November 23, 2015

1. November 23, 2015 Flexible Budgets, Variance Analysis & Standard Costs

2. Variance Analysis What is a Flexible Budget Flexible versus Static Budget Shortcomings of Static Budgets Advantages of Flexible Budgets Building a Flexible Budget Standard Costs Today’s Agenda

3. Variance Analysis Cycle Take corrective actions Receive explanations Identify questions Conduct next period’s operations Analyze variances Prepare standard cost performance report Begin

4. Characteristics of Flexible Budgets • Planning budgets are prepared for a single, planned level of activity. • Evaluation is difficult when actual activity varies from planned activity. • Flexible Budgets are prepared to provide an accurate budget for differing levels of output. • When comparing actual performance to budgeted performance at the actual level of output, we can better identify and isolate problem areas and areas which over performed

5. May be prepared for any activity level within the relevant range. Show costs that should have beenincurred at the actual level ofactivity, enabling “apples to apples”cost comparisons. Reveal variances related tocost control. Improve performance evaluation. Flexible Budgets Flexible Budget

6. Deficiencies of the Static Planning Budget Leung’s Actual Results Compared with the Planning Budget

7. Establish the “relevant range” of activity Range in which fixed costs remain in place; i.e., no requirement for stepped up investment (or step down) Develop a cost function (mathematical equation) as to has each cost line item should behave based on differing activity levels Calculate the budget for forecast activity Creating a Flexible Budget

8. Preparing a Flexible Budget Leong’s Flexible Budget

9. Revenue and Spending Variances Flexible budget revenue Actual revenue The difference is a revenue variance. Flexible budget cost Actual cost The difference is a spending variance.

10. Revenue and Spending Variances Leong’s Flexible Budget Compared with the Actual Results Spending variances

11. Standard Costs – Setting Cost Formulas for Flexible Budgets • To build a flexible budget, we need to establish a “standard” for costs • What is Standard Cost and what is its purpose? • How are they set? • Direct Material Standard • Direct Labour Standard • Variable Overhead Standard • Standard Cost versus Actual Cost • Variance Analysis • Benefits and Problems with Standard Cost

12. Standard Costs Standards are benchmarks or “norms” formeasuring performance. In managerial accounting, two types of standards are commonly used. Quantity standardsspecify how much of aninput should be used tomake a product orprovide a service. Price standardsspecify how muchshould be paid foreach unit of theinput. Examples: Firestone, Sears, McDonald’s, hospitals, construction, and manufacturing companies.

13. Standard Cost • Standard Costs are benchmark costs that management believes are appropriate for measuring performance • Quantity Standards • How many units of an input should be used to produce a unit of output • E.g., it should take 20 minutes of Direct Labour to produce one cell phone • Price Standards • What is the appropriate price of a unit • E.g., an hour of labour should cost $5 • In this case, the Direct Labour Standard is .33 * 5, or $1.67 per unit

14. Standard Cost • Standard Cost information is used for several purposes: • Budgeting • Build up of expected appropriate costs are input into budgets • Monitoring costs • Budgets are tracked on a regular basis • Controlling costs • With budgeted inputs in place, managers are incentivized to work to and exceed targets • Isolating problems • When compared to actual costs, it is helpful in identifying problem areas and isolating the source

15. Variance • Deviations from Standard Cost are called “Variances” • Variances can be “Favourable” or “Unfavourable” • In the case of the cell phone manufacturer, any Direct Labour cost per unit which is • above the Standard Cost of $1.67 would be described as an Unfavourable Variance • Below the Standard Cost of $1.67 would be described as a Favourable Variance • Managers can focus in particular on Unfavourable Variances • There could be a problem in the production process • There could be a problem with the application of the methodology

16. Who Sets Standard Costs • Setting appropriate Standard Costs requires the input of several people • Purchasing Managers • Pricing of Direct Materials • Production Managers • Quantity of Direct Materials • Required Labour • Engineers • Optimizing processes and determining impact on Standard Cost • Accountants • Verification • Calculation and monitoring • Exception reporting • As managers will be held to account for Variances, therefore Standard Costs should be “reasonable” and achievable (remember “Participating Budgeting Process”) • Additional incentive can be provided for reducing costs, designing out high value parts and processes, etc.

17. Product Costing, revisited • Product Costs • Direct Labour • Direct Materials • Manufacturing Overhead • Variable • Fixed • Flexible budgets require all variable costs to be separated from fixed costs • Recall “Absorption Costing” - included fixed and variable Manufacturing Overhead • Recall “Variable Costing” – included only Variable Overhead

18. Standard Costs – Direct Materials & Labour • Direct Materials • Quantity Standard • Quantity or each component required • Lead times – impacts inventory financing costs (as apposed to standard cost) • Price Standard • Price of the components at the volume required • Net of discounts, shipping etc. – “landed cost” • Direct Labour • Time Standard • Time required from Direct Labour to “Convert” the Direct Materials into a Finished Product • Rate Standard

19. Standard Quantityper Unit Summarized in a Bill of Materials. Final, deliveredcost of materials,net of discounts. Setting Direct Materials Standards Standard Price per Unit • What costs are included in “final, delivered” materials, net of discounts? • What is a “Bill of Materials”?

