218 Understanding the Numbers enter a budgeted number in the ledgers in anticipation of an actual number. For instance, city governments will enter budgeted revenues as a debit on the left side of the ledger account. Then when the sales are actually made, they will enter the actual revenues as a credit on the right column of the ledger account. The effect is that at the end of the year, only variances are left in accounts. For instance, sales greater than expected would leave a credit variance.” Standard Variable Costs “The second exception involves so-called standard cost systems. In a typical implementation, the standard cost of a product, not the actual cost incurred, is entered into the work-in-process account. The difference between the stan- dard cost and the actual cost creates a variance—in the actual accounts. For example, in the case of paper used, the inventory account would be charged with the standard $4.00 for every ream used but only $3.50 would be paid to the supplier. The difference of $0.50 would be shown in a separate variance account in the books of the company. “The existence of a credit variance in the accounts indicates that the bud- geted unit cost exceeds the actual unit cost, that is, there is a favorable vari- ance. Were the variance a debit, it would be unfavorable. “By the end of the job, after they have produced 1,200 reams, they will show in their accounts a variance of $0.50 per ream on all their variable costs times 1,200 reams, or a credit of $600. This is the same favorable $600 variance that we saw in Exhibit 7.4 when we subtracted the actual cost from the flexible budget. Standard cost systems, in other words, track the flexible budget. “Each of these variances is identical to the variances computed above; each can be stated in percentage terms to indicate their relative size, that is, material costs are down 12.5%, labor costs are even, and variable overhead costs are down 16.67%. The key point to realize is that variances generated by a standard cost system are identical to those generated by a budgetary control system—once one removes the volume effect.” Standard Fixed Costs “The parallels between standard cost systems and budgetary control systems do not extend to fixed costs, unfortunately. The reason lies in the way fixed costs are applied to products. In a standard cost system, a fixed overhead rate is established at the start of a period by dividing the budgeted fixed overhead by the budgeted volume. In our case, the predetermined fixed overhead rate was $4,000 divided by 1,000 reams, which equals $4.00 per ream. The pre- determined fixed overhead rate is therefore based on the static budget. “Fixed overhead is then applied to goods as they are produced by multi- plying the number of reams produced by this overhead rate. In this case, one charges $4.00 of fixed overhead to each of the 1,200 reams produced. The re- sult is $4,800, which is known as the applied overhead. The problem is that this Measuring Productivity 219 is neither actual nor budgeted. It is really a miscomputed number. If the num- ber of actual reams had been known in advance, one should have divided the $4,000 by 1,200 reams, giving $3.33 per ream. In other words, one should have used the flexible budget. Using that rate would have led to the application of $4,000 of fixed overhead exactly. The difference between the budgeted amount of $4,000 and the amount actually applied, namely $800, is said to have been over-applied—one might say over-applied in error. A correcting entry is typically made in the accounting system to fix this error. “The accounts of the company record that it actually had fixed overhead costs of $4,680 and applied overhead of $4,800. This generates a credit vari- ance of $120 in the accounts. Regardless of what appears in the accounts, the spending variance that should be reported is an unfavorable $680—not a favor- able $120. No matter the confusions in the ledger, the only variance that one is interested in is: “The difference between the variance produced by a standard cost system and the variance wanted for budgetary control purposes is: “In short, the error in the fixed overhead variance appearing in a standard cost system is due to volume changing from 1,000 units to 1,200 units. The result is a variance in the standard cost system that is useless for control purposes. “The budgeted overhead will be equal to the applied overhead only when the actual volume equals the budgeted volume, which rarely happens. More commonly, a fixed cost variance is found in the ledger, but this is of no interest for budgetary control. For control purposes, you should compute the spending variance directly and simply