Will Crocker is an accountant at Southeast Accounting, a regional accounting firm headquartered in Charlotte, North Carolina.
Accounting personnel at Southeast Accounting are required to report time spent working on clients’ accounts. The actual reported time is used to estimate the labor time required for sim- ilar jobs for other clients and for subsequent jobs for the same client. Therefore, the reported time has two primary purposes. It is used to determine engagement fees—the amount the client will be charged for the job. It is also used to evaluate personnel efficiency—whether or not the employee is able to complete the job in the expected time.
Will has recently completed an engagement at a client’s loca- tion. Will’s actual time on the engagement was 70 hours, but the engagement was budgeted for 50 hours. Will is reluctant to report the 70 hours actually worked because it will create an unfavor- able direct labor efficiency variance. Accountants at Southeast Accounting often report actual engagement time at or just slightly above the budgeted time even if the actual time is substantially more. Should Will report the actual time spent on the engagement or under-report the time to avoid an unfavorable variance?
How much time should employees report?
DECISIONS
Solution
Will should report the actual time spent on each engagement.
Management, not aware that engagements are taking longer than expected, is routinely underestimating the time needed for the engagements in subsequent years. The employees’ actions are causing a never-ending loop—budgeted hours are too low, employees fail to report the actual higher amounts, and, therefore, subsequent budgeted hours are also too low. To help solve the problem, management needs to emphasize the need for accurate figures for budgeting purposes. By continually using inaccurate amounts, the firm is underestimating the cost to complete the engagements, which also causes it to undercharge the clients. This can create serious profitability issues.
Management also needs to work to erase the climate of fear at the firm, where employees feel threatened by the variance system and the impact unfavorable variances could have on their jobs. Variances should be used to investigate and make changes, not punish employees. In the current environment, it is improbable management will collect accurate information from the employees.
Sometimes managers think that only unfavorable variances should be evaluated, but both favorable and unfavorable variances should be investigated, if substantial, to deter
mine their causes. For example, suppose a company avoided routine maintenance on machinery which caused a favorable cost variance in the current period. In a later period, the company could have a major breakdown that could have been avoided if the machinery had been properly maintained. The breakdown could require not only a substantial repair bill, but also a halt in production that could lead to lost sales. Therefore, managers should look at any variance that is significant.
Let’s look at the flexible budget variances for direct materials and direct labor and separate them into their two components—cost and efficiency.
Direct Materials Variances
The flexible budget variance for direct materials is $13,000 unfavorable. Additional data concerning direct materials follow, including standards discussed in the previous section:
Direct materials cost standard $1.75 per pound of paraffin
Direct materials efficiency standard 1.00 pound of paraffin per batch of crayons Actual amount of paraffin purchased and used 65,000 pounds
Actual cost of paraffin purchased and used $104,000 Direct Materials Cost Variance
Using the above information, we can determine the direct materials cost variance which measures the difference between the amount actually paid for direct materials (actual cost) and the amount that should have been paid (standard cost). This variance measures how well the business keeps unit costs of direct materials within standards. Notice, first, that Cheerful Colors paid less than expected for the paraffin. The actual cost per pound of par
affin is $1.60 ($104,000 / 65,000 pounds = $1.60 per pound). Using the formula, the direct materials cost variance is $9,750 favorable. The calculation follows:
Favorable variances are good, right? Why should they be investigated?
Direct Materials Cost Variance The difference between the amount
actually paid for direct materials (actual cost) and what should have been paid (standard cost).
(AC- SC)*AQ.
Exhibit23-10 | Flexible Budget Variances for Production Costs
Direct Materials Direct Labor Units (Batches of 100)
Budget Amounts
per Unit Actual Results
Flexible Budget
Variance Flexible Budget
Variable Costs:
Fixed Costs:
Totals
Variable Overhead
Fixed Overhead
0.75 3.00
$ 1.75
52,000
30,160
23,920
$ 303,680
$ 104,000 145,600
$ 311,000 52,000
39,000
25,000
$ 91,000 156,000 8,840
1,080
$ 7,320
$ 13,000 10,400
U F F
F F
Direct Materials Cost Variance = (AC − SC) : AQ
= (+1.60 per pound - +1.75 per pound) * 65,000 pounds
= +9,750 F
The direct materials cost variance is favorable because the purchasing department paid less for paraffin than the standard cost.
