Chapter 10: Advanced variances

Chapter learning objectives

Upon completion of this chapter you will be able to:

• define, for a manufacturing company, material mix and yield variances
• calculate, from information supplied, material mix and yield variances
• for given or calculated material mix and yield variances, interpret and explain possible causes, including possible interrelationships between them
• explain, using simple non-numerical examples, the wider issues involved in changing mix, e.g. cost, quality and performance measurement issues
• identify and explain the interrelationship between price, mix and yield, using a simple numerical example
• suggest and justify alternative methods of controlling production processes in manufacturing environments
• using revised standards supplied, calculate a revised budget
• calculate and explain sales mix and quantity variances
• from supplied data, calculate planning and operational variances for sales (including market size and market share)
• from supplied data, calculate planning and operational variances for materials
• from supplied data, calculate planning and operational variances for labour
• identify and explain those factors that, in general, should and should not be allowed to revise an original budget
• explain and resolve the typical manipulation issues in revising budgets.
• describe the dysfunctional nature of some variances in the modern environment of Just-in-time (JIT) and total quality management (TQM)
• describe the major behavioural problems resulting from using standard costs in rapidly changing environments
• discuss the major effects that variances have on staff motivation and action.

1 Material mix and yield

Introduction to material mix and yield variances

These are calculated if:

• A product contains more than one type of material.
• These materials are interchangeable.

A mix variance is used to monitor the cost of material. Forinstance, if more of an expensive material has been used and less of acheap material, then the cost will be higher - and the variance adverse.

Method :

(1) Setup the following table :

(2) Calculate the total of the AQAM column (in kgs, litres, metres etc) and copy the total across to the next 'AQSM' column :

(3) Share this total 'upwards' into thestandard mix, which will be given as a proportion in the question or inthe standard cost card :

(4) In the 'difference' column, work line byline and find the difference between the AQSM and the AQAM. The total ofthe difference should be equal to 0. In the last column, multiply thedifference by the standard price to get the mix variance.

A yield variance measures the efficiency of turning theinputs into outputs. If the yield variance is adverse, it suggests thatactual input is lower than the expected output. This could be due tolabour inefficiencies, higher waste, inferior materials, or using acheaper mix with a lower yield.

Method 1 : The 'total' method 

Method 2 : The 'individual' method

'SQSM' is the standard quantity of material used for actual production, shared in the standard mix.

Test your understanding 1 - Material mix and yield

A company manufactures a chemical using two components, A and B.The standard information for one unit of the chemical are as follows:

In a particular period, 160 units of the chemical were produced, using 1,000 kgs of material A and 1,460 kgs of material B.

Required:

Calculate the material usage, mix and yield variances for each material.

Interpretation of material mix and yield variances

Mix - a favourable total mix variance would suggest that a higherproportion of a cheaper material is being used hence reducing theoverall average cost per unit.

Yield - an adverse total yield variance would suggest that lessoutput has been achieved for a given input, i.e. that the total input involume is more than expected for the output achieved.

• These variances may be interrelated. A favourable material mix variance may lead to an adverse material yield variance. This is due to differences in quality between the materials used.     
• Any change in mix should be judged by the impact on the overall total materials variance.
• The operating statement would include a separate line for each variance.

Test your understanding 2 - Additional mix and yield question

Hondru operates a standard costing system. The standard direct materials to produce 1,000 units of output is as follows:

During April the actual output of the product was 21,000 units. The actual materials issued to production were:

Required:

Calculate the material mix variance for each material, and intotal, and calculate the total material yield variance. Comment on thefigures calculated.

Test your understanding 3 - Mix and yield with material waste

Pan-Ocean Chemicals has one product, which requires inputs fromthree types of material to produce batches of Synthon. Standard costdetails for a single batch are shown below:

A standard loss of 10% of input is expected. Actual output was15,408 kgs for the previous week. Details of the material used were:

Required:

Calculate the individual material mix and yield and the total usage variance.

Changing the mix – the wider issues

It has already been shown that changing the mix of material inputcan affect the material yield of the process. It can impact on:

• cost
• quality
• performance measurement.

Illustration 1 – Mix and yield: wider issues

A company produces pre-cast concrete sections for the constructionindustry. The mix of materials used to produce the concrete can bevaried and different mixes are suitable for different products. Discussthe issues that management should consider when setting standardmaterial costs.

