STANDARD COST DEFINITION:

An estimated or predetermined cost of performing an operation or producing a good or service, under normal conditions. Standard costs are used as target costs (or basis for comparison with the actual costs), and are developed from historical data analysis or from time and motion studies. They almost always vary from actual costs, because every situation has its share of unpredictable factors. It is also called as normal cost. Hence, a standard is a type of budgeted number; one characterized by a certain amount of rigor in its determination, and by its ability to motivate managers and employees to work towards the companys objectives for production efficiency and cost control.

Standard Costing Systems: A standard costing system initially records the cost of production at standard. Units of inventory flow through the inventory accounts (from work-in-process to finished goods to cost of goods sold) at their per-unit standard cost. When actual costs become known, adjusting entries are made that restate each account balance from standard to actual (or to approximate such a restatement). The components of this adjusting entry provide information about the companys performance for the period, particularly with regard to production efficiency and cost control.

Standard costing system is not a distinct system of accounting but it is a technique which is applicable in all types of costing such as process costing or job costing. The standard costing technique consists in- (a) element wise standard costs are predetermined; (b) standard costs are compared with actual costs; & (c) with reference to causes & points of incidence, variances are measured & analyzed.

Example:

If you were to design a cost accounting system with no accounting education other than financial accounting courses, you would probably design an accounting system that collects, summarizes, and reports actual costs. This approach would be consistent with the implicit assumption throughout every financial accounting course that when financial statements report historical cost data, such as would normally be the case for cost-of-goods-sold and ending inventory, that the information reported represents actual costs. Therefore, it comes as a surprise to most students that the initial journal entries to record the production and movement of inventory in the costing systems of most manufacturing firms are not based on actual costs at all, but rather are based on budgeted per-unit costs.

In most manufacturing firms, the initial journal entries to debit work-in-process, finished goods and cost-of-goods-sold are based on the actual quantity of output produced, multiplied by budgeted data about the inputs necessary to produce those outputs, and the budgeted costs of those inputs. Then, at the end of the month (or possibly quarterly), an adjusting or closing entry is made to record in the inventory accounts the difference between actual costs incurred, and the budgeted information that has formed the basis for the journal entries during the month. The nature of this adjusting entry depends on the materiality of the amounts involved. If the differences between actual costs and budgeted costs are small, this adjusting entry might be made in an expedient manner, involving only cost-of-goods-sold, but if the differences are large, the adjusting entry might also involve work-inprocess and finished goods inventory accounts. The accounting system described above is called a standard costing system, and it is widely-used by companies in the manufacturing sector of the economy.
2

There is an important distinction between standard costs and a standard costing system. Standard costs are a component in a standard costing system. However, even companies that do not use standard costing systems can utilize standards for budgeting, planning, and variance analysis.

Standard costing is Variance analysis between the Standard and Actual components. Variance Analysis shows the performance of company or a project with budgets / standard. Standard costing is defined by the ICMA, London, As the preparation and use of Std. costs, Their comparison with actual costs and the analysis of variances to their causes and point of incidence. Standard costing is a system of costing which can be used in any method of costing, like job costing, process costing, etc.

Reasons for using a Standard Costing System: There are several reasons for using a standard costing system:

Cost Control: The most frequent reason cited by companies for using standard costing systems is cost control. One might initially think that standard costing provides less information than actual costing, because a standard costing system tracks inventory using budgeted amounts that were known before the first day of the period, and fails to incorporate valuable information about how actual costs have differed from budget during the period. However, this reasoning is not correct, because actual costs are tracked by the accounting system in journal entries to accrue liabilities for the purchase of materials and the payment of labor, entries to record accumulated depreciation, and entries to record other costs related to production. Hence, a standard costing system records both

budgeted amounts (via debits to work-in-process, finished goods, and cost-of-goods-sold) and actual costs incurred. The difference between these budgeted amounts and actual amounts provides important information about cost control. This information could be available to a company that uses an actual costing system or a normal costing system, but the analysis would not be an integral part of the general ledger system.

Smooth out short-term fluctuations in direct costs: Similar to the reasons given in the previous chapter for using normal costing to average the overhead rate over time, there are reasons to average direct costs.

When actual overhead rates are used, production volume of each product affects the reported costs of all other products: This reason represents an advantage of standard costing over actual costing, but does not represent an advantage of standard costing over normal costing.

Costing systems that use budgeted data are economical: Accounting systems should satisfy a cost-benefit test: more sophisticated accounting systems are more costly to design, implement and operate. If the alternative to a standard costing system is an actual costing system that tracks actual costs in a more timely (and more expensive) manner, then management should assess whether the improvement in the quality of the decisions that will be made using that information is worth the additional cost. In many cases, standard costing systems provide highly reliable information, and the additional cost of operating an actual costing system is not warranted.

Summary of Actual Costing, Normal Costing and Standard Costing: The following table summarizes and compares three commonly-used costing systems.

