Standard Costing & Variance Analysis

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Using Standard-Costing Systems for Control

STANDARD COST a budget for the production of one unit of product or service ACTUAL COST used in the production of the product or service

COST VARIANCE the difference between the actual cost and the standard cost

Management by Exception
Take the time to investigate only significant cost variances What is significant?

Depends on the Size of the Organization

Depends on the Type of the Organization

Depends on the Production Process

Setting Standards
Analysis of Historical Data
What DID the product cost? Used in a mature production Process

Task Analysis

What SHOULD the product cost?

Analyze the process of manufacturing the product

A Combined Approach

Analyze the process for the step that has changed, but use historical data for the steps that have not changed

Perfection Vs. Practical Standards

PERFECTION STANDARDS
Can only be attained under near perfect conditions Peak efficiency Lowest possible input prices best-quality material no disruption in production

PRACTICAL OR ATTAINABLE STANDARDS

Tight as practical, but still are expected to be attained Occasional machine breakdowns Normal amounts of raw material waste

Use Of Standards
Standards can be used by service firms, nonprofit organizations, and governmental units

COST BENEFITS

Implementing and maintaining cost standards can be time-consuming, labor-intensive, and expensive.

Cost Variance Analysis

DIRECT MATERIAL STANDARDS
The total amount of material normally required to produce a finished product including allowances for normal waste or efficiency Tent Camp Company The total delivered cost, after subtracting any purchase discounts
Standard quantity: Fabric in finished product 11 sq. meters Allowance for normal waste 1 sq. meters Total standard quantity required per tent 12 sq. meters
Purchase price per sq. meter of fabric (net of purchase discounts) Transportation cost per sq. meter Total standard price per sq. meter of fabric

Rs 7.75 0.25

Rs 8

Cost Variance Analysis

DIRECT LABOR STANDARDS
Standard quantity: Direct labor required per tent Standard rate: Hourly wage rate Fringe benefits (20% of wages) Total standard rate per hour

Tent Camp Company

2 hours Rs 15 3 Rs18

Standard Costs Given Actual Output

The standard cost for the direct-material and direct-labor inputs is based upon Tent camp actual output of 3,000 tents They should incur a cost of Rs396,000 (Rs288,000 + Rs108,000) to make 3,000 tents
Direct material: Standard direct-material cost per tent (12 sq. meters x Rs8 pr sq. meter) Actual output Total standard directmaterial cost

Rs 96 x3,000 Rs 288000

Tent Camp Company

Direct labor: Direct labor cost per tent (2 hours x Rs18 per hour) Rs36 Actual output X 3,000 Total standard direct-labor cost Rs 108000

Analysis Of Material Variances

Actual quantity 40,000 sq. meters x purchased x Actual price Actual quantity x Standard price Standard Standard x quantity price 36,000 Rs8.00 per sq. meters x sq. meter allowed

Rs8.15 per sq. meter

40,000 sq. Rs8.00 per meters x sq. meter purchased

Rs326,000

Rs320,000

Rs288,000

Rs6,000U Direct-material price variance 36,400 sq. meters used Rs291,200 Rs8.00 per sq. meter Rs3,200U

Directmaterial quantity variance

Direct-Material Variances
What caused Tent camp to spend more than the anticipated amount on direct material?
First, the company purchased fabric at a higher price (Rs8.15 per square meter) than the standard price (Rs8.00 per square meter).

Direct-material price variance = (PQ X AP) - (PQ X SP) = PQ(AP - SP) where: PQ = Quantity purchased AP = Actual price SP = Standard price

Tent camps direct- material price variance for June is computed as follows: Direct-material price variance = PQ(AP - SP) = 40,000 (Rs 8.15 Rs 8.00) = Rs6,000 unfavorable

Direct-Material Variances
What caused Tent camp to spend more than the anticipated amount on direct material?
Second, the company used more fabric than the standard price. (36,400 sq. meters actually used, instead of the standard amount of 36,000 sq. meters)
Direct-material quantity variance = (AQ X SP) - (SQ X SP) = SP(AQ - SQ) where: AQ = Actual quantity used SQ = Standard quantity allowed Tent camps direct- material quantity variance for June is computed as follows: Direct-material quantity variance = SP(AQ - SQ) = Rs8.00(36,400 - 36,000) =Rs3,200 unfavorable

Analysis of Direct-Labor Variances

Actual Labor Cost Actual Actual X hours rate 5,900 hours used X Rs19 per hour Actual hours 5,900 hours used Standard price Rs18 per hour Standard Labor Cost Standard Standard X Hours rate 6,000 X Rs18 per hour

X
X

Rs112,100 Rs5,900 Unfavorable Direct-labor rate variance

Rs106,200

Rs108,000 Rs1,800 Favorable Direct-labor efficiency variance

Rs4,100 Unfavorable Direct-labor variance

Direct-Labor Variances
What caused Tent camp to spend more than the anticipated amount on direct labor?
First, the company incurred a cost of Rs19 per hour for direct labor instead of the standard amount of Rs18 per hour Direct-labor rate variance = (AH X AR) - (AH X SR) = AH(AR - SR) where: AH = Actual hours used AR = Actual rate per hour SR = Standard rate per hour

