1 INTRODUCTION In this lesson we explain the objective of analysis and provide a practical example of how the difference between budgeted and actual profit can be broken down into its constituent elements by analysing the sales margin and production cost s. YOUR AIMS At the end of this lesson you should be able to: state the objectives of analysis define the main s understand the linkage between individual s and the difference between budgeted and actual profit explain the potential causes of favourable and adverse s reconcile budgeted and actual profit using analysis appreciate the significance of s.
2 OBJECTIVE OF VARIANCE ANALYSIS A is the difference between standard and actual cost. In order that effective action may be taken, it is necessary both to calculate and to classify the. Classification is required to identify the cause of the (e.g. material price rise, increased labour usage) and the reasons why it occurred. Variances that are not meaningful, not reported promptly, and not acted upon do not meet management's requirement of standard costing. The objective of analysis is to analyse the difference between actual and expected (budgeted) profit into the constituent elements of labour, material, overheads and sales. For this to be useful the s once classified and calculated must then be subject to investigation with the following points being addressed. Is the significant? Minor variations are unlikely to be worth investigating. Is the reporting timely? Is the reporting to the right people who can take responsibility? Is there a relationship between s? A decrease in material price may be linked to an increase in material usage due to poorer quality (cheaper) material resulting in increased wastage. Where the shows that the actual cost is less than the standard, then this is a 'favourable' and where the actual cost is greater than the standard, this is an 'adverse'.
3 The diagram below shows the most common s and the relationship between them. The total of the linked s equals the overall operating profit. Direct labour total Rate Efficiency Direct materials total Price Usage Total cost Variable overhead Expenditure Efficiency Operating profit Fixed overhead Expenditure Volume Capacity Efficiency Total sales margin Sales margin price Sales margin quantity
4 VARIANCE ANALYSIS EXAMPLE We shall examine each of the common s by using the following example: Axe Ltd. Profit & Loss Statement for year ending 31 March 1991. Budget Actual Variance Sales 100 000 78 400 21 600 A Production Cost Direct labour 30 000 25 080 4 920 F Direct materials 20 000 12 000 8 000 F Variable overhead 8 000 6 930 1 070 F Fixed overhead 32 000 32 390 390 A 90 000 76 400 13 600 F Profit 10 000 2 000 8 000 A A = Adverse F = Favourable
5 The Profit and Loss statement was derived from the following information: Budget Actual Sales units 20 000 16 000 price 5.00 4.90 Production units 20 000 16 000 Labour hours paid 40 000 33 000 rate/hour 0.75 0.76 Material tonnes 20 000 11 811 price/tonne 1 1.016 Variable overhead hours 40 000 33 000 rate/hour 0.20 0.21 Fixed overhead hours 40 000 rate/hour 0.80 } 32 390 actual incurred Total production cost/unit 4.50 The standard direct labour hours per unit = 2 hours The standard direct material per unit = 1 tonne The standard profit margin per unit is 0.50 (5.00 4.50) The shown against each item in the Profit and Loss statement gives a breakdown of the adverse profit of 8000. Why is the information potentially misleading?
6 The s relate only to cost and not to cost and volume. The favourable production cost s are comparing the costs associated with 16 000 units against the budget costs for 20 000 units. For a meaningful comparison we need to calculate the s produced when the actual costs of producing 16 000 units are compared against the standard cost of that level of production. Budget Actual Variance Sales 80 000 78 400 1 600 A Production Cost Direct labour 24 000 25 080 1 080 A Direct materials 16 000 12 000 4 000 F Variable overheads 6 400 6 930 530 A Fixed overheads 25 600 32 390 6 790 A 72 000 76 400 4 400 A Profit 8 000 2 000 6 000 A This statement has the drawback of not relating the to the actual revenue generated. To do this, an operating statement can be drawn up which includes sales revenue on the basis of the difference between budgeted revenue and actual profit:
7 Budgeted Sales Revenue 100 000 Variance (21 600) Actual Sales Revenue 78 400 Standard Cost of Actual Production (72 000) Direct labour (1 080) Direct material 4 000 Variable overhead (530) Fixed overhead (6 790) Actual Production Costs (76 400) Actual Profit 2 000
8 ANALYSIS OF VARIANCE TOTAL VARIANCE A total is the difference between the actual cost (or revenue) and the standard cost (or revenue). A total is analysed into two elements : price how the actual price differs from the standard price volume how the actual amount bought (or sold) differs from the standard volume. We shall now consider each in turn using the same example of Axe Ltd before looking at the interrelationship between the individual and total s.
