Advantages / Benefits of Standard Costing System:
Standard costing System has the following main advantages or benefits:
1. The use of standard costs is a key element in a management by exception approach. If costs
remain within the standards, Managers can focus on other issues. When costs fall significantly
outside the standards, managers are alerted that there may be problems requiring attention. This
approach helps managers focus on important issues.
2. Standards that are viewed as reasonable by employees can promote economy and efficiency.
They provide benchmarks that individuals can use to judge their own performance.
3. Standard costs can greatly simplify bookkeeping. Instead of recording actual costs for each job,
the standard costs for materials, labour, and overhead can be charged to jobs.
4. Standard costs fit naturally in an integrated system of responsibility accounting. The standards
establish what costs should be, who should be responsible for them, and what actual costs are
under control.
Disadvantages / Problems / Limitations of Standard Costing System:
1. Standard cost variance reports are usually prepared on a monthly basis and often are released
days or even weeks after the end of the month. As a consequence, the information in the reports
may be so stale that it is almost useless. Timely, frequent reports that are approximately correct
are better than infrequent reports that are very precise but out of date by the time they are
released. Some companies are now reporting variances and other key operating data daily or even
more frequently.
2. If managers are insensitive and use variance reports as a club, morale may suffer. Employees
should receive positive reinforcement for work well done. Management by exception, by its
nature, tends to focus on the negative. If variances are used as a club, subordinates may be
tempted to cover up unfavourable variances or take actions that are not in the best interest of the
company to make sure the variances are favourable. For example, workers may put on a crash
effort to increase output at the end of the month to avoid an unfavourable labour efficiency
variance. In the rush to produce output quality may suffer.
3. Labour quantity standards and efficiency variances make two important assumptions. First, they
assume that the production process is labour-paced; if labour works faster, output will go up.
However, output in many companies is no longer determined by how fast labour works; rather, it
is determined by the processing speed of machines. Second, the computations assume that labour
is a variable cost. However, direct labour may be essentially fixed, then an undue emphasis on
labour efficiency variances creates pressure to build excess work in process and finished goods
inventories.
4. In some cases, a "favourable" variance can be as bad or worse than an "unfavourable" variance.
For example, McDonald's has a standard for the amount of hamburger meat that should be in a
Big Mac. A "favourable" variance would mean that less meat was used than standard specifies.
The result is a substandard Big Mac and possibly an unsatisfied customer.
5. There may be a tendency with standard cost reporting systems to emphasize meeting the
standards to the exclusion of other important objectives such as maintaining and improving
quality, on-time delivery, and customer satisfaction. This tendency can be reduced by using
supplemental performance measures that focus on these other objectives.
6. Just meeting standards may not be sufficient; continual improvement may be necessary to survive
in the current competitive environment. For this reason, some companies focus on the trends in
the standard cost variances - aiming for continual improvement rather than just meeting the
standards. In other companies, engineered standards are being replaced either by a rolling average
of actual costs, which is expected to decline, or by very challenging target costs.
In sum, managers should exercise considerable care in their use of a standard cost system. It is
particularly important that managers go out of their way to focus on the positive, rather than just on the
negative, and to be aware of possible unintended consequences.
Nevertheless standard costs are still found in the vast majority of manufacturing companies and in many
service companies, although their use is changing. For evaluating performance, standard cost variances
may be supplanted in the future by a particularly interesting development known as the balanced
scorecard.
Direct Materials Price Standards:
Definition and Explanation:
Standard price per unit of direct materials is the price that should be paid for a single unit of materials,
including allowances for quality, quantity purchased, shipping, receiving, and other such costs, net of any
discounts allowed.
Price standards for direct materials permit checking the performance of the purchasing department and
the influence of various internal and external factors. It also includes measuring the effect of a price
increase or decrease on the company's profits. Determining the price or cost to be used as the standard
cost is often difficult because the prices used are controlled more by external factors than by company's
management. Prices selected should reflect current market prices and are generally used throughout the
forthcoming fiscal period. If the actual price paid is more or less than the standard price, a price variance
occurs. This is usually called direct materials price variance. Price increases or decreases occurring during
the fiscal period are recorded in the materials price variance account(s). Price standards are revised at
inventory dates or whenever there is a major change in the market price of any of the principle materials
or parts.