Direct Materials Efficiency Variance
The direct materials efficiency variance measures the difference between the direct materials actually used (actual quantity) and the direct materials that should have been used for the actual output (standard quantity). This variance measures how well the business uses its materials. To calculate the direct materials efficiency variance, the standard quantity of inputs has to be deter
mined. The standard quantity of inputs is the quantity that should have been used for the actual units produced. For Cheerful Colors, the standard quantity of inputs (paraffin) that workers should have used for the actual number of crayon batches produced is 52,000 pounds (1.00 pound per batch * 52,000 batches). The direct materials efficiency variance is as follows:
Direct Materials Efficiency Variance
The difference between the direct materials actually used (actual quantity) and the direct materials that should have been used for the actual output (standard quantity).
(AQ -SQ) *SC.
Direct Materials Efficiency Variance = (AQ − SQ): SC
= (65,000 pounds - 52,000 pounds) * +1.75 per pound
= +22,750 U
The direct materials efficiency variance is unfavorable because workers used more paraffin than was planned (budgeted) for 52,000 batches of crayons.
Exhibit23-11 | Direct Materials Variances
AC × AQ
$104,000
SC × SQ
$1.75 per pound
× 52,000 pounds
$91,000 SC × AQ
$1.75 per pound
× 65,000 pounds
$1.60 per pound
× 65,000 pounds
$113,750
Total Direct Materials Variance
$13,000 U
Efficiency Variance Cost
Variance
$9,750 F $22,750 U
Favorable and unfavorable variances are netted together in the same way debits and credits are. Favorable variances are added together to create a total favorable variance. Unfavorable variances are added together to create a total unfavorable variance.
But if a favorable and an unfavorable variance exist, the variances are subtracted from each other. The variance is determined to be favorable or unfavorable based on
which one is the larger amount.
Summary of Direct Materials Variances
Exhibit 2311 summarizes how Cheerful Colors divides the $13,000 unfavorable direct
Let’s consider why each variance may have occurred and who may be responsible.
1. The purchasing manager is in the best position to explain the favorable cost variance.
Cheerful Colors’s purchasing manager may have negotiated a lower cost for paraffin.
2. The production manager in charge of making crayons can explain why workers used so much paraffin to make the 52,000 batches of crayons. Was the paraffin of lower quality that caused crayons to be rejected? Did workers waste materials? Did the production equipment malfunction? Cheerful Colors’s top management needs this information to decide what corrective action to take.
These variances raise questions that can help pinpoint problems. But be careful!
A favorable variance does not always mean that a manager did a good job, nor does an unfavorable variance mean that a manager did a bad job. Perhaps Cheerful Colors’s pur
chasing manager got a lower cost by purchasing inferiorquality materials. This could lead to wasted materials and poorquality crayons. If so, the purchasing manager’s decision hurt the company. This illustrates why good managers use variances as a guide for investigation, rather than merely to assign blame, and investigate favorable as well as unfavorable variances.
Kellogg Company was founded in 1906 and manufactures and markets ready-to-eat cereal and convenience foods. The com- pany’s brands include Apple Jacks, Corn Pops, Mueslix, and Rice Krispies Treats. The company also custom-bakes cookies for the Girl Scouts of the U.S.A. The primary raw materials used by Kel- logg Company include corn, wheat, potato flakes, soy bean oil, sugar, and cocoa. The cost of these agricultural commodities could fluctuate from budgeted costs due to government policy, weather conditions, and unforeseen circumstances. For example, over the last five years the cost of soy bean oil has decreased from
$1,255.67 per metric ton to $748.53 per metric ton.
What is the financial impact if actual commodity costs are different from budgeted commodity costs?
When actual costs are different from budgeted costs, a variance occurs. Understanding variances are important because they help companies, such as Kellogg Company, understand why a compa- ny’s operating income is higher or lower than expected. Variances can be either favorable (have a positive impact on operating income) or unfavorable (have a negative impact on operating income). Suppose that Kellogg had budgeted the cost of soy
bean oil at $1,255.67 per metric ton instead of $748.53. Kellogg would experience a cost variance because the actual cost would be less than the standard cost. This would create a significant favorable variance that would have a positive impact on operat- ing income.
Suppose Kellogg Company noticed that the total actual cost of soy bean oil was significantly different than the total budgeted amount. How could Kellogg Company investigate this difference in order to better understand the cause?
Kellogg Company should investigate this difference by deter- mining the total direct materials variance. The total direct materials variance is comprised of two parts: the cost vari- ance and the efficiency variance. The cost variance determines the difference in actual cost compared to standard cost. The efficiency variance looks at the quantity used to produce the cereal and is the difference in actual quantity used compared to the standard quantity. Kellogg Company must investigate both the cost variance and the efficiency variance in order to under- stand why the total direct materials cost varied from the total budgeted amount.
TYING IT ALL TOGETHER
Direct Labor Variances
Cheerful Colors uses a similar approach to analyze the direct labor flexible budget variance.
The flexible budget variance for direct labor is $10,400 favorable, as shown in Exhibit 2310.
