling products. ● Create a flexible budget, which enables a more in-depth understanding of deviations from the static budget. ● Flexible Budgets ○ Calculates budgeted revenues and budgeted costs based on the actual output in the budget period. ○ Prepared at the end of the period, after managers know the actual output ○ The hypothetical budget that the company would have prepared at the start of the budget period if it had correctly forecasted output ○ Steps to prepare the flexible budget ■ Identify the actual quantity of output

■ Calculate the flexible budget for revenues based on the budgeted selling price and actual quantity of output ■ Calculate the flexible budget for costs based on the budgeted variable cost per output unit, actual quantity of output, and budgeted fixed costs ● Flexible-Budget Variances and Sales-Volume Variances ○ Sales-volume variance is the difference between a flexible-budget amount and the corresponding static-budget amount. ■ Arises solely from the difference between actual quantity sold and the quantity expected to be sold in the static budget ● Flexible-budget amount - Static-budget amount = Sales-Volume Variance for operating income ● (Budgeted Contribution Margin per Unit) * (Actual units sold - Static budget units sold) ■ Reflects the effects of selling fewer units or inaccurate forecasting of sales ■ By removing this component from the static-budget variance, managers can compare their firm’s revenues earned and costs incurred against the flexible budget ○ Flexible-budget variance is the difference between an actual result and the corresponding flexible-budget amount ■ Better measure of sales price and cost performance than static-budget variances because they compare actual revenues to budgeted revenues and actual costs to budgeted costs for the same output ■ Flexible-budget variance = Actual result - flexible-budget amount ■ Flexible-budget variance 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 ● (Actual Selling Price - Budgeted Selling Price) * Actual Units Sold ○ Variance analysis provides suggestions for further investigation rather than establishing conclusive evidence of good or bad performance. ● Standard Costs for Variance Analysis ○ To gain further insight, a company will subdivide the flexible-budget variance for its direct cost inputs into two more detailed variances ■ A price variance that reflects the difference between an actual input price and a budgeted input price ● Managers have less control over this because changes in materials prices or wage rates are heavily influenced by external market forces. ■ An efficiency variance that reflects the difference between an actual input quantity and a budgeted input quantity. ● Managers have more control over this because the quantity of inputs used is primary affected by factors inside the company (such as efficiency with which operations are performed) ○ Obtaining Budgeted Input Prices and Budgeted Input Quantities

○ A standard refers to many different things ■ A standard input is a carefully determined quantity of input, such as square yards of cloth or direct manufacturing labor hours, required for one unit of output, such as a jacket ■ A standard price is a carefully determined price a company expects to pay for a unit of output, such as the standard wage rate the firm expects to pay its operators ■ A standard cost is a carefully determined cost of a unit of output, such as the standard direct manufacturing labor cost of a jacket ■ Standard Cost per output unit for each variable direct cost input = standard input allowed for one output unit. ○ How are the words budget and standard related? ■ Budget is a broader term ● Budgeted input prices, input quantities, and costs need not be based on standards ● Could be based on past data or competitive benchmarks ● When standards ARE used to obtain budgeted input quantities and prices, the terms standard and budget are used interchangeably ● Price Variances ○ Difference between actual price and budgeted price, multiplied by the actual input quantity such as direct materials purchased ○ Sometimes called a rate variance, especially when it’s used to describe the price variance for direct manufacturing labor ○ Price Variance = (Actual price of input - Budget price of input) * Actual quantity of input ● Efficiency Variances ○ Difference between the actual input quantity used (such as square yards of cloth) and the budgeted input quantity allowed for actual output, multiplied by budgeted price. ○ Sometimes called a usage variance ○ Efficiency Variance = (Actual quantity of input used - budgeted quantity of input allowed for actual output) * Budgeted price of input ○ Given a certain output level, a company is inefficient if it uses a larger quantity of input than budgeted ■ A company is efficient if it uses a smaller input quantity than was budgeted for that output level. ● Levels of Variance Analyses

○ Level 1 ■ Static-budget variance for operating income ○ Level 2 ■ Flexible-budget for operating income ● Selling price variance ● Direct materials variance ● Direct manufacturing labor variance ● Variable manufacturing overhead variance ● Fixed manufacturing overhead variance ■ Sales-volume variance for operating income ○ Level 3 ■ Direct materials price variance ■ Direct materials efficiency variance ■ Direct manufacturing labor price variance ■ Direct manufacturing labor efficiency variance ● Journal Entries Using Standard Costs ○ Unfavorable variances are always debits (decrease operating income) ○ Favorable variances are always credits (increase operating income) ○ Record Direct Materials Purchased ■ Isolate the direct materials price variance at the time the materials are purchased by increasing (debiting) the Direct Materials Control account by the standard rice for materials ● Debit Direct Materials Control (x materials * $y per material) ● Credit Direct Materials Price Variance (x materials * $z per material) ● Credit Accounts Payable Control (x materials * $y-$z per material) ○ Record Direct Materials Used ■ Isolate the direct materials efficiency variance at the time the direct materials are used by increasing (debiting) the Work-in-Process Control account. ■ Use the standard quantities allowed for the actual output units manufactured times their standard purchase prices. ● Debit Work-in-Process Control (x units * y materials per unit * $y per material) ● Debit Direct Materials Efficiency Variance (z materials * $y per material) ● Credit Direct Materials Control (x materials * $y per material) ○ Record the Liability for Direct Manufacturing Labor Costs ■ Isolate the direct manufacturing labor price variance and efficiency variance at the time labor is used by increasing (debiting) the Work-in-Process Control by the standard hours and standard wage rates allowed for the actual units manufactured.

