UNIT 3: STANDARD COSTING

Contents
3.0 Aims and Objectives
3.1 Introductions
3.2 Setting Standards
3.3 A Word about Motivation
3.4 Flexible Budgets
3.5 The Anatomy of Variances: Materials and Labor
3.6 Responsibility for Variances
3.6.1 Do It Yourself Example in Materials and Labor Variances
3.7 Variable and Fixed Overhead Analysis
3.7.1 Do it Yourself Example in Variable and Fixed Overheads
3.8 Investigation Variances
3.9 Sales Variances
3.10 Summary
3.11 Answers to Check Your Progress
3.12 Model Examination Questions

3.0 AIMS AND OBJECTIVES

After completing this unit, you should be able to understand:

 the relationship between budgeting and standard costing
 how standard cost are set;
 the motivational aspects of standards;
 the role of flexible budgets;
 how to calculate the principal variances surrounding material, labor and overhead costs;
 the possible reasons for variances and when to investigate then;
 how to calculate sales variances and the managerial significance of the number
produced.

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3.1 INTRODUCTION

Budgeting, the subject of the previous unit, is concerned with planning the activates of an
organization for a specific time period, usually 12 months. As we read in unit one the master
budget for the business is built up from various functional budgets, sales, production,
administration and so on. All of these budgets tend to focus on global figures. Take the
materials budget for the Abebe trolley co., for example although the base figure for the budget
was the number of meters of wire metal required to make each trolley the budget was
ultimately expressed in total numbers, quarter by quarter. This is not surprising when one
conceder two factors:
1. Management is keen to gain a forward picture of cash flow. This permits the business, if
necessary, to negotiate facilities with their bakers; facilities negotiated in a planned
manner are always on more advantageous terms than sudden requests. Total figures are
sufficient for this
2. Top executives of quoted companies must equip themselves to deal with the probing
questions from professional investment analysts whose job is to advise investors and
potential investors about the prospects in certain companies. These analysts pay regular
visits to companies and are searching for inter aria, an indication of profit level for the
forthcoming financial year. While it would be imprudent on the part of the company to
disclose its budgeted profit, nevertheless it must be in a position to respond to the analysts
leading questions. The total picture of the company’s future as portrayed by the master
budget arms the management with much of the information required for these meetings.

Once constructed the budget should be used to control the actual operations of the business for
the accounting period under review. There can be no better benchmark to judge actual
performance than the plan for the period provided that plan was carefully worked out. If
performance than the plan for the period –provided that plan was carefully worked out. If
performance is not up to scratch then remedial managerial action can be taken to put things
right. But for this purpose the global numbers of the budget are not sufficient. Management
needs detailed costs and revenues of individual components of the business so that corrective
action can be taken at the source of problem. We use standard costs for this control process.
Standard costs are budgeted costs for individual cost items. Put another way, a budget is built

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up from many standard costs. Standard costs are compared with actual costs and explanations
are sought for any differences between the two.

3.2 SETTING STANDARDS

Conceder the following example

Standard full cost of cabinet standard variable cost of trolley

$ $
Direct material direct material
Chipboard----------10 10 meters of metal-----$ 10
Veneer------------------3 direct labor 1.5 hrs
$20 per hour----------30
Metal trim-------------2
trim-------------2 variable overhead
15.0 1.5hours *10 prHr.---15
prHr.---15
standard variable cost—55
cost—55

Direct labor
1.5 hours $ 5 per hour-------7.5
hour-------7.5
Prime cost --------------------22.5
Manufacturing overhead-------2.5
overhead-------2.5
Manufacturing cost--------------25
Share of non-manufacturing
Overhead-----------------------------5
Overhead-----------------------------5
Standard full cost ------------------3
------------------3

Conceder first the matter of setting standards for materials and labor. With out doubt the best
indicator material usage per unit of product will be the consumption records of the previous
period. If each trolley consumed 11 meters of wire metal this year it would be pointless to set a
standard for next yea at 10 meters unless the company could demonstrate an ability to save one
meter due to new processes or techniques. Equally, it would be wistful to assume a usage of 11
meters per trolley if this year, and perhaps for year before, this number included inefficiencies
in selection of correct lengths and the consequent trimming of sizeable ends of mental which
could not be used for any purpose other than sale for scrap. When a firm put a prototype into

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production, and from time to time during the products life cycle in production, a detailed
engineering study is required to establish precisely how much material is required. Such a study
wile take into account the complexity of design of the product, the availability of the required
quality of material, the skill of labor required to make the product, and the engineering
precision of the production machinery. The resultant figure will be the ideal or engineered
standard, that amount of material which should be required if every aspect of production work
to maximum efficiency. But of course this seldom happens in reality: machines break down or
require recalibration;; workers make mistakes or opera at faster or slower speeds than panned;
the quality of raw materials varies even when purchased from the same supplier. Most
companies recognize these realties of production in their standards by relaxing marginally the
stringencies, which underpin the engineering standard. The normal or operating standards are
those which could be expected to be achieved by a productive operation operating carefully and
efficiently but which also reflect the normal perils which also reflect the normal perils which
surround a process where so many things can go wrong.

As for materials price, the standard selected for the year will be based on the expected purchase
pattern, the supplier’s estimates of price movements quantity discounts negotiated, and the
quality of raw material required. A business whose raw material inputs are subject to
significant fluctuations in price, e.g. commodities such as cocoa beans, wheat, oil or precious
metals, may choose to reduce their budget period to a length of weeks or months over which
management has some confidence of price movement. External economic indicators are a
useful supplement to the judgment of the purchasing executes.

