Standard Costing: Material variances (Price, Usage, Mix & Yield)

By Jackie, Researcher

Topic: Education

Area of discussion: Cost & Management Accounting

Chapter: Standard Costing – Material variances (Price, Usage, Mix & Yield)

The objectives of this posting are to guide students in the computation of all material variances, to share a random picked ACCA Paper 8 Managerial Finance’s question with clear step-by-step workings and explanation, and finally show you how to double check your answers. Ideally, professional exams like ACCA and LCCI require students to compute advanced variances (i.e. direct materials mix and yield variances). Normally, students will not face any problems in handling direct materials price and usage variances, but struggling in solving those advanced variances (students often confuse when normal loss exists). Hopefully, this sharing will help students to understand this topic clearer and better.

The breakdown of the materials variances

Formulas and descriptions:

Total direct materials variance

The total direct materials variance is the difference between the standard materials cost for the actual production and the actual materials cost. Alternatively, it can also be computed by summing up direct materials price variance and direct materials usage variance.

Total direct materials variance = standard materials cost – actual materials cost

Total direct materials variance = direct materials price variance + direct materials usage variance

Material price variance

The material price variance is equal to the difference between the standard price and the actual price per unit of materials multiplied by the quantity of material purchased:

Material price variance = (standard price per unit of material – actual price) x quantity of material purchased

Material usage variance

The material usage variance is equal to the difference between the standard quantity required for actual production and the actual quantity used multiplied by the standard material price:

Material usage variance = (standard quantity of materials for actual production – actual quantity used) x standard price per unit

Materials mix variance

The materials mix variance arises when the mix of materials used differs from the predetermined mix included in the calculation of the standard cost of an operation. If the mixture is varied so that a larger than standard proportion of more expensive materials is used, there will be an unfavourable variance. When a larger proportion of cheaper materials are included in the mixture, there will be a favourable variance.

Materials mix variance = (actual quantity in standard mix proportions – actual quantity used) x standard price

Materials yield variance

The materials yield variance arises because there is a difference between the standard output for a given level of inputs and the actual output attained.

Materials yield variance = (actual yield – standard yield from actual input of material) x standard cost per unit of output 

Answers and comments:

Additional readings, related links and references:

This link provides an extremely good and detailed step-by-step calculation and there are a lot of worked examples. Full formulas are provided and alternative methods for computation are shown clearly.

http://www.futureaccountant.com/standard-costing-variance-analysis/study-notes/material-cost-variance.php

Materials mix and yield: Relevant to ACCA qualification paper F5. An extremely good discussion on variance analysis with excellent illustration, worked examples and clear explanation.

http://www.chinaacc.com/upload/html/2012/12/4/liuxim1542020121204164534135519.pdf

Standard Costing 2 Material Variances: “Managerial Accounting SFCC Fall 2007 Chapter 9 Videos”

http://www.youtube.com/watch?v=EnKCt68FvQI

This link provides a number of standard costing examples. There are a total of 6 parts in it. Good site to look at in order to master variance analysis.

http://www.accountingcoach.com/online-accounting-course/30Xpg02.html

Material mix and yield variances: Grahame Steven explains why understanding material mix and yield variance is a recipe for success.

http://www.cimaglobal.com/Documents/ImportedDocuments/ci_apr_01_p26-27.pdf

Comparison of Net Present Value and Internal Rate of Return Methods

By Jackie, Researcher

Topic: Education

Area of discussion: Cost & Management Accounting

Chapter: Capital Budgeting & Cost Analysis

The objective of this posting is to discuss, explain, and justify the superiority of NPV over the IRR. We will look into the conditions which make IRR method becomes inappropriate for usage purpose (i.e. the IRR’s technical shortcoming).

Introduction

Net Present Value Method

It calculates the expected monetary gain or loss from a project by discounting all expected future cash inflows and outflows back to the present point in time using the required rate of return. In other words, it is the present value of the net cash inflows less the present value of the net cash outflows (if any), and then minus the project’s initial investment outlay. A positive NPV indicates that an investment should be accepted, while a negative value indicates that it should be rejected. A zero NPV calculation indicates that the firm should be indifferent to whether the project is accepted or rejected.

