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Unformatted text preview: STUDY UNIT SEVEN
STANDARD COSTS AND VARIANCES n of resources. Numerically, it is the quantity of inputs budgeted for use in the production
BO) times the standard price for a unit of input (SP). Once the period has ended, the actual e known. Numerically, this consists of the actual quantity of inputs consumed (AQ) times the
e per unit (AP). The third element In the preparation of variance analysis IS the flexible
Calculation of the flexible budget requires the derivation of a new term, expected quantity ch reflects the amount of resources that Should have been consumed to produce the achieved
'tput. Numericaily, EQ' IS the actual number of units of output produced (AO) times the number of inputs required to produce a Single unit of output (SI/O) EQ times the standard
nit of input (SP) produces the flexible budget. ping the three principal amounts this way aids in the calculation of variances: Actual Results Flexible Budget Static Budget
AQ X AP EQ X SP SQ X SP Once the three principal amounts have been calculated, the Variances can be derived. The total
variance to be explained is called the static budget variance. It is the difference between what the
tlrm budgeted to spend and what it actually spent. Numerically, it is the static budget minus the actual
resuits. This total variance can be decomposed into two component variances. The flexible budget
variance is the difference between what the Company actually spent on inputs and what it should have
spent given the achieved level of production. ‘Numerically, it is the flexible budget minus the actual
results. The other component of the total variance is the sales volu'me'variance, which is the
difference between what the company should have spent given the achieved level of production and
what it budgeted to spend for the period. NumeriCally, it is the static budget minus the flexible budget. The formulas are as follows: Variance ' Formula
Static Budget Variance ‘ (30 x SP) — (AQ x AP)
Sales Volume Variance (SQ — EQ) x SP
Flexible Budget Variance (EQ x SP)  {AQ x AP) From comparison of these formulas, it is clear that the sales volume variance isolates the deviation
of input quantity by holding price constant. However, the flexible budget variance does not hold either
factor constant. In order to isoiate the quantity and price deviations within the flexible budget variance,
it is further decomposed into two component variances. To derive these component variances, a third
budget amount must be calculated, consisting of the actual number of inputs consumed times the
standard price. The direct materials price (labor rate) variance reports the deviation“ In input quantity
by holding price constant. Numerically, it is the third budget minus the actual results. The direct
materialsquantity (labor efficiency) variance reports the deviation in price by holding input quantity
constant. Numerically, it is the flexible budget minds the third budget. The formulas are as follows: Variance Formula
Flexible Budget Variance (EQ x SP)— (AQ x AP)
Quantity/Efficiency variance (EQ — A0) x SP
Price/Rate Variance AQ x (SP —AP) The materials quantity variance is also called the materials usage variance. The following diagram
depicts the relationships among these amounts and their related variances: Materials and Labor Variances
Actual Results 'Third Budget Flexible 3—dget Static 3—dget
Actual inputs Actual inputs Expected Inputs Budgeted Inputs,
x x x
Actual Price Standard Price Standard Price Standard Price \. Mate rials Price 1 Mat. Qua ntityl
Labor Efﬁciency
Variance Labor Rate
Variance Fiextble Budget
VarIa nce _a[es Volume
_ariance Static Budget
Va rIance The interpretation of unfavorable variances is straightforward. An unfavorable price (rate)
variance means that the actual price (wage) paid for inputs was higher than expected. An unfavorable
quantity (efficiency) variance means that the actual number of inputs (labor hours) consumed was  higher than expected. An unfavorable materials quantity variance is usually caused by waste, shrinkage, or theft. It may be the responsibility of the production department supervisor because the excess usage occurred while the materials were under the person’s supervision. An unfavorable labor
‘ efficiency variance may be caused by worker’s taking unauthorized work breaks. it may also be caused by production delays resulting from materials shortages 'or interior materials. Favorable
varianCes may be good or bad depending'on the circumstances. A favorable price (rate) variance is always a good sign. It means that input costs were lower than expected. A favorable quantity
(efficiency) variance is more ambiguous. A favorable materials quantity variance indicates that the workers either have been unusually efficient or are producing lower quality products with less than
