Chapter-3

Flexible Budgets and Standards

3.1. Static vs. Flexible budgets

3.1.1. Flexible budget
 A flexible budget is one that is allowed to adjust based on a change in the assumptions
used to create the budget during management's planning process.
 A flexible budget is a budget that adjusts or flexes for changes in the volume of activity.
 The flexible budget is more sophisticated and useful than a static budget, which remains
at one amount regardless of the volume of activity.
 To compute the value of the flexible budget, multiply the variable cost per unit by the
actual production volume. Here, the figure indicates that the variable costs of producing
125,000 should total $162,500 (125,000 units x $1.30).

3.1.2. Static Budget

 A static budget is a type of budget that incorporates anticipated values about inputs and
outputs that are conceived before the period in question begins. When compared to the
actual results that are received after the fact, the numbers from static budgets are often
quite different from the actual results.
 A static budget remains the same even if there are significant changes from the
assumptions made during planning.
 Static scheduling is the traditional method of covering shifts. You tell your supervisor at
the beginning of the semester what your class schedule looks like and they build a static
schedule of work around your classes. So you'll work the same shifts, on the same days,
at the same times each week.
 To calculate a static budget variance, simply subtract the actual spend from the planned
budget for each line item over the given time period. Divide by the original budget to
calculate the percentage variance.

 Differences between fixed budget and flexible budget

Basis for
Fixed Budget Flexible Budget
Comparison
The budget designed to remain constant, The budget designed to change with
Meaning regardless of the activity level reached is the change in the activity levels is
Fixed Budget. Flexible Budget.
Nature Static Dynamic
Activity Level Only one Multiple
A static budget is a budget that does not change as volume changes. If a company's annual
master budget is a static budget, the budget for sales commission’s expense will be one amount
such as $200,000 for the year.

First, subtract the budgeted amount from the actual expense. If this expense was over budget,
then the result will be positive. Next, divide that number by the original budgeted amount and
then multiply the result by 100 to get the percentage over budget.

3.2. Standards for material and labor

Performance measure serves a critical role in attaining goals. It provides a feedback concerning
what works and what does not work and it help motivate people to sustain their effort. A
standard is a benchmark for measuring performance. They are used widely in managerial
accounting relating to quantity and cost (acquisition price) of inputs used in manufacturing goods
or providing services. Quantity standards specify how much of an input should be used to make a
product or provide service. Price standards specify how much should be paid for each input.
Actual quantities and prices are compared with these standards and if variance exists, managers
investigate the cause of the problem. This process is called management by exception.

Any type of business organization uses a standard cost. Manufacturing companies have highly
developed standard costing system in which standards for direct materials, direct labor and
overhead are created for each product. They have a standard cost cards showing the standard
quantities and costs of inputs required to produce a unit of s specific product

3.2.1 Setting standard cost

To set price and quantity standards requires the expertise of those who are responsible for
purchasing and using the inputs. This may include accountants, purchasing managers, engineers;
production supervisor etc… past records of purchase prices and input usage can be helpful in
setting standards.

Ideal vs. practical standards

Standards fall into two categories as ideal and practical standards.

Ideal standards: can be attained only under the best circumstances. They do not allow for
machine breakdown or other work interruptions. They require for level of effort that can be
attained only by the most skilled and efficient employees working at peak effort of 100% all the
time. Some managers feel that such kind of standards result in continuous improvement.
Variances from such standards are difficult to interpret.

Practical standards: are standards that are “tight” but attainable. They allow for machine
downtime and employee rest periods and can be attained through reasonable but efficient efforts
by workers. Variances form these standards need management attention because they represent
deviation that fall outside of normal operating conditions.

3.2.1.1.Setting direct materials standard

The first step in setting this standard is to prepare price and quantity standards for raw materials.
The standard price per unit should reflect final, delivery cost of materials net of any discounts
taken.

Purchase price xxx

Freight xxx
Less purchase discounts (xxx)
Standard price per kg xxx

The standard quantity per unit for direct materials should reflect the amount of material required
for each unit of finished product as well as an allowance for unavoidable waste.
Materials required for one unit xxx
Allowance for waste and spoilage xxx
Allowance for rejections xxx
Standard quantity per unit xxx

3.2.1.2Setting direct labor standards

Direct labor price and quantity standards are expressed in terms of a labor rate and labor hours.
The standard rate per hour for direct labor includes wages, employment taxes and fringe benefits.

Basic wage rate per hour xxx

Employment taxes xxx
Excessive benefits xxx
 Standard rate per direct labor hour xxx
Many companies prepare a single standard rate per hour for all employees in a department which
reflects mix of workers even though actually wage rates may vary according to skills and
seniority.
The standard hour per unit is the most difficult standard to compete. There are different
approaches used to simplify the process one of which is to breakdown the task into elemental
body movements such as reaching, pushing, turning over etc… after that the standards for each
movement can be used to estimate the total time required to complete the task. Another approach
is for an industrial engineer to do time and motion study actually clocking the time required for
each task. The standard time should include allowances for breaks, personal needs of employees,
cleanup and machine down time.

Basic labor time per unit, in hour’s xxx

Allowance for breaks and personal needs xxx
Allowance for cleanup and machine downtime xxx
Allowance for rejections xxx
Standard direct labor hours per unit of product xxx
Once the rate and time standards have been set, the standard direct labor cost per unit of product
is computed as:

= direct labor hour per unit * direct labor hour rate

3.2.1.3. Setting variable manufacturing overhead standards

As with direct labor, the price and quantity standards for variable manufacturing overhead are
expressed in terms of rate and hours. The rate represent the variable portion of the predetermined
overhead rate whereas the hours relate to the activity base that is used to apply overhead to units
of product usually machine-hour or labor-time.

Therefore, standard variable manufacturing overhead cost per units is

= direct labor hour per unit * variable overhead rate

The reason for separating price and quantity standards is because these two represent the
responsibility of two managers. One is responsible for buying and the other is responsible for
using inputs. Therefore, it is important to distinguish between deviations from price standards
and deviation from quantity standards.

Inputs standard Qty/hrs standard price/rate standard cost

Direct material xx xx xx

Direct labor xx xx xx

Variable MOH xx xx xx

Total standard cost per unit xx

3.3. Understanding Variance analysis

The primary objective of variance analysis is to exercise cost control and cost reduction.
Under standard costing system, the management by exception principle is applied through
variance analysis. The variances are related to efficiency. The showing of efficiency leads to
favorable variance. In this case, the responsible persons are rewarded. On the other hand, the
showing of in efficiency leads to unfavorable variance. In this case, the responsible persons are
enquired and find the root causes for such unfavorable variances. This type of findings is used
for taking remedial action.

Meaning of Variance

A variance is the deviation of actual from standard or is the difference between actual and
standard.

Definition of Variance analysis

Variance analysis is the resolution into basic parts and explanation of variances”.

Variance analysis is the measurement of variances, location of their root causes, measuring their
effect and their disposition”.

Thus, variance analysis can be defined as the segregation of total cost variances into different
elements in such a way as to indicate or locate clearly the cause for such variances and persons
held responsible for them.

Types of Variances

There is a need of knowing types of variances before measuring the variances. Generally, the
variances are classified on the following basis.

A. On the basis of Elements of Cost.

 1. Material Cost Variance.
2. Labor Cost Variance.
3. Overhead Variance.

B. On the basis of Controllability

1. Controllable Variance.
2. Uncontrollable Variance.

C. On the basis of Impact

1. Favorable Variance.
2. Unfavorable Variance

D. On the basis of Nature

1. Basic Variance.
2. Sub-variance.

 A brief explanation of the above mentioned variances are presented below

1. Material Cost Variance: It is the difference between actual cost of materials used and
the standard cost for the actual output.
2. Labour Cost Variance: It is the difference between the actual direct wages paid and the
direct labour cost allowed for the actual output to be achieved.
3. Overhead Variance: Overhead variance is the difference between the standard cost of
overhead allowed for actual output (in terms of production units or labour hours) and the
actual overhead cost incurred.
4. Controllable Variance: A variance is controllable whenever an individual or a
department or section or division may be held responsible for that variance.

According to ICMA, London,

“Controllable cost variance is a cost variance which can be identified as primary

responsibility of a specified person”.

5. Uncontrollable Variance: External factors are responsible for uncontrollable variances.

The management has no power or is unable to control the external factors. Variances for
which a particular person or a specific department or section or division cannot be held
responsible are known as uncontrollable variances.
6. Favourable Variances: Whenever the actual costs are lower than the standard costs at
per-determined level of activity, such variances termed as favorable variances. The
management is concentrating to get actual results at costs lower than the standard costs. It
shows the efficiency of business operation.
7. Unfavorable Variances: Whenever the actual costs are more than the standard costs at
predetermined level of activity, such variances termed as unfavorable variances. These
 variances indicate the inefficiency of business operation and need deeper analysis of
these variances.
8. Basic Variances: Basic variances are those variances which arise on account of monetary
rates (i.e. price of raw materials or labour rate) and also on account of non-monetary
factors (such as physical units in quantity or time). Basic variances due to monetary
factors are material price variance, labour rate variance and expenditure variance.
Similarly, basic variances due to non-monetary factors are material quantity variance,
labour efficiency variance and volume variance.
9. Sub Variance: Basic variances arising due to non-monetary factors are further analyzed
and classified into sub-variances taking into account the factors responsible for them.
Such sub variances are material usage variance and material mix variance of material
quantity variance. Likewise, labour efficiency variance is subdivided into labour mix
variance and labour yield variance. At the same time, variable overhead variance is sub-
divided into variable overhead efficiency variance and variable overhead expenditure
variance.

Advantages of Variance analysis

The following are the merits of variance analysis.

1. The reasons for the overall variances can be easily find out for taking remedial action.

2. The sub-division of variance analysis discloses the relationship prevailing between different
variances.

3. It is highly useful for fixing responsibility of an individual or department or section for each
variance separately.

4. It highlights all inefficient performances and the extent of inefficiency.

5. It is used for cost control.

6. The top management can follow the principle of management by exception. Only unfavorable
variances are reporting to management.

7. Sometimes, the variances can be classified as controllable and uncontrollable variances. In this
case, controllable variances are taken into consideration for further action.

8. Profit planning work can be properly carried on by the top management.

9. The results of managerial action can be a cost reduction.

10. It creates cost consciousness in the minds of the every employee of business organization.
A direct materials variance results from one of two conditions: differences in the prices paid for
materials or discrepancies in the quantities used in production. To find these variances, you can
use formulas or a simple diagram approach.

3.3.1. Direct material

Using formulas to calculate direct materials variances

The total direct materials variance is comprised of two components: the direct materials price
variance and the direct materials quantity variance.

To compute the direct materials price variance, take the difference between the standard price
(SP) and the actual price (AP), and then multiply that result by the actual quantity (AQ):

Direct materials price variance = (SP – AP) x AQ

To get the direct materials quantity variance, multiply the standard price by the difference
between the standard quantity (SQ) and the actual quantity:

Direct materials quantity variance = SP x (SQ – AQ)

The total direct materials variance equals the difference between total actual cost of materials
(AP x AQ) and the budgeted cost of materials, based on standard costs (SP x SQ):

Total direct materials variance = (SP x SQ) – (AP x AQ)

For example, Band Book’s standard price is $10.35 per pound. The standard quantity per unit is
28 pounds of paper per case. This year, Band Book made 1,000 cases of books, so the company
should have used 28,000 pounds of paper, the total standard quantity (1,000 cases x 28 pounds
per case). However, the company purchased 30,000 pounds of paper (the actual quantity), paying
$9.90 per case (the actual price).

Based on the given formula, the direct materials price variance comes to a positive $13,500, a
favorable variance:

Direct materials price variance = (SP – AP) x AQ = ($10.35 – $9.90) x 30,000 = $13,500
favorable

This variance means that savings in direct materials prices cut the company’s costs by $13,500.

The direct materials quantity variance focuses on the difference between the standard quantity
and the actual quantity, arriving at a negative $20,700, an unfavorable variance:

Direct materials quantity variance = SP x (SQ – AQ) = $10.35 x (28,000 – 30,000) = –$20,700
unfavorable
This result means that the 2,000 additional pounds of paper used by the company increased total
costs $20,700. Now, you can plug both parts in to find the total direct materials variance.
Compute the total direct materials variance as follows:

Total direct materials variance = (SP x SQ) – (AP x AQ) = ($10.35 x 28,000) – ($9.90 x 30,000)
= $289,800 – $297,000 = –7,200 unfavorable

3.3.2. Direct labor

The difference between actual time incurred to manufacture a certain number of units and the
time allowed by standards to manufacture that number of units multiplied by standard direct
labor rate is called direct labor efficiency variance or direct labor quantity variance.

Favorable and unfavorable variance:

Like direct labor rate variance, this variance may be favorable or unfavorable. If workers
manufacture a certain number of units in an amount of time that is less than the amount of time
allowed by standards for that number of units, the variance is known as favorable direct labor
efficiency variance. On the other hand, if workers take an amount of time that is more than the
amount of time allowed by standards, the variance is known as unfavorable direct labor
efficiency variance.

The direct labor efficiency variance may be computed either in hours or in dollars. Suppose, for
example, the standard time to manufacture a product is one hour but the product is completed in
1.15 hours, the variance is 0.15 hours – unfavorable. If the labor cost is $6.00 per hour the
variance in dollars would be $0.90 (0.15 hours × $6.00). For proper financial measurement the
variance is normally expressed in dollars.

Formula

The following formula is used to calculate this variance:

Direct labor efficiency variance = (AH × SR) – (SH × SR )

Example

Nice furniture manufacturing company presents the following data for the month of March 2013.

Standard direct labor rate per hour $6.50

Actual direct labor rate per hour $6.75

Standard time to produce on unit of product 3 hours

Production during the month of March 2013 600 units

Hours worked during the month of March 1850 hours

Required:

1. Compute direct labor efficiency variance.

2. Indicate whether the variance is favorable or unfavorable.

Solution

Direct labor efficiency variance = (AH × SR) – (SH × SR )

= (1850 hours × $6.50) – (1,800 hours × $6.50)

= $12,025 – $11,700

= $325 unfavorable

The variance is unfavorable because labor worked 50 hours more than what was allowed by
standard.

Alternatively, the variance can be calculated by using factored formula as follows:

Direct labor efficiency variance = SR × (AH – SH)

= $6.50 × ( 1,850 hours – 1,800 hours * )

= $6.50 × 50 hours

= $325 Unfavorable

*Standard hours allowed to manufacture 600 units:

600 units × 3 hours = 1,800 hours

Note: The actual direct labor rate is not used to compute this variance.

Causes of unfavorable direct labor efficiency variance:

There are a lot of reasons of unfavorable direct labor efficiency variance. Some common reasons
are as follows:

1. Inexperienced workers
2. Poorly motivated workers
3. Old or faulty equipment
4. Purchase of low quality or unsuitable direct materials
5. Poor supervision
6. Insufficient demand for company’s product
 7. Frequent breakdowns
8. Shortage of raw materials
9. Just in time manufacturing s

3.3.4. Overheads

Variable Overhead Efficiency Variance

Variable Overhead Efficiency Variance Overview

The variable overhead efficiency variance is the difference between the actual and budgeted
hours worked, which are then applied to the standard variable overhead rate per hour.

The formula is:

Standard overhead rate x (Actualhours - standard hours)= Variable overhead efficiency variance

A favorable variance means that the actual hours worked were less than the budgeted hours,
resulting in the application of the standard overhead rate across fewer hours, resulting in less
expense incurred. However, a favorable variance does not necessarily mean that a company has
incurred less actual overhead; it simply means that there was an improvement in the allocation
base that was used to apply overhead.

