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MANAGEMENT BY EXCEPTION

MANAGEMENT
BY EXCEPTION

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MANAGEMENT BY EXCEPTION

MANAGEMENT BY EXCEPTION

Management by exception can be defined as an approach to increase management’s efficiency and


effectiveness. Through its proper application, managers can better focus on the truly relevant problems
confronting the firm and avoid the waste of valuable time on matters of lesser concern. This is
accomplished through establishment of predetermined standards and the comparison of actual results
with such standards at the end of a period. Accordingly, both the planning and control functions of
management are important activities associated with management by exception.

STANDARDS SETTING

Standards are appropriate for both revenues and costs. Examples of revenue standards include sales
quota, rates of return, and profit margins. A sales quota will only provide personnel with a specific goal,
but in addition, can be used to evaluate performance at the end of the period through a comparison of
actual results with the quota (i.e. the predetermined standard). Positive variances would imply that
actual sales activity exceeded standards, and therefore that an individual’s performance was above
expectations. Negative variances would imply that sales results were less than the set standard, which
implies that expectations were not satisfied. The most commonly used standard relates to the control of
costs. Standard costs can be developed for any costs component, whether costs of goods sold, costs of
services rendered, or simply operating costs. As with revenue standards, the objective is the comparison
of actual results with standard amounts in order to assess performance.

The crucial and most important factor associated with management by exception is the setting of
standards. Standards must be understood and accepted by relevant personnel in order to be useful. This
is due to the principal use of standards as a tool for evaluation purposes. Accordingly, sufficient time
and effort must be given determining the standard and explaining its application.

Standards are commonly established through extensive time and motion studies conducted by industrial
engineers. Following the completion of such studies, the resulting standard amounts are normally
adjusted for expectation of less than perfect operations. Examples for costs standards include
adjustments for raw materials spoilage (in restaurants), power failures in hotels, and less productive
personnel. If appropriately determined, the resulting standard can be used as an accurate predictor of
what costs should be.

Besides investing sufficient time in developing standards, it is also important to properly communicate
the significance and purpose of standard to those individuals whose performance will be judged by it.
With their understanding as to how the standard is calculated and used, appropriate personnel will not
support its application. Without support, standards cannot be used as a means of motivation.

An Example – Use of Standards in Tourism

As discussed previously, standards are most commonly used for control purposes through the
calculation and interpretation of variances. A variance is the difference between what a revenue or cost
actually was (i.e. the actual amount) and what it should have been (i.e. the amount determined by the

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standard). For revenue standards, positive variances denote favourable results and negative variances
denote unfavourable results.

For cost standards, positive variances imply that actual costs exceeded the standard amount; therefore,
considered unfavourable. Negative variances indicate that actual costs were less than the standard
amount. Accordingly, negative variances describe a favourable outcome whereby the firm utilized its
resources with great efficiency than was planned for. As with the use of any standard, variances must be
investigated and the cause of the variance explained. The following example illustrates the application
of standards and the calculation of variances for the cost of labor associated with a manufacturing
operation.

 Suppose:

Direct labor standard = 1 hour for each 0.5 units of finished product
produced
Standard wage rate = US$8.00 per hour
Actual production of finished product = 1,000 units of final product
Actual number of direct labor hours used = 2,500 actual hours
Actual wage rate = US$7.00 per hour

 Variance Calculation

Here, for the above example:

Actual direct labor cost = Actual unit price x Actual quantity


= $7.00/hr x 2,500 hrs.
= $17,500

Standard labor cost = Standard unit price x Actual quantity


= $8.00/hr x 2,500 hrs
= $20,000

Direct labor price variance = Actual direct labor cost – Standard labor cost
= $17,500 - $20,000
= ($2,500) Favorable

Direct labor quantity variance = (standard unit price x actual quantity standard) –
(standard unit price x standard quantity)
= ($8.00/hr x 1,000 units) – ($8.00/hr x 500 units)
= $8,000/hr - $4,000/hr
= $4,000

Total direct labor variance = direct labor quantity variance – direct labor price variance
= $4,000 – $2,500
= $1,500 Unfavorable

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 Implication

The total unfavourable direct labor variance of US$1,500 can be explained in terms of two components
of the variance; the price and quantity components. The firm was apparently efficient in terms of the
price paid for labor hours employed; it was however, inefficient in terms of labor hours used. A possible
scenario is that the firm economized on the wage rate paid to service personnel, but failed to recognize
the loss of productivity which can be associated with a less skilled and experienced labor force.
Accordingly, the favourable price variance was more than offset by the unfavourable quantity variance
of US$4,000 resulting in a net unfavourable direct labor variance of US$1,500.

