APT TECHNICAL CPD - MAF

STANDARD COSTING

Standard CostingNicholas Riemer

Nicholas.Riemer@firstrand.co.za

Agenda

• Workflow to understanding standard costing

• What is standard costing? Generic Problem

• Industry considerations?

• What is the specific problem?

• How to incorporate into your file

Standard costing Workflow Approach

Standard costing generic problem

What is standard costing?

• Financial control system

• Analyze deviations from budget

• Generally applied to manufacturing activities, but can be applied in other environments (i.e. service environment):

– Common / repetitive operations

– Input to produce output can be specified

– Can be applied where different products are produced, as long as there are common operations / processes

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Introduction cont.

• Standard cost:

– Predetermined

– Target cost under efficient operating conditions

– Represent future target costs, therefore more useful for decision making than actual past costs

• Difference between a BUDGET and a STANDARD:

– Budget – for TOTAL activity

– Standard – the budget on a PER UNIT basis

– Therefore, take the budget ÷ budgeted number of units to get standard (i.e. per unit)

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Introduction cont.

• Variances:

• What is a variance?

• Analyse variance per process, not per product

• Allocated to responsibility centres

• Remember: for production variances, compare actual costs and usage to standard costs and usage for ACTUAL PRODUCTION

• If reason for variance is permanent change, then standards should be changed

• Two main elements of variances:• Price

• Quantity / Usage

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Overview of standard costing system

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STANDARD cost of ACTUAL output

RECORDED for each responsibility centre

ACTUAL costs TRACED toeach responsibility centre

Standard and actual costs COMPARED and VARIANCES ANALYSED and REPORTED

Variances INVESTIGATED and CORRECTIVE ACTION taken

STANDARDS MONITORED and ADJUSTED to reflect changes in standard usage and / or prices

Setting standard costs

• Set for performing an OPERATION, not the complete product

• Standard cost for each operation:

• Multiply amount that SHOULD have been USED by the amount that SHOULD have been PAID

• Therefore STANDARD QUANTITIES X STANDARD PRICES

• Use past HISTORICAL records:

• Danger they includes past inefficiencies

• Use ENGINEERING studies

• Unavoidable / inevitable wastage and delays SHOULD BE taken into account when setting standards

• Need to unitise FIXED OVERHEADS for STOCK VALUATION purposes

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Uses of standard costing

• Decision making:

• Represent future target costs, eliminating avoidable inefficiencies

• Preferable to estimates based on past costs that could include avoidable inefficiencies

• Motivation:

• Provide challenging target

• Help setting budgets and evaluating managerial performance

• Control device:

• Highlighting areas that are ‘out of control’

• Pinpoint where issues are arising through detailed analysis of variances

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Uses of standard costing cont.

• Simplifies profit measurement and inventory valuation:

• Inventory valued at standard cost

• Variances written off through the Income Statement as a period cost

• Comparison of standard and actual costs done at responsibility centre level and not at the product level, therefore actual costs are not assigned to individual products

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Variances

Flexing – NB!

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BUDGET FLEXED BUDGET ACTUAL

BUDGETED units X STANDARD PRICES and STANDARD QUANTITIES per unit

ACTUAL units X STANDARD PRICES and STANDARD QUANTITIES per unit

ACTUAL units X ACTUAL PRICES and ACTUAL QUANTITIES per unit

FLEXING = KEY

Variances

• Cost determined by PRICE paid and QUANTITY used

• Therefore, ACTUAL cost can differ from STANDARD cost because:

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Actual quantity used differs from standard quantity you ‘should have’

used

Actual price paid differs from standard price you ‘should have’

paid

USAGE / EFFICIENCY variancePRICE / RATE variance

For price variances, use ACTUAL purchases / sales / production / hours etc. because that is HOW MANY TIMES the ‘different’ price

happened

For usage variances, keep prices at STANDARD because we aren’t evaluating that now – we want to ISOLATE the usage / efficiency

only

Materials

Materials variances

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(Actual Quantity used – what you SHOULD HAVE used for

ACTUAL production) X Standard Price per unit of

material

(Actual Price per unit of material – Standard Price per unit of material) X Number of units ACTUALLY purchased

or used

USAGE variancePRICE variance

MIX YIELD

Based on quantity purchased or quantity used?

