Chapter 23

Performance Evaluation Using

Variances from Standard Costs
Objectives
1. Describe the types of standards and how they are established.
2. Describe and illustrate how standards are used in budgeting.
3. Compute and interpret direct materials and direct labor
variances.
4. Compute and interpret factory overhead controllable and
volume variances.
5. Journalize the entries for recording standards in the accounts and
prepare an income statement that includes variances from
standard.
6. Describe and provide examples of nonfinancial performance
measures.
Standards
• Standards are performance goals. Manufacturing companies
normally use standard cost for each of the three following product
costs:
1. Direct materials
2. Direct labor
3. Factory overhead

• Accounting systems that use standards for product costs are called
standard cost systems.

• Standard cost systems enable management to determine the

following:
▫ How much a product should cost (standard cost)
▫ How much it does actually cost (actual cost)

• When actual costs are compared with standard costs, the exceptions
or cost variances are reported
 allows management to focus on correcting the cost variances
Standards
Companies set standards at one of two levels
 Ideal standards represent optimum levels of performance under
perfect operating conditions.
 Normal standards represent efficient levels of performance that are
attainable under expected operating conditions.

Reviewing and Revising Standards

 periodically reviewed to ensure that standards reflect current operating
conditions
 should not be revised just because standards differ from actual costs
 standards should be revised when prices, product designs, labor rates,
or manufacturing methods change.
Budgetary Performance Evaluation
• The standard cost per unit for direct materials, direct
labor, and factory overhead is derived from the standard
price to be paid and the standard quantity to be used.
Budgetary Performance Evaluation

▫ direct materials price standard : the cost per unit of direct

materials that should be incurred.
▫ direct materials quantity standard : the quantity of direct materials
that should be used per unit of finished goods.
▫ direct labor price standard : the rate per hour that should be
incurred for direct labor.
▫ direct labor quantity standard : the time that should be required to
make one unit of the product.
Budget Performance Report
Summarizes
▫ Actual costs
▫ Standard costs at actual production level
 compare actual costs for the actual level of activity to the
standard costs for the actual level of activity
Budget Performance Report
• The differences between Actual and Standard costs (at actual volume) are
called cost variances.
▫ Favorable cost variance:
Actual cost < Standard cost at actual volume
▫ Unfavorable cost variance:
Actual cost > Standard cost at actual volume

• Variances highlight areas where action may be necessary

• Variances guide managers to seek explanations and to take early
corrective action
• Variances enable managers to focus their efforts on the most critical
areas
• Variances can be a result of performance or/and assumptions that have
now, been proved, to be incorrect.
• Analyzing variances begins by determining the cost elements that
comprise the variance
Review Question

A variance is favorable if actual costs are:

a. less than budgeted costs.

b. less than standard costs.

c. greater than budgeted costs.

d. greater than standard costs

 Direct
DirectMaterials
MaterialsPrice
Price
Direct
Direct Variance
Variance
Materials
Materials
Cost
CostVariance
Variance Direct
DirectMaterials
Materials
Quantity
QuantityVariance
Variance

Direct
DirectLabor
LaborRate
Rate
Total
Total Direct
Direct Variance
Variance
Manufacturing
Manufacturing Labor
Labor
Cost
CostVariance
Variance Cost
CostVariance
Variance Direct
DirectLabor
LaborTime
Time
Variance
Variance
difference
between total
standard costs Variable
VariableFactory
FactoryOverhead
Overhead
and total actual Factory
Factory Controllable
ControllableVariance
Variance
cost for the
Overhead
Overhead
units produced
Cost
CostVariance
Variance Fixed
FixedFactory
FactoryOverhead
Overhead
Volume
VolumeVariance
Variance
 Direct Material Cost Variances
Actual DM Cost = Actual Price x Actual Quantity

-Standard DM Cost = Standard Price x Standard Quantity

DM Cost Variance Price Difference Quantity Difference

Illustration
• During June, Western Rider reported an unfavorable direct
materials cost for the production of 5,000 XL style jeans
▫ Actual Price $5.50 per sq. yd.
▫ Actual Quantity 7,300 sq. yds

• Standard direct material cost

▫ Standard Price $5.00 per sq. yd.
▫ Standard Quantity per Pair 1.5 sq. yds.