The variable overhead efficiency variance is a compilation of production expense information

submitted by the production department, and the projected labor hours to be worked, as
estimated by the industrial engineering and production scheduling staffs, based on historical and
projected efficiency and equipment capacity levels. It is entirely possible that an improperly-set
standard number of labor hours can result in a variance that does not represent the actual
performance of an entity. Consequently, investigation of the variable overhead efficiency
variance should encompass a review of the validity of the underlying standard.

Variable Overhead Efficiency Variance Example

The cost accounting staff of Hodgson Industrial Design calculates, based on historical and
projected labor patterns, that the company's production staff should work 20,000 hours per
month and incur $400,000 of variable overhead costs per month, so it establishes a variable
overhead rate of $20 per hour. In May, Hodgson installs a new materials handling system that
significantly improves production efficiency and drops the hours worked during the month to
19,000. The variable overhead efficiency variance is:

$20 Standard overhead rate/hour x (19,000 hours worked - 20,000 standard hours)
= $20,000 Variable overhead efficiency variance
 Chapter- 4.
Measuring Mix and Yield Variances

4.1. Sales variance is the difference between actual sales and budget sales. It is used to measure
the performance of a sales function, and/or analyze business results to better understand market
conditions.

When calculating sales variances as part of variance analysis, one issue that arises is when a
company sells more than one product. Two possible scenarios can occur:

 If customers are unlikely to buy one product instead of another from the same company,
then separate sales volume variances can be calculated
 If, on the other hand, customers might substitute one product for another, then the
concept of sales mix is important and separate sales volume variances can be replaced by
a combined sales mix variance.

Calculation

Sales variances can be explained as follows :

(1) Sales price variances are calculated by comparing the actual selling price per unit and the
budgeted selling price per unit; each price variance is multiplied by the number of units for each
type of product.

(2) A sales volume variance is the difference between the actual number of units sold, and the
budgeted number. Each difference is multiplied by the budgeted profit per unit. Sales volume in
turns splits into a sales mix variance and a sales quantity variance.

(3) A sales mix variance indicates the effect on profit of changing the mix of actual sales from
the standard mix. A Sales Mix variance can be calculated in one of two ways :
(a) The difference between the actual total quantity sold in the standard mix and the actual
quantities sold, valued at the standard profit per unit;

(b) The difference between the actual sales and budgeted sales, valued at the standard profit per
unit less the budgeted weighted average profit per unit.

(4) A sales quantity variance indicates the effect on profit of selling a different total quantity
from the budgeted total quantity. Like the mix variance, it can be calculated in one of two ways :

(a) The difference between actual sales volume in the standard mix and budgeted sales valued at
the standard profit per unit.

(b) The difference between actual sales volume and budgeted sales valued at the weighted
average profit per unit.

4.1.3. Market-size and market-share variance.

a. Market-Share Variance
The market-share variance is the difference in budgeted contribution margin for actual market
size in units caused solely by actual market share being different from budgeted market share.
The formula for computing the market share variance is as follows:

M-SH-V =AMS-in units* (A.M.SH-B.M.SH.) *Budgeted contribution margin per unit

b. Market-Size Variance
The market-size variance is the difference in budgeted contribution margin at budgeted market
share caused solely by actual market size in units being different from budgeted market size in
units. The formula for computing the market size variance is as follows:

M-Size-variance =AMS-in units* (AMS-BMS) *BCM per unit*B.M.Share

4.2. Input variances

I. Material Variance:

The following variances constitute materials variances:

Material Cost Variance:

Material cost variance is the difference between the actual cost of direct material used and stand-
ard cost of direct materials specified for the output achieved. This variance results from
differences between quantities consumed and quantities of materials allowed for production and
from differences between prices paid and prices predetermined.

This can be computed by using the following formula:

Material cost variance = (AQ X AP) – (SQ X SP)

Where AQ = Actual quantity

AP = Actual price

SQ = Standard quantity for the actual output

SP = Standard price

Material Usage Variance:

The material quantity or usage variance results when actual quantities of raw materials used in
production differ from standard quantities that should have been used to produce the output
achieved. It is that portion of the direct materials cost variance which is due to the difference
between the actual quantity used and standard quantity specified.

As a formula, this variance is shown as:

Materials quantity variance = (Actual Quantity – Standard Quantity) x Standard Price

A material usage variance is favorable when the total actual quantity of direct materials used is
less than the total standard quantity allowed for the actual output.

Example:

Compute the materials usage variance from the following information:

Standard material cost per unit Materials issued

Material A — 2 pieces @ Rs. 10=20 (Material A 2,050 pieces)

Material B — 3 pieces @ Rs. 20 =60 (Material B 2,980 pieces)

Total = 80

Units completed 1,000

Solution:

Material usage variance = (Actual Quantity – Standard Quantity) x Standard Price

Material A = (2,050 – 2,000) x Rs. 10 = Rs. 500 (unfavourable)

Material B = (2980 – 3000) x Rs. 20 = Rs. 400 (favourable)

Total = Rs. 100 (unfavourable)

It should be noted that the standard rather than the actual price is used in computing the usage
variance. Use of an actual price would have introduced a price factor into a quantity variance.
Because different departments are responsible, these two factors must be kept separate.

4.2.1(a) Material Mix Variance:

The materials usage or quantity variance can be separated into mix variance and yield variance.

For certain products and processing operations, material mix is an important operating variable,
specific grades of materials and quantity are determined before production begins. A mix
variance will result when materials are not actually placed into production in the same ratio as
the standard formula. For instance, if a product is produced by adding 100 kg of raw material A
and 200 kg of raw material B, the standard material mix ratio is 1: 2.

Actual raw materials used must be in this 1: 2 ratio, otherwise a materials mix variance will be
found. Material mix variance is usually found in industries, such as textiles, rubber and
chemicals, etc. A mix variance may arise because of attempts to achieve cost savings, effective
resources utilisation and when the needed raw materials quantities may not be available at the
required time.

Materials mix variance is that portion of the materials quantity variance which is due to the
difference between the actual composition of a mixture and the standard mixture.

It can be computed by using the following formula:

Material mix variance = (Standard cost of actual quantity of the actual mixture – Standard cost of
actual quantity of the standard mixture)

Or

Materials mix variance = (Actual mix – Revised standard mix of actual input) x Standard price

Revised standard mix or proportion is calculated as follows:

Standard mix of a particular material/Total standard quantity x Actual input

Example:

A product is made from two raw materials, material A and material B. One unit of finished
product requires 10 kg of material.

The following is standard mix:

During a period one unit of product was produced at the following costs:

Compute the materials mix variance.

Solution:

Material mix variance = (Actual proportion – Revised standard proportion of actual input) x
Standard price.
4.2.1(b) Materials Yield Variance:

Materials yield variance explains the remaining portion of the total materials quantity variance. It
is that portion of materials usage variance which is due to the difference between the actual yield
obtained and standard yield specified (in terms of actual inputs). In other words, yield variance
occurs when the output of the final product does not correspond with the output that could have
been obtained by using the actual inputs. In some industries like sugar, chemicals, steel, etc.
actual yield may differ from expected yield based on actual input resulting into yield variance.

The total of materials mix variance and materials yield variance equals materials quantity or
usage variance. When there is no materials mix variance, the materials yield variance equals the
total materials quantity variance. Accordingly, mix and yield variances explain distinct parts of
the total materials usage variance and are additive.

The formula for computing yield variance is as follows:

Yield Variance = (Actual yield – Standard Yield specified) x Standard cost per unit

Example:

Standard input = 100 kg, standard yield = 90 kg, standard cost per kg of output = Rs 200

Actual input 200 kg, actual yield 182 kg. Compute the yield variance.

In this example, there is no mix variance and therefore, the materials usage variance will be
equal to the materials yield variance.

The above formula uses output or loss as the basis of computing the yield variance. Yield vari-
ance can also be computed on the basis of input factors only. The fact is that loss in inputs equals
loss in output. A lower yield simply means that a higher quantity of inputs have been used and
the anticipated or standard output (based on actual inputs) has not been achieved.

Yield, in such a case, is known as sub-usage variance (or revised usage variance) which can
be computed by using the following formula:

Sub-usage or revised usage variance = (Revised Standard Proportion of Actual Input – Standard
quantity) x Standard Cost per unit of input

Example:

Standard material and standard price for manufacturing one unit of a product is given
below:
Materials yield variance always equal sub-usage variance. The difference lies only in terms of
calculation. The former considers the output or loss in output and the latter considers standard
inputs and actual input used for the actual output. Mix and yield variance both provide useful
information for production control, performance evaluation and review of operating efficiency.

Materials Price Variance:

A materials price variance occurs when raw materials are purchased at a price different from
standard price. It is that portion of the direct materials which is due to the difference between
actual price paid and standard price specified and cost variance multiplied by the actual quantity.
Expressed as a formula,

Materials price variance = (Actual price – Standard price) x Actual quantity

Materials price variance is un-favourable when the actual price paid exceeds the predetermined
standard price. It is advisable that materials price variance should be calculated for materials
purchased rather than materials used. Purchase of materials is an earlier event than the use of
materials.

Therefore, a variance based on quantity purchased is basically an earlier report than a variance
based on quantity actually used. This is quite beneficial from the viewpoint of performance
measurement and corrective action. An early report will help the management in measuring the
performance so that poor performance can be corrected or good performance can be expanded at
an early date.

Recognizing material price variances at the time of purchase lets the firm carry all units of the
same materials at one price—the standard cost of the material, even if the firm did not purchase
all units of the materials at the same price. Using one price for the same materials facilities
management control and simplifies accounting work.

If a direct materials price variance is not recorded until the materials are issued to production, the
direct materials are carried on the books at their actual purchase prices. Deviations of actual
purchase prices from the standard price may not be known until the direct materials are issued to
production.

Example:

Assuming in Example 1 that material A was purchased at the rate of Rs 10 and material B
was purchased at the rate of Rs 21, the material price variance will be as follows:

Materials price variance = (Actual Price – Standard Price) x Actual Quantity

Material A = (10 – 10) x 2,050 = Zero

Material B = (21 – 20) x 2,980 = 2980 (un-favourable)

Total material price variance = Rs 2980 (un-favourable)

The total of materials usage variance and price variance is equal to materials cost variance.
II. Labour Variances:

Direct labour variances arise when actual labour costs are different from standard labour costs. In
analysis of labour costs, the emphasis is on labour rates and labour hours.

Labour variances constitute the following:

Labour Cost Variance:

Labour cost variance denotes the difference between the actual direct wages paid and the
standard direct wages specified for the output achieved.

This variance is calculated by using the following formula:

Labour cost variance = (AH x AR) – (SH x SR)

Where:

AH = Actual hours

AR = Actual rate

SH = Standard hours

SR = Standard rate

4.2.2 Labour Efficiency Variance:

The calculation of labour efficiency or usage variance follows the same pattern as the computa-
tion of materials usage variance. Labour efficiency variance occurs when labour operations are
more efficient or less efficient than standard performance. If actual direct labour hours required
to complete a job differ from the number of standard hours specified, a labour efficiency
variance results; it is the difference between actual hours expended and standard labour hours
specified multiplied by the standard labour rate per hour.

Labour efficiency variance is computed by applying the following formula:

Labour efficiency variance = (Actual hours – Standard hours for the actual output) x Std. rate per
hour.

Assume the following data:

Standard labour hour per unit = 5 hr

Standard labour rate per hour = Rs 30

Units completed = 1,000

Labor cost recorded = 5,050 hrs @ Rs 35

Labor efficiency variance = (5,050-5,000) x Rs 30 = Rs 1,500 (unfavorable) It may be noted that

the standard labor hour rate and not the actual rate is used in computing labor efficiency
variance. If quantity variances are calculated, changes in prices/rates are excluded, and when
price variances are calculated, standard quantities are ignored.

4.2.2(i) Labor Mix Variance:

Labor mix variance is computed in the same manner as materials mix variance. Manufacturing or
completing a job requires different types or grades of workers and production will be complete if
labor is mixed according to standard proportion. Standard labor mix may not be adhered to under
some circumstances and substitution will have to be made. There may be changes in the wage
rates of some workers; there may be a need to use more skilled or expensive types of labor, e.g.,
employment of men instead of women; sometimes workers and operators may be absent.

These lead to the emergence of a labor mix variance which is calculated by using the
following formula:

Labor mix variance = (Actual labor mix – Revised standard labor mix in terms of actual total
hours) x Standard rate per hour

To take an example, suppose the following were the standard labor cost data per unit in a
factory:

In a period, many class B workers were absent and it was necessary to substitute class B
workers. Since the class A workers were less experienced with the job, more labour hours were
used.
The recorded costs of a unit were:

Labor mix variance will be calculated as follows:

Labor mix variance = (Actual proportion – Revised standard proportion of actual total hours) x
standard rate per hour

Revised standard proportion:

4.2.2(ii) Labor Yield Variance:

The final product cost contains not only material cost but also labor cost. Therefore, gain or loss
(higher or lower output than the standard output) should take into account labor yield variance
also. A lower output simply means that final output does not correspond with the production
units that should have been produced from the hours expended on the inputs.

It can be computed by applying the following formula:

Labor yield variance = (Actual output – Standard output based on actual hours) x Av. Std. Labor
Rate per unit of output.

Or

Labour yield variance = (Actual loss – Standard loss on actual hours) x Average standard labour
rate per unit of output

Labour yield variance is also known as labour efficiency sub-variance which is computed in
terms of inputs, i.e., standard labour hours and revised labour hours mix (in terms of actual
hours).

Labour efficiency sub-variance is computed by using the following formula:

Labour efficiency sub-variance = (Revised standard mix – standard mix) x Standard rate

2. Labour Rate Variance:

Labour rate variance is computed in the same manner as materials price variance. When actual
direct labour hour rates differ from standard rates, the result is a labour rate variance. It is that
portion of the direct wages variance which is due to the difference between actual rate paid and
standard rate of pay specified.

The formula for its calculation is:

Labour rate variance = (Actual rate – Standard rate) x Actual hours

Using data from the example given above, the labour rate variance is Rs 25,250, i.e.,

Labour rate variance = (35 – 30) x 5050 hours = 5 x 5050 = Rs 25,250 (unfavourable)

The number of actual hours worked is used in place of the number of the standard hours speci-
fied because the objective is to know the cost difference due to change in labour hour rates, and
not hours worked. Favourable rate variances arise whenever actual rates are less than standard
rates; unfavourable variances occur when actual rates exceed standard rates.

3. Idle Time Variance:

Idle time variance occurs when workers are not able to do the work due to some reason during
the hours for which they are paid. Idle time can be divided according to causes responsible for
creating idle time, e.g., idle time due to breakdown, lack of materials or power failures. Idle time
variance will be equivalent to the standard labour cost of the hours during which no work has
been done but for which workers have been paid for unproductive time.

Suppose, in a factory 2,000 workers were idle because of a power failure. As a result of this, a
loss of production of 4,000 units of product A and 8,000 units of product B occurred. Each
employee was paid his normal wage (a rate of? 20 per hour). A single standard hour is needed to
manufacture four units of product A and eight units of product B.

Idle time variance will be computed in the following manner:

Standard hours lost:

Product A = 4, 000/ 4 = 1,000 hr.

Product B = 8, 000 / 8 = 1,000 hr.

Total hours lost = 2,000 hr.

Idle time variance (power failure)

2,000 hours @ Rs 20 per hour = Rs 40,000 (Adverse)

III. Overhead Variances:

The analysis of factory overhead variances is more complex than variance analysis for direct
materials and direct labour. There is no standardisation of the terms or methods used for calculat-
ing overhead variances. For this reason, it is necessary to be familiar with the different
approaches which can be applied in overhead variances.

