financial analysing

Analyzing Financial
Performance Reports
This chapter focuses on analyzing financial performance measures. The first part describes how variances between actual and budgeted data are calculated for business units. Because expense and revenue budgets are part of the budgets for business units, the discussion can be extended to cover expense and revenue centers as well. The second part describes how reports of these variances are used by senior management to evaluate business unit performance. In the next chapter, we describe how nonfinancial performance measures can be incorporated into the management control process.
Calculating Variances:
Although the focus of this section is on comparing is on actual performance with the budget, competent operating managers nevertheless adopt a continuous improvement, or Kaizen, mentality;
They do not assume that optimal performance is being “on budget.” Most companies make a monthly analysis of the differences between actual and budget revenues and expenses for each business unit and for the whole organization (some do this quarterly.). some companies merely report the amount of these variances, as in exhibit 10.1. this statement shows that the actual profit was $52,000 higher than budget, and that the principal reason for this was that revenues were higher than budget. It doesn’t illustrate why the revenues were higher or whether there were significant offsetting differences in the variances of the expenses items that were netted out in the overall numbers.
A more through analysis identifies the causes of the variances and the organization unit responsible. Effective systems identify variances down to the lower level of management. Variances are hierarchical. As shown in exhibit 10.2, they begin with the total business unit performance, which is divided into revenue variances and expenses variances. Revenue veriances are further divided into volume and price variances for the total business unit and for each marketing responsibility centre within the unity. They can be further divided by sales area and sales
EXHIBIT 10.1 performance report, January (000s)
XXXX
EXHIBIT 10.2 variance analysis disaggregation
XXXX
District. Expense variance can be divided between manufacturing expenses and other expenses. Manufacturing expenses can be further subdivided factories and departments within factories. Therefore, it is possible to identify each variance with the individual manager who is responsible for it. This type of analysis is a powerful tool, without which the efficacy of profit budgets would be limited.
The profit budget has embedded in it certain expectations about the state of the total industry and about the company ‘s market share, its selling prices, and its cost structure. Results from variance computations are more “actionable” if change in actual results are analyzed against each of these expectations. The analytical framework we use to conduct variance analysis incorporates the following ideas:
• Identify the key casual factors that affect profits.
• Break down the overall profit variance by these key casual factors.
• Focus on the profit impact of variation in each casual factor.
• Try to calculate the specific, separable impact of each casual factor by varying only that factor while holding all other factors constant (“spinning only one DL at a time”).
• Add complexity sequentially, one layer at a time, beginning at a very essential basic “commonsense” level (“peel the onion”).
• Stop the process when the added complexity at a newly created level is not justified by added useful insights into the casual factors underlying the overall profit variance.
Exhibit 10.3 provides details of the budget of the business unit whose performance is required in exhibit 10.1.
Revenue Variances:
In this section, we describe how to calculate selling price, volume, and mix variances. The calculation is made for each product line, and the product line results are then aggregated to calculate the total variances. A positive variances is favorable, because it indicates that actual profit exceeded budgeted profit, and a negative variance is unfavorable.
Selling Price Variance
The selling price variance is calculated by multiplying the difference between the actual price and the standard price by the actual volume. The calculation is shown in exhibit 10.4. It shows that the price variance is $75,000, unfavorable.
Exhibit 10.3 Budget for January ($000s)
XXXX
Exhibit 10.4 selling price variances, January (000s)
XXXX
Exhibit 10.5 sales mix and volume variance, January ($000s)
XXXX
Mix and volume variance
Often the mix and volume variance are not separated. The equation for the combined for the mix and volume variance is:
Mix and volume variance = (Actual volume – Budgeted volume)
*Budgeted unit contribution
The calculation of mix and volume variance is shown in Exhibit 10.5; it is $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 proportion of products 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 (i.e., a 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 actual volume and mix variances are joint, so techniques for separating them are somewhat arbitrary. One such technique is described next.
Mix Variance
The mix variance for each product is found from the following equation:
Mix variance = [(Actual volume of sales)
- (Total actual volume of sales * Budgeted proportion)
*Budgeted unit contribution]
Exhibit 10.6 Mix Variance, January ($000s)
XXXX
Exhibit 10.7 Sales volume variance, January ($000s)
XXXX
The calculating of the mix variances is shown in exhibit 10.6. It shows that the higher proportion of the product B and a lower proportion of the product A were sold. Since product B has a higher unit contribution than product A, the mix variance is favorable, by $35,000.
Volume Variance
The volume variance can be calculated by subtracting the mix variance from the combined mix and volume variance. This is $150,000 minus $35,000, or $115,000. It can also be calculated for each product as follows:
Volume Variance = [(Total actual volume of sales) * (Budgeted percentage)
- (Budgeted sales)] * (Budgeted unit contribution)
The calculation of the volume variance is shown in Exhibit 10.7.
Other revenue analyses
Revenue variances may be further subdivided. In our example, exhibits 10.4, 10.5, 10.6, and 10.7 provide the information needed to classify them by product. Such a classification is shown in exhibit 10.8.
