Standard Costing and Variance Analysis

Standard Costing and Variance Analysis

Having understood the operational aspects of standard costing, let us now understand the process of variance analysis. The variance can be explained as a gap (deviation) between actual cost and standard cost. This can also be called as difference between the two.

If actual cost is lesser than standard cost or the actual outcome is favorable than the standard one, it is called favorable variance. However, on the other side, if actual cost exceeds the standard cost or actual outcome is not up to the required standards, it is called unfavorable or adverse variance.

Remember: The variances may be analyzed with respect to various elements of costs, sales and profit.

• Material cost variances
• Labor cost variances
• Overhead variances
• Sales variances
• Profit variances

The variances in actual and standard costs can happen on account of following:

• Variance on account of functions, such as cost function, profit function and sales function.
  
  
• Variance in relative terms, for example, difference between actual and standard cost in unit terms or percentage terms. It can be absolute term when difference in standard cost and actual cost is measured in money terms.
  
  
• Variance can be favorable or unfavorable as explained earlier.
  
  
• Variance may be controllable when the decision of management can affect the cost control. It can also be non-controllable variance if it cannot be controlled due to external factors.

Now let us understand the measurement of variances in detail.

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Material Cost Variance

It is the difference between the standard cost of materials that were planned to be used and the cost of materials actually used. The standard cost of material can be achieved depending on the standard quantity of materials used for actual production, but it has to be valued at the pre-determined standard prices.

Suppose, standard quantity required for production of 1,000 units of a product was 10,000 kg of raw material at a standard price of Rs. 10 per kg, but actual production was 1,100 units for which standard quantity should have been 11,000 kg and standard cost of raw materials considering standard price could have been Rs. 1,10,000 (11,000 kg × Rs. 10 standard price). However, the actual price paid to purchase 11,000 kg material would have been different, either Rs. 10.50 or Rs. 9.80. Therefore, this will result in variance between standard cost of raw materials and actual cost of raw materials.

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Material Price Variance

As explained earlier, this variance occurs due to the difference between the standard price already fixed and the actual price paid for the quantity used. If the actual price is higher than the standard price, it would result in unfavorable price variance and if the actual price is lower than standard price, it will result in favorable price variance. We may use the following equation for determining material price variance:

Material price variance = Actual quantity used × (Standard price – Actual price)

Material price variance may happen on account of any of the following reasons:

• Variations in the market price than the standard price.
  
  
• Change in quantity actually purchased in comparison to standard quantity required.
  
  
• Purchase of non-standard materials as per the need.
  
  
• Higher or lesser carrying cost than the budgeted one.
  
  
• Inefficient purchase policy of the firm.
  
  
• Difference in actual purchase discounts than expected.
  
  
• Other external reasons, such as inflation and scarcity of raw materials.

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Material Usage (Quantity) Variance

Material usage variance may happen on account of difference between the standard quantity planned for production initially and actual quantity used for production. This is already explained earlier as the quantity planned to purchase was 10,000 kg, but actual quantity purchased was 11,000 kg. This resulted in material usage variance. We may use the following equation to ascertain the material usage variance:

Material usage variance = Standard price × (Standard quantity – Actual quantity)

Material usage variance may happen on account of any of the following reasons:

• Higher or lower wastage on account of leakages, evaporation, etc., in storage as compared to expected quantity losses.
  
  
• Difference in the quality of materials actually purchased as compared to planned quality of materials. It may be either superior quality or inferior quality.
  
  
• Higher or lesser wastage on account of scrap, normal wastage, spoilage, etc., than the standard quantity of wastage.
  
  
• Improper upkeep of materials resulting pilferage of materials.
  
  
• Theft and leakages of materials due to improper security arrangements at the storage.
  
  
• The standards set might not be correct.
  
  
• Technological reasons resulting in higher or lesser consumption of materials.
  
  
• Inefficient handling of materials in the production process.

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Material Mix Variance

Material mix is the phenomenon when a firm uses more than one material in a product. Suppose three different kinds of materials are used to produce a final product called “A.” This mix is already decided, which is known as standard mix. We can presume that three materials required have a standard mix of 30%, 30% and 40%, respectively. However, when the mix is actually used in the production process, it is not the same.

