Assignment Exercise 17–1: Variance Analysis
Greenview Hospital operated at 120% of normal capacity in two of its departments during the year. It operated 120% times 20,000 normal capacity direct labor nursing hours in routine services and it operated 120% times 20,000 normal capacity equipment hours in the laboratory. The lab allocates overhead by measuring minutes and hours the equipment is used; thus equipment hours.
Assumptions:
For Routine Services Nursing:
• 20,000 hours × 120% = 24,000 direct labor nursing hours.
• Budgeted Overhead at 24,000 hours = $42,000 fixed plus $6,000 variable = $48,000 total.
• Actual Overhead at 24,000 hours = $42,000 fixed plus $7,000 variable = $49,000 total.
• Applied Overhead for 24,000 hours at $2.35 = $56,400.
For Laboratory:
• 20,000 hours × 120% = 24,000 equipment hours.
• Budgeted Overhead at 24,000 hours = $59,600 fixed plus $11,400 variable = $71,000 total.
• Actual Overhead at 24,000 hours = $59,600 fixed plus $11,600 variable = $71,200 total.
• Applied Overhead for 24,000 hours at $3.455 = $82,920.
Required:
1. Set up a worksheet for applied overhead costs and volume variance with a column for Routine Services Nursing and a second column for Laboratory.
2. Set up a worksheet for actual overhead costs and budget variance with a column for Routine Services Nursing and a second column for Laboratory.
3. Set up a worksheet for volume variance and budget variance totaling net variance with a column for Routine Services Nursing and a second column for Laboratory.
4. Insert input data from the Assumptions.
5. Complete computations for all three worksheets
Assignment Exercise 17–2: Three-Level Revenue Forecast
Three eye-ear-nose-and-throat physicians decide to hire an experienced audiologist in order to add a new service line to their practice.* They ask the practice manager to prepare a three-level volume forecast as a first step in their decision-making.
Assumptions: for the base level (most likely) revenue forecast, assume $200 per procedure times 4 procedures per day times 5 days equals 20 procedures per week times 50 weeks per year equals 1,000 potential procedures per year.
For the best case revenue forecast, assume an increase in volume of one procedure per day average, for an annual increase of 250 procedures (5 days per week times 50 weeks equals 250). (The best case is if the practice gains a particular managed care contract.)
For the worst case revenue forecast, assume a decrease in volume of 2 procedures per day average, for an annual decrease of 500 procedures. (The worst case is if the practice loses a major payer.)
*Audiologists were designated as “eligible for physician and other prescriber incentives” as discussed elsewhere. Thus the new service line was a logical move.
Required: Using the above assumptions, prepare a three-level forecast similar to the example in Figure 17–5 and document your calculations.
Assignment Exercise 17–3: Target Operating Income
Acme Medical Supply Company d ...
1. Assignment Exercise 17–1: Variance Analysis
Greenview Hospital operated at 120% of normal capacity in two
of its departments during the year. It operated 120% times
20,000 normal capacity direct labor nursing hours in routine
services and it operated 120% times 20,000 normal capacity
equipment hours in the laboratory. The lab allocates overhead
by measuring minutes and hours the equipment is used; thus
equipment hours.
Assumptions:
For Routine Services Nursing:
• 20,000 hours × 120% = 24,000 direct labor nursing hours.
• Budgeted Overhead at 24,000 hours = $42,000 fixed plus
$6,000 variable = $48,000 total.
• Actual Overhead at 24,000 hours = $42,000 fixed plus $7,000
variable = $49,000 total.
• Applied Overhead for 24,000 hours at $2.35 = $56,400.
For Laboratory:
• 20,000 hours × 120% = 24,000 equipment hours.
• Budgeted Overhead at 24,000 hours = $59,600 fixed plus
$11,400 variable = $71,000 total.
• Actual Overhead at 24,000 hours = $59,600 fixed plus $11,600
variable = $71,200 total.
• Applied Overhead for 24,000 hours at $3.455 = $82,920.
