 Hello and welcome to the session. This is Professor Farhad and this session we would look at variance analysis introduction to it and specifically we're going to be covering sales activity and price or profit variance. This lecture as well as other lectures will be posted on my website along the PowerPoint slides so you can access this from my slides. In this session we're going to be introducing the idea of variance. What is a variance? Well it's all based on the idea of budgeting. If you remember in the prior session we look at budgeting. We looked at how do we budget and we learn about budgeting. Well budgeting is good so but let's assume the budget is here so we budgeted we plan to do certain things that's that's good nothing wrong with that but what matters is we want to look at what happened actually okay so we're going to have to compare the actual to the budget to see what happened to compare our performance to understand what we did right what we did wrong and if there's any changes we need to make we need to make those changes to get back our performance online we need to constantly review our budget versus actual. Now in this session we're going to be introducing new terms something called favorable variance and something called unfavorable variance. How do we know because I'm going to be defining those or I'm going to be using those so before I use them I would like to define them how do we know if something is favorable or something is unfavorable? When do we say a variance is favorable? It's when the variance that's taken alone that specific variance increases operating income if that change increases your operating income what does that mean? It's meaning either either have more revenues or less expenses then it's a favorable variance. What is unfavorable variance? Variance that's taken alone reduces operating profit. When do you reduce your operating profit? It's either when you have less revenues or your expenses went down your expenses or your cost went up. So to illustrate this concept the best way to illustrate this concept is to basically draft real quick a budget a budget compare the budget to the results and talk about this analyze them line by line. Now the budget that I'm going to be working with or the budget the numbers I'm going to be working with here they're they're on the PowerPoint slides but I would like to I'd like to put them down step by step this way you see what happens. So let's assume we are dealing with the month of January just for the sake of illustration. So we're going to be looking at sales and sales and and sales is 840,000 and for the activity this is the actual this is what happened actually and we make this a little bit smaller maybe because this is a little bit large and there we go and we sold we happened to have sold 80,000 units so this is for 80,000 units so the sales was 80,000 then from the sales we are going to deduct less variable cost which is variable manufacturing cost happens to be 329,680 we're going to deduct variable cost that's selling variable cost that's selling and that's going to be 68,000 so we have variable cost of total of 397,680 this so this is total variable cost sales minus variable cost gives us a contribution margin of 442,000 320 dollars this is what's this this is the contribution margin sales minus total variable cost now let's let's list our fixed cost we have fixed manufacturing fixed manufacturing cost and it happens to be 195,500 fixed selling cost it happens to be 132,320 the total fixed cost is 327,820 and our profit is 114,500 this is our profit so this is the numbers that we're going to be working with this is what actually happened for that particular month we said let's consider it month of January now we're going to compare this to our budget and specifically to our planning budget planning or static budget okay our planning budget sales should have been we budgeted sales of a million dollar we budgeted variable manufacturing cost of 380 we budgeted variable selling of 90,000 the total was 470 of variable cost the contribution margin that we planned for was 530,000 okay then the fixed cost fixed manufacturing cost was 200,000 and the fixed selling cost was 140,000 a total of 340 and we planned the profit of we planned the profit of 190,000 which is contribution margin minus the fixed cost I hope you guys following this so we planned profit of 190,000 so the question becomes what happens well well I did not tell you this but I need to tell you this which is very relevant what we did is we planned when we plan our budget we plan to have sold 100,000 units okay guess what we only sold 80,000 unit so the question is can we compare this budget to this budget can we compare the actual to the planning and the answer is nothing will stop us we can compare we can compare the budget to the the the actual to the planning but what's going to happen it's going to be in a sense not that meaningful why because here what you're comparing you're comparing two level of activities you you plan for 100,000 unit and you actually sold 80,000 unit of course of course you're going to have overall unfavorable