It might differ to 30%, 35% and 35%, respectively. This will create variation in the materials cost as all the materials have different prices. Therefore, when there is a difference in standard mix and actual mix of quantity of materials used, it results into the material mix variance. The material mix variance can be ascertained with the following equation:

Material mix variance = (Standard cost of actual mix at standard rate of mix) – (Actual cost of actual mixture)

= Standard price × (Actual quantity in standard mix [known as RSQ] – Actual quantity)

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Material Yield Variance

Material yield variance is the difference between standard yield (output) that could have been obtained using actual quantity of materials as per pre-decided standards and actual output obtained. This can be understood through an example. Suppose, if 1,000 kg of raw material is used, the standard output is 950 kg.

However, the actual material used is 1,100 kg. In this case standard output should have been 1,045 kg (1,100 × 95/100). However, the actual output might be different and this causes material yield variance. We can calculate the material yield variance through the following equation:

Material yield variance = Standard cost of material per unit of output (Standard output for actual inputs of raw material – Actual output)

Standard cost of material per unit of output = Total cost of actual output at standard price / Standard output for actual inputs

Finally, we can summarize the material cost variance as:

• Material cost variance
  • Material price variance
  • Material usage variance
    • Material mix variance
    • Material yield variance

Remember: Material cost variance can mainly occur on account of differences either in standard price and actual price of raw materials or variation in usage of actual quantity and standard quantity of raw materials. Similarly, material usage variance can occur only on account of either difference between standard mix and actual mix of raw materials or variation in standard and actual output.

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Labor Cost Variances

Labor cost variance is the difference between the standard direct labor cost and actual direct labor cost. The labor cost basically has two components, one the wage rate and other the time taken (labor hours) to complete a unit of product. Therefore, labor cost has two major variances: labor wage rate variance and labor efficiency variance. Let us understand these two terms.

Labor Rate Variance

When there is a difference between standard wage rate per hour and actual wage rate per hour, it causes labor rate variance. For example, if the standard wage rate per hour to a non-skilled labor is Rs. 10 per hour, and the actual wage rate paid is Rs. 10.75 per hour, it will result in adverse labor rate variance as the actual labor cost will be more than the standard labor cost. It may also be vice versa when the actual wage rate paid is lesser than the standard. Labor rate variance can be calculated through the following equation.

Labor rate variance = Actual labor time worked × (Standard wage rate – Actual wage rate)

Labor rate variance may occur on account of following reasons:

• Change in labor mix than the pre-determined standards, may be on account of shortage of labor in a particular category, labor sitting idle for want of materials and other equipment.
  
  
• Rise in wage rates due to inflation or wage rate policy of the government such as minimum wages act.
  
  
• Hike in wage rate due to overtime work where the wage rate is higher or working in night shifts. In both the cases, the actual wage rate will be higher than the standard.
  
  
• Improper allocation of job among the workers.
  
  
• Policy changes in the incentive schemes to be provided to the employees.
  
  
• Increased idle labor time due to external factors, such as power failure and machine breakdown.

Labor Efficiency Variance

Labor efficiency is measured in terms of labor productivity. The workers are required to produce a product in a pre-determined time known as standard labor time. However, the actual time to produce a product may be higher or lower than the standard time. In such a scenario, labor efficiency variance will occur. The labor efficiency variance may be ascertained through the following equation:

Labor efficiency variance = Standard wage rate × (Standard labor hours – Actual labor hours)

The labor efficiency variance may arise on account of the following reasons:

• More wastage of time due to lack of proper monitoring and supervision.
• Inefficiency of labor productivity may be on account of adverse working conditions.
• Higher number of labor turnover.
• Power failure or any other unexpected event such as machine breakdown.
• Frequent interruptions in the production process.
• Lack of trained and skilled workforce.
• Ineffective co-ordination among different units

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Idle Time Variance

The idle time can be defined in terms of time spent by workers without any productivity or we can say remaining idle without any work. Thereare standard norms for idle time as a firm needs to give required time for tea break, natural calls, etc., to the workers, and this is known as standard idle time. Obviously, the cost of idle time is included in the production process itself. However, there may be occasions where workers actually spend more time without work.

