Standard Costing and Variance analysis Notes | Management Accounting Notes | Industries where Standard Costing is Applicable

[Standard Costing Notes, Variance Analysis Notes, Management Accounting Notes, Difference Between, Advantages and Limitations, Industries where Standard Costing is Applicable]

Standard Costing and Variance Analysis Notes

Meaning of Standard Costing

Cost control is a basic objective of cost accountancy. Standard costing is the most powerful system ever invented for cost control. Historical costing or actual costing is nothing but, a record of what happened in the past. It does not provide any ‘Norms’ or ‘Yardsticks’ for cost control. The actual costs lose their relevance after that particular accounting period. But, it is necessary to plan the costs, to determine what should be the cost of a product or service. It the actual costs do not conform to what the costs should be, the reasons for the change should be assessed and appropriate action should be initiated to eliminate the causes.

Definition of Standard, Standard Cost and Standard Costing

Standard: According to Prof. Eric L.Kohler, “Standard is a desired attainable objective, a performance, a goal, a model”. Standard may be used to a predetermined rate or a predetermined amount or a predetermined cost.

Standard Cost: Standard cost is predetermined cost or forecast estimate of cost. I.C.M.A. Terminology defines Standard Cost as, “a predetermined cost, which is calculated from management standards of efficient operations and the relevant necessary expenditure. It may be used as a basis for price-fixing and for cost control through variance analysis”. The other names for standard costs are predetermined costs, budgeted costs, projected costs, model costs, measured costs, specifications costs etc. Standard cost is a predetermined estimate of cost to manufacture a single unit or a number of units of a product during a future period. Actual costs are compared with these standard costs.

Standard Costing: Standard Costing is defined by I.C.M.A. Terminology as, “The preparation and use of standard costs, their comparison with actual costs and the analysis of variances to their causes and points of incidence”. Standard costing is a method of ascertaining the costs whereby statistics are prepared to show:

a)    The standard cost

b)   The actual cost

c)    The difference between these costs, which is termed the variance” says Wheldon. Thus the technique of standard cost study comprises of:

1.    Pre-determination of standard costs;

2.    Use of standard costs;

3.    Comparison of actual cost with the standard costs;

4.    Find out and analyse reasons for variances;

5.    Reporting to management for proper action to maximize efficiency.

Advantages of standard costing:

a.    Cost control: Standard costing is universally recognised as a powerful cost control system. Controlling and reducing costs becomes a systematic practice under standard costing.

b.    Elimination of wastage and inefficiency: Wastage and inefficiency in all aspects of the manufacturing process are curtailed, reduced and eliminated over a period of time if standard costing is in continuous operation.

c.     Norms: Standard costing provides the norms and yard sticks with which the actual performance can be measured and assessed.

d.    Locates sources of inefficiency: It pin points the areas where operational inefficiency exists. It also measures the extent of the inefficiency.

e.    Fixing responsibility: Variance analysis can determine the persons responsible for each variance. Shifting or evading responsibility is not easy under this system.

f.     Management by exception: The principle of ‘management by exception can be easily followed because problem areas are highlighted by negative variances.

g.    Improvement in methods and operations: Standards are set on the basis of systematic study of the methods and operations. As a consequence, cost reduction is possible through improved methods and operations.

h.    Guidance for production and pricing policies: Standards are valuable guides to the management in the formulation of pricing policies and production decisions.

i.      Planning and Budgeting: Budgetary control is far more effective in conjunction with standard costing. Being predetermined costs on scientific basis, standard costs are also useful in planning the operations.

j.      Inventory valuation: Valuation of stocks becomes a simple process by valuing them at standard cost.