variance of course you're going to have unfavorable variance in the sense that your profit under the actual will be less overall why because you sold simply less unit you sold 20,000 unit so to make to make such comparison it will be in a sense useless can you make it sure sure you can okay let's go ahead and look at such such a variance so if you want to do so here's the variance between the actual and the master budget well sales revenue is unfavorable variable manufacturing cost is favorable variable selling cost is favorable overall you have unfavorable contribution margin your fixed cost manufacturing was favorable fixed selling was favorable overall you are unfavorable 75,500 once again this is practically not practically in a sense we're not going to use it we're not going to use it because it's not that useful for us so what does that mean does it mean we need to throw away our planning budget no what we need to do now we need to flex the budget and what's flexing the budget flexing the budget means taking the taking the activity level to 80,000 so rather than making a budget based on 100,000 we are going to make a budget based on 80,000 units so we're going to call this let me do it in a different color the flexible the flexible budget okay flexible budget in this budget this flexible budget it's going to be based on 80,000 unit so basically what would have happened if we actually sold 80,000 unit well what was our selling price what was our budget at selling price well we were planning to get a million dollar we were planning to get a million dollar okay a million dollar in sales based on a 100,000 unit so our selling price was our selling price was 10 dollars well if we plan to sell 80,000 unit our sales should have been 800,000 well our variable manufacturing cost was 380,000 based on a 100,000 unit output that means it's 380 and our variable variable selling cost was 90,000 based on a 100,000 unit output 90 pennies now what we do is we take 80,000 80,000 unit times 380 which is 304,000 once again this is 80,000 unit times 380 then we're going to compute our variable selling price which happens to be 72,000 and that is 80,000 unit times 0.9 90 cent per unit now we can compute our total variable cost under the flexible budget 376,000 our contribution margin is sales minus variable cost which is 424,000 then then we're going to now list our fixed cost but before we proceed that's before before we proceed let's analyze this let's analyze the difference here before we proceeds let's analyze the difference between between the the profit the contribution margin profit the contribution margin profit let's find the difference so what was the difference okay so we we were planning to have 530,000 and for comparing the flexible to the planning in 424 that's a difference of 106,000 there was a difference in the contribution margin of 106,000 so what caused that difference what caused that contribution margin difference well one thing and one thing only caused the difference between the flexible budget and the planning budget so when we find the difference between the flexible budget and the planning budget we call this difference sales activity variance and why do we call it sales activity variance so this is a term you want to be familiar with sales activity variance so the sales activity variance is the difference between the flexible budget and the planning budget what causes the 106,000 difference this 106,000 difference it it's caused only this the sole cost for it is the number of units sold guess what under the planning budget we sold more units let me show you remember our selling price per unit is $10 okay our variable cost is $380 okay and our variable manufacturing costs $380 variable selling price is 90 so per unit if you look at per unit $10-380 clear $10 selling price minus $3.80 minus 90 pennies clear again 10-3.8-0.9 $5.30 is your contribution margin per unit and you sold 20,000 unit less times 20,000 unit $5.30 times 20,000 unit less that's your variance of 106,000 so the difference between your flexible budget and your planning budget gives you what's called your sales activity variance so the only the only thing that explained this is the sales activity variance okay why just because of the sales so notice here if you want to you could compute the difference for each this is 200,000 you could compute the difference for those two and you could compute the difference for those two and when you net them they net to be 106,000 so this is how we compute the sales activity variance okay so this is one term you need to be familiar with sales activity variance now when it comes to the flexible budget guess what the fixed cost should be the same for the fixed manufacturing and the fixed selling because the definition of fixed cost is it's fixed in relationship to the activity so there should be no difference there therefore if you look at the bottom line if you take 424 minus the fixed cost minus the fixed cost let's let's go ahead and compute this the fixed cost is 340 so let's state 424 424 424 minus 340 that's going to give you a profit of 84,000 now if we take 84,000 