Module 8
Variance Analysis and Capital Investment Decisions
a. Profit Variance
The variance analysis is indeed a fundamental tool in assessing performance,
offering a snapshot of the deviations between actual and budgeted figures. In the case of
Bayou's profit variance of $75,500, which reflects the actual profit of $114,500 against
the budgeted profit of $190,000, it's evident that the outcome fell short of expectations,
hence categorized as an unfavorable variance. However, delving deeper into the analysis
unveils a richer understanding of Bayou's operational dynamics.
To begin with, dissecting the elements contributing to this variance can shed light
on the underlying factors at play. By segmenting the profit components such as revenue,
expenses, and cost of goods sold, one can pinpoint specific areas where the variance
originates. For instance, a closer examination might reveal that revenue fell short due to
lower-than-anticipated sales volumes or pricing pressures in the market. Conversely,
expenses might have exceeded projections due to unexpected increases in production
costs, labor expenses, or overhead expenditures.
Furthermore, conducting a variance analysis over multiple periods enables trend
identification, offering insights into whether the unfavorable performance is a one-time
occurrence or part of a broader pattern. If Bayou consistently experiences unfavorable
variances over consecutive periods, it suggests systemic issues that require attention, such
as inefficiencies in operations, inadequate cost controls, or ineffective pricing strategies.
Moreover, external factors need consideration in the analysis. Economic
conditions, industry trends, regulatory changes, and competitive pressures can all impact
performance and contribute to variances. By evaluating how these external factors
intersect with internal operations, a more comprehensive understanding of the variance
emerges, enabling proactive adjustments and strategic decision-making.
Additionally, variance analysis provides a platform for benchmarking against
industry standards or competitors' performance. By comparing Bayou's variances with
industry norms or peer benchmarks, management gains valuable insights into its relative
position and identifies areas for improvement or competitive advantage.
Furthermore, engaging stakeholders across the organization in the variance
analysis process fosters a culture of accountability, transparency, and continuous
improvement. Departments can collaborate to identify root causes, develop corrective
actions, and monitor implementation to drive performance enhancements effectively.
In summary, while the initial observation of an unfavorable profit variance
provides a surface-level indication of performance shortfall, a comprehensive analysis
unravels the underlying complexities, enabling management to diagnose issues, formulate
targeted strategies, and drive sustainable improvements in Bayou's operations and
financial outcomes.
Understanding the nuanced implications of favorable and unfavorable variances is
essential for effective performance evaluation and decision-making within an
organization. While these labels traditionally denote whether actual outcomes deviate
positively or negatively from budgeted figures, their significance extends beyond mere
directional indicators. Delving deeper into their interpretation reveals insights into
underlying operational dynamics, strategic implications, and the broader context within
which variances occur.
At its core, a favorable variance signifies that actual results surpass budgeted
expectations, contributing positively to operating profits. However, the interpretation of
favorability must be contextualized within the specific metric being analyzed. For
instance, in the context of revenue, a favorable variance indicates higher-than-anticipated
sales or pricing outcomes, potentially signaling strong market demand, effective pricing
strategies, or successful sales initiatives. Similarly, in terms of costs, a favorable variance
suggests that actual expenditures are lower than budgeted, possibly due to cost-saving
measures, improved efficiency, or favorable market conditions.
Conversely, an unfavorable variance denotes a shortfall in actual performance
compared to the budget, resulting in decreased operating profits. While this might raise
concerns, it's crucial to recognize that not all unfavorable variances are inherently
negative. For instance, in the case of revenue, an unfavorable variance could stem from
strategic decisions to invest in long-term growth initiatives or penetrate new markets,
which may temporarily depress short-term profitability but yield substantial returns in the
future. Similarly, certain cost increases might be incurred as part of essential investments
in quality improvement, innovation, or talent acquisition, laying the groundwork for
sustainable growth and competitiveness.
Moreover, the labels of favorable and unfavorable variances serve as starting
points for deeper analysis rather than definitive judgments of performance. Additional
investigation is necessary to understand the underlying drivers, contextual factors, and
strategic implications associated with each variance. This entails scrutinizing the root
causes, evaluating the impact on overall business objectives, and assessing the trade-offs
between short-term financial outcomes and long-term strategic goals.
Furthermore, the dynamic nature of business environments necessitates a holistic
approach to variance analysis, taking into account not only internal factors but also
external market dynamics, competitive pressures, regulatory changes, and
macroeconomic trends. By integrating these broader contextual elements into the
analysis, organizations can gain a more comprehensive understanding of variances and
tailor their responses accordingly, whether through operational adjustments, strategic
realignment, or risk mitigation strategies.
In conclusion, while the labels of favorable and unfavorable variances provide
initial indications of performance divergence from budgeted expectations, their true value
lies in guiding deeper inquiry, strategic decision-making, and continuous improvement
efforts within organizations. By adopting a nuanced perspective that considers the
multifaceted drivers and implications of variances, businesses can navigate complexities,
capitalize on opportunities, and drive sustainable success in an ever-evolving landscape.
Analyzing the variance of each income statement line item offers a granular
perspective on Bayou's performance, enabling managers to pinpoint areas for
improvement with greater precision. By dissecting the variance of revenue and cost
categories, management gains valuable insights into the specific drivers behind the
overall profit variance. This deeper level of analysis not only elucidates the root causes of
performance deviations but also guides strategic decision-making and operational
adjustments to enhance future performance.
For instance, examining revenue variances can reveal insights into sales
performance, pricing dynamics, product mix, and customer behavior. A favorable
revenue variance may stem from higher-than-expected sales volumes, increased average
selling prices, successful product launches, or enhanced market penetration. Conversely,
an unfavorable revenue variance could indicate weaker demand, pricing pressures,
competitive challenges, or ineffective sales and marketing strategies. By understanding
the nuances of revenue variances, managers can devise targeted initiatives to capitalize
on strengths, address weaknesses, and optimize revenue generation.
Similarly, dissecting cost variances provides visibility into expenditure patterns,
cost drivers, efficiency levels, and resource utilization. A favorable cost variance may
result from cost-saving initiatives, operational efficiencies, favorable supplier contracts,
or proactive cost management practices. Conversely, an unfavorable cost variance might
be attributed to unexpected cost escalations, inefficiencies in production processes, labor
overruns, material price increases, or unanticipated expenses. By scrutinizing cost
variances, managers can identify opportunities for cost optimization, process
improvement, resource allocation, and cost containment measures.