Generally, the computation of the following overhead variances are suggested:

(1) Total Overhead Cost Variance:

This overall overhead variance is the difference between the actual overhead cost incurred and
the standard cost of overhead for the output achieved.

This can be computed by applying the following formula:

(Actual overhead incurred) – (Standard hours for the actual output x Standard overhead rate per
hour)

Or

(Actual overhead incurred) – (Actual output x Standard overhead rate per unit)

To illustrate the overall overhead variance, assume that the actual overhead for a department
amounts to Rs 1,00,000 for the month of January and standard (or allowed) hours for work
performed total 4,500 hours, while actual hours used are 5,000.

If overhead rate is Rs 20 per hour, the overall overhead variance will be the following:

(2) Variable Overhead Variance:

It is the difference between actual variable overhead cost and standard variable overhead allowed
for the actual output achieved.

The formula for computing this variance is as follows:

(Actual Variable Overhead Cost) – (Actual Output x Variable Overhead rate per unit)

Or

(Actual Variable Overhead Cost) – (Std. hours for actual output x Std. Variable overhead rate per
hour)

(3) Fixed Overhead Variance:

This variance indicates the difference between the actual fixed overhead cost and standard fixed
overhead cost allowed for the actual output.

This variance is found by using the following formula:

Fixed Overhead Variance = (Actual Fixed Overhead Cost – Fixed Overhead absorbed)

Or

(Actual Fixed Overhead Cost) – (Actual Output x Fixed Overhead rate per unit)

Or

(Actual fixed overhead cost) – (Std. hours for actual output x Std. fixed overhead rate per hour)

(4) Variable Overhead Expenditure (Spending or Budget) Variance:

This variance indicates the difference between actual variable overhead and budgeted variable
overhead based on actual hours worked.

This variance is found by using the following:

(Actual variable overhead – Budgeted variable overhead)

(5) Variable Overhead Efficiency Variance:

This variance is like labour efficiency variance and arises when actual hours worked differ from
standard hours required for good units produced. The actual quantity produced and standard
quantity fixed might be different because of higher or lower efficiency of workers employed in
the manufacturing of goods.

This variance is found by using the following formula:

(Actual hours – Standard hours for actual output) x Standard variable overhead rate per hour

(6) Fixed Overhead Expenditure (Spending or Budget) Variance:

This variance indicates the difference between actual fixed overhead and budgeted fixed
overhead.

The formula for computing this variance is as follows:

(Actual fixed overhead – Budgeted fixed overhead)

If actual fixed overhead costs are greater than budgeted fixed costs, an unfavourable variance
results because actual costs exceed the budget. Actual overhead costs seldom equal budgeted
costs because property tax rates may change, insurance premiums may increase or equipment
changes may affect depreciation rates. As an illustration, assume that a company completed
36,000 units (equal to 18,000 standard production hours) in 18,500 hours at the recorded fixed
cost of Rs 7,51,000. The standard fixed cost rate per hour is Rs 40. Therefore,
Expenditure variance = (Actual fixed overhead costs – Budgeted fixed overhead costs)

That is, = 7,51,000 – (18,500 x 40)

= 7,51,000 – 7,40,000

= Rs 11,000 (Unfavourable)

The expenditure or budget variance provides management with information which helps in
controlling costs. The budget variance is usually prepared on a departmental basis and the factors
that cause the budget variances are, therefore, controllable by departmental managers.

(7) Fixed Overhead Volume Variance:

Volume variance relates to only fixed overhead. This variance arises due to the difference
between the standard fixed overhead cost allowed (absorbed) for the actual output and the
budgeted fixed overhead based on standard hours allowed for actual output achieved during the
period. The variance shows the over-or-under-absorption of fixed overheads during a particular
period. If the actual output is more than the standard output, there is over-absorption and
variance is favourable. If actual output is less than the standard output, the volume variance is
unfavourable.

The formula for computing this variance is as follows:

(Budgeted fixed overhead applied to actual output – Budgeted fixed overhead based on standard
hours allowed for actual output)

Or

(Actual production – Budgeted production) x Std. fixed overhead rate per unit

Volume variance is further sub-divided into three variances:

(8) Fixed Overhead Calendar Variance:

It is that portion of volume variance which is due to the difference between the number of actual
working days in the period to which the budget is applicable and budgeted number of days in the
budget period.

If actual working days is more than the budgeted working days, the variance is favourable as
work has been done on days more than budgeted or allowed and vice-versa.

The formula is as follows:

(No. of actual working days – No. of budgeted working days) x Std. fixed overhead rate per day.
Calendar variance can be computed based on hours or output.
Then the formulae are:

Hours Basis:

Calendar Variance = (Revised Budget Capacity hours – Budget Hours) x Std. Fixed Overhead
rate per hour

If revised budgeted capacity hours are more than the budgeted hours, the variance will be
favourable. In the reverse situation, the variance will be unfavourable.

Output Basis:

Calendar Variance = (Revised budgeted quantity in terms of actual number of days worked –
Budgeted quantity) x Standard fixed overhead rate per unit

If revised budgeted quantity is more than the budgeted quantity; the variance is favourable; if
revised budgeted quantity is less, the variance will be unfavourable.

(9) Fixed Overhead Efficiency Variance:

It is that portion of volume variance which arises when actual hours of production used for actual
output differ from the standard hours specified for that output. If actual hours worked are less
than the standard hours, the variance is favourable and when actual hours are more than the
standard hours, the variance is unfavourable.

The formula is:

Fixed Overhead Efficiency Variance = (Actual hours – Standard hours for actual production) x
Fixed overhead rate per hour

Fixed Overhead Efficiency Variance = (Actual production – Standard production as per actual
time available) x Fixed overhead rate per unit

(10) Fixed Overhead Capacity Variance:

It is that part of fixed overhead volume variance which is due to the difference between the
actual capacity (in hours) worked during a given period and the budgeted capacity (expressed in
hours). The formula is

Capacity Variance = (Actual Capacity Hours – Budgeted Capacity) x Standard fixed overhead
rate per hour

This variance represents idle time also. If actual capacity hours are more than the budgeted
capacity hours, the variance is favourable and if actual capacity hours are less than the budgeted
capacity hours the variance will be unfavourable.
In case actual number of days and budgeted number of days are also given, then budgeted
capacity hours will be calculated in terms of actual number of days and it will be known as
revised budgeted capacity hours, i.e., budgeted hours in actual days worked.

In this situation, the formula for calculating capacity variance will be as follows:

Capacity Variance = (Actual Capacity hours – Revised Budgeted Capacity hours) x Standard
fixed overhead rate per hr.

In the above formula, the variance will be favourable if actual capacity hours are more than the
revised budgeted hours. However, if actual capacity hours are lesser than the revised budgeted
hours, the variance will be adverse as lesser hours means that lesser actual hours have been
worked taking the actual days utilised into account.

Two-way, Three-way and Four-way Variance Analysis:

The above overhead variances are also classified as Two-way, Three-way and Four-way
variance.

The different variances under these categories are listed below:

(A) Two-way Variance Analysis:

The two-way analysis computes two variances budget variance (sometimes called flexible
budget or controllable variance) and volume variance, which means:

(i) Budget variance = Variable spending variance + Fixed spending (budget) Variance + Variable
efficiency variance

(ii) Volume variance = Fixed volume variance

(B) Three -Way Variance Analysis:

The three-way analysis computes three variances spending, efficiency and volume variances.
Therefore,

(i) Spending variance = Variable spending variance + Fixed spending (budget) variance

(ii) Efficiency variance = Variable efficiency variance

(iii) Volume variance = Fixed volume variance

(C) Four-way Variance Analysis:

The four-way analysis includes:

(i) Variable spending variance

(ii) Fixed spending (budget) variance

(iii) Variable efficiency variance

(iv) Fixed volume variance.

Illustrative Problem 1:

Budgeted hours for month of March = 180 hours

Standard rate of article produced per hour = 50units

Budgeted fixed overhead = Rs 27, 000

Actual Production = 9, 2000 units

Actual hours for Production = 175 hours

Actual fixed Overhead Costs = Rs 28, 000

Calculate Overhead Cost Variances.

Solution:

1. Overhead Cost Variance:

(Actual Overhead Cost – Standard Overhead of actual output)

(Rs 28,000-9,200 units x 3)

Rs 28,000 – 27,600 = Rs 400 (unfavourable)

Standard Overhead rate per unit = Rs 27,000/(180 hrs x 50) = 27,000/9, 000 = Rs 3

2. Overhead Expenditure Variance:

(Actual Overhead – Budgeted Overhead)

(Rs 28,000 – 27,000) = Rs 1,000 (unfavourable)

3. Overhead Volume Variance:

(Budgeted Overhead for actual output – Budgeted fixed overhead)

(Rs 3 x 9,200 units – 2,700)

(27,600 – 27,000) = Rs 600 (favourable)

It can be calculated in the following manner also:

(Actual Production – Budgeted Production) x Std. rate per unit

(9,200 – 9,000) x Rs 3 = Rs 600 (favourable)

Or

(Budgeted hrs for actual production – Budgeted hours) x Std. rate per hour

( 184 hrs-180) x Rs 150

4 x 150 = Rs 600 (favourable)

For 9,000 units standard hours required = 180 hrs.

For 9,200 units standard hours (9, 200 x 180)/9, 000 = 184 hrs

Illustrative Problem 2:

From the following data, calculate overhead variances:

Solution:

1. Total Overhead Cost Variance:

Actual overhead cost – (Actual units x Std. Rate)

(Rs 3,05,000 + 4,70,000) – (16,000 x Rs 50)

Rs 7,75,000 – Rs 8,00,000 = Rs 25,000 (favourable)

Standard rate = Standard Overhead /Standard Output

2. Variable Overheads Variance:

Actual variable cost – (Actual units x Std. Rate)

4,70,000 – (16,000 x Rs 30)

Rs 4,70,000 – Rs 4,80,000 = Rs 10,000 (favourable)

3. Fixed Overhead Variance:

Actual fixed overhead cost – (Actual units x Std. Rate of fixed overhead)

3,05,000-(16,000 x 20)

3,05,000 – 3,20,000 = Rs 15,000 (favourable)

4. Volume Variance:

(Actual units x St. rate) – Budgeted fixed overheads

(16,000 x Rs 20) – Rs 3,00,000 = Rs 20,000 (favourable)

5. Expenditure Variance:

Actual fixed overheads – Budgeted fixed overheads

Rs 3,05,000 – Rs 3,00,000 = Rs 5,000 (unfavourable)

6. Capacity Variance:

Std. Rate x (Revised budget units – Budgeted units)

Revised budgeted units = Budgeted units + Increase in capacity

= 15,000 + 5/100 x 15,000= 15,750 units 100

= Capacity variance

= Rs 20 (15,750 units – 15,000 units)

= Rs 20 x 750 = Rs 15,000 (favourable)

7. Calendar Variance:
Increase or decrease in production due to more or less working days x Std. rate per unit within 25
days, standard production with increased capacity = 15,750 units within 2 days (27 – 25),

production will be increased by = (15, 750 x 2)/25 = 1,260 units

Calendar variance = 1,260 units x Rs 20

= Rs 25,200 (favourable)

8. Efficiency Variance:

Std. rate x (Actual production – Std. production)

Standard production:

Budgeted production = 15,000 units

Production increased due to increase in capacity 5% = 750 units

Now budgeted production = 15,000 + 750 = 15,750 units

Production increased due to 2 more working days

Units for 2 days = (15, 750 x 2)/25 days = 1,260 units

Total units = 15,750 + 1,260

= 17,010 units

Efficiency Variance = Rs 20 (16,000 units – 17,010 units)

Rs 20 (- 1,010 units) = Rs 20,200 (unfavourable)

Illustrative Problem 3:

In department A the following data is submitted for the week ending 31st October:
Statement of fixed overhead variances of department A:
A. Expenditure variance:

(Actual overhead – Budgeted overhead)

Rs 1,50,000 – Rs 1,40,000 = Rs 10,000 (Adverse)

B. Volume variance:

Std. fixed overhead rate per unit x (Actual output – Budgeted output)

Rs 100 (1,200 – 1,400) = Rs 20,000 (Adverse)

C. Total overhead cost variance:

(Actual overhead – Overhead recovered by actual output)

Rs 1,50,000 – Rs 1,20,000 = Rs 30,000 (Adverse)

(a) Efficiency variance:

Std. fixed overhead rate per unit x (Actual production – Std. production for actual hours)

Rs 100 (1200 – 32 x 35) = Rs 8000 (Favourable)

(b) Capacity variance:

Std. fixed overhead rate per hour (Actual hours – Standard hours)

Rs 3,500 (32 – 40) = Rs 28,000 (Adverse)

Illustrative Problem 4:

A Cost Accountant of a company was given the following information regarding the
overheads for February, 2012:

(a) Overheads cost variance Rs 1,400 adverse.

(b) Overheads volume variance Rs 1,000 adverse.

(c) Budgeted hours for February 2012, 1,200 hours.

(d) Budgeted overheads for February 2012, Rs 6,000.

(e) Actual rate of recovery of overheads Rs 8 per hour.

You are required to assist him in computing the following for February, 2012:
(1) Overheads expenditure variance.

(2) Actual overheads incurred.

(3) Actual hours for actual production.

(4) Overheads capacity variance.

(5) Overheads efficiency variance.

(6) Standard hours for actual production.

Solution:

Computation of Required Variances

(1) Overheads Expenditure Variance

= Overheads Cost Variance – Overheads Volume Variance

= Rs 1,400 (A) – Rs 1,000 (A)

= Rs 400 (A)

(2) Actual Overheads incurred

= Budgeted Overheads + Overhead Expenditure Variance

= Rs 6,000 + Rs 400 (A)

= 6,400

(3) Actual hours for actual production

Actual overheads incurred/Actual rate of recovery of overheads per hour

= Rs 6,400/8 = 800 hours

(4) Overheads Capacity Variance

= Standard Overhead x (Actual Hours – Budgeted Hours)

= 5 x (800 hours – 1,200 hours)

= Rs 2,000 (A)
= Standard Rate of Overhead = Budgeted overheads / Budgeted hours

= Rs 6, 000/1, 200 = Rs 5 per hour

(5) Overhead Efficiency Variance

= Overheads Volume variance – Overhead Capacity variance

= Rs 1,000 (A) – Rs 2,000 (F)

= Rs 1,000 (F)

(6) Standard Hours for Actual Production

Volume Variance= Standard Overheads Rate x (Standard hours for Actual Production –
Budgeted Hours) or 1,000 (A) = 5 (x- 1,200)

or 1,000 (A) = 5 x – 6,000

or -5 x = – 5,000

or x = 1,000 hours

Illustrative Problem 5:

New India Company uses a standard costing system. The company prepared its budget for 2012
at 10,00,000 machine hours for the year. Total budgeted overhead costs is Rs 12,50,00,000. The
variable overhead rate is Rs 100 per machine hour (Rs 200 per unit).

Actual results for 2012 are as follows:

Required:

(I) Compute for the fixed overhead

(a) Budgeted amount

(b) Budgeted cost per machine hour

(c) Actual cost

(d) Volume variance

(II) Compute variable overhead spending variance and variable overhead efficiency variance.

Solution:

(I) For fixed overhead:

(a) Budgeted Amount:

Total budgeted overhead = Rs 12,50,00,000

Less: Budgeted variable overhead (10,00,000 machine hrs x Rs 100 budgeted rate per machine
hour) = 10,00,00,000

Budgeted fixed overhead 2,50,00,000

(b) Budgeted (fixed) cost per machine hour:

= Rs 2,50,00,000 budgeted amount/10,00,000 budgeted machine hours

= Rs 25 per machine hour

(c) Actual cost (fixed):

It is calculated through fixed overhead spending variance.

