 Namaste, today we are going to discuss about standard costing and variance analysis. So far in our course in Cost and Management Accounting, we have discussed various techniques which were targeted at cost control as well as decision making. If you remember, we have already discussed techniques like marginal costing, CVP analysis, BEP, most of them were useful for decision making. We have also learned budgeting and budgetary control. This technique is useful for both decision making as well as cost control. Today we are going to learn a technique known as standard costing or variance analysis that is primarily useful for cost control purposes. Now what is meant by cost control? In cost control, we set a benchmark, we set a standard and try to achieve that standard. In other words, efforts are directed to ensure that actual cost does not exceed the benchmark or does not exceed the standard cost. Since we are discussing cost accounting, the aim is to cut down the cost, aim is to reduce the cost. So all efforts are made to improve efficiency and to keep costs within the given benchmark. So in cost accounting, the efforts will be made first to make or set a correct standard then measure the actual, try to see that we do not deviate from the standard. If we do deviate, then there is what is known as variance. Then we will try to analyze the reasons for that variance so that timely corrective action can be taken. This is in nutshell what is standard costing and variance analysis. Let us discuss it in little more details. Now in this presentation we are going to learn about the definition, the steps, the types of standards, variances and the type of variances, analysis of variances and the advantages and disadvantages of standard costing. Now what is a standard cost? As the name suggests, it is a standard or a benchmark. So it needs to be predetermined and it is based on the standards of efficient operations. So it is a predetermined cost which will be incurred provided the operations are made very efficiently. It may be used as a basis for price fixing and primarily it is useful for cost control through variance analysis. We can also look at it as a budget for production of one unit and it is chosen as a benchmark in the budgetary control system. Now these are the steps in standard costing. First we set the standard, then we study the actual, compute the variances and analyze the variances that is break them down for knowing the reasons for variances. Now setting the standard, now it is a predetermined or a standard cost per unit. It is a budgeted cost which is determined based on the standard costing. Next step is study of actuals. Now we will need to calculate the actual costs so that they can be compared with the standards. The third step is cost variance. Now the actual is compared with the variance, actual is compared with the budget or the standard cost and the cost variance is calculated. Then we break down the variances and fix the responsibility for controlling the cost. If the variance is more than what is desired, suitable action will be taken so that such instances of deviation are not repeated and if required one may go for resetting the standard based on the feedback from the actual cost. Now what are the types of standards? As we have seen the first step in the standard costing is setting up of standard. If the standards are too high they become unachievable. So it demotivates the people to put their effort to achieve them. At the same time if standards are too low it becomes senseless to put effort to achieve them because they would automatically be achieved and hardly there will be any motivation to improve the performance. That is why it is very much necessary to set the standards correctly for that let us understand different types of standards so that we can choose a suitable standard for ourselves. The first one is ideal standards. Now they represent the level of performance attainable when the prices and the labor are most favorable and when the highest output is achieved and the best equipment and layout is used and the maximum utilization of all the resources happen. So this is the most ideal condition where the output is maximum and the costs are minimum. That is why it is ideal scenario and such standards are called as ideal standards. Now the next is normal standards. As you all know it becomes really very difficult to achieve ideal standards. That is why we come we sort of bring them down to normal standards. Now these may be achieved under normal operating conditions. So instead of assuming the highest possible production here we assume that there will be some normal idle time and activity will proceed with a normal efficiency and there are good equipments but they are not necessarily the best equipment. The demand is good but is not necessarily the maximum. So these are the normal standards which are set for normal conditions. Now this is basic or bogie standards. These standards are used when they are likely to remain constant or unaltered for a fairly long time. So a base year is chosen and there may not be any time or expertise to set standards in a systematic way. So whatever is achieved in the base year if the base year is normal a suitable base year is chosen and whatever is achieved in the base year is considered as a standard. That is why it is called as a basic standards. Now the variance is calculated as a percentage of the basic cost. Now the next one is known as current standards. Now these standards reflect the management's anticipation of the actual cost for the current