Paper F2 Management Accounting 2018/11/18

Chapter 21 Basic variance analysis 2018/11/18

Basic variance analysis Chapter Preview Basic variance analysis Total variance Price variance Quantityvariance 2018/11/18 Ji Weili, JXUFE

A standard cost card might look like this: A standard cost card might look like the one shown on the screen. First, we see a standard quantity. In this case, direct materials is expressed in terms of pounds, direct labor in hours, and variable manufacturing overhead in hours. Second, we have a standard price or standard rate, and finally, we have a standard cost per unit. 2018/11/18 Ji Weili, JXUFE

Manufacturing Overhead Manufacturing Overhead Variances A standard cost variance is the amount by which an actual cost differs from the standard cost. Direct Material Direct Material Standard cost Amount Direct Labor Direct Labor You can see from this diagram that direct labor cost is equal to the standard cost for labor, while direct material cost is above standard and manufacturing overhead cost is below standard. The difference between actual cost and standard cost is called a standard cost variance. Manufacturing Overhead Manufacturing Overhead Type of Product Cost 2018/11/18 Ji Weili, JXUFE

Manufacturing Overhead Variances This variance is favorable because the actual cost is less than the standard cost. This variance is adverse because the actual cost exceeds the standard cost. Direct Material Standard cost Direct Labor In the example shown, the material variance is adverse because the actual cost exceeds the standard cost. The manufacturing overhead cost is favorable because the actual cost is less than standard cost. Manufacturing Overhead 2018/11/18 Ji Weili, JXUFE

Variance Analysis Receive explanations Identify questions Take corrective actions Identify questions Analyze variances Conduct next period’s operations Variance analysis involves comparing actual costs with standard costs. If variances exists, we investigate by asking appropriate managers for explanations and possible causes for the variances. Our objective is to correct problems that caused adverse variances and to possibly adopt and reward the practices that resulted in favorable variances. Prepare standard cost performance report Begin 2018/11/18 Ji Weili, JXUFE

Standard Cost Variances Computing Variances Standard Cost Variances Quantity Variance Price Variance The difference between the actual price and the standard price The difference between the actual quantity and the standard quantity Price variances result when we pay an actual price for a resource that differs from the standard price that should have been paid. Quantity variances are caused by using an actual amount of a resource that differs from the standard amount that should have been used. 2018/11/18 Ji Weili, JXUFE

Computing Variances Price Variance Quantity Variance Actual Quantity Actual Quantity Standard Quantity × × × Actual Price Standard Price Standard Price Price Variance Quantity Variance Standard price is the amount that should have been paid for the resources acquired. Here’s a general model for computing standard cost variances. We multiply the actual quantity times the actual price and compare that to the actual quantity times the standard price. The difference is the price variance. Then we compare the actual quantity times the standard price to the standard quantity at the standard price. The difference is the quantity variance. Standard price is the amount we should pay for the resource acquired. 2018/11/18 Ji Weili, JXUFE

Computing Variances Price Variance Quantity Variance Actual Quantity Actual Quantity Standard Quantity × × × Actual Price Standard Price Standard Price Price Variance Quantity Variance Standard quantity is the quantity that should have been used for the actual good output. The standard quantity is the standard quantity for one unit multiplied times the number of good units produced. It is the amount of a resource that should have been used given the actual good output achieved. 2018/11/18 Ji Weili, JXUFE

Computing Variances Price Variance Quantity Variance Actual Quantity Actual Quantity Standard Quantity × × × Actual Price Standard Price Standard Price Price Variance Quantity Variance AQ(AP - SP) SP(AQ - SQ) AQ = Actual Quantity SP = Standard Price AP = Actual Price SQ = Standard Quantity We can reduce these relationships to mathematical equations. For example, we can determine the material price variance by multiplying the actual quantity times the difference between the actual price and the standard price, and we can determine the material quantity variance by multiplying the standard price times the difference between the actual quantity and the standard quantity. 2018/11/18 Ji Weili, JXUFE

Computing Material and Labor Variances G-Max Company makes golf clubheads with the following standard cost information: In this example the G-Max Company produces golf clubheads. The direct materials standard allows one pound per clubhead at one dollar per pound. The direct labor standard allows one hour per clubhead at eight dollars per hour. 2018/11/18 Ji Weili, JXUFE

