With regard to variance analysis for all production costs (direct material, direct labour, and overhead), it is important to note that each variance does not represent a separate and distinct problem to be handled in isolation. All variances in one way or another are interdependent.
Required:
i) Explain what you understand by the term “inter-relationship between variances”. (2 marks)
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Variances, like ratios, should never be viewed in isolation when being interpreted. Inter-relationship between variances means that there is often a natural connection between variances which are calculated. This connection may become apparent when management is seeking explanations to variances which have arisen in a period. Identifying these connections helps provide assurance that the reasons being suggested are logical and are more likely than not to be correct.
ii) Explain possible reasons for inter-relationship between material variances and labour variances. Support your answer with examples. (4 marks)
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Note: The question does not ask for causes of labour and material variances, but for inter-relationship. The key is to think about quality of labour and materials used.
Materials used
If we use a low grade raw material we may get it more cheaply and therefore experience a favourable price variance. The downside on this is that we may use more of it due to breakages, waste and spoilage. This will not only cause an adverse usage variance but also may also cause a greater time to be taken due to waste and rejection and therefore result in adverse labour efficiency.
Labour used
Using a low grade of unskilled labour may cause a favourable rate variance whilst resulting in the job taking longer due to lack of experience. At the same time, their lack of knowledge may also result in lower quality of work causing waste of materials and there being more rejections. This may cause an adverse material usage variance.