Labor usage and price standards are set in similar manner to those for materials. The
engineering study already described should be able to measure the time required by a skilled
operative to manufacture, assemble and test the product.
Again, the normal standard would reflect the time taken for refreshment breaks, casual
conversations wit supervisors and colleagues, fetching raw material and consumables and
carrying finished components to the next workspace or collection point note that such a study
would describe the quality of operative and the nature of training to be undertaken before
production commences. Labors usage is usually measured in units of time. The standard price,
or rate of pay, for direct labor input

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Is calculated by having regard to current rates and any anticipated uplift during the budget
period due to negotiated cost of living or time served increments and anticipated bonus
payments for superior effort. Unless the business is located in a heavily unionized industry with
a poor record of industrial relations, labor rates tend to be the easiest to establish of the four
standard so far described.

Overhead standard tend to be determined by reference to one of the four standards already
described. Remember the nature of overhead; overhead comprises those which a business
incurs in support of production but not necessarily directly related to production. The standards
for both variable and fixed overhead depend on three components:

a. The budgeted cost of each overhead;

b. The allocation key to be used to allocate overhead to product
c. The volume expected of each allocation key to used
For example, assume budgeted fixed overhead amounts to $100,000 for next year and the
allocation key to used is machine-hours for all fixed overhead. If 400,000 machine-hours is
anticipated next year a budgeted fixed overhead rate of $.25 per machine hour will be used. A
product that uses 10 machine hours will have a standard fixed overhead rae of $2.5 for next
year. A change in either (a) or (b) will have the effect of altering the standard overhead cost per
unit even if (a) remain the same.

3.3 A WORD ABOUT MOTIVATION

Budgets, and their unitary equivalent standards, serve as devices to assist in

Planning and controlling the operations of the business. But perhaps their greatest role, if
properly used, is in motivating the workforce to perform at their highest level of achievement.
Budgets and standards should not be used as sticks to beat recalcitrant workers into shape; they
are best used as carrots to encourage and reward superior performance. If employees are
presented with a budget which is well beyond their reach they will not attempt to come
anywhere near the level expected; if the budget is slack, there is little incentive for an employee
to sharpen performance. Hence the use of ideal, engineered standards is a short-sighted
denominational device which should be resisted. On the other hand, a normal standard,
provided there has been built into it an element of 'stretch' and rigors, will give the incentive to

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well-intentioned employees to strive to reach the level expected, and to reward them for so
doing. The setting of budgets and standards is therefore a task which must involve every level
of the organization and 'external observers' alongside those employees who know most about
the processes under review. For instance, the purchasing director is the person most
knowledgeable about the procedures of purchasing and the likely deals that the company will
be able to enter into over the next 12 months. But if the worker's performance, and that of his or
her colleagues, is going to be judged and perhaps rewarded on the basis of the standards set, it
is important that someone from outside the function ensures that these standards are not too
slack.

Additionally, to ensure the necessary element of 'stretch' within the standard, it is desirable to
review continuously the production processes from a technical point of view. New
technologies, higher levels of training, better-quality materials, more conducive work
environments - all combine to lead, prima facie, to a tightening of standards expected. Without
this regular review a company may allow inefficiencies to creep into its procedures, which will
have a negative effect on its competitive position in the marketplace.

3.4 FLEXIBLE BUDGETS

Imagine a quarterly report on production cost performance along the following lines:

Third quarter ended 31 March 1998

Total unit
Of production Budget
2000 Actual
1800
Cost of materials $8000 $7380
Cost of labor 6000 5310
Cost of overhead 2000 2050
Total production cost 16,000
16,000 14,740

Commentary by production manager to chief executive:

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'Yet again we've had a good quarter by coming in £1260 below budgeted cost. One more
quarter like this and the production team will be wanting to share in the savings by way of a
year-end bonus.'

After such a comment the only savings the production teams are likely to see is, that of their
production manager's salary when he is fired! True, the production facility has spent $1260 less
than budgeted but the production level was reduced from 2000 to 1800. It is therefore futile to
compare the actual costs of making 1800 with the budgeted costs of making 2000. The
metaphor of comparing apples with oranges is apposite in this context. But which column
should be adjusted? Should we flex the budget column down to the 1800 level or the actual
column up to the 2000 level?

The answer is that we must flex the budgeted column of costs down to the level of output
actually achieved so that management can compare the actual costs of producing 1800 with
those, which should have been incurred in producing 1800. (Flexing the actual costs to the
2000 level would leave management comparing two columns neither of which reflected
reality!)

A far more meaningful presentation would use a flexible budget presentation:

Third quarter ended 31 March 1998

Budget Actual Variance* Planned production in
units 2000
Actual production in units 1800 1 800

Cost of materials 7200 7380 (180)

Cost of labor 5400 5310 90
Cost of overhead** 1900 2050 (150)

14500 14740 (240)

* The term 'variance' means the difference between the budgeted (or standard) cost and actual
cost.

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11 Overhead comprises a fixed component of $1000 and a variable component of $0.50 per unit
produced (1800 x $0.50 = $900).

This report now gives a better picture of the activities of production over the third quarter to 31
March 1998. And it is a bleak picture. Materials and overhead exceeded budget while labor was
less than -budget. The net effect of these overruns and under runs was $240, or 1.65 per cent
over budget; management would need to decide whether these variances from budget required
investigation. This style of report is much more informative than the earlier one which was, in
fact, dangerously misleading. But even in the preferred report, an explanation of why the
production level had fallen from 2000 to 1800 would be necessary. This could reflect some
serious production difficulties (machine unreliability or raw material supply problems?) which,
if not resolved, could lead to customer supply problems in Quarter 4 and beyond as finished
goods inventory levels decline.

Note that the flexible budget for 1800 units was based on the standard cost of the unit.

Material----------------------------$4.00
Labor ------------------------------3.00
Variable overhead ----------------0.50
Fixed overhead* -------------------0.50
-------------------0.50
$8.00

* Based on the planned production level of 2000 units per quarter.

Note that the per-unit fixed overhead component of standard cost is only valid if 2000 units are
made, simply because the fixed overheads amount to $1000 regardless of volume produced.
The flexed budget above explains how the overhead is included in the total amount for
overhead. Beware the temptation to multiply the fixed overhead per unit ($0.50) by units
produced (1800) to calculate fixed overheads in total. (You should revise the previous unit if
you are unsure of the risk of unitizing fixed costs.)

