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 13 of the text.)
a. Compute variances based on the difference between the actual 2016 results in Exhibit 2 and the static budget amounts in Exhibit 1. These variances are referred to as static budget variances.
b. Explain how Pat’s preliminary conclusions relate to the static budget variances. Also, discuss the limitations of using the static budget variances to draw conclusions about Mike’s performance for 2016.

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. The way a cost in the budget “flexes” depends on the behavior of the cost. For example, when the actual level of output is 90% of the planned level, a flexible budget variable cost will be 90% of the corresponding static budget variable cost and a flexible budget fixed cost will be the same as (100% of) the static budget fixed cost. The level of output for Parker Pancakes is measured as dollars of sales. Therefore, the static budget is based on the original planned sales volume shown in Table A while your flexible budget will be based on the actual sales volume, also shown in Table A.
Just as the actual sales volume can differ from the original static budget sales volume, selling prices of output and costs of inputs can differ from the original static budget. 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 prepare the flexible budget using actual selling prices but the planned cost for inputs. More specifically,
a) For selling prices, use the actual gross meal prices less the actual discounts to arrive at the flexible budget net revenue. Using this approach, your flexible budget revenue numbers will be the same as the actual revenue numbers shown in the right-hand column of Table C.
b) For input costs, base your flexible budget on the actual volume of output but the planned input cost. That is, use the actual gross revenue and the planned costs of inputs. As examples:
(i) assume that food costs will be 40% of actual gross revenue
(ii) assume that the variable component of labor costs will be 31% of gross revenue (do not include the 2.5% effect of the new payroll tax in your flexible budget for labor because the payroll tax was not a planned cost - to be discussed further in class)
(iii) assume that local advertising will be 1% of gross revenue

3. Use your flexible budget to compute the sales-activity variance (difference between the static budget and the flexible budget) and the flexible-budget variance (difference between the flexible budget and actual results) 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 efficiency variances. (Note that these efficiency variances are sometimes instead referred to as quantity variances because they reflect the difference between the flexible budget quantity and the actual quantity used.)
To make the input quantities for labor more clear, assume that the cost of variable labor used in preparing the static and flexible budgets is $10 per hour while the actual cost of variable labor (after the 2.5% payroll tax increase) is $10.25, and then use the combination of the cost per hour and the total expenditure to compute the number of hours.
In this case, food consists of an unspecified mix of food (bread, eggs, milk, flour, bacon, hamburger, etc.). We don’t have information about prices of individual items but we know that on average actual food prices are 4% lower than budgeted. This makes the calculation of price and efficiency variances for food a bit more abstract. To better visualize the calculation of price and quantity variances for food, you may find it helpful to think of the unspecified mix of food as consisting of “food units” with a planned cost of $1 per food unit and an actual cost 4% lower at $.96 per food unit. The flexible budget is prepared under the assumption that the budgeted quantity of food units required is a function of the gross revenue of food sold. The actual quantity of food units used may be either higher or lower than budgeted (resulting in the efficiency variance, the planned price of $1 per food unit multiplied by the difference between the flexible budgeted quantity of food units and the actual quantity of food units used). We know that the actual cost per food unit was 4% lower than budgeted (resulting in the price variance), so the price variance can be visualized as $.04 per food unit multiplied by the actual quantity of food units.

5. Evaluate the effect on 2016 profit of the decision by Mike Dukatz to increase spending on local advertising that includes $1-off lunch coupons. Ignore any possible effects on breakfast and dinner revenue and costs, and focus on the effect of local advertising on lunch revenues and costs. 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 resulted 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 write 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 2015? How does this compare to the amount in your flexible budget?
b) Evaluate the incremental effect of additional advertising spending on gross and net revenue from lunch. For this evaluation, you need the actual gross and net revenue that resulted from Mike’s decision to increase local advertising, which we have 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. Consider two alternative assumptions about what lunch revenue would have been:
The first, and simplest, assumption is that if Mike had not increased advertising, gross and net lunch revenue would have been equal to the budgeted amounts shown in Table B. The second, alternative, assumption is suggested by a close inspection of the data. Table A shows that the numbers of breakfasts and dinners served dropped below the budgeted numbers by an average of about 15%. Thus, an 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.
Calculate the incremental effect of advertising on lunch revenue under each of the two alternative assumptions.
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 flexible budgeted costs of serving lunch are related to the gross revenue and, because you considered two alternative assumptions for what gross revenue would have been if Mike had not increased advertising, you will prepare two alternative evaluations of the incremental cost of lunch due to increased advertising.
Second, use the originally budgeted percentages rather than the actual percentages to find the expected incremental costs. 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, remember that 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.
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. (Remember, 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 in part c.)

6. Discuss (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.

Pat Leizinger owns a number of restaurants throughout the western United States that are part of the Parker Pancakes chain. In December 2015, Pat met with Mike Dukatz, the manager of his Bozeman, Montana restaurant, to develop the 2016 budget shown in the right column of Exhibit 1. Exhibit 2 shows the corresponding actual results for 2016. 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 (wait staff, busboys, assistant cooks) that depends directly on sales volume. 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 2016, the index showed that food costs for the local area during 2016 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. These coupons create a difference between the gross revenue (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), as 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 new payroll tax on expenditures for labor was not anticipated and is not included in the static budget in Exhibit 1. However, this increase is included in the total actual labor expenditures in Exhibit 2, which includes a fixed cost component of $178,350, i.e., the budgeted amount of $174,000 plus the additional 2.5% payroll tax, or $4,350. The remainder of total actual labor expenditures is due to variable cost components.

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 52-week year.

Pat’s preliminary conclusions
Pat has reviewed Tables A-C and compared the results in Exhibits 1 and 2. He is now preparing to meet with Mike to discuss the following preliminary conclusions about the results for 2016:
1) Profitability is lower than it should be, 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 2016. 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 believes 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.

1. In this case, we have the Exhibit 1 budget based on an original...