Variance repoting

BILASPUR (C.G.) 495009

DEPARTMENT OF MANAGEMENT
STUDIES

M.B.A. III SEM.

SESSION: 2011-12

SUBJECT: MANAGEMENT CONTROL SYSTEM

PRESENTATION TOPIC: “VARIANCE REPORTING ”

Submitted To: Submitted By:
Dr. B. D. MISHRA NILESH KUMAR RAJPUT
Associate Professor
M. A. (Eco.); M.B.A.; Ph.D.
.

CONTENTS

1. INTRODOCTION…………………………………

……..01

2. REVENUE VARIANCES ……………………..

………02

3. EXPENSE VARIANCES.…….

………………………….04

4. VARIANCES IN

PRACTICE……………………………04

5. EVALUATION

STANDARDS.....................................06

6. LIMITATIONS ON STANDARDS ……………….

…….08

7. LIMITATIONS OF VARIANCE ANALYSIS

………....10

8. CONCLUSION………………………………………

..…..12

9. REFERENCES

INTRODUCTION

Most company made a monthly analysis of difference between actual and budgeted revenues and
expense for each business unit and for the whole organization (some do this quarterly).

A more through analysis identifies the cause of the variances and the organization unit
responsible. Effective systems identify variances down to the lowest level of management.

Variances are hierarchical as shown below:

They begin with the total business unit performance, which is divided into revenue variance
and expense variance. Revenue variance is further divided into volume and price variance for the total
business unit and for each marketing responsibility center within the unit. They can be further divided
into sales area and sales district. Expense variances can be divided between manufacturing expenses
and other expenses. Manufacturing expenses can be further subdivided by factories and departments
within factories. Therefore, it is possible to identify each variance with the individual manager who is
responsible for it. This type of analysis is a powerful tool, without which the efficacy of profit budgets
would be limited.

The profit budget has embedded in it certain expectations about the state of the total industry and
about the company's market share, its selling prices, and its cost structure. Results from variance
computations are more "actionable" if changes in actual results are analyzed against each of these
expectations. The analytical frame-work we use to conduct variance analysis incorporate the
following ideas:

•Identify the key causal factors that affect profits.
•Break down the overall profit variances by these key causal factors.
•Focus on the profit impact of variation in each causal factor.
•Try to calculate the specific, separable impact of each causal factor by varying only that factor while
holding: all other factors constant ("spinning only one dial at a time"). -

•Add complexity sequentially one layer at a time, beginning at a very basic "commonsense" level
("peel the onion").
•Stop the process when the added complexity at a newly created level is not justified by added useful
insights into the causal factors underlying the overall profit variance. ..-

Revenue Variances

Revenue variance includes selling price, volume, and mix variances. The calculation is made for each
product/line, and the product line results are then aggregated to calculate the total variance. A positive
variance is favorable, because it indicates that actual profit exceeded budgeted profit, and a negative
variance is unfavourable.

Selling Price Variance

The selling price variance is calculated by multiplying the difference between the actual price
and standard price by the actual volume.

Mix and Volume Variance

Often the mix and volume variances are not separated. The equation for the combined mix and volume
variance is:

Mix and volume variance = (Actual volume -Budgeted volume) * Budgeted unit contribution

The volume variance results from selling more units than budgeted .The mix variance results from
selling a different proportion of products from that assumed in the budget. Because products earn
different contributions per unit, the sale of different proportions of products from those budgeted will
result in a variance. If the business unit has a "richer" mix (i.e. a higher proportion of products with a
high contribution margin) the actual profit will be higher than budgeted; and if it has a "leaner" mix,
the profit will be lower.

MiX Variance

The mix variance for each product is found from the' following equation:

Mix variance = [(Total actual volume of sales * Budgeted proportion)
- (Actual volume of sales)]* Budgeted unit contribution

Volume Variance

The volume variance can be calculated by subtracting the mix variance from the combined mix
and volume variance.

Volume variance = [(Total actual volume of sales) * (Budgeted percentage)]
- [(Budgeted sales) * (Budgeted unit contribution)]

Other Revenue Analysis

Revenue variances may be further subdivided.

