Additional info to questions is attached

Questions:

1. In this case, we have the Exhibit 1 budget based on an original planned volume, referred to as the static budget, and in question 2 below, you will prepare a budget adjusted for the actual achieved volume, referred to as the flexible budget. (Formal definitions of the budgets and variances used in this case are found in Chapter 8 of the text.)

a. Compute variances based on the difference between the actual 2015 results in Exhibit 2 and the static budget amounts in Exhibit 1. These variances are referred to as static budget variances.

b. Pats preliminary conclusions are based on these static budget variances. Discuss the limitations of using the static budget variances to draw conclusions about Mikes performance for 2015.

2. Prepare a flexible budget that reflects actual gross and net annual revenue as shown in the tables above. The key idea of a flexible budget is to "flex" the budget to reflect the actual level of output rather than the planned level reflected in the original static budget in Exhibit 1. Therefore, in contrast to the static budget based on original planned numbers of meals shown in Table A, your flexible budget will be based on the actual numbers of meals, also shown in Table A.

Just as the level of output can differ from the original budgeted level of output, selling prices and input costs can differ from the original plan. An important question is whether to incorporate these differences in the flexible budget. The flexible budget could be constructed using either planned or actual selling prices, and using either planned or actual input costs. The usual convention, and the one we will follow here, is to use the actual selling prices but the planned cost for inputs. (We will discuss further in class why this is the way flexible budgets are usually constructed.) More specifically,

a) for selling prices, use the actual gross meal prices and the actual net meal prices, so that your flexible budget gross and net revenue numbers reflect the actual volume and the actual selling prices shown in Table C. By doing this, your flexible budget revenue numbers will look exactly like the actual revenue numbers shown in the right-hand column of Table C.

b) For input costs, base your flexible budget on the same assumptions used in preparing the static budget in Exhibit 1. As examples: (i) assume that food costs will be 40% of gross revenue (do not include the effect of 4% lower food costs in your flexible budget) (ii) assume that the variable component of labor costs will be 31% of gross revenue (do not include the effect of 2.5% higher labor cost in your flexible budget) (iii) assume that local advertising will be 1% of gross revenue (do not include the higher actual expenditures on local advertising in the flexible budget)

3. Use your flexible budget to compute the sales-activity variance and the flexible-budget variance for each line of the income statements shown in Exhibits 1 and 2 (and in your flexible budget). Use these variances to answer the following specific questions.

a. What was the budgeted effect on profit of selling different numbers of meals and different average purchases than planned when the static budget was constructed?

b. How much more was spent on all costs combined than predicted in your flexible budget?

c. How much more was spent on food than predicted in the flexible budget? How much more was spent on the variable portion of labor than predicted in the flexible budget?

d. How much more was spent on fixed costs than predicted in the flexible budget, in total and item by item?

4. Use the additional information about changes in the prices of food and labor to further separate the flexible-budget variances for food costs and for the variable portion of labor costs into price and quantity variances.

5. Evaluate the effect on 2015 profit of the decision by Mike Dukatz to increase spending on local advertising that includes $1-off lunch coupons. Consider (but don't try to quantify) what effects, if any, local advertising with $1 off lunch coupons might have had on revenue and costs for breakfast and dinner. Then, ignoring any possible effects on breakfast and dinner revenue and costs you identified, evaluate Mikes decision to spend more money on local advertising during 2015. Compare your evaluation with Pats preliminary conclusion (5) about advertising costs. The basic question we are trying to answer is whether Mikes decision to increase advertising results in higher or lower profit for the Bozeman restaurant.

This question requires careful thought and some additional assumptions. Please make a sincere effort to formulate an answer, but if you find you are spending more than 20-30 minutes on this question, feel free to stop and just right down a description of whatever partial answer you have been able to formulate.

