Standard costing and variance analysis.

Parts dealt with in this topic. o What is standard costing? o How the standards are developed? o The limitation of standards used. o How variance is structured and calculated? o Limitation of variance analysis. Cost data basically has three uses: 1. Cost control. 2. Price setting. 3. Decision making. Standard costs, using the unit costing method, represent the only system that provides all three uses from the same set of data without the need for reconstruction. Cost accountants play an important part in the unit cost standard costing system. They become involved in establishing, manufacturing and updating standards. They are also involved in measuring variance from standards and in issuing reports to management on an exception basis, which are used for control and possibly in price setting.

Basic of standard costs

A standard cost system may be defined as the comparison of actual costs with predetermined standards for the purpose of developing variance. The process of examining variance for the purpose of cost control and improvement is called variance analysis. The term standard cost is a unit concept, in other words. The standard cost of material is Rs 1 per unit. However, the term budgeted cost is a total concept; in other words, the budgeted cost of material is Rs 10000 if 10000 units are to be produced. Technical standards determine standard quantities for material and labour. Work study and the learning curve are useful techniques for this purpose. You should note that a standard hour is not just a measure of time, but a measure of work content. For example, 100 chairs at three hours per chair and 200 desks at six hours per desk can be expressed as 1500 hours of output. Cost standards determine standard prices and rates for material and labour. Suppliers prices, discounts, inflation, union negotiation, etc. are some of the variables that must be considered when these standards are set. Standards can be of three types: basic, ideal and practical. a) Basic standards: These are unchanging standards relating to past circumstances and are therefore seldom used. They do have an advantage of identifying trends of efficiency and price changes over the years.

b) Ideal standards: These assume perfect conditions; in other words, material and labour can be acquired at the cheapest cost and there is no inefficiency, wastage or machine break-downs. These standards are unrealistic and tend to have an adverse motivational effect on the workforce. c) Practical (currently attainable) standards: These are realistic and do allow for some normal loss, machine break-down and inefficiency. However, a practical standard is high enough to have a motivational effect on employees and tends to be commonly used. There are imperfections in both definitions of ideal and practical. Basically, standards are only as good as the conditions under which they are established. Standards are created by peoples and people make mistakes; so a standard thought to be ideal may actually be either too tight or too loose, depending on the ability of the person defining standard and the conditions under which standards were set. Standards that are set too tight discourage shop managers; they realize they cannot meet the standards no matter how well they perform and they will spend an inordinate amount of time explaining variances over which they have no control. Loose standards, on other hand, serve to camouflage opportunities of for cost improvement, which could increase profits. All in all, the best standards are those that are neither too tight nor loose but acquiring such a balance require a little extra effort. Therefore tight stabdards should be set so that operators of the system will consider the achievement of standard performance to be worthwhile. However, it is important that standards are not too tight as they become unrealistic (that is, unattainable) and therefore not worth the challenge. Advantages and limitations of standard costing Advantages of standard costing all as under: a) Standards are building blocks used to complete budgets. b) Actual costs can be compared with standard costs in order to measure performance. c) The setting of standards should result in best resources and methods being used, which will increase efficiency. d) It highlights areas of strength and weakness. e) Standard costs can be used to value stock and as a basis for setting wage incentive scheme. f) It operates through the management by exception principle, where only those variances, that are outside certain tolerance limits, are investigated, thereby economizing on managerial time. g) Standard costing simplifies bookkeeping, as information is recorded at standard, instead of a number of historic figures. h) Control action is immediate; for example, as soon as material is issued from store to make a product it can be compared with the standard material which should have been used for the actual production.

i) Managers are made responsible for standards. Limitations of standard costing are as under: a) A heavy load of input data is required which is expensive. b) Standard costing is only applicable in organizations where processes or jobs are of a repetitive nature. c) Unless standards are set which are accurate with respect to labour efficiency, quality and price of material, any consumption with actual will be meaningless. d) Because of uncertainty, especially that related to inflation, standards need to be continually updated and revised.

Variance analysis
Variances are the differences between expected and actual results allowing us to prepare operating statements which help reconcile actual profit and budgeted profit or contribution.

Direct material
Earlier we defined direct material as any raw material or finished, purchased part that can be physically identified with the finished products. For example, a finished, purchased part, such as a pump, may be assembled into an end product without further processing. Also, metal bar or sheet stock may be machined into a finished product using machine tools such as lathes or boring mills. The steps performed by the production worker in assembling the parts or changing the shape of metal are called operations. When the total value of the operations performed by the worker is joined with an allocation of overhead, the result is called conversion cost. Conversion cost, sometimes called contributed value, represents the cost of converting raw materials and finished, purchased parts into the product.

