Understanding Production Order Variance - Part 1 Performance Evaluvation Through Standard Costs - SAP Blogs

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Understanding Production Order Variance –

Part 1 Performance Evaluvation Through
Standard Costs
October 23, 2012 | 12,337 Views |
Ranjit Simon John

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MAN Production Planning (PP)

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Understanding Production Order

Variance – Part 1
Managerial Accounting – Performance
Evaluation Through Standard Costs
Author: Ranjit Simon John
The ultimate aim of any company will be generating profit and increasing the
profit margin. There are many interpretations of the word profit. Time, resource,
money, effort, effectiveness etc are in one instance or the other equated to
profit. We can say all these words can be consolidated and merged into
“Efficiency“. By measuring the efficiency of a firm we can calculate the profit
and by improving the efficiency the profit margin grows. Lets drill down to find
the ingredients of “Efficiency“. Efficiency focuses on the cost of accomplishing
the task.
Lets explain “Efficiency” with an example. To evaluate the effectiveness of a
product produced the following questions has to be answered effectively;
1. Was the best cost obtained in purchasing raw materials.
2. Whether the specified quantity of raw material was used.
3. Was extra raw materials used
4. Was the specified amount and level of overheads used
5. Was the task completed within specified time
Measuring all these and confirming to the specified range will increase the
effectiveness there by increasing efficiency.
The importance of “STANDARDS“
Many finance managers argues on the point, actual price should only be
followed while valuating finished and semi finished goods, not the standard
price. The starting point of better controlling begins with better
“STANDARD“, let it be for price determination or for employee performance
evaluation.
In our daily life we are bound to meet certain standards; the food we eat,
the mobile phone we use, the car we drive, Government standards,
organizational standards are few to be noted. All and everything in our daily
life has to meet certain “STANDARD“.
Difference between Standard Cost and Budget:
Standards and Budgets are essentially the same in concept. Both are
predetermined costs and both contribute significantly to management planning
and control. A Standard is a Unit amount, whereas a budget is a Total amount.
There are important accounting differences between budgets and standards.
Budget data are not journalized in cost accounting. Standard cost will be
incorporated into accounting systems.

Why Standard Costs?
Standard Cost offer the following advantages;
Facilitate Management Planning by establishing expected future costs
Makes employees more “Cost Conscious”
Useful for Setting “Selling Price” for finished goods
Contribute to Management Control by providing a basis for evaluating
the performance of managers responsible for controlling costs.
Performance may be evaluated through management by exception, as
deviations (or Variances) from standard are highlighted
When standard costs are incorporated into the accounting system, they
simplify the costing of inventories and reduce clerical costs.
Provides a clear overview of the entire process in the company.
Setting Standard Costs

Setting up standard cost is a highly difficult task. Standards may be set at
one of two levels: Ideal Standards or Normal Standards.
Ideal Standards represent the optimum level of performance under perfect
operating conditions.
Normal Standards represent an efficient level of performance that is
attainable under expected operating conditions.
To be effective in controlling costs, standard costs need to be current at all
times. Thus, Standards should be under continuo’s review and should be
changed whenever it is determined that the existing standard is not good
measure of performance.
To establish the standard cost of producing a product, it is necessary to
establish standards for each manufacturing cost element – direct materials,
direct labor and manufacturing overhead. The standard for each element is
derived from a consideration of the standard price to be paid and the
standard quantity to be used.
The three Standard Cost calculation sections;
1) Direct Materials:
Direct Materials Price Standard
The direct materials price standard is the cost per unit of direct materials
that should be incurred. This standard should be the Cost of raw materials,
which is frequently based on an analysis of current purchase prices.
Item / Unit Price
Raw Material Purchase Price 2.70
Transportation Charge 0.20
Receiving and Handling 0.10
Standard Direct Material Price Per Ton 3.00
Direct Materials Quantity Standard
The direct materials quantity standard is the quantity of direct materials

thats should be used per unit of finished goods. The standard is expressed
as a physical measure. Consideration should be given to both the quality
and quantity of material required to manufacture the product. The standard
should include allowances for unavoidable waste and normal spoilage.
Item Quantity
Required Raw Material 3.50
Allowance for Waste 0.40
Allowance for Spoilage 0.10
Standard Direct Materials Quantity per Unit 4.00
The Standard Direct Material Cost Per Unit = Standard

Direct Material Price x Standard Direct Materials Quantity
2) Direct Labor
Direct Labor Price Standard
The direct labor price standard is the rate per hour that should be
incurred for direct labor.
Item Price
Hourly Wage Rate 7.50
Cost of Living 0.25
Other benifits 2.25
Standard Direct Labor Rate / Hour 10.00
Direct Labor Quantity Standard

