CHAPTER 2

Variance Analysis
 Learning Objective

 General Objective – to understand and

apply the principles of variance analysis
 Specific Objectives:
1. Explain the meaning of variance
2. Calculate basic material, labour and
overhead variances
3. Identify the typical causes of each
variance and its implications
4. Make an adjustment between actual profit
and standard profit
 Introduction

 Managers need to know how effective

or efficient is business operation
 Actual performance is compared to
expected/budgeted performance
(comparisons among actual results, master budgets
and flexible budgets to evaluate organizational
performance)
 Standard costing – predetermined cost
of products/services
A General Approach to
Variance Analysis
An analysis of the difference between a standard
cost and actual cost is called variance analysis.
The process decomposes the difference in two
components.
For direct material: materials price and materials
quantity variance.
For direct labor: labor rate (price) and labor
efficiency (quantity) variance.
For overhead: overhead volume variance and
controllable overhead variance.
Material Price Variance
MPV is the difference between the actual purchase
price and standard purchase price of materials.
Direct materials price variance is calculated either
at the time of purchase of direct materials or at the
time when the direct materials are used.
When this variance is computed at the time of
purchase of materials it is called direct
materials purchase price variance. When this
variance is computed at the time of usage this is
typically called direct materials price usage
variance.
Material Price Variance
The material price variance is expressed as
(AP – SP)AQp where:
(AP) = actual price per unit of material.
(SP) = standard price per unit of direct material.
(AQp) = actual quantity of material purchased.

If actual price > standard price, then the

variance is unfavorable.
If actual price < standard price, then the
variance is favorable.
 MPV – An Example

 Standard price of material is $4.00 per pond and 6,500 pounds of

materials have been purchased at a cost of $3.80 per pound. This cost
figure includes freight and handling and is net of quantity discount. All
the materials purchased has been used and an output of 2000 units is
produced during the period.
 Required: Calculate materials price variance.

 Calculation of direct materials price variance:

 = (6,500 pounds × $3.80) − (6,500 pounds × $4.00)
 = $24,700 − $26,000
 = $1,300 Favorable
 A favorable material price variance of $1,300 exists because the
actual price of materials purchased is less than the standard price of
materials purchased. A material price variance is called unfavorable
materials price variance if the actual price of materials purchased is
more than the standard price of materials purchased.
 Exercise
 Exercise 1: Materials Variance Analysis

The Schlosser Lawn Furniture Company uses 12 meters of aluminum

pipe at $0.80 per meter as standard for the production of its Type
A lawn chair. During one month's operations, 100,000 meters of the
pipe were purchased at $0.78 a meter, and 7,200 chairs were
produced using 87,300 meters of pipe. The materials price variance is
recognized when materials are purchased. Calculate materials price
variance.
 Exercise 2: Materials Variance Analysis
The standard price for material 3-291 is $3.65 per liter. During
November, 2,000 liters were purchased at $3.60 per liter. The quantity
of material 3-291 issued during the month was 1775 liters and the
quantity allowed for November production was 1,825 liters. Calculate
materials price variance, assuming that:
 It is recorded at the time of purchase (Materials purchase
price variance).
 It is recorded at the time of issue (Materials price usage variance).
 Solution
 Solution 1:

Meters of pipe Unit Cost Amount

Actual quantity purchased 100,000 $0.78 actual $78,000
Actual quantity purchased 100,000 $0.80 standard $80,000
---------- ----------------- ----------
Materials purchase
Price Variance 100,000 $(0.02) $(2,000)fav.
===== ====== ========
 Solution
Solution 2:

Liters Unit cost Amount

Actual quantity purchased 2,000 3.60 actual $7,200
3.65
2,000 7,300
Actual quantity purchased standard
Materials purchase price
2,000 ($0.05) $(100) fav.
variance
Actual quantity used 1775 3.60 actual $6,390.00
3.65
1775 $6,478.75
Actual quantity used standard

Materials price usage variance 1775 ($0.05) -88.75

 Material Quantity Variance
Also known as Direct materials efficiency
variance and Direct materials usage
variance.
It measures the difference between the quantity
of materials used in production and the quantity
that should have been used according to the
standard that has been set.
Although the variance is concerned with the
physical usage of materials, it is generally stated
in dollar (RM) terms to help gauge its
importance.
Material Quantity Variance
The material quantity variance is expressed as
(AQu – SQ)SP where:

(AQu) = actual quantity of material used.

