In order to measure efficiency of each employee or department. Preparing budget and comparing its actual result is a major factor. In any business we prepare monthly, quarterly, or yearly budget of cost and sales.
However, budget is not made out of nowhere, every budget’s cost takes its base of previous year expenses cost plus any future adjustment such as inflation, technology change, scarcity, quality of materials, quality of labor, working conditions. In this competitive market, it’s not possible to control the selling price. Hence, we should control the cost so that profit would be maximum. In order to control cost we compare actual cost with standard/ budget. At first any business prepare budgeted cost sheet and then compare it with actual cost sheet. However, budget and actual cost sheet should be prepared with same basis i.e. on Same sales quantity. If budgeted sales quantity differs from actual then revised budgeted cost sheet (on the basis of actual sales quantity) shall be computed in order to compare both costs.
Note: In below calculations, budgeted rate / quantity are all revised budgeted rate/quantity.
In reality, actual profit may vary from budgeted profit. The difference between budgeted profit and actual profit is called variance. The reason for this variance could be due to many factors such as difference in actual and budgeted rate of raw material or labor, consumed quantity of raw materials, hours worked for each product, etc. All these variances contribute to difference in budgeted and actual profit.
Raw material cost variance= Revised budgeted cost of raw material – Actual cost of raw material, this variance is due to difference in actual cost of raw material with its budgeted cost. Variance could be whether favorable (i.e. incurred less cost than budgeted) or unfavorable/adverse(i.e. incurred more cost than budgeted). Further, in order to make responsible party accountable in their performance, we give credit to the responsible party for these loss/ gain and as in business there is purchase department who is responsible for purchase rate of raw material, hence making them accountable for any rate differences.
Raw material rate variance = (Budgeted rate of raw material- Actual rate of raw material)x Actual quantity consumed,
Then there comes production department who is responsible for consumption of raw material, so if they consume more or less raw material than standard, then we can figure out through raw material usage variance= “(Standard quantity-actual quantity)*Standard rate”,
here we are taking standard rate instead of actual rate because difference due to rate has been covered by rate variance plus production department is in-charge of consuming right quantity of material hence actual rate ,that may be high or less than standard rate is either hard work or negligence of purchase department is accounted for in rate variance. Either Production department takes credit for utilizing raw material or is held accountable for wasting them. hence “raw material usage variance”= “Difference of quantity * standard rate per quantity”. However, Production manager can be at fault on rate only when it demands the material on emergency way not giving sufficient time for purchase manager for placing the order, then the excess rate due to emergency purchase is responsibility of production manager.
Labor cost variance is the variance of actual labor cost with budgeted labor cost,
Labor cost variance= Budgeted labor cost(i.e. Budgeted labor hour x budgeted rate)- Actual labor cost(i.e. Actual rate x Actual labor hour)
We can see that there are two factors- rate and labor hours, either rate or labor hour changes then it will also give rise to variance. labor works in production section so their productivity is measured by their hours worked, for measuring gain/ loss due to their efficiency we calculate labor efficiency variance,
“Labor efficiency variance”= “(Budgeted hours- actual working hours) x Budgeted rate per unit” ‘Or’ “Difference in hours x budgeted rate per unit”
Here actual rate has not been used because rate is responsibility of personnel manager/ HR manager, any overpayment or underpayment is not charged to production managers. Production manager is responsible for efficiency variance, efficiency variance come from efficient or inefficient working, that is speed of working. Here, actual hour and actual working hour may be different because some hours may remain idle. This idle time may be due to insufficient raw material, machine breakdown etc. Management is held accountable for idle time because it’s management’s responsibility to maintain machinery, to timely stock up sufficient raw materials. Hence, difference of actual hours and actual working hours is due to management. So, responsibility of idle labor hour payment is of management.
“Idle hour variance”= “(Actual hours-Actual working hours) x standard rate”
“Labor rate variance”= “(Budgeted rate-Actual rate) x Actual labor hour ‘OR’ Difference in rate x Actual labor hour”,
whether over payment or under payment it’s impact has been seen on actual profit per unit amounting to the difference of rate in actual labor hour. In case of inefficient hour, personnel manager may try to manipulate the management, if this hour has not been inefficient we need not have to pay rate on those inefficient hour too, making point for the excess rate on inefficient hour to be borne by production manager. However, what management have to keep in mind is its not the matter of concern of personnel manager to see whether labor hour is efficient or inefficient, their concern is just rate so if personnel manager had charged right rate, the payment on inefficient hours also would have been lower. Hence, we have to take actual labor hour in multiple of difference of rate for measuring labor rate variance. Hence, rates over payment or underpayment, its credit goes to personnel manager.
Lets talk about variable overhead difference, There could be variable overhead cost variance which could be either due to variable overhead rate variance or variable overhead efficiency variance. The efficiency of variable overhead is computed by labor machines hours. Variable overheads examples are: Power charges due to running of machinery(major portion comes from machines), it’s gonna work as long as labors are working in it. Hence, labor efficient or inefficient this will directly impact on usage of machines, powers, so variable overhead is charged on labor machines hours. Hence, charge will be high due to labor inefficiency and vice-versa.
“Variable overhead variance”= “Budgeted cost – actual cost”, Where “actual cost = Actual rate x actual working hours” Just taking machines or huge power hours in it and in below calculation.
“Variable overhead rate variance”= “(Budgeted V OH. rate-actual V OH rate) x Actual labor working hour”, as in idle time, machines or power will not work hence there will be no charge of it on idle period.
“Variable overhead efficiency variance”= “(Budgeted hours- actual working hours) x Budgeted V OH. rate per unit”
Where, “V OH.” =”Variable Overhead”
