Chapter 9 Standard costing and variance analysis

Question 1

1.1 Standard costing

Answer 1

A standard cost is a pre-determined unit cost which is prepared for each unit cost. The standard represents a target cost against which performance can be measured with variance analysis. A standard cost card is drawn up in advance of a period and shows the expected usage, efficiency and price of resources for each unit cost.

Question 2

1.2 Standard costing and budgets

Answer 2

Standards provide an expected cost for one unit. Budgets (financial plans for a period of time) are complied by reference to the standard cost card.

Question 3

1.3 Standard costing advantages

Answer 3

Providing standard costs are monitored to ensure they are reasonable and reliable; advantages of standard costing include:
- Aids more accurate budgeting
- Gives targets for employees
- Provides a framework for scheduling activities
- Simplifies accounting
- Enables management by exception via variance analysis
Variance analysis is the comparison of actual costs with budgets. This allows control by exception, for example management ignore activities which conform to expectation and concentrate on activities which exceed acceptable tolerable limits.

Question 4

1.3 Standard costing in service environments

Answer 4

Standard costing was originally used in manufacturing environments, and it is criticised for its lack of applicability in service industries, for the following reasons:
- Difficulty in establishing a measurable cost unit
- In some service organisations, every cost unit will be different (heterogeneous)
- Strong influence of the human influence on output

Question 5

2.1 What is variance analysis

Answer 5

Cost and sales variances can be used to explain the difference between the budgeted profit for a period and the actual profit.
When actual results are better than expected results, a favourable variance occurs. When the result is worse, an adverse variance occurs.

Question 6

2.2 Approaches to calculating variances

Answer 6

There are three different approaches that can be used to calculate variances:
- Tabular approach: what has been the change in profit due to the x being different to budget
- Did-should approach: what did I actually pay, what should I have paid, the difference is the variance?
- Formulae
You only calculate variance using one method. The variance calculated will be different depending on whether a marginal or absorption costing system is adopted. Only variances calculated using marginal costing is on the MI syllabus. The variances are:
- Sales variance
- Materials variance
- Labour variance
- Variable overhead variance
- Fixed overhead variance

Question 7

2.3 Data bias in variance analysis

Answer 7

Variance types of bias can appear in variance analysis, so professional scepticism is important. Examples of bias include:
- Omitted variable bias: material price variance was favourable due to purchasing manager purchasing cheaper material. Adverse sales volume variance at a later date, for which the sales manager has been penalised
- Cognitive bias: a variance report may be produced to highlight a manager has achieved a favourable variance. However, the total of the favourable variance has been declining over previous periods, the manager changed the scale of the graph on the report, so the reduction did not appear as great

Question 8

3.1 Sales variances

Answer 8

There are two different sales variances:
- Sales volume variance: purpose is to determine the effect on contribution and thus profit, of the actual number of units sold being different from budgeted units sold. Therefore, the sales volume variance explains the difference in profit between the fixed and flexed budgets
- Sales price variance: purpose is to determine the effect on contribution and thus profit, of the actual selling price per units sold being different from budgeted price

Question 9

3.2 Tabular approach

Answer 9

Sales volume variance:
- S x S: budgeted quantity (BQ) x standard contribution per unit (SCPU) = budgeted contribution per the fixed budget (1)
- A x S: actual quantity (AQ) x standard contribution per unit (SCPU) = what budgeted contribution would have been for the actual level of production (2)
If 1-2 is positive, the variance is adverse, and vice versa.
- A x A: actual selling price per unit (AP) x actual quantity sold (AQ) = actual revenue (3)
- S x A: standard selling price per unit (SP) x actual quantity sold (AQ) = what budgeted revenue would have been for the actual level of sales (4)
If 3 – 4 is positive, the variance is favourable, and vice versa

Question 10

3.3 Did-should approach

Answer 10

Sales volume variance:
Actual sales volume less budgeted sales volume = difference in units
Valued at standard CPU (units x variance)
If the difference is positive the variance is favourable, and vice versa.
Sales price variance:
Actual quantity of units sold did sell for less actual quantity of units sold should sell for equals sales price variance.
If the difference is positive, the variance is favourable and vice versa

Question 11

3.4 Formulae approach

Answer 11

Sales volume variance
(AQ – BQ) x SCPU
If the calculation is positive, the variance is favourable
Sales price variance
(AP-SP) x AQ
If the calculation is positive, the variance is favourable

Question 12

3.5 Possible causes of sales variance

Answer 12

Sales price variance: for favourable it could be because of supply shortage, fewer quantity discounts than expected and standard selling price being too low. For adverse it could be because of supply surplus, more quantity discounts than expected and standard selling price too high.
Sales volume variance: favourable could be because of efficient sales force, successful advertising campaign, potential market larger than expected, additional demand attracted by a reduced price and budgeted sales volume too conservative. For adverse it could be because of demotivated sales force, competitor increased advertising, unexpected fall in demand due to recession, failure to satisfy demand due to production difficulties and budgeted sales volume being too optimistic.