The direct labor quantity standard is the time that should be required to
make one unit of the product.
Item Quantity
Actual Production Time 1.50
Rest Periods and Cleanup 0.20
Setup and Downtime 0.30
Standard Direct Labor Hours Per Unit 2.00
The Standard Direct Labor Cost Per Unit = Standard Direct

Labor Rate x Standard Direct Labor Hours
3) Manufacturing Overhead
For manufacturing overhead, a Standard Predetermined Overhead rate
is used in setting the standard. This overhead rate is determined by dividing
budgetd overhead costs by an expected standard activity index. For
example the index can be standard direct labor hours or standard machine
hours.
Budgeted Amount Standard Overhead Rate
Overhead Direct Per Direct

Costs Labor Labor Hour
Hours
Budgeted Overhead / Standard Direct = Overhead Rate Per Direct
Costs Ampunt Labor Hour Labor Hour
Variable 79,200.00 26,400.00 3.00
Fixed 52,800.00 26,400.00 2.00
Total 132,000.00 26,400.00 5.00
The Standard Manufacturing Overhead Rate Per Unit =

Predetermined Overhead Rate x Direct Labor Quantity
Standard
The total standard cost per unit is the sum of the standard costs of Direct
Materials, Direct Labor and Manufacturing Overheads.
Manufacturing Cost Standard Standard Price = Standard
Elements Quantity x Cost
Direct Materials 4 TON 3 12.00
Direct Labor 2 Hours 10 20.00
Manufacturing Overheads 2 Hours 5 10.00
Total Manufacturing 42.00

Cost
The standard cost provides the basis for determining variances from
standards.
Determining Variances from Standards
One of the major management use of standard cost is the determination of
Variances. Variances are the differences between total actual costs and
total standard cost. The process by which the total difference between
standard and actual results is analysed is known as variance analysis.
When actual results are better than the expected results, we have a
favourable variance (F). If, on the other hand, actual results are worse than
expected results, we have an adverse (A).
The following types of variance can be calculated;
Planning variances
– Input price variance
– Resource-usage variance
– Input quantity variance
– Remaining input variance
– Scrap variance
Production variances
– Input price
– variance
Production variance of the period
– Input price
– variance
– Scrap variance
– Mixed-price variance
– Output price variance
– Lot size variance
Total variance
– Input price
– variance
– Scrap variance
– Mixed-price variance
– Output price variance
– Lot size variance
– Remaining variance
* In make-to-stock production, standard cost is calculated in the standard

cost estimate for the material. In sales-order-related production with a
valuated sales order stock, standard cost is determined using a predefined
valuation strategy.
* During production, actual costs are collected on the order (product cost
collector or manufacturing order). The actual costs that are compared with
the target costs are reduced by the work in process and scrap variances
(the result is called the net actual cost).
* We can determine the production variances of the period by comparing an

alternative material cost estimate with the (net) actual costs. This alternative
material cost estimate can be the modified standard cost estimate or the
current cost estimate, for example.
Example: Let us assume that the standard manufacturing cost per ton of
“Material A” is 42.00. Production departement has produced 100 Ton of the
material. So Standard manufacturing cost = 100 * 42 = 42,000.00
In actual the consumption was as follows
Item Amount
Direct Materials 13,020.00
Direct Labor 20,580.00
Variable Overhead 6,500.00
Fixed Overhead 4,400.00
Total Actual Cost 44,500.00
Variance Posted
Actual Cost 44,500.00
Standrad Cost 42,000.00
Total Variance 2,500.00 (A)
Unfavourable and Favourable Variance

When actual costs exceed standard costs, the variance is unfavourable (A).
Thus, the 2,500.00 variance is unfavourable. An unfavourable variance has
a negative connotation. It suggests that too much was paid for one or more
manufacturing cost elements or that the elements were used inefficiently.
If the actual costs are less than standard costs, the variance is favourable
(F). A favourable variance has a positive inference. It suggests efficiencies
in incurring manufacturing costs and in using direct materials, direct labour,
and manufacturing overhead. Favourable variance can also be by using
inferior quality materials.
Analyzing variances begins with a determination of the cost elements that
comprise the variance. For each Cost element a total variance is
calculated. Then this variance is analyzed into a price variance and a
quantity variance.
Each of the Variance are explained in detail below.