Actual System

Costing

Normal Costing System

Standard Costing System

Direct Costs:

(Actual prices or rates x actual quantity of inputs per output) x actual outputs

(Actual prices or rates x

(Budgeted prices or rates x

actual quantity of inputs standard inputs allowed for per output) x actual each output) x actual outputs

outputs

Actual overhead rates Overhead Costs: x actual quantity of the allocation incurred. base

Budgeted overhead rates x actual quantity of the

Budgeted

overhead

rates

(standard inputs allowed for actual outputs achieved)

allocation base incurred.

The following points are worth noting:

1.

All three costing systems record the cost of inventory based on actual output units produced. The static budget level of production does not appear anywhere in this table.

2.

Actual costing and normal costing are identical with respect to how direct costs are treated.

3.

With respect to overhead costs, actual costing and normal costing use different overhead rates, but both costing systems multiply the overhead rate by the same amount: the actual quantity of the allocation base incurred.

4.

Normal costing and standard costing use the same overhead rate.

5.

Standard costing records the cost of inventory using a flexible budget concept: the inputs that should have been used for the output achieved.

There are costing systems other than these three. For example, some service sector companies apply direct costs using budgeted prices multiplied by actual quantities of inputs. For example, many accounting firms track professional labor costs using budgeted professional staff hourly rates multiplied by actual staff time incurred on each job.

The

Techniques

of

standard

costing:

The techniques of standard costing are the following:

a. There is a pre-determination of data which are related to production. Thus pre-determination of materials & labour operations in details which is necessary for each product; pre-

determination of losses which are unavoidable, level of expected efficiency, level of activity etc are involved in standard costing. b. For each element i.e., material, labour & overhead, standard costs are setup in detail. c. Ascertainment of variances, which arises as a result of differences between the actual costs & corresponding standard cost in detail & element wise; is done by the comparing the actual costs & performance with corresponding standards. d. For the purpose of determining the causes for the differences between the actual costs & standard costs, analysis of variances are done. e. Presentation is made in a most suitable manner to the appropriate management, of the information which is available from the above

analysis so that it becomes possible to take remedial measures or the revising the standards, if it is necessary.

In the concerns which manufacture standard products repeatedly, standard costing can be most suitably applied, because in those concerns, the standards which are realistic & attainable can be set easily. This does not mean that the benefit from the standard costing technique cannot be available to the industries which does jobs of non-repetitive nature e.g., manufacture of automobiles, ships etc because many operations & processes are there which is undertaken by these industries for which it becomes possible to set standard & apply standard costing technique.

Advantages of standard costing:

The main advantages of standard costing are:

a. Comparison is made between actual performance & pre-determined standard, thereby exposing favorable or adverse variances. Establishment of variances which arises due to external influences, for instance, increase in price over which management has little control; & which arises due to internal influences, becomes possible. Hence, indication can be made of places where remedial action has become necessary & how the same can be done. b. Standard costing is an example of management by exception, in that managements attention can be directed by studying variances towards the items those are not performing according to plan. Management, by confining its attention to the deviations from the plans, can use its energies in the directions which is most profitable. c. As under standard costing system variances can be reported, cost control is more effective under this system. Reappraisal of working methods, materials used, etc. gets encouraged by the whole procedure of setting, revising & monitoring standards; thereby leading to cost reduction. d. As opposed to average of past performances, what cost should be assigned to the parts & products is represented by standard costing, & as such, compared to historical costs, standard costing are a better guide to pricing. e. A simple basis of valuation of stock is provided by standard costing. f. Identification of responsibilities for performances is enabled by standard costing. g. Being a pre-determined costs, standard costing are particularly useful in planning & budgeting. Since information regarding deviations of actual costs from standard costs is

provided continuously, for the coming years preparation of a more accurate & effective budget becomes possible. h. A positive, cost-effective attitude can be created among all levels of management through properly developed standard costing system with full participation & involvement.

Limitations of standard costing:

The limitations of standard costing are:

a. Installation & maintenance of standard costing system may be expensive & time-consuming. A high level of skill & expertise is required for standard costing system. Hence, small concerns may find establishing this system difficult. b. For fixing responsibilities, segregation of variances into two categories controllable, which are caused by internal factors & uncontrollable, which are caused by external factors, becomes essential. Such segregation is not always an easy task. c. Standards rapidly becomes out of date in situations where rates, prices & methods change quickly, thereby they lose their control & motivational effects. d. For all kind of industries standard costing system is not suitable. Industries producing nonstandardized products or jobs which are made according to specifications of the customers, may find the system costly & unsuitable. e. Standards set at too high a level will be unattainable. In such a situation, morale & motivation of the employees are adversely affected & thereby lead to resistance by standard costing.
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Distinction between Standard Costing & Budgetary control:

Controlling of business operations is the common objectives of both the systems of standard costing & budgetary control. Accounting of variances between actual results & a pre-determined plan is involved in both the techniques. Investigation of variances & taking of corrective action is done in both the cases.

There are inter-relations between the two systems & both are complementary to each other but they are not inter-dependent. Operation of one without the other is possible. However, if the two systems are operated together, the control system of an organization will be most effective.