Question 13

4.1 Material variances

Answer 13

There are three main materials variances:
- Material total variance explains difference between material cost in flexed budget and the actual material cost incurred. This is analysed into two sub variances, the materials price variance and the material usage variance. The material total variance is calculated by adding together the two sub variances
- Material price variance: the purpose is to ascertain whether the company paid more or less per kg than expected for materials used or purchased
- Material usage variance: purpose is to ascertain whether the company used more or less material than expected to produce the actual number of cost units produced. This difference in usage is valued at the standard price per unit of material

Question 14

4.2 Tabular approach

Answer 14

• A x A: actual quantity of material (AQ) x actual price of material (AP) = actual expenditure on materials (1)
• A x S: actual quantity of material (AQ) x standard price of material (SP) = what actual quantity of materials used should have cost (2)
• S x S: standard quantity of material to make the actual number of cost units produced (SQ) x standard price of material (SP) = budget material per the flexed budget (3)
  If 1 – 2 is positive the material price variance is adverse. If 2 – 3 is positive, the material usage variance is adverse

Question 15

4.3 Did-should approach

Answer 15

Material price variance
Actual quantity materials purchased did cost less actual quantity materials purchased should cost = material price variance.
If the difference is positive, the variance is adverse.
Material usage variance
Actual quantity of cost units produced did use less actual quantity of cost units produced should use (units x actual kg used), this gets the difference. Then valued at standard material cost per kg (kg x price).
If the difference is positive, the variance is adverse.

Question 16

4.4 Formulae approach

Answer 16

Material price variance
(SP – AP) x AQ purchased. If the calculation is positive, the variance is favourable
Material usage variance
(SQ used – AQ used) x SP. If the calculation is positive, the variance is favourable

Question 17

4.5 Possible causes of material variances

Answer 17

• Material price variance causes for favourable could be unforeseen discounts received, more care taken when purchasing, supplies from a cheaper source and standard material price too high. Causes for adverse include price increase in market, careless purchasing, supplies bought from more expensive source and standard material price too low
• Material usage variance causes for favourable include material used of higher quality than standard, more effective use of material and budgeting too much material per job. Causes for adverse include defective material or poorer quality material used than standard, excessive waste, theft, stricter quality control and budgeting too little material per job

Question 18

5.1 Labour variances

Answer 18

There are three main labour variances:
- Labour total variance explains difference between the labour cost in the flexed budget and the actual labour cost. Variance can be analysed into two sub variances, the labour rate and the labour efficiency. The labour variance calculated by adding together the two sub variances
- Labour rate variance: purpose is to ascertain whether the company paid more or less than expected in wages for the actual number of hours employees were paid for
- Labour efficiency variance: purpose is to ascertain whether the employees worked for more or less labour hours than expected to produce the actual volume of cost units. The difference in hours is valued at the standard labour rate per hour

Question 19

5.2 Tabular approach

Answer 19

• A x A: actual hours (AH) x actual rate per labour hour (AR) = actual expenditure on labour (1)
• A x S: actual hours (AH) x standard rate per labour hour (SR) = what actual number of labour hours should have cost (2)
• S x S: standard hours for actual number of cost units produced (SH) x standard rate per labour hour (SR) = budgeted labour per the flexed budget (3)
  If 1 – 2 is positive, the labour variance is adverse. If 2 – 3 is positive, the labour usage variance is adverse.

Question 20

5.3 Did-should approach

Answer 20

Labour rate variance
Actual hours paid did cost less actual hours paid should cost (hours x hourly rate) = labour rate variance.
If the calculation is positive, the variance is adverse.
Labour efficiency variance
Actual quantity of cost units produced did take less actual quantity of cost units produced should take (units x hours) = the difference, which is valued at standard labour rate per hour (hours x standard rate).
If the difference is positive, the variance is adverse.

