What Are Cost Variances?
Cost variances for Material, Labour and Overhead result from a variety of different causes. Hence, in 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?
Management should accept variance as a rule rather than the exception. The probability that actual quantities and prices will exactly match the standard are very remote. Also, management must decide when a particular variance has to 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 management may decide that variances under 10 percent of standard need not be investigated.
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, the management has no choice but to forget about the variances.
Hence variances should be analyzed when the expected saving through investigation appears to be greater than the expected cost of conducting the investigation.
(2) What Action Should Be Taken?
Variance analysis helps in the determination of the causes of the variance. Management should get to the causes of variances before praising or belittling managers. If variances are favorable, the causes should be found. Whether the cause is due to a loose standard or truly effective management. Similarly, unfavorable variances should be investigated. Are the causes beyond the control of the management due to certain unexpected changes, e.g., price increases, rush orders, etc.
Hence, all significant variances should be investigated and corrective action taken to find out why the variance occurred. Probably, with better control, the variance can be eliminated or reduced in the future. If the standards are unrealistic, they should be revised.
Evaluation of Cost Variances
Cost variances can help managers in identifying problem areas and in controlling costs in the future months. For example, a favorable material price and quantity variance indicates that the purchasing and production departments are using material in a very efficient manner.
A favorable material price variance indicates that the manager responsible for material purchases paid 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 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 allowed by the standards, better than expected machine efficiency, more efficient use of raw materials, etc.
However, the production manager has a serious problem regarding labor efficiency variance. The actual time being taken by the workers is much more than the standard time allowed to produce a given amount of product.
Unfavorable labor efficiency variances can be caused by a management decision to use poorly trained workers or poorly maintained machinery or by downtime resulting from the use of low-quality materials. In some cases, generally bad working conditions and low employee morale may also adversely affect the efficiency of the workers. A favorable labor rate variance may signify that lower paid (or lower skilled) workers were used or that actual wage rates are below the standard labor rates.
An unfavorable overhead spending variance indicates excessive levels of expenditure. This could have resulted both from increasing prices of goods and services used and from excessive consumption of these goods and services. An unfavorable overhead volume variance indicates that the factors employed or the activity base used in costing overheads to the products has been used inefficiently.
Good Luck Ltd. has a manufacturing division which makes a product to which the following details relate:
Materials: 5 kg at $3, $15
Direct labor: 10 hours at $2, $20
Variable overhead: 10 hours at $2,$10
Relevant fixed overheads are budgeted at $8,000 per month and planned output is 2,000 units per month. The selling price is $50 per unit.
An incentive scheme is in operation in the division concerned whereby employees are paid a bonus of 10% of the standard cost of materials saved and 40% of direct labor time saved valued at standard direct labor hour rate. During a recent month when output was 1,700 units, the following actual results were recorded:
Direct material used (8,0000 kg) = 24,800
Direct wages (18,000 hours @ $2.20 per hour) = 39,600
Variable overhead = 20,000
Fixed overhead = 10,000
(1). Calculate the variance which occurred during the month.
(2). Calculate the total bonus payment to the employees.
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)
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
(1,7000 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:
- Fixed Overhead Efficiency Variance = SR (AQ – SQ)
- 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 (A 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)
Material Quantity Variance = 1,500 (F)
Bonus 1,500 x 10% = 150
Standard cost of labour = 2,000 (A)
Since the labor efficiency variance is negative, no bonus is paid to the workers.
Hence, total bonus payment to the employees = $150