Fixed overhead spending variance = Actual cost incurred – Budgeted amount

Actual cost = Budgeted amount + Unfavourable spending variance

= 2,50,00,000+ 60,00,000 A

= Rs 3,10,00,000

Because fixed overhead spending variance is unfavourable, the amount of actual costs is higher
than the budgeted amount.

(d) Production Volume Variance:

Budgeted variable overhead per unit = Rs 200

Budgeted variable overhead rate = Rs 100 per machine hour

Therefore budgeted machine hours allowed per unit = Rs 200/Rs 100

= 2 machine hours

Formula:

Budgeted fixed overhead – Fixed overhead absorbed or allowed for actual output units

= Rs 2,50,00,000 – (Rs 25 per machine hour x 2 machine hours per unit x 4,98,000 units)

= Rs 2,50,00,000 – Rs 2,49,00,000 (absorbed fixed overhead)

= Rs 1,00,000 Adverse

Or

Another formula:

(St hrs for actual production – Budgeted hrs) x St. fixed overhead rate per hr

= (2 x 4,98,000) – (10,00,000 hrs) x Rs 25

= (9,96,000 hrs – 10,00,000 hrs) x Rs 25

= Rs 1,00,000 Adverse

Or

Another formula:

(Budgeted production – Actual production) x St. fixed overhead rate per unit

Standard fixed overhead rate per unit = Budgeted fixed overhead/Budgeted units

= Rs 2,50,00,000/5,00,000 units

= Rs 50 per unit

Budgeted units = 2 machine hour needed for 1 unit

In 10,00,000 machine hours, units produced will be

= 10,00,000/2 = 5,00,000 units

Now, applying the formula

(5,00,000 units – 4,98,000 units) x Rs 50

= 2,000 units x Rs 50 = Rs 1,00,000 Adverse

(II) For Variable overhead

(a) Variable overhead spending variance:

(Budgeted Variable overhead cost – Actual Variable overhead)

Budgeted variable overhead cost = Actual hrs works x St. Variable overhead rate per hour

= 9,60,000 hrs x Rs 100

= Rs 9,60,00,000

Now, applying the formula

(Rs 9,60,00,000 – Rs 10,08,00,000)

= Rs 48,00,000 Adverse

Or

Another formula:

(St. machine hr rate – Actual machine hr rate) x Actual hrs worked

= (Rs 100 – Rs 10, 08, 00, 000/9, 00, 000 hrs) x 9, 60, 000 hrs

= (Rs 100 – Rs 105) x 9,60,000 hrs

= Rs 48,00,000 Adverse

(b) Variable overhead efficiency Variance:

(St. hours for actual output – Actual hrs) x St. Variable overhead rate per hour

= ((4,98,000 units x 2 hrs) – 9,60,000 hrs) x Rs 100

= (9,96,000 hrs – 9,60,000 hrs) x Rs 100

= 36,000 hours x Rs 100

= Rs 36,00,000 Favourable

Note:

The other variances, although not asked in the question, have been computed as below.

(Ill) For Fixed overhead:

Calender Variance, Efficiency Variance, Capacity Variance.

(a) Fixed overhead Calender Variance:

= (Budgeted hrs – Revised budgeted Capacity hrs) x St. fixed overhead rate per hour

= (10,00,000 hrs – 2 hrs x 4,98,000 units) x Rs 25

= (10,00,000 hrs – 9,96,000 hrs) x Rs 25

= 4,000 hrs x 25 = Rs 1,00,000 Adverse

Variance is adverse because of lesser use of hours available.

(b) Fixed overhead Efficiency Variance:

(st. hr for actual production – Actual hrs) x Fixed overhead rate per hour

= (2 hrs x 4,98,000 units) – 9,60,000 hrs ) x 25

= (9,96,000 hrs – 9,60,000 hrs) x 25

= 36,000 hrs x Rs 25

= Rs 9,00,000 F

It is favourable because actual hrs are less than standard hours.

(c) Fixed Overhead Capacity Variance:

(Budgeted Capacity hrs – Actual Capacity hours) x St. fixed overhead rate per hr

= (9,96,000 hrs – 9,60,000 hrs) x Rs 25

= 36,000 hrs x Rs 25

= Rs 9,00,000 Adverse
Since actual hours are less than budgeted hours, in terms of capacity utilisation, it indicates
Adverse Variance

Fixed Overhead Expenditure Variance:

(also known as Spending or Budget Variance)

(Budgeted fixed overhead – Actual fixed overhead)

= Rs 2,50,00,000 – Rs 3,10,00,000

= Rs 60,00,000 Adverse

This is already given in the question.

Fixed Overhead Variance:

(budgeted fixed overhead cost – Actual fixed overhead cost)

Budgeted fixed overhead cost =

(i) Actual output units x St. fixed overhead rate per unit

Or

(ii) St. hours for actual output x St. fixed overhead rate per hour

Applying the formula:

(i) (4,98,000 units x Rs 50 per unit) – Rs 3,10,00,000

= 2,49,00,000-3,10,00,000

= Rs 61,00,000 Adverse

Or

(ii) (9,96,000 hrs x Rs 25 per hr) – Rs 3,10,00,000

= Rs 2,49,00,000 – Rs 3,10,00,000

= Rs 61,00,000 Adverse

Verification:
Fixed overhead Variance = Fixed overhead expenditure variance + Fixed overhead volume
variance

Rs 61,00,000 A = Rs 60,00,000 A + Rs 1,00,000 A

Variable Overhead Variance:

(Budgeted variable overhead cost – Actual variable overhead cost)

Budgeted variable overhead cost =

(i) Actual output units x St. variable overhead rate per unit

Or

(ii) St. hours for actual output x St. variable overhead rate per hour

Applying the formula:

(i) (4,98,000 units x Rs 200 per unit) – Rs 10,08,00,000

= Rs 9,96,00,000 – Rs 10,08,00,000

= Rs 12,00,000 Adverse

Or

(ii) (9,96,000 hrs x Rs 100) – Rs 10,08,00,000

= Rs 9,96,00,000 – Rs 10,08,00,000

= Rs 12,00,000 Adverse

Verification:

Variable overhead variance = Variable overhead expenditure variance + Variable overhead

efficiency variance

Rs 12,00,000 A = Rs 48,00,000 A + Rs 36,00,000 F

Rs 12,00,000 A = Rs 12,00,000 A

Total Overhead Cost Variance:

(Budgeted overhead cost – Actual overhead cost)

Budgeted overhead cost =

(i) Actual output units x St. overhead rate per unit

Or

(ii) St. hours for actual output x St. overhead rate per hour

Applying the formula:

St. overhead rate per unit = Variable overhead rate + Fixed overhead rate = Rs 200 + Rs 50 = Rs
250

Or

St. overhead rate per hour =

= Variable overhead rate per hour + Fixed overhead rate per hour

= Rs 100 + Rs 25 = Rs 125

(i) (4,98,000 units x Rs 250) – (Rs 3,10,00,000 + Rs 10,08,00,000)

= Rs 12,45,00,000 – Rs 13,18,00,000

= Rs 73,00,000 Adverse

Or

(ii) (9,96,000 hrs x Rs 125) – (Rs 3,10,00,000 + Rs 10,08,00,000)

= Rs 12,45,00,000-Rs 13,18,00,000

= Rs 73,00,000 Adverse

Verification:

Total overhead cost variance = Fixed overhead cost variance + Variable overhead cost variance

Rs 73,00,000 A = Rs 61,00,000 A + Rs 12,00,000 A

Rs 73,00,000 A = Rs 73,00,000 A

Illustrative Problem 6:
The following information has been extracted from the books of Goru Enterprises which is
using standard costing system:

Actual output = 9,000 units

Direct wages paid = 1,10,000 hours at Rs 22 per hour, of which 5,000 hour, being idle time, were
not recorded in production

Standard hours = 10 hours per unit

Labour efficiency variance = Rs 3,75,000 (A)

Standard variable Overhead = Rs 150 per unit

Actual variable Overhead = Rs 16,00,000

You are required to calculate:

(i) Idle time variance

(ii) Total variable overhead variance

(iii) Variable overhead expenditure variance

(iv) Variable overhead efficiency variance.

Solution:

Actual output = 9,000 units

Idle time = 5,000 hours

Production time (Actual) = 1,05,000 hours

Standard hours for actual production = 10 hours/unit x 9,000 units = 90,000 hours.

Labour efficiency variance = Rs 3,75,000 (A)

i.e. Standard rate x (Standard Production time – Actual production time) = Rs 3,75,000 (A).

SR (90,000 – 1,05,000) = – 3,75,000

SR = -3,75,000/-15,000 = Rs 25

(i) Idle time variance = 5,000 hours x 25 Rs hour = Rs 1,25,000. (A)

(ii) Standard Variable Overhead = Rs 150/unit

Standard hours = 10 hours/unit

Standard Variable Overhead rate/hour =150/10 = Rs15/hour

Total Variable Overhead variance = Standard Variable Overhead – Actual Variable Overhead

= Standard Rate x Standard hours – Actual rate x Actual hours

= (15) x (10 x 9,000) – 16,00,000

= 13,50,000 -16,00,000

Total Variable Overhead Variance = 2,50,000 (A)

(iii) Variable Overhead Expenditure Variance = (Standard Rate x Actual Hours) – (Actual Rate x
Actual Hours)

= (15 x 1,05,000) – 16,00,000

= 15,75,000 – 16,00,000

= Rs 25,000 (A)

(iv) Variable Overhead Efficiency Variance = Standard Rate x (Standard Hours for actual output
– Actual hours for Actual output)

= 15 (90,000 – 1,05,000)

= 15 (-15,000)

= Rs 2,25,000 (A)

Alternative Solution:

Actual Output = 9,000 Units

Idle time = 5,000 hrs

Direct Wages Paid = 1,10,000 hours @ Rs 22 output of which 5,000 hours being idle, were not
recorded in production.

Standard hours = 10 per unit.

Labour efficiency variance = Rs 3,75,000 (A)

Or

Standard Rate (Standard Time – Actual Time) = – 3,75,000

Or (90,000 – 1,05,000) = – 3,75,000/Standard Rate.

Or Standard Rate = Rs 25/-

(i) Idle time variance = Standard Rate x Idle time

25 x 5,000 = Rs 1,25,000 (A)

(ii) Standard Variable Overhead/unit =150

Standard Rate = 150/10 = Rs 15/hour

Standard Quantity = 10 hours

Actual Variable Overhead = 16,00,000

Standard Variable Overhead = 150 x 9,000 = 13,50,000

Actual Variable Overhead = 16,00,000

Total Variable Overhead Variance = 2,50,000 (A)

(iii) Variable Overhead expenditure Variance = Standard Variable Overhead for actual hours –
Actual Variable Overhead

= (150 x 1,05,000)-16,00,000

= 15,75,000-16,00,000

= 25,000 (A)

(iv) Variable overhead efficiency variance = (Standard Variable Overhead for actual output –
Standard Variable Overhead for Actual hours)

= 15 (10 hours x 90,000 units – 1,05,000)

= 15 (90,000 – 1,05,000)

= 15 (- 15,000)

= 2,25,000 (A)
Illustrative Problem 7:

The Norkhill Furniture Company has the following standard cost per unit of furniture:

For July 2012, when 1100 units of furniture were produced, the following information is
available:

Lumber purchased: 50,000 feet at Rs 390 per 100 feet

Lumber used: 56,000 feet

Direct labour: 3,100 hours @ Rs 105

Variable overhead: Rs 1,55,000

Fixed Overhead: Rs 2,90,000

Any materials price variance is assigned to the purchasing department at the time of purchase.

You are required to:

(a) Prepare a flexible budget for the actual level of activity.

(b) Prepare a complete analysis of all variances, including a three-way analysis of overhead
variances.
Three-way Analysis of Overhead Variances:

(i) Spending variance = (Actual Overhead costs – Budgeted overhead costs based on actual
hours)

= 4,45,000 – (Rs 3,00,000 + 100 x 33,100 hours)

= 4,45,000- 4,55,000

= Rs 10,000 (F)

(ii) Efficiency variance

= (Budgeted overhead costs based on actual hours – Budgeted overhead costs based on Std.
hours)
= (Rs 4,55,000 – (Rs 3,00,000 + Rs 50 x 3300 hrs)

= 4,55,0000 – 4,65,000

= Rs 10,000 (F)

(iii) Volume variance

= (Budgeted overhead Costs based on Std. hours in terms of actual units – Applied over head
costs)

= (Rs 150 x 3300 hrs) – (Rs 150 x 3100 hrs)

= Rs 4,95,000 – 4,65,000

= Rs 30,000 (F)

Illustrative Problem 8:

Jumbo Food Products Ltd. operates a system of standard costing and in respect of one of
its products which is manufactured within a single cost centre, data for one week have been
analysed as follows:
The production and sales achieved resulted in no changes of stock. You are required to
compute:

(i) The actual output;

(ii) Actual profit;

(iii) Actual price per kg of material;

(iv) Actual rate per labour hour;

(v) Amount of production overhead incurred;

(vi) Amount of production overhead absorbed;

(vii) Production overhead efficiency variance;

(viii) Selling price variance;

(ix) Sales volume profit variance.

IV. Sales Variances:

Sales variance is the difference between the actual value of sales achieved in a given period and
budgeted value of sales. There are many reasons for the difference in actual sales and budgeted
sales such as selling price, sales volume, sales mix.

Sales variance can be calculated by using any of the following two methods:

A. Sales variance based on turnover

B. Sales variances based on margin (i.e.,contribution margin or profit)

The first approach i.e., sales variance based on turnover, accounts for difference in actual sales
and budgeted sales. The sales variances using margin approach accounts for difference in actual
profit and budgeted profit. In the margin method, it is assumed that cost of production is
constant, i.e., no difference is assumed between actual cost of production and standard cost of
production.

The reason for this assumption is that cost variances are calculated separately to analyse the
difference between actual cost and standard cost of production. Therefore, cost side of the sales
variance is assumed constant under the margin method.

Sales variances computed under these two methods show different amounts of variance.

The different sales variances under these two approaches and their formula are given
below:

A. Sales Variances Based on Turnover:

(i) Sales Value Variance:

Also known as sales variance, this variance shows the difference between actual sales value and
budgeted sales value.

The formula is:

Sales Value Variance = (Actual value of sales – Budgeted value of sales)

Actual sales = Actual quantity sold x Actual selling price

Budgeted sales = Standard quantity x Standard selling price

Or

Sales value variance = (Actual quantity x Actual selling price) – (Standard quantity x Standard
selling price)

If actual sales are more than the budgeted sales, there is favourable variance and if actual sales
are less than the budgeted sales, unfavourable variance arises.

(ii) Sales Price Variance:

This variance is due to the difference between actual selling price and standard or budgeted
selling price.

The formula is:

Sales price variance = (Actual selling price – Budgeted selling price) x Actual quantity

If actual selling price is less than the budgeted selling price, variance is favourable and if actual
selling price is more than the budgeted selling price, there will be unfavourable sales price
variance.

(iii) Sales Volume Variance:

Sales volume variance arises when the actual quantity sold is different from the budgeted
quantity. If actual sales quantity exceeds the budgeted sales quantity, there is a favourable sales
volume variance and if actual quantity sold is less than the budgeted quantity, the variance is
unfavourable.

The formula is:

Sales volume variance = (Actual quantity – Budgeted quantity) x Budgeted selling price

Sales volume variance is divided into two variances:

(i) Sales mix variance

(ii) Sales quantity variance

(i) Sales Mix Variance:

Sales mix variance is one part of overall sales volume variance. This variance shows the
difference between actual mixes of goods sold and budgeted mix of goods sold.

