Chapter 12

Standard costs and variance analysis

A General Model for Variance Analysis. A variance is the difference between standard
prices and quantities on the one hand and actual prices and quantities on the other hand. A
general model can be used to describe the variable cost variances.

1.Price variance. The price variance is the difference between the actual quantity of
inputs at the actual price and the actual quantity of inputs at the standard price. As
discussed later, the ‘actual quantity of inputs’ ordinarily refers to the actual quantity of
inputs purchased, which may differ from the actual quantity of inputs used.

2.Quantity variance. The quantity variance is the difference between the actual
quantity of inputs used at the standard price and the standard quantity of inputs allowed
for the actual output at the standard price. The ‘standard quantity allowed for the actual
output’ means the amount of the input that should have been used to produce the actual
output of the period. It is computed by multiplying the standard quantity of input per
unit of output by the actual output.

The formulas for the price variance are:

Price (rate) variance = (AQ  AP) - (AQ  SP)

or
Price (rate) variance = AQ (AP - SP)

The formulas for the quantity variance are:

Quantity (efficiency) variance = (AQ  SP) - (SQ  SP)

or
Quantity (efficiency) variance = SP (AQ - SQ)
Where:
AQ = Actual quantity of inputs purchased (or used)
AP = Actual price per unit of inputs purchased
SP = Standard price per unit of input
SQ = Standard input allowed for the actual output

-Standard price is the amount that should have been paid for the resources acquired.
- Standard quantity is the quantity allowed for the actual good output.

Direct material variances

The materials price variance is the difference between what is paid for a given
quantity of materials and what should have been paid according to the standard. Most
firms compute the material price variance when materials are purchased rather than
when the materials are placed into production. Generally speaking, the purchasing
manager has control over the price to be paid for goods and is therefore responsible for
any price variance. For purposes of control, it is best to recognise the variance

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immediately rather than wait until the materials are withdrawn for use in production.
Also, if the material price variance is recognised at time of issuance to production rather
than at time of purchase, then someone must keep track of the actual cost of each item
until it is used. If the variance is recognised when the materials are purchased, then the
materials inventories can be carried at standard cost—which enormously simplifies the
bookkeeping.

The materials quantity variance is the difference between the quantity of materials
used in production and the quantity that should have been used according to the
standard—all multiplied by the standard price per unit of input. Ordinarily, the materials
quantity variance is the responsibility of the production department. However, there
may be times when the purchasing department is responsible for an unfavourable
material quantity variance due to the purchase of inferior quality materials.

Direct labour variances.

The labour rate variance measures any deviation from standard in the average hourly
rate paid to direct labour workers. Students often wonder how there can be a labour rate
variance since firms generally know each employee’s wage rate in advance. A labour
rate variance can arise for a number of reasons. The mix of workers, and hence of lower
and higher wage rates, can be different from what was planned due to absences, changes
in the composition of the work force, and a variety of other circumstances. Additionally,
labour rate variances can occur if there is overtime.

The quantity variance for direct labour is called the labour efficiency variance .
Traditionally, this has been the most closely monitored variance by management. The
usefulness of this variance is questionable, however, due to changes in employment
policies and in production processes. When the employment force is flexible and can be
adjusted to changes in workloads at will, the main causes of the labour efficiency
variance include poorly trained workers, poorly motivated workers, poor quality
materials which require more labour time and processing, faulty equipment which
causes breakdowns and work interruptions, and poor supervision. However, in many
firms, there is very little ability to adjust the work force to the workload in the short-
term. In such firms, the major cause of a labour efficiency variance is likely to be
fluctuations in demand for the firm’s products rather than the efficiency with which
workers do their jobs.

Variable overhead variances. These variances will be discussed in greater depth in the
next chapter. You may want to defer all discussion of the interpretations of these
variances until you take up that chapter.

The variable overhead spending variance is computed as follows when the variable
overhead rate is expressed in terms of direct labour-hours:

Variable overhead spending variance =

Actual hours x (Actual rate – Standard rate)

The variable overhead spending variance compares actual spending on variable

overhead to the amount of spending that would be expected, given the actual direct
labour-hours for the period. The critical assumption is that variable overhead spending

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 is proportional to the actual direct labour-hours. The usefulness of this variance depends
upon the validity of this assumption. If in fact there is little relationship between actual
direct labour-hours and the optimal level of variable overhead spending, then this
variance has little meaning.

