10. Cost and Variance Analysis

Question 1

Variance Analysis Overview

Answer 1

• A performance evaluation system must be used to monitor progress towards budget objectives
• Variance analysis is the basis of any performance evaluation system
• The intent of booking variances is to provide information for use of controlling the cost of production
• The significance of variances depends not only on their amount but also on Direction, Frequency and Trend. Persistent variances may indicate that standards need to be reevaluated.
• Variance analysis enables Management By Exception - the practice of giving attention primarily to significant deviations from expectations (whether Favorable or Unfavorable)
• Management By Exception reduces information overload, unfocused management action and reports for production cost
• Reliance on advance planning is important for management by exception
• Least valid reason for Variance Analysis is to identify the manager responsible for NOT achieving results.
• A crucial part of Variance Analysis is assignment of responsibility to take corrective actions and continuous improvements - also to promote learning.
• The beginning of variance analysis is Static Budget
• The static budget variance consist of Flexible Budget
  Variance and Sales volume Variance
• Flexible budget consist of costs that should have been incurred given the actual level of production. Is NOT appropriate to control FOH
• Standard costs should be established for DM, DL and OH
• Sales Volume Variance is the difference between flexible budget and static budget IF the Selling Price and Costs are constant
• Review P.3
• All variances are controllable EXCEPT FOH production volume variance
• Advantages of Variance Analysis:
  1) Identify areas where actual differs from budget
  2) Provides accountability among personnel - assign responsibility
  3) Evaluates performance
  5) Identify if budget estimates requires revision
• Benefits for using variance analysis for measuring performance:
  1) Provide framework for judging performance
  2) Motivate managers and employees
  3) Promote communication and coordination
• Disadvantages of Variance Analysis:
  1) There is a focus on the past without looking at the future
  2) Lengthy process to identify problems and take corrective actions by management
• Assigning ALL favorable variance to COGS would result in a HIGHER income

Question 2

Static and Flexible Budget Variance

Answer 2

• Under flexible budgeting variable costs are stated per unit, fixed costs are in total
• Under Flexible budget - FIXED COSTS ARE NEVER CHANGED, THEY ARE TAKEN AS IS FROM STATIC BUDGET
• Static budget is prepared BEFORE the budget period begins and is NOT changed
• Actual results are prepared AFTER the budget period ends
• Disadvantage of static budget that it is made ONLY for ONE level of driver
• Standard costs MUST be kept CURRENT
• Standard cost should be set with input from the personnel directly involved in the process
• Standard cost focus on QUANTITATIVE NOT QUALITATIVE factors
• Standard costing allows employees to better understand what is expected of them.
• Standard costs CAN’T be EASILY changed
• A well designed standard cost system should produce fewer unfavorable variance
• Static budget variance is Static Budget minus Actual Results
• Tight standards are difficult to attain, practical standards are possible but difficult to attain
• Flexible budget gives best feedback in planning and performance reporting
• The use of standard costs in budgeting process signifies that management has implemented flexible budgeting
• A flexible budget using standard costs help management determine how much of the static budget variance arose from inaccurate forecast of outputs
• Flexible budget can be adjusted to different level of activities(series of budgets) for a SPECIFIC RANGE unlike static budget. It can be adapted for unanticipated level of production
• Flexible budget using standard costing EXCLUDES past inefficiencies and take into account expected future changes

Question 3

Direct Material Variance

Answer 3

• DM Price Variance is under the responsibility of purchasing department.
• DM price variance is calculated on units PURCHASED.
• Unfavorable DM Price Variance indicates that prices in the industry have risen AND standard prices should be updated. If there is ONLY 1 source for the raw material, the purchasing manager will not be negatively evaluated, the standard should be CHANGED to reflect the new price
• Favorable DM Price Variance indicates that prices in the industry have fallen AND standard prices should be updated OR lower quality DM have been purchased. An analysis must be made to determine whether the LOWER quality materials results in a LOWER product or excessive use of quantity
• DM Quantity Variance is under the responsibility of Production department first then purchasing department
• Product design is a possible cause of a materials efficiency variance
• Unfavorable DM Quantity Variance is usually blamed on the excessive use of materials by the production department OR theft of materials OR other waste and shrinkage. Also may be attributable to using unskilled labors.
• Sales volume of the product should NOT be a contributing factor to a materials efficiency variance.
• Favorable DL rate variance may have contributed to an Unfavorable materials quantity variance
• Favorable DM Quantity Variance indicates that workers have been unusually efficient. Another factor might Producing lower quality products. Favorable variance is NOT always desirable

Question 4

Direct Labor Variance

Answer 4

• DL Rate Variance is the under the responsibility of production department and HR
• Unfavorable DL Rate Variance is caused by assigning skilled workers to a production process OR a new union contract resulted in a higher wage to workers in which standard prices should be updated
• Favorable DL Rate Variance is caused by assigning workers with less skill to a job which will result in Unfavorable material efficiency variance
• Unfavorable DL Efficiency Variance means that workers are spending too much time on production process which means that EITHER workers are less skilled than expected OR Lower quality material have been purchased
• Favorable DL Efficiency Variance means that employees are working efficiently

Question 5

Mix And Yield Variance

Answer 5

• In some production processes, inputs are substitutable, for example a baker of pecan pies may use pecan from Florida instead of Georgia or high skilled labor instead of low skilled labor
• Mix Variance measure the relative use of higher priced and lower priced inputs in the production process

