Module 3 Lecture-Transcripts

Managerial Accounting
Professor Gary Hetch
Module 3 ........................................................................................................................... 2
Lesson 3.1: Fundamental Concepts ............................................................................. 2
Lesson 3.1: Cost Variance Classification and General Framework .............................. 7
Lesson 3.1: Causes of Variances ............................................................................... 14
Lesson 3.2: An Example Scenario and Direct Materials Variances ............................ 18
Lesson 3.2: Direct Labor Variances ............................................................................ 24
Lesson 3.2: Variable Overhead Variances ................................................................. 27
Lesson 3.2: Fixed Cost Variances .............................................................................. 29
Lesson 3.2: Production Volume Variances ................................................................. 33
Lesson 3.2: What We've Learned in Lesson 3.2 ........................................................ 37
Lesson 3.3: Fundamentals and General Framework .................................................. 38
Lesson 3.3: An Example Scenario .............................................................................. 42
Lesson 3.3: What We've Learned in Lesson 3.3 ........................................................ 47
Lesson 3.3: Module 3 Review ..................................................................................... 48
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Module 3
Lesson 3.1: Fundamental Concepts
Welcome to module three, standard costing and variance analysis. In this first lesson,
we'll achieve the following objectives. You will ultimately understand the definition of
standard costs, the purpose of a standard costing system, and the fundamentals of
variance analysis. Let's start at the beginning and talk about what a standard actually is.
Well, the unsatisfying book definition of a standard is that it's a carefully predetermined
price, cost, or quantity amount.
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It is generally expressed on a per-unit basis, and it is generally predetermined through

the budgeted process. An important note to make here is that a standard is part of the
budget. In the previous module, we talked about budgets at a more aggregate level. We
talked about plan total sales, total costs, or total net income. A standard is also a
budgeted piece of information or an expectation that managers have, but it's a very
fundamental, small piece of the overall budget. We usually think about standards on a
per-unit basis. In the coming lessons, you'll see the difference between the overarching
or aggregate budget and the standard.
3
No standards and standard costing systems provide control. Of course, the help to
facilitate decisions that go on inside of the organization, but here we're talking about
influencing decisions. At a very general level, you can think about control systems being
diagnostic. That is, that these controls are being implemented at the end of an
accounting period so that managers can see what went on and make the appropriate
corrections or leverage the strengths that were exhibited. In a general level, you can
think about a firm setting targets or goals. And then, at the end of an accounting period,
monitoring the actual performance against those targets to see if goals were achieved.
In the previous module, we talked about this setting target process as budgeting. And in
this module, we're extending to the monitoring performance via an exploration of
variance analysis. So let's first talk about some fundamental of variance analysis.
4
First off, consider variance analysis as providing a comparison of actual outcomes and
expected outcomes. Why do this? Well, first off, for the purposes of measuring
performance that occurred during an accounting period. It also allows us to evaluate the
judgements and decisions made by managers and employees throughout the
accounting period. And also, looking forward, it allows us to leverage the strengths that
we observe, as well as correct weaknesses or find opportunities for improvement in
future accounting periods.
A second fundamental about variance analysis is that allows for a detailed investigation
of the various sources of differences from expectations. This isn't about looking at the
total net income for a month and seeing that we surpassed our goal at that aggregate
level. We're looking at very detailed analyses and looking all the different sources or
reasons for why there would be a difference between actual performance and expected
performance.
And finally, variance analysis facilitates a management by exception approach. When a

variance is small or in-line with expectations, then the management need not address
that area of the company or the organization. However, when I variance is significantly
large, management can spend their time and energy in the right places to investigate
why actual performance was different than expected. In the future lessons, we'll talk
about this threshold and the points at which management decides to investigate
variances versus when they do not.
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Two important points need to be made at this time about variance analysis. At the top
level, we need to distinguish between static budgets and flexible budgets.
A static budget talks about how much we should have spent given the planned level of
production or some other activity that we're engaged in.
A flexible budget talks about how much we should have spent given our actual level of
production. This is very useful because one of the first things that strays from
expectations is what goes on outside in the marketplace.
Sales might be higher or lower than we had planned, and so therefore, we had to adjust
our production level. If this is the case, we don't throw the entire budget out of the
window, we still use the standards at the heart of the budget to consider how much we
should have spent or incurred in costs given what we actually produced. This distinction
will be made more clear as we get into the calculations in future lessons.
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A second piece has to do with categorizing variances. Now in future lessons, we'll talk
about variable costs versus fixed costs variances, as well as revenue variances. We'll
talk about spending, efficiency, activity variances, and other types as well. But across all
variances of all types, we can categorize them as either unfavorable or favorable.
Unfavorable refers to a situation when the source of the variance or a particular

