Bbma3203 T4

Topic X Standard
4 Costing and
Variance
Analysis
LEARNING OUTCOMES
By the end of this topic, you should be able to:
1. Explain the importance and use of standard costing;
2. Discuss variance cost analysis;
3. Compute advanced variances, including mix and yield variances
for materials, labour and sales, market share and size variances,
operating and planning variances, and operating statement; and
4. Identify the investigation of variances, the interdependence
between variances and the variance investigating approaches.
X INTRODUCTION
In this topic, you will be introduced to standard costing as a measurement of
productivity and quality in an organisation.
You will also be exposed to the importance and uses of standard costing and
approaches in determination of standard cost. Students will need to identify
types of standards and following that, the advantages and disadvantages of
standard costing will be explained.
Copyright © Open University Malaysia (OUM)

104 X TOPIC 4 STANDARD COSTING AND VARIANCE ANALYSIS
4.1 STANDARD COSTING AND ITS

IMPORTANCE
Usually, at the end of a budget period, managers will analyse business
performance by comparing actual achievement against the budget. The manager
will want to know if the company has reached the targeted level of profitability.
From the aspect of cost control, the manager will ensure that all expenses and
costs incurred are within the budget.
To evaluate the achievement level of the company, these three main elements
must be made available:
(a) Standard or pre-determined achievement level;
(b) Actual achievement; and
(c) Comparison between standard achievement and actual achievement.
These three elements usually exist in any control system.
What is meant by standard costing?
Standard costing is a method of cost formulation or standard achievement

level to be made a benchmark or measurement level.
Among the main uses of standard costing is for the purpose of planning and
control such as management and cost control, preparation of budgets,
determining cost of product and performance evaluation (refer to Figure 4.1).
Figure 4.1: Main uses of standard costing
Hence, it is used as a benchmark for comparison to the performance or actual

level of operational development of a business.

TOPIC 4 STANDARD COSTING AND VARIANCE ANALYSIS W 105
In a budget control system, a management accountant will determine a standard

cost which will be the benchmark. With that, the management accountant will
use standard cost per unit to determine the total standard production cost or the
budgeted cost. Next, an accountant will measure the actual cost incurred in the
production process.
Early measures for cost control are done by comparing the actual production cost
and budgeted production cost. This comparison is called variance analysis.
What is meant by variance analysis?
Variance analysis is the process of calculating and interpreting the difference

between actual production cost and budgeted production cost.
Any difference between the two is known as a variance. The result of variance
analysis will provide an illustration pertaining to the performance level of an
activity, unit, department or even a manager whether it is favourable or not, in
comparison to the standard performance determined. Cost variance is an
indication where cost control measures need to be initiated, given due attention
or action taken if deemed reasonable.
Standard costing is often used for two main reasons, which are for planning,
control and product costing. Standard costing is extremely useful for the purpose
of product costing and for the process that follows it, that is, setting the price of
the product. It is not realistic to wait for manufacturing of the product to
complete before identifying the product cost to determine sales price. Standard
cost information is used to estimate cost of product and in turn set product
pricing at an earlier stage without waiting for the completion of production.
Standard costing simplifies the process of preparing a budget. The standard cost
per unit determined is subsequently used to obtain the amount budgeted for
each componentÊs cost of production. This budget is used as a guide to plan
requirement for materials, labour, overhead and other expenses.
From the aspect of cost control, this standard cost functions as a benchmark to
compare against the actual cost incurred. This comparison process is executed
through variance analysis which you will study in this topic. Significant cost
variance will be given due attention and its causes examined. Following that, the
manager will analyse and take control and corrective actions to improve the
production process as a whole.

SELF-CHECK 4.1
Explain what is meant by standard costing and its importance.
4.2 SETTING STANDARD COST

In determining standard cost, involvement from various parties will guarantee
accuracy, credibility, acceptance and compliance with the determined standard.
It requires a combination of expertise from various parties responsible for the
price of input and the effective use of input in production. They include
management accountants, engineers, purchase managers, production managers,
supervisors and production operators. Old records related to price and the use of
input can be used to determine standard.
The determination of standard cost is rather a difficult process. The management

accountant has to ensure that the standard cost determined is reasonable,
realistic, illustrates the production capacity level of the company, and is not too
low or too high, making it impossible or too easy to attain.
In general, there are two approaches that are usually used by the management
accountant to determine the standard cost, which is through task analysis and
historical data analysis as shown in Figure 4.2.
Figure 4.2: The two approaches used by

management accountant to determine standard cost

Standard cost can be formulated based on experience or historical cost

information.
What is historical cost information?
Historical cost information which are relevant can be used as a basis to

forecast or estimate future costs, especially for production processes that have
matured, for example, companies with extensive experience on production.
Even though historical cost is relevant, accountants have to be cautious and not
rely too much on it. It should be reminded that standards are supposed to be
designed to encourage operations efficiency in the future and not to repeat past
inefficiencies.
Therefore, accountants will always have to make adjustments on forecasts or

estimates to illustrate movements in price level or changes in technology in the
production process. Sometimes, small changes in the production process may
deem historical cost information irrelevant.
To be realistic and effective, new products require new standard costs. New
products based on genetic engineering, for example will surely do not have
historical costs. Therefore, accountants have to move on to a different approach
to determine its standard cost.
Using an alternative method, that is, task analysis, standard cost is determined
by studying and analysing the production processes, one step after another.
The focus of the management accountant is to determine what costs must be

incurred. In this process, the accountant will cooperate with skilled engineers in
the production process to study and determine the amount of direct materials to
be used and how machines should be utilised in the production process and so
on. Engineering methods such as marketing and movement research must be
executed to determine how long, for instance, it would take for direct labour or
machines to execute the work at each step of the production process. In certain
situations, the result from a combination of both approaches can be used.

Example 4.1
As an example, assume that there is a change in technology involving just one

step in the production process. The management accountant can then
cooperate with the engineer to determine standard cost in that particular
section only. Meanwhile, standard cost for other steps can be determined
based on historical cost information.
4.3 TYPES OF STANDARDS

The determination of a suitable level of standard cost in a business depends on
the requirements of management and the purpose for which the relevant
standard is used for. A suitable standard will become a stimulus factor to
efficiency, effectiveness and productivity. Meanwhile, an unsuitable standard
may give rise to other unexpected issues.
In general, there are two categories of standards, which are shown in Figure 4.3.
Figure 4.3: Types of standard

The first standard we will elaborate on is the ideal standard followed by the
practical standard.
(a) Ideal Standard

What is meant by an ideal standard?
The ideal standard is a standard set at a perfect level and is the most
difficult to attain.