Limitations of Standard Costing:

a.    Variation in price: One of the chief problems faced in the operation of the standard costing system is the precise estimation of likely prices or rate to be paid.

b.    Varying levels of output: If the standard level of output set for pre-determination of standard costs is not achieved, the standard costs are said to be not realised.

c.     Changing standard of technology: In case of industries that have frequent technological changes affecting the conditions of production, standard costing may not be suitable.

d.    Applicability: It cannot be used in those organizations where non-standard products are produced. If the production is undertaken according to the customer specifications, then each job will involve different amount of expenditures.

e.    Difficult to set standard: The process of setting standard is a difficult task, as it requires technical skills. The time and motion study is required to be undertaken for this purpose. These studies require a lot of time and money.

f.     Problem in fixing Responsibility: The fixing of responsibility is not an easy task. The variances are to be classified into controllable and uncontrollable variances. Standard costing is applicable only for controllable variances.

Essentials or Preliminaries before Setting Standard:

While setting standard cost for operations, process or product, the following Preliminaries must be gone through:

a.    There must be Standard Committee, similar to Budget Committee, in which Purchase Manager, Personnel Manger, and Production Manager are represented. The Cost Accountant coordinates the functions of the Standard Committee.

b.    Study the existing costing system, cost records and forms in use. If necessary, review the existing system.

c.     A technical survey of the existing methods of production should be undertaken so that accurate and reliable standards can be established.

d.    Determine the type of standard to be used.

e.    Fix standard for each element of cost.

f.     Determine standard costs for each product.

g.    Fix the responsibility for setting standards.

h.    Classify the accounts properly so that variances may be accounted for in the manner desired.

i.      Comparison of actual costs with pre-determined standards to ascertain the deviations.

j.      Action to be taken by management to ensure that adverse variances are not repeated.

List of Companies which uses standard cost / List out any 10 industries where standard costing used

Standard costing is most suitable for those industries that are producing standard products and goods of repetitive nature. Some of the industries where standard costing used are listed below:

1) Sugar Industries

2) Textiles Industries

3) Fertilizers Industries

4) Steel industries

5) Power generation and distribution industries.

6) Petroleum industries

7) Agricultural and food industries

8) Transport Industries

9) Water Supply Industries

10) Coal mining industries

But Standard Costing is not suitable for:

a) Job order industries

b) Industries where contract costing is used

c) Non-standard product manufacturers

d) Service industries where operating or operation system is not applicable.

Introduction of Standard Costing System in an Establishment

Introducing standard costing in any establishment requires the fulfillment of following preliminaries:

a) Establishment of cost centers: A cost Centre is a location, person or item of equipment for which costs may be ascertained and used for the purpose of cost control. The cost centers divide an entire organisation into convenient parts for costing purpose. The nature of production and operations, the organisational structure, etc. influence the process of establishing cost centers. No hard and fast rule can be laid down in this regard. Establishment of the cost centers is essential for pin pointing responsibility for variances.

b) Classification and codification of accounts: The need for quick collection and analysis of cost information necessitates classification and codification. Accounts are to be classified according to different items of expenses under suitable headings. Each of the headings is to be given a separate code number. The codes and symbols used in the process facilitate introduction of computerization.

c) Determining the types of standards and their basis: Standards can be classified into two broad categories on the basis of the length of use:

i. Current standards: These are standards which are related to current conditions, particularly of the budget period. They are for short-term use and are more suitable for control purpose. They are also more amenable for combining with budgeting.

ii. Basic standards: These are long-term standards; some of them intended to be in use for even decades. They are helpful for planning long-term operations and growth.

Basic standards: There can be significant difference in the standards set depending on the base used for them. The following are the different bases for setting standard, whether they are current standards for short-term or basic standards for long-term use.

Ideal standards: These standards reflect the best performance in every aspect. They are like 100 marks in a paper for students taking up examinations. What is possible under ideal circumstances in all aspects is reflected in these standards. They are impractical and unattainable in practice. There utility for control purpose is negligible.

Past performance based standards: The actual performance attained in the past may be taken as basis and the same may be retained as standard. Such standards do not provide any incentive or challenge to the employees. They are too easy to attain. Their value from cost control point of view is minimal.

