8_Profit Variance Analysis - Issues in Accounting Education...

Unformatted text preview: Issues in Accounting Education Vol. 4 No. 2 Fall 1989 Profit Variance Analysis: A Strategic Focus Vijay Govindaraian and John K. Shank ABSTRACT: This paper uses a disguised case to compare and con- trast three different frameworks in analyzing profit variances—two that are in common usage today and one that Is not but, in our view, should be. The purpose of the paper is to demonstrate how variance analysis needs to be tied explicitly to the strategic context of the firm and its business units. ROFIT variance analysis is the process of summarizing what happened to profits during the period to highlight the salient managerial issues. Variance analysis is the formal step leading to determining what corrective actions are called for by management. Thus it is a key link in the management control process. We believe this element is underutilized in many companies be- cause of the lack of a meaningful ana- lytical framework. It is handled by accountants in a way that is too tech- nical. This paper proposes a different profit variance framework as a "new idea” in management control. Historically. variance analysis in- volved a simple methodology where ac- tual results were compared with the budget on a line-by-line basis. We call this Phase I thinking. Phase II thinking was provided by Shank and Churchill [1977] who proposed a management- oriented approach to variance analysis. Their approach was based on the dual " Copyright©2001.A|| Rights Rééé‘fiiéafi’""' ‘ ideas of profit impact as a unifying theme and a multilevel analysis in which complexity was added gradu- ally, one level at a time. We believe that the Shank and Churchill approach needs to be modified in important ways to take explicit account of strategic issues. Our framework, which we call Phase III thinking, argues that variance analysis becomes most meaningful when it is tied explicitly to strategic analysis. John K. Shank is Noble Profes- sor of Managerial Control and Vijay Govindarajan is Associate Professor of Accounting, both at The Amos Tuck School of Business Adminis- tration, Dartmouth College. The authors wish to acknowledge help- ful discussions with Ray Stephens. 396 Govindaraian and Shank 397 TABLE 1 United Instruments, Inc. Income Statement for the Year 1987 Sales Cost of goods sold Gross margin Less: Other operating expenses Marketing R&D Administration $1,856 1,480 1,340 Profit before taxes This paper presents a short disguised case, United Instruments, Inc., to illus- trate the three phases or generations of thinking about profit variance analysis. We believe it also demonstrates the su- periority of integrating strategic plan- ning and overall financial performance evaluation, which is the essence of Phase III thinking. The purpose of this paper is to emphasize how variance analysis can be, and should be, redi- rected to consider the strategic issues that have, during the past 15 years, be- come so widely accepted as a concep- tual framework for decision making.1 UNITED INSTRUMENTS, INC.: AN INSTRUCTIONAL CASE2 Steve Park, president and principal stockholder of United Instruments, Inc., sat at his desk reflecting on the 1987 results (Table 1). For the second year in succession, the company had exceeded the profit budget. Steve Park was obviously very happy with the 1987 results. All the same, he wanted to Budget Actual (1,0005) (1.0003) $16,872 $17,061 9,668 9,865 $ 7,204 $ 7,196 $1,440 932 4,676 1,674 4,046 $ 2,528 $ 3,150 get a better feel for the relative contri- butions of the R&D, manufacturing, and marketing departments in this overall success. With this in mind, he called his assistant, a recent graduate of a well-known business school, into his office. ”Amy," he began, “as you can see from our recent financial results, we have exceeded our profit targets by $622,000. Can you prepare an analysis showing how much R&D, manufactur- ing, and marketing contributed to this overall favorable profit variance?" ‘ During the past 15 years, several books (e.g., Andrews [1971], Henderson [1979], and Porter [1980]) as well as articles (e.g., Buzzell et al. [1975] and Govindarajan and Gupta [1985]) have been published in the field of strategic management. In addition, two new journals (Strategic Management Journal and Journal of Business Strategy) have been introduced in the strategy area during the past ten years. Also, tra- ditional management journals such as Administrative Science Quarterly, Academy of Management Iournal, and Academy of Management Review have, during the past decade, started to publish regularly articles on strategy formulation and implementation. ‘ This case is motivated by a similar case titled "Kinkead Equipment Ltd.,” which appears in Shank [1982]. Copyright © 2001 . All Rights Reserved. 