performance evaluation

Performance Evaluation

Chapter 8

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada8-2

Preparing Flexible Budgets

Static budgetsare prepared for a

single, planned levelof activity.

Performance evaluation is difficult when actual activity

differs from the planned level of

activity.

Hmm! Comparingstatic budgets withactual costs is likecomparing apples

and oranges.

Let’s look at Melrose Co.


F = Favourable varianceActual sales exceeded

budgeted level of sales.



Would you expect thesevariances to be

favourableor unfavourable giventhe favourable sales

variance?



I don’t think Ican answer thequestion usinga static budget.

Actual activity is belowbudgeted activity which

is unfavorable.

So, shouldn’t variable costsbe lower if actual activity

is lower?




The relevant question is . . .

“What portion of the variances is due to activity and price changes, and whatportion is due to cost control?”

To answer the question, we must

the budget for the

actual activity.


Improve performance evaluation.

May be prepared for any activity level in the relevant range.

Show revenues and expensesthat should have occurred at theactual activity.

Reveal variances due to good costcontrol or lack of cost control.



Central Concept

If you can tell me what your activity wasfor the period, I will tell you what your costs and revenue should have been.



To a budget for different activitylevels, we must know how costs behave

with changes in activity levels.

Total variable costschange in directproportion to changes in activity.

Total fixed costsremain unchangedwithin the relevantrange.

FixedVaria

ble




Let’s prepare budgets for the Melrose Co.


UnitVariableAmount

Unit sales 18,000 19,000 20,000

Sales revenue 80.00$ 1,440,000$ Less variable costs: Materials 12.00 216,000 Labour 16.80 302,400 Mfg. Overhead 5.60 100,800 G,S,&A 15.00 270,000 Contribution margin 30.60 550,800 Less fixed costs: Mfg. Overhead 201,600 G,S,&A 90,000

Net Income 259,200$

Flexible Budgets

18,000 units × $12.00 per unit = $216,000



UnitVariableAmount

Unit sales 18,000 19,000 20,000

Sales revenue 80.00$ 1,440,000$ 1,520,000$ 1,600,000$ Less variable costs: Materials 12.00 216,000 228,000 240,000 Labour 16.80 302,400 319,200 336,000 Mfg. Overhead 5.60 100,800 106,400 112,000 G,S,&A 15.00 270,000 285,000 300,000 Contribution margin 30.60 550,800 581,400 612,000 Less fixed costs: Mfg. Overhead 201,600 201,600 201,600 G,S,&A 90,000 90,000 90,000

Net Income 259,200$ 289,800$ 320,400$

Flexible Budgets




“What portion of the variances is due to activity

and price changes, and what portion is due to

cost control?”


Sales PriceStatic Activity Flexible & Cost Actual

Budget Variances Budget Variances Results

Unit sales 18,000 1,000 F 19,000 0 19,000

Sales revenue 1,440,000$ 80,000 F 1,520,000$ 38,000 U 1,482,000$ Less variable costs: Materials 216,000 12,000 U 228,000 4,180 F 223,820 Labour 302,400 16,800 U 319,200 8,550 U 327,750 Mfg. Overhead 100,800 5,600 U 106,400 2,850 U 109,250 G,S,&A 270,000 15,000 U 285,000 1,900 F 283,100 Contribution margin 550,800 30,600 F 581,400 43,320 U 538,080 Less fixed costs: Mfg. Overhead 201,600 0 201,600 8,400 U 210,000 G,S,&A 90,000 0 90,000 5,000 F 85,000