Solution

For each product management should consider the optimum mix ofinput materials that will maximise profits to the business. This mayinvolve consideration of:

• the relationship between cost, quality and price. Reducing the cost of input materials by using a greater proportion of a cheaper material may reduce the quality of the product and lead to a reduction in the price that can be charged;
• costs of reduced quality. Using a greater proportion of a cheaper input material may lead to higher quality failure costs;
• impact on other variances. Increasing the proportion of a cheaper input material may result in increased labour costs or overhead costs if this leads to more time having to be spent producing a product. Increased rejects may lead to higher overhead costs.

It may be the case that, whilst changing a material mix could leadto an overall favourable material variance this could have an adverseimpact on the profitability of the business if prices have to be reducedbecause of reduced quality or quality failure costs exceed materialcost savings. Thus it is important to set the standard mix at the levelwhich optimises profit taking all factors into consideration.

Test your understanding 4

Discuss how the performance measurement system should be designed when the mix of input materials can be varied in a process.

The control of production processes in manufacturing environments

As well as variances, organisations can also use other performancemeasures and targets for controlling production processes, e.g.:

• quality measures e.g. reject rate, time spent reworking goods, % waste, % yield
• average cost of inputs
• average cost of outputs
• average prices achieved for finished products
• average margins
• % on-time deliveries
• customer satisfaction ratings.
• detailed timesheets
• % idle time

2 Sales mix and quantity variances

Sales variances can be explained as follows :

(1)  Sales price variances are calculated by comparing theactual selling price per unit and the budgeted selling price per unit;each price variance is multiplied by the number of units for each typeof product.

(2)  A sales volume variance is the difference between theactual number of units sold, and the budgeted number. Each difference ismultiplied by the budgeted profit per unit. Sales volume in turnssplits into a sales mix variance and a sales quantity variance.

(3)  A sales mix variance indicates the effect on profit ofchanging the mix of actual sales from the standard mix. A Sales Mixvariance can be calculated in one of two ways :

(a)  The difference between the actual total quantity sold in thestandard mix and the actual quantities sold, valued at the standardprofit per unit;

(b)  The difference between the actual sales and budgeted sales,valued at the standard profit per unit less the budgeted weightedaverage profit per unit.

(4) A sales quantity variance indicatesthe effect on profit of selling a different total quantity from thebudgeted total quantity. Like the mix variance, it can be calculated inone of two ways :

(a) The difference between actual sales volume in the standard mix and budgeted sales valued at the standard profit per unit.

(b) The difference between actual sales volume and budgeted sales valued at the weighted average profit per unit.

Test your understanding 5 - Sales mix and quantity variances

CABCo operates an absorption costing system and sells threeproducts B, R and K which are substitutes for each other. The followingstandard selling price and cost data relate to these three products :

Budgeted fixed production overhead for the last period was $81,000.This was absorbed on a machine hour basis. The standard machine hoursfor each product and the budgeted levels of production and sales foreach product for the last period are as follows :

Actual volumes and selling prices for the three products in the last period were as follows :

Required:

Calculate the following variances for overall sales for the last period:

(i)sales price variance

(ii) sales volume profit variance

(iii)sales mix profit variance

(iv)sales quantity profit variance.

3 Planning and operational variances

Revised standards and budgeting

The standard is set as part of the budgeting process which occursbefore the period to which it relates. This means that the differencebetween standard and actual may arise partly due to an unrealisticbudget and not solely due to operational factors. The budget may need tobe revised to enable actual performance to be compared with a standardthat reflects these changed conditions.

Planning and operational variances may be calculated for:

• Sales
• Materials
• Labour

The operating statement would include a separate line for each variance calculated.

Each of the variances will be reviewed in turn.

Planning and operational variances for sales

The sales volume variance can be sub-divided into a planning and operational variance:

Test your understanding 6 - Market size and share

Hudson has a sales budget of 400,000 units for the coming yearbased on 20% of the total market. On each unit, Hudson makes a profit of$3. Actual sales for the year were 450,000, but industry reports showedthat the total market volume had been 2.2 million.

(a) Find the traditional sales volume variance.

(b) Split this into planning and operational variances (market size and market share). Comment on your results.