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Check Your Progress –1

1. Explain how standard can be set in manufacturing enterprise

………………………………………………………………………………………………
………………………………………………………………………………………………

2. What is flexible budget

………………………………………………………………………………………………
………………………………………………………………………………………………

3.5 THE ANATOMY OF VARIANCES: MATERIALS AND LABOR

The variances column in the flexible budget is informative but only to a degree. Take materials:
for management of the production facility to be told that $180 more was spent in Quarter 3 than
anticipated tells them that something did not go according to plan, but gives them no indication
of where the problem is. More detail is required.

Material costs can be more (or less) than standard for only two reasons: (a) actual production
used more (or less) material than planned, and/or (b) the price to purchase the material was
more (or less) than planned.

A combination of these two reasons leads us to split them out for individual analysis:

Material efficiency variance

= [Standard quantity - Actual quantity] x [Standard price per unit price] = (SQ - AQ)SP

Material price variance

= [Standard price per unit - Actual price per unit] x [Actual quantity used] = (SP - AP)AQ

Example.
Example. A kilt-making firm in Addis Ababa on makes 50 kilts per month. Last month, against
a budgeted production cost of $3000 it reported a production cost of $2860. Management has
called for an explanation. You determine that the standard cost of each Kilt contains four meters
of tartan tweed purchased in bales from a company in Addis, each meter coasted at $15. Last
month each kilt consumed 4.4 meters and each meter cost $13.

Application of the above formulae produces the following variances:

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Material efficiency variance = (SQ - AQ) SP = [(50 x 4) - (50 x 4.4)$15 = (200 - 220)$15 = £300 unfavorable

Material price variance = (SP - AP) AQ = ($15 - $13) 220

= $440 favorable

Total material variances = $300 adverse + $440 favorable = $140 net favorable

An adverse (unfavorable) variance is one where actual cost is above standard cost; a favorable
variance is one where actual cost is less than standard cost.
Calculation of variances is of little value unless it prompts investigation into possible reasons
for them. Here are a number of possible reasons for the variances so far calculated:

Material efficiency = $300 adverse

• faulty bale of tweed which prevented easy matching of pattern;
• inexperienced staff leading to waste, mismatch or excessive hems;
• use of sewing machines which require maintenance;
• pilferage among staff leading to inventory losses;
• poor-quality material (see below).

Material price = $440 favorable

• change of supplier (although this looks unlikely given the facts supplied);
• quantity discounts given being more generous than planned for;
• inferior quality of tweed (which leads to more meters being used);
• end-of-tartan bales which are supplied at a lower price.

Labor cost variances are caused by a combination of the same two reasons: (a) actual
production requiring more (or less) time than planned; and/or (b) the labor rates actually paid
were more (or less) than planned.

A combination of these two reasons leads us to split them out for individual analysis:

Labor efficiency variance

= [Standard time allowed - Actual time taken] x [Standard rate per hour]
= (ST - AT) SR

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Labor rate variance
= [Standard rate per hour - Actual rate per hour] x [Actual time taken] = (SR – AR) AT

Note that the term 'rate' is used here for labor variances and 'price' is used for material.
Sometimes 'price' is used for both variances. Also, the formulae are sometimes laid out as
follows: e.g. Labor rate variances AT (SR - AR).

Example

At the end of the same month as above, the kilt makers' production department reported its
actual labor costs equaling the budgeted labor costs at $3000. Initially management is pleased
with this outcome until you investigate the standard costs and produce the variances, which
follow. Each kilt's standard tingle to cut and sew is three hours, each hour being paid at the
standard rate of F.70. In the month under review 175 hours were used, costing $2999.50.

Application of the above formulae produces the following variances:

Labor efficiency variance = (ST - = [(50 x 3) - (50 x 3.5) 120 = (150 - 175) 20 = $500
unfavorable

Labor rate variance = (SR - AR)AT = (20 - 17.14)175 = $500 favorable

Total labor variances = $500 adverse + $500 favorable = Nil

Management would be well advised to ignore the fact that labor variances net to Nil because
both efficiency and rate require investigation and possible managerial remedy action. Possible
explanations?

Labor efficiency = $500 adverse

0 use of faulty material requires more time spent per kilt;

0 uncertain supply of material leading to broken runs and downtime;
0 inexperienced staff;
0 untrained staff or faulty equipment.

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Labor rate = £500 favorable
- Lower caliber of staff used during the month leading to more time required;
- Anticipated pay settlement deferred until later in the year;
- Less overtime paid than budgeted for.

3.6 RESPONSIBILITY FOR VARIANCES

As in the preparation and monitoring of budgets (unit 1)

1) it is imperative that personnel are not
judged, or held responsible, for variances which lie outside their control. For instance, a price
rise in material is difficult to control in the short term. Perhaps the purchasing department could
negotiate a better deal with another supplier, or bulk discounts with the current one but, in
general, we can assume that externally imposed price rises fall outside company control.

3.6.1 Do-It-Yourself Example in Materials and Labor Variances

Consider the following standard cost data for a business making cases for carriage clocks:

Direct material 0.4 sq m metal @ $20 per sq m ----$8

Direct labor 2 hours@ $10 per hour------------------20
hour------------------20
$28.00
Actual statistics for last month were:
Cases produced -------------------------------------6000
Square meters of metal purchased @ £22 per sq m ------2100sq m
Square meters of metal used----------------------------------2280sq m
Direct labor @ £10.10 per hour------------------------------11000 hrs

Using the pro forma analysis sheet below, calculate the material and labor variances and
consider possible reasons for these variances. The material variances should recognize the
responsibilities of the production manager and purchasing manager respectively.

