1.1 Flexible Budgets and Performance Analysis: Part 1 - Section C Performance Management

Part 1 - Section C
Performance Management
1.1 Flexible Budgets and Performance Analysis
I. Managing the Organization

A. In Section B you studied planning and budgeting. Section C is focused on
performance management. The performance management process begins with a
master budget in place. Before stepping forward into the detailed work of
performance management, it's important to first step back and see the big picture
of decision making and management in organizations.
B. Managers establish operational objectives and then work to achieve those
objectives using a decision-making and management process that involves
planning, controlling, and evaluating operations in the organization. This
management process is a feedback loop that can be illustrated as shown.
1. Operational planning is where the strategy is defined into operational

objectives, performance measures are set, and resources are committed.
This is the budgeting process for the organization.
2. Controlling operational processes requires that expectations are
established and incentivized, and results are gathered and reported. It is in
this process that management accountants capture and report variances.
3. Evaluating the operations involves rewarding performance, determining
why objectives were met or not, and using the insight gained to complete
Part 1 - Section C
the feedback loop and inform the planning stage for the upcoming
operational cycle.
C. Performance analysis begins by capturing and reporting variances in operations
(Controlling), and then determining causes for variances in order to incentivize
employees (Evaluating).
II. Performance Analysis Using the Master (Static) Budget
A. The best way to understand variances is to work with the process of measuring
variances. These first five lessons in Section C will use Sunbird Boat Company, a
hypothetical company that manufactures custom wood-built rowboats. (We also
used the Sunbird Boat Company in Section B to explore the budgeting process.)
B. Assume that Sunbird Boat Company used the following standards to establish a
master budget before the start of the upcoming operating year.
1. Note that Sunbird has two types of boats it sells. The Classic boat is made
with a less expensive wood (oak), and the Deluxe boat is made with a
more expensive wood (teak). In the upcoming year, Sunbird plans to sell
156 Classic boats and 41 Deluxe boats.
2. Before the year began, the standard prices and variable costs were
established based on careful management analysis, and the budgeted fixed
cost is determined based on expectations for the upcoming year.
C. At the end of the year, Sunbird had the following results.
D. Clearly, Sunbird's results were different from the master budget. With the
application of a little math, the following performance report can be established.
Part 1 - Section C
E. Even though Sunbird sold six fewer boats than expected, revenue on Classic boats
was higher than expected, resulting in a $28,200 favorable (F) performance
variance. What happened? Notice that you can compute the actual average selling
price for Classic boats, which is $683,400 ÷ 150 boats = $4,556 per boat.
Apparently, even though Sunbird sold fewer Classic boats, it did so at a higher
price—a price high enough to make up the shortfall in volume and still have a
favorable performance on revenue.
1. Go ahead and analyze the $18,475 F variance on Deluxe boats. Sunbird
sold more boats (four more boats) than expected, but did it also sell them
at a higher price? Take a moment and determine the selling price variance
on Deluxe boats for Sunbird.
2. The solution for the selling price variance begins with $403,875 ÷ 45
boats = $8,975 actual price per Deluxe boat. The actual price is less than
the standard price of $9,400 per Deluxe boat. Hence, there's a $9,400 –
$8,975 = $425 U (unfavorable) performance variance on selling price for
Sunbird.
F. Operating performance can be distinguished into goals related to effectiveness
and goals related to efficiency. Sunbird is effective as an organization based on
how well it achieves its revenue (output) goals. Sunbird is efficient based on how
well it achieves its cost (input) goals. Based on the results above, Sunbird is
effective overall in achieving its revenue goals for the year, even though it had an
unfavorable sales volume variance on Classic boats and an unfavorable sales price
variance on Deluxe boats.
G. How about Sunbird's efficiency performance, that is, how well did it perform with
its costs for the year? This is actually a difficult analysis to perform using the
Part 1 - Section C
Master Budget numbers above. The master budget is computing budgeted costs
based on expected sales of 156 Classic boats and 41 Deluxe boats. However, the
actual cost results are for actual sales of 150 Classic boats and 45 Deluxe boats.
Hence, we'd expect that actual costs for Classic boats would be lower for Classic
boats and higher for Deluxe boats. We need a different kind of budget in order to
analyze the efficiency of cost performance for Sunbird.
III. Performance Analysis Using the Flexible Budget
A. Sunbird needs to be efficient with its costs. In order to assess efficiency at
Sunbird for the last year of operations, the question to be answered is, “What level
of costs would be efficient for the number of boats it actually produced and
sold?” The master budget was built assuming 156 Classic boats and 41 Deluxe
boats, but that didn't turn out to be the actual output level. Hence, Sunbird needs
to establish a budget for costs based on what it actually produced and sold. This
type of budget is called a “flexible budget.”
B. What costs are expected to shift based on change in the output level? Only
variable costs are expected to shift. Fixed costs should remain constant. Hence, a
flexible budget needs to “flex” on the variable costs used to assess actual output.
Budgeted fixed costs should not shift in the flexible budget (i.e., there is no flex in
fixed costs!). Below is a flexible budget report for Sunbird's actual sales volume.
1. The most important factor in a flexible budget is that it is based on the

actual outcome results (i.e., actual production and sales). This approach
makes the costs in this budget relevant for analyzing the efficiency
performance of the organization. That is, these are the input costs
that should have been used to create the actual output.
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2. The basic approach to building a flexible budget for costs is to use the
following equation:
Total costs=Variable costrate(Activity volume)+Total fixed costs
3. Note that Sunbird's standard variable cost rate is $2,785 for Classic boats
and $6,315 for Deluxe boats. Total fixed costs are budgeted to be
$183,600. These are the cost inputs used to establish the flexible budget
above.
4. The budgeted variable costs in the flexible budget ($701,925) are different
from the budgeted variable costs in the master budget ($693,375) due to
the fact that the flexible budget is based on actual output (150 Classic
boats and 45 Deluxe boats) while the master budget (sometimes called the
static budget) is based on the original expectations for output (156 Classic
boats and 41 Deluxe boats).
5. Again, there is no flex in the budgeted fixed costs. This part of the budget
is the same for both the master (static) budget and the flexible budget
($183,600).
C. Now compare the variance analysis results using the master budget and the
flexible budget. There are two basic differences.
1. First, the total revenue variance is different ($46,675 F versus $34,275 F).
The $46,675 F variance in the master budget is due to the fact that sales
volumes and sales prices were different than planned. Essentially, this
variance number commingles these two results, making it difficult for
managers to clearly control and evaluate issues involving sales volumes
and sales prices. On the other hand, the $34,275 F variance in the flexible
budget is based strictly on the difference between standard sales prices and
actual sales prices. Hence, this variance isolates one issue for
management, which is the issue of controlling and evaluating sales price
performance for Sunbird. We'll talk more about sales price and sales
volume variances in the next lesson.
2. Second, the total variable cost variance is also different ($14,823 F versus
$23,373 F). The $14,823 F variance in the master budget is actually
irrelevant for management use because it is comparing the budgeted costs
to produce and sell 156 Classic boats and 41 Deluxe boats with the actual
costs of 150 Classic boats and 45 Deluxe boats. These are not comparable
costs. What about the $23,373 F variance in the flexible budget? This
number is useful for managers at Sunbird because it is based on the
variable costs that Sunbird should have used for its actual volume of boats.
However, as we will study in subsequent lessons, cost variances are the
consequence of two management issues, which are using more or less
inputs (e.g., materials, labor, etc.), or paying more or less for those inputs.
We need more information about Sunbird's costs before we can break
down this $23,373 F variance into information useful for controlling and
evaluating operations.
IV. Using Variance Reports to Manage
Part 1 - Section C
A. In this lesson we've used master budgets and flexible budgets to introduce you to
the concept and computation of performance variances. Before we move forward
into the next four lessons, we need to establish two important management
concepts involving variances.
B. The first concept is that variance computations are based on the ceteris
paribus principle, which is Latin for “all other things being equal.” This means
that a variance computation isolates the effect of a single issue in the organization
and measures that effect on operating income. If the effect of the single issue is to
increase operating income, then it is described as a “favorable” variance. And if
the effect of the single issue decreases operating income, it is an “unfavorable”
variance.
1. It is important to understand that “favorable” and “unfavorable” doesn't
always mean “good” and “bad.” Often management will make a decision
leading to a particular unfavorable variance because the decision also
leads to one or more favorable decisions that when combined together
have an overall positive effect on operating income.
2. One example of a good result from an unfavorable variance could be a
decision to accept an unfavorable labor cost variance because it provides
for a better product or service that leads to a favorable sales price variance.
C. The second key management concept involving variances is the concept of
“management by exception.” Variances provide a signal to management that
indicates something in the organization is out of compliance with cost standards
or budget expectations, regardless of whether the variance is favorable or
unfavorable. If the variance is large enough, it calls attention to management. The
value of this management-by-exception approach is it helps the organization focus
on current processes that may need attention. It's important to note that variances
do not inform management on what the actual problem is or what needs to be
done. Variances are simply signals to management to investigate.
Practice Question
Faircloth & Company makes two types of products, Heather and Sage, and sells them for $20
and $25 per pound, respectively. Faircloth wants to analyze performance for the month.
Originally, Faircloth planned to sell 30,000 pounds of Heather and 12,000 pounds of Sage in the
upcoming month. Below are Heather's standard costs.
Cost Type Cost Formula

Power: $0.50 per direct labor hour
(DLH)
Maintenance: $1.25 per DLH + $134,500
Labor: 18.00 per DLH + $68,400
Rent: $31,500
The Heather product requires 0.6 direct labor hours per pound and the Sage product requires 0.8
direct labor hours per pound.
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Actual sales for the month were 32,000 pounds of Heather and 10,400 pounds of Sage at prices
of $19.20 and $28.10, respectively. Below are Faircloth's actual costs for the month.
Heather variable costs: $387,200

Sage variable costs: $175,136
Total fixed costs: $231,000
Build a variance report using Faircloth's original master budget. Then build a variance report
using Faircloth's flexible budget.
Answer
Before building the budgets, first determine Faircloth's standard variable cost rates and expected
total fixed costs as follows:
 Variable cost per DLH = $0.50 + $1.25 + $18.00 = $19.75 per DLH

 Heather standard variable cost rate = $19.75 per DLH × 0.6 DLH per pound = $11.85
 Sage standard variable cost rate = $19.75 per DLH × 0.8 DLH per pound = $15.80
 Expected total fixed costs = $134,500 + $68,400 + $31,500 = $234,400
Master Budget Variance Analysis
Flexible Budget Variance Analysis

Part 1 - Section C
Summary
Beginning with the next lesson we will work on computing a number of specific variance
computations that managers use to control and evaluate operations. As we work through these
computations, it's important that you remember how the master budget compares to the flexible
budget for computing variances. The master budget (also called the static budget) is based on the
original expectations for production and sales volumes before the start of the operating period. In
contrast, the flexible budget is built after the conclusion of the operating period and is based on
actual production and sales volumes. The variance analysis using the master budget is useful
only for evaluating the effectiveness of performance output involving sales volumes. The
flexible budget, on the other hand, is focused on managing the efficiency of inputs used to
produce and sell the organization's actual volume of products or services.
1.2 Management by Exception and Sales Revenue Variances
I. Variance Frameworks and Variance Formulas

A. As described in the last lesson, it is crucial in the computation of variances to
isolate on the organizational factor creating the variance between expected
(budgeted) and actual performance. There are two ways to approach the
computation of variances—the framework approach and the formula approach.
Either approach results in the same computation that isolates the factor causing
the variance.
B. The framework approach is the more visual method of the two approaches. The
most basic form of the variance framework is presented below.
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1. As you can see, the framework clearly distinguishes between quantities

and prices. Revenue performance is the result of quantities sold and prices
received, and cost performance is the result of quantities used and prices
paid.
2. Moving from left to right, the framework approach begins by computing
(or observing) the actual results based on actual quantity and prices. The
next step is to compute how much should have been received (for
revenues) or paid (for costs) based on the standard price. The difference
between these two values (actual quantity at actual price and actual
quantity at standard price) isolates the effect of price on operating profits
and is called the price variance.
3. The quantity variance is computed from continuing to move left to right.
The third value in the framework is the standard quantity at the standard
price. When working with revenue, the standard quantity represents how
much quantity was expected to be sold (and is often referred to as the
“expected quantity”). This quantity of expected output is represented in
the organization's master budget.
4. When working with costs, the standard quantity represents how much
input (e.g., materials, labor, etc.) should have been used to produce
the actual volume of output (and is often referred to as the “standard
quantity allowed”). When computing cost variances, be sure to use the
standard quantity allowed for the actual output, which comes from the
organization's flexible budget.
5. As can be seen above, the quantity variance is computed by comparing the
actual quantity at standard price with the standard quantity at standard
price. This approach isolates the effect of the quantity variance on
operating profit.
C. The formula approach to computing variances effectively shortcuts the visual
framework approach by directly computing the variance.
1. For the price variance, the formula is as follows:
Actual quantity×(Standard price−Actual price)=Price variance
2. For the quantity variance, the formula is as follows:

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(Standard quantity−Actual quantity)×Standard price=Quantity variance
 Note in the structure of these formulas that the source of the

variance is contained with parentheses.
D. Finally, with respect to determining whether the variance is favorable (F) or
unfavorable (U), it is best to make this determination before computing the
variance. Remember from the last lesson that favorable and unfavorable doesn't
necessarily mean “good” and “bad.” Hence, don't worry about whether the
computation results in a negative or positive number.
1. For example, in the formula for the price variance above, note that if the
actual price is higher than the standard price, the result will be a negative
number. If this is a cost variance being computed, then the organization is
actually paying a higher price (for materials or labor) than the standard,
and that has an unfavorable (negative) effect on operating profit.
2. On the other hand, what if the price variance formula above is used to
compute a revenue variance? If the actual price is higher than the standard
price (which results in a negative number in the formula structure above),
the variance has a favorable (positive) effect on operating profit.
E. In the process of computing variances (using either the framework approach or
formula approach), it's easy to become confused about whether the computational
result is a favorable or unfavorable variance. Hence, don't wait to do the
computation and then determine whether the variance is favorable or unfavorable.
Instead, before computing the variance, consider the factor being isolated (price
or quantity) and logically conclude if the relation between actual and standard has
a favorable or unfavorable effect on operating profit. With the “U” or the “F” in
place, then compute the size of the variance.
II. Sales Price Variance
A. Let's return now to our work with the Sunbird Boat Company. Below are some
numbers you'll recognize from Lesson 1.
B. We can use the framework approach to compute the sales price variance for
Sunbird. The specific framework for the sales price variance is below, followed
by the computations.
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1. Because the left-side result of the framework with the actual sales price is
higher than the right-side result with the standard sales price, this is a
favorable (F) variance.
B. Alternatively, we can use the formula approach. Before computing the variance,
note that the actual sales price for Classic boats ($4,556) is higher than the
standard price ($4,200). Hence, the sales price variance for Classic boats is
favorable. In contrast, the actual sales price for Deluxe boats ($8,975) is lower
than its standard price ($9,400), which means the variance for Deluxe boats is
unfavorable.
1. The formula approach for the sales price variance is as follows:
Actual volume×(Standard price−Actual price)Classic:150boats×($4,200−

$4,556)=$53,400FDeluxe:45boats×($9,400−$8,975)=$19,125UTotal sales
price variance:$53,400F+$19,125U=$34,275F
2. Note that the computational solution for Classic boats is actually a

negative value, but the result is reported as an absolute value (i.e., non-
negative). Variances are not reported as negative or positive values, but as
unfavorable (U) or favorable (F) values. Hence, even though the
computation solution for Deluxe boats is a positive value, the variance is
actually unfavorable as we determined before computing the size of the
variances.
2. Sales Volume Variance—Measured by Price
A. In addition to actual sales prices being different from standard prices, Sunbird
Boat Company also experienced sales volumes being different than expected
(budgeted). Using the framework approach, the size and direction of Sunbird's
sales volume variance is computed below.
Part 1 - Section C
1. Again, because the left-side result of the framework with the actual sales
volume is higher than the right-side result with the expected sales volume,
this is a favorable (F) variance.
B. Using the formula approach, we can replicate the sales volume variance
computation. But first let's determine if the results will be favorable or
unfavorable. The actual sales volume for Classic boats (150 boats) is lower than
expected (156 boats), which is an unfavorable result. On the other than, the actual
volume for Deluxe boats (45 boats) is higher than expected (41 boats), which is a
favorable result.
1. The formula approach for the sales volume variance is as follows:
(Expected volume−Actual volume)×Standard priceClassic:

(156boats−150boats)×$4,200=$25,200UDeluxe:
(41boats−45boats)×$9,400=$37,600FTotal sales volume variance:
$25,200U+$37,600F=$12,400F
2. Again, remember that these computations are reported as absolute values.

