Lecture 10 Standard Costing and Variance Analysis Student Version

7/28/2019 Lecture 10 Standard Costing and Variance Analysis Student Version

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STANDARD COSTING AND VARIANCE ANALYSIS

After the lecture, class and recommended reading

you should be able to:

Outline the nature and purpose of an operational

control system and the role of budgets,

standards and variances.

Explain how standard costs are set and define

basic, ideal and currently attainable standards

Compile flexible budgets and from these

calculate labour, materials overhead and sales

variances and reconcile actual profit withbudgeted profit

Identify the causes of variances and discuss the

factors leading to the decision to investigate

variances

Discuss the limitations of traditional standard

costing systems and assess alternatives


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Essential Reading

Drury Chapters 12, 15 and 16 (pages 461 and 468-

482)

Drury C (1999) Standard costing: a technique at

variance with modern management?, Management

Accounting, November

Graham C, Lyall D and Puxty A (1992) Cost control:

the managers perspective Management Accounting,

October

Kaplan RS and Norton DP (2000) The Balanced

Scorecard Measures that Drive Performance.Harvard Business Review, January-February, pages

71-79.

Recommended Reading

Gowthorpe: Chapter 18

Atrill and McLaney, Chapter 7


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Stages in the planning process

(Drury 2005, page 265)

1. Establish objectives

2. Identify potential courses of

actions (i.e. strategies)

Long term

planningprocess

3. Evaluate alternative strategic

options

4. Select alternative courses ofaction

5. Implement long-term plan in the

form of the annual budget

6. Monitor actual results

Annual

budgeting

process

7. Respond to divergences from

plan


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Feedback control

Steps are taken to get operations back on track as

soon as there is a signal that they have gone wrong

(see above)

Feed forward controls

Predictions are made about what could go wrong and

then steps taken to avoid that outcome e.g. in the

preparation of budgets


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HOW IS VARIANCE ANALYSIS CARRIED OUT?

(Drury 2005, page 342)

Standard cost of

actual output

recorded for each

responsibility

centre

Actual costs

traced to each

responsibility

centre

Standard and

actual costs

compared and

variances analysed

and reported

Variances

investigated and

corrective action

taken

Standards

monitored and

adjusted to

reflect changes in

standard usage

and/or prices


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Prepare the budget using standard costs and

budgeted prices

Q: Should we compare the budgeted output with the actual

output to calculate the variances?

A: No, first flex the budget

Flex the budget for changes in activity level

(changes in units of output)

Calculate the differences between budget and

actual output these are termed variances

Reconcile the original budgeted profit and actual

profit

Relationship between the budgeted and actual profit

(McLaney & Atrill 2002, page 398)

Budgeted profitplus

All favourable variancesminus

All adverse (unfavourable) variancesequals

Actual profit


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WHAT ARE STANDARD COSTS AND PRICES?

Standard costs

These are predetermined costs. They are target

costs that should be incurred under efficient

operating conditionson a per unit basis (Drury,

2005, page 340)

Standard costing is most suited for organisationswhere the activities are common or repetitive. The

examples we shall use will be for manufacturing

organisations.


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Types of cost standard (Drury 2005, pages 346-347)

Basic cost

standards

Left unchanged over long periods of

time. Helps to establish efficiency

trends. Seldom used, as they do not

represent current target costs, so

not very useful for control.

Idealstandard

s

Represent perfect performance.Minimum costs under the most

efficient operating conditions. Can

be demotivating and unlikely to be

used in practice.

Currentlyattainable

standards

Costs that should be incurred underefficient operating conditions.

Difficult, but not impossible, to

achieve. Can be set at various levels

of difficulty.


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Numerical Example(adapted from Newman 2002, ignores idle time variances)

Original budget data (using standard costs)

Sales 4,000 units @

50/unit

200,000

Direct materials 5kg per unit @

3/kg

(60,000)

Direct labour 2 hours @ 8/hr (64,000)

Variable production

overheads

2 hours @ 1/hr (8,000)

Fixed production

overheads

2 hours @

2.50/hr

(20,000)

Budgeted profit 48,000

Actual data for the period

Sales 4,150 units 205,425

Direct materials 21,250kg (61,350)

Direct labour 8,250 hours (68,500)Variable production

overheads

(8,225)

Fixed production

overheads

(19,000)

Budgeted profit 48,350


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Original Budget

(4,000 units)

Flexed budget

(4,150 units)

Variance

s

Actual results

(4,150 units)

