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Variance Analysis (2)
Week 16

Learning Outcomes
At the end of the session, you should be able to:

Identify the issues surrounding variance analysis for
overheads
Reconcile budgeted to actual profit
Calculate yield and mix variances for process accounting
Appreciate the criticisms of traditional budgeting
Illustrate the differences in the process of preparing rolling
forecasts, kaizen budgets, zero-based budgets and activity-
based budgets
Recap - Overhead Costs
Some forms have overheads of between 30 50% of
their total costs
Analysing these costs becomes as important as analysing
the variable cost or marginal cost of one unit of
production
Traditionally an allocation base is needed this could be
direct labour hours or machine hours

BUT most of the time actual overhead costs are only
known at the end of the process in most cases a
company would use standard costs to measure
performance...
Example
A firm has budgeted units of production of 12,000
for period 1
The variable overheads are estimated at 30,000 and
fixed overhead is estimated at 25,000. The
allocation base is direct labour hours, which are
budgeted at 4,800 hours
Actual output at the end of the period was 10,000
units, with a fixed overhead spend of 24,000, and a
variable overhead of 28,700, with direct labour
hours of 4,100

Analyse the variable OH variance

Solution
Firstly, draw the chart budget information on the left, actual
information on the right, and a gap in the middle, to show the flexed
budget to reflect actual economic activity

Calculate the flexed budget using an appropriate OH rate
In this case, use DL hours to work out a variable OH rate
(30,000 / 4,800 hrs) = 6.25
Use this rate to work out the flexed variable OH rate
(12,000 / 4,800 hrs) x 10,000 = 25,000
And the total number of hours that should be used to make 10,000
units: 25,000/6.25 = 4000
Fill in the flexed Budget figures, and then calculate the price and
volume variance
Reconciling Budget to
Actual Profit
Fixed Actual Flexible Variances
Sales volume 75,000 82,000 82,000
Sales 750000 650667 820000 -169333
Less variable costs
Food costs 300000 270500 328000 57500
Other variable costs 90000 85000 98400 13400
Contribution 360000 295167 393600 33600
Less fixed costs
Labour costs 158000 165000 158000 -7000
Overheads 78000 65000 78000 13000
Net profit 124000 65167 157600
Statement Reconciling Budget Net Profit with
Actual Net Profit
Budgeted net profit 124,000
Sales price variance -169,333
Sales margin variance
(contribution) 33,600
Food costs variance 57,500
Other variable costs variance 13,400
Labour costs variance -7,000
Overhead costs variance 13,000 -58,833

Actual net profit 65,166
Mix variance

1. A mix variance arises when the actual mix differs from the pre-
determined standard mix.

Example
Standard mix to produce 9 litres of output:
5 litres of X at 7 per litre = 35
3 litres of Y at 5 per litre = 15
2 litres of Z at 2 per litre = 4
54

Standard loss =10% of input. Actual output = 92 700 litres

Actual inputs:
53 000 litres of X at 7 = 371 000
28 000 litres of Y at 5.30 = 148 400
19 000 litres of Z at 2.20 = 41 800
100 000 561 200
2. Mix variance = (SQ x SP) - (AQ SP)

How much should have been used How much was actually used

SQ SP AQ SP
X =100 000 5/10 7 350 000 53 000 7 371 000
Y =100 000 3/10 5 150 000 28 000 5 140 000
Z =100 000 2/10 2 40 000 19 000 2 38 000
540 000 549 000

Mix variance = 9 000 A
So a greater proportion of inferior material has been used.

Standard prices are used to calculate the variances to remove the effect of
price on variance. Price effects can be misleading an unfavourable variance
can be caused by substituting higher quality material for cheaper ones this
maybe in best interests of company but an adverse variance will not reflect
this.
Yield variance

Yield variance is the difference between the standard output for a given
level of inputs and the actual output:

= (Actual yield Standard yield from actual input)
SC per unit of output

= (92 700 90 000 ) 54 / 9 = 16 200 F


If Adverse variable:
Failure to follow standard procedures
Inferior quality material



Sales mix and quantity variances

1. Where a company sells several different products that have
different profit margins, it is possible to divide the sales volume variance
into a quantity and mix variance.

Example
Budgeted sales

X = 8 000 units at 20 contribution = 160 000
Y = 7 000 units at 12 contribution = 84 000
Z = 5 000 units at 9 contribution = 45 000
20 000 289 000

Actual sales

X = 6 000 units at 20 contribution = 120 000
Y = 7 000 units at 12 contribution = 84 000
Z = 9 000 units at 9 contribution = 81 000
22 000 285 000
Sold more than we expected (22000 instead
of 20000)
However Contribution was less than expected
(4000A Total sales margin variance).
Probably because
sold more of product Z which provides less
contribution per unit.
Sold less of product X which provides greatest
contribution per unit.
Sales Mix variance = (AQ SQ in budgeted proportions) Standard margin

SQ in budgeted proportions:
X = 40% (8/20) of 22000 = 8800
Y = 35% (7/20) of 22000 = 7700
Z = 25% (5/20) of 22000 = 5500

AQ SQ in budgeted proportions x Standard margin
X 6 000 8 800 20 = 56 000 A
Y 7 000 7 700 12 = 8 400 A
Z 9 000 5 500 9 = 31 500 F
22 000 32 900 A
Adverse sale mix variance suggests that a higher proportion of the low margin
products were sold during the period than expected in the budget.
Demand for the more profitable products being lower than anticipated
Decrease in the production of the high margin products due to supply side
limiting factors (e.g. shortage of raw materials or labor)
Sales team not focusing on selling products with higher margins due to for
example lack of awareness or misaligned performance incentives (e.g.
uniform sales commission on the entire product range may not motivate sales
staff to compete for high margin sales)
Increase in demand or supply of the less profitable products

