Community

Ask a Question Write a Blog Post Login / Sign

Ranjit Simon John

October 23, 2012 | 12 minute read

Understanding Production Order

Variance – Part 1 Performance
Evaluvation Through Standard
Costs

! 12 " 47 # 61,018

Understanding Production
Order Variance – Part 1
Managerial Accounting –
Performance Evaluation
Through Standard Costs
Author: Ranjit Simon John
The ultimate aim of any company will be generating pro!t
and increasing the pro!t margin. There are many
interpretations of the word pro!t . Time, resource, money,
e"ort, e"ectiveness etc are in one instance or the other
equated to pro!t . We can say all these words can be
consolidated and merged into “E#ciency“. By measuring
the e#ciency of a !rm we can calculate the pro!t and by
improving the e#ciency the pro!t margin grows. Lets drill
down to !nd the ingredients of “E#ciency“. E#ciency
focuses on the cost of accomplishing the task.
Lets explain “E#ciency” with an example. To evaluate the
e"ectiveness of a product produced the following questions
has to be answered e"ectively;
1. Was the best cost obtained in purchasing raw
materials.
2. Whether the speci!ed quantity of raw material was
used.
3. Was extra raw materials used
4. Was the speci!ed amount and level of overheads used
5. Was the task completed within speci!ed time

Measuring all these and con!rming to the speci!ed range

will increase the e"ectiveness there by increasing e#ciency.
The importance of “STANDARDS“
Many !nance managers argues on the point, actual
price should only be followed while valuating !nished
and semi !nished goods, not the standard price. The
starting point of better controlling begins with better
“STANDARD“, let it be for price determination or for
employee performance evaluation.
In our daily life we are bound to meet certain standards;
the food we eat, the mobile phone we use, the car we
drive, Government standards, organizational standards
are few to be noted. All and everything in our daily life
has to meet certain “STANDARD“.
Di"erence between Standard Cost and Budget:
Standards and Budgets are essentially the same in concept.
Both are predetermined costs and both contribute
signi!cantly to management planning and control. A
Standard is a Unit amount, whereas a budget is a Total
amount.
There are important accounting di"erences between
budgets and standards. Budget data are not journalized in
cost accounting. Standard cost will be incorporated into
accounting systems.
Why Standard Costs?
Standard Cost o"er the following advantages;

Facilitate Management Planning by establishing expected

future costs
Makes employees more “Cost Conscious”
Useful for Setting “Selling Price” for !nished goods
Contribute to Management Control by providing a basis
for evaluating the performance of managers responsible
for controlling costs.
Performance may be evaluated through management by
exception, as deviations (or Variances) from standard are
highlighted
When standard costs are incorporated into the
accounting system, they simplify the costing of
inventories and reduce clerical costs.
Provides a clear overview of the entire process in the
company.

Setting Standard Costs

Setting up standard cost is a highly di#cult task.
Standards may be set at one of two levels: Ideal
Standards or Normal Standards.
Ideal Standards represent the optimum level of
performance under perfect operating conditions.
Normal Standards represent an e#cient level of
performance that is attainable under expected
operating conditions.
To be e"ective in controlling costs, standard costs need
to be current at all times. Thus, Standards should be
under continuo’s review and should be changed
whenever it is determined that the existing standard is
not good measure of performance.
To establish the standard cost of producing a product, it
is necessary to establish standards for each
manufacturing cost element – direct materials, direct
labor and manufacturing overhead. The standard for
each element is derived from a consideration of the
standard price to be paid and the standard quantity to
be used.
The three Standard Cost calculation sections;
1) Direct Materials:
Direct Materials Price Standard
The direct materials price standard is the cost per
unit of direct materials that should be incurred. This
standard should be the Cost of raw materials, which is
frequently based on an analysis of current purchase
prices.
Item / Unit Price
Raw Material Purchase Price 2.70
Transportation Charge 0.20
Receiving and Handling 0.10
Standard Direct Material Price Per Ton 3.00

Direct Materials Quantity Standard

The direct materials quantity standard is the
quantity of direct materials thats should be used per
unit of !nished goods. The standard is expressed as a
physical measure. Consideration should be given to both
the quality and quantity of material required to
manufacture the product. The standard should include
allowances for unavoidable waste and normal spoilage.

Item Quantity
Required Raw Material 3.50
Allowance for Waste 0.40
Allowance for Spoilage 0.10
Standard Direct Materials Quantity per Unit 4.00

The Standard Direct Material Cost Per Unit =

Standard Direct Material Price x Standard Direct
Materials Quantity

2) Direct Labor
Direct Labor Price Standard
The direct labor price standard is the rate per hour
that should be incurred for direct labor.
Item Price
Hourly Wage Rate 7.50
Cost of Living 0.25
Other beni!ts 2.25
Standard Direct Labor Rate / Hour 10.00

Direct Labor Quantity Standard

The direct labor quantity standard is the time that
should be required to make one unit of the product.

Item Quantity
Actual Production Time 1.50
Rest Periods and Cleanup 0.20
Setup and Downtime 0.30
Standard Direct Labor Hours Per Unit 2.00

The Standard Direct Labor Cost Per Unit =

Standard Direct Labor Rate x Standard Direct
Labor Hours

3) Manufacturing Overhead
For manufacturing overhead, a Standard Predetermined
Overhead rate is used in setting the standard. This
overhead rate is determined by dividing budgetd overhead
costs by an expected standard activity index. For example
the index can be standard direct labor hours or standard
machine hours.

Budgeted Amount Standard Overhead

Overhead Direct Rate
Costs Labor Per Direct
Hours Labor Hour
Budgeted / Standard = Overhead
Overhead Costs Direct Labor Rate Per
Ampunt Hour Direct Labor
Hour
Variable 79,200.00 26,400.00 3.00
Fixed 52,800.00 26,400.00 2.00
Total 132,000.00 26,400.00 5.00

The Standard Manufacturing Overhead Rate Per

Unit = Predetermined Overhead Rate x Direct
Labor Quantity Standard

The total standard cost per unit is the sum of the

standard costs of Direct Materials, Direct Labor and
Manufacturing Overheads.
Manufacturing Standard Standard Standard
Cost Elements Quantity Price = Cost
x
Direct Materials 4 TON 3 12.00
Direct Labor 2 Hours 10 20.00
Manufacturing 2 Hours 5 10.00
Overheads
Total 42.00
Manufacturing
Cost

The standard cost provides the basis for determining

variances from standards.
Determining Variances from Standards
One of the major management use of standard cost is
the determination of Variances. Variances are the
differences between total actual costs and total standard
cost. The process by which the total difference between
standard and actual results is analysed is known as
variance analysis. When actual results are better than the
expected results, we have a favourable variance (F). If, on
the other hand, actual results are worse than expected
results, we have an adverse (A).
The following types of variance can be calculated;

Planning variances

– Input price variance

– Resource-usage variance

– Input quantity variance

– Remaining input variance

– Scrap variance

Production variances

– Input price

– variance

– Resource-usage variance

– Input quantity variance

– Remaining input variance

Production variance of the period

– Input price

– variance

– Resource-usage variance

– Input quantity variance

– Remaining input variance

– Scrap variance

– Mixed-price variance

– Output price variance

– Lot size variance

Total variance

– Input price

– variance

– Resource-usage variance

– Input quantity variance

– Remaining input variance

– Scrap variance

– Mixed-price variance

– Output price variance

– Lot size variance

– Remaining variance

* In make-to-stock production, standard cost is calculated

in the standard cost estimate for the material. In sales-
order-related production with a valuated sales order stock,
standard cost is determined using a predefined valuation
strategy.

* During production, actual costs are collected on the order

(product cost collector or manufacturing order). The actual
costs that are compared with the target costs are reduced
by the work in process and scrap variances (the result is
called the net actual cost).

* We can determine the production variances of the period

by comparing an alternative material cost estimate with the
(net) actual costs. This alternative material cost estimate
can be the modified standard cost estimate or the current
cost estimate, for example.

