PROJECT REPORT ON

“Variance Analysis in Standard Costing”

Submitted toUniversity of Mumbai

In Partial Fulfillment of the Requirement

For

M.Com (Accountancy) Semester IIn the subject

Cost Accounting

By

Name of the student : - Vivek ShriramMahajanRoll No. : - 14 -7288

Name and address of the collegeK. V. Pendharkar College

Of Arts, Science & CommerceDombivli (E), 421203

NOVEMBER 2014

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DECLARATION

I VIVEK SHRIRAM MAHAJAN Roll No. 14 – 7288, the student of

M.Com (Accountancy) Semester I (2014), K. V. Pendharkar College,

Dombivli, Affiliated to University of Mumbai, hereby declare that the project

for the subject Strategic Management of Project report on “Variance

Analysis in Standard Costing” submitted by me to University of Mumbai,

for semester I examination is based on actual work carried by me.

I further state that this work is original and not submitted anywhere else for any examination.

Place : Dombivli

Date:

Signature of the Student

Name: - Vivek Shriram Mahajan Roll No: - 14 -7288

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ACKNOWLEDGEMENT

It is a pleasure to thank all those who made this project work possible.

I Thank the Almighty God for his blessings in completing this task. The successful completion of this project is possible only due to support and cooperation of my teachers, relatives, friends and well-wishers. I would like to extend my sincere gratitude to all of them.

I am highly indebted to Principal A.K.Ranade, Co-ordinater P.V.Limaye, and my subject teacher Prajakta Karmarkar for their encouragement, guidance and support.

I also take this opportunity to express sense of gratitude to my parents for their support and co-operation in completing this project.

Finally I would express my gratitude to all those who directly and indirectly helped me in completing this project.

Name of the studentVivek Shriram Mahajan

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CHAPTER No Topic Page no

CHAPTER 1 Introduction

Introduction to Subject………………………..Definition and Purpose of Standard Costs...................

56

CHAPTER 2 Advantages & Disadvantages of Standard Costing

Advantages of Standard Costing.................Disadvantages of Standard Costing.............................

910

CHAPTER 3 Classification of costs

Classification of cost ………………………… 11

CHAPTER 4 Variance Analysis

Definition........................................Standard costing and variance analysis in practice......

1819

CHAPTER 5 Conclusion

Conclusion………………………………….. 35

Bibliography…………………………………………. 36

Table of Contents:

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CHAPTER 1: Introduction

Introduction to Subject

Definition and concept

Standard cost

'The planned unit cost of the product, component or service produced in a period. The standard cost may be determined on a number of bases. The main use of standard costs is in performance measurement, control, stock valuation and in the establishment of selling prices.’

CIMA Official Terminology, 2005

Cost accounting is a process of collecting, analyzing, summarizing and evaluating various alternative courses of action. Its goal is to advise the management on the most appropriate course of action based on the cost efficiency and capability. Cost accounting provides the detailed cost information that management needs to control current operations and plan for the future.

Since managers are making decisions only for their own organization, there is no need for the information to be comparable to similar information from other organizations. Instead, information must be relevant for a particular environment. Cost accounting information is commonly used in financial accounting information, but its primary function is for use by managers to facilitate making decisions.

Unlike the accounting systems that help in the preparation of financial reports periodically, the cost accounting systems and reports are not subject to rules and standards like the Generally Accepted Accounting Principles. As a result, there is wide variety in the cost accounting systems of the different companies and sometimes even in different parts of the same company or organization.

Origins

All types of businesses, whether service, manufacturing or trading, require cost accounting to track their activities. Cost accounting has long been used to help managers understand the costs of running a business. Modern cost accounting originated during the industrial revolution, when the complexities of running a large scale business led to the development of systems for recording and tracking costs to help business owners and managers make decisions.

In the early industrial age, most of the costs incurred by a business were what modern accountants call "variable costs" because they varied directly with the amount of production. Money was spent on labour, raw materials, power to run a factory, etc. in direct proportion to production. Managers could simply total the variable costs for a product and use this as a rough guide for decision-making processes.

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Some costs tend to remain the same even during busy periods, unlike variable costs, which rise and fall with volume of work. Over time, these "fixed costs" have become more important to managers. Examples of fixed costs include the depreciation of plant and equipment, and the cost of departments such as maintenance, tooling, production control, purchasing, quality control, storage and handling, plant supervision and engineering. In the early nineteenth century, these costs were of little importance to most businesses. However, with the growth of railroads, steel and large scale manufacturing, by the late nineteenth century these costs were often more important than the variable cost of a product, and allocating them to a broad range of products lead to bad decision making. Managers must understand fixed costs in order to make decisions about products and pricing.

For example: A company produced railway coaches and had only one product. To make each coach, the company needed to purchase $60 of raw materials and components, and pay 6 labourers $40 each. Therefore, total variable cost for each coach was $300. Knowing that making a coach required spending $300, managers knew they couldn't sell below that price without losing money on each coach. Any price above $300 became a contribution to the fixed costs of the company. If the fixed costs were, say, $1000 per month for rent, insurance and owner's salary, the company could therefore sell 5 coaches per month for a total of $3000 (priced at $600 each), or 10 coaches for a total of $4500 (priced at $450 each), and make a profit of $500 in both cases.