Standard price per unit for direct materials should reflect the final delivered cost of materials, net of any
discounts taken. Allowances for freights and handling should also be taken into account.
Example:
Calculation of standard price per unit of direct materials or raw materials:
Purchase price, top-grade pewter ingots, in 40-pounds ingots
Freight, by truck, from suppliers warehouse
Receiving and handling
Less purchase discount
Standard price per pound
$ 3.60
+0.44
+0.05
-0.09
-------$4.00
====
Notice that the standard price reflects a particular grade of materials (top grade), purchased in particular
lot size (40 pound ingots), and delivered by a particular type of carrier (truck). Allowances have also been
made for handling and discounts. If everything proceeds according to these expectations, the net cost of a
pound of pewter (direct material in the example above) should therefore be $4.00.
Direct Materials Quantity Standards:
Definition and Explanation:
Standard quantity per unit of direct materials is the amount of direct materials or raw materials that should
be required to complete a single unit of product, including allowances for normal waste, spoilage, rejects,
and similar inefficiencies.
Quantity of usage standards are generally developed from materials specifications prepared by the
department of engineering (mechanical, electrical, or chemical) or product design. In a small or medium
sized company, the superintendent or even the foremen will state basic specifications regarding type,
quantity, and quality of raw materials need and operations to be performed.
Quantity standards should be set after the most economical size, shape, and quality of the product and the
results expected from the use of various kinds and grades of materials have been analyzed The standard
quantity should be increased to include allowances for acceptable levels of waste, spoilage, shrinkage,
seepage, evaporation, and leakage. The determination of spoilage or waste should be based on figures that
prevail after the experimental and developmental stages of the product have been passed.
The standard quantity per unit for direct materials should reflect the amount of material required for each
unit of finished product, as well as an allowance for unavoidable waste, spoilage, and other normal
inefficiencies.
Example:
Calculation of standard quantity per unit of direct materials or raw materials:
Materials requirement (in pounds) per unit as specified in the bill of
materials*
Allowance for wastage and spoilage
Allowance for rejects
Standard of materials requirements (in pounds)
2.7
0.2
0.1
-----3.0
====
*A bill of materials is a list that shows the quantity of each type of material in a unit of finished product.
It is a handy source of determining the basic material input per unit, but it should be adjusted for waste
and other factors as shown above, when determining the standard quantity per unit of product. "waste and
spoilage" in the table above refers to materials that are wasted as a normal part of the production process
or that spoil before they are used. "Rejects" refers to the direct material contained in units that are
defective and must be scrapped.
Although it is common to recognize allowances for waste, spoilage, and rejects when setting standard
costs, this practice is now coming into question. Those involved in total quality management (TQM) and
similar other business improvement programs argue that no amount of waste or defects should be
tolerated. If allowances for waste, spoilage, and rejects are built into the standard cost, the levels of those
allowances should be periodically reviewed and reduced over time to reflect improvement process, better
training, and better equipment.
Once the direct materials price and quantity standards have been set, the standard cost of a material
per unit of finished product can be computed as follows.
3 pounds per unit × $ 4.00 per pound = $ 12 per unit
This $12 cost figure will appear as one item on the product's standard cost card as shown by the following
example.
