Smithton, Inc. makes and sells one product, the standard costs of which are as follows:
| £ |
| Direct materials (2 kg at £3.00/kg) | 6.00 |
| Direct labour (30 minutes at £10.00/hr) | 5.00 |
| Fixed overheads | 2.50 |
| Total | 13.50 |
| Selling price | 20.00 |
| Standard profit margin | 6.50 |
The monthly production and sales are planned to be 1,300 units.
The actual results for May were as follows:
| £ |
| Sales revenue | 20,000 |
| Less: Direct materials | (6,500) (2,100 kg) |
| Direct labour | (5,250) (510 hr) |
| Fixed overheads | (3,100) |
| Operating profit | 5,150 |
There were no inventories at the start or end of May.
Your supervisor has asked you to calculate the budgeted profit for May and then reconcile it to the actual profit through variances, going into as much detail as possible from the information available.
Once you have the figures computed, prepare a detailed report for your supervisor that includes a discussion of the following information:
- A listing of the variances that occurred within the month of May.
- An analysis of the standards developed and utilised by the organisation.
- An analysis of each variance with regards to the possible explanations of why it occurred.
- An analysis of the business/strategic implications that exist for your organisation in light of the new information.
Smithton, Inc. makes and sells one product, the standard costs of which are as follows: £ Direct materials (2 kg at £3.00/kg) 6.00 Direct labour (30 minutes at £10.00/hr) 5.00 Fixed overheads 2.50 Total 13.50 Selling price 20.00 Standard profit margin 6.50 The monthly production and sales are planned to be 1,300 units. The actual results for May were as follows: £ Sales revenue 20,000 Less: Direct materials (6,500) (2,100 kg) Direct labour (5,250) (510 hr) Fixed overheads (3,100) Operating profit 5,150 There were no inventories at the start or end of May. Your supervisor has asked you to calculate the budgeted profit for May and then reconcile it to the actual profit through variances, going into as much detail as possible from the information available. Once you have the figures computed, prepare a detailed report for your supervisor that includes a discussion of the following information: A listing of the variances that occurred within the month of May. An analysis of the standards developed and utilised by the organisation. An analysis of each variance with regards to the possible explanations of why it occurred. An analysis of the business/strategic implications that exist for your organisation in light of the new information. STANDARD COSTING AND VARIANCE ANALYSIS CALCULATION AND EVALUATION SOLUTION According to the standards set the firm’s income statement should have recorded the following if sales were equal to 1,300 units FLEXIBLE BUDGET (using standard costs) INCOME STATEMENT Sales Revenue (1,300 x £20.00) £26,000.00 Direct Materials (1,300 x £6.00) £7,800.00 Direct Labour (1,300 x £5) £6,500.00 Fixed Overheads (1,300 x £2.50) £3,250.00 17,550.00 Profit Margin £8,450.00 FLEXIBLE BUDGET VARIANCE INCOME STATEMENT ACTUAL BUDGETED VARIANCE Sales Revenue £20,000.00 £26,000.00 £6,000.00 U Direct Materials £6,500.00 £7,800.00 £1,300.00 F Direct Labor £5,250.00 £6,500.00 £1,250.00 F Fixed Overheads 3,100.00 £3,250.00 £150.00 F Total Costs £14,850.00 17,550.00 £2,700.00 F Profit Margin £5,150.00 £8,450.00 £3,300.00 U SUPERVISOR’S REPORT: FURTHER ANALYSIS AND DISCUSSION OF THE VARIANCES CAUSES OF THE VARIANCES: DIRECT MATERIALS Direct Material Price Variance This variance is the difference between the actual purchase price and the standard purchase price of material. It is calculated as follows: (Actual quantity purchased × Actual price) − (Actual quantity purchased × Standard price) (2100 kg x £3.095) – (2,100 kg x £3.00) = £199.50 U (rounded to £200.00 U) In this case, the firm paid more for its material than it planned to pay. This may have occurred because the firm bought material that was of a higher quality than it had planned to buy, or inflation may have taken the price of the material above the standard level. Another possible reason is that the firm was unable to take advantage of expected quantity discounts because it did not purchase as many units as were needed to get such a discount. The way that material is delivered can also affect the cost of the material since delivery cost or freight is added to the cost of items purchased. The purchasing manager of a firm is usual the one in control of the purchase of materials. As such, any unfavorable price variance should be brought to his/her attention so that the reason for the variance can be isolated and dealt with as quickly as possible to avoid further deviations from the plans of the firm. At times, someone