Definition and Purpose of Standard Costs

A standard cost is a carefully predetermined cost. Narrowly defined, it is the estimated cost to manufacture a single unit of a product or to perform a single service.

More broadly defined, it is the estimated cost of a product, job, project, or operation, including manufacturing, selling, and administrative costs.

A budgeted cost is a standard cost multiplied by a volume figure. In other words, a standard cost is a unit cost while a budgeted cost is a total amount, although the terms are often used interchangeably.

Because standard costs are incorporated into budgeting systems, they play a key role in the planning, control, motivation, and performance evaluation functions of management.

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Having predetermined costs provides timely information to help managers plan and make decisions about product emphasis, bidding, and pricing, since such decisions often have to be made before production is complete. For control purposes, standard costs allow for a detailed analysis of variances between actual performance and budgeted performance, to determine where inefficiencies or problems exist. Because standard costs provide concrete targets that employees can aspire to achieve, they can also be used to motivate employees to minimize inefficiencies and to correct problems.

Commitment to attaining standards is usually enhanced when employees have been involved in setting the standards. Finally, evaluation of performance against predetermined standards is generally perceived to be fairer than evaluation based on vague expectations.

Standard costs may provide additional benefits if they are incorporated into the accounting system. A standard costing system, also known as a standard cost system, is an accounting system that uses standard costs to accumulate material, labour, and overhead costs. Standard costing systems are often more practical than actual or normal costing systems, and simplify the accounting process and records.

Standard costing application

This is generally best suited to organizations with repetitive activities. It is probably most relevant to manufacturing organizations with repetitive production processes. Standard costing cannot be applied easily to non-repetitive activities because there is no clear basis for observing and recording operations. It is difficult to determine a clear standard.

Two commonly used approaches are used to set standard costs.

1. Past historical records can be used to estimate labour and material usage.

2. Engineering studies can be used. This may involve a detailed study or observation of operations in terms of material, labour and equipment usage.

The most effective control is achieved by identifying standards for quantities of material, labour and services to be used in an operation, rather than an overall total product cost. Variances from standard on all component parts of cost should be reported to identify the cause – and ultimate responsibility – for the variance from standard.

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Development of Standard Costs

Developing standards for direct materials costs involves selecting the desired combination of quality, quantity, and price. Setting standards for labour costs requires understanding the nature of the work and the skill levels of employees. Developing standards for overhead costs involves the selection of a valid cost allocation base and a reasonable level of activity. The organization may use a single plant-wide rate or multiple departmental rates.

Several techniques are available to develop standard costs:

1. Activity analysis (or task analysis) – Identify and evaluate all activities required to complete a product, job, or operation to determine exactly how much direct materials should be required, how long each step performed by direct labourers should take, and how machinery should be used in the production process, etc.

2. Historical data – Use historical data in conjunction with management judgment to ensure that standards do not perpetuate past inefficiencies.

3. Benchmarking – Collect information from other firms in the same industry or firms considered to have “best practices” across industries.

4. Market expectations and strategic decisions – Determine the standard required to achieve a target cost or to achieve satisfactory progress towards a continuous improvement strategy.

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CHAPTER 2: Advantages & Disadvantages of Standard Costing

Advantages Of Standard Costing

A standard costing is a rule of measurement established by authority, which provides a yardstick for performance evaluation.

Standard costing system minimizes the wastage by detecting variance and suggesting for corrective actions.

Under the standard costing system, cost centers are established and responsibility is assigned to the concerned departments and persons and thus it helps to increase the effective delegation of authority.

A properly developed standard costing system with full participation and involvement creates a positive, cost effective attitude through all levels of management.

The standard system encourages reappraisals of methods, materials and techniques that help to reduce the unfavorable variances.

The standard costing system helps to draw management's attention towards those items which are not proceeding according to plan.

Standard costing system makes the whole organization cost-conscious as it gives the focus to the standard cost and variance analysis.

Standard costing system provides a basis for incentive scheme to workers and supervisors.

Standard costing system simplifies the cost control procedures.

Standard costing acts as an effective tool for business planning, budgeting, marginal costing, inventory valuation etc.

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Disadvantages Of Standard Costing

Standard costing system may be tedious, expensive and time consuming to install and keep up to date.

The standard costing system controls the operating part of an organization only as it ignores the other items like quality, lead-time, service, customer satisfaction and so on.

The standard costing system will become less useful in modern factories where the just in time principles are adopted.

The standard costing system may not be applicable in case of small firms as it requires high degree of skill.

The standard costing may not be very effective in those organizations where non-standardized products are manufactured and services are rendered.

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CHAPTER 3: Classification of costs

Classification of cost means, the grouping of costs according to their common characteristics. The important ways of classification of costs are:

1. By Element: There are three elements of costing i.e. material, labor and expenses.

2. By Nature or Traceability: Direct Costs and Indirect Costs are directly attributable/traceable to Cost Object. Direct costs are assigned to Cost Object. Indirect Costs are not directly attributable/traceable to Cost Object. Indirect costs are allocated or apportioned to cost objects.

