Chapters 10 & 11 Notes
Page 1
Variances
Companies prepare cost budgets as part of their
planning process. These budgets assume a
given level of activity (e.g., financial statements
assume that 10,000 units will be produced and
sold). Budgets that are tied to a specific level of
activity are referred to as Static Budgets.
Firms will compare their budgeted costs to their
actual costs in order to control costs, evaluate
employee performance, and evaluate the budgeting process. This comparison is done
by computing Budget Variances. A variance is the dollar difference between a budgeted
cost and the actual cost. Unfortunately, the actual activity level is very likely to be
different from the budgeted activity level (e.g., firm actually produced 9,000 units).
When dealing with Variable Costs, in order to have
a meaningful comparison, the budgeted and actual
costs must relate to the same activity level (e.g.,
comparing your actual labor costs [when you
produce 9,000 units to your labor cost budget (that
is based on 10,000 units)]. Consider the following
analogous situation, assume that your employer
asks you to: (i) produce a spectacular commercial,
and (ii) reserve a 30-second spot during the Super
Bowl in which you will showcase the commercial.
You are given a $10 million budget for this project. Instead of producing and running the
commercial, you contract with PBS to take over the sponsorship of Masterpiece Theatre
from Exxon Mobil for $9 million. Coming $1 million under budget is not very impressive,
when the activity that you did (Masterpiece Theatre) is significantly different than the
activity assumed in the budget (Super Bowl).
In order to have a valid comparison for Variable Costs, we use Flexible Budgets when
computing Budget Variances. A Flexible Budget is a cost function that produces a
different budgeted cost for different activity levels (e.g., Flexible Budget says that your
labor cost is equal to $30 for each unit produced). Using a Flexible Budget, you can
compare: (i) the actual cost, with (ii) a budgeted cost for the work that you actually did
(actual activity level).
Budgets and Variances
As noted above, Budget Variances are important tools used in evaluating your
operations. When comparing actual results to a Flexible Budget, there can be two
different reasons for a Budget Variance. For example, if your Direct Labor Costs on a
particular project exceeded the amount budgeted for that project, it can be due to: (i)
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Chapters 10 & 11 Notes
Page 2
paying your workers a higher rate per hour than you budgeted (Reason 1), and/or (ii)
your workers spending more time doing the project than you expected (Reason 2). It is
important for you to know which of the reasons is true. If the Budget Variance was due
to the first reason, then you need to talk to your HRM department (or whoever hires and
sets compensation). If the variance was due to the second reason, then you need to
speak to the person supervising the project. We subdivide Budget Variances in order to
identify which of the reasons is applicable to our situation.
The total difference between the actual cost and the Flexible Budget is called the
Budget Variance. We calculate a Budget Variance for each component of cost. The
Budget Variance is divided into a Price Variance and a Quantity Variance. The Price
Variance quantifies how much of the Budget Variance is due to a company having paid
an actual price for a cost component that is different than the budgeted price (Reason
1). The Quantity Variance quantifies how much of the Budget Variance is due to a firm
using an actual amount of a cost component that is different than the budgeted amount
(Reason 2).
Standards
As part of the budgeting process, firms develop standards:
•
Standard Price (SP) is the estimated price per unit of the cost component (not a
unit of product) that will be paid for that cost component (e.g., $10 per hour for
Direct Labor Costs).
•
Standard Quantity (SQ) is the estimated amount of the cost component that is
expected to be used to make one unit of product (e.g., 3 Direct Labor Hours to
produce one computer). When calculating Quantity Variances, the term,
“Standard Quantity,” is used to describe the amount of a cost component that is
expected to be used to make all of the units of product actually produced in a
given period. (e.g., we expect it to take 3 Direct Labor Hours to make a
computer; we made 1,000 computers this month; we therefore think it should
take 3,000 Direct Labor Hours to make those 1,000 computers). Because the
Standard Quantity is linked to the actual number of units of product produced, it
creates the Flexible Budget for a cost when it is multiplied by the Standard Price
($10 x 3 DLHs x 1,000 units = $30,000).
Companies develop these standards using a variety of sources (e.g., historical
experience, engineering studies, and input from operating personnel). Standards can
either be attainable or ideal. If they are ideal, you run the risk of debasing the value of
the standard cost because your workers know that it is unlikely that the standards will
be met.
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Chapters 10 & 11 Notes
Page 3
Calculation
When calculating Budget Variances, we also need to know the following information
about our actual costs:
•
Actual Price (AP) is the actual price that the firm paid for a unit of a cost
component (e.g., $11 per Direct Labor Hour).
•
Actual Quantity (AQ) is the actual amount of a cost component that was used to
make all of the units of the product produced (e.g., 3,300 Direct Labor Hours to
make 1,000 computers).
For a given component of cost: (i) the actual costs are calculated by multiplying the
Actual Price by the Actual Quantity; and (ii) the Flexible Budget is calculated by
multiplying the Standard Price by the Standard Quantity. In the following table, we set
up two columns to reflect the actual cost of a cost component (left column) and the
Flexible Budget for that cost component (right column). The difference between the
totals of each of these columns is the Budget Variance for the cost component in
question:
Actual Cost
AP X AQ
Flexible Budget
SP X SQ
In a Standard Costing system, which we will discuss shortly, the standard cost to
produce a unit is treated as the cost of each unit produced, and this amount is added to
Work In Process. The cost applied to Work In Process is the amount that appears in
the Flexible Budget column, and the difference between the two columns represents the
variance that appears in the accounting system. This is similar to the Manufacturing
Overhead Variance that we discussed previously, where the difference between the
actual overhead and the amount applied to Work In Process constituted the amount of
the variance.
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In order to divide the Budget Variance into a Price Variance and a Quantity Variance,
we will introduce a middle column that consists of the product of the Standard Price
multiplied by Actual Quantity. Once you have the totals of the three columns, you then
subtract the middle column from the left column in order to get the Price Variance. You
also subtract the right column from the middle column in order to get the Quantity
Variance:
Actual Cost
Mixed
Flexible Budget
AP X AQ
SP X AQ
SP X SQ
|_________ ________________| |________________ ________|
(-)
(-)
Price Variance
Quantity Variance
AQ (AP – SP)
SP (AQ – SQ)
Subtracting the middle column from the left column produces the following result:
(AP x AQ) - (SP x AQ)
When you factor out the common Actual Quantity, you get the formula used to calculate
the Price Variance:
AQ (AP - SP)
As the equation indicates, when we subtract the columns, we are holding the Actual
Quantity constant and comparing the Standard Price (budget) of a cost component to
the Actual Price paid. This comparison gives us the Price Variance.
Subtracting the right column from the middle column produces the following result:
(SP x AQ) - (SP x SQ)
When you factor out the common Standard Price, you get the formula used to calculate
the Quantity Variance:
SP (AQ - SQ)
As the equation indicates, by subtracting the right column from the middle column, we
are holding the Standard Price constant and comparing the Standard Quantity (budget)
of the cost component to the Actual Quantity used. This comparison gives you the
Quantity Variance.
Notice that you are always subtracting the budget (standard) from the actual. If you are
over budget, then the actual will be greater than the standard and you have a positive
number. Because we do not want to be over budget, this is referred to as an
“unfavorable” variance. If you are under budget, then the standard is greater than the
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Chapters 10 & 11 Notes
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actual, and you have a negative number. Because we want to be under budget, this is
referred to as a “favorable” variance.
Favorable Variance
Unfavorable Variance
Negative Number
Positive Number
Variance Example
Assume that Ralph, Inc., a clothing and fragrance
manufacturer, wishes to begin production of a
new line of shirts with really big logos (for people
who are nearsighted). Ralph estimates that
every new shirt will cost $6 in Direct Materials
using the following standards:
•
•
$ 2.00 a yard for the material; and
3 yards of material used in each shirt.
During its first month of operations, Ralph, Inc. produced 1,000 shirts at a Direct
Materials cost of $5,880. Ralph paid $2.10 a yard for materials and it used 2,800 yards
of material to produce the shirts. You would calculate the Direct Materials Price and
Quantity Variances as follows:
Actual Cost
Mixed
Flexible Budget
AP X AQ
SP X AQ
SP X SQ
$2.10 x 2,800 yds
$2.00 x 2,800 yds
$2.00 x 3,000 yds
$5,880
$5,600
$6,000
|_________ ________________| |________________ ________|
(-)
(-)
Price Variance
Quantity Variance
$5,880 - $5,600 = $280 U
$5,600 - $6,000 = - $400 F
Budget Variance $5,880 - $6,000 = -$120 F
The $120 favorable Direct Materials Budget Variance ($3880 - $6000=-$120) is
subdivided into the Price Variance and the Quantity Variance [$280 + (-$400) = -$120].
