what clients don’t know about cost variances

you want the best information possible.

by ed mendlowitz
77 ways to wow!

when we discuss estimates – trailing amounts based on previous transactions and costs, it is important to have the amounts as accurate as possible to reduce the variances, but they will exist.

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the estimated costs will be measured at the end of a period, i.e., week, month, quarter or year, and the reasons should be investigated and reconciled.

illustration: absolute lowest cost on a special one-time-only job

use the following table and provide in column 2 a model showing the absolute lowest cost for a one-time-only special order for a quantity equivalent to 30 percent of next month’s average sales.

provide a brief explanation. then see suggested afterward. (no peeking.)

	column 1 normal model	column 2 special order model	explanation
+ actual cost of what is sold	$100.00
+ salaries of people making or adding to what is being sold (including taxes and benefits)	40.00
+ allocated portion of other or indirect labor	10.00
+ allocated factory, plant or warehouse overhead	12.00
+ packaging and shipping costs per item	9.00
+ commissions (2% of sales or $2.50 per item sold when a bargain sale is made)	5.00
+ selling costs allocated	4.00
+ administrative exp. allocated	15.00
+ interest costs allocated	5.00
total costs
+ desired profit (before income taxes)	50.00
= selling price	250.00

illustration: suggested response

estimated lowest absolute cost

	column 1 normal model	column 2 special order model	explanation
+ actual cost of what is sold	$100.00	100	cannot include a lower amount
+ salaries of people making or adding to what is being sold (including taxes and benefits)	40.00	15	assumed direct labor is “fixed” in that within given ranges it would not increase or decrease. in this situation it is assumed that overtime will be paid to the current workers. calculation is 25% addl. hours at time and a half.
+ allocated portion of other or indirect labor	10.00	4	same ratio as direct labor – rounded up
+ allocated factory, plant or warehouse overhead	12.00		no extra overhead
+ packaging and shipping costs per item	9.00	9	this is cost per unit
+ commissions (2% of sales or $2.50 per item sold when a bargain sale is made)	5.00	3	rounded up $2.50 per unit
+ selling costs allocated	4.00		no added selling costs
+ administrative exp. allocated	15.00		no added admin exp
+ interest costs allocated	5.00		no added interest
total costs	200	131
+ desired profit (before income taxes)	50.00
= selling price	250.00

report of direct labor cost variances

this report shows the calculation of direct labor variances.

illustration: calculation of direct labor variances

illustration of the explanation of direct labor variances from the above chart:

milling #1

standard: 40 hours at a cost of $1200 [1200 ÷ 40] = $30.00 standard cost per hour

actual: 35 hours at a cost of $1120 [1120 ÷ 35] = $32.00 actual cost per hour

difference in hours: 40 – 35 = 5 hours less than standard

performance variance:

5 hours at standard cost of $30.00 = $150.00 favorable variance (they spent 5 hours less than standard)

rate variance:

difference per hour: $2.00

35 actual hours: [35 x $2.00] = $70.00 unfavorable variance (the actual cost was $2.00 an hour higher than standard)

weighted average

weighted averages are used when there are products with different cost structures or gross profits (also referred to as gross margins). this provides an overall gross profit or gross margin percent. it is used to model the effect of changes in the sales of higher or lower gross profit products.

keep in mind that using percentages is an analytical tool, and the underlying issues are the generation of additional profits, or gross profits.

for example, the very large quantity of low-gross-profit products that are being sold are what cause the sales of the highest gross-profit products, because those sales are only received from a portion of the customers who buy the low-gross-profit products.

reducing the sales of low-gross-profit products will directly result in reduced sales of very high-gross-profit products. understanding the interactions and underlying dynamics is essential to being an effective manager.

weighted averages are also used in break-even analyses to determine overall margins when there are multiple products with different profit margins.

illustration: when the client is borrowing at three different rates

source	quoted interest rates	% of borrowing from each source	weighted average interest rate
1	5.00%	30.00%	1.50%
2	9.00%	25.00%	2.25%
3	16.00%	45.00%	7.20%
weighted average interest rate			10.95%

 

illustrations: weighted average

here are two illustrations showing the shift in sales from a higher-cost to a lower-cost product.

this illustration shows two alternatives.

1. the sales of products shifted from a higher-cost to a lower-cost product.
2. the lower-cost product’s sales were increased without affecting the higher-cost product’s sales.

1. the sales in products shifted from a higher-cost to a lower-cost product

	direct costs	% of total sales	wtd. avg. of direct costs	$ sales		direct costs	gross profit
food sales	40.00%	60.00%	24.00%	60,000		24,000	36,000
liquor and beer	30.00%	15.00%	4.50%	15,000		4,500	10,500
wine	20.00%	25.00%	5.00%	25,000		5,000	20,000
total		100.00%	33.50%	$100,000		$33,500	$66,500
weighted average profit margin			66.50%	$66,500

 

2. the lower-cost product’s sales were increased without affecting the higher-cost product’s sales

	direct costs	% of total sales	wtd. avg. of direct costs	total $ sales remain the same (they just shifted from food to wine)	sales of wine increase 20% and food sales remain the same	new direct costs	new gross profit
food sales	40.00%	40.00%	16.00%	50,000	60,000	24,000	36,000
liquor and beer	30.00%	15.00%	4.50%	15,000	15,000	4,500	10,500
wine	20.00%	45.00%	9.00%	35,000	30,000	6,000	24,000
total		100.00%	29.50%	$100,000	$105,000	$34,500	$70,500
weighted average profit margin			70.50%	$70,500
additional profit				$4,000

posted on august 14, 2023