Computing variances

As stated earlier, standard costs represent goals. Standard cost is the amount a cost should be under a given set of circumstances. The accounting records also contain information about actual costs.

The amount by which actual cost differs from standard cost is called a variance. When actual costs are less than the standard cost, a cost variance is favorable. When actual costs exceed the standard costs, a cost variance is unfavorable. Do not automatically equate favorable and unfavorable variances with good and bad. You must base such an appraisal on the causes of the variance.

The following section explains how to compute the dollar amount of variances, a process called isolating variances, using data for Beta Company. Beta manufactures and sells a single product, each unit of which has the following standard costs:

We present additional data regarding the production activities of the company as needed.

The standard materials cost of any product is simply the standard quantity of materials that should be used multiplied by the standard price that should be paid for those materials. Actual costs may differ from standard costs for materials because the price paid for the materials and/or the quantity of materials used varied from the standard amounts management had set. These two factors are accounted for by isolating two variances for materials—a price variance and a usage variance.

Accountants isolate these two materials variances for three reasons. First, different individuals may be responsible for each variance—a purchasing agent for the price variance and a production manager for the usage variance. Second, materials might not be purchased and used in the same period. The variance associated with the purchase should be isolated in the period of purchase, and the variance associated with usage should be isolated in the period of use. As a general rule, the sooner a variance can be isolated, the greater its value in cost control. Third, it is unlikely that a single materials variance—the difference between the standard cost and the actual cost of the materials used—would be of any real value to management for effective cost control. A single variance would not show management what caused the difference, or one variance might simply offset another and make the total difference appear to be immaterial.

Materials price variance In a manufacturing company, the purchasing and accounting departments usually set a standard price for materials meeting certain engineering specifications. They consider factors such as market conditions, vendors’ quoted prices, and the optimum size of a purchase order when setting a standard price. A materials price variance (MPV) occurs when a company pays a higher or lower price than the standard price set for materials. Materials price variance is the difference between actual price paid (AP) and standard price allowed (SP) multiplied by the actual quantity of materials purchased (AQ). In equation form, the materials price variance can be done in two ways:

Materials price variance = (Actual price – Standard price) x Actual quantity purchased

OR

Materials price variance = (Actual price x Actual quantity purchased) – (Standard price x Actual quantity purchased)

To illustrate, assume that a new supplier entered the market enabling Beta Company to purchase 60,000 sheets of material at a price of $ 5.90 each. Since the standard price set by management is $ 6 per sheet, the materials price variance is computed as:

Materials price variance= (Actual price – Standard price) x Actual quantity purchased

= ($5.90 – $6.00) x 60,000 sheets of material

= (-0.10) x 60,000 sheets = -6,000 which means $6,000 favorable

OR

Materials price variance = (Actual price x Actual quantity purchased) – (Standard price x Actual quantity purchased)

= ($5.90 x 60,000)  – ($6.00 x 60,000 sheets of material)

= $345,000 – $360,000 =  -6,000  which means $6,000 favorable

The materials price variance of $ 6,000 is considered favorable since the materials were acquired for a price less than the standard price. If the actual price had exceeded the standard price, the variance would be unfavorable because the costs incurred would have exceeded the standard price.   We do not show variances with a negative or positive but at the absolute value with favorable or unfavorable specified. 

Materials usage variance Because the standard quantity of materials used in making a product is largely a matter of physical requirements or product specifications, usually the engineering department sets it. But if the quality of materials used varies with price, the accounting and purchasing departments may perform special studies to find the right quality.

The materials usage variance occurs when more or less than the standard amount of materials is used to produce a product or complete a process. The variance shows only differences from the standard quantity caused by the quantity of materials used; it does not include any effect of variances in price. Thus, the materials usage variance  is :

Materials usage variance = (Actual qty – Standard qty allowed) x Standard price

OR

Materials price variance = (Actual Qty x Standard price) – (Standard Qty x Standard price)

To illustrate, assume that Beta Company used 55,500 sheets of material to produce 11,000 units of a product for which the standard quantity allowed is 55,000 sheets (5 sheets per unit allowed x 11,000 units actually produced). Since the standard price of the material is $ 6 per sheet, the materials usage variance of $ 3,000 would be computed as follows:

Materials usage variance = (Actual qty – Standard qty allowed) x Standard price

= (55,500 actual sheets – 55,000 allowed sheets) x $6 per sheet

= 500 sheets x $6 per sheet

= $ 3,000 which means $3,000 unfavorable variance

OR

Materials price variance = (Actual Qty x Standard price) – (Standard Qty x Standard price)

= (55,500 actual sheets x $6) – (55,000 allowed sheets x $6 per sheet)

= $333,000 – 330,000

= $ 3,000 which means $3,000 unfavorable variance

The variance is unfavorable because more materials were used than the standard quantity allowed to complete the job. If the standard quantity allowed had exceeded the quantity actually used, the materials usage variance would have been favorable.