An ideal standard can be attained in certain conditions or operating

situations that is almost perfect. The situations include:
(i) Efficiency at an optimal level;
(ii) The input price is at the lowest possible;
(iii) Materials are of the best quality; and
(iv) No disturbance or breakdown in the production process.
Some managers believe that the ideal standard will motivate workers to
attain the lowest cost possible or closest to the standard. On the other hand,
there are some with the opinion that an ideal standard will frustrate
workers because it is quite impossible to attain. Moreover, an unrealistic
standard will drive workers to neglect or sacrifice product quality in the
process of attaining lower cost.
(b) Practical Standard

What is meant by a practical standard?
A practical standard or attainable illustrates the attainable level

according to the companyÊs or industryÊs best practices.
A practical standard assumes the production process is efficient in normal

operating conditions. It takes into account situations such as normal machine
breakdown, and normal amount of wastage or surplus of raw materials. It is
attainable at an efficient and a high level of initiativeness by workers. Due to
this, many are confident that practical standard encourages positive attitude
among workers and productivity in comparison to the ideal standard.
To summarise, an entity that uses standard costing must always update

and improve its standard costing by holding on to its principles or
continuous improvement goals. This will ensure that the company will be
able to control costs and plan the operations of the company more
efficiently and effectively.

4.4 ADVANTAGES AND DISADVANTAGES OF

STANDARD COSTING
Standard cost is used by most industries including manufacturing industries,
service sectors, catering and non-profit organisations.
Example 4.2
Hospitals for example, have daily standard costs (for food, laundry, treatment
and others) for each bed. It is the same for fast food businesses such as
McDonaldÊs, which determines an accurate standard for the quantity of meat
that goes into each of its burgers, as well as a standard for the time taken to
fulfil each order from its customers.
In short, wherever we go, we can witness the use of standard costs by all types of
businesses. Standard costing is practised because of its advantages, especially
from the aspect of cost control and planning as discussed earlier. It assists
managers in controlling business operations by making the standard cost as the
operationsÊ achievement target.
Thus, when actual performance does not reach the target level, an examination or
inspection will be conducted to identify its causes and following that, identify the
problem so that the same problem will not recur. Management by exception
proposes that the manager concentrates fully on the activities or operations that
are very much different from the determined standard.
Standard cost is also used for the purpose of performance evaluation. The
performance of workers including the manager can be evaluated or measured by
comparing it with achievement standard. Achievement standard is one of the
motivating factors for workers. Workers will strive to attain or increase their
performance to a level that they have agreed upon as the expected level of
achievement standard.
As previously explained, standard cost determined according to cost per unit is

useful in the pricing process of products sold or services offered. By using
standard cost, the management will roughly know the cost of each unit
manufactured.
This makes it easier for the manager to set a selling price after determining the
mark-up rate required by the company. The standard cost can be reviewed or
changed according to current conditions. However, in general, standard cost is

quite stable, therefore the cost of product which was determined using the
standard cost is also stable. This also applies to the selling price.
Even though standard costing system is rather expensive to develop, it saves the
cost of processing information. Standard cost is able to simplify and facilitate the
process of record-keeping, and thus reduces the costs related to administration.
However, the standard costing system has its disadvantages. Extra emphasis on
cost reduction factor may neglect the aspect of product quality. For example, the
purchasing manager may purchase cheaper materials to reduce cost. As a result,
the quality of goods may be compromised, more so if the purchasing manager in
question, is only evaluated based on his efficiency and not on the purchase of
materials.
Standard cost may not be a suitable practice in a modern manufacturing

environment. Changes in the manufacturing environment such as the intensive
use of robots and machines and fully automated systems will reduce cost and the
use of labour. As such, the importance of related standard cost and the analysis
of labour cost will be correspondingly less.
It is neither practical nor profitable to apply standard costing in a flexible

manufacturing operation where the life span of the product is much shorter.
Standard cost is quite expensive to develop, therefore it is not economical to use
standard cost that constantly has to be renewed or updated every time a new
product emerges.
A comparison between the advantages and disadvantages of standard costing is

shown in Table 4.1.
Table 4.1: Advantages and Disadvantages of Standard Costing
Advantages Disadvantages
Is an important element in Âmanagement by The Âmanagement by exceptionÊ approach
exceptionÊ. As long as cost is within the is said to give more focus on negative
standard, managers can focus on other matters. Workers should also receive
issues. Conversely, if the cost deviates far positive encouragement for work
from the standard, it is a possible sign that completed. If the manager is not careful in
there may be a problem that would require using variances report, this will cause
the managerÊs attention. subordinates to take actions that are not in
the best interest of the company by
ensuring that the variances are at a
satisfactory level.

Assists the manager in controlling Extra emphasis on the adherence of

business operations by making the standard cost may neglect other important
standard cost as a target in operations objectives such as improving quality,
attainment. prompt delivery and customer satisfaction.
Evaluate performance of worker/ manager Not suitable for practice in a modern
by comparing it with achievement manufacturing environment. For example,
standard. Indirectly providing motivation in a manufacturing industry that uses
to workers to attain the level of robots and machines intensively. Thus, the
achievement standard determined and to importance of standard cost relating to
evaluate oneÊs own performance. labour cost analysis will lessen.
Standard cost determined according to Expensive to develop and not economical
cost per unit assists in the product pricing to use standard cost if there is a need to
of products sold/offered. constantly renew/update every time a new
product is manufactured.
Saves costs in processing information,
able to simplify and facilitate record
keeping process. Indirectly reduces
administrative costs.
4.5 ADVANCED VARIANCE ANALYSIS

Variance analysis allows us to find where deviations have occurred between
planned and actual results, assists us in inspecting the reasons for the differences,
and supports managerial actions in improving the companyÊs planning
processes. In the following sections, we shall continue and extend our
discussions on variance analysis to include several more advanced variances.
4.5.1 Material Mix and Yield Variance

A finished product may require blending of several types of raw material inputs.
Imagine a cheese cake; well, you can easily identify the main ingredients used to
make it. Or think about a more complex production; can you list the raw
materials needed to produce a car? So, it is normal in production that the
materials used are sometimes interchangeable or substitutable for each other.
This raw material mix may change, which will directly affect the quantities and
prices of the mix accordingly. Thus, these changes would have an impact on the
overall costs, which will result in cost variances.
In this case, materials quantity or usage variance can be broken-up into mix and
yield variances as shown in Figure 4.4. If material inputs are not interchangeable
then conventional materials quantity or usage variance should be computed for
each input.
Total raw material variance = [raw material price variance (RMPV)

+ raw material usage variance (RMUV)]
Raw material usage variance (RMUV) = [raw material mix variance (RMMV)
+ raw material yield variance (RMYV)]
(if more than one material input)
Figure 4.4: Raw material variance breakdown
Material mix refers to the proportion of material inputs used in a particular

production. The standard mix is the expected proportion of materials to be used
in a given mix while the actual mix is the actual proportion of materials used. A
material mix variance measures the cost of material. Thus, the mix variance
calculated represents the cost difference between the actual proportion and the
standard mix. If the amount of expensive material used is more than the amount
of cheap material, then the overall cost will be higher and the variance adverse.
Material yield refers to the relationship of inputs in total to the outputs. A yield
variance measures the efficiency of turning the inputs into outputs. For instance,
an adverse yield variance indicates that actual output is lower than the expected
output. The reasons for adverse yield variance include excess waste, sub-quality
materials, labour inefficiencies, and cheaper mix with a lower yield. Any changes
in material mix would affect the overall total materials variance.
Those two variances may be interrelated. A favourable mix variance may lead to
an unfavourable yield variance and vice versa. A favourable mix variance
indicates that cheaper mix materials are used, thus the overall average cost per
unit is lower. However, it could have an adverse effect on yield variance,
whereby total input in volume is more than expected for the output achieved.
Here is the formula for those variances:

Abbreviation for the following terms can be used to facilitate the variance
formula as follows.
AQAM = actual quantity at actual mix

AQSM = actual quantity at standard mix
SQSM = standard quantity at standard mix
Illustration: Computation of mix and yield variance.