Market Penetration and
Industry Volume

Market Penetration

One extension of revenue analysis is to separate the mix and volume variance into the amount caused
by differences in market share and the amount caused by differences in industry volume. The principle
is that the business unit managers are responsible for market share, but they are not responsible for the
industry volume because that is largely influenced by the state of the economy. To make this
calculation, industry sales data must be available.

The following equation is used to separate the effect of market penetration from industry volume on
the mix and volume variance:

Market share variance = [(Actual sales) - (Industry volume)]
* Budgeted market penetration
* Budgeted unit contribution

Industry Volume

The industry volume variance can also be calculated for each product as follows:

Industry variance= (Actual industry volume - Budgeted industry volume)
* Budgeted market penetration
* Budgeted unit contribution

This calculation of variance due to industry volume is shown in Section D.

Expense Variances:

It includes:

Fixed Costs and Variable Costs

Fixed Costs

Variances between actual and budgeted fixed cost are obtained. Simply by subtraction, since these
costs are not affected by either the volume of sales or the volume of production.

Variable Costs

Variable costs are costs that vary directly and proportionately with volume. The budgeted variable
manufacturing costs must be adjusted to the actual volume of production.

Variances in Practice

As discussed above, is relatively straightforward way of identifying the variance that caused actual
profit in a business unit to be different from the budgeted profitability. Some variations from this
approach are described in this section

Time period of the Comparison

Some companies use performance for the year to date as the basis for comparison; for the period
ended June 30, they would use budgeted and actual amounts for the six months ending on June
30, rather than the amounts for June. Other companies compare the budget for the whole year
with the current estimate of actual performance for the year. The actual amounts for the report
prepared as of June 30 would consist of actual numbers for the first six months plus the best
current estimate of revenues and expenses for the second six months.

A comparison for the year to date is not as much influenced by temporary aberrations
that may be peculiar to the current month and, therefore, that need not be of as much concern to
management. On the other hand, it may mask the emergence of an important factor that is not
temporary.

A comparison of the annual budget with current expectation of actual performance for
the whole year shows how closely the business unit manager expects to meet the annual profit
target. If performance for the year to date is worse than the budget for the year to date, it is
possible that the deficit will be overcome in the remaining months. On the other hand, forces
that caused actual performance to be below budget for the year to date may be expected to
continue for the remainder of the year, which will make the final numbers significantly different
from the budgeted amounts. Senior management needs a realistic estimate of the profit for the
whole year, both because it may suggest the need to change the dividend policy, to obtain

additional cash, or to change levels of discretionary spending, and also because a current
estimate of the year's performance is often provided to financial analysts and other outside
parties.

Obtaining a realistic estimate is difficult. Business unit managers tend to be optimistic about
their ability to perform in the remaining months because, if they are pessimistic, this casts doubt on
their ability to manage. To some extent, this tendency can be overcome by placing the burden of proof
on business unit managers to show that the current trends in volume, margins, and costs are not going
to continue. Nevertheless, an estimate of the whole year is soft, whereas actual performance is a matter
of record. An alternative that lessens this problem is to report performance both for the year to date
and for the year as a whole.

Focus on Gross Margin

In many companies, changes in costs or other factors are expected to lead to changes in selling prices,
and the task of the marketing manager is to obtain a budgeted gross margin-that is, a constant spread
between costs and selling prices. Such a policy is especially important in periods of inflation. A
variance analysis in such a system would not have a selling price variance. Instead, there would be a
gross margin variance. Unit gross margin is the difference between selling prices and
manufacturing costs.

The variance analysis is done by substituting “gross margin “for “selling price” in the price" in
the revenue equations. Gross margin is the difference between actual selling prices and the standard
manufacturing cost. The current standard manufacturing cost should take into account changes in
manufacturing costs that are caused by changes in wage rates and in material prices (and, in some
companies, significant changes . other input factors, such as electricity in aluminum manufacturing).
The standard, rather than the actual, cost is used so that manufacturing inefficiencies do not affect the
performance of the marketing organization.

Evaluation Standards

In management control systems, the formal standards used in the evaluation of reports on actual
activities are of three types:

(1) Predetermined standards or budgets,

(2) Historical standards, or
(3) External standards.

(1) Predetermined Standards or Budgets

If carefully prepared and coordinated, these are excellent standards. They are the basis against
which actual performance is compared in many companies. If the budget numbers are collected in a
haphazard manner, they obviously provide will not a reliable basis for comparison.

