Chapter Twenty-Two: Tools for Enterprise Performance Evaluation
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The questions and problems accompanying this text serve as a self-test to help identify areas where a student’s understanding is not clear. They provide feedback on areas where additional study is needed. Such “performance evaluations” are an important part of managing and improving one’s education. Clearly, professors rely on some form of performance evaluation in assigning grades. Through this feedback method students are able to sense areas of strength and weakness. The method also provides a key “motivator” to study and learn. Excellent students are rewarded. Poor students are signaled to work harder or consider alternative fields of study. Performance evaluations can sometimes seem harsh, but are generally viewed as necessary in striving toward an end result. Businesses must also adopt performance evaluation methods.
Earlier chapters focused on techniques used for costing products and services, understanding cost behavior, budgeting, and so forth. These basic tools and techniques are essential to a well-managed organization. But, one must also be mindful that managers must be held accountable for the results of their decisions and related execution. Without performance-related feedback, the business will not perform at its best possible level, and opportunities for improvement may go unnoticed or unrealized.
Given that managers must be held accountable for decisions, actions, and outcomes, it becomes very important to align a manager’s area of accountability with his or her area of responsibility. The “area” of responsibility can be a department, product, plant, territory, division, or some other type of unit or segment. Usually, the attribution of responsibility will mirror the organizational structure of the firm. This is especially true in organizations that have a decentralized approach to decision making.
Sometimes by plan, and sometimes simply as a result of top management’s leadership style, an organization will tend to gravitate to either a centralized or a decentralized style of management. With a centralized style, the top leaders make and direct most important decisions. Lower-level personnel execute these directives but are generally powerless to independently make policy decisions. A centralized organization is benefited by strong coordination of purpose and methods, but it has some glaring deficiencies. Among these are the stifling of lower-level managerial talent, suppression of innovation, and reduction in employee morale.
Many successes have occurred in highly decentralized organizations. Top management concentrates on strategy and leaves the day-to-day operation and decision-making tasks to lower-level personnel. This facilitates rapid “front-line” response to customer issues and provides for identifying and training emerging managers. It can also improve morale by providing each employee with a clear sense of importance that is often lacking in a highly centralized environment. Decentralization can prove a fertile ground for cultivating new and improved products and processes.
A decentralized environment results in highly dispersed decision making. As a result, it is imperative to monitor and judge the effectiveness of each manager. This is easier said than done. Not all units are capable of being evaluated on the same basis. Some units do not generate any revenue; they only incur costs in support of some necessary function. Other units that deliver goods and services have the potential to be assessed on the basis of profit generation.
As a generalization, the part of an organization under the control of a manager is termed a responsibility center. To aid performance evaluation it is first necessary to consider the specific character of each responsibility center. Some responsibility centers are cost centers and others are profit centers. On a broader scale, some are considered to be investment centers. The logical method of assessment will differ based on the core nature of the responsibility center.
Obviously most business units incur costs, so this alone does not define a cost center. A cost center is perhaps better defined by what is lacking; the absence of revenue, or at least the absence of control over revenue generation. Human resources, accounting, legal, and other administrative departments are expensive to support and do not directly contribute to revenue generation. Cost centers are also present on the factory floor. Maintenance and engineering fall into this category. Many businesses also consider the actual manufacturing process to be a cost center even though a saleable product is produced (the sales “responsibility” is shouldered by other units).
It stands to reason that assessments of cost control are key in evaluating the performance of cost centers. This chapter will show how standard costs and variance analysis can be used to pinpoint areas where performance is above or below expectation. Cost control should not be confused with cost minimization. It is easy to reduce costs to the point of destroying enterprise effectiveness. The goal is to control costs while maintaining enterprise effectiveness. Nonfinancial metrics are also useful in monitoring cost centers: documents processed, error rates, satisfaction surveys, and other similar measures can be used. The concept of a balanced scorecard is discussed later in this chapter, and it can be very relevant to evaluating a cost center.
Some business units have control over both costs and revenues and are therefore evaluated on their profit outcomes. For such profit centers, “cost overruns” are expected if they are coupled with commensurate gains in revenue and profitability.
A restaurant chain may evaluate each store as a separate profit center. The store manager is responsible for the store’s revenues and expenses. A store with more revenue would generate more food costs; an assessment of food cost alone would be foolhardy without giving consideration to the store’s revenues. For profit centers, the flexible budgets discussed in this chapter are useful evaluative tools. Other techniques include a unit-by-unit profitability analysis using traditional financial statement ratios.
