VARIANCE ANALYSIS

Variance Analysis

Stocks can be valued at standard cost. That would mean that you would not have to deal with actual cost whether using FIFO, LIFO or the weighted average basis. For the financial accounts at the year-end, the organization should check that standard costs approximate to the actual costs.

Ø      By comparing standard costs to the actual costs, the business has a way of judging performance. Difference between actual and standard costs is known as variances.

Ø      Record-keeping during the year is greatly simplified. As units pass from one department to another, they are recorded at their standard costs. The business does not have to keep calculating actual costs.

Instead of tracing the actual costs to production, the standard costs are used. Of course, actual costs have to be accounted for at some time, but using standard costs has the following advantages:

Ø      Pre-determined costs that should be incurred under normal efficient operating conditions.

 Principles of Variance analysis

Variances are calculated by comparing actual costs (or income) with the costs (or income) that there would have been had everything gone according to plan.

•         When something goes better than planned, there will be a favourable variance.

•         When something goes worse than planned, there will be an adverse variance.

Variances therefore indicate where there are discrepancies between actual and planned performance. Such discrepancies may be fruitful places for management to look when trying to improve performance or when trying to pinpoint why poor performance has occurred.

Example

Standard Materials

Cost = $5

Usage=10kg/unit

Standard material cost per unit= $50

Actual materials

Cost = $72000

Units made= 1000

When the resources used for a month are measured, the following is discovered:

You can see that more has been spent than would have been if the business had kept to the standard: 1,000 units should have cost $50,000, so there has been an overspend of $22,000. This would be known as an adverse variance of $22,000.

Roles and Nature of Management accounting

In a business, Management accountant plays different internal roles such as:-

1.1. Planning and controlling organisation’s budget

According to Yazdifar, et al (2008) management accountants plans and control the budget of the business. This means that management accountants are the one forecasting the future revenue and expenditure of the organisation and make sure that the company do not go beyond the limited amount of expenditure planned to be spent in the year or receive less than expected revenue in a year. Moreover management accountants can forecast the future cash flow of the organisation and advice the management with reference to the cash budget of the organisation.

1.2. Evaluation of business performance

The association for accountants and financial professional in business argues that management accountants are the one evaluating the performance of the business. This means that they are the one looking on where the business came from, current situation, and where it is going. Furthermore management accountants can advice the management on how they can improve the performance of the business by offering them techniques or ideas which can help improving performance of the business. For example Tesco offers of buy now pay later within six month without interest on large screen TV. This was an idea of management accountants at Tesco who want to increase the movement of big screen TV and improve revenue of the business.

1.3. Profit improvement

Glynn, et al (2003) argue that profit improvement is management accountant’s role and not sales manager since most of the  sales managers are looking to increase the volume of sales without considering the effect on profit. Therefore, management accountants are the one to advice top management on different ways or techniques of which they can use to improve their profit. Management accountants can play an important role towards improvement of profit by advising the top management on whether to reduce the price in order to increase volume and hence increase profit or to give discounts to royal customers or for large orders in order to encourage buying in large quantities. For example at Tesco, customers with 100 points will receive discount vouchers.

1.4. Problem solving

According to Upchurch (1998) management accountants as management support help top management in solving different problems within the organisation. This is by providing the management with information about the cause of the problem and the positive and negative consequences of a possible course of action. By doing so, management accountants solved the problem because once the source of the problem is known, the problem is half solved. For example Tesco may have high production cost which made them selling some of their products at high price. Management accountants may look on what makes Tesco incur high production cost if it is due to high wages, type of material or machines used. If the source of production is high wage level paid to Tesco employees, management accountant may advice the top management to move its factory to Asia where it can get cheap labour and on top of that they will give effects of moving factory there such as high initial cost and so on.

