CHAPTER FOUR: Standard Costing, Flexible Budgeting and Variance Analysis

4.1. Definition of terms

Standard costing vs budgeting
A standard cost is a carefully determined cost per unit that should be attained
 A budget relates to an entire activity or operation;
 While a standard presents the same information on a per unit basis
 Standard costing involves assigning predetermined costs to products or services, serving as benchmarks for
evaluating actual performance.
 These standard costs are established based on historical data, industry norms, or managerial expectations and
includes direct materials, direct labor, and overhead costs.
 Generally A standard therefore provides cost expectations per unit of activity and a budget provides the cost
expectation for the total activity.
Example: A manufacturing company sets a standard cost of Br 50 for direct materials per unit produced.
Flexible vs Fixed Budget
Flexible Budgeting- it is based on standard costing system. Its calculates budgeted revenues and budgeted
costs based on the actual output in the budget period.
The flexible budget is prepared at the end of the period, after the actual output of is known.
Flexible budgeting adjusts budgeted figures based on actual activity levels, providing a more accurate
comparison between budgeted and actual performance.
 Standard costing provides the benchmarks for costs, flexible budgeting adjusts these benchmarks based on
actual activity levels, and variance analysis identifies and explains differences between these adjusted
benchmarks and actual results.
Fixed or static budget that never changes with level of activity. It is based on the level of output planned
at the start of the budget period.
Fixed budget is rigid and does not change with the volume of activity achieved.
A fixed budget is prepared for a particular level of activity and for a particular set of conditions; it is
prepared under the premise that there will be no change in the outside conditions.
4.2. Variance Analysis
 Variance analysis involves comparing actual financial outcomes to standard or budgeted figures to identify
discrepancies, known as variances.
 This process helps in understanding the reasons behind performance deviations and informs corrective
actions.

Types of Variances:
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1. Material Variances=Actual price x actual quantity- standard quantity x standard price
 Material Price Variance: Difference between the actual prices paid for materials and the standard price.
MPV = (Actual Price-Standard Price) x Actual Quantity purchased
 It measures how much is paid for material and how much should have been paid.
 Material Usage /quantity Variance: Difference between the actual quantity of materials used and the
standard quantity expected for actual production levels.
MUV= (Actual Quantity used –Standard Quantity allowed) x SP
Example: A cement industry planned to use 10 kg of sand to make 1quntial cement, but the actual amount used
was 12 kg due to inefficiency in the production process. A company expected to pay Br 5 per kg sand, but due to a
supply chain issue, the actual price paid was Br 6 per kg.
Required: Calculate material price variance and material usage variance
Solution
Given
 Standard cost: Br 5 per kg
 Actual cost: Br 6 per unit
 Standard quantity: 10kg
 Actual quantity: 12kg
1. Material Price Variance = (Actual Price - Standard Price) × Actual Quantity used=Act. Price x Act.
Quan-stand. Price x act quan
 MPV = (Br6 - Br5) × 12= Br 12 unfavorable variance (because the company paid more than expected).
2. Material Quantity Variance = (Actual Quantity - Standard Quantity) × Standard Price
 MQV = (12 - 10) × Br 5 = Br 10 unfavorable variance (because more material was used than expected).
 Total material variance = MPV+MUV= Br 12U+Br 10U=Br 32U
Example2: XYZ Company produces and sold pools. The companies prepare budgets using standard costing
system. The following data’s given as follows:
Standards Actual result 10 pools were built
Direct materials cost Br 3.575 per cubic foot. AP paid per cubic foot = $3.00
Materials allowed were 1,000 cubic feet per pool. AQ of materials used = 12,000 cubic feet
Required: calculate MPV & MUV
solution
Price variance = 12,000($3.00 – $3.575) = $6,900 favorable
Usage variance = $3.575(12,000 – 10,000) = $7,150 unfavorable
Total material variance = $6,900F + $7,150U = $250 unfavorable
2. Labor Variances: refers to the difference between the actual labor cost incurred and the labor coast that
were expected or budgeted for a specific level of production.
Act hour x actual rate- standard hour x standard rate

