Variance Analysis

CIMA-BA2 · Chapter 9

Variance Analysis

Standard costing sets a planned (standard) cost for each unit, a standard selling price and a budgeted volume. At the end of each period the actual results are compared with a budget flexed to the actual activity, and each total variance is analysed into its causes – price and usage for materials; rate, idle time and efficiency for labour; expenditure and efficiency for variable overheads; expenditure for fixed overheads; and price and volume for sales.

The variances are then set out in an operating statement that reconciles the budgeted profit with the actual profit in a marginal costing format, and are investigated to find out why they arose.

1 Introduction

In the previous chapter we prepared a flexed budget and calculated the total variances. In this chapter we are going to analyse these variances in order to provide more useful information.

The analysis in this chapter uses marginal costing: units and inventory are valued at standard variable cost, the sales volume variance is valued at standard contribution, and the only fixed overhead variance is the fixed overhead expenditure variance.

Standard costs, prices and volumes

A standard cost is the planned cost of one unit, built up from the standard quantity of each input (kg of material, hours of labour) and the standard price of that input. The standards for one unit are set out on a standard cost card – Example 1 below has one: 4 kg of material at $4.50 per kg = $18, and so on. Together with a standard selling price and budgeted sales and production volumes, the standards are useful because:

Planning – the budget is built from them: budgeted volumes × standard costs and prices.
Control – the actual results can be compared with what the actual output should have cost, and the differences (variances) analysed so that each manager can be asked about the part they control. Management can concentrate on the significant variances.
Responsibility and motivation – the standards give each manager a target: the buyer the price per kg, the production manager the kg and hours per unit, the sales manager the selling price and volume.
Inventory valuation – inventory can be valued at standard cost every month, rather than at a cost that changes as actual prices move up and down.
Pricing and decisions – the standard cost per unit gives a reliable basis for setting prices and making decisions (chapter 7).

2 Total variances

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A company has prepared the following standard cost card:

	$ per unit
Materials (4 kg at $4.50 per kg)	18
Labour (5 hrs at $5 per hr)	25
Variable overheads (5 hrs at $2 per hr)	10
Standard variable cost	53

Fixed overheads have been budgeted at $130,500.

Budgeted selling price $75 per unit.

Budgeted production	8,700 units
Budgeted sales	8,000 units

There is no opening inventory.

The actual results are as follows:

Sales	8,400 units for $613,200
Production	8,900 units with the following costs:

	$
Materials (35,464 kg)	163,455
Labour (paid 45,400 hrs; worked 44,100 hrs)	224,515
Variable overheads	87,348
Fixed overheads	134,074

Prepare a flexed budget and calculate the total variances.

	Original fixed budget	Flexed budget	Actual	Variances
	$	$	$	$
Sales (units)	8,000	8,400	8,400
Production (units)	8,700	8,900	8,900
Sales	600,000	630,000	613,200	16,800 A
Materials	156,600	160,200	163,455	3,255 A
Labour	217,500	222,500	224,515	2,015 A
Variable overheads	87,000	89,000	87,348	1,652 F
	461,100	471,700	475,318
Closing inventory (at $53)	(37,100)	(26,500)	(26,500)
Variable cost of sales	424,000	445,200	448,818
Contribution	176,000	184,800	164,382
Fixed overheads	(130,500)	(130,500)	(134,074)	3,574 A
Profit	45,500	54,300	30,308	23,992 A

Fixed budget: production 8,700 × $18 = $156,600, × $25 = $217,500, × $10 = $87,000; closing inventory 700 units × $53 = $37,100. Flexed budget: sales 8,400 × $75; production 8,900 × the standard costs; closing inventory 500 units × $53 = $26,500. Fixed overheads are not flexed.

Contribution can be checked directly: 8,000 × $22 = $176,000 and 8,400 × $22 = $184,800, where $22 = $75 − $53 is the standard contribution per unit.

Closing inventory is valued at the standard cost of $53 in the actual column too. For variance analysis inventory is always valued at standard cost, so that its value does not change from month to month with actual prices.

