Question

Chapter 7 in Horngren's cost accounting 16th edition textbook

In summarizing its painstaking analysis of revenue and direct cost variances, the textbook refers to three levels of analysis. What specifics are revealed with regard to the difference between a master budget and actual results at each level?

Answer 1

Answer.

THREE TYPES OF COST ANALYSIS IN EVALUATION:

Cost allocation, cost-effectiveness analysis, and cost-benefit analysisrepresent a continuum of types of cost analysis which can have a place in program evaluation. They range from fairly simple program-level methods to highly technical and specialized methods. However, all have specialized and technical aspects. If you are not already familiar with these methods and the language used, you should plan to work with a consultant or read some more in-depth texts (see some suggested references at the end of this discussion) before deciding to attempt them.

COST ALLOCATION: Cost allocation is a simpler concept than either cost-benefit analysis or cost-effectiveness analysis. At the program or agency level, it basically means setting up budgeting and accounting systems in a way that allows program managers to determine a unit cost or cost per unit of service. This information is primarily a management tool. However, if the units measured are also outcomes of interest to evaluators, cost allocation provides some of the basic information needed to conduct more ambitious cost analyses such as cost-benefit analysis or cost-effectiveness analysis. For example, for evaluation purposes, you might want to know the average cost per child of providing an after-school tutoring program, including the costs of staff salaries, snacks, and other overhead costs.

Besides budget information, being able to determine unit costs means that you need to be collecting the right kind of information about clients and outcomes. In many agencies, the information recorded in service records is based on reporting requirements, which are not always in a form that is useful for evaluation. If staff in a prenatal clinic simply report the number of clients served by gender, for example, you might know only that 157 females were served in March. For an evaluation, however, you might want to be able to break down that number in different ways. For example, do young first-time mothers usually require more visits than older women? Do single mothers or women with several children miss more appointments? Is transportation to appointments more of a problem for women who live in rural areas? Are any client characteristics commonly related to important outcomes such as birth weight of the the baby? Deciding how to collect enough client and service data to give useful information, without overburdening staff with unnecessary paperwork requirements, requires a lot of planning. Larger agencies often hire experts to design data systems, which are called MIS or management-and-information-systems.

If you are working for an existing agency, your ability to separate out unit costs for services or outcomes may depend on the systems that are already in place for budgeting, accounting, and collecting service data.

COST-EFFECTIVENESS AND COST-BENEFIT STUDIES

Most often, cost-effectiveness and cost-benefit studies are conducted at a level that involves more than just a local program (such as an individual State Strengthening project). Sometimes they also involve following up over a long period of time, to look at the long-term impact of interventions. They are often used by policy analysts and legislators to make broad policy decisions, so they might look at a large federal program, or compare several smaller pilot programs that take different approaches to solving the same social problem. People often use the terms interchangeably, but there are important differences between them.

COST-EFFECTIVENESS ANALYSIS: Cost-effectiveness analysis assumes that a certain benefit or outcome is desired, and that there are several alternative ways to achieve it. The basic question asked is, "Which of these alternatives is the cheapest or most efficient way to get this benefit?" By definition, cost-effectiveness analysis is comparative, while cost-benefit analysis usually considers only one program at a time. Another important difference is that while cost-benefit analysis always compares the monetary costs and benefits of a program, cost-effectiveness studies often compare programs on the basis of some other common scale for measuring outcomes (eg., number of students who graduate from high school, infant mortality rate, test scores that meet a certain level, reports of child abuse). They address whether the unit cost is greater for one program or approach than another, which is often much easier to do, and more informative, than assigning a dollar value to the outcome.

COST-BENEFIT ANALYSIS: The basic questions asked in a cost-benefit analysis are, "Do the economic benefits of providing this service outweigh the economic costs" and "Is it worth doing at all"? One important tool of cost-benefit analysis is the benefit-to-costs ratio, which is the total monetary cost of the benefits or outcomes divided by the total monetary costs of obtaining them. Another tool for comparison in cost-benefit analysis is the net rate of return, which is basically total costs minus the total value of benefits.

The idea behind cost-benefit analysis is simple: if all inputs and outcomes of a proposed alternative can be reduced to a common unit of impact (namely dollars), they can be aggregated and compared. If people would be willing to pay dollars to have something, presumably it is a benefit; if they would pay to avoid it, it is a cost. In practice, however, assigning monetary values to inputs and outcomes in social programs is rarely so simple, and it is not always appropriate to do so.

Master Budget Vs Actual

The master budget is the aggregation of all lower-level budgets produced by a company's various functional areas, and also includes budgeted financial statements, a cash forecast, and a financing plan. The master budget is typically presented in either a monthly or quarterly format, and usually covers a company's entire fiscal year. An explanatory text may be included with the master budget, which explains the company's strategic direction, how the master budget will assist in accomplishing specific goals, and the management actions needed to achieve the budget. There may also be a discussion of the headcount changes that are required to achieve the budget.

The difference between the budgeted amount for a figure and the actual result in the report is referred to as the budget variance.
A budget variance can be displayed as a hard number or it can be put in a percentage format.

There are several reasons why there will discrepancies between the budget and the actual amount for expenditures and revenues. These differences can occur because of the strength of the economy, consumer needs or preferences and the actions of competitors. Because these factors can be unpredictable, it's important for small businesses to reflect on the exact cause or causes that resulted in the variance.

How can small business owners interpret the variances?

Creating a budget vs. actual comparison is extremely important for small businesses because it allows them to alter their future financial forecasts based upon the numbers collected in the monthly reports. Business owners can see where the budget can be improved, as well as parts of the budget that were very accurate. Through better planning, monitoring, evaluating and controlling, small business owners can improve their processes after analyzing the budget vs. actual comparison.

What can be done about the variances?

Depending upon how the actual results compared to the budget, small business owners can make the necessary adjustments to their budget. Whether it be modifying ongoing expenditures or strategies, or cutting back spending on marketing and advertising, small business owners need to use this informative data to improve their budgeting strategies and enhance their operations. However, small business owners should be sure not to overreact and change their budget drastically based on temporary factors that will affect a business for only a short period of time.