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KNGX NOTES
ACCT2522

5. STANDARD COSTS AND VARIANCE

ANALYSIS
5.1 STANDARD COSTING AND ITS USES

Standard Cost: the budgeted cost, based on estimates of the cost of material, labour and overhead
resources, that should be used to make one unit of product

COST CONTROL OVERVIEW

Planning and Control: ensure that plan and objectives are achieved:

- Control systems provide regular information to assist in control, which is an essential part of effective
resource management

Requirements for control:

- Standard costing is a part of the budgetary control system

o A standard cost is a budgeted cost of one unit of product
o Includes cost of direct materials, direct labour and overhead
- Product costing
- Performance evaluation
- Standard cost variances are used to evaluate actual performance and control costs
- Standard costs can be developed for direct material, direct labour and overheads
- When cost variances are significant, the cause of the variance must be investigated
o May result in operations being changed to bring cost back in line with standards
o Management may reconsider whether the standard costs are appropriate benchmarks
o Investigate causes of variances

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ACCT2522

5.2 METHODS AND BEHAVIOURAL EFFECTS OF SETTING COST STANDARDS

METHODS OF DEVELOPING STANDARDS

Most companies will use a combination of them as they all have different pros and cons

Pros Cons

Historical Experience Relevant and “economical” The past is not always a good
(e.g. regression) predictor of the future

Engineering Studies For new processes and efficient Difficult to achieve

operations Behaviour of employees may be
different during engineering studies
(may overstate resources required)

Benchmarking Improve competitiveness Difficulty in identifying a benchmark

Participative Standard Higher accuracy and enhancing Incorporation of budgetary slack

Setting goal commitment

THE TYPES OF STANDARDS AND THEIR BEHAVIOURAL IMPACTS

There are two types of standards:

1. Perfection/Ideal/Theoretical Standards 2. Practical Standards

- Minimum attainable costs - Challenging but attainable performance

- Maximally efficient operations under - Efficient operations under normal
near-perfect operating conditions operating conditions
- Issues to consider: - Issues to consider:
o Is it achievable? o More achievable
o Will it cause dysfunctional o Encourage inefficiencies
behaviour? o Can build in continuous
o “Forcing” continuous improvement improvements into standards?

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KNGX NOTES
ACCT2522

5.3 DEVELOPING STAND ARD COSTS FOR DIRECT MATERIAL AND DIRECT LABOUR

DIRECT MATERIAL STANDARDS

Standard Material Quantity

- The total amount of direct material required to produce one unit of product

Standard Material Price

- The total delivery cost of direct material required to produce one unit of product, less quantity
discounts
- Based on ordering a certain quality of material in specific order quantities from a specified supplier

DIRECT LABOUR STANDARDS

Standard Direct Labour Quantity

- The number of labour hours required to manufacture one unit of product

Standard Labour Rate

- The total hourly cost of wages, including on-costs

- On-costs: are extra salary-related costs that all Australian companies have to pay; usually treated as
part of the cost of labour

5.4 CALCULATING DIRECT MATERIAL AND DIRE CT LABOUR VARIANCES

Standard Cost Variance: the difference between the actual cost and the budgeted/standard cost

Variance analysis is used for cost control and compare actual against standard cost

- How do we calculate standard cost variances?

- What do they mean?
- What do we do with these variances?
- What are some behavioural implications of using variance analysis?

ACCT2522 focuses on direct costs:

1. Direct materials variances

2. Direct labour variances

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KNGX NOTES
ACCT2522

DIRECT MATERIALS VAR IANCES

DIRECT MATERIAL (DM) PRICE VARIANCE

Price Variance:

- Was actual DM price paid = budgeted DM price?

- The measure of the effect on cost of purchasing at a price that is different from standard

Where:
PQ = Purchased quantity; (NOT AQ)
Price Variance = PQ(AP – SP)
AP = Actual price
SP = Standard price

Note: calculating price variance using Actual Quantity is also a method described in the textbook, but not used
in the ACCT2522 course

DIRECT MATERIAL (DM) QUANTITY VARIANCE

Quantity Variance:

- Was the actual DM quantity used = Budgeted DM quantity?

- A measure of the effect on cost of using a different quantity of material in production compared with
the standard quantity that should have been used for the actual production output

Where
SP = Standard price
Quantity Variance = SP(AQ – SQ)
AQ = Actual quantity used
SQ = Standard quantity allowed given actual output

Note: the standard quantity is based on actual output (i.e. how much quantity should have been used given
the number of units sold)

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KNGX NOTES
ACCT2522

DIRECT LABOUR VARIANCE

DIRECT LABOUR (DL) RATE VARIANCE

Rate Variance

- Was actual DL rate paid = Budgeted DL rate?

- A measure of the effect on cost of paying a different labour rate, compared with standard

Where
AH = Actual Hours Used
Rate Variance = AH(AR – SR)
AR = Actual Rate Per Hour
SR = Standard Rate Per Hour

DIRECT LABOUR (DL) EFFICIENCY VARIANCE

Efficiency Variance

- Was actual DL hours used = Budgeted DL hours used?

- A measure of the effect on cost of using a different number of direct labour hours, compared with the
standard hours that should have been used for the actual production output

Where
SR = Standard Rate per hour
Efficiency Variance = SR(AH – SH)
AH = Actual Hours used
SH = Standard Hours allowed given actual output

5.5 INTERPRETING AND INVESTIGATING VARIANCES

INVESTIGATING VARIANCEES

Consider:

- Are the variances significate?

- What caused the variance?
- Are there any actions or decisions that impact on more than one variance?
- Never look at variances in isolation

Steps:

1. Look at all interactions  e.g. low quality DM are cheaper but may decrease DL efficiency
2. Draw on case information

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ACCT2522

SIGNIFICANT VARIANCES

Management by exception: only significant cost variances are reported and investigated

What are Significant Variances? Consider:

- Size of variance: the relative size of the variance compared with the standard
- Recurring variances: whether the variance occurs repeatedly or only infrequently
- Trends: if there are any concerning trends in the larger picture
- Controllability: a manager is more likely to investigate variances that is controllable by someone in
the organization
- Both unfavourable and favourable: it is important to investigate both as favourable variances may
indicate new methods, more efficient processes that can be formally implemented etc.

STATISTICAL APPROACH TO VARIANCE INVESTIGATION

- Statistical Control Chart: a plot of the standard cost variances across time compared with a
statistically determined critical value to highlight the variances that should be investigated
- Critical value: the point at which a variance should be investigated.

INVESTIGATING TAKING CORRECTIVE ACTION

Once variances are identified as significant managers must

- Find the causes of those variances

- Take corrective actions

Mangers must also consider the Cost of Investigating Variances

- Time spent investigating variances

o Disruption to production process
- Corrective Actions

Benefits of investigating variances

- Reduced costs (if variance is eliminated)

- Causes of favourable variances may improve work practices

Management judgement and experience is used to weigh up these cost vs benefits

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KNGX NOTES
ACCT2522

COST CONTROL THROUGH ASSIGNING RESPONSIBILITY

Which managers should be held responsible for the following variances?

- DM Price Variance:
o who influences material prices?
o E.g. Purchasing manager
- DM Quantity Variance:
o who determines quantity of materials used
o E.g. Production managers or supervisors
- DL Rate Variance:
o who determines wage rates of employees
o E.g. hiring manager or human resources team
- DL Efficiency Variance:
o who is responsible for the use of employee time?
o E.g. Project managers, supervisors or even employees themselves

CAUTION WHEN INVESTIGATING VARIANCES

- Need to interpret variance carefully

o Watch out for interactions!
- Not all favourable variances are desirable and unfavourable variances are undesirable