○ Labor variances are calculated as employees log into production-floor terminals and punch in their employee numbers, start and end times, and the quantity ofp product they helped produce. ○ Enterprise Resource Planning (ERP) Systems have made it easy for firms to track standard, average, and actual costs and assess variances in real time. ■ Managers use this instantaneous feedback to immediately detect and correct cost-related problems. ○ Companies implementing total quality management programs use standard costing to control materials costs ■ Service-sector companies use standard costs to control albor costs. ○ Companies implementing computer-integrated manufacturing (CIM) use flexible budgeting and standard costing to manage activities such as materials handling and setups. ○ Variance information helps managers identify areas of the firm’s manufacturing or purchasing process that most need attention. ● Management’s Use of Variances ○ Evaluate performance after decisions are implemented ○ Trigger organization learning ○ Make continuous improvements ○ Serve as an early warning system to alert managers to existing problems or to prospective opportunities ○ Enables managers to evaluate the effectiveness of the actions and performance of personnel in the current period, as well as to fine tune strategies for achieving improved performance in the future. ● Multiple Causes of Variances ○ To interpret variances correctly and to make appropriate decisions, managers need to understand the multiple causes of variances. ■ Must not interpret a variance in isolation. ■ A variance in one part of the value chain may result from decisions made in the same or another part of the value chain. ● When to Investigate Variances ○ A standard is not a single measure but rather a range of acceptable input quantities, costs, output quantities, or prices. ○ A variance within an acceptable range is considered to be an “in-control occurrence” and calls for no investigation or action. ○ For critical items such as product defects, even a small variance can prompt an investigation. ○ For other items such as direct material costs, labor costs, and repair costs, companies generally have rules such as “investigate all variances exceeding $5000 or 20% of the budgeted cost, whichever is lower” ○ Variance analysis is subject to the same cost-benefit test as al other phases of a management control system. ● Using Variances for Organization Learning

○ The goal of variance analysis is for managers to understand why variances arise, to learn, and to improve their firm’s future performance. ○ Should not be used to “play the blame game” but to help managers learn about what happened and how to perform better in the future. ○ Companies need to strike a delicate balance between using variances to evaluate performance and to promote organizational learning. ■ If performance evaluation is overemphasized, managers will lose focus on setting and meeting targets that are easy to attain rather than targets that are challenging, require creativity and resourcefulness, and lead to learning. ■ Overemphasizing performance might have other negative consequences ● Manufacturing managers might push workers to produce products within the time allowed, even if this leads to poorer quality, which would later hurt revenues. ● Using Variances for Continuous Improvement ○ Repeatedly identifying causes of variances, taking corrective actions, and evaluating results. ○ Some companies use Kaizen budgeting to specifically target reductions in budgeted costs over successive periods. ■ Makes continuous improvement goals explicit ○ Continuous improvement goals need to be implemented thoughtfully. ■ Injecting too much discipline and focusing on incremental improvement may dissuade creativity and truly innovative approaches. ■ Over relying on gaining efficiencies should not deter employees from taking risky approaches or from challenging basic assumptions about products and processes. ● Financial and Nonfinancial Performance Measures ○ Financial measures are critical in a company because they indicate the economic impact of diverse physical activities. ■ This knowledge allows managers to make trade-offs, such as increasing costs of one physical activity to reduce the costs of another physical measure. ● Benchmarking and Variance Analysis ○ Benchmarking is the continuous process of comparing one company’s performance levels against the best levels of performance in competing companies or in companies having similar processes. ■ When benchmarks are used as standards, managers and management accountants know that the company will be competitive in the marketplace if it can meet or beat those standards. ○ Companies develop benchmarks and calculate variances on items that are the most important to their businesses. ○ Finding appropriate benchmarks is not easy ■ Many companies purchase benchmark data from consulting firms. ○ Identifying comparable benchmarks to make an apples to apples comparison

Understanding Variances: Actual vs. Budgeted Performance in Business - Prof. Stubing, Study notes of Management Accounting

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