The variances against the flexed budget explain $23,992 of the difference between the flexed profit ($54,300) and the actual profit ($30,308). The rest of the difference from the original budget, $54,300 − $45,500 = $8,800, is due to selling 400 more units than budgeted.

3 Analysis of cost variances

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The total variance that we have calculated for materials indicates that the actual expenditure on materials was not $18 per unit. However, this could be either because we used the wrong amount of materials (which should have been 4 kg per unit) or that we paid the wrong price (which should have been $4.50 per kg). More likely of course, it would be a combination of the two.

We will therefore analyse this and the other variances in as much detail as possible.

Different managers are usually responsible for the different parts of a variance – the buyer for the price paid per kg, the production manager for the kg used per unit – which is why each total variance is split.

Using the data from Example 1, analyse each of the cost variances.

(a) Materials

(b) Labour

(a) Materials

Materials price (expenditure) variance	$
35,464 kg purchased at actual cost	163,455
35,464 kg at standard cost ($4.50)	159,588
Price variance	3,867 A

Materials usage variance	kg
Actual usage	35,464
Standard usage for actual production (8,900 units × 4 kg)	35,600
Difference	136
Usage variance (136 kg × standard cost $4.50)	$612 F

Check: $3,867 A − $612 F = $3,255 A, the total materials variance in Example 1.

(b) Labour

Labour rate of pay variance	$
45,400 hours paid at actual cost	224,515
45,400 hours paid at standard cost ($5)	227,000
Rate of pay variance	2,485 F

Labour idle time variance	Hours
Actual hours paid	45,400
Actual hours worked	44,100
Idle hours	1,300
Idle time variance (1,300 hrs × standard cost $5)	$6,500 A

Labour efficiency variance	Hours
Actual hours worked	44,100
Standard hours for actual production (8,900 units × 5 hrs)	44,500
Hours saved	400
Efficiency variance (400 hrs × standard cost $5)	$2,000 F

Check: $2,485 F − $6,500 A + $2,000 F = $2,015 A, the total labour variance.

(c) Variable overheads

Variable overhead expenditure variance	$
44,100 hours worked at actual cost	87,348
44,100 hours worked at standard cost ($2)	88,200
Expenditure variance	852 F

Variable overhead efficiency variance	Hours
Actual hours worked	44,100
Standard hours for actual production (8,900 units × 5 hrs)	44,500
Hours saved	400
Efficiency variance (400 hrs × standard cost $2)	$800 F

Variable overheads are assumed to be incurred only in the hours actually worked, so both variable overhead variances use the 44,100 hours worked, not the 45,400 hours paid. The efficiency variance is the same 400 hours as for labour, valued at the variable overhead rate. Check: $852 F + $800 F = $1,652 F.

The calculations follow the same pattern each time – actual quantity at actual price, compared with actual quantity at standard price, compared with the standard quantity for the actual production at standard price:

Variance	Calculation
Materials price (expenditure)	Actual kg purchased × actual price, compared with actual kg purchased × standard price
Materials usage	(Actual kg used − standard kg for actual production) × standard price
Labour rate of pay	Actual hours paid × actual rate, compared with actual hours paid × standard rate
Labour idle time	(Hours paid − hours worked) × standard rate – always adverse
Labour efficiency	(Hours worked − standard hours for actual production) × standard rate
Variable overhead expenditure	Hours worked × actual rate, compared with hours worked × standard rate
Variable overhead efficiency	(Hours worked − standard hours for actual production) × standard variable overhead rate
Fixed overhead expenditure	Actual fixed overheads compared with budgeted fixed overheads

A variance is favourable (F) when it increases profit compared with standard – paying less, using less, working faster – and adverse (A) when it reduces profit.

4 Sales variances

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Although we have already calculated the sales variances in Example 1, you may be asked to calculate them independently.

Using data from Example 1, calculate the sales price variance and the sales volume variance.

Sales price variance	$
Actual sales at actual selling price	613,200
Actual sales at standard selling price (8,400 units × $75)	630,000
Sales price variance	16,800 A

Sales volume variance	Units
Actual sales	8,400
Budgeted sales	8,000
Extra units sold	400
Sales volume variance (400 units × standard contribution $22)	$8,800 F

The sales volume variance is valued at the standard contribution per unit ($75 − $53 = $22) because under marginal costing each extra unit sold should add its standard contribution to profit. It equals the difference between the flexed budget profit and the original budget profit: $54,300 − $45,500 = $8,800.

