Managing a Business/Accounting for managers
Please do need ful help.
q-1.State the group of persons having an interest in a business
organization And examine the nature of their information needs.
Q.2 Examine the role of accounting concepts in the preparation
of financial statements.
Q.3 following information relates to Ram sons operation for a
period ending December 31, 2002,the first year of operations.
From this information complete the accompanying profit and
Loss Account and Balance Sheet.
Revenues and expenses of the period are as follows:
Depreciation expense 5,000
Purchases (raw material) 50,000
Purchase discount 5,000
Sales 1, 00,000
Returns inwards and allowances 2.000
Sales Discount 1,000
Interest expenses 2,000
Miscellaneous Expenses 5,000
Interest on deposits received 2,000
Balance shown by asset and liability accounts on 31st December 2002 is as
Deposits with bank 20,000
Inventory of raw material 10,000
Buildings and equipments 90,000
Advance tax paid 5,000
Tax payable ?
Accounts receivable 20,000
Accounts Payable 19,500
Long term Loan 50,000
Retained earning ?
Profit and Loss Account
For the Year ending 31st December 2002
Inventory consumed ________ Sales ________
Wages ________ Less: Returns and ________
Gross Profit ________ Allowances ___ _____
Depreciation expense ________ Gross profit ________
Rent ________ purchases discount ________
Sales Discount ________
Interest expenses ________
Miscellaneous exp. ________
Operation Profit ________
Operating Profit ________
Net Profit before tax _______ Interest on deposit ________
Income Tax@50% _______ Net profit before tax ________
Profit retained _______
As on 31st December2002
Assets Liabilities and Capital
Currents Assets Current Liabilities
Cash ______ Accounts Payable _________
Deposit with bank ______ Tax payable _________
Accounts receivable ____ Total current Liabilities _________
Advance tax paid _____ Long-term Loan ________
Total Current assets ______ Capital ________
Retained earnings ________
Less: Accumulated Depreciation ____ _______
Q.4 From the following data, calculate:
i) Break-even point expressed in rupee sales.
ii) Number of units that must be sold to earn a profit of
Selling price Rs.20per unit
Variable price Rs.10per unit
Variable selling costs Rs. 5per unit
Fixed Factory overheads Rs.5,00,000per year
Fixed selling costs Rs.2,00,000per year
Q.5 Discuss the importance of variance analyses in operational
and management control. How does this technique help
in, what is popularly known as ‘management by exception’?
Q.6 From the following data, calculate overhead variances:
Fixed overhead budget for November Rs.50,000
Variable overhead budget for November Rs.1,00,000
Budgeted production for the month 25,000units
Actual production for the month 27,000 units
Actual Fixed overhead incurred Rs.60,000
Actual variable overhead incurred Rs.1,20,000
Q.7 in what way is financial leverage related to operating
leverage? Discuss with an example.
Q.8 ABC co. Wishes to arrange overdraft facilities with its
bankers during the period April to June when it will be
manufacturing mostly for stock. Prepare Cash Budget
inclosing the extent of bank facilities he company will
require at the end of each month for the above period from
the following data.
a) Sales Purchases Wages
February 1,80,000 1,24,800 12,000
March 1,92,000 1,44,000 14,000
April 1,08,000 2,43,000 11,000
May 1,74,000 2,46,000 10,000
June 1,25,000 2,68,000 15,000
b) 50 per cent of credit sales is realized in the month following
the sale and the remaining 50percent in the following second
month. Creditors are paid in the month following the month of
Cash at bank on the 1st April (estimated) is Rs. 25,000.
Q.9 A company wishes to determine the optimal capital
structure form the following information. Determine the
optimum capital Structure form the viewpoint of minimizing the
cost of capital.
Financing Dabt Equity After tax Cost of
Plan Amount Amount Cost of equity ke%
A 8,00,000 2,00,000 14 20
B 6,00,000 4,00,000 13 18
C 5,00,000 5,00,000 12 16
D 2,00,000 8,00,000 11 18
q-1.State the group of persons having an interest in a business organization And examine the nature of their information needs.
a).There are several groups of people who have a stake in a businessorganization. They are the following:
•Potential InvestorsAdditionally the community at large has economic and social interestin the activities of such organizations. This interest is expressed atnational level by the concern of government in various aspects of firm’s activities such as their economic well being, their contributionto welfare, their part in the growth of national product.Information needs of various users are:
SHAREHOLDERS & INVESTORS
Since shareholders and other investors have invested their wealth ina business enterprise, they are interested in knowing about theprofitability of the enterprise, the soundness of their investment andthe growth prospects of the enterprise. Historically, businessaccounting developed to supply information to those who hadinvested their funds in business enterprises.
