Book Part 1 Decision Analysis

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[Performance Management ]
Section C
US CMA
PART I
(20 %)
Section C.1
Variance analysis
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Section C.2
Responsibility centers and reporting
segments
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Section C.3
Performance measures 3
Dear Students …..
Do take a look at Section D
Before you begin Section C;
Section D is “Cost Management”;

Covers Cost Accounting and Cost Measurement.
Section C begins with Variance Analysis
Comparing Standards Costs with Actual Costs.
If you are not familiar with Cost Accounting
You may not understand Standard Costing
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An integral part of Section C
So before you proceed ...
Do take a look at Section D 4
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Variance Analysis
Index
What is VA, what are standard costs , what is budget cost ?
Static Budget , Flexible Budget and Sales Volume Variances

Material Variances
Labor Variances
Overhead Variances
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Sales Variances
Interdependencies among variances 6

Variance Analysis - Introduction
Each organization has its strategic objectives
Short term operational objectives - “Budget”
Difference between actual performance and budgeted

performance - “Variances”
Variances may be Favorable or Unfavorable “F” or “U”
Performance Management includes activities which ensure that
goals are consistently met in an effective and efficient manner
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“Variance Analysis” is the quantitative investigation of the material
differences between actual and planned behavior
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Variance Analysis - Advantages
Variance Analysis based on Standard Costing is a performance
measure of a cost center.

Results in Cost Control and Cost Reduction
By fixing responsibility, accountability
Facilitates remedial action resulting in continuous improvements
Enables management by exception
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Facilitates decision making like price fixing, inventory valuation….
Employee participation, awareness and motivation 8
Variance Analysis
Remember:
Variance Analysis is only a tool

Draws attention to areas which need investigation
Further analysis and investigation may be necessary
Corrective and remedial action needs to be taken
Significance of variances depends on their amount, direction,
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trend and frequency
Persistent variances mean that standards have to be re evaluated
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Process of Variance Analysis
Process of Variance Analysis
1. Lay down standards

Price per unit of material, qty of material required per unit
of output, wage rate, productivity per hour
2. Prepare budget Yearly, quarterly, monthly…….from Master Budget

3. Compare actual performance with budget
4. Variance = Budget - Actual

If actual costs are higher than budget - Unfavourable Variance
If actual revenues are higher than budget - Favourable Variance
5. Who is responsible?
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Fix accountability
6. Take remedial action Continuous learning and improvement
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Sources of Standards
Standard costs may be set up by using:
1.Historical records

Past data on similar operations to understand material and labor usage
2. Engineering studies of each activity/operation
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Standard costs are set up based on careful specifications of material,
labor and equipment
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Sources of Standards
Historical records: Engineering studies:
More convenient when reliable Use the services of engineers,
past data is available

management accountants,
Less costly and time production workers etc...
consuming More expensive and time consuming
More widely used A precise method for determining
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Could carry forward the standard costs
inefficiencies of the past
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Standard Cost and Budget
What is a Standard Cost ?
“What a cost ought be….”

Standard costs are computed at the beginning of each period
Standard costs are estimates of what the management thinks
the costs and revenues should be for a unit of output
Based on the standard costs and demand estimates Standard
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(Static) Budget is drawn
Standard budget would depend on the level of activity
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Level of Activity
Level of activity may be :
a) Ideal / Perfect / Theoretical level of activity
Assumes no breakdowns, no Ideal but impractical,

wastage……
b) Practical level of activity

Maximum level less normal wastage, idle time, normal learning curve…. Attainable
…
c) Normal/Budgeted level of activity
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Normal level or Master Budget level based on average 3 years of consumer demand
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Static and Flexible Budgets
Static and Flexible Budget in VA
Static Budget is a fixed budget prepared at the beginning of a
period
Budget for a single level of activity

