MCS UNS chapter 6 :Variance Analysis

28.03.05

Course Map Where are we?

Chps 13 Belief Systems CoreValues Values Core Chps 12 & 13 Boundary Systems Risks to be Avoided

Organizing for Performance Chp 3

What to Control Chp 4

Building and Evaluating Budgets Chps 5, 6, 7 Measuring Performance Chps 8 & 9 Designing Employee Goals and Incentives Chp 11

Business Strategy
Strategic Uncertainties Interactive Control Systems Chp 10 Chp 2 Chp 14
Internal Controls Chp 13

Todays Topic Critical Perf Variables Diagnostic Control Systems Chp 10

4 LEVERS OF CONTROL

Chp 6 - Evaluating Strategic Profit Performance

Introduction
Variance

Analysis Overview Theory behind Crunching the Numbers

Disadvantages

Analysis

and Advantages of Variance

Monitoring the Business Strategy

Diagnostic

Function Used to evaluate:

Effectiveness extent to which we met our desired goals; compare actual to expected Efficiency level of resources used to achieve specific outputs

Two Components of Strategic Profitability (or Value Creation)

Strategic

Profitability =

Profit (loss) from competitive effectiveness

(revenue variance)

+ Profit (loss) from competitive efficiency

(cost variance)

Variance Analysis
Variance

difference between actual and expected (budgeted) performance Favorable variance actual profit is higher than planned Unfavorable variance actual profit is lower than planned

Three Conditions necessary in order to Evaluate

There

must be an way to measure outputs. A predetermined standard of performance must exist. There must be an ability to use variance information as feedback to make corrections and improvements.

Variance Analysis Cycle

Strategic Profitability Analysis

A

tool used to evaluate the success of a business in generating profit from the implementation of its strategy Composed of:
Analysis of competitive effectiveness Analysis of operating efficiencies

Strategic Profitability Analysis

Strategic Variance Analysis

Competitive Effectivenes s REVENUE

Total Variance

Competitive Efficiency

COST

Market Size Market Share

Sales Price Product Mix

Production Efficiency

Nonvariable Spending

Production Spending

Pros & Cons of Strategic Analysis

Advantages Disadvantages

Competitive Effectiveness
Must

be able to set and implement market strategy Used for profit centers and stand alone businesses Measured by two output indicators:
Market share growth Price premium

Market Share Variances

Change

in profits due to our market share:

Tells us how much of our change in profits is due to increases or decreases in our hold on the market
Change

volume:

in market share due to industry

Tells us how much of our increased (decreased) sales is due to a bigger (smaller) overall market for our products

Revenue Variances

Increase in profit due to changes in selling prices

Result of this variance lets management know how successful their price strategy was Did they have to lower their price to sell products? Or were customers willing to pay a price premium?

Increase in profit due to changes in product mix

Results from selling a different proportion of products than planned Must evaluate why customers chose one product over another

Increase in profit due to changes in volume

This variance tells us whether we sold more units than planned.

Operating Efficiencies
How

many resources were consumed to achieve the actual outputs? This analysis can be used for any type of business unit; including cost centers. Revenue variances tell us about performance in the market, and spending and efficiency variances inform us about how well managers used their internal capabilities of the business. Good to benchmark

Flexible Budget
Flexible

budget budget made out for many levels of activities To calculate operating efficiencies, we must use the budget for our actual level of activity, not the static budget (if different from actual) Static 100,000 units, actual 102,000 units Must make out a new budget for 102,000 units to compare actual to budget

Variable Costs
Materials

and labor can often be broken down into price and quantity variances. Texts also call these spending and efficiency variances. Materials Spending variance - Tells if you spent more or less than standard price per unit of material Causes and responsibility for variance

Variable Costs
Materials Efficiency variance tells whether you used more or less materials than the standard called for Causes and responsibility for variance Labor Spending variance -tells if you spent more or less than standard price per unit on labor Causes and responsibility for variance Labor Efficiency variance tells whether you used more or less labor hours than the standard called for Causes and responsibility for variance

Nonvariable costs
Spending

variance: Planned cost Actual cost Committed fixed costs Discretionary fixed costs Activity-Based costs
Volume variance - Impact on profits due to changes in cost-driver activity Efficiency variance Impact on profits due to changes in efficiency Spending variance Impact on profits due to changes in cost of resources

Cost Center and Discretionary Cost Center

The

hallmark of two centers should be understood in terms of the following factors: Budget preparation Type control Performance measurement

Uses of Variance Analysis

Calculation

of variances do not explain causes Variances should be investigated

Often reasons for variances are explained beside the calculated variance
Favorable

variances are not always good Unfavorable variances are not always bad It is not good to net variances
Netting of variances may cancel out large favorable variances against large unfavorable variances

Uses of Variance Analysis

Management

by exception allows managers to focus only on those variances which are truly out of the ordinary

Variance

analysis should be performed often in order to make corrections as early as possible at least every month if possible Any variance is only as good as the standards or planned activity to which actual is compared!!!!!!

Management by exception allows managers to focus on certain areas Maximizes return on management

Evaluation Standards

Predetermined standards carefully determined standards can be established using ideal circumstances, practical circumstances, or some other basis.
Ideal standards will show a lot of unfavorable variances.

Historical standards often past inefficiencies passed on External standards benchmarks

Comparison to other companies in industry Can be obtained from private sources for a fee Some library sources

Strategic Variance Analysis Exercise

You are the new controller for a firm and are asked to analyze these nonvariable cost variances: 1. Advertising shows an unfavorable variance

2. 3.

Are you concerned?

Should you reward the R&D manager?

R&D spending is far below budget

Employee training has a large negative variance

Should you fire the HR Manager?

Summary Strategic Variance Analysis

It
In

is an imperfect control tool

reality, it is not important if the variance is U (unfavorable) or F (favorable) is key is that managers are asking the right questions and then pursuing appropriate action

What