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 Labor Rate Variance: Difference between the actual wage rate paid and the standard rate
 It measures how much material is consumed and how much should have been consumed
LRV= (Actual Rate-Standard Rate) X Actual Hours worked
 It measures how much is paid and how much should have been paid.
 Efficiency Variance: Difference between the actual labor hours used and the standard hours expected for the
actual output.
LEV= (AH worked- SH allowed) X SR
 It measures how much time is used and how much should have been used
Example: XYZ Company also budgeted for direct labor using standard costing system to produce cements for a
specified period.
Standards Actual Results
Direct labor cost was Br 6,000 per quintal. 10 quintals were built
The rate was Br 15 per hour. Actual rate was Br 16.10 per hour.
Standard hours per quintal were 400. Actual hours were 3,800.
Required: DLRV & DLUV
Solution
Labor rate variance = 3,800× (Br 16.10 – Br 15.00) = Br4, 180 unfavorable
Labor Efficiency variance = Br15.00 (3,800 – 4,000) = Br3, 000 favorable
Total labor variance = Br4, 180U +Br3, 000F = Br1, 180 unfavorable
3. Overhead Variances: Overhead variance refers to the difference between the actual overhead costs incurred
and the expected (or standard) overhead costs.
 Overhead costs can be categorized into two types: variable overhead and fixed overhead. The
variances related to these overheads are typically divided into the following:
1. Variable Overhead Variance
The variable overhead variance is further broken down into two components:
I. Variable Overhead Spending (Rate) Variance: This measures the difference between the actual variable
overhead rate and the standard variable overhead rate, multiplied by the actual hours worked (or activity
level of the allocation base).
Formula: Variable Overhead Spending Variance= (Actual Orate – Standard OH Rate) ×Actual Hours
II. Variable Overhead Efficiency (Usage) Variance: This measure the difference between the actual hours
worked and the standard hours that should have been worked for the actual production, multiplied by the
standard variable overhead rate.
Formula:
Variable Overhead Efficiency Variance= (Actual Hours−Standard Hours) ×Standard OH Rate
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Example:
 Standard variable overhead rate: $5/hour
 Actual variable overhead rate: $6/hour
 Actual hours worked: 200 hours
 Standard hours for production: 180 hours
 Actual hours worked 200 hours
 Standard variable overhead rate: $5/hour
Required: Calculate VOSV & VOEV
Solution
Variable Overhead Spending Variance: (6−5) ×200=1×200=200 (unfavorable)
This means the company spent $200 more than expected on variable overhead, due to paying a higher rate than
planned.
Variable Overhead Efficiency Variance: (200−180) ×5=20×5=100 (unfavorable)
This means the company spent $100 more on variable overhead due to using more hours than planned.
Total Variable Overhead Variance: The total variable overhead variance is the sum of the spending variance and the
efficiency variance.
Total Variable Overhead Variance=Variable Overhead Spending Variance+Variable Overhead Efficiency Variance
=200 (unfavorable spending variance) +100 (unfavorable efficiency variance) =300 (unfavorable total variance)
2. Fixed Overhead Variance: Fixed overhead variance consists of two components:
 Fixed Overhead Spending (Budget) Variance: The difference between the actual fixed overhead costs and the
budgeted (or standard) fixed overhead costs.
 This variance is typically caused by changes in costs that were not anticipated, like unexpected increases in rent
or insurance.
Formula: Fixed Overhead Spending Variance=Actual Fixed Overhead−Budgeted Fixed Overhead
Example:
o Budgeted fixed overhead: $10,000
o Actual fixed overhead: $12,000
Fixed Overhead Spending Variance: 12,000−10,000=2,000 (unfavorable)
This indicates the company spent $2,000 more on fixed overhead than planned.
 Fixed Overhead Volume (Efficiency) Variance: The difference between the expected fixed overhead based on
the actual activity level (usually measured in units or machine hours) and the fixed overhead based on the
planned level of activity.
 This variance happens because fixed costs do not change with the number of units produced, but the application
rate of fixed overhead may change depending on the level of production.
Formula: Fixed Overhead Volume Variance= (Standard Hours for Actual Production−Budgeted Hours) ×Fixed Overhead Rate
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 Example:
o Budgeted hours: 1,000 hours
o Actual hours: 1,200 hours
o Fixed overhead rate: $10/hour
Fixed Overhead Volume Variance: (1,200−1,000) ×10=200×10=2,000 (favorable)
This means the company saved $2,000 on fixed overhead because it produced more than planned, spreading the
fixed costs over a greater number of units.
 Total Fixed Overhead Variance: The total fixed overhead variance is the sum of the spending and volume
variances.
Total Fixed Overhead Variance=Fixed Overhead Spending Variance +Fixed Overhead Volume Variance
In this case: 2,000 (unfavorable spending variance) +2,000 (favorable volume variance) =0
This means that the overall fixed overhead variance is neutral; the increased production offset the extra spending on
fixed costs.
4.3. Uses and Limitations of Standard Costing Methods
Uses of Standard Costing
1. Cost Control
o Standard costing helps in controlling costs by comparing actual expenses with predetermined standards.
o Variance analysis identifies deviations and allows corrective action.
2. Budgeting and Planning
o Provides a reliable basis for preparing budgets and setting financial targets
o Helps managers make informed decisions about resource allocation.
3. Performance Evaluation
o Assists in assessing the efficiency of employees, departments, and production processes
o Encourages cost-conscious behavior among employees
4. Pricing Decisions
o Helps in setting product prices by providing insights into expected production costs
o Ensures profitability by considering cost variations.
5. Inventory Valuation
o Used to value inventory in financial statements, providing consistency in cost measurement.
o Simplifies accounting for raw materials, work-in-progress, and finished goods.
6. Improved Decision-Making
o Managers can use variance reports to identify problem areas and take proactive measures.
o Helps businesses forecast costs for future production.
Limitations of Standard Costing

