 Hello and welcome to this session. This is Professor Farhad. In this session we would look at direct labor and direct material variances and to be more specific price and usage rate and efficiency variance. In another session I would look at the overhead direct overhead variance as well as fixed overhead variance. This lecture as well as my other lectures are posted on my website as well as the PowerPoint slides will be posted there. So before we start this session we need to be familiar with something called standard cost so we need to be familiar what is a standard cost and how does it work. Well hopefully you are familiar with the food recipe. A food recipe basically tells you this is how much you need of material to make a cupcake. This is how much flour, how much yeast, so on so forth. As long as you mix it together you follow the recipe you should have the cupcake or if you're making a pizza you need the dough, the sauce, the cheese, as long as you flour, as long as you mix it together correctly and you bake it as instructed you will get the pizza. And in theory if you follow it and practice it should work but you know for a fact if you have a recipe and you follow the recipe exactly oftentimes it doesn't come out exactly in the shape or taste that you want and guess what in the manufacturing world, in the real world, engineers, companies, management they put together what's called a cost sheet. And what is a cost sheet? A cost sheet is what should go into the product, what type of material, how much time we should spend on that product to have that product finish. So a standard cost or a cost sheet is a form providing the standard quantities how much we should use in quantities of each input required to produce a unit of output and the standard price. So in the quantities we have material and we have direct labor and for the material we need to pay money for that and for the labor we need to pay money for the labor. So the standard cost sheet tells you how much you should invest or how much you should put into your production so each unit comes out the same as the other unit. We know for a fact in theory this is how it works in reality that may not be true. And to be like even more realistic or a little bit more interesting what I'm going to try to do in this example start with an example that we are all familiar with. Let's assume you are starting to deliver you are starting a business delivering pizza and a salad. So that's what you do. You make pizza and a salad and you deliver that to working people okay that's that's what you want to do. And here are the ingredient for your pizza and your salad okay and these are the instructions well obviously you need labor to do so so you cannot do this by yourself. Okay so this is what you're going to be making pizza and salad and delivering pizza and salad to people. So here's what's going to happen. So based on this information I'm going to kind of make up some numbers okay and tell you what are your standard. So your direct material standard. So what I did I added up I added up all the weight for the ingredient and just just make it I'm just making things up. So you need one pound of material of direct material and I add up all the prices here are all the prices for that pound and you need for that you need to pay four dollars and eighty eight cents for the material which is direct material per one pizza is four dollars and eighty eight cents. Also for the this is for the direct material for the direct labor you need one hour okay and you can hire someone at ten dollar per hour so it's going to cost you ten dollars. So all in all you have direct labor and direct materials of fourteen dollars and eighty eight cents. Now keep in mind you're going to be producing high quality pizza and high quality salad that people are willing to pay for it and you're going to deliver it for that matter okay that's your business. So now let's see let's work some work some numbers and see what's going to happen. Let's assume you purchased you purchased and used for that matter and used so let me just make sure and used 500 pounds for the month of June 500 pounds of material for the month of June you paid five dollars per pound so to buy the material you paid five dollars per pound and you thought you were going to pay four eighty eight based on this based on this this thing that you find online the price was a little bit higher for some of the ingredients you had we happened to pay five dollars that's fine and notice you use that you use that all up and let's also let's assume also you produced 400 pizzas and salads so you produce 400 pizzas and salad and we're going to assume those are the same unit pizzas and salad you're producing pizza and salad is one unit you produce 400 meals more or less all right now we need to know what happened in terms of variances did you exactly follow the recipe what happened so i'm going to show you how you will need to solve this problem okay and basically if you if you follow this if you follow this you should be good to go so here's what's going to happen i'm going to show you a three column method first what you do is you have a column called actual okay and under the actual you're going to take your actual quantity times the actual price and it's your actual quantity how much you actually use times the actual price this is column one i'm