ANALYZING FINANCIAL PERFORMANCE REPORTS

CALCULATING VARIANCES
Kaizen Mentality- a continuous improvement where competent operating managers do not
assume that optimal performance is being on budget.

Most companies make a monthly analysis of the differences between actual and budgeted
revenues and expenses for each business unit and for the whole organization. The table shows
that the actual profit was $52,000 higher than the budget, and that the principal reason for this
was that the revenues were higher than budget. It doesnt illustrate why the revenues were
higher or whether there were significant offsetting differences in the variances of the expense
items that were netted out in the overall numbers.

PERFORMANCE ACTUAL BUDGET ACTUAL BETTER

REPORT, JANUARY (Worse) than
(000s) BUDGET
Sales $875 $600 $275
Variable Costs of sales 583 370 (213)
Contribution 292 230 62
Fixed overhead 75 75 ___
Gross profit 217 155 62
Selling Expense 55 50 (5)
Administration Expense 30 25 (5)
Profit before taxes $132 $ 80 $ 52

VARIANCE ANALYSIS DISAGGREGATION

Total
Varianc
e

Nonmanufactu Manufacturi Sales

ring costs ng Costs

Administra Marketi R&D Variable Fixed Volume Selling

tion
ng Costs Costs Price

Material Direct Variable Market Industr

Labor Overhe Share y
ad Volume
A more thorough analysis identifies the causes of the variances and the organization unit
responsible. Effective systems identify variances down to the lowest level of management. Variances are
hierarchical. They begin with the total business unit performance which is divided into revenue
variances and expense variances. Revenue variances are further divided into volume and price
variances for the total business unit and for each marketing responsibility center within the unit. They
can be further divided by sales area and sales district. Expense variances can be divided between
manufacturing expenses and other expenses. Manufacturing expenses can be further subdivided by
factories and departments within factories. Therefore, it is possible to identify each variance with the
individual manager who is responsible for it.

The analytical framework used to conduct variance analysis incorporates the following ideas:

Identify the key causal factors that affects profits.

Breakdown the overall profit variances by these key causal factors.
Focus on the profit impact of variation in each causal factor
Try to calculate the specific, separable impact of each causal factor by varying only that
factor while holding all other factors constant
Add complexity sequentially, one layer at a time, beginning at a very basic commonsense
level (peel the onion)

FINANCING EDUCATIONAL SYSTEM ANALYZING FINANCIAL PERFORMANCE REPORTS ALLAN JAYSON

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 Stop the process when the added complexity at a newly created level is not justified by
added useful insights into the causal factors underlying the overall profit variance.

REVENUE VARIANCES

A positive variance is favorable, because it indicates that actual profit exceeded budgeted
profit, and a negative variance is unfavorable.

Selling Price Variance- calculated by multiplying the difference between the actual
price and the standard price by the actual volume = (actual price-standard price) X actual
volume

PRODUCT
A B C Total
Actual Volume (units) 100 200 150
Actual Price per unit $0.90 $2.05 $2.50
Budget Price per unit 1.00 2.00 3.00
Actual over/(under) (0.10) 0.05 (0.50)
budget per unit
Favorable/ (10) 10 (75) (75)
(unfavorable) price
variance
$75,000---unfavorable

Mix and Volume Variance often not separated

= (Actual Volume- Budgeted Volume) X Budget unit Contribution

(1) (2) (3) (4) (5) (6)

Product Actual Volume Budgeted Difference Unit Variance
Volume (2)-(3) Contribution (4)x (5)
A 100 100 ----- ----- ------
B 200 100 100 $0.90 $90
C 150 100 50 1.20 60
Total 450 300 $150
$150,000--- favorable

The volume variance results from selling more units than budgeted. The mix variance
results from selling a different proportion of products from that assumed in the budget. Because
products earn different contributions per unit, the sale of different proportions of products from
those budgeted will result in a variance. If the business unit has a richer mix (higher proportion
of products with a high contribution margin), the actual profit will be higher than budgeted; and if
it has a leaner mix, the profit will be lower. The volume and mix variances are joint, so techniques
for separating them are somewhat arbitrary.

Mix Variance = ((Actual Volume of Sales)-(Total Actual Volume of Sales X Budgeted

Proportion) X (Budgeted Unit Contribution))

(1) (2) (3) (4) (5) (6) (7)

Product Budgeted Budgeted Actual Difference Unit Variance
Proportion Mix at Sales (4)-(3) Contribution (5)x (6)
actual
Volume
A 1/3 150 100 (50) $0.20 $ (10)
B 1/3 150 200 50 $0.90 45
C 1/3 150 150 ---- ----- ----
Total 450 450 $ 35
Since B has higher unit contribution than product A, mix variance is favorable by $ 35,000

Volume Variance= subtracting the mix variance from the combined mix and volume
variance

= ((Total Actual Volume of Sales) X (Budgeted Percentage)- (Budgeted Sales)) X (Budgeted unit
contribution)

(1) (2) (3) (4) (5) (6)

Product Budgeted Budgeted Differenc Unit Volume
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 Mix at Volume e (2)- Contribution Variance
actual (3)
Volume
A 150 100 50 $0.20 $10
B 150 100 50 0.90 45
C 150 100 50 1.20 60
Total 450 300 150 $ 115
$150,000 - $ 35,000= $ 115,000

Other Revenue Analyses- revenue variances by product

Product
A B C Total
Price $(10) $ 10 $(75) $(75)
Variance
Mix (10) 45 --- 35
Variance
Volume 10 45 60 115
Variance
Total $(10) $100 $(15) $ 75

Market Penetration and Industry Volume

Market Share Variance= (actual sales-industry volume) x budgeted market
penetration
x Budgeted unit contribution
The market share variance is found for each product separately, and the
total variance is the algebraic sum. The calculation is shown in section C. it shows that
$104,000 of the favorable mix and volume variance of $150,000 resulted from the fact that
market penetration was better that the budget. The remaining $46,000 resulted from the fact
that actual industry dollar volume was higher than the amount assumed in the budget.

