16–1
Chapter 16
Fundamentals of Variance Analysis
Learning Objectives
1. Use budgets for performance evaluation.
2. Develop and use flexible budgets.
3. Compute and interpret the sales activity variance.
4. Prepare and use a profit variance analysis.
5. Compute and use variable cost variances.
6. Compute and use fixed cost variances.
7. (Appendix) Understand how to record costs in a standard costing system.
16–2
Chapter Overview
I. USING BUDGETS FOR PERFORMANCE EVALUATION
II. PROFIT VARIANCE
• Why are Actual and Budgeted Results Different?
III. FLEXIBLE BUDGETING
IV. COMPARING BUDGETS AND RESULTS
• Sales Activity Variance
o Interpreting Variances
V. PROFIT VARIANCE ANALYSIS AS A KEY TOOL FOR MANAGERS
• Sales Price Variance
VI. PERFORMANCE MEASUREMENT AND CONTROL IN A COST CENTER
• Variable Production Costs
o Direct Materials
o Direct Labor
o Variable Production Overhead
VII. VARIABLE COST VARIANCE ANALYSIS
• General Model
• Direct Materials
o Responsibility for Direct Materials Variances
• Direct Labor
o Direct Labor Price Variance
o Labor Efficiency Variance
• Variable Production Overhead
o Variable Production Overhead Price Variance
o Variable Overhead Efficiency Variance
• Variable Cost Variances Summarized in Graphic Form
VIII. FIXED COST VARIANCES
• Fixed Cost Variances with Variable Costing
IX. SUMMARY OF OVERHEAD VARIANCES
• Key Points
16–3
Chapter Overview, continued
X. APPENDIX: RECORDING COSTS IN A STANDARD COST SYSTEM
• Direct Materials
• Direct Labor
• Variable Manufacturing Overhead
• Fixed Manufacturing Overhead
• Transfer To Finished Goods Inventory and to Cost of Goods Sold
• Close Out Variance Accounts to Cost of Goods Sold
16–4
Chapter Outline
LO 16-1 Use budgets for performance evaluation.
USING BUDGETS FOR PERFORMANCE EVALUATION
• The development of the master budget is the first step in the budgetary planning and control
cycle.
o The budgeting process provides a means to coordinate activities among units of the
organization, to communicate the organization’s goals to individual units, and to ensure
o The budget is management’s plan for financial performance.
• The master budget includes:
o Operating budgets (such as the budgeted income statement, production budget,
budgeted cost of goods sold, and supporting budgets)
• Variance is the difference between planned result and actual outcome. That is:
Variance = Actual result – Budgeted performance.
o Variance analysis is used to:
16–5
PROFIT VARIANCE
• The simplest measure of performance is the variance between actual income and budgeted
income.
o A favorable variance is the variance that, taken alone, results in an addition to operating
profit.
o An unfavorable variance is the variance that, taken alone, reduces operating profit.
o The labels “favorable” and “unfavorable” should not be considered as evaluations of
performance without additional investigation. (See Business Application box “When a
Favorable Variance Might Not Mean “Good” News.”)
▪ Although a simple comparison of planned and actual profit suggests that performance
was better (or worse) than planned, the additional data (such as those in Exhibit 16.2)
provide information on the impact on profit performance from each of the revenue
and cost line items.
▪ The additional information is useful for two reasons:
• Why are Actual and Budgeted Results Different?
o An important part of variance analysis is to understand:
▪ What might cause a difference between actual and budgeted results.
16–6
o The following table summarizes the variance analysis between actual results and the
master budget for line items comprising the operating profit:
(1)
Actual
(3) = (1) – (2)
Variancea
(2)
Master Budget
Units
xxx
xxx F or U
xxx
Sales revenue
$ xxx
$xxx F or U
$ xxx
=
+
Unit Variable
×
See Demonstration Problem 1
LO 16-2 Develop and use flexible budgets.
FLEXIBLE BUDGETING
• One obvious reason that actual results might differ from budgeted results is that the actual
activity itself differed from the budgeted or expected activity.
o A static budget is developed in detail for one level of anticipated activity, such as a
master budget.
o A flexible budget indicates budgeted revenues, costs, and profits for virtually all feasible
levels of activities.
