Labor and material variances are instrumental in comparing the budgeted amount of labor and material utilized and the actual amount of labor and material utilized. This comparison is useful to management in determining whether there is a favorable or unfavorable variance which in turn aids them in initiating appropriate changes in their budgets and planning in future ventures. It implies thus that in definition, that variance is considered to be the difference between budgeted and actual financial results. Consequently, a standard cost system is one in which standard, as opposed to actual, costs flow through the formal accounting records. It thus should be noted that an ideal standard is a standard that calls for perfect implementation and utmost efficiency in each facet of the operation (Mendoza, 2011). However, a standard It is not easily attainable and could discourage employees rather than serving as a motivating factor. There are notably three facets of standard cost for direct materials namely; quality, quantity, and price. It is pertinent to appreciate that direct material variances include material price variance and material usage variance.
Price variance is computed by finding the difference between the actual price and flexible budget; standard price multiplied by the actual quantity purchased i.e. purchase price variance or times the actual quantity used i.e. material used price variance. On the other hand, usage variance is calculated by taking the actual quantity used minus standard quantity (allowed quantity per unit times number of units produced) multiplied by standard prices. Price variance is an indicator of purchasing efficiency while usage variance is indicative of manufacturing efficiency.
The difference between actual direct labor cost and the flexible budget amount is referred to as direct labor variance. This is made up of direct labor rate variance (LRV) and direct labor efficiency variance (LEV). LRV computation involves taking the difference between the actual and standard hourly wage rate times the actual direct labor hours used in production. On the other hand, LEV represents the difference between the actual and standard direct labor hours for the units manufactured multiplied by the standard hourly wage rate.
An Overview of Standard Costing System
Standard costing is a vital tool of providing standard cost for budgeting purpose in a bid to plan future performance. Since standards are pre-determined, the standard costing system aids an organization to economically and efficiently attain its objectives. The system appreciates the fact that the labor is likely to waste some material or might become absent owing to various reasons such as illnesses and consequently give a provision of an allowance for wastage and idle time. Standards are compared against actual outcomes and the deviations are found. Reasons for such deviations are given for the purposes of establishing the appropriate corrective actions. In addition, it is helpful in managing human resources through giving signals to the effect that their performances are being analyzed, measured and compared (Mendoza, 2011).
The fundamental functions of a standard costing system are valuation, planning, and controlling. Valuation involves the process of assigning the standard cost to the actual output. Planning represents the use of current standards in estimating future sales volume and future costs. Controlling is the evaluation of performance by way of determining the efficiency of the current operations. While standards must be set for materials, labor and overheads, the best results call for the application of an integrated approach. The standard cost of direct materials is closely related to the quantities and prices of materials to be utilized in production. There are thus two related standards to be set namely material usage standard and materials price standard. The rationale of setting material usage standard is to achieve maximum efficiency in material usage while setting the material price standard is aimed at achieving maximum efficiency of purchasing and store-keeping functions and in so doing minimize direct material costs (Mendoza, 2011). However, currently the computation of material price variance is considered less important. This follows the fact that most companies enter into long-term contracts with reputable suppliers.
Direct labor costs are dependent upon labor time as well as wage rates and hence setting standard cost for direct labor involves setting of standard labor time and labor rate standard. Standard labor time is indicative of the precise time in hours that labor of a given grade should take to perform a particular operation. The reason behind setting standard labor time is to attain maximum efficiency in the usage of labor time (Mendoza, 2011). The standard time is normally set subject to past performances with the provision of adjustments for changes in conditions. The Labor rate standard refers to the wage rates expected to be paid to different grades of labor employed in an organization.
The purpose of labor rate standard is to make plans for actual wages to be paid. Other standards that are set include standard overhead rates, standard administration cost, and standard cost for selling and distribution. Computation of labor efficiency variance in high tech firms with flexible manufacturing systems has been considered less significant. This follows from the fact that these firms attach little or no importance to labor rate and efficiency variances. These firms emphasize zero-defect and continuous improvement in quality. Considering the theory of constraint, the focus on improving overall efficiency of a firm lies in improving throughput time that relates to efficiency in bottleneck areas (Rao & Bargerstock, 2011).
The focus of standard cost system is to influence behavior through positive reinforcement. Unreasonable standards and expectations can make a good standard a failure. In cost flows and ledger entries of a standard costing system, items purchased are debited to a raw materials inventory account at standard cost. The material purchased price variance is preferably recognized at the point of purchase. Standard usage is charged to work in process. Any difference is charged to material usage variance. Labor is also charged to production at standard rates for what should have been used. Any difference in rate and efficiency is accumulated in LR and LE variance accounts (Mendoza, 2011). Units completed are transferred to finished goods inventory at standard cost. Units sold are cleared from finished goods inventory and charged to cost of goods sold also at standard prices.
In standard costing, variance is a term used to refer to the divergence of actual cost from standard cost Variances of various cost items provides the basic key to cost control. They are indicative of whether and to what extent set standards have been achieved thus enabling the management in making corrections to adverse tendencies. Variance analysis is the process of computing the amount of and isolating the cause of variances between actual costs and standard costs. Variance analysis involves computation of individual variances and determination of the causes of each variance (Scherer, 2006).
Actual cost is higher than the standard cost is indicative of inefficiency and the difference is considered adverse or unfavorable since the variance reduces the profit. Analyses are done for each variance in a bid to ascertain the causes so that the management is better advised on exercising the proper control. The cause is affixed to the respective variance and such classification is vita in placing proper emphasis on the controllable variance subject to the management by exception principle. Variances that occur in a period may be compared with variances on the same account expressed as the percentage of the standard costs and a comparison is made with the percentage for the previous period (Mendoza, 2011).
There is a two-way analysis of variances whereby each variance is analyzed a incurring variance and recovery variance. Additionally, the causes leading to a variance is taken as either efficiency or inefficiency in the utilization of resources as well as change in the price paid for the resources.
Material cost variance represents the difference between the standard cost of materials specified and the actual cost of materials used. Market variance comes up due to a variation in the price of the material or in its usage.
Material price variance is taken as the portion of the material cost variance which rises from the difference between the standard price specified and the actual price paid. This represents the portion of the direct materials cost variance implying the difference between the standard price specified and the actual price paid for the direct materials used. It is taken as an incurring variance reflecting the surplus price incurred on the units purchased. Standard consumption of units is never considered during the calculation of this variance. This implies that the material price variance represent the difference between what the material actually cost and what would have cost if the actual usage has been paid for at the standard price (Scherer, 2006).
Changes in the market price of materials used are the major cause of variance in material price. Other causes of material price variance include; changes in quantity of purchase resulting in different prices, failure in obtaining cash or trade discounts provided in standards setting, rush orders made in a bid to meet supply shortage, emergency purchases, changes in duties and taxes, usage of substitute material with a higher or lower unit price, and changes in issue price due to store-keeping, handling and carriage expenses (Rao & Bargerstock, 2011).
Material usage variance forms the portion of material cost variance that is subject to the difference between the standard quantity of materials specified and the actual quantity used. This is the portion of direct material cost variance representing the difference between standard quantity specified for the production attained and the actual quantity used both valued at standard prices (Mendoza, 2011). Lack of due care in usage, defective production, abnormal wastage, inefficiency in production, use of inferior materials and rigid technical specifications are some of the chief causes of material usage variance.
Labor cost variance, also referred to as direct wage variance, represents the difference between standard direct wages specified for an activity achieved and the actual direct wages paid. Owing to the fact that cost of labor is subject to labor time and wages, the labor cost variance is made up of either or both variances related to labor time and labor rate and it is thus analyzed into two separate variances i.e. labor rate variance and labor efficiency variance as presented in the diagrammatic representation below (Scherer, 2006).
Labor rate variance stands for the fraction of wages variance emanating from the difference between the actual rate and standard rate of any specified labor grade. Some of the causes of wage/labor rate variance include; change in basic wage structure, overtime work exceeding that provided in the standard rate, payment of guaranteed wages to workers who are not in a position to earn normal wages, new employees that are not allowed full normal wage rates, and different methods of payment. It should be noted that wage rates are subject to factors beyond the control of personnel department such as labor market conditions, and wage awards by wage boards (Scherer, 2006). This implies that labor rate variances are mostly uncontrollable except for situations that come up due to deployment of wrong grade of labor for which the department officials may be held liable.
Labor efficiency variance is the other portion of direct labor variance which is subject to the difference between the specified standard labor hours and the actual labor hours spent. This variance is vital in ensuring the control of employees’ efficiency as well as labor cost which qualifies it is a usage variance (Mendoza, 2011). The possible root causes of labor efficiency variance include lack of appropriate supervision, defective equipment and machinery, poor working conditions, workers discontentment, and increase in labor turnover.
Variances Accounting Approaches
Under the standard costing system, the cost records as well as entries made vary from one organization to another subject to the information and data that is desired from the cost records. In addition, the disparity is dependent on the intended purposes of standard cost and variance analysis. Disposing of variances emerging from standard costing and recording is done through various ways such as; transfer to costing profit and loss account, allocation of variances to finished stock, cost of sales account and work-in progress, and transfer to reverse account (Scherer, 2006).
Owing to the fact that standard costs are incorporated into budgeting systems, they play a fundamental role in the planning, control, motivation, and performance evaluation functions of an organization’s management. Formulating predetermined costs allows timely information to help managers plan and make decisions regarding product emphasis, bidding, and pricing, because such decisions habitually have to be made prior to completion of production. For the sake of control, standard costs provide a detailed analysis of variances between actual performance and budgeted performance, in a bid to determine where inefficiencies exist. Since standard costs provide tangible targets that employees can endeavor to achieve, they can also be employed to motivate employees to lessen inefficiencies as well as correct problems. Dedication to achieving standards is typically improved when employees are involved in setting the standards. In conclusion, evaluation of performance against predetermined standards is generally professed to be fairer than appraisal based on indistinct prospects. Standard costs may provide additional benefits if they are incorporated into the accounting system. Additionally, a standard costing system is an accounting system that utilizes standard costs to accumulate material, labor, and overhead costs. It is thus evident that standard costing systems are often more practical than actual or normal costing systems, and they do simplify the accounting process and records.