STANDARD COSTS, FLEXIBLE BUDGETS, AND PERFORMANCE EVALUATION

Standard costs are building blocks of budgeting and performance evaluation. Most well-managed
businesses use an effective budgeting system to assist in realizing of company objectives. Budgets are
useful planning tools and provide managers with a framework for evaluating performances. Fixed
budgets are prepared for a single level of activity. If the actual activity is close to that budgeted, the
fixed budget can assist managers plan business activities and provide a basis for measuring
performance.

Actual activity may differ significantly from budgeted activity; for example, a pilot’s strike for an airline,
cancelation of an order, an unexpected new business (new competitor), or other factors may cause the
actual activity of a business to deviate significantly from the level that was expected when the budget
was prepared. In order to deal with this type of question, a flexible budget, also called a dynamic
budget is prepared for more than one level of activity. For example, a hotel may prepare budgets for
10,000, 12,000, and 14,000 room-nights of occupancy. The objective of preparing budgets for multiple
levels of activity is to provide managers with information about a range of activity in case expected
activity is different from the actual activity attained. Managers continue to rely on expected activity
level in budgeting resource equipments, but the flexible budget provides additional information in
modifying plans if operating data indicate that some other level of activity will be realized. When
performance reports are prepared, actual outcomes are compared with a budget based on the actual
level of activity that the firm achieved.

OVERHEAD VARIANCE ANALYSIS

Overheads are defined as all necessary costs of production other than direct labor and materials. By
definition, overheads include all indirect costs which cannot be identified with specific products and
services. Yet these costs are real, and often just as important as direct costs (labor and material), and
must be included as part of the product cost. All indirect costs are recorded in the overheads control
account. However, recording overhead costs in this control account does not assign these costs to
specific product. The process of assigning overheads to specific products is called overhead application.
The normal way of applying overheads to product is to assign them as they are produced. However,
since overhead costs not known at the time of production, the amount to be applied must be estimated.
To this, an overhead rate must be estimated. An overhead rate is a predetermined amount derived from
the expected overhead cost and the expected quantity of production. For example, a hotel may
estimate that overhead costs for the year will be US$100,000 and direct labor hours will be 50,000. In
this case, the predetermined overhead rate is US$2 per direct labor hour. This rate can also be

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expressed in terms of per room-night if not room-night is used as application base. In this case for each
hour of direct labor US$2 of overhead will be applied in computing per room-nights cost.

The primary consideration in deciding on an overhead rate is the relation of revenues to the expenses,
i.e. matching concept of accounting, which states that all expenses would be matched with revenues
generated. Overheads constitute a very large portion of cost. Therefore, the rate used to apply
overheads to products should do the best possible job of matching overheads with products. The
selection of a proper overhead rate is usually decided upon before the accounting period starts. Once
the rate is determined, overheads can be charged to production on a timely basis along with direct labor
and direct material. As the year goes on, the overhead applied account accumulates the total amount of
overheads to products; but this is not the actual amount of overhead incurred. The actual amount of
overheads accumulates in the overhead control account. At the end of the year or accounting period,
these two accounts should be of the same magnitude. However, the two accounts seldom have equal
balances and the difference must be reassigned to related products. Small differences go to costs of
goods or services sold, large differences are prorated to cost of goods sold and other accounts like
inventories if they exist.

After the overheads have been determined, an attempt must be made to separate this rate into fixed
and variable components. With a flexible budget this separation is a relatively simple task. The total
variable cost changes proportionately with activity level. However, the amount of fixed overheads (rent,
insurance, etc.) remains constant throughout the relevant range of activity, and the amount of fixed
overheads assigned to each direct labor (if direct labor is used as the application base) is determined by
the estimated activity level expressed in direct labor hours. In practice, the total estimated overhead for
the period is divided by estimated normal capacity in order to find the fixed overhead application rate.
The larger the denominator, the smaller the rate will be.

When a standard cost system is extended to overheads, the total variance is computed by taking the
differences between actual overheads and the applied overheads. There are various methods of
overhead variance analysis. One of the common method is called the two-variance method; this
attempts to isolate the variance that is controllable by management and the variance caused by
operating an activity level other than the budgeted level of activity. The controllable variance is:

Actual overhead – Flexible budget based on actual level of activity

On the other hand, the difference between applied overheads and the flexible budget based on actual
activity is due to under- or overutilization of the productive capacity. For this reason, it is called volume
variance. An example clarifies this method. Assume that actual overheads are US$110,000 and applied
overheads US$90,000, giving an unfavourable variance of US$20,000 for the period. Further assume that
actual activity was 9,000 hours. (Application rate was based on US$100,000 / 10,000 hours, of which
US$50,000 was expected fixed cost.)

Flexible budget based on actual activity level = Standard hours x Variable overhead per hour + Fixed
overhead costs
= 9,000 x US$5 + US$50,000
= US$95,000
In this case, the total overhead variance is 110,000 – 90,000 = 20,000 which can be broken down as
shown in Figure 1.

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Figure 1. Breakdown of total overhead variances

Flexible budget based on


Actual Overhead Applied
actual activity level

US$110,000 US$95,000 US$90,000

Controllable Variance Volume Variance


US$15,000 Unfavorable US$5,000 Unfavorable

Total Variance
US$20,000 Unfavorable

The controllable variance is the difference between actual overhead and a flexible budget based on
actual output. The variance is called controllable because standards are benchmarks of performance,
and a flexible budged based on activity level reflects achievement for managers. In the above case,
US$15,000 controllable variance is unfavourable because budgeted costs are smaller than the actual
cost.

The volume variance reflects the amount of variance that occurs because the actual activity level of
activity is different from the budgeted amount of production. It arises when standard hours are different
from the budgeted activity level. In the above case, the application rates are obtained by spreading the
fixed cost to the expected activity level and adding to it the expected variable cost. The US$5,000
difference represents volume variance that is the difference between actual level of production and the
budgeted level of production. Simply stated, the actual activity was less than the expected activity which
was used for determining the application rates.

BENEFITS OF MANAGEMENT BY EXCEPTION

Management by exception provides tourism managers with tools that stress the establishment of labor
and, in some cases like restaurants, material standards. Since most tourism operations are conducted
with sizable overheads, standards for overheads become extremely important in order to control such
costs. Standards are building blocks of any budgetary process and they are useful in assessing
performance. By focusing on exceptional deviation, a manager can maintain a good grasp on controlling
costs.

CONCLUSION

Variances occur whenever actual costs are different from the standard costs. Variance analysis based
on the exception principle refers to the systematic evaluation of variances in an attempt to provide
managers with useful information for measuring efficiency and improving performance. The analysis is
performed to find out the amount of difference between actual and standard costs. But more important

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than measurement, the variance analysis directs manager’s attention to the question of why the
difference occurred and how it can be remedied in the future.

REVIEW QUESTIONS

1. What is the purpose or importance of standards and standard setting in management by


exception?
2. What is the difference between revenue standards and standard costs?
3. Differentiate fixed budgets from flexible / dynamic budget.
4. What is an overhead?
5. What is a variance? When does a variance occur?

EXERCISE

1. Suppose:

a. Direct labor standard = 1 hour for each 1 units of finished product


produced
b. Standard wage rate = P32.00 per hour
c. Actual production of finished product = 1,100 units of final product
d. Actual number of direct labor hours used = 2,800 actual hours
e. Actual wage rate = P 30.00 per hour

Solve for the Total Direct Labor Variance

2. Assume that actual overheads are P 220,000 and applied overheads P 210,000. Further assume that
actual activity was 10,000 hour with a variable overhead cost of P 130,000 and Fixed cost as
P180,000. (Application rate was based on P 100,000 / 10,000 hours) Find the Controllable variance,
the Volume Variance and the Total Variance.

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