Although, in principle, the two systems are similar; but in scope & technique of operation, they are different. The important points of difference are:

a. Estimation of costs of products & services is involved in standard costing process. Only to cost the scope of standard costing is limited. Whereas, budgetary control is concerned with all the functional areas of business & estimation of revenues as well as expenditure is involved by it. Thus for activities like production, purchases, sales & distribution, cash flows, capital expansion etc. the budgets are prepared. Thereby, the scope of the budgetary control is much wider. b. In standard costing, comparison of actual cost with standard costs is made for the purpose of exercising control whereas in budgetary control by comparing actual figures with those budgeted, control is exercised. c. By nature wise, standard costing is more intensive in nature while budgetary control is more extensive in nature.
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d. Operation in parts or elements is not possible under standard costing. All expenditure items which are included in cost units are needed to be accounted for. Whereas, depending upon the attitude of the management, operation in parts, sections or even departments is possible under budgetary control. Preparation of budgets only for certain key areas of the business is also possible. e. Concept wise, standard costing is a unit concept while budgeted cost is a total concept. f. Under the standard costing system, usually through double entry accounts, standards & the resulting variances are usually revealed. However, budgets are memorandum figures & in double entry accounting system they do not form part. g. Standard costing is a projection of cost accounts while budgetary control is a projection of financial accounts. h. Standardization of products is required by standard costing whereas; standardization of products does not necessarily involve under budgetary control. i. Standard costing is a far more technically improved system by which analysis in minute details can be done of the causes of the variances & in a more specific & effective manner, exercise of control is possible. However, budgeting & control of expenses are by nature more broad & elementary. j. Only when standard costing becomes inappropriate for current operating conditions, they are revised. Such kind of revision may take place more or less frequently than budget revisions. However, revision of budgets is done periodically normally on annual basis.

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COST VARIANCES:

Definition: It is the difference between an actual cost and the associated budgeted or estimated cost.

For Cost variance = Std. Actual Profit Variance = Actual Standard/Budgeted.

TYPES OF VARIANCES:

Variances can be divided according to their effect or nature of the underlying amounts.

When effect of variance is concerned, there are two types of variances:

When actual results are better than expected results given variance is described as favorable variance. In common use favorable variance is denoted by the letter F - usually in parentheses (F).

When actual results are worse than expected results given variance is described as adverse variance, or unfavourable variance. In common use adverse variance is denoted by the letter U or the letter A - usually in parentheses (A).

The second typology (according to the nature of the underlying amount) is determined by the needs of users of the variance information and may include e.g.:

Variable cost variances

Direct material variances

12

o o

Direct labour variances Variable production overhead variances

Fixed production overhead variances Sales variances

ANALYSIS OF VARIANCES:

Variance analysis, in budgeting (or management accounting in general), is a tool of budgetary control by evaluation of performance by means of variances between budgeted amount, planned amount or standard amount and the actual amount incurred/sold. Variance analysis can be carried out for both costs and revenues

A)MATERIAL VARIANCES: Material cost = Qty. x Price ( Q x P ) Std. Cost = Std. qty. x Std. Price (SQ*SP) Actual Cost = Actual qty. x Actual Price(AQ*AP)

Material Variance occurs by two factors : 1. Usages (Qty.), 2. Price

- Variance in usages is responsibility of production department to use unit in efficiently manner and reduce the scrap, abnormal losses.

- Variance in price is responsibility of purchase department to purchase raw materials at cheap rate and reduce cost to availed discount, etc
13

1)Material Cost Variance(MCV):

Material cost variance is the deviation from the standard direct material cost, of the actual production volume and the actual cost of direct material. Material cost variance is also concerned as a sum of the direct material usage and price variances. The variances can be favorable or unfavorable. If the actual cost is lower than the standard cost, it is considered as favorable variance and if the actual cost exceeds the standard cost, the difference is unfavorable. There is not any rule of thumb for the calculation of direct material cost variances.

Formula:

MCV = Standard Cost for standard quantity - Actual Cost for actual quantity = (SQ*SP)-(AQ*AP) = Standard cost Actual cost = (SC-AC)

Standard quantity (SQ) should be revised if standard outputs and actual outputs differ. Revised Where, SQ SP AQ = = = Standard Standard Actual Quantity Price Quantity standard quantity (RSQ) = (SQ/SO x AO)

14

AP SO AO

= = =

Actual Standard Actual

Price Output Output

Material cost variance represents the total of material price variance and material usage variances. As such, MCV = Material price variance (MPV) + Material usage variance(MUV) If the resulting figure is positive, the difference is denoted by favorable variance i.e.(F) and if the resulting figure is negative, the difference is denoted by unfavorable variance i.e.(U).

Illustration - Standard quantity of material Q for 500 units of output is fixed as 800 kg. Standard Actual Actual price per quantity price Actual of kg. of of material material material output was was Q is Q $ estimated was 4.5 400 to be 800 per $ 5 kg. kg. units.

Solution, Since the standard outputs and actual outputs differ, the standard quantity should be revised. Revised standard quantity (RSQ) = (SQ/SO) x AO =800/500 x 400 = 640 units. Now, Material Cost Variance(MCV) = (SQ x SP)-(AQ x AP) = (640x5)-(800x4.5) = $ 400 (U)

Since, the resulting figure is negative the variance is denoted as unfavorable i.e. (U).