Direct Material Variance
For producing 1,000 Ton of Cement, company A used 4,200 Ton of raw
material purchased at a cost of 3.10 per unit. The total material variance
is computed from the following formual;
The total material variance for Comapny A is 1,020 (A) (13,020 – 12,000).
(unfavourable variance)
(4,200 x 3.10) – (4,000 x 3.00) = 1,020.00 (A)
The material price variance is computed from the formula given below
The material price variance for Company A is 420.00 (A) (13,020 – 12,600).
(unfavourable Variance)
(4,200 x 3.10) – (4,200 x 3.00) = 420.00 (A)
The material quantity (usage) variance is determined from the following
formula;
The material quantit unfavourable variance is 600 (A) (12,600 – 12,000).

(Unfavourable Variance)
(4,200 x 3.00) – (4,000 x 3.00) = 600 (A)
Item Variance
Material Price Variance 420
Material Quantity VAriance 600
Total Material Variance 1,020 (A)
Variance Matrix
Variance matrix can be used to determine and analyze a variance. When
the matrix is used, the formulas for each cost element ar computed
rst and then the variances.
Applying variance martix:
Direct Labor Variance

The process of determining direct labor variance is the same as for
determining the direct material variance.
The total labor variance is obtained from the formula;
The total labor unfavourable variance is 580 (A) (20,850 – 20,000).

(Unfavourable Variance)
(2,100 x 9.8) – (2,000 x 10.00) = 580 (A)
The labor price (or rate) variance is calculated using the formula;
The labor price variance is 420 (F) (20,580 – 21,000). (Favourable

Variance)
(2,100 x 9.8) – (2,100 x 10.00) = 420 (F)

The labor quantity (or e ciency) variance is calculated using the
formula;
The labor quantity variance is 1,000 (A) (21,000 – 20,000). (unfavourable

variance)
(2,100 x 10.00) – (2,000 x 10.00) = 1,000 (A)
The total direct labor variance can be derieved from;
Item Variance
Labor Price Variance (420)
Labor Quantity Variance 1,000
Total Direct Labor Variance 580 (A)
Using the Variance Matrix;
Note: When idle time occurs the efficiency variance is based on hours
actually worked (not hours paid for) and an idle time variance (hours of
idle time x standard rate per hour) is calculated.
Manufacturing Overhead Variance
The computation of the manufacturing overhead variance is conceptually
the same as the computation of the materials and labor variances.
Total Overhead Variance
The total overhead variance is the difference between actual overhead
costs and overhead costs applied to work done. With standard costs,
manufacturing overhead costs are applied to work in process on the basis
of the standard hours allowed for the work done. Standard hours allowed
are the hours that should have been worked for the units produced. In the
example company A’s standard hours allowed for completing work B is
2,000 and the predetermined overhead rate is 5 per direct labor hour. Thus
overhead applied is 10,000 (2,000 x 5)
Note: The actual hours of direct labor are not used in applying
manufacturing overhead.
The formula for the total overhead variance is:
Thus total overhead variance for Comapny A is 900.

10,900 – 10,000 = 900
The overhead variance is generally analyzed through a price variance and a
quantity variance. The name usually given to the price variance is the
overhead controllable variance, whereas the quantity variance is referred to
as the overhead volume variance.
Overhead Controllable Variance
The overhead controllable variance (also called the budget or spending
variance) is the difference between the actual overhead costs incurred and
the budgeted costs for the standard hours allowed. The budgeted costs
are determined from the flexible manufactruning overhead budget.
The budget for Company A is as follow;
As shown, the budgeted costs for 2,000 standard hours are 10,400 (6,000
variable and 4,400 fixed)
The formula for the overhead controllable variance is;
The overhead controllable variance for Comapny A is 500 (unfavourable).

10,900 – 10,400 = 500
Most controllable variance are associated with variable costs which are
controllable costs. Fixed costs are usually at the time the budget is
prepared.
Overhead Volume Variance:

The overhead volume variance indicates whether plant facilities were
efficiently used during the period. The formula for calculating overhead
volume variance is as follows;
Both the factors on this formula has been explained above. The overhead
budgeted is the same as the amount used in computing the controllable
variance . Overhead applied is the amount used in determining the totoal
overhead variance.
In example for Company A the pverhead volume variance (unfavourable) is
400
10,400 – 10,000 = 400
The budgeted overhead consist of variable and fixed.
A careful examination of this analysis indicates that the overhead volume

variance relates solely to xed costs. Thus, the volume variance
measures the amount that xed overhead costs are under -or over
applied.
If the standard hours allowed are less than the standard hours at normal
capacity, fixed overhead costs will be underapplied.
If production exceeds normal capacity, fixed overhead costs will be
overapplied.
An alternative formula for computing the overhead volume variance is
shown below;
In example the normal capacity is 26,400 hours for the year or 2,200 hours
for a month (26,400 / 12), and the fixed overhead rate is 2 per hour. Thus,
the volume variance is 400 unfavourable;
2x (2,200 – 2,000) = 400
Overhead controllable variance 500
Overhead volume variance 400
Total Overhead Variance 900
Using Variance Matrix:
All variances should be reported to appropriate levels of management as