Consider Case 1 of Dali Frozen Meat Sdn Bhd (DFM), as presented in the
following section, we shall calculate the raw material price, raw material mix
and raw material yield variances respectively.
Raw materials price variance (RMPV) is the basic variance that you have learnt in
the earlier part of this topic.
Actual Standard Actual

Material Price- Price-SP Quantity (AP-SP) * AQ
AP AQ
Grade A RM14 RM16 12,000 (RM14-16)*12,000 = RM24,000
Grade B RM11 RM12 8,000 (RM11-12)*8,000 = RM8,000
Grade C RM10 RM10 4,000 Nil
Total RMPV = (Favourable) RM32,000
The raw materials price variance is favourable (RM32,000) meaning that the
purchased cost is lower than the standard cost. This is mainly due to the falling
market price of meat caused by the mad cow epidemic.
Case 1: Dali Frozen Meat Sdn Bhd (DFM)

DFM processes raw meat into burger meat, sausages, meat balls and other frozen
meat products. The highest selling item is burger meat, which is made of three
grades of raw meat. The standard cost of the raw materials used in the
manufacture of each 100 kilograms of burger meat is as follows:
Raw Meat Kilograms-KG Standard Price per KG

Grade A 40 RM16
Grade B 70 RM12
Grade C 15 RM10
Total Input 125
Normal loss (20% of input) (25)
Output 100

In preparing its budget for 2013, DFM forecasted that there would be demand for
100,000 kilograms of burger meat and that represents a 50% share of this market.
The estimated selling price for the burger meat is RM20 per kilogram.
Unfortunately, during 2013 the fast food industry worldwide was adversely
affected by diminishing consumer confidence in meat products, which was
mainly due to the mad cow epidemic rooted in the USA. Consequently, the
actual total market size was only 80,000 kilograms of burger meat (instead of the
estimated 100,000 kilograms). DFM was able to sell only 20,000 kilograms of its
product.
The actual raw materials used by DFM in 2013 were as follows:
Raw Meat Kilograms-KG Actual Price per KG

Grade A 8,000 RM14
Grade B 10,500 RM11
Grade C 5,500 RM10
Total 24,000
Initially, in preparing the budget those three raw materials were estimated to be
used in a certain proportion or mix. However, if the actual mix differs from the
budgeted mix, then this will result in cost variance. The effect of a change in
material mix can be captured by computing the raw material mix variance
(RMMV), a subcomponent of RMUV. Here are the steps to calculate raw
material mix variance:
(a) Step 1: The standard raw materials mix is:
Materials Grade A Grade B Grade C Total

Standard input quantities (kg.) 40 kg 70 kg 15 kg 125 kg
Standard input quantities (%) 32% 56% 12% 100%
(b) Step 2: Calculation of raw material mix variance:
Material Actual Actual Quantity Standar [AQ in actual mix ă AQ

Quantity (24,000 kg) d price in standard mix] * SP
(24,000 kg) in standard mix per (AQAM ă AQSM)* SP
in actual [32%:56%:12%] kilogra
mix m
Grade A 8,000 [32% * 24,000] RM16 [8,000 ă 7,680] * RM16

= 7,680 kg = RM5,120 U

Grade B 10,500 [56% * 24,000] RM12 [10,500 ă 13,440] * RM12

= 13,440 kg = RM35,280 F
Grade C 5,500 [12% * 24,000] RM10 [5,500 ă 2,880] * RM10

= 2,880 kg = RM26,200 U
24,000 24,000 RMMV = RM3,960 F
The RMMV shows favourable variance (RM3,960), which is because DFM

has changed the standard mix to take advantage of the decreased price, and
at the same time maintained the quality of its product. Please remember to
use the standard price in the calculations of RMMV because we want to
examine the effect of the change in material mix alone (while assuming the
price variable as constant by ignoring price changes). It is also because
RMMV is a sub-component of the raw materials usage variance (RMUV),
which is computed based on standard price as well.
The formula for RUMV:
RMUV = (Actual Quantity ă Standard Quantity) * Standard Price
Raw materials yield variance (RMYV) is the second subcomponent of the RMUV.
The RMYV compares between total input (ignoring the question of „mix‰) and
total output. In DFM case, the budget assumed that every 125 kilograms of input
will yield 100 kilograms of output. Thus, a non-zero RMYV (either extra yield or
loss yield) would indicate that the actual input/output ratio differed from this
budgetary assumption. Next, let us compute the RMYV:
(a) 24,000 kg of raw materials were used, so if the standard yield (SY) had been
achieved, then the output would have been:
[24,000 kg * (100 / 125) ] = 19,200 kilograms.
(b) Luckily, the actual yield (AY) achieved was 20,000 kilograms of output,
meaning that there were 800 kilograms more than the standard yield. This
„extra‰ yield (when actual output is larger than expected output) indicates
the efficiency in turning the inputs into outputs.
(c) The financial benefit of this extra yield is calculated as below

RMYV = (AY ă SY) * Standard RM Cost per kg of output #
= (20,000 kg ă 19,200 kg) * RM16.30 = RM13,040 Favourable
# Standard RM Cost per kg of output:
(40kg × RM16 ) + (70kg × RM12 ) + (15kg × RM10)

= RM16.30 per kg of output
100 kg of output
Both favourable RMMV and RMYV represent cost saving. However, sometimes
this cost saving also means lower quality of product because a cheaper mix of
materials has been used instead. This could also have an effect on the market
share and market size variances.
In brief, material mix and yield variances are computed when there is more than one
type of materials being used to produce a product. The mix is assumed to be
controllable by the management. If management cannot control the mix, then the
usage or efficiency variance should not be broken down into mix and yield variance.
Instead, compute only the usage variance for each of the individual materials.
SELF-CHECK 4.2
Explain the breakdown of raw material variances and write down the
formula for each of the variances.
4.5.2 Labour Mix and Yield Variance

Similar to material usage, labour usage may also involve more than one type of
labour such as professional labour, unskilled labour, or different grades of
labour. The mixture of labour employed in producing a product or providing a
service may not be fixed all the time, the mixture could be changed due to several
reasons like capacity, availability, and market factors (demand and supply
condition, price changes, etc.). Likewise, you can calculate labour mix and yield
variance in exactly the same way as material mix and yield variance. Again we
are assuming that the mix of labour utilised is controllable by and known to the
management. Otherwise, only the labour efficiency variance is computed for
each individual labour type. The subcomponents of labour variances are as
shown in Figure 4.5, and look at how they are interrelated.

