Relevance of Standard Costing and Variance Analysis - Report Example

?Relevance of Standard Costing & Variance Analysis Contents Contents 2 Introduction 3 Critical Analysis of Standard Costing & Variance Analysis 3 Conclusion 6 References 7 Bibliography 7 Introduction This project involves a critical analysis of the standard costing system and variance analysis in modern management. Due to shift in cost structures and factory automation the process of standard costing has been criticised due its declined relevance and contradiction with the modern manufacturing philosophy of JIT and continuous improvement. Critical Analysis of Standard Costing & Variance Analysis According to CIMA, standard costing is a technique to control costs by comparing the actual costs to the pre-set standards to obtain variances which facilitates in performance measurement (Walker, 2009, p.119). The standard cost is a predetermined unit cost i.e. the price and standard amount of each resource to be utilized in manufacturing a product and providing a service. A variance is the difference of actual cost incurred and expected standard cost. The variance analysis involves breakup of total variance to explain how much variance is caused by difference in use of resources from the standard usage quantity and how much variance is caused by the difference in prices of resources from the standard costs (Scarlett, 2008, p.96). The standard costing can be advantageous only if the cost standards are carefully established and prudently used. The use of standards solely for placing blame can have negative impact on management and employees. The major advantages include better management planning, promotes economy by making the employees understand importance of cost reduction, setting selling price, management control, highlights variances in management by exception and simplify the inventories’ costs reducing clerical costs (Weygandt, Kimmel & Kieso, 2009, p.495). Standard costing system was developed in accordance with the traditional manufacturing environment which has changed drastically in recent competitive environment. The critics of standard costing and variance analysis site the following reasons for its declining relevance: Changing Cost Structure: Provided that the standard costing is suited to the control of variable and direct costs but not fixed and indirect costs, the usefulness of standard costing has been questioned because the in recent times the overhead costs have become the relevant factory costs whereas the importance of direct labour costs has diminished. Inconsistency with JIT (Just-in-Time) Philosophy: JIT is an inventory system which works towards keeping zero inventories and reducing handling, warehousing and financing costs and time associated with tracking stocks and movements (Ajami & Goddard, 2006, p.357). This system has been widely adopted by American and European firms in the last decade. Although critics of standard costing and variance analysis assert that if performance of purchasing department is evaluated on the basis of purchase price variance then the purchase managers will be motivated to obtain materials at the lowest possible costs which can result in selection of many suppliers on the basis of lowest price, large quantity purchases resulting in larger inventories, low quality goods and indifference towards attainment of on-time delivery. This contradicts the JIT philosophy. Overemphasis on the importance of Direct Labour: The fact that direct labour has lost its importance in modern manufacturing and is a small proportion of the total factory costs, makes the standard costing irrelevant because most of the overhead costs are allocated to the cost centres on the basis of direct labour hours. To reduce their allocated costs the managers try to reduce the direct labour hours which diverts the attention from controlling the rising overhead costs. This is not an inadequacy of standard costing rather a faulty application of it to rely on volume variances to control short term costs and performance evaluation. Inconsistent with Continuous Improvement Philosophy: The standards in standard costing represent the targets to be achieved and maintained. This is highly inconsistent with the philosophy of continuous improvement. Delayed Feedback Reporting: The variance of performance reports arrive too late to be of any assistance in daily control of the production process (Smith, 2007, p.323-326). Robert S. Kaplan (1990) has noticed the influence of factory automation (FA) over use of standard costing and criticised saying that the goal of FA is to achieve zero human presence in factory which makes standard costing meaningless to use. Furthermore advanced technology has led to stable production process which otherwise used to be achieved by standard costing. As the product life cycle has shortened the standard-setting process for new products has become time consuming affair, for example it takes 2 months to set standard costs in a big automobile company. However standard costing is still used by some companies for two reasons as it still helps in reducing the production costs by 2-5% by effectively controlling costs at production stage and it makes easy to prepare financial statements due to easy computations involved. Although the method is not useful in controlling indirect labour (Kaplan, 1990, p.47). Many of these criticisms can be addressed by updating the standard costs regularly, use of demanding performance standards, segregated variance analysis, more focus on variance of variable overheads and quality costs than labour costs and real time information systems to immediately respond to reported variances (Scarlett, 2009, p.158). In the words of Drury the standards represent targets to be achieved rather than the philosophy of continuous improvement which requires the actual performance measures, not comparison with the standards to be reported periodically (Scarlett, 2009, p.158). However variance analysis does not seem to be incompatible with continuous improvement. It can be argued that it is the way in which the standards are traditionally formulated and maintained which has led to such a view as Drury’s. Conclusion The reasons stated by critics such as Kaplan and Drury for declined relevance of standard costing are changed cost structures, inconsistency with JIT and continuous improvement, delayed feedback towards reported variances and factory automation. However despite these shortcomings of standard costing many firms continue to use this system because of its simplicity to adopt and its effectiveness in reducing production costs. The shortcomings of standard costing have also been attributed to the way the cost standards have been formulated and maintained but not prudently used. These shortcomings can be mitigated by updating the standard costs regularly, use of demanding performance standards, segregated variance analysis, more focus on variance of variable overheads and quality costs than labour costs and real time information systems to immediately respond to reported variances. References Ajami, R.A. & Goddard, G.J. (2006). International business: theory and practice 2nd illustrated ed. M.E. Sharpe. Kaplan, R.S. (1990). Measures for manufacturing excellence. Harvard Business Press. Scarlett, R. (2008). CIMA Official Learning System Management Accounting - Performance Evaluation 5th ed. Elsevier. Scarlett, R. (2009). CIMA Official Learning System - Performance Operations 6th ed. Butterworth-Heinemann. Smith, J.A. (2007). Handbook of Management Accounting 4th illustrated ed. Elsevier. Walker, J. (2009). CIMA Official Learning System Fundamentals of Management Accounting 4th ed. Butterworth-Heinemann. Weygandt, J.J. Kimmel, P.D. & Kieso, D.E. (2009). Managerial Accounting: Tools for Business Decision Making 5th illustrated ed. John Wiley and Sons. Bibliography Cokins, G. (2001). Activity-based cost management: an executive's guide. John Wiley and Sons. Hilton, R.W. (2008). Managerial Accounting 7th ed. Tata McGraw-Hill Education. Weil, R.L. & Maher, M. (2005). Handbook of cost management 2nd illustrated ed. John Wiley and Sons. Read More