PERFORMANCE

MANAGEMENT
CMA PART 1- SECTION C

ABU DHABI, UAE

OCTOBER 25, 2019
 PROFILING
 Name
 Philippines(CiTY/PROVINCE)
 Education degree
 Job title/role, company (optional)
 What’s your accounting and/or
managerial experience?
 What motivates you to take CMA?
 What benefits will the title
bring to you?
 Motivation
• Promotion (position, salary,
recognition)
• New Career (Job Change)
• CPE/CPD Requirement (40 units)
• Expand Knowledge (curiosity)
• Self Satisfaction (to prove ones
worth)
• Kill time (boredom)
• Rebound (heartbroken)
 Performance Management

 This section is 20% of the Part 1 Exam

 The main topics within Section C are:
 Introduction- Cost and Variance Measures

 Variance Analysis Concepts

 Manufacturing Input Variances

 Sales Variances

 Market Variances

 Variance Analysis for a Service Company

 Responsibility Centers and Reporting Segments

 Performance Measures
 Variance Analysis

 Variance analysis is the comparison between the
actual results for the period and the budgeted
results.
 Variance analysis is an attempt to determine why the
actual results were different from the budgeted
results.
 Either the quantity sold (or purchased), or the price
received (or paid), was different than expected, or
both.
 Variances enable management to focus its attention
on areas where something was wrong.
 MBO vs MBE
♣ Management by Objectives (MBO) – a management model that
attempts to devise a common objective that is acceptable for both
the management and employees, which will improve the overall
performance of the organisation.
- Appraisal is linked with a system to identify objective achievement
levels.

♣ Management by Exception (MBE) – a management style which

identifies the practical deviations from the standards or the
best practices.
- If the actual performance does not show significant deviation, no
action needs to be taken.
Management by Exception
 Variance reporting enables management by
exception which permits management to
focus on areas where there are problems, as
identified by the variance from the standard.

 Disadvantages of management by exception:

 Negative trends may be overlooked at earlier
stages, before they show up as variances.
 If too many deviations from the standards occur,
it becomes a very confusing and involved process
because management is trying to fix all of the
problems at once.
Standard - a benchmark set by management in aid of
performance measurement. When applied to
production, standards are classified as follows:

 Quantity Standard – indicates the quantity of raw

materials or labor time required to produce a unit
of product. This is normally expressed per unit
output (e.g., 3 pounds per unit)
 Cost Standard – indicates what the cost of the
quantity standard should be. This is normally
expressed per unit of input (e.g., $ 2.5 per pound)

Standard Costs – systematically pre-determined costs

established by management to be used as a basis for
comparison with actual cost
 A standard cost is not the same thing as a standard
cost system.
 A standard cost prescribes expected
performance in terms of cost.
 A standard cost system is an accounting system
that uses standard costs and standard cost
variances in the formal accounting system.
 There are other types of accounting systems, and
standard costs can be used with those accounting
systems as well. In these other systems the
standard costs are used for control purposes
outside the formal accounting system.
Standard Costs Cont’d
A standard cost system can be used with
either a job order costing system or a process
costing system.
A process costing system is used to assign costs to
individual products when the products are all
relatively similar and are mass-produced, as on an
assembly line.
A job-order costing system is a method in which all
of the costs associated with a specific job (or
client) are accumulated and charged to that job
(or client).

STANDARD COSTS CONT’D

STANDARD COSTS CONT’D
 Standard costs are used with a flexible budgeting
system.
 A flexible budget enables the company to
identify differences from the budget that are not
simply due to the actual quantity sold or
produced being different from the budgeted or
standard quantity to be sold or produced.
A flexible budget is a budget prepared using standard
per-unit amounts and the actual level of activity.
 Costs are the result of activities that create products or
render services. Standards should be established for
the cost drivers underlying the costs.
 An expected, or budgeted, level of activity for
production must be determined in order to calculate
standard costs.
 It is important to use the correct level of activity when
developing standards.
 • Choices of levels of activity to use:
• Ideal, perfect, or theoretical level of output – assumes no
breakdowns, no waste and no time lost and that workers are working
at maximum efficiency.
• Practical, or currently attainable, level of output – the level achieved
given the normal amount of time lost, waste, and a normal learning
curve for employees. Attainable, but difficult to attain.
• Normal level of output – an average expected level of production
within a period of several years, given effective and efficient
production and customer demand.
• Master budget capacity – the planned output for the next budget
period.

Determining the Level of Activity

Cont´d
Reviewing the Established
Standard Cost
 The
established standard costs
need to be reviewed periodically,
because costs of the inputs into the
manufacturing process will change
over time.
 Standards can be set using several sources:
 Activity analysis:
 Identifying, delineating or outlining, and evaluating all the
activities necessary to complete a job, a project or an operation
 Considers everything required to complete the task efficiently
and involves personnel from several areas including engineers,
management accountants and production workers
 Time consuming and expensive.

 If properly executed, it is the most precise way to

determine standard costs.
 Use of historical data
 less costly way since historical data for a similar product can be a
good source if reliable information is available.
 Advantage: using historical data is that it is based on the way the
particular firm has operated in the past.

SOURCES OF STANDARDS
 Sources of Standards
Cont´d

 Standards can be set using several sources:

 Benchmarking:
 based on current practices of similar operations in
other firms.
 Associations of manufacturers often collect industry
information and have data available. The firm can
use this data as guidelines
 By using benchmarking to set standard costs, a firm
can have access to the best performance anywhere
and this can help sustain its competitive edge.
 A disadvantage of using benchmark data is that it
might not be completely applicable to the firm’s own
situation.
• Standards can be set using several sources:
• Use of target costing:
• Use of target costing to set standard costs puts the focus on the market
and on the price the product can be sold for
• A target price is the price the firm can sell its product for, and the target
cost is the cost that must be attained for the firm to realize its desired
profit margin for the product.
• Once the target cost has been determined, detailed standards are then
set to attain the desired cost.
• Strategic decisions:
• Strategic decisions may affect a product’s standard cost. For instance, a
decision to replace an obsolete machine with a new, computer-controlled
machine would require an adjustment to the standard cost for the
process.

SOURCES OF STANDARDS CONT´D

BUDGETS VS. STANDARDS

BUDGETS STANDARDS
Standards pertain to what costs should
Budgets are statements of be given a certain level of
Purpose expected costs performance.

Budgets emphasize cost levels Standards emphasize the levels to

Emphasis that should not be exceeded which costs should be reduced

Budgets are set for all

departments in the firm (e.g., Standards are set only for the
sales, administration, production or manufacturing division
Coverage manufacturing) of the firm

When actual data differ from The nature and cause of the significant
the budget, it may be an variance are investigated so that
indication of either good or necessary corrective actions are taken
Analysis bad performance accordingly
Variance Analysis
Concepts
Variance Analysis Concepts
• Variances are a comparison between the actual
results and the budgeted, or standard, results.

• More detailed levels of variance analysis

determine the cause for the difference:

• whether the actual quantity was different or

• whether the actual price per unit was different,
or
• whether both quantity and price differences
caused the variance.
 Standard Costing
 Variance Materials Cost Variance
AC- SC MQV = (AQ - SQ)SP
AC > SC UF (Debit) MPV = AQ(AP - SP)
AC < SC F (Credit) AQ x AP MPV
 Materials Variance AQ x SP MQV
AC AQ x AP SQ x SP
SC SQ x SP

*MPV = Spending, Money, Rate, Price Usage

*MQV = Usage, Efficiency
*M Price V Purchased (M Purchase Var)
Silent used: MQV used
 Labor Variance
AC AH x AR
SC SH x SR

 Labor Cost Variance

LEV = (AH – SH)SR
LRV = AH(AR – SR)

AH x AR LRV
AH x SR LEV
SH x SR
*LRV = Price, Spending, Money
*LEV = Hours, Usage, Time
 FOH Variance

1. One-Way
AFOH AH x AR FOH
SFOH SH x SR Variance
Applied FOH

 Flexible Budget Formula: Fx + VR (x)

Number of Hours
AFOH Controllable
BASH Volume/Capacity (Fixed)
SHSR

*BASH Budg FFOH + (SH x Var FOH Rate)

 Three-Way (S-E-VOL)

AFOH Spending
BAAH Efficiency (Variable)
BASH Volume (Fixed)
SHSR

*BAAH Budg FFOH + (AH x Var FOH Rate)

 Four-Way (S-S-E-VOL)
(V) AFOH – BAAH – Variable Spending
(F) AFOH – BAAH – Fixed Spending

BAAH Efficiency (Variable)

BASH Volume
SHSR
BAAH Efficiency (Variable)
BASH Volume
SHSR
Static Budget vs Flexible Budget Variances

• Variances can be looked at from a variety of levels and perspectives.