Level 1 Variances
Actual - Static Budget = Static / Fixed Budget Variance
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Static Budget Variance = $236 (U)
Static Budget Variance = $236 (U)19
Static and Flexible Budget in VA
Static Budget is a fixed budget prepared at the beginning of a
period
Budget for a single level of activity

Level 1 Variances
Actual - Static Budget = Static / Fixed Budget Variance
Actual output and sales may be different from the Static Budget
Flexible budget is prepared by adjusting the Static Budget for the
actual level of output
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Actual result - Flexible Budget = Flexible Budget Variance
Level 2 Variances
Static Budget - Flexible Budget = Sales Volume Variance 20
Static Budget Variance

Sales Volume Variance Flexible Budget Variance
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Sales Volume Variance Flexible Budget
= $6,000 (U) Variance = $5,764 (F)
Static Budget Variance = $236 (U) 22

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= $6,000 (U) Variance = $5,764 (F)
Components of a Flexible Budget
Variance
Flexible Budget Variance

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Direct Materials Direct Labour Factory Overhead
Variance Variance Variance
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Components of a Sales Volume Variance (Multi
Product)
Sales Volume Variance

Sales Yield Variance Sales Mix Variance
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Direct Material Variances
??? ???
Budgeted output Budgeted cost of material = 10,000 pieces x $10 per piece

of 10,000 units
Actual cost of material = 11,000 pieces x $11 per piece
Budgeted cost of Material Cost Variance = 21,000

material = $100,000
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Actual output = 10,000 units
Actual material cost= $121,000 Price Variance = Quantity Variance =
$1 x 11,000 = 1000 pcs x $10 =
$11,000 $10,000
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Material Variances
Material Variance = (SQ x SR) - (AQ x AR)
(Flexible Budget Variance) Std cost for Actual material
actual output cost

The variance may arise on account of the difference in material
prices; actual and standard
It may also arise due to the difference in the quantity used
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Again, the difference in quantity could be due to a difference in the
material mix ratio when more than one material is used.
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Direct Materials Variance
(SP x SQ - AP x AQ)

Direct Materials Price Direct Materials
Variance Quantity Variance
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AQ (SP - AP) SP (SQ - AQ)
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Material Variance: Example
The standard requirement for 1 unit of a product is 1 kg of raw
material @ $6/kg. The actual output of 9600 units consumed 9800
kg @ $6.10/kg. Compute DM Price Variance and DM Usage
Variance.

DM Cost variance = (SQ x SR) - (AQ x AR)
= (9600 units x 1 x 6) - (9800 x 6.10) = 57600 - 59780 = 2180 (U)
DM Price variance = AQ (SR - AR)

= 9800 (6 - 6.10) = 58800 - 59780 = 980 (U)
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DM quantity variance = SR (SQ - AQ)
= 6(9600 - 9800) = 6 x 200 = 1,200 (U)
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The standard requirement for 1 unit of a product is 1 kg of raw
material @ $6/kg. The actual output of 9600 units consumed 9800
kg @ $6.10/kg. Compute DM Price Variance and DM Usage
Variance.

Quantity variance Price variance
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1,200 (U) 980 (U)
Total variance
2180 (U) 31
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= $6,000 (U) Variance = $5,764 (F)
Unfavorable Material Price Variance
An unfavorable price variance may be due to:
❖ General rise in the material prices

Uncontrollable
❖ Scarcity of the material reasons
❖ Increase in transportation or related costs
Purchases were not made in time
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Controllable
❖ Poor price negotiation reasons
❖ Discounts were not availed of 33

Favorable Material Price Variance
A favorable price variance may be due to:

❖ Efficiency of the purchase function
❖ Reduction in prices
❖ Reduction in purchase related costs
❖ Purchase of inferior quality materials
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Total direct materials
variance
(SP x SQ - AP x AQ)

Direct materials price Direct materials quantity
variance variance
AQ (SP - AP) SP (SQ - AQ)
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Direct materials mix Direct materials yield
variance variance
SP (RAQ - AQ) SP (AQ - RAQ)
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For producing one unit of a product, the materials standard is :
Material X : 6 kg @ $8 per kg and Material Y : 4 kg @ $10 per kg
In a week, 1000 units were produced with actual consumption as:

Material X: 5,900 kg. @ $9 /kg and Material Y: 4,800 kg. @ $9.50 / kg.
Compute the various variances.
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For producing one unit of a product, the materials standard is :
AQ =5900 + 4800 = 10,700
Material X : 6 kg @ $8 per kg and Material Y : 4 kg @ $10 per
RAQkg(X) = 10,700 x 6/10 =6420)
In a week, 1000 units were produced with actual consumption as: RAQ (Y) = 10,700 x 4/10 =4280)
Material X: 5,900 kg. @ $9 /kg and Material Y: 4,800 kg. @ $9.50 / kg.

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Material Usage Variance
An unfavorable material usage variance may be due to:
❖ Inferior quality of material

❖ Wastage of material
❖ Pilferage of material
❖ Change in the standard mix
Unskilled or new labor force
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❖
Could be overcome by ensuring quality of material maybe by inspection etc, maintaining

control over materials issued to production, adequately training workers...
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Material Purchase Price Variance
Material Price Variance is usually applied on material used/

consumed.
If Material Purchase Price Variance is required to be computed,

we use the purchased quantity instead of the quantity used.
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Usually, Material Price Variance refers to Material Price Usage
Variance
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Direct Labor Variances
Labour Variances
Labor Variance = (SH x SR) - (AH x AR)
(Flexible Budget Variance) Std cost for Actual labor
actual output cost

The variance may arise on account of the difference in labor rates
It may also arise due to the difference in efficiency
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Again, the difference in efficiency could be due to a difference in
the gang composition as also a difference in the total hours used
as compared to the standard
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Total direct labor variance
(SH x SR - AH x AR)

Direct labor efficiency
Direct labor rate variance variance
AH (SR - AR) SR (SH - AH)
Yield variance
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Direct labor mix Direct labor net
variance efficiency variance
SR (RAH - AH) SR(AH - RAH)42
Labor Cost Variance: Example
The standard requirement of labour for 1 unit of a product is 2 hours
The actual output of 9600 units consumed 20,160 hours. The
standard rate of pay was $4.50 per hour while the actual rate of pay
was $4.40 per hour. Compute Wage Rate Variance and Direct

Labour Efficiency Variance.
DL Rate variance
= AH (SR - AR)
= 20160 (4.5 – 4.4)
DL Cost variance = (SH x SR) - (AH x AR) = 90,720 – 88,704 = 2016 (F)
= (9600 x 2 hrs x $4.50) - (20160 x 4.40)
= 86,400 – 88,704 = 2304 (U)
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DL Efficiency variance
= SR (SH - AH)
= 4.50(19,200 – 20,160)
= 86400 - 90720 = 4320 (U)
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Labor Variance
The standard requirement of labour for 1 unit of a product is 2 hours The actual
output of 9600 units consumed 20,160 hours. The standard rate of pay was
$4.50 per hour while the actual rate of pay was $4.40 per hour. Compute Wage
Rate Variance and Direct Labour Efficiency Variance.

Efficiency variance Rate variance
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4320 (U) 2016 (F)
Total variance
2304 (U) 44
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= $6,000 (U) Variance = $5,764 (F)
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Labour Variance: Example with labor mix
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Labour Variance: Example
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Unfavorable Wage Rate Variance
An unfavorable wage rate variance may be due to:
❖ General rise in the wages

❖ New labor contract
❖ More skilled workers May result in a better efficiency variance
❖ Excessive overtime hours

Different gand composition
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❖
❖ Discounts were not availed of
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Unfavorable Wage Rate Variance
An unfavorable wage rate variance may be due to:
❖ General rise in the wages

❖ New labor contract
❖ More skilled workers May result in a better efficiency variance
❖ Excessive overtime hours
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❖ Different gang composition
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Unfavorable Labor Efficiency Variance
An unfavorable labor efficiency variance may be due to:
❖ Substandard materials
❖ Untrained employees

❖ Poor working conditions
❖ Improper scheduling of work
❖ Lack of supervision
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❖ Poor equipment, constant breakdown
Training employees, proper maintenance of equipment, proper scheduling of work..