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 1. Difficulty in Setting Accurate Standards
o Establishing precise cost standards requires extensive data and assumptions.
o Changes in market conditions, inflation, or technology can make standards obsolete.
2. Not Suitable for Dynamic Environments
o Industries with frequent price changes or customized production (e.g., technology, fashion) may find
standard costing ineffective.
3. Focuses on Cost Reduction Over Quality
o Employees may compromise quality to meet cost targets, leading to lower customer satisfaction.
4. Time-Consuming and Costly
o Setting up and maintaining a standard costing system requires significant time and effort.
5. Limited Use in Service Industries
o More suitable for manufacturing firms; less effective for businesses with intangible outputs, such as
consulting or healthcare.
6. Does Not Account for External Factors
o Economic changes, supplier price fluctuations, and unforeseen events (e.g., pandemics) can make
standard costs unrealistic.
4.4. The determination of standards
 Determining accurate standards is a critical aspect of standard costing, as these benchmarks serve as the
foundation for measuring performance and identifying variances.
 The process involves establishing predetermined costs for various cost components, including direct materials,
direct labor, and manufacturing overhead.
 The standards are determined:
1. Direct Materials Standards
 Quantity Standards: Specify the expected amount of materials required to produce a single unit of product.
o Determination: Conduct engineering studies or analyze historical usage data to establish precise
material requirements.
 Price Standards: Indicate the anticipated cost per unit of material.
o Determination: Review supplier quotations, consider market trends, and evaluate purchasing
contracts to set realistic price expectations.
2. Direct Labor Standards
 Time Standards: Define the expected labor hours needed to complete one unit of product.
o Determination: Perform time and motion studies or assess historical performance data to determine
standard labor hours.
 Rate Standards: Reflect the expected wage rate per labor hour.

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 o Determination: Consider current wage agreements, industry standards, and labor market conditions to
establish appropriate wage rates.
3. Manufacturing Overhead Standards
 Variable Overhead Standards: Costs that vary directly with production volume, such as utilities or indirect
materials.
o Determination: Analyze historical data to determine the variable overhead rate per unit of activity
(e.g., machine hours).
 Fixed Overhead Standards: Costs that remain constant regardless of production volume, such as rent or
salaries of supervisory staff.
o Determination: Allocate fixed overhead costs based on normal production capacity to establish a
standard rate per unit.
General Considerations in Setting Standards
 Historical Data Analysis: Utilize past performance data to inform standard setting, ensuring that standards are
grounded in actual operational experience.
 Industry Benchmarks: Compare standards with industry averages to ensure competitiveness and realism.
 Continuous Improvement: Regularly review and adjust standards to reflect process improvements,
technological advancements, or changes in operating conditions.
4.5. Flexible Budgets and Variances
1. Flexible Budgets
 A flexible budget is a financial plan that adjusts for changes in the level of activity, allowing companies to
compare actual results against budgeted figures more accurately.
 Unlike a static budget, which remains unchanged regardless of actual performance, a flexible budget updates
revenue and expenses based on actual production or sales levels.
Key Features of a Flexible Budget:
✔ Adjusts budgeted figures for different levels of output or activity.
✔ Helps managers evaluate performance more accurately.
✔ Identifies inefficiencies by comparing actual vs. budgeted costs at the same level of activity.
Steps to Prepare a Flexible Budget:
1. Identify fixed costs (which remain constant).
2. Determine variable costs per unit (which change with activity levels).
3. Adjust total costs based on actual production or sales volume.
4. Compare the flexible budget with actual results to identify variances.
Example: A company budgets for 1,000 units with the following costs:
 Fixed Costs = $10,000
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  Variable Cost per Unit = $5
 Total Budgeted Cost = $10,000 + (1,000 × $5) = $15,000
If actual production is 1,200 units, the flexible budget would be:
 Total Cost = $10,000 + (1,200 × $5) = $16,000
Now, actual costs can be compared against this adjusted budget, not the original static budget.
2. Variance Analysis
Variance Analysis helps companies understand why actual results differ from budgeted figures. It is used for
cost control, decision-making, and performance evaluation.
Types of Variances:
1. Sales Variances:
o Sales Volume Variance: Difference due to selling more or fewer units than expected.
o Sales Price Variance: Difference caused by selling at a different price than budgeted.
2. Cost Variances:
o Material Price Variance: Actual material cost differs from the standard cost per unit.
o Material Usage Variance: More or fewer materials used than expected.
o Labor Rate Variance: Labor cost per hour differs from standard cost.
o Labor Efficiency Variance: More or fewer labor hours used than budgeted.
o Overhead Variance: Differences in fixed or variable overhead expenses.
3. Importance of Flexible Budgets & Variance Analysis
✔ Provides a more realistic performance evaluation.
✔ Helps businesses respond to changes in market conditions.
✔ Identifies inefficiencies and cost overruns early.
✔ Aids in better decision-making and future planning.
4.6. Identification and calculation of variances: sales variances (including quantity and mix); cost variances
(including mix and yield); absorption and marginal approaches
 Variance analysis is a fundamental aspect of managerial accounting, enabling organizations to assess
performance by comparing actual outcomes to budgeted expectations.
1. Sales Variances
I. Sales Quantity Variance: Measures the impact of the difference between actual units sold and budgeted
units on profit.
Sales Quantity Variance= (Actual Units Sold−Budgeted Units Sold) ×Standard Profit per Unit
Or Sales Quantity Variance= (Actual Units Sold−Budgeted Units Sold) ×bud. CM/composite unit for
budgeted mix