Normal standard: It is defined as “the average standard which, it is anticipated can be attained over a future period of time, preferably long enough to cover one trade cycle”. They are average standard reflecting the average performance over a complete trade cycle which may take three to five years. For a specific period, say a budget period, their relevance is negligible.

Attainable high performance standards: They are based on what can be achieved with reasonable hard work and efforts. They are based on the current conditions and capability of the workers. These standards are considered to be of great practical value because they provide sufficient incentive and challenge to the workers to attain them. Any variances from such standard are really significant because the standard which is attainable with effort is not attained.

d) Determining the expected level of activity: Capacity of operation or level of activity expected over a future period is vital in fixing current or short-term standards. When the activity level is decided on the basis of sales or production, whichever is the limiting factor; all standard can be developed with the activity level as the focal point. The purchase of material, usage of material, labour hours to be worked, etc. are solely governed by the planned level of activity.

e) Setting standards: Standards may be either too strict or too liberal because they may be based on theoretical maximum efficiency attainable good performance or average past performance. Setting standards may also be called developing standards or establishment of standard cost because as a consequence of setting standards for various aspects, standard cost can be computed.

Material quantity standards: The following procedure is usually followed for setting material quantity standards.

(a) Standardization of products: Detailed specifications, blueprints, norms for normal wastage etc., of products along with their designs are settled.

(b) Product classification: Detailed classified list of products to be manufactured are prepared.

(c)  Standardization of material: Specifications, quality, etc., of materials to be used in the standard products are settled.

(d)  Preparation of bill of materials: A bill of material for each product or part showing description and quantity of each material to be used is prepared.

(e)  Test runs: Sample or test runs under regulated conditions may be useful in setting quantity standards in a precise manner.

Labour quantity standards: The following are the steps involved in setting labour quantity standards:

(a) Standardization of products: Detailed specifications, blueprints, norms for normal wastage etc., of products along with their designs are settled.

(b) Product classification: Detailed classified list of products to be manufactured are prepared.

(c) Standardization of methods: Selection of proper machines to use proper sequence and method of operations.

(d) Manufacturing layout: A plan of operation for each product listing the operations to be performed is prepared.

(e) Time and motion study is conducted for selecting the best way of completing the job.

(f) The operator is given training to perform the job or operations in the best possible manner.

Differences between Standard Cost and Estimated Cost

Estimates are predetermined costs which are based on historical data and are often not very scientifically determined.  They usually compiled from loosely gathered information and therefore, they are unsafe to use them as a tool for measuring performance.  Standard costs are a predetermined cost which aims at what the cost should be rather then what it will be.  Both the standard costs and estimated costs are used to determine price in advance and their purpose is to control cost.  But, there are certain differences between these two costs as stated below:

The following are some of the important differences between standard cost and estimated cost:

Basis	Standard Cost	Estimated Cost
Emphasis	Standard cost emphasizes as what the cost ‘should   be’ in a given set of situations.	Estimated cost emphasizes on what the cost ‘will be’.
Basis for calculation	Standard costs are planned costs which are determined by technical experts after considering   levels of efficiency and production.	Estimated costs are determined by taking into consideration the historical data as the basis and adjusting it to future trends.
Efficiency measurement	It is used as a devise for measuring efficiency	It cannot be used as a devise to determine efficiency.  It only determines expected costs.
Cost control	Standard costs serve the purpose of cost control	Estimated costs do not serve the purpose of cost control.
Part of cost accounting	Standard costing is part of cost accounting process	Estimated costs are statistical in nature and may not become a part of accounting.
Technique of cost accounting	It is a technique developed and recognised by management and academicians.	It is just an estimate and not a technique
Applicability	It can be used where standard costing is in operation	It may be used in any concern operating on a historical cost system.