Figure 4.5: Labour variance breakdown

Labour mix refers to the combination of different types or grades of labour used
in production. Whenever the standard or predetermined mix is changed, then the
total labour cost would be affected as well because they are interrelated as shown
in the above Figure 4.3. Labour mix variance (LMV), which is also known as
gang-composition variance, measures the cost of labour. It captures the amount
of labour cost which is due to changes in the labour mix. The labour mix will
show adverse variance whenever a larger than standard proportion of a higher
grade of labour is used. On the other hand, a favourable labour mix variance can
occur when a larger than standard mix of a lower grade of labour is included in
the mix.
Labour yield describes the relationship of labour inputs in total to the outputs.
Labour yield variance (LYV) exists when there is a difference between the
standard output and the actual output attained for a given level of input
(measured in terms of hours). Adverse variance or loss yield implies inefficiency
in turning the input into output, and vice versa.
Illustration: Computation of labour mix variance (LMV)
There could be several ways to calculate those variances. Here we will look at
one of the ways. Consider the following Case 2 for computing the variances:
Case 2:
Data for standard and actual usage of two types of labour are presented below:
Standard Actual
Skilled Labour 300 hrs RM40 per hr 280 hrs RM44 per hr
Semi-Skilled Labour 600 hrs RM20 per hr 700 hrs RM18 per hr
Production Volume 12,000 units of a product 11,500 units of a product
Labour Mix / Proportion 300 hrs : 600 hrs = 1:2 260 hrs : 650 hrs = 2:5

Around 20 hours of Skilled Labour time and 50 hours of Semi-Skilled Labour

time were lost due to breakdown which is abnormal.
Next, let us calculate the total cost of labour at standard mix and actual mix as
shown below:
Standard Actual
(Production- 12,000 (Production: 11,500 units)
units)
Total Gross Total Net Abnormal
Rate Time Cost Rate
(RM Time Cost Time Cost Time Cost
(RM/hr) (Hr) (RM)
/hr) (Hr) (RM) (Hr) (RM) (Hr) (RM)
Skilled 40 300 12,000 44 280 12,320 260 11,440 20 880
Semi 20 600 12,000 18 700 12,600 650 11,700 50 900
Skilled
Total 900 24,000 980 24.920 910 23,140 70 1,780
The total labour mix variance is the sum of the variances measured for each
labour type separately. The basic formula for labour mix variance ă LMV is:
= [Standard Cost (SR) of Standard Time (ST) for Actual Mix (AM)
î Standard Cost (SR) of Actual Time(AT)]
LMV = SC of ST for AM î SC of AT
AT(N)Mix
LMV = ({ ï ST} ă AT(N)) ï SR
STMix
Please note that AT(actual time) must always be the net time used after
considering the abnormal loss.
Using the above formula, let us calculate the LMV:

(a) Firstly we need to calculate the mix variance for each type of labour
separately; and
(b) Then we sum-up the variances of all types of labour to arrive at the total
LMV.

Skilled = ({910 hrs × 300 hrs} - 260 hrs) × RM40 /hr

900 hrs
= ({1.011 ï 300 hrs) î 260 hrs) ï RM40 /hr
= (303.33 hrs î 260 hrs) ï RM40 /hr
= (+ 43.33 hrs) ï RM40 /hr
= RM1,733.20 Favourable
Semi- = ({910 hrs × 600 hrs} - 650 hrs) × RM20 /hr
Skilled 900 hrs
= ({1.011 ï 600 hrs) î 650 hrs) ï RM20 /hr
= (606.67 hrs î 650 hrs) ï RM20 /hr
= (- 43.33hrs) ï RM20 /hr
= (-RM866.67) Adverse
Therefore, adding together all the variances to arrive at the Total LMV
= RM1,733.20 - RM866.67 = RM866.53 Favourable.
Since this is labour cost variance, thus any favourable variance means cost
saving. This LMV captures the effect of actual proportion being different from
the standard mix. Accordingly, the people or department responsible for
authorising the work time usage and mixing of component labourers for
production can be held responsible for this variance.
Illustration: Computation of labour yield variance (LYV).
There could be several ways to calculate these variances. Here we will look at one
of the ways. Using Case 2 from the previous illustration, next we will compute
the LYV. This variance cannot be computed separately for each labour type;
instead it must be in total for all types of labour used. The basic formula for
LMV:
=[Standard Cost (SC) of Actual Output (AO) î Standard Cost (SC) of

Standard Output (SO) for Actual Time (AT)]

LYV = SC of AO î SC of SO for AT(N)
AT(N)
= (AO ï SR(SO)) î ï SO ï SR(SO)
ST
AT(N)
= (AO î ï SO) ï SR(SO)
ST
Using this formula, let us compute the LYV:
Total LYV = (11,500 units ă {910 hrs × 12,000 unit} ) × RM24,000

900 hrs 7,500 units
= ({11,500 units ă 12,133 units) ï RM2 /unit
= (- 633.33 units) ï RM2 /unit
= (- RM1,266) Adverse
This labour yield shows the relationship between the total input (labour hours)
and the total output produced. Thus, unfavourable variance means less efficiency
in using the input. Since this variance measures whether there is more or less
yield, or output, for the labour time used, the manager or department responsible
for production, possibly the manufacturing department, would be held
responsible for this variance.
SELF-CHECK 4.3
What do the unfavourable labour mix and yield variances mean?
4.5.3 Sales Mix and Sales Quantity Variances

Sales variance is also known as marketing variance. Sales variance is normally
used by non-manufacturing organisations for decision making and control
purposes. Nowadays, many companies sell more than one product. In fact, most
of those companies sell a combination or variety of products and these products
could be either from the same product line or different ones, and sell to the same
or different markets. Some sales of certain products depend very much on the
sales of another product. This proportion of different products on sale is known

as the sales mix. This pre-determined sales mix or the budgeted mix may change
over the time due to several reasons such as changing in customersÊ taste and
needs, new products or substitute products, change in fashion and trend. Any
change in sales mix will directly affect sales volume and total sales, which will
result in contribution margin or profit variances. The breakdown of sales
variance is as shown in Figure 4.6.
Figure 4.6: Sales variance breakdown
In order to have a valid analysis for sales variances, it is very crucial to note that
these variances must be computed for products which are sold into the same
market. Furthermore, it is important to distinguish between competing and
complementary products. Competing products are similar to substitute products,
which are sold to the same market and they are competing against each other
and rivalsÊ products. On the other hand, complementary products are products
whose sales are depending on or very much influenced by sales of the other
products. Thus, it is invalid to compute these variances in relation to products
sold to different markets because demands and preferences are determined by
different factors for different markets.
There are three bases for computing sales variances, namely profit margin,
contribution margin and sales price. So which basis is to be used? Well, it
depends on a companyÊs cost structure. If a company has a high level of variable
costs and the remainder of its costs are largely fixed over its expected range of
activity, then contribution will probably give a satisfactory analysis. On the other
hand, if a company has a relatively low level of variable costs and a significant
level of semi-fixed costs, gross profit should be used.
Sales mix variance (SMV) refers to contribution margin or profit difference as an

effect of changing the mix, whereby the mix of actual sales differs from the
standard mix. Similar to material mix, there are several ways to compute sales

mix variance. For simplicity, only one formula for each variance will be
illustrated here.
SMV = (AM% ă SM%) × AQ sold x SCM
SQV = (AQ sold ă SQ) × SM% x SCM
Abbreviation for the following terms can be used to facilitate the variance
formula as follows.
(a) AQ = actual quantity sold;
(b) ACM = actual contribution margin;
(c) SQ = standard quantity for sales;
(d) SCM = standard contribution margin;
(e) AM% = actual mix percentage; and
(f) SM% = standard mix percentage.
Sales quantity variance (SQV) measures the effect on contribution margin of

selling a different total quantity from the budgeted total quantity. It indicates
how much more (less) contribution margin or profit would have been made if
sales were above (below) budget for a competing range of products since it
calculates what should have been sold of each product if total actual sales were in
line with the budget sales mix %. For simplicity, the illustration will be based on
the above formula. For illustration, contribution margin (selling price ă variable
cost) will be used as the basis for sales variances.
For illustration, let us consider the following case:
Case 3: Magic Clean Sdn Bhd (MC)