Determination of standard material cost

Standard for raw materials are determined by two elements: the amount of material required and its price. The blueprint, or drawing, of the part provides the mean for determining the weight and type of material to be used. For example, the standards for parts made from sheet metal are generally arrived at by determining the outer dimensions of the parts. Multiplying the length, width, and thickness together yields the volume of material needed. Applying the density or specific gravity (kgs per cubic cm) to the volume results in the amount of material needed for one piece. Some consideration, however, must be given to the size of the sheet from which the pieces will be cut. To be economical, one should consider what size of sheet stock should be purchased so that there will be few or no end pieces left over. The ideal situation, which is usually unattainable, would be to have, say; 10 pieces cut from a sheet without any material (short ends) left over. Generating short ends, however, is not always uneconomical. This leads to a theory called the preferred sizes theory. The price of sheet stock is determined by three factors; base price, size extra, and quantity extra. In determining the number of pieces that can be obtained from one sheet, one must now consider the factors of quantity extra and size extra. For example, if the

decision is made to buy sheets only in sizes that leave no short ends, low production of the part may cause quantity and size extra costs to be added to the base price. This may more than offset the cost of the waste ends produced when using a sheet size for more than one application. The preferred sizes theory states that the purchase of frequently used sizes of sheet stock can avoid the quantity and size extras in the price of the material. For example, a steel sheet of 36 by 96 inches (width and length) is very common and generally has multiple applications, so that sufficient quantity is manufactured at the rolling mill to eliminate both the quantity and size price adders. 70 pieces each of 6 inches square are obtained from one sheet with dimensions of 36 by 96 inches. Attempting to buy a few sheets leaving no extra material left over would probably be uneconomical. The standard for each piece is determined by computing the weight of the complete sheet and dividing by 70, thus including the scrap end and side pieces in the per-piece cost. If the scrap end is large enough to have possible future applications, it can be saved; otherwise, it is sold for scrap with the receipts derived from the sale possible being included as other income on the companys profit and loss statement. In our case, the volume of the sheet is 216 cubic inches. With a density or specific gravity of 287 kgs per cubic inch, each sheet weighs 62.0 kgs, resulting in 88.6 rupees per 100 pieces. The latter would represent the material weight standard for this example. Cost accounting generally plays a part in determining the weight of the part to be used as a standard, taking into consideration the preferred sizes theory. To complete the standard for material, one must know the price per kg of the part (if the part is to be made internally form raw materials) or the price per piece (if the part is one that will be used in the end product without further work other than assembly). The purchasing organization generally determines the price to be paid, using quotations for the period of manufacture and taking into consideration any fluctuations in the economy that may take place while the standards are in effect.

Material Variances
Once material standards have been established, all future transactions regarding the manufacture of the part must be examined to determine the variances from standard. A variety of variances may be obtained. Categorizing variances makes for better cost control.

Material Price Variance

Price variance is determined by examining the actual purchase cost of the finished purchased part or raw material to determine the variance from the previously established standard. Thus, if a purchased part has a standard of Rs.10.00 per piece, a price variance of Rs.0.25 per piece is generated. When the actual purchase price exceeds the standard, it is said that an unfavourable variance has been realized. A favourable variance is generated when the standard is greater than the purchase price. In the case of raw materials, similar comparisons are made, using the price per kg of material or some other basis for payment established.

Material Usage Variance

The material usage variance is perhaps the most difficult variance to determine, since it involves control of the size of stock used in manufacturing the part. Many companies do

not bother to determine the usage variance because of the cost of administration. As an example of the material usage variance, return to the example above. There it was expected that a sheet of size 1/16 by 36 by 96 must be exercised to see that the stockroom sends the right size of stock to the shop. One means of control is to have a production control system, which in this case would call for the exact number of sheets to be sent to the shop for the manufacture of the appropriate number of pieces in a particular period. No further stock should be released without records showing the additional material is needed to compensate for scrap. Copies of scrap tickets can be accumulated until an additional sheet or more is needed. Any materials required in addition to those justified by the scrap tickets must be assumed to have been caused by the uneconomical or incorrect use of the materials, such as not using the correct size sheet, and the system provides for picking up the additional material cost as a material usage variance. Very few companies are able to exercise good control of the material usage variance, but it should always remain an objective.

