COST AND MANAGEMENT ACCOUNTING UNIT IV: STANDARD COSTING AND VARIANCE ANALYSIS FOR MBA 2 SEM

UNIT IV: STANDARD COSTING AND VARIANCE ANALYSIS

Learning Objectives

By the end of this unit, students will be able to:

Understand the concept and purpose of standard costing
Identify advantages and limitations of standard costing systems
Calculate and analyze various types of variances
Apply variance analysis for management decision-making
Compute budgeting and operating budgets effectively
Apply management accounting concepts for business decision-making

1. INTRODUCTION TO STANDARD COSTING

1.1 Meaning of Standard Cost

Standard cost refers to the predetermined cost of a product or service under normal operating conditions. It represents what the cost should be rather than what it actually is. Standard costs are established based on careful analysis of past performance, current conditions, and future expectations.

Key Characteristics:

Predetermined and planned costs
Based on scientific analysis and engineering studies
Established under normal operating conditions
Used as benchmarks for performance evaluation

1.2 Meaning of Standard Costing

Standard costing is a cost accounting technique that uses standard costs for planning, control, and decision-making purposes. It involves setting predetermined costs for all elements of cost (material, labor, and overhead) and comparing actual costs with these standards to identify variances.

Process of Standard Costing:

Setting standards for all cost elements
Recording actual costs incurred
Comparing actual costs with standard costs
Analyzing variances to identify causes
Taking corrective action where necessary

2. ADVANTAGES OF STANDARD COSTING

2.1 Cost Control Benefits

Performance Measurement: Provides benchmarks for evaluating actual performance
Exception Management: Highlights areas requiring management attention through variance analysis
Cost Reduction: Encourages efficiency and waste elimination

2.2 Planning and Budgeting

Budget Preparation: Facilitates accurate budget preparation and forecasting
Price Setting: Assists in determining selling prices and quotations
Inventory Valuation: Simplifies inventory valuation procedures

2.3 Operational Benefits

Responsibility Accounting: Enables evaluation of departmental and individual performance
Decision Making: Provides reliable cost data for management decisions
Motivation: Encourages employees to achieve predetermined targets

3. LIMITATIONS OF STANDARD COSTING

3.1 Implementation Challenges

Complex Setup: Requires significant time and resources to establish standards
Maintenance Cost: Standards need regular revision to remain relevant
Resistance to Change: May face opposition from employees and management

3.2 Practical Limitations

Static Nature: Standards may become outdated in dynamic business environments
Behavioral Issues: May create pressure and demotivation if standards are unrealistic
Limited Scope: Not suitable for all types of industries or products

3.3 Technical Limitations

Assumptions: Based on assumptions that may not hold true in practice
Overhead Allocation: Difficulties in setting accurate overhead standards
External Factors: Cannot account for uncontrollable external factors

4. APPLICATIONS OF STANDARD COSTING

4.1 Manufacturing Industries

Mass production industries with standardized products
Process industries with repetitive operations
Industries with stable operating conditions

4.2 Service Industries

Transportation companies
Utility companies
Healthcare organizations

4.3 Management Functions

Cost Control: Monitoring and controlling costs
Performance Evaluation: Assessing efficiency and effectiveness
Strategic Planning: Supporting long-term planning decisions

5. VARIANCE ANALYSIS

5.1 Concept of Variance

Variance is the difference between actual cost and standard cost. It can be favorable (when actual cost is less than standard) or unfavorable (when actual cost exceeds standard).

Formula: Variance = Actual Cost - Standard Cost

Types of Variances:

Favorable Variance: Actual < Standard (shown as positive)
Unfavorable Variance: Actual > Standard (shown as negative)

6. MATERIAL VARIANCE

6.1 Material Cost Variance

Total Material Cost Variance = (Actual Quantity × Actual Price) - (Standard Quantity × Standard Price)

6.2 Material Price Variance

Material Price Variance = Actual Quantity × (Actual Price - Standard Price)

Causes of Material Price Variance:

Changes in market prices
Quantity discounts not availed
Emergency purchases
Inflation or deflation

6.3 Material Usage Variance (Quantity Variance)

Material Usage Variance = Standard Price × (Actual Quantity - Standard Quantity)

Causes of Material Usage Variance:

Inefficient use of materials
Defective materials
Poor supervision
Machine breakdowns

6.4 Material Mix Variance

Material Mix Variance = Standard Price × (Actual Mix - Standard Mix)

Applicable when:

Multiple materials are used
Materials can be substituted
Standard mix is predetermined

6.5 Material Yield Variance

Material Yield Variance = Standard Price × (Actual Yield - Standard Yield)

Applicable in:

Process industries
Chemical industries
Food processing

7. OVERHEAD VARIANCE

7.1 Variable Overhead Variance

7.1.1 Variable Overhead Cost Variance

Variable Overhead Cost Variance = Actual Variable Overhead - Standard Variable Overhead

7.1.2 Variable Overhead Efficiency Variance

Variable Overhead Efficiency Variance = Standard Rate × (Actual Hours - Standard Hours)

