Understanding Variance Analysis
Variance analysis is a method for companies to compare its actual performance vs its budgeted amount for that cost measurement (related to the flexible budget).
The differences between the standard (budgeted) amount of cost and the actual amount that the organization incurs is referred to as a variance. By analyzing variances, the company can better understand what aspects of the business they can improve. Could they purchase raw materials at a lower price? Could they be more efficient in their manufacturing process? If we think about what types of questions can be answered by the company when performing variance analysis, we will go from trying to memorize the material to actually learning how to perform and apply variance analysis!
For the variances section of this exam, you should be familiar with the calculation for direct material, direct labor, variable manufacturing overhead, and fixed manufacturing overhead variances. We’ll also cover selling price and sales volume variances. Additionally, you should be able to determine if the variance is considered favorable or unfavorable (which won’t be memorized!). Here are a few key terms:
Standards (budgeted) – Measures the cost (or price) that companies expect to incur during production. In standard costing systems, standard cost will be used for all manufacturing costs (i.e., direct materials, direct labor, and manufacturing overhead). You must understand that standard and budgeted rates mean the same thing!
Favorable variance – If the actual cost is lower than the standard (budgeted) cost, a favorable variance will result. We won’t memorize this, but we will learn why it would be considered a favorable variance.
Unfavorable variance – If the actual cost is higher than the standard (budgeted) cost, an unfavorable variance will result. We won’t memorize this, but we will learn why it would be considered an unfavorable variance.
Manufacturing Variances Data Set
The information below will be used to go through each type of variance and simulate the process for a company!
Direct Materials Variance
Direct Materials Variance:
The direct materials variance is an analysis that will compare the budgeted quantity of materials used to create a certain level of output and compare it to the actual quantity of output. The two direct materials variances are the direct materials price variance and direct materials usage variance.
Direct materials price variance – Also called the direct material spending or direct material rate variance. It represents the difference between the actual amount spent on direct material purchases during a given period and the amount that would have been spent had the material been acquired at standard (or budgeted) price. This variance would be the responsibility of the purchasing manager.
In our example, the company purchase units of material for $4.75, which was lower than the standard amount of $5.00 per unit. This results in a $0.25 variance per unit, and when we multiply by actual units purchased of 4,000, that results in a direct materials price variance of $1,000. The variance is favorable as the company paid less for each unit of material than they had budgeted. The purchasing manager did a great job in the period!
Direct materials usage variance – Represents the difference between the actual and budgeted (standard) unit quantity needed to manufacture products. This variance is generally used alongside the price variance and would be used by the production manager to determine if they can be more efficient with the manufacturing process.
In our example, the company used actual units of material of 4,000 which was lower than the budgeted amount of 4,750. The difference of 750 units is then multiple by the standard price per unit of $5.00, and that is how we arrive at a direct materials usage variance of $3,750. The variance would be favorable since the actual quantity used in production was less than the standard or budgeted amount.
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Direct Labor Variance
The direct labor variance is an analysis that will help compare the budgeted amount of time to create a certain output and compare it to the actual amount of time spent. The two variances within the direct labor variance are the direct labor rate variance and direct labor efficiency variance.
Direct labor rate variance – Represents the comparison of the actual labor rate paid per direct labor hour to the budgeted or standard direct labor rate per hour. This difference is then multiplied by the actual number of labor hours to determine the variance.
In our example, the company had an actual labor rate per hour of $8.50, which was $0.50 higher than the standard labor rate per hour of $8.00. When we multiply this $0.50 difference by actual labor hours in the period of 4,750, we arrive at a variance of $2,375. The variance is unfavorable as the actual labor rate per hour was higher than the budgeted.
While the variance is unfavorable, the company may learn that they hired more qualified employees who were more efficient. There might be other areas of the business that improved from paying a higher labor rate.
Direct labor efficiency variance – The direct labor efficiency variance will determine how much time is being spent to create a certain level of output and answers the question as to whether the employees in the production department were efficient or inefficient in producing the product this period.
In our example, the company incurred actual labor hours of 4,750 compared to the standard/budgeted labor hours of 5,000, which means they incurred 250 fewer hours. When we multiply by the standard direct labor rate of $8.00/hr., that results in a direct labor efficiency variance of $2,000.
The variance would be favorable since the company incurred fewer hours, which means the manufacturing employees worked more efficiently in the period. This could be due to better training or a more efficient manufacturing process.
Variable and Fixed Overhead Variances
Manufacturing overhead variances is broken out into both variable and fixed overhead variances. Remember, manufacturing overhead is basically any cost incurred to product the product that is not considered a direct material or direct labor. You should be able to identify and calculate the differences between both fixed and variable manufacturing overhead.
Variable Manufacturing Overhead:
Variable overhead variance can be broken out into a variable overhead rate (spending) variance as well as a variable overhead efficiency variance.
Variable overhead spending variance – The difference between the actual amount of a variable overhead expense and the expected (or budgeted) amount of an organizations variable expense. The variable overhead spending variance indicates whether a company has spent more or less on variable overhead than originally expected.
In our example, the first step would be to compare the actual variable overhead (OH) rate of $2.21 to the standard variable OH rate of $2.00. This rate is based on direct labor hours, which is considered to be the driver of variable overhead. With a difference in the rate of $0.21, we then multiply by actual labor hours of 4,750 incurred during the period (the driver), and that results in a variable OH spending variance of $1,000. The variance would be unfavorable since the variable overhead rate per direct labor hour was higher than the standard rate.
Variable overhead efficiency variance – The variable overhead efficiency variance is the difference between the actual and budgeted hours worked (e.g., labor hours, machine hours etc.) which is subsequently applied by the standard variable overhead rate per hour. This variance will indicate whether more or less hours (or whatever the cost driver is) were used for production then originally budgeted.
With our 2-step approach, we first calculate the difference in quantity of labor hours (driver of variable overhead), and then we multiply the difference by the standard variable overhead application rate.
In our example, the actual quantity was 4,750 of direct labor hours and the standard quantity allowed was 5,000 direct labor hours. That results in 250 fewer direct labor hours that expected, so at a standard variable OH application rate of $2.00 per direct labor hour, that results in a variable overhead efficiency variance of $500 favorable. The result is favorable since fewer hours were incurred than expected, which means the company was more efficient with their resources during the period.
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Fixed Manufacturing Overhead
Fixed Manufacturing Overhead:
Furthermore, fixed overhead variances can be broken out into a spending variance as well as a production volume variance. Fixed manufacturing overhead would be favorable when less fixed manufacturing overhead is incurred than the standard or budgeted fixed overhead amount for the period.
Fixed overhead spending variance – Represents the difference between the actual fixed overhead expense incurred and the budgeted fixed overhead expense. Fixed overhead costs should be easy to budget for a company since they are fixed, right?
In our example, the company budgeted standard fixed overhead to be $13,000, but actual fixed overhead was $13,500, which results in an unfavorable variance of $500.
The company would want to understand why fixed costs were higher than the budgeted or standard amount. Was the budget inaccurate, were there changes in the fixed cost (e.g., rent increased), or did we have unplanned costs? Those are all questions the production manager would try to understand when evaluating the fixed overhead spending variance.
Fixed overhead production volume variance – Represents the difference between the amount of fixed overhead actually applied to produce goods based on actual production volume, and the amount that was budgeted (standard) to be applied to the production process for the period.
Determining whether the variance is favorable or unfavorable is a tricky concept. If applied fixed overhead is greater than the standard or budgeted fixed overhead, this is a favorable variance and indicates the company used their fixed resources to efficiently produce goods in the period. If the variance is unfavorable, this indicates that the company did not efficiently use their fixed resources to produce product in the periods.
In our example, we calculate applied fixed overhead by taking the fixed overhead application rate of $26 per unit and multiply by 7,/500 units actually produced. This results in applied fixed overhead of $19,500. However, the standard or budgeted fixed overhead was $13,000, which results in an unfavorable variance of $6,500. This means that that the company should have been able to produce more goods with their fixed resources during the period.
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Sales price and sales volume variances
Sales price variance – Represents the difference between the price the company expected or budgeted to sell the product for and what the actual selling price for the period was. As you might expect, the company hopes the actual selling price of the product is higher than the budgeted or standard selling price.
- Favorable sales price variance – Occurs when the actual sales price is higher than the budgeted or standard amount. This could be due to a reduction in competition, inflation, effective marketing campaigns, etc.
- Unfavorable sales price variance – Occurs when the actual sales price is lower than the budgeted or standard price. This could be due to increased competition, heavy sales discounts, or increased regulation in the industry.
In our example below, the actual sales price per unit was $17.00 and the standard or budgeted sales price per unit was $15.00, which results in a $2.00 difference. Since the company sold actual units of 750, the total sales price variance was $1,500, which would be favorable since the actual sales price was higher than the standard or budgeted price.
Sales volume variance – Represents the difference between the actual sales volume and the budgeted or standard sales volume for a period. This variance helps a company understand the impact on revenue and profitability from meeting their sales volume targets or falling short.
Favorable sales volume variance – Occurs when the actual sales volume is higher than the budgeted or standard volume. The goal is for the sales team to exceed sales targets from a volume perspective, right?
Unfavorable sales price variance – Occurs when the actual sales volume is lower than the budgeted or standard volume. Falling short of budgeted sales volume means that the company would look to understand what went wrong and how they can improve their sales and marketing approach.
With our 2-step approach for calculating, we start by calculating the difference between actual sales volume and standard (budgeted) sales volume. We then multiply that difference by the standard profitability per unit (sale price or contribution profit) or the standard selling price to calculate the sales volume variance. The company can use either of these methods to calculate a sales volume variance. The only difference is that the standard profitability per unit factors in the variable costs associated with each unit. The exam will clearly indicate which method to use.
Sales Volume Variance (Option #1) – Contribution Profit
In our example, the actual sales volume was 750 units, and the standard (budgeted) sales volume was 500, so the company sold 250 more units than they had planned for. When we multiply 250 units by the standard profitability per unit of $4.00 (contribution profit), that results in a sales volume variance of $1,000.
Sales Volume Variance (Option #2) – Sales Price
As previously mentioned, the company could also calculate the sales volume variance by multiplying by the standard or budgeted sales price. The difference in volume of 250 units remains the same, except we multiply by the standard sale price of $15 per unit, which results in a favorable variance of $3,750.
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