Management and Cost Accounting, 11th Edition (BUKU PEDOMAN) - 485-497

LABOUR VARIANCES 463
material variance. Similarly, the total material variance for material B is £6,400, consisting of a favour-
able price variance of £10,100 and an adverse usage variance of £16,500.
Note that if the price variance is calculated on the actual quantity purchased instead of the actual
quantity used, the price variance plus the usage variance will agree with the total variance only when the
quantity purchased is equal to the quantity that is used in the particular accounting period. Reconciling
the price and usage variance with the total variance is merely a reconciliation exercise, and you should
not be concerned if reconciliation of the sub-variances with the total variance is not possible.
LABOUR VARIANCES
The cost of labour is determined by the price paid for labour and the quantity of labour used. Thus a
price variance (wage rate variance) and a quantity variance (labour efficiency variance) will also arise
for labour.
Wage rate variance

The price (wage rate) variance is calculated by comparing the standard price per hour with the actual
price paid per hour. In Example 17.1, the standard wage rate per hour is £9 and the actual wage rate is
£9.60 per hour, giving a wage rate variance of £0.60 per hour. To determine the importance of the vari-
ance, it is necessary to ascertain how many times the excess payment of £0.60 per hour is paid. As 28,500
labour hours are used (see Example 17.1), we multiply 28,500 hours by £0.60. This gives an adverse wage
rate variance of £17,100. The formula for the wage rate variance is:
The wage rate variance is equal to the difference between the standard wage rate per hour (SR) and
the actual wage rate (AR) multiplied by the actual number of hours worked (AH):
(SR 2 AR) 3 AH
Note the similarity between this variance and the material price variance. Both variances multiply the
difference between the standard price and the actual price paid for a unit of a resource by the actual
quantity of resources used. The wage rate variance is probably the one that is least subject to control
by management. In most cases, the variance is due to wage rate standards not being kept in line with
changes in actual wage rates and for this reason it is not normally controllable by departmental man-
agers, except where different grades or skills of labour were being managed and different rates applied.
Labour efficiency variance

The labour efficiency variance represents the quantity variance for direct labour. The quantity of
labour that should be used for the actual output is expressed in terms of standard hours produced. In
Example 17.1, the standard time for the production of one unit of sigma is three hours. Thus a pro-
duction level of 9,000 units results in an output of 27,000 standard hours. In other words, working at
the prescribed level of efficiency, it should take 27,000 hours to produce 9,000 units. However, 28,500
direct labour hours are actually required to produce this output, which means that 1,500 excess direct
labour hours are used. We multiply the excess direct labour hours by the standard wage rate to cal-
culate the variance. This gives an adverse variance of £13,500. The formula for calculating the labour
efficiency variance is:
The labour efficiency variance is equal to the difference between the standard labour hours for
actual production (SH) and the actual labour hours worked (AH) during the period multiplied by
the standard wage rate per hour (SR):
(SH 2 AH) 3 SR
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464 CHAPTER 17 STANDARD COSTING AND VARIANCE ANALYSIS 1
This variance is similar to the material usage variance. Both variances multiply the difference between
the standard quantity and actual quantity of resources consumed by the standard price. The labour effi-
ciency variance is normally controllable by the manager of the appropriate production responsibil-
ity centre and may be due to a variety of reasons. For example, the use of inferior quality materials,
different grades of labour, failure to maintain machinery in proper condition, the introduction of
new equipment or tools and changes in the production processes will all affect the efficiency of
labour. An efficiency variance may not always be controllable by a production manager; it may be
due, for example, to poor production scheduling by the planning department, or to a change in
quality control standards.
Total labour variance

From Figure 17.3, you will see that this variance represents the total variance before analysis into the
price and quantity elements. The formula for the variance is:
he total labour variance is the difference between the standard labour cost (SC) for the actual
T
production and the actual labour cost (AC):
SC 2 AC
In Example 17.1, the actual production was 9,000 units, and, with a standard labour cost of £27 per unit,
the standard cost is £243,000. The actual cost is £273,600, which gives an adverse variance of £30,600.
VARIABLE OVERHEAD VARIANCES

A total variable overhead variance is calculated in the same way as the total direct labour and material
variances. In Example 17.1, the output is 9,000 units and the standard variable overhead cost is £6
per unit produced. The standard cost of production for variable overheads is thus £54,000. The actual
variable overheads incurred are £52,000, giving a favourable variance of £2,000. The formula for the
variance is:
The total variable overhead variance is the difference between the standard variable overheads
charged to production (SC) and the actual variable overheads incurred (AC):
SC 2 AC
Where variable overheads vary with direct labour or machine hours of input the total variable overhead
variance will be due to one or both of the following:
1 a price variance arising from actual expenditure being different from budgeted expenditure;
2 a quantity variance arising from actual direct labour or machine hours of input being different
from the hours of input which should have been used.
These reasons give rise to the two sub-variances which are shown in Figure 17.3: the variable overhead
expenditure variance and the variable overhead efficiency variance.
Variable overhead expenditure variance

