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STANDARD COSTING-DETAILED ANALYSIS OF MATERIAL VARIANCE

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STANDARD COSTING-DETAILED ANALYSIS OF
MATERIAL VARIANCE

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STANDARD COSTING-DETAILED ANALYSIS OF MATERIAL VARIANCE

  1. 1. 1 STANDARD COSTING-DETAILED ANALYSIS OF MATERIAL VARIANVE Introduction to Standard Costing Standard costing is an important subtopic of cost accounting. Standard costs are usually associated with a manufacturing company's costs of direct material, direct labor, and manufacturing overhead. Rather than assigning the actual costs of direct material, direct labor, and manufacturing overhead to a product, many manufacturers assign the expected or standard cost. This means that a manufacturer's inventories and cost of goods sold will begin with amounts reflecting the standard costs, not the actual costs, of a product. Manufacturers, of course, still have to pay the actual costs. As a result there are almost always differences between the actual costs and the standard costs, and those differences are known as variances. Standard costing and the related variances is a valuable management tool. If a variance arises, management becomes aware that manufacturing costs have differed from the standard (planned, expected) costs. If actual costs are greater than standard costs the variance is unfavorable. An unfavorable variance tells management that if everything else stays constant the company's actual profit will be less than planned. If actual costs are less than standard costs the variance is favorable. A favorable variance tells management that if everything else stays constant the actual profit will likely exceed the planned profit. The sooner that the accounting system reports a variance, the sooner that management can direct its attention to the difference from the planned amounts. If we assume that a company uses the perpetual inventory system and that it carries all of its inventory accounts at standard cost (including Direct Materials Inventory or Stores), then the standard cost of a finished product is the sum of the standard costs of the inputs:
  2. 2. 2 Direct material Direct labor Manufacturing overhead Variable manufacturing overhead Fixed manufacturing overhead Usually there will be two variances computed for each input: Since the calculation of variances can be difficult, we developed several business forms to help you get started and to understand what the variances tell us. Let's assume that your Uncle Pete runs a retail outlet that sells denim aprons in two sizes. Pete suggests that you get into the manufacturing side of the business, so on January 1, 2013 you start up an apron production company called Denim Works. Using the best information at hand, the two of you compile the following estimates to use as standards for 2013: The aprons are easy to produce, and no apron is ever left unfinished at the end of any given day. This means that your company never has work-in-process inventory. When we make your journal entries for completed aprons (shown below), we'll use an account called Inventory-FG which means Finished Goods Inventory. (Some companies will use WIP Inventory or Work-in-Process Inventory). We'll also use the account Direct Materials Inventory. (Other account titles often used for direct materials are Raw Materials Inventory or Stores.) Direct Materials Purchased: Standard Cost and Price Variance Direct materials refer to just that—raw materials that are directly traceable into a product. In your apron business the direct material is the denim. (In a food manufacturer's business the direct materials are the ingredients such as flour and sugar; in an automobile assembly plant, the direct materials are the cars' component parts). Denim Works purchases its denim from a local supplier with terms of net 30 days, FOB destination. This means that title to the denim passes from the supplier to Denim Works when
  3. 3. 3 Denim Works receives the material. When the denim arrives, Denim Works will record the denim received in its Direct Materials Inventory at the standard cost of rs3 per yard (see standards table above) and will record the liability at the actual cost for the amount received. Any difference between the standard cost of the material and the actual cost of the material received is recorded as a purchase price variance. Examples of Standard Cost of Materials and Price Variance Let's assume that on January 2, 2013 Denim Works ordered 1,000 yards of denim at rs2.90 per yard. On January 8, 2013 Denim Works receives 1,000 yards of denim and an invoice for the actual cost of rs2,900. On January 8, 2013 Denim Works becomes the owner of the material and has a liability to its supplier. On January 8 Denim Works' Direct Materials Inventory is increased by the standard cost of rs3,000 (1,000 yards of denim at the standard cost of rs3 per yard), Accounts Payable is credited for rs2,900 (the actual amount owed to the supplier), and the difference of rs100 is credited to Direct Materials Price Variance. In general journal format the entry looks like this: The rs100 credit to the price variance account communicates immediately (when the denim arrives) that the company is experiencing actual costs that are more favorable than the planned, standard cost. In February, Denim Works orders 3,000 yards of denim at rs3.05 per yard. On March 1, 2013 Denim Works receives the 3,000 yards of denim and an invoice for rs9,150 due in 30 days. On March 1, the Direct Materials Inventory account is increased by the standard cost of rs9,000 (3,000 yards at the standard cost of rs3 per yard), Accounts Payable is credited for rs9,150 (the actual cost of the denim), and the difference of rs150 is debited to Direct Materials Price Variance as an unfavorable price variance: After the March 1 transaction is posted, the Direct Materials Price Variance account shows a debit balance of rs50 (the rs100 credit on January 2 combined with the rs150 debit on March 1). A debit balance in a variance account is always unfavorable—it shows that the total of actual costs is higher than the total of the expected standard costs. In other words, your company's profit will be rs50 less than planned unless you take some action.
