Standard Costing and Variance Analysis

Meaning of Standard Costing

Standard Costing is an effective management tool for planning , co-ordination

and control. It involves the preparation of and use of standard cost, their

comparison with actual cost costs to analyse deviation so as to take corrective

action

It is a system of cost accounting which makes the use of pre determined

Standard costs relating to each element cost namely, material, labor and

overhead for each line of product manufactured or services rendered. It is a

method of costing by which standard costs are employed. According to ICMA,

London, Standard Costing is “the preparation and use of standard costs,

their comparison with actual cost and the analysis of variances to their

causes and points of incidence”.

Standard Costing involves:

(i) Ascertainment and use of Standard Costs;

(ii) Recording the actual costs;

(iii) Comparison of actual costs with standard costs in order to find out the variance;

(iv) Analysis of variance; and

(v) After analysing the variance, appropriate action may be taken where necessary.
 Objectives of Standard Costing
The objectives of Standard Costing for which it is implemented are:

(a) It helps to implement budgetary control system in operation;

(b) It helps to ascertain performance evaluation.

(c) It supplies the ways to utilize properly material, labour and also overhead
which will be economic in character.

(d) It also helps to motivate the employees of a firm to improve their

performance by setting up a ‘standard’.

(e) It also helps the management to supply necessary data relating to

cost element to submit quotations or to fix up the selling price of a firm.

(f) It also helps the management to make proper valuations of inventory

(viz., Work-in- progress, and finished products).

(g) It acts as a control device to the management.

(h) It also helps the management to take various corrective decisions viz.,

fixation of price, make-or-buy decisions etc. which will be more beneficial to

the firm.

 Advantages of Standard Costing:

The following advantages may be derived from Standard Costing:

(i) Standard Costing serves as a guide to the management in several

management functions while formulating prices and production policies etc.
(ii) More effective cost control is possible under standard costing if the
same is reviewed and analysed at regular intervals for improvements and
immediate action can be taken if deviations from standards are found out
which, ultimately, leads to cost reduction.
(iii) Analysis of variance and its measurement helps to detect inefficiencies
and mistakes which enable the management to investigate the reasons.

(iv) Since standard costs are predetermined costs they are very useful for
planning and budgeting. It also helps to estimate the effect of changes in Cost-
Price-Volume relationship which also helps the management for decision-
making in future.

(v) As standard is fixed for each product, its components, materials, process
operation etc. it improves the overall production efficiency which also
ultimately reduces cost and thereby increases profit.

(vi) Once the Standard Costing System is implemented it will lead to saving
cost sincemost of the costing work can be eliminated.

(vii) Delegation of authority and responsibility becomes effective by

setting up standards for each cost centre as the supervisors or executives of
each cost centre will know the standard which they have to maintain.

(viii) This system also helps to prepare Profit and Loss Account promptly
for short period in order to know the trend of the business which helps the
management to take decisions promptly.

(ix) Standard costing also is used for inventory valuation purposes. Stock
can be valued at standard cost which can reduce the fluctuation of profit for
different methods of valuation for the same.

(x) Efficiency of labour is promoted.

(xi) This system creates cost-consciousness among all employees,

executives and top management which increase efficiency and productivity
as well.

 Disadvantages of Standard Costing

The disadvantages of Standard Costing are:
(i) Since Standard Costing involves high degree of technical skill, it is,
therefore, costly. As such, small organisations cannot, introduce the system due
to their limited financial resources. But, once introduced, the benefits achieved will be far
in excess to its initial high costs.

(ii) The executives are liable for those variances that are found from actions
which are actually controllable by them. Thus, in order to fix up the
responsibilities, it becomes necessary to segregate variances into non-
controllable and controllable portions although that is not an easy task.

(iii) Standards are always changing since conditions of the business are
equally changing. So, standards are to be revised in order to make them
comparable with actual results. But revision of standards creates many
problems, particularly in inventory adjustment.

(iv) Standards are either too liberal or rigid sincethe same are based on
average past results, attainable good performance or theoretical maximum
efficiency. So, if the standards are very high, it will adversely affect the
morale and motivation of the employees.

Standard Costing Budgetary Control

1. It is concerned with the

1. It is concerned with control of costs
operation of business without
or expenses.
interruption.
2. It is a projection of financial
2. It is the projection of cost accounts.
accounts.
3. It does not necessarily
3. It requires standardization of
involve standardization of
products.
products.
4. It should be applied in whole
4. It can be adopted only for a
organisation and cannot be applied for
section also.
only one section or division.
5. Budgeting is necessary for adopting 5. Standard costing is not
 Standard Costing Budgetary Control

necessary for adopting

standard costing.
budgetary control.
6. It indicates the minimum target to be 6. It fixes the ceiling of costs
achieved. or expenses.
7. It is based on past records
7. It is based on technical information.
and future expectations.
8. Standards are set for the expenses 8. Budgets are prepared for
only. income also.
9. It cannot be used for forecasting 9. It can be used for
purpose. forecasting also.
10. It deals with the variances of
10. It deals with total
elements of cost i.e. material, labor,
variances only.
overhead and sales separately.