(SQ) = standard quantity of material allowed.
(SP) = standard price of material.
If actual quantity > standard quantity, then the
variance is unfavorable.
If actual quantity < standard quantity, then the
variance is favorable.
 MUV – An Example
 Colonial Pewter Company provides the following data:
 3.0 pounds of materials are required to produce a unit of product according
to standards set by the management. The standard price of direct materials
is $4.00 per pound. During the period 2000 unit were completed with an
actual consumption of 6,500 pounds of direct materials.
 Calculate direct materials quantity variance or direct materials
usage variance.

Calculation:

MUV = (AQ – SQ ) x SP
=(6,500 pounds × $4.00) − (6,000* pounds × $4.00)
= $26,000 − $24,000
= 2000 Unfavorable

*Standard quantity allowed (3.00 per unit × 2,000 units)

 MUV – An Example
Colonial Pewter Company

Performance Report - Production Department

(1) (2) (3) (4) (5)

Standard Total
Actual Difference
Type of Standard Quantity Quantity
Quantity in Quantity Explanation
Materials Price
(pounds)
Allowed Variance
(pounds)
(2) – (3) (1) × (4)

Low quality
$2,000 materials
Pewter $4.00 6,500 6,000 500
Unfavorable unsuitable for
production

Above calculation shows an unfavorable direct materials quantity variance.

When materials are used more than what is allowed by standard an unfavorable
quantity variance occurs. If materials used is less than the quantity allowed
a favorable direct materials quantity variance occurs.
 Exercise
 Materials Variance Analysis

The Schlosser Lawn Furniture Company uses 12
meters of aluminum pipe at $0.80 per meter as
standard for the production of its Type A lawn chair.
During one month's operations, 100,000 meters of
the pipe were purchased at $0.78 a meter, and
7,200 chairs were produced using 87,300 meters of
pipe. The materials price variance
is recognized when materials are purchased.
Calculate materials quantity variance or direct
materials efficiency variance.
 Solution
Solution:

Actual quantity used 87,300 $0.80 standard $69,840

Standard quantity allowed 86,400 $0.80 standard $69,120

Materials quantity variance 900 $0.80 $720 unfav.

*Standard quantity allowed (7200 x 12 = 86400 meters)

 Labor Rate Variance/
Direct Labour Cost Variance

Direct labor rate variance is the difference between

the amount of actual hours worked at actual rate
and actual hours worked at standard rate

This variance measures any deviation

from standard in the average hourly rate paid
to direct labor workers.
 Labor Rate Variance/
Direct Labour Cost Variance

The labor rate (price) variance is expressed as

(AR – SR) x AH where:

(AR) = actual wage rate (price).

(SR) = standard wage rate (price).
(AH) = actual number(quantity) of labor hours.
If actual rate > standard rate, then the variance
is unfavorable.
If actual rate < standard rate, then the variance
is favorable.
 Example
 Suppose that 2,000 units have been produced during the period
and 5,400 direct labor hours have been worked at a rate of
$13.75 per direct labor hour. Standard rate per direct labor hour
is $14.00. Calculate labor rate variance.

Calculation
LRV = (Actual hours worked × Actual rate) − (Actual hours worked
×Standard rate)
= (5,400 × $13.75) − (5,400 × $14.00 )
= 74,250 − 75,600
Labor rate variance = $(1,350) Favorable

Calculation shows a favorable labor rate variance because actual

rate paid to workers is less than standard rate. When the actual rate
is more than the standard rate an unfavorable labor rate
variance results.
 Exercise

 Exercise : Labor Variance Analysis

The processing of a product requires
a standard of 0.8 direct labor hours per unit
for Operation 4-802 at a standard wage
rate of $6.75 per hour. The 2,000
units actually required 1,580 direct labor
hours at a cost of $6.90 per hour.

 Required: Calculate labor rate variance or

Labor price variance.
 Solution

Solution:
Time Rate Amount

Actual hours worked 1,580 $6.90 actual $10,902

Actual hours worked 1.58 $6.75 standard 10,665

Labor rate variance 1,580 $0.15 $237 unfav.

 Labor Efficiency Variance
The quantity variance for
direct labor is generally called direct labor efficiency
variance or direct labor usage variance.