Market penetration and industry volume
One extension of revenue analysis is to separate the mix and volume variance into the amount caused by differences in market share and the amount caused by differences in industry volume. The principle is that the business unit managers are responsible for market share, but
Exhibit 10.8 Revenue variances by product, January ($000s)
XXXX
They are not responsible for the industry volume because that is largely influenced by the state of the economy. To make this calculation, industry sales data must be available. This calculation is given in exhibit 10.9.
Section A of exhibit 10.9 provides the assumptions that were made in the original budget shown in exhibit 10.3, and section B provides details on actual industry volume and market share for the month of January.
The following equation is used to separate the effort of market penetration from industry volume on the mix and volume variance:
Market share variance = [(Actual sales) – (Industry volume)]
*Budget market penetration
*Budget 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 $46,000 resulted from the fact that actual industry dollar volume was higher than the amount assumed in the budget.
The $46,000 industry volume variance can also be calculated for each product as follows:
Industry volume variance = (Actual industry volume – budget industry
Volume) * Budget market penetration
*Budgeted unit contribution
This calculation of variances due to industry volume is shown in section D.
Expense variances
Fixed costs
Variance costs are costs that vary directly and proportionally with volume. The budgeted variance manufacturing costs must be adjusted to the actual volume of production. Assume that the January production was as follows: product A, 150,000 units; product B, 120,000 units;
EXHIBIT 10.9 industry volume and market share variances, January ($000s)
XXXX
EXHIBIT 10.10 fixed – cost variances, January ($000s)
XXXX
Exhibit 10.11 variance manufacturing expense variances, January ($000s)
XXXX
Product C, 200,000 units. Assumed also that the variable manufacturing costs incurred in January were as follows: material, $470,000; $65,000; variable manufacturing overhead, $90.000. exhibit 10.3 shows the standard unit variable costs.
The budgeted manufacturing expenses is adjusted to the amount that should have been spent at the actual level of production by multiplying each element of standard cost for each product by the volume of proportion for that product. This calculation is shown in exhibit 10.11.
This exhibit shows that there was an unfavorable variance of $13,000 in January. This is called a spending variance because it results from spending $13,000 in excess of the adjusted budget. It consist of unfavorable overhead spending variance of $11,000 and $12,000, respectively. These are partially offset by a favorable overhead spending variance of $10,000.
The volume that is used to adjust the budgeted variable manufacturing expenses is the manufacturing volume, not the sales volume, which was used in finding the revenue variances.
In the simple given here, we assumed that the two volumes were the same-namely, that the quantity of each product manufactured in January was the same as the quantity sold in January. If production volume different from sales volume, the cost difference would show up in changes in inventory. Depending on the company’s inventory costing method, this might or might not result in a production volume variance. Calculating of such a variance is explained in the next section.
In this example, we assumed that all the nonmanufacturing expenses were fixed. If some of them had variable components, the variances should be calculated in the same way as was used for the calculation of manufacturing cost variances.
Summary of variances:
There are several ways in which the variances can be summarized in a report for management. One possibility is shown in exhibit 10.12. it was used primarily because the amounts can be traced easily to the earlier exhibits. Another from of presentation is to show the actual amounts, as well as the variances. This gives an indication of the relative importance of each variance as a variance as a fraction of the total revenue or expense item to which it relates.
Variations in practice:
The example just given, although complicated, is a relatively straight forward way of identifying the variances that caused actual profit in a business unit to be different from the budgeted profitability. Some variations from this approach are described in this section.
Exhibit 10.12 summary performance report, January ($000s)
Actual profit (Exhibit 10.1) $132
Budget profit (Exhibit 10.1) 80
Variance $ 50

Analysis of variance-Favorable/(unfavorable)
Revenue variances: $ (75)
Price (exhibit 10.4) 35
Mix (Exhibit 10.6) 115
Volume (Exhibit 10.7) $ 75
Net revenue variances
Variable-cost variances (Exhibit 10.11):
Material $(11)
Labor (12)
Variable overhead 10
Net variable-cost variances $(13)
Fixed-cost variances (Exhibit 10.10):
Selling expense $(5)
Administrative expense (5)
Net fixed-cost variances $(10)
Variance $(52)
Time Period of the comparison
The example compared January’s budget with January’s actual. Some companies use performance for the year to date as the basis for comparison; for the period ended June 30, they would use budgeted and actual amounts for the six months ending on June 30 rather than the amounts for June. Other companies compare the budget for the whole year with the current estimate of actual performance for the year. The actual amounts for the report prepared as of June 30 would consist of actual numbers for six months plus the best current estimate of revenues and expenses for the second six months.
A comparison for the year to date is not as much influenced by temporary aberrations that may be peculiar to the current month and, therefore, that need not be of as much concern to management. On the other hand, it may mask the emergence of an important factor that is not temporary.
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 for the remainder of the year, which will make the final numbers significantly different from the budgeted amounts. Senior management needs a realistic estimation of the profit for the whole year, both because it may suggest the need to change the dividend policy, to obtain additional cash, or to change levels of discretionary spending, and also because a current estimate of the year’s performance is often provided to financial analysts and other outside parties.