7.1.3 Variable Overhead Expenditure Variance

Variable Overhead Expenditure Variance = Actual Hours × (Actual Rate - Standard Rate)

7.2 Fixed Overhead Variance

7.2.1 Fixed Overhead Cost Variance

Fixed Overhead Cost Variance = Actual Fixed Overhead - Standard Fixed Overhead

7.2.2 Fixed Overhead Volume Variance

Fixed Overhead Volume Variance = Standard Rate × (Standard Hours - Budgeted Hours)

7.2.3 Fixed Overhead Expenditure Variance

Fixed Overhead Expenditure Variance = Actual Fixed Overhead - Budgeted Fixed Overhead

8. SALES VARIANCE

8.1 Sales Price Variance

Sales Price Variance = Actual Quantity Sold × (Actual Price - Standard Price)

Interpretation:

Favorable: Actual selling price higher than standard
Unfavorable: Actual selling price lower than standard

8.2 Sales Volume Variance

Sales Volume Variance = Standard Price × (Actual Quantity - Standard Quantity)

Interpretation:

Favorable: Actual sales volume higher than standard
Unfavorable: Actual sales volume lower than standard

8.3 Sales Mix Variance

Sales Mix Variance = Standard Price × (Actual Mix - Standard Mix)

Applicable when:

Multiple products are sold
Products have different profit margins
Standard sales mix is predetermined

9. SALES MARGIN VARIANCE

9.1 Sales Margin Price Variance

Sales Margin Price Variance = Actual Quantity × (Actual Margin per unit - Standard Margin per unit)

9.2 Sales Margin Volume Variance

Sales Margin Volume Variance = Standard Margin per unit × (Actual Quantity - Standard Quantity)

9.3 Sales Margin Mix Variance

Sales Margin Mix Variance = (Actual Mix - Standard Mix) × Standard Margin per unit

9.4 Sales Margin Yield Variance

Sales Margin Yield Variance = Standard Margin per unit × (Actual Total Quantity - Standard Total Quantity)

10. PRACTICAL APPROACH TO VARIANCE ANALYSIS

10.1 Steps in Variance Analysis

Calculate Variances: Compute all relevant variances
Identify Causes: Investigate reasons for significant variances
Assign Responsibility: Determine who is responsible for each variance
Take Action: Implement corrective measures where necessary
Monitor Results: Track the effectiveness of corrective actions

10.2 Variance Investigation

Criteria for Investigation:

Variances exceeding predetermined limits
Persistent variances over time
Variances showing unusual patterns
Variances in critical areas

10.3 Reporting Variances

Effective Variance Reports Should:

Be timely and accurate
Highlight significant variances
Provide comparative data
Include explanations for major variances
Suggest corrective actions

12. BUDGETING AND OPERATING BUDGETS

12.1 Integration with Standard Costing

Standard costing forms the foundation for effective budgeting by providing predetermined cost standards that serve as building blocks for budget preparation. The relationship between standard costing and budgeting creates a comprehensive planning and control system.

12.2 Computing Budgets Using Standard Costs

12.2.1 Production Budget Computation

Formula: Production Budget = Sales Budget + Closing Stock - Opening Stock

Using Standard Costs:

Apply standard material costs per unit
Apply standard labor costs per unit
Apply standard overhead rates
Calculate total production cost budget

12.2.2 Material Budget Computation

Steps:

Determine material requirements from production budget
Apply standard material prices
Consider opening and closing material inventory
Calculate material purchase budget

Formula: Material Purchase Budget = (Production Units × Standard Material per Unit) + Closing Material Stock - Opening Material Stock

12.2.3 Labor Budget Computation

Calculation: Labor Budget = Production Units × Standard Labor Hours per Unit × Standard Labor Rate per Hour

Components:

Direct labor requirements
Indirect labor costs
Overtime provisions
Efficiency considerations

12.2.4 Overhead Budget Computation

Variable Overhead Budget: Variable Overhead Budget = Production Units × Standard Variable Overhead Rate

Fixed Overhead Budget: Fixed Overhead Budget = Budgeted Fixed Costs (independent of production volume)

12.3 Operating Budget Components

12.3.1 Sales Budget

Foundation of all other budgets
Based on sales forecasts and standard selling prices
Considers market conditions and capacity constraints

12.3.2 Administrative Budget

General administrative expenses
Selling and distribution costs
Research and development expenses

12.3.3 Capital Expenditure Budget

Investment in fixed assets
Replacement and expansion plans
Integration with operational requirements

13. MANAGEMENT ACCOUNTING APPLICATIONS FOR BUSINESSES

13.1 Strategic Decision Making

13.1.1 Make or Buy Decisions

Analysis Framework:

Compare standard costs of internal production
Evaluate external supplier quotations
Consider qualitative factors (quality, reliability, capacity)
Calculate financial impact of each alternative

Standard Costing Application:

Use standard costs for internal production estimates
Identify variable and fixed cost components
Assess capacity utilization impacts