variance creates actual net income that is lower than what was budgeted. And in the
opposite case, a favorable variance signals that actual net income is higher than
budgeted. Now this does not mean that the entire company's net income is higher or
lower than budget. It's just particular to this variance that we're looking at.
So multiple variances can be unfavorable or favorable, and they would offset each other
in the aggregate level. Because we're looking at a single variance, we need to make an
important note. That is, do not necessarily interpret unfavorable variances as bad or
favorable variances as good. What we need to understand is why these variances are
the way they are and the reasons for them, and that allows us to deem a situation
positive or negative, good or bad, desirable, or undesirable. So keep this in mind as we
go through our calculations and classify our variances as favorable or unfavorable.
Lesson 3.1: Cost Variance Classification and General Framework
7
So let's explore cost variances. First of all, we'll talk about variable costs. And as you
recall from previous modules there are usually three categories of variable costs: direct
materials, direct labor, and variable overhead. We'll think about each of these types of
variable costs on three levels. That is we'll have three different types of variances:
spending, efficiency, and activity, or sometimes referred to as volume variances. We'll
have each of these variances for each type of cost.
So for direct materials, and even each individual material type, we'll calculate a
spending variance, an efficiency variance, and an activity variance. We'll calculate these
three variances for direct labor, as well, and all the different types of labor that we have
in our organization.
And, finally, depending on how we parcel out the overhead category, we'll have
spending, efficiency, and activity variances for each type of overhead that falls in the
variable category. When we combine the consideration of all these different types of
cost with all the different types of variances that each cost uses we have, kind of, a
messy picture here. But that's ultimately a signaling the complexity of variance analysis.
8
At the end of the day we can combine spending, efficiency, and activity variances for
materials or individual materials, labor or individual types of labor, and all the variable
overhead costs into what's referred to as a generic static budget variance. This is the
overall difference between actual spending on each type of cost and what was originally
expected or budgeted.
But the static budget variance broken down leads us to the spending efficiency and
activity variance, which creates a lot of information to analyze at the end of a period and
use for decision-making purposes. Now one important distinction is that between
variable costs and fixed costs-and I'll get into the details of the logic and reasoning later-
but fixed cost variances are calculated in a much more simple manner.
Ultimately we'll have just a generic static budget variance for fixed costs. There are
some exceptions to this and we'll see that in a future lesson.
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So let's introduce a generic framework for calculating variable costs. It will help us to
simplify this very complex setting. I'm a sports-oriented person so I wanted to bring in a
sports-oriented example. And I could bring in any type of equipment. A soccer ball, a
football, tennis ball, baseball, but the simplest sports product that I can identify comes
from my favorite sport and that is ice hockey.
So let's think about an ice hockey puck. It's a single material good and it would surprise
you how complex the production process is for this process. But in terms of materials,
it's just one thing. So let's use this example to develop our framework.
So when we think about the costs associated with the materials in an ice hockey puck
you can think about how much we would spend in a month to create all the hockey
pucks that we manufacture.
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So at the end of the month we have spent some total dollar amount on materials for
creating all of our ice hockey pucks. And that's something that we know at the end of
the period. So we would call that actual. Now that's the total spending. But let's think
about the individual drivers of this total spending.
Again, just for the materials that the hockey puck is made of you can think about the
input, the raw materials rubber, and how much we pay for that on a per unit basis. Now
you can measure the raw material in a variety of ways-let's say it's ounces or grams-and
we think about buying the raw material rubber from a supplier. And that's going to be in
terms of some dollar amount, per some weight unit.
Ounces or, again, grams. So that's one driver of the overall cost. But then we can also
think about how much of the input the raw material we use for each hockey puck. And
so that is in terms of some weight unit, ounces, per unit produced per puck. And then
the final driver leads to the total amount of materials dollars we spend in a given
timeframe is the number of pucks that we produce.
And when we multiply each of those individual components by each other we're left with
the total dollar spent for materials. So dollars per ounce multiplied by ounces per puck
will yield a dollar per puck figure in terms of materials costs. When we multiply that by
the number of pucks we produce we have the total dollar amount that we have spent.
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So these are all actual pieces of information that we have identified at the end of an
accounting period. Our accounting records tell us how much we paid per ounce, how
many ounces we use per puck, and how many pucks we produced.
But, of course, we have a plan or an expectation, a static budget, if you will, where each
of those individual components can be presented on a budgeted or expected basis.
These are our standards. We can have a standard price, we can have a standard input,
and we can have a standard output.
Same principle applies here. The standard price is what we expect to pay for an ounce
of rubber. The raw material. The standard input is how much of the rubber that we use,
again in ounces, per puck that we produce. And the standard output is the number of
pucks that we expected to produce. So in essence we have an analogues line-column-
over here. In the sense that we have a standard price, standard input, and standard
output compared to the actual information in the left hand column.
When multiplying each of those three components in the same way we come up with
how much our direct material spending should have been. What we have budgeted.
Now, if we were to compare these two things in their aggregation we would see that, oh,
we have spent more direct materials dollars than we had planned to. Or, perhaps, we
have spent less in any one given month.
But that wouldn't provide you a lot of information. The reason is there are many different
sources of that overall difference. You might have paid a different amount for your input,
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you might have used a different amount of input per output then you had expected, or
you might have produced more or less than you though in terms of number of pucks. So
variance analysis allows us to delve into those details.
So let's move from this static budget column where everything is expected, everything is
budgeted, and go eventually create the actual column. So the next column in we'll refer
to that as the flexible budget. And recall from previous slide that that is how much we
should have spent given what we actually produced. So comparing the flexible budget
to the static budget is all expected numbers. Standard numbers.
Standard price, standard input, but actual output. It takes into account what we actually
produced, but at the standard price and standard input amounts. So it tells us what we
should have spent given what our actual production was. When we multiply the
standard price, standard input, and actual output numbers we get the flexible budget for,
in this case, materials. The next column in doesn't necessarily have an official name, I
just call it the standard price column.
And in that one we're going to change the next component. We've already changed
standard output to actual output as we move from right to left. So we can leave that the
same. Actual output. But what we haven't done is considered how these standard input
per output differs from the actual input per output.
So let's change that component as we move from column three to what is in column two
and leave everything else the same so that we can isolate this individual component.
When we multiplied the standard price, multiplied by the actual input per output,
multiplied by the actual output, we get a total dollar number there again.
And now our variances fallout from the bottom of the columns. The difference between
the actual and selling price column totals can be calculated. The same for the difference
between the selling price, standard price column, and the flexible budget column. And,
finally, the same for the flexible budget and static budget column.
As you can see what this framework allows is to see the isolation in the variance
analysis for each individual component. The difference between the flexible budget
column and the static budget column comes down to the difference between actual
output and standard output. The different between the two middle columns is focused
on the difference between the actual and standard input per output.
And the difference between the first two columns is the difference between the actual
price paid for each of our inputs and the standard price that we had expected to pay. So
these individual differences that fallout from this framework are referred to as the
spending variance, the efficiency variance, and the activity variance.
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Firms call these things different things, different labels, depending on their preferences,
but these are generic labels that I think are useful in most cases.
But, ultimately, what this framework allows us to see is that there are different reasons
or different sources of an overall difference between the actual amount spent on
materials and what we had planned to spend. And some of that has to do with each
component. Variances provide us a quantification of each reason or each source of that
variance.
Lesson 3.1: Causes of Variances
So now let's talk about interpreting these variances. Let's start with direct material
spending variances and think about what would cause a direct material spending
variance. Well, there are many different factors that can influence paying a different
price for each unit of input then we thought we were going to. In other words our actual
price is different than our standard price.
Perhaps something occurred in the marketplace that increased the supply or decreased
the supply of that raw material and that influenced the market price for that material.
Something inside of our firm may have influenced what we've paid. Perhaps a
purchasing manager took it upon himself or herself to buy a higher quality input.
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In this case they might have ended up paying more than they had expected then our
standards suggested. In terms of direct material efficiency variances where would those
come from?
Again, a direct material efficiency variance occurs when we use a different amount of
input per unit of output then we expected to and established as a standard. It could be
that we had more scrap during this particular accounting period. We wasted more of our
input, our raw material, then we had thought we were going to.
And, therefore, on average we ended up using more input per unit of output that we
produced. Maybe we became more efficient along the way. You can think about how
direct materials price variances or spending variances and direct material efficiency
variances are interrelated. Let's go back to that example of the purchasing manager
buying a higher quality product.
They would incur an unfavorable spending variance because we would have ended up
paying an actual amount higher than what we set as the standard. But that higher
quality product may have been able to be more efficient with the actual input. We had
less waste or the quality of the products was better. So you can see how there might be
a relationship between different variances calculated for direct materials. In this case
the spending variance and efficiency variance.
15
Let's think a little bit more about variances and move onto direct labor. In terms of direct
labor spending variances what would cause that? Well, it might be that we unexpectedly
gave some of our employees an increase in wages, a raise, or perhaps they worked
more overtime for which we had to pay them a higher wage rate than we had expected
and built into our standard. That might lead to a difference in what we pay our labor and
what we expected to pay or created a standard about.
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Direct labor efficiency variances. What would cause those? Well, again, it's the number
of hours that an employee uses to produce so many units of output. That would be the
input in this case. And so they might be more or less efficient than the standard
assumed.
In this case direct labor variances are interrelated, as well. In terms of direct labor
spending variances we might have lost some of our higher paid workers, more
experienced individuals, and replaced them with more introductory workers. That would
lead to a favorable direct labor spending variance because our wages on average would
be lower than we had expected and built into our standard.
But, perhaps, introductory workers are less efficient. And in this case we would have an
unfavorable efficiency variance. Perhaps because learning curves are higher and it
takes introductory level workers more hours to create the same number of goods. So
there is interrelationships within direct labor variances just like in direct material
variances. And, of course, there are interrelationships between direct materials
variances and direct labor.
Again, let's go back to that purchasing manager who purchased a higher quality input.
In this case we had an unfavorable direct material spending variance. We spent more
per unit of input than we had planned, but that may have led to inefficiencies, both in
terms of direct materials, where a higher quality input led to less waste, as well as if
maybe it's perhaps easier to work with. Direct labor hours were perhaps less than we
had planned because the quality of the input was greater.
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So interrelationships tell a nice story between variances. And it might be that as you
investigate one variance in one area it leads you down a path to investigate other
variances, as well.
So what have we learned in this first lesson in Module 3? Well we first talked about the
definition of standard costs and their role within an organization's costing system. But
we spend most of our time talking about the fundamental concepts underlying variance
analysis. We developed a framework for calculating variable cost variances and will use
that framework in the next lesson when we get into more in-depth calculations.
Lesson 3.2: An Example Scenario and Direct Materials Variances
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Now moving into lesson 3-2. Our objectives in this lesson are to understand materials,
labor and overhead variance calculations. So our variable cost variances. We'll get into
the nuances of how we calculate those. We'll do the same thing for fixed cost variance
calculations. And then we'll talk about interpreting these cost variances, as we calculate
them.
So let's introduce an example scenario. Let's suppose that a company, for a given
month or other time period, has the following standard cost information. They have
three categories of variable costs: materials, labor and variable overhead. And let's
suppose that they have just a single input of material. Each unit that they produce is
supposed to use 6 pounds of that material. That's its standard input. And we are
supposed to spend, approximately 50 cents per pound; that's our standard price.
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In terms of labor, we measure this activity in terms of direct labor hours. And each unit
that we produce is supposed to take 1 direct labor hour. On average, we pay our
employees $8 per each of those direct labor hours. And for variable overhead, we have
a cost driver that we've identified to estimate the usage of overhead resources. And for
this we use machine hours.
Our standard usage of machine hours per unit is 1 machine hour. And our cost, per
machine hour, in terms of variable overhead costs, is $2 per machine hour. In terms of
production, at the beginning of the period, we estimated that we would produce 4,750
units. At the end of the period, we found that we only produced 4,250.
And in terms of actual cost incurred throughout the accounting period, direct material,
the total cost incurred was $12,750 and we actually used 26,100 pounds of material, in
completing the 4,250 units of production. In terms of direct labor, we actually spent a
total of $34,445, and we actually used 4,150 direct labor hours.
And for variable overhead, we actually incurred cost of $10,100. And we used 4,700
machine hours to complete the production. So let's first calculate the variances for direct
materials. So when I'm creating these variances, I start with what we know at the
beginning of the accounting period, and that would be our static budget.
20
So beginning with our static budget, we talked in the previous lesson about their being
three components to the overall budgeted amount. The first is the standard price. And
per the given information, we were told that the standard price is 50 cents per pound.
The standard input per output was 6 pounds per output unit. And at the beginning of the
period, we estimated that we were going to produce 4,750 units of output.
When we multiply those three components together, we get the total direct materials
spending static budget. And that total is $14,250. Now, given what we know at the end
of the accounting period, we can calculate what we actually incurred. And we can take
each of our individual components and parse out them as sources of our overall
variants.
So our first column, moving from right to left, was called the "flexible budget", flex
column. And the only thing that was different between the flexible budget column, and
the static budget column was the outputs produced. Everything else was as originally
reported. So we use the standard price of 50 cents, we use the standard input of 6
pounds, but we change our output from the standard output that we had at the
beginning of the accounting period, and use what we actually produced.
And that, per the information provided was 4,250 units that we actually produced. So
given what our actual production level was, in terms of units of output, we should have
spent $12,750. Again, this is the amount we should have spent given our standard
price, and our standard usage, or standard input, given how many units we actually
produced. By comparing the flexible column, and the static column, we're focused on
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one single source of difference in the overall variance, and that is, due to the level of
production being different than originally planned.
So now let's parse out further ones. We called this second column, or the third column
from the right, the standard price column. That reminded me that I should use the
standard price of 50 cents per pound. We're changing our standard input to actual input
in this column. Now looking back at the example, we were told that we used 26,100
pounds to produce all of our units of output.
So on average, we used 26,100 divided by the 4,250 units that we actually produced.
That was our input per unit of output. And then we actually produced 4,250. So when
we multiply that actual input and the act per unit, and the actual output in total units,
times the standard price, we're given $13,050 as the column total there. And then our
actual spending was just given to us, as a total amount. And per the given information,
that was $12,750.
So now that we've completed our framework, we can calculate each of the individual
variances. The difference between the actual column and the standard price column is
$300. That is the amount of variance that's due to the fluctuation in the actual price per
unit of input, and the standard price per input. The difference between the second and
third columns is our efficiency variance. That is also $300. And that difference is due to
the fact that we used a different number of inputs per output than we had planned and
created as a standard.
And finally, the difference between the third and fourth column, has to do with the
activity. The fact that we produced a different number of units than we had planned and
created as a standard. And that amount is $1,500. Now one thing that we have yet to do
is to calculate, or categorize these variances as favorable or unfavorable. So let's talk
about that for an instance. Let's look at the difference between the flexible budget and
the static budget. In the static budget, everything is at standard.
So that's our completely static budget world; every piece of information is at the
standard level. In the flexible column, the price that we use is standard, the input that
we use is standard, and the output that we use is actual. So comparing just these two
columns, the more actual piece of information is represented in the flexible budget
column, at least compared to the static budget column.
So the static budget column is our complete, our standard world, or budgeted world,
and the flexible column is our pseudo-actual world. Well, these are costs. These are
direct materials costs. And so, in our pseudo-actual world, the cost was $12,750. In our
pseudo-standard world, the static budget column, the cost was $14,250. This means, as
we move from more of a standard world, or budgeted world, to a more actual world,
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costs decreased. The cost in the flexible column is less than the cost in the static
column.
This means that relative to planned or standard net income, the more actual net income
would be higher. Since costs are less, all else equal, net income would be higher. And
we characterize that as a favorable variance. Now, in classifying the efficiency variance,
the $300 in the middle, we're looking at the two columns labeled standard price and
flexible.
And as we did before, in the flexible column, we have a standard piece of information, a
standard piece of information, and an actual piece of information. In the standard price
column, we have a standard, an actual, and an actual piece of information. So in
comparing these two columns, the standard price column is the more actual world. And
the flexible column is the more standard world, relative to each other.
So in this case, the more standard world, $12,750 is less than the more actual world, of
$13,050. And in this case, we have the opposite scenario to the first variance that we
calculated and classified. In this case the more actual world has higher costs, by $300.
That means that relative to a standard comparison point, we're going to have less net
income. When costs are higher, all else equal, net income will be lower. So we'll classify
this variance as unfavorable.
And finally, comparing the first and the second column, on the left hand side, we have
the complete actual world, and the standard price world. Which one is the more actual
piece of information? Well, that's the one that's all actual. So, comparing the $12,750
that we actually spent to the benchmark which has more standard information
embedded into it, the standard price piece, the cost is actually less in the more actual
world, than it is in the standard world.
And that's the case if costs are less, compared to standard, then all else equal, net
income will be higher. So therefore, this $300 spending variance is classified as
favorable. Now, two points to make here. Recall in lesson 1, that we talked about the
fact that favorable doesn't always mean good, and unfavorable doesn't always mean
bad. And the activity variance that we calculated initially, is a perfect example of that.
While our costs were less, and therefore, all else equal, our net income would be
higher, in the more actual world, this variance doesn't necessarily signal a good
situation. We produce less, perhaps, because the demand for our product was less. So
until you identify the reason for the variance existing, you can't really understand if the
situation is desirable or not. We've only classified these variances as unfavorable or
favorable, given their effect on, or given their speaking to the difference between actual
and standard amounts.
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And another point to make is that, if we did not engage in this variance analysis, we
would be disguising the fact that there are two variances, or two sources of variances
that are off-setting each other perfectly. That is, if we just compare the $12,750 to the
$14,250 that we had budgeted, then we might say, "Oh, that's close enough." But what
we're not seeing, if we don't calculate these detailed variances, is that we have a price
variance that's exactly off-setting an efficiency variance.
Now the total amount of $300 may or may not be material, but the spirit of the example
is that different variances can offset one another, and until you compute the variances
at a deep level, you may not understand that completely.
Lesson 3.2: Direct Labor Variances
Now that we've calculated direct material variances, let's move on to the next category
of variable costs, and calculate direct labor variances. We'll use the same example as
what we started with for direct materials. So, one take away from these calculations will
be that it is perfectly analogous to the calculations that we did for direct materials. And
that will demonstrate the point that all variable cost variances can be calculated in the
same manner. So using the direct, but labor information, we can start in the same exact
place as we did with direct materials, and that is with the static budget.
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Per the standard information that was provided in the given information, we're supposed
to spend on average per hour of labor, $8. That's $8 per direct labor hour. Our input on
a standard basis is one direct labor hour per unit of output. And of course we had
originally planned to produce 4,750 units of output.
You'll notice in the calculations in for direct materials that we have the same number in
that third component place, the 4,750 units of output. That makes sense because for all
variances, that are variable cost, we'll be thinking about outputs, and output or
production would be the same, regardless whether or not we we're talking about
materials, labor, or variable overhead.
But ultimately for direct labor costs, the $8 per direct labor hour, multiplied one, by one
direct labor hour per output multiplied by the 4,750 units of output, yields a total static
budget of $38,000. Now thinking about our flexible budget, and that is how much our
direct labor costs should have been, given what we actually produced, instead of
planned to produce, all components are the same, in this column as they are in the
static budget, with the exception of the output.
So we have our $8, our one direct labor hour per output, and instead of 4,750 planned
or expected units, we actually produced 4,250 units of output. Multiplying the eight times
the one direct labor hour per output, by the number of units that we actually produced
4,250, yields 34,000. Moving to the standard price column, we're going to keep the price
the same, we're going to keep the output, which has been convert moving from right to
left to the actual output the same, but we're going to think about how many u-- hours,
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direct labor hours, we actually used to produce what we did. And thinking about that on
a per unit basis, means that, the given information said 4,150 direct labor hours were
used to produce the 4,250 units.
So on average it's a little less than one direct labor hour per output. Multiplying all those
three components together, yields a total dollar amount of $33,200. And then our actual
amount was just provided to us, and that was given as $34,445. Now one thing I didn't
do for direct materials is to complete the different components of the actual column and
that could certainly be done given the way that the information was presented.
The $34,445 is a-- is calculated using all actual information, and we are given that in
terms of outputs, in terms of units of input the direct labor hours in this case, per unit of
output, and then we can back into this unknown here. We can divide 34,445 by the
other two components, and ultimately we get that to be about $8.30 per hour. So
calculating our variances, our actual comparison to the standard price comparison that
yields our spending variance for direct labor for this case, that variance is 1,245.
The difference between the standard price column and flexible price column is referred
to the efficiency variance for direct labor, and that difference is 800. And the difference
between the flexible budget and the static budget is 4,000. Again, we can go through
the exercise of classifying these variances as favorable or unfavorable. And using the
same methodology and logic that we did for direct materials, we can apply that here. So
the static budget, standard piece of information, standard piece of information, standard
piece of information, compared to the flexible budget, standard, standard, actual.
Our flexible number is our more actual piece of information, compared to the static
budget, that cost is lower than what we had planned in a perfectly standardized world.
So the cost being lower means that all else equal, our net income will be higher than we
had expected. So this variance is favorable.
Using the same logic in looking at the efficiency variance, we would classify that as
favorable as well, the more actual piece of information, the cost is lower than the more
standard piece of information, and given that our expected net income, or our actual net
income, would be higher than what we had expected, again a favorable variance.
And the opposite logic applies, or the, the same logic applies, but the opposite outcome
for the spending variance, that variance is actually unfavorable. Now I can look at these
individual components and talk about why they're favorable or unfavorable to help with
the interpretation. In terms of the efficiency measure, we used less than one hour of
direct labor per unit of output. That means on average costs would be lower, all else
equal. So that's going to be a lower cost, a higher than planned net income, a favorable
variance.
26
When I look at the price, what I calculated as $8.30 being the actual price that we spent
per direct labor hour, we spend more than we had expected. That means that relative to
what we expected or standard, or our standard, we, we would have higher costs. Higher
costs, all ees-- , all all, all else equal would yield lower net income, so therefore it's an
unfavorable variance.
Lesson 3.2: Variable Overhead Variances
So now let's complete our overview of variable cost variances with our calculations of
variable overhead variance, using again the same example that we had before. For
overhead we can start in the same place that we did for direct materials and direct
labor. And we were told-- And we were told that our static budget information included
the following standards; $2 per machine hour. Machine hour was identified as the cost
driver that best represented variable overhead spending.
27
One machine hour per output and our planned output of 4,750 units. That total static
budget for variable overhead is $9,500. Our flexible budget uses $2 as the standard
price, one machine hour per unit of output for the standard input. And those two items
are multiplied by the actual output. That total is $8,500.
Our standard price column uses the same standard price that we just had, the same
actual output that we just had, but takes into consideration the actual number of
machine hours used to create the units of product that we actually produced. And the
given information there was we actually used 4,700 machine hours to produce our 400--
4,250 units of output. The total of that column is $9,400.
And finally we were given what our actual variable overhead spending was and that was
$10,100. In case you're keeping score the actual price that we paid per machine hour is
$2 and approximately 15 cents. So looking at the spending, efficiency, and activity
variances for variable overhead we calculate $700 for the spending variance and that is
classified as unfavorable. We calculate $900 as the efficiency variance for variable
overhead. That too is unfavorable. And the activity variance that we have for variable
overhead is $1,000 and that will be classified as favorable.
28
Lesson 3.2: Fixed Cost Variances
Now let's turn our attention to fix costs, and we'll show how those are calculated
differently than what we just did for variable cost variances. Let's turn to the same
example but with some additional information added on. -- So, for the coming month we
know the following about fixed costs, and the budget for them.
The fixed cost is budgeted to be $16,625, and as we learned from variable overhead the
firm has identified the cost driver as machine hours, and we're supposed to use, in a
standard world, one machine hour per unit produced. At the end of the accounting
period, we collect the actual information. And that is, that we've actually spent in fixed
cost $16,900. We actually produced 4,250 units and our machine hour's use was 4,700.
29
So, in terms of developing a framework for fixed costs, let's think about what is relevant
from our variable cost framework. In that one we had a static budget -- that was
comprised of standard price, standard input, and standard output. We had a flexible
budget in which everything was standard except our output.
30
We had a third column, standard price column where the only standard piece of
information that we included in that calculation was the price itself. Everything else was
in actual terms. And then, of course, we had a completely actual column.
Actual price, actual input, and actual output. Now we talked about the spending
variance, the efficiency variance, and the activity variance for variable costs. And the
activity variance was due to the fact that we produced a different amount than we
thought we were going to produce when it came to the outputs, our units of production.
When we think about fixed costs, by definition, fixed costs don't fluctuate with units of
production, assuming we're on the same relevant range.
So, this variance, the activity variance for fixed costs doesn't really apply logically. So, in
essence, we can ignore for fixed costs the notion of a flexed budget column. Exceptions
will be noted later. But, for the purposes of thinking about spending efficiency and
activity variances for fixed costs, there really is no activity variance that we can attribute
in overall difference too.
Now, in terms of thinking about the flexible budget versus this standard price column,
and we calculate the efficiency variance that had to do with fluctuations in the actual
input compared to the standard input per our unit of output. And again, for fixed costs,
that doesn't really actually create a variance. It does not logical to attribute some usage
of an input to the fixed cost because different levels of activity whether you're talking
about inputs or outputs don't really drive fixed costs.
31
So, in essence, we can ignore the standard price column as well, for fixed costs. Now,
in terms of price, that does make sense to think about at a fixed cost level. You could
think about a rent for an apartment or a home and during the year you think that you're
going to spend $1,000 per month on that rent but, suppose that the landlord raised the
rent during the second half of the year.
You ended up paying a different price, in actual terms, than you thought you were going
to pay. So, of course, the price for fixed costs can vary over an accounting period, and
that's what we will attribute all of our fixed costs variances to. The fact that the price of
those fixed costs was different than what we had budgeted, expected, and created as a
standard.
So, in terms of our example, would be much simpler than a variable cost variance is
concerned. We were told that we would budget $16,625 for our fixed costs for the
month. The given information suggested - that we actually spent $16,900. The
difference between those two is $275, and some managers talk about that cost being a
static budget variance because that's the only variance that's applicable to fixed costs at
this point, and other people just call this a fixed cost spending variance because, the
price was different than what you thought.
By the way, classifying this as favorable or unfavorable would lead me to label this an
unfavorable variance. And, the reason is, is because we actually spent more than we
thought, our costs were actually higher, therefore, all else equal, our net income would
be lower, yielding an unfavorable variance.