At higher levels within an organization, unit managers will be held accountable not only for cost control and profit outcomes, but also for the amount of investment capital that is deployed to achieve those outcomes. In other words, the manager is responsible for adopting strategies that generate solid returns on the capital he or she is entrusted to deploy. Evaluation models for investment centers become more complex and diverse. They usually revolve around calculated rates of return.
One popular method was pioneered by E. I. du Pont de Nemours and Company. It is commonly known as the DuPont return on investment (ROI) model and is pictured at right. This model consists of a margin subcomponent (Operating Income ÷ Sales) and a turnover subcomponent (Sales ÷ Average Assets). These two subcomponents can be multiplied to arrive at the ROI. A bit of algebra reveals that ROI reduces to a simpler formula: Operating Income ÷ Average Assets.
A prudent manager who is to be evaluated under the ROI model will quickly realize that the subcomponents are important. ROI can be improved by increasing sales, reducing expenses, and/or decreasing the deployed assets. The DuPont approach encourages managers to focus on increasing sales, while controlling costs and being mindful of the amount invested in productive assets. A disadvantage of the ROI approach is that some “profitable” opportunities may be passed by managers because they fear potential dilution of existing successful endeavors.
Lower-level managers may only be responsible for a small subset of business activities. As such, they should only be held accountable for results of their specific business unit. As one moves higher within the organizational chart, mid- and upper-level managers naturally assume ever greater degrees of responsibility. The reporting system should mimic the expanded scope and develop information that reveals the performance for all units within the nexus of control of a particular manager. At successively higher steps, individual performance reports are combined to reveal the success or failure of all activities beneath a particular manager. This can result in one manager being held accountable for a combination of cost, profit, and investment centers. A keen manager must be familiar with the specific techniques for managing and gauging the success of each.
Out to Lunch is a rapidly growing fast-food restaurant chain. Its business model revolves around a uniquely flavored hamburger and a very simple menu consisting of a hamburger, fries, and drinks. It provides simple “round number” pricing, few products, and rapid service. Out to Lunch also has a catering service for sporting events, corporate outings, and similar occasions.
Following is an organization chart for Out To Lunch. The block colors in the organization chart indicate the character of performance/responsibility evaluation that is germane to each position. The Chief Executive Officer reports to the owners, and the owners are primarily interested in their return on investment. Three vice presidents report to the CEO:
- The VP of Operations is responsible for the overall investment in operations, which is driven heavily by the combined profits of each store. The VP of Operations oversees procurement, store management, and catering management. The Procurement Manager oversees purchasing of food and dishware. These activities are evaluated as cost centers, relying on budgets and standard costs to control activities. The Store and Catering managers oversee supervisors from each location. These managers are responsible for producing profits and are evaluated accordingly.
- The VP of Finance is viewed and evaluated as a cost center.
- The VP of Real Estate is responsible for site acquisition and construction. Although the activities are largely viewed in the context of a cost center, there is an expected rate of return for each new real estate investment. Therefore, the VP of Real Estate is evaluated for cost control and return on investments.
A company’s accounting system should support preparation of an accounting report for each responsibility center. This information is essential to monitor, control, and direct each business unit. Oftentimes, the reports will provide a comparison between budgeted and actual data, with the difference being reported as a variance. These reports should be consistent with the organizational structure of the firm. At higher levels, the reports tend to include less transaction-specific detail and more combinations of business units. For Out to Lunch, each store may have a customized performance report as shown:
Location A’s performance report provides a basis for analysis of numerous facets of the business. Graphics can be used to facilitate understanding. For example, each store supervisor knows that fries and drinks have the highest profit margins and is encouraged to train employees to sell these items by asking customers “what type of drink did you prefer?” As a result, the report is “specialized” to show the product mix proportions. In addition, each manager gets a bonus if food costs are below 20% of sales. This incentive is designed to reduce food waste and encourage sales of high-margin products. The report provides detail to show if the objectives are met. Notice that unfavorable variances are highlighted in red. Location A did not meet the budgeted goal for hamburger sales. But, the profit objectives were nevertheless exceeded because the product mix of fries and drinks produced offsetting higher margins. Location A also managed to contain other variable costs.