20. Standard Rateper Hour Standard Hoursper Unit Often a singlerate is used that reflectsthe mix of wages earned. Use time and motion studies foreach labor operation. Setting Direct Labor Standards

21. Standard Costs – Variable Manufacturing Overhead • Variable Manufacturing Overhead • Price Standards • Quantity Standards • The 3rd and final cost to address for Flexible Budgeting is Variable Manufacturing Overhead • Think back to the POHR (Predetermined Overhead Rate) in Product Costing • We selected a basis for allocating Manufacturing Overhead • Eg, Overhead/Labour hour; or Overhead/Machine hours; etc. • The “Activity Base” • We will do something similar here, but applied only to Variable Overhead • It is only the Variable portion of overhead that will “Flex” with volume/output

22. PriceStandard QuantityStandard The rate is the variable portion of the predetermined overhead rate. The quantity is the activity in the allocation base for predetermined overhead. Setting Variable Manufacturing Overhead Standards

23. Activity base andvariable overheadshould becausally related. Activity base shouldbe simple andeasily understood. Activity base shouldnot be expressedin dollars orother currency. The Measure of Activity– A Critical Choice Three importantfactors in selecting anactivity base for an overheadflexible budget

24. Standard Cost Card – Variable Production Cost • A Standard Cost Card is produced for each SKU

25. Price Variance Quantity Variance Difference betweenactual price and standard price Difference betweenactual quantity andstandard quantity A General Model for Variance Analysis Variance Analysis

26. Actual Quantity Actual Quantity Standard Quantity × × × Actual Price Standard Price Standard Price Price Variance Quantity Variance A General Model for Variance Analysis (AQ × AP) – (AQ × SP) (AQ × SP) – (SQ × SP) AQ =Actual Quantity SP =Standard PriceAP =Actual Price SQ =Standard Quantity

27. General Variance Analysis Applied • Assumptions: • Standard Rate = $104 • Standard Quantity = 1,000 • Actual Quantity = 900 • Actual Cost = $100,080 • What is the Price and quantity Variance?

28. General Variance Analysis Applied • Actual Rate = 900 units / $100,080 = $111.20 • Price Variance = 93,600 – 100,080 = -$6,480 (unfavourable) • Quantity Variance = 104,000 – 93,600 = $10,400 (favourable) • NOTE: Less quantity isn’t exactly “favourable” for the business, but it removes the difference due to volume and highlights the inefficiencies relative to budget

29. Detailed Variance Analysis • General Variance Analysis exposed unfavourable performance relative to budget • Applying the same analysis to the three components can isolate particular problems, which can then be addressed • The same formulas were applied for General Variance are applied to: • Direct Materials • Direct Labour • Variable Manufacturing Overhead

30. Actual Costs • On completion of the accounting period, we can obtain actual costs • Actual costs are compared to Standard Costs to analyze and identify problem areas

31. Detailed Variance Analysis Applied – Direct Materials • Variance Analysis is applied in the same way for detailed accounts as it is in general • Direct Materials, Direct Labour, Variable Overhead • If need be, we can “drill down” line by line into the Bill of Materials • Both Price and Quantity Variance are Unfavourable • Too many scrapped pieces? • Poor purchasing? Or supply shortage?

32. Your poor scheduling sometimes requires me to rush order materials at a higher price, causing unfavorable price variances. I am not responsible for this unfavorable materialsquantity variance. You purchased cheapmaterial, so my peoplehad to use more of it. Responsibility for Materials Variances Production Manager Purchasing Manager

33. Detailed Variance Analysis Applied – Direct Labour • Production manager upgraded to more costly, skilled labour which could work faster • Labour quantity came down to 2 hours per unit from 3 hours per unit • Quantity variance is hugely favourable • While price variance was unfavourable, the cost increase was justified by the decrease in quantity

34. Mix of skill levelsassigned to work tasks. Level of employee motivation. Quality of production supervision. Quality of training provided to employees. Responsibility for Labour Variances Production managers areusually held accountablefor labor variancesbecause they caninfluence the: • How would you rate this production manager’s performance?

35. I think it took more time to process the materials because the Maintenance Department has poorly maintained your equipment. I am not responsible for the unfavorable laborefficiency variance! You purchased cheapmaterial, so it took moretime to process it. Possible Conflicts - Labour Variances

36. Detailed Variance Analysis Applied – Variable Manufacturing Overhead • Quantity variance is “favourable” only due to the reduced output • Price variance is unfavourable, the cause of which needs to be investigated

37. Summary of Variances • The sum of the variances for each product cost equals the total variance • Recall that in many accounting systems, it is Standard Costs which are charged to Inventory and COGS accounts as products are produced • In these companies, Variance from Standard Costs will require adjustments to accounts • Fixed Costs – the same principles apply • Inevitably, even within the relevant range, there will be variances in fixed costs • In an Absorption Costing system, fixed costs may have been over or under applied and need to be cleared

38. Cost Flows in a Standard Cost System • Inventories are recorded at standard cost. • Variances are recorded as follows: • Favorable variances are credits, representing savings in production costs. • Unfavorable variances are debits, representing excess production costs. • Standard cost variances are usually closed out to cost of goods sold. • Unfavorable variances increase cost of goods sold. • Favorable variances decrease cost of goods sold.

39. Larger variances, in dollar amount or as a percentage of the standard, are investigated first. Variance Analysis and Management by Exception How do I knowwhich variances to investigate?

40. Advantages Advantages of Standard Costs Promotes economy and efficiency Management byexception Enhances responsibilityaccounting Simplifiedbookkeeping

41. PotentialProblems Potential Problems with Standard Costs Emphasizing standardsmay exclude otherimportant objectives. Favorablevariances maybe misinterpreted. Standard costreports maynot be timely. Emphasis onnegative mayimpact morale. Continuous improvement maybe more importantthan meeting standards. Invalid assumptionsabout the relationshipbetween laborcost and output.

42. Variance Analysis What is a Flexible Budget Flexible versus Static Budget Shortcomings of Static Budgets Advantages of Flexible Budgets Building a Flexible Budget Standard Costs Review