Creditors may be short term or long term lenders. Short termcreditors include suppliers of materials, goods or services. They are normally known as trade creditors. Long term creditors are thosewho have lent money for a longer period, usually in the form of secured loans. The main concern of creditors is focused on the creditworthiness of the firm and its ability to meet its financial obligations.Therefore they are concerned with the liquidity of the firm, itsprofitability and financial soundness. In other words creditors aremainly interested in information which deals with the solvency,liquidity and profitability so that they could assess the financialstanding of the firm.
The view that business organizations exist to maximize the returns toshareholders has been undergoing change as a result of socialchanges. A broader view is taken today of economic and social role of management. The importance of harmonious industrial relations b/wmanagement and employees can not be over emphasized. That theemployee has a stake in the outcomes of several managerialdecisions is recognized. Greater emphasis on industrial democracythrough employee participation in management decisions hasimportant implications for the supply information to employees.Matters like settlement of wages, bonus and profit sharing rest onadequate disclosure of relevant facts.
In the mixed economy it is considered to be the responsibility of thegovernment to direct the operation of the economic system in such amanner that it sub serves the common good. Controls andregulations on the operation of government agencies collectinformation about various aspects of activities of businessorganizations. All the information is very important in evolvingpolicies for managing the economy.
Organizations may or may not exist for the sole purpose of profit.However, information needs of the managers of both kinds of organizations are almost the same, because the managerial processi.e. planning, organizing and controlling is the same. All thesefunctions have one thing in common and it is that they all areconcerned with making decisions, which have their own specificinformation requirements.
Consumer organizations, media, welfare organizations and public atlarge are also interested in condensed accounting information inorder to appraise the efficiency and social role of the enterprise indifferent sectors of the economy i.e. what levels of profits andoutputs are being achieved and in what manner the growth is beingplanned by the enterprises in accordance with the national priorities.
THE MANAGEMENT INFORMATION NEEDS ARE
Types of Systems
Management information systems can be used as a support to managers to provide a competitive advantage. The system must support the goals of the organization. Most organizations are structured along functional lines, and the typical systems are identified as follows:
Accounting management information systems: All accounting reports are shared by all levels of accounting managers.
Financial management information systems: The financial management information system provides financial information to all financial managers within an organization including the chief financial officer. The chief financial officer analyzes historical and current financial activity, projects future financial needs, and monitors and controls the use of funds over time using the information developed by the MIS department.
Manufacturing management information systems: More than any functional area, operations have been impacted by great advances in technology. As a result, manufacturing operations have changed. For instance, inventories are provided just in time so that great amounts of money are not spent for warehousing huge inventories. In some instances, raw materials are even processed on railroad cars waiting to be sent directly to the factory. Thus there is no need for warehousing.
Marketing management information systems: A marketing management information system supports managerial activity in the area of product development, distribution, pricing decisions, promotional effectiveness, and sales forecasting. More than any other functional area, marketing systems rely on external sources of data. These sources include competition and customers, for example.
Human resources management information systems: Human Resource Management information systems are concerned with activities related to workers, managers, and other individuals employed by the organization. Because the personnel function relates to all other areas in business, the human resources management information system plays a valuable role in ensuring organizational success. Activities performed by the human resources management information systems include, work-force analysis and planning, hiring, training, and job assignments.
The above are examples of the major management information systems. There may be other management information systems if the company is identified by different functional areas
Q.2 Examine the role of accounting concepts in the preparation of financial statements.
Accounting concepts are the ground rules of accounting that are (or should be) followed in preparation of all accounts and financial statements.
The four fundamental concepts are:1).
Revenue and expenses are taken account of when they occurand not when the cash is received or paid out.2).
Once an entity has chosen an accounting method, it shouldcontinue to use the same method, except for a sound reasonto do otherwise. Any change in the accounting method mustbe disclosed.3).
It is assumed that the business entity for which accounts arebeing prepared is solvent and viable, and will continue to be inbusiness in the foreseeable future.4).
Revenue and profits are included in the balance sheet onlywhen they are realized (or there is reasonable 'certainty' of realizing them) but liabilities are included when there is areasonable 'possibility' of incurring them. Also called
.Other concepts include
Total assets of an entity equal total liabilities plus owners'equity.6).
Financial records pertaining only to a specific period are to beconsidered in preparing accounts for that period.7).
Asset value recorded in the account books should be the actualcost paid, and not the asset's current market value.8).
Accounting records reflect the financial activities of a specificbusiness or organization, and not of its owners or employees.9).
