Standard Costing and

Variance Analysis
PERFOMANCE MANAGEMENT – BAC 3 2021/22
OBJECTIVES

1. To understand how standard costing are set

and operate
2. To identify and describe the
purposes/benefits of standard costing and
variance analysis and their limitations
3. To calculate labour, material, overhead
variances and explain causes of variances
4. To calculate material price planning and
material price operational variances
5. Apply variance analysis in making decision
Meaning of Standard Cost
 Standard cost refers to expected costs under anticipated
conditions.
 Standard cost systems allow for comparison of standard versus
actual costs.
 Differences are referred to as standard cost variances.
 Variances should be investigated if significant.
 The difference between standard cost and budgeted cost is
that:
 The first refers to the estimated cost of a single unit while the
later refers to the cost of the total number of budgeted units
based on standard cost.
Purpose of Standard cost

 Standard cost represent future target cost, thus its purpose is to

provide prediction of future costs for decision making
 Standard costs provide challenge and motivation for individual
to achieving objectives.
 Assistingin setting budget and evaluating managerial
performance
 Acting as a control device. With standard costing variances are
analysed
 Simplifying
the task of tracing costs to product for profit
measurement and inventory valuation.
Advantages of Standard Costing
 Standard costing facilitates optimum utilisation of resources within the
organisation.
 Provide sensible basis for cost comparisons - it allows computation of
standard cost at actual activity level which is then compared with the
actual cost incurred.
 Computation of standard costs and cost variances enables managers to
adopt management by exception which conserve managers’ time.
 Variancesprovides the basis of performance evaluation and rewarding
employees
 Standard motivates employees to adhere upon since variances are used
in performance evaluation
 Using standard cost in product costing and in pricing results into a
stable product cost and price
Limitations of Standard Costing
 Standard setting requires a lot of skills, assumptions and experience; if all
these are not coherent it may not bring desired results.
 Standard costing is useful when outcome/deviations can be linked with
responsibilities, but sometimes it is difficult to establish the linkage
 Standard costing should be reflecting the current working conditions but
current conditions changes rapidly
 Standard costing may not be applicable in situations in which production
inputs (material, labour , overhead) cannot be standardized.
 Lack of interest by appropriate management level may make standard
costing useless/ineffective
 Sometimes it is difficult to segregate controllable and uncontrollable
elements which limits the usefulness.
 Techniques For Developing Standard Costs
 Activity analysis (or task analysis) – Identify and evaluate all
activities required to complete a product, job, or operation to determine
exactly how much direct materials , labour hours and overhead should
be required, how long each step performed by direct labour should
take, and how machinery should be used in the production process, etc.
 Historical data – Use historical data in conjunction with management
judgment to ensure that standards do not perpetuate past inefficiencies.
 Benchmarking – Collect information from other firms in the same
industry or firms considered to have “best practices” across industries.
 Market expectations and strategic decisions – Determine the
standard required to achieve a target cost or to achieve satisfactory
progress towards a continuous improvement strategy.
Setting right standard cost
 Preliminary activities for determination of standard costing
involve the following necessary activities:
 Study of technical aspects of factory/firms - actual
situations of the firm have to be known
 Organization chart – line of authority and responsibility to be
clearly defined
 Establishment of cost centres - for fixing responsibility for
favourable and unfavourable variances
 Allocation and apportionment of overheads: existing
methods and policies have to be reviewed
 Training to staff: proper training is needed before
introduction of the standard costing
 Types Standard Costs

 Stand costing are normally classified into three broad categories:

 Theoretical or Ideal Standard,
 Basic Standard and
 Expected or currently attainable standard
 Theoretical or Ideal Standard,
 Is based on the assumption of perfect performance that is it assumes
minimum costs that are possible under the most efficient operating
conditions,
 It assumes no obstacles to the production process will be encountered.
 Ideal standards are unlikely to be used in practice because they may
de-motivate employees
 They are sometimes referred to as perfection standards
Types Cost Standards
 Basic Standard
 It is established for use over a long period of time and it’s set up for
some base year.
 The main advantage of Basic Standard is that actual cost can be
compared through a period of years with the same standard this enable
to determine efficiency trends over time.
 When changes in production methods, prices, and other related
factors, basic standards are not very useful. Therefore basic standards
are less used.
 Expected or currently attainable standard
 is based not on ideal conditions but on expected performance.
 It is developed under the assumption that there will be occasional
problems in the production process such as equipment failure, labor
turnover, and materials defects
Problems in setting standard cost
1. Deciding how to incorporate inflation into planned unit costs.
2. Agreeing a labour efficiency standard (for example, should current
time, expected time or idle time be used in the labour efficiency
standard.)
3. Deciding on the quality of material to be used, because a better quality
of material will cost more but perhaps will reduce the material wastage.
4. Estimating materials prices where seasonal price variations or bulk price
discount may be significant.
5. Possible ‘behavioral’ problem. Managers responsible for the achieveme
nt of standard costing control system for fear of being ‘blamed’ for any a
dverse variance.
6. The cost of setting up and maintaining a system for establishing standard
 VARIANCE ANALYSIS
 Variance is the difference between the actual and
standard cost related to materials, labour, and overheads.
 The difference between the standard and actual cost
component and analyzing the reasons for the difference is
called variance analysis.
 Variance analysis enable management to assign
responsibility for the departure from the standard
performance.
 Variance analysis is the foundation for Standard Costing.
A General Model for Variance Analysis (material, labour, and
overhead)
Actual Quantity Standard quantity x
x Standard Price
Actual Price Actual Quantity x
(standard cost – SC)
(Actual cost – AC) Standard Price