The formula is:

Sales Mix Variance = (Actual Mix of quantity sold – Actual quantity in standard proportion) x
Standard selling price

Or

Sales Mix Variance = (Budgeted price per unit of actual mix – Budgeted price per unit of
budgeted mix) x Total actual quantity.

If actual sales mix are more than the mix in standard or budgeted proportion, the variance is
favorable and if actual mix sales are less than the standard mix (of actual sales), the variance is
unfavorable. Similarly, if budgeted price per unit of actual mix is more than the budgeted price
per unit of budgeted mix, favorable variance will arise. In the reverse situation, variance will be
unfavorable.

(ii) Sales Quantity Variance:

This variance is also a part of overall volume variance. This variance shows the difference
between total actual sales quantity and total budgeted sales quantity. If total actual quantity is
more than the total budgeted quantity, variance will be favourable and if total actual quantity is
less than the total budgeted quantity, there will be unfavourable sales quantity variance.

The formula is:

Sales quantity variance = (Total actual quantity – Total budgeted quantity) x Budgeted price per
unit of budgeted mix

The total of sales mix variance and sales quantity variance will be equal to sales volume
variance.

B. Sales Variance Based on Margin (i.e., Contribution Margin or Profit):

The sales variances using margin approach show the difference in actual profit and budgeted
profit only whereas sales variances based on turnover show the difference between total actual
sales and total budgeted sales.

The following sales variances are calculated if margin or profit is the basis of calculation:

Sales Variances based on Margin or Profit

(i) Total Sales Margin Variance:

This variance indicates the aggregate or total variance under the margin method. This variance
shows the difference between actual profit and budgeted profit.

The formula is:

Total sales margin variance = Actual Profit – Budgeted profit

If actual profit is more than the budgeted profit, variance will be favourable and if actual profit is
less than the budgeted profit, unfavourable variance will arise.

(ii) Sales Margin Price Variance:

This variance is one part of total sales margin variance and arises due to the difference between
actual margin per unit and budgeted margin per unit. It is significant to note that, assuming cost
of production being constant, the difference in the actual margin and budgeted margin will only
be because of the difference between actual selling price and budgeted selling price. The formula
for calculating sales margin price variance is

Sales Margin Price Variance = (Actual Margin per unit – Budgeted Margin per unit) x Actual
quantity

If actual margin per unit is more than the budgeted margin per unit, favourable variance will be
found and if actual margin is less than the budgeted margin, variance will be unfavourable.

(iii) Sales Margin Volume Variance:

This variance shows the difference between actual sales units and budgeted sales units.

The formula is:

Sales Margin Volume Variance = (Actual quantity – Budgeted quantity) x Budgeted Margin per
unit.
If actual sales units are more than the budgeted sales units, variance will be favorable and if
actual sales units are less than the budgeted sales units, unfavorable variance will arise.

Sales margin volume variance can be calculated using another formula which is:

Sales margin volume variance = (Standard profit on actual quantity of sales – Budgeted profit)

If standard profit exceeds budgeted profit, variance will be favorable and if standard profit is less
than the budgeted profit, unfavorable variance will emerge.

Sales margin volume variance consists of:

(i) Sales margin mix variance and

(ii) Sales margin quantity variance.

(i) Sales Margin Mix Variance:

This variance shows the difference between actual mix of goods and budgeted (standard) mix of
goods sold.

The formula is:

Sales Margin Mix Variance = (Actual sales mix – Standard proportion of actual sales mix) x
Budgeted margin per unit.

If budgeted margin per unit on actual sales mix is more than the budgeted margin per unit on
budgeted mix, variance will be favourable. In the reverse situation, unfavourable variance will
arise.

(ii) Sales Margin Quantity Variance:

This variance will be found when the total actual sales quantity in standard proportion is
different from the total budgeted sales quantity.

The formula is:

Sales Margin Quantity Variance = (Actual sales in standard proportion – Budgeted sales) x
Budgeted margin per unit on budgeted mix

If actual sales (in standard proportion) are more than the budgeted sales, variance will be fa-
vourable and if actual sales are less than the budgeted sales, unfavourable variance will arise.
Reference:

http://www.yourarticlelibrary.com/accounting/variances-analysis/variance-analysis-material-
labour-overhead-and-sales-variances/52883/

The objectives of this posting are to guide students in the computation of all material variances,
to share a random picked ACCA Paper 8 Managerial Finance’s question with clear step-by-step
workings and explanation, and finally show you how to double check your answers. Ideally,
professional exams like ACCA and LCCI require students to compute advanced variances (i.e.
direct materials mix and yield variances). Normally, students will not face any problems in
handling direct materials price and usage variances, but struggling in solving those advanced
variances (students often confuse when normal loss exists). Hopefully, this sharing will help
students to understand this topic clearer and better.

The breakdown of the materials variances

Formulas and descriptions:

Total direct materials variance

The total direct materials variance is the difference between the standard materials cost for the
actual production and the actual materials cost. Alternatively, it can also be computed by
summing up direct materials price variance and direct materials usage variance.
Total direct materials variance = standard materials cost – actual materials cost
Total direct materials variance = direct materials price variance + direct materials usage
variance
Material price variance
The material price variance is equal to the difference between the standard price and the actual
price per unit of materials multiplied by the quantity of material purchased:
Material price variance = (standard price per unit of material – actual price) x quantity of
material purchased

Material usage variance

The material usage variance is equal to the difference between the standard quantity required for
actual production and the actual quantity used multiplied by the standard material price:
Material usage variance = (standard quantity of materials for actual production – actual
quantity used) x standard price per unit

Materials mix variance

The materials mix variance arises when the mix of materials used differs from the predetermined
mix included in the calculation of the standard cost of an operation. If the mixture is varied so
that a larger than standard proportion of more expensive materials is used, there will be an
unfavourable variance. When a larger proportion of cheaper materials are included in the
mixture, there will be a favourable variance.
Materials mix variance = (actual quantity in standard mix proportions – actual quantity
used) x standard price

Materials yield variance

The materials yield variance arises because there is a difference between the standard output for
a given level of inputs and the actual output attained.
Materials yield variance = (actual yield – standard yield from actual input of material) x
standard cost per unit of output
Answers and comments:
Standard Costs
When budgets are prepared, the costs are usually computed at two levels, in total dollars so an
income statement can be prepared, and cost per unit. The cost per unit is referred to as a
standard cost. A standard cost can also be developed and used for pricing decisions and cost
control even if a budget is not prepared. A standard cost in a manufacturing company such as
Pickup Trucks Company consists of per unit costs for direct materials, direct labor, and
overhead. The per unit costs can be further divided into the expected amount and cost of
materials per unit, the expected number of hours and cost per hour for direct labor, and the
expected total overhead costs and a method for assigning those costs to each unit. Within the
expected amount of materials, waste or spoilage must be considered when determining the
standard amount. For example, if a product, such as a chair, requires material, more material than
is actually needed for the chair must be ordered because the shape of the seat and the fabric are
usually not exactly the same. The scraps of material are called waste, which is not avoidable,
given that the chair is being produced with this specific fabric. The cost of the full piece of
material is used as the standard cost because the waste has no other use.

Similarly, when considering labor hours, downtime from production due to maintenance or start up and
break time must be included in the number of hours it takes to make a product. Once standards are
established, they are used to analyze and determine the reasons for actual cost variances from
standards. The variances may be in quantity of materials or hours used to manufacture a product or in
the cost of the materials or labor. Because overhead is normally applied on some basis, the variances in
overhead will occur because the total overhead pool of dollars or the activity level (for example, direct
labor dollars or hours) used to allocate the overhead is different from what was planned. Once standard
costs are used in preparing budgets, analysis of variances can be used to provide management with
information about whether a variance is caused by quantity or price so that appropriate action can be
taken.

To illustrate how cost variance analysis works, assume you are the plant manager for Bases, Inc.,
a company that makes a set of soft bases for playing baseball in gymnasiums. The budget
assumes 150,000 sets of bases will be produced annually. The following standard cost per set of
bases was developed:
The predetermined overhead rate of $1.30 will result in $0.65 of overhead being allocated to
each set of bases produced. (It is calculated using .5 direct labor hours per set times $1.30 per
hour.)
For the month of October, the company produced 13,300 sets of bases. The following
information was taken from the October financial report.

Variance Analysis

In order to understand the $1,175 unfavorable monthly variance, it must be analyzed by its
component parts: direct materials variances, direct labor variances, and overhead variances. Each
of these variances can further be broken down into a price (rate) variance and a quantity (usage
or efficiency) variance. A general template that can be used for direct materials variances, direct
labor variances, and variable overhead variances uses three amounts — actual, flexible budget,
and standard — as a basis for calculating the variances.

The price variance is favorable if actual costs are less than flexible budget costs. The quantity
variance is favorable if flexible budget costs are less than standard costs. The total variance is
favorable if the actual costs are less than standard costs.

Direct Materials Variances

The total direct materials variance is $2,835 favorable and consists of a $3,000 favorable price
variance and a $165 unfavorable quantity variance.

TYPES OF STANDARD COSTING

There are many ways to use standard costing in terms of the timeliness and completeness of the
information recorded. However, it is convenient to separate standard costing into two general
categories: 1. complete methods, and 2. partial methods. The difference between these concepts
is illustrated in Exhibit 10-1.
Complete Standard Cost Methods

When a complete standard cost method is used, standard costs are charged to work in process
(WIP). The differences between actual and standard costs are charged to variance accounts. This
method is illustrated in the top section of Exhibit 10-1 where the materials, payroll and overhead
accounts are aggregated into a summary account to simplify the illustration. The debits to WIP
represent the standard costs allowed for all finished and partially finished units during the period.
The credits to the materials, payroll and factory overhead accounts represent the cost of all work
performed during the period. This method is said to be complete because all work performed
during the period is represented and evaluated in the performance measurements, i.e., variance
analysis.

Partial Standard Cost Methods

When a partial method is used only part of the productive work performed during the period is
evaluated during the period. In the partial method illustrated in the middle section of Exhibit 10-
1, actual costs are charged to work in process. Standard costs are not recorded until the
completed units are transferred to finished goods. Variances are calculated and recorded at the
time of the transfer. This is a partial method because the work remaining in WIP is not evaluated.
From the performance measurement point of view, a complete standard cost method is better
because: 1) it identifies the variances or differences between actual costs and standard costs in a
more timely manner and 2) the variances are based on all productive work performed during the
period, not just the work performed on the completed units.

Another partial method is illustrated in the bottom section of Exhibit 10-1. In this approach,
actual costs flow into finished goods. Then standard costs are charged to cost of goods sold and
the variances are recorded at the time of sale. The credit to finished goods represents the actual
cost of the units sold. One reason for using this method is to avoid having to adjust the inventory
accounts from standard to actual costs for external reporting purposes. However, for internal
evaluation and control purposes this is even less useful than the second method illustrated,
because only the work performed on the units sold is evaluated. Again, from a performance
evaluation perspective, it is better to evaluate all productive work, not just the work performed
on the units completed as in the first partial method, or only the work performed on the units sold
as in this approach. For this reason, the illustrations in this chapter are based on a complete
standard cost method, rather than either of the partial methods.

Other Uses of Standard Costs

There are some other ways to use standard costs. As noted in Chapter 8, backflush accounting
usually relies on standard costs for the amounts charged back to the inventory accounts at the end
of the period. Backflush cost accumulation methods might be thought of as partial methods,
although they are simplified with little, or no variance analysis. Another approach involves using
standard cost as a control device without recording the standard costs in the accounts. In this
approach variance analysis is performed to provide information for management, but normal
historical costing is used in the general ledger.

Cost Flow and Analysis in Complete Standard Costing

The following pages include illustrations of how each type of manufacturing cost is recorded and
analyzed using a complete standard cost method. Several types of illustrations are presented to
help you see the concepts and techniques from different perspectives. First, a T-account
approach is presented to provide a comprehensive view of the product costing and variance
analysis involved. T-accounts are very useful for organizing and working comprehensive
standard cost problems. The generic set of accounts introduced in Chapter 4, in connection with
normal historical costing, is also used in this chapter, although some additional accounts are
needed for the variances. This generic standard cost account structure appears in Exhibit 10-2.
Exhibit 10-2 includes eight variance accounts along with the usual generic accounts used in
normal historical costing. There are two variances for direct materials (DM). These include the
direct materials price variance and the direct materials quantity variance. Since a cost always
involves a price and a quantity, the idea is to isolate (analyze or separate) the effects of
differences between actual and standard prices from the effects of differences between actual and
standard quantities. The same idea is used to analyze direct labor (DL) costs, although the DL
variances are frequently referred to as the DL rate variance and DL efficiency variance. The
analysis of factory overhead (i.e., indirect resource) costs is less precise because the individual
prices and quantities of the various types of indirect resources are not captured by traditional cost
accounting systems. However, there are a variety of ways to analyze factory overhead costs. The
four overhead variances that appear in Exhibit 10-2 provides one possibility. These include the
variable overhead (VO) spending variance, VO efficiency variance, the fixed overhead (FO)
spending variance and the production volume variance. As we shall see later in this chapter, the
overhead variances are not price and quantity variances and are much more difficult to interpret
in any meaningful way.

The illustrations in this chapter extend the Expando Company problem illustrated in Chapter 9 to
provide a comprehensive illustration of the planning and control aspects of accounting systems.
In addition to the T-account approach, the costs and variances are recorded using general journal
entries. Variance analysis is also illustrated for each type of cost using equations, flexible budget
diagrams and graphs. Each approach provides a different view of the analysis to help you
strengthen your understanding of the mechanics and concepts associated with standard cost
systems.

DIRECT MATERIALS

The following symbols are used below to illustrate how direct material costs are recorded and
analyzed in standard costing.

AQP = Actual quantity of direct material purchased.

AQU = Actual quantity of direct material used in production.
SQA = Standard quantity of direct material allowed for the good output. Good units produced
multiplied by the standard quantity per unit.
AP = Actual price of material per unit of measure, e.g., pounds, gallons, board feet.
SP = Standard price of material per unit of measure.

There are two methods of evaluating material prices and recording direct materials costs in the
perpetual inventory accounts. These include:

1. Recording the material price variance when material is received, i.e., based on the quantity
purchased. This means that direct materials purchases are charged to materials control at
standard prices and the direct materials price variance is recorded when the purchase is recorded.
Then the direct material quantity variance is recorded when direct materials are used.

2. Recording the material price variance when material is used, i.e., based on the quantity used in
production. This means that direct materials purchases are charged to materials control at actual
prices. Then both the direct materials price variances and direct materials quantity variances are
recorded when the material is used.

EXAMPLE 10-1

Recall from Chapter 9 that the Expando Company uses a type of pressed wood referred to as
particle board to produce entertainment centers. Other materials, such as glue and screws are
viewed as insignificant and are charged to overhead as indirect materials. The information
needed to record direct materials purchases and usage is given below.

Standard price = $10 per particle board sheet. (Each sheet is 3/4" by 4' by 8')
Standard quantity allowed per unit = 2 sheets
Direct material purchased = 22,000 sheets at $10.20 per sheet
Direct material used = 20,050 sheets
Units of output (entertainment centers) produced = 10,000

METHOD 1: DM PRICE VARIANCE BASED ON QUANTITY PURCHASED

The T-account Approach

Direct material purchases and usage are recorded and analyzed in T-accounts in Exhibit 10-3.
The 22,000 sheets of direct material purchased are charged to materials control at the standard
price (SP) of $10, although the actual price (AP) is $10.20 per sheet. As a result, the debit to
materials control is $4,400 less than the credit to accounts payable. This difference represents an
unfavorable materials price variance.

