PRODUCTION COST VARIANCE ANALYSIS

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I. OVERVIEW
A. Variances: is the differences between actual results compared to budget or standard amounts. This
variance is used to monitor the costs incurred by a business, with management taking action when a
material negative variance is incurred. A standard cost variance can be unusable if the standard baseline
is not valid.
1. Management by exception: is the concept that supports variance analysis. Only significant
variances need to be analyzed because it entails cost. The purpose of the management by exception
concept is to only bother management with the most important variances from the planned direction
or results of the business. Managers will presumably spend more time attending to and correcting
these larger variances. The concept can be fine-tuned, so that smaller variances are brought to the
attention of lower-level managers, while a massive variance is reported straight to senior
management. Decision makers are guided by cost-benefit criteria.
2. It is a tool management for performance evaluation. It is intended to measure effectiveness and
efficiency.
3. Feedback attained from variance analysis will be used for planning and control

B. Absorption vs. Variable Costing

Absorption costing is a Managerial accounting method that records in the accounting books
manufacturing related transactions. It is intended for external reporting, thus it is required to comply with
Financial Accounting Reporting standards. On the other hand, variances are recorded in the books during the
production period, hence variances arise only under Absorption costing. Variable costing is a managerial
accounting reporting method intended to analyze and control cost for internal users. There are no journal
entries prepared under Variable costing, hence variances are not recognized under this system. For a more
in-depth discussion, please refer to the category of Variable and Absorption costing.

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II. CAUSES OF VARIANCES AND ANALYSIS
A. The 4 Cost Accounting Systems.
For the decision maker to fully understand variance analysis, one must go back to the grassroots of the
cost accounting systems.
1) Actual cost system- is a cost accounting system that uses actual cost or actual rates, and actual
quantities or hours used in production to determine the cost of specific products. There are no
variances that arise from Actual cost system. The major disadvantage of an actual cost system is the
difficulty of giving quotations for products ordered in advanced because it has to wait for the
completion of the product to determine the actual cost. Cost are directly allocated to the finished
product.
2) Normal cost system- is a costing method under which a company measures the actual costs of
direct materials and direct labor, but uses predetermined factory overhead rates to measure the
factory overhead cost for a period. In other words, throughout the production time, the company
measures and records the actual costs of direct materials and direct labor used, but it estimates a
portion of factory overhead to be assigned to products. Normal costing system provides timely cost
estimates of products or batches of products
3) Extended normal cost system or Flexible budget- is a costing method used to track production
costs. Extended normal costing determines the cost of production using budgeted costs of the inputs
used in production multiplied by the actual quantity of the inputs that were used in production. The
budgeted costs of production are predetermined by a firm's management, typically at the beginning of
the year. Extended normal costing uses these budgeted input costs instead of the actual costs of
production
4) Standard Cost system or Static budget- a standard costing system is a tool for planning budgets,
managing and controlling costs, and evaluating cost management performance. A standard costing
system involves estimating the required costs of a production process. But before the start of the
accounting period, determine the standards and set regarding the amount and cost of direct materials
required for the production process and the amount and pay rate of direct labor required for the
production process. In addition, these standards are used to plan a budget for the production
process.

B. Static and Flexible budget variances

It is difference between actual result and corresponding amount in static or flexible budget. Better
insights are gained when using flexible budgets when computing for variances. The difference between the
Static and Flexible budget usually gives rise to volume variances.

A flexible budget variance is any difference between the results generated by a flexible budget model
and actual results. If actual revenues are inserted into a flexible budget model, this means that any variance
will arise between budgeted and actual expenses, not revenues. If the number of actual units sold is inserted
into a flexible budget model, there can then be variances between the standard revenue per unit and the
actual revenue per unit, as well as between the actual and budgeted expense levels.

The static budget is used as the basis from which actual results are compared. The resulting variance
is called a static budget variance. Static budgets are commonly used as the basis for evaluating sales
performance. However, they are not effective for evaluating the performance of cost centers. For example, a
cost center manager may be given a large static budget, and will make expenditures below the static budget
and be rewarded for doing so, even though a much larger overall decline in company sales should have
mandated a much larger expense reduction. The same problem arises if sales are much higher than expected
- the managers of cost centers have to spend more than the amounts indicated in the baseline static budget,
and so appear to have unfavorable variances, even though they are simply doing what is needed to keep up
with customer demand.

C. Favorable vs. Unfavorable

The designation of the variance depends on the net effect on income. If income will increase it is
favorable and unfavorable if otherwise. Favorable variance is attained if actual costs are less that standard or
budget. In the same manner it is favorable if actual revenues are greater than budget.