Moreover, analyzing the interplay between revenue and cost variances offers
valuable insights into profitability drivers and margin dynamics. For instance, a scenario
where revenue variances outperform cost variances indicates robust top-line growth and
favorable margin expansion, signaling a healthy business performance. Conversely, a
situation where cost variances outweigh revenue variances highlights challenges in cost
control, operational efficiency, or pricing strategy, potentially eroding profitability
margins. By assessing the balance between revenue and cost variances, managers can
gauge the overall health and sustainability of Bayou's profitability and prioritize actions
to enhance financial performance.
Furthermore, integrating variance analysis with trend analysis and benchmarking
against industry peers facilitates a comprehensive assessment of Bayou's competitive
position, performance trajectory, and areas of relative strength and weakness. By
benchmarking against industry norms, best practices, and historical performance
benchmarks, managers can identify opportunities for performance improvement, strategic
differentiation, and competitive advantage.
In conclusion, analyzing the variance of each income statement line item
empowers managers with actionable insights to drive performance improvement,
strategic decision-making, and operational excellence at Bayou. By delving into the
specific drivers behind revenue and cost variances, managers can identify areas for
optimization, implement targeted interventions, and align resources effectively to achieve
sustainable growth and profitability.
Analyzing the variance of each income statement line item not only provides
valuable insights into the drivers of off-budget performance but also facilitates more
efficient investigation and targeted corrective action. This multifaceted approach to
variance analysis enables managers to identify areas with significant variances and
prioritize resources and efforts towards resolving underlying issues. Moreover, it serves
as a powerful tool for evaluating the performance of subordinate managers responsible
for specific aspects of the firm's operations, such as marketing and production.
One of the primary benefits of dissecting variances at a detailed level is the ability
to streamline the investigation process. By focusing on areas with substantial variances,
managers can allocate resources more efficiently and target root causes effectively.
Rather than conducting a broad and indiscriminate review of all operations, managers can
narrow their focus to specific revenue and cost categories exhibiting significant
deviations from budgeted expectations. This targeted approach accelerates the
identification of underlying issues, enhances problem-solving efficiency, and increases
the likelihood of implementing timely and effective corrective actions.
Furthermore, leveraging variance analysis for performance evaluation enables
managers to assess the effectiveness and accountability of subordinate managers
responsible for various functional areas. By attributing variances to specific departments
or individuals, managers can evaluate performance against predetermined targets and
benchmarks, identify areas of strength and weakness, and provide constructive feedback
for improvement. This fosters a culture of accountability, transparency, and continuous
improvement, where managers are incentivized to proactively manage their areas of
responsibility and drive performance enhancements.
For instance, if the marketing department consistently exceeds revenue targets
while the production department struggles with cost overruns, managers can tailor their
performance evaluations and coaching efforts accordingly. Recognizing and rewarding
exemplary performance in revenue generation while addressing deficiencies in cost
management ensures alignment with overall organizational goals and objectives.
Similarly, managers can identify training needs, resource allocation priorities, and
process improvement opportunities based on the specific challenges and opportunities
revealed by variance analysis.
Moreover, integrating variance analysis into performance evaluation frameworks
enhances the objectivity and fairness of managerial assessments. By quantifying
performance deviations in financial terms and comparing actual outcomes against
predefined benchmarks, managers can establish clear performance expectations, measure
progress objectively, and differentiate between exceptional performance and areas
requiring improvement. This data-driven approach minimizes subjective biases and
fosters a meritocratic culture where performance is recognized, rewarded, and
incentivized based on tangible results.
In summary, leveraging variance analysis for investigation and performance
evaluation purposes empowers managers to diagnose performance issues, implement
targeted interventions, and hold subordinate managers accountable for achieving
organizational objectives. By aligning performance evaluation with strategic goals and
using variance analysis as a diagnostic tool, managers can drive continuous improvement,
optimize resource allocation, and enhance overall organizational effectiveness and
profitability.
The decomposition of profit variance into revenue and cost components indeed
provides a more detailed understanding of performance drivers, but to enact meaningful
control and drive improvement, managers must delve deeper into the underlying causes
of variance within each line item. This requires a nuanced analysis that identifies not only
the specific factors contributing to deviations from budgeted results but also the relative
significance of each factor in influencing overall profit variance. By systematically
dissecting the drivers of variance and quantifying their respective contributions,
managers can formulate targeted strategies to optimize marketing and production
operations and enhance overall performance.
To begin with, understanding the potential causes of variance between actual and
budgeted results necessitates a comprehensive examination of internal and external
factors impacting revenue and cost line items. For instance, revenue variances may be
influenced by factors such as changes in market demand, shifts in consumer preferences,
fluctuations in pricing dynamics, competitive pressures, effectiveness of marketing
campaigns, or macroeconomic trends. Similarly, cost variances can stem from factors like
variations in raw material prices, changes in production volumes, fluctuations in labor
costs, efficiency levels, supply chain disruptions, regulatory changes, or unexpected
expenses.
Moreover, conducting a root cause analysis helps identify the underlying drivers
behind each variance component. This involves examining operational processes,
performance metrics, and key performance indicators (KPIs) to pinpoint areas of
inefficiency, waste, or underperformance. For instance, a revenue variance may be
attributed to ineffective sales strategies, suboptimal pricing decisions, poor customer
targeting, or inadequate marketing investments. On the other hand, cost variances may
arise from inefficient production processes, quality control issues, inventory management
challenges, or supplier relationships.
Furthermore, quantifying the relative contribution of each identified cause to the
total profit variance provides valuable insights into where managerial focus and resources
should be directed for maximum impact. This involves conducting variance analysis
using techniques such as variance decomposition, contribution margin analysis, or Pareto
analysis to prioritize improvement efforts based on the significance of each factor. By
identifying high-impact drivers and addressing them systematically, managers can
optimize resource allocation, mitigate risks, and drive performance improvements in a
targeted manner.
Additionally, fostering a culture of continuous improvement and cross-functional
collaboration is essential for effective variance analysis and performance management.
By involving stakeholders from marketing, production, finance, and other relevant
departments in the variance analysis process, managers can leverage diverse perspectives,
collective expertise, and interdisciplinary insights to identify innovative solutions,
implement best practices, and drive sustainable performance gains. This collaborative
approach facilitates knowledge sharing, promotes accountability, and strengthens
organizational resilience in the face of evolving challenges and opportunities.
