Chapter 8

Analysis of Variances
 Motivation Example
• You own a bakery. The budget (plan) for 2017 was as follows:
 sales revenue $30,000: 1,000 cakes × price $30
 variable costs:
 direct materials $6,000: 1000 cakes × 2 lbs per cake × price $3/lb
 direct labor $10,000: 1000 cakes × 0.5 hrs per cake × price $20/hr (wage)
 no variable overhead, for simplicity
 fixed costs: $5,000
 profit: $9,000
• Actual performance for 2017 was different:
 sales revenue $20,000: 800 cakes × price $25
 variable costs:
 direct materials $4,500: 800 cakes × 2.25 lbs per cake × price $2.5/lb
 direct labor $9,000: 800 cakes × 0.75 hrs per cake × price $15/hr
 fixed costs: $6,000
 profit: $500

How did we perform in different areas? Who should be fired?

 Variances
Variance = difference between actual and budgeted
performance
• Favorable variance (F): actual is better than budgeted
 Revenue: actual > budgeted
 Costs: actual < budgeted
• Unfavorable variance (U): actual is worse than budgeted
 Revenue: actual < budgeted
 Costs: actual > budgeted

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 Analysis of Variances
Where does the difference between actual and
budgeted profit come from? Is it caused by
• Sales volume?
• Sales price?
• Input prices for DM and DL?
• Input efficiencies for DM and DL?
• Fixed costs?

Analysis of variances is used to

• Evaluate employee performance
• Identify problem areas
• Revise unrealistic assumptions in budget

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 Computation of Variances
1. Total profit variance = total difference between actual and
budgeted profit

Budgeted Actual
profit $9,000 $500

Total profit variance is  F  U

Total profit variance = actual profit − budgeted profit

= $500 - $9,000 = ($8,500) U

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 Computation of Variances
2. Sales volume variance = impact of the difference between
actual and budgeted sales volume on profit

Budgeted Actual
sales volume 1,000 units 800 units
sales price
Budgeted $30 per unit
unit VC = $16 (budgeted $25
cost of DM per
and DLunit
per unit)

Sales volume variance is  F U

Sales volume variance

=(act. sales volume − bud. sales volume) × bud. unit CM
= (800 − 1,000 units) × ($30 − $16 per unit) = ($2,800) U

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 Computation of Variances
3. Sales price variance = impact of the difference between
actual and budgeted sales price on profit

Budgeted Actual
sales volume 1,000 units 800 units
sales price $30 per unit $25 per unit

Sales price variance is  F  U

Sales price variance

=(act. sales price − bud. sales price) × act. sales volume
= ($25 − $30 per unit) × 800 units = ($4,000) U

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 Computation of Variances
4. Fixed cost variance = impact of the difference between actual
and budgeted fixed costs on profit

Budgeted Actual
fixed costs $5,000 $6,000

Fixed cost variance is  F  U

Fixed cost variance = budgeted FC − actual FC

= $5,000 − $6,000 = ($1,000) U

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 Computation of Variances
5. Input efficiency variance = impact of the difference between
actual and budgeted input efficiency on profit
(where greater efficiency = lower DM or DL quantity per unit)

Budgeted Actual
DM input price $3 per lb $2.50 per lb
DL input price $20 per hr $15 per hr
DM input quantity per unit 2 lbs per cake 2.25 lbs per cake
DL input quantity per unit 0.5 hrs per cake 0.75 hrs per cake

Input efficiency variances are

DM:  F  U
DL:  F  U

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 Computation of Variances
5. Input efficiency variance (continued)
Budgeted Actual
DM input price $3 per lb $2.50 per lb
DL input price $20 per hr $15 per hr
DM input quantity per unit 2 lbs per cake 2.25 lbs per cake
DL input quantity per unit 0.5 hrs per cake 0.75 hrs per cake

Input efficiency variance

= (flexible budget input Q − act. input Q) × bud. input P
where
flexible budget input Q = act. sales volume × bud. DM or DL per unit
(i.e., how much DM or DL we should have used for actual output)
flexible budget = the budget at the actual level of sales

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 Computation of Variances
5. Input efficiency variance (continued)
Budgeted Actual
DM input price $3 per lb $2.50 per lb
DL input price $20 per hr $15 per hr
DM input quantity per unit 2 lbs per cake 2.25 lbs per cake
DL input quantity per unit 0.5 hrs per cake 0.75 hrs per cake
Actual sales volume = 800 cakes.