Hence, even though the Deluxe boats computational result is negative, it is
reported as a non-negative favorable (F) value.
2. Sales Volume Variance—Measured by Contribution Margin
A. When the volume of sales is different than expected, it affects both the revenue
and the operating profit of the organization, but the dollar-size effect of the sales
volume variance is different for revenue compared to the effect on operating
profit.
B. With respect to the Sunbird Boat Company, we used the standard sales price to
compute the sales volume variance as $12,400 F. The dollar value of this variance
represents how much revenue will increase due to increased sales, but it doesn't
Part 1 - Section C
represent how much the operating profit will increase for Sunbird. Why? Because
increased sales volume not only increases revenue but also increases some costs
—specifically, it increases the organization's variable costs.
C. Some organizations will use the standard sales price to understand how the sales
volume variance affects revenues, but most organizations are focused on the
“bottom-line effect” of the sales volume variance. In order to isolate the effect of
the sales volume variance on operating profit, the organization needs to use
the standard contribution margin per unit (rather than the standard sales price per
unit) to establish the dollar value of the variance.
D. We introduced Sunbird's standard variable costs per boat in Lesson 1. That
information is provided below, along with the actual sales volume data needed to
compute the sales volume variance measured in contribution margin dollars.
E. Using the framework approach, we can recompute Sunbird's sales volume

variance measured in terms of contribution margin. The computations are below.
Part 1 - Section C
1. The total sales volume variance measured in standard contribution margin

dollars is $3,850 F. Remember that we previously computed this volume
variance measured in standard sales price dollars as $12,400 F. What these
two values tells us is due to the volume of sales being different than
planned, Sunbird's revenue will be $12,400 higher and its operating profit
will be $3,850 higher.
2. Notice something interesting in these results. Sunbird actually sold a total
of 195 boats (150 + 45). However, it expected to sell a total of 197 boats
(156 + 41). Even though Sunbird total sales volume measured in boats
was less than expected, the sales volume variance measured in dollars
is favorable. Why? It has to do with selling more of the Deluxe boats,
which have a higher standard contribution margin per boat. We'll explore
this issue in the last part of our lesson.
F. Now let's use the formula approach to compute the sales volume variance
measured in standard contribution margin (CM) dollars. We've already
determined whether the computations will be favorable (F) or unfavorable (U).
This determination is based strictly on comparing the volume of boats expected
compared to actual volume. Using standard sales prices or standard contribution
margins doesn't affect the direction of the variances.
1. The formula approach is as follows:
(Expected volume−Actual volume)×Standard CM=Sales volume

varianceClassic:(156boats−150boats)×$1,415=$8,490UDeluxe:
(41boats−45boats)×$3,085=$12,340FTotal sales volume variance:
$8,490U+$12,340F=$3,850F
2. Again, most organizations prefer to measure the sales volume variance in

terms of standard contribution margin in order to understand the bottom
line effect on operating profit. Hence, for the remainder of our work on
variances, we're going to use standard contribution margin to measure all
variances involving the sales volume.
3. Sales Mix and Quantity Variances
A. Before we wrap up our discussion on planning and controlling sales revenue using
variance analysis, we need to work through one more management issue. Most
organizations sell a mix of products or services, which means that the sales
volume variance results not only from selling more or less total volume of goods
and services, but also from selling relatively more or less of one type of product
versus another. The financial size of the sales volume variance is affected by both
of these issues.
B. For Sunbird Boat Company, note that Deluxe boats have a higher standard price
and a higher standard contribution margin compared to Classic boats. When
customers come to Sunbird to purchase a boat, they're choosing to buy either a
Deluxe or Classic boat, and Sunbird certainly cares about which boat they buy!
This means that Sunbird should work to sell more overall boats and sell more
Deluxe boats compared to Classic boats. Performance on these two issues needs
Part 1 - Section C
to be measured in order to control and evaluate sales volume operations at

Sunbird Boat Company.
C. Variance analysis can break down the sales volume variance into two separate
variances that distinguish the financial effect of selling more or less of one type of
product or service relative to another, as well as the financial effect of selling
more or less total products or services. The framework approach provides a visual
method of seeing and computing these two variances.
1. As you can see above, the mix variance and the quantity variance are
subsets of the volume variance. By inserting a middle box (total actual
volume × expected mix percentage × standard contribution margin)
between the two original boxes in the volume variance framework, we
neatly split the volume variance into two parts—the mix variance and the
quantity variance.
Part 1 - Section C
2. The logic of this middle box is seen by expanding the two original boxes
as displayed in the bottom framework. Sunbird Boat Company is selling
two different boat products, Classic and Deluxe. Each of those boat
product lines has its own actual and expected level of sales volume.
Combined, Sunbird actually sold 195 boats and expected to sell 197 boats,
with an actual and expected mix percentage of each type of boat, as shown
below.
Note that the total expected sales volume (197 boats) multiplied by the
expected mix percentage of Classic boats (79.19%) is equal to the
expected volume of Classic boats (156 boats). Hence, we can compute the
two original boxes in the sales volume framework using total quantities
and product line mix percentages. This additional computational work
doesn't change the results, but it does provide a way to see how the mix
variance isolates the effect of selling more or less of one boat line
compared to another boat line at Sunbird. This view also helps us see how
the quantity variance is isolating the effect of Sunbird selling more or
less total boats.
3. Using the framework approach, we compute the sales mix variance as

shown below.
Part 1 - Section C
When using mix percentages, it's very important to use the precise
percentage number (don't round off the percentage). For example, the
79.19% in the formula above that calculates $218,499 must be used with
its full precision (156 boats ÷ 197 boats = .791878).
4. This mix variance is favorable (F) because Sunbird's actual mix of Deluxe
boats (23.08%) is higher than its expected mix percentage (20.81%)
relative to the mix percentage of Classic boats. This has a favorable effect
on operating profit because the standard contribution margin of Deluxe
boats ($3,085) is higher than Classic boats ($1,415). In short, Sunbird was
able to increase the percentage of sales to the product line with a higher
contribution margin per unit.
5. Using the framework approach, we compute the sales quantity variance as
shown below.
Part 1 - Section C
Again, be sure to use precise sales mix percentages when computing this
variance. By doing so, the sales quantity variance combined with the sales
mix variance will equal the sales volume variance ($7,375 F + $3,525 U =
$3,850 F).
6. The sales quantity variance is unfavorable (U) because Sunbird sold fewer
total boats (195 boats) than expected (197 boats). This computation
isolates the effect of the total quantity variance by holding constant the
standard sales mix in both boxes above.
D. The framework approach to computing the sales mix and sales quantity variances
is rather involved, but it has the advantage of visually demonstrating how these
two variances are subsets of the volume variance. Alternatively, we can compute
these variances using the formula approach.
1. The formula approach for the sales mix variance is as follows:
Total actual volume×(Expected mix%−Actual mix%)×Standard

CMClassic:195boats×(79.19%
−76.92%)×$1,415=$6,249UDeluxe:195boats×(20.81%
−23.08%)×$3,085=$13,624FTotal sales mix variance:$6,249U+
$13,624F=$7,375F
2. The formula approach for the sales quantity variance is as follows:
(Total expected volume−Total actual volume)×Expected mix%×Standard

CMClassic:(195boats−197boats)×79.19%×$1,415=$2,241UDeluxe:
(195boats−197boats)×20.81%×$3,085=$1,284UTotal sales quantity
variance:$2,241U+$1,284U=$3,525U
Part 1 - Section C
E. Note that the percentages used to compute the mix variance and the quantity
variance are not rounded off in the computations above. For example, the
expected sales percentage mix used for Classic boats is not exactly 79.19% but is
closer to 79.1878173%. It's important to use a precise percentage mix in order to
have the mix variance and the quantity variance sum up to the volume variance.
By keeping the computations precise in the two variances (which are a subset of
the volume variance), you can verify that you've handled the computations
accurately if the sales mix variance and the sales quantity variance sum up
precisely to the original sales volume variance ($7,375 F + $3,525 U = $3,850 F).
Practice Question
This question expands the Practice Question from Lesson 1. Faircloth & Company makes two
types of products, Heather and Sage, and sells them for $20 and $25 per pound, respectively.
Originally, Faircloth planned to sell 30,000 pounds of Heather and 12,000 pounds of Sage in the
upcoming month. Actual sales for the month were 32,000 pounds of Heather and 10,400 pounds
of Sage at prices of $19.20 and $28.10, respectively. Heather's standard variable costs per pound
are $11.85 for Heather and $15.80 for Sage.
Compute the following variances for Faircloth & Company.
a. Sales price variance

b. Sales volume variance measured by contribution margin
c. Sales mix variance measured by contribution margin
d. Sales quantity variance measured by contribution margin
Answer
a. Sales price variance

o Note first that Faircloth has an unfavorable (U) price variance for the Heather
product (actual price < standard price) and a favorable (F) price variance for the
Sage product (actual price > standard price).
Sales price variance=Actual volume×(Standard price−Actual

price)Heather:32,000pounds×($20.00−
$19.20)=$25,600USage:10,400pounds×($25.00−$28.10)=$32,240FTotal sales
price variance:$25,600U+$32,240F=$6,640F
b. Sales volume variance

o Faircloth has a favorable (F) volume variance for the Heather product (actual
volume > expected volume) and an unfavorable (U) volume variance for the Sage
product (actual volume < expected volume).
Standard contribution margin per pound for Heather:$20.00−

$11.85=$8.15Standard contribution margin per pound for Sage:$25.00−
$15.80=$9.20Sales volume variance=(Expected volume−Actual
volume)×Standard priceHeather:
Part 1 - Section C
(30,000pounds−32,000pounds)×$8.15=$16,300FSage:
(12,000pounds−10,400pounds)×$9.20=$14,720UTotal sales volume variance:
$16,300F+$14,720U=$1,580F
c. Sales mix variance

o Heather sales mix percentages (don't round off these percentages):
30,000pounds÷42,000pounds=71.43% expected sales mix

percentage32,000pounds÷42,400pounds=75.47%actual sales mix
percentage(Favorable for Heather)
o Sage sales mix percentages (don't round off these percentages):
12,000pounds÷42,000pounds=28.57%expected sales mix

percentage10,400pounds÷42,400pounds=24.53%actual sales mix
percentage(Unfavorable for Sage)
o Overall sales mix variance will be unfavorable (U) because Faircloth is selling
relatively less of the product with the highest standard contribution margin (Sage).
Sales mix variance=Total actual volume×(Expected mix%−Actual mix

%)×Standard CMHeather:42,400pounds×(71.43%
−75.47%)×$8.15=$13,971FSage:42,400pounds×(28.57%
−24.53%)×$9.20=$15,771UTotal sales mix variance:$13,971F+
$15,771U=$1,800U
d. Sales quantity variance

o Faircloth has a favorable (F) quantity variance because it sold more total pounds
(42,400) than expected (42,000).
Sales quantity variance=(Total expected volume−Total actual volume)×Expected

mix%×Standard CMHeather:
(42,000pounds−42,400pounds)×71.43%×$8.15=$2,329FSage:
(42,000pounds−42,400pounds)×28.57%×$9.20=$1,051FTotal sales quantity
variance:$2,329F+$1,051F=$3,380F
Summary
The overall variance framework is a useful way to visually work through the construction of
specific variance formulas. Be sure to take note of this framework, which is the first exhibit in
this lesson. Price variances are based on the difference between the actual price and standard
price, multiplied by the actual quantity sold (or used). Quantity variances are based on the
difference between actual quantity and standard quantity, multiplied by the standard price. When
controlling and evaluating sales revenue, the quantity variance is usually referred to as the sales
volume variance and is based on the difference between actual volume sold and the expected
Part 1 - Section C
volume sold. The standard price used to determine the dollar size of the volume variance can be
either the standard selling price or the standard contribution margin. Generally, most
organizations use the standard contribution margin to establish the sales volume variance. The
sales volume variance can be separated into the sales mix variance and the sales quantity
variance. The sales mix variance is based on the difference between each product's expected and
actual sales mix percentage of total sales, multiplied by the total actual volume of all products
and the product's standard price or contribution margin. The sales quantity variance is based on
the difference between the total expected sales volume of all products or service compared to
the total actual volume, multiplied by each product's expected sales mix percentage and standard
price or contribution margin.
1.3 Direct Material and Direct Labor Cost Variances
I. Standard Cost Systems

A. Standard cost systems were thoroughly discussed in Section B. As a reminder,
companies use cost standards throughout the management process of planning,
controlling, and evaluating costs in the organization.
B. A standard cost sheet functions like a “recipe card” that specifies standard prices
and standard quantities to build and deliver a single product or service, as
demonstrated below for the Sunbird Boat Company and its Classic boat product.
Note that the input quantity multiplied by the cost per input equals cost per boat.
Also note in this example that manufacturing overhead (MOH) costs are being
allocated on the basis of total direct labor hours (DLH).
II. Direct Materials Cost Variances

A. Cost variances follow the same computational framework as revenue variances.
The basic framework, which we introduced in the previous lesson, is presented
below.
Part 1 - Section C
B. The approach we followed in the previous lesson to compute revenue variances

works similarly for the cost variances used in controlling and evaluating direct
materials costs. There are two important distinctions with direct materials cost
variances, which are represented in the specific variance framework below for
direct materials.
1. The best management approach to successfully control and evaluate costs

is to identify the cost variance as soon as possible. When it comes to direct
materials, rather than compute the price variance on the quantity used, best
practice is to identify and report the price variance as soon as direct
materials are purchased (i.e., quantity purchased). This means that the
price variance should be computed for the quantity purchased, not the
quantity used subsequently in production.
2. To emphasize that the direct materials quantity variance is based on the
quantity used in production, the variance is typically called the “usage
variance.” What's more important is to note that the variance isn't based on
the standard quantity in the original master budget, but on the standard
quantity in the flexible budget. This quantity is often referred to as the
“standard quantity allowed” for the actual volume of production and sales.
Part 1 - Section C
C. Let's return now to our Sunbird Boat Company example. Sunbird produces and
sells two types of boats, but for cost variance purposes in our lesson we'll focus
just on cost management for the Classic boats using the standard costs provided at
the beginning of this lesson, as well as the following actual information:
1. 15,000 ft2 of wood was purchased for $141,750 of which 13,290 ft 2 was
used in production.
2. 150 Classic boats were produced and sold during the year.
B. We can use the framework approach to compute the direct materials price
variance for Sunbird as shown below.
Note that we can compute the actual price paid per ft 2 of wood as $9.45 per
ft2 ($141,750 ÷ 15,000 ft2). Since this actual price is less than the standard price,
the direct materials price variance is favorable (F).
C. Alternatively, we can use the formula approach to compute direct material price
variance.
1. The formula approach for this variance is as follows:
Actual quantity purchased × (Standard price - Actual price)

Direct materials price variance: 15,000 ft2× ($10.00 - $9.45) = $8,250 F
2. If Sunbird management chooses to compute the price variance on the

direct materials quantity used, this is a simple adjustment in either the
framework approach or the formula approach as follows:
Actual quantity used × (Standard price − Actual price)

Direct materials price variance: 13,290 ft2× ($10.00 − $9.45) = $7,309.50
F
Part 1 - Section C
B. To complete the direct material variance analysis for Sunbird Boat Company, we
turn attention to how much material was actually used in production, and how
much material should have been used to support the actual production output (i.e.,
standard quantity allowed). Based on the standard quantity of 80 ft 2 of oak wood
per Classic boat and actual production and sales of 150 boats, Sunbird should
have used 12,000 ft2 of wood for its actual production (80 ft2 × 150 boats).
C. Using the framework approach, we can compute the usage variance. Before doing
so, note that this variance is clearly unfavorable (U) based on comparing the
standard quantity allowed of 12,000 ft2 against the actual quantity reported above
of 13,290 ft2.
D. Using the formula approach, the direct materials usage variance can be computed
quickly as follows:
(Standard quantity allowed − Actual quantity used) × Standard price

Direct materials usage variance: (12,000 ft2− 13,290 ft2) × $10.00 = $12,900 U
2. Direct Labor Cost Variances

A. Direct labor cost variances are quite similar to direct materials cost variances. Of
course, most organizations don't purchase the direct labor in advance of actually
using labor, so the variance framework for direct labor is very similar to the
conceptual framework as shown below.
Part 1 - Section C
Note that there are two shifts in terminology for this framework that are specific
to direct labor costs. First, “rate” is used in place of “price.” Direct labor prices
are often described as labor rates. Second, using more or less direct labor than
budgeted is often an issue of managing the efficiency of labor usage. Hence, the
quantity variance here is described as an efficiency variance.
B. Assume the following actual direct labor results on Classic boats for the Sunbird
Boat Company:
1. Artisans were paid a total of $123,804 to work 2,715 hours, and assistants
were paid a total of $87,135 to work 4,710 hours.
B. With the actual results above, and the standard inputs and costs provided earlier,
we'll use the framework approach to compute the direct rate variance for Sunbird
as shown below.
Since the left side of the framework, which is based on actual labor rates, is larger
than the right side, this variance is unfavorable (U).
C. Now we'll compute the labor rate variance using the formula approach. Note that
the artisans’ actual labor rate is lower than standard ($45.60 versus $47.50,
respectively), which indicates a favorable (F) rate variance. The assistants’ actual
labor rate is higher than standard ($18.50 versus $15.00, respectively), which
indicates an unfavorable (U) rate variance.
Actual quantity × (Standard rate − Actual rate)

Artisans: 2,715 hours × ($47.50 − $45.60) = $5,158.5 F
Assistants: 4,710 hours × ($15.00 − $18.50) = $16,485.0 U
Total labor rate variance: $5,158.5 F + $16,485.0 U= $11,326.5 U
Part 1 - Section C
D. Let's now shift to the labor efficiency variance for Sunbird Boat Company.
Remember that Sunbird produced and sold 150 Classic boats. Based on the
standard number of direct labor hours provided in the standard cost sheet for
Classic boats, the standard hours allowed for artisans is 3,000 hours (150 boats ×
20 hours), and the standard hours allowed for assistants is 4,500 hours (150 boats
× 30 hours). The framework approach delivers the direct labor efficiency variance
as shown below.
The left side of the framework (representing the actual quantity of labor hours) is
smaller than the right side, so this variance is favorable (F).
E. Using the formula approach, we can replicate the results above. Note that the
artisans’ actual total hours are lower than the standard hours allowed for actual
production (2,715 hours versus 3,000 hours, respectively), which indicates a
favorable (F) efficiency variance. And the assistants’ actual hours are higher than
standard allowed (4,710 hours versus 4,500 hours, respectively), which indicates
an unfavorable (U) efficiency variance.
(Standard hours allowed − Actual hours used) × Standard rate

Artisans: (3,000 hours − 2,715 hours)× $47.50 = $13,537.5 F
Assistants: (4,500 hours − 4,710 hours)× $15.00 = $3,150.0 U
Direct laborefficiency variance: $13,537.5 F + $3,150.0 U = $10,387.5 F
 Mix and Yield Cost Variances

A. When it comes to controlling and evaluating labor costs, it's important that
Sunbird measure and manage the relative proportions of its two types of labor
(artisans and assistants) in the process of building boats. In fact, the sales mix and
quantity variance we studied in the previous lesson is very similar to the direct
labor mix and yield cost variances presented here as we close out this lesson.
Part 1 - Section C
B. Artisan labor hours cost substantially more than the labor hours of assistants. If
artisan labor hours start increasing relative to assistant labor hours in the
production process, that contributes to an unfavorable labor efficiency variance.
In addition, if the totallabor hours of both artisans and assistants are increasing,
that also creates an unfavorable labor efficiency variance. This means that
Sunbird management can (and should) separate the labor efficiency variance into
a labor mix variance and a labor yield variance. (The term yield refers to how
much input was used to produce or yield an output.). We use the framework
approach below to visualize and compute these two variances.
1. Similar to the sales volume variance relationship with sales mix and sales
quantity, the mix variance and the yield variance are subsets of the labor
efficiency variance. The middle box (total actual quantity × standard mix
percentage × standard price) splits the efficiency variance into the mix
variance and the yield variance.
2. The logic of this middle box is seen by expanding the two original boxes
in the bottom part of the framework. Sunbird Boat Company uses two
different types of labor to produce boats. Each of those types of labor has
its own actual quantity and standard quantity allowed of hours for the
Part 1 - Section C
boats produced. Combined, Sunbird used a total of 7,425 hours to build

and sell 195 Classic boats, with an actual and standard mix percentage for
each labor type as shown below.
Note, for example, that the actual total quantity of hours (7,425 hours)
multiplied by the actual mix percentage of artisan hours (36.57%) is equal
to 2,715 hours, which is the actual quantity of artisan hours (be sure to not
round off the mix percentage). Hence, we can compute the two original
boxes in the direct labor efficiency framework using total quantities and
labor mix percentages. This additional computational work doesn't change
the results, but it does provide a way to seeing how the mix variance
isolates the effect of using more or less of one labor type compared to
another at Sunbird. This view also helps us see how the yield variance is
isolating the effect of Sunbird using more or less total direct labor hours.
3. Using the framework approach, we compute the direct labor mix variance
as shown below.
Part 1 - Section C
4. This mix variance is favorable (F) because Sunbird's actual mix of

expensive artisan labor hours (36.57%) is lower than its standard mix
percentage (40.00%) relative to the mix percentage of cheaper assistant
hours. This shift in relative labor inputs has a favorable effect on operating
profit.
5. Using the framework approach, we compute the direct labor yield variance
as shown below.
6. The direct labor yield variance is favorable (F) because Sunbird's total
actual direct labor hours (7,425 hours) is fewer than total standard hours
allowed (7,500 hours). This computation isolates the effect of the direct
labor yield variance by holding constant each of the standard labor mix
percentages in both boxes above.
7. Again, be sure to use precise mix percentages when computing this
variance. By doing so, the yield variance combined with the mix variance
will equal the efficiency variance ($8,287.5 F + $2,100 F = $10,387.5 F).
B. Alternatively, we can compute both of these variances using the formula
approach.
1. The formula approach for the labor mix variance is as follows:
Total actual quantity × (Standard mix% − Actual mix%)× Standard rate

