Accounting (9706) | Standard costing

Standard Costing: Setting Benchmarks for Success (A Level 9706)

Hello future accountants! This chapter, Standard Costing, is one of the most powerful tools in management accounting. It moves us beyond simply reporting what happened (actual costs) and helps us understand why it happened by comparing those actuals to what should have happened (standards).

Mastering this topic will allow you to diagnose problems, pinpoint efficiency issues, and make strong, data-driven recommendations. Don't worry if the formulas seem overwhelming at first—we will break them down step-by-step!

1. What is Standard Costing?

1.1 Defining the Standard

Standard Costing is a system that uses pre-determined costs (or revenues) for materials, labour, and overheads, against which actual costs are compared. It is a control system designed to measure performance and improve efficiency.

• Think of a standard cost as the ideal 'recipe' for making a product. It tells you exactly:
  • How much flour (materials) should be used.
  • How long the chef (labour) should take.
  • How much the power/rent (overheads) should cost per cake.

When you make the cake, you compare the actual flour used against the standard flour that was specified. The difference is the variance.

1.2 Types of Standards

Standards can be set at different levels of difficulty:

• Ideal Standards: Perfection! Achieved only under the best operating conditions (no waste, no delays). These are often too discouraging for employees.
• Attainable/Practical Standards: High but achievable targets that include normal waste, unavoidable downtime, and realistic production levels. These are usually the best for motivation and control.

1.3 Advantages and Disadvantages of Standard Costing

Standard costing is a robust system, but it has its limitations:

Advantages:

• Performance Measurement: It highlights where costs are out of line, focusing management attention using the principle of management by exception.
• Cost Control: Provides a target for employees, encouraging efficiency and waste reduction.
• Stock Valuation: Inventory can be valued at standard cost, simplifying calculations.
• Budgeting Aid: The standards provide a reliable baseline for preparing future budgets.

Disadvantages:

• Costly to Implement: Setting up the initial standards can be time-consuming and expensive.
• Outdated Standards: Standards must be regularly updated (e.g., if technology or material prices change), or they become meaningless.
• Morale Issues: If standards are set too high (ideal), they can demotivate staff. If they are too loose, they provide no challenge.
• Not suitable for all businesses: It works best in mass-production environments, less so in custom job environments.

2. Introduction to Variance Analysis

A Variance is simply the difference between the Actual Cost (or Revenue) and the Standard Cost (or Revenue).

2.1 Favourable vs. Adverse Variances

• Favourable (F): This variance increases the expected profit or decreases the expected cost. (Good news!)
• Adverse (A): This variance decreases the expected profit or increases the expected cost. (Bad news!)

Memory Tip: When calculating cost variances, think about money leaving the bank. If Actual Cost < Standard Cost, you saved money, so it’s Favourable (F). If Actual Cost > Standard Cost, it’s Adverse (A).

2.2 The General Formula

All cost variances follow a basic structure:

$$ \text{Variance} = \text{Standard Cost} - \text{Actual Cost} $$

If the result is positive, it is Favourable. If negative, it is Adverse.

3. Calculating Cost Variances

We break down the total variance into smaller, explainable pieces (sub-variances) to determine who is responsible and what caused the difference.

3.1 Direct Material Variances

Materials variance is split into two parts: one related to the price we paid, and one related to the amount we used.

A. Direct Material Price Variance

This measures the difference between the standard price and the actual price paid for the materials actually purchased.

$$ \text{DMPV} = (\text{Standard Price} - \text{Actual Price}) \times \text{Actual Quantity purchased} $$

Example: If the standard price for copper is \$10 per kg, but you actually paid \$11 per kg for 500 kg, the variance is Adverse:
\( (\$10 - \$11) \times 500 \text{ kg} = -\$500 \text{ (A)} \)

B. Direct Material Usage Variance

This measures the difference between the standard quantity that should have been used for the actual output, and the actual quantity used, valued at the standard price.

$$ \text{DMUV} = (\text{Standard Quantity for Actual Output} - \text{Actual Quantity used}) \times \text{Standard Price} $$

Example: Standard usage is 5 kg per unit. You made 100 units, so standard quantity should be 500 kg. You actually used 510 kg (Standard Price \$10).
\( (500 \text{ kg} - 510 \text{ kg}) \times \$10 = -\$100 \text{ (A)} \) (We wasted 10 kg).

3.2 Direct Labour Variances

Labour variance is split into the rate paid and the efficiency (time taken).

A. Direct Labour Rate Variance

This measures the difference between the standard rate and the actual rate paid for the actual hours worked.

$$ \text{DLRV} = (\text{Standard Rate} - \text{Actual Rate}) \times \text{Actual Hours worked} $$

This variance is often the responsibility of the HR/Payroll Department.

B. Direct Labour Efficiency Variance

This measures the difference between the standard hours allowed for the actual output and the actual hours taken, valued at the standard rate.

$$ \text{DLEV} = (\text{Standard Hours for Actual Output} - \text{Actual Hours worked}) \times \text{Standard Rate} $$

This variance is often the responsibility of the Production Manager.

3.3 Fixed Overhead Variances (The Detailed Section!)

Fixed overheads (like rent or management salaries) are tricky because, in the short term, they don't change with output. However, in standard costing, we often absorb them into the product cost based on activity (e.g., labour hours).

