PART 1 LESSON 4 COST AND VARIANCE MEASURES

LESSON 4 COST AND VARIANCE MEASURES

CONTENT
1. Standard costs 2. Material Standards 3. Labor Standards 4. Standard Cost cards 5. Variance Analysis 6. Mix and Yield Variances 7. Overhead Standards & Variances

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PART 1 LESSON 4 COST AND VARIANCE MEASURES

Standard Costs:
In a standard costing system, standard costs and actual costs are recorded. This helps cost control. Standard costs are budgeted or estimated costs to manufacture a single unit of product or perform a single service. Standards are developed by examining inputs necessary to produce an output and the quality of the output desired. Sometimes same output may be generated but with different inputs. Furniture can be produced by using teak or rose wood etc. However, the quality of the output may differ according to the inputs. Once management establishes desired quality of output and determines the input to be used, quantity and price standards are developed

Material Standards:
1) 2) 3) 4) a. b. c. 5) 6) 7) The first step in developing material standards is to identify and list direct material Engineering department prepares a list of materials required. In the absence of such documentation, material specification are developed Three things must be known with regard to material inputs: What types of inputs to be used? What quantity of inputs to be used? Quality of inputs to be used? In making quality decisions, managers seek the advice of materials experts, engineers, Given the quality selected, quantity estimates are made in terms of weight, size, volume Information of product components, quantities needed, specifications etc are compiled in by quantity to be used

observation on shop floor

cost accountants, marketing personnel, and suppliers or other measures. a document called bill of materials (BOM)

Labor Standards:
1) Development of labor standards requires same basic procedures as those used for materials 2) Each production operation performed by workers or machinery is identified. RukshiCA 2

PART 1 LESSON 4 COST AND VARIANCE MEASURES 3) Work Study is performed to determine the motions involved and time required a. Motion study determines the operations involved in performing a task. The operations include tasks like bending, reaching, lifting, moving materials, decorating, packing etc. Standard motion studies use THERBLIGS symbols b. Time study is performed to determine the time required to perform each task. Time may be determined using stop watch c. Sometimes micro motion study is made in order to determine the motions of hands. Such study is made using cameras. 4) The operations required to perform a task are recorded in a document called Operations Flow Document or Routing Document 5) Time and motion studies are likely to be performed in large companies because of expenses involved. 6) Instead of performing a detailed work-study, companies may also use PREDETERMINED MOTION AND TIME STANDARDS applicable to particular industry. 7) Another way to determine time standard is to use the average time needed to manufacture a product during past year. Such information can be obtained from time sheets. Information obtained from time records may be adjusted for inefficiencies based on subjective judgment of supervisors

Standard cost card:

Standard cost card is prepared after determining material and labor standards. A standard cost card is a record of direct material and direct labor standard quantities. Standard cost card information is used to assign costs to inventory accounts Standard costing Journal entries: 1) Raw materials inventory Materials Price Variance Accounts payable (To record purchase of materials) Dr. xxx xxx xxx Cr.

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PART 1 LESSON 4 COST AND VARIANCE MEASURES 2) Work in process inventory Materials Quantity Variance Raw materials inventory (To record issuance and usage of materials) 3) Work in process inventory Labor Rate Variance Labor efficiency variance Wages payable (To record the usage of direct labor time) Uses of Standard Costing: 1) Clerical Efficiency: A company using standard costs requires less clerical time and effort to trace and record accounting entries 2) Motivation: Standards communicate managements expectations of efficiency to workers. Workers are shown the standards and are informed of rewards for achieving those standards. Standards must be reasonable and attainable 3) Planning: Planning requires estimates. Standard costs provide basis for estimates 4) Controlling: Standards provide a basis for comparing the actual and variance indicate deviations. Variance analysis helps management to take corrective steps 5) Decision-making: Standard cost information help in decision-making. For instance, managers can compare quoted price to standard price to decide to accept or reject an offer. Or to decide whether to make or buy a component or part etc 6) Performance evaluation: Variance analysis helps management to make performance evaluation of subordinate mangers. Helps management pinpoint the areas requiring investigation xxx xxx xxx xxx xxx xxx xxx

VARIANCE ANALYSIS
1) In actual cost system, actual material and labor costs are debited to work in process account 2) In standard cost system both actual and standard costs are recorded 3) Standard costs are debited to work in process inventory

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PART 1 LESSON 4 COST AND VARIANCE MEASURES 4) Any difference between actual and standard is called variance 5) Journal entries incorporate variances 6) Total variance is the difference between total actual cost incurred and total standard cost applied to the output produced during the period: Actual price of actual production inputs Standard price of actual production outputs