▪ Because variable costs and revenues change with changes in activity levels, these
amounts are budgeted to be different at each activity level in the flexible budget.
▪ Flexible budget line is the expected costs at different output levels and can be
represented by the following formula:
Contribution margin
$xxx
$xxx F or U
Operating profit
$ xxx
$xxx F or U
$ xxx
16–7
LO 16-3 Compute and interpret the sales activity variance.
COMPARING BUDGETS AND RESULTS
• A comparison of the master budget with the flexible budget and with actual results is the
basis for analyzing differences between plans and actual performance.
• Sales Activity Variance
o Sales activity variance (also known as sales volume variance) is the difference between
operating profit in the master budget and operating profit in flexible budget that arises
because the actual number of units sold is different from the budgeted number.
▪ That is:
o The sales activity variance, as shown in Exhibit 16.4, is useful for management because:
16–8
o Interpreting Variances
▪ Holding everything else constant, a decrease in sales creates an unfavorable sales
activity variance as shown in Exhibit 16.4. Does this indicate poor performance?
LO 16-4 Prepare and use a profit variance analysis.
PROFIT VARIANCE ANALYSIS AS A KEY TOOL FOR MANAGERS
• Profit variance analysis shows the causes of differences between budgeted profits and the
actual profits earned.
o The actual results can be compared with both the flexible budget and the master budget in
a profit variance analysis, as shown in Exhibit 16.5.
(1)
(2)
(3)
(4)
(5)
(6)
(7)
Actual
(Based on
Actual
Activity)
Manufacturing
Variances
Marketing And
Administrative
Variance
Sales Price
Variance
Flexible
Budget
(Based on
Actual
Activity)
Sales
Activity
Variance
Master
Budget
(Based on
Planned
Activity)
Sales revenue
$xxx
$xx U or F
$xxx
$xxx U or F
$xxx
Less:
Variable costs
Variable manufacturing cost
administrative cost
Contribution margin
$xxx
$xxx U or F
Less:
Fixed costs
Fixed manufacturing cost
administrative cost
16–9
o Cost variances result from deviations in costs and efficiencies in operating the company.
They are important for measuring productivity and for helping to control costs.
• Sales Price Variance
o Column (4) shows the sales price variance as derived from the difference between the
actual revenue and budgeted selling price multiplied by the actual number of units sold.
▪ That is:
Sales Price
Variance
=
Actual
Revenue
–
Budgeted
Selling Price
×
Actual
Units Sold
=
Selling Price
–
Budgeted
×
Actual
Units Sold
• Variable Production Cost Variances
o Variable costs in Column (5) represent what should have been spent given the actual
sales volume.
• Fixed Production Cost Variance
See Demonstration Problem 2
PERFORMANCE MEASUREMENT AND CONTROL IN A COST CENTER
• For cost centers whose production managers typically do not control what they are asked to
produce, the actual unit production (not sales) should be used as a baseline.
• Variable Production Costs
o For any unit variable cost (such as direct materials), the variable cost in the budget is
determined by multiplying the budgeted amount of the direct material in each unit of
output by the expected price of each unit of direct material.
o Direct Materials
o Direct Labor
o Variable Production Overhead
▪ The overhead “quantity” is expressed in terms of the units of the cost driver chosen
(such as direct labor hours) because that is what is being used to apply the overhead.
16–11
LO 16-5 Compute and use variable cost variances.
VARIABLE COST VARIANCE ANALYSIS
• General Model
o Comparing the budget (based on standard costing) to actual results identifies production
cost variances.
o Both the actual and standard input quantities are for the actual output attained.
▪ A price variance is the difference between actual costs and budgeted costs arising
from changes in the cost of inputs to a production process or other activity.
o Managers who are responsible for price variances would not be held responsible for
efficiency variances and vice versa.
16–12
▪ That is,
Actual Costs =
Actual Input Quantity
at Actual Input Price
(AP X AQ)
Actual Input
Quantity at Standard
Input Price
(SP X AQ)
Flexible Production Budget =
Standard Input Quantity Allowed
For Actual Output at Standard
Input Price
(SP X SQ)
Price (Rate, or Spending) Quantity (Usage, or Efficiency)
Variance Variance
• Direct Materials
o A flexible production budget is calculated as standard input price times standard
quantity of input allowed for actual good output. It is based on actual production volume.
