BA2 Fundamentals of Management Accounting

BA2 Fundamentals of Management Accounting

Module: 09

Standard Costing and Variance Analysis

Standard costing, I - Standard costing and variance analysis

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1. Standard costing

Introduction

Let’s look at a scenario to introduce the key concepts behind standard costing

and variance analysis:

Imagine you are asked to set-up a hot dog stand at the school fair this

weekend. You know you’re going to need a grill, gas, hot dogs, bread rolls,

sauces and transport. You estimate all your costs and calculate that it’s

going to cost you £500 altogether to make 500 hot dogs. That works out as

£1 each.

This is known as your standard cost.

Finally, the weekend comes around and you’re ready to make some money.

You decide you’re going to sell your hot dogs for £3 each for a total income of

£1,500. That’s £1,000 profit for a weekend’s work!

However, a few things don’t go according to plan. Near the end of the day

your grill’s gas tank runs out. This is known as downtime. You were left

with a handful of hotdogs you couldn’t cook and sell.

During the day you also burn about 30 hotdogs because you were too busy

playing a game on your phone. You couldn’t sell these and had to feed them

to the pigeons instead. This is known as waste.

You also had to send your little brother to buy more ketchup and napkins, as

they ran out faster than you expected.

At the end of the day you try to work out how much you earned. You had to

buy more napkins, more ketchup and more hot dogs due to waste and

excess usage. There were also a few hotdogs you didn’t have time to cook

and can’t sell any more due to your grill’s downtime.

As a result, your costs actually increased to £600, which was £100

higher than you had planned. You also only sold 440 hot dogs instead

of your planned 500. These are known as variances, which are basically

differences compared to your plan.

You go home and write up a summary of your actual profit. You consider why

and how your costs and sales ended up being different to what you originally

planned, and why you ended up experiencing adverse cost and sales

variances instead of favourable variances. With this information in hand,

you’re now well prepared to increase your profits at the next school fair!

This scenario represents the basic idea of standard costing and variance

analysis. It revolves around calculating pre-set standards for your unit costs


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and unit sales and then comparing this to actual costs and sales. What

follows is a variance analysis to determine why the standards were or were

not achieved. This is a valuable process that enhances a business’s ability to

maximise efficiency.

Why use standards?

We use standard costing for various different reasons. However, the main

goal of standard costing is to maximise the efficiency of our

production process while also minimising waste of any resource

whether it be labour, materials or overheads. Standard costing helps us to

achieve this through the following avenues:

Setting accurate budgets – If we set accurate and realistic standards, this

information can also be used to set effective budgets. Notice how

calculating the cost per hot dog helped us budget for the day.

Highlights areas of concern – Standard costs act as a benchmark.

Through variance analysis, we can highlight the areas that require

attention (not getting distracted by the mobile phone game, and possible

overuse or under-budgeting for napkins). We can also highlight the

areas that are performing well. Management can then focus their time

and attention accordingly.

Performance evaluation – Standard costing provides benchmarks and

goals for staff to aspire to achieve (selling 500 hot dogs or making £1000 in

this case). The system can then be used as a means of assessment for

bonuses etc.


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Planning – Having set standards of materials and labour allows us to plan

ahead effectively. We know how many workers to hire, how many hours to

allow and how much material to order before production has even started.

This allows for effective resource allocation and budgetary planning.

Inventory valuation – Standard costing provides a simple alternative for inventory valuation, in which stock can be valued at standard cost.

Calculating standard cost

Standard costing is a unique budgetary control in that it calculates a

budgeted cost for each individual unit as opposed to a budget for a whole

period or project.

To calculate the standard cost of a unit, both the amount and the cost of

the resources used are detailed. For example, standard costing for

materials might be detailed as 5kg per unit at £25 per kg. The importance of

such detail will become clear during our variance analysis section further on.

Management might decide to set their standard cost based on previous

performance, competitor’s performance, or simply in accordance with their

own goals. Whichever they choose, the difficulty of the level of standard

would fall into one of three categories:

Ideal standard

An ideal standard is technically only achievable if the production process is

perfectly efficient. That means no waste, no downtime and normal loss.

