Understanding and Analyzing Cost Variances in Production, Exams of Business Fundamentals

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P1 Management Accounting

Module: 09

Variance Analysis – Standard Costing

and unit sales and then comparing this to actual costs and sales. What follows is a variance analysis to determine why the standards were or were not achieved. This is a valuable process that enhances a business’s ability to maximise efficiency.

Why use standards?

We use standard costing for various different reasons. However, the main goal of standard costing is to maximise the efficiency of our production process while also minimising waste of any resource whether it be labour, materials or overheads. Standard costing helps us to achieve this through the following avenues: Setting accurate budgets – If we set accurate and realistic standards, this information can also be used to set effective budgets. Notice how calculating the cost per hot dog helped us budget for the day. Highlights areas of concern – Standard costs act as a benchmark. Through variance analysis, we can highlight the areas that require attention (not getting distracted by the mobile phone game, and possible overuse or under-budgeting for napkins). We can also highlight the areas that are performing well. Management can then focus their time and attention accordingly. Performance evaluation – Standard costing provides benchmarks and goals for staff to aspire to achieve (selling 500 hot dogs or making £1000 in this case). The system can then be used as a means of assessment for bonuses etc.

Planning – Having set standards of materials and labour allows us to plan ahead effectively. We know how many workers to hire, how many hours to allow and how much material to order before production has even started. This allows for effective resource allocation and budgetary planning. Inventory valuation – Standard costing provides a simple alternative for inventory valuation, in which stock can be valued at standard cost.

Calculating standard cost

Standard costing is a unique budgetary control in that it calculates a budgeted cost for each individual unit as opposed to a budget for a whole period or project. To calculate the standard cost of a unit, both the amount and the cost of the resources used are detailed. For example, standard costing for materials might be detailed as 5kg per unit at £25 per kg. The importance of such detail will become clear during our variance analysis section further on. Management might decide to set their standard cost based on previous performance, competitor’s performance, or simply in accordance with their own goals. Whichever they choose, the difficulty of the level of standard would fall into one of three categories: Ideal standard An ideal standard is technically only achievable if the production process is perfectly efficient. That means no waste, no downtime and normal loss. As this is practically impossible, setting an ideal standard will always result in

Labour rate Information from payroll or HR on current wage rates. Allowances for bonuses/overtime. Allowances for specialist workers. Forecasts of wage increases/current negotiations. Labour hours The standard to be used – i.e. ideal standard, attainable standard etc. Allowances for downtime, idle time. Work study exercises, i.e. studies of how much time should be required to complete each task. Specifications of each task to be performed and details of any special tasks involved. Production overhead costs Overhead absorption rates. Trend information and historical data. Quotations from suppliers.

Revising standard cost

Comparing results to standard costs which are out-dated is obviously a meaningless exercise. Therefore, standard costs need to be continually updated if they are to be useful. Standard costs should be revised so they are representative of current material prices, labour rates and methods of production.

2. Variance analysis

Any difference between the standard cost and the actual cost incurred is known as a variance. We use variance analysis to determine the size of the difference and why the difference occurred. You should recall that our standard costs include both price and quantity, e.g. £3 per kg at 25kg per unit. Therefore, when we break down our variances we will be able to see how much of our variance was caused by a price variance and how much was caused by a quantity variance. If we achieve an actual cost lower than our standard cost, the variance will be considered favourable. If the actual cost is higher, the variance is considered adverse.

Example

Imagine we are the management accountant at a company that manufactures office furniture – tables, chairs, desks etc. Let’s assume we operate using a standard costing system and are carrying out variance analysis on one of our products. The standard variable costs are as follows: Unit costs Direct material 17kg £5 per kg £ Direct labour 30 hours £3 per hour £ Variable overhead 30 hours £2 per hour £ £ We produced 400 units during the period. Our actual costs were as follows: Direct material 6,600kg £34, Direct labour 11,520 hours £32, Variable overhead 11,520 hours £24, Budgeted fixed production overhead £7, Actual fixed production overhead £9, Budgeted output (units) 350 Actual output (units) 400

Direct material cost variance

400 units at standard cost (£85/unit) £34, 400 units at actual cost £34, Variance £320 adverse To calculate this variance, we determine the standard material cost for the actual units produced (400 in this case) and compare it to the actual material cost of the actual units produced. In the above example, actual cost exceeds standard cost. This means the variance is adverse. This variance can relate to either price being more or less than expected or the quantity being more or less than expected. In this case, perhaps the adverse variance was caused by material price being higher and/or the quantity of material used to be more than expected. The next step then is to break the variance down into the price portion and the quantity portion.

Issues with stock valuation There may be times when then the quantity of material purchased, and the quantity of material used is different. In this case, we need to know which amount to use as our “actual quantity” in our direct material price variance calculation. The rule is if we value our stock at standard cost, we base our variance on material purchased. If we value our stock at actual cost, we base our variance on material used.

Direct labour cost variance

400 units at standard cost (£90/unit) £36, 400 units at actual cost £32, Variance £3,744 favourable To calculate this variance, we determine the standard labour cost of our actual output (400 units) and compare it to the actual labour cost of our actual output. In the above example actual cost is less than standard cost, leading to a favourable variance which indicates that we spent £3,744 less than expected on labour costs. This variance can relate to both price (here the price of staff could be less than expected) and quantity of labour (it may suggest we used less labour than expected). The next step is to break the variance down into the price portion and the quantity portion to get more information to help our decision making. Direct labour rate variance 11,520 hours should have cost (£3/hour) £34, 11,520 hours actually cost £32, Variance £2,304 favourable To calculate this variance, we determine the standard cost of the actual hours of labour and compare it to the actual cost of the actual hours of labour. In this example, the favourable variance indicates that we spent £2, less than standard due to us paying a lower hourly rate than expected. This may be because labour rates fell or less skilled staff were used, or perhaps the original estimate was poor.

Direct labour efficiency variance 400 units should have used (30 hours/unit) 12,000 hours 400 units actually used 11,520 hours Variance 480 hours favourable 480 hours at standard cost (£3/hour) £1,440 favourable To calculate this variance, we determine the standard number of hours required and compare to the actual number of hours that were required. To express the variance in monetary terms, we multiply the difference in hours by the standard hourly rate of labour. In this example, the favourable variance indicates that we spent £1,440 less than standard due to us requiring fewer labour hours than expected, perhaps due to more efficient procedures, better skilled labour, or again because of a poor original estimate. For a quick guide on how to calculate variances for the direct labour cost, direct labour rate and the direct labour efficiency, see the following graph: Reconcile As before, we need to reconcile the individual variances: Direct labour price variance £2,304 favourable Direct labour quantity variance £1,440 favourable Direct labour cost variance £3,744 favourable

For a quick guide on how to calculate variances for the variable overhead cost, variable overhead expenditure and the variable overhead efficiency, refer to the following diagram: Reconcile Variable overhead expenditure variance £1,382 Adverse Variable overhead efficiency variance £960 favourable Variable overhead cost variance £422 Adverse

Fixed production overhead variance

To calculate the variance, we need to calculate the amount of over/under absorption. You should be familiar with the following calculation from the absorption costing examples earlier on. First, we need to determine our overhead absorption rate: Budgeted fixed production overhead £7, Budgeted output (units) 350 Overhead absorption rate (per unit) £ Next, we need to calculate the total amount of fixed overheads absorbed. This is simply our overhead absorption rate multiplied by our number of units produced: Overhead absorption rate £ Actual output (units) 400 Fixed production overhead absorbed £8,

We can now work out the amount of under/over absorption: Actual fixed production overhead incurred £9, Fixed production overhead absorbed £8, Total amount of under absorption £1, Because our fixed overheads are under absorbed the variance is considered adverse. This is because our actual expenditure on fixed overheads exceeds the amount we absorbed, i.e. we overspent! We know that over/under absorption can occur due to two things: either our actual expenditure was different to our budget or our actual output was different to our budget. We can determine how much of our fixed production overhead variance relates to each through the following: Fixed production overhead expenditure variance This is simply the difference between budgeted and actual expenditure: Budgeted fixed production overhead £7, Actual fixed production overhead £9, Variance £2,000 adverse This adverse variance indicates that our fixed overhead costs were £2, higher than standard. This portion of our over/under absorption occurs due to actual expenditure being different to our budget. Fixed production overhead efficiency variance This is the amount of variance that will arise due to a difference in volume of units produced: Actual output (units) 400 Budgeted output (units) 350 Variance 50 x overhead absorption rate (£20 per unit) 1,000 favourable The variance of £1,000 is considered favourable because actual units produced exceed budgeted units, i.e. we beat our target! Now look at the following diagram for a quick reminder of how to calculate the variance for fixed production overheads, fixed production overhead expenditure and fixed production overhead efficiency:

Budget £ Sales and production volume (units) 350 Selling price (per unit) 500 Variable cost (per unit) 235 Fixed cost (per unit) 20 Budget profit per unit 245 Actual Sales and production volume (units) 400 Selling price (per unit) 480 The cost information above is simply a summary of the cost information from our previous example rewritten here for your convenience. Selling price variance Standard selling price 500 Actual selling price 480 Difference 20 adverse x sales volume (units) 400 Selling price variance 8,000 adverse To calculate this variance, we take the difference between actual and standard selling price and multiply it by actual sales volume. In this example the variance is adverse, indicating that our revenue was £8,000 less than standard due to us selling our product at a lower price than expected. Perhaps that was due to market prices falling, negotiation of discounts by customers, or original estimates being poor. Sales volume profit variance Budgeted sales volume 350 Actual sales volume 400 Difference 50 favourable x budget profit per unit 245 Sales volume variance 12,250 favourable To calculate this variance, we take the difference between our budgeted and actual sales volume and multiply it by our budgeted profit per unit. The variance is favourable, showing that our profit is £12,250 higher due to our sales volume being higher than expected, perhaps due to the lower

price being charged (see the price variance), a good marketing campaign or an unexpected increase in demand. Note that we use the standard profit per unit rather than actual profit in this variance calculation. Look at this diagram for a summary of how to calculate sales variances:

Budget to actual profit reconciliation

Once we have calculated all our variances, we can check their accuracy by preparing reconciliation between budget and actual profit. The statement below reconciles budgeted gross profit to actual gross profit, incorporating each of the variances we have just calculated. A manager in charge of this department would look over this statement in detail and attempt to understand why the variances happened using their knowledge of the business. Their aim will be to try to avoid adverse variances (e.g. trying to manage material costs better) and keep the favourable variances (e.g. retain the lower pricing policy if it was that that caused sales volumes to rise so much).

Fixed overhead volume variance This variance does not exist under a marginal costing system. This is because fixed overheads are not absorbed under marginal costing and therefore are not affected by volume. Sales volume contribution variance The sales volume contribution variance is very similar to the sales volume profit variance. The only difference is that in this calculation we use contribution per unit rather than profit per unit. This is because the profit variance incorporates absorbed fixed costs which do not exist in a marginal costing system. To calculate this variance for the above example, we first need to work out budgeted contribution per unit. Remember, contribution does not include a deduction for fixed costs: Selling price per unit £ Variable cost per unit £ Contribution per unit £ The next step, as with the sales volume profit variance, is to multiply this contribution amount by the variance in sales volume: Budgeted sales volume 350 Actual sales volume 400 Difference 50 favourable x budget contribution per unit £ Sales volume variance £13,250 favourable Note that we use budgeted rather than actual contribution in this variance calculation.

Budget to actual reconciliation

With our updated variances, we are now in a position to produce a budget to actual profit reconciliation: Budget to actual profit reconciliation under marginal Original budgeted contribution costing £ £ (350 units x £265 contribution per unit) Sales volume contribution variance 13,

Selling price variance Cost variances

Direct material price (1,320) Direct material usage 1, Direct labour rate 2, Direct labour efficiency 1, Variable overhead expenditure (1,382) Variable overhead efficiency Actual contribution

Budgeted fixed costs (7,000) Fixed overhead expenditure variance Actual gross profit

We know the reconciliation is correct as the final figure we arrive at is our original gross profit figure of £92,002 - the same as in the previous example. Remember that our overall profit does not change between marginal costing and absorption costing (as long as there is no change in inventories in the year). Also notice how we exclude fixed cost variances from the contribution section. You should already recall that this is because fixed costs are not included in contribution in a marginal costing system but are rather deducted in full at the end of each period.