Chapter 18

Planning, control and performance: Standard costing

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Introduction

Cost accounting has two main branches: costing, and planning, control and performance. Standard costing, along with budgeting, is one of the two parts of planning, control and performance. Standard costing can be seen as a more specialised and formal type of budgeting. A particular feature of standard costing is the breakdown of costs into various cost components such as direct labour, direct materials, variable overheads and fixed overheads. In standard costing, expected (or standard) sales or costs are compared against actual sales or costs. Any differences between them (called variances) are then investigated. In management accounting, the normal terminology is ‘sales’ rather than ‘revenue’ variances and this is the convention we use in this book. Variances are divided into those based on quantity and those based on prices. Standard costing, therefore, links the future (i.e., expected costs) to the past (i.e., costs that were actually incurred). Standard costing has proved a useful planning and control tool in many industries. However, standard costing, as Soundbite 18.1 shows, has limitations in times of change.

Nature of Standard Costing

Standard costing is a sophisticated form of budgeting. Standard costing was originally developed in manufacturing industries in order to control costs. Essentially, standard costing involves investigating, often in some detail, the distinct costing elements which make up a product such as direct materials, direct labour, variable overheads and fixed overheads. After this investigation the costs which should be incurred in making a product or service are determined (see Definition 18.1). For example, a table might be expected to be made using eight hours of direct labour and three metres of wood. These become the standard quantities for making a table.

After a table is made the direct labour and direct materials actually used are compared with the standard. For example, if nine hours are taken rather than eight, this is one hour worse than standard. However, if two metres of wood rather than three metres are used, this is one metre better than standard.

These differences from standard are called variances, which may be favourable (i.e., we have performed better than expected) or unfavourable (i.e., we have performed worse than expected). Unfavourable variances are sometimes called adverse variances. The essence of a good standard costing system is to establish the reason for any variances. Although standard costing is associated with manufacturing industry, it can be adopted in other industries, such as hotel and catering. Just as in normal budgeting, managers are often rewarded on the basis of whether they have met their targets or standards. Real-World View 18.1 gives an example of this in budgetary context.

Setting standards involves making a decision about whether you are aiming for ideal, attainable or normal standards. They are all different. There is no such thing as a perfect standard. Ideal standards are those which would be attained in an ideal world. Unfortunately, the real world differs from the ideal world. Attainable standards are more realistic and can be reached with effort. Normal standards are those which a business usually attains. Attainable standards are the standards most often used by organisations.

Standards are usually set by industrial engineers in conjunction with accountants. This often causes friction with the workers who are actually monitored by the standards. Real-World View 18.2 gives a flavour of these tensions. Although dating from the last century, this has a contemporary feel about it.

Standard Cost Variances

In order to explain how standard costing works, the illustration of manufacturing a table is continued. In a succession of examples, more detail is gradually introduced. Figure 18.1 introduces the basic overview information for Alan Carpenter who is setting up a furniture business. In May, he makes a prototype table. To simplify the presentation in the figures favourable variances are shorted to ‘Fav’. and unfavourable variances to ‘Unfav’.

Before the prototype table was actually made, Alan Carpenter thought it would cost £20 and that he could sell it for £30. He, therefore, anticipated a profit of £10. In actual fact, the table was sold for £33. Carpenter thus made £3 more sales than anticipated. However, the table cost £22 (£2 more than anticipated). Overall, therefore, actual profit is £11 rather than the predicted standard profit of £10. Carpenter benefits £3 from selling well, but loses £2 through excessive costs. There is an overall favourable sales variance of £3, and an overall unfavourable cost variance of £2 which gives a £1 favourable profit variance.

We now expand the example and look at Alan Carpenter's operations for June. In June he anticipates making and selling 10 tables. In actual fact, he makes and sells only nine tables (see Figure 18.2).

Before calculating the variances, we must flex the budget. Flexing the budget simply means adjusting the budget to take into account the actual quantity produced. We need to do this because we need to calculate the costs which would have been incurred if we actually made nine tables. If we made only nine tables, we would logically expect to incur costs for nine rather than ten tables. In addition, we would expect to sell nine not ten tables. The budget must, therefore, be calculated on the basis of the nine actual tables made rather than the ten predicted.

By making nine rather than ten tables, the profit for one table is lost. This was £10 (as there was £100 profit for ten tables). There is thus a £10 drop in profits. This is called a sales quantity variance. (Note that we are assuming, at this stage, that all the costs will vary in direct relation to the number of tables.) We can now compare the sales and costs actually earned and incurred for nine tables with those that were expected to be earned and incurred. As Figure 18.2 shows, the nine tables were expected to sell for £270, but were actually sold for £290. In other words, we received £20 more than we had anticipated for our tables. This was the sales price variance. Note that the sales quantity variance is caused by lost profit. By contrast, the sales price variance is caused by the fact we are selling the tables for more than we anticipated. There is thus a favourable sales price variance of £20. The budgeted cost for nine tables was £180. However, the actual cost incurred is only £170. There is thus a favourable cost variance of £10. The difference between the budgeted profit of £100 and the actual profit of £120 can be explained by these three variances (unfavourable sales quantity variance (£10), favourable sales price variance (£20) and favourable cost variance (£10)).

So far, we have seen that it is important to flex the budget, and looked at the sales volume variance and the sales price variance. It is now time to look in more detail at the cost variances. When looking at cost variances, it is important to distinguish between variable and fixed costs. As we saw in Chapter 15, variable costs are those costs that directly vary with a product or service (for example, direct materials, direct labour or production overheads). The more products made, the more the variable costs. Thus, if it costs £20 to make one table, it will cost £200 to make ten tables. Fixed costs, however, do not vary. You will pay the buildings insurance of £10 per month whether you make one table or 100 tables. In continuing the Alan Carpenter example, the costs are now divided into fixed and variable. In effect, therefore, we are using a variable costing system where firm's costs are not allocated to inventory. In an absorption costing system where inventory would be valued there would need to be an additional variance, a volume variance. However, as these variables are not very useful for controlling or analysing a company's activities, they are not considered further here.

Essentially, all the variable costs (direct materials, direct labour, and variable overheads) have two elements – price and quantity. For example, when making a table we might predict using the following standard prices and standard quantities:

When our actual price and actual quantity vary from standard, we will have price and quantity variances. In other words, the overall cost variances for direct labour, direct materials and variable overheads can be divided into a quantity and a price variance. Price variances are caused when the standard price of a product differs from the actual price. Quantity variances are caused when the standard quantity differs from the actual quantity. These differences between the standard and the actual quantity when multiplied by standard price will give us the overall quantity variance. Favourable variances are where we have done better than expected; unfavourable variances are where we have done worse than expected. For fixed overheads, which do not vary with production, we compare the actual fixed overheads incurred with the standard. We call this difference the fixed overheads quantity variance.

An overview of all these variances is given in Figure 18.3 and in Figure 18.4 the main elements of all the variances are summarised. For simplification, this book uses the terms price and quantity variances throughout. Often, however, more technical terminology is used (these alternative technical terms are shown in the second column of Figure 18.4).

In order to see how these variances all interlock, we now expand the Alan Carpenter example (see Figure 18.5).

Using Figure 18.5, we now calculate the variances in two steps: flexing the budget and calculating the individual variances.

Flexing the Budget

Note that fixed overheads are not flexed! This is because by their very nature they do not vary with production. The flexed budget is used in the calculation of variances so that the levels of activity are the same and can be used as a basis for meaningful comparisons.

By flexing the budget, we have automatically calculated (1) the sales price variance, and (2) the overall cost variances for direct materials, direct labour and variable overheads. It is important to note that the flexed budget gives us the standard quantity of the actual production. The cost variances will then be broken down into the individual price and quantity variances (see Figure 18.6). However, first we need to calculate the sales quantity variance.

Calculating Individual Variances

(a) Sales Quantity Variance

Notes:

* This is budgeted profit before fixed overheads (£110) divided by the budgeted number of tables (10). Therefore, we have, £110 ÷ 10 = £11. Note that this is calculated before fixed overheads. This is because fixed overheads will remain the same whatever the value of sales. They must be excluded from the calculation and their variance calculated separately.

** This represents the difference between the budgeted profit (£100) less the flexed budget (£89). In practice, this is the easiest way to calculate this variance.

(b) Individual Price and Quantity Variances

When we calculate the price and quantity variances based on our flexed budget, we can use the standard price and quantity formulas given below (see Figure 18.6). We then need to remember that the standard price for sales is the standard selling price per unit, for direct materials it is the price per unit of direct materials used and so on. For quantity we need to remember that we are concerned with the standard quantity of materials, labour, etc. Figure 18.6 is based on Figure 18.5 and our flexed budget.

We can now draw up a standard cost reconciliation statement. This statement reconciles the budgeted profit of £100 to the actual profit of £120.

Interpretation of Variances

A key aspect of both budgeting and standard costing is the investigation of variances. In Figure 18.7 we look at some possible reasons for variances.

These variances represent differences in what actually happened to what we expected to happen. It must be remembered that variances are only as good as the original budgets or standards that are set. Therefore, if unrealistic, incorrect or unattainable standards are set, this will create misleading variances. As we saw earlier, setting the original standards can often cause severe tensions between the standard setters and the employees. In standard costing a more sophisticated, systematic approach is taken to the investigation of variances than in budgeting.

The nature of variable overheads means that these variances are tied into the basis of absorption (for example, direct labour hours). The causes for the variable overhead variances will, therefore, tend to reflect those for the direct labour hours. It is not, therefore, particularly meaningful to investigate the reasons for these variances separately. Variable overheads have, therefore, been excluded from Figure 18.7. When interpreting variances it is important to distinguish between those factors that are controllable (such as the amount of labour used) and those that are not controllable (such as supplier price rises or price rises caused by changes in foreign currency). Non-financial considerations such as risk and customer satisfaction are also important.

Conclusion

Standard costing is a sophisticated form of budgeting. It was originally used in manufacturing industries, but is now much more widespread. Standard costing involves predetermining the cost of the various elements of a product or service (such as selling price, direct materials, direct labour and variable overheads). These standard costs are then compared with the actual costs and any differences, called variances, investigated. These variances are split into price and quantity variances. Standard costing allows costs to be monitored very closely. In many businesses, it is thus a very useful form of planning, control and performance. However, it is important to appreciate the fact that budgeting and standard costing, although key elements of planning, control and performance have their limitations and can actually change, and indeed influence, performance. This is neatly demonstrated in Real-World View 18.3 with which we conclude this section.

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