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Standard costing and variance analysis has been in use since the early twentieth century. In recent years the role of standard costing and variance analysis as a useful part of the management accounting tool kit has been increasingly questioned.

Standard costs – an effective tool for business?

Standard costing and variance analysis has been in use since the early twentieth century. In recent years the role of standard costing and variance analysis as a useful part of the management accounting tool kit has been increasingly questioned.

The extent to which standards and/or variances have a role to play in modern business is open to question. This will be linked to the adaptation of processes, markets and policies in a changing business environment. The rate of change in product type and design due to technological improvement, customer requirements and increased competition has led to rapid change in how businesses operate. The need to respond to customer demands for speedy availability of products, shortening product life cycles and higher quality standards has contributed to a number of changes in the way in which businesses operate. These include:

  • Just-in-time systems allied to flexible manufacturing systems aimed to ensure that customer demand may be satisfied on a 'pull through' basis. Stocks and work-in progress will be minimised and the business operating cycle tailored to cater for the specific customer requirements.
  • Total quality programmes aim at continuous improvement, with the identification and elimination of non-value added activities and the effective provision of value added activities.
  • Greater emphasis on the value chain, from close links with suppliers of input materials and services to identification of customer needs in respect of quality, delivery and changing requirements through time.
  • Accurate product costing and pricing information to facilitate improvement in planning and decision-making. This will include the use of activity-based costing and budgeting systems and the use of target costing.
  • Improved speed and flexibility of information availability. This may be linked to the availability of on-line information in a computer integrated manufacturing environment.

What of standards and variances in modern business? Can planning and decision-making be accomplished in an effective manner without reference to some standard or base and without recourse to some measurement through time of the achievement of, progress towards or variation from such standard or base? What elements of a traditional standard cost/variance model will still have some relevance?

Questions may be raised and discussed in a number of areas in which standards and variances may feature:

  • Planning: some sort of standards are likely to be required as building blocks for budgeting. For example, material specification standards may be used in constructing a material purchases budget when used in conjunction with planned levels of production and sales of products. Similarly, labour or machine standard output rates may be used in the construction of labour and conversion cost budgets in conjunction with wage rates and expense costs and production quantities. Even in a quality improvement environment linked to a TQM approach, budgeting will require a quantification of the plan. To what extent will internal and external failure costs occur? What level of prevention and appraisal costs is planned? To which product or customer group will the specific incidence of such costs apply? For example, standards may be set whereby production losses must not exceed 3% of production for product A and returns from customers for the same product should not exceed 1% of deliveries during the budget period.

  • Control: will this be applied through the use of variance analysis? In many processing situations, even where automated input of materials occurs, it may be deemed relevant to measure the cost of mix and/or yield changes from plan. Such changes may either be actual or proposed.

  • Decision-making: an example may be in the evaluation of new product costs and profitability. Existing standards may be used as the starting point for the construction of components of an estimated cost for a new product. For example, the time taken to perform a specific task which is already performed as part of the manufacturing process for another product.

  • Performance measurement: where the product mix is relatively stable, performance monitoring may be enhanced by the use of ex-post standards. In this approach the non-controllable (ex-ante) variances are segregated from the ex-post variances which measure the difference between the ex-post standards and actual events. In addition, the trend of variances may be measured in physical or percentage terms in order to highlight potential areas of concern.

  • Product pricing: where it is necessary to tender for work an accurate cost estimate must be calculated to which an acceptable profit mark-up may be added. The use of standards will help in the construction of the cost estimate. In addition, in a target costing situation where the product price, market size and required return are known, the target costs may be estimated. The target cost may be compared with a current standard in order to establish the size of any 'cost gap' which exists. This gap may then be investigated with a view to its reduction or elimination through the application of techniques such as value engineering. Sakurai (1989) in his article 'Target costing and how to use it' states 'a target costing system cannot be implemented successfully without the support of standard costing or budgeting, as well as such cost engineering tools as JIT, VE and TQC'.

  • Improvement and change: this may be aided through the monitoring of variance trend through time. Trends may be monitored in order to establish whether the situation is deemed to be 'in control' with variances fluctuating within acceptable limits. Alternatively, the variance trend may indicate an 'out of control' situation which must be investigated with a view to improving and changing product design, production methods, etc.

    Many candidates are unable to carry out the necessary computational aspects of an examination question. This is likely to be caused, at least in part, because of a lack of understanding of the physical situation which the data is intended to represent. A further problem is a lack of ability to relate the physical information that has been calculated and the discussion about its relevance as a business tool in planning, control, etc. The example that follows provides an illustration of the use of standards and discussion of their relevance.

    Illustrative Example
    Linguella plc has prepared standard material and assembly labour specifications for product A as follows:

    1. Each finished unit of product A contains 2 units of component X and should require 0.15 hours of assembly labour time.
    2. The standard input requirements for the product must allow for losses of 10% of material and labour input during processing.
    3. The standard purchase price for component X is £8 per unit.
    4. The standard wage rate for assembly labour is £6 per hour.

    Customer demand for period 2 for product A is budgeted at 2,280 units. It is budgeted that returns of faulty product units from customers requiring free replacement will be 5% of goods delivered to customers.

    No stocks of raw material, work-in-progress or finished goods are planned.

    We are required to calculate both the material purchases budget for component X and the assembly labour budget for period 2. As part of a quality management initiative it is also required that we calculate the budgeted internal and external failure cost for both material (component X) and assembly labour.

    Figure 1
    Component X and Assembly Labour Budget ' period 2

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