Standard Costing and Variance Analysis
Standard costing is the establishment of cost standards for activities and their periodic analysis to determine the reasons for any variances. Standard costing is a tool that helps management account in controlling costs.
For example, at the beginning of a year a company estimates that labor costs should be $2 per unit. Such standards are established either by historical trend analysis of the cost or by an estimation by any engineer or management scientist. After a period, say one month, the company compares the actual cost incurred per unit, say $2.05 to the standard cost and determines whether it has succeeded in controlling cost or not.
This comparison of actual costs with standard costs is called variance analysis and it is vital for controlling costs and identifying ways for improving efficiency and profitability. If actual cost exceeds the standard costs, it is an unfavorable variance. On the other hand, if actual cost is less than the standard cost, it is a favorable variance.
Variance analysis is usually conducted for
- Direct material costs (price and quantity variances);
- Direct labor costs (wage rate and efficiency variances); and
- Overhead costs.
Analysis of variance in planned and actual sales and sales margin is also vital to ensure profitability.
Written by Obaidullah Jan, ACA, CFA