The WIP account is charged with the standard materials cost of the 10,000 units produced. The
standard quantity allowed (SQA) is 20,000 sheets, i.e., 2 sheets multiplied by 10,000 units. Thus,
the debit to WIP is for 20,000 sheets at the standard price of $10 per sheet, or $200,000. Since
direct materials flow through the materials control account at standard prices, the difference
between the debit to WIP and the credit to materials control results solely because of the
difference between the actual quantity of material used and the standard quantity allowed. In this
case the $500 difference represents an unfavorable materials quantity variance since the
company used 50 sheets more material (20,050 - 20,000) than the standard allowed.

The Equation Approach

The variances are easy to calculate and record using the T-account approach because they are the
differences between the debits and credits to the original generic set of accounts. Mechanically,
the variances represent a bookkeeping tool to insure that the debits and credits are equal. As a
result, the calculations that appear in the variance T-accounts in Exhibit 10-3 are not needed
except to check, or validate the accuracy of the entries. If you look closely you will see that the
T-account analysis shows that each variance calculation can be performed in two ways using the
following equations:

Material Price Variance = (AP)(AQP) - (SP)(AQP) or (AP-SP)(AQP)

Material Quantity Variance = (SP)(AQU) - (SP)(SQA) or (AQU-SQA)(SP).

Actual costs of $63,000 are less than flexible budget costs of $66,000, so the materials price
variance is $3,000 favorable. The variance can also be thought of on a price per unit basis. The
actual costs of $63,000 were for 60,000 feet of direct material, so the actual price per foot is
$1.05 ($63,000 ÷ 60,000). The original budget was for a direct materials cost of $1.10 per foot,
so it was expected that 60,000 feet of material would cost $66,000. The direct materials actually
cost less than budget by $0.05 per foot ($1.10 budget versus $1.05 actual), so the variance is
favorable. The direct materials quantity variance of $165 unfavorable means this company used
more direct materials than planned because flexible budget costs of $66,000 are higher than the
standard costs of $65,825. To produce 13,300 sets of bases, the company expected a cost of
$4.95 per set (4.5 feet of material at $1.10 per foot), for a total cost of $65,835. This can also be
analyzed by identifying the total feet of material it should have taken to produce 13,300 sets of
bases and multiplying by the cost per foot of material (13,300 sets × 4.5 feet per unit = 59,850
feet of direct materials × $1.10 per foot = $65,835). It actually used 60,000 feet, which prices out
at an expected $1.10 per foot to be $66,000. The total direct materials variance is calculated by
adding the price and quantity variances together or by comparing actual cost of direct materials
with the standard cost of producing 13,300 sets of bases.
Another way of computing the direct materials variance is using formulas.

Using the formulas to calculate the variances would work like this:

Comparing the first form of each equation to the entries in Exhibit 10-3 shows that the variances
are simply the differences between the credits and debits in the accounts payable, materials
control and work in process accounts. While the short form of each equation is used in Exhibit
10-3, the longer form of each equation is used below in the Flexible budget diagram approach.

The Journal Entry Approach

General journal entries provide a somewhat more formal approach for recording and analyzing
direct materials costs. The entries to record materials purchases and usage for the example above
are presented in Exhibit 10-4.

EXHIBIT 10-4
Journal Entries When DM Price Variances are Based on Quantity Purchased
Materials control 220,000
Entry to record direct material
Direct material price variance 4,400
purchases
Accounts payable 224,400
Work in process 200,000
Entry to record direct material
Direct material quantity variance 500
usage
Materials control 200,500

Flexible Budget Diagram Approach

Although the mechanics of standard costing are adequately illustrated with T-accounts, journal
entries and equations, the concepts are somewhat more illusive. Conceptually the variances
represent an attempt to evaluate materials costs by isolating the effects of price and quantity
differences. The flexible budget diagram in Exhibit 10-5 provides a more revealing way to
emphasize these performance measurement concepts.
The difference between the actual cost of direct material purchased (A) and a flexible budget
based on actual quantity purchased (B) is the material price variance. The flexible budget (B)
represents an estimate of what the purchase costs should have been. The flexible budget (B) is
the debit to the materials control account. The actual cost (A) is the credit to accounts payable.
The difference between the debit and credit is the performance measurement, i.e., the price
variance.

Be careful with the term flexible budget. Every time the standard price of a variable input is
multiplied by any quantity of the input, the result is a flexible budget. In fact, there are three
flexible budgets included above. The direct material quantity variance is the difference between a
flexible budget based on actual quantity used (C, which is also the credit to materials control)
and a flexible budget based on standard quantity allowed (D, which is the standard material costs
charged to work in process). When the entries are made, flexible budgets are used to record and
provide a way to evaluate the costs simultaneously.

Graphic Approach

A graphic approach provides a different way to place emphasis on the flexible budgets and
concepts involved. Consider Figure 10-1. Point A represents the actual cost of material
purchases. Points B, C and D represent the three flexible budgets that all fall on the flexible
budget line. The slope of the flexible budget line is the standard price (SP). The fact that point A
does not fall on the flexible budget line means that the actual price must be different from the
standard price. Therefore, the vertical difference between points A and B represents the material
price variance based on quantity purchased. The vertical difference between points C and D
represents the material quantity variance.

METHOD 2: DM PRICE VARIANCE BASED ON QUANTITY USED

T-account Approach

In the second method of evaluating material prices, the price variance is based on the quantity of
material used in production, rather than the quantity purchased. This means that direct materials
are charged to materials control at actual, rather than standard prices. Then, both the price and
quantity variances are calculated when materials are charged to work in process. This approach
is illustrated in Exhibit 10-6. The debit to work in process is the same as in the previous example.
However, the credit to materials control is based on the actual price of $10.20. The difference
between the debit to WIP and the credit to materials control represents the total mixed price and
quantity variance of $4,510. Thus, both variances must be calculated separately and recorded
when standard costs are charged to the WIP account. In this method the DM price variance is
only $4,010, rather than $4,400 as in the previous example because the unused material is not
considered in the performance measurement.

The Equation Approach

The equations for the DM price variance based on quantity used are:

Material Price Variance = (AP)(AQU) - (SP)(AQU) or (AP-SP)(AQU)

The difference between these equations and the previous price variance calculations is that the
actual quantity used (AQA) replaces the actual quantity purchased (AQP). Although (AP)(AQU)
represents the credit to materials control, (SP)(AQU) does not represent the debit to WIP. This is
because the entry to WIP involves both price and quantity variances.

The quantity variance calculations are the same regardless of how the price variance is
calculated. Therefore, the equations for the material quantity variance are not restated here.
Comparing Exhibits 10-3 and 10-6 is a good way to see the similarities and differences between
the two methods.

Journal Entries

The entries to record the materials purchases and usage when the price variance is based on
quantity used are presented in Exhibit 10-7.

EXHIBIT 10-7
Journal Entries When DM Price Variances are Based on Quantity Used
Entry to record direct materials Materials control 224,400
purchases Accounts payable 224,400
Work in process 200,000
Entry to record direct material Direct material price variance 4,010
usage Direct material quantity variance 500
Materials control 204,510

Flexible Budget Diagram Approach

The diagram in Exhibit 10-8 emphasizes the flexible budgets involved in the analysis above.
Only two flexible budgets are used in this approach. Since the total variance for direct material is
the difference between actual and standard costs (A' and D), the flexible budget based on actual
quantity used (C) separates the total variance of $4,510 into two parts to isolate the effects of
price and quantity differences.
The Graphic Approach

The relationships in the analysis above are also illustrated in the graphic approach presented in
Figure 10-2. The total variance is the vertical difference between points A' and D. Since the
actual costs, represented by point A' do not fall on the flexible budget line, the actual price must
be different from the standard price. The vertical difference between points A' and C represents
the material price variance based on quantity used. Points A and B are no longer relevant
because they are based on the quantity purchased. The vertical difference between points C and
D (two points on the flexible budget line) represents the materials quantity variance. The
quantity variance is the same as in Figure 10-1.
Advantages of Method 1

From a control perspective, recording material price variances based on the quantity purchased
provides several advantages over the second method. These include the following:

1. The entire price variance is calculated in Method 1, i.e., based on all materials purchased. In
Method 2, the price variance is only calculated for the material used. However, obtaining the best
price for materials is a purchasing function, not a responsibility of the production manager.
Therefore, it is logical to calculate the price variance on the basis of the entire quantity
purchased. This is consistent with the concept of responsibility accounting discussed in Chapter
9.

2. Using quantity purchased means evaluating prices at the time the materials and invoice are
received. This is more timely than waiting until materials are charged into work in process. The
idea is that if a cost is out of control, it is better to find out sooner, rather than later, so corrective
action can be taken as soon as possible.

3. Using quantity purchased means comparing current period standard prices with current period
actual prices. If the quantity used is the basis of the evaluation, then materials are charged into
materials control at actual prices. This means that a cost flow assumption (FIFO, average cost, or
LIFO) will determine which actual prices are compared with the current period standard prices.
In some cases prior period actual prices may be compared with current period standard prices.
This is not a very meaningful or useful comparison. Determining the credit to materials control is
also more difficult when several inventory layers exist, i.e., layers of materials that were
purchased at different prices.

In summary, Method 1 provides more complete, more timely and more relevant information
concerning the purchasing function than Method 2. A disadvantage of method 1 is that the
materials control account would need to be adjusted to actual cost periodically for external
reporting purposes.

Direct Material Variance Causes and Tradeoffs

A conceptual view of direct material cost drivers is presented in Exhibit 10-9. The illustration
shows that materials costs are driven by prices and quantities, which in turn are driven by many
other factors. Prices are driven by the supply and demand for the materials involved, the quality
and quantity of the materials purchased and other factors such as services included by the
vendor, the negotiating skills of buyers and sellers and any contract specifications. Of course
random variations in these factors are likely to cause a large percentage of the price fluctuations.

Price variances result when changes occur in any of the factors mentioned above that were not
anticipated when the standards were established. For example, a price variance will normally
result if the quality of the materials purchased is different from engineering specifications.
Purchasing materials that are higher (or lower) in terms of design quality can produce
unfavorable (or favorable) price variances. Favorable price variances can also be obtained by
receiving quantity discounts for purchasing large quantities. Of course, purchasing more material
than needed conflicts with the logic of JIT that focuses on the total cost of purchasing, handling,
storing and using materials, not just the purchase price.

Material quantities are driven by product diversity, production volume, the productivity or yield
associated with the materials and in some cases, material mix. The effects of product diversity
(size and complexity) are reflected in the standard quantities allowed. Production volume
variations are accounted for in the flexible budget used in the material quantity variance
calculation. Therefore the major causes of material quantity variances are variations in materials
productivity, or yield2 and material mix.
Responsibility for managing the quantity of material used is normally assigned to production
management. However, before any attempt is made to identify the causes of a quantity variance,
it is important to understand that most variances are caused by random variations in the system.
It is best to think of any standard as a mean of acceptable outcomes that have upper and lower
limits analogous to those on a control chart. Variances outside these limits (where the limits are
based on management intuition and experience) are the only ones that might require additional
attention. With this control concept in mind, there are some causes of a quantity variance that
may require management attention. Low quality materials, in terms of conformance to
specifications, (e.g., materials that become damaged easily, or dry up or evaporate more than
expected) can cause unfavorable quantity variances. The purchasing department or vendor may
be at fault in such cases. Direct labor might waste materials because of carelessness or
inexperience. In addition, production equipment might damage materials if the equipment is not
properly adjusted and maintained. This problem may be the responsibility of the machine
operator, or the maintenance department, or a combination of both production workers and
maintenance workers. Quantities may also vary beyond acceptable limits because of material
mix differences. In some situations, different materials can be substituted for each other as in the
case of many liquid products (e.g., beverages, soups cleaning fluids). These variations in the
materials mix are influenced by the substitutability and availability of the various materials, as
well as the skill and experience of the workers involved3.
An advantage of isolating price and quantity variances is that it allows for separate responsibility
to be assigned. This is consistent with the responsibility accounting concept introduced in
Chapter 9. However, a disadvantage is that isolating the variances for separate responsibility
tends to ignore the fact that purchasing and production are interdependent. Purchasing inferior
materials (low design quality) can cause favorable price variances, but result in unfavorable
quantity variances. This can easily cause behavioral conflicts between purchasing and production
employees. Purchasing higher quality materials (i.e., higher design quality) than required by the
product specifications tends to have the opposite effect. The goal is to purchase the desired
quality and quantity of material at the lowest price and to use it as efficiently as possible.
Conceptually, the purpose of variance analysis is to constantly monitor whether or not this goal
is being achieved.

To summarize the ideas in this section, the standard cost methodology recognizes that prices and
quantities drive costs, but the typical analysis does not reveal the causes of the variances beyond
that level. Variance analysis does not identify why actual prices and quantities are different from
standard, only that they are different. From a practical standpoint, the benefits of developing
routine analysis below the price and quantity level (see Exhibit 10-9) would not likely exceed the
additional costs. However, when variances are outside an acceptable range established by
management, they should be investigated and corrective action taken if it appears to be needed.
When implementing this idea, management should take care not to blame workers for variations
caused by the system. Corrective action refers to adjustments to eliminate special causes.
Reduction in system variation requires an improvement in the system as explained in Chapter 3.

Behavioral Problems Associated With Direct Material Variances

In attempting to achieve favorable price variances, purchasing agents may purchase larger
quantities of materials than needed to obtain quantity discounts. Too much emphasis on shopping
around for the lowest price can also result in a lack of emphasis on quality (i.e., quality of
conformance), excess inventory and an excessive number of vendors. On the other hand, too
much emphasis on quantity variances at either the department or plant level can motivate
production managers to push defective products to the next department, division, or to
marketing. Of course this is inconsistent with the JIT concepts of demand pull, quality at the
source (jidoka) and cross functional cooperation.

Main Disadvantage of the Traditional Analysis

The main disadvantage of the traditional variance analysis illustrated above is that only two of
the aspects associated with total materials costs are included. As indicated in Chapter 8, overall
materials costs include the costs of ordering, receiving, inspecting, unpacking, moving, storing,
scheduling, reworking and returning defective materials to vendors, as well as the costs
associated with price and quantity used. Therefore, from the lean enterprise perspective, the
traditional analysis is too narrow and focuses on the wrong measurements. JIT advocates argue
that the analysis should focus on the overall cost of materials and several non financial
measurements to optimize the system, not the performance measurement for any particular
function, department or subsystem.
DIRECT LABOR

The following symbols are used to illustrate how direct labor costs are recorded and analyzed in
standard costing.

AR = Actual rate per hour.

SR = Standard rate per hour.
AHU = Actual direct labor hours used.
SHA = Standard direct labor hours allowed for the good output. Good units produced multiplied
by the standard hours per unit.

EXAMPLE 10-2

This example extends the Expando Company illustration to include direct labor. The information
needed to record and analyze direct labor cost is given below.

Standard direct labor rate per hour = $15

Standard direct labor hours allowed per unit = .4
Actual direct labor used = 4,100 hours at $15.15 per hour.
Units of output produced = 10,000

T-account Approach

Direct labor cost is recorded and analyzed in the manner illustrated in Exhibit 10-10. The entries
and variance analysis for direct labor are very similar to the analysis of direct material costs
under method 2, although the account titles and terminology are different. Actual direct labor
costs of $62,115 are charged to the payroll clearing account and the liabilities for wages &
salaries payable and the various withholding accounts are credited. Indirect labor costs and the
details for withholding (e.g., federal and state income taxes and FICA) are ignored in this
example to keep it simple.

Standard labor costs of $60,000 are charged to work in process based on 4,000 standard hours
allowed (.4 hours per unit multiplied by 10,000 units) and a standard rate of $15 per hour. The
credit to the payroll account is $62,115 since the actual direct labor cost just flow though the
account. The difference between the debit to WIP and the credit to the factory payroll account
represents the total direct labor cost variance. Therefore, the direct labor rate (or price) and
efficiency (or quantity) variances must be calculated to complete the entry. Alternative equations
are provided below for this purpose.
Equation Approach

The variances needed to complete the entries in Exhibit 10-10 can be calculated in two ways.

