Analysis of Variance

Transcription

1 Course: Discipline 1-Commerce and BMS Subject: Accounting for Managers Lesson: Lesson Developer: Deepika Dewan College/ Department: Bharati College, University of Delhi 1

2 Lesson: Table of Contents 1: Learning Outcomes 2: Introduction 3: Concept of Variance and Variance Analysis 3.1: Rationality of Variance Analysis 3.2: Variants of Variances 3.3: Role of Standard and Standard Costing in Variance Analysis 4: Process of Variance Analysis 5: Computation of Variances 5.1: Material Cost Variances 5.2: Labour Cost Variances Summary Glossary Exercises References 1. Learning Outcomes: After you have read this lesson you should be able to: understand the concept of variance and variance analysis, identify the existence of variance and the type of variances, explain the implications of various variances, appreciate the role of variance analysis in the managerial process, apply the knowledge to find the variances and deal with it, comprehend the inter-relationship among various variances, explain how standards are established, compute and interpret the variances. 2

3 Favourable Unfavourable or Adverse 2. Introduction: Analysis of variance is one of the important techniques of control. And control is the most significant function of management. This function assists the management to measure and ascertain the performance of the organisation as a whole. The presence and successful implementation of control ensures the achievement of pre-determined targets and required efficiency. Under planning, the organisation decides on what, how and when the actions have to be implemented. But under control one evaluates if the planning has been executed. If it is executed whether it is implemented in the manner it was planned. One needs to identify the difference(s) in the planned and achieved targets for evaluating the managerial efficiencies and be more cost effective. This calls for analysis and measurement of differences between the planned and achieved targets. The analysis helps to determine the unplanned effects on the achieved results. The managers can correct effects if they are detrimental for the organisation or to enhance it if effects are beneficial. 3. Concept of Variance and Variance Analysis: The variance is the quantified difference between the actual results achieved and expected performance. Variance(s) = Expected or Estimated - Actual An illustration Suppose you are travelling and expect to reach your destination in normal traffic and normal conditions around in an hour. The time estimations and time keeping are done with all the considerations of the prevalence of normal conditions. But it took one and a half hour to reach the destination. The difference of half an hour that exists between the expected time frame of one hour and the actual time taken is called variance. In our example variance is adverse because actual time taken was more than expected. This boils down to the fact that there can be a favourable variance too. If the actual time taken would have been less than the expected, the difference would be favourable and enjoyed by everyone. Figure 1: Nature of Variance Variance 3

4 The favourable variance is positive and adverse variance is negative. The expected input, if is greater than the actual achievement, that suggests that the efforts were expected to be more but the target is achieved in the lesser effort therefore, it is a matter of favour and if the effort put in for achieving the target is more than the expected or estimated amount, it is an adverse condition. Hence, this situation is referred to as the adverse variance. But, simply the identification of the quantum of variance is meaningless, if it is not analyzed. If one does not strive for knowing the reasons behind favourable or adverse variances the whole exercise of determining the variances is futile. Variance Analysis The exercise of analyzing the variances is referred to as Variance Analysis. Variance analysis is part of control process that involves calculation of variance and interpretation of results so as to find out various factors that are responsible for the variances. Variance analysis is a tool that helps the organizations to look into the causes of the discrepancies that arise or occur during the working of an organization. Besides identifying the differences between the desired or planned objectives or targets set for the particular period and the targets actually achieved, the variance analysis assists in identifying the causes for such discrepancies. Illustration Continued.. It is a known fact that there is bound to be a difference between the expected time and the actual time taken for reaching a particular destination, continuing with the same example of reaching a destination in a specified time. This difference may be due to several factors i) differences in the assumptions made while estimating the expected time to reach the destination with regard to the traffic, weather etc. and the actual conditions and assumptions; ii) the process of determining and comparing actual time taken with the expected time; iii) speed maintained to reach the destination, and iv) the mode of travelling etc. The variance analysis tends to help in locating the reasons for such variances. The variances can exist in any field; wherever the estimation is done the variance analysis can be applied. The parameters of measurement can be time, cost, profit, yield, sales, revenue or any other thing. The discussion, here in this chapter is limited to variance analysis of cost. Cost has different components like material, labour and overhead. But, again this chapter is restricted to discuss only two major components of cost i.e. labour and material. In 4

5 management accounting the variances are computed on the basis of the benchmarks known as standards. Let s understand the concept of variance analysis in terms of cost. The figure given below shows the basic concept of variance analysis that variance(s) can be favorable as well as unfavourable. It is clear that any inefficiency in production process leads to higher actual cost because of which unfavourable variance arises and amount of profit decreases. This occurs because pre-determined standards or benchmarks were too high and not viable or feasible to achieve in the present situation. Conversely, efficiencies in production lead to lower actual costs and that results in favourable variance and higher profits. This situation arises when benchmarks are either too low or understated and the present environment or scenario is more favourable. Figure 2: Concept of Variance Inefficiency in Production Actual cost > Standard Cost Unfavourable Variance Reduction in Profit Neither Efficiency Nor When Inefficiency Actual Cost= Standard Cost No Variance Efficiency in Production Actual Cost< Standard Cost Favorable Variance Increase in Profit Dr. Balance Cr. Balance Indicated by A i.e adverse Indicated by F i.e favourable Whenever actual cost matches with the standard cost it shows absence of any variance. But this happens very rarely in the actual practice. The assumptions on which the norms or the standards are based seldom go together with the actual scenario. To comprehend the concept of variance analysis clearly the understanding of the standard and standard costing is necessary that is discussed in the later section of the chapter. 3.1 Rationality of Variance Analysis: Only the planning or setting the benchmarks do not serve any purpose unless actual results are matched with the standards. It is a well-known fact that the difference or variance between the planned and the actual is bound to occur. Need of variance analysis arises from this fact that in any organization there is a difference between the planned outcomes and the actual outcomes. So, it is necessary to check why these differences/variances arise. It is 5

6 important to understand why the difference has arisen so that the difference can be justified and then either the plans are reviewed or the production process is changed or modified from the point of view of quality, supply, usage, pricing etc. with regard to material or labour, so that any bottleneck or hindrance in the achievement of standards can be removed. In an organization whether objectives have been achieved or not, basic need is to analyze the reason behind that. If objectives have been achieved then main focus should be to maintain that rhythm in the organization and if objectives have not been achieved then emphasis should be on eliminating those forces or factors that work as hindrance in the achievement of organizational objectives. So, it becomes imperative for managers to analyze the variances that exist, the reason behind their existence and how these variances can be handled. At the same time it is necessary to understand that normally organizations are divided into different segments and the differences may exist between organizational objectives and individual segment objectives. Managers normally strive for the achievement of both organizational as well as individual segment objectives. Citing an example will help in understanding why analysis of variance is required. Figure3: Need of Variance Analysis Before result a student was expecting to get at least 94% in his board. On the basis of his preparation he made following standards for himself keeping in mind his own strength and weakness.english-99, Math-95, Science- 90,Hindi-94,Socialcience-94 Result Declared After result he was able to score 95.4% marks. His result was English- 95, Math-98, Science- 92,Hindi-94,Social science-98 In the above illustration it looks, on the face of it that student has achieved his standard or that he has surpassed his own standard and as such no improvement is required, he just needs to maintain it. But if we take a deeper look he has achieved his overall standard but not the individual one. The marks obtained in each subject differ from his pre-determined standard. In the same way in an organization it is necessary to check whether individual targets are achieved or not even if overall standards or targets of organization are achieved. In other words, the standards of all individual segments and organisation as a whole should be 6

7 achieved. For example, if the standards of sales are met, it is not necessary that all other standards related to price and material are also met. 3.2: Variants of Variances In an organization, variances can arise due to many reasons like efficiency or inefficiency of labour, difference between actual and pre-determined sales or prices or volume etc. So on this basis variance can be grouped in to three categories: Variances of Efficiency Variances of Price Variances of Volume Figure 4: Variants of Variances Variances of Efficiency When variance arises due to efficiency or inefficiency while using the material or labour, it is called variance of efficiency. Variances of Prices When variance arises due to difference between actual price and standard price, it is called variance of prices. Variances of Volume When variance arises due to a gap between actual level of activity and standard level of activity, it is called variance of volume. Types of Variances: One of the objectives of any organization is to maximize its profit and profit is the difference between sales and cost. Thus, to analyze the difference between actual profit and expected profit, it is important to analyze the difference between actual sales and expected sales; and actual and expected cost. The difference between actual and expected sales may arise due to turnover and margin; and difference between actual and expected cost may arise due to material, labour or overhead etc. Thus, on the basis of this variances can be categorized into three broad categories namely: Sales Variance 7

8 Production Cost Variance Non- Production Cost Variance. Or the variances can be categorized in two categories only i.e. sales and cost which are further divided into sub categories. For example, Sales variance is broadly divided into two categories price and turnover. And the cost variances are divided on the basis of production and non-production costs. The production cost variance is further divided on the basis of components of costs: Material, labour and overheads. We commonly understand these to be the only variances, which is not true. The variances have to be analyzed from all points of views. The figure given below describes this categorization of variances along with its sub categories. Figure 5: Types of Variances Total Profit Variance Sales Variance Sales Price Variance Sales Turnover Variance Production Cost Direct Material Variance Direct Labour Variance Cost Variance Overhead Variance Non- Production Cost Marketing Cost Administrati ve Cost Sales Variance: Sales variance is difference between expected sales and actual sales. It can be analyzed on the two bases: Sales Turnover Sales Margin/ Profit Whenever actual sales are more than expected sales, it is called favourable sales variance and if actual sales are less than expected sales, it is called adverse sales variance. Since sales means profit. Production Variance: Production Variance refers to difference between expected cost of production and actual cost of production. Cost of production has three basic components material, labour, and overhead. So, therefore Production variance can be further divided in to three categories 8

