BUDGETARY CONTROL: STANDARD COSTING AND VARIANCE ANALYSIS By Chandrasekharan Kunnath INTRODUCTION Budgetary Control is an integral part of management.

It consists in comparisons between the results of actual performance and budgeted performance. Central to this kind of comparison is Standard Costing and Variance Analysis. The purpose of this article is to explain simply to the student and the reader what variance analysis is all about, avoiding pure technicalities and the jargon of accountants. Attention is confined to costs and cost variances in this article. A similar treatment of revenue and revenue variances would also be necessary to obtain a proper perspective. However, control primarily means control of costs as revenue is mainly determined by market forces beyond the control of management. STANDARD COSTS Budgetary Control is a continuous process of comparing the actual performance with budgeted performance. The first step in budgetary control is the setting up of standard costs with which the actual costs can be compared. Any serious deviations are investigated and the required corrective action taken to bring the business back on its planned course. Before discussing Standard Costs, the elements of cost will be discussed. The cost of one unit of a product of a manufacturing business is made up of the following elements: Material Cost Labour Cost Overhead Cost Each of these will now be explained: Material Cost This is the cost of the material content of a unit of manufactured product. Typically, the material content consists of more than one material: the material content of a car consists of metal, plastic, paint, rubber etc. One car is a combination of specific quantities of these materials. Determining the material cost of one unit of output is part of the work of an industrial engineer. The material cost is obtained by multiplying the quantity of material by the unit cost of the material. Labour Cost This is the cost of labour applied to the material content of a unit of manufactured product during its processing. Typically, the labour content consists of more than one kind of labour (unskilled,

semi-skilled, skilled etc.): the labour content of a car consists of the cost of the labour of welders, painters, electricians etc. One car is the result of application of specific numbers of hours of these different kinds of labour. Determining the labour cost of one unit of output is also part of the work of an industrial engineer. The labour cost is obtained by multiplying the number of hours of labour by the wage rate for each kind of labour. Overhead Cost This is the cost of overhead applied to the material content of a unit of manufactured product during its processing. Typically, the overhead content consists of more than one kind of overhead (machine hours, power etc.): the overhead content of a car consists of the cost of machine hours, electricity, water, depreciation (based on machine hours) etc. One car is the result of application of specific numbers of hours of these different kinds of overhead. Determining the overhead cost of one unit of output is also part of the work of an industrial engineer. The overhead cost is obtained by multiplying the number of hours of overