BILASPUR (C.G.) 495009 DEPARTMENT OF MANAGEMENT STUDIES M.B.A. III SEM. SESSION: 2011-12 SUBJECT: MANAGEMENT CONTROL SYSTEMPRESENTATION TOPIC: “VARIANCE REPORTING ” Submitted To: Submitted By: Dr. B. D. MISHRA NILESH KUMAR RAJPUT Associate Professor M. A. (Eco.); M.B.A.; Ph.D. .
CONTENTS1. INTRODOCTION………………………………… ……..012. REVENUE VARIANCES …………………….. ………023. EXPENSE VARIANCES.……. ………………………….044. VARIANCES IN PRACTICE……………………………045. EVALUATION STANDARDS.....................................066. LIMITATIONS ON STANDARDS ………………. …….087. LIMITATIONS OF VARIANCE ANALYSIS ………....10
8. CONCLUSION……………………………………… ..…..129. 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 varianceand expense variance. Revenue variance is further divided into volume and price variance for the totalbusiness unit and for each marketing responsibility center within the unit. They can be further dividedinto sales area and sales district. Expense variances can be divided between manufacturing expensesand other expenses. Manufacturing expenses can be further subdivided by factories and departmentswithin factories. Therefore, it is possible to identify each variance with the individual manager who isresponsible for it. This type of analysis is a powerful tool, without which the efficacy of profit budgetswould be limited.The profit budget has embedded in it certain expectations about the state of the total industry andabout the companys market share, its selling prices, and its cost structure. Results from variancecomputations are more "actionable" if changes in actual results are analyzed against each of theseexpectations. The analytical frame-work we use to conduct variance analysis incorporate thefollowing 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 whileholding: 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 usefulinsights into the causal factors underlying the overall profit variance. ..-Revenue VariancesRevenue variance includes selling price, volume, and mix variances. The calculation is made for eachproduct/line, and the product line results are then aggregated to calculate the total variance. A positivevariance is favorable, because it indicates that actual profit exceeded budgeted profit, and a negativevariance is unfavourable.Selling Price Variance The selling price variance is calculated by multiplying the difference between the actual priceand standard price by the actual volume.Mix and Volume VarianceOften the mix and volume variances are not separated. The equation for the combined mix and volumevariance is:Mix and volume variance = (Actual volume -Budgeted volume) * Budgeted unit contributionThe volume variance results from selling more units than budgeted .The mix variance results fromselling a different proportion of products from that assumed in the budget. Because products earndifferent contributions per unit, the sale of different proportions of products from those budgeted willresult in a variance. If the business unit has a "richer" mix (i.e. a higher proportion of products with ahigh contribution margin) the actual profit will be higher than budgeted; and if it has a "leaner" mix,the profit will be lower.MiX VarianceThe 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 contributionVolume VarianceThe volume variance can be calculated by subtracting the mix variance from the combined mixand volume variance.
Volume variance = [(Total actual volume of sales) * (Budgeted percentage)] - [(Budgeted sales) * (Budgeted unit contribution)]Other Revenue AnalysisRevenue variances may be further subdivided. Market Penetration and Industry VolumeMarket PenetrationOne extension of revenue analysis is to separate the mix and volume variance into the amount causedby differences in market share and the amount caused by differences in industry volume. The principleis that the business unit managers are responsible for market share, but they are not responsible for theindustry volume because that is largely influenced by the state of the economy. To make thiscalculation, industry sales data must be available.The following equation is used to separate the effect of market penetration from industry volume onthe mix and volume variance:Market share variance = [(Actual sales) - (Industry volume)] * Budgeted market penetration * Budgeted unit contributionIndustry VolumeThe 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 contributionThis calculation of variance due to industry volume is shown in Section D.Expense Variances: It includes: Fixed Costs and Variable CostsFixed Costs
Variances between actual and budgeted fixed cost are obtained. Simply by subtraction, since thesecosts are not affected by either the volume of sales or the volume of production.Variable CostsVariable costs are costs that vary directly and proportionately with volume. The budgeted variablemanufacturing costs must be adjusted to the actual volume of production.Variances in PracticeAs discussed above, is relatively straightforward way of identifying the variance that caused actualprofit in a business unit to be different from the budgeted profitability. Some variations from thisapproach are described in this sectionTime period of the ComparisonSome companies use performance for the year to date as the basis for comparison; for the periodended June 30, they would use budgeted and actual amounts for the six months ending on June30, rather than the amounts for June. Other companies compare the budget for the whole yearwith the current estimate of actual performance for the year. The actual amounts for the reportprepared as of June 30 would consist of actual numbers for the first six months plus the bestcurrent estimate of revenues and expenses for the second six months. A comparison for the year to date is not as much influenced by temporary aberrationsthat may be peculiar to the current month and, therefore, that need not be of as much concern tomanagement. On the other hand, it may mask the emergence of an