• Calculate direct materials cost variance

Illustration (cont.)
Actual DM Cost = Actual Price x Actual Quantity
$40,150 = $5.50 x 7,300 sq. yds
- - -
Standard DM Cost = Standard Price x Standard Quantity
$37,500 = $5.00 x 7,500 sq. yds
(1.5 sq. yds x 5,000 pair)
DM Cost Variance Price Difference Quantity Difference

$2,650 = $0.50 x (200) sq. yds

•Unfavorable direct materials cost variance of $2,650 is caused by

1. A price per square yard of $0.50 more than standard
2. A quantity usage of 200 square yards less than standard
Direct Materials Variance Relationships
• Direct Materials Price Variance
= (Actual Price – Standard Price) x Actual Quantity
= ($5.50 - $5.00) x 7,300 sq.yds. = $3,650

Unfavorable direct
materials price variance

Western
Western Rider
Riderpaid
paid $0.50
$0.50 more
more per
per
square
square yard
yard of
of material
material than
than the
the standard.
standard.
Direct Materials Variance Relationships

• Direct Materials Quantity Variance

= (Actual Quantity – Standard Quantity) x Standard Price
= (7,300 sq. yds. – 7,500 sq. yds.) x $5.00 = – $1,000
Favorable direct
materials quantity
variance

Western
Western Rider
Rider used
used 200
200 square
square yards
yards less
less than
than
the
the standard.
standard.
Direct Materials Variance Relationships
Reporting Direct Materials Variances
• The direct materials quantity variances should be
reported to the manager responsible for the variance.

• An unfavorable quantity variance might be caused by

either of the following:
 Equipment that has not been properly maintained
 the operating department responsible for maintaining the equipment
should be held responsible for the variance

 Low-quality (inferior) direct materials

 the Purchasing Department should be held responsible.
 Direct Labor Cost Variances
Actual DL Cost = Actual Rate x Actual Time

- Standard DL Cost = Standard Rate x Standard Rate

DL Cost Variance Price Difference Time Difference

Illustration
• Western Rider produces XL jeans that requires 0.8
standard hours per pair at a standard hourly rate of
$9.00 per hour.
• During June, Western Rider reported actual direct labor
costs incurred of $38,500 to produce 5,000 pair
 Actual Rate per Hour $10
 Actual Time 3,850 hours
• What is the direct labor (a) rate variance, (b) time
variance, and (c) cost variance?
 Direct Labor Cost Variances
Actual DL Cost = Actual Rate x Actual Time
$38,500 $10.00 3,850 hrs
- - -
Standard DL Cost = Standard Rate x Standard Rate
$36,000 $9.00 4,000 hrs
(0.8hrs x 5,000 pairs)

DL Cost Variance Price Difference Time Difference

$2,500 $1.00 (150 hours)
Direct Labor Variance Relationships
Reporting Direct Labor Variances
• Production supervisors are normally responsible for
controlling direct labor cost.

▫ An unfavorable rate variance may be caused by the

improper scheduling and use of employees.
 skilled, highly paid employees may be used in jobs that are
normally performed by unskilled, lower-paid employees

▫ An unfavorable time variance may be caused by a shortage

of skilled employees
 an abnormally high turnover rate among skilled employees
Factory overhead Cost Variances
• Factory overhead cost includes
▫ fixed cost elements
▫ variable cost elements

• Factory overhead variance is separated into

▫ a controllable variance
▫ a volume variance
Factory Overhead Variances
Budgeted Factory Overhead
at Normal Capacity
Factory Overhead Rate=
Normal Productive Capacity

Budgeted Variable Overhead

Variable Factory at Normal Capacity
=
Overhead Rate Normal Productive Capacity

Budgeted Fixed Overhead

Fixed Factory at Normal Capacity
=
Overhead Rate Normal Productive Capacity

The normal productive capacity is expressed in terms of an activity

base such as direct labor hours, direct labor cost, or machine hours.
Illustration ( exhibit 6 p. 1054)
 Illustration
$3,000
Factory Overhead Rate = = $6.00 per direct labor hr.
5,000 (hrs.)
$18,000
Variable Factory
= = $3.60 per direct labor hr.
Overhead Rate 5,000 (hrs.)

$12,000
Fixed Factory
= = $2.40 per direct labor hr.
Overhead Rate 5,000 (hrs.)
 Variable Factory Overhead Controllable Variance

Variable Factory
Actual Variable Budgeted Variable
Overhead Controllable = – Factory Overhead
Factory Overhead
Variance
- $4,000 Favorable Variance = $10,400 - $14,400

Standard Hours for Actual Variable Factory

Units Produced x Overhead Rate
4,000 direct labor hrs. x $3.60

The variable factory overhead controllable variance indicates the ability

to keep the factory overhead costs within the budget limits.
 Fixed Factory Overhead Volume Variance

Fixed Factory Standard Hours Standard

Overhead Fixed
for 100% of Hours for
Volume = – x Factory
Normal Actual Units Overhead
Variance Capacity Produced Rate
5,000 direct 4,000 direct
= – X $2.40
labor hours labor hours

= $2,400 Unfavorable Variance

Western Rider’s volume variance is unfavorable in June because
the actual production is 4,000 direct labor hours, or 80% of normal volume.