The variable overhead efficiency variance is computed as follows when the variable overhead
rate is expressed in terms of direct labour-hours:

Variable overhead efficiency variance =

Standard rate x (Actual hours – Standard hours)

Note the similarity between the direct labour efficiency variance and the variable
overhead efficiency variance. In both cases, the actual direct labour-hours are compared
to the standard direct labour-hours allowed for the actual output. The only difference
between the variances is the standard rate that is applied to difference between the
actual and standard hours. In the case of the direct labour efficiency variance, the rate is
the standard labour rate. In the case of the variable overhead efficiency variance, the
rate is the standard (predetermined) variable overhead rate per direct labour-hour.
Therefore, these two variances really measure the same thing. Those who criticise the
labour efficiency variance as irrelevant or counter-productive would likewise criticise
the variable overhead efficiency variance.

Evaluation of controls based on standard costs.

Advantages of standards costs. Standard cost systems have a number of advantages:

 Managers are alerted when something requires attention.
 Standard costs provide benchmarks that individuals can use to judge their own
performance.
 Standard costs can greatly simplify bookkeeping.
 Standards costs fit naturally in an integrated system of responsibility
accounting.

Potential Problems with the use of Standard Costs.

Some of the potential disadvantages of standard costs have been mentioned in passing above.
A more complete list follows:
 Standard cost variance reports are usually prepared on a monthly basis and are
released long after the end of the month. As a consequence, the information in
the reports may be so stale that it is almost useless. It is better to have timely,
frequent reports that are approximately correct than to have untimely, infrequent
reports that are very precise but too old to be of much use. Some companies are
now reporting variances and other key operating data daily or even more
frequently.

 If managers are insensitive and use variance reports as a club, morale may
suffer. There should be positive reinforcement for work well done. Management
by exception, by its nature, tends to focus on the negative. Moreover, if
variances are used as a club, subordinates may be tempted to cover up
unfavourable variances or take actions that are not in the best interests of the
company to make sure the variances are favourable. For example, workers may

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 put on a crash effort to increase output at the end of the month to avoid an
unfavourable labour efficiency variance. During such crash efforts, quality may
not be a major concern. It is claimed that in the old Soviet Union, workers used
hammers instead of screwdrivers at the end of the month to meet production
quotas.

 Labour quantity standards and labour efficiency variances make two important
assumptions. First, they assume that the production process is labour-paced; if
labour works faster, output will go up. However, output in many companies is
no longer determined by how fast labour works; rather, it is determined by the
processing speed of machines. Second, these computations assume that labour is
a variable cost. However, as discussed in earlier chapters, in many companies
direct labour may be more of a fixed cost than a variable cost. And if labour is a
fixed cost, then an undue emphasis on labour efficiency variances creates
pressure to build excess work-in-progress and finished goods inventories as
discussed above. If a workstation is not a bottleneck, its capacity exceeds the
capacity of the bottleneck. If every workstation is being evaluated based on its
labour efficiency variance, then every workstation will attempt to produce at
capacity. But if the work stations in front of the bottleneck produce at capacity,
the inevitable result will be a build up of work in progress inventories in front of
the bottleneck. This reasoning applies to any two successive workstations with
differing capacities. If the first work station has greater capacity that the second
work station and attempts to produce to its capacity, the result will be ever
increasing piles of work in progress inventory in front of the second work
station.

 In some cases, a ‘favourable’ variance can be as bad or worse than an

‘unfavourable’ variance. For example, there are standard doses for vaccines. If
there is a ‘favourable’ variance, it means that less vaccine was used than the
standard specifies. The result may be an ineffective inoculation.

 There may be a tendency with standard cost reporting systems to emphasise

meeting the standards to the exclusion of other important objectives such as
maintaining and improving quality, on-time delivery, and customer satisfaction.

 Continual improvement—not just meeting standards—may be necessary to

survival in the current competitive environment. For that reason, some
companies focus on the trends in the standard cost variances—aiming for
continual improvement rather than just meeting the standards.