Determine whether a variance is favorable or unfavorable by reliance on reason or logic. If more materials were used than the standard quantity, or if a price greater than the standard price was paid, the variance is unfavorable. If the reverse is true, the variance is favorable.

The standard labor cost of any product is equal to the standard quantity of labor time allowed multiplied by the wage rate that should be paid for this time. Here again, it follows that the actual labor cost may differ from standard labor cost because of the wages paid for labor, the quantity of labor used, or both. Thus, two labor variances exist—a rate variance and an efficiency variance.

Labor rate variance The labor rate variance occurs when the average rate of pay is higher or lower than the standard cost to produce a product or complete a process. The labor rate variance is similar to the materials price variance.

To compute the labor rate variance, we use the actual direct labor-hour rate paid (AR),  the standard direct labor-hour rate allowed (SR) and the actual hours of direct labor services worked (AH).  It can also be calculated in either of the following ways:

Labor rate variance= (Actual rate – Standard rate) x Actual hours worked

OR

Labor rate variance = (Actual rate x actual hours worked) – (Standard rate x actual hours worked)

To continue the Beta example, assume that the direct labor payroll of the company consisted of 22,200 hours at a total cost of $ 233,100 (an average actual hourly rate of  $ 10.50). Because management has set a standard direct labor-hour rate of $ 10 per hour, the labor rate variance is:

Labor rate variance = (Actual rate – Standard rate) x Actual hours worked

= ($10.50 actual rate – $10 per hour standard) x 22,200 actual hours

= $ 0.50 x 22,200

= $ 11,100 or $11,100 unfavorable variance

OR

Labor rate variance = (Actual rate x actual hours worked) – (Standard rate x actual hours worked)

= ($10.50 actual rate x 22,200 hours) – ($10 per hour standard x 22,200 actual hours)

= $ 233,100 – $ 222,000

= $ 11,100 or $11,100 unfavorable variance

The variance is positive and unfavorable because the actual rate paid exceeded the standard rate allowed. If the reverse were true, the variance would be favorable.

Labor efficiency variance Usually, the company’s engineering department sets the standard amount of direct labor-hours needed to complete a product. Engineers may base the direct labor-hours standard on time and motion studies or on bargaining with the employees’ union. The labor efficiency variance occurs when employees use more or less than the standard amount of direct labor-hours to produce a product or complete a process. The labor efficiency variance is similar to the materials usage variance.

To compute the labor efficiency variance, we will use the actual direct labor-hours worked (AH), the standard direct labor-hours allowed (SH), and the standard direct labor-hour rate per hour (SR) in either of the following ways:

Labor efficiency variance= (Actual DL hours – Standard DL hours) x Standard DL rate per hour

OR

Labor efficiency variance = (Actual DL hours x Std Rate) – (Std DL hours x Std Rate)

To illustrate, assume that the 22,200 hours of direct labor-hours worked by Beta Company employees resulted in 11,000 units of production. Assume these units have a standard direct labor-hours of 22,000 hours (11,000 units at 2 hour unit). Since the standard direct labor rate is $ 10 per hour, the labor efficiency variance is $ 2,000, computed as follows:

Labor efficiency variance= (Actual hours worked – Standard hours allowed) x Standard rate

= (22,200 actual DL hours x 22,000 standard DL hours) x $10 per hour

= 200 hours x $10

= $ 2,000 unfavorable variance

OR

Labor efficiency variance=  (Actual DL hours x Std Rate) – (Std DL hours x Std Rate)

= (22,200 actual DL hours x $10 per hour) – x (22,000 standard DL hours x $10 per hour)

= $222,000 – 220,000

= $ 2,000 unfavorable variance

The variance is unfavorable since more hours than the standard number of hours were required to complete the period’s production. If the reverse were true, the variance would be favorable.

The unfavorable labor rate variance is not necessarily caused by paying employees more wages than they are entitled to receive. More probable reasons are either that more highly skilled employees with higher wage rates worked on production than originally anticipated, or that employee wage rates increased after the standard was developed and the standard was not revised. Favorable rate variances, on the other hand, could be caused by using less-skilled, cheaper labor in the production process. Typically, the hours of labor employed are more likely to be under management’s control than the rates that are paid. For this reason, labor efficiency variances are generally watched more closely than labor rate variances.

Summary of labor variances The accuracy of the two labor variances can be checked by comparing their sum with the difference between actual and standard labor cost for a period. In the Beta Company illustration, this difference was:

This $13,100 unfavorable variance is made up of two labor variances:

Since both the rate and efficiency variances are unfavorable, we would add them together to get the TOTAL labor variance.  If we had one favorable and one unfavorable variance, we would subtract the numbers.

Still unsure about material and labor variances, watch this Note Pirate video to help.