This is known abnormal idle time. This may happen for two reasons: either a deliberate attempt to waste more time by workers or due to external factors on account of power failure or machine breakdown. It is the abnormal idle time that needs to be calculated for variance purpose. This variance is always unfavorable. This can be calculated as follows:

Idle time variance = Abnormal idle time × Total man hours × Standard wage rate per hour

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Labor Yield Variance

Just like material yield variance, there is also labor yield variance. This happens on account of difference in standard yield in given number of work hours and actual yield obtained in actual work hours. Suppose a product requires 2 hours to produce and in a particular process workers worked for 1,200 hours.

As per the standards, the output in given number of hours would have been 600 units. However, the actual output may differ. It may be either higher or lower than the required as per standard. This difference between actual and standard causes variance, may be favorable or unfavorable.

This variance can be obtained through the following equation:

Labor yield variance = (Standard yield in units expected from the actual hours worked – Actual yield) × Standard labor cost per unit

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Labor Mix Variance

The different composition of workers comprising skilled, semi-skilled, unskilled, man and woman is known as labor mix. The firm may have pre-determined standards of labor mix among various groups. The actual mix may differ at the time of production. This causes variation due to change in composition of workers as the wage rate for different groups are different and therefore affect the costs. The changes in workers composition may occur on account of non-availability of required number of workers in a particular category or change in a firm’s policy to change the composition in view of cost considerations.

This could be ascertained through the following equation:

Labor mix variance = (Revised standard hours – Actual hours) × Standard rate per hour

The revised standard hours can be calculated as follows:

Revised standard hours = Standard hours for the particular composition/ Total standard hours × Total actual hours

Remember: The labor cost variance is sum of labor rate variance and labor efficiency variance. Then labor efficiency variance occurs on account of labor yield, variance, idle time variance and labor mix variance (Fig). Following are the equations for labor cost variance:

Labor cost variance = Labor rate variance + Labor efficiency variance

Labor efficiency variance = Idle time variance + Yield variance + Labor mix variance

On the basis of these equations, we can self-check the accuracy of the variance analysis.

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Overhead Variances

As we have already discussed, overheads are indirect costs associated with a product, which are absorbed based on certain criteria. A firm has standard overhead rate that is fixed for a particular product. The standard overheads are compared with the actual overheads. The overheads are further categorized into two categories: fixed and variable overheads. The fixed overheads may be pre-determined depending on capacity of production. The variable overheads can be fixed on per unit basis.

We can observe variance in overheads also as actual overheads may be different from the standard overheads. It may happen on account of lesser or higher output than budgeted. Since overheads are variable and fixed in nature, overhead variance can be calculated separately for fixed and variable overheads. The overhead variance occurs on account of fixed and variable overhead variances. Both variances are influenced by expenditure and volume variances.

• Total overhead variance
  • Variable overhead variance
  • Fixed overhead variance
    • Expenditure variance
    • Volume variance
      • Efficiency variance
      • Capacity variance
      • Calendar variance

Variable Overhead Variance

This variance could be obtained on account of difference between the standard variable overheads and absorbed variable overheads. This can be a favorable or unfavorable variance depending on variable overhead absorbed to actual output is more or less than the pre-determined standards. Overhead variance is the difference between the amount calculated at standard rate of variable overhead and the amount calculated at actual rate of variable overhead on the actual output.

We can ascertain overhead variance through the following equation:

Overhead variance = AO (SR – AR)

= (AO × SR) – (AO × AR)

= SVO – AVO

where AO = actual output, SR = standard rate, AR = actual rate, SVO = standard variable overhead and AVO = actual variable overhead.

Variable overhead variance indicates the difference between the variable overhead expenses actually recovered for actual output as per the standard rate and the actual variable overhead expenses incurred in the production process.

