A standard cost is a predetermined cost of manufacturing, servicing, or marketing an item during a given future period. It is based on current and projected future conditions. The norm is also dependent on quantitative and qualitative measurements. Standards may be based on engineering studies looking at time and motion. The formulated standard must be accurate and useful for control purposes. Standards are set at the beginning of the period. They may be in physical and dollar terms. Standards assist in the measurement of both effectiveness and efficiency. Examples: sales quotas, standard costs (e.g., material price, wage rate), and standard volume. Variances are not independent, so a favorable variance in one responsibility area may result in an unfavorable one in other segments of the business.
Variance analysis compares standard to actual performance. It could be done by division, department, program, product, territory, or any other responsibility unit. When more than one department is used in a production process, individual standards should be developed for each department in order to assign accountability to department managers. Variances may be as detailed as necessary, considering the cost/benefit relationship. Evaluation of variances may be done yearly, quarterly, monthly, daily, or hourly, depending on the importance of identifying a problem quickly. Because actual figures (e.g., hours spent) are not known until the end of the period, variances can be determined only at this time. A material variance requires notifying the person responsible and taking corrective action. Insignificant variances need not be looked into further unless they recur repeatedly and/or reflect potential difficulty. Generally, a variance should be investigated when the inquiry is anticipated to result in corrective action that will reduce costs by an amount exceeding the cost of the inquiry.
When the production cycle is long, variances that are computed at the time of product completion may be too late for prompt corrective action to be taken. In such a case, inspection may be undertaken at key points during the processing stage. This allows for spoilage, labor inefficiency, and other costs associated with problems to be recognized before product completion.
One measure of materiality is to divide the variance by the standard cost. A variance of less than 5 percent may be deemed immaterial. A 10 percent variation may be more acceptable to a company using tight standards compared to a 5 percent variation to a company employing loose standards. In some cases, materiality is looked at in terms of dollar amount or volume level. For example, a company may set a policy looking into any variance that exceeds $10,000 or 20,000 units, whichever is less. Guidelines for materiality also depend on the nature of the particular element as it affects performance and decision-making. For example, where the item is critical to the future functioning of the business (e.g., critical part, promotion, repairs), limits for materiality should be such that reporting is encouraged.
Further, statistical techniques can be used to ascertain the significance of cost and revenue variances. An acceptable range of tolerance should be established for managers (e.g., percent). Even if a variance never exceeds a minimum allowable percentage or minimum dollar amount, the manager may want to bring it to upper management’s attention if the variance is consistently close to the prescribed limit each year. This may indicate the standard is out of date and proper adjustment to current levels is mandated to improve overall profit planning.
Because of the critical nature of costs, such as advertising and maintenance, materiality guidelines are more stringent. Often the reasons for the variance are out-of-date standards or a poor budgetary process and not actual performance. By questioning the variances and trying to find answers, the manager can make the operation more efficient and less costly. It must be understood, however, that quality should be maintained.
If a variance is out of the manager’s control, follow-up action by the manager is not possible. For example: utility rates are not controllable internally. Standards may change at different operational volume levels. Further, standards should be appraised periodically, and when they no longer realistically reflect conditions, they should be modified. Standards may not be realistic any longer because of internal events, such as product design, or external conditions, such as management and competitive changes. For instance, standards should be revised when prices, material specifications, product designs, labor rates, labor efficiency, and production methods change to such a degree that current standards no longer provide a useful measure of performance. Changes in the methods or channels of distribution, or basic organizational or functional changes, would require changes in selling and administrative activities.
Significant favorable variances should also be investigated and should be taken advantage of further. Those responsible for good performance should be rewarded. Regression analysis may provide reliable association between costs and revenue. Variances are interrelated, and hence the net effect has to be examined. For example, a favorable price variance may arise when lower-quality materials are bought at a cheaper price, but the quantity variance will be unfavorable because of more production time to manufacture the goods due to poor material quality.
In the case of automated manufacturing facilities, standard cost information can be integrated with the computer that directs operations. Variances can then be identified and reported by the computer system and necessary adjustments made as the operation proceeds.