DIRECT LABOUR
We defined an operation as one of the steps performed by the production worker in converting raw materials to finished goods or assembling parts in final or subassemblies. This definition of operation is understandable when you consider such things as the work of production employees who operate lathes that cut chips. In such cases it is clear that the part comes closer to being completed with each operation. Other types of chips. In such cases it is clear that the part comes closer to being completed with each operation. Other types of operation, however, fall into grey areas where company policy may be the deciding factor as to whether a given operation is called direct labour or included in overhead. One such operation is inspection or quality control, the function that determines whether or not the finished part conforms to the specifications that were established for its manufacturing. Opinion is divided as to how this service should be treated. Some companies treat all inspection as an overhead item, liquidating all of the expenditures that the function has made toward completing the manufacture of the product. However, classifying inspection as an overhead item reduces the opportunity for control, because the expense is buried and no attempt is made to see whether or not the expenses of a given product are greater than they should be in the area of inspection or other quality control items. In order to exercise control, many companies charge the expenditure related to the inspection of parts made internally to the direct labour cost of the product. In this way they can see how much is spent against each product; if the cost begins to fluctuate, management, can examine the situation to determine the causes and institute corrective action. Other companies go a step further by charging to the manufacturing losses portion of direct labour. Such a practice allows this cost to be examined, thus enabling management to determine the reasons for the labour and to take steps towards reducing such costs. Increasingly, companies are charging the inspection and quality control connected with the acceptance or rejection of parts and materials received from vendors to a separate overhead account. This account is liquidated against the material cost of the product. The work of testing the product to see that it meets the specifications included in the warranty agreement is generally handled in the same way as inspection, since testing is in

fact a type of inspection or quality control. Testing should be isolated in direct labour so that it can be examined and causes of extraordinary expenditures can be determined. Again, any retesting of the product after reworking should be charged against manufacturing losses. The premium or bonus paid to workers for overtime is sometimes charged as direct labour. For purposes of this course, overtime premium will be isolated in overhead, where it can be examined in relation to the entire overhead structure.

Direct Labour Cost Standards

Direct labour standards are a function of two variables; the time taken to do the operation and the labour rate paid to the worker according to the skills required in performing the operation. There are many ways of determining the time allowed to perform the operation. The most popular system is piecework, in which the worker is paid a fixed amount of money for each good part manufactured. The word good should be emphasized here, because most piecework systems pay the worker only for those pieces that pass inspection. If the defective work that caused the part to be rejected can be corrected by the worker, he or she is required to correct it on his or her own time before he is paid the official piecework price. This system is perhaps the most economical way of paying the worker, since there is an incentive for the person to work hard in order to receive a good weeks pay. There are several disadvantages to using the piecework system, however. Piecework prices are determined by time studies performed while the employee is going through the sequence of steps required to perform the particular operation. This time becomes the basis for establishing the price after certain allowances are added, such as personal time to go to the lavatory and time to get tools from the tool crib. A base hourly rate is used to reach the final price. The curse of piecework is that, in some cases, employees deliberately drag their feet during the time study so that a high price is established. Once the price has been established, the workers operate at their normal pace and are able to take home excessively high pay cheques. Another problem with piecework is the need for constant inspection and administration. An efficient inspection system is required to determine the parts for which payment should be made and those that employees must repair on their own time. With nonpiecework systems it is sometimes possible to inspect on a sampling basis, but under a piecework system comprehensive and careful inspection is required. One major disadvantage of using a piecework system involves those situations in which the employees perform work for which a piecework price has not been established. In such cases, employees are paid a percentage of their average earned hourly rate. The average hourly rate is determined by dividing the number of hours worked on piecework during the accounting period into the total piecework earnings. Take, for example, the worker whose piecework prices are determined by a base rate of Rs.5.00 per hour and whose earnings have been averaging 40 percent over the base rate. This means the persons actual paid rate is Rs.7.00 per hour. If this worker were assigned to a job for a few hours based upon 80 percent of his or her average earnings, the person would be paid Rs.5.60 per hour. But this is an hourly rate, not a piecework rate, so there is no incentive for this person to do the work in the shortest time possible.