• The total static budget variance is the difference between the actual
results and the static (or master) budget.
• This is the broadest variance, and not very useful because much
of it may be explained by the fact that actual sales were different
than expected.

• This variance may be broken down into two sub-variances:

1. The flexible budget variance is the difference between actual
results and the flexible budget amount.
2. The sales volume variance is the difference between the flexible
budget and the static budget amount.
Level 2 Variance Report
Flexible Budget Variance

Col. 1 Col. 2 Col. 3 Col. 4 Col. 5 Col. 6

(2)=(1)-(3) (6)=(1)-(5)
also
(6)=(2)-(4)
Flexible Sales Static
Actual budget Flexible volume Static budget
Results variances budget variances budget variances
Units Sold 20,000 0 20,000 4,000- U 24,000 4,000- U
Revenues $2,500,000 100,000+ F $2,400,000 480000-U $2,880,000 $380,000- U
Variable Costs
Direct Materials 1,243,200 43,200+ U 1,200,000 240,000- F 1,440,000 196,800- F
Direct Manufacturing Labor 396,000 76,000+ U 320,000 64,000- F 384,000 12000+ U
Variable Manufacturing overhead 261,000 21,000+ U 240,000 48,000- F 288,000 27,000- F
Total Variable cost $ 1,900,200 140,200+ U $ 1,760,000 352,000- F $ 2,112,000 $211,800- F
Contribution Margin $599,800 40,200- U $640,000 128,000 - U $768,000 $168,200- U
Fixed Costs 570,000 18000+ U 552,000 0 552,000 1800+ U
Operating Income $29,800 58,200- U $88,000 128,000- U $216,000 $186,200- U
$58,200- U $128,000- U

Total flexible Total sales

budget variance volume variance

$186,200- U

Total static budget variance

Level 2 Variance Report
Flexible Budget Variance

Col. 1 Col. 2 Col. 3 Col. 4 Col. 5 Col. 6

(2)=(1)-(3) (6)=(1)-(5)
also
(6)=(2)-(4)
Flexible Sales Static
Actual budget Flexible volume Static budget
Results variances budget variances budget variances
Units Sold 20,000 0 20,000 4,000- U 24,000 4,000- U
Revenues $2,500,000 100,000+ F $2,400,000 480000-U $2,880,000 $380,000- U
Variable Costs
Direct Materials 1,243,200 43,200+ U 1,200,000 240,000- F 1,440,000 196,800- F
Direct Manufacturing Labor 396,000 76,000+ U 320,000 64,000- F 384,000 12000+ U
Variable Manufacturing overhead 261,000 21,000+ U 240,000 48,000- F 288,000 27,000- F
Total Variable cost $ 1,900,200 140,200+ U $ 1,760,000 352,000- F $ 2,112,000 $211,800- F
Contribution Margin $599,800 40,200- U $640,000 128,000 - U $768,000 $168,200- U
Fixed Costs 570,000 18000+ U 552,000 0 552,000 1800+ U
Operating Income $29,800 58,200- U $88,000 128,000- U $216,000 $186,200- U
$58,200- U $128,000- U

Total flexible Total sales

budget variance volume variance

$186,200- U

Total static budget variance

 Variances: Favorable or Unfavorable
When calculating variances for incomes or expenses, always subtract the
Budget amount from the Actual amount.

Actual − Budget = Variance

 A positive variance for an income item is a Favorable variance

 A negative variance for an income item is an Unfavorable variance
 A positive variance for an expense item is an Unfavorable variance
 A negative variance for an expense item is a Favorable variance
 Types of Variances
 Manufacturing Input Variances
 Direct Materials Variances
 Price Variance
 Quantity or Efficiency Variance
 Mix Variance
 Yield Variance

 Direct Labor Variances

 Rate (Price) Variance
 Efficiency (Quantity) Variance
 Mix Variance
 Yield Variance
 Factory Overhead Variances
◦ Total Variable Overhead Variance
 Variable Overhead Spending Variance
 Variable Overhead Efficiency Variance

◦ Total Fixed Overhead Variance

 Fixed Overhead Spending or Budget Variance
 Fixed Overhead Production-Volume Variance

 Sales Variances
◦ Sales Price Variance
◦ Sales Volume Variance
 Quantity Variance
 Mix Variance
VARIANCE ABBREVIATIONS
 The formulas for the different variances all have common
elements to them. The following abbreviations are used:

 AQ – Actual Quantity
 SQ – Standard Quantity for the actual level of output
 AP – Actual Price
 SP – Standard Price
 WASPAM – The weighted average standard price of
the actual mix
 WASPSM – The weighted average standard price of
the standard mix
Manufacturing Input Variances
 Concerned with inputs to the manufacturing process
 Whether the amount of inputs used per unit
manufactured was over or under the standard
 Whether the cost of inputs used per unit manufactured
was over or under the standard

 Standard (expected, budgeted) costs are determined

using an estimated cost and estimated level of usage.
 If the company either pays a different price per unit of
the input purchased than planned or uses a different
amount of inputs than planned, the actual cost will be
different from the budgeted cost.
 Manufacturing Input
Variances Cont´d
 Input cost variances are subdivided into
 A price variance reflecting the difference between
actual and budgeted input prices, and
 A quantity variance, also called an efficiency
variance, reflecting the difference between actual
and budgeted input quantities.

 Variance analysis enables management to identify the

specific reasons for variances and then to focus its
efforts on the variances that are unfavorable.
Intro to Direct Materials Variances
• The total materials variance is the difference between the actual
direct material costs and the expected direct material costs in the
flexible budget.

• Note that these variances are not caused by manufacturing

more units than were planned.

• Variances are caused by either using more inputs per unit

manufactured than the standard per unit, or by paying more
per unit used than the standard per unit, or both.

• These differences need to be further examined to identify what

caused the difference.
 The total materials variance may be broken down
into two smaller variances:

1. The quantity variance, and

2. The price variance

 The Quantity Variance
 The quantity variance is also called the efficiency
variance, or the usage variance.
 It measures the effect on the total variance that
was caused by the actual quantity used being
different from the expected quantity to be used
for the actual level of output that was produced.
 The formula for the quantity variance is:
(AQ – SQ) × SP
 If the result is positive, actual cost was greater
than planned because the company used more
inputs per unit manufactured than it had planned.
Since this is a cost, the variance is Unfavorable.
 If the result is negative, actual cost was lower
than planned, and the variance is Favorable.
 The price variance measures the effect on the total variance that
was caused by the actual price being different from the
expected price.
 The formula for the price variance is:
(AP – SP) × AQ
 If the result is positive, actual cost was greater than planned
because the he company paid more than it expected to for each
unit that was purchased. Since this is a cost, the variance is
Unfavorable.
 If the result is negative, actual cost was lower than planned,
and the variance is Favorable.
The Variance Formulas and Using
Them
 In addition to being able to solve for the amount of the variance, you
also need to be able to use these formulas to solve for any of the
variables.
 In a question, it is possible that you will be given what the variance
is and will need to calculate what the standard price, or the actual
quantity, or another variable was.

