Flexible Budgets and Basic Variance Analysis AND performance measurement Lecture Notes and revision questins

1. Flexible Budgets
Class Exercise
Lamu Ltd. produces a popular brand of biscuits under the brand name TAMU. The biscuits are sold in
packets of 100grammes each. To reduce the distribution cost, the firm is only selling its product through
the supermarkets at sh. 12 per packet. The budgeted standards for the year ended 31st
Dec 2011 are given
below:
Annual fixed manufacturing costs Sh. 500,000
Direct material per packet Sh. 2.50
Direct cost per hour Sh200
Variable factory overheads per hour Sh. 275
Selling cost per unit(variable) Sh.0.80
Output: No of packets per hour 100
Number of working hours per week 40
At the end of the year, an analysis of the results revealed the following:
1. The actual selling price was sh. 12.75 per unit.
2. Direct material cost per unit reduced by 5%.
3. The actual production rate was 98 packets per hour although there was no idle time.
4. All units produced were sold
5. Actual fixed costs were sh. 480,000.
6. There was no change in selling and distribution costs per unit.
7. Actual variable overheads amounted to sh.550,000
Required:
a) The original( static) budget
b) Actual income statement for the year
c) The flexed budgeted income statement for the year.
STANDARD COSTING AND VARIANCE ANALYSIS
There are two methods of establishing standards

2.  Use past historical data
 Engineering method
Purpose of standards
1. To provide prediction for future cos are motivated to achieve
2. Assist in setting budget and evaluating management performance
3. Acts as a control device: highlighting those activities which do not conform to play start
management on situations that may be out of control, and need corrective action
4. Simplify the task of tracing costs to products for profit management and inventory valuation
purposes
TYPES OF STANDARDS
1. Basic standards: constant standards: They remain unchanged for a long period of time. They
do not reflect current conditions. They are unattainable and not useful for cost control.
2. Current standards: -These are flexible standards and reflect current conditions. They remain
in operation for a short time.
TYPES OF CURRENT STANDARDS
a) Ideal standards – They assume 100% operational efficiency i.e. a perfect working capital.
They are unrealistic, very hard to attain and therefore not useful for cost control.
b) Expected standards – They are future standards expected to be attained. They are based
on expected conditions making allowance for reasonable loss of resources. They are
attainable and therefore useful for cost control.
c) Normal standards – They are standards based on past performance: performance and
experience. They are used to develop expected standards and themselves are not used for
cost control.
BASIC VARIANCE ANALYSIS
Illustration: Variance Analysis

3. Alpha manufacturing company produces a single product, sigma. The product requires a single operation
& the standard costs for this operation is presented in the following standard cost card.
Standard cost card for product sigma Sh.
Direct materials:
2 kg of A at sh. 10 per kg 20
1kg of B at sh. 15 per kg 15
Direct labor ( 3hrs at 9sh. Per hour) 27
Variable overheads (3 hrs at 2sh per direct labor hour) 6
Total standard variable cost 68
Standard contribution margin 20
Standard selling price 88
Alpha Ltd plans to produce 10,000 units of sigma in the month of April, and the budgeted costs based on
the information contained in the standard cost card are as follows:
Sh. Sh. Sh.
Sales(10,0000 unit s of sigma @ sh.88 per unit) 880,000
Direct materials:
A: 20,000kg at sh. 10 per kg 200,000
B: 10,000kg at sh. 15 per kg 150,000 350,000
Direct labor (30,000 hours at sh. 9 per hour) 270,000
Variable overheads (30,000 hours at sh. 2 per DLH) 60,000 680,000
Budgeted contribution 200,000
Fixed overheads 120,000
Budgeted profit 80,000
Annual budgeted fixed overheads are sh. 1,440,000 and are assumed to be incurred evenly throughout the
year. The company uses a variable costing system for internal profit measurement.
The actual results for April are:
Sh. Sh. Sh.
Sales(9,0000 unit s of sigma at sh90 per unit) 810,000
Direct materials:
A: 19,000kg at sh. 11 per kg 209,000
B: 10,100kg at sh. 14 per kg 141,000 350,400
Direct labor(28,500 hours at sh. 9.60 per hour 273,600
Variable overheads 52,000 676,000
Actual contribution 134,000
Fixed overheads 116,000