Material Variances During May, G-Max produced 3,500 clubheads using 3,600 pounds of material. G-Max paid $1.05 per pound for the material. Compute the material price and quantity variances. During May, G-Max purchased and used three thousand, six hundred pounds of material to make three thousand, five hundred clubheads. G-Max paid one dollar and five cents per pound for the the three thousand, six hundred pounds of material. Use this information to compute the material price and quantity variances before you go to the next slide. 2018/11/18 Ji Weili, JXUFE

Material Variances Price variance $180 adverse SQ = 3,500 units × 1 lb. per unit = 3,500 lbs. Actual Quantity Actual Quantity Standard Quantity × × × Actual Price Standard Price Standard Price 3,600 lb. 3,600 lbs. 3,500 lbs. × × × $1.05 per lb. $1.00 per lb. $1.00 per lb. $3,780 $3,600 $3,500 Now you can check your work. The total actual price paid for the material was three thousand, seven hundred eighty dollars. Since the standard price was one dollar per pound, G-Max should have paid only three thousand, six hundred dollars for the material. The difference between three thousand, seven hundred eighty dollars and three thousand, six hundred dollars is the one hundred eighty dollars adverse price variance. G-Max actually used three thousand, six hundred pounds of material, one hundred pounds more than the standard quantity of three thousand, five hundred pounds. Using an extra one hundred pounds resulted in the one hundred dollars adverse quantity variance. Price variance $180 adverse Quantity variance $100 adverse 2018/11/18 Ji Weili, JXUFE

Responsibility for Material Variances You used too much material because of poorly trained workers and poorly maintained equipment. Also, your poor scheduling requires me to rush order material at a higher price, causing adverse price variances. I am not responsible for this adverse material quantity variance. You purchased cheap material, so my people had to use more of it. The production manager is responsible for material usage. Since his performance evaluation is negatively impacted by the adverse material quantity variance, he is trying to find reasons for the adverse variance other than his own production operation. 2018/11/18 Ji Weili, JXUFE

Let’s turn our attention to labor variances. Now that we have computed material variances, we can apply the same concepts to labor. 2018/11/18 Ji Weili, JXUFE

Labor Variances Rate Variance Efficiency Variance Actual Hours Actual Hours Standard Hours × × × Actual Rate Standard Rate Standard Rate Rate Variance Efficiency Variance Materials price variance Materials quantity variance Labor rate variance Labor efficiency variance Variable overhead Variable overhead expenditure variance efficiency variance AH(AR - SR) SR(AH - SH) AH = Actual Hours SR = Standard Rate AR = Actual Rate SH = Standard Hours Instead of price and quantity, for direct labor we use the terms rate and hours. Also, instead of price and quantity variances, for labor, we use the terms rate and efficiency variances. The underlying concepts are the same as we saw for material. The standard rate is the amount we should pay per hour for the work performed. Standard hours are the hours that should have been worked for the actual good output achieved. Just as with material, we can reduce these relationships to mathematical equations. For example, we can determine the labor rate variance by multiplying actual hours times the difference between the actual rate and the standard rate, and we can determine the labor efficiency variance by multiplying the standard rate times the difference between actual hours and standard hours. -Quantity is the standard quantity for one unit multiplied times the number of good units produced. It is the amount of a resource that should have been used. 2018/11/18 Ji Weili, JXUFE

Labor Variances During May, G-Max produced 3,500 clubheads working 3,400 hours. G-Max paid an average of $8.30 per hour for the hours worked. Compute the labor rate and efficiency variances. During May, G-Max employees worked three thousand, four hundred hours to make the three thousand, five hundred clubheads. G-Max paid an average of eight dollars and thirty cents per hour to the employees for the three thousand, four hundred hours worked. Use this information to compute the labor rate and efficiency variances before you go to the next slide. 2018/11/18 Ji Weili, JXUFE

SH = 3,500 units × 1 hour per unit = 3,500 hours Labor Variances SH = 3,500 units × 1 hour per unit = 3,500 hours Actual Hours Actual Hours Standard Hours × × × Actual Rate Standard Rate Standard Rate 3,400 hours 3,400 hours 3,500 hours × × × $8.30 per hour $8.00 per hour $8.00 per hour $28,220 $27,200 $28,000 Now you can check your work. The total actual wages paid for three thousand, four hundred hours were twenty eight thousand, two hundred twenty dollars. Since the standard rate was eight dollars per hour, G-Max should have paid only twenty seven thousand, two hundred dollars for three thousand, four hundred hours. The difference between twenty eight thousand, two hundred twenty dollars and twenty seven thousand, two hundred dollars is the one thousand, twenty dollars adverse rate variance. G-Max employees actually worked three thousand, four hundred hours; one hundred hours less than the standard of three thousand, five hundred hours. Working one hundred hours less than allowed by the standard for labor time resulted in the eight hundred dollars favorable efficiency variance Rate variance $1,020 adverse Efficiency variance $800 favorable 2018/11/18 Ji Weili, JXUFE

