Performance Management

A static budget is prepared for one planned level of output. Comparing actual results with it mixes two stories: you sold a different volume, and you earned or spent differently per unit. A flexible budget restates the budget at the actual volume using budgeted prices and costs per unit, so the two stories separate cleanly.

flowchart TD
  S[Static budget variance] --> V[Sales-volume variance]
  S --> FB[Flexible-budget variance]
  V --> MX[Sales mix variance]
  V --> QT[Sales quantity variance]
  FB --> SP[Selling-price variance]
  FB --> DM[Materials: price + usage]
  FB --> DL[Labor: rate + efficiency]
  FB --> OH[Overhead: spending + efficiency + volume]
  DM --> MY[Usage = mix + yield]

Every input variance uses the same three columns: actual quantity at actual price, actual quantity at standard price, and the standard quantity allowed for actual output at standard price. Moving across one column at a time changes one thing, so each variance has a single cause.

Point of recognition

• Most firms isolate the price variance when materials are purchased, using the quantity purchased. Inventory is then carried at standard price.
• The usage variance always uses the quantity used. When purchases ≠ usage, the two variances do not add up to a single "total".
• Price variance owners: purchasing (supplier choice, order size, freight). Usage variance owners: production (waste, spoilage, machine settings).

• Rate variances come from overtime premiums, a different skill mix than planned, or wage settlements. HR and the production supervisor who schedules crews usually share them.
• Efficiency variances come from training, machine downtime, poor scheduling, or poor-quality materials. A cheap material purchase can show up here as extra hours.
• A favorable rate variance paired with an unfavorable efficiency variance often means less-skilled (cheaper, slower) workers were used.

Variable overhead behaves like labor: it is applied on an activity base (direct labor or machine hours), so it has a spending (rate) and an efficiency (quantity) variance. Fixed overhead does not change with activity, so it has a spending variance and a production-volume variance, and no efficiency variance.

Revenue-side variances explain why contribution margin differed from the static budget. Price effects use actual units; volume, mix and quantity effects use budgeted contribution margin per unit so that price is never counted twice.

When inputs can be substituted (chemicals, food ingredients, a mix of labor grades), the usage variance splits into a mix variance (a different proportion of inputs) and a yield variance (more or less total input than standard for the output achieved).

Who owns which variance

Controllability is the organizing rule. A manager should be evaluated on revenues, costs and assets that the manager can significantly influence. It does not require complete control; shared influence is normal.

• Controllable margin evaluates the manager: it subtracts only fixed costs the manager can change (local staff, local advertising).
• Segment margin evaluates the segment: it also subtracts fixed costs traceable to the segment but decided elsewhere (equipment depreciation, the segment manager's salary).
• A traceable cost disappears if the segment is dropped (over the relevant horizon). A common cost remains.

Companies still allocate shared costs (IT, a warehouse, headquarters) to price products, to make managers aware that the services are not free, and to discourage overuse. The basis matters, and so does whether managers can influence the result.

• Cause and effect (cost drivers) is the preferred basis; benefits received is next; ability to bear (e.g. sales dollars) is the weakest and penalises successful segments.
• Budgeted, not actual, rates: charging users actual service costs passes the service department's inefficiency on to them.
• Dual-rate: charge fixed service costs as a lump sum based on capacity reserved, and variable costs on actual usage, so one user's usage does not shift fixed cost onto another.

• Idle capacity: nothing is displaced, so the minimum is the seller's incremental (usually variable) cost, less any costs avoided on internal sales.
• Full capacity: each unit transferred displaces an outside sale, so the minimum is the market price less costs avoided internally.
• Partial capacity: only units beyond the idle capacity carry an opportunity cost, so the minimum per unit is a weighted average.

• The company goal is maximum total after-tax profit, not one division's result.
• A higher transfer price moves taxable income to the selling country but raises any import duty, which is levied on the transfer price.
• Tax authorities require an arm's-length price (US IRC §482; OECD guidelines), supported by documentation. Prices outside the acceptable range invite adjustments and penalties.
• Currency controls, repatriation limits, political risk and local minority shareholders also shape the policy.

Customers consume resources differently: order frequency, rush deliveries, returns, support calls. Customer profitability analysis assigns these cost-to-serve activities with activity-based rates. Ranking customers by profit usually produces a "whale curve": a minority of customers generate more than all the profit, and the least profitable customers destroy part of it.

• Asset base choices: total assets, assets employed (excluding idle assets), net book value, or gross book value.
• Net book value makes ROI rise as assets age, rewarding managers who postpone replacing equipment. Gross book value removes this effect.
• Use average assets when income is earned over a period and the asset base changed during it.

• RI fixes the ROI rejection problem: every project earning more than the hurdle rate raises RI.
• RI and EVA are absolute dollar amounts, so larger divisions show larger numbers. Do not rank different-sized divisions on them directly.
• EVA uses after-tax profit and the WACC, and may adjust accounting figures (e.g. capitalize R&D) to reflect economic reality.

Critical success factors are the few things the strategy must get right. The balanced scorecard turns them into KPIs across four perspectives, linked by cause and effect in a strategy map.

flowchart BT
  L[Learning & growth: trained staff, better systems] --> P[Internal process: shorter cycle time, fewer defects]
  P --> C[Customer: on-time delivery, retention]
  C --> F[Financial: revenue growth, ROI]

• Leading indicators predict future results (training, defects); lagging indicators report results already achieved (profit, ROI).
• Good KPIs are tied to strategy, few in number, a mix of financial and non-financial, controllable by the person evaluated, timely and objectively measured.

• Sources: engineering studies (accurate, costly), adjusted historical data, benchmarking, and participation by the people who will be measured.
• Participation improves acceptance but invites budgetary slack.
• Price standards include freight and are net of discounts; quantity standards include normal waste; labor rates include payroll taxes and fringe benefits.

Inventories and work in process are carried at standard. Each variance gets its own account: unfavorable variances are debits (extra cost) and favorable variances are credits.

• Immaterial variances are closed to cost of goods sold.
• Material variances are prorated to work in process, finished goods and cost of goods sold (and materials inventory for a price variance recognized at purchase), in proportion to the standard cost in each account, so that inventories approximate actual cost as GAAP requires.

• Management by exception: investigate based on size (dollars and percent), recurrence, trend, controllability, and whether the expected benefit exceeds the cost of investigating.
• Statistical control charts separate random variation from an out-of-control process: investigate points outside the limits or non-random runs.
• Investigate large favorable variances too: cheap materials, skipped maintenance or a loose standard can all look favorable.
• Limits: standards go stale in fast-changing processes; price-variance pressure encourages bulk or low-quality buying (at odds with JIT and TQM); efficiency pressure encourages building unneeded inventory.