minus 190,000 the difference between those two is 106 so notice fixed cost is not really relevant in this comparison because the flexible budget and the planning budget the fixed cost should be the same in a sense so once again the only difference in the in the bottom line between the flexible and the planning budget is it has to do with the sales activity you sold less unit well you're gonna have less less less profit how much less profit you're going to have it's your contribution margin times the less profit and the opposite would have been true if you sold more units than more units than what you planned for okay so now let's now move to the other side of the the other side of the budget and now we're gonna be doing rather than rather than the sales activity we're gonna be looking at the difference so we're done with the sales activity now we're now we're gonna be comparing the actual the deflexible the actual to the flexible so let's take a look at the difference well the difference in sales that Let's start with sales, the difference in sales. The difference in sales is $40,000 and that's favorable. What does it mean favorable? That means if you report sales of 840 versus 800,000, your profit will be higher by 40,000. Therefore, the variance is favorable. So what caused this variance of $40,000? Well, what caused this variance is the selling price. So what caused the $40,000 favorable variance? It's the selling price. So what happened is somehow, somehow you had a pricing power. You had a pricing power. Maybe there was a high demand for your product. Therefore, what happened? Your marketing people up the price, up the price. So now you have $40,000 more. So let's compare it on a per unit base. Your planning, your selling price was $10. That's what you planned for. But guess what? You sold 800,000, your sales was $840,000 divided by 80,000 unit. So 840,000 divided by 80,000 unit. You were able to charge your customers $10 on average, $10.50. So that's good. So you had a favorable, favorable, and we call this, this is the sales price variance. This is the, this column, we're going to call it the sales price variance or the profit variance. Well, you made more profit. Why? Because you were able to sell at a higher price. Not because you sold more or less unit. Now this column here is the selling price. Let's compare your variable manufacturing overhead to your, between the flexible and the actual. And here what happened is you should have spent $304,000. You spent $329,000. So now what you have is, well, this is unfavorable, not good, not a good, not a good variance. $25,000, $680,000, and that's to you. That's unfavorable variance. Now why did that happen? We'll examine that later when we drill a little bit down. All we're focusing here is on the sales variance. Let's look at the variable selling price. Variable selling price. You're supposed to spend $72,000. You spend only $68,000. That's good. So there's a difference of $4,000. And that's a favorable variance because you spent less. Now if you want to, you could compute the contribution margin, the difference between the contribution margin variance. And let's do so. So $424,000 minus $442,000, $320,000. And that's $18,000, $320,000. So you have more profit $18,000, $320,000, which is favorable. Or you could do, you could also net these out. Favorable, unfavorable, and favorable. And you'll get to the same figure, which is $18,000, $18,320. So that's basically what we did. We did the sales price variance. Sales price variance. Now the only thing we're going to also analyze in this example is the fixed cost variance. Well, to tell you the truth, the fixed cost variance, you should not have any. In theory, and in practice, to a great degree. Why? Because fixed cost is fixed cost within the relevant range, and we're assuming within the relevant range. The fixed cost should not change. But let's first compute the figures, and we analyze it a little bit further. Your flexible budget is $200,000. You only incur $195,500, which is, in a sense, it's good. In a sense, it's good, which is how much it's better by $4,500 favorable. And you plan $140,000. You only spend on the fixed selling, $132,320. So you have also a favorable of $7,680. Now you can, that's also favorable. Now you could also compute the all the favorable, and obviously this is favorable, favorable, favorable. But what happened to the fixed cost? Well, again, the nature of fixed cost, it should be fixed. What could explain this change? What could explain the change? Well, one thing is maybe you forgot. Maybe the company forgot to include something or did not do something they were supposed to do. So they did not incur an expenditure that they were supposed to do. Or they maybe anticipated a rate increase, maybe their insurance. They anticipated a rate increase in their insurance, in their insurance premium, but it did not happen. So that's why they planned $200,000. They thought, well, the insurance company, they're gonna hit us with a rate increase, but it did not happen. That could be the case. But to a great degree, to a great degree, to a great degree, there should not be no change. There should not be no change between the two, between the two, okay? So let's take a look at the overall difference at the profit analysis. 