This variance measures the productivity of labor time.

No variance is more closely watched by management,
since it is widely believed that increasing the
productivity of direct labor time is vital to reducing
costs.
Labor Efficiency Variance
The labor efficiency (quantity) variance is
expressed as (AH – SH) x SR where:

(AH) = actual number of hours worked.

(SH) = standard number of hours worked.
(SR) = standard labor wage rate.
If actual hours > standard hours, then the
variance is unfavorable.
If actual hours < standard hours, then the
variance is favorable.
 Example
A company produces 2000 units of finished products using 5,400 hours.
Standard time allowed for a unit of finished product is 2.5 hours. Standard rate
that is paid to workers is $14.00 per direct labor hour. Calculate direct labor
efficiency variance or direct labor quantity variance.

LEV = (Actual hours worked × Standard rate) − (Standard hours allowed ×

Standard rate)
= (5,400 × $14.00 ) − (5,000* × $14.00)
= $75,600 − $70,000
= $5,600 Unfavorable

5,000* = 2,000 actual production × 2.50 standard hour allowed per unit

Processing of 2000 units required more time than what was allowed by
standards. The result is an unfavorable labor efficiency variance. A favorable
labor efficiency variance occurs when actual processing time is less than the
time allowed by standards.
 Exercise
Exercise : Labor Variance Analysis

The processing of a product requires a standard of

0.8 direct labor hours per unit for Operation 4-802
at a standard wage rate of $6.75 per hour. The
2,000 units actually required 1,580 direct labor
hours at a cost of $6.90 per hour.

Required: Calculate labor efficiency variance or

Labor usage variance.
 Solution

Time Rate Amount

Actual hours worked 1,580 $6.75 standard $10,665

Standard hours
allowed *1,600 $6.75 standard 10,800

Labor rate variance (20.00) $6.75 $(135) fav.

*Standard hour allowed (2000 x 0.8 = 1600 hours)

Variable Production Overhead Variance
The difference between the actual
cost of manufacturing a number of units and
the budgeted cost of manufacturing the units.
Two methods in analyzing:
1. Using unit of production as a basis for absorbing
variable overhead into production
2. Using labor hours as a basis for absorbing
variable overhead production

If actual > budget, then the variance is unfavorable.

If actual < budget, then the variance is favorable.
 Example

A manufacturing company which

budgeted expenditures of $10,000
to produce 1,000 units
of product ($10/product). After production was
complete, the company realized a cost of
$12,500 for 1,000 units ($12.50/product). The
variable production overhead variance was
$2,500 ($12,500-$10,000) - UF
 Exercise
The budgeted variable production overhead for
ABC Limited for the year 2012 is RM
50,000.Budgeted direct labor time for the year
was RM 10,000 hours, mean while the standard
labor time for a unit of product was 5 hours.
During the year, the actual production was 200
units and the number of hours worked were
1500. The actual variable overhead was RM
6000. Calculate:
1. Variable production overhead variance base on unit of
production
2. Variable production overhead variance base on labor
hours of production
 Solution (1)
VPOV = AC - SC

Unit of production used as a basis for absorption

Variable production overhead rate

= RM 50,000
----------------
*2000 units *(10000/5) (1 unit 5 hours if
10000 hours, how many unit can be produce ?
= RM 25 perunits

Therefore variable production overhead variance:

= RM 6000 – (200 units x RM 25)
= RM 1000 (UF)
 Solution (2)

VPOV = AC - SC
Labour hours used as a basis for absorption
Variable production overhead rate

= RM 50,000
----------------
10000 hours
= RM 5

Therefore variable production overhead variance:

= RM 6000 – [( 5 hours x 200 units) x RM 5)]
= RM 1000 (UF)
 Variable Production
Overhead Expenditure Variance

AC - SC
VOH (Expenditure) = Actual Overhead – (Actual
hours x Standard Variable Overhead Rate)
= AVOH – SVOH

Using the same example to calculate VOH:

VOH(expenditure) = RM 6000 – (1500 x RM 5)
= RM -1500 (UF)
 Variable Production
Overhead Efficiency Variance

VOH (Efficiency) = (SVOH for Actual Hours) – (SVOH

for Actual Output)
= Actual Hours – Standard Hours) x Standard Rate

Using the same example to calculate VOH (Efficiency):