Required:
1. Set up a worksheet for applied overhead costs and volume
variance with a column for Routine Services Nursing and a
second column for Laboratory.
2. Set up a worksheet for actual overhead costs and budget
variance with a column for Routine Services Nursing and a
second column for Laboratory.
3. Set up a worksheet for volume variance and budget variance
totaling net variance with a column for Routine Services
Nursing and a second column for Laboratory.
4. Insert input data from the Assumptions.
2. 5. Complete computations for all three worksheets
Assignment Exercise 17–2: Three-Level Revenue Forecast
Three eye-ear-nose-and-throat physicians decide to hire an
experienced audiologist in order to add a new service line to
their practice.* They ask the practice manager to prepare a
three-level volume forecast as a first step in their decision-
making.
Assumptions: for the base level (most likely) revenue forecast,
assume $200 per procedure times 4 procedures per day times 5
days equals 20 procedures per week times 50 weeks per year
equals 1,000 potential procedures per year.
For the best case revenue forecast, assume an increase in
volume of one procedure per day average, for an annual
increase of 250 procedures (5 days per week times 50 weeks
equals 250). (The best case is if the practice gains a particular
managed care contract.)
For the worst case revenue forecast, assume a decrease in
volume of 2 procedures per day average, for an annual decrease
of 500 procedures. (The worst case is if the practice loses a
major payer.)
*Audiologists were designated as “eligible for physician and
other prescriber incentives” as discussed elsewhere. Thus the
new service line was a logical move.
Required: Using the above assumptions, prepare a three-level
forecast similar to the example in Figure 17–5 and document
your calculations.
Assignment Exercise 17–3: Target Operating Income
Acme Medical Supply Company desires a target operating
income amount of $100,000, with assumption inputs as follows:
• Desired (target) operating income amount = $100,000
• Unit price for sales = $80
• Variable cost per unit = $60
• Total fixed cost = $60,000
Compute the required revenue to achieve the target operating
income and compute a contribution income statement to prove
3. the totals.
Our variance analysis example and practice exercise use the
flexible budget approach. A flexible budget is one that is
created using budgeted revenue and/or budgeted cost amounts.
A flexible budget is adjusted, or flexed, to the actual level of
output achieved (or perhaps expected to be achieved) during the
budget period. A flexible budget thus looks toward a range of
activity or volume (versus only one level in the static budget).
Examples of how the variance analysis works are contained in
Figure 17–1 (the elements), in Figure 17-2 (the composition),
and in Figures 17–3 and 17–4 (the calculations). Study these
examples before undertaking the Practice Exercise. PLEASE
SEE BELOW
We have restated Exhibit 17–2 in a worksheet format for
purposes of this example. The new format appears as follows.
(The numbers have not changed.)
Practice Exercise 17–1
Exhibit 17–2 presents the Variance Analysis for hospital rehab
services for the third quarter. For our practice exercise we will
duplicate this report for the fourth quarter. We are able to
reformat the information in Exhibit 17–2 into a worksheet as
follows. The fourth quarter assumptions appear below the
worksheet.
Actual Cost $920,000
Less: Flexible Budget $990,000
Price Variance (favorable) $70,000
Budgeted Cost $937,500
Less: Flexible Budget $990,000
4. Quantity Variance (unfavorable) -$52,500
Net Variance (unfavorable) $17,500
Assumptions (Refer to Exhibit 17-2)
Overhead Cost divided by # Therapy
Minutes (Activity Level) equals Cost per Therapy Minute
Actual (1) $920,000
(3) 330,000 (5) $2.79
Budgeted (2) $937,500
(4) 312,500 (6) $3.00
*Practice Exercise 17–1
Exhibit 17–2 below presents the Variance Analysis for hospital
rehab services for the third quarter. For our practice exercise we
will duplicate this report for the fourth quarter. We are able to
reformat the information in Exhibit 17–2 into a worksheet as
follows. The fourth quarter assumptions appear below the
worksheet.
Required
1.Set up a worksheet for the fourth quarter like that shown in
Exhibit 17–2 below for the third quarter.
2.Insert the Fourth Quarter Input Data (per assumptions given
above) on the worksheet.
3.Complete the “Actual Cost,” “Flexible Budget,” and
“Budgeted Cost” sections at the top of the worksheet.
4.Compute the Price Variance and the Quantity Variance in the
middle of the worksheet.
5.Indicate whether the Price and the Quantity Variances are
favorable or unfavorable for the four
*
Solution
5. to Practice Exercise 17-1
Actual Cost
$950,000
Less: Flexible Budget
$1,050,000
Price Variance (favorable)
$100,000
Budgeted Cost
$930,000
Less: Flexible Budget
$1,050,000
Quantity Variance (unfavorable)
-$120,500
Net Variance (unfavorable)
-$20,000
The Price Variance is $100,000 (favorable).
The Quantity Variance is $120,000 (unfavorable).
The Net Variance is $20,000 (unfavorable)
Assumptions
Overhead Cost divided by # Therapy Minutes
(Activity Level) equals Cost per Therapy Minute
Actual (1) $950,000 (3)
350,000 (5) $2.71
Budgeted (2) $930,000 (4)
6. 310,000 (6) $3.00
Optional
Can you compute how the $950,000 actual overhead costs and
the $930,000 budgeted overhead costs were calculated?
The $950,000 actual overhead cost represents 350,000 therapy
minutes times $2.71 per therapy minute.
The $930,000 budgeted overhead cost represents 310,000
therapy minutes times $3.00 per therapy minute.
Figure 17–1 Elements of Variance Analysis.
Figure 17–2 Composition of Two- and Three-Variance Analysis.
Figure 17–3 A Calculation of Two-Variance Analysis.
Note: To obtain proof total, perform the following calculation:
A, Actual Cost Incurred, less B, Applied Cost = Total Variance
Different Names for the Three Variable Cost Elements
Another oddity in variance analysis that contributes to
confusion is this: all three variable cost elements—that is,
direct materials, direct labor, and variable overhead—can have
7. a price variance and a quantity variance computed. But the
variance is not known by the same name in all instances.
Exhibit 17–1 sets out the different names. Even though the
names differ, the calculation for all three is the same. Note, too,
that variance analysis is primarily a matter of input–output
analysis. The inputs represent actual quantities of direct
materials, direct labor, and variable overhead used. The outputs
represent the services or products delivered (e.g., produced) for
the applicable time period, expressed in terms of standard
quantity (in the case of materials) or of standard hours (in the
case of labor). In other words, the standard quantity or standard
hours equates to what should have been used (the standard)
rather than what was actually used. This is an important point to
remember.
Figure 17–4 Calculation of Three-Variance Analysis.
Note: To obtain proof total, perform the following calculation:
A, Actual Cost Incurred, less B, Applied Cost = Total Variance
*Practice Exercise 17–2
Target Operating Income Using the Contribution Margin
Method
A target operating income computation allows the manager to
8. determine how many units must be sold in order to yield a
particular operating income. We will describe the contribution
margin method of computing target operating income. This
method is particularly useful to the manager because it is easily
understood and can be applied in many circumstances. The
formula for the contribution margin method of determining
target operating income is as follows:
The necessary inputs for this formula include the following:
•Desired (target) operating income amount
•Unit price for sales
•Variable cost per unit
•Total fixed cost
Let us consider an example:
•Desired (target) operating income amount = $1,600
•Unit price for sales = $100
•Variable cost per unit = $60
•Total fixed cost = $2,000
The contribution margin per unit therefore amounts to $40
($100 sales price per unit less $60 variable cost per unit), and
the formula will appear as follows:
Therefore: 90 units times $100 unit price for sales = $9,000
required revenue.
