Cost Variance

COST VARIANCES

Cost variances can be divided into four categories.

• Direct Material Cost Variance

• Direct Labour Cost Variance

• Variable Overhead Cost Variance

• Fixed Overhead Cost Variance

Variances occur generally as a result of the following reasons:

• Poor budgeting
• Poor measurement or recording
• Operational factors such as production efficiency, supervision, etc.
• Random factors such as price level changes, political factors, technological factors, etc.

A.    Direct Material Cost Variance: It is the difference between the standard cost of direct materials allowed or expected to be used for a given output and the actual cost of direct materials used. That is,

Direct Material Cost Variance = (Standard Direct Material Cost) – (Actual Direct Material Cost)

Standard cost of direct material expected to be used for a given output produced can be calculated as shown;

• Standard cost = (Actual output produced) × (standard materials allowed per unit of actual output) × (standard price of material)                                                                                                                                                 
• Standard materials allowed for a given output = (Actual output produced)× (Standard materials allowed per unit of output)                                                                                                                 
• Standard materials allowed are also called Standard Quantity.

EXAMPLE 1

Calculate the standard materials allowed and the standard cost from the following data in respect of Alex, production worker.

Actual output produced in the past week                               100 bottles

Standard materials allowed per bottle produced                    20 litres

Standard price per litre of direct materials used                     $700

Solution

Note that apart from the output produced, the other results (20 litres and $700) are expected results. If Alex produced 100 bottles, he would be expected to use 2,000 litres (i.e. 20×100) of the raw materials. Thus standard direct materials allowed or expected = Actual output × Standard materials allowed per bottle                                                                                            = 100 × 20                                                                                                                                                                  = 2,000 litres

Standard cost of direct materials = Standard direct materials allowed × Standard price per litre                                                                                  = 2,000 × 700                                                                                                                                                              = $1,400,000

                                                                                

Direct Material Cost Variance can be sub-divided into:

1.          Direct Material Price Variance: It is the difference between the standard price and the actual price for the actual quantity of materials used. That is,

      Direct Material Price Variance = (Standard Price –Actual Price) × Actual Direct Material Used

• Standard price of material is the price expected to be paid for every metre, kilogram, litre, etc of material purchased.

·      Actual price of material is the price actually paid for every metre, kilogram, litre, etc of material purchased.           

Causes of Material Price Variances

The possible causes are:

          i.    poor budgeting;

         ii.   poor recording or measurement;

        iii.  unexpected price changes;

        iv.  different source of supply;

         v.   alteration in quantity discounts;

        vi.  substitution of a different grade of material;

    vii.    standard set at mid-year price leading to favourable price variance in early months and adverse variance later.

2.       Direct Material Usage Variance: It is the difference between the standard quantity of direct materials allowed for the actual production and the actual quantity of direct materials used, at standard purchase price. That is,

Direct Material Usage Variance = (Standard Direct Material Quantity – Actual Direct Material Quantity) × Standard Price

Causes of Material Usage Variance

This could be due to:

          i.          poor planning;

         ii.         poor recording or measurement;

        iii.        level of supervision;

        iv.        usage of faulty machine or plant;

         v.         higher/lower incidence of scrap;

        vi.        alteration to product design;

       vii.       substitution of a different grade of material;

      viii.      substitution of a different grade of employees.

B.     Direct Labour Cost Variance: It is the difference between the standard direct labour cost and the actual direct labour cost incurred for the actual production achieved. That is,

Direct Labour Cost Variance = (Standard Direct Labour Cost) – (Actual Direct Labour Cost)

Standard cost of direct labour expected to be incurred for a given output produced can be calculated as shown;

      Standard cost = Standard hours allowed × Standard rate per hour                                                                                                                                                  

Standard hours allowed = Actual output produced × Standard direct labour hours allowed per unit

Following from the example above in respect of Alex, assuming

Actual output produced in the past week was still                             100 bottles

Direct labour hour allowed per bottle is                                             2 hours

Standard direct labour rate per hour is                                               $8,000

Solution

If Alex produced 100 bottles, he would be expected to use 200 (i.e. 20×100) of direct labour hours. That is,   

Standard direct labour hours expected/allowed = Actual output × Standard direct labour hours per bottle