VOH(efficiency) = (actual hours – standard hours) x
standard rate
= RM 6000 – ( 5 hours x 200 units) x RM 5
= RM 2500 (UF)
Fixed Production Overhead Variance
The difference between the incurred cost of
fixed production overhead and
the amount of overhead actually absorbed.
The amount of overhead absorbed
is calculated by using the overhead rate, which is
the total fixed production overhead (the
numerator) divided by the budgeted labor
hours of produced units (the denominator).
Particular attention is paid to whether the
overhead is over-absorbed or under-absorbed, with
the absorption being determined by how close
the estimated numerator and denominators are to
the actual figure.
Fixed Production Overhead Variance
Two main variances:
1. Fixed Production Overhead Expenditure
2. Fixed Production Overhead Volume Variance

Eg. The budgeted fixed production overhead for XYZ Ltd for
the year 2012 is 144,000. It is estimated that the labor
time for the year is 36,000 hours and the standard labor
time for one unit product is 3 hours. The company
manage to produce a total of 11,700 units within 34,500
hours. Actual fixed overheard incurred was RM 150,000.
Calculate:
i. Fixed Production Overhead Expenditure Variance
(FOHEV)
ii. Fixed Production Overhead Volume Variance
(FOHVV)
 Fixed Production Overhead Variance
i) FOHEV = Actual Expenditure – Budgeted Expenditure

= RM 150,000 – RM144,000
= RM 6000 (UF)

ii) FOHVV = Budgeted Expenditure – (Standard Hour x

Standard Rate)

= Budgeted Expenditure – Standard Cost Absorbed

= RM 144,000 – (11,700 units x 3 hours x RM 4*
= RM 144,000 – RM 140,400
= RM 3600 (UF)

* Standard cost = 144,000/36000) = RM 4

 Computing Fixed Overhead
Variances - Exercise

ColaCo
Production and Machine-Hour Data
Budgeted production 30,000 units
Standard machine-hours per unit 3 hours
Budgeted machine-hours 90,000 hours
Actual production 28,000 units
Standard machine-hours allowed for the actual production 84,000 hours
Actual machine-hours 88,000 hours
 Computing Fixed Overhead
Variances

ColaCo
Cost Data
Budgeted variable manufacturing overhead $ 90,000
Budgeted fixed manufacturing overhead 270,000
Total budgeted manufacturing overhead $ 360,000

Actual variable manufacturing overhead $ 100,000

Actual fixed manufacturing overhead 280,000
Total actual manufacturing overhead $ 380,000
 Predetermined Overhead Rates

Predetermined Estimated total manufacturing overhead cost

=
overhead rate Estimated total amount of the allocation base

Predetermined $360,000
=
overhead rate 90,000 Machine-hours

Predetermined
= $4.00 per machine-hour
overhead rate
 Predetermined Overhead Rates

Variable component of the $90,000

=
predetermined overhead rate 90,000 Machine-hours
Variable component of the
= $1.00 per machine-hour
predetermined overhead rate

Fixed component of the $270,000

=
predetermined overhead rate 90,000 Machine-hours
Fixed component of the
= $3.00 per machine-hour
predetermined overhead rate
 Applying Manufacturing Overhead

Overhead Predetermined Standard hours allowed

= ×
applied overhead rate for the actual output

Overhead $4.00 per

= × 84,000 machine-hours
applied machine-hour

Overhead
= $336,000
applied
Investigation of Standard Cost
Variances
It is important to note that standard
cost variances are not a definitive
sign of good or bad performance.
These variances are merely
indicators of potential problems
which must be investigated. And
there are many plausible
explanations for them.
Management by Exception
Because investigation of standard cost
variances is itself a costly activity,
management must decide which
variances to investigate. Most managers
practice management by exception. What
is “exceptional?” Usually an absolute
dollar amount or a percentage dollar
amount.
Basic Concepts
 Static-Budget Variance (Level 0) – the
difference between the actual result and the
corresponding static budget amount
 Favorable Variance (F) – has the effect of
increasing operating income relative to the
budget amount
 Unfavorable Variance (U) – has the effect of
decreasing operating income relative to the
budget amount
“Favorable” Variances May Be
Unfavorable
The fact that a variance is “favorable” does not
mean that it should not be investigated. Raw
materials are good examples of this
phenomenon, especially considering the
competitive pricing environment for most
commodities. Suppose inferior, low-priced
materials are ordered. One the one hand, a
favorable price variance will arise. On the other
hand, most likely there will be substantially
more scrap and rework, and thus a higher
quantity variance.
Responsibility Accounting and
Variances
As noted previously, managers should
be held responsible only for costs they
can control. This is true in the area of
variance analysis. For example, a
purchasing agent may be held
responsible for direct material price
variances, but certainly not direct
material quantity (usage) variances.
 Responsibility for Labor Variances

