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JAMAR Vol. 9 · No. 2· 2011
Research Note
Introduction
A New Framework for This paper extends Yahya-Zadeh (2002) to
Capacity Costing and integrate inventory variances into flexible
Inventory Variance budgeting and profit variance analysis. While
traditional profit variance analysis "flexes" the
Analysis static budget to actual sales volume, Yahya-
Zadeh (2002) argued that a more appropriate
benchmark for measuring the performance of a
Massood Yahya-Zadeh* firm or its profit centres would be an ex post
optimal budget. An ex post optimal budget, it
Abstract was argued, was the result of an optimization
program using the latest data available by the
The proposed framework in this article end of the budget period. Using linear
presents a new framework for capacity programming as the optimization tool, the
costing and inventory variance analysis by study showed that changes in market
introducing linear programming (LP) into conditions, such as a change in the firm's
variance analysis to allow for optimal relative output and input prices, could render a
budgeting in a firm with two production traditional flexible budget misleading.
departments and two products. In Measuring and rewarding responsibility centre
addition, the proposed framework managers for achieving outdated budget
replaces the traditional concept of ex ante targets could lead some profit centre managers
flexible budget, with the concept of ex post to increase production of the wrong
flexible budget, which allows management department or the wrong product.
to optimally revise the budget in response Additionally, it would penalize profit centre
to changes in market and operational managers making strategic and timely
conditions. Additionally, an inventory decisions to change course to respond to
variable is added to the linear changing market conditions. The present paper
programming model to capture complements Yahya-Zadeh (2002) by
management’s planned and actual incorporating inventory and cost of capacity
inventory decisions. variances to it.
The proposed framework further In the accounting literature, the concept of an
distinguishes between practical and ex post budget based on an optimized linear
budgeted capacity in each department program was introduced by Demski (1967).
and explicitly identifies the planned and Hulbert and Toy (1977) initiated a similar
unplanned changes in inventory levels discussion in the marketing literature. They
and in capacity utilization. Collectively, suggested using the ex post data, information
these modifications to traditional flexible available to marketing manager at the end of
budgeting and variance analysis enhance the budget period, for analysing marketing
their managerial and pedagogical variances. The ex post information enabled
applications. them to isolate the planning component of
marketing variance from its performance
component. Consequently, poor performance
Keywords: due to inadequate planning could be separated
from variances due to substandard
performance. Hulbert and Toy further
Inventory Variance Analysis introduced the concepts of market size
Linear Programming (LP) variance and market share variance. Market
Ex Ante Flexible Budgets share variance was treated as controllable,
Ex Post Flexible Budgets while market size variance was considered
Practical and Budgeted Capacity uncontrollable for marketing managers.
Hulbert and Toy’s study was extended by
several other studies in the marketing literature
*George Mason University (Weber, et al., 1997; Sharma and Achabal,
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JAMAR Vol. 9 · No. 2· 2011
1982; Jaworski, 1988; Mitchell and Olsen, incorporate inventory variance and cost of
2003). unused capacity into traditional profit variance
analysis. The use of the linear programming
The incentive to overproduce under absorption method makes it possible to view annual
costing has been the subject of much debate in budgeting as an optimization exercise in the
management accounting. The incentive to context of multi-department and multi-product
overproduce under absorption costing and companies. In addition, it redefines flexible
thereby capitalize higher portions of fixed budget, as an ex post, instead of an ex ante,
manufacturing overhead has been well known. concept. In determining inventory and cost of
Overproducing inventory defers current capacity variances, the current study follows
manufacturing costs to future periods through the methodology of Balakrishnan and Sprinkle
inventory account. Interpreting fixed (2002). Additionally, it extends their study by
manufacturing overhead cost as “cost of integrating ex post flexible budget into their
capacity” implies that increased inventory is model.