Many companies avoid the piecework system because of the problems noted above. Instead, straight daywork is most often used. In this system, employees are paid the same rate per hour regardless of the number of pieces produced. Unfortunately, in some unionized companies, the employees bargaining unit indicates (unofficially) how many pieces the employees should manufacture in a given workday. The alternative is to use what is known as measured daywork. Under this system, motion-time surveys are made to determine how long it should take to perform a certain operation using a certain machine with certain specifications. An agreement is then made with the bargaining unit that specifies that employee do a minimum number of pieces, generally the equivalent of the piecework results, using normal effort. In this way a reasonable number of pieces are produced by the employee in return for a reasonable days pay. One final payment system which deserves mention is group incentive. The earnings of each employee under the incentive system are pooled and divided among the number of employees working in the pool. The employees themselves monitor the system, admonishing any member of the team who lags behind in production, since that persons failure to produce reduces the earnings of all of the members of the team. Some companies charge the straight-time portion of overtime work to direct labour and the premium time to overhead, while others charge the entire amount to direct labour. Charging overtime premium to direct labour causes direct labour variances to fluctuate wildly and makes cost estimating difficult. For purposes of this course, all premium payments will be charged to indirect expense. Regardless of the method adopted to determine standards used for payment or measuring variances, it is important that the shop foreman, who is responsible for meeting the standards, be a party to the final data to be included.

Direct Labor Variances

Like direct material variances, direct labour variances are the differences between the standard established and the actual amount paid. If the standard is less than the amount paid, an unfavourable variance has been experienced. If the standard is greater than the amount paid, a favourable variance has been experienced.

Labour Efficiency Variance

The labour efficiency variance is the difference between the standard hours and the actual hors extended by the standard hourly labour rate. In piecework systems, it is not possible to generate this type of variance, since the break-down of the hours portion of the piecework price is generally not shown but is buried in the details making up the basis for the piecework price. For control purposes, however, periodic statements may be issued showing the comparison between the rate included in the price and the actual rate paid. If, for example, the actual rate is 40 percent over the anticipated average earned hourly rate, management may want to decide whether a new study is required for.

Labour Rate Variance

This variance is the difference between the base standard hourly rate for the type of work performed and the actual rate paid, extended by the number of hours worked. There are several reasons for rate variances. For example, a worker may be temporarily transferred from a higher-rated one in order to get a specific job completed in time to meet the

customers requirements. Or new employees may be given a progression of pay increases until they reach the rate for their specific job. In this case, a favourable labour rate variance may be experienced, which may be offset by an unfavourable efficiency variance, since the new employee is still learning the job and has not reached the peak of efficiency. Opinion is divided over what type of labour rate to use as a basis for the standard cost system. Some companies elect to use the beginners rate; others use the top rate after the wage increase progression has been completed. At times an average rate for the entire cost centre is used. The use of an average rate makes it easy to establish standards, but when issuing control reports, one must remember that the reason for the variance may be caused by the actual rate being more or less than the average rate for the centre, so any criticism of the employee or the foreman would be unjustified.

Makeup Payments
In some piecework systems, employees are guaranteed that they will take home a minimum amount of pay each week. When the pay fails to reach this minimum, an adjustment is made. The handling of this adjustment as a direct labour variance can cause problems if the employee performs a multitude of tasks, since it is difficult to tell which task requires the makeup payment. In many companies this payment is treated as an item of overhead, where it becomes highlighted against the burden of the entire cost centre. For purposes of this chapter, makeup payments will be considered an overhead item.

Manufacturing Losses
Defective work that cannot be corrected is charged to manufacturing losses. Labour losses differ from material losses only to the extent that, when a part is scrapped, all of the material is lost, while only the labour operations performed up to the point of rejection are chargeable as losses. If there are sufficient inspection points during the manufacturing process, defects will be discovered before the part is completed. Thus, labour losses are generally not as extensive as material losses. The operations performed to correct defective work, as well as extra operations required that were not anticipated when standards were originally set, are charged as manufacturing losses. An example for this would be the case where a job called for the use of 3-inch stock, but due to faulty inventory control or materials 3-stock had to be used to meet the customers shipping date. In theory, the extra labour involved in machining the oversized stock should be charged as a manufacturing loss rather than a labour efficiency variance.

Advantages and disadvantages of the unit standard cost method

Once standards have been established for both materials and labours, the shop ordering and paperwork system can be instituted based on the standards established. For example, materials ordering forms can show the size of sheets required under the preferred sizes theory. By having forms of this type on hand in both the purchasing and raw stock areas, control can be exercised to see that the proper material size is ordered and proper material is withdrawn and sent to the shop for manufacture. If a particular quantity of parts is to be as a single release to the shop, the ordering department can specify the exact number of sheets that should be withdrawn from raw stores. The raw stores clerk can than be instructed to refuse requests for additional sheets unless some control document is

