1. Topic Six by Dr. Ong Tze San tzesan@econ.upm.edu.my
Variance Analysis
Topic Six
by Dr. Ong Tze San
This chapter begins our study of management control and performance measures. It explains how standard costs are used by managers to control costs. It also introduces the balanced scorecard as a method for top management to translate its strategy into performance measures that employees can understand and influence.

2. Standard Costs
Standards are benchmarks or “norms” for measuring performance. Two types of standards are commonly used.
Quantity standards specify how much of an input should be used to make a product or provide a service.
Cost (price) standards specify how much should be paid for each unit of the input.
A standard is a benchmark or “norm” for measuring performance. In managerial accounting, two types of standards are commonly used by manufacturing, service, food and not-for-profit organizations:
 Quantity standards specify how much of an input should be used to make a product or provide a service. For example: a. Auto service centers like Firestone and Sears set labor time standards for the completion of work tasks. b. Fast-food outlets such as McDonald’s have exacting standards for the quantity of meat used in a sandwich.
 Cost (price) standards specify how much should be paid for each unit of the input. For example: a. Hospitals have standard costs for food, laundry, and other items b. Home construction companies have standard labor costs that they apply to sub-contractors such as framers, roofers, and electricians.

3. Setting Standard Costs
Accountants, engineers, purchasing agents, and production managers combine efforts to set standards that encourage efficient future production.
Setting price and quantity standards requires the combined expertise of everyone who has responsibility for purchasing and using inputs. In a manufacturing setting, this might include managerial accountants, engineers, purchasing managers, production managers, line managers, and production workers. Standards should be designed to encourage efficient future operations, not just a repetition of past inefficient operations.

4. Setting Direct Material Standards
Price Standards
Quantity Standards
Summarized in a Bill of Materials.
Final, delivered cost of materials, net of discounts.
The standard price per unit for direct materials should reflect the final, delivered cost of the materials, net of applicable discounts. Standard quantities are amounts needed to meet the production designs. 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. A bill of materials is a list that shows the quantity of each type of material in a unit of finished product.

5. Setting Direct Labor Standards
Rate Standards
Often a single rate is used that reflects the mix of wages earned.
Time Standards
Use time and motion studies for each labor operation.
Instead of the terms price and quantity used for material, we use rate and time when we apply standard cost concepts to direct labor. Labor rates can be determined by wage surveys of rates paid in comparable companies or by labor contracts. The standard rate per hour for direct labor includes not only wages earned but also fringe benefits and other labor costs. Many companies prepare a single rate for all employees within a department that reflects the “mix” of wage rates earned.
The standard hours per unit reflects the labor hours required to complete one unit of product. Standard times can be determined by using available references that estimate the time needed to perform a given task, or by relying on time and motion studies.

6. Setting Variable Overhead Standards
Rate Standards
The rate is the variable portion of the predetermined overhead rate.
Activity Standards
The activity is the base used to calculate the predetermined overhead.
For variable manufacturing overhead, we use a rate standard which is the variable portion of the predetermined overhead rate. The activity standard is the units of activity in the base used to apply our predetermined overhead. Examples of the activity base might be direct labor hours or machine hours, depending on which is used as the allocation base in the predetermined overhead rate.

7. Price and Quantity Standards
Price and quantity standards are determined separately for two reasons:
The purchasing manager is responsible for raw material purchase prices and the production manager is responsible for the quantity of raw material used.
Price and and quantity standards are determined separately for two reasons
Different managers are usually responsible for buying and for using inputs For example: The purchasing manager is responsible for raw material purchase prices and the production manager is responsible for the quantity of raw material used.
The buying and using activities occur at different points in time. For example: Raw material purchases may be held in inventory for a period of time before being used in production.
The buying and using activities occur at different times. Raw material purchases may be held in inventory for a period of time before being used in production.

8. A General Model for Variance Analysis
Price Variance
Difference between actual price and standard price
Quantity Variance
Difference between actual quantity and 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. The act of computing and interpreting variances is called variance analysis.

9. A General Model for Variance Analysis
Price Variance
Quantity Variance
Price and quantity variances can be computed for all three variable cost elements – direct materials, direct labor, and variable manufacturing overhead – even though the variances have different names as shown.
Materials price variance Labor rate variance VOH spending variance
Materials quantity variance
Labor efficiency variance
VOH efficiency variance

10. A General Model for Variance Analysis
Price Variance
Quantity Variance
Actual Quantity Actual Quantity Standard Quantity × × × Actual Price Standard Price Standard Price
We can reduce these relationships to mathematical equations as shown on your screen. For example, we can determine the price variance by subtracting the actual quantity times the standard price from the actual quantity times the actual price, and we can determine the quantity variance by subtracting the standard quantity times the standard price from the actual quantity times the standard price.
(AQ × AP) – (AQ × SP) (AQ × SP) – (SQ × SP)
AQ = Actual Quantity SP = Standard Price AP = Actual Price SQ = Standard Quantity

11. Variances: Using the Factored Equations
Materials price variance
MPV = AQ (AP - SP)
Materials quantity variance
MQV = SP (AQ - SQ)
Labor rate variance
LRV = AH (AR – SR
Labor efficiency variance
LEV = SR (AH - SH)
Variable manufacturing overhead spending variance
VMSV = AH (AR - SR)
Variable manufacturing overhead efficiency variance
VMEV = SR (AH - SH)
Part I
The equations that we have been using thus far can be factored and used to compute material price and quantity variances.
Part II
We can determine the material price variance by multiplying the actual quantity times the difference between the actual price and the standard price.
Part III
We can determine the material quantity variance by multiplying the standard price times the difference between the actual quantity and the standard quantity.

12. A Statistical Control Chart
Exh.
10-9
A Statistical Control Chart
Warning signals for investigation • •
Favorable Limit • • • •
Desired Value • •
Unfavorable Limit •
Plotting variance analysis data on a statistical control chart is helpful in variance investigation decisions. Variances are investigated if:
They are unusual relative to the normal level of random fluctuation.
An unusual pattern emerges in the data. 1 2 3 4 5 6 7 8 9
Variance Measurements