Standards for Control and Variance Analysis

3.1  Introduction

Many organizations, specially manufacturing companies use standard cost accounting systems for planning and controlling operations. Standards are useful in detailed planning, cost control, performance measurement, and pricing decision. This unit examines how standards are set for material, labour, and manufacturing overheads. It illustrated the calculation of material, labour and manufacturing overheads variances and their analysis and interpretation.

 

Standards are mostly used in manufacturing organizations with the objectives of attaining strong control over costs.

Standard cots are defined as, carefully predetermined costs created by management and used as a basis for comparison with actual costs.  Like all standards, standard costs are measure of achievement.  Consequently, managers must use care to ensure that the standards are appropriate measures of performance that encourage attainment of organizational goals.

Types of standards. Different firms may fix different standards and the same firm may adopt different standards at different points of time.  This difference in standards arises due to the variation in circumstances or conditions under which standards are fixed.  On the basis of circumstances, the standards may be classified as under:

1. Ideal standard: A standard is said to be an ideal if it is based on ideal conditions of work.  It reflects the most optimistic expectations of management.  Ideal standards (also called perfection standards) can be achieved only with perfect operating conditions.  It pre-supposes most favorable conditions of work and rules out any possibility of loss arising out of abnormal conditions such as break-down of machines, failure of power, employee error, labor strikes, changes in government policy, defective raw material, inventory shortage, etc.  In brief, it assumes no production problems of any sort.  Some managers believe that perfection (or ideal) standards motivate employees to achieve the lowest cost possible.  They claim that since the standard is theoretically attainable, employees will have an incentive to come as close as possible to achieving it.
   Other managers and many behavioral scientists disagree.  They feel that ideal standards discourage employees, since they are so unlikely to be attained.  Moreover, setting unrealistically difficult standards may encourage employees to sacrifice product quality to achieve lower cost.
2. Basic standard: It is a fixed standard that provide a framework for comparing performance over a period of years.  They are sometimes called long-range standards because once created, they are used for several years or longer.  Since a basic standard remains unchanged, it does not suggest, “What the cost for the year ought to be?” Therefore, it cannot be used for valid comparisons as rapidly rising resource costs and charging production technology often make basic standards difficult to use.  As a result, not many firms use basic standards.
3. Normal standard:  Normal standards can also be termed as historical standards as it is based on the average performance in the past years.  It can be fairly a satisfactory standard if the performance in the past has been fairly stable.  In case of constantly improving efficiency or erratic performance, the normal standards will fail to serve the purpose.  It suffers from all the defects of an arithmetic average based on a series of items that include few extreme items.
4. Attainable standard:  It is one that can be attained under the conditions and circumstances prevailing within the organization.  Currently attainable standards are the most commonly used standards.  They represent benchmarks for efficient production in the current environment.  Currently attainable standards are not as stringent as ideal standards because they allow for normal production problems, such as equipment maintenance, downtime, random employee errors, and occasional inventory shortages.  Still, currently attainable standards represent desirable information.  Currently attainable standards are also called practical standards.

Cost information may be used for many different purposes.  It should be noted that cost information that serves one purpose might not be appropriate for another.  Therefore, the purpose for which cost information is to be used should be clearly defined before procedures are developed to accumulate cost data.  Standard costs may be used for the following purposes:

i. Cost control:  Monitoring and controlling the cost of production, marketing, and administrative activities are among the primary functions of managers.  Cost control is not merely the minimization of costs; it is identifying costs with their benefits and ensuring that the costs are justified, given the benefits derived.  Standard costs provide a useful framework for cost control.

Typically, standards are expressed in terms of one unit of output.  When standards are expressed in terms of a single unit of output, they can be used to measure cost with standard costs as frequently as desired – monthly, weekly, daily, or for each work shift.  As long as production output can be measured and actual cost accumulated, cost performance can be measured.

ii. Product pricing:  The selling price of a unit and the cost per unit are usually closely related.  The cost data are readily available under standard costing system and the price can be quoted on the basis of standard costs without fear of under or over pricing.  Standard cost is the predetermined normal cost of normal output and as such forms basis for price fixation.

iii. Estimating budgets:  Standard costs and budgets are similar, because they both represent planned costs for a specific period.  Standard costs are very useful when developing a budget, since they form the building blocks of a total cost goal (or budget).  Budgets, in effect, are standard costs multiplied by the volume or activity level expected.