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Variable Overhead Variances
Variable Overheads
❖ Variable overheads change as the level of production changes
❖ All expenses, other than labor, that changes with the number

of units is a variable overhead
❖ They cannot be identified physically with a product and

therefore are indirect costs i.e. overheads
But they change with the number of units produced…,
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❖
therefore they are variable costs
❖ Power and other utilities, packing costs etc.. 54

Variable Overhead Variance = (SH x SR) - (AH x AR)
(Flexible Budget Variance) Std cost for Actual labor cost
actual output

The variance may arise on account of the difference in the
predetermined rate of variable overhead/unit and the actual rate
incurred Variable Overhead Expense Variance
It may also arise due to the efficiency or inefficiency of the
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allocation base used, usually labor hours or machine hours
Variable Overhead Efficiency Variance
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Variable Overhead
Variance
(SR x SH - AR x AH)

Variable Overhead Variable Overhead
Spending Variance Efficiency Variance
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AH (SR - AR) SR (SH - AH)
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Variable Cost Variance: Example
A company estimated an output of 10,000 units, but the actual output
was 9,600 units. The standard requirement was 2 hours per unit though
the actual was 2.10 hours per unit. The standard rate of variable
overhead was $ 7.50 per hour while the actual rate was $7.20 per hour.

Compute the variable overhead variances.Varibale Cost Expense variance
= AH (SR - AR)
= 20160 (7.5 – 7.2)
= 151,200 – 145,152 = 6048 (F)
Variable Cost variance
= (SH x SR) - (AH x AR) Variable Cost Efficiency variance
= (9600 x 2 hrs x $7.50) - (9600 x 2.1 x 7.20) = SR (SH - AH)
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= 144,000 – 145,152 = 1,152 (U) = 7.50(19,200 – 20,160)
= 144,000 - 151,200 = 7200 (U)
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Total Variance = 1,152 (U)
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Variable Cost Variance
A company estimated an output of 10,000 units, but the actual output was 9,600
units. The standard requirement was 2 hours per unit though the actual was 2.10
hours per unit. The standard rate of variable overhead was $ 7.50 per hour while
the actual rate was $7.20 per hour. Compute the variable overhead variances.

Efficiency variance Expense variance
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7200 (U) 6048 (F)
Total variance
1152 (U) 58
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= $6,000 (U) Variance = $5,764 (F)
Variable overhead variances may arise due to:

❖ Change in rates of indirect expenses after budget was made
A power rate hike

❖ Change in rates of indirect labor Expense
variance
❖ Change in prices of indirect materials
❖ Difference in processing time due to difference in labor
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efficiency, quality of material, machine operating conditions...
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Fixed Overhead Variances
Fixed Overhead Variance
Actual Fixed Overheads:
Refers to the actual incurred overheads

Budgeted Fixed Overheads
Refers to the o/h as fixed at the beginning of the year. It is a static

budget variance, but fixed cost is fixed… so no sales volume variance
Applied / Absorbed Fixed Overheads:
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Refers to the overheads absorbed based on a standard rate per unit
or based on the standard hours required for actual output 62
Fixed Overhead Variance is the difference between the absorbed
overheads and the actual overheads.
Over absorption is favorable (F) and under absorption is unfavorable (U)

Absorbed fixed overheads = Actual output X FOAR
Fixed Overhead Absorption Rate
Example: Fixed Overhead Absorption rate = $ 10/unit