Obtain a realistic estimate is difficult. Business unit managers tend to be optimistic about their ability to perform in the remaining months because, if they are pessimistic, this casts doubt on their ability to manage. To some extent, this tendency can be overcome by placing the burden of proof on business unit managers to show that the current trends in volume, margins, and costs are not going to continue. Nevertheless, an estimation of the whole year is soft, whereas actual performance is a matter of record. An alternative that lessens this problem is to report performance both for the year to date and for the year as a whole.
Focus on gross margin
In the example, we assumed that selling prices were budgeted to remaining constant throughout the year. In many companies, changes in cost or other factor are expected to lead to changes in selling prices, and the task of the marketing manager is to be obtain a budgeted gross margin-that is, a constant spread between costs and selling prices. Such a policy is especially important in periods of inflation. A variance analysis in such a system would not have a selling price variance. Instead, there would be a gross margin variance. Unit gross margin is the difference between selling prices and manufacturing costs.
The variance analysis is done by substituting “gross margin” for “selling price” in the revenue equations. Gross margin is the different between actual selling prices and the standard manufacturing cost. The current standard manufacturing costs that are caused by changes in wage rates and in material prices(and, in some companies, significant changes in other input factors, such as electricity in aluminum manufacturing). The standard, rather than the actual, cost is used so that manufacturing inefficiencies do not affect the performance of the marketing organization.
Evaluation standards
In management control system, the formal standards used in the evolution of perfect reports on actual activities are of three types: (1) predetermined standards or budgets, (2) historical standards, or (3) external standards.
Predetermined standards or budgets
If carefully prepared and coordinated, these are excellent standards. They are the basis against which actual performance is compared in many companies. If the budget numbers are collected in a haphazard manner, they obviously will not provide a reliable basis for comparison.
Historical standards
These are records of past actual performance. Result for the current month may be compared with the result for the last month or with result for the same month a year ago. This type of standards has two serious weakness: (1) conditions may have changed between the two periods in a way that invalidates the comparison, and (2) the prior period’s performance may not have been acceptable. A supervisor whose spoilage cost is $500 a month, month after month, is consistent; but we do not know, without other evidence, whether the performance was consistently good or consistently poor. Despite these inherent weakness, historical standards are used in some companies, often because valid predetermined standards are not available.
External standards
These are standards derived from the performance of other responsibility centers or other companies in the same industry. The performance of one branch sales office may be compared with similar, such a comparison may provide an acceptable basis for evaluating performance.
Some companies identify the company that they belive to be the best managed in the industry and use numbers from that company-either with cooperation of that company or from published material-as a basis of comparison. This process is called benchmarketing.
Data for individual companies are available in annual and quarterly reports and in form 10k. (form 10k data are available from the securities and exchange commission and are published on the internet for about 13,000 companies.) data for industries are published in dun & bradstreet Inc., key business ratios; standard & poor’s compustat services Inc., Robert morris association annual statement studies; and annual surveys published in fortune, business week, and forbes. Trade associations publish data for the companies in their industries.
Many companies publish their financial satatements on the internet. A problem with using this information as a basis for comparison with competitors performance is that the names for account titles are not same. The American institute of CPAs has a project that seeks to establish a standard set of account titles used in internet reports. This is named the XBRL project. When these become accepted, it should be easy to obtain averages and other data for competitors by a simple computer program. Current information about this project can be obtained from the AICPA website: www.oasis.open.org/cover/ siteindex.html. the financial executives institute provides information about performance of member companies, but most is available only to subscribers of its project. Tidbits are published in its journal, financial executive.
Limitations on standards
A variance between actual and standard performance is meaningful only if it is derived from a valid standard. Although it is convient to refer to favorable and unfavorable variances, these words imply that the standard is a reliable measure of what coasts should have been under the circumstances. This situation can arise for either or both of two reasons: (1) the standard was not set properly, or (2) although it was set properly in light of conditions existing at the time, changed conditions have made the standard obsolete. An essential first step in the analysis of a variance is an examination of the validity of the standard.
Full-cost systems
If the company has a full-cost system, both variable and fixed overhead costs are included in the inventory at the time standard cost per unit. If the ending inventory is higher than the beginning inventory, some of the fixed overhead costs incurred in the period remain in inventory rather than flowing through to cost of sales. Conversely, if the inventory balance decreased during the period, more fixed overhead costs were released to cost of sales than the amount actually incurred in the period. Our example assumed that the inventory level did not change. Thus, the problem of treating the variance associated with fixed overhead costs did not arise.
If inventory levels change, and if actual production volume is different from budgeted sales amount of the production volume variance should be calculated and reported. This variance is the difference between budgeted fixed production costs at the actual volume (as stated in the flexible budget) and standard fixed production costs as that volume.
If the company has a variable – cost system, fixed production costs are not included in inventory, so there is no production volume variance. The fixed production expense variance is simply the difference between the budgeted amount and the actual amount.
The important point is that production variances should be associated with production volume, not sales volume.
