VARIANCE ANALYSIS

Performance Operations
ADFM005/S3PFMQ2
Chapter 5 and 6
 Breakdown

After you have completed this unit, you should be able to do the following:

1. Explain how standard costs operates;

2. Explain how standard cost are set;
3. Explain the meaning of standard hours produced;
4. Identify and describe the purpose of standard costing;
5. Calculate labour, material, overhead and sales margin variances
and reconcile actual profit with budgeted profit;
6. Identify the causes of labour, material, overhead and sales
margin variances;
7. Distinguish between standard variable costing and absorption
costing. material mix and yield variances
d calculate
8. Explain an

Footnote 3
 Definitions

Standard costing Standard costs

predetermined costs
a financial control system
target costs that should be incurred
under efficient operating conditions
enables deviations from
budget to be analysed in not the same as budgeted costs

detail
budget – provides the cost expectation
for total activity
thus enabling costs to be
controlled more effectively standard – provides cost expectations
per unit of activity

Footnote 4 4
 Standard costing

Who can use it?

►Organisations whose activities consist of a series of repetitive operations
► input required to produce each unit of output can be specified
Manufacturing service industries?
companies
What does a standard costing system involve?
Is there any point in comparing actual performance with standard
performance, as these comparisons can only be made after the
event?

• If people know in advance that their performance is going to be judged, they

are likely to act differently
• An analysis of how well a person has performed in the past may indicate
ways of obtaining better performance in the future

Footnote 5 5
 Establishing cost standards

Standards should be set for the quantities and prices of

materials, labour and services to be consumed in
performing each operation associated with a product

Product standard costs are derived by listing and adding

the standard costs of operations required to produce a
particular product

Footnote 6 6
 Establishing cost standards
Two approaches are used for setting standard costs:
Past historical records can be
used to estimate labour and Standards can be set based on
material usage: engineering studies

• Danger = past inefficiencies will be

included • A detailed study of each operation is
• Standards are set based an average undertaken under controlled
past performance for the same/similar conditions, based on high levels of
operations efficiency, to ascertain the quantities of
• Known excess usage of
labour and materials required
labour/materials should be eliminated
• Disadvantage = does not focus
attention on finding the best • Target prices are then applied based
combination of resources, production
methods and product quality on efficient purchasing to ascertain the
standard costs

Footnote 7 7
 DIRECT MATERIAL
Direct material standards

undertake an intensive study of the input quantity necessary for

each operation → product specifications

• establish most suitable materials based on product design + quality

policy and optimal quantity that should be used after taking into
account any wastage/loss that is considered inevitable
• recorded on a bill of materials → states the required quantity of
materials for each operation

►std material product cost = std quantities x std prices

►std prices → purchasing department → search of alternative
suppliers + select suppliers who can provide the required
quantity of sound quality materials at the most competitive
price

Footnote 8 8
 DIRECT LABOUR

Direct labour standards

• each operation is studied and an allowed time computed

→ after carrying out a time and motion study
• analyse each operation to eliminate any unnecessary elements
+ to determine the most efficient production method.

• followed by time measurements

→ to determine standard hours required by an average worker to
complete the job

unavoidable delays, machine breakdowns, routine maintenance

→ included in the standard time

Footnote 9 9
 OVERHEAD COSTS

Overhead standards
establish predetermined overhead rat es

separate rates for fixed and variable overheads

• product overhead cost is based on hourly overhead rates

multiplied by standard hours

Standard cost card should

sho be maintained for each product and
operation
→ reveals the quantity of each unit of input that should be used to
produce one unit of ou
output

Footnote 10 10
 Standard cost

Standard hours produced

• It is not possible to measure output in terms of units
produced for a department making several different
products or operations
• This problem is overcome by ascertaining the amount of
time, working under efficient operating conditions, it should
take to make each product = standard hours
Standard hours thus represents an output measure that acts as
a common denominator for adding together the production of
unlike items

•Compare output hours with input hours

Footnote 11 11
 Purposes of standard costing

►providing a prediction of future costs that can be used for decision making
►providing a challenging target which individuals are motivated to achieve
►providing a reliable and convenient source of data for budget preparation
►acting as a control device by highlighting those activities that do not conform
to plan and thus alerting managers to those situations that may be ‘out of
control’ and in need of corrective action
►simplifying the task of tracing costs to products for profit measurements and
inventory valuation purposes
► Inventories and cost of goods sold are recorded at standard cost and a
conversion to actual cost is made by writing off all variances arising during the
period as a period cost.

