Notes & videos
[pdf-embedder url=”https://rcmonlinecollege.co.ke/wp-content/uploads/2025/06/Topic-10-Standard-costing-and-variances-1.pdf”]
JANUARY APRIL 2024
PREVIOUS SEMESTERS
PREVIOUS SEMESTERS
https://vimeo.com/813282735/c0ec566450?share=copy
https://vimeo.com/769782963/dd70dd33d5?share=copy
STANDARD COSTING AND VARIANCES
Standard cost is a yardstick that measures how well the organization has achieved its set objectives.
Standard costing is mainly applicable in the manufacturing industry. It is the basis on which variance analysis is done. All planned productions are based on specific standards
This lesson describes how a standard cost is arrived at and the various types of standard costs and the application of standard costing in budgeting. The critical part of the chapter is variance analysis, the real life application of standard costing in budgeting and cost control. The behavioral implications of standard costs emanating from them are also briefly outlined.
Tutorial note:
It is especially critical that you establish a link between standard costs and budgets. At this point, you need to put it in your mind that standard costs are the “building blocks and cement” used to “build” a budget. There are other ways of establishing a budget other than using the standard costs, but the use of standard costs makes budgeting very easy and realistic!
To effectively control the costs of a certain organization, we need a yardstick to measure the actual performance against. Traditionally, most organizations are known to use the previous period costs as the yardstick. But due to the fast changing business environment that businesses operate in today, managers always find that the previous period’s performance is not an appropriate yardstick to measure the next and future periods’ performance against. This is why most organizations develop standard costs.
Standard cost is, therefore, a yardstick that measures how well the organization has achieved its set objectives. This simple definition standard cost shows that a standard cost is developed simply for performance evaluation and cost control purposes. A standard cost has, therefore, to be developed in advance before the actual performance to be measured begins. For this reason, a standard cost is a predetermined costs based on certain assumptions. One has to appreciate the fact that a standard cost is a mere estimate of expected costs under certain conditions.
From the above discussion, a standard cost clearly comes out as a cost set before the actual costs are actually incurred. Some scholars, therefore,· refer to it as the “cost level that should be” under attainable, acceptable performance conditions. Others refer to standard costs as carefully predetermined costs of production used as a basis for measurement and comparison. It is one of the most important techniques used in management accounting. It basically tries to establish a predetermined cost for products or services with which actual costs will be composed to establish whether there are any variances. The predetermined cost is an estimated unit cost built up of standards for each cost element ( standard resource price and standard usage )
Standard costs establish the minimum desirable costs. When actual costs incurred exceed or are below the standard costs, we then investigate the variances with an objective to take appropriate corrective measures. Standard costing, on the other hand, is defined as the process of establishing predetermined estimates of the costs of products and services and comparing this with the actual cost when they are incurred. Thus, it is an exercise that determines the expected cost levels under certain conditions (standard costs), then applies the standard costs to the actual performance (performance analysis) so as to determine the difference (variance).
This difference can be good (favorable) or bad (unfavorable) depending on whether it is more or less than the standard; it is the basis of taking corrective action (Control). The variance needs to be further analyzed to determine how it came about. This is referred to as variance analysis and it is important
Process of Setting Standards
because it pinpoints the exact causes of favorable (F) or unfavorable (U) deviation. Such causes can be corrected so as to achieve the desired performance.
Establishing a correct standard is very important because accuracy of the standards usually determine the success of the standard cost system. It is more of an art than a science which requires combined thinking and expertise of all the persons who have responsibility over prices and quantities of input.
As we will see later, the standard cost system has very serious behavioral implications for the staff whose performance will be measured against the standards. If the staff feel that the standards are too high, (unachievable), they will be frustrated and will be greatly demotivated. Also, if a disciplinary action is taken on an employee who fails to achieve the standards, but the employees feel that it is unfair as the standard was inaccurate, this will bring about resentment, sabotage and demotivation to the employees. On the other hand, if the standards are too low, they will be easily achieved by employees and they will not be challenged to work harder.
In determining standard cost, each cost should be carefully analyzed to ensure all factors affecting the cost level (in the period the costs are to be used) have been considered. In addition, managers in charge of the departments responsible for meeting the standards should approve the bases for the standards.
For the standard setting process and standards implementation to be successful, the employees responsible for meeting the standards should have the opportunity to participate in the Standard Setting Process. They are the best positioned in pinpointing inaccuracies in the set standards. It is easier to enforce standards once their acceptance is solicited through participation in the setting process.
The manager overseeing the setting of standards should also have an honest desire to set achievable ii. Setting standards for direct labor
targets, and also to assist their lower managers and employees to achieve them. Also, standards should only be set after there has been interaction between all the individuals involved.
Last, and very important, the top management must fully support the standard costing process from Standards Setting to standards implementation. This support gives the standards the enforcement they need to be effected in the whole organization.
These are based on product specifications derived from an intensive study of the input quantity necessary for each operation the. The material content of the product: raw material, sub assemblies, piece parts, finishing materials, e.t.c. constitute the material quantity standards that are usually recorded on a bill of materials.
The intensive study should establish most suitable material for each product and also the optimal quantity that should be used after allowing for inevitable wastage or loss. The study is important as savings and alternative materials and ways of using materials are usually discovered.
When it comes to standard price, the onus is on the purchasing department. They estimate direct material cost per unit on the knowledge of the following
a) Purchasing contracts already agreed
b) Pricing discussions with regular suppliers
c) Forecast movement of prices in the market
d) Availability of bulk purchase discounts
e) Quality of material required
f) Carriage and packaging charges
The cost ought to include allowance for bulk discounts and it could be weighted average if different suppliers are used.
To set labor standards, a time motion study has to be performed for an activity. This is in a bid to establish, at efficiency level, how many labor hours will be needed to complete an activity having removed all the unnecessary elements. Standard hour: amount of work achievable at standard efficiency levels in an hour or minute. Unavoidable delays such as machine breakdowns and routine maintenance are included in the standard time.
The standard wage rate will be set by reference to the payroll and to any agreements on pay rises with trade union representatives of the employees.
STANDARD HOURS PRODUCED EXPLAINED
The learning effect must be incorporated in setting the standard times. Learning effect is the increase in efficiency with time of a worker in handling a specific task. For instance, a football player will not perform as good on the first day as he will three months after exercising.
It is not possible to measure output in terms of units produced for a department making several different products or operations.
If a department produces 100 units of X, 200 of Y and 300 if Z, it is not possible to add their production since they aren’t homogeneous.
What would solve this is the use of standard hours that can act as a common denominator for adding together the production of unlike items.
That is, assume that the unit standard times are as follows
X – 5std hours
Y – 2std hours
Z – 3std hours
The production for the department will be calculated in standard hours as follows.
STD hrs/unit Actual output STD hrs produced
X 5 100 500
Y 2 200 400
Z 3 300 900
1800
From the illustration, we expect the output of 1800 standard hours to take 1800 direct labor hours of input if the department works at the present level of efficiency.
iii. Setting standards for overheads
In setting standard overhead costs we apply what we have learnt in our earlier chapter (in absorption costing). The predetermined overhead absorption rates become the standards for overheads for each cost center using the budgeted standard labor hours as the activity base or planned production volume.