9 DIRECT LABOUR COST VARIANCE DIRECT LABOUR TOTAL VARIANCE This is the difference between the actual amount paid and the amount that should have been paid to produce the actual production achieved. Actual hours actual rate 25 080 Standard hours to produce actual output standard rate 24 000 1 080 A This total can be further analysed into price (rate) and volume (efficiency) s. Rate Variance This analyses the difference between what was paid and what should have been paid for the actual hours worked. Actual hours actual rate 25 080 Actual hours standard rate 24 750 Direct labour rate 330 A This shows that the rate increased and caused an adverse labour rate.
10 Efficiency Variance This analyses the difference between the actual hours at the standard rate and the standard cost for the actual production. By monitoring the rate at the standard rate it measures the level of efficiency (hours of labour required) achieved in actual production against the standard expected. Actual hours standard rate 24 750 Standard hours to produce actual output standard rate 24 000 750 A This shows that more labour hours were required than the standard amount for the actual level of production achieved. The two s added together give the total (this applies in all cases) : Direct Labour: Rate 330 A Efficiency 750 A Total 1080 A
11 What could cause adverse or favourable direct labour rate and efficiency s? Rate Different grade of labour Unplanned overtime Unplanned bonus Higher/Lower wage increases than expected. Efficiency Incorrect grade of labour Different working conditions Poor supervision Poor quality of materials Work to rule.
12 DIRECT MATERIAL COST VARIANCE DIRECT MATERIAL TOTAL VARIANCE This is the difference between the actual cost of the materials and the amount they should have cost in order to produce the actual production achieved. Actual amount actual price 12 000 Standard amount standard price 16 000 4000 F This can be sub-analysed into price and usage (volume) s. Price Variance This analyses the difference between what was actually paid and what should have been paid for the amount actually used. Actual materials actual price 12 000 Actual materials standard price 11 811 189 A This shows that the actual price (1.016/tonne) was greater than the expected price (1/tonne).
13 Usage Variance This analyses the difference between the standard cost of the actual amount of materials used and the standard cost of the amount of materials that should have been required to produce the actual output. Actual amount standard price 11 811 Standard amount to produce actual output standard price 16 000 4 189 F This shows less than expected material usage for the actual output achieved. What could cause adverse or favourable direct material price and usage s?
14 Price Quantity discounts (loss or gain) Different quality/different material Different supplier. Usage Different quality/different material Higher/Lower production waste Levels of theft Different mix of materials Different quality of staff.
15 VARIABLE OVERHEAD COST VARIANCE It should be recalled from the earlier lessons that overheads can be absorbed using predetermined overhead absorption rates. (If marginal costing is used only variable overheads are absorbed and hence analysed.) It is assumed that variable overheads are incurred with the labour hours worked and this forms the basis of variable overhead analysis. VARIABLE OVERHEAD TOTAL VARIANCE This is the difference between what the variable overhead did cost and what it should have cost for the actual output achieved. Actual hours actual rate 6930 Standard cost (16 000 2 hours 0.20) 6400 530 A This can be sub-analysed into expenditure (rate) and efficiency (usage) s.
