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Session 10

47-701 Accounting for Decision Making and Control. 2. Budgeting. Budget: detailed plan for the acquisition and use of financial and other resources over a periodTwo stages of budgetingPlanning -- involves developing objectives and preparing various budgets to achieve these objectives.Control -- i

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Session 10

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    1. Budgeting and Variance Analysis Session 10

    2. 47-701 Accounting for Decision Making and Control 2 Budgeting Budget: detailed plan for the acquisition and use of financial and other resources over a period Two stages of budgeting Planning -- involves developing objectives and preparing various budgets to achieve these objectives. Control -- involves the steps taken by management that attempt to ensure the objectives are attained.

    3. 47-701 Accounting for Decision Making and Control 3 Budgeting Period

    4. 47-701 Accounting for Decision Making and Control 4 The Master Budget

    5. 47-701 Accounting for Decision Making and Control 5 Incentive Issues in Budgeting “Stretch” level vs. “highly achievable” level “Bottom-up (participative, self-imposed ) vs. Top-down approach Communicating specialized knowledge vs. performance evaluation Budget ratcheting How top management uses budgeted data How often do we hear “meet the budget?” Avoid using budget as a club to punish

    6. 47-701 Accounting for Decision Making and Control 6 Incentive Issues in Budgeting Line-item budgets Authorize spending only up to the specified amount on each line item. Often used in governments. Budget lapsing Incremental vs. zero-based budgets

    7. 47-701 Accounting for Decision Making and Control 7 Static Budgets (for OH) and Performance Reports

    8. 47-701 Accounting for Decision Making and Control 8 Have we done a good job controlling costs? Using static budgets to measure performance fails to distinguish between production control and cost control. Production control: make sure production goals in terms of output are met (budgeted production vs. actual production). Cost control: make sure the given output is produced at the least possible cost. Static Budgets (for OH) and Performance Reports

    9. 47-701 Accounting for Decision Making and Control 9 Flexible Budget Central idea: If you tell me what your activity was for the period, I will tell you what your costs and revenue should have been at that level To FLEX a budget for different activity levels, it is critical to know how costs behave with changes in activity levels. Total variable costs change in direct proportion to changes in activity. Total fixed costs remain unchanged within the relevant range.

    10. 47-701 Accounting for Decision Making and Control 10 Machine hour as the OH allocation basis Machine hour standard: 0.8MH/unit Budgeted MH: 10,000, corresponding to 12,500 budgeted units Actual production: 10,000 units; Actual machine hours: 9,000 MH Prepare the flexible budgets and performance report. (Note: Flexible budgets for DL and DM can be prepared in exactly the same way as variable OH shown next.) Flexible Budget: OH Example

    11. 47-701 Accounting for Decision Making and Control 11 Preparing a Flexible Budget: OH Example

    12. 47-701 Accounting for Decision Making and Control 12 Flexible Budget OH Performance Report

    13. 47-701 Accounting for Decision Making and Control 13 Comparison of OH Performance Reports

    14. 47-701 Accounting for Decision Making and Control 14 Actual and Normal Cost Systems The costing methods we’ve learned so far can be termed “actual” or “normal” cost systems: the cost of a cost component is calculated by multiplying (actual or budgeted) price/rate by actual quantity. DM = actual purchase price ? actual consumption DL = actual wage rate ? actual labor hours MOH = actual rate? actual activity level (actual costing) predetermined rate ? actual activity level (normal costing) Problems: No incentive to control cost unguided planning

    15. 47-701 Accounting for Decision Making and Control 15 Standard Cost System

    16. 47-701 Accounting for Decision Making and Control 16 Cost Flows: DM or DL Normal cost system: There is no variance as all actual cost is assigned to products. Standard cost system: How much cost is assigned? What is the variance?

    17. 47-701 Accounting for Decision Making and Control 17 Cost Flows: OH Normal cost system: Standard cost system:

    18. 47-701 Accounting for Decision Making and Control 18 Cost Flows: What to Do With Variance? The variance is nothing but the over- or under-application of costs relative to the actual level. The rules are the same as when we discussed the over- or under-application of OH in Session 2: in the end, we can close to Cost of Goods Sold if the amount is immaterial; or, allocate between WIP, finished goods and COGS

    19. 47-701 Accounting for Decision Making and Control 19 Variance Analysis Variance analysis provides a powerful tool for managerial control: Provides the performance and reward measures Help identify the problems Help pinpoint the causes of the problems Management should attend to material variances. How big is material is always a subtle issue.