▪ An alternative way to view these variances graphically is shown below. Quantities are
16–13
▪ Exhibit 16.8 applies the general model to direct materials variances.
o Responsibility for Direct Materials Variances
▪ Responsibility for the direct materials price variance is usually assigned to the
purchasing department.
See Demonstration Problem 3
• Direct Labor
o Exhibit 16.9 applies the general model to direct labor variances.
o Direct Labor Price Variance
o Labor Efficiency Variance
▪ The labor efficiency variance is a measure of labor productivity and is usually
controlled by production managers.
See Demonstration Problem 4
• Variable Production Overhead
o Exhibit 16.10 applies the general model to variable overhead variances. The variable
overhead standard rate is derived from a two-stage estimation of:
o Variable Production Overhead Price Variance
▪ The variable overhead price variance could have occurred because
o Variable Overhead Efficiency Variance
▪ The variable overhead price variance actually contains some efficiency items as well
as price items. Some companies separate those components.
See Demonstration Problem 5
• Variable Cost Variances Summarized in Graphic Form
o Exhibit 16.11 summarizes the variable production cost variances.
▪ A summary of this nature is useful for reporting variances to high-level managers. It
provides both an overview of variances and their sources.
16–15
LO 16-6 Compute and use fixed cost variances.
FIXED COST VARIANCES
• It is usually assumed that fixed costs are unchanged when volume changes within the
relevant range, so the amount budgeted for fixed overhead is the same in both the master and
flexible budgets.
• Fixed Cost Variances with Variable Costing
o When the income statement is prepared using variable costing, there is no absorption of
the fixed costs by units of production. All the fixed manufacturing overhead is charged to
income in the period incurred.
o Exhibit 16.12 shows a variance analysis for fixed overhead.
▪ That is:
Actual
Flexible Production
Budget
Price (Spending) Variance
(Efficiency Variance is not Applicable)
16–16
o Developing the Standard Unit Cost for Fixed Production Costs
▪ The fixed manufacturing standard cost is determined before the start of the production
period using the following formula from Chapter 7:
Standard (or Predetermined)
Fixed Production Overhead Cost
=
Budgeted Fixed Manufacturing Overhead
Budgeted Activity Level
o Compare with the Fixed Production Cost Price Variance
▪ Exhibit 16.13 demonstrates the variance analysis for fixed overhead under absorption
costing.
• That is:
▪ An alternative way to present fixed overhead variances graphically is shown below
16–17
• Since fixed overhead is unitized through the calculation of predetermined fixed
overhead rate, fixed overhead is applied as if it were variable cost, as seen in the
application line.
▪ The production volume variance applies only to fixed costs as a result of allocating a
fixed period cost to units on a predetermined basis. It does not represent resources
spent or saved, and is unique to full-absorption costing.
See Demonstration Problem 6
SUMMARY OF OVERHEAD VARIANCES
• The method of computing overhead variances described is known as the four-way analysis of
overhead variances because it computes the following four variances:
• Key Points
o Exhibit 16.15 summarizes the four-way analysis of variable and fixed overhead variances.
16–18
LO 16-7 (Appendix) Understand how to record costs in a standard costing
system.
APPENDIX: RECORDING COSTS IN A STANDARD COST SYSTEM
• When using standard costing, costs are transferred through the production process at their
standard costs.
o Standard costing is an accounting method that assigns costs to cost objects at
predetermined amounts.
