P1 Management Accounting

Module: 10

Variance Analysis - Standard

Throughput Costing

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1. Standard throughput costing That's marginal costing covered! It is common to see standard costing integrated into this system (one could dare say it is almost...standard!) but you may find it far less common to see standard costing integrated into throughput accounting, but it is still done in some instances. Let’s work through an example to see how this is done.

Example:

We produce two different toy cars, Car A and Car B. The details of each car’s production costs and prices are as follows:

Throughput Car A

Selling price £ 1,000

Materials £ 300

£ 700

Car B 2,000 500 1,500

Fixed costs Machine

£

8,500

Labour 19,000

Other expenses 8,000

Machine hours required

Car A 10

Car B 40

Labour hours required 20 30

We are told that we produced 25 of Car A and 15 of Car B during the period. The bottleneck resource is labour.

Step 1: Produce a budget profit statement

You should find it relatively simple to put together a budget profit statement from the above information. Remember, throughput is revenues less material costs but does not take off other costs, so they will need to be deducted to get to the profit figure. Here’s what it should look like:

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Budget profit statement

Throughput

£ £

Car A (25 units at £700 throughput) 17,500

Car B (15 units at £1,500 throughput) Total throughput

22,500 40,000

Operating costs Machine

8,500

Labour 19,000

Other expenses 8,000

Total costs 35,500 Profit 4,500

Step 2: Calculate standard costs

We are now in a position to allocate our labour and machine costs to products. First, we’ll work out the cost per machine and labour hour from the information given:

Output Units Machine hrs Labour hrs Car A (10 machine hrs, 20 labour hrs) 25 250 500 Car B (40 machine hrs, 30 labour hrs). 15 600 450 850 950

Total Cost £8,500 £19,000 Cost per hour £10 £20

As we now have the cost per hour and we know the amount of hours required by each car, we can go ahead and calculate the cost per car:

Cost per car Machine Labour Car A (10 machine hrs, 20 labour hrs) £100 £400 Car B (40 machine hrs, 30 labour hrs) £400 £600

After these calculations we now have our standard costs for each product:

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Per unit Car A £ Car B £ Selling price 1,000 2,000

Standard materials 300 500 Standard machine cost 100 400 Standard labour cost 400 600 Standard profit 200 500

New information

During the period, we decide to spend an extra £5,000 on labour to increase output through our bottleneck resource. This extra labour boosts our output of Car A by 10 units.

We work out that this will increase our throughput by £7,000 (£700 throughput of each Car A x 10 units), and after the deduction of the extra £5,000 in labour will result in a £2,000 increase in profit (£7,000-£5,000 = £2,000). Therefore, our actual profit will increase to £6,500 (£4,500 budget profit + £2,000 increase).

We want to conduct a variance analysis and reconcile our budget to actual profit for the period. Before we do this, it is important that you remember the concepts of throughput accounting. You should recall that throughput accounting considers all costs except materials to be fixed. Therefore, our variances are calculated slightly differently compared to our marginal and absorption costing examples.

Also, bear in mind that only sales and production of Car A has changed, so we will only conduct variance analysis on Car A.

Sales volume variance

There is no difference in how sales are recognised between TA, marginal and absorption costing. Therefore, this variance is calculated in the same way as our other examples:

Budgeted sales volume of Car A 25 Actual sales volume (10 extra units produced) 35 Difference 10 favourable x budget profit per unit of Car A £200 Sales volume variance £2,000 favourable

Labour expenditure variance

Under TA labour is a fixed cost, therefore this is calculated the same way as a fixed cost expenditure variance:

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Budgeted labour costs £19,000

Actual labour costs £24,000

Variance £5,000 Adverse

Labour volume variance

Under TA labour is a fixed cost, therefore this is calculated the same way as a fixed cost efficiency variance. You should understand that if we treat labour as a fixed cost, it needs to be absorbed. The absorption rate is simply the labour cost per unit (£400), as that is the amount of cost we have allocated to each product per our calculations above.

Remember that the variance in this example is considered favourable because we produced more units than we budgeted for, i.e. we exceeded our target.