Production volume will depend on two factors:
– production capacity (or volume capacity) measured in standard hours of output which in turn reflects direct production labor hours
Efficiency of costing by labor or machines, allowing for rest times and contingency allowances
Separate rates for fixed and variable overheads are essential.
Standard variable OAR = Budgeted Variable Overheads for cost center
Budgeted Standard labour hours for cost center
Standard variable OAR = Budgeted Fixed Overheads for cost center
Budgeted Standard labour hours for cost center
N.B: The level of activity adopted will be assumed as 100% capacity and for control purposes and will be the base for the master budget.
A department has a workforce of 20 men working a 30-hour week making standard units. Each unit has a standard time of 2 hours to make. The expected efficiency of the workforce is 125%.
a. Budgeted capacity of indirect labor hours = 20*30= 600 production hours per week
b. Budgeted efficiency is 125%, so that the workforce would take only 1 hour of actual production time to produce 1.25 standard hours of output
c. This means that budgeted output is 600*1.25=750 standard hours with each requiring 2 standard hours, the production activity or volume of 375 units per week.
Setting of product selling price is a top-level decision that is based on factors such as:
• anticipated market demand
• manufacturing costs • competing
products • inflation estimates.
After much discussions and deliberation, a price for the product is set; this is the standard selling price. The standard sales margin is the difference between the standard cost and the standard selling price.
A standard cost is a predetermined calculation of how much is expected to be incurred under certain specified working conditions. It is a benchmark for measuring performance. In managerial and cost accounting, standards relate to the quantity and cost of inputs used in manufacturing goods and services. Quantity standards say how much of a specific input should be used in manufacturing a unit of product or in providing a unit of service. Cost standards say what the cost of the input should be.
It is not an average of past costs since these may contain mistakes of past inefficiencies and may not incorporate changes in the business’ operating environment e.g. technological changes.
Standard costs are developed from a scientific study of the various production cost elements involved in producing a certain good or service (These are usually specified in a product’s technical specifications). To develop these costs, one needs to have a good idea or reliable estimate of the materials, labour and other cost levels that will apply during a specified period.
Standard costs give a basis of cost control through variance analysis. It is one of the leases. It is also the basis of budgeting. Standard costs are also applied in setting prices, valuing closing stocks and performance evaluation
Standard costing systems provide cost information for various uses. These include:
(i) Setting of budgets
Standard costing systems assist in setting budgets and evaluating performance of the managers. Standard costs are of particular importance for budgeting as they provide reliable and convenient source of data to be used in the budgeting process. This, thus, reduces the budgetary time because for instance, once the desired output units is known, then the budgeted cost is simply derived by multiplying the budgeted cost per unit and the desired output in units.
(ii) Act as control devices and simplifies performance evaluation
Standard costing systems act as control devices by highlighting those costs or items that do not conform to the budget or plan and thus alerts managers to those situations that need corrective action. It acts as a yardstick against which costs and other items are measured to determine whether the variance is favorable or unfavorable.
Once the budgets are prepared and agreed upon, the employees’ performance can be acceptably measured against the set standards to determine whether the performance is acceptable or not. Appropriate corrective measures can then be taken by the management.
(iii) Profit measurement and inventory valuation
Standard costing makes inventory valuation much easier as it simplifies the task of tracing costs to products for inventory valuation and profit measurement purposes. If the actual number of physical units in inventory is known then the value of inventory is simply obtained by multiplying the standard cost per unit by the physical units. This is because, profit measurement may be time consuming thus making it cumbersome to allocate costs as per the period incurred. Variances are calculated later and written off in the books of account as period costs. This enables the reflection of inventory at actual cost while at the same time determining the correct profit figure.
(iv) Decision making
Standard costing provides a prediction of the future costs that can be used for decisionmaking purposes. Standard costs are preferable to estimates based on adjusted past costs because the later may incorporate avoidable inefficiencies.
(v) Management by exception
Standard costing is an example of management exception. By studying the variances, management’s attention is directed towards those items that are not proceeding as per the plan. Most of management’s time is saved and can be directed to other value adding activities. Management only concentrates on the few exceptions reported.
(vi) Motivation
A standard costing system provides a challenging target that individuals are motivated to strive and achieve. Involving the management and employees at all levels of operation in the setting of standards makes them feel as part of the system thus working to meet the standards that they set for themselves.
(vii) Pricing
Standard costs act as a reliable base of calculating total cost of producing a good or service to which a margin can be added to determine the selling price. (Cost plus markup method of price determination)
(viii) Cost reduction
The process of setting, revising and monitoring standards encourages reappraisal of methods materials and techniques thus leading to cost reductions. Analysis of variance (Anova) directs cost analysis to factors that are causing unfavorable variances and thus costs can be controlled, leading to cost reduction.
This is a card record of the Standard or expected costs in producing a given output. It gives the physical quantities of inputs as well as their monetary values. It also gives the quality required, e.g.
Grade A labour. The process of setting standards results in the establishment of the standard cost for the product. The make up of the standard cost is recorded on a standard cost card.
SK’s ltd. produces a product B which consumes 2 types of materials, A56 and C91, and passes through 3 departments X, Y and Z. The following information relates to the product B and its production process;
Materials: A56: 5 kg each @ Shs.7.4: it is applied in department A
C91: 500 units @ Shs.7.50 per 100 units: It is applied in department B.
Labour for the period just ended:
4.8 hours @ Shs.2.5/hr in Department A
9.2 hours @ Shs.2.5/hr in Department B.
16.4 hours @ Shs.1.75/hr in Department C.
Absorption of Production overheads:
Machine overheads: based on direct labour hours. They are incurred as Shs.11/hr in departments A and B.
Indirect labour: based on direct labour hours in Department C above at Shs.6/hr.
Required
SK’s Ltd
Standard cost card for product B
Revised : By: 31.12.20 XX
JKC
Cost type and Quantity Standard rate (Shs) Dept A (Shs) Dept B (Shs) Dept C (Shs) Total ( Shs )
Direct materials
5 kg of A56
Shs7.4
37.0 —
—
37.00
500 units of C91 Shs7.5 per 100 units — 37.5 — 37.50
74.50
Direct labour
Department A: 4.80 hrs
2.50
12 —
—
12.00
Department B: 9.20 hrs 2.50 — 23 — 23.00
Department C: 16.4 hrs 1.75 — — 28.70 28.70
63.70
Production overheads
Machining
11
52.80
101.20
—
154.00
Indirect labour 6 — — 98.40 _98.40
252.40
Standard cost Summary Shs
Direct materials 74.50
Direct Labour 63.70
Production overheads 252.40 Standard cost per unit 390.52
Prepare a standard cost card for product B.
Solution:
The process of standard costing involves setting standards for:
• Material costs.
• Direct labor.
• Sales price and margin.
Standard costing systems provide information for various uses. These include:
• Setting of budgets
• Acts as a control device and simplifies performance evaluation
• Facilitates profit measurement and inventory valuation • Aids in decision making, motivation, pricing and cost reduction
1. .
