EXHIBIT 9–5 Activity Variances from Comparing the Planning Budget to the Flexible Budget Based on Actual Activity
For example, the budget based on 1,000 client-visits shows revenue of $180,000 (= $180 per client-visit × 1,000 client-visits). The flexible budget based on 1,100 client-visits shows revenue of $198,000(= $180 per client-visit × 1,100 client-visits). Because the salon had 100 more client-visits than anticipated in the budget, actual revenue should have been higher than budgeted revenue by $18,000 (= $198,000 − $180,000). This activity variance is shown on the report as $18,000 F(favorable). Similarly, the budget based on 1,000 client-visits shows electricity costs of $1,600 (= $1,500 + $0.10 per client-visit × 1,000 client-visits). The flexible budget based on 1,100 client-visits shows electricity costs of $1,610 (= $1,500 + $0.10 per client-visit × 1,100 client-visits). Because the salon had 100 more client-visits than anticipated in the budget, actual electricity costs should have been higher than budgeted costs by $10 (= $1,610 − $1,600). The activity variance for electricity is shown on the report as $10 U (unfavorable). Note that in this case, the label “unfavorable” may be a little misleading. Costs should be $10 higher for electricity simply because business was up by 100 client-visits; therefore, is this variance really unfavorable if it was a necessary cost of serving more customers? For reasons such as this, we would like to caution you against assuming that unfavorable variances always indicate bad performance and favorable variances always indicate good performance.
Because all of the variances on this report are solely due to the difference in the level of activity between the planning budget from the beginning of the period and the actual level of activity, they are called activity variances. For example, the activity variance for revenue is $18,000 F, the activity variance for electricity is $10 U, and so on. The most important activity variance appears at the very bottom of the report; namely, the $13,710 F (favorable) variance for net operating income. This variance says that because activity was higher than expected in the planning budget, the net operating income should have been $13,710 higher. We caution against placing too much emphasis on any other single variance in this report. As we have said above, one would expect some costs to be higher as a consequence of more business. It is misleading to think of these unfavorable variances as indicative of poor performance.
On the other hand, the favorable activity variance for net operating income is important. Let’s explore this variance a bit more thoroughly. First, as we have already noted, activity was up by 10%, but the flexible budget indicates that net operating income should have increased much more than 10%. A 10% increase in net operating income from the $16,800 in the planning budget would result in net operating income of $18,480 (= 1.1 × $16,800); however, the flexible budget shows much higher net operating income of $30,510. Why? The short answer is: Because of the presence of fixed costs. When we apply the 10% increase to the budgeted net operating income to estimate the profit at the higher level of activity, we implicitly assume that the revenues and all of the costs increase by 10%. But they do not. Note that when the activity level increases by 10%, three of the costs—rent, liability insurance, and employee health insurance—do not increase at all. These are all purely fixed costs. So while sales do increase by 10%, these costs do not increase. This results in net operating income increasing by more than 10%. A similar effect occurs with the mixed costs which contain fixed cost elements—wages and salaries, electricity, and miscellaneous. While sales increase by 10%, these mixed costs increase by less than 10%, resulting in an overall increase in net operating income of more than 10%. Because of the existence of fixed costs, net operating income does not change in proportion to changes in the level of activity. There is a leverage effect. The percentage changes in net operating income are ordinarily larger than the percentage increases in activity.