The next step up in the organizational chart is the Senior Manager of Store Operations. This person is concerned with making sure that each unit is profitable. Underperforming stores are identified, problems are studied, and corrective measures are taken. Very little time is spent on locations that are meeting or exceeding corporate profit goals. Although this manager has access to the detailed reports for each store, the performance report of interest is a compilation of summary data for each location that quickly highlights the areas of needed improvement. Review the following performance report, noting the carry forward of Location A’s data into the report. Obviously, some stores are performing much better than others. The senior manager will certainly want to focus on store E immediately! Also notice that there is $1,500,000 of fixed costs associated with store operations that is not traceable to any specific location; nevertheless, the senior manager of store operations must control this cost, and it is subtracted in calculating the overall margin. Thus, the total fixed cost for all store operations is $9,500,000 ($8,000,000 + $1,500,000).
Continuing up the organizational chart, the VP of Operations will focus on summary data from store, catering, and procurement management. Notice that the “stores” column is derived from information found in the “combined” column (from the performance report for all stores). Again, note the presence of fixed costs that are not traceable to any specific operating segment ($1,300,000). Even though this cost is not assigned to a specific segment, it remains a cost for which the VP of Operations is responsible.
The CEO would have access to all reports from within the organization, but would mostly focus on reports emanating from each vice president. Management will tend to focus on areas where corrective measures are necessary. This is generally referred to as management by exception.
The preceding reports separated fixed expenses between those that were traceable to a specific business unit and common fixed costs. Traceable fixed costs would not exist if the unit under evaluation ceased to exist. Common fixed costs support the operations of more than one unit. Great care must be taken in distinguishing between the two. Effective performance evaluations require a clear alignment of responsibility and accountability. To the extent a unit manager is burdened with allocations of common costs, poor signaling of performance can result.
The illustrated reports are useful, but do suffer from a limitation. It is sometimes difficult to “mine data” pertinent to a specific inquiry. For example, if the VP of Operations wanted to know the overall corporate sales mix (hamburgers:fries:drinks), a specific request would be initiated to the store and catering managers. Each manager would need to gather individual reports from each location and develop a combined report to channel back up to the VP. This is very inefficient and may have the undesirable outcome of forcing management to make decisions based on incomplete information. Increasingly, companies are developing customized electronic database systems that capture data and store it in such a way as to enable accurate and real time retrieval of information relevant to an almost endless number of potential questions.
The previous chapter provided a comprehensive budget illustration using a static budget. The static budget is one that is developed for a single level of activity. It is very useful for planning and control purposes.
However, there is a potential shortcoming in using static budgets for performance evaluation. Specifically, when the actual output varies from the anticipated level, variances are likely to arise. These variances can be quite misleading.
The genesis of the problem is that variable costs will tend to track volume. If the company produces and sells more products than anticipated, one would expect to see more variable costs (and vice versa). Presumably, it is a good thing to produce and sell more than planned, but the variances resulting from the higher costs can appear as a bad thing! The opposite occurs when volume is less than anticipated.
To illustrate, assume that Mooster’s Dairy produces a premium brand of ice cream. Mooster’s Dairy uses a static budget based on anticipated production of 100,000 gallons per month. Cost behavior analysis revealed that direct materials are variable and anticipated to be $1 per gallon ($100,000 in total), direct labor is variable and anticipated to be $0.50 per gallon ($50,000 in total), and variable factory overhead is expected to be $1.50 per gallon ($150,000 in total). Fixed factory overhead is planned at $205,000 per month. The monthly budget for total manufacturing costs is $505,000, as shown in the budget column below.
July of 20X9 was hotter than usual, and Mooster found itself actually producing 105,000 gallons. Total factory costs were $513,000. Mooster’s July budget versus actual expense analysis reveals unfavorable variances for materials, labor, and variable factory overhead. Does this mean the production manager has done a poor job in controlling costs? Remember that actual production volume exceeded plan. At a glance, it is challenging to reach any conclusion. What is needed is a performance report where the budget is “flexed” based on the actual volume.
The flexible budget reveals a much different picture. Rather than incurring $8,000 of cost overruns as portrayed by the variances associated with the static budget, one can see that total production costs were $7,000 below what would be expected at 105,000 units of output. On balance, it appears that the production manager has done a good job.
Specifically, direct materials cost exactly $1.00 per gallon of output. Direct labor totaled $500 in excess of the plan amount of $52,500 (105,000 units X $0.50 = $52,500), resulting in an unfavorable labor variance. This could be due to using more labor hours, paying a higher labor rate per hour, or some combination thereof. The variable factory overhead was expected at $157,500 (105,000 units X $1.50 per unit = $157,500), but actually cost only $155,000. Fixed factory overhead was $5,000 less than anticipated.