32
Lesson 3.2: Production Volume Variances
So, as you can see the fixed cost variance calculations are much simpler than the
variable cost variances. But, we're not going to get away with things that easy. For fixed
cost variances there is a different variance that many companies use. It's called the
production volume variance. And, what it represents is a different, difference than what
we've been calculating thus far.
The difference between the budgeted, or expected overhead and overhead that is
estimated during an accounting period. What we've been doing thus far is looking at
budgeted, or expected, or standard information compared to what actually happened.
But, as you recall from earlier module, we estimate overhead throughout an accounting
period to help facilitate decisions.
Some firms will calculate a variance between how much has been estimated and what
was originally budgeted at the beginning of the period. Depending on the time period
we're talking about, not all firms calculate this. But, just in case, here's a bit of
background about the production volume variance.
33
The calculation actually depends on how overhead is estimated, or how it's applied.
And, there are differences between what we're talking about, a standard costing system,
and other costing systems. Specifically, what's generally referred to as a normal costing
system. These get a little bit confusing but, just keep in mind that the calculations are
basically comparing the budgeted overhead which is created at the beginning of the
accounting period, and that which is estimated throughout. Let's turn to our example to
explore this idea a little bit more. -- -
So, the first step we have to perform in order to calculate the production volume
variance is figure out what predetermined overhead rate was calculated. We were told,
at the beginning of the accounting period, that we would expect $16,625 in fixed
overhead costs. Now, we divvy that up over our units of cost driver, and we were told
that we can expect one machine hour for each unit that we produce, and that we are
supposed to produce 4,750 units of output. That comes out to be $3.50 per machine
hour.
34
Now, the second step is to actually estimate overhead, and when we estimate overhead
there are multiple choices that we have to do. -- Under a standard costing system we
estimate, or apply overhead in the following manner. We use the predetermined
overhead rate of $3.50 per machine hour, and we multiply that by however many
machine hours we should have used given what we actually produced. That's one
machine hour, per output, and we were told that we actually produced 4,250 units of
output.
So, our applied overhead throughout the accounting period is, $14,875. So now we're
able to calculate the difference between the amount of overhead that we budgeted at
the beginning of the year, and that which we have estimated throughout the accounting
period. And, that would be the difference between $14,875 applied, or estimated
overhead, and the $16,625 of budgeted overhead. In this case, we calculate a variance
of $1,750. Under a different costing system, namely a normal costing system, we
estimate to our applied overhead a bit differently.
We actually take the same predetermined overhead rate of $3.50 per machine hour,
and we use the actual number of machine hours that we used throughout the
accounting period to estimate the overhead. This is different than the standard costing
system which used the number of machine hours that we were supposed to use given
our actual production volume.
35
But this, we go right to the number of machine hours that we actually used, under a
normal costing system. That $3.50 per machine hour would be multiplied by the actual
number of machine hours used which was given to us as 4,700 machine hours. That
yields an estimated overhead of $16,450, and, the difference between that version of
applied overhead and the budgeted amount of $16,625 is $175.
This would be the production volume variance calculated under a normal costing
system. Now, firms choose whether they adopt a standard costing system or a normal
costing system. And, as we've talked about a lot, many factors influence what choice of
costing system a firm makes.
But, regardless of choice, you can always calculate the production volume variance.
Again, the difference between the predetermined budgeted of total amount of overhead,
and that which is been applied, or estimated throughout the accounting period.
36
Lesson 3.2: What We've Learned in Lesson 3.2
So this concludes Lesson 3-2. Let's talk about what we learned. We started with a
general framework and the calculations related to variable costs, and even in a simple
world where there are just three categories (materials, labors, and variable overhead)
we can see that the calculations are quite complex. We turned our attention then to
fixed costs variance calculations and focused on the difference between those and the
variances that are calculated for variable costs.
And along the way we've been talking about how to interpret these variances. The
interpretation is the key when it comes to variance analysis. As we'll talk about in the
next module, variance analysis itself doesn't necessarily provide you with any answers,
but ultimately it asks-- it allows you to ask the right questions.
37
Lesson 3.3: Fundamentals and General Framework
Now we turn to lesson three dash three. In lesson three dash three, we turn our
attention to revenue variances. Specifically our objectives are to ultimately understand
fundamentals of revue variances, how to calculate revue variances, and how to interpret
those revenue variances.
Just like with cost variances, we're going to develop a generic frame work for calculating
revenue variances. When we think about revenues, we can think about two inherent
drivers of those revenues, just like with cost variances, we can think about those things
happening at an actual level, or an expected, or budgeted level.
So, when we think about actual revenues, we can think about the product that we sell,
and the price we charge our customers for each unit of that product. So, we have an
actual price to calculate total revenues we would take that actual price again per unit
sold, and multiply by some actual quantity.
38
By multiplying these to components, we would have total actual revenues. Now, when
we make the world a little but more complex, we can think of a multi product firm. And in
multi product firms, they usually have cut-- , they usually have products that are
compliments, or substitutes. So just like in previous modules, we can think of the
percentage of our overall quantities sold, of a particular type of product. For example, in
a couple of slides we'll talk about a cookie manufacturer.
And the cookie manufacturer might have three different types of cookies. Some
proportion of their overall cookie sold are of variety one, another proportion is of variety
two, and the third is comprised of variety three. So, in actual terms we can think about
the percentage of our overall quantity sold that is of a particular product type, and that
we'll call the actual mix, or proportion of our overall quantity cook-sold, that is of a
particular type of product.
Now, just like in cost variances, we can have an analogous world where everything is
budgeted or standardized. With respect to revenues, we usually refer to revenues and
prices as budgeted as opposed to standards, that's just to help differentiate the different
types of stan-- different types of variances. But, over in our complete budgeted world,
we would have the budgeted price for our product, the expected or budgeted mix, and
the budgeted total quantity of units sold.
Multiplying these three budgeted items yields a total budgeted revenue dollar amount.
And just like with cost variances, we can turn one dial at a time, separating our
39
individual reasons as to why the actual revenues collected differ from that which was
expected or budgeted. So, we can move to a flexible budget type of column, where the
budgeted price and budgeted mix are held constant, but rather than use the total
quantity sold, we, on a budgeted basis, we use the actual quantity.
Multiplying those three components gives us another, another column total. And again
the difference between what is column three and four, or the two right hand columns,
parses out the difference between the actual quantity and total terms sold, versus that
which was expected. Another dial turn, leads us to think about the mix. We leave our
price in budgeted terms. We've already converted out budgeted quantity to actual
quantity, so we'll leave that as actual quantity, and we'll change the next dial to actual
mix.
The difference between columns two and three, parse out the source of differences
between actual and budgeted proportions or mix of sales. And finally the comparison
between the first and second column, parses out differences between actual and
budgeted selling price. Just like in the cost variance framework, we have three
individual variances that we can focus on.
And again, depending on what company organization is using this analysis, will
determine what names are being used.
You can refer it to the selling price variance, the sales mix variance, and the quantity, or
volume, variance. Again just like the cost variances, analyzing at this level of detail
40
allows us to understand the role of different components fundamental issues in the

calculation of revenue and how they drive differences between actual revenues and
budgeted revenues.
41
Lesson 3.3: An Example Scenario
So now let's exercise this generic framework for revenue variances and calculate a few
using our cookie based example. For our company in this situation, we are provided
with budgeted and actual information all related to revenue type components, so first off
we received budgeted information. We know from this information that we manufacture
and sell three different types of cookies, chocolate chip, oatmeal raisin, and macadamia
nut.
We have selling prices that we plan to charge for each cookie that we sell. For
chocolate chip the selling price is 4 50. For oatmeal raisin it's $5 and for macadamia nut
it's 6 50. And then we have projected, or budgeted, or expected sales volumes of
cookies over this time period. We expect to sell 45,000 units of chocolate chip cookies,
25,000 units of oatmeal raisin, and 15,000 of macadamia nut. Now, one thing that we
can see, that's not actually listed here, is that we expected to sell in total 85,000
cookies, in total.
42
That's the 45,000, 25,000, and 15,000 combined. Now we also, at the end of the period,
acquire actual revenue information. For the same three cookie lines, we learn that our
actual selling price for chocolate chip was what we planned it to be $4.50, for whatever
reason we charge a slightly higher price on average for our oatmeal raisin cookies than
we had planned, at 5 20. And we also raised the price compared to what we had
budgeted on the macadamia nut cookies, and charges $7 per unit for those.
Our sales volumes were different than expected. We sold 57,600 units of chocolate chip
cookies, 18,000 of oatmeal raisin, and 21,600 of macadamia nut. You can see for the
different cookies that we sold, may be more or less, than what we had planned. But the
total that we ended up actually selling comes out to be 97,200. That's 57,600 plus the
18,000 plus the 21 6.
So now let's calculate the revenue variances for one of these cookies, and let's focus on
the chocolate chip. So, in using the budgeted information, and using our generic
framework for calculating revenue variances, we can start over at the completely
budgeted column. All information is as planned. Per the information on the previous
slide, the selling price that was budgeted for chocolate chip cookies was $4.50 per
chocolate chip cookie.
The proportion of our overall sales that we expected to sell for chocolate chip cookies
was 45,000 out of the 85,000 total cookies that we expected to sell. And then of course,
the total quantity of cookies that we would sell was our 85,000. When we multiply these
three components, we get what we expected to earn in terms of revenue from just the
43
chocolate chip cookie line, and that comes out to be $202,500. Now, turning one dial at
a time and trying to parse out the different components, or sources of difference
between budgeted revenues and actual revenues, allows us to move from right to left to
the third column. Generically we refer to that as flex.
We leave our budgeted price to be the same, $4.50 per chocolate chip cookie. We'll
assume that we had the same mix, 45,000 out of the total 85,000 that we had planned
to sell. But we'll change the total quantity from our budgeted number to the actual
number. And as I suggested on the previous slide, that total number of cookies that we
sold during this accounting period in actual terms was 97,200 cookies, that's all three
lines combined.
So, given the total number of cookies that we actually sold across all three lines, but
assuming that we were in line with the budgeted mix and charged the budgeted price,
would yield a total of 231,565, with a little bit of rounding in there. Again this is how
much revenue we would have expected to collect, had we sold the budgeted mix, at the
budgeted price, of the actual total quantity of cookies sold.
Moving on to the next variance, we can change the next level or next component. We'll
leave the price the same at 4 50, we'll leave the total quantity at its actual terms of
97,200 total cookies, but now let's take into account the actual mix. The actual
proportion of our total quantity that were of the chocolate chip variety, and that was the
total number of chocolate chip cookies sold. That's 57,600 out of the 97,200 total
cookies sold. Multiplying the 4 50 times the actual mix, times the total quantity actually
sold, yields 259,200. And finally let's look at the column where all of the components are
in their actual versions.
So, the actual quanti-- actual revenues that we have earned. We are changing the
budgeted price into the actual price. But if you recall from the given information we didn't
change the actual price from budgeted. We actually charged the same as what we
expected, so, that number is 4 50, but it's reflected of what we actually charged, not
what we budgeted. The actual mix is 57,600 over the 97,200, that's the proportion of our
total cookies sold that was of the chocolate chip variety in actual terms, and the actual
total quantity 97,200.
Multiplying those three components together yields the actually revenue earned from
chocolate chip cookies during this accounting period, and that is 259,200. So now, we
can calculate the individual variances on the revenue side of this business. The
difference between the first and the second column is the selling price variance, it
actually is $0. The reason again, we didn't have a fluctuation in the selling price for
chocolate chip cookies, so therefore there is no variance on that level.
44
The difference between the second the third column, referred to as the mix variance,
comes out to be $27,635. And the difference between the third and the forth column,
which has to do with the fluctuation from budgeted towards actual total cookies sold,
comes out to be $29,065. Now, just like with cost variances we can classify these
individual variances as favorable or unfavorable.
Looking at the volume or activity variance on the sales on-- for chocolate chip cookies,
you can see that the budgeted world, the column where all the information is budgeted,
is being compared to two budgeted pieces of information, but then also one actual piece
of information. So for purposes of classifying this variances favorable or unfavorable,
the flex column is the pseudo actual world, and the budgeted world, budgeted column,
is the budgeted world. In this case, the revenues in the more actual column are greater
than the revenues in the more budgeted column.
This would mean from a revenue perspective hat all else equal net income would be
higher than what was expected, so therefore, this variance is classified as favorable.
Now, moving to the comparison between the second and the third column, the mix
variance, we can see that what we had thought was going to be the proportion of the
chocolate chip cookies out of the total was, was different than what actual occurred. So
there is a bi-- there is a variance there.
The flexible column represents the pseudo budget world because it has two pieces of
budget information and only one actual, the budgeted price has one piece of budgeted
information and two actual. So the budgeted price column total of 259,200, the more
actual piece of information, is greater than what we have in the comparison that's more
of the budgeted piece of information. Again, all else equal, this would suggest that our
rev-- our net income is higher than what would be expected, so just like for the activity
variance, or quantity variance, we have a favorable variance there.
And when we have a $0 variance we call it neither unfavorable nor favorable. But that's
actually quite a rare occurrence anyway. Ultimately using this framework, you can
calculate the same set of variances for all of our other cookie types, and you'll start to
see interrelationships between the different cookies. For instance, the budgeted mix for
cookie-- for chocolate chip cookies, was lower than the actual mix of chocolate chip
cookies. This insinuated that there was a favorable variance on that level. We have-- we
sold a greater proportion of chocolate chip cookies than we did-- than we planned.
45
But for another cookie type, that insinuates that we sold less proportion, because we
sold more chocolate chip cookies than we thought, we probably sol-- we, we, we did sell
less other types of cookies. So therefore there's going to be a budgeted-- there's going
to be a sales mix variance for another type of cookie that will be unfavorable it won't
equate to this dollar amount because other factors influence what that dollar amount is,
but from that you can start to see the interrelationships between those types of
variances.
46
Lesson 3.3: What We've Learned in Lesson 3.3
So what did we learn in lesson three? Well, we talked about the fundamentals of
revenue variances, and we developed a framework for calculating revenue variances,
specifically the sales quantity variance, the sales mixed variance, and the sales price
variance. We worked through the calculation and the interpretation of those revenue
variances as well.
47
Lesson 3.3: Module 3 Review
This concludes Module 3. To review we first talked about the fundamentals and purpose
of variance analysis. We focused on calculating and interpreting cost variances first. We
distinguished between variable costs, as well as fixed costs. And, finally, we concluded
with the calculation and interpretation of revenue variances. As you can see from this
module, variance analysis is an extremely powerful tool to help both facilitate, as well as
align and guide decisions made by managers and employees.
48

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Managerial Accounting

Professor Gary Hetch

Lesson 3.1: Fundamental Concepts ............................................................................. 2

Lesson 3.1: Cost Variance Classification and General Framework .............................. 7

Lesson 3.1: Causes of Variances ............................................................................... 14

Lesson 3.2: An Example Scenario and Direct Materials Variances ............................ 18

Lesson 3.2: Direct Labor Variances ............................................................................ 24

Lesson 3.2: Variable Overhead Variances ................................................................. 27

Lesson 3.2: Fixed Cost Variances .............................................................................. 29

Lesson 3.2: Production Volume Variances ................................................................. 33

Lesson 3.2: What We've Learned in Lesson 3.2 ........................................................ 37

Lesson 3.3: Fundamentals and General Framework .................................................. 38

Lesson 3.3: An Example Scenario .............................................................................. 42

Lesson 3.3: What We've Learned in Lesson 3.3 ........................................................ 47

Lesson 3.3: Module 3 Review ..................................................................................... 48

It is generally expressed on a per-unit basis, and it is generally predetermined through

And finally, variance analysis facilitates a management by exception approach. When a

Unfavorable refers to a situation when the source of the variance or a particular

Lesson 3.1: Cost Variance Classification and General Framework

Lesson 3.1: Causes of Variances

Lesson 3.2: An Example Scenario and Direct Materials Variances

Lesson 3.2: Direct Labor Variances

Lesson 3.2: Variable Overhead Variances

Lesson 3.2: Fixed Cost Variances

Lesson 3.2: Production Volume Variances

Lesson 3.2: What We've Learned in Lesson 3.2

Lesson 3.3: Fundamentals and General Framework

allows us to understand the role of different components fundamental issues in the

Lesson 3.3: An Example Scenario

Lesson 3.3: What We've Learned in Lesson 3.3

Lesson 3.3: Module 3 Review

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