Accounting (9615) | Standard costing and variance analysis

Welcome to Advanced Accounting! Standard Costing and Variance Analysis

Hello future accountants! We are stepping into the world of management accounting, where we don't just record what happened (Financial Accounting), but we actively measure, plan, and control costs. This chapter, "Standard Costing and Variance Analysis," is a cornerstone of operational control.

It answers the crucial question: Why was our actual performance different from what we planned?

Don't worry if the formulae look intimidating at first. We will break them down into simple, logical steps. Mastery here allows management to take corrective action, making the business more efficient and profitable!

1. Understanding the Standard Costing System

1.1 Core Terminology

The entire system relies on two main concepts:

• Standard Cost: This is the pre-determined, target cost for one unit of product or service under efficient operating conditions. Think of it as the perfect recipe price.
• Variance Analysis: This is the process of calculating the difference (the variance) between the Standard Cost and the Actual Cost, and then splitting that difference into specific reasons (variances).

Analogy: Imagine you plan to bake a cake. The standard cost is what your recipe *should* cost if you buy exactly the right amount of ingredients at the planned price. If the actual cost is higher, variance analysis tells you if it was because the eggs were more expensive (price variance) or if you used too many eggs (usage variance).

1.2 Purpose of Standard Costing

A standard costing system helps management in several key areas:

• Planning: Standards provide a clear goal (the budget) for all departments.
• Control: By focusing on variances, management uses the principle of management by exception—they only investigate results that are significantly off target.
• Performance Measurement: It provides a benchmark to judge how well managers are controlling costs.
• Stock Valuation: Standard costs simplify the valuation of finished goods and work-in-progress.

1.3 Advantages and Disadvantages

Advantages (Why we use it)

• It promotes cost consciousness among employees.
• It provides a rapid way to highlight areas of inefficiency (control).
• It simplifies record-keeping and inventory valuation.
• It is often used in setting a realistic selling price.

Disadvantages (Why it can be tricky)

• Setting accurate standards can be difficult and time-consuming, especially if conditions change rapidly.
• It might discourage continuous improvement if managers only aim to meet the standard and not beat it.
• If standards are too tight, they can be demotivating for staff.
• The calculation of variances is historical; management must still investigate the cause of the variance quickly to be effective.

2. Cost Variances: Materials

Cost variances are used to explain the difference between the Standard Total Cost and the Actual Total Cost incurred for direct materials used in production.

Total Material Variance = (Standard Quantity for Actual Production \(\times\) Standard Price) - (Actual Quantity \(\times\) Actual Price)

This total variance is split into two parts: price and usage.

2.1 Material Price Variance

This variance measures the difference between the actual price paid for materials and the standard price that should have been paid.

Formula:

\[ (AP - SP) \times AQ \]

• AP = Actual Price per unit of material
• SP = Standard Price per unit of material
• AQ = Actual Quantity of material purchased or used (usually purchased)

Interpretation:

• If AP < SP, the variance is Favorable (F): We saved money.
• If AP > SP, the variance is Adverse (A): We overspent.

Possible Causes: Changes in market conditions, negotiating better/worse discounts, using a different quality supplier.

2.2 Material Usage Variance

This variance measures the difference between the amount of material actually used and the amount that should have been used for the actual output achieved, valued at the standard price.

Formula:

\[ (AQ - SQ) \times SP \]

• AQ = Actual Quantity of material used
• SQ = Standard Quantity allowed for Actual Output (This is the tricky number: if we made 100 units and each unit should take 2kg, SQ = 200kg)
• SP = Standard Price per unit of material (We use SP to isolate the variance caused purely by quantity difference)

Interpretation:

• If AQ < SQ, the variance is Favorable (F): We used less material than expected (efficient).
• If AQ > SQ, the variance is Adverse (A): We used more material than expected (wasteful).

Possible Causes: Worker carelessness, poor quality materials (leading to scrap), machine inefficiency.

3. Cost Variances: Labour

Labour variances explain the difference between the standard labour cost for the actual output and the actual labour cost incurred. These are also split into two components: rate and efficiency.

3.1 Labour Rate Variance

This variance measures the difference between the actual wage rate paid and the standard wage rate that should have been paid.

Formula:

\[ (AR - SR) \times AH \]

• AR = Actual Rate (wage) per hour
• SR = Standard Rate (wage) per hour
• AH = Actual Hours worked

Interpretation:

• If AR < SR, the variance is Favorable (F): We paid less per hour.
• If AR > SR, the variance is Adverse (A): We paid more per hour (expensive).