9 Direct Material Cost Variance Direct Labour Cost Variance Overhead Cost Variance Again, these variances can be measured in terms of efficiency and expenditure. Efficiency referred to as usage or quantity variance and expenditure is referred to as price variance. These variances are discussed in detail in the later sections of this lesson. Non- Production Cost Variances: Non-Production cost variances can be defined as the difference between expected cost of goods sold and actual cost of goods sold. Non production cost variance can arise because of any two or both the factors i.e. marketing cost and administrative cost. So, whenever expected marketing or administrative cost is greater than actual marketing or administrative cost than respective favourable variance arises or vice versa there would be adverse variance. Table 1: Types of Variances 9

10 Types of Variance Meaning 1) Cost Variance Whenever actual cost of a product differs from the pre-determined standard cost variance arises. Material Cost Variance It arises due to difference between actual cost of product and standard cost of product. Labour Cost Variance It arises due to difference between actual wages paid to labour and standard wages planned to produce a particular level of output. Overhead Variance Whenever actual overhead incurred differs from the overhead observed, that variance is called overhead variance. 2) Sales Variance There can be difference between actual sales occurred over a period of time and pre-determined standard to achieve a particular turnover. Whenever there is a difference between the two sales figures, the variance exists. Sales Price Variance It arises when the price received by an organization for a particular product is less than the budgeted or standard price. Sales Volume Variance It arises when the actual number of units of a particular product sold by an organization differs from the predetermined standard. 3) Non-Production Variance Whenever actual non production cost of goods is greater than expected cost then adverse non-production cost variance would exist. Marketing Cost Variance It arises due to difference between actual and expected marketing cost of goods sold. Administrative Cost Variance Value Addition 1: Did You Know Causes of Variances The causes of variance can be grouped into two categories: special and common. Special causes are those causes that are not inherent in the system and are unpredictable. Common causes are those that are predictable and inherent in the production process. Visit the following URL to acquire detailed knowledge about these causes of variance : Interrelatedness of Variances: It arises due to difference between actual and expected administrative cost of goods sold. 10

11 Variances are interrelated and dependent on each other. Favourable or unfavourable variance in any one component may affect the variance of another component also. Sales and cost are two basic components of profit. So, any deficiency in one component will pass on to other component. The interrelatedness of variances can be understood clearly with the help of an example. The figure given below also shows how variance in cost leads to the variance in sales. It is known that cost and sales are basic components of profit and to achieve the objective of profit maximization an organization is required to either reduce the cost of production or increase the level of sales. But any variance in cost or sales may result in non-achievement of organizational objective. Any kind of favourable cost variance that occurs in the beginning of production process may lead to unfavourable profit variance by the end of the process. Following example shows how achievement of cost objective that is favourable cost variance may also lead to unfavourable profit variance. Figure 6: Relatedness of Variance Suppose to reduce cost of production Low quality products resulted in less expected sales That resulted in adverse sales variance less skilled labour was hired Because of which adverse efficiency variance arises Due to adverse sale variance profits were less than expected That resulted in favourable labour variance But because of that, the final product was of inferior quality Finally there will be adverse profit variance It is essential to understand that material, labour and overhead variances are not studied in isolation. It means that existence of one variance may create a situation leading to the emergence of another variance. Let s take an example, explained through the figure, to understand the interrelatedness of variance. Figure 7: Interrelatedness of Labour Variance and overhead variance 11

12 Suppose that the standard rate for labour was Rs.50 per hour. The manager of the company manged to get a little less skilled labour at Rs.40 per hour It leads to favourable labour variance because SC>AC. But in reality because of less efficeint labour, wastage of material was increased. Now the situation is that the manager was happy because of favourable varinace of labour cost but in reality he created adverse variance of material cost. So, one variance is related to other variance in some way or the other. Now it must be clear through the above example that the presence of one variance may lead to another variance, favourable or adverse. One needs to remember, while analyzing and interpreting the variances that production is a sequence of interrelated steps. So, if any variance arises in first step that is bound to be transferred to next step too. It is evident that variances are interrelated and can t be studied in isolation from each other. Disposition of Variances in Costing: After the complete analysis and determination of variances it is important to understand how these variances are disposed of in cost accounting i.e. treatment of variances in costing. Variances of any organization can be disposed in any of the following ways as explained in the following table: Table 2: Ways of Disposition of Variances Method Transfer to standard costing profit and loss Transfer to reserve Allocation of variances to finished stock, work-in-progress and cost of sales Treatment of Variances In this method all variances are charged to costing profit and loss account. Under this method stock of work-in-progress, finished stock and cost of sales are maintained at standard cost Under this method favourable variances are carried forward as deferred credit until they are set off by adverse variances Under this method variances are distributed over stocks of finished goods, work-inprogress and to cost of sales account in proportion to the closing balances of each account depending upon the type of variance. 12