iv. Performance evaluation: Performance evaluation is a difficult task involving many different variables, some of which are subjective and therefore difficult to use in comparing employees.  When standards are established for performance evaluation, they provide tangible measures that can be applied uniformly to all personnel.  For example, the standard labor time for performing various production activities may be used to evaluate the efficiency of employees.  Similarly, production department supervisors may be evaluated on how close their department came to achieving standards.  Standards can be effective in performance evaluation if employees have a clear understanding of the standards and the way they are used.  In addition, employees must be given timely reports evaluating their performance.  The timely reports are possible because the standards are readily available for quick comparison and reporting.

v. Simplify performance reports.  The performance reports presented in the form of variance analysis are simple to understand as they clearly distinguish between favorable and unfavorable variances.  The busy top management can concentrate on significance variances and take appropriate action in the matter. 

vi. Record Keeping:  Detailed record keeping may be reduced when standard costs are used in conjunction with actual costs.  For example, when materials are kept at standard cost, the materials ledgers need only keep tack of quantities.

vii. Cost awareness:  Accountants and financial managers are aware of the costs associated with the activities of the business, because they deal with them daily.  Many other employees, however, have little or no awareness of costs.  They may be concerned with increasing daily production, improving employee morale, and improving production efficiency, all of which have an impact on costs, but many employees do not understand the cost consequences of these activities.  Standard costs and standard cost performance reports inform employees about the cost implications of their actions.  Such cost awareness may result in better employee efforts at cost control.

 

3.5 The Standard Cost System

Three fundamental activities in a standard cost system are:

• setting the standards
• Accumulation of actual costs.
• Variance analysis

Setting Standards:  The first step in a standard cost system is the creation of the standards to be used as a basis for measuring performance.  Standard setting is an important activity because poorly conceived standards result in inappropriate measures of performance.  Standard setting is not a one – time activity.  As resource costs and production methods change, revision of the standard is necessary.  In many firms standards are evaluated on a regular basis, such as annually or every 6 months.

Management accountants typically use two methods for setting standards:  analysis of historical data and task analysis.

i. Historical data:  Often the immediate past is the best indicator of the near future.  Firms that have been producing the same product using the same production technology for a number of years may base their standards on their historical experience.  They may use various cost estimation techniques to determine the past relationship between in put usage and output produced or between input purchases and input prices.  The past relationships and prices are then used as standards. However, the management accountant often will need to adjust these predictions to reflect movements in price levels or technological changes in the production process.

ii. Task analysis:  Another way to set cost standards is to analyze the process of manufacturing a product to determine what it should cost.  The emphasis shifts from what the product did cost in the past to what it should cost in the future.  In using task analysis, the management accountant typically works with engineers who are intimately familiar with the production process.  Together they conduct studies to determine how much direct material should be required and how machinery should be used in the production process.  Time and motion studies are conducted to determine how long each step performed by direct laborers should take.

Accumulation of actual costs: A standard cost system does not eliminate the need for accumulating actual production costs.  Actual costs are compared with standard costs to determine variances.  In manufacturing, actual costs are accumulated in a job order or a process costing system.  With non-manufacturing activities, actual costs are also accumulated and compared with standards established for non-manufacturing activities.

Variance analysis: A variance occurs when actual costs differ from standard costs.  Variances are expressed in total birr amounts and separated into specific classifications to facilitate cost analysis and control.  Variance analysis is a systematic process of identifying variances and reporting them to management.

 

   3.5.1 Setting The Standards

As discussed earlier, an integral part of any standard cost system is the setting of standards.  Establishment of standards for direct materials and direct labor will be presented here under, along with variance analysis to these two basic cost elements of manufacturing.

DIRECT MATERIALS STANDARDS

Direct materials cost standards may be divided into:

1. Quantity (usage) standards.
2. Price standards.

1. Quantity (usage) standards: It refers to predetermined specifications of the quantity of direct materials that should go into the production of one finished unit under normal conditions.  If more than one direct material is required to complete a unit, individual standards must be computed for each direct material.  The number of direct materials required to complete one unit can be developed from engineering studies, analyses of past experiences, and /or tests runs under controlled conditions.

The engineering department is normally responsible for setting quantity standards because it is generally responsible for designing production processes for making a product.  Many manufacturing companies have separated departments that are assigned the responsibility for setting standards.

2. Price standards: It refers to prices at which direct materials should be purchased.  The cost accounting department and /or the purchasing department are normally responsible for setting materials price standards because they have ready access to price data and should have knowledge of market conditions.  If more than one direct material is used in a production process, a standard unit price must be computed for each one.