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 Budgeted Budgeted Budgeted
Cm/ composite units = sales mix × CM/ Unit
For budgeted mix
On the other hand, sales quantity variance is the sum of market share and market size variances.
 Market share: it is a key performance indicator that reflects the percentage of total sales or revenue in a specific
market that a company, brand, or product controls.
 It’s a measure of a company’s competitiveness and success relative to its peers in the same industry. By knowing
your market share, you can assess your company's position in the market, track performance over time, and
identify growth opportunities.
 It is the percentage of total sales volume in a market captured by a firm.
 It shows the percentage of the market size served by a specific company.
 Market-share variance:-is the difference in budgeted contribution margin for actual market size in units caused
solely actual market share being different from budget market share.
 Formula for computing market share variance is as follows:
 MSV= (Actual mkt share- budgeted mkt share) x Bud. CM/composite unit for budgeted mix x actual mkt size in
unit
 Market-share variance will favorable when actual market share exceeds budgeted market share
 Market size: Refers to the total sales volume or total revenue of all products or services in a specific market
over a defined period (typically a year).
 It gives a clear picture of the potential or scale of a market, allowing businesses to understand the overall demand
and growth opportunities within that market.
 Its the number of individuals in a certain market who are potential buyers of a product.
 It is the expected total demand for the specific product.
Formula for computing market size variance is as follows:
MSV=(actual mkt size in unit-Budgeted mkt size in unit) x bud. CM/composite unit for budgeted mix
 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 units.
 The market size variance will favorable when the actual market size increased from the budgeted market size.
 Sales volume variance: is the sum of sales mix and sales quantity variances
II. Sales Mix Variance: Assesses the effect on profit due to the variation in the proportion of different products
sold compared to the budgeted mix.
 Sales mix -Sales mix refers to the relative proportion of different products or services that a company sells
within its total sales. It’s essentially the combination of products or services a business offers, and it’s
important for analyzing how changes in the sales of each product affect the company’s profitability

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 3. Sales Mix Variance=(Actual Sales Mix Percentage−Budgeted Sales Mix Percentage)×Actual Total Units So
ld× Standard Profit per Unit
Or Sales mix variance= (Actual Sales Mix %−Budgeted Sales Mix %) ×Actual Total Units Sold× Budgeted
contribution margin per unit
 Note: The standard profit per unit is used under absorption costing, while standard contribution per unit is
used under marginal costing.
 Absorption and Marginal Costing Approaches
 Absorption Costing: Allocates all manufacturing costs, both fixed and variable, to individual units of
production. This method is typically used for external financial reporting.
 Marginal Costing: Considers only variable costs as product costs, treating fixed costs as period expenses.
This approach is often utilized for internal decision-making and performance evaluation.
Illustration: Assume ET fruit sales two types of juice namely: Mango juice and Orange juice.
ET fruit budgeted the following for the year ended June 30 2016.
A composite unit is a hypothetical unit with weights based on the mix of individual units.
For the actual mix the composite unit consists of 84% of sales the mango juice and 16%of the sales to orange juice.
For the budgeted mix, the composite unit consists of 80% unit of sales to Mango juice and 20% unit of sales to the
orange juice.
Total budget is to produce and sale 890,000 units of juice while the actual units of juice produced and sold is
900,000 units.
Budgeted CM is $0.49/unit for Mango juice and $0.98/unit for Orange juice.
Required:
• Sales mix variance =?
Mango juice= 900,000 × [0.84-0.80] × 0.49 = 17,640F
Orange juice =900,000 × [0.16-0.20] × 0.98 = 35,280U
So, total sales mix variance for both juice = 17,640U
• Sales quantity variance =?
Mango juice = (900,000-890,000) X 0.80 X $0.49/unit = $3920F
Orange juice = (900,000-890,000) X 0.20 X $0.98/unit = $1,960F
Total sales quantity variance ………………………….. $ 5,880F
Since ET fruit sales 10,000 more units of juice than were budgeted (i.e. 900,000-890,000) it results in a favorable
sales quantity variance of $5,880F.
Sales quantity variance can also be calculated by using the 10,000 additional units sold
(900,000-890,000=10,000) multiplied by the budgeted contribution margin per composite unit for budgeted mix.
10,000 X 0.5880 = $5,880F

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When sales increases, managers wants to investigate the reason of increment such as:
Is competitors’ distribution problem?
Price increments?
Is there quality problem in the competitors’ side?
Is that because of increased demand?
Did the result from ET fruit better customer service or growth in overall market?
Assume ET fruit managers estimate that 25% market share for the year ended June 30, 2008 and the budgeted
market size is 3,560,000 units. This gives 25% X 3,560,000 = 890,000 units. But for the budget year the actual
market size is 4,000,000 units. The actual market share is 22.5% (900,000/ 4,000,000units =22.5%). Based on this
data calculate
A. Market share variance
B. Market size variance
A. MSV = 4,000,000 units X (0.225-0.25) X 0.5880/unit
= $ 58,800U
Or it is computed as follows:
Budgeted Budgeted Budgeted CM/composite
CM/unit sales mix unit for budgeted mix
Mango Juice $0.49 0.80 $0.3920
Orange Juice 0.98 0.20 0.1960
Total $0.5880
The market share variance is unfavorable because the budgeted market share was 25% (890,000/ 3,560,000) while
the actual market share is 22.5% (890,000/ 4,000,000) of the total actual market size.
Since the managers estimate that the total market share will be 3,560,000 units but the actual market size is
4,000,000 units.
Therefore the market share has declined from estimated 25% to 22.5% that results in $58,800U.
B. MSV = (4,000,000-3,560,000) X 0.25 X 0.588/unit
= (440,000) X 0.25 X 0.588 = $64,680F
The market size variance is favorable because the actual market size increased by 12.4% (440,000/ 3,560,000)
compared to the budgeted market size.
Thus, the sum of the market share variance and the market size gives us the sales quantity variance.
For Example: Sales Mix Variance Calculation: Suppose a company budgets to sell 7,000 units of Product A and
3,000 units of Product B, totaling 10,000 units. The budgeted sales mix percentages are 70% for Product A and 30%
for Product B.