furnished, such as scrap tickets showing that excessive scrap has been realized. At the same time, labour vouchers to be used by employees to record the amount of time worked and number of pieces completed can be reprinted, showing the operations to be performed and the standards that have been established. The principle disadvantage of the unit standard cost method is in the area of direct labour. To achieve a realistic cost for any period, all of the operations called for in the manufacture of the product must be performed. There are occasions, however, when production requirements prevent this from taking place. For example, parts that need reworking are sometimes set aside to be reworked later so that rush order can be finished. This means that the cost for the current period may be understated. Conversely, when the rush order is completed, production workers may spend an inordinate amount of their time on the rework operations, thus overstating the manufacturing losses for the period. Conditions such as these make it necessary to temper the use of standards for predicting future costs of parts with an analysis of the conditions under which the parts are manufactured. The average cost for a number of past accounting period, during which chances are that all manufacturing problems are experienced, is a better base from which to start the process of estimating what the future cost of parts may be.

Factory overhead variance

Factory overhead is applied as products are made and services are provided. At the and of the period, the actual overhead incurred is compared to the overhead applied to determine over or under-applied overhead. The over or under-applied amount is a type of variance that can be explained or analysed by two sub-variances: spending variance and idle capacity variance. For example, if actual factory overhead was Rs 250,000 and the applied amount was Rs 221,000, then overhead would be under-applied by Rs 29,000, which is an unfavourable variance- more overhead needs to be applied and, as a result, net income will be unfavourably impacted. The under-applied amount of Rs 29000 can be decomposed into the spending and idle capacity variances. This example will be expanded upon the next two sections to reveal that the Rs 29000 variance is made up of Rs 5000 unfavourable spending variance and the Rs 24000 ubfavourable idle capacity variance. The spending variance is to due to budgeted or expense factors, while the idle capacity variance occurs because of volume or activity factors. In the next two sections, you will see how these variances are calculated and interpreted.

Overhead spending variance

The overhead spending variance is the difference between the actual overhead and the budgeted allowance estimated for the capacity utilized. In other words, the actual overhead is compared to a flexible budget amount for actual activity. A flexible budget is a budget based on actual output (production). Figure 10.1 shows that a factory estimates that its normal capacity is 20000 machine hours and its budgeted factory overhead at a level of 20000 hours will be 260000. Of the Rs 260000 of budgeted overhead, fixed costs are Rs 160000 and variable costs are Rs 100000. This results in a budgeted variable overhead rate of Rs 5 per hour. The actual machine hours are 17000 with actual overhead at Rs 250000. To compare the actual with the flexible budget amount you must calculate

a new fixed overhead budget for the actual machine hours, which is done in the following steps: 1. 2. Calculate a new budget for variable overhead costs by multiplying the actual activity level by the application rate (for example, 17000 actual machine hours Rs 5) Add the fixed overhead budgeted amount to the new variable budget amount to derive the total budgeted factory overhead budget (also known as the flexible budget) allowance based on actual activity.

Figure 10.1 shows the calculation of the spending variance using the example of actual factory overhead of Rs 250000 and an actual activity level of 17000. The calculation is also summarized below: Base Total Variance Normal capacity 20000 Estimated factory overhead Rs 260000 Applied rate Rs 13.00/hr Fixed factory overhead Rs 160000 Applied rate Rs 8.00/hr Variable Rs 100000 Applied rate Rs 5.00/hr Actual machine hours 17000 Actual factory overhead Rs 250000 Budgeted Allowance based on Actual Hours: Variable Fixed Total Spending Variance Unfavourable Budgeted Allowance Based on Actual Hours Applied Factory Overhead ( 17,000 machine hours ) Rs. 221,000 Idle Capacity Variance Total Variance Actual Overhead Applied Overhead Variance Rs.85,000 Rs. 160,000 Rs. 245,000 (Rs.5,000) Rs, 245,000

(Rs 24,000) Unfavourable (Rs.29,000) Rs. 250,000 Rs. 221,000 (Rs, 000) Unfavourable

Figure 10.1: Spending and Idle Capacity Variances Flexible Budget at 17,000 Actual Machine Hours: Actual Factory Overhed Rs. 250,000 Budgeted Allowance Based on Actual Hours: Variable Rs. 85,000 Fixed 160,000 Total Rs. 245,000 Spending Variance - 5,000 Unfavorable It is useful to break down the spending variance and compare each actual overhead cost item with the budget figure, as is illustrated in figure 10.2 below . (Rs) Fixed Variable Overheads Indirect labar Supplies Repairs Utilities Fuel Water Total Total Overhead Budgeted Allowance 160,000 45,000 8,000 10,000 9,000 12,000 1,000 85,000 245,000 Actual 160,000 45,000 10,000 11,000 10,100 13,000 900 90,000 250,000 Spending Variance 0 0 (2,000) (1,000) (1,100) 100 100 5,000 (5,000)