going to have column three obviously there's column two in between and column three you're going to be using the standard and i'm going to call this actual quantity ap and actual actual quantity aq and actual price ap you're going to be using standard quantity sq times the standard price sp okay in the third column and the column in the middle here's what's going to happen so when you do variances here what we're going to do for each item we're going to keep one constant and change the other so what's going to happen in the middle we're going to go with actual quantity which is this item here actual quantity times this item here standard price actual quantity times the standard price so if you set up your formulas like this and you're i'm going to explain this a little bit further what i did okay so let's try to punch in some numbers and see what we did so for the first column further let's compare column one and column two let's compare one and two once again notice the actual quantity is the same or what you did is you change the price so any any change between those two column has to do with the price because all what you did is you change the price the quantity is the same all right so let's see what was the actual quantity that you used you used 500 pounds of material and what was the actual price how much did you pay you paid five dollars therefore your actual price your actual column will have 2500 what was the actual quantity that you used 500 dollars how much you should have paid you should have paid four dollars and 88 cent so if we take 500 times times 500 times clear 500 times 0.488 that's gonna give us 2440 what does that mean well it means the difference between those two and we already know it's unfavorable why because we thought we're gonna pay 488 but we paid five dollars so 2500 minus 2440 we have a 60 dollars unfavorable price variance simply but we paid little bit more than what we should have little bit more 60 dollar more it's not a big deal let's move on and compare column two to column three column two already prepared column two 2440 let's look at column three column three is the standard quantity i produced 400 pizzas well for my standard quantity i should have 400 pizzas and and 400 pizzas right and one pound per pizza so i'm gonna be using 400 and my standard price my standard price should have been four dollars and 88 cent well what's 400 well what's 400 times 400 times 4.88 that's 1,952 wow so all right let's see now we're gonna compare 1,952 to 2,440 you'll find the difference let's find the difference first 2440 minus 1,952 and that's 488 dollars is this favorable or unfavorable and i hope you know it's unfavorable because to make to make 400 pizzas we need 400 pounds but we actually used as 500 pounds so that basically our employee in the process they basically lost 100 pound maybe they were making the pizza it wasn't good they throw it away they were making the salad it didn't come out right they throw the material away so there's a lot of wastage that's what we're saying here okay so this is the usage usage has to do with quantity so this is quantity this is the quantity variance and this is the price variance so on both ends we were not good so the price it wasn't that bad 60 dollars but the usage we need to train those employees those employees are either not trained not supervised some something's wrong we gave them 500 pounds of material based on our recipe they should be able to make 500 pizzas they only made 400 pizzas and i'm assuming here that all that the all the material was used if all the material was not used then it would have been a little bit different let's assume we only used well let's finish this let's finish this example before we make any assumptions so what is the total variance the total variance the gather is 488 plus 60 and it's 548 dollars unfavorable we're doing something wrong okay especially with the usage variance now let's assume just let's let's assume for the sake of the example that we only used remember we purchased 500 let's assume we only used 450 pounds then the the middle column what we need to do here the middle column the middle column what we do when we do the usage variance will take 400 we would have took if we used only 450 pound we would have used 450 times 4.88 when we're making the comparison between two and three okay so the comparison between one and two will stay the same because what we purchased is what we purchased but the usage if let's assume we only used 450 in this example i said i bought 500 and i used 500 okay but if i said i only used 450 when you compare two and three you would use the usage what you actually use for the usage comparison so let's just okay good so that's that so we did really bad on this now for the labor we need to do the same thing the same analysis for the labor see how bad or how good the labor variance is well the material was no good let's look at the labor the labor we use the same exact concept we use actual quantity times actual price standard quantity times the standard price okay so we use the same concept and i'm gonna abbreviate here we're gonna be using for column one actual quantity times actual price column three standard quantity times standard price and in between actual quantity times standard price actual quantity times standard price now what are we gonna be what assumption