3. By Functions: production, administration, selling and distribution, R&D.

4. By Behavior: fixed, variable, semi-variable. Costs are classified according to their behavior in relation to change in relation to production volume within given period of time. Fixed Costs remain fixed irrespective of changes in the production volume in given period of time. Variable costs change according to volume of production. Semi-variable costs are partly fixed and partly variable.

5. By control ability: controllable, uncontrollable costs. Controllable costs are those which can be controlled or influenced by a conscious management action. Uncontrollable costs cannot be controlled or influenced by a conscious management action.

6. By normality: normal costs and abnormal costs. Normal costs arise during routine day-to-day business operations. Abnormal costs arise because of any abnormal activity or event not part of routine business operations. E.g. costs arising of floods, riots, accidents etc.

7. By Time: Historical Costs and Predetermined costs. Historical costs are costs incurred in the past. Predetermined costs are computed in advance on basis of factors affecting cost elements. Example: Standard Costs.

8. By Decision making Costs: These costs are used for managerial decision making.

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Marginal Costs: Marginal cost is the change in the aggregate costs due to change in the volume of output by one unit.

Differential Costs: This cost is the difference in total cost that will arise from the selection of one alternative to the other.

Opportunity Costs: It is the value of benefit sacrificed in favor of an alternative course of action.

Relevant Cost: The relevant cost is a cost which is relevant in various decisions of management.

Replacement Cost: This cost is the cost at which existing items of material or fixed assets can be replaced. Thus this is the cost of replacing existing assets at present or at a future date.

Shutdown Cost: These costs are the costs which are incurred if the operations are shut down and they will disappear if the operations are continued.

Capacity Cost: These costs are normally fixed costs. The cost incurred by a company for providing production, administration and selling and distribution capabilities in order to perform various functions.

Other Costs

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COMPARISON OF COSTS

Cost Accounting vs. Financial Accounting

Financial accounting aims at finding out results of accounting year in the form of Profit and Loss Account and Balance Sheet. Cost Accounting aims at computing cost of production/service in a scientific manner and facilitates cost control and cost reduction.

Financial accounting reports the results and position of business to government, creditors, investors, and external parties.

Cost Accounting is an internal reporting system for an organization’s own management for decision making.

In financial accounting, cost classification based on type of transactions, e.g. salaries, repairs, insurance, stores etc. In cost accounting, classification is basically on the basis of functions, activities, products, process and on internal planning and control and information needs of the organization.

Financial accounting aims at presenting ‘true and fair’ view of transactions, profit and loss for a period and Statement of financial position (Balance Sheet) on a given date. It aims at computing ‘true and fair’ view of the cost of production/services offered by the firm.

Cost is a sacrifice of resources to obtain a benefit or any other resource. For example in production of a car, we sacrifice material, electricity, the value of machine's life (depreciation), and labor wages etc. Thus these are our costs.

Product Costs vs. Period Costs

Product costs are costs assigned to the manufacture of products and recognized for financial reporting when sold. They include direct materials, direct labor, factory wages, factory depreciation, etc.

Period costs are on the other hand are all costs other than product costs. They include marketing costs and administrative costs, etc

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Breakup of Product Costs

The product costs are further classified into:

Direct materials: Represents the cost of the materials that can be identified directly with the product at reasonable cost. For example, cost of paper in newspaper printing, cost of

Direct labor: Represents the cost of the labor time spent on that product, for example cost of the time spent by a petroleum engineer on an oil rig, etc.

Manufacturing overhead: Represents all production costs except those for direct labor and direct materials, for example the cost of an accountant's time in an organization, depreciation on equipment, electricity, fuel, etc.

The product costs that can be specifically identified with each unit of a product are called direct product costs. Whereas those which cannot be traced to a specific unit are indirect product costs. Thus direct material cost and direct labor cost are direct product costs whereas manufacturing overhead cost is indirect product cost.

Fixed Costs vs. Variable Costs

Fixed costs are costs which remain constant within a certain level of output or sales. This certain limit where fixed costs remain constant regardless of the level of activity is called relevant range. For example, depreciation on fixed assets, etc.

Variable costs are costs which change with a change in the level of activity. Examples include direct materials, direct labor, etc

Sunk Costs vs. Opportunity Costs

The costs discussed so far are historical costs which means they have been incurred in past and cannot be avoided by our current decisions. Relevant in this regard is another cost classification, called sunk costs. Sunk costs are those costs that have been irreversibly incurred or committed; they may also be termed unrecoverable costs. In contrast to sunk costs are opportunity costs which are costs of a potential benefit foregone.

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Types of cost accounting

The Following are different Cost Accounting Approaches:

1. Standardized or standard cost accounting2. Lean accounting3. Activity-based costing4. Resource consumption accounting5. Throughput accounting6. Life cycle costing7. Environmental accounting8. Target costing

Standard cost accounting

In modern cost account of recording historical costs was taken further, by allocating the company's fixed costs over a given period of time to the items produced during that period, and recording the result as the total cost of production. This allowed the full cost of products that were not sold in the period they were produced to be recorded in inventory using a variety of complex accounting methods, which was consistent with the principles of GAAP (Generally Accepted Accounting Principles). It also essentially enabled managers to ignore the fixed costs, and look at the results of each period in relation to the "standard cost" for any given product.