15

2)MATERIAL USAGE VARIANCE (MUV):

Direct Material Usage Variance is the measure of difference between the actual quantity of material utilized during a period and the standard consumption of material for the level of output achieved.

Formula is:

- Actual Quantity x Standard Price

= Standard Quantity x Standard Price

-Standard Cost of Actual Quantity

= Standard Cost of Standard Quantity

- (Actual Quantity - Standard Quantity) x Standard Price

So, MUV= (SQ-AQ)*SP

Since the effect of any variation in material price from the standard is calculated in the material price variance, material usage variance is calculated using the standard price.

Example: Cement PLC manufactured 10,000 bags of cement during the month of January. Consumption of raw materials during the period was as follows:

Quantity Material Used

Standard Usage Per Actual Price Bag

Standard Price

Limestone

100 tons

11 KG

$75/ton

$70/ton

16

Clay Sand

150 tons 250 tons

14 KG 26 KG

$21/ton $11/ton

$20/ton $10/ton

Material Usage Variance will be calculated as follows:

Step 1: Calculate Standard Quantity

11 Limestone: 10,000 units X 1000 14 Clay: 10,000 units X 1000 26 Sand: 10,000 units X 1000

/ = 110 tons

/ = 140 tons

/ = 260 tons

Step 2: Calculate the Variance

Material Usage Variance = [Actual Quantity - Standard Cost (Step 2)] x Standard Price

Limestone:

(100 - 110)

$70

($700)

Favorable

17

Clay: Sand:

(150 - 140) (250 - 260)

x x

$20 $10

= =

$200 ($100)

Adverse Favorable

Total Usage Variance

($600)

Favorable

Note: Actual price paid for the acquisition of materials shall be ignored since the variation between standard price is already accounted for in the material price variance.

Analysis:

A favorable material usage variance suggests efficient utilization of materials. An adverse material usage variance indicates higher consumption of material during the period as compared with the standard usage.

3)MATERIAL PRICE VARIANCE (MPV):

Direct Material Price Variance is the difference between the actual cost of direct material and the standard cost of quantity purchased or consumed.

Formula for MPV is:

Actual

Actual Quantity x Actual Price

= Quantity x Standard Price

Standard Cost of

- Actual Cost =Actual Quantity

So, MPV= (SP-AP)*AQ

18

Actual Quantity is the quantity purchased during a period if the variance is calculated at the time of material purchase

Actual Quantity is the quantity consumed during a period if the variance is calculated at the time of material consumption Analysis

A favorable material price variance suggests cost effective procurement by the company. An adverse material price variance indicates higher purchase costs incurred during the period compared with the standard.

4)MATERIAL MIXTURE VARIANCE (MMV):

Direct Material Mix Variance is the measure of difference between the cost of standard proportion of materials and the actual proportion of materials consumed in the production process during a period.

Formula:

MMV=Standard Rate*(Revised quantity-Actual Quantity)

= SR*(RQ-AQ)

19

As material mix variance is an extension of the material usage variance, the variance is based on the standard price rather than actual price since the difference between actual and standard material price is accounted for separately in the material price variance.

Example:

Cement PLC manufactured 10,000 bags of cement during the month of January. Consumption of raw materials during the period was as follows:

Quantity Material Used

Standard Mix Per Actual Price Bag

Standard Price

Limestone Clay Sand

100 tons 150 tons 250 tons

11 KG 14 KG 26 KG

$75/ton $21/ton $11/ton

$70/ton $20/ton $10/ton

Material Mix Variance will be calculated as follows:

Step 1: Calculate the total consumption of raw materials

Total Raw Materials Consumption (100 + 150 + 250) = 500 tons

Step 2: Calculate the Standard Mix

We need to calculate the quantity of each raw material which would have been consumed had the total usage of raw materials (500 tons) been based on the standard mix.

Limestone: Clay: Sand:

500 tons units x 500 tons units x 500 tons units x

11 / 51* = 14 / 51* = 26 / 51* =

108 tons 137 tons 255 tons

* Total Quantity under Standard Usage (11 + 14 + 26) = 51 KG per bag

Note that the sum of the standard mix of raw materials calculated above equals the actual total consumption of 500 tons. This is because in material mix variance, we are not concerned about the efficiency of raw material consumption but rather their relevant proportions.

Step 3: Calculate the Variance

Material Usage Variance = [Actual Mix - Standard Mix (Step 2)] x Standard Price

Limestone: Clay:

(100 - 108) (150 - 137)

x x

$70 $20

= =

($560) $260

Favorable Adverse

21

Sand:

(250 - 255)

$10

($50)

Favorable

Total Usage Variance

($350)

Favorable

Note: Actual price paid for the acquisition of materials shall be ignored since any variation between standard price is already accounted for in the material price variance..

Analysis

A favorable material mix variance suggests the use of a cheaper mix of raw materials than the standard. Conversely, an adverse material mix variance suggests that a more costly combination of materials have been used than the standard mix.

5)MATERIAL YIELD VARIANCE(MYV):

Direct Material Yield Variance is a measure of cost differential between output that should have been produced for the given level of input and the level of output actually achieved during a period.

