Management Accountant-Standard Costing & Variance Analysis

STANDARD COSTING AND VARIANCE ANALYSIS

Introduction; Management accounting is managing a business through accounting information. In this process, management accounting is facilitating managerial control. It can also be applied to your own daily/monthly expenses, if necessary.

•   These measures should be applied correctly so that performance takes place according to plans. Planning is the first tool for making the control effective. The vital aspect of managerial control is cost control. Hence, it is very important to plan and control costs.

•   Standard costing is a technique which helps you to control costs and business operations. It aims at eliminating wastes and increasing efficiency in performance through setting up standards or formulating cost plans.

Meaning of Standard

•   When you want to measure some thing, you must take some parameter or yardstick for measuring. We can call this as standard. What are your daily expenses? An average of $50! If you have been spending this much for so many days, then this is your daily standard expense.

•   The word standard means a benchmark or yardstick. The standard cost is a predetermined cost which determines in advance what each product or service should cost under given circumstances.

•   “Standard cost is the amount the firm thinks a product or the operation of the process for a period of time should cost, based upon certain assumed conditions of efficiency, economic conditions and other factors.”

What is standard costing?

•   CIMA terminology defines standard costing as a control technique which compares standard cost and revenues with actual results to obtain variance which are used to stimulate improved performance.

•   It is a technique of cost accounting which compares the standard cost of each product or service with actual cost to determine the efficiency of operation so that any remedial action may be taken immediately. The technique of using standard costs for the purposes of cost control is known as standard costing.

• It is a system of cost accounting which is designed to find out how much should be the cost of a product under the existing conditions. The actual cost can be ascertained only when production is undertaken. The predetermined cost is compared to the actual cost and a variance between the two enables the management to take necessary corrective measures

•  The standard cost may be stored on a standard cost card, on a computer, or as part of a spreadsheet so that it can be used in the calculations of variances. The standard cost may be prepared using either absorption costing principles or marginal costing principles.

Types of standards

There is a whole range of bases upon which standards may be set within a standard costing system. This choice will be affected by the use to which the standards will be   put and includes:

Ideal standard

Standards may be set at ideal levels, which make no allowance for normal losses, waste and machine down time.  This type of ideal standard can be used if managers wish to highlight and monitor the full cost of factors such as waste, etc.  This standard can be very demotivating for individuals who feel that an adverse variance suggests that they have performed badly.  There are some amounts of wastes which are usually unavoidable which will always result in adverse variances.

Attainable standard

Standard may also be set at attainable levels which assume efficient levels of operation, but which include allowances for factors such as normal loss, waste and machine down time. This type a standard does not have the negative motivational impact that can arise with an ideal standard because it makes some allowance for unavoidable inefficiency.  Adverse variances will reveal whether inefficiency have exceeded this unavoidable amount.

Current standard

Standards based on current performance level.  (Current wastage, current inefficiencies) are known as current standards.  Their disadvantage is that they do not encourage any attempt to improve on current levels of efficiency.

Basic standard

A basic standard is one which is kept unchanged over a period of time.  It is used as the basis for preparing more update standards for control purposes.  A basic standard may be used to show the trend in costs over a period of time.

BASIC VARIANCE ANALYSIS

What is variance Analysis?

•   A variance is the difference between the expected standard cost and the actual cost incurred.  A unit standard cost contains details concerning both the usage of resources and the price to be paid for the resource

Variance analysis can simply be defined as the process of analyzing the difference between the standard cost and the actual cost (this difference is called the variance) into its constituent parts.  The causes of variances are determined and management can take appropriate measures.

Why Perform Variance Analysis?

Variance analysis is aimed at obtaining practical pointers to the causes of off-the –standard performance so that management can improve operations, increase efficiency, utilize resources more effectively and reduce costs.  For this to be achieved, the following need to be met:

A simple standard costing system that is easily understood by everyone in the organization.

Fast and timely reporting of variances at the point of incidence so as to attach responsibility for favourable or unfavourable variance.

Rapid management action to correct adverse (unfavourable) variances and encourage favourable variances.

Utmost commitment to the process of setting standards and performance evaluation by all managers and employees.

However, not all variances are identified and acted upon.  Only those types of variances, which fulfil the cost control needs of the organization and meet performance evaluation purposes of the entity are identified, calculated and acted upon.  Thus, the only criterion for the calculation of a variance is its usefulness to the organization:  if it is not useful for management purposed, then it should not be calculated!

