Cost Management: A Strategic Emphasis 5th Edition by David Stout, Edward Blocher, Gary Cokins

Exercise 56

Use of Payoff Tables (Appendix): Past experience indicates an 85 percent probability that a reported overhead cost variance is not due to a specific cause (i.e., is attributable to random fluctuations). Past experience also shows that the average cost to investigate the underlying cause of a variance is $750 and that the cost to correct an out-of-control process is, on average, $3,000. If the underlying variance is systematic and management decides not to investigate the cause of the variance, the costs are thought to be significant: $25,000.

Required Set up an Excel spreadsheet to answer the following questions:

1. Given the preceding information, what is the expected value of investigating the reported variance?

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2. Prepare a payoff table that summarizes the above information. (Hint: Your table should include cells for combinations of management actions (investigate vs. do not investigate) and states of nature (systematic cause vs. random event), plus cells to represent the expected cost of each management action.

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3. Given the above information, what is the probability level, p, for nonrandom variance that makes management indifferent between the two courses of action: investigate versus do not investigate? (Hint: You can use the formula in the text to calculate p. You could also use the “goal-seek” function from the Tools menu in Excel to calculate this number.)

Step 1 of 2

Budget is a statement prepared by the management of the business entity which helps them to estimate the expenses, income, receipts, payment, sales and purchases during the period. It is prepared keeping in mind the companies objectives and abilities with respect to resources they have. Often businesses deviate from their budgeted figures either in favourable way or unfavourable way. Such deviations are commonly referred to as variances.