Magic Clean supplies liquid detergent in one litre containers and one litre refill
bags to Mr Dobi laundry chains. Containers and refill bags are sold by the case. A
case of containers contains about the same amount of liquid as a case of refill
bags. Below is the information on the budgeted and actual sales:
Budgeted Actual
Quantity Price Variable Quantity Price
Cost
Container 2,000 RM140 RM50 2,250 RM125
Refill bags 3,000 RM100 RM30 3,050 RM110

Total sales variance : Actual CM ă Budgeted CM

= (AQ × ACM) ă (SQ × SCM)
= [(2,250 × RM(125-50) + (3,050 × RM(110-30)]
ă [(2,000 × RM(140-50) + (3,000 × RM100-30)]
= RM412,750 ă RM 390,000
= RM22,750 Favourable
It is important to recognise that containers and refill bags are competing products
and substitutable. Based on the above Magic Clean case, the total sales variance
was RM22,750, favourable. This variance can be broken down into various
subcomponents (as in Figure 4.6 ă sales variance breakdown) in order to better
analyse and understand customer profitability, set more reasonable prices, and
create better marketing campaigns. Firstly, let us break it down into price
variance and volume variance in Table 4.2.
Figure 4.6: Sales variance breakdown

Table 4.2: Computation of Price Variance and Volume Variance
Containers Refill Bags Total

Actual CM RM75 RM80
Standard CM ă RM90 ă RM70
CM difference U RM15 F RM10
Actual quantity X 2,250 X 3,050
Price Variance U RM33,750 F RM30,500 U RM3,250
Actual quantity 2,250 3,050

Standard quantity 2,000 3,000
Quantity difference F 250 F 50
Standard CM X RM90 X RM70
Volume Variance F RM22,500 F RM3,500 F RM26,000
Total Variance U RM11,250 F RM34,000 F RM22,750
Based on the above table, we would be interested to know what caused the
favourable volume variance. Firstly, you can observe that the total units sold
(5,300 units) was more than the budgeted amount (5,000 units). Secondly, a
higher fraction of containers was sold than budgeted. Both containers and refill
bags are substitutes, meaning that customers can substitute one for the other.
This volume variance of RM22,500 for containers and RM3,500 for refill bags can
be broken down into two more variances: the SMV and SQV. These variances are
very beneficial especially when the company offers multiple and substitutable
products. The mix variance measures the effect of substitution among the
products, while the quantity variance captures the differences in total actual and
standard quantities sold.
The computations are as in the following table. For mix variance, the higher
fraction of containers sold brought about an additional contribution margin of
RM11,700, but at the same time reduced the refill bags sales contribution margin
by RM9,100. Combining both mix variances, we get a total of RM2,600,
favourable. This increase in contribution margin represents how much of the
volume variance is due to the change in product mix, while the number of units
sold is kept constant.
The additional cases sold of 300 generated additional contribution margins of

RM23,400 (RM10,800 and RM12,600 combined), which is shown as quantity
variance. In doing this, the mix is kept constant at the standard mix percentages
(40%:60%). Therefore, quantity variance represents how much of the volume
variance is due to increase in actual sales (see Table 4.3). We could conclude that
most of the favourable volume variance of RM26,000 comes from the additional

300 cases sold, not from the shift of demand from refill bags to containers. Mix
variance is not necessary for products which do not have competing products.
Table 4.3: Computation of Sales Mix Variance and Quantity Variance
Container Refill Bags Total

Actual mix % 42.45% 57.55%
Standard mix % 40.00% 60.00%
% difference 2.45% 2.45%

Total actual units sold X 5,300 X 5,300
Difference in units 130 130

Mix Variance F RM11,700 U RM9,100 F RM2,600
Total actual units sold 5,300 5,300

Total standard unit sold 5,000 5,000
Difference in units sold F 300 F 300
Standard mix % 40% 60%
Additional sales 120 180

Quantity Variance F RM10,800 F RM12,600 F RM23,400
Volume Variance F RM22,500 F RM3,500 F RM26,000
In brief, sales quantity and mix variances offer valuable information to managers
about market movements. In case total sales are above budget the sales quantity
variance would specify how much more contribution margin or profit should
have been made as a result of increased demand. Whereas, the sales mix variance
determines which products customers bought relatively more or less of at the
increased level of demand. After clarifying the reasons for the variances then
appropriate decision and actions can be executed such as:
(a) Changing advertising strategy;
(b) Replacing or improving products;
(c) Amending policies on mix, price etc.; and
(d) Understanding and recognising changing customersÊ preferences.

SELF-CHECK 4.4
How is sales mix variance related to total sales variance?
4.5.4 Market Share and Market Size Variances

The sales quantity variance can be further divided into market size and market
share variances. Market share and market size variances can be added to the
breakdown of sales variance as shown below. If reliable market data can be
obtained, then these market variances would offer more insight into product
performance. Market data can be obtained from trade associations, which collect
data from their members and make it available to them on an anonymous basis.
Market size variance (MSZV) examines the relationship between a company or

organizationÊs percentage of a market and the overall size of that market. Market
size variance measures how much more/less profit would have been made if
budget market share was maintained. It represents the portion of the sales
activity variance attributable to changes in industry volume.
Market share variance (MSHV) arises when there is a difference between the
actual market share of a company and the expected or budgeted market share.
For example, if a company budgets for a 20% market share but eventually obtains
only a 15% market share, this represents a market share variance. It measures the
effect on profitability of actual market share being different from budget market
share.
For illustration: Computing the MSZV and MSHV

We will be using the previous Case 3 on Magic Clean Sdn Bhd (MC) as shown
below. In addition, the last two columns contain data obtained from the trade
association that represents companies which supply household products,
specifically laundry detergent:
Budgeted Actual Market data

Budget Actual
Variable
Quantity Price Quantity Price Demand Demand
Cost
Quantity Quantity
Containers 2,000 RM140 RM50 2,250 RM125 10,000 14,000
Refill bags 3,000 RM100 RM30 3,050 RM110 12,000 15,000

To calculate MSZV, firstly we need to calculate the expected % of market share

from the budget market data, then multiply the differences between expected
and budget sales by standard price, as shown in Table 4.4.
Table 4.4: Computation of Price Variance and Volume Variance
Container Refill Bags Total

Budget quantity 2,000 3,000
Budget demand quantity ÷ 10,000 12,000
Budget sales mix % 20% 25%

