What you will learn to do: identify direct cost standards and variances

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. However, do not automatically equate favorable and unfavorable variances with good and bad. You must base such an appraisal on the causes of the variance. For instance, a favorable raw materials cost variance may indicate that a purchasing manager, under pressure to meet financial goals, is buying inferior (cheap) goods.

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.

For instance, if prices are going up, but the workforce is being more efficient and therefore using fewer materials per item, an unfavorable price variance may be obscured by a favorable quantity variance.

Under a standard cost system, managers establish expectations for each of the three major categories of inputs:

• Direct labor
• Direct materials
• Manufacturing overhead

Each input has a cost standard and an efficiency standard

Cost standard – for example, management expects to pay no more than $5 per board feet of lumber (raw materials)

Efficiency standard – for example, management expects employees to use no more than two board feet of alder to make one blank

Therefore, each input has two variances (deviations from the standard):

• A cost variance (cost was higher or lower)
• An efficiency variance (amount used was higher or lower)

A cost variance measures how well the business is keeping the costs of materials and labor within the set standards.

An efficiency variance measures how well the business is using materials and human resources—in other words, the efficiency variance tracks the efficiency of the conversion process.

Here are the variances, summarized:

Direct materials

• Direct Materials cost variance
  • For instance, if materials costs are higher than expected, the direct material cost variance will be unfavorable.
• Direct Materials efficiency variance
  • For instance, if it is taking more raw materials to assemble a product than expected, the direct material efficiency variance will be unfavorable.

Direct labor

• Direct Labor cost variance
  • For instance, if labor costs are higher than expected, the direct labor cost variance will be unfavorable.
• Direct Labor efficiency variance
  • For instance, if it is taking longer to assemble a product than expected, the direct labor efficiency variance will be unfavorable.

Manufacturing overhead

Manufacturing overhead can be subdivided into variable overhead costs and fixed overhead costs, and so the variances are:

• Variable Manufacturing Overhead Cost Variance
• Variable Manufacturing Overhead Efficiency Variance
• Fixed Manufacturing Overhead Cost Variance
• Fixed Manufacturing Overhead Volume Variance

The manufacturing overhead (indirect cost) variances will be discussed in the next section. In this section, we’ll focus on the direct materials and direct labor variances.

When you are done with this section, you will be able to:

• Compute the direct materials cost variance
• Compute the direct materials efficiency variance
• Compute the direct labor cost variance
• Compute the direct labor efficiency variance

Learning Activities

The learning activities for this section include the following:

• Reading: Direct Materials Cost Variance
• Self Check: Direct Materials Cost Variance
• Reading: Direct Materials Efficiency Variance
• Self Check: Direct Materials Efficiency Variance
• Reading: Direct Labor Cost Variance
• Self Check: Direct Labor Cost Variance
• Reading: Direct Labor Efficiency Variance
• Self Check: Direct Labor Efficiency Variance