A standard costing system is the traditionally used costing system. It has two main purposes: cost control and product costing. Standard costs are determined by accountants working together with other employees of the organization. Such costs are created for direct material, direct labor, and manufacturing overhead. A cost manager would use these standard cost figures as a benchmark with which to compare actual costs. This allows managers to determine if there are any substantial cost variances.
The variances that management will compute to monitor performance include the following:
Direct material price is the difference between the actual and standard price
Direct material quantity is the difference between the actual quantity and the standard quantity
Direct labor rate is the difference between the actual and standard hour rate
Direct labor efficiency is the difference between the actual hours and the standard hours
There is no set rule to indicate when a variance is considered too high. Managers must use their own judgment and business sense to make this determination.
Overhead is one of the most difficult costs to account for because it is a large pool of all the different indirect costs. Tracing the overhead costs to each individual product or service is laborious, which is why a flexible budget is created. In a flexible budget, overhead costs are specified for various activity levels. There are two types of flexible budgets that can be used. The first, thecolumnar flexible budget, is based on several different activity levels. The other type, the formula flexible budget, is used for a continuous range of activity.
Once the flexible budget is created, variances can also be examined to find out how well the company is performing.
These variances include the following:
Variable overhead spending is the product of the difference between the actual and standard overhead rates and actual quantity [(Actual overhead rate – Standard overhead rate) × Actual quantity].
Variable overhead efficiency is the difference between the actual and standard quantity (Budget allowance on actual quantity – Budget allowance on standard quantity).
Fixed overhead budget is the difference between actual and fixed overhead (Actual overhead – Fixed overhead).
Fixed overhead volume is the difference between budgeted fixed overhead and applied fixed overhead (Budgeted fixed overhead – Applied fixed overhead).
When analyzing variances it is important to understand whether the variance is favorable or unfavorable. A favorable variance indicates that the company has benefited from the variance, for example, when actual costs are less than budgeted. An example of an unfavorable variance would be that actual costs were greater than budgeted.
The analysis of variance can be a difficult task, but it is important to spend the time necessary to do this because variances tell a lot about the overall performance of a company. Knowing how well a company is performing is necessary for maintaining long-term success.