Tent camps direct-labor rate variance for June is computed as follows: Direct-labor rate variance = AH(AR - SR) = 5,900 (Rs19 - Rs18) =Rs5,900 unfavorable

Direct-Labor Variances
What caused Tent camp to spend more than the anticipated amount on direct labor?
Tent camp used only 5,900 hours of direct labor, which is < standard quantity of 6,000 hours, given actual output of 3,000 tents. The increased efficiency does not fully offset the unexpectedly high wage rate. Direct-labor efficiency variance = (AH X SR) - (SH X SR) = SR(AH - SH) where: SR=Standard Rate AH = Actual hours used SH = Standard hours allowed Tent camps direct - labor efficiency variance for June is computed as follows: Direct - labor efficiency variance = SR(AH - SH) = Rs18 (5,900 - 6,000) = Rs1,800 favorable

Multiple Types Of Direct Material Or Direct Labor

When there are several types of direct material or direct labor, price and quantity variances are computed for each type, and then added to obtain a total price variance and a total quality variance

Direct material X Rs1,500 F Rs1,900 U Direct material Y 2,400 U 300 U Direct material Z 900 U 400 F Total variance Rs1,800 U Rs1,800 U

Allowance For Defects Of Spoilage

In some manufacturing processes, a certain amount of defective production or spoilage is normal.
Example: 1,000 liters of chemicals are normally required in a chemical process in order to obtain 800 liters of good output. If total good output in February is 5,000 liters, what is the standard allowed quantity of input?
Good output quantity Good output quantity 80% 5,000 liters of good output 80% = 80% X Input quantity = Input quantity allowed = 6,250 liters of input allowed

Management by Exception

What constitutes an exception? How does a manager know when to follow up on a cost variance and when to ignore it?

Size of Variance
Absolute Amount

Relative Amount

RULE OF THUMB: Investigate variances that are either greater than Rs10,000 or greater than 10 percent of standard cost

Recurring Variances
MONTH VARIANCE % OF STANDARD COST September Rs6,000 F 6.0% October 6,400 F 6.4% November 3,200 F 3.2% December 6,200 F 6.2%
None of the variances are greater than Rs10,000 or 10%, but this variance should be investigated because it has occurred at a reasonably high amount for four months
Standard direct labor cost is Rs100,000

Trends
MONTH VARIANCE % OF STANDARD COST September Rs250 U 0.25% October 840 U 0.84% November 4,000 U 4.0% December 9,300 U 9.3%
None of the variances are greater than Rs10,000 or 10%, but this variance should be investigated because it has an unfavorable trend.
Standard direct labor is Rs100,000

Additional Issues
Controllability
A manager is more likely to investigate a variance that is controllable by someone in the organization than one that is not

Favorable Variances
It is as important to investigate significant favorable variances as well as significant unfavorable variances

Cost and Benefits of Investigation

The decision whether to investigate a variance is a cost benefit decision

Statistical Analysis
A STATISTICAL CONTROL CHART plots cost variances across time and compares them with a statistically determined critical value that triggers an investigation
Favorable variances 1 standard deviation Critical value

Investigate

X X

X X X

X
Time

1 standard deviation Unfavorable Jan. variances

Feb. March April

May

June

Behavioral Effects Of Standard Costing

Standard costs, budgets, and variances are used to evaluate the performance of individuals and departments They can profoundly influence behavior when they are used to determine salary increases, bonuses, and promotions

Which Managers Generally Influence Cost Variances?

Direct-material price variance The purchasing manager
Get the best prices available for purchased goods and services through skillful purchasing practices

Direct-material quantity variance

The production supervisor

Skillful supervision and motivation of production employees, coupled with the careful use and handling of materials, contribute to minimal waste

Direct-labor rate variance

The production supervisor

Generally results from using a different mix of employees than that anticipated when the standard were set

Direct- labor efficiency variance

The production supervisor

Motivating employees toward production goals and effective work schedules improves efficiency

Interaction Among Variances

Interaction among variances often occur making it difficult to determine the responsibility for a particular variance Variances in one part of the value chain can be due to root causes in another part of the chain

Value Chain
Physical resources

Perspective

Human resources

Research and development

Design

Supply

ProducDistriMarketing tion bution

Customer service

Disposition Of Variances
Cost of Goods Sold

Variances are temporary accounts, like revenue and expense accounts, and they are closed out at the end of the accounting period.

Unfavorable variances represent costs of operating inefficiently, relative to the standards, and thus cause the Cost of Goods Sold to be higher

Favorable variances represent costs of operating efficiently, relative to the standards, and thus cause the Cost of Goods Sold to be lower

Standard Costing: Advantages

Allows managers to use management by exception Provides a basis for sensible cost comparisons Provides a means of performance evaluation and rewards for employees

Provides motivation for employees to adhere to standards Results in more stable product costs Is less expensive than actual- or normal- costing systems

Criticisms Of Standard Costing In Todays Environment

Variances are often too aggregated. They are not tied to specific product lines, production batches, or to the flexible management system Variances are often too late to be useful Too much focus on the cost and efficiency of direct labor

Shorter product life cycles mean that standards are only relevant for a short time Too much focus on cost minimization rather than increasing product quality or customer service Automated manufacturing processes tend to be more consistent in meeting production specifications.

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