In a standard costing system, the costs of production, inventories, and the cost of goods sold are initially recorded using the standard costs. In the case of direct materials, it means the standard quantity of direct materials that should have been used to make the good output. If the manufacturer uses more direct materials than the standard quantity of materials for the products actually manufactured, the company will have an unfavorable direct materials usage variance. If the quantity of direct materials actually used is less than the standard quantity for the products produced, the company will have a favorable usage variance.
This would be a theoretical standard, that can only be met if the circumstances are optimal. Or, a realistic standard could be used that incorporates reasonable inefficiency levels, and which comes close to actual results. Generally, the latter approach is preferable, if only to avoid a depressing series of negative efficiency variances. During planning, you come up with a standard or budgeted price of $5 per pound for aluminum. When you review your actual costs, you find that the real price paid was $5.75 per pound. With this figure in hand, management can make adjustments to overheard and other factors.
Direct Materials Efficiency Variance
But on the other hand, if only 45 labor hours were actually used, then the efficiency variance would be +5, indicating that the manufacturing process was more productive and cost-effective than initially assumed. Before we go on to explore direct labor variances, check your understanding of the direct materials efficiency variance. Even though the answer is a positive number, the variance is unfavorable because more materials were used than the standard quantity allowed to complete the job.
- See direct material total variance#Example and direct material price variance#Example for computations of both components.
- In a standard costing system, the costs of production, inventories, and the cost of goods sold are initially recorded using the standard costs.
- Efficiency variance calculations not only apply to the output of tangible goods, but they also apply to the completion of cerebral tasks, such as the number of hours it takes to audit an individual’s tax records.
If a company uses less of a resource than the standard, it will have a favorable efficiency variance. Conversely, if it uses more of a resource than the standard, it will have an unfavorable efficiency variance. Managers often use efficiency variance analysis to identify inefficiencies and improve the company’s operations. It’s thus typical for management personnel to set expectations and benchmarks for both costs and output, while the manufacturing activity is still in its planning stage before the production process even starts.
After removing 290 yards of materials, the balance in the Direct Materials Inventory account as of January 31 is $2,130 (710 yards x $3 standard cost per yard). In order to calculate the direct materials usage (or quantity) variance, we start with the number of acceptable units of products that have been manufactured—also known as the good output. If DenimWorks produces 100 large aprons and 60 small aprons during January, the production and the finished goods inventory will begin with the cost of the direct materials that should have been used to make those aprons. The material price variance is $7,500 unfavorable because your actual costs ($57,500) were more than the actual quantity at budgeted price ($50,000). Another key component of any efficiency variance is the basis upon which the standard is set. For example, the number of units of direct material could assume the absence of scrap, when in fact a standard amount of scrap is normally realized, causing a continuing negative efficiency variance.
Efficiency variance definition
In manufacturing, efficiency variance can be used to analyze the effectiveness of an operation with respect to labor, materials, machine time, and other production factors. During the planning stages, the management staff might have projected that it will take 50 labor hours to produce one unit of a specific product. However, after the first round of products is completed, records indicate that 65 labor hours were used, to complete the item in question. Accountants determine whether a variance is favorable or unfavorable by reliance on reason or logic. If more materials were used than the standard quantity, or if a price greater than the standard price was paid, the variance is unfavorable.
- An important factor in measuring efficiency variance is the development of a set of realistic assumptions surrounding the theoretical amount of inputs that should be required.
- The material price variance is $7,500 unfavorable because your actual costs ($57,500) were more than the actual quantity at budgeted price ($50,000).
- It may also be that our expectations are unrealistic, and we need to change our budget parameters.
- The expected inputs to produce the unit of output are based on models or past experiences.
- On the other hand, if actual inputs are less than the amounts theoretically required, then there would be a positive efficiency variance.
- In business, management sets the standards of what quantity of materials should be used for a particular job.
This could be due to several reasons such as lower worker productivity, machine breakdowns, etc. ABC Manufacturing would now analyze this variance to identify the reasons and take corrective actions to improve its labor efficiency. Harold Averkamp (CPA, MBA) has worked as a university accounting instructor, accountant, and consultant for more than 25 years. He is a four-time Dummies book author, a blogger, and a video host on accounting and finance topics. The real reason you go through all of this analysis is to identify areas where you can improve. By “improve,” you want to reduce costs, increase demand, or raise prices to generate a higher profit.
Examples of Efficiency Variance
Efficiency variance calculations not only apply to the output of tangible goods, but they also apply to the completion of cerebral tasks, such as the number of hours it takes to audit an individual’s tax records. Let us assume further that during given period, 100 widgets were manufactured, using 212 kg of unobtainium which cost € 13,144. For the remainder of our explanation, we will use a common format for calculating variances.
To summarize the distinction between the two variances, you either paid more or less than planned (price variance) or used more or less than planned (efficiency variance). However, due to various factors, perhaps the company actually used 3,200 hours of labor to produce these 1000 units. Standard costs are sometimes referred to as the “should be costs.” DenimWorks should be using 278 yards of denim to make 100 large aprons and 60 small aprons as shown in the following table. To produce 2,000 bikes, you plan to use 6 pounds of aluminum per bike, or a total of 12,000 pounds. Assume that for the same 2,000 bikes produced, you used only 5 pounds of aluminum per bike (because you were so efficient, of course).
Another way to improve your business performance is to be more efficient — “to work smart,” as the business cliché goes.
How to Implement a Standard Cost System
For example, an efficiency variance can be calculated for the number of hours required to complete an audit versus the budgeted amount. The Direct Materials Inventory account is reduced by the standard cost of the denim that was removed from the direct materials inventory. Let’s assume that the actual quantity of denim removed from the direct materials inventory and used to make the aprons in January was 290 yards. Because Direct Materials Inventory reports the standard cost of the actual materials on hand, we reduce the account balance by $870 (290 yards used $3 standard cost per yard).
Efficiency variance is the difference between the theoretical amount of inputs required to produce a unit of output and the actual number of inputs used to produce the unit of output. The expected inputs to produce the unit of output are based on models or past experiences. The difference between expected required input and the actual required input can be attributed to inefficiencies in labor or use of resources, or they may be due to errors in the assumptions used to set input expectations. Subtracting from that the product of the Standard Quantity of raw materials (AQ) and the Standard Cost (SC) would give the total expected cost of materials if the conversion process used those materials exactly as expected. See direct material total variance#Example and direct material price variance#Example for computations of both components. An important factor in measuring efficiency variance is the development of a set of realistic assumptions surrounding the theoretical amount of inputs that should be required.
If the actual amount of inputs used exceeds the amount theoretically required, there is a negative efficiency variance. From the accounting records, we know that the company purchased and used in production 6,800 BF of lumber to make 1,620 bodies. Based on a standard of four BF per body, we expected raw materials usage to be 6,480 (1,620 bodies x 4 BF per blank). You have a $7,500 unfavorable price variance and a $10,000 favorable efficiency variance. Because this is a cost variance, a negative number indicates less actual spending than planned, and that’s a good thing.