Figure 10.2: Breakdown of spending variance

Overhead Idle capacity variance The overhead idle capacity variance occurs because of volume or activity factors it is calculated as follows: Budgeted factory overhead Applied factory overhead For example, figure 10.1 shows budgeted fixed overhead at Rs. 245,000, while the applied factory overhead was Rs. 221,000, which was applied at a rate of Rs13 per machine hour, for an unfavorable variance of Rs. 24,000. The idle capacity variance can also be computed by multiplying the idle capacity (i.e., budgeted machine hours less actual machine hours) by the fixed cost rete. For example , the idle capacity in the example is 3,000 machine hours (20,000 17, 000). If you multiply 3,000 machine hours by Rs.8, the fixed cost portion of the application rate, the result is an unfavourable, it means that capacity was not fully utilized and here fore fixed overhead cost could not be

spread over the full capacity output. If the idle capacity is favourable, it means that capacity was greater than the normal capacity and the fixed overhead cost could be spread over a greater output than was expected . In figure 10.1, the total variance of Rs 29,000 was unfavourable. Of the Rs. 29.000 unfavorable Rs. 5,000 (Spending Variance ) was the result of spending more on certain variable cost than was anticipated (see figure 10.2: more was spent on supplies, repairs, utilities, and fuel ) while Rs. 24.000 of the total variance was the result of idle Capacity . Standard capacity can be used in both process and job order costing systems. Variances are examined and analyzed to control cost and to improve performance. Standard cost are used for all the cost components of a product, materials, labour and overhead- and typically, several variances are calculated for each category of cost. For materials, both use and price variances are important, while for labour, efficiency and rate are carefully monitored. For factory overhead, spending and idle capacity are the frequently used variances. Basic reasons for variances could be summarized as follows : Labour rate Use of higher/lower grade of skilled workers, and wage inflation Labour efficiency Use of higher/lower grade of skilled workers, and quality of material used. Idle time Machine breakdown, and hold-ups because of lack of material, of lack of biders. Material price Good/bad purchasing and material price inflation. Material usage High/low quality of material, quality control, efficiency of workforce. Overhead expenditure Inflation, and greater/less economical use of services. Overhead capacity Underutilization/overutilisation of plan activity. Overhead efficiency A difference recovery of overhead from that of standard, as expected and actual output differed. You should note that the interdependence between variance; for example an adverse material price variance may be a result of buying a superior quality of material, which in turn has caused a favorable material usage variance. Another example is where favorable efficiency variances may be a result of using more highly paid and skilled workers, which causes an adverse labour rate variance. Figure 10.3 provides a summary of the main variances that are normally calculated

Figure 10.3 Summary of main variances The basic methodogy of analyzing variances makes it clear that a total variance (cost variance) can be subdivided into two (or more) component variances, namely : a) Price rate or expenditure variance and b) Usage efficiency or volume variance. Price or rate variance Actual cost Actual quantity X actual price is compared with is compared with what it should cost actual quantity

This can be simplified to the formula of : ( Actual price standard price ) X actual quantity Usage or efficiency variance Actual quantity used. Actual quantity X standard price is compared with is compared with what should be cost Standard quantity X Standard price

This can be simplified to the formula of : ( Actual quantity standard quantity X Standard price

In order to find the standard quantity for actual production it will be necessary to flex the budget . This analysis can be used to calculate any variance that we so require. Following data is available for smart company.

a) Standard data per unit Standard price Direct labour Material Variable Contribution Fixed overheads Profit Rs6 0.64 3.00 0.16 (0.20) Rs. 2.00 ( Standard material cost Rs. 1.50/ Kg and each unit required 2 kg ) b) Actual data 11,500 units manufactured -2,320 direct labour hours, paid for at Rs. 3.25/ hour. 25,000 Kg of material were purchased for Rs.1.48/ Kg were consumed stocked are valued at standard cost. Actual variable overheads Rs 1,750 Actual fixed overheads Rs. 2,462 10,000 units were sold for Rs. 7 each Prepare opening statements using absorption and marginal costing principles Solution a) Calculation of variances (3.80) 2.20 Budget fixed over- heads Rs 2,400 dased on direct labour hours ( budget for 2,400 direct labour hours (12,000 units ) stander labour cost Rs. 3.20/ hour ) (5 units/ hour to be made (budget variable overheads/ direct labour hour = Rs.0.80/ 5 units per hour )

Labour variances Rate variance = (actual rate standard rate ) actual hours paid = (Rs.3.25 Rs. 3.20 hours = Rs 116 adverse Efficiency variance = ( actual hours worked standard hours ) standard eate.

