STANDARD COSTING AND VARIANCE ANALYSIS

 

 

Learning Objectives:

After studying this chapter, you should be able to:

·      explain the concept of a standard

·      explain the different types of standards

·      explain the procedure for establishing standards and standard cost

·      analyze a variance into its smallest parts

·      compute the various cost variances and sales margin variances

·      reconcile budgeted profit and actual profit, using variances

·      compute activity, capacity and efficiency ratios

·      explain the factors that influence the investigation of variances.

INTRODUCTION

In order for organisations to function effectively, it is important for them to plan ahead of time. Organisational planning is greatly enhanced when standards are established to form the basis of planning and also as a yard stick for measuring performance. When standards are set, budgeting becomes relatively easy to establish and the control process which compares the standards set with the actual achievements ensures that variances are determined and corrective action taken to remedy the deviations and drive the business closely towards its objectives.

Section 1: Standard Costing

1.1 Standard Cost as Control Mechanisms

Standards are control mechanisms which establish predetermined estimates of costs of products and services and then compare these predetermined costs with actual costs as they are incurred to ascertain variances which are analysed into their various components and investigated.

319

NOTE:        This is a work in progress.  All topics in the syllabus are covered but editing for

necessary corrections is in progress.

Thanks.

Standard cost is a predetermined calculation of how much cost should be, under			specified
working conditions. In other words, standard cost is a standard	expressed	in	money

terms. It is built up from an assessment of the value of cost elements. Its main uses are providing bases for performance measurement, control by exception reporting, valuing stock and establishing selling prices

1.1.1   What standard cost is not?

Standard cost is not an average of past costs. This is because:

i.   these may contain results of past mistakes and inefficiencies.

ii.   comparison with past cost is inappropriate due to likely:

·      changes in methods

·      changes in technology

·      changes in prices

1.3        Types of standards

There are four types of standards; namely: basic standards, ideal standards, attainable standards and current standards.

1.2.1    Basic Standards

These are long term standards remaining unchanged over several years. They are standards established for use over a long period from which a current standard can be developed

The use of basic standards

a.            To show trends over time for such items as:

-      materials prices

-      labour rates

-      efficiency levels and the long term effects of changing methods

b.            Used as a basis for setting current standards. Basic standards

can not be used to highlight current efficiency or inefficiency and would not normally form part of the reporting system except as a background statistical exercise.

320

NOTE:        This is a work in progress.  All topics in the syllabus are covered but editing for

necessary corrections is in progress.

Thanks.

1.2.2    Ideal Standards

These are standards which can only be attained under the most favorable working conditions. Ideal standards are based on optimal operating conditions such as:

-              no break downs of machinery

-              no wastage of materials

-              no stoppages

-              no idle time

-              no spoilage

-              no shrinkage of materials etc. The Uses of Ideal Standards

a.            used as long term targets

b.            used for long term development purposes and investigative purposes

1.2.3    Attainable standards

These are standards which can be attained if a standard unit of work is carried out efficiently, a machine properly operated or material properly used. Allowances are made for normal losses and machine breakdowns. It represents future performance and objectives which are reasonably attainable

Uses of attainable Standards

1.            Frequently used for routine control with the purpose of

-              providing tough but realistic targets

-              motivating staff and management to achieve targets

2.             Used for stock valuation for purposes of:

-              product costing

-              cost control

Attainable standards should be revised periodically to reflect:

-      new conditions

-      new prices, methods, technology etc.

321

NOTE:        This is a work in progress.  All topics in the syllabus are covered but editing for

necessary corrections is in progress.

Thanks.

1.2.4    Current Standards

These are standards set for use over a short period to reflect current changed conditions. Where conditions are stable then current standards will be the same as attainable standards. But where a temporary problem exist then a current standard could be set to deal with the problem

Uses of current standards

1.                 where there is a temporal problem with material quality

2.          unexpected    price     rise     due     to    inflationary

circumstances

3.                 energy crises

4.                 significant standards containing some subjective elements etc.

Important points to note

1.                the type of standard directly affects the amount of variances and the meaning of the variance

2.                every standard contains some subjective elements.

1.3   Other Standard Costing Issues

1.3.1    The process of standard costing

1.    set the standard cost (building the total cost up from the individual elements of cost

2.    measure the actual cost (for each of the elements of cost and in total)

3.    Compare the standard cost with the actual cost, any difference is called a variance, which can either be favorable or better performance than planned or unfavorable or worse performance than the set standard.