  4. 4. 4 On June 1 your company receives 3,000 yards of denim at an actual cost of rs2.92 per yard for a total of rs8,760 due in 30 days. The entry is: Direct Materials Inventory is debited for the standard cost of rs9,000 (3,000 yards at rs3 per yard), Accounts Payable is credited for the actual amount owed, and the difference of rs240 is credited to Direct Materials Price Variance. A credit to the variance account indicates that the actual cost is less than the standard cost. After this transaction is recorded, the Direct Materials Price Variance account shows an overall credit balance of rs190. A credit balance in a variance account is always favorable. In other words, your company's profit will be rs190 greater than planned due to the favorable cost of direct materials. Note that the entire price variance pertaining to all of the direct materials received was recorded immediately. In other words, the price variance associated with the direct materials received was not delayed until the materials were used. We will discuss later how to handle the balances in the variance accounts under the heading "What To Do With Variance Amounts". Direct Materials Usage Variance Under a standard costing system, production and inventories are reported at the standard cost— including the standard quantity of direct materials that should have been used to make the products. If the manufacturer actually uses more direct materials than the standard quantity of materials for the products actually manufactured, the company will have an unfavorable direct materials usage variance. If the quantity of direct materials actually used is less than the standard quantity for the products produced, the company will have a favorable usage variance. The amount of a favorable and unfavorable variance is recorded in a general ledger account Direct Materials Usage Variance. (Alternative account titles include Direct Materials Quantity Variance or Direct Materials Efficiency Variance.) Let's demonstrate this variance with the following information.
  5. 5. 5 January 2013 In order to calculate the direct materials usage or quantity variance, we start with the number of acceptable units of products that have been manufactured—also known as the good output. At Denim Works this is the number of good aprons physically produced. If Denim Works produces 100 large aprons and 60 small aprons during January, the production and the finished goods inventory will begin with the cost of the direct materials that should have been used to make those aprons. Any difference will be a variance. Note: We are not determining the quantity of aprons that Denim Works should have made. Rather, we are determining whether the 100 large aprons and 60 small aprons that were actually manufactured were produced efficiently. In the case of direct materials, we want to determine whether or not the company used the proper amount of denim to make the 160 aprons that were actually produced. (For the purposes of calculating the direct materials usage variance, it does not concern us whether Denim Works had a goal to produce 100 aprons, 200, aprons, or 250 aprons.) Standard costs are sometimes referred to as the "should be costs." Denim Works should be using 278 yards of denim to make 100 large aprons and 60 small aprons as shown in the following table. We determine the total standard cost of the denim that should have been used to make the 160 aprons by multiplying the standard quantity of denim (278 yards) by the standard cost of a yard of denim (rs3 per yard):
  6. 6. 6 An inventory account (such as F.G. Inventory or Work-in-Process) is debited for rs834; this is the standard cost of the direct materials component in the aprons manufactured in January 2013. The Direct Materials Inventory account is reduced by the standard cost of the denim actually removed from the direct materials inventory. Let's assume that the actual quantity of denim removed from the direct materials inventory and used to make the aprons in January was 290 yards. Because Direct Materials Inventory reports the standard cost of the actual materials on hand, we reduce the account balance by rs870 (290 yards used rs3 standard cost per yard). After removing 290 yards of materials, the balance in the Direct Materials Inventory account is rs2,130 (710 yards x rs3 standard cost per yard). The Direct Materials Usage Variance is: [the standard quantity of material that should have been used to make the good output minus the actual quantity of material used] X the standard cost per yard. In our example, Denim Works should have used 278 yards of material to make 100 large aprons and 60 small aprons. Because the company actually used 290 yards of denim, we say that Denim Works did not operate efficiently—an extra 12 yards of denim was used (278 vs. 290 = 12). When we multiply the 12 yards by the standard cost of rs3 per yard, the result is an unfavorable direct materials usage variance of rs36. Let's put the above information into a format commonly used for computing variances:
  7. 7. 7 Direct Materials Usage/Quantity/Efficiency Variance Analysis The journal entry for the direct materials portion of the January production is: February 2013 Let's assume that in February 2013 Denim Works produces 200 large aprons and 100 small aprons and that 520 yards of denim are actually used. From this information we can compute the following:
  8. 8. 8 Let's put the above information into our format: Direct Materials Usage (or Quantity) Variance Analysis The journal entry for the direct materials portion of the February production is:
  9. 9. 9 Standard Costing Standard costing is the practice of substituting an expected cost for an actual cost in the accounting records, and then periodically recording variances that are the difference between the expected and actual costs. This approach represents a simplified alternative to cost layering systems, such as the FIFO and LIFO methods, where large amounts of historical cost information must be maintained for items held in stock. Standard costing involves the creation of estimated (i.e., standard) costs for some or all activities within a company. The core reason for using standard costs is that there are a number of applications where it is too time-consuming to collect actual costs, so standard costs are used as a close approximation to actual costs. Since standard costs are usually slightly different from actual costs, the cost accountant periodically calculates variances that break out differences caused by such factors as labor rate changes and the cost of materials. The cost accountant may also periodically change the standard costs to bring them into closer alignment with actual costs. Advantages of Standard Costing Though most companies do not use standard costing in its original application of calculating the cost of ending inventory, it is still useful for a number of other applications. In most cases, users are probably not even aware that they are using standard costing, only that they are using an approximation of actual costs. Here are some potential uses: Budgeting: A budget is always composed of standard costs, since it would be impossible to include in it the exact actual cost of an item on the day the budget is finalized. Also, since a key application of the budget is to compare it to actual results in subsequent periods, the standards used within it continue to appear in financial reports through the budget period. Inventory costing: It is extremely easy to print a report showing the period-end inventory balances (if you are using a perpetual inventory system), multiply it by the standard cost of each item, and instantly generate an ending inventory valuation. The result does not exactly match the actual cost of inventory, but it is close. However, it may be necessary to update standard costs frequently, if actual costs are continually changing. It is easiest to update costs for the highest-
  10. 10. 10 dollar components of inventory on a frequent basis, and leave lower-value items for occasional cost reviews. Overhead application: If it takes too long to aggregate actual costs into cost pools for allocation to inventory, then you may use a standard overhead application rate instead, and adjust this rate every few months to keep it close to actual costs. Price formulation: If a company deals with custom products, then it uses standard costs to compile the projected cost of a customer’s requirements, after which it adds on a margin. This may be quite a complex system, where the sales department uses a database of component costs that change depending upon the unit quantity that the customer wants to order. This system may also account for changes in the company’s production costs at different volume levels, since this may call for the use of longer production runs that are less expensive. Nearly all companies have budgets and many use standard cost calculations to derive product prices, so it is apparent that standard costing will find some uses for the foreseeable future. In particular, standard costing provides a benchmark against which management can compare actual performance. Problems with Standard Costing Despite the advantages just noted for some applications of standard costing, there are substantially more situations where it is not a viable costing system. Here are some problem areas: Cost-plus contracts: If you have a contract with a customer under which the customer pays you for your costs incurred, plus a profit (known as a cost-plus contract), then you must use actual costs, as per the terms of the contract. Standard costing is not allowed. Drives inappropriate activities: A number of the variances reported under a standard costing system will drive management to take incorrect actions to create favorable variances. For example, they may buy raw materials in larger quantities in order to improve the purchase price variance, even though this increases the investment in inventory. Similarly, management may schedule longer production runs in order to improve the labor efficiency variance, even though it is better to produce in smaller quantities and accept less labor efficiency in exchange.