The flexible budget responds to changes in activity and generally provides a better tool for performance evaluation. It is driven by the expected cost behavior. Fixed factory overhead is the same no matter the activity level, and variable costs are a direct function of observed activity.
When performance evaluation is to be based on a static budget, there is very little incentive to drive sales and production above anticipated levels because increases in volume tend to produce more costs and unfavorable variances. The flexible budget-based performance evaluation provides a remedy for this phenomenon.
The flexible budget illustration for Mooster’s Dairy was prepared after actual production was known. While this tool is useful for performance evaluation, it does little to aid advance planning. But, flexible budgets can also be useful planning tools if prepared in advance. For instance, Mooster’s Dairy might anticipate alternative volumes based on temperature-related fluctuations in customer demand for ice cream. These fluctuations will be very important to managers as they plan daily staffing and purchases of milk and cream to support the manufacturing operation. As a result, Mooster’s Dairy might prepare an advance flexible budget based on many different scenarios.
The following flexible budget reveals the expected aggregate expense levels. In reality, supporting flexible budget documents would resemble the comprehensive budget documents portrayed in the prior chapter. Such comprehensive documents would provide the information necessary to manage the smallest of operating details that must be adjusted as production volumes fluctuate.
It perhaps goes without saying that computers are most helpful in preparing budget information that is easily flexed for changes in volume. Indeed, even the preparation of the very simple illustrative information for Mooster’s Dairy was aided by an electronic spreadsheet. Businesses save millions of dollars in accounting time by relying on computers to aid budget preparation.
But, this savings is inconsequential when compared to the production efficiency and inventory savings that results from using computerized flexible budgeting tools. As production volumes ramp up and down to meet customer demand, computerized flexible budgets are adjusted on a real-time basis to send signals throughout the modern organization.
Selected information may also be shared with a business’s suppliers and customers via electronic data interchange. The net result is that the supply chain is immediately adjusted to match raw material orders to actual production levels, thereby eliminating billions of dollars of raw material waste and scrap.
Budgets deal with total expected costs. But, as with Mooster’s Dairy, these overall estimates are based upon fundamental assumptions about standard quantity and cost of inputs required in producing a single unit of output. Recall for Mooster: “. . . direct materials are variable and anticipated to be $1 per gallon ($100,000 in total), direct labor is variable and anticipated to be $0.50 per gallon ($50,000 in total), and variable factory overhead is expected to be $1.50 per gallon ($150,000 in total).”
Standards are the predetermined expectations of the inputs necessary to achieve a unit of output. Standard costs provide an assessment of what those inputs should cost. Standards are important ingredients in planning and controlling a business. They influence the budget preparation process. They are also integral to the assumptions needed for proper cost-volume-profit analysis discussed in an earlier chapter. Standards can also be used in pricing goods and services.
For example, a car repair is likely based on an hourly rate applied to a standard number of hours for the job. In a restaurant, managers set standards for how many tables must be “turned.” The bus staff is allowed only so much “breakage.” Virtually every business has a similar set of standards. In a traditional manufacturing environment, a unit of finished goods is decomposed into its components to determine how much raw material, labor, and overhead is necessary to produce the item. These component quantities are then considered in terms of what they should cost.
The decision about the quantity and cost of productive components is more complex than it may seem. If one were building a new home, how much sheetrock (wall board) would be needed for the job? In calculating the quantity, one would begin with the overall wall dimensions and back out the area for windows and doors. But, one would also realize that some of the cutouts for windows would result in useless scrap material. In addition, it is inevitable that some material will be damaged or cut in error.
In estimating the quantity of material, one would need to provide for such elements. Determining the right quantity of sheetrock is much like setting standards in a business environment. Standard setters need to understand waste, spoilage, evaporation, and other characteristics that consume raw materials. Standard setters need to be mindful of how much time it takes to perform certain tasks, remembering that humans will make mistakes and need time to correct them. Humans must also have periods of rest.
Standards are applicable to manufacturing and nonmanufacturing tasks. Even the accountants who are seen as the monitors of standards are themselves subject to standards. An auditor may be allowed a certain number of hours to audit payroll, verify a bank reconciliation, and so forth. Without standards, the tasks may expand in scope and time, beyond what is prudent or necessary.