Following are some suggestions about how to structure your evaluation:

a) Assuming that the fee paid to Parker Pancakes for national advertising was the standard 2% of actual revenue, how much did Mike spend on local advertising? How does this compare to the amount in the static budget prepared in December 2014? How does this compare to the amount in your flexible budget?

b) Evaluate the effect of additional advertising spending on gross and net revenue from lunch. For this evaluation, you need the gross and net revenue that resulted from Mikes decision to increase local advertising. This is straightforward because we have the actual gross and net lunch revenue in Table B. However, you also need to know the gross and net lunch revenue that would have occurred if Mike had not increased local advertising. There are two main possibilities that should be considered here:

First, you could assume that if Mike had not increased advertising, gross and net lunch revenue would have been equal to the budgeted amounts shown in Table B. However, a close inspection of the data suggests a second, alternative assumption. There is reason to believe that if Mike had not increased advertising, the number of lunches served might have fallen below the amounts used in constructing the static budget. Table A shows that the numbers of breakfasts and dinners served dropped below the budgeted numbers by an average of about 15%. Thus, a second, alternative assumption is that if Mike had not increased advertising, the number of lunches served would also have dropped by about 15% below the budgeted number and the average lunch check and average lunch discount would have been as budgeted.

c) Evaluate the effect of Mikes advertising on the incremental costs of lunch. That is, calculate and compare the expected effect of Mikes decision to advertise more on the costs of serving lunch. Keep the following three things in mind: First, remember that the costs of serving lunch are related to the gross revenue, rather than the net revenue, and because you considered two alternative possibilities for what gross revenue would have been if Mike had not increased advertising, you will have to prepare two alternative evaluations of what cost would have been. Second, focus on the expected effect on costs if these costs had been the originally budgeted percentages rather than the actual percentages they turned out to be. For example, the expected cost of food was 40% of gross revenue, the expected cost of labor was 31%, and the expected cost of other operating expenses was 3.5%. Third, the costs budgeted as fixed are not changed by Mikes decision to advertise more, so these costs are not incremental with respect to Mikes decision and can be left out of your evaluation.

d) Combine Mikes incremental spending on advertising from part a with your evaluation of the incremental revenue from increased advertising in part b and your evaluation of the incremental cost in part c to form your evaluation of Mikes decision. (Because you are considering two alternative estimates of what lunch revenue would have been if Mike had not increased advertising, you will have two alternative evaluations of incremental revenue in part b and two corresponding evaluations of incremental cost.)

