Standard costing, its role in performance appraisal and cost control 1. Introduction: The information in budgets is based on expectations of future costs and revenues. The costs which are expected to be incurred in manufacturing a specific given product, or performing a specific given activity, are known as standard costs. However, these costs are more than just expectations; they are also short-term goals that the business should achieve in order to meet its objectives (because the budget is a plan for doing this), and therefore standard costs act as targets or limits for management to aim for. Budgets are quantified plans and detailed expectations about future performance. Once some part of the budget period has elapsed we are able to compare the original budget (prepared in the past), to the actual performance to date. If actual performance differs from expected, we need to understand why so that we can take corrective action or adjust our expectations for the remainder of the period (as necessary). The use of budgets (and the standard costs on which they are based) to provide targets for motivation in this way is a rich area of behavioural research in accounting. We will see that these issues are important when attempting to interpret the meaning of variances you have calculated, as it is necessary to assign responsibility for deviations from budget fairly and appropriately. 1.2 Standard costing for performance evaluation: As variances are often related or have common causes, this complicates the evaluation of management performance relative to budget. It would be unfair to punish or reward a manager on the basis of a variance for which he or she was not responsible. What behavioural implications do you think using a variance – over which the manager has no control, for his or her performance evaluation – might have? Standard costing is a technique to evaluate the performance of executive staff using variance analysis. More obviously, standard costing per unit is calculated according to direct material, direct labor, and overheads. So, material, direct labor and factor overhead variances help to check staff performance. For example, production manager and purchasing manager are responsible for production quantity variance. There should be clarification whether production manager lacks in controlling their employees not to waste materials or purchasing manager bought cheap materials. Another example is direct labor variance. If the actual labor time is more than initially estimated standard time. There should be clarification if the employees do not work in time, or they are not qualified enough to complete their task. 1.3 Standard costing for cost control: The information in budgets is based on expectations of future costs and revenues. The costs which are expected to be incurred in manufacturing a specific given product, or performing a specific given activity, are known as standard costs. However, these costs are more than just expectations; they are also short-term goals that the business should achieve in order to meet its objectives (because the budget is a plan for doing this), and therefore standard costs act as targets or limits for management to aim for. The process of setting the level of standard costs can raise awareness of costs throughout the business, and may lead to cost reductions. Standard costs are usually presented in the form of a standard cost card or schedule. These cards break down the costs of each unit of output into its component parts.The card is based on the assumption of a given level of output; without this assumption, it would not be possible to calculate the amount of fixed overhead to be absorbed into each unit of product.1 The cost card also gives us information about the standard quantities of inputs such as direct materials and labour, required to produce each unit. Finally, the cost card also tells us the expected sales price per unit, and the expected contribution and profit to be made from each unit.There are a number of different ways in which standard costs may be set and the costs will be unique to each organisation. They may be based on past experience as well as future expectations, or may be assessed entirely from scratch. As standard costs represent targets they may sometimes be set at a level which reflects long-run expectations or requirements based on perfect efficiency in the business. These types of standard costs may be known as ideal, because they are the ultimate limit for the business. However, ideal costs are rarely achievable in practice. 1.4 Variance Analysis: Budgetary control involves the following steps: 1. preparation of a budget 2. recording actual achievements 3. investigation of differences where necessary, taking action and/or revising the budget. The idea is to learn lessons from past events in order to influence, and hopefully improve, future performance, planning and decision-making. The differences that are observed between the original budget and actual performance are called variances. The overall difference between budgeted profit and actual profit, is broken down into smaller differences in order to help identify its causes. The causes of different variances are often related, so it is best to wait until all of the variances have been calculated before trying to interpret them. Favourable variances arise when actual performance is better than expected. For example, when more units have been sold, or when materials costs per unit are lower, than expected. Unfavourable (or adverse) variances arise when actual performance is worse than expected. A favourable variance may be directly related to an unfavourable variance. For example, more units may have been sold than expected (favourable), but only because the price at which they were sold was lower than expected (unfavourable). Other variances may also be affected. For example, labour costs may have been higher than expected (unfavourable) due to overtime payments necessary to produce the higher level of output outside normal working hours. Variances are presented in the form of an operating statement which reconciles the original budgeted profit, to the actual profit that has been achieved. Variance analysis is the process of identifying costs and revenues that differ from those that were expected or planned (the standard costs and revenues). Ultimately, the aim is to understand how and why the actual profits achieved differ from the budgeted profit. Some of the differences may arise purely because the actual level of output is different from the budgeted output. Other differences may arise because more or less of a particular resource (e.g. materials, labour, or overheads such as electricity) was needed to produce each unit of output than expected. Yet more differences may be the result of the input or sales prices being more or less than expected. Different variances are calculated to quantify each of these differences separately. So, to calculate one particular variance, we only consider the effect of one specific difference between actual performance, and the budget. In particular, in order to keep differences that are the result of changes in output volume relative to budget separate from differences in inputs and prices/costs, we need to flex the budget. Flexing the budget recalculates the original budget, which was based on the original expected output level, to reflect the actual output level that has been achieved. This allows us to compare actual sales revenue, input quantities and costs to the standard sales revenue, input quantities and costs, which would have been incurred according to budget, without getting confused by the differences in output level. The variances that we calculate to quantify the effects of these differences are known as price, efficiency (usage) or spending variances. Of course, the differences in output level also matter because we are still trying to understand how the original budgeted profit differs from the actual profit, so we also calculate separate variances to quantify these effects, which are known as volume variances. How many volume variances are calculated depends on the type of sales volume variance which we calculate. The total volume variance represents the additional profit that the business should have earned from the increase in output, if all other expectations had been met. This means that the business has in fact done worse in terms of sales prices, input quantities and input costs, than it would appear from simply looking at the overall total variance between the actual profit, and the original budgeted profit. 1.5 Sales variances: In the case of sales, we calculate both a price variance and a volume variance. We have a choice of two different volume variances to calculate. Depending on which one we calculate, we may or may not also need to calculate a fixed overhead volume variance. If we calculate the sales contribution volume variance, this will be equal to the total volume variance, so we do not need to calculate the fixed overhead volume variance. The price variance reflects the difference between the standard selling price for each unit (from the original budget), and the actual selling price achieved (from the actual results). Sales price variance = Actual quantity sold × Actual price per unit – Actual quantity sold × Standard price per unit = AQ × AP – AQ × SP The two different volume variances are calculated as follows: Sales contribution volume variance = Actual quantity sold × Standard contribution per unit – Standard quantity sold × Standard contribution per unit = AQ × SC – SQ × SC Sales margin volume variance = Actual quantity sold × Standard profit margin per unit – Standard quantity sold × Standard profit margin per unit = AQ × SM – SQ × SM Because we want to isolate the effect of just the change in output, we make sure this time that we keep either the contribution per unit, or the profit margin per unit (depending on which version we are calculating), constant. If the difference calculated is positive, then the actual quantity (AQ) is higher than the expected quantity (SQ), so the business has been able to sell more units, and the variance is favourable (F). If the difference is negative, then the variance is adverse (A). We should only calculate one of these sales volume variances. If you are asked to calculate two variances for each category, then you should calculate the sales margin volume variance, as this will mean that you also need to calculate the fixed overhead volume variance. 1.6 Price and efficiency variances for variable costs: As well as sales, we can calculate two variances for each category of input costs. These will be separated into price variances which quantify the impact of changes in the prices of resources such as labour, materials or variable overheads, and efficiency (or usage) variances which quantify the impact of changes in the standard quantities of these resources used per unit of output.8 The idea is the same for each category of variable cost. Here are the calculations for materials: Materials price variance = Actual quantity used x Actual price – Actual quantity used × Standard price = AQ × AP – AQ x SP Materials efficiency variance = Actual quantity used × Standard price – Standard quantity that would have been used for actual output × Standard price = AQ × SP – SQ × SP Please note that the quantities used for these calculations are the quantities of the resource, not the quantities of output. Similarly, the prices used for these calculations are the prices per unit of the resource, not the prices per unit of output. So, if materials quantities are expressed in terms of kilograms, the quantities would be in numbers of kilograms, and the prices would be the price per kilogram. To calculate the variances for labour (and usually also for variable overheads), quantities and prices will be expressed in terms of hours. If these price variances are positive, they must be adverse (A), because the actual price paid must be higher than the standard price. If the efficiency variances are positive, they must similarly be adverse (A), because the actual quantity of resource used must be higher than the standard quantity would have been. Conversely, if the variances are negative, they must be favourable (F). 