  11. 11. 11 Fast-paced environment: A standard costing system assumes that costs do not change much in the near term, so that you can rely on standards for a number of months or even a year, before updating the costs. However, in an environment where product lives are short or continuous improvement is driving down costs, a standard cost may become out-of-date within a month or two. Slow feedback: A complex system of variance calculations are an integral part of a standard costing system, which the accounting staff completes at the end of each reporting period. If the production department is focused on immediate feedback of problems for instant correction, the reporting of these variances is much too late to be useful. Unit-level information: The variance calculations that typically accompany a standard costing report are accumulated in aggregate for a company’s entire production department, and so are unable to provide information about discrepancies at a lower level, such as the individual work cell, batch, or unit. The preceding list shows that there are a multitude of situations where standard costing is not useful, and may even result in incorrect management actions. Nonetheless, as long as you are aware of these issues, it is usually possible to profitably adapt standard costing into some aspects of a company’s operations. Standard Cost Variances A variance is the difference between the actual cost incurred and the standard cost against which it is measured. A variance can also be used to measure the difference between actual and expected sales. Thus, variance analysis can be used to review the performance of both revenue and expenses. There are two basic types of variances from a standard that can arise, which are the rate variance and the volume variance. Here is more information about both types of variances: Rate variance: A rate variance (which is also known as a price variance) is the difference between the actual price paid for something and the expected price, multiplied by the actual quantity purchased. The “rate” variance designation is most commonly applied to the labor rate variance, which involves the actual cost of direct labor in comparison to the standard cost of
  12. 12. 12 direct labor. The rate variance uses a different designation when applied to the purchase of materials, and may be called the purchase price variance or the material price variance. Volume variance: A volume variance is the difference between the actual quantity sold or consumed and the budgeted amount, multiplied by the standard price or cost per unit. If the variance relates to the sale of goods, it is called the sales volume variance. If it relates to the use of direct materials, it is called the material yield variance. If the variance relates to the use of direct labor, it is called the labor efficiency variance. Finally, if the variance relates to the application of overhead, it is called the overhead efficiency variance. Thus, variances are based on either changes in cost from the expected amount, or changes in the quantity from the expected amount. The most common variances that a cost accountant elects to report on are subdivided within the rate and volume variance categories for direct materials, direct labor, and overhead. It is also possible to report these variances for revenue. It is not always considered practical or even necessary to calculate and report on variances, unless the resulting information can be used by management to improve the operations or lower the costs of a business. When a variance is considered to have a practical application, the cost accountant should research the reason for the variance in considerable detail and present the results to the responsible manager, perhaps also with a suggested course of action. Standard Cost Creation At the most basic level, you can create a standard cost simply by calculating the average of the most recent actual cost for the past few months. In many smaller companies, this is the extent of the analysis used. However, there are some additional factors to consider, which can significantly alter the standard cost that you elect to use. They are: Equipment age: If a machine is nearing the end of its productive life, it may produce a higher proportion of scrap than was previously the case. Equipment setup speeds: If it takes a long time to setup equipment for a production run, the cost of the setup, as spread over the units in the production run, is expensive. If a setup reduction plan is contemplated, this can yield significantly lower overhead costs.
  13. 13. 13 Labor efficiency changes: If there are production process changes, such as the installation of new, automated equipment, then this impact the amount of labor required to manufacture a product. Labor rate changes: If you know that employees are about to receive pay raises, either through a scheduled raise or as mandated by a labor union contract, then incorporate it into the new standard. This may mean setting an effective date for the new standard that matches the date when the cost increase is supposed to go into effect. Learning curve: As the production staff creates an increasing volume of a product, it becomes more efficient at doing so. Thus, the standard labor cost should decrease (though at a declining rate) as production volumes increase. Purchasing terms: The purchasing department may be able to significantly alter the price of a purchased component by switching suppliers, altering contract terms, or by buying in different quantities. Any one of the additional factors noted here can have a major impact on a standard cost, which is why it may be necessary in a larger production environment to spend a significant amount of time formulating a standard cost.