Test your understanding 7 - Additional example

A company sets its sales budget based on an average price of $14per unit and sales volume of 250,000 units. Competition was more intensethan expected and the company only achieved sales of 220,000 and had tosell at a discounted price of $12.50 per unit. The company was unableto reduce costs so profit per unit fell from $4 per unit to $2.50 perunit. It was estimated that the total market volume grew by 10% from1,000,000 units to 1,100,000 units.

Required:

(a) Calculate the sales price and volume variances.

(b) Analyse the volume variances into market share and market size.

(c) Discuss whether the price variance is a planning or operational variance.

Revising the budget

When applying planning and operating principles to cost variances(material and labour), care must be taken over flexing the budgets. Theaccepted approach for use in the exam is to flex both the original andrevised budgets to actual production levels:

Note: If pushed for time in the exam, then calculatedetailed operating variances but give a single total planning variancefor each category.

Illustration 2 – Revising the budget

Rhodes Co manufactures Stops which it is estimated require 2 kg ofmaterial XYZ at $10/kg In week 21 only 250 Stops were produced althoughbudgeted production was 300. 450 kg of XYZ were purchased and used inthe week at a total cost of $5,100. Later it was found that the standardhad failed to allow for a 10% price increase throughout the materialsupplier's industry. Rhodes Ltd carries no stocks.

Planning and operational analysis

The first step in the analysis is to calculate:

(1) Actual Results

(2) Revised flexed budget (ex-post).

(3) Original flexed budget (ex-ante).

Additional example on revising the budget

A transport business makes a particular journey regularly, and hasestablished that the standard fuel cost for each journey is 20 litres offuel at $2 per litre. New legislation has forced a change in thevehicle used for the journey and an unexpected rise in fuel costs. It isdecided retrospectively that the standard cost per journey should havebeen 18 litres at $2.50 per litre.

Required:

Calculate the original and revised flexed budgets if the journey is made 120 times in the period.

Solution

Planning and operational variances for materials

Examiner's article: visit the ACCA website, www.accaglobal.com, to review the examiner's article on this topic (March 2009).

Planning and operational variances can be calculated for materials in the same way as above.

Test your understanding 8 - Price variances

The standard cost per unit of raw material was estimated to be$5.20 per unit. However, due to subsequent improvements in technology,the general market price at the time of purchase was $5.00 per unit. Theactual price paid was $5.18 per unit. 10,000 units of the raw materialswere purchased during the period.

Required:

Calculate the planning and operational materials price variances. Comment on the results.

Test your understanding 9 - Price and usage variances

Holmes Ltd uses one raw material for one of their products. Thestandard cost per unit at the beginning of the year was $28, made up asfollows:

Standard material cost per unit = 7 kg per unit at $4 per kg = $28.

In the middle of the year the supplier had changed thespecification of the material slightly due to problems experienced inthe country of origin, so that the standard had to be revised asfollows:

Standard material cost per unit = 8 kg per unit at $3.80 per kg = $30.40.

The actual output for November was 1,400 units. 11,000 kg of material was purchased and used at a cost of $41,500.

Calculate

(a) material price and usage variances using the traditional method

(b) all planning and operational material variances.

Planning and operational variances for labour

Planning and operational variances for labour can be calculated in the same way as for materials.

Test your understanding 10

The standard hours per unit of production for a product is 5 hours.Actual production for the period was 250 units and actual hours workedwere 1,450 hours. The standard rate per hour was $10. Because of ashortage of skilled labour it has been necessary to use unskilled labourand it is estimated that this will increase the time taken by 20%.

Required:

Calculate the planning and operational efficiency variances.

Test your understanding 11 - Additional example

POV Ltd uses a standard costing system to control and report uponthe production of its single product. An abstract from the originalstandard cost card of the product is as follows:

For period 3, 2,500 units were budgeted to be produced and sold but the actual production and sales were 2,850 units.

The following information was also available:

(1) At the commencement of period 3 the normalmaterial became unobtainable and it was necessary to use an alternative.Unfortunately, 0.5 kg. per unit extra was required and it was thoughtthat the material would be more difficult to work with. The price of thealternative was expected to be $16.50 per kg. In the event, actualusage was 12,450 kg at $18 per kg

(2) Weather conditions unexpectedly improvedfor the period with the result that a 50c per hour bad weather bonus,which had been allowed for in the original standard, did not have to bepaid. Because of the difficulties expected with the alternativematerial, management agreed to pay the workers $8 per hour for period 3only. During the period 18,800 hours were paid for.