Amount of detail
In the example, we analyzed revenue variances at several levels: first, in total; then by volume, mix, and price; then by analyzing the volume and mix variance by industry volume and market share. At each of these levels to another is often reffered to as “peeling the onion”- that is, successive layers are peeled off, and the process continues as long as the additional details is judged to be worthwhile. Some companies do not develop as much layers as shown in our example; other develop more. It is possible, and in some cases worthwhile to develop additional sales and marketing variances, such as the following: by sales territories, and even by individual salesperson; by sales to individual countries or regions; by sales to key customers, principal types of customers, or customers in certain industries; by sales originated from direct mail, from customer calls, or from other sources. Additional detail for manufacturing costs can be developed by calculating variances for lower-level responsibility centers and by identifying variances with specific input factors, such as wage rates and material prices.
These layers correspond to the hierarchy of responsibility centers. Taking action based on the reported variances is not possible unless they can be associated with the managers responsible for them.
With modern information technology, about any level of detail can be supplied quickly and at reasonable cost. The problem is to decide how much is worthwhile. In part, the answer depends on the information requested by individual managers – some are oriented, others are not. In the ideal solution, the basic data exist to make any conceivable type of analysis, but only a small fraction of these data are reported routinely.
Engineered and Discretionary Costs
As we pointed out in chapter 4, variances in engineered costs are viewed in a fundamentally different way from variances in discretionary costs.
A “favorable” variance in engineered costs is usually an indication of good performance; that is, the cost the better the performance. This is subject to the qualification that quality and on-time delivery are judged to be satisfactory.
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. This is because a favorable variances may indicate that the responsibility center did not perform adequately the functions that it had agreed to perform. Because some elements in a discretionary expense center are in fact engineered (e.g., the bookkeeping functions in the controller organization), a favorable variance is usually truly favorable for these elements.
Limitations of variance analysis
Although variance analysis is a powerful tool, it does have limitations. The most important limitations is that although it identifies where a variance occurs, it does not tell why the variance occurred or what is being done about it. For example, the report may show there was a significant unfavorable variance in marketing expenses, and it may identify this variance with high sales promotion expenses. It does not, however, explain why sales promotion expenses were high and what if any actions were being taken. A narrative explanation, accompanying the performance report, should provide such an explanation.
A second problem in variance analysis is to decide whether there is a significant difference between actual and standard performance for certain processes; these techniques are usually referred to as statistical quality control. However, they are applicable only when the process is repeated at frequent intervals, such as the operation of a machine tool on a production line. The literature contains a few articles suggesting that statistical quality control be used to determine whether a budget variance is significant, but this suggestion has little practical relevance at the business unit level because the necessary number of repetitive action is not present. Conceptually, a variance should be investigated only when the benefit expected from
correcting the problem exceeds the cost of the investigation, but a model based on this premise has so many uncertainties that it is only of academic interest. Managers therefore rely on judgment in deciding what variances are significant. Moreover, if a variance is significant but is uncontrollable (such as unexpected inflation), there may be no point in investigating it.
A third limitation of variance analysis is that as the performance reports become more highly aggregated, offsetting variances might mislead the reader. For example, a manager looking at business unit manufacturing cost performance might notice that it was on budget. However, this might have resulted from good performance at one plant offset by poor performance at another. Similarly, when different product lines at different stages of development are combined, the combination may obscure the actual results of each product line.
Also, as variances become more highly aggregated, managers become more dependent on the accompanying explanations and forecasts. Plant manager know what is happening in their plant and can easily explain causes of variances. Business unit managers and everyone above them, however, usually must depend on the explanation that company the variance report of the plant.
Finally, the reports show only what has happened. They do not show the future effects of actions that the manager has taken. For example, reducing the amount spent for employee training increases current profitability, but it may have adverse consequences in the future. Also, the report shows only those events that are recorded in the accounts, and many important events are not reflected in current accounting transactions. The accounts don’t show state of morale, for instance.
Management Action
There is one cardinal principle formal financial reports: the monthly profit report should contain no major surprises. Significant information should be communicated quickly by telephone, fax, electronic mail, or personal meetings as soon as it becomes known. The formal reports conforms the general impression that the senior manager has learned from these sources. Based on this information, he or she may have acted prior to the receipt of the formal report.
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. Further, the information from informal sources may be incomplete or misunderstood; the numbers in the formal report provide mare accurate information, and the report may confirm or cast doubts on the information received from informal sources. Also, the formal report provides a basis for analysis information from the informal source soften is general and imprecise.
Usually, there is a discussion between the business unit manager and his or her superior, in which the business unit manager explains the reasons for significant variances, the action being taken to correct unfavorable situations, and the expected timing of each corrective action. These explanations are necessarily subjective, and they may be biased. Operating managers, like most people, don’t like to admit that unfavorable variances caused by their errors. A senior manager has an opinion, based on experience, as to the likelihood that a business unit manager will be frank and forthcoming, and he or she judges the report accordingly.