Although performance reports may be prepared by managerial accountants, the standards themselves should originate with personnel who best understand the productive process. These personnel should develop standards that are based on realistic information derived from careful study of business processes. For example, an industrial engineer may engage in time and motion studies to determine the appropriate amount of time to complete a given task. Past data may be used to provide realistic measures of the raw material quantity that is needed to complete a finished unit.
Some standards are based on averages; total estimated costs are divided by total estimated output or activity. For example, standard variable overhead can be determined by dividing estimated variable overhead by the estimated activity level for the upcoming period. Likewise, fixed standard per-unit overhead would be determined by dividing estimated fixed overhead by the estimated activity level.
Standards can be set very tight, allowing almost no room for waste or rest. Or, management may adopt a more realistic set of standards that are within reach. After all, standards are somewhat like goals. In playing a round of golf, most players will see “par” as a benchmark against which to compare a score; realistically, few players expect to achieve “par” on a consistent basis. Nevertheless, it constitutes a standard. At other times, golfers will calculate their “handicap” to determine a target score they plan to shoot on a given round of golf. This is also a standard, but one that is expected to be achieved. In setting standards within a business environment, management needs to consciously consider the level of standards to adopt:
- Achievable standards are realistically within reach. Such standards take into account normal spoilage and inefficiency. Such standards are intended to allow workers to reach the established benchmarks.
This level of standard provides a clear set of metrics against which job performance can be evaluated. The interpretation is generally unambiguous; when goals are not met, improvement is needed. It is also thought to reduce the opportunity for frustration and discouragement that can be associated with less-attainable goals.
- Ideal standards may never be reached. They represent what will result in a state of perfection without spoiled goods, worker fatigue, or errors. The idea behind such standards is that employees will never rest on their laurels. Instead, they will achieve their full potential by striving to hit the lofty goal.
Many businesses avoid ideal standards because they fear that employees will see ideal standards as meaningless since they cannot hope to achieve them. In other words, the employees cease to strive for a goal they cannot hope to reach. Further, such goals may not help in performance evaluations; what is the feedback value of telling employees they failed to meet such standards (after all, isn’t that what was expected)?
A manager also needs to consider the downside of standards and develop compensating balances. For instance, if employees are encouraged to work fast, quality can suffer. Standards need to be in place to make sure that quality of output is not adversely affected. On the other hand, some seasoned employees may have become so skilled that they can easily meet their output goals and find themselves able to coast through the workday. Usually skilled workers receive a higher pay scale; it is not unfair to expect them to produce more output. Therefore, one standard may not fit all. A good manager is particularly adept at helping to establish fair standards and using them to plan and control the operations within his or her area of responsibility.
Standard costs provide information that is useful in performance evaluation. Standard costs are compared to actual costs, and mathematical deviations between the two are termed variances. Favorable variances result when actual costs are less than standard costs, and vice versa. The following illustration is intended to demonstrate the very basic relationship between actual cost and standard cost. AQ means the “actual quantity” of input used to produce the output. AP means the “actual price” of the input used to produce the output. SQ and SP refer to the “standard” quantity and price that was anticipated. Variance analysis can be conducted for material, labor, and overhead.
Management is responsible for evaluation of variances. This task is an important part of effective control of an organization. When total actual costs differ from total standard costs management must perform a more penetrating analysis to determine the root cause of the variances. The total variance for direct materials is found by comparing actual direct material cost to standard direct material cost. However, the overall materials variance could result from any combination of having procured goods at prices equal to, above, or below standard cost, and using more or less direct materials than anticipated. Proper variance analysis requires that the Total Direct Materials Variance be separated into the:
- Materials Price Variance: A variance that reveals the difference between the standard price for materials purchased and the amount actually paid for those materials [(standard price - actual price) X actual quantity].
- Materials Quantity Variance: A variance that compares the standard quantity of materials that should have been used to the actual quantity of materials used. The quantity variation is measured at the standard price per unit [(standard quantity - actual quantity) X standard price].
Note that there are several ways to perform the intrinsic variance calculations. One can compute the values for the red, blue, and green balls and note the differences. Or, one can perform the algebraic calculations for the price and quantity variances. Note that unfavorable variances (negative) offset favorable (positive) variances. A total variance could be zero, resulting from favorable pricing that was wiped out by waste. A good manager would want to take corrective action, but would be unaware of the problem based on an overall budget versus actual comparison.
