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Chapter 9

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STANDARD COSTING, FLEXIBLE BUDGETS AND VARIANCE ANALYSIS

- Standards are performance benchmarks that allow comparisons against actual performance.
- Flexible budgeting is a simple, but powerful technique to improve comparability and support performance measurement, planning and decision making.
- At the end of a period, you can use variance analysis to uncover ‘real-life’ factors that did not meet, or exceeded, expectations. Thus variance analysis requires detailed standards, dividing (or ‘drilling down’) costs and revenues to find the precise causes and to support continuous improvements.
- Standard costing and variance analysis have been widely adopted for over a hundred years.

- What are standard costs and variance analysis? Standard costs are expected costs under normal conditions, and refer to one unit of activity (for example, one unit of product or service).
- Variance analysis can be used to compare the expected cost with the actual cost of producing such an order (that is, to calculate the variances) and identify the ‘real-life’ factors causing the differences.
- When variances are unfavourable (for example, actual cost is higher than expected), you must identify and solve underlying problems.
- When variances are favourable, you should learn how to sustain that good performance, and even transfer that knowledge to other areas of the organization.

- Uses of standard costing and variance analysis 1. Decision making. Standard costs provide a basis for decision making, since they provide readily available estimates of future costs. 2. Planning, motivation, performance evaluation and control. Standards are objectives, or benchmarks, to be achieved. Unit level standards are essential to produce budgets, in particular flexible budgets – a popular planning and control tool to produce budgets for different activity levels and product mixes. Flexible budgets enable calculating meaningful variances, comparing actual costs with budgeted costs for the actual level of activity and product mix. Variance analysis, in a contextualized and critical way, can provide insights to control and assist performance evaluation.
- So, standards and variance analysis are important motivation tools, setting objectives and monitoring and rewarding performance

3. Reporting. Standard costs simplify calculating profits and valuing inventories.

- Cost of goods sold and end of period inventories are also valued at standard costs, in the income statement and in the statement of financial position, respectively.
- Variances between actual and standard costs are recorded separately and directly affect the income statement. Standard costs are a simple basis on which to value quantities and avoid the need to trace actual costs to individual products.
- Standard costing is not applicable when output units are heterogeneous or produced in varied, non-standardized ways.

- Information sources for setting standards Management accountants may set standards based on various approaches: historical data analysis; engineering studies and interviews; external benchmarking.

- Standards are usually associated with costs, but they can also be defined about revenues.
- Manufacturing costs: direct materials, direct labour, variable overheads and fixed overheads.

- Worked Example 9.2 DrinkNat budgeted £30,000 for VOH and chose machine hours (MH) as the allocation base because, we shall assume, almost all VOH is related to energy used by machines. Based on the standard machine time of 0.04 MH/unit and estimated production of 100,000 units, DrinkNat estimated needing the following machine hours:

- Budgeted volume of the allocation base = 0.04 MH/unit × 100,000 units = 4,000 MH. Standard VOH rate = £30,000/4,000 MH = £7.50/MH Since one unit should require 0.04 MH, Standard VOH cost = 0.04 MH × £7.50/MH = £0.30/unit (one bottle of MangOrange). Note that DrinkNat has only one product (the ‘MangOrange’ smoothie). So, overheads can also be allocated directly according to budgeted production: Standard VOH cost = £30,000/100,000 units = £0.30/unit

- However, companies usually produce multiple, heterogeneous products. In those cases, the budgeted volume of the allocation base (MH) must allow the manufacture of all products (not just one) and an allocation rate is indispensable to split costs across products.

- Worked Example 9.3 Fixed overheads, such as rent, machines depreciation, wages of operational personnel not directly involved in production and other FOH, were budgeted at £20,000 and estimated to remain fixed as long as DrinkNat produced less than 150,000 units – the relevant range. It was decided to allocate FOH according to budgeted capacity utilization of 4,000 machine hours (MH) to obtain 100,000 units, corresponding to a requirement of 0.04 MH/unit (see above). So: Standard FOH rate = £20,000/4,000MH = £5.00/MH (on a MH basis)

- or Standard FOH cost = £5.00/MH × 0.04 MH/unit = £0.20/unit (on an output unit basis) As commented about VOH, rates per allocation base unit are necessary for multi-product companies. However, in the single-product company, DrinkNat, the budgeted capacity utilization of 4,000MH is exclusively related to the budgeted 100,000 MangOrange units.
- So, you can readily obtain the same standard FOH cost of £0.20/unit by dividing £20,000/100,000 units.