QUESTION ONE
a) Distinguish between practical standards and ideal standards (10 marks )
b) Explain how direct materials standards and labour standards are set (10 marks )
QUESTION TWO
(a) Enumerate the advantages and disadvantages of using standard costs (10 marks )
(b) Explain how a manager would determine whether a variance constituted an exception that would require his or her attention. (10 marks )
QUESTION THREE
(a) Explain the importance of a standard cost card. (10 marks )
(b) Distinguish between standard costing and budgetary control (10 marks)
Introduction
BSI was the first national standards-making body in the world. It was founded in London in 1901 and is the UK’s National Standards Body. Today it is part of the BSI Group with offices throughout the world. Businesses choose to conform to standards as they protect consumers, lead to new developments and bring benefits to industry. Businesses that apply standards are recognized as providers of quality and BSI works with a wide range of groups to decide on standards.
Research
Most new products are the result of research and the application of standards throughout the research process. Standards increase the effectiveness of many goods and services, help to lower costs and reduce the time it takes to develop a concept into a viable product. Each standard has a number and description, which shows if it is a British (BS), European (EN) or International (ISO) Standard. BSI identifies best practice and uses this to create standards that provide a framework for research. Standards even help with new technology. For example, BSI supports nanotechnology research. This involves making new products by controlling individual atoms. Development
BSI sets out guidelines for developers to follow which show best practice. By following best practice, businesses can become more effective, more efficient and able to make more profit. Standards provide a common framework for products that need to work together. For example, all CDs are the same size so they fit into CD players around the world. A team of experts discuss what factors are needed to make a product safe, reliable and of high quality. This panel creates a list of rules and tests that a product or process needs to meet. Even services have standards, for instance, the process for businesses to handle complaints from customers.
Testing
Testing is vital when bringing new products to the market. Products must be safe and fit for purpose meant. This means they must do what customers expect of them. A product with a Kitemark is BSI tested and businesses need a BSI license in order to use the Kitemark. Some standards are compulsory. For instance, fire extinguishers must meet health and safety regulations, – without this, they cannot legally be sold. The CE marking shows that a product meets the requirements of European laws. Some products, like toys, must carry this mark.
Production and launch
BSI helps companies from research and development through to product launch and marketing. During pre-production, trained assessors and inspectors check that processes and production comply with the standards before products are considered ‘fit for sale’. On launch, a BSI certificate gives customers confidence. Working to standards helps businesses because:
• It helps attract customers and encourages them to buy
• It demonstrates market leadership
• It creates competitive advantage
• It maintains best practice.
Conclusion
New products, processes and services are continually coming onto the market. Innovative product developers research and develop new ideas. However, they need a framework in which to work. BSI can support every stage of the process by creating standards, providing advice and supporting research.
VARIANCE ANALYSIS
A variance is factually a deviation from the expected.
Price/rate variance measures the difference between the actual price (AP) paid and the standard price (SP) that should have been paid.
Quantity/efficiency variance measures the difference between the actual quantity (materials or labour hours) used and the standard quantity that should have been used
Fast forward;
Variance analysis relies to a great extent on standard costing. Standard prices and quantities and actual prices and quantities must be known in order to calculate variances. Variance analysis is used as a control and evaluation tool.
This chapter covers variance analysis. In here we first discuss the various types of variances and how they are calculated. We go further to establish the causes of those variances.
General model for variance analysis
Actual Quantity (AQ) Actual Quantity (AQ) Standard Quantity (SQ) x x
x
Actual Price (AP) Standard Price (SP) Standard Price (SP)
Price Variance Quantity Variance
AQ (AP – SP) SP (AQ – SQ)
AQ = Actual quantity SP = Standard Price
AP = Actual Price SQ = Standard Quantity
Material Price variance Labour rate variance Material usage variance
Labour efficiency variance
Variable OH spending variance Variable OH efficiency variance
Note: Total variance = Price variance + Quantity variance
The diagram on the previous page shows the general relationship between variables that are used to compute the various variances. For instance, AQ will represent actual quantity of materials used when calculating material price variance, actual labour hours worked when calculating labour rate variance and actual units of the absorption base incurred.
Material variances
Material variances comprise both material price variance and material usage variance. Material price variance deals with the price paid for the materials while material usage variance deals with the quantity used in the production process. Thus material variance may arise if the quantity used in the production process differs from the budgeted or if the actual price paid for the materials is different from the standard.
Material price variance (MPV)
Material price variance measures the difference between the actual price (AP) paid for a given quantity of materials and the standard price (SP) that should have been paid for the same quantity of materials purchased (AQ). This variance arises in the purchasing department.
It can, therefore, be calculated as
Material Price variance = (Actual Price x Actual Quantity) – (Standard Price x Actual quantity)
MPV = (AP X AQ) – (SP x AQ)
MPV = (AP – SP) x AQ
The simplified formula above is the most widely used in calculating material price variance as it is simple.
When calculating variances, the sign obtained does not tell the nature of the variance, i.e. whether Favorable or Adverse. What matters is the interpretation. One needs to understand variance analysis to correctly interpret the results obtained. For instance, MPV may also be calculated as (SP – AP) x AQ. If one person uses the first formula and obtains a negative value and a second person uses the second formula and obtains a positive value, assuming same data, then the two will interpret the variances differently.
The following information relates to product XYZ for the period just ended.
▪ The standard direct material cost for a product is Shs.50 per unit (12·5 kg at Shs.4 per kg).
▪ The actual amount paid for 45,600 kg of material purchased and used was Shs.173,280 Required: Calculate the direct material price variance for the period just ended. Solution
month. Each unit is budgeted to use 2 kg of material. The standard cost of material is Shs2·50 per kg. Actual materials in the month cost Shs.68,000 for 13,500 units and 26,500 kg were purchased and used.
What was the adverse material price variance?
Solution
Material price variance = (Actual Price x Actual Quantity) – (Standard Price x Actual quantity)
= Shs.68,000 – Shs.2.50 x 26,500
= Shs.1,750 (Unfavorable)
Possible causes of material price variance
The variance is unfavorable since the price paid for the materials is above the standard price the company should have paid.
▪ Actual prices may change following a change in the market conditions that cause a general price increase or decrease for the type of materials used. Thus the company may end up paying more or less than the standard price.
▪ Inferior quality materials, which are less expensive, may be bought thus translating to a favorable material price variance. Buying of substitute materials due to unavailability of the planned ones may translate to favorable or unfavorable material price variance.
▪ A shortage in materials which calls for an urgent purchase at short notice may increase the purchase costs where the company may be required to airlift the materials or pay for other costs associated with that order. This will translate to unfavorable material price variance.
▪ Quantity discounts lost or gained by buying in smaller or larger quantities than planned also translate to a material price variance.
Material Usage Variance (MUV)
Material Usage Variance measures the difference between the Actual Quantity of materials used in production (AQ) and the standard quantity (SQ), which should have been used according to the standard set, all valued at the standard purchase price. This variance arises due to the production department using more or less than the expected or standard material input. However, there are instances where the purchasing department may be held responsible for the unfavorable material usage variance e.g. purchase of inferior goods. When calculating MUV, one uses the actual quantity used and not the actual quantity purchased. This is because there are instances where the actual quantity purchased is more than the actual quantity used thus leaving some materials in stock.