DIRECT LABOR STANDARDS

Direct labor cost standards may be divided into:

1. Efficiency (time or usage) standards.
2. Rate (wage) standards.

1. Efficiency (time or usage standards) standards: These are predetermined performance standards of the cost of direct labor that should go into production, under normal conditions, of one finished unit.  Time – and – motion studies is very helpful in developing direct labor efficiency standards.  In these studies, an analysis is made of procedures to be followed by workers, and the conditions (space, temperature, equipment, tools, lighting, etc.) under which the worker must perform assigned tasks.  Procedures and conditions are closely related; and therefore, a change in one is usually accompanied by a change in the other.  For example, the introduction of an additional piece of equipment to an assembly line would require a change in the procedures followed by workers.  When either the situations or procedures are changed, a new standard should be developed.  Time – and – motion studies must be performed for all steps in the production process.

Staff specialists are usually given the responsibility for setting direct labor efficiency standards.  Staff specialists should have a thorough knowledge of the production process used by the factory in addition to knowledge of the techniques of time – and – motion studies.  Many companies have departments devoted solely to the establishment of direct labor efficiency standards.

2. Rate (wage)  standards: These are predetermined wage rates for a period.  The cost accounting, engineering, or personnel departments are normally responsible for setting direct labor rate standards, because they usually have access to the data required to set standards.

   3.5.2 Standard Cost Variance Analysis

Variances are the differences arising when actual results do not equal the standard because of either external or internal factors.  Management has little control over internal factors.  Therefore, external factors (uncontrollable variances) should be separated form internal factors (controllable variances).  Variance analysis is a valuable technique for separating the two.  It is defined as the systematic evaluations of variances to provide managers with useful information for measuring efficiency and improving performance.  Variance analysis is performed in order to answer two general questions: What is the amount of difference between actual and standard cost? Why did the difference occur?

The first question deals with the measurement of the variance, which is basically a computation process.  Accountants accumulate actual cost data and compare them with the standards to find the variances.

The second question addresses the cause of the variance.  Often the question of why the variance occurred is the more difficult of the two questions to answer.  Sometimes variances result from a complex interaction of human and physical variables.

In this section, the discussion emphasis primarily on the computation of several specific variances.  The more complex issue of explaining their cause is beyond the scope of this course.

Variances can be computed for all three of the basic cost elements – direct materials, direct labor, and manufacturing overhead.  The computation for materials and labor is quite similar.  Manufacturing overhead variances require different and somewhat more complex situations.

      3.5.2.1 Direct Material Variances

Direct materials variances may be divided into:

• Quantity (usage) variance.

•    Price variance.

Material Quantity Variance: The material quantity variance measures the amount of variance caused by using more or less materials than standard.  Direct materials quantity variance is favorable when the actual quantity used is less than the standard quantity allowed and is unfavorable when more materials are used than standard. 

The formula for the variance can be expressed as follows

MQV = (AQ – SQ) x SP

Where MQV = direct materials quantity variance

    AQ = actual quantity used

    SQ = standard quantity allowed

    SP = standard unit price

Standard quantity allowed is the amount of direct materials that should have been used to produce the actual unit out put of the period.  And it is equal to the predetermined    quantity of direct materials that should go into one finished unit multiplied by the number of units produced.

Standard quantity of Materials allowed  = Actual output  Achieved x materials allowed per unit of output                                      

Material quantity variance highlights deviations between the quantity of material actually used and the standard quantity allowed. Thus, it makes sense to compute this variance at the time the material is used in production.

The production department or cost center that controls the input of direct materials into the production process is usually assigned the responsibility for this variance.

Material Price Variance: The material price variance measures the amount of variances from standard that occurs because the price paid for raw materials is different from the standard cost.  If the actual materials cost is greater than standard, the price variance is unfavorable.  A favorable variance occurs if the cost of materials is less than standard.  The equation of the material price variance is

   MPV = (AP – SP) x AQ

      Where MPV = direct materials price variance

            AP = actual price or unit cost

            SP = standard price

            AQ = actual quantity purchase.

As stated above, the direct material price variance is based on the actual quantity purchased because deviations between the actual and standard price relate to the purchasing function in the firm.

Management has little control over price variances, especially when they result from rising prices.  However, the purchasing department may have some control over prices by ordering in economical quantities, and /or finding suppliers who offer the same quality of goods at lower prices.

Note that: The sum of the direct material usage and price variances equals the total direct material flexible budget variance (MFBV).

               MFBV = MQV + MPV

 

       3.5.2.2 Direct Labor Variances

The computation of direct labor variances is very similar to that of direct materials variances.  However, there are some differences between labor and materials in setting variances, in the controllability of the variances, and in the timing of the variance reports.  Consequently, labor and materials variances are treated separately.

Direct labor variances may be divided into

1. Efficiency variance.
2. Rate variance.

i. Labor Efficiency Variance: The labor efficiency variance identifies the amount of total labor variance caused by using more or less than the standard quantity.  The term efficiency expresses the idea that the labor is used favorably if fewer hours than standard are used to make a product. Conversely, labor is used inefficiently if more labor hours than standard are used.  The equation for the direct labor efficiency is

      LEV = (AH – SH) x SR

     Where LEV = direct labor efficiency variance

         AH = actual hours worked

         SH = standard hours allowed

         SR = standard wage rate.

Standard hours allowed is equal to the number of direct labor hours that should be worked in the production of one finished unit multiplied by the number of unit’s production.

The supervisor of the department or cost center in which the work performed is usually held responsible for direct labor efficiency variances if procedures and conditions remain constant (for example, if no new procedures or equipment were introduced).

ii. Labor Rate Variance: It isolates the portion of the total labor variance that is caused by the actual labor rate’s being different from the expected (standard) labor rate.  It is computed in the same way as the material price variance.  The formula is:

     LRV = (AR – SR) x AH

     Where LRV = direct labor rate variances

         AR = actual wage rate

         SR = standard wage rate

         AH = actual hours worked

As in the case of the direct materials price variances, management has very little control over rate variances.  However, some companies hold the supervisor of the department or cost center where the work is performed responsible if, for example, workers with a high rate were used in a particular process and as a result, the greatest worker loss efficiency was achieved.

 Note that the sum of the direct labor usage and rate variances equals the direct labor flexible – budget variances (LFBV).

            LFBV = LEV + LRV

 

       3.5.2.3 Manufacturing Overhead Variances

In the previous section we have seen the two very important cost components of an out put, direct material and direct labour, how standards are set and how the variations of actual quantity or price be analyzed from the standards allowed.  Another very important cost component of a product is a manufacturing Over head or a factory over heads.

The flexible overhead budget is the manufacturer’s primary tool for the control of manufacturing overhead costs. At the end of each accounting period, the management accountant uses the flexible overhead budget to determine the level of overhead that should have been incurred, given the actual level of activity. Then the accountant compares the overhead cost in the flexible budget with the actual overhead costs incurred. The accountant then computes separates overhead variances, each of which conveys separate information useful in controlling overhead costs. 

Nevertheless, many manufacturing organizations believe that it is not worthwhile to monitor individual overhead items like indirect material, indirect labour, depreciation, factory supplies...etc. Therefore, overhead variances often are not subdivided the flexible budget variances- the complexity of the analysis may not be worth the effort.

However , in some cases it may be useful to subdivide the flexible-budget overhead variances, especially those for variable overhead.  Part of the variable overhead flexible budget variance is related to the control of cost driver and part of it to the control of overhead spending itself.

When actual cost driver activity differs from the standard amount for the actual output achieved, a variable overhead efficiency variance (VOEV) will occur.  Whenever actual cost driver activity exceeds that has been allowed for the actual output achieved, overhead efficiency variances will be unfavorable and vice versa. In essence this efficiency variance tells management the cost of not controlling the use of cost driver activity. The remainder of the flexible budget variance measures control overhead spending itself, given actual cost driver activity.

The following are the formulae  used to compute the two overheads variance:

            i. The variable overhead efficiency variance (VOEV)

The variable over head efficiency variance is a measure of the difference between the actual activity of a period and the standard activity allowed, multiplied by the variable part of the predetermined overhead rate. The formula for the variance can be expressed as follows:

          VOEV =(AH-SH) X VOHR

       Where: AH =actual direct labor hours

             SH = standard direct labor hours allowed

             VOHR = standard variable overhead rate per hour

ii. The variable overhead spending variance (VOHSV)

As its name indicates, it measures deviations in amounts spent for overhead inputs such as spare parts  and utilities. The formula for the variance can be expressed as follows:

     VOHSV = AH (AR-SR)

   Where: AH= actual direct labor hours used

         AR= actual variable overhead rate

        SR = standard variable overhead (VOH) rate

OR

    VOHSV = AH (AR-SR)

    VOHSV =(AH x AR)– (AH x SR)

 = Actual variable overhead – (actual direct labor hours used x standard VOH rate)

 

   3.5.3 Measuring Mix, Yield And Productivity  Variances

Standard Costs and Variances

Calculation of a standard cost is based on physical standards, two types of which are often discussed: basic and current. A basic standard is a yard stick against which both expected and actual performances arte compared. It is similar to an index number against which all later results are measured. Current standards are of three types: expected actual standard, normal standard and theoretical standard.  these things have been discussed in detail in the previous section.