Actual demand quantity X 14,000 X 15,000
Expected quantity 2,800 3,750

Budget quantity – 2,000 – 3,000
Difference in quantity F 800 F 750

Standard CM RM90 RM70
Market Size Variance F RM72,000 F RM52,500 RM124,500
The calculations indicate that an additional contribution margin of RM124,500

would have been made if the budget market share was achieved. Although the
actual demand from the industry has increased the increase in sales for both
products was not big enough to retain the budgeted market share percentage.
To calculate MSHV, the first step is to compare actual sales with expected sales.
Then multiply the differences between actual and expected sales by the standard
price to arrive at market share variance. The calculation of a market share
variance reflects the effect on contribution margin of actual market share being
different from budget market share.
Containers Refill Bags Total

Actual quantity 2,250 3,050
Expected quantity ă 2,800 ă 3,750
Difference in quantity (500) (700)

Market Share Variance UF RM45,000 UF RM49,000 (RM94,000)

The calculations indicate that a loss of RM94,000 was made as a result of not
maintaining its market share for all its products. The budgeted market share
percentages were 20% (containers) and 25% (refill bags) and the actual market
share percentages were reduced to 16%-containers (2,250/14,000) and 20.3%-refill
bags (3,050/15,000).
In conclusion, this sales or marketing variances helps especially non-

manufacturing organisation to identify and understand why budgeted
contribution margins or profits differ from actual contribution margins. These
variances largely reflect the impact of external factors. The breakdown of sales
variance into sub-variances provides very useful data in making decisions for
marketing and selling purposes and policy setting.
4.6 PLANNING AND OPERATIONAL

VARIANCE ANALYSIS
In the standard setting process, managers make their best estimates and
forecasts. Indeed, most of the standards are set on a forecast basis, which is
known as ex ante or before the event. Thus their estimations and forecast of costs
and revenues at the budgeting or planning stage may not be accurate or close to
actual results. This will result in planning variance.
Standards and budgets could possibly be revised once more information

becomes visible and observable after the event or also known as ex post. But the
differences between the revised budget and the actual performance may still exist
and be called operational variance, as depicted in Figure 4.7.
Figure 4.7: Planning and operating variances
Planning variances reflect the difficulties and errors in setting the original
standards. Normally, standards are revised due to change in condition,
assumptions or environment. Managers may not be held responsible because
those causes are regarded as beyond their control. Basically, a planning variance
is the difference between the ex ante and the ex post standards. Using similar
concept of other variances ă „actual versus budget‰, planning variance compares

original standards with revised standards. A favourable variance means the ex

post standard cost is lower than the original ex ante standard cost. In contrast, an
adverse variance shows that the ex post standard cost is higher than the ex ante
standard cost.
Operational variances compare revised standards with actual performance. It is

assumed that these variances occur due to operational factors. Hence, these
variances are within management control, thus relevant managers or
departments can be held responsible. The variances include material, labour,
overhead and sales variances. They are computed by comparing the actual
results with the ex post standard, instead of the original standard.
For illustration: Computing the planning and operational variances

Consider Case 4 as shown below.
Case 4: The following data concerns material A:

Original standard price RM20 per litre
Revised standard price RM23 per litre
Actual price RM22
Standard usage 100 litres
Actual usage 95 litres
Based on the traditional approach, material price and usage variances are
computed as shown in Figure 4.8:
SQSP AQSP AQAP

(100 litres × RM20) (95 litres × RM20) (95 litres × RM22)
= RM2,000 = RM1,900 = RM2,090
Usage Variance Price Variance

RM100 F RM190 A
SQSP AQSP AQAP

(100 litres × RM23) (95 litres × RM23) (95 litres × RM22)
= RM2,300 = RM2,185 = RM2,090
Usage Variance Price Variance

RM115 F RM95 F
Figure 4.8: Traditional approach

Favourable (F) material usage variance indicates operating efficiency, while

favourable price variance may reflect good bargaining skills, etc.
Some variances will appear due to factors that are practically or completely
within the control of management, for instance, the material usage variance that
reflects manufacturing efficiency in material consumption. These controllable
variances are known as operational variances. Variances that arise as a result of
changes in environment external to the business are known as planning variances
like price variance. Since planning variances are beyond the control of
operational management, managers cannot be charged for these variances.
Significant planning variances may lead to standard revision. Management

should have valid reasons to decide on revising the standards. Some possible
reasons for revising the standards are:
(a) Unexpected change in the rate or compensation for workforce;
(b) Unexpected increase in material prices in the market;
(c) Change in materials used in production; and
(d) Change in production setting, policies or procedures that alter the
consumption of resources.
Planning and operational variances are very useful for dynamic and volatile
environments. They help in determining planning deficiencies, offer up-to-date
information about degree of efficiency, make standard costing more acceptable
and become a motivating factor. Nevertheless, they are also subject to criticism
and have potential drawbacks. It is said that they are time consuming, create
conflict between planning and operational staff, and generate temptation to shift
the blame on the external factors.
SELF-CHECK 4.5
Explain the difference between planning and operational variances?
Figure 4.9 summarises the common variances. As mentioned in the previous

section, the sales variances could be measured based on selling price,
contribution margin or gross profit.

Figure 4.9: Chart of common variances

Source: Lucey (1996)
4.7 OPERATING STATEMENT (VARIABLE

COSTING AND ABSORPTION COSTING
TECHNIQUES)
Standard costing has long been used as a control system, whereby the budgeted
or planned cost and revenues are compared with the actual results. The resulting
variances will be reported to management as part of performance measurement
and control. Managers will prepare a report called cost reconciliation statement
disclosing all cost variances. The operating statement is another reconciliation
report that summarises both sales variances and cost variances. The format of the
reconciliation or the operating statement is different under variable (marginal)
and absorption costing. Table 4.5 shows the format of operating statement under
absorption costing.

Table 4.5: Operating Statement under Absorption Costing
RM
Budgeted profit xxx
Sales volume profit variance xx/(xx)
Standard profit on actual sales (= flexed budget profit) xxx
Selling price variance xx/(xx)
xxxx
Cost Variances: Favour. Adverse

RM RM
Material price xx (xx)
Material usage xx (xx)
Labour rate xx (xx)
Labour efficiency xx (xx)
Variable overhead expenditure xx (xx)
Variable overhead efficiency xx (xx)
Fixed production overhead expenditure variance xx (xx)
Fixed production overhead capacity variance Fixed xx (xx)
production overhead efficiency variance xx (xx)
Total xx/(xx)
Actual Profit xxxx
The operating statement under variable or marginal costing is quite similar to the
one under absorption costing, but with several differences as listed below (also
see Table 4.6).
(a) A sales volume contribution variance is used in place of a sales volume
profit variance;
(b) Only fixed overhead expenditure variance is included; and
(c) The reconciliation is from budgeted to actual contribution then fixed
overheads are deducted to arrive at a profit.

Table 4.6: Operating Statement under Variable Costing
RM
Budgeted contribution
(budgeted production x budgeted contribution/unit) xxx
Sales volume profit variance xx/(xx)
Standard contribution on actual sales
(= flexed budget contribution) xxx
Selling price variance xx/(xx)
xxxx
Variable Cost Variances
Favour. Adverse
RM RM RM
Material price xx (xx)
Material usage xx (xx)
Labour rate xx (xx)
Labour efficiency xx (xx)
Variable overhead expenditure xx (xx)
Variable overhead efficiency xx (xx)
Total xx/(xx)
Actual contribution xxx
Budgeted fixed production overhead xxx
Fixed overhead expenditure variance xx/(xx)
Actual Profit xxxx
Please remember that adverse variances increase actual cost whereas favourable
variances reduce actual cost. Variable costing distinguishes between fixed and
variable cost. Under variable costing, the sales volume variance would be based
upon contribution per unit rather than profit per unit. In brief, for absorption
costing, it is important to distinguish between the sales volume and the rate and
efficiency causes of deviations from budget. On the other hand, for variable
costing it is crucial to separate the effects on contribution, fixed and variable
costs. If you have a computerised accounting package, this will be a very simple
task.