  14. 14. 14 FORMULA Direct Materials Variances: Materials purchase price variance Formula: Materials purchase price variance = (Actual quantity purchased × Actual price) – (Actual quantity purchased × Standard price) Materials price usage variance formula Materials price usage variance = (Actual quantity used × Actual price) – (Actual quantity used × Standard price) materials quantity / usage variance formula Materials price usage variance = (Actual quantity used × Standard price) – (Standard quantity allowed × Standard price) Materials mix variance formula (Actual quantities at individual standard materials costs) – (Actual quantities at weighted average of standard materials costs) Materials yield variance formula (Actual quantities at weighted average of standard materials costs) – (Actual output quantity at standard materials cost)
  15. 15. 15 MATERIAL COST VARIANCE (SQ*SP) - (AQ*AP) STD COST – ACT COST MATERIAL USAGE VARIANCE (SQ*SP) - (AQ*SP) (SQ-AQ) * SP MATERIAL PRICE VARIANCE (SP*AQ) - (AP*AQ) (SP-AP) *AQ MATERIAL MIX VARIANCE 𝑇𝑄 𝑜𝑓 𝑎𝑐𝑡𝑢𝑎𝑙 𝑚𝑖𝑥 𝑇𝑄 𝑜𝑓 𝑠𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑚𝑖𝑥 ∗ 𝑠𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑄 𝑜𝑓 𝑥 MATERIAL YEILD VARIANCE (SP*SQ) – (SP*RQ) (SQ-RQ) *SP I.e. MCV = MUV + MPV MCV = MMV + MYV
  16. 16. 16 Materialcostvariance Learning Objectives To know how to calculate material cost variance To know how to calculate material usage variance To know how to calculate material price variance Terminology for Material Variance Calculation SQ =Standard Quantity SR = Standard Rate AQ = Actual Quantity AP = Actual Price RSQ = Resaved STD Quantity MCV = Material Cost Variance MUV = Material Usage Variance MPV = Material Price Variance MMV = Material Mix Variance MYV = Material Yield Variance
  17. 17. 17 Problem 1 The following information is obtained from X Co. Ltd.Product SQ SP AQ AP(Units) (Rs.) (Units) (Rs.)A 1050 2.00 1100 2.25B 1500 3.25 1400 3. 50C 2100 3.50 2000 3.75Calculate the following: Material cost variance Material price variance Material usage variance Solution 1. MCV = (SQ x SR) – (AQ x AR)A = (1050 x 2.00) – (1100 x 2.25)= 2100 – 2475 = Rs. 375 (A)B = (1500 x 3.25) – (1400 x 3.50)= 4875 – 4900 = 25 (A) 2C = (2100 x 3.50) – (2000 x 7.25)= 7350 – 7500 = 150 (A)--------------------550 A---------------- ----2. MPV = AQ (SP-AP)A = 1100(2.00 – 2.25) = 1100 x (0.25) = Rs. 275 (A)B = 1400(3.25 – 3.50) = 1400 x (-0.25) = Rs. 350 (A)C = 2000(3.50 – 3.75) = 2000 x (-0.25) = Rs. 500 (A)------- ----------1125 A-----------------3. MUV = SP (SQ-AQ)A = 2 (1050 -1100) = 2 (- 50) = Rs. 100 (A)B = 3.25 (1500 – 1400) = 3.25 (100) = Rs. 325 (F)C = 3.50 (2100 - 2000) = 3.50 (100) = Rs. 350 (F)---------------575 (F)--------------- Verification MCV = MPV + MUVRs. 550 (A) = 1125(A) + 575 F550 (A) = 550 (A) Problem 2 Product SQ SP Total AQ AP TotalA 10 2 20 5 3 15B 20 3 60 10 6 60C 20 6 120 15 5 75--- ----- - -- -----Total 50 200 30 150--- ----- --- -----Find out (1) MCV (2) MPV (3) MMV (4) MUV Sol.: (1) MCV = (SQ x SR) – (AQ x AR)A = (10 x 2) – (5 x 3) = 5 FB = (20 x 3) – (10 x 6) = Nil
  18. 18. 18 Direct Material Price Variance Direct material price variance (also called the direct material spending/rate variance) is the product of actual quantity of direct material used and the difference between standard price and actual price per unit of direct material. It is calculated using the following formula: DM Price Variance = (SP − AP) × AQ Where, SP is the standard unit price of direct material AP is the actual price per unit of direct material AQ is the actual quantity of direct material used Analysis Direct material price variance is calculated to determine the efficiency of purchasing department in obtaining direct material at low cost. A positive value of direct material price variance is favorable which means that direct material was purchased for lesser amount than the standard price. A negative value of direct material price variance is unfavorable because more than estimated price per unit is paid. However, a favorable direct material price variance is not always good; it should be analyzed together with direct material quantity variance. It is quite possible that the purchasing department may purchase low quality raw material to generate a favorable direct material price variance. Such a favorable material price variance will be offset by an unfavorable direct material quantity variance due to wastage of low quality direct material. Example Calculate the direct material price variance if the standard price and actual unit price per unit of direct material are RS4.00 and RS4.10 respectively; and actual units of direct material used during the period are 1,200. Determine whether the variance is favorable or unfavorable.