As this is practically impossible, setting an ideal standard will always result in

an adverse variance and might leave staff unable to reach goals and


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bonus achieving levels. It can however be helpful to highlight wastage

and lost capacity.

Attainable standard

An attainable standard provides a reasonable allowance for downtime,

waste and normal loss, but still set in line with an efficient operation.

Therefore any variance at this standard indicates excessive losses that

should be avoidable. This is a preferable to an ideal standard as it is an

achievable goal and hence a good motivator for staff and management.

Basic/Historic standard

This is often left unchanged and can be helpful for trend analysis and comparison purposes. Essentially it is an assessment of how much time

and cost the activity spent in the past.

How to set standards

When setting a standard, both absorption costing and marginal costing principles

can be used, depending on the costing system of the business.

The standard costs are compared to actual costs to measure the

performance of the operation. Such comparisons will tell us whether we

are operating efficiently and where and how we can improve. Therefore it is

imperative that the standards we set are accurate and attainable. Here are

some of the sources of information we can use when setting standards to

ensure our standard costing system is effective:

Material price

• Quotations from suppliers.

• Previous invoices and payments, e.g. details of discounts, special

deals.

• Trend information where prices may fluctuate, e.g. coal, gold, oil.

• Type of material, e.g. higher quality will cost more.

• Information for related charges, e.g. freight, packaging.

Material quantity

• The standard to be used – i.e. ideal standard, attainable standard or

basic standard.

• Quality of material – might require higher quantities if material is low

quality and vice versa.

• Historical data, i.e. how much we used in the past.


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• How much allowance to make for normal levels of waste, losses.

• Machinery/techniques to be used.

Labour rate

• Information from payroll or HR on current wage rates.

• Allowances for bonuses/overtime.

• Allowances for specialist workers.

• Forecasts of wage increases/current negotiations.

Labour hours

• The standard to be used – i.e. ideal standard, attainable standard

etc.

• Allowances for downtime, idle time.

• Work study exercises, i.e. studies of how much time should be

required to complete each task.

• Specifications of each task to be performed and details of any special

tasks involved.

Production overhead costs

• Overhead absorption rates.

• Trend information and historical data.

• Quotations from suppliers.

Revising standard cost

Comparing results to standard costs which are out-dated is obviously a

meaningless exercise. Therefore, standard costs need to be continually

updated if they are to be useful. Standard costs should be revised so they are

representative of current material prices, labour rates and methods of

production.

2. Variance analysis

Any difference between the standard cost and the actual cost incurred is

known as a variance. We use variance analysis to determine the size of the

difference and why the difference occurred. You should recall that our

standard costs include both price and quantity, e.g. £3 per kg at 25kg per

unit. Therefore, when we break down our variances we will be able to see

how much of our variance was caused by a price variance and how much was

caused by a quantity variance.

If we achieve an actual cost lower than our standard cost, the variance will be

considered favourable. If the actual cost is higher, the variance is

considered adverse.


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Example

Imagine we are the management accountant at a company that manufactures office furniture – tables, chairs, desks etc. Let’s assume we

operate using a standard costing system and are carrying out variance

analysis on one of our products.

The standard variable costs are as follows:

Unit costs

Direct material 17kg £5 per kg £85

Direct labour 30 hours £3 per hour £90

Variable overhead 30 hours £2 per hour £60

£235

We produced 400 units during the period. Our actual costs were as follows:

Direct material 6,600kg £34,320

Direct labour 11,520 hours £32,256

Variable overhead 11,520 hours £24,422

Budgeted fixed production overhead

£7,000

Actual fixed production overhead £9,000

Budgeted output (units)

350

Actual output (units) 400

Direct material cost variance

400 units at standard cost (£85/unit) £34,000

400 units at actual cost £34,320

Variance £320 adverse

To calculate this variance, we determine the standard material cost for the

actual units produced (400 in this case) and compare it to the actual

material cost of the actual units produced. In the above example, actual cost

exceeds standard cost. This means the variance is adverse.

