Direct material price variances are usually extracted at the time of the receipt of the materials rather than at the time of usage.
Suppose that a company uses raw material P in production, and that this raw material has a standard price of $3 per metre. During one month 6,000 metres are bought for $18,600, and 5,000 metres are used in production. At the end of the month, inventory will have been increased by 1,000 metres. In variance analysis, the problem is to decide the material price variance. Should it be calculated on the basis of materials purchased (6,000 metres) or on the basis of materials used (5,000 metres)?
The answer to this problem depends on how closing inventories of the raw materials will be valued.
(a) If they are valued at standard cost, (1,000 units at $3 per unit) the price variance is calculated on material purchases in the period.
(b) If they are valued at actual cost (FIFO) (1,000 units at $3.10 per unit) the price variance is calculated on materials used in production in the period.
A full standard costing system is usually in operation and therefore the price variance is usually calculated on purchases in the period. The variance on the full 6,000 metres will be written off to the costing income statement, even though only 5,000 metres are included in the cost of production.
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There are two main advantages in extracting the material price variance at the time of receipt.
(a) If variances are extracted at the time of receipt they will be brought to the attention of
managers earlier than if they are extracted as the material is used. If it is necessary to correct any variances then management action can be more timely.
(b) Since variances are extracted at the time of receipt, all inventories will be valued at standard price. This is administratively easier and it means that all issues from inventory can be made at standard price. If inventories are held at actual cost it is necessary to calculate a separate price variance on each batch as it is issued. Since issues are usually made in a number of small batches this can be a time-consuming task, especially with a manual system.
The price variance would be calculated as follows:
$
6,000 metres of material P purchased should cost (× $3) 18 000
but did cost 18 600
Price variance 600 (U)
3 Direct labour cost variances
Section overview
• The direct labour total variance can be subdivided into the direct labour rate variance and the direct labour efficiency variance.
• If idle time arises, it is usual to calculate a separate idle time variance, and to base the calculation of the efficiency variance on active hours, when labour actually worked, only. It is always an
unfavourable variance.
The direct labour total variance is the difference between what the output should have cost and what it did cost, in terms of labour.
The direct labour rate variance. This is similar to the direct material price variance. It is the difference between the standard rate and the actual rate for the actual number of hours paid for.
In other words, it is the difference between what the labour did cost and what it should have cost.
The direct labour efficiency variance is similar to the direct material usage variance. It is the
difference between the hours that should have been worked for the number of units actually produced, and the actual number of hours worked, valued at the standard rate per hour.
In other words, it is the difference between how many hours should have been worked and how many hours were worked, valued at the standard rate per hour.
The calculation of direct labour variances is very similar to the calculation of direct material variances.
Worked Example: Direct labour variances
The standard direct labour cost of product X is as follows:
2 hours of grade Z labour at $5 per hour = $10 per unit of product X.
During period 4, 1,000 units of product X were made, and the direct labour cost of grade Z labour was
$8 900 for 2 300 hours of work.
Calculate the following variances:
(a) The direct labour total variance.
(b) The direct labour rate variance.
(c) The direct labour efficiency (productivity) variance.
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Solution
(a) The direct labour total variance
This is the difference between what 1 000 units should have cost and what they did cost.
$
1 000 units should have cost (× $10) 10 000
but did cost 8 900
Direct labour total variance 1 100 (F)
The variance is favourable because the units cost less than they should have done.
Again we can analyse this total variance into its two constituent parts.
(b) The direct labour rate variance
This is the difference between what 2 300 hours should have cost and what 2 300 hours did cost.
$
2 300 hours of work should have cost (× $5 per hr) 11 500
but did cost 8 900
Direct labour rate variance 2 600 (F)
The variance is favourable because the labour rate was less than the standard rate.