Example of standard cost card:
Inputs
Direct materials
Direct labour
Variable manufacturing overhead
(1)
Standard
Quantity or
Hours
3.0 pounds
2.5 hours
2.5 hours
(2)
Standard
Price or
Rate
$ 4.00
$ 14.00
$ 3.00
Total standard cost per unit
(3)
Standard
Cost
(1) × (2)
$ 12.00
$ 35.00
$ 7.50
---------$54.50
=====
An important reason for separating standards into two categories - price and quantity - is that different
managers are usually responsible for buying and for using inputs and these two activities occur at
different points in time. In the case of raw materials the purchasing manager is responsible for the price,
and this responsibility is exercised at the time of purchase. In contrast, the production manager is
responsible for the amount of raw materials used, and this responsibility is exercised when the materials
are used in production, which may be many weeks or months after the purchase date. It is important,
therefore, that we cleanly separate discrepancies due to deviations from price standards from those due to
deviations from quantity standards. Differences between standard prices and actual prices and standard
quantities and actual quantities are called variances. The act of calculating and interpreting variances is
called variance analysis.
In Business | Standards in the Spanish Royal Tobacco Factory
Standards have been used for centuries in commercial enterprises. For example, the
Spanish Royal Tobacco Factory in Seville used standards to control costs in the 1700s. The
Royal Tobacco Factory had a monopoly over snuff and cigar production in Spain and was
the largest industrial building in Europe. Employee theft of tobacco was a particular
problem, due to its high value. Careful records were maintained of the amount of tobacco
leaf issued to each worker, the number of cigars expected to be made based on
standards, and the actual production. The worker was not paid if the actual production
was less than the expected production. To minimize theft, tobacco was weighed after each
production step to determine the amount of wastage.
Source: Salvador Carmona, Mahmoud Ezzamel, and Fernando Gutierrez, "Control and Cost Accounting Practices in the
Spanish Royal Tobacco Factory, "Accounting, Organizations, and Society 22, no. 5, 1997, pp. 411-446"
Variance
A variance occurs when there is a difference between the actual result and the corresponding budgeted
amount.
Static Budget
The static budget is really the master budget established at the start of the budget period for the business
entity. This budget is prepared based on an assumed level of output.
Static Budget Variance
This is the first level of variance analysis referred to as Level 0 and is calculated as below:
Static Budget Variance = Actual Operating Income – Static Budget Operating Income
A favourable variance results in the increase in the entity’s operating income, whereas an unfavourable
variance results in the decrease in the entity’s operating income.
The static-budget variance is comprised of the results of two variances, firstly the Flexible-Budget
variance and the Sales-Volume variance.
Flexible Budget
The Flexible budget calculates budgeted revenues and expenses based on actual output in the budget
period. It really is the static budget that has been “flexed” or adjusted to reflect the expenses and revenues
based on the actual production/sales.
The Flexible budget is prepared by proportionately increasing/decreasing variable costs and revenues in
keeping with the relevant level of output. Fixed costs remain unchanged, provided that they remain within
the relevant range.
Flexible Budget Variance
Flexible Budget Variance = Actual Operating Income –Flexible Budget Operating Income
The Flexible Budget variance exists because the following items differ from the budgeted amount:
 Revenue
 Variable Costs
 Fixed Costs
Sales Volume Variance
Sales Volume Variance = Flexible Budget Operating Income – Static Budget Operating Income
The sales volume variance can also be computed as below:
(Actual units sold - Budgeted units sold) x Budgeted price per unit = Sales volume variance
An unfavourable variance means that the actual number of units sold was lower than the budgeted number
sold. The budgeted number of units sold is derived by the sales and marketing managers, and is based on
their estimation of how the company's product market share, features, price points, expected marketing
activities, distribution channels, and sales in new regions will impact future sales. 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 favourable, even though the selling price variance is unfavourable.
There are a number of possible causes of a sales volume variance. For example:
Cannibalization:
The company may have released another product that competes with the product
in question. Thus, sales of one product cannibalize sales of the other product.
Competition:
Competitors may have released new products that are more attractive to
customers.
Price:
The company may have altered the product price, which in turn drives a change
in unit sales volume.
Trade restrictions:
A foreign country may have altered its barriers to competition.