Additional data concerning direct labor follow, including standards discussed in the previous section:
Direct labor cost standard $12.00 per DLHr
Direct labor efficiency standard 0.25 DLHr per batch of crayons Actual amount of direct labor hours 10,400 DLHr
Actual cost of direct labor $145,600
Direct Labor Cost Variance
Using the prior information, we can calculate the direct labor cost variance, which measures the difference between the actual amount paid for direct labor (actual cost) and the amount that should have been paid (standard cost). This variance measures how well the business keeps its unit costs of labor input within standards. Notice that Cheerful Colors paid more than expected for direct labor. The actual cost per hour of direct labor is $14.00 ($145,600 / 10,400 DLHr = $14.00 per DLHr) and the standard cost per hour of direct labor is $12.00. Using the formula, the direct labor cost variance is $20,800 unfavorable. The calculation follows:
Direct Labor Cost Variance The difference between the actual amount paid for direct labor (actual cost) and the amount that should have been paid (standard cost).
(AC-SC) *AQ.
Direct Labor Efficiency Variance = (AQ − SQ) : SC
= (10,400 DLHr - 13,000 DLHr) * +12.00 per DLHr
= +31,200 F Direct Labor Cost Variance = (AC− SC) : AQ
= (+14.00 per DLHr - +12.00 per DLHr) * 10,400 DLHr
= +20,800 U
The $20,800 direct labor cost variance is unfavorable because Cheerful Colors paid workers $2.00 more per hour than budgeted ($14.00 actual cost - $12.00 standard cost).
Direct Labor Efficiency Variance
Now let’s see how efficiently Cheerful Colors used its labor. The direct labor efficiency variance measures the difference between the actual labor hours (actual quantity) and the labor hours that should have been used (standard quantity). This variance measures how well the business uses its human resources. The standard quantity of direct labor hours that workers should have used to make 52,000 batches of crayons is 0.25 direct labor hours each, or 13,000 total direct labor hours (52,000 batches * 0.25 DLHr per batch). The direct labor efficiency variance is as follows:
Direct Labor Efficiency Variance The difference between the actual labor hours (actual quantity) and the labor hours that should have been used (standard quantity).
(AQ -SQ) *SC.
The $31,200 direct labor efficiency variance is favorable because laborers actually worked 2,600 fewer hours than the flexible budget called for to produce 52,000 batches of crayons.
Summary of Direct Labor Variances
Exhibit 2312 summarizes how Cheerful Colors divides the $10,400 favorable direct labor flexible budget variance into its cost and efficiency components.
Exhibit23-12 | Direct Labor Variances
AC × AQ
$145,600
SC × SQ
$12.00 per DLHr
× 13,000 DLHr
$156,000 SC × AQ
$12.00 per DLHr
× 10,400 DLHr
$14.00 per DLHr
× 10,400 DLHr
$124,800
Efficiency Cost
Actual overhead cost and Standard overhead allocated to production
Try It!
Tipton Company manufactures shirts. During June, Tipton made 1,200 shirts and gathered the following additional data:
Direct materials cost standard $6.00 per yard of fabric Direct materials efficiency standard 1.50 yards per shirt Actual amount of fabric purchased and used 1,680 yards Actual cost of fabric purchased and used $10,500
Direct labor cost standard $15.00 per DLHr Direct labor efficiency standard 2.00 DLHr per shirt Actual amount of direct labor hours 2,520 DLHr Actual cost of direct labor $36,540 Calculate the following variances:
7. Direct materials cost variance 8. Direct materials efficiency variance 9. Total direct materials variance 10. Direct labor cost variance 11. Direct labor efficiency variance 12. Total direct labor variance
Check your answers online in MyAccountingLab or at http://www.pearsonhighered.com/Horngren.
For more practice, see Short Exercises S23-6 through S23-8. MyAccountingLab The $10,400 favorable direct labor variance suggests that total labor costs were significantly less than expectations. To manage Cheerful Colors’s labor costs, we need to gain more insight:
• Workers made 52,000 batches of crayons in 10,400 hours instead of the budgeted 13,000 hours—for a favorable efficiency variance.
• Cheerful Colors paid its employees an average of $14.00 per hour in 2019 instead of the standard rate of $12.00—for an unfavorable cost variance.
This situation reveals a tradeoff. Perhaps Cheerful Colors hired more experienced, and thus more expensive, workers and had an unfavorable cost variance. However, due to more advanced skills, experience, and/or motivation, the workers turned out more work than expected, and the strategy was successful. The overall effect on profits was favorable.
This possibility reminds us that managers should take care in using variances to evaluate performance. Managers should always carefully analyze the data before taking action.