Chapter 9

Analyzing Financial Performance Reports

Need for comparing actual to
budgeted
 Even the best run organization cannot make perfect
forecasts.
 Forecasts always contain errors – random and non-
random.
 How should we assess the performance of a
responsibility center manager when the budgeted
performance does not match actual performance.
 Through variance analysis, a control mechanism.
 Variance analysis would reveal what caused the
deviations and what should be done in future.
In this chapter, we will discuss:
 Post-budget control.
 The need for computing variances
 Variance as a control measure
 The different types of variances
 Using variances to evaluate performance
Variances
 Traditionally, variances or deviation of
actual from budgeted numbers is done at
periodic intervals.
 Is this adequate?
 Recent approach: do such analysis on a
routine basis or as a continuous
improvement approach.
Variances
 Computing variances is simple; it should be
extended from top to the lowest levels of
management to develop a true
understanding of the causes.
 The variance should be broken into its
different elements – revenue, expenses,
etc.
 Before we proceed, let us briefly go over
a few basic cost/managerial concepts

 The following costs:

 Standard cost
 Fixed cost
 Variable cost
 Are standard cost same as budgets?
Standard Costs
 Standards are benchmarks.
 In the context of manufacturing or
services, standard costs represent each
major input (e.g. raw materials, labor time)
that a product or service must use.
 Cost standards refer to how much you
should pay for an item or service.
 It is a management by exception concept.
Fixed costs
 A cost that remains constant, in total,
regardless of changes in the level of
activity.
 Examples: rent, investment in machinery,
building
 Consequently, more the level of activity,
smaller the fixed cost per unit of activity or
vice versa.
Variable Costs
 Variable cost is cost that varies, in total, in
direct proportion to changes in the level of
activity.
 Example: as units produced increases,
raw material usage, direct labor costs will
go up proportionately.
 Total costs rises and falls with the level of
activity.
Cost behavior
 Remember: Costs – both fixed and variable
work only within a relevant range.
 For example, whether you produce 10 units
or 100,000 units, will the variable cost per
unit remain the same? No.
 Many costs might also have a fixed and
variable components. E.g. Telephone bill
Basic Variance Analysis
 Analyzing the factors that caused the actual and
budgeted (costs, revenues, production units,
etc.) is called variance analysis.
 Usually, variance analysis is separated into two
categories – quantity and price.
 This is because the same individual may not be
responsible for both quantity and price.
 A basic variance model –
Price and Quantity variances
Actual Quantity Actual Quantity Standard Quantity
of inputs of inputs allowed for output
at Actual Price at Standard Price at Standard Price
(AQ x AP) (AQ X SP) (SQ x SP)
(1) (2) (3)

Price Variance Quantity Variance

1-2 2 -3
Materials Price Materials Quantity Variance
Variance Labor efficiency variance
Labor rate variance Variable overhead efficiency
Variable overhead variance
spending variance

Total Variance
 Let us use the following data from
Colonial Pewter Co.
Std. Qty Std. Price Std.
Cost
Inputs or Hours or Rate
(1) (2) (1) x
(2)
Direct materials 3 pound $ 4.00 $12.00
Direct Labor 2.5 hours 14.00 35.00
Variable Mfg. overhead 2.5 hours 3.00 7.50
Total std. cost per unit $54.50
Standard cost of direct materials per unit of product = 3 lbs x $4 per lb = $12 per unit.
Purchasing records show that in June, 6,500 lbs. of pewter were purchased at a cost of
$3.80 per pound. The cost included freight and handling. All of the materials purchased
was used during June to manufacture 2,000 lbs of pewter bookends. Using the data, let us
computer price and quantity variances.
Price and Quantity variances for Colonial
Pewter
Actual Quantity Actual Quantity Standard Quantity
of inputs of inputs allowed for output
at Actual Price at Standard Price at Standard Price
(AQ x AP) (AQ X SP) (SQ x SP)
(1) (2) (3)