Materials and labor costs are generally based on normal, current conditions, allowing for alterations of prices and rates and tempered by the desired efficiency level. Factory overhead is based on normal conditions of efficiency and volume.  This subsection's major objective however, is to discuss and illustrate the measurement of mix yield and productivity variances.

Material Mix Variance

It is common for more than one material to be required in a production process. In a cotton fabric, for example, cotton from many parts of the world with the hope that the new mix and its costs will contribute to improved profits. The proportion or ratio of one material to another material is called the mix. In many cases, the new mix is accompanied by either a favorable or unfavorable yield of the final product.

A mix variance shows the change in cost that results from changing the proportions of materials added to the production mix. It measures the effect of using a different combination of materials.

Material mix variance is calculated by measuring the difference in cost, at standard prices, between the actual mix of quantities used and the standard mix of the total quantity used.
 

Material Yield Variance

Yield can be defined as the amount of prime product manufactured from a given amount of materials. The yield variance is the result of obtaining a yield different from the one expected on the basis of input.

A yield variance measures whether a change in mix affected the yield and shows the difference in cost that result if the actual yield (out put) varies from the standard quantity of yield determined for a given input of materials.

 

3.6 Summary

• Standard cots are carefully predetermined costs created by management and used as a basis for comparison with actual costs. Mangers and accountants make use of standard costs for planning and controlling their manufacturing and service giving operations. Standards are useful in detailed planning, cost control, performance measurement, and pricing decision

• The major types of standards used by many organizations are: Ideal standards, basic standards, attainable standards, and normal standards. Standards are used to attain the following objectives of firms: Better cost control, Product pricing, estimating budgets, performance evaluation, simplify performance reporting, record keeping and cost awareness.
• The three fundamental activities in standard cost system are the following: standard setting, actual cost accumulation and variance analysis. To set standards accountants and managers make use of historical data or task analysis. Variances are deviations of actual cost incurred or quantity used from the standards allowed.
• The major standards relating to direct material are: Direct material quantity standards and direct material price standards. Standards relating to direct labour are: direct labour efficiency standards (usage standards) and direct labour rate standards.
• Variances are deviations of actual costs or actual quantity used from the standards set or allowed. Variances relating to material are: material quantity variance and material price variance. Variances relating to labour are labour efficiency variance and Labour rate variance.
• Material usage variance occurs when actual material quantity used varies from the standard quantity allowed. Material price variance occurs when actual price of material vary from the standard price allowed. Labour usage (efficiency) variance occurs when actual labour hours used varies from the standard hours allowed. Labour price variance occur when actual wage paid vary from the standard wage allowed.
• The sum of material usage variance and material price variance is material flexible variance. The sum of labour rate variance and labour efficiency variance is labour flexible budget variance.
• The flexible overhead budget is the manufacturer’s primary tool for the control of manufacturing overhead costs. At the end of each accounting period, the management accountant uses the flexible overhead budget to determine the level of overhead that should have been incurred, given the actual level of activity. Then the accountant compares the overhead cost in the flexible budget with the actual overhead costs incurred. The accountant then computes separates overhead variances, each of which conveys separate information useful in controlling overhead costs. 
• The variable over head efficiency variance is a measure of the difference between the actual activity of a period and the standard activity allowed, multiplied by the variable part of the predetermined overhead rate.
• The variable overhead spending variance measures deviations in amounts spent for overhead inputs such as spare parts and utilities
• The proportion or ratio of one material to another material is called the mix. In many cases, the new mix is accompanied by either a favorable or unfavorable yield of the final product. A mix variance shows the change in cost that results from changing the proportions of materials added to the production mix. It measures the effect of using a different combination of materials.
• Yield is defined as the amount of prime product manufactured from a given amount of materials A yield variance measures whether a change in mix affected the yield and shows the difference in cost that result if the actual yield (out put) varies from the standard quantity of yield determined for a given input of materials