Material Usage variance is calculated as follows:
Material Usage Variance = Standard quantity x Standard Price – Actual Quantity x Standard
Price
= (SQ x SP) – (AQ x SP )
= (SQ – AQ) x SP
A company has a budgeted material cost of Shs.125,000 for the production of 25,000 units per month. Each unit is budgeted to use 2 kg of material. The standard cost of material is Shs2·50 per kg. Actual materials in the month cost Shs.136,000 for 27,000 units and 53,000 kg were purchased and used.
Required: calculate the material usage variance?
Solution
Standard cost = Budgeted material cost = Shs.125,000 = Shs.2.50 per kg
Budgeted material input 25,000 units x 2kg per unit
Actual quantity = 53,000 kg
Standard quantity = 27000 units x 2 kg per unit = 54,000
MUV = Actual Quantity x Standard Price – Standard quantity x Standard Price
= Shs2.5 x 53000 – Shs2.50 x 54,000
= Shs2,500 (Favorable )
= (AQ – SQ) x SP = (53,000 – 54,000) x Shs2.50 = 2,500 (F )
>>> Illustration IV (MUV )
The following information relates to product XYZ for the period just ended.
▪ The standard direct material cost for a product is Shs50 per unit (12·5 kg at Shs4 per kg).
▪ The actual amount paid for 45,600 kg of material purchased and used was Shs173,280
▪ The direct material usage variance was Shs15,200 (Unfavorable)
Required: Calculate the actual production for the period just ended.
Solution
Material Usage variance = (Actual Quantity x Standard price) – (Standard quantity x Standard
Price)
15200 = (45600 x Shs4.00) – (SQ x Shs 4.00)
Shs4.00 (SQ) = (45600 x Shs4.00) – Shs. 15,200
= Shs (182,400-15,200)
= Shs 167,200
SQ = Shs.167,200 = 41,800kg
Shs. 4 per unit
SQ = Actual output x Standard quantity per unit
Actual Output = SQ/Standard qty per unit
=
41,800kg = 3,344 units
Possible causes of material usage variance
12.5kg per unit
▪ Careless handling of materials by production personnel or working with untrained workers who are poorly supervised OR extremely high quality labour than expected.
▪ Inferior quality materials thus requiring more input than budgeted OR higher quality materials than budgeted that reduces the quantity of material input below the budgeted.
▪ Faulty or inefficient machinery OR efficient machinery
▪ Theft and pilferage
Total material variance
▪ Changes in methods of production and quality control, greater or lower rate of scrap than anticipated
Total material variance comprises of material price variance and material usage variance.
Material variance= Material Price variance + Material Usage variance
= [(AP x AQ) – (SP x AQ)] + [(AQ x SP) – (SQ x SP )]
= AP•AQ – SP•AQ +SP•AQ – SP•SQ
= AP•AQ -SP•SQ
Therefore, Material Variance shall be given by the difference between the actual quantity bought and used at actual cost less standard Quantity that should have been bought and used at standard
price. However, when the materials purchased are more than materials used, the summation of the MUV and MPV will not agree with the total material variance.
The total material variance for product XYZ (Illustrations I and IV) is equal to
MV = MPV + MUV
= 9120 (F) + 15,200 (A ) = 6,080 (A )
= AP•AQ -SP•SQ
= Shs.173,280 – (Shs.4 x 3,344 units x 12.5 kg per unit )
= Shs.6,080 (A )
The total labour variance comprises of labour rate variance and labour efficiency variance. Labour rate variance occurs when there is a difference between the price (wages) paid out and the standard wages, which should have been paid. It measures the deviation, if any, from the standard of the average wages paid to direct labour hours. Labour efficiency occurs when there is a difference between the actual number of hours taken and the standard hours that would have been taken to complete and assignment. It measures the productivity of labour time.
Labour Rate Variance (LRV)
Labour rate variance measures the deviation from the standard of the average wages paid to direct labour hours. It is calculated by comparing the standard price per hour with the actual price paid per hour and multiplying the difference with actual hours taken.
In many organizations, LRV tends to be nonexistent since most of the rates paid to workers are set by union contracts. This means that the actual wage rate paid equals the standard wage rate paid. However, there are instances in which wage rate variance may arise. This, in most cases, depends on the way labour is used. For instance, highly skilled workers are more expensive to hire and if it demands that they be hired to take up an assignment, which was initially to be taken up by semiskilled workers, then the wage rate paid to them shall be higher than the standard set initially. This will automatically translate to an adverse labour rate variance. The officers in charge of effective utilization of labour time are held responsible in ensuring that labor rate variances are kept under control.
Labor rate variance is calculated using the following formula;
Labor rate variance = Actual rate x Actual hours – Standard rate x Actual hours
= AR•AH – SR•AH
= (AR – SR) x AH
The following information relates to labour costs for the period just ended: Budget Labour rate Shs.100 per hour
Actual Wages paid Shs.1,760,000
Production 5 ,500 units Total hours worked 14 ,000 hours There was no idle time.
Required: Calculate the labour rate variance?
Solution
Labor rate variance = Actual rate x Actual hours–Standard rate x Actual hours
= Shs.1,760,000 – Shs.100 x 14000 hrs
= Shs.360,000 (A)
A company operating a standard costing system has the following direct labour standards per unit for one product AB611.
4 hours at Shs.12·50 per hour
In the period just ended, when 2,195 units of the product were manufactured, the actual direct labour cost for the 9,200 hours worked was Shs.110,750.
Required: Calculate labour rate variance for the period
Solution
Labour rate variance = Actual rate x Actual hours–Standard rate x Actual hours
= Shs.110,750 – Shs.12.50 x 9200
Possible causes of Labour Rate Variance
= Shs.4,250 (F )
▪ Negotiation of wages where the employee may demand a higher rate than the standard, this may be considered as uncontrollable as the employer has very little, if any, control on the wage rate. Higher wages than planned may be paid.
▪ Unexpected overtime, which has an element of premium and bonus may also cause this variance
Labor Efficiency variance (LEV)
▪ Misallocation of workforce, allocating semi-skilled workers
Labour efficiency variance measures the productivity of labour. It is equivalent to material usage variance. This variance is closely watched by management as increasing the productivity of labour is the vital key to minimizing unit cost of production. Labor efficiency variance is calculated as follows:
Labor efficiency variance = Standard hours x Standard rate – Actual hours x Standard rate
= SH•SR – AH•SR
= (SH – AH) x SR
The following information relates to labour costs for the past month:
Budget Labour rate 10 per hour
Production time 15 ,000 hours
Time per unit 3 hours
Production units 5 ,000 units
Actual Wages paid Shs176,000
Production 5 ,500 units
Total hours worked 14 ,000 hours
There was no idle time.
Required: calculate the labour efficiency variance?
Solution
Labour efficiency variance = Standard hours x Standard rate – Actual hours x Standard rate = 5500 units x 3hrs x Shs.10 per hr – 14,000 hrs x Shs.10 per hr
= Shs.165,000 – Shs. 140,000
= Shs.25,000 (F )
Causes of labour efficiency variance
▪ Labour efficiency variance may be caused by various factors including
▪ Use of poor quality materials and poorly trained workers or incorrect grade of workers and poor supervision of workers, requiring more labour time in processing.