ignore the net overhead variance derived in the books.” “Now I see why you ignored the fixed overhead when doing the variances originally,” said Tom. “Let’s hope that my management understands this as well as you seem to do!” BUDGETARY CONTROL REVISITED “Budgetary control, as we noted at the outset,” Jane continued, “consists of comparing actual results with budget estimates. When doing this one is advised to distinguish between revenues and costs that vary with volume and those that are fixed with respect to volume changes. A revised budget, adjusted for the actual volumes rather than the predicted volumes, yields a flexible budget as opposed to the original or static budget. Budgeted Overhead Applied Overhead−=− =× −× =× $, $, ($ , ) ($ , ) $ 4 000 4 800 4 1 000 4 1 200 4 200 Applied Overhead Budgeted Overhead−=−$, $,4 680 4 000 220 Understanding the Numbers “Since the static and the flexible budgets for fixed costs are identical, the fixed-cost spending variance is simply the difference between the actual and the original budget. The spending index for fixed costs is their quotient. “In the case of variable costs and revenues, a few simple rules emerge. The ratio between the flexible and the static budgets indicates the difference in the quantities expected and the quantities actually experienced. The ratio between the actual results and the flexible budget indicates the change in costs or revenues that can be attributed to changes in unit costs or selling prices. “In the case of multiple outputs or multiple inputs, the quantity indices can be further refined. They break into at least two indices. The first reveals the effect of changing mixes of either outputs or inputs. The second reveals the effect of changing the overall volume. The mix variance may be computed directly or simply by dividing the quantity index by the volume index. In the case of variable costs, it is usually possible to draw out another index indicating the total yield, that is, the amount of input required to produce a given amount of output. “All these indices can be computed using an accounting system that col- lects only actual costs and comparing these in a spreadsheet with the budgeted costs. Alternatively, they may be derived by keeping a standard cost system. The variances that emerge as one enters standard costs into work-in-process and credits the corresponding asset or liability account at actual are identical to those derived from a flexible budgeting control system. The one exception to this identity is fixed costs, but the difference here is easily reconciled. “In short, budgetary control analysis provides one vehicle for controlling a business. The budget reflects, ideally, a company’s strategies and objectives. As actual results emerge they are compared with the budget to see to what ex- tent the enterprise has met its goals and productivity targets. Any difference encountered can be decomposed to determine whether it was due to a change in usage or a change in price. Where inputs or outputs are substitutable, one can also examine the changing mix for further insight into how one achieved one’s goals. “In each case, the index derived is neither good nor bad. It simply indi- cates a change. As noted earlier, the same rise in sales may be a matter for con- gratulation when markets are declining and a matter for concern when markets are expanding faster than one’s sales. All that the index does is to point one to where still more information must be gathered.” FOR FURTHER READING Anthony, Robert N., David F. Hawkins, and Kenneth A. Merchant, Accounting: Text and Cases, 10th ed. (New York: Irwin/McGraw-Hill, 1999), esp. chs. 19 and 20. Davidson, Sidney, and Roman L. Weil, Handbook of Cost Accounting (New York: McGraw-Hill, 1978), esp. chs. 15 and 16. Measuring Productivity 221 Ferris, Kenneth R., and J. Leslie Livingstone, eds., Management Planning and Control: The Behavioral Foundations (Columbus, OH: Century VII, 1989), esp. chs. 3, 8, and 9. Horngren, Charles T., Gary L. Sundem, and William O. Stratton, Introduction to Management Accounting, 11th ed. (Englewood Cliffs, NJ: Prentice-Hall, 1999), esp. chs. 7 and 8. Kaplan, Robert S., and Anthony A. Atkinson, Advanced Management Accounting, 3rd ed. (Englewood Cliffs, NJ: Prentice-Hall, 1998), esp. chs. 9 and 10. Maher, Michael W., Clyde Stickney, Roman L. Weil, and Sidney Davidson, Manager- ial Accounting (Fort Worth, TX: Harcourt College Publishers, 1999), esp. chs. 10 and 11. Shank, J.K., and N.C. Churchill, “Variance Analysis: A Management-Oriented Ap- proach,” The Accounting Review, 52 (Oct. 1977): 950–957. Welsch, Glenn A., Ronald W. Hilton, and Paul N. Gordon, Budgeting: Profit Planning and