Direct Material And Labour Variances, Flexible Budget, And Essay.

Direct Material Quantity Variance

The direct material variances mainly occur due to two reasons. One is due to the differences in the prices paid for direct material and the other is the discrepancies in the material quantity utilized in the production. The direct material variances have two different components, namely, direct material quantity variance and the direct material price variance.

Direct Material Quantity Variance

The direct material quantity variance is calculated using the formula shown below:

Direct Material Quantity Variance = Standard Price X (Standard Quantity – Actual Quantity)

Where, Standard quantity = 100 kgs x 1000 = 100,000 kgs

Actual Quantity = 102,500 kgs

Standard Price = $1 per kg

Thus, direct material quantity variance = 1 * (100000 – 102500) = -2500 (Unfavourable)

Direct Material Price Variance

The formula to calculate the direct material price variance is shown below:

Direct material price variance = Actual Quantity * (Standard price – Actual price)

Where, Actual Quantity = 102500

Standard price = $1 per kg

Actual price = $101,000 / 102500 = $0.985 (approx.)

Thus, Direct Material Price Variance = 102,500 * (1 – 0.985) = $1500 (Favourable)

Therefore, direct material variance = -$2500 + $1500 = -$1000 (unfavorable).

The Direct Labour variances mainly occurs due to differences in the rate of labour costs or the different in hours taken during the production process or both. There are two components of direct labour variances, namely, labour efficiency variance and labor rate variance.

The labour efficiency variance is calculated using the following formula:

Labour efficiency variance = Standard rate * (Standard hour – Actual Hour)

Where, standard rate = $24 per hour

Standard Hour = 0.5 * 1000 = 500 hour

Actual Hour = 475 hour

Labour efficiency variance = 24 * (500 – 475) = 600 Favourable

The labour rate variance is calculated using the following formula:

Labour rate variance = Actual Hour * (Standard rate – Actual rate)

Where, Actual Hour = 475 hours

Standard Rate = $24 per hour

Actual Rate = $12,000/475 = 25.2631 (approx.)

Therefore, Labour rate variance = 475 * (24 – 25.2631) = -600 (unfavorable)

Therefore, total direct labour variance = 600 (f) – 600(UF) = 0

Direct Material Variances: The direct material variance occurs due to the increase in material quantity than the standard quantity of material required for 1 bag. The increase in material may be due to the wastage of material while filling up the bags. It shows that 102500 kgs of material were used to produce 1000 units of bags. The total unfavorable variance was 2500 from material. The actual price per kg of material was less than the actual price which helps the company in recovering a portion of unfavorable variance from material quantity. Thus, the overall direct material comes out to be $1000, which is unfavorable. It indicates that the cost of direct material has increased.

Direct Labour Variance: The labor efficiency variance was favorable as the labour force was able to prepare 1000 bags within 475 hours, against the standard rate of 500 hours. The company has paid $12,000 for 475 hours which is reflected in Unfavourable labor rate variance. The company has paid its labor at a higher rate than the standard rate of $24 per hour. However, the direct labor variance comes out to be null, as the unfavorable labor rate variance is covered by the labor efficiency.

The costs and benefits analysis reveals that the company should manufacture 30,000 units internally, as the company would be able to save around $120,000 through manufacturing. The above calculation shows that the company would have to incur the total costs of $1,640,000, if it plans to purchase it from the supplier.  The rental income of $20,000 would bring down the actual cost of purchasing to $1,620,000; which is higher than the manufacturing costs. The manufacturing costs for the parts is calculated as $1,500,000. Therefore, it is recommended that the firm should make the part internally.

The relevant costs refer to those costs that are relevant to a particular decision. A cost can be said as relevant only if it has the ability to change the cash flow of the firm. Joseph Giovine is looking forward to expand its business by leasing the space next door. It is important for Joseph to understand which costs and benefits are relevant to the decision of expanding into the new space. The costs identified from the scenario include leasing costs of $1,000 per month, tables and chairs costs, cost of old bagel machine, cost of larger machine, and the variable costs.

Among the above-mentioned costs, all the costs are relevant for the decision of expanding into the new space, except the cost of old bagel machine. It will not have an impact on the future cash flows of the firm. The relevant benefits arising from the expansion include the sales revenue of $5,500 per month and the annual profit of $17,700 (calculated above).

The irrelevant costs are those costs that do not have an impact on the cash flows. It can also be referred as ‘sunk costs’. The sunk costs are those costs which are already incurred and cannot be recovered. In the given scenario, the cost old bagel machine of $4,500 five years ago, was irrelevant costs. It is because the owners have already spent $4,500 five years ago. There is no irrelevant benefits discussed in the scenario.

Advantages and disadvantages of Debt

The advantages of raising capital through debt include:

• It enables the company to retain control with themselves.
• The amount paid on interest is deductible for tax purpose.
• It helps in developing easier plans as the company know well in advance about the principal and the interest to be paid in future.

The disadvantages of raising capital through debt include:

• The company requires good credit rating for receiving funds.
• It requires collateral security in the form of business assets.
• Interest expense must be paid even if the company is at loss.
• The company need to maintain the financial discipline by paying interest on time.

Advantages and disadvantages of Common Shares

The advantages of raising capital through common equity are as follows:

• It provides less burden to the business owners as there is no interest or repayment of fund.
• The problem of creditworthiness is eliminated as it does not require credit history of the borrower.
• No dividend payment is compulsory to the investors.
• Equity financing may enable informal partnerships which might help in business growth.

The disadvantages of raising capital through common equity include:

• The business needs to share profits in the form of dividends to the investors.
• It gives ownership rights to the shareholders which results in loss of control.
• Involving others at work may cause conflicts among the members.

Advantages and disadvantages of Preferred Shares

• It does not require transfer of ownership to the investors.
• No legal obligation to pay dividend.
• It improves the borrowing capacity of the firm by improving debt-to-equity ratio.
• No security is required for obtaining finance through preferred stocks.

The disadvantages of raising capital through preferred shares are as follows:

• It is a costly source of capital as skipping dividend disregard the market image of the company.
• The company need to pay a fixed rate of dividend.