For example: if the railway coach company normally produced 40 coaches per month, and the fixed costs were still $1000/month, then each coach could be said to incur an Operating Cost/overhead of $25 =($1000 / 40). Adding this to the variable costs of $300 per coach produced a full cost of $325 per coach.

This method tended to slightly distort the resulting unit cost, but in mass-production industries that made one product line, and where the fixed costs were relatively low, the distortion was very minor.

For example: if the railway coach company made 100 coaches one month, then the unit cost would become $310 per coach ($300 + ($1000 / 100)). If the next month the company made 50 coaches, then the unit cost = $320 per coach ($300 + ($1000 / 50)), a relatively minor difference.

An important part of standard cost accounting is a variance analysis which breaks down the variation between actual cost and standard costs into various components (volume variation,

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material cost variation, labor cost variation, etc.) so managers can understand why costs were different from what was planned and take appropriate action to correct the situation.

Types of standards

Following are different types of standards:

Basic standards Normal standards Current standards Attainable (expected) standards Ideal (theoretical) standards

Basic standards

These are standards established considering those factors that are basic in nature and remain unchanged over a long period of time and are altered only when the business operations change significantly affecting the very basic foundations of the entity and nature of busienss. These standards help compare business operations over a longer period of time. Basic standards are used not only to evaluate actual results but also current expected results (current standards). We can say that basic standards work as a standard for other standards. As basic standards are not updated according to latest circumstances thus they are not used often as they cannot help in short term period variance analysis.

Normal Standards

These are such standards which are expected if normal circumstances prevail. Term normal represents the normal conditions of the business in the absence of any unexpected fluctuations (either favourable or unfavourable). Even through normal standards is more of a theoretical in nature as reality cannot be sufficiently predicted with all its fluctuations in advance. Also, circumstances may change in such a way that factors which were expected to be controllable are not so controllable by the mangers. Thus it has limited application in today’s business environment. However, normal standards acts as a good yardstick that represents challenging yet attainable results and can be used by management in such environment which is simple in nature and is not prone to great fluctuations.

Current standards

These standards are representative of current business conditions. These are mostly short term in nature and are widely used as they are the most relevant standards to be used for control purposes. These standards represent the state that business currently achieving or must achieve.

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Attainable standards / Expected standards

These standards are based on current conditions and circumstances and represents what can be attained with the present setup in place and if the current conditions prevail. Current standards may be set lower or easier then expected standards but good managers always try to achieve what is attainable so that no resource is left unused. It means that attainable standards are representative of the potential that business is capable to achieve. For example a machinery is expected to run for 4,000 hours where it can run for 5,000. Thus current standard is 4,000 hours where attainable is 5,000 hours. These standards are useful as they help management to analyze their performance and to use the unused potential at the right time.

Ideal standards / Theoretical standards.

These standards represent what business operations would be under ideal set of circumstances where everything is running at the optimum level with an ideal balance. These standards are representative of long term goals rather than for short term performance measurement. But with the advancement of technology and inventions even the ideal standards become attainable over the period of time but with every step taken forward and every question answered, more questions and more complexities pop up and its in human nature that it always extends the way forward with every milestone achieved. Therefore, ideal standards are not meant to be achieved rather to act like a guiding star.

Which type of standard should be selected?

This is not like that one standard is always good and the other always bad. Its all relative. It is a matter of situation and involves judgment to decide which standard is suitable for a particular situation and which can provide relevant and reliable information which is also easily available and applicable. Therefore, it depends on the requirements on the basis of which it is determined what type of standard is suitable for use.

For example, in financial or environmental crisis it will be good if management stick with current standards rather than using attainable standards as even maintaining current standards is sometime difficult.

On the other hand if management is of the opinion that circumstances are favourable and also the resources available are capable of facing a challenge then it may switch to attainable or even normal standards and a bit to the extreme ideal standards where ideal standards may help to motivate staff to perform at its peak.

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CHAPTER 4: Variance Analysis

‘The evaluation of performance by means of variances, whose timely reporting should maximize the opportunity for managerial action”.

Variance analysis is the process of calculating the deviation of the actual costs from the standards and of interpreting the results. Variance analysis helps to ascertain the magnitude of each of the variances and causes of variance so that corrective actions can be taken.

Overview and comparison

Standard costing is a control system that enables any variances from standard cost or budget to be analyzed in some detail. This allows for more effective cost control.

A standard costing system consists of the following four elements:

1. Setting standards for each operation.

2. Comparing actual with standard performance.

3. Analyzing and reporting variances arising from the difference between actual and standard performance.

4. Investigating significant variances and taking appropriate competitive action.

Direct material standards and variance analysis

Direct material standards are derived from the amount of material required for each product or operation. This should take into account the most suitable material for the product specification and design. It should also include any anticipated wastage or losses in the process.

Direct material standards should also consider the standard price of the material, based on the most suitable and competitive price as required by the most suitable quality of material. These prices should also include economic order quantity, discounts and credit terms offered by suppliers.

The standard material used and the standard cost of the material are combined to calculate the standard material cost. By comparing the actual material price and the actual material used with the standards calculated, the material price and the material usage variance can be determined.