important factor that is nottemporary. A comparison of the annual budget with current expectation of actual performance forthe whole year shows how closely the business unit manager expects to meet the annual profittarget. If performance for the year to date is worse than the budget for the year to date, it ispossible that the deficit will be overcome in the remaining months. On the other hand, forcesthat caused actual performance to be below budget for the year to date may be expected tocontinue for the remainder of the year, which will make the final numbers significantly differentfrom the budgeted amounts. Senior management needs a realistic estimate of the profit for thewhole 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 currentestimate of the years performance is often provided to financial analysts and other outsideparties. Obtaining a realistic estimate is difficult. Business unit managers tend to be optimistic abouttheir ability to perform in the remaining months because, if they are pessimistic, this casts doubt ontheir ability to manage. To some extent, this tendency can be overcome by placing the burden of proofon business unit managers to show that the current trends in volume, margins, and costs are not goingto continue. Nevertheless, an estimate of the whole year is soft, whereas actual performance is a matterof record. An alternative that lessens this problem is to report performance both for the year to dateand for the year as a whole.Focus on Gross MarginIn 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 spreadbetween costs and selling prices. Such a policy is especially important in periods of inflation. Avariance analysis in such a system would not have a selling price variance. Instead, there would be agross margin variance. Unit gross margin is the difference between selling prices andmanufacturing costs. The variance analysis is done by substituting “gross margin “for “selling price” in the price" inthe revenue equations. Gross margin is the difference between actual selling prices and the standardmanufacturing cost. The current standard manufacturing cost should take into account changes inmanufacturing costs that are caused by changes in wage rates and in material prices (and, in somecompanies, 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 theperformance of the marketing organization.Evaluation StandardsIn management control systems, the formal standards used in the evaluation of reports on actualactivities 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 againstwhich actual performance is compared in many companies. If the budget numbers are collected in ahaphazard 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 comparedwith the results for last month or with results for the same month a year ago. This type of standard hastwo serious weaknesses: (1) Conditions may have changed between the two periods in a way that invalidates the comparison, and (2) The prior periods performance may not have been acceptable.A supervisor whose spoilage cost is $500 a month, month after month, is consistent; but we do notknow, without other evidence, whether the performance was consistently good or consistently poor.Despite these inherent weaknesses, historical standards are used in some companies, often becausevalid predetermined standards are not available.(3) External StandardsThese standards derived from the performance of other responsibility centers or of othercompanies in the same industry. The performance of one branch sales office may be comparedwith the performance of other branch sales offices. If conditions in these responsibility centers are similar, such a comparison may provide anacceptable basis for evaluating performance. Some companies identify the company that they believe to be the best managed in theindustry and use numbers from that company-either with the cooperation of that company or frompublished material-as a basis of comparison. This process is called benchmarking. Data for individual companies are available in annual and quarterly reports and in Form10K (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 & Poors Compustat Services, Inc.; RobertMorris Associates Annual Statement Studies; and annual surveys published in Fortune, BusinessWeek, and Forbes. Trade associations publish data for the companies in their industries. Many companies publish their financial statements on the Internet. A problem with usingthis information as a basis for comparison with competitors performance is that the names foraccount titles are not the same. The American Institute of CPAs has a project that seeks toestablish 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 forcompetitors by a simple computer program. Current information about this project can beobtained from the AICPA Web site: www.oasis.open.orgl coverlsiteindex.html. The FinancialExecutives Institute provides information about performance of member companies, but most isavailable only to subscribers of its project. Tidbits are published in its journal, FinancialExecutive.Limitations on StandardsA variance between actual and standard performance is meaningful only if it is derived from avalid standard. Although it is convenient to refer to favorable and unfavorable variances, thesewords imply that the standard is a reliable measure of what performance should have been. Evena 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, changedconditions have made the standard obsolete.An essential first step in the analysis of a variance is an examination of the validity of thestandard.Full Cost SystemsIf the company has a full-cost system, both variable and fixed overhead costs are included in theinventory at the standard cost per unit. If the ending inventory is higher than the beginninginventory, 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 theperiod. For example assume that the inventory level did not change. Thus, the problem oftreating the variance