Financial Accounting

Standard Costing and Variance analysis

Standard costs are predetermined costs. They are target costs that should be incurred
under efficient operating conditions. It links with the budgetary process; budgets
relate to an entire activity or operation and so, provide the total cost plan.

Standard costing relates to activity on a per unit basis and so provides the cost plan at
a unit of production level. It will be most useful for an organisation whose activities
consist of a series of common operations. Thus, standard costs should be developed
for repetitive operations and product standard costs are derived simply by combining
the standard cost from the operations which are necessary to make the product.

There will always be a difference between budgeted and actual results. This
difference is called ‘variance’. It can be first sub-divided into different components of
profit, i.e. Material, labour, overhead, etc and then into the original cause of each
component variance. (Those arising out of price or quality or volume difference)

Advantages

1) Developing budgets and selling performance yardsticks

2) Allowing control by highlighting the area which maybe out of line with
expectations.
3) Identifying areas where corrective action is taken.
4) Predicting future cost for decision making.
5) Making management cost-aware.
6) Motivating performance through target-setting.
7) Providing product costs for stock valuation and profit determination.
8) Providing a basis for more accurate price-setting than historical data.
9) Facilitating continuous improvement by re-examining production standards.

Disadvantages

1) Often easy to confuse variances- the start point for investigations-with

explanations.
2) Interlink age of variance may lead to wrong explanations or performance
appraisal and bad decisions thereafter.
3) Can be abused in a management culture which is characterized by
‘Punishment Accounting’ where failure to achieve a given standard is equated
with poor performance and explanations are excused.
4) Much time is taken in updating standards regularly. But outdated standards
means that ‘White nose’ drowns significant variances.