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Standard costing and variance analysis in practice

In a recent CIMA research study on Contemporary Management Accounting Practices in UK Manufacturing, over 70% of UK manufacturing companies studied employed standard costing practices. All companies which used standard costing set standards for material costs, while 90% set standards for labour costs and nearly 70% set standards for overheads.

However, standard cost variances often do not appear as part of profit and loss information. Over half of companies using standard costing based their reports on actual costs. Some companies added back variances, while others updated material standards so that they approximated actual costs. Despite not appearing in the account, most of the standard cost companies calculated some material and labour variances for control purposes. Overhead variances were much less well used and reported, and only one company sub-divided both variable and fixed overheads.

The conclusion from the report was that although most manufacturing companies do use standard costing, they tend to be very selective in their use of variance analysis, especially overhead variances. The use of fixed overheads was particularly scarce.

The analysis of variances facilitates action through ‘management by exception’. Here managers concentrate on business areas that are performing below or above expectations. Managers can largely ignore those that appear to be conforming to expectation.

The setting of standards and revision and monitoring encourages reappraisal of methods, materials and techniques. This leads to cost reductions and process improvement.

A properly developed and understood standard costing system with full participation and involvement creates a positive attitude towards cost control throughout the organization.

Modern technology and reporting software has allowed for variance analysis to be undertaken automatically without the need for complex manual calculations. Microsoft Excel Work Essentials is a commonly used tool to undertake variance analysis.

Types of variances

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Variances can be divided according to their effect or nature of the underlying amounts.

When effect of variance is concerned, there are two types of variances:

When actual results are better than expected results given variance is described as favorable variance. In common use favorable variance is denoted by the letter F - usually in parentheses (F).

When actual results are worse than expected results given variance is described as adverse variance, or unfavourable variance. In common use adverse variance is denoted by the letter U or the letter A - usually in parentheses (A).

The second typology (according to the nature of the underlying amount) is determined by the needs of users of the variance information and may include e.g.:

1. Variable cost variances

2. Direct material variances

3. Direct labour variances

4. Variable production overhead variances

5. Fixed production overhead variances

6. Sales variances

DIRECT MATERIAL TOTAL VARIANCE

In variance analysis (accounting) direct material total variance is the difference between the actual cost of actual number of units produced and its budgeted cost in terms of material. Direct material total variance can be divided into two components:

1. The direct material price variance.2. The direct material usage variance.

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Direct Material Price Variance

Definition

Direct Material Price Variance is the difference between the actual cost of direct material and the standard cost of quantity purchased or consumed.

Formula

Direct Material Price Variance:

=   Actual Quantity x Actual Price -Actual Quantity x Standard Price

= Actual Quantity x(Standard price – Actual price)

Where:

Actual Quantity is the quantity purchased during a period if the variance is calculated at the time of material purchase

Actual Quantity is the quantity consumed during a period if the variance is calculated at the time of material consumption

Analysis

A favourable material price variance suggests cost effective procurement by the company.

Reasons for a favourable material price variance may include:

An overall decrease in the market price level Purchase of materials of lower quality than the standard (this will be reflected in

adverse material usage variance) Better price negotiation by the procurement staff Implementation of better procurement practices (e.g. invitation of price quotations

from multiple suppliers) Purchase discounts on larger orders

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An adverse material price variance indicates higher purchase costs incurred during the period compared with the standard.

Reasons for adverse material price variance include:

An overall hike in the market price of materials Purchase of materials of higher quality than the standard (this will be reflected in

favorable material usage variance) Increase in bargaining power of suppliers Loss of purchase discounts due to smaller order sizes Inefficient buying by the procurement staff

Direct Material Usage Variance

Definition

Direct Material Usage Variance is the measure of difference between the actual quantity of material utilized during a period and the standard consumption of material for the level of output achieved.

Formula

Direct Material Usage Variance:

=   Actual Quantity x Standard Price-Standard Quantity x Standard Price

=   Standard Cost of Actual Quantity-Standard Cost of Standard Quantity

=   (Actual Quantity - Standard Quantity) x Standard Price

Since the effect of any variation in material price from the standard is calculated in the material price variance, material usage variance is calculated using the standard price.

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Analysis

A favorable material usage variance suggests efficient utilization of materials.

Reasons for a favorable material usage variance may include:

Purchase of materials of higher quality than the standard (this will be reflected in adverse material price variance)

Greater use of skilled labor Training and development of workforce to improve productivity Use and improvement of automated manufacturing tools and processes

An adverse material usage variance indicates higher consumption of material during the period as compared with the standard usage.

Reasons for adverse material usage variance include:

Purchase of materials of lower quality than the standard (this will be reflected in a favorable material price variance)

Use of unskilled labor Increase in material wastage due to depreciation of plant and equipment

Direct Material Mix Variance

Definition

Direct Material Mix Variance is the measure of difference between the cost of standard proportion of materials and the actual proportion of materials consumed in the production process during a period.

