1. Standard Costing and Variance Analysis
February 6th 2007

2. Lecture and Reading Objectives
Outline the nature and purpose of an operational control system and the role of budgets, standards and variances.
Explain how standard costs are set and define basic, ideal and currently attainable standards
Compile flexible budgets and from these calculate labour, materials overhead and sales variances and reconcile actual profit with budgeted profit
Identify the causes of variances and discuss the factors leading to the decision to investigate variances
Discuss the limitations of traditional standard costing systems and assess alternatives

3. Essential Reading Drury Chapters 12, 15 and 16 (pages 461 and 468-482)
Drury C (1999) ‘Standard costing: a technique at variance with modern management?’, Management Accounting, November
Graham C, Lyall D and Puxty A (1992) ‘Cost control: the managers perspective’ Management Accounting, October
Kaplan RS and Norton DP (2000) ‘The Balanced Scorecard – Measures that Drive Performance.’ Harvard Business Review, January-February, pages

4. An overview of a standard costing system

5. Budgets & Standard Costs
Prepare the budget using standard costs and budgeted prices
Q: Should we compare the budgeted output with the actual output to calculate the variances?
A: No, first flex the budget
Flex the budget for changes in activity level (changes in units of output)
Calculate the differences between budget and actual output – these are termed “variances”
Reconcile the original budgeted profit and actual profit

6. All favourable variances minus All adverse (unfavourable) variances
Relationship between the budgeted and actual profit (McLaney & Atrill 2002, page 398)
Budgeted profit
plus
All favourable variances
minus
All adverse (unfavourable) variances
equals
Actual profit

7. What are standard costs and prices?
These are predetermined costs. They are target costs that should be incurred under efficient operating conditions…on a per unit basis (Drury, 2005, page 340)
Standard costing is most suited for organisations where the activities are common or repetitive. The examples we shall use will be for manufacturing organisations.

8. Types of cost standard Basic cost standards
Left unchanged over long periods of time. Helps to establish efficiency trends. Seldom used, as they do not represent current target costs, so not very useful for control.
Ideal standards
Represent perfect performance. Minimum costs under the most efficient operating conditions. Can be demotivating and unlikely to be used in practice.
Currently attainable standards
Costs that should be incurred under efficient operating conditions. Difficult, but not impossible, to achieve. Can be set at various levels of difficulty.

9. Numerical Example
Example

10. Sales Variances 50,500 – 48,000 = £2,550 (F)
Difference between Original Budget Profit and Flexed Budget Profit = Sales Volume Variance (Drury calls this the sales margin volume variance)
50,500 – 48,000 = £2,550 (F)
Difference between Flexed Budget Sales and Actual Sales = Sales Price Variance
(Drury calls this the sales margin price variance)
207,500 – 205,425 = 2,075 (A)

11. Materials Variances
Material Price Variance: What did we pay for the quantity of materials we actually bought compared to what we had budgeted for?
Need standard price = 61,350/21,250 = 2.887
(SP – AP) X QP =
(Standard price – Actual price) X Quantity purchased =
(3.00 – 2.887) X 21,250 = (0.113) X 21,250 = 2,400 (F)

12. Materials Variances
Materials Usage Variance: How much materials did we use compared to what we thought we should have used? Work this out at budgeted costs.
(SQ – AQ) X SP
(Standard quantity – Actual quantity) X Standard price =
(20,750 – 21,250) X 3.00 = 500 X 3.00 = 1,500 (A)

13. Labour Variances
Labour Rate Variance: What did we pay for the hours we actually used compared to what we had budgeted for?
Need standard rate = 68,500/8,250 = 8.303
(SR – AR) X AH =
(Standard rate – Actual rate) X Actual hours =
(8.00 – 8.303) X 8,250 = 2,500 (A)

14. Labour Variances
Labour Efficiency Variance: How much labour did we use compared to what we thought we should have used. Work this out at budgeted costs.
Need standard hours = 4,150 X 2 = 8,300
(SH – AH) X SR
(Standard hours – Actual hours) X Standard rate =
(8,300 – 8,250) X 8.00 = 50 X 8.00 = 400 (F)

15. Variable & Fixed overhead variances
Can be broken down into: Variable Overhead Expenditure Variance and Variable Overhead Efficiency Variance
(This breakdown is not always done, but the technique is the same as for the labour variances, see Drury. In the Workshop example this variance is not broken down)
8,300 – 8,225 = 75 (F)
Difference between Fixed Overheads Flexed budget and Actual Results = Fixed Overhead Expenditure Variance
20,000 – 19,000 = 1,000 (F)

16. Purposes of Standard Costing
Providing a prediction of future costs that can be used for decision-making purposes
Providing a challenging target
Assisting in setting budgets
Acting as a control device
Simplifying the task of tracing costs to products for profit measurement and inventory valuation

17. Should variances always be investigated?
Significant adverse variances may indicate a fault that could prove very costly
Cost-benefit analysis – keep insignificant variances under review
Significant favourable variances should also be investigated (McLaney & Atrill say “probably”)

18. Reasons for variances (from Brown 1999)
Demski (1967) divided variances into planning and operational variances. Advocated isolating permanent changes and making an “after the fact” budget.
Variances should be analysed as:
Planning (uncontrollable) variances
Arise from the difference between the original planned performance and the revised planned performance
These variances provide a check on forecasting skills and also help to provide a revised base for use in forward planning
Operational (controllable) variances
Arise from efficiencies or inefficiencies between target and actual results
These variances provide a more relevant focus for management control action

19. Some examples of reasons for variances (Drury 2005)
Sales volume variance (adverse)
Economic recession
Increase in selling price
Direct materials usage variance (adverse)
Careless handling of materials
Substandard materials
Pilferage
Consider interplay of variances – how might materials usage/materials price variance, and labour rate/labour efficiency variances affect each other?

