Internal Control

Management 122
Michael Williams

Variances
After the accounting period is over, we need
to learn what went well and what went poorly.
We need a baseline of comparison.
We can use the original budget as a baseline.
By comparing actual results to budget, we
can identify potential problems to investigate.
We refer to the differences in the two reports
as variances.
Variances that boost profit are called
favorable and those that reduce profit,
unfavorable.

Flexible budget
The original budget was made in ignorance
of actual volume.
A given cost could exceed budget either due
to wastefulness or simply because volume
was high.
To separate these effects, we can construct a
flexible budget.
The flexible budget adjusts the original
budget to reflect true volume. Revenue and
variable costs are adjusted appropriately.

Use of flexible budget

By comparing actual costs to flexible budget
costs, we can identify variances that might be of
concern.
We refer to these variances as basic cost
variances.
Two additional variances of note are sales
volume and sales price variances.
Sales price variance is actual revenue
flexible budget revenue.
Sales volume variance is flexible budget profit
minus original budget profit.

Key identity
The following will always be true:

Actual profit budgeted profit =

Sales volume variance +
Sales price variance +
Sum of all basic cost variances.
Thus, all the variances collectively explain
why we earned a different profit than
expected.

Williams Citrus Co.

Budgeted

Actual

4,000

4,500

300

400

Labor (V)

1,200

1,300

Land rent (F)

2,000

2,400

Citrus tax (V)

200

300

3,700

4,400

300

100

5,000

6,000

Revenue
Materials (V)

Total cost
Profit
Pounds of oranges

Decomposing variances
A variance can be ambiguous as to its cause.
We need to know why a variance is favorable or
unfavorable.
It is often useful to decompose variances into
components.
Two contexts for this are cost and sales volume
variance.

Production variances
This is useful for variable costs with measurable inputs:
Materials (e.g., tons)
Labor (e.g., hours)

There are three reasons the cost will vary from budget:
Production volume
Utilization of the resource
Price of the resource

To identify which of these effects are present, we first

need standards for utilization and price.

Production variances (cont.)

Actual

Budgeted

Volume of production output

Va

Vb

Usage of input per unit of output

Ua

Ub

Price per unit of input

Pa

Pb

Actual

Super-flexible budget

Flexible budget

Budget

Va x Ua x Pa

V a x U a x Pb

Va x Ub x Pb

Vb x Ub x Pb

Price variance

Volume variance
Efficiency variance

The efficiency variance is the most controllable

as it can identify wasted resources.

Marketing variances
I = industry volume
S = company's share of the industry
Actual volume

Expected volume

Budgeted volume

Ia x Sa

Ia x Sb

Ib x Sb

Market share

Industry volume

Multiply by budgeted Mb.

Industry volume is outside your control.
Market share is controllable, so this is an
important variance.

Marketing variances (cont.)

V = company's total volume
Si = product i's share of the company's volume
Actual volume
of product i

Expected volume
of product i

Budgeted volume
of product i

Va x Sia

Va x Sib

Vb x Sib

Sales mix

Sales quantity

Multiply by Mib.
Add up values for all products to get the variance.

Sales mix variance

Calculate if
Selling multiple products
Products have significantly different contribution
margins
Product volumes are comparable
Products are demand substitutes
Cannibalism is likely

If unfavorable, two interpretations:

Low margin products are cannibalizing high
margin products
Salespeople are emphasizing the wrong products

Variance investigation
Costs

Benefits

Time spent on investigation

Efficiency

Testing costs

High quality

Lost production

Proper incentives

Costs of making changes

Types of variances:
Information system variances
Random variances
Controllable operating variances

Variance investigation
Threshold approach:
Determine Probability of type 3 (P3) for each
variance
Set threshold based on P3 (high if P3 is low)
Adjust threshold for the costliness of investigating
Investigate if variance exceeds threshold

Trading off materiality, controllability, and

prescriptive ambiguity