Formula

Direct Material Mix Variance:

=   Actual Quantity x Standard Price - Standard Mix Quantity x Standard Price

=   Standard Cost of Actual Actual Mix -Standard Cost of Standard Mix

=   (Actual Mix Quantity - Standard Mix Quantity) x Standard Price

As material mix variance is an extension of the material usage variance, the variance is based on the standard price rather than actual price since the difference between actual and standard material price is accounted for separately in the material price variance.

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Explanation

Material Mix Variance quantifies the effect of a variation in the proportion of raw materials used in a production process over a period.

Material mix variance is a sub-division of material usage variance While material usage variance illustrates the overall efficiency of raw material consumption during a period (in terms of the difference between the amount of materials which should have been used and the actual usage), material mix variance focuses on the aspect of proportion of raw materials used in the production process.

Material mix variance is only suitable for performance measurement and control where the proportion of inputs to the production process can be altered without reducing the effectiveness of the final product. It may not therefore be used in industries that require a high degree of precision in the input variables such as in the pharmaceuticals sector

Analysis

A favorable material mix variance suggests the use of a cheaper mix of raw materials than the standard. Conversely, an adverse material mix variance suggests that a more costly combination of materials have been used than the standard mix.

A change in the material mix must also be analyzed in the context of other organization wide implications that may follow. Some of the effects a change in direct material mix include:

Change in the quality, performance and durability of the final product

Price offered by customers may vary as a result of a change in perceived quality of the product

Change in material mix may affect the workability of materials which may in turn affect labor efficiency

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Direct Material Yield Variance

Definition

Direct Material Yield Variance is a measure of cost differential between output that should have been produced for the given level of input and the level of output actually achieved during a period.

Formula

Direct Material Yield Variance:

= (Actual Yield - Standard Yield) x Standard Material Cost Per Unit

Explanation

Material Yield Variance measures the effect on material cost of a change in the production yield from the standard.Material yield variance is used in conjunction with material mix variance in order to provide additional analysis of the material usage variance.The difference between material usage and material yield variance is that the former focuses on the utilization of input at the start of production process whereas latter focuses on the efficiency in terms of the output yield during a period.

Analysis

A favorable material yield variance indicates better productivity than the standard yield resulting in lower material cost.Conversely, an adverse material yield variance suggests lower production achieved during a period for the given level of input resulting in higher material cost.

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Direct Labour Rate Variance

Definition

Direct Labour Rate Variance is the measure of difference between the actual cost of direct labor and the standard cost of direct labor utilized during a period.

Formula

Direct Labor Rate Variance:

= Actual Quantity x Actual Rate - Actual Quantity x Standard Rate

= Actual Cost - Standard Cost of Actual Hours

Analysis

A favorablelabor rate variance suggests cost efficient employment of direct labor by the organization.

Reasons for a favorable labor rate variance may include:

Hiring of more un-skilled or semi-skilled labor (this may adversely impact labor efficiency variance

Decrease in the overall wage rates in the market due to an increase in the supply of labour which may be caused, for example, due to the influx of immigrants as a result of the relaxation of immigration policy

Inappropriately high setting of the standard cost of direct labor which may, in the hindsight, be attributed to inaccurate planning

An adverse labor rate variance indicates higher labor costs incurred during a period compared with the standard.

Causes for adverse labour rate variance may include:

Increase in the national minimum wage rate Hiring of more skilled labour than anticipated in the standard (this should be reflected

in a favorable labour efficiency variance Inefficient hiring by the HR department Effective negotiations by labour unions

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Direct Labor Efficiency Variance

Definition

Direct Labor Efficiency Variance is the measure of difference between the standard cost of actual number of direct labor hours utilized during a period and the standard hours of direct labor for the level of output achieved.

Formula

Direct LaborEffciency Variance:

=   Actual Hours x Standard Rate - Standard Hours x Standard Rate

=    Standard Cost of Actual Hours - Standard Cost

Note: As the effect of difference between standard rate and actual rate of direct labor is accounted for separately in the direct labor rate variance, the efficiency variance is calculated using the standard rate.

Analysis

A favorablelabor efficiency variance indicates better productivity of direct labor during a period.

Causes for favorablelabor efficiency variance may include:

Hiring of more higher skilled labor (this may adversely impact labor rate variance

Training of work force in improved production techniques and methodologies

Use of better quality raw materials which are easier to handle

Higher learning curve than anticipated in the standard

An adverse labor efficiency variance suggests lower productivity of direct labor during a period compared with the standard.

Reasons for adverse labor efficiency variances may include:

Hiring of lower skilled labor than the standard (this should be reflected in a favorable labor rate variance

Lower learning curve achieved during the period than anticipated in the standard Decrease in staff morale and motivation

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Idle time incurred during a period caused by disruption or stoppage of activities (idle time variance may be calculated separately from the labor efficiency variance to reflect the underlying increase or decrease in labor productivity during a period)

Direct Labour Idle Time Variance

Definition

Labor Idle Time Variance is the cost of the standby time of direct labor which could not be utilized in the production due to reasons including mechanical failure of equipment, industrial disputes and lack of orders.

Formula

Idle Time Variance: = Number of idle hours x Standard labour rate

Explanation

Idle time variance illustrates the adverse impact on the profitability of an organization as a result of having paid for the labor time which did not result in any production. Idle time variance is therefore always described as an 'adverse' variance.