Price variance Quantity variance

- Material price variance -material usage variance
- wage rate variance -Labour efficiency variance
- Variable overhead -variable overhead
expenditure variance efficiency variance

Total (material, labour, overhead) variance (SC – AC)

Material cost variance; labour cost variance; and variable
overhead variance
 Variance analysis!!
Variance can be: Who is responsible
• Material price(wages) for the variances?
• Materials usage (efficiency)
 • Total variance
• Planning variances
• Operational variances Why variance
analysis?
1. Increase
It depends on the cause: efficiency,
• If controllable it is the one
who controls a respective
2. improve
cost centre operation,
• Uncontrollable no one is
3. reduce
responsible.
costs.
Activity 1 – Material & Labour Variances
 During May, Chikando Ltd purchased 6,000 kg of material at
a price of Tsh. 7,300 per kg. Actual cost incurred in that
month to produce 2,000 units of were as follows:
 Direct Material Tsh 30,660,000
 Direct labour Tsh 116,745,000 (@18,100 per hour)
 The standards for one unit are as follows:
 Direct Material: 2kg per unit @ Tsh 7,000 per kg
 Direct Labour: 3 hours per unit @ Tsh 18,000 per hour
 Required: calculate
i) Material price variance (MPV); Material usage (quantity) variance
(MUV) & Material cost variance (MCV)
ii) Labour rate variance, Labour Efficiency Variance & total Labour
cost Variance
 Workings
Material price variance (MPV)
 This is that portion of the material cost variance, that is difference
between the standard price specified and the actual price paid.
 MPV = (SP – AP) × AQ
 Material usage (quantity) variance
 This is that portion of the material cost variance, that is difference
between the standard quantities and the actual quantity used.
 MUV = (SQ – AQ) × SP
Total material cost variance
 MCV = (SQ × SP) – (AQ × AP)
 
 Note: Total Material Cost Variance = MUV + MPV
Activity 2: Material and Labour Variances

The following is the standard cost for product ‘Y’ produced by MZ Ltd
 Material per unit 8 kgs @ Tsh.1,750 per kg Tsh 14,000
 Direct Labour 0.25 hrs @ Tsh 8,000 per hr 2,000
Tsh 16,000
During April 2020, the company purchased 160,000 kgs of direct material at a
total cost of Tsh 304,000,000. Total wages in that month amounted to Tsh
42,000,000, whereby 90% was for direct labour. The company produced 19,000
units during March, consuming 142,500 kgs of direct material and 5,000 direct
labour hours.
Required: Calculate
 Direct material price variance (MPV)
 Direct material usage (quantity) variance (MQV)
 Direct labour rate variance
 Direct labour efficiency variance
Idle Time Variance
 It refers to the difference between the standard cost of the hours paid
to the workers and that of actual hours worked
 The variance is almost always adverse and it reflects managerial
inefficiencies over the causes of idle time such as machine breakdown
material stock-out and poor supervision
 Idle time variance = (Hours paid – Hours worked) x SR
Common Reasons for MPV

This variance usually arises due to the following reasons:

 Change in the basic prices of materials (Uncontrollable).
 Failure to purchase the standard quality (controllable).
 Uneconomical size of purchase orders (controllable).
 Not availing cash discounts, when standards set are based on such
discounts (controllable).
 Bad purchasing (controllable).
 Change in transportation costs (less controllable).
 Rush purchases from uneconomical markets (controllable).
 Change in the rates of excise duty, purchase tax, etc (uncontrollable)
 Off-season purchasing, especially, for certain seasonal products like
jute, cotton, etc (controllable).
Responsibility on material variances

