The actual costs and quantities incurred for direct materials, direct labor, and variable manufacturing overhead are reported in Exhibit 8-1. Standard costing allows comparison between actual costs incurred and budgeted costs based on standards. In a manufacturing environment, variance analysis may be performed separately for the different components of costs, i.e. direct materials, direct labor, and factory overhead. The number of units produced each quarter multiplied by the number of hours per unit equals the required direct labor hours needed to be scheduled in order to meet production needs. The total number of hours is next multiplied by the direct labor rate per hour, and the labor cost can be budgeted and used in the cash disbursement budget and operating budget.
Spice International has determined the following based on new machinery will be added in October. This machine will reduce the labor required per unit and increase the labor rate for those employees qualified to operate the machinery. In a merchandising firm, retailers purchase, rather than produce, their inventory. Instead, merchandisers substitute the number of units to be purchased in place of the number of units to be produced; the result is the amount of merchandise inventory to be purchased. The number of units expected to be sold plus the desired ending inventory equals the number of units that are available.
The variance is obtained by calculating the difference between the direct labor standard cost per unit and the actual direct labor cost per unit. If the actual direct labor cost is lower, it means that it costs lower to produce one unit of a product than the standard direct labor rate, and therefore, favorable. Labor efficiency variance equals the number of direct labor hours you budget for a period minus the actual hours your employees worked, times the standard hourly labor rate. Standard costs and quantities are established for each type of direct labor. These standards are compared to the actual number of direct labor hours worked and the actual rate paid for each type of direct labor. When discussing direct labor, price is referred to as rate, and quantity is referred to as efficiency.
Calculating Normal Costing
As shown in Exbibit 8-1, Brad projects that the standard variable cost to make one unit of product is $7.35. He estimates that each unit should require 4.2 feet of flat nylon cord that costs $0.50 per foot for total direct material costs per unit of $2.10. Each unit should require 0.25 direct labor hours to assemble at an average rate of $18 per hour for total direct labor costs of $4.50 per unit. Variable manufacturing overhead costs are applied to the product based on direct labor hours. The standard variable manufacturing overhead rate is $3 per direct labor hour.
However, detailed variance analysis is necessary to fully assess the nature of the labor variance. As will be shown, Blue Rail experienced a very favorable labor rate variance, but this was offset by significant unfavorable labor efficiency. The completed top section of the template contains all the numbers needed to compute the direct labor efficiency (quantity) and direct labor rate (price) variances. The direct labor efficiency and rate variances are used to determine if the overall direct labor variance is an efficiency issue, rate issue, or both.
Examining Variances
Standard costs variance analysis is used to determine the variances between the standard amounts projected for manufacturing costs and the actual amounts incurred. It is important to remember that standards are the planned or projected amounts. Any variance between the standard amounts allowed and actual amounts incurred should be investigated. Since direct labor hours are the cost driver for variable manufacturing overhead in this example, the variance is linked to the direct labor hours worked in excess of the standard labor hours allowed. This overage in direct labor hours means that $22,500 of additional variable manufacturing overhead was incurred based on the standard amount applied per direct labor hour.
To illustrate standard costs variance analysis for variable manufacturing overhead, refer to the data for NoTuggins in Exhibit 8-1 above. Per the standards, the variable manufacturing overhead rate is $3 and each unit requires 0.25 direct labor hours. During the period, 45,000 direct labor hours were actually worked and actual variable manufacturing overhead of $121,500 was incurred.
( Standard direct labor hours allowed for January production:
As mentioned previously, standard rates and quantities are established for variable manufacturing overhead. When discussing variable manufacturing overhead, price is referred to as rate, and quantity is referred to as efficiency. Any variance between the standard costs allowed and the actual costs incurred is caused by a difference in efficiency or a difference in rate. The total variance for variable manufacturing overhead is separated into the variable manufacturing overhead efficiency variance and the variable manufacturing overhead rate variance. The total variances can be calculated in the last line of the top section of the template by subtracting the actual amounts from the standard amounts projected. The standard quantity allowed is 37,500 hours less the actual hours worked of 45,000 hours equals a variance of (7,500) direct labor hours.
Knowing the direct labor cost per unit makes pricing and margin management much easier. A business that produces goods or services must develop and maintain accurate estimates of the cost of production. Direct labor, meaning toe work required to actually make a product, is a critical component of manufacturing costs. Without knowing the direct labor cost, a business may overprice its goods and lose customers to competitors. The unfavorable labor rate variance is not necessarily caused by paying employees more wages than they are entitled to receive.
- One can compute the values for the red, blue, and green balls and note the differences.
- Since 1,300 units needed to be available and there are zero units in beginning inventory, Big Bad Bikes needs to manufacture 1,300 units.
- When the beginning inventory is subtracted from the number of units available, management knows how many units must be produced during that quarter to meet sales.
- A favorable variance occurs when your actual direct labor costs are less than your standard, or budgeted, costs.
Actual Cost Tracking Vs. Normal Costing
Refer to the total direct materials variance in the top section of the template. Total standard quantity is calculated as standard quantity per unit times actual production or 4.2 feet of flat nylon cord per unit times 150,000 units produced equals 630,000 feet of flat nylon cord. Total direct material costs per the standard amounts allowed are the total standard quantity of 630,000 ft. times the standard price per foot of $0.50 equals $315,000. Per the standard cost formulas, Brad projected he should have paid $315,000 for the direct materials necessary to produce 150,000 units. This math results in a favorable variance of $4,800, indicating that the company saves $4,800 in expenses because its employees work 400 fewer hours than expected. If the actual quantity used is greater than the standard quantity, the variance is unfavorable.
Total variable manufacturing overhead costs per the standard amounts allowed are calculated as the total standard quantity of 37,500 times the standard rate per hour of $3 equals $112,500. During the period, Brad projected he should pay $112,500 for variable manufacturing overhead to produce 150,000 units. actual quantity is the actual direct material or direct labor used to manufacture the This results in an unfavorable variance since the actual rate was higher than the expected (budgeted) rate.
Unfortunately, they were unable to manufacture any units before the end of the current year, so the first quarter’s beginning inventory is 0 units. Sales in quarter 2 are estimated at 1,000 units; since 30% is required to be in ending inventory, the ending inventory for quarter 1 needs to be 300 units. With expected sales of 1,000 units for quarter 2 and a required ending inventory of 30%, or 300 units, Big Bad Bikes needs to have 1,300 units available during the quarter. Since 1,300 units needed to be available and there are zero units in beginning inventory, Big Bad Bikes needs to manufacture 1,300 units. As with material variances, there are several ways to perform the intrinsic labor variance calculations.
- If the total actual cost is higher than the total standard cost, the variance is unfavorable since the company paid more than what it expected to pay.
- These standards are then compared to the actual quantities used and the actual price paid for each category of direct material.
- But the actual quantity used may be more or less than the quantity allowed by standards.
- As shown in Exbibit 8-1, Brad projects that the standard variable cost to make one unit of product is $7.35.
- Manufacturing firms can use actual cost tracking or normal costing to account for production costs.
Manufacturing Overhead Budget
Knowing that variable manufacturing costs were $181,500 over budget is helpful, but it doesn’t isolate the production issue or issues. Therefore, the next step is to individually analyze each component of variable manufacturing costs. The total variable manufacturing costs variance is separated into direct materials variances, direct labor variances, and variable manufacturing overhead variances. To illustrate standard costs variance analysis for direct labor, refer to the data for NoTuggins in Exhibit 8-1 above. Each unit requires 0.25 direct labor hours at an average rate of $18 per hour for a total direct labor cost of $4.50 per unit. During the period, 45,000 direct labor hours were worked and $832,500 was paid for direct labor wages.
Management uses the same information in the production budget to develop the direct labor budget. This information is used to ensure that the proper amount of staff is available for production and that there is money available to pay for the labor, including potential overtime. Typically, the number of hours is computed and then multiplied by an hourly rate, so the total direct labor cost is known. For the direct material budget, it is important to note that we use Required Production. Similar to the production budget, management wants to have an ending inventory available to ensure there are enough materials on hand. The direct materials budget illustrates how much material needs to be ordered and how much that material costs.
When less is spent than applied, the balance (zz) represents the favorable overall variances. Favorable overhead variances are also known as “overapplied overhead” since more cost is applied to production than was actually incurred. Such variance amounts are generally reported as decreases (unfavorable) or increases (favorable) in income, with the standard cost going to the Work in Process Inventory account.