The unfavorable volume variance of $2,400 can be viewed as the cost of the
unused capacity (1,000 direct labor hours).
Fixed Factory Overhead Volume Variance
• The volume variance measures the use of fixed overhead
resources (plant and equipment)
▫ Unfavorable fixed factory overhead variance.
The actual units produced is less than 100% of normal capacity;
thus, the company used its fixed overhead resources (plant and
equipment) less than would be expected under normal operating
conditions.
▫ Favorable fixed factory overhead variance.
The actual units produced is more than 100% of normal capacity;
thus, the company used its fixed overhead resources (plant and
equipment) more than would be expected under normal
operating conditions.
Unfavorable Volume Variance
An unfavorable volume variance may be due to
factors such as the following:
1. Failure to maintain an even flow of work
2. Machine breakdowns
3. Work stoppages caused by lack of materials or
skilled labor
4. Lack of enough sales orders to keep the factory
operating at normal capacity
Reporting Factory Overhead Variances

• A factory overhead cost variance report is useful to

management in controlling factory overhead costs.
Budgeted and actual costs for variable and fixed factory
overhead along with the related controllable and volume
variances are reported by each cost element.
Factory Overhead Variances

Total Factory Overhead = Actual FOH - Applied FOH

Cost Variance

•Underapplied Factory Overhead (actual > applied)

= Unfavorable Total Factory Overhead Cost Variance
•Overapplied Factory Overhead (actual < applied)
= Favorable Total Factory Overhead Cost Variance
Illustration – exhibit 8 p. 1059
Factory Overhead Account
Applied
Factory = Standard Hours for x Total Factory
Overhead Actual Units Produced Overhead Rate

5,000 jeans x 0.80

= x $6.00
direct labor hr. per
pair

= 4,000 direct labor hrs. x $6.00 = $24,000

Factory Overhead Account
Total Factory Overhead Actual Factory – Applied Factory
=
Cost Variance Overhead Overhead

Standard Hours for x Total Factory

Actual Units Produced Overhead Rate

5,000 jeans x 0.80 direct

x $6.00 = $24,000
labor hr. per pair
Factory Overhead Account
Total Factory Overhead Actual Factory – $24,000
=
Cost Variance Overhead

Total Factory Overhead $22,400 – $24,000

=
Cost Variance

Total Factory Overhead – $1,600 Favorable Variance

=
Cost Variance
Factory Overhead Account
Recording and Reporting Variances
Western Rider Inc. purchased, on account, the 7,300 square yards
of blue denim at $5.50 per square yard. The standard price is $5.00
per square yard. The entry to record the purchase and the
unfavorable direct materials price variance is as follows:

$5.50 x 7,300 = $40,150 $3,650 unfavorable direct

$5.00 x 7,300 = $36,500 materials price variance
Recording and Reporting Variances
Western Rider Inc. used 7,300 square yards of blue denim to
produce 5,000 pairs of XL jeans. The standard quantity of denim
for the 5,000 jeans produced is 7,500 square yards. The entry to
record the materials used is as follows:

$5.00 x 7,500 = $37,500

– $1,000 favorable direct materials
$5.00 x 7,300 = $36,500 quantity variance
Nonfinancial Performance Measures
• Inventory turnover
• Percent on-time delivery
• Elapsed time between a customer order and product
delivery
• Customer preference rankings compared to competitors
• Response time to a service call
• Time to develop new products
• Employee satisfaction
• Number of customer complaints
Nonfinancial Performance Measures

• Nonfinancial measures can be linked to either

the inputs or outputs of an activity or process.
• A process is a sequence of activities linked
together for performing a particular task.
 Nonfinancial Performance Measures
Fast Food Restaurant
Inputs
Inputs
Employee
Employeetraining
training
Employee
Employeeexperience
experience
Number Activity Outputs
Outputs
Numberof ofnew
newmenu
menu
items Line
Linewait
wait
items Counter
Number Percent
Percentorder
orderaccuracy
accuracy
Numberof ofemployees
employees service
Fryer Friendly
Friendlyservice
servicescore
score
Fryerreliability
reliability
Fountain
Fountainsupply
supply
availability
availability
Homework
• EX 23-15
• PR 23.2A
• PR 23.3A
• PR 23.4A