Footnote 12 12
 Variance analysis
Example 17.1, page 440

Alpha manufacturing company produces a single product, which is known as

sigma. The product requires a single operation, and the standard cost for this
operation is presented in the following standard cost card:
Standard cost card for product Sigma R
Direct materials:
2 kg of A at R10 per kg 20
1 kg of B at R15 per kg 15
Direct labour (3 hours at R9 per hour) 27
Variable overhead (3 hours at R2 per direct labour hour) 6

Total standard variable cost 68

Standard contribution margin 20
Standard selling price 88
Footnote 13 13
 Variance analysis
Example 17.1, page 440
Alpha Ltd plan to produce 10 000 units of Sigma in the month of April, and the
budgeted costs based on the information contained in the standard cost card
are as follows:
Budget based on the above standard costs and an output of 10 000 units
Sales(10 000 units at R88 per unit) 880 000
Direct materials: 350 000
A
A: 20 000 kg at R10 per kg 200 000
B
B: 10 000 kg at R15 per kg 150 000
Direct labour (30 000 hours at R9 per hour) 270 000
Variable overheads (30 000 hours at R2 60 000 680 000
per direct labour hour)
Budgeted contribution 200 000
Fixed overheads 120 000
Budgeted profit 80 000

Footnote 14 14
15

Variance analysis
Annual budgeted fixed overheads are R 1 440 000 and are assumed to be incurred
evenly throughout the year. The company uses a variable costing system for internal
profit measurement purposes.

The actual results for April are:

Sales(9 000 units at R90) 810 000
Direct materials:
A: 19 000 kg at R11 per kg 209 000
B: 10 100 kg at R14 per kg 141 400
Direct labour (28 500 hours at R9.60 per hour) 273 600

Variable overheads 52 000 676 000

Contribution 134 000
Fixed overheads 116 000
Profit 18 000

Footnote 15
 Standard variable and absorption costing
Material variances
Material price variance
Difference between the standard price (SP) and the actual price (AP) per unit of
materials multiplied by the quantity of materials purchased
(QP): (SP – AP) x QP
A: (10 – 11) x 19 000 = 19 000 A
B: (15 – 14) x 10 100 = 10 100 F
OR:
A: Should have paid: (19 000 X 10) 190 000
Did pay 209 000
Variance 19 000 (A)
B: Should have paid: (10 100 X 15) 151 500
Did pay 141 400
Variance 10 100 (F)
• efficiency of the purchasing department →failure to seek the most advantageous sources of
supply
• change in market conditions → general price increased
• purchase of inferior quality materials →may lead to inferior product quality or more wastage
• shortage of materials resulting from bad inventory control → emergency purchase → additional
handling and freight charges on special rush orders → charge a higher price

Footnote 16 16
 Standard variable and absorption costing
Material usage variance
Compare the standard quantity that should have been used with the actual quantity which
has been used.
It is necessary to remove the price effects from the usage variance calculation, and this is achieved by
valuing the variance
Difference between at the
the standard
standardprice.
quantity (SQ) required for actual production and the actual
quantity (AQ) used multiplied by standard
material price (SP): (SQ - AQ) x SP
A : (18 000 – 19 000) x 10 = 10 000 A
B : ( 9 000 – 10 100) x 15 = 16 500 A

A: Should have used (9 000 X 2) 18 000

Did use 19 000
1 000 @ R10 = R10 000(A)
B: Should have used (9 000 X 1) 9 000
Did use 10 100
1 100 @ R15 = R16 500(A)

• careless handling of materials

• purchase of inferior quality materials
• pilferage
• changes in quantity control requirements
• changes in methods of production

Footnote 17 17
 Standard variable and absorption costing
Joint price usage variance

Mat A: 18 000 kg required at a standard price of R10 per kg

19 000 kg used at a price of R11
The purchasing officer might readily accept responsibility for the price variance of R1
per kg for 18 000 kg, but may claim that the extra 1 000 kg at R1 is more the
responsibility of the production foreman → it may be argued that if the foreman had
produced in accordance with the standard then the extra 1 000 kg would not have
been needed.
The foreman, on the other hand, will accept responsibility for the 1 000 kg excess
usage at a standard price of R10, but will argue that he should not be held accountable
for the additional purchase price of R1 per unit.
Solution:
Report the joint price/quantity variance of R1 000 (1 000 kg x R1) separately and do not
charge it to either manager.