Total Variance Total variance can be computed for each production cost element - materials, labor and overheads. Variances indicate difference between actual and expected production cost. Total variances do not provide useful information as to why such differences occurred. Therefore, a deeper analysis is required. Actual price of actual production inputs Standard price of actual production Inputs Standard price of standard production outputs

(Price Component)

(Usage Component)

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PART 1 LESSON 4 COST AND VARIANCE MEASURES Price or Rate Variance Quantity or Efficiency Variance 1) A price variance reflects the difference between the price paid for inputs and standard price fixed for the actual input. A price variance measures how well the business keeps unit prices of material and labor inputs within standards 2) A usage variance is the difference between the quantity of actual inputs used and quantity of standard inputs that should have been used to produce given outputs. 3) Thus variance can be caused either a. Variance in price (Price component) or b. Variance in usage (Usage component)

Input AP X AQ

Input SP X AQ

Output SP X SQ

Price Variance AP= Actual material price or average actual labor rate AQ= Actual quantity of materials or actual labor hours

Usage Variance

SP= Standard material price or average standard labor rate SQ= Standard quantity of materials or standard labor hours allowed for the actual quantity of production achieved Price Element = (AP SP) (AQ) Usage Element = (AQ SQ) (SP)

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PART 1 LESSON 4 COST AND VARIANCE MEASURES Point of purchase materials Variance Model: Input AP X AQ Input SP X AQp

Material Price Variance Input SP X AQu Output SP X SQu

Material Usage Variance Point of purchase materials Variance Model: 1) Generally, total variance is equal to sum of price sub variance and usage sub variance. But an exception occurs when the quantity of material purchased is not the same as the quantity of material placed into production 2) In such cases, Actual Quantity purchased may not be equal to Actual Quantity used. Therefore, Total Variance cannot be determined by adding up Price sub variance and Usage sub variance. 3) However sub variances are still computed to provide information to management as to where the variance is occurring wither at purchase point or usage point 4) Labor variances are calculated similar to material variances

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PART 1 LESSON 4 COST AND VARIANCE MEASURES 5) Labor rate variance shows the difference between actual weighted average rate paid to labor for the period and standard rate for all hours actually worked 6) Labor efficiency variance shows the difference between number of hours actually worked and the standard hours allowed for production of given units Using Variances: 1) Firms monitor volume, material usage, labor efficiency on day to day and even hour to hour basis 2) Technology such as bar coding, computerized data entry makes it possible to gather variance data quickly Using Variances to Evaluate Employees performance: 1) Some variances are caused by factors not controllable by managers 2) Sometimes variances are caused by inaccurate records 3) Managers sometimes trade off variances. Managers may decide to give overtime to workers to complete rush orders. This may result in labor rate variance, but this may be offset by favorable volume variance resulting from better utilization of equipment and facilities 4) Evaluations based on one variance can make managers take actions to make that variance look good while ignoring others. Example, if managers are evaluated on price variance only, they may opt for low quality materials, which are cheaper and provide favorable price variance. However, this may be offset by unfavorable quantity variance due to greater usage because of low quality. If managers are not evaluated on both the variances, then distorted evaluations may result. Mix and Yield Variances: 1) A combination of many materials and various classifications of direct labor are used to produce goods a. When a companys product uses more than one material, it combines materials such a way as to produce the desired product quality at lowest possible cost b. Sometimes, materials are substituted for one another without affecting product quality.

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PART 1 LESSON 4 COST AND VARIANCE MEASURES c. Sometimes only one specific materials or type of material can be used example either teak or Sal can be used to make furniture 2) Labor also can be combined in different ways. Some combinations will be less expensive than others; some will be more efficient a. Potential combinations may call for mix of skilled and unskilled workers b. Management desires most efficient labor inputs 3) Each possible combination of materials or labor is called mix. Management sets up standards for materials and labor mix based on experience, judgment, and experimentation 4) An underlying assumption in material/labor mix decisions is that there is potential for substitution among the material and labor components. If this assumption is invalid, changing mix cannot improve the yield.