In conclusion, while decomposing profit variance into revenue and cost
components provides valuable insights, true control and performance improvement
require a deeper understanding of the underlying causes of variance within each line item.
By conducting root cause analysis, quantifying the relative contributions of each factor,
and fostering a culture of continuous improvement, managers can identify opportunities
for optimization, prioritize improvement efforts, and drive sustainable growth and
profitability in Bayou's marketing and production operations.
b. Comparing Budgets and Results
Sales Activity Variance The difference between operating profi ts in the master
budget and operating profi ts in the fl exible budget is called a sales activity variance. The
$106,000 unfavorable variance is due to the activity that resulted in a 20,000 unit
difference between actual sales and planned sales. Furthermore, the resulting fl exible
budget shows budgeted sales, costs, and operating profi ts after considering the activity
decrease but before considering differences in unit selling prices, variable costs, and fi
xed costs from the master budget. As noted, we refer to this change from the master
budget plan as the sales activity variance, also known as sales volume variance.
Note the makeup of the $106,000 sales activity variance. First, the difference
between the master budget sales of $1,000,000 and the fl exible budget sales of $800,000,
which is the budgeted $10 unit sales price multiplied by the 80,000 units actually sold, is
$200,000. This is based on the 20,000-unit decrease in sales volume multiplied by the
budgeted $10 unit sales price. We use the budgeted unit sales price instead of the actual
price because we want to isolate the impact of the activity decrease from changes in the
sales price. We want to focus on the effects of volume alone. Thus, the sales amount in
the fl exible budget is not the actual revenue (actual price times actual volume) but the
budgeted unit sales price times the actual number of units sold . Second, variable costs
are expected to decrease by $94,000, giving an unfavorable contribution margin of
$106,000 (= $200,000 − $94,000), which is the unfavorable sales activity variance.
Holding everything else constant, the 20,000-unit decrease in sales creates an
unfavorable sales activity variance as shown. Does this indicate poor performance?
Perhaps it does not. Economic conditions could have been worse than planned,
decreasing the volume demanded by the market. Hence, perhaps, the 20,000-unit
decrease in sales volume could have been even greater, taking everything into account.
Note that both variable cost variances are labeled favorable, but this doesn’t mean that
they are good for the company. Variable costs are expected to decrease when volume is
lower than planned.
c. Profit Variance Analysis as a Key Tool for Managers
The profit variance analysis shows additional detail about the differences between
budgeted profi ts and actual profi ts earned. The actual results can be compared with both
the fl exible budget and the master budget in a profi t variance analysis. Column (2)
summarizes manufacturing (production) variances, which are discussed in more detail
later in this, and Column (3) shows marketing and administrative variances. Costs have
been divided into fi xed and variable portions here and would be presented in more detail
to the managers of centers having responsibility for them. Cost variances result from
deviations in input prices and effi ciencies in operating the company. They are important
for measuring productivity and helping to control costs.
The sales price variance, is derived from the difference between the actual
revenue and budgeted selling price multiplied by the actual number of units sold [$40,000
= ($840,000 − {$10 × 80,000 units})]. This is equivalent, of course, to the difference
between the average actual selling price ($10.50 = $840,000 ÷ 80,000 units) and the
budgeted selling price ($10) multiplied by the actual quantity sold [= $40,000 = ($10.50
− $10) × 80,000 units].
Be careful to distinguish the variable cost variances in Columns (2) and (3) ,
which are input variances, from the variable cost variances in Column (6), which are part
of the sales activity variance. Management expects the costs in the fl exible budget to be
lower than the master budget, creating a sales activity variance, because the sales volume
is lower than planned. As indicated in Column (5), variable production costs should have
been $304,000 for a production and sales volume of 80,000 units, not $380,000 as
expressed in the master budget in Column (7). Column (1) indicates that the actual
variable production costs were $329,680, or $50,320 (= $76,000 F − $25,680 U) lower
than the master budget, but $25,680 higher than the fl exible budget. Which number
should be used to evaluate production cost control, the $50,320 F variance from the
master budget or the $25,680 U variance from the fl exible budget?
The number to use to evaluate production performance is the $25,680 U variance
from the fl exible budget. This points out a benefi t of fl exible budgeting. A superfi cial
comparison of the master budget plan with the actual results would have indicated a
favorable variance of $50,320. In fact, production is actually responsible for an
unfavorable variance of $25,680, which is caused by deviation from production norms.
We discuss the source of this $25,680 in more detail in the following section.
The fi xed production cost variance is simply the difference between actual and
budgeted costs. Fixed costs are treated as period costs here; they should not be affected
by activity levels within a relevant range. Hence, the fl exible budget’s fi xed costs equal
the master budget’s fi xed costs. Marketing and administrative costs are treated like
production costs. Variable costs are expected to change as activity changes; hence,
variable costs were expected to decrease by $18,000 between the fl exible and master
budgets because volume decreased by 20,000 units. The $4,000 favorable variance for
variable marketing and administrative costs must be caused by factors other than sales
activity. Comparing actual costs with the fl exible budget reveals a $7,680 favorable
variance for fi xed marketing and administrative costs. Fixed marketing and
administrative costs do not change as volume changes; hence, the fl exible and master
budget amounts are the same.
d. Performance Measurement and Control in a Cost Center
Before this point, we have considered the measurement of variances for the
evaluation and control of profi t centers. The performance measure was profi t and the
variances were computed as differences between various components of profi ts. To
investigate the cost variances further, we now change the focus of the analysis to a cost
center level and consider using costs (budgeted, or planned, versus actual) as a basis for
performance evaluation. Because we are focusing on cost centers whose production
managers typically do not control what they are asked to produce, we will use actual unit
production, not sales, as a baseline. We begin with the costs associated with the fl exible
budget and analyze differences between actual costs and these fl exible budget costs.
We start the analysis with the budgeting information used to determine variable
product costs, namely the quantities of inputs and the input unit prices. For any variable
resource (e.g., direct materials), the unit variable cost in the budget is determined by
multiplying the expected (budgeted) amount of the resource used in each unit of output
by the expected price of each unit of the resource. For the basic data for the analysis of
Bayou’s production cost variances in the standard cost sheet. This standard cost sheet
provides the quantities of each input required to produce a unit of output along with the
budgeted unit prices for each input. Notice that overhead “quantity” is expressed in terms
of direct labor-hours because that is what is being used to apply the overhead. Thus, the
standard cost per unit of input for overhead is really the standard labor-based burden rate.