Formula: MYV= (Standard quantity Revised quantity) x Standard price

= (SQ-RQ)*SP

Revised Quantity=Total quantity of actual mix/ total quantity of standard mix*standard quantity

Example

22

Cement PLC manufactured 10,000 bags of cement during the month of January. Consumption of raw materials during the period was as follows:

Quantity Material Used

Standard Mix Per Actual Price Bag

Standard Price

Limestone Clay Sand

100 tons 150 tons 250 tons

11 KG 14 KG 26 KG

$75/ton $21/ton $11/ton

$70/ton $20/ton $10/ton

Material Yield Variance shall be calculated as follows:

Step 1: Calculate the Standard Yield for the total materials input

500 tons of materials should have yielded 9,804 bags

Standard Yield = 500 tons x 1000 / 51 KG = 9,804 bags

Step 2: Calculate the Standard Cost of materials per bag

Total material cost of 1 bag of cement:

23

Limestone: Clay: Sand:

11 KG x 14 KG x 26 KG x

$70 $20 $10

= = =

$770 $280 $260

Total

$1,310 per bag

Actual material price should be ignored since the variance between actual and standard price is accounted for in the material price variance.

Step 3: Calculate the Total Yield Variance

Material Usage Variance = [Actual Yield - Standard Yield (Step 1)] x Standard Cost / Unit (Step 2)

Actual Yield - Standard Yield = 10,000 - 9,804 (Step 1) = 196 bags

Total Material Yield Variance = 196 bags x $1,310 (Step 2) = $256,760 Favorable

As the actual output achieved during the period is higher than the standard yield, the variance is favorable. Favorable material yield variance indicates the amount of savings in material costs as a result of better output yield than the standard.

24

Step 4: Calculate the Material Wise Yield Variances

Individual material yield variance can be calculated in a similar way to the total yield variance.

Actual Yield - Standard Yield Materials: (Step 3) x

Standard Cost per bag = (Step 2) Yield Variance

Limestone: Clay: Sand:

196 bags 196 bags 196 bags

x x x

$770 $280 $260

= = =

$150,920 $54,880 $50,960 $256,760

Note that sum of individual material yield variances equals the total yield variance calculated in step 3.

Analysis A favorable material yield variance indicates better productivity than the standard yield resulting in lower material cost .Conversely, an adverse material yield variance suggests lower production achieved during a period for the given level of input resulting in higher material cost. THEREFORE, MCV = MUV + MPV MUV = MYV + MMV

25

B)LABOUR VARIANCES:

A labor variance arises when the actual expense associated with a labor activity varies (either better or worse) from the expected amount. The labor variance concept is most commonly used in the production area, where it is called a direct labor variance.

This variance can be subdivided into two additional variances, which are:

Labor efficiency variance. Measures the difference between actual and expected hours worked, multiplied by the standard hourly rate.

Labor rate variance. Measures the difference between the actual and expected cost per hour, multiplied by the actual hours incurred.

The labor variance can be used in any part of a business, as long as there is some compensation expense to be compared to a standard amount. It can also include a range of expenses, beginning with just the base compensation paid, and potentially also including payroll taxes, bonuses, the cost of stock grants, and even benefits paid.

1)LABOUR COST VARIANCE(LCV): Direct labour cost variance is the difference between the standard cost for actual production and the actual cost in production. Labor cost variance can be defined as the deviation of the actual direct wages paid from the direct wages specified for the standard output.

Labor cost variance represents the total of the labor rate variance and the labor efficiency variance. Therefore, LCV = Labour rate variance (LRV) + Labour efficiency variance LEV)

26

If the resulting figure is positive, the difference is denoted by F i.e. favorable variance and if the resulting figure is negative, the difference is denoted by U i.e. unfavorable variance.
FORMULA:

LCV= Standard cost-Actual cost

=SC-AC

There are two kinds of labour variances. Labour Rate Variance is the difference between the standard cost and the actual cost paid for the actual number of hours. Labour efficiency variance is the difference between the standard labour hour that should have been worked for the actual number of units produced and the actual number of hours worked when the labour hours are valued at the standard rate.

2)LABOUR RATE VARIANCE (LRV):

Direct labor rate variance (also called direct labor price/spending variance or wage rate variance) is the product of actual direct labor hours and the difference between the standard direct labor rate and actual direct labor rate. Direct labor rate variance is similar to direct material price variance. The following formula is used to calculate direct labor rate variance:

DL Rate Variance = ( SR AR ) AH

Where, SR is the standard direct labor rate

27

AR

is

the

actual

direct

labor

rate

AH are the actual direct labor hours Analysis Direct labor rate variance determines the performance of human resource department in negotiating lower wage rates with employees and labor unions. A positive value of direct labor rate variance is achieved when standard direct labor rate exceeds actual direct labor rate. Thus positive values of direct labor rate variance are favorable and negative values are unfavorable. However, a positive value of direct labor rate variance may not always be good. When low skilled workers are recruited at lower wage rate, the direct labor rate variance will be favorable however, such workers will be inefficient and will generate a poor direct labor efficiency variance. Direct labor rate variance must be analyzed in combination with direct labor efficiency variance. Example: Calculate the direct labor rate variance if standard direct labor rate and actual direct labor rate are $18.00 and $17.20 respectively; and actual direct labor hours used during the period are 800. Is the variance favorable or unfavorable? Solution

Standard Rate

$ 18.00

Actual Rate

17.20

28

Difference Per Hour

0.80

Actual Hours

130

Direct Labor Rate Variance

$104

Since the actual labor rate is lower than the standard rate, the variance is positive and thus favorable.