To compare the actual overhead expenditure with the budgeted expenditure, it is necessary to flex the
budget (see Chapter 16 for an explanation of flexible budgeting). Because it is assumed in Example 17.1
that variable overheads will vary with direct labour hours of input, the budget is flexed on this basis.
Actual variable overhead expenditure is £52,000, resulting from 28,500 actual direct labour hours of input.
For this level of activity, variable overheads of £57,000, which consist of 28,500 input hours at £2 per hour,
A GENERIC ROUTINE APPROACH TO VARIANCE ANALYSIS FOR VARIABLE COSTS 465
should have been spent. Spending was £5,000 less than it should have been and the result is a favourable
variance.
If we compare the budgeted and the actual overhead costs for 28,500 direct labour hours of input, we
shall ensure that any efficiency content is removed from the variance. This means that any difference
must be due to actual variable overhead spending being different from the budgeted variable overhead
spending. The formula for the variance is:
he variable overhead expenditure variance is equal to the difference between the budgeted flexed
T
variable overheads (BFVO) for the actual direct labour hours of input and the actual variable over-
head costs incurred (AVO):
BFVO 2 AVO
Because it is assumed that variable overheads vary with the actual direct labour hours of input the bud-
geted flexed variable overheads (BFVO) has been derived by multiplying the actual quantity of direct
labour hours of input by the standard variable overhead rate.
Variable overhead represents the aggregation of a large number of individual items, such as indirect
labour, indirect materials, electricity, maintenance and so on. The variable overhead variance can arise
because the prices of individual items have changed. It can also be affected by how efficiently the indi-
vidual variable overhead items are used. Waste or inefficiency, such as using more kilowatt hours of
power than should have been used, will increase the cost of power and, thus, the total cost of variable
overhead. The variable overhead expenditure on its own is therefore not very informative. Any mean-
ingful analysis of this variance requires a comparison of the actual expenditure for each individual item
of variable overhead expenditure against the budget.
Variable overhead efficiency variance

In Example 17.1, it is assumed that variable overheads vary with direct labour hours of input. The vari-
able overhead efficiency variance arises because 28,500 direct labour hours of input were required to
produce 9,000 units. Working at the prescribed level of efficiency, it should take 27,000 hours to produce
9,000 units of output. Therefore an extra 1,500 direct labour hours of input were required. Because vari-
able overheads are assumed to vary with direct labour hours of input, an additional £3,000 (1,500 hours
at £2) variable overheads will be incurred. The formula for the variance is:
he variable overhead efficiency variance is the difference between the standard hours of output (SH)
T
and the actual hours of input (AH) for the period multiplied by the standard variable overhead rate (SR):
(SH 2 AH) 3 SR
You should note that if it is assumed that variable overheads vary with direct labour hours of input,
this variance is identical to the labour efficiency variance, apart from the fact that the standard variable
overhead rate is used instead of the wage rate.
A GENERIC ROUTINE APPROACH TO VARIANCE

ANALYSIS FOR VARIABLE COSTS
In our discussion of each of the variable cost variances in the preceding sections, a theoretical approach
was adopted that began by explaining the fundamental meaning of each variance so that you could log-
ically deduce the formula for each variance. Although it is the author’s recommendation that you adopt
this approach, feedback indicates that some readers prefer to use an alternative routine generic approach
that is presented in Appendix 17.1. You should only read Appendix 17.1 if you have found the variance
calculations in the previous section confusing and wish to adopt the alternative routine generic approach,
although it does provide a convenient numerical summary of the calculations.
FIXED OVERHEAD EXPENDITURE