Artisans: 7,425 hours× (40.00% − 36.57%)× $47.50= $12,112.5 F
Assistants: 7,425 hours × (60.00% − 63.43%)× $15.00= $3,825.0 U
Total direct labor mix variance: $12,122.5 F + $3,825.0 U = $8,287.5 F
2. The formula approach for the labor yield variance is as follows:

Part 1 - Section C
(Total standard qty allowed− Total actual qty) × Standard mix% ×

Standard rate
Artisans: (7,500 hours − 7,425 hours) × 40.00% × $47.50= $1,425 F
Assistants: (7,500 hours − 7,425 hours) × 60.00% × $15.00= $675 F
Total direct labor yield variance: $1,425 F + $675 F = $2,100 F
C. Mix and yield variances can be computed for direct materials costs as well. That
said, it is typically more realistic to consider the tradeoff of one type of labor
versus another type of labor. Often employees are able to shift to other lines of
work in the production process, and the organization should control and evaluate
production processes to be sure the most efficient (cost-effective) employees are
working each stage of the process. Certain products (e.g., some food products)
can realistically shift the relative percentages of one type of direct material versus
another, but for most products (e.g., cars, computers, etc.) it doesn't make sense to
break down the direct materials usage variance into a mix and yield variance.
Practice Question
This question expands the Practice Question from Lessons 1 and 2. Faircloth &
Company makes two types of products. The standard cost sheet is provided below
for one of those products, Sage. Actual sales on the Sage product last month were
10,400 lbs.
Faircloth purchased 68,640 ounces of Zyph last month for $130,416 and
purchased 108,160 ounces of Noosh for $27,040. All materials were completely
used to produce and sell 10,400 pounds of Sage.
Faircloth also used 433.33 direct labor hours (26,000 direct labor minutes) at a
cost of $6,760 to produce the 10,400 pounds of Sage that was sold last month.
Compute the following variances for the Sage product.
1. Direct materials price variance

2. Direct materials usage variance
Part 1 - Section C
3. Direct materials mix variance

4. Direct materials yield variance
5. Direct labor rate variance
6. Direct labor efficiency variance
Answer
7. Direct materials price variance
First, the actual price paid for Zyph was $1.90 per ounce ($130,416 ÷
68,640 ounces). And the actual price paid for Zyph was $0.25 per ounce
($27,040 ÷ 108,160 ounces). Based on comparing actual prices to standard
prices, Faircloth has a favorable (F) price variance for Zyph and an
unfavorable price variance for Noosh.
Direct materials price variance = Actual volume × (Standard price −

Actual price)
Zyph: 68,640 ounces × ($2.00 − $1.90) = $6,864 F
Noosh:108,160 ounces × ($0.20 − $0.25) = $5,408 U
Total direct materials price variance: $6,864 F+ $5,408 U= $1,456 F
8. Direct materials usage variance
Based on the standard number of ounces reported in the standard cost

sheet for the Sage product, the standard ounces allowed for Zyph is 62,400
ounces (10,400 pounds × 6.00 ounces), and the standard ounces allowed
for Noosh is 124,800 ounces (10,400 pounds × 12.00 ounces). Faircloth
has an unfavorable (U) usage variance for Zyph and a favorable (F) usage
variance for Noosh.
Direct materials usage variance = (Standard quantity allowed − Actual

quantity used) × Standard price
Zyph: (62,400 ounces − 68,640 ounces) × $2.00 = $12,480 U
Noosh:(124,800 ounces − 108,160 ounces) × $0.20 = $3,328 F
Total direct materials usage variance: $12,480 U+ $3,328 F= $9,152 U
9. Direct materials mix variance
Faircloth purchased and used a total of 176,800 ounces of direct materials

(68,640 ounces of Zyph + 108,160 ounces of Noosh). Faircloth should
have used (the standard quantity allowed) a total of 187,200 ounces of
Part 1 - Section C
direct materials, which is computed as (6.00 standard ounces + 12.00

standard ounces) × 10,400 actual pounds sold of Sage.
Zyph mix percentages (don't round off these percentages):
62,400 ounces ÷ 187,200 ounces = 33.33% standard sales mix percentage

68,640 ounces ÷ 176,800 ounces = 38.82% actual sales mix percentage
(Unfavorable for Zyph)
Noosh mix percentages (don't round off these percentages):
124,800 ounces ÷ 187,200 ounces = 66.67% standard sales mix percentage

108,160 ounces ÷ 176,800 ounces = 61.18% actual sales mix percentage
(Favorable for Noosh)
The overall direct materials mix variance on the Sage product will be
unfavorable (U) because Faircloth is using relatively more of the direct
material with the highest standard price (Zyph).
Direct materials mix variance = Total actual qty used × (Standard mix% −
Actual mix%) × Standard price
Zyph: 176,800 ounces × (33.33% − 38.82%) × $2.00 = $19,413 U
Noosh: 176,800 ounces × (66.67% − 61.18%) × $0.20 = $1,941 F
Total direct materials mix variance: $19,413 U+ $1,941 F= $17,472 U
10. Direct materials yield variance
Faircloth has a favorable (F) yield variance on the Sage product because
its total ounces of direct materials used (176,800 ounces) to produce
10,400 pounds of Sage was less than the total standard quantity allowed
(187,200 ounces).
Direct materials yield variance = (Total standard qty allowed − Total

actual qty used) × Standard mix% × Standard price
Zyph: (187,200 ounces − 176,800 ounces) × 33.33% × $2.00 = $6,933 F
Noosh:(187,200 ounces − 176,800 ounces) × 66.67% × $0.20 = $1,387 F
Total direct materials yield variance: $6,933 F+ $1,387 F= $8,320 F
11. Direct labor rate variance

Part 1 - Section C
Faircloth paid $6,760 for 26,000 direct labor minutes (DLM). This works
out to an actual rate of $0.26 per minute (or $15.60 per hour). Faircloth's
standard labor rate to produce Sage is $0.25 per minute (or $15.00 per
hour). Hence, Faircloth has an unfavorable direct labor rate variance,
which can be computed as follows:
Actual quantity × (Standard rate − Actual rate) = 26,000 DLM × ($0.25 −

$0.26) = $260 U
12. Direct labor efficiency variance
Faircloth used 26,000 direct labor minutes (DLM) to produce 10,400

pounds of Sage. The standard labor time to produce one pound of sage is
2.00 DLM. Hence, standard quantity allowed for the actual production of
10,400 pounds of sage is 20,800 DLM (10,400 pounds × 2.00 DLM).
Since actual labor time is more than the standard quantity allowed,
Faircloth has an unfavorable direct labor efficiency variance, which can be
computed as follows:
(Standard qty allowed − Actual qty) × Standard rate = (20,800 DLM −

26,000 DLM) × $0.25 = $1,300 U
Summary
The computation of cost variances is quite similar to the computation of revenue

variances. When computing any variances, be sure you can visualize the process
with respect to the overall variance framework. By doing so, you'll see that the
computation of cost variances is quite similar to the computation of revenue
variances. Direct labor rate variances are based on the difference between the
standard rate and the actual rate, multiplied by the actual quantity used.
Computing direct materials prices variances is very similar except that many
organizations will often multiply the difference between standard and actual
prices by the actual quantity purchased. For both direct materials and direct labor,
when there is more than one type of input used in the product or service, mix
variance and yield variance can be computed. The mix variance is based on the
difference between each input's standard and actual mix percentage, multiplied by
the total actual quantity of all inputs and each input's standard price or rate. The
yield variance is based on the difference between the total standard quantity
allowed of all inputs compared to the totalactual quantity, multiplied by each
input's standard mix percentage and standard price or rate.
1.4 Factory Overhead Cost Variances
I. Overhead Costs Application Systems

Part 1 - Section C
A. In these lessons we've been computing variances to support the management

process of controlling and evaluating revenues and costs. This lesson is focused
on variance analysis of overhead costs. The challenge with overhead costs is they
are “indirect,” which means that these costs are not directly affected by the
volume of production and sales.
1. In contrast, the assumption in variance analysis of materials and labor
costs is that those costs are “direct,” which means the production and sales
output volume of the organization's products or services will directly
cause materials and labor input costs to shift in a way that is variable and
measurable.
2. Of course, it is not true in all organizations that materials and labor costs
are tied directly to production output. Organizations with “indirect”
materials and labor costs will need to control and evaluate these costs in a
manner similar to overhead costs. The key management issue with indirect
costs is that these costs are applied to production, and the reality of that
cost application process changes the approach to variance analysis.
B. Overhead costs are typically divided into variable overhead and fixed overhead.
Variable overhead costs shift generally in the same direction as shifts in output
volumes, but the cost movement does not coincide perfectly with output. For
example, power costs in a manufacturing organization will move up and down
with shifts in production, but that movement can't be perfectly predicted. Hence,
the management accounting system is set up to apply VOH costs to production
using an application basis such as machine hours, direct labor hours, or the
production units themselves.
C. Of course, fixed overhead costs do not shift at all as production and sales volumes
change. Nevertheless, in order to track the “full costs” of its product or services,
the organization needs to apply these costs as well. A very simplified approach to
applying indirect overhead costs is to group all the costs into a single overhead
cost application system. We will use a single cost application system for our
ongoing work with the Sunbird Boat Company.
D. The overhead cost application system is established as part of the master
budgeting process (master budgeting was introduced in the first lesson). Before
the start of the year, Sunbird established an overhead cost budget for the Classic
boat product line. Specifically, the management accountants budgeted for $58,500
in variable overhead costs and $78,000 in fixed overhead as part of the production
plan to produce 156 Classic boats. The accountants then determined to apply
these costs on the basis of direct labor hours. Recall that the production standard
for each Classic boat requires 20 artisan hours and 30 hours from assistants for a
total of 50 direct labor hours for each boat. As a result, the following overhead
cost rates were established in the master budget:
1. Planned production: 156 Classic boats

2. Budgeted direct labor hours: 156 boats × 50 hours = 7,800 direct labor
hours
3. Variable overhead application rate: $58,500 ÷ 7,800 hours = $7.50 per
direct labor hour
Part 1 - Section C
4. Fixed overhead application rate: $78,000 ÷ 7,800 hours = $10.00 per

direct labor hour
B. These overhead cost rates are included in the standard cost sheet presented below
for Classic boats. In the last lesson we used these standard costs to establish
variances for direct materials and direct labor. We'll also use standard costs from
the standard cost sheet to compute variances for variable overhead and fixed
overhead.
Note in the standard cost sheet above that there are actually two overhead rates
that can be used to apply overhead. There is an overhead cost rate per direct labor
hour (DLH) and an overhead cost rate per boat. For example, for every Classic
boat produced Sunbird will use a standard number of 50 direct labor hours
multiplied by $7.50 to apply variable overhead, or Sunbird can simply use $375
per boat to apply variable overhead. Either approach will apply the same amount
of overhead cost.
 Variable Manufacturing Overhead Variances

A. By the end of the year Sunbird Boat Company had the following actual results for
the Classic boat product line:
2. Artisans worked a total 2,715 hours, and assistants worked a total of 4,710
hours.
3. Actual variable overhead costs were $74,992.50.
4. Actual fixed overhead costs were $87,360.
B. Variable overhead costs follow the same variance framework as all other
variances we've studied so far. The framework is provided below.
Part 1 - Section C
1. There are two important points to be made about variable overhead costs
and the variance framework above. First, overhead costs (both variable
and fixed) are an accumulation of specific types of costs. For example,
variable overhead costs can include utilities, travel, supplies, etc. Hence,
there's no “actual quantity” or “actual price” for overhead. Determining
the actual overhead in the first box above is a matter of summing up all the
overhead costs actually used during the period.
2. Second, because there isn't a specific “quantity” of overhead, how are the
second and third boxes above computed? There is a quantity of the
overhead application basis, often called the allocation activity basis.
Sunbird used direct labor hours to apply overhead. Hence, the actual
quantity of DLH is used in the second box, and the standard quantity
allowed of DLH (based on actual boats produced) is used in the third box.
The specific framework for variable overhead (VOH) costs is presented
below.
B. With the variable overhead application rate and the actual results provided above,
we can use the framework approach to compute the variable overhead spending
variance below for Sunbird Boat Company.
Part 1 - Section C
1. What is the meaning of the spending variance for variable overhead?

Sunbird's management accountants chose to use direct labor hours to
apply variable overhead costs. That choice should be based on some
expectation that direct labor hours are correlated at least somewhat with
variable overhead costs. If that is true, then we assume that actual direct
labor hours can be used to “predict” actual variable overhead costs.
2. Artisans and assistants worked a total of 7,425 hours during the year.
Based on a VOH rate of $7.50 per hour, we can predict that Sunbird would
actually spend $55,687.50 for variable overhead. The difference between
predicted and actual spending is unfavorable (U), which indicates that
spending may be out of control and needs to be investigated.
(Alternatively, this result might mean that direct labor hours are a poor
predictor of variable overhead costs.)
C. D. We can also compute directly the variable overhead spending variance using
the formula approach as follows:
(Actual activity used×Standard rate)−Actual costsVariable overhead spending

variance:(7,425hours×$7.50)−$74,992.50=$19,305U
D. Moving on, we compute below the variable overhead efficiency variance using
the framework approach.
Part 1 - Section C
1. Note that the $562.50 F variance is based entirely on the difference

between actual direct labor hours and the standard labor hours allowed for
actual production. What this means is that this variance really isn't about
the efficient or inefficient use of variable overhead resources – it is about
the efficiency of the underlying activity basis used to allocate variable
overhead costs!
2. If you were to return back to the last lesson where we computed the direct
labor efficiency variance, you'll see that the variance is $10,387.50 F. In
the case of Sunbird Boat Company, the variable overhead efficiency
variance here is actually providing the same management signal as the
direct labor efficiency variance. Sunbird is efficient with its direct labor
resources, but we actually don't know anything about the efficiency of
variable overhead resources.
E. The formula approach for the variable overhead efficiency variance is displayed
below. It should look familiar to you. It's the same formula as the direct labor
efficiency variance formula. It simply uses a different rate to put a dollar size on
the variance.
(Standard activity allowed−Actual activity used)×Standard rateStandard activity

allowed:150actual boats×50direct labor hours=7,500hoursVOH efficiency
variance:(7,500hours−7,425hours)×$7.50=$562.50F
2. Fixed Manufacturing Overhead Variances

A. Fixed manufacturing overhead variances follow a completely different approach
from revenue, direct costs, and variable overhead costs. The reason for this
difference is simply that these costs are fixed, and all other costs (and revenues)
are expected to follow the movement of production volumes. Nevertheless, by
establishing a fixed overhead rate and applying these costs to each unit of output,
the overhead cost application process treats these fixed costs as if they are
Part 1 - Section C
variable. That's a strange process for fixed manufacturing costs, but it creates an
important management signal regarding how the actual production output
compares to the expected production output. This is called the production volume
variance, and it will be the last variance we study in this lesson.
B. Before we compute the production volume variance, we need to analyze fixed
manufacturing costs to determine the spending variance. This is a very simple
variance. It's the difference between the original master budget for total fixed
costs and the total amount of actual fixed costs spent, which you can see in the
fixed overhead variance framework provided below.
C. If the original master budget for fixed overhead costs isn't available, the master
budget can be recreated using the fixed overhead (FOH) rate. Remember that the
FOH rate is $10.00 per direct labor hour or $500 per boat. The computation,
which we performed above, is provided again below.
1. Fixed manufacturing overhead budget: $78,000

2. Planned production: 156 Classic boats
3. Budgeted direct labor hours: 156 boats × 50 hours = 7,800 direct labor
hours
4. FOH rate: $78,000 ÷ 7,800 hours = $10.00 per DLH
5. FOH rate: $78,000 ÷ 156 boats = $500.00 per boat
B. The framework approach for the fixed overhead spending variance is
demonstrated below.
Part 1 - Section C
C. The formula approach for the fixed overhead spending variance is as follows:
Master budget−Actual costs spent
1. -or-
(Master budget production volume×FOH rate)−Actual costs spentFixed

overhead spending variance:$78,000−$87,360=$9,360U
D. The fixed overhead volume variance is often simply referred to as the production
volume variance. This is because this variance results strictly from producing
more or less output than originally planned in the master budget. It is important to
note that because fixed selling and administrative costs are not allocated to
production, this variance involves only fixed manufacturing overhead costs. The
framework approach for the production volume variance is displayed below.
Part 1 - Section C
1. In order to see clearly how Sunbird's production volume variance works

out to be $3,000 U, return back to the framework solution for the fixed
overhead spending variance and observe the two alternative calculations
for the master budget costs.
2. The difference between Sunbird's master budget for fixed production costs
and applied fixed production costs is due to the difference in planned and
actual production output. You can compute this difference simply by using
the original production plan (156 boats) and the actual production by the
year's end (150 boats). This difference is also seen in the master budget for
78,000 direct labor hours based on the original production plan compared
to the standard 75,000 hours allowed based on actual production.
B. The formula approach for the production volume variance is perhaps the most
straightforward method for computing the production volume variance. Before
approaching the formula, first observe whether the variance will be favorable or
unfavorable, which is done by comparing actual production output to the original
master plan (i.e., budget). If actual exceeds budget, the production volume
variance is favorable.
Applied costs−Master budget costs
1. -or-
(Actual production volume−Master budget volume)×FOH rateFixed

overhead production volume variance:
(150boats−156boats)×$500=$3,000U
 Reconciling Overhead Variances to Over- or Under-Applied Overhead

A. Remember that variances for manufacturing overhead costs are complicated by
the fact that these indirect costs are not directly related to production and so have
Part 1 - Section C
to be applied using an overhead cost application system. This system actually

presents a check figure for the four variance computations.
B. At the end of each reporting period, the organization must evaluate the
Manufacturing Overhead account and reconcile the over- or under-applied
overhead amount to subsequent inventory and cost of goods sold accounts.
Computing the over- or under-applied overhead amount is straightforward for
Sunbird Boat Company, as follows:
Total actual manufacturing overhead:$74,992.50+$87,360=$162,352.50Total

applied manufacturing overhead:150boats
produced×$875=$131,250Under−applied manufacturing overhead:$162,352.50−
$131,250=$31,102.50
C. This under-applied overhead number represents costs that have to be added to

inventory and cost of goods sold accounts, which will reduce reported operating
profit. This is an unhappy (i.e., unfavorable) situation for Sunbird. But this
amount is a check figure for the four overhead variances, which should all add up
to be $31,102.50 U (remember to subtract the favorable efficiency variance). As
you can see below, the four overhead variances reconcile to the under-applied
overhead amount for Sunbird.
Variable overhead spending variance: $19,305.00 U