▪ Use of incorrect materials or experiencing machine problems
Total Labor Variance
▪ Use of higher or better quality materials
▪ Use of faulty equipment causing breakdowns and work interruptions.
Total labor variance, like total material variance, comprises two elements; labour rate variance and labour efficiency variance:
Total labor variance = labour rate variance + labour efficiency variance
= AH(SR – AR) + SR(SH – AH )
= AH•SR – AH•AR + SR•SH – AH•SR
= SR•SH – AH•AR
Budget Labour rate Shs10 per hour
Production time 15 ,000 hours
Time per unit 3 hours
Production units 5 ,000 units
Actual Wages paid 176,000
Production 5,500 units
Total hours worked 14 ,000 hours
There was no idle time.
Required: Calculate total labour variance
Solution
Labor rate variance = Actual rate x Actual hours–Standard rate x Actual hours
= Shs.176,000 – Shs.10 x 14000 hrs
= Shs.36,000 (A)
Labor efficiency variance = Standard hours x Standard rate – Actual hours x Standard rate
= 5500 units x 3hrs x Shs.10 per hr – 14,000 hrs x Shs.10 per hr
= Shs.165,000 – Shs. 140,000
= Shs.25,000 (F )
Total labor variance = Labour rate variance + Labour Efficiency Variance
= Shs.36,000 (A) + Shs.25,000 (F)
= Shs.11,000 (A )
OR
Total labor variance = SR•SH – AH•AR
= Shs.10 x 5,500 units x 3 – Shs. 176,000
= Shs.11,000 (A )
Overhead variances
Direct materials and direct labour vary directly with the output. However, total overheads do not. This is because they can further be classified into variable and fixed components. The variable overheads, which vary directly with output can be analyzed and controlled using the variance formulas used to analyze direct materials and direct labour variances.
Tutorial notes:
1. Overheads refer to fixed overheads that cannot be traced directly to a particular product or unit of production. Overheads are absorbed into costs by means of predetermined overhead absorption rates (OAR), which are determined as follows:
OAR = Budgeted Overhead cost for the period
Budgeted Activity level
2. The activity level so budgeted could be expressed as units, weight, sales, e.t.c.; but the most useful concept of the activity level is the standard hour.
Thus the total overhead absorbed = OAR x Standard hours of production.
3. Overhead variances can be analyzed into variable overhead variances and fixed overheads variances.
Variable Overhead Variances (VOV)
Variable overhead variance comprises two elements; variable overhead expenditure variance and variable overhead Efficiency variance.
Variable Overhead Expenditure variance (equivalent to material price variance or labour rate variance) measures the deviation from the standard in amount spent for overhead input. It measures the difference between the budgeted flexed variable overheads for the actual units of the absorption base and the actual variable overhead costs incurred. The reason why we use the same multiplier (the actual units of the absorption base) is to remove any element of inefficiency; meaning that any difference arising is purely due to a difference in actual variable overhead spending and standard variable overhead spending.
The formula for the variable overhead Expenditure variance can be expressed as:
VOXV = Standard rate x Actual hours – Actual rate x Actual hours
= SR•AH –AR •AH = (SR – AR) x AH
Possible causes of variable overhead expenditure variance
These include all factors that can cause a change in the standard overhead absorption rate; this may include a change in the overheads to be absorbed or a decrease in the activity level which is more than or less than proportionate increase in the overheads.
Variable overhead efficiency variance measures the difference between the actual activity of a period and the standard activity allowed, multiplied by the variable part of predetermined overhead rate. It is the difference between the allowed variable overheads and the absorbed variable overheads.
Variable overhead expenditure variance can be caused by any factor that causes a deviation of actual hours of production from the standard hours of production. This may include inefficiencies caused by use of faulty equipment thus increasing repair and maintenance and unskilled indirect laborers.
In general, all factors that may cause labor efficiency variance can cause variable overhead efficiency variance.
Fixed Overhead Variances (FOV)
Where marginal costing systems are in place, only variable overheads are absorbed into production costs and thus only variances relating to variable overheads arise. However, where full costing system is used, fixed overhead variances may arise. Fixed overheads are assumed to remain unchanged in the short term in response to changes in the level of activity, but they may change in response to changes in other factors.
Fixed overhead variances fall into two categories; fixed overhead expenditure variance and fixed overhead volume variance. Fixed overhead volume variance comprises of fixed overhead efficiency variance and fixed overhead capacity variance.
A diagrammatical illustration of fixed overhead variances
Total fixed
Ov er h ea d s
Capacity variance efficiency variance
Fixed Overhead Expenditure Variance (FOEV)
Fixed overhead expenditure variance explains the difference between the budgeted fixed overheads and the actual fixed overheads. It is the difference between the budgeted fixed overheads and actual fixed overheads.
Fixed overhead expenditure variance = budgeted fixed overheads – Actual fixed overheads
A company operates a standard marginal costing system. Last month, its actual fixed overhead expenditure was 10% above budget resulting in a fixed overhead expenditure variance of Shs.36,000. What was the actual expenditure on fixed overheads last month?
Solution
Fixed overhead expenditure variance = budgeted fixed overheads – Actual fixed overheads Let the budgeted fixed overheads be x
(36,000) = x – 1.1x
Since the actual overheads were more, then make the variance figure a negative. Alternatively, it can be expressed as
Fixed overhead expenditure variance = Actual fixed overheads – budgeted fixed overheads
36000 = 1.1x – x
36,000 = 0.1 x
x = 36,000 = Shs.360,000
0.1
The budgeted fixed expenditure on fixed overheads was Shs. 360,000 and, therefore, the actual was Shs.396,000
Fixed Overheads Volume Variance (FOVV)
This is the difference between the standard cost absorbed in the production achieved and the budget cost allowed for the period. It arises due to the actual production volume differing from the planned: this is in turn caused by volume differing form the planned, labour efficiency variance and or capacity variance (hours of working being less or more than planned). The fixed overhead
Fixed overheads capacity variance
volume variance has a portion of fixed overheads capacity variance and fixed overheads efficiency variance:
This is the portion of the fixed overhead volume variance, which is the difference between the standard cost absorbed in the production achieved whether completed or not, and the actual labour hours worked. (Valued at the standard hourly absorption rate).
Summary of the fixed overhead variances and their
Fixed overheads efficiency variance
This partly explains why the actual production was greater than the budgeted production. It accrues to labour efficiency or inefficiency. For instance, a team may be assigned a specific task, which in ordinary circumstances can take 10 hours (standard). However, the team may cooperate and finish the task in eight hours (being more efficient). The saving will be expressed in monetary units by multiplying the difference with standard fixed overhead absorption rate to reflect the amount of fixed overheads equivalent that was not absorbed at the standard rate.
It means that the part of overheads that could be absorbed in the 2 hours saved shall not be absorbed in the cost of the job. However, fixed cost being fixed shall still be incurred.
Efficiency ratio: This is the standard hours equivalent to the work produced, expressed as a percentage of the actual hours spent in producing that work. It measures the efficiency in the utilization of hours available. It compares the standard time and the actual time taken. Efficiency ratio, therefore, represents the measure of fixed budgeted hours to match the actual level of production achieved.
