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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? As we argue later, EM and EI
have very different industry character-
istics and compete in very different , ...V_i.gw...m...wWflm..wWW. t 401 "— $3 Dam o
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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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