Making Teddy Bears: A Variance Analysis Example
The purchase price variance is the number of units of an item multiplied by the difference between the actual and expected price to purchase the item. The resulting variance can be favourable or unfavourable. Following is an example of an unfavourable, also termed adverse, purchase price variance.
The Teddy Bear Company makes teddy bears, and these bears have plastic eyes. The Teddy Bear Company purchases the plastic eyes in bulk from the Plastic Eye Company. The Teddy Bear Company expects to sell 50,000 bears in the month of June, so the manager, John, who is responsible for putting the eyes on the bears projects an order of 100,000 eyes for the month.
Typically the Plastic Eye Company sells their eyes for ten cents each at orders up to 80,000. Because the Teddy Bear Company is projecting an order of 100,000 eyes, they receive a discounted bulk rate of eight cents per plastic eye. This brings the order total to $8,000 for 100,000 plastic eyes. However, the plastic eyes are not delivered all at once. John the manger orders 10,000 eyes at a time to reduce inventory in line with company policies.
Production begins for the month of June and plastic eyes are attached to bears as quickly as possible. The bears are then shipped to the stores to await sale. As soon as the stores get low on stock of bears, the Teddy Bear Company produces fresh stock and ships them out to the stores. The production process is very short and the Teddy Bear Company practices just-in-time production strategy and inventory management. John knows just when to order a new stock of fresh plastic eyes for production of bears on the assembly line.
However, this month the sales of the Teddy Bear Company bears is not as brisk as usual. The bears are not moving off the store shelves. John delays his expected order of eyes from the Plastic Eye Company to keep pace with the reduced demand. By the end of the month, John has only ordered 70,000 plastic eyes. This no longer entitles the Teddy Bear Company to the 100,000 eye discount of two cents per eye, and they must pay ten cents per eye for a total of $7,000.
At the end of the month, the variance is calculated as 70,000 eyes multiplied by two cents, or the difference between the actual and expected purchase price. This amounts to $1,400, which is the unfavorable variance. The accountants write their report explaining the reason for the variance as follows: "Purchases from the Plastic Eye Company were $7,000 or $1,400 more than the budgeted $5,600. This adverse variance was due to lower than usual sales of bears, which resulted in a loss of bulk discount and higher cost for materials from the Plastic Eye Company."
This simple example of variance analysis explains how variance, in this case unfavorable or adverse, occurs in the business cycle. The analysis can provide lessons that may be useful in business decision-making in the future.