Bayou determines the standard price of the materials it uses to make frames as
follows. For simplicity we assume that a single material (metal) is used and each frame
requires 4 pounds of this material. Bayou’s purchasing manager estimates that the cost of
metal with the correct specifi cations and quality should be $0.55 per pound. The $0.55 is
the standard price for a unit of input, not output. The standard materials cost for a unit of
output, a frame, is $2.20 (= 4 pounds × $0.55 per pound).
Direct labor standards are based on a standard labor rate for the work performed
and the standard number of labor-hours required. The standard labor rate includes wages
earned as well as fringe benefi ts, such as medical insurance and pension plan
contributions, and employer-paid taxes (for example, unemployment taxes and the
employer’s share of an employee’s Social Security taxes). Most companies develop one
standard for each labor category. We assume that Bayou Division has only one category
of labor. The standard labor cost for each good frame completed is $1 (= 0.05 hours ×
$20 per hour).
Bayou uses a simple variable overhead basis, direct labor-hours, to determine its
variable overhead standards. Management reviewed prior period activities and costs,
estimated how costs will change in the future, and performed a regression analysis in
which overhead cost was the dependent variable and labor-hours the independent
variable. After analyzing these estimates, the accountants determined that the best
estimate was $12.00 per standard labor-hour as the variable production overhead rate.
The standard variable overhead cost for each good frame completed is $0.60 (= 0.05
hoursM× $12.00 per hour).
e. Variable Cost Variance Analysis
The conceptual cost variance analysis model compares actual input quantities and
prices with standard input quantities and prices. Both the actual and standard input
quantities are for the actual output attained . A price variance and an efficiency variance
can be computed for each variable manufacturing input. The actual costs incurred—
Column (1)—for the time period are compared with the standard allowed per unit times
the number of good units of output produced—Column (3). This comparison provides the
total cost variance for the cost or input. Some companies compute only the total variance.
Others make a more detailed breakdown into price and effi ciency variances. Managers
who are responsible for price variances would not be held responsible for effi ciency
variances and vice versa. For example, purchasing department managers are usually held
responsible for direct materials price variances, and manufacturing department managers
are usually held responsible for using the direct materials efficiently.
This breakdown of the total variance into price and effi ciency components is
facilitated by the middle term, Column (2). In going from ColumnM(1) to Column (2), we
go from actual price ( AP ) times actual quantity ( AQ ) of input to standard price ( SP )
times actual quantity ( AQ ) of input. Thus, the variance is calculated as Price variance =
( AP × AQ ) − ( SP × AQ ) = ( AP − SP ) × AQ The effi ciency variance is derived by
comparing Column (2), standard price ( SP ) multiplied by actual quantity of input
( AQ ), with Column (3), standard price ( SP ) multiplied by standard quantity of input
allowed for actual good output produced ( SQ ). Thus, the effi ciency variance is
calculated as Effi ciency variance = ( SP × AQ ) − ( SP × SQ ) = SP × ( AQ − SQ ) This
general model could seem rather abstract at this point, but as we work examples, it will
become more concrete and intuitive to you.
As the general model outlined is applied to each variable cost incurred, a more
comprehensive cost variance analysis results. The general model of the comprehensive
cost variance analysis will be applied to Bayou Division’s variable production costs. The
comprehensive cost variance analysis will ultimately explain, in detail, the unfavorable
variable production variance of $25,680.
As we proceed through the variance analysis for each production cost input—
direct materials, direct labor, and variable production overhead—you will notice some
minor modifi cations to the general model presented. It is important to recognize that
these are modifi cations to one general approach rather than a number of independent
approaches to variance analysis. In variance analysis, a few basic methods can be applied
with minor modifi cations to numerous business and nonbusiness situations.
An alternative way to view these variances graphically is shown below. Material
quantities are shown on the horizontal axis and the prices for the materials are shown on
the vertical axis. The area of the outside box is $196,800 (= $0.60 × 328,000Mpounds), the
actual price multiplied by the actual quantity of material. The area of the box on the
lower left-hand side is the standard or budgeted cost of the materials for the actual
quantity of output produced, $176,000 (= $0.55 × 320,000Mpounds). The areas of the
other two boxes are the price and effi ciency variances.
Note that Column (3) is called the flexible production budget. The fl exible
budget concept can be applied to production as well as to sales. The fl exible budget was
based on actual sales volume (that is, number of frames sold ). The fl exible budget is
based on actual production volume (that is, number of frames produced.
The direct materials price variance shows that in August, the prices paid for direct
materials exceeded the standards allowed, thus creating an unfavorable variance of
$16,400. Responsibility for this variance is usually assigned to the purchasing
department. Reports to management include an explanation of the variance, for example,
failure to take purchase discounts, higher transportation costs than expected, different
grade of direct materials purchased, or changes in the market price of direct materials.
f. Fixed Cost Variances
Variance analysis treats fi xed production costs and variable production costs
differently. Because fi xed costs are unchanged when volume changes (at least within the
relevant range), the amount budgeted for fi xed overhead is the same in both the master
and fl exible budgets. This is consistent with the variable costing method of product
costing in which fi xed production overhead is treated as a period cost.
The income statements were prepared using variable costing. Therefore, there is
no absorption of the fi xed costs by units of production. All the fi xed manufacturing
overhead is charged to income in the period incurred. Fixed overhead has no input-output
relationships and, thus, no effi ciency variance. The difference between the fl exible
budget and the actual fi xed overhead is entirely due to changes in the costs that make up
fi xed overhead (for example, insurance premiums on the factory are higher than
expected). Hence, the variance falls under the category of a price variance (also called a
spending or a budget variance ). The fi xed manufacturing overhead in both the fl exible
and master budgets was $200,000. The actual cost was $195,500.
So far, we have assumed that fi xed manufacturing costs are treated as period
costs, which is consistent with variable costing. If fi xed manufacturing costs are unitized
and treated as product costs, another variance is computed. This occurs when companies
use full absorption, standard costing.
