Managerial

Accounting, 16e

Chapter 9:
Evaluating Variances from
Standard Costs
 Chapter Objectives
By the end of this chapter, you should be able to:
Obj. 1 Describe the types of standards and how they are established.
Obj. 2 Describe and illustrate how standards are used in budgeting.
Obj. 3 Compute and interpret direct materials and direct labor variances.
Obj. 4 Compute and interpret factory overhead controllable and volume
variances.
Obj. 5 Describe and illustrate the recording and reporting of standards and
variances.
Obj. 6 Describe and illustrate the use of the direct labor time variance in
evaluating staff performance in a service setting.
Obj. 7 Compute and interpret revenue variances.
 Standards
(Learning Objective 1)

• Standards are performance goals.

• Manufacturing companies normally use standard cost for each of the
three following product costs:
• Direct materials
• Direct labor
• 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 cost (actual cost)
 Setting Standards and Types of Standards
• One of the major objectives in setting standards is to motivate employees
to achieve efficient operations.
• Ideal standards, or theoretical standards, are standards that can be
achieved only under perfect operating conditions, such as no idle time, no
machine breakdowns, and no materials spoilage.
• Such standards may have a negative impact on performance because they
may be viewed by employees as unrealistic.
• Normal standards, sometimes called currently attainable standards, are
standards that can be attained with reasonable effort.
• Such standards, which are used by most companies, allow for normal
production difficulties and mistakes.
• Standard costs should be periodically reviewed to ensure that they reflect
current operating conditions.
 Criticisms of Standards Costs

• Criticisms of using standard costs for performance evaluation include:

• Standards limit operating improvements by discouraging improvement
beyond the standard.
• Standards are too difficult to maintain in a dynamic manufacturing
environment, resulting in “stale standards.”
• Standards can cause employees to lose sight of the larger objectives of the
organization by focusing only on efficiency improvement.
• Standards can cause employees to unduly focus on their own operations,
possibly harming other operations that rely on them.

• However, standards are used widely and are only one part of the
performance evaluation system used by most companies.
 Knowledge Check Activity 1

Which of the following is a major objective in setting standards within a

standard cost system?

a. Making employees work as quickly as possible

b. Producing as many products as possible during the period
c. Motivating employees to achieve efficient operations
d. Firing managers who are responsible for unfavorable variances
 Knowledge Check Activity 1: Answer

Which of the following is a major objective in setting standards within a

standard cost system?

Answer: c. Motivating employees to achieve efficient operations

One of the major objectives in setting standards is to motivate

employees to achieve efficient operations.
 Budgetary Performance Evaluation
(Learning Objective 2)

• The master budget assists a company in planning, directing, and controlling

performance.
• The control function, or budgetary performance evaluation, compares the actual
performance against the budget.
• Western Rider Inc., a manufacturer of blue jeans, uses standard costs in its
budgets.
• The standards for direct materials, direct labor, and factory overhead are
separated into two components: standard price and standard quantity.
• The standard cost per unit for direct materials, direct labor, and factory overhead
is computed as follows:
Standard Cost per Unit = Standard Price  Standard Quantity
Exhibit 1 - Standard Cost for XL Jeans
 Exhibit 2 - Cost Variances

• The differences between actual and standard costs are called cost
variances.
• A favorable cost variance occurs when the actual cost is less than the
standard cost.
• An unfavorable cost variance occurs when the actual cost exceeds the
standard cost.
 Budget Performance Report

• The report that summarizes actual costs, standard costs, and the
differences for the units produced is called a budget performance report.
• Assume that Western Rider Inc. produced the following pairs of jeans
during June:
Exhibit 3 - Budget Performance Report
 Exhibit 4 - Manufacturing Cost Variances

For control purposes, each product cost variance is separated into two additional variances.
 Manufacturing Cost Variances

• The total direct materials variance is separated into a price variance and a
quantity variance:

• The total direct labor variance is separated into a rate variance and a time
variance:

The total factory overhead variance is separated into a controllable variance and a volume variance. Because
factory overhead has fixed and variable cost elements, it uses different variances than direct materials and
direct labor, which are variable costs.
 Knowledge Check Activity 2

Which of the following is not a component of total manufacturing cost

variance?

a. Direct materials cost variance

b. Fixed and variable cost variance
c. Direct labor cost variance
d. Factory overhead cost variance
 Knowledge Check Activity 2: Answer

Which of the following is not a component of total manufacturing cost

variance?

Answer: b. Fixed and variable cost variance

The total manufacturing cost variance is the difference between total

standard costs and total actual costs for the units produced. It is broken
down into the components of direct materials cost variance, direct labor
cost variance, and factory overhead cost variance.
 Direct Materials and Direct Labor Variances
(Learning Objective 3)

Exhibit 5 - Direct Materials and Direct Labor Cost Variances

The total direct materials and direct labor variances are separated into the direct
materials cost and direct labor cost variances for analysis and control purposes.
 Direct Materials Variances
• During June, Western Rider Inc. reported an unfavorable total direct materials cost
variance of $2,650 for the production of 5,000 XL style jeans.
• This variance was based on the following actual and standard costs:

• The actual costs incurred of $40,150 consist of the following:

Actual Direct Materials Cost = Actual Price × Actual Quantity
= ($5.50 per sq. yd.) × (7,300 sq. yds.)
= $40,150

• The standard costs of $37,500 consist of the following:

Standard Direct Materials Cost = Standard Price × Standard Quantity
= $5.00 per sq. yd. × 7,500 sq. yds.
= $37,500
 Direct Materials Price Variance
• The direct materials price variance is computed as follows:
Direct Materials Price Variance = (Actual Price – Standard Price)  Actual Quantity

• If the actual price per unit exceeds the standard price per unit, the variance
is unfavorable.
• If the actual price per unit is less than the standard price per unit, the
variance is favorable.
• The direct materials price variance for Western Rider Inc. for June is $3,650
(unfavorable), computed as follows (assumes the amount of materials
budgeted for production equals the amount purchased):
Direct Materials Price Variance = (Actual Price – Standard Price) × Actual Quantity
= ($5.50 – $5.00) × 7,300 sq. yds.
= $3,650 Unfavorable Variance
 Direct Materials Quantity Variance
• The direct materials quantity variance is computed as follows:
Direct Materials Quantity Variance = ( Actual Quantity − Standard Quantity )  Standard Price

• If the actual quantity for the units produced exceeds the standard quantity,
the variance is unfavorable.
• If the actual quantity for the units produced is less than the standard quantity,
the variance is favorable.
• The direct materials quantity variance for Western Rider Inc. for June is
$1,000 (favorable), computed as follows:
Direct Materials Quantity Variance = (Actual Quantity – Standard Quantity) × Standard Price
= (7,300 sq. yds. – 7,500 sq. yds.) × $5.00
= $(1,000) Favorable Variance
Exhibit 6 - Direct Materials Variance Relationships
 Reporting Direct Materials Variances
• The direct materials quantity variances should be reported to the manager
responsible for the variance.
• For example, an unfavorable quantity variance might be caused by either of the
following:
• Equipment that has not been properly maintained
• Low-quality (inferior) direct materials
• Not all variances are controllable.
• An unfavorable materials price variance might be due to market-wide price
increases, and sometimes there is nothing the Purchasing Department might
have done to avoid the unfavorable variance.
• However, if materials of the same quality could have been purchased from
another supplier at the standard price, the variance was controllable.
 Direct Labor Variances
• During June, Western Rider Inc. reported an unfavorable total direct labor cost
variance of $2,500 for the production of 5,000 XL style jeans.
• This variance was based on the following actual and standard costs:

• The actual costs incurred of $38,500 consist of the following:

Actual Direct Labor Cost = Actual Rate per Hour × Actual Time
= $10.00 per hr. × 3,850 hrs.
= $38,500

• The standard costs of $36,000 consist of the following:

Standard Direct Labor Cost = Standard Rate per Hour × Standard Time
= $9.00 per hr. × 4,000 hrs.
= $36,000
 Direct Labor Rate Variance

• The direct labor rate variance is computed as follows:

Direct Labor Rate Variance = ( Actual Rate per Hour − Standard Rate per Hour )  Actual Hours

• If the actual rate per hour exceeds the standard rate per hour, the variance is
unfavorable.
• If the actual rate per hour is less than the standard rate per hour, the variance is
favorable.
• The direct labor rate variance for Western Rider Inc. in June is $3,850
(unfavorable), computed as follows:

Direct Labor Rate Variance = (Actual Rate per Hour – Standard Rate per Hour) × Actual Hours
= ($10.00 – $9.00) × 3,850 hours
= $3,850 Unfavorable Variance
 Direct Labor Time Variance
• The direct labor time variance is computed as follows:
Direct Labor Time Variance = ( Actual Direct Labor Hours − Standard Direct Labor Hours )  Standard Rate per Hour

• If the actual direct labor hours for the units produced exceed the standard direct
labor hours, the variance is unfavorable.
• If the actual direct labor hours for the units produced are less than the standard
direct labor hours, the variance is favorable.
• The direct labor time variance for Western Rider Inc. for June is $1,350 (favorable)
computed as follows:
Direct Labor Time Variance = (Actual Direct Labor Hours – Standard Direct Labor Hours)
× Standard Rate per Hour
= (3,850 hours – 4,000 direct labor hours) × $9.00
= $(1,350) Favorable Variance
Exhibit 7 - Direct Labor Variance Relationships
 Reporting Direct Labor Variances
• Production supervisors are normally responsible for controlling direct labor cost.
• An investigation can reveal causes for unfavorable rate and time variances:
• An unfavorable rate variance may be caused by the improper scheduling and
use of employees.
• In such cases, skilled, highly paid employees may be used in jobs that are
normally performed by unskilled, lower-paid employees, and the unfavorable
rate variance should be reported to the managers who schedule work
assignments.
• An unfavorable time variance may be caused by a shortage of skilled
employees.
• In such cases, there may be an abnormally high turnover rate among skilled
employees, and production supervisors with high turnover rates should be
questioned as to why their employees are quitting.
 Direct Labor Standards
for Nonmanufacturing Activities
• Direct labor time standards can also be developed for use in administrative,
selling, and service activities.
• This is most appropriate when the activity involves a repetitive task that produces
a common output.
• To illustrate, standards could be developed for customer service personnel who
process sales orders.
• A standard time for processing a sales order (the output) could be developed and
used to control sales order processing costs.
• When labor-related activities are not repetitive, direct labor time standards are
less commonly used.
 Discussion Activity 1

You have seen the detailed analysis of using a standard costing system
over the previous slides and in the text. The resources to maintain a
standard cost system are a consideration to many firms, and they must
commit to using the information to aid in decision making.
After learning about standard costing, do you think it is a worthwhile
expense and effort to use the system? Refer to Exhibits 6 and 7 to
support your opinion in terms of what kind of information would be
valuable to a company.
Share your thoughts in a class discussion.
 Discussion Activity 1: Debrief
In previous years, a standard costing system involved a lot of manual
effort and dedication to make it worthwhile. With modern technology
and software, the cost of implementation and maintenance has
decreased, as well as the time needed to provide the analyses that can
make a big difference in the “bottom line,” especially for manufacturers.
Using a standard costing system can prevent unnecessary costs that
could be avoided during a reporting period. For example, poor-quality
material can cause a favorable direct materials price variance but also
create an unfavorable direct labor time variance because the material
was defective and had to be reworked. In most instances, the cost
benefit of having a standard costing system outweighs the resources
needed to maintain it.
 Factory Overhead Variances
(Learning Objective 4)

• Factory overhead costs are analyzed differently than direct labor and direct
materials costs because factory overhead costs have fixed and variable
cost elements.
• For example, indirect materials and factory supplies normally behave as a
variable cost as units produced change.
• In contrast, straight-line plant depreciation on factory machinery is a fixed
cost.
• Factory overhead costs are budgeted and controlled by separating factory
overhead into fixed and variable components.
 The Factory Overhead Flexible Budget
(1 of 2)

• The budgeted factory overhead rate for Western Rider is $6.00 per direct labor
hour:
Budgeted Factory Overhead at Normal Capacity
Factory Overhead Rate =
Normal Productive Capacity
$30,000
= = $6.00 per direct labor hr.
5,000 direct labor hrs.

• For Western Rider, 100% of normal capacity is 5,000 direct labor hours.
• The budgeted factory overhead cost at 100% of normal capacity is $30,000,
consisting of variable overhead of $18,000 and fixed overhead of $12,000.
• For analysis purposes, the budgeted factory overhead rate is subdivided into a
variable factory overhead rate and a fixed factory overhead rate.
 The Factory Overhead Flexible Budget
(2 of 2)

• For Western Rider, the variable overhead rate is $3.60 per direct labor hour, and
the fixed overhead rate is $2.40 per direct labor hour, computed as follows:
Budgeted Variable Overhead at Normal Capacity
Variable Factory Overhead Rate =
Normal Productive Capacity
$18,000
= = $3.60 per direct labor hr.
5,000 direct labor hrs.

Budgeted Fixed Overhead at Normal Capacity

Fixed Factory Overhead Rate =
Normal Productive Capacity
$12,000
= = $2.40 per direct labor hr.
5,000 direct labor hrs.

• To summarize, the budgeted factory overhead rates for Western Rider Inc. are as
follows:
 Exhibit 8 - Factory Overhead Cost Budget
Indicating Standard Factory Overhead Rate
 Variable Factory Overhead Controllable Variance
(1 of 2)

• The variable factory overhead controllable variance is the difference between

the actual variable overhead costs and the budgeted variable overhead for actual
production:
Variable Factory Overhead Controllable Variance = Actual Variable Factory Overhead
– Budgeted Variable Factory Overhead

• If the actual variable overhead is less than the budgeted variable overhead, the
variance is favorable.
• If the actual variable overhead exceeds the budgeted variable overhead, the
variance is unfavorable.
• The budgeted variable factory overhead is the standard variable overhead for
the actual units produced:
Budgeted Variable Factory Overhead = Standard Hours for Actual Units Produced
 Variable Factory Overhead Rate
 Variable Factory Overhead Controllable Variance
(2 of 2)
• The budgeted variable overhead for Western Rider Inc. for June, when 5,000
units of XL jeans were produced, is $14,400:
Budgeted Variable Factory Overhead = Standard Hours for Actual Units Produced
 Variable Factory Overhead Rate
= 4,000 direct labor hrs.  $3.60
= $14,400

• Assume Western Rider incurred the following actual factory overhead costs:

• The variable factory overhead controllable variance is a $4,000 favorable variance:

Variable Factory Overhead Controllable Variance = Actual Variable Factory Overhead
– Budgeted Variable Factory Overhead
= $10,400 – $14,400
= $(4,000) Favorable Variance
 Fixed Factory Overhead Volume Variance
(1 of 2)

• Fixed factory overhead volume variance is the difference between the budgeted
fixed overhead at 100% of normal capacity and the standard fixed overhead for the
actual units produced.
Fixed Factory Overhead Volume Variance = (Standard Hours for 100% of Normal Capacity
– Standard Hours for Actual Units Produced)
 Fixed Factory Overhead Rate
• Interpretation of an unfavorable and a favorable fixed factory overhead volume
variance is as follows:
• Unfavorable fixed factory overhead volume variance means actual units
produced is less than 100% of normal capacity; thus, the company used its
fixed overhead resources less than would be expected.
• Favorable fixed factory overhead volume variance means actual units
produced is more than 100% of normal capacity; thus, the company used its
fixed overhead resources more than would be expected.
 Fixed Factory Overhead Volume Variance
(2 of 2)

• To illustrate, the fixed factory overhead volume variance for Western Rider Inc. is
a $2,400 unfavorable variance:

• Western Rider’s fixed factory overhead 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).
Exhibit 9 - Graph of Fixed Overhead
Volume Variance

• For production levels more

than 100% of normal capacity
(5,000 direct labor hours), the
volume variance is favorable.
• For production levels less than
100% of normal capacity (5,000
direct labor hours), the volume
variance is unfavorable.
 Reporting Factory Overhead Variances
• An unfavorable volume variance may be due to factors such as:
• Failure to maintain an even flow of work
• Machine breakdowns
• Work stoppages caused by lack of materials or skilled labor
• Lack of enough sales orders to keep the factory operating at normal capacity
• Total factory overhead cost variance can also be determined as the sum of the
variable factory overhead controllable and fixed factory overhead volume
variances:

• A factory overhead cost variance report is useful to management in controlling

factory overhead costs.
Exhibit 10 - Factory Overhead Cost Variance Report
 Factory Overhead Account
(1 of 2)

• The applied factory overhead for Western Rider Inc. for the 5,000 XL jeans
produced in June is $24,000:
Applied Factory Overhead = Standard Hours for Actual Units Produced × Total Factory Overhead Rate
= (5,000 jeans × 0.80 direct labor hr. per pair of jeans) × $6.00
= 4,000 direct labor hrs. × $6.00 = $24,000

• Total factory overhead cost variance for Western Rider is a $1,600 favorable
variance, computed as follows:
Total Factory Overhead Cost Variance = Actual Factory Overhead – Applied Factory Overhead
= $22,400 – $24,000 = $(1,600) Favorable Variance
 Factory Overhead Account
(2 of 2)

• At the end of the period, the factory overhead account normally has a balance.
• A debit balance represents underapplied overhead and a credit balance
represents overapplied overhead.
• Underapplied and overapplied factory overhead account balances represent the
following total factory overhead cost variances:
• Underapplied Factory Overhead = Unfavorable Total Factory Overhead Cost
Variance
• Overapplied Factory Overhead = Favorable Total Factory Overhead Cost Variance
 Exhibit 11 - Factory Overhead Variances

• If the actual factory overhead exceeds (is less than) the budgeted factory overhead, the controllable variance is unfavorable (favorable).
• If the applied factory overhead is less than (exceeds) the budgeted factory overhead, the volume variance is unfavorable (favorable).
 Knowledge Check Activity 3
JB Industries, Inc., produces a line of luxury home furnishings. During the
most recent period, its actual factory overhead was $28,500 and its applied
factory overhead was $22,700. What is the balance of the factory overhead
account at the end of the period?

a. $5,800 underapplied
b. $22,700 overapplied
c. $5,800 overapplied
d. $28,500 underapplied
 Knowledge Check Activity 3: Answer
JB Industries, Inc., produces a line of luxury home furnishings. During the
most recent period, its actual factory overhead was $28,500 and its applied
factory overhead was $22,700. What is the balance of the factory overhead
account at the end of the period?

Answer: a. $5,800 underapplied

In the factory overhead account, actual factory overhead is debited (left side
of T account) and applied factory overhead is credited (right side of T
account). Since the actual factory overhead is $28,500 and the applied
factory overhead is $22,700, they are underapplied by $5,800, resulting in a
debit balance in the account of $5,800 (see example on slide 43).
Recording and Reporting Variances from Standards
(Learning Objective 5) (1 of 3)

• Many companies include standard costs in their accounts, and one method for doing
so records standard costs and variances at the same time the actual product costs
are recorded.
• Western Rider Inc. purchased, on account, 7,300 square yards of denim at $5.50
per square yard, which has a standard price of $5.00 per square yard.
• To record the purchase and the unfavorable direct materials price variance:

• A debit balance in the direct materials price variance account represents an

unfavorable variance and a credit balance represents a favorable variance.
Recording and Reporting Variances from Standards
(2 of 3)

• The direct materials quantity variance is recorded in a similar manner:

• A debit balance in the direct materials quantity variance account represents an

unfavorable variance and a credit balance represents a favorable variance.
Recording and Reporting Variances from Standards
(3 of 3)
• The journal entries to record the standard costs and variances for direct labor are
similar to those for direct materials, summarized as follows:
• Work in Process is debited for the standard cost of direct labor.
• Wages Payable is credited for the actual direct labor cost incurred.
• Direct Labor Rate Variance is debited for an unfavorable variance and credited for a
favorable variance.
• Direct Labor Time Variance is debited for an unfavorable variance and credited for a
favorable variance.
• The actual factory overhead is compared with the budgeted factory overhead to
determine the controllable variance, and the budgeted factory overhead is
compared with the applied factory overhead to determine the volume variance.
• At the end of the period, the balances of each of the variance accounts indicate
the net favorable or unfavorable variance for the period and are reported in an
income statement prepared for management’s use.
 Exhibit 12 - Variance from Standards
in Income Statement

A sales price of $28 per pair of jeans, selling expenses of $14,500, and administrative expenses of $11,225 are assumed.
 Analysis for Decision Making:
Service Staffing Variances
(Learning Objective 6) (1 of 2)
• Standards can be used in nonmanufacturing settings where the tasks are
repetitive in nature.
• To illustrate, Marion Hotel uses labor standards to control the costs of the
housekeeping staff, where a housekeeping employee is expected to clean a
room in 42 minutes and is paid $13 per hour.
• Information for a recent week follows:
• Number of guest room nights 1,050
• Number of housekeeping staff hours 840
• Guest room nights can be translated into standard staff hours as follows:
 Analysis for Decision Making:
Service Staffing Variances
(2 of 2)

• The direct labor time variance can be computed as:

• The actual staff hours were greater than the standard hours, causing an
unfavorable staff time variance.
• Management can investigate the causes of the variance, which may include
overscheduling staff, insufficient staff training, difficult room cleaning
situations, and staff inefficiency.
 Discussion Activity 2

Variance analysis can be useful in nonmanufacturing entities,

especially when tasks are repetitive in nature. This allows
management to analyze costs and make decisions to avoid higher
expenses. In addition to the previous example involving
housekeeping and hotels, can you think of any service-type
repetitive tasks that could benefit from management analysis?
In groups of three to four students, brainstorm areas within service
businesses that would fall under this category. Share your group’s
examples with the class.
 Discussion Activity 2: Debrief
Students will find various examples of repetitive tasks in service
businesses that could benefit from variance analysis. Examples include
cleaning airplanes between flights, serving customers at a fast-food
restaurant, changing the oil in cars at a quick oil-change facility, etc.
The package delivery service is known for having a “standard” amount
of time to deliver packages that drivers should strive to attain to
maximize the efficiency of their operations. Have you or someone you
know worked at a service-type company that has a set time to complete
tasks?
 Appendix: Revenue Variances
(Learning Objective 7) (1 of 2)

• Operating income is affected by differences between expected (planned) revenues

and actual revenues, called revenue variances.
• A difference between actual and planned revenues may be due to an increase or
decrease in unit sales price and/or units sold.
• The effects of the preceding two factors on revenue may be analyzed by
computing the revenue price variance and the revenue volume variance.
• The revenue price variance is caused by a difference in the planned and actual
unit sales price on the actual units sold:
Revenue Price Variance = (Planned Selling Price per Unit – Actual Selling Price per Unit)
 Actual Units Sold

• The revenue volume variance is caused by a difference in the planned and

actual units sold, assuming no change in unit sales price or unit cost:
Revenue Volume Variance = (Planned Units Sold − Actual Units Sold)  Planned Sales Price
 Appendix: Revenue Variances
(2 of 2)

• The following is August data for Noble Inc., which sells a single product:

Revenue Price Variance = (Planned Selling Price per Unit – Actual Selling Price per Unit) × Actual Units Sold
= ($8.00 – $7.50) × 125,000
= $62,500 Unfavorable Variance

Revenue Volume Variance = (Planned Units Sold − Actual Units of Sales )  Planned Sales Price
= (100,000 − 125,000 )  $8.00
= $ ( 200,000 ) Favorable Variance

• The favorable revenue volume variance of $200,000 has the effect of increasing
revenues and operating income.
 Exhibit 13 - Revenue Analysis

For internal reporting, companies may report revenue variances separately or together with cost variances on an income statement.
 Summary
Now that the lesson has ended, you should have learned how to:
• Describe the types of standards and how they are established.
• Describe and illustrate how standards are used in budgeting.
• Compute and interpret direct materials and direct labor variances.
• Compute and interpret factory overhead controllable and volume variances.
• Describe and illustrate the recording and reporting of standards and
variances.
• Describe and illustrate the use of the direct labor time variance in
evaluating staff performance in a service setting.
• Compute and interpret revenue variances.