 This is not difficult as it is simply an algebraic equation in which you

need to solve for the missing variable. This is easy after you have
identified the equation that must be used.

 You also need to be able to understand what may cause a variance or

a combination of variances.
 Accounting for Direct
Materials Variances

 Standard costing systems use actual variance accounts to record the
variances from the standard costs as they occur.

 The following accounting is performed at the time of purchase:

 Purchases of direct materials are recorded as debits to the
materials inventory account at their standard cost
 If the company recognizes price variances at the time of
purchase, any difference in price from the standard is recorded
in a direct materials purchase price variance account (a debit if
the price is higher than the standard and a credit if the price is
lower than the standard)
 The credit is booked to accounts payable
 Accounting for Direct Materials Variances Cont´d

• The following accounting is performed at the time of material

requisition to production:
o When direct materials are requisitioned from the materials
inventory for use in production, the debit to Work-in-Process
inventory is for the standard quantity of materials that should
have been used for manufacturing the units manufactured at
their standard cost.
o The credit to the materials inventory account is for the total
amount of the material actually used at their standard cost
o The difference is the direct materials quantity variance, and it is
recorded in the direct materials quantity variance account
ACCOUNTING FOR DIRECT MATERIALS VARIANCES
CONT´D

 These entries isolate the variances in special

accounts so they can be analyzed. It also
maintains standard costs in the Work-in-
Process inventory accounts during the
production process.

 At the end of the period, the variances are

closed out to cost of goods sold or, if material,
prorated among cost of goods sold, Work-In-
Process inventory, and Finished Goods
inventory.
Exam Tips
• If a question asks for the materials price variance (or materials price
usage variance), use the units used, not the units purchased, in the
variance calculation.

• If a question asks for the materials purchase price variance, or if the

question says that the company recognizes variances as early as
possible ( or some other description of the materials purchase price
variance), use the quantity purchased instead of the quantity used.

• Most questions ask for the materials price usage variance, using the
units placed into production. However, a question could be about the
materials purchase price variance instead. Therefore, be aware of this
possible variation.
  The direct labor variances are almost exactly the same as the direct
material variances.
 The formulas are the same, but the names given to the variances are a
little bit different.
 The total labor variance is the difference between the actual labor
costs and the expected labor costs in the flexible budget.
◦ Variances result either by using more direct labor per unit
manufactured than the standard per unit, or by paying more per
unit used than the standard per unit, or both.
◦ This difference needs to be further examined to identify what
caused the difference.
 The total labor variance may be broken down
into two smaller variances:

1. The labor rate (or price) variance, and

2. The labor efficiency (or quantity) variance

* The labor rate variance measures the effect on the
total variance that was caused by the actual labor rate
being different from the expected labor rate.
* The formula for the price variance is:
(AP – SP) × AQ

* If the result is positive, the variance is Unfavorable.

This means that the company paid more than it
expected to for each unit of labor that was used.
* If the result is negative, the variance is Favorable.

*
 The efficiency variance measures the effect on the total
variance that was caused by the actual quantity used
being different from the expected quantity to be used
for the actual level of output that was produced.
 The formula for the labor efficiency variance is:
(AQ – SQ) × SP
 If the result is positive, the variance is Unfavorable
because the company used more labor than it expected
to for the level of output actually produced.
 If the result is negative, the variance is Favorable.
Accounting for Direct Labor Variances
 Standard costing systems use actual variance accounts to
record the variances from the standard costs as they occur.
 The following accounting is performed at the time of
production for direct labor:
 The production payroll is recorded by debiting Work-in-Process
inventory for the total number of standard hours for the
units manufactured at the standard hourly rate.
 The credit is accrued payroll at the total number of hours
actually spent and at the actual rate.
 The difference is recorded in the direct labor variance accounts
depending upon the type of variance.
 At the end of the period, the variances are
closed out to cost of goods sold or, if material,
prorated among cost of goods sold, Work-In-
Process inventory, and Finished Goods inventory.

 Note: the company must also choose how the

costs of employee related costs such as
employee benefits and payroll taxes are treated.
They may be included in the cost of direct labor
or treated as an overhead and allocated to the
units produced. In some cases they may be
treated as a period cost.
 More than One Material or
Labor Input
• The variances already discussed are used when there is
only one type (or class) of labor or material.
• When there is more than one input (either labor or
material), the total price (or rate) variance, is calculated as
follows:
1. The price (or rate) variance is calculated for each
individual input separately, and
2. These individual variances are added together.
• When there is more than one input, the total quantity (or
efficiency) variance is calculated in the same manner as
the total price (or rate) variance.
 More than One Material or Labor Input Cont´d

• When there is more than one type of labor (as in skilled and
unskilled) or materials (as in different ingredients), the materials
quantity variance and the labor efficiency variance may be broken
down into two sub-variances:
• Mix Variance and
• Yield Variance
• These sub-variances determine whether the quantity
variance was caused by the mix of the inputs being
different from the standard or by the actual total volume
of usage being different from the standard, or both.
 The Mix Variance (Materials or
Labor)
• The mix variance is the part of the quantity variance that
is caused by the mix of materials (ingredients) actually
used being different from the mix that should have been
used.
• Needed (calculate):
• Weighted Average Standard Price of the Actual Mix
(WASPAM)
• Weighted Average Standard Price of the Standard Mix
(WASPSM)
• The formula for the mix variance is:
(WASPAM − WASPSM) × AQ
The Yield Variance (Materials or
Labor)
 The yield variance results from a difference
between the total quantity of the inputs that were
actually used to produce the actual output and the
total standard quantity that should have been used
to produce the actual output.
 Needed (calculate):
 WeightedAverage Standard Price of the Standard Mix
(WASPSM)
 The formula for the yield variance is:
(AQ − SQ) × WASPSM
Materials Price, Mix and Yield Variances

These variances are calculated whenever the production process involves

combining several materials in varying proportions to produce a unit of
product; mix and yield variances also apply to direct labor.

Materials variance = Actual Cost – Standard Cost

Analysis:
Price Variance: AQ x ΔP = Actual Quantity(Actual Price – SP)
Mix Variance: AQ x SP
Less: Total Actual Quantity at Average Standard Price
Mix Variance
Yield Variance: TAQASP
Less: Standard Cost
Yield Variance

Materials Price, Mix and Yield Variances Cont’d…

Materials Price, Mix and Yield Variances

Bonarita Merger produces the popular Sweet n' Sour face powder. Bonarita has in its budget the
following standards for one kilo of the Sweet n' Sour face powder:

Ingredients Standard Quantity

(Input) Grams) Standard Unit Cost Standard Cost

Paminta (20%) 200 $3 $ 600

Gawgaw (70%) 700 $4 $ 2800
Atsuete (10%) 100 $5 $ 500
TOTAL 1,000 $ 3,900

The company reported the following production and cost data for the June operations:

Ingredients Actual Quantity

( Input) (Grams) Actual Unit Price Actual Total Cost
Paminta 45,000 $4 $ 180,000
Gawgaw 125,000 $3 $ 375,000
Atsuete 30,000 $6 $ 180,000
TOTAL 200,000 $ 735000

Sweet n' Sour face powder production in June totaled 190 kilos

REQUIRED: Determine the following

1 Total materials cost variance
21. Materials
Materials Mix Variance
price
32. Materials
Materials mixYield Variance
variance
4 Materials yield variance
 Factory Overhead Variances

 In addition to calculating variances for materials and labor,

variances may also be calculated for manufacturing (factory)
overhead. These variances are:

 Total Variable Overhead Variance

 Variable Overhead Spending Variance
 Variable Overhead Efficiency Variance

 Total Fixed Overhead Variance

 Fixed Overhead Spending (or Budget) Variance
 Fixed Overhead Production-Volume Variance
 This is also called the flexible budget variance.
 It is equal to the difference between the actual
variable overhead incurred and the standard variable
overhead applied, based on the standard usage of the
allocation base.
 The total variable overhead variance is calculated as:
Actual Total Variable Overhead Incurred
− Flexible Budget Amount of Variable Overhead
= Total Variable Overhead Variance
 The total variable overhead variance can be broken
down into spending and efficiency variances.
 This is essentially the same as a price variance and
determines how much of the total variance was caused
by the actual variable overhead cost per unit of the
allocation base actually used being different from the
standard overhead application rate per unit of the
allocation base actually used.
 The formula is:
(AP – SP) × AQ
 Remember that it is not a price in this case, but rather
the overhead application rate. We have left the
variables the same to indicate how similar this is to
the materials and labor variances.
 Variable Overhead Spending Variance Cont´d

 This variance is also the difference between the actual amount of

variable overhead incurred and the standard amount of variable
overhead allowed for the actual quantity used of the variable
overhead allocation base for the actual output produced.
Actual Variable Overhead Incurred
− Standard amount of variable overhead allowed
for the actual quantity used of the variable
overhead allocation base for the actual output
= Variable Overhead Spending Variance
• This is essentially the same as the quantity variance and determines
how much of the total variance was caused by the actual number of
the allocation base (direct labor hours, number of parts…) used
being different than the expected number of the allocation base to
be used.
• The formula is:
(SQ – AQ) × SP

• Again, remember that it is not a price in this case, but rather the
overhead application rate. We have left the variables the same to
indicate how similar this is to the materials and labor variances.
Example: Variable Overhead Variances
 Variable overhead is applied based on machine hours.
 Total budgeted production: 200,000 units
 Standard quantity of machine hours allowed per unit: 2.
 Standard variable overhead cost per machine hour: $1.50.
 Actual production: 180,000 units
 Actual machine hours used: 450,000 hours
 Actual variable overhead incurred: $603,000
 Example: Total Variable OH Variance

The Total Variable Overhead Variance is:

Actual Variable Overhead Incurred $603,000

Less: Flexible Budget Amount of VOH 540,000 1

Total Variable Overhead Variance $ 63,000

U

1 180,000 units produced × 2 MH standard per unit × $1.50

standard variable overhead cost/MH = $540,000
The Variable Overhead Spending Variance is:
Actual Variable Overhead Incurred $603,000

Less: Standard Amount of VOH $

Allowed for the Actual Quantity of the
VOH Allocation Base Used for the
Actual Output 675,0001

Total Variable Overhead Variance $ (72,000)

F

1 450,000 machine hours actually used × $1.50/hr. = $675,000

 Example 2: VOH Spending
Variance
Using the variance formula (AP − SP) × AQ:
The Variable Overhead Spending Variance is:
($1.341 − $1.50) × 450,000 = (72,000) F
1$603,000 VOH actually incurred ÷ 450,000 machine hours
actually used = $1.34 actual variable overhead cost
per unit of the allocation base actually used.
The Variable OH Spending Variance was $72,000 Favorable
because the actual variable overhead incurred per machine
hour used was lower than the standard: $1.34 actual variable
overhead cost per machine hour, compared with the standard
of $1.50 per machine hour.
Example: VOH Efficiency
Variance
The Variable Overhead Efficiency Variance, using the
variance formula (AQ − SQ) × SP is:

(450,000 − 360,0001) × $1.50 = $135,000 U

12.0 machine hrs. standard/unit × 180,000 units produced

= standard quantity of 360,000 MH

The Variable OH Efficiency Variance was $135,000

Unfavorable because instead of the 2.0 machine hours
planned to be used for each unit produced, 2.5 machine
hours were used (450,000 total actual hours used ÷ 180,000
units produced).
 Example: Total Variable OH Variance

Here are the individual variable overhead variances

combined, and their total is the Total Variable
Overhead Variance:
Variable Overhead Spending Variance $(72,000)
F
Variable Overhead Efficiency Variance 135,000
U
Total Variable Overhead Variance $ 63,000
U
EXAMPLE: INTERPRETATION OF VARIABLE OH
VARIANCES
 Calculating variances is only the beginning. The
next step is to interpret them.

 The Total Variable Overhead Variance was $63,000

Unfavorable, because the actual amount of variable
overhead incurred was $63,000 greater than the
flexible budget amount. Why?

 Investigation should be performed into why more

machine hours were used per unit than planned and
why the actual variable overhead incurred per
machine hour was lower than the expected amount.
 The fixed overhead variances are different from all of the
previous variances we have looked at. This is because fixed
factory overhead (rent, for example) is not dependent on
quantity produced, or sales, or anything.

 Also, because of the nature of these expenses, much less

control can be maintained or effected over these costs. If
the production is less than expected, there will be an
unfavorable variance, but there is little that can be done to
change, or control, the fixed overhead costs.
 Total Fixed Overhead
Variance

 The total fixed overhead variance analysis is the difference between the
actual fixed overhead incurred and the amount that was applied using
the standard rate and the standard usage for the actual level of output.
Actual Fixed Overhead Incurred
− Applied Fixed Overheads1
= Total Fixed Overhead Variance
1Standard rate per unit of application base × Standard amt. of
application base for actual output
 Note that this amount is the same as the over- or under-applied fixed
factory overhead.
 Fixed Overhead Spending
(Budget) Variance
 The Fixed Overhead Spending (also called the Fixed
Overhead Budget) Variance is simply the difference
between the actual fixed overhead costs and the
budgeted fixed overhead amount.

Actual Fixed Overhead Incurred

− Budgeted Fixed Overhead (Static Budget Amt.)
= Fixed Overhead Budget/Spending Variance
The Fixed Overhead Production-Volume Variance is the
difference between the budgeted amount of fixed over-
head and the amount of fixed overhead applied. It is
caused by the actual production level being different
from the production level used to calculate the
budgeted fixed overhead rate.
Budgeted Fixed Overhead (Static Budget Amt.)
− Applied Fixed Overheads1
= Fixed overhead production-volume variance
1Standard rate per unit of application base × Standard amt. of
application base for actual output
 Fixed overhead is applied based on machine hours.
 Total budgeted fixed overhead: $1,000,000
 Total budgeted production: 200,000 units
 Standard quantity of machine hours allowed per unit: 2.
 Standard fixed overhead cost per machine hour:
$1,000,000 ÷ 200,000 units ÷ 2 MH/unit = $2.50/MH.
(Also, $5 per unit)
 Actual production: 180,000 units
 Actual machine hours used: 450,000 hours
 Actual fixed overhead incurred: $1,200,000
 EXAMPLE: TOTAL FIXED OVERHEAD VARIANCE

Actual Fixed Overhead Incurred $1,200,000

Less: Fixed Overhead Applied 900,000

Total Fixed Overhead Variance $ 300,000U

The Total Fixed Overhead Variance is:

1$2.50/MH × 2 MH/unit × 180,000 units produced

The variance is Unfavorable because the actual fixed overhead
incurred was greater than the amount of fixed overhead applied.
Example: Fixed Overhead Spending Variance

The Fixed Overhead Spending (Budget)

Variance is:

Actual Fixed Overhead Incurred $1,200,000

Less: Static Budget Fixed Overhead

1,000,000

Fixed Overhead Spending Variance $ 200,000 U

The variance is Unfavorable, meaning the actual fixed

overhead incurred was greater than the fixed overhead
budgeted.
 Example: FOH Production-Volume Variance
The Fixed Overhead Production-Volume Variance is:
Static Budget Fixed Overhead $1,000,000

Less: Fixed Overhead Applied 900,000 1

Fixed Overhead Production-

$ 100,000 U
Volume Variance
1$2.50/MH × 2 MH/unit × 180,000 units produced
The variance is Unfavorable because the actual output was lower
than planned. The facilities were under-used, and so less overhead
was applied to units produced than anticipated.
 Here are the individual fixed overhead variances combined,
and their total is the Total Fixed Overhead Variance:

Fixed Overhead Spending Variance $200,000 U

Fixed Overhead Production- U

100,000
Volume Variance

Total Fixed Overhead Variance $300,000 U

 The $200,000 Unfavorable Fixed Overhead Spending Variance needs to be
investigated to find out why fixed costs were higher than planned, to identify
the source of the variance.

