Presentation on theme: "Standard Costing and Variance Analysis"— Presentation transcript:
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 standardsCompile flexible budgets and from these calculate labour, materials overhead and sales variances and reconcile actual profit with budgeted profitIdentify the causes of variances and discuss the factors leading to the decision to investigate variancesDiscuss 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, NovemberGraham C, Lyall D and Puxty A (1992) ‘Cost control: the managers perspective’ Management Accounting, OctoberKaplan RS and Norton DP (2000) ‘The Balanced Scorecard – Measures that Drive Performance.’ Harvard Business Review, January-February, pages
5 Budgets & Standard Costs Prepare the budget using standard costs and budgeted pricesQ: Should we compare the budgeted output with the actual output to calculate the variances?A: No, first flex the budgetFlex 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 profitplusAll favourable variancesminusAll adverse (unfavourable) variancesequalsActual 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 standardsRepresent perfect performance. Minimum costs under the most efficient operating conditions. Can be demotivating and unlikely to be used in practice.Currently attainable standardsCosts that should be incurred under efficient operating conditions. Difficult, but not impossible, to achieve. Can be set at various levels of difficulty.
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 VariancesMaterial 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 VariancesMaterials 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 VariancesLabour 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 VariancesLabour 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 Variance20,000 – 19,000 = 1,000 (F)
16 Purposes of Standard Costing Providing a prediction of future costs that can be used for decision-making purposesProviding a challenging targetAssisting in setting budgetsActing as a control deviceSimplifying 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 costlyCost-benefit analysis – keep insignificant variances under reviewSignificant 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) variancesArise from the difference between the original planned performance and the revised planned performanceThese variances provide a check on forecasting skills and also help to provide a revised base for use in forward planningOperational (controllable) variancesArise from efficiencies or inefficiencies between target and actual resultsThese variances provide a more relevant focus for management control action
19 Some examples of reasons for variances (Drury 2005) Sales volume variance (adverse)Economic recessionIncrease in selling priceDirect materials usage variance (adverse)Careless handling of materialsSubstandard materialsPilferageConsider 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’ activitiesCurrent debate (centred on the “modern” business environment)Rate of change of product type and design is swiftCustomer demand is for speedy availability of productsProduct life cycles are shorterThere are higher quality standards
21 This has changed the way businesses operate, as follows: JIT systems allied to flexible manufacturing systems respond to customer demandTQM programmes aim at continuous improvement and effective provision of value-added activitiesGreater emphasis on the value chainChanges to ABC and target costingImproved 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 costsInconsistency with a JIT philosophy (supplier chains, bulk purchases, effect on quality)Motivates behaviour that is inconsistent with TQM philosophyOveremphasises the importance of direct labourDelay in feedback reportingStandards 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 criticismsTheir 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 controlAreas of responsibility may not have clear lines of demarcationEven 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 PlanningStandards may be useful as building blocks for budgeting, which has to happen even in a TQM environmentControlEven where automated input of materials occurs, it may still be relevant to analyse costs of changes from planDecision makingExisting standards may be the starting point for the estimated costs of new products
25 Points in favour of standard costing Performance measurementWhen product mix is stable, performance monitoring may be enhanced by the use of controllable standardsProduct pricingUse 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 appliedImprovement and changeMonitoring 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 measuresEach organisation must decide what are its critical performance measures – this will vary over time and be linked to the strategy of the organisationPerformance measures must be tied to strategies
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 = 2,800Data on materials and labour:Material S ,500 kg at a TOTAL cost of £39,900Skilled labour 14,700 hours at a TOTAL cost of £117,600
29 Calculation of totals & unit costs StandardsMaterial S total use (kg) 3.25 X 2,800 = 9,100total cost 9,100 X £4.00 = £36,400Skilled labour total hours 5 X 2,800 = 14,000total cost 14,000 X 7.90 = £110,600ActualsMaterial S unit cost 39,900 / 10,500 = £3.80Skilled 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 variance110, ,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)
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