Material variance labor variances

Martial efficiency=(SQ-AQ) SP labor efficiency= (ST-AT ) SR

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POSSIBLE EXPANATIONS?
Material price= (SP-AP) AQ labor rare= (SR-AR)AT

Worked solution
Material efficiency = (SQ - AQ) SP
= ((6000 x 0.4) - (6000 x 0.38)) $20 = (2400 - 2280) $20 = $2400 favorable
• better calibrated cutting equipment;
• use of more appropriate sheets of metal;
• superior quality of metal;
• change in design since setting of standard.
Material Price
(SP - AP) AQ
= ($20 - $22) 2100
= £4200 adverse (unfavorable)
* price rise due to world shortage; * change of supplier.

Labor efficiency = (ST - AT) SR

= ((6000 x 2) - (6000 x 1.85)) $10 = (12000 - 11 100) $10 = $9000 favorable
& greater motivation;
& result of increased training;
a improved Mechanization.

Labor rate

= (SR - AR) AT

@= ($10 I- $10.10) 11 100

= $1110 adverse
- & unforeseen wages settlement;
-more overtime;
- superior level of operatives.

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Notes 1 The production manager is responsible only for volume of raw material used, hence
we use the square meters of metal drawn from stores into production. On the other hand the
purchasing manager is responsible for the price obtained for the quantity purchased. The, price
variance's 'actual quantity' is deemed to be the number of square meters purchased (as opposed
to the number issued to production). Had the production manager also been held responsible for
the material price variance, the variance would have been:
(SP - AP) AQ
= ($20 - $22) 2280 = $4560 adverse (unfavorable)

Variances should be calculated at the stage when they arise and the products should be passed
on to the next department or process at standard cost. For example, the carriage clock casings
will be passed to the assembly department; it would be inappropriate to 'pass on' the $2400
favorable material efficiency variance arising in the easing department. This variance is the
responsibility of the casing department's manager.
Consistent variances arising in the same area of operations may indicate that the standard is no
longer appropriate and needs adjustment. For example, in the casing department above, it may
be seen that a sizeable favorable variance in labor efficiency occurs every month. If this is so
then the labor input process needs further engineering study to establish the new standard time
in the light of improved machining and automated techniques. A detailed study could conclude
that 1.85 hours per clock actually achieved

Above is excessive in comparison with what could be achieved at normal efficiency.

We have used simple formulae above to calculate four variances. We would caution readers
against memorizing these without fully understanding the concepts behind them. In our
experience managers understand the identities inside the brackets but are unsure of those
outside the brackets. Take the material variances:

Efficiency = (SQ - AQ) SP

Price =(SP - AP)AQ

Why do we use standard price outside the brackets with efficiency and actual quantity outside
the brackets with price?

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Careful thought about what is being examined will give a satisfactory answer: with the
efficiency variance formula we are analyzing the financial impact on the business of the
manufacturing or assembly process taking more or less material than standard to do the job.
The physical quantity of material beyond standard is valued at standard price; otherwise the
combined sum would be a hotchpotch of two variances, efficiency and price. By holding all
prices at standard, management can gain an insight into the efficiency of production. On the
other hand, with the price variance, the gain or slippage in price achieved for raw materials
used or purchased is multiplied by the actual quantity used or purchased. Were we to use the
standard quantity we would produce a figure, which bore no resemblance to reality; thus, in the
worked example above the purchasing department actually purchased 2100 square meters of
metal, each one $2 more than standard. If the standard quantity of 2400 square meters were
used, the purchasing manager would be penalized with a higher adverse variance than he
incurred. In the example we could argue that he kept the purchasing of metal to a minimum so
as to minimize the impact of the increase in unit price. The price variance recognizes this
foresight by using actual quantity outside the brackets.

3.7 VARIABLE AND FIXED OVERHEAD ANALYSIS

In an earlier paragraph in this unit we reminded readers that overheads, by definition, comprise
those costs, which a business incurs in support of production but not necessarily directly related
to production. Accountants must therefore use an allocation key to spread overhead over the
products in a, manner which best reflects the products' usage of the overhead resources.
Variance analysis, the examination of the difference between how much overhead was incurred
and how much should have been incurred, is based on the allocation keys used to spread
overhead.

Consider first variable overheads. In a manufacturing environment these typically comprise

electricity and power associated with productive equipment, indirect labor, repairs and
maintenance linked to machine use, downtime due to stock-outs or breakdowns, consumables
and supplies. Variable overheads move up and down in volume in proportion to productive
output as measured by the allocation key used (e.g., direct labor hours, direct labor cost, or
machine-hours). If then there is a close linkage between variable overhead incurrence and, say,

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direct labor hours, we can use efficiency and price as the criteria for our analysis of over or
under spending.

Example

Consider the carriage clock business again (see Section 2.6.1). Imagine that at the beginning of
the year the management of the company planned to make 60000 casings and that each easing
would take two hours to make. Variable overheads for 120,000 direct labor hours were
budgeted at $180000, or $1.50 per direct labor hour, or $3 per unit.

In the month under review variable overheads amounted to $17200 when 6000 cases were
manufactured and 11,100 direct labor hours were recorded.

Variable overhead analysis starts with the simple question: how much variable overhead should
have been incurred, given that 6000 units were produced, and how much was incurred?

Standard cost of variable overheads

(6000 x 2 hours x $1.50) = $18 000
= $800 favorable

Less

Actual cost of variable overheads

$17200

For much management the level of analysis of this variance would be sufficient. But it conceals
two components which merit further examination. Because the business is employing direct
labor hours as an allocation key, we can break down this overall variance of $800 into
efficiency and price (usually referred to as spending).

Variable overhead Efficiency variance

= Standard cost of flexible budget time allowance for units produced

= (6000 x 2 x $1.50) = $18000

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Less Standard cost of actual time taken for units produced

(11 100 x $1.50) $16650

= $1350 favorable

Variable overhead spending variance

= Standard cost of actual time taken for units produced

= 11 100 x $1.50 = $16650

Less

Actual costs incurred

$17200
= $550 adverse

The efficiency variance should not surprise management given that direct labor hours is the
allocation key for variable overhead and that a favorable efficiency variance for direct labor has
already been calculated. Nine hundred fewer direct labor hours have been recorded in the
production of the monthly output than allowed for in the flexible budget using a standard time
of two hours per unit; fewer direct labor hours leads to fewer variable overheads being
incurred. Of course this can only be expected to portray commercial reality if the allocation key
(in this case direct labor hours) is directly correlated to the components comprising variable
overheads. This is unlikely; therefore the efficiency variance must be treated with some
caution. Superb efficiency in the use of direct labor may not necessarily lead to a proportionate
reduction in variable overhead.