9. We can then create a contribution income statement to prove the
formula results, as follows:
Revenue $100/unit × 90 units = $9,000
Variable costs $60/unit × 90 units = 5,400
Contribution margin $3,600
Fixed costs 2,000
Desired (target) operating income = $1,600
In summary, note that this formula is one type of cost-volume-
profit (CVP) equation. (For a further discussion of the CVP
concept, refer to the chapter about cost behavior and break-even
analysis.
Worksheet Example
Julie Smith is the Metropolis Health System’s Director of
Community Relations. She has been informed that the Health
System will participate in the first area Wellness Gala, to be
held at the city convention center. The gala is an annual
fundraising event in which a variety of nonprofit organizations
each have an opportunity to earn dollars for their cause.
Individuals attending the gala will be prepared to, and are
expected to, purchase items from the various booths. Julie’s
boss wants their proceeds to go to the Health System’s
auxiliary.
It is now Julie’s responsibility to make the financial
arrangements and to coordinate the Health System’s
participation in the event. Last year the booth expense was
10. $1,000, and Julie uses this figure as her assumption of fixed
cost for the coming year’s event. She finds a local vendor who
assembles unique gift baskets. Her wholesale cost per basket
will be $30 apiece, if she can place the order within 10 days
(otherwise, the cost rises after the 10 days expires).
Julie believes the gift baskets will sell at the gala for a sales
price of $50 apiece. She prepares a worksheet to determine what
dollar amount of sales would be required to earn three ranges of
operating income: $5,000, $6,250, and $7,500. Exhibit 17–3
illustrates Julie’s worksheet. Line number 1 contains her first
set of assumptions: $1,000 fixed cost for the booth rental and
$30 variable cost for each basket.
The convention center representative now e-mails Julie with
news: due to a recent renovation of the convention center, booth
rental fees have increased. It will cost Julie $1,500 for the
booth. She then adds line 2 to her worksheet with a second set
of assumptions: $1,500 fixed cost for the booth rental and the
same $30 variable cost for each basket. She is now prepared to
discuss her findings with her boss.
Break-Even Point Using the Contribution Margin Method
You will recall that the break-even point is the point at which
operating revenues and costs equal each other and operating
income is zero. There is a graph method to illustrate the break-
even point (which was previously discussed in the chapter about
cost behavior and break-even analysis). In this sensitivity
11. analysis section we will describe another method to determine
the break-even point. It is called the “contribution margin
method.” The advantage of this method is its transparency. The
manager can easily explain his or her results, because the
computations can be easily seen and understood.
Exhibit 17–3 Target Operating Income Worksheet
(A) (B)
(C)
At $50 Sales Price per Unit, $$ Sales Required to Earn
Operating Income of:
Fixed Cost Variable Cost per Unit
(1) $1,000 $30 $5,000
$6,250 $7,500
(2) $1,500 $30 $6,250
$7,500 $8,750
It is understood that operating income is zero at the break-even
point. It follows, then, that the number of units at break-even
point can be computed. The formula is as follows:
To compute the contribution margin per unit, subtract the
variable costs per unit from the sales price per unit. In the
Target Operating Income formula inputs as previously
described, the sales price per unit was $100 and the variable
costs per unit were $60. Thus the contribution margin per unit is
12. $40 ($100 less $60 equals $40).
Using the same inputs, our break-even formula will now appear
as follows:
Thus the break-even number of units will equal $2,000 divided
by $40 = 50 units.
We can create a contribution income statement to prove this
formula’s results, as follows:
Revenue $100/unit × 50 units = $5,000
Variable costs $60/unit × 50 units = 3,000
Contribution margin $2,000
Fixed costs 2,000
Operating income at break-even = $-0
Closely study the chapter text concerning target operating
income above. The necessary inputs for target operating income
include the following:
• Desired (target) operating income amount = $20,000
• Unit price for sales = $500
• Variable cost per unit = $300
• Total fixed cost = $10,000
Compute the required revenue to achieve the target operating
income and compute a contribution income statement to prove
the totals.
*