Financial statements and their notes (footnotes) shouldcontain all pertinent data.10).
Lower of cost or market value:
Inventory is valued either at cost or the market value(whichever is lower) to reflect the effects of obsolescence.11).
Maintenance of capital:
Profit can be realized only after capital of the firm has beenrestored to its original level, or is maintained at apredetermined level.
Transactions affecting both revenues and expenses should berecognized in the same accounting period.13).
Relatively minor events may be ignored, but the major onesshould be fully disclosed.14).
Accounting process records only those activities that can beexpressed in monetary terms (with some exceptions, as incost-accounting).15).
Only the activities measurable in terms of money should berecorded.16)
Financial statements should be based only on verifiableevidence, comprising an audit trail.17).
Any change in the market value of an asset or liability is notrecognized as a profit or loss until the asset is sold or theliability is paid off (discharged).18).
Unit of Measurement:
Financial data should be recorded with a common unit of measure (dollar, pound sterling, yen, etc.). Also calledaccounting conventions, accounting postulates, or accountingprinciples.
While going through all these concepts, we have developed a feelingthat they come in conflict with each other. For example, a firmacquired a piece of land in 1975 at a price of Rs. 60,000. Factorypremises were constructed in 1976 and operation started in 1977.The firm has a great success with a profit profile for the past 18 years.The balance sheet for the year 1995 is being prepared and land isrequired to be valued. The estimated current market price of thisland is Rs.600,000.Should we recommend that land valued at Rs. 600,000. ? The answeris “NO”. Obviously land would be carded on balance sheet as itsoriginal cost of Rs. 60,000 only. This decision is supported by severalof the concepts. First of all, the stability of purchasing power of money implied in the money measurement concept prevents us fromrecognizing increase in value as a result of changing price levels. Thenthe realization concept will not allow unrealized profits to beincluded as long as land is held by the firm and not sold away. Wemay note that the continuity or going concern concept makes anypossible market value of land irrelevant for balance sheet becausethe firm has to continue in business and land will be needed by it forits own use. In this regard, it could be argued that if land was shownon the balance sheet as its estimated current market value, theowner might decide to discontinue the business, sell the land andretire. The estimate of current profit market value figure may besuspect. It raises many questions. Do we have a market quotation foran identical plot of land? Has a similar to land been sold recently andcan we pick it up as verifiable evidence of the current market place?Is it possible to estimate the value of land without factory buildingsand other facilities constructed on it? The answer is “NO” and theconservation concept will then deter us from accepting an estimateof market value since it can not be ascertained with reasonableaccuracy.
Q.5 Discuss the importance of variance analyses in operational and management control. How does this technique help in, what is popularly known as ‘management by exception’?
Variance analysis, also described as analysis of variance or ANOVA, involves assessing the difference between two figures. It is a tool applied to financial and operational data that aims to identify and determine the cause of the variance. In applied statistics, there are different forms of variance analysis. In project management, variance analysis helps maintain control over a project's expenses by monitoring planned versus actual costs. Effective variance analysis can help a company spot trends, issues, opportunities and threats to short-term or long-term success.
Budget vs. Actual Costs
Variance analysis is important to assist with managing budgets by controlling budgeted versus actual costs. In program and project management, for example, financial data are generally assessed at key intervals or milestones. For instance, a monthly closing report might provide quantitative data about expenses, revenue and remaining inventory levels. Variances between planned and actual costs might lead to adjusting business goals, objectives or strategies.
A materiality threshold is the level of statistical variance deemed meaningful, or worth noting. This will vary from company to company. For example, a sales target variance of $100,000 will be more material to a small business retailer than to a national retailer accustomed to generating billions in annual revenues. Conversely, a 2 percent cost overrun might be immaterial for a small business but translate into millions of dollars for a large company.
Relationships between pairs of variables might also be identified when performing variance analysis. Positive and negative correlations are important in business planning. As an example, variance analysis might reveal that when sales for widget A rise there is a correlated rise in the sales for widget B. Improved safety features for one product might result in sales increases. This information might be used to transfer this success to other similar products.
An important type of prediction is business forecasting. It uses patterns of past business data to construct a theory about future performance. Variance data are placed into context that allows an analyst to identify factors such as holidays or seasonal changes as the root cause of positive or negative variances. For example, the monthly pattern of sales of television sets over five years might identify a positive sales trend leading up to the beginning of the school year. As a result, forecasts for television sales over the next 12 months might include increasing inventory by a certain percentage — based on historical sales patterns — in the weeks before the start of local universities' fall term.
