Standard Costs & Variance Analysis

Standard Costs

• Based on predetermined amounts for planning labor, material and overhead.
• Benchmarks for measuring performance; a planned cost done in advance for comparison.
• Variance analysis compares standard costs against actual results.

Setting Standard Costs

• Collaboration between accountants, engineers, personnel, and production managers is essential.

Ideal vs. Practical Standards

• Ideal Standards:
  • Discourage diligent workers; attained only under best circumstances (skilled workers at 100% efficiency).
  • Few firms use due to limited meaning and difficulty in managing by exception.
• Practical Standards:
  • Signal abnormal conditions; used in forecasting and inventory planning.
  • Based on efficient but not perfect conditions ('tight but attainable'), allowing for downtime and rest.

Why Use Standard Costing?

• Determines suitable materials and operations, acting as a performance yardstick.
• Monitors costs, motivating employees to be cost-conscious.
• Motivates employees to achieve attainable standards.
• Saves management effort by investigating significant variances only (management by exception).
• Used in inventory valuation, budget setting, and decision-making (e.g., pricing).

Preparation of Standard Costs

• Individual standards are set for each cost component.
• A standard cost is prepared for each product/service.

Standard Cost Card Example

• Direct Materials: 5 Kgs @ €2 per kg = €10
• Direct Labour: 3 hours @ €8 per hour = €24
• Variable Overhead: 3 hours @ €4 per hour = €12
• Fixed Overhead: €4 per unit
• Standard Cost: €64
• Standard Profit: 25% mark-up (€16)
• Standard Selling Price: €80

Who Sets Standards?

• Materials:
  • Specification (Design Department), Usage (Production Department), Price (Buying Department).
• Labour Cost:
  • Grade (Production Department), Time (Industrial Engineers), Wage Rate (HR Department).

Variances

• Difference between planned (budgeted or standard) and actual costs or revenues.
• Variance Analysis: Establishes why a variance occurred.
  • Favorable Variance: Actual results better than expected (underspend).
  • Adverse Variance: Actual results worse than expected (overspend).

Variance Analysis Cycle

• Identify questions, analyze variances, receive explanations, take corrective actions.

Variances Impact

• Original Budgeted Profit + Favorable Variances - Adverse Variances = Actual Profit

Flexible Budget

• Adjusted to show costs for the actual level of activity.

Example: Harry Limited

• Illustrates sales volume, sales price, materials, and labor variances.

Materials Variances

• Total Direct Material Variance = Direct Materials Usage Variance + Direct Materials Price Variance$$Total\,Direct\,Materials\,Variance = Direct\,Materials\,Usage\,Variance + Direct\,Materials\,Price\,Variance$</li> </ul> <h3 id="labourvariances">Labour Variances</h3> <ul> <li>Total Direct Labour Variance = Efficiency Variance + Rate Variance$$Total\,Direct\,Labour\,Variance = Efficiency\,Variance + Rate\,Variance$

Reconciliation Statement

• Original Budgeted Profit + Favorable Variances - Adverse Variances = Actual Profit

Reasons for Adverse Variances

• Sales Volume: Downturn in demand.
• Sales Price: Downturn in demand, reduced prices.
• Direct Materials Usage: Poor production, substandard materials, faulty machinery.
• Direct Materials Price: Increased material prices.
• Labour Efficiency: Poor supervision, insufficient skills, substandard materials.
• Labour Rate: Increased pay rates.
• Fixed Overheads: Poor supervision, increased costs.

Investigating Variances

• Consider relevance, reliability, comparability, and understandability.
• Assess significance (percentage or specific amount).

Suggested Approach

1. Investigate significant adverse variances.
2. Investigate significant favorable variances (good performance or unrealistic target?).
3. Keep insignificant variances under review.

Compensating Variances

• Trading off linked variances (e.g., cheaper materials causing higher usage).
• As long as Favorable > Adverse.