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ILLUSTRATION 9-6 Prudent Business Limited manufactures a single product, which has a standard cost of N80 made up as follows: N Direct Materials 15 square metres at N3/sq. mtr. 45 Direct Labour 5 hours at N4/hour 20 Variable Overheads 5 hours at N2/hour 10 Fixed Overheads 5 hours at N1/per hour 5 80 The standard selling price of the product is N100 per unit. The monthly budget projects production and sales of 1,000 units. Actual figures for the month of April are as follows: Sales 1,200 units at N102 Production 1,400 units Direct materials 22,000 square metres at N4 per square metre Direct wages 6,800 hours at N5 Variable Overheads N11,000 Fixed Overheads N6,000 You are required to prepare a trading account reconciling actual and budgeted profit and showing all appropriate variances. 9.9.1 Fixed Overhead Cost Variance This is simply the difference between the Actual fixed overhead incurred and the fixed overhead absorbed using the predetermined absorption rate. From the Illustration 9-3 Actual Fixed Overhead incurred was Absorbed Fixed Overhead (based on actual production) was 1,400 units x N5 Therefore, F/ohd cost variance (over-absorption of overhead) N 6,000 7,000 1,000 F

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9.9.2

Fixed Overhead Expenditure Variance Fixed Overhead Expenditure Variance is simply that part of fixed overhead cost variance which was due to the failure to budget the amount of fixed overhead correctly, that is: N Budgeted Fixed Expenditure (1,000 units x N5) 5,000 Actual Fixed Overhead Expenditure 6,000 (1000) A Fixed Overhead Volume Variance This is that part of fixed overhead cost variance, which was due to the failure to budget production volume correctly. The reader will recall from the topic Overhead Absorption that the Absorption rate was predetermined by estimating the amount of overhead and the estimated volume. Thus: Budgeted production volume 1,000 units Actual production volume 1,400 units Difference 400 units Therefore, fixed overhead would be over absorbed @ N5 in the sum of 400 X N5 that is, N2,000 F. This is the Fixed overhead volume variance. Fixed Overhead Capacity and Efficiency Variances Investigating the volume variance further, it would be discovered that two major factors could be responsible. First, is the capacity budgeted to work. That is, based on a budget of 1,000 units and a working period of 5 hours per unit, the company had planned to work for 5,000 hours. If the workers fail to work for the 5,000 hours, that is, under utilization of available capacity they might not succeed in producing the 1,000 units except if they worked above normal efficiency. Hence, the efficiency of the labour force could also affect the production volume. It should, however, be borne in mind that we are working in terms of labour hours and so the fixed overhead rate will have to be expressed in terms of labour hours to obtain the fixed overhead capacity and the fixed overhead efficiency variances. Thus, in the Illustration 9-3,

9.9.3

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Fixed Overhead Capacity Variance Budget Capacity = 1,000 x 5 hours, that is, 5,000 hours Actual Hours Worked 6,800 hours Therefore, Fixed Overhead Capacity Variance= 1,800 hours =1,800 x N1 (FOAR per hr) = N1,800 F It is favourable, because more hours worked should result in increased production volume. Fixed Overhead Efficiency Variance The effect of the efficiency of labour on overhead absorption. Actual hours allowed for actual output = 1,400 unit x 5 hours = 7,000 hours Actual hours worked = 6,800 hours Hours saved = 200 hours Therefore, Fixed Overhead Efficiency Variance = 200 x N1 (FOAR per hour) = N200 F Reconciling, Fixed overhead volume variance: N2,000 F

Fixed Overhead Capacity Variance N1,800 F Variable Overhead Variances

Fixed Overhead Efficiency Variance N200 F

The same idea of Overhead absorption would also help simplify the calculation of variable overhead variances. Variable overhead cost variance is simply the difference between the Actual variable overhead expenditure incurred and the Variable overhead absorbed.

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From the Illustration 9-3,

Actual Variable Overhead Expenditure was Absorbed Fixed Overhead would be Actual production x the predetermined absorption rate (VOAR) that is, 1,400 x N10 14,000 Therefore, Variable Overhead Cost Variance = 3,000 F The variance is favourable because there was an over-recovery of the overhead. The Variable Overhead Cost Sub-Variances There is no volume variance in the Variable overhead analysis. This is because, by the very nature of this expenditure it should change when there is a change in volume. For this reason, some cost analysts stop the calculation of the variable overhead variance at the level of the variable overhead cost and call it variable overhead expenditure variance. However, many analysts also attempt to go further to see the effect of the labour on the overhead recovery. Then variable overhead is analysed into expenditure and efficiency. The calculation at this stage is quite similar to the calculation of the fixed overhead capacity and efficiency variances in that they use labour hours and express the absorption rates in terms of labour hours. Variable Overhead Expenditure Variance This is based on the assumption that variable overhead varies with actual labour hours worked. Therefore, variable overhead expenditure is the difference between the actual variable overhead expenditure and the allowed variable overhead expenditure based on actual hours worked.