Variable overhead efficiency variance: $ 562.50 F
Fixed overhead spending variance: $ 9,360.00 U
Fixed overhead volume variance: $ 3,000.00 U
Total $31,102.50 U
Practice Question
This question expands the Practice Question from Lessons 1 through 3. The standard cost sheet
is provided below for one of Faircloth & Company's products, Sage. Actual sales on the Sage
product last month were 10,400 lbs.
Part 1 - Section C
In its master budget, Faircloth budgeted $12,600 for variable manufacturing overhead costs and
$120,000 for fixed manufacturing overhead costs. Faircloth originally planned in its master
budget to produce and sell 12,000 pounds of Sage, using 24,000 direct labor minutes (DLM).
Faircloth ultimately spent $10,920 and $115,500 for variable and fixed manufacturing overhead,
respectively, and used 26,000 DLMs to produce and sell 10,400 pounds of Sage.
Compute the following variances for the Sage product:
a. Variable overhead spending variance

b. Variable overhead efficiency variance
c. Fixed overhead spending variance
d. Production volume variance
Answer
a. Variable overhead spending variance
(Actual activity used×Standard rate)−Actual costsVariable overhead spending variance:

(26,000DLMs×$0.45)−$10,920=$780F
b. Variable overhead efficiency variance
(Standard activity allowed−Actual activity used)×Standard rateStandard activity

allowed:10,400pounds×2DLMs=20,800DLMsVOH efficiency variance:
(20,800DLMs−26,000DLMs)×$0.45=$2,340U
c. Fixed overhead spending variance
Master budget−Actual costs spentFixed overhead spending variance:$120,000−

$115,500=$4,500FNote:12,000pounds of Sage×$10.00FOH rate=$120,000Master
Budget
d. Production volume variance
(Actual production volume−Master budget volume)×FOH rateFixed overhead production

volume variance:(10,400pounds−12,000pounds)×$10=$16,000UAlternative:
(20,800standard allowed DLMs−24,000master budget DLMs)×$5=$16,000U
Summary
Variance analysis for overhead costs is complicated by the fact that overhead represents indirect
costs, which means these costs must be applied using an overhead cost application system.
Hence, variance analysis for overhead is different compared to variance analysis for direct
materials and labor costs. The variable overhead spending variance compares actual overhead
costs with the overhead costs that are “predicted” using the actual volume of the activity basis
(such as machine hours or direct labor hours). The variable overhead efficiency variance is
Part 1 - Section C
essentially the same computation as the labor efficiency variance, which is the difference
between actual activity and the standard activity allowed for actual production, multiplied by the
variable overhead rate. The fixed overhead spending variance is simply the difference between
total actual costs and the original total master budget costs. Finally, the production volume
variance, which is focused entirely on fixed manufacturing overhead costs, is the difference
between the actual volume of production and the original master budget production volume,
multiplied by the fixed overhead rate.
1.5 Management Work with Variance Analysis
I. Variance Analysis of Selling and Administrative Costs

A. Let's return once more to the Sunbird Boat Company example that has been the
focus of the lessons to this point in this section. Below is the standard cost card
we've been using to compute all the variances for Sunbird.
B. The focus of our variance computations has been on the product costs for
Sunbird: direct materials, direct labor, and manufacturing overhead. But there's
one cost above that isn't a production cost. Selling overhead is a sales and
administration expense, and we've yet to compute a variance on this cost. Let's
assume for Sunbird Boat Company that the standard cost of $210 per boat
represents the budgeted costs of delivering a boat to a customer.
C. Having worked through the previous lessons, computing a price or spending
variance on sales and administrative (S&A) costs should not be difficult.
Remember the variance framework (below), and assume the following for
Sunbird's delivery costs on Classic boat sales:
 Actual total delivery costs: $31,766.70
 Actual sales volume: 150 boats
 Actual boats delivered: 147 boats (three boats were picked up by
customers)
Part 1 - Section C
 1. The actual delivery cost (price) on the 147 boats that were actually
delivered can be computed as $216.10 per boat ($31,766.70 ÷ 147 boats).
Clearly, Sunbird has an unfavorable variance compared to the standard
cost of $210 per boat. Computing a price variance on this cost follows the
standard formula.
Actual quantity delivered × (Standard price − Actual price) Selling

overhead price variance: 147 boats × ($210 - $216.10) = $896.70 U
 2. Assuming that Sunbird expects to deliver all boats sold to customers

(i.e., its standard is to deliver each boat), we can compute a quantity
variance that represents the efficiency of Sunbird's delivery work. Note
that this is going to be a favorable variance since Sunbird didn't actually
handle the delivery of all boats sold.
(Standard delivery events allowed − Actual boats delivered) × Standard

rate Selling overhead efficiency variance: (150 boats − 147 boats) × $210
= $630.00 F
D. Variances can (and should) be computed on all costs that have a standard or
budgeted level of performance. It doesn't really matter if the costs are part of a
production process or not. If the cost is variable (that is, the cost is a function of
some activity), then both a price (or rate) and a quantity (or efficiency) variance
can be computed. If the cost is fixed, then only a spending (or budget) variance
can be computed, which would simply be the difference between the total
budgeted cost and the total actual cost.
II. Variance Analysis in Service and Merchant Organizations
A. Generally, there are three types of organizations in the economy: manufacturing,
service, and merchandising. In these lessons we've been focused on a
manufacturing organization—Sunbird Boat Company. But our example could
have been a service organization or a merchant company. In any case, the same
variance framework can be used to compute signals that management should
investigate to determine why actual costs are different than expected costs.
Part 1 - Section C
B. Let's assume that Sunbird Boat Company is a small consulting firm that provides
instruction and guidance to clients who want to build their own customized
wooden rowboat. Sunbird has two different consulting services or “products.”
Clients can arrange for a Sunbird consultant to come to their home or personal
woodshop and provide coaching and feedback on their boat design plan or
construction process. Sunbird would charge by the hour for this service.
Alternatively, clients can register for and attend a class wherein a Sunbird
instructor teaches the attendees about the process of designing and building their
own boat. Sunbird charges a flat registration fee for this course of instruction that
has a set number of classroom hours.
 Sunbird will want to manage revenues by planning and controlling the

price of consulting hours and classroom events. In addition to sales price
variances, Sunbird can use the variance framework to track sales volume
variances and can break down the volume variance into the mix variance
related to the tradeoff of consulting hours versus classroom hours, and
sales quantity variance representing the revenue effect or more or less total
hours of combined consulting and classroom hours.
 While Sunbird may use supplies in the process of consulting or classroom
teaching, the cost is likely not significant. Hence, Sunbird may not need to
control and evaluate direct materials costs in its business. On the other
hand, Sunbird has very significant costs in the direct labor of consulting
and classroom teaching. Sunbird should establish standard labor rates and
standard number of hours “allowed” for a client engagement or a
classroom event, and track rate variances and efficiency variances.
 Sunbird will also have overhead costs in the form of a building or
buildings, equipment, vehicles, executive and staff salaries, etc. Some of
these costs may increase or decrease based on the volume of consulting or
classroom hours and should be controlled and evaluated using spending
and efficiency variances.
 Much of Sunbird's overhead may be fixed costs, and each category of
fixed overhead costs should be tracked with simple spending variances
(total budgeted costs less total actual costs). Will Sunbird have a
production volume variance? It is possible, and perhaps advisable, for
Sunbird to establish a normal capacity of consulting hours and classroom
hours that its organization is set up to provide, and then compute a volume
variance. Traditional accounting systems allocate fixed production costs
only to tangible products that can be inventoried. Sunbird does not build
“inventories” of consulting or classroom hours and so is not required to
track the full cost of producing inventories by allocating fixed
“production” costs to its service products. Nevertheless, by establishing a
fixed overhead rate based on normal capacity of consulting and classroom,
and then allocating that rate to actual consulting and classroom hours sold
to clients, Sunbird can compute a favorable or unfavorable volume
variance that provides a signal on its ability to use its consulting and
teaching capacity.
Part 1 - Section C
B. Alternatively, assume that Sunbird Boat Company is a merchandising

organization that purchases boats at wholesale prices and sells these boats at
marked-up retail prices to customers who come to its product showroom or who
place orders through its website.
 Obviously, Sunbird will be tracking price variances in its retail business,
as well as sales volume variances. And if Sunbird prices its showroom
boats differently than boats sold through its website, then its management
team should expand the volume variance into a mix variance and a
quantity variance.
 As a retailer, Sunbird has significant costs invested in its inventory of
boats, which represent the “direct materials” cost of its business. It may or
may not have an input quantity variance for boats sold. If every boat it
purchases is sold, then a direct materials quantity variance will represent
the same performance as the sales volume variance. However, Sunbird
may not be able to sell all the boats it purchases, or it may experience
some loss of inventory due to breakage or theft. In these circumstances,
Sunbird should compute a type of direct materials quantity variance that
represents unsold inventory or inventory shrinkage.
 Sunbird as a merchant will have labor costs, but most of that labor may
not be directly involved as an “input” in the process of acquiring and
selling each boat. To the extent it has sales agents in the product
showroom or perhaps telephone sales agents taking calls on website
purchases, it may then compute direct labor variances. Otherwise, the rest
of its labor costs will be managed and variances computed as part of its
overhead cost structure.
2. Investigating Variances and Managing Operations
A. Remember that variances do not identify a problem in the organization. Variances
provide a signal in the manage-by-exception system that something is different
than expected and should be investigated. The variance may be signaling a
problem to be rectified, or the variance could be part of a desirable result based on
an operational goal (even if the variance itself is unfavorable). Sometimes the
variance doesn't represent anything about actual results in the organization, but
instead managers learn on investigating the variance that a standard price or
standard quantity in the budget system is no longer relevant and needs to be
adjusted.
B. Assuming that revenue and cost standards are up to date, what kinds of factors
cause a variance to occur? Factors can be both internal (and largely controllable)
or external (and largely uncontrollable) to the organization. Let's consider
variances related to revenue.
 The marketing department in the organization is often most responsible for
evaluating the market and setting a sales price that represents the branding
of the product or service and how the organization wants to compete in the
market. Of course, it's the sales department that must actually generate
desired sales volumes based on price.
 However, price and volume of demand are not independent of each other
in the market. Depending on the nature of the market and the type of
Part 1 - Section C
product, price and demand can move together or move in opposite

directions. Hence, a favorable price variance might combine with an
unfavorable volume variance, but that combination could lead to higher or
lower overall revenue. Marketing and sales departments have more or less
influence on prices and volumes of demand. Nevertheless, all revenue
variances need to be carefully investigated in the important process of
controlling and evaluating price and demand.
C. Causes for direct materials variances can also be spread across different parts of
the organization.
 In the case of direct materials price variances, which are typically the
responsibility of the purchasing department in the organization, internal
factors affecting price may include decisions affecting the quantity and
cash discounts available on each purchase, the quality of materials
selected in the purchase, and the delivery method used to receive the
purchase. However, the price variance may be beyond the control of the
purchasing department due to external factors such as prices rising or
falling based on economic events. Or perhaps the price variance is the
result of unexpected demands by another department (such as the
production department) that makes it necessary to expedite (speed up) a
purchase and delivery, making it impossible to obtain standard pricing.
 The production department is often the area of the organization most
responsible for direct materials usage variances. Depending on the
experience, training, and motivation of the production crew, the usage
variance could be better (favorable) or worse (unfavorable). How well
production equipment is maintained or how well quality control processes
are managed can lead to direct materials usage variances. Sometimes these
variances are the result of decisions in other departments that can't be
controlled by the production department. For example, the purchasing
department may be acquiring direct materials at higher or lower quality
standards, which lead to favorable or unfavorable usage variances.
D. Direct labor variances can interact with direct materials variances, as described
above. In addition, the ability to control labor variances is spread across
departments.
 Labor rates are a function of human resource (HR) goals and the
availability of labor in the market (i.e., levels of unemployment in the
economy). The HR department in the organization is responsible to find,
hire, and initially train new employees. Achieving the standard labor rates
for the organization is a key responsibility of the HR department, although
achieving labor rate standards is impacted not only by the economy, but
by demands of other departments for certain types of employees.
 While the initial ability of newly hired employees is a function of the HR
process, the efficiency of that labor in the manufacturing or service
process quickly becomes the responsibility of the production department
(remember that organizations may be producing tangible manufactured
products or may be “producing” intangible service products with their
direct labor). Managers of manufacturing and service processes are
Part 1 - Section C
responsible for the ongoing training and motivation of their team, which
directly impacts labor efficiency variances.
E. Overhead costs are typically a compilation of many factors, which complicates
the investigation and management process. That being said, in many
organizations, the costs related to overhead exceed the costs of direct materials
and the costs of direct labor, and in some organizations overhead
costs substantially exceed the combined cost of direct materials and direct labor!
As a result, many organizations with complicated overhead cost structures will
often expand their system for tracing overhead cost variances to include many
different types, prices, and inputs of overhead. Hence, the responsibility for
overhead variances can spread across the entire organization, requiring careful
control and evaluation by management processes.
F. As we wrap up our work on variances, it should be clear to you that variance
analysis is a key aspect of management of revenues and costs in organizations.
Variance computations are based on isolating causes and determining the
monetary impact of each cause as a favorable or unfavorable result. However (and
this is important!), it is not necessarily the goal of management to make sure that
there are no unfavorable variances in the organization. Good management is about
managing complexity across many factors with the intent to effectively achieve
integrated, strategic goals.
 For example, managers may choose to pay more for direct materials (i.e.,
an unfavorable price variance) in order to reduce scrap and breakage in the
production process (i.e., favorable materials usage and favorable labor
efficiency variances).
 Another example of managing complexity across combinations of
performance variances is the management choice to accept somewhat
lower sales prices (i.e., unfavorable variance) as a result of substantially
reducing materials and/or labor costs (i.e., favorable variances). Of course,
this second example can work profitably in the opposite direction, too.

Practice Question
Scranton Training, Inc. provides executive training seminars on time management skills. These
seminars are sold as a training event to organizations, which then schedule to bring in their own
employees. Seminars are held at hotels in a location that is convenient to the client organization.
Scranton has a large number of certified seminar coaches that it contracts to travel to the event
and provide the training. The standard price for a training seminar event is $30,000. Below are
Scranton's standard variable costs for a seminar event.
Part 1 - Section C
In addition to the standard variable costs listed above, Scranton has budgeted $86,000 as an
annual fixed cost for advertising.
For the year just completed Scranton had originally planned for 70 seminar events with 50
participants per event. Scranton actually held 68 seminar events for the year with an average of
54 participants at each event and collected $2,029,800 in revenue. Scranton's actual costs and
activity volumes are listed below.
 Printed materials: $251,288 for 4,040 packets

 Coaches: $390,400 for 122 coach contract payments
 Travel: $140,300 for 122 travel reimbursements
 Hotels: $945,200 for 68 hotel bookings
 Advertising: $92,200 total
Compute the following variances for the Scranton Training, Inc.:
a. Revenue price variance and volume variance

b. Printed materials price variance and usage variance
c. Coaches rate variance and efficiency variance
d. Travel rate variance and efficiency variance
e. Hotel spending variance
f. Advertising spending variance

Answer

a. Revenue price variance and volume variance (measured by price)
Note that Scranton's average price per seminar event was actually $29,850 per event
($2,029,800 ÷ 68 events) and is unfavorable.
Revenue price variance = Actual volume × (Standard price − Actual price)

Revenue price variance = 68 events × ($30,000 − 29,850)= $10,200 U
Part 1 - Section C
Revenue volume variance = (Expected volume − Actual volume) × Standard price

Revenue volume variance = (70 seminars − 68 seminars) × $30,000 = $60,000 U
b. Printed materials price variance and usage variance
Note that Scranton's average price per packet was actually $62.20 per packet ($251,288 ÷
4,040 packets) and is unfavorable. The standard packets allowed for the 68 actual events
is 3,400 packets (50 standard packets per event × 68 actual events) and is unfavorable.
(Remember that the flexible budget is based on the actual product output the organization
sells into the market. Scranton sells seminar events for groups with a standard expectation
of 50 attendees. It doesn't sell individual registrations for attendees. Hence, the printed
materials standard used by Scranton is 50 packets per event, not 1 packet per attendee.)
Materials price variance = Actual quantity × (Standard price − Actual price)

Materials price variance = 4,040 packets × ($55.00 − $62.20) = $29,088 U
Materials usage variance = (Standard quantity allowed − Actual quantity used) ×
Standard price
Materials usage variance = (3,400 packets − 4,040 packets) × $55 = $35,200 U
c. Coaches rate variance and efficiency variance
Scranton's average rate paid on coach contracts was actually $3,200 per contract
($390,400 ÷ 122 coach contracts) and is unfavorable. The standard coach contracts
allowed for the 68 actual events is 136 contracts (2 contracts per event × 68 actual events)
and is favorable (Scranton did not always have two coaches at every training event).
Coaches rate variance = Actual quantity × (Standard rate − Actual rate)

Coaches rate variance = 122 contracts × ($3,000 − $3,200) = $24,400 U
Coaches efficiency variance = (Standard quantity allowed − Actual quantity used) ×
Standard price
Coaches efficiency variance = (136 contracts − 122 contracts) × $3,000 = $42,000 F
d. Travel rate variance and efficiency variance
Scranton's average amount reimbursed on coach travel costs was actually $1,150 per
reimbursement ($140,300 ÷ 122 reimbursements) and is unfavorable. The standard travel
reimbursements allowed for the 68 actual events is 136 reimbursements (2
reimbursements per event × 68 actual events) and is favorable (again, Scranton did not
always have two coaches at every training event).
Part 1 - Section C
Travel rate variance = Actual quantity × (Standard rate − Actual rate)

Travel rate variance = 122 contracts × ($1,000 − $1,150) = $18,300 U
Travel efficiency variance = (Standard quantity allowed − Actual quantity used) ×
Standard price
Travel efficiency variance = (136 reimbursements − 122 reimbursements) × $1,000 =
$14,000 F
e. Hotel spending variance
Scranton's average booking cost on hotels is $13,900 per booking ($945,200 ÷ 68 events)
and is favorable. Since this is the only source of hotel cost variance, this price variance
represents the entire spending variance.
Hotel spending variance = (Actualactivity used × Standard rate) − Actual cost

Hotel spending variance= (68 bookings × $15,000) − $945,200= $74,800 F
f. Advertising spending variance
Because advertising is a fixed cost, the spending variance computation is very

straightforward.
Advertising spending variance = Budgeted cost − Actual cost

Advertising spending variance = $86,000 − $92,200 = $6,200 U
Practice Question
The management team at Scranton Training, Inc. is meeting to analyze profit performance for the
last year. A flexible budget has been prepared based on the 68 actual training events that
Scranton delivered, and variances computed to provide the report below.
Part 1 - Section C
Management is disappointed that the company was ineffective in achieving its sales goal of 70
training events for the year. However, apparently due to cost efficiencies, profits are $7,412
higher than expected based on the actual 68 training events that Scranton was able to sell.
What might the management team at Scranton Training, Inc. learn from this variance report, and
what further questions should be asked and ascertained?
Answer
The unfavorable revenue price variance may be based on external economic realities in the
market place. If the overall demand for executive training seminars is down in the market,
Scranton may not be able to control this price variance. On the other hand, it may be true that the
underlying cause for this price variance is internal due to a problem with how the marketing and
sales department is managing client pricing.
Scranton paid $7.20 more per packet than planned. Further, there appears to be some inefficient
waste in that 640 more packets were sent out to seminars than actually needed based on the
number of total seminar attendees. It may be the case that packet copy prices are increasing in
the market, or perhaps the purchasing department is not managing that cost. On the other hand,
there is little question that the production team needs to better plan and control the number of
packets being sent out.
Scranton paid on average $200 more for coaching contracts than budgeted. On the other hand,
Scranton saved substantial costs based on using one coach (rather than two) at some seminar
events. These two variances combined may indicate that Scranton is struggling to acquire
coaches (based on paying more than expected and an inability to secure two coaches for every
event). Further, if clients are unhappy about having one coach rather than two, this may explain
Part 1 - Section C
why Scranton failed to book all the seminar events it had planned. This situation needs to be
carefully examined.
Travel costs are increasing. Scranton reimbursed on average $150 more on each travel request
than budgeted. Perhaps travel costs in the economy are increasing. More likely, coaches need
some training and incentives to reduce their travel costs. On the other hand, the fact that Scranton
is efficient in terms of how many coaches traveled to events is tied back to the earlier issue that
Scranton isn't able to get two coaches for every seminar. The favorable efficiency variance on
travel costs is not necessarily a good outcome.
There were a number of unfavorable cost issues during Scranton's last year of operations.
However, the substantial cost savings on hotels is the main reason Scranton was able to increase
operating profit above expectation. Some of the cost savings on booking hotels may be due to
better negotiations on pricing (which is good) or may be due to decisions to use cheaper hotels
(which may or may not be good). Alternatively, if overall hotel booking prices are down in the
market, perhaps Scranton should adjust this cost standard.
Finally, Scranton spent $6,200 more on advertising than expected. Although unfavorable, this
variance may be the result of an important decision to increase the advertising effort in order to
reduce the shortfall in the volume of seminar events. If in fact the volume of seminars would
have been even lower had advertising costs not been increased, the question to be asked is if this
actual cost should have been even higher in order to help Scranton achieve its sales volume goal
of 70 seminars for the year.
Summary
So long as a standard (budgeted) price or quantity has been established by management, the
variance framework can be used to analyze the actual results of any type of revenue or cost.
Further, the variance framework is relevant to any type of organization structure, including
manufacturing, service, and merchandising organizations. It's important to remember that
variance computations by themselves do not communicate the problem in the organization, or
even if a problem is actually occurring. Variances are signals (i.e., exceptions) that managers
should investigate in order to determine the cause. The cause of most variances can potentially
originate from more than one location or department in the organization, necessitating careful
investigation in the controlling and evaluating management process. Finally, while each variance
computation is focused on isolating a single cause, organizations should approach the
management of variances as an integrated mix of conditions. It's often desirable to allow for
some unfavorable variances in order to secure other more favorable variances, which then
combine to generate overall higher profits.
2.1 Business Units and Performance Evaluation
I. ASC 280 (Segment Reporting) and IFRS 8 (Operating Segments)

A. The fundamental GAAP (generally accepted accounting principles) concept
underlying both ASC (Accounting Standards Codification) 280 and IFRS
(International Financial Reporting Standards) 8 is that the company's segment
Part 1 - Section C
disclosures should be consistent with the reporting structure used by executive

management to plan, control, and evaluate the organization.
B. Segments are defined as the business units that report directly to the chief
operating decision maker (CODM). The CODM can be the company president,
chief executive officer, chief operating officer, or even an executive committee.
C. Operating segments can be organized in different ways, including by products and
services, by geography, by type of customer, or by legal entity.
D. Generally, companies must report segments with revenues, profits, or assets
greater than 10% of the organization's combined revenues, profits, or assets,
respectively. Companies must also report information about “major” customers
(i.e., customers that represent 10% or more of the company's revenue).
E. Segment financial reporting requirements include revenue and profit, as well as
assets (if applicable). Segment profit is determined based on performance
measures used to make decisions about allocating resources and assessing
performance.
II. Responsibility Centers
A. Companies generally minimize the number of segments they must report
externally to the public. On the other hand, big organizations may internally
organize themselves into hundreds of business units that report up through several
layers of management. This type of organization is demonstrated in the
organization chart below for IMC (a hypothetical organization).
Part 1 - Section C
B. Effectively managing the organization's business processes requires clear

stewardship responsibilities, coupled with appropriate measures and incentives. In
order for performance measurement and performance incentives to be effective,
business units should have the necessary decision rights to manage their
performance.
C. Responsibility accounting is a system in which managers are assigned and held
accountable for certain costs, revenues, and/or assets. There are two important
behavioral considerations in assigning responsibilities to managers.
1. The responsible manager should be involved in developing the plan for the
unit over which the manager has control. People are more motivated to
achieve a goal if they participate in setting it.
2. The manager should be held accountable only for those costs, revenues, or
assets for which the manager has “substantial control.” For example, labor
costs are generated within the business unit, but employee wages may be
determined by a union scale controlled elsewhere inside or even outside of
the organization. On the other hand, a manager given latitude to invest in
marketing campaigns and adjust prices should be accountable for revenue
performance in the business unit.
D. Responsibility centers are generally defined into four types. The performance
measures and incentives used to manage responsibility centers should be aligned
with the specific nature of each center being either a cost center, revenue center,
profit center, or investment center of operations.
1. Cost centers. As the name implies, a cost center is any organizational unit
in which the manager of that unit has control only over the costs incurred.
The manager of a cost center has no responsibility for revenues or assets,
either because revenues are not generated in the center or because
revenues and assets are under the control of someone else. The
Manufacturing Division for the Korea Operations in the Far East Region
of IMC's Acme Computer Company, for example, could be designated a
cost center.
2. Revenue centers. If a business unit is set up to focus exclusively on
generating sales and revenue, without any responsibility for costs, that unit
would be designated as a revenue center. This is not a very common type
of business unit, but such a designation demonstrates the concept that a
responsibility center should be held responsible only for the costs,
revenues, and/or assets for which it has significant control. In our example
with IMC, the Sales Division for Korea Operations could be treated as a
revenue center assuming it does not have significant control over its costs.
3. Profit centers. A profit center manager has responsibility for both costs
and revenues. Profit centers are usually found at higher levels in an
organization than are cost centers. The various country operations for
IMC, such as China, Japan, and Korea operations within the Far East
region of Acme, are likely to be profit centers, or perhaps even investment
centers (described below).
4. Investment centers. The U.S., Far East, and Europe geographic regions at
IMC are most likely to be treated as investment centers. The key
Part 1 - Section C
responsibility that belongs solely to an investment center is the

stewardship to manage the assets that generate revenue and consume costs
for the business unit. If the manager has been delegated the responsibility
to make decisions regarding the purchase, deployment, and retirement of
the assets used in her or his business unit, then that unit is described as an
investment center and investment-oriented performance measures are used
accordingly.
III. Indirect Cost Allocation Methods
A. Three of the four types of responsibility centers (cost centers, profit centers, and
investment centers) are charged with management of costs. When assigning costs
to a business unit for performance evaluation purposes, it is important to
distinguish between controllable costs, direct costs, and indirect costs.
1. Costs that managers of business units can significantly influence or
directly control are considered to be the controllable costs of the business
unit. These costs should be used to assess the performance of the manager
or management team.
2. The direct costs of a business unit include the controllable costs as well as
any other costs that are directly connected to the operations of the unit.
The key distinction on direct costs is if the organization chooses to remove
the business unit, the direct costs can be either removed or recovered by
the organization. For example, direct costs that are not controllable by the
business unit's management team might include occupancy costs (rent and
property taxes) or the management team's own salaries.
3. Indirect costs are costs allocated to the business unit that represent general
administrative costs for the organization. Executive salaries, bank interest
charges, and accounting and legal expenses are all possible examples of
indirect costs. The key distinction is that if the organization removes the
business unit, the allocated indirect costs cannot be removed or recovered;
rather, they are reallocated to remaining business units. Other names used
to describe indirect costs are common costs, allocated costs, and
administrative burden costs.
B. The Far East Region of IMC's Acme Computer Company is evaluating the profit
performance of its three operations: China, Japan, and Korea. External reporting
standards require that costs are fully allocated to subsidiary divisions.
C. For external reporting purposes, IMC's cost allocation methods need to be applied
consistently (year to year) using methods that are representative of general
industry practices. Specific allocation methods are not mandated, but cost
allocation practices generally follow either a stand-alone method or an
incremental method.
D. To demonstrate and compare a stand-alone cost allocation method and an
incremental cost allocation method, let's assume that IMC's Far East Region in the
Acme Computer Company needs to allocate 120,000,000 yen (¥120M) across its
three operations in Japan, China, and Korea (yen is the functional reporting
currency for IMC's Far East Region).
1. Stand-alone cost allocations identify a common base of activity (e.g.,
revenue dollars, headcount, units produced, etc.) to proportionally allocate
Part 1 - Section C
indirect costs. Using a stand-alone cost allocation method based on each

business unit's revenue, the operating profit & loss report is provided
below for last year's operations.
(COGS indicates Cost of Goods Sold, and S&A indicates Selling and
Administrative)
Note that Japan Operations was allocated 50% of the ¥120M in corporate
costs, with China Operations and Korea Operations receiving 33.3% and
16.7%, respectively.
2. Alternatively, IMC could have used each unit's contribution margin as the
allocation basis, which would have resulted in the following assignment of
indirect costs:
Note that using this basis would have allocated more costs to Japan
Operations and less to the other two operations. You can imagine that the
managers of each of these operations will have strong opinions about the
appropriate cost basis, and that these managers will likely never fully
agree on which basis to use!
3. Another approach to allocating indirect costs is to use an incremental

method. The basic concept underlying incremental cost allocation methods
is to identify the historical change in indirect (common) costs as each
Part 1 - Section C
business unit was established within the organization. Consider the

operating profit & loss report below for the Far East Region, which is
based on allocating corporate costs using an incremental method.
4. The ¥80M in corporate costs allocated to Japan Operations is based on the

approximate size of corporate costs when the Far East Region was
established with Japan as the only center of operations. Subsequently,
when China Operations were added, corporate costs increased another
¥35M. Recently, when Korea Operations began, Far East Region
corporate costs increased very little—approximately ¥5M. The problem
with this method is that more recently added business units benefit from
earlier units paying the majority of costs for shared corporate services—a
result that may not represent the value each business unit receives for
shared services.
IV. Performance Evaluation and Common Costs
A. External reporting requirements typically mandate that common corporate costs
are allocated across all reporting segments. This is appropriate for external
reporting needs, but the practice of allocating indirect (common) costs can
interfere with effective performance evaluation decisions that are internal to the
organization.
B. When evaluating the performance of a manager for a cost, profit, or investment
center, it is important to use only controllable costs. When evaluating the
performance of the business unit itself, particularly for decisions regarding
keeping or dropping the business unit from the organization, it is crucial to use
only direct costs in the analysis.
C. When evaluating the performance of business units for decisions regarding
keeping or dropping the business unit from the organization, or even for decisions
involving distribution of investment resources to business units, analysis of profits
computed with allocated indirect costs can lead to management decisions
with death spiral results.
D. To demonstrate a decision with potential death spiral results, let's return to the
original operating profit & loss report for IMC's Far East Region with costs
Part 1 - Section C
allocated on a stand-alone basis using revenue (review the first profit & loss
report above).
1. Note that Korea Operations is reporting a loss of -¥15M. Based on this
performance report, Acme Computer Company managers or IMC
executives may conclude that profits for the Far East Region would
improve by ¥15M to ¥27M if Korea Operations were dropped from the
business.
2. However, if the ¥120M of corporate costs are truly indirect, then the
business activities in the three operations (Japan, China, and Korea) will
not directly affect these costs, and next year's performance report could
look like the following (assuming all other revenues and costs remain the
same as last year):
3. Note that corporate costs in the report above remain at ¥120M and
continue to be allocated on the basis of revenue for the remaining
operations. Also note that operating profit did not rise to ¥127M but fell
by ¥5M to ¥7M!
4. Most importantly, note that China Operations is now reporting a -¥4M
loss. What if the management team now decides to drop China from the
Far East Region? If allocated corporate costs continue to be indirect to
these two business units, the results of dropping China would be disastrous
(i.e., have a deadly effect) on profits for the Far East Region!
E. The fundamental problem with allocating indirect costs is that by definition there
is no direct relationship between these costs and the business units to which
they're being assigned. External regulations may require that allocations be made,
but those regulations do not dictate internal accounting practices that
support internal decision making.
F. Alternatively, IMC could determine not to allocate indirect costs to subsidiary
business units when building performance reports for internal decision making.
This management approach would result in the performance report below for Far
East Region's three centers of operations.
Part 1 - Section C
1. Note that this operating profit & loss report highlights the financial value
created directly by each center of operations. The ¥120M in corporate
costs are not allocated to operations but are reported in the Total column
for the Far East Region. This approach indicates that the ¥120M corporate
costs are indirect to the three centers of operations but are direct costs for
the Far East Region, i.e., these costs can only be removed if executive
management decides to remove the Far East Region from the organization.
2. More importantly, this report solves the mystery of why profits are
reduced by ¥5M if Korea Operations were to be dropped. A new reporting
line has been added above, which is segment margin. This new number
reports on the “true” profit (or loss) created directly by each business unit.
Korea Operations is generating ¥5M of segment profit margin. That value
is lost if this business unit is dropped.
Practice Question
Weston Company is composed of two separate business units. Common corporate costs include
salary and wages of executive staff and office rent costs. These costs are allocated on the basis of
each division's revenue. Weston's most recently monthly profit & loss report is provided below.
Part 1 - Section C
Weston management is concerned that Division A regularly reports a loss similar to the $1,100
loss above. The management team has determined to drop Division A in order to improve
company monthly profits by $1,100.
What is likely to happen to company profits based on this decision?
What is a better way to report operating performance at Weston Company?
Answer
Assuming that corporate costs are all indirect with respect to operations within each division, the
$8,000 corporate cost is not going to be reduced by the removal of Division A. Instead, Weston
Company will likely have the following performance in the near future.
Answer
Weston should avoid allocating indirect corporate costs when assessing division performance—
especially for decisions involving dropping divisions from the organization. An alternative
(better) monthly profit & loss report would be as follows:
Note that Division A is reporting a segment margin of $4,500. This number explains why
Weston profits went down by $4,500 when Division A was dropped.
Part 1 - Section C
Summary
External reporting regulations based on generally accepted accounting principles mandate that
companies provide public financial reports identifying business segments that meet certain
conditions. While most organizations desire to minimize the number of segments that they report
publicly, for internal management reasons most organizations will define a reporting structure
involving layers of many business units. For control and evaluation purposes, these business
units should be identified as cost centers, revenue centers, profit centers, or investment centers.
While external reporting regulations typically mandate that all costs are allocated across all
reported business segments, this isn't true of cost assignment for internal management purposes.
Costs should be identified as controllable, direct, or indirect. When allocating indirect costs,
either stand-alone or incremental cost allocation methods can be used. Nevertheless, for internal
performance reports, indirect costs should not be allocated at all, else decisions made using these
performance reports can have death spiral results.
2.2 Transfer Pricing
I. Need for Transfer Pricing

A. Remember in our last lesson that business units can be set up as cost centers,
revenue centers, profit centers, and investment centers. Cost centers and revenue
centers often struggle with incentives that aren't aligned well with the overall
organization.
1. Cost centers are incentivized to reduce costs, but that incentive can
motivate a cost center to minimize or delay support and services to other
business units and damage overall company profitability.
2. Revenue centers are incentivized to increase revenue without respect to
costs. This kind of motivation can lead revenue centers to be very
inefficient with resources of other business units, also leading to reduced
overall profits in the company.
B. As organizations increase in size and complexity, competitive internal pricing can
be used to motivate performance and discipline processes in cost centers and
revenue centers. Transfer pricing systems align cost centers and revenue centers
with the organization's profit focus.
C. A transfer price is essentially a budget transfer between business units that by
itself doesn't actually change overall profits in the organization. However, transfer
prices allow both cost centers and revenue centers to be reestablished as profit
centers, and that new orientation will better align incentives with the organization
at large.
D. Since the transfer price represents a revenue to the supplying business unit and a
cost to the receiving business unit, managers of both business units will be
focused on the maximizing the “profit” in this internal transaction. If the price is
set correctly, the receiving business unit will expect quality and timeliness in the
transaction, and the supply unit will be incentivized to provide the quality and
timeliness. Setting the right transfer price is key for the transaction to take place.
II. Variable Cost Transfer Pricing
Part 1 - Section C
A. Let's return to the International Manufacturing Corporation (IMC) example from

