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.
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