Parker Pancakes* Pat Leizinger owns a number of restaurants throughout the western United States that are part of the Parker Pancakes chain. In December 2014, Pat met with Mike Dukatz, the manager of his Bozeman, Montana restaurant, to develop the 2015 budget shown in the right column of Exhibit 1. Exhibit 2 shows the corresponding actual results for 2015. Like other managers of Pat's restaurants, Mike makes staffing and scheduling decisions, oversees quality of food and service, and makes decisions about local advertising, including promotional specials. Staffing and scheduling Labor cost consists of two components. First, there is a variable component that depends directly on customer volume (wait staff, busboys, assistant cooks). Adjusting the schedule and staffing to correspond to fluctuations in volume is an important part of Mike's job. This component of labor cost is budgeted at 31% of gross revenue. Second, labor also has a fixed component (Mike's salary and the cost of cleanup and maintenance labor) that does not vary with volume. The budgeted fixed component of labor cost totals $174,000 per year. Cost and quality of food An important element of the success of the Parker Pancakes chain is the reputation of the restaurants for consistent quality and good value. The Parker Pancakes restaurants all use basically the same menu but prices in each restaurant are based on local food cost. Prices are set at approximately 250% of the expected average cost of food ingredients. Thus, the menu prices represent an average markup of 150% above expected food cost or, equivalently, food costs are budgeted at an average of 40% of menu prices. Pat handles purchasing of all the food for his restaurants. Pat follows an index of food costs for the Bozeman area where he purchases food. By the end of 2015, the index showed that food costs for the local area during 2015 averaged 4% lower than the costs that were expected when the budget was constructed and menu prices were set. Advertising Advertising expenditures comprise two pieces. First, the Parker Pancakes chain charges each restaurant a fee equal to 2% of actual gross revenue to support Parker's national advertising campaigns. Second, Pat's restaurants also advertise in local publications. About 1% of revenue is budgeted for local advertising but the local managers make the decisions about the local advertising campaigns and promotions. Therefore, the advertising budget (combining both national and local advertising) is 2% + 1% = 3% of gross revenue. Mike has found that one of the most effective forms of local advertising is to run ads with coupons that provide $1 off any order of $10.00 or more during the hours when lunch is served. For lunch, these coupons create a difference between the gross revenue ** Page 1 (representing the menu price of a lunch check) versus net revenue (representing $1 less than the menu price for lunch meals whenever a customer uses the $1 off coupon). These effects are summarized in Table B below. These coupons apply only to the lunch menu, so there are no differences between gross and net revenue for breakfast and dinner. Additional information Other operating expenses are budgeted at 3.5% of gross revenue per year. Depreciation, insurance, property taxes, rent, and miscellaneous are budgeted as fixed costs at the amounts shown in Exhibit 1. During the year, the state adopted a new payroll tax amounting to 2.5% of total payroll. This new tax applies to both the variable and fixed components of labor for Parker Pancakes. The effect of this increase was not anticipated and is not included in the static budget in Exhibit 1. However, this increase is reflected in the total actual labor expenditures in Exhibit 2. The fixed cost component of the actual labor expenditures was $178,350, i.e., the budgeted amount of $174,000 plus the additional 2.5% payroll tax, or $4,350. The actual advertising expenditures in Exhibit 2 consist of the fee paid to support national advertising equal to 2% of actual gross revenue plus the actual expenditures to pay for the local advertising that includes the coupons for $1 off lunch orders of $10 or more. The following tables show the average weekly and annual budgeted and actual numbers of customers by meal (Table A), the annual gross and net lunch revenue (Table B), and the annual gross and net total revenue for the breakfast, lunch, and dinner menus (Table C). Note that throughout the case, the annual amounts assume a 52week year. Preliminary conclusions Pat has reviewed Tables AC and compared the results in Exhibits 1 and 2. He is now preparing to meet with Mike to discuss the results for 2015. Pat has developed the following preliminary conclusions: 1) Profitability is lower than it should be. Profit is roughly $95,000 lower than budgeted. 2) As shown in Table C, total gross revenue was down about $70,000, due at least in part to difficult general economic conditions in Bozeman during 2015. Pat is concerned that net revenue was down even more, by about $112,000, because so many people used lunch coupons - as shown in Table B, lunch discounts used were about $42,000 greater than budgeted. 