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Eldenburg & Wolcott’s Cost Management, 2e Slide # 1

Cost Management Measuring, Monitoring, and Motivating Performance

Chapter 11 Standard Costs and Variance Analysis

Eldenburg & Wolcott’s Cost Management, 2e Slide # 2

Chapter 11: Standard Costs & Variance Analysis

Learning objectives • Q1: How does variance analysis contribute to the strategic

management process? • Q2: What is a standard costing system and how is it used?

• Q3: How are direct cost variances calculated?

• Q4: How is direct cost variance information analyzed and used?

• Q5: How are variable and fixed overhead variances calculated?

• Q6: How is overhead variance information analyzed and used?

• Q7: How are manufacturing cost variances closed?

• Q8: Which profit-related variances are commonly analyzed?

Eldenburg & Wolcott’s Cost Management, 2e Slide # 3

Q2: Standard Costs

• Organizations set standards to help plan operations.

• A standard cost is the expected cost of providing a good or service.

• In manufacturing, the standard cost of a unit of output is comprised of: • the standard price (SP) of the input, and • the standard quantity of the input expected

to be consumed in the production of one output unit.

Eldenburg & Wolcott’s Cost Management, 2e Slide # 4

Q2: Standard Costs

Eldenburg & Wolcott’s Cost Management, 2e Slide # 5

Q2: Establishing & Using Standard Costs

• Standards can be set using: • Information from the prior year • Engineered estimates • New information available

• Standards can be used for: • Planning future operations • Monitoring current operations • Motivating manager and employee behavior • Evaluating performance

Advantages • Information can be used

to quickly estimate job or project costs

• Monitor resources to measure efficiency

• Communicates targets (goals) to employeess

• Provides information to analyze operations

Disadvantages • May reduce employee

motivation if the standards are too high or low

• Time involved in setting standards and analyzing variances

• Incorrect standards could result in inappropriate employee rewards or penalties

Eldenburg & Wolcott’s Cost Management, 2e Slide # 6

Q2: Standard Costing Systems

Eldenburg & Wolcott’s Cost Management, 2e Slide # 7

Q1: Variance Analysis

• The difference between an actual cost and the standard cost of producing goods or services at the actual volume level is called a standard cost variance.

• Managers investigate the reasons for standard cost variances so that: • efficiencies can be rewarded and replicated, • inefficiencies can be minimized, and • the validity of the standards can be assessed.

Eldenburg & Wolcott’s Cost Management, 2e Slide # 8

Q1: Variance Analysis in Diagnostic Control System • Investigating Variances

– Must decide what amount of variance needs to be investigated (% of budget, given $ amount)

– Trends in variances should also be considered – Separating variances into component parts improves

analysis • Conclusions and Actions

– After determining reasons for variances, managers need to draw conclusions about what happened

– Determine if corrective action is required – Must consider behavioral implications and employee

incentives to ensure standards are promoting overall success

Eldenburg & Wolcott’s Cost Management, 2e Slide # 9

Q3: Direct Cost Variances

• A price variance is the difference between the standard cost of resources purchased (or that should have been consumed) and the actual cost.

• An efficiency variance measures whether inputs were used efficiently. • It is the difference between the inputs used

and the inputs that should have been used, times the standard price of the input

Eldenburg & Wolcott’s Cost Management, 2e Slide # 10

Q3: Direct Cost Variances

Eldenburg & Wolcott’s Cost Management, 2e Slide # 11

Q3: Direct Labor Cost Variances

• The direct labor price and efficiency variances are a decomposition of the direct labor flexible budget variance.

• The year-end flexible budget direct labor cost is based on the standard direct labor hours for the actual output, or standard quantity allowed (SQA).

• Other abbreviations used: • SP = standard price of the input • AP = actual price of the input • AQ = actual quantity of the input used

Eldenburg & Wolcott’s Cost Management, 2e Slide # 12

Q3: Direct Labor Cost Variances

The direct labor price and efficiency variances are a decomposition of the direct labor flexible budget variance.