In appraising variances, consideration should be given to information that may have been, for whatever reason, omitted from the reports. Have there been changes in the production processes that have not been reflected in the reports? Have new product lines increased setup times that necessitate changes in the standards? Usefulness of Variance Analysis. Standards and variance analyses resulting from them are essential in financial analysis and decision making.
Advantages of Standards and Variances
- Aid in inventory costing
- Assist in decision making
- Sell price formulation based on what costs should be
- Aid in coordinating by having all departments focus on common goals
- Set and evaluate divisional objectives
- Allow cost control and performance evaluation by comparing actual to budgeted figures. The objective of cost control is to produce an item at the lowest possible cost according to predetermined quality standards.
- Highlight problem areas through the “management by exception” principle
- Pinpoint responsibility for undesirable performance so that corrective action may be taken. Variances in product activity (cost, quality, quantity) are typically the production manager’s responsibility. Variances in sales orders and market share are often the responsibility of the marketing manager. Variances in prices and methods of deliveries are the responsibility of purchasing personnel. Variances in profit usually relate to overall operations. Variances in return on investment relate to asset utilization.
- Motivate employees to accomplish predetermined goals
- Facilitate communication within the organization, such as between top management and supervisors
- Assist in planning by forecasting needs (e.g., cash requirements)
- Establish bid prices on contracts
Standard costing is not without some drawbacks, such as the possible biases in deriving standards and the dysfunctional effects of establishing improper norms and standards. When a variance has multiple causes, each cause should be cited.
Standards may be set by engineers, production managers, purchasing managers, and personnel administrators. Depending on the nature of the cost item, computerized models can be used to corroborate what the standard costs should be. Standards may be established through test runs or mathematical and technological analysis. Standards are based on the particular situation being appraised. Some examples:
Cost reduction Tight
Pricing policy Realistic
High-quality goods Perfection
Capacity may be expressed in units, weight, size, dollars, selling price, and direct labor hours. It may be expressed in different time periods (e.g., weekly, monthly, yearly).
Types of Standards
- Basic. These are not changed from period to period and are used in the same way as an index number. They form the basis to which later period performance is compared. What is unrealistic about basic standards is that no consideration is given to a change in the environment.
- Maximum efficiency. These are perfect standards assuming ideal, optimal conditions, allowing for no losses of any kind, even those considered unavoidable. They will always result in unfavorable variances. Realistically, certain inefficiencies will occur, such as materials will not always arrive at workstations on time and tools will break. Ideal standards cannot be used in forecasting and planning because they do not provide for normal inefficiencies.
- Currently attainable (practical).These refer to the volume of output possible if a facility operated continuously, but after allowing for normal and unavoidable losses such as vacations, holidays, and repairs. Currently attainable standards are based on efficient activity. They are possible but difficult to achieve. Considered are normal occurrences such as anticipated machinery failure and normal materials shortage. Practical standards should be set high enough to motivate employees and low enough to permit normal interruptions. Besides pointing to abnormal deviations in costs, practical standards may be used in forecasting cash flows and in planning inventory. Attainable standards typically are used in practice.
- Expected. These are expected figures based on foreseeable operating conditions and costs. They come very close to actual figures.
Standards should be set at a realistic level. Those affected by the standards should participate in formalizing them so there will be internalization of goals. When reasonable standards exist, employees typically become cost conscious and try to accomplish the best results at the least cost. Standards that are too tight will discourage employee performance. Standards that are too loose will result in inefficient operations. If employees receive bonuses for exceeding normal standards, the standards may be even more effective as motivation tools.
A standard is not an absolute and precise figure. Realistically, a standard constitutes a range of possible acceptable results. Thus, variances can and do occur within a normal upper-lower limit. In determining tolerance limits, relative magnitudes are more important than absolute values. For instance, if the standard cost for an activity is $100,000, a plus or minus range of $4,000 may be tolerable.
Variance analysis usually is complicated by the problem of computing the number of equivalent units of production. Variances may be controllable, partly controllable, or uncontrollable. It is not always easy to assign responsibility, even in the case of controllable variances. The extent to which a variance is controllable depends on the nature of the standard, the cost involved, and the particular factors causing the variance.