 The $100,000 Unfavorable Fixed Overhead Production-Volume Variance

measures the amount of excess fixed costs that the company incurred for fixed
manufacturing capacity that it planned to use but did not use. By their very
nature, fixed costs do not decrease if usage is lower than anticipated.

 The interpretation of this variance depends upon the reason for the lower
production, which should be investigated.
2-way, 3-way and 4-way
Analysis
 The Overhead Variances may be combined in different ways and
measured as either 2-way, 3-way or 4-way variance.

 In 4-way variance analysis, each of the 4 subvariances are looked at

and measured individually.

 In 3-way variance analysis, the variable and fixed overhead spending

variances are combined into one spending variance.

 In 2-way variance analysis, the spending variance is combined with the

variable overhead efficiency variance in what is called the controllable
variance.
In table format, this is the presentation of 2-way, 3-way and 4-way variance
analysis, with our variances:
Variable Overhead Variances Fixed Overhead Variances

Efficiency Spending Spending Prod.-Volume

Variance Variance Variance Variance
$135,000 U ($72,000) F $200,000 U $100,000 U
Efficiency Spending Variance (Var & Prod.-Volume
Variance Fixed) Variance
$135,000 U $100,000 U
$128,000 U
Controllable Variance Prod.-Volume
Variance
$263,000 U $100,000 U
 OH Variance Summary Cont´d
The Controllable Variance of $263,000 is equal to the difference
between the total actual overhead incurred (variable and fixed)
and the total flexible budget overhead (variable and fixed).1
Variable Fixed Total

Total Actual Overhead $603,000 $1,200,000 $1,803,000

Less: Total Flexible

540,000 1,000,000 1,540,000
Budget Overhead

Total Variances $ 63,000 $ 200,000 $ 263,000

1Note:For fixed overhead, the flexible budget and the static budget amounts
are the same, because fixed overhead does not change with changing activity
levels.
Factory Overhead Variance Analysis (Two, Three, Four-Way Variance Method)

Canon Company Provides the following production data

Total Standard overhead cost per unit of product: 4 hours at $ 3.00 per hour = $ 12.00 per unit

Budgeted fixed factory overhead $ 20,000

Normal production 2,500 units
Actual Production 2,000 units
Actual Hours 7,500 hours
75%
Actual Factory overhead incurred (75% fixed) fixed 26,000

REQUIRED: Determine the following

1 Budgeted Factory Overhead 6 Volume Variance
2 Standard Factory Overhead 7 Spending Variance
3 Budgeted FOH based on actual hours8 Variable Efficiency Variance
4 Budgeted FOH based on standard hours
9 Variable Spending Variance
5 Controllable Variance 10 Fixed Spending Variance
 Sales Variances
• Variance analysis can be used to assess the selling
department as well as the production department.

• Sales variances are used to explain the differences between

actual and budgeted amounts of revenue, variable costs,
and contribution margin caused by differences between
actual sales results and planned or budgeted sales results.

• These variances can be caused by differences in sales prices

charged, differences in sales volume, differences in variable
cost per unit, and by differences in the mix of products sold.

• They are called Sales Variances to differentiate them from

manufacturing input variances.
• The Sales Price Variance is the same as the Flexible Budget
Variance.
• Since the Flexible Budget is adjusted to the actual sales
volume, the only cause for a variance between the actual
and the flexible budget amounts is sales price charged (for
revenue) or variable costs of sales (for costs) – i.e., price
variances.
• The Sales Price Variance for a single product firm is
calculated as:
(AP − SP) × AQ
 Sales Volume Variance for a Single Product Firm

 The Sales Volume Variances measures the impact of the

difference in sales volume between the actual results and the
STATIC budget.
 The Sales Volume Variance for a single product firm is
calculated as:
(AQ – SQ) × SP

 If only a Flexible Budget is used to make comparisons to

actual results, the Sales Volume Variance will be zero,
because the actual quantity sold will be the same as the
budgeted (i.e., “standard”) quantity.
 Single Product Firm Variances Cont´d

 The Sales Price Variance and the Sales Volume Variance can be
calculated for the Revenue, Variable Costs, and Contribution
Margin lines.
 For Revenue and Contribution Margin, a positive variance
amount is Favorable (revenue or contribution margin were
higher than planned); and a negative variance amount is
Unfavorable (they were less than planned).
 For Variable Costs, a positive variance amount is Unfavorable
(costs were higher than planned); and a negative variance
amount is Favorable (they were less than planned).
 Summary of Single Product Variances

 For a single product firm, Flexible Budget Variances are due to

differences in prices, and Sales Volume Variances are due to differences
in quantity.

 When comparing actual results to the static budget, the Flexible

Budget Variances are due to price while the Sales Volume Variances are
due to quantity.

 When comparing actual results to the flexible budget, there will be

no Sales Volume/Quantity Variance (i.e., the variance will be zero). This
is because the quantity in the flexible budget is the same as the actual
quantity.

 The Flexible Budget Variance plus the Sales Volume Variance equals the
Static Budget Variance.
Sales Variances When More Than One
Product Is Sold

 When more than one product is sold, the Sales Price Variance is
calculated differently from the way it is calculated for a single
product firm.
 The Sales Volume Variance (or Sales Quantity Variance) is also
calculated differently, although it is also true that when the
actual results are compared with the Flexible Budget, the Sales
Volume Variance will be zero.
 The Sales Volume Variance is subdivided into a Sales Mix
Variance and a Sales Quantity Variance.
 This breakdown of the Sales Volume Variance is similar to the way
manufacturing quantity variances are subdivided when there is more
than one input.
 Sales Price Variance for a Multi-
Product Firm
 This is also the Flexible Budget Variance.
 Calculate each product’s individual sales price variance and
sum the variances:
The Sales Price Variance for a multi-product firm is:
∑ (AP − SP) × AQ

 This variance can be calculated for revenue, variable costs, or

contribution margin.
 It is the portion of the total variance caused by the fact that
the sales prices received for the units sold were different from
the budgeted sales prices.
 Sales Volume Variance for a
Multi-Product Firm
 The total Sales Volume Variance for a multi-product firm is
the total of the Sales Volume Variances for each individual
product.
The Sales Volume Variance for a multi-product firm,
calculated for revenue, variable cost, or contribution
margin, is:
∑ (AQ – SQ) × SP
 The detail by product for this variance tells us the effect
on income and expense of the differences between the
actual units sold and budgeted amounts for each product.
The sum is the net effect.
 The total Sales Price Variance and the total Sales Volume
Variance together make up the total Static Budget
Variance.
Sales Volume Variance for a Multi-Product Firm
Cont’d