Management accounting- Pricing

A pottery has to quote for a special order of clay pipe fittings to be made in its two departments, Blunging and Extruding.  Details are as follows:

                                                                              Blunging                            Extruding

Standard direct wage rate per hour                            £5                                      £3

Standard variable overhead per hour                          £2.50                                 £2

Standard fixed overhead per hour                              £6                                      £4

Direct labour hours per unit for the first

1000 clay fittings                                                        12                                      6

Direct labour hours available per period                     40,000                               30,000

Expected rate of learning curve, applied

per block of 1000 units                                               80%                                   70%

Cost of clays used in Blunging are as follows:

                                                Level of output                         Cost per clay fitting

                                                      (fittings)                                              £

                                                         1000                                              36.00

                                                         2000                                              32.40

                                                         8000                                              27.00

No overtime premium has been included in the calculation of overhead, but overtime is paid at time and a half.

The special order involves special tooling to be used in Extruding at a total cost of £6,000, chargeable to the customer.

In arriving at selling prices, the company adds profit mark-ups of 20%.

If the order is for 2000 clay fittings or fewer, it will need to be done during period 5 which already has a workload of:

Blunging                                          25,600 direct labour hours

Extruding                                         14,000 direct labour hours.

Required:

a)      Recommend the price to be charged for clay fittings made entirely within the company for an order of:

         (i)      1000 clay pipe fittings

         (ii)     2000 clay pipe fittings.                                                       

b)      Assume that an order for 2000 clay pipe fittings has been placed as in a) (ii) above, recommend the lowest price the company could charge for an additional order of 600 clay pipe fittings in the following conditions:

         (i)      The company wished to treat this as an incremental order but did not wish to make a loss on it;

         (ii)     the additional work would be done when there were no capacity constraints for either department; and

         (iii)    the materials suppliers would charge the price at the 8000 level.

                 

Solution

                                                                                    Blunging                      Extruding

Direct labour hours for order of 1,000 units                  12,000                           6,000

Current workload                                                           25,600                         14,000

Total hours with order of 1,000 units                            37,600                         20,000

                                                                                       =====                         =====

Direct labour hours for order of 2,000 units

2,000 x 12 x 0.8                                                          19,200 (2,000 x 6 x 0.7)          8,400

Current workload                                                        25,600                            14,000

Total hours with order of 200 units                            44,800                            22,400

                                                                                    =====                            =====

Overtime hours required                                               4,800

Overtime premium (x £2.50)                                       £12,000

                                                                                    = £6 per unit

a)      Assuming that the order is to be costed as part of the normal business of the company and will therefore be required to absorb the full amount of fixed overhead.

                                                            (i) Order of                              (ii) Order of

                                                                1,000 units                             2,000 units

         Blunging                                    £/unit     £/unit                         £/unit    £/unit

         Direct wages           12 x £5         60.00                     x 0.80      48.00

         Variable overhead 12 x £2.50    30.00                     x 0.80        24.00

         Fixed overhead      12 x £6          72.00                     x 0.80      57.60

         Overtime premium                              0                                       6.00

                                                                            162.00                                    135.60

         Extruding

         Direct wages            6 x £3          18.00                    x 0.70       12.60

         Variable overhead  6 x £2            12.00                    x 0.70         8.40

         Fixed overhead       6 x £4           24.00                    x 0.70       16.80

                                                                             54.00                                      37.80

         Direct materials (clays)                               36.00                                      32.40

         Special tooling £6,000 ÷ 1,000                     6.00     £6,000 ÷ 2,000         3.00

                                                                           258.00                                    208.80

         Profit Margin (20%)

                                                                             51.60                                       41.76

         Recommended price per unit                      309.60                                   250.56

b)      If the company wishes to treat the order as incremental only those costs which are incurred as a direct result of the order would be included in the estimate.  assuming that fixed overheads will not increase, they are excluded from the calculations.

         Since the company wishes to charge the lowest price possible without making a loss, no profit margin will be added.

         A further order of 600 units in addition to an initial order for 200 would bring cumulative volume to 800 units.  this means that the original volume of 200 fittings would be doubled twice.

                                                                        2,000  fittings              8,000 fittings

                                                                        £/unit                           £/unit

                                                                        (from a(ii))

         Direct wages and variable

         overhead

              Blunging                                           72.00     x 0.8 x 0.8     46.08

              Extruding                                          21.00     x 0.7 x 0.7     10.29

         Direct materials                                      32.40                           27.00

                                                                      125.40                           83.37

                                                                      =====                           ====

                                                                                                                  £

         Incremental cost of 8,000 units 8,000 x £83.37                        666,960

         Less incremental cost of 200 units 200 x £125.40                     250,800

         Incremental cost of 6,000 units                                                 416,160

                                                                                                            ======

                                                                                                    =      £69.36 per unit

         The lowest unit price that the company could charge for an additional order of 600 units is £69.36.

