Explain the various factors and considerations used in determining if a variance is overor underapplied
Under or Over Applied overhead is the difference between the amount of overhead
applied to products and the actual overhead costs incurred during the period.
Basically, the overhead variances break the under or over applied overhead down
into variances that can be used by managers for control purposes. The sum of the
overhead variances equals the under or over applied overhead costs for a period.
Furthermore, in a standard cost system, unfavorable variances are equivalent to
underapplied over head, and favorable variances are equivalent to Overapplied
overhead. Unfavorable variances occur because more was spent on overhead than
the standards allow.
The critical factor in determining whether a variance has been under or over
applied is the denominator level of activity (Machine hours, Direct Labor
Hours…etc.); if the denominator level of activity is greater than the standard hours
allowed for the output of the period, then the volume variance is unfavorable,
signifying an underutilization of available facilities and the opposite is true.
Why is this type of analysis important to managers?
Variance Analysis is an important element of management by exception. Simply
put, management by exception means that the manager’s attention should be
directed toward those parts of the organization where plans are not working out for
one reason or another. It is also important since the variances reveal that the
process is not working in the way it is supposed to work. Thus variances can point
out new ways of working as also ensure that work is done efficiently.
What are some causes of variances? How should they be addressed? Who should be held
responsible for these variances?
The causes of variances depend on the type of variance and that also decides who
should be held responsible.
Material Variances – Material variances could be
Price Variance – Price variance is if the actual price of the material is different from
the standard price. The variances could be due to lower quality purchase of material
or taking quantity discount through higher purchase. If materials of higher quality
are purchased at a higher price, the purchasing manager is held responsible for
price variance.
Quantity Variance – This arises if the material used is different that the standard
quantity. Possible causes could be either poor quality of higher quality material.
Unforeseen breakdown of machinery may also result is quantity variance. The
production manager is held responsible for quantity variance
Labor Variance – Labor variance could be
Rate Variance – The rate paid to labor is different than the standard rate. The
reason could be that either lower of higher skilled labor is used. At time labor may
be in short supply and so higher wages may need to be paid. If some overtime is
done, than also higher wages need to be paid. The human resources manager would
be held responsible for rate variance.
Efficiency Variance – This arises if the labor time used is different than the
standard time. The reason could be lower skilled workers are used or there are
unscheduled breakdowns. The production manager would be held responsible for
efficiency variance
Variable Overhead Variance
Variable Overhead Spending Variance - This variance measures the differences in
price of the resources used in overhead, and also includes elements of waste. The
waste portion of the variance is most directly controllable by plant management.
The price portion may or may not be controllable by management, depending on the
nature of the item involved. That is, electricity rates normally would not be
controllable by management, whereas prices paid for indirect materials might be
controllable.
Variable Overhead Efficiency Variance – This depends on the base used and is
usually labor hours and this variance moves in the same way as the labor efficiency
variance and should be the responsibility of the person who has the responsibility of
labor efficiency variance.
All variances either favorable or unfavorable need to be investigated. A threshold
may be fixed at say 5% and all variances above this should be investigated. The
causes of the variances should be ascertained and the processes changed so as to
ensure that the variances do no recur. If it is found that variances are due to
incorrect standards in which case the standards themselves need to be changed.
7-21 Price and efficiency variances. Peterson Foods manufactures pumpkin scones. For
January 2007, it budgeted to purchase and use 15,000 pounds of pumpkin at $0.89 a
pound. Actual purchases and usage for January 2007 were 16,000 pounds at $0.82 a
pound. It budgets for 60,000 pumpkin scones. Actual output was 60,800 pumpkin scones.
1. Compute the flexible-budget variance.
The key information items are:
Output units (scones)
Input units (pounds of pumpkin)
Cost per input unit
Actual
60,800
16,000
$0.82
Budgeted
60,000
15,000
$0.89
Peterson budgets to obtain 4 pumpkin scones from each pound of pumpkin.
The flexible-budget variance is $408 F.
Pumpkin costs
Actual
Results
(1)
$13,120
FlexibleBudget
Variance
(2) = (1) –
(3)
$408 F
Flexible
Budget
(3)
$13,528
SalesVolume
Variance
(4) = (3) –
(5)
$178 U
Static
Budget
(5)
$13,350
Calculations:
16,000*$0.82 = $13,120
60,800*$0.82 = $13,528
60,000*$0.89 = $13,350
2. Compute the price and efficiency variances.
Actual Costs
Incurred
(Actual Input Qty.
× Actual Price)
$13,120
Actual Input Qty.
× Budgeted Price
$14,240
$1,120 F
Price variance
Flexible Budget
(Budgeted Input
Qty. Allowed for
Actual Output
× Budgeted Price)
$13,528
$712 U
Efficiency variance
$408 F
Flexible-budget variance
3. Comment on the results in requirements 1 and 2.
The favorable flexible-budget variance of $408 has two offsetting components:
(a)
Favorable price variance of $1,120––reflects the $0.82 actual purchase
cost being lower than the $0.89 budgeted purchase cost per pound.
