Chapter 5 - Variance Analysis

Standard

• A benchmark measurement of resource usage or revenue or profit generation, set in defined conditions.

Standard Cost for Product/Service

• Predetermined (planned) unit cost, based on a standard specification of the resource needed to supply it and the costs of those resources.

• Based on technical specifications for the materials, labour time and other resources required and the prices/rates for the materials/labour.

• Standard costs can be prepared using either absorption or marginal costing.

Standard Price for a Product/Service

• Is the expected price for selling the standard product or service.

• When there is a standard sales price and standard cost per unit, there is also a standard profit per unit (absorption costing) or standard contribution per unit (marginal costing).

Types of Standard

• Attainable - Efficient but not perfect

• Basic - Long-term unchanging standard

• Current - Current working conditions

• Ideal - Perfect operating conditions

Standard Costing in Modern Business Environment

• Standard costing was developed for more stable business environments.

• Difficult to set a standard cost appropriate over time in dynamic environments.

• Continuous improvement necessary for competitiveness.

• Emphasis on labour variances less appropriate with automated production.

• Modern digital products lead to quickly changing and unpredictable costs.

• Standard must be valid, relevant and up-to-date.

• Frequent updating may be necessary to represent latest methods, operations and prices.

Variance Analysis

• A variance is the difference between actual results and the budget or standard.

• Important for performance measurement and control, timely reporting maximises opportunity for managerial action.

• Variance reports comparing actual results with standards or budget are produced regularly (monthly).

Two Groups of Variance Analysis

• Cost variances analyse the difference between actual and standard costs.

• Sales variances analyse the difference between actual and budgeted sales prices and sales volumes.

• Taken together, cost and sales variances can be used to explain the difference between the budgeted profit for a period and the actual profit.

Favourable (F) Variance

• When actual results are better than expected results.

3 Groups of Variances

1. Sales Variances

2. Fixed Overhead Variances

3. Variable Cost Variances

   1. Material Variance

   2. Labour Variance

   3. Variable Overhead Variance

Sales Variances

They explain the effect of differences between:

• Actual and standard sales prices

• Budgeted and actual sales volumes

Sales Price Variance

• Shows the effect on profit of a change in revenue caused by the actual selling price differing from the budgeted.

• It is calculated as the difference between:

  • Actual selling price x Actual no of units sold

  • Standard selling price x Actual no of units sold

• Favourable: actual sales revenue > actual sales at standard price

• Adverse: actual sales revenue < actual sales at standard price

Sales Volume Variance

• A measure of the effect on contribution/profit of not achieving the budgeted volume of sales.

• It is the difference between actual and budgeted sales volumes valued at:

  • Standard Profit - Absorption Costing System

  • Standard Contribution - Marginal Costing System

• Favourable: actual sales volumes > budgeted

• Adverse: actual sales volumes < budgeted

Causes of Sales Price Variances

1. Higher-than-expected discounts offered to customers to persuade them to buy larger, bulk quantities. ADVERSE.

2. Lower-than-expected discounts, perhaps due to strength of sales demand. FAVOURABLE.

3. The effect of low-price offered during a marketing campaign. ADVERSE.

4. Market conditions forcing an industry-wide price change. ADVERSE OR FAVOURABLE.

Causes of Sales Volume Variances

1. Successful or unsuccessful direct selling efforts. FAVOURABLE OR ADVERSE.

2. Successful or unsuccessful marketing efforts. FAVOURABLE OR ADVERSE.

3. Unexpected changes in customer needs and buying habits, increasing/decreasing demand. FAVOURABLE OR ADVERSE.

4. Failure to satisfy demand due to production difficulties. ADVERSE

5. Higher demand due to a cut in selling prices, or lower demand due to an increase in sales price. ADVERSE

Direct Material Total Variance

• Measurement of the difference between the standard material cost of the output produced and the material cost incurred.

• The difference between what direct material DID cost vs SHOULD have cost:

  • the actual direct material cost vs

  • the standard direct material cost of the actual production

• Favourable: Actual Material Cost < Expected Material Cost

• Adverse: Actual Material Cost > Expected Material Cost

Limitation of Total Material Variance

It conveys very little useful information, further analysis is required. It can be analysed into two sub-variances:

1. Direct material price variance (paying more/less than expected for materials)

2. Direct material usage variance (using more/less material than expected for actual output)

Material Price Variance

• The difference between the actual price paid for purchased materials and their standard cost.

• It is calculated as the difference between:

  • Actual purchase price x actual quantity of material purchased/used.

  • Standard purchase price per kg (or other metric) x actual quantity of material purchased/used.

• Favourable: Material Price Paid < Material Price Expected

• Adverse: Material Price Paid > Material Price Expected

Causes of Material Price Variance

1. Using a different supplier who is cheaper (FAVOURABLE) or more expensive (ADVERSE).

2. Buying larger-sized orders, larger bulk discounts (FAVOURABLE) or smaller sized, less bulk discounts (ADVERSE).

3. Unexpected increase in the prices charged by a supplier (ADVERSE).

4. Unexpected buying costs such as high delivery charges (ADVERSE).

5. Efficient (FAVOURABLE) or inefficient (ADVERSE) buying procedures.

6. A change in material quantity, resulting in higher (ADVERSE) or lower price (FAVOURABLE)

Inventory Valuation & Material Price Variance

• Raw material inventory valued at standard cost: price variance calculated based on materials purchased in the period.

