Variances [PDF]

Chapters 10 & 11 Notes

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Variances Companies prepare cost budgets as part of their planning process. These budgets assume a given level of activity (e.g., financial statements assume that 10,000 units will be produced and sold). Budgets that are tied to a specific level of activity are referred to as Static Budgets. Firms will compare their budgeted costs to their actual costs in order to control costs, evaluate employee performance, and evaluate the budgeting process. This comparison is done by computing Budget Variances. A variance is the dollar difference between a budgeted cost and the actual cost. Unfortunately, the actual activity level is very likely to be different from the budgeted activity level (e.g., firm actually produced 9,000 units). When dealing with Variable Costs, in order to have a meaningful comparison, the budgeted and actual costs must relate to the same activity level (e.g., comparing your actual labor costs [when you produce 9,000 units to your labor cost budget (that is based on 10,000 units)]. Consider the following analogous situation, assume that your employer asks you to: (i) produce a spectacular commercial, and (ii) reserve a 30-second spot during the Super Bowl in which you will showcase the commercial. You are given a $10 million budget for this project. Instead of producing and running the commercial, you contract with PBS to take over the sponsorship of Masterpiece Theatre from Exxon Mobil for $9 million. Coming $1 million under budget is not very impressive, when the activity that you did (Masterpiece Theatre) is significantly different than the activity assumed in the budget (Super Bowl). In order to have a valid comparison for Variable Costs, we use Flexible Budgets when computing Budget Variances. A Flexible Budget is a cost function that produces a different budgeted cost for different activity levels (e.g., Flexible Budget says that your labor cost is equal to $30 for each unit produced). Using a Flexible Budget, you can compare: (i) the actual cost, with (ii) a budgeted cost for the work that you actually did (actual activity level).

Budgets and Variances As noted above, Budget Variances are important tools used in evaluating your operations. When comparing actual results to a Flexible Budget, there can be two different reasons for a Budget Variance. For example, if your Direct Labor Costs on a particular project exceeded the amount budgeted for that project, it can be due to: (i) Please send comments and corrections to me at [email protected]

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paying your workers a higher rate per hour than you budgeted (Reason 1), and/or (ii) your workers spending more time doing the project than you expected (Reason 2). It is important for you to know which of the reasons is true. If the Budget Variance was due to the first reason, then you need to talk to your HRM department (or whoever hires and sets compensation). If the variance was due to the second reason, then you need to speak to the person supervising the project. We subdivide Budget Variances in order to identify which of the reasons is applicable to our situation. The total difference between the actual cost and the Flexible Budget is called the Budget Variance. We calculate a Budget Variance for each component of cost. The Budget Variance is divided into a Price Variance and a Quantity Variance. The Price Variance quantifies how much of the Budget Variance is due to a company having paid an actual price for a cost component that is different than the budgeted price (Reason 1). The Quantity Variance quantifies how much of the Budget Variance is due to a firm using an actual amount of a cost component that is different than the budgeted amount (Reason 2).

Standards As part of the budgeting process, firms develop standards: •

Standard Price (SP) is the estimated price per unit of the cost component (not a unit of product) that will be paid for that cost component (e.g., $10 per hour for Direct Labor Costs).

•

Standard Quantity (SQ) is the estimated amount of the cost component that is expected to be used to make one unit of product (e.g., 3 Direct Labor Hours to produce one computer). When calculating Quantity Variances, the term, “Standard Quantity,” is used to describe the amount of a cost component that is expected to be used to make all of the units of product actually produced in a given period. (e.g., we expect it to take 3 Direct Labor Hours to make a computer; we made 1,000 computers this month; we therefore think it should take 3,000 Direct Labor Hours to make those 1,000 computers). Because the Standard Quantity is linked to the actual number of units of product produced, it creates the Flexible Budget for a cost when it is multiplied by the Standard Price ($10 x 3 DLHs x 1,000 units = $30,000).

Companies develop these standards using a variety of sources (e.g., historical experience, engineering studies, and input from operating personnel). Standards can either be attainable or ideal. If they are ideal, you run the risk of debasing the value of the standard cost because your workers know that it is unlikely that the standards will be met.