Blue Rail produces handrails, banisters, and similar welded products. The primary raw material is 40-foot long pieces of steel pipe. This pipe is custom cut and welded into rails like that shown in the accompanying picture. In addition, the final stages of production require grinding and sanding operations, along with a final coating of paint (welding rods, grinding disks, and paint are relatively inexpensive and are classified as indirect material within factory overhead).
Blue Rail measures its output in “sections.” Each section consists of one post and four rails. The sections are 10’ in length and the posts average 4’ each. Some overage and waste is expected due to the need for an extra post at the end of a set of sections, faulty welds, and bad pipe cuts. The company has adopted an achievable standard of 1.25 pieces of raw pipe (50’) per section of rail. During August, Blue Rail produced 3,400 sections of railing. It was anticipated that pipe would cost $80 per 40’ piece. Standard material cost for this level of output is computed as follows:
The production manager was disappointed to receive the monthly performance report revealing actual material cost of $369,000. A closer examination of the actual cost of materials follows.
The total direct material variance was unfavorable $29,000 ($340,000 vs. $369,000). However, this unfavorable outcome was driven by higher prices for raw material, not waste as follows:
MATERIALS PRICE VARIANCE
(SP - AP) X AQ = ($80 - $90) X 4,100
Materials usage was favorable since less material was used (4,100 pieces of pipe) than was standard (4,250 pieces of pipe). This resulted in a favorable materials quantity variance:
MATERIALS QUANTITY VARIANCE
(SQ - AQ) X SP = (4,250 - 4,100) X $80
A company may desire to adapt its general ledger accounting system to capture and report variances. Do not lose sight of the very simple fact that the amount of money to account for is still the money that was actually spent ($369,000). To the extent the price paid for materials differs from standard, the variance is debited (unfavorable) or credited (favorable) to a Materials Price Variance account. This results in the Raw Materials Inventory account carrying only the standard price of materials, no matter the price paid:
Work in Process is debited for the standard cost of the standard quantity that should be used for the productive output achieved, no matter how much is used. Any difference between standard and actual raw material usage is debited (unfavorable) or credited (favorable) to the Materials Quantity Variance account:
The price and quantity variances are generally reported by decreasing income (if unfavorable debits) or increasing income (if favorable credits), although other outcomes are possible. Examine the following diagram and notice the $369,000 of cost is ultimately attributed to work in process ($340,000 debit), materials price variance ($41,000 debit), and materials quantity variance ($12,000 credit). This illustration presumes that all raw materials purchased are put into production. If this were not the case, then the price variances would be based on the amount purchased while the quantity variances would be based on output.
The logic for direct labor variances is very similar to that of direct material. The total variance for direct labor is found by comparing actual direct labor cost to standard direct labor cost. If actual cost exceeds standard cost, the resulting variances are unfavorable and vice versa. The overall labor variance could result from any combination of having paid laborers at rates equal to, above, or below standard rates, and using more or less direct labor hours than anticipated.
In this illustration, AH is the actual hours worked, AR is the actual labor rate per hour, SR is the standard labor rate per hour, and SH is the standard hours for the output achieved.
The Total Direct Labor Variance consists of:
- Labor Rate Variance: A variance that reveals the difference between the standard rate and actual rate for the actual labor hours worked [(standard rate - actual rate) X actual hours].
- Labor Efficiency Variance: A variance that compares the standard hours of direct labor that should have been used to the actual hours worked. The efficiency variance is measured at the standard rate per hour [(standard hours - actual hours) X standard rate].
As with material variances, there are several ways to perform the intrinsic labor variance calculations. One can compute the values for the red, blue, and green balls. Or, one can perform the noted algebraic calculations for the rate and efficiency variances.
Recall that Blue Rail Manufacturing had to custom cut, weld, sand, and paint each section of railing. The company has adopted a standard of 3 labor hours for each section of rail. Skilled labor is anticipated to cost $18 per hour. During August, remember that Blue Rail produced 3,400 sections of railing. Therefore, the standard labor cost for August is calculated as:
The monthly performance report revealed actual labor cost of $175,000. A closer examination of the actual cost of labor revealed the following:
The total direct labor variance was favorable $8,600 ($183,600 vs. $175,000). However, detailed variance analysis is necessary to fully assess the nature of the labor variance. As will be shown, Blue Rail experienced a very favorable labor rate variance but this was offset by significant unfavorable labor efficiency.