16 Expenditure Variance This analyses the difference between the actual variable overhead cost and the cost that should have been incurred for the actual hours worked. Actual hours actual rate 6930 Actual hours standard rate 6600 330 A This shows that the actual rate was greater than expected. Efficiency Variance This analyses the difference between the cost of the actual hours worked at the standard variable overhead rate and the standard hours allowed to produce the actual output achieved at the standard variable overhead rate. Actual hours standard rate 6 600 Standard hours to produce actual output standard rate 6 400 200 A This shows that the actual hours worked were greater than expected.
17 FIXED OVERHEAD COST VARIABLE FIXED OVERHEAD TOTAL VARIANCE This is the difference between what the fixed overhead cost and what it should have cost for the actual output achieved. Actual cost 32 390 Standard hours to produce actual output standard rate 25 600 6 790 A This can be sub-analysed into expenditure and volume s. Expenditure Variance Fixed costs do not vary with the level of production. Therefore the expenditure can be calculated by comparing actual to budgeted cost. Actual cost 32 390 Budgeted cost 32 000 390 A This shows actual fixed costs to have been greater than expected.
18 Volume Variance As with variable overheads, fixed overheads are normally recovered on the basis of direct labour hours (budgeted fixed costs are divided by budgeted direct labour hours): this analyses the difference caused by an alteration in the volume of production. Budgeted cost = 32 000 Budgeted labour hours = 40 000 Fixed overhead absorption rate = 32 000 40 000 =. 080hour / Budgeted hours standard rate 32 000 Standard hours to produce actual output standard absorption rate 25 600 6 400 A This shows that an under-recovery of fixed overheads is caused by budgeted hours exceeding standard hours. The reverse would also hold true. The volume can be sub-divided into two further s which explain why the level of activity differed from the budgeted level.
19 Capacity Variance This is the over- or under-recovery of overhead because more or less than the budgeted number of hours were worked. Budgeted hours standard rate 32 000 Actual hours standard rate 26 400 5 600 A Efficiency Variance This is caused by the use of more or less than the standard number of hours for the production of the actual output achieved. Actual hours standard rate 26 400 Standard hours to produce actual output standard rate 25 600 800 A Note that the efficiency (800 A) plus the capacity (5600 A) equals the volume (6400 A).
20 What could cause adverse or favourable overhead expenditure and capacity s? Expenditure Increase in indirect costs (supplies and services). Capacity Variations in demand. Shortages of material/labour. Breakdowns increased idle time.
21 That concludes the examination of expenditure s. It is now possible to show how each and sub- builds up to the total cost : 4400 A Total cost 1080 A 4000 F 530 A 6790 A Direct labour Direct material Variable overhead Fixed overhead 330 A 750 A 330 A 200 A 390 A 6400 A Rate Efficiency Expenditure Efficiency Expenditure Volume 189 A 4189 F 5600 A 800 A Price Usage Capacity Efficiency
22 SALES MARGIN VARIANCE The cost s we have examined are used to control costs. To achieve planned profit, management also need to control profit. This is done by the calculation and examination of sales margin s. Sales margin analysis takes products at standard cost. This is because the cost analysis has already taken into account all the differences between actual and budgeted costs. SALES MARGIN TOTAL VARIANCE This is the difference between the actual sales margin and the budgeted sales margin. The cost of sales is valued at the standard cost of production for both the actual and budgeted sales margin. Actual sales actual margin 6 400 [16 000 (4.90 4.50)] Budgeted sales standard margin 10 000 [20 000 (5.00 4.50)] 3 600 A This obviously differs from the earlier sales that was calculated. This explains the difference between actual and budgeted sales margin and enables an operating statement to be produced that reconciles the difference between budgeted and actual profit. First though, we will consider the sales margin sub-s.
23 Price Variance This analyses the difference between the actual margin per unit and the standard margin per unit for the actual level of sales. This basically gives the price. Actual sales actual margin 6400 Actual sales standard margin 8000 1600 A This shows the effect of a change in the profit margin. Note that it gives the same result as the standard sales calculated on page 6. Consider why this is so. Volume Variance This analyses the difference between actual sales and the budgeted sales, both valued at the standard margin per unit. Actual sales standard margin 8 000 Budgeted sales standard margin 10 000 2 000 A This shows the effect of a change in the volume of sales.