Difference between what your cost SHOULD HAVE BEEN (Standard Price x Standard Quantity) for your ACTUAL level of production and what your cost ACTUALLY WAS (Actual Price x Actual Quantity)

See following slides

Materials mix and yield variances

• Relevant where use more than one material to produce product AND can be used in differing ratios i.e. can be substituted

• Need to establish ‘target’ (i.e. standard) mix of materials

• Use laboratory and engineering studies

• Goal of target mix?

• Deviating from standard mix can result in changes in cost and changes in yield

• Could be conscious decision based on changes in costs of raw materials

• Could be due to inefficiencies etc.

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Materials mix and yield variances cont.

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What should you have used and what did you use to

produce output (regardless of what mix should have

been)

USAGE variancePRICE variance

MIX YIELD

TOTAL variance

(Actual Quantity – Actual Quantity in STANDARD MIX) X Standard Price per unit of

material

(Actual Quantity in STANDARD MIX – Standard Quantity in STANDARD MIX) X Standard Price per unit of

material

For materials you ACTUALLY used, what was mix and what should it have been;

Regardless of how much you should have used – take what you ACTUALLY used and just look at MIX;

‘Ignore’ efficient / inefficient usage for now.

What SHOULD you have used in the STANDARD MIX and what did you ACTUALLY use in STANDARD MIX;

‘Ignore’ differences in your mix at this point.

Materials mix and yield variances cont.

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Mix and Yield must add up to Usage variance

USAGE variancePRICE variance

MIX YIELD

TOTAL variance

Concerned with PROPORTION of materials

used NOT with whether I was efficient or inefficient

Concerned with HOW MUCH materials I should have used

NOT the proportion I used

Use ACTUAL TOTAL quantity of material used –

split this into the STANDARD proportions and compare to the ACTUAL amount of each

material used

Work out how much total material I SHOULD HAVE used and compare to the total I ACTUALLY used –

ALL in STANDARD proportion

On the USAGE side of the variance, therefore use STANDARD PRICES

Compare what I ACTUALLYused per material with what I

SHOULD have used per material

Analysis examples

• Materials price variance:• Doesn’t always reflect efficiency of purchasing department: market conditions could have

changed influencing price of material• Adverse: failure to source most advantageous sources of supply• Favourable: could be due to purchase of inferior quality materials, could lead to more

wastage and inferior quality final product

• Materials usage variance:• Usually controllable by manager of appropriate production responsibility centre• Adverse: careless handling of materials; purchase of inferior quality; theft• Either: changes in quality control requirements; changes in method of production

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Analysis examples cont.

• Materials mix variance:• Unfavourable could be due to using more of the expensive, better quality input – affects the

yield (i.e. amount and quality produced)

• Favourable (i.e. using more of the cheaper material) could lead to sub-par product

• Materials yield variance:• Unfavourable variance could be due to use of inferior inputs

• Could indicate that standard procedure wasn’t followed (e.g. used a less efficient method)

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Labour

Labour variances

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(Actual hours worked – how many hours SHOULD have been worked for ACTUAL

production) X Standard wage rate per hour

(Actual wage per hour –Standard wage per hour) X ACTUAL number of hours

EFFICIENY (‘USAGE’) varianceRATE (‘PRICE’) variance

IDLE TIME / CAPACITY USAGE

Difference between what your labour cost SHOULD have been (standard wage rate x standard hours) for your ACTUAL level of production and what your cost ACTUALLY was (actual rate x actual hours)

Further analysis

Analysis examples

• Wage rate variance:

• One of least controllable variances

• Generally due to standards not being adjusted to reflect changes in wage rates

• Labour efficiency variance:

• Normally controllable by manager, but sometimes not if due to change in quality control standards or poor production scheduling by planning department

• Adverse: inferior quality materials; failure to maintain equipment properly

• Either: using different grades of labour; introduction of new equipment; changes in the production process

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Clocked vs productive hours

• Clocked hours = hours ‘logged’ or hours ‘at work’; includes idle time

• Productive hours = clocked hours that were actually spent working and being productive

• NB – if you are working with clocked hours, make sure you use the RATE and USAGE for CLOCKED hours; if you are working with PRODUCTIVE hours, make sure you use the RATE and USAGE for PRODUCTIVE hours!

• Can use either for rate and efficiency variance (if don’t split further)

• Easier to work with clocked hours as opposed to productive hours – however you need to work with productive hours if when you want to calculate an idle time variance

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Variable overheads

Overheads variances

• Get variances for variable and fixed overheads

• Variable:– Unitise based on some input e.g. linked to labour hours or machine hours

• Fixed:– Not really necessary to unitise for cost control

BUT

– Need to unitise for STOCK VALUATION (as per absorption costing)

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Variable overheads variances

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Difference between amount of machine / labour hours you SHOULD have used

to produce your ACTUAL output and the ACTUAL hours you used X

STANDARD allocation rate

Difference between STANDARD rate and ACTUAL rate X ACTUAL hours (machine / labour depending on how

variable costs are allocated)

EFFICIENY (“USAGE”) varianceEXPENDITURE (“PRICE”) variance

Difference between what your variable overhead cost SHOULD have been (standard rate x standard hours) for your ACTUAL level of production and what your cost ACTUALLY was (actual rate x actual

hours).

Where variable overheads are allocated based on labour / machine

hours, we get sub-variances

Analysis examples

• Variable overheads expenditure variance:• Variable overheads represent many items e.g. indirect labour, indirect

materials, maintenance etc.• Therefore variance could be due to change in price of any of the above• How efficiently variable overhead items are used• Meaningful analysis must look at individual items making up variable

overheads

• Variable overheads efficiency variance:• Same principle as labour efficiency variance

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Fixed overheads

Fixed overheads variances

• Different for variable and absorption costing

• In variable costing system: fixed overheads variance is simply difference between BUDGETED overheads and ACTUAL overheads

• Analysis examples:• In itself, not very meaningful; need to break down and analyse components

• Change in number of supervisors, salary of supervisors

• Likely to be uncontrollable in the short-term

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Standard absorption costing• Additional variance is now fixed overhead volume variance

• Also has impact on calculation of sales variances

• Standard allocation rate: budgeted fixed overheads divided by budgeted production

• Where different products are produced, convert units into standard hours and allocate fixed overheads based on standard hours

• NB – fixed NON-manufacturing costs are NOT allocated to inventory (i.e. closing and opening stock)

• Link between over- / under-absorption and variances?

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Fixed overheads variances (absorption costing basis)

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Budgeted units vs Actual units produced x Standard rate per unitDifference between ACTUAL fixed

overheads and BUDGETED fixed overheads on a TOTAL level

VOLUME varianceEXPENDITURE variance

TOTAL variance Difference between what your fixed overheads ACTUALLY were and what you ABSORBED i.e.

STANDARD allocation rate X STANDARD hours (or allocation unit) for ACTUAL production (OR simply fixed overhead allocation rate / unit X number of units ACTUALLY produced)

ACTUAL production differed from BUDGETED – keep everything

else at STANDARD;E.g. You budgeted on making

10,000 units and you actually only made 9,000 units; isolate THAT

and keep everything else at STANDARD e.g. hours

VOLUME EFFICIENCY VOLUME CAPACITY

See next slides

FAVOURABLE VS ADVERSE?

OVER- / UNDER-ABSORPTION?

Fixed overheads variances (absorption costing basis) cont.

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Need to analyse underlying i.e. labour hours, machine hours etc.

Therefore can’t work per unit.VOLUME varianceEXPENDITURE variance

VOLUME EFFICIENCY VOLUME CAPACITY

TOTAL variance

How efficient / inefficient you were regarding hours;

Difference between ACTUAL hours and STANDARD hours for

ACTUAL production X STANDARD allocation rate / hour

“Extra” capacity or capacity you didn’t use at all;Difference between number of hours you BUDGETED on using (BUDGETED production at STANDARD hours) vs number of hours you ACTUALLY used X STANDARD allocation rate / hour

If adverse: failure to use capacity EFFICIENTLY (think of labour efficiency variance)

If adverse: failure to use capacity AT ALL (difference between BUDGETED hours and ACTUAL hours)

FAVOURABLE VS ADVERSE?

Sales

Sales variances

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Difference between ACTUAL number sold and BUDGETED number sold at

STANDARD contribution / profit per unit OR STANDARD price per unit

Difference between ACTUAL selling price per unit and STANDARD

selling price per unit X ACTUAL number sold

VOLUME variancePRICE variance

Difference between ACTUAL number sold at ACTUAL price and BUDGETED number sold at STANDARD price

When to use which?What is more meaningful?

NB – Impact on recon! (see slides on recons)

NB – Isolate the difference due to quantity sold only, therefore use STANDARD price / contribution /

profit

MIX QUANTITY

See next slides

Sales variances cont.

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What you should have sold (i.e. budget) and what you did sell (regardless of what

mix should have been)VOLUME variance

PRICE variance

MIX QUANTITY

TOTAL variance

(Actual Quantity sold – Actual Quantity sold in STANDARD

MIX) X Standard Price / Contribution / Profit per unit

Difference between what you ACTUALLY sold in STANDARD mix

and what you BUDGETED on selling

(which already reflects standard mix) X Standard Price /

Contribution / Profit per unit

When company sells different products with different profit margins;

Illustrates that not only volume of sales is important –mix matters too.

NB – Keep everything in Standard mix;Isolating the difference between what you sold and what you budgeted on selling, therefore ‘ignore’ mix

NB – for mix and quantity, standard contribution provides most meaningful information

Analysis examples

• Sales variances:• Might not be very meaningful to analyse into price and volume variances, as changes in price

could impact changes in volume sold • Changes in sales might be due to external factors not under the control of the sales function e.g.

economic recession • Alternative ways to monitor / evaluate sales function:

• Track market shares (actual vs target; trend in market shares)• Compare to competitors’ prices

• Sales mix and yield variances:• Illustrates that not only volume of sales is important – mix matters too• Will have adverse variance when sell more of product with below average contribution and vice

versa

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Budget, Actual, Reconciliations

Reconciling actual and budgeted profit

• Why?

• Add favourable variances and deduct unfavourable variances to the BUDGETED Income Statement to get us to ACTUAL

• Broad picture for top management

• In reality companies have many different products, processes and responsibility centres – need to analyse for each

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Accounting

Accounting

• Recap:• Used for planning, control and decision-making purposes

• Also for inventory valuation

• Can be used for reporting purposes as long as standard costs approximate actual, are current and attainable

• NB – must include fixed costs for accounting, therefore standard ABSORPTION costing system

• Variances are debited or credited in the accounts:• Adverse variances = DEBITS because they represent “additional costs”

• Positive variances = CREDITS as they represent “cost savings”

• NB – only production variances are recorded, NOT sales variances. Why?

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Variance Investigation

Variance investigation

• Planning vs operating variances:• Standards are set under expectation of a certain operating environment

• For performance analysis, changes in environment should be taken into account (“ex-post” variance analysis)

• Separate into planning variance (uncontrollable) and efficiency / operational variance (controllable)

• After calculating and reporting variances, management must decide which ones must be investigated:

• Investigate all?

• Investigate too few?

• Optimal policy?

• Cost vs benefit

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Variance investigation cont.

• Various reasons for variances:

• Measurement errors (e.g. incorrect recording of labour hours)• Investigation might lead to improvement in recording system, but won’t normally result

in increased efficiency

• Standards become out of date (e.g. due to frequent changes in price of inputs; learning curve effects; technological changes)

• Analysis of these variances will highlight the need to improve the accuracy of the standards

• Inefficiencies (e.g. failure to follow proper methods; faulty machinery; human error)

• Random or chance fluctuations for which no causes can be found (i.e. due to random / uncontrollable factors)

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Variance investigation cont.

• To summarise, three main causes of variances:

1. Random, uncontrollable factors where operation is under control

2. Assignable causes, but cost of investigation exceed any benefits

3. Assignable causes, but where benefits exceed costs of investigation

• Some managers use ‘arbitrary’ criteria for investigation (e.g. only investigate if variances exceed a certain %):

– One way to try improve is apply different % thresholds to items differing in importance

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Variance investigation cont.

• Statistical investigation models:

– Use statistical control charts

– Determine mean/average usage (of operation observed under control) and standard deviation

– Set control limits

– Actual variances plotted on control chart – investigate those that fall outside control limits

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Industry considerations

• Using variance analysis for decision making

• Incorporation of variance analysis into the business

• Difficulty of determining standards, involves in depth engineering analysis.

• Mainly used for planning and control purposes as opposed to inventory valuation.

• Service industries incorporating standard costing

• Many companies adopt a unique analysis, not the standard variances in theoretical textbooks. Banks:Transaction analysis, Uber:Cost per Km, time per trip, revenue per trip from there projected profits

Specific issues

• Manager wants to incorporate standard’s into decision making, how to go about this?

• Developing of standards in a practical sense

• Analysis of variances, writing a report to management explaining what courses of action should be taken

• Cost benefit, Identifying inefficiencies, detailed explanation and examples of cost of identification vs what costs could be saved.

File

• Coverage……….

• I would say for this topic there would have to be many things to consider in the pre release and Info on the day.

• Number 1, 2, 3………

• The technical variances are one thing, but how they are analyzed, industry idea’s and answering of direct questions would be key.

• Remember Technical, context (applying the technical), research and Coverage!

• Ensure your file is equipped to handle the above.