soon as possible. The sooner management is informed, the sooner
problems can be evaluvated and corrective actions taken if necessary.
Cause of Vraicnes
The causes of variance may relate to both external and intrenal factors.
Materials Variance
Labor Variance
Manufacturing Overhead Variance
Reference : “Accounting Principles” by Weygandt. Kieso. Kell
Also check the following links: Understanding Production Order Variance
Part 2 – The SAP Perspective
Understanding Production Order Variance
Part 3 – Price Difference Variance
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11 Comments
You must be Logged on to comment or reply to a post.
Jack Wu
October 31, 2012 at 3:41 am
Why do many pictures not display?
Could you modify the pictures?
Ranjit Simon John Post author
December 6, 2012 at 4:52 am
Hi,
I am able to see the pics. can you let me know which pics are not
getting displayed.
Netrananda Nayak
March 14, 2013 at 2:28 pm
Thanks a lot for this. Great one.
arturo senosain
June 17, 2013 at 10:01 pm
Hi.
Nice doc!
Amit Kumar Kataria
June 28, 2013 at 7:44 am
Very nice document !!!!!!!!!
Ikram hazari
July 18, 2013 at 8:26 pm
thanks
Devendra F
February 8, 2014 at 6:26 am
Thanks Ranjit,
It is lifetime saver,
Regards,
Devendra
Ranjit Simon John Post author
February 9, 2014 at 1:16 pm
Thank You Devendra, Good to know it helped
Aditya S
June 30, 2014 at 4:33 pm
Hi Ranjit,
At first i would like to thank you for the blog.
I have a query:-
I see you have mentioned that “
Thus total overhead variance for Comapny A is 900.
10900-10000=900″ in the section- “Manufacturing Overhead Variance“.
Can you please elaborate how the value 10900 is arrived here.
Thanks in advance.
vijay allam
August 6, 2016 at 8:00 pm
Its really helpful to understand the business…thanq so much…
Joy Knowledge
November 4, 2016 at 5:42 pm
Thank you, Its an interesting read, helping to understand production easing analysis
and reporting
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Products Industries Support Training Community Developer Partner

Understanding Production Order Variance –

Ranjit Simon John

MAN Production Planning (PP)

Understanding Production Order

incorporated into accounting systems.

Setting Standard Costs

Raw Material Purchase Price 2.70

Transportation Charge 0.20

Receiving and Handling 0.10

Standard Direct Material Price Per Ton 3.00

Direct Materials Quantity Standard

The direct materials quantity standard is the quantity of direct materials

Required Raw Material 3.50

Allowance for Waste 0.40

Allowance for Spoilage 0.10

Standard Direct Materials Quantity per Unit 4.00

The Standard Direct Material Cost Per Unit = Standard

Hourly Wage Rate 7.50

Cost of Living 0.25

Other benifits 2.25

Standard Direct Labor Rate / Hour 10.00

Direct Labor Quantity Standard

Actual Production Time 1.50

Rest Periods and Cleanup 0.20

Setup and Downtime 0.30

Standard Direct Labor Hours Per Unit 2.00

The Standard Direct Labor Cost Per Unit = Standard Direct

Budgeted Amount Standard Overhead Rate

Overhead Direct Per Direct

Budgeted Overhead / Standard Direct = Overhead Rate Per Direct

Costs Ampunt Labor Hour Labor Hour

Variable 79,200.00 26,400.00 3.00

Fixed 52,800.00 26,400.00 2.00

Total 132,000.00 26,400.00 5.00

The Standard Manufacturing Overhead Rate Per Unit =

Direct Materials 4 TON 3 12.00

Direct Labor 2 Hours 10 20.00

Manufacturing Overheads 2 Hours 5 10.00

Total Manufacturing 42.00

– Input price variance

– Input quantity variance

– Remaining input variance

– Input quantity variance

– Remaining input variance

Production variance of the period

– Input quantity variance

– Remaining input variance

– Output price variance

– Lot size variance

– Input quantity variance

– Remaining input variance

– Output price variance

– Lot size variance

* In make-to-stock production, standard cost is calculated in the standard

* We can determine the production variances of the period by comparing an

Direct Materials 13,020.00

Direct Labor 20,580.00

Variable Overhead 6,500.00

Fixed Overhead 4,400.00

Total Actual Cost 44,500.00

Actual Cost 44,500.00