DM: flexible budget input Q = 800 units × 2 lbs per unit = 1,600 lbs
actual input Q = 800 units × 2.25 lbs per unit = 1,800 lbs
input efficiency variance DM = (1,600 − 1,800 lbs) × $3 per lb
= ($600) U
DL: flexible budget input Q = 800 units × 0.5 hrs per unit = 400 hrs
actual input Q = 800 units × 0.75 hrs per unit = 600 hrs
input efficiency variance DL = (400 − 600 hrs) × $20 per hr
11 = ($4,000) U
 Computation of Variances
6. Input price variance = impact of the difference between
actual and budgeted input price for DM or DL on profit
Budgeted Actual
DM input price $3 per lb $2.50 per lb
DL input price $20 per hr $15 per hr
DM input quantity per unit 2 lbs per cake 2.25 lbs per cake
DL input quantity per unit 0.5 hrs per cake 0.75 hrs per cake
Input price variances are
DM:  F  U
DL:  F  U

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 Computation of Variances
6. Input price variance (continued)
Budgeted Actual
DM input price $3 per lb $2.50 per lb
DL input price $20 per hr $15 per hr
DM input quantity per unit 2 lbs per cake 2.25 lbs per cake
Actual
DL input quantity per unitsales volume
0.5 hrs =per
800 cakes. 0.75 hrs per cake
cake

Input price variance

= act. input Q × (bud. input price − act. input price)
DM: actual input Q = 800 units × 2.25 lbs per unit = 1,800 lbs
input price variance = 1,800 lbs × ($3 − $2.5 per lb) = $900 F

DL: actual input Q = 800 units × 0.75 hrs per unit = 600 hrs
input price variance = 600 hrs × ($20 − $15 per hr) = $3,000 F

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 Budget Reconciliation Report

Master Budget Profit $9,000

Sales volume variance ($2,800) U
Sales price variance ($4,000) U
Materials variances
Input price variance $900 F
Input efficiency variance ($600) U
Labor variances
Input price variance $3,000 F
Input efficiency variance (4,000) U
Fixed cost variance ($1,000) U
Actual Profit $500

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 Analyzing Variances
• Investigate all large variances
• Both favorable and unfavorable
• Consider the total picture
• e.g., a favorable input price variance for DL might
indicate cheap, unskilled labor. This could be the cause
of unfavorable variances for input efficiency, sales price,
and sales volume.

15
 Additional Exercises

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 Exercise: Favorable/unfavorable variances
Budgeted Actual
sales price $10 per unit $12 per unit
sales volume 2,500 units 2,400 units
DM input price $4 per lb $4.50 per lb
DL input price $15 per hr $14 per hr
DM input quantity per unit 0.5 lbs per unit 0.45 lbs per unit
DL input quantity per unit 0.2 hrs per unit 0.15 hrs per unit
fixed costs $22,000 $23,000

Without any computations, characterize the following variances as

favorable or unfavorable. How do you know?
• sales volume variance  F  U
• sales price variance  F  U
• input efficiency variance for DM  F  U
• input price variance for DM  F  U
• input efficiency variance for DL  F  U
• input price variance for DL  F  U
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• fixed costs variance  F  U
 Exercise: Computing sales volume
and sales price variances
Budgeted Actual
sales price $10 per unit $12 per unit
sales volume 2,500 units 2,400 units
unit VC $6 per unit $7 per unit

Compute the sales volume and sales price variances.