Control, 5th ed. (Englewood Cliffs, NJ: Prentice-Hall, 1988), esp. ch. 16. INTERNET LINKS Internet links and Web sites have an uncomfortable way of disappearing. The reader is advised, therefore, to do her or his own search under key words such as “variance analysis” and “standard costing.” This will turn up sites such as Conoco’s and Corn Products International’s discussions of their results at www.conoco.com and www.cornproducts.com. Both make excellent use of variance analysis. The U.S. Army Cost and Economic Analysis Center at www.ceac.army.mil/web/default.html provides a good discussion of standards, while the Association of Accounting Technicians, at www.aat.co.uk, provides an excellent forum for questions and answers on this and many other accounting topics. The Institute of Management Accountants maintains a site at www .imanet.org that provides all kinds of managerial accounting resources. Finally, the reader is invited to visit my own site, at www.smu.edu/∼mvanbred, with its many links and notes on both financial and managerial accounting. NOTES 1. R. Kaplan and D. Norton, “The Balanced Scorecard—Measures That Drive Performance,” Harvard Business Review, 70 (Jan.–Feb. 1992): 71–79. 2. National Association of Accountants, Standard Costs and Variance Analysis (New York: NAA, 1974): 9. 3. Whyte, W.F., ed., Money and Motivation: An Analysis of Incentives in Indus- try (New York: Harper & Row, 1955). 4. Cooper, Robin, and Robert S. Kaplan, “How Cost Accounting Distorts Prod- uct Costs,” Management Accounting, 69 (Apr. 1988): 20–27. PART TWO PLANNING AND FORECASTING 225 8 CHOOSING A BUSINESS FORM Richard P. Mandel THE CONSULTING FIRM Jennifer, Jean, and George had earned their graduate business degrees to- gether and had paid their dues in middle management positions in various large corporations. Despite their different employers, the three had maintained their friendship and were now ready to realize their dream of starting a con- sulting practice. Their projections showed modest consulting revenue in the short term offset by expenditures for supplies, a secretary, a small library, per- sonal computers, and similar necessities. Although each expected to clear no more than perhaps $25,000 for his or her efforts in their first year in business, they shared high hopes for future growth and success. Besides, it would be a great pleasure to run their own company and have sole charge of their respec- tive fates. THE SOFTWARE ENTREPRENEUR At approximately the same time that Jennifer, Jean, and George were hatching their plans for entrepreneurial independence, Phil was cashing a seven-figure check for his share of the proceeds from the sale of the computer software firm he had founded seven years ago with four of his friends. Rather than rest on his laurels, however, Phil saw this as an opportunity to capitalize on a com- plex piece of software he had developed in college. Although Phil was con- vinced that there would be an extensive market for his software, there was 226 Planning and Forecasting much work to be done before it could be brought to market. The software had to be converted from a mainframe operating system to the various popular mi- crocomputer systems. In addition, there was much marketing to be done prior to its release. Phil anticipated that he would probably spend over $300,000 on programmers and salespeople before the first dollar of royalties would appear. But he was prepared to make that investment himself, in anticipation of retain- ing all the eventual profit. THE HOTEL VENTURE Bruce and Erika were not nearly as interested in high technology. Directly fol- lowing their graduation from business school, they were planning to construct and operate a resort hotel near a popular ski area. They had chosen as their location a beautiful parcel of land in Colorado owned by their third partner, Michael. Rich in ideas and enthusiasm, the three lacked funds. They were cer- tain, however, that they could attract investors to their enterprise. The loca- tion, they were sure, would virtually sell itself. THE PURPOSE OF THIS CHAPTER Each of these three groups of entrepreneurs would soon be faced with what might well be the most important decision of the initial years of their busi- nesses: which of the various legal business forms to choose for the operation of their enterprises. It is the purpose of this chapter to describe, compare, and contrast the most popular of these forms in the hope that the reader will then be able to make such choices intelligently and effectively. After discussing the various business forms, we will revisit our entrepreneurs and analyze their choices. BUSINESS FORMS Two of the most popular business