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# UNIT 5

## Materials Price Variance

Definition: The materials price variance is the difference between the actual and budgeted cost to
acquire materials, multiplied by the total number of units purchased. The formula is:

(Actual price - Standard price) x Actual quantity used = Material price variance

The key part of this calculation is the standard price, which is decided upon by the engineering and
purchasing departments, based on estimates of usage, probable scrap levels, required quality, likely
purchasing quantities, and several other factors. Politics can enter into the standard-setting decision,
which means that standards may be set so high that it is quite easy to acquire materials at prices less
than the standard, resulting in a favorable variance. Thus, the decision-making process that goes into
the creation of a standard price plays a large role in the amount of materials price variance that a
company reports.

If the standard price is reasonable, then a materials price variance may be caused by such valid
factors as the following:

Rush deliveries

## Market-driven pricing changes, such as changes in the prices of commodities

Bargaining power changes by suppliers, who may be able to impose higher prices than
expected

Buying in unusually large or small volumes in comparison to what was expected when the
standard was created

## A change in the quality of the materials purchased

As an example of the variance, the purchasing staff of ABC Manufacturing estimates that the budgeted
cost of a palladium component should be set at \$10.00 per pound, which is based on an estimated
purchasing volume of 50,000 pounds per year. During the year that follows, ABC only buys 25,000
pounds, which drives up the price to \$12.50 per pound. This creates a materials price variance of
\$2.50 per pound, and a variance of \$62,500 for all of the 25,000 pounds that ABC purchases.

## Material Yield Variance

Definition
Direct Material Yield Variance is a measure of cost differential between output that should have been
produced for the given level of input and the level of output actually achieved during a period.
Material Yield Variance Overview

The material yield variance is the difference between the actual amount of material used and the
standard amount expected to be used, multiplied by the standard cost of the materials. The formula
is:

(Actual unit usage - Standard unit usage) x Standard cost per unit = Material yield variance

An unfavorable variance means that the unit usage was greater than anticipated. There are a number
of possible causes of a material yield variance. For example:

Scrap. Unusual amounts of scrap may be generated by changes in machine setups, or because
changes in acceptable tolerance levels are altering the amount of scrap produced. A change in
the pattern of quality inspections can also alter the amount of scrap.

Material quality. If the material quality level changes, this can alter the amount of quality
rejections. If an entirely different material is substituted, this can also alter the amount of
rejections.

Spoilage. The amount of spoilage may change in concert with alterations in inventory handling
and storage.

Freight in issues. The transport service that ships materials to the company may have
damaged them in transit, rendering them unusable.

The standard unit usage is developed by the engineering staff, and is based on expected scrap rates in
a production process, the quality of raw materials, losses during equipment setup, and related factors.

## Material Yield Variance Example

The engineering staff of Hodgson Industrial Design estimates that 8 ounces of rubber will be required
to produce a green widget. During the most recent month, the production process used 315,000
ounces of rubber to create 35,000 green widgets, which is 9 ounces per product. Each ounce of rubber
has a standard cost of \$0.50. Its material yield variance for the month is:

(315,000 Actual unit usage - 280,000 Standard unit usage) x \$0.50 Standard cost/unit
= \$17,500 Material yield variance

Explanation
Material Yield Variance measures the effect on material cost of a change in the production yield from the
standard. Material yield variance is used in conjunction with material mix variance in order to provide
additional analysis of the material usage variance. The difference between material usage and material
yield variance is that the former focuses on the utilization of input at the start of production process
whereas latter focuses on the efficiency in terms of the output yield during a period.
Analysis
A favorable material yield variance indicates better productivity than the standard yield resulting in lower
material cost. Conversely, an adverse material yield variance suggests lower production achieved during
a period for the given level of input resulting in higher material cost. - See more at: http://accountingsimplified.com/management/variance-analysis/material/yield.html#sthash.uHPoiwaI.dpuf