The separate calculation of idle time variance ensures a more meaningful analysis of the underlying productivity of the workforce demonstrated in the labor efficiency variance as illustrated in the example below.

As with the labor efficiency variance, the calculation of idle time variance is based on the standard rate since the variance between actual and standard labor rate is separately accounted for in the labor rate variance.

Analysis

Reasons for idle time may include: Disruption of production activities due to mechanical failures Lack of purchase orders especially in case of seasonal businesses Industrial disputes

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Variable Manufacturing Overhead Spending Variance

Definition

Variable Overhead Spending Variance is the difference between variable production overhead expense incurred during a period and the standard variable overhead expenditure. The variance is also referred to as variable overhead rate variance and variable overhead expenditure variance.

Formula

Variable Overhead Spending Variance:

= Actual Manufacturing Variable Overheads Expenditure

Less

Actual hours x Standard Variable Overhead Rate per hour

where:

Actual Hours is the number of machine hours or labor hours during a period.

Explanation

Variable Overhead Spending Variance is essentially the difference between what the variable production overheads did cost and what they should have cost given the level of activity during a period.

Standard variable overhead rate may be expressed in terms of the number of machine hours or labor hours. So for example, in case of a labor intensive manufacturing business, standard variable overhead rate may be expressed in terms of the number of labor hours whereas in case of predominantly automated production processes, a standard rate based on the number of machine hours may be more appropriate. Very often however, companies have a combination of manual and automated business processes which may necessitate the use of both basis of variable overhead absorption.

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Analysis

Favorable variable manufacturing overhead spending variance indicates that the company incurred a lower expense than the standard cost.

Possible reasons for favorable variance include:

Economies of scale (e.g. increase in order size of indirect material leading to bulk discounts on purchase)

A decrease in the general price level of indirect supplies More efficient cost control (e.g. optimizing electricity consumption through the

installation of energy efficient equipment) Planning error (e.g. failing to take into account the learning curve effect which could

have reasonably be expected to result in a more efficient use of indirect materials in the upcoming period)

An adverse variable manufacturing overhead spending variance suggests that the company incurred a higher cost than the standard expense.

Potential causes for an adverse variance include:

A rise in the national minimum wage rate leading to a higher cost of indirect labor

A decrease in the level of activity not fully offset by a decrease in overheads (e.g. electricity consumption of machines during set up is usually same even if a smaller batch of output is required to be produced)

In efficient cost control (e.g. not optimizing the batch production quantities leading to higher set up costs)

Planning error (e.g. failing to take into account the increase in unit rates of electricity applicable for the level of activity budgeted during a period)

Limitations

Variable production overheads by their nature include costs that cannot be directly attributed to a specific unit of output unlike direct material and direct labor which vary directly with output. Variable overheads do however vary with a change in another variable. Traditional management accounting often define blanket variables such as machine hours or labor hours which seldom provides a meaningful basis of cost control. The use of activity based costing to calculate overhead variances can significantly enhance the usefulness of such variances.

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Fixed Manufacturing Overhead Total Variance

Definition

Fixed Overhead Total Variance is the difference between actual and absorbed fixed production overheads during a period.

Formula

Fixed Overhead Total Variance = Actual Fixed Overheads - Absorbed Fixed Overheads

Explanation

Fixed Overhead Total Variance is the difference between the actual fixed production overheads incurred during a period and the 'flexed' cost (i.e. fixed overheads absorbed).

In case of absorption costing, the fixed overhead total variance comprises the following sub-variances:

Fixed Overhead Expenditure Variance: the difference between actual and budgeted fixed production overheads.

Fixed Overhead Volume Variance: the difference between fixed production overheads absorbed (flexed cost) and the budgeted overheads.

Under marginal costing system, fixed production overheads are not absorbed in the cost of output. Fixed overhead total variance in such instance will therefore equal to the fixed overhead expenditure variance because the budgeted and flexed overhead cost shall be the same.

Fixed Overhead Volume Variance

Definition

Fixed Manufacturing Overhead Volume Variance quantifies the difference between budgeted and absorbed fixed production overheads.

Formula

Fixed Overhead Volume Variance = Absorbed Fixed overheads - Budgeted Fixed Overheads

Explanation

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Fixed Overhead Volume Variance is the difference between the fixed production cost budgeted and the fixed production cost absorbed during the period. The variance arises due to a change in the level of output attained in a period compared to the budget.

The variance can be analysed further into two sub-variances:

Fixed Overhead Capacity Variance Fixed Overhead Efficiency Variance

The sum of the above two variances should equal to the volume variance.

Fixed overhead volume variance helps to 'balance the books' when preparing an operating statement under absorption costing.

As fixed costs are not absorbed under marginal costing system, fixed overhead volume variance (and its sub-variances) are to be calculated only when absorption costing is applied.

Fixed Overhead Capacity Variance

Fixed Overhead Capacity Variance calculates the variation in absorbed fixed production overheads attributable to the change in the number of manufacturing hours (i.e. labor hours or machine hours) as compared to the budget.