SQA x SP

Year-end flexible budget

Year-end actual results

AQ x APAQ x SP

DL flexible budget variance

DL price varianceDL efficiency variance

DLPV = [SP – AP] x AQDLEV = [SQA – AQ] x SP

Eldenburg & Wolcott’s Cost Management, 2e Slide # 13

Matthews Manufacturing makes a product that is expected to use ¼ hour of direct labor to produce. At the beginning of the year Matthews expected to produce 10,000 units. Actual production, however, was 9,800 units. The standard price of direct labor is $10/hour. Actual direct labor costs were $24,696 for the 2,520 labor hours used. Compute the direct labor cost variances.

Q3: Direct Labor Cost Variances Example

First compute SQA for direct labor:

SQA = 9,800 units x ¼ hour/unit = 2,450 hours

DLPV = [SP – AP] x AQ = [$10/hour - $9.80/hour] x 2,520 hours = $504F

Then compute AP for direct labor: AP = $24,696/2,520 hours = $9.80/hour

DLEV = [SQA – AQ] x SP = [2,450 hours - 2,520 hours] x $10/hour = $700U

Note that the DL FBV = $504F + $700U = $196U

Eldenburg & Wolcott’s Cost Management, 2e Slide # 14

What are some possible explanations for the direct labor cost variances of Matthews Manufacturing?

Q4: Direct Labor Cost Variances Example

• The favorable price variance could be due to:

• an incorrect standard price,

• using a higher percentage of lower-paid workers than expected, or

• a favorable renegotiation of a labor contract.

• The unfavorable efficiency variance could be due to:

• an incorrect standard quantity for labor,

• inefficiency of direct labor personnel,

• unexpected problems with machinery, or

• lower quality of inputs that were more difficult to use.

Eldenburg & Wolcott’s Cost Management, 2e Slide # 15

Q3: Direct Material Cost Variances

• The direct materials and direct labor efficiency variances are computed in the same fashion.

• The direct material price variance is computed slightly differently than the direct labor price variance.

• Direct materials can be purchased and stored, and direct labor is consumed as it is purchased.

• The direct materials price and efficiency variances do not sum to the direct material flexible budget variance when there are any direct materials inventories.

Eldenburg & Wolcott’s Cost Management, 2e Slide # 16

Q3: Direct Material Cost Variances

The direct material price variance is based on the actual quantity of direct materials purchased, not the actual quantity of direct materials used.

SQA x SP

Year-end flexible budget

AQ x SP

DM price variance

DM efficiency variance

DMPV = [SP – AP] x Actual Quantity Purchased

DMEV = [SQA – AQ] x SP

Actual Quantity Purchased x SP

Actual Quantity Purchased x AP

Remember that AQ=Actual quantity

used, not actual quantity purchased.

Eldenburg & Wolcott’s Cost Management, 2e Slide # 17

Matthews Manufacturing makes a product that is expected to use 2 pounds of direct material to produce. At the beginning of the year Matthews expected to produce 10,000 units. Actual production, however, was 9,800 units. The standard price of direct materials is $3/pound. Matthews purchased 20,500 pounds of direct material at $3.10/pound, and used 19,400 pounds. Compute the direct material cost variances.

Q3: Direct Material Cost Variances Example

First compute SQA for direct materials:

SQA = 9,800 units x 2 pounds/unit = 19,600 pounds

DMPV = [SP – AP] x Actual Quantity Purchased =

[$3/pound - $3.10/pound] x 20,500 pounds = $2,050U

DMEV = [SQA – AQ] x SP =

[19,600 pounds - 19,400 pounds] x $3/pound = $600F

Eldenburg & Wolcott’s Cost Management, 2e Slide # 18

What are some possible explanations for the direct material cost variances of Matthews Manufacturing?

Q4: Direct Material Cost Variances Example

• The unfavorable price variance could be due to:

• an incorrect standard price,

• an unexpected price increase from a supplier, or

• the purchase of higher quality materials.

• The favorable efficiency variance could be due to:

• an incorrect standard quantity for material,

• efficient use of direct materials during production, or

• less waste of direct materials due to higher material quality.