sufficient attention. A favorable quantity (efficiency) variance, therefore, may suggest that costs have “ been reduced at the expense of product quality. When multiple raw materials or wage rates are used in the production process, the direct materials '_ quantity (labor efficiency) variance can be further subdivided to isolate which portion of the variance is _
=_ attributable to the mix of inputs and which to the yield therefrom. The mix variance equals total actual
;. quantity times the difference between the weightedaverage unit standard cost of the budgeted mixof ingredients and the weightedaverage unit standard cost of the actual mix. The yield variance is the 'fweightedaverage unit standard cost of the budgeted mix multiplied by the difference between the
actual quantity of materials used and the standard quantity. Certain relationships may exist among the
if: various materials variances. For instance, an unfavorable price variance may be offset by a favorable mix or yield variance because materials of better quality and higherprice are used. Also, a favorable ' mix variance may result in an unfavorable yield variance, or vice versa. For manufacturing overhead, variances are calculated separately for the variable and fixed portions. The variances for the variable portion are calculated identically to those for direct materials
‘5‘? and direct labor. The variable overhead static budget amount is the number of allocation base units budgeted for use in the production process (BO) times the budgeted allocation rate (SP). As with
materials and labor, the actual results are calculated once the period has ended. Obviously, actual
overhead costs for the period are simply totaled to prepare for variance calculation. This total can be
divided by the actual number of allocationbase units expended (A0) to derive an “actual rate” (AP). The variable overhead flexible budget amount reflects the number of allocationbase units that should have been consumed to produce the achieved level of output. Numerically, it is the actual number of
units of output‘produced times the budgeted number of allocationbase units required to produce a
single unit of output (EQ), times the budgeted rate (SP). As with direct materials and direct labor the . static budget variance is the total variance to be explained (the static budget minus the actual results), and it can be subdivided into two component variances. Once the three amounts have been calculated, the variances can be derived. As with direct
materials and direct labor, the total variance to be explained is called the static budget variance. It is
the difference between what the firm expected to spend on variable overhead andwhat it actually
spent. Numerically, it is the static budget minus the actual results. This total variancecah be .
decomposed into twocomponent variances. The flexible budget variance is the difference between
what the company actually spent on variable overhead and what it should have spent given the '
achieved level of output. 'Numerically, it is the flexible budget minus the actual results. The other
component of the total variance is the sales volume variance, which is the difference between what
the company should have spent given the achieved level of output and what it expected to spend for the period. Numerically, it is the static budget minus the flexible budget. The shortcut formulas are the
same as those for materials and labor. Once again, the flexible budget variance. is further decomposed into two component variances. To
derive these component variances, a fourth budget amount must be calculated, consisting of the actual
number of allocationbase units consumed times the budgeted rate. The variable overhead efficiency
variance reports the deviation in allocationbase usage by holding the rate constant. Numerically, it is
the flexible budget minus the fourth budget. The variable overhead spending variance reports the r
deviation in the rate by holding allocationbase usage constant. Numericaliy, it is the fourth budget
minus the actual results. The shortcut formulas are the same as those for materials and labor. 1 The following diagram depicts the relation‘ships among these amounts and their related variances: Variable Overhead Variances Actual Output
x l Actual Results Flexible Budget Static Budget
l AQxAP EQxSP BQx SP Actual Driver Actual Driver Budgeted Driver Budgeted Driver
per Unit of Output
x x x x
Actual Rate Budgeted Rate Budgeted Rate Budgeted Rate \. Variable OH
Spending
Variance Variahle 0H
Efﬁciency
Variance Sales Volume
Variance _ Static Budget
Variance For the fixed portion of overhead, the static and flexible budgets are identical. This is due to the
fact that fixed costs are by their nature unchanging within the relevant range of the budgeting cycle.