13 So far the lesson takes care of the variance analysis and their disposition. But the discussion would be incomplete, till the concept of standards and their setting process is discussed. Hence, the following section deals with the concept of standard, types of standards and their setting process. 3.3 Concept of Standard and Standard Costing: Standard can be defined as a benchmark or a yardstick against which actual situation or activity can be compared to find the difference or variance between them, if any. Simply, the standard is what the norm or the benchmark should be, not that what it would be. That differentiates it from the estimation. The estimations may be based on guesses or hunches but the standards are based on certain scientific assumptions and calculations. For example, in case of labour, the determination of standard hour to produce actual output is based on the time and motion study, the average performance, efficiency desired, required time frame etc. The standards thus, provide a practical target which should be achieved, in the normal circumstances. In an organization, the standards or the norms are fixed with respect to labour hours, normal hours, wastages, cost, normal production, yield, pilferage; break down of plan and machinery, quality of material, substitute of material, price of material, working condition etc. One thing must be remembered standard cost is determined for a fixed period of time (usually a quarter, half year or a year) and is thus subject to revision from time to time. Value Addition 2 : Did you Know Meaning of Standard Cost Standard cost, in simple words, refers to the cost that should be the incurrence in reality. It is a pre-determined cost and is fixed for each product or job in advance but while fixing standard cost for any product one general rule should be followed neither it should be too easy to achieve nor unattainable. Standard cost is the pre-determined cost based on technical estimates for material, labour and overhead for a selected period of time for a prescribed set of working conditions-by CIMA London. The standard cost is a pre-determined cost which determines what each product or service should cost under a given circumstances- By Brown and Howard Role of Standard Cost in Costing and it s Significance In cost accounting standard cost plays an important role. Variance Analysis is one of the control techniques and can t have any existence without certain pre-determined cost that is called standard cost. Standard cost can be referred to cost calculated in advance based on certain historical data and engineering specifications that affects cost standards. Standard cost is always set for a specific period only and can be attained only under normal conditions. But in reality whether those conditions exist or not that is a question to answer and gives rise to the concept of variance analysis. Whenever normal conditions on which standard depend differs from the actual conditions of production process, variance arises. For example standard price that is based on the cost of goods sold itself depends on standards related to labour, material, quality etc. Suppose standard price of a commodity was fixed Rs. 100 per unit after making following estimates for factors of productions. 13

14 Material (Quality A) Labour (Skilled) Overheads Rs.35 Rs.25 Rs.20 Now assume that quality A of material is not available in the market and if available then not at the estimated price. In that case two situations may arise (i) If quality A is purchased at higher price that is more than the estimated in that case adverse material price variance will arise. (ii) Otherwise, if low quality material is purchased in that case initially favourable material price may arise but low quality of material will affect efficiency of labour that may result in more wastage, so eventually unfavourable variance may arise. It is clear from the above example that whenever actual conditions do not match with the hypothetical situations on which standards are based then variances will arise in the production process. Since the actual results are compared with those of the predetermined standards, the standards should not be very ideal but should be practically attainable so that they may not lead to frustration but helps to motivate the productive workers. Value Addition 3: Did You Know Types of Standards Standards can be determined on different basis like current scenario, ideal situation, attainability etc. Basic Standard Standard that is based on some base year and remain in use over a long period of time is called basic standard. The main disadvantage in basic standard is that it may be outdated. Current Standard Current standards are related to current situations and can be used over a short period of time. Ideal Standard Ideal standard means a standard that belongs to most favourable situations. At the time of setting ideal standard no provision will be made for waste, breakdown or shrinkage etc. Attainable Standard Attainable or expected standard is a standard that is based on certain expectations after giving allowances for unavoidable losses. Watch the video on the linkhttp:// know more about standards and role of standard costing in day to day life. 4. Process of Variance Analysis: Figure 8: Process of Variance Analysis 14