Cost control entails that responsibility centers should be identified with the standard cost
for the output achieved. Control can be achieved by comparing total actual cost with total standard
costs for each operation or responsibility center for a period . The standard costs for
the actual output for a particular period will be traced to managers of each responsibility center and be held responsible for the various operations.
Control over cost should be corrected through action at the point where cost is incurred. In
performing an operation, standard should be set for the quantities of materials, labour and service to be consumed. Deviation from standard should be reported to management to show their causes and factors responsible for such deviation.
In variance analysis, the difference between actual cost and its budgeted or standard cost
is segregated into price and quantity components. A favourable variance occurs when output exceeds input or when the price paid fora good or service is less than expected. An unfavourable
variance arises when output is less than input or when the price for a good or service is greater than expected .
For accounting information to serve as a useful tool for control, it should provide an
accurate representation of capability of a process. Hence, the process managers will have the ability and authority to control the components of the process . The
question that readily comes to mind is ‘would variance analysis be able to provide this"? This study attempted to empirically assess the above statement and its relevance. It thus focused on the analysis of variances and how variance serves as accounting information for management control
tool. The following specific objectives were pursued in order to achieve this broad aim:
i. Examination of variance based on pre-determined and actual production likewise
ii. Assessment of the homogeneity of the variances of all the selected brands.
iii. Evaluation of the mean of all the selected brands for both production and sales
iv. Offering of recommendations based on the findings from the study.
The study is limited in scope, to the production and sales of five brands of 7 feet
mattresses for five-years (2001-2005) and concentrated on process in relation to production capacity.
In order to answer the research questions and achieve the purpose of the study, the following research propositions in form of hypotheses were formulated and tested empirically. Let Ho be the
null hypothesis and HI be the alternative hypothesis.
Ho: There is no under-utilization of capacity in the production of all brands.
Hi: There is under-utilization of capacity in the production of all brands.
Decision Rule: Reject Ho if there is no under utilization of capacity in the production of all
brands. This is reflected in tables 1 and 2. Accept Hr if otherwise.
Ho: There is no significant difference in the variances of all brands for production and
H.: There is significant difference in the variances of all brands for production and sale.
Decision Rule: Reject Ho if F calculated is greater than F tabulated, at 0.05 degree of
freedom. Accept Hi if otherwise.
Ho: There is no significant difference between the mean of predetermined and actual for
both production and sales of all brands.
Hi: There is significant difference between the mean of predetermined and actual for both
production and sales of all brands.
Decision Rule: Reject Hc if T calculated is greater than T tabulated at 0.05 degree of
freedom. Accept Hi if othewvise.
Typically, management establishes accounting standards and budgets to provide some
indications of what they expect from those individuals operating the system and to motivate people;
management compares accounting results with the predetermined standards and budgets. Hence, where significant variance results, an appropriate action is taken depending on the direction of the
variance . Standards, which can be used for control purposes rest on foundation of
properly organized, standardized method and procedures and a comprehensive information
simply defines variance as the difference between what is expected and
what is really received. "variance analysis is the process whereby
the difference between standard cost and actual cost is sub-analyzed into their constituent parts”.
This means that evaluation or performance by means of variances, with timely reporting should maximize the opportunity for managerial action.
Variance can be analysed in process capability by the use of statistical process control.
Deming (1993) states that statistical process control was developed to establish steps for the achievement of quality control in production; and to curb wastes in the use of material and labour. An lwarere (2000) state that the extent to
which actual result deviates from the planned figures is the level of positive or negative efficiency
attained. Noah (2007) submits that performance evaluation is the process by which the managers
at all levels gain information about performance against predetermined or pre-established criteria
as set out in the budgets, plans or goals.
As a matter of facts, every firm, be it manufacturing or service, will usually set goals to be
achieved and further put in place some mechanisms in ensuring that the set goals are achieved as
planned. Hilton (1999) views that any good control system must contain the following three basic
parts: a predetermined or standard performance level; a measure of actual performance; and a
comparison between standard and actual performance. Without doubt, variance analysis is
capable of detecting the level of deviation if any.
The prominent among the variance relevant in this study are direct material variance,
direct labour variance, variable overhead variance, fixed overhead and idle variance. Castellano
(2000) highlights likely variances that occur in production process. They include the following:
Material Variance: This comprises of material price variance and material usage variance. These measure the difference among the standard production material cost of the actual production volume and the actual cost of materials. Drury (2000) defines material variance as a measurement
of the difference between the standard material cost and the quantities of material purchased and
used, the total variance should be calculated as the sum of usage and price variances.