OR SPENDING VARIANCE
The final production variance shown in Figure 17.3 is the fixed overhead expenditure variance. With
a variable costing system, fixed manufacturing overheads are not unitized and allocated to products.
Instead, the total fixed overheads for the period are charged as an expense in the period in which they are
incurred. Fixed overheads are assumed to remain unchanged in the short term in response to changes in
the level of activity, but they may change in response to other factors. For example, price increases may
cause expenditure on fixed overheads to increase. The fixed overhead expenditure variance therefore
explains the difference between budgeted fixed overheads and the actual fixed overheads incurred. The
formula for the fixed overhead expenditure variance is:
The difference between the budgeted fixed overheads (BFO) and the actual fixed overhead (AFO)
spending:
BFO 2 AFO
In Example 17.1, budgeted fixed overhead expenditure is £120,000 and actual fixed overhead spending
£116,000. Therefore the fixed overhead expenditure variance is £4,000. Whenever the actual fixed over-
heads are less than the budgeted fixed overheads, the variance will be favourable. The total of the fixed
overhead expenditure variance on its own is not particularly informative. Any meaningful analysis of
this variance requires a comparison of the actual expenditure for each individual item of fixed overhead
expenditure against the budget. The difference may be due to a variety of causes, such as changes in sal-
aries paid to employees, or the appointment of additional supervisors, increases in property costs, etc.
Only by comparing individual items of expenditure and ascertaining the reasons for the variances can
you determine whether the variance is controllable or uncontrollable. Generally, this variance is likely to
be uncontrollable in the short term.
SALES VARIANCES
Sales variances can be used to analyse the performance of the sales function or revenue centres on
broadly similar terms to those for manufacturing costs. The most significant feature of sales variance
calculations is that they are calculated in terms of profit or contribution margins rather than sales
values. Consider Example 17.2.
It is possible to report the variances in relation to sales value, but this does not give us any informa-
tion about the impact of sales on profit, neither does it align with the results of the cost variances which
were focused on profit. You will see that when the variances are calculated on the basis of sales value, it is
necessary to compare the budgeted sales value of £110,000 with the actual sales of £120,000. This gives a
favourable variance of £10,000. This calculation, however, ignores the impact of the sales effort on profit.
The budgeted profit contribution is £40,000, which consists of 10,000 units at £4 per unit, but the actual
impact of the sales effort in terms of profit margins indicates a profit contribution of £36,000, which con-
sists of 12,000 units at £3 per unit, indicating an adverse variance of £4,000.
The standard cost per unit is £7. Actual sales are

EXAMPLE 17.2 £120,000 (12,000 units at £10 per unit) and the
actual cost per unit is £7.
T he budgeted sales for a company are £110,000

consisting of 10,000 units at £11 per unit.
SALES VARIANCES 467
REAL WORLD reservations (Hertz) call centre. Staff at these cen-

VIEWS 17.2 tres will have a standard customer handling time
to adhere to 2 perhaps three minutes. It is not
always possible to deal with customer issues or
The effect of standards on product make a sale in the allotted time. Exceeding the
and service quality standard handling time ultimately increases cost
Setting standards in an organization may be primarily to as more staff may be needed to handle customer
assist in the calculation of a standard cost for the prod- call volume. By the same token, by strictly adhering
uct or service for management accounting purposes. to a standard handling time, customer satisfaction
Standards are also relevant for operational and cus- and quality of service may be reduced. Thus, in a
tomer service managers as they may affect the manu- service company scenario, a fine balance between
facture of the product or the quality of the service. standards and quality must be achieved to ensure
Take McDonald’s, Burger King or Coca-Cola customer satisfaction in the longer term.
for example. All three companies produce prod-
ucts that adhere to standard ingredients, albeit Discussion points
with some minimal regional variation. A BigMac
or Whopper for example, will contain a beef pattie 1 Do you
think it is
Images/Shutterstock
that is manufactured to an exact uncooked weight.
© Monkey Business
Similarly, every bottle of Coca-Cola will contain a plausible
similar amount of cola concentrate. As the ingre- to set
dients are standardized according to ‘recipes’, a standards
standard cost can be readily calculated and used for delivery
for cost control and performance reporting. Per- of services
haps more importantly, the customer is confident which are
of getting a similar product on each purchase. primarily dictated by cost?
In comparison, consider a car-hire company 2 Is it possible to measure the delivery of a
like Hertz or a bank like HSBC. Most service service (e.g. a mortgage application) against a
organizations will have a customer care (HSBC) or set standard?
If we examine Example 17.2, we can see that the selling prices have been reduced and that this has led
not only to an increase in the total sales revenue but also to a reduction in total profits. The objective
of the selling function is to influence total profits favourably. Thus a more meaningful performance
measure will be obtained by comparing the results of the sales function in terms of profit or contribu-
tion margins rather than sales revenues. Let us now calculate the sales variances for a standard variable
costing system from the information contained in Example 17.1.
Total sales margin variance

