UNIT5:VARIANCE ANALYSIS
Management Accounting | Experimental Version | Student Book | Senior SixKey unit competence: To be able to interpret the variance and advice the top management
Introductory activity:
Read the following case study of Specialty Food ltd profit Report for the
month of June.
MUHIRE, the new management accountant, has just completed his first
month’s work. He has entered a huge amount of data into the finance and
accounting system and is now faced with a pile of report. One such report
is shown below.Specialty Foods ltd profit Report: June (unit-FRW)
a) Explain the meaning of the above report
b) What is the budget variance analysis?
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5.1. Identify any significant deviation
Activity 5.1
Read the following case study and answer the question below:
The chocolate Cow Ice Cream Company has grown substantially recently,
and management now feels the need to develop standard and compute
variances. A consulting firm was hired to develop the standards and the
format for the variance computation. One standard in particular that the
consulting firm developed seemed too excessive to plant management. The
consulting firm’s standard was production of 100 gallons of ice cream every
45 minutes. The plant’s middle level of management thought the standard
should be 100 gallons every 55 minutes, while the top management of the
company thought that the consulting firm’s standard would provide more
motivation to the employees.
1.Why is the company establishing a standard costs for production
2.What are some factors the company may need to consider beforeselecting one of the proposed standard costs
5.1.1. Meaning of Variance
Variance: is the difference between a forecasted variable and the actual
variable. Variances are common in budgeting, but you can have a variance
in anything that you forecast. In many accounting applications, a variance is
considered to be ”the difference between an actual cost and standard coast”.
The act of computing and interpreting variances is called Variance Analysis.
-Variance analysis: refers to identifying and examining the difference between
the standard numbers expected by the business and the actual numbers
achieved.
Frank wood and Allan Sangster defined variance analysis as” a mean of
assessing the difference between a predetermined cost and actual cost.
Analysing variance helps businesses understand current outgoings and them
budgeting for future expenses. Businesses often carry out variance analysis a
quantitative investigation into differences between planned and actual costsand revenues.
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Variance analysis can be applied to both revenues and expenses. When actual
results are better than planned, variance is referred to as “favourable”. If resultsare worse than expected, variance is referred to as” adverse” or” unfavourable”
5.1.2. Purpose of variance analysis
Variance analysis helps to reveal where your business exceeded expectations
and where it came up short.
A company must use variance analysis to determine how managers have
performed to achieve their objectives. In this case, variance analysis enhances
the benefits of budgeting. Variance analysis promotes responsibility in various
areas. Variance analysis can also identify any errors in a budget.
Variance analysis can provide information to prepare budgets in the future.
Variance analysis fixed that by establishing actual performance.
5.1.3. Structure of variance
The total difference between the budgeted profit and actual profit for a specific
period is divided into various parts. These parts relate to material, labour,
overhead and sales variances. The particular variances which are computed in
any given organization are those which are relevant to its operations.
The operating profit variance is the difference between budgeted and actual
operating profit for a specific period. This variance is the sum of all other
variances. i.e. cost variances and sales variances.
5.1.4. Causes of budget variance
There are three primary causes of budget variance: errors, changing business
condition, and unmet expectations.
1. Errors by the creators of the budget can occur when the budget is being
compiled. There are a number of reasons for this, including faulty math,
using the wrong assumptions, or relying on stale or bad data.
2. Changing business conditions, including changes in the overall economy
or global trade, can cause budget variances. There could be an increase
in the cost of raw materials or new competitors may have entered the
market to create pricing pressure. Political and regulatory changes that
were not accurately forecast are also included in this category
3. Budget variance will also occur when the management team exceeds or
underperforms expectations. Expectations are always based on estimates
and projects, which also rely on the values of inputs and assumptions builtinto the budget. As a result, variances are more common than company
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managers would like them to be.
5.1.5. Types of budget variance
There is a need of knowing types of variance before measuring the variance.