- Variance analysis: zooming in and zooming out
- Variance analysis creates insights about ‘what actually went right or wrong’ across multiple areas of organizational performance, ranging from manufacturing and non-manufacturing costs, to revenues and profitability margins

- Calculate a flexible budget Let us first calculate the flexed budget for mangos. For the actual 110,000 units sold, and given the standard quantity of 0.6 kg of mangos per unit, we could have anticipated to need: Flexed quantity of mangos = £0.60/unit × 110,000 unit = 66,000 kg Flexible budget variances: drilling-down on organizational performance

- Sales price variance In addition to sales volume, prices charged to customers influence sales revenues. So, in addition to the sales margin volume variance analysed above, we calculate the sales price variance

- The sales price variance is the difference between the actual price (ap) and the standard price (sp), applied to the actual sales volume (AV), that is: (ap - sp) × AV = (£2.00 - £2.50) × 110,000 units = -0.5 × 110,000 = £55,000U
- To calculate this variance you can also compare actual and standard contribution margins (am and sm), provided that the actual contribution margin ‘am’ (like the standard contribution margin ‘sm’) is also based on standard costs (sc). Then, we have: am = ap - scsm = sp - scThe following alternative formula, based on contribution margins, is directly comparable with the sales margin volume variance:
(am - sm) × AV = (£0.50 - £1.00) × 110,000 units = 0.5 × 110,000 = £55,000U

- Both formulas are based on standard costs, thus preventing the performance of the industrial area (concerning actually incurred costs) to influence the evaluation of the sales area.
- However, since sales price and volume are typically inversely related, we should interpret the two sales variances in combination, as you can see next, when you analyse the total sales variance.

- Total sales margin variance The total sales margins variance sums the two above variances to measure how changes in sales price and volume affected margins, In general: the total sales margin variance is the difference between actual contribution (AC, based on standard costs) and budgeted contribution (BC), that is, AC - BC.

- Actual contribution (based on standard cost) = = Actual volume x Actual margin (based on standard cost) AC = AV x am 110,000 units x £(2.00–1.50)/unit = 110,000 x 0.5 = £55,000
- Actual volume x Standard margin AV x sm 110,000 units x £(2.50–1.50)/unit = 110,000 x 1 = £110,000

- Budgeted contribution = = Budgeted volume x Standard margin BC = BV x sm 100,000 units x £(2.50–1.50)/unit = 100,000 x 1 = £100,000 Sales price variance (am–sm) x AV (0.50–1) x 110,000 = £55,000U Sales margin volume variance (AV–BV) x sm (110,000–100,000) x 1 = £10,000F F = Favourable variance U = Unfavourable variance
- Total sales margin variance Actual contribution–Budgeted contribution = AC–BC (AV x am)–(BV x sm) (110,000 x 0.5)–(100,000 x 1) = £45,000U

- Labour efficiency variance The labour efficiency variance compares hours actually used with hours expected to be needed, that is, the flexed quantity of the input, considering the actual production volume. See in Table 9.1 that DrinkNat estimated that a worker should need 0.02 DLH to obtain one bottle of smoothie. In general: The labour efficiency variance is the difference between direct labour flexed hours (FH) and actual hours used (AH), valued at the standard wage rate (sr), that is, (FH - AH) × sr = (110,000 units × 0.02 DLH/unit - 2,500 DLH) × £10.00/DLH = -300 DLH × £10.00/DLH = £3,000U

- Total labour variance Total labour variance aggregates wage rate and labour efficiency variances, in a similar way to Exhibit 9.3 (on materials). So: Total labour variance is the difference between labour flexed costs (FC) and actual costs (AC), that is: FC - AC [for labour costs]

- Variable overheads (VOH) are allocated to products based on the standard allocation rate and the allocation base volume (remember that DrinkNat choose machine hours – MH – as the allocation base). But which volume? Standard costing systems consider the flexed volume of MH.
- Variable overhead spending variance The VOH spending variance is based on comparing standard and actual VOH rates. In general: The variable overhead spending variance is the difference between the standard rate (sr) and actual rate (ar) of variable overheads, applied to the actual volume of the allocation base (actual hours, AH)

- Worked Example 9.6 Calculating allocated variable overheads Based on: - actual production volume (110,000 units of MangOrange) - the standard quantity of MH (0.04 MH/unit),
DrinkNat could expect using 4,400 MH.