Where a variable costing approach is adopted, the total sales margin variance seeks to identify
the influence of the sales function on the difference between budget and actual profit contribution.
In Example 17.1, the budgeted contribution to fixed overheads and profit is £200,000, which consists of
budgeted sales of 10,000 units at a contribution of £20 per unit. This is compared with a contribution
derived from the actual sales volume of 9,000 units. Because the sales function is responsible for the
sales volume and the unit selling price, but not the unit manufacturing costs, the standard cost of sales
and not the actual cost of sales is deducted from the actual sales revenue. The calculation of the contribu-
tion for ascertaining the total sales margin variance will therefore be as follows:
(£)
Actual sales revenue (9,000 units at £90) 810,000
Standard variable cost of sales for actual sales volume (9,000 units at £68) 612,000
Profit contribution margin 198,000
To calculate the total sales margin variance, we deduct the budgeted contribution for the period of
£200,000 from the above profit contribution of £198,000. This gives an adverse variance of £2,000.
The formula for calculating the variance is as follows:
The total sales margin variance is the difference between actual sales revenue (ASR) less the stan-
dard variable cost of sales (SCOS) and the budgeted contribution (BC):
(ASR 2 SCOS) 2 BC
Using the standard cost of sales in the above formula and calculation ensures that production variances
do not distort the calculation of the sales variances. This means that sales variances arise only because of
changes in those variables controlled by the sales function (i.e. selling prices and sales quantity). Figure
17.3 indicates that it is possible to analyse the total sales margin variance into two sub-variances – a sales
margin price variance and a sales margin volume variance.
Sales margin price variance

In Example 17.1, the actual selling price is £90 and the standard selling price is £88. In order to ensure
that production variances do not distort the calculation of the sales margin price variance, the standard
unit variable cost of £68 should be deducted from both the actual and the standard selling prices. This
gives a contribution of £22 that is derived from the actual selling price and a contribution of £20 derived
from the standard selling price. Because the actual sales volume is 9,000 units, the increase in selling
price means that the increase in contribution of £2 per unit is obtained 9,000 times giving a favourable
sales margin variance of £18,000. In formula terms, the variance is calculated as follows:
[(Actual selling price 2 Standard variable cost) 2 (Standard selling price 2 Standard variable cost)]
3 Actual sales volume
Since the standard variable cost is deducted from both the actual and standard selling price, the above
formula can be simplified by omitting standard variable cost so that:
The sales margin price variance is the difference between the actual selling price (ASP) and the
standard selling price (SSP) multiplied by the actual sales volume (AV):
(ASP 2 SSP) 3 AV
Sales margin volume variance

To ascertain the effect of changes in the sales volume on the difference between the budgeted and the
actual contribution, we must compare the budgeted sales volume with the actual sales volume. You will
see from Example 17.1 that the budgeted sales are 10,000 units but the actual sales are 9,000 units and to
enable us to determine the impact of this reduction in sales volume on profit, we must multiply the 1,000
units by the standard contribution margin of £20. This gives an adverse variance of £20,000.
The use of the standard margin (standard selling price less standard cost) ensures that the volume
variance will not be affected by any changes in the actual selling prices. The formula for calculating the
variance is:
The sales margin volume variance is the difference between the actual sales volume (AV) and the
budgeted volume (BV) multiplied by the standard contribution margin (SM):
(AV 2 BV) 3 SM
Difficulties in interpreting sales margin variances

The favourable sales margin price variance of £18,000 plus the adverse volume variance of £20,000 add
up to the total adverse sales margin variance of £2,000. It may be argued that it is not very meaningful
RECONCILING BUDGETED PROFIT AND ACTUAL PROFIT 469
to analyse the total sales margin variance into price and volume components, since changes in selling
prices are likely to affect sales volume. A favourable price variance will tend to be associated with an
adverse volume variance and vice versa. It may be unrealistic to expect to sell more than the budgeted
volume when selling prices have increased.
REAL WORLD The software also includes several reports such

VIEWS 17.3 as variance reports by department, labour cost
variances and flexible budget reports, all of which
are useful for budgetary control and future budget
Standard costing in healthcare preparation. Integration with other Meditech soft-
Meditech South Africa (Pty) Ltd provides software modules and other systems implies cost data
ware solutions to meet the information needs of can be calculated at a departmental, procedure or
healthcare organizations in Africa and the Middle patient level. For example, the cost accounting mod-
East. According to their website, the software can ule can integrate with payroll systems and report
encompass all areas of healthcare from doctors’ on labour variance using labour productive hours
offices to hospitals. While their software products and dollars.
are generally patient centric, healthcare cost man-
agement also features in some of their products.
For example, the software designed for hospi- Questions
tals includes some functionality for finance man-
agers on cost accounting. The functions include 1 Do you think standards can be applied to
budgets and standard cost definition. Costs can procedures in hospitals?
be defined for labour, materials and overhead and 2 Do you think standard cost variance reports
can draw cost information from other Meditech are useful in healthcare?
software modules. With standard costs defined,
actual costs can be compared to standard/budget.
Reference
Standard costs can also be used as a basis to
Meditech website. Available at ehr.meditech.com/
reimburse costs from health insurers, or actual global/meditech-south-africa and home.meditech
costs of providing the services can be compared .com/en/d/functionalitybriefs/otherfiles/
to reimbursement levels. costaccounting.pdf (accessed 28 April 2020).
A further problem with sales variances is that the variances may arise from external factors and may not
be controllable by management. For example, changes in selling prices may be a reaction to changes; in
the selling prices of competitors. Alternatively, a reduction in both selling prices and sales volume may
be the result of an economic recession that was not foreseen when the budget was prepared. In general,
they may be useful in engaging management in discussion of the reasons for performance changes;
however, for control and performance appraisal, it may be preferable to compare actual market share
with target market share for each product. In addition, the trend in market shares should be monitored
and selling prices should be compared with competitors’ prices. These more ‘strategic’ performance
measures are increasingly being adopted by companies in addition to, or in place of, some of the stan-
dard cost variances.
RECONCILING BUDGETED PROFIT AND ACTUAL PROFIT

Top management will be interested in the reason for the actual profit being different from the budgeted
profit. By adding the favourable production and sales variances to the budgeted profit and deducting
the adverse variances, the reconciliation of budgeted and actual profit shown in Exhibit 17.4 can be
presented in respect of Example 17.1.
EXHIBIT 17.4 Reconciliation of budgeted and actual profits for a standard variable costing system
(£) (£) (£)
Budgeted net profit 80,000

Sales variances:
Sales margin price 18,000F
Sales margin volume 20,000A 2,000A
Direct cost variances:
Material: Price 8,900A
Usage 26,500A 35,400A
Labour: Rate 17,100A
Efficiency 13,500A 30,600A
Manufacturing overhead variances:
Fixed overhead expenditure 4,000F
Variable overhead expenditure 5,000F
Variable overhead efficiency 3,000A 6,000F 62,000A
Actual profit 18,0000
Example 17.1 assumes that Alpha Ltd produces a single product consisting of a single operation and
that the activities are performed by one responsibility centre. In practice, most companies make many
products, which require operations to be carried out in different responsibility centres. A reconciliation
statement such as that presented in Exhibit 17.4 will therefore normally represent a summary of the vari-
ances for many responsibility centres. The reconciliation statement thus represents a broad picture to top
management that explains the major reasons for any difference between the budgeted and actual profits.
STANDARD ABSORPTION COSTING

