Welcome to Week 5! In Week 4, you were introduced to responsibility centers and transfer pricing. You learned about cost centers, profit centers, investment centers, return on investment (ROI), residual income, EVA, IASB, GAAP, IFRS, and transfer pricing. These are all now a part of your accounting vocabulary!

In Week 5, you will continue to build your accounting vocabulary as you study standard costs and variances.

This week:

In terms of the specific learning objectives, you will:

• Analyze standard costing in terms of improving efficiency
• Analyze material and labor variances
• Evaluate alternatives based on information provided by variances

In terms of course-level outcomes, you will:

• Evaluate various accounting measures and their relevance to a wide range of stakeholders
• Analyze various types of budgets, strategic planning, and forecasting
• Employ managerial accounting approaches and information to make effective decisions
• Demonstrate effective communication skills to present accounting information to stakeholders
• Assess managerial accounting tools and their usefulness to organizational leaders
• Apply accounting principles ethically and appropriately to personal and professional contexts

Understanding Variances

How can an organization determine if the cost of the products it produces or the services it renders are reasonable? If a company makes baseballs, how much should it cost to produce one baseball? How much material should be used? How much time should it take? If a company services automobiles, how much time should it take to complete an oil change? How much oil should be used?

As you consider these questions, it becomes evident that standards are needed in order to provide a comparison to the actual costs. The difference between the standard costs and the actual costs is a variance. If actual costs are higher than standard costs, the variance is unfavorable. If actual costs are lower than standard costs, the variance is favorable. These variances are used to judge performance (Zimmerman, 2020).

Two important variances are the direct labor variance and the direct materials variance. We will look at the direct labor variance first by using an example:

JJ Company’s standard labor cost of producing one unit of its product L is 4 hours at
$12.00 per hour. During last month, 40,800 hours of labor were incurred to produce
10,000 units at a cost of $12.10 per hour. The company’s standard materials cost is $2.50 per pound and eight pounds are needed for one unit. The actual costs last month were $180,000 for 90,000 pounds ($2 per pound).

First, it may be helpful for you to examine the acronyms which are considered standard terminology.

AH = actual hours AQ = actual quantity
AR = actual rate AP = actual price
SH = standard hours SQ = standard quantity
SR = standard rate SP = standard price
TLV = total labor variance TMV = total materials variance
LWV = labor wage variance MPV = materials price variance
LEV = labor efficiency variance MQV = materials quantity variance

1. The formula to compute the total labor variance is:

TLV = (AH x AR) – (SH x SR)

In this example, the computations are as follows:

TLV = (40,800 x $12.10) – (40,000* x $12.00)

*Since it takes 4 hours to make one unit and 10,000 units were produced, the standard hours for the units produced totals 40,000.

TLV = $493,680 – $480,000

TLV = $13,680 unfavorable. The result is unfavorable because the actual was greater than the standard.

Next, you will separate the total labor variance into the wage variance and the efficiency variance.

2. The formula for the wage variance is:

LWV = AH(AR – SR)

LWV = 40,800($12.10 – $12.00)

LWV = 40,800($0.10)

LWV = $4,080 unfavorable. The result is unfavorable because the actual hourly wage was greater than the standard hourly wage.

3. The formula for the efficiency variance is:

LEV = SR(AH – SH)

LEV = $12.00(40,800 – 40,000)

LEV = $12.00 (800)

LEV = $9,600 unfavorable. The result is unfavorable because the actual hours worked was greater than the standard hours.

Note: Since TLV = LWV + LEV, you can check your numbers to be sure your calculations are correct.

$13,680U = $4,080U + $9,600U

There could be many causes for these variances. For example, the standards could be outdated or unreliable, workers could have recently received a pay raise, there is a misallocation of workers causing some more skilled workers to be utilized at lower levels, etc. It is also possible that the efficiency variance could be due to factors beyond the control of the workers such as inferior quality materials, working too much overtime, etc. Significant variances should be examined whether they are favorable or unfavorable. Small variances do not need to be analyzed unless there is a cumulative month after month affect.

4. The formula for the total materials variance is:

TMV = (AQ x AP) – (SQ x SP)

TMV = ($180,000) – (80,000 x $2.50)

TMV = $180,000 – $200,000

TMV = $20,000 favorable

Next, you will separate the total material variance into a material price variance and a material quantity variance.

5. The formula for the material price variance is:

MPV = AQ(AP – SP)

MPV = 90,000($2.00 – $2.50)

MPV = 90,000(-$0.50)

MPV = -$45,000. This is a favorable variance because the actual price per pound is less than the standard price per pound.

6. The formula for the material quantity variance is:

MQV = SP(AQ – SQ)

MQV = $2.50(90,000 – 80,000)

MQV = $2.50(10,000)

MQV = $25,000 unfavorable. The variance is unfavorable because the actual quantity was greater than the standard quantity.

Note: Since TMV = MPV + MQV, you can check the accuracy of the computations follows:

$20,000F = $45,000F + $25,000U (Subtract the unfavorable variance from the favorable variance.)

It is interesting to note that in this example the price variance was favorable while the quantity variance was unfavorable. This could mean that the purchasing department bought less expensive material, but it was of a poor quality so there was more waste.

In summary, all significant variances should be examined to determine the causes. This knowledge will help managers make better decisions in the future or show them that they are doing well and that they should continue using processes that contribute to effective and efficient operations.

References

Zimmerman, J. (2020). Accounting for decision making and control (10th ed.). McGraw-
Hill.