The fi xed production cost price variance is the difference between actual and
budgeted fi xed production costs. Unlike the production volume variance, the price
variance commonly is used for control purposes because it is a measure of differences
between actual and budgeted period cost summarize the computation of the fi xed
production price (spending) and production volume variances. Reviewing them will help
you see the relationship between actual, budgeted, and applied fi xed production costs.
g. Profit Variance Analysis When Units Produced Do Not Equal Units Sold
Bayou Division was projected to produce and sell 100,000 units, but in fact only
produced and sold 80,000. Suppose instead that Bayou had produced 90,000 units, but
still only sold 80,000. How would this affect our prior analysis, and what new
information is useful for managers to consider as they evaluate operations? In this, we
consider how the presence of inventory affects our earlier analysis of variances. We also
consider some new variances that arise when fi rms are interested in evaluating shifts of
market share, in industry growth rates, in the mix of products that customers purchase
(for fi rms that sell a range of related products at different prices), and in the effi cient use
of a mix of inputs than can substitute for one another.
Note that the assumption that production was greater than sales has no effect on
the sales activity variance because the master budget and fl exible budget are based on
sales volume. In addition, the sales price variance is based on units sold, so Column (4)
remains the same. Generally, marketing and administrative costs are not affected by
producing 90,000 instead of 80,000 units, so we assume that they do not change. This
allows us to focus on Columns (1) and (2), which do change. We assume that actual
variable production manufacturing costs are $4.121 per unit (based on $329,680 ÷ 80,000
units as in and actual fi xed production costs are $195,500 for the period . This leaves the
fi xed production cost variance of $4,500 F unchanged. In addition to the $4,500
favorable fi xed overhead price variance, there is now a $20,000 unfavorable production
volume variance caused by producing 90,000 units when the budget called for production
of 100,000 units [$20,000 = (90,000 – 100,000) × $2.00].
The entire variable production cost variance for units produced in August is
$28,890 U. This amount can be treated as a period cost and expensed in August, or it can
be prorated to units sold and units still in inventory. If prorated, 8/9 (80,000 units ÷
90,000 units), or $25,680, is charged to units sold in this case because 10,000 of the
90,000 units produced in August are still in inventory at the end of August. Most
companies would write off the $28,890 variance due to August’s production as a period
expense. The $28,890 appears as a variance. Note that the actual variable production
costs of $332,890 are really a hybrid: $304,000 in fl exible budget costs (based on 80,000
units sold this period multiplied by $3.80 estimated variable cost per unit) plus the
$28,890 variable production cost variance from the 90,000 units produced this period.
Assume that Bayou Division produced 90,000 units and sold 80,000 of them in
August. There was no beginning inventory on August 1, so the ending inventory on
August 31 was 10,000 units. Using variable costing, the entire fi xed production cost of
$195,500 is expensed as shown. This would not be the case, however, when standard, full
absorption costing is used and production and sales volume are not the same.
h. Sales Activity Variances with Multiple Products
A sales mix variance provides useful information when a company sells multiple
products and the products are (imperfect) substitutes for each other. For example, a
computer dealer sells two types of computers, graphics professional (pro) and consumer.
For May, the company estimated sales of 500 computers, 100 pro models and 400
consumer models.
Assume that Custom Electronics makes and sells two models of electrical
switches, industrial and standard. Data on the two models for February are shown on the
next page. Although there are several approaches to calculating a sales mix variance, our
computation allows us to break down the sales activity variance into two components:
sales mix and sales quantity. The sales mix variance measures the impact of substitution
(it appears that the industrial model has been substituted for the standard model) while
the sales quantity variance measures the variance in sales quantity, holding the sales mix
constant for calculations for this example. The sales price variance is unaffected by our
analysis; the sales activity variance is broken down into the mix and quantity variances.
By separating the activity variance into its mix and quantity components, we have
isolated the pure mix effect by holding constant the quantity effects, and we have isolated
the pure quantity effect by holding constant the mix effect.
Although we have calculated the mix variance of each product sold to show the
exact source, the total mix variance ($4,800MF) is most frequently used. In this example,
the favorable mix variance results from the substitution of the higher contribution
industrial model for the lower contribution standard model.
i. Production Mix and Yield Variances
Our analysis of mix and quantity variances for sales also can be applied to
production. Often a mix of inputs is used in production. Chemicals, steel, fabrics,
plastics, and many other products require a mix of direct materials, some of which can be
substituted for each other without affecting product quality.
Our computation of the mix variance breaks down the direct materials effi -
ciency variance into two components, mix and yield. The mix variance for costs is
conceptually the same as the mix variance for sales, and the yield variance is
conceptually the same as the sales quantity variance. The production mix variance
measures the impact of substitution (material D-12 appears to have been substituted for
material C-30); the production yield variance measures the input-output relationship
holding the standard mix inputs constant. Standards called for 100,000 gallons of
materials to produce 100,000 gallons of output; however, 104,000 gallons of input were
actually used. The overuse of 4,000 gallons is a physical measure of the yield variance.
To derive mix and yield variances, we use the term ASQ , which is the actual
amount of input used at the standard mix. Calculations for the three variances (price, mix,
yield) for Jersey Chemicals are shown. Note that the sum of the mix and yield variances
equals the materials effi ciency variance, which was discussed. In examining these
calculations, recall that the standard proportions (mix) of direct materials are C-30, 60
percent, and D-12, 40 percent; 104,000 gallons were used in total.
j. Variance Analysis in Nonmanufacturing Settings
The need for analysis of price and effi ciency variances in nonmanufacturing
settings is increasing. Banks, fastfood outlets, hospitals, consulting fi rms, retail stores,
and many other organizations apply the variance analysis techniques discussed in both to
their labor and overhead costs. In some cases, an effi ciency variance can be used to
analyze variable nonmanufacturing costs; its computation requires a reliable measure of
output activity. Ideally, this requires some quantitative input that can be linked to output.
For example, personnel in the purchasing department of Bayou Division are expected to
process ten transactions per day. The standard labor cost is $175 per day including benefi
ts. During August, personnel worked 120 staff days and processed 1,130 transactions.
The actual labor cost was $20,040. For 1,130 transactions, the number of standard
staffdays allowed is 113 (= 1,130 transactions ÷ 10 transactions per day). Favorable price
and unfavorable effi ciency variances were computed The calculations in the exhibit are
similar to the ones used for labor variances in manufacturing.