Favorable sales mix variance suggests that a higher proportion of more profitable
products were sold during the period than was anticipated in the budget.
Concentration of sales and marketing efforts towards selling the more
profitable products Increase in the demand for the higher margin products
(where demand is a limiting factor)
Increase in the supply of the more profitable products due to for example
addition to the production capacity (where supply is a limiting factor)
Decrease in the demand or supply of the less profitable products
Sales quantity variances

3. Quantity variance = (AQ in budgeted proportions BQ) Actual SM

X = (8 800 8 000) 20 = 16 000 F
Y = (7 700 7 000) 12 = 8 400 F
Z = (5 500 5 000) 9 = 4 500 F
28 900 F

4. If planned mix had been achieved the sales volume variance would
have been 28 900 F.


Splitting variances in this way allows us to see how promoting overall
sales volume is not as beneficial as promoting the most desirable
products.

Favorable sales quantity variance suggests that the
company was able to sell a higher number of products in
aggregate as compared to the total number of units
budgeted to be sold during a period.
Improved marketing of company products
Installation of a new production plant
More efficient production

Adverse sales quantity variance indicates that the company
sold lesser number of goods on aggregate basis as
compared to the total number of units budgeted to be sold
during a period.
A reduction in the overall demand in industry (e.g. due to the
introduction of a better or cheaper substitute in the market)
Unavailability of a critical manufacturing component or raw
material
Decline in the productivity of the workforce
Criticisms of traditional budgeting
Traditional budgeting uses a detailed line approach which is
subject to an incremental change in forthcoming years.
There are alternative systems which can be used within the
budgeting process.
There are also management philosophies that argue budgeting should
not be used in any form.

The CIMA 2009 survey clearly demonstrates that traditional
budgeting is still the most popular form of budgeting.
However, traditional budgeting is renowned for its limitations.
The biggest concern with traditional budgeting is the inability to
respond to a fast-changing environment.

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Traditional budgeting
Reeves and Deimler (2011) argue that:
Traditional budgeting assumes the world is predictable
and relatively stable!
In order to remain competitive, companies need to be able
to respond and learn fast, which will impact the budget.

Frow et al (2010) argue that:
Organizations are facing economic uncertainty through
new technologies, business models and shorter product
life cycles
All of which need to be constantly updated within the
budgets

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Alternative budgeting systems
There are many alternative budgeting
systems:

Rolling forecasts
Zero-based budgeting
Kaizen budgeting
Activity-based budgeting
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Rolling Forecasts
An approach to budgeting that uses a continuous updating
approach to forecasting, the time period of the budget
remains constant
In the majority of cases they will have 6-8 rolling quarterly
forecasts
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Zero-based budgeting

An approach to budgeting that starts with a
blank piece of paper every accounting period.
Resources are allocated on needs rather than
past budgeted information.
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Zero based budgeting
1. All activities within the organization are identified. Report
generated to analyse costs of each activity, justify the
reason for the activity to go ahead and to present all
alternatives. Targets should be identified as a performance
tool. These activity reports are commonly referred to as
decision packages.

2. Every activity report will then be given due consideration
and they will be ranked in order of what is required for that
up and coming budget period.

3. The final stage is the allocation of resources which is
determined by the ranking performed in stage two.
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Zero based budgeting
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Kaizen Budgeting
Budgeting based on a continuous improvement philosophy.
Seeking small improvements in the operating processes which
are recorded within the budget statement.
Although it is about cost reduction it is a cultural mindset.

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Activity-based budgeting
Budgeting based on activities rather than units, products, or
departments. An extension of ABC.
CIMA (2009) reports that nearly 50% of the respondents used
ABB.
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Activity-based budgeting
Process:
1. Analyse products and customers to be able to predict
the production and sales demand.
2. Use the information from the ABC system to estimate
the resources required to perform organizational
activities.
3. With demand predicted, estimate the quantity of each
resource that will be needed to meet the demand.
4. Allocate resources based on these predictions for each
activity.
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Beyond budgeting
A philosophy which seeks the abandonment of budgets.
Using relative target measure this approach seeks
innovation and value added activities to measure the
success of a department, under a devolved process.

Traditional budgeting was deemed to have many
problems.

Hope and Fraser (2003) brought the discussion of the
beyond budgeting philosophy to the wider audience.
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Beyond budgeting
The arguments towards using this philosophy are as follows:

1. Using fixed budgets to set targets will only ever achieve
small improvements.
2. Setting incentives based on fixed targets can create fear,
rather than encouraging innovation.
3. Fixed targets create a sense of compliance rather than
adding value.
4. Allocating resources through traditional budgeting
encourages managers to hoard resources rather than use
them where they are needed.
5. Centralization ignores market reactions.
Source: Adapted from Hope and Fraser, 2003

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Beyond budgeting
Moving away from fixed targets, by using relative targets through bench
marking, will encourage employees to improve their own performance.

Using relative targets will encourage employees to be innovative and
provide the confidence to take (positive) risks they would not have done
before.

By continuously readdressing plans employees are encouraged to think
about value creation rather than achieving set numbers within the
budget.

By using on demand allocation of resources rather than allocating for the
year ahead reduces costs.

Using decentralization and passing the decision making to small local
teams means market feedback is used within the process.

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Beyond budgeting

So why isnt everyone using this philosophy?
It is very difficult to move away from the
traditional budgeting process, cultural mindset.
It is difficult to generate relative benchmarks for
lower level managers
Some of the principles need more detailed
explanation
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