Profit reports are worthless unless they lead to action. The action may consist of praises for a job well done, suggestions for doing things differently. “chewing out,” or more drastic personnel actions. However, these actions are by no means taken for every business unit every month. As long as business is going well, praise is the most that may be necessary, and most people don’t even expect praise routinely.
Suggested Additional Readings
Drunk, Alan S. “Reliance on budgetary control for manufacturing process automation and production subunit performance.” Accounting, organization and society XVII, no. 4 (April-may 1992), pp. 195-204.
Govindrajan, vijay. “appropriateness of accounting data in performance evaluation: an empirical examination of environment uncertainity as an intervening variable.” Accounting, organizations and society IX, no. 2 (1984), pp. 125-35.
Govindarajan, vijay, and john K. shank. “profit variance analysis: a strategic.” Issues in accounting education 4, no. 2 (Fall 1989), pp. 396-410.
Instituete of management accounts. “fundamentals of reporting information to managers.” Statement on management accounting. Supplement 5-6. Montvale, NJ, 1992.
Case10.1
Variance analysis problems
I. In this case you are asked to analyze the February and march financial performance of the temple division of the ABC company as compared with its budget, which is shown in exhibit 9.3 of the text.
Part A-February 1988
Below are the data describing the actual financial results of the temple division for the month of February 1988.

Sales $781
Variable cost of sales 552
Contribution 229
Fixed manufacturing costs 80
Gross profit 149
Selling expense 57
Administrative expense 33
Net profit $ 59

Sales
Product unit sales price dollar sales
A 120 $0.95 $114
B 130 1.90 247
C 150 2.80 420
Total 400 781
Production
Manufacturing cost
Units variable
Product produced materials labor overhead total
A 150 $80 $20 $40 $140
B 130 91 21 35 147
C 120 190 15 30 235
Total 400 361 56 105 522
Questions
1. Prepare an analysis of variance from profit budget assuming that the temple division employed a variable standard cost accounting system.
2. Prepare an analysis of variance from profit budget assuming that the temple division used a full standard cost accounting system. Under this assumption, the actual cost of sales amount would be$632,000. (Can you derive this figure?)
3. Industry volume are presented below. Separate the mix and volume variance into the variance resulting from differences in market penetration and variance resulting from differences in industry volume. Make the calculation for the variable cost system only. Industry volume, February 1988:
Units(000)
Product A 600
Product B 650
Product C 1,500
Part B-March 1988
Below are the data describing the actual financial results for temple division for the month of march 1988.
Income statement
Sales $498
Variable cost of sales 278
Contribution 220
Fixed manufacturing costs 70
Gross profit 150
Selling expense 45
Administrative expense 20
Net profit $ 85
Sales
Product unit sales price dollar sales
A 90 $1.10 $99
B 70 2.10 147
C 80 3.15 252
Total 240 498
Production
Manufacturing cost
Units variable
Product produced materials labor overhead total
A 90 $40 $8 $17 $65
B 80 55 10 18 85
C 100 150 8 19 177
Total 270 245 26 54 325
Question
Answer the same questions posed at the end of part A. the actual cost of sales using full standard costing would be $340,500 in march. Industry volume for march was:
II. The profit budget for the crocker company for January 1988 was as follows:
Units(000)
Product A 500
Product B 600
Product C 1,000
($000)
Sales $2,500
Standard cost of sales 1,620
Gross profit 880
Selling expense $250
Research and development expense 300
Administrative expense 120
Total expense 670
Net profit before taxes $210
The product information used in developing the budget was as follows:
E F G H
Sales-units(000) 1,000 2,000 3,000 4,000
Price per unit $0.15 $0.20 $0.25 $0.30
Standard cost per unit:
Material 0.04 0.05 0.06 0.08
Direct labor 0.02 0.02 0.03 0.04
Variable overhead 0.02 0.03 0.03 0.05
Total variable cost 0.08 0.10 0.12 0.17
Fixed overhead ($000) 20 60 60 160
Total standard cost per unit 0.10 0.13 0.14 0.21
The actual revenues and costs for January 1988 were as follows:
($000)
Sales $2,160
Standard cost of sales 1,420
Net standard cost of variances 160
Actual cost of sales 1580
Gross profit 580
Selling expense $290
Research and development expense 250
Administrative expenses 110
Total expense 650
Net loss $ (70)
Operating statistics for January 1988 were as follows:
E F G H
Sales-units 1,000 1,000 4,000 3,000
Sales Price $0.13 $0.22 $0.22 $0.31
Production 1000 1000 2000 2000
Actual manufacturing costs (000):
Material $360
Labor 200
Overhead 530
Question
Prepare an analysis of variance between actual profits and budgeted profits for January 1988.
Case 10-2
Solartronics, Inc.
Jhon holden, president and general manager of solartronics, Inc., was confused. Lisa blocker, the firm’s recently hired controller and financial manager, had instituted the preparation of a new, summarized income statement. This statement was to be issued on a monthly basis. Mr.Holden had just received a copy of the statement for January 1984 (see exhibit 1).