Eldenburg & Wolcott’s Cost Management, 2e Slide # 19

• The direct material price variance is recorded when the materials are purchased.

• The direct material efficiency variance is recorded when the materials are used in production.

• The direct labor price and efficiency variances are recorded when labor is used in production.

• Work in process inventory is debited for the standard cost of the inputs that should have been used to produce the actual quantity of outputs (SP x SQA).

Q3: Recording Direct Cost Variances

Eldenburg & Wolcott’s Cost Management, 2e Slide # 20

The journal entry to record the use of direct labor is:

Q3: Recording Direct Labor Cost Variances

dr. Work in process inventory SP x SQA dr. or cr. DLEV [SQA-AQ] x SP dr. or cr. DLPV [SP-AP] x AQ

cr. Accrued payroll AP x AQ

Unfavorable variances are debited to the variance accounts and favorable variances

are credited to the variance accounts.

Eldenburg & Wolcott’s Cost Management, 2e Slide # 21

Prepare a summary journal entry to record the direct labor costs for Matthews Manufacturing, including the direct labor cost variances. Refer to slide #8.

Q3: Recording Direct Labor Cost Variances Example

dr. Work in process inventory 24,500 [2,450 hrs x $10/hr]

dr. DLEV 700 [(2,450 hrs – 2,520 hrs) x $10/hr]

cr. DLPV 504 [($10/hr - $9.80/hr) x 2,520 hrs]

cr. Accrued payroll 24,696 [given]

Eldenburg & Wolcott’s Cost Management, 2e Slide # 22

The journal entry to record the purchase of direct materials is:

Q3: Recording Direct Material Cost Variances

dr. Raw materials inventory SP x Actual Qty Purch’d dr. or cr. DMPV [SP–AP] x Actual Qty Purch’d

cr. Accounts payable AP x Actual Qty Purch’d

The journal entry to record the use of direct materials is:

dr. Work in process inventory SP x SQA dr. or cr. DMEV [SQA-AQ] x SP

cr. Raw materials inventory SP x AQ

Eldenburg & Wolcott’s Cost Management, 2e Slide # 23

The journal entry to record the purchase of direct materials is:

Q3: Recording Direct Material Cost Variances Example

dr. Raw materials inventory [$3/lb x 20,500 lbs] 61,500 dr. DMPV [($3/lb –$3.10/lb) x 20,500 lbs] 2,050

cr. Accounts payable [$3.10/lb x 20,500 lbs] 63,550

The journal entry to record the use of direct materials is:

dr. Work in process inventory [$3/lb X 19,600 lbs] 58,800 cr. DMEV [(19,600 lbs – 19,400 lbs) x $3/lb] 600 cr. Raw materials inventory [19,400 lbs x $3/lb] 58,200

Prepare summary journal entries to record the purchase and the use of direct material for Matthews Manufacturing, including the direct material cost variances. Refer to slide #12.

Eldenburg & Wolcott’s Cost Management, 2e Slide # 24

Q5: Allocating Overhead Costs

• Chapter 5 covered the allocation of overhead to units of production.

• Estimated overhead rates are calculated for both fixed and variable overhead.

Standard variable

overhead allocation rate

Estimated variable overhead costs Estimated volume of an overhead allocation base=

Standard fixed overhead

allocation rate Estimated fixed overhead costs

Estimated volume of an overhead allocation base=

Eldenburg & Wolcott’s Cost Management, 2e Slide # 25

Q5: Overhead Cost Management

• For both variable and fixed overhead, cost management includes reducing non-value-added costs.

• For each variable overhead cost pool, cost management includes reducing the consumption of the related cost allocation base.

• For fixed overhead, cost management involves a trade-off between insufficient and excess capacity.

Eldenburg & Wolcott’s Cost Management, 2e Slide # 26

Q5: Overhead Cost Variances

Eldenburg & Wolcott’s Cost Management, 2e Slide # 27

Q5: Variable Overhead Cost Variances

• The variable overhead cost variances are computed in the same fashion as the direct labor cost variances.