13.1.2 Product Mix Decisions

Optimization Approach:

Calculate standard contribution margin per unit
Identify limiting factors (capacity, materials, labor)
Determine optimal product mix for profit maximization

Formula: Contribution per Limiting Factor Unit = (Standard Selling Price - Standard Variable Cost) ÷ Limiting Factor per Unit

13.1.3 Pricing Decisions

Cost-Plus Pricing: Standard Cost per Unit + Desired Profit Margin = Selling Price

Competitive Pricing:

Use standard costs to determine minimum acceptable prices
Analyze competitor pricing strategies
Assess market positioning

13.2 Performance Management

13.2.1 Responsibility Center Evaluation

Cost Centers:

Evaluate performance using cost variances
Focus on efficiency and cost control
Set targets based on standard costs

Profit Centers:

Assess both revenue and cost performance
Use sales and cost variances for evaluation
Measure return on investment

Investment Centers:

Evaluate overall performance including asset utilization
Use residual income and EVA concepts
Integrate standard costing with capital allocation

13.2.2 Balanced Scorecard Integration

Financial Perspective:

Cost variance analysis
Profitability measures using standard costs
Return on investment calculations

Operational Perspective:

Efficiency measures from variance analysis
Quality indicators from material and labor variances
Capacity utilization metrics

13.3 Business Process Improvement

13.3.1 Continuous Improvement Programs

Kaizen Costing:

Set continuously improving standards
Monitor incremental cost reductions
Encourage employee participation in cost reduction

Six Sigma Integration:

Use variance analysis to identify process variations
Apply statistical tools with standard costing data
Measure improvement in terms of cost savings

13.3.2 Lean Manufacturing Support

Waste Elimination:

Identify waste through variance analysis
Focus on material usage and efficiency variances
Support just-in-time inventory management

Value Stream Mapping:

Use standard costs to evaluate value-added activities
Identify non-value-added costs
Optimize process flows

13.4 Financial Planning and Control

13.4.1 Cash Flow Management

Cash Budget Preparation:

Use standard costs for cash outflow projections
Plan for material purchases and labor payments
Integrate overhead payment schedules

Working Capital Management:

Optimize inventory levels using standard costs
Manage accounts receivable and payable
Improve cash conversion cycle

13.4.2 Risk Management

Sensitivity Analysis:

Assess impact of changes in standard costs
Evaluate scenarios with different cost assumptions
Identify critical cost drivers

Break-even Analysis: Break-even Point = Fixed Costs ÷ (Standard Selling Price - Standard Variable Cost)

13.5 Digital Transformation and Technology Integration

13.5.1 ERP System Integration

Automate standard cost updates
Real-time variance reporting
Integration with production planning systems

13.5.2 Business Intelligence Applications

Dashboard creation for variance monitoring
Trend analysis using historical variance data
Predictive analytics for cost forecasting

14. PRACTICAL BUSINESS APPLICATIONS

14.1 Case Study Framework

Implementation Steps:

Establish standard costing system
Develop comprehensive budgeting process
Create variance analysis procedures
Design management reporting systems
Train personnel and stakeholders

14.2 Industry-Specific Applications

14.2.1 Manufacturing Industries

Production planning and control
Inventory management optimization
Quality cost management
Capacity planning and utilization

14.2.2 Service Industries

Service delivery cost management
Resource allocation optimization
Performance benchmarking
Customer profitability analysis

14.2.3 Retail Industries

Merchandise planning and budgeting
Store performance evaluation
Inventory turnover optimization
Category management support

14.3 Success Factors for Implementation

Organizational Factors:

Top management commitment
Clear communication of objectives
Adequate training and support
Integration with existing systems

Technical Factors:

Accurate standard setting
Regular review and updates
Appropriate variance investigation
Effective reporting mechanisms

Standard costing and variance analysis are powerful tools for cost control and performance evaluation. While they have limitations, their benefits in terms of planning, control, and decision-making make them valuable for organizations operating in suitable environments. The key to successful implementation lies in setting realistic standards, regular monitoring, and taking appropriate corrective actions based on variance analysis.

KEY TERMS

Standard Cost: Predetermined cost under normal conditions
Variance: Difference between actual and standard cost
Favorable Variance: Actual cost less than standard
Unfavorable Variance: Actual cost exceeds standard
Material Variance: Difference in material costs
Overhead Variance: Difference in overhead costs
Sales Variance: Difference in sales performance
Sales Margin Variance: Difference in profit margins

PRACTICE QUESTIONS

Explain the meaning and objectives of standard costing.
Discuss the advantages and limitations of standard costing.
Calculate material variances from given data.
Analyze overhead variances and their causes.
Evaluate sales performance using variance analysis.
Prepare a variance analysis report for management review.
Compute production and material budgets using standard costs.
Develop an operating budget for a manufacturing company.
Apply standard costing concepts for make-or-buy decisions.
Design a performance measurement system using variance analysis.
Integrate standard costing with budgeting for strategic planning.
Evaluate business performance using management accounting tools.