Budgeted output : 6,000 units
Actual output: 6,100 units Fixed o/h absorbed = $ 10 x 6100 = $ 61,000
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Budgeted overheads: $60,000 Fixed o/h variance = $ 61,000 - $ 70,000
Actual overheads: $70,000 = $9,000 (U)
Total Fixed O/H Variance = ?
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Example:
Budgeted output : 6,000 units Actual O/H = 70,000
Actual output: 6,100 units Budgeted O/H = 60,000

Budgeted overheads: $60,000 Absorbed O/H = SH x SR /hr
=(6,100 units x 2 hours) x $5
Actual overheads: $70,000
= $61,000
Standard hour/unit = 2
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Fixed o/h absorption rate = $5/hr
Actual hours = 13,000
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(Absorbed O/H - Actual O/H)

Fixed O/H Expenditure Fixed O/H Production Volume Variance
Variance
(Absorbed O/H - Budgeted O/H)
(Budgeted O/H - Actual O/H)
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Fixed O/H Efficiency Variance Fixed O/H Capacity Variance
BR(SH - AH) BR(AH - BH) 65

Actual O/H = 70,000
Example: Budgeted O/H = 60,000
Budgeted output : 6,000 units Absorbed O/H = 6100 x 10 = $ 61,000
Actual output: 6,100 units 1. Total Fixed O/H Variance =

Absorbed - Actual O/H = 9000 (U)
Budgeted overheads: $60,000

Actual overheads: $70,000 2. Fixed O/h Expenditure Variance =
Budgeted - Actual O/H = 10,000 (U)
Standard hour/unit = 2
3. Fixed O/H Volume Variance =
Actual hours = 13,000
Absorbed - Budgeted O/H = 1,000 (F)
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Example:
Budgeted output : 6,000 units; Actual output: 6,100 units
Budgeted overheads: $60,000 ; Actual overheads: $70,000
Standard hour/unit = 2; Actual hours = 13,000

In Marginal Costing only Expenditure
Variance of 10,000(U)
Absorbed Overheads Budgeted Overheads Actual Overheads

($61,000) ($60,000) ($70,000)
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Volume Variance = 1,000 (F) Expenditure Variance = 10,000 (U)
Total Fixed O/H Variance = 9,000 (U) 67

Fixed Overhead Expenditure Variance
Fixed O/H Budget Variance or Fixed O/H Spending Variance
Budgeted Fixed Manufacturing O/H - Actual Fixed Manufacturing

O/H
Indicates the cost deviations that were not expected at the time of
setting standards and budgets.
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The overheads absorbed may not have moch relevance from control
point of view
Therefore, Expenditure Variance is the relevan variance here…. 68

Fixed Overhead Production Volume Variance
F O/H Volume Variance = Absorbed F O/H - Budgeted F O/H
This is applicable only in case of Absorption Costing (not in MC)

Consists of F O/H Capacity Variance and F O/H Efficiency
Variance
Capacity variance indicates increased/ decreased capacity .. If
actual capacity is more than that budgeted, it is favorable
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Efficiency variance relates to variations in the level of efficiency
i.e. if actual hours are more/less than the standard hours for the
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actual output
Budgeted output : 6,000 units;
Fixed Overhead Variance Actual output: 6,100 units
(Absorbed O/H - Actual O/H) Budgeted overheads: $60,000 ;
Actual overheads: $70,000
SH/unit=2; AH = 13,000

Fixed O/H Expenditure Fixed O/H Volume Variance
Variance
61,000 - 60,000 = 1,000(F)
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BR(SH - AH)= 5(12,200 - 13,000)= 4,000(U)
BR(AH - BH)= 5(13,000 - 12,000)=5,000(F)
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Budgeted output : 10,000 units;
Fixed Overhead Variance Actual output 9,600 units
(Absorbed O/H - Actual O/H) Budgeted overheads: $75,000 ;
7.5 x 9,600 – 78,000 Actual overheads: $78,000
72,000 - 78,000 = 6,000(U) SH/unit=2; AH = 20,160