(AQ at AM) x AP

(AQ at AM) x SP

(AQ at SM) x SP

(SQ at SM) x SP

Material Mix Variance Price Variance

Material Yield Variance Usage Variance

Materials Price, Mix, and Yield Variances: A material price variance shows dollar effect of paying prices that differ from standard raw material prices. 1) The materials mix variance measures the effect of substituting a nonstandard mix of materials during the production process 2) The materials yield variance is the difference between the actual total quantity of input and standard total quantity allowed based on output 3) The sum of material mix and yield variance is equal to material quantity variance RukshiCA 9

PART 1 LESSON 4 COST AND VARIANCE MEASURES

(AH at AM) x AR

(AH at AM) x SR

(AH at SM) x SR

(SH at SM) x SR

Labor Mix Variance Price Variance Labor Rate, Mix, and Yield Variances:

Labor Yield Variance

Efficiency Variance

1) The labor rate variance is a measure of cost of paying workers at other than standard rates 2) Labor mix variance is the financial effect arising from changing the proportionate amount of higher or lower paid workers in production 3) The labor yield variance reflects the monetary impact of using more or fewer total hours than the standard allowed A. OVERHEAD STANDARDS AND VARIANCES

WHEN VARIABLE

AND FIXED OVERHEADS ARE NOT SEPARATELY ACCOUNTED:

OVERHEAD STANDARDS: 1) Predetermined Overhead Rates: a. Actual overheads information is not available in timely manner and cannot be assigned to cost of production to generate useful information/estimates b. To overcome this problem predetermined overhead application rates are used. Predetermined overhead rates are used to apply overheads to Work in Process accounts.

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PART 1 LESSON 4 COST AND VARIANCE MEASURES c. A predetermined overhead rate is used to apply overheads to production. This is called a Combined Overhead rate because it does not segregate Fixed and Overhead components: Combined OH Rate = Total Overhead Cost at Selected Capacity Selected Capacity measure (Volume) 2) Flexible Budgets and Standard Overhead Rates: I. For control purposes, managers estimate total overhead required at different volumes. a. Such a presentation of overheads at different volumes is called FLEXIBLE BUDGET b. Such a presentation of overheads at different volumes requires classification of overheads as Fixed, Variable and Mixed overheads II. Variable Overheads: a. Variable overheads vary with volume. Flexible budgets provide variable overheads at different volumes b. The variable overhead rates remain constant within a given range of volume and beyond that range; the variable overhead rate may change. c. The range of volume over which predetermined overhead rate is fixed is called relevant range III. Fixed Overheads: Fixed Overheads are constant at all levels of activity a. Fixed overheads are applied uniformly for all levels of activity b. Fixed overheads are computed for expected annual capacity c. Flexible Budgets can be prepared for Fixed Overheads although they remain constant over all levels of activities d. Fixed Overhead per unit decline with increase in volume. IV. With Flexible Budgets two overhead components are segregated into: Variable OH Rate (VOHR) = Variable Overhead Cost at Selected Capacity Selected Capacity measure (Volume) Plus (+)

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PART 1 LESSON 4 COST AND VARIANCE MEASURES Budgeted Fixed Overhead for estimated Annual capacity

OVERHEAD VARIANCES: Total Actual 1) Overhead

Total Applied Overhead (Combined OH Rate x Standard Input Allowed for Actual Production) (SP X SQ)

Total Overhead Variance

1) One Variance Approach: (With only Predetermined overhead rate and no Flexible Budgets are used) a. Combined OHR (Predetermined Overhead Rate) is used to apply the standard overheads to production in the combined Work in Process account b. Total overhead variance will be equal to Actual Overheads less Applied Overheads c. This approach is the general peanut butter absorption costing approach FORMULA: Variance = Total Actual Overhead (SP x SQ) WHERE: SQ = Standard Hours allowed SP = Predetermined Overhead Rate SP x SQ = Applied Overhead

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PART 1 LESSON 4 COST AND VARIANCE MEASURES

Flexible Budget overheads based on Standard input for Allowed for Output achieved (Budgeted) Total Actual Overhead {(VOHR x SQ) + Budgeted Fixed Overheads}

Total Applied Overhead based on Combined OHR (SP x SQ)

Budgeted Variance/ Controllable Variance

Volume Variance/ Non-Controllable Variance Total Overhead Variance

2) Two Variance Approach: (When Flexible Budgets are used) a. Preparation of Flexible Budgets provide additional insights into the overhead variances b. Where Flexible Budgets provide additional information on Variable and Fixed components of overheads, two variance approach can be adopted as above c. The middle column provides information on the expected total overhead cost based on the standard input allowed for given volume. The information is obtained from Flexible Budgets: I. The Budgeted Variance equals total actual overhead minus budgeted overhead based on the standard input allowed for the periods production