15 Setting standards Determination of actual results Comparing actual results with standards Determinig and evaluating the diffrences Analyze variances and its causes Disposition of variances Take action Step-1: Setting Standards First step in the process of variance analysis is setting standards. Whole process of variance analysis is based on standards, so while determining the standards certain things need to be kept in mind. Standard should be set for each and every element of cost like price, material, overhead etc. Standard should be based on assumption that what will be the cost if normal conditions exist. It should be assumed that plant will operate at maximum possible efficiency. So one thing needs to be understood that success of standard costing and variance analysis depends on the reliability and accuracy of standard. If standards are faulty, it will affect the whole process and all planning will fail because planning is also based on standard. Establishment of standard for cost is important for any organization. Some of the advantages of setting standard are as follows. Planning, the first function of management is incomplete without the establishment of standards. Standard can work as a tool to motivate workers to attain a certain standard to prove their efficiency and productivity. Standards are tools to control the production process. It is a yardstick to check whether actual production process is going on the line of planned production or not. Standards can also serve as a benchmark to decide whether a worker s work should be rewarded or not. If a worker achieves standard, he/she should be rewarded for his/her efficiency. 15

16 Value Addition 4: Activity Visit the following URL to deeply understand the concept of standard cost and how it is established. Step-2: Determination of actual results Once organization has set the standards, next step will be to determine the actual outcomes in relation to each and every element of cost like labour, material or overhead, sales, revenue or profit. Step-3: Comparing results with actual standards After determination of standards and actual results the variance analysis calls for their comparison. Standards are of no use if they are not compared with actual results. So, next step is the comparison of actual occurrence and expected occurrence to know whether organization is working efficiently or inefficiently. It becomes important thus to actually quantify the difference. Step-4: Determining and evaluating the differences or variances When actual results are compared with the standards, next step is to analyze the variances. It has been already been discussed that variances can be positive as well as negative. So, it becomes necessary to evaluate the differences along with their directions i.e. positive or negative, between the actual and standard norms. Step-5: Analysis of variances and tracing the causes of difference and the nature of variance Evaluation of results leads to next step of the process that is analysis of variance to find the causes and nature of variance (s). Variance can arise due to many reasons like unskilled labour, low quality of material, wrong assumptions on which standards were based, unfavourable market conditions etc. It is essential for an organization to find out the causes of variance and quantum of variance. Quantum of variance gives the idea how much variance has occurred and causes explain why it has occurred. Both are vital components for future reference. Value Addition 5: Did You Know There can be many causes of variances. Follow the link given below to get detail knowledge of causes of variances and its comparison with standards. Step-6: Disposition of Variances Disposition refers to treatment of variances that is how the variances can be recorded in an organization. Disposition of variances has already been discussed above. Step-7: Take an action Final step in the process of variance analysis is to take an action. As variances can be positive or negative also, but both calls for a plan of action. Firstly, review the standards, if variance is positive it shows that standards are understated and need a revision. On the other hand if variance is negative, standards are overstated and need to be corrected. So, in any case revision of standards is essential. 16

17 Secondly, after finding the causes of variances, it is necessary to stop their occurrence. So it becomes important to check and modify production process to avoid nay wastage of raw material, time etc. and any break in the flow of work. 5. Calculation of Variances: To evaluate the performance of an organization calculation of variance is important. Variance can be calculated for both cost and revenue. Cost variance can be further divided in two other categories depending upon the elements of cost like price, quantity, Composition and yield. 5.1 Material Cost Variance (MCV): Material cost variance represents difference between standard cost of material for actual output and actual cost of material to produce that output. Variance arises due to inefficiency or efficiency in the use of material or price of the material. So when material is utilized efficiently it amounts to positive variance on the other hand when material is not utilized efficiently or wasted it is said to be negative variance. Important Terms: Before the computation process, it is necessary to know the meaning of following terms: Standard quantity of material for actual output This amount shows that as per standards to produce a particular level of output how many units of material should be used. So standard quantity of material for actual output is: Standard quantity of material required per unit Actual Output (SQ AQ) Standard cost for standard quantity for actual output This amount shows standard cost for standard quantity for actual output. It can be calculated as Standard quantity of material for actual output Standard Price(SQ AP) Figure 9: Types of Material Cost Variances 17

18 Material Cost Variance Material Usage or Quantity Variance Matreial Price Variance Material Mix Variance Material yield Variance Value addition 6: Did you know? How many material standards are required to establish? To calculate material cost variance two standards must be developed. Material usage or quantity standards Material price standards Material Usage Standard The work of deciding the standard quantities of material that should be used to produce a commodity is of Production Manager and engineers. Many factors like quality of material, standard ratio mix of different material, design of product should be kept into consideration. At the same time inherent wastage attached with the production process should also be kept in mind. Material Price Standard The standard price for material is mostly decided by cost accountant in consultation with purchase manager. The criterion to decide standard price may be past average prices, current prices or expected future prices. Computation: Computation of material cost variance can be explained with the help of following example: Example: Supposed to produce one unit of Good X, 2kg of Material A is required and price is Rs. 5/kg. 10 units of product X was manufactured and 22 units of material A was used. The actual price is Rs.6/kg. 18