6,500 pounds x $3.80 6,500 lbs. x $4.00 6,000 lbs. x

per lb. = $24,700 = $26,000 $4.00 = $24,000

Price variance = $1,300 F Quantity Variance =

$2,000 U

Total Variance = $700 U

Interpretation
 First, $24,700 refers to the actual total cost of the pewter that
was purchased during June.
 Second, $26,000 refers to what the pewter would have cost if it
had been purchased in the standard price of $4.00 a pound
rather than the actual price of $3.80 per pound.
 Difference between first and second, $1,300 is the price
variance.
 Third, $24,000 represents cost of Pewter if it were purchased at
standard price and if standard quantity had been used.
 The difference between second and third is the quantity
variance.
Price and Quantity variances when
quantity purchased and used differ
Actual Quantity Actual Quantity Standard Quantity
of inputs of inputs allowed for output
at Actual Price at Standard Price at Standard Price
(AQ x AP) (AQ X SP) (SQ x SP)
(1) (2) (3)

6,500 pounds x $3.80 6,500 lbs. x $4.00 4,800 lbs. x

per lb. = $24,700 = $26,000 $4.00 = $19,200

Price variance = $1,300 F

5,000 lbs. x 4.00 per pound = $20,000

Quantity Variance =
$800 U
Revenue variances
 Unlike cost variances, revenue variances
focus on
 selling prices and how
 Volume of sales and
 Mix (of various products)
 Impact revenue and profitability
Selling Price Variance

 Difference between the price you set

(budgeted price) and the actual price at
which you sell (using actual volume of
sales).
 Sales Price Variance
 Three products – A, B, and C
 The budgeted prices are $1.00, 2.00, and 3.00
respectively
 Actual selling price was $0.90, 2.05, and 2.50
respectively.
 Actual volume of sales in units – 100, 200, and
150 respectively.
 Sales price variance is = [100 (1.00 -0.90) + 200
(2.00 – 2.05) + 150 (3.00 – 2.50)] = 75
Mix and Volume Variance
 The firm sells several products (mix) and the
volume of sales for each is different.
 If we do not separate the mix and volume into
separate components (to get a general
overview), then the equation to compute a
combined mix/volume variance is
 Mix/Vol. variance = [Actual Vol. – Bud. Volume]
* Budgeted contribution
 Contribution = Selling price – variable costs only
Combined Mix and Volume Variance

Actual Bud. Difference Unit Variance

Product Volume Volume 4 contribution 6
1 2 3 (2-3) 5 (4-5)
A 100 100 0 -- --
B 200 100 100 $0.90 $90.00
C 150 100 50 1.2 $60.00

Total 450 300 150

The$150 variance is favorable in this example because the actual sales volume for
the three products combined was more than what was budgeted
 Mix Variance
B ud. Mix
B ud. at Actual Difference Unit Variance
P roduct P roportion Volume Actual S ales 5 contribution 7
1 2 (3 ) 4 (4 -3 ) 6 (5 ) * (6 )
A 1/3 150 100 -50 0.2 -10
B 1/3 150 200 50 $0.90 45
C 1/3 150 150 0

T o ta l 0 450 450 0 1.1 35

• See Column 3 and 4 – A higher proportion of B was sold while a lower

proportion A was sold to A.
• Since the contribution margin for B is higher (0.90) compared to A (0.20),
the mix variance is favorable (35)
Volume variance separated from mix variance

 We already computed the combined

mix/volume variance (three slides earlier).
It is 150.
 The mix variance we just computed is 35.
 Therefore, volume variance =
150 - 35 = 115
Isolation of Variances
 At what point should variances be isolated and
brought to the attention of the management?
 Earlier the better.
 What should management do?
 Variances should be viewed as ‘red flags.”
 Seek explanations for the reasons behind
variances and then decide, responsibility,
course of action.
Other relevant issues of Variance Analysis –
Time period comparison

Is comparison of annual budgets with

annual performance reports better than,
 Quarterly budgets with quarterly
performance comparisons?
 Or, shorter period comparisons?
 It depends on the objectives of the
decision maker.
Other relevant issues of Variance Analysis –
selling price or gross margin?

 We computed revenue variances based

on selling prices. Is this realistic?
 Does selling price remain constant
throughout the year?
 And, if not, a better approach would be to
focus on gross margin (selling price- cost
per unit) than on sales prices to compute
variances.
 Who is generally responsible for
monitoring and taking action on
variances?

 One who can control the variance.

 Example:
 Purchase manager for purchase price
variance and
 Production manager for quantity variance.
Thank You