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Standard costing and Variance analysis

Standard costs are predetermined costs, or planned unit costs. They are target costs that should
be measured under efficient operating conditions. They are not the same as budgeted costs. A
budget relates to an entire activity or operation and a standard presents the same information on a
per unit basis.

A standard therefore provides cost expectations per unit of activity and a budget provides the
cost expectations for the total activity.

Therefore the term standard cost is a unit cost concept and the term budgeted cost is a total
concept.

Standard costing

This is a control technique which compares standard costs and revenues with actual results to
obtain variances, which are used to stimulate improved performance.

The main purpose of the standard costing system is to provide a means of planning and
controlling the day-to-day running of a business activities.

Variance costing

This analysis of performance is by means of variances.

It is used to promote management action at the earliest possible stages. Its main purpose is to
eliminate efficiencies.

Uses of standard costs

1. They are implicit in the preparation of budgets and are thus part fo the budgetary control/
variance analysis activities of an organisation.
2. Standard costs may be used for stock valuation and as a basis for providing pricing
decisions. It is an alternative method of valuation like FIFO, and LIFO. Standard cost
minimises administration costs in the areas of stock valuation and promote the use of
management by exception.
3. Standard costing provides a base for performance measurement. Standard costing is part
of the cost control system. Control is achieved by comparing actual performance with the
standard that has been set and explaining the cause of the difference.
4. Standard costing stimulates cost consciousness, by providing a challenging target which
individuals are motivated to achieve.

Standard costing is most suited to an organisation whose activities consist of a series of


common or respective operations and the input required to produce each unit of output can be
specified.
Requirements for standard costing system

a. Accurate preparation
Estimates of quantities and prices should be made giving regard to the likely level of
inflation and price changes expected in the budget period.
b. Measuring performance
Standard costing is part of the control system. Control is achieved by comparing
actual performance with the standard that has been set and explaining the cause of the
difference.
c. Reviewing standards
The calculation of variances may identify that the standard is not achievable or it is
out of date. In such a case, the standard is not providing a realistic target and it should
be revised.

Types of standards

I. Ideal standard
This is achieved under the efficient or favourable conditions with no allowance made for
normal losses, waste and machine down time. It is a perfection standard.
II. Attainable standard
This assumes efficient levels of operation, but which includes allowances for normal loss,
waste and machine down time.
III. Current attainable standards
These are costs that should be incurred under very efficient operating conditions. They
are difficult but possible to achieve.
IV. Basic standards
These represent constant standards that are left unchanged over long periods.

Variance analysis

Variances

A variance is the difference between a planned, budgeted, or standard cost and the actual cost
incurred. The same comparisons may be made for revenues. The process by which the total
difference between standard and actual results is analysed is known as variance analysis.

Variance analysis

Variance analysis is defined as the evaluation of performance by means of variances, whose


timely reporting should maximise for opportunity for managerial action.

When actual results are better than expected results, we have a favourable variance (F). if on the
other hand, actual results are worse than expected results, we have ans adverse variance (A).
Material Variances

The costs of materials which are used in many manufactured products are determined by two
basic factors: the price paid for the materials, and the quantity of materials used in production.
This gives rise to the possibility that the actual costs will differ from the standard quantity and or
the actual price will be different from the standard price. We can therefore calculate a material
usage and a material price variance.

Direct materials total variance

The direct materials total variance is the difference between what the output actually cost and
what it should have cost in terms of material.

Its purpose is to quantify the effect on costs (and thus profits) of the actual material cost (for
actual production).

The formula for the total material variance is the difference between the standard material costs
(SC) for the actual production and the actual cost (AC).

Direct material total variance = SC AC

Material price variance

The direct material price variance is the difference between the standard cost and the actual cost
for the actual quantity of materials used or purchased. In other words, it is the difference between
what the material did cost and what it should have cost.

Its purpose is to identify the extent to which profits will differ from those expected by reason of
the actual price paid for direct materials being different from the standard price.

The material price variance is equal to the difference between the standard price (SP) and the
actual price (AP) per unit of material multiplied by the quantity of material purchased (QP).

Material price variance = (SP AP)* QP

Material usage variance

The direct material usage variance is the difference between the standard quantity of materials
that should have been used for the number of units actually produced, and the actual quantity of
materials used, valued at the standard cost per unit of material.

Its purpose is to quantify the effect on profit of using a different quantity of raw material from
that expected for the actual production achieved.
The formula of the material usages variance is equal to the difference between the standard
quantity (SQ) required for actual production and the actual quantity (AQ) used multiplied by the
standard material price (SP)

Material usage variance = (SQ AQ) * SP

Labour variances

The cost of labour is determined by the price paid for labour and the quantity of labour used.

Thus a price and quantity variance will also arise for labour. Unlike materials, labour cannot be
stored, because the purchase and usage of labour normally takes place at the same time. Hence,
the actual quantity of hours purchased will be equal quantity of hours used for each period.

For this reason the price variance plus the quantity variance should agree with the total labour
variance.

Its purpose of the labour total cost variance is to quantify the effect on costs (and thus profits) of
the actual labour cost being different form standard labour cost (for actual production).

The formula for the total variance is the difference between the standard labour cpost (SC) for
the actual production and the actual labour cost (AC).

Total labour variance = SC AC

The direct labour total variance is the difference between what the output should have cost and
what it did cost in terms of labour.

Labour rate variance

The direct labour rate variance is the difference between the standard cost and the actual cost for
the actual number of hours paid for.

Its purpose is to identify the extent to which profits will differ from those expected by reason of
the actual wage rate per hour being different from the standard.

The formula for the wage rate variance is equal to the difference between the standard wage rate
per hour (SR) and the actual wage rate (AR) multiplied by the actual number of hours (H).

Labour rate variance = (SR AR) * AH

Labour efficiency variance

This is the difference between the hours that should have been worked for the number of units
actually produced, and the actual number of hours worked, valued at the standard rate per hour.
Its purpose is to quantify the effect on profit of using a different number of hours than expected
for actual production achieved.

The formula is the difference between the standard labour hours for actual production (SH) and
the actual labour hours worked (AH) multiplied by the standard wage rate per hour. (SR).

Labour efficiency variance = (SH AH) * SR

Idle time variance

In variance analysis, this is always an adverse efficiency variance

Variable production over head variances

It is assumed that variable overheads vary with; labour hours worked.

Absorption rate for overheads is therefore based on budgeted costs and budgeted hours.

The total variable overhead costs is the difference between the standard variable OHs charged to
production (SC) and the actual variable OHs incurred (AC).

Total variable overheads variance = SC AC

Variable overhead expenditure variance

Variable overhead efficiency variance

Fixed production overhead variance

Fixed overhead expenditure variance

Fixed overhead volume variance

Fixed overhead capacity variance

Fixed overhead efficiency variance