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PART 1 LESSON 4 COST AND VARIANCE MEASURES II. The Budgeted Variance is equal to Budgeted Variable Overheads for Standard Quantity produced Plus Budgeted Fixed Overhead as per Flexible Budget III. The Budgeted Variance is also called controllable variance d. Sometimes instead of Flexible Budgets, STATIC or FIXED Budgets are used. In such cases, the budgeted amount will be fixed at all levels of activities. Whereas in a Flexible budget the budget is classified into Variable portion and Fixed portion. FORMULA Total Variance = Budget Variance + Volume Variance Budget Variance = Total Actual Overhead {(VOHR x SQ)-Budgeted Fixed Overhead} Volume Variance = {(VOHR x SQ)-Budgeted Fixed Overhead} {SP x SQ} WHERE: VOHR = Variable Overhead Rate as per Flexible Budget SQ = Standard Hours Allowed for given output SP = Predetermined Overhead Rate SP x SQ = Applied Overhead Total Actual Overhead Budgets Based on Actual Input Activity
Budget Based on Standard Input Allowed for Output Achieved

Total Applied overhead

OH Spending Variance

OH Efficiency Variance

OH Volume Variance

OH Budget Variance

OH Volume Variance

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PART 1 LESSON 4 COST AND VARIANCE MEASURES

Total Overhead Variance 3) Three Variance Approach (Budgeted Overhead variance is further analyzed) a. Two variance approach is modified to provide three variance approach b. Under three variance approach the Budgeted (Controllable) Variance is further divided into I. Overhead Spending variance: This is equal to total actual overhead minus total Budgeted overhead calculated at budgeted rate for actual hours of activity II.Overhead Efficiency variance: This is arrived by calculating the difference between Budgeted overhead calculated at budgeted rate for actual hours taken for given output minus Budgeted overhead calculated at budgeted rate for standard hours fixed for given output. (The basis for this variance is that actual hours taken to produce a given output may vary from the standard hours fixed to produce the given output due to variance in the efficiency of workers) FORMULA: Total Variance = Budget Variance + Volume Variance Budget Variance = OH Spending Variance + OH Efficiency Variance OH Spending Variance = OH Efficiency Variance = Total Actual Overhead {Budgeted overhead for actual input} {Budgeted Overhead for actual input] [Budgeted Overhead for standard input]} Volume Variance = {(VOHR x SQ) +Budgeted Fixed Overhead} {SP x SQ} WHERE: VOHR = Variable Overhead Rate as per Flexible Budget SQ = Standard Hours Allowed for given output

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PART 1 LESSON 4 COST AND VARIANCE MEASURES SP = Predetermined Overhead Rate AQ= Actual Hours taken for given output SP x SQ = Applied Overhead

JOURNAL ENTRIES WHEN VARIABLE AND FIXED OVERHEADS ARE NOT SEPARATELY ACCOUNTED: Dr.
Manufacturing Overheads To Various Accounts Payable (To record actual overheads incurred) Work in process inventory To Manufacturing Overheads xxx xxx xxx xxx

Cr.

(To apply overheads at predetermined rates to Work in Process) Overhead Spending Variance Overhead Efficiency Variance Overhead Volume Variance To Manufacturing Overheads To Overhead Spending Variance To Overhead Efficiency Variance To Volume Variance they are positive or negative) xxx xxx xxx xxx xxx xxx xxx

(To record variances. The variances may be debited or credited depending on whether

B. OVERHEAD STANDRDS AND VARIANCES WHEN VARIABLE AND FIXED OVERHEADS ARE SEPARATELY ACCOUNTED:
Four Variance Approach: 1) Where Variable Overheads and Fixed Overheads are separately accounted for, the separate computations provide managers with greater details RukshiCA 16

PART 1 LESSON 4 COST AND VARIANCE MEASURES 2) Overhead variances are computed separately for Variable Overhead component and Fixed Overhead Component 3) Thus we have: a. Variable overhead price sub-variance - Variable OH Spending Variance b. Variable overhead usage sub-variance Variable OH Efficiency Variance c. Fixed overhead price sub-variance Fixed OH Spending Variance d. Fixed overhead usage sub-variance Volume Variance

Variable Overhead Variance Analysis (Separately Accounted system)

Actual Variable Overhead Cost (AP x AQ)

Variable Overhead Applied to Production (SP x SQ)

Total Variable Overhead Variance (Over or under absorbed Variance)

AP= Actual price or rate AQ= Actual labor hours SP= Standard rate or predetermined overhead rate SQ= Standard hours required to produce the actual output

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PART 1 LESSON 4 COST AND VARIANCE MEASURES 1) Total Variable Overhead Variance a. Variable Overhead Applied to production is the amount of Overhead debited to Work in Process using standard rates (SP x SQ) b. Actual variable overhead cost is the amount of variable overhead cost incurred and debited to expenses account c. The over or under absorbed overhead is transferred to cost of goods sold at the end of the year

Actual VOH AP X AQ

Budgeted VOH SP X AQ

Applied VOH SP X SQ

(Price Sub-variance) VOH Spending Variance

(Usage Sub-variance) VOH Efficiency Variance

Total Variable Overhead Variance (Over or under absorbed) AP= Actual price or rate AQ= Actual labor hours SP= Standard rate or predetermined overhead rate SQ= Standard hours required to produce the actual output Price Element = (AP SP) (AQ) Usage Element = (AQ SQ) (SP) 2) Two Variable Overhead variance analysis (Separately Accounted system): a. The total variable overhead variance is divided into VOH Spending Variance (Price sub-variance) and VOH Efficiency Variance (Usage sub-variance) b. The difference between actual variable overhead (AP x AQ) and budgeted variable overhead based on actual input (SP x AQ) is variable overhead spending variance

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PART 1 LESSON 4 COST AND VARIANCE MEASURES c. The difference between budgeted VOH at actual input activity (SP x AQ) and budgeted VOH at standard input allowed (SP x SQ) is the variable overhead efficiency variance Fixed Overhead Variance Analysis (Separately Accounted system)

Actual Fixed Overhead Cost

Fixed Overhead Applied to Production (SP x SQ)

Total Fixed Overhead Variance (Over or under absorbed Variance)

SP= Standard rate or predetermined overhead rate SQ= Standard hours required to produce the actual output 1) One Variance Approach: a. Actual fixed overhead cost is amount debited to Fixed Overhead account b. Applied Fixed Overhead is the amount debited to Work in Process account based on predetermined overhead rate c. The difference between the two represents total fixed overhead variance (that is over or under absorbed overhead) which is recovered by charging cost of goods sold

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PART 1 LESSON 4 COST AND VARIANCE MEASURES

Actual FOH Cost

Budgeted FOH Cost As per Flexible Budget

Applied FOH SP X SQ (Applied at predetermined rate)

(Price Sub-variance) FOH Spending Variance

Volume Variance

Total Fixed Overhead Variance (Over or under absorbed) SP= Standard rate or predetermined overhead rate SQ= Standard hours required to produce the actual output 2) Two variance approach a. FOH Spending variance is the difference between Actual Cost and Budgeted Fixed Overhead. Actual cost is not arrived by multiplying AQ x AP because fixed overheads are incurred lump sum and not at rate per unit b. The middle portion represents Budgeted Fixed overhead as per flexible budget. This remains constant for any volume of production over relevant range. This usually represents estimated annual capacity c. The Applied FOH is the amount charged to Work in Process account at predetermined Fixed Overhead Recovery rate. This represents capacity utilization for the units produced.

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PART 1 LESSON 4 COST AND VARIANCE MEASURES d. The difference between Applied FOH and the Budgeted FOH represents volume variance. The variance arising due to underutilization or overutilization of capacity. This arises when the volume produced is either lesser or more than the annual capacity

JOURNAL ENTRIES WHEN VARIABLE AND FIXED OVERHEADS ARE SEPARATELY ACCOUNTED:
Variable Manufacturing Overheads To Various Accounts Payable (To record actual variable overheads incurred) Fixed Manufacturing Overheads To Various Accounts Payable (To record actual fixed overheads incurred) Work in process inventory To Variable Manufacturing Overheads To Fixed Manufacturing Overheads xxx xxx xxx xxx xxx xxx xxx

(To apply overheads at predetermined rates to Work in Process) VOH Spending Variance VOH Efficiency Variance To Variable Manufacturing Overheads To VOH Spending Variance To VOH Efficiency Variance depending on whether they are positive or negative) FOH Spending Variance FOH Volume Variance To Fixed Manufacturing Overheads xxx xxx xxx xxx xxx xxx xxx xxx

(To record Variable Overhead variances. The variances may be debited or credited

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PART 1 LESSON 4 COST AND VARIANCE MEASURES To FOH Spending Variance To FOH Volume Variance depending on whether they are positive or negative) Conversion cost and Variance Analysis: 1) The traditional approach for analyzing costs is to separate them into Material, Labor and Overhead costs 2) However, in highly automated situations labor cost is minimal. Such companies treat all labor costs as indirect costs 3) In highly automated situations, companies may opt to have only two elements of costs. That is Material cost and Conversion cost 4) Conversion costs include all production costs other than materials; they include all overheads and labor costs 5) Variance analysis for conversion cost in automated plants focuses on: a. Spending variances for overhead costs b. Efficiency variances for machinery and production costs rather than labor costs c. Volume variances for production xxx xxx

(To record Fixed Overhead variances. The variances may be debited or credited

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