The variance can be calculated as follows:

Fixed Overhead Capacity Variance:

= (budgeted production hours - actual production hours) x FOAR*

* Fixed Overhead Absorption Rate / unit of hour

Fixed Overhead Efficiency Variance

Fixed Overhead Efficiency Variance calculates the variation in absorbed fixed production overheads attributable to the change in the manufacturing efficiency during a period (i.e. manufacturing hours being higher or lower than standard).

The variance can be calculated as follows:

Fixed Overhead Efficiency Variance:

= (standard production hours - actual production hours) x FOAR*

Limitations

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Fixed Overhead Volume Variance is necessary in the preparation of operating statement under absorption costing as it removes the arithmetic duplication as discussed earlier. However, besides its role as a balancing agent, the variance offers little information in its own right over and above what can be ascertained from other variances (e.g. sales quantity variance already illustrates the effect of an increase in sales quantity on the overall profitability).

The traditional calculation of sub-variances (i.e. fixed overhead capacity and efficiency variances) does not provide a meaningful analysis of fixed production overheads. For instance, if the workforce utilized fewer manufacturing hours during a period than the standard (the effect of which is more adequately reflected in labor efficiency variance, it is hard to imagine a significant benefit of calculating a favorable fixed overhead efficiency variance.

Limitations of Standard Costing & Variance

Analysis While standard costing and variance analysis are important tools in an organization's budgetary control system, it is important for a management accountant to appreciate their limitations and disadvantages.

Non Standardized Production

Standard Costing is traditionally suited to businesses involved in the manufacture of standardized products in mass production environments.

Problems arise when standard costing is applied to organizations involved in the production of small batches of customized products because of the lack of historical benchmark standards for the new custom products. While new standards could be developed for every new batch of custom products, the amount of time that would be required to oversee the entire process for products with such short life cycle may not make it practically feasible.

Service Organizations

Standard costing and variance analysis is more difficult to apply to service sector organizations because major portion of their cost is comprised of overhead expenses rather than production expenses (e.g. direct labor cost, direct materials cost, etc). While traditional variance analysis of overheads does not provide very useful information for overheads control purposes, application of newer approaches to standard costing (e.g. use of activity based costing) can provide a constructive basis for variance analysis of overheads in service sector organizations although this may require significant time and investment in the implementation of a management information system that is capable of delivering such information.

Assigning Responsibilities

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Responsibility accounting is a major function of standard costing and variance analysis. Variances could arise for a number of reasons ranging from unrealistic standards (e.g. failing to take into account an expected increase in wage rates) to operational causes (e.g. increase in direct material usage due to hiring of lower skilled labor). Planning inefficiencies that may have caused large variances due to the setting of faulty standards could be dealt with by computing planning and operational variances retrospectively. It can however be more difficult to ascertain the precise causes and assigning responsibilities of an operational variance to a specific individual, department or function within an organization. It may however be argued that although the causes and responsibilities for variances can get blurred at times, variance analysis does provide a basis for investigation that could actually promote a better understanding of the operational environment among an organization's management.

Reporting Delay

Variance analysis is usually conducted as part of the annual budgeting exercise. The usefulness of variance analysis as a control mechanism declines as the duration of reporting period increases because the delay in the provision of such information reduces its relevancy for the decision making needs of management. Use of continuous budgeting system can significantly reduce the lead times associated with variance analysis although it might be costly in terms of management time and the resources required to implement an information system with the required functionality.

Behavioral Issues

Standard costing and variance analysis may encourage short-termism due to their inherent tendency towards short-term, quantified objectives and results.

A negative perception of an organization's standard costing and variance analysis process can also encourage other sub-optimal behavior among employees such as attempts to incorporate budget slacks.

The behavioral issues associated with standard costing and variance analysis could be managed by involving employees during budget setting so that they do not view the process as unfair. It is also important for an organization's performance measurement system to be based on a wide range of quantitative and qualitative measures so as to encourage management to adopt a long term view that is aligned with an organization's strategic direction.

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CHAPTER5: Conclusion

Standard costing underlies most business activities. The cost of a product must be ascertained prior to production for pricing and control purposes. Standard costing may also lead to cost reductions. Perhaps the most important benefit which results from a standard costing system is the atmosphere of cost consciousness which is fostered among managers.

Standard cost data are compared with actual cost data for the purpose of ascertaining variances. Such variances are normally broken down into two basic components-quantity variances and price variances. The control of overhead costs as distinct from direct costs requires a method which takes into account the possibility of changes in the level of production during the planning period. Flexible budgeting affords such a method, and provides for each department a series of budget allowance schedules for various volume levels within the normal range of operations.

The ascertainment of variances is only the first stage in assessing results. Variances should be analysed in depth in order to establish whether they are significant, whether they are controllable and if so where responsibility lies.

At the same time, the analysis of variances enables established standards to be validated and methods for establishing standards in the future to be improved.

Standard costing not only provides a means of controlling costs but also monitoring revenue through the analysis of sales variances. Linear programming may allow the control process to be improved, providing that future developments in accounting information systems allow opportunity costs to be recorded.

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Bibliography

https://www.academia.edu/

http://www.cimaglobal.com/

http://www.tax-accountants.co.uk/

http://www.slideshare.net/

http://www.accountingcoach.com/

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