Example: Let us assume that the standard manufacturing

cost per ton of “Material A” is 42.00. Production
departement has produced 100 Ton of the material. So
Standard manufacturing cost = 100 * 42 = 42,000.00
In actual the consumption was as follows
Item Amount
Direct Materials 13,020.00
Direct Labor 20,580.00
Variable Overhead 6,500.00
Fixed Overhead 4,400.00
Total Actual Cost 44,500.00

Variance Posted

Actual Cost 44,500.00

Standrad Cost 42,000.00
Total Variance 2,500.00 (A)

Unfavourable and Favourable Variance

When actual costs exceed standard costs, the variance
is unfavourable (A). Thus, the 2,500.00 variance is
unfavourable. An unfavourable variance has a negative
connotation. It suggests that too much was paid for
one or more manufacturing cost elements or that the
elements were used ine#ciently .
If the actual costs are less than standard costs, the
variance is favourable (F). A favourable variance has a
positive inference. It suggests e#ciencies in incurring
manufacturing costs and in using direct materials, direct
labour, and manufacturing overhead. Favourable
variance can also be by using inferior quality materials.
Analyzing variances begins with a determination of the
cost elements that comprise the variance. For each
Cost element a total variance is calculated. Then
this variance is analyzed into a price variance
and a quantity variance.

Each of the Variance are explained in detail below.

Direct Material Variance
For producing 1,000 Ton of Cement, company A used
4,200 Ton of raw material purchased at a cost of 3.10
per unit. The total material variance is computed
from the following formual;

The total material variance for Comapny A is 1,020 (A)

(13,020 – 12,000). (unfavourable variance)
(4,200 x 3.10) – (4,000 x 3.00) = 1,020.00 (A)
The material price variance is computed from the
formula given below

The material price variance for Company A is 420.00 (A)

(13,020 – 12,600). (unfavourable Variance)
(4,200 x 3.10) – (4,200 x 3.00) = 420.00 (A)
The material quantity (usage) variance is
determined from the following formula;

The material quantit unfavourable variance is 600 (A)

(12,600 – 12,000). (Unfavourable Variance)
(4,200 x 3.00) – (4,000 x 3.00) = 600 (A)
Item Variance
Material Price Variance 420
Material Quantity VAriance 600
Total Material Variance 1,020 (A)

Variance Matrix
Variance matrix can be used to determine and analyze a
variance. When the matrix is used, the formulas
for each cost element ar computed !rst and then
the variances.
Applying variance martix:

Direct Labor Variance

The process of determining direct labor variance is the
same as for determining the direct material variance.
The total labor variance is obtained from the formula;

The total labor unfavourable variance is 580 (A) (20,850

– 20,000). (Unfavourable Variance)
(2,100 x 9.8) – (2,000 x 10.00) = 580 (A)
The labor price (or rate) variance is calculated
using the formula;

The labor price variance is 420 (F) (20,580 – 21,000).

(Favourable Variance)
(2,100 x 9.8) – (2,100 x 10.00) = 420 (F)
The labor quantity (or e#ciency) variance is
calculated using the formula;

The labor quantity variance is 1,000 (A) (21,000 –

20,000). (unfavourable variance)
(2,100 x 10.00) – (2,000 x 10.00) = 1,000 (A)
The total direct labor variance can be derieved from;
Item Variance
Labor Price Variance (420)
Labor Quantity Variance 1,000
Total Direct Labor Variance 580 (A)

Using the Variance Matrix;

Note: When idle time occurs the e#ciency

variance is based on hours actually worked (not
hours paid for) and an idle time variance (hours
of idle time x standard rate per hour) is
calculated.
Manufacturing Overhead Variance
The computation of the manufacturing overhead
variance is conceptually the same as the computation of
the materials and labor variances.
Total Overhead Variance
The total overhead variance is the di"erence
between actual overhead costs and overhead costs
applied to work done. With standard costs,
manufacturing overhead costs are applied to work in
process on the basis of the standard hours allowed
for the work done. Standard hours allowed are the
hours that should have been worked for the units
produced. In the example company A’s standard hours
allowed for completing work B is 2,000 and the
predetermined overhead rate is 5 per direct labor hour.
Thus overhead applied is 10,000 (2,000 x 5)
Note: The actual hours of direct labor are not used in
applying manufacturing overhead.
The formula for the total overhead variance is:

Thus total overhead variance for Comapny A is 900.