Sales volume variance
= (act. sales volume − bud. sales volume) × bud. unit CM
=

Sales price variance

=(act. sales price − bud. sales price) × act. sales volume
=

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 Exercise: Computing input price and
input efficiency variances
Budgeted Actual
sales volume 2,500 units 2,400 units
DM input price $4 per lb $4.50 per lb
DL input price $15 per hr $14 per hr
DM input quantity per unit 0.5 lbs per unit 0.45 lbs per unit
DL input quantity per unit 0.2 hrs per unit 0.15 hrs per unit

Compute input efficiency and input price variances for DM.

actual input Q = act. sales volume × act. input per unit
=
flexible budget input Q = act. sales volume × bud. input per unit
=
input price variance = act. input Q × (bud. input price − act. input price)
=
input efficiency variance
= (flexible budget input Q − act. input Q) × bud. input price
=
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 Exercise: Computing input price and
input efficiency variances
Budgeted Actual
sales volume 2,500 units 2,400 units
DM input price $4 per lb $4.50 per lb
DL input price $15 per hr $14 per hr
DM input quantity per unit 0.5 lbs per unit 0.45 lbs per unit
DL input quantity per unit 0.2 hrs per unit 0.15 hrs per unit

Compute input efficiency and input price variances for DL.

actual input Q = act. sales volume × act. input per unit
= 2,400 units * 0.15 hrs per unit = 360 hrs
flexible budget input Q = act. sales volume × bud. input per unit
= 2,400 units * 0.2 hrs per unit = 480 hrs
input price variance = act. input Q × (bud. input price − act. input price)
= 360 hrs * ($15 - $14 per hr) = $360F
input efficiency variance
= (flexible budget input Q − act. input Q) × bud. input price
= (480 hrs – 360 hrs) * $15 per hr= $1,800F
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 Exercise: Interpreting Variances
Scenario 1: You hired unskilled assembly workers at an
unusually low wage. They waste time and materials, and they
make a low-quality product that is difficult to sell even after
reducing the selling price by 20%.
Characterize the following variances
(“no effect” = there will not be a predictable favorable or unfavorable
variance)
sales volume variance  F  U  no effect
sales price variance  F  U  no effect
DL input price variance  F  U  no effect
DM input price variance  F  U  no effect
DL input efficiency variance  F  U  no effect
DM input efficiency variance  F  U  no effect

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 (continued) Interpreting Variances
Scenario 2: Mid-level managers in all areas of operations (e.g.,
sales, production, purchasing, HR) successfully manipulated the
budgeting process. As a result of this manipulation, they have
very easy performance targets in the budget.
Characterize the following variances

sales volume variance  F  U  no effect

sales price variance
DL input price variance
DM input price variance
DL input efficiency variance
DM input efficiency variance
 F  U  no effect
 F  U  no effect
 F  U  no effect
 F  U  no effect
 F  U  no effect

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 (continued) Interpreting Variances
Scenario 3: The CEO introduced a new incentive policy for HR
and Purchasing managers to reduce costs. Under the new
policy, HR managers get a bonus only if the actual wage per
hour of direct labor is less than budgeted. Similarly, Purchasing
managers get a bonus only if the actual price per pound of
materials is less than budgeted.
Characterize the following variances
sales volume variance  F  U  no effect
sales price variance  F  U  no effect
DL input price variance  F  U  no effect
DM input price variance  F  U  no effect
DL input efficiency variance  F  U  no effect
DM input efficiency variance  F  U  no effect

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 Quick sanity check for variances:
What is wrong with these computations?

A. (1,250 lbs  1,100 lbs) × $15 per hr

B. (2,000 lbs  1.1 lbs) × $5 per lb

C. (2,500 lbs  2,000 units) × $25 per lb

D. (3,000  3,200) × 10

E. 1,250 lbs  1,100 lbs × $15 per lb

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 Flexible budget
• The budget at the actual level of sales
Budget Flexible budget Actual
Sales Revenue $30,000 $24,000 $20,000
Sale price $30 $30 $25
Sale volume 1,000 units 800 units 800 units

Variable costs $16,000 $13,500

Direct Labor 1,000*20*0.5 800*15*0.75
DL price $20/hr $15/hr
DL efficiency 0.5 hrs per cake 0.75 hrs per cake
Direct Materials 1,000*3*2 800*2.5*2.25
DM price $3/lb $2.5/lb
DM efficiency 2 lbs per cake 2.25 lbs per cake

25 Fixed costs $5,000 $6,000