398 Issues in Accounting Education TABLE 2 Additional Information Electric Electronic Meters Instruments (EM) (El) Selling prices per unit Average standard price $40.00 $180.00 Average actual prices, 1987 30.00 206.00 Variable product costs per unit Average standard manufacturing cost $20.00 $50.00 Average actual manufacturing cost 21.00 54.00 Volume information Units produced and sold—actual 141,770 62,172 Units produced and sold—planned 124,800 66,000 Total industry sales, 1987—actual $44 million $76 million Total industry variable product costs, 1987—actual $16 million $32 million United's share of the market (percent of physical units) Flamed 10% 15% Actual 16% 9% Planned Actual Firm-wide fixed expenses (1,0005) Fixed manufacturing expenses $3,872 $3,530 Fixed marketing expenses 1,856 1,440 Fixed administrative expenses 1,340 1,674 Fixed R&D expenses (exclusively for electronic instruments) 1,480 932 W Amy Shultz, with all the fervor of a recent convert to professional manage- ment, set to her task immediately. She collected the data in Table 2 and was wondering what her next step should be. United Instruments' products can be grouped into two main lines of busi- ness: electric meters (EM) and electronic instruments (El). Both EM and EI are industrial measuring instruments and perform similar functions. However, these products differ in their manufac- turing technology and their end-use characteristics. EM is based on mechan- ical and electrical technology, whereas Copyright © 2001 . All Rights Resé'nié‘d.‘ E1 is based on microchip technology. EM and BI are substitute products in the same sense that a mechanical watch and a digital watch are substitutes. United Instruments uses a variable costing system for internal reporting purposes. PHASE I THINKING: THE ”ANNUAL REPORT APPROACH” TO VARIANCE ANALYSIS A straightforward, simple-minded explanation of the difference between actual profit ($3,150) and the budgeted profit ($2,528) might proceed according Govindamjan and Shank 399 TABLE 3 The ”Annual Report Approach" to Variance Analysis Budget Actual (1,000s) (1,0005) Sales $16,872 (100%) $17,061 (100%) Cost of goods sold 9,668 (58%) 9,865 (58%) Gross margin $ 7,204 (42%) $ 7,196 (42%) Less: Other expenses Marketing $1,856 (11 %) $1,440 (8%) R&D 1,480 (9%) 932 (6%) Administration 1,340 (8%) 4,676 (28%) 1,674 (10%) 4,046 (24%) Profit before tax $ 2,528 (14%) 5 3,150 (18%) to Table 3. Incidently, this type of vari- ance analysis is what one usually sees in published annual reports (where the comparison is typically between last year and this year). If we limit our- selves to this type of analysis, we will draw the following conclusions about United's performance: 1. Good sales performance (slightly above plan). 2. Good manufacturing cost con- trol (margins as per plan). 3. Good control over marketing and R&D costs (costs down as percentage of sales). 4. Administration overspent a bit (slightly up as percentage of sales). 5. Overall Evaluation: Nothing of major significance; profit perfor— mance above plan. How accurately does this summary re- flect the actual performance of United? One objective of this paper is to demonstrate that the analysis is mis- leading. The plan for 1987 has em- bedded in it certain expectations about the state of the total industry and about United’s market share, its selling prices, and its cost structure. Results from variance computations are more "ac- tionable" if changes in actual results for 1987 are analyzed against each of these expectations. The Phase I analysis sim- ply does not break down the overall favorable variance of $622,000 accord— ing to the key underlying causal factors. PHASE II THINKING: A MANAGEMENT-ORIENTED APPROACH TO VARIANCE ANALYSIS The analytical framework proposed by Shank and Churchill [1977] to con— duct variance analysis incorporates the following key ideas: 1. Identify the key causal factors that affect profits. 2. Break down the overall profit variance by these key causal factors. 3. Focus always on the profit im- Copyright © 2001 . All Rights Reserved. 400 pact of variation in each causal factor. 4. Try to calculate the specific, sep- arable impact of each causal fac- tor by varying only that factor while holding all other factors constant ("spinning only one dial at a time"). 5. Add complexity sequentially, one layer at a time, beginning at a very basic “common sense” level (“peel the onion"). 