24 OPERATING STATEMENT PROFIT RECONCILIATION The first operating statement that was produced reconciled budgeted revenue and actual profit. Having calculated the sales margin it is now possible to produce an operating statement that reconciles budgeted profit and actual profit. This provides management with a concise statement incorporating each and explains the difference between the anticipated, budgeted profit and the actual result: AXE LTD Operating statement for year ending 31 March 2006 (Adverse s are shown in parentheses) Budgeted Profit 10 000 Sales Margin Variance Price (1600) Volume (2000) Total Sales Margin Variance (3600) 6400
25 Production Cost Variance Labour rate (330) efficiency (750) Material price (189) usage 4189 Variable expenditure (330) efficiency (200) Fixed expenditure (390) capacity (5600) efficiency (800) Total Production Cost Variance (4400) Actual Profit 2000
26 SIGNIFICANCE OF VARIANCES Variance analysis does not establish the reason for a occurring nor does it correct it. It simply highlights the and then it is management's responsibility to establish the reasons for it and to take the necessary action to correct it. Standard costing is management by exception. However, not all s are significant and need investigating, especially when it is remembered that time and cost are likely to be incurred. A control range is normally set, for example ±10% of the standard cost, and provided that the lies within this range it is not regarded as significant and therefore will not be investigated. The control range is usually set by estimation based upon previous experience. There are likely to be different ranges for different standard costs based upon the nature of the cost involved and the experience gained of its operation.
27 NOTES
28 SELF-ASSESSMENT QUESTIONS 1. What are the sub-s of the fixed overhead? 2. Define the labour rate. 3. What are the likely causes of a labour rate? 4. A company producing sprockets has set its budget to produce 8000 units in each period. The unit standards are: Sales price : 12.00 Direct labour : 12 mins at 10.00/hour Direct material : 250g at 6.00/kg Variable overhead : 20.00/hour Fixed overhead : 75% direct labour cost The actual production in the period was 8200 units with costs as follows: Sales revenue : 99 200 Direct labour : 1515 hours costing 15 301.50 Direct material : 2200 kg costing 12 980 Variable overheads : 35 250 Fixed overheads : 11 800 Prepare an operating statement reconciling the budgeted and actual profit for the period.
29 NOTES
30 ANSWERS TO SELF-ASSESSMENT QUESTIONS 1. Fixed overhead Expenditure Volume Capacity Efficiency 2. The labour rate analyses the difference between what was paid and what should have been paid for the actual hours worked. It is actual hours worked multiplied by the actual rate minus the actual hours worked multiplied by the standard rate. 3. The likely causes of a labour rate are: different grade of labour unplanned overtime unplanned bonus higher/lower wage increases than expected.
31 4. Budgeted Profit 24 000 Sales Margin Variance Price 800* Volume 600 Total Sales Margin Variance 1 400 25 400 Production Cost Variance Labour rate (151.50) efficiency 1250 Material price 220 usage (900) Variable expenditure (4950) efficiency 2500 Fixed expenditure 200 capacity (637.50) efficiency 937.50 Total Production Cost Variance (1531.50) Actual Profit 23 868.50 *We have already seen that the sales margin price is the same as the standard sales (page 22), so: Sales Margin Price Variance = (Actual sales actual price) (Actual sales standard price) = Total sales revenue (Actual sales standard price) = 99 200 (8200 12) = 99 200 98 400 = 800
32 SUMMARY Variance analysis is a useful management tool which explains the difference between budgeted and actual profit. A clear understanding of how to calculate each and its relevance is required if the technique is to be applied successfully. It must be remembered that the technique only reports s. Action is required to investigate why any has occurred and to take corrective action if necessary. The point at which a becomes significant should be pre-set and it is normal for this control range to be based upon previous experience and judgement.