Industry Volume Variance= (actual industry volume Budgeted industry volume)

x Budgeted Market Penetration X Budgeted
Unit Contribution

A. BUDGETED SALES PRODUCT

VOLUME A B C TOTAL
Estimated industry Volume 833 500 1,667 3,000
(units)
Budgeted Market Share 12% 20% 6% 10%
Budgeted Volume (units) 100 100 100 300
B. ACTUAL MARKET SHARE PRODUCT
A B C TOTAL
Actual Industry Volume, units 1,000 1,000 1,000 3,000
Actual Sales, units 100 200 150 450
Actual market share 10% 20% 15% 15%
B. VARIANCE DUE TO PRODUCT
MARKET SHARE A B C TOTAL
(1) actual sales (units) 100 200 150 450
(2) budgeted shares at actual 120 200 60 380
industry volume
(3)difference (1-2) (20) --- 90 70
(4) budgeted unit contribution $0.20 $ 0.90 $1.20
(5) variance due to market (4.00) --- 108 $104
share (3 x 4)
B. VARIANCE DUE TO PRODUCT
INDUSTRY VOLUME A B C TOTAL
(1) actual industry volume 1,000 1,000 1,000 3,000
(2) budgeted industry volume 833 500 1,667 3,000
(3)difference (1-2) 167 500 (667) ---
(4) budgeted market share 12% 20% 6%
(5) (3 x 4) 20 100 (40)
(6) unit contribution (budget) $0.20 $0.90 $1.20
(7) total (5 x 6) 4.00 90.00 (48.00) $ 46

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 EXPENSE VARIANCES
Fixed Cost- costs which are not affected by either the volume of sales or the volume of
production.
Variable Cost- cost that vary directly and proportionately with volume

VARIATIONS IN PRACTICE

TIME PERIOD OF COMPARISON

A comparison of the annual budget with current expectation of actual performance for the
whole year shows how closely the business unit manager expects to meet the annual profit target. If
performance for the year to date is worse than the budget for the year to date, it is possible that the
deficit will be overcome in the remaining months. On the other hand, forces that caused actual
performance to be below budget for the year to date may be expected to continue for the remainder of
the year, which will make the final numbers significantly different from the budgeted amounts. Realistic
estimate of the profit for the whole year is necessary because it suggest the need to change the
dividend policy, to obtain additional cash, or to change the levels of discretionary spending.

FOCUS ON GROSS MARGIN

Unit gross margin is the difference between selling prices and manufacturing costs.
Variance analysis is done by substituting gross margin for selling price in the revenue equations.
Gross margin is the difference between actual selling prices and standard manufacturing
costs. Current standard manufacturing cost should take into account changes in manufacturing costs
that are caused by changes in wage rates and in material prices. The standard, rather than actual cost is
used so that manufacturing inefficiencies do not affect the performance of the marketing organization.

EVALUATION STANDARDS (3 types)

Predetermined Standards or Budgets- the basis against which actual performance
Historical Standards- records of past actual performance necessary for comparison to the previous
month or to the same month a year ago. The only weakness of this standard is that certain conditions
might have already changed which invalidates the comparison and prior periods performance may not
have been acceptable.
External Standards- derived from performance of other possibility centers or of other companies in the
same industry. If conditions in these responsibility centers are similar, such comparison may provide an
acceptable basis for evaluating performance. It uses the process of benchmarking

Limitations on Standards--- a variance between actual and standard performance is

meaningful only if it is derived from a valid standard. Although it is convenient to refer to favorable and
unfavorable variances, these words imply that the standard is a reliable measure of what performance
should have been. An essential first step in the analysis of a variance is an examination of the validity of
the standard.

ENGINEERED AND DISCRETIONARY COST

A favorable variance in engineered costs is usually an indication of good performance; that is, the
lower the cost the better the performance. By contrast, the performance of a discretionary expense
center is usually judged to be satisfactory if actual expenses are about equal to the budgeted amount,
neither higher nor lower.

LIMITATIONS OF VARIANCE ANALYSIS

It does not tell why the variance occurred or what is being done about it. It does not
explain why sales promotion expenses were high and what, if any, actions were being
taken.
Problem in deciding whether a variance is significant. Statistical techniques (aka.
statistical quality control) is used to determine significant difference
As the performance reports become more highly aggregated, offsetting variances might
mislead the reader.
As variances become more highly aggregated, managers become more dependent on the
accompanying explanations and forecasts.
Reports only show what has happened. They do not show the future effects of actions that
the manager has taken.

MANAGEMENT ACTION

Cardinal Principle in analyzing formal financial report: The monthly profit report should contain
no major surprises. Significant information should be communicated quickly by telephone, fax, email, or
personal meetings as soon as it became known.

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 The formal report is nevertheless important. One of the most important benefits of formal
reporting is that it provides the desirable pressure on subordinate managers to take corrective actions
on their own initiative. Information from informal sources may be incomplete or misunderstood and
often is general and imprecise; the numbers in the formal report provide more accurate information.
Profit reports are worthless unless they lead to action. As long as business is going well, praise is
the most that may be necessary, and most people dont even expect praise routinely.

FINANCING EDUCATIONAL SYSTEM ANALYZING FINANCIAL PERFORMANCE REPORTS ALLAN JAYSON

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