Performance management

Reconcile the static budget, flexible budget and actual result

A static budget uses planned activity. A flexible budget applies the original prices and cost standards to actual activity. Comparing actual with flexible separates performance from the effect of volume. Comparing flexible with static explains the activity effect. The two bridges should reconcile to the total difference; an unexplained residual means a driver or sign is missing.

For cost variances, actual cost above the relevant benchmark is unfavorable. For revenue or profit, a higher amount is normally favorable. State the convention rather than attaching favorable/unfavorable labels mechanically. A favorable purchase-price variance can accompany lower material quality, extra labor or returns. The label describes the numerical direction, not the quality of the managerial decision.

Split input price from input efficiency

For materials used, price variance can be measured as actual quantity × (actual price - standard price), and usage variance as standard price × (actual quantity used - standard quantity allowed for actual output). If price variance is recognized at purchase, use quantity purchased for that variance. Purchases and usage can differ, so do not force those two bases into one reconciliation without an inventory bridge.

Labor rate variance uses actual hours × (actual rate - standard rate). Efficiency variance uses standard rate × (actual hours - standard hours allowed). Calculate the allowed quantity or hours from actual good output. Substituting the original planned output mixes the volume difference back into the performance comparison.

Fixed overhead introduces capacity and denominator assumptions. A spending variance compares actual fixed overhead with budget. A production-volume variance compares budgeted fixed overhead with the amount applied under the stated absorption system. Low utilization can create an unfavorable volume variance even if the manager spent exactly the authorized fixed budget.

Match the measure to the manager’s decision rights

A cost center is assessed primarily on costs within its remit; a revenue center on revenue; a profit center on both; an investment center also influences the asset base. Controllability depends on the time horizon and authority, not merely on a cost being traceable. A division may occupy a building without controlling the rent negotiated centrally.

Segment reporting should distinguish variable expenses, traceable fixed costs and common allocations. A positive contribution margin means revenue exceeds variable cost; it does not establish that the segment covers avoidable fixed commitments. Conversely, an allocated corporate charge does not necessarily disappear when the segment closes. Report the accounting result and the relevant decision economics separately.

Use ROI and residual income without creating bad incentives

ROI can be decomposed into operating margin × asset turnover when definitions are consistent: operating income/sales multiplied by sales/investment. That decomposition identifies whether a change came from margins or asset use. Specify average versus ending assets and gross versus net book value; depreciation policy can change the ratio without changing operations.

Residual income charges the unit for capital employed. An investment earning above the required return increases residual income, even if its percentage return is below the division’s current ROI. This is a classic reason that a manager rewarded only for preserving a high ROI may reject an economically attractive project.

Connect the scorecard and transfer price to company objectives

A balanced scorecard combines financial, customer, internal-process, and learning-and-growth perspectives. Start with a strategic hypothesis, such as better training reducing rework and improving delivery. Choose a leading measure, a result measure, an owner and a review interval. Adding many unrelated metrics does not make a scorecard balanced.

Transfer prices distribute internal profit and can influence whether divisions trade. With spare capacity, the seller’s economic minimum may be incremental cost. With constrained capacity, add contribution lost from displaced external sales. The buyer’s maximum normally reflects an equivalent outside alternative. Evaluate the group result as well as divisional reported profit; international tax and regulatory constraints require separate consideration.