Companies also substitute different types of labor. Deloitte might substitute
partner time for staff time on a particular audit job, for example. Suppose the Cleveland
offi ce has bid a job for 3,000 hours: 900 hours of partner time at a cost of $300 per hour
and 2,100 hours of staff time at a cost of $100 per hour. Due to scheduling problems,
both the partner and the staff member spend 1,500 hours on the job. If the actual costs are
$300 and $100 for partner and staff time, respectively, there is no labor price variance.
Two factors are important when considering mix variances. First, there is an
assumed substitutability of inputs, just as there was an assumed substitutability of sales
products to make the sales mix variance meaningful. Although partner time may have
been substitutable for staff time, the reverse may not have been true. Second, the input
costs must be different for a mix variance to exist. If the hourly costs of both partners and
staff were the same, the substitution of hours would have no effect on the total cost of the
job.
k. Keeping an Eye on Variances and Standards
We noted at the beginning that every organization has its own approach to
variance analysis, although virtually all are based on the fundamental model presented
here. The variances that will be important for a particular company will depend on the
strategic imperatives for the company. What are the essential things that the company
must do well to succeed? Once managers are clear on this, they can work with
accountants to determine whether the costs of providing specifi c analyses are suffi
ciently benefi cial to warrant the time and effort necessary to complete the calculations.
Because of the unique circumstances in each organization, we cannot generalize very
much about which variances should be calculated. Managers and accountants in each
organization should perform their own cost-benefi t analysis to ascertain which
calculations are justified.
In deciding how many variances to calculate, it is important to note the impact
and controllability of each variance. When considering impact, we ask, Does this
variance matter? Is it so small that the best efforts to improve effi ciency or control costs
would have very little impact even if the efforts were successful? If so, it’s probably not
worth the trouble to calculate and analyze. Hence, detailed variance calculations for small
overhead items might not be worthwhile. When considering the controllability of a
variance, we ask, Can we do something about it? No matter how great its impact, if
nothing can be done about the variance, justifying spending resources to compute and
analyze it is diffi cult. For example, materials purchase price variances are often high-
impact items. They are diffi cult to control, however, because materials prices fl uctuate
because of market conditions that are outside the control of managers.
In general, high-impact, highly controllable variances should get the most
attention, and low-impact, uncontrollable variances should get the least attention. Labor
and materials effi ciency variances often are highly controllable. With suffi cient
attention to scheduling, quality of employees, motivation, and incentives, these variances
often can be dealt with effectively. An example of a high-impact but diffi cult-tocontrol
item for many companies has been the cost of energy. Many organizations, from airlines
to taxicab companies to steel mills, have been able to do little about rising energy costs in
the short run. Over time, of course, they can take actions to reduce energy usage by
acquiring energy-effi cient equipment. In general, the longer the time interval considered,
the greater the ability to control an item.
After computing variances, managers and accountants must decide which ones to
investigate. Because their time is a scarce resource, managers must set some priorities.
This can be done by using cost-benefi t analysis. Only the variances for which the benefi
ts of correction exceed the costs of follow-up should be pursued. In general, this is
consistent with the management by exception philosophy, which says, in effect, Don’t
worry about what is going according to plan; worry about the exceptions. This is easier
said than done, however. It can be almost impossible to predict either the costs or benefi
ts of investigating variances. So, although the principle is straightforward, the application
is diffi cult. In this section, we identify some characteristics that are important in
determining which variances to investigate.
Some problems are easily corrected as soon as they are discovered. When a
machine is improperly set or a worker needs minor instruction, the investigation cost is
low and the benefi ts are very likely to exceed the costs. This is often true for a usage or
effi ciency variance, which is reported frequently, often daily, so that immediate
corrective action can be taken. Some variances are not controllable in the short run. Labor
price variances that are due to changes in union contracts and overhead spending
variances resulting from unplanned utility and property tax rate changes might require
little or no follow-up in the short run. Such variances sometimes prompt long-run action,
such as moving a plant to a locale with lower wage rates and lower utility and property
tax rates. In such cases, the short-run benefi ts of variance investigation are low, but the
long-run benefi ts could be higher.
Many variances occur because of errors in recording, bookkeeping adjustments,
or timing problems. A variance reporting system (and the accounting department) can
lose credibility if it makes bookkeeping errors and adjustments. For this reason, the
accounting staff must carefully check variance reports before sending them to operating
managers.
Standards are estimates. As such, they might not refl ect conditions that actually
occur, especially when standards are not updated and revised to refl ect current
conditions. If prices and operating methods are changed frequently, standards could be
constantly out of date. Many companies revise standards once a year. Thus, variances
occur because conditions change during the year but the standards do not. When
conditions change but are known to be temporary, some companies develop a planned
variance . For example, we discussed in the problems caused by using expected
production to allocate fi xed overhead using expected activity when a fi rm has excess
capacity. For this reason, some fi rms use a long-run “normal” volume to allocate fi xed
production costs. In a year when expected activity will be below normal volume, the
company expects, or plans for, an unfavorable volume variance. Using a planned
variance, the company sends managers the right signal about product costs, but, because
they planned for the unfavorable production volume variance, it does not affect the
performance evaluation and control activity
l. Analyzing Cash Flows for Present Value Analysis
Capital investment models play a critical role in guiding strategic decision-
making within organizations, as they provide a framework for evaluating the economic
viability and potential returns of investment opportunities. These models are grounded in
the principle of the time value of money, which recognizes that the timing and magnitude
of cash flows associated with a capital investment project have significant implications
for its economic value.
The fundamental premise underlying capital investment models is that cash
received earlier holds greater economic value than cash received later. This is primarily
because cash received sooner can be reinvested in alternative profit-making
opportunities, allowing for the realization of additional returns over time. Consequently,
any capital investment project represents an opportunity cost for the cash committed to it,
as those funds could have been deployed elsewhere to generate returns.
Given that capital investment decisions typically extend over multiple years, the
time value of money emerges as a critical consideration for managers. To account for
this, future cash flows associated with a project are adjusted to their present value using a
predetermined discount rate. This discount rate reflects the firm's cost of capital or
required rate of return, taking into account factors such as the risk profile of the
investment, prevailing market conditions, and the organization's strategic objectives.
The computation of a project's net present value (NPV) serves as a key metric for
evaluating its economic value to the company at a given point in time. NPV represents
the sum of the discounted values of future cash flows minus the initial investment
required for the project. A positive NPV indicates that the project is expected to generate
returns in excess of the discount rate, thereby adding value to the firm. Conversely, a
negative NPV suggests that the project's expected returns fall short of the required rate of
return, signaling potential value destruction.