other than the purchasing manager can be responsible for the unfavorable material price variance. For instance, the scheduling of production can lead the purchasing manager to require delivery of materials quickly. The speed of delivery may require that a more expensive transportation means is used, thereby increasing the cost of the materials. In such an instance, the production manager would be the one at fault and not the purchasing manager. The firm must, therefore, example various possibilities before determining the changes that need to be made in order to control the cost of materials. Direct Material Efficiency (or Quantity) Variance The direct material efficiency variance is the difference between the quantity of materials used in production and the quantity that should have be utilized according to the standards set by the firm. It is calculated as follows: (Actual quantity used × Standard price) − (Standard quantity allowed × Standard Price)] (2,100 kg x £3.00) – [(2 kg x 1300) x £3.00] =£1,500.00 F In this case the Direct Material Efficiency variance was favorable, indicating that the firm actually used less direct materials than the standard amount that should have been used for the level of production achieved. This may be related to the fact that the direct materials price variance was unfavorable. Quite often a higher costing, higher quality material can actual require fewer units to get the job done. This would lead to higher prices for the material but more efficient use it. Other possible reasons for a favorable material efficiency variance could be a well supervised production department and/or well trained production staff who are able to avoid wastage of materials. Notice: When the Price and efficiency variances are added we should get the total Direct Material Variance = £200.00 U + £1,500.00 F = 1,300.00 F DIRECT LABOR Direct Labor Price Variance This variance measures the difference in the actual price of labor and the standard price of labor. It is calculated as follows: (Actual quantity used × Actual price) − (Actual quantity used × Standard price) (510 hrs x 10.294) – ( 510 hrs x 10) = 149.94 U (rounded up to 150.00 U) When the labor price variance is unfavorable, it can be because of changes in the salary levels. Unionized workers often lobby for increases in salaries. However, such a small variance is more likely the result of poor supervision in the production department. Poor supervision can lead to slow work by employees and the need for the firm to pay overtime wages in order to get the required production completed on time. Direct Labor Efficiency Variance This variance measures the productivity of labor time. This is one of the variances that is closely monitored by management, because it is believed that a production department that can increase the productivity of direct labor time will greatly reduce its production costs. (Actual quantity used × Standard price) − (Standard quantity allowed × Standard Price)] (510 hrs x 10.00) – (650 x 10.00) = $1,400 F In this case the variance is favorable. Indicating that the production department has actually used less time to complete production than the standard time allowed. While this can indicate that the management and supervision team of the production department is doing a great job at increasing efficiency, it could also be tied in to the unfavorable material price variance. The fact that high quality materials may have been purchased, can lead a reduction in the labor processing time. If this is the case, then the Purchasing manager is the one who deserves the credit for this favorable labor efficiency variance. It is more likely, however, that well trained and well supervised staff in the production department were able to work faster than the standard level and therefore increased the efficiency of the production process and as such reduced the cost of the process. It is also important to note that the question mentioned that there was no inventory at the beginning or end of the period. This could mean that a very efficient Just In Time Inventory system is being used by the firm. Notice: When the price and efficiency variances are added you arrive at the total direct material variance calculated in the flexible budget table above (1,400 F + 150.00 U = $1,250 F) FIXED OVERHEAD Fixed Overhead Spending Variance The information provided in this case does not allow us much opportunity to discuss the overhead variance. We can only say that in this case the firm actually spent less than the standard amount expected for fixed overheads. Actual fixed overhead costs incurred - Budgeted fixed overhead costs =3,100 – 3,250 = 150.00 F This lead to a favorable fixed overhead spending variance.