Yes
No No
Yes No
Yes
Compute Variance
Is the Variance Favorable (F)?
Is It Significant?
Is It Controllable?
What Are the Causes?
Take Corrective Action
No Action is Needed
No Action is Needed
No Action is Needed
Analysis of Variance Analysis for 6-4 Cost Control
III. General Model for Variance Analysis
Two general types of variances can be calculated for most cost items: a price (rate, spending) variance and a quantity (usage, efficiency) variance.
The price variance is calculated as follows:
Price Variance
= Actual Quantity *(Actual price - Standard price)
= AQ * (AP - SP)
= (AQ * AP) - (AQ * SP) The quantity variance is calculated as follows:
Quantity Variance = (Actual Quantity – Standard Quantity) * Standard Price
= (AQ – SQ) * SP
= (AQ * SP) – (SQ * SP)
It is important to note four things:
1. A price variance and a quantity variance can be calculated for all three variable cost items -- direct materials, direct labor, and the variable portion of factory overhead.
The variance is not called by the same name, however. For example, a price variance is called a materials price variance in the case of direct materials, but a labor rate variance in the case of direct labor and a variable overhead spending variance in the case of variable factory overhead.
2. A cost variance is unfavorable (U) if the actual price AP or actual quantity AQ exceeds the standard price SP or standard quantity SQ; a variance is favorable (F) if the actual price or actual quantity is less than the standard price or standard quantity.
3. The standard quantity allowed for output -- item (3) -- is the key concept in variance analysis. This is the standard quantity that should have been used to produce actual output. It is computed by multiplying the actual output by the number of input units allowed.
4. Variances for fixed overhead are of questionable usefulness for control purposes, since these variances are usually beyond the control of the production department.
We will now illustrate the variance analysis for each of the variable manufacturing cost items.
A. MATERIALS VARIANCES
A materials purchase price variance is isolated at the time of purchase of the material. It is computed based on the actual quantity purchased. The purchasing department is responsible for any materials price variance that might occur. The materials quantity (usage) variance is computed based on the actual quantity used. The production department is responsible for any materials quantity variance.
Analysis of Variance Analysis for 6-5 Cost Control
Unfavorable price variances may be caused by inaccurate standard prices, inflationary cost increases, scarcity in raw material supplies resulting in higher prices, and purchasing department inefficiencies. Unfavorable material quantity variances may be explained by poorly trained workers, by improperly adjusted machines, or by outright waste on the production line.
EXAMPLE 6.1
Mighty Kings Corporation uses a standard cost system. The standard variable costs for product J are as follows:
Materials: 2 pounds per unit at $3 per pound ($6 per unit of Product J) Labor: 1 hour per unit at $5 per hour ($5 unit of Product J)
Variable overhead: 1 hour per unit at $3 per hour ($3 per unit of Product J)
During March, 25,000 pounds of material were purchased for $74,750 and 20,750 pounds of material were used in producing 10,000 units of finished product. Direct labor costs incurred were $49,896 (10,080 direct labor hours) and variable overhead costs incurred were $34,776.
It is important to note that the amount of materials purchased (25,000 pounds) differs from the amount of materials used in production (20,750 pounds). The materials purchase price variance was computed using 25,000 pounds purchased, whereas the materials quantity (usage) variance was computed using the 20,750 pounds used in production. A total variance cannot be computed because of the difference.
We can compute the materials variances as follows:
Materials purchase price
Labor variances are isolated when labor is used for production. They are computed in a manner similar to the materials variances, except that in the 3-column model the terms efficiency and rate are used in place of the terms quantity and price. The production department is responsible for both the prices paid for labor services and the quantity of labor services used. Therefore, the production department must explain why any labor variances occur.
Analysis of Variance Analysis for 6-6 Cost Control
Unfavorable rate variances may be explained by an increase in wages, or the use of labor commanding higher wage rates than contemplated. Unfavorable efficiency variances may be explained by poor supervision, poor quality workers, poor quality of materials requiring more labor time, machine breakdowns, and employee unrest.
EXAMPLE 6.2
Using the same data given in Example 6.1, the labor variances can be calculated as:
The variable overhead variances are computed in a way very similar to the labor variances.
The production department is usually responsible for any variable overhead variance.
Unfavorable variable overhead spending variances may be caused by a large number of factors: acquiring supplies for a price different from the standard, using more supplies than expected, waste, and theft of supplies. Unfavorable variable overhead efficiency variances might be caused by such factors as: poorly trained workers, poor-quality materials, faulty equipment, work interruptions, poor production scheduling, poor supervision, employee unrest, and so on.
When variable overhead is applied using direct labor hours, the efficiency variance will be caused by the same factors that cause the labor efficiency variance. However, when variable overhead is applied using machine hours, inefficiency in machinery will cause a variable overhead efficiency variance.
EXAMPLE 6.3
Using the same data given in Example 6.1, the variable overhead variances can be computed as follows:
Variable overhead spending variance = AH (AR - SR)
= (AH * AR) - (AH * SR)
= (10,080 hours) ($3.45 - $3.00) = $34,776 - $30,240
= $4,536 (U)
Variable overhead efficiency variance = (AH - SH) SR
= (10,080 hours - 10,000 hours) * $3.00 = $30,240 - $30,000
= $240 (U)
Analysis of Variance Analysis for 6-7 Cost Control
IV. Flexible Budgets and Performance Reports
A flexible budget is a tool that is extremely useful in cost control. The flexible budget is characterized as follows:
1. It is geared toward a range of activity rather than a single level of activity.
2. It is dynamic in nature rather than static. By using the cost-volume formula (or flexible budget formula), a series of budgets can be easily developed for various levels of activity.
The static (fixed) budget is geared for only one level of activity and has problems in cost control. Flexible budgeting distinguishes between fixed and variable costs, thus allowing for a budget which can be automatically adjusted (via changes in variable cost totals) to the particular level of activity actually attained. Thus, variances between actual costs and budgeted costs are adjusted for volume ups and downs before differences due to price and quantity factors are computed.
The primary use of the flexible budget is to accurately measure performance by comparing actual costs for a given output with the budgeted costs for the same level of output.
EXAMPLE 6.4
To illustrate the difference between the static budget and the flexible budget, assume that the Assembly Department of Omnis Industries, Inc. is budgeted to produce 6,000 units during June. Assume further that the company was able to produce only 5,800 units. The budget for direct labor and variable overhead costs is as follows: