Cost Variances

Definition

A cost variance exists when standard costs differ from actual costs.

Explanation

Cost variances for materials, labor, and overheads result from different causes. Hence, when evaluating the efficiency of a manufacturing organization, these variances should be measured and analyzed.

Every manager should try and answer two important questions regarding every variance:

  1. Is the variance significant?
  2. What action should be taken?

1. Is the Variance Significant?

Management should accept variance as a rule rather than an exception. The probability that actual quantities and prices will exactly match the standard is very remote.

Also, management must determine when a particular variance should be investigated or when variances should be ignored.

The basic criterion here is the magnitude of the variance (i.e., is a variance large enough to require investigation?). For example, some managers may decide that variances under 10% of the standard cost aren’t worth investigating.

Another criterion relates to the consistency of occurrence. A once-in-a-while variance of $1,000 may not be as significant as a $500 variation that recurs frequently.

A third criterion relates to the management’s ability to control the variance. If the variances are beyond the control of the management, there is no choice but to forget about them.

Therefore, variances should be analyzed when the expected savings from investigating them are greater than the expected cost of performing the investigation.

2. What Action Should Be Taken?

Variance analysis helps to determine the causes of variance.

A company should seek to identify the causes of variances before praising or disciplining managers. Whether variances are favorable or unfavorable, the causes should be found.

Another important question is to determine whether the causes of the variance are beyond the control of managers (e.g., due to unexpected changes such as price increases, rapid growth in order volumes, and so on).

Therefore, all significant variances should be investigated, and corrective actions should be taken to find out why the variance occurred.

Probably, with better control, it is possible to eliminate the variance or reduce it in the future. If the standards are unrealistic, they should be revised.

Evaluation of Cost Variances

Cost variances allow managers to identify problem areas and control costs for the upcoming months of business.

For example, favorable prices on materials and good quantity variance indicate that the purchasing and production departments are using materials in a very efficient way.

A favorable material price variance indicates that the manager responsible for purchasing materials pays less per unit than the price allowed by the standards. This may be a result of receiving discounts, effective bargaining, or some other factor.

In some cases, when a favorable price variance may be due to bulk purchases or the purchase of materials of substandard quality, the manager’s performance will be questioned.

A favorable material quality variance may be due to factors such as less material waste than estimated by the standards, better than expected machine efficiency, more efficient use of raw materials, and others.

However, production managers can experience serious problems in terms of labor efficiency variance. The actual time taken by workers may be significantly greater than the standard time allowed to produce a given amount of product.

Unfavorable labor efficiency variances may arise from managerial decisions to use poorly trained workers or poorly maintained machinery. It is also attributable to downtime resulting from the use of low-quality materials.

In some cases, bad working conditions and low employee morale can also adversely affect the efficiency of the workers.

A favorable labor rate variance may reflect that low-paid (or low-skilled) workers were used or that actual wage rates were below the standard labor rates.

An unfavorable overhead spending variance indicates excessive levels of expenditure. This may result from both increasing the prices of goods and services used and from the excessive consumption of these goods and services.

An unfavorable overhead volume variance indicates that the factors used or the activity base used in costing overheads to the products have been used inefficiently.

Example

Good Luck Ltd. has a manufacturing division that produces a product with the following details per unit:

  • Materials: 5 kg at $3, $15
  • Direct labor: 10 hours at $2, $20
  • Variable overhead: 10 hours at $2, $10
  • Relevant fixed overheads: budgeted at $8,000 per month
  • Planned output: 2,000 units per month
  • Selling price: $50 per unit

An incentive scheme is in operation in the manufacturing division. Employees are paid a bonus of 10% of the standard cost of materials saved and 40% of direct labor time saved, valued at the standard direct labor hour rate.

During a recent month when output was 1,700 units, the following results were recorded at the Good Luck Ltd.’s production facility:

  • Direct material used (80,000 kg) = 24,800
  • Direct wages (18,000 hours @ $2.20 per hour) = 39,600
  • Variable overhead = 20,000
  • Fixed overhead = 10,000

Required:

  1. Calculate the variance which occurred during the month
  2. Calculate the total bonus payment to the employees

Solution

Material Variances
MCV = MPV + MQV
(i). Material Price Variance (MPV)
= AQ (SR – AR)
= AQ x SR – AQ x AR
= (8,000 x 3) – 24,800
= 800 (A)
(ii). Material Quantity Variance (MQV)
= SR (SQ – AQ)
= 3 (8,500 – 8,000)
= 3 (500)
= 1,500 (F)
(iii). Material Cost Variance (MCV)
= (SR x SQ) – (AR x AQ)
= 25,500 – 24,800
= 700 (F) (1,700 x 5 = 8,500 kg at $3 = $25,500)
Labor Variance
LCV = LRV + LEV
(i). Labor Rate Variance (LRV)
= AH (SR – AR)
= 18,000 (2 – 2.20)
= 3,600 A
(ii). Labor Efficiency Variance (LEV)
= SR (SM – AH)
= 2(17,000 – 18,000)
= 2,000 A
(iii). Labor Cost Variance (LCV)
= (SR x SH) – (AR x AH)
= (2 x 17,000) – (2.20 x 18,000)
= 34,000 – 39,600
= 5,600 A
(17,000 x 10 = 17,000 hours at $2 = $34,000)
Variable Overhead Variance
VOHV = VOH Exp. V + VOH Eff. V
(i). Expenditure or Spending Variance (VOH Exp. V)
= Standard variable overheads – Actual variable overheads
= (1,800 x 10) – (20,000)
= 18,000 – 20,000
= 2,000 (A)
(ii).Variable Overhead Efficiency Variance (VOH Eff. V)
= Standard Variable Overhead rate per hour (AQ – SQ)
= 10 (1,700 – 1,800)
= 1,000 (A)
Variable overhead variances (VOHV) = Recovered variable overheads – Actual variable overheads
= 17,000 – 20,000
= 3,000 (A)
Actual hours worked / Standard time per unit (hrs.) = 18,000S Q / 10 = 1,800 units
Fixed Overhead Variances
(i). Fixed Overhead Expenditure Variance
= Budgeted fixed overheads – Actual fixed overheads
= 8,000 – 10,000
= 2,000 (A)
(ii). Fixed Overhead Volume Variance
= SR (Actual output – Budgeted output)
= 4 (1,700 – 2,000)
= 1,200 (A)
(iii). Fixed Overhead Cost Variance
= Recovered fixed overheads – Actual fixed overheads
= 6,800 – 10,000
= 3,200 (A)
Recovered fixed overheads = 1,700 x 4 = $6,800
Standard fixed overhead rate per unit = Budgeted fixed overheads / Budgeted output
Fixed overhead volume variance can be devided into two types:

  1. Fixed Overhead Efficiency Variance = SR (AQ – SQ)
  2. Fixed Overhead Capacity Variance = SR (SQ – BQ)

= 4 (2,000 – 1,800)
= 800 (A)
Variable Overhead Variance
Variable overhead cost variance = Standard variable overhead cost – Actual variable overhead cost
= 1,700 x 10 – 20,000
= 3,000 (Variable overhead spending variance = Actual hours (Standard overhead rate – Actual variable overhead rate)
= 18,000 x 1 -20,000
= 2,000 (A)
Variable overhead efficiency variance = Standard variable overhead rate (Standard hours – Actual hours)
= 1 (17,000 – 18,000)
= 1,000 (A)
Bonus
Material quantity variance = 1,500 (F)
Bonus 1,500 x 10% = 150
Standard cost of labor = 2,000 (A)
Since the labor efficiency variance is negative, no bonus is paid to the workers.
Hence, the total bonus payment to the employees is $150.

True is a Certified Educator in Personal Finance (CEPF®), contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.

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