## Direct Material Mix Variance

Definition
Direct Material Mix Variance is the measure of difference between the cost of standard proportion of
materials and the actual proportion of materials consumed in the production process during a period.
Explanation
Material Mix Variance quantifies the effect of a variation in the proportion of raw materials used in a
production process over a period.
Material mix variance is a sub-division of material usage variance. While material usage variance
illustrates the overall efficiency of raw material consumption during a period (in terms of the difference
between the amount of materials which should have been used and the actual usage), material mix
variance focuses on the aspect of proportion of raw materials used in the production process.
Material mix variance is only suitable for performance measurement and control where the proportion of
inputs to the production process can be altered without reducing the effectiveness of the final product. It
may not therefore be used in industries that require a high degree of precision in the input variables such
as in the pharmaceuticals sector.
Analysis
A favorable material mix variance suggests the use of a cheaper mix of raw materials than the standard.
Conversely, an adverse material mix variance suggests that a more costly combination of materials have
been used than the standard mix.
A change in the material mix must also be analyzed in the context of other organization wide implications
that may follow. Some of the effects a change in direct material mix include:

## Change in the quality, performance and durability of the final product

Price offered by customers may vary as a result of a change in perceived quality of the product
Change in material mix may affect the workability of materials which may in turn affect labor
efficiency

## Direct Material Mix Variance

Direct material mix variance is the product of the standard price per unit of direct material and
the difference between standard mix quantity and actual quantity of direct material used.
Standard mix quantity is the quantity of a particular direct material which, if mixed with one of
more different materials in a standard ratio, would have been consumed on the actual quantity
of a product produced. Direct material mix variance can be calculated only for a product
having two or more input materials. The formula is:

DM Mix Variance = ( SM AQ ) SP

Where,
SM is the standard mix quantity of direct material
AQ is the actual quantity of material used
SP is the standard price per unit of direct material used

## Standard mix quantity is calculated by multiplying standard mix percentage of a given

material by total actual quantity of the material used. For example, if three materials A, B and
C are mixed in ratio 5:3:2 and actual quantity of material used is 2.5 kg then,

## A positive value of DM mix variance is favorable whereas as a negative value is unfavorable.

"Direct

labor" refers to the work done by those employees who actually make the product on the

production line. ("Indirect labor" is work done by employees who work in the production area, but do
not work on the production line. Examples include employees who set up or maintain the
equipment.)
Unlike direct materials (which are obtained prior to being used) direct labor is obtained and used at
the same time. This means that for any given good output, we can compute the direct labor rate
variance, the direct labor efficiency variance, and the standard direct labor cost at the same time.

## Direct labour cost variance

Direct labour cost variance is the difference between the standard cost for actual production and
the actual cost in production.
There are two kinds of labour variances. Labour Rate Variance is the difference between the
standard cost and the actual cost paid for the actual number of hours. Labour efficiency variance
is the difference between the standard labour hour that should have been worked for the actual
number of units produced and the actual number of hours worked when the labour hours are
valued at the standard rate.
Direct Labor Idle Time Variance

Definition
Labor Idle Time Variance is the cost of the standby time of direct labor which could not be utilized in the
production due to reasons including mechanical failure of equipment, industrial disputes and lack of
orders.
Formula Idle Time Variance: = Number of idle hours x Standard labor rate
Explanation
Idle time variance illustrates the adverse impact on the profitability of an organization as a result of having
paid for the labor time which did not result in any production. Idle time variance is therefore always
described as an 'adverse' variance.
The separate calculation of idle time variance ensures a more meaningful analysis of the underlying
productivity of the workforce demonstrated in the labor efficiency variance as illustrated in the example
below.

As with the labor efficiency variance, the calculation of idle time variance is based on the standard rate
since the variance between actual and standard labor rate is separately accounted for in the labor rate
variance.
Analysis
Reasons for idle time may include:

## Fixed Overhead Volume Variance

Fixed Manufacturing Overhead Volume Variance quantifies the difference between budgeted and
absorbed fixed production overheads.
The fixed overhead volume variance is the difference between the amount of fixed overhead actually
applied to produced goods based on production volume, and the amount that was budgeted to be
applied to produced goods.