6. Stop the process when the added complexity at a newly created level is not justified by added useful insights into the causal factors underlying the overall profit variance. Tables 4 and 5 contain the explanation for the overall favorable profit variance of $622,000 using the above approach. In the interest of brevity, most of the calculational details are suppresed (de- tailed calculations are available from the authors). What can we say about the perfor- mance of United if we now consider the variance analysis summarized in Table 5? The following insights can be offered organized by functional area: Marketing Comments: Market Share (SOM) increase benefitted the firm $1,443 F But, unfortunately, sales mix was managed toward the lower margin product 921 U Control over marketing expendi- ture benefitted the firm (especially in the face of an increase in SOM) 416 F Net effect $ 938 F Uncontrollables: Unfortunately, the overall market declined and cost the firm $ 680 U Overall evaluation: Very good performance ‘ “C‘cspy‘right © 2001 . All Rights R'é‘séhiéd. Issues in Accounting Education Manufacturing Comments: Manufacturing cost control cost the firm 5 48 U Overall evaluation: Satisfactory performance RGD Comments: Savings in R&D budget Overall evaluation: Good performance $ 548E Administration Comments : Administration budget overspent $ 334 U Overall evaluation: Poor performance Thus, the overall evaluation of the general manager under Phase 11 think- ing would probably be “good,” though specific areas (such as manufacturing cost control or administrative cost con- trol) need attention. The above sum- mary is quite different—and clearly su- perior—to the one presented under Phase I thinking. But, can we do better? We believe that Shank and Churchill’s framework needs to be modified in im- portant ways to accommodate the fol- lowing ideas. Sales volume, share of market, and sales mix variances are calculated on the presumption that United is essen- tially competing in one industry (i.e., it is a single product firm with two differ- ent varieties of the product). That is to say, the target customers for EM and EI are the same and that they view the two products as substitutable. Is United a single product firm with two product offerings, or does the firm compete in two different markets? In other words, does United have a single strategy for EM and E1 or does the firm have two different strategies for the two busi- nesses? 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Govindaraian and Shank .8:nt~> «5805?: an 928:2: D van 8593 23238 a p.235: m 6qu w .25..— m —u>w‘— N TE H ES Ema—n5 vacatm> ii 3.26 19am :ozanEcoU £89 w3mt~> 83 "538.3 52¢ 280 8E 9:3 is. $13 22.7. «av—.82 .819: Eek "mm—ovum .820 >3— Copyright © 2001 . All Rights Reserved. 402 Issues in Accounting Education TABLE 5 Variance Summary for the Phase II Approach Overall market decline Share of market increase Sales mix change Sales prices improved EM $1,418 U El $1,616 F Manufacturing cost control Variable costs $390 U Fixed costs $342 F Other R&D Administration Marketing Total 5 680 U 1,443 F 921 U 198 F 48U 548 F 334 U 416 F S 622 F markets, thereby, requiring quite dif- ferent strategies. It is, therefore, more useful to calculate market size and mar- ket share variances separately for EM and El. Just introducing the concept of a sales mix variance implies that the average standard profit contribution across EM and EI together is mean- ingful. For an ice cream manufacturer, for example, it is probably reasonable to assume that the firm operates in a single industry with multiple product offer- ings, all targeted at the same customer group. It would, therefore, be meaning- ful to calculate a sales mix variance be- cause vanilla ice cream and strawberry ice cream, for instance, are substitut- able and more sales of one implies less sales of the other for the firm (for an elaboration on these ideas, refer to the Midwest Ice Cream Company case [Shank, 1982, pp. 157-173]). On the "W“MWM“M "”‘ACopyright © 2001 . All Rights"Reéér\}éHZ"""" " other hand, for a firm such as General Electric, it is much less clear whether a sales mix variance across jet engines, steam turbines, and light bulbs really makes any sense. This is more nearly the case for United because one unit of EM (which sells for $30) is not really fully substitutable for one unit of El (which sells for $206). An important issue in the history of many industries is to determine when product differentiation has progressed sufficiently that what was a single busi- ness with two varieties is now two busi- nesses. Some examples include the growth of the electronic cash register for NCR, the growth of the digital watch for Bulova, or the growth of the industrial robot for General Electric. Following Phase II thinking, perfor- mance evaluation did not relate the variances to the differing strategic con- texts facing EM and EI. Govindaraian and Shank PHASE III THINKING: VARIANCE ANALYSIS USING A STRATEGIC FRAMEWORK We argue that performance