Variance Analysis in Budgeting by using Standard Costs

Before we begin with the topic for today, let us take a quick look at what a budget is. A budget is a quantitative expression of a plan of action prepared in advance of the period to which it relates. Budget may be departmental or functional, or even for the business as a whole. The process of preparing and agreeing budgets is a means of translating the overall objectives of the organization into detailed feasible plans of action.

Benefits of budgeting

Some of the benefits of budgeting and the budgetary process as a whole includes:

• Planning and coordination: It involves setting up a framework for the long term ; overall objectives to produce detailed operational plans for different sectors and facets of the organization. Planning is very important to the organization as a whole, it determines the success in business; and it is included into the budgeting process. Also the budgeting process provides for the coordination of the activities and department of the organization so that each facet of the operation contributes towards the overall plan.

• Communication: The budgetary process is all inclusive, everyone participates in it; it therefore serves as an important avenue of communication between top management and middle management regarding the firm’s objectives and the practical problems of implementing these objectives. When the budget is finalized, it communicates the agrees plan to all the parties involved.

• Control: The main topic for today, Variance analysis is a step in the control process. In control, actual results are compared with budgeted results; and the reason for variations if any are analyzed and corrected.

• Motivation: By including everyone in the budgetary process and establishing clear targets against which performance can be judged ,lower level management, middle level management and senior management are motivated to accomplish the targets they set for themselves.

Limiting factors in Budgets:

A limiting factor is a bottleneck; it effectively limits the activities of an organization. It may be machine hours, shortage of labor, material, customer demand, finance and more.  Because such a constraint will have a pervasive effect on all plans and budgets, the limiting factor must be identified and its effect on each of the budget preparation process must be ascertained.

Now that we have briefly gone through the budget process, let us now look at standard costs and progress to variance analysis.

Standard Cost

A standard cost is a carefully predetermined unit cost for each cost unit. Standard cost sets a desired standard for production, it contains the standard amount and price of each resource nthat will be utilized in the production process; right from materials to labor and overheads.

Standard costs and standard prices provide the basic unit information which is needed for valuing budgets and for determining total expenditures and revenues. The standard data serves as the foundation of variance analysis alongside the budget. With a standard cost, actual performance can be compared to the budget.

Types of Standards

• Ideal standards: This standard makes no allowance for inefficiencies such as waste, machine downtime etc. Ideal standard can be achieved only under perfect working conditions. Ideal standards mostly results in adverse variances because a certain amount of waste is usually unavoidable. This can be demoralizing to employees if they know that no matter how hard they work, they cannot meet the standard.

• Attainable Standard: These are standards that assume efficient levels of operation, but can be achieved; this is because there is room for factors such as losses, machine downtime, wastes, idle time etc.

• Current standards: These are standards based on current performance levels with current acceptable wastage

Variance Analysis

A variance is the difference between the expected standard cost and the actual cost incurred. Variance analysis is broken down into two parts; which are the usage and price variance of resources. These variances can be combined to reconcile the total cost difference revealed by the comparism of the actual and standard cost.

Variable cost analysis

As we know variable cost varies with the level of activity of the business. Examples of variable cost include direct material cost, direct labor cost and variable overhead. Let us now look at the variance analysis of direct material, direct labor, and variable overhead.

Direct material cost variance

Direct material price variance: This reveals how much of the direct material total variance was caused by paying a different price for the material used.

The formula =     (Standard price – Actual price) X Actual quantity

If the result is negative, it represents an adverse which means that more was paid for each unit of direct material used. If positive, it represents a favorable variance which means that less was paid for each unit of direct material used.

Direct material usage variance: Direct material usage variance reveals how much of the direct material variance was caused by using a different quantity of material, compared to the standard allowance for production ahead.

The formula for material usage variance =   (Standard Quantity – Actual Quantity) X Standard Price

A favorable material usage variance results from using a lower amount of material than standard expected for the level of output. Adverse material variance results from using a higher amount of material than standard expected for the level of output.

Direct Material Total variance:

The formula = (Standard direct material cost – Actual direct material cost). We can also derive it by saying: (Direct material price variance + Direct material usage variance.)

Direct labor cost variance

Direct labor rate variance: The direct labor rate variance reveals how much of the direct labor total variance was caused by paying a different rate per hour for the labor hours worked.

The formula = (Standard rate – Actual Rate) X Actual hours

A favorable direct labor rate variance indicates that less than standard was paid for each hour of labor. An adverse direct labor rate variance indicates that more than standard was paid for each hour of labor.

Direct labor efficiency Variance: Direct labor efficiency variance shows how much of direct labor total variance was caused by using a different number of hours of labor, compared with the standard allowance for the production achieved.

The formula for direct labor efficiency variance =

(Standard hour – Actual hour) X Standard rates

A favorable variance indicates that there have been savings in labor costs resulting from fewer labor hours than expected for the level of output. An adverse variance on the other hand, indicates that more labor hours than expected has been utilized thereby leading to an increase in labour cost.

Direct Labor total variance = Direct labor rate variance + direct labor efficiency variance

Or Total budget labor costs – Total Actual labor cost.

Variable overhead cost variances

Variable overhead expenditure variance: The variable overhead expenditure variance reveals how much of the variable overhead total variance was caused by paying a different hourly rate of overhead for the hours worked.

The formula =  (Standard overhead – Actual overhead rate) X Actual hours

Variable overhead efficiency variance: The variable overhead efficiency variance reveals how much of the variable overhead total variance was caused by using a different number of hours of labor compared to the standard allowance for the production achieved.

Formula = Standard overhead hours – Actual overhead hours) X Standard overhead rate

A favorable efficiency variance value (Positive +) indicates that there has been savings in variable overhead costs resulting from using fewer labor hours than the standards expected for the level of output.

An adverse efficiency variance (Negative -) indicates that there is an increase in variable overhead cost which results to more using more labor hours than the standard envisaged.

Recommended Reading

Jae Shim., and Joel Shigel, Schaum’s outline of Managerial Accounting