Capacity ratio: This is the relationship between the budgeted number of working hours and the maximum possible number of hours in a budget period. Capacity measures whether there is enough resources as was budgeted for. If the hours that were available are less than the budgeted hours, then the firm operated below its capacity.
Total fixed overhead is given by the summation of fixed overhead expenditure variance and
Total fixed overhead variance
fixed overhead volume variance. But fixed overhead variance has two portions; Fixed overhead capacity variance and Fixed overhead efficiency variance.
example
JVM Company uses a standard absorption costing system. Last month budgeted production was 8,000 units and the standard fixed production overhead cost was Shs15 per unit. Actual production last month was 8,500 units and the actual fixed production overhead cost was Shs17 per unit.
What was the total adverse fixed production overhead variance for last month? Calculate the fixed overheads volume variance
Total fixed overheads variance = Absorbed fixed overheads – actual fixed overheads
= (Shs.15 x 8,500 units) – (Shs.17 x 8,500)
= Shs. (127,500 – 144,500)
= Shs.17,000 (Adverse )
Fixed overhead expenditure variance = budgeted fixed overheads – Actual fixed overheads
= (Shs.15 x 8,000) – (Shs.17 x 8,500)
= Shs.120,000 – Shs. 144,500
= Shs.24,500 (Adverse )
Fixed overhead Volume variance = Fixed overheads variance – fixed overheads expenditure variance
= Shs.17,000 (A) – Shs.24,500 (A )
= Shs.7,500 (F )
These can be used to analyze the performance of the sales function or revenue centers.
N.B. Sales variance calculations are calculated in terms of profit or contribution margin rather than sales values. If sales values are used (actual sales compared to budgeted) there is the risk of ignoring the impact of the sales effort on profit. The term profit margin is used when absorption costing approach of determining profit is applied, whereas the term Contribution Margin is used when Marginal costing approach is applied.
Total sales margin variance
It is the total difference between the actual margin and the budgeted margin from sales when cost of sales is valued at standard cost of production.
A.C – B.C Sales margin price variance
It is that portion of total sales margin variance, which is the difference between the standard margin per unit and actual margin per unit for the number of units sold in the period.
( A.M – S.M) * A.Q Sales margin volume variance
It is the difference between the actual sales volume and the budgeted volume multiplied by the standard margin per unit.
( A.V – B.V) * S.M
Ideally, the above variances are assuming that there’s only one product being sold. In reality, organizations will have a portfolio of different products each with different prices and costs and consequently profits or contributions.
The sales margin volume variance could, therefore, be further analyzed into:
Sales mixture variance
This is the portion of sales margin volume variance that’s the difference between the total number
Sales margin volume variance
of units at the actual mix and the actual total number of units at standard mix valued at standard margin per unit.
This is the portion of sales margin quantity variance, which is the difference between the actual total quantities of units sold and the budgeted total number of units at standard mix valued at standard margin per unit.
Total Sales Margin
Quantity
Sales margin
variance
Sales margin Price variance
(Actual units @actual mix Sales margin Variance Sales Margin Mix variance @actual margin)
Provided below is data for three products A, B and C.
UNITS UNITS
Total
Sales Volume Price Margin Total margin Total sales Volume Price Margin Total margin
A 10000 500 20 5 2500 10560 480 22 8 3840
B 8000 200 40 20 4000 6120 170 36 15 2550
C 9000 300 30 15 4500 8500 250 34 20 5000
27000 1000 11000 25180 900 11390
Required:
Sales Margin volume variance
a) Sales margin volume variance
Total actual units is 900
Standard mix is 50%, 20% and 30 %
(450*5) + (180*20) + (270*15) = 9900
Sales margin volume variance = 9900 – 11000 = 1100 (A)
b) Sales margin mix variance
The actual units in the actual proportion and standard margin is calculated as:
(480*5) + (170*20) + (250*15) = 9550
Sales margin mix variance = 9900 – 9550 = 350 (A)
c) Sales margin price variance
= 11390 – 9550 = 1840 (F )
N.B. Sales margin quantity variance = sales margin mix variance + sales margin volume variance.
= 1100 (A) + 350 (A) = 1450 (A )
Total variance could be confirmed by getting the difference between the budgeted margin and the actual margin.
11390 – 11000 = 390 (F )
Criticisms of sales margin variances
The purpose of variance analysis is to see if there are any deviations for the budget. If there are and it is within the control of the manager, he is to take steps to correct the situation to avoid further deviations. The manager has very little control over the sales and thus some writers would find the usefulness of the variances doubtful.
However, they could be useful in a situation where the organization has some control over the sales price. It could also be useful where a manager is in charge of two substitute products where he can use the mix variances.
Mix and quantity variances provide useful information only when there is an identifiable relationship between the products sold. If there is no relationship, sales variance analysis should be done on the separate products. Providing managers with mix and quantity variances for products that have no relationship is misleading as it implies that the possible cause of sales volume variance is change in the mix (Gibson, 1990).
He gave examples of where relationships might exist:
▪ Similar products differentiated by single characteristics e.g. size where sales of individual products are expected to vary proportionately with total sales.
▪ From the sale of complementary products where sales of one product are expected to result in increased sales in another
▪ From the sale of substitute products where the increased sales of one product leads to a decrease in sales of another
Mix Variances
▪ Sale of heterogeneous products quantities of which are limited by factors of production e.g. sale of product with lower contribution margins per limiting factor is made only if products with higher margins cannot be sold.
In the previous section, we looked at variances where we assumed that we only had one product. However, we have focused on mix variances to some extent while calculating the sales variances. This section focuses on material variances assuming more than one type of material input.
N.B. Mix and yield analysis will only give meaningful results where there is some degree of interchangeability between materials and products.
Variation from the standard input of materials may arise where one material may be over-utilized while the other is under-utilized, evaporation of some input materials, breakages and machine inefficiency.
Three variances will be observed in a scenario:
a) Material price variance: This would arise where the materials have been bought at different prices for the standard.
b) Mix variance: This arises where the materials have been used in different proportions from the standard.
c) Yield variance: This arises where a different total quantity of materials from standard ( for actual output) have been used.
The sum of the mix variance and yield variance make up the Total Usage Variance.
Formulae
Price variance Actual quantity Actual quantity
@actual mix – @actual mix
@actual prices @STD prices
@actual mix – @STD proportion @STD prices @STD prices
Material Tons Price/ton Total
X 550 $6.00 3300
Y 330 $5.00 1650
Z _220 $4.50 _990
Total 1100 5940
Normal loss _110 _ –
(10%) _990 5940
The average material cost per ton Shs.5,940 = Shs.6.00
990
The actual production of 990 tons used materials at prices as follows.