 For a multi-product firm, the total Sales Volume Variance is

sub-divided into
 the Sales Quantity Variance and
 the Sales Mix Variance.
 The Sales Quantity Variance tells us how much of the Sales
Volume Variance was caused by the fact that, in total, the
number of units sold was different from what was budgeted.
 The Sales Mix Variance tells us how much of the Sales Volume
Variance was caused by the fact that the mix of products
sold was different from the budgeted mix.
 These variances can be calculated for revenue, variable costs,
and contribution margin.
 Sales Quantity Variance for a
Multi-Product Firm
 To calculate the Sales Quantity Variance, we use our quantity
variance formula, but we use the weighted average standard
price for the standard mix (WASPSM) in the formula as the
standard price. The Quantity figures are the total actual and
budgeted units sold.
The formula is:
(AQ – SQ) × WASPSM
 For a multi-product firm, the Sales Quantity Variance
analyzes only the effect of differences between actual and
budget in terms of total units sold, regardless of what
products were sold.
Sales Mix Variance for a Multi-
Product Firm
 The Sales Mix Variance incorporates the impact of the
differences between the actual product mix sold and the
budgeted product mix and its effect on whichever line is
being analyzed (revenue, variable cost, or contribution
margin).
 It works in much the same manner as the mix variance for
labor or material, using the weighted average standard
price for the actual mix WASPAM) and the weighted
average standard price for the standard mix (WASPSM).
 The formula is:
(WASPAM – WASPSM) × AQ
 Market
Variances
Market Variances

 The Sales Quantity Variance can also be analyzed

as to why it occurred.
 The difference between actual and expected sales
units may be connected to two potential areas
related to the market.
1. The actual market was bigger or smaller than was
expected,
2. The company’s market share was bigger or smaller
than expected.
 The market variances measure how much of the
difference was a result of these two potential
factors.
Market Size Variance
 This measures how much of the Sales
Quantity Variance for the contribution margin
was caused by the market itself being bigger
or smaller than was expected.
 The formula for the Market Size Variance is:

(Actual Market Size in

Standard Weighted
Units – Expected Market
Size in Units) × Expected
× Average Contribution
Margin per Unit
Market Share %
Market Share Variance

 This variance measures the difference in the

budgeted contribution margin caused by the
actual market share being different from the
expected market share.
 The formula for the Market Size Variance is:
(Actual Market Share –
Standard Weighted
Expected Market Share)
× Actual Market Size in
× Average Contribution
Margin per Unit
Units
 Variance Analysis for a Service
Company
 A service company’s “product” is the service it provides.
An example of a pure service company is a public
accounting firm. The public accounting firm has no cost of
goods sold because its sole product is the service it
provides.
 Service companies can have the following variances: price,
volume (quantity), mix (related to the services they
provide) and overhead
 If a service company provides service only, then it can
calculate price, quantity and mix variances for the revenue
line.
Variance Analysis for a Service
Company Cont´d

• If the company provides both a service and a product such

as replacement parts, the company should segregate its
service revenue from its parts revenue in its accounting
system.
 It can then analyze its service revenue in isolation while
analyzing the parts sales variances the same way a reseller
would analyze its sales variances: revenue, variable costs,
and contribution margin.
Variance Analysis for a Service
Company Cont´d
 Variance analysis can also be done by any company on its
selling, and general and administrative overhead costs.
 Variable overhead can be a large component of a service
company’s costs, and it needs to be used in
 A service organization may have high fixed overhead costs. If
revenue declines, the fixed overhead costs remain, and the
company can quickly find itself in financial trouble.
 Fixed overhead variance reporting can detect this early and
may enable the company to make changes in its fixed cost
structure to respond to the decreased sales.
 Variance Analysis for a Service
Company Cont´d
• A company that manufactures a product or resells a
product will have both fixed and variable overhead costs
for its non-manufacturing functions. These costs need to
be included in pricing and product mix decisions. Variance
analysis provides a way of doing that.
Responsibility Centers and
Reporting Segments
 Responsibility Centers
 A responsibility center is any part of an organization. It may be a
product line, a geographical area, or any other meaningful unit.
 The main classifications of centers, from the most fundamental (basic)
to the least fundamental, are:
 A cost center is responsible only for the incurrence of costs (any
revenue it may earn is immaterial).
 Costcenters are measured on their efficiency (obtaining the
most with the least use of resources).
 Training and maintenance are examples of cost centers.
 A service center is a type of cost center that provides services
to other departments.
Responsibility Centers Cont´d

 Classifications of responsibility centers continued:

 A revenue center is responsible only for generating
revenues and is not measured by its expenses.
 A sales department is a revenue center.
 Itis measured on its effectiveness (how much did it
sell).
 A profit center is responsible for both the incurrence of
costs and generating revenue.
 Itis measured in respect to both efficiency and
effectiveness.
 An example is a department within a larger store,
such as linens.
Responsibility Centers Cont´d

 An investment center is responsible not only for

the incurrence of costs and generating revenues,
but also for providing a return on an investment.
 An investment center is most like a complete business in
and of itself. However, it is part of the larger
organization.
 A branch office in a different location would be an
example.
 It is measured using return-on-investment.
 Return on investment emphasizes that the department
must provide a return to the larger company.
 A company wants to have as many of its units be
investment centers as possible.
Evaluating Managers and
Departments
 Whenever an evaluation of a manager is made, it is
important that the manager be evaluated only on things
that they are able to control.
 For example, a line manager may be evaluated based on
the cost of production as they have control over that, but
should not be evaluated by the effectiveness of the
marketing campaign as they have no control over that.
 Similarly, departments should not be evaluated on
things that they cannot control.
 Local departments cannot control the amount of
central costs that are charged to them, so these
costs should generally not be included when
evaluating the department.
 Allocation of Common Costs
 Common costs are costs that are shared by two or more
responsibility centers.
 Common costs are non-manufacturing overhead costs such
as IT, human resources, or accounting.
 These are service departments. Their costs need to be
allocated between or among the responsibility centers that
benefit from them in order to properly evaluate people
and departments.
 The method of allocation should:
 Provide accurate departmental and product costs
 Motivate managers to make their best effort
 Provide a fair evaluation of managers´ performance
 Provide incentives for managers to make decisions that are
consistent with the company’s goals,
 Justify costs for transfer prices or cost based contracts
 Systems for Cost Allocation
• Cost allocations can be done based on various systems:
• Cause and effect: activities that cause resources to be
consumed are identified, and cost allocations are based upon
each responsibility center´s usage of the resources
• Benefits received: based upon the benefit received by each
responsibility center
• Fairness or equity: allocation should be “reasonable” or
“fair”. It is a matter of judgment. This approach is often a
requirement for government contracts when a price to the
government is based on costs and cost allocations.
• Ability to bear: costs are allocated based upon the ability of
the responsibility center to bear the cost
Systems for Allocating Common Costs
Cont´d

 An alternative: allocate some percentage of each

department’s contribution to covering the common
costs, rather than actually allocating common costs
to each department.
 This will enable managers to see themselves as
contributing to the overall success of the
company rather than paying for a central
administration cost that they may not perceive
as adding value to their operations.
Ways of Allocating Common
Costs
 There are two main ways in which common
costs may be allocated:
 Stand alone cost allocation, and
 Incremental cost allocation.
 Stand-Alone Cost Allocation
 The stand-alone cost allocation method allocates
costs proportionately among all users on some
basis that relates to each user’s proportion of the
entire organization.
 This could be based on each responsibility center’s
other costs as a proportion of the company’s total
costs; or it could be the proportion of each
responsibility center’s sales in relation to total sales
of the entire company.
 The cost allocation methods discussed in Section C
of this text (i.e., direct method, step method,
reciprocal method) are all stand-alone cost allocation
methods.
 Incremental Cost Allocation
 The incremental cost-allocation method ranks users of
a cost object according to their total usage or on some
other basis.
 The first-ranked user of the activity is called the
primary user. The primary user is charged for costs up to
what its cost would be if it were the only user.
 Then, the next-ranked user(s) are called the
incremental users and are allocated the additional cost,
proportionately if there is more than one incremental
user.
 This is advantageous for a new responsibility centers such as a
new branch office just building its business, if it can be charged
as an incremental user ,as its costs can be lower.
The Contribution Income Statement
 One way to be able to more easily
identify the performance of different
managers or departments in the
organization is to use a contribution
income statement.
 In short, this classifies costs according to
who controls them.
 We will look at the different lines of the
contribution income statement.
Sales xx
Var. Manufacturing Cost xx
Manufacturing Contrib. Margin xx
Variable Selling and Admin xx
Contribution Margin xx
Controllable Fix Cost xx
Short Run Performance Measure xx
Non Controllable Fix Cost xx
Segment Margin xx
Allocable Common Costs xx
Income xx
 Company as a Division Division
whole 1 2
Net Revenues $10,000 $3,000 $7,000
Variable manufacturing costs 3,900 900 3,000
Manufacturing Contribution Margin (Level
1) 6,100 2100 4000
Variable Manufacturing costs 600 100 500
Contribution Margin (Level 2) 5500 2000 3500
Controllable Fixed costs 1,250 500 750
Controllable Margin or Short-term
Segment Manager Performance (Level 3) 4,250 1500 2750
Non-controllable, Traceable Fixed Costs 2,000 600 1400
Contribution by Strategic Business Unit or
Segment Performance (Segment Margin)
(Level 4) 2,250 $900 $1350
Non-controllable, Untraceable, Common
Costs 1,000
Operating Income $1250
 Manufacturing Contribution
Margin
Net Revenue
− Variable manufacturing costs
= Manufacturing contribution margin