4.8 INTERDEPENDENCE BETWEEN VARIANCES

Normally, the people in the accounting department are the ones who prepare
and calculate all variances, but those performing the accounting function are less
likely to know the causes of the variances. Actually, it is operational managers
who should determine the causes and only they should provide input into the
management report on the figures. Effective management decisions on the
appropriate course of action can be made possible only if we know the true
cause.
We need to recognise the inter-relationships among variances. For instance, the

purchase of low quality materials by a purchase manager may cut the cost a bit
and result in a favourable materials price variance. However, these poor quality
materials may cause production employees to use more materials than expected
and they may have to spend more time working with the materials, and
eventually this may result in an adverse materials efficiency variance and an
adverse labour efficiency variance. Furthermore, if labour hours are the cost-
allocation base for variable overhead, then most probably overhead efficiency
variance will also be an unfavourable variable. Now, think about who is going to
be held responsible for those variances. Do you think it is fair for production
managers to be charged for all those adverse variances which were entirely due
to poor quality materials?
Therefore, understanding and recognising the interdependence between

variances are very crucial especially in determining the true underlying cause of
the variances so that proper corrective action can be taken. Secondly, no
managers should be wrongly held responsible or be blamed for variances which
were caused by others.
Variance analysis which is not supported by effective planning processes may

adversely create dysfunctional behaviour among managers. Consider the
following example. Normally, the human resource (HR) manager takes full
charge of unfavourable variance in labour costs, whereas the production
manager is held responsible for fully utilising manufacturing capacity. This
arrangement encourages the production manager to keep production running at
full capacity all the time. Whenever demand increases, the production manager
would contract more labour rather than expanding capacity. This short-term
measure is costly for the company and it is the HR manager who is going to be
responsible for this variance, not the production manager. These kinds of
dysfunctional behaviours that favour short-term measures at the expense of long-
term organisational goals are not healthy for the survival of the company.
Therefore, acknowledging the reliance of variances upon each other, individual
managers should consider the implications of their decisions on others before

taking further action. In order to guide managers, or even to prevent them from
focusing on the interest of their departments/sections alone in isolation from
others, variance analysis should be aligned to and focused on achieving the
strategic goals of an organisation.
In many situations, like in the above scenario, the misallocation of

responsibilities, off-track focus and penalties for unfavourable variances may
create a culture of fear, blame and frustration. The focus is not on achieving
strategic goals. One way to alleviate this issue is to link advanced variance
analysis to the companyÊs planning and budgeting processes. By reviewing
which managers should be responsible for common types of variances, you can
make any necessary adjustments. You can then determine which variances are
critical to strategic performance. By linking variance analysis to a target-based
budget derived from the firmÊs business plan, you create an effective tool to
improve the firmÊs strategic performance.
4.9 INVESTIGATING VARIANCE

Why do we need to investigate a variance? Of course, the purpose is to determine
the underlying cause of the variance so that proper corrective action can be
taken. Companies often establish criteria to determine which variances to focus
on rather than simply investigating all variances. Some may apply what we call
management by exception (MBE), whereby managers focus exclusively on
variances that are significant. Management decision to take further investigation
depends on many factors. Some of the factors that should be considered are as
follows:
(a) Reliability and accuracy of the figures ă Possibility of mistakes in
calculating budget figures, or in recording actual costs and revenues.
(b) Materiality ă A company may predetermine the size of the variance that
reflects the magnitude of the problem and its potential benefits gained from
its correction.
(c) Interdependencies between variances ă Any interdependent variances
should be considered jointly before making an investigation decision.
(d) Natural variability in costs and revenues ă Some variances are considered
normal like oil prices of high volatility in nature, but some other variances
are quite stable thus a small variance may signal a problem.
(e) Adverse or favourable ă Normally adverse variances get all the attention
because they reflect problems. However, do not just ignore favourable
variances because they may signal that the standards are too low and thus

need revision. Alternatively, favourable variances should be highlighted so

that a business can learn from its successes.
(f) Trends and patterns ă Occurrence of variances is either at random or
persistent. A series of adverse variances usually indicates a problem.
(g) Controllability and probability of correction ă No corrective action is
necessary for uncontrollable variances.
(h) Costs and potential benefits of correction ă If the cost of corrective action
outweighs its potential benefits from the correction, there is no need for
further investigation.
Next, let us learn more about cause and controllability issues. Variances can be
divided into two classifications: random and systematic. Random variances are
uncontrollable, either from technical or financial aspects. For instant, price
fluctuations in the open market at the time of acquisition and the time allowed to
acquire the goods or services are definitely beyond the control of management.
Thus, no further action from the management is needed since these variances are
basically random variances.
In contrast, systematic variances are persistent, and most likely to reappear if

they are not corrected. Normally, they are controllable, in which management
can take corrective actions to remove or reduce them. Immediate action is
required if the variances are material. Causes for these systematic variances
include inaccuracy or errors in prediction, modelling, measurement and
implementation. Each cause requires different further investigation and effective
managerial action to rectify the variance. Next, we will look at the different types
of errors and the necessary corrective action.
(a) Prediction errors refer to inaccurate estimation of variables in the standard-
setting process, such as increases in materials price are faster or higher than
estimated. Corrective action for prediction errors would be to modify the
standard and the standard setting process.
(b) Modelling errors occur when management has failed to include all relevant
variables or has included wrong or irrelevant ones in the standard-setting
process. For instant, a modelling error occurs when a firm fails to consider
for normal material lost or waste. The unfavourable material usage variance
that the firm experiences is a result of modelling error, not because of
inefficient operations. Setting the standard at 1,000 kgs of input materials to
produce 1,000 kg of output is a modelling error, knowing that the
manufacturing process has 10% normal waste. Corrective actions for
modelling errors include the firm changing its standard and the standard-
setting process.