This variance can relate to either price being more or less than expected or

the quantity being more or less than expected. In this case, perhaps the

adverse variance was caused by material price being higher and/or the

quantity of material used being more than expected. The next step then is to

break the variance down into the price portion and the quantity portion.


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Direct material price variance

6,600kg should have cost (at £5/kg) £33,000

6,600kg actually cost £34,320

Variance £1,320 Adverse

To calculate this variance, we determine the standard cost of the actual

materials used (6,600kg) and compare it to the actual cost of the actual

materials used.

In this example, the adverse variance indicates that we spent £1,320 more than standard, suggesting that we paid a higher price for materials than we

budgeted for.

Direct material usage variance

400 units should have used (17kg/unit) 6,800kg

400 units actually used 6,600kg

Variance 200kg favourable

200kg x standard cost (£5/kg) £1,000 favourable

To calculate this variance, we determine the standard quantity of materials

required for the actual units produced (400 units) and compare it to the

actual quantity of materials that were used. To express this variance in

monetary terms, we then multiply it by the standard price of the materials.

In this example, the favourable variance indicates that we used less

material than originally estimated, perhaps due to using better quality

materials or more efficient processes, and this resulted in a total saving of

£1,000 at the standard cost.

Reconcile

It’s important that after separating our variances into their price and quantity

elements, we add them together to ensure they add up to our original total

variance:

Direct material price variance £1,320 adverse

Direct material quantity variance £1,000 favourable

Direct material cost variance £320 adverse

Because our individual price and quantity variances add up to the correct total

variance, we can be confident our calculations are correct.


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Issues with stock valuation

There may be times when then the quantity of material purchased and the quantity

of material used is different. In this case, we need to know which amount to use as

our “actual quantity” in our direct material price variance calculation.

The rule is if we value our stock at standard cost, we base our variance on

material purchased. If we value our stock at actual cost, we base our

variance on material used.

Direct labour cost variance



Variance £3,744 favourable

To calculate this variance, we determine the standard labour cost of our actual output (400 units) and compare it to the actual labour cost of our

actual output.

In the above example actual cost is less than standard cost, leading to a

favourable variance which indicates that we spent £3,744 less than

expected on labour costs. This variance can relate to both price (here the

price of staff could be less than expected) and quantity of labour (it may

suggest we used less labour than expected). The next step is to break the

variance down into the price portion and the quantity portion to get more

information to help our decision making.

Direct labour rate variance

11,520 hours should have cost (£3/hour) £34,560

11,520 hours actually cost £32,256

Variance £2,304 favourable

To calculate this variance, we determine the standard cost of the actual hours

of labour and compare it to the actual cost of the actual hours of labour.

In this example, the favourable variance indicates that we spent £2,304

less than standard due to us paying a lower hourly rate than expected.

This may be because labour rates fell or less skilled staff were used, or

perhaps the original estimate was poor.


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Direct labour efficiency variance

400 units should have used (30 hours/unit) 12,000 hours

400 units actually used 11,520 hours

Variance 480 hours favourable

480 hours at standard cost (£3/hour) £1,440 favourable

To calculate this variance, we determine the standard number of hours required and compare to the actual number of hours that were required. To

express the variance in monetary terms, we multiply the difference in hours by

the standard hourly rate of labour.

In this example, the favourable variance indicates that we spent £1,440 less

than standard due to us requiring fewer labour hours than expected,

perhaps due to more efficient procedures, better skilled labour, or again

because of a poor original estimate.

For a quick guide on how to calculate variances for the direct labour cost,

direct labour rate and the direct labour efficiency, see the following graph:

Reconcile

As before, we need to reconcile the individual variances:

Direct labour price variance £2,304 favourable

Direct labour quantity variance £1,440 favourable

Direct labour cost variance £3,744 favourable


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Variable overhead cost variance



Variance £422 adverse

To calculate this variance, we determine the standard overhead cost for the

units produced and compare it to the actual overheads allocated.

In the above example, actual cost exceeds standard cost leading to an

adverse variance. This suggests we spent £422 more than standard on

variable overheads.

The next step is to break this variance down into its expenditure and

efficiency components.