• The manufacturing contribution margin is the amount

available after all variable manufacturing costs are covered
to cover nonmanufacturing variable costs, all fixed costs,
and leave some for profit.
• Variable manufacturing costs are the variable costs of
production – labor, materials, and variable overhead
incurred in the production of the units sold
Contribution Margin

Manufacturing contribution margin

− Variable nonmanufacturing costs
= Contribution margin
 This is the amount that is available to cover fixed
costs after all variable costs are covered, and leave
some for profit.
 Controllable Margin
 This is also called short-term segment manager performance.
Contribution margin
− Controllable fixed costs
= Controllable margin
 Controllable fixed costs are the costs the segment manager can
control.
 This is important because it is a measurement of all the revenues
and expenses (variable and fixed) that are controllable by the
individual managers on a short-term (less than one year) basis.
 The controllable margin is a good measure of a manager’s short-
term performance.
 Segment Margin
 This is also called contribution by strategic business
unit.
Controllable margin
− Noncontrollable, traceable fixed costs
= Segment Margin
 Noncontrollable, traceable fixed costs are costs the
segment manager cannot control over the short term,
such as depreciation, but they can be traced to that
department.
 The segment margin is a measure of the performance of each business unit. It may
also be used as a measure of the long-term performance of the manager, if the
manager can control the noncontrollable traceable fixed costs over a long-term
period.
 Net Income
Segment margin
− Noncontrollable, untraceable fixed costs
= Net income
 Noncontrollable, untraceable fixed costs are the costs that are
incurred at the company level and would continue even if the
individual segment were discontinued.
 Because they would continue if any individual segment was
discontinued, these costs should not be allocated to the
individual departments or segments.
 Rather, they are subtracted from the sum of the segment margins
to calculate the company’s net income.
 Transfer Pricing
 The transfer price is the price charged by one unit of the
company to another unit of the same company for the
services or goods produced by the first unit and “sold”
to the second unit.
 Profit and investment centers use transfer pricing to
calculate the costs of services received from service
departments and revenues when “selling” a product that
has an outside market to another department.
 Transfer pricing is most common in firms that are
vertically integrated, i.e., they are engaged in several
different value-creating operations for a product.
 Goals of a Transfer Pricing
System
 A transfer system must accomplish the following:
 It must give senior management the information it needs to
evaluate the performance of the profit centers
 It must motivate the profit center managers to pursue their
own profit goals while also working towards the success of
the company as a whole
 It must encourage the cost center managers’ efficiency while
maintaining their autonomy as managers of profit centers
 It must be equitable, permitting each unit of a company to
earn a fair profit for the functions it performs
 It must meet legal and external reporting requirements
 It should be easy to apply
Responsibility Center and Transfer Pricing

 Upper Limit (Maximum) Transfer Price – Cost of

Buying From Outside Supplier
Higher between:
1. Cost of buying from outside supplier
2. SP to Outside Customers
 Lower Limit (Minimum Transfer Price)
Excess Capacity: VC/u
Full Capacity: SP

VC/u + (SP-VC/u)
*Opportunity Cost : Occur at full capacity
 Transfer Pricing Decisions
 Ultimately, the method used to calculate the transfer price is
determined by top management.
 They must identify a method that will motivate managers to
make the best decisions for the entire company.
 The methods used for transfer pricing include:
 Market price (this is often the best method)
 Cost of production plus opportunity cost
 Variable cost
 Full cost
 Cost plus
 Negotiation
 Arbitrary pricing
 Dual-Rate pricing
 Transfer Pricing Methods
 Market price – the transfer price is set as the current price of
the selling division’s product in an arm’s-length transaction (a
transaction made under the same terms as with an unrelated 3rd
party).
 When there is an external market for the product, this is usually
the best transfer price to use.
 However, sometimes there is no external market and thus a
market price is not available.
 Cost of production plus opportunity cost – includes not only
the cost of production, but also the contribution that the selling
department gives up by selling internally rather than externally.
 Transfer Pricing Methods Cont´d

 Variable cost – the variable costs of the selling division

only.
 Advantage: Works well when the seller has excess
capacity and when the objective is just to satisfy the
internal demand for goods.
 Disadvantage: Not appropriate if the seller is a profit or
investment center because it decreases their profitability.
 Full cost – the full cost of production including all
materials, labor, and a full allocation of overhead.
 Advantages: Well understood and cost information is
easily available. No need to eliminate intracompany
profits in consolidated statements; easy comparison
between actual and budgeted costs.
 Disadvantage: Because it includes fixed costs, it can be
misleading and cause poor decision-making.
Transfer Pricing Methods Cont´d

 Cost plus – A fixed dollar amount or percentage of costs

is added to the cost of production (the cost of
production is defined in the contract). Can be used
when a market price is not available. May use either
standard costs or actual costs.
 If standard costs are used, there is an opportunity to
separate out the variances.
 If actual costs are used, the manager of the selling
department has no motivation to control the costs,
because whatever the actual costs are will be passed on
to the purchasing department.
 Transfer Pricing Methods Cont´d
 Negotiation – the selling and buying departments agree
on a price.
 Each department must have the ability to determine the
amount of materials it buys or the amount of its output
it sells.
 Enables both parties to operate as if they were dealing
with an unrelated party and can lead to good long-term
decisions.
 Most useful when the products in the market are rapidly
changing and companies need to react quickly to the
changes.
 Also helpful when the units are having a conflict and
negotiation can bring about a resolution.
 It can negatively impact the units’ autonomy.
 Transfer Pricing Methods Cont´d
 Arbitrary Pricing – central management decides on a
price to achieve some overall objective such as tax
minimization

 Advantage of this approach is that it achieves the

objectives that central management considers most
important
 Disadvantages far outweigh the advantages because it
defeats the goal of making divisional managers profit
conscious. It hampers their autonomy as well as their
profit incentive
Transfer Pricing Methods Contd́
• Dual-Rate pricing – the selling and purchasing departments
each record the transaction at different prices.

• Advantage of this method is that the selling division has an

incentive to expand sales and production; while, at the same
time, the buying division gets to book the product at its actual
cost to the firm. No artificial profit exists for the selling division.
Variable cost is used for decision making but market price is
used for evaluation
• Disadvantage of this method is the complexity because
divisional profits are determined using different bases.
 Transfer Pricing Cont´d
• Any cost-based method does not provide any motivation for
the producing department to control costs.
• However, cost-based transfer pricing is perhaps the best
method if the buying department is not required to buy from
another internal department.
• If the buying department is unable to choose its supplier,
the manager of the supplying department will not be
motivated to control costs.
• In deciding which method to use, management considers:
• The goals of the company
• The capacity of the producing department
• If the producing department has excess capacity and can produce
what is required by the other department, the minimum price that
they will charge is the variable cost of production.
• Any transfer price between the variable cost of production and
the market price will be beneficial to both departments.