equivalent to moving capacity costs into future
periods. Pedagogically, the present study offers a new
way of thinking about variances and capacity
Cooper and Kaplan (1992) argued that costing. Cost accounting textbooks (e.g.,
companies should specifically examine the Horngren, et al.) often present variances for
cost of resources supplied (i.e., cost of individual products, and individual
available capacity) and differentiate it from departments. Further, they tend to ignore
cost of resources (capacity) used. While inventory variance except in the discussion of
periodic financial statement reporting is based product costing. Budgeted capacity is
on cost of resources supplied, activity-based routinely used to determine fixed overhead
costing provides information of cost of rate and the significance of using practical
resources used. Cooper and Kaplan (1992) capacity in activity-based costing and in
argue that cost of unused capacity is useful for overhead variance analysis is downplayed or
managerial decisions and should be reported completely overlooked. Traditional textbooks
for each activity. They made a distinction provide limited coverage of the linear
between budgeted and practical capacity and programming tool in the discussion of short-
argued in favour of using practical capacity for term product-mix decisions. At the same time,
computation of activity rates in activity-based the present study extends the work of the
costing. Kaplan (1994) extended this idea. earlier studies by emphasizing the need for an
Kaplan suggested decomposing activity rates optimal budgeting concept and by integrating
to their committed (i.e., fixed) and flexible linear programming into the discussion of
(i.e., variable) components. He used these inventory and capacity cost variances.
rates to determine budgeted unused capacity
costs and capacity utilization variances for The practical value of present study stems
each activity and to integrate ABC and flexible from its ability to view variance analysis in the
budgeting. context of overall optimization decisions.
Management’s midyear decision to adjust
Balakrishnan and Sprinkle (2002) presented a production levels of different departments or
new framework for profit variance analysis products is discussed relative to overall profit
that specifically identified and reported the maximization decision. Consequently,
cost of planned unused capacity and the cost unplanned changes in production levels of a
of unplanned use of idle capacity. In addition, department, treated as unfavourable moves
they specifically determined inventory change under the traditional approach, may be treated
variance as an integral part of profit variance as a positive step by the framework proposed
computations. The key features of their in this study. Management may have to change
improved variance analysis framework was its production plans midway through the
using practical capacity for computing fixed budget period and cause “unfavourable”
overhead costs and introducing a flexible capacity variances in some departments.
budget that was adjusted for actual sales Unless such decisions are examined through
volume and budgeted changes in inventory. the lens of a global optimization plan, it would
be hard to make sense of recurring or shifting
The present study uses the linear programming changes in inventory and capacity variances.
framework, as in Yahya-Zadeh (2002), to By integrating variance analysis and profit
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JAMAR Vol. 9 · No. 2· 2011
optimization decisions, the present study units of X and Y, respectively. Actual fixed
demonstrates an approach for improving overhead cost in Department 1 was $37,500
measurement and interpretation of inventory, and actual fixed overhead in Department 2 was
capacity, and profit variances. $30,000.
The present paper illustrates the new inventory Observe that in this example Department 1 is
and capacity variances using a numerical planned to operate at its full practical capacity
example. First, the limitations of textbook (5,000 hours), whereas Department 2 is
variance analysis in dealing with multi-product budgeted to operate under capacity (4,143 ×
and multi-department situations are discussed. 0.2 + 3,457 × 0.8 = 3,594). This feature is the
In subsequent sections, an improved outcome of optimizing production and
framework for computation of inventory and inventory plans using the linear programming
capacity variances and for evaluating method (see Table 5 for optimization
management’s production decisions is procedure). This feature enables the study to
presented. examine mid-year changes in actual or
budgeted production and sales levels
Hypothetical Example differently than under the traditional approach.
Specifically, it charts the consequences of
Consider a firm with two production market changes beyond limits foreseen in the
departments and two products, X and Y. The static budget. A brief review of Balakrishnan
firm’s production, price, and inventory and Sprinkle’s (2002) helps set the stage for
information are shown in Table 1. the description of our numerical example.