Management Accounting- Divisions

 Question

The Benmac Corporation has three operating divisions.  The managers of these divisions are evaluated on their divisional Net Income Before Taxes, a figure which includes an allocation of corporate overhead proportional to the sales of each division.  The operating statement for the first quarter of 1994 appears below:

                                                                                                Division                      

                                                                           A                B                C             Total

Net sales (000)                                                 £2,000        £1,200        £1,600        £4,800

Cost of sales                                                     1,050             540             640          2,230

Division Overhead                                                 250             125             160             535

Division Contribution                                             700             535             800          2,035

Corporate Overhead                                              400             240             320             960

Net Income Before Taxes                                     £300           £295           £480        £1,075

                                                                         ====          ====          ====        =====

The manager of Division A is unhappy that his profitability is about the same as Division B and much less than Division C's, even though his sales are much higher than either of these other two divisions.  The manager knows that he is carrying one line of products with very low profitability.  He was going to replace this line of business as soon as more profitable product opportunities became available, but has retained it until now since the line was still marginally profitable and used facilities that would otherwise be idle.  The manager now realises, however, that the sales from this product line are attracting a fair amount of corporate overhead because of the allocation procedure and maybe the line is already unprofitable for him.

This low margin line of products had the following characteristics for the quarter:

                        Net Sales (000)                                              £800

                        Cost of Sales                                                 600

                        Allocated Divisional Overhead                         100

                        Contribution                                                  £100

                                                                                           ====

Thus the product line accounted for 40 percent of divisional sales but less than 15 percent of divisional profit.

Required:

1.      Prepare the operating statement for the Benmac Corporation for the second quarter of 1994 assuming that sales and operating results are identical to the first quarter except that the manager of Division A drops the low margin product line entirely from his product group.  Is the Division A manager better off from this action?  Is the Benmac Corporation better off from this action?                                                                     

2.      Suggest improvements to the Benmac Corporation's divisional reporting and evaluation system that will improve local incentives for decision-making that is in the best interests of the firm.

                                                                                                                   

 Answer

1.      Without the £800,000 in sales from the low margin product line in Division A, the second quarter operating statements will be:

                                                                                                Division                      

                                                                           A                B                C             Total

         Net sales (000)                                        £1,200        £1,200        £1,600        £4,000

         Cost of sales                                               450             540             640          1,630

         Division Overhead                                        150             125             160             435

         Division Contribution                                    600             535             688          1,935

         Corporate Overhead                                     288             288             384             960

         Net Income Before Taxes                            £312           £247           £416           £975

                                                                         ====          ====          ====          ====

         The Division A manager is able to show a £12,000 higher profit because the £100,000 in lost contribution margin from the dropped product line is more than offset by the £112,000 reduction in corporate overhead.  Divisional sales are now only 30 percent of corporate sales rather than the previous 41.7 percent of sales.  The Benmac Corporation is worse off because it has lost the £100,000 contribution margin from the dropped product line with no reduction in corporate overhead.

2.         The easiest solution is to not allocate fixed corporate overhead to divisions.  Then, the problem of dysfunctional behaviour will not arise.  But central management may want the division managers to "see" the cost of corporate operations so that they will understand that the corporation as a whole is not profitable unless the combined divisions' contribution margins exceed corporate overhead.  In this case, an allocation basis should be chosen that is not manipulatable or under the control of division managers, and has the property that the actions of one division do not affect the allocations to other divisions (as occurred in the second quarter for the Benmac Corporation).  In general, a lump sum allocation based on, say, budgeted net income, or budgeted assets, rather than an allocation that varies proportionately with an actual measure of activity (such as sales or actual net income) will minimise dysfunctional behaviour.  The allocation should be such that managers treat it as a fixed, unavoidable charge, rather than a charge that will vary with decisions they take