Net Income 259,200$ $30,600 F 289,800$ $ 46,720 U 243,080$

Sales price variance 19,000 units × ($80 per unit – $78 per unit)Variances due to

activity change

Sales and Cost Variances


Sales and Cost Variances

Sales PriceStatic Activity Flexible & Cost Actual

Budget Variances Budget Variances Results

Unit sales 18,000 1,000 F 19,000 0 19,000

Sales revenue 1,440,000$ 80,000 F 1,520,000$ 38,000 U 1,482,000$ Less variable costs: Materials 216,000 12,000 U 228,000 4,180 F 223,820 Labour 302,400 16,800 U 319,200 8,550 U 327,750 Mfg. Overhead 100,800 5,600 U 106,400 2,850 U 109,250 G,S,&A 270,000 15,000 U 285,000 1,900 F 283,100 Contribution margin 550,800 30,600 F 581,400 43,320 U 538,080 Less fixed costs: Mfg. Overhead 201,600 0 201,600 8,400 U 210,000 G,S,&A 90,000 0 90,000 5,000 F 85,000

Net Income 259,200$ $30,600 F 289,800$ $ 46,720 U 243,080$

Variances dueto cost control


Standard Costs

We will use standard costs analysis to

determine the causes for manufacturing cost

variances.


Establishing Standards

Benchmarks formeasuring performance.

The expected levelof performance.

Based on carefullypredetermined amounts.

Used for planning labor, material,and overhead requirements.Standard

Costs are


Accountants, engineers, personnel administrators, and production managers combine efforts to set

standards based on experience and expectations.




Should we usepractical standardsor ideal standards?

EngineerManagerialAccountant

Practical standardsshould be set at levels

that are currentlyattainable withreasonable andefficient effort.



Productionmanager

HumanResourcesManager

I agree. Idealstandards, basedon perfection, areunattainable and discourage most

employees.

Lax standardscreate

motivational problems.


Need for Standards

DirectMaterial

Managers focus on quantities and coststhat exceed standards, a practice known as

management by exception..

Type of Product Cost

Am

ou

nt

DirectLabour

ManufacturingOverhead

Standard


Selecting Variances to Investigate

How do I knowwhich variancesto investigate?

Materiality, frequency, capacity

to control, and characteristics of the cost are items

to consider.


Manufacturing Cost VariancesP

rod

uct

Co

st

Standard

This variance is unfavourablebecause the actual cost

exceeds the standard cost.

A standard cost variance is the amount by whichan actual cost differs from the standard cost.


I see that thereis an

unfavourable variance.

But why arevariances

important to me?

First, they point to causes ofproblems and directions

for improvement.

Second, they trigger investigations in departments

having responsibility for incurring the costs.

Manufacturing Cost Variances


Prepare standard cost performance

report

Conduct next period’s

operations

Analyze variances

Identifyquestions

Receive explanations

Takecorrective

actions

Begin

Manufacturing Cost Variances


Price and Usage Variances

Price Variance

The difference betweenthe actual price and the

standard price

Standard Cost Variances

Usage Variance

The difference betweenthe actual quantity andthe standard quantity


Actual Quantity Actual Quantity Standard Quantity × × × Actual Price Standard Price Standard Price

Price Variance Usage Variance

Standard price is the amount that should have been paid for the resources acquired.





Standard quantity is the quantity that shouldhave been used for the output achieved.



AQ(AP - SP) SP(AQ - SQ)

AQ = Actual Quantity SP = Standard Price AP = Actual Price SQ = Standard Quantity





Calculating the Materials Priceand Usage Variances

Let’s apply what we have learned

calculate standard cost variances,

starting withmaterial.


Hanson Inc. has the following material standards to manufacture one Zippy:

1.5 kilograms per Zippy at $4.00 per kilogram

Last week 1,700 kilograms of material were purchased and used to make 1,000 Zippies.

The material cost a total of $6,630.

Zippy



What is the actual price per kilogrampaid for the material?

a. $4.00 per kilogram.

b. $4.10 per kilogram.

c. $3.90 per kilogram.

d. $6.63 per kilogram.






Zippy













AP = $6,630 ÷ 1,700 kgsAP = $3.90 per kg

Zippy



Hanson’s material price variance (MPV)for the week was:

a. $170 unfavourable.

b. $170 favourable.

c. $800 unfavourable.

d. $800 favourable.



b. $170 favourable.


d. $800 favourable.