3) Food costs. Actual food expenditures were about $44,000 less than budgeted, so it looks like Mike is doing a very good job of managing food costs. 4) Labor costs. Actual labor expenditures were about $4,000 less than budgeted, so Pat concludes Mike is doing a reasonable job of managing labor costs. 5) Advertising costs. Actual advertising expenditures were approximately $32,000 greater than budgeted, so Mike may be spending too much on advertising, especially since this advertising resulted in about $42,000 more discounting of lunch sales as outlined in item 2. This $32,000 + $42,000 accounts for most of the $95,000 profit shortfall. Page 2 Table A Number of Customers by Meal Budget Actual Per Week Per Year Per Week Per Year Number of customers per week Breakfast customers 1,900 98,800 1,600 83,200 Lunch customers 2,000 104,000 2,400 124,800 Dinner customers 2,100 109,200 1,800 93,600 Total number of customers 6,000 312,000 5,800 301,600 Table B Annual Gross and Net Lunch Revenue Budget Actual Per Meal Annual Per Meal Annual Average gross lunch check $10.50 1,092,000 $11.00 1,372,800 Average net lunch check $10.00 1,040,000 $10.25 1,279,200 Average lunch discount $.50 $52,000 $.75 $93,600 Table C Annual Gross and Net Total Revenue Budget Actual Per Meal Annual Per Meal Annual Average breakfast check $8.50 839,800 $8.50 707,200 Average gross lunch check $10.50 1,092,000 $11.00 1,372,800 Average dinner check $14.00 1,528,800 $14.00 1,310,400 Total Annual Gross Revenue $3,460,600 $3,390,400 Less: Lunch discount ($.50) ($52,000) ($.75) ($93,600) Total Annual Net Revenue $3,408,600 $3,296,800 Exhibit 1 Parker Pancakes Budget for 2015 (Prepared December 15, 2014) Budget Gross Revenue 3,460,600 Less: Coupon Discounts 52,000 Net Revenue 3,408,600 Food 1,384,240 Labor 1,246,786 Advertising 103,818 Other Operating Expenses 121,121 Depreciation 21,000 Insurance 8,500 Property taxes 13,500 Page 3 Rent Miscellaneous Profit 84,000 7,000 418,635 Page 4 Exhibit 2 Parker Pancakes Actual results for 2015 Gross Revenue Less: Coupon Discounts Net Revenue Food Labor Advertising Other Operating Expenses Depreciation Insurance Property taxes Rent Miscellaneous Profit Actual 3,390,400 93,600 3,296,800 1,340,533 1,242,600 135,616 117,968 21,000 8,650 13,500 84,000 9,500 323,433 Questions: 1. In this case, we have the Exhibit 1 budget based on an original planned volume, referred to as the static budget, and in question 2 below, you will prepare a budget adjusted for the actual achieved volume, referred to as the flexible budget. (Formal definitions of the budgets and variances used in this case are found in Chapter 8 of the text.) a. Compute variances based on the difference between the actual 2015 results in Exhibit 2 and the static budget amounts in Exhibit 1. These variances are referred to as static budget variances. b. Pat's preliminary conclusions are based on these static budget variances. Discuss the limitations of using the static budget variances to draw conclusions about Mike's performance for 2015. 2. Prepare a flexible budget that reflects actual gross and net annual revenue as shown in the tables above. The key idea of a flexible budget is to "flex" the budget to reflect the actual level of output rather than the planned level reflected in the original static budget in Exhibit 1. Therefore, in contrast to the static budget based on original planned numbers of meals shown in Table A, your flexible budget will be based on the actual numbers of meals, also shown in Table A. Just as the level of output can differ from the original budgeted level of output, selling prices and input costs can differ from the original plan. An important question is whether to incorporate these differences in the flexible budget. The flexible budget could be constructed using either planned or actual selling prices, and using either planned or actual Page 5 input costs. The usual convention, and the one we will follow here, is to use the actual selling prices but the planned cost for inputs. (We will discuss further in class why this is the way flexible budgets are usually constructed.) More specifically, a) for selling prices, use the actual gross meal prices and the actual net meal prices, so that your flexible budget gross and net revenue numbers reflect the actual volume and the actual selling prices shown in Table C. By doing this, your flexible budget revenue numbers will look exactly like the actual revenue numbers shown in the righthand column of Table C. b) For input costs, base your flexible budget on the same assumptions used in preparing the static budget in Exhibit 1. As examples: (i) assume that food costs will be 40% of gross revenue (do not include the effect of 4% lower food costs in your flexible budget) (ii) assume that the variable component of labor costs will be 31% of gross revenue (do not include the effect of 2.5% higher labor cost in your flexible budget) (iii) assume that local advertising will be 1% of gross revenue (do not include the higher actual expenditures on local advertising in the flexible budget) 3. Use your flexible budget to compute the salesactivity variance and the flexiblebudget variance for each line of the income statements shown in