Explanation
Fixed Overhead Volume Variance is the difference between the fixed production cost budgeted and the
fixed production cost absorbed during the period. The variance arises due to a change in the level of
output attained in a period compared to the budget.
The variance can be analyzed further into two sub-variances:

## Fixed Overhead Efficiency Variance

The sum of the above two variances should equal to the volume variance.
Fixed overhead volume variance helps to 'balance the books' when preparing an operating statement
under absorption costing.
Sales Quantity Variance already takes into account the change in budgeted fixed production overheads
as a result of increase or decrease in sales quantity along with other expenses.
At the same time, fixed overhead expenditure variance accounts for the difference between actual and
budgeted expense rather than the flexed expense unlike other expenditure variances.
This implies that the difference between budgeted and flexed fixed cost is included twice in the operating
statement. Sales volume variance removes the effect of such duplication.
As fixed costs are not absorbed under marginal costing system, fixed overhead volume variance (and its
sub-variances) are to be calculated only when absorption costing is applied.

## Fixed Overhead Capacity Variance

Fixed Overhead Capacity Variance calculates the variation in absorbed fixed production overheads
attributable to the change in the number of manufacturing hours (i.e. labor hours or machine hours) as
compared to the budget.
The variance can be calculated as follows:
Fixed Overhead Capacity Variance:
= (budgeted production hours - actual production hours) x FOAR*
* Fixed Overhead Absorption Rate / unit of hour

## Fixed Overhead Efficiency Variance

Fixed Overhead Efficiency Variance calculates the variation in absorbed fixed production overheads
attributable to the change in the manufacturing efficiency during a period (i.e. manufacturing hours being
higher or lower than standard ).
The variance can be calculated as follows:
Fixed Overhead Efficiency Variance:
= (standard production hours - actual production hours) x FOAR*
* Fixed Overhead Absorption Rate / unit of hour
Limitations
Fixed Overhead Volume Variance is necessary in the preparation of operating statement under
absorption costing as it removes the arithmetic duplication as discussed earlier. However, besides its role
as a balancing agent, the variance offers little information in its own right over and above what can be
ascertained from other variances (e.g. sales quantity variance already illustrates the effect of an increase
in sales quantity on the overall profitability). The traditional calculation of sub-variances (i.e. fixed
overhead capacity and efficiency variances) does not provide a meaningful analysis of fixed production
overheads. For instance, if the workforce utilized fewer manufacturing hours during a period than the
standard (the effect of which is more adequately reflected in labor efficiency variance), it is hard to
imagine a significant benefit of calculating a favorable fixed overhead efficiency variance.
For example, a company budgets for the allocation of \$25,000 of fixed overhead costs to produced
goods at the rate of \$50 per unit produced, with the expectation that 500 units will be produced.

However, the actual number of units produced is 600, so a total of \$30,000 of fixed overhead costs are
allocated. This creates a fixed overhead volume variance of \$5,000.

The fixed overhead costs that are a part of this variance are usually comprised of only those fixed
costs incurred in the production process. Examples of fixed overhead costs are:

Factory rent

Equipment depreciation

## Insurance on production facilities

Utilities

Being fixed within a certain range of activity, fixed overhead costs are relatively easy to predict.
Because of the simplicity of prediction, some companies create a fixed overhead allocation rate that
they continue to use throughout the year. This allocation rate is the expected monthly amount of fixed
overhead costs, divided by the number of units produced (or some similar measure of activity level).

Conversely, if a company is experiencing rapid changes in its production systems, as may be caused
by the introduction of automation, cellular manufacturing, just-in-time systems, and so forth, it may
need to revise the fixed overhead allocation rate much more frequently, perhaps on a monthly basis.

