24/02/20201LO2: Variance AnalysisDr Fidelis AkangaLearning outcomesBy the end of this unit Define and explain the purpose of standardcosts Discuss the usefulness of variances Calculate and interpret variances24/02/20202Recall Planning involves systematically looking at thefuture, so that decisions can be made today whichwill bring the company its desired results. Control can be defined as the process of measuringand correcting actual performance to ensure thatplans for implementing the chosen course of actionare carried out.Currently Attainable Standard Costs These standards represent those costs that should beincurred under efficient operating conditions. They arestandards that are difficult, but not impossible, toachieve. Attainable standards are easier to achievethan ideal standards because allowances are madefor normal spoilage, machine breakdowns and losttime. Attainable standards provides the best norm towhich actual costs should be compared.24/02/20203Standard costing andmanagement by exception Standard costs when set are usually average unitcosts. Hence actual results will vary to some extentabove the average. These differences (or variances)and should only be reported if there is significantdifference between actual and standard. This costing therefore enables the principle ofmanagement by exception to be practised. Management by exception is defined by CIMA as thepractice of concentrating on activities that requireattention and ignoring those which appear to beconforming to expectations.Setting standards costsStandards for units of production or service should bebased on careful investigation and research, andstandards should be continually monitored to ensure thatthey are reasonable and reliable.If there is an inaccuracy in the standard cost, acomparison of actual against the standard will providemeaningless and unhelpful variance information.24/02/20204Purpose of standard costing Predicting future costs that can be used for decision making.Standard costs represents future target costs derived from theelimination of avoidable inefficiencies Provides challenging targets that individuals are motivated toachieve Assist in setting budgets and evaluating managerialperformances. Used for control by highlighting those activities that do notconform to plan and alerting mangers about those situationsthat maybe out of control Used in tracing costs to products for profit measurement andinventory valuation purposes.Managing CostsComparison betweenstandard and actualperformancelevelActualcostStandardcostCostvariance24/02/20205Variance Analysis Variance = Standard Costs – Actual Costs= SC – AC The variance could be either a favourable or anadverse variance: A favourable variance arises when the actualcost is less than the standard cost. An adverse (unfavourable) variance arises whenthe actual cost is greater than the standard cost.Cost Variance AnalysisStandard Cost VariancesPrice Variance(Rate Variance)The difference betweenthe actual price and thestandard priceQuantity Variance(or Usage Variance)(Efficiency Variance)The difference betweenthe actual quantity andthe standard quantity24/02/20206Variances to be analysedDirectLabourDirectMaterialsManufacturingOverheads1. Direct materials Total Direct Material Cost Variance =Standard Costs – Actual Costs Standard Cost = Standard Price × Standard QuantitySP SQ Actual Cost = Actual Price × Actual QuantityAP AQPurchases Manager Production Manager24/02/20207Direct Materials Cost Variances The Total Direct Materials Variance is split up into twoSubsidiary Variances1. Price Variance =(Standard Price – Actual Price) × Actual Quantity(SP – AP) × AQ2. Usage Variance =(Standard Quantity – Actual Quantity) × Standard Price(SQ – AQ) × SPSummary Direct Material Variance = SC – AC Standard Cost Actual Cost==SP × SQAP × AQ Price Variance = (SP – AP) × AQ Price Usage= (SQ – AQ) × SP 24/02/20208Example 1 Hanson Ltd has the following direct materialstandard to manufacture product Z: 1.5 kgs per product Z at £4.00 per kg Last week 1,700 kgs of material werepurchased and used to make 1,000 Zs. Thematerial cost a total of £6,630.Example 1 Solution What is the actual price per poundpaid for the material?a. £4.00 per kg.b. £4.10 per kg.c. £3.90 per kg.d. £6.63 per kg. AP = £6,630 ÷ 1,700 kgs.AP = £3.90 per kg. 24/02/20209Example 1 Solution Cont. What is Hanson’s direct-material pricevariance (MPV) for the week?a. £ 170 unfavourable.b. £ 170 favourable.c. £ 800 unfavourable.d. £ 800 favourable. MPV = AQ(SP MPV = (£ 4.00 — 3.90)x 1700 Kgs AP)MPV = £ 170 favorableExample 1 Solution Cont.Hanson’s direct-material quantity variance(MQV) for the week was:a. £170 unfavourable.b. £ 170 favourable.c. £ 800 unfavourable.d. £ 800 favourable.MQV = SP(SQ – AQ)MQV = £4.00(1,500 kgs – 1,700 kgs)MQV = £800 unfavorable24/02/2020102. Direct Labour Total Direct Labour Cost Variance =Standard Costs – Actual Costs Standard Cost = Standard Rate × Standard HoursSR SH Actual Cost = Actual Rate × Actual HoursAR AHHR Manager Production ManagerDirect Labour Cost Variances The Total Direct Labour Variance is split up intotwo Subsidiary Variances:1. Rate Variance =(Standard Rate – Actual Rate) × Actual Hours(SR – AR) × AH2. Efficiency Variance =(Standard Hours – Actual Hours) × Standard Rate(SH – AH) × SR24/02/202011Summary Direct Labour Variance = SC – AC Standard Cost = SR × SH Actual Cost = AR × AH Rate Variance = (SR – AR) × AH Efficiency Variance = (SH – AH) × SR Total Labour Cost Variance= (SR x SH) – (AR x AH)Example 2 Hanson has the following direct labourstandard to manufacture one product Zzz: 1.5 standard hours per Zzz at £10.00 perdirect labour hour Last week 1,550 direct labour hours wereworked at a total labour cost of £15,810 tomake 1,000 Zzzs.24/02/202012Example 2 SolutionWhat was Hanson’s Actual Rate (AR)for labour for the week?a. £10.20 per hour.b. £ 10.10 per hour.c. £ 9.90 per hour.d. £ 9.80 per hour.AR = £15,810 ÷ 1,550 hoursAR = £ 10.20 per hourExample 2 Solution Cont.What was Hanson’s labour rate variance (LRV)for the week?a. £310 unfavourable.b. £ 310 favourable.c. £ 300 unfavourable.d. £ 300 favourable.LRV = AH(SR – AR)LRV = 1,550 hrs(£10.00 –£10.20)LRV = £310 unfavorable24/02/202013Example 2 Solution Cont.The standard hours (SH) of labour thatshould have been worked to produce 1,000Zzzs is:a. 1,550 hours.b. 1,500 hours.c. 1,700 hours.d. 1,800 hours.SH = 1,000 units × 1.5 hours per unitSH = 1,500 hoursExample 2 Solution Cont.Hanson’s labour efficiency variance (LEV)for the week was:a. £510 unfavourable.b. £510 favourable.c. £500 unfavourable.d. £500 favourable.LEV = SR(SH – AH)LEV = £10.00(1,500 hrs – 1,550 hrs)LEV = £500 unfavorable24/02/2020143. Manufacturing OverheadVariances• Whereas direct materials and direct labour arevariable costs, manufacturing overhead iscomprised of both variable and fixed costcomponents. Therefore, the analysis of theoverhead cost variance differs somewhat from theanalysis of materials and labour variances.• There are two elements of the overhead costvariance:1. The Variable Overhead Variance; and2. The Fixed Overhead Variance.Manufacturing Variable OverheadVariances Total Var. Overhead Variance = SC – ACStandard CostActual Cost==SR × SHAR × AHRate Variance = (SR – AR) × AHEfficiency Variance = (SH – AH) × SR 24/02/202015Manufacturing Fixed OverheadVariances• Total Fixed Overhead Costs Variance =Budgetary Fixed Costs Actual Fixed CostsNote that no one is responsible for thisvariance because it results from schedulingproduction at any level other than normalExample Auto plc manufactures motorbikes. The following is anextract from its last budgetary period: Actual production: Budgeted production: Actual Fixed overheads: Budgeted fixed overhead; Calculate fixed overhead variance275,000 units250,000 units£526,000,000£50,000,000 24/02/202016Solution Fixed overhead absorption rate:budgeted fixed overheadsbudgeted output 50,000,000/250,000 = £200Budgeted Fixed Overhead – Actual Fixed overhead526,000,000 – 275,000*200526,000,000 – 55,000,000 = £471,000,00024/02/202017Reading List Drury, C. (2018), Management & CostAccounting, 10th Edition. Chapter 17.
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