PORTABLE MBA IN FINANCE AND ACCOUNTING CHAPTER 7 docx

“So they know not only the total amount that their actual costs differed fromthe budget but also causes of this difference, namely the drop in 10 hours andthe drop in the rate of $6.12,

Michael F van Breda

“Control is what we need Cost control And urgently,” said owner-managerDana Jackson emphatically to her management team “Just a glance at thesereports tells me that our costs are going up faster than our revenues We won’tsurvive much longer on that basis.”

“Well, we could try using cheaper inks and lower quality paper,” said TomDodge, production manager of Jackson Printing, half-facetiously

“That’s not the answer,” exclaimed marketing manager Ahmad Grande

“We’re having a hard enough time as it is selling in this competitive market If

we start to produce an inferior product, our sales will tumble even further body is going to pay our prices and take cheaper quality.”

No-“Ahmad’s right,” said Dana “Our aim should not be to reduce costs somuch as to control them Remember that we have a goal to meet in this organi-zation—to produce the best-quality products that we can If we don’t keep oureyes on that goal we won’t be effective as an organization

“What I’m really after is efficiency I want to see us produce qualityproducts as cheaply as possible—but I don’t want us to produce cheap prod-ucts We must improve productivity

“To get the ball rolling, I want Tom to draw up a set of standards for duction Our attorney has been explaining the new system they have installed

pro-in their office to control their billable hours We could do somethpro-ing similar pro-inour business.”

As eyes rolled, Dana explained what their law firm had done “I wastelling their senior partner about our concerns and he related to me his own

conversation with one of his associates She was expected to bill approximately

500 hours each quarter to clients She had actually reported 570 hours, whichpleased him, but she had only brought in $70,500 when he would have ex-pected $85,500 based on her standard billing rate of $150 per billable hour.That was $15,000 below his expectations

“She explained to him that on the Prescot case the partner that she wasassisting had asked her to do some library research on an alternative theory ofliability She spent 80 hours working on this research, but in the end the part-ner decided not to adopt that alternative theory The partner instructed hernot to charge those 80 hours out, so, at her hourly billing rate of $150, that was

$12,000 of the total shortfall

“As for the other $3,000, she explained that on the Klinger case the clientfelt that the $150 per hour was an excessive rate to charge for an inexperiencedlawyer like her The partner in charge of this case agreed to cut her hourly rate

to $125 She spent 120 hours on that case, so, at $25 per hour not billed, therewas the other $3,000 He summarized her results for me like this:

“In other words, as he explained it, she actually put in only 490 billable hours,even though she worked 570 hours, as opposed to the expected 500 hours Shecharged an average $143.88 instead of the expected $150 They use these num-

bers to break their total variance into two parts: a volume variance and a rate

variance computed as follows:

“They like to do this in percentage or index terms, too

“So they know not only the total amount that their actual costs differed fromthe budget but also causes of this difference, namely the drop in 10 hours andthe drop in the rate of $6.12, and they can identify the effect of each cause ontheir costs in dollars and percentage terms That way they can pinpoint theareas that need particular investigation Things that don’t need attention can

be safely neglected, leaving time to more carefully manage the exceptions

“The percentage approach also enables them to introduce two otherindices, that of the hours billed to the hours actually worked, namely 490/570

or 86%, and the hours actually worked to those budgeted, 570/500 or 114% Inother words, this associate worked 14% more than she should have but actually

Volume Index or a 2% drop

490

500 0 98

143 88

150 0 96

Volume Variance hours $150.00 = $1, 500

Actual Billings billable hours per hour

Budgeted Billings billable hours per hour

Total Variance billable hours unfavorable

billed only 86% of those hours As he noted, that suggests a serious problem,especially when one compares her with the firm average.

“Their firm,” continued Dana, “does this for every one of their associates.They can thereby track the actual revenues of their firm and compare it withthe budgeted revenues They can see whether any shortfalls or overages aredue to charging out more or fewer billable hours than expected, or to chargingclients more or less than the standard rate, or to some combination of the two

It gives them an excellent tool to see how their firm is doing They can also alyze productivity in the firm: in total, month by month, as well as by depart-ments within the law firm, such as trust and estate, corporate, litigation, familylaw, and so on, right down to individual lawyers in the firm And knowing whathas happened in the past, they have an excellent tool for beginning to plan forthe future I think we should be doing something similar!

an-“If we do, we’ll have an idea whether the production staff is working ciently If we have those standards in hand, then we can check how much ourproduct should be costing us And, we’ll be able to compare that figure with ac-tual product cost Checking the difference between actual and budget will tell

effi-us where our big problems are With that information in hand, we should beable to get our costs much more under control and our productivity up.”

