206 Understanding the Numbers
Price Indices
“If you only examine Panel A of Exhibit 7.2,” Jane said, “you will think that net
income leaped 62% and that the reason for the dramatic increase lies in the rel-
atively sharp increase of 15% in revenue. This increase in revenue appears to
have more than compensated for the apparent increase in variable costs of 7%
and fixed costs of 17%. You might be tempted to attribute the increase in net
income to the superior ability of the sales staff.”
“The fallacy of this interpretation is apparent when you examine Panel B,
which compares the actual results with the f lexible budget. Now, after adjust-
ing for sales volume, we find that instead of that dramatic increase of 62% in
net income, there was a 19% drop in net income from budget. Using that same
basis of comparison, revenue actually fell by 4% instead of our earlier increase
of 15%. Now you can also see that, after adjusting for sales activity, variable
costs actually showed a steep decline of 11% rather than the increase of 7%
shown in Panel A. In other words, at the actual volume of 1,200 units as op-
posed to the budgeted volume of 1,000 units, you should have budgeted more
for variable costs than at first expected. The $8,400 is, in retrospect, the more
appropriate budget figure.
“The apparent rise in revenues shown in Panel A melts away in Panel B, as
does the apparent rise in variable costs shown in Panel A. The result is a whole
new story. Volume rose perhaps because of the efforts of the sales staff but
more probably because of the fall in the selling price from $12 per unit to
$11.50 per unit.
“Fortunately,” Jane said with a broad grin on her face, “the loss was par-
tially offset by the heroic efforts of the production staff in getting their per-
unit costs down by 11%.”
“I like that heroic part,” said Tom approvingly.
“ You should, because with the volume effect eliminated, all of the fall in
variable costs must be attributed to a fall in unit variable costs. More precisely,
standard variable costs were $7.00 but actual unit variable costs were just
$6.25. Dividing the actual unit cost of $6.25 by the standard variable cost of
$7.00 yields an index of 0.89, or precisely the 11% decrease in variable costs
noted earlier.”
Activity Indices
“Now look at Panel C,” said Jane. “This compares the f lexible budget with the
static budget. The only factor that changes between the two is sales activity, so
the percentages measure the change in the number of units sold. As there is
only one measure of activity, it is not surprising that all the activity-based in-
dices show an increase of 20%, that is, 200 units extra on a base of 1,000. Fixed
costs, though, are independent of activity levels. Net income, which is a combi-
nation of activity-related and activity-independent numbers, shows an increase
that ref lects its mixed nature.”