(c) The direct labour efficiency variance
1 000 units of X should have taken (× 2 hrs) 2 000 hrs
but did take 2 300 hrs
Efficiency variance in hours 300 hrs (U)
× standard rate per hour × $5
Efficiency variance in $ $1 500 (U)
The variance is unfavourable because more hours were worked than should have been worked.
(d) Summary
$
Rate variance 2 600 (F)
Efficiency variance 1 500 (U)
Total variance 1 100 (F)
4 Variable production overhead variances
Section overview
• The variable production overhead total variance can be subdivided into the variable production overhead expenditure variance and the variable production overhead efficiency variance (based on actual hours).
Worked Example: Variable production overhead variances
Suppose that the variable production overhead cost of product X is as follows:
2 hours at $1.50 = $3 per unit
During period 6, 400 units of product X were made. The labour force worked 820 hours, of which 60 hours were recorded as idle time. The variable overhead cost was $1 230.
Calculate the following variances:
(a) The variable overhead total variance.
(b) The variable production overhead expenditure variance.
(c) The variable production overhead efficiency variance.
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Solution
Since this example relates to variable production costs, the total variance is based on actual units of
production. (If the overhead had been a variable selling cost, the variance would be based on sales volumes.)
$
400 units of product X should cost (× $3) 1 200
but did cost 1 230
Variable production overhead total variance 30 (U)
In many variance reporting systems, the variance analysis goes no further, and expenditure and efficiency variances are not calculated. However, the unfavourable variance of $30 may be explained as the sum of two factors:
(a) The hourly rate of spending on variable production overheads was higher than it should have been, that is there is an expenditure variance.
(b) The labour force worked inefficiently, and took longer to make the output than it should have done.
This means that spending on variable production overhead was higher than it should have been, in other words there is an efficiency (productivity) variance. The variable production overhead efficiency variance is exactly the same, in hours, as the direct labour efficiency variance, and occurs for the same reasons.
It is usually assumed that variable overheads are incurred during active working hours, but are not incurred during idle time (for example, the machines are not running, therefore power is not being consumed, and no indirect materials are being used). This means in our example that although the labour force was paid for 820 hours, they were actively working for only 760 of those hours and so variable production overhead spending occurred during 760 hours.
The variable production overhead expenditure variance is the difference between the amount of variable production overhead that should have been incurred in the actual hours actively worked, and the actual amount of variable production overhead incurred.
(a)
$ 760 hours of variable production overhead should cost ( × $1.50) 1 140
but did cost 1 230
Variable production overhead expenditure variance 90 (U) The variable production overhead efficiency variance. If you already know the direct labour efficiency variance, the variable production overhead efficiency variance is exactly the same in hours, but priced at the variable production overhead rate per hour.
(b) In our example, the efficiency variance would be as follows.
400 units of product X should take (× 2hrs) 800 hrs
but did take (active hours) 760 hrs
Variable production overhead efficiency variance in hours 40 hrs (F)
× standard rate per hour ×$1.50
Variable production overhead efficiency variance in $ $60 (F) (c) Summary
Variable production overhead expenditure variance 90 (U)$
Variable production overhead efficiency variance 60 (F))
Variable production overhead total variance 30 (U)
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5 Fixed production overhead variances
Section overview
• The fixed production overhead total variance can be subdivided into an expenditure variance and a volume variance. The fixed production overhead volume variance can be further subdivided into an efficiency and capacity variance.
You may have noticed that the method of calculating cost variances for variable cost items is essentially the same for labour, materials and variable overheads. Fixed production overhead variances are very different.
In an absorption costing system, they are an attempt to explain the under- or over-absorption of fixed production overheads in production costs.
The fixed production overhead total variance (i.e. the under- or over-absorbed fixed production overhead) may be broken down into two parts as usual:
• An expenditure variance.
• A volume variance.
You will find it easier to calculate and understand fixed overhead variances, if you keep in mind the whole time that you are trying to 'explain' (put a name and value to) any under- or over-absorbed overhead.