(b)
Unfavorable efficiency variance of $712–-reflects the actual materials
yield of 3.80 scones per pound of pumpkin (60,800 ÷ 16,000 = 3.80)
being less than the budgeted yield of 4.00 (60,000 ÷ 15,000 = 4.00).
(The company used more pumpkins (materials) to make the scones
than was budgeted.)
One explanation may be that Peterson purchased lower quality pumpkins at a lower
cost per pound.
How can determining the causes of these variances help the company improve?
Determining the causes of variances would help the company improve as managers’
attention could be focused on problematic areas, if for example materials of higher
quality are purchased at a higher price, such price increase should be taken into
account when preparing the budget for the next period. If lower quality materials
have been purchased, the purchasing manager should be advised not to use lower
quality materials as this would result in a lower product quality. In the case of
Quantity Variances could be a result from an unexpected machinery breakdowns,
for example, hence managers would need to put a maintenance schedule for the
machines to avoid such unpleasant problems.
In the case of an Unfavorable Efficiency Variance which mostly result from hiring
unskilled workers, management can start arranging training courses for such
unskilled labor so as they achieve the company’s standards
In short, all variances either favorable or unfavorable need to be investigated. A
threshold may be fixed at say 5% and all variances above this should be
investigated. The causes of the variances should be ascertained and the processes
changed so as to ensure that the variances do no recur. If it is found that variances
are due to incorrect standards in which case the standards themselves need to be
changed.
7-18 Flexible-budget preparation and analysis. Bank Management Printers, Inc.,
produces luxury checkbooks with three checks and stubs per page. Each checkbook is
designed for an individual customer and is ordered through the customer’s bank. The
company’s operating budget for September 2007 included these data:
Number of checkbooks 15,000
Selling price per book $20
Variable cost per book $8
Fixed costs for the month $145,000
The actual results for September 2007 were:
Number of checkbooks produced and sold 12,000
Average selling price per book $21
Variable cost per book $7
Fixed costs for the month $150,000
The executive vice president of the company observed that the operating income for
September was much less than anticipated, despite a higher-than-budgeted selling price
and a lower-than-budgeted variable cost per unit. As the company’s management
accountant, you have been asked to provide explanations for the disappointing September
results. Bank Management develops its flexible budget on the basis of budgeted peroutput-unit revenue and per-output-unit variable costs without detailed analysis of
budgeted inputs.
1. Prepare a level 1 analysis of the September performance.
Level 1 Analysis
Actual
Results
(1)
12,000
a
$252,000
d
84,000
168,000
150,000
$ 18,000
Units sold
Revenue
Variable costs
Contribution margin
Fixed costs
Operating income
Static-Budget
Variances
(2) = (1) – (3)
3,000 U
$ 48,000 U
36,000 F
12,000 U
5,000 U
$ 17,000 U
Static
Budget
(3)
15,000
c
$300,000
f
120,000
180,000
145,000
$ 35,000
$17,000 U
Total static-budget variance
2. Prepare a level 2 analysis of the September performance.
Level 2 Analysis
Units sold
Revenue
Variable costs
Contribution
margin
Fixed costs
Operating income
Actual
Results
(1)
12,000
a
$252,000
d
84,000
FlexibleBudget
Flexible
Variances
Budget
(2) = (1) – (3)
(3)
0
12,000
b
$12,000 F $240,000
e
96,000
12,000 F
168,000
150,000
24,000 F
5,000 U
$ 18,000
$19,000 F
Sales
Volume
Static
Variances
Budget
(4) = (3) – (5)
(5)
3,000 U
15,000
c
$300,000
$60,000 U
f
120,000
24,000 F
144,000
145,000
36,000 U
0
180,000
145,000
$ (1,000)
$36,000 U
$ 35,000
$19,000 F
$36,000 U
Total flexible-budget
Total sales-volume
variance
variance
$17,000 U
Total static-budget variance
a 12,000 × $21 = $252,000 d 12,000 × $7 =
$ 84,000
b 12,000 × $20 = $240,000 e 12,000 × $8 =
$ 96,000
c 15,000 × $20 = $300,000 f 15,000 × $8 = $120,000
3. Why might Bank Management find the level 2 analysis more informative than the level
1 analysis? Explain your answer.
Level 2 analysis provides a breakdown of the static-budget variance into a flexiblebudget variance and a sales-volume variance. The primary reason for the staticbudget variance being unfavorable ($17,000 U) is the reduction in unit volume from
the budgeted 15,000 to an actual 12,000. One explanation for this reduction is the
increase in selling price from a budgeted $20 to an actual $21. Operating
management was able to reduce variable costs by $12,000 relative to the flexible
budget. This reduction could be a sign of efficient management. Alternatively, it
could be due to using lower quality materials (which in turn adversely affected unit
volume).