Variance	Calculation
Sales price	(Actual selling price − standard selling price) × actual units sold
Sales volume	(Actual units sold − budgeted units sold) × standard contribution per unit

5 The operating statement

The operating statement is a statement that reconciles the actual profit with the budgeted profit.

It always starts with the original budgeted profit, adds the favourable variances and deducts the adverse ones, and ends with the actual profit.

Using the previously calculated variances, prepare an operating statement for the company.

Operating statement (marginal costing)

	F $	A $	$
Budgeted profit			45,500
Sales volume variance			8,800 F
Sales price variance			16,800 A
			37,500
Materials price variance		3,867
Materials usage variance	612
Labour rate of pay variance	2,485
Labour idle time variance		6,500
Labour efficiency variance	2,000
Variable overhead expenditure variance	852
Variable overhead efficiency variance	800
Fixed overhead expenditure variance		3,574
Total cost variances	6,749	13,941	7,192 A
Actual profit			30,308

The fixed overhead expenditure variance is simply actual fixed overheads $134,074 − budgeted $130,500 = $3,574 A. The statement explains to management why they made $30,308 when they expected $45,500.

6 The interpretation of variances

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Calculating the variances is only the start. Management will want to know why each one arose – usually month by month – so that a problem can be corrected before it happens again. Each significant variance is discussed with the manager responsible; favourable variances are investigated too, to find out whether the saving will continue.

Variance	Possible reasons
Materials price	Supplier price rise or inflation; exchange rate changes on imports; poor buying (wrong supplier, discounts missed); better-quality material bought; standard set wrongly
Materials usage	Quality of material; wastage, spoilage or theft; skill of the workers; condition of the machines
Labour rate of pay	Pay rise not in the standard; overtime premiums; a different grade of worker used
Labour idle time	Machine breakdowns; shortage of materials; lack of orders; bottlenecks in production
Labour efficiency	Skill, training and motivation of the workers; quality of material; condition of the machines
Variable overhead expenditure	Price changes for items such as power and consumables
Sales price	Price cut to win more sales or meet competitors; discounts given; market conditions
Sales volume	Change in selling price; changes in demand; competitors’ actions; quality of the product

Interrelationships. Variances should not be judged one at a time as simply good or bad, because one cause can produce several variances. Buying better material may give an adverse price variance but a favourable usage variance (less waste) and a favourable efficiency variance (faster working). Cutting the selling price gives an adverse sales price variance but may give a favourable sales volume variance. Using cheaper, less skilled labour may give a favourable rate of pay variance but adverse efficiency and usage variances. Where variances are linked, look at them together.

In the previous example there was a materials price variance.

Suggest possible reasons for its occurrence.

The adverse materials price variance of $3,867 means that more than the standard $4.50 was paid for each kg. (It is not about using too much material – that is measured separately by the usage variance.) Possible reasons:

A price increase by the supplier since the standard was set (or a change in exchange rates if the material is imported). This is outside the buyer’s control.
Poor buying – the material could still have been bought for $4.50, but the buyer used the wrong supplier or failed to obtain the discounts allowed for in the standard. This can be corrected for the future.
A wrong standard – the $4.50 was a mistake when the budget was set; the standard should be revised.
Better-quality material bought deliberately. Then look at the linked variances: there is a favourable usage variance ($612 – less waste), and favourable labour and variable overhead efficiency variances ($2,000 and $800 – faster working). But the sales price variance is adverse, so it does not look as though a better product allowed a higher price.

If better material was the reason, the $3,867 extra cost should be judged together with the savings it produced: here even $612 + $2,000 + $800 = $3,412 does not cover it, so on these figures the better material would not have paid for itself.

7 Test your knowledge

Two quick checks before you move on: work through the flashcards to fix this chapter’s terms and definitions, then sit the objective questions for exam-style practice. Both mark themselves and explain the answers as you go.

Answer the questions one at a time. Your progress is saved so you can leave and come back.

Open chapter practice