Sales Volume Variance 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) x $65 Budgeted price per unit
= $260,000 Unfavourable sales volume variance
Definition and Explanation of Direct Materials Price Variance
Direct materials price variance is the difference between the actual purchase price and standard purchase
price of materials. Direct materials price variance is calculated either at the time of purchase of direct
materials or at the time when the direct materials are used. When this variance is computed at the time of
purchase of materials it is called direct materials purchase price variance. When this variance is computed
at the time of usage this is typically called direct materials price usage variance.
Direct materials price variance formula:
Following formula is used to calculate materials price variance:
Materials Price Variance = (Actual price – Budgeted price) × Actual quantity
Example:
Colonial Pewter Company provides the following information:
Standard price of material is $4.00 per pond and 6,500 pounds of materials have been purchased at a cost
of $3.80 per pound. This cost figure includes freight and handling and is net of quantity discount. All the
materials purchased have been used and an output of 2,000 units is produced during the period.
Required: Calculate materials price variance.
= ($3.80 - $4.00) x 2,000
= ($1,300) Favourable
A favourable material price variance of ($1,300) exists because the actual price of materials purchased
is less than the standard price of materials purchased. A material price variance is called unfavourable
materials price variance if the actual price of materials purchased is more than the standard price of
materials purchased.
Variance analysis reports are often issued in a tabular format. An example of such a variance report
follows along with an explanation for the materials price variance that has been calculated above for
Colonial Pewter Company.
Colonial Pewter Company
Performance Report - Purchasing Department
Item Purchased
Pewter
Quantity
Purchased
Actual Price
Standard Price
1
2
3
6,500 pounds
$3.80
$4.00
Difference in
Price
Total Price
Variance
4
5
(2) – (3)
(1) × (4)
$0.20
($1,300)
Favourable
Explanation
Bargained for an
especially good
price
Who is Responsible for Material Price Variance?
Generally speaking, the purchase manager has control over the price paid for goods and is therefore
responsible for any price variation. Many factors influence the price paid for the goods, including number
of units ordered in a lot, how the order is delivered, and the quality of materials purchased. A deviation in
any of these factors from what was assumed when the standards were set can result in price variance. For
example purchase of second grade materials rather than top-grade materials may be a reason of
favourable price variance, since the lower grade material will generally be less costly but perhaps less
suitable for production and can be a reason of unfavourable materials quantity variance.
However, someone other than purchasing manager could be responsible for materials price variance. For
example, production is scheduled in such a way that the purchasing manager must request express
delivery. In this situation the production manager should be held responsible for the resulting price
variance.
Exercise 1: Materials Variance Analysis
The Schlosser Lawn Furniture Company uses 12 meters of aluminium pipe at $0.80 per meter as standard
for the production of its Type A lawn chair. During one month's operations, 100,000 meters of the pipe
were purchased at $0.78 a meter, and 7,200 chairs were produced using 87,300 meters of pipe. The
materials price variance is recognized when materials are purchased. Calculate materials price variance.
Solution:
Actual quantity purchased
Actual quantity purchased
Materials purchase price variance
Meters of pipe
100,000
100,000
--------100,000
=======
Unit Cost
Amount
$0.78 actual
$78,000
$0.80 standard
$80,000
----------------$(0.02)
$(2,000) fav.
=======
=======
Exercise 2: Materials Variance Analysis
The standard price for material 3-291 is $3.65 litres. During November, 2,000 litres were
purchased at $3.60 per litre. The quantity of material 3-291 issued during the month was
1775 litres and the quantity allowed for November production was 1,825 litres. Calculate
materials price variance, assuming that:
1. It is recorded at the time of purchase (Materials purchase price variance).
2. It is recorded at the time of issue (Materials price usage variance).
Solution:
Actual quantity purchased
Actual quantity purchased
Materials purchase price variance
Actual quantity used
Actual quantity used
Materials price usage variance
Litres
2,000
2,000
--------2,000
======
1775
1775
--------1775
======
Unit cost
Amount
3.60 actual
$7,200
3.65 standard
7,300
-----------------$ (0.05)
$(100) fav.
======
======
3.60 actual
$6390.00
3.65 standard $6478.75
----------------$(0.05)
(88.75)
======
=======
Source: http://www.accountingformanagement.com/direct_materials_price_variance.htm
Definition and Explanation of Direct Material Quantity Variance:
Direct materials quantity variance is also known as Direct materials efficiency variance and Direct
materials usage variance. It measures the difference between the quantity of materials used in
production and the quantity that should have been used according to the standard that has been set.
Although the variance is concerned with the physical usage of materials, it is generally stated in dollar
terms to help gauge its importance.
Materials Efficiency variance Formula:
Materials efficiency variance =
(Actual quantity used - Standard quantity allowed) × Standard Price
Example:
Colonial Pewter Company provides the following data:
3.0 pounds of materials are required to produce a unit of product according to standards set by the
management. The standard price of direct materials is $4.00 per pound. During the period 2000 unit were
completed with an actual consumption of 6,500 pounds of direct materials.
Calculate direct materials efficiency variance.
Calculation of Materials Quantity Variance =
= (6,500 pounds − 6,000* pounds) × $4.00
= $2,000 Unfavourable
*Standard quantity allowed (3.00 per unit × 2,000 units)
Colonial Pewter Company
Performance Report - Production Department
(1)
(2)
Type of
Materials
Standard Price
Actual Quantity
Pewter
$4.00
6,500 Pounds
(3)
(4)
Standard Quantity Difference in Quantity
Allowed
(2) – (3)
6,000 Pounds
500 Pounds
(5)
Total Quantity
Variance
(1) × (4)
Explanation
$2,000
Unfavourable
Low quality
materials
unsuitable for
production
Above calculation shows an unfavourable direct materials quantity variance. When materials are used
more than what is allowed by standard an unfavourable quantity variance occurs. If materials used is less
than the quantity allowed a favourable direct materials quantity variance occurs.
Who is Responsible for Material Efficiency Variance?
Excessive usage of materials that is usually a reason of unfavourable direct materials quantity
variance may be due to inferior quality of materials, untrained workers, poor supervision etc. Generally
speaking production managers are held responsible for this variance. However purchasing department
may also be held responsible for purchasing materials of inferior quality to economize on prices. Where
purchasing department purchases low grade direct materials at low prices to show a favourable materials
price variance, the materials quantity variance is usually unfavourable due to inferior quality of direct
materials.
A word of caution is in order. Variance analysis should not be used as an excuse to conduct which hunts
or as a means of beating line managers and workers over the head. The emphasis must be on control in
the sense of supporting the line managers and assisting them in meeting the goals that they have
participated in setting for the company. In short, the emphasis should be positive rather than negative.
Excessive dwelling on what has already happened, particularly in terms of trying to find someone to
blame, can destroy morale and kill any cooperative spirit.
Exercise 1: Materials Variance Analysis
The Schlosser Lawn Furniture Company uses 12 meters of aluminium pipe at $0.80 per meter as standard
for the production of its Type A lawn chair. During one month's operations, 100,000 meters of the pipe
were purchased at $0.78 a meter, and 7,200 chairs were produced using 87,300 meters of pipe. The
materials price variance is recognized when materials are purchased. Calculate materials efficiency
variance.
Solution:
Actual quantity used
Standard quantity allowed
Materials quantity variance
$0.80
$69,840
standard
$0.80
86,400
$69,120
standard
------------------------ --------900
$0.80
$720 unfav.
=======
======= =======
87,300
Direct Labour Price Variance
Direct Labour price variance is also termed as direct labour rate variance. This variance measures
any deviation from standard in the average hourly rate paid to direct labour workers. In other words,
direct labour rate variance is the difference between the amount of actual hours worked at actual rate and
actual hours worked at standard rate.
Direct Labour Rate Variance Formula:
Following formula is used to calculate direct labour rate variance or direct labour price variance:
Labour rate variance = (Actual rate - Standard rate) x Actual hours worked
Example:
Suppose that 2,000 units have been produced during the period and 5,400 direct labour hours have been
worked at a rate of $13.75 per direct labour hour. Standard rate per direct labour hour is $14.00.
Calculate labour rate variance;
= ($13.75 - $14.00) x 5,400 hours
Labour rate variance = $(1,350) Favourable
Calculation shows a favourable labour rate variance because actual rate paid to workers is less than
standard rate. When the actual rate is more than the standard rate an unfavourable labour rate variance
results.
Rates paid to the workers are usually predictable. Nevertheless, rate variances can arise through the way
labour is used. Skill workers with high hourly rates of pay may be given duties that require little skill and
call for low hourly rates of pay. This will result in an unfavourable labour rate variance, since the actual
hourly rate of pay will exceed the standard rate specified for the particular task. In contrast, a favourable
rate variance would result when workers who are paid at a rate lower than specified in the standard are
assigned to the task. However, the low pay rate workers may not be as efficient. Finally, overtime work at
premium rates can be reason of an unfavourable labour price variance if the overtime premium is charged
to the labour account.
Who is responsible for the labour rate variance?
Since rate variances generally arise as a result of how labour is used, production supervisors bear
responsibility for seeing that labour price variances are kept under control.
Exercises:
Exercise 1: Labour Variance Analysis
The processing of a product requires a standard of 0.8 direct labour hours per unit for Operation 4-802 at
a standard wage rate of $6.75 per hour. The 2,000 units actually required 1,580 direct labour hours at a
cost of $6.90 per hour.
Required: Calculate labour rate variance or Labour price variance.
Solution:
Time
1,580
1.580
-------1,580
Actual hours worked
Actual hours worked
Labour rate variance
Rate
$6.90 actual
$6.75 standard
-------$0.15
Amount
$10,902
10,665
-------$237 unfav
Direct Labour Efficiency Variance
The quantity variance for direct labour is generally called direct labour efficiency variance or direct
labour usage variance. This variance measures the productivity of labour time. No variance is more
closely watched by management, since it is widely believed that increasing the productivity of direct
labour time is vital to reducing costs. The formula for the labour efficiency variance is expressed as
follows:
Formula of labour efficiency variance:
Labour efficiency variance =
(Actual hours worked − Standard hours allowed) × Standard rate
Example:
A company produces 2000 units of finished products using 5,400 hours. Standard time allowed for a unit
of finished product is 2.5 hours. Standard rate that is paid to workers is $14.00 per direct labour hour.
Calculate direct labour efficiency variance or direct labour quantity variance.
= (5,400 − 5,000*) × $14.00
= $5,600 Unfavourable
5,000* = 2,000 actual production × 2.50 standard hour allowed per unit
Processing of 2000 units required more time than what was allowed by standards. The result is an
unfavourable labour efficiency variance. A favourable labour efficiency variance occurs when actual
processing time is less than the time allowed by standards.
Who is Responsible for Labour Efficiency Variance?
The manager in charge of production is generally considered responsible for labour efficiency variance.
However, purchase manager could be held responsible if the acquisition of poor materials resulted in
excessive labour processing time. Possible causes / reasons of an unfavourable efficiency variance
include poorly trained workers, poor quality materials, faulty equipment, and poor supervision. Another
important cause / reason of an unfavourable labour efficiency variance may be insufficient demand for
company's products.
If customers’ orders are insufficient to keep the workers busy, the work centre manager has two options,
either accept an unfavourable labour efficiency variance or build up inventories. The second option is
opposite to the basic principle of just in time (JIT). Inventory with no immediate prospect of sale is a bad
idea according to just in time approach. Inventories, particularly work in process inventory leads to high
defect rate, obsolete goods, and generally inefficient operations. As a consequence, when the work force
is basically fixed in the short term, managers must be cautious about how labour efficiency variances are
used. Some managers advocate dispensing with labour efficiency variance entirely in such situations―at
least for the purpose of motivating and controlling workers on the shop floor.
Exercises:
Exercise 1: Labour Efficiency Variance Analysis
The processing of a product requires a standard of 0.8 direct labour hours per unit for
Operation 4-802 at a standard wage rate of $6.75 per hour. The 2,000 units actually
required 1,580 direct labour hours at a cost of $6.90 per hour.
