MN20485
Accounting and Decision Making
for Managers
Lectures 8 & 9
Budgeting, Standard costing & Variance Analysis
Lecture Objectives
• Standard costing
• Variance analysis
Materials
Labour
Variable overheads
Fixed overheads
Sales
• Reconciliation of budgeted profit and actual profit  operating
statements
• Interpret and offer explanations for variances
Standard Costing
Standard Costing
Standard Costing: A control technique that establishes
predetermined estimates of costs and compares these with
actual costs as incurred
• Standard costs  predetermined costs
• Most suitable for:
- Mass production or repetitive assembly work
- Where inputs for production can be specified
Difference between standard and actual = Variance
Standard Costs
Standard costs  predetermined costs
• average expected target costs under efficient (normal) operating
conditions
• represents what should happen vs. what has happened
• Calculated based on expectations of:
- Efficiency levels in the use of materials and labour
- Expected price of materials, labour and expenses
- Budgeted overhead costs and activity levels
• Standard price, standard cost, standard profit (absorption
costing), standard contribution (marginal costing)
Standard Cost Card
Standard cost card Product X
£ per unit:
(40kg @ £5.30)
212
Bonding:
(48 hours @ £2.50)
120
Finishing
(30 hours @ £1.90)
57
Direct materials
Direct wages:
Prime cost
389
Variable production overhead:
Bonding
(48 hours @ £0.75)
36
Finishing
(30 hours @ £0.50)
15
Variable production cost
440
Fixed production overhead
40
Total production cost
480
Selling and distribution overhead
20
Administration overhead
10
Total cost
510
Purpose of Standard Setting
1. To provide a prediction of
future costs that can be used
for decision-making
2. To provide a challenging target
that individuals are motivated
to achieve.
3. To assist in setting budgets
and evaluating performance.
4. To act as a control device by
highlighting those activities
that do not conform to plan.
5. To simplify the task of tracing
costs to products for inventory
valuation.
Budgets vs. Standards
A budget is a quantified monetary plan for a future period
A standard is a predetermined quantity/target
Similarities:
• Future perspective
• Both used for control purposes (interrelated & similar)
i.e. use a standard cost as basis for cost budgets
Differences:
• Budgets: (planned) total aggregate costs, prepared for all functions,
expressed in monetary terms
• Standards: show resources used for a single task
i.e. limited to situations where repetitive actions are performed and
output can be measured: and don’t need to be expressed in
monetary terms
Standard Costing System Overview
Variance Analysis
Variance Analysis
Variance analysis: the evaluation of performance by means of
variances, whose timely reporting should maximise the opportunity for
managerial action – CIMA
Purpose: Explain the difference between actual and expected results,
and facilitate performance evaluation and control purposes
• Variances can be calculated for both costs and sales.
• Favourable (F) variance  Actual better than expected results
• Adverse (A) variance  Actual worse than expected results
Three types:
1. Variable cost variances
2. Fixed overhead variances
3. Sales variances
Variances
Sales Variance
+/- Variable Cost Variances
+/- Fixed Cost Variances
Profit Variances
Profit variance
Total production cost
variance
Total sales margin
variance
Sales margin
price variance
Total direct
materials
variance
Materials
price
variance
Materials
usage
variance
Total direct
labour variance
Labour
rate
variance
Labour
efficiency
variance
Total variable
o/h variance
Variable o/h
expenditure
variance
Sales margin
volume variance
Fixed o/h
expenditure
variance
Variable o/h
efficiency
variance
Fixed o/h
volume
variance
Traditional Variance Analysis
Abbreviations
Materials
Fixed overheads
• SP = standard price
• BFO = budgeted fixed overhead
• AP = actual price
• AFO = actual fixed overhead
• SQ = standard quantity (of
the actual output)
• BO = budgeted output
• AQ = actual quantity
Labour
• SR = standard rate
• AR = actual rate
• SH = standard hours
(of the actual output)
• AH = actual hours
• AO = actual output
Sales
• BV = budgeted volume
• AV = actual volume
• SM = standard margin (either
profit or contribution)
Cost Variances
3 components of Prime Costs
1. Materials
2. Labour
3. Variable overheads
Material Variances
A General Model for Variance Analysis
Materials Price & Usage Variances
Material Variances Summary
Material Price Variances Example
Hanson plc. has the following direct material standard to
manufacture one unit: 1.5 kgs per unit at £4.00 per kg. Last week
1,700 kgs of material were purchased and used to make 1,000 units.
The material cost a total of £6,630.