Direct Price Variance: defines direct price variance as the difference between the
standard price and the actual purchase price for the actual quantity of material. Direct material usage variance measures efficiency in the use of material, by comparing the standard cost of
material used with the standard material cost of what has been produced (actual production multiply by standard material cost per unit) minus ( actual material used multiply by standard cost
Outlines the following as likely causes of material variance.
- Paying higher or lower prices than planned. This means the processing manager do not have direct control on the price of materials to be used for production of a certain product.
It is the demand and supply forces that can determine the price of a given material at any point in time.
0 Losing or gaining quantity discounts by buying in smaller or larger quantities than planned.
The quantity oi material purchased determines the price which the purchasing manager
will pay for a material. The higher the quantity produced the lower the price because a
discount is sometimes given to a purchaser as an incentive to buy more.
0 Efficiency / inefficiency of purchasing department. This shows the bargaining power of purchasing manager in pricing a certain material in the market.
0 Buying lower or higher quantity than planned. This depends on the availability of fund with the purchasing manager as budgeted. If the price of material budgeted for is higher than
what was budgeted for, the purchasing manager may decide to buy a lower quality material than planned and if the price is lower than budgeted he can decide to buy higher
quality material than planned.
0 Buying substitute material due to unavailability of planned material. The purchasing manager can decide to buy a substitute material when the planned material is not available
in the market so that the production will not stop.
- Careless handling; pilferage: During production process, some labourers especially, it cheap labour was employed, do handle the materials carelessly.
- Purchase of inferior quality, changes in quality control. If materials of inferior qualities were purchased, the purchasing manager is very likely to use more material than expected in
the production. By so doing, the quantity of product produced will be reduced. Moreso, if
there is a change in the quality control of a product, this also can lead to shortagel
increase in the quantity of the product produced. This depends on quality control if it is upward or downward.
Direct Labour Variances: defines direct labour variances as the difference
between the standard direct labour cost of the output, which has been produced and the actual
direct labour cost incurred (standard hours produced multiply by standard direct labour rate per
hour) minus (actual hour paid multiply by actual direct labour rate per hour). These comprise direct
labour rate / wage variance and direct labour efficiency variance.
- Direct labour rate/wage variance:- Direct labour rate/wage variance is defined
as “the difference between the standard and actual direct labour hour rate per hour for the total
hours worked". Drury (2000) and Lucey (2003) opined the following as possible causes of wages/rate variance.
0 Higher rates being paid than planned due to wage award. This usually happens when a company uses casual workers who do not have fix salary. The labourers do sometimes dictate amount they would collect for a specific job or work.Sometimes, the company pays
more than what was budgeted for.
0 Higher or lower grade of workers being used than planned. If the company eventually used
higher or lower grade of workers than what was planned for, this affects the amount to be
paid to the workers. It could be upward or downward.
0 Payment of unplanned overtime or bonus. if the company paid the workers for overtime or
bonus for the extra hours used in the production of the product produced, this eventually
affects the purse of the company.
- Direct Labour Efficiency Variance:- Direct Labour Efficiency Variance indicates the standard
labour cost of any change from the standard level of labour efficiency (actual production in
standard hours multiply by standard direct labour rate per hour) minus (actual direct labour hours
worked multiply by standard direct labour rate per hour) (Hilton1999). According to him, the causes
of labour efficiency variance are as follows.
~ Use of incorrect grade of labour: if correct grade of labourers are not employed, this can
affect the efficiency of labour.
0 Poor supervision: if the labourers employed were not given close supervision, efficiency of
labour tends to be low..
. Incorrect materials and / or machine problem: if the materials purchased are of lower grade
or the machine has fault during the production, these can affect the efficiency of labour.
Variable Overhead Total Variance: This is the difference between the actual variable overheads
incurred and the variable overheads absorbed. This variance is simply the over or under absorption
of overhead expenditure variance and variable overhead efficiency variance. Variable overhead
expenditure variance is the difference between the actual variable overheads incurred and the
allowed variable overheads based on the actual hours worked. Variable overhead efficiency variance is the difference between the allowed variable overheads and the absorbed variable
Fixed Overhead Total Variance: This is the difference between the standard cost of fixed overhead absorbed in the production and achieved whether completed or not, and the fixed
overhead attributed and charged to the period. Total fixed overhead variance comprises of
overhead expenditure and volume variance .
- Fixed overhead expenditure variance*.- This is the difference between the budget cost allowance for production for a specified control period and the actual fixed expenditure attributed
and charged to that period.
