Standard Costing and Variance Analysis

Introduction to Standard Costing

Standard costing is a system of cost ascertainment in which costs are predetermined and are compared with actual costs to measure the efficiency of operations. It involves establishing a standard cost for each element of cost (material, labour, and overheads) and then comparing the actual costs incurred with these standard costs. The difference between the standard cost and the actual cost is known as a variance.

The primary objective of standard costing is to control costs and improve efficiency. It helps in:

• Cost control and reduction
• Performance appraisal
• Budgeting and planning
• Pricing decisions
• Inventory valuation
• Simplifying cost accounting procedures

Setting Standards

Standards are benchmarks or targets set for costs and quantities. They should be realistic, achievable, and based on careful analysis of past performance, engineering studies, market research, and anticipated future conditions. Standards can be set for:

• Quantity Standards: The amount of input (e.g., kilograms of raw material, hours of labour) that should be consumed per unit of output.
• Price/Rate Standards: The cost per unit of input (e.g., cost per kilogram of material, wage rate per hour of labour).

The standard cost per unit of product is calculated as: Standard Quantity × Standard Price.

Variance Analysis

Variance analysis is the process of identifying, measuring, and interpreting the differences between standard costs and actual costs. These variances highlight areas where performance deviates from the planned standards. Analyzing variances helps management understand the causes of deviations and take corrective actions.

Variances can be classified into different types, but the most common ones relate to direct material, direct labour, and overheads. We will focus on material and labour variances in detail.

Material Variances

Material variances measure the difference between the standard cost of materials and the actual cost of materials used in production. They are further divided into two main categories:

• Material Cost Variance
• Material Price Variance
• Material Usage (Quantity) Variance

Material Cost Variance (MCV)

This variance measures the overall difference between the standard cost of materials that should have been used for the actual output achieved and the actual cost of materials consumed.

Formula: MCV = Standard Cost of Actual Output - Actual Cost of Materials Used MCV = (SQ × SP) - (AQ × AP) Where: SQ = Standard Quantity of material for actual output SP = Standard Price per unit of material AQ = Actual Quantity of material used AP = Actual Price per unit of material

A favorable variance (shown in brackets or as a positive number, depending on convention) means actual costs were less than standard costs, while an adverse variance means actual costs were more than standard costs.

Material Price Variance (MPV)

This variance measures the difference between the actual cost of materials purchased and the standard cost of those materials. It reflects the difference in the price paid for materials compared to the standard price.

Formula: MPV = Actual Quantity Purchased × (Standard Price - Actual Price) MPV = AQ_p × (SP - AP) Where: AQ_p = Actual Quantity of material purchased SP = Standard Price per unit of material AP = Actual Price per unit of material

Note: If materials are purchased and consumed in the same period, AQ_p will be the same as AQ. If materials are purchased in one period and consumed in another, it's important to use the quantity purchased for MPV.

Causes of MPV:

• Changes in market prices of raw materials.
• Purchasing in bulk to get discounts.
• Changes in supplier or quality of materials.
• Errors in purchasing or recording prices.

Material Usage (Quantity) Variance (MUV)

This variance measures the difference between the standard quantity of material that should have been used for the actual output and the actual quantity of material used. It reflects efficiency in using materials.

Formula: MUV = Standard Price × (Standard Quantity for Actual Output - Actual Quantity Used) MUV = SP × (SQ - AQ) Where: SQ = Standard Quantity of material for actual output AQ = Actual Quantity of material used SP = Standard Price per unit of material

Causes of MUV:

• Differences in the quality of materials used.
• Inefficiency in handling materials (wastage, spoilage).
• Changes in production methods or processes.
• Errors in setting quantity standards.
• Poor supervision or training of workers.

Example: Material Variances

A company provides the following information for the production of Product X:

• Standard material required per unit: 2 kg
• Standard price per kg: $5
• Actual output produced: 100 units
• Actual quantity of material used: 220 kg
• Actual price paid per kg: $5.20

Calculations:

• Standard Cost of Actual Output: 100 units × 2 kg/unit × $5/kg = $1,000
• Actual Cost of Materials Used: 220 kg × $5.20/kg = $1,144
• MCV: $1,000 - $1,144 = -$144 (Adverse)
• MPV: 220 kg × ($5 - $5.20) = 220 kg × (-$0.20) = -$44 (Adverse)
• MUV: $5 × ( (100 units × 2 kg/unit) - 220 kg ) = $5 × (200 kg - 220 kg) = $5 × (-20 kg) = -$100 (Adverse)
• Verification: MCV = MPV + MUV = -$44 + (-$100) = -$144. The calculation is correct.

Labour Variances

Labour variances measure the difference between the standard cost of labour and the actual cost of labour incurred for production. They help in assessing the efficiency and cost-effectiveness of the workforce. The main labour variances are:

• Labour Cost Variance
• Labour Rate Variance
• Labour Efficiency Variance
• Labour Mix Variance (for multiple types of labour)
• Labour Yield Variance (less common)

We will focus on the first three.

Labour Cost Variance (LCV)

This variance measures the overall difference between the standard labour cost for the actual output achieved and the actual labour cost incurred.

Formula: LCV = Standard Labour Cost for Actual Output - Actual Labour Cost LCV = (SH × SR) - (AH × AR) Where: SH = Standard Hours of labour for actual output SR = Standard Rate of pay per hour AH = Actual Hours of labour worked AR = Actual Rate of pay per hour

A favorable variance indicates that actual labour costs were less than standard, while an adverse variance indicates they were higher.

Labour Rate Variance (LRV)

This variance measures the difference between the actual labour cost and the standard labour cost, arising from paying a different rate per hour than the standard rate.

Formula: LRV = Actual Hours Worked × (Standard Rate - Actual Rate) LRV = AH × (SR - AR) Where: AH = Actual Hours of labour worked SR = Standard Rate of pay per hour AR = Actual Rate of pay per hour

Causes of LRV:

• Employment of workers at rates higher or lower than standard (e.g., using skilled workers for unskilled tasks or vice versa).
• Changes in wage rates due to overtime, statutory changes, or union agreements.
• Incorrect pay calculations.
• Using casual labour at different rates.

Labour Efficiency Variance (LEV)

This variance measures the difference between the standard hours allowed for the actual output and the actual hours worked. It reflects the efficiency of labour in terms of time taken.

Formula: LEV = Standard Rate × (Standard Hours for Actual Output - Actual Hours Worked) LEV = SR × (SH - AH) Where: SH = Standard Hours of labour for actual output AH = Actual Hours of labour worked SR = Standard Rate of pay per hour

Causes of LEV:

• Inefficiency or increased efficiency of workers.
• Poor supervision or motivation.
• Changes in the quality of materials or machinery.
• Incorrect standard times set for operations.
• Idle time due to machine breakdown or lack of work.

Example: Labour Variances

For the production of 100 units of Product Y:

• Standard labour hours per unit: 3 hours
• Standard wage rate per hour: $10
• Actual hours worked: 330 hours
• Actual wage rate paid per hour: $10.50

Calculations:

• Standard Labour Cost for Actual Output: 100 units × 3 hours/unit × $10/hour = $3,000
• Actual Labour Cost: 330 hours × $10.50/hour = $3,465
• LCV: $3,000 - $3,465 = -$465 (Adverse)
• LRV: 330 hours × ($10 - $10.50) = 330 hours × (-$0.50) = -$165 (Adverse)
• LEV: $10 × ( (100 units × 3 hours/unit) - 330 hours ) = $10 × (300 hours - 330 hours) = $10 × (-30 hours) = -$300 (Adverse)
• Verification: LCV = LRV + LEV = -$165 + (-$300) = -$465. The calculation is correct.

Labour Mix and Yield Variances (Brief Overview)

When different grades or types of labour are used, and their proportions or efficiency differ from the standard, additional variances arise:

• Labour Mix Variance: This arises when the actual proportion of different types of labour used differs from the standard proportion. It measures the cost impact of using a different mix of labour grades.
• Labour Yield Variance: This occurs when the actual output obtained from labour hours differs from the standard output expected for the hours worked. It measures the impact of labour efficiency on output quantity.

These are more complex and are calculated by comparing the actual labour mix/hours with a 'standardized' mix/hours based on the actual total hours worked.

Activity-Based Costing (ABC)

Introduction to Activity-Based Costing

Traditional costing systems often allocate overhead costs using a single, volume-based cost driver (like direct labour hours or machine hours). This can lead to inaccurate product costing, especially in companies with diverse product lines and high overhead costs that are not directly related to production volume.