1,400, 500, minus 84,000. The difference is 30,500. Again, you can reconcile, and this is obviously favorable. So we did better. And the reason, the main reason why we did better this month is because we were able to sell at a higher price. And that's a little bit unusual for companies to plan for 10 and to get 10, 50, unless the marketing people, they already knew they couldn't get it for, they can get it for 10, 50, and they priced it for 10. So they look good, beside the point here. But the point here is they were able to do it. And let's reconcile. If we take the 30,500, 30,500, and we can analyze the numbers. So we have 18,320 favorable, just to make sure you could reconcile this, 18,320. Then we have 4,500 in the fixed manufacturing favorable and 7,600 in the selling. And if you net these out, they net out to zero. It means, you know, you're able to explain everything. So this is basically the sales variance. Now I'm gonna go back to the PowerPoint slides and I'm just gonna go over this. Again, we said this number is really useless in a sense because you're looking at apple versus orange here. So this way, this is not very good. This is not very good. Remember the static budget is for a single activity, usually the master budget. Then we learn how to flex the budget, the budget that indicate revenue, cost, and profit at different level of activities. And what we did here is we flexed the budget. The static was 100,000 unit. We flexed it to 80,000. Then we did our analysis. Remember the sales activity variance is the difference between the operating profit and the master budget and the operating profit and the flexible budget. It's called the sales activity variance. I showed it to you. The variance arise because the actual number of units sold. It has to do with the number of unit sold. It has to do with the number of units sold. And this is the sales activity column that I showed you earlier, but this is cleaner. Okay, you could examine this. Okay. The profit variance analysis is analysis of the causes of the difference between the budgeted profit and the actual profit earned. Okay, so what was the budgeted profit? What should have been the budgeted profit and the actual profit tested with sales price variance? This is what we focused on. Fixed production cost variance, variable production cost variance, marketing and administrative cost variance. And this is basically an overall picture what I just showed you. So this is the 75,200 comparing the master budget to the actual budget. And we say you really don't wanna use this because if you are asked to do so, that's fine. This is the total variance from the master budget, but just in the real world, you don't do it. In the real world, what you do, you prepare a flexible budget and this is what I did. This is what I did. Then what you do is you start with, if you want to start with the sales activity variance and you analyze the difference. And this is the 106 that was unfavorable because we sold less unit. It has to do with less unit. And whatever we get favorable or unfavorable, that's gonna go down to the bottom line to the profit because the fixed cost, it should not have any effect on the sales activity variance because fixed cost is fixed in terms of sales. Then you could compare the flexible budget to the actual budget. And here what they did in this slide, they broke it down into sales price variance. And we said here, you were able to charge more. Therefore your sales was higher, although you are selling 80,000 unit. Your variable manufacturing overhead cost was unfavorable. Your variable selling price, which was favorable. And don't worry, we are going to do a little bit more into these figures. But the point that I want you to, the big picture that I want you to start to see is this. Notice what we did in our analysis. Let's, I'm gonna break it down into two component here. I'm gonna break this down into two component. So this is the flexible budget. Basically the flexible budget is the middle. What we did here, we looked at the quantity. So this is the change in Q quantity because on this side, everything happened because of the quantity. And on this side, everything happened because of the price. Okay, and what we're gonna be doing later, we're gonna be drilling when we do additional analysis. This is just an introduction when we drill into our direct material, into our direct labor, into variable manufacturing overhead. We're gonna be broken down. We're gonna be broken those figures into price and quantity or efficiency and usage variance. Okay, so just get, just look at, I wanna make sure you understand the big picture. And we'll look at this later. Don't worry about this. Don't worry about this. But this is an overall analysis about the sales activity variance and the profit analysis. If you have any questions, any comments by all, by all means email me. If you're studying for your CPA, make sure you study hard or for your CMA. Good luck and study hard.