Calculating Variance- Direct Labor, Direct Materials, and Overhead

Presented by Juan F. Pujol, Jr.

Most manufacturing companies divide manufac-turing costs into three broad categories: direct materials, direct labor, and manufacturing overhead.

Calculating Variance- Direct Materials, Direct Labor, and Overhead

Direct materials The materials that go into the final product are called raw materials. Actually, raw materials refer to any materials that are used in final product; and the finished product of one company can be the raw materials of another company.

Direct materials are those materials that become an integral part of the finished product and that can be physically and conveniently traced to it. Direct Labor

Calculating Variance- Direct Materials, Direct Labor, and Overhead

The term direct labor is served for those labor costs that can be easily traced to individual unit of product. Direct labor is sometimes called touch labor, since direct labor workers typically touch the product while it is being made.

Manufacturing Overhead

Calculating Variance- Direct Materials, Direct Labor, and Overhead

Manufacturing overhead, the third element of manufacturing cost, included all cost of manufacturing except direct materials and direct labor.
Manufacturing overhead includes items such as: indirect materials indirect labor maintenance and repair production equipment

Direct Materials Price Variance

property taxes depreciation insurance on manufacturing facilities Direct materials price variance is the difference between the actual purchase price and standard purchase price of materials. Direct materials price variance is calculated either at the time of purchase of direct materials or at the time when the direct materials are used.

Direct Materials Price Variance

When this variance is computed at the time of purchase of materials it is called -

direct materials purchase price variance.

When this variance is computed at the time of usage this is typically called

direct materials price usage variance.

Direct Materials Price Variance

Direct materials price variance formula: Following formula is used to calculate materials price variance: [Materials Price Variance = (Actual quantity purchased Actual price) (Actual quantity purchased Standard price)] This formula is usually preferred and used by managers because it permits calculation of materials purchase price variance very quickly.

Direct Materials Price Variance

Example:

Colonial Pewter Company provides the following information:

Standard price of material is $4.00 per pound and 6,500 pounds of materials have been purchased at a cost of $3.80 per pound. This cost figure includes freight and handling and is net of quantity discount. All the materials purchased have been used and an output of 2000 units were produced during the period.

Direct Materials Price Variance

Required: Calculate materials price variance

Calculation of direct materials price variance:

= (6,500 pounds $3.80) (6,500 pounds $4.00) = $24,700 $26,000 = $1,300 Favorable

A favorable material price variance of $1,300 exists because the actual price of materials purchased is less than the standard price of materials purchased.

Direct Labor: Standard Cost, Rate Variance, Efficiency Variance

"Direct labor" refers to the work done by those employees who actually make the product on the production line.
("Indirect labor" is work done by employees who work in the production area, but do not work on the production line. Examples include employees who set up or maintain the equipment.)

Direct Labor: Standard Cost, Rate Variance, Efficiency Variance

Unlike direct materials (which are obtained prior to being used), direct labor is obtained and used at the same time. This means that for any given good output, we can compute the direct labor rate variance, the direct labor efficiency variance, and the standard direct labor cost at the same time. January 2012 Let's begin by determining the standard cost of direct labor for the good output produced in January 2012:

Direct Labor: Standard Cost, Rate Variance, Efficiency Variance

Large Small Total Aprons Aprons Actual aprons manufactured Standard hours of direct labor per apron manufactured Total standard hours of direct labor for actual aprons manufactured Standard cost per direct labor hour incl. payroll taxes 100 60

0.3 hr. 0.2 hr. 30 hr. $10 $300 12 hr. $10 $120 42 hr. $10 $420

Standard cost of direct labor in the good output

Direct Labor: Standard Cost, Rate Variance, Efficiency Variance

Assuming that the actual direct labor in January adds up to 50 hours and the actual hourly rate of pay (including payroll taxes) is $9 per hour, our analysis will look like this:

Direct Labor: Standard Cost, Rate Variance, Efficiency Variance

Direct Labor Variance Analysis for January 2012:
1. DebitInvent 2. Actual ory-FG for 3. Direct hoursof direct the standard LaborEfficienc 4. labor hours of direct yVariance(Std Credit Wages 5. Direct used x thestan labor that Hr - Act Hr) x Payable for the LaborRate Var dard hourly should have Std Cost actual direct iance pay rate been used to labor cost. Act Hr x (Std make the good Rate - Act output x thesta Rate) ndard hourly pay rate.

Act Hr x Act Rate

50 act hr x $9 $450

Difference 50 hr x $1

Act Hr x Std Rate

50 act hr x $10 $500

Difference (8 hr) x $10

Std Hr x Std Rate

42 std hr x $10 $420

$50Favorable

$80 Unfavorable

Direct Labor: Standard Cost, Rate Variance, Efficiency Variance

In January, the direct labor efficiency variance (#3 above) is unfavorable because the company actually used 50 hours of direct laborthis is 8 hours more than the standard quantity of 42 hours allowed for the good output. The additional 8 hours is multiplied by the standard rate of $10 to give us an unfavorable direct labor efficiency variance of $80. (The direct labor efficiency variance could be called the direct labor quantityvariance or usage variance.)

