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The Institute of Cost and Works Accountants, London have defined Standard costs, “Standard costs are prepared and used to clarify the final results of a business, particularly by measurement of the variations of the actual costs from standard costs and the analysis of the causes of variations for the purpose of maintaining efficiency by executive action”.
Standard costing involves:
1. Establishment of cost centers: A cost center is a location, person or equipment for which costs may be ascertained.
2. Classification of Accounts: Accounts are classified to meet a certain purpose. This includes classification into revenue item or an asset item or a cost item.
3. Setting the standard costs and the use of standard cost. Standard costs may be set based on current standards based on the short period of time and which is related to current conditions. Alternatively, standard costs can be set at a level in relation to a base year which is called as setting basic standards.
4. Ascertaining the Actual costs
5. Comparing the standard cost and actual costs that establishes the variances
6. Analyze the causes of variances and take appropriate action whenever necessar
Working of Standard Costs
The most important managerial tool is the study of variance parameters with the help of standard costing. Variance is the difference between the ‘actual’ and the ‘standard’ and variance analysis is made to assign responsibilities for off standard performances.
There are fundamentally two types of variances:
Price Variance
a) Material Price Variance
b) Labor price Variance
c) Variable Overhead Expenditure Variance
d) Fixed Overhead Expenditure Variance
e) Sale Price Variance
Volume Variance
a) Material Usage Variance
b) Labor Efficiency Variance
c) Fixed Overhead Volume Variance
d) Sale Volume Variance
Calculation of Variances:
(A) Material Cost Variance = Standard Cost – Actual Cost
Standard Cost = Standard price per unit * standard quantity
Actual Cost = Actual price per unit * actual quantity consumed
Further:
Ø Total Material Cost Variance = Material Price Variance + Material Yield Variance + Material Mix Variance + Yield Variance
Ø Material Price Variance = (Standard Unit Price – Actual Unit Price) * (Actual quantity of material used)
Price variations may be caused due to changes in prices, uneconomical purchasing, and failure to avail concessions and discounts and so on.
Ø Material quantity or usage variance = (Standard quantity – Actual quantity) * Standard price per unit
The cause that may lead to usage variances includes use of different qualities of material, inefficiencies of labor and change in the product design and so on.
Ø Mix Variance = Standard unit price * (Revised Standard quantity – Actual quantity)
This variance represents the difference between the actual proportion and the standard proportions of materials used in production of actual output. In other words mix variance is caused due to a change in composition of the mixture.
Ø Yield Variance = Standard rate * (Actual yield – Standard yield)
Yield variance is an output variance while the material price, quantity and mix variance are input variances. Yield Variance represents loss in production in process industries. Yield variance occurs when actual output differs from standard output due to abnormal process losses.
(B) Labor Cost Variance = Standard Cost – Actual Cost
Or
(Standard hours * Standard Rate) – (Actual hours * Actual Rate)
Further:
Ø Total Labor Cost Variance = Rate of Pay Variance + Efficiency Variance + Idle Time Variance + Labor Mix Variance
Ø Rate of Pay Variance = (Standard Rate – Actual Rate) * Actual hours per unit of output
This variance arises due to a change in the methodology of wages rate, payment at a rate higher or lower than the standard rate and so on.
Ø Efficiency Variance = (Actual Production – Standard Production) * Standard Rate per Unit
Or
(Standard Time for actual production –Actual Time excluding abnormal idle time) * Standard Hourly Rate
Ø Idle Time Variance = Abnormal Idle Hours * Standard Hourly rate
This variance will always be adverse or unfavorable. This happens when any employee remains idle due to abnormal circumstances like power failure, strikes and lockouts and so on.
Ø Labor Mix Variance = Standard Cost of Standard Mix – Standard Cost of Actual Mix
This arises when there is a non-availability or shortage of labor or a change in the grade of labor employed.
(C) Overheads Expenditure Variance = Standard Overheads Allowed – Actual Overheads Incurred
Overheads constitute of Variable Overheads and Fixed Overheads. Variable overhead expenses will vary directly in proportion to production. Fixed overheads are a vital element in the cost of production and by nature does not vary with variance in production.
After such a variance analysis has been made, the reasons for the deviations are then found out. This serves as an instrument of control in the hands of the management. The management will then strive to initiate actions to rectify an unfavorable variance or sustain and support a favorable variance.
Standard costing provides guidance to the management. By setting standards and acting as a yardstick for analyzing performance, it helps the management in effective cost control and also in formulating price and production policies. It makes it possible for the management to investigate into the causes of variances due to reasons such as mistakes and inefficiencies and so on. The entire exercise stimulates cost consciousness among all the executives and also enables fixing responsibilities amongst cost centers. Most importantly, whenever standard costing is implemented, the management need not concern itself with those activities that go according to the plan. The management can apply the principle of “Management by Exception” where they concentrate on points of exception. Standard costing once properly planned and introduced can help simplify the costing procedure and will enable savings in costs on the overall.