(2) Historical standards

These are records of past actual performance. Results for the current month may be compared
with the results for last month or with results for the same month a year ago. This type of standard has
two serious weaknesses:

(1) Conditions may have changed between the two periods in a way that invalidates the
comparison, and

(2) The prior period's performance may not have been acceptable.

A supervisor whose spoilage cost is $500 a month, month after month, is consistent; but we do not
know, without other evidence, whether the performance was consistently good or consistently poor.
Despite these inherent weaknesses, historical standards are used in some companies, often because
valid predetermined standards are not available.

(3) External Standards

These standards derived from the performance of other responsibility centers or of other
companies in the same industry. The performance of one branch sales office may be compared
with the performance of other branch sales offices.

If conditions in these responsibility centers are similar, such a comparison may provide an
acceptable basis for evaluating performance.

Some companies identify the company that they believe to be the best managed in the
industry and use numbers from that company-either with the cooperation of that company or from
published material-as a basis of comparison. This process is called benchmarking.

Data for individual companies are available in annual and quarterly reports and in Form
10K (Form 10K data are available from the Securities and Exchange Commission and are

published on the Internet for about 13,000 companies.) Data for industries are published in Dun
& Bradstreet, Inc., Key Business Ratios; Standard & Poor's Compustat Services, Inc.; Robert
Morris Associates Annual Statement Studies; and annual surveys published in Fortune, Business
Week, and Forbes. Trade associations publish data for the companies in their industries.

Many companies publish their financial statements on the Internet. A problem with using
this information as a basis for comparison with competitors' performance is that the names for
account titles are not the same. The American Institute of CPAs has a project that seeks to
establish a standard set of account titles used in Internet reports. This is named the XBRL project.
When these titles become accepted, it should be easy to obtain averages and other data for
competitors by a simple computer program. Current information about this project can be
obtained from the AICPA Web site: www.oasis.open.orgl coverlsiteindex.html. The Financial
Executives Institute provides information about performance of member companies, but most is
available only to subscribers of its project. Tidbits are published in its journal, Financial
Executive.

Limitations on Standards

A variance between actual and standard performance is meaningful only if it is derived from a
valid standard. Although it is convenient to refer to favorable and unfavorable variances, these
words imply that the standard is a reliable measure of what performance should have been. Even
a standard cost may not be an accurate estimate of what costs should have been under the circum-
stances. This situation can arise for either or both of two reasons:

(1) The standard was not set properly, or

(2) Although it was set properly in light of conditions existing at the time, changed
conditions have made the standard obsolete.

An essential first step in the analysis of a variance is an examination of the validity of the
standard.

Full Cost Systems

If the company has a full-cost system, both variable and fixed overhead costs are included in the
inventory at the standard cost per unit. If the ending inventory is higher than the beginning
inventory, some of the fixed overhead costs incurred in the period remain in inventory rather than

flowing through to cost of sales. Conversely, if the inventory balance decreased during the period,
more fixed overhead costs were released to cost of sales than the amount actually incurred in the
period. For example assume that the inventory level did not change. Thus, the problem of
treating the variance associated with fixed overhead costs did not arise.

If inventory levels change, and if actual production volume is different from budgeted
sales volume, part of the production volume variance is included in inventory. Nevertheless, the
full amount of the production volume variance should be calculated and reported. This variance
is the difference between budgeted fixed production costs at the actual volume (as stated in the
flexible budget) and standard fixed production costs at that volume.

If the company has a variable-cost system, fixed production costs are not included in
inventory, so there is no production volume variance. The fixed production expense variance is
simply the difference between the budgeted amount and the actual amount.

The important point is that production variances should be associated with production
volume, not sales volume.

Amount of Detail

Previously we saw that we analyzed revenue variances at several levels: first, in total; then by
volume, mix, and price; then by analyzing the volume and mix variance by industry volume and
market share. At each of these levels, we analyzed the variances by individual products. The
process of going from one level to another is often referred to as "peeling the onion" -that is,
successive layers are peeled off, and the process continues as long as the additional detail is
judged to be worthwhile. Some companies do not develop as many layers as shown in our
example; others develop more. It is possible, and in some cases worthwhile, to develop
additional sales and marketing variances, such as the following: by sales territories, and even by
individual salesperson; by sales to individual countries or regions; by sales to key customers,
principal types of customers, or customers in certain industries; by sales originating from direct
mail, from customer calls, or from other sources. Additional detail for manufacturing costs can
be developed by calculating variances for lower-level responsibility centers and by identifying
variances with specific input factors, such as wage rates and material prices.