- Fixed overhead volume variance:- This is that portion of the fixed production overhead variance which is the difference between the standard cost absorbed in the production achieved, whether completed or not, and the budget cost allowance for a specified control period. The volume
variance arises from the actual volume of production differing from the planned volume, and can be
subdivided into fixed overhead efficiency variance and fixed overhead capacity variance. Fixed
overhead capacity variance is the potion of the fixed production overhead volume variance which is
due to working at higher or lower capacity than standard. Capacity is often expressed in terms of
average direct labour hours per day while the variance is the difference between the budget cost allowance and the actual direct labour hours worked (valued at the standard hourly absorption
Idle Time Variance:- This is the non-productive hours recorded in a costing system. Idle time is
usually caused by machine breakdown and bottlenecks in production, shortage of orders from customers or for any reason, the company cannot productively engage its labour force.
Unproductive hours paid for is inefficiency and therefore, idle time is always an adverse efficiency
Control is the process of ensuring that a firm’s activities conform to its plan and that its objectives are achieved. Ducker (1964) distinguishes between ‘controls’ and ‘control’. Controls are measurement and information, whereas control means direction. ‘Controls’ are purely a means to
an end; the end is control. ‘Control’ is the function that makes sure that actual work is done to fulfill
the original intention, and ‘Controls’ are used to provide information to assist in determining the
control action to be taken.
‘Control’ will indicate that costs exceed budget and that this may be because the purchase of inferior quality materials causes excessive wastage. ‘Control’ is the action that is taken to
purchase the correct quality materials in the future to reduce excessive wastage.
The difference between strategic control and management control is that strategic control
has an external focus. The emphasis is on how a firm, given its strengths, weakness and
limitations, can compete with other firms in the same industry. On the other hand, management
control systems consist of a collection of control mechanisms that primarily have an internal focus.
The aim of management control systems is to influence employees’ behaviour in desirable ways in order to increase the probability that an organisation's objectives will be achieved.
Merchant emphasized that senior managers do not have to be knowledgeable about the
means required to achieve the desired results or be involved in directly observing the action of subordinates. They merely rely on output reports to ascertain whether or not the desired outcomes
have been achieved. Accounting control system can be described as a form of output controls.
They are mostly defined in monetary terms such as revenues, costs, profits and ratios, e.g. return on investment.
Result controls resemble the thermostat control model. Standards of performance are
determined, measurement systems monitor performance; comparisons are made between the standard and actual performance and feedback provides information on the variances.
Management control in an accounting context, is defined as:
“a process whereby expectation and actual performance are compared and the comparison will
serve as basis for determining the appropriate reaction to the operating result". Management
control system is a system designed to ensure that organizational strategies are implemented. The
accounting information system provides the information necessary to make the management
control system work. Employees at each level must understand what they are expected to do, and
then they need feedback indicating whether or not they are doing it. Managerial decision-making is
usually based on relevant and related information, which will affect the organization as a whole.
This is with the aim of attaining the goals and objectives of the organization. It has also been argued that sound management involves sound decision-making, which is scientific information
Any control should have three parts: a predetermined or standard performance level; a measure of actual performance; and a comparison between standard and actual performance.
Budgeting, standard costing and variance analysis have all these three. Apart from the three basic
parts, variance analysis has above the two others, the means of analyzing operation in process
capability with the use of statistical process (SPC). Rius, et. al. (1997) on their part postulate
multivariate statistical process control. This model was accessed by comparing the prediction of
the model with actual performance to ascertain the level of deviation from plan.
The need for accounting information in any organization especially, in manufacturing
industries cannot be over-emphasized. This will not only assist the management in the planning but
also the control of the future events.
Apart from the control of the future events, the information provided through the variance
analysis, helps the manager to segregate this variance into price and quantity component. Another
effect of the variance is that, it helps to determine the measurement system, monitor performance
and comparisons are made between the standard and actual performance.
Source and Method of Data Collection
Data used for this study were mainly secondary. These include production and sales
figures for 7 feet mattress from both production and sales departments of five brands of mattresses
studied. The data were subjected to statistical techniques such as F distribution and student T distribution.
Testing of the significance of difference between the variance of two different variables can
be done using F-test depending on the sample size. Two different samples (i.e. variables) must be
present before F-test can be conducted. Here, from the data obtained there are two variables that
are predetermined and actual figures for both productions and sales hence, F-test was then used
to analyse and test the significance of difference that exists between the variances of production
and sales as proposed in our hypotheses.
The significance of the difference between the mean of two different samples can be
tested using either paired t-test or Z-test depending on the sample size. if the sample size is less
than 30, t-test is used; otherwise, Z-test is to be used. For this study therefore, t-test was adopted
since the assumptions underlying its use were present in our data.