Variable overhead expenditure variance

11,520 hours should have cost (£2/hour) £23,040

11,520 hours actually cost £24,422

Variance £1,382 adverse

To calculate this variance, we determine the standard overhead cost of the actual hours worked and compare it to the actual overhead cost allocated.

In this example, the adverse variance indicates that we spent £1,382 more

than standard on variable overheads – perhaps energy costs rose more than

expected for example.

Variable overhead efficiency variance

We know that our variable overheads are allocated based on labour hours.

Therefore, a variance here will arise due to the number of labour hours used being

different to the standard allowance. We have already calculated this amount in

our previous direct labour efficiency variance calculation:

400 units should have used (30 hours/unit) 12,000 hours

400 units actually used 11,520 hours

Variance 480 hours favourable

With this information already available, all we need to do is multiply the

variance in hours by the standard overhead rate.

480 hours at standard cost (£2/hour) £960 favourable


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The favourable variance indicates that our variable overheads were £960

less than standard due to a lower number of labour hours being required.

For a quick guide on how to calculate variances for the variable overhead

cost, variable overhead expenditure and the variable overhead efficiency,

refer to the following diagram:

Reconcile

Variable overhead expenditure variance £1,382 Adverse

Variable overhead efficiency variance £960 favourable

Variable overhead cost variance £422 Adverse

Fixed production overhead variance

To calculate the variance we need to calculate the amount of over/under

absorption. You should be familiar with the following calculation from the

absorption costing examples earlier on.

First we need to determine our overhead absorption rate:

Budgeted fixed production overhead £7,000

Budgeted output (units) 350

Overhead absorption rate (per unit) £20

Next we need to calculate the total amount of fixed overheads absorbed. This

is simply our overhead absorption rate multiplied by our number of units

produced:


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Overhead absorption rate £20


Fixed production overhead absorbed £8,000

We can now work out the amount of under/over absorption:

Actual fixed production overhead incurred £9,000

Fixed production overhead absorbed £8,000

Total amount of under absorption £1,000

Because our fixed overheads are under absorbed the variance is considered

adverse. This is because our actual expenditure on fixed overheads exceeds

the amount we absorbed, i.e. we overspent!

We know that over/under absorption can occur due to two things: either our

actual expenditure was different to our budget or our actual output was

different to our budget. We can determine how much of our fixed production

overhead variance relates to each through the following:

Fixed production overhead expenditure variance

This is simply the difference between budgeted and actual expenditure:

Budgeted fixed production overhead £7,000

Actual fixed production overhead £9,000

Variance £2,000 adverse

This adverse variance indicates that our fixed overhead costs were £2,000

higher than standard. This portion of our over/under absorption occurs due to

actual expenditure being different to our budget.

Fixed production overhead efficiency variance

This is the amount of variance that will arise due to a difference in volume of

units produced:


Budgeted output (units) 350

Variance 50

x overhead absorption rate (£20 per unit) 1,000 favourable

The variance of £1,000 is considered favourable because actual units

produced exceed budgeted units, i.e. we beat our target!


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Now look at the following diagram for a quick reminder of how to calculate the

variance for fixed production overheads, fixed production overhead

expenditure and fixed production overhead efficiency:

Reconcile

As with our other variances, we need to add the two together to ensure they match

our total variance:

Expenditure variance 2,000 adverse

Efficiency variance 1,000 favourable

Fixed production overhead variance 1,000 adverse

Sales variances

It is important to set standards not only for our costs but also for our revenues. To determine if we’ve met these standards we use sales

variances.

Following on from our previous example, we receive the following additional

information:


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Budget £

Sales and production volume (units) 350

Selling price (per unit) 500

Variable cost (per unit) 235

Fixed cost (per unit) 20

Budget profit per unit 245

Actual

Sales and production volume (units)

400

Selling price (per unit) 480

The cost information above is simply a summary of the cost information from

our previous example rewritten here for your convenience.

Selling price variance

Standard selling price 500

Actual selling price 480

Difference 20 adverse

x sales volume (units) 400

Selling price variance 8,000 adverse

To calculate this variance, we take the difference between actual and

standard selling price and multiply it by actual sales volume.