= (2,320 hours 2,300 hours ) Rs 3.20 = Rs 64 adverse 11,500 units Material Variances Rate variance = ( actual price standard price) actual quantity purchased = (1.48- Rs 1.50) 25,000 Kg = Rs 500 favourable Usage variance = (actual quantity used standard quantity) standard price. = ( Rs 23,400 Kg 23,000 Kg ) Rs. 150 = Rs. 600 adverse 11,500 units 11,500 units should use 2kg /unit (flex to actual production)11,500 units should use 5 units / hour (flex to actual production)

Variable overheads Expenditure variance = (actual rate standard rate ) actual hours worked. = (Rs 1,750 Rs 0.80 X 2,320 hours ) (variable overheads are not incurred during idle time) (Actual hours Standard x Actual X actual rate) rate hours . Efficiency Variance = Rs 106 favourable

= (actual hours worked standard hours )standard rate = (2,320 hours 2,300 hours) Rs 0.80 = Rs16 adverse 11,500 units 11,500 units should use 5 units /hour (flex to actual production)

Fixed overheads The analysis of fixed overhead variances differs from the general approach towards variable cost. At the outset, a budgeted fixed overhead absorption (recovery) rate is calculated by dividing the budgeted cost by the normal activity level (in this case selecting direct labour hours as the basis of activity ) = Rs. 2,400 / 2,400 hours = Re 1/hour. This is the basis of the charge to production for fixed overheads . overheads recovered By production may differ from actual overheads incurred for reasons of expenditure and / or volume

Expenditure variance = (actual fixed overheads budgeted fixed overheads) = ( Rs2,462 Rs 2,400) = Rs 62 adverse Volume Variance = ( budgeted hours standards hours ) standard fixed Overhead rate = ( 2,400 hours 2,300 hours ) Re1 = Rs 100 adverse This variance (volume) is adverse because the fixed overheads can under recovered this may have arisen from one of two causes a capacity effect and an efficiency effect. Capacity variance = ( budgeted hours actual hours worked ) standard fixed overhead rate = (2,400 hours 2,320 hours) Re 1 This is adverse as capacity was underutilized resulting in a under recovery of overheads Efficiency variance = (actual hours worked standard hours) standard fixed overhead rate = (2,320 hours 2,300 hours) Re 1 = Rs.20 adverse This is adverse as more units shouls have been made in the hours actually worked. This volume variance Rs 100 adverse = = capacity + efficiency variances Rs. 80 adverse

You should note note that it is impossible to have volume variances associated with variable cost because by definition, the amounts of the cost is expected to vary with activity These variances calculate the effect that that sales price differences or sale volume difference between budget and actual have on the profit or contribution margin Price variance Volume variance = ( actual quantity sold budgeted quantity sold) standard profit or contribution per unit. = ( 10,000 units 12, 000 units 12,000 units ) Rs 2.20 = Rs 4,400 adverse Under marginal costing using standard contribution For simple sales sale variances showing budgeted sales revenue actual sale revenue shall not be used as it ignores changes in costs, that is, the net effect of a volume change. b) Calculation of actual profit Sale Less: Cost of good sold Rs. 70,000 = (actual price standard price) actual quantity sold = ( Rs 7 Rs 6) 10,000 units = Rs. 10,000 Favourable

Meterials (25.5000 Kg x Rs 1.48) Less: Closing stock valued at standard ( 1,600 Kg X Rs 1.50) (2,400) Labour 7,540 Fixed overheads 2,462 Variable overheads 1,750 Less: Closing stack finished units valued at standard (1,500 units x Rs 4 (6,000) Actual profit =

Rs 37,000 Rs.34,600 46,352 (40,352) Rs. 29, 648

The difference of Rs 300 between the profit in the standard absorption and standard marginal operating statements is due to the valuation of finished good stock. Stock. Stock 1,500 units stock valuation (Absorption = Rs 4.00 unit marginal = Rs 3.80 unit ) = Rs 300 profit difference c) Operating statements The operating statement is a simple list of variances in a particular format, reconciling budgeted profit or contribution to actual profit Standard absorption costing operating statement Budgeted profit Rs. 24,000 Less: Volume variance (4,000) adverse Flexed budgeted profit 20,000 Add: Sales price variance 10,000 favourable Profit subject to cost variances 30,000 Cost variances Adverse Favourable Material Price Rs. 500 Usage Rs 600 Labour rate 116 Efficiency 64 Variable overheads Efficiency 16 Expenditure 106 Fixed overheads Expenditure 62 Capacity 80 Efficiency 20 _________________________ (958) 606 (352) Adverse __________________________