Use of Variances
These variances are used in the evaluating the performance of workers, as well as, the
validity of the standards used. In the Ralph, Inc. example, the Price Variance gives us
information on the job performance of Ralph’s materials buyer. Ralph should ask the
buyer to explain why he or she paid $2.10 per yard for Direct Materials when Ralph’s
Standard Price is $2.00 per yard. This difference cost Ralph $280 (the Price Variance).
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Chapters 10 & 11 Notes
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It is possible that the standard is too low. It is also possible that there may have been
an unforeseeable event that caused material prices to change. A poor job performance
by the purchaser is another possible explanation.
The Quantity Variance tells us that Ralph’s production supervisor used $400 less Direct
Materials than Ralph expected. Ralph should examine the supervisor’s performance in
order to determine whether the favorable variance is due to the Production
Department’s superior performance (e.g., there was less waste than is usually the
case), or whether it is likely to be repeated (e.g., due to instituting new techniques, or
the standard was too low to begin with). If the performance is likely to be repeated, then
Ralph should consider revising its Standard Quantity per unit.
Variance Names
The procedure described above (along with the formulas) can be used to calculate
variances for each of the Variable Costs of production: Direct Labor, Direct Materials,
and Variable Manufacturing Overhead. A number of different names are given to these
variances. Common variance names used for Variable Costs include:
Input
Direct Materials:
Direct Labor:
Variable Overhead:
Type
Price:
Quantity:
Price:
Quantity:
Price:
Quantity:
Variance Name
Materials Price Variance
Materials Usage, Efficiency or Quantity Variance
Labor Rate or Price Variance
Labor Efficiency Variance
Variable OH Spending or Price Variance
Variable Efficiency Variance
Special Rule For Materials Price Variance
In the foregoing example, we assumed that the firm bought the same amount of Direct
Materials that it used in the production process. If we buy an amount of Direct Materials
that is different from the amount used, then, contrary to the suggestion made in your
book, most firms calculate the Material Price Variance using the Actual Quantity
purchased rather than the Actual Quantity used.
There are two reasons for using the amount purchased in the calculation of the
Materials Price Variance:
•
First, if the Actual Quantity used is included in the calculation, then there would
be a delay in the evaluation of the material buyer’s job performance. The job
performance occurs when materials are purchased. The evaluation occurs when
the variance is calculated. Depending on the firm, the time between the
purchase of materials and their use in the production process could be lengthy.
Most firms want timely performance evaluations, and calculating the variance at
the time that the materials are purchased accomplishes this.
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Chapters 10 & 11 Notes
•
Page 7
Second, when using the Standard Costing system (which we will discuss shortly),
a company only knows the amount purchased at the time that the Materials Price
Variance is calculated.
Continuing with the Ralph, Inc. example, if Ralph bought 5,000 yards of Direct Materials
for the period in question, and it calculated the Materials Price Variance at the time of
purchase, then you would calculate the Direct Materials Variances as described below:
Actual Cost
AP X AQ
Mixed
SP X AQ
Flexible Budget
SP X AQ
SP X SQ
$2.10 x 5,000 yds
$2.00 x 5,000 yds
$10,500
$10,000
|________ ________|
(-)
Price Variance
$2.00 x 2,800 yds
$2.00 x 3,000 yds
$5,600
$6,000
|________ ________|
(-)
Quantity Variance
$10,500 - $10,000 = $500 U
$5,600 - $6,000 = - $400 F
AQ is the quantity purchased in the Materials Price Variance, and AQ is the quantity
used in the Materials Quantity Variance.
Fixed Manufacturing Overhead
The variances for Fixed Manufacturing Overhead are calculated differently than the
variances for the Variable Costs that we discussed above. This difference is due to the
fact that Fixed Manufacturing Overhead is a Fixed Cost, and a comparison of actual
costs to the Static Budget (rather than a Flexible Budget) provides a meaningful Budget
Variance. Having a budget change as the number of units produced changes is
appropriate for Variable Costs (Flexible Budget). By definition, the total Variable Cost
changes as the volume of the number of units changes. Fixed Manufacturing
Overhead, however, is a Fixed Cost, and we expect that the total Fixed Cost will remain
unchanged regardless of a change in the number of units produced (Static Budget).