4. Budgeted profit 18,000
Manufacturing overheads are charged to production on the basis of direct labor hour. Actual production
and sales for the period were 9,000 units.
Required:
a) Material variances
b) Labor variances
c) Variable overhead variances
d) Fixed overhead variances/Spending variances
e) Statement of reconciling budgeted profit and the actualprofit
MATERIAL VARIANCE.
Solution to question (Hand out)
Material price variance:
(SP – AP) AOP
i) Material A ( 10 -11 ) 19,000 = 19,000 A
ii) Material B ( 15 – 14) 10,100 = 10,000 F
8,900A
Where SP – Std Price, AP – Actual price ,
QP - Quantity purchased.
b) Material usage variance = (SQ – AQ) SP
SD – Std quality read for actual production = [SR * AQ]
Material A= [(2 x 9,000) – 19,000] x 10 = 10,000A

5. Material B = [(1 * 9,000) – 10,100] x 15 = 16,500A
26,500A
Total material variance 35,400
c) Total material variance: = SC - AC
SC – std cost (Std material cost for Actual quality production)
AC - Actual cost (Actual cost x actual quality produced)
Material A [(20 x 9,000) - 209,000] = 29,000A
Material B [(15 x 90000) - 141, 400] = 6,400A
35,400A
OR material price + material usage variance
2. LABOUR VARIANCE
a) Labour price variance : ( labour rate variance /wage rate variance). (SR – AVR) AH.
(9.0 – 9.60) X 28,500 = 17,100 A
II) Labour efficiency variance (QUANTITY): (SH - AH) SR.
SH = Std rate x Actual production
[(3 x 9,000) - 28,500) x 9 13,500A
Total labour variance 30,600A
Or
Total labour variance = SC – AC: = 27 ( 9,000) - 273,600 = 30,600A
3. VARIABLE OVERHEAD VARIANCE
a) Variable Overhead efficiency Variance (Qnty) –

6. = (SH – AH) SR = [Std hrs of output] - Actual hr] SR
Where SH = S.R. x AP = ( 27,000 – 28,500) 2 3,000A
b) Variable Overhead Expenditure Variance = BFVO - AVO.
(2 X 28,500) - 52,000 5,000 F
2,000F
c) Variable overhead price variance
= SC – AC = [Std variable overheads charged to production] – [Actual off incurred]
(SR x A.P) -AC = [6 X 9,000) - 52,000] = 2,000 F
NB:
Total variable overhead variance = variable OH Exp + variable OH efficiency variance
=5,000 F + 3,000A = 2,000F
3. FIXED OH EXPENDITURE VARIANCE
Variable costing systems treat Fixed Costs as period costs (that do not change with levels of
activity but due to other factors e.g. increase in price may change expenditure on fixed costs
(Cause an increase)
Fixed OH Variance = Budgeted Fixed OH – Actual Fixed OH.
BFO – AFO = 120,000 - 116,000 = 4,000F
CAUSES
Changes in salaries to supervisors
Appointment of new supervisors
Controllable in the S.R.

7. 4. SALES VARIANCES
Sales margin price variance = (AM – SM) AV where: AM – actual margin ,
SM – Std margin , AV- Actual sales volume
1. Sales margin price variance = (AM - BM) AV.
[ (90 – 68) – [ 88-68) ] 8 9,000 18,000F
2. Sales margin volume variance (AS - BS) BM.
[9,000-10,000] 20 20,000A
Sales margin variance 2,000A
OR
SMV (sales margin variance) = AM(actual margin)– BM(budgeted margin)
AM = Actual sales (9,000 x 90) 810,000
Less std. variable costs for actual sales volume
(9,000 x 68) (612,000)
198,000
Budgeted margin ( 88- 68) x 10,000 200,000
2,000 A
NOTE: TOPIC FOR DAC 304: ADVANCED MA
RECONCILING BUDGETED II AND ACTUAL PROFITS
Budgeted net profit 80,000
Sales variance
Sales margin price 18,000F
Sales margin volume 20,000 2,000A
Direct cost variance
DM: Price 8,900A
Volume/usage 26,500A 35,400A
Labour: Rate 17,100A
Efficiency 13,500A 30,600A

8. Mf’g off: fixed olt exp
Var olt exp
Var H eff
4,000F
5,000F
3,000A 6,000F 62,000A
Actual profit 18,000
NOTE: TOPIC FOR DAC 304: ADVANCED MA
RESPONSIBILITY ACCOUNTING
DIVISIONAL PERFORMANCE MEASURES
Large companies produce and sell a wide variety of product through out the county or world and
therefore because of complexity in operations it maybe difficult for top management o directly
control operations on a company centrally therefore, the company maybe divided into separate
segments or divisions giving some substantial independence to divisional managers. The danger
however is that divisional managers may not pursue goals in the best interest of the overall
company. They must be therefore be controlled by measuring their performance this can be done
using financial performance measures like profit, return on capital employed, residual income,
economic value added etc. in additional non-financial measures relating to areas such as
competitiveness, product leadership quality delivery, innovation and flexibility of responding to
changes should be factored.
Types of organizational structures

9. 1. Functional structures – this is one in which all activities of a similar type within a company
are place under the control of departmental managers.
2. Divisional structure (Decentralized structure) – the organisation is spilt into divisions in
accordance with products made. Each divisional manager is for all operations relating to its
product(s).
Objectives of decentralization
The general purpose of creating divisional structures or decentralization is to enhance efficiency
of the enterprise properly organized and controlled decentralization should;
i) Improve local decision making because the division manager is in close touch with today
– today operations.
ii) Improve strategic decision making as top managers are relieved of day – to – day routine
decisions
iii) Increase flexibility and reduce communication problems, because managers are given
some autonomy.
iv) Increase motivation of divisional management which is the key most feature of
decentralization
v) Greater training exposure and increased experience of junior management.
Problems with decentralization
If divisions are highly interdependent a potential problem is that of sub-optimal decision making
that is benefits of decisions made by one division maybe accompanied by higher costs to other
divisions and the company as a whole.
Duplication of certain services in divisions and at the headquarters e.g. market research,
computing services, personnel function e.t.c this increase the cost of the organisation.
Decentralization requires a sophisticated information system which may not be available or
expensive.
Friction often occurs between division managers especially where performance of 1 division
depends on another e.g. in setting of transfer prices

10. Objectives of performance appraisal
To promote goal congruence i.e. performance appraisal system should help management direct
their operations to fulfilling company’s objectives.
Feedback – performance appraisal will provide relevant and regular feedback to central
management on how the bottom line is performing.
Motivation – if well structured performance appraisal encourages initiative and motivation for
this to be achieved the appraisal system should be not be narrowly conceived or rapidly applied
so as to bill incentives.
Perspective – performance appraisal should encourage the long – run view rather than short-term
expediencies.
Performance evaluation is therefore the establishment of how well an activity, department or
somebody is doing in relation to a plan. It is a vital part of control process. When performance is
measure in terms of accounting results the name given to the procedure is called responsibility
accounting and the measures used are called financial measures.
ADVANTAGES OF DIVISIONAL STRUCTURE
1. Decisions on the division can be made immediately. Delays of calling meetings are
avoided.
2. CEO delegates the responsibility to the divisional managers. This provides greater
freedom to divisional managers.
3. There is motivational of managers as there is assessment by oves performance at the end
of a period.
4. Managers can be developed
5. Remuneration is fair
DISADVANTAGES
1. Duplication of resources

11. 2. It can create negative competition among the divisional managers, if they wish to be
assessed on how they manage their resources e.g. by / may choose to buy outside the
division to avoid providing interaction market to another department.
MEASURING PERFORMANCE
Performance is measured in two dimensions:
A) Performance of divisional manager
B) Performance of a division
PURPOSE: To determine
a) The industry in which in the division is performing
b) Managers performance by evaluating the factor s that are directly under his control; and
whose use and productivity he can influence.
MEASUREMENT OF DIVISIONAL PERFORMANCE
A) FINANCIAL MEASURES
1. Net profit (after tax profit)
2. Return on investment (ROI)
3. Residual income
4. Economic Value Added (EVA)
NET PROFIT ANALYSIS
Sales xx
Less variable costs (xx)
Variable short run controllable margin xx- a profit figure
Less fixed controllable costs xx
Controllable contribution (xx)- a profit figure
xx
Less non –controllable (Avoidable costs) (xx)

