One of
the main purposes of budgeting is budgetary control and the control of costs.
Costs can be controlled by comparing budgets with the results actually achieved.
Variance
Analysis therefore, is a tool for budgetary control, it is the difference
between expected results and actual results.
THINGS TO KNOW
Variances
can be either favourable (F) or adverse (A) depending on whether the results
achieved are better or worse than expected.
Variance
analysis explains the difference between the fixed budget profit and the actual
profit in detail.
Variable cost variances can be calculated for all items of
variable cost (direct materials, direct labour and variable production
overhead). The method of calculating the variances is similar for each variable
cost item.
The total cost variance for the variable cost item is the
difference between the actual variable cost of production and the standard
variable cost of producing the items.
When actual cost is higher than standard cost, the cost variance
is adverse (A) or unfavourable (U).
When actual cost is less than standard cost, the cost
variance is favourable (F).
Favourable variances increase the reported profit.
Adverse variances reduce the reported profit.
METHOD OF CALCULATING VARIANCES
The
method of calculating variances is
similar for all variable production cost items (direct materials, direct labour
and variable production overhead).
Direct Material Cost Variance
The
total direct material cost variance is the difference between the actual material
cost in producing units in the period and the standard material cost of producing
those units.
Formula
Direct
Material Price Variance:
= Actual
unit Produced x Actual Quantity x Actual Price = Actual Total Cost
= Actual
unit Produced x Actual Quantity x Standard Price = Standard Total
Cost
Where:
Actual
unit Produced is the total production
for the period
Actual
Quantity is the quantity purchased during a period if the variance is
calculated at the time of material purchase
Actual
Quantity is the quantity consumed during a period if the variance is calculated
at the time of material consumption
Example
Cement
PLC manufactured 10,000 bags of cement during the month of January. Following
raw materials were purchased and consumed by Cement PLC during the period:
Material

Quantity

Actual Price

Standard Price

Limestone

100 tons

$75/ton

$70/ton

Clay

150 tons

$20/ton

$24/ton

Sand

250 tons

$10/ton

$12/ton

Material
Total Cost Variance will be calculated as follows:
Step 1:
Calculate Actual Cost
Actual Cost = Total unit Produced x Actual Quantity x Actual Price


Limestone: 10,000 x

100 tons

x

$75

=

$75,000,000

Clay: 10,000 x

150 tons

x

$20

=

$30,000,000

Sand: 10,000 x

250 tons

x

$10

=

$25,000,000

Step 2:
Find the Standard Cost of Actual Quantity
Standard Total Cost = Total unit Produced x Actual Quantity x Standard
Price


Limestone: 10,000 x

100 tons

x

$70

=

$70,000,000

Clay: 10,000 x

150 tons

x

$24

=

$36,000,000

Sand: 10,000 x

250 tons

x

$12

=

$30,000,000

Step 3:
Calculate the Variance
Material Total Cost Variance = Actual Cost (Step 1)  Standard Cost
(Step 2)


Limestone:

$75,000,000



$70,000,000

=

($5,000,000)

Adverse

Clay:

$30,000,000



$36,000,000

=

$6,000,000

Favorable

Sand:

$25,000,000



$30,000,000

=

$5,000,000

Favorable

Total Cost Variance

$6,000,000

Favorable

The
direct materials total cost variance can be further analysed into a price variance and a usage
variance.
A price
variance measures the difference between the actual price paid for materials
and the price that should have been paid (the standard price).
A usage
variance measures the difference between the materials that were used in
production and the materials that should have been used (the standard usage).
Direct Material Price Variance
Material
price variance is the difference between the actual cost of direct material and
the standard cost of quantity purchased or consumed.
Formula
Direct
Material Price Variance:
=
Actual Quantity x Actual Price = Actual Cost
=
Actual Quantity x Standard Price= Standard Cost of Actual Quantity
Where:
Actual
Quantity is the quantity purchased during a period if the variance is
calculated at the time of material purchase
Actual
Quantity is the quantity consumed during a period if the variance is calculated
at the time of material consumption
Example
Cement
PLC manufactured 10,000 bags of cement during the month of January. Following
raw materials were purchased and consumed by Cement PLC during the period:
Material

Quantity

Actual Price

Standard Price

Limestone

100 tons

$75/ton

$70/ton

Clay

150 tons

$20/ton

$24/ton

Sand

250 tons

$10/ton

$12/ton

Material
Price Variance will be calculated as follows:
Step 1:
Calculate Actual Cost
Actual Cost = Actual Quantity x Actual Price


Limestone:

100 tons

x

$75

=

$7,500

Clay:

150 tons

x

$20

=

$3,000

Sand:

250 tons

x

$10

=

$2,500

Step 2:
Find the Standard Cost of Actual Quantity
Standard Cost = Actual Quantity x Standard Price


Limestone:

100 tons

x

$70

=

$7,000

Clay:

150 tons

x

$24

=

$3,600

Sand:

250 tons

x

$12

=

$3,000

Step 3:
Calculate the Variance
Material Price Variance = Actual Cost (Step 1)  Standard Cost (Step
2)


Limestone:

$7,500



$7,000

=

($500)

Adverse

Clay:

$3,000



$3,600

=

$600

Favorable

Sand:

$2,500



$3,000

=

$500

Favorable

Total Price Variance

$600

Favorable

Analysis
A
favorable material price variance suggests cost effective procurement by the
company.
Reasons
for a favorable material price variance may include:
An
overall decrease in the market price level
Purchase
of materials of lower quality than the standard (this will be reflected in
adverse material usage variance)
Better
price negotiation by the procurement staff Implementation of better procurement
practices (e.g. invitation of price quotations from multiple suppliers)
Purchase
discounts on larger orders
An
adverse material price variance indicates higher purchase costs incurred during
the period compared with the standard.
Reasons
for adverse material price variance include:
An
overall hike in the market price of materials
Purchase
of materials of higher quality than the standard (this will be reflected in
favorable material usage variance)
Increase
in bargaining power of suppliers
Loss of
purchase discounts due to smaller order sizes
Inefficient
buying by the procurement staff
Materials usage Variance
A usage
variance measures the difference between the materials that were used in
production and the materials that should have been used (the standard usage).
Formula
Direct
Material Price Variance:
=
Actual Quantity Used x Standard Cost = Actual Usage
= Standard
Quantity Used x Standard Cost= Standard Usage
Using
the above example, am sure you would be able to calculate the material usage variance
Possible
causes of favourable materials usage variances include:
Wastage rates were lower than expected.
Improvements
in production methods resulted in more efficient usage of materials (favourable
usage variance).
Possible
causes of adverse materials usage variances include:
Wastage rates were higher than expected.
Poor materials handling resulted in a large
amount of breakages (adverse usage variance). Breakages mean that a quantity of
materials input to the production proves are wasted.
Materials used were of cheaper quality than
standard, with the result that more materials had to be thrown away as waste.
Note: The total
of the price and Usage Variances will equal the Total Material Cost Variance
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