Actual output of Car A (units) 35 Budgeted output of Car A (units) 25 Variance 10

x overhead absorption rate (£400 per unit) £4,000 favourable

Machine volume variance

As machine costs are also fixed under TA, this variance is calculated in the exact same way as the labour volume variance above. The only difference is that we obviously need to use machine cost per unit instead of labour cost per unit as our overhead absorption rate:

Actual output of Car A (units) 35 Budgeted output of Car A (units) 25 Variance 10

x overhead absorption rate (£100 per unit) £1,000 favourable

Reconcile budget to actual profit

As with our other costing systems, it is important to reconcile our budget to actual profit to ensure our variances are correct. Let’s see how this looks under a throughput accounting system:

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Budget to actual profit reconciliation Budget profit

£ £ 4,500

Sales volume variance 2,000

Labour expenditure variance (5,000)

Labour volume variance 4,000

Machine volume variance Total variances

1,000 2,000

Actual profit 6,500

As you can see, our statement correctly reconciles our budgeted profit of £4,500 to our actual profit of £6,500. This statement is of value to us because it shows us that although we decided to spend an extra £5,000 on labour (resulting in the adverse labour expenditure variance) the end result was an increase in output leading to an increase of £2,000 in overall profit.

By using the approach laid out we can benefit from applying variance analysis to throughput accounting systems.

2. Idle time Have you ever gone into your office or place of business during a quiet period (over Christmas etc.) and found that there is nothing to do? No one else is in and no external work is coming in due to the office being 'closed'. You spend the morning sitting around playing solitaire until you decide you may as well go home. In accountancy terms, what you have experienced is known as idle time.

Idle time is when facilities are available to produce units but are not used due to a shortage of another resource such as materials or staff. During idle time, no units are being produced but wages still need to be paid. As a result, labour workers are effectively being paid to do nothing.

You might have already realised that this will have an adverse effect on your labour efficiency variance, because it will appear that you need more labour hours than you actually do. Therefore, in order to increase the accuracy of this variance it is important that the idle time portion of it is isolated. This brings the issue of idle time to management’s attention, so it can then be dealt with as a separate issue from worker inefficiency.

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Example

The standard variable costs are as follows:

Unit costs

Direct material 17kg £5 per kg £85 Direct labour 30 hours £3 per hour £90 Variable overhead 30 hours £2 per hour £60

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We produced 400 units during the period. Our actual costs were as follows:

Direct material 6,600kg £34,320 Direct labour 11,520 hours £32,256 Variable overhead 11,520 hours £24,422

Budgeted fixed production overhead

£7,000 Actual fixed production overhead £9,000

Budgeted output (units)

350 Actual output (units) 400

A car manufacturer carried out the following calculation:

400 units should have used (30 hours/unit) 400 units actually used Variance

12,000 hours 11,520 hours

480 hours

favourable

480 hours at standard cost (£3/hour) £1,440 favourable

Let us assume that in our above example, of the 11,520 hours of paid labour, 500 hours were idle time. We are asked to determine how much of our direct labour efficiency variance (£1,440 favourable, as calculated earlier) is due to idle time. This is calculated as follows:

Idle time variance

To calculate this, we simply calculate the standard cost of our idle hours:

Idle time (hours) 500

Standard cost of labour per hour £3

Idle time variance £1,500 adverse

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This variance represents the standard cost of our labour that was paid during idle time, i.e. when no products were produced. Now let’s recalculate our direct labour efficiency variance.

Direct labour efficiency variance

400 units should have used (30 hours/unit) 12,000 hours 400 units actually used (idle time excluded) 11,020 hours Variance 980 hours favourable

980 hours at standard cost (£3/hour) £2,940 favourable

This is the same calculation as our original direct labour efficiency variance calculation, except that in this instance we have used active hours only.

Take notice of how the variance is more favourable than before (£1,440 favourable before versus £2,940 favourable now). This is because we removed the idle hours, meaning our actual hours required figure is reduced.

You should also notice that this variance (£2,940 favourable) and our idle time variance (£1,500 adverse) add up to our original direct labour efficiency variance (£1,440 favourable). However, the benefit now is that we know the portion that relates to idle time, which can now be addressed as a separate issue to labour efficiency.

Now let’s take a look at how our variable overhead variances change after adjusting for idle time:

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Variable overhead expenditure variance

11,020 hours should have cost (£2/hour) £22,040 11,020 hours actually cost £24,422 Variance £2,382 adverse

Variable overhead efficiency variance

400 units should have used (30 hours/unit) 12,000 hours 400 units actually used (idle time excluded) 11,020 hours Variance 980 hours favourable

980 hours at standard cost (£2/hour) £1,960 favourable

the difference in these calculations is we are using active hours only (11,020 hours) instead of total hours (11,520 hours).