LABOR RATE VARIANCE
(SR - AR) X AH = ($18 - $14) X 12,500
The hourly wage rate was lower because of a shortage of skilled welders. Less-experienced welders were paid less per hour, but they also worked slower. This inefficiency shows up in the unfavorable labor efficiency variance:
LABOR EFFICIENCY VARIANCE
(SH - AH) X SR = (10,200 - 12,500) X $18
If Blue Rail desires to capture labor variances in its general ledger accounting system, the entry might look something like this:
Once again, debits reflect unfavorable variances, and vice versa. Such variance amounts are generally reported as decreases (unfavorable) or increases (favorable) in income, with the standard cost going to the Work in Process Inventory account.
The following diagram shows the impact within the general ledger accounts.
Variance analysis should also be performed to evaluate spending and utilization for factory overhead. Overhead variances are a bit more challenging to calculate and evaluate. As a result, the techniques for factory overhead evaluation vary considerably from company to company. To begin, recall that overhead has both variable and fixed components (unlike direct labor and direct material that are exclusively variable in nature). The variable components may consist of items like indirect material, indirect labor, and factory supplies. Fixed factory overhead might include rent, depreciation, insurance, maintenance, and so forth. Because variable and fixed costs behave in a completely different fashion, it stands to reason that proper evaluation of variances between expected and actual overhead costs must take into account the intrinsic cost behavior. As a result, variance analysis for overhead is split between variances related to variable overhead and variances related to fixed overhead.
The cost behavior for variable factory overhead is not unlike direct material and direct labor, and the variance analysis is quite similar. The goal will be to account for the total “actual” variable overhead by applying: (1) the “standard” amount to work in process and (2) the “difference” to appropriate variance accounts.
Review the following graphic and notice that more is spent on actual variable factory overhead than is applied based on standard rates. This scenario produces unfavorable variances (also known as “underapplied overhead” since not all that is spent is applied to production). As monies are spent on overhead (wages, utilization of supplies, etc.), the cost (xx) is transferred to the Factory Overhead account. As production occurs, overhead is applied/transferred to Work in Process (yyy). When more is spent than applied, the balance (zz) is transferred to variance accounts representing the unfavorable outcome.
The next illustration is the opposite scenario. When less is spent than applied, the balance (zz) represents the favorable overall variances. Favorable overhead variances are also known as “overapplied overhead” since more cost is applied to production than was actually incurred.
A good manager will want to explore the nature of variances relating to variable overhead. It is not sufficient to simply conclude that more or less was spent than intended. As with direct material and direct labor, it is possible that the prices paid for underlying components deviated from expectations (a variable overhead spending variance). On the other hand, it is possible that the company’s productive efficiency drove the variances (a variable overhead efficiency variance). Thus, the Total Variable Overhead Variance can be divided into a Variable Overhead Spending Variance and a Variable Overhead Efficiency Variance.
Before looking closer at these variances, it is first necessary to recall that overhead is usually applied based on a predetermined rate, such as $X per direct labor hour. This means that the amount debited to work in process is driven by the overhead application approach. This will become clearer with the following illustration.
Blue Rail’s variable factory overhead for August consisted primarily of indirect materials (welding rods, grinding disks, paint, etc.), indirect labor (inspector time, shop foreman, etc.), and other items. Extensive budgeting and analysis had been performed, and it was estimated that variable factory overhead should be applied at $10 per direct labor hour. During August, $105,000 was actually spent on variable factory overhead items. The standard cost for August’s production was as follows:
The total variable overhead variance is unfavorable $3,000 ($102,000 - $105,000). This may lead to the conclusion that performance is about on track.
But, a closer look reveals that overhead spending was quite favorable, while overhead efficiency was not so good. Remember that 12,500 hours were actually worked.
Since variable overhead is consumed at the presumed rate of $10 per hour, this means that $125,000 of variable overhead (actual hours X standard rate) was attributable to the output achieved. Comparing this figure ($125,000) to the standard cost ($102,000) reveals an unfavorable variable overhead efficiency variance of $23,000. However, this inefficiency was significantly offset by the $20,000 favorable variable overhead spending variance ($105,000 vs. $125,000).
This entry applies variable factory overhead to production and records the related variances:
The variable overhead efficiency variance can be confusing as it may reflect efficiencies or inefficiencies experienced with the base used to apply overhead. For Blue Rail, remember that the total number of hours was “run up” because of inexperienced labor. These welders may have used more welding rods and had sloppier welds requiring more grinding. While the overall variance calculations provide signals about these issues, a manager would actually need to drill down into individual cost components to truly find areas for improvement.