Material Tons price/ton Total
X 444 $7.5 3330
Y 446 $6.0 2676
Z 240 $4.5
1130
140
990
–
7086
i. Material price variance
Actual Quantity X 444*6 = 2664
@actual mix Y 446*5 = 2330
@STD prices Z 240*4.5 =
1130
Actual quantity
@actual mix
@actual prices 7086
ii. Material mix variance
Actual quantity 1112 ( A )
@actual mix
@STD prices 5974
Actual quantity X 565*6 = 3390
@STD mix Y 339*5 = 1695
@STD prices Z 226*4.5=1017 6102
iii. Material yield
Actual quantity 128 ( F )
@STD mix
@STD prices 6102
STD quantity @STD mix
@STD prices 5940
162 ( A )
Usage variance = Yield variance + mix variances
128 ( A) + 162 (A) = $34 (A )
Causes of mix variances
a) Mix variances
Favorable Mix variance arises when less of more expensive material and more of the cheaper materials are used. For instance, in the example above, 128 (F) arises because less of more expensive material X has been used and more of the cheaper materials Y and Z
b) Yield variance
Favorable yield variance arises when the output is less than expected: when the actual loss exceeds the normal loss. Use of cheaper but low quality materials may result to a drop in good production. For instance, the change to a cheaper mix of material has resulted in the drop in yield of good production in relation to the standard.
The material mix variance could be further analyzed to splitting and getting the variances for the individual products.
Actual Actual quantity Variance STD price Mix variance
In STD mix
X 444 565 121 (F) 6 726 ( F )
Y 446 339 107 (A) 5 535 ( A )
Z 240 226 14 (A) 4.5 63 (A)
128 ( F )
The total mix variance is made up of a series of favorable and adverse variances. Using smaller quantities of the more expensive material gave us a favorable variance whereas the more use of the cheaper material gave an adverse variance.
Without further analysis, a manager might conclude that using more of material X is good and increasing the levels of Y and Z is quite detrimental in terms of adverse variances. There is a danger in simply looking at mix variances in isolation from yield variances.
Conventional mix and yield variances are based on assumptions some of which might be considered absurd or impracticable. The reliance, however, on mix and yield variances should be done together with a good understanding of principles and objectives of variance analysis and not just the mechanical application of a few formulae.
The variances just show the effect of changes from the original standard but doesn’t show whether the results were optimal given relative prices, qualities and availability of materials. Where materials can be substituted, where characteristics of material are variable and where there are relative price changes, the optimal mix may be continually changing and static conventional variance calculation is unlikely to be appropriate. Getting the optimal mix requires one that gives us the maximum contribution based on a limiting factor. Where limiting factors are many, linear programming is usually applied on a continuous basis.
It also assumes a constant correlation between physical inputs and outputs regardless of the mix of output i.e. if the mix of output changes, some relationship is assumed between the new mix and output as between original standard mix and output.
Technical acceptability of the output is ignored as it is assumed that output is acceptable regardless of the input mix of materials.
Linear substitutability of material is ignored. For example, if they reduce A by one unit, they should increase B by one unit. Further substitution would result in a mix consisting of one material only; the cheapest.
Assuming the technical acceptability of the output based on the premise that the standard represents the optimum position, we should never get a favorable mix variance because the lower standard cost of actual mix means that it should have been the original standard in the first place.
In addition to the variances, technical and commercial factors affecting the process being considered should be done. This could include:
▪ Relative prices, availability and technical characteristics of input material at the time of the mix.
▪ The extent of technical substitutability of material
▪ Planned yield format given actual mix of material not merely the yield form standard mix.
▪ Interdependencies between material variances and other process inputs e.g. what effect does it have on labor costs?
This chapter has covered the various types of variances. The formula used to calculate the variances include.
Note:
SQ = Standard quantity
SP = Standard price
AQ = Actual quantity
AP = Actual Price
AR = Actual rate
AR = Standard rate
VOAR = Variable overhead absorption rate
AH = Actual hours
Material variance = SQ x SP – AQ x AP
Material price variance = SP x AQ – AP x AQ
Material usage variance = SQ x SP – AQ x SP
Labour rate variance = SR x AQ – AR x AQ
Labour efficiency variance = SQ x SR – AQ x SR
Variable overhead efficiency variance = SH x VOAR – AH x VOAR
Variable overhead expenditure variance = SRxAH – AR xAH
CHAPTER QUIZ
1. What is a variance?
2. Distinguish between capacity ratio and efficiency ratio.
3. Define total sales margin price variance.
4. Highlight the possible causes of labour rate variance
1. A variance is a deviation from the expected.
2. Efficiency ratio is the standard hours equivalent to the work produced, expressed as a percentage of the actual hours spent in producing that work. The efficiency ratio measures the efficiency in the utilization of hours available.
3. Capacity ratio is capacity ratio is the relationship between the budgeted number of working hours and the maximum possible number of hours in a budget period. Capacity measures whether there is enough resources as was budgeted for
4. Sales margin price variance = (Actual Margin – Standard Margin) * Actual Quantity
5. Possible causes of labour rate variance include; negotiation of wages, unexpected overtime and misallocation of workforce.
Questions from this chapter have been examined in the following examination sittings.
06/ 07 Q5; 05/ 06 Q1; 05/ 06/ Q6(b); 05/ 05 Q2; 06/ 04 Q3; 06/ 03 Q2; 12/01 Q1(b); 05/ 01 Q2; 12 /00 Q5; 06/ 00 Q 4
Question One
Whitaker plc has obtained the following information regarding costs and revenue for the past financial year:
Original budget:
Sales 10 ,000
units
Production 12 ,000
units
Standard cost per unit: Shs
Direct materials 5
Direct labour 9
Fixed production overheads _8
22
Selling price 30
Actual results:
Sales 9,750 units
Revenue Shs.325,000
Production 11,000 units
Material cost Shs.65,000
Labour cost Shs.100,000
Fixed production overheads Shs.95,000
There were no opening stocks.
Required:
a) Produce a statement showing the flexed budget and actual results. Calculate the variances between the actual and flexed figures for the following:
▪ Sales;
▪ Materials;
▪ Labour; and
▪ Fixed production overhead (7 marks )
b) Explain briefly how the sales and materials variances calculated in (a) may have arisen.
Question Two
T-mo plc manufactures and sells product CD95. The company operates a standard marginal costing system. The standard cost card for CD95 includes the following:
Shs. per unit
Direct material 20
Direct labour (6 hours at Shs.7·50 per hour) 45
Variable production overheads 27
–––
92 ––– The budgeted and actual activity levels for the last quarter were as follows:
Budget
Actual
Units Units
Sales 20,000 19,000
Production 20,000 21,000
The actual costs incurred in last quarter were:
Shs
Direct material 417,900
Direct labour (124,950 hours) 949,620
Variable production overheads 565,740 Required:
a) Calculate the total variances for direct material, direct labour and variable production overheads (3 marks )
b) Provide an appropriate breakdown of the total variance for direct labour calculated in (a) above (3 marks ) c) Suggest TWO possible causes for EACH variance calculated in (b) (4 marks )
Question Three
Mwaniki Ltd manufactures a single product which has a standard selling price of Shs22 per unit. It operates a standard marginal costing system. The standard variable production cost is Shs9 per unit. Budgeted annual production is 360,000 units and budgeted non-production costs of Shs1,152,000 per annum are all fixed. The following data relate to last month:
Budget Actual
Units units
Production 30,000 33,000
Sales 32,000 34,000
Last month, the budgeted profit was Shs200,000 and the actual total sales revenue was Shs731,000.