Zippy





b. $170 favourable.


d. $800 favourable.



b. $170 favourable.


d. $800 favourable. MPV = AQ(AP - SP) MPV = 1,700kgs. × ($3.90 - 4.00) MPV = $170 Favourable

Zippy



The standard quantity of material thatshould have been used to produce1,000 Zippies is:

a. 1,700 kilograms.

b. 1,500 kilograms.

c. 2,550 kilograms.

d. 2,000 kilograms.


a. 1,700 kilograms.

b. 1,500 kilograms.

c. 2,550 kilograms.

d. 2,000 kilograms.

Zippy




a. 1,700 kilograms.

b. 1,500 kilograms.

c. 2,550 kilograms.

d. 2,000 kilograms.


a. 1,700 kilograms.

b. 1,500 kilograms.

c. 2,550 kilograms.

d. 2,000 kilograms. SQ = 1,000 units × 1.5 kgs per unit SQ = 1,500 kgs.

Zippy



Hanson’s material usage variance (MUV)for the week was:


b. $170 favourable.


d. $800 favourable.



b. $170 favourable.


d. $800 favourable.

Zippy





b. $170 favourable.


d. $800 favourable.



b. $170 favourable.


d. $800 favourable. MUV = SP(AQ - SQ) MUV = $4.00(1,700 kgs - 1,500 kgs) MUV = $800 unfavourable

Zippy



1,700 kgs. 1,700 kgs. 1,500 kgs. × × × $3.90 per kg. $4.00 per kg. $4.00 per kg.

= $6,630 = $ 6,800 = $6,000

Price variance$170 favorable

Usage variance$800 unfavorable


Material Variances Summary


I need the price variancesooner so that I can better

identify purchasing problems.

You accountants just don’tunderstand the problems thatpurchasing managers have.

I’ll start computingthe price variance

as soon as theinformation is

available.

Responsibility for Materials Variances


I am not responsible for this unfavourable material

usage variance.

You purchased cheapmaterial, so my peoplehad to use more of it.

You used too much material because of poorly trained

workers and poorly maintained equipment.

Also, your poor scheduling sometimes requires me to

rush order material at a higher price, causing

unfavourable price variances.

Responsibility for Materials Variances


Now let’s calculate standard cost variances for

labour.

Labour Variances


Hanson Inc. has the following direct labour standard to manufacture one Zippy:

1.5 standard hours per Zippy at $6.00 perdirect labour hour

Last week 1,550 direct labour hours were worked at a total labor cost of $9,610 to

make 1,000 Zippies.

ZippyLabour Variances


What was Hanson’s actual price (AP)for labor for the week?

a. $6.20 per hour.

b. $6.00 per hour.

c. $5.80 per hour.

d. $5.60 per hour.

What was Hanson’s actual price (AP)for labor for the week?

a. $6.20 per hour.

b. $6.00 per hour.

c. $5.80 per hour.

d. $5.60 per hour.



What was Hanson’s actual price (AP)for labour for the week?

a. $6.20 per hour.

b. $6.00 per hour.

c. $5.80 per hour.

d. $5.60 per hour.

What was Hanson’s actual price (AP)for labour for the week?

a. $6.20 per hour.

b. $6.00 per hour.

c. $5.80 per hour.

d. $5.60 per hour.

AP = $9,610 ÷ 1,550 hours AP = $6.20 per hour



Hanson’s labour price variance (LPV) for the week was:


b. $310 favourable.


d. $300 favourable.



b. $310 favourable.


d. $300 favourable.





b. $310 favourable.


d. $300 favourable.



b. $310 favourable.


d. $300 favourable.

