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Variance Analysis

See Also:
Direct Labor Variance Formulas
Direct Material Variance Formulas
Asset Market Value versus Asset Book Value
Accounting Income vs Economic Income
ProForma Financial Statements

Variance Analysis

Variance analysis measures the differences between expected results and actual results of a production process or other business activity. Measuring and examining variances can help management contain and control costs and improve operational efficiency.

Prior to an accounting period, a budget is made using estimates of material and labor costs and amounts that will be required for the period. After the accounting period, compare the actual material and labor costs and amounts to the estimates to see how accurate the estimates were. The differences between the estimates and the actual results observed at the end of the period are called the variances.

Commonly measured variances include direct labor rate variance, direct labor efficiency variance, direct material price variance, and direct material quantity variance. These variance analyses compare expected results to actual results. The purpose is to see if budget targets were met. Or they see if the operations ended up being more expensive or less costly than originally planned.


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Variance Interpretation

Variance analysis will let managers and cost analysts see if the budgeted costs and requirements for an operation accurately forecasted the actual costs and requirements of the operation.

Often, you will find variance between the budgeted requirements and the actual requirements. It is then up to managers and cost analysts to determine if that variance was favorable or unfavorable.

When a variance is favorable, that means that the actual costs and requirements of the operations were less than the expected costs and requirements for the operations. In other words, they expected the production process to cost a certain amount and it ended up costing less. Hence, this is a favorable variance.

When a variance is unfavorable, that means that the actual costs and requirements of the operations were more than the expected costs and requirements for the operations. In other words, they expected the production process to cost a certain amount and it ended up costing more. In conclusion, this is an unfavorable variance.

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variance analysis

Source:

Hilton, Ronald W., Michael W. Maher, Frank H. Selto. “Cost Management Strategies for Business Decision”, Mcgraw-Hill Irwin, New York, NY, 2008.

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Standard Costing System

See Also:
Standard Costing Example
Process Costing
Activity Based Costing vs Traditional Costing
Absorption vs Variable Costing
Implementing Activity Based Costing
Cost Driver
Budgeting 101: Creating Successful Budgets
Analyzing Your Return on Investment (ROI)
Product Pricing Strategies

Standard Costing System

In accounting, a standard costing system is a tool for planning budgets, managing and controlling costs, and evaluating cost management performance.

A standard costing system involves estimating the required costs of a production process. But before the start of the accounting period, determine the standards and set regarding the amount and cost of direct materials required for the production process and the amount and pay rate of direct labor required for the production process. In addition, these standards are used to plan a budget for the production process.

At the end of the accounting period, use the actual amounts and costs of direct material. Then utilize the actual amounts and pay rates of direct labor to compare it to the previously set standards. When you compare the actual costs to the standard costs and examine the variances between them, it allows managers to look for ways to improve cost control, cost management, and operational efficiency.

(NOTE: Want to take your financial leadership to the next level? Download the 7 Habits of Highly Effective CFO’s. It walks you through steps to accelerate your career in becoming a leader in your company. Get it here!)

Advantages and Disadvantages of Standard Costing

There are both advantages and disadvantages to using a standard costing system. The primary advantages to using a standard costing system are that it can be used for product costing, for controlling costs, and for decision-making purposes.

Whereas the disadvantages include that implementing a standard costing system can be time consuming, labor intensive, and expensive. If the cost structure of the production process changes, then update the standards.

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standard costing system

Source:

Hilton, Ronald W., Michael W. Maher, Frank H. Selto. “Cost Management Strategies for Business Decision”, Mcgraw-Hill Irwin, New York, NY, 2008.

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Joint Costs

See Also:
Sunk Costs
Inventoriable Costs
Financial Distress Costs
Agency Costs
Bankruptcy Costs

Joint Costs Definition

In accounting, a joint cost is a cost incurred in a joint process. Joint costs may include direct material, direct labor, and overhead costs incurred during a joint production process. A joint process is a production process in which one input yields multiple outputs. It is a process in which seeking to create one type of output product automatically also creates other types of output product.

Joint Process Examples

Joint processes are production processes in which the creation of one product also creates other products. It is a process in which one input yields multiple outputs. Joint production processes are common in the agriculture industry, the food manufacturing industry, and the chemical industry.

For instance, let’s consider a poultry plant. The plant takes live chickens and turns them into chicken parts used for food. The chickens yield chicken breasts, drumsticks, livers, gizzards, and other parts of the chicken that are used for human consumption. They also yield miscellaneous chicken byproducts that are used for hotdogs, jerky sticks, or animal provender.