• The variable overhead spending variance is similar to the direct labor price variance.

• The variable overhead efficiency variance is similar to the direct labor efficiency variance.

• The variable overhead (flexible) budget variance is the sum of these two variable overhead variances.

Eldenburg & Wolcott’s Cost Management, 2e Slide # 28

Q5: Variable Overhead Cost Variances

The standard quantity allowed (SQA) in the variable overhead cost variance calculations is the quantity of the variable overhead allocation base that should have been used to produce the actual output. SR is the standard variable overhead allocation rate.

SQA x SR

Year-end flexible budget

Year-end actual results

Total actual VOAQ x SR

VO flexible budget variance

VO spending varianceVO efficiency variance

VOSV = [AQ x SR] – actual VOVOEV = [SQA – AQ] x SR

Eldenburg & Wolcott’s Cost Management, 2e Slide # 29

Matthews Manufacturing makes a product that is expected to use ¼ hour of direct labor to produce. At the beginning of the year Matthews expected to produce 10,000 units. Actual production, however, was 9,800 units. The estimated variable overhead allocation rate is $4 per direct labor hour, actual variable overhead costs were $10,450, and actual direct labor hours were 2,520. Compute the variable overhead cost variances.

Q5: Variable Overhead Cost Variances Example

First compute SQA for direct labor, the VO cost allocation base:

SQA = 9,800 units x ¼ hour/unit = 2,450 hours

VOSV = AQ x SR – actual VO = 2,520 hrs x $4/hr - $10,450 = $370U

VOEV = [SQA – AQ] x SR = [2,450 hours - 2,520 hours] x $4/hour = $280U

Note that the VO FBV = $280U + $370U = $650U

Eldenburg & Wolcott’s Cost Management, 2e Slide # 30

What are some possible explanations for the variable overhead cost variances of Matthews Manufacturing?

Q6: Variable Overhead Cost Variances Example

• The favorable spending variance could be due to:

• an incorrect standard variable overhead rate per direct labor hour,

• lower prices than expected for the components of the variable overhead cost pool (e.g. a lower price per quart of machine oil), or

• lower consumption than expected of the components of the variable overhead cost pool (e.g. less indirect labor used per direct labor hour).

• The unfavorable efficiency variance could be due to:

• an incorrect standard quantity for labor,

• inefficiency of direct labor personnel,

• unexpected problems with machinery, or

• lower quality of inputs that were more difficult to use.

Eldenburg & Wolcott’s Cost Management, 2e Slide # 31

The summary entry to record the incurrence of variable overhead costs is:

Q5: Recording Variable Overhead Cost Variances

dr. Variable overhead cost control Actual VO costs cr. Various accounts Actual VO costs

The summary entry to record the allocation of variable overhead costs is:

dr. Work in process inventory SR x SQA cr. Variable overhead cost control SR x SQA

The year-end entry to close the Variable overhead cost control and record the variable overhead cost variances will:

• close the Variable overhead cost control account with a debit or credit, whichever is required, and

• debit (credit) the Variable overhead spending variance and Variable overhead efficiency variance accounts for unfavorable (favorable) variances.

Eldenburg & Wolcott’s Cost Management, 2e Slide # 32

The journal entry to record the incurrence of variable overhead costs is:

Q3: Recording Variable Overhead Cost Variances Example

dr. Variable overhead cost control 10,450 cr. Various accounts 10,450

The journal entry to record the allocation of variable overhead is:

dr. Work in process inventory [$4/hr X 2,450 hrs] 9,800 cr. Variable overhead cost control 9,800

Prepare summary journal entries to record the incurrence of and the allocation to work in process of variable overhead costs for Matthews Manufacturing. Also prepare the year-end entry to close variable overhead control and record the variances. Refer to slide #22.

The year-end entry to close the Variable overhead cost control account is:

dr. VOSV 280 dr. VOEV 370

cr. Variable overhead cost control 650

Eldenburg & Wolcott’s Cost Management, 2e Slide # 33

Q5: Fixed Overhead Cost Variances

• The fixed overhead spending variance is the same as the fixed overhead (flexible) budget variance.