  19. 19. 19 Standard Price RS4.00 − Actual Price 4.10 Difference Per Unit − 0.10 × Actual Quantity 1,200 Direct Material Price Variance − RS 120 Since the price paid by the company for the purchase of direct material is more than the standard price by RS120, the DM price variance is unfavorable. In managerial accounting, variance means deviation of actual costs from standard costs. Materials price variance is the result of deviation of actual price paid for materials from what has been set as standard. Direct materials price and quantity standards are set after keeping in mind the current market prices and anticipated changes in materials prices in near future. However things do not always happen as expected. The actual price of materials may significantly deviate from standard price. Moreover, the expenses associated with the order (freight, duties, handling expenses etc.) may increase or reduce the price of materials available for use. The business may have to pay more or less price than what has been considered as normal at the time of setting standards. If the actual price paid for materials is more than the standard price, an unfavorable materials price variance occurs. On the other hand, if the actual price paid for the materials is less than the standard price, a favorable materials price variance occurs. An example is given below for more explanation: Example The Aptex Company manufactures and sells small speakers that are used in mobile phones. The speakers are sold in bulk to mobile manufacturing companies where complete mobiles are produced. The direct material of Aptex Company is a thin copper coil. One meter of the copper coil is the standard requirement to manufacture one speaker. The standard cost to manufacture one speaker is as follows:
  20. 20. 20 Direct materials: 1meters × RS1.50 per meters RS1.50 Direct labor RS1.00 Manufacturing overhead RS0.50 —– Total RS3.00 —– During the month of June, Aptex purchased 5,000 meters of copper coil @ RS1.70 per meter and produced 2,500 speakers using 3,000 meters of copper coil. The materials price variance for the month of June can be calculated using the following formula/equation: = (5,000 × RS1.70) – (5,000 × RS1.50) = RS8,500 – RS7,500 = 1,000 Unfavorable Aptex has an unfavorable materials price variance for June because the actual price paid (RS8,500) is more than the standard price allowed (RS7,500) for 5,000 meters of copper coil. This variance can also be computed by using the factored form of above formula: AQ × (AP – SP) 5,000 meters × (RS1.70 – RS1.50) 5,000 meters × RS0.20 RS1,000 Unfavorable
  21. 21. 21 Reasons of direct materials price variance: A favorable or unfavorable material price variance may occur due to one or more of the following reasons: Order size: Some suppliers allow discount on large orders. The materials purchased in large quantities may reduce the unit price and a favorable price variance may occur. Rise in price: The rise in the general price level may increase the input costs of the vendor and as a result vendor may increase the price of the materials. The rise in price is very common reason of an unfavorable variance. Urgent needs: If production department does not indicate the need of materials on time, the purchasing department may have to order on urgent basis that may increase the price of materials and other expenses associated with the order. Quality: A favorable price variance may be the result of purchasing low quality materials and an unfavorable variance may be the result of purchasing high quality materials. Inefficient standard setting: Inefficiencies in terms of forecasting and environmental scanning during standard setting process can be a reason of huge variances. Transportation: Transportation is a part of total direct materials cost. Any change in the transportation expenses can change the total and per unit cost of direct materials available for use and can become the reason of favorable or unfavorable direct materials price variance. The role of just in time manufacturing: A company that operates under just in time (JIT) manufacturing system may have to face shortage of direct materials due to a sudden increase in demand for the product. The orders in rush normally increase the costs. In that case company will have to either accept an unfavorable materials price variance or lost sales. Inefficient or unreliable Suppliers: A deviation from standard material costs may be the result of inefficient or unreliable vendors. For example, if suppliers of raw materials are unable to meet the demand, the company may have to look for another supplier who may be more costly.