We start with the Standard Absorption Rate (SAR):

$$ \text{SAR} = \frac{\text{Budgeted Fixed Overhead}}{\text{Budgeted Activity (e.g., hours or units)}} $$

A. Fixed Overhead Expenditure Variance (FOHEV)

This is the simplest. It measures if we spent more or less than we budgeted.

$$ \text{FOHEV} = \text{Budgeted Fixed Overhead} - \text{Actual Fixed Overhead} $$

B. Fixed Overhead Volume Variance (FOHVV)

This measures the difference between the fixed overhead absorbed into actual production and the fixed overhead budgeted. If we produce more than budgeted, we "over-absorb" the fixed costs, which is Favourable.

$$ \text{FOHVV} = (\text{Actual Volume/Hours} - \text{Budgeted Volume/Hours}) \times \text{SAR} $$

Don't worry if this seems tricky at first. Remember: if you manufacture more (high volume), you spread the fixed costs thinner, which is Favourable for absorption.

C. Fixed Overhead Sub-Variances: Capacity and Efficiency

The Volume Variance (B) can be split into two further sub-variances to give better insight: Capacity (Did we work the scheduled time?) and Efficiency (How well did we use that time?).

1. Fixed Overhead Capacity Variance (FOHCV)
Measures the effect of working more or fewer hours than budgeted (the utilisation of the factory).

$$ \text{FOHCV} = (\text{Actual Hours Worked} - \text{Budgeted Hours}) \times \text{SAR} $$

2. Fixed Overhead Efficiency Variance (FOHEFV)
Measures the effect of the efficiency of the workforce (similar to labour efficiency, but valuing the difference at the SAR).

$$ \text{FOHEFV} = (\text{Standard Hours for Actual Output} - \text{Actual Hours Worked}) \times \text{SAR} $$

Important Check: The sum of the Capacity Variance and the Efficiency Variance must equal the Volume Variance.
\( \text{FOHCV} + \text{FOHEFV} = \text{FOHVV} \)

4. Sales Variances (The Revenue Side)

Variances can also arise in revenue, measuring how successful the sales department was.

Crucial Note: Sales variances are calculated based on profit, not cost. Therefore, if Actual Sales Price > Standard Sales Price, it is Favourable.

4.1 Sales Price Variance (SPPV)

Measures whether the actual selling price was higher or lower than the standard selling price.

$$ \text{SPPV} = (\text{Actual Selling Price} - \text{Standard Selling Price}) \times \text{Actual Quantity Sold} $$

4.2 Sales Volume Variance (SVVV)

Measures the impact on profit caused by selling a different quantity of units than budgeted. This is valued at the Standard Profit per unit.

$$ \text{SVVV} = (\text{Actual Quantity Sold} - \text{Budgeted Quantity Sold}) \times \text{Standard Profit per Unit} $$

Did you know? In advanced management accounting, Sales Volume Variance is sometimes calculated using Contribution Margin instead of Profit per Unit, but for the 9706 syllabus, the Standard Profit per Unit is the appropriate measure.

5. Analysis, Interrelationships, and Decision Making

Calculation is only half the battle. The other half is using the results to explain performance and recommend improvements.

5.1 Possible Causes of Variances

When preparing your report, you must evaluate possible causes for variances:

• Material Price Variance (A): Unexpected inflation, rush orders, poor purchasing strategy, buying smaller quantities (losing volume discounts).
• Material Usage Variance (A): Poor quality materials (which might cause a Favourable Price Variance!), machine failure, inexperienced staff, pilferage/theft.
• Labour Rate Variance (F): Using junior staff instead of senior staff (cheaper), temporary pay decrease.
• Labour Efficiency Variance (A): Poor supervision, machine downtime, lack of training, using poor quality materials (making the workers take longer).
• Sales Price Variance (A): Forced to offer large discounts due to competition, lowering price to clear old stock.
• Sales Volume Variance (F): Successful marketing campaign, unexpected high market demand, aggressive sales strategy.

5.2 Interrelationship of Variances

Variances rarely occur in isolation. One decision in one area affects another area. You must discuss these relationships in your analysis.

Classic Example: The Vicious Cycle

1. The Purchasing Manager decides to buy cheaper, lower quality materials.
   Result: Direct Material Price Variance is Favourable (F).
2. The Production Manager uses the low-quality materials. They break easily, causing waste and rework.
   Result: Direct Material Usage Variance is Adverse (A).
3. The low-quality materials also take longer to process.
   Result: Direct Labour Efficiency Variance is Adverse (A), and Fixed Overhead Efficiency Variance is Adverse (A).

Evaluation: The initial Favourable variance on price was offset by multiple Adverse variances in production, leading to a net loss of efficiency and higher overall cost.

5.3 Non-Financial Factors

Management decisions based purely on variance analysis can be short-sighted. Always consider non-financial aspects:

• Quality: Does using cheaper labour (Favourable Rate Variance) reduce product quality and damage reputation?
• Employee Morale: Are workers rushing to meet a tight standard (Favourable Efficiency) but resulting in stress and burnout?
• Customer Satisfaction: Did quick delivery (Adverse Labour Efficiency because of overtime) please the customer?
• Environmental Impact: Did cost-saving measures (e.g., lower material quality) lead to greater waste disposal problems?

5.4 Using Data for Business Decisions and Recommendations

Your final step in an exam question is often to make a recommendation. Use the variances to justify your advice.

• If the Material Price Variance is consistently Adverse due to high supplier prices, recommend finding new bulk suppliers or negotiating better terms.
• If Labour Efficiency is severely Adverse, recommend investing in better staff training or replacing outdated machinery.
• If Fixed Overhead Capacity is Adverse, recommend the sales team seek out more orders or lease out unused factory space to maximise capacity utilisation.