A standard cost is an estimated/target cost of a product or service
Uses of Standard Costing
For planning, control and motivation
To value inventories and cost production for cost accounting purposes
As a control device by establishing standards (planned costs), highlighting activities that are not conforming to plan and thus alerting management to areas which may be out of control and in need of corrective action
Variances provide feedback to management indicating how well, or otherwise, the company is doing.
Standard costs are essential for calculating and analysing variances.
Before any meaningful comparison can be made, the original budget should be ‘flexed’ to the actual level of performance.
A flexible budget
A flexible budget is a budget that adjusts or flexes for changes in the volume of activity.
The flexible budget is more sophisticated and useful than a fixed budget, which remains at one amount regardless of the volume of activity.
For example, a firm may have prepared a fixed budget at a sales level of $100,000.
Flexible budgets may be prepared at different activity levels e.g. anticipated activity 100% and also 90%, 95%, 105% and 110% activity.
A flexed budget
A flexed budget is a budget prepared to show the revenues, costs and profits that should have been expected from the actual level of production and sales.
If the flexed budget is compared with the actual results for a period, variances will be much more meaningful.
Consider this - you plan to make 10 products.
Each product should use 2Kg each.
Therefore the budgeted number of Kg is 20Kg
Actually 14 products were made and 25Kg used.
If the budget wasn't flexed you would compare 25Kg to the budgeted 20Kg and get an ADVERSE variance of 5Kg.
But this is not taking into account the fact that 4 more products were made than budgeted
So we need to flex this budget..
Actual Quantity of 14 should take 2kg each = 28kg
Actual Kg used 25kg
Therefore, the usage variance is actually 3 kg FAVOURABLE
The budget was for 100 items at a labour cost of $200
The actual amount produced was 120 items at a labour cost of $250
Flex the budget and compare actual to budgeted
$200 / 100 x 120 = $240 (Flexed Budget)
Compare to actual = $250
$10 over budget
Reasons for Variances
Possible causes of sales variances:
Unplanned price increases
Unplanned price reduction to attract additional business
Unexpected fall in demand due to recession
Increased demand due to reduced price
Failure to satisfy demand due to production difficulties
The direct material total variance can be subdivided into the direct material price variance and the direct material usage variance.
Variance Favourable Adverse Material price Unforeseen discounts received Price increase More care taken in purchasing Careless purchasing Change in material standard Change in material standard Material usage Material used of higher quality than standard Defective material More effective use made of material Excessive waste Theft Errors in allocating material to jobs Errors in allocating material to jobs Stricter quality control
The total labour variance can be subdivided between labour rate variance and labour efficiency variance.
Variance Favourable Adverse Labour rate Use of apprentices or other workers Wage rate increase Use of higher grade labour Idle time The idle time variance is always adverse Machine breakdown Non-availability of material Illness or injury to worker Labour efficiency Output produced more quickly than expected Lost time in excess of standard allowed Errors in allocating time to jobs Errors in allocating time to jobs
Variable Overhead Variances
The variable production overhead total variance can be subdivided into the variable production overhead expenditure variance and the variable production overhead efficiency variance (based on actual hours).
Variance Favourable Adverse Variable overhead Expenditure Savings in costs incurred Increase in cost of overheads used More economical use of overheads Excessive use of overheads Change in type of overheads used Change in type of overheads used Variable overhead Efficiency Labour force working more efficiently Labour force working less efficiently Better supervision or staff training Lack of supervision
Fixed Overhead Variances
Variance Favourable Adverse Fixed overhead Expenditure Savings in costs incurred Increase in cost of services used Changes in prices Excessive use of services Fixed overhead volume - Efficiency Labour force working more efficiently Labour force working less efficiently Lost production through strike Fixed overhead volume - Capacity Labour force working overtime Machine breakdown, strikes, labour shortages
When should a variance be investigated?
When deciding which variances to investigate, the following factors should be considered:
Reliability and accuracy of the figures
Mistakes in calculating budget figures
or in recording actual costs and revenues, could lead to a variance being reported where no problem actually exists (the process is actually ‘in control’).
The size of the variance may indicate the scale of the problem and the potential benefits arising from its correction.
Possible interdependencies of variances
Sometimes a variance in one area is related to a variance in another.
For example, a favourable raw material price variance resulting from the purchase of a lower grade of material, may cause an adverse labour efficiency variance because the lower grade material is harder to work with.
These two variances would need to be considered jointly before making an investigation decision.
The inherent variability of the cost or revenue
Some costs, by nature, are quite volatile (oil prices, for example) and variances would therefore not be surprising.
Other costs, such as labour rates, are far more stable and even a small variance may indicate a problem.
Adverse or favourable?
Adverse variances tend to attract most attention as they indicate problems.
However, there is an argument for the investigation of favourable variances so that a business can learn from its successes.
Trends in variances
One adverse variance may be caused by a random event. A series of adverse variances usually indicates that a process is out of control.
Controllability/probability of correction
If a cost or revenue is outside the manager’s control (such as the world market price of a raw material) then there is little point in investigating its cause.