Variances

Variances are a key tool in a management accountant’s toolbox to understand why we spent more or less than we anticipated.

Knowing that we did spend more or less than we budgeted isn’t anywhere near as useful as knowing why you spent more or less than you budgeted.  If you know why then you can probably do something about it.

Variances

Variances are a key tool in a management accountant’s toolbox to understand why we spent more or less than we anticipated.

Knowing that we did spend more or less than we budgeted isn’t anywhere near as useful as knowing why you spent more or less than you budgeted.  If you know why then you can probably do something about it.

It isn’t always just about looking into why you spent more than you budgeted on, it is just as useful to know why you spent less than you budgeted on.  Spending less than you budgeted on isn’t always a good thing!  You might buy some cheap material but if that leads to customer complaints and then lost business you might find the savings are not worthwhile!

Understanding the Importance of Variances

There are lots of different types of variances that you can calculate but my favourites are the material and labour direct variances.  These allow us to see if we spent more or less than the budgeted amount for labour and material and what caused it.  If we spent more than we budgeted on this is known as an adverse variance and if we spent less than we have a favourable variance.

Calculating Variances

Before we can calculate any variance, we need to have our budgeted standards in place, which are for labour; the budgeted labour hours per unit of production and the budgeted rate per hour we will pay our staff.  For our material variances we will need the budgeted quantity of material per unit of production and what we budgeted on paying per unit of material, the amount per kilo for example.

Labour Variances

If you have spent more on labour than you budgeted on, it can be due to either you using more labour hours per unit of production, and/or, you paid your staff more per hour than you intended.  We can split the labour costs into the labour rate variance and the labour efficiency variance.  The labour rate variances investigates if we spent more or less per hour than we budgeted on and puts into monetary terms how much the difference in the rate per hour we spent cost us or saved us.  We calculate this as the actual number of hours we used at the actual amount we paid per hour, compared to the actual number of hours valued at the standard rate per hour.  In our calculation the number of hours we are comparing are both the actual number of hours, so any difference can only be due to the difference on the rate per hour that we paid compared to the budgeted rate per hour.

The other labour variance is the labour efficiency variance, this shows us the difference in cost due to if our staff worked faster or slower than we budgeted on.  To calculate this, we take the actual number of hours we used and compare this to the actual volume of production multiplied by the budgeted number of hours each unit should take.  This gives us a difference in hours between what we did use and what we budgeted on using based on our actual level of production.  However, we want to know the actual monetary cost of this difference, so we multiply it by the standard cost per hour.  This shows us how much extra it has cost us, or saved us, depending on whether staff worked faster or slower than we budgeted on.

Material Variances

The other major cost in a manufacturing company is material, and the material variances are split into the material usage variance and the material price variance.

The material usage variance is similar in concept to the labour efficiency variance as this shows the monetary value of difference in the amount of material per unit we used.  Here I use kilos, but it could be litres or grams depending on what you are making!  To calculate the material usage variance, we compare the actual amount of material we did use to the actual number of units produced multiplied by the budgeted amount of material per unit.  This gives us the difference in kilos between what we did use for what we produced to what we budgeted on using for the level of production we achieved.  But if we want to express this as a monetary term we multiply it by the standard amount per kilo we budgeted on paying.  This the extra cost or saving in pounds of using more or less material per unit of production than we thought we should.

The material price variance is very akin to the labour rate variance as it shows the extra cost or cost saving due to the difference in the amount per kilo you paid.  To calculate the material price variance, we compare the actual amount of material we used at the actual price per kilo we paid compared to the actual amount we used valued at the standard price per kilo.  You can see in the formula the quantities we have used both times is the actual quantity, so the difference is only due to the difference in what we paid per kilo.

Unraveling the Complexities of Variances

You might find that the causes of these variances can be linked, for example you might find you have a favourable labour rate variance because you paid your cheap labour less per hour, but if they work much slower, you might find that you actually spend more money on labour as they work much slower and you get a greater adverse labour efficiency variance.  Likewise, an adverse material price variance might be linked to buying better quality material, which in turn lead to a great reduction in wastage and an even greater favourable variance in the material usage variance.

Or they might not be linked at all! Or it might also be linked to things that you cannot do anything about, like a global price rise, but at least you know how much it cost you!

 

For help or advice on your studies, please get in touch with us today.

Did you know about our YouTube channel?

Register for our weekly student webinar.

For more news and exclusive tips from First Intuition, visit FI Hub.

Further reading

AAT - Summaries of tax changes - website

AAT Summaries of Tax Changes

tax points

AAT – Tax points

AAT Exam Technique Masterclasses

AAT Exam Technique Masterclasses

SHARE THIS ARTICLE

Date

Title