Similarly, let’s consider an oil refinery. The refinery takes crude oil and refines it into a substance that may be used for auto gasoline, motor oil, heating oil, or kerosene. All of these various outputs come from a single input – crude oil. In both of these examples, a single input yields multiple outputs. These are both examples of joint production processes.

Joint Cost Allocation

Allocate joint costs to the primary output products of the joint process, not the incidental byproducts or scrap. Allocate them using a physical measure or a monetary measure.

The physical measure allocates joint costs to primary products based on a physical characteristic, such as units produced, or pounds or tons produced, barrels produced, or some other physical measure that is appropriate for the volume of output of the primary products. To use this method, simply divide the total production cost by the appropriate measure of output volume to yield the cost per unit of output.

One type of monetary measure of joint cost allocation is the sales value method. Using the sales value method, separate and differentiate the primary products according to sales value. Then divide them into proportions of sales value that add up to 100%. Then multiply the percentage proportions by the total production cost to yield the allocated cost per primary product type.

Joint Costs

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Job Costing

See Also:
Implementing Activity Based Costing
Standard Costing System
Process Costing
Activity-based Costing (ABC) vs Traditional Costing
Absorption vs Variable Costing

Job Costing Definition

Job costing is defined as a method of recording the costs of a manufacturing job, rather than process. With job costing systems, a project manager or accountant can keep track of the cost of each job, maintaining data which is often more relevant to the operations of the business.

Job Costing Meaning

Job costing, generally, means a specific accounting methodology used to track the expense of creating a unique product. Due to the fact that certain projects, such as construction, require different operations, accountants use this methodology to trace the expenses of each job in order to use this information for analysis and tax needs. Job costing forms have spaces to include direct labor, direct materials, and overhead.

Costs stay in the work-in-process account throughout the job. When the job is finally completed, they are transferred to the finished goods account. By using this method, accountants can make sense of complicated jobs which are moving towards the process of completion.

Indirect costs, like overhead, are applied as a fraction of direct costs. This is usually done in one of two ways: an association with labor hours or using activity based costing. This way, either through use of labor or certain tools, overhead will not be left out of the equation and a company can make sure to cover all essential costs using job costing.

Industries which produce products as jobs use this method. This includes job costing for construction, but goes much farther than just this. Shipping, auditing, maintenance and repair, installation, and any industry which creates products unique to each need. In this situation, job costing is often the most efficient method.

Job Costing Example

For example, Roy was once the curator of a large museum in the United States. Connecting with the science community on many levels, he has enjoyed his career. After some time, Roy decided he would make a career change. He has since started a company which provides maintenance work on historical works which reside in museums.

Roy has all the connections he needs for this business: other curators, archaeologists, and the entire community in his rolodex. After a little effort, he was able to connect with the people who perform this work. Roy will take the role of salesperson, but he needed to hire a team to perform operations. Roy is quite successful. His one concern, an area of ignorance for him, is how the bookkeeping will take place. So he hires an accountant, sets a meeting, and begins to learn about how his business will overcome this need.

The Most Efficient Accounting Methodology

The accountant shares that job costing will be, probably, the most efficient accounting methodology. Roy can keep track of the costs for each of his contracts by implementing this type of accounting. He will be able to find which items take more or less time to maintain. Additionally, he can make sure to create company profits by adding a margin on top of his costs. By using a job costing software, bookkeepers can run the system quite smoothly.

Roy can rest at ease with this accounting method. Knowing he can rely on his accountant, Roy begins to contact prospect customers and former peers. He has confidence that his business will be a success. He looks forward to gaining his first customer.

Job costing is just another way to know your economics or financials. Click here to download the Know Your Economics Worksheet to shape your economics to result in profit.

Job Costing

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Direct Material Variance Formulas

See Also:
Direct Cost vs Indirect Cost
Direct Materials
Variance Analysis
Direct Labor Variance Formulas
Cost Driver

Direct Material Variance Formulas

Commonly used variance formulas for direct materials include the direct material price variance and the direct material quantity variance. Below are the formulas for calculating each of these variances.

Direct Material Price Variance

Direct material price variance measures the cost of the difference between the expected price of materials required for the operations and the actual price of materials required for the operations.

