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STANDARD COSTING TECHNIQUE AND VARIANCE ANALYSIS

BY

PROFESSOR T.O. ASAOLU

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• The technique known as standard costing consists of setting of predetermined estimate of costs and the comparison of this with actual cost as they are incurred. The difference between the actual cost and standard cost is termed the VARIANCE. Variance analysis is used to attribute variances to the various causes.

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Standard cost can be defined as “a predetermined cost of how much costs should be under specified work and conditions (CIMA).”

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TYPES OF STANDARD

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(1) Basic Standards:

This is defined by the CIMA as a standard established for use over a long period from which a

current standard can be developed.

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They are established for use unaltered over the years. Its variance report helps the management to highlight trends (i.e. over material, prices, labour, efficiency). They are not very useful for preparation of budgets as basic standards are not up to date.

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The information they provide for cost control in terms of various analysis cannot be used as a basis for actual control nor can there be any motivational effect from the use of basic standard. They cannot be used to highlight current efficiency or inefficiency.

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(2) Ideal Standards: This is a standard which can be

attained under the most favourable conditions. i.e. no breakdowns, no material wastage, no stoppages or idle time, in short, there is perfect efficiency. It will be revised periodically in the light of development of technology improvements in materials. Clearly, ideal standard would be unattainable in practice accordingly, it is rarely used.

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However, their uses could be considered worthwhile for investigation and development purposes, but not for normal day to day control activities. Ideal standards will be used where management believes that it would provide the best type of standard needed for motivation and cost control.

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In some cases, it will be reasonable to expect that no wastage of material will occur however, in terms of labour efficiency, ideal standards will assume no inefficiency, no breakdown, no loss of efficiency due to fatigue, may lie no more than a dream. Ideal standard is not widely used in practice because it may influence employee motivation adversely. It is otherwise known as the Alice in the wonderland Standard.

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(3) Currently Attainable Standards:This can be defined as a standard

which can be attained if a standard unit of work is carried out efficiently (CIMA), a machine properly operated or a material properly used. It will show the cost to be incurred under the normal efficient operation condition and allowances are made for normal wastage of material, machine breakdown loss of efficiency from

fatigue.

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Although, currently attainable standard should be possible to achieve, it should also represent a high standard of performance. Standard cost determined in this way can be used for a variety of purposes, e.g. for budget preparation, for cost control by mean of variance analysis, for product costing and for motivation.

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(4) Current Standards: This is a standard established for use

over a short period of time to reflect current conditions (CIMA). Where stable conditions of prices exist, the current standard is equivalent to an attainable standard but where for example a temporary problem exists with material quality or there is an unexpected inflation, then a current standard could be set for a limited period to deal with the temporary problem.

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It is useful in inflationary circumstances where current standards could be set, perhaps on a monthly basis.

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(5) Expected Standard: This is the standard which is

anticipated can be attained during a future specific budget period and based on current or prevailing conditions. Standards set are on a short-term basis and it is often revised as may be necessary.

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• Advantages of Standard Costing

(i) It helps in preparation of annual budget, i.e. Planning.

(ii) It is useful in setting prices in advance, mostly in making tender.(iii)It is useful in motivating employees, labour efficiency.

(iv) It helps in determining various standard of actual costs for future planning.

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(v) It helps management in planning for the future.

(vi) It is useful for cost control.

• Disadvantages of Standard Costing

(i) It may be expensive and time consuming to install and maintain the system.

(ii) In an inflationary period or improving technological environment, standards quickly become obsolete and consequently lose their control and motivational effects.

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VARIANCE ANALYSIS

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A variance is the difference between standard cost and actual cost. Variance analysis therefore is the process whereby the difference between standard cost and actual cost is sub-analyzed into their constituent parts.

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A variance could be favorable or adverse. It would be favorable where the actual cost is less than the standard or where actual revenue is higher than the budgeted revenue. It would be an adverse variance where the actual cost is higher than the standard cost or where actual revenue is less than the budgeted revenue.

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METHODS OF CALCULATING VARIANCES

There are two methods of calculating variances. These are:

(1) Formulae method and

(2) Narrative method.

The formulae method will only be mentioned in passing and our discussion will focus on the narrative method.

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DIRECT MATERIAL VARIANCES:

Direct Material Total Cost Variance:

This is the addition of the usage variance and the price variance. The CIMA officially defines it as "the differences between the standard production material cost of the actual production volume and the actual cost of direct material".

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Direct Material Price Variance:

The CIMA officially defines this as "the difference between the standard price and the actual purchase price for the actual quantity of material." It can be calculated at the time of purchase or the time of usage. Its formula is given as the:

"Actual purchase quantity x Actual price minus Actual purchase quantity x Standard Price"

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Direct Material Usage Variance:

The CIMA officially defines this as "the difference between the standard quantity specified for the actual production and the actual quantity used, at the standard purchase price." Its formula is given as the:

“Actual quantity used for actual production x Standard Price minus Standard quantity for actual production x Standard Price"

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ILLUSTRATION 1 Material Cost Variances

A product (A) has a standard direct material cost as follows:

5 kilograms of material M @ N2 = N10 per unit of A. During April 1995, 100 units of the product are manufactured, using 520 kilograms of material M which cost N l,025.

Required: Calculate the:

(a) Total direct material cost variance.

(b) Material price variance.

(c) Material usage variance.

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DIRECT LABOUR VARIANCES Direct Labour Total Cost Variance:

This is defined as "the difference between the standard direct labour cost and the actual direct labour cost incurred for the actual production level achieved" - CIMA Terminology.

Direct Labour Rate/Wage Variance: The CIMA officially defines this as "the difference between the standard and actual direct labour hour rate per hour for the total hours worked". Its formula is given as:

Actual labour hours x Actual rate minus Actual labour hours x Standard rate.

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Direct Labour Efficiency Variance:

The CIMA officially defines this as "the difference between the standard hours for the actual production achieved and the hours actually worked, valued at the standard labour rate". Its formula is given as:

"Actual labour hours x Standard rate" minus "Standard labour x Standard rate".

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ILLUSTRATION 2

Direct Labour VarianceThe standard direct labour cost of product B is 4 hours of grade S labour at-N3 per hour = N12 per unit. During May 1995, 200 units of product B were made, and the direct labour cost of grade S was N2,440 for 785 hours of work.

You are required to calculate the :(a) Total direct labour cost variance.(b) Direct labour rate variance.(c) Direct labour efficiency (productivity)

variance.

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• Idle Time Variance

This is the non-productive hours recorded in a costing system. Idle time is usually caused by machine breakdowns, bottlenecks in production, shortage of orders from customers or for any reason, the company cannot productively engage its labour force even though they are ready to work and at any rate, they would be paid for the unproductive hours.

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Unproductive hours paid for is inefficiency and therefore, idle time is always an adverse efficiency variance.

An idle time variance can be calculated by multiplying the hours of idle time by the standard rate.

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ILLUSTRATION 3 Direct Labour Variances (with Idle Time)

The direct labour cost of product C is as follows: 3 hours of Grade T labour @ N2.50 per hour = N7.50 per unit. During June 1995, 300 units of product C were made and the labour cost of grade T was N2,200 for 910 hours. During the month, there was a machine breakdown, and 40 hours were recorded as idle time.

You are required to calculate the:

(a) Direct labour total cost variance.(b) Direct labour rate variance.(c) Idle time variance.(d) Direct labour efficiency variance

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solution

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