3)LABOUR EFFICIENCY VARIANCE(LEV): Direct labor efficiency variance (also called direct labor quantity/usage variance) is the product of standard direct labor rate and the difference between the standard direct labor hours allowed and actual direct labor hours used. The basic concept of direct labor efficiency variance is similar to that of direct material quantity variance. Formula:

DL Efficiency Variance = ( SH AH ) SR

Where, SH AH are are the the standard actual direct direct labor labor hours hours allowed used

SR is the standard direct labor rate per hour The standard direct labor hours allowed (SH) in the above formula is the product of standard direct labor hours per unit and number of finished units actually produced.
29

Analysis: The purpose of calculating the direct labor efficiency variance is to measure the performance of production department in utilizing the abilities of the workers. A positive value of direct labor efficiency variance is obtained when the standard direct labor hours allowed exceeds the actual direct labor hours used. Thus a positive value is favorable. Negative value of direct labor efficiency variance implies that more direct labor hours have been used than actually needed.. 4)LABOUR MIX VARIANCE (LMV): LMV is also known as Gang Composition Variance. The term gang represents the composition of more than one grade workers/employees. This composition may differ in between the standard and the actual. Hence, the labor mix or gang composition variance occurs due to the difference between standard labor grades specified and actual labor grades utilized.

Formula:

LMV Where, LMV SR RH AH

SR

(RH

AH)

= = = =

Labor Standard Revised Actual

mix

variance Rate hours hours

standard

NOTE: RST = (Total hours of actual mix/Total hours of standard mix) x Standard hours of each grade of
30

employees.

If the resulting figure is positive, it is denoted as favorable and if the resulting figure is negative, it is denoted as unfavorable or adverse variance. 5)LABOUR YIELD VARIANCE (LYV): The labor yield variance is one of the components of labor efficiency variance, which results from the difference between actual output of worker and standard output of worker specified. Labor yield variance can be obtained from the difference between the labor mix variance and labor idle time variance.

Formula: LYV Where, AH SH SR = = = Standard Actual Standard rate per hours hours unit = (SH-AH) x SR

If the resulting figure is positive it is denoted as favorable variance and if the resulting figure is negative, it is denoted as unfavorable or adverse variance. HENCE, LCV=LEV+LRV LEV=LYV+LMV
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C)SALES VARIANCES:

Sales variance is the difference between actual sales and budget sales. It is used to measure the performance of a sales function, and/or analyze business results to better understand market conditions. There are two reasons actual sales can vary from planned sales: either the volume sold varied from plan (sales volume variance), or sales were at a different price from what was planned (sales price variance). Both scenarios could also simultaneously contribute to the variance.

For example: The plan was to sell 5 widgets at $3 each, for a budgeted sales of: (5*$3)=$15. In reality, 6 widgets were sold at $2 each, for an actual sales of: (6*$2)=$12. The total variance was thus ($12-$15)= $3Unfavourable or minus $3, since total sales was less than planned.

1) SALES VALUE VARIANCE (SVV):

This Variance is also called Sales revenue variance. This is the net variance of sales as a whole. It is the difference between budgeted sales and actual sales .

The formula for computing this variance is: Sales Value Variance = Actual Sales Budgeted Sales

If actual sales are more than the budgeted sales a favourable variance would be reported and vice versa. This variance is on account of difference in price or volume of sales. It is further subdivided into two variances as (i) Sales price variance and (ii) Sales volume variance 2) SALES VOLUME VARIANCE (SVLV):

32

The sales volume variance is the difference between the actual and expected number of units sold, multiplied by the budgeted price per unit.

The formula is:

SVLV= (Budgeted quantity sold-Actual quantity sold) x Budgeted price per unit

= (BQ-AQ)*BP

An unfavorable variance means that the actual number of units sold was lower than the budgeted number sold. If the product's selling price is lower than the budgeted amount, this may spur sales to such an extent that the sales volume variance is favorable, even though the selling price variance is unfavorable..

Example:

The marketing manager of Hodgson Industrial Design estimates that the company can sell 25,000 blue widgets for $65 per unit during the upcoming year. This estimate is based on the historical demand for blue widgets, as supported by new advertising campaigns in the first and third quarters of the year. During the new year, Hodgson does not have a first quarter advertising campaign, since it is changing advertising agencies at that time. This results in sales of just 21,000 blue widgets during the year. Its sales volume variance is:

(21,000

Units

sold

25,000

Budgeted

units)

$65

Budgeted

price

per

unit

= $260,000 Unfavorable sales volume variance.