Thus, the fixed overhead static budget variance, the fixed overhead flexible budget variance, and
the fixed overhead spending variance are all the same, equal to the flexible/static budget minus the
actual results. instead of an efficiency variance for fixed overhead, a fixed overhead production
volume variance iscalculated: the difference between the allocated amount (the number of units of actually produced, times the budgeted number offixed overhead allocationbase units required to
produce a single unit of output, times the‘budgeted allocation rate) minus the flexible/static budget. Flexible Budget
Variance Fixed Overhead Variances Actual Flexible 2 Static Allocated
Results Bud et ' EQ X SP
Actual Output . _ x
Actual Costs Budgeted Costs Budgeted Driver incurred per Unit of Output x
Budgeted Rate Fixed 0H
Spending
Variance Fixed OH
ProductionVolume
Variance  Flexible Budget
Variance Static Il Budget
‘J , . ‘ Variance l . Fourway overhead variance analysis consists of the variable overhead spending and efficiency
I‘s‘yariances and the fixed overhead spending and productionvolume variances. The following tables use
”Issample numbers for illustrative purposes: Production 4Way Analysis Volume
Variance "Ir—
———— Spending
Variance Efficiency 
Variance I I Threeway overhead variance analysis consists ‘of the two spending variances combined, the
variable overhead efficiency variance, and the fixed overhead production—volume variance.
Volume 3Way Analysis
, I Variance
Total'OH $1,496,U $240 F . $457 U . Twoway ov‘erhead variance analysis consists of the two spending variances combined with the
vaariable overhead efficiency variance, and the fixed overhead productionvolume variance. Production , Spending
Variance Efficiency
Variance Flexible Production Budget Volume
Variance Variance Total OH $1,256 U The purchase price variance is a nonmanufacturing variance that measures the deviation of the
'amount paid to purchase raw materials during a period from the amount expected to be paid. The Its": general formula is [Quantity Purchased x (SP — AP)]. Stating the formula in this way produces a '7 positive result when the variance, is favorable. ' 2Way Analysis , Analysis of revenues and revenue variances involves allocating cr, preferably, tracing revenues to , specific products, services, customers, etc. Revenue allocation is necessary when, for example, products, services, etc., are bundled (e.g., software packages). A bundled product or service is sold
for one price but consiSts of distinct items that may be sold separately. The difference between
allocation and tracing of revenues and revenuerelated items, such as sales returns, is similar to that
between alloéation and tracing of costs. Moreover, the consequences of an arbitrary assignment of
revenues (abroad averaging of revenue items over products, services, etc., that is, peanutbutter
revenue assignments) are similar to the dysfunctional effects of inaccurate cost assignments. Like
costs (see Study Unit 6), revenues may be allocated using a standalone or an incremental method.
Standalone revenue allocation may use a weighting scheme based on unit selling prices, for ’
example, average actual prices, which is the theoretically preferable method; unit costs; or physical
units in the bundle. incremental revenue allocation establishes priorities among the items in a
bundle. The primary product is assigned 100% of its standalone revenue, with the remaining revenue
from the bundle assigned sequentially to the other items. A Variance analysis can be applied to the effectiveness of the selling departments as well as to that
of the manufacturing departments. Analysis of variances on the revenue side tends to focus on
contribution margin rather than sales or operating income. Sales variances are notvhelpful because
they exclude consideration of costs, and operating income variances provide no additional information
since operating income moves in tandem with contribution margin (owing to the fact that fixed costs do
not vary across the relevant range). Once again, the total difference to be explained is the static
budget variance, and it can be subdivided into a sales price variance and a sales volume variance.
The sales price variance measures the portion of the total variance attributable to the contribution
margin deviating from what was expected (holding quantity constant). The sales volume variance
measures the portion or the total variance attributable to the quantity of product sold deviating from “what was expected (holding contribution margin constant). The sales volume variance may be decomposed into a sales mix variance and a sales quantity variance. The sales mix variance
measures the portion of the sales volume variance attributable to the deviation of the actual product mix
from the budgeted product mix (holding unit sales and contribution margin constant). The sales
quantity varianCe measures the portion of the sales volume variance attributable to the deviation of the
actual unit sales from the budgeted unit sales (holding product mix and contribution margin constant). I. u u 
Contribution Margin Variances Actual Results Flexible —udget ' Static Budget
AS x AM x AUCM S x AM x BUCM BS x BM x BUCM Actual Total Actual Total Actual Total Budgeted Total
Unit Sales Unit Sales Unit Sales Unit Sales
_ x x  x x
Actual Mix % Actual Mix % Budgeted Mix % ' Budgeted Mix %
x x _ X x '
Actual Unit Budgeted Unit Budgeted Unit Budgeted Unit
Contribution Margin Contribution Margin Contribution Margin Contribution Margin Sales Mix Sales Quantity Variance Variance
Sales Volume Variance /\ ' Static Budget
Variance _ales Price _ariance Variances usually do not appear on the financial statements. They are used for managerial
control, and are recorded in the ledger accounts. According to GAAP (ARB 43, Chapter 4), standard
costs may be used to record inventory if the amounts are adjusted at reasonable intervals to reflect
current conditions. The balance sheet should then report amounts that reasonably approximate those
computed under one of the recognized inventory accounting methods. When standard costs are
recorded in inventory accounts,'variances are also recorded. Thus, direct labor is recorded as a liability
at actual cost, but it is charged to WIP control at its standard cost for the standard quantity used. The
direct labor rate and efficiency variances are recognized at that time. Direct materials, however, should
be debited to materials control at standard prices at the time of purchase. The purpose is to isolate the
direct materials price variance as soon as possible. When direct materials are used, they are debited
to WIP at the standard cost for the standard quantity, and the materials quantity variance is then
recognized. Actual overhead costs are debited to overhead control and credited to accounts payable,
wages payable, etc. Applied overhead is credited to an overhead applied account (orto overhead
control) and debited to WIP control. The simplest method of recording the overhead variances is to
wait until year—end. The variances can then be recognized separately when the overhead control, and overhead applied accounts are closed (by a credit and a debit, respectively). The balancing debits or
credits are to the variance accounts. Variances should be carefully analyzed before they are used for evaluating performance and
improving operations. Isolating a given variance is beneficial only if the effect on achievement of
overall organizational goals' IS understood. Thus, variances should be considered' In aggregate,
because measures taken to Improve one variance may degrade another variance. An activity' In any
part of the firm’ s value chain (e. g., design of a product) or supply chain (e. g., quality of materials
provided by a supplier) may affect activities in any other part of the value chain. Furthermore Disposition of variances is accomplished most often by closing them to cost of goods sold or
income summary if they are immaterial Variances that are material may be prorated. A simple 1,) approach to proration Is to allocate the total net variance to WIP, finished goods, and cost of goods sold " based on the balances In those accounts. However, more complex methods are possible. ‘ Several alternative approaches to the timing of recognition of variances are possible. For
' example, direct materials and labor might be transferred to WIP at their actual quantities. In that case,
he direct materials quantity and direct labor efficiency variances might be recognized when goods are
_ ransferred from WIP to finished goods. Furthermore, the direct materials price variance might be isolated at the time of transfer to W.P These methods, however delay the recognition of variances
.' Early recognition is desirable for control purposes. ‘ Traditional variance analysis assumes that flexible budget amounts are determined using a single
unit—level cost driver, such as direct labor hours. The costing formula used to develop the flexible _ budget defines certain costs as fixed In total and certain other costs as fixed per unit of the driver. In ‘ .an ABC setting, however, the costing formula Is based on multiple drivers and the cost hierarchy
(unitlevel, batch— level, product or service level, and facility level), and activities having the same driver
are grouped for computational convenience. The results should provide a better understanding of " which activities add value, more detailed and accurate predictions of costs at different levels of activity, '
[and more meaningful variance analysis and performance measurement. These benefits arise because, in effect, a flexible budget' Is developed for each group of activities having the same driver. However, a iflexible budget has the same variable and fixed overhead variances fer an activity (or group of
" ctivities) as in a traditional system. ‘ Productivity measures are related to the efficiency, mix, and yield variances. They can be
developed for both manufacturing and service entities, although the latter may sometimes find that
output is difficult to measure. Productivity is the relationship between outputs and inputs (including the
mix of inputs). The higher this ratio, the greater the productivity. Improvem...
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