forms could be described as the default forms because the law will deem a business to be operating under one of these forms unless it makes an affirmative choice otherwise. The first of these forms is the sole proprietorship. Unless he or she has actively chosen another form, the individual operating his or her own business is considered to be a sole pro- prietor. Two or more persons operating a business together are considered a partnership (or general partnership), unless they have elected otherwise. Both of these forms share the characteristic that for all intents and purposes they are not entities separate from their owners. Every act taken or obligation as- sumed as a sole proprietorship or partnership is an act taken or obligation as- sumed by the business owners as individuals. Choosing a Business Form 227 Many of the rules applicable to the operation of partnerships are set forth in the Uniform Partnership Act, which has been adopted in one form or another by 49 states. That Act defines a partnership as “an association of two or more persons to carry on as co-owners a business for profit.” Notice that the defini- tion does not require that the individuals agree to be partners. Although most partnerships can point to an agreement between the partners (whether written or oral), the Act applies the rules of partnership to any group of two or more persons whose actions fulfill the definition. Thus, the U.S. Circuit Court of Ap- peals for the District of Columbia, in a rather extreme case, held, over the de- fendant’s strenuous objections, that she was a partner in her husband’s burglary “business” (for which she kept the books and upon whose proceeds she lived), even though she denied knowing what her husband was doing at nights. As a re- sult of this status, she was held personally liable for damages to the wife of a burglary victim her husband had murdered during a botched theft. In contrast, a corporation is a legal entity separate from the legal identities of its owners, the shareholders. In the words James Thurber used to describe a unicorn, the corporation “is a mythical beast,” created by the state at the request of one or more business promoters upon the filing of a form and the payment of the requisite, modest fee. Thereupon, in the eyes of the law, the corpora- tion becomes for most purposes a “person” with its own federal identification number! Of course, one cannot see, hear, or touch a corporation, so it must in- teract with the rest of the world through its agents, the corporation’s officers and employees. Corporations come in different varieties. The so-called professional cor- poration is available in most states for persons conducting professional prac- tices, such as doctors, lawyers, architects, psychiatric social workers, and the like. A subchapter S corporation is a corporation that is the same as a regular business corporation in all respects other than taxation. These variations are discussed later. A fourth common form of business organization is the limited partner- ship, which may best be described as a hybrid of the corporation and the gen- eral partnership. The limited partnership consists of one or more general partners—who manage the business much in the same way as do the partners in a general partnership—and one or more limited partners, who are essen- tially silent investors with no control over business operations. Like the general partnership, limited partnerships are governed in part by a statute, the Uni- form Limited Partnership Act (or its successor, the Revised Uniform Limited Partnership Act), which has also been adopted in one form or another by 49 states. The limited liability company (LLC), is now available to entrepreneurs in all 50 states. The LLC is a separate legal entity owned by “members” who may, but need not, appoint one or more “managers” (who may but need not be mem- bers) to operate the business. A few states require that there be more than one member, but the trend is toward allowing single-member LLCs. An LLC is formed by filing an application with the state government and paying the . the partners in a general partnership—and one or more limited partners, who are essen- tially silent investors with no control over business operations. Like the general partnership, limited partnerships. is the limited partner- ship, which may best be described as a hybrid of the corporation and the gen- eral partnership. The limited partnership consists of one or more general partners—who manage. the individuals agree to be partners. Although most partnerships can point to an agreement between the partners (whether written or oral), the Act applies the rules of partnership to any group of