It’s interesting to note that our overall variable overhead variance is the same regardless of whether we exclude idle time or not. Our new variable overhead expenditure variance (£2,382 adverse) and our new variable overhead efficiency variance (£1,960 favourable) still add up to £422 – our original total.

However, the difference is that our efficiency variance has had a change in the favourable direction and our expenditure variance has had a change in the adverse direction. Here’s why:

By excluding idle time in the expenditure variance, we are comparing to a standard cost that is now lower, as we excluded idle hours from our standard cost calculation. However, actual cost is obviously unchanged. This variance now highlights that we overspent by more than we expected.

On the other hand, excluding idle time in the efficiency variance highlights the fact that we completed our products in even less time than originally thought, resulting in a move towards a more favourable variance.

Expected idle time

In various industries idle time is expected. Consider industries that are seasonal such as fruit growing or tourism. In these situations, a corporation might include an allowance for a ‘normal’ amount of idle time. In such cases, only idle time that exceeds the normal amount would be truly considered ‘idle’ in our calculations.

Let’s follow on from our example and take a look at how our variances might change in the event of expected idle time. Let’s assume that due to seasonality we expect 5% idle time throughout the period.

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Idle time variance

First of all, we need to adjust our hourly labour rate for our expected idle time. To do this we take our standard hourly cost of labour and divide it by our active time percentage:

Standard hourly rate of labour £3 Active time percentage 0.95 Adjusted hourly rate of labour £3.16

Next, we’ll calculate the difference between expected idle time and our actual idle time of 500 hours. The standard cost of this difference will be our idle time variance:

Expected idle time (11,520 hours x 5%) 576 Actual idle time 500 Variance 76 favourable x standard hourly labour rate £3.16 Idle time variance £240.16 favourable

Notice how our idle time variance is now favourable even though we had 500 hours of idle time. This is because we actually expected 576 hours of idle time. Therefore, the variance is considered favourable. It’s important to note that favourable idle time variances are only possible in environments where “expected” idle time is recognised.

Direct labour efficiency variance

400 units should have used (30 hours/unit) 12,000 hours 400 units actually used (idle time excluded) 11,020 hours Variance 980 hours favourable

x standard hourly labour rate £3.16 Direct labour efficiency variance £3,096.80 favourable

The only difference in this calculation is that we use the adjusted rate of labour (£3.16) as oppose to the original rate of £3.

As you can see, this variance is slightly more favourable than we previously calculated. This is because the adjusted rate of labour used accounts for expected idle time. Therefore, only a portion of our idle time is considered ‘bad’.

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3. Backwards variances There may be an exam question in which you will be given variances and then be required to work backwards to calculate standard or actual data. Your ability to do this will depend largely on your understanding of the variances themselves and their formulae.

The best approach to completing such a question is to fill in all the data provided to you into the variance formulae and then work backwards step by step until every piece of information is filled in.

Let’s go through a typical example to give you an idea of how this approach might work.

Example:

Actual hours worked 11,520 Total direct labour cost £32,256 Direct labour rate variance £2,304 favourable Direct labour efficiency variance £1,440 favourable

Calculate the following:

• Standard hourly labour rate. • Standard total hours required.

Step 1:

First, we’ll lay out the formulae for each variance to see what information we have and what information we need to work out.

Labour rate variance Standard cost of actual hours missing Actual cost of actual hours £32,256 Variance £2,304 favourable

Labour efficiency variance Standard hours missing Actual hours used 11,520 Difference missing Multiplied by standard hourly rate missing Variance £1,440 favourable

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Step 2:

Let’s go through each variance and see which figures we can backwards calculate.

Labour rate variance

Standard cost of actual hours £34,560 Actual cost of actual hours £32,256

Variance £2,304 favourable

What we are missing in this variance calculation is the standard cost of actual hours. However, we know that actual cost was £32,256, and that we had a favourable variance of £2,304. That means our standard cost was £2,304 higher than £32,256. Therefore, simple addition tells us that the standard cost of hours worked is £34,560, as marked in red above.