After using conventional variances for some time, POV Ltd iscontemplating extending its system to include planning and operationalvariances.

(a) Prepare a statement reconciling budgetedcontribution for the period with actual contribution, using conventionalmaterial and labour variances.

(b) Prepare a similar reconciliation statement using planning and operational variances.

(c) Explain the meaning of the variances shown in statement (b)

When should a budget be revised?

There must be a good reason for deciding that the original standardcost is unrealistic. Deciding in retrospect that expected costs shouldbe different from the standard should not be an arbitrary decision,aimed perhaps at shifting the blame for bad results due to pooroperational management or poor cost estimation.

A good reason for a change in the standard might be:

• a change in one of the main materials used to make a product or provide a service
• an unexpected increase in the price of materials due to a rapid increase in world market prices (e.g. the price of oil or other commodities)
• a change in working methods and procedures that alters the expected direct labour time for a product or service
• an unexpected change in the rate of pay to the workforce.

These types of situations do not occur frequently. The need toreport planning and operational variances should therefore be anoccasional, rather than a regular, event.

If the budget is revised on a regular basis, the reasons for thisshould be investigated. It may be due to management attempting to shiftthe blame for poor results or due to a poor planning process.

Pros and cons of revising the budget

A company is operating in a fast changing environment and isconsidering whether analysing existing variances into a planning andoperational element would help to improve performance. Discuss theadvantages and disadvantages of the approach.

Solution

Advantages may include:

• Variances are more relevant, especially in a turbulent environment.
• The operational variances give a ‘fair' reflection of the actual results achieved in the actual conditions that existed.
• Managers are, theoretically, more likely to accept and be motivated by the variances reported which provide a better measure of their performance.
• The analysis helps in the standard-setting learning process , which will hopefully result in more useful standards in the future.

Disadvantages:

• The establishment of ex-post budgets is very difficult. Managers whose performance is reported to be poor using such a budget are unlikely to accept them as performance measures because of the subjectivity in setting such budgets.
• There is a considerable amount of administrative work involved first to analyse the traditional variances and then to decide on which are controllable and which are uncontrollable.
• The analysis tends to exaggerate the interrelationship of variances, providing managers with a ‘pre-packed' list of excuses for below standard performance. Poor performance is often excused as being the fault of a badly set budget.
• Frequent demands for budget revisions may result in bias.

Variance analysis in the modern manufacturing environment

Variance analysis may not be appropriate because:

Non-standard products

Standard product costs apply to manufacturing environments in whichquantities of an identical product are output from the productionprocess. They are not suitable for manufacturing environments whereproducts are non-standard or are customised to customer specifications.

Standard costs become outdated quickly

Shorter product life cycles in the modern business environment meanthat standard costs will need to be reviewed and updated frequently.This will increase the cost of operating a standard cost system but, ifthe standards are not updated regularly, they will be of limited use forplanning and control purposes. The extra work involved in maintainingup-to-date standards might limit the usefulness and relevance of astandard costing system.

Production is highly automated

It is doubtful whether standard costing is of much value forperformance setting and control in automated manufacturing environments.There is an underlying assumption in standard costing that control canbe exercised by concentrating on the efficiency of the workforce. Directlabour efficiency standards are seen as a key to management control.However, in practice, where manufacturing systems are highly automated,the rates of production output and materials consumption, are controlledby the machinery rather than the workforce.

Ideal standard used

Variances are the difference between actual performance andstandard, measured in cost terms. The significance of variances formanagement control purposes depends on the type of standard cost used.JIT and TQM businesses often implement an ideal standard due to theemphasis on continuous improvement and high quality. Therefore, adversevariances with an ideal standard have a different meaning from adversevariances calculated with a current standard.

Emphasis on continuous improvement

Standard costing and adherence to a preset standard is inconsistentwith the concept of continuous improvement, which is applied within TQMand JIT environments.

Detailed information is required

Variance analysis is often carried out on an aggregate basis (totalmaterial usage variance, total labour efficiency variance and so on)but in a complex and constantly changing business environment moredetailed information is required for effective management control.

