VARIANCE ANALYSIS 1 LECTURE 8

OBJECTIVES: Describe the basic concepts underlying variance analysis Explain the difference between a favourable and an adverse/unfavourable variance Compute materials usage and price variances Calculate labour efficiency and price/wage rate variances

Flexible Budget Steps in developing a flexible budget Identify the actual quantity of output Calculate the flexible budget for revenues based on budgeted selling price and actual quantity of output Calculate the flexible budget for costs based on budgeted variable cost per output unit, actual quantity of output, and budgeted fixed costs

Flexible Budget An Example Actual Results Original Budget Flexible Budget Output (units) 900 1,000 £ Sales 92,000 100,000 90,000 Raw Materials (36,900) (40,000) (36,000) Labour (17,500) (20,000) (18,000) Fixed O/H (20,700) Profit 16,900 20,000 16,000 Budgeted: Selling price = £100 per unit Raw materials = £40 per unit Labour = £20 per unit

Variances Variance ~ difference between the budgeted and actual amounts. Variance analysis ~ a means of assessing these differences Variance is use to: Assist managers in planning and control Evaluate performance Suggest changes in strategies Assist managers in planning and controlling - management by exception. Draw managers’ attentions to those areas not operating ass expected (for example a shortfall in sales of a product) and giving less attention to those areas operating as expected. Managers use variance analysis to direct their energies, pay more attention to areas with large variances. Evaluate performance - Incentives may be tied to achieving the budgeted amount of operating costs. Variance analysis provides information on the performance of each division. Managers are able to identify divisions which achieve the targets from those that did not Suggest changes in strategies - Variance analysis provides information on price and usage efficiency and effectiveness of the division. Excessive defect rates for a new product may suggest a flawed product design and managers may want to re-evaluate the product strategies

Variances Standard Costing Standard costing uses the costs that should have been incurred Standard costing uses standards of performance and of prices derived from studying operations and of estimating future prices, for materials, labour, and overheads Each unit produced can have both actual and standard costs for direct materials, direct labour, and manufacturing overheads When we discussed about static and flexible budgets, we compare the actual results with the expected results. Those expected results are actually the standard that we set based on what we think we should have achieved if everything runs according to plans. The method that we use to prepare the standards for all the costs that we think we should have incurred is called standard costing. It uses the costs that should have been incurred, instead of what we actually incurred. We prepare the standards based on our own expectations about the future performance, by carefully studying our operations, and by estimating what the future costs would be.

Variances Standard Costing Standard input A carefully determined quantity of input, e.g., square metres of laminated material Standard price A carefully determined price that a company expects to pay for a unit of input, e.g., £1 per square metres of laminated material Standard cost A carefully determined cost of a unit of output

Variance Analysis Variances fall into 2 categories Favourable variances occur when actual amount is less than the standard amount Unfavourable variances arise when actual amount is greater than the standard amount

Direct Material Variances Material variance = difference between the actual expenditure and budgeted expenditure on direct materials Material Budget Variance Price variance Usage/Efficiency variance

Materials Price Variance Material J Standard price per metre £4 Standard usage per unit of product 5 metres Actual price per metre £3 Actual usage per unit of product 5 metre Actual cost per unit (5m * £4) £20 Standard cost per unit (5m * £3) £15 Variance (favourable) £5 Materials price variance arises due to the difference between the actual price and the standard price for the materials purchased. The quantity we actually used for production is the same as the standard we have set previously. It is a favourable materials price variance because we actually paid less than the standard that we should have been paid. The actual usage is exactly the same as the standard. The only difference is the PRICE for raw materials.

Materials Price Variance Material K Standard price per metre £9 Standard usage per unit of product 8 metres Actual price per metre £11 Actual usage per unit of product 8 metre Actual cost per unit Standard cost per unit Variance The actual price paid is now greater than the standard price should have been paid. It is an adverse/unfavourable materials price variance. The quantity of materials actually used is the same as the standard. The only difference is the PRICE.

Materials Usage Variance Material L Standard price per tonne £5 Standard usage per unit of product 100 tonnes Actual price per tonne Actual usage per unit of product 95 tonnes Actual cost per unit (95 * £5) £475 Standard cost per unit (100 * £5) £500 Variance (favourable) £25 The materials usage variance arises due to the difference between the actual quantity of raw materials used and the standard quantity of raw materials that should have been used. The actual quantity used in producing 1 unit of product is less than the standard quantity should have been used. It is a favourable materials usage variance. No difference in price. The only difference is the QUANTITY.

Materials Usage Variance Material M Standard price per tonne £8 Standard usage per unit of product 60 tonnes Actual price per tonne Actual usage per unit of product 65 tonnes Actual cost per unit Standard cost per unit Variance The actual quantity used is greater than the quantity should have been used. It is an adverse / unfavourable materials usage variance. No difference in price. The only difference is the QUANTITY.

Materials Price & Usage Variances ~ Formulae Materials price variance (Standard price – Actual price) * Actual quantity purchased (SP – AP) * AQ Materials usage variance (Standard quantity – Actual quantity) * Standard price (SQ – AQ) * SP

Materials Price & Usage Variances ~ Formulae Material N Standard price per metre £6 Standard usage per unit of product 25m Actual price per metre £7 Actual usage per unit of product 24m Actual cost per unit (24m * £7) £168 Standard cost per unit (25m * £6) £150 Variance (adverse / unfavourable) £18 Materials price variance: (£6 - £7) * 24m (£24) Materials usage variance: (25m – 24m) * £6 Net variance (£18) Most variances are combinations of materials price variance and materials usage variance. They can be favourable in price variance, adverse in usage variance, or the other way round, or both favourable, or both adverse. We are able to use the previous method to identify the net variance straight away, but it is important for the variance analysis purposes that we show both the price variance and the usage variance, so that we know how well we have performed in terms of the price and the usage of raw materials.

Material Variances What caused the variance? Price Variance Price changed due to inflation Government has imposed taxes on the materials Purchase higher quality material Usage Variance Wastage occurs due to old machines Lack of training among employees

Direct Labour Variances Labour variance = difference between the actual labour cost and the standard labour cost for actual production Direct labour budget variance Direct labour wage rate variance Direct labour efficiency variance

Wage Rate Variance Product A Standard hours to produce 100 Actual hours to produce Standard wage rate per hour £0.9 Actual wage rate per hour £1.0 Actual cost per unit Standard cost per unit Variance Just like materials price variance, if the actual wage rate is less than the standard wage rate that should have been paid, then it is a favourable wage rate variance because we actually paid less than what we have anticipated to pay. Again, it is a wage rate variance because the quantity of labour hours actually used is the same as the standard that we anticipate would use. The actual wage rate is higher than the standard wage rate that should have been paid. It is an adverse wage rate variance. No difference in quantity of labour hours. The only difference is the WAGE RATE.

Labour Efficiency Variance Product B Standard hours to produce 400 Actual hours to produce 370 Standard wage rate per hour £1.0 Actual wage rate per hour Actual cost per unit (370 * £1) £370 Standard cost per unit (400* £1) £400 Variance (favourable) £30 Just like the materials usage variance, it is a favourable labour efficiency variance when the actual labour hours used to produce the product are less than the standard labour hours we anticipated to use. It is an adverse labour efficiency variance when the actual labour hours used are greater than the standard labour hours we anticipated to use. It is called efficiency variance because it looks at how efficient the labours are. The more efficient they are, the less labour hours they actually used. There is no difference in wage rate between the actual and the standard. The actual labour hours used are less than the standard labour hours that should have been used. It is a favourable labour efficiency variance. No difference in wage rate. The only difference is the LABOUR HOURS.

Labour Wage Rate and Efficiency Variances ~ Formulae Wage rate variance (Standard wage rate per hour – Actual wage rate) * Actual hours worked/used (SR – AR) * AH Labour efficiency variance (Standard labour hours for actual production – Actual labour hours worked) * Standard wage rate per hour (SH – AH) * SR

Labour Wage Rate and Efficiency Variances ~ Formulae Product C Standard hours to produce 500 Actual hours to produce 460 Standard wage rate per hour £0.9 Actual wage rate per hour £1.1 Actual cost per unit (460 * £1.1) £506 Standard cost per unit (500* £0.9) £450 Variance (adverse / unfavourable) £56 Wage rate variance: (£0.9 - £1.1) * 460 (£92) Labour efficiency variance: (500 – 460) * £0.9 £36 Net variance (adverse / unfavourable) (£56) Again, the wage rate variance and the labour efficiency variance can exist at the same time. They can be both favourable, the labours are efficient and at the same time we are paying a lower wage rate than what we anticipated to pay. Or they can both be adverse. Labours are inefficient and we are paying more than the standard. Or one of them can be favourable while the other one be adverse. So if we use the previous method, we will get the net variance immediately, but what is more important is to be able to show both wage rate variance and labour efficiency variance. This would help us to analyse what has gone wrong.

Direct Labour Variances What caused the variance? Labour wage rate variance Anticipated wage increase failed Higher grade of labour was used Labour efficiency variance New training scheme reduce labour hours Employees worked more efficient due to higher quality material used, less wastage