Variances and Interrelationship between Labour Rates - Case Study Example

MANAGEMENT ACCOUNTING Reasons Why the Variances May Have Occurred and the Interrelationship between Them Labour Rate Variance The disparity in the real time spent to create or manufacture a given quantity of units and the time permitted by the standards to make that quantity of units multiplied by the standard direct rate of labour is known as the direct labour efficiency variance. It is also known as the direct quantity variance. In a similar way as direct labour rate variance, this might be unfavourable variance or favourable variance. In case employees make a given number of units in quantities or duration of time that is less than the length of time required by standards for that same quantity of units, this variance may be termed as favorable direct labour efficiency variance. In contrast, unfavorable direct labour efficiency variance arises when the employees consume more amount of time than is stipulated by the standards of the company (LiDestri, Picone & Minà, 2012; p. 87). The variance might occur for various reasons. Some of the regular reasons that might result in unfavourable direct labor efficiency variance include recruitment and use of workers without experience or technical knowledge of the job or poorly motivated employees may work with less enthusiasm. At times, the equipment being used may be faulty, slowing down employees in the production department. Similarly, the company might buy low quality or direct materials that cannot be sustained or still the materials might be in low quantity to accomplish the desired production. Lack of strict supervision may make some employees complacent in their duties, which might be doubled with regular breakdowns of machines that further deteriorate the situation. Lastly, inadequate demand for the products of the company and application of the just-in-time system in time system of manufacturing will lead unfavorable direct labour rate efficiency variance. These are some of the reasons that might have caused the variance in the direct labour rate in part (a). Material Variance The material price variance occurs when there is a deviation of the real price exchanged for the materials from what was actually predetermined by the company as standard price. Direct materials quantity and price averages are determined upon taking into consideration the present market prices and the expected variation in the price of the materials in the foreseeable future. Nonetheless, events do not occur as anticipated (Drucker, 1999; p. 73). The definite cost of materials might considerably digress from the set price. Furthermore, the costs related with the order such as duties, freight and handling costs might rise up or decrease the cost of materials accessible for utilization. The company might also be forced to pay increased or reduced cost as opposed to the standard price at the time of determining what is taken as normal prices. In the event the real cost exchanged for the materials is way above what is considered as normal price, there occurs unfavorable materials price variance. Alternatively, in the event the real cost exchanged for the materials is less than what was considered as the normal price, there occurs favorable materials price variance for the business. Appreciation of the variance in price when the purchase of raw materials takes place offers more well-timed information for the administration in regard to the price of direct materials as well as the efficiency of the department of purchasing. Consequently, this strategy for determining the price variance has much to contribute to the success of the company. Nevertheless, in this scenario, the summation of the price variance as well as the quantity variance might not be similar to flexible budget variance with the exception of twist of fate or when the starting or final amounts of raw materials are nil. Rationales of Direct Materials Price Variance A scenario of unfavorable or favorable material price might take place based on various reasons such as: the order size, where huge orders might attract quantity discounts, which might lead to favorable price variance. Increase in price might raise the cost of inputs of the supplier hence in return the supplier increases the costs of materials leading to unfavorable variance. Urgent need of the materials may also increase the costs related to ordering for urgent materials. The quality of materials ordered may also influence price since high quality attract high costs compared to low quality materials. Inadequate setting of standards in connection to estimation and environmental screening in the process of setting standards might also attract high variances (Pauline, 2006; p. 44). Transportation costs also add up to the direct material price where any deviation in cost of transport might influence price of materials, which may lead to favorable or unfavorable variance. In addition, the contribution of just in time production of any given business will lead to frequent material shortage because of abrupt increase in the product demand hence higher costs related to urgent orders. Lastly, unpredictable suppliers where they may supply materials in low quantities that might result into extra costs. Accountability of the Variance The department of purchasing is accountable for placing of orders for direct materials hence variance is normally taken as the duty of the manager in charge purchasing. Nonetheless, this rationale justify that the variance in price for direct materials might or might not be the consequence of inadequacies of the purchasing division. The incidences of variances are common. They take place for nearly all elements of cost and must not be applied to make someone wholly to blame. At times, the variance might not be noticeable and at times, it might lead into elements that become beyond the managers control. Variances are costs control tools, help to improve on effectiveness and must then be applied optimistically. Activity Based Costing Method vs. Traditional Method of Costing Activity Based costing is a technique for costing that acknowledges transactions or activities in a business and allocates the specific cost for every activity with inputs to all services and products in line with the real time consumption