    20. 47-701 Accounting for Decision Making and Control 20 Variance Analysis for DM and DL

    21. 47-701 Accounting for Decision Making and Control 21 DM/DL Variance: Graphical Analysis

    22. 47-701 Accounting for Decision Making and Control 22 Material Variances Example Hanson Inc. has the following direct material standard to manufacture one Zippy: 1.5 pounds per Zippy at $4.00 per pound Last week 1,700 pounds of material were purchased and used to make 1,000 Zippies. The material cost a total of $6,630.

    23. 47-701 Accounting for Decision Making and Control 23 Material Variances Example What if the amount purchased differs from the amount used? The price variance is computed on the entire quantity purchased. The quantity variance is computed only on the quantity used. Example: Last week 2,800 pounds of material were purchased at a total cost of $10,920, and 1,700 pounds were used to make 1,000 Zippies. Other info is the same.

    24. 47-701 Accounting for Decision Making and Control 24 Who’re Responsible for Material Variances? Generally purchase people are responsible for price variances and production people for quantity variances. However, the two variances may be related E.g. Cheap and low quality materials may have favorable price variance but more have to be used leading to unfavorable quantity variance. E.g. Poor scheduling on the production side may force purchase people to rush orders at higher prices.

    25. 47-701 Accounting for Decision Making and Control 25 Who’re Responsible for Labor Variances? Rate variance Using highly paid skilled workers to perform unskilled tasks results in an unfavorable rate variance. Production managers who make work assignments are generally responsible for rate variances. Efficiency variance: can be caused by Poorly trained workers ? personnel dept? Poor supervision of workers ? production manager Poor quality materials ? purchasing dept Poorly maintained equipment ? production manager

    26. 47-701 Accounting for Decision Making and Control 26 Unlike DM and DL costs which can be applied in actual amounts as costs are incurred and directly traceable, OH is applied indirectly to products using some common allocation (activity) base such as DL hours. The predetermined rate is calculated at the beginning of a period using expected or budgeted activity volume (BV). OH costs are allocated based on standard volume (SV): what the activity volume should be according to the standard given the actual units produced. Finally, the activities are performed at the actual volume (AV) for the actual production. Overhead Variances: Background

    27. 47-701 Accounting for Decision Making and Control 27 OH has both fixed (FOH) and variable (VOH) parts and would behave: OH = FOH + VOH ? V At the beginning of a period, budgeted OH is at the level: BOH = FOH + VOH ? BV Predetermined allocation rate (POHR) is calculated as: POHR = BOH/BV = FOH/BV + VOH Under normal cost system, OH is applied by: POHR ? AV (Slide # 17) Under standard cost system, OH is applied by: POHR ? SV (Slide # 17) Variance is the difference between actual spending and the amount allocated. Overhead Variances: Background

    28. 47-701 Accounting for Decision Making and Control 28 Overhead Variance Analysis

    29. 47-701 Accounting for Decision Making and Control 29 Overhead Variance: Graphical Analysis

    30. 47-701 Accounting for Decision Making and Control 30 Who’re Responsible for OH Variances? OH controllable variance: can be caused by Unexpected changes in the prices of variable OH items, e.g. lubricating oil Unexpected changes in fixed costs, e.g. lower-than-expected property tax Changes in production technology Inefficient use of overhead items such as supplies and utilities, e.g. waste or excessive usage.

    31. 47-701 Accounting for Decision Making and Control 31 Who’re Responsible for OH Variances? OH volume variance Results from the inability to operate at the activity planned for the period. Explainable by and controllable only through activity Has no significance for cost control (may induce buildup of inventories if used for measuring and rewarding performance)

    32. 47-701 Accounting for Decision Making and Control 32 Takeaways of This Session Preparation of simple budgets. The difference between normal and standard costing and why standard costing is used in many companies Cost flows under standard costing Performance evaluation by variance analysis for DM, DL and OH.

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