19 As per standard price If 10 units of product X are produced then 20(10*2) units of material A should be used. So as per standard price cost of product X is 20*5 i.e As per actual price If to produce 10 units of product X 22 units of material A has been utilized at Rs.6 per unit then actual cost of producing 10 units is 22*6 i.e. 132 So the difference between two costs is called variance. It shows that material was not used efficiently because as per standard 20 units should be used to produce the commodity but in actual production process 22 units were used. So as AC>SC it shows an unfavourable variance of =12 (A) Material Cost Variance= Standard cost for Actual Output Actual Output Or Standard Price Standard Quantity for actual output Actual Price Actual Quantity Or (SP SQ AP AQ) Or (SC AC) Illustration1: Product X requires 20 meter of material at the rate of Rs 8 per meter. The actual consumption of material for the production of product X came to 24 meter of material at the rate of Rs.9 per meter. Calculate cost variance. Solution 1: Material Cost Variance = Standard cost for actual output Actual cost = (SP SQ - AP AQ) = ( ) = =Rs56(Adverse) Adverse material cost variance shows that standard were not achieved and actual cost of producing the commodity is higher than the pre-determined cost that is standard. The basic problem in the above examples which can be highlighted is that there is a difference between actual cost and standard cost but the reason for variance whether price or quantity or both can t be ascertained. This question of material cost variance can be understood by further dividing it into sub categories. There are two components of material cost variance Material Price variance Material Usage Variance Material Mix Variance Material Yield Variance 19

20 Material Cost Variance = Material Price Variance + Material Usage Variance Material Usage Variance = Material Mix Variance + Material Yield Variance Material Price Variance (MPV) Variance that arises due to difference between actual price of material and standard price of material is called material price variance. If actual price is greater than standard price than variance will be adverse otherwise favourable. i.e. if AP>SP (A) and if SP>AP (F) Therefore MPV = AQ(SP-AP) Illustration2: Calculate material price variance using illustration 1. Material Price Variance = AQ (SP-AP) = 24(8-9) = Rs24(A) Material Usage Variance (MUV) Material usage variance is that part of material cost variance that arises due to difference in actual quantity used and standard quantity decided. If actual quantity is greater than standard quantity than variance will be adverse otherwise favourable. i.e. if AQ>SQ (A) and if SQ>AQ (F) Therefore MUV = SP(SQ-AQ) Illustration3: Calculate material usage variance in illustration 1. Material Usage Variance = SP(SQ-AQ) = 8(20-24) = Rs32 (A) Material Mix Variance (MMV) Material usage variance can be further divided in to material mix variance and material yield variance. To produce a product it is possible that more than one raw material is needed and in different proportions. Whenever the proportion of different raw materials actually used in the production process do not match with the pre-determined standards than material mix variance arises. For example: 20

21 If to produce good A raw material X and raw material Y should be used in the ratio of 2:1 i.e. 2 units of material X and 1 unit of material Y and whenever in actual production the mix of raw material will not be equal to 2:1 that will show the existence of material mix variance. So in simple words we can say that material mix variance is that part of material usage variance that arises whenever there is difference between standard mix of all the raw materials and actual mix of all the raw material. While calculating material mix variance two different situations may arise: (i) (ii) When actual weights of mix and standard weight of mix do not differ When actual weights of mix and standard weight of mix differ Situation 1: Suppose that actual weight of mix and standard weight of mix do not differs then Material Mix Variance = Standard unit cost (Standard Quantity Actual Quantity) If due to any shortage or any other situation standard of a particular material was revised then Material Mix Variance = Standard unit cost (Revised Standard Quantity Actual Quantity) Illustration 4: From the following data, calculate material mix variance: Materials Standards Actual X 100 Rs Rs. 10 Y 200 Rs. 12 Rs. 13 Due to shortage of material Y by 20% and increase of material X by 20%. Solution 4: Because of shortage firstly we need to calculate revised standard mix: Revised material mix is: Material X: 100 units 20% of 100 = 80 units Material Y: 200 units + 20% of 200 = 240 units So material mix variance is: Standard Unit Cost (Revised Standard Quantity Actual Quantity) Material X = 10(80-140) = Rs. 600(A) Material Y = 12( ) = Rs. 960(F) Rs. 360(F) 21

22 Situation 2: Suppose actual weight of mix differs from the standard weight of mix then Material Mix Variance = {(Total Weight of Actual Mix/Total Weight of (Revised) St. Mix) Standard Cost of standard mix} Standard cost of actual mix. Illustration 5: From the following data calculate material mix variance: Standard Actual Quantity(Kg) Price Total Quantity(Kg) Price Total Material A Material B Material C Total Solution 5: Material Mix Variance: Firstly calculate consumption of raw material = ( ) = 150 Secondly calculate total weight of standard mix=( )=100 Thirdly standard cost of standard mix = = 560 Fourthly calculate standard cost of actual mix = = 720 MMV= (150/100) = 120 (F) Material Yield Variance: Yield means productivity. So whenever there is difference between the actual yield obtained from the material and the standard yield specified in the standard it is called material yield variance. Material Yield Variance = (Actual Yield Standard Yield specified) Standard cost per unit Illustration 6: Standard cost per tonne of output = Rs. 200 Standard Input = 100 Kg. Standard Yield = 90 Kg. Actual Input = 200 Kg. Actual Yield = 182 Kg. Compute the yield variance. Solution 6: Standard yield for the actual output = (90/100) 200 = 180 Kg 22