For example, if:
(i)
(ii)
(iii)
you believe that your Fixed Manufacturing Overhead will be $100,000,
you apply Fixed Manufacturing Overhead as a function of units of product
produced, and
you estimate that you will produce 10,000 units,
then your Standard Price will be $10 per unit ($100,000/10,000). If you only produce
9,000 units, your Flexible Budget will produce a cost of $90,000. Traditionally, Fixed
Costs do not change if your activity level changes, and your budget for Fixed
Manufacturing Overhead should still be $100,000 at this production level (not $90,000).
The amount of Fixed Manufacturing Overhead that the Flexible Budget column
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Chapters 10 & 11 Notes
Page 8
produces will only coincide with your true budget for Fixed Manufacturing Overhead
when you produce 10,000 units. Because the right column does not really reflect your
budget for Fixed Manufacturing overhead, it is a misnomer to label that column as the
“Flexible Budget.” Instead, we will call it the “Standard Cost.”
This is a major problem with Fixed Manufacturing Overhead. As we saw in our
discussion of Normal Costing, we estimate our Fixed Manufacturing Overhead and then
divide it by our estimated Cost Driver. We then apply the overhead as a function of the
Cost Driver despite the fact that a Fixed Cost has no relationship with its Cost Driver. At
the end of the year, it is likely that you will have applied an amount of Fixed
Manufacturing Overhead that is different than your actual Fixed Manufacturing
Overhead cost because: (i) your estimate of your Fixed Manufacturing Overhead is
wrong (Reason A); and/or (ii) your estimate of your Cost Driver is wrong (Reason B).
We create two Fixed Manufacturing Overhead variances in order to quantify how much
of the Fixed Manufacturing Overhead Budget Variance is due to each reason: (i) the
Fixed Overhead Spending Variance (Reason A), and (ii) the Fixed Overhead Volume
Variance (Reason B).
In order to calculate these two variances, we replace the middle (Mixed) column with a
new middle column, which contains the true budget for Fixed Manufacturing Overhead
(Static Budget).
Actual Cost
Static Budget
Standard Amount
AP X AQ
The Fixed Overhead Budget
SP X SQ
|________ __________| |___________ ________|
(-)
Budget (Spending) Variance
(-)
Volume Variance
If you have not been given the Static Budget for Fixed Manufacturing Overhead, you
can calculate it. Remember that the Predetermined Fixed Overhead Rate is the
Standard Price (SP):
Fixed Overhead Budget / Estimated Number of Units = SP
Fixed Overhead Budget = SP x Estimated Number of Units
In order to calculate the Static Budget, you need to be given the estimated number of
units (or other Cost Driver) that was used in calculating the Standard Price for Fixed
Manufacturing Overhead. The Estimated Number of Units is sometimes referred to as
the firm’s Normal Capacity.
The Fixed Overhead Volume Variance compares: (i) the Static Budget, and (ii) the
Standard Cost for Fixed Manufacturing Overhead. It is called the Volume Variance
because the reason that the variance exists is the fact that the number of units (volume)
that you assumed when calculating the Standard Price is different than the actual
number of units produced. An unfavorable Volume Variance indicates that you
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Chapters 10 & 11 Notes
Page 9
produced fewer units than you estimated. It is considered unfavorable because you are
under-utilizing your factory. A favorable Volume Variance indicates that you produced
more units than you estimated. It is considered favorable because you are utilizing your
factory at a rate that is higher than expected.
Some authorities describe an unfavorable Volume Variance is the cost incurred to
obtain factory capacity that you did not use. This interpretation of the Volume Variance
is not accurate. If your budget for Fixed Manufacturing Overhead at the actual level of
production is the same as your budget at the estimated level of production, then there
was no additional cost incurred in order to obtain the unused capacity. The truth is that
you just guessed wrong on the activity level when you calculated the Standard Price.
The Fixed Overhead Budget Variance compares: (i) what you spent on Fixed
Manufacturing Overhead (actual), to (ii) your true budget for Fixed Manufacturing
Overhead. There is no need to divide the variance into a Price Variance and a Quantity
Variance, because Fixed Costs are a function of price alone. In theory, quantity does
not affect Fixed Costs. This variance is also referred to as the Fixed Overhead
Spending Variance.