1.7 Fixed overhead variances Although we can calculate two variances for fixed overheads, only the spending variance is meaningful for control and decision-making purposes. The fixed overhead volume variance, which we need to calculate only if we have previously calculated the sales margin volume variance, merely reflects the accounting implications of changes in output level to the absorption of fixed overheads, at a predetermined rate, into product costs. By definition, fixed costs should not vary with output. Therefore, any difference between the original budget for fixed costs, and the actual amount of fixed costs, is not due to changes in output volume. The two variances are calculated as follows: Spending variance = Actual fixed overhead expense – Original budgeted fixed overhead expense = AC – SC Fixed overhead volume variance = Budgeted fixed overhead expense – Applied fixed overhead expense = SC – Actual output × SP/unit Because the purpose of variance analysis is to reveal how actual profit differs from the expected profit (in order to investigate the causes of differences and take corrective action where necessary), it is useful to present variances in the form of an operating statement. An operating statement is a formal reconciliation of the actual, to the original budgeted profit. Remember that adverse variances indicate worse performance than expected, whereas favourable variables indicate better performance than expected. 1.8 Limitations of standard costing: Firstly, it can be too costly to implement for small business since it requires additional skilled staff. Moreover, it is time consuming to develop standards. Business environment is changing fast. Hence, there should be frequent review of standards which takes a lot of time. Unfortunately, it is not always possible to establish ‘standards’ in a scientific or objective way. How long it should take to do a particular piece of work is often disputed. Moreover, it is not clear on what basis standards should be established, and the following are sometimes suggested: 1. Ideal standards, which are a very high target to aim for. It assumes working under ideal conditions with no wastage or hold-ups. In theory this may be what is aimed for, but it can be very demotivating if standards are set that are more like targets that cannot realistically be attained. 2. Attainable standards, which are stretching, but make some allowance for inevitable inefficiencies. 3. Current standards are based on what is currently happening with no expectation of significant improvement. These provide a realistic basis for planning, decision-making and valuing inventories. 4. Basic standards remain the same for long periods of time and can be useful for comparing efficiency from year to year. Standard costs are sometimes discredited, especially when they are used as a basis for remuneration, and some people find ways around them. It is necessary to keep standards current, alive and real otherwise they can become discredited and unrealistic. When there are significant changes in the costs of raw materials and components, it is always a problem to know how often to change standards. Standard costing has tended to concentrate on direct materials and direct labour, but in modern manufacturing production, overheads are often much greater than direct costs, and are more difficult to control. The need for just-in-time manufacturing has also tended to de-emphasize standard costing. There is a need for continuous improvement across the board, rather than aiming for standards that are sometimes out of date and not very soundly based. 1.9 Conclusion: Once we have calculated some variances, it is always possible to say something about them, even if it is little more than identifying the most important (the largest) ones. Small variances are not usually worth investigating as the costs of doing so could easily exceed the benefits, so you can also identify those variances that you feel are too small to worry about in your comments. A good starting point for any discussion is the total variance between actual and budgeted profit, as whether this is favourable or adverse could set the tone for your remaining comments. It is important to try to suggest reasons for the variances you observe whenever possible, and also to show that you understand how the different variances may be related to each other by trying to link them together. If you can suggest a coherent story that fits with more than one result, it is more likely to be true, and will show that you understand the relationships between different areas of the business. Standard costing is still widely used in manufacturing organizations, although it is seen as being a traditional technique, and has been much criticized. It can also be used in a range of professional and service organizations. The idea of establishing a standard, what something should cost, is inherently appealing, and provides a basis for control information. Once standards and budgets are established; it is possible to calculate ‘variances’ showing how actual performance differs from what it should be. Variance analysis provides a systematic approach to explaining differences. It does not provide all the answers; it points to where further investigation is likely to prove fruitful.
