Relationship Between Variances
If the direct labor is not efficient when producing the good output, there will be an unfavorable labor efficiency variance. That inefficiency will likely cause additional variable manufacturing overhead which will result in an unfavorable variable manufacturing overhead efficiency variance. If the inefficiencies are significant, the company might not be able to produce enough good output to absorb the planned fixed manufacturing overhead costs. This in turn can also cause an unfavorable fixed manufacturing overhead volume variance.
We will pursue the interdependence of variances in the following examples.
Assume your company's standard cost for denim is $3 per yard, but you buy some denim at a bargain price of $2.50 per yard. For each yard of denim purchased, DenimWorks reports a favorable direct materials price variance of $0.50.
Let's also assume that the quality of the low-cost denim ends up being slightly lower than the quality to which your company is accustomed. This lesser quality denim causes the production to be a bit slower as workers spend additional time working around flaws in the material. In addition to this decline in productivity, you also find that some of the denim is of such poor quality that it has to be discarded. Further, some of the finished aprons don't pass the final inspection due to occasional defects not detected as the aprons were made.
You get the picture. If the favorable $0.50 per yard price variance correlates with lower quality, that denim was no bargain. The $0.50 per yard favorable variance may be more than offset by the following unfavorable quantity variances:
- Direct material usage variance
- Direct labor efficiency variance
- Variable manufacturing overhead efficiency variance
Keep in mind that the standard cost is the cost allowed on the good output. Putting material, labor, and manufacturing overhead costs into products that will not end up as good output will likely result in unfavorable variances.
Let's assume that you decide to hire an unskilled worker for $9 per hour instead of a skilled worker for the standard cost of $15 per hour. Although the unskilled worker will create a favorable direct labor rate variance of $6 per hour, you may see significant unfavorable variances such as a direct material usage variance, a direct labor efficiency variance, a variable manufacturing overhead efficiency variance, and possibly a fixed manufacturing overhead volume variance.
These two examples highlight what experienced managers know: you need to look at more than price. A low cost for an inferior input is no bargain if it results in costly inefficiencies.
What To Do With Variance Amounts
Throughout our explanation of standard costing we showed you how to calculate the variances. In the case of direct materials and direct labor, the variances were recorded in specific general ledger accounts. The manufacturing overhead variances were the differences between the accounts containing the actual costs and the accounts containing the applied costs. Now we'll discuss what we do with those variance amounts.
Direct Materials Price Variance
Let's begin by assuming that the account Direct Materials Price Variance has a debit balance of $3,500 at the end of the accounting year resulting from one purchase:
Because of the cost principle, the financial statements for DenimWorks report the company's actual cost. If none of the direct materials purchased in this journal entry was used in production (all of the direct materials remain in the direct materials inventory), the company's balance sheet must report the direct materials inventory at $13,500. In other words, the balance sheet will report the standard cost of $10,000 plus the price variance of $3,500.
If all of the materials were used in making products, and all of the products have been sold, the $3,500 price variance is added to the company's standard cost of goods sold.
If 20% of the materials remain in the direct materials inventory and 80% of the materials are in the finished goods that have been sold, then $700 of the price variance (20% of $3,500) is added to the standard cost of the direct materials inventory, $2,800 (80% of $3,500) is added to the standard cost of goods sold.
Now let's assume the direct materials are in various stages of use:
- 20% have not been used yet
- 5% are in work-in-process
- 15% are in finished goods on hand
- 60% are in finished goods that have been sold
We need to assign or allocate the unfavorable $3,500 direct materials price variance to the four places where the direct materials are now located. Since the $3,500 is an unfavorable amount, the following amounts are added to the standard costs:
Accounting professionals have a materiality guideline which allows a company to make an exception to an accounting principle if the amount in question is insignificant. (For example, a large company may report amounts to the nearest $1,000 on its financial statements, or an inexpensive item like a wastebasket can be expensed immediately instead of being depreciated over its useful life.) This means that if the total variance of $3,500 shown above is a very, very small amount relative to the company's net income, the company can assign the entire $3,500 to the cost of goods sold instead of allocating some of the amount to the inventories.
If the balance in the Direct Materials Price Variance account is a credit balance of $3,500 (instead of a debit balance) the procedure and discussion would be the same, except that the standard costs would be reduced instead of increased.
Direct Materials Usage Variance
Let's assume that the Direct Materials Usage Variance account has a debit balance of $2,000 at the end of the accounting year. A debit balance is an unfavorable balance resulting from more direct materials being used than the standard amount allowed for the good output.
The first question to ask is "Why do we have this unfavorable variance of $2,000?" If it was caused by errors and/or inefficiencies, it cannot be assigned to the inventory. Errors and inefficiencies are never considered to be assets; therefore, the entire amount must be expensed immediately.
On the other hand, if the unfavorable $2,000 variance is the result of an unrealistic standard for the quantity of direct materials needed, then we should allocate the $2,000 variance to wherever the standard costs of direct materials are now located. If 90% of the related direct materials have been sold and 10% are in the finished goods inventory, then the $2,000 should be allocated and added to the standard direct material costs as follows:
If $2,000 is an insignificant amount relative to a company's net income, the entire $2,000 unfavorable variance can be added to the cost of goods sold. This is permissible because of the materiality guideline.
If the $2,000 balance is a credit balance, the variance is favorable. This means that the actual direct materials used were less than the standard quantity of materials called for by the good output. We should allocate this $2,000 to wherever those direct materials are physically located. However, if $2,000 is an insignificant amount, the materiality guideline allows for the entire $2,000 to be deducted from the cost of goods sold on the income statement.
The examples above follow these guidelines:
If the variance amount is very small (insignificant relative to the company's net income), simply put the entire amount on the income statement. If the insignificant variance amount is unfavorable, increase the cost of goods sold—thereby reducing net income. If the insignificant variance amount is favorable, decrease the cost of goods sold—thereby increasing net income.
If the variance is unfavorable, significant in amount, and results from mistakes or inefficiencies, the variance amount can never be added to any inventory or asset account. These unfavorable variance amounts go directly to the income statement and reduce the company's net income.
If the variance is unfavorable, significant in amount, and results from the standard costs not being realistic, allocate the variance to the company's inventory accounts and cost of goods sold. The allocation should be based on the location of the inputs from which the variances arose.
If the variance amount is favorable and significant in amount, allocate the variance to the company's inventories and its cost of goods sold.
The following table will serve as a guide for reporting variances that are significant in amount:
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