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If the actual sales are 7,500 units of Product A and 3,700 units of Product B, totaling 11,200 units, the actual sales
mix percentages are approximately 66.96% for Product A and 33.04% for Product B.
The sales mix variance for Product A would be calculated as:
SMV= (66.96%−70%) ×11,200 This calculation would yield a favorable or unfavorable variance, indicating the
impact of the sales mix change on profit.
Understanding and calculating these variances enable businesses to pinpoint specific areas where performance
deviates from expectations, allowing for targeted corrective actions and strategic planning.
2. Cost Variances
 Materials Mix Variance: Evaluates the cost impact of deviations from the standard mix of materials used in
production.
Materials Mix Variance= (Actual Quantity of Each Material−Standard Quantity of Each Material) ×Standard
Cost per Unit of Material
 Materials Yield Variance: Measures the effect on cost due to the difference between the actual output and the
expected output from a given input of materials.
Materials Yield Variance= (Actual Total Quantity Used−Standard Quantity Allowed for Actual Output) ×
Standard Cost per Unit
Note: These variances are particularly useful when materials are interchangeable, and substitution can occur.
 Direct Materials mix and yield variance/Input variance-This input mix variance provides managers to have
some alternative way in combining and substituting these inputs.
 When inputs are substitutable direct materials efficiency improvement relative to budget costs can come from
two sources:
 Using a cheap mix of inputs to produce a given quantity of output, measured by the total direct material mix
variance and
 Using less input to achieve a given quantity of output, measured by the direct materials yield variance.
I. Direct materials mix variance: is the sum of the direct materials mix variance for each input:
DMMV for each input used= (actual DM inputs mix percentage- Budgeted DM input mix percentage) x actual
total quantity DM input used x budgeted price of DM input
III. Direct materials yield variance: is the sum of the direct materials yield variance for each input.
DMYV for each input= (actual total quantity of all DM input used- Budgeted total quantity of all DM inputs) x
budgeted price of DM input
Illustration: Awash agro-industry Company produces different fruit salad from different fruits.
 Awash production standards require 1.6 tons of tomato to produce 1 ton of tomato salad.
 The salad uses three different varieties of tomato namely A, B, and C.
 The budgeted standard of the three product mix are 5:3:2 ratio of A, B and C tomato types for the year end June,
30/ 2015.
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 Since Awash uses fresh tomatoes to make the salad, no inventories of tomato are kept.
 For the budgeted year, ending June 30, 2015 the actual results shows that 6,500 tons of tomatoes were used to
produce 4,000 tons of salad.
 The actual price and mix percentage are given below.

Input A B C Total
Tons 3250 2275 975 6500
Actual cost/ton Br 70 Br 80 Br 96
Budgeted cost/ton Br 70 Br 80 Br 90
Actual mix % 50% 35% 15%
Budgeted mix % 50% 30% 20%
Required: compute DMMV &DMYV
Solution
1. DM mix variance =sum of each Act tot DM input used(Act mix-Bud mix)
A = 6,500ton X (0.5-0.5) X $70/ton = 0
B = 6,500ton X (0.35-0.30) X $80/ton =$ 26,000U
C = 6,500ton X (0.15-0.20) X $90/ton = $29,250
DM mix variance---------------------------------------------- $3,250F
The reason for DM mix variance to be favorable is Awash has used or substituted 5% of cheaper tomato variety B
for more 5% of the more expensive input tomato C.
2. Direct Material yield variance = Sum of(Act tot DM input used- Budgeted tot DM input) x bud mix x bud
price
A = (6,500-6,400ton) X 0.5 X $70/ton = $3,500U

B = (6,500-6,400ton) X 0.3X $80/ton = $2,400U

C = (6,500-6,400ton) X 0.2 X $90/ton = $1,800U

DM yield variance------ $7,700U

The direct material yield variance is unfavorable because Awash used 6,500 tons of tomato rather than the budgeted
or standard tons of 6,400 tons (1.6 ton X 4,000 tons of output salad) that it should have used to produce 4,000 tons of
salad.
Budgeted cost per one ton of salad is calculated as follows:
50% X 1.6 ton of A X $70/ton = $56.00
30% X 1.6 ton of B X $80/ton = $38.40
20% X 1.6 ton of C X $90/ton = $28.80
Total budgeted cost of 1.6 tons of tomato = $123.20
Budgeted average cost/ton of tomato is $123.20/1.6 ton = $77/ton