12. c) Divisional contribution Xx - a profit figure
Less Allocated corporate costs (xx)
d) Divisional net profit before tax xx- a profit figure
NOTES
A) Can we evaluate a manager on profits at level (A)? YES: Reason variable short run costs are
within the production manager’s control. However the profit figure is not adequate because it
leaves out certain costs which he is personally responsible for but they have not been reduced
from the net profit.
B) Can we assess a manager on controllable contribution basis? YES it is most appropriate
because it takes care of all the costs under his control.
C) Can we assess a manager based on divisional contribution? Yes; but is not a fair measure. It
incorporates other costs under the control of the CEO and where the manager has no control
over costs.
D) Assessing at level (D) is appropriate for assessing a divisional manager but not a
departmental manager.
FINANCIAL PERFORMANCE MEASURES
1. Return on Investment (ROI): This is a ratio =
It is the most popular financial measure of performance. It expresses the divisional net profits as
C percentage of Total Net Assets supplied.
Eg: Consider the following (2) situations:
A B
Profit 1m 2m
Assets 4m 10M
ROI ¼ X 100% 2/10 x 100%
= 25% = 20%

13. Using net profit done, division B seems to be doing better but using ROI, Division A seems to be
doing better.
ROI provides us a useful approximation on the success of a firms past investment policy.
It can also be used where we have varying investment values.
2. RESIDUAL INCOME:
This is the controllable contribution less cost of capital charged on the investment by the
divisional manger.
For evaluating economic performance of a division, residual income may be defined as a
divisional contribution less cost of capital charged on the total investment on assets.
E.g. Suppose a company has two divisions: X and Y and the following data relates to their
performance.
X Y
Investment 40,000 40,000
Contribution 10,000 5,000
Cost of capital (15% of 40,000) (6,000) (6,000)
Residual income 4,000 (1,000)
Conclusion: X is doing better than Y using residual income
3. ECONOMIC VALUE ADDED (EVA)
It is the profit earned in excess of the minimum return required by all contributors of debts and
equity capital. EVA is calculated from straight forward adjustments to convert book values on
income statements and balance sheet to economic basis.
Adjustments may be done in R & D or other methods.
By using conventional P & L a/c, we can adjust certain items in the balance sheet then charge
them to cost of capital (Kd). In order for us to arrive at assets which will be subjected to cost of
capital, we shall; make the following adjustments.

14. 1. Consider assets which are directly controlled by the divisional manager and leave out
those assets that are controlled at higher quarters.
2. Fixed Assets may be valued of either original Cost or their written down value (NBV)
3. Any liabilities that are within the control of the division should be deducted from the
asset base.
4. Where debtors or cash is administered directly, by the head office, then either of their
shall be excluded form the assets of the division
Illustration: Company X’S 5 years performance :( using Asset Base)
Initial investment = 1M.
Year 1 2 3 4 5
Net cash flows 350,000 350,000 350,000 350,000 350,000
Depreciation Expense (200,000) (200,000) (200,000) (200,000) (200,000)
150,000 150,000 150,000 150,000 150,000
Less cost of capital
(10%)
(100,000) (180,000) (160,000) (40,000) (20,000)
EVA 50,000 70,000 90,000 110,000 130,000
ROI
%
Workings NB: Initial investment = 1m.
Depr – straightline = 200,000 p.a.
yr1 yr2 yr3 yr4 yr5

15. Investment 1,000,000 1,000,000 800,000 600,000 400,000
Less depr --0--- (200,000) (200,000) (200,000) (200,000)
Investment (Net of depr. costs) 1,000,000 800,000 600,000 400,000 200,000
10% cost of capital 100,000 80,000 60,000 40,000 20,000
NON – FINANCIAL PERFORMANCE MEASURES
Balanced scorecard approach
This is an approach in the provision of information to management systematically and
strategically. It emphasizes the need to provide a set of information addressing all areas of
performance in an objective and unbiased fashion. It requires performance of a manager to
go beyond financial measures by including non-financial elements covering areas such as
customer satisfaction internal efficiencies, employee satisfaction innovations e.t.c. It helps
top management to review the company strategically and the level of achievements. The
approach was introduced by 2 lecturers: Kaplan and Norton in Harvard University in 1996.
It can be summarized as follows:
The balanced scorecard technique requires business performance to be reviewed in 4 main
perspectives;
i) Customer perspective – this seeks to identify the key elements of the organizations
performance through the eyes of its customers. The following questions are asked:
a) How do customers view our company?
b) Are customers satisfied with our services?
c) Do customers get value for their money?
To address the questions the following objectives, measures and initiatives can be applied.
Objectives
1. Increase market share
2. Increase customer satisfaction