10,900 – 10,000 = 900
The overhead variance is generally analyzed through a
price variance and a quantity variance. The name usually
given to the price variance is the overhead controllable
variance, whereas the quantity variance is referred to as
the overhead volume variance.
Overhead Controllable Variance
The overhead controllable variance (also called the
budget or spending variance
variance) is the di"erence
between the actual overhead costs incurred and the
budgeted costs for the standard hours allowed. The
budgeted costs are determined from the $exible
manufactruning overhead budget.
The budget for Company A is as follow;

As shown, the budgeted costs for 2,000 standard hours

are 10,400 (6,000 variable and 4,400 !xed)
The formula for the overhead controllable variance is;

The overhead controllable variance for Comapny A is

500 (unfavourable).
10,900 – 10,400 = 500
Most controllable variance are associated with variable
costs which are controllable costs. Fixed costs are
usually at the time the budget is prepared.
Overhead Volume Variance:
The overhead volume variance indicates whether
plant facilities were e#ciently used during the period.
The formula for calculating overhead volume variance is
as follows;

Both the factors on this formula has been explained

above. The overhead budgeted is the same as the
amount used in computing the controllable variance .
Overhead applied is the amount used in determining the
totoal overhead variance.
In example for Company A the pverhead volume
variance (unfavourable) is 400
10,400 – 10,000 = 400
The budgeted overhead consist of variable and !xed.

A careful examination of this analysis indicates that the

overhead volume variance relates solely to !xed
costs. Thus, the volume variance measures the
amount that !xed overhead costs are under -or
over applied.
If the standard hours allowed are less than the standard
hours at normal capacity, !xed overhead costs will be
underapplied.
If production exceeds normal capacity, !xed overhead
costs will be overapplied.
An alternative formula for computing the overhead
volume variance is shown below;

In example the normal capacity is 26,400 hours for the

year or 2,200 hours for a month (26,400 / 12), and the
!xed overhead rate is 2 per hour. Thus, the volume
variance is 400 unfavourable;
2x (2,200 – 2,000) = 400

Overhead controllable variance 500

Overhead volume variance 400
Total Overhead Variance 900

Using Variance Matrix:

All variances should be reported to appropriate levels of

management as soon as possible. The sooner
management is informed, the sooner problems can be
evaluvated and corrective actions taken if necessary.
Cause of Vraicnes
The causes of variance may relate to both external and
intrenal factors.
Materials Variance
Labor Variance
Manufacturing Overhead Variance
Reference : “Accounting Principles ” by Weygandt.
Kieso. Kell
Also check the following links: Understanding
Production Order Variance Part 2 – The SAP Perspective
Understanding Production
Order Variance Part 3 – Price Di"erence Variance

Follow " Like $ RSS Feed

Alert Moderator

Assigned Tags

MAN Production Planning (PP)

Engineering, Construction, and Operations

Mill Products

Public Sector

SAP Business Process Management

SAP ERP

Business Process Monitoring

View more... %

Similar Blog Posts &

Understanding Production Order Variance - Part 3 Price
Di"erence Variance
By Ranjit Simon John Mar 27, 2012

Understanding Production Order Variance - Part 2 The

SAP Perspective
By Ranjit Simon John Mar 13, 2012

Basics of SAP Standard Cost estimate- understanding

costing variant-Part 2
By Hrusikesh Dalai Nov 19, 2013

Related Questions &

Production order settlement
By thiru jack Oct 26, 2017

production order variance

By Former Member Mar 26, 2012

Production
By Former Member Jul 14, 2013

Join the Conversation &

SAP TechEd
Tune in for tech talk. Stay for inspiration.
Upskill your future.

SAP BTP Learning Group

SAP Business Technology Platform Learning
Journeys.

Co"ee Corner
Join the new Co"ee Corner Discussion
Group.