LPV = AH(AP - SP) LPV = 1,550 hrs($6.20 - $6.00) LPV = $310 unfavourable



The standard hours (SH) of labour that should have been worked to produce1,000 Zippies is:

a. 1,550 hours.

b. 1,500 hours.

c. 1,700 hours.

d. 1,800 hours.


a. 1,550 hours.

b. 1,500 hours.

c. 1,700 hours.

d. 1,800 hours.




a. 1,550 hours.

b. 1,500 hours.

c. 1,700 hours.

d. 1,800 hours.


a. 1,550 hours.

b. 1,500 hours.

c. 1,700 hours.

d. 1,800 hours. SH = 1,000 units × 1.5 hours per unit SH = 1,500 hours




Hanson’s labour usage variance (LUV)for the week was:


b. $290 favourable.


d. $300 favourable.



b. $290 favourable.


d. $300 favourable.




b. $290 favourable.


d. $300 favourable.



b. $290 favourable.


d. $300 favourable. LUV = SP(AH - SH) LUV = $6.00(1,550 hrs - 1,500 hrs) LUV = $300 unfavourable



Actual Hours Actual Hours Standard Hours × × × Actual Price Standard Price Standard Price

Price variance$310 unfavourable

Usage variance$300 unfavourable

1,550 hours 1,550 hours 1,500 hours × × × $6.20 per hour $6.00 per hour $6.00 per hour

= $9,610 = $9,300 = $9,000



Responsibility for Labour Variances

High skill,high rate

Low skill,low rate

Using highly paid skilled workers toperform unskilled tasks results in an

unfavourable rate variance.

Production managers who make work assignmentsare generally responsible for rate variances.

Production managers who make work assignmentsare generally responsible for rate variances.


UnfavourableUsage

Variance

Poorlytrainedworkers

Poorquality

materials

Poorlymaintainedequipment

Poorsupervisionof workers




I am not responsible for the unfavourable labor

usage variance!

You purchased cheapmaterial, so it took more

time to process it.

You used too much time because of poorly

trained workers and poor supervision.



Maybe I can attribute the laborand material variances to personnel

for hiring the wrong peopleand training them poorly.


Variable Overhead Variances

Many companies do not calculate price and usage variances for

variable overhead.

Flexible budget variances are used to evaluate variable overhead cost control.


Fixed Overhead Variances

Now let’s turn our attention

to fixed overhead.


Fixed Overhead BudgetPOHR =

Overhead costs are assigned to products and services using a predetermined

overhead rate (POHR):

Assigned Overhead = POHR × Standard Activity

Static Budget Activity



Spending Variance

VolumeVariance

POHR = Fixed Overhead RateSH = Standard Hours Allowed

SH × POHR

Actual Fixed Fixed Fixed Overhead Overhead Overhead Incurred Budget Applied



Fixed Overhead Variances Zippy

Hanson Inc. has the following budgeted and actual fixed overhead information:

Calculate the fixed overhead spendingand volume variances.

Planned Production 1,200 Units × 1.5 hours per unit = 1,800 hoursActual Production 1,000 UnitsBudgeted Fixed Overhead $5,400Actual Fixed Overhead $5,250Standard Hours 1,000 Units × 1.5 hours per unit = 1,500 hoursPredetermined Overhead Rate $5,400 ÷ 1,800 hours = $3.00 per hour



1,500 hours × $3.00 per hour

Spending variance$150 favourable

$5,250 $5,400 $4,500

Volume variance$900 unfavourable

SH × POHR

Actual Fixed Fixed Fixed Overhead Overhead Overhead Incurred Budget Applied

Zippy


Spending Variance Volume Variance

Results from paying moreor less than expected for

overhead items.

Results from operatingat an activity leveldifferent from theplanned activity.



Results when standard hoursallowed for actual output differs

from the budgeted activity.

VolumeVariance

Favourablewhen standard hours

> budgeted hours

Unfavourablewhen standard hours

< budgeted hours

Volume Variance - A Closer Look


Results when standard hoursallowed for actual output differs

from the budgeted activity.

VolumeVariance

Favorablewhen standard hours

> budgeted hours

Unfavorablewhen standard hours

< budgeted hours

Volume Variance - A Closer Look

Does not measure over- or under spending

Explainable by and controllable only through

activity


End of Chapter 8

We made it!

performance evaluation

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