Direct Costs in Standard Costing

3. Cost variance analysis

Let's start with definitions of a standard cost variance and standard variance analysis:

Standard cost variance is the difference between a standard cost and an actual cost.

Standard variance analysis is the process of identifying variances between standard and actual costs and then analyzing the reasons for their occurrence. In general, variance analysis is performed for bookkeeping and monitoring purposes.

Companies first calculate the dollar amount of variances by comparing actual and standard costs. Then, they select important variances for further investigation; selected variances usually play an important role in the management's decision making process (e.g. workers' productivity or labor efficiency rate). Finally, companies identify the reasons for variances, make conclusions, and take action. This process is illustrated below:

Illustration 3: Standard cost variance analysis

Standard Cost Variance Analysis

Management, with the help from accountants, determines the reasons for variance occurrence and decides whether to take any further action. To make such a decision, management may utilize the following guidelines:

  1. Inappropriate standard: Revise the standard to improve the accuracy of future budgeting.
  2. Operations out of control: Change (correct) operations.
  3. Better than expected operations: Make sure quality is maintained.
  4. Better than expected operations and high quality: Change operations to take advantage of operating efficiency and review standards.
  5. Accounting error: Correct the error as well as the accounting system.
  6. Random variance: Do nothing.

As mentioned earlier, companies select important variances and break them down into components in order to make the variance analysis easier to interpret. In this tutorial we will look at the direct cost variances. Then, in a separate tutorial we can study variable and fixed overhead variances.

4. Direct cost variances

As you may recall direct costs (i.e. direct materials and direct labor) have two major components:

  • Price (rate) standard (relates to price variance)
  • Efficiency (usage) standard (relates to efficiency variance)

As the result, direct costs have two major types of variance: price variance and efficiency variance. It is important to note that variances for factory overhead are different, which is why we will talk about them later. So, what do price and efficiency variances mean?

Price variance is the difference between actual and standard prices paid for resources used in production.

We encounter price variances on a daily basis. For instance, if you usually pay $2.00 per loaf of bread and then buy the same bread for $2.20 at a different store, the 20 cents difference ($2.00 2.20) is a price variance. In this example, it is also an unfavorable variance ($2.00 2.20 = - $0.20) because you had to pay a higher than standard (normal) price for the product. On the other hand, if you purchase two loafs of bread for $2.50, you essentially paid $1.25 per loaf of bread. In this case, you have a favorable price variance of 75 cents (per loaf of bread: $2.00 $1.25).

The latter scenario is also applicable for businesses because they often try to take advantage of bargain purchases. Bargain purchases might affect the quality of the material, usage requirements (e.g., need to use more material of a lower quality), storage space, and cash flows. Unfortunately, a price variance does not tell how bargain purchases affect production efficiency. In such a case, we use efficiency variances.

Efficiency variance tells how economically and efficiently direct materials and direct labor are used in production.

We encounter efficiency variances on a daily basis as well. For instance, if it usually takes you 30 minutes to get to work by car, and then one day you get to work in 20 minutes, you have a favorable efficiency variance of 10 minutes (i.e., which can be transferred into a dollar value; for example, $15).

Now that you reviewed these examples let's look at price and efficiency variances in greater detail.

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