the previous lesson. The organization chart for IMC is provided below.
1. The U.S. Region in the Acme Computer Company has been purchasing
monitor screens from an outside vendor that is assembled into the
computers being manufactured and sold in the U.S. for $900 per computer.
This business unit pays $110 per screen. Combined with $340 in other
variable costs, the U.S. Region has a $450 contribution margin on each
computer sold. U.S. Region monthly sales volume is 5,000 computers.
2. China Operations is selling monitor screens in its market at a $140
equivalent price (actual China Operations revenue is in Chinese yuan).
The equivalent variable cost to manufacture each screen is $90, resulting
in a $50 contribution margin. The China Operations monthly sales volume
is 20,000 screens.
3. Data on both business units are provided below, including monthly fixed
costs. Without any transfers taking place between the two business units,
monthly performance combines to equal $950,000 in total profit for IMC.
Part 1 - Section C
B. IMC, through its U.S. Region, is paying $110 to purchase computer monitor
screens. But it can manufacture monitor screens at a variable cost of $90 in its
China Operations. It makes sense for China Operations to build and transfer
screens to the U.S. Region, but at what transfer price? It turns out that for the
overall IMC organization it doesn't matter what transfer price is used in the
internal transaction.
C. Let's assume that the transfer takes place using China Operations’ variable cost to
produce a monitor screen. China Operations has the capacity to build the
additional 5,000 screens needed in the U.S., and the cost to build these additional
screens will be just the variable cost of $90. A transfer using the variable cost
would result in the following combined monthly performance report.
The bottom highlighted line reports the increase or decrease in operating profit
compared to the original combined monthly performance report with no transfer
Part 1 - Section C
taking place between the business units. China Operations has no change in
monthly profit, but the U.S. Region's profit will increase by $100,000, because it
will save $20 per monitor screen ($110 – $90) by purchasing the screens
internally ($20 × 5,000 computers = $100,000).
D. Setting the transfer price based on variable costs is often profitable for the
receiving business unit, but the supplying business unit has no profit incentive to
agree to the transfer at the variable cost price (except that it provides the means to
give more employment for the business unit's employees).
III. Full Cost Transfer Pricing
A. Alternatively, organizations can set transfer prices based on full costs. This
approach is often used by organizations since it represents a cost that is typically
reported in accounting systems. A full cost transfer price provides a contribution
margin to the supplying business unit to help cover its full costs, but it results in a
higher price that the receiving business unit may not want to pay.
B. Returning to our example, let's assume that the transfer price is based on China
Operation's full cost per unit. This business unit's total fixed costs are $600,000
(and are not expected to increase based on the additional 5,000 screens for the
U.S. Region). The fixed cost per unit is computed as follows:
$600,000 ÷ (20,000 screens + 5,000 screens) = $24 per screen
C. A transfer using the full cost of $114 per monitor screen ($90 + $24) will provide
the following combined monthly performance report
Note that China Operations has an increase in monthly profit of $120,000 but the
U.S. Region's profit will decrease by $20,000 based on paying $4 more per
monitor screen ($110 – $114).
Part 1 - Section C
D. Most importantly, note that IMC's overall profit will increase by $100,000 using
either the variable cost or the full cost. The company's overall profit is unaffected
by the transfer price. The only thing that affects overall profit is whether or not
the transfer takes place.
IV. Managing Transfer Pricing
A. There are two issues in transfer pricing that need to be clearly managed and
separately evaluated. First, does the organization want the transfer to take place
between the two business units? In other words, will a transfer increase or
decrease overall profits for the organization?
1. If there isn't an external supplier (vendor), then without an outside
alternative the only option available is a transfer between the two business
units.
2. If the option to use an external supplier does exist, then the organization
must determine if it is cheaper to buy externally or internally produce and
transfer the product or service. The method to determine the right solution
is as follows:
 Is external market price > variable cost + opportunity cost +
incremental fixed cost?
 If market price is higher, then the organization will be benefited by
an internal transfer. (Opportunity costs and incremental fixed costs
will be discussed later.)
B. Assuming the organization wants the transfer to take place, the second issue to
manage is setting the transfer price such that both business units will be
incentivized to participate in the transfer.
1. The supplying business unit needs to cover its variable costs plus any
opportunity costs of making the transfer (i.e., lost profits in the open
market) as well as any incremental fixed costs that may be required to
provide the product to the receiving business unit. If the supplying
business unit can make a profit on these costs, it will have incentive to do
the transfer.
2. The receiving business unit does not want to pay more than the price
available in the external market. If there are any transaction savings by
doing an internal transfer (for example, packaging or shipping that can be
avoided), the receiving business unit may be willing to pay a higher price
so long as the difference is offset by transaction savings. The key to
incentivizing the receiving business unit is a transfer price that results in a
net cost savings.
V. Market-Based Transfer Pricing and Opportunity Costs
A. In determining the transfer price, the supplying business unit sets the floor
(minimum) on that price and the receiving business unit sets the ceiling
(maximum). When using costs to set price, the receiving business unit wants to
pay the variable cost, and the supplying business unit wants to charge the full
cost. How do these two business units resolve on the transfer price? If there is an
outside market for the product or service, then most organizations will set the
transfer price on the market price that the receiving business unit would normally
pay.
Part 1 - Section C
B. The receiving unit's market price creates a competitive pressure (and opportunity)
for the supplying business unit to reduce costs while improving the quality and
timeliness of the product or service in order to compete effectively with the
outside market for the transaction. This incentive aligns well with the
organization's overall goals.
C. What about the outside market for the supplying business unit? If the supplying
business unit is selling to an outside market, that situation is relevant only if the
supplying business unit is running out of production capacity.
1. If the supplying business unit has to give up any outside business in order
to transfer product to the receiving business unit, then the lost contribution
margin on that outside business is an opportunity cost that needs to be
factored into the transfer price.
2. In this case, the supplying business unit will set the minimal transfer price
as follows:
(Total variable costs to supply units + total contribution margin lost) ÷

total units supplied
3. And if there is an incremental fixed cost for the supplying business unit to
produce and transfer product to the receiving business unit (e.g., special
equipment or training), that fixed cost also needs to be factored into the
minimal transfer price, as follows:
(Total variable costs + contribution margin lost + incremental fixed costs)

÷ total units supplied
D. With the IMC example, let's assume that China Operations’ production capacity
limit is 24,000 monitor screens each month. If this is an all-or-nothing transfer
situation, then China Operations must give up 1,000 units of the 20,000 units of
outside sales in order to supply the U.S. Region with 5,000 screens. In addition,
assume that China Operations must pay $10,000 each month for the shipping
container to get the monitor screens to the U.S. Region.
1. Remember that China Operations normally makes the equivalent of $50
on each monitor screen it sells into its market. Hence, it has an opportunity
cost of $50,000 ($50 × 1,000 screens) in lost contribution margin by
making the internal transfer.
2. Combined with the $10,000 of incremental fixed costs, the minimal
transfer price that China Operations will demand is:
($50,000 + $10,000) ÷ 5,000 screens + $90 variable production cost per

screen = $102
3. The U.S. Region is currently paying $110 to an external vendor in its

market to obtain monitor screens. Hence, these two business units should
be incentivized to set the price between $102 and $110 and make the
Part 1 - Section C
transfer. Assuming the transfer price is set at $106 per screen, the
following combined monthly performance report would result:
4. The overall improvement in IMC profits ($40,000) is due to the difference

in the total cost to make and transfer monitor screens versus the cost to
purchase from an external vendor, multiplied by the number of screens.
($110 − $102) × 5,000 screens = $40,000 total costs saved
5. Remember that it doesn't matter to the IMA organization what transfer

price is used between these two business units. Whatever transfer price is
established will effectively divide the $40,000 in cost savings between the
two business units. Hence, it's a negotiating process.
E. Remember that the first issue in managing the transfer price process is to
determine if the transfer takes place at all. In other words, will it improve overall
profits for the organization to internally produce and transfer the product versus
buy the product from an outside vendor? This is a straightforward make-or-buy
decision.
1. To demonstrate, let's assume that production capacity at China Operations
is actually 23,000 monitor screens per month, which means it will give up
2,000 units of outside sales to make the internal transfer.
2. These lost sales have an opportunity cost of $100,000 (= $50 contribution
margin × 2,000 units). As a result, the cost to produce and transfer the
5,000 monitor screens (i.e., the minimum transfer price) is:
($100,000 + $10,000) ÷ 5,000 screens + $90 variable production cost per

screen = $112
Part 1 - Section C
3. This cost is higher than the $110 outside market price (i.e., the maximum
transfer price), which means IMA will lose $10,000 if the internal transfer
takes place.
($110 − $112) × 5,000 screens = $10,000 total cost increase
4. Clearly, the transfer should not take place.

VI. Negotiated Pricing and Dual-Rate Pricing
A. The intent of the transfer price computations we've been doing are to (1)
determine if a transfer should in fact take place, and (2) identify the price range
(floor and ceiling) within which the supplying (selling) business unit and
receiving (buying) business unit will negotiate a transfer price. The decision tree
below can be used to guide and summarize this process.
B. A key aspect of successful management using transfer pricing is to create an

“open market” within the organization wherein business units compete and
negotiate with each other to set prices and make transfers. This approach creates
positive competitive pressure to keep costs down and quality up on goods and
services being delivered within the organization.
Part 1 - Section C
C. The challenge with an “open market” approach is that managers of business units
don't always make the most optimal decision for the organization. For example,
due to poor accounting information or misaligned incentives, managers of
business units may choose to not transfer when it's actually optimal for the overall
organization to have a transfer take place.
D. When managers of business units are making suboptimal decisions to engage in a
transfer or not, it is tempting for the executive management team to step in and
force the optimal decision. Generally, this is not advisable; otherwise, the benefits
of important management objectives related to delegation, decision speed, and
management training are lost.
E. A compromise approach to encourage managers of business units to make optimal
decisions is to establish an accounting system that allows dual pricing.
1. For example, the accounting system could be designed to allow the
supplying business to use a full cost-based price to recognize revenue into
its profit performance report while allowing the receiving business unit to
use a variable cost-based price to recognize costs into its profit
performance report.
2. The difference between the two prices will have to be carried in the
organization's accounting system and reconciled at the end of the reporting
period.
VII. Managing International Issues
A. This lesson has emphasized the principle that the only transfer pricing factor
affecting actual company profits at IMC is whether a transfer actually takes place
between business units. The transfer price used in the transaction simply
determines how the cost savings is split between each business unit. The transfer
price itself doesn't affect overall profits for the organization.
B. However, this principle is only true when the organization conducts business
within a single economic geography. When the organization's business units are
spread across different economic zones, then issues such as tax rates, tariffs,
exchange rates, and currency restrictions enter into the management decision on
whether to conduct an internal transfer and what transfer price to use.
C. The transfer pricing example used in this lesson (IMC) is based on internal
transactions between a business unit in China and a business unit in the U.S.
Because transactions between these two business units cross international
boundaries, a number of issues can complicate how IMC manages its transfer
pricing processes.
1. For example, if the income tax rate in the U.S. is comparatively higher
than in China, IMC may encourage transfer prices that result in most of
the cost savings being split toward China Operations. In the choice
between variable cost and full cost pricing, IMC will reduce its tax
expense if full cost pricing is used to locate most of the cost savings from
the transfer in China.
2. As another example, trade tariffs are another form of a tax. If the U.S.
places a high tariff rate on the value of computer technology goods
coming into its country, then IMC is likely to encourage lower transfer
prices on the monitor screens that China Operations ships to the U.S.
Part 1 - Section C
Region. Hence, in the choice between variable costs or full costs, IMC
will reduce the cost of tariffs by using variable costs to set transfer prices.
3. A final example: In order to manage the economic impact of large
outflows of cash or assets from its country, governments can use currency
restriction laws to limit how much cash a company can transfer out of the
country's economy over a certain period of time. An organization can use
transfer pricing to manage this risk (sometimes called “expropriation risk”
or “policy risk”) of having its cash retained in one country when it's
needed in another country. If IMC is concerned that the U.S. is going to
restrict the transfer of currency out of its country, it may encourage the use
of full cost-based transfer pricing to increase the amount of cash that the
U.S. Region pays China Operations for monitor screens.
D. As a final note on international issues involved in transfer pricing policy, most
country governments pay close attention to companies that use internal transfer
prices primarily to reduce income tax expense, avoid paying tariffs, or work
around currency restriction laws. To that end, there is significant government
regulation involved in the process of setting transfer prices for international
organizations like IMC.
Practice Question
Green River, Inc. sells fly-fishing equipment. One of its main products is a starter set for value-
conscious consumers that includes a fishing rod, a reel, fishing line, and an assortment of flies,
strike indicators, and other small supplies. Green River has a finished assembly operation that
purchases various components from external supplies to compile the finished package.
Recently, Green River acquired a fishing reel manufacturing company. This fishing reel
manufacturer is selling reels to external customers for $95 per unit. The variable cost to build the
reels is $60 per reel. The manufacturer is currently selling 7,500 reels a month with a production
capacity of 10,000 reels a month.
Green River's assembly operation is currently buying fishing reels from another external vendor
for $85 per unit. The remaining variable costs (other components and direct labor) to assemble a
finished package total $650 per package. Green River is currently assembling and selling 5,000
packages each month, priced at $850 per package.
The Green River management team wants the fishing reel manufacturing unit to provide all the
reels needed by the finished assembly business unit. To do this, the reel manufacturing operation
will need to hire a part-time employee to handle special packaging and paperwork on the reels
going to the package assembly operation. The fixed cost will be $2,500 per month.
If the transfer takes place between the two business units, what is the potential increase in total
monthly profit for Green River, Inc.?
What is the range of the transfer price within which these two business units will negotiate to do
the transfer?
Answer
Part 1 - Section C
Green River will save $25 per package by shifting purchases of the 5,000 reels from the external
vendor to the variable costs in the fishing reel manufacturing operation. But due to capacity
constraints in the reel manufacturing operation, 2,500 units of external sales will be forgone,
which means the contribution margin on these lost sales will be an opportunity cost. In addition,
another fixed cost will have to be added to the organization. This nets out to a $35,000 increase
in total profits for Green River, Inc.
$125,000 cost savings in assembly = ($85 − $60) × 5,000 assembled packages
− 87,500 opportunity cost in manufacturing = ($95 − $60) × 2,500 reels not sold
−2,500 incremental fixed costs in manufacturing
$35,000 net increase in corporate profit
The minimum transfer price that the fishing reel manufacturing operation will accept is:
$60.00 to cover the variable cost per unit
+17.50 to cover the lost contribution margin = $87,500 ÷ 5,000 reels
+0.50 to cover the incremental fixed costs = $2,500 ÷ 5,000 reels
$78.00 total minimum price
The package assembly operation won't pay more than the $85 price it's paying on the open
market for fishing reels. Hence, the price range for the negotiation between these two business
units will be $78.00 to $85.00.
Summary
Transfer prices are simply budget transfers between different business units in an organization.
However, transfer prices can be a powerful management mechanism to encourage better
performance by establishing “competitive markets” between business units within the
organization. If a business unit can supply a product or service to another business unit at a
cheaper price and/or at a higher quality than an external vendor, a transfer price can be used to
share (i.e., split) the cost savings or value created by the internal exchange. Transfer prices are
based on a combination of internal costs and external market prices. Internal costs include the
variable costs, any incremental fixed costs, and the opportunity cost of lost sales for the
supplying business unit (i.e., the seller). These three potential internal costs for the seller serve as
the floor price for the internal transfer. If the receiving business unit (i.e., the buyer) is able to
obtain the product or service from an external vendor, then the market price that the buyer would
have to pay the external vendor serves as the ceiling price for the internal transfer.
3.1 Evaluating Product and Customer Profitability
I. Measuring Profits
A. In the last lesson involving transfer pricing, the focus was on establishing a price
on a particular product, whether it be a tangible product or a service product, in
order to “sell” the product in an internal transfer between two business units
Part 1 - Section C
within the same organization. The transfer pricing process establishes centers of
operations within the organization as profit centers, each with its own internal
revenue and costs. The result is an “open market” management system that
incentivizes efficiency and value creation.
B. The actual market in the economy, however, is more complicated and typically
demands a more strategic approach to competition and profitability. This lesson
explores a comprehensive (i.e., strategic) approach to defining and measuring
profitability in the “real world” of a competitive economy.
C. In the previous lesson we described centers of operations in an organization as a
“business unit.” The intent of that description is to emphasize the idea of internal
business units functioning as profit centers. In this lesson we focus on “strategic
business units" (SBUs). An SBU is a comparatively larger center of business that
is responsible for an outward-facing product or product line that is being delivered
into a specific market segment. A company with a focused product line functions
as a single SBU. On the other hand, large corporations may be composed of
multiple SBUs, each of which is responsible for its own profitability.
D. The classic approach to measuring profitability is to establish what it costs to
manufacture a product or provide a service compared to what the product or
service can be sold for. This approach underscores the accounting definition of a
product cost, which is composed of direct material costs, direct labor costs, and
manufacturing (or production) overhead. On the income statement, these costs
form the “cost of goods sold” that is used to determine a margin on sales revenue.
E. The danger with this approach to product costs is the emphasis it places on
profitability on each product or service sold into the marketplace. It is not always
feasible, and sometimes it's not even wise, to be profitable on each product or
product line. Most products (including services) follow a life cycle with an infant
state, a mature state, and a declining state of existence. The typical unprofitability
of a product in its infant state can very much support the SBU's long-term strategy
of creating and deploying an evolving portfolio of products and services in the
marketplace. Some products may never be individually profitable, but still fill an
important complementary role in the SBU's product portfolio.
F. Do you remember the Boston Consulting Group (BCG) Growth-Share Matrix?
The BCG Matrix is a strategy planning tool that visually represents an SBU's
products or services across two market dimensions: the overall growth of the
market, and the SBU's share of the market. Without going into much detail, the
BCG Matrix describes four types of business or product lines: cash cows, rising
stars, question marks, and dogs. Cash cow products provide the resources for the
SBU to mature rising star products into profitability while exploring question
mark products to determine if they can become rising star products or are dog
products that need to be pruned from the business portfolio.
G. The competitive reality for most SBUs is the need to manage a mix of products
and services that form a strategic portfolio. This portfolio represents an
interrelated set of revenues and costs that needs to be managed well in order to
establish sustainable profitability for the SBU. Profitability isn't sustainable if it
isn't sufficient to do two things: (1) provide for an ongoing infrastructure of
capital assets necessary to continue running the business, and then (2) provide a
Part 1 - Section C
return to the investors in the business, whether that be the larger corporation that
owns the SBU or actual shareholders who have purchased stock in the SBU.
H. This concept of sustainable profitability across a portfolio of products and
services can be represented in the International Manufacturing Corporation (IMC)
example used in the last two lessons. The IMC organization chart is provided
(again) below.
IMC has three strategic business units (SBUs), each with its own focused strategy
and defined market segments: Acme Computer Company, Edison Automobile
Company, and Jennifer Cosmetics Company.
I. Acme Computer Company has three regions, each of which has three in-country
operation centers. As a strategic business unit, Acme focuses its performance
reports on geographic profit lines. As can be seen below, some operation centers
are more profitable than others. Korea is a newly opened operations center. Both
the France and Spain operation centers are struggling in a down economy, but
Acme management hopes those economy sectors will be improving in the near
future.
Part 1 - Section C
1. First, note that there is $12 M more in the selling and administrative
expense total than is represented across the 12 in-country operations. This
additional $12 M represents the annual costs of running the executive
offices and staff for the management team at Acme.
2. Overall, Acme is running a profitable SBU representing a strategic mix of
geographic profit lines. Korea is a question mark that Acme expects will
become a rising star in its portfolio. Both France and Spain are also
question marks that hopefully won't become dogs in the portfolio due to
an ongoing sluggish economy.
3. The final point to be underscored in this performance report is the $38 M
cost of capital near the bottom. This number represents the economic cost
of maintaining all the capital assets necessary to maintain a business
structure across so many countries. The remaining “residual” income is
available to send back to IMC headquarters if needed for other purposes.
We'll be discussing the residual income concept more in another lesson.
II. Customer Profitability
A. Acme Computer Company obviously sells computer products. As we've
demonstrated, a successful SBU like Acme doesn't have to be profitable on every
computer or line of computers it sells, nor does it have to be constantly profitable
across all in-country operations. But it does need to track profit performance on
all computer sales in order to plan, control, and evaluate its portfolio strategy.
B. In addition to tracking profits on computer sales, there is another strategic
perspective that Acme can track in managing its strategy, and that is profitability
of customers or customer groups. As you can see in the annual performance report
above, much of Acme's total costs (approximately 37%) is tied up in selling and
administrative expense. While these costs are not connected to computer
production, many of these costs are tied directly to supporting the customer
relationship process. Traditional accounting systems rarely track these
“downstream costs” to customers.
C. Customer relationship management (CRM) is rich with a variety of activities and
demand for downstream support costs, including:
1. Warehousing, showrooms, and online shopping
2. Ordering processes and change orders
Part 1 - Section C
3. Discounting, private labeling, and special packaging

4. Delivery, setup, and training
5. In-person, telephone, and online post-sales support
6. Returns, refunds, and restocking
D. Different customers demand different types and different levels of customer
support in the process of purchasing the SBU's product or service. In that process,
customers demonstrate different levels of overall profitability with respect to the
costs of producing the product or service they purchase combined with the costs
of servicing their relationship demands on the SBU.
E. Most SBUs are quite effective at controlling and evaluating costs of goods sold
(i.e., the product cost) in order to determine profitability of products and services.
On the other hand, too many SBUs are not extending the same effort to break out
the CRM costs that are often buried in the selling and administrative expense. As
a result of not being able to clearly identify “high-quality” and “low-quality”
customers (in terms of customer contribution to SBU profitability), these
organizations are unable to focus on either removing unprofitable customers from
their business or migrating those customers into profitable relationships.
F. The impact of not measuring and reporting customer profitability is demonstrated
below in what's known as a whale curve chart. It's called a whale curve because
the top of the potential profit shape resembles the top of a whale coming out of
the water.
1. If organizations are able to track all the costs related to each of these

customers (both costs of product purchased and costs to serve the
customer relationship), they can then identify the profitability of each
customer. The whale curve chart above demonstrates an analysis of
customer profitability by organizing customers from most profitable to
least profitable and comparing that relationship to total profits in the
organization. The top of the whale curve demonstrates a crossover point
for individual customer profitability. Customers lined up to the right of the
Part 1 - Section C
highest point on the whale curve are unprofitable customers that reduce
overall profitability.
2. The message of the whale curve to management is that company profits
could be much higher than current actual profit if the company were to do
one of two things with unprofitable customers: either manage the costs to
serve these customers in order to migrate them to profitability or, as
necessary, raise prices on some customers to the point that they leave the
company's business portfolio.
G. In most markets, the cost to acquire new customers is significant, which is why
most SBUs are cautious about moving current customers out of their business
portfolio. The migration of unprofitable customers toward profitability is twofold
and is demonstrated in the migration chart below.
1. This chart represents the twofold relationship between the total margin on
purchased goods and services that a customer generates and the total costs
to serve that customer's relationship with the SBU. Customers that demand
a lot of special support activities in the CRM process and yet don't
produce much profit margin on product sales are the most unprofitable
customers in the portfolio. On the other hand, customers who purchase a
high volume of product or services or who select high-margin
products and engage in customer support processes efficiently are the
most profitable customers for the SBU.
2. The same crossover point in the whale curve is demonstrated in the
migration chart above with the customers whose margin on purchases and
Part 1 - Section C
offsetting use of support processes results in either a small profit or a

small loss. These customers should likely be the priority focus to migrate
toward more profitable relationships. On the other hand, customers with
significant losses need to be closely (and quickly) evaluated to determine
if the relationship is recoverable. Otherwise, these customers should likely
be the priority focus to raise prices in order to remove them from the
business portfolio.
III. Getting Performance Measurement Right
A. Before wrapping up this lesson on measuring performance on profitability, it's
important to emphasize three key principles on performance measurement and
management. These three key principles must be carefully balanced in the
management process of planning, controlling, and evaluating.
1. The first principle is performance measures must be designed to represent
the strategic objectives of the organization. This seems obvious, but it is
actually challenging work. Strategy is constantly evolving and, therefore,
performance measures in the organization need to constantly evolve as
well if they are to be clearly tied to strategic outcomes.
2. Second, compensation and incentives need to be clearly tied to achieving
performance measures; otherwise, employees will never be energized to
accomplish work that is strategically critical to the organization. This also
seems obvious but getting the incentives to function well is another
challenging aspect of balancing performance measurement processes. Too
much incentive on any one measure can result in hyperfocus, even
potentially fraudulent behavior, in one area of the organization's strategy.
And, of course, not enough incentive leaves other aspects of the strategy
underachieved.
3. The third principle involves assigning the responsibility and decision
rights necessary to accomplish the performance measure. Frustration is the
natural result of not delegating the proper authority to get the assigned job
done. The complication in this principle is based in the reality of complex
bureaucracy in large organizations. Strategic goals require multiple people
and processes. It's difficult to identify and incentivize performance
measures that are strategically aligned that don't require the efforts of
multiple teams. In that interrelated structure, it's difficult to identify which
individuals are solely responsible for what aspects of each performance
target.
B. These three principles can be described as a three-legged stool, each necessary to
supporting a balanced management structure involving performance
measurement. This relationship is depicted below.
Part 1 - Section C
Source: BEPictured/Shutterstock
What is critical to remember in this relationship is that adjustments to any one

aspect of this management structure must be followed by adjustments in the other
two aspects. If a performance measure is changed, then new incentives must be
evaluated and decision rights realigned.
C. Finally, watch out for measurement surrogation! Measures function as imperfect

surrogates (or representatives) for the actual strategic objective in the
organization. The measurement for operating profits on the income
statement represents profitability as a strategic goal for the organization, but
operating profits in any one operating period is not the actual strategic objective.
If managers focus too much on this particular measure, they start making the
mistake of making decisions strictly to move up that measure, regardless of
possible negative effects on the long-term profitability of the organization, which
is truly the strategic objective. This mistake is called measurement surrogation.
Too much focus on reducing reported costs and increasing reported revenues can
lead to a loss of focus on sustainable cost drivers and quality revenue drivers.
1. For example, operating costs can be reduced by cutting maintenance costs
or firing employees needed for next year's operation. This isn't sustainable.
2. Another example is indiscriminately marketing for any kind of customer
who will purchase the product without consideration for the impact that
certain customers can have on selling and administrative expense. This
leads to the accumulation of low-quality customers who drag down overall
profitability.
Practice Question
Part 1 - Section C
The sales manager of Flying Carpets, a carpet manufacturer and wholesaler, is analyzing
the profitability of two of the company's customers. One customer, a boutique store, purchases
small orders for individual clients and often wants a custom-run carpet. The other customer, a
discount retailer, buys large lots of standard carpets. The sales manager is concerned that
providing services for the boutique store is costing more than the contribution margin from its
business. The accountant has gathered the following relevant information for the past year. All
employees are guaranteed a 40-hour work week. Sales representatives are paid $20 per hour, and
the production line supervisor is paid $18 per hour. Employee benefits and human resource
services amount to approximately 50% of hourly wages. The discount retailer picks up large lots
of carpets four times a year. Deliveries to customers of the boutique store must be made as the
carpets are completed.
1. Compute the profitability for each of these two customers.

2. Flying Carpets would like to retain the boutique store as a customer because its clients'
homes are often featured in the local lifestyle magazine and the publicity is free
advertisement. What suggestions can you make for negotiations with the customer about
service costs?
3. If Flying Carpets can replace either customer with other business, what is your
recommendation?
Answer
1. Computation of sales representative costs, including benefits and HR services:
Boutique Store: 60 hours × $20 × 150% = $1,800

Discount Retailer: 24 hours × $20 × 150% = $720
2. Computation of production line supervisor costs, including benefits and HR services:
Boutique Store: 90 hours × $18 × 150% = $2,430

Discount Retailer: 36 hours × $18 × 150% = $972
Part 1 - Section C
3.
4. Flying Carpet could ask that the Boutique Store pay for the additional customer service
costs such as sales representative time, production line supervisor time, and delivery
costs. Flying Carpet could also raise its Boutique Store prices to ensure that the total
product and service costs as a percent of revenues are similar to the discount retailer.
5. If there is another potential customer who can provide more total profit than the Boutique
Store, it's possible that it should be replaced. However, managers at Flying Carpets do not
know whether sales at the discount retailer are affected by the featured homes in the local
lifestyle magazine. Without data about potential losses in sales, it may be risky for Flying
Carpet's strategy to stop serving the Boutique Store.
Summary
Planning, controlling, and evaluating profitability in the open market for a strategic business unit
(SBU) is complicated. The process involves more than simply being profitable on every product
or service sold. SBUs often pursue strategies that involve maturing products or services that are
initially unprofitable, and may also include unprofitable products or services in their business
portfolio because of the complementary nature of these loss leaders. In addition, SBUs should
consider the full cost of their customers. Including costs to serve customers along with the costs
of products or services purchased allows SBUs to compute customer profitability, and work to
effectively manage profitability of customers or customer groups. When establishing
performance measures on profits (or on any other strategic objective), SBUs need to be sure that
the management structure in the organization balances accurate deployment of strategically
connected measures, appropriate levels of incentives, and effective delegation of decision rights.
3.2 Return on Investment and Residual Income
I. Return on Investment (ROI)

A. Remember that responsibility centers include cost centers, revenue centers, profit
centers, and investment centers. In this lesson we discuss classic performance
measures on investment centers. Investment centers are responsible for the
efficient use of capital assets to effectively manage costs and revenues, which
results in profit. The fact that investment centers are responsible for costs,
revenues, and assets means that their management focus is largely aligned with
Part 1 - Section C
the strategic focus of the organization, which is why investment centers are
typically classified as strategic business units (SBUs).
B. The most common performance measure for an organization or SBU is return on
investment or ROI. This measure has been around for a long time and there are a
number of specific versions of this measure. The basic ROI computation, as
suggested by its name, is as follows:
Income ÷ Investment = Return on investment (ROI)
C. Starting with the numerator, there are many ways to define income when

measuring ROI. After-tax net income, as the bottom line of the income statement,
is certainly a valid definition of the ROI numerator. Alternatively, pre-tax income
could be used in the ROI numerator, or operating profit, gross margin, or even
cash flow from operations. Hence, it's important to carefully define exactly what
version of “income” is used in the ROI measure. It all depends on what strategic
performance is being measured for management purposes.
D. Similarly, investment in the denominator has multiple definitions. Typically, total
assets are used in this computation. However, remember that assets = debt +
equity. If the strategic issue is to manage total assets in order to create value that
achieves a particular goal, then return on total assets is the right formulation. On
this basis, the ROI formula is computed as follows:
Income ÷ Total assets = Return on assets (ROA)
1. Alternatively, based on an assumption that generally only long-term debt

and equity require a return on the money employed (i.e., short-term
operating liabilities usually don't carry explicit interest rates), the ROI
formula can be focused on creating value to cover the costs of the long-
term capital employed by the business, and is computed as follows:
Income ÷ (Long-term debt + Equity) = Return on capital employed

(ROCE)
Or
Income ÷ (Total assets - Short-term debt) = Return on capital employed
(ROCE)
2. Another version of ROI is focused on the fact that the true investors in the
organization are the shareholders who have provided equity and expect a
return on their equity investment. If the ROI formula is focused on
measuring the ability of management to capture value after paying all
obligations in order to provide that value to shareholders, then the formula
is computed as follows:
Part 1 - Section C
Income ÷ Equity = Return on equity (ROE)

Or
Income ÷ (Total assets - Total debt) = Return on equity (ROE)
E. The DuPont Corporation is credited with creating the ROI formula, which is why
it is often called the DuPont Equation. However, in the 1920s when the formula
was first employed, DuPont managers didn't limit the formula to a single measure.
The formula was expanded to form what's still known as the DuPont Model or
DuPont Analysis. Consider below an ROI formula based on total assets (ROA)
that demonstrates a DuPont analysis. Note that the ROA formula is separated into
two important components: Profit Margin and Asset Turnover.
1. Of the two components, profit margin is likely the most familiar. This
component of ROA measures the percentage of sales revenue that is
captured as profit. While a large profit margin is certainly good for ROA,
generating a significant profit margin is not necessarily the strategic focus
of all organizations. Some organizations engage the market and their
competition on very thin profit margins. Nevertheless, these organizations
can still generate a healthy ROI performance.
2. Asset turnover is determined above as sales ÷ assets. This ROA
component is based on an assumption that the primary purpose of assets is
to create a volume of business for the organization (i.e., to generate sales).
This component of ROA reports on the number of sales dollars generated
by each dollar invested into assets. Of course, each sales dollar is then
used by the profit margin measure to determine the percentage of that
dollar captured as profit. This means that an organization that can
efficiently churn out (i.e., turn over) a lot of sales dollars from its assets
can still accumulate a significant amount of total profit despite competing
on a thin profit margin percentage.
F. Let's take a look at how a DuPont analysis works with the International
Manufacturing Corporation (IMC) example we've been using in our lessons to
this point. Remember that IMC has three SBUs, which are reported in the DuPont
Part 1 - Section C
analysis below. Consider the ROA measures provided in this report and how they
combine to illustrate the investment center performance for each SBU.
1. Before starting the analysis, note the use of average assets in the
performance report above. Remember that revenue and profit are totals
that accumulate over a period of time while balance sheet numbers
represent a financial position at a single point in time. In order to bring
together numbers from the income statement and the balance sheet, it is
good practice to use the beginning and ending balances from the balance
sheet and create an average balance that (hopefully) represents a
reasonable approximation of the assets available for use throughout the
operating period.
2. It is important not to round off results on profit margin and asset turnover
when using these intermediate numbers to compute ROA.
3. Note that Acme Computer Company and Edison Automobile Company
both provide fairly similar ROA measures (8.35% and 8.30%,
respectively). Yet these two SBUs generated their investment returns
following different performance paths. Compared to Edison, Acme has a
larger profit margin (10.49%), but less turnover on assets ($0.796 in
revenue for every $1.00 invested in assets). On the other hand, Edison
with its lower profit margin is more efficient with the capital investment in
assets compared to Acme, generating $1.220 in revenue for every $1.00 in
assets. Depending on its strategic objectives, its capital structure, and the
nature of its market competition, each of these two SBUs could improve
ROA performance by focusing on either profit margin (reduce costs or
increase sales) or asset turnover (reduce assets or increase sales).
4. The best of the three SBUs is the Jennifer Cosmetics Company with an
ROA of 19.88%, which is based on comparatively strong performance in
both profit margin (9.58%) and asset turnover ($2.076 per asset dollar).
Part 1 - Section C
Clearly, Jennifer is doing very well as an SBU within the IMC

organization.
II. Residual Income
A. Using an ROI measure as a performance evaluation tool can occasionally lead to
decisions by some SBUs that are suboptimal for the overall organization. Let's
take a look at Jennifer Cosmetics Company and consider a scenario wherein
Jennifer management is considering a significant capital investment to expand the
business. The new business will need $52M in additional capital investment
(assets) and is expected to generate $8M in annual profit. This means that the
expansion generates a 15.38% ROA (= $8M ÷ $52M).
1. This 15.38% ROA is a good rate of return for IMC, especially compared
to the returns generated by Acme and Edison SBUs. But the Jennifer
management team may hesitate to take on this new business because its
ROI will dilute the SBU's overall ROA.
2. This dilution effect can be computed. Note that Jennifer's original ROA is
19.88% based on its current income and assets ($34M ÷ $171M =
19.88%). However, when the new business is added to the Jennifer
Cosmetics Company portfolio, the result for the SBU is as follows:
Profit ÷ Assets = ($34M + $8M) ÷ ($171M + $52M) = 18.83% ROA
3. If IMC assesses SBU performance based on ROA, the Jennifer

management team is not likely to take on a 15.38% project that would
boost IMC's overall 10.10% rate of return while diluting their own 19.88%
rate of return. In short, the ROI approach to performance assessment
creates a misalignment in the management structure for high-performing
SBUs with particular investment decisions. This misalignment is
illustrated below.
4. If an SBU's current ROI performance is higher than the minimum

expected ROI for the organization, that SBU will avoid investments
desired by the organization if the ROI is below (i.e., will dilute) the SBU's
current ROI performance. This is an inherent limitation of ROI as a
performance measure within an organization. Let's explore an alternative
measure that avoids this limitation.
Part 1 - Section C
B. In the last lesson we briefly mentioned the concept of cost of capital and residual
income. This can be a rather involved financial issue. The basic concept is that
assets are obtained using debt and equity. Debt financing requires regular
payments based on effective interest rates, and equity financing results in capital
commitments and opportunity costs in the market to satisfy shareholder demands.
These cost commitments can be represented as a combined rate of return required
to cover financing costs.
1. Until an organization earns enough income to pay the costs of its debt and
equity financing structure, it is not really making an economic profit. This
view, representing an economic breakeven concept, can be used to
establish a “hurdle rate” that an SBU, functioning as an investment center,
must clear in order to create economic value (over and above its cost of
capital) for the organization.
2. This hurdle rate is a benchmark for ROI performance and represents the
organization's minimum required ROI. If we assume that IMC has an
economic hurdle rate of 6.5%, then all three of its SBUs are clearing that
hurdle and providing economic value to the organization. However, the
difference between this hurdle rate and each SBU's current ROI represents
a potential misalignment zone.
C. An alternative to the ROI measure is the “residual income” measure, which is
computed as follows (using total assets to represent the capital investment):
Assets × Hurdle rate = Required income

Current income − Required income = Residual income
D. Returning to IMC, let's compute the residual income for each of its SBUs.
In terms of evaluating each SBU's performance, the residual income measure is

consistent with the ROA measure. The Jennifer Cosmetics Company is
significantly outperforming the other two strategic business units.
Part 1 - Section C
E. The real value of using residual income to assess performance is the alignment of
all SBUs with the organization's objective to maximize residual income. Let's
return to the business opportunity being considered by Jennifer Cosmetics
Company and observe that using residual income to assess SBU performance will
encourage Jennifer to take on a project that is good for IMC. Remember that the
expansion available to Jennifer will require $52M in additional assets and will
generate $8M in additional annual profit.
1. First, note that Jennifer's current performance is $22.9M in residual
income. The new business opportunity will generate the following residual
income:
$52M × 6.5% = $3.4M Required income

$8.0M − $3.4M = $4.6 Residual income
2. This $4.6 of additional residual income will improve Jennifer's

performance to $27.5M (= $22.9M + $4.6M). Hence, the Jennifer
management team is motivated to take on a business opportunity that is
good overall for IMC.
III. Comparing ROI and Residual Income
A. Which measure is best to use when controlling and evaluating the performance of
investment centers? Organizations should consider the benefits and limitations of
each measure in the design of their management structure.
B. Return on investment (ROI) measures (including ROA, ROIC, and ROE) are
easily understood by managers and widely used in practice. These types of
measures make it easy to compare performance across different business units.
However, as described above, ROI measures will discourage SBU managers from
investing in certain business projects that are good for the organization if the
project ROI will dilute the SBU's current ROI.
C. Residual income measures avoid the ROI incentive problem on projects with
desirable rates of return that are below the high-performing SBUs’ current rates of
return. However, the concept of capital costs and economic income is a bit more
difficult to understand and communicate than is the ROI concept. In addition,
residual income measures can cause a bias when comparing performance between
different SBUs that are dramatically different in size because larger SBUs will
typically have an inherent advantage in generating more residual income dollars
compared to smaller SBUs.
D. Both ROI and residual income measures are focused on performance involving
costs, revenues, and assets. This focus makes these measures useful for evaluating
the performance of investment centers in organizations. However, this overall
focus also leads to three fundamental concerns with using either ROI or residual
income as the core performance measure on SBUs.
1. First, both of these measures are based on the assumption that costs,
revenues, and assets can be clearly distinguished between business units in
the organization. However, when assets are jointly shared by different
business units or revenues of one business unit are affected by
Part 1 - Section C
performance in another business unit or common costs are shared and

allocated across business units, it can become difficult to clearly
distinguish performance of one business unit from another.
2. Second, accounting policies occasionally shift within organizations and
across economic zones. When this happens, ROI and residual income
measures are affected by modifications in revenue and expense
recognition policies, as well as by adjustments in asset measurement
policies. The result is performance measures that change due to
accounting policy rather than due to actual performance.
3. Finally, financial performance measures such as ROI or residual income
do not provide a full strategic view of business performance. These
measures tend to focus on short-term operating results and are obviously
limited to financial objectives. Management of strategy involves much
more than financial performance indicators. Strategy is a long-term
process of integrating multifaceted objectives involving quality,
timeliness, innovation, service, positioning, throughput, safety, etc. When
performance is focused solely or largely on financial measures, the
imbalance in that limited perspective creates blind spots in management
and limits the organization's success and viability. In another lesson, we
will explore a larger and more integrative model of performance measures
that better supports the management process of planning, controlling, and
evaluating.
Practice Question
Trenton Industries evaluates SBU managers on the basis of ROI. Since the cost of capital for
Trenton is 14%, managers are evaluated on their ability to exceed an ROI of 14%. At the close of
the last quarter, the Sandy Manufacturing Plant had operating income of $1.35 million on total
assets of $7.5 million. The Sandy manager is considering a potential plant investment of $1.5
million that is expected to generate additional income of $240,000.
What does Trenton Industries want the Sandy manager to do with this investment decision?
What will the Sandy manager most likely do with this investment decision?
Answer
Currently, the Sandy Manufacturing Plant ROI = $1,350,000 ÷ $7,500,000 = 18%. The ROI on
the new plant investment = $240,000 ÷ $1,500,000 = 16%. Because the cost of capital for
Trenton is 14%, any return greater than 14% is valuable (optimal) to the company. Trenton
Industries will want the Sandy manager to make this investment.
However, because this investment will dilute Sandy's current ROI performance to 17.67% (see
computation below), the manager will not be inclined to make this investment, which is a
suboptimal decision overall for Trenton Industries.
Sandy's diluted ROI = ($1,350,000 + $240,000) ÷ ($7,500,000 + $1,500,000) = 17.67%