Solartronics, Inc., a small, texas-based manufacturer of solar energy panels, had been in business since mid-1977. By the end of 1983, it had survived some bad years and positioned itself as a reasonably good-sized firm within the industry. As part of a conscious effort to “professionalize” the firm, Mr.holden had added Ms.Blocker to the staff in the autumn of 1983. Previous to that time, sorartronics had employed the services of a full-time, full-charge bookkeeper.
Mr.holden’s confusion arose from the fact that he had not expected the firm to report a loss for the month of January. While he knew that sales had been down, primarily due to the normal seasonal downturn, and that production had been scaled back to help reduce the level of inventory, he was still surprised. He wondered if this first month’s result were a bad omen in terms of the likelihood of meeting the budgeted results for the year (see exhibit 2.) even though the 1984 budget represented only a 10 percent increase in scale volume over 1983, he was concerned that such a poor start to the year might make it difficult to get “back on stream.”
Exhibit 1
XXXX
Exhibit 2
XXXX
The standard cost of goods sold consisted of: $420,000 direct labor; $780000 direct materials;$360000 variable factory overhead; and $420000 fixed factory overhead. Ms.bloker treated direct labor and direct materials as a variable costs. Of this amount, $120000 was considered to be fixed. The remaining $3000000 represented the 10 percent commission paid on sales.
The expected sales volume for the year was 5000 equivalent units.
An equivalent unit represented the most popular model sold by solartronics.
Questions
1. Why are the reported results for January so poor, particularly in light of the expected, average monthly of $30,000?
2. What additional data would be useful in analyzing the firm’s January performance? Why?
Case-10.3
Galvor Company
When M.Barsac replaced M.Chambertin as galvor’s controller in april of 1974, at the age of 31, he became the 1st of a new group of senior managers resulting from the acquisition by universal electric. It was an accepted fact that, in the large and sprawling universal organization, the controller’s department represented a key function. M.Barsac, who was a skilled accountant, had had 10years experience in a large French subsidiary of universal.
He recalled his early days with galvor vividly and admitted they were, to say the least, hectic.
I arrived at galvor in early april 1974, a few days after m.chmbertin had left. I was the first universal man here in Bordeaux and I became quickly immersed in all the problems surrounding the change of ownership. For example, there were no really workable financial statements for the previous two years. This made preparation of the business plan, which Mr.Hennessy and I began in june, extreamly difficulty. This plan covers every aspects of the business, but the great secrecy which had always been maintained at galvor about the company’s financial affairs made it almost impossible for anyone to help us.
M.Barsac’s duties could be roughly divided into two major: first, the preparation of numerous reports required by universal, and second, supervision of galvor’s internal accounting and control function as it developed after universals acquisition of galvor.
To control its operating units, universal relied primarily on an extensive system of financial reporting. Universal’s European controller, M.Boundary, as much more than a device to “check up” on the operating units. According to M.Boundry:
In addition to measuring our progress in the conventional sense of sales, earings, and return on investment, we belive the reporting system causes our operatiung people to focus their attension on critical areas which might the not otherwise receive their major attension. An example would be the level of investment in inventory. The system also forces people to think about the future and to commit themselves to specific future goals. Most operating people are under standable involved in today’s problems. We belive some device is required to force them to look beyond the problems at hand and to consider longer-range objectives and strategy. You could say we view the reporting system as an effective training and educational device.
Background
The galvor company had been founded in 1946 by M.georges later, who continued as its owner and president until 1974. Throughout its history, the company had acted as a fabricator, buying parts and assembling them into high quality, moderate cost electric and electronic measuring and test equipments. In its own sector of the electronics industry-measuring instrumenets-galvor was one of the major French firms; however, there were many electronics firms in the more sophisticated sectors of the industry that were vastly larger than galvor.
Golvor’s period of greatest growth began around 1960 and 1971, sales grew from 2.2 million 1971 new francs to 12 million, and aftertax profits from 120,000 1971 new franc to 1,062,000. Assets as of December 31, 1971, totaled 8.8 million new francs. (one 1971 new franc=$0.20.) the firm’s prosperity resulted in a number of offers to purchase equity in the firm, but M.Latour had remained steadfast in his belief that only if he had complete ownership of Galvor could he direct its affairs with a free hand. As owner/president, Latour had continued over the years to be personally involved in every detail of the firm’s operations, including signing of all of the companies important cheeks.
As of early 1972, M.latour was concerned about the development of adequate successor management for galvor. In January 1972 latour hired “technical director” as his special assistant, but this person resigned in November 1972. Following the 1973 unionization of galvor’s workforce, which latour had opposed, latour (then 54 years old) began to entertain seriously the idea of selling the firm and devoting himself “to family, philanthropic, and general social interests.” On april 1, 1974, galvor was sold to universal electric company for $4.5 million worth of UE’s stock. M.latour became chairman of the board of galvor, and david hennessy was appointed as galvor’s managing director. Hennessy at that time was 38 years old and had been with universal electric for nine years.
The Business Plan:
The heart of universal’s reporting and control system was an extreamly comprehensive document-the business plan-which was prepared annually by each of the operating units. The business plan was the primary standard for evaluating the performance of unit managers, and everything possible was done by universal’s top management to give authority to the plan.
Each January, the geneva headquarters of universal set tentative objectives for the following two years for each of its European operating units was a “first look”-an attempt to provide a broad band statement of objectives that would permit the operating units to develop their detailed business plans. For operating units that produced more than a single product line, obtained were established for both the unit as a whole and for each product line. Primary responsibilities for establishing these tentative objects rested with eight product-line-managers located in geneva, each of whom was responsible for group of products lines. On the basis of his knowledge of the product lines and his best judgement of their market potential, each product-line manager set the tentative objectives for his lines.
For reporting purposes, universal consideration that Galvor represented a single product line, even though galvor’s own executives viewed the company’s products as falling into three distinct lines-multimeters, panel meters, and electronic instruments.
For each of over 3000 universal product lines in Europe, objectives were established for five key measures.
1. Sales
2. Net income
3. Total assets.
4. Total employees
5. Capital expenditures
From January to april, these tentative objectives were “negotiated” between geneva headquarters and the operating managements. Formal managements were held in geneva to resolve differences between the operating unit managers and product – line managers or other headquarter personnel.
Negotiations also took place at the same time on products to be discontinued. Mr.Hennessy described this process as a “sophisticated exercise which includes a careful analysis of the effect on overhead costs of discontinuing a product and also recognizes the cost of holding an item in stock. It is a good analysis and one method universal uses to keep the squeeze on us.”
During may, the negotiated objectives were reviewed and approved by universal’s European headquarters in Geneva and by corporate headquarters in the united states. These final reviews focused primarily on the five key measures noted above. In 1976, the objectives for total capital expenditures and for the total number of employees received particularly close surveillance. The approved objectives provided the foundation for preparation of business plans.
In june and july, galvor prepared its business plan. The plan, containing up to 100 pages, described in detail how galvor intended to achieve its objectives for the following two years. The plan also contained a forecast, in less details, for the fifth year hence (e.g., for 1981 in the case of the plan prepared in 1976).
Summary Reports:
The board scope of the business plan can best be understood by a description of the type of information it contained. It began with a brief one-page financial and operating summary containing comparative data for:
Preceding year (actual data).
Current year (budget).
Next year (forecast).
Two years hence (forecast).
Five years hence (forecast).
This one-page summary continued condensed data dealing with the following measures for each of the five years:
Net income.
Sales.
Total assets
Total capital employed (sum of long-term debt and net worth)
Recievables
Inventories
Plant,property and equipmentcapital expenditures
Provision for depreciation
Percent return on sales
Percent return on total assets
Percent return on total capital employed
Percent total assets to sales
Percent receivable to scales
Orders received
Orders on hand
Average number of full-time employees
Total cost of employee compebsation
Sales per employee
Net income per employee
Sales per $1,000 of employee compensation
Net income per thousand square feet of flour space
Anticipated changes in net income for the current year and for each of the next two years were summarized according to their cause, as follows:
Volume of sales
Product mix
Sales prices
Raw materials purchase prices.
Cost reduction programs
Accounting changes and all other causes
This analysis of the causes in net income forced operating managements to appraise carefully the profit implications of all management actions affecting prices, costs, volume, or product mix.
Financial Statements
These condensed summary reports were followed by a complete set of projected financial statement-income statement, balance sheet, and a statement of cash flow-for the current year and for each of the next two years. Each major item on these financial statements was then analyzed in details in separate reports, which covered such matters as transactions with headquarters, proposed outside financing, investment in receivables and inventory, number of employees and employee compensation, capital expenditures, and nonrecurring write-off’s of assets.
Management Actions
The business plan contained description of the major management actions for the next two years, with an estimate of the favorable or unfavorable effect each action would have on total sales, net income, and total assets. Among some of the major management actions described in galvor’s 1976 business plan (prepared in mid-1975) were the following:implement standard cost system
Revise prices
Cut oldest low-margin items from line
Standardize and simplify product design
Create forward research and development plan
Implementing product planning
Separate plans were presented for each of the functional areas-marketing, manufacturing, research and development, financial control, and personnel and employee relations. These functional plans began with a statement of the same functions mission, an analysis of its present problems and opportunities, and a statement of the specific actions it intended to take in the next two two years. Among the objectives set set for the control area in the 1976 business plan, M.Barsac stated that he hoped to:
Better distribution task
Make mare intensive use of IBM equipment
Replace nonqualified employees with better-trained and more dynamic people
The business plan closed with a series of comparative financial statements which depicted the estimated item-by-item effect if sales fell to 60 percent or to 80 percent of forecast or increased to 120 percent of forecast. For each of these levels of variable costs, and management discretionary into three categories: fixed costs, unavoidable variable costs, and management discretionary cost. Management described the specific actions it would take to control employment, total assets, and capital expenditures in case of a reduction in sales, and when these actions would be put into effect. In its 1976 business plan, galvor indicated that its program for contraction would be put into effect if incoming orders drapped below 60 percent of budget for two weeks, 75 percent for four weeks, or 85 percent for eight weeks. It noted that assets would be cut only 80 percent in a 60 percent year and to 90 percent in an 80 percent year, “because remondernization of our business is too essential for survival to slow down much more.”