• Direct Materials
Work-in-Process Inventory
xxx
Materials Price Variancea
xxx
Materials Efficiency Variancea
xxx
xxx
16–19
• Direct Labor
Work-in-Process Inventory
xxx
Direct Labor Price Variancea
xxx
• Variable Manufacturing Overhead
Work-in-Process Inventory
xxx
Variable Overhead (Applied)
xxx
(To record the application of Variable overhead to Work-in–Process on
the basis of standard input allowed)
Variable Overhead (Actual)
xxx
Miscellaneous Payables and Inventory Accounts
xxx
(To record actual variable overhead costs)
Variable Overhead (Applied)
xxx
Variable Overhead Efficiency Variancea
xxx
Variable Overhead (Actual)
xxx
(To record variable overhead variances and close the applied and
actual accounts)
Work-in-Process Inventory
xxx
Fixed Overhead (Applied)
xxx
(To record the application of fixed overhead to Work-in-Process on the
basis of standard input allowed)
Fixed Overhead (Actual)
xxx
Miscellaneous Payables and Inventory Accounts
xxx
(To record actual fixed overhead costs)
a Favorable variances should be credited; unfavorable variances should be debited. The
variances are debited here for illustration only.
• Fixed Manufacturing Overhead
Direct Labor Efficiency Variancea
xxx
Wages Payable
xxx
(To record the purchase and use of direct labor at actual cost and the
transfer to Work-in-Process at standard cost)
16–20
• Transfer to Finished Goods Inventory and to Cost of Goods Sold
Finished Goods Inventory
xxx
Work-in-Process Inventory
xxx
(To record the transfer to Finished Goods Inventory at standard cost)
Accounts Receivable
xxx
Sales Revenue
xxx
Cost of Goods Sold
xxx
Finished Goods Inventory
xxx
(To record the sale and the standard cost per unit sold)
• Close out variance accounts to Cost of Goods Sold
Cost of Goods Sold
xxx
Materials Price Variancea
xxx
Materials Efficiency Variancea
xxx
Direct Labor Price Variancea
xxx
Direct Labor Efficiency Variancea
xxx
Variable Overhead Price Variancea
xxx
Variable Overhead Efficiency Variancea
xxx
Fixed Overhead Price Variancea
xxx
Fixed Overhead Production Volume Variancea
xxx
(To close the variance accounts to Cost of Goods Sold)
Fixed Overhead (Applied)
xxx
Fixed Overhead Price Variancea
xxx
Fixed Overhead Production Volume Variancea
xxx
Fixed Overhead (Actual)
xxx
actual accounts)
16–21
Matching
A.
Cost variance analysis
K.
Profit variance analysis
B.
Efficiency variance
L.
Sales activity variance
C.
Favorable variance
M.
Sales price variance
D.
Financial budgets
N.
Spending (or budget) variance
E.
Flexible budget
O.
Standard cost sheet
F.
Flexible budget line
P.
Standard costing
G.
Flexible production budget
Q.
Static budget
H.
Operating budgets
R.
Total cost variance
I.
Price variance
S.
Unfavorable variance
J.
Production volume variance
T.
Variance
_____ 1. Budgeted income statement, production budget, budgeted cost of goods sold, and
supporting budgets.
_____ 2. Budgets of financial resources—for example, the cash budget and the budgeted
balance sheet.
_____ 3. Variance that, taken alone, results in an addition to operating profit.
_____ 4. Budget for a single activity level; usually the master budget.
_____ 5. Difference between operating profit in the master budget and operating profit in the
flexible budget that arises because the actual number of units sold is different from
the budgeted number.
_____ 6. Comparison of actual input amounts and prices with standard input amounts and
prices.
_____ 7. Difference between actual costs and budgeted costs arising from changes in the cost
of inputs to a production process or other activity.
_____ 8. Price variance for fixed overhead.
_____ 9. Difference between planned result and actual outcome.
_____ 10. Budget that indicates revenues, costs, and profits for different levels of activity.
_____ 11. Accounting method that assigns costs to cost objects at predetermined amounts.
_____ 12. Difference between budgeted and actual results arising from differences between the
inputs that were budgeted per unit of output and the inputs actually used.
_____ 13. Expected monthly costs at different output levels.
_____ 14. Analysis of the causes of differences between budgeted profits and the actual profits
earned
_____ 15. Standard input price times standard quantity of input allowed for actual good output.
_____ 16. Variance that, taken alone, reduces operating profit.
_____ 17. Variance that arises because the volume used to apply fixed overhead differs from the
estimated volume used to estimate fixed costs per unit.
_____ 18. Difference between budgeted and actual results (equal to the sum of the price and
efficiency variances).
_____ 19. Difference between actual revenue and actual units sold multiplied by budgeted
selling price.
