Summary by David Montgomery
Master of Accountancy Program
University of South Florida, Summer 2003
The two most fundamental financial management tools are budgets and variance analyses; however, variance reports are not particularly useful for the typical manager. The main problem is that when performing variance analyses, cost must be identified as being either fixed or variable. In reality, many costs do not behave in this manner. This leads to limitations within the reports and poor management behavior. According to the author, “The time has come for financial managers to develop: models of cost reflecting how costs actually behave, and variance reporting using enhanced cost models” (Wing, 29). The author’s purpose is to explain how to handle variance calculations for semi-variable costs, for step-fixed costs, and for several situations where a shifting mix affects cost behavior.
Volume Variance with Semi-Variable Costs
Semi-variable costs have a unique characteristic. They are fixed below a certain level of volume, known as the breakpoint, and they are variable above that level. As explained, these costs act differently over a range of volume. Therefore, their volume variance behaves similarly: volume variance is zero in the fixed cost range, and volume variance is the same as for a variable cost over the variable cost range. The following four cases compare budgeted volume (BV) and actual volume (AV) to the breakpoint (BP), and the resulting volume variance.
Case 1: Where BV & AV < BP the Volume variance = 0.
Case 2: Where BV < BP ; AV > BP the Volume variance is the same as for a variable cost.
Case 3: Where BV > BP ; AV < BP the Volume variance = 0
Case 4: Where BV & AV > BP the Volume variance is the same as for a variable cost.
Volume Variance with Step-Fixed Costs
Step-fixed costs also have a unique characteristic. They are fixed up to a certain level of volume, and then they increase to an even higher level of fixed cost to a certain level of volume. This process is repeated over and over with fixed costs increasing to higher levels. When dealing with step-fixed costs it is important to recognize at what points costs increase and to what levels they increase. Once this is accomplished, the volume variance is what the cost is suppose to be at budgeted volume minus what the cost is supposed to be at actual volume.
For the most part, cost centers contain four types of costs: Variable; Fixed; Semi-variable; and Step-fixed. Once the volume variances for each of these four types are known, the volume variance for the entire cost center is just the sum of each of these volume variances.
The first step in determining a mix variance is to create a pair of “what-if” budgets. According to the author, “Budgeted variable costs are based on budgeted unit volume, budgeted procedure mix, and budgeted unit cost for each procedure. Actual variable costs are based on actual volumes, actual procedure mix, and actual but unknown unit costs for each procedure” (Wing, 32).
The first “what-if” budget to be created is based upon budgeted procedure mix, budgeted unit cost per procedure, and actual volume. In this case, the volume variance equals the budgeted variable cost minus the flexible budget. In other words, how much variable costs should have differed from budget if the uncontrollable change in volume were the only change from budget that occurred.
The second “what-if” budget to be created is known as the mix index. It is based upon actual procedure mix and actual volume but budgeted unit costs by procedure. In this case, the mix variance equals the flexible budget minus the mix index. In other words, how much costs should have differed from budget if only the mix had differed from budget.
Mix Variance with Semi-Variable Costs
When determining a mix variance with semi-variable costs you must calculate two “what-if” budgets that will allow a comparison of numbers that differ in only one respect. In this case, budgeted semi-variable costs minus the flexible budget equals the volume variance. The flexible budget minus the mix index equals the mix variance. And the mix index minus actual semi-variable costs equals the unit cost. However, if actual volume is less than or equal to the breakpoint, the mix variance is zero. According to the author, “When there is a mix variance with semi-variable costs, variances should not be calculated on data for aggregate periods. Rather variances for the shortest reporting period ought to be aggregated in order to report variances for longer periods” (Wing, 33).
Mix Variances with Step-Fixed Costs
In order to determine the mix variance with step-fixed costs, a flexible budget should be created based upon actual volume, budgeted mix, and the budgeted step-fixed-cost function. A mix index based upon actual volume, actual mix, and the budgeted step-fixed-cost function should also be created. In this case, budgeted step-fixed costs minus the flexible budget equals the volume variance. Meanwhile, the difference between the flexible budget and the mix index equals the mix variance.
A problem can occur however, because actual step-fixed costs can differ from the mix index for either of the following reasons: 1.) Too much of the step-fixed resource was used for the amount of volume; or 2.) The proper amount was used, but the price was too high. According to the author, “To separate out these two causes, calculate another ‘what-if’ budget called the consumption index, which is based on actual consumption of the step-fixed resource and the budgeted step-fixed-cost function” (Wing, 35). Once this additional “what-if” budget has been completed, the difference between the mix index and the consumption index creates the unit consumption variance. Which is compared to the price variance (consumption index minus actual step-fixed costs), to determine the variance caused by the price of the resource.
Variances for Departments with Mixed Costs
In the real world, departments may have several variations of mixed costs. Therefore, in most cases a department’s total budgeted variance will be equal to the sum of the variances of each different kind of cost. This holds true as long as all costs in the department are classified as one kind or another.
Management decisions are significantly effected by the accounting systems that are designed and implemented. If a system is based on a poor model, it will either be used or ignored. If it is used it will lead to poor management decisions. According to the author, “The assumed behavior of a cost - whether fixed, variable, semi-variable, step-fixed, or something else – is a basic assumption affecting any kind of planning, financial analysis, or control” (Wing, 35). Managers can no longer just assume a cost to be fixed or variable. In conclusion, significant costs must be modeled more accurately leading to better management decision making.
“Developing other, more sophisticated cost models and variance reporting is an important direction for the management accounting and financial management profession that will lead to improved control and decision making.”
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