Actual fixed factory overhead may show little variation from budget. This results because of the intrinsic nature of a fixed cost. For instance, rent is usually subject to a lease agreement that is relatively certain. Depreciation on factory equipment can be calculated in advance. The costs of insurance policies are tied to a contract. Even though budget and actual numbers may differ little in the aggregate, the underlying fixed overhead variances are nevertheless worthy of close inspection.
Blue Rail budgeted total fixed overhead at $72,000, but only $70,000 was spent. The objective is to allocate $70,000 between work in process and variance accounts. Work in Process should reflect the standard fixed overhead cost for the actual output. Assume that Blue Rail had planned on producing 4,000 rail systems during the month; only 3,400 systems were actually produced. This means that the planned fixed overhead was $18 per rail ($72,000 ÷ 4,000 = $18). Because 3 labor hours are needed per rail, the fixed overhead allocation rate is $6 per direct labor hour ($18 ÷ 3).
As illustrated, $61,200 should be allocated to work in process. This reflects the standard cost allocation of fixed overhead (i.e., 10,200 hours should be used to produce 3,400 units). Notice that this differs from the budgeted fixed overhead by $10,800, representing an unfavorable Fixed Overhead Volume Variance.
Since production did not rise to the anticipated level of 4,000 units, much of the fixed cost (that was in place to support 4,000 units) was “under-utilized.” For Blue Rail, the volume variance is offset by the favorable Fixed Overhead Spending Variance of $2,000; $70,000 was spent versus the budgeted $72,000. Following is an illustration showing the flow of fixed costs into the Factory Overhead account, and on to Work in Process and the related variances.
Following is the entry to apply fixed factory overhead to production and record related volume and spending variances:
The following spreadsheet summarizes the Blue Rail case study. Carefully trace amounts in the spreadsheet back to the illustrations.
Notice that the standard cost of $686,800 corresponds to the amounts assigned to work in process inventory via the various journal entries, while the total variances of $32,200 were charged/credited to specific variance accounts. By so doing, the full $719,000 actually spent is fully accounted for in the records of Blue Rail.
Not all variances need to be analyzed. One must consider the circumstances under which the variances resulted and the materiality of amounts involved. One should also understand that not all unfavorable variances are bad. For example, buying raw materials of superior quality (at higher than anticipated prices) may be offset by reduction in waste and spoilage. Likewise, favorable variances are not always good. Blue Rail’s very favorable labor rate variance resulted from using inexperienced, less expensive labor. Was this the reason for the unfavorable outcomes in efficiency and volume? Perhaps! The challenge for a good manager is to take the variance information, examine the root causes, and take necessary corrective measures to fine tune business operations.
In closing this discussion of standards and variances, be mindful that care should be taken in examining variances. If the original standards are not accurate and fair, the resulting variance signals will themselves prove quite misleading.
Selected non-financial metrics should also be employed in performance evaluation. This is sometimes referred to as maintaining a balanced scorecard, meaning that performance assessment should take a holistic approach. Long-term business success will not be achieved if the focus is only on near-term financial outcomes. With the balanced scorecard approach, an array of performance measurements is developed. Each indicator should be congruent with the overall entity objectives. Further, each measure should be easily determined and understood. These measurements can relate to financial outcomes, customer outcomes, or business process outcomes. Although a balanced scorecard approach may include target thresholds that should be met, the primary mantra is on improvement.
Blue Rail had a number of financial goals that could be included in a balanced scorecard assessment. Examples include the standard cost for material, the standard labor hours per rail set, the expected production level, and so forth. Examples of potential customer outcomes include results of a customer satisfaction survey, product returns/warranty work rates, estimated market share, and the frequency that customer bids lead to customer orders. Examples of potential business process outcomes include defect-free units as a proportion of total production, time from order receipt to shipment, size of customer order backlogs, and employee turnover rates.
The metrics are intended to measure progress toward fulfillment of the corporate objectives, and the managerial accountant is apt to be heavily involved in gathering the necessary data for inclusion in the balanced scorecard performance reports. These reports are often graphical in nature to facilitate easy use and interpretation, with particular emphasis on timely identification of trends. Sometimes, the metrics are prominently posted in the workplace. By prominent display of such data, employees are constantly reminded of, and vigilant to meet, key performance goals.