The variable overhead spending variance is potentially a more interesting variance than the
efficiency. Here management is told that instead of incurring $16650 in variable overhead (that
is, the level of overhead allowed for in the flexible budget given the actual number of direct
labor hours incurred), the business spent $17200, or $550 too much. This could be caused by
either an increase in prices paid for the components comprising variable overhead or poor
control (inefficiency!) over the use of these items. The fact that the reasons may be difficult to

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detect does not invalidate the managerial requirement to attempt an analysis. Failure to go
behind the single $800 favorable variable overhead variance would have concealed from
management a serious overspending on some items making up variable overhead.

Consider next fixed overheads. Such items as depreciation of productive plant and equipment,
supervisory salaries and space costs typically comprise fixed overheads. Remember: fixed
overheads do not vary with production levels within the relevant range of output. But, given the
fact that a production-based allocation key is used to spread fixed costs over production the
impression may be given by the accounting system that fixed costs do in fact vary with output.

Example

We now provide further extension of the example portraying the standard costing system of the
casing department of the carriage clock business (see Section 2.6.1): the budgeted fixed
overheads for the year were $360000 to be incurred evenly through the year, i.e. $30000 per
month. Actual fixed overhead amounted to $32500. Fixed overhead is to be allocated using
direct labor hours. Management expect 120 000 direct labor hours to be incurred annually.
Therefore the predetermined fixed overhead rate for this year is:

$360000/120000 UNITS = £3 per direct labor hour 120 000 hours

The denominator volume level of 120000 is based on the planned output of 60000 cases, each
taking two direct labor hours to produce. On a monthly basis this would read:

$30000/10000hours =$3 per direct labor

If, during the month under review, exactly 5000 units were produced (leading to 10 000
standard direct labor hours being incurred) and £30000 was the actual level of monthly spend
on fixed overhead, then no fixed overhead variances would arise. This seldom happens!
Again the straightforward analytical question would be: how much fixed overhead was incurred
against how much was budgeted for?

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Budgeted amount. Less Actual amount
$30 000 - $32 500

= $2 500 unfavorable

But this analysis, usually termed the fixed overhead spending variance, does not reveal the full
picture (unlike the total variance of $800 calculated for variable overhead). True it yet again
leads management to investigate the apparent cost overruns in the elements comprising fixed
overheads (e.g. an increased outlay for factory rent or unforeseen recruitment in supervisory
services). But it ignores the fact that more fixed overhead were applied to the product than were
budgeted for. We must therefore calculate another variance, again using the budgeted amount of
$30,000 as one of the elements.

Fixed overhead

Denominator variance =budgeted amount less amount applied

Unit produced

= $30000 - (6000Х2X$3)
=$30000 - $36000
=$6000 favorable

Here we see fixed overhead appearing to behave like variable overheads. But beware of
appearances! At the beginning of the budget period, a predetermined overhead allocation rate of
$3 per direct labor hour was calculated. If everything went exactly according to plan, I.e.
60,000 cases were produced consuming 120000 direct labor hours, there would be no
denominator variance because the actual and budgeted denominator would be the same. But
when the actual volume of output used in the denominator moves away from budget, units of
production are allocated more or less fixed overhead than budgeted for. (Note the words are
allocated ; this does not mean that the fixed overhead spend is more or less.) In our example
the business has made 1000 more casings in the month than budgeted. Each casing uses two
direct labor hours, therefore 2000 more direct labor hours were recorded than planned. If each
recorded hour is used to allocate fixed overhead then 2000X$3=$6000 more fixed overhead has
been allocated to production than was budgeted for. This is deemed to be a favorable variance

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because volume of output is grater than budgeted. It is unlikely that management would be
prompted to take action in any one month; rather they would want to see if, over the year, the
individual monthly denominator variances netted to zero.

However, management must stay alert to monthly variances if they indicate a consistent
pattern. Take the situation where the monthly denominator variances were always generously
favorable. This would indicate that the original budgeted denominator production level of
120000 direct labor hours (or 60000 casings) was seriously understated. Such an
understatement could lead to the Perceived cost of the product being higher than it really is
(that is, each is asked to bear too high a share of fixed overheads), and market prices being
perhaps set at too high a level. This could negatively impact the business's market share even
though the actual outlays on fixed overhead are exactly as budgeted. Conversely where
management's assumption on volume level is excessive the business will consistently report
adverse denominator variances, which have to be written off in the profit and loss account.
Thus a firm could report satisfactory gross profit percentages (that is, the cost of sales figure
includes a fixed overhead component lower than actual volume would indicate) but have this
reduced significantly by adverse denominator variances.

Readers should now attempt the following example. In checking your solutions do not be
satisfied by getting the right numerical answer; be sure that you understand the concepts and
explanations underpinning the numbers.

Check Your Progress –2

1. Explain materials and labor variance

………………………………………………………………………………………………
………………………………………………………………………………………………
2. Elaborate variable and fixed overhead analysis
………………………………………………………………………………………………
………………………………………………………………………………………………

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3.7.1 Do-it-Yourself Example in Variable and Fixed Overheads

A company uses a standard cost system to plan and control its manufacturing process of
compact discs. The standard cost of a disc, based on a denominator volume of one million discs
per annum, includes four machine-hours of variable overhead at $0.50 per hour and four
machine-hours of fixed overhead at $10 per hour. Actual output for the year under review was
1.2 million discs; actual variable overhead was $1 900 000; actual machine-hours recorded
were 4 100 000; actual fixed overhead was $39 000 000.
Variable overhead variances
Efficiency =( standard cost of flexible budget less ( standard cost of actual time
taken
time allowance for unit produced ) for units produced)

Possible explanation?
explanation? Spending =

[Standard cost of actual time taken for units produced]

Less

[Actual costs incurred]

Possible explanation?