Internal Rate of Return Method

It is the rate of return promised by an investment project over its useful life. It is sometimes referred to simply as the yield on a project. The internal rate of return is computed by finding the discount rate that equates the present value of a project’s cash outflows with the present value of its cash inflows. In other words, the internal rate of return is the discount rate that results in a net present value of zero. The decision rule is that if the IRR is greater than the opportunity cost of capital, the investment is acceptable as it is profitable and will yield a positive NPV. Alternatively, if the IRR is less than the cost of capital, the investment should be rejected as it is unprofitable and will result in a negative NPV. When the IRR is equal to the opportunity cost of capital, the firm should be indifferent to whether the project is acceptable or rejected.   

Comparison of Net Present Value and Internal Rate of Return Methods

In many situations the internal rate of return method will result in the same decision as the net present value method. In the case of conventional projects (in which an initial cash outflow is followed by a series of cash inflows) that are independent of each other (i.e. where the selection of a particular projects does not preclude the choice of the other), both NPV and IRR rules will lead to the same accept/reject decisions. However, there are also situations where the IRR method may lead to different decisions being made from those that would follow the adoption of the NPV procedure. 

Mutually exclusive projects 

If projects are mutually exclusive (i.e. the acceptance of one project excludes the acceptance of another project), it is possible for the NPV and the IRR methods to suggest different rankings as to which project should be given priority. For example, choosing one out of three possible factory locations. When evaluating mutually exclusive projects, the IRR method is prone to indicate wrong decisions (i.e. incorrectly rank projects) due to its reinvestment assumptions especially when dealing with unequal lives or unequal levels of initial investment outlay. For instance, compare an investment of £ 10,000 that yields a return of 50 per cent with an investment of £15,000 that yields a return of 40 per cent. If only one of the investments can be undertaken, normally managers will choose the project which has the highest IRR, but bear in mind that in actual fact, the first investment will only yield £5,000 but the second investment will yield £6,000. Thus, if the objective is to maximize the shareholders’ wealth the NPV provides the correct measure.

Percentage returns 

We can sum NPVs of individual projects to calculate a NPV of a combination or portfolio of projects as NPV method is expressed in monetary terms, not in percentages. For example, Project Alpha consists of two smaller projects: South (NPV = £12,500) and West (NPV = £7,500). Then, the NPV of Project Alpha will be £20,000. In contrast, IRRs of individual projects cannot be added or averaged to represent the IRR of a combination of projects.

Volatile cost of capital 

NPV method can also be used when the cost of capital varies over the life of a project. For instance, Vortex Plc has made an initial investment of £10,000 and expected to receive cash inflow as much as £25,000 in year 1 when the cost of capital is 12%, followed by another cash inflow of £18,000 when the cost of capital is 10% in year 2 and finally, £5,000 cash inflow in year 3 when the cost of capital is 8%. Then, the NPV can be calculated as £31,163 (see below). It is not possible to use IRR method in this case. This is because different cost of capital in different years means that there is no single cost of capital that the IRR (a single figure) can be compared against to decide whether the project should be accepted or rejected. 

Reinvestment assumptions 

The assumption concerning the reinvestment of interim cash flows from the acceptance of projects provides another reason for supporting the superiority of the NPV method. The implicit assumption if the NPV method is adopted is that the cash flows generated from an investment will be reinvested immediately at the cost of capital (i.e. the returns available from equal risk securities traded in financial markets). However, the IRR method makes a different implicit assumption about the reinvestment of the cash flows. It assumes that all the proceeds from a project can be reinvested immediately to earn a return equal to the IRR of the original project. This assumption is likely to be unrealistic because a firm should have accepted all projects which offer a return in excess of the cost of capital, and any other funds that become available can only be reinvested at the cost of capital.

Unconventional cash flows 

When the signs of the cash flows switch overtime (i.e. when there are outflows, followed by inflows, followed by additional outflows and so forth), it is possible that more than one IRR may exist for a given project. In other words, there may be multiple discount rates that equate the NPV of a set of cash flows to zero (see below). In such cases, it is difficult to know which of the IRR estimates should be compared to the firm’s required rate of return.

Additional readings, related links and references:

“Perils of the Internal Rate of Return”: This is an extremely good link. It heavily focuses on discussion with clear and detailed examples. Calculations and graphs are all provided. This is highly recommended for those who are doing a research project on this issue or doing revision for coming exams.

http://www.sambaker.com/econ/invest/invest.html

“Which is a better measure for capital budgeting, IRR or NPV?”: This site is suitable for beginner. It provides a brief explanation, examples and concepts. It can give you a quick understanding.
http://www.investopedia.com/ask/answers/05/irrvsnpvcapitalbudgeting.asp#axzz2Favl7l6v

“Chapter 6 - Investment decisions - Capital budgeting”: Well, this site looks like an e-book to me. The good thing about this link is it offers more detailed calculations instead of theories. Complete formulas are given too. 

http://www.fao.org/docrep/W4343E/w4343e07.htm

“Net Present Value Vs Internal Rate Of Return (NPV & IRR) & Excel Calculations For DCF”: If you prefer to learn via hearing instead of reading, then this might suit you. 

http://www.youtube.com/watch?v=aziR2zNtPHk

“How to calculate NPV and IRR in Excel”: The voice is clear, good explanation and most importantly, it is a step-by-step tutorial approach.

http://www.youtube.com/watch?v=kCnwCplibAk

Leadership

By Jackie, Researcher

Topic: Education

Area of discussion: Management

Chapter: Leadership: Transformational Leadership

The objective of this posting is to share a real-life example of transformational leadership. This example is based on Siemens (German multinational heavy engineering and electronics conglomerate) and its previous leader, Von Pierer (CEO of the company from 1992-2005). This posting emphasizes more on practical application as compared to theoretical concept. Ideally, leadership is extremely important in determining a company’s survival ability nowadays. It is a process by which a person exerts influence over other people and inspires, motivates, and directs their activities to help achieve group or organizational goals.

      Siemens was in a hard time during 1992 because of rising worldwide competition, having an inflexible hierarchy as well as practising conservative culture which greatly reduced decision making speed, stifled creativity and innovation (Jones & George 2003, p.459). Fortunately, Siemens’ Chairman, Von Pierer has taken a ‘shift-in-style’ approach by utilising transformational leadership. He removed two layers of middle management, downsized workforce by 7.5% through early retirement and sold slow-growing businesses at $2 billion (Miller 1995, p.53). Decision making processes were also speed up through the creation of new management boards (Boddy 2005, p.385). At the new Siemens, subordinates were given chances to critique their managers, who were in return receiving training to be more democratic and participative while employees were given ample ‘speaking freedom’ to express their thoughts.

 

      Jones and George (2003, p.460) highlight that Von Pierer has successfully transformed his subordinates in three essential ways. Firstly, he has ‘brainwashed’ his employees’ passive mindset and increased their awareness about the importance of their jobs as well as high performance to attain Siemens’ goals. For instance, upon realising that microprocessor sales managers were not acting on their best as they thought that their job are unimportant, he called Siemens’ top customers like Opel, Ford and Sony to critic and express their dissatisfaction for receiving lousy service and unreliable delivery schedule. Secondly, his subordinates are aware of their own needs for growth, development, and accomplishment. For example, Von Pierer has organised numerous workshop and training session as well as developing fast track career programs like TOP (Time-optimized processes) and launched a high-profile educational campaign for all level of employees. Thirdly, he also motivated his workers to work for the good of the company, not just for their personal gain or benefit. This can be seen when he tried to make all employees to think in the similar manner by inserting self-addressed postcards in the company magazine, urging them to send their ideas for improvement purposes directly to him.

      He also engaged in development consideration such as providing counselling sessions with a psychologist for managers who face difficulties in adapting to Siemens’ changes and sponsoring hiking trips to stimulate employees’ thinking and work in new ways (Miller 1995, p.52). One of the greatest outcome is a team of Siemens’ engineers working in jeans in a rented house has developed a machine-tool control system by just using one-third of the time and cost as compared to previous system. The effectiveness of Von Pierer has been portrayed in GLOBE research related to German leaders, where “tough on the issue, soft on the person” strategy seems to be the ultimate recipe for success in Siemens (Brodbeck, Frese & Javidan 2002, pp.21-24).

Appendix

References

 Boddy, D 2005, Management: An Introduction, 3^rd edn, Prentice Hall, Harlow, p.385.

 Brodbeck, FC, Frese, M & Javidan, M 2002, ‘Leadership made in Germany: Low on compassion, high on performance’, Academy of Management Executive, vol.16, no.1, pp.21-24, viewed 24 September 2012, http://bschool.nus.edu/Departments/ManagementNOrganization/publication/MichaelFreseJournal/brodbeck%20frese%20javidan%20ame02%20germany%20globe.pdf

Jones, GR & George, JM 2003, Contemporary Management, 3^rd edn, McGraw-Hill, New York, pp.459-462.

Miller, KL 1995, ‘Siemens Shapes Up’, Business Week, 30 April, pp.52-53, viewed 12 October 2012, http://www.businessweek.com/stories/1995-04-30/siemens-shapes-up