[ Music ] >> Now moving into lesson 3-2. Our objectives in this lesson are to understand materials, labor and overhead variance calculations. So our variable cost variances. We'll get into the nuances of how we calculate those. We'll do the same thing for fixed cost variance calculations. And then we'll talk about interpreting these cost variances, as we calculate them. So let's introduce an example scenario. Let's suppose that a company, for a given month or other time period, has the following standard cost information. They have three categories of variable costs: materials, labor and variable overhead. And let's suppose that they have just a single input of material. Each unit that they produce is supposed to use 6 pounds of that material. That's its standard input. And we are supposed to spend, approximately 50 cents per pound; that's our standard price. In terms of labor, we measure this activity in terms of direct labor hours. And each unit that we produce is supposed to take 1 direct labor hour. On average, we pay our employees $8 per each of those direct labor hours. And for variable overhead, we have a cost driver that we've identified to estimate the usage of overhead resources. And for this we use machine hours. Our standard usage of machine hours per unit is 1 machine hour. And our cost, per machine hour, in terms of variable overhead costs, is $2 per machine hour. In terms of production, at the beginning of the period, we estimated that we would produce 4,750 units. At the end of the period, we found that we only produced 4,250. And in terms of actual cost incurred throughout the accounting period, direct material, the total cost incurred was $12,750 and we actually used 26,100 pounds of material, in completing the 4,250 units of production. In terms of direct labor, we actually spent a total of $34,445, and we actually used 4,150 direct labor hours. And for variable overhead, we actually incurred cost of $10,100. And we used 4,700 machine hours to complete the production. So let's first calculate the variances for direct materials. So when I'm creating these variances, I start with what we know at the beginning of the accounting period, and that would be our static budget. So beginning with our static budget, we talked in the previous lesson about their being three components to the overall budgeted amount. The first is the standard price. And per the given information, we were told that the standard price is 50 cents per pound. The standard input per output was 6 pounds per output unit. And at the beginning of the period, we estimated that we were going to produce 4,750 units of output. When we multiply those three components together, we get the total direct materials spending static budget. And that total is $14,250. Now, given what we know at the end of the accounting period, we can calculate what we actually incurred. And we can take each of our individual components and parse out them as sources of our overall variants. So our first column, moving from right to left, was called the "flexible budget", flex column. And the only thing that was different between the flexible budget column, and the static budget column was the outputs produced. Everything else was as originally reported. So we use the standard price of 50 cents, we use the standard input of 6 pounds, but we change our output from the standard output that we had at the beginning of the accounting period, and use what we actually produced. And that, per the information provided was 4,250 units that we actually produced. So given what our actual production level was, in terms of units of output, we should have spent $12,750. Again, this is the amount we should have spent given our standard price, and our standard usage, or standard input, given how many units we actually produced. By comparing the flexible column, and the static column, we're focused on one single source of difference in the overall variance, and that is, due to the level of production being different than originally planned. So now let's parse out further ones. We called this second column, or the third column from the right, the standard price column. That reminded me that I should use the standard price of 50 cents per pound. We're changing our standard input to actual input in this column. Now looking back at the example, we were told that we used 26,100 pounds to produce all of our units of output. So on average, we used 26,100 divided by the 4,250 units that we actually produced. That was our input per unit of output. And then we actually produced 4,250. So when we multiply that actual input and the act per unit, and the actual output in total units, times the standard price, we're given $13,050 as the column total there. And then our actual spending was just given to us, as a total amount. And per the given information, that was $12,750. So now that we've completed our framework, we can calculate each of the individual variances. The difference between the actual column and the standard price column is $300. That is the amount of variance that's due to the fluctuation in the actual price per unit of input, and the standard price per input. The difference between the second and third columns is our efficiency variance. That is also $300. And that difference is due to the fact that we used a different number of inputs per output than we had planned and created as a standard. And finally, the difference between the third and fourth column, has to do with the activity. The fact that we produced a different number of units than we had planned and created as a standard. And that amount is $1,500. Now one thing that we have yet to do is to calculate, or categorize these variances as favorable or unfavorable. So let's talk about that for an instance. Let's look at the difference between the flexible budget and the static budget. In the static budget, everything is at standard. So that's our completely static budget world; every piece of information is at the standard level. In the flexible column, the price that we use is standard, the input that we use is standard, and the output that we use is actual. So comparing just these two columns, the more actual piece of information is represented in the flexible budget column, at least compared to the static budget column. So the static budget column is our complete, our standard world, or budgeted world, and the flexible column is our pseudo-actual world. Well, these are costs. These are direct materials costs. And so, in our pseudo-actual world, the cost was $12,750. In our pseudo-standard world, the static budget column, the cost was $14,250. This means, as we move from more of a standard world, or budgeted world, to a more actual world, costs decreased. The cost in the flexible column is less than the cost in the static column. This means that relative to planned or standard net income, the more actual net income would be higher. Since costs are less, all else equal, net income would be higher. And we characterize that as a favorable variance. Now, in classifying the efficiency variance, the $300 in the middle, we're looking at the two columns labeled standard price and flexible. And as we did before, in the flexible column, we have a standard piece of information, a standard piece of information, and an actual piece of information. In the standard price column, we have a standard, an actual, and an actual piece of information. So in comparing these two columns, the standard price column is the more actual world. And the flexible column is the more standard world, relative to each other. So in this case, the more standard world, $12,750 is less than the more actual world, of $13,050. And in this case, we have the opposite scenario to the first variance that we calculated and classified. In this case the more actual world has higher costs, by $300. That means that relative to a standard comparison point, we're going to have less net income. When costs are higher, all else equal, net income will be lower. So we'll classify this variance as unfavorable. And finally, comparing the first and the second column, on the left hand side, we have the complete actual world, and the standard price world. Which one is the more actual piece of information? Well, that's the one that's all actual. So, comparing the $12,750 that we actually spent to the benchmark which has more standard information embedded into it, the standard price piece, the cost is actually less in the more actual world, than it is in the standard world. And that's the case if costs are less, compared to standard, then all else equal, net income will be higher. So therefore, this $300 spending variance is classified as favorable. Now, two points to make here. Recall in lesson 1, that we talked about the fact that favorable doesn't always mean good, and unfavorable doesn't always mean bad. And the activity variance that we calculated initially, is a perfect example of that. While our costs were less, and therefore, all else equal, our net income would be higher, in the more actual world, this variance doesn't necessarily signal a good situation. We produce less, perhaps, because the demand for our product was less. So until you identify the reason for the variance existing, you can't really understand if the situation is desirable or not. We've only classified these variances as unfavorable or favorable, given their effect on, or given their speaking to the difference between actual and standard amounts. And another point to make is that, if we did not engage in this variance analysis, we would be disguising the fact that there are two variances, or two sources of variances that are off-setting each other perfectly. That is, if we just compare the $12,750 to the $14,250 that we had budgeted, then we might say, "Oh, that's close enough." But what we're not seeing, if we don't calculate these detailed variances, is that we have a price variance that's exactly off-setting an efficiency variance. Now the total amount of $300 may or may not be material, but the spirit of the example is that different variances can offset one another, and until you compute the variances at a deep level, you may not understand that completely.