Introduction
Standard costs and variance analysis are essential concepts in managerial accounting, providing the foundation for cost control, performance measurement, and operational efficiency in manufacturing and service organizations. Companies ranging from global giants like Firestone and McDonald’s to local manufacturers rely on standard costing systems to benchmark performance, identify inefficiencies, and drive strategic improvements.
This comprehensive guide explores the definitions, calculations, real-world applications, and strategic implications of standard costs and variances. Whether you’re an accounting student, a business owner, or a finance professional, mastering these concepts is crucial for maximizing profitability and staying competitive.
What Are Standard Costs?
Standard costs are predetermined benchmarks or “norms” that organizations use to measure performance and control costs. They represent the expected cost of producing a product or delivering a service, based on efficient operations under normal conditions.
Types of Standards in Managerial Accounting
- Quantity Standards: Specify how much of an input (materials, labor, etc.) should be used.
- Price Standards: Specify how much should be paid for each unit of input.
Example:
A fast-food restaurant like McDonald’s might set a standard for the amount of potatoes used per order of fries and the price they should pay per pound of potatoes.
Setting Direct Materials, Labor, and Overhead Standards
- Direct Materials: Establish both a standard price per unit (e.g., $5.00 per kg of fiberfill) and a standard quantity per unit (e.g., 0.1 kg per jacket).
- Direct Labor: Set a standard labor rate (e.g., $10.00 per hour) and the standard hours required (e.g., 1.2 hours per unit).
- Variable Manufacturing Overhead: Determine the standard rate per allocation base, such as direct labor hours.
These standards are documented on a Standard Cost Card for each product.
Using Standards in Flexible Budgets
Standard costs enable companies to prepare flexible budgets, which can then be compared to actual results. This comparison reveals variances—differences between actual and standard costs—which provide critical insights for management action.
Variance Analysis: The Heart of Cost Control
Variance analysis identifies the reasons for differences between actual and expected performance. The two primary types of variances are:
- Price Variance: Difference between the actual price paid and the standard price.
- Quantity (Efficiency) Variance: Difference between the actual quantity used and the standard quantity allowed.
The General Model for Variance Analysis
For each input (materials, labor, overhead):
- Actual Quantity × Actual Price (AQ × AP)
- Actual Quantity × Standard Price (AQ × SP)
- Standard Quantity Allowed × Standard Price (SQ × SP)
Formulas:
- Price Variance: (AQ × AP) – (AQ × SP) = AQ(AP – SP)
- Quantity Variance: (AQ × SP) – (SQ × SP) = SP(AQ – SQ)
- Spending Variance: (SQ × SP) – (AQ × AP)
Practical Examples of Variance Analysis
Direct Materials Variances
Example: Glacier Peak Outfitters
- Standard: 0.1 kg of fiberfill per parka at $5.00/kg.
- Actual: 210 kg used for 2,000 parkas at $4.90/kg (total cost $1,029).
Calculations:
- Materials Price Variance (MPV):
210 kg × ($4.90 – $5.00) = $21 Favorable - Materials Quantity Variance (MQV):
$5.00 × (210 kg – 200 kg) = $50 Unfavorable
Direct Labor Variances
Example:
- Standard: 1.2 hours per parka at $10.00/hour.
- Actual: 2,500 hours worked for 2,000 parkas at $10.50/hour.
Calculations:
- Labor Rate Variance (LRV):
2,500 hours × ($10.50 – $10.00) = $1,250 Unfavorable - Labor Efficiency Variance (LEV):
$10.00 × (2,500 hours – 2,400 hours) = $1,000 Unfavorable
Variable Manufacturing Overhead Variances
Example:
- Standard: 1.2 hours per parka at $4.00/hour.
- Actual: 2,500 hours at $4.20/hour.
Calculations:
- Overhead Rate Variance:
2,500 hours × ($4.20 – $4.00) = $500 Unfavorable - Overhead Efficiency Variance:
$4.00 × (2,500 hours – 2,400 hours) = $400 Unfavorable
Who Is Responsible for Variances?
- Materials Price Variance: Typically, the purchasing manager is accountable.
- Materials Quantity Variance: Production manager is usually responsible.
- Labor Variances: Production managers, though often influenced by purchasing or maintenance decisions.
- Overhead Variances: Responsibility can vary based on what drives the variance (rate or efficiency).
Note: Variances are not always entirely controllable by a single person. For example, lower-quality materials purchased to save money may increase waste, causing unfavorable quantity variances in production.
Strategic Implications: Advantages and Potential Problems
Advantages of Standard Costs
- Management by Exception: Managers focus only on significant deviations from standards.
- Benchmarking: Standards provide clear performance targets.
- Efficiency: Standard costs streamline accounting and reporting.
- Responsibility Accounting: Variances help identify areas for managerial improvement.
Potential Problems and Limitations
- Outdated Information: Monthly variance reports may not reflect real-time issues.
- Automation: In modern factories, labor is often a fixed cost, making some variances less relevant.
- Morale and Dysfunction: Overemphasis on variances can harm employee morale or lead to undesirable shortcuts.
- Continuous Improvement: Meeting standards isn’t enough; ongoing process improvement is essential for competitiveness.
- Quality and Customer Focus: Cost standards must not overshadow quality and customer satisfaction goals.
Key Takeaways: Mastering Standard Costs and Variances
- Standard costs and variances are vital for cost control, performance evaluation, and strategic management.
- A robust variance analysis system enables quick identification and correction of inefficiencies.
- Organizations must balance cost control with other goals like quality, delivery, and employee motivation.
Conclusion
Understanding and applying standard costing and variance analysis empowers managers to drive efficiency, cut unnecessary costs, and sustain high performance in today’s dynamic business environment. Use the formulas, examples, and strategic insights from this guide to optimize your operations and achieve your business goals.
Frequently Asked Questions
Q1: What is the main purpose of standard costing?
A1: To provide benchmarks for performance, control costs, and support effective decision-making.
Q2: Who is responsible for variance analysis?
A2: Typically, production and purchasing managers, but true responsibility often spans multiple departments.
Q3: Are standard costs still relevant in automated industries?
A3: Yes, but companies must adapt variance analysis to reflect automation and focus on continuous improvement.
Sources: Noreen, E., Brewer, P., & Garrison, R. (Managerial Accounting), Chapter 10: Standard Costs and Variances