Required: Calculate labour efficiency variance or Labour usage variance.
Solution:
Actual hours worked
Standard hours allowed
Labour rate variance
Time
1,580
1,600
-------(20)
Rate
$6.75 standard
$6.75 standard
-------$6.75
Amount
$10,665
10,800
-------$(135) fav.
Variable overhead efficiency variance
When companies adopt four variance analysis approach they divide the overhead efficiency variance
(which is calculated when three variance approach is used) into its variable and fixed components.
Variable component is called variable overhead efficiency variance and fixed component is called fixed
overhead efficiency variance.
Formula of Variable Overhead Efficiency Variance:
Following formula is used for the calculation of variable overhead efficiency variance:
(Actual hours - standard hours) x Standard overhead rate*
Note the similarity with the Labour efficiency variance
Example:
Esquire Clothing manufactures designer suits. Variable manufacturing overheads are allocated on the
basis of manufacturing labour hours per suit. For January 2010, the completion of each suit is budgeted to
take four labour hours. Budgeted variable manufacturing overhead cost per labour hour is $12. The
budgeted number of suits to be manufactured in January 2010 is 1,040.
Actual variable manufacturing costs in January 2010 is $52,164 for 1,080 suits started and completed.
There was no start or ending inventory of suits. Actual direct manufacturing labour hours for January
2010 were 4,536.
Required: Compute the Variable Overhead Efficiency Variance
[4,536 – (4hrs per unit x 1,080 suits)] x $12
= [4,536 - 4,320] x $12
= $2,592 Unfavourable
The variance is unfavourable because the company would have absorbed more variable overheads given
that the allocation base of 4,536 hours was greater than the standard quantity of labour hours that should
have been used – 4,320. The higher allocation base would have resulted in the company absorbing more
overheads.
An unfavourable variance may reflect one or more of the following issues:





Workers are less skilled than expected
More machine hours were used due to inefficient scheduling of jobs
Workers are experiencing fatigue and are not performing at their best
The need to complete a rush delivery resulted in the use of more labour hours
The budgeted number of labour hours was set too low
A favourable variance means that the actual hours worked were less than the budgeted hours, resulting in
the application of the standard overhead rate across fewer hours, resulting in less expense incurred.
However, a favourable variance does not necessarily mean that a company has incurred less actual
overhead; it simply means that there was an improvement in the allocation base that was used to apply
overhead.
The variable overhead efficiency variance is a compilation of production expense information submitted
by the production department, and the projected labour hours to be worked, as estimated by the industrial
engineering and production scheduling staffs, based on historical and projected efficiency and equipment
capacity levels.
Variable Overhead Spending Variance
This is calculated as below:
Variable O/H Spending Variance =
(Actual O/H Allocation rate – Budgeted O/H Allocation rate) x Actual Hours
Example:
Esquire Clothing manufactures designer suits. Variable manufacturing overheads are allocated on the
basis of manufacturing labour hours per suit. For January 2010, the completion of each suit is budgeted to
take four labour hours. Budgeted variable manufacturing overhead cost per labour hour is $12. The
budgeted number of suits to be manufactured in January 2010 is 1,040.
Actual variable manufacturing costs in January 2010 is $52,164 for 1,080 suits started and completed.
There was no start or ending inventory of suits. Actual direct manufacturing labour hours for January
2010 were 4,536.
Required: Compute the Variable Overhead Spending Variance
[($52,164 ÷ 4,536 labour hrs) - $12 per labour hr] x 4,536 labour hrs
= [$11.50 - $12.00] x 4,536
= ($2,268) Favourable
A favourable variance means that the actual variable overhead expenses incurred per labour hour were
less than expected. The variable overhead spending variance is a compilation of production expense
information submitted by the production department, and the projected labour hours to be worked, as
estimated by the industrial engineering and production scheduling staffs, based on historical and projected
efficiency and equipment capacity levels.
