Accounting for variances
/What is a Variance?
A variance is the difference between an actual measured result and a basis, such as a budgeted amount. In many accounting applications, a variance is considered to be the difference between an actual cost and a standard cost. There are a multitude of possible variances that can be reported to management, so the person reporting this information should be selective in only forwarding those variances that management can take action to correct. If a variance is insignificant or cannot be corrected in the future, there is less reason to present the information.
What is the Accounting for Variances?
There is usually no need to account for variances. A variance arises when actual results differ from expected results. There are detailed procedures available for reporting variances to management, along with the reasons for the variances. But this is simply internal reporting that does not impact the general ledger. This type of reporting is considered to be managerial reporting, as opposed to financial reporting.
For nearly all transactions, actual revenues and expenditures are being recorded, and accounting standards require that the actual monetary amounts associated with transactions be recorded and reported. When there is a variance from a budgeted amount, there is no need to record this variance, since the only number that matters is the one relating to the actual transaction, not the budget being used for comparison purposes.
Related AccountingTools Course
Standard Costs and Variance Analysis
Accounting for Inventory Variances
The exception is when transactions are initially recorded at their standard costs in the accounting records. This only happens when inventory is recorded at its standard cost, rather than its actual cost. If such is the case, and there is a variance from the standard cost, how do you account for the variance? The answer depends upon how well standard costs have been constructed. If the standards are well-researched and have been updated recently, any variances should be outside of the costing expectations of the business, and so should be recognized in the current period. Since the original transaction was already recorded at its standard cost, this means that there is no need to account for the variance.
What about the alternative, where the standard cost used to record a transaction is likely incorrect? If so, it is entirely possible that the standard should be adjusted to reflect recent conditions, which means that there should be no variance. If the accountant recognizes that this type of variance is based on an incorrect standard, then there should be a journal entry to adjust the standard cost of the inventory item. This type of adjustment is only likely to arise if there is an ongoing program of actively investigating why variances are occurring.
Example of the Accounting for Inventory Variances
The company produces 500 units of a product during the period.
Standard Costs:
Direct Material Standard:
2 kg of material per unit × $5 per kg = $10 per unit
Total standard direct material = 500 units × $10 = $5,000
Direct Labor Standard:
1.5 hours per unit × $12 per hour = $18 per unit
Total standard direct labor = 500 units × $18 = $9,000
Actual Results:
Direct Material:
1,050 kg of material were purchased and used (instead of 1,000 kg standard)
Actual price paid = $5.20 per kg
Actual material cost = 1,050 kg × $5.20 = $5,460
Direct Labor:
770 direct labor hours were worked (instead of 750 standard)
Actual labor rate = $11.50 per hour
Actual labor cost = 770 hours × $11.50 = $8,855
Step 1. Direct Material Variance Calculation:
Material Price Variance
= (Standard Price - Actual Price) × Actual Quantity
= ($5.00 - $5.20) × 1,050 kg
= $210 UnfavorableMaterial Usage Variance
= (Standard Quantity - Actual Quantity) × Standard Price
= (1,000 kg - 1,050 kg) × $5.00
= $250 Unfavorable
Step 2. Direct Labor Variance Calculation:
Labor Rate Variance
= (Standard Rate - Actual Rate) × Actual Hours
= ($12.00 - $11.50) × 770 hours
= $385 FavorableLabor Efficiency Variance
= (Standard Hours - Actual Hours) × Standard Rate
= (750 hours - 770 hours) × $12.00
= $240 Unfavorable
Step 3. Accounting for Inventory Variances:
The standard costs used by the company were well-designed, so these two variances can be considered anomalies that should be charged to expense in the current period. The net of the two variances is $145 favorable, which reduces the cost of goods sold for the current period.