For this assignment, imagine that for the second quarter in a row, profits are d

Question

For this assignment, imagine that for the second quarter in a row, profits are down at Waterfall division. Division Management budgeted $250,000 in profits for the 2nd quarter but actual results were only $197,000 in profits. The division management insists that the budgets were developed realistically but admits sales were down. The division has been under pressure to improve profitability. Corporate Management has asked you to identify the primary cause of the shortfall – revenue or costs?

• How will you approach your analysis of the situation?
• What variance analysis and / or trends would be helpful to evaluate?

• What are three possible situations that could be the cause for the shortfall in profits?
• What actions would you recommend for these three possible situations?
• What recommendations would you make to management to improve the budget process for next year?
When complete, submit your work. Prior to doing so, make sure your assignment meets the following criteria.

Explanation / Answer

The approach I’ll use to evaluate the profit variance requires me to categorize the overall variances into different categories, to pinpoint the specific area that needs improvement. Broadly speaking, separating variable and fixed costs will be of help in the given situation. One of the most effective approaches to use is a Contribution Margin Approach in which analysis is divided into two parts: 1) The factors that are involved with the calculation of contribution margin and 2) The fixed costs incurred during a given period. Variable and fixed costs must be treated separately in profit variance analysis because sales volume has a different effect on each type of cost behavior. Although costs are incurred for the manufacturing, selling, administrative functions, the most important aspect of the cost performance for profit variance analysis is the way each cost responds to changes in sales volume. The variables costs reported on the income statement are affected by two types of change: a) A change in the unit cost of producing or selling a product because of different amounts of such cost elements as materials, labor, variable manufacturing overhead, or sales commissions and b) A change in the sales volume that proportionately increases or decreases the total variable costs. Other three factors that can contribute to a profit variance – sales volume, selling price, and sales mix – also will affect the amount of contribution margin reported on the income statement. Profit variance = Actual Net Income – Budgeted Net Income Profit variance =$197000 - $250000 = - $53000 Therefore, for analyzing this profit variance I’ll break variances into specific variances that contribute towards the total profit variance. The ingredient variances are as follows: 1. Sales volume variance 2. Selling Price Variance 3. Variable Cost Variance 4. Fixed cost variance Following are the three possible situations that can cause this unfavorable profit variance: Sales volume variance Sales volume variance is incurred when the actual number of units sold differs from the units planned during the budgeting process. Sales Volume Variance is calculated as follows: Sales Volume Variance = (actual sales units – Budgeted Sales units) x Budgeted contribution margin/unit General causes of sales volume variances include the following: • Price changes • The action of a competitor that increases its share of the market • An economic downturn • An ineffective marketing effort • The inability of the production function to produce enough units to fill the sales orders obtained by the sales department • A general decline in sales for the industry involved. In the given scenario the following causes can be the ones causing the cost rise or revenue shortfall: • The action of a competitor that increases its share of the market • An economic downturn • An ineffective marketing effort • A general decline in sales for the industry involved Selling Price Variance It is the result of selling an actual number of units during a given period at an actual price that is different from the planned price. In the given scenario following can be the causes of selling price variance that the management would have ignored to take into account: • Change in price in reaction to competition • Opening a new marketing territory In short, selling price variance seems like an improbable factor that would’ve caused the overall profit variance mainly because it is too noticeable for management to ignore such factors. In addition to it, no detail or hint has been given in the scenario presented that points out towards selling price variance. Variable Cost Variance It arises when the actual variable costs needed to produce or sell a product differ from those planned. Common causes are: • An inefficient use of direct materials • Low productivity from direct labor • Excessive spending for advertising • Less promotional cost than the amount planned • Higher actual sales commissions than those planned This variable cost variance can be observed in the production and as well as in the selling department. The causes mentioned above can be some probable possibilities in the scenario given that is causing rise in unfavorable profit variance or revenue shortfall. Recommendations 1. In order to deal with variable cost variance, the management has to keep both materials and labour in consideration. Fluctuations in materials price and quantity in addition to labour/wage rate and labour hour quantity and their respective affect on overall performance. To elaborate on the point, by controlling the negative or unfavourable variances in materials and labour prices and quantity, the company will be able to control or reduce its overhead costs therefore increasing the profitability and decreasing cost per unit. 2. Secondly, for controlling the unfavourable sales volume variance, the management has to pay attention to its marketing efforts and the results it is producing. The company should train its sales force team better and check whether the commissions paid to the sales people are appropriate enough to provide good levels of motivation. 3. Thirdly, to deal with unfavourable selling price variance, the management should ensure that it is offering a competitive price strategy in its target market. It has to ensure that the brand is well-positioned and is targeting the right customers with best suitable prices as against its competitors.

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