Capital investment decision models aim to optimize the economic value to the
firm by maximizing the NPV of future cash flows. Projects with positive NPVs are
typically considered attractive investment opportunities, as they are expected to deliver
returns that exceed the cost of capital, thereby enhancing shareholder value. In contrast,
projects with negative NPVs may be deemed unviable or suboptimal from a financial
perspective, as they fail to meet the firm's return expectations.
It's worth noting that capital investment models provide a structured framework
for assessing investment opportunities, but they are inherently subject to uncertainties and
assumptions. Factors such as changes in market conditions, regulatory developments,
technological advancements, and competitive dynamics can all impact the accuracy of
cash flow projections and discount rate assumptions. Therefore, it's essential for
managers to conduct sensitivity analyses and scenario planning to assess the robustness
of investment decisions under different conditions.
In summary, capital investment models serve as indispensable tools for evaluating
the economic viability and potential returns of investment opportunities, taking into
account the time value of money and the firm's cost of capital. By systematically
assessing NPV and considering key risk factors, managers can make informed decisions
that align with the organization's strategic objectives and enhance shareholder value over
the long term.
The timing disparity between revenue recognition and cash inflow, as well as
between cost incurrence and cash outflow, is a common occurrence in business
operations. This discrepancy underscores the importance of distinguishing between cash
flows and revenues/costs, particularly in the context of capital investment analysis. While
revenue and cost recognition adhere to accounting principles and standards, capital
investment analysis focuses on cash flows, as they directly impact the firm's liquidity,
financial health, and ability to invest in future opportunities.
Revenue recognition typically occurs when goods or services are delivered, and
the company has fulfilled its obligations to the customer, irrespective of when payment is
received. In contrast, cash inflows occur when payments are actually received from
customers. Similarly, costs are incurred when goods or services are consumed in the
production process or when obligations are met, whereas cash outflows occur when
payments are made to suppliers, employees, or other entities.
For instance, consider a scenario where a company makes a sale and recognizes
revenue immediately upon delivery of goods to the customer. However, the payment
from the customer may not be received until a later date, resulting in a timing difference
between revenue recognition and cash inflow. During this interim period, the company
may experience a cash flow gap, wherein the revenue generated from the sale is not yet
available for other investment or consumption purposes until it is collected.
In capital investment analysis, it is imperative to focus on cash flows rather than
accounting-based revenues and costs. Cash flows represent the actual movement of cash
in and out of the business, providing a more accurate reflection of the firm's financial
position and cash-generating ability. By considering cash flows, managers can assess the
liquidity impact of investment decisions, evaluate the timing and magnitude of cash
inflows and outflows, and make informed decisions to optimize cash utilization and
maximize shareholder value.
Moreover, understanding the nature of cash flows associated with investment
projects is essential for assessing their financial viability and risk. For instance, a project
with significant upfront costs and delayed cash inflows may pose liquidity challenges in
the short term, requiring careful cash management and financing arrangements.
Conversely, projects with steady cash inflows and minimal upfront investment may offer
more favorable liquidity profiles and quicker payback periods.
Furthermore, incorporating cash flow analysis into capital investment decision-
making enables managers to account for factors such as opportunity costs, financing
costs, and the time value of money. By discounting future cash flows back to their
present value using an appropriate discount rate, managers can assess the economic value
and profitability of investment opportunities, considering the timing and risk associated
with cash flows.
In conclusion, while accounting principles govern revenue recognition and cost
allocation, capital investment analysis emphasizes the importance of cash flows in
evaluating investment opportunities. By distinguishing between cash flows and
revenues/costs, managers can gain insights into the liquidity impact, financial viability,
and risk profile of investment projects, enabling them to make informed decisions that
align with the firm's strategic objectives and enhance shareholder value over the long
term.
Asset acquisition involves both the cost of purchasing and installing new assets
and the cash infl ows that can result from the proceeds, net of taxes, of selling replaced
equipment. Additionally, there could be a loss or gain from the difference between the
sale proceeds and the tax basis of the equipment being replaced. The primary outfl ow for
most capital investments is the acquisition cost of the asset. Acquisition costs can be
incurred in time 0 and in later years. In some cases, they are incurred over periods of 10
to 20 years. All acquisition costs are listed as cash outfl ows in the years in which they
occur. Installation costs are also considered a cash outfl ow. If the depreciation tax basis
of the replaced equipment does not equal the proceeds received from the sale of the
replaced equipment, a gain or loss will occur and will affect the tax payment. The tax
effect will be considered a cash infl ow (for a loss) or a cash outfl ow (for a gain). The
calculation of this category for Mezzo is straightforward because it is not disposing of
another asset. The initial outfl ow is the $600,000 purchase price of the equipment.
In addition to the cash required for the purchase of long-term assets, many
projects require additional funds for working capital needs; for example, a retail
establishment needs to have cash available in a bank account because future cash
payments often precede cash receipts. The working capital committed to the project
normally remains constant over the life of the project, although it is sometimes increased
because of infl ation. Mezzo plans to commit an additional $120,000 in working capital at
time 0 to maintain a cash balance in a bank account to cover future cash transactions.
The investment tax credit (ITC) allows a credit against the federal income tax
liability based on the cost of an acquired asset. This credit effectively reduces the cost of
making investments by giving companies a credit against their corporate income taxes
equal to, for example, 10 percent of the purchase price. The investment tax credit has
been in effect at various times since the early 1960s. Currently, there is no investment tax
credit for which Mezzo qualifi es.
The primary reason for acquiring long-term assets is usually to generate positive
periodic operating cash fl ows . These positive fl ows can result from revenue-generating
activities, such as new products, and from cost-saving programs. In either case, actual
cash infl ows and outfl ows from operating the asset are usually determinable in a
straightforward manner. The most important task is to identify and measure the cash fl
ows that will differ because of the investment. If the revenues and costs are differential
cash items, th Costs that do not involve cash (depreciation, depletion, and amortization)
are excluded. If cash costs in other departments change as a result of the project, the costs
of the other department(s) should be included in the differential cash fl ow schedule.
