1. 3310 - Chapter 16 Fundamentals of Variance Analysis

2. The Use of Variances Difference between actual and budget is called a VARIANCE. For costs: –Variances are FAVORABLE if Actual < Budget for costs –Variances are UNFAVORABLE if Actual > Budget for costs For revenues, the opposite holds true. –FAVORABLE: Actual > Budget –UNFAVORABLE: Actual < Budget

3. Static Budgets and Static-Budget Variances Budget serves as a guideline Budget must be “flexible” –Static budget - budget prepared for one level Budget prepared for 1,000 units Costs $10,000 + $5 x Budgeted Cost = ? Suppose actual units prepared 900 units costing $14,700 Did we beat budget?

4. Flexible Budgets We did beat the static budget but that amount is really meaningless because we produced less units than the static budget Flexible budget prepared for several levels –A new budget must be produced for actual units produced –900 units x $5 = 4,500 + 10,000 = $14,500 –Budget = $14,500, Actual = $14,700 –We are over budget by $200.

5. Flexible Budget for Several Levels 900 units1000 units 1100 units Variable Costs $5 unit 4,500 5,000 5,500 Fixed costs 10,000 Total costs 14,50015,00015,500

6. Variances Static budget variances –Difference in actual and budgeted amounts –Can be broken down into many more detailed variances Sales activity variance –difference in flexible budget sales and static budget sales (what we should have brought in for the units actually sold and what we should have brought in for the units we budgeted to sell) Profit variances –difference in actual and flexible budget amounts –Broken down into price and efficiency variances

7. Profit Variances Sales price variance –Difference in actual price and budgeted sales price Variable production cost variances –Difference in actual variable cost and budgeted variable cost Fixed production cost variance –Difference in actual fixed costs incurred and budgeted amounts Marketing and administrative variances –Difference in actual marketing and admin. Costs and budgeted amounts

8. Standard Cost Systems Benchmark or norm used for planning and control purposes; a model or budget against which actual results are compared and evaluated. Comparable to a budget broken down to a unit figure Like predetermined OH rates Developed for DM, DL, and OH

9. Standard Cost Systems Benefits Easier bookkeeping Motivation Planning Control costs Decision making Performance evaluation

10. Standard Cost Systems Who develops standard costs? –Engineers –Cost accountants –Managers –Workers Types of standards –Expected standards –Practical standards –Ideal standards

11. Standard costs Developed for DM, DL, and OH (both variable and fixed) Each category involves a price and quantity element

12. Direct Material Variances Price Variance Efficiency (Quantity) Variance Causes

13. Direct Material Variances AP x AQ SP x AQ SP x SQ |__________________| |_____________| Price Variance Efficiency Variance |_________________________________| Total Materials Variance

14. Standard Quantity Allowed Standard Quantity per unit X units produced = Standard Quantity Allowed Example: 4 yards per sleeping bag X 100 bags produced = 400 yards of fabric allowed

15. Direct Labor Variances Price (Rate) Variance - difference in rates actually paid and standard wage rates per hour Efficiency Variance - difference in actual hours worked and standard hours that should have been worked. Causes

16. Direct Labor Variances AR x AH SR x AH SR x SH |__________________| |_____________| Rate Variance Efficiency Variance |_________________________________| Total Labor Variance

17. Responsibility for Variances Materials price - Purchasing Materials quantity - Production, Purchasing Labor rate - Personnel, Production Labor efficiency - Production, Purchasing BUT: Must investigate the variance to see who is actually responsible

18. Overhead Variances The standard price for the overhead is determined by the predetermined overhead rate. This rate is separated for variable and fixed overhead. The rate is determined by choosing a level, the “denominator” level, at which a company thinks it will produce.

19. Predetermined OH Rates Variable OH: $4,500/900 = $5 $5,000/1,000 = $5 $5,500/1,100 = $5 It makes no difference which level of output we choose to set the variable OH rate. It is $5 for all of the levels.

20. Predetermined OH Rates Fixed OH: $10,000/900 = $11.11 $10,000/1,000 = $10 $10,000/1,100 = $9.09 It DOES make a difference which level of output we choose to set the fixed OH rate. The OH rate varies from $11.11 to $9.09 based on the level of units we choose to set the rate. This chosen level is called the DENOMINATOR LEVEL.

21. Predetermined OH Rates If we choose to use 900 units to set our OH rate, we will have the higher $11.11 OH rate. More overhead will be allocated than the other two levels. We are more likely to have overapplied OH with a higher rate.

22. Variable Overhead Profit variances –Price variance Difference in actual cost and predetermined variable overhead rate multiplied by the actual cost driver –Efficiency variance Difference in actual cost driver and budgeted cost driver multiplied by the predetermined variable overhead rate Causes

23. Fixed Overhead Flexible budget rates - based on denominator level Profit variance – termed price variance –Difference in actual amount spent and budgeted amount –Controllable variance

24. Fixed Overhead Production-volume variance –Difference in flexible budget and predetermined fixed overhead rate x standard activity –Depends on denominator level chosen –This is part of the sales activity variance –Deemed an “uncontrollable” variance Causes

25. Journal Entries Standard costs debited to Inventories and COGS Unfavorable Variances - debited (more costs) Favorable Variances - credited (less costs) Actual costs credited At end of period, variances are usually closed into cost of goods sold

26. Closing Journal Entry Debit Variable Overhead Applied (standard price x standard activity for actual output) to close Debit (credit) unfavorable (favorable) Variable OH Price Variance Debit (credit) unfavorable (favorable)Variable OH Efficiency Variance Credit Variable Overhead (Actual) for actual overhead costs incurred (to close)

27. Closing Journal Entry Debit Fixed Overhead Applied (standard price x standard activity for actual output) to close Debit (credit) unfavorable (favorable) Fixed OH Price Variance Debit (credit) unfavorable (favorable) Fixed OH Production Volume Variance Credit Fixed Overhead (actual) for actual overhead costs incurred (to close)

28. Management Uses of Variances Management by Exception Performance Measurement –Effectiveness –Efficiency Continuous Improvement Financial and Nonfinancial Performance Measures

29. Other Topics Benchmarking and variance analysis –Benchmark is a quantity from an outside company –Benchmarks often represent “best practices” –Efficient use of hours, material, prices, etc. –Set up the benchmark as your standard