Production variances

What Are Production Variances?

Production variances represent the differences between the actual costs incurred in a manufacturing or service process and the predetermined, expected costs (known as standard cost). They are a core component of managerial accounting, specifically cost accounting, designed to help businesses monitor and control expenses related to production. By comparing what was expected to what actually happened, companies can identify inefficiencies, track performance, and make informed decisions regarding cost control and operational improvements.

History and Origin

The roots of modern cost accounting and, by extension, production variances, can be traced back to the Industrial Revolution. As businesses grew in complexity and manufacturing processes became more elaborate, a greater need arose for detailed information beyond simple financial statements to manage internal operations effectively. Early forms of cost accounting emerged in the 19th century to help manufacturers calculate the cost of goods produced, set prices, and control expenditures. The concept of "standard costs" and subsequent variance analysis began to take more formal shape in the early 20th century, notably influenced by the efficiency movement. Pioneers like Harrington Emerson, a contemporary of Frederick Winslow Taylor, advocated for comparing actual outcomes against predetermined standards to pinpoint deviations and improve industrial efficiency. This move from merely recording actual cost to proactive cost management marked a significant evolution in business practices, allowing for more granular insights into production performance.⁶

Key Takeaways

Deviation from Standard: Production variances measure the difference between actual production costs and established standard costs.
Performance Monitoring: They serve as a vital tool for monitoring operational efficiency and identifying areas requiring management attention.
Categories: Common production variances include those for direct materials, direct labor, and overhead.
Favorable vs. Unfavorable: Variances are classified as favorable (actual cost less than standard) or unfavorable (actual cost greater than standard).
Actionable Insights: Analyzing production variances helps management understand why costs differed and guides corrective decision-making.

Formula and Calculation

Production variances are typically calculated for each element of production cost: direct materials, direct labor, variable overhead, and fixed overhead. The general approach involves comparing the actual quantity or rate used at actual prices to the standard quantity or rate allowed at standard prices.

Direct Material Variances

Direct Material Price Variance (DMPV): Measures the difference between the actual price paid for materials and the standard price, multiplied by the actual quantity purchased.
$DMPV = (AP - SP) \times AQ$ $D MP V = (A P - SP) \times A Q$
Where:
- (AP) = Actual Price per unit of material
- (SP) = Standard Price per unit of material
- (AQ) = Actual Quantity of material purchased
Direct Material Quantity Variance (DMQV): Measures the difference between the actual quantity of materials used and the standard quantity allowed for actual production, multiplied by the standard price.
$DMQV = (AQ - SQ) \times SP$ $D MQ V = (A Q - SQ) \times SP$
Where:
- (AQ) = Actual Quantity of material used
- (SQ) = Standard Quantity of material allowed for actual production
- (SP) = Standard Price per unit of material

Direct Labor Variances

Direct Labor Rate Variance (DLRV): Measures the difference between the actual labor rate paid and the standard labor rate, multiplied by the actual hours worked.
$DLRV = (AR - SR) \times AH$ $D L R V = (A R - SR) \times A H$
Where:
- (AR) = Actual Rate per hour
- (SR) = Standard Rate per hour
- (AH) = Actual Hours worked
Direct Labor Efficiency Variance (DLEV): Measures the difference between the actual hours worked and the standard hours allowed for actual production, multiplied by the standard rate.
$DLEV = (AH - SH) \times SR$ $D L E V = (A H - S H) \times SR$
Where:
- (AH) = Actual Hours worked
- (SH) = Standard Hours allowed for actual production
- (SR) = Standard Rate per hour

Variable Overhead Variances

Variable Overhead Rate Variance (VORV): Measures the difference between the actual variable overhead rate and the standard variable overhead rate, multiplied by the actual activity base (e.g., actual direct labor hours).
$VORV = (AR - SR) \times AA$ $V OR V = (A R - SR) \times AA$
Where:
- (AR) = Actual Variable Overhead Rate
- (SR) = Standard Variable Overhead Rate
- (AA) = Actual Activity (e.g., actual direct labor hours)
Variable Overhead Efficiency Variance (VOEV): Measures the difference between the actual activity base and the standard activity base allowed for actual production, multiplied by the standard variable overhead rate.
$VOEV = (AA - SA) \times SR$ $V OE V = (AA - S A) \times SR$
Where:
- (AA) = Actual Activity
- (SA) = Standard Activity allowed for actual production
- (SR) = Standard Variable Overhead Rate

Fixed Overhead Variances

Fixed Overhead Budget Variance (FOBV): Measures the difference between the actual fixed overhead costs and the budgeted fixed overhead costs.
$FOBV = Actual~Fixed~Overhead - Budgeted~Fixed~Overhead$
Fixed Overhead Volume Variance (FOVV): Measures the difference between the standard hours allowed for actual production and the normal capacity hours, multiplied by the standard fixed overhead rate.
$FOVV = (Normal~Capacity~Hours - Standard~Hours~Allowed) \times Standard~Fixed~Overhead~Rate$

Interpreting Production Variances

Interpreting production variances involves more than just noting a positive or negative number; it requires understanding the underlying causes. A "favorable" variance means that actual costs were less than standard, potentially indicating good cost control or higher than expected efficiency. Conversely, an "unfavorable" variance means actual costs exceeded standard, signaling potential problems like waste, higher prices, or lower efficiency.

For example, an unfavorable direct material price variance might be due to unexpected increases in raw material costs, while an unfavorable direct labor efficiency variance could result from poorly trained workers or machine breakdowns. Management uses these insights for performance management to address issues, refine budgeting processes, and continuously improve operations. It's crucial to investigate the root causes rather than simply assigning blame, as a favorable variance in one area might be offset by an unfavorable variance elsewhere, or even hide an underlying problem.

Hypothetical Example

Consider "Apex Manufacturing," a company that produces custom furniture. They have established the following standards for producing one wooden chair:

Direct Materials (Wood): 10 board feet at a standard cost of $5 per board foot.
Direct Labor: 2 hours at a standard rate of $20 per hour.

In July, Apex Manufacturing produced 500 chairs. Their actual costs were:

Direct Materials: 5,200 board feet purchased and used at an actual cost of $5.20 per board foot.
Direct Labor: 1,050 hours worked at an actual rate of $21 per hour.

Let's calculate the direct material and direct labor production variances:

Direct Material Variances:

Direct Material Price Variance (DMPV):
- $DMPV = (Actual~Price - Standard~Price) \times Actual~Quantity~Purchased$
- $DMPV = (\$5.20 - \$5.00) \times 5,200~board~feet$
- $DMPV = \$0.20 \times 5,200$
- $DMPV = \$1,040~Unfavorable$
- Interpretation: Apex paid $0.20 more per board foot than expected for 5,200 board feet, leading to an unfavorable price variance.
Direct Material Quantity Variance (DMQV):
- Standard Quantity Allowed for 500 chairs = (500~~chairs \times 10~~board~~feet/chair = 5,000~~board~feet)
- $DMQV = (Actual~Quantity~Used - Standard~Quantity~Allowed) \times Standard~Price$
- $DMQV = (5,200~board~feet - 5,000~board~feet) \times \$5.00$
- $DMQV = 200~board~feet \times \$5.00$
- $DMQV = \$1,000~Unfavorable$
- Interpretation: Apex used 200 board feet more than standard to produce 500 chairs, resulting in an unfavorable quantity variance. This could impact overall profitability.

Direct Labor Variances:

Direct Labor Rate Variance (DLRV):
- $DLRV = (Actual~Rate - Standard~Rate) \times Actual~Hours$
- $DLRV = (\$21 - \$20) \times 1,050~hours$
- $DLRV = \$1 \times 1,050$
- $DLRV = \$1,050~Unfavorable$
- Interpretation: Apex paid $1 more per hour than expected for 1,050 hours, causing an unfavorable rate variance.
Direct Labor Efficiency Variance (DLEV):
- Standard Hours Allowed for 500 chairs = (500~~chairs \times 2~~hours/chair = 1,000~hours)
- $DLEV = (Actual~Hours - Standard~Hours~Allowed) \times Standard~Rate$
- $DLEV = (1,050~hours - 1,000~hours) \times \$20$
- $DLEV = 50~hours \times \$20$
- $DLEV = \$1,000~Unfavorable$
- Interpretation: Apex used 50 more hours than standard to produce 500 chairs, leading to an unfavorable efficiency variance.

This example illustrates how production variances highlight specific areas where actual performance deviates from expectations, prompting further investigation.