evalu- ation, which is a critical component of the management control process, needs to be tailored to the strategy being fol- lowed by a firm or its business units. We offer the following set of arguments in support of our position: (1) different strategies imply different tasks and re- quire different behaviors for effective performance [Andrews, 1971; Gupta and Govindarajan, 1984a; and Govin- darajan, 1986a]; (2) different control systems induce different behaviors [Govindarajan, 1986b; Gupta and Govindarajan, 1984b]; (3) thus, supe- rior performance can best be achieved by tailoring control systems to the re- quirements of particular strategies [Govindarajan, 1988; Gupta and Govindarajan, 1986].3 We will first define and briefly elaborate the concept of strategy before illustrating how to link strategic consid- erations with variances for management control and evaluation. Strategy has been conceptualized by Andrews [1971], Ansoff [1965], Chandler [1962], Govin- darajan [1989], Hofer and Schendel [1978], Miles and Snow [1978], and others as the process by which man- agers, using a three- to five-year time horizon, evaluate external environ- mental opportunities as well as internal strengths and resources in order to de- cide on goals as well as a set of action plans to accomplish these goals. Thus, a business unit’s (or a firm’s) strategy de- pends upon two interrelated aspects: (1) its strategic mission or goals, and (2) the way the business unit chooses to com- 403 pete in its industry to accomplish its goals—the business unit's competitive strategy. Turning first to strategic mission, consulting firms such as Boston Con- sulting Group [Henderson, 1979], Arthur D. Little [Wright, 1975], and A. T. Kearney [Hofer and Davoust, 1977], as well as academic researchers such as Hofer and Schendel [1978], Buzzell and Wiersema [1981], and Govindarajan and Shank [1986], have proposed the following three strategic missions that a business unit can adopt: Build: This mission implies a goal of in- creased market share, even at the expense of short-term earnings and cash flow. A business unit following this mission is expected to be a net user of cash in that the cash throw- off from its current operations would usually be insufficient to meet its capital investment needs. Business units with “low market share" in “high growth industries" typically pursue a “build" mission (e.g., Apple Computer's Maclntosh business, Monsanto's Biotechnology business). Hold: This strategic mission is geared to the protection of the business unit’s market share and competitive posi- tion. The cash outflows for a —-——_————_ 3 Several studies have shown that when an indi- vidual’s rewards are tied to performance along certain dimensions, his or her behavior would be guided by the desire to optimize performance with respect to those dimensions. Refer to Govindaraian and Gupta [1985] for a review of these studies. Copyright © 2001 . All Rights Reserved. s. new“, ...... WMWWMWW. .. .., business unit following this mission would usually be more or less equal to cash inflows. Businesses with ”high market share" in "high growth industries" typically pursue a “hold" mission (e.g., IBM in mainframe computers). Harvest: This mission implies a goal of maxi- mizing short-term earnings and cash flow, even at the expense of market share. A business unit following such a mission would be a net sup- plier of cash. Businesses with ”high market share” in "low growth in- dustries" typically pursue a ”har- vest" mission (e.g., American Brands in tobacco products). In terms of competitive strategy, Porter [1980] has proposed the follow- ing two generic ways in which busi- nesses can develop sustainable com- petitive advantage: Low Cost: The primary focus of this strategy is to achieve low cost relative to com- petitors. Cost leadership can be achieved through approaches such as economies of scale in production, learning curve effects, tight cost control, and cost minimization in areas such as R&D, service, sales force, or advertising. Examples of firms following this strategy in- clude: Texas Instruments in con- sumer electronics, Emerson Electric in electric motors, Chevrolet in automobiles, Briggs and Stratton in gasoline engines, Black and Decker in machine tools, and Commodore in business machines. “ “ ' ’ Copyright© 2001 . All Rights Re’se’r’i’ié'd." Issues in Accounting Education Differentiation: The primary focus of this strategy is to differentiate the product offering of the business unit, creating some- thing that is perceived by custom- ers as being unique. Approaches to product differentiation include brand loyalty (Coca-Cola in soft drinks), superior customer service (IBM in computers...
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