  • Ensures all variances accounted for as soon as purchases are made, inventory is held in standard cost.

• Raw material inventory values at actual cost: price variance calculated based on materials used in the period.

  • Not usual or recommended, as standard costing aims to value all inventory at standard cost.

Material Usage Variance

• Measures efficiency in the use of material, by comparing standard material usage for actual production with actual material used, the difference is valued at standard cost.

• Based on quantity of materials used.

• It is calculated as the difference between:

  • Actual quantities used x standard purchase price

  • Standard quantities of material specified for the actual production x standard purchase price

• Favourable: Actual Material Usage < Expected Material Usage

• Adverse: Actual Material Usage > Expected Material Usage

Causes of Material Usage Variances

1. Higher-than-expected (ADVERSE) or lower-than-expected (FAVOURABLE) rate of scrap or wastage.

2. Different quality of material affects wastage rate, higher quality/less waste (FAVOURABLE), lower quality/more waste (ADVERSE).

3. Defective materials (ADVERSE).

4. Better quality control (FAVOURABLE).

5. More efficient work procedures, resulting in better material usage rates (FAVOURABLE).

6. Changing labour mix, higher grade labour/less errors (FAVOURABLE), lower grade/more errors (ADVERSE).

7. Changing material mix, more expensive/better quality (FAVOURABLE), less expensive/worse quality (ADVERSE).

Direct Labour Total Variance

• The difference between the standard direct labour cost of the output which has been produced and the actual direct labour cost incurred.

• The difference between:

  • The actual cost of direct labour

  • The standard direct labour cost of the actual production.

• FAVOURABLE: Actual Labour Cost < Expected Labour Cost

• ADVERSE: Actual Labour Cost > Expected Labour Cost

Direct Labour Rate Variance

• Indicates the actual cost of any change from the standard labour rate of remuneration.

• The difference between:

  • Actual rate per hour x actual hours paid for

  • Standard rate per hour x actual hours paid for

• FAVOURABLE: Actual Rate Paid < Expected Rate Paid

• ADVERSE: Actual Rate Paid > Expected Rate Paid

Causes of Direct Labour Rate Variance

1. Unexpected increase in basic rate of pay (ADVERSE).

2. Payments of bonuses if recorded as direct labour cost (ADVERSE).

3. Using more (ADVERSE) or less (FAVOURABLE) experienced labour than the standard.

4. Change in composition of workforce, increase (ADVERSE) or decrease (FAVOURABLE) in average rates of pay.

Direct Labour Efficiency Variance

• Standard labour cost of any change from the standard level of labour efficiency.

• The difference between:

  • Actual hours worked x standard hourly rate

  • Standard hours specified for actual production x standard hourly rate

• FAVOURABLE: Actual Labour Efficiency < Expected Labour Efficiency

• ADVERSE: Actual Labour Efficiency > Expected Labour Efficiency

Causes of Direct Labour Efficiency Variance

1. Taking more (ADVERSE) or less (FAVOURABLE) time than expected to complete work due to inefficient/efficient working.

2. Using labour that is more (FAVOURABLE) or less (ADVERSE) experienced than the standard.

3. Change in composition or mix of workforce, more (FAVOURABLE) or less (ADVERSE) efficient.

4. Improved working methods (FAVOURABLE).

5. Industrial action by the workforce: ‘working to rule’ (ADVERSE).

6. Poor supervision (ADVERSE).

7. Improvements in efficiency due to an unexpected ‘learning effect’ amongst the workforce (FAVOURABLE).

8. Unexpected lost time due to production bottlenecks and resource shortages (ADVERSE).

Direct Labour Idle Time Variance

• When hours paid exceed hours worked and there is an extra cost caused by this idle time.

• It increases the accuracy of the labour efficiency variance.

• FAVOURABLE: Actual Idle Time < Standard Idle Time

• ADVERSE: Actual Idle Time > Standard Idle Time

Variable Production Overhead Total Variance

• Measures the difference between the variable overhead that should be sued for actual output and variable production overhead actually used.

• The difference between:

  • Actual cost of variable production overheads.

  • Standard variable overhead cost of the actual production.

• FAVOURABLE: Actual Cost < Expected Cost

• ADVERSE: Actual Cost > Expected Cost

Variable Production Overhead Expenditure Variance

• The actual cost of any change from the standard rate per hour. Hours refer to either labour or machine hours depending on the recovery base chosen for variable production overhead.

• FAVOURABLE: Actual Expenditure < Expected Expenditure

• ADVERSE: Actual Expenditure > Expected Expenditure

Variable Production Overhead Efficiency Variance

• Standard variable overhead cost of any change from the standard level of efficiency.