In this example the variance is adverse, indicating that our revenue was

£8,000 less than standard due to us selling our product at a lower price than

expected. Perhaps that was due to market prices falling, negotiation of discounts

by customers, or original estimates being poor.

Sales volume profit variance

Budgeted sales volume 350

Actual sales volume 400

Difference 50 favourable

x budget profit per unit 245

Sales volume variance 12,250 favourable

To calculate this variance, we take the difference between our budgeted and

actual sales volume, and multiply it by our budgeted profit per unit.

The variance is favourable, showing that our profit is £12,250 higher due to

our sales volume being higher than expected, perhaps due to the lower


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price being charged (see the price variance), a good marketing campaign or

an unexpected increase in demand.

Note that we use the standard profit per unit rather than actual profit in this

variance calculation.

Look at this diagram for a summary of how to calculate sales variances:

Budget to actual profit reconciliation

Once we have calculated all our variances, we can check their accuracy by preparing reconciliation between budget and actual profit. The statement

below reconciles budgeted gross profit to actual gross profit, incorporating

each of the variances we have just calculated.

A manager in charge of this department would look over this statement

in detail and attempt to understand why the variances happened using

their knowledge of the business. Their aim will be to try to avoid adverse

variances (e.g. trying to manage material costs better) and keep the

favourable variances (e.g. retain the lower pricing policy if it was that that

caused sales volumes to rise so much).


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Budget to actual profit reconciliation

Original budgeted gross profit

(350 units x £245 gross profit per unit)

£ £

85,750

Sales volume profit variance 12,250


Cost variances

(8,000) 90,000

Direct material price (1,320)

Direct material usage 1,000

Direct labour rate 2,304

Direct labour efficiency 1,440

Variable overhead expenditure (1,382)

Variable overhead efficiency 960

Fixed overhead expenditure (2,000)

Fixed overhead volume 1,000

Actual gross profit 92,002

Check

Actual sales

192,000

Less:

Actual direct materials

34,320

Actual direct labour 32,256

Actual variable overhead 24,422

Actual fixed overhead 9,000

Actual gross profit 92,002

Remember, ultimately it’s not the numbers that are important to the business,

it’s the interpretation of them, how the department manager can use this to

improve for the future!

3. Standard marginal costing

So how does all this new information about about standard costings and variances tie in with the costing systems we have spoken about previously?

Well, under a marginal costing system, the following variances are

calculated slightly differently.


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Fixed overhead volume variance

This variance does not exist under a marginal costing system. This is because

fixed overheads are not absorbed under marginal costing and therefore are

not affected by volume.

Sales volume contribution variance

The sales volume contribution variance is very similar to the sales volume

profit variance. The only difference is that in this calculation we use

contribution per unit rather than profit per unit. This is because the profit

variance incorporates absorbed fixed costs which do not exist in a marginal

costing system.

To calculate this variance for the above example, we first need to work out

budgeted contribution per unit. Remember, contribution does not include a

deduction for fixed costs:

Selling price per unit £500

Variable cost per unit £235

Contribution per unit £265

The next step, as with the sales volume profit variance, is to multiply this

contribution amount by the variance in sales volume:

Budgeted sales volume 350

Actual sales volume 400

Difference 50 favourable

x budget contribution per unit £265

Sales volume variance £13,250 favourable

Note that we use budgeted rather than actual contribution in this variance

calculation.


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Budget to actual reconciliation

With our updated variances, we are now in a position to produce a budget to

actual profit reconciliation:

Budget to actual profit reconciliation under marginal

Original budgeted contribution

costing

£

£

(350 units x £265 contribution per unit)

Sales volume contribution variance

13,250

92,750


Cost variances

(8,000) 98,000

Direct material price (1,320)

Direct material usage 1,000

Direct labour rate 2,304

Direct labour efficiency 1,440

Variable overhead expenditure (1,382)

Variable overhead efficiency

Actual contribution

960 101,002

Budgeted fixed costs (7,000)

Fixed overhead expenditure variance

Actual gross profit

(2,000) 92,002

We know the reconciliation is correct as the final figure we arrive at is

our original gross profit figure of £92,002 - the same as in the previous

example. Remember that our overall profit does not change between

marginal costing and absorption costing (as long as there is no change in

inventories in the year).