 VARIANCE ANALYSIS

The primary objective of variance analysis is to exercise cost control and cost reduction. Under
standard costing system, the management by exception principle is applied through variance
analysis. The variances are related to efficiency. The showing of efficiency leads to favorable
variance. In this case, the responsible persons are rewarded.

On the other hand, the showing of in efficiency leads to unfavorable variance. In this case, the
responsible persons are enquired and find the root causes for such unfavorable variances. This
type of findings are used for taking remedial action.

 Meaning of Variance

A variance is the deviation of actual from standard or is the difference between actual and
standard.

 Definition of Variance analysis

I.C.M.A., “Variance analysis is the resolution into constituent parts and explanation of
variances”.

S.P.Gupta, “Variance analysis is the measurement of variances, location of their root causes,
measuring their effect and their disposition”.

Thus, variance analysis can be defined as the segregation of total cost variances into different
elements in such a way as to indicate or locate clearly the cause for such variances and persons
held responsible for them.

 ADVANTAGES OF VARIANCE ANALYSIS

The following are the merits of variance analysis.

1. The reasons for the overall variances can be easily find out for taking remedial
action.

2. The sub-division of variance analysis discloses the relationship

prevailing between different variances.

3. It is highly useful for fixing responsibility of an individual or

department or section for each variance separately.

4. It highlights all inefficient performances and the extent of inefficiency.

5. It is used for cost control.

6. The top management can follow the principle of management by

exception. Only unfavorable variances are reporting to management.

7. Sometimes, the variances can be classified as controllable and

uncontrollable variances. In this case, controllable variances are taken into
consideration for further action.

8. Profit planning work can be properly carried on by the top management.

9. The results of managerial action can be a cost reduction.

10. It creates cost consciousness in the minds of the every

employee of business organization.
 Disadvantages of Variance Analysis:

1. Use Of Standards
The first limitation of variance analysis comes from its use of standards. As a
part of standard costing, companies must establish standards for each cost or
income they incur. However, this process can be lengthy, and any problems
within the process can cause significant deficiencies during variance analysis.
Similarly, companies need to revise their standards continuously to account for
any changes.
2. Lengthy Process
The process of establishing standard costs can be lengthy in itself. However,
companies still need to perform variance analysis on actual performance. The
process can become complicated and lengthy, which is a limitation of variance
analysis. Companies need to consider the time and effort it requires to perform
variance analysis when using the tool.
3. Costly Process
As mentioned, variance analysis requires companies to go through a lengthy
process. It can translate to higher costs for companies. The process of
calculating variances, investigating and then reporting them is complicated.
Companies must use professional employees to complete the process and
come back with results. It can, therefore, increase costs, which can be higher
than the benefits that companies receive from the process.
4. Subjective Interpretation
Once companies calculate variances, they need to investigate them to reach a
conclusion. However, this process may result in subjective interpretations.
Similarly, companies need to establish thresholds for the variances that they
want to investigate. This judgement can also be subjective and may result in
substantial variances to be overlooked or missed.
5. Reactive Approach
Unlike some other tools in management accounting, variance analysis takes a
reactive approach. Therefore, this tool cannot be useful in preventing any
problems. Variance analysis can only detect deficiencies or problems once
they have occurred. While it is still beneficial for companies to do so, it can
also result in significant losses before companies catch the deficiencies.

6. Manipulation Of Data
Variance analysis works through establishing standards that departments
within a company must follow. The problem arises when companies enforce
variance analysis strictly. It can result in data manipulation from departmental
managers who would want to show a favourable variance. Some companies
may also associate bonuses with favourable variances, which can further
motivate managers to manipulate information.
Types of Variances which we are going to study in this chapter are:-
1. Cost Variances
2. Material Variances
3. Labor Variances
4. Overhead Variance
5. Fixed Overhead Variance
6. Sales Variance
7. Profit Variance

1] Cost Variances
A cost variance is a difference between an actual expenditure and the expected (or budgeted)
expenditure. A cost variance can relate to virtually any kind of expense, ranging from
elements of the cost of goods sold to selling or administrative expenses. This variance is most
useful as a monitoring tool when a business is attempting to spend in accordance with the
amounts stated in its budget.