“Agreed,” responded Ahmad “People will pay for a quality product if it iscompetitively priced We’ve just got to make sure that we’re working as effi-ciently as our competition, and we’ll be fine That means, when we draw up

a price quote, we need to be able to come in at or below the quotes of our competitors.”

“That’s all very well for you to say,” said Tom, feeling a little aggrieved

“You’re not the one who has to draw up these productivity standards I’ve trieddoing this before and it’s not easy, let me tell you For starters everyone seems

to want perfection.”

“The other thing that I think we need to be aware of,” added Ahmad, “isthat variance analysis is just a start We need a range of performance measuresthat capture not only our productivity but also the value that we are adding toour customers For instance, we know from the newspapers that the firm savedthe Prescots tens of thousands of dollars That was a very successful case for

them, and that needs noting What we really need is a balanced scorecard that

adds a customer perspective to our more internal focus.”1

With that the meeting broke up Tom went back to his office, realizingthat he was not quite sure where to begin For one thing, he hadn’t shared thefact that he had not succeeded in his last attempt to install a standard cost sys-tem What chance did he have this time? A call to a friend of his, Jane Halver-son, who had just completed her MBA, seemed in order

BUDGETARY CONTROL

“Jane, I need your help badly,” Tom pleaded “My boss is after a set of tion standards and I don’t know what to do or where to begin!”

produc-Def ining Standards

That evening Tom went over to Jane’s home, and she pulled out her cost counting textbook “Tell me everything you think I need to know about stan-dard costs,” Tom said

ac-“Okay First, Tom, let’s get straight what we mean by a standard and

why we’re calculating it A standard is a basis of comparison; it’s a norm, ifyou will, or a yardstick Some like to compare it to a gauge—a gauge to mea-sure efficiency

“But a standard is more than that really because it is also the basis for trol Standards enable management to keep score The difference betweenstandards and actuals directs management’s attention to areas requiring theirefforts In that sense, standards are attention getters They form the heart of

con-what is known as management by exception, the concept that one does not

watch everything all the time; instead one focuses one’s attention on the tions, the events that are unexpected.”

excep-Tom smiled knowingly “I’ve experienced this and it’s terrible My boss at

my last job never noticed the good job that I did every day But, when thing went wrong, he was down like a shot to bawl me out!”

some-“That’s one of the traps of managing by exception,” said Jane “But you’resmart enough as a manager to know that people need to be rewarded for theirregular jobs You also know that the exceptions are highlighted so that you canhelp them remedy things—not shout at them Also, outstanding performanceshould be rewarded, and so, by means of management by exception, favorableresults are highlighted, allowing high performers to receive praise.”

Types of Standards

“Then you have to realize,” Jane went on, “that there are different kinds of

standards First you have your basic standards These are the one’s that are

un-changing over long periods of time Many of these are captured in policy ments and may ref lect things like the percentage of waste that is permitted orthe amount of time one might be away from a workstation Basic standards arenot much use in forming costs, though, because the work environment tends tochange too much

state-“At the other extreme there are theoretical or ideal standards These get

set by engineers and are the ideals to which one is expected to strive These arethe standards that I think you feel are unrealistic.”

“Hear! Hear!” broke in Tom “My guys never would accept those dards—that’s the perfection mentality I was telling you about.”

stan-“But,” asked Jane, “aren’t the Japanese always striving towards idealstandards?”

“True, but the difference between them and us is that their system oflifetime employment provides a more supportive atmosphere in which they canstrive for perfection and not feel they are going to get fired if they don’t quite

make it this time around It’s not enough to look at standards in isolation Onemust view them in the context of total management.”

“Right,” said Jane approvingly “And that means that your best norms to

develop are probably what are called currently attainable standards These are

standards that can be met but still represent a challenging goal Let me readyou a quote:

Such standards provide definite goals, which employees can usually be pected to reach, and they also appear to be fair bases from which to measuredeviations for which the employees are held responsible A standard set at alevel which is high yet still attainable with reasonably diligent effort and atten-tion to the correct methods of doing the job may also be effective for stimulat-ing efficiency.2

ex-I think that’s the kind of standard you are after.”

“You’re right And, I tell you there are real advantages to standards set atthis level My guys find them very motivating Also, when it comes time to cost-ing jobs out for pricing purposes, we have a reasonable shot at making thosestandards Of course, that wouldn’t stop us from trying for perfection It’s justthat we wouldn’t have management breathing down our necks when we didn’tmake it.”

Budgets

“Tell me one more thing, though,” said Tom Why do we have to go to all thisbother to develop standards Why can’t top management just use last year’snumbers? That will give them a base for comparison.”

“True,” said Jane “But you’ve got to remember that last year’s actuals

re-f lect last year’s circumstances Things may have changed this year so muchthat last year is not a fair comparison How would you like it if they didn’t ad-just your materials budget for inf lation but expected you to produce as muchthis year as you did last?”

“Okay—you’ve made your point But, why can’t they just get our troller to draw up a budget at the start of the year Why do I have to get involved?”

con-“Two reasons One is that the controller can’t draw up a budget withoutstandards Standard costs are the unit costs that go into a budget The budgetcontains your standards multiplied by the expected volume of sales provided

by the marketing department

“The other reason you need to get involved is that the budget needs to be

adjusted for volume You want them to evaluate you on the basis of a f lexible budget, as opposed to a static budget The only way to be fair to people is to use

a f lexible budget Look at these numbers for instance.” Jane scribbled downthe numbers appearing in Exhibit 7.1

“Notice how the budget is drawn up in the first column: You estimate thevolume for the year and multiply it by the estimated unit selling price or the

estimated unit cost, the standard cost Fixed costs remain the same, of course,and are just inserted into the budget The last column shows the actual rev-enues and actual costs: To get them you multiply the actual selling or the actualunit cost by the actual volume The middle column shows the estimated sellingprice and the estimated unit costs multiplied by the actual volume.

“Note that the only difference between the f lexible budget in column 2and the static budget in column 1 lies in the volume being used The static bud-get uses the expected volume while the f lexible budget uses the actual volume

In other words, the difference between f lexible and static may be attributed

entirely to changing activity levels The difference is, therefore, dubbed an

ac-tivity variance.

“The unit price and cost terms for the actual revenues and costs in umn 3 differ from the corresponding price and cost terms for the f lexible bud-get in column 2; however, the activity level is the same: Both use the actuallevel of sales In other words, the difference between actual and f lexible may

col-be attributed to changing selling and cost prices These differences are dubcol-bed

the price variances Let’s summarize the definitions of these terms.

“Now look what happens if all you have is the budget from the beginning of theyear The variable costs, for which you are responsible, are $1,400 above bud-get You could reasonably expect to have your boss down here chewing you outfor not controlling your costs But, if you know your standard costs, you can ad-just the budget for volume and give him the number in the second column.That comparison shows that you actually got your costs down by $900 Let meshow you what I mean in more depth.”

Price Variance Actual Results Flexible BudgetActivity Variance Flexible Budget Static BudgetPrice Index Actual Results

Flexible BudgetActivity Index =Flexible Budget

Static Budget

=

EXHIBIT 7.1 Static versus f lexible budgets.

Budget (Static) Budget (Flexible) Actual

With that Jane started to prepare Exhibit 7.2 First, to prepare Panel Ashe compared the actual results with the original budget, the static budget Shederived the percentage change by dividing the actual by the budget, subtract-ing one from the result, and multiplying the remainder by 100 For instance, inthe case of revenue:

She did similar computations for the other lines and other panels

Price Indices

“If you only examine Panel A of Exhibit 7.2,” Jane said, “you will think that netincome leaped 62% and that the reason for the dramatic increase lies in the rel-atively sharp increase of 15% in revenue This increase in revenue appears tohave more than compensated for the apparent increase in variable costs of 7%and fixed costs of 17% You might be tempted to attribute the increase in netincome to the superior ability of the sales staff.”

“The fallacy of this interpretation is apparent when you examine Panel B,which compares the actual results with the f lexible budget Now, after adjust-ing for sales volume, we find that instead of that dramatic increase of 62% innet income, there was a 19% drop in net income from budget Using that samebasis of comparison, revenue actually fell by 4% instead of our earlier increase

of 15% Now you can also see that, after adjusting for sales activity, variablecosts actually showed a steep decline of 11% rather than the increase of 7%shown in Panel A In other words, at the actual volume of 1,200 units as op-posed to the budgeted volume of 1,000 units, you should have budgeted morefor variable costs than at first expected The $8,400 is, in retrospect, the moreappropriate budget figure

“The apparent rise in revenues shown in Panel A melts away in Panel B, asdoes the apparent rise in variable costs shown in Panel A The result is a wholenew story Volume rose perhaps because of the efforts of the sales staff butmore probably because of the fall in the selling price from $12 per unit to

$11.50 per unit

“Fortunately,” Jane said with a broad grin on her face, “the loss was tially offset by the heroic efforts of the production staff in getting their per-unit costs down by 11%.”

par-“I like that heroic part,” said Tom approvingly

“You should, because with the volume effect eliminated, all of the fall invariable costs must be attributed to a fall in unit variable costs More precisely,standard variable costs were $7.00 but actual unit variable costs were just

$6.25 Dividing the actual unit cost of $6.25 by the standard variable cost of

$7.00 yields an index of 0.89, or precisely the 11% decrease in variable costsnoted earlier.”