are what are we gonna be making here i'm gonna assume that we spend the employees that we hire spend 350 hours to make those pizzas times one because we need one hour per pizza and we pay them eight dollars wow 350 times 8 2800 so remember when i first started this problem i said i'm gonna hire someone at 10 dollars so guess what i had a lot of people coming and said i can do this for you i can do this for you had a lot of i have a lot of supplies so you know i said let me lower my price let me offer them eight dollars and they took it they took the eight dollars that's fine what was my standard quantity my standard quantity was if i needed to produce 400 pizzas 400 pizzas times one hour per pizza that's gonna give me 400 times 10 dollars i should pay 10 dollars i am go i was i was supposed to pay for 400 pizzas four thousand dollars okay this is the standard quantity this is the actual so this is the actual and this is the standard now let's take the actual 350 times the standard equal to 3500 we're gonna do the same exact comparison again we're gonna look at column one and column two sir one we have column one right here column two and column three and we're gonna compare column one and column two and this is gonna give us the rate variance rate variance if we look at look at the difference 3500 minus 2800 i saved 700 dollars this is favorable variance and let me let me let me take let's look at it from a different perspective i saved two dollars per hour and they worked for me 350 hours therefore i saved 700 dollars so on the labor i got cheaper labor this could explain this could explain why my material usage was bad okay because maybe i paid for a cheap labor and i'm paying i paid the price now for the efficiency how efficient were they i'm gonna have to compare two and three so this is the rate the rate variance and the other variance it's the efficiency variance again not usage we call it efficiency efficiency efficiency so the difference between four thousand and four thousand and three thousand five hundred is five hundred that's also favorable that's also favorable okay that's also favorable there is 500 other favorable because i spend less time than i should have well that's also favorable so together we have 1200 favorable variance when it comes to labor wow they worked fast these people were trying to impress me so they work fast that could also explain because they work fast they could also explain the problem with the usage they did work fast they did work fast but they wasted a lot of money so what should i do under those circumstances well i'm gonna ask them to keep working fast i just we need i need to cut down on the material usage make them more efficient for next month so this is how i this is how i analyze my variances also i paid 60 more that's my fault you know i'm the owner i'm the one who made the purchases so maybe i need to find something cheaper okay now this is basically how what you could do how you can use this now i'm gonna go ahead and work another example just that's kind of um just for for illustration purposes so let's assume we have the following standard we have we are making frames and direct material we need four pounds and the cost the input cost for us is 55 cent so it's gonna cost us material per frame 222 we need to put the frame together 0.05 of an hour real quick we're gonna have to pay someone 20 dollars so uh 20 dollars time 0.05 it's gonna cost us one dollar and direct labor so this is what we're gonna be producing this frame right here so let's take a look at what we have here and what we can do and again what you should do here you should go with column one column two and column three so you know see if you can see if you can see if you can solve this problem so what happened is this the standard cost the standard cost for us for the sake of this example the standard cost was uh four pound at 55 cent per pound 220 okay we happen to produce 80 thousand pounds let's do this real quick so let me just go through column one column two and column three for this example column one column one actual quantity well let's let's since we have column three readily available so we produce 80 thousand frame and it should it should cost us it should cost us uh if 80 thousand frame we use four pound per frame four pound per frame um 80 thousand frames times four pounds that's three how many how many pounds is this times four equal to 320 thousand times 0.55 that's equal to let me just do this real quick three hundred and twenty two thousand pound times 0.55 that's 176 thousand so standard quantity times standard price should have been 322 thousand times 55 pennies which it should be 176 thousand um what we actually use is 300 actual pound used 328 so let's just put the formula again actual quantity times actual price actual quantity is 328 thousand times 0.6 times 0.6 so this is going to be 196 thousand 800 dollars so this is the column one the actual and in the middle what's going to happen is in the middle we're going to have actual quantity which is 328 thousand pound times the standard price which is 55 pennies and that's equal to 180 thousand 400 dollars now all we have to do is compare column one to column two okay which is what do we call this we call this the price variance the price variance we already know we paid a little bit more we know we know we already