If the variance demonstrates that the actual price of materials required was higher than expected price of materials required, the variance will be considered unfavorable. If the variance demonstrates that the actual price of materials required was less than expected price of materials required, the variance will be considered favorable.

Using the formula shown below, a positive DMPV would be unfavorable and a negative DPMV would be favorable.

DMPV = PQ (AP – SP)

DMPV = Direct material price variance
PQ = Actual quantity of materials purchased
AP = Actual price paid for materials
SP = Standard price, or the estimated price of materials required for the operations

Direct Material Quantity Variance

Direct material quantity variance measures the cost of the difference between the expected quantity of materials required for the operations and the actual quantity of materials required for the operations.

If the variance demonstrates that the actual quantity of materials required was higher than expected quantity of materials required, the variance will be considered unfavorable. If the variance demonstrates that the actual quantity of materials required was less than expected quantity of materials required, the variance will be considered favorable.

Using the formula shown below, a positive DMQV would be unfavorable and a negative DPQV would be favorable.

DMQV = SP (AQ – SQ)

DMQV = Direct material quantity variance
SP = Standard price, or the estimated price of materials required for the operations
AQ = Actual quantity of materials required for the operations
SQ = Standard quantity, or the estimated quantity of materials required for the operations

Improve your pricing – and your profits– by downloading the free Pricing for Profit Inspection Guide.

direct material variance formulas

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direct material variance formulas

Source:

Hilton, Ronald W., Michael W. Maher, Frank H. Selto. “Cost Management Strategies for Business Decision”, Mcgraw-Hill Irwin, New York, NY, 2008.

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Absorption Cost Accounting

See Also:
Semi Variable Costs
Standard Costing System
Variable vs Fixed Cost

Absorption Cost Accounting

Absorption cost accounting (also known as the “Cost-Plus” approach), is a method that is centered upon the allocation of Manufacturing Cost to the product. This method is important for situations when a company needs to decide if it can be competitive in a market, or when the company has control over the pricing in general. This means that Direct Labor, Direct Materials, as well as fixed and variable Overhead Definition are all “absorbed” into product pricing as well as product costing.

(NOTE: Want to take your financial leadership to the next level? Download the 7 Habits of Highly Effective CFO’s. It walks you through steps to accelerate your career in becoming a leader in your company. Get it here!)

Absorption Cost Per Unit

Because absorption cost accounting is a “per-unit” method, it is necessary to understand how to determine the absorption cost per unit. So the fair question remains: What is the absorption cost approach? Ultimately, all of the calculations are done on a Per-Unit basis. For example, Wintax Company creates 5,000 products with Variable Cost per unit being $60 direct materials, $110 direct labor, and $40 variable overhead. In addition to the per-unit costs, the fixed overhead is $100,000. In order to obtain the product cost under absorption costing, first the per-unit costs are added together (direct labor, direct materials, variable overhead). After that, per-unit costs need to be obtained from the fixed overhead so that the per-unit overhead can be applied to the per-unit cost. Adding the overhead to the per-unit costs completes what is absorption costing per unit. See how to work out the problem below.

Solution

Per-Unit Costs Fixed-overhead per-unit
(direct labor + direct materials +variable overhead) + (fixed overhead / number of units)
($210) + ($20)
Absorption cost per unit: $230

Absorption Cost Unit Pricing

In addition to determining the overall cost of a singular product, absorption cost accounting gives one the ability to determine the appropriate selling price of a unit as well. As long as there is a target profit, the absorption costing method can calculate the appropriate price. For example, Bizzo Company desires a profit of $180,000 while producing 10,000 products. In addition, each product costs $150 to produce in total. In order to determine the appropriate selling price, first, divide profit by the number of products. Add that number to the original product cost in order to achieve the correct product price. Check out the solution worked out below.

Solution

((Desired Profit) / (Number of Units)) + (Product Cost Per-Unit)
( $180,000 / 10,000 ) + ( $150 )
Target Product Price= $168

Absorption Costing Formulas

(Absorption Cost per-unit) = (Per-Unit Variable Costs) + (Per-Unit Fixed Overhead)
Sales Price = (Manufacturing Cost Per-Unit) + (Sales and Administrative Cost Per-Unit) + (Profit Markup)

Deciding whether to be competitive in pricing or maintain status in the market is one of the many key decisions a financial leader has to make. Download the free 7 Habits of Highly Effective CFOs to find out how you can become a more valuable financial leader.

Absorption Cost Accounting

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Absorption Cost Accounting

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