Also notice how we exclude fixed cost variances from the contribution

section. You should already recall that this is because fixed costs are not

included in contribution in a marginal costing system but are rather

deducted in full at the end of each period.


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4. Variance analysis in the modern manufacturing environment

So, variance analysis seems very useful, but variance analysis was created a

little while ago and since then the manufacturing environment has changed.

For example, it used to be the case that products were fairly simple to

produce, with long product life-cycles, such as furniture. Additionally,

products like this would typically require labour intensive production

techniques, which ins this instance would be carving the furniture from

wood, sanding it down, oiling it and varnishing it etc.

However, in the modern manufacturing environment products are now considered non-standard, which means that they are essentially customised products.

Additionally, these products tend to have short life-cycles and are produced by

machines. A good example of this would be the Apple Watch, because there

are a variety of models, all only differing slightly from each other, so that the

customer can feel like the product is customised to their needs.

Moreover, this product would have been using machine intensive production

techniques and will have a short product life-cycle, as Apple typically

release a new generation of each of their products every couple of years or

so.

So, how does variance analysis and standard costing work in the modern

manufacturing environment?

The answer is not so well and for the reasons why, please refer to the table below:


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Reasons why variance analysis may not be appropriate for the modern

manufacturing environment

e.g. there are three types of Apple Watch (Apple Watch, Apple

Non-standard

(customised) products

Customised products

take different

manufacturing times

and material quantities.

Watch Sport and Apple

Watch edition), all of

which have numerous

variations, wit each one most likely taking a

slightly different amount of time and

materials to produce.

e.g. because of the fast changing nature of technology Apple Standards need to be regularly release new

Short product life-cycles updated frequently in

order to remain

versions of their

products, which have relevant. been updated with the latest, so that their products can remain

relevant.

e.g. the majority of the A manager can ask their production process for

Machine intensive workforce to speed up most of Apple’s products

production techniques but they can't ask a is done by machine and machine to speed up! this will simply take as

long as is necessary.

Information is needed to e.g. all the different do a variance analysis processes involved in and a very complex the creation of much of

Complex processes process may have

hundreds of different

Apple’s products would

make it difficult to steps which would be collate the necessary very difficult to do a information needed for

variance analysis on. a variance analysis.

Variances in a Just-In-Time (JIT) and Total Quality Management (TQM) systems

Just-In-Time (or JIT), is a business and production strategy that seeks

to eliminate excess stock of products or raw materials, producing

reactively to customer demands and not before. The aim is to have the right

material, at the right time, at the right place and in the exact amount.


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Total Quality Management on the other hand is the principle of a culture

of quality throughout the whole organisation. Making it part of everyday

activities until it becomes installed as part of what everyone does.

Regardless, how does variance analysis work under both the JIT and TQM

systems?

Well, there are some traditional variances which go against the overall

aims of JIT and TQM. This means that a favourable variance in a traditional

system, is actually a bad thing in a TQM system.

Confused?

If so, then simply look below to further elucidate yourself.

A traditional variance is the material price variance, because traditional

systems are focussed on getting materials at the lowest price possible.

However, in TQM and JIT higher quality materials are typically more

desirable in order to improve overall quality and customer satisfaction.

Therefore, the material price variance is not very appropriate in this

instance.

Additionally, labour, variable overhead and fixed overhead efficiency

variances are less applicable. For example, in TQM a longer production

time (more labour hours) may be acceptable if it produces a products with no

defect and reaches customer expectations.

Finally, the material usage variance will have different meaning in JIT,

TQM and traditional environments. In JIT more wastage can be expected,

as the production process is made to order and very fast. However, in TQM

the buyers will attempt to use suppliers who provide the highest quality

materials, but because a fault free product is the goal, there may be more

materials used to make it.

