Question

The reason we use the word favorable and unfavorable when evaluating variances is made clear when we look at the closing of accounts. To see this, consider that (1) all variance accounts are closed at the end of each period (temporary accounts), (2) a favorable variance is always a credit balance, and (3) an unfavorable variance is always a debit balance. Write a half page memo to our instructor with three parts that answer the fallowing three requirements. (Assume that variance accounts are closed to Cost of Goods Sold.)

Required -

1. Does COGS increase or decrease when closing a favorable variance? Does gross margin increase or decrease when favorable variance is closed to COGS? Explain.

2. Does COGS increase or decrease when closing an unfavorable variance? Does gross margin increase or decrease when favorable variance is closed to COGS? Explain.

3. Explain the meaning of favorable and unfavorable variance.

Answer 1

Favourable variance simply indicates that our actual cost are less than budgeted or standard cost thereby increasing our profits and decreasing our COGS whereas Unfavourable variance simply means that our actual cost are greater than budgeted costs or standard costs.

In light of above description:

Q1) Favourable variance when closed

It decreases our COGS as we have actually spent less than our standard costs whereas

It increases our Gross margin as our COGS reduces.

Q2)  

Unfavourable variance when closed

It increases our COGS as we have actually spent more than our standard costs whereas

It decreases our Gross margin as our COGS increases.

Q3)

Favourable variance = Standard costs > Actual costs

As the name suggests favourable that means company has worked more effeciently than what was budgeted thereby reducing actual costs such that actual costs are less than standard costs allowed for production.

Unfavourable variance = Standard costs < Actual costs

As the name suggests unfavourable that means company has not worked effeciently than what was budgeted thereby increasing actual costs such that actual costs are more than standard costs allowed for production.

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