Generally ,the variances are classified on the following basis.
a) On the basis of element of cost
1. Material variance
2. Labour variance
3. Overhead variance
b) On the basis of controllability
1. Controllable variance
2. Uncontrollable variance
c) On the basis of impact
1. Favourable variance
2. Unfavourable variance
d) On the basis of nature
1. Basic variance
2. Sub-variance
5.1.6. Calculation of budget Variance
A brief explanation of the above mentioned variance is presented below
1. Material variance
It is the difference between actual cost of material used and the standard cost for
the actual output. The difference between the standard cost of direct materials
and the actual cost of direct materials that an organisation uses for production
is known as Material variance
Types/Methods of Material cost variances are:
a) Material cost variance (MCV): It is the difference between the
standard cost of materials and actual cost. If actual cost is less than the
standard cost, it is a favorable variance and vice versa.Material cost variance formula:
Management Accounting | Experimental Version | Student Book | Senior Six
Management Accounting | Experimental Version | Student Book | Senior Six
c) Material usage (or Quantity) Variance (MQV): It measures the difference
in material cost arising, from higher of less consumption of material than the
standard consumption. It is calculated by multiplying the standard Price with the
difference between the standard Quantity and actual Quantity
MUV= (Standard Quantity-Actual Quantity) × Standard PriceExample: The Standard and Actual figures of product ‘Z’ are as under
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c) Material Cost Variance
d) Material Mix variance (MMV): This variance arises when more than one
type of materials is used in manufacturing the product and the quantities of
materials issued are not in predetermined proportion. It is that part of direct
material usage variance, which is due to difference between the standard and
actual composition of a mixture. It is obtained by multiplying the standard price
of materials with the difference between revised standard Quantity and theActual Quantity.
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hours. But actual wage rate is Frw 22.5 per hour and actual hours used are 12
hoursCalculate Labor cost Variance
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Required: Calculate the following Variances
a) Labor Rate Variance
b) Efficiency Variancec) Total Labor Cost Variance
LMV arises due to change in composition of labor force (like mix in material).
It tells the management how much labor efficiency variance occurs due to
change in its composition and thus it a part of labor efficiency variance.
Its computation is:
i) If standard composition/mix of time and actual composition of time (time spent
by them) is same.
LMV =Standard cost of standard composition – Standard cost of actual
composition
Or
Total actual time spent by labour (standard rate per hour of standard mix –standard rate per hour of actual mix)
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Or
ii) If standard composition/mix of time and actual composition of time is not thesame
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Fixed Overhead Variance: This is a cost that is not directly related to output;
itVolume variance can further be divided into three variances, which are:a) Capacity Variance
b) Calendar Variance
c) Efficiency Variance
a) Capacity Variance This is the portion of volume variance that arises due to
high or low working capacity. It is influenced by idle time, machine breakdown,
strikes or lockouts, or shortages of materials and labor. Thus, Standard rate
(Revised units – budgeted hours)
b) Calendar Variance This variance arises due to the difference in the number
of working days when the actual number of working days is greater than the
Standard working days. It is regarded as a favorable type of variance. It is
expressed in the following way:
Calendar variance = No. of working days more or less × Standard (st.)
rate per unit
c) Efficiency Variance This is the portion of volume variance that is due to
the difference between the budgeted output efficiency achieved. This is due to
Labor working efficiency. Thus, it can be expressed as:
Efficiency Variance = Std. rate (Actual production – Std. production)
in unit is a general time-related cost. Specially, fixed overhead variance is defined as
the difference between standard cost and fixed overhead allowed for the actual
output achieved and the actual fixed overhead cost incurred.
Formula to calculate Fixed Overhead Variance:
FOV=Actual output ×Standard fixed overhead rate-Actual fixed overheads
The following are the other variances:
i. Expenditure Variance
This shows the over/under absorption of fixed overheads during
a particular period. When the actual output exceeds the standard
output, it is known as over-recovery of fixed overheads. Expenditure
variance (EV) is expressed as follows:
EV = (Standard overhead – Actual overhead)
ii. Volume Variance
It is favorable if the actual output is less than the standard output, and
vice -versa.