Using the standard allocation rate of £7.50/MH (based on dividing £30,000 budgeted VOH and 4,000 MH), as done on you will allocate:

4,400 MH × £7.50/MH = £33,000 VOH Check that this figure is in DrinkNat’s flexed budget (Table 9.5).

- Worked Example 9.7 Variable overhead spending variance Check again that the standard VOH rate is £7.50/MH. You can see in Table 9.5 that actual VOH spending is £31,000. Additionally, consider that 5,000 MH were used (this figure had not been provided before). The actual VOH rate divides actual VOH spending by the actual allocation base volume, that is:
£31,000/5,000 MH = £6.20/MH – lower than the standard.

- The favourable difference is then applied to the allocation base actual volume. (sr - ar) × AH = (£7.50/MH - £6.20/MH) × 5,000 MH = £1.30/MH × 5,000 MH = £6,500F
- The variable overhead efficiency variance is the difference between the allocation base flexed volume (flexed hours, FH) and actual volume (actual hours, AH), valued at the standard variable overhead rate (sr), that is, (FH - AH) × sr = (110,000 units × 0.40 MH/unit – 5,000 MH) × £7.50/MH = -600 MH × £7.50/MH = £4,500U

- Fixed overhead allocation under standard absorption costing In a standard absorption costing system, we unitize FOH and calculate standard FOH allocation rates

- Sales margin volume variance (in standard absorption costing) under absorption costing, the sales margin volume variance is the difference between actual sales volume (AV) and budgeted sales volume (BV), valued at the standard profit margin (spm), that is: Sales margin volume variance = (AV - BV) × spm
- Fixed overhead spending variance The fixed overhead spending variance is the same in both costing systems. It reconciles budgeted and actual FOH, that is, BC - AC
- Fixed overhead volume variance The FOH volume variance is related with actual volume having used more or less production capacity than budgeted. Since fixed costs do not vary according to capacity usage, leaving capacity unused means missing the opportunity to produce some units at zero (fixed) cost.

- The fixed overhead volume variance is the difference between flexed capacity utilization (flexed MH, FH) and budgeted capacity utilization (budgeted MH, BH), valued at the standard FOH rate (sr), that is, FOH volume variance = (FH - BH) × sr The total fixed overhead variance is the difference between flexed costs (FC) and actual costs (AC) for fixed overhead items, that is, FC = AC [for FOH]
- Criticisms to standard costing – not because of the technique itself, but because of the potential dysfunctional effects when avoiding unfavourable variances becomes a target per se, regardless of a wider organizational view. Finally, an unfavourable FOH volume variance does necessarily mean that existing capacity is excessive.

- The use (or misuse) of variance analysis can promote undesirable behavioural outcomes – for example, pursuing favourable material price variances and labour efficiency variances may promote neglecting quality, and pursuing favourable fixed overhead volume variances may promote excessive production and inventories.
- This is the risk of myopia, when attaining standards – particularly through cost reduction – becomes the main goal per se, overlooking wider and more important organizational interests. These risks have fuelled criticisms to standard costing.

Research persistently reports the popularity of standard costing and variance analysis.

- In the latest CIMA survey (CIMA, 2009), variance analysis was in the fourth position among all management accounting techniques, with over 70 per cent of adopters.
- Among costing tools, variance analysis came first. Standard costing ranked third and approaching a 50 per cent adoption rate. Flexible budgeting was only sixth among nine budgeting tools (around 30 per cent adoption).
- However, even if not very explicitly and autonomously reported, the flexible budgeting rationale underlies variance analysis (the most popular technique), and still outranks most ‘modern’ budgeting approaches discussed in the next chapter