Fixed O/H Expenditure Fixed O/H Volume Variance
Variance
7.5 x 9,600 – 78,000
75,000 - 78,000 = 3,000(U) 72,000 - 75,000 = 3,000(U)
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BR(SH - AH)= 3.75(19,200 – 20,160)= 3,600(U)
BR(AH - BH)= 3.75(20,160 – 20,000)=600(F)
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= $6,000 (U) Variance = $5,764 (F)
Exercise: Compute Fixed Overhead variances
Budgeted Actual
Fixed overhead for July $ 10,000 $10,200
Units of production in July 5,000 5,200
Standard time for one unit 4 hours

Actual hours worked 20,100 hours
Actual O/H = 10,200; Budgeted O/H = $ 10,000

Absorbed O/H = 5200 x 2 = $ 10,400
1. Total Fixed O/H Variance = Absorbed - Actual O/H = 200 (F)

2. Fixed O/h Expenditure Variance =Budgeted - Actual O/H = 200 (U)
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3. Fixed O/H Volume Variance =Absorbed - Budgeted O/H = 400 (F)
Capacity Variance = BR(AH - BH) = 0.50(20100 - 20,000) = 50 (F)

Efficiency Variance =BR(SH - AH) = 0.50(5200 x 4 - 20100) = 350 (F) 73
Causes of Fixed O/H Expenditure Variance
❖ Business expansion not planned at the time of preparing budget

❖ Changes not anticipated like change in insurance premium rate..

❖ Accidents or unexpected repairs
❖ Inefficiencies and lack of control in the management of fixed
overheads
Lack of planning at the time of setting of budgets
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❖
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Causes of Fixed Overhead Volume Variance
❖ When demand for a product changes from what was expected.
❖ When the actual amount of the allocation base varies from the
amount built into the budgeted allocation rate, it causes a fixed

overhead volume variance
❖ Efficiency improves due to some performance measures
introduced
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❖ If the company outsources some part of the production…
❖ If sales are seasonal and production volume therefore irregular

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Summary
Summary
Variance = Standard Cost - Actual Cost
Variance Analysis fix responsibility, identify problem, correct, improve
Standard Cost vs Budget Cost Different in scope

Flexible budget & Static Budget
Standard cost is what the cost should be for actual output
Static Budget Variance = Actual - Budget
Sales Volume Variance = Standard - Budget
Sales mix & sales quantity variances
Flexible Budget Variance = Actual - Standard
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Material, labor, overhead & sales rice variances
Advantages of Variance Analysis
Cost control & reduction, managemet by exception, pricing decision
Cannot be applied for non standard jobs, only a tool, standards may have to
be revisited 77
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Market Size Variance =
(Actual Mkt Size – B Mkt Size) units
x B M Share(%) x BM

Market Share Variance =
(Actual Mkt Share – B Mkt Share)%
x Actual Ind Sale units x BM
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Static Budget , Flexible Budget and Sales Volume Variances

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Interdependencies among variances 6

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1. Lay down standards

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4. Variance = Budget - Actual

6. Take remedial action Continuous learning and improvement

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2. Engineering studies of each activity/operation

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b) Practical level of activity

c) Normal/Budgeted level of activity

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Static Budget Variance = $236 (U) 22

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Budgeted cost of Material Cost Variance = 21,000

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It may also arise due to the difference in the quantity used

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DM Price variance = AQ (SR - AR)

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❖ General rise in the material prices

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❖ Increase in transportation or related costs

Purchases were not made in time

❖ Discounts were not availed of 33

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❖ Inferior quality of material

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Could be overcome by ensuring quality of material maybe by inspection etc, maintaining

Material Price Variance is usually applied on material used/

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If Material Purchase Price Variance is required to be computed,

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It may also arise due to the difference in efficiency

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❖ General rise in the wages

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❖ Excessive overtime hours

❖ Discounts were not availed of

❖ General rise in the wages

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❖ Excessive overtime hours

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Training employees, proper maintenance of equipment, proper scheduling of work..

❖ Variable overheads change as the level of production changes