Standard Costing and Variance Analysis

Standard costing is a system that establishes predetermined costs for materials, labour, and overheads. Actual results are compared to these standards to calculate variances, which are then investigated and acted upon. It is a key management control tool.

Types of standard:

The standard cost card sets out the expected cost of one unit of output:

Total material cost variance = Standard cost of materials for actual production − Actual cost of materials

Material Price and Usage Variances

Material Mix and Yield Variances

Total labour cost variance = Standard labour cost for actual production − Actual labour cost

Labour rate variance (LRV):

= (Standard rate − Actual rate) × Actual hours paid

Measures whether workers were paid more or less per hour than standard.

Labour efficiency variance (LEV):

= (Standard hours for actual production − Actual hours worked) × Standard rate

Measures whether workers took more or fewer hours than the standard allows for the actual output. Uses actual hours worked (productive hours).

Idle time variance:

= Idle hours × Standard rate

Measures the cost of unproductive time — hours paid but not worked (e.g., machine breakdowns, waiting for materials, power cuts). Always adverse.

Relationship when idle time exists:

Total hours paid = Hours worked + Idle hours

The rate variance uses hours paid. The efficiency variance uses hours worked. The idle time variance captures the gap.

Total labour variance = Rate variance + Efficiency variance + Idle time variance

Variable overheads are typically absorbed on a labour hour (or machine hour) basis.

Variable overhead expenditure variance:

= (Standard VO rate × Actual hours worked) − Actual VO cost

Or: = (Standard rate per hour − Actual rate per hour) × Actual hours worked

Measures whether the actual variable overhead cost per hour differed from the standard rate.

Variable overhead efficiency variance:

= (Standard hours for actual production − Actual hours worked) × Standard VO rate per hour

Uses the same hours difference as the labour efficiency variance. If workers are inefficient and take longer, more variable overhead is consumed. The efficiency variance has the same sign (favourable/adverse) as the labour efficiency variance but is valued at the VO rate rather than the labour rate.

Fixed overhead variances arise under absorption costing because fixed overheads are absorbed into products at a predetermined rate. They do not exist under marginal costing.

Total fixed overhead variance = Fixed overhead absorbed − Actual fixed overhead incurred

This equals the over- or under-absorption.

Expenditure and Volume Variances

Volume Sub-Variances: Capacity and Efficiency

Sales variances measure the impact of differences between actual and budgeted sales on profit.

Sales price variance:

= (Actual selling price − Standard selling price) × Actual quantity sold

Measures the profit impact of selling at a price different from the standard. Selling above standard → favourable; below → adverse.

Sales volume variance:

This depends on the costing method used:

• Absorption costing:
  = (Actual units sold − Budgeted units sold) × Standard profit per unit
  Measures the profit impact of selling more or fewer units than budgeted, valued at standard profit margin.
• Marginal costing:
  = (Actual units sold − Budgeted units sold) × Standard contribution per unit
  Valued at standard contribution margin (more useful for decision-making).

Note: Sales variances are calculated differently from cost variances — favourable sales variances increase profit (more revenue). A favourable sales price variance means the selling price was higher than standard; a favourable sales volume variance means more units were sold than budgeted.

The operating statement is a summary that reconciles budgeted profit to actual profit by listing all variances. It provides management with a clear view of why actual profit differed from the plan.

Absorption costing operating statement format:

Favourable variances are added to budgeted profit; adverse variances are deducted.

Possible causes:

Key interrelationships between variances:

• Material price ↔ usage: Buying cheaper materials (favourable price) may cause more waste (adverse usage). Buying higher-quality materials (adverse price) may reduce waste (favourable usage). Evaluate the net effect.
• Labour rate ↔ efficiency: Using cheaper, less experienced workers (favourable rate) may cause slower work (adverse efficiency). Using higher-grade workers (adverse rate) may improve efficiency (favourable efficiency).
• Material usage ↔ labour efficiency: Poor-quality materials may be harder to work with, causing both adverse material usage (more waste) AND adverse labour efficiency (takes longer).
• Sales price ↔ sales volume: Cutting the selling price (adverse price) may increase demand (favourable volume). Raising prices (favourable price) may reduce demand (adverse volume).
• Variable OH efficiency = labour efficiency: The VO efficiency variance always has the same sign as the labour efficiency variance (same hours difference, different rate). If workers are slow, both are adverse.

Significance and investigation: Not all variances need investigating. Management should focus on variances that are significant (above a threshold — e.g., >5% or >£X), controllable (the manager responsible can influence the cause), persistent (occurring repeatedly, not a one-off), and not expected to self-correct.