Standard Costing and Basic Variance Analysis

1 Introduction

In the chapter on budgeting we identified the budget as a means of controlling an organisation. By comparing budgeted figures with actual results, areas can be identified that may need corrective action, and problems can be addressed in an attempt to control future outcomes.

This chapter deals with the setting of standard costs, which form the basis of those budgeted figures, and with the calculation and interpretation of the basic variances that arise when actual results differ from them.

What this chapter serves. It carries syllabus outcome A3b (standard costing) and the whole of A3c, variance analysis (without mix and yield variance) — the topics named as price and rate variances, usage and efficiency variances, and interpretation of variances. It also supplies the flexed budget that section B3 relies on.

All basic variances — calculation and interpretation — are examinable. The formulae are set out in full in section 3.2. Planning and operational variances, and activity based costing variances, are an extension of this material and are dealt with in the next chapter.

2 Standard costs

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A standard costing system uses these predetermined values to estimate income and expenditure under standard conditions. It was developed primarily for manufacturing, although it can be applied to services, and was designed for environments in which there is mass production of homogeneous products.

The standard costs form the basis of the budget totals, which can then be compared with actual results as part of the performance management process.

2.1 The standard cost card

The standard cost card sets out the standard prices and the standard usage or efficiency rates expected to produce one unit. Any deviation from those expected rates produces a variance, favourable or adverse.

2.2 Uses of standard costing

• inventory valuation, for internal and for external reporting;

• as a basis for pricing decisions;

• for budget preparation;

• for budgetary control;

• for performance measurement;

• for motivating staff, by using the standards as targets.

2.3 Limitations of standard costing

• obtaining appropriate standards can be difficult;

• standards may differ depending on their purpose (see section 2.5);

• standard costing is less useful where the environment does not involve mass production of homogeneous items;

• it can lead to an over-emphasis on quantitative measures of performance at the expense of qualitative ones such as customer satisfaction, quality and employee morale;

• traditional standards are based on the entity’s own costs. A more modern approach is benchmarking, which measures against the best practice of other organisations.

Standard costing was designed for a stable, repetitive manufacturing environment. Where production is just-in-time, where quality is managed to a zero-defect target, or where product life cycles are short, standards go out of date faster than they can be revised, and the variances they produce then measure the standard rather than the performance. That is a limitation of the technique rather than of its arithmetic. Chapter 7 sets out the modern costing methods — target costing, life cycle costing and the cost of quality — that answer it.

2.4 McDonaldisation

McDonaldisation describes the increasing level of standardisation in society. It takes its name from the fast-food chain’s approach to the mass delivery of standardised products.

Through the use of predetermined products and methods on a global scale, the chain is described as achieving efficiency, calculability, predictability and control — the same four qualities a standard costing system seeks.

Critics argue that this is achieved at the expense of individuality, and that cost reduction takes priority over other important factors such as employee motivation and consumer choice.

2.5 Types of standard

There is no rule about how a standard is set; that is a matter for the individual entity. Four types are distinguished.

3 Variance analysis

A variance is a difference: the difference between what a figure actually was and what, for the activity actually achieved, it should have been. A variance is favourable (F) when on its own it increases profit and adverse (A) when on its own it reduces profit.

If variances are to be investigated properly and used for control, it is not enough to know that a total was missed. We need to know why — and that means analysing each total into its component parts.

3.1 Flexing the budget

Comparing actual results with the original fixed budget is not a sensible comparison. If more units were produced than budgeted, more will have been spent on materials; that tells us nothing about whether the right amount per unit was spent.

The flexed budget rewrites the original budget for the activity level actually achieved, using the original standard prices and usage rates. It answers the question: for the units we actually made and sold, what should the revenue and the costs have been?

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3.2 The variance formulae

Every cost variance in this chapter is one of two shapes. Learn the two shapes and the individual rules follow.

The price family — materials price, labour rate of pay, variable and fixed overhead expenditure. Take the quantity actually bought or paid for, and ask what it cost against what it should have cost:

Price variance = (SP − AP) × AQ

The usage family — materials usage, labour efficiency, variable overhead efficiency. Take the standard price, and ask how much was used against how much should have been used for the output actually achieved:

Usage variance = (SQ for actual output − AQ) × SP

Applied to each cost, and to sales, that gives:

3.3 Analysing the total variances

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The total materials variance in Example 1 tells us that the actual spend was not $18 a unit. That could be because the wrong quantity of material was used — it should have been 4 kg per unit — or because the wrong price was paid — it should have been $4.50 per kg. Most often it is a combination of the two, and the two are usually the responsibility of two different managers.

The same argument applies to labour and to the overheads. Each total is therefore analysed into its component parts.

3.4 The operating statement

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The operating statement is the summary presented to management. It begins with the original budgeted profit, lists every variance, and ends with the actual profit — so it explains, line by line, why the two differ.

You will not be asked to prepare a complete operating statement in an objective test, but you are expected to know what it is, what it starts from, what it ends at and how any individual line in it is calculated.

4 Variances under absorption costing

In the previous example the company was using marginal costing. It could instead have used absorption costing. The variances are calculated in very much the same way, but two of them change.

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1. The SALES VOLUME variance is valued at the standard PROFIT per unit rather than at the standard contribution per unit, because under absorption costing each unit carries a share of the fixed overhead.

2. A FIXED OVERHEAD VOLUME variance appears. It does not exist under marginal costing.

The fixed overhead volume variance exists because the standard profit per unit assumes the budgeted level of production. Absorb fixed overhead at $15 a unit on a budget of 8,700 units, then produce 8,900, and the overhead actually recovered is not $15 a unit at all. The volume variance corrects for that:

Fixed o/h volume variance = (actual production − budgeted production) × OAR per unit

It is favourable when production exceeds budget, because more overhead has been absorbed, and adverse when production falls short. It can be analysed further into two parts, which answer the question “why did we manage to produce more?”:

5 Interpretation of variances

Calculating a variance is only half the work. The syllabus names interpretation of variances as a topic in its own right, and it is tested as readily as the arithmetic. Management will want an explanation from the responsible manager for every significant variance, and above all will want to know whether anything can be done about it in future periods.

5.1 The interdependence of variances

Variances are frequently linked, and the link usually runs across the boundary between two managers:

• cheaper material (favourable price) that is harder to work with (adverse usage, adverse labour efficiency);

• a lower selling price (adverse sales price) taken deliberately to win volume (favourable sales volume);

• less-skilled labour at a lower rate (favourable rate) that works more slowly and wastes more (adverse efficiency, adverse materials usage);

• a machine breakdown (adverse idle time) that also produces an adverse fixed overhead capacity variance.

5.2 Deciding whether to investigate

Investigation costs time and money, so not every variance is investigated. The usual considerations are:

• the SIZE of the variance, in absolute terms and as a percentage of the standard;

• whether it is FAVOURABLE or adverse — a large favourable variance is worth understanding too, both because it may be repeatable and because it may indicate a standard that is too loose;

• the TREND: a small variance in the same direction every month matters more than one large isolated variance;

• CONTROLLABILITY — there is little point investigating something no manager can influence; and

• the RELIABILITY of the standard itself, which is the subject of the next chapter.

6 Test your knowledge

Two quick checks before you move on: work through the flashcards to fix this chapter’s key terms and definitions, then sit the objective questions for exam-style practice. Both mark themselves and explain the answers as you go.