BUS105 Study Guide

Unit 8: Variance Analysis

8a. Explain the purpose of flexible budgeting

How is the level of activity for a budget determined?
Why are flexible budgets necessary?
What would happen if performance evaluation was based on the original budget without adjusting for the actual level of activity?

Budgets are based on assumptions and estimates regarding production activity levels. Usually, the actual level of production activity levels differs from the budgeted amount, due to changing or unforeseen circumstances. Therefore, for control purposes, flexible budgets are used. A flexible budget is a revised master budget that is based on the actual level of activity.

A flexible budget can be used to compare budgeted costs at the actual level of activity to actual costs. This plays a crucial role in the control function of management. In order to review the results of the current period's operation and make improvements for the next period, results must be compared to budgeted amounts at actual levels and not budgeted amounts at estimated levels.

Review Flexible Budgets.

8b. Explain how standard costs are established

Why is it important to determine standard costs?
How are standard costs determined?
What is the difference between standard costs and budgeted costs?
Why would managers generally prefer to use attainable standards as opposed to ideal standards?

Managers must determine costs they are expected to incur in order to provide a good or service. These expected costs are known as standard costs. Standard costs are usually established for all parts of production such as direct labor, direct material, and manufacturing overhead. Standard costs are used not only for monetary costs but can also apply to hours worked, minutes taken to prepare something, or similar items. Whatever it is measuring, it is the standard by which the actual production will be judged.

Establishing standard costs entails collecting information from various sources. Information can come from previous periods' experience, suppliers, competitors, or industry standards. Some of the standards that can be set include standard quantity for direct materials, standard price for direct materials, standard hours for direct labor, and standard rate for direct labor. Standard quantity for variable manufacturing overhead and standard rate for variable manufacturing overhead can be established as well.

Generally, managers prefer using attainable standards which take into account unforeseen events such as broken equipment or employee illnesses that may occur during a production period. The other option would be to use ideal standards which are set assuming that production conditions are always perfect. Judging against ideal standards will generally reflect poorly on management as conditions are seldom perfect.

Review Standard Costs.

8c. Calculate variances from direct materials, direct labor, variable manufacturing overhead, and fixed manufacturing overhead

Why is it important to measure variances in direct material and direct labor in two different dimensions?
When evaluating variances, why are negative differences considered favorable and positive differences unfavorable?
Is it possible that a favorable materials quantity difference may actually be caused by something negative?

There are two types of variances that can be used to explain the difference between actual costs and budgeted costs of direct materials. These are the materials price variance and the materials quantity variance.

The materials price variance measures the difference between actual costs for materials purchased and budgeted costs based on established standards. This is measured as:

Materials price variance = (AQ^P × AP) −(AQ^P × SP)

where AQ^P is the actual quantity purchased, AP is the actual price and SP is the standard price. A negative difference would indicate that direct materials cost less than the standard amount. This would be called a favorable variance. A positive difference would be an unfavorable variance and indicate that the cost was more than the standard. Care must be taken though, to ensure that a favorable price difference is not because cheaper quality raw materials were used.

The materials quantity variance is the difference between the actual quantity of materials used in production and budgeted materials based on standards. This is measured as:

Materials quantity variance = (AQ^U × SP) − (SQ × SP)

where AQ^U is the actual quantity used, and as above, AP is the actual price and SP is the standard price. Here also a negative amount would be favorable as it would indicate fewer materials than standard were used and a positive amount would be unfavorable.

For differences in labor cost, we use the labor rate variance and labor efficiency variance. The labor rate measures the difference between actual costs for direct labor and budgeted costs based on established standard rates. This is measured as:

Labor rate variance = (AH × AR) − (AH × SR)

where AH is actual hours worked, AR is the actual labor rate and SR is the standard rate. A negative difference indicates that labor costs less than the standard amount. This would be called a favorable variance. A positive difference would be an unfavorable difference and indicate that the cost was more than the standard. Here too, care must be taken that not too few hours were worked that may harm the product's quality.

