# Variance Analysis (Product Costs) - Explained

What is a Variance Analysis of Product Costs?

# What is a Variance Analysis for Direct Materials?

Variances must be calculated to identify the exact cause of the cost overrun.

Variances are used to analyze the difference between actual direct material costs and standard direct material costs.

This will allow the manager to investigate the causes of the variances.

The difference between actual costs and standard (or budgeted) costs is typically explained by two separate variances:

• the materials price variance and
• materials quantity variance.

The materials price variance is the difference between actual costs for materials purchased and budgeted costs based on the standards.

The materials quantity variance is the difference between the actual quantity of materials used in production and budgeted materials that should have been used in production based on the standards.

You must also have the actual materials cost and materials quantity data to calculate the variances described previously.

AQP = Actual quantity of materials purchased.

AP = Actual price of materials.

AQU = Actual quantity of materials used in production.

SP = Standard price of materials.

SQ = Standard quantity of materials for actual level of activity.

## Direct Materials Price Variance Calculation

The materials price variance answers the question, did we spend more or less on direct materials than expected?

If the variance is unfavorable, we spent more than expected. If the variance is favorable, we spent less than expected.

The materials price variance is the difference between the actual quantity of materials purchased at the actual price and the actual quantity of materials purchased at the standard price:

Materials price variance = (AQP × AP) – (AQP × SP)

Alternative Calculation. Since we are holding the actual quantity constant and evaluating the difference between actual price and standard price, the materials price variance calculation can be simplified as follows:

Materials price variance = (AP – SP) × AQP

Note that both approaches—the direct materials price variance calculation and the alternative calculation—yield the same result.

## Direct Materials Quantity Variance Calculation

The materials quantity variance answers the question, did we use more or fewer direct materials in production than expected?

If the variance is unfavorable, we used more than expected. If the variance is favorable, we used fewer than expected.

The materials quantity variance is the difference between the actual quantity of materials used in production at the standard price and the standard quantity of materials allowed at the standard price:

Materials quantity variance = (AQU × SP) – (SQ × SP)

Alternative Calculation. Since we are holding the standard price constant and evaluating the difference between actual quantity used and standard quantity, the materials quantity variance calculation can be simplified as follows:

Materials quantity variance = (AQU – SQ) × SP

Note that both approaches—the direct materials quantity variance calculation and the alternative calculation—yield the same result.

## Variance Analysis for Direct Labor

What variances are used to analyze these types of direct labor cost overruns?

Direct labor variance analysis involves two separate variances:

• the labor rate variance, and
• labor efficiency variance.

The labor rate variance is the difference between actual costs for direct labor and budgeted costs based on the standards.

The labor efficiency variance is the difference between the actual number of direct labor hours worked and budgeted direct labor hours that should have been worked based on the standards.

## Direct Labor Rate Variance Calculation

The direct labor rate variance answers the question, did we spend more or less on direct labor than expected?

If the variance is unfavorable, we spent more than expected. If the variance is favorable, we spent less than expected.

The labor rate variance is the difference between the actual hours worked at the actual rate and the actual hours worked at the standard rate:

Labor rate variance = (AH × AR) − (AH × SR)

The metrics include:

AH = Actual hours of direct labor.

AR = Actual rate incurred for direct labor.

SR = Standard rate for direct labor.

SH = Standard hours of direct labor for actual level of activity.

Alternative Calculation. Because we are holding the actual hours constant and evaluating the difference between actual rate and standard rate, the labor rate variance calculation can be simplified as follows:

Labor rate variance = (AR − SR) × AH

Note that both approaches—direct labor rate variance calculation and the alternative calculation—yield the same result.

## Direct Labor Efficiency Variance Calculation

The direct labor efficiency variance answers the question, did we use more or less direct labor hours in production than expected?

The labor efficiency variance is the difference between the actual hours worked at the standard rate and the standard hours at the standard rate:

Labor efficiency variance=(AH×SR)−(SH×SR)

Because we are holding the standard rate constant and evaluating the difference between actual hours worked and standard hours, the labor efficiency variance calculation can be simplified as follows:

Labor efficiency variance = (AH − SH) × SR

## Variance Analysis for Variable Manufacturing Overhead

Variable manufacturing overhead variance analysis involves two separate variances.

