Variances

Management 122
Michael Williams
 Variances
• After the accounting period is over, we need to learn
what went well and what went poorly.
• We need a baseline of comparison.
• We can use the original budget as a baseline.
• By comparing actual results to budget, we can
identify potential problems to investigate.
• We refer to the differences in the two reports as
variances.
• Variances that boost profit are called favorable and
those that reduce profit, unfavorable.
 Flexible budget
• The original budget was made in ignorance of actual
volume.
• A given cost could exceed budget either due to
wastefulness or simply because volume was high.
• To separate these effects, we can construct a flexible
budget.
• The flexible budget adjusts the original budget to
reflect true volume. Revenue and variable costs are
adjusted appropriately.
 Use of flexible budget
• By comparing actual costs to flexible budget costs,
we can identify variances that might be of concern.
• We refer to these variances as basic cost variances.
• Two additional variances of note are sales volume
and sales price variances.
• Sales price variance is actual revenue – flexible
budget revenue.
• Sales volume variance is flexible budget profit
minus original budget profit.
 Key identity
• The following will always be true:

Actual profit – budgeted profit =

Sales volume variance +
Sales price variance +
Sum of all basic cost variances.

• Thus, all the variances collectively explain why we

earned a different profit than expected.
 Williams Citrus Co.
Budgeted Actual
Revenue 4,000 4,500

Materials (V) 300 400

Labor (V) 1,200 1,300
Land rent (F) 2,000 2,400
Citrus tax (V) 200 300

Total cost 3,700 4,400

Profit 300 100

Pounds of oranges 5,000 6,000

 Decomposing variances
• A variance can be ambiguous as to its cause.
• We need to know why a variance is favorable or
unfavorable.
• It is often useful to decompose variances into
components.
• Two contexts for this are cost and sales volume
variance.
 Production variances
• This is useful for variable costs with measurable inputs:
▫ Materials (e.g., tons)
▫ Labor (e.g., hours)

• There are three reasons the cost will vary from budget:
▫ Production volume
▫ Utilization of the resource
▫ Price of the resource

• To identify which of these effects are present, we first

need standards for utilization and price.
 Production variances (cont.)
Actual Budgeted

Volume of production output Va Vb

Usage of input per unit of output Ua Ub

Price per unit of input Pa Pb

Actual Super-flexible budget Flexible budget Budget

Va x Ua x Pa Va x U a x P b Va x Ub x Pb Vb x Ub x Pb

Price variance Volume variance

  Efficiency variance  

• The efficiency variance is the most controllable

as it can identify wasted resources.
 Marketing variances
• I = industry volume
• S = company's share of the industry

Actual volume Expected volume Budgeted volume  

Ia x Sa Ia x Sb Ib x Sb  

Market share Industry volume  

• Multiply by budgeted Mb.

• Industry volume is outside your control.
• Market share is controllable, so this is an
important variance.
 Marketing variances (cont.)
• V = company's total volume
• Si = product i's share of the company's volume
Actual volume Expected volume Budgeted volume
 

of product i of product i of product i

Va x Sia Va x Sib Vb x Sib  

Sales mix Sales quantity  

• Multiply by Mib.
• Add up values for all products to get the variance.
 Sales mix variance
• Calculate if
▫ Selling multiple products
▫ Products have significantly different contribution
margins
▫ Product volumes are comparable
▫ Products are demand substitutes
▫ Cannibalism is likely
• If unfavorable, two interpretations:
▫ Low margin products are cannibalizing high
margin products
▫ Salespeople are emphasizing the wrong products
 Variance investigation
Costs Benefits
Time spent on investigation Efficiency
Testing costs High quality
Lost production Proper incentives
Costs of making changes  

• Types of variances:
▫ Information system variances
▫ Random variances
▫ Controllable operating variances
 Variance investigation
• Threshold approach:
▫ Determine Probability of type 3 (P3) for each
variance
▫ Set threshold based on P3 (high if P3 is low)
▫ Adjust threshold for the costliness of investigating
▫ Investigate if variance exceeds threshold

• Trading off materiality, controllability, and

prescriptive ambiguity