Possible Causes: Using highly skilled/expensive staff for standard work (Adverse), using trainees or lower-skilled staff (Favorable), or unexpected overtime payments.

3.2 Labour Efficiency Variance

This variance measures the difference between the hours actually worked and the hours that should have been worked for the actual output achieved, valued at the standard rate.

Formula:

\[ (AH - SH) \times SR \]

• AH = Actual Hours worked
• SH = Standard Hours allowed for Actual Output (Similar to SQ, this is based on production volume)
• SR = Standard Rate per hour (Used to isolate the variance caused purely by time difference)

Interpretation:

• If AH < SH, the variance is Favorable (F): Workers were faster/more efficient.
• If AH > SH, the variance is Adverse (A): Workers took longer/were inefficient.

Possible Causes: Machine breakdowns, poor supervision, lack of training (Adverse), or highly motivated, high-quality material usage (Favorable).

4. Revenue Variances: Sales

Unlike materials and labour, which measure cost differences, sales variances measure why the actual revenue or profit differed from the budgeted amount.

We focus on two key sales variances: sales price and sales volume.

4.1 Sales Price Variance

This variance measures the difference between the actual selling price and the standard (budgeted) selling price, multiplied by the actual quantity sold.

Formula:

\[ (AP - SP) \times AQ \]

• AP = Actual Selling Price per unit
• SP = Standard (Budgeted) Selling Price per unit
• AQ = Actual Quantity Sold

Interpretation:

• If AP > SP, the variance is Favorable (F): We sold the product for more than planned.
• If AP < SP, the variance is Adverse (A): We gave unexpected discounts or had to lower prices.

4.2 Sales Volume Variance (based on Profit/Contribution)

This variance measures the change in profit or contribution resulting purely from selling a different quantity of units than budgeted.

Note: For effective management reporting, this variance is calculated using the Standard Profit per unit (SC), not just the selling price, as we want to measure the impact on the bottom line.

Formula:

\[ (AQ - BQ) \times SC \]

• AQ = Actual Quantity Sold
• BQ = Budgeted Quantity Sold (The original sales target)
• SC = Standard Contribution or Profit per unit

Interpretation:

• If AQ > BQ, the variance is Favorable (F): We sold more than budgeted, increasing our profit.
• If AQ < BQ, the variance is Adverse (A): We sold less than budgeted, hurting our profit.

Possible Causes: Better/worse marketing, changes in consumer demand, economic slump, or competitor actions.

5. Interrelationships and Reconciliation

5.1 The Interrelationship Between Variances

It is rare for variances to occur in isolation. One decision in procurement can cascade effects throughout production, linking variances together. Understanding this is key to providing meaningful interpretation to management.

Example of Interrelationship:

1. Management decides to buy cheaper, lower-quality raw materials. This results in a Favorable Material Price Variance.
2. However, because the materials are lower quality, the production staff creates more scrap and waste, and they have to spend more time adjusting machines.
3. This leads to an Adverse Material Usage Variance AND an Adverse Labour Efficiency Variance.

In this case, the apparent saving (Favorable Price) was entirely wiped out, or even exceeded, by the losses in efficiency and usage (Adverse Usage and Efficiency). Management needs to know the full story!

Did you know? Accountants often produce a narrative report alongside the variance calculations, explaining these links to help managers make better decisions.

5.2 Reconciliation of Budgeted and Actual Figures

The final crucial step is proving that the variances calculated are correct by using them to bridge the gap between the budget and the actual result. The two main reconciliations required are for Cost and Profit.

A. Reconciliation of Budget and Actual Cost

This is typically done departmentally (e.g., reconciling the budgeted cost of materials against the actual cost of materials).

B. Reconciliation of Budgeted and Actual Profit

This is the reconciliation most frequently required in examinations, showing how all variances affect the company’s bottom line.

Step-by-Step Reconciliation Statement:

1. Start with the Budgeted Profit.
2. Add all Favorable variances (these increase profit).
3. Subtract all Adverse variances (these decrease profit).
4. The resulting total must equal the Actual Profit.

Final Encouragement

Standard Costing is one of the most practical parts of management accounting. Once you understand the logic—compare actual input/price with standard input/price, hold the other factor constant—the formulae will start to make perfect sense. Practice those calculations, and you'll be able to tell management exactly why their results differed from the plan! Good luck!