Mix of skill levels

assigned to work tasks.
Production
managers are Level of employee
usually held motivation.
accountable
for labor variances Quality of production
because they can supervision.
influence the:
Quality of training
provided to employees.
Appendix A: Recording
Standard Costs in Accounts
In a standard costing system, Related Learning Objectives:
the costs added to the Raw 1. Record standard costs in the
Materials Inventory, Work in account of a manufacturing
firm.
Process Inventory, Finished
Goods Inventory, and Cost of
Goods Sold accounts are all
recorded at standard rather
than actual cost. Variances
are also calculated and
recorded for management’s
use in performance
evaluation.
Recording Material Costs
Purchase of raw materials inventory: Related
Account dr. cr. Learning
Raw Material Inventory (std.) x Objectives:
Material Price Variance x Record standard
costs in the
Accounts Payable (actual) x account of a
(This is an unfavorable price variance) manufacturing firm.
Usage of raw materials inventory:
Account dr. cr.
Work in Process Inventory x
Material Quantity Variance x
Raw Material Inventory x
(This is an unfavorable quantity variance)
Recording Labor Cost
Account dr. cr. Related
Work in Process Inventory (std.) x Learning
Labor Rate Variance x Objectives:
Labor Efficiency Variance x Record standard
costs in the
Salaries Payable (actual) x account of a
(Note: both the labor rate variance and manufacturing firm.
efficiency variance are unfavorable)
Recording Manufacturing
Overhead
Recording manufacturing overhead in a Related
standard costing system is a three-step Learning
process: Objectives:
Record standard
1. Actual overhead is recorded in the costs in the
manufacturing overhead account. account of a
manufacturing firm.
2. Overhead is applied to Work in Process
Inventory at the standard cost.
3. The difference between actual overhead
and overhead applied at standard is
closed and overhead variances are
identified.
More
Recording Manufacturing
Overhead (Step 1)
To record actual overhead cost: Related
Learning
Account dr. cr. Objectives:
Manufacturing Overhead x Record standard
costs in the
*Various Accounts x account of a
manufacturing firm.

*Various accounts include indirect wages

payable, utilities payable and accumulated
depreciation.
Recording Manufacturing
Overhead (Step 2)
To apply overhead cost to work in process Related
inventory at cost: Learning
Objectives:
Account dr. cr. Record standard
Work in Process Inventory x costs in the
account of a
Manufacturing Overhead x manufacturing firm.
Recording Manufacturing
Overhead (Step 3)
To close out manufacturing overhead cost to Related
work in process inventory at cost: Learning
Objectives:
Account dr. cr. Record standard
Manufacturing Overhead x costs in the
account of a
Overhead Volume manufacturing firm.
Variance x
Controllable Overhead
Variance x
Recording Finished Goods
To record completed units sent to finished Related
goods: Learning
Objectives:
Account dr. cr. Record standard
Finished Goods Inventory x costs in the
account of a
Work in Process manufacturing firm.
Inventory x
Recording Cost of Goods Sold
To apply overhead cost to work in process Related
inventory at cost: Learning
Objectives:
Account dr. cr. Record standard
Cost of Goods Sold x costs in the
account of a
Finished Goods manufacturing firm.
Inventory x
Closing Variance Accounts
At the end of the accounting period, the Related
temporary variance accounts must be closed. Learning
As a practical matter this is usually Objectives:
accomplished by debiting or crediting the
Record standard
variances to cost of goods sold. costs in the
Account dr. cr. account of a
Cost of Goods Sold x manufacturing firm.

Overhead Volume Variance x

Controllable Overhead Variance x
Material Price Variance x
Material Quantity Variance x
Labor Rate Variance x
Labor Efficiency Variance x