 Normally, the purchase manager is responsible for material

price variance.
 However, s/he cannot be held responsible for variance
caused by market prices and variances that are outside
his/her control such as purchase of smaller quantity or
poor quality materials due to shortage of finances, which
is a financial matter, beyond his control.
Reasons for labour inefficiency variance
One or more of the following reasons may causes this variance:
 Poor working conditions e.g. inadequate lighting and ventilation,
excessive heating, etc.
 Defective tools and plant and machinery.
 Inefficient workers.
 Incompetent supervision.
 Use of defective or non-standard materials, which requires more or
less time than the standard time for processing.
 Time wasted by factors like waiting for materials, tools etc. or
machine breakdown.
 Insufficient training of workers.
 Change in the method of operation.
Common reasons for labour rate variance
 Change in the basic wage rates.
 Use of a different method of wage payment.
 Employing workers of different grades from the standard
grades specified.
 Unscheduled overtime.
 New workers not being paid at full rates.
Responsibility on labour rate variances
 Often, labour rate variance are uncontrollable.
 Labour rates are usually determined by demand and
supply conditions in the labour market, backed by a
negotiable strength of the trade union.
 Where this variance is due to the use of a grade of
labour other than that specified, there may well be
such acceptable explanations as non-availability of the
labour grade specified.
 But when managers carelessly employs a wrong grade of
labour on a job, they may be held responsible
Overhead Standards Variances

 Where overheads vary with activities, a standard

variable overhead rate is used.
 When the overhead do not vary with activities in
a short term are usually classified as fixed
overhead
 Itis important for an organization to identify
which measure most influences overhead cost
Variable overheads
 VOV is the difference between standard variable overhead cost
(SC) and the actual variable overhead cost (AC)
 VOV = SC – AC
 Variable overhead expenditure variance (VOEV), is equal to the
difference between the budgeted flexed variable overheads for the
actual direct labour or machine hours of input (BFVO), and the
actual variable overheads incurred (AVO).
 VOEV = BFVO – AVO or AH (SR-AR)
 Variable overhead efficiency variance (VOEV) is the difference
between the standard hours (SH) of input and the actual hours (AH)
of input for the period, multiplied by the standard variable
overhead rate (SR).
 VOEV = (SH - AH) x SR
 Fixed overheads
 Total Fixed overhead Cost variance is the difference between
actual overhead cost and absorbed fixed overhead
 This may arise due to either variations in expenditure or
volume of production or both
 Fixed Overhead cost (Expenditure) Variance is the difference
between the actual fixed overheads incurred and budgeted fixed
overhead.
= Actual Fixed Overheads - Budgeted Fixed Overheads
 Favorable fixed overhead expenditure variance suggests that
actual fixed costs incurred during the period is lower than
budgeted cost, and its opposite is unfavourable variance.
 Fixed Overhead Volume Variance
 Fixed Overhead Volume Variance is the difference between the
budgeted fixed overheads and the standard fixed overhead for
actual production.
 It is the difference between budgeted and absorbed fixed
production overheads
= Standard fixed overhead for actual production – Budgeted
fixed overhead.
 Thisvariance happens only when the actual volume differs from
budgeted volume. When actual volume is higher than budgeted
volume the variance is favourable and its vice versa is for
unfavourable variance.
 Activity 3: Variable and Fixed Overhead Variances
 TheWedding Cloth Ltd manufactures wedding suits. Each suit requires direct
materials, direct labour, variable manufacturing overheads and fixed
manufacturing overhead. The company allocated variable and fixed
manufacturing overheads using direct labour hours.
 For the last month the company budgeted to produce 1,000 suits; each suit was
budgeted to spend 4 labour hours and the budgeted variable manufacturing overhead
cost per hour was Tsh 1,200.
 In that month, the company spent 4,620 direct labour hours and Tsh 5,313,000 for
variable manufacturing overhead to manufacture 1,100 suits.
 The budgeted fixed overhead for that month was Tsh 60,000,000 and the actual fixed
overhead was Tsh 65,010,000.
 Required:
 Variable overhead spending variance, efficiency variance, and total variance
 Fixed overhead spending variance, fixed overhead volume variance and total fixed
overhead cost variance
 MATERIAL USAGE VARIANCE – EXTENDED ANALYSIS
 For a product which consumes more than one type of material, the variation
in material usage can be attributed by either of the two factors, or both:
 The first is the variation resulting from proportionate mix of the materials
 Material Mix Variance = std cost of std mixture for actual output – Std cost of actual mix
= (Std mixture for actual output-Actual mixture for actual output)*SP
 The second is the variation resulting from ability of the input (material) to give output
i.e. material yield
 Material Yield variance = Actual yield – std yield
 It is the difference between 1 and 2 provided below:
1:(Actual Total Qty of all inputs used x Budgeted input mix)x Budgeted prices
2:(Budgeted Total Qty of all inputs allowed for actual output x Budgeted input
mix)Budgeted prices

 For detailed examples – see Saxena & Vashist (2007) pg A.5.17 - 19

 Sales Variance
 Sales variances explain the difference between actual sales and standard(planned) sales
 It can be computed in terms of sales revenues or in terms of profits (sales margin)
 Sales Price Variance explains how much change in sales revenue is attributable by the
difference in selling price,
= (Actual Selling Price– Standard Selling Price) x Actual Units Sold
 The formula assumes costs are at standard; hence any changes in price have direct effect on
profit.
 When Actual price is higher than standard price it is favourable and its vice versa is represents
unfavourable
 Sales volume Variance explains the effect of a change in the sales volume on the profit or
contribution over the period.
= (Actual Units Sold – Budgeted sales Units)   x   Standard Profit Per Unit
 Note: Multiply by standard profit per unit when absorption costing is used, alternatively
multiply by standard contribution margin per unit if marginal costing is used)
 Sales volume variance can be analyzed further into sales quantity variance and sales mix
variance (see Chapter 16- Horngren, Foster and Datar (2002).
Activity 4: Sales Price Margin and Volume Variances
 ABC company manufactures and sells a single product. The
following data are available for the month of March 2021:
 The company budgeted to sell 4,000 units at a price of Tsh 2,400 each
 Actual sales in units were 4,500 units and these were sold at a price of
Tsh. 2,200.
 The standard variable overhead per unit was 1,200.
 Required: Calculate
 Sales price variance
 Sales Volume Variance
 Total sales variance
 Sales Mix and Quantity variance
 Sales Mix variance =(Actual Quantity sold-Unit sales at std mix)x
std profit/CM per unit
 Whereas unit sales at std mix = std mix x Total actual units sold for all
products
= (Actual mixture-std mixture for actual sales)x std profit/CM
 Sales quantity variance = (Budgeted sales-unit sales at std mix)x Std
profit/CM
Activity 5: Sales Variances
 Following information of Latifa Co ltd is for Nov 2019:
 Budgeted sales : Product A 500 units @ Tsh. 2000
Product B 700 units @ Tsh. 1500
 Actual sales: Product A 560 units @ Tsh.1950
Product B 710 units @ Tsh. 1400
 The standard cost per unit of A is Tsh. 1750 while for B is Tsh. Tsh. 1300
 Required: Calculate
 i) Sales price variance
 ii) Sales volume variance
 iii) Sales mix variance
 iv) Sales quantity variance
Variance Reconciliation Statement

 It is the statement which reconciles the standard cost and actual cost

Sales (units) Xxx actual xxx variance xxx budget

Sales revenue Xxx xxx xxxx
Less: Variable costs
Variable mfg. costs xxxx xxxx xxxx
Variable selling and administrative xxxx xxxx xxxx
Total variable costs xxxx xxxxx xxxx
Contribution margin xxxx xxxx xxxx
Fixed costs:
Fixed manufacturing overhead xxxx xxxx xxxx
Fixed selling and administrative costs xxxx xxxx xxxx
Total fixed costs xxxx xxxx xxxx
Profit xxxxx xxxx xxxx
 PLANNING AND OPERATIONAL VARIANCES
 Budgets some times are revised, this lead to variances in planning and
executing of an activity. These variances are referred to planning and
operational variances
 Basically, the difference between actual cost and standard cost might be
resulting from either, the variations in underlying assumptions used to
establish standard (planning variance) or operational inefficiencies
(operational variance)
 Material Price Planning variance MPPV – shows the effect of revising the
standard cost by comparing the standard cost of actual material under the old
and new standard cost
 MPPV = (Standard price – revised price) x actual quantity
 Material price operational variance (MPOV) shows the effect of revising the
standard cost by comparing the actual cost of actual material under the old
and new standard cost
 MPOV = (Revised price – Actual Price) x actual quantity
Activity Six: Material Mix and Yield Variance
 Mwaga Company uses three types of materials H,G,K, which are used in the
proportions 50:40:10 to manufacture a single product. The materials cost
TZS5,000, TZS 2,500 and TZS 2,000 per kg respectively. Budgeted
production per week is 1,000kg, but actual production and material
proportions always vary.
 The standard and actual material usage data are as follows:-
Standard Qty Actual Qty
H 500kg 600kg
G 400kg 360kg
K 100kg 80kg
1,000kg 1,040kg
Required: Calculate material usage variance, material mix variance and
material yield variance
Activity Seven: Material Mix and Yield Variances
 Farmchemical Ltd uses two types chemicals A and B to produce pesticides. The
standard composition is 40% of A and 60% of B and their standard prices per kilogram
are TZS 2,000 and TZS 3,000 respectively. Usually a normal loss of 5% is expected in
production process.
 For the month of February 2020, material cost data incurred to produce 3.8 tonnes
were as follows:-
A 1980kg @ TZS 1,800
B 2420kg @ TZS 3,500
4,400kg
Required: Calculate:
Material price variance,
Material usage variance,
Material mix variance, and
Material yield variance