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Holding the budgeted mix and budgeted price of tomatoes constant the budgeted cost per ton of tomato is $77/ton.
The unfavorable yield variance represents the budgeted cost of using 100 more tons of tomato, that is (6,500-6,400
ton) X $77/ton=$7,700U.Awash would want to investigate reasons for the unfavorable yield variance.
 Direct labor mix and yield variance
 Labor Mix Variance: It is also known as Gang Composition Variance.
 It is a component of labor efficiency variance that measures the cost impact resulting from deviations in the
proportion of different types or grades of labor used in production compared to the standard or planned mix.
 This variance is particularly relevant in environments where multiple labor categories—such as skilled,
semi-skilled, and unskilled workers—are employed.
 This variance arises due to the differences between the actual compositions than the standard composition.
A. Direct Labor mix and yield variance
Labor Mix Variance = Standard Rate × (Revised Standard Hours – Actual Hours) Where:
 Standard Rate (SR): The predetermined wage rate for each labor category.
 Revised Standard Hours (RST): The total actual labor hours multiplied by the standard proportion of each
labor type. i.e tot actual time/total standard time* total actual hour
 Actual Hours (AH): The actual labor hours worked for each labor category.
 Labor Yield variance=( actual output- standard output) x standard labor cost per unit
Example: Labor Mix Variance (LMV)
Scenario: A company plans to produce a product using a mix of skilled and unskilled labor.
Standard Labor Mix:
 Skilled Labor: 60% of total hours at $30/hour
 Unskilled Labor: 40% of total hours at $20/hour
 Total Standard Hours: 1,000 hours
Actual Labor Used:
 Skilled Labor: 500 hours
 Unskilled Labor: 600 hours
 Total Actual Hours: 1,100 hours
 Step 1: Calculate the Revised Standard Hours (RSH) based on actual total hours:
 Skilled Labor: 60% of 1,100 = 660 hours
 Unskilled Labor: 40% of 1,100 = 440 hours
Step 2: Compute LMV for each labor type:
 Skilled Labor: $30 × (660 - 500) = $4,800 (Favorable)
 Unskilled Labor: $20 × (440 - 600) = -$3,200 (Unfavorable)
Total Labor Mix Variance: $4,800 (F) - $3,200 (U) = $1,600 Favorable

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Interpretation: The actual labor mix was more cost-effective than planned, resulting in a favorable variance.
Example 2: Labor Yield Variance (LYV)
Scenario: The same company evaluates the efficiency of labor in producing output.
Standard Output: 100 units require 1,000 labor hours (10 hours/unit)
Actual Labor Hours Used: 1,100 hours
Actual Output Achieved: 105 units
Standard Labor Cost per Unit: $25
Step 1: Calculate Standard Output for Actual Hours:
1,100 hours ÷ 10 hours/unit = 110 units
Step 2: Compute LYV:
 (105 units - 110 units) × $25 = -5 units × $25 = -$125 (Unfavorable)
Interpretation: The actual output was less than expected for the labor hours used, indicating inefficiency and
resulting in an unfavorable variance.
PRODUCTIVITY MEASUREMENT
 Productivity measures the relationship between actual inputs used (both quantity and cost) and out puts
produced.
 The fewer inputs needed to produce a given output, the more productive the organization is.
 Labor-intensive organizations especially service rendering organizations are concerned with increasing the
productivity of labor, so labor-based measures are appropriate.
 Highly automated companies are concerned with machine use and productivity of capital investments, so
capacity based measures such as the percentage of time machine are available.
PARTIAL PRODUCTIVITY MEASURES

 Partial productivity is the most frequently used productivity measure compares the quantity of output
produced with the quantity of an individual input used.
 Partial productivity is expressed as the ratio of output produced to quantity of input used

DM partial productivity = Quantity of units produced

DM quantity used to produce that out put
Example: Mugger cement Factory has used 2,000,000 tons of raw materials to produce 500,000 Quintals of cement.
What is the DM partial productivity for mugger?
DM partial productivity = 500,000 Quintals /2000, 000tons = 0.25 Quintal/ton
Thus, mugger’s productivity is 0.25 quintals of cement for each one ton of direct materials used.
NB: The DM partial productivity ignores other input used such as direct labor, manufacturing costs and research and
development costs.
4.7. Identification of Significant Variances and Their Interrelationship
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1. Identification of Significant Variances
 A significant variance is a difference between actual and budgeted performance that is large enough to require
managerial investigation. Not all variances require action, so managers must decide which variances are
significant based on:
✔ Magnitude – Larger variances require more attention.
✔ Recurring Trends – Consistently unfavorable variances signal deeper issues.
✔ Controllability – Managers focus on variances within their control.
✔ Financial Impact – Variances affecting profitability or cash flow are prioritized.
Examples of Significant Variances:
 A 10% increase in material costs due to unexpected supplier price hikes.
 A consistent labor efficiency variance suggesting productivity issues.
 Large deviations in sales volume indicating shifts in consumer demand.
2. Interrelationship of Variances
Variances are often interconnected, meaning that a change in one area can influence others. Analyzing these
relationships helps managers find root causes rather than treating symptoms.
Common Variance Interrelationships:
1. Sales Volume Variance & Fixed Overhead Variance
o If actual sales are lower than expected, production volume may drop, leading to under-absorbed
fixed overhead costs (higher per-unit fixed costs).
2. Material Price Variance & Material Usage Variance
o Using cheaper materials (favorable price variance) might lead to higher waste (unfavorable usage
variance).
3. Labor Rate Variance & Labor Efficiency Variance
o Hiring skilled workers at higher wages (unfavorable rate variance) could result in higher efficiency
(favorable efficiency variance), balancing total labor costs.
4. Sales Mix Variance & Contribution Margin Variance
o A shift in sales mix towards lower-margin products may increase overall sales but decrease total
profitability.
5. Variable Overhead Efficiency Variance & Labor Efficiency Variance
o Longer production times (unfavorable labor efficiency) may also cause higher variable overhead
costs, such as electricity and machine hours.
3. Managerial Implications of Variance Analysis