The test of the significance of difference between the variances can be obtained by:
F = 82 actual iVr, v2 o
For production and sales Decision: Reject Ho if F-calculated > FV1, v2 o and accept it it
Where: S2 = Standard deviation
0 = Alpha,
v1 = verse 0 of actual,
v2 = variance of predetermined test of difference in means.
v1 and v2 = degrees of freedom of actual and predetermined units respectively.
N1 + N; — 2 = the degree of freedom
Decision: Reject Ho if t > tN1 + N2 - 2, o and accept other wise for both productions and sales
means in all the brands.
X1 = mean of actual
X2 = mean of predetermined
S2 = variance
N = Number of observation
N1 = Samples of production
N2 = Samples of sales
812 = Variance in actual
S22 = VanIance in predetermined
Results and Discussions
The secondary data obtained are presented in Tables 1 and 2, comparing predetermlne<
and actual production units, likewise sales figures revealing the level of variance.
For accounting information to serve as a useful tool for control, it
should provide an accurate representation of capability of a process.
Hence, the studied establishments can use predetermined figures to represent the actual figure
since the variance between them is so insignificant.
Conclusions and Recommendations
Based on the findings it could be concluded that variance analysis is a useful tool for
management control system. with the use of F-distribution and T-test. F-distribution shows that
there is no signiﬁcant difference between the variances of all the brands of mattresses studied. The
study observed that the variances in both predetermined and actual figures were so small hence,
the management of the establishment studied could use either predetermined production figures -
to project their future productions likewise the same thing for sales. Furthermore, where there were
under-utilizations of capacity, it is suggested that establishment studied should make use of the
resource judiciously to maximize profit.
T-test shows that there is no significant difference in means of all the brands of mattresses
studied. This shows that one can pick the result of one of the brands studied to estimate or project
the perforrnanoe of the other.
On the whole, the issue of what really brings about the variances was not known. it is not
known whether prices set by all the brands studied were at fault or other factors are responsible for
the variances. These and other issues may be taken upon in subsequent research.
The following recommendations are proffered based on the findings of the study.
(0 Production departments of all the brands studied should strive to achieve full utilization
of capacity in their operation since the organizations have the potentials;
(H) Since there is variability between the predetermined and actual, the establishments
can use either predetermined or actual figures of productions to make estimate of
sales and turnover;
(iii) Management should not rely solely on accounting target/numbers in evaluation of
performance because a successful completion of operation comprises several
components that interact together.
Budget variances and management by exception
A key word to understand when you are looking at budgets is “variance”
A variance arises when there is a difference between actual and budget figures
Variances can be either:
• Positive/favourable (better than expected) or
• Adverse/unfavourable ( worse than expected)
A favourable variance might mean that:
• Costs were lower than expected in the budget, or
• Revenue/profits were higher than expected
By contrast, an adverse variance might arise because:
• Costs were higher than expected
• Revenue/profits were lower than expected
Should variances be a matter of concern to management? After all, a budget is just an estimate of what is going to happen rather than reality. The answer is – it depends.
The significance of a variance will depend on factors such as:
• Whether it is positive or negative – adverse variances (negative) should be of more concern
• Was it foreseen?
• Was it foreseeable?
• How big was the variance - absolute size (in money terms) and relative size (in percentage terms)?
• The cause
• Whether it is a temporary problem or the result of a long term trend
“Management by exception” is the name given to the process of focusing on activities that require attention and ignoring those that appear to be running smoothly
Budget control and analysis of variances facilitates management by exception since it highlights areas of business performance which are not in line with expectations.
Items of income or spending that show no or small variances require no action. Instead concentrate on items showing a large adverse variance.
Are all adverse variances bad news?
Here is a point that students often find hard to understand – or believe!
An adverse variance might result from something that is good that has happened in the business.
For example, a budget statement might show higher production costs than budget (adverse variance). However, these may have occurred because sales are significantly higher than budget (favourable budget).
Remember, it is the cause and significance of a variance that matters – not whether it is favourable or adverse.
Consider the following budget statement:
Item Budget Actual Variance Favourable
£'000 £'000 £'000 or Adverse
Standard product 75 90 15 F
Premium product 30 25 -5 A
Total sales revenue 105 115 10 F
Wages 35 38 3 A
Rent 15 17 2 A
Marketing 20 14 -6 F
Other overheads 27 35 8 A
Total costs 97 104 7 A
Profit 8 11 3 F
What do the numbers in the budget statement tell us?
Looking at the sales revenue section, you can see that actual sales of standard product were £15k higher than budget – this is a positive (favourable) variance.
Turning to the costs section, actual wages were £3k higher than budget – i.e. an adverse (negative) variance.