The static budget indicates that during the Traditional Approach to Flexible Budgeting
upcoming year the firm plans to sell 4,143 and
3,457 units of products X and Y, respectively. Table 2 (Panel A) presents alternative
Manufacturing one unit of product X requires computations of overhead rates using budgeted
0.96 labour hours in Department 1 and 0.24 and practical capacities. Panel B of Table 2
labour hours in Department 2. Product X has a determines unit product costs using an
budgeted selling price of $88 and a budgeted overhead rate based on budgeted capacity and
unit variable manufacturing cost of $66. Panel C calculates unit product costs using
Beginning inventory for Product X is 200 units practical capacity as the denominator. The
and the desired ending inventory is 414 units planned increase in the firm’s inventories
(set at 10% of budgeted sales volume for the (10% increase) implies the need to determine
current period). The corresponding quantities unit costs in the beginning inventory and the
and prices for product Y (Table 1) should be need to use a cost flow assumption. LIFO is
1
interpreted in a similar manner. The practical the assumed inventory flow . Also, observe
capacity of Departments 1 and 2, measured in that practical capacity is used in computation
labour hours, are 5,000 and 4,000 labour of unit costs in the beginning inventories (see
hours, respectively. The current year’s Table 2, Panel C).
budgeted capacity of Departments 1 and 2 are
5,000 and 3,594 hours, respectively. Table 3 demonstrates the traditional flexible
Departments 1 and 2, respectively, have budgeting approach applied to the current
budgeted fixed annual manufacturing example. Budgeted gross profit for the period
overhead costs of $35,000 and $25,875. is $100,791.
Budgeted (and actual) total demand for the
two products is 7,600 units. Buyers can easily
substitute one product for another because of
similarity of their features and functions.
By the end of the budget year, the firm had 1
sold 3,814 units of product X and 3,786 of These assumptions are consistent with
product Y at average prices of $86.50 and $75, Balakrishnan and Sprinkle (2002). The use of
respectively. Actual inventory levels increased practical capacity for determination of unit costs in
far beyond the budgeted levels to 572 and 568 the beginning inventory is for consistency and
comparability of Tables 3, 4, and 6.
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JAMAR Vol. 9 · No. 2· 2011
Table 1: Production and Inventory Levels Under Actual, Budgeted and Traditional Definition of Flexible
Budget
Actual (AR) Flexible Budget Static Budget (SB)
(based on actual (based on actual (based on ex ante
sales and sales and optimal sales and
Item inventory levels) inventory levels) inventory levels)
X Y X Y X Y
Sales volume a (units) 3,814 3,786 3,814 3,786 4,143 3,457
Unit price ($) $86.50 $75.00 $88.00 $74.00 $88.00 $74.00
Unit variable cost ($) 66.00 54.00 66.00 54.00 66.00 54.00
Unit contribution margin ($) 20.50 21.00 22.00 20.00 22.00 20.00
Beginning inventory (units) 200 400 200 400 200 400
Desired ending inventory (units) 572 568 572 568 414 346
Production volume (units) 4,186 3,954 4,186 3,954 4,357 3,403
Labour hours required in Dept. 1 per unit 0.96 0.24 0.96 0.24 0.96 0.24
Labour hours required in Dept. 2 per unit 0.2 0.8 0.2 0.8 0.2 0.8
Additional information:
Total market demand for products X and Y: 7,600 units
Department 1 Department 2
Current year budgeted capacity (labour hours) 5,000 3,594
Current year practical capacity (labour hours) 5,000 4,000
Last year’s practical capacity (labour hours) 5,000 4,000
Budgeted fixed manufacturing overhead (years 1, 2) $35,000 $25,875
Actual fixed manufacturing overhead—current year 37,500 30,000
Overhead rate based on budgeted capacity $7.00 $7.20
Overhead rate based on practical capacity 7.00 6.74
Product X Product Y
Budgeted increase in inventory level for current year 10% 10%
Actual increase in inventory level for current year 15% 15%
64
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