Activity Indices

“Now look at Panel C,” said Jane “This compares the f lexible budget with thestatic budget The only factor that changes between the two is sales activity, sothe percentages measure the change in the number of units sold As there isonly one measure of activity, it is not surprising that all the activity-based in-dices show an increase of 20%, that is, 200 units extra on a base of 1,000 Fixedcosts, though, are independent of activity levels Net income, which is a combi-nation of activity-related and activity-independent numbers, shows an increasethat ref lects its mixed nature.”

Market Ef fects

“The rise in volume may or may not be attributable to good management Onepossibility is that it was driven by an increase in the total market For instance,one can imagine the larger market to have an expected 8,000 units in sales Thecompany was expecting to get 12.5% of the market If one now assumes thatthe market grew to 12,000 units, then the company’s sales of 1,200 units actu-ally represents a decrease in market share Writing this out more formally:

In other words, given this scenario, the sales staff really should be queried onwhy they had a decrease of 20% in market share in a market that increased50%.”

Summar y

“Finally, let’s try to summarize what we have learned to this point First, notethat Panel B confirms that the price index in any variance computation can bederived by dividing the actual figure by the f lexible budget figure Panel Cdemonstrates that the activity index can be derived by dividing the f lexible fig-ure by the static figure In short, the relationship between the overall index ofthe change from budget to actual is given by:

To summarize, then, in the example shown in Exhibits 7.1 and 7.2, one has thefollowing relationships connecting the actual results back to the static, throughthe f lexible budget:

Overall Index Price Index Activity IndexRevenue:

FlexibleStaticPrice Index Activity Index

% %

%,

So, as you can see, the pieces fit together quite logically The points underlyingthese pieces can be summarized quite brief ly:

1 First, we saw the need to distinguish between basic, ideal, and currentlyattainable standards

2 Second, we saw the wisdom of distinguishing f lexible from static budgets

3 Third, we noted that our standards are the foundation stones on whichthese budgets are based

4 We noted that all cost variances follow one simple formula: Actual Costless Budgeted Cost equals Standard Cost Variance

5

6 Flexible budgets adjust variable cost and their variances for volume

7 Volume has no effect on fixed costs or the variances derived from fixedcosts

VAR IABLE COST BUDGETS

“That’s fine, but what am I going to do with these variances?” Tom asked a tle impatiently “Everything that I’ve seen so far may help top management, butit’s not much help to me.”

lit-“Good point, Tom That’s why we need to examine productivity, which

is the relationship between inputs and outputs We’ll enhance your tivity and your control over costs if we can focus on the elements that go intoyour costs.”

produc-With that Jane began to explain how in a typical cost accounting systemthe variable cost of a product or service is a function of:

1 The hours of labor (both direct and indirect) that go into a product

2 The units of material that are used

3 The other components of overhead

4 The unit cost of each of these items

“Let’s call the amount of input that goes into one unit of output the ductivity rate For instance, one might need 500 pages or sheets of paper and

pro-16 minutes of labor to produce a ream of letterhead The material productivityrate is 500 pages per ream; the labor productivity rate is 18 minutes or 0.30hour per ream When the expected cost of the inputs is attached to the ex-pected productivity rates, a standard cost is said to result The productivity

Activity Variances Flexible Budget Static Budget

Price Variances Actual Results Flexible Budget

Activity Indices Flexible Budget

Static BudgetPrice Indices Actual Results

rates themselves are also known as standards They are typically established byengineers.”

As before, Jane began sketching out a numerical illustration of the pointsthat she was making Her sketches appear in Exhibit 7.3 “These are the stan-dards,” she said, “that determine the variable portion of the budget for pro-duction Note the assumption here that variable overhead is a function ofmachine hours, or how long the machine runs Other assumptions are possiblebut we will stick with this one in our example

“Fixed overhead is a little different because it does not really have a ductivity rate Let’s just put down the fixed overhead on a budgeted and an ac-tual basis, and we can come back and discuss the details later.” From thesestandards she began to derive the standard variable cost of the product; also itsactual variable cost:

pro-Standard Cost Material Cost Labor Cost Variable Overhead Cost

pages per page) hours $5.00 per hour) ( hours $ per hour)

per reamActual Cost Material Cost Labor Cost Variable Overhead Cost

pages per page) hours $6.00 per hour) ( hours $ per hour)

Labor:

Variable Overhead: