Variance Analysis

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INTRODUCTION TO STANDARD COSTING
Standard Costing is a comprehensive and powerful tool for maintaining standard, current and projected costs for both accounting and manufacturing operations. Its unique features are ideal for helping you manage the planning and budgeting of your entire operation. A standard is a benchmark or norm for measuring performance. We encounter standards in many facets of daily life, i.e., standard to obtain a driver's license, standard to get into an MBA program, etc. In the past industry has made extensive use of standards. Standards are set for various cost inputs such as material, labor, and overhead. Actual quantities purchased and used are compared to standard. Any significant difference between actual and standard creates a variance and can be investigated by management.

There are two broad types of standards. An ideal or perfection standard is the absolute minimum cost under ideal conditions. Practical standards can be described as a "tight but attainable" standard and they allow for normal downtime and employee rest periods. As you can imagine, most of us operate better when practical standards are in place.

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. In managerial accounting we deal with standards related to both price and quantity. A price standard is the amount that should be paid for some input--direct material, direct labor, or overhead. A quantity standard relates to how much of the input should be used--direct material, direct labor, overhead. After setting price and quantity standards, the organization compares actual results to standard cost and calculates a variance--either favorable or unfavorable. This process facilitates management by exception--depending on the significance of the variance, management takes appropriate action. Insignificant variances are disregarded.

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.

Variance Analysis and Management by Exception. Management by exception means that the manager's attention should be directed towards areas where things are not proceeding according to plans. Standard cost variances signal performance different from what was expected. Since not all variations require the attention of management, some method of identifying those variations that do require attention is required. Statistical analysis can be useful in this task and the basics of this approach are sketched in the text.

Potential Problems with Using Standard Costs. Some of the potential disadvantages of standard costs have been mentioned in passing above. A more complete list follows:

1. Standard cost variance reports are usually prepared on a monthly basis and ...