Strategic planning is the critical process of gathering data to plan your company’s direction. Planning involves budgeting, which you’ll likely see on the CPA exam's business environment and concepts (BEC) test. Nearly all firms plan costs, levels of production and sales, as well as prices. At the end of a month or year, companies compare budgeted amounts to actual results.
This process is called variance analysis. Firms review variances to make changes and improve profit.
An increasing number of companies use a balanced scorecard to evaluate company performance. This tool considers both financial and nonfinancial measurements, which businesses find valuable. A company’s strategy includes nonfinancial measurements, like customer satisfaction and product quality.
Cause and effect: Managing with balanced scorecards
A balanced scorecard is a strategic planning tool that aligns business performance with a company’s vision and goals. The scorecard is considered balanced because it includes both financial and nonfinancial measurements. Nonfinancial measurements may include the number of incoming customer calls or the average time to resolve a client complaint.
Balanced scorecards are often communicated using a strategy map, which displays cause-and-effect relationships in the form of a graph or chart. The elements of your strategy (causes) connect to the results your business achieves (effects).
Suppose that you manage a warehouse that supplies auto parts to repair shops in your city. You implement a strategy to lower prices on all your products by 10 percent. The lower-price strategy results in increased sales. In this example, the price cut is a cause, and the increased sales are an effect.
Plans versus results: Budgeting with variance analysis
Proper planning requires that your firm have a formal budgeting process. That means that you have a process for implementing a budget: You gather information from all company departments and put together budgets that management discusses and approves. Part of the budgeting process is to plan your costs and levels of production and sales. Finally, you review your actual results and compare them with your budget.
A variance is defined as a difference between budgeted and actual results. Companies review variances related to costs and those tied to sales:
Favorable variance: A favorable variance means that actual costs are lower than planned or that actual sales are higher than planned. You see that a favorable variance increases profit, either with lower costs or higher sales.
Unfavorable variance: An unfavorable variance means that actual costs are higher than planned or that actual sales were lower than planned. An unfavorable variance decreases profit, either with higher costs or lower sales.
The BEC test may have you calculate material and labor variances. This section provides an example of a material variance.
To generate a budget, accountants compute standards. For example, if you manufacture wooden doors, you plan your budget by computing a standard price for the wood you purchase and a standard amount of wood per door. Suppose you budget a 60-inch square piece of wood to manufacture a door, and the material has a cost of $20. Here are two possible variances from your budgeting plans:
Material price variance: You pay more or less for the wood.
Material usage (or efficiency) variance: You use more or less wood than you planned.
On a basic level, you have a variance because you paid more or less than planned or you used more or less than planned.
If your actual use of wood is the same as your budgeted amount, you don’t have a material usage variance. Suppose, however, that your actual cost is $23 per door. You have an unfavorable price variance because you paid more than you planned.
To study this topic, memorize the formulas to compute material and labor variances; you can find them easily on the web. You’ll find price and usage variances for material and price and usage variance for labor.