• There is no fixed overhead efficiency variance because changes in the quantity of the fixed overhead allocation base do not cause changes in actual total fixed overhead costs.

• The production volume variance occurs when actual volume is different than the static budget estimated volume.

Eldenburg & Wolcott’s Cost Management, 2e Slide # 34

Q5: The Production Volume Variance

• Allocating fixed overhead to production using a standard rate per unit of a cost allocation base treats fixed overhead as a variable cost for bookkeeping purposes.

• Since fixed overhead is not a variable cost, the fixed overhead allocated to production will differ from budgeted fixed overhead when actual volume differs from static budget estimated volume.

• The production volume variance is favorable (unfavorable) when actual volume exceeds (is less than) static budget estimated volume.

Eldenburg & Wolcott’s Cost Management, 2e Slide # 35

Q5: Fixed Overhead Cost Variances

The standard quantity allowed (SQA) in the fixed overhead cost variance calculations is the quantity of the fixed overhead allocation base that should have been used to produce the actual output. SR is the standard fixed overhead allocation rate.

Total FO budget variance

FO spending varianceFO production volume variance

FOPVV = [SQA x SR] – estimated FO

SQA x SR

Static & year- end budget

Year-end actual results

Total actual FOEstimated FO

Allocated fixed overhead

FOSV = Estimated FO – actual FO

Eldenburg & Wolcott’s Cost Management, 2e Slide # 36

Matthews Manufacturing makes a product that is expected to use 1.2 machine hours to produce. At the beginning of the year Matthews expected to produce 10,000 units. Actual production, however, was 9,800 units. Estimated fixed overhead at the beginning of the year was $60,000 and actual fixed overhead was $58,100. Actual machine hours for the year totaled 12,200 hours. Compute the fixed overhead cost variances.

Q5: Fixed Overhead Cost Variances Example

First compute SQA for machine hours:

SQA = 9,800 units x 1.2 hours/unit = 11,760 hours

FOSV = Estimated FO – actual FO = $60,000 - $58,100 = $1,900F

FOPVV = SQA x SR – estimated FO =

11,760 hours x $5/hr - $60,000 = $1,200U

Next compute the estimated fixed overhead rate per machine hour:

SR = $60,000/[10,000 units x 1.2 hrs/unit] = $5/hr

Eldenburg & Wolcott’s Cost Management, 2e Slide # 37

What are some possible explanations for the fixed overhead cost variances of Matthews Manufacturing?

Q6: Fixed Overhead Cost Variances Example

• The favorable spending variance could be due to:

• an incorrect estimate for fixed overhead costs,

• a decision to forgo a budgeted discretionary fixed cost, or

• a favorable renegotiation of leasing agreements.

• The unfavorable production volume variance is due to:

• an actual volume level that is less than the static budget volume level.

Eldenburg & Wolcott’s Cost Management, 2e Slide # 38

The summary entry to record the incurrence of fixed overhead costs is:

Q5: Recording Fixed Overhead Cost Variances

dr. Fixed overhead cost control Actual FO costs cr. Various accounts Actual FO costs

The summary entry to record the allocation of fixed overhead costs is:

dr. Work in process inventory SR x SQA cr. Fixed overhead cost control SR x SQA

The year-end entry to close the fixed overhead cost control and record the fixed overhead cost variances will:

• close the Fixed overhead cost control account with a debit or credit, whichever is required, and

• debit (credit) the fixed overhead production volume variance and fixed overhead spending variance accounts for unfavorable (favorable) variances.

Eldenburg & Wolcott’s Cost Management, 2e Slide # 39

The journal entry to record the incurrence of variable overhead costs is:

Q5: Recording Fixed Overhead Cost Variances Example

dr. Fixed overhead cost control 58,100 cr. Various accounts 58,100

The journal entry to record the allocation of fixed overhead is:

dr. Work in process inventory [$5/hr x 11,760 hrs] 58,800 cr. Fixed overhead cost control 58,800

Prepare summary journal entries to record the incurrence of and the allocation to work in process of fixed overhead costs for Matthews Manufacturing. Also prepare the year-end entry to close Fixed overhead control and record the variances. Refer to slide #29.