associated with fixed overhead costs did not arise. If inventory levels change, and if actual production volume is different from budgetedsales volume, part of the production volume variance is included in inventory. Nevertheless, thefull amount of the production volume variance should be calculated and reported. This varianceis the difference between budgeted fixed production costs at the actual volume (as stated in theflexible budget) and standard fixed production costs at that volume. If the company has a variable-cost system, fixed production costs are not included ininventory, so there is no production volume variance. The fixed production expense variance issimply the difference between the budgeted amount and the actual amount. The important point is that production variances should be associated with productionvolume, not sales volume.Amount of DetailPreviously we saw that we analyzed revenue variances at several levels: first, in total; then byvolume, mix, and price; then by analyzing the volume and mix variance by industry volume andmarket share. At each of these levels, we analyzed the variances by individual products. Theprocess 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 isjudged to be worthwhile. Some companies do not develop as many layers as shown in ourexample; others develop more. It is possible, and in some cases worthwhile, to developadditional sales and marketing variances, such as the following: by sales territories, and even byindividual 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 directmail, from customer calls, or from other sources. Additional detail for manufacturing costs canbe developed by calculating variances for lower-level responsibility centers and by identifyingvariances with specific input factors, such as wage rates and material prices. These layers correspond to the hierarchy of responsibility centers. Taking action basedon the reported variances is not possible unless they can be associated with the managersresponsible for them.
With modern information technology, about any level of detail can be supplied quicklyand at reasonable cost. The problem is to decide how much is worthwhile. In part, the answerdepends 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 ofanalysis, but only a small fraction of these data are reported routinely.Engineered and Discretionary CostsVariances in engineered costs are viewed in a fundamentally, different way from variances indiscretionary 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 thatquality and on-time delivery are judged to be satisfactory. By contrast, the performance of a discretionary expense center is usually judged to besatisfactory if actual expenses are about equal to the budgeted amount, neither higher norlower. This is because a favorable variance may indicate that the responsibility center did notperform adequately the functions that it had agreed to perform. Because some elements in adiscretionary expense center are in fact engineered (e.g., the bookkeeping functions in thecontroller organization), a favorable variance is usually truly favorable for these elements.Limitations of Variance AnalysisAlthough 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 doesnot tell why the variance occurred or what is being done about it. For example, the report may show there was a significant unfavorable variance inmarketing expenses, and it may identify this variance with high sales promotion expenses. Itdoes 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 differencebetween actual and standard performance for certain processes; these techniques are usuallyreferred to as statistical quality control. However, they are applicable only when the process isfrequent, such as the operation of a machine tool on a production line. The literature contains a few articles suggesting that statistical quality control be usedto determine whether a budget variance is significant, but this suggestion has little practicalrelevance at the business unit level because the necessary number of repetitive actions is notpresent. Conceptually, a variance should be investigated only when the benefit expected fromcorrecting the problem exceeds the cost of the investigation, but a model based on thispremise has so many uncertainties that it is only of academic interest. Managers thereforerelay on judgment in deciding what variances are significant. Moreover, if a variance issignificant but is uncontrollable (such as unexpected inflation), there may be no point ininvestigating it.(3) A third limitation of variance analysis is that as the performance report become morehighly aggregated; offsetting variances might mislead the reader. For example, a managerlooking 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 poorperformance 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 dependenton the accompanying explanations and forecasts. Plant managers know what is happening intheir 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 variancereport of the plant.(4) Finally the reports show only what has happened. They do not show the futureeffects of action that the manager has taken. For example reducing the amount spent foremployee training increases current profitability, but it may have adverse consequencesin the future. Also, the report shows only those events that are recorded in the accountsand many important events reflected in current accounting transactions. The accountsdon’t show the state of morale, for instance.CONCLUSION:Business unit managers repot their financial performance to senior management regularly usuallymonthly. The formal report consists of a comparison of actual revenues and costs with the budgetedamounts. The differences, or variances, between these two amounts can be analyzed at several levelsof detail. This analysis identifies the causes of the variance from budgeted profit and the amountattributable 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.