D. Analysis of Variances
Guided by the principle of Management by Exception, production variances are analyzed to determine
corrective actions and to improve operational efficiency. However, Overhead Volume Variance is not
analyzed because it not controlled by any individual in the organization. It is a deviation from standard hours
allowed for the production actually attained against the normal capacity of a company.

When analyzing variances, understand the causes of a variance before using it as a performance
measure, focus should be on reducing the total costs of the company as a whole. Avoid excessive emphasis
on a single performance measure. Always consider possible inter-dependencies among variances and do not
interpret them in isolation of each other

E. Treatment of Variances
Variances are close to closed to CGS if the variance is insignificant. But it is prorated to Work in
Process Ending Inventory, Finished Goods Ending Inventory, and Cost of Goods Sold. Significant levels
is pre-determined by the company during the start of the year.

Production variances are closed to CGS to convert the CGS from Standard amounts to Actual
amounts. Standard amounts are intended for internal reporting to control costs, whereas Actual amounts
are needed for external reporting.

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III. PRICE FACTOR AND QUANTITY FACTOR
 There are only 2 factors that will give rise to any variance, they are the change in price, and change in
quantity or the physical factor.
1. Price factor- deviation from actual price/rate against standard price/rate
a. known as input-price variance or rate variance
b. Samples are Materials Price Variance, Labor Rate Variance, Overhead Spending Variance
(Variable and Fixed)

2. Physical factor- deviation from actual consumption of input components against what standard or
budget allows.
a. known as usage or efficiency variance
b. Mix and Yield variances occur if a company uses a combination of raw material or labor.
c. Samples are Materials Quantity Variance, Labor Efficiency Variance, Overheard Efficiency, and
Volume/Capacity Variance.

Summary of Production Variances in Relation to Cost Behavior

Price Factor Physical Factor
Variable Cost
Direct materials Materials Price Variance Materials Quantity Variance
Direct labor Labor Rate Variance Labor Efficiency Variance
Variable Overhead Overhead Spending Variance Overhead Efficiency Variance

Fixed Cost
Fixed Overhead Overhead Spending Variance Overhead Volume/ Capacity Variance

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IV. MATERIALS VARIANCES
 The direct material variance is the difference between the standard cost of materials resulting from
production activities and the actual costs incurred. The direct material variance is comprised of two other
variances, which are:

Purchase price variance. This is the difference between the standard and actual cost per unit of the direct
materials purchased, multiplied by the standard number of units expected to be used in the production process.
This variance is the responsibility of the purchasing department.

Material quantity variance. This is the difference between the standard and actual number of units used in
the production process, multiplied by the standard cost per unit. This variance is the responsibility of the
production department.

It is customary to calculate and report these two variances separately, so that management can
determine if variances are caused by purchasing issues or manufacturing problems. The direct material variance
is usually charged to the cost of goods sold in the period incurred.

Materials variance are intended to measure the performance of the purchasing officer and the production
manager. The purchasing officer is directly responsible for the Materials Price Variance because he has the
authority to grant acquisition of raw materials. The Production manager is directly responsible for the Materials
Quantity Variance because he authorizes consumption of raw materials. However, the Purchasing manager is
indirectly responsible for the variance because he bought the materials used in production. The materials
variances are computed as follows:
a) Materials Price Variance-
= (Actual Price - Standard Price) x Actual Quantity
= Actual Total Materials Cost - Flexible Budget Allowed

b) Materials Quantity Variance

= (Actual Quantity - Standard Quantity) x Standard Material Price
= Flexible Budget - Static Budget

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V. LABOR VARIANCES
 A labor variance arises when the actual cost associated with a labor activity varies (either better or worse)
from the expected amount. The expected amount is typically a budgeted or standard amount. The labor variance
concept is most commonly used in the production area, where it is called a direct labor variance. This variance
can be subdivided into two additional variances, which are:

Labor efficiency variance. Measures the difference between actual and expected hours worked, multiplied
by the standard hourly rate.

Labor rate variance. Measures the difference between the actual and expected cost per hour, multiplied
by the actual hours incurred.

The labor variance can be used in any part of a business, as long as there is some compensation
expense to be compared to a standard amount. It can also include a range of expenses, beginning with just the
base compensation paid, and potentially also including payroll taxes, bonuses, the cost of stock grants, and even
benefits paid.

Labor variances are designed to measure the performance of the Human Resource Manager and the
Production Manager. The Human Resource Manager has direct control over the Labor Rate Variance because he
is responsible in setting the wage rate of the workers. On the other hand, the Production Manager is directly
responsible in the Labor Efficiency Variance because he has the authority to grant under or over time. The
Human Resource Manager is indirectly responsible for the Labor Efficiency Variance because the skills of the
workers in the production department are dependent on the training and development programs administered by
the Human Resource Manager. The Labor variances are computed as follows:

a) Labor Rate Variance

= (Actual Rate - Standard Rate) x Actual Hours
= Actual Total Payroll - Flexible Budget Allowed

b) Labor Efficiency Variance

= (Actual Hours - Standard Hours) x Standard Labor Rate
= Flexible Budget - Static Budget

Mix and Yield Variance of Materials and Labor

The Quantity or Efficiency variance can be divided into Mix and Yield variance if a company uses more
than one raw material or combination of workers to finish a product.
Mix refers to the relative proportion of various ingredients of input factors such as materials and labor.
Yield is a measure of productivity. The material mix variance indicates the impact on material costs of the
deviation from the standard mix. The labor mix variance measures the impact of changes in the labor mix on labor
costs. Mix Variance is a deviation from the standard combination of raw materials or labor
= (AMix%- Smix%) x Total Actual Consumption x Std Rate

The material quantity variance is divided into a material mix variance and a material yield variance. The
material mix variance measures the impact of the deviation from the standard mix on material costs, while the
material yield variance reflects the impact on material costs of the deviation from the standard input material
allowed for actual production. We compute the material mix variance by holding the total input units constant at
their actual amount.

We compute the material yield variance by holding the mix constant at the standard amount. The
computations for labor mix and yield variances are the same as those for materials. If there is no mix, the yield
variance is the same as the quantity (or usage) variance. Yield Variance is a deviation from expected output of
input components, ie materials and labor
= (Total Actual Consumption – Total Standard Consumption) x Smix% x Std Rate

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VI. OVERHEAD VARIANCES

 Overhead variance refers to the difference between actual overhead and applied overhead. You can
only compute overhead variance after you know the actual overhead costs for the period. Overhead is
applied based on a predetermined rate and a cost driver. This is essentially a way of estimating overhead
costs before they actually incur. At the end of the fiscal period, it is possible to compare the actual overhead
costs with the predetermined estimates. The difference between the actual overhead costs and the applied
overhead costs are called the overhead variance.

When the actual amount of overhead expenses exceeds the applied amount of overhead expenses,
the difference is called underapplied overhead. The predetermined rate underestimated the overhead costs
for the period, and the applied overhead expenses were lower than the actual overhead expenses. The
predetermined rate did not apply enough overhead expense for the period, so call the difference
underapplied overhead.

4 Way Analysis allows the decision maker to analyze the overhead variances arising from the price
and physical factors and down to analyzing variances based on cost behaviors variable and fixed costs.

Variable Spending or Variable Budget Variance measures the deviation from Flexible Budget Allowed
against the actual cash disbursements for variable overhead. Variable Efficiency Variance is directly related
to Labor Efficiency Variance because Overhead is applied to Work Ii Process together with Direct Labor.
Moreover, the basis of evaluating efficiency for both Labor and Overhead relies on the same labor hours.

The variable and fixed overhead variances are computed as follows:

Variable Component
a) Variable Spending Variance
= Actual Total Variable Overhead - Flexible Budget Allowed or (Standard Variable Rate x Actual
Hours)

b) Variable Overhead Efficiency Variance

= (Actual Hours - Standard Hours) x Standard Variable Overhead Rate
= Flexible Budget - Static Budget

Fixed Spending or Fixed Budget Variance is a deviation from Budgeted Fixed overhead from actual
payments for fixed overhead. Examples of fixed overhead paid in cash are salaries of supervisors, rental of
production facilities, and the like. Volume or Capacity variance is a deviation from the production capacity of
the plantation. It is an application of the principle of Economies of Scale, the more units produced the lesser
the production cost per unit and vice versa. Of the 4 variances, Volume or Capacity Variance is not analyzed
because it is not controllable by anyone in the company.

Fixed Component
c) Fixed Spending Variance
= Actual Total Fixed Overhead - Budgeted Fixed Overhead

d) Fixed Overhead Volume/Capacity Variance

= (Budget Hours - Standard Hours) x Standard Fixed Overhead Rate
= Budgeted Fixed Overhead - Standard Fixed Overhead

3 Way Analysis is simply combining the Variable Spending and Fixed Spending Variance. The three
variance are computed as follows:
a) Spending Variance
= Variable Spending + Fixed Spending
= Total Actual Factory OH – BAAH

b) Variable Efficiency Variance

Same with 4-way analysis

c) Capacity or Volume
Same with 4-way analysis

2 Way Analysis divides the variance into the Controllable and Non-controllable variance or the Volume
variance. The two way analysis are:

a) Controllable Variance
= Variable Spending + Fixed Spending + Variable Efficiency
= Total Actual Factory Overhead – BASH

b) Volume or Capacity
Same with 4-way analysis