The external financial accounting regulations in most countries require that companies should value
inventories at full absorption manufacturing cost. The effect of this is that fixed overheads should be
allocated to products and included in the closing inventory valuations. With the variable costing system
illustrated above, fixed overheads are not allocated to products. Instead, the total fixed costs are charged
as an expense to the period in which they are incurred. (For a discussion of the differences between vari-
able and absorption costing systems, you should refer back to Chapter 7.) With an absorption costing
system, an additional fixed overhead variance is calculated. This variance is called a volume variance.
In addition, the sales margin variances must be expressed in unit profit margins instead of contribution
margins. These variances are not particularly useful for control purposes but are required for profit
measurement and inventory valuation purposes.
With a standard absorption costing system, predetermined fixed overhead rates are established by
dividing annual budgeted fixed overheads by the budgeted annual level of activity. We shall assume that,
in respect of Example 17.1, budgeted annual fixed overheads are £1,440,000 (£120,000 per month) and
budgeted annual activity is 120,000 units (10,000 units per month). The fixed overhead rate per unit of
output is calculated as follows:
Budgeted fixed overheads (£1,440,000)
5 £12 per unit of sigma produced
Budgeted activity (120,000 units)
Where different products are produced, units of output should be converted to standard hours. In
Example 17.1, the output of one unit of sigma requires three direct labour hours. Therefore, the budgeted
STANDARD ABSORPTION COSTING 471
output in standard hours is 360,000 hours (120,000 3 3 hours). The fixed overhead rate per standard
hour of output is:
Budgeted fixed overheads (£1,440,000)
5 £4 per standard hour
Budgeted standard hours (360,000)
By multiplying the number of hours required to produce one unit of sigma by £4 per hour, we also get a
fixed overhead allocation of £12 for one unit of sigma (3 hours 3 £4). For the remainder of this chapter,
output will be measured in terms of standard hours produced.
We shall assume that production is expected to occur evenly throughout the year. Monthly budgeted
production output is therefore 10,000 units, or 30,000 standard direct labour hours. At the planning stage,
an input of 30,000 direct labour hours (10,000 3 3 hours) will also be planned, as the company will bud-
get at the level of efficiency specified in the calculation of the product standard cost. Thus the budgeted
hours of input and the budgeted hours of output (i.e. the standard hours for the products produced) will be
the same at the planning stage. In contrast, the actual hours of input may differ from the standard hours
for the actual output of the products produced. In Example 17.1, the actual direct labour hours of input
are 28,500, and 27,000 standard hours should have been used for the products actually produced.
With an absorption costing system, fixed overheads of £108,000 (27,000 standard hours for an actual
output of 9,000 units at a standard rate of £4 per hour) will have been charged/allocated to products for the
month of April. Actual fixed overhead expenditure was £116,000. Therefore, £8,000 (£116,000 – £108,000)
has not been allocated to products. In other words, there has been an under-recovery of fixed overheads.
Where the fixed overheads allocated to products exceed the overhead incurred, there will be an over-
recovery of fixed overheads. The under- or over-recovery of fixed overheads represents the total fixed
overhead variance for the period. The total fixed overhead variance is calculated using a formula similar to
those for the total direct labour and total direct materials variances:
he total fixed overhead variance is the difference between the standard fixed overhead charged to
T
production (SC) and the actual fixed overhead incurred (AC):
SC (£108,000) 2 AC (£116,000) 5 £8,000A
Note that the standard cost for the actual production can be calculated by measuring production in
standard hours of output (27,000 hours 3 £4 per hour) or units of output (9,000 units 3 £12 per unit).
The under- or over-recovery of fixed overheads (i.e. the fixed overhead variance) arises because the
fixed overhead rate is calculated by dividing budgeted fixed overheads by budgeted output. If actual
output or actual fixed overhead expenditure differs from budget, an under- or over-recovery of fixed
overheads will arise. In other words, the under- or over-recovery may be due to the following:
1 a fixed overhead expenditure variance of £4,000 arising from actual expenditure (£116,000)
being different from budgeted expenditure (£120,000);
2 a fixed overhead volume variance arising from actual production differing from budgeted
production.
The fixed overhead expenditure variance also occurs with a variable costing system. The favourable
variance of £4,000 was explained earlier in this chapter and this is the only fixed overhead variance
occurring in a variable costing system. The volume variance arises only when inventories are valued on
an absorption costing basis.
Volume variance
This variance seeks to identify the portion of the total fixed overhead variance that is due to actual
production being different from budgeted production. In Example 17.1, the standard fixed overhead
rate of £4 per hour is calculated on the basis of a normal activity of 30,000 standard hours per month
(i.e. 10,000 units). Only when standard hours for the products actually produced are 30,000 will the
budgeted monthly fixed overheads of £120,000 be exactly recovered. Actual output, however, is only
9,000 units or 27,000 standard hours. The fact that the actual production is 3,000 standard hours less
than the budgeted output hours will lead to a failure to recover £12,000 fixed overhead (3,000 hours at
£4 fixed overhead rate per hour). The formula for the variance is:
The volume variance is the difference between the standard hours for the actual production (SH)
and the budgeted hours for the budgeted production (BH) for a period multiplied by the standard
fixed overhead rate (SR):
(SH 2 BH) 3 SR
The volume variance reflects the fact that fixed overheads do not fluctuate in relation to output in the
short term. Whenever actual production is less than budgeted production, the fixed overhead charged
to production will be less than the budgeted cost and the volume variance will be adverse. Conversely, if
the actual production is greater than the budgeted production, the volume variance will be favourable.
When the adverse volume variance of £12,000 is netted with the favourable expenditure variance
of £4,000, the result is equal to the total fixed overhead adverse variance of £8,000 calculated earlier. It
is also possible to analyse the volume variance into two further sub-variances 2 the volume efficiency
variance and the capacity variance.
Volume efficiency variance

If we wish to identify the reasons for the volume variance, we may ask why the actual production was
different from the budgeted production. One possible reason may be that the labour force worked at a
different level of efficiency from that anticipated in the budget.
The actual number of direct labour hours of input was 28,500. Hence one would have expected
28,500 hours of output (i.e. standard hours produced) from this input (that is, 9,500 units), but only
27,000 standard hours were actually produced. Thus one reason for the failure to meet the budgeted
output was that output in standard hours was 1,500 hours fewer than it should have been. If the labour
force had worked at the prescribed level of efficiency, an additional 1,500 standard hours would have
been produced and this would have led to a total of £6,000 (£1,500 hours at £4 per standard hour) fixed
overheads being absorbed. The inefficiency of labour is therefore one of the reasons why the actual
production was less than the budgeted production and this gives an adverse variance of £6,000. The
formula for the variance is:
he volume efficiency variance is the difference between the standard hours of output (SH) and
T
the actual hours of input (AH) for the period multiplied by the standard fixed overhead rate (SR):
(SH 2 AH) 3 SR
You may have noted that the physical content of this variance is a measure of labour efficiency and
is identical with the labour efficiency variance and in sympathy with the variable overhead effi-
ciency variance. Consequently, the reasons for this variance will be identical with those previously
described for the labour efficiency variance. All of these efficiency calculations assume there is an
association between overheads and hours, either standard or actual. We shall say more on this in the
next chapter.
Volume capacity variance