4.    analyse the variance (variance analysis) into its smallest parts or elements

5.    investigate the real causes for the variances (only for material variances)

The most is obtained from standard costing techniques when it is applied to a production process involving a substantial degree of repetition (mass production and repetitive assembly work)

322

NOTE:        This is a work in progress.  All topics in the syllabus are covered but editing for

necessary corrections is in progress.

Thanks.

1.3.2    Objectives of Standard Costing

1.    to provide a basis for assessing performance and efficiency

2.    to control costs by establishing standards and the analysis of variances and ascertaining the reasons for the variances

3.    to facilitate the practice of management by exception at the operational level

4.    to assist in formulating budgets

5.    the standard costs can be used as ends for:

-              valuing stocks and work in progress

-              Profit planning and decision making

-              pricing policy (especially where cost plus

pricing systems are used

6.     to motivate staff and management

1.3.3    Merits of Standard Costing

1.    assists in assessing performance and efficiency

2.    enhances cost control by encouraging re-appraisal of methods, materials and techniques

3.    makes budgeting easier

4.    facilitates the prudent practice of management by exceptions

5.    it provides guidance on possible ways of improving performance

6.    provides a basis for estimation and forecasting

7.    it is a source of motivation (if full participation and involvement is sought)

8.    simplifies stock valuation and pricing policy

9.    assigns responsibility for non-standard performance

1.3.4    Limitations of Standard Costing

1.    the philosophy of standard costing is challenged as being inappropriate

323

NOTE:        This is a work in progress.  All topics in the syllabus are covered but editing for

necessary corrections is in progress.

Thanks.

2.    standard costing can only exist realistically within the frame work of a budgetary system

3.    Variance analysis merely directs attention to the cause of off-standard performances. It does not solve the problem nor does it establish the reasons behind the variance. Solutions to the identified problems are management tasks

4.    all standards involve forecasting which is subjective with the inherent possibility of error.

5.    the process is a bit complex and difficult and is not understood by most line managers

6.    variance analysis are post mortems on past events and does not correct that past error or wrong.

7.    it may be expensive and time consuming to install

8.    in volatile conditions with rapidly changing methods, rates and prices, standards quickly becomes out of date losing their control and motivational effects

9.    the usefulness of a number of variances is questionable

1.4        Setting standard Costs

To be able to set standards, we take every element that contributes to the operations of an organisation and set standards for each of them.

We consider the following:

-      the types, and prices of material and parts

-      the grades, rates of pay and time for the labour

-      the production methods and layouts

-      the tools, jigs and machines to be used

1.4.1    Setting standards for materials

1.        The materials content of each product is derived through engineering studies. Examples may include:

·      raw materials

·      sub-assemblies

·      piece parts

324

NOTE:        This is a work in progress.  All topics in the syllabus are covered but editing for

necessary corrections is in progress.

Thanks.

·      finishing materials

2.        Determine the quantities required of each of the inputs, making allowance for normal losses in production arising from

·      machining loss

·      evaporation

·      expected breakages

·      expected rejections etc

3.            Obtain material prices from the purchases or procurement department

·      these prices should be the forecast or expected prices for the relevant budget period and not past costs

·      the prices should reflect :

o  trend in material prices

o anticipated changes in purchasing policies o quantity and cash discounts

o  carriage and packing charges

On the basis of the variables obtained above, you then set standards for materials as standard quantities of each material at the standard material price per unit.

1.4.2    Setting standards for labour

·    Specify the exact grades of labour to be used. This can be by the use of work study projections, techniques of work measurement etc.

·    Determine the time to be taken for a unit of output. The standard hour – which is the quantity of work achievable at standard performance in an hour or minute

·    the personnel department should make a forecast of the relevant wage rates for the control period

·    set the standard labour cost as standard hour at standard wage rate

1.4.3    Setting standards for overheads

325

NOTE:        This is a work in progress.  All topics in the syllabus are covered but editing for

necessary corrections is in progress.

Thanks.

The predetermined overhead absorption rates are the standard rates for overheads for each cost centre using the budgeted standard labour hours as the activity base

VOAR =         budgeted variable overheads for cost center

Budgeted standard labour hours for cost centre

FOAR =         budgeted fixed overheads for cost centre

Budgeted standard labour hours for cost centre

Where: VOAR is Variable Overhead Absorption Rate, and

FOAR is Fixed Overhead Absorption Rate

1.4.4    Setting standard for selling price

This activity is a top management activity, which is done after considering the following factors:

·      anticipated market demand

·      competing products

·      inflation estimates

·      elasticity of demand etc.

1.4.4.1                Standard sales margin

Standard sales margin is the difference between standard selling price and standard cost. Where a standard marginal costing system is in use, then the standard contribution margin is the difference between the standard selling price and the standard marginal cost.