Required:
Calculate Hanson’s material price variance (MPV) for the week
Answer:
Actual Price (AP) = £6,630 ÷ 1,700 kgs = £3.90 per kg
MPV = AQ × (SP - AP)
MPV = 1,700 kgs × ( £4 – £3.9 )
MPV = £170 F
Material Quantity Variances Example
Hanson plc. has the following direct material standard to
manufacture one unit: 1.5 kgs per unit at £4.00 per kg. Last week
1,700 kgs of material were purchased and used to make 1,000 units.
The material cost a total of £6,630.
Required:
Calculate Hanson’s material quantity variance (MQV) for the week
Answer:
Standard Quantity (SQ) = 1,000 units × 1.5 kgs = 1,500 kgs
MQV = SP × (SQ - AQ)
MQV = £4 × (1,500 kgs – 1,700 kgs)
MQV = £800 A
Material Variances Summary
Material Price Example (cont.)
Hanson plc. has the following
direct material standard to
manufacture one unit: 1.5 kgs
per unit at £4.00 per kg. Last
week 2,800 kgs of material were
purchased at a total cost of
£10,920, and 1,700 kgs were
used to make 1,000 units.
Material Price Example Notes
• The price variance is computed on the quantity PURCHASED i.e.
2,800 kgs
• Price variance increases because quantity purchased increases.
• The quantity variance is computed on the quantity USED for
production i.e. 1,700 kgs
• Quantity variance is unchanged: i.e. £800 (A)
Material Variances Interpretation
Material Price Variance: Favourable
- Purchase of a lower grade material at a discount
- Buying large quantities to take advantage of quantity discounts
- A change in the market price of the material, or
- Strong bargaining by the purchasing department
Material Quantity Variance : Adverse
Since this variance is adverse, more materials were used to produce the actual output
than were called for by the standard. This could occur for a variety of reasons:
- Poorly trained or supervised workers
- Improperly adjusted/maintained machines
- Defective materials (possibly from the purchase of inferior grade materials above)
Labour Variances
Labour Rate & Idle Time Variances
Labour Efficiency Variance
Labour Rate & Efficiency Variances
Labour Rate Variance:
AH × (SR – AR)
Labour Efficiency Variance:
SR × (SH – AH)
SR: Standard Rate
AH: Actual Hours
SH: Standard Hours
AR: Actual Rate
Labour Rate Variances Example
Hanson plc. has the following direct labour standard to manufacture
one unit: 1.5 standard hours per unit at £6.00 per direct labour hour.
Last week 1,550 direct labour hours were paid at a total labour cost
of £9,610 to make 1,000 units.
Required:
Calculate Hanson’s labour rate variance (LRV) for the week
Answer:
Actual Rate (AR) = £9,610 ÷ 1,550 hrs = £6.20 per hour
LRV = AH × (SR – AR)
LRV = 1,550 hrs × ( £6 – £6.20)
LRV = £310 A
Labour Efficiency Variances Example
Hanson plc. has the following direct labour standard to manufacture
one unit: 1.5 standard hours per unit at £6.00 per direct labour hour.
Last week 1,550 direct labour hours were paid at a total Labour cost
of £9,610 to make 1,000 units.
Required:
Calculate Hanson’s labour efficiency variance (LEV) for the week
Answer:
LEV = SR × (SH - AH)
LEV = £6 × ( £1,500 – 1,550)
LEV = £300 A
Labour Idle Time Variances Example
Hanson plc. has the following direct labour standard to manufacture
one unit: 1.5 standard hours per unit at £6.00 per direct labour hour.
Last week 1,550 direct labour hours were paid (that included 20 idle
hours) at a total labour cost of £9,610 to make 1,000 units.
Required:
Calculate Hanson’s labour idle time variance for the week.
Answer:
Actual hours paid = 1,550
Actual hours worked = 1,530
£6 × (1,550 – £1,530) = £120 A
Labour Variances Summary
Labour Variances Interpretation
Labour Rate Variance: Adverse
- Using highly paid skilled workers to perform unskilled tasks
Labour Efficiency Variance: Adverse
- Poorly trained workers
- Poor quality material
- Poor supervision of workers
- Poorly maintained equipment
Which Managers Influence Cost Variances?