The year-end entry to close the fixed overhead cost control account is:

dr. Fixed overhead cost control 700 dr. Fixed overhead production volume variance 1,200

cr. Fixed overhead spending variance 1,900

Eldenburg & Wolcott’s Cost Management, 2e Slide # 40

• At the end of the year, all eight variance accounts are closed out to Work in process inventory, Finished goods inventory, and Cost of goods sold.

Q7: Closing Manufacturing Variances

• The net of the variance accounts is generally prorated to the three accounts using a ratio of the accounts’ ending balances.

• Technically, a portion of the direct materials price variance should also be allocated to Raw materials inventory, but this complication is ignored here.

Eldenburg & Wolcott’s Cost Management, 2e Slide # 41

• The revenue budget variance measures the difference between actual revenues and static budget revenues, and has two components:

Q8: Revenue Budget Variance

• The sales price variance is due to the difference between actual average selling price and the budgeted selling price per unit.

• The revenue sales quantity variance is due to the difference between the actual number and the budgeted number of units sold.

Eldenburg & Wolcott’s Cost Management, 2e Slide # 42

Q8: Revenue Budget Variance

ASP is the actual average selling price per unit; BSP is the budgeted selling price from the static budget.

Revenue budget variance

Revenue sales quantity varianceSales price variance

[ASP – BSP] x actual units sold

ASP x actual units sold

Static budget revenue

BSP x budgeted unit sales

BSP x actual units sold

Actual revenue

[Actual – budgeted units] x BSP

Eldenburg & Wolcott’s Cost Management, 2e Slide # 43

Matthews Manufacturing makes a product with a budgeted selling price of $15/unit. At the beginning of the year Matthews expected to sell 10,000 units. Actual sales, however, were 9,800 units, and actual revenue was $156,800. Compute the revenue budget variances.

Q7: Revenue Budget Variance Example

First compute the actual average selling price per unit:

ASP = $156,800/9,800 units = $16/unit

Note the revenue budget variance is $9,800F + $3,000U = $6,800F

Sales price variance = [$16/unit - $15/unit] x 9,800 units = $9,800F

Revenue sales quantity variance = [9,800 units – 10,000 units] x $15/unit = $3,000U

Eldenburg & Wolcott’s Cost Management, 2e Slide # 44

• The contribution margin budget variance measures the difference between actual contribution margin and the contribution margin budgeted at the beginning of the year. It has two components:

Q8: Contribution Margin Budget Variance

• The contribution margin variance is the difference between the actual contribution margin and the budgeted contribution margin in in the year-end flexible budget (which is based on actual sales levels).

• The contribution margin sales volume variance is difference budgeted contribution margin at the beginning of the year and the budgeted contribution margin in the year-end flexible budget.

Eldenburg & Wolcott’s Cost Management, 2e Slide # 45

• When a company sells more than one product, the contribution margin sales volume variance itself has two components:

Q8: Contribution Margin Sales Volume Variance

• The contribution margin sales mix variance is the portion of the contribution margin sales volume variance caused by a change in the sales mix from the budgeted mix.

• The contribution margin sales quantity variance is the portion of the contribution margin sales volume variance caused by the difference between budgeted total unit sales at the beginning of the year and actual total unit sales.

Eldenburg & Wolcott’s Cost Management, 2e Slide # 46

Q7: Profit-Related Variances Example

Matthews Manufacturing produces three products, Alpha, Beta, and Gamma. You are given the following information from Matthews’ static budget:

Eldenburg & Wolcott’s Cost Management, 2e Slide # 47

Q7: Profit-Related Variances Example

You are given below the actual results for Matthews Manufacturing. Compute the revenue budget variances.

Eldenburg & Wolcott’s Cost Management, 2e Slide # 48

Q7: Profit-Related Variances Example

Use the given information on the prior two slides to compute all of the contribution margin budget variances for Matthews Manufacturing.