N 11,000

Hint: You can first calculate the variable overhead absorption rate per
labour hour. In this question, this becomes. Budgeted Variable Overhead = N10,000 Budgeted Labour Hour 5,000 = N2 per hour Variable Expenditure Variance Actual Variable Overhead Expenditure Allowed Variable Overhead = N11,000

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(6,800 hours x N2) Variable Overhead Efficiency Variance

N13,600 N2,600 F

This is the difference between the allowed variable overhead and the absorbed variable overhead. If the time-based bonus schemes of remuneration in Labour Costing in Chapter 3 is brought to mind, the variable overhead efficiency variance can be looked at as the labour efficiency indicated by the time saved, but now valued at the variable overhead absorption rate (VOAR) per labour hour. that is, Allowed Variable Overhead Expenditure (1,400 units x 5 x N2) Absorbed Variable Overhead (6,800 hours x N2) Alternatively, Time Allowed (1,400 x 5) Time Taken Time Saved = = N 14,000 13,600 N400 F 7,000 hours 6,800 200 hours = N400 F

Therefore, Variable Overhead Efficiency Variance (200 hours x N2) Calculation of Sales Margin Total Variance

This is the difference between the Budgeted Margin and the Actual Margin attained. Actual Margin should be understood, to be the Actual sales revenue less the Standard cost of sales. From Illustration 9-3: Total Sales Margin Variance Actual Sales Revenue = 1,200 x N102 Standard Cost of Sales = 1,200 x N80 Therefore, Actual Margin is Budgeted Margin 1,000 units X (100 80) Therefore, Total Sales Margin Variance N 122,400 96,000 26,400 20,000 6,400 F

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Sales Margin Price Variance This is the variance due to selling at a price different from the standard selling price. This is similar to the material price and the labour rate variances. N Actual Quantity Sold @ Actual Selling Price (1,200 x 102) = 122,400 Less Actual Quantity Sold @ Standard Selling Price (1,200 x 100) = 120,000 2,400 F Sales Margin Volume Variance This is Profit Variance due to a change in budgeted volume: Budgeted volume = 1,000 units Actual volume = 1,200 units Difference 200 units @Standard Margin of N20 = N4,000 F Exception to the variances computed above is sales margin variance where more than one product is for sales, that is, where it is possible or necessary to calculate the sales margin (mix and quantity) variances. We can now illustrate how the operating statement reconciling budgeted profit with actual profit is prepared. You are requested to complete the other cost variances on your own, that is, material price, material usage, labour rate and labour efficiency. The operating statement should start with the name of the organisation, and the title of the statement including the relevant period. Prudent Business Limited Operating Statement for the month of June 2005 Fav Adv N N N Budgeted Profit 20,000 Sales Margin Variance Price Volume Cost Variances Materials - Price - Usage Labour - Rate - Efficiency 2,400 4,000 22,000 3,000 6,800

6,400 26,400

800

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Variable Overhead - Expenditure - Efficiency Fixed Overhead - Expenditure - Volume Actual Loss

2,600 400 2,000 5,800 1,000 32,800 (27,000) (600)

The listing of the variances explains why the Budgeted Profit was not achieved. The actual loss can be proved as follows: Actual Result Sales Cost of Sales Materials Labour Variable Overhead Fixed Overhead 1,200 x N102 22,000 x N4 6,800 x N5 88,000 34,000 11,000 6,000 139,000 (16,000) (123,000) (600) N N 122,400

less: Closing stock at standard cost 200 x N80 Actual Loss Sales Margin Mix Variance

Where more than one product is sold, it is possible to isolate the effects on profit of a change in the volume due to proportions in which the products were sold, that is, the mix, and the absolute quantity difference. The sales margin volume variance can be analysed into sales margin mix variance and sales margin quantity (or yield) variance. Two approaches are possible the unit approach and the sales value approach. Though, the unit approach will be used in this illustration, it is warned that where the relative sales value of the products are significantly different, it will be advisable to use the sales value approach. This will be considered at the higher level of your study, that is, in the Management Accounting paper.

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