  22. 22. 22 Responsibility of the variance: Purchasing department is responsible to place orders for direct materials so this variance is generally considered the responsibility of purchase manager. However, the above reasons clarify that the materials price variance may or may not be the result of inefficiencies of the purchasing department. The occurrence of variances is very normal. They occur for almost all cost elements and should not be used to find someone to blame. Sometimes they may not be very significant and sometimes they may be the result of the factors that are beyond the control of managers. Variances are tools to control costs, improve efficiencies and should be used positively. Direct Material Quantity Variance Direct material quantity variance (also called the direct material usage/efficiency variance) is the product of standard price of a unit of direct material and the difference between standard quantity of direct material allowed and actual quantity of direct material used. The formula to calculate direct material quantity variance is: DM Quantity Variance = ( SQ − AQ ) × SP Where, SQ is the standard quantity allowed AQ is the actual quantity of direct material used SP is the standard price per unit of direct material Standard quantity allowed (SQ) is calculated as the product of standard quantity of direct material per unit and actual units produced. Analysis Direct material quantity variance is calculated to determine the efficiency of production department in converting raw material to finished goods. In order to improve efficiency, wastage of raw material must be reduced. A negative value of direct material quantity variance is
  23. 23. 23 unfavorable and it implies that more quantity of direct material has been used in the production process than actually needed. A positive value of direct material quantity variance is favorable implying that raw material was efficiently converted to finished goods. Example Use the following information to calculate direct material quantity variance. Also specify whether the variance is favorable or unfavorable. Standard Price of a Unit of Direct Material RS4 Standard Quantity of Direct Material Per Unit 2 Actual Units Produced During the Period 620 Actual Quantity Used During the Period 1,200 Solution Actual Units Produced 620 × Standard Quantity of Direct Material Per Unit 2 Standard Quantity Allowed 1,240 Standard Quantity Allowed 1,240 − Actual Quantity 1,200 Difference 40 × Standard Price of a Unit of Direct Material RS4 Direct Material Quantity Variance RS160 In this case the production department performed efficiently and saved 40 units of direct material. Multiplying this by standard price per unit yields a favorable direct material quantity variance of RS160.
  24. 24. 24 Direct Material Usage Variance Direct Material Usage Variance is the measure of difference between the actual quantity of material utilized during a period and the standard consumption of material for the level of output achieved. Direct Material Usage Variance: = Actual Quantity x Standard Price - Standard Quantity x Standard Price = Standard Cost of Actual Quantity - Standard Cost of Standard Quantity = (Actual Quantity - Standard Quantity) x Standard Price Since the effect of any variation in material price from the standard is calculated in the material price variance, material usage variance is calculated using the standard price. Example Cement PLC manufactured 10,000 bags of cement during the month of January. Consumption of raw materials during the period was as follows: Material Quantity Used Standard Usage Per Bag Actual Price Standard Price Limestone 100 tons 11 KG RS75/ton RS70/ton Clay 150 tons 14 KG RS21/ton RS20/ton Sand 250 tons 26 KG RS11/ton RS10/ton Material Usage Variance will be calculated as follows: Step 1: Calculate Standard Quantity Limestone: 10,000 units x 11 / 1000 = 110 tons Clay: 10,000 units x 14 / 1000 = 140 tons Sand: 10,000 units x 26 / 1000 = 260 tons
  25. 25. 25 Step 2: Calculate the Variance Material Usage Variance = [Actual Quantity - Standard Cost (Step 2)] x Standard Price Limestone: (100 - 110) x RS70 = (RS700) Favorable Clay: (150 - 140) x RS20 = RS200 Adverse Sand: (250 - 260) x RS10 = (RS100) Favorable Total Usage Variance (RS600) Favorable Note: Actual price paid for the acquisition of materials shall be ignored since the variation between standard price is already accounted for in the material price variance. Analysis A favorable material usage variance suggests efficient utilization of materials. Reasons for a favorable material usage variance may include: Purchase of materials of higher quality than the standard (this will be reflected in adverse material price variance) Greater use of skilled labor Training and development of workforce to improve productivity Use and improvement of automated manufacturing tools and processes An adverse material usage variance indicates higher consumption of material during the period as compared with the standard usage. Reasons for adverse material usage variance include: Purchase of materials of lower quality than the standard Use of unskilled labor Increase in material wastage due to depreciation of plant and equipment
  26. 26. 26 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. Direct Material Mix Variance: = Actual Quantity x Standard Price - Standard Mix Quantity x Standard Price = Standard Cost of Actual Mix - Standard Cost of Standard Mix = (Actual Mix Quantity - Standard Mix Quantity) x Standard Price As material mix variance is an extension of the material usage variance, the variance is based on the standard price rather than actual price since the difference between actual and standard material price is accounted for separately in the material price variance. Example Cement PLC manufactured 10,000 bags of cement during the month of January. Consumption of raw materials during the period was as follows: Material Quantity UsedStandard Mix Per BagActual Price Standard Price Limestone 100 tons 11 KG RS75/ton RS70/ton Clay 150 tons 14 KG RS21/ton RS20/ton Sand 250 tons 26 KG RS11/ton RS10/ton