Labor Variances Using highly paid skilled workers to perform unskilled tasks results in an adverse rate variance. High skill, high rate Low skill, low rate One possible explanation for an adverse rate variance is that the production manager used highly paid, skilled workers to perform tasks that only required unskilled workers. We pay a higher rate for the same number of hours using workers with higher skills than required for the work. Generally, production managers are responsible for any rate variances. Production managers who make work assignments are generally responsible for rate variances. 2018/11/18 Ji Weili, JXUFE

Adverse Efficiency Variance Labor Variances Poorly trained workers Poor supervision of workers Poor quality materials Poorly maintained equipment Adverse Efficiency Variance A number of factors can cause an adverse efficiency variance. All too often an adverse efficiency variance is blamed on inefficient workers. The reasons listed on your screen are much more likely to be the causes for adverse labor efficiency variances. 2018/11/18 Ji Weili, JXUFE

Responsibility for Labor Variances You used too much time because of poorly trained workers and poor supervision. I am not responsible for the adverse labor efficiency variance! You purchased cheap material, so it took more time to process it. If an adverse labor efficiency variances arises, the production manager is generally held responsible. Since his performance evaluation is negatively impacted by adverse labor variances, he may again be trying to find reasons for the the adverse variance other than his own production operation. 2018/11/18 Ji Weili, JXUFE

Responsibility for Labor Variances Maybe I can attribute the labor and material variances to personnel for hiring the wrong people and training them poorly. Since the production manager’s arguments could not shift responsibility for adverse variances to purchasing, he is now thinking of other reasons that might have caused the variances. 2018/11/18 Ji Weili, JXUFE

Overhead Standards and Variances Let’s change topics again. Now that we have mastered material and labor variances, we can apply the same concepts to overhead. 2018/11/18 Ji Weili, JXUFE

Overhead Standards and Variances Recall that overhead costs are assigned to products and services using a predetermined overhead rate (POHR): Assigned Overhead = POHR × Standard Activity Recall from our work in previous chapters that the predetermined overhead rate is calculated by dividing estimated overhead costs for the operating period by the estimated activity for the operating period. We then use the predetermined overhead rate to assign overhead costs to products as they are manufactured. Estimated total overhead costs Estimated activity POHR = 2018/11/18 Ji Weili, JXUFE

Setting Overhead Standards Contains a fixed overhead rate which declines as activity level increases. Contains a variable unit rate which stays constant at all levels of activity. Overhead Rate The predetermined overhead rate contains both fixed and variable components of overhead. The variable overhead rate will be the same for all levels of activity. However, the fixed portion of the overhead rate will differ depending on the activity level used in the denominator of the predetermined overhead rate computation. Flexible budgets for overhead will help us see these relationships. Function of activity level chosen to determine rate. 2018/11/18 Ji Weili, JXUFE

Setting Overhead Standards Flexible budgets, showing budgeted amount of overhead for various levels of activity, are used to analyze overhead costs. G-Max’s flexible budget for overhead We will continue the example using the G-Max company to examine variable and fixed overhead standards 2018/11/18 Ji Weili, JXUFE

Flexible Overhead Budget Here we see flexible budgets for overhead prepared at several levels of activity. The activity levels are expressed as a percentage of capacity. Notice that the variable overhead rate is one dollar per unit for all levels of activity. Multiplying the one dollar variable overhead rate times the number of units at each production level results in the flexible budget for variable overhead. For example, at the three thousand, five hundred unit level of activity, the variable overhead budget is three thousand, five hundred dollars, computed by multiplying one dollar per unit times three thousand, five hundred units. Notice that the fixed portion of the overhead budget is unchanged at four thousand dollars for all levels of activity. Including the fixed overhead in the computation of the predetermined overhead rate results in a declining unit cost for overhead, from two dollars and fourteen cents per hour at the three thousand, five hundred unit level of activity to one dollar and eighty cents per hour at the five thousand unit level of activity. $7,500 ÷ 3,500 hours = $2.14 per hour 2018/11/18 Ji Weili, JXUFE

