Assignment 4 – Variances (5 marks)

Q1. Woodeezer Ltd makes quality wooden benches for both indoor and outdoor use. Results have been
disappointing in recent years and a new managing director, Peter Beech, was appointed to raise
production volumes. After an initial assessment Peter Beech considered that budgets had been set at
levels which made it easy for employees to achieve.
He argued that employees would be better motivated by setting budgets which challenged them more in
terms of higher expected output. Other than changing the overall budgeted output, Mr Beech has not yet
altered any part of the standard cost card.
Thus, the budgeted output and sales for November 2002 was 4,000 benches and the standard cost card
below was calculated on this basis:
£
Wood 25 kg at £3.20 per kg 80.00
Labour 4 hours at £8 per hour 32.00
Variable overheads 4 hours at £4 per hour 16.00
Fixed overheads 4 hours at £16 per hour 64.00
192.00
Selling price 220.00
Standard profit 28.00
Overheads are absorbed on the basis of labour hours and the company uses an absorption costing
system. There were no stocks at the beginning of November 2002. Stocks are valued at standard cost.

Actual results for November 2002 were as follows:

£
Wood 80,000 kg at £3.50 per kg 280,000
Labour 16,000 hours at £7.00 per hour 112,000
Variable overheads 60,000
Fixed overheads 196,000
Total production cost 648,000
Closing stock (400 benches at £192) 76,800
Cost of sales 571,200
Sales (3,200 benches) 720,000
Actual profit 148,800
The average monthly production and sales for some years prior to November 2002 had been 3,400 units
and budgets had previously been set at this level. Very few operating variances had historically been
generated by the standard costs used.
Mr Beech has made some significant changes to the operations of the company. However, the other
directors are now concerned that Mr Beech has been too ambitious in raising production targets. Mr
Beech had also changed suppliers of raw materials to improve quality, increased selling prices, begun
to introduce less skilled labour, and significantly reduced fixed overheads.
The finance director suggested that an absorption costing system is misleading and that a marginal
costing system should be considered at some stage in the future to guide decision-making.
Required:
Prepare an operating statement for November 2002. This should show all operating variances and
should reconcile budgeted and actual profit for the month for Woodeezer Ltd. (14 marks)

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Q2. McDermott plc is a manufacturer of beds. It uses a standard absorption costing system to monitor
performance of managers and departments. A standard absorption cost card for one of its models, the
Dreamer, is given below.
£ £
Selling price 250·00
Production costs
Direct material: 12 metres at £1·50 per metre 18·00
Direct labour: 4 hours at £6·00 per hour 24·00
Variable overhead: 4 hours at £15·00 per hour 60·00
Fixed overhead: 4 hours at £10·00 per hour 40·00
142·00
Gross profit 108·00
Budgeted production and sales are 1,000 Dreamers per month.
Actual results for the manufacture and sale of Dreamers for the most recent month were as follows:
Sales: 1,200 beds at £240 each.
Production: 1,300 beds
Direct material (purchased and used): 16,000 metres at £1·40 per metre
Direct labour (worked and paid): 5,000 hours at £6·00 per hour
Variable overhead £75,500
Fixed overheads £54,600.
There were no opening stocks of finished goods.
Required:
(a) Calculate the following variances for the most recent month
(i) Direct materials price and usage variance;
(ii) Direct labour rate and efficiency variance;
(iii) Variable overhead rate and efficiency variance; and
(iv) Fixed overhead expenditure and volume variance.
(v) Sales volume contribution and sales price variance;
Explain the differences between standard absorption costing and standard marginal costing in the
following areas:
(i) the sales volume variance;
(ii) the fixed overhead variances;
(iii) stock valuation and its effect upon profit.
(no further calculations are required) (10 marks)

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Q4. The summary production budget of a factory with a single product for a four week period is as
follows:
Production and sales quantity 240,000 units
Production costs:
Material: 336,000 kg at £4.10 per kg
Direct labour: 216,000 hours at £4.50 per hour
Variable overheads: £475,200
Fixed overheads: £1,521,600
Sales revenue £6,000,000
Variable and fixed overheads are absorbed at a predetermined direct labour hour rate.

During the four week period the actual production and sale was 220,000 units which incurred the
following costs:
Material: 313 060 kg costing £1 245 980
Direct labour: 194 920 hours costing £886 886
Variable overheads: £433 700
Fixed overheads: £1,501,240
Sales revenue £6,160,000
Required:
(a) Calculate standard cost card showing gross profit (6 marks)
(b) Calculate the cost variances for the period.
i. Material price variance (£37,566 fav)
ii. Material usage variance (£ 20,746 adv)
iii. Labour rate variance (£9,746adv)
iv. Labour efficiency variance (£13,860 fav)
v. Variable overhead efficiency variance (£6,776 fav)
vi. Variable overhead expenditure variance (£4,876 adv)
vii. Fixed overhead expenditure variance (£20,360 fav)
viii. Fixed overhead volume variance (£126,800 adv)
ix. Sales price variance (£660,000 fav)
x. Sales volume variance (Gross profit: £6.89 / unit, £137,800 adv) (12 marks)
(c) Give reasons in each case why the direct labour efficiency, variable overhead efficiency and fixed
overhead volume variances may have arisen. (8 marks)

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 Q5. Extract from the records of AMAX Limited are as under
Budget (£) Actual (£)
Sales revenue 27,000,000 27,295,000
Variable cost
Raw material 7,500,000 8,461,450
Labour 9,375,000 9,463,125
Variable overheads 3,000,000 2,976,125
Contribution 7,125,000 6,396,300
An analysis of the above figures has revealed the following:
 Actual units manufactured and sold were 3% (1,500 units) more than the budgeted production and sales
quantity and actual sale price was lower by £10 per unit.
 One unit of finished product requires 3 kgs of raw material and actual raw material price was 6% higher
than the budgeted price.
 Budgeted labour cost per hour was equivalent to 150% of budgeted raw material cost per kg.
 Production department records show that labour utilization per unit of finished product was 1/8 hour more
than the budget.
 Variable overheads varied in line with labour hours.
Required:
Compute eight relevant variances and prepare a statement reconciling budgeted contribution with the
actual contribution. (20 marks)

Q6.

The company uses FIFO method for inventory valuation.

All materials are added at the beginning of the process. Conversion costs are incurred evenly
throughout the process. All Inspection takes place when the units are 80% complete. Under normal
conditions, no spoilage should occur.
Required
(a) Prepare a quantity and equivalent production schedules for material and conversion costs.
(b) Calculate material, labour and variable overhead variances. (Assume that the material price variance
is calculated as materials are used rather than as they are purchased).
(c) Calculate the over(under) absorption of fixed production overhead and analyse it into expenditure
variance and volume variance.

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Theory of standard costing and variances
Standard costing system most suited to an organization whose activities consists of a series of common
or repetitive operations and the input required to produce each unit of output is specified

What is a standard cost?

A standard cost is a planned or forecast unit cost for a product or service, which is assumed to hold good
given expected efficiency and cost levels within an organisation. It represents a target cost and is useful
for planning, controlling and motivating within an organisation.

Standard costing can be used for

Standard costs have many uses.
 They can be used to predict and forecast future costs for use in decision-making and budgeting.
 They can be used as a basis for controlling costs arising in actual operations through detailed variance
analysis, that is, the comparison of actual results with standard costs.
 They can be used as a basis for measuring and assessing the performance of managers and
employees.
 They can provide targets for motivating managers and employees to improve performance and meet
organisational objectives.
 They can be used as a basis for profit measurement and stock valuation.

Critism of standard costing

 Sometimes hard to define an ‘attainable standard’
 Uncontrollability of performance within operations e.g. discounts lost due to the reduction in the
quantity ordered or seasonal price fluctuations within the period of appraisal
 With more automation within operations, they become less valuable as information
 Revisions to standards may be too frequent to guide performance over time
 Performance measurement would be inadequate as a process if the standard is wrong
 The reason or cause of the variance are sometimes overlooked or not investigated

Types of standard
There are four types of standard cost, as follows.
Ideal standard
This is a standard that reflects perfect performance and is the minimum cost that is possible under ideal
operating conditions (for eg no losses, no idle time, 100% efficiency of labour, no machine breakdown etc).
Because ideal standards are unattainable, they are unlikely to be used in practice, since inability to achieve
them is likely to have a demotivating effect on managers and employees.
Basic standard
This is a standard that remains unchanged for long periods of time. Because it remains unchanged, it
allows efficiency trends over time to be identified. Because basic standards do not reflect current
conditions, they are of limited use if current conditions differ significantly from those existing when the
standard was set. They are therefore seldom used.
Attainable standard
This standard allows for normal levels of wastage and operation, and represents a cost level achievable
under reasonably efficient working. Attainable standards may be difficult to achieve, but they do not
represent impossible targets for employees.
An attainable standard is considered to represent the best target against which to compare current
activity and is the preferred standard to use in planning, budgeting and cost control.
Current standard
This standard is one established for use over a short period of time and relates to current conditions.

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The preparation of standard costs
A standard cost has two elements, namely a physical measure of a resource and a price per unit of
resource. A standard cost for material, for example, consists of a specification of the kilograms of material
required per unit of product, and a specification of the price paid per kilogram. When setting standards,
both elements need to be determined.
Standard costing is best suited to operations which are repetitive, where the quantity of resource needed
to produce a given quantity of output can be specified. It is therefore suited to manufacturing processes
and the provision of repetitive services, such as the processing of loan applications in a financial
institution.
Standard costs can be developed through the application of quantitative analysis, such as the engineering
approach, which uses technical specifications or time and motion study, and the accounts analysis
approach, which analyses past accounting information. Quantitative analysis of past accounting
information through techniques such as the high-low method and regression analysis can provide a cost
function that can be used in the preparation of a standard cost.