Attaching the Variance to Responsible Persons

In calculating variances, the calculations need to be detailed enough so that the responsibility for the variance can be assigned to a particular individual.  This is necessary because it would be almost impossible to control costs if the responsibility for a certain variance is spread between many managers since each of them will “pass the buck” or refuse to accept personal responsibility for the variance.

For example, the material cost variance can be analyzed into usage variance and price variance.  The usage variance is the responsibility of the foreman or production manager using those materials, while the price variance is the responsibility of the purchasing manger.

The above example illustrates how variance analysis is utilized to attach responsibility for cost variances to individuals.  Such individuals cannot claim that they are not responsible for the variances arising.  However, to be able to attach such responsibility, the costs must be controllable by the concerned individuals!

Due to tendency of budgetary control and standard costing variance analysis responsibilities to individuals, it is usually referred to as responsibility accounting.  But where departments are interdependent, then responsibility accounting may not be straight forward due to inefficiencies or efficiency brought in from other departments.

Relationship between variances

We cannot over emphasize the central aim of variance analysis as outlined in the above paragraphs:  i.e. to assign responsibility for a particular variance to a specific individual, assuming there is adequate independence between departments and the managers have full control of their departments so that they can be held fully responsible for the resulting variances.

Variance analysis subdivides the total difference between the budgeted profit and actual profit for the period into the detailed difference.  This is illustrated in the figure below.  Each of the managers responsible for each of the detailed variances can then he held responsible.  But remember that only those variances useful for management controls are calculate.

•   Variance analysis involves breaking down the total variance to explain how much of it is caused by the usage of resources being different from the standard and how much of it is caused by the price of resources being different from the standard. These variances can be combined to reconcile the total cost difference revealed by the comparison of the actual and standard cost

INSIGHT NOTE:

Carefully note that when prices are being charged to production, this can be done at the actual or standard price.  For purposes of making variances analysis useful, instant and easily understood, we will assume that the process of production changes the costs to production units at the standard costs. When units are changed with standard costs, it is now very easy to compare the standard cost with the actual costs and compute the variance immediately:  consequently, the responsibility for the variances can also be assigned immediately and corrective measures implemented

We will look at variances in the following order:

a)      Direct Material Total Variance

b)      Direct Labour Total Variance

c)      Variable Overhead Total Variance

d)      Fixed Overhead Total Variance.

For purposes of our calculations, we will assume the following basic data for company ABC limited:

£ Per unit

Direct materials 81 kg ×£7 per kg                      567

Direct labour 97hours ×£4 per hour                   388

Variance overhead 97 hours ×£3 per hour         291

1246

During January 530 units were produced and the costs incurred were as follows

Direct material 4284 kg purchased and used, cost £308484

Direct labour51380 hours worked, cost £200382

Variable overhead cost £156709

You are required to calculate the variable cost variances for January.

Solution

 

DIRECT MATERIAL COST VARIANCES

(a) Direct material total variance

Std cost of actual production less actual cost (use actual units produced)

(b) Material Price Variance

(Std price –actual price) actual quantity

(SP-AP) AQ

(C) Material Usage Variance

(Std quantity-actual quantity) Std price

(SQ-AQ) SP

(a) Material total variance

530 units should cost (×567)               300510

But did cost                                         308484

Total direct material cost variance       7974 adverse

(b) Direct material price variance

(Standard price per kg – actual price per kg) × Actual purchased quantity

= (£7-308454 ÷ 42845) × 42845

= £8569 Adverse

(c) Direct material usage variance

(Standard usage for actual production – actual usage) standard price/kg

= (530 ×81 kg) - 42845) ×7

= £595 Favourable

Check: 8569 adverse + 595 favourable = 7974 adverse (the correct total variance)

All of the quantity variances are always valued at the standard price and the quantity variances for labour and for variable overhead. .the efficiency variances are valued at the standard rate per hour.

DIRECT LABOUR COST VARIANCES

(a) Direct labour total variance

Std labour cost of actual production (cost per unit (£) for actual units produced) less labour actual cost

(b) Labour efficiency variance

(Standard hours for actual production-Actual hours-) Std Rate

(C) Labour Rate Variance

(Std rate-actual rate) Actual Hours

(SR-AR) AH

(a) Total cost variance.

530 units should cost (×£388)             205640

But did cost                                         200382

Total direct labour cost variance              5258 favourable

(b) Direct labour rate variance

Standard rate per hour – actual rate per hour) × actual hours

= (£4 – 200382 ÷ 51380) × 51380 hours

= £5138 favourable

(c) Direct labour efficiency variance

Standard hours for actual production – actual hours) × standard rate/hour

= (530× 97 hours) – 51380) ×£4

= £120 favourable

Check £5138 favourable + £120 favourable = £5258 favourable (correct total variance)

VARIABLE OVERHEAD COST VARIANCES

(A) Variable Overheads Total Variance

=Std variable cost for actual production (use actual units) less actual variable overheads.

(B) Variable Overheads Expenditure Variance

Budgeted variable overheads less Actual variable overheads

(Std rate per hour –actual rate per hour) Actual hours

(C) Variable Overheads Efficiency Variance

(Std hours for actual production less actual hours) V.O.A.R

(SH-AH worked) V.O.A.R

(a)    Variable overhead total variance

£

530 units should cost (×£291)             154230

but did cost                                          156709

Total variable overhead cost variance      2479 adverse

(b) Variable overhead expenditure variance

(Standard rate per hour – actual rate per hour) × Actual hour

= (£3 – 156709 ÷ 51380) ×51380 hours

= £2569 adverse

(c) Variable overhead efficiency variance

(Standard hours for actual production – actual hours) × Standard rate per hour

= (530 × 97 hours – 51380) ×£3

= £90 favourable

Check £2569 adverse + £90 favourable= £2479 adverse (the correct total variance)

Typical Causes of Material Variances

Price Variances

a)      Paying higher or lower prices than planned.

b)      Losing or gaining quantity discounts by buying in smaller or larger quantities than planned.

c)      Buying lower or higher quality than planned.

d)      Buying substitute material due to unavailability of planned material.

Usage (Efficiency) Variances

a)      Greater or lower field from material than planned.

b)      Gains or losses due to use of substitute or gather/lower quality than planned.

c)      Inefficiency or efficient machinery.

d)      Grater or lower rate of scrap than anticipated.

e)      Poorly trained workers or extremely high quality labour.

Typical Causes of Labour Variances

Labour Rate Variances

a)      Higher rates being paid than planned due to wage (increase) awards.

b)      Higher or lower grade of workers being used than planned.

c)      Payment of unplanned overtime or bonus.

Labour Efficiency Variances

a)      Use of incorrect grade of labour e.g. poorly trained personnel.

b)      Poor workshop organization or supervision.

c)      Incorrect materials or machine problems.

d)      Use of better quality labour

e)      Increase labour or decrease labour efficiency.

FIXED PRODUCTION OVERHEAD VARIANCES

•   The total fixed production overhead variance is equal to the under or over absorbed fixed production overhead for the period.

•   Factors which could lead to under-absorption will cause adverse fixed overhead variances.  Factors which could lead to over absorption will cause favourable fixed overhead variances.

The reasons for under or over absorption of overhead

•   There are 2 reasons why fixed overheads are under or over absorbed and they are both linked to the calculation of the overhead absorption rate:

Overhead absorption rate = budgeted fixed overhead

Budgeted activity level

The overhead will be under or over absorbed for either or both of the following reasons

(a)    The actual overhead expenditure was different from budget (this difference is expressed by the overhead expenditure variances)

(b)   The actual activity level was different from budget (this difference is expressed by the overhead volume variance)

Note: For fixed overhead (in an absorption costing system) there are 2 variances, a price variance (the expenditure variance) and a quantity variance (the volume variance) as for all the costs we have considered so far.

QUESTION1

A company manufactures a single product. Budget and actual data for the latest period is as follows:

Budget; Fixed production overhead expenditure £103,000;    Production output 10300 units

Actual; Fixed production overhead expenditure £108540;      Production output 10605 units

The fixed production overhead total variance

This is equal to the over-or under absorption of overhead

Solution

Predetermined overhead absorption rate = £103000

10300 unit = £10 per unit

Overhead absorbed during period                    £

£10 ×10605 units                                 106050

Actual overhead incurred                    108540

Fixed production overhead total variance   2490 adverse

An adverse total variance represents under-absorbed overhead

(b) The fixed production overhead expenditure variance

This is the amount of the total variance which is caused by the expenditure on overheads being different from the budgeted amount.

=Budgeted fixed overheads less actual fixed overheads

Budgeted fixed production overhead expenditure       103000

Actual fixed production overhead expenditure            108540

Fixed production overhead expenditure variance            5540 adverse

Note: the difference between the expenditure variances for fixed overheads and for variable overhead.  With the variable overhead expenditure variance an allowance is made for the actual number of hours worked (i.e. the budget is flexed to the actual activity level).  With the fixed overhead expenditure variances the allowance is not flexed because fixed overhead expenditure should not change if activity level changes.