period. Now in a dynamic scenario it may not be appropriate to go for basic standards because the prices are going to change, markets are going to be change, input costs are going to be change. Incorporating those aspects current standards are set and for the planned output what is likely to be the cost with efficient operation that gives us the current standard. Now next one is variance. As we know the difference between the standard and actual is known as variance. It is a deviation from the set benchmark, obviously it can be either favorable or un-favorable. Let us assume that you set up for yourself a standard of getting 95 marks or let us say O grade. If actually you get only 85 marks it will mean a variance of 10 marks. Is this a favorable or unfavorable variance? Obviously it is unfavorable because we are talking about performance or achievement. So more the better. But what we are discussing here is standard cost. In case of cost the lesser the better. So suppose for a given output the standard cost is 1000 rupees and if actual is 1300. What is a variance? The standard was 1000 actually is 1300. So variance is 300. It is an unfavorable variance because we have incurred more cost than what was budgeted. Same way if actual cost is lesser we will consider it as a favorable variance. Now just by knowing this difference of 300 may not be enough because we would like to know the cost. We would like to know the origin as to why this variance has happened. So we may break it down for its reasons and then take necessary remedial steps so that at least in the next month or the next period that excessive expenditure is avoided. So that is what is a variance. Now the variances can be broken into controllable and uncontrollable. Now the purpose of standard costing is to improve efficiency. To improve efficiency we want to avoid variances. So we investigate for the reasons of major variances and we wish to take corrective action. For that it is suitable to break down the variances into controllable and uncontrollable. As the name suggests controllable means those variances which can be controlled at a departmental level. So we can take suitable corrective action and avoid this variances. Because uncontrollable variances are those which are beyond our control it is not possible to avoid them. So standard themselves may be revised so that in future the variances can be avoided. Can you give me any example of controllable and uncontrollable variance? Let us assume that we had taken an example that the standard cost was 1000. Let us say it is a raw material cost and we are consuming 50 units of raw material at rupees 20 per unit. So 50 into 20 gives us 1000 rupees as material cost fine. Now in reality instead of 50 units if we consume 60 units and instead of 20 rupees our input cost becomes 30 rupees. Then what will be the actuals 60 into 30 means actual cost will be as high as 1800 versus a standard of 1000. So there is a variance of 800 unfavorable. Now which part of it is controllable and which is not controllable? Now we need more information. Because it is told that extra consumption of units is because of carelessness of workers but the increase in the prices is because the market prices themselves have gone up. So now can you break down into controllable and uncontrollable? I think it will be possible now for you to do it because instead of 50 units we have consumed 60 units. So 10 units more is because of carelessness so we can mark it as a controllable variance but the prices are not our in our control. So it was budgeted that we will obtain each unit of raw material at 20 rupees but now the price has become 30. So 10 rupees per unit what is extra that is because of uncontrollable reasons. So we can mark it as a uncontrollable variance. Of course do not be under impression that always quantity variances are controllable and prices are uncontrollable. It can be other way around also but in our given example just for us to understand you would have got as to controllable means something which can be controlled by the department by improving the efficiency whereas something which is because of external forces which are not within our domain then we will call it as an uncontrollable variance got it? Now let us look into what is variance analysis. So just by knowing total variance it is not enough for us we would like to know its causes. To know its causes we need to break it down into reasons then only we can take corrective action. So now one important reason for variance is variances due to efficiency. As the name suggests if company or the concerned department is not using the resources effectively it will be the variance due to efficiency. It can be material quantity that excessive material is wasted, it can be labour hour I think we are all used to wasting our time due to variety of reasons that is an inefficient use of time that is also an inefficiency variance. So it can be for material, it can be labour, it can be for power. So when unwanted use of resource happens it gives us a loss that is an inefficiency variance. There are also variances because of price factors. Now there might be changes in the market prices. If the material prices increase or decrease it will lead to price variances. Same way if wage rates or labour rates increase or decrease it leads to price variances. If the indirect cost increase like say electricity bill increases, cost of petrol increases they are called as price variances. So the major two causes are efficiency and price. But there is one more, there are more crosses