The use of standard costs

Standard costs have many uses. They can be used to predict and forecast future costs for use in decision-
making and budgeting. They can be used as a basis for controlling costs arising in actual operations
through detailed variance analysis, that is, the comparison of actual results with standard costs. They can
be used as a basis for measuring and assessing the performance of managers and employees. They can
provide targets for motivating managers and employees to improve performance and meet organisational
objectives. They can be used as a basis for profit measurement and stock valuation.

The review of standard costs

Currently attainable standards only remain relevant if they continue to relate to current circumstances,
that is, if they are regularly reviewed to take account of any changes in operating methods and any
changes in the economic and business environment. If changes are small and not significant, the standard
may be left unchanged. If changes are more significant, management may consider using reporting
planning and operational variances to highlight differences that have arisen and to keep reported
variances useful from a responsibility accounting perspective.

Whether to investigate a variance or not

When deciding whether to investigate a variance, the following factors should be considered.
i) The size of the variance
Investigating large variances is likely to lead to large cost savings. Since ‘large variance’ is an imprecise
term, a company can require that all variances above a given size should be investigated. This size
threshold could be specified in percentage terms relative to the underlying cost, i.e. all variances of 5% or
more should be investigated.
ii) Whether the variance is favourable or adverse
This should not influence whether a variance is investigated. While it is natural to focus on adverse
variances in order to bring actual profitability back into line with planned profitability, investigation of
favourable variances can provide useful information. Budgetary slack may be discovered, or the budget
may not be demanding enough to be motivating, or improvements in operating practices may have arisen.
iii) Whether the cost is greater than the benefit
The expected cost of investigating a variance should not normally exceed the benefit arising from its
explanation or correction, since this goes against the drive to increase profitability.

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iv) What has happened in the past
The historic pattern of variances should be considered and variances identified which are unusual
compared to variances recorded in previous periods. Statistical control charts may be used for this
purpose. Here, variations about the arithmetic mean are recorded and compared to control limits, set for
example at plus and minus two standard deviations from the mean.
Variances outside of the control limits are investigated. Statistical analysis of performance in previous
periods can be used to determine the expected mean value and the standard deviation.

Causes of variances
Reasons for material price variance
Purchasing department is responsible for price variance
Favourable (actual price less than standard price)
 Company might have used cheap quality material
 Company might have changed supplier
 Availability of unforeseen discount
 Overall decrease in price level
 Overall decrease in demand or increase in supply
 Standard might be inappropriate
Adverse (actual price higher than standard price)
 Company might have used high quality material
 Urgent purchasing due to poor inventory management
 Overall increase in price level
 Overall increase in demand or decrease in supply
Reasons for material usage variance
Production department is responsible for usage variance.
Favourable (actual consumption less than standard consumption)
 Company might have used high quality material
 This might be result of skilled labour
 Proper machine maintenance
 Standard might be inappropriate
Adverse (actual price higher than standard price)
 Company might have used cheap quality material
 Company might have employed unskilled labour
 Lack of proper machine maintenance
 Standard might be inappropriate

Reasons for labour rate variance

Personnel department is responsible for labour wage rate variance.
Favourable (actual wage rate less than standard wage rate)
 Unskilled labour
 Low inflation than expected
 Increase in supply of labour
 Inappropriate standard
Adverse (actual price higher than standard price)
 Use of experienced labour
 Overtime premium or other incentive paid to labour
 Increase in minimum wage rate by government
 Inappropriate standard

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Reasons for labour efficiency variance
Production department is responsible for usage variance.
Favourable (actual hours less than standard hours required)
 Use of experienced labour
 Use of good quality material
 Better machine or equipment available for the manufacturing
 Improved working conditions
Adverse (actual hours higher than standard hours required)
 Use of less skilled labour or lack of training
 Use of low quality material
 Lack of machine maintenance
 Poor working conditions

Variable overhead variance

 Unexpected price changes for overhead items.
 Labour efficiency variances

Fixed overhead expenditure variance

 Changes in prices relating to fixed overhead items e.g. rent increase.
 Over a whole year the seasonal effects would cancel out.)
Fixed overhead volume variance
 Change in production volume due to change in demand or alterations to stockholding policy.
 Changes in productivity of labour or machinery.
 Production lost through strikes etc.

Sales price variance

 Change in demand or supply of product
 Different quality of product
 To achieve a targeted sales volume
 Increase or decrease in competition level
Sales volume variance
 Change in price of the product
 Reduction in market share
 Due to discontinuation of complementary product