Fixed Overhead Variances

Predetermined fixed overhead application rate

Machine-hours Spending
$/machine hours = £10 per machine-hour Budgeted amount

Possible explanation? Denominator

Budgeted amount Less Actual amount applied to units produced

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Possible explanation? Worked Solutions

Variable overhead variances

Efficiency = [Standard cost of Less [Standard cost of flexible budget time
actual time taken for allowance for units units produced]
produced]

= (1 200 000 x 4 x $0.50) - (4 100 000 x $0.50) = =

=$2400000 - $2 050000
= $350 000 favorable

Possible explanation? The number of hours budgeted for downtime did not materialize
and therefore the machine-hours recorded in manufacturing 1.2 mil- lion compact discs were
700 000 less than anticipated. Alternatively, the standard time of four machine-hours per disc
needs to be tightened up.

Spending = Standard cost of actual Less Actual costs incurred time taken for units
produced
= (4 100 000 x $0.50) $1900000 = $2050000 $1900 000 =
$150 000 favorable

Possible explanation? Given the variable overhead allowed for every machine- hour recorded,
the company was entitled to spend $2050000 on variable over- head; instead it spent $1 900
000. This could indicate tighter operational control over the components of variable overhead
or more advantageous prices negotiated than budgeted for.

Fixed Overhead Variances Predetermined overhead rate

$40 000000/4000000=machine hours=$10 per machine hours

Spending= Budgeted amount = $40 000 000 less Actual amount $39000000
= $1 million favorable

Possible explanation? The sheer magnitude of fixed overheads may be surprising. But in high-
technology industry with a high level of automation and high level of research and
development expenditure, this proportion between variable and fixed overhead can be expected.

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The difference between the two amounts is small in percentage terms (2.5 per cent) and would
be perhaps due to slightly less expensive machines being acquired, thereby lowering the fixed
annual depreciation charge or to an extended view on machine life cycles (which would have a
similar effect on depreciation).

Denominator = Budgeted amount less Amount applied to units produced

=$400000 - 1200000 x 4 x $10
. =$400000 $48000000
= 8 000 000 favorable

Possible explanation? Production was running at 20 per cent higher than budgeted. This
'inevitably led to 20 per cent more fixed overhead being applied to the production than
budgeted. (Note: the increased production would have no impact on the amount of fixed
overhead actually spent.) If this increase in output is viewed as normal then the denominator
volume has to be increased for next year's pre determined overhead rate thereby reducing the
cost of each unit of product.

3.8 INVESTIGATION OF VARIANCES

Management needs clear, relevant and up-to-date information to control on going operations.
Variances from budget, in principle, should be of interest to managers; they can learn
immediately where there may be problems and take remedial action. But good managers are
busy people; they do not want to be pestered by sheets of detailed numbers revealing that
everything is under control! What they want is a well-presented report revealing the most
significant variances only, not the workings behind the variances, only the big numbers - with a
brief comment on possible reasons for these. This form of reporting is called exception
reporting or management by exception where managers receive information only on items,
which appear to be out of control.

Defining 'out of control' is not easy. The. Limits must be determined over time and through
experience, and in consultation with the engineering, staff. Determining a percentage limit is a
useful start: for example, all material variances below 4 per cent are not reported. But a rigid
interpretation of this limit may lead to important control information being suppressed. A

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business may consistently report a 3.8 per cent adverse (unfavorable) variance on material
efficiency, month after Month, which should provoke an investigation into raw material usage
but because the monthly percentage falls below the limit, the cumulative impact of this
variance escapes managerial attention. Some computer-based management

Information systems, which permit graphical displays of variances, perhaps on a daily or

weekly basis, can be programmed to alert managers to consistently under performing
operations even though, on a strict interpretation of the individual variances, reporting would
not be triggered. Limits may have to be reviewed as a result of experience and cost/benefit
analyses, that is, can the cost of variance calculation and investigation be justified in terms of
the savings implemented by executive action?

Another difficulty experienced by managers in investigating variances is the interdependencies

among the variances; a decision to investigate one variance may lead to additional work on
others. Conversely the search for one common reason could explain two or more variances.
Here is a selection of possible linkages:

1 An adverse materials efficiency variance may be caused by the use of inferior-quality

materials, which would be reflected in favorable material price variance.
2 The same inferior-quality raw materials may lead to an adverse labor efficiency variance
because more time has to be spent selecting suitable batches of material.
3 A favorable labor rate variance caused by employing less-skilled operatives may be
counterbalanced by adverse variances in labor and material efficiency.
4 If direct labor is used to apply variable overhead then the variable overhead efficiency
variance will be of the same magnitude as the labor efficiency variance even although
there may exist a tenuous link between labor efficiency and the consumption of resources
comprising variable overhead.
5 A favorable denominator variance in fixed overhead may provoke the production staff to
aim for even higher levels. But this would have a negative impact on inventory levels
(high) and cash levels (low).

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3.9 SALES VARIANCES

So far we have focused our attention on the cost of sales figure surrounding production,
encompassing direct material, direct labor, variable and fixed overhead. Now we turn our
attention to the top line of businesses' profit and loss accounts, sales. And for this discussion we
relax the one-product assumption that has characterized the variance analysis carried out so far.
Most businesses manufacture and sell many products in differing proportions, each product
contributing differently to the overall profits. Management must be given an insight into the
consequences of not achieving the sales volumes and sales mix planned for in the budget; if the
budget provided for sales of 100 units of Product X and 60 units of Product V, the company
needs to quantify the impact on profit of achieving sales of 60 units of Product X and, 100 units
of Product Y.

