Information for comparison

1 Introduction

Presenting a piece of information on its own is of little value. You would not know, for example, whether or not sales of $5 million or a gross profit of 20% is good or bad. To make a judgement you have to compare figures to ‘get a feel’ for performance.

2 Basis of comparison

The normal bases of comparison are:

1. Previous period information

For example, compare revenue and expenses of this year so far to last year’s revenue and expenses. This has the advantage that the last period’s information is usually readily available, but has the disadvantage that the period lengths will normally not match. For example, comparing the results of the current three months with the last 12 months.

2. Corresponding period information

Here you would, for example, compare the result of 1/1/2015 – 31/3/2015 to those of 1/1/2014 – 31/3/2014. This has the advantage of taking into account any seasonal factors that might be relevant.

3. Forecast/budget information

Forecasts and budgets are often used to set targets and comparing the current actual information with budget information will give a feel for whether or not the organisation is on target to meet its budget.

4. Other organisations

This needs care as there is little point in comparing a supermarket’s results to those of an airline. However, large chains of supermarkets keep a careful eye on each other to judge their performance: market share, gross profit, overhead costs. Even within one business sector, such as supermarkets some care is needed to ensure comparisons are valid as different companies might target different sectors or have within them a degree of diversification. For example, in the UK some of our supermarkets also run banks and credit card operations whereas others specialise in food.

3 The forecasting and budgeting process

Most budgets are created by looking at last year’s budget and updating for price changes, changes in product lines and so on. This approach is known as incremental budgeting and it is relatively quick and easy to carry out. However, it is often criticised because the operations of the company are not necessarily examined and challenged during the budgeting process. Just because last year IT cost $3 million and inflation is running at 10%, there is no need to assume that next year IT should cost $3.3 million. Technological advances or eliminating surplus reports and processing could allow savings to be made. Alternatively, improving the web-site dramatically could cause expenditure to be much higher in the next period. Some companies attempt zero-based budgeting which implies starting from scratch and building up the budget, justifying each $ spent.

Forecasting sales for a budget is particularly difficult as this will depend on prices, the economy, competitor action, the success of new products, the continuing popularity of old products and the effectiveness of advertising. Statistical approaches might be of some use. For example, it should be possible to predict future seasonality of sales from the patterns in previous years.

4 Feedback and feed forward control

Once budgets and forecasts have been established, then feedback control and feed forward control become possible.

Feedback control: for example, budget costs $1/unit, actual costs $1.5/unit. It appears that costs are running out of control and action should be taken to try to bring the costs back into line. This would be negative feedback control as it attempts to reduce the deviation from budget. In feedback control the problem or deviation has already happened. If sales were running ahead of budget, then there would be positive feedback control to try to keep or increase the deviation.

Feed forward control: this is where a problem in the future is anticipated and action is taken to avert that occurring. For example, if the cash flow budget is suggesting that, because of poorer than expected sales, the company will be short of cash in six months, then action could be taken now to avoid the problem. That action could be to increase the amount of borrowing that’s available, or to cut back on discretionary expenditure to maximise cash.

5 Flexible budgets

Often budgets are drawn up for only one level of activity, such as assuming production and sales will be 10,000 units. This is known as a fixed budget.

However, fixed budgets are of limited comparative value if actual production and sales are very different to the budget. Therefore, some companies draw up in advance flexible budgets. These are budgets produced at a number of different activity levels. For example, at production levels of 6,000, 8,000, 10,000 and 12,000 units. Having a range of possible forecasts will make comparisons to actual results more meaningful and also facilitates creating additional budgets between two existing flexible budgets.

To build a flexible budget you split every cost into its fixed and variable parts, then repeat the budget at each activity level you want to see. Only the variable costs move.

Notice that the total cost per unit falls from $12.67 to $11.00 to $10.00 as output rises, because the fixed costs are spread over more units. That is the whole point of drawing the budget at several levels: management can see in advance what the cost will be whichever way demand turns out.

6 Variances

A variance is the difference between actual and budgeted expenditure or income. Some care is needed to ensure that the comparison is valid.

If actual expenditure is higher than it should be, the variance is described as being ‘unfavourable’ (or ‘adverse’); if actual expenditure is lower than it should be then the variance is described as being ‘favourable’.

For example, assume that the raw material budget for a period is $100,000, but that actual expenditure is $110,000. Because expenditure is $10,000 above the budget it might look as though the production manager had been careless in the use of material.

However, this might be an invalid conclusion. What if you were told that the budget assumed that production would be 10,000 units but that because of extra demand actual production was increased to 12,000 units? Increasing production by 20% implies that raw material costs should increase 20% to $120,000. Viewed in that light, it can be argued that the production manager has actually saved $10,000 ($120,000 - $110,000). This would be a $10,000 favourable variance.

Adjusting the budget in line for the units produced is known as ‘flexing the budget’ and the result is a ‘flexed’ budget. Note this is different to a flexible budget as described above.

Amounts that need to be flexed are those which vary with production volume, typically:

• Raw material
  

• Variable labour
  

• Variable overheads (machine costs)
  

Sales figures can also show variance ie revenue can be greater or less than budgeted for each line of inventory.

Some amounts do not need to be flexed in line with output because they are not variable ie they do not depend on production volumes. These are the company’s fixed costs. Examples include:

• Rent
  

• Depreciation
  

• Administrative salaries
  

Therefore, if the actual rent is $15,000 above budget this will be an adverse variance no matter what production is.

7 Causes of variances

Identifying the amount and sign of a variance is only the first step. Unless the cause of the variance is investigated and understood, knowing what the size of the variance is rather useless. Only once its cause has been discovered can steps be taken to try to eliminate it (in the case of an adverse variance) or to repeat it (in the case of a favourable variance).

Typical causes of variances are

Note that many variances can be interdependent. So, if sale prices are reduced then sales volumes are likely to increase. If more money is spent on training (potentially an overhead variance) then labour and material costs are likely to decrease because the workforce is more efficient and wastes less material. If cheap material is bought then you might expect more to be used because it is of poor quality. It follows that an adverse variance will not always mean that a wrong decision has been made or that performance is poor. Certainly, large adverse variances would probably be investigated, but spending more than expected on training might be repaid many times over in lower expenditure on materials and labour.

8 Exception reporting

Exception reporting is the idea that if a business is producing results in line with a budget or forecast, then not much management action will be needed. If however there are substantial deviations from a plan then this needs to be investigated and management attention is required. For example, if sales are below budget, then management might have to think about increasing advertising spend, or decreasing prices. If wages and salaries are too high, management might consider a recruitment freeze or limiting pay rises.

In other words, management should be particularly interested where unusual or exceptional events occur. Variance analysis is of great help here as, in general, large variances imply unusual, exceptional that are worthy of management attention. Generally management would set control limits for each variance and if a variance went over that then an explanation would be required.

9 Investigation of variances

The following are the main influences on whether or not to investigate a variance.

• Cost v benefit. Variance investigation takes employee time and this has costs attached. Variances are only worth investigating if the cost of the investigation is less than the benefit likely to arise. There is little point in spending $1,000 investigating a cost overrun of $10.
  

• Size of the variance. Larger implies that the investigation is more worthwhile. In most cases using the percentage deviation will be more appropriate than the absolute variance. In a small business $10,000 might be very material, but in a large multi-national business $10,000 will be trivial.
  

• Sign of the variance. Most people will be keener to investigate the cause of an adverse variance than a favourable variance. There is a feeling that the adverse variance implies something going wrong and that we want to ‘stop the rot’, or at least be able to explain to our boss what the cause is.
  

• Likelihood that the variance can be controlled. If heating costs were above average, but the weather had been particularly cold, then there is little management can do to stop the additional expenditure.
  

• Natural variability. Some amounts will vary quite a lot from month to month (eg direct labour overtime payments will depend on orders and production that month) whereas other amounts will be much more stable (eg admin salary costs). It is likely to be more useful investigating a 5% overrun on admin costs than a 10% variation on overtime.