There are a number of possible causes of a variable overhead spending variance. For example:
Account misclassification:
The variable overhead category includes a number of accounts, some of
which may have been incorrectly classified and so do not appear as part
of variable overhead (or vice versa).
Outsourcing:
Some activities that had been sourced in-house have now been shifted to
a supplier, or vice versa.
Supplier pricing:
Suppliers have changed their prices, which have not yet been reflected in
updated standards.
Fixed Overhead Spending Variance
Fixed O/H Spending Variance = Actual Fixed O/H – Flexible Budget Fixed O/H
An unfavourable variance means that actual overhead expenditures were greater than planned. 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 unfavourable variance. For example, if a hotel leases a property and
desires to increase their capacity by leasing additional space, the fixed lease expense will now increase
because the hotel exceeded the relevant range of the initial expense.
Also, there may be some seasonality in fixed overhead expenditures, which may cause both favourable
and unfavourable 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 unfavourable if the actual overhead costs
incurred are greater than the budgeted amount.
Example:
Esquire Clothing manufactures designer suits. Variable manufacturing overheads are allocated on the
basis of manufacturing labour hours per suit. For January 2010, the completion of each suit is budgeted to
take four labour hours. Budgeted variable manufacturing overhead cost per labour hour is $12. The
budgeted number of suits to be manufactured in January 2010 is 1,040.
Actual variable manufacturing costs in January 2010 is $52,164 for 1,080 suits started and completed.
There was no start or ending inventory of suits. Actual direct manufacturing labour hours for January
2010 were 4,536.The company allocates fixed manufacturing overheads to each suit using budgeted direct
manufacturing labour hours per suit. Budgeted fixed manufacturing overheads for January 2010 was
$62,400 and actual overhead cost was $63,916.
$63,916 - $62,400 = $1,516 Unfavourable
Fixed Overhead Production-Volume Variance
This is the difference between budgeted fixed overhead and fixed overhead allocated on the basis of
actual output produced. It is calculated as per below:
Production
Volume
Variance
=
Budgeted
Fixed O/H
-
Fixed O/H allocated using
budgeted input allowed for actual
output units produced
Example:
Using the information about Esquire, calculate the Production Volume Variance
Solution
First we calculate the Budgeted Fixed O/H allocation rate =
Budgeted Fixed O/H ÷ Budgeted quantity of the allocation base
= $62,400 ÷ (4 labour hrs x 1,040 suits to be produced)
= $62,400 ÷ 4,160 hours
= $15 per labour hour
Production Volume Variance = $62,400 – [4 labour hours per suit x 1,080 suits produced x $15 per hr)
= $62,400 – $64,800
= ($2,400) Favourable Production Volume Variance
The variance is favourable because we over-allocated the fixed costs to actual output produced. The
allocation of more cost to each unit was based on the sole fact of producing more than budgeted. Note that
as long as the producer remains within the relevant range, fixed costs per unit remain fixed. Therefore, by
producing more, the producer has spread the fixed costs over more units and in effect, he has reduced his
fixed cost per unit. It is on this basis why we conclude that the variance is favourable.
Further analysis reveals something interesting; the overall Fixed O/H Cost Variance is the difference
between the Actual Fixed O/H Cost and the Fixed O/H Cost allocated based on output –
$63,916 – (4 labour hrs x 1,080 suits x $15 per suit)
$63,916 - $64,800
($884) Favourable
If we add the results of the Fixed O/H Spending and Volume variances we derive the same answer as
above.
$1,516 + ($2,400)
= ($884) Favourable
The same is true for the overall Variable O/H Cost Variance which is the difference between the Actual
Variable O/H Cost and the Variable Cost allocated based on actual output –
$52,614 – (4 labour hrs x 1,080 suits x $12 per suit)
$52,614 - $51,840
$324
If we add the results of the Variable O/H Efficiency and Spending variances we derive the same answer
as above.
$2,592 + ($2,268)
$324