1. VARIANCE ANALYSIS 1
LECTURE 8

2. 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

3. 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

4. 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

5. 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

6. 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.

7. 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

8. 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

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

10. 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.

11. 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.

12. 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.

13. 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.

14. 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

15. 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.

16. 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

17. 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

18. 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.

19. 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.

20. 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

21. 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.

22. 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