Flexible Overhead Budget Because the predetermined overhead rate is different at each level of activity, G-Max must select an activity for its predetermined overhead rate. In this case, G-Max selected four thousand units. At this level of activity, the predetermined overhead rate is two dollars per hour, made up of one dollar per hour variable overhead rate, and one dollar per hour fixed overhead rate. Choosing any other level of activity would have resulted in the same variable overhead rate, but a different fixed overhead rate. G-Max predicted an 80 percent activity level 2018/11/18 Ji Weili, JXUFE

Computing Overhead Variances Now that we can compute the overhead rates, let’s use them to determine variable and fixed overhead variances. We now have the fixed and variable overhead rates for G-Max. Next, we can use these overhead rates in a standard cost system to calculate variable and fixed overhead variances. 2018/11/18 Ji Weili, JXUFE

Computing Variable Overhead Variances Actual Flexible Budget Applied Variable for Variable Variable Overhead Overhead at Overhead at Incurred Actual Hours Standard Hours AH × AVR AH × SVR SH × SVR Expenditure Variance Efficiency Variance When we compare actual hours times actual variable overhead rate to actual hours times the standard variable overhead rate, we get the expenditure variance for variable overhead. When we compare actual hours times the standard variable overhead rate to standard hours at the standard variable overhead rate, we get the efficiency variance for variable overhead. AH = Actual Hours of Activity AVR = Actual Variable Overhead Rate SVR = Standard Variable Overhead Rate SH = Standard Hours Allowed 2018/11/18 Ji Weili, JXUFE

Computing Variable Overhead Variances During May, G-Max produced 3,500 clubheads working 3,400 hours. G-Max budgeted for 4,000 units (80%). Actual variable overhead was $3,650 and actual fixed overhead was $4,000. Compute the variable overhead expenditure and efficiency variances and the fixed overhead expenditure and volume variances. Let’s continue with our G-Max example. Production volume and hours worked are the same as we used for the material and labor analysis earlier. Recall that in our flexible budget information for G-Max, four thousand units, eighty percent of capacity, was selected as the activity level used to compute the predetermined overhead rate. The actual costs for variable overhead and fixed overhead on your screen, is new information. 2018/11/18 Ji Weili, JXUFE

Computing Variable Overhead Variances Actual Flexible Budget Applied Variable for Variable Variable Overhead Overhead at Overhead at Incurred Actual Hours Standard Hours 3,400 hours 3,500 hours × × $1.00 per hour $1.00 per hour $3,650 $3,400 $3,500 Actual expenditure for variable overhead was three thousand, six hundred fifty dollars. Since the standard variable overhead rate was one dollar per hour, G-Max should have spent three thousand, four hundred dollars for the three thousand, four hundred hours worked. The difference between three thousand, six hundred fifty dollars and three thousand, four hundred dollars is the two hundred fifty dollars adverse expenditure variance. G-Max actually worked three thousand, four hundred hours; one hundred hours less than the standard of three thousand, five hundred hours. Working one hundred hours less than allowed by the standard for direct labor time resulted in the one hundred dollars favorable efficiency variance. The $1.00 per hour is a reasonable estimate of allocating variable costs per hour such as utility costs which include heating, cooling, electricity, etc. Expenditure variance $250 adverse Efficiency variance $100 favorable 2018/11/18 Ji Weili, JXUFE

Variable Overhead Variances Expenditure Variance Efficiency Variance Results from paying more or less than expected for overhead items and from excessive usage of overhead items. A function of the selected cost driver. It does not reflect overhead control. The expenditure variance results from paying more or less than expected for variable overhead items, or from the excessive use of those variable overhead items. The efficiency variance is controlled through proper management of the overhead cost driver activity level, direct labor hours for G-Max. 2018/11/18 Ji Weili, JXUFE

Computing Fixed Overhead Variances Actual Fixed Fixed Fixed Overhead Overhead Overhead Incurred Budget Applied SH × SFR Expenditure Variance Volume Variance The budget variance for fixed overhead is determined by comparing the fixed overhead actually incurred to the budgeted fixed overhead. The volume variance for fixed overhead is determined by comparing the budgeted fixed overhead to the fixed overhead applied. The applied fixed overhead is the product of the fixed overhead rate times standard hours. SFR = Standard Fixed Overhead Rate SH = Standard Hours Allowed 2018/11/18 Ji Weili, JXUFE