The cost variance formula is usually comprised of two elements, which are:
 Volume variance. This is the difference in the actual versus
expected unit volume of whatever is being measured, multiplied by the
standard price per unit.

 Price Variance. This is the difference between the actual versus the
expected price of whatever is being measured, multiplied by the standard
number of units.

When you combine the volume variance and the price variance, the combined variance
represents the total cost variance for whatever the expenditure may be.

2] Material Variances
The difference between the standard cost of direct materials and the actual cost of direct
materials that an organization uses for production is known as Material Variance.

Material Cost Variance Formula:

Standard Cost – Actual Cost

In other words, (Standard Quantity x Standard Price) – (Actual Quantity x Actual Price)

Material Variance is further sub-divided into two heads:

 Material Price Variance:
MPV = (Standard Price – Actual Price) x Actual Quantity
 Material Usage Variance:
MUV = (Standard Quantity – Actual Quantity) x Standard Price
 Material Usage Variance:
Material yield variance = (Actual unit usage - Standard unit usage) x Standard cost per unit
 Material Usage Variance:
Material yield variance = (Standard output × Standard cost) – (Actual output ×
Standard cost)

Or

Material yield variance = (Actual quantity used × Standard cost) – (Standard

quantity allowed for actual output × Standard cost)
Problem 1: Sanrare Perfumery Ltd. provides the following information from
their records:

The standard material requirements for 10 kg. of a product are :

During March, 1999, 100 kgs. of the product were produced. The actual consumptions of materials
were as under:
under:
Calculate:
(i) Material Cost Variance

(ii) Material Price Variance

(iii) Material Usage Variance

Problem 2:
The Standard Material cost to produce a tonne of chemical is:
300 kgs. of material A @ Rs.10 per

kg. 400 kgs. of material B @ Rs. 5

per kg. 500 kgs. of material C @ Rs.

6 per kg.

During a period, 100 tonnes of mixture X were produced from the usage of:
35 tonnes of material A at a cost of Rs.9,000 per tonne

42 tonnes of material B at a cost of Rs.6,000 per tonne

53 tonnes of material C at a cost of Rs.7,000 per tonne

Calculate material price, usage and mix variances.

1. Material Cost Variance:

Standard Cost for Actual Quantity – Actual Cost

= Rs.8,00,000 – Rs.9,38,000 = Rs.1,38,000 (A)

2. Material Price Variance = AQ (SP – AP):

3]Labour Variances:
Labor Variance arises when there is a difference between the actual cost associated with a
labour activity from the standard cost.

Labor Variance Formula: Standard Wages – Actual Wages

In other words, (Standard Hours x Standard Rate) – (Actual Hours x Actual Rate)
Labor Variance is further sub-divided into two heads:
 Labor Rate Variance:
LRV = (Standard Rate – Actual Rate) x Actual Hours
 Labor Efficiency Variance:
LEV = (Actual Hours – Standard Hours) x Standard Rate
 Labour Yield Variance:
This variance arises on account of the difference between Standard Yield and Actual Yield :
Labour Yield Variance = (AY – SY) x SLC per unit
Labour Mix. Variance:
Labour Mix. Variance = (Revised Hours – Actual Hours) x

S.R. Revised Hours will be calculated:

RH = Actual Hours x Standard Mix Ratio. Alternative Approach Labour Cost Variances
Problem : 3
Calculate variances from the following data:
4]Overhead (Variable) Variance:
Variable Overhead Variance arises when there is a difference between the actual variable
overhead and the standard variable overhead based on budgets.

Variable Overhead Variance Formula:

Standard Variable Overhead – Actual Variable Overhead
In other words, (Standard Rate – Actual Rate) x Actual Output

Variable Overhead Variance is further sub-divided into two heads:

 Variable Overhead Efficiency Variance:
VOEV = (Actual Output – Standard Output) x Standard Rate
 Variable Overhead Expenditure Variance:
VOEV = (Standard Output x Standard Rate) – (Actual Output x Actual Rate)

Problem 4:
Calculate variable overhead variance from the following information:

Particulars Standard Actual

Output in units 2500 Units 2000 Units

Labour (Hrs) 5000 Hrs 6000 Hrs

Variable overhead ₹1000 ₹1500

1. VOCV=
  ( Actual Output in Units * Standard Rate Per Unit ) – ( Actual output * actual rate
per unit )
= (2000*1000/2500)- (2000*1500/2000) = (2000*0.4)- (2000*0.75)= 800 – 1500 =  700A
A means Adverse for Unfavourable amount and For Favourable Amount “F” word .

2. VO Expenditure Variance= (Actual Total Time *Standard Rate Per Hour)- (Actual
output * actual rate per hour)
= ( 6000 * 1000/5000 ) – (2000 * 1500/6000) =  1200-1500 = 300A
3. VO Efficiency Variance = (Actual output* Standard Rate Per unit)- (Actual hour*
Standard Rate Per hour)
=         ( 2000*1000/2500)- (6000*1000/5000)  = 800-1200= 400A

Verification ~ Cost = Exp + Efficiency

                  700A  = 300A + 400A

5]Fixed Overhead Variance

It arises when there is a difference between the standard fixed overhead for actual output and
the actual fixed overhead.

Fixed Overhead Variance Formula:

= (Actual Output x Standard Rate per unit) – Actual Fixed Overhead

Fixed Overhead Variance is further sub-divided into two heads:

 Fixed Overhead Expenditure Variance:
FOEV = Standard Fixed Overhead – Actual Fixed Overhead
 Fixed Overhead Volume Variance:
FOVV = (Actual Output x Standard Rate per unit) – Standard Fixed Overhead

Problem 5:

Calculate the fixed overhead volume variance using the following figures:
Budgeted Fixed Overheads $50,000
Budgeted Units 10,000
Actual Units Produced 10,700

Solution
FOH Application Rate
$50,000
= = $5 per unit
10,000
Applied Fixed Overhead
= 10,700 × $5
= $53,500
Fixed Overhead Volume Variance
= $53,500 – $50,000
= $3,500 Favorable

6]Sales Variance:
Sales Variance is the difference between the actual sales and budgeted sales of an
organization.

Sales Variance Formula: -

(Budgeted Quantity x Budgeted Price) – (Actual Quantity x Actual Price)

Sales Variance is further sub-divided into two heads:

 Sales Volume Variance:
SVV = (Budgeted Quantity – Actual Quantity) x Budgeted Price
 Sales Price Variance:
SPV = (Budgeted Price – Actual Price) x Actual Quantity

Problem 6:

John Trading Co. Furnishes the following details for January 2019:

Budgeted Sale Product Sales Qty. Sales Price per unit

A 1,200 15

B 800 20

C 2,000 40

Actual Price

A 880 18

B 880 20
 C 2,640 38

Required:
Calculate the following variances:
(i) Sales Quantity Variance, (ii) Sales Mix Variance, (iii) Sales Price Variance, (iv) Total
Sales Variance

Solution:
Basic Calculations

Budget Actual

Product
Qty. Qty.
Rate ($) Amount ($) Rate ($) Amount ($)
(unit) (unit)

A 1,200 15 18,000 880 18 15,840

B 800 20 16,000 880 20 17,600

C 2,000 40 80,000 2,640 38 1,00,320

Total 4,000 1,14,000 4,400 1,33,760

Calculation for standard sales

Product Actual Qty. (A) Budgeted Price (B) Standard Sales ($)(A x B)

A 880 15 13,200
 B 880 20 17,600

C 2,640 40 1,05,600

4,000 1,36,400

Calculation for revised standard quantity

Revised Standard Qty. = (Total AQ / Total SQ) x St. quantity
A = (4,400 / 4,000) x 1,200 = 1,320
B = (4,400 / 4,000) x 800 = 880
C = (4,400 / 4,000) x 2,000 = 2,200
Calculation for variances
(i) Sales value variance
= Actual sales – Budgeted sales
= 1,33,760 – 1,14,000 = $19,760 (F)
(ii) Sales price variance
= (AP – SP) x AQ
A = (18 – 15) x 880 = $2,640 (F)
B = (20 – 20) x 880 = Nil
C = (38 – 40) x 2,640 = $5,280 (A)
Total = $2,640 (A)
(iii) Sales volume variance
= (AQ – BQ) – SP
A = (880 – 1,200) x 15 = $4,800 (A)
B = (880 – 800) x 20 = $1,600 (F)
C = (2,640 – 2,000) x 40 = $25,600 (F)
Total = $22,400 (A)

7]Profit Variance
Profit variance is the difference between the actual profit experienced and the budgeted profit
level. There are four types of profit variance, which are derived from different parts of the
income statement. They are:
 Gross profit variance. This measures the ability of a business to
generate a profit from its sales and manufacturing capabilities, including all
fixed and variable production costs.
 Contribution margin variance. This is the same as the gross profit
variance, except that fixed production costs are excluded.
 Operating profit variance. This only measures the results of operations;
it excludes all financing and extraneous gains and losses. This variance provides
the best view of how the core operations of a business are functioning.
 Net profit variance. This is the most commonly-used version of the
profit variance. It encompasses all aspects of a company’s financial results,
without exception.