Monitoring performance is important

Variance analysis control reports tend to be made available tomanagers at the end of a reporting period. In the modern businessenvironment managers need more ‘real time' information about events asthey occur.

Test your understanding 12

Comment on whether standard costing applies in bothmanufacturing and service businesses and how it may be affected bymodern initiatives of continuous performance improvement and costreduction.

Standard costs and behavioural issues

Standard costs are set with a view to measuring actual performanceagainst the standard, and reporting variances to the managersresponsible. The aims of setting standards include:

• setting a target for performance
• motivating the managers responsible to achieve those targets
• holding these managers accountable for actual performance
• perhaps rewarding managers for good performance and criticising them for poor performance.

Managers and employees might respond in different ways to standard setting.

Factors to consider include:

The type of standard set

Individuals might respond to standards in different ways, accordingto the difficulty of achieving the standard level of performance.

• Ideal standard: When a standard level of performance is high, e.g. an ideal standard, employees and their managers will recognise that they cannot achieve it. Since the target is not achievable, they might not even try to get near it.
• Current standard: When the standard of performance is not challenging (e.g. a current standard), employees and their managers might be content simply to achieve the standard without trying to improve their performance.
• Attainable standard: An attainable standard might be set which challenges employees and their managers to improve their performance. If this attainable standard is realistic, it might provide a target that they try to achieve. Some employees will be motivated by this challenge and will work harder to achieve it. However, some employees may prefer standards to be set at a low level of performance, in order to avoid the need to work harder.
• Basic standard: This type of standard may motivate employees since it gives them a long-term target to aim for. However, the standard may become out of date quickly and, as result, may actually demotivate employees.

The level of participation in standard setting

The use of pay as a motivator

If standards are used as a way of encouraging employees to improvetheir performance, motivation could be provided in the form of higherpay if targets are reached or exceeded.

However, if employees are offered a bonus for achieving standardcosts, this could increase their incentive to set low standards ofperformance, i.e. include ‘slack' in the standard cost. Lowerstandards will increase the probability that the standards will beachieved and a bonus will be earned.

Test your understanding 13

Which one of the following is not an advantage of participation in standard setting?

(a) The time taken to reach decisions will be quicker via assorted committee meetings.

(b) The quality of decisions should improve with collective decision making.

(c) There will be improved communication between staff.

(d) Staff are more likely to accept standards that they have helped set.

4 Chapter summary

Test your understanding answers

Test your understanding 1 - Material mix and yield

Material A usage variance

Material B usage variance

Material mix variance

Material yield variance

Alternatively, the material yield variance can be calculated in total using the following method:

Total mix and yield variance = $12,480 F + $360 F = $12,840 F (as per the usage variance)

Test your understanding 2 - Additional mix and yield question

Material mix variance

Comment

The favourable mix variance is due to more of materials A and B being used in place of material C.

Material yield variance

Working

Standard cost per unit = ((600 × $1.10) + (240 × $2.40) + (360 × $1.50)) ÷ 1,000 units = $1.78 per unit

Comment

The favourable variance is due to more output being achieved than was expected from the materials input.

Test your understanding 3 - Mix and yield with material waste

Material mix variance

The material mix variance is not affected by the material wastage and should be calculated in the normal way:

Material yield variance

The yield variance will take account of the material wastage of 10%:

Material usage variance

Total usage variance = $775.08 A + $284.22 A = $1,059.3 A

Test your understanding 4

In a performance measurement system managers are often rewarded forimproving the performance of cost and/or revenues under their control.The production manager may be responsible for the material mix decisionand, if the reward system is based on achieving cost savings, then thecheapest mix may be used. This may have a detrimental effect on companyprofit if quality is reduced and this leads to a lower price or qualityfailure costs.

It may therefore be preferable to reward managers on the basis oftotal company profit so that the full impact of the mix decision istaken into account.