This variance indicates the second reason why the actual production might be different from the
budgeted production. The budget is based on the assumption that the direct labour hours of input
will be 30,000 hours, but the actual hours of input are 28,500 hours. The difference of 1,500 hours
STANDARD ABSORPTION COSTING 473
reflects the fact that the company has failed to utilize the planned capacity. If we assume that the 1,500
hours would have been worked at the prescribed level of efficiency, an additional 1,500 standard hours
could have been produced and an additional £6,000 fixed overhead could have been absorbed. Hence
the capacity variance is £6,000 adverse. Whereas the volume efficiency variance indicated a failure
to utilize capacity efficiently, the volume capacity variance indicates a failure to utilize capacity at all.
The formula is:
he volume capacity variance is the difference between the actual hours of input (AH) and the
T
budgeted hours of input (BH) for the period multiplied by the standard fixed overhead rate (SR):
(AH 2 BH) 3 SR
A failure to achieve the budgeted capacity may be for a variety of reasons. Machine breakdowns, mate-
rial shortages, poor production scheduling, labour disputes and a reduction in sales demand are all pos-
sible causes of an adverse volume capacity variance. The volume efficiency variance is £6,000 adverse
and the volume capacity variance is also £6,000 adverse. When these two variances are added together,
they agree with the fixed overhead volume variance of £12,000. Exhibit 17.5 summarizes the variances
we have calculated in this section.
EXHIBIT 17.5 Diagram of fixed overhead variances
Total fixed overhead variance

SC – AC
£108,000 – £116,000
£8,000A
Fixed overhead expenditure variance Volume variance

BFO – AFO (SH – BH) × SR
£120,000 – £116,000 (27,000 – 30,000) × £4
£4,000F £12,000A
Volume capacity variance Volume efficiency variance

(AH – BH) × SR (SH – AH) × SR
(28,500 – 30,000) × £4 (27,000 – 28,500) × £4
£6,000A £6,000A
You should note that the volume variance and two sub-variances (capacity and efficiency) are some-
times restated in non-monetary terms as follows:
Standard hours of actual output (27,000)

Production volume ratio 5 3 100
Budgeted hours of output (30,000)
5 90%
Standard hours of actual output (27,000)

Production efficiency ratio 5 3 100
Actual hours worked (28,500)
5 94.7%
Actual hours worked (28,500)

Capacity usage ratio 5 3 100
Budgeted hours of input (30,000)
5 95%
RECONCILIATION OF BUDGETED AND ACTUAL PROFIT

FOR A STANDARD ABSORPTION COSTING SYSTEM
The reconciliation of the budgeted and actual profits is shown in Exhibit 17.6. You will see that the rec-
onciliation statement is identical with the variable costing reconciliation statement, apart from the fact
that the absorption costing statement includes the fixed overhead volume variance and values the sales
margin volume variance at the standard profit margin per unit instead of the contribution per unit. If
you refer back to Example 17.1, you will see that the contribution margin for sigma is £20 per unit sold
whereas the profit margin per unit after deducting fixed overhead cost (£12 per unit) is £8. Multiplying
the difference in budgeted and actual sales volumes of 1,000 units by the standard profit margin gives
a sales volume margin variance of £8,000. Note that the sales margin price variance is identical for
both systems.
EXHIBIT 17.6 Reconciliation of budgeted and actual profit for a standard absorption costing system
(£) (£) (£) (£)
Budgeted net profit 80,000

Sales variances:
Sales margin price 18,000F
Sales margin volume 8,000A 10,000F
Direct cost variances:
Material – Price: Material A 19,000A
Material B 10,100F 8,900A
– Usage: Material A 10,000A
Material B 16,500A 26,500A 35,400A
Labour – Rate 17,100A
Efficiency 13,500A 30,600A
Manufacturing overhead variances:
Fixed – Expenditure 4,000F
Volume 12,000A 8,000A
Variable – Expenditure 5,000F
Efficiency 3,000A 2,000F 6,000A 62,000A
Actual profit 18,000
SUMMARY
The following items relate to the learning objectives listed at the beginning of the chapter.
●● Explain how a standard costing system operates.

Standard costing is most suited to an organization whose activities consist of a series of repeti-
tive operations and the input required to produce each unit of output can be specified. A standard
costing system involves the following: (a) the standard costs for the actual output are recorded
for each operation for each responsibility centre; (b) actual costs for each operation are traced
to each responsibility centre; (c) the standard and actual costs are compared; (d) variances are
investigated and corrective action is taken where appropriate; and (e) standards are monitored
and adjusted to reflect changes in standard usage and/or prices.
SUMMARY 475
●● Explain how standard costs are set.