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✔ Root Cause Identification – Helps managers distinguish between temporary and structural issues.
✔ Better Decision-Making – Guides pricing, cost-cutting, and process improvement strategies.
✔ Performance Improvement – Encourages departments to work towards efficiency.
4.8. The uses of planning and operational variances
Planning and operational variances are analytical tools used in management accounting to dissect deviations between
actual performance and budgeted expectations. By distinguishing between these variances, organizations can better
understand the root causes of performance gaps and implement targeted corrective actions.
Planning Variances
Planning variances arise when there is a difference between the original budgeted figures and revised standards or
budgets. These discrepancies typically result from changes in external factors or initial budgeting inaccuracies. Since
planning variances often stem from factors beyond management's immediate control, they are generally not used to
evaluate managerial performance.
Uses of Planning Variances:
 Environmental Assessment: Identifying planning variances helps organizations recognize shifts in the
external environment, such as economic changes or new regulations, allowing for strategic adjustments.
 Budget Accuracy Evaluation: Analyzing these variances enables companies to assess the precision of their
initial budgeting processes and improve future forecasting accuracy.
Operational Variances
Operational variances compare the revised standards or budgets to actual performance. These variances are
influenced by internal factors and are within the control of management. Therefore, they are crucial for assessing
operational efficiency and managerial effectiveness.
Uses of Operational Variances:
 Performance Evaluation: Operational variances provide insights into how well management and staff
adhere to operational plans, facilitating performance appraisals.
 Process Improvement: By identifying areas where actual performance deviates from revised standards,
organizations can implement targeted process improvements to enhance efficiency.
Interrelationship Between Planning and Operational Variances
Understanding the interplay between planning and operational variances is vital for comprehensive variance
analysis. A significant total variance can be dissected into planning and operational components, each requiring
different managerial responses.
Example:
Suppose a company experiences a total unfavorable material cost variance. Upon analysis, it is determined that part
of this variance is due to an unexpected increase in raw material prices (planning variance), while the remainder is
due to inefficient material usage (operational variance). Addressing the planning variance might involve negotiating

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better supplier contracts or seeking alternative materials, whereas tackling the operational variance would focus on
improving production processes to reduce waste.
By differentiating between planning and operational variances, organizations can more accurately pinpoint the
sources of performance issues and develop appropriate strategies to address them.
4.9. Trends, Materiality, and Controllability of Variances
Variance analysis is most effective when managers consider trends, materiality, and controllability to determine
which variances require action and how they should be addressed.
1. Trends in Variances
Tracking variance trends over time helps managers identify patterns and determine whether a variance is a one-
time occurrence or a recurring issue.
🔹 Stable Variance: Occurs consistently and may indicate a systematic issue in budgeting or operations.

🔹 Increasing Variance: Worsening variance over time suggests inefficiencies or external changes that need urgent
attention.
🔹 Fluctuating Variance: May result from seasonal demand, supplier price volatility, or inconsistent operational
efficiency.
🔹 Example: If a company sees an increasing labor efficiency variance, it might indicate declining worker
productivity or outdated machinery requiring maintenance.
2. Materiality of Variances
Materiality refers to the significance of a variance in financial or operational terms. A small variance may not
justify investigation, while a large variance could indicate a critical issue affecting profitability.
🔹 Materiality Thresholds: Companies set thresholds (e.g., variance > 5% of budgeted cost) to determine whether
a variance requires action.
🔹 Financial Impact: A variance that significantly affects profit margins, cost structure, or cash flow is
considered material.
🔹 Risk Assessment: Material variances that indicate potential fraud, inefficiencies, or supply chain disruptions
demand immediate attention.
🔹 Example: A $500 variance in a department with a $1,000,000 budget is immaterial, but the same variance in a
small project with a $5,000 budget is highly material.
3. Controllability of Variances
Not all variances can be controlled by managers. Managers should focus on controllable variances while
acknowledging uncontrollable factors.
🔹 Controllable Variances: Can be managed through process improvements, better budgeting, or operational
changes.
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  Examples: Labor efficiency variance, material usage variance, overhead spending variance.
 Action: Investigate root causes and implement corrective measures.
🔹 Uncontrollable Variances: Result from external factors beyond managerial control.
 Examples: Raw material price hikes due to inflation, government policy changes, natural disasters.
 Action: Adjust budgets, renegotiate contracts, or explore alternative suppliers.
🔹 Example: If material costs increase due to global shortages, management cannot control the price but can
negotiate better supplier contracts or seek alternative materials.
Managerial Action Steps
✅ Identify Significant Variances: Focus on large, recurring, and controllable variances.

✅ Analyze Trends: Look for patterns in variances over time to predict future issues.
✅ Differentiate Controllable vs. Uncontrollable: Take corrective action where possible and adjust strategies for
uncontrollable factors.
✅ Improve Decision-Making: Use variance analysis to refine budgeting, pricing, and operational efficiencies.
4.8. Uncertainty and variance analysis
Variance analysis is a pivotal tool in management accounting, enabling organizations to assess performance by
comparing actual outcomes to budgeted expectations. However, the presence of uncertainty can significantly
influence the interpretation and reliability of variance analysis. Understanding how uncertainty affects variance
analysis is crucial for making informed decisions.
Sources of Uncertainty in Variance Analysis
1. Measurement Uncertainty: Inaccuracies in data collection can lead to errors in reported figures, affecting
the calculation of variances. For instance, imprecise measurement instruments can introduce errors in
recorded material usage, leading to incorrect material usage variance calculations.
2. Input Variability: Fluctuations in input variables, such as raw material costs or labor rates, can introduce
uncertainty into variance analysis. These variations can stem from market volatility, supplier pricing
strategies, or economic conditions.
3. Model Assumptions: Variance analysis often relies on assumptions about relationships between variables. If
these assumptions are incorrect or overly simplistic, the resulting variances may not accurately reflect reality.
Impact of Uncertainty on Variance Analysis
 Misinterpretation of Variances: Unrecognized uncertainty can lead to incorrect conclusions about
performance.
For example, a favorable variance might be mistakenly attributed to efficiency improvements when it
actually results from measurement errors.

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  Decision-Making Risks: Decisions based on uncertain variances may not yield the desired outcomes. For
instance, cost-cutting measures implemented in response to perceived inefficiencies might be unnecessary if
the variances are due to data inaccuracies.
Managing Uncertainty in Variance Analysis
1. Quantify Measurement Uncertainty: Assess the precision of measurement tools and incorporate this
uncertainty into variance calculations. This approach provides a more accurate picture of performance.
2. Sensitivity Analysis: Evaluate how changes in input variables affect variances. Sensitivity analysis helps
identify which variables have the most significant impact on variances, allowing for targeted data accuracy
improvements.
3. Variance Decomposition: Break down variances into components attributable to different sources of
uncertainty. This method aids in understanding the relative contribution of each source to the overall
variance, facilitating more effective management strategies.
4. Monte Carlo Simulations: Use computational algorithms to model the impact of uncertainty on variances.
By simulating a range of possible outcomes, organizations can better understand the potential variability in
their variance analysis.
4.9. Identification of relevance, strengths and weaknesses of standard costing and variance analysis for
performance and control
1. Relevance of Standard Costing and Variance Analysis
Standard costing and variance analysis remain crucial tools for performance measurement and cost control in
many industries. Their relevance depends on:
✔ Industry Type – Effective in manufacturing, retail, and service industries where costs can be standardized.
✔ Business Size & Complexity – Useful for both small businesses and large enterprises but may require
modifications in dynamic or service-based industries.
✔ Decision-Making – Helps identify inefficiencies, improve budgeting, and support strategic planning.
✔ Technological Changes – As businesses adopt automation and AI-driven analytics, traditional standard
costing may need enhancements.
2. Strengths of Standard Costing and Variance Analysis
🔹 Cost Control & Efficiency Improvement
 Helps businesses monitor and control direct and indirect costs.
 Identifies inefficiencies in materials, labor, and overheads
🔹 Performance Measurement & Accountability
 Variance analysis pinpoints areas of improvement for departments and employees.
 Encourages managers to meet efficiency targets

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🔹 Budgeting & Decision-Making
 Provides a benchmark for setting realistic budgets
 Helps in forecasting future costs and setting pricing strategies
🔹 Profitability Analysis
 Allows businesses to analyze cost behaviors and optimize profit margins.
 Helps identify underperforming products, services, or departments.
3. Weaknesses of Standard Costing and Variance Analysis
🔸 Not Always Suitable for Modern Businesses
 Lean & Agile Environments: Traditional standard costing struggles with industries using just-in-time
(JIT) inventory and lean manufacturing.
 Service Sector Challenges: Hard to standardize labor costs in businesses like consulting, healthcare, and
IT.
🔸 Limited Flexibility
 Does not adapt well to rapidly changing market conditions.
 Static cost standards may become outdated quickly.

🔸 Behavioral Issues & Misalignment with Strategy

 Can lead to dysfunctional behavior, such as cost-cutting at the expense of quality.
 Employees may focus on meeting cost targets rather than innovation and customer satisfaction.
🔸 Focus on Cost Reduction Over Value Creation
 Overemphasizing variance analysis may lead to short-term decision-making rather than long-term growth.
 Does not capture intangible benefits like employee morale, brand reputation, and customer satisfaction.
4. Managerial Implications and Modern Adaptations
 Integrate with Activity-Based Costing (ABC): For more accurate cost allocation.
 Use in Combination with Strategic Performance Measures: Such as Balanced Scorecards and Key
Performance Indicators (KPIs).
 Leverage AI & Automation: Modern software tools can enhance real-time variance tracking.
 Shift Focus from Cost-Cutting to Value Optimization: Balance efficiency with innovation.

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