_____ 20. Form providing standard quantities of inputs used to produce a unit of output and the
standard prices for the inputs.
Matching Answers
1. H
16–23
Multiple Choice
1. Which of the following statements is not correct?
a. Unfavorable variance occurs when actual costs are lower than budgeted costs.
b. The labels “favorable” and “unfavorable” should not be considered as evaluations of
performance without additional investigation.
c. An important part of variance analysis is to understand what might cause a difference
between actual and budgeted results.
d. Variance = Actual result – Budgeted performance.
2. With a planned volume of 15,000 units, the master budget includes variable costs of
$450,000 and fixed costs of $350,000. If the actual volume is 12,000 units, what is the
amount of the total costs in the flexible budget?
a. $490,000
b. $560,000
c. $650,000
d. $710,000
3. Which of the following is correct regarding sales activity variance?
a. Sales activity variance is driven by the volume difference between actual results and
flexible budget.
b. Variable costs are expected to decrease when volume is higher than planned.
c. Sales activity variance is the difference between operating profit in the master budget and
operating profit in flexible budget.
d. Sales activity variance can be seen on the master budget’s profit-volume line.
4. Which of the following statements is correct?
a. Marketing and administrative cost variances are treated differently from production cost
variances.
b. The fixed production cost variance is the difference between flexible budget and master
budget costs.
c. Variable cost variances are output variances.
d. Profit variance analysis shows the causes of differences between budgeted profits and the
actual profits earned.
16–24
Use the following information to answer questions 5 through 8:
Actual results
Budget data
20,000 units produced and sold
19,000 units planned
Direct materials: 62,300 units of
input purchased and used @
$29 per input unit
$1,806,700
Direct materials: 3 units of input
allowed per output unit @ $30
per input unit
$90
Direct labor: 51,500 hours used
per output unit @ $21.50 per
hour
1,107,250
Direct labor: 2.5 hours of input
allowed per output unit @ $20
per hour
50
5. What is the materials price variance?
a. $62,300 Unfavorable
b. $62,300 Favorable
c. $69,000 Favorable
d. $77,250 Favorable
6. What is the materials total cost variance?
a. $7,500 Unfavorable
b. $11,250 Unfavorable
c. $7,500 Favorable
d. $6,700 Unfavorable
7. What is the labor price variance?
a. $77,250 Unfavorable
b. $30,000 Unfavorable
c. $62,300 Favorable
d. $69,000 Unfavorable
8. What is the labor efficiency variance?
a. $77,250 Unfavorable
b. $30,000 Unfavorable
c. $62,300 Favorable
d. $69,000 Unfavorable
9. Which of the following statements regarding variable overhead variances is correct?
a. The variable overhead price variance could have occurred because actual costs are
different from those expected.
b. The relationship between variable production overhead costs and the basis chosen is
perfect.
c. The variable overhead price variance usually contains only the efficiency items.
d. The variable overhead efficiency variance is related to the use of variable costs.
16–25
10. Which of the following statements regarding fixed overhead is correct?
a. Production volume variance is the difference between the actual and applied fixed
overhead.
b. When the income statement is prepared using variable costing, there is no absorption of
the fixed costs by units of production.
c. Production volume variance applies only to fixed costs.
d. Both b and c are correct.
11. A company purchased and used 10,000 pounds of materials while incurring $2,000
unfavorable price variance. The standard cost for materials is $4.80 per pound. What was the
actual price of materials per pound?
a. $5.00.
b. $4.90.
c. $5.10.
d. $5.20.
12. Which of the following statements regarding standard costing system is incorrect?
a. The difference between actual costs assigned and the standard costs of the work done
determines the variance.
b. Favorable variances should be credited.
c. The use of standard costs contributes to management control.
d. Standard costing system complicates the costing of inventories.
16–26
Multiple Choice Answers
16–27
16–28
Demonstration Problem 1
The accountant at EZ Toys, Inc. is analyzing the production and cost data for its Trucks Division.
For October, the actual results and the master budget data are presented below.