The labor efficiency variance is the difference between the actual hours of labor worked in production and budgeted hours based on standards. This is measured as:

Labor efficiency variance = (AH × SR) − (SH × SR)

where AH is actual hours worked, AH is the standard hours budgeted for and SR is the standard labor rate. Here too, a negative amount would be favorable as it would indicate fewer hours were needed than originally thought, but a positive amount would be unfavorable.

Finally, for variable overhead, we use a variable overhead spending variance and a variable overhead efficiency variance. The variable overhead spending variance is the difference between actual costs for variable overhead and budgeted costs based on the standards. It is calculated as:

Variable overhead spending variance = Actual costs − (AH × SR)

where SR is the standard rate for that company's allocation base. This measures if there were overhead costs above what was expected for this level of production.

The variable overhead efficiency variance is measured as:

Variable overhead efficiency variance = (AH × SR) − (SH × SR)

This measures if more or less of the company's allocation base was used compared to what was expected based on standards.

Review Direct Materials Variance Analysis, Direct Labor Variance Analysis, and Variable Manufacturing Overhead Variance Analysis.

8d. Analyze a set of variances to determine which ones to investigate

Why are all variances not automatically investigated?
What is meant by management by exception?
What are some methods that can be used to determine which variances to investigate and which not to?
What are some of the drawbacks associated with only investigating variances that are above a certain percentage of a flexible budgeted amount?

Investigating variances can become very costly. These costs may involve employees spending time talking with personnel from different areas of an organization to determine the cause of variances as well as fighting out how to control costs in the future. Thus, managers tend to only invest time and energy into investigating variances that seem significant. This is known as management by exception.

Every company needs to establish criteria for themselves to use in determining which variances to investigate and which can be safely ignored. Many times a company will only investigate a variance that is above a certain percentage of the flexible budget. However, if the item in question has a relatively small dollar amount, a large percentage variance might not indicate any real issue. Other companies may investigate all variances above a certain dollar amount. Here too, depending on how large the item in question is, this may or may not indicate a real issue. Some companies may combine the two options and investigate variances that are above a certain dollar amount as well as being above a certain percentage of the flexible budget.

Review Determining Which Cost Variances to Investigate.

8e. Explain how to use cost variance analysis with activity-based costing

Why is there a need to slightly modify cost variance analysis when using activity-based costing?
Why will a company using activity-based costing always have to calculate more variances than those using a traditional costing method?
How would you calculate a spending variance or an efficiency variance when using activity-based costing?

If a company is using activity-based costing, that means that instead of one overhead rate, there are numerous overhead rates; one for each cost activity. Therefore, the process of variance analysis will entail several standard variable overhead rates and quantities, each having its own cost driver. Other than that, the method to analyze variances would be the same as under traditional costing.

Namely, the variable overhead spending variance for activity-based costing would be calculated for each activity as follows (repeated from 8c.):

Variable overhead spending variance = Actual costs − (AH × SR)

AQ = actual quantity of whatever activity we are measuring and SR = the standard rate for that activity.

The variable overhead efficiency variance for each activity would be calculated as follows (repeated from 8c.):

Variable overhead efficiency variance = (AH × SR) − (SH × SR)

SQ is the standard quantity for that activity.

Review Using Variance Analysis with Activity-Based Costing.

Unit 8 Vocabulary

This vocabulary list includes terms you will need to know to successfully complete the final exam.

attainable standards
favorable variance
flexible budgets
ideal standards
labor efficiency variance
labor rate variance
management by exception
materials price variance
materials quantity variance
production
standard costs
standard hours for direct labor
standard price for direct materials
standard quantity for direct materials
standard quantity for variable manufacturing overhead
standard rate for direct labor
standard rate for variable manufacturing overhead
unfavorable variance
variable overhead efficiency variance
variable overhead spending variance