• Spending variance, and
• efficiency variance.

The variable overhead spending variance is the difference between actual costs for variable overhead and budgeted costs based on the standards.

For a company that allocates variable manufacturing overhead to products based on direct labor hours, the variable overhead efficiency variance is the difference between the number of direct labor hours actually worked and what should have been worked based on the standards.

AH = Actual hours of direct labor. (This measure will depend on the allocation base that the company uses.)

SR = Standard variable manufacturing overhead rate per direct labor hour.

SH = Standard hours of direct labor for actual level of activity.

*Since variable overhead is not purchased per direct labor hour, the actual rate (AR) is not used in this calculation. Simply use the total cost of variable manufacturing overhead instead.

## Variable Overhead Spending Variance Calculation

The variable overhead spending variance is the difference between what is actually paid for variable overhead and what should have been paid according to the standards:

Variable overhead spending variance = Actual costs − (AH × SR)

As with direct materials and direct labor variances, all positive variances are unfavorable, and all negative variances are favorable.

Note that there is no alternative calculation for the variable overhead spending variance because variable overhead costs are not purchased per direct labor hour.

## Variable Overhead Efficiency Variance Calculation

The variable overhead efficiency variance is the difference between the actual hours worked at the standard rate and the standard hours at the standard rate:

Variable overhead efficiency variance = (AH × SR) − (SH × SR)

Alternative Calculation. Since we are holding the standard rate constant and evaluating the difference between actual hours worked and standard hours, the variable overhead efficiency variance calculation can be simplified as follows:

Variable overhead efficiency variance = (AH−SH) ×SR

Note that both approaches—the variable overhead efficiency variance calculation and the alternative calculation—yield the same result.

## Fixed Manufacturing Overhead Variance Analysis

Many organizations also analyze fixed manufacturing overhead variances.

Manufacturing companies are required to assign fixed manufacturing overhead costs to products for financial reporting purposes (this is called absorption costing).

It is common for companies to apply fixed manufacturing overhead costs to products based on direct labor hours, machine hours, or some other activity.

Companies using a standard costing system apply fixed overhead based on a standard dollar amount per unit produced.

This information can be used to perform fixed overhead cost variance analysis.

It is important to start by noting that fixed overhead in the master budget is the same as fixed overhead in the flexible budget because, by definition, fixed costs do not change with changes in units produced.

Fixed manufacturing overhead variance analysis involves two separate variances:

• the spending variance, and
• the production volume variance.

## Fixed Overhead Spending Variance Calculation

The fixed overhead spending variance is the difference between actual and budgeted fixed overhead costs.

Thus the spending variance is calculated as follows:

Fixed overhead spending variance = Actual costs − Budgeted costs

Further investigation of detailed costs is necessary to determine the exact cause of the fixed overhead spending variance.

## Fixed Overhead Production Volume Variance Calculation

Before discussing the production volume variance, a word of caution: do not equate the fixed overhead production volume variance with the variable overhead efficiency variance.

There is no efficiency variance for fixed manufacturing overhead because, by definition, fixed costs do not change with changes in the activity base.

The fixed overhead volume variance is solely a result of the difference in budgeted production and actual production.

Thus the production volume variance is calculated as follows:

Fixed overhead production volume variance = Budgeted costs − Applied costs

The fixed overhead production volume variance is a direct result of the difference in volume (units) between budgeted production and actual production.

Thus an alternative approach to this calculation can be used assuming the standard fixed overhead cost per unit.

Fixed overhead production volume variance = Standard fixed overhead cost per unit × (Budgeted units produced − Actual units produced)

## Favorable Versus Unfavorable Variances

The terms favorable and unfavorable relate to the impact the variance has on budgeted operating profit. A favorable variance has a positive impact on operating profit.

An unfavorable variance has a negative impact on operating profit. Companies using a standard cost system ultimately credit favorable variances and debit unfavorable variances to income statement accounts.

Related Topics