This is due to the nature of fixed overheads, which are not expected
to change with the change in output. This variance can be expressed
Management Accounting | Experimental Version | Student Book | Senior Sixas:
Volume Variance = (Actual output ×Standard rate)-Budgeted
fixed overheads
Volume variance can further be divided into three variances, which are:
a) Capacity Variance
b) Calendar Variance
c) Efficiency Variance
a) Capacity Variance This is the portion of volume variance that arises due to
high or low working capacity. It is influenced by idle time, machine breakdown,
strikes or lockouts, or shortages of materials and labor. Thus, Standard rate
(Revised units – budgeted hours)
b) Calendar Variance This variance arises due to the difference in the number
of working days when the actual number of working days is greater than the
Standard working days. It is regarded as a favorable type of variance. It is
expressed in the following way:
Calendar variance = No. of working days more or less × Standard (st.)
rate per unit
c) Efficiency Variance This is the portion of volume variance that is due to
the difference between the budgeted output efficiency achieved. This is due to
Labor working efficiency. Thus, it can be expressed as:
Efficiency Variance = Std. rate (Actual production – Std. production)in unit
Example: Using the information given below compute the fixed overhead cost,Expenditure, and Volume variance
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2. Variable overhead Variance
Variable overheads consist of expenses other than direct material and direct
labor which vary with the level of production. If variable overhead consists of
indirect materials, then in this case it varies with the direct material used. On the
other hand, if variable overhead is depending on number of hours worked then
in this case it will vary with labor hours or machine hours. If nothing is mentioned
specially then we take labor hours as basis. Variable overhead cost variance
calculation is similar to labor cost variance.
Variable overhead cost variance = (standard variable overhead for
production -Actual variable overheads)
The variable overhead cost variance is divided into two parts
Variable overhead expenditure variance
Variable overhead Efficiency variance
Variable overhead Expenditure variance= (Standard variable Overheads
for actual hours) –(Actual variable overhead)
Variable overhead Efficiency Variance= (Standard Variable Overheads for
production) – (Standard Variable Overheads for Actual Hours)
Example: From the following information of G ltd,Calculate i) variable Overhead Cost Variance
Management Accounting | Experimental Version | Student Book | Senior Six
Management Accounting | Experimental Version | Student Book | Senior Six
Total sales margin variance is the difference between the budgeted margin from
sales and the actual margin when the cost of sales is valued at the standard
cost of production. This is the sum of sales margin price variance and sales
margin quantity variance.
a) Sales Margin Price Variance
This is that portion of the total sales margin variance which is the difference
between the standard margin per unit and the actual margin per unit for the
number of units sold in the period.It is calculated as under:
Sales Margin Price Variance=Actual sales-(Standard selling price-Actual sales
quantity)
Sales Margin Quantity Variance
This is that portion of the total sales margin variance which is the difference
between the budgeted number of units sold and the actual number sold valued
at the standard margin per unit. It is calculated as under:
Sales Margin Quantity Variance=Standard sales Margin or profit (Actual Sales
Quantity – Budgeted Sales Quantity)Example: From the following information, calculate the sales variances
Sales selling price per unit FRW 30
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Controllable cost variance is a cost variance which can be identified as a primary
responsibility of a specified person.
6. Uncontrollable Variances
External factors are responsible for uncontrollable variances. The management
has no power or is unable to control the external factors. Variance for which a
particular person or a specific department or section or division can’t be held
responsible are known as uncontrollable variances.
7. Favourable variances
Whenever the actual costs are lower than the standard costs at per-determined
level of activity, such variance termed as favourable variances. The management
is concentrating to get actual results at cost lower than the standard costs. It
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shows the efficiency of business operation.
8. Unfavourable variances
Whenever the actual costs are more than the standard costs at predetermined
level of activity, such variances termed as unfavourable variances. These
variances indicate the inefficiency of business operation and need deeper
analysis of these variances.
9. Basic Variances
Basic variances are those variances which arise on account of monetary rates
(i.e.price of raw materials or labour rate) and also on account of non- monetary
factors (such as physical units in quantity or time)
10. Sub Variance
Basic variance arising due to non-monetary factors are further analysed and
classified into sub-variances taking into account the factor responsible for them.
Such sub variances are material usage variance and material quantity variance
5.1.7. Reconciliation Statement budgeted profit with actual
profit
We have discussed above various cost variances and sales margin variances.
Sometimes the budgeted profit and actual profit are given and the students
are required to reconcile the budgeted profit with actual profit after calculating
various variances. The layout of a reconciliation statement is given as under:Statement showing the reconciliation of Budgeted Profit with Actual Profit
Management Accounting | Experimental Version | Student Book | Senior Six
Management Accounting | Experimental Version | Student Book | Senior Six
5.1.8. Accounting entries of Variance
The difference between Standard and Actual figures are called variances.