3) SALES PRICE VARIANCE (SPV):

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The selling price variance is the difference between the actual and expected revenue that is caused by a change in the price of a product or service. The formula is:

SPV= (Budgeted price - Actual price) x Actual quantity

= (BP-AP)*AQ

An unfavorable variance means that the actual price was lower than the budgeted price. The budgeted price for each unit of product or sales is developed by the sales and marketing managers, and is based on their estimation of future demand for these products and services, which in turn is affected by general economic conditions and the actions of competitors. If the actual price is lower than the budgeted price, the result may actually be favorable to the company, as long as the price decline spurs demand to such an extent that the company generates an incremental profit as a result of the price decline.

Example:

The marketing manager of Hodgson Industrial Design estimates that the company can sell a green widget for $80 per unit during the upcoming year. This estimate is based on the historical demand for green widgets. During the first half of the new year, the price of the green widget comes under extreme pressure as a new supplier in Ireland floods the market with a lower-priced green widget. Hodgson must drop its price to $70 in order to compete, and sells 20,000 units during that period. Its selling price variance during the first half of the year is:

($70 Actual price - $80 Budgeted price) x 20,000 units = $(200,000) Selling price variance

4) SALES QUANTITY VARIANCE (SQV):

It is also known as Sales Sub-Volume Variance. It is that portion of SVV which is due to the difference between the Budgeted Quantity of sales and the Revised Quantity of sales.

Formula:

SQV= (Budgeted Quantity- Revised Quantity)*Budgeted Price

= (BQ-RQ)*BP This variance arises only when there are 2 or more products are sold. SQV is said to be favourable when revised quantity is more than budgeted quantity and is said to be adverse when budgeted quantity is more than revised quantity. 5) SALES MIX VARIANCE (SMV): Effect on profit of selling a different proportionate mix of products than had been budgeted. This variance arises when different products have different contribution margins. The sales mix variance shows how well the department has done in terms of selling the more profitable products while the sales volume variance measures how well the firm has done in terms of its sales volume. It is the difference between budgeted sales mix and actual sales mix. Formula: SMV= (Revised quantity-Actual quantity)*Budgeted price = (RQ-AQ)*BP RQ= total quantity of actual mix/ total quantity of budgeted mix*budgeted quantity SMV is said to be favourable when actual sale quantity exceeds revised quantity and is said to be adverse when revised quantity exceeds budgeted quantity.

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HENCE, SVV= SVLV + SPV SVLV=SQV + SMV

D)OVERHEAD VARIANCES:

CONCEPT OF OVERHEAD:

In business, overhead or overhead expense refers to an ongoing expense of operating a business; it is also known as an "operating expense". Examples include rent, gas, electricity, and wages. The term overhead is usually used when grouping expenses that are necessary to the continued functioning of the business but cannot be immediately associated with the products or services being offered (i.e., do not directly generate profits). Closely related accounting concepts are fixed costs and variable costs as well as indirect costs and direct costs.Overhead expenses are all costs on the income statement except for direct labour, direct materials, and direct expenses. Overhead expenses include accounting fees, advertising, insurance, interest, legal fees, labor burden, rent, repairs, supplies, taxes, telephone bills, travel expenditures, and utilities.

OVERHEAD VARIANCES:

It implies variation in absorption or recovery of overheads.

a)FIXED OVERHEAD VARIANCES:

1)TOTAL FIXED OVERHEAD VARIANCE (FOV):

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FOV is the difference between the standard fixed overheads specified for the output achieved and the actual fixed overheads.

Formula:

FOV= Standard fixed overhead-Actual fixed overhead = SO FO

It is said to be favourable when actual overhead is less than standard overhead and is said to be adverse when actual overhead exceeds standard overhead.

2)FIXED OVERHEAD VOLUME VARIANCE (FVV):

The difference between the budgeted fixed production overhead volume and the budgeted amount. Both the budgeted and actual overhead are multiplied by the overhead rate. It is further divided into: a) fixed overhead efficiency variance; b) fixed overhead capacity variance.

Formula:

FVV= (Standard hours- Budgeted hours)* Standard rate

= (SH-BH)*SR

For example, a company budgeted production overhead volume of 1,000 units and multiplies that by the overhead rate of $20/unit to get a $20,000 budget. If the actual volume of units is 1,200 there will be a favorable fixed production overhead volume variance of $4,000 (1,200 units x $20/unit $20,000).

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So, FVV is said to be favourable when budgeted hours are less than the standard hours and is said to be adverse when budgeted hours exceeds standard hours.

3)FIXED OVERHEAD EXPENDITURE OR (BUDGET) VARIANCE (FEV):

The fixed overhead spending variance is the difference between the actual fixed overhead expense incurred and the budgeted fixed overhead expense. An unfavorable variance means that actual overhead expenditures were greater than planned.

The formula is:

FEV=Budgeted fixed overhead - Actual fixed overhead = BO AO

The amount of expense related to fixed overhead should (as the name implies) be relatively fixed, and so the fixed overhead spending variance should not theoretically vary much from the budget. However, if the manufacturing process reaches a step cost trigger point, where a whole new expense must be incurred, then this can cause a significant unfavorable variance. Also, there may be some seasonality in fixed overhead expenditures, which may cause both favorable and unfavorable variances in individual months of a year, but which cancel each other out over the full year. Other than the two points just noted, the level of production should have no impact on this variance.The fixed overhead spending variance will be unfavorable if the actual overhead costs incurred are greater than the budgeted amount.