Test your understanding 5 - Sales mix and quantity variances

Working 1 : OAR

so OAR = $4.50 per machine hour

Working 2 : Standard Profit

Working 3 : Weighted average Standard Profit

(i)Sales price variance :

Therefore, total sales price variance = $4,750 F + $6,750 F+ $8,500 F = $20,000 F

(ii) Sales volume profit variance :

Therefore, total sales volume profit variance = $2,000 A + $1,500 F + $2,500 A = $3,000 A

(iii)Sales mix profit variance :

Alternative method :

(iv)Sales quantity profit variance :

Alternative method :

500 units adverse @ standard profit $3.875 = $1,937.5 Adverse

Test your understanding 6 - Market size and share

(a) Traditional sales volume variance

(b) Planning and operational variances Therevised (ex-post) budget would show that Hudson Ltd should expect tosell 20% of 2.2 million units = 440,000 units.

Total sales volume variance = $120,000 F + $30,000 F = $150,000 F

Comment:

Most of the favourable variance can be attributed to the increasein overall market size. However, some can be put down to effort by thesales force which has increased its share from 20% to 20.5% (450,000/2,200,000).

Managers should only be appraised on the operational variance, i.e. the market share variance.

Test your understanding 7 - Additional example

(a) Sales price variance

(b) Budgeted market share = 250,000/1,000,000 = 25%

(c) It could be argued that the increasedcompetition in the market was not foreseen when the budget was set andthe variance is thus a planning variance. However, this line ofreasoning would suggest that any unforeseen issues give rise just toplanning variances. Perhaps sales managers should have identifiedpotential threats sooner? Also, once extra competition was experienced,managers had to decide how to respond. This could have involvedadditional advertising rather than price cuts, e.g. it could be arguedthat price cuts were made to try (unsuccessfully) to protect marketshare, in which case managers should be held (at least partly)responsible for such a decision.

Test your understanding 8 - Price variances

Operational variance: The cost per unit was higher than therevised budgeted cost resulting in the adverse variance. This varianceis controllable by management and should be linked to their performanceevaluation

Planning variance: The improvement in technology resulted ina lower price per unit and hence a favourable variance. This is aplanning difference and is therefore uncontrollable by management.

A traditional variance calculation would present as follows :

Test your understanding 9 - Price and usage variances

(a) Traditional variances

(b)Planning and Operational variances

Test your understanding 10

Test your understanding 11 - Additional example

(a) Reconciliation of budgeted and actual contribution using conventional variances

Assumption: No sales price variance.

Workings

Conventional variances

(i)Materials

(ii) Labour

(b) Reconciliation statement using planning and operational variances

Workings

Planning variances

(i)Material

(ii) Labour rate

Operational variances

(i)Material

(ii) Labour

(c) The analysis of variances in part (b) makesit possible to separate those variances which are non-controllable (theplanning variances) from the variances which are controllable by theindividual managers (the operational variances) .In this case the changein type of material used was unavoidable. Similarly, the change inweather conditions could not have been anticipated.

The cost implications of these changes are reflected in theplanning variances. Management's attention should be focused primarilyon the operational variances. In particular, why did the firm pay $18per kg for material when this was expected to cost $16.50? Theoperational material usage variance indicates that less material wasused than expected – this could be due to the workers spending longerworking with the material (as evidenced by the adverse efficiencyvariance.

Test your understanding 12

Standard costing is most suited to organisations whose activitiesconsist of a series of common or repetitive operations. Typically, massproduction manufacturing operations are indicative of its area ofapplication. It is also possible to envisage operations within theservice sector to which standard costing may apply, though this may notbe with the same degree of accuracy of standards which apply inmanufacturing. For example, hotels and restaurants often use standardrecipes for preparing food, so dealing with conference attendance can belike a mass production environment. Similarly, banks will have commonprocesses for dealing with customer transactions, processing cheques,etc. It is possible therefore that the principles of standard costingmay be extended to service industries.

In modern manufacturing and service businesses, continuousimprovement and cost reduction are topical. In order to remaincompetitive it is essential that businesses address the cost levels oftheir various operations. To do this they have to deal with the costingof operations. But the drive to ‘cost down' may mean in some casesthat standards do not apply for long before a redesign or improvementrenders them out of date. In such a setting an alternative to the use ofstandard costs is to compare actual costs with those of the previousoperating period. We have seen above that a standard costing system has avariety of purposes. It is for management to judge their variousreasons for employing standard costing and, consequently, whether theiraims of continuous improvement and cost reduction render the systemredundant.

Test your understanding 13

A is the correct answer.

Greater participation by staff in standard setting is likely to slow down the process of agreeing values.

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