Baking A Pie: An Accounting Story
Author’s Note:
Explaining accounting and finance can be pretty dull. That’s a problem, if you need to learn accounting or finance.
On a plane from St. Louis to Seattle in 2015, I decided to try and fix the problem. What if I could wrap some accounting concepts inside of a quirky (funny?) short story? My goal here is to present some information, and then add another step in the story. So, when you get to the end, you’ve been reminded of an accounting concept- but you’ve received the information in a light-hearted way.
Anyway, that’s the goal here. This post explains cost variances and budget variances. Enjoy!
Just how many Nordstrom mailers were they going to get this Christmas season? Greg left the latest batch of mail on the counter and headed out to his truck. They came in every size, style and shape imaginable: letters, flyers, full catalogs. The minute November 1st arrived, they started coming everyday.
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It’s as if his wife and girls had adopted a child from a war-torn country- and the child was living at the nearby Nordstrom…
Greg owned and operated MountainView clothing. His firm manufactured shoes and clothing for the hiking and biking market. The customers were serious outdoor sports people who liked the quality products, and Greg sold to outdoor sports shops- he stayed away from dealing with the big chain stores.
Lately, he’s noticed that his actual production costs were higher than planned. Greg started to think through the process as he got on the highway. He had taken the time to budget before the year started, and part of that process was planning the labor, material and overhead costs for production.
He flipped down the sun visor. Now that he was into November, he noticed that his costs were higher than planned. Since he had already set prices with his customers, higher costs cut into his profit.
His accountant, Joe, told him to perform variance analysis. A variance, Joe explained, was a difference between budgeted and actual results. In other words, Greg’s business had a budget variance.
Greg got to the office and turned on his Mac. The goal today was to go through each of the 15 products MountainView sold. He has his budgets from the beginning of the year, and his year-to-date cost results.
He decided to start with the Tundra Tough hiking shorts, his biggest seller. Greg turned on the space heater under his desk, then pulled up the Turdra Tough budget:
Tundra Tough Shorts: 2015 Price and Cost Per Unit Budget
Price: $100
Direct Material
StretchAll Cotton $50
Metal, plastic inserts $10
Direct Labor
Cutting, sewing $20
Total Direct Costs $80
Indirect Costs $5
Total Costs $85
Profit per unit $15 (15%)
“Greg, that tech guy’s on the phone about the cloud backup problem”. Tony, his production manager, pointed to Greg’s phone.
“Hi, I’m returning your call…….cloud……”
“I’m sorry- what?” Greg asked.
For 10 minutes, Greg talked to tech support. Well, sort of. The tech person obviously had a headset on that kept cutting out. Frustrating. Finally, at the end of the call, the tech person asked Greg to take a quick survey.
The phone prompts on the survey were as clear as a bell. Why couldn’t the tech support be as clear as the survey? Greg shook his head and turned back to Tundra Tough. His accounting software generated a variance report:
Tundra Tough Shorts:
2015 Budget vs. Actual Variances/ Year-To-Date
Budget Actual Variance
StretchAll Cotton $50 $45 $5 favorable
Cutting, sewing $20 $30 $10 unfavorable
Total Variance $5 unfavorable
To explain budget variances, Joe the Accountant explained that a favorable variance meant that actual costs were lowered than budgeted. In this case, the cost he paid for StretchAll Cotton was less than planned ($45 per unit vs. $50 per unit).
An unfavorable variance meant that actual costs were higher than planned. Greg was paying more for cutting and sewing labor costs than planned ($30 vs. $20). In total, the variance was $5 unfavorable per pair. Cost variances are not unusual, Joe pointed out.
He headed over to the plant to check on today’s production run. As he left his office, he noticed the TV in the lobby. A cable news station had “ Breaking News!” running a bright red across the bottom of the screen. Isn’t it always breaking news on cable? After awhile, the phrase didn’t make any impact on the viewer…
OK, back to the variance thing. Direct costs, as Joe explained, were costs that you could trace directly to the product. The common example was either labor or materials. Overhead costs, on the other hand, were allocated based on some activity level.
As Joe explained it, a variance is similar to what happens when you follow a recipe. Say that you’re baking a pie, Joe said, and the cost of the pie was different than what you planned.
Well, there are two reasons why. You either paid more or less for materials than planned- or you used more or less than planned. In this case, Greg paid less for the StretchAll Cotton than planned ($5 favorable variance). He also used more labor hours than planned ($10 unfavorable).
Joe explained that other issues, including activity-based costing, and decisions to sell or process further complicated the analysis- but that was a story for another day.
He was headed to the factory to check on just how his staff was cutting and sewing material. The higher labor cost might be because he needed to train his staff to be more productive.
Well, we can negotiate a lower price for the cotton, since we’re buying so much of it, Greg thought. If I can fix the labor variance, I’ll be back on track.
Whose idea was it to turn Beatles songs into soft jazz? Someone in the factory should turn that down…
Ken Boyd
Author: Cost Accounting for Dummies, Accounting All-In-One for Dummies, The CPA Exam for Dummies and 1,001 Accounting Questions for Dummies
(email) ken@stltest.net
(website and blog) https://www.accountingaccidentally.com/
(you tube channel) kenboydstl
Image: Danube 66, Pumpkin Pie (CC By 2.0)