Actual profit = rs 29, 648 See notes in d) below d) Standard marginal costing operating statement Budgeted contribution Less: Volume variance Flexed budget contrivance Add: sales price variance Contribution subject to cost variances Cost variance Adverse (Only variable variances) Material price Usage Rs. 600 Labour rate 116 Efficiency Variable overheads Efficiency 16 Expenditure Actual contribution Less: Budgeted fixed overheads Plus expenditure variance

Rs. 26,400 (4,400) adverse 22,000 10,000 favourable 32,000 Favourable Rs. 500

106 (190) adverse

31,810 2,400 62 adverse 2462 Actual profit = Rs 29, 348 Notes: you should observe the following points concerning the above operating statements: i) Volume variance In the absorption operation statement standard profit/ unit is used whereas in the marginal operating statement standard contribution/ unit is used The fixed overhead expenditure is the same in both statements but there cannot be a fixed overhead volume variance in a marginal operating statement due to the budget because fixed overheads are not absorbed into products. They are charged to the period.

ii)

Fixed overhead variances

Sales variances will not appear in the books of account as sales are recorded at the actual amount b) Further points to be noted = (hours paid hours worked) standard rate = (2,320 hours 2,320 hours) Rs.320 = nil

i) Idle times variance

In this question hours paid and worked are the same but that will not always be the case. ii) Material piece variances are calculated on quantities purchased for the actual amount c) Further points to be noted = (hours paid hours worked) standard rate = (2,320 hours 2,320 hours) Rs 3.20 = nil

i) Idle time variance

In this question hours paid and worked are the same, but that will not always be the case iii) Meterial price variances are calculated on quantities purchased for the following reasons: 1) material stock can be valued at standard price instead of FIFO etc .; (2) price variances are calculated when material is purchased rather than later when material is used. This facilitates responsible accounting. At the end of the period it will be necessary to por-rate the material price variances relating to materials in goods sold are charged to the profit and loss account. In the above example (the Rs.500 favorable price variance) 1,600 kg of stock 1,600xRs500= Rs 32 (credit stores 25,000 23,400 kg of cost of sales 23,400xRs 500 = Rs 468 (credit P and L) 25,000 (Debit variance account) Rs.500 Stocks are now revalued from standard to actual cost (1,600 Kg XRs 500 = Rs 2,400) = Rs 2,400 Rs 32 = Rs 2,368 (actual cost) At the beginning of the next accounting period stocks are revalued back to standard price by debiting stores account and crediting variance account. Students should note

that if material stocks are valued at actual cost, the price variance is based on materials used. Also materials issued to production are valued at standard cost iii) standard costing ratios can be used for departmental comparisons: Efficiency ration = Standard hours of actual production x 100 Actual hours worked = 2,300 x 100=99.14% 2,320 Capacity ratio = Actual hours worked x 100 Budgeted hours = 2,320 x 100= 96.67% 2,400 Activity ratio = Standard hours of actual production x 100 Budgeted hours = 2,300 x 100 = 95.83 % 2,400 Activity ratio = Efficiency ratio x capacity ratio 95.83 % = 99.14% x 96.67 % Problems Encountered in the interpretation of variances Variance analysis highlights areas of strength and weakness, but dose not indicate what action, if any should be taken. A manager must be able to interpret correctly the significance of variances before he can initiate control action. The following instances need to be remembered when interpreting variances so that the right meaning is not lost. a) Because of the various pressures on a budgetary control system inaccuracies can arise in the recording of actual results (material, labour and machine time used) This undermines the credulity of the variances reported. b) Efficiency variances will depend on the tightness or looseness of the standards set and therefore any decisions regarding these variances must be taken in the light of the standards used. c) There may be interdependence between variances; for example, buying chearper material usage and labour efficiency variances d) Inflation poses a problem If standard average price levels have been set them in the first half of the year actual prices will be below standard prices resulting in favourable price variances However , in he second half of the year actual will exceed standard causing adverse price variances. If the standards are based on

current price levels they will have to be continually revised otherwise adverse price variances will just as continually arise e) Some variances are controllable so that accurse. Other variances may be uncontrollable, resulting in the revision of budgets f) The size of a variance is important tolerance limits are set so that only variances which exceed these limits are reported Tolerance limits can be either subjectively or statistically established.