Required:
(i) Calculate the sales price and sales volume contribution variances for last month showing clearly whether each variance is favorable or adverse. (4 marks )
(ii) Explain how the two variances calculated in (a) could be interrelated. (3 marks )
(iii) Calculate the BUDGETED profit for last month assuming that the company was using absorption costing. (3 marks )
Question four
Last month, Isaac’s Company’s budgeted sales were 5,000 units. The standard selling price was Shs6 per unit with a standard contribution to sales ratio of 60%. Actual sales were 4,650 units with a total revenue of Shs.30,225 What were the favorable sales price and adverse sales volume contribution variances?
Sales price Sales volume contribution Shs Shs
A 2,325 1,260
B 2,500 1,260
C 2,325 2,100
D 2,500 2,100 (5 marks)
Question five
Woodeezer Ltd makes quality wooden benches for both indoor and outdoor use. Results have been disappointing in recent years and a new managing director, Peter Beech, was appointed to raise production volumes. After an initial assessment Peter Beech considered that budgets had been set at levels which made it easy for employees to achieve. He argued that employees would be better motivated by setting budgets which challenged them more in terms of higher expected output. Other than changing the overall budgeted output, Mr Beech has not yet altered any part of the standard cost card. Thus, the budgeted output and sales for November 2002 was 4 ,000 benches and the standard cost card below was calculated on this basis :
Shs.
Wood 25 kg at Shs3·20 per kg 80·00
Labour 4 hours at Shs8 per hour 32·00
Variable overheads 4 hours at Shs4 per hour 16·00
Fixed overhead 4 hours at Shs16 per hour 64·00
–––––––
192·00
Selling price 220·00
–––––––
Standard profit 28·00
–––––––
Overheads are absorbed on the basis of labour hours and the company uses an absorption costing system. There were no stocks at the beginning of November 2002. Stocks are valued at standard cost. Actual results for November 2002 were as follows:
Shs
Wood 80,000 kg at Shs.3·50 280,000
Labor 16,000 hours at Shs.7 112,000
Variable overhead 60,000
Fixed overhead 196,000
––––––––
Total production cost (3,600 benches) 648,000
Closing stock (400 benches at Shs192) 76,800
––––––––
Cost of sales 571,200
Sales (3,200 benches) 720,000
––––––––
Actual profit 148,800
––––––––
The average monthly production and sales for some years prior to November 2002 had been 3,400 units and budgets had previously been set at this level. Very few operating variances had historically been generated by the standard costs used.
Mr Beech has made some significant changes to the operations of the company. However, the other directors are now concerned that Mr Beech has been too ambitious in raising production targets. Mr Beech had also changed suppliers of raw materials to improve quality, increased selling prices, begun to introduce less skilled labour, and significantly reduced fixed overheads.
The finance director suggested that an absorption costing system is misleading and that a marginal costing system should be considered at some stage in the future to guide decisionmaking.
Required:
(a) Prepare an operating statement for November 2002. This should show all operating variances and should reconcile budgeted and actual profit for the month for Woodeezer
Ltd. (14 marks )
(b) In so far as the information permits, examine the impact of the operational changes made by Mr Beech on the profitability of the company. In your answer, consider each of the following:
(i) Motivation and budget setting; and
(ii) Possible causes of variances. (6 marks )
(a) Re-assess the impact of your comments in part (b), using a marginal costing approach to evaluating the impact of the operational changes made by Mr Beech.
Show any relevant additional calculations to support your arguments. (5 marks )
(25 marks) McDermott plc is a manufacturer of beds. It uses a system of standard absorption costing and variances to monitor performance of managers and departments. A standard cost card for one of its models, the Dreamer, is given below.
£ per unit £ per unit
Selling price 250.00
Direct material: Wood: 12m @ £1.50 per m 18.00
Fabric: 6m2 @ £2.00 per m2 12.00
Direct labour: 4 hours @ £6.00 per hour 24.00 Variable overhead: 4 hours @ £15.00 60.00
Fixed overhead: 4 hours @ £10.00 40.00
154.00
Profit 96.00
Budgeted production and sales are 1,000 Dreamers per month.
Actual results for the manufacture and sale of Dreamers for the most recent month are as follows:
Sales: 1,200 units @ £240 each
Production: 1,300 units
Wood 16,000m @ £1.40 per m
Fabric 7,800m2 @ £2.10 per m2
Direct labour: 5,000 hours @ £7.00 per hour Variable overhead: 5,000 hours @ £15.10 per hour Fixed overhead: £54,600.
There was no opening stock.
Terminology
Throughout this article, the term ‘adverse variance’ (Adv) describes a situation where actual results are worse than standard and have a detrimental effect on profit (costs are higher or revenues lower). ‘Favorable’ (Fav) describes the opposite situation. Many candidates omit these signs and thus lose half of the marks available for calculation. In practice, and in the exam, variances are of little use without a sign. Some candidates use negative signs or brackets for adverse variances, and no signs for favorable variances. This causes marking problems, because it becomes difficult to tell the difference between a favorable variance and one without a sign.
Lesson 1 Always clearly label variances as either adverse or favorable. These labels will represent 50 % of the marks available for variance calculations. Variable Cost Variances
The direct labour variance is usually the simplest variance to calculate. Actual direct labour cost was £35,000 (5,000 hours x £7.00). This needs to be compared with the standard cost. A very common error in candidates’ calculations is to make the following comparison:
Actual hours x actual rate
= 5,000 hours x £7.00 = £35,000
> £11,000 Adv labour variance
Budgeted hours x standard rate
= 1,000 units x 4 hours x £6.00 = £24,000
This is not a sensible comparison. Actual costs relate to producing 1,300 units. Budgeted figures relate to producing 1,000 units. It is important to compare like with like. If labour is a variable cost, then we would expect the extra 300 units to require extra labour hours.
A more sensible, and correct, calculation is to compare the actual labour cost with the flexed budget labour cost of producing 1,300 units, as follows
Actual hours x actual rate
= 5,000 hours x £7.00 = £35,000
>£3,800 Adv labour variance
Standard hours for actual production x standard rate
= 1,300 units x 4 hours x £6.00 = £ 31,200
Lesson 2
It is important when calculating variable cost variances that figures are based on flexed budget figures, not original budgeted figures.
The total labour variance of £3,800 adverse has two potential causes – either the firm has paid a different hourly rate to standard, or it has used a different amount of hours per unit to standard, or possibly both. If we insert a third line into the analysis, we can separate out these two causes.
Actual hours x actual rate
= 5,000 hours x £7.00 = £35,000
> £5,000 Adv rate variance
Actual hours x standard rate
= 5,000 hours x £6.00 = £30,000
> £1,200 Fav efficiency variance
Standard hours for actual production x standard rate
= 1,300 units x 4 hours x £6.00 = £31,200
We can now see that the total variance of £3,800 adverse has two causes. First, a rate (or more generally expenditure) variance, caused by paying more per hour than standard. Second, an efficiency variance, caused by making 1,300 units in 5,000 hours rather than the flexed budget 5 ,200 hours (1,300 units x 4 hours ).
Tabular or formula approach?
Many textbooks present the above calculation in a ‘formula’ format rather than the tabular layout adopted above. For example, the labour rate variance calculation is often presented as follows:
(Actual rate per hour – Standard rate per hour) x Actual hours = Labor rate variance = (£6.00 – £7.00) x 5,000 hours = £5,000 Adv.