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Calculation When calculating Budget Variances, we also need to know the following information about our actual costs: •

Actual Price (AP) is the actual price that the firm paid for a unit of a cost component (e.g., $11 per Direct Labor Hour).

•

Actual Quantity (AQ) is the actual amount of a cost component that was used to make all of the units of the product produced (e.g., 3,300 Direct Labor Hours to make 1,000 computers).

For a given component of cost: (i) the actual costs are calculated by multiplying the Actual Price by the Actual Quantity; and (ii) the Flexible Budget is calculated by multiplying the Standard Price by the Standard Quantity. In the following table, we set up two columns to reflect the actual cost of a cost component (left column) and the Flexible Budget for that cost component (right column). The difference between the totals of each of these columns is the Budget Variance for the cost component in question: Actual Cost AP X AQ

Flexible Budget SP X SQ

In a Standard Costing system, which we will discuss shortly, the standard cost to produce a unit is treated as the cost of each unit produced, and this amount is added to Work In Process. The cost applied to Work In Process is the amount that appears in the Flexible Budget column, and the difference between the two columns represents the variance that appears in the accounting system. This is similar to the Manufacturing Overhead Variance that we discussed previously, where the difference between the actual overhead and the amount applied to Work In Process constituted the amount of the variance.

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In order to divide the Budget Variance into a Price Variance and a Quantity Variance, we will introduce a middle column that consists of the product of the Standard Price multiplied by Actual Quantity. Once you have the totals of the three columns, you then subtract the middle column from the left column in order to get the Price Variance. You also subtract the right column from the middle column in order to get the Quantity Variance: Actual Cost Mixed Flexible Budget AP X AQ SP X AQ SP X SQ |_________ ________________| |________________ ________| (-) (-) Price Variance Quantity Variance AQ (AP – SP)

SP (AQ – SQ)

Subtracting the middle column from the left column produces the following result: (AP x AQ) - (SP x AQ) When you factor out the common Actual Quantity, you get the formula used to calculate the Price Variance: AQ (AP - SP) As the equation indicates, when we subtract the columns, we are holding the Actual Quantity constant and comparing the Standard Price (budget) of a cost component to the Actual Price paid. This comparison gives us the Price Variance. Subtracting the right column from the middle column produces the following result: (SP x AQ) - (SP x SQ) When you factor out the common Standard Price, you get the formula used to calculate the Quantity Variance: SP (AQ - SQ) As the equation indicates, by subtracting the right column from the middle column, we are holding the Standard Price constant and comparing the Standard Quantity (budget) of the cost component to the Actual Quantity used. This comparison gives you the Quantity Variance. Notice that you are always subtracting the budget (standard) from the actual. If you are over budget, then the actual will be greater than the standard and you have a positive number. Because we do not want to be over budget, this is referred to as an “unfavorable” variance. If you are under budget, then the standard is greater than the Please send comments and corrections to me at [email protected]

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actual, and you have a negative number. Because we want to be under budget, this is referred to as a “favorable” variance. Favorable Variance Unfavorable Variance





Negative Number Positive Number

Variance Example Assume that Ralph, Inc., a clothing and fragrance manufacturer, wishes to begin production of a new line of shirts with really big logos (for people who are nearsighted). Ralph estimates that every new shirt will cost $6 in Direct Materials using the following standards: • •

$ 2.00 a yard for the material; and 3 yards of material used in each shirt.

During its first month of operations, Ralph, Inc. produced 1,000 shirts at a Direct Materials cost of $5,880. Ralph paid $2.10 a yard for materials and it used 2,800 yards of material to produce the shirts. You would calculate the Direct Materials Price and Quantity Variances as follows: Actual Cost

Mixed

Flexible Budget

AP X AQ

SP X AQ

SP X SQ

$2.10 x 2,800 yds $2.00 x 2,800 yds $2.00 x 3,000 yds $5,880 $5,600 $6,000 |_________ ________________| |________________ ________| (-) (-) Price Variance Quantity Variance $5,880 - $5,600 = $280 U $5,600 - $6,000 = - $400 F Budget Variance
$5,880 - $6,000 = -$120 F The $120 favorable Direct Materials Budget Variance ($3880 - $6000=-$120) is subdivided into the Price Variance and the Quantity Variance [$280 + (-$400) = -$120].

Use of Variances These variances are used in the evaluating the performance of workers, as well as, the validity of the standards used. In the Ralph, Inc. example, the Price Variance gives us information on the job performance of Ralph’s materials buyer. Ralph should ask the buyer to explain why he or she paid $2.10 per yard for Direct Materials when Ralph’s Standard Price is $2.00 per yard. This difference cost Ralph $280 (the Price Variance). Please send comments and corrections to me at [email protected]

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It is possible that the standard is too low. It is also possible that there may have been an unforeseeable event that caused material prices to change. A poor job performance by the purchaser is another possible explanation. The Quantity Variance tells us that Ralph’s production supervisor used $400 less Direct Materials than Ralph expected. Ralph should examine the supervisor’s performance in order to determine whether the favorable variance is due to the Production Department’s superior performance (e.g., there was less waste than is usually the case), or whether it is likely to be repeated (e.g., due to instituting new techniques, or the standard was too low to begin with). If the performance is likely to be repeated, then Ralph should consider revising its Standard Quantity per unit.

Variance Names The procedure described above (along with the formulas) can be used to calculate variances for each of the Variable Costs of production: Direct Labor, Direct Materials, and Variable Manufacturing Overhead. A number of different names are given to these variances. Common variance names used for Variable Costs include: Input Direct Materials: Direct Labor: Variable Overhead:

Type Price: Quantity: Price: Quantity: Price: Quantity:

Variance Name Materials Price Variance Materials Usage, Efficiency or Quantity Variance Labor Rate or Price Variance Labor Efficiency Variance Variable OH Spending or Price Variance Variable Efficiency Variance

Special Rule For Materials Price Variance In the foregoing example, we assumed that the firm bought the same amount of Direct Materials that it used in the production process. If we buy an amount of Direct Materials that is different from the amount used, then, contrary to the suggestion made in your book, most firms calculate the Material Price Variance using the Actual Quantity purchased rather than the Actual Quantity used. There are two reasons for using the amount purchased in the calculation of the Materials Price Variance: •

First, if the Actual Quantity used is included in the calculation, then there would be a delay in the evaluation of the material buyer’s job performance. The job performance occurs when materials are purchased. The evaluation occurs when the variance is calculated. Depending on the firm, the time between the purchase of materials and their use in the production process could be lengthy. Most firms want timely performance evaluations, and calculating the variance at the time that the materials are purchased accomplishes this.

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Second, when using the Standard Costing system (which we will discuss shortly), a company only knows the amount purchased at the time that the Materials Price Variance is calculated.

Continuing with the Ralph, Inc. example, if Ralph bought 5,000 yards of Direct Materials for the period in question, and it calculated the Materials Price Variance at the time of purchase, then you would calculate the Direct Materials Variances as described below: Actual Cost AP X AQ

Mixed SP X AQ

Flexible Budget SP X AQ

SP X SQ

$2.10 x 5,000 yds $2.00 x 5,000 yds $10,500 $10,000 |________ ________| (-) Price Variance

$2.00 x 2,800 yds $2.00 x 3,000 yds $5,600 $6,000 |________ ________| (-) Quantity Variance

$10,500 - $10,000 = $500 U

$5,600 - $6,000 = - $400 F

AQ is the quantity purchased in the Materials Price Variance, and AQ is the quantity used in the Materials Quantity Variance.

Fixed Manufacturing Overhead The variances for Fixed Manufacturing Overhead are calculated differently than the variances for the Variable Costs that we discussed above. This difference is due to the fact that Fixed Manufacturing Overhead is a Fixed Cost, and a comparison of actual costs to the Static Budget (rather than a Flexible Budget) provides a meaningful Budget Variance. Having a budget change as the number of units produced changes is appropriate for Variable Costs (Flexible Budget). By definition, the total Variable Cost changes as the volume of the number of units changes. Fixed Manufacturing Overhead, however, is a Fixed Cost, and we expect that the total Fixed Cost will remain unchanged regardless of a change in the number of units produced (Static Budget). For example, if: (i) (ii) (iii)

you believe that your Fixed Manufacturing Overhead will be $100,000, you apply Fixed Manufacturing Overhead as a function of units of product produced, and you estimate that you will produce 10,000 units,

then your Standard Price will be $10 per unit ($100,000/10,000). If you only produce 9,000 units, your Flexible Budget will produce a cost of $90,000. Traditionally, Fixed Costs do not change if your activity level changes, and your budget for Fixed Manufacturing Overhead should still be $100,000 at this production level (not $90,000). The amount of Fixed Manufacturing Overhead that the Flexible Budget column Please send comments and corrections to me at [email protected]

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produces will only coincide with your true budget for Fixed Manufacturing Overhead when you produce 10,000 units. Because the right column does not really reflect your budget for Fixed Manufacturing overhead, it is a misnomer to label that column as the “Flexible Budget.” Instead, we will call it the “Standard Cost.” This is a major problem with Fixed Manufacturing Overhead. As we saw in our discussion of Normal Costing, we estimate our Fixed Manufacturing Overhead and then divide it by our estimated Cost Driver. We then apply the overhead as a function of the Cost Driver despite the fact that a Fixed Cost has no relationship with its Cost Driver. At the end of the year, it is likely that you will have applied an amount of Fixed Manufacturing Overhead that is different than your actual Fixed Manufacturing Overhead cost because: (i) your estimate of your Fixed Manufacturing Overhead is wrong (Reason A); and/or (ii) your estimate of your Cost Driver is wrong (Reason B). We create two Fixed Manufacturing Overhead variances in order to quantify how much of the Fixed Manufacturing Overhead Budget Variance is due to each reason: (i) the Fixed Overhead Spending Variance (Reason A), and (ii) the Fixed Overhead Volume Variance (Reason B). In order to calculate these two variances, we replace the middle (Mixed) column with a new middle column, which contains the true budget for Fixed Manufacturing Overhead (Static Budget). Actual Cost

Static Budget

Standard Amount

AP X AQ

The Fixed Overhead Budget

SP X SQ

|________ __________| |___________ ________| (-) Budget (Spending) Variance

(-) Volume Variance

If you have not been given the Static Budget for Fixed Manufacturing Overhead, you can calculate it. Remember that the Predetermined Fixed Overhead Rate is the Standard Price (SP): Fixed Overhead Budget / Estimated Number of Units = SP Fixed Overhead Budget = SP x Estimated Number of Units

In order to calculate the Static Budget, you need to be given the estimated number of units (or other Cost Driver) that was used in calculating the Standard Price for Fixed Manufacturing Overhead. The Estimated Number of Units is sometimes referred to as the firm’s Normal Capacity. The Fixed Overhead Volume Variance compares: (i) the Static Budget, and (ii) the Standard Cost for Fixed Manufacturing Overhead. It is called the Volume Variance because the reason that the variance exists is the fact that the number of units (volume) that you assumed when calculating the Standard Price is different than the actual number of units produced. An unfavorable Volume Variance indicates that you Please send comments and corrections to me at [email protected]

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produced fewer units than you estimated. It is considered unfavorable because you are under-utilizing your factory. A favorable Volume Variance indicates that you produced more units than you estimated. It is considered favorable because you are utilizing your factory at a rate that is higher than expected. Some authorities describe an unfavorable Volume Variance is the cost incurred to obtain factory capacity that you did not use. This interpretation of the Volume Variance is not accurate. If your budget for Fixed Manufacturing Overhead at the actual level of production is the same as your budget at the estimated level of production, then there was no additional cost incurred in order to obtain the unused capacity. The truth is that you just guessed wrong on the activity level when you calculated the Standard Price. The Fixed Overhead Budget Variance compares: (i) what you spent on Fixed Manufacturing Overhead (actual), to (ii) your true budget for Fixed Manufacturing Overhead. There is no need to divide the variance into a Price Variance and a Quantity Variance, because Fixed Costs are a function of price alone. In theory, quantity does not affect Fixed Costs. This variance is also referred to as the Fixed Overhead Spending Variance.

Standard Costing As we have mentioned previously, when you use actual amounts as the cost components that you record in your accounting system, it is referred to as an Actual Costing System. A Normal Costing System uses the actual cost of Direct Materials and Direct Labor, but uses the Standard Price and Actual Quantity for its Manufacturing Overhead. This is the system that we learned under Job-Order Costing. With a Standard Costing System, you use the Standard Price and the Standard Quantity for all of the cost components. If a Standard Costing System, the Flexible Budget Column (and the Standard Amount Column) in our table becomes the cost of the units that is transferred to Work In Process. With a Standard Costing System, all of the Budget Variances that we learned above are recorded in the accounting system. When a cost is incurred, the actual cost is recorded in the accounting system, when the cost is applied to the Work In Process Account, it is applied using the Standard Price and the Standard Quantity. The difference between these costs is recorded in the appropriate variance account. At the end of the year, all of these variances are closed to Cost of Goods Sold (or Cost of Goods Sold, Finished Goods, and Work In Process).

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When you buy Direct Materials: Dr.

Materials Inventory Materials Price Variance (Dr. or Cr.) Cr. Accounts Payable

SP x AQ AQ (AP – SP) AP x AQ

As noted above, when using Standard Costing, the Materials Price Variance is calculated using the amount purchased as the Actual Quantity because the amount used is not known at this point. When you requisition Direct Materials: Dr.

Work In Process Materials Usage Variance (Dr. or Cr.) Cr. Materials Inventory

SP x SQ SP (AQ – SQ) SP x AQ

When you incur Direct Labor: Dr.

Work In Process Labor Rate Variance (Dr. or Cr.) Labor Efficiency Variance (Dr. or Cr.) Cr. Wages Payable

SP x SQ AQ (AP – SP) SP (AQ – SQ) AP x AQ

In the Standard Costing system, you can divide your Manufacturing Overhead into two accounts, Variable Manufacturing Overhead and Fixed Manufacturing Overhead. As we saw in the Job-Order Costing discussion, the amounts remaining in the overhead accounts at the end of the period represent the amounts of the overhead variances. Debits are actual costs incurred and the credits are the Standard Costs applied: When you incur Variable Manufacturing Overhead (actual): Dr.

Variable Manufacturing Overhead Cr. Accounts Payable

AP x AQ AP x AQ

When you apply Variable Manufacturing Overhead (standard): Dr.

Work In Process Cr. Variable Manufacturing Overhead

SP x SQ SP x SQ

When you incur Fixed Manufacturing Overhead (actual): Dr.

Fixed Manufacturing Overhead Cr. Accounts Payable

AP x AQ

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AP x AQ

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When you apply Fixed Manufacturing Overhead (standard): Dr.

Work In Process Cr. Fixed Manufacturing Overhead

SP x SQ SP x SQ

At the end of the period, we close these accounts to the appropriate variance accounts. Whether accounts are debited or credited depends upon: (i) whether the overhead is over-applied or under applied, and (ii) whether the variance in question is favorable or unfavorable. For example, if the Fixed Manufacturing Overhead was under-applied (a debit balance remains in the Fixed Manufacturing Overhead account), and you had an unfavorable Fixed Overhead Spending Variance and an unfavorable Fixed Overhead Volume Variance: Dr.

Fixed Overhead Spending Variance Fixed Overhead Volume Variance Cr. Fixed Manufacturing Overhead

(AQxAP) – Budget Budget – (SPxSQ) (APxAQ)-(SPxSQ)

If the Variable Manufacturing Overhead was over-applied (a credit balance remains in the Variable Manufacturing Overhead account), and you had a favorable Variable Overhead Spending Variance and a favorable Variable Overhead Efficiency Variance: Dr. Variable Manufacturing Overhead Cr. Variable Overhead Spending Variance Variable Overhead Efficiency Variance

(APxAQ)-(SPxSQ)

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AQ (AP – SP) SP (AQ – SQ)