paid a little bit more what's the difference between what's the difference between column one and column two 196 thousand 800 minus 180 thousand 400 16 thousand 400 16 thousand 400 and that's unfavorable and we already know this okay we already know this and let me just show you this real quick this is actual quantity times standard price if you take those two formulas what you can do you can factor out the actual quantity you can factor out the actual quantity so actual quantity times the difference in the price standard price minus actual price okay which is 0.05 0.05 times the actual quantity 328 thousand so this is basically a short cut to this okay so if you take 328 thousand pound times 0.05 we'll give you 16 400 this is the price the usage variance let's see if we use more or less let's first find the difference between the two 180 thousand 400 minus 176 thousand that's 4400 that's 4400 we were supposed to use 320 thousand pound we actually used 328 that's unfavorable okay because remember remember that the 55 pennies is constant in this in this so so we change the other one notice here if we take actual quantity times standard price minus standard quantity times standard price we can factor out the standard price standard price if we factor out the standard price its actual quantity minus the standard quantity okay so we find the difference in the quantity times the standard price it's going to give us 4400 also unfavorable so let's take a look at the solution this is basically we are talking about here, actual quantity times actual price, standard quantity times the standard price, and actual quantity times the standard price in the middle, the difference is unfavorable and unfavorable for both. The price difference is unfavorable and the efficiency or the usage is unfavorable. Now let's take a look at the labor. The labor cost, the labor cost is 0.05 per frame times $20. It's going to cost us $1 per frame. We produced $80,000 frame, it should cost us, that's easy, $80,000. Actual hour work, $4,400. Average cost, we paid on average $18. Okay, let's do this. This is column one, the actual quantity times actual labor price. Actual quantity, which is $4,400. We spend times, we paid actually $18. This is the column one. Column three, the standard quantity, we should have spent $4,000 because we produced $4,000 frame and we should have paid $20 per labor time, which is $4,000 times $20 is $80,000. So this is column three. Now what we have to do is find the difference between column one and column two, and it's going to give me the price variance, and the difference between column two and column three, it's going to give me the efficiency variance. So I'm going to have to take actual quantity times standard labor price, actual quantity $4,400 times the standard price times the standard price, which is $20. That gave me $8,000, $88,000. So if I compare $88,000 to $79,200, I have a favorable variance of $8,800. And I should notice it's going to be favorable. Why? Because I saved $2 per hour. I saved $2 per hour because I thought I was going to pay $20. I paid $18. I saved $2 per hour times they work for me $4,400. Therefore, I saved that much. Now once again, let me show you the formula that I showed you earlier. Maybe here it's clearer. Notice if I take those two formulas, okay, if I take this formula and this formula, what I can do, I can factor out, notice the actual quantity is a common between the two. If I take the actual quantity times the standard price minus the actual price, $20 minus $18 gives me $2 and the actual quantity was $4,400. I have a variance of $8,800 and it's favorable. Now let's compare column two to column three. I already have column two, column three, standard quantity times the standard price, and I find the difference and it's $8,000. Is it favorable or is it unfavorable? Well, I was supposed to use $4,000 hours to produce those $80,000 frame. I actually incur $4,800. It means the variance is unfavorable by $8,000. Once again, let me show you how another way to look at this formula. We have this formula minus this formula. If we have this formula minus this formula, what's common between the two is standard price. If I take the standard price factor out times the difference between because we're subtracting those two, sorry, to the actual quantity minus standard quantity, and the difference between them is $400 and the standard price is $20. That's going to give me $8,000. That's unfavorable. That's unfavorable. Overall, what does that mean? What does that mean? It means when it comes to the labor, I got a cheaper labor, $2 cheaper, but they were not efficient. Again, I hired cheap labor. Overall, my labor is inefficient. I'm sorry, I saved $800 on my labor, but for my usage, big mistake. Big mistake that labor wasn't good because my material variance was really bad. Overall, if I take overall variance, $20,800 minus, which is negative, and I saved $800 on the labor, I'm still down $20,000 on this project. Not good at all, but this is how you break down the direct material and the direct labor variance, which is a topic you will see in your managerial accounting as well, cost accounting, as well as on the CPA exam, as well on the CMA exam. If you have any questions, any comments by all means, email me or see me in class. If you're studying for your CPA, study hard, it's worth it.