                                                                           = 100 × 2

                                                                           = 200 hours

Standard direct labour Cost = Standard direct labour hours allowed × Standard direct labour rate per hour

                                             = 200 × 8,000                                                                                                                

                                             = $1,600,000

Direct Labour Cost Variance can be sub-divided into:

1.          Direct Labour Rate Variance: It is the difference between the standard and the actual direct labour hour rate, for the total hours actually worked. That is,

            Direct Labour Rate Variance = (Standard Direct Labour Hour Rate –Actual Direct Labour Hour Rate) ×

            Actual Direct Labour Hours Worked

• Standard direct labour hour rate is the rate expected to be paid for every direct labour hour worked.

·      Actual direct labour hour rate is the rate actually paid for every direct labour hour worked.

Causes of Labour Rate Variance

The possible causes are:

        i.     poor planning;

      ii.     poor recording or measurement;

    iii.     unexpected wage award;

    iv.     overtime or bonus payments different from plan;

      v.     substitution of a different grade of labour.

2.          Direct Labour Efficiency Variance: It is the difference between the standard hours required for the actual production achieved and the hours actually worked, valued at standard direct labour hour rate. That is,

      Direct Labour Rate Variance = (Standard Direct Labour Hours – Actual Direct Labour Hours) ×

      Standard Direct Labour Hour Rate

Causes of Labour Efficiency Variance

The possible causes are:

        i.     poor planning;

      ii.     poor recording or measurement;

    iii.     level of supervision;

    iv.     working conditions including workshop organisation;

      v.     consequences of the learning effect;

    vi.     introduction of incentive scheme or staff training;

  vii.     efficiency of machine;

viii.     substitution of a different grade of labour.

Where the hours recorded or clocked by employees are more than the actual hours worked, idle time is recorded. This will lead to idle time variance. This is calculated by multiplying the idle hours by the standard labour rate thus,

Idle Time Variance = Idle hours × Standard labour rate

Idle time variance is always adverse.

EXERCISE 1

Joy Company manufactures one standard product. The standard cost of producing one unit is calculated as follows:                                                                                     $

            Materials: 20 kg @ $300 per kg                    6,000

            Labour: 6 hours @ $250 per hour                   1,500

7,500

            Production overheads                                     2,500

                                                                                  10,000

For the month of October 1994, 800 units were produced. A total of 14,400 kg of materials were bought and used at a total cost of $5,040,000. A total of $1,120,000 was paid as wages for the 4,000 labour hours used in the month.

You are required to calculate:

(a) Total Material Cost Variance analysed into Price Variance and Usage Variance;

(b) Total Labour Cost Variance analysed into Rate Variance and Efficiency Variance.          

EXERCISE 2

An extract of a standard cost card for one tonne of a product called Zain is as below:

                                                                                        $

Direct material: 50kg @ $100 per kg              5,000

            Direct labour: 10 hours @ $800 per hour       8,000

During April 2009, 70 tonnes of Zain was produced. Other costs were:

            Direct material: 3,200kg costing $384,000

            Direct labour: 800 hours costing $608,000.

You are required to calculate:

(a) direct material price variance;

(b) direct material usage variance;

(c) total direct material cost variance;

(d) total direct labour cost variance;

(e) direct labour rate variance;

(f) direct labour efficiency variance.

C.    Fixed Production Overhead Variances                                                                           

The overall fixed overhead variance is the fixed overhead total variance. It is the difference between fixed overhead incurred (actual fixed overhead) and fixed overhead absorbed. This is the same as the fixed overhead under- or over-absorbed.

It is calculated as;

Fixed overhead total variance = Fixed overhead absorbed – Fixed overhead incurred

Fixed overhead absorbed is calculated as;

Fixed overhead absorbed = Actual output × Standard hours per unit × Fixed overhead absorption rate per hour

Fixed overhead total variance can be sub-divided into fixed overhead expenditure variance and fixed overhead volume variance.