Direct Labor Rate Variance = (AR)(AHU) - (SR)(AHU) or (AR-SR)(AHU)

Direct Labor Efficiency Variance = (SR)(AHU) - (SR)(SHA) or (AHU-SHA)(SR)

The shorter form of each equation is used to obtain the variances in Exhibit 10-10. Since the
company paid 15 cents more per hour than the standard allowed, the $615 rate variance is
unfavorable. The efficiency variance is also unfavorable because 100 additional hours were used
above the 4,000 standard hours allowed.

Journal Entries

The general journal entries to record the direct labor costs are presented in Exhibit 10-11. The
first entry combines wages & salaries payable with the withhold accounts to simplify the
example.

EXHIBIT 10-11
Journal Entries to Record Direct Labor Costs
Entry to record the Factory Payroll 62,115
payroll Wages & Salaries payable & withholding accounts 62,115
Work in Process 60,000
Entry to record DL rate variance 615
direct labor usage DL Efficiency variance 1,500
Factory Payroll 62,115

Flexible Budget Diagram

The diagram in Exhibit 10-12 emphasizes the flexible budgets involved in the direct labor
variance analysis.

Two flexible budgets are used to analyze direct labor costs, but one of them is the standard costs
charged to work in process (D). The key is the flexible budget based on actual hours used (B)
because it is used to separate the total variance of $2,115 into two parts, i.e., the rate and
efficiency variances.

The Graphic Approach

The graphic illustration presented in Figure 10-3 emphasizes the two flexible budgets involved.
Although this is the same approach referred to as Method 2 for direct material, the method is not
subject to the same disadvantages discussed above for direct material. The reason is that the
quantity of direct labor purchased is the same as the quantity of direct labor used, i.e., A = A'.
Therefore, the flexible budgets based on the quantities purchased and used are the same as
indicated by points B and C on the graph.

Direct Labor Variance Causes and Tradeoffs

A conceptual view of direct labor cost drivers is presented in Exhibit 10-13. Although a large
number of labor rate and efficiency variances are likely to be caused by random variations, there
are a number of other possibilities. The supply and demand for labor is always a factor in
determining labor rates as well as the education, training and experience required to perform the
work, the geographic location of the company and the rates negotiated by union contract.
Changes in any of these factors that were not considered in establishing the standards can cause
rate variances. In addition, where average rates are used for groups of workers, direct labor rate
variances result when the actual mix of workers is different from the mix used to establish the
standard rate. For example, higher or lower paid workers might be used in cases where there is a
shortage of production workers with the required skills.

Labor quantities (hours) are driven by product diversity, production volume, labor productivity,
or efficiency and labor mix. The effects of variations in product diversity (size and complexity)
are reflected in the standard quantities allowed. Variations in production volume are accounted
for by using flexible budgets in the efficiency variance calculations. Therefore, the main causes
of labor efficiency variances are labor productivity and labor mix.

Efficiency variances occur when direct labor takes more (or less) time to produce the good
output than the standard allows. Of course this can occur because the standards are either too
tight or too loose. Unfavorable efficiency variances can occur when new inexperienced workers
begin work, or when workers are not well motivated or poorly trained. Low quality material,
inadequate equipment and equipment maintenance can also cause an excessive amount of labor
time. In addition, direct labor efficiency variances are also influenced when the labor mix is
different and individual rates, rather than average rates, are used in the variance calculations.4

There are also some tradeoffs between the direct labor rate and efficiency variances that can lead
to behavioral conflicts. For example, poor hiring and training by the human resource function,
can cause unfavorable labor efficiency variances that are used in the evaluation of production
supervisors.

Variance analysis was designed to help management uncover the various problems mentioned
above before they become too disruptive to efficient operations. It should be understood
however, that if a company does not qualify vendors, and lacks strong hiring, training and
preventive maintenance procedures, then the resulting variances are caused by the system and
should not be blamed on lower level managers and individual workers. The fact that large
unfavorable variances occur does not mean that the system is out of control. It may simply mean
that the system is poorly designed. In such cases, reducing the variances requires changing the
system.

Behavioral Problems Associated With Labor Variances

Placing too much emphasis on labor rate variances can motivate managers to use less qualified
workers than needed, although the resulting unfavorable effect on the efficiency variance is a
deterrent to that sort of behavior. However, a more serious problem is that labor efficiency
variances tend to promote competitive behavior among lower level managers that can destroy the
cooperation needed to optimize the system. Competitive behavior tends to occur when the
variances are used to evaluate performance at the departmental level. To generate favorable
efficiency variances, production managers are motivated to build excess inventory and push it
downstream with little emphasis on quality. Of course this behavior violates the concepts of just-
in-time and the theory of constraints. A way to promote cooperation, rather than competitive
behavior, is to use variance analysis at the plant level to monitor overall operations, but not as a
way to micro manage at the departmental level. At the department level, there are more
important measurements that are process oriented rather than financial results oriented. Many of
these measurements were discussed in Chapter 8.

VARIABLE OVERHEAD

In this section and the following section on fixed overhead, we will consider the equation
approach first, followed by flexible budget diagrams and graphic illustrations. The T-account
approach and the journal entries for overhead costs are presented after all four of the overhead
variances have been discussed individually.

The analysis of variable overhead costs in standard costing typically includes two variances, the
spending variance and the efficiency variance. The following symbols are used below to help
illustrate these measurements.

SVOR = Standard variable overhead rate per direct labor hour.

AHU = Actual direct labor hours used.
SHA = Standard direct labor hours allowed for the good output.
AVO = Actual total variable overhead cost incurred.

EXAMPLE 10-3

A continuation of the Expando Company example is used to illustrate the techniques and
concepts. Assume that standard overhead rates are based on 4,800 direct labor hours per month.
The variable overhead rate calculation and other relevant data appear below.
SVOR = $144,000 ÷ 4,800 D.L. Hours = $30 per hour
Standard direct labor hours allowed per unit = .4
Standard direct labor hours allowed = (.4)(10,000 units produced) = 4,000
Actual Direct labor hours used = 4,100
Actual total variable overhead cost incurred = $121,500

The Equation Approach

The variable overhead spending variance was introduced in Chapter 4, but to refresh your
memory, this variance is calculated as follows:

Variable Overhead Spending Variance5 = AVO - (SVOR)(AHU) = $121,500 - (30)(4,100) =

121,500 - 123,000 = 1,500 favorable

If some other activity measure were used to apply overhead, (e.g., machine hours) then the
flexible budget would be based on the actual quantity of that measurement, rather than actual
direct labor hours (AHU). The only difference between this illustration and the Chapter 4
illustration is the reference to a standard variable overhead rate (SVOR), as opposed to just a
variable overhead rate (VOR) in the normal historical costing illustration in Chapter 4. Since
both rates should be based on estimates of what variable overhead costs should be for the
denominator activity level chosen, these rates and the spending variance calculations are
mechanically and conceptually identical in normal historical costing and standard costing.

The variable overhead efficiency variance represents an estimate of the quantity variance for
indirect resources that is caused by efficient or inefficient use of the overhead allocation basis.
This is difficult to understand at first, so before we examine this interpretation in more depth,
consider how the variance is calculated.

Variable Overhead Efficiency Variance = (SVOR)(AHU) - (SVOR)(SHA) or = (AHU -

SHA)(SVOR)
= (30)(4,100) - (30)(4,000) = (4,100 - 4,000)(30) = 123,000 - 120,000 = (100)(30) = $3,000
unfavorable

Some authors refer to this variance as the variable overhead quantity variance, but part of the
quantity variance is likely to be included in the spending variance. Therefore, the V.O. efficiency
variance is only an estimate of that part of the variable overhead quantity variance caused by the
efficient, or inefficient use of the allocation basis. The quantities compared in the calculation are
quantities of the allocation basis, (usually direct labor hours) not quantities of the resources
represented by the variable overhead costs. If the variations in the activity measure, (in this case
direct labor hours) were perfectly correlated (i.e., r2 = 1) to the variations in the indirect
resources represented by the variable overhead costs, the efficiency variance would represent an
accurate measure of the entire quantity variance for variable overhead. Then, the spending
variance would represent an accurate measure of the variable overhead price variance. Since
interpreting the overhead variances is confusing, an expanded discussion of the traditional
interpretation of these variances is provided later in this chapter.
A Flexible Budget Diagram For Variable Overhead Analysis

The variance analysis for variable overhead is more revealing when presented in a manner that
places emphasis on the flexible budgets involved. Consider the diagram in Exhibit 10-14. Since
the total variance in variable overhead costs is the difference between the actual costs incurred
(A) and standard costs allowed (D), the diagram shows how the flexible budget based on actual
hours (B) is used to separate the total $1,500 unfavorable variance into two parts.

The traditional interpretation of the separate variances is as follows. The $3,000 unfavorable
efficiency variance represents an attempt to measure the effect of labor inefficiency on variable
overhead costs. Since actual direct labor hours were 100 above the standard hours allowed, the
efficiency variance is unfavorable. This interpretation is based on the implicit assumption that
direct labor activity drives variable overhead costs, or more specifically, causes indirect
resources to be used.6

Therefore, it is estimated that $3,000 of additional variable overhead costs, ($30)(100 hours)
were incurred because labor required more time to produce the 10,000 units than the standard
time allowed. The $1,500 favorable variable overhead spending variance is assumed to include
the variance caused by differences between budgeted and actual prices of the indirect resources
and any quantity variance in indirect resource usage not caused by direct labor inefficiency. The
validity of these interpretations depends on the strength of the relationships between the activity
measure, or allocation basis, and the indirect resources. These interpretations are examined
below after the graphic approach is presented.

The Graphic Approach

A graphic approach for variable overhead analysis is presented in Figure 10-4. The vertical
difference between points A (actual variable overhead costs) and B (flexible budget variable
overhead costs based on actual direct labor hours) represents the variable overhead spending
variance. The vertical difference between points B and D (standard variable overhead costs)
represents the variable overhead efficiency variance. Since direct labor hours used and purchased
are equal, A' and C are not needed in the analysis. As you can see from the graph, the variable
overhead efficiency variance is the difference between two point estimates, i.e., two points on the
flexible budget line.

Interpreting The Meaning Of The Traditional Variable Overhead Variances

To understand the meaning of the traditional variable overhead variances, it is helpful to consider
the conceptual view of factory overhead cost drivers presented in Exhibit 10-15. This exhibit
shows that factory overhead, or indirect resource costs are driven by prices and quantities, just
like any other costs and these prices and quantities are driven by many other factors, just like any
other prices and quantities. The prices of the various indirect resources (e.g., indirect labor,
indirect materials, electricity, water) are influenced by the supply and demand for these resources
as well as the quality and quantities of the resources purchased. In addition, the geographic
location of the company, any vendor services included with a resource and random variations
also affect prices. The quantities of indirect resources used are driven by product diversity,
production volume, direct labor efficiency and the efficiency of the resource providers. Resource
providers include those outside the company, such as vendors, as well as those who provide
services inside the company. Inside resource providers include the various departments or
functional areas such as materials planning, purchasing, receiving, inspecting, moving, storing,
packing and shipping as well as machine setups, engineering, power, heating, cooling,
maintenance and housekeeping.

Consider the following three questions: 1) Are the variable overhead spending and efficiency
variances equivalent to price and quantity variances? 2) If not, what causes them to be different?
and 3) How do they differ from price and quantity variances? The answer to the first question is
no, the spending and efficiency variances are not price and quantity variances in the same sense
of the terms price and quantity used for direct materials and direct labor. These variances are
different from price and quantity variances for two reasons. First, the overhead rates are not
individual prices. Instead they are aggregates of many prices and quantities converted into a
composite rate per activity measure, e.g., per direct labor hour. Second, these variances are
influenced by an unavoidable estimating error caused by ignoring some of the indirect resource
quantity drivers illustrated in Exhibit 10-15. More specifically, the effects of product diversity
and indirect resource provider efficiency (not related to direct labor or production volume) are
ignored, along with the inevitable randomness associated with the use of any resource.

An estimating error occurs when a flexible budget based on the actual inputs of the allocation
basis is used to separate the total variable overhead variance into two parts. When this is done,
the analyst is implicitly using the actual quantity of one type of resource, (usually actual direct
labor hours) to estimate the quantities of the indirect resources such as kilowatt hours of
electricity, hours of indirect labor, and quantities of indirect materials. When the estimates differ
from the actual quantities consumed (as they always do), an estimating error is included in the
analysis. The effect on the spending and efficiency variances caused by this estimating error is
the difference between the flexible budget based on the actual quantity of the overhead allocation
basis and the flexible budget that would be calculated for this purpose if the actual quantities of
the indirect resources were used instead. Although the size and direction of this effect is
unknowable in actual practice, the concept is illustrated in Exhibit 10-16.

The traditional spending and efficiency variances are calculated on the left-hand side of Exhibit
10-16 using the flexible budget based on the actual quantity of the allocation basis (B2).
Theoretically, the price and quantity variances on the right-hand side of Exhibit 10-16 could be
calculated using a flexible budget based on the actual quantities and budgeted prices of the
indirect resources (B1). However, these variances cannot be calculated in the traditional analysis
because the actual quantities and budgeted prices of each of the indirect resources are simply not
available.

Perhaps you are thinking, if the variable overhead variances aren't price and quantity variances,
then what are they? Well, that is a good question. The traditional interpretation of the variable
overhead spending and efficiency variances is illustrated in Exhibit 10-17. The traditional
interpretation is that the spending variance includes the price variance and the part of the
quantity variance caused by factors other than the efficiency or inefficiency of the allocation
basis, i.e., 1 = 3 + 4 in Exhibit 10-17. However, the part of the quantity variance caused by
unknown factors could be fairly large because it includes the effects of random variations, the
effects of any non-production volume related cost drivers and any error in estimating the
influence of direct labor efficiency on indirect resource consumption. The efficiency variance is
interpreted as that part of the quantity variance for variable overhead that is caused by the
efficiency or inefficiency of the allocation basis, i.e., that 2 = 5 in Exhibit 10-17.

Although these traditional interpretations are intuitively appealing, the spending and efficiency
variances are not precise measures and can be very misleading. This is because there are two
invalid assumptions underlying the traditional analysis. One assumption is that production
volume and direct labor efficiency are the only significant drivers of indirect resource usage.7
The other assumption is that the cause and effect relationship between the activity measure
(allocation basis) and indirect resource consumption is fairly precise. Precise enough so that it
accurately measures the effect of the efficiency of the allocation basis on the quantities of
indirect resources consumed.

The problem caused by the first assumption can be eliminated by using activity based costing
concepts, i.e., using different cost pools and activity measures (both production volume and non
production volume) to allocate or trace indirect resource costs to products. However, the problem
caused by the second assumption is more troublesome. The choice of an allocation basis
(Traditional or ABC) and the resulting overhead rates are not based on an engineered
relationship like the relationships between the direct resources (direct material and direct labor)
and output. Instead the allocation measurement is usually based on one of the cost behavior
techniques discussed in chapter 3, management experience and intuition, or more likely in
traditional cost systems, direct labor dollars or hours because they are conveniently captured by
the payroll system. The efficiency variance is essentially the difference between two point
estimates on a regression line (see Figure 10-4). Sometimes these estimates are overstated and
sometimes they are understated. (Remember the standard error of the estimate in Chapter 3). To
assume that the difference between two points on a regression line precisely measures the effect
of the independent variable on the dependent variable between those two points is not warranted,
or supported, by the least squares technique. The result can be very misleading. For example, if
the variable overhead efficiency variance substantially overstates, or understates the effect of
direct labor inefficiency on indirect resource costs, an offsetting variance amount will
automatically appear in the spending variance. This under, or overstatement might easily be
misinterpreted, although it is not interpretable at all. Thus, the main point of this discussion is
that the traditional analysis can only provide a rough estimate of the nature of the total variance
for a particular type of variable overhead. For this reason, it is probably best not to separate the
total variable overhead variance into spending and efficiency variances unless the correlation
between the allocation basis and the consumption of each type of indirect resource is fairly high.