Approval of plan:
By mid summer, the completed business plan was submitted to universal headquarters; and beginning in the early fall, meetings were held in geneva to review each company’s business plan.
Each plan had to be justified and defended at these meetings, which were attended by senior executives from both universal’s European and American headquarters and by the general managers and functional managers of many of the operating units. Universal viewed these meetings as an important element in its constant effort to encourage operating managements to share their experience in resolving problems.
Before final approval of a company’s business plan at the geneva review meeting’s, changes were often proposed by universal’s top management. For example, in September 1976, the 1977 forecasts of sales and net income in galvor’s business plan were accepted; but the years-end forecasts of total employees and total assets were reduced about 9 percent and 1 percent, respectively, galvor’s proposed capital expenditures for the year were cut 34 percentage, a reduction primarily attributable to limitation imposed by universal on all operating units throughout the corporation.
The approved business plan become the foundation of the budget for the year, which was due in geneva by mid-november. The general design of the budget resembled that of the business plan, except that the various dollar amounts, which were presented in the business plan on an annual basis, were broken down by months. Minor changes between the overall key results forecast in the business plan and those reflected in greater detail in the budget were not permitted. Requests for major changes had to be geneva no later than mid-october.
Reporting to universal:
Every universal unit in Europe had to submit periodic reports to geneva according to a fixed schedule of dates. All units in universal, whether based in the united states or elsewhere, adhered to essentially the same reporting system. Identical forms and account numbers were used throughout the universal organization. Science the reporting system made no distinction between units of different size, galvor submitted the same reports as a unit with many times its sales. Computer processing of these reports facilitated combining the results of universal’s European operations for prompt review in geneva and transmission to corporate headquarters in the united states.
the main focus in most of the reports submitted to universal was on the variance between actual and budgeted results. Sales and expense data were presented for both the latest month and for the year to date. Differences between the current year and the prior year also were reported, because these were the figures submitted quarterly to universal’s shareholders and to newspapers and other financial reporting services.
Description of reports:
Thirteen different reports were submitted by the controller on a monthly basis, ranging from a statement of preliminary net income, which was due during the first week following the close of each month, to a report on the status of capital projects due on the last day of each month. The monthly reports included:
Statement of preliminary net income
Statement of income
Balance sheet
Statement of changes in retained earnings
Statement of cash flow
Employment statistics
Status of orders received, canceled, and outstanding
Statement of intercompany with headquarters
Analysis of inventories
Analysis of receivables
Status of capital projects
Controller’s monthly operating and financial review
The final item, the controller’s monthly operating and financial review, often ran to 20 pages or more. If contained an explanation variances from budget, as well as a general commentary on the financial affairs of the unit.
Cost of the system
The control and reporting system, including preparation of the annual business plan, imposed a heavy burden in time and money on the management of an operating unit. M.Barsac commented on this aspect of the system in the section of galvor’s 1976 business plan dealing with the control functional area.
Galvor’s previous administrative manager [controller], who was a tax specialist above all, had to prepare a balance sheet and statement of income once a year. Cost accounting, perpetual inventory valuation, inventory control, production control, customer accounts receivable control, budgeting, at cetera did not exist. No information was given to other department heads concerning sales results, costs, and expenses. The change to a formal monthly reporting system has been very difficult to realize. Due to the low level of employee training, many tasks, such as consolidation, monthly and quarterly reports, budgets, the business plan, implementation of the new cost system, various analysis, restatement of prior years accounts, at cetera must be fully performed by the controller and chief accountant, thus appending 80 percent of their full time in spite of working 55-60 hours per week. The number of employees in the controller’s department in subsequent years will not depend on galvor’s volume of activity, but rather on universal’s requirements.
Implementation of the complete universal cost and production control system in a company where nothing existed before is an enormous task, which involves establishing 8,000 machining and 3,000 assembly standard times and codifying 15,000 piece parts.
When interviewed early in 1977, M.Barsac stated:
Getting the data to universal on time continues to be a problem. We simply don’t have the necessary people who understand the reporting system and its purpose. The reports are all in English and few of my people are conversant in English. Also, American according methods are different from procedures used in france. Another less serious problem concerns the need to convert all of our internal records, which are kept in frances, to dollars when reporting to universal.
I am especially concerned that few of the reports we prepare for universal are useful to our operating people here in Bordeaux. Mr.Hennessy, of course, uses the reports, as do one or two others. I am doing all that I can do to encourage greater use of these reports. My job is not only to provide facts but to help the managers understand and utilize the figures available. We have recently started issuing monthly cost and expenses reports for each department showing the variances from budget. These have been well received.
Mr.Hennessy also commented on meeting the demands imposed by universal’s reporting system.
Without the need to report to universal, we would do something in less formal way or at different times. Universal decides that the entire organization must move to certain basis by a specified date. There are extra costs involved in meeting these deadlines. It should be noted, also, that demands made on the controller’s department are passed on to other areas, such as marketing, engineering, and production.