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 profit and increasing the profit margin. There are many interpretations of the word profit. Time, resource, money, effort, effectiveness etc are in one instance or the other equated to profit. We can say all these words can be consolidated and merged into "Efficiency". By measuring the efficiency of a firm we can calculate the profit and by improving the efficiency the profit margin grows. Lets drill down to find the ingredients of "Efficiency". Efficiency focuses on the cost of accomplishing the task.
Lets explain "Efficiency" with an example. To evaluate the effectiveness of a product produced the following questions has to be answered effectively;
- Was the best cost obtained in purchasing raw materials.
- Whether the specified quantity of raw material was used.
- Was extra raw materials used
- Was the specified amount and level of overheads used
- Was the task completed within specified time
Measuring all these and confirming to the specified range will increase the effectiveness there by increasing efficiency.
The importance of "STANDARDS"
Many finance managers argues on the point, actual price should only be followed while valuating finished and semi finished 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".
Difference between Standard Cost and Budget:
Standards and Budgets are essentially the same in concept. Both are predetermined costs and both contribute significantly to management planning and control. A Standard is a Unit amount, whereas a budget is a Total amount.
There are important accounting differences 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 offer the following advantages;
- Facilitate Management Planning by establishing expected future costs
- Makes employees more "Cost Conscious"
- Useful for Setting "Selling Price" for finished 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 difficult 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 efficient level of performance that is attainable under expected operating conditions.
To be effective 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 finished 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 benifits | 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 Overhead Costs | Amount | Standard Direct Labor Hours | Overhead Rate Per Direct Labor Hour |
|---|---|---|---|
Budgeted Overhead Costs Ampunt | / Standard Direct Labor Hour | = | Overhead Rate Per 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 Cost Elements | Standard Quantity x | Standard Price = | Standard Cost |
|---|---|---|---|
| Direct Materials | 4 TON | 3 | 12.00 |
| Direct Labor | 2 Hours | 10 | 20.00 |
| Manufacturing Overheads | 2 Hours | 5 | 10.00 |
| Total Manufacturing Cost | 42.00 |
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 inefficiently.
If the actual costs are less than standard costs, the variance is favourable (F). A favourable variance has a positive inference. It suggests efficiencies 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 first 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 efficiency) 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 efficiency 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 difference 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) is the difference between the actual overhead costs incurred and the budgeted costs for the standard hours allowed. The budgeted costs are determined from the flexible 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 fixed)
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 efficiently 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 fixed.
A careful examination of this analysis indicates that the overhead volume variance relates solely to fixed costs. Thus, the volume variance measures the amount that fixed overhead costs are under -or over applied.
If the standard hours allowed are less than the standard hours at normal capacity, fixed overhead costs will be underapplied.
If production exceeds normal capacity, fixed 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 fixed 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
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