These variances may be favourable or unfavourable. These are recorded into
cost accounts. For this purpose, the following procedures are adopted:
a) Variance is calculated at the time of occurrence or when the respective
elements of cost are charged to production.
b) Variance accounts are maintained for each type of variance.
c) Transfers between the work – in- progress, finished goods and cost of
sales are made at the standard figures.
d) Stocks of raw materials, work-in- progress and finished goods are valued
at standard cost.e) Unfavorable price or expenditure variances are credited to the respective
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control account and debited to the respective variance account. For
example, adverse labor rate variance is debited to the labor rate variance
account and credited to wages control account. Similarly, adverse material
price variance is debited to material price variance account and credited
to stores control account. Favorable price or expenditure variances are
debited to respective control account and credited to respective variance
account.
f) Unfavorable usage or efficiency variances are debited to respective
variance account and credited to work-in-progress account. For example,
adverse material usage variance of adverse labor efficiency variance is
debited to material usage variance account or labor efficiency account
and credited to W.I.P. account. If the usage or efficiency variances
are favorable then debit W.I.P. account and credit respective variance
account.
g) At the end of the year, the balances in the variance accounts are transferred
to the profit and loss account. It means adverse variances are debited to
the profit and loss account and favorable variances are credited to the
profit and loss account.
Example; ABC Ltd. makes and sells a single product, Z. The company
operates a standard cost system and during a period, the followingdetails were recorded:
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Management Accounting | Experimental Version | Student Book | Senior Six
Management Accounting | Experimental Version | Student Book | Senior Six
Management Accounting | Experimental Version | Student Book | Senior Six
Management Accounting | Experimental Version | Student Book | Senior Six
Application activity 5.1
Management Accounting | Experimental Version | Student Book | Senior Six
5.2. The use of budgetary control to ensure organization achievement of target
Learning Activity 5.2
Read the following information and answer the question below
Budgetary control is a system of controlling costs which includes the
preparation of budgets, coordination the departments and establishing
responsibilities, comparing actual performance with the budgeted, and
acting upon results to achieve maximum profitability.What are the functions of budgets in achieving the goal of an organization?
5.2.1 Management efficiency with budgetary control
Budgetary control is known as setting up particular budget by management to
know the variation between the company’s actual performance and budgetary
performance.
It is also helps managers utilize these budgets to monitor and control various
costs within a particular accounting period.
Importance of budgetary control is reflected from the fact that it helps the
management to efficiently track the company’s performance. Such monitoring
ensures that the deviation of the company’s actual performance from the
budgeted one is always under the scanner and can be rectified before it toolate.
Application activity 5.2
What are the benefits of having budgetary control mechanism to abusiness?
5.3. Report and Recommendation to Management
Read the following information and answer the questions below.
The reporting to management is a process of providing to various levels of
management, so as to enable them judging the effectiveness of their responsibility
centres and become a base for taking corrective measures.
Management Accounting | Experimental Version | Student Book | Senior SixQuestion:
What are the benefits of report and recommendation to management?
5.3.1. Report to Management
Reporting to management can be defined as an organized method of providing
each manager with all the data and which he needs for his decision, when
he needs them and in a form which aids his understanding and stimulates his
action.
Finally, compile all of the results into a singular report for management. The
report should contain the identified variances and the root causes of each
variance. It should also contain corrective actions and recommendations for
management on what to do.
5.3.2. Recommendation to Management
Management recommendations means determinations of, amount of, level of
intensity, timing of, any restrictions , conditions , mitigation , or allowances for
activities proposed for a project area pursuant to this rule.
Before approaching management with any recommendation, first point out the
following:
• Clarify your thoughts through the act writing.
• Serve as notes you can refer to during your discussion• Provide your manager with written record to refer to late
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Application activity 5.3
Skills Lab 5
Students visit the manufacturing company located in their school
environment with their teacher. The later requests in favour of students the
budget prepared for last 10 months. The planning officer or budget officer
provide again the document showing the actual cost incurred. Referring
to those two different documents, the students in manageable groups arerequested to calculate the variance if any and advice the current managers.
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End of unit assessment 5
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Accounting Management | Student Book | Senior Six