• If the producing department does not have excess capacity, they

will need to charge a transfer price that:
• Covers the variable costs of production, and
• Recovers any lost contribution from the units that they are not
able to produce because of this order.
Performance Measures
 Performance Measures
 Performance needs to be measured and rewarded in a way that
motivates managers to achieve the company’s strategic
objectives and operational goals.
 Goal congruence – Individuals and organization segments are all
working toward achieving the organization’s goals. Managers should
be evaluated on their achievement of goals that benefit the
company, not on their achievement of goals that benefit their own
department or division.
 Short-term versus long-term focus – Emphasis on short-term profits
endangers long-term success because managers will eliminate or
postpone activities that are vital for the firm’s long-term success.
Performance Measures Cont’d

 Timing of feedback is important. Feedback not

received in a timely manner is not useful.
 The proper timing of feedback depends on
who the information is going to, how critical the
information is, and what the information is.
PERFORMANCE MEASUREMENT
 In addition to the contribution income statement, there are
other tools for financial and performance measurement
that you need to be familiar with:
 Return on Investment (ROI), and
 Residual Income (RI).
Responsibility Accounting

 Responsibility Center
 Return on Investment (ROI)

ROI = Margin x Turnover

𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐼𝑛𝑐𝑜𝑚𝑒 𝑆𝑎𝑙𝑒𝑠
= x
𝑆𝑎𝑙𝑒𝑠 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐴𝑠𝑠𝑒𝑡𝑠

𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐼𝑛𝑐𝑜𝑚𝑒
=
𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐴𝑠𝑠𝑒𝑡𝑠
 Residual Income (RI)
Operating Income xx
Required Income (xx)
Residual Income xx

Operating Assets x Min ROI

 Economic Value Added (EVA)

Operating Income after Tax xx

Req./Target Income (xx)
Economic Value Added (EVA) xx

Required Income:
(Total Assets –Current Liability) x WACC
 For each of the following independent cases, the
minimum desired Return on Investment (ROI) is
20%. Compute for each division’s missing item.

Division A1 Division B2 Division C3

Sales P400,000 (5) P700,000
Operation Income (1) (6) pP42,000
Operating Assets (2) P300,000 (9)
Margin 15% 8% (10)
Turnover (3) 3 times (11)

Return on Investments 30% (7) (12)

Residual Income (4) (8) P22,000
Return on Investment
 ROI is the key performance measure for an
investment center.
 It provides the measure of the percentage of
return that was provided on the dollar
amount of the investment (i.e., assets).
 The formula is:
Net income of the Investment Center
Average Total Assets (Investment Base) of the
Investment Center
 Several different measurements of investment are used.
Return on Investment Cont´d
• The different bases of investment (the denominator) that may be
used are:
▫ Working capital plus fixed assets (if this information is provided
in the problem, use this)
▫ Total assets
▫ Long-term assets
▫ Total assets employed
▫ Average invested capital

• Note: Shareholders’ equity should not be used as the base because this
includes decisions that are made only at the corporate level, so they are
probably outside the control of the manager.
 Return on Investment Cont´d
• One problem with ROI is that it measures return as a
percentage rather than as a dollar amount. While it is
good to have a higher rate of return, the company is
ultimately interested in the amount of the return.
– As a result of this shortcoming, ROI is often used together with other
measurement tools.
• Also, when a manager is evaluated using ROI, the manager
may make decisions that are good for short-term ROI, but
bad for the company in the long-term.
– A profitable project may be rejected because its ROI is lower than the
segment’s current ROI and would bring it down; even though the project
would increase profits for the company.
 Residual Income
 Residual Income provides a $ based measure instead of
a % measure. It measures the amount of income the
company achieved in excess of a determined target
income.
 Two terms that are involved in RI are:
◦ The targeted amount of return is usually some
percentage of the total assets of the division or the
invested capital in the division, and
◦ The percentage used in the calculation is the
target rate that management has set.
 The residual income formula is:
Net income before taxes
− Target return in dollars1
= Residual Income
 Residual income may be a negative amount. This occurs
when the profits that the division or project actually
achieved are less than the target income that was set for
the division or project.

1a percentage of assets or invested capital.

 Residual Income Cont´d
• Because it measures a dollar amount, RI is not useful in
comparing projects or departments of different sizes.
• RI is useful when different projects (or departments)
have different risks or operating environments, because
a different target rate can be used for each segment to
take these into account.
• RI is useful for evaluating managers, because it
motivates them to maximize an absolute amount
(dollars) instead of a percentage.
Accounting Methods and
Performance Measurement
• When items such as inventory and fixed assets are
used in calculating performance measures, their values
are influenced by the chosen accounting methods.

• When comparing two business units, both units

should use the same inventory valuation,
depreciation, revenue recognition and expense
recognition methods in order to be comparable.
 Performance Measurement in Multinationals

 When a company operates in different countries, it creates

additional difficulties in comparing performance of its operating
divisions.
 Government controls on selling prices
 Varying tax rates
 Tariffs and customs duties
 Availability and costs of labor, materials and infrastructure vary
 Economic, legal, political, social and cultural environments vary
 Different currencies, exchange rate fluctuations and differences in
inflation rates
 Expropriation risk
 Foreign currency calculation of ROI used to
compare two divisions:
o Both divisions’ incomes should be restated
into U.S. dollars at the average exchange
rate in effect during the year.
o Both divisions’ assets should be restated into
U.S. dollars at the exchange rate that was in
effect when the assets were acquired.
• More companies are using a more encompassing method
of evaluation that includes financial and nonfinancial
measures - called a balanced scorecard.

• The common categories (perspectives) measured are

• Financial perspective - profitability
• Customer perspective - identifying the market segment(s) to
target and then measuring success in those segments.
• Internal business process perspective - products and services,
operations and customer service/support
• Innovation and learning – a culture that supports employee
innovation, growth and development
 The scorecard used by an individual business
should depend upon its strategy.
 The business should select just a few measures –
critical success factors – that are most relevant
to its business strategy and track those measures
rigorously.
 Management’s attention needs to be focused on
these few key measures and not be distracted by
measures that are not critical.
Balanced Scorecard Contd́
• A strategy map links the four perspectives together and provides a way
for all employees to see how their work is linked to the corporation’s
goals.

• Beginning at the bottom, innovation and learning contributes to the

goals of the internal business process perspective.

• Operational improvements made in operations support (business

process perspective) contribute to the company’s ability to fulfill the
goals of customer satisfaction (customer perspective).

• Customer satisfaction brings about increased business, increased profits

and improved financial performance (financial perspective).
THE BALANCED SCORECARD CONT´D
The balanced scorecard is a tremendous evaluation tool
when it is used correctly.
 However, there are several problems with using the
balanced scorecard approach to performance
evaluation:
 It is difficult to use scorecards to make comparisons across
business units, because each business unit has its own
scorecard.
 In order to implement balanced scorecard performance
measurement, it is necessary for a firm to have extensive
enterprise resource planning systems to capture the
detailed information required.
 Nonfinancial data is not subject to control or audit and thus
its reliability could be questionable.
Customer Profitability Analysis

 80% of profits usually come from the top 20% of a firm’s

customers.
 To maintain competitive advantage, a firm needs to work to
attract and keep profitable customers while discouraging
unprofitable customers from dragging down profits.
 Customer profitability analysis can be used to determine the
profitability of individual customers or groups of customers.
 Profitability information can be used for targeted marketing,
as well.
Product Profitability Analysis

 Product profitability analysis can identify products

and services that are unprofitable so those
products and services can be either repriced or
discontinued.
 Accurate allocations of common costs are critical
when customers and products are being
evaluated for their profitability.
 WOW:
“Your biggest battle today is
preparing you for your
greatest testimony
tomorrow.”