Overall, the profit variance was positive (favourable) – i.e. better than budget
Q.7 in what way is financial leverage related to operating leverage? Discuss with an example.
Leverage, as a business term, refers to debt or to the borrowing of funds to finance the purchase of a company's assets. Business owners can use either debt or equity to finance or buy the company's assets. Using debt, or leverage, increases the company's risk of bankruptcy. It also increases the company's returns; specifically its return on equity. This is true because, if debt financing is used rather than equity financing, then the owner's equity is not diluted by issuing more shares of stock.
Investors in a business like for the business to use debt financing but only up to a point. Beyond a certain point, investors get nervous about too much debt financing as it drives up the company's default risk.
There are three types of leverage:
What is Operating Leverage?
Breakeven analysis shows us that there are essentially two types of costs in a company's cost structure -- fixed costs and variable costs. Operating leverage refers to the percentage of fixed costs that a company has. Stated another way, operating leverage is the ratio of fixed costs to variable costs. If a business firm has a lot of fixed costs as compared to variable costs, then the firm is said to have high operating leverage. These firms use a lot of fixed costs in their business and are capital intensive firms.
A good example of capital intensive business firm are the automobile manufacturing companies. They have a huge amount of equipment that is required to manufacture their product - automobiles. When the economy slows down and fewer people are buying new cars, the auto companies still have to pay their fixed costs such as overhead on the plants that house the equipment, depreciation on the equipment, and other fixed costs associated with a capital intensive firm. An economic slowdown will hurt a capital intensive firm much more than a company not quite so capital intensive.
You can compare the operating leverage for a capital intensive firm, which would be high, to the operating leverage for a labor intensive firm, which would be lower. A labor intensive firm is one in which more human capital is required in the production process. Mining is considered labor intensive because much of the money involved in mining goes to paying the workers. Service companies that make up much of our economy, such as restaurants or hotels, are labor intensive as well. They all require more labor in the production process than capital costs.
In difficult economic times, firms that are labor intensive typically have an easier time surviving than capital intensive firms.
What does operating leverage really mean? It means that if a firm has high operating leverage, a small change in sales volume results in a large change in EBIT and ROIC, return on invested capital. In other words, firms with high operating leverage are very sensitive to changes in sales and it affects their bottom line quickly.
Business risk is just one portion of the risk that determines a business firm's future return on equity. Business risk is the risk that a firm's shareholders face if the firm has no debt. It is the risk inherent in the firm's operations. It rises from economic uncertainty which leads to uncertainty about future profits and capital requirements.
One component of business risk is variability in product demand. Customers always have to have food so in difficult economic times, the Publix grocery store chain will have less product variability than Ford Motor Company. Customers don't have to buy new cars during periods of economic uncertainty. Most business firms also have variability in product sales prices and input costs. Firms that are slower to bring new products to market expose themselves to more business risk. Think of the American automobile companies. Foreign car companies brought fuel efficient cars to market faster than American car companies, exposing them to more business risk.
If a business firm has high fixed costs and their costs do not decline as demand declines, then the firm has high operating leverage which means high business risk.
What is Financial Leverage?
Financial leverage refers to the amount of debt in the capital structure of the business firm. If you can envision a balance sheet, financial leverage refers to the right-hand side of the balance sheet. Operating leverage refers to the left-hand side of the balance sheet - the plant and equipment side. Operating leverage determines the mix of fixed assets or plant and equipment used by the business firm. Financial leverage refers to how the firm will pay for it or how the operation will be financed.
As discussed earlier in this article, the use of financial leverage, or debt, in financing a firm's operations, can really improve the firm's return on equity and earnings per share. This is because the firm is not diluting the owner's earnings by using equity financing. Too much financial leverage, however, can lead to the risk of default and bankruptcy.
One of the financial ratios we use in determining the amount of financial leverage we have in a business firm is the debt/equity ratio. The debt/equity ratio shows the proportion of debt in a business firm to equity.
What is Combined, or Total, Leverage
Combined, or total, leverage is the total amount of risk facing a business firm. It can also be looked at in another way. It is the total amount of leverage that we can use to magnify the returns from our business. Operating leverage magnifies the returns from our plant and equipment or fixed assets. Financial leverage magnifies the returns from our debt financing. Combined leverage is the total of these two types of leverage or the total magnification of returns. This is looking at leverage from a balance sheet perspective.
It is also helpful and important to look at leverage from an income statement perspective. Operating leverage influences the top half of the income statement and operating income, determining return from operations. Financial leverage influences the bottom half of the income statement and the earnings per share to the stockholders.
The concept of leverage, in general, is used in breakeven analysis and in the development of the capital structure of a business firm.