16. Measures
1. Find the actual market share of our product.
2. Use questionnaires to find customer satisfaction
3. Customer retention rate
4. The total number of new customers acquired
5. Customer profitability.
These measures should be computed by the management accountant and given as additional
report together with financial reports. Customer profitability for e.g. can be given as
Initiatives
i) Identify future customers
ii) Identify future needs of current customers
Internal business process perspective (innovation) this perspective identifies the business
processes and technologies which are used internally to achieve manufacturing capability,
quality and differentiation. The perspective will address the following issues:
Objectives
1. Improve business operations
2. Improve decision making process
3. Reduce operation cost
4. Improve quality of products
5. What are we doing or should we do to differentiate our business from competitions?
To achieve this objectives the internal business process perspective comprises 3 principle sub-
process.
a) The innovation process - this involves creating products, services and processes that are
unique to meet customer needs. Measures here will include:

17. i) Manufacturing capability e.g. what is the total output capability per annum
ii) Number of new products introduced
iii) Number of new patterns and copyrights
iv) Number of new technologies adopted e.t.c
The initiatives here will be;
i) Organize research and development to boost manufacturing processes.
ii) Monitor competitor’s progress to ensure we stay ahead.
b) Operations process. This involves producing and delivering existing products and services to
customers in the most efficient and cost effective way.
Objectives
i) Improve manufacturing quality and productivity
ii) Reduce delivery time to customers
Measures
i) Number of detective units produced.
ii) Time taken to deliver products to customers
iii) Number of units produced
iv) Set up time
v) Manufacturing down time (idle time)
Initiatives
i) Identify causes of problems and improve on quality
ii) Improve on the delivery process time.
c) After sales service – This involves providing service and support to customers after the sale
of delivery of a product or service.
Objective
i) Meet the specified terms of sale.
Measures
i) Time taken to replace or repair defective products.
ii) Hours of customer training for using our product

18. iii) Number of defective units returned.
Initiatives
i) Re-engineering constantly improving our products to reduce the need for repairs
ii) Constant touch with customers post sale
Learning and growth perspective
This perspective focuses on employees in terms of their capabilities training and satisfaction. The
organisations learning and growth comes from 3 sources i.e. people, systems and procedures. It
addresses the question how do we continue to grow and improve.
Objectives
i) Develop people skill
ii) Empower work force
iii) Align employees and organizations goals (congruence)
iv) Enhance systems capabilities.
v) Improve manufacturing processes.
Measures
 Employees education and level of training
 Training days per employee
 Employee satisfaction scores from questionnaires
 Employee turnover rates
 Information systems availability
 Total sales as a ratio of employees.
Initiatives
 Employee training programs
 Let supervisors act as coaches or cordiantors rather than decision makers
 Employee satisfaction and suggestion programs to build tomorrow and improve on
cordiantion

19.  Involve employees in research and development to modify development.
Financial perspective
The process identifies profitability of the business by considering factors relevant to financial
health it addresses the following issues;
Objectives
vi) How do we look to our shareholders
vii) Do shareholders get value for their input
viii) How is the profitability of our company
Measures
 Operating profit
 Revenue form new products
 Revenues from new growth
 Cost reduction in key areas
 Residue income
 Economic value added
 Return on investment
All other accounting ratios which address
1. Liquidity – This addresses the firms ability to meet its current obligations and its
basically the ratio between current assets and current liabilities.
2. Profitability – this measures the rate of which revenue and assets are converted into
profits.
3. Gearing – this is basically the ratio between equity and debt. It shows the leverage of the
firm in terms of financial risk.
4. Investment ratios - this show basically the returns that shareholders and other investors
including creditors are getting from the firms operations e.g. interest yield, interest cover
e.t.c

20. 5. Efficiency ratios – this show the level at which a firm is making good use of its current
assets and current liabilities. It includes debtors days, stock turnover, creditors days cash
cycle etc
Initiatives
Managed costs and capacity
Build on possible intervene areas
Improve on all the other perspectives
Advantages of balanced
1. Provides a comprehensive framework for translating the companies strategic goals into
coherent financial measures by developing major goals for the 4 perspectives.
2. It helps managers consider all important operational measures so that improvement in one
area is not tat the expense of another.
3. It improves communication within the organisation through participation in the
implementation of the 4 perspectives
Criticisms of Balanced scorecard
1. The assumption of cause and effect relationship among the perspective is too ambiguous
i.e. to improve on financial measures for e.g. a manager may have to destroy the other
perspectives vice-versa.
2. Omission of environmental and societal perspectives quite misleading.