Direct Materials Price Variance

A variance is the difference between planned, budgeted or standard cost and the actual costs or revenues received. Variance analysis is to measure performance, correct inefficiencies, deal with the accountability function. When a variance is worse that the budgeted or standard cost it is said to be adverse and it is an accounting convention that adverse variances are shown in brackets. If the costs and revenues are better than the budgeted or standard costs the variance is favourable.

Direct Materials Price Variance

This is defined as the difference between the standard price and the actual purchase price for the actual quantity of the material. This can be calculated at the time of delivery or at the time of usage. It is best to calculate whether or not a variance has occurred when the material is delivered. It is also good accounting practice to write off or add to profit any variance which has occurred at the earliest opportunity.

Formula for Calculating whether or not a variance has occurred

Actual Quantity Purchased x (Standard Price – Actual Price)

Causes of Material Price Variances

In the case of materials, an adverse price variance usually means that a supplier has increased the price of the goods after the standard has been set. If prices are rising because of inflation there is little the firm can do. Whenever the purchasing department place a large order with one supplier an attempt should be made to fix a price for the life of the contract. This may not always be possible due to inability to meet minimum order levels and does not become entitled to discounts. This type of situation shows standards are predictions and are a measure of forecasting rather than a measure of operating efficiency.

Direct Material usage Variance

This is the difference between the standard quantity specified for the actual production and the actual quantity used, at standard purchase price. It is calculated using the following formula:

(Standard Quantity specified for actual production – Actual Quantity used) x Standard Price

Causes of Usage Variances

Management should be able to control usage variances because the difference will have taken place within the firm. Often the variance will have been brought about by carelessness, e.g. incorrect storage which could lead to spillage o deterioration. It may also have occurred because of careless usage or the workforce being unskilled or inexperienced in using the material. Lastly the materials used may have been of poor quality. This often brings about a high usage variance as many of the units produced will fail to meet the required quality levels and will therefore have to be scrapped.

Direct Labour Variance

This is the difference between the standard direct labour cost and the actual direct labour cost incurred for the production achieved. By doing this calculation, the hours worked or actually booked to the job can be compared with the actual standard hours produced at the end of the programme of work. The variance is calculated using the following formula:

(Standard direct labour hours produced x Standard rate per hour)
less
(Actual direct labour hours worked x Actual rate per hour)

Direct Labour Rate Variance

This is defined as the difference between the standard and the actual direct labour rate per hour of the total hours worked/paid. The variance is calculated by the following formula:
(standard rate per hour – Actual rate per hour) x Actual hours worked/paid.

Causes of Labour Rate Variances

Labour rate variances need not arise if standards are based on the current union negotiated pay rates. Sometimes the standards are set before the pay rates have been negotiated and so it is important for management to identify the difference between the standard rate and the agreed settled rate. If this is not the case other causes must be investigated. Temporary labour may also have been used and they may have been paid a t a different rate. Lastly, special allowances may have been paid to staff for overtime etc which will effectively increase the hourly rate.

Direct Labour Efficiency Variance

This is the difference between the standard hours for the actual production achieved and the hours actually worked, valued at the standard labour rate. It is calculated by the formula:
(Standard hours produced – actual hours worked) x Standard rate per hour.

Causes of Efficiency Variances

Inadequate training may be responsible for the variance. If the workers are inexperienced they usually take longer to do the job or there may be quality problems resulting in more rejects being produced. The cause could also be due to poor quality materials being purchased because the usual source is temporarily out of stock.

Overhead Variances

The variable overheads will be activity related whereas the fixed overheads will be time related. An overhead expenditure variance is defined as the difference between budgeted and actual overhead expenditure.

Fixed overheads are calculated using the following formula:
Fixed overhead budgeted cost – Actual conversion overhead incurred.

Variable overheads are calculated as follows:
(Actual units produced x variable overhead absorption rate per unit) less actual stock.

Variance investigation

1. A variance by itself seldom provides sufficient information for making good decisions.
2.  A manager is usually uncertain whether a variance is caused by a problem or is a random fluctuation.
3.  Aggregating variances over time provides managers with more confidence about the origins of the variance.
4.  To understand the cause of a variance, a manager must investigate the source of the variance.
5.  Investigation is costly so not every nonzero variance should be investigated.
6.  Factors affecting the decision to investigate include the size of the variance, the opportunity cost of investigation, the opportunity cost of not investigating, and the ease of correcting the problem if it exists.

 Factors affecting the decision to investigate include the size of the variance, the opportunity cost of investigation, the opportunity cost of not investigating, and the ease of correcting the problem if it exists.