Overhead Variances
Variable overheads
Fixed overheads
Variable O/H: Expenditure & Efficiency Variances
Expenditure Variance:
AH × (SR - AR)
Efficiency Variance:
SR × (SH - AH)
SR: Standard Rate
AH: Actual Hours
SH: Standard Hours
AR: Actual Rate
Variable O/H: Expenditure & Efficiency Variances
Variable O/H: Expenditure Variances Example
Hanson plc. has the following variable manufacturing overhead standard to
manufacture one unit: 1.5 standard hours per unit at £3.00 per direct
labour hour. Last week 1,550 hours were paid to make 1,000 units, and
£5,115 was spent for variable manufacturing overhead.
Required:
Calculate Hanson’s variable overhead expenditure variance for variable
manufacturing overhead for the week
Answer:
Actual Rate (AR) = £5,115 ÷ 1,550 hrs = £3.30 per hour
EV = AH × (SR - AR)
EV = 1,550 hrs × ( £3 – £3.30)
EV = £465 A
Variable O/H: Efficiency Variances Example
Hanson plc. has the following variable manufacturing overhead standard to
manufacture one unit: 1.5 standard hours per unit at £3.00 per direct
labour hour. Last week 1,550 hours were paid to make 1,000 units, and
£5,115 was spent for variable manufacturing overhead.
Required:
Calculate Hanson’s variable overhead efficiency variance for variable
manufacturing overhead for the week
Answer:
EffV = SR × (SH - AH)
EffV = £3 × (1,500 hrs - 1,550 hrs)
EffV = £150 A
Variable Overhead Variances Summary
Variable Overhead Variances Interpretation
Expenditure Variance:
- Results from paying more (or less) than expected for variable
overhead items and/or excessive use of these items
Efficiency Variance:
- Controlled by managing the overhead cost driver
- [In the previous example it was labour hours]
Fixed Overhead Variances
Absorption costing:
• Fixed overhead expenditure & volume variances
• Adverse variances  under-absorbed overhead
• Favourable variances  over-absorbed overhead
Fixed Overhead Variances: AC
Actual overhead
Overhead Absorbed
Under/(Over) absorption
X
(X)
X/(X)
Fixed Overhead Variances Example
Cola Co’s overhead is absorbed on the basis of machine hours
(i.e. using AC). Below is a flexed budget:
The estimated level of activity is 3,000 machine hours; therefore
OAR = £9k Fixed OH / 3k hours (i.e. £3/hr)
Actual production required 3,200 standard machine hours.
Actual fixed overhead was £8,450.
Total FO Variances = (£3 x 3,200) – £8,450 = £1,150 F
i.e. over-absorbed
Fixed Overhead Variances Summary
Sales Variances
Sales Price & Volume Variances
Sales Price & Volume Variances Notes
Sales Variances: Measure the effect on expected profit of:
• Different selling price to the standard
• Different volume of sales to the original budget
Sales Price Variance = (Standard Price – Actual Price) X Actual Quantity
Note: a favourable variance is a negative amount; and vice
versa
Sales Volume Variance = (BV – AV) * (Standard profit [AC])
Note: Computed in terms of contribution/profit margins rather
than sales revenues
Sales Variances: Example
The budgeted sales for Hans & Co are £110,000 consisting of
10,000 units at £11 per unit. The standard cost per unit is £7 (AC).
Actual sales are £120,000 (12,000 units at £10 per unit) and the
actual cost per unit is £6.
Required
Calculate the sales margin variances.
Answer
Sales price variance = 12,000 × £1 (£11 - £10) = £12,000 A
Sales volume variance = £4 ×2,000 (12,000 – 10,000) = £8,000 F
Total sales variance in terms of profit margin = £4,000 Adverse
Sales Variances Summary
Sales Variances Interpretation
•
Not very meaningful to separate the Sales Variances into price and volume
variances for substantive reasoning
- Change in selling prices are likely to affect volumes
- Due to the price elasticity of demand
• E.g. SPV-Adverse & SVV-Favourable
- Adverse price variance will tend to be associated with a favourable volume
variance (so has an inverse correlation)
• Some external factors may not be controllable by management
- e.g. competition, economic recession, etc
- May have a direct correlation on sales variances
• Better/alternative performance appraisal for sales team?
- Market share, market dynamics, competitor’s prices, etc.
- Balanced Scorecard
Operating Statement
Reconciliation of budgeted profit and actual profit
Operating Statements: Standard ABSORBTION Costing System
Valued at
st’d profit
Interpretation of Variances
•
•
•
Consider overall consequence
See pdf file on Moodle
‘Operational causes of
variances’
Interdependencies of
variances:
-
-
Identified for effective
interpretation
When two variances are
interdependent; one is
favourable and the other
adverse i.e. sales variances