Direct Labor: Standard Cost, Rate Variance, Efficiency Variance

Note that DenimWorks paid $9 per hour for labor when the standard rate is $10 per hour. This $1 differencemultiplied by the 50 actual hoursresults in a $50 favorable direct labor rate variance. (The direct labor rate variance could be called the direct labor price variance.)

Direct Labor: Standard Cost, Rate Variance, Efficiency Variance

The journal entry for the direct labor portion of the January production is:
Date Account Name Debit Credit

Jan. 31, 2012

Inventory-FG Direct Labor Efficiency Variance Direct Labor Rate Variance Wages Payable

420 80 50 450

Direct Labor: Standard Cost, Rate Variance, Efficiency Variance

February 2012 In February your company manufactures 200 large aprons and 100 small aprons. The standard cost of direct labor for the good output produced in February 2012 is computed as:

Direct Labor: Standard Cost, Rate Variance, Efficiency Variance

Large Small Total Aprons Aprons Actual aprons manufactured Standard hours of direct labor per apron manufactured Total standard hours of direct labor for actual aprons manufactured Standard cost per direct labor hour incl. payroll taxes Standard cost of direct labor in the good output 200 100

0.3 hr. 0.2 hr.

60 hr.
$10 $600

20 hr.
$10 $200

80 hr.
$10 $800

Direct Labor: Standard Cost, Rate Variance, Efficiency Variance

If we assume that the actual labor hours in February add up to 75 and the hourly rate of pay (including payroll taxes) is $11 per hour, the total equals $825. The analysis for February 2012 looks like this:

Direct Labor: Standard Cost, Rate Variance, Efficiency Variance

1. DebitInvento 2. Actual ry-FG for 3. Direct hoursof direct the standard LaborEfficienc 4. labor hours of direct yVariance(Std Credit Wages 5. Direct used x thestan labor that Hr - Act Hr) x Payable for the LaborRate Vari dard hourly should have Std Cost actual direct ance pay rate been used to labor cost. Act Hr x (Std make the good Rate - Act Rate) output x thesta ndard hourly pay rate. Act Hr x Act Rate 75 act hr x $11 $825 $75 Unfavorable

Direct Labor Variance Analysis for February 2012:

Difference
75 hr x ($1)

Act Hr x Std Rate 75 act hr x $10 $750

Difference
5 hr x $10

Std Hr x Std Rate 80 std hr x $10 $800

$50 Favorable

Direct Labor: Standard Cost, Rate Variance, Efficiency Variance

Notice that for the good output in February, the total actual labor costs amounted to $825 and the total standard cost of direct labor amounted to $800. This unfavorable difference of $25 agrees to the sum of the two labor variances:
Direct labor efficiency variance $50 Favorable

Direct labor rate variance

Total Direct Labor Variance

$75 Unfavorable
$25 Unfavorable

Direct Labor: Standard Cost, Rate Variance, Efficiency Variance

The journal entry for the direct labor portion of the February production is:
Date Account Name Debit Credit

Feb. 28, 2012

Inventory-FG Direct Labor Rate Variance Direct Labor Efficiency Variance Wages Payable

800 75 50 825

Tips Divide the direct labor used by the number of units produced to get the direct labor per unit.

Manufacturing Overhead
In the world of manufacturingas competition becomes more intense and customers demand more servicesit is important that management not only control its overhead but also understand how it is assigned to products and ultimately reported on the company's financial statements. We view overhead as two types of costs and define them as follows: 1. Manufacturing overhead (also referred to as

factory overhead, factory burden, and manufacturing support costs) refers to indirect factory-related costs that are incurred when a product is manufactured.

Manufacturing Overhead
Along with costs such as direct material and direct labor, the cost of manufacturing overhead must be assigned to each unit produced so that Inventory and Cost of Goods Sold are valued and reported according to generally accepted accounting principles (GAAP).
Manufacturing overhead includes such things as:the electricity used to operate the factory equipment

depreciation on the factory equipment and building supplies and factory personnel (other factory than direct labor)

Manufacturing Overhead
How these costs are assigned to products has an impact on the measurement of an individual product's profitability.

2. Nonmanufacturing costs (sometimes referred to as administrative overhead) represent a manufacturers expenses that occur apart from the actual manufacturing function. In accounting and financial terminology, the nonmanufacturing costs include Selling, General and Administrative (SG&A) expenses, and Interest Expense.

Manufacturing Overhead
Since accounting principles do not consider these expenses as product costs, they are not assigned to inventory or to the cost of goods sold. Instead, nonmanufacturing costs are simply reported as expenses on the income statement at the time they are incurred. Nonmanufacturing costs include activities associated with the Selling and General Administrative functions. Examples include: the compensation of nonmanufacturing personnel

Manufacturing Overhead
occupancy expenses for nonmanufacturing facilities (rent, light, heat, property taxes, maintenance, etc.) depreciation of nonmanufacturing equipment expenses for automobiles and trucks used to sell and deliver products interest expenses Note: factory administration expenses are considered part of manufacturing overhead.

Manufacturing Overhead
Although nonmanufacturing costs are not assigned to products for purposes of reporting inventory and the cost of goods sold on a companys financial statements, they should always be considered as part of the total cost of providing a specific product to a specific customer. For a product to be profitable, its selling price must be greater than the sum of the product cost (direct material, direct labor, and manufacturing overhead) plus the nonmanufacturing costs and expenses.