Case The manager of a sports goods chain of shops is delighted at the monthly management
accounting report for the month of May. From the information contained therein he learns
that his contribution margin on tennis shoes rose by $25 000 from the budgeted level of $85
000 even though he is aware that volume of sales has fallen. He sells two varieties, a top-of-
the-range pair, Ace'em, selling for $50, and a cheaper version for less athletic individuals,
Plodder, selling for $12.50. The budgeted and actual figures for May are given below (a pair
of shoes = 1 unit).

Budgeted figures

Ace’em plodder total

units price total units price total units price total
sales 2000 50 100,000 18000 12.5 225000 20000 16.5 325000
bought in
cost--------2000 30 60000 18000 10 180000 20000 12 240000
contribution
margin 2000 20 40000 18000 2.5 45000 20000 4.25 85,000

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Note that the total columns comprise the additions of the units sold and revenue and bought-in
costs for both styles of shoes; the total 'price' is derived by dividing the total figures of revenue
and bought-in costs by 20 000. The figures of $16.25, $12.00 and $4.25 are therefore weighted
average numbers (heavily influenced by the preponderance of the cheaper Plodder shoe).

Actual results

aceem plodder total

unit price total unit price total unit price total
sales 4000 51.25 205000 10000 12.5 125000 14000 23.57 330000
bought in
cost----------4000 30 120000 10000 10 100000 14000 15.71 220000
contribution
margin 4000 21.5 85000 10000 2.5 25000 14000 7.86 110000

He asks for your help in analyzing the increase in contribution of $25 000 in the face of a
decline in sales volume.

An initial glance at the numbers in the case shows that the high-ticket item, Ace'em, has
doubled in sales volume and he has managed to squeeze an extra £1.25 per pair from the
customers. The very significant positive impact of this increase in contribution from Ace'em is
reduced by a serious decline in the Plodder line. The manager believes that this drop is due to
an increase in consumer spending power with a consequent increase in leisure outlays. Even the
least promising tennis player is prepared to spend money on up market clothes and equipment.

A more detailed calculation of line contributions reveals the following pattern in contribution
margin percentages (contribution margin as a percentage of sales price).

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 aceem plodder total
Budget 40% 20% 26.154%
Actual 41.0463% 20% 33.347%

Note that gearing effect of the aceem contribution where a modest percentage of 1.463 percent
increase on a high base of 40 percent lifts the combined contribution margin percentage by
7.193 percent.

Sales variance analysis enables the manager to gain detailed insight beyond the casual
View afforded above. Total contribution earned from sales depends on contribution per unit and
volume

Contribution variance = difference in contribution margin per unit times

actual sales in unit s
Aceem =($21.25 - $20.00) *4000=
$5000 favorable
Plodder =2.5 -2.5) * 10000=
nil

Volume
Volume variance = (actual sales less budgeted sales) times budgeted
contribution margin per unit
Aceem = (4000 – 2000) X $20 = $40000
favorable
Plodder = (10000 – 18000) X $2.5 = $20000
unfavorable
$ 20000
favorable
The manager can therefore see that the increase in sales price of the Aceem line had a much
less significant impact on total contribution than the switch in product sales. This information
may lead him to drop the plodder line and take on another superior brand but perhaps not so
exclusive as the Aceem line. If the Aceeem sales can be maintained at this level during the
summer months the sports chain many be able to negotiate volume discounts with its suppliers

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thereby increasing contribution margin per pair sold. In future months he will have to bet rid of
the ploder inventory by reducing the price, but note that margins are already tighter on this line
than on Aceem.

Even grater insight is possible by exploding the volume variance into its two constituents,
quantity and mix, because not only did the individual number of units sold peer line differ from
budget but so did the internal mix anticipated.

Sales = actual sales less budgeted sales * {budgeted weighted average

Quantity contribution margin per unit}
Aceem = (4000 – 2000) X$4.25 = $8500
Ploddr = (10000 – 18000) X$4.25 = $ 34000 un favorable
$25500 un favorable
sales mix = (actual sales less times {budgeted contribution margin
variance budgeted sales) per unit less budgeted weight
ed average contribution ma
rgin per unit}
aceem = 4000 – 2000) X($20-$4.25) = $31000 favorable
plodder = (10000-18000) X ($2.5- $4.25) = $14000 favorable
= $45500 favorable
check: (sales quantity variance +
sales mix variance) = sales volume variance
$25500anfavorable +$45500 favorable = $20000 favorable

The sales quantity variance and the sales mix variance require explanation. Sales quantity for
both lines of shoes is priced at the weighted average contribution margin per unit drawn from
the initial data in the case.
This variance therefore treats one pair of acceem shoes as being equal to one pair of plodder
shoes. A drop in overall volume in sales of 6000 units will produce an adverse variance (at
$4.25 per unit) of $25500. for any manager this is not good news. A drop in volume perhaps
indicated fewer customers entering the floor space (which may have other goods on display),
excessive floor space given over to the tennis shoes and surplus sales assistants (because it
takes the same effort to sell a $50 pair of shoes as a $12.5 pair). A significant drop in volume

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also indicates ether an excessively optimistic view of the future when the budget was drawn up
or a failure to predict a decline in volumes, the evidence for which should have been observable
to an informed salesperson.

The sales mix variance proceeds to value the increase or drop in units sold per line by the
difference between the actual contribution margin per line and the budgeted weighted average
contribution line. Therefore for a business to sell fewer than budgeted units at a contribution
margin lower than average (the situation with the plodder line) is as beneficial as selling more
than the number of budgeted units of a line whose contribution margin is higher than average
(the situation with the Aceeem line)

Readers should ponder the managerial significance of this analysis. The manger of the sports
goods chain may be confused by the signals coming from these numbers. On the one hand, the
sales quantity variances indicate that a decline in overall sales volume has cause a decline in
total contribution margin (an intuitively reasonable message); on the other hand , the sales mix
variance tells him that the fewer plodder shoes has sells the better (an intuitively unreasonable
message). What is he going to make of the information? Wouldn’t he be better with the volume
variance on its own which gave him the big picture?