by every component (Cokins & Net Library, 2001; p. 57). Compared to the traditional costing method this model allocates more overhead costs into direct costs. Activity based costing can also be described as the method of assessing and costing of business activities which entails trace of consumption of resources and costing the ultimate outputs. The resources are allocated to various activities and the activities to the objects costs on estimates of consumption. With activity based costing, a business can effectively approximate the cost factors of the whole products, services and activities. The purpose of activity based costing method is to recognize and do away with the services and products that are not profitable to the business and reduce the costs of the products and services that are overpriced. This is known as the service and product portfolio purpose. The method has also the objective of recognizing eliminating the processes of production or service process that are not effective and assign concepts of processing that result into the very similar product at a better output. In a commercial firm, the activity based costing technique helps to allocate the costs to the organizational resources through transaction like services or exchange of products given to the clients. Activity based costing in general is applied as a tool for comprehending the customer cost and product costs as well as returns found on the process of performance and production process (Velmurugan, 2010; p. 31). In this respect, Activity Based Costing has largely been applied to encourage and promote strategic choices like pricing of commodities, outsourcing of services; recognition and determination of process upgrade measures. Pros and Cons of Activity-Based Costing There is higher rate of costing precision in the fundamental benefit of activity based costing. The businesses are able to allocate costs to the services and products that call for the production activity. This technique does away with assigning inappropriate costs to a product. Other benefits of this method of costing entail the ease of interpreting the costs related to internal management, the capacity to enhance standardization and an increased knowledge of the overhead expenses (Jensen, 2008; p. 13). The main demerits come where substantial amount of resources are required by the company to implement it. This can also prove to be detrimental for firms with constrained sources of funds. Besides, another basic demerit of this method of costing is that some final users can easily misconstrue the method. Differences between Activity Based costing and Traditional method Fundamentally, manufacturing firms to allocate overhead costs to the units produced within the company apply the tradition method of costing regularly. Using the tradition costing method, the accountant assigns an overhead costs to the products. The negative aspect of this technique of costing is that it does not take into account the costs related manufacturing such as costs of administration, which are linked to the process of production. Currently, such technique is perceived as out of date since plenty of the manufacturing and processing firms are already making use of the computers as well machineries for their production process. In addition, the financial accounting software is in place already hence it is being used broadly. On the positive side, the method of traditional costing is simple to utilize in particular for the firms that have or produce only a single product. Alternatively, the activity based costing is mostly a rational method of allocating overhead cost of manufacturing to the products. As opposed to the traditional method of costing that merely allocate costs found on the work hours for a given machine; the activity based costing allocates first the costs to the processes and activities that resulted into the overhead. Subsequently, these costs are then allocated specifically to the products that demand for the activities. In simple words, the activity based costing is essentially applied as an added costing structure for the manufacturing company. To put it briefly the preceding are the functional distinctions of the two techniques of costing: The conventional method of costing pays more attention on the system as opposed to the processes whilst the activity based costing is based more on the activities compared to the system. Besides, the conventional or traditional method of costing is by now out of date in particular with the varying trends in technology like the initiation of the software for business accounting while Activity based costing is more in use now (Arora, 2010; p. 11). In addition, the activity based costing offers more precision product costs compared ton the tradition costing methods. Finally yet importantly, it is evident while the traditional method of costing has become out dated, the activity based costing is gaining prevalence in use since the year 1981. In view of the calculations in question (a) of this exercise, it will be prudent to say that the results would not be the same if the ABC method was applied in the costing of the direct materials and direct labour efficiency cause there would be some form of deviation in the final outcome. Therefore, the two methods do not produce similar results. Therefore the best recommendation would be to use activity based costing for better outcome. List of References Arora, M. N. (2010). Cost accounting; principles and practice. New Delhi: Vikas Publishing House Pvt. Ltd. Cokins, G., & Net Library, Inc. (2001). Activity-based cost management: An executives guide. New York: Wiley. Drucker, P. (1999). Management Challenges of the 21st Century. New York: Harper Business. Jensen, P. E. (2008). Evaluating the ABC model of rational emotive behavior therapy theory: An analysis of the relationship between irrational thinking and guilt. Mocciaro Li Destri A., Picone P. M. & Minà A. (2012), Bringing Strategy Back into Financial Systems of Performance Measurement: Integrating EVA and PBC, Business System Review, Vol 1. Issue 1, 85-102 Velmurugan, M. (2010). The Success and Failure of Activity-Based Costing Systems. Journal of Performance Management 23.2 (2010): 3-3 Weetman, Pauline (2006). Financial and Management Accounting. Pearson Education. Read More