We can also explain variable overhead variance as follows:

Variable overhead variance = (Standard variable cost per unit × Actual output) – Actual output

= (Standard hours × Standard variable overhead rate per hour) – (Actual hours × Actual variable overhead rate per hour)

The variable overheads can be further categorized as explained in the following sections.

Variable Overhead Spending (Expenditure) Variance

This will vary with direct labor hours of input that is budgeted and actual labor hours. The actual variable overhead spending may be different from the budgeted variable overhead spending. This will cause variance either favorable or unfavorable. This can be calculated as follows:

Variable overhead spending variance = (Actual hours × Standard variable overhead rate per hour) – (Actual hours × Actual variable overhead rate per hour)

Variable Overhead Efficiency Variance (VOEV)

As the name suggests, efficiency variance measures the efficiency of labor hours working with the standard output. Therefore, the variation between the actual hours used to complete the work and the standard hours required to complete the work may vary. This certainly indicates the efficiency or inefficiency. The efficiency can be measured in terms of cost savings or excess cost incurred.

We can calculate the variance as follows:

Variable overhead efficiency variance = (Standard hours allowed for actual output – Actual hours used for actual output) × Standard variable overhead rate per hour = (Actual output hours × Standard per unit) – (Actual hours × Standard variable overhead recovery rate)

The variable overhead efficiency variance can occur on account of labor efficiency or inefficiency due to various factors, such as workers grievances, inappropriate incentive plans, faulty work process, frequent machine faults and inferior materials quantity.

Fixed Overhead Variance

Fixed overhead variance is caused due to over-absorption or underabsorption of fixed overheads. The fixed overheads are not affected by the volume of output as it remains the same. Fixed overhead variance occurs on account of difference between standard fixed overhead and actual fixed overhead on the actual output.

Fixed overhead variance = TSC – TAC or [AO × SFO] – [AO × AFO] or TSO – TAO

where TSC = total standard cost for actual output, TAC = total actual cost, AO = actual output, SFO = standard fixed overhead, AFO = actual fixed overhead, TSO = total standard overhead and TAO = total actual overhead.

The fixed overhead variance may be further sub-divided into expenditure variance and volume variance.

Expenditure or Spending Variance

There are fixed overheads charged as an expense for a particular time period. These remain unchanged during a short span of time. Fixed overhead expenditure variance explains the difference between the amount actually spent during a certain period as fixed overhead and the amount of fixed overhead budgeted for the period. Through the fixed overhead cost variance analysis, we can analyze if the actual amount of fixed overhead is lesser or higher than the amount already budgeted.

We can calculate the variance through the following equation:

Expenditure variance = Budgeted fixed overhead – Actual fixed overhead

Volume Variance

Volume relates to measurement of output. This variance may be caused mainly due to the difference between budgeted output and actual output. To arrive at this variance, we may find out the difference in budgeted output and actual output and then multiply it by the standard fixed overhead absorption rate. This variance indicates the over-absorbed overhead or under-absorbed overheads may be on account of the difference in budgeted level of output and actual level of output.

We can calculate this variance through the following equation:

Volume variance = SC (AQ – BQ)

where SC = standard cost per unit of fixed overheads, AQ = actual output in actual hours worked and BQ = budgeted standard output planned in budgeted standard hours.

The volume variance may occur on account of labor efficiency or inefficiency resulting in higher or lower output than the budgeted. Also, the number of hours available for working may be lesser or higher than the planned hours in the budget.

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Sales Variances

So far we have done analysis of different cost variances to ascertain the difference and take needed measure to control the costs within the predetermined standards. Now, we will understand sales and profit variances. The sales variance occurs on account of selling price, and the selling price depends on the cost of product per unit. Therefore, a firm may understand the consequences and implications of cost variances on the selling price and sales volume.

Further, sales and volume of profit are also interlinked; therefore, to have a better understanding, an analysis of variances between the actual profit and the standard profit is also necessary. On the other hand, it is equally important to make an analysis of sales variances to measure the profit variance as we know that the profit is the difference between sales and cost. Therefore, this analysis becomes more significant.