For this case, the answer must be yes because the position is starkly clear from the original
data. When the number of products increases and the switch in mix
More subtle than in this case, the deeper layer of analysis will provide more useful information.

Check Your Progress –3

1. How do you investigate variances

……………………………………………………………………………………………
……………………………………………………………………………………………
2. Explain sales variances
……………………………………………………………………………………………
……………………………………………………………………………………………

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3.10 SUMMARY

A standard cost is the budgeted cost for one unit of output. Budgets are therefore broken down
into standard costs so that detailed parts of an organization can be controlled. Actual costs are
compared with standard costs and variances can be calculated and explained.

Care must be exercised in setting standards; standards, which reflect perfect operating
conditions and which are unlikely to be encountered in practice, are de motivating and
demoralizing for managers who are asked to meet them. Standard costs per unit are used to flex
annual budgets so that actual costs may be compared with the budget for a similar volume of
output.

Material and labor variance can be split into piece or rate variances and quantity (efficiency
variances; variable overhead variances comprise spending and efficiency while fixed overhead
variances can be divided into spending and denominator variances. The calculation of variances
represents only one step in variance analysis; seeking explanation for these variances and
taking necessary remedial actions is the more important function. Only the most significant
variances should be investigated.

The signals given by variance analysis may be counter-intuitive, that is, they may report a
variance as being favorable (or adverse) when ones visual inspection of the underlying data
would lead one to the opposite conclusion. Readers should revise the deeper analysis sales
volume variances to gain confirmation of this issue.

3.11 ANSWERS TO CHECK YOUR PROGRESS

1. 1) Refer section 3.2

2) Refer section 3.4
2. 1) Refer section 3.5
2) Refer section 3.7
3. 1) Refer section 3.9
2) Refer section 3.9

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 3.12 MODEL EXAMINATION QUESTIONS

Problem 1

From the following data and relating to Addis Tyre Company Calculate

1. Flexible – budget variance

2. Variable overhead efficiency variance
3. Variable overhead spending variance

Static Budget
Actual Amounts
Amount
1. Units of Tires produced and sold 180,000 151,200
2. Batch size (units/batch) 150 140
3. Number of batches (line 1÷ line 2) 1,200 1,080
4. Setup hours per batch 6 6.25
5. Total setup hours (line 3 ÷ line 4) 7,200 6,750
6. Variable overhead cost per setup hours $20 $21
7. Variable setup overhead costs (line 5 x line 6) $144,000 $141,750
8. Total fixed setup overhead costs $216,000 $220,000

Solution:
Solution: -
1. Flexible– budget variance = Actual costs – Flexible costs – budget
= 6,750 x $21 – 6,048 x $20
= $141,750 - $120,960
= $20,790U

Variable Actual units of Budgeted units of

overhead 2. variable overhead variable overhead Budgeted
efficiency = cost-allocation cost-allocation X variable
variance base used for base allowed for overhead rate
actual output actual output

= (6,750 – 6,048) x $20 = 702 x $20 = $14,040U

Actual quantity
Variable Actual variable Budgeted variable of variable
overhead overhead cost per overhead costs per
spending = unit of cost- unit of cost X overhead cost
allocation base
variance allocation base allocation base used for actual
output
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 3.

= ($21 - $20) x 6,750 = $1 x 6,750 = $6,750 U

Problem: 2

From the following data relating to Nazareth Textiles for April 2003. In which it produced
50,000 export quality shirts.

Cost item/allocation base – Actual Results – Budget flexible amount

Actual Budgeted

a. Output units (shirts) - 50,000 50,000

b. Machine hours - 22,500 20,000
c. Machine-hours per output unit (b/a) - 0.45 0.40
d. Variable manufacturing
Overhead costs - $652,500 $600,000
e. Variable manufacturing overhead
Costs per machine hour (d/b) $29 $30
f. Variable manufacturing overhead costs
per output unit (d/a) - $13.05 $12.00

Required
1. Calculate variable overhead flexible budget variance
2. Variable overhead efficiency variance
3. Variable overhead spending variance

Solution:
1. Variable Overhead
= Actual results —Flexible Budget amounts
Flexible-budget variance

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 = 652,500—600,000
= 52,500U

Variable Actual units of Budgeted units of

overhead variable overhead variable overhead Budgeted
efficiency 2.= cost-allocation cost-allocation X variable
variance base used for base allowed for overhead rate
actual output actual output

= [22,500 – (0.40 x 50,000)] x $30

= [22,500 – 20,000] x $30
= 75,000 U

Actual quantity
Variable Actual variable Budgeted variable of variable
overhead overhead cost per overhead costs per
spending =
3. unit of cost- unit of cost X overhead cost
allocation base
variance allocation base allocation base used for actual
output

= ($29—30) x 22,500
= 1 x 22,500
= 22,500 F
Problem: 3

From the given information compute flexible budget variance, the spending variance, and the
efficiency variance.
Data:
Actual Results Budgeted
Units 1080 1048
Variable overhead $52,164 ?
Labor cost per hour $12
Labor per unit 4 hours
Labor hours 4,536
Solution
1) Flexible Budget Variance = Actual cost — Flexible Budget
= 52,164 — (4 x 12 x 1080)

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 = 52,164 — 51,840 = 324U
2) Spending variance = (11.5 – 12.00) x 1080 = 540F
3) Variable overhead spending variance
= (4536 – 4320) = 216U
Proof
Flexible budget variance = spending variance + efficiency variance
= 324 = 540 + (-216)

1. Actual costs Incurred actual

52,164 52,272 51,840
(4536x11.5) 4356x12 4 x 1080 x 12

108 F 432 U

Spending variance Efficiency variance

Comments on the results

324 U

2. Workers are less skill full since actual hours taken for 1080 units is 4536 whereas it
should be 1080 x 4 = 4320 hours resulting $432 unfavorable.
3. They spent less amount of on labor rate than budgeted by $.50 resulting a saving of
108F

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