23 Yield Variance = ( ) 200 = 400 (F) 5.2 Labour Cost Variance Labour cost variance shows the difference between actual wages paid to labour for actual output and pre-determined standard wages for actual output. Labour Cost Variance = Actual wages paid Standard Wages = AH AR - SH SR = AC SC Where AH= Actual hour AR = Actual rate SH = Standard hour SR = Standard rate If AC > SC Adverse variance and if AC<SC favorable variance Value addition 7: Did you know? How many labour standards are required to establish? To calculate material cost variance two standards must be developed. Labour usage or efficiency standards Labour rate standards Labour usage standard: Standard time required to complete a job must be ascertained. But at the time of deciding standard time required to complete a job certain factors like fatigue, set-up time, breakdown of machinery, waiting time of operations should also be taken in to consideration as these all are unavoidable reasons. Labour rate Standard: Labour rate standard means price of labour in terms of money, decided in advance. Before setting any labour rate standard some factors like experience of labour, skills, knowledge, Union negotiations, should be properly considered. Example: Suppose to produce one unit of Good X, 4 units of Labour A is required and wage rate is Rs. 10/day. 20 units of product X was manufactured and 90 units of labour A was used. The actual price is Rs.12/day. As per standard price If 20 units of product X are produced then 10(4*20) units of material A should be used. So as per standard price cost of product X is 10*80 i.e As per actual price If to produce 20 units of product X 90 units of labour A has been utilized at Rs.12 per unit then actual cost of producing 20 units is 90*12 i.e

24 So the difference between two costs is called variance. It shows that labour was not used efficiently because as per standard 20 units should be used to produce the commodity but in actual production process 22 units were used. So as AC>SC it shows an unfavourable variance of =280 Labour Cost Variance= Standard cost for Actual Output Actual Output Or Standard rate Standard Hours for actual output Actual Rate Actual Hour Or (SR SH AR AH) Or (SC AC) Figure 10: Types of Labour Variances Illustration 7: From the information given below calculate labour cost variance. Standard Actual Output 200 units 400 units Labour hours required per 4 Hours per unit 6 Hours per unit unit of output Rate per hour 8 6 Solution 7: Labour Cost Variance = (SH SR - AH AR) Standard hours for actual output = =1600 Actual hours for actual output = = 2400 LCV = ( ) = 1600 (A) 24

25 In the above example adverse variance shows that standard wages that must have been paid to produce actual output is less and actual wages paid to them is more. But real reason of this variance is quantity or rate or both that can t be ascertained with the help of final answer. Therefore to solve this problem labour cost variance is further divided in to two parts. Labour Efficiency Variance Labour Rate Variance Labour Mix Variance Labour Yield Variance Idle Time Variance Labour Rate Variance: Labour rate variance arises due to difference between actual labour hour rate and standard rate for direct labour. It can be described as that portion of labour cost variance that arises due to difference between actual hour rate paid to labour and standard hour rate fixed for labour. Labour Rate Variance = (AR-SR) AH If AR>SR Adverse variance and if AR<SR Favourable Variance. Illustration 8: Compute labour rate variance for illustration 7. Solution 8: Labour Rate Variance = (AR-SR) AH = (6-8) 2400 = Rs4800 (F) Labour Efficiency Variance Labour will be considered efficient only when their performance matches with or is more than the standard. Whenever actual direct labour hour taken by labour to produce a commodity is less or more than the standard hours fixed for the production of that commodity labour efficiency arises. Labour Efficiency variance = (AH SH) SR If AH > SH Illustration 9: Adverse Variance and if AH < SR Favourable Variance Calculate labour efficiency variance for illustration 7. Solution 9: Labour Efficiency Variance = (AH SH) SR = ( ) 8 Labour Mix Variance: = 6400 (A) 25