  27. 27. 27 Material Mix Variance will be calculated as follows: Step 1: Calculate the total consumption of raw materials Total Raw Materials Consumption (100 + 150 + 250) = 500 tons Step 2: Calculate the Standard Mix We need to calculate the quantity of each raw material which would have been consumed had the total usage of raw materials (500 tons) been based on the standard mix. Limestone: 500 tons units x11 / 51*=108 tons Clay: 500 tons units x14 / 51*=137 tons Sand: 500 tons units x26 / 51*=255 tons * Total Quantity under Standard Usage (11 + 14 + 26) = 51 KG per bag Note that the sum of the standard mix of raw materials calculated above equals the actual total consumption of 500 tons. This is because in material mix variance, we are not concerned about the efficiency of raw material consumption but rather their relevant proportions. Step 3: Calculate the Variance Material Usage Variance = [Actual Mix - Standard Mix (Step 2)] x Standard Price Limestone: (100 - 108) x RS70 = (RS560) Favorable Clay: (150 - 137) x RS20 = RS260 Adverse Sand: (250 - 255) x RS10 = (RS50) Favorable Total Usage Variance (RS350) Favorable
  28. 28. 28 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
  29. 29. 29 Direct 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. Direct Material Yield Variance: = (Actual Yield - Standard Yield) x Standard Material Cost Per Unit Example Cement PLC manufactured 10,000 bags of cement during the month of January. Consumption of raw materials during the period was as follows: Material Quantity UsedStandard Mix Per BagActual Price Standard Price Limestone 100 tons 11 KG RS75/KG RS70/KG Clay 150 tons 14 KG RS21/KG RS20/KG Sand 250 tons 26 KG RS11/KG RS10/KG Material Yield Variance shall be calculated as follows: Step 1: Calculate the Standard Yield for the total materials input 500 tons of materials should have yielded 9,804 bags Standard Yield = 500 tons x 1000 / 51 KG = 9,804 bags
  30. 30. 30 Step 2: Calculate the Standard Cost of materials per bag Total material cost of 1 bag of cement: Limestone: 11 KGxRS70 =RS770 Clay: 14 KGxRS20 =RS280 Sand: 26 KGxRS10 =RS260 Total RS1,310 per bag Actual material price should be ignored since the variance between actual and standard price is accounted for in the material price variance. Step 3: Calculate the Total Yield Variance Material Usage Variance = [Actual Yield - Standard Yield (Step 1)] x Standard Cost / Unit (Step 2) Actual Yield - Standard Yield = 10,000 - 9,804 (Step 1) = 196 bags Total Material Yield Variance = 196 bags x RS1,310 (Step 2) = RS256,760 Favorable As the actual output achieved during the period is higher than the standard yield, the variance is favorable. Favorable material yield variance indicates the amount of savings in material costs as a result of better output yield than the standard.
  31. 31. 31 Step 4: Calculate the Material Wise Yield Variances Individual material yield variance can be calculated in a similar way to the total yield variance. Materials: Actual Yield - Standard Yield (Step 3) x Standard Cost per bag (Step 2) =Yield Variance Limestone: 196 bags xRS770 =RS150,920 Clay: 196 bags xRS280 =RS54,880 Sand: 196 bags xRS260 =RS50,960 RS256,760 Note that sum of individual material yield variances equals the total yield variance calculated in step 3. 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.
  32. 32. 32 Conclusion Standard costing is a technique used for the purpose of determining standard cost and their comparison with the actual cost to find out the cause of difference between the two so that remedial action may be taken immediately. Direct material cost variance is the difference between the standard cost of materials specified for the output achieved, and the actual cost of direct materials consumed. Direct material price variance is the difference between actual price and standard price of materials consumed. Material usage variance is that portion of material cost which arises due to the difference between the standard quantity specified and the actual quantity used. Material mix variance may be defined as that portion of the material usage variance which is due to the difference between the standard and actual composition of material mixture. Material yield variance is calculated on the basis of output while the other variance are calculated on the basis of input. The variance is calculated as the difference between the standard output and actual output.
  33. 33. 33 Reference http://www.accountingcoach.com/standard-costing/explanation/1 http://www.accountingcoach.com/standard-costing/explanation/2 http://www.accountingtools.com/standard-costing http://www.accounting4management.com/variance_formulas.htm http://accountingexplained.com/managerial/standard-costing/dm-price-variance http://www.accountingformanagement.org/direct-materials-price-variance/ http://accounting-simplified.com/management/variance-analysis/material/usage.html http://accountingexplained.com/managerial/standard-costing/dm-quantity-variance http://accounting-simplified.com/management/variance-analysis/material/mix.html http://accounting-simplified.com/management/variance-analysis/material/yield.html https://www.scribd.com/doc/6988338/Material-Cost-Variance-Analysis

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