Variances represent the differences between standard costs and actual costs. The standard cost is what the cost is estimated to be and this is compared to what the cost is actually.

Variances are classified as favourable if the actual costs are less than the standard costs and profit is increased as a consequence. Adverse variances decrease profits. Some variances may be controllable if the individual manager can influence the actual costs.

Some organisations operate on the principle of management by exception. The accountant presents an exception report which highlights the significant variances. This means management need only investigate certain variances which lie outside set tolerance levels.

A Standard cost is defined as ‘ a pre-determined cost calculated in relation to a prescribed set of working conditions, correlating technical specifications and scientific measurements of materials and labour to the prices and wage rates expected to apply during the period to which the standard cost is expected to relate, with an addition of an appropriate share of budgeted overhead’. It is a cost worked out in advance of production of the expected cost of a product or service.

Advantages of Standard costing

1. It provides management with a consistent method of comparing actual performance with planned performance.

2. It provides a means of ensuring that prodution resources are purchased and used efficiently.

3. In establishing standards management can examine and appraise existing practices and procedures to ensure cost-effectiveness and efficiency.

4. It can inculcate cost-conciousness in the staff.

5. It helps to motivate staff by setting realistic standards.

6. Using variance analysis performance ca be monitored and improvements in work methods can result.

Types of Standard

• Ideal standard - assumes perfect production conditions with no mechanical failure, no stock-outs, no staff absenteeism etc. It is unattainable but is an indication of what to strive for.

• Attainable standard - is a realistic target and is based on efficient working conditions with allowance made for machine breakdown , stockouts etc.

• Basic standard - is a standard set for use over a long period of time and is used to compare with current standards to to see the effect of changes in conditions over the years.

• Current standard - is set to reflect current conditions so has limited use in time. In times of inflation such standards may be set monthly.

Variance Analysis

Direct Material Variance

The main reason for actual and estimated costs being different are either a change in the price of materials or a change in the usage of material.

1. Materials price variance is the difference in cost that results from the price being different to the standard.

( Standard price - Actual price ) x Actual material usage

2 Materials usage variance is the difference between the actual usage of material and the standard usage multiplied by the standard price.

( Actual usage - Standard usage ) x Standard price

3 Total material variance = Actual Material cost - Standard Material cost

Direct Labour Variances

1. Labour rate variance is the difference between the actual wage rate and the standard rate of pay times the actual hours worked.

( Actual - Standard rate of pay ) x Actual hours worked

2 Labour efficiency variance is the difference between the actual hours worked and the standard hours ie. the hours that should have been worked to produce the actual output.

( Actual hours - Standard hours ) x Standard rate of pay

3 Total labour variance = Actual Labour cost - Standard L abour cost

Variable Overhead Variances

1. The variable overhead variance is the difference between the variable overhead cost actually incurred and the cost which should have been incurred for the actual hours worked. This assumes that variable overheads are directly attributable to labour hours.

Actual expenditure - ( Standard hours worked x Variable Overhead rate )

2 The variable overhead efficiency variance is the difference between the amount of overheads recovered based on the standard hours of production and the amount which should have been recovered if the actual hours worked had been at standard efficiencey.

( Actual hrs. worked - Standard hrs. worked ) x Variable Overhead rate

3 Total Variable O’H Variance = Actual Variable O’H cost - Standard Variable O’H cost

Fixed Overhead Variances

1. The fixed overhead expenditure variance is the difference between the expenditure actually incurred and that actually budgeted.

Actual expenditure - Budgeted expenditure

2 The fixed overhead volume variance measure the amount of any under or over recovery of overheads due to actual output ( measure in terms of standard hours of actual production ) being different to that budgeted.

Total Fixed Overhead Variance = Actual Cost - Standard Cost

Sales Variances

1. The sales margin price variance gives the effect on profits of a change in selling price.

( Actual price - Standard price ) x Sales volume

2 The sales margin quantity variance is the difference in profit which results from a change in the sales volume.

( Actual sales - Budgeted sales ) x Standard profit margin

3 Total Sales Variance = Actual Sales - Standard Sales

Problems with Standard Costing

1. Standard setting is a lengthy and costly procedure.

2. Standards are often seen by the staff as restrictions on their behaviour which can lead to dysfunctionalism.

3. Reporting variances may not be timely, cost effective and encourage managerial response.

4. Standards invariably produce variances some of which may not be controllable eg. material prices which can result in unnecessary reporting and investigation.

5. Standard costing may be inappropriate for certain kinds of manufacturing eg. Just-in- Time.

Example

A company X Ltd. produces a single product. The standard cost per unit and the actual results for a 4 week period are as follows:

Standard Costs		Actual Costs
	£		£
Direct Materials (1 kilo)	10	Sales	319,000
Direct Labour (2 hours)	10	Direct Materials
Variable Overheads	2	11,200 kilos @ £9.8	109,760
Fixed Overheads	5	Direct Labour
		21,000 hours @ £5	105,000
Standard Cost	-------------- 27	Variable Overheads	21,500
Standard Margin	3 ---------------	Fixed Overheads	52,000 --------------
Standard Selling Price	30 ---------------	Net Profit	30,700 ---------------
Budget output for the month 10,000 units		Actual output 11,000 units

Solution

Materials Price Variance

( SP - AP ) x AQ

( £10 - £9.80) x 11,200 kilos = £2240 (F)

Materials Usage Variance

( SQ - AQ ) x SP

( 11000k - 11200k ) x £10 = £2000 (A)

Labour rate variance

( SR - AR ) x AH

( £5 -£5 ) x 21000hrs. = 0

Labour efficiency variance

( SH - AH ) x SR

( 22000hrs. - 21000hrs. ) x £5 = £5000 (F)