Practice Question
Part 1 - Section C
Continuing with Trenton Industries, assume now that Trenton Industries evaluates SBU
managers on the basis of residual income. Since the cost of capital for Trenton is 14%, managers
are evaluated on their ability to generate income that exceeds the 14% required income level.
Again, the Sandy Manufacturing Plant had operating income of $1.35 million on total assets of
$7.5 million, and the Sandy manager is considering a potential plant investment of $1.5 million
that is expected to generate additional income of $240,000. Based on the residual income
measure, what will the Sandy manager do with this investment decision?
Answer
Currently, the Sandy Manufacturing Plant residual income = $1,350,000 – ($7,500,000 × 14%) =
$300,000. The residual income on the new plant investment = $240,000 – ($1,500,000 × 14%) =
$30,000. Because this investment will increase Sandy's residual income to $330,000, the
manager will be inclined to make this investment, which is an optimal decision overall for
Trenton Industries.
Summary
Investment centers are assigned the responsibility to manage costs, revenues, and assets. These
types of business units are often referred to as strategic business units (SBUs). Performance
measures such as return on investment (ROI) and residual income represent the work by SBUs to
improve profits (revenues and costs) while efficiently using assets. The basic ROI measure is
income ÷ investment. The basic ROI measure can further be expanded to (income ÷ sales) ×
(sales ÷ assets) in order to evaluate profit margin and asset turnover. Residual income is
measured as current income – (assets × hurdle rate). Each measure has benefits and limitations
that need to be understood by management in order to effectively use these tools in planning,
controlling, and evaluating the business.
3.3 The Balanced Scorecard
I. Key Performance Indicators (KPIs)

A. A good way to get a quick sense of an organization's strategy is to look at the key
performance indicators (KPIs) being used to guide decision making and track
progress within the organization. KPIs are not just another term to describe
measures at the organization. Many companies will track thousands of measures
in the process of running the business. KPIs, as the name implies, are a small set
of critical data points that indicate to the executive team and other stakeholders
whether the organization is on track to accomplishing its strategic objectives.
B. Each strategic objective established by company leaders should be identified by
one or two KPIs. For example, if customer satisfaction is a strategic objective for
the company, then below is a list of possible KPIs to represent customer
satisfaction:
 Survey scores submitted by customers
 Type of comments gathered from social media platforms
 Likelihood of customers to recommend the company to friends
 Complaint resolution rates at support centers
 Number of returning customers
Part 1 - Section C
C. As you consider the list of possible measures above, you might wonder which
measure should actually be used to represent customer satisfaction, or you may
consider that all of these measures should be used. Alternatively, you may take a
position that some of these measures don't actually represent customer
satisfaction, or that none of these measures can perfectly represent customer
satisfaction. The questions or concerns you have about the list represent some of
the challenges with designing strategic objectives and selecting KPIs to use in
managing strategy. Company leaders and executive teams run into a number of
challenges in the process of designing and deploying KPIs, including the
following:
 Accurately representing a strategic objective with one or more KPIs

 Essentially abandoning a strategic objective by failing to establish a KPI
for it
 Creating "orphan" KPIs that are not tied to a strategic objective.
 Not adjusting KPIs as the strategy evolves
 Having so many KPIs in the organization that it creates confusion
 Struggling to determine which KPIs are most important in the organization
For the remainder of this lesson, we'll focus on a strategic measurement model
that helps to address these kinds of challenges with KPIs.
2. The Balanced Scorecard Model

A. The Balanced Scorecard (BSC) is a strategic performance measurement model
that came into practice in the 1990s. The initial design of the BSC is to support
for-profit organizations based on four connected strategy perspectives or themes
(BSC models have been subsequently developed to effectively support not-for-
profit organizations). These four themes are illustrated in the BSC model
presented below. Note that at the center of the BSC is the organization's strategic
vision and strategic mission. In an earlier section of this learning series, we
defined the organization's vision as a statement of what it intends to be or
become while the mission is the core statement of what the organization
intends to do.
Part 1 - Section C
 The financial perspective in the BSC is where the organization's vision

and mission are translated into financial performance. Identifying how
financial performance should be tied to an organization's vision and
mission is a matter of answering the question: “How do we look to our
shareholders?” The organization needs to identify why exactly their
particular shareholders have invested in the company. For example, are
they looking for diversification, market share and revenue growth,
earnings, or dividend payments? Identifying what the shareholders are
expecting from their investment will define the types of financial
performance measures that should be established for the organization.
 The customer perspective is focused on answering the question: “What do
our customers value?” The competitive concept here is often described as
delivering “value-added” products and services to customers. If asked,
customers generally respond that they're interested in receiving all kinds
of value, such as low price, high quality, innovative design, timely
delivery, excellent post-sale support, etc. However, the key to
understanding what customers truly value is identifying what value
customers are willing to pay for. Clearly defining and focusing on the
value that customers will pay for establishes a sustainable relationship
with customers and provides a key connection between the customer
perspective and the financial perspective in the organization's BSC.
 The internal perspective in the BSC is also known as the internal process
perspective. Successfully answering the strategic question, “At what
business processes must we excel?” depends on how the organization's
internal processes are tied to successfully delivering on the customer
perspective. Generally, there are three types of internal processes that can
potentially establish value that customers will pay for: research and
development (or innovation), production and delivery, and post-sale
Part 1 - Section C
service or support. Think about various companies where you spend

money. You should be able to easily define the internal process that you
value at each company. Is it the innovation of the product (or service)
design? Is it the quality and/or price of the product delivered to you? Or is
it the dependability of the company's support of the product once you've
received it?
 The most foundational perspective in the BSC is the learning perspective,
also known as the learning and growth perspective. However, compared to
the financial, customer, and internal process perspectives, the learning and
growth perspective is often the least developed aspect of the organization's
strategic performance measurement model. Answering the question: “How
do we sustain change and progress?” is about identifying the key areas to
be improving in order to support key internal processes and key customer
values. One obvious area of learning and growth is employees, but this
perspective isn't limited to employee development. The other two
traditional areas for learning and growth are systems (computers,
communication, security, etc.) and management structure (measures,
incentives, decision rights, etc.).
B. Before moving on, we need to emphasize one other aspect of the BSC model.
Note within each perspective is a deployment list that includes objectives,
measures, targets, and initiatives. The order here is intentional. Within each
perspective the organization must first establish a clear set of actionable strategic
objectives that answers the key strategic question for each perspective. With the
strategic objectives in place, the organization then designs one or more measures
(i.e., KPIs) to capture progress on each objective. Before the start of each
operating period, the target or goal for each measure is determined. Finally,
initiatives are put in place (i.e., resources are committed) to accomplish the target.
Using these four steps, the organization's strategy is operationalized through the
BSC.
3. The Balanced Scorecard Strategy Map
A. Perhaps the most important aspect of a successful BSC is establishing links
between strategic objectives through interconnected strategic measures. The
“balance” in a good BSC model is the idea that no single strategic objective or
strategic measure (KPI) is more important than another. Each objective and
measure is designed to follow from and/or lead to another objective and measure.
Designing and deploying a successful strategy is very much about “hypothesis
testing.” That is, management determines that success in a particular financial
objective requires effective deployment of core customer objectives that are
dependent upon implementation of critical internal processes that are sustained by
ongoing learning and growth initiatives. If management is right about the strategic
linkages they establish in the BSC, the organization should succeed.
B. It is difficult to demonstrate these critical linkages between strategic objectives
and between KPIs using the classic BSC model illustrated above. Therefore, a
different perspective is needed—the BSC strategy map. Let's return once more to
the IMC example and look at a possible BSC strategy map for the Acme
Computer Company (below).
Part 1 - Section C
 First of all, note how Acme Computer Company has stated a response to
each of the questions that define each of the four BSC perspectives. These
statements represent the strategic objective for each perspective.
 Next, observe that two or three KPIs have been established to represent
each objective in the management structure at Acme. For example, the
three measures in the Internal Perspective should clarify how Acme
intends to accomplish its objective to achieve innovation in rugged
hardware technology and low cost production.
 Finally, and perhaps most importantly, you can see arrows linking
measures together that represent hypotheses about cause-and-effect
relationships in the Acme strategic plan. For example, one set of
connected relationships represent the Acme belief that increasing the
number of employees who participate in the ESOP (employee stock
ownership plan) will reduce employee turnover. This is important because
experienced employees are better positioned to find and deliver
improvements in production throughput, which reduces production costs
and increases residual income. These connections are rigorously tested by
gathering performance data and observing whether relationships between
strategic objectives and KPIs are demonstrated.
4. Implementing a Balanced Scorecard
Part 1 - Section C
A. The process of implementing a BSC can be (and should be) an elaborate process,
especially if the effort also involves designing and implementing the
organization's strategy. The BSC implementation process starts with the
leadership team working to clarify the organization's vision and mission into a
strategy that can be communicated as an actionable statement(s) to all key
stakeholders (employees, investors, suppliers, etc.).
B. Next, the leadership team drafts out a balanced scorecard and strategy map to
introduce to middle management supervisors. This is a key communication
process that is focused on generating feedback to refine the BSC and obtain buy-
in from the managers who will be working daily with operations and employees
to accomplish the strategic objectives.
C. When ready, an implementation team is established composed of a cross-
functional representation of key leaders, managers, and front-line employees. This
team handles the front-line issues involved in a significant change management
process for the organization. Specifically, the implementation team works to
further refine the BSC as needed to accommodate implementation, design and
deploy the marketing campaign through the organization, and execute and guide
training events.
D. While the implementation team is engaged in rolling out the change process, the
leadership team takes on the particularly sticky challenge of identifying and
eliminating nonstrategic investments (product lines, business units, customer
groups, etc.) in the organization. This realistic task represents the truth that
strategy is as much about determining what to stop doing as it is deciding what to
start or keep doing.
E. While eliminating nonstrategic investments, the leadership team also works to
realign the organization to tightly focus on the strategic objectives and KPIs
represented in the BSC. This effort involves identifying how each business unit,
department, team, and individual in the organization relates to one key aspect or
another of the BSC. Of course, this realignment effort is done in concert with the
implementation team's campaign and training events.
F. If eliminating nonstrategic investments in the organization is the hardest aspect of
implementing a new strategy and BSC, the second hardest aspect is adjusting
incentives and compensation. Remember from a previous lesson that management
structure is a three-legged stool composed of measures, incentives, and decision
rights. If one leg of the stool is adjusted, the other two must be adjusted as well. A
BSC realignment certainly requires new performance measures as well as new
responsibility and reporting structures. That being said, until compensation and
incentives are adjusted to support the new strategic focus, little will actually
change in the organization. Significant changes to compensation systems almost
always encounter significant resistance at all levels in the organization.
Leadership will need to establish compensation transition processes while the
implementation team educates everyone on the new incentive system.
G. Remember that designing strategic objectives and KPIs is very much about
hypothesis testing. Objectives, measures, and linkages between measures will
never be perfect. Data gathering, feedback, and refining is an ongoing process.
Implementing a balanced scorecard must be viewed as a learning process. Hence,
Part 1 - Section C
the last step of implementation is a commitment to constantly test strategic

assertions with data while gathering feedback from employees and working to
better design and deploy a scorecard that effectively guides decision making and
operation processes in a constantly evolving business environment.

Practice Question
Eastern Ensign Bank is a community bank that focuses on small business commercial loans. Its
vision is to be the most valued banking partner in the local business community. Its mission
statement is “Creating lending solutions that work for individual needs.” The bank partners at
Eastern Ensign are committed to creating a balanced scorecard solution to guide strategy and
have worked through the four BSC perspectives to craft an answer for each key question. These
questions and answers are below:
Financial Perspective
Question: How do we look to our partners? Answer: Growth in returns on partner investments.
Customer Perspective
Question: What do our customers value? Answer: Personalized service and excellent results that
earn client loyalty.
Internal Process Perspective
Question: At what business processes must we excel? Answer: Fast lending solutions that are
the beginning of a client relationship.
Learning and Growth Perspective
Question: How do we sustain change and progress? Answer: Continuous professional
development that leads to happy employees.
Working with their management team, the partners have identified the following ten KPIs:
 Return on Partner Equity (ROE)

 Lending Income (monthly)
 Loan Portfolio Growth (quarterly percentage growth)
 Client Promotion Score (survey on likelihood of clients to recommend bank to
colleagues)
 Client Loan Satisfaction (survey score)
 Number of Customer Solutions (created for clients)
 Number of Client Touch Points (personally connecting with client to acknowledge
business events, family celebrations, etc.)
 Loan Processing Speed and Accuracy (a combined score based on days to fund loan and
loan errors)
 Employee Satisfaction (survey score)
 Number of Employee Training Events
Part 1 - Section C
Guided by the partners’ question and answer for each BSC perspective, consider the KPIs listed
above and decide where to locate each KPI within the BSC perspectives. Then build a BSC
strategy map that demonstrates linkages between KPIs. (Note: This is a subjective exercise.
Make your best assumptions about where to locate each KPI and how it links to other KPIs, and
then compare your solution to the solution provided.)
Answer
Remember that this is a subjective solution. For example, the KPI “Custom Solutions” could be
located within the Internal Process perspective rather than within the Customer perspective. Be
sure to review through each KPI's position in the BSC Strategy Map and how it is being linked
from and to other KPIs to determine if the choices in this solution make sense to you.
Summary
Key performance indicators (KPIs) are an essential tool in designing and deploying strategy
within an organization. The Balanced Scorecard (BSC) model provides an effective approach to
guide the development and use of KPIs. The BSC model is generally based on four strategic
perspectives: financial, customer, internal process, and learning and growth. KPIs should be
associated with a specific BSC perspective. Just as importantly, managers need to carefully
consider and map out how KPIs are related to each other as a set of strategic linkages (i.e., cause-
and-effect relationships). Implementing a BSC model and strategy map across an organization is
an involved process that requires careful development, organization realignment, cross-
Part 1 - Section C
functional participation, employee training and buy-in, compensation restructuring, and

continuous feedback and refinement.

1.1 Flexible Budgets and Performance Analysis: Part 1 - Section C Performance Management

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1.1 Flexible Budgets and Performance Analysis: Part 1 - Section C Performance Management

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Part 1 - Section C

1.1 Flexible Budgets and Performance Analysis

I. Managing the Organization

1. Operational planning is where the strategy is defined into operational

1. The most important factor in a flexible budget is that it is based on the

Total costs=Variable costrate(Activity volume)+Total fixed costs

Cost Type Cost Formula

Heather variable costs: $387,200

 Variable cost per DLH = $0.50 + $1.25 + $18.00 = $19.75 per DLH

Master Budget Variance Analysis

Flexible Budget Variance Analysis

1.2 Management by Exception and Sales Revenue Variances

I. Variance Frameworks and Variance Formulas

1. As you can see, the framework clearly distinguishes between quantities

Actual quantity×(Standard price−Actual price)=Price variance

2. For the quantity variance, the formula is as follows:

(Standard quantity−Actual quantity)×Standard price=Quantity variance

 Note in the structure of these formulas that the source of the

1. The formula approach for the sales price variance is as follows:

Actual volume×(Standard price−Actual price)Classic:150boats×($4,200−

2. Note that the computational solution for Classic boats is actually a

1. The formula approach for the sales volume variance is as follows:

(Expected volume−Actual volume)×Standard priceClassic:

2. Again, remember that these computations are reported as absolute values.

E. Using the framework approach, we can recompute Sunbird's sales volume

1. The total sales volume variance measured in standard contribution margin

(Expected volume−Actual volume)×Standard CM=Sales volume

2. Again, most organizations prefer to measure the sales volume variance in

to be measured in order to control and evaluate sales volume operations at

3. Using the framework approach, we compute the sales mix variance as

Total actual volume×(Expected mix%−Actual mix%)×Standard

2. The formula approach for the sales quantity variance is as follows:

(Total expected volume−Total actual volume)×Expected mix%×Standard

a. Sales price variance

a. Sales price variance

Sales price variance=Actual volume×(Standard price−Actual

b. Sales volume variance

Standard contribution margin per pound for Heather:$20.00−

c. Sales mix variance

30,000pounds÷42,000pounds=71.43% expected sales mix

o Sage sales mix percentages (don't round off these percentages):

12,000pounds÷42,000pounds=28.57%expected sales mix

Sales mix variance=Total actual volume×(Expected mix%−Actual mix

d. Sales quantity variance

Sales quantity variance=(Total expected volume−Total actual volume)×Expected

1.3 Direct Material and Direct Labor Cost Variances

I. Standard Cost Systems

II. Direct Materials Cost Variances

B. The approach we followed in the previous lesson to compute revenue variances

1. The best management approach to successfully control and evaluate costs

1. The formula approach for this variance is as follows:

Actual quantity purchased × (Standard price - Actual price)

2. If Sunbird management chooses to compute the price variance on the

Actual quantity used × (Standard price − Actual price)

(Standard quantity allowed − Actual quantity used) × Standard price

2. Direct Labor Cost Variances

Actual quantity × (Standard rate − Actual rate)

(Standard hours allowed − Actual hours used) × Standard rate

 Mix and Yield Cost Variances

boats produced. Combined, Sunbird used a total of 7,425 hours to build

4. This mix variance is favorable (F) because Sunbird's actual mix of

Total actual quantity × (Standard mix% − Actual mix%)× Standard rate

2. The formula approach for the labor yield variance is as follows:

(Total standard qty allowed− Total actual qty) × Standard mix% ×

Compute the following variances for the Sage product.

1. Direct materials price variance

3. Direct materials mix variance

7. Direct materials price variance

Direct materials price variance = Actual volume × (Standard price −

8. Direct materials usage variance

Based on the standard number of ounces reported in the standard cost

Direct materials usage variance = (Standard quantity allowed − Actual

9. Direct materials mix variance

Faircloth purchased and used a total of 176,800 ounces of direct materials

direct materials, which is computed as (6.00 standard ounces + 12.00

Zyph mix percentages (don't round off these percentages):