1. Fixed Overhead Expenditure Variance: This is the difference between budgeted fixed overhead expenditure and actual fixed overhead expenditure. Thus,

     Fixed overhead expenditure variance = Budgeted fixed overhead – Fixed overhead incurred

2. Fixed Overhead Volume Variance: This is the difference between actual and budgeted volume of output

    multiplied by the standard fixed overhead absorption rate per unit of output. Thus,

    Fixed overhead volume variance = (Actual output – Budgeted output) Standard fixed overhead rate per unit

It can also be calculated as;

Fixed overhead volume variance = (Standard hours – Budgeted hours) Standard fixed overhead rate per hour

Fixed overhead volume variance can be sub-divided into fixed overhead volume capacity variance and fixed overhead volume efficiency variance.

a.      Fixed Overhead Capacity Variance: This is the difference between actual hours worked and budgeted hours, valued at fixed overhead absorption rate per hour.

               

i.e. Fixed overhead capacity variance = (Actual Hours Worked – Budgeted Hours) Fixed overhead rate

                                                                                                                                       per hour

b.      Fixed Overhead Efficiency Variance: This is the difference between standard hours worked (i.e. hours that actual production should have taken) and actual hours worked, valued at fixed overhead absorption rate per hour.

               

i.e. Fixed overhead efficiency variance =

      (Standard Hours of Actual production – Budgeted Hours) Fixed overhead absorption rate per hour

D.    Variable Production Overhead Variances

The behaviour of variable costs, compared with fixed costs, calls for different techniques when analysing variable overhead variances. Variable overheads are expected to change with the level of activity while fixed overheads are expected to remain the same regardless of the level of production.

1.      Variable Overhead Total Variance: This is the difference between variable overhead absorbed and actual variable overhead incurred. It can be calculated as below;

Variable overhead total variance = Variable overhead absorbed – Actual variable overhead incurred

Variable overhead absorbed = Actual output × Standard hours per unit × Variable overhead absorption rate                              

                                                                                                                        per hour

The variable overhead total variance can be divided into variable overhead expenditure and variable overhead efficiency variances.

a.       Variable Overhead Expenditure: This is the difference between the variable overhead that should have been incurred for the actual hours worked (i.e. standard variable overhead) and the actual variable overhead incurred. That is;

Variable overhead expenditure variance = Standard variable overhead – Actual variable overhead

Standard variable overhead = Actual hours worked × Variable overhead absorption rate

b.      Variable Overhead Efficiency Variance: This is the difference between standard hours and actual hours worked for the actual output produced, valued at the variable overhead absorption rate. That is,

Variable overhead efficiency variance = (Standard hours – Actual hours) Variable overhead absorption rate

EXERCISE 3

The standard cost card of Beware Enterprise for product Dragon is shown below:

		$
Direct material	(5kg @ $4)	20
Direct labour	(7hours @ $3)	21
Prime cost		41
Variable overhead	(7hours @ $6)	42
Fixed overhead	(5hours @ $8)	56
Total standard cost Standard profit Standard selling price		139   11 150
Budgeted output was	13,500 units

In the course of operating activities, it was realized that the above standards failed to take certain factors into consideration which would have made the standard cost card look as below

		$
Direct material	(4kg @ $6)
Direct labour	(6hours @ $4)
Prime cost
Variable overhead	(9hours @ $8)
Fixed overhead	(8hours @ $5)
Standard profit		25
Budgeted output was	13,500 units

Required: Calculate

1. (a) direct material price variance;    (b) direct material usage variance;      (c) total direct material cost variance;

(d) total direct labour cost variance;   (e) direct labour rate variance;            (f) direct labour efficiency variance.

(g) Fixed overhead total variance       (h) Fixed overhead expenditure variance    (i) Fixed overhead volume variance

(k) Fixed overhead capacity variance (l) Fixed overhead efficiency variance       (m) Variable overhead total variance   (n) Variable overhead expenditure variance     (o) Variable overhead efficiency variance. ( p) Total sale Variance

(q) sales volume profit variance   (r) sale  price variance

2. a. Planning Direct Material cost variance    b. Operational Direct material cost variance c. Planning direct material price variance d. planning direct material usage variance e. Operating direct material price variance  f. Operating material usage variance  g. Planning Direct labour cost variance  h. Operating direct labour cost variance i. Planning labour rate variance j. Planning labour efficiency variance    k. Operating labour rate variance      L. Operating labour efficiency variance