The original price variance of R19 000 would be analysed as follows:

Pure price variance (18 000 kg x R1 per kg) 18 000 A
Joint price/quantity variance (1 000 kg x R1p/ kg) 1 000 A
19 000 A

Footnote 18 18
 Standard variable and absorption costing

TOTAL MATERIAL VARIANCE

Difference between the standard material cost (SC) for the actual production and the actual
cost (AC): SC – AC
A: (9 000 x 20)180 000 – 209 000 = 29 000 A
(19 000 A + 10 000 A)

B: (9 000 x 15)135 000 – 141 400 = 6 400 A

(10 100 F + 16 500 A) summary
Quantity purchased vs quantity used →
Total variance = Price variance + Usage variances only if purchased = used

Footnote 19 19
 Material Variances Summary
Material A

Actual Quantity Actual Quantity Standard Quantity

× × ×
Actual Price Standard Price Standard Price
19 000 kgs. 19 000 kgs. 18 000 kgs.
× × ×
11 per kg. 10 per kg. 10 per kg.
= 209 000 = 190 000 = 180 000

Price variance Quantity variance

19 000 unfavourable 10 000 unfavourable
Footnote 20
 Material Variances Summary
Material B

Actual Quantity Actual Quantity Standard Quantity

× × ×
Actual Price Standard Price Standard Price
10 100 kgs. 10 100 kgs. 9 000 kgs.
× × ×
14 per kg. 15 per kg. 15 per kg.
= 141 400 = 151 500 = 135 000

Price variance Quantity variance

10 100 favourable 16 500 unfavourable
Footnote 21
 Standard variable and absorption costing
Labour variances
Wage rate variance
Difference between the standard wage rate per hour (SR) and
the actual wage rate (AR) multiplied by the actual number of
hours worked (AH): (SR – AR) x AH
(9 – 9.60) x 28 500 = 17 100 A.
OR:
Should used (28 500 X 9) 256 500
Did use 273 600
Variance 17 100 (A)

• negotiated increase in wage rates not yet reflected in standard wage rate
• unexpected overtime
• a standard is used that represents a single average wage rate for a given operation
performed by workers who are paid at several different rates
• assignment of skilled labour to work that is normally performed by unskilled labour →
should have matched the appropriate grade of labour to the task at hand

Footnote 22 22
 Standard variable and absorption costing

Labour efficiency variance

Difference between the standard labour hours for actual production (SH) and the actual
labour hours worked (AH) during the period multiplied by the standard wage rate per hour
(SR): (SH – AH) x SR
(9 000 x 3)(27 000 – 28 500) x 9
= 13 500 A
OR:
Should use (9 000 X 3) 27 000 hours
Did use 28 500 hours
1 500 hours @ R9
Variance R13 500 (A)

• use of inferior quality materials

• different grades of labour
• failure to maintain machinery in proper condition
• introduction of new equipment / tools and changes in production processes
• poor production scheduling
• change in quality control standards

Footnote 23 23
 Standard variable and absorption costing

Total labour variance

Difference between the standard labour cost (SC) for the actual production and
the actual labour cost (AC): SC – AC

(9 000 x 27) = 243 000

243 000 – 273 600 = 30 600 A (17 100 A + 13 500 A)

Footnote 24 24
 Labour Variances Summary

Actual Hours Actual Hours Standard Hours

× × ×
Actual Rate Standard Rate Standard Rate
28 500 hours. 28 500 hours. 27 000 hours.
× × ×
9.6 per hour. 9 per hour. 9 per hour.
= 273 600 = 256 500 = 243 000

Rate variance Efficiency variance

17 100 unfavourable 13 500 unfavourable
Footnote 25
 Standard variable and absorption costing
Variable overhead expenditure variance
R
Difference between the budgeted flexed variable overheads (BFVO) for the actual direct
labour hours of input and the actual variable overhead costs incurred
(AVO): BFVO – AVO
• prices of individual items have changed
(28 500 X 2) = 57 000
57 000 – 52 000 = 5 000 F • waste or inefficiency

Variable overhead efficiency variance

Difference between the standard hours of output (SH) and the actual hours of input (AH) for
the period multiplied by the standard variable overhead rate (SR): (SH – AH) x SR
(9 000 X 3) = 27 000 hours
(27 000 – 28 500) x 2 = 3 000 A

Total variable overhead variance

Difference between the sstandard variable overheads charged to production (SC) and the
incurred (AC): SC – AC
actual variable overheads inc
(9 000 x 6) 54 000 – 52 000 = 2 000 F (5 000 F + 3 000 A)
Footnote 26 26
 Variable Overhead Variances Summary

Actual Hours Actual Hours Standard Hours

× × ×
Actual Rate Standard Rate Standard Rate
28 500 hours. 28 500 hours. 27 000 hours.
× × ×
1.82456 per hour. 2 per hour. 2 per hour.
= 52 000 = 57 000 = 54 000

Expenditure variance Efficiency variance

5 000 favourable 3 000 unfavourable
Footnote 27
 Standard variable and absorption costing

Fixed overhead expenditure or spending variance

Difference between budgeted fixed overheads (BFO) and
actual fixed overheads (AFO) incurred: BFO–AFO

120 000 – 116 000 = 4 000 F

• ascertain reasons for variances by comparing individual

items of expenditure

Footnote 28 28
 Variable vs Absorption Costing

VARIABLE ABSORBTION

FIXED
OVERHEADS

• Not allocated to products • Allocated to products and included in

• Expense in the period incurred closing inventory

Sales variance – contribution margin Sales variance – profit margin

Fixed overhead volume variance arising from actual production differing

from budgeted production
→ Only arises when inventories are valued on an absorption costing basis

Footnote 4 4
 Standard Absorption Costin g An additional fixed
overhead variance, called
TEXT BOOK EXAMPLE continued: Information provided... a volume variance, is
calculated.
Manufacturing overheads are charged to productio n on the basis of direct labour hours.
Actual production and sales for the period was 9 000 units.

The sales margin variances are expressed in unit profit margins

instead of contribution margins.

Predetermined fixed overhead rates:

Budgeted fixed overheads (120 000 x 12months) = 1 440 000 annual fixed o/heads

Budgeted activity (10 000 x 12months) 120 000

= R12 per unit of sigma produced

Footnote 5 5
 Standard Absorption Costin g An additional fixed
overhead variance, called
TEXT BOOK EXAMPLE continued: Information provided... a volume variance, is
calculated.
Manufacturing overheads are charged to productio n on the basis of direct labour hours.
Actual production and sales for the period was 9 000 units.

The sales margin variances are expressed in unit profit margins

instead of contribution margins.
In most situations more than one product will be produced –
where different products are produced, units of output should
be converted to standard hours:

Budgeted standard hours = 120 000 x 3 DLH = 360 000

1 440 000
360 000 = R4 per standard hour x 3 hours per unit
= R12 fixed o/head allocation for one unit of sigma

Footnote 6 6
 Standard Absorption Costin g An additional fixed
overhead variance, called
a volume variance, is
calculated.
Volume variance
The standard fixed overhead rate of R4 per hour is calculated on a basis
of normal activity of 30 000 standard hours per month.
Only when actual standard hours produced are= 30 000 will the
budgeted monthly fixed overheads of R120 000 be exactly recovered.

Difference between actual production (AR) and budgeted production

(BP) for a period multiplied by the standard fixed overhead rate

(SR): (AP – BP) x SR

(9 000 units x 3hours per unit – 10 000 units x 3hours per unit)
(27 000 – 30 000) x 4 = 12 000 A

Footnote 7 7
 Fixed Overhead Variances Summary
Standard Absorption Costing

Actual Fixed Fixed Fixed

Overhead Overhead Overhead
Incurred Budget Applied
SH × FR
27 000 hours
given given ×
R4 per hour
116 000 120 000 108 000

Expenditure variance Volume variance

4 000 favourable R12 000 unfavourable
Footnote
Variable costing 8
system
 Standard Absorption Costing
Whenever actual production is less than budgeted production, the fixed
overhead charged to production will be less than the budgeted cost, and
the volume variance will be adverse.
ACTUAL less BUDGET ► adverse
If actual production is greater than budgeted production, volume
variance will be favourable

ACTUAL greater BUDGET ► favourable

Changes in production volume from the amount budgeted may be caused by:

• shifts in demand for products,

• labour disputes,
• material shortages,
• poor production scheduling,
• machine breakdowns,
• labour efficiency and
• poor production quality.

