Standard costing, variances, and performance
Standards set expected costs. Comparing actual results with standards shows where performance went off track and why.
Standard costs
A standard cost is the expected cost of producing one unit, combining standard quantities and standard prices for materials, labour, and overhead. Ideal standards assume perfect efficiency; practical (attainable) standards allow for normal waste and downtime and are usually better for motivation.
Materials variances
The materials price variance = (actual price - standard price) x actual quantity purchased. The materials quantity (usage) variance = (actual quantity used - standard quantity allowed for actual output) x standard price. Unfavourable price variances may reflect supplier price rises; unfavourable quantity variances may reflect waste or poor-quality materials.
Labour variances
The labour rate variance = (actual rate - standard rate) x actual hours. The labour efficiency variance = (actual hours - standard hours allowed) x standard rate. Using more experienced, higher-paid workers might cause an unfavourable rate variance but a favourable efficiency variance.
Interpreting variances
A variance is favourable when actual costs are lower than standard, and unfavourable when higher, but 'favourable' is not always good: buying cheaper, poor-quality materials may create a favourable price variance and unfavourable quantity and quality problems. Management by exception focuses attention on significant variances.
Responsibility accounting
Responsibility accounting evaluates managers on what they control. Cost centres are responsible for costs (such as a production department); revenue centres for revenue; profit centres for both (such as a store); investment centres for profits and invested assets (such as a division).
Return on investment and residual income
Investment centres are often evaluated by return on investment (ROI = operating income / average operating assets) and residual income (operating income - required return x average operating assets). ROI can discourage managers from accepting projects that would lower their division's ROI even if they exceed the company's required return; residual income avoids this problem.
The balanced scorecard
Robert Kaplan and David Norton's balanced scorecard (1992) measures performance from four perspectives: financial, customer, internal business processes, and learning and growth. It links strategy to a mix of financial and non-financial measures, such as customer satisfaction, defect rates, and employee training.
Worked example
The standard is 2 kg of material per unit at 5 dollars per kg. For 1,000 units, the factory used 2,200 kg bought at 4.80 dollars per kg. Price variance = (4.80 - 5.00) x 2,200 = 440 dollars favourable. Quantity variance = (2,200 - 2,000) x 5 = 1,000 dollars unfavourable. The cheaper material may have caused extra waste, netting 560 dollars unfavourable.
Key takeaways
Standard costs combine standard quantities and prices; practical standards motivate better than ideal ones. Materials variances split into price and quantity; labour into rate and efficiency. Favourable variances are not always good; investigate significant variances by exception. Responsibility accounting uses cost, revenue, profit, and investment centres. ROI and residual income evaluate investment centres; residual income avoids rejecting good projects. The balanced scorecard adds customer, process, and learning measures.
Flashcard
Expected cost per unit
Check your understanding
Standard labour rate is 20 dollars per hour. Workers worked 1,100 hours at 21 dollars per hour. What is the labour rate variance?