5. Standards and variances in non-manufacturing organisations

Service industries

Variance analysis through standard costing has been criticised for being

poorly suited to service industries, with critics claiming that in such

industries the human influence is too great to allow accurate standards to be

set. Additionally, establishing a measurable cost object for certain services

is even more difficult, as in many service industries each cost object is

never truly the same (consider how a tour company will need to modify each

itinerary to suit diets, weather, number of passengers etc.).


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Nevertheless standard costing is still used in the service industry today,

aided by the use of certain techniques to help standardise services and

identify measurable cost objects. One such phenomenon is the idea of

‘McDonaldisation’.

McDonaldisation

McDonaldisation lies in direct contrast to the criticism that standard costing is

ineffective because of its lack of incentive for constant improvement.

Instead, it tries to argue that offering high volumes of highly homogeneous

products that never change (similar to McDonald’s fast food offerings) is

highly advantageous in the modern business environment.

This ideology is often applied to the service industry in an effort to

standardise services and reduce the element of human influence wherever

possible. McDonaldisation aims to deliver four key advantages:

Calculability

Every McDonald’s meal is identical in weight, size and price, serving as a

measurable cost object for which a standard price can be set.

Efficiency

Due to the homogeneous nature of the products, they are cheap and fast to

produce, and are efficient in their use of resources.

Predictability

Customers can be confident of what to expect when they purchase the

product, regardless of time or place. A Big Mac from Australia will be the same

as a Big Mac from the UK.

Control

Human influence is removed wherever possible. Each item is produced using

a known set of materials and a predetermined set of tasks. This allows for

effective comparisons between actual and standard inputs and outputs.

In applying the concept of McDonaldisation to service industries, providers

aim to homogenise their offerings as much as possible. If every service is the

same as the last, it is possible for a standard cost to be set that can be

meaningfully be compared to actual outputs. The calculability factor can be

overcome by establishing a measurable cost object, a good example being

the use of ‘passenger miles’ in the airline industry.

Public services

In the healthcare industry there have been instances of standard costing

being employed in order to help evaluate performance and determine


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remuneration levels of healthcare providers. This is done by determining a

standard cost for treating patients with specific medical conditions.

A common method of implementing this model is through the use of

Diagnostic Reference Groups (DRG’s).

A DRG is established for each medical condition, with patients then being

classified into DRG’s upon this basis. It is then assumed that each patient

within the DRG is suffering from the same condition and therefore will

require similar treatment.

Healthcare funders (such as the government or health insurance

providers) then proceed to apply standard costing principles based on

these groups. If treating a patient for heart disease is believed to have a

standard cost of £5,000 and a hospital runs up costs of £8,000, this is

considered an adverse variance and the hospital’s operations will be

considered inefficient.

While it does exist in the real world, the use of standard costing in such an

environment has been widely criticised. Every patient is different, and

similar symptoms will not always translate into similar treatments.

In the above example, there may be one patient with heart disease who

requires emergency surgery, while another simply requires a dietician

consultation and a slap on the hand for eating too many cheeseburgers.

Using such a system can also encourage healthcare providers to offer

“standard” treatments where it may not be completely appropriate, all in an

effort to cut costs or secure funding.

Using evaluation measures that can encourage such practises is a sensitive

issue, particularly in healthcare where the need for quality and complete

service is arguably more important than cost or profit. Needless to say a

costing system in such an environment is a delicate issue and must be

carefully implemented in order to be viable.

Professions

A labour mix variance- while often used in manufacturing environments -is

unique in that it is actually best suited to the service industry.

Consider an audit firm’s everyday operation and how it employs the use of

several different levels of staff. Graduates may carry out much of the basic

work of collating data and preparing simple summaries, while the partner in

charge will typically consider the big picture issues and sign his name to the

final report. Somewhere along the line the seniors, assistant managers and

managers will take care of everything in between.

As every level of staff has a different pay rate, determining the mix of staff that would incur the lowest cost can be a challenging issue. Perhaps tasks

undertaken by seniors could be done just as quickly by graduates, or


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perhaps the partner is spending too much time on tasks which could

reasonably be delegated.

Using the labour mix variance can be a good indicator of the efficiency of

professional practices, as a key operational challenge in such environments

is the effective integration of junior and senior staff.

BA2 Fundamentals of Management Accounting

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