Footnote 10 10
 Standard Absorption Costing
Volume variance:

Volume efficiency variance Volume capacity variance

Why was actual production different from The budget is based on the assumption that
budgeted production? direct labour hours of input will be 30 000
One possible reason = labour force worked hours, but the actual hours of input are 28
at a different level of efficiency from that 500 hours.
anticipated in the budget. The difference of 1 500 hours reflect the fact
Actual direct labour hours of input = 28 500, that the company has failed to utilise the
but only 27 000 (9 000 x 3) standard hours planned capacity.
were actually produced.
If the labour force had worked at the If we assume that the 1 500 hours would
prescribed level of efficiency an additional 1 have been worked at the prescribed level of
500 hours would have been used, and this efficiency, an additional 1 500 standard hours
would have led to a total of R6 000 (1 500 x could have been produced and an additional
4) fixed overheads being absorbed. R6 000 fixed overhead could have been
Difference between the standard hours of absorbed
output (SH) and the actual hours of input (AH – BH) x SR
(AH) for the period x the standard fixed (28 500 – 30 000) x 4 = 6 000 A
overhead rate → Capacity variance = R 6 000 A
(SR): (SH – AH) x SR
(27 000 – 28 500) x 4 = 6 000 A
12 000
Footnote 11 11
 Standard Absorption Costing
§ Volume efficiency variance indicated a failure to utilise capacity efficiently
§ Capacity variance indicates a failure to utilise capacity at all.

Machine breakdowns, material shortages, poor production

scheduling, labour disputes, reduction in sales demand.

Footnote 12 12
 Fixed Overhead Volume Variances Summary: Absorption Costing
Volume variance:

Volume efficiency variance Volume capacity variance

SH AH BH
x x x
SR SR SR

27 000 hours 28 500 hours 30 000 hours

x × ×
4 per hour 4 per hour 4 per hour
108 000 114 000 120 000

Efficiency variance Capacity variance

6000 unfavourable 6 000 unfavourable
Footnote 13
 Standard Absorption Costing
Total fixed overhead variance

Difference between the standard fixed overhead charged to

production (SC) and the actual fixed overhead incurred
(AC):SC-AC
SC (27 000 standard hours x R4 per hour) or
(9 000 units x R12 per unit) = 108 000
Less: AC 116 000
8 000 A (12 000 A + 4000F)
The under- or over-recovery may be due to:

• Fixed overhead expenditure variance of R4 000 arising from actual

expenditure (116 000) being different from budgeted expenditure
(120 000)
• Fixed overhead volume variance arising from actual production
differing from budgeted production → Only arises when inventories
are valued on an absorption costing basis
Footnote 14 14
 Standard variable and absorption costing

Sales variances
Absorption costing – profit margins are used

Variable costing – contribution margins are used

Total sales margin variance

Difference between actual contribution (AC) and budgeted
contribution (BC) both based on standard unit costs: AC – BC
Actual contribution :
Actual sales revenue 810 000
Standard variable cost of sales for actual sales volume (9 000 X 68) 612 000
198 000
Less:
Budgeted contribution (10 000 x 20) 200 000
2 000 A

Footnote 29 29
 Standard variable and absorption costing

Sales margin price variance

Difference between the actual contribution margin (AM) and the standard margin
(SM) (both based on standard unit costs) multiplied by the actual sales volume
(AV): (AM – SM) x AV
((90 – 68) 22 – (88 – 68) 20) x 9 000 = 18 000
OR (Work with standard contribution, because effect of selling price difference has
to be calculated)

Contribution:
• Actual selling price – Standard V costs 90 –68= R22
• Standard selling price – Standard V costs 88 –68= R20
• Sales price variance: Actual units x Diff in contribution
9 000 X R2 = R18 000 (F)