Standards should be set for the quantities and prices of materials, labour and services to be
consumed in performing each operation associated with a product. Product standard costs are
derived by listing and adding the standard costs of operations required to produce a particular
product. Two approaches are used for setting standard costs. First, past historical records
can be used to estimate labour and material usage. Second, standards can be set based on
engineering studies. With engineering studies, a detailed study of each operation is undertaken
under controlled conditions, based on high levels of efficiency, to ascertain the quantities of
labour and materials required. Target prices are then applied based on efficient purchasing to
ascertain the standard costs.
●● Explain the meaning of standard hours produced.

It is not possible to measure output in terms of units produced for a department making several
different products or operations. This problem is overcome by ascertaining the amount of time,
working under efficient operating conditions, it should take to make each product. This time cal-
culation is called standard hours produced. Standard hours thus represents an output measure
that acts as a common denominator for adding together the production of unlike items.
●● Identify and describe the purposes of a standard costing system.

Standard costing systems can be used for the following purposes: (a) providing a prediction of
future costs that can be used for decision-making; (b) providing a challenging target which individ-
uals are motivated to achieve; (c) providing a reliable and convenient source of data for budget
preparation; (d) acting as a control device by highlighting those activities that do not conform to
plan and thus alerting managers to those situations that may be ‘out of control’ and in need of
corrective action; and (e) simplifying the task of tracing costs to products for profit measurement
and inventory valuation purpose.
●● Calculate labour, material, overhead and sales margin variances and reconcile actual
profit with budgeted profit.
To reconcile actual profit with budget profit, the favourable variances are added to the budgeted
profit and adverse variances are deducted. The end result should be the actual profit. A summary
of the formulae for the computation of the variances is presented in Exhibit 17.7. In each case,
the formula is presented so that a positive variance is favourable and a negative variance unfa-
vourable. Alternatively, you can use the routine generic approach shown in Appendix 17.1.
●● Identify the causes of labour, material, overhead and sales margin variances.
Quantity cost variances arise because the actual quantity of resources consumed differs from
the standard quantity. Examples of adverse variances include excess usage of materials and
labour arising from the usage of inferior materials, careless handling of materials and failure
to maintain machinery in proper condition. Price variances arise when the actual prices paid
for resources differ from the standard prices. Examples include the failure of the purchasing
function to seek the most efficient sources of supply or the use of a different grade of labour
from that incorporated in the standard costs.
●● Distinguish between standard variable costing and standard absorption costing.

With a standard variable costing system, fixed overheads are not allocated to products.
Sales margin variances are therefore reported in terms of contribution margins and a sin-
gle fixed overhead variance, that is, the fixed overhead expenditure variance is reported.
With a standard absorption costing system, fixed overheads are allocated to products and
this process leads to the creation of a fixed overhead volume variance and the reporting
of sales margin variances measured in terms of profit margins. The fixed overhead volume
variance is not particularly helpful for cost control purposes, but this variance is required
for financial accounting purposes.

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LABOUR VARIANCES 463

Wage rate variance

Labour efficiency variance

Total labour variance

VARIABLE OVERHEAD VARIANCES

Variable overhead expenditure variance

Variable overhead efficiency variance

A GENERIC ROUTINE APPROACH TO VARIANCE

FIXED OVERHEAD EXPENDITURE

The standard cost per unit is £7. Actual sales are

T he budgeted sales for a company are £110,000

REAL WORLD reservations (Hertz) call centre. Staff at these cen-

Total sales margin variance

Sales margin price variance

Sales margin volume variance

Difficulties in interpreting sales margin variances

REAL WORLD The software also includes several reports such

RECONCILING BUDGETED PROFIT AND ACTUAL PROFIT

(£) (£) (£)

Budgeted net profit 80,000

STANDARD ABSORPTION COSTING

SC (£108,000) 2 AC (£116,000) 5 £8,000A

Volume efficiency variance

Volume capacity variance

EXHIBIT 17.5 Diagram of fixed overhead variances

Total fixed overhead variance

Fixed overhead expenditure variance Volume variance

Volume capacity variance Volume efficiency variance

Standard hours of actual output (27,000)

Standard hours of actual output (27,000)

Actual hours worked (28,500)

RECONCILIATION OF BUDGETED AND ACTUAL PROFIT

(£) (£) (£) (£)

Budgeted net profit 80,000

●● Explain how a standard costing system operates.

●● Explain how standard costs are set.

●● Explain the meaning of standard hours produced.

●● Identify and describe the purposes of a standard costing system.

●● Distinguish between standard variable costing and standard absorption costing.

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