(c) The fixed production overhead volume variance.

This is the amount of the total variance which is caused by the activity level being different from the budget.

(Actual activity level- Budgeted activity level)F.O.A.R

(10605 units-10300 units) 10

Check £5540 adverse + £3050 favourable = £2490 adverse (the correct total variance)

Note. The actual activity level was higher than budgeted favourable.  This means that more overheads would have been absorbed, which results in a favourable variance.

ü  The fixed overheads volume variance is of two types;

(A)   Fixed overheads capacity variance

= (actual hours less Budgeted hours) f.o.a.r per hour

(B)   Fixed overheads efficiency variance

= (Std hours for actual production (use actual units) less actual hours worked) F.0.A.R per hour

QUESTION 2

The following information is available for J Ltd for period 4

Budget

Fixed production overheads                                        $22,960

Units                                                                            6,560

The standard time to produce each unit is 2 hours

Actual                                                                          $24,200

Fixed production overheads                                        6,460

Labour hours                                                               12,600 hrs

Required

Calculate the following

a)      (i) FOAR per unit

(ii) Fixed overhead expenditure variance

(iii) Fixed overhead volume variance

b)      (i)  FOAR per hour

(ii) Fixed overhead expenditure variance

(iii) Fixed overhead capacity variance

(v) Fixed overhead efficiency variance

What Causes Overhead Variances?

Overhead variances arise mainly due to the conventions of the overheads absorption process.  The overhead absorption rates utilized in this process are calculated form two main estimates:

1. Estimates of expenditure levels.
2. Estimates of the activity levels during the budget period.

Since the two elements are mere estimates, they hardly coincide with reality, and therefore will almost certainly cause a favourable or unfavourable variance in any given accounting period.

Overhead variances are also caused by efficiency variations.  Because overheads are frequently absorbed into production by means of labour hours, overhead variances arise when labour                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        efficiency is greater or less than planned.

How are Overhead Variances Useful for Control Purposes?

Overhead variances are essentially a book balancing exercising providing an arithmetic reconciliation between the standard costs and actual costs.  Apart form the expenditure variance, the calculation of the other overhead variances provides little real control information, since they are related more to the conventions of overhead absorption than to the organization’s operational reality.

SALES VARIANCES

(a) Total sales margin variance

This is based on the standard cost, not on the actual cost.

Total sales margin variance = actual margin (based on standard unit costs) – budgeted margin = (actual sales value less standard cost of sales) – (budgeted sales value less budgeted cost of sale.)

= (Actual profit-std profit)

This variance explains the influence which the sales function has on the difference between budgeted and actual profit. The budgeted profit is compared with change from the actual sales volume. Because the sales function is accountable for sales revenue but not manufacturing cost. The standard cost of sales and not the actual cost of sales are deducted from the actual sales revenue.

(b) Sales margin price variance.

= (actual price- Std price) actual units

(c)    Sales volume variance

(Actual sales –budgeted sales) std profit margin/contribution

Causes of sales variances

Sale price variances have many causes which may include:

• Higher or lower  discounts  than expected offered  to customers
• A greater  or lesser  proportion of higher priced products  sold than  expected
• More  or less price  competition  from competitors

Sales volume variances may be caused by:

• Changes in customers buying habits
• Successful  or unsuccessful marketing campaigns
• Higher demand as a result of price cuts, or vice versa.

MATERIALS MIX AND YIELD VARIANCES

• The materials usage variance can be subdivided into a material mix and material yield variance when more than one material is used in the product.

A mix variance and yield variance are appropriate in the following situations

a)      where proportion of materials in a mix are changeable and controllable

b)      Where the usage variance of individual materials is of limited value because of the variable of the mix. And a combined yield variance for all the materials together is more helpful for control.

It would be totally inappropriate to calculate a mix variance where the materials in the ‘mix’ are discrete items. A chair, for example, might consist of wood, covering material, stuffing and glue.  These materials are separate components, and it would not be possible to think in terms of controlling the proportions of each material in the final product.  The usage of each material must be controlled separately.