20. Standard Costing – a status check
Survey results, use of variance analysis:
Puxty and Lyall survey (1989) - 90%; Drury et al survey (1993) - 76%
CIMA Accountants – Survey 2004 (Importance of Standard Costing)
Of critical importance %
Very important %
Of some importance %
Of little or no importance 12.87%
University of Bath analysis of CIMA members’ activities
Current debate (centred on the “modern” business environment)
Rate of change of product type and design is swift
Customer demand is for speedy availability of products
Product life cycles are shorter
There are higher quality standards

21. This has changed the way businesses operate, as follows:
JIT systems allied to flexible manufacturing systems respond to customer demand
TQM programmes aim at continuous improvement and effective provision of value-added activities
Greater emphasis on the value chain
Changes to ABC and target costing
Improved speed and flexibility of information availability e.g. online information in a computer integrated manufacturing environment

22. Criticisms of Standard Costing
Impact of the changing cost structure - standard costing is most suited where there are direct and variable costs
Inconsistency with a JIT philosophy (supplier chains, bulk purchases, effect on quality)
Motivates behaviour that is inconsistent with TQM philosophy
Overemphasises the importance of direct labour
Delay in feedback reporting
Standards are a static base against which actual events are measured (standards can quickly become out of date; also see problem with TQM above)

23. More criticisms
Their main objective is control, with conformance to standards and the elimination of any variances – this is seen as restrictive and inhibiting (problem for JIT and TQM systems)
Can have adverse effects on performance if the link between cost and activity is not well understood, variances may be out of a manager’s control
Areas of responsibility may not have clear lines of demarcation
Even with these criticisms, there are still uses for standard costing and variance analysis – for a balanced view read Graham, Lyall and Puxty 1992

24. Points in favour of standard costing
Planning
Standards may be useful as building blocks for budgeting, which has to happen even in a TQM environment
Control
Even where automated input of materials occurs, it may still be relevant to analyse costs of changes from plan
Decision making
Existing standards may be the starting point for the estimated costs of new products

25. Points in favour of standard costing
Performance measurement
When product mix is stable, performance monitoring may be enhanced by the use of controllable standards
Product pricing
Use of standards can aid the construction of accurate cost estimates for pricing. Target costs may be compared with current standards to highlight the “gaps” in costing – value engineering techniques might then be applied
Improvement and change
Monitoring standards over time can help to identify situations that are “out of control” (useful in TQM environments)

26. Kaplan & Norton – Balanced Scorecard
Kaplan and Norton devised and later refined the notion of the “balanced scorecard”
Aim of the scorecard: to provide a comprehensive framework for translating a company’s strategic objectives into a coherent set of performance measures
Each organisation must decide what are its critical performance measures – this will vary over time and be linked to the strategy of the organisation
Performance measures must be tied to strategies

27. Elements of a balanced scorecard

28. A further example (exam style)
Bath Ltd is a manufacturing company.
The data below relates to one of their products called the "Claverton"
The product uses only 1 type of raw material and is made using only skilled labour.
The company budgeted to make 3,000 units.
Standard costs per unit are:
Material S kg at a cost of £4.00 per kg.
Skilled labour hours at a cost of £7.90 per hour.
At the end of the production run ACTUAL production data were compiled.
The data extracted are shown below:
Actual units produced = 2,800
Data on materials and labour:
Material S ,500 kg at a TOTAL cost of £39,900
Skilled labour 14,700 hours at a TOTAL cost of £117,600

29. Calculation of totals & unit costs
Standards
Material S total use (kg) 3.25 X 2,800 = 9,100
total cost 9,100 X £4.00 = £36,400
Skilled labour total hours 5 X 2,800 = 14,000
total cost 14,000 X 7.90 = £110,600
Actuals
Material S unit cost 39,900 / 10,500 = £3.80
Skilled labour unit cost 117,600 / 14,700 = £8.00

30. The variances Total materials variance 36,400 - 39,900 = 3,500 (A)
Materials price variance
( ) X 10,500 = 2,100 (F)
Materials usage variance
(9, ,500) X 4.00 = 5,600 (A)
3,500 (A)
Total Labour variance
110, ,600 = 7,000 (A)
Labour wage rate variance
( ) X 14,700 = 1,470 (A)
Labour efficiency variance
(14, ,700) X 7.90 = 5,530 (A)
7,000 (A)