Question 6

Overhead Variance

Answer 6

• Production department is responsible for OH variance
• Overtime premium arising from heavy overall volume of work is treated as OH.
• Variable OH variance is the flexible budget variance
• Variable OH spending variance could appear also if the company is using normal costing system
• Variable OH efficiency Variance is related to Labor E Efficiency Variance IF variable OH is applied on the basis of direct labor hour
• If overhead is applied on the basis of units of OUTPUT, the variable overhead efficiency variance will be ZERO
• Sales department are responsible for FOH Variance
• Fixed OH spending Variance is more helpful in bringing attention to a potential short term problem in the control of OH. FOH Spending variance is the same as the fixed OH flexible budget variance
• Fixed OH Efficiency Variance is NEVER meaningful - NOT prepared for FOH
• Production Volume Variance is the amount of the Underapplied or Overapplied FOH
• Production Volume Variance measures the deviation from the normal or denominator level of activity
• Production Volume Variance will be Unfavorable if actual cost is LESS than standard cost which means the is Unutilized capacity
• Types of OH analysis:
  1) Four Way variance analysis which includes ALL four components of total OH variance
  2) Three Way Variance analysis combines the Variable and Fixed spending variance and reports Variable efficiently and Fixed production Volume variances separately
  3) Two Way Variance analysis combines Spending and Efficiency variances into flexible budget variance and reports the Fixed Production Volume Variance separately. Flexible budget Variance in Two Way Variance analysis is also called Controllable Variance

Question 7

Sales Variances

Answer 7

• Consists of Sales Price Variance and Sales Volume Variance.
• The analysis if these variances CONCENTRATES in contribution margin because Fixed Costs are assumed to be constant.
• Multi products sales variances are calculated same as single products then sum the 2 products together

Question 8

Rules for Calculation

Answer 8

• Quantity = efficiency = hours = volume
• Price = rate = spending
• SP = Standard price
• SQ = Standard quantity
• SH = Standard hours
• Review P.3
• Static budget = SP * SQ
• Actual results = AP * AQ
• Static budget variance = Static budget - Actual result
• Flexible Budget = SP * AQ
• Flexible budget variance = AQ * (AP - SP)
• Sales volume variance = SP * (AQ - SQ)
• Total material variance = flexible budget - actual result
• DM price variance = (SP - AP) * AQ
• Exam tip: if each unit contains 1.5 yards of DM and 25% is spoilage, how much yards do they need = 1.5 / 75%. The 1.5 yards are the remaining after spoilage
• DM quantity variance = (SQ @ actual production level of output - AQ) * SP
• Additional quantities used = Quantity variance / SP
• Actual quantity material purchased = Actual quantity materials used in production + Ending quantity materials + favorable or unfavorable quantity variance
• Total labor efficiency variance = DL rate variance + DL efficiency variance
• DL rate variance = (SP - AP) * AH
• DL efficiency variance = (SH @ actual production level of output - AH) * SP
• Standard Mix Standard Price SMSP = (Budgeted hour or materials * SP) / total budgeted hours or materials
• Actual Mix Standard Price AMSP = (Actual hour or materials * SP) / total actual hours or materials
• Mix variance = (SMSP - AMSP) * ATQ
• Yield variance = (ATQ - STQ) * SMSP
• Variable OH variance = Actual Variable OH - Applied Variable OH
• Variable OH spending variance = (SP - AP) * AH OR Actual total variable OH - (AH * SP)
• Variable OH efficiency variance = (SH @ actual production level of output - AH) * SP
• Fixed OH Variance = Actual Fixed OH - Applied Fixed OH
• Applied Fixed OH = Actual units produced * standard per unit fixed rate
• Fixed OH spending variance - Actual Fixed OH - Budgeted Fixed OH
• Production Volume Variance = Budgeted Fixed OH - Applied Fixed OH
  OR
  (AQ - SQ) * Standard Fixed per unit , If ACTUAL quantity is LESS then it is unfavorable. VERY IMPORTANT TO REMEMBER THAT IT WILL BE UNFAVORABLE IS ACTUAL LESS THAN BUDGET
• Under Two way OH analysis when Actual FOH = Budgeted FOH then variance is {Actual VOH - (SH @ actual level of output * budget OH rate)}
• Sales Price Variance = (AP - SP) * AQ
• Sales Volume Variance = (AQ - SQ) * standard contribution margin per unit
• Sales Volume variance for Operating income = Standard budget operating income - Flexible budget operating income
• Total change in Contribution margin = Sales price variance + Sales Volume Variance
• Exam tip: Assume that year 2 prices are lower than year 1 by 15%, what is the decrease in profit due to price reduction. We must calculate year 2 sales at year 1 prices then Year 2 sales 950,400/ 85% = 1,118,118
  Reduction in profit = 1,118,118 - 950,400
• Market size Variance = Budget market share % * ( Actual market size in units * budget weighted avg unit contribution margin)
  Actual market size in units gives an indication of the change in CM caused by change in market size
• Market Share variance = (Actual market share % - Budget market share %) * (Actual market size in units * budget weighted avg unit contribution margin
  Actual market size in units gives indication of the change in contribution margin gained (forgone) because of the change in the market share