These layers correspond to the hierarchy of responsibility centers. Taking action based
on the reported variances is not possible unless they can be associated with the managers
responsible for them.

With modern information technology, about any level of detail can be supplied quickly
and at reasonable cost. The problem is to decide how much is worthwhile. In part, the answer
depends on the information requested by individual managers-some are numbers-oriented,
others are not. In the ideal situation, the basic data exist to make any conceivable type of
analysis, but only a small fraction of these data are reported routinely.

Engineered and Discretionary Costs

Variances in engineered costs are viewed in a fundamentally, different way from variances in
discretionary costs.

A "favorable" variance in engineered costs is usually an indication of good performance;
that is, the lower the cost the better the performance. This is subject to the qualification that
quality and on-time delivery are judged to be satisfactory.

By contrast, the performance of a discretionary expense center is usually judged to be
satisfactory if actual expenses are about equal to the budgeted amount, neither higher nor
lower. This is because a favorable variance may indicate that the responsibility center did not
perform adequately the functions that it had agreed to perform. Because some elements in a
discretionary expense center are in fact engineered (e.g., the bookkeeping functions in the
controller organization), a favorable variance is usually truly favorable for these elements.

Limitations of Variance Analysis

Although variance analysis is a powerful tool, it does have limitations.

(1)The most important limitation is that although it identifies where a variance occurs, it does

not tell why the variance occurred or what is being done about it.

For example, the report may show there was a significant unfavorable variance in

marketing expenses, and it may identify this variance with high sales promotion expenses. It

does not, however, explain why the sales promotion expenses were high and what, if any,

actions were being taken. A narrative explanation, accompanying the performance report,

should provide such an explanation.

(2)A second problem in variance analysis is two decide whether a variance is significant.

Statistical technique can be used to determine whether there is a significant difference

between actual and standard performance for certain processes; these techniques are usually

referred to as statistical quality control. However, they are applicable only when the process is

frequent, such as the operation of a machine tool on a production line.

The literature contains a few articles suggesting that statistical quality control be used

to determine whether a budget variance is significant, but this suggestion has little practical

relevance at the business unit level because the necessary number of repetitive actions is not

present. Conceptually, a variance should be investigated only when the benefit expected from

correcting the problem exceeds the cost of the investigation, but a model based on this

premise has so many uncertainties that it is only of academic interest. Managers therefore

relay on judgment in deciding what variances are significant. Moreover, if a variance is

significant but is uncontrollable (such as unexpected inflation), there may be no point in

investigating it.

(3) A third limitation of variance analysis is that as the performance report become more

highly aggregated; offsetting variances might mislead the reader. For example, a manager

looking at business unit manufacturing cost performance might notice that it was on budget.

However, this might have resulted from good performance at one plant being offset by poor

performance at another. Similarly, when different product lines at different stages of de-

velopment are combined, the combination may obscure the actual results of each product line.

Also, as variances become more highly aggregated, managers become more dependent

on the accompanying explanations and forecasts. Plant managers know what is happening in

their plant and can easily explain causes of variances. Business unit managers and everyone

above them, however, usually must depend on the explanations that accompany the variance

report of the plant.

(4) Finally the reports show only what has happened. They do not show the future

effects of action that the manager has taken. For example reducing the amount spent for

employee training increases current profitability, but it may have adverse consequences

in the future. Also, the report shows only those events that are recorded in the accounts

and many important events reflected in current accounting transactions. The accounts

don’t show the state of morale, for instance.

CONCLUSION:

Business unit managers repot their financial performance to senior management regularly usually

monthly. The formal report consists of a comparison of actual revenues and costs with the budgeted

amounts. The differences, or variances, between these two amounts can be analyzed at several levels

of detail. This analysis identifies the causes of the variance from budgeted profit and the amount

attributable to each cause.

Reference:

1. Robert N .Anthony & Vijay Govindarajan; “Management control system”; Second reprint 2004; Tata Mc-
Graw Hill Publishing House Limited New Delhi; Page No. 558-571.

Variance repoting

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