Question 21

5.4 Formulae approach

Answer 21

Labour rate variance
(SR – AR) x AH, if the calculation is positive, the variance is favourable.
Labour efficiency variance
(SH – AH) x SR, if the calculation is positive, the variance is favourable

Question 22

5.5 Possible causes of labour variances

Answer 22

• Labour rate variance causes for favourable include use of lower paid workers and less overtime or fewer bonus payments than budgeted. Causes for adverse include use of a higher-grade labour than standard, more overtime and bonus payments than budgeted and unexpected wage rate increase
• Labour efficiency variance causes for favourable include improved motivation, equipment, materials or methods leading to quicker production of output, consequences of the learning effect and budgeting too much time per job. Causes for adverse impact include lost time in excess standard allowed, lower output because of deliberate restriction, lack of training or sub-standard material used and budgeting too little time per job.

Question 23

6.1 Variable overhead variances

Answer 23

There are three main variable overhead variances:
- Variable overhead total variance explains the difference between the variable overhead cost in the flexed budget and the actual variable overhead cost. This can be analysed into two sub variances, the variable overhead expenditure variance and the variable overhead efficiency variance. The variable overhead total variance is calculated by adding together the two sub variances.
- Variance overhead expenditure variance: purpose is to ascertain whether the company paid more or less per hour than expected for variable overheads.
- Variable overhead efficiency variance: purpose is to ascertain whether the company used more or less variable overheads by working more or less labour hours than expected.

Question 24

6.2 Tabular approach

Answer 24

• A x A: actual hours (AH) x actual rate per labour hour (AR) = actual expenditure on variable overheads (1)
• A x S: actual hours worked (AH) x standard rate per labour hour (SR) = what actual variable overhead should have cost (2)
• S x S: standard hours for actual number of cost units produced (SH) x standard rate per labour hour (SR) = budgeted variable overheads per the flexed budget (3)
  If 1 – 2 is positive, the variable overhead expenditure variance is adverse.
  If 2 – 3 is positive, the variable overhead efficiency variance is adverse.

Question 25

6.3 Did-should approach

Answer 25

Variable overhead expenditure variance
Actual hours worked did cost less actual hours worked should cost (hours x cost) = variable overhead expenditure variance.
If the calculation is positive, the variance is adverse.
Variable overhead efficiency variance
Actual quantity of cost units produced did take less actual quantity of cost units produced should take (units x hours) = difference, valued at standard variable overhead rate per hour (hours x cost).
If the calculation is positive, the variance is adverse.

Question 26

6.4 Formulae approach

Answer 26

Variable overhead expenditure variance
(SR – AR) x AH, if the calculation is positive, the variance is favourable.
Variable overhead efficiency variance
(SH – AH) x SR, if the calculation is positive, the variance is favourable

Question 27

6.5 Possible causes of variable overhead variances

Answer 27

Variable overhead expenditure variance causes of favourable is a change in type of overhead or decrease in its cost. Causes of adverse are changes in type of overhead or increase in its cost.
Variable overhead efficiency variance (assuming based on labour hours): causes of favourable include improved, motivation, equipment, materials or methods leading to quicker production of output and budgeting too much time per job. Causes of adverse include lost time in excess of standard allowed, output lower than standard set because of deliberate restriction, lack of training or sub-standard material used and budgeting too little time per job.

Question 28

7.1 Fixed overhead variances

Answer 28

This is the difference between budgeted and actual expenditure on fixed overheads during the period. There is no volume related variance because the definition means that the total fixed cost is constant regardless of activity level. The variance is only caused by expenditure differences.
Tabular approach and did-should approach
Actual expenditure – budgeted expenditure = fixed overhead variance.
If the calculation is positive, the variance is adverse.
Formulae approach
(AC – BC), if calculation is positive, the variance is adverse.
Possible causes of fixed overhead variances
Causes for favourable include any element of fixed overhead being lower than budgeted. Causes for adverse include any element of fixed overhead being higher than budgeted.

Question 29

8.1 Possible interrelationships between variances

Answer 29

The cause of a variance may affect another variance in a corresponding or opposite way. Examples include:
- If supplies of a material are not available, this may lead to a favourable price variance (cheaper material used), an adverse usage variance (cheaper material causes more waste) and adverse sales volume variance (unable meet demand due to production difficulties)
- New improved machine bought causes an adverse fixed overhead expenditure variance (machine costs more and depreciation higher) offset by favourable wages efficiency variance (higher productivity)
- Workers trying to improve productivity (favourable labour efficiency variance) might become careless and waste more material (adverse materials usage variance)