Actual Results:
Budget Data:
10,000 Trucks Produced and Sold
12,000 Trucks Planned
Unit selling price
$15
Unit selling price
$14
Variable costs:
Unit variable cost:
Direct materials
$ 52,800
Direct materials
$ 5
Direct labor
51,000
Direct labor
4
Variable overhead
23,000
Variable overhead
2
Total variable costs
$126,800
Total unit variable costs
$11
Fixed overhead
$9,000
Fixed overhead
$9,600
Required:
Prepare a variance analysis to compare actual results and the master budget.
16–29
Demonstration Problem 1 – Solution
(1)
Actual
(3) = (1) – (2)
Variance
(2)
Master Budget
Units
10,000
2,000 U
12,000
Sales revenue
$18,000 U
Variable costs
Direct materials
52,800
Direct labor
51,000
3,000 U
Variable overhead
Total variable costs
Contribution margin
23,200
36,000
Fixed overhead
Operating profit
$12,200 U
16–30
Demonstration Problem 2 – Solution
(Continued from Demonstration Problem 1)
Required:
Prepare a profit variance analysis.
Demonstration Problem 2 – Solution
Actual
(Based on
Actual
Activity
of 10,000
Units
Sold)
Manufacturing
Variances
Sales
Price
Variance
Flexible
Budget
(Based on
Actual
Activity of
10,000
Units Sold)
Sales
Activity
Variance
Master
Budget
(Based
on 12,000
Units
Planned)
Sales revenue
$150,000
$10,000 F
$140,000a
$28,000 U
$168,000
Variable costs
Direct
10,000 F
Direct labor
Variable
Total variable
126,800
22,000 F
132,000
Contribution
Fixed
9,000
0
$ 14,200
$10,000 F
$ 6,000 U
$ 26,400
16–32
Demonstration Problem 3
(Continued from Demonstration Problem 1)
Information about the use of direct materials at EZ Toys’ Trucks Division for October follows:
Standard costs:
2 units per truck @ $2.50 per unit
=
$5 per truck
Trucks produced in October
=
10,000
Actual materials purchased and used:
22,000 units @ $2.40 per unit
=
$52,800
There was no beginning inventory on October 1.
Required:
Prepare the Truck Division’s direct materials variances for October.
16–33
Demonstration Problem 3 – Solution
Actual Costs =
Actual Input Quantity
Actual Input Quantity
Flexible Production Budget =
Standard Input Quantity Allowed
for Actual Output
16–34
Demonstration Problem 4
(Continued from Demonstration Problem 1)
Information about the use of direct labor at EZ Toys’ Trucks Division for October follows:
Standard costs:
0.4 hour per truck @ $10 per hour
=
$4 per truck
Trucks produced in October
=
10,000
Actual direct labor costs:
Actual hours worked
=
5,000
Total actual labor cost
=
$51,000
Average cost per hour
=
$10.20
Required:
Prepare the Truck Division’s direct labor variances for October.
Demonstration Problem 4 – Solution
Actual Costs =
Actual Input Quantity
Actual Input Quantity
Flexible Production Budget =
Standard Input Quantity Allowed
for Actual Output
16–36
Demonstration Problem 5
(Continued from Demonstration Problem 1)
Information about the use of variable overhead at EZ Toys’ Trucks Division for October follows:
Standard costs:
0.4 hour per truck @ $5 per hour
=
$2 per truck
Trucks produced in October
=
10,000
Actual variable overhead cost
=
$23,000
Required:
Prepare the Truck Division’s variable overhead variances for October.
16–37
Demonstration Problem 5 – Solution
Actual Costs =
Sum of Actual Variable
Actual Input Quantity
Flexible Production Budget =
Standard Input Quantity Allowed
for Actual Output
16–38
Demonstration Problem 6
(Continued from Demonstration Problem 1)
Information about the use of fixed overhead at EZ Toys’ Trucks Division follows:
Annual budget data:
Fixed overhead
=
$115,200
Direct labor hours
=
57,600
Standard fixed overhead rate
=
$2 per hour
Standard costs:
0.4 hour per truck @ $2 per hour
=
$0.80 per truck
Trucks produced in October
=
10,000
Actual variable overhead cost
=
$9,000
Required:
Prepare Truck Division’s fixed overhead variances for October.
Demonstration Problem 6 – Solution