When the actual amount of the allocation base varies from the amount built into the budgeted
allocation rate, it causes a fixed overhead volume variance. Examples of situations in which this
variance can arise are:

The allocation base is the number of units produced, and sales are seasonal, resulting in
irregular production volumes on a monthly basis. This disparity tends to even out over the
course of a full year.

The allocation base is the number of direct labor hours, and the company implements new
efficiencies that reduce the actual number of direct labor hours used in production.

The allocation base is the number of machine hours, but the company then outsources some
aspects of production, which reduces the number of machine hours used.

When the cumulative amount of the variance becomes too large over time, a business should alter its
budgeted allocation rate to bring it more in line with actual volume levels.
Formula:
=fixed overhead cost absorbed-budgeted fixed overhead cost
Where, budgeted fixed overhead cost=budgeted output x budgeted rate per unit
Or= budgeted time x budgeted rate per hour

## Fixed Manufacturing Overhead Expenditure / Spending Variance

Definition
Fixed Overhead Expenditure Variance, also known as fixed overhead spending variance, is the
difference between budgeted and actual fixed production overheads during a period.
Fixed Overhead Spending Variance Overview

The fixed overhead spending variance is the difference between the actual fixed overhead expense
incurred and the budgeted fixed overhead expense. An unfavorable variance means that actual fixed
overhead expenses were greater than anticipated.

Formula
Fixed Overhead Expenditure Variance:
= Actual Fixed Overheads - Budgeted Fixed Overheads
Explanation
Fixed Overhead Spending Variance is calculated to illustrate the deviation in fixed production costs
during a period from the budget. The variance is calculated the same way in case of both marginal and
absorption costing systems. As under marginal costing fixed overheads are not absorbed in the standard
cost of a unit of output, fixed overhead expenditure variance is the only variance relating to fixed
overheads calculated under marginal costing (i.e. fixed overhead expenditure variance is equal to fixed
overhead total variance under marginal costing system).

Analysis
Favorable fixed overhead expenditure variance suggests that actual fixed costs incurred during the period
have been lower than budgeted cost.
Reasons for a favorable variance may include:

Planned business expansion, which was anticipated to cause a stepped increase in fixed
overheads, not being undertaken during the period.
Cost rationalization measures carried out during the period aimed at reducing fixed overheads
by elimination of inefficiencies (e.g. through process re-engineering and optimization of the
usage of shared resources and facilities).
Planning inaccuracies (e.g. actual salary raise being lower than anticipated in budget).
Adverse fixed overhead expenditure variance indicates that higher fixed costs were incurred
during the period than planned in the budget.

## An adverse variance may be caused by the following:

Expansion of business undertaken during the period, which was not taken into consideration in
the budget setting process, causing a stepped increase in fixed overheads.
Inefficient fixed overheads management (e.g. due to empire building pursuits of senior
management).
Planning errors (e.g. increase in insurance premium being higher than budget due to changes in
the risk profile of business).

## The formula for this variance is:

Actual fixed overhead - Budgeted fixed overhead = Fixed overhead spending variance

The amount of expense related to fixed overhead should (as the name implies) be relatively fixed, and
so the fixed overhead spending variance should not theoretically vary much from the budget. However,
if the manufacturing process reaches a step cost trigger point where a whole new expense must be
incurred, this can cause a significant unfavorable variance. Also, there may be some seasonality in
fixed overhead expenditures, which may cause both favorable and unfavorable variances in individual
months of a year, but which cancel each other out over the full year. Other than the two points just
noted, the level of production should have no impact on this variance.

This is one of the better cost accounting variances for management to review, since it highlights
changes in costs that were not expected to change when the fixed cost budget was formulated.

## Fixed Overhead Spending Variance Example

The production manager of Hodgson Industrial Design estimates that the fixed overhead should be
\$700,000 during the upcoming year. However, since a production manager left the company and was
not replaced for several months, actual expenses were lower than expected, at \$672,000. This created
the following favorable fixed overhead spending variance:

## (\$672,000 Actual fixed overhead - \$700,000 Budgeted fixed overhead) =

\$(28,000) Fixed overhead spending variance