Mezzo forecasts annual increases in cash revenues of $400,000 and increased cash
operating expenses of $170,000. After tax, these will result in net cash fl ows of $138,000
[= ($400,000 − $170,000) × (1 − 40%)]. Financing costs such as interest costs on loans,
principal repayments, and payments under fi nancing leases are typically excluded under
the assumption that the fi nancing decision is separate from the asset-acquisition decision.
Under this assumption, the decision to acquire the asset is made fi rst. If the asset-
acquisition decision is favorable, a decision will be made to select the best fi nancing. For
analysis purposes, asset acquisitions typically are recorded in the full amount when the
cash purchase payments are made, regardless of how that cash was acquired. The cost of
fi nancing is included in the discount rate. ey are relevant for the capital investment
decision.
The income tax effects of the periodic cash fl ows from the project are also
computed and considered in the present value analysis. Note that for purposes of
calculating the net present value, only the tax effects related to differential project cash fl
ows are considered. The steps to compute the net operating cash fl ows for the project are
repeated for each year of the project’s life. In some cases, the computations can be
simplifi ed by using an annuity factor if the project is expected to yield identical cash fl
ows for more than one year.
To measure the income of an organization or one of its subunits, depreciation is
used to allocate the cost of long-term assets over their useful lives. These depreciation
charges are not cash costs and thus do not directly affect the net present values of capital
investments. However, tax regulations permit depreciation write-offs that reduce the
required tax payment. The reduction in the tax payment is referred to as a tax shield . The
depreciation deduction computed for this tax shield is not necessarily the same amount as
the depreciation computed for fi nancial reporting purposes . The predominant
depreciation method for fi nancial reporting has been the straight-line method . With this
method, the cost of the asset, less any salvage value, is allocated equally to each year of
the expected life of the asset. Income tax regulations allow depreciation write-offs to be
made faster.
The tax allowance for depreciation is one of the primary incentives used by tax
policy-makers to promote investment in long-term assets. The faster an asset’s cost can
be written off for tax purposes, the sooner the tax reductions are realized and, hence, the
higher the net present value of the tax shield. In recent years, tax depreciation has been
accelerated to allow write-offs over very short time periods regardless of an asset’s
expected life. To maximize present value, it is usually best to claim depreciation as
rapidly as possible.
Consider the tax depreciation schedule of the new equipment that Mezzo Diner is
evaluating. It has a depreciation tax basis of $500,000 over fi ve years. This is computed
as the outlay cost of the equipment ($600,000) less the estimated disposal or salvage
value of $100,000. The equipment is assumed to have a fi ve-year life for tax purposes,
so using straight-line depreciation, annual depreciation on the equipment is $100,000 (=
$500,000 ÷ 5 years). (All amounts given in this text are for illustrative purposes only.
They do not necessarily refl ect the amount of depreciation allowed by the tax
regulations, which varies by type of asset and often changes as Congress passes new “tax
reforms.”) As a result of depreciation expense, Mezzo’s tax payment will be lower by
$40,000 (= $100,000 × 40% tax rate) every year. It is important to note that the
depreciation expense itself is not included in the analysis. It is not a cash expense. (More
important, we have already included the cost of the equipment in the initial outlay. To
include the depreciation expense would be to double-count the equipment cost.)
When a project ends, some inventory, cash, and other working capital items that
were used to support operations are usually left over. These working capital items are
then freed for use elsewhere or are liquidated for cash. Therefore, at the end of a project’s
life, the return of these working capital items is shown as a cash infl ow. In the example
of Mezzo Diner, it will have $120,000 in working capital available for other uses, which
is the money it put in the bank to facilitate cash transactions. It is important not to double-
count these items. Suppose that cash collected from a customer was already recorded as a
cash infl ow to the company, but it was left in the project’s bank account until the end of
the project’s life. It should not be counted again as a cash infl ow at the project’s end. The
return of working capital is recorded as an infl ow when it is freed for use in other
organizational activities. If that does not occur until the end of the project’s life, the cash
infl ow is included as part of disinvestment fl ows.
Ending a project often includes the disposal of its assets. These are usually sold in
secondhand markets. In some cases, more money can be spent disassembling the assets
and disposing of them than their sale gains. Any net outfl ows from the disposal of a
project’s assets become tax deductions in the year of disposal. The net salvage value
(sometimes negative) of an asset is listed as a cash infl ow or outfl ow at the time it is
expected to be realized (or incurred), regardless of its book value or tax basis . The
difference between the book value (tax basis) and the net salvage value can result in a
taxable gain or loss. For an asset replacement decision, the forgone salvage value (and
related tax effects) from the old asset must also be considered. For example, assume that
“asset new” replaced “asset old” for the next fi ve years. Asset old could be sold for
$2,000 at the end of fi ve years; asset new could be sold for $10,000 at the end of fi ve
years. If asset new replaces asset old, the $8,000 incremental salvage value should be the
disinvestment cash fl ow for the analysis. Any additional taxes paid (or tax payments
reduced) because we are salvaging asset new instead of asset old should be included in
the analysis.
Any difference between the tax basis of a project’s assets (generally, the
undepreciated balance) and the amount realized from project disposal results in a tax gain
or loss. Therefore, a company’s tax liability is affected in the year of disposal. Tax laws
on asset dispositions are complex, so tax advice should be sought well in advance of the
proposed disposal date. Here, we assume that any gains or losses on disposal are treated
as ordinary taxable income or losses. Suppose that an asset is carried in the fi nancial
accounting records at a net book value of $80,000 and is salvaged for $30,000 cash. The
tax basis of the asset is $10,000, and the tax rate is 40 percent. What are the cash fl ows
from disposal of this asset? First, the company receives the $30,000 as a cash infl ow.
Second, it reports a $20,000 taxable gain, which is the difference between the $30,000
cash infl ow and the $10,000 tax basis. This $20,000 gain is taxed at 40 percent, resulting
in an $8,000 cash outfl ow.
The computations shown illustrate how to compute net present values using the
present value factors. However, these calculations are builtin functions in Excel, so there
is no reason to compute (or enter) individual present value factors. s that follow how to
complete this calculation using Excel directly. The fi rst step is to modify the spreadsheet
slightly to remove the present value factors and set up the Excel calculation. The basic
spreadsheet is shown.. In addition to removing the rows with the present value factors,
we have introduced some new cells: one with the discount rate; one for the computation
of the present value of the cash infl ows; one with the initial investment amount; and one
for the computation of the net present value.
