Direct Costs in Standard Costing

4.4. Reasons for direct cost variances

There are many events or circumstances that can cause direct materials and direct labor variances. For example, companies may make a trade-off between price and efficiency. Companies may purchase direct materials at a lower price; such materials could be of a lower quality or more difficult to work with. In such a case, the company might have to either use more materials (of a lower quality) than the standard requires or use more direct labor hours to produce the product. Purchasing materials of a quality higher than needed could also result in an unfavorable variance. Expensive high-quality materials not always result in the higher sales of the product made of such materials, and the company would incur higher product costs in such a case.

Moreover, there can be a trade-off between different variances. Elimination of one unfavorable variance could cause the occurrence of another unfavorable variance. For example, if a company's management increases the monitoring of its employees working with expensive direct materials, this could improve the materials efficiency variance (e.g., from an unfavorable to a favorable variance), but at the same time it could have an adverse affect on the labor efficiency (i.e., cause an unfavorable labor efficiency variance). Thus, in this example you see a trade-off between an unfavorable materials efficiency variance and an unfavorable labor efficiency variance.

Examples of reasons causing direct cost variances are provided in the table below:

Illustration 7: Reasons for direct cost variances

 

Price Variance

Efficiency Variance

Direct Materials

Unreasonable materials price standard (unreasonable SP).

Unreasonable materials quantity standard (unreasonable SQ).

Change in purchase price (e.g. new supplier, change in quantity of materials purchased, change in purchase discount).

Change in the quantity of spoiled materials due to the changes in quality / equipment / technology, equipment malfunction, worker damage, etc.

Accounting error (in the actual price of materials).

Accounting error (in quantity of materials used).

Normal fluctuation in the usage of materials.

Change in production processes.

Theft of raw materials.

Direct Labor

Unreasonable labor price standard.

Unreasonable labor hours standard.

Changes in average wages paid to employees (e.g. changes in workers' experience and skills, in the minimum wage rate, labor union strikes).

Change in the average labor hours due to the changes in workers' experience and skills, in production processes or equipment, intentional workers' slowdown, etc.

Accounting error (in the actual price of direct labor).

Accounting error (in the actual quantity of labor hours).

Overtime hours (unanticipated).

Normal fluctuation in labor hours.

Underreporting of labor hours.

As you can see from the table above, there are various reasons for direct cost variances. It is important for management to analyze such reasons and take action. For example, when cost standards are unreasonable, they could cause unfavorable variances. In such a case, management should review and change cost standards.

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