cause and effect
Standard costing is a control technique which compares standard costs and revenues with actual results to obtain variances which are used to stimulate improved performance. In order to stimulate improved performance, we need to understand the potential causes of variances. In general, variances have four causes. These are outlined below. Inappropriate standard If a standard is set at a level that does not reflect current conditions, then variances will be recorded even if the organisation is operating at the required level of efficiency. For example, if price standards have not been updated for inflation, an expenditure variance calculated against out-of-date price ...view middle of the document...
To stimulate improvements management accountants need to isolate the variances caused by operating efficiency. These are potentially controllable variances and management action can lead to improved organisational performance in these areas. Operating efficiency variances can be identified by a process of elimination. If standards are set at the correct level, if actual data are correctly recorded and random events are noted, then what remains must be due to operating inefficiency. Variances caused by random events can often be identified by talking to departmental managers (‘Has anything unusual happened this week?’). Emphasising the need for accurate record-keeping can help eliminate variances caused by poor recording of actual data. The effect of inappropriate standards can be eliminated by the recalculation of variances based upon revised standards. This involves using hindsight to update standards for known, uncontrollable changes in circumstances. Example 1 demonstrates this approach. Note that in the Paper 7 examination, candidates would not be required to calculate the split of the variance into its controllable and uncontrollable elements (as in this example), but might be required to explain why it is done. EXAMPLE 1 The direct labour standard for a product is three hours of labour per unit at a standard cost of £10 per hour. During a particular period, 2,000 units of product were manufactured using 6,500 hours of labour at an actual average cost of £12 per hour. The usual calculation would result in the following labour rate variance:
understanding the causes of variances
relevant to CAT Scheme Paper 7 and Professional Scheme Paper 1.2
Actual hours at the actual rate: 6,500 hours x £12.00 = £78,000 Labour rate variance >£13,000 Adv Actual hours at the standard rate: 6,500 hours x £10.00 = £65,000 However, assume that (with hindsight) we discover that, due to wage inflation, a more realistic standard for the period should have been £11.50 per hour. The variance can then be recalculated as: Actual hours at the actual rate: 6,500 hours x £12.00 = £78,000 Possible controllable labour rate variance >£3,250 Adv Actual hours at the revised standard rate: 6,500 hours x £11.50 = £74,750 Uncontrollable labour rate variance >£9,750 Adv Actual hours at the original standard rate: 6,500 hours x £10.00 = £65,000 With hindsight, it can be seen that of the £13,000 total rate variance, £9,750 is due to an increase in market wage rates that was beyond the control of managers. The remaining £3,250 could possibly be controlled by managers, depending upon their level of control over wage rates, overtime working, and labour deployment. Holding managers responsible for the uncontrollable element of the variance is contrary to the principles of responsibility accounting, which state that managers should only be held accountable for items they can control....