Practical Applications

Production variances are widely used across various industries, particularly in manufacturing, but also in service-oriented businesses where costs can be standardized. Their practical applications include:

Performance Evaluation: Managers and departments are often evaluated based on their ability to manage costs within standard allowances. Favorable or unfavorable production variances provide a quantifiable measure of their effectiveness in cost control and resource utilization.
Budgeting and Forecasting: Historical variance data can inform future budgeting processes, leading to more realistic and accurate financial plans. If certain variances consistently occur, it may signal a need to revise standard cost estimates or production methods.
Pricing Decisions: Understanding the true cost of production, as revealed by variance analysis, is crucial for setting competitive and profitable selling prices for products or services.
Process Improvement: Significant unfavorable variances can trigger investigations into production processes, identifying root causes such as inefficient machinery, material defects, or inadequate employee training. This allows companies to implement corrective actions to improve efficiency and reduce waste.
Internal Controls and Accountability: The systematic calculation and review of production variances support strong internal controls by providing a feedback mechanism for financial and operational accountability.³, ⁴, ⁵ This also ties into overall financial performance monitoring. Management accounting, which includes variance analysis, is a profession that involves partnering in decision-making, devising planning and performance management systems, and providing expertise in financial reporting and control to assist management in the formulation and implementation of an organization's strategy.²

Limitations and Criticisms

While production variances offer valuable insights, they also have limitations and have faced criticisms:

Timeliness: Variance reports are often generated after the production period has ended, meaning the information may be historical rather than real-time. This can limit their usefulness for immediate corrective action. In fast-paced production environments, by the time a variance is analyzed, the underlying issue might have already been resolved or changed, or it might be too late to prevent further cost overruns.
Oversimplification and Blame: Focusing solely on favorable or unfavorable variances can lead to oversimplification of complex operational issues. Managers might be tempted to "manage to the variances" rather than truly optimizing processes, or they might assign blame without a thorough understanding of interconnected factors. For instance, a favorable material price variance might be due to purchasing lower-quality materials that then lead to unfavorable quantity or labor efficiency variances later in the production process.
Standard Setting Challenges: Establishing accurate and realistic standard cost can be challenging. Standards that are too tight can demoralize employees, while standards that are too loose can mask inefficiencies. External factors, such as sudden changes in material prices or labor markets, can quickly render established standards obsolete.
Cost of Analysis: The process of collecting data, calculating, and analyzing numerous production variances can be time-consuming and expensive, potentially outweighing the benefits for smaller organizations or less complex operations.
Focus on Cost Reduction Only: An overemphasis on minimizing unfavorable variances might discourage innovation or investment in long-term improvements if they initially cause unfavorable short-term variances. Some academic discussions have even suggested a "decline" in the traditional role of management accounting, potentially due to these rigidities and the rise of more dynamic performance measurement systems.¹

Production Variances vs. Sales Variances

While both production variances and sales variances are types of variance analysis used in managerial accounting, they focus on different aspects of a business's operations and financial performance.

Production Variances deal exclusively with the costs incurred during the manufacturing or service delivery process. They compare the actual costs of inputs (like direct materials, direct labor, and overhead) to the standard cost expected for the actual output achieved. The primary goal of production variance analysis is to assess the efficiency and effectiveness of resource utilization in operations and cost control.

Sales Variances, on the other hand, focus on the revenue side of the business. They compare actual sales revenue or volume to budgeted or standard sales revenue or volume. Key sales variances include sales price variance (comparing actual selling price to standard selling price) and sales volume variance (comparing actual units sold to budgeted units sold). The purpose of sales variance analysis is to evaluate the effectiveness of sales and marketing efforts and understand how deviations from sales targets impact overall profitability.

In essence, production variances look inward at the efficiency of making a product or delivering a service, while sales variances look outward at the effectiveness of selling that product or service. Both are crucial for a holistic understanding of a company's financial results.

FAQs

What causes an unfavorable production variance?

An unfavorable production variance occurs when actual costs are higher than standard cost. This can be caused by various factors, such as paying more for direct materials or direct labor, using more materials than planned due to waste or defects, or working more hours than expected due to inefficiencies or machine breakdowns.

Are favorable variances always good?

Not necessarily. While a favorable variance means actual costs were less than standard, it's important to investigate why. For example, a favorable material price variance might occur if cheaper, lower-quality materials were purchased. These cheaper materials could then lead to more waste (unfavorable quantity variance) or require more labor to process (unfavorable labor efficiency variance), ultimately increasing overall costs or reducing product quality. A holistic view through variance analysis is essential.

How do companies use production variances for decision-making?

Companies use production variances to identify specific areas that deviate from planned performance. This information helps managers make informed decision-making regarding operational adjustments, resource allocation, and strategic planning. For instance, if labor efficiency variances are consistently unfavorable, management might invest in employee training or new equipment to improve productivity.