• FAVOURABLE: Actual Efficiency > Expected Efficiency

• ADVERSE: Actual Efficiency < Expected Efficiency

Idle Time Variances & Variable Production Overhead

• When recovery base chosen for variable production overhead is direct labour hours, the variable production overhead efficiency variance is calculated in the same way that direct labour efficiency variance is calculated when there is idle time.

• The variable production overhead expenditure variance, when there is idle time, is the difference between:

  • The standard variable overhead cost of the active hours worked.

  • The actual variable overhead cost.

Fixed Overhead Total Variance

• The difference between:

  • Actual fixed production overheads incurred

  • Standard fixed production overhead absorbed by the actual production (i.e. standard absorption rate)

• The total cost variance for fixed production overhead is the amount of over-absorbed or under-absorbed overhead which occurs when the OAR is based on inaccurate predictions causing a fixed overhead total variance.

• FAVOURABLE: Over-absorbed overhead

• ADVERSE: Under-absorbed overhead

Fixed Production Overhead Expenditure Variance

• If actual expenditure differs from budgeted expenditure, there is an expenditure variance.

• The difference between:

  • Actual fixed production overhead

  • Budgeted fixed production overhead

• FAVOURABLE: Actual Overhead < Budgeted Overhead

• ADVERSE: Actual Overhead > Budgeted Overhead

• Doesn’t just have to be production, could be fixed administration or fixed sales & distribution overhead expenditure variance.

Fixed Production Overhead Volume Variance

• The volume variance is calculated as the difference between:

  • Actual output in units

  • Budgeted output in units x standard fixed overhead absorption rate per unit

• Fixed production overhead volume variance indicates the amount of fixed overhead under or over-absorbed due to differing actual and budgeted production volumes.

• Has two sub-variances, capacity and efficiency, that explain why the level of activity was different from budgeted.

• FAVOURABLE: Over-absorbed overhead

• ADVERSE: Under-absorbed overhead

Marginal Costing & Fixed Overhead Variances

• In marginal costing system, fixed overhead volume variance does not occur as no overheads absorbed, and amount spent is related as a period cost and written off.

• The only fixed overhead variance in marginal costing is the difference between budgeted and actual expenditure, known as the fixed overhead expenditure variance.

Fixed Overhead Capacity Variance

• In ABSORPTION costing systems, if the fixed overhead is absorbed based on HOURS, then the fixed overhead volume variance can be subdivided into capacity and efficiency variances.

• The capacity variance measures whether the workforce worked more or fewer hours than budgets for the period.

• FAVOURABLE: Actual Hours > Budgeted Hours (more hours worked = greater capacity to produce units).

• ADVERSE: Actual Hours < Budgeted Hours

Fixed Overhead Efficiency Variance

• In ABSORPTION costing systems, if the fixed overhead is absorbed based on HOURS, then the fixed overhead volume variance can be subdivided into capacity and efficiency variances.

• The efficiency variance measures whether the workforce took more or less time than STANDARD in production their output for the period.

• FAVOURABLE: Actual Hours < Standard Hours for Actual Production

• ADVERSE: Actual Hours > Standard Hours for Actual Production

Marginal/Absorption Costing & Fixed Overhead Variances

• In absorption costing, if FOAR is in units then expenditure & volume variances can be calculated.

• In absorption costing, if FOAR is in hours then expenditure, volume (capacity/efficiency) can be calculated.

• In marginal costing, only the Fixed Overhead Expenditure Variance can be calculated.

Causes of Fixed & Variable Overhead Variances

1. Fixed overhead expenditure adverse variances result from exceeding the budget, while detailed analysis is needed to understand the reasons for the variance.

2. Fixed overhead volume variance, including capacity and efficiency variances, is caused by changes in production volume influenced bus sales volume or labour productivity fluctuations.

3. Variable production overhead expenditure variances often stem from changes in machine running costs, such as fluctuations in electricity rates.

4. The causes of fixed and variable production overhead efficiency variances are similar to those for direct labour efficiency variances.

Variance Interdependence

• Using cheaper materials may lead to a favourable material price variance but an adverse material usage variance and reduced labour productivity causing adverse labour and variable overhead efficiency variances.

• Employing more experienced labour may result in an adverse labour rate variance but higher productivity leading to favourable labour and variable overhead efficiency variances.

• Workers aiming to improve productivity for a bonus may create adverse material usage to save time, resulting in an adverse efficiency variance.

• Lowering sales prices could cause an adverse sales price variance but higher sales demand, resulting in a favourable sales volume variance.

Variance Analysis using ABC Costing

• As part of variance analysis managers will need to establish standard costs.

• Compared to traditional absorption costing, the use of ABS is most likely to impact overhead variances.

• Standard costs can be compared to actual and an overhead expenditure/efficiency variance calculated.

• The activity (efficiency) variance reports the cost impact of undertaking more or less activity than standard/

• The expenditure variance reports the cost impact of paying more or less than standard for the actual activities undertaken.