Activity-Based Costing (ABC) is a costing method that identifies activities in an organization and assigns the cost of each activity to all products and services according to the actual consumption by each. It recognizes that many overhead costs are driven by activities, not just production volume.

Key Concepts in ABC

ABC involves the following key concepts:

• Activities: Specific tasks or actions performed by an organization (e.g., machine setup, material handling, quality inspection, customer order processing, product design).
• Cost Pools: Groupings of overhead costs related to a specific activity.
• Cost Drivers: Factors that cause the cost of an activity to increase or decrease. These are measures of the frequency and intensity of the demand placed on an activity by cost objects (products, services, customers). Examples include number of setups, number of material moves, number of inspections, number of orders.
• Cost Objects: Anything for which a cost measurement is desired (e.g., products, services, customers, projects).

Steps in Implementing ABC

Implementing ABC typically involves these steps:

1. Identify Major Activities: Determine the significant activities that consume resources within the organization.
2. Assign Costs to Activity Cost Pools: Trace or allocate overhead costs to the identified activities. This is often done by identifying the resources consumed by each activity.
3. Identify Cost Drivers for Each Activity: Determine the most appropriate measure (cost driver) that reflects the consumption of each activity by cost objects.
4. Calculate the Activity Rate: Divide the total cost in each activity cost pool by the total volume of its cost driver.

   Activity Rate = Total Cost in Activity Pool / Total Volume of Cost Driver

5. Assign Costs to Cost Objects: Multiply the activity rate by the volume of the cost driver consumed by each cost object (product, service, etc.).
6. Analyze and Interpret: Use the cost information to make better decisions regarding pricing, product mix, process improvement, and cost reduction.

Example: ABC vs. Traditional Costing

Consider a company producing two products, A and B.

• Product A: High volume, simple design.
• Product B: Low volume, complex design, requires more setups and inspections.

Assume total overhead is $1,000,000.

Traditional Costing: Overhead is allocated based on direct labour hours. Total direct labour hours = 10,000. Overhead Rate = $1,000,000 / 10,000 DLH = $100 per DLH. If Product A uses 8,000 DLH and Product B uses 2,000 DLH:

• Product A Overhead: 8,000 DLH × $100/DLH = $800,000
• Product B Overhead: 2,000 DLH × $100/DLH = $200,000

This might undercost Product B (complex) and overcost Product A (simple).

Activity-Based Costing: Assume overhead is driven by two activities: Machine Setups and Quality Inspections.

• Activity 1: Machine Setups
  • Total Cost: $400,000
  • Cost Driver: Number of Setups
  • Total Setups: 200 (Product A: 50, Product B: 150)
  • Setup Rate: $400,000 / 200 setups = $2,000 per setup
• Activity 2: Quality Inspections
  • Total Cost: $600,000
  • Cost Driver: Number of Inspections
  • Total Inspections: 600 (Product A: 200, Product B: 400)
  • Inspection Rate: $600,000 / 600 inspections = $1,000 per inspection

ABC Cost Allocation:

• Product A:
  • Setup Cost: 50 setups × $2,000/setup = $100,000
  • Inspection Cost: 200 inspections × $1,000/inspection = $200,000
  • Total ABC Overhead for A: $100,000 + $200,000 = $300,000
• Product B:
  • Setup Cost: 150 setups × $2,000/setup = $300,000
  • Inspection Cost: 400 inspections × $1,000/inspection = $400,000
  • Total ABC Overhead for B: $300,000 + $400,000 = $700,000

ABC shows that Product B consumes more overhead resources ($700,000 vs $300,000) than traditional costing suggested ($200,000 vs $800,000). This provides a more accurate cost picture for decision-making.

Benefits of ABC

ABC offers several advantages:

• More accurate product costing, especially for complex products or diverse operations.
• Better understanding of cost drivers and overhead costs.
• Improved decision-making regarding pricing, product mix, and profitability analysis.
• Identification of non-value-added activities, leading to process improvements and cost reduction.
• Enhanced customer profitability analysis.

Limitations of ABC

Despite its benefits, ABC also has limitations:

• It is more complex and costly to implement and maintain than traditional costing systems.
• Identifying appropriate activities and cost drivers can be challenging.
• It may not be suitable for companies with simple operations or where overhead costs are predominantly volume-driven.
• It is an accounting system, not necessarily a replacement for financial accounting.