Exhibits 1 and 2 (and in your flexible budget). Use these variances to answer the following specific questions. a. What was the budgeted effect on profit of selling different numbers of meals and different average purchases than planned when the static budget was constructed? b. How much more was spent on all costs combined than predicted in your flexible budget? c. How much more was spent on food than predicted in the flexible budget? How much more was spent on the variable portion of labor than predicted in the flexible budget? d. How much more was spent on fixed costs than predicted in the flexible budget, in total and item by item? 4. Use the additional information about changes in the prices of food and labor to further separate the flexiblebudget variances for food costs and for the variable portion of labor costs into price and quantity variances. 5. Evaluate the effect on 2015 profit of the decision by Mike Dukatz to increase spending on local advertising that includes $1off lunch coupons. Consider (but don't try to quantify) what effects, if any, local advertising with $1 off lunch coupons might have had on revenue and costs for breakfast and dinner. Then, ignoring any possible effects on breakfast and dinner revenue and costs you identified, evaluate Mike's decision to spend more money on local advertising during 2015. Compare your evaluation with Pat's preliminary conclusion (5) about advertising costs. The basic question we are trying to answer is whether Mike's decision to increase advertising results in higher or lower profit for the Bozeman restaurant. Page 6 This question requires careful thought and some additional assumptions. Please make a sincere effort to formulate an answer, but if you find you are spending more than 2030 minutes on this question, feel free to stop and just right down a description of whatever partial answer you have been able to formulate. Following are some suggestions about how to structure your evaluation: a) Assuming that the fee paid to Parker Pancakes for national advertising was the standard 2% of actual revenue, how much did Mike spend on local advertising? How does this compare to the amount in the static budget prepared in December 2014? How does this compare to the amount in your flexible budget? b) Evaluate the effect of additional advertising spending on gross and net revenue from lunch. For this evaluation, you need the gross and net revenue that resulted from Mike's decision to increase local advertising. This is straightforward because we have the actual gross and net lunch revenue in Table B. However, you also need to know the gross and net lunch revenue that would have occurred if Mike had not increased local advertising. There are two main possibilities that should be considered here: First, you could assume that if Mike had not increased advertising, gross and net lunch revenue would have been equal to the budgeted amounts shown in Table B. However, a close inspection of the data suggests a second, alternative assumption. There is reason to believe that if Mike had not increased advertising, the number of lunches served might have fallen below the amounts used in constructing the static budget. Table A shows that the numbers of breakfasts and dinners served dropped below the budgeted numbers by an average of about 15%. Thus, a second, alternative assumption is that if Mike had not increased advertising, the number of lunches served would also have dropped by about 15% below the budgeted number and the average lunch check and average lunch discount would have been as budgeted. c) Evaluate the effect of Mike's advertising on the incremental costs of lunch. That is, calculate and compare the expected effect of Mike's decision to advertise more on the costs of serving lunch. Keep the following three things in mind: First, remember that the costs of serving lunch are related to the gross revenue, rather than the net revenue, and because you considered two alternative possibilities for what gross revenue would have been if Mike had not increased advertising, you will have to prepare two alternative evaluations of what cost would have been. Second, focus on the expected effect on costs if these costs had been the originally budgeted percentages rather than the actual percentages they turned out to be. For example, the expected cost of food was 40% of gross revenue, the expected cost of labor was 31%, and the expected cost of other operating expenses was 3.5%. Third, the costs budgeted as fixed are not changed by Mike's decision to advertise more, so these costs are not incremental with respect to Mike's decision and can be left out of your evaluation. Page 7 d) Combine Mike's incremental spending on advertising from part a with your evaluation of the incremental revenue from increased advertising in part b and your evaluation of the incremental cost in part c to form your evaluation of Mike's decision. (Because you are considering two alternative estimates of what lunch revenue would have been if Mike had not increased advertising, you will have two alternative evaluations of incremental revenue in part b and two corresponding evaluations of incremental cost.) Page 8