Difference between Budgetary Control and Standard Costing

Both standard costing and budgetary control achieve the same objective of maximum efficiency and cost reduction by establishing predetermined standards, comparing actual performance with the predetermined standards and taking corrective measures, where necessary. Thus, although both are useful tools to the management in controlling costs, they differ in the following respects:

Budgetary Control	Standard Costing
Budgetary control deals with the operations of a department of business as a whole.	Standard costing is applied to manufacturing of a product, process or processes or providing a service.
It is extensive in its application, as it deals with the operation of department or business as a Whole.	It is intensive, as it is applied to manufacturing of a product or providing a service.
Budgets are prepared for sales, production, cash etc.	It is determined by classifying recording and allocating expenses to cost unit.
It is a part of financial account, a projection of all financial accounts.	It is a part of cost account, a projection of all cost accounts.
Control is exercised by taking into account budgets and actual. Variances are not revealed through accounts.	Variances are revealed through difference accounts.
Budgeting can be applied in parts.	It cannot be applied in parts.
It is more expensive and broad in nature, as it relates to production, sales, finance etc.	It is not expensive because it relates to only elements of cost.
Budgets can be operated with standards.	This system cannot be operated without budgets.

Variance and Variance analysis

Control is a very important function of management. Through control, management ensures that performance of the organisation conforms to its plans and objectives. Analysis of variances is helpful in controlling the performance and achieving the profits that have been planned.

The deviation of the actual cost or profit or sales from the standard cost or profit or sales is known as “Variance”. When actual cost is less than standard cost or actual profit is better than standard profit it is known as favourable variance and such a variance is usually a sign of efficiency of the organisation. On the other hand, when actual cost is more than the standard cost or actual profit or turnover is less than standard profit or turnover it is called unfavourable or adverse variance and is usually an indicator of inefficiency of the organisation. Variance of different items of cost provide the key to cost control because they disclose whether and to what extent standards set have been achieved.

Variance analysis is the process of analysing variance by sub-dividing the total variance in such a way that management can assign responsibility for off standard performance. It, thus, involves the measurement of the deviation of actual performance from the intended performance. That is, variance analysis is a tool to measure performances and based on the principle of management by exception. In variance analysis, the attention of management is drawn not only to the monetary value of unfavourable and favourable managerial performance but also to the responsibility and causes for the same. After the standard costs have been fixed, the next stage in the operation of standard costing is to ascertain the actual cost of each element and compare them with the standard already set. Computation and analysis of variances is the main objective of standard costing. Actual cost and the standard cost is known as the ‘cost variance’.

As per I.C.M.A, Variance Analysis is “the resolution into constituent parts and explanation of variances”. The definition indicates two aspects-resolutions into constituent parts is the first aspect which is nothing but subdivision of the total cost variance. Explanation of variance includes the probing and inquiry for causes and responsible persons”.

Utility of Variance Analysis

a.    Variances are analysed to find out the causes or circumstances leading to it so that management can exercise proper control. Variance analysis sub divides the total variance based on difference contributory causes. This gives a clear picture of the different reasons for the overall variance.

b.    The sub division of variance establishes and highlights the interrelationship between different variances.

c.     Variance analysis ‘explains’ the causes for each variance. It paves way for fixing responsibility for all variances.

d.    It highlights all inefficient performances and the extent of inefficiency.

e.    It is a powerful tool leading to cost control. Analysis of variances is helpful in controlling the performance and achieving the profits that have been planned.

f.     It enables the top management to practice ‘management by exception’ by focusing on the problem areas. It helps the management to concentrate only on operations and segments of an enterprise where deviations are there from targeted performance.

g.    It segregates variance into controllable and uncontrollable, thereby indicating where action is warranted. This division of variance into controllable and uncontrollable is extremely important because the attention of the management is drawn particularly towards controllable variance.

h.    It acts as the basis for profit planning.

i.      By revealing each and every deviation, along with the causes, variance analysis creates and nurtures ‘cost consciousnesses among the employees.