FIXED OVERHEAD

The analysis of fixed overhead costs also includes two variances, the fixed overhead spending
variance and the production volume variance. The fixed overhead spending variance was
introduced in Chapter 4 and the planned production volume variance was discussed in Chapter 9.
Now we are ready to include these variances in standard costing. The following additional
symbols are used to illustrate the analysis of fixed overhead.

SFOR = Standard fixed overhead rate per direct labor hour.

AFO = Actual total fixed overhead.
DH = Denominator hours, i.e., the number of hours used as a basis for the overhead rate
calculations.
BFO = (SFOR)(DH) = Budgeted fixed overhead.

EXAMPLE 10-4
This example extends the Expando Company illustration to include fixed overhead. Assume that
the standard fixed overhead rate is based on 4,800 direct labor hours per month. The fixed
overhead rate calculation and other relevant data appear below.

SFOR = $240,000 ÷ 4,800 D.L. Hours = $50 per hour

Standard direct labor hours allowed = (.4 per hour)(10,000 produced) = 4,000
Actual Direct labor hours used = 4,100 and Actual total fixed overhead cost incurred = $242,500.

Equation Approach

The fixed overhead spending variance is calculated by comparing the actual fixed overhead costs
with the budgeted fixed overhead costs as follows:

Fixed Overhead Spending Variance = Actual Total Fixed overhead - Original Fixed Overhead
Budgeted

= AFO - (DH)(SFOR) = 242,500 - (4,800)(50) = 242,500 - 240,000 = $2,500 unfavorable

Remember that budgeted fixed overhead costs are the same for all activity levels. The total
amount is frequently a given in standard cost problems, but in some situations you may need to
divide the annual amount by 12 to arrive at a monthly budget, or multiply denominator hours by
the fixed overhead rate as shown above. Remember, the rate calculation is:

SFOR = Budgeted Fixed Overhead costs ÷ denominator hours

therefore, if it is not given, you can easily find budgeted fixed overhead as shown above, i.e.,
(DH)(SFOR).

This variance was also introduced in Chapter 4 since it can be calculated in normal historical
costing. It measures any price and quantity differences between actual and budgeted prices and
actual and budgeted quantities for the various types of resources represented by the fixed
overhead costs. Notice that the meaning of the fixed overhead spending variance is different
from the meaning of the variable overhead spending variance. The fixed overhead spending
variance does not include an estimating error because the analysis does not include as estimate of
the actual quantities of fixed resources consumed. However, it does include a variance resulting
from any variation in the quantities of the resources represented in the fixed overhead costs. For
example, a quantity effect occurs when a salaried employee resigns during the period, and when
there are increases or decreases in the company's fixed assets during the period.

Production Volume Variance

The planned production volume variance was introduced in Chapter 9. This section introduces
the actual production volume variance. Remember that the planned production volume variance
is based on the difference between denominator hours and the standard (or budgeted) hours
allowed for the budgeted units to be produced. The actual production volume variance is very
similar, but it is based on the difference between denominator hours and standard hours allowed
for the actual units produced. For the Expando Company example, the variance is as follows:

Production Volume Variance = Budgeted Fixed Overhead costs - Standard Fixed Overhead
costs

= (SFOR)(DH) - (SFOR)(SHA) or (DH-SHA)(SFOR)

= (50)(4,800) - (50)(4,000) or (4,800 - 4,000)(50)
= 240,000 - 200,000 or (800)(50) = $40,000 unfavorable

The variance is unfavorable, as in this case, if standard fixed overhead costs are less than
budgeted. Actual production was 800 hours below the average monthly denominator level.
Therefore, the variance represents the cost of unused capacity and under-utilizing capacity is
viewed as unfavorable.

The production volume variance is similar to the idle capacity variance introduced in Chapter 4.
They are both measures of capacity utilization. The production volume variance measures the
variance caused by the difference between the denominator output level, i.e., capacity used to
calculate the overhead rates, and the output level actually achieved. If unit data are available, it
may also be calculated in the following manner.

Alternative Calculation for the Production Volume Variance

Production Volume Variance = (Denominator units - Actual units)(Fixed overhead per unit)

= (12,000 - 10,000)(20) = (2,000)(20) = $40,000 unfavorable

The difference between the idle capacity variance and the production volume variance is in how
the actual capacity level is measured. The idle capacity variance uses actual direct labor hours as
a measure of capacity utilization, while the production volume variance uses standard direct
labor hours. The difference is that using standard hours is equivalent to using actual units of
output in the calculation which excludes the effect of direct labor efficiency.8 The production
volume variance is a better measurement if the plant facilities represent the main capacity
constraint, (e.g., a bottleneck machine) as opposed to the number of direct labor hours available.
An alternative approach is presented in Appendix 10-1 using the idle capacity variance.

Controllability of the Variances

The production volume variance is considered to be uncontrollable for the same reason the idle
capacity variance is considered to be uncontrollable. Recall that control refers to the ability to
influence actual costs. But, neither the idle capacity variance or the production volume variance
calculations involve actual costs. They merely represent more or less applied fixed overhead
costs than budgeted fixed overhead costs. Both variances occur because of the attempt to match
cost against benefits and obtain the advantages of using a predetermined overhead rate, e.g.,
normalizing unit overhead cost and more timely costing and pricing. The main purpose of
calculating either of these variances is to remove them from the total overhead variance, so that
the other parts, i.e., the controllable variances, can be isolated for further evaluation and possible
investigation.

Diagram Of Fixed Overhead Variances

A diagram approach may also be used for fixed overhead variance analysis, although a flexible
budget is not involved. Consider the analysis presented in Exhibit 10-18.

The original static budget for fixed overhead (B) is used to separate the $42,500 total variance in
fixed overhead costs into two parts, spending and production volume, or controllable and
uncontrollable. Denominator hours are used in the budget calculation to find the static budgeted
fixed overhead amount if it is not otherwise available. But remember, budgeted fixed costs are
not flexible, thus a flexible budget calculation for fixed overhead is not appropriate.

The Graphic Approach For Fixed Overhead

A graphic approach for fixed overhead analysis is presented in Figure 10-5. This graph not only
provides a way to illustrate fixed overhead variance analysis in a standard cost system, but more
importantly, it provides a way to emphasize the difference between budgeted costs and standard
costs. Budgeted fixed costs are represented by a horizontal line which indicates that budgeted
fixed overhead costs do not change as the level of production changes. However, the standard
fixed overhead cost line is up-sloping which shows that standard costs increase as production
increases. This is because fixed overhead is treated as a variable cost when applied to the units
produced, i.e., for inventory valuation purposes.

Observe that the slope of the standard cost line is the standard fixed overhead rate (SFOR). The
two lines intersect at the capacity level chosen as the denominator for calculating the standard
overhead rates. Standard fixed overhead costs are equal to budgeted fixed overhead costs only
when denominator hours (DH) are equal to standard hours allowed (SHA). In that specific case,
the production volume variance is zero since SHA=DH, (SHA)(SFOR)=(DH)(SFOR) and, as a
result, Points B and D would be in precisely the same place on the graph at the intersection of the
two lines. When standard hours allowed are not equal to denominator hours, a production
volume variance results and is represented by the vertical difference between Points B and D. In
Figure 10-5 the production volume variance is unfavorable because standard hours allowed are
less than denominator hours. It is favorable when SHA>DH.

Denominator capacity can be any level of capacity from zero to 100 percent of maximum. The
most common capacity levels used are: 1.) planned, i.e., master budget units to be produced, 2.)
practical, i.e., the maximum level of production under efficient, but not perfect, operating
conditions, and 3.) normal, i.e., a long run average level of production.
The Unplanned Production Volume Variance

The unplanned production volume variance is a more useful measure of capacity utilization than
the actual production volume variance because it results from a comparison of planned and
actual capacity utilization. Referring back to the Expando Company budget in Chapter 9, recall
that the planned production volume variance for March was $19,000 unfavorable. Since the
actual variance for March is $40,000 unfavorable, the unplanned variance is $21,000
unfavorable. Although the production volume variance is referred to as uncontrollable, a large
unplanned variance may need to be investigated and explained. The unplanned variance above
could have been caused by a decrease in the demand for the Company's product, or by various
production problems. The calculations are presented in Exhibit 10-18A as a more revealing
alternative to the analysis in Exhibit 10-18.

alternative to the analysis in Exhibit 10-18.

T-account Approach for Factory Overhead

Expando Company's factory overhead costs and the resulting variances are recorded in T-account
form in Exhibit 10-19.
Exhibit 10-19 shows three entries. The first entry records the actual factory overhead costs of
$364,000 and shows a credit to miscellaneous accounts. The second entry charges the standard
(applied) overhead costs of $320,000 to the work in process account. This leaves a debit balance
in the factory overhead account of $44,000 that represents an unfavorable total factory overhead
variance. The third entry closes the factory overhead account by distributing the variances to the
four variance accounts.

Journal Entries

The general journal entries required to record the factory overhead costs are presented in Exhibit
10-20.

EXHIBIT 10-20
Journal Entries to Record Factory Overhead Costs
Entry to record actual overhead Factory Overhead Control 364,000
costs Miscellaneous Accounts* 364,000
Entry to record standard Work in Process 320,000
overhead costs Factory Overhead Control 320,000
 VO Efficiency variance 3,000
FO Spending variance 2,500
Entry to close the control
Production volume variance 40,000
account
VO Spending variance 1,500
Factory Overhead Control 44,000
* e.g., Accounts payable, accumulated depreciation, factory payroll, etc.

Summary Combined Overhead Analysis

All of the overhead variances can be calculated in a combined approach that emphasizes the
flexible budgets involved. Exhibit 10-21 illustrates the idea. A four variance approach appears on
the right-hand side of the exhibit and a two variance approach appears on the left side. The
difference between items 1 and 4 is the total unfavorable variance in factory overhead costs of
$44,000. The difference between actual total overhead costs (1) and a flexible budget based on
actual direct labor hours (2) is the total spending variance of $1,000 U. This variance can easily
be separated into variable and fixed spending variances as illustrated on the right-hand side of
the exhibit. The difference between the flexible budget based on actual direct labor hours (2) and
a flexible budget based on standard direct labor hours (3) is the variable overhead efficiency
variance. Budgeted fixed overhead does not affect the variable overhead efficiency variance
calculation because it is the same static amount in both flexible budgets. The difference between
the flexible budget based on standard direct labor hours (3) and standard total factory overhead
(4) is the production volume variance. Variable overhead does not affect this variance calculation
because standard variable overhead in item 4 is the same as the flexible budgeted variable
overhead based on standard direct labor hours in item 3.

In the two variance approach on the left-hand side of Exhibit 10-21, the Controllable variance is
the difference between actual total overhead (1) and a flexible budget based on standard hours
allowed (3). The Controllable variance is a combination of the two spending variances and the
VO Efficiency variance. The Uncontrollable variance is just another term for the production
volume variance. In addition to the methods above, there are many other ways to analyze the
total overhead variance in standard costing. Some additional alternatives are presented in
Appendix 10-1.

Potential Behavioral Problems Associated with Overhead Variances

The behavioral problems associated with overhead variances are similar to those associated with
the direct labor variances. This is understandable since variable overhead efficiency variances
are derived from the direct labor efficiency measurement. As a result, when the variable
overhead efficiency variance is used to evaluate individual department managers, it reinforces
the temptation to overproduce and to de-emphasize quality. The production volume variance has
the same effect since managers can cause the variance to be less unfavorable, or more favorable,
by producing more than is needed. A partial solution to this potential behavioral problem, at least
as far as the production volume variance is concerned, is to compare the actual production
volume variance to the planned production volume variance, i.e., emphasize the unplanned
variance rather than the actual variance. This avoids the implication in departmental performance
reports that the production managers are somehow responsible for a variance that is planned
based on budgeted sales. Of course another solution, as indicated earlier, is to use variance
analysis at the plant level to monitor overall operations, but not as a way to micro manage at the
departmental level.

Accounting for the Variances at Month and Year End Closing

The variance accounts for materials, labor and overhead may be: 1) closed to the income
summary for interim reporting and then reversed, or 2) closed to cost of goods sold, or 3)
prorated to the inventory accounts and cost of goods sold at the end of the period. The first
alternative is preferable for internal reporting because alternatives 2 and 3 cancel the normalizing
and control benefits obtained from using predetermined or standard overhead rates. (This point
was discussed in Chapter 4.) Using the first alternative provides the information for monthly and
year to date comparisons. For example, the computer program for this chapter shows the
variances separately on the income statement below gross profit (See Appendix 10-2). For
external reporting purposes, alternatives 2 or 3 should be used, since GAAP and the IRS require
actual costs in the external statements. Alternative 3 is preferable when the variances are
significant. Then the variances are charged to the inventory accounts and cost of goods sold in
proportion to the current period costs remaining in those accounts.

SUMMARY OF THE STANDARD COST CONTROVERSY

The various behavioral problems associated with standard costing have been discussed
throughout this chapter. In summary, the main argument against the standard cost control
methodology is that it emphasizes financial performance measurements that tend to motivate
managers to manage the short term financial results rather than the processes that add value and
contribute to the company's long run profitability. The main types of dysfunctional behavior
include creating excess direct materials and finished goods inventory, (a push system rather than
JIT demand pull system) de-emphasizing quality and promoting competitive behavior among
employees and production department managers. From the perspective of the just-in-time and
theory of constraints lean enterprise concepts, this behavior creates a great deal of waste and
prevents optimizing the company's overall performance.

In defense of standard costing, one can argue that it provides a powerful planning device
(Chapter 9) and macro performance monitoring system (Chapter 10) that allows middle and
upper level managers to see the big picture on a periodic basis. If other non-financial
performance measurements (Chapter 8) are used to guide and evaluate lower level managers,
then standard costing can still play an important role in the overall management of the
organization, even in a JIT or TOC environment. From this defense perspective, it is just a matter
of developing a balanced system that does not overemphasize any particular aspect of
performance. Kaplan and Norton build on this idea using an approach referred to as the balanced
scorecard.9 Balanced scorecards are systems that balance the various aspects of performance
including financial and non-financial, short term and long term, leading and lagging, and internal
and external measurements. (See MAAW's Balanced Scorecard topic for more information).
Perhaps the implementation of the balanced scorecard approach will help resolve the controversy
over standard cost control in the long run, but this issue is not likely to be resolved in the near
future and it is certainly not a trivial issue. Surveys have indicated that the majority of
manufacturing firms use some form of standard costing.10 Therefore, it is important to recognize
that where people are involved, performance measurement systems simultaneously measure and
influence behavior.

The methods illustrated in Exhibit 10-21 provide a convenient way to calculate all of the
overhead variances at once and a better overall picture of how overhead costs are evaluated.
However, be careful with this combined approach. It is important to recognize that a total budget
must be calculated in two parts. We cannot multiply fixed overhead per hour by actual or
standard hours to arrive at budgeted fixed overhead. Since fixed costs do not vary with the level
of productive activity, we must use the amount from the original budget. Remember, if this is not
available, we can calculate it by taking 1/12 of the annual fixed overhead budget, or by
multiplying denominator hours for one month by the fixed overhead rate.