Standard Costing
As we have mentioned previously, when you
use actual amounts as the cost components
that you record in your accounting system, it is
referred to as an Actual Costing System. A
Normal Costing System uses the actual cost of
Direct Materials and Direct Labor, but uses the
Standard Price and Actual Quantity for its
Manufacturing Overhead. This is the system
that we learned under Job-Order Costing.
With a Standard Costing System, you use the
Standard Price and the Standard Quantity for
all of the cost components. If a Standard Costing System, the Flexible Budget Column
(and the Standard Amount Column) in our table becomes the cost of the units that is
transferred to Work In Process.
With a Standard Costing System, all of the Budget Variances that we learned above are
recorded in the accounting system. When a cost is incurred, the actual cost is recorded
in the accounting system, when the cost is applied to the Work In Process Account, it is
applied using the Standard Price and the Standard Quantity. The difference between
these costs is recorded in the appropriate variance account. At the end of the year, all
of these variances are closed to Cost of Goods Sold (or Cost of Goods Sold, Finished
Goods, and Work In Process).
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When you buy Direct Materials:
Dr.
Materials Inventory
Materials Price Variance (Dr. or Cr.)
Cr. Accounts Payable
SP x AQ
AQ (AP – SP)
AP x AQ
As noted above, when using Standard Costing, the Materials Price Variance is
calculated using the amount purchased as the Actual Quantity because the amount
used is not known at this point.
When you requisition Direct Materials:
Dr.
Work In Process
Materials Usage Variance (Dr. or Cr.)
Cr. Materials Inventory
SP x SQ
SP (AQ – SQ)
SP x AQ
When you incur Direct Labor:
Dr.
Work In Process
Labor Rate Variance (Dr. or Cr.)
Labor Efficiency Variance (Dr. or Cr.)
Cr. Wages Payable
SP x SQ
AQ (AP – SP)
SP (AQ – SQ)
AP x AQ
In the Standard Costing system, you can divide your Manufacturing Overhead into two
accounts, Variable Manufacturing Overhead and Fixed Manufacturing Overhead. As
we saw in the Job-Order Costing discussion, the amounts remaining in the overhead
accounts at the end of the period represent the amounts of the overhead variances.
Debits are actual costs incurred and the credits are the Standard Costs applied:
When you incur Variable Manufacturing Overhead (actual):
Dr.
Variable Manufacturing Overhead
Cr.
Accounts Payable
AP x AQ
AP x AQ
When you apply Variable Manufacturing Overhead (standard):
Dr.
Work In Process
Cr.
Variable Manufacturing Overhead
SP x SQ
SP x SQ
When you incur Fixed Manufacturing Overhead (actual):
Dr.
Fixed Manufacturing Overhead
Cr.
Accounts Payable
AP x AQ
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AP x AQ
Chapters 10 & 11 Notes
Page 11
When you apply Fixed Manufacturing Overhead (standard):
Dr.
Work In Process
Cr.
Fixed Manufacturing Overhead
SP x SQ
SP x SQ
At the end of the period, we close these accounts to the appropriate variance accounts.
Whether accounts are debited or credited depends upon: (i) whether the overhead is
over-applied or under applied, and (ii) whether the variance in question is favorable or
unfavorable.
For example, if the Fixed Manufacturing Overhead was under-applied (a debit balance
remains in the Fixed Manufacturing Overhead account), and you had an unfavorable
Fixed Overhead Spending Variance and an unfavorable Fixed Overhead Volume
Variance:
Dr.
Fixed Overhead Spending Variance
Fixed Overhead Volume Variance
Cr.
Fixed Manufacturing Overhead
(AQxAP) – Budget
Budget – (SPxSQ)
(APxAQ)-(SPxSQ)
If the Variable Manufacturing Overhead was over-applied (a credit balance remains in
the Variable Manufacturing Overhead account), and you had a favorable Variable
Overhead Spending Variance and a favorable Variable Overhead Efficiency Variance:
Dr. Variable Manufacturing Overhead
Cr. Variable Overhead Spending Variance
Variable Overhead Efficiency Variance
(APxAQ)-(SPxSQ)
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AQ (AP – SP)
SP (AQ – SQ)