Computing Fixed Overhead Variances under-/over- absobed Actual Fixed Fixed Fixed Overhead Overhead Overhead Incurred Budget Applied 3,500 hours × $1.00 per hour $4,000 $4,000 $3,500 Actual expenditure for fixed overhead was four thousand dollars. The budget for fixed overhead was also four thousand dollars, so the budget variance is zero. G-Max applied three thousand, five hundred dollars of fixed overhead to products using the fixed overhead rate of one dollar per standard hour. Since the three thousand, five hundred standard hours are less than the four thousand hours used to compute the predetermined overhead rate, G-Max has an adverse five hundred dollars volume variance. Expenditure variance $0 Volume variance $500 adverse 2018/11/18 Ji Weili, JXUFE

Fixed Overhead Variances Expenditure Variance Volume Variance Results from paying more or less than expected for fixed overhead items. Results from the inability to operate at the activity planned for the period. Has no significance for cost control. The budget variance results from paying more or less than expected for fixed overhead items. The volume variance results from operating at an activity level different from the activity level used to compute the predetermined overhead rate. 2018/11/18 Ji Weili, JXUFE

$500 Volume Variance adverse 3,500 units × $1.00 fixed overhead rate $4,000 expected fixed OH $3,500 applied fixed OH { $500 Volume Variance adverse 3,500 units × $1.00 fixed overhead rate Cost Fixed overhead applied to products Part I Take a few minutes and pay particular attention to this graph of fixed overhead relationships where we have plotted fixed overhead costs on the vertical axis and volume on the horizontal axis. The fixed overhead applied line begins at the origin. Part II At a volume of three thousand, five hundred units, we have applied three thousand, five hundred dollars of fixed overhead costs. Since the original fixed overhead budget was five hundred dollars at a volume of four thousand units, the adverse volume variance is four thousand, dollars as shown on the vertical axis. Volume 3,500 Actual Units 4,000 Expected Units 2018/11/18 Ji Weili, JXUFE

SH = 3,500 units × 1 hour per unit = 3,500 hours Volume Variances SH = 3,500 units × 1 hour per unit = 3,500 hours Fixed Actual hour Fixed Overhead × Overhead Budget SFR Applied 4,000 hours 3,400 hours 3,500 hours × × × $1.00 per hour $1.00 per hour $1.00 per hour $4,000 $3,400 $3,500 Now you can check your work. The total actual wages paid for three thousand, four hundred hours were twenty eight thousand, two hundred twenty dollars. Since the standard rate was eight dollars per hour, G-Max should have paid only twenty seven thousand, two hundred dollars for three thousand, four hundred hours. The difference between twenty eight thousand, two hundred twenty dollars and twenty seven thousand, two hundred dollars is the one thousand, twenty dollars adverse rate variance. G-Max employees actually worked three thousand, four hundred hours; one hundred hours less than the standard of three thousand, five hundred hours. Working one hundred hours less than allowed by the standard for labor time resulted in the eight hundred dollars favorable efficiency variance Volume capacity variance $600 adverse Volume efficiency variance $100 favorable 2018/11/18 Ji Weili, JXUFE

Overhead Variance Analysis Total Overhead Variance Variable Overhead Fixed Overhead Expenditure Variance Efficiency Variance Expenditure Variance Volume Variance Volume Capacity Variance Volume Efficiency Variance 2018/11/18 Ji Weili, JXUFE

Standard Costs for Control Managers focus on quantities and costs that differ from standards, a practice known as management by exception. Direct Material Standard cost Amount Direct Labor Standard cost analysis enables managers to focus on problems that need their attention. As long as operations are functioning without variances, managers are free to deal with other issues. In those instances when variances do occur, manager redirect their efforts to correcting the problems causing the variances. This process is referred to as management by exception. Manufacturing Overhead Type of Product Cost 2018/11/18 Ji Weili, JXUFE

Reasons for Cost Variance There are many possible reasons: Favorable Adverse Usage variances Price variances to investigate or not? 2018/11/18 Ji Weili, JXUFE

The significance of cost variances Materiality Controllability The type of standard being used Interdependence between variances Variance trend Cost of investigation 2018/11/18 Ji Weili, JXUFE

Interdependence of variances Variances may affect each other e.g. Cheaper materials Favourable price variance Inferior quality Adverse usage variance (& labour efficiency?) 2018/11/18 Ji Weili, JXUFE

Interdependence of variances Variances may affect each other e.g. Higher rates for skilled worker Adverse rate variance High efficiency Favourable efficiency variance 2018/11/18 Ji Weili, JXUFE

End of Chapter 21 I Need Some Help! 2018/11/18 Ji Weili, JXUFE