Example: The production manager of Hodgson Industrial Design estimates that the fixed overhead should be $700,000 during the upcoming year. However, since a production manager left the
38

company and was not replaced for several months, actual expenses were lower than expected, at $672,000. This created the following favorable fixed overhead spending variance:

($672,000

Actual

fixed

overhead

$700,000

Budgeted

fixed

overhead)

$(28,000) Fixed overhead spending variance.

4)FIXED OVERHEAD EFFICIENCY VARIANCE (FEFV):

It is the portion of FVV which is the difference between the standard volume of output specified and the actual volume of output.

Formula:

FEFV=(Standard hours-Actual Hours)*Standard Rate =(SH AH)*SR

It is said to be favourable when the actual hours are less than the standard hours and is said to be adverse when the actual hours exceeds standard hours.

5)FIXED OVERHEADS CAPACITY VARIANCE (FCPV):

The difference between the actual number of hours worked and the budgeted number of hours. This figure is then multiplied by the overhead rate for an hour of labor. Formula: FCPV= (Actual hours-Budgeted hours)*Standard rate = (AH-BH)*SR
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Example: If a company budgeted 1,000 labor hours at an overhead rate of $10/hour, but actually used 1,200 labor hours it would have an adverse variance of 200 hours (1,200 - 1,000). This variance would be multiplied by the overhead rate (200 hours x $10/hour) to show a fixed production overhead volume capacity variance of $2,000. When calculating fixed production overhead volume capacity variance, note that more hours being worked than budgeted creates an over-absorption of overhead, which in this case is favorable. b)VARIABLE OVERHEADS VARIANCES: 1)TOTAL VARIABLE OVERHEADS VARIANCE (VOV): It is the difference between the standard variable overheads specified for the output achieved and the actual variable overheads. Formula: VOV= Standard variable overheads actual variable overheads = (SO VO) VOV is said to be favourable when the actual overheads are less than the standard overheads and is said to be adverse when the actual overheads exceeds standard overhead. 2)VARIABLE OVERHEADS EFFICIENCY VARIANCE (VEFV): Variable overhead efficiency variance is the product of standard variable overhead rate and the difference between the standard units allowed of the variable overhead application base and actual

40

units used of the variable overhead application base. Assuming that variable overhead application base is direct labor hours, the formula to calculate variable overhead efficiency variance will be:

VOH Efficiency Variance = ( SH AH ) SR

Where, SH AH are are standard the direct actual labor direct hours labor allowed hours

SR is the standard variable overhead rate The standard direct labor hours allowed (SH) in the above formula is calculated by multiplying standard direct labor hours per unit and actual units produced. Analysis As the name suggests, variable overhead efficiency variance measure the efficiency of production department in converting inputs to outputs. Variable overhead efficiency variance is positive when standard hours allowed exceed actual hours. Therefore a positive value is favorable implying that production process was carried out efficiently with minimal loss of resources. On the other hand when actual hours exceed standard hours allowed, the variance is negative and unfavorable implying that production process was inefficient. Example Calculate the variable overhead efficiency variance using the following figures:

Number of Units Produced

620

41

Standard Direct Labor Hours Per Unit

0.2

Actual Direct Labor Hours Used

130

Standard Variable Overhead Rate

$9.40

Solution

Actual Units Produced

620

Standard Direct Labor Hours Per Unit

0.2

Standard Direct Labor Hours Allowed

124

Standard Hours Allowed

124

Actual Hours Used

130

Difference

42

 Standard Variable Overhead Rate

$9.4

Direct Labor Efficiency Variance

$56.4

The variance calculated above is negative and thus unfavorable. 3)VARIABLE OVERHEADS EXPENDITURE VARIANCE (VEXV): Variable Overhead spending variance (also called variable overhead rate variance) is the product of actual units of the allocation base of variable overhead and the difference between standard variable overhead rate and actual variable overhead rate. The formula to calculate the variable overhead spending variance is:

VOH Spending Variance = ( SR AR ) AH

Where, SR AR is is the the standard actual variable variable overhead overhead rate rate

AU are the actual hours The standard variable overhead rate is the same as variable overhead application rate. The allocation base is usually the number of labor hours used. The above formula can also be stated alternatively as follows:

VOH Spending Variance = ( SR AU ) Actual Variable Overhead Cost

Analysis
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A positive value of variable overhead rate is obtained when standard variable overhead application rate is more than actual variable overhead rate whereas a negative value of variable overhead rate is obtained when actual variable overhead rate exceeds standard variable overhead rate. Thus a positive value of variable overhead spending variance is favorable and a negative value is unfavorable. In case of a negative variable overhead spending variance, production department is usually responsible. Example Calculate variable overhead spending variance if actual labor hours used are 130, standard variable overhead rate is $9.40 per direct labor hour and actual variable overhead rate is $8.30 per direct labor hour. Also specify whether the variance is favorable or unfavorable. Solution

Standard Variable Overhead Rate

$ 9.40

Actual Variable Overhead Rate

8.30

Difference Per Hour

$ 1.10

Actual Labor Hours

130

Variable Overhead Spending Variance

$143

The variable overhead variance calculated above is favorable

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