When budgets are prepared, the costs are usually computed at two levels, in total dollars so an income statement can be prepared, and cost per unit. The cost per unit is referred to as a standard cost
. A standard cost can also be developed and used for pricing decisions and cost control even if a budget is not prepared. A standard cost in a manufacturing company such as Pickup Trucks Company consists of per unit costs for direct materials, direct labor, and overhead. The per unit costs can be further divided into the expected amount and cost of materials per unit, the expected number of hours and cost per hour for direct labor, and the expected total overhead costs and a method for assigning those costs to each unit. Within the expected amount of materials, waste or spoilage must be considered when determining the standard amount. For example, if a product, such as a chair, requires material, more material than is actually needed for the chair must be ordered because the shape of the seat and the fabric are usually not exactly the same. The scraps of material are called waste, which is not avoidable, given that the chair is being produced with this specific fabric. The cost of the full piece of material is used as the standard cost because the waste has no other use.
Similarly, when considering labor hours, downtime from production due to maintenance or start up and break time must be included in the number of hours it takes to make a product. Once standards are established, they are used to analyze and determine the reasons for actual cost variances from standards. The variances may be in quantity of materials or hours used to manufacture a product or in the cost of the materials or labor. Because overhead is normally applied on some basis, the variances in overhead will occur because the total overhead pool of dollars or the activity level (for example, direct labor dollars or hours) used to allocate the overhead is different from what was planned. Once standard costs are used in preparing budgets, analysis of variances can be used to provide management with information about whether a variance is caused by quantity or price so that appropriate action can be taken.
To illustrate how cost variance analysis works, assume you are the plant manager for Bases, Inc., a company that makes a set of soft bases for playing baseball in gymnasiums. The budget assumes 150,000 sets of bases will be produced annually. The following standard cost per set of bases was developed:
The predetermined overhead rate of $1.30 will result in $0.65 of overhead being allocated to each set of bases produced. (It is calculated using .5 direct labor hours per set times $1.30 per hour.)
For the month of October, the company produced 13,300 sets of bases. The following information was taken from the October financial report.
In order to understand the $1,175 unfavorable monthly variance, it must be analyzed by its component parts: direct materials variances, direct labor variances, and overhead variances. Each of these variances can further be broken down into a price (rate) variance and a quantity (usage or efficiency) variance. A general template that can be used for direct materials variances, direct labor variances, and variable overhead variances uses three amounts — actual, flexible budget, and standard — as a basis for calculating the variances.
The price variance is favorable if actual costs are less than flexible budget costs. The quantity variance is favorable if flexible budget costs are less than standard costs. The total variance is favorable if the actual costs are less than standard costs.
Direct Materials Variances
The total direct materials variance is $2,835 favorable and consists of a $3,000 favorable price variance and a $165 unfavorable quantity variance.
Actual costs of $63,000 are less than flexible budget costs of $66,000, so the materials price variance is $3,000 favorable. The variance can also be thought of on a price per unit basis. The actual costs of $63,000 were for 60,000 feet of direct material, so the actual price per foot is $1.05 ($63,000 ÷ 60,000). The original budget was for a direct materials cost of $1.10 per foot, so it was expected that 60,000 feet of material would cost $66,000. The direct materials actually cost less than budget by $0.05 per foot ($1.10 budget versus $1.05 actual), so the variance is favorable. The direct materials quantity variance of $165 unfavorable means this company used more direct materials than planned because flexible budget costs of $66,000 are higher than the standard costs of $65,825. To produce 13,300 sets of bases, the company expected a cost of $4.95 per set (4.5 feet of material at $1.10 per foot), for a total cost of $65,835. This can also be analyzed by identifying the total feet of material it should have taken to produce 13,300 sets of bases and multiplying by the cost per foot of material (13,300 sets × 4.5 feet per unit = 59,850 feet of direct materials × $1.10 per foot = $65,835). It actually used 60,000 feet, which prices out at an expected $1.10 per foot to be $66,000. The total direct materials variance is calculated by adding the price and quantity variances together or by comparing actual cost of direct materials with the standard cost of producing 13,300 sets of bases.
Another way of computing the direct materials variance is using formulas.
Using the formulas to calculate the variances would work like this:
Once the variances are calculated, management completes the analysis by obtaining explanations for why the variances occurred. For example, a question raised is “Why did materials cost less than planned?” As an answer, management may learn there was a price decrease, or the direct materials were acquired from another source, or lower quality materials were obtained. The explanations for price variances must relate to the cost of the direct materials, not the quantity of the materials used. Similarly, the reasons for the quantity variance need to relate to the amount of materials used, not the price paid for the materials. Reasons for a quantity variance could be more waste or scrap than was planned, or that lower quality materials were used, or less skilled workers were hired or used on the production line, or machine problems occurred that damaged materials.
Recording direct materials variances. The direct materials price variance is recorded when the direct materials are purchased. The materials are recorded using actual quantity and standard cost. A separate account is used to track each variance.