Footnote 30 30
 Standard variable and absorption costing

Sales margin volume variance

Difference between the actual sales volume (AV) and the budgeted
volume (BV) multiplied by the standard contribution margin (SM):
(AV – BV) x SM
(9 000 – 10 000) x 20 = 20 000 A
OR: To ascertain the effect of changes in the sales volume on the
difference between the budgeted and actual contribution

Standard contribution R20.00

Actual sales : 9 000 Budgeted sales : 10 000

Contribution @ budgeted sales = 200 000

Contribution @ actual sales = 180 000
Variance = 20 000 (A)

Footnote 31 31
 Sales Margin Variances Summary
Standard Variable Costing

Actual Volume Actual Volume Budgeted Volume

× × ×
Actual Margin Standard Margin Standard Margin
9 000 units. 9 000 units. 10 000 units.
× × ×
22 20 20
= 198 000 = 180 000 = 200 000

Margin Price variance Margin Volume variance

18 000 favourable 20 000 unfavourable
Footnote 32
Sales Margin Variances Summary
Absorption Costing

Actual Volume Actual Volume Budgeted Volume

× × ×
Actual Margin Standard Margin Standard Margin
9 000 units. 9 000 units. 10 000 units.
× × ×
10 8 8
= 90 000 = 72 000 = 80 000

Margin Price variance Margin Volume variance

18 000 favourable 8 000 unfavourable
 Difficulties in interpreting sales margin variances

It is not meaningful to analyse total sales margin variance

into price and volume components, since changes in selling
price are likely to affect sales volume.
Variances may arise from external factors and may not be
controllable by management
• Changes in selling prices may be the result of a response to
changes in selling prices of competitors
• A reduction in both selling prices and sales volume may be
the result of an economic recession that was not foreseen
when the budget was prepared
Reconciling budgeted profit and actual profit

Footnote 33 33
 Reconciliation Standard Variable Costing

Budgeted net profit 80 000

Sales variances
Sales margin price 18 000F
Sales volume price 20 000A
Direct cost variance
Material Price: Material A 19 000A
Material B 10 100F 8 900A
Material Usage: Material A 10 000A
Material B 16 500A 26 500A
Labour Rate 17 100A
Efficiency 13 500A
Manufacturing overhead variances
Fixed: Expenditure 4 000F
Variable Expenditure 5 000F
Efficiency 3 000A 62 000A
Actual Profit 18 000

Footnote 9 9
 Reconciliation Standard Absorption Costing
£ £ £ £
Budgeted net profit 80 000
Sales variances
Sales margin price 18 000 F
Sales margin volume 8 000 A 10 000 F
Direct cost variance
Material Price: Material A 19 000 A
Material B 10 100 F 8 900 A
Usage: Material A 10 000 A
Material B 16 500 A 26 500 A 35 400 A
Labour Rate 17 100 A
Efficiency 13 500 A 30 600 A
Manufacturingin overhead
variances
Fixed Expenditure 4 000 F
Volume capacity 6 000 A
Volume efficiency 6 000 A 8 000 A
Variable Expenditure 5 000 F
Efficiency 3 000 A 2 000 F 6 000 A 62 000 A
Actual profit 18 000

Footnote 16 16
 Reconcilliation

Variable Costing Absorption Costing

Budgeted net profit 80 000 £ £ £ £
Sales variances Budgeted net profit 80
Sales variances 000
Sales margin price 18 Sales margin price 18 000
Sales volume price 000F
20 000A Sales margin volume F8 000 10 000
Direct cost variance Direct cost variance A F
Material Price: Material A 19 000A Material Price: Material A 19 000
Material B A
10 100 8 900
Material B 10 8 900A Usage: Material A F 000
10 A
Material Usage: Material A 100F
10 000A Material B A 500
16 26 500 35 400
Material B 16 500A 26 500A Labour Rate A A 100
17 A
Efficiency A 500
13 30 600
Labour Rate 17 100A
Manufacturingin overhead A A
Efficiency 13 500A variances
Fixed Expenditure 4 000
Manufacturing overhead variances Volume capacity 6F 000
Fixed: Expenditur 4 000F Volume efficiency A 000
6 8 000
e Variable Expenditure A5 000 A
Variable Expenditur 5 000F
Efficiency 3F 000 2 000 6 000 62 000
e
Efficiency 3 000A 62 000A A F A A 18
Actual profit
Actual Profit 18 000 000

17Footnote 17
Next lecture…

46