Standard Costing and Variance Analysis

The standard cost of the 900 utensils Salem Steel Utensils made was ₹5,58,000. It actually spent ₹6,04,850. That is ₹46,850 over. A manager needs to know where the money went, not only that it went.

The steps. Set the standard, measure the actual cost, compare the two, identify the variances and their causes, and report and act on them.

The sign. This chapter follows the usual rule: a variance is favourable when the actual cost is less than the standard, and adverse when it is more. In the tables that follow, F means a gain and A a loss.

Don’t compare actual cost with the budget for a different output. Salem’s standards are set for one utensil. The standard cost of the 900 actually made is the yardstick, not the cost of the 1,000 budgeted. Comparing with the budgeted output mixes a volume effect into every variance.

Where it breaks. Standards are estimates, and can be set too loose (easy to beat) or too tight (always missed). If prices are rising fast, the standards go out of date. A variance is a question, not a verdict: an adverse usage variance may come from poor material, not poor work.

For exams. Know the order of the steps, the sign convention, and the four total-variance identities.

Set, measure, compare, find the cause, act.

A cement plant makes the same product all year. If each month’s cost differs a little, is that bad luck or poor control? Only a yardstick set in advance can tell.

Where it suits. Standard costing works best for firms making standard products again and again, such as cement, steel or sugar. It suits jobbing work poorly, because every job is different and a standard for each would cost too much to set.

Advantages. It gives management a way to judge performance. It helps in fixing standards and in production planning and pricing. It is a measuring rod for variances, and it helps remove inefficiency through corrective action.

Management by exception. A variance flags a result that is not as planned, whether better or worse. Management can spend its time on the large or repeated variances and leave results that follow the standard alone.

Don’t treat an ideal standard as a fair test. An ideal standard assumes no waste and no breakdowns. Workers can never reach it, so adverse variances will always appear and may be ignored. A current or expected standard, set at attainable levels, is more useful for control.

Where it breaks. Standards go out of date when prices or methods change, and then every variance is noise. They can also be too loose, which lets inefficiency pass. Setting and reviewing them costs time and money.

For exams. Know the definition, the difference from estimated cost, the five kinds of standard, the suitability and the advantages.

Standard: should be. Estimate: will be.

Salem used 3,800 kg of steel to make 900 utensils, against a standard of 3,600 kg, and paid ₹52 a kg instead of ₹50. Two causes, two variances, and each belongs to a different person.

SQ is the standard quantity for the actual output (900 × 4 kg = 3,600 kg). Price and usage add up to the cost variance.

Labour. Salem paid for 2,800 hours at ₹82, but 150 of them were idle (a power cut), so 2,650 hours were worked. The standard hours for 900 utensils are 2,700. Here AH in the cost and rate formulas means hours paid.

Salem was ₹5,600 over on wage rate and ₹12,000 over on idle time, and gained ₹4,000 by working 50 hours faster than standard.

Mix and yield. When several materials are used, the usage variance splits further. A standard 100 kg input of A (60 kg at ₹10) and B (40 kg at ₹20) yields 80 kg. A batch used 700 kg of A and 300 kg of B and made 780 kg. Material usage variance is ₹650 F. The mix variance, SP × (RSQ − AQ), is ₹1,000 F, because the batch used more of the cheaper material. The yield variance is ₹350 A, as the output was 20 kg short of the 800 kg that 1,000 kg should give, at ₹17.50 a kg of output.

A second case to practise. Standard output was 800 units but 1,000 were made. Standard material was 1 kg a unit at ₹4, and 1,200 kg were used at ₹5. Cost variance = (1,000 × ₹4) − (1,200 × ₹5) = ₹2,000 A; price variance = 1,200 × (₹4 − ₹5) = ₹1,200 A; usage variance = ₹4 × (1,000 − 1,200) = ₹800 A. For labour, a standard rate of ₹3 an hour and 2 hours a unit, 160 units made, 300 hours worked at ₹3.5: standard hours are 320. Cost variance = ₹960 − ₹1,050 = ₹90 A; rate = 300 × (₹3 − ₹3.5) = ₹150 A; efficiency = ₹3 × (320 − 300) = ₹60 F.

Don’t treat idle time as efficiency. Idle time is paid time with no work, and is always adverse. The efficiency variance concerns the hours that were worked. Mixing the two hides a power cut inside a supervisor’s results.

Where it breaks. A favourable mix variance can come from using poorer material, which later shows as low yield. Read mix and yield together. A usage variance may also flow from poor purchases, so check the cause before blaming a person.

For exams. Write the formula first, then substitute. State SQ and SH as for actual output, and the sign convention.

Price for what you pay, usage for what you use; rate for the wage, efficiency for the hours.

Material and labour have a clear quantity and price. Overhead does not: factory rent and power are spread over many units. Variances show whether the firm spent more than it planned, or used the factory less than planned.

Standard fixed overhead is the absorbed amount for the actual output: 2,700 hours × ₹40 = ₹1,08,000. Salem budgeted for 3,000 hours and worked fewer, so ₹12,000 of fixed overhead was not recovered by the output. That is the volume variance.

The overhead cost variance. The two parts together give the total overhead variance, recovered overhead less actual overhead. For Salem it is (₹54,000 + ₹1,08,000) − (₹55,650 + ₹1,22,000) = ₹15,650 A, which is ₹1,650 A for variable and ₹14,000 A for fixed. Typical causes: bills paid in advance or late, a breakdown that needed repairs, spoilage, overtime, or the same fixed spending spread over a different output.

Don’t call the volume variance a spending error. Salem did not overspend on fixed overhead by ₹12,000. The factory made fewer than budgeted, so the fixed cost was spread over fewer units. The cause is the sales or production plan, not the accounts payable desk.

Where it breaks. Fixed overhead is not controllable at the shop-floor level in the short run, so a volume variance mostly tests the plan. Variable overhead variances assume overhead follows hours, which is not true for all firms; activity-based costing uses other drivers.

For exams. Remember the pairs: expenditure and efficiency for variable; expenditure and volume for fixed. Learn each formula and say which part of the plant it tests.

Variable: spend and speed. Fixed: spend and volume.

Salem budgeted to sell 1,000 utensils at ₹50. It sold 900 at ₹52. Revenue fell short by ₹3,200. Was it the price or the volume?

Salem got ₹1,800 more from a higher price and lost ₹5,000 by selling 100 fewer. The volume loss is bigger, so the net is an adverse ₹3,200. Raising the price may well be what cut the volume.

On a profit basis. Volume is sometimes valued at the standard margin, not the price. With a standard profit of ₹20 a utensil, 100 fewer sold cost ₹2,000 of profit.

Mind the sign when you copy the cost formulas. For costs, a variance is favourable when actual is below standard, so the formula is standard minus actual. For sales it is the opposite: actual above budget is favourable, so it is actual minus standard. Some notes print the cost-style signs for sales, and that makes a lower price look favourable.

Where it breaks. The price and volume effects are linked. A higher price often lowers the volume, so each variance alone can mislead. Market conditions, not the sales team, may be the cause. For several products, a mix variance also arises.

For exams. Show the three variances and check that price plus volume equals value. State the sign rule.

Sales: actual minus standard, so above is favourable.