MATERIALS MIX

• This variance is calculated when two or more materials are mixed together to produce a specific product.  For example, when cement is added to sand and gravel to make concrete then this variance can arise

Standard                  Actual                                                 Actual

Price                  quantity in           LESS                  quantity in

Standard         actual mix

Proportions                                                       proportions

• The mix variance shows the effect of changing the proportions of the mix of inputs into the process.
• The standard mix shows the proportion of a material that we expect to use in a given mix.  The mix variance identifies the amount by which the actual proportion differs from the standard mix.
• A mix variance occurs when the materials are not mixed or blended in standard proportions and it is a measure of whether the actual mix is cheaper or more expensive than the standard mix.
• The mix variance is calculated as the difference between the actual total quantity used in the standard mix and the actual quantities used in the actual mix, valued at standard cost.
• A favourable total mix variance would suggest that a higher proportion of a cheaper material is being used hence reducing the overall average cost per unit.

MATERIALS YIELD

• Material yield is the relationship of inputs in total to the outputs.  A yield variance identifies if the inputs (in total) are greater or less than expected for a given output.
• The yield variance shows the difference between the actual and the expected output or yield of the process.

• A yield variance arises because there is a difference between what the input should have been for the output achieved and the actual input.
• `The yield variance is calculated as the difference between the standard input for what was actually output, and the actual total quantity input (in the standard mix), valued at standard cost

Standard material           standard qty of                                actual qty

Cost                                 actual output           LESS              of std mix

• An adverse total yield variance would suggest that less output has been achieved for a given input, i.e. that the total input in volume is more than expected for the output achieved

Question 1

A company manufactures a chemical, Dynamite, using two compounds Flash and Bang.  The standard materials usage and cost of one unit of Dynamite are as follows.

$

Flash                            5 kg at $2 per kg                                 10

Bang                            10 kg at $3 per kg                               30

40

In a particular period, 80 units of Dynamite were produced from 500kg of Flash and 730 kg of Bang.

Required

Calculate the material usage, mix and yield variances

Question 2

The standard materials cost of product D456 is as follows

$

Material X                   3kg at $2.00 per kg                             6

Material Y                   5kg at $3.60 per kg                             18

24

During period 2, 2,000 kgs of material X (costing $4,100) and 2,400 kgs of material Y (costing $9,600) were used to produce 500 units of D456.

Required

Calculate the following variances

a)      Price variances

b)     Mix variances

c)      Yield variances – in total and foe each individual material

MAKING VARIANCE ANALYSIS MORE MEANINGFUL

To make variance analysis a useful aid to management is the main objective of variance calculations.  But this can only be done if we investigate the variances and the data used to calculate them. Typical questions that could be asked include:

i.            Is there any relationship between the vacancies e.g. did we report an unfavourable material usage variance because we reported a favourable material price variance as a result of purchasing low quality materials?

ii.            Can further information than merely the variance be provided by the management as to what could have resulted in the variance?  E.g. did the budget use an unrealistic overhead absorption rate leading to capacity and efficiency variances?

iii.            Is the variance significant and worth reporting?  (Materiality).  It is no point concentrating on very small variances. Normally the management sets a significance level of variances e.g. variances are only investigated only if they beyond 20% of the expected value.  Thus, a variance of between 1% and 19% would not be investigated.

iv.            Are the variances being reported quickly enough, to the right people, in sufficient or too much detail, with explanatory notes and is follow-up done to ensure correction of the situations leading to variances occurring?

CONSIDERATIONS IN VARIANCE INVESTIGATION:

As already noted above, not all variances are investigated; it is only the material and meaningful (for cost control purposes) variances that are investigated for further management action.  But even as we go into investigating what caused a variance to occur, we need to consider the following factors:

i.            Materiality Management should define the materiality level which when reached needs to be investigated.  All variances below the materiality level are not investigated.

ii.            Sensitivity to Cash Flow; We need to consider which variances translate into cash flow implications e.g. price variances.  If a variance is very highly sensitive to cash flows, then we need to set a low materiality level while if a variance has very low sensitivity to cash flow, then we need to set a high materiality level.

iii.            Frequency of Occurrence; A variance that occurs frequently or consistently needs to be investigated as early as possible.

iv.            Control We only need to hold managers accountable for the variances which they could control.  Variances caused by factors beyond the manager’s control cannot be blamed on the manager, e.g. external factors such as the government actions, inflation and unfavourable exchange rates could cause adverse variances which the managers cannot be held responsible for.

v.            Cost-Benefit Analysis If the cost of investigating a variance exceeds the benefits of such organization, then there is no need of investigating the variance as it is a waste of resources.  The reverse is correct.

vi.            The management Style In an autocratically managed organization all variances are investigated as actions are not expected to deviate from the stipulated.  In a democratically managed organization, only the material variances would be investigated.