26 Whenever a good is produced or a job is done, a particular type and quantity of labour in a fixed number is required. Labour mix belongs to that portion of labour efficiency variance that arises due to difference between standard composition of labour and actual composition of labour. Labour Mix Variance = (actual labour mix revised standard labour mix in terms of actual hours) Standard rate per hour Revised Hour = (Standard hour of labour/total standard hour) total actual hours Illustration 10: Compute labour mix variance from the information given below. Standard Actual Hours Rate per hour Hours Rate per hour Labour P Labour Q Standard Output 85 Kg Actual Output 1700 Kg. Solution 10: Revised standard Hour = (Standard hour of one grade/total standard hours) total actual hours Labour P = (20/50) 1050=420 Labour Q = (30/50) 1050=630 Labour mix Variance= (RH-AH) SR Labour P = ( ) 6=1230 Labour Q = ( ) 4.5=922.5 LMV = 307.5(A) Labour Yield Variance: Labour Yield Variance is also known as labour efficiency sub-variance and is calculated in terms of input. Yield means productivity. Whenever productivity of labour will be higher variance will be positive. A lower output shows that because of adverse yield that is low productivity final output is less than what should have been produced with in standard hours. So labour yield is that portion of efficiency variance that arises due to difference standard yield expected from labour and actual yield occurred. Labour Yield Variance= (Actual yield- Standard Yield) Average standard output rate Where Standard yield for actual hours = (standard output for total standard hours/total standard hours of all grades for actual output). Average standard output rate = (Standard cost of standard hours of all grades of labour for actual output/standard output for total standard hours). Illustration 11: Calculate labour yield variance of illustration

27 Solution 11: Standard yield for actual output = (85/50) 1050= 1785 hours Average Standard output rate = {(20 6) + (30 4.5)}/85 = 3 Labour Yield variance= (Actual yield- Standard Yield) Average standard output rate = ( ) 3 = 255 (A) Idle time variance: During working hours, there may be certain time period in which worker is not able to work because of some reasons like breakdown of machinery etc. Labour do get payment for that portion of idle time, so idle time is that unproductive time for which the worker gets payment without any corresponding production. Idle time variance can be described as that part of labour efficiency variance which is due to abnormal idle time. It arises due to difference between actual labour hour worked and actual labour hour paid. Idle time variance= (Actual hours worked-actual hours paid) standard rate Or Idle time variance= Idle hours standard rate Idle time variance will always be adverse because it shows unproductive hours that is a loss. Illustration 12: In a company ABC Ltd. 150 workers produced 1500 units in a time period of 40 hours in a week despite 4% of time was lost due to some abnormal reason. The standard wage rate per hour was Rs. 8 and actual wage rate per hour was Rs.10. The standard output is 35 units per hour in a department employing 150 workers. Calculate idle time variance. Solution 12: Idle Time Variance = Idle hours standard rate = 4% of (150 40) 8 = 2400 (A) It is necessary to understand that material, labour and overhead variances are not studied in isolation means that existence on variance may create a situation for the emergence of another variance. Summary: Standards are benchmarks against which actual situation can be compared. Standards are decided for a particular span of time, therefore, subject to revision. There can be 27

28 different basis to establish standard in an organization like Current standard, expected standard, basic standard, ideal standard etc. Difference between standard and actual is known as variance. In costing variance analysis is a process in which actual cost, profit, sales are compared with the predetermined standard to find out if any deviations exist. Variance can be favourable as well as unfavourable. Variance analysis is a cost control technique that helps an organization to compare actual cost with pre-determined cost called standard cost, then find out the variance if any and causes of those variances. Variances are not studied in isolation; emergence of one variance may lead to arise of other variance, so variances are interrelated not independent. There are basic two types of variance i) cost variance ii) sales variance. Cost variance shows variance that arises due to difference between actual cost and standard cost but there are three basic components of cost; labour, material and overheads. Therefore, cost variance = Material variance+ Labour Variance+ Overhead variance. Sales variance arises whenever actual sales do not match with the determined standards. Sales variance has two components; price and volume. Material cost Variance has two components:material Price Variance and Material Usage variance. And material usage variance can further be divided in to two category:material mix variance and Material usage variance To produce a commodity, a certain level of several materials is required. Whenever standard mix of material does not match with the actual mix of material mix variance arises. Yield means productivity that is input-output ratio. Material Yield variance occurred whenever final output do not match with the standard output that could have been produced by using units of material that have been actually used. Labour cost variance arises whenever there is a difference between standard labour cost and actual wages paid to them. Labour cost variance = Labour efficiency variance + Labour rate variance Labour Rate Variance arises due to difference between actual labour hour rate and standard rate for direct labour. When actual performance of labour does not match with the pre-determined standard, labour efficiency variance arises. Idle time variance arises due to the fact that there is always a difference between actual labour hour worked and actual labour hour paid. Labour yield is that portion of labour efficiency variance that arises due to difference standard yield expected from labour and actual yield occurred. Glossary: Standard Costing:Standard costing is technique of cost accounting which compares standard cost of each job or activity with the actual cost, to determine the success of any operation and if any deviation exists, then to find the remedial action for the same. Budgeting:In simple words budgeting can be defined as a process of preparing budgets. Budgets are plan prepared by an organization to achieve the long and short term objectives. So the process of preparing those budget that outlines the future activities of an organization to achieve the objectives, is called budgeting. 28