You may have already realised that we can now calculate our standard hourly rate of labour as well, as required by the question. We know the standard cost of actual hours, and we know the actual hours used, so this is just a matter of simple division:

Standard cost of actual hours £34,560 Actual hours worked 11,520 Standard cost per hour £3

Now let’s move on to calculating the next required figure – standard hours:

Labour efficiency variance Standard hours missing Actual hours used 11,520 Difference missing Multiplied by standard hourly rate £3 Variance £1,440 favourable

We can complete all the missing pieces in this variance using a step by step approach. We know the variance is a favourable one of £1,440. We’ve also just worked out our standard hourly rate, which is £3. This means using simple division, we can calculate the variance in hours:

Variance in £ £1,440 Standard hourly rate £3 Variance in hours 480

Let’s plug that into our formula:

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Labour efficiency variance Standard hours missing Actual hours used 11,520 Difference 480 favourable Multiplied by standard hourly rate £3 Variance £1,440 favourable

The final step is to add the difference to our actual hours used. The resulting figure will be the number of standard hours used:

Labour efficiency variance Standard hours 12,000 Actual hours used 11,520 Difference 480 favourable Multiplied by standard hourly rate £3 Variance £1,440 favourable

We’re done! By working backwards step by step, we were able to work out the standard hourly rate of £3 and the standard total hours of 12,000. This approach should serve you well in an exam situation and will be effective if you understand the formulae and the data required for each variance.

4. Causes of variances Previously we looked at how to calculate variances. Accountants often fall into the trap of thinking that doing the calculation is enough. It is not! In fact, the most important element is yet to come!

So, the most important element of variances is identifying the possible causes of an adverse or favourable outcome. After all, there is no value in identifying the effect a weakness in an organisation if you have no idea of what is causing it let alone whether or not it can be fixed! Below are some of the more common reasons that variances might occur:

Variance Favourable Adverse

Material price

Price decrease Discounts Efficient purchasing, e.g. fewer deliveries, lower prices negotiated

Price increase Inefficient purchasing

Material Less waste than expected Materials are of poor quality,

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usage

Higher efficiency, e.g. workers more efficient, upgraded machinery

damaged or spoiled More waste than expected Strict quality control High number of defects

Labour rate

Wage rates lower than expected Bonuses/wage increases less than anticipated

Wage rates higher than expected Unexpected wage rate increases Bonuses higher than expected

Labour efficiency

Higher skilled workers hired Good worker motivation to produce faster than expected Upgraded materials, machinery allowed faster worker speed

Poor training Poor worker motivation Poor quality machinery or materials hindered worker speed

Idle time

Efficient purchasing of materials Maintenance of machinery Note: Idle time variance can only be favourable in systems where “expected idle time” is recognised

Excessive machine downtime/breakdowns Supply chain issues Worker illness

Fixed overhead expenditure

Unexpected savings in fixed costs, e.g. discount received, change in service provider

Unexpected increase in fixed costs, e.g. extra use of service, extra payments required, price increase

Fixed overhead volume

Output higher than expected, i.e. over absorption

Output lower than expected, i.e. under absorption

Variable overhead expenditure

More economical use of service (reasons will depend on specific overhead)

Higher than expected use of service (reasons will depend on specific overhead)

Variable overhead efficiency

Will depend on allocation basis, i.e. machine hours, labour hours

Will depend on allocation basis, i.e. machine hours, labour hours

Typically, accountants will investigate the reasons with the relevant staff and report those reasons to manager and directors.

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Management can then take the necessary action to resolve any problems. If material prices were too high for instance, then changing supplier might be the solution.

5. Interrelationship of variances One of the key skills in variance analysis is to understand the relationships between them. It is seldom enough simply to consider variances as either adverse or favourable and address them as individual issues on that basis alone. You will find that variances have the ability to influence each other - addressing only one variance might cause an adverse or favourable effect in another. Let’s consider some of the more common interrelationships in the scenarios below:

Scenario 1:

While producing toy cars, we notice that the testing stage is extremely complicated, and our current workers are struggling to complete it properly. We instruct the manager to hire a specialist car tester, who will need to be paid twice as much as our regular factory workers. The manager is reluctant to do so as we already have an adverse direct labour rate variance. This variance will increase even more upon hiring of this specialist worker, which will reduce the manager’s chance of a bonus.

In this scenario, it is important to understand that an increase in an adverse labour rate variance is not necessarily a bad thing. If the workers who are currently doing the testing are untrained and unable to do the task properly, it simply leads to wasted labour hours which would have an adverse effect on our labour efficiency variance anyway. It is possible that the specialist tester may be able to complete car testing 3 to 4 times faster than our regular workers, as well as doing a better job at it in the process.

This could realistically translate into a small increase in labour cost but a large decrease in labour hours. The result is a large favourable change in our labour efficiency variance that would outweigh the adverse effect on our labour rate variance. By considering the effects on all variances, the manager would see that upon hiring the specialist there is a good chance overall labour costs will decrease.

Scenario 2:

Manager Bob is in charge of dealing with our suppliers and purchasing materials. We decide to offer him a bonus if he can produce a favourable material price variance. Manager Dan works in the factory and is in charge of production. We also offer him a bonus in the event that he can produce a favourable material usage variance. During the period, our supplier offers Bob materials of a lower standard at a price that is 40% lower than

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our regular price. Bob goes ahead with the purchase. The price reduction results in a large favourable material price variance, and he receives his bonus.

However, in the factory, Manager Dan is having issues with the material. There are many defects, breakages, and some materials are easily damaged in transit. Workers are also having trouble dealing with the more fragile material which is leading to high amounts of wastage and overtime. As a result, we fail to fill all of our orders on time and experience a large decrease in profit for the period. Needless to say, Dan does not qualify for his bonus.

The problems in this scenario should be obvious. By thinking that our variances were independent of each other, we alienated one of our managers and decreased in the profitability of our business. We needed to be aware that a favourable change in our material price variance is only beneficial if the change was not to the detriment of our other variances. However, in this case lower material prices resulted in more labour hours, more waste, more material being required and lower output. Had we looked at the interdependence of each variance it would have been obvious to us that cheaper material will not necessarily translate into higher profits.

This highlights the importance of not looking at variances as individual issues but rather as a group of interrelated components. If we had understood the influence each variance has on each other, we might have put the same manager in charge of both variances, or tried to unite the goals of each manager, i.e. bonuses paid to both managers based on profit. This would have encouraged each manager to make decisions that benefit each other rather than just their specific department.

6. When to investigate variances Calculating variances is a meaningless exercise unless the variances are actually investigated and acted upon. However, investigating a variance involves a large amount of further analysis in order to pinpoint its specific causes. Therefore, investigating every single variance would probably be too time consuming and expensive to be worthwhile.

For this reason, management needs to consider the merits of investigating each individual variance. Some factors that might influence this decision are:

The size of the variance – Variances are expected. It is very unlikely that standard costs are met down to the very last cent. Therefore, management needs to decide how large of a variance is acceptable. A typical approach is setting an acceptable range that variances can fall within, and any variances outside that range are looked into further. The size of the variance also needs to be looked at in relation to the type of standard set. If

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using an ideal standard, the variance will obviously be larger than it would have been under an attainable standard.

The controllability of the variance – Some variances are uncontrollable to an extent and therefore do not require an investigation. For example, if a product is highly dependent on oil and oil prices increase significantly, there is little that can be done about it. Management will also already know the cause of the inevitable adverse material price variance, so an investigation won’t be required.

The cost of an investigation – It will be counterproductive to investigate a £1,000 variance if the investigation itself will cost £10,000.

The interrelationship of the variance – An adverse material price variance may not require investigation if it has clearly translated into a favourable material usage variance, i.e. more expensive material leading to more efficient material usage. Only if the variance has had an overall negative effect on profit should an investigation be a necessity.

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7. Criticisms of standard costing and variance analysis As with many costing systems, the effectiveness of standard costing has changed with the modern era of manufacturing. Some of the main criticisms are:

Standard costing is best suited for environments that are stable. However, in the modern age of business, factors are prone to change so frequently that stable conditions can never be assumed.

With such a fast-changing environment, regular revisions of standard costs are necessary. This is both a long and expensive process.

These days it is so important to improve constantly if you are to stay competitive. Standard costing encourages you to simply meet standards rather than seek out improvements and maximise efficiency.

Complex, customisable products which are common nowadays are less suited to standard costing.

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Standard costing encourages ‘management by exception’. The general idea of this approach is that if there is no adverse variance or ‘exception’, there is no need to seek improvement. Therefore, corporations might dismiss valuable opportunities to improve simply due to the fact that the area in question already operates ‘up to standard’.