Sales 4,000 x 50 =

200,000 205,425

Direct materials 5kg x 4,000

units =

20,000kg x 3

=

60,000

5kg x 4,150 units

=

20,750kg

x 3 =

62,250

21,250kg

61,350

Direct labour 2hrs x 4,000 =

8,000 hours x

8 =

64,000

8,250 hours

68,500

Variable production

overheads

8,000 hours x

1 =8,000

8,225

Fixed production

overheads

20,000 19,000

Budgeted profit 48,000 48,350


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Difference between Original Budget Profit and Flexed

Budget Profit = Sales Volume Variance

(Drury calls this the sales margin volume variance)

Difference between Flexed Budget Sales and Actual Sales =

Sales Price Variance

(Drury calls this the sales margin price variance)


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Difference between Material Flexed Budget and Actual

Materials = Total Direct Materials Variances

Can be broken down into: Materials Price Variance andMaterials Usage Variance

Material Price Variance: What did we pay for the quantity

of materials we actually bought compared to what we had

budgeted for?

We bought (in kg):

We paid:

We would have expected to pay:

Variance =

Materials Usage Variance: How much materials did we use

compared to what we thought we should have used? Work

this out at budgeted costs.

We used:We expected to use:

This is a kg difference

Work this out at budgeted cost per kg =


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Difference between Labour Flexed budget and Actual

Results = Direct Labour Variances

Can be broken down into: Labour Rate Variance and LabourEfficiency Variance

Labour Rate Variance: What did we pay for the hours we

actually used compared to what we had budgeted for?

Labour Efficiency Variance: How much labour did we usecompared to what we thought we should have used. Work

this out at budgeted costs.


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Difference between Variable Overheads Flexed budget and

Actual Results = Variable Overheads Variance

Can be broken down into: Variable Overhead ExpenditureVariance and Variable Overhead Efficiency Variance

(This breakdown is not always done, but the technique is the

same as for the labour variances, see Drury. In the

Workshop example this variance is not broken down)

Difference between Fixed Overheads Flexed budget

and Actual Results = Fixed Overhead Expenditure

Variance


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Operating Statement (reconciliation of profit)

Original budgeted profit

+ Sales volume variance Favourable

= Flexed budget profit

Sales price variance

+ Materials price variance Favourable

- Materials usage variance Adverse- Labour rate variance Adverse

+ Labour efficiency variance Favourable

+ Variable overhead

expenditure variance

Favourable

+ Fixed overhead

expenditure variance

Favourable

= Actual profit


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Or:

Original budgeted profit 48,000

Add favourable variances:

Sales volume variance 2,550

Materials price variance 2,400

Labour efficiency variance 400

Variable overhead expenditure

variance

75

Fixed overhead expenditure

variance

1,000

6,425

Less adverse variances:

Sales price variance (2,075)Materials usage variance (1,500)

Labour rate variance (2,500)

(6,075)

= Actual profit 48,350


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PURPOSES OF STANDARD COSTING

(Drury 2005, pages 347-348)

Providing a prediction of future costs that can

be used for decision-making purposes

Providing a challenging target

Assisting in setting budgets

Acting as a control device

Simplifying the task of tracing costs to

products for profit measurement and inventory

valuation


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Should variances always be investigated? (McLaney &

Atrill 2002)

Significant adverse variances may indicate a

fault that could prove very costly

Cost-benefit analysis keep insignificant

variances under review

Significant favourable variances should also be

investigated (McLaney & Atrill say probably)

Note the concentration on adverse variances in

McLaney & Atrill (2002)


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REASONS FOR VARIANCES

From Brown (1999)

Demski (1967) divided variances into

planning and operational variances.

Advocated isolating permanent changes and

making an after the fact budget.

Variances should be analysed as:

o Planning (uncontrollable) variances

Arise from the difference between the

original planned performance and the revisedplanned performance

These variances provide a check on

forecasting skills and also help to provide a

revised base for use in forward planning

o Operational (controllable) variances

Arise from efficiencies or inefficiencies

between target and actual results

These variances provide a more relevant

focus for management control action


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Some examples of reasons for variances

(Drury 2005)

Sales volume variance (adverse)

Economic recession

Increase in selling price

Direct materials usage variance (adverse)

Careless handling of materials

Substandard materials

Pilferage

Consider interplay of variances how might

materials usage/materials price variance, andlabour rate/labour efficiency variances affect

each other?