(c) Measurement errors refer to using wrong numbers due to improper or

inaccurate accounting systems or procedures. For example, allocating
overhead incurred for setups based on machine hours rather than the
number of setups is a measurement error. Corrective actions for
measurement errors would be to redesign the firm's accounting system or
procedures.
(d) Implementation errors occur when operators deviate from the standard in
performing their jobs. Examples of implementation errors include setting a
cutting machine to cut plywood in lengths of 2 x 3.97 feet, instead of 2 x 4
feet, and using material of low or lesser quality than those specified that has
resulted in unfavourable materials usage variance. Some errors are
temporary and disappear in subsequent periods in the normal course of
operations like excessive or wrong use of materials in production may
occur only in one or a few production runs. However, some errors could be
continuing and reappear until the firm takes proper corrective action, i.e.
resetting the length of the cutting machine. Proper immediate actions are
very crucial for this type of implementation error.
Investigation of variances involves time and money. In brief, companies,

therefore, need to determine whether the benefits of investigating the variance
outweigh the costs, how important the item is to the production process or
service experience, whether there has been a trend in the variance over a period
of time, whether the variance is persistently or repeatedly occurring and whether
someone in the organisation has the ability to control a particular cost or revenue,
before deciding on further investigation of the variances.
4.9.1 Variance Investigation Models

There are a number of variance investigation models available. These models can
be as simple as consisting of set of rules or procedures for investigating
variances. A simple control chart or the statistical model-control chart is quite a
popular and widely used method. Alternative methods involve more
sophisticated models such as probability-based approach, and stochastic
processes such as dynamic programming model.
(a) Percentage of standard cost approach

The percentage of standard cost approach is a simple method to apply. This
method allows certain variances within a fixed percentage of standard cost.
Thus, any variance larger than this percentage will require investigation.
Nevertheless, the main limitation of this approach is that it does not
consider most of the issues related to making decisions on investigating
variance as mentioned in the investigating variance section. Such issues like

reliability of the figures, interdependence between variances, the natural

variability of the costs involved, recent trends in variances, or the costs and
potential benefits of investigation are not taken into consideration.
(b) Control chart

Random and systematic variances can be identified by using a control chart.
Control charts offer a visual representation of the variation of actual costs
around standard and clearly portray trends in variance. A control chart has
a horizontal axis, a vertical axis, a horizontal line at the level of the
desirable characteristic, and one or two additional horizontal lines for the
allowable range of variation (see Figure 4.10). The horizontal line represents
time intervals, batch numbers or production runs. The vertical line denotes
scales for the characteristic of interest, such as the amount of the cost
variance. Upper and lower borders limit the allowable range of the
variance. If actual costs fall outside the warning limits, this signals close
monitoring is necessary. If actual costs shift towards outside the action
limits, this would call for corrective action.
Figure 4.10: Variance control chart

Source: www2.accaglobal.com
The management is responsible for setting the upper and lower control
limits in control charts. Managers may set the warning and action limits
based on their past experience, or a standard normal distribution. When the
control limits are established using a statistical model, the chart is called a
statistical control chart as depicted in Figure 4.11.

Figure 4.11: Statistical model-control chart

Source: http://dl.groovygecko.net
In the above statistical control chart, the control limits are set at two
standard deviations from the mean. This means that 95% of the variance
amounts should lie within the control limits. A control chart is very useful
in the case where an average cost can be established, but its use is
commonly limited to efficiency variances.
(c) Probability based and dynamic programming methods

A probability-based model appears very rational; however, it requires
accurate estimation of probabilities. Another complex method is the
dynamic programming method, which was suggested by Kaplan in 1969
for making cost variance investigation decisions. This model tries to
minimise the expected total cost (or the expected present value of total
costs) over a specified time frame or horizon and does include a
consideration of decisions in future periods.
Previous studies have reported that there is lack of application of more complex
cost investigation models, which could be due to several reasons, including that
the added costs may outweigh the potential benefits, lack of awareness, and
choice of simple over complicated models.

• Advanced variance offers further analysis by breaking down the basic

variances into several compositions that enable us to understand more about
those variances in improving overall financial performance.
• This topic discusses the evaluation of the achievement level of a company

from the aspect of planning and control by using standard costing as a
benchmark.
• Standard costing can be used in management activities and cost control,

budget preparation, product pricing and performance evaluation.
• At the end of this topic, students will have learned cost control through
variance analysis and following that, the approach used in the formulation of
standard cost and types of standard costs.
• The effectiveness of the use of standard costing, among others, will assist
managers in controlling business operations other than assisting in the
process of pricing products for sale. Manufacturing-based organisations that
produce products using multiple or many types of raw materials and labours
may find advanced variances like material mix and yield variances, and
labour mix and yield variances very useful in evaluating their resource
management and performance management in general.
Ć Sales or marketing variances such as sales mix and quantity variances,

market share and size variances are very beneficial for non-manufacturing or
service organisations in investigating their sales performance and market
movement.
Ć Variances may require further investigation for several reasons that may lead
to revision of standard setting. A number of models or approaches for
investigating variances are available.

Ideal standard Operating statement

Labour mix variance Practical standard
Labour yield variance Standard costing
Market share variance Sales mix variance
Market size variance Sales quantity variance
Material mix variance Variance analysis
Blocher, E. J., Stout, D. E., & Cokins, G. (2010). Cost management: A strategic
emphasis. New York: McGraw-Hill/Irwin.
CIMA. (2011). CIMA official study text: Paper P2 Performance Management. UK:
Elsevier Limited and Kaplan Publishing.

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4.1 STANDARD COSTING AND ITS

These three elements usually exist in any control system.

What is meant by standard costing?

Standard costing is a method of cost formulation or standard achievement

Figure 4.1: Main uses of standard costing

Hence, it is used as a benchmark for comparison to the performance or actual

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In a budget control system, a management accountant will determine a standard

What is meant by variance analysis?

Variance analysis is the process of calculating and interpreting the difference

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Explain what is meant by standard costing and its importance.

4.2 SETTING STANDARD COST

The determination of standard cost is rather a difficult process. The management

Figure 4.2: The two approaches used by

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Standard cost can be formulated based on experience or historical cost

What is historical cost information?

Historical cost information which are relevant can be used as a basis to

Therefore, accountants will always have to make adjustments on forecasts or

The focus of the management accountant is to determine what costs must be

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As an example, assume that there is a change in technology involving just one

4.3 TYPES OF STANDARDS

Figure 4.3: Types of standard

(a) Ideal Standard

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An ideal standard can be attained in certain conditions or operating

(b) Practical Standard

A practical standard or attainable illustrates the attainable level

A practical standard assumes the production process is efficient in normal

To summarise, an entity that uses standard costing must always update

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4.4 ADVANTAGES AND DISADVANTAGES OF

As previously explained, standard cost determined according to cost per unit is

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Standard cost may not be a suitable practice in a modern manufacturing

It is neither practical nor profitable to apply standard costing in a flexible

A comparison between the advantages and disadvantages of standard costing is

Table 4.1: Advantages and Disadvantages of Standard Costing

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Assists the manager in controlling Extra emphasis on the adherence of

4.5 ADVANCED VARIANCE ANALYSIS

4.5.1 Material Mix and Yield Variance

Total raw material variance = [raw material price variance (RMPV)

Figure 4.4: Raw material variance breakdown

Material mix refers to the proportion of material inputs used in a particular

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AQAM = actual quantity at actual mix

Illustration: Computation of mix and yield variance.

Actual Standard Actual

Case 1: Dali Frozen Meat Sdn Bhd (DFM)

Raw Meat Kilograms-KG Standard Price per KG

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The actual raw materials used by DFM in 2013 were as follows:

Raw Meat Kilograms-KG Actual Price per KG

(a) Step 1: The standard raw materials mix is:

Materials Grade A Grade B Grade C Total

(b) Step 2: Calculation of raw material mix variance:

Material Actual Actual Quantity Standar [AQ in actual mix ă AQ

Grade A 8,000 [32% * 24,000] RM16 [8,000 ă 7,680] * RM16