The sales volume variance takes place on account of changes in selling price and sales volume as against the standards. The actual sales and price can either be on the lower or higher side which causes variations. The sales volume variance again may occur on account of changes in actual sales mix and sales sub-volume as compared to standards.

This has been explained in Figure.

Remember: Sales value variance measures the difference between actual sales value and planned sales value. This difference again may occur on account of two factors, one there may be difference in actual selling price and standard selling price and two there may be a variation in planned sales volume and actual sales volume.

Further, the sales volume may be affected by another two factors, one there may be difference in actual sales mix and standard sales mix and two there may be difference between actual sales sub-volume and planned sales sub-volume. We will now understand all these factors in detail.

Sales Value Variance

As already explained, sales value variance is the difference between the planned value of sales and actual value of sales in a given time period. A firm should make all efforts to measure this gap and further analyze the reasons for the variations. We can calculate the sales value variance through the following equation:

Sales value variance = Actual value of sales – Standard value of sales

Sales value variance can be favorable or unfavorable, and this may arise on account of following reasons:

• There may be a difference in standard selling price and actual selling price which may be higher or lower than the pre-determined standard price. Obviously, this will cause variation in sales total sales value.
  
  
• Further, the actual quantity of goods sold may also vary than the planned one which could be higher or lesser. This will also cause variance in sales value.
  
  
• As already mentioned, there may be a difference in actual sales mix and the standard sales mix. The sales mix can be explained in terms of combination of different products/varieties produced by a firm.

Sales Price Variance

Sales price variance can be explained in terms of difference in actual sales price and budgeted sales price. This will cause difference in actual sales value as compared to planned sales value. We can calculate the sales price variance through the following equation:

Sales price variance = Actual quantity sold × (Actual price – Standard price)

It will be favorable if actual selling price is higher than the standard selling price and vice versa. The actual selling price depends on market conditions and other external factors. Therefore, this variance is common.

Sales Volume Variance

Sales volume variance can be explained in terms of difference in actual quantity of sales and budgeted quantity of sales. This will cause difference in actual sales value as compared to planned sales value. We cancalculate the sales volume variance through the following equation:

Sales volume variance = Standard price × (Actual quantity of sales – Standard quantity of sales)

It is easy to understand that the quantity of sales directly affect the sales value. If the quantity sold is higher than the budgeted, it will be favorable variance and if quantity sold is lesser, it will be unfavorable. We must also understand that the difference in sales quantity is multiplied by the standard selling price. This is on account of comparison with the standard.

Sales Mix Variance

Sales mix variance can be explained in terms of difference in actual quantity of sales mix and budgeted quantity of sales mix. This will cause difference in actual sales volume as compared to planned sales volume as all the varieties or products have different selling price. We have already discussed that sales mix is the combination of various products produced by a firm and sold during a given period of time. We can calculate the sales mix variance through the following equation:

Sales mix variance = Standard value of actual mix – Standard value of revised standard mix

Sales Sub-volume Variance

This is explained in terms of difference between the budgeted sales and revised standard sales. The sub-variance is calculated to understand the effect of RSQ as compared to budgeted sales quantity. This is also known as sales quantity variance. We can calculate the sales sub-volume variance through the following equation:

Sales quantity variance = (Revised standard sales quantity × Standard selling price) – (Standard sales quantity × Standard selling price)

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Variances Based on Profits

Total Sales Margin Variance

We can also calculate variances based on budgeted profit and actual profit. This is a composite variance that is arrived based on other sub-variances. Basically, it represents the difference between the standard margin of profit in relation to budgeted quantity of sales during a particular time period and the margin between the standard cost and the actual selling price. We can calculate the sales margin variance through the following equation:

Total sales margin variance = Standard or budgeted margin – Actual margin

Remember: The total sales margin variance may occur on account of variance in selling price or quantity of goods sold. Let us understand both.

Sales Margin Variance Due to Selling Price

Sales margin variance may occur on account of the difference between the standard price of the quantity of sales offered during the period and the actual price. This can be calculated as follows:

Sales price variance = (Actual quantity of sales × Standard price) – (Actual quantity of sales × Actual price)

We can also calculate sales margin variance on account of difference in selling price as follows:

Sales price variance = Budgeted profit on actual sales at standard price and standard cost – Actual profit

Sales Margin Variance Due to Volume of Sales

The volume represents the quantity. The sales margin variance on account of quantity of sales may occur due to the difference between the budgeted quantity of sales and the actual quantity of sales. For further analysis, we can calculate two more sub-variances on account of change in the ratio of quantities of sales of different products known as mix variance. This may occur on account of actual mix of quantities that may be more or lesser than the budgeted sales mix of different quantities.

This can be calculated as follows:

Sales volume variance = Budgeted profit on standard quantity of sales – Standard profit on actual quantity of sales

or

Sales volume variance = Budgeted profit – Profit on actual sales at standard price and standard costs

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Control Ratios

A firm needs to monitor the performance from time to time to evaluate and assess actual performance as against the budgeted and planned performance. To achieve this goal, control ratios are very important. The control ratios measure the extent of variation from the standards as compared to actual performance. We can also understand whether the variation between the actual and the budgeted is favorable or unfavorable.

This can be explained through an example. Suppose, budgeted labor hours to complete a job is 200 but actually the work is completed in 180 hours. Therefore, in this case the difference of 20 hours is favorable since the actual time taken to complete the work is lesser than the budgeted time.

Standard Hour

Standard hour (SH) denotes the ideal time to complete a job within normal circumstances. This is the basic concept to understand and to further evaluate control ratios. SH is a measurement tool to measure the output. Sometimes, a firm may be engaged in manufacturing of different types of products or varieties of products that may differ in size, shape, value and utility, in that case it becomes difficult to measure the output of different products.

Therefore, the concept of SH becomes more significant to identify the total output. We can further understand this concept through the following example. Suppose the standard monthly output of a firm in a particular production process is 6,000 units of A and 4,000 units of product B. Further, we assume that it takes 10 hours to produce 1 unit of A and 8 hours to produce 1 unit of product B. In this case, the budgeted output measurement in terms of SH will be:

Budgeted output in SH = 6000/10 + = 4000/8 = 600 + 500 = 1100 SH

Now, suppose in any particular month, the firm has produced 6,200 units of A and 4,400 units of product B, the actual output in terms of SH can be measured as follows:

Actual output in SH = 6200/10 + = 4400/8 = 620 + 550 = 1170 SH

Therefore, the actual output (1,170 SH) is more than the budgeted output (1,100 SH), and in that case the firm has performed more efficiently as compared to the budgeted level.

Remember: We may calculate different control ratios based on SH concept. We explain some of them here.

Activity Ratio

Through this ratio, we can measure actual level of production as compared to the budgeted level of production and find out the variance. It aims to measure whether actual level is higher or lesser than the performance level. This ratio is also known as production volume ratio. We can measure the level of activity to be achieved over a given time period.

Following is the equation of activity ratio:

Actual ratio Actual output in SH / Budgeted output in SH x ´100

Suppose actual output and budgeted output for a particular month are 600 SH and 560 SH, respectively. In that case, the activity ratio will be 107.15% (600/560). Therefore, we can say that in activity ratio, the actual SH is represented as percentage of budgeted SH.

Capacity Ratio

Through this ratio, we can establish the relationship between the actual hours worked and the budgeted hours pre-planned for completion of a job in a particular time period. Therefore, this ratio measures as to what extent the actual hours worked are different from the budgeted hours for a particular time period. It assesses the difference between “how many hours should have been worked as per standards” and “how many hours actually have been worked to complete a job.”

The capacity ratio can be calculated as follows:

Capacity ratio Actual hours worked / Budgeted hours x ´100

Efficiency Ratio

This ratio establishes the relationship between the actual output in terms of SH and the actual hours worked for actual production. This ratio can be calculated as follows:

Efficiency ratio Actual output in terms of SH / Actual hours = for actual output x 100

Calendar Ratio

This ratio indicates the relationship between actual number of days worked during the budget period and the budgeted working days planned during the budget period. It can be calculated as follows:

Calendar ratio = Actual no of days in budget period / No of budgeted days in budget period x 100