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STANDARD COSTING A STATUS CHECK

(Brown 1999)

Survey results, use of variance analysis:

Puxty and Lyall survey (1989) - 90%; Drury et

al survey (1993) - 76%

Current debate (centred on the modern

business environment)

Rate of change of product type and design is

swift

Customer demand is for speedy availability of

products

Product life cycles are shorter

There are higher quality standards


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This has changed the way businesses operate, as

follows:

JIT systems allied to flexible manufacturing

systems respond to customer demand

TQM programmes aim at continuous

improvement and effective provision of value-

added activities

Greater emphasis on the value chain

Changes to ABC and target costing

Improved speed and flexibility of

information availability e.g. online information

in a computer integrated manufacturing

environment


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CRITICISMS OF STANDARD COSTING

(Drury 1999; Brown 1999; McLaney & Atrill

2002)

Impact of the changing cost structure -

standard costing is most suited where there

are direct and variable costs

Inconsistency with a JIT philosophy (supplier

chains, bulk purchases, effect on quality)

Motivates behaviour that is inconsistent with

TQM philosophy

Overemphasises the importance of direct

labour

Delay in feedback reporting

Standards are a static base against which

actual events are measured (standards can

quickly become out of date; also see problem

with TQM above)


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Their main objective is control, with

conformance to standards and the elimination

of any variances this is seen as restrictiveand inhibiting (problem for JIT and TQM

systems)

Can have adverse effects on performance if

the link between cost and activity is not well

understood, variances may be out of a

managers control

Areas of responsibility may not have clear

lines of demarcation

Even with these criticisms, there are still uses

for standard costing and variance analysis for

a balanced view read Graham, Lyall and Puxty

1992 (in Room 274)


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STANDARD COSTING A STATUS CHECK

(continued)

Area Points in favour of standard

costing

Planning Standards may be useful as

building blocks for budgeting,

which has to happen even in a

TQM environment

Control Even where automated input of

materials occurs, it may still

be relevant to analyse costs of

changes from plan

Decision making Existing standards may be the

starting point for the

estimated costs of new

products

Performance

measurement

When product mix is stable,

performance monitoring may

be enhanced by the use of

controllable standards


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Product pricing Use of standards can aid the

construction of accurate costestimates for pricing. Target

costs may be compared with

current standards to highlight

the gaps in costing value

engineering techniques might

then be applied

Improvement

and change

Monitoring standards over

time can help to identify

situations that are out of

control (useful in TQMenvironments)


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AN ALTERNATIVE THE BALANCE

SCORECARD AND STRATEGIC MANAGEMENT

ACCOUNTINGDrury Chapters 15 and 16;

Kaplan and Norton (2000)

Drury, Chapter 15, deals with alternative

ways of improving performance. It also

explains some of the terminology used above

e.g. target costing, value engineering,

business process re-engineering, total

quality management, just-in-time, and so

on.

Drury, Chapter 16, introduces the balanced

scorecard, as one way of integrating

performance measurement and strategy.


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Kaplan and Norton devised and later refined

the notion of the balanced scorecard

o Aim of the scorecard: to provide a

comprehensive framework for

translating a companys strategic

objectives into a coherent set of

performance measures

o Each organisation must decide what are

its critical performance measures this

will vary over time and be linked to the

strategy of the organisation

o Performance measures must be tied to

strategies


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Kaplan and Nortons Balanced Scorecard

Financial Perspective

Goals Measures How do we

look to

shareholders?

How do

customers

see us?

What must we

excel at?

Customer Perspective Business PerspectiveGoals Measures Goals Measures

Innovation And

Learning Perspective

Goals Measures Can we

continue to

improve and

create value?


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Kaplan and Norton 1992 Example ECI

Corporate Mission: To be number one in delivering value to

customers

Financial Perspective Customer Perspective

Goals Measures Goals Measures

Survive

Succeed

Prosper

Cash flow

Quarterly sales

growth and

operating income

by division

Increased market

share and ROE

New products

Responsive

supply

Preferred

supplier

Customer

partnership

% of sales from new

products

% of sales from

proprietary products

On-time delivery

(defined by customer)

Share of key

accounts business

Ranking by key

accounts

Number of

cooperative

engineering efforts

Internal

Business Perspective

Innovation and

Learning

Perspective

Goals Measures Goals Measures

Technology

capability

Manufacturing

excellence

Design

productivity

New product

introduction

Manufacturing

geometry vs.

competition

Cycle time, unit

cost, yield

Silicon efficiency,

engineering

efficiency

Actual introduction

schedule vs plan

Technology

leadership

Manufacturinglearning

Product focus

Time to market

Time to develop next

generation

Process time tomaturity

Percent of products

that equal 80% of

sales

New product

introduction vs

competition

Lecture 10 Standard Costing and Variance Analysis Student Version

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