also one important cause is because of volume that is because of change in the level of activity. Because we have made a budget at a particular level of activity. If our level of activity increases that also leads to change in the cost that those changes are called as volume variances. Now we have all learned variable costs and fixed costs. Suppose the level of activity changes, the volume variance will be generated in which of the cost variable or fixed can you just think and try to answer. If you remember variable cost by design is intended to change with the level of activity. So with every extra unit variable cost is set to change. So the standard variable cost will also change with the number of units. But when it comes to fixed costs, it is a budgeted fixed cost it does not change with number of units. But when number of units change for us it impacts its impact will change. Are you getting me? Suppose rent is 1 lakh that is as per budget. As per our estimate the number of units were 5000. So 1 lakh upon 5000 means 20 rupees per unit is a rent cost which is charged on the production cost. In reality if number of units increase from 5000 to 10000 the cost per unit will come down. The total cost will remain same 1 lakh but cost per unit will come down. That will lead to volume variance because we had estimated 20 per unit actually it is good that actual cost is just 10 per unit. This difference is volume variance. Other way round if the actual output falls it will lead to adverse volume variance. Are you getting me? We are going to take the cases but this was just an understanding of that concept. So there are 3 major reasons efficiency related, price related and volume related. Now the variances can also be broken as per elements of cost. So here we can break down the variance into material, labour, overheads and sales variances. These overhead variances in turn can be broken into variable overheads and fixed overheads but these are the major causes leading to variance. Now the reasons for material variance, as we know the material cost is units of consumption into the price, input prices. So the causes also are derived from that if there is a change in the basic price that can be one important cause. Other is changes in the quantity, more consumption or less consumption. Sometimes the material which we get is of substandard quality leading to losses in the production process. Sometimes while using the material there is an inefficient use maybe because machine is faulty or workers are careless. There can also be causes like pilferage that the material which is stored is being misused or mishandled. Now let us concentrate on how to calculate material variances. Please understand it carefully because these formulas are the base. If you understand material variances carefully you can use the similar formulas for labour, overheads, sales and so on. Now the total variance, the main variance is a material cost variance. Now this is a comparison of standard and actual. So it is standard cost minus actual cost. The standard cost is arrived by standard quantity into standard price minus actual quantity into actual price. This will give us the total variance. This is the material cost variance. Now we want to break them down into causes. It can be because of price related reasons or it can be because of usage related reasons. So material price variance is a difference between the prices. That is in bracket we have got standard price minus actual price and we multiplied by actual quantity. So this is the difference between the price. The other one is usage variance or also known as quantity variance. So it is a difference between standard quantity and actual quantity and we multiplied by standard price. Now the total of usage plus price should match the cost. Now do you realize as to why here we multiplied it by actual quantity. But when we compared quantities we multiplied by standard price. Can you think of the cause? Why not take actual quantity and actual price or standard quantity and standard price? It would not work. We have to take actual quantity and standard prices. One of course for mathematical reasons. If at both the places we take actual it will be duplication of subparance. The second and more important cause is theoretically those which are in charge of prices. This is a purchase department. They have purchased at a wrong price, more or less price or it could be because of market reasons. But it is something to do with purchase or the market and they are handling actual quantity. That is why the comparison of prices that is the first formula we multiplied by actual quantity. But when it comes to comparison of usage it is something happening in the factory. So instead of consuming standard quantity we have consumed either more or less quantity. But the workers or supervisors in the factory do not know anything about actual market prices. They only know the standard market price. That is why when we are holding them responsible it is logical to take standard prices. But for the purchase department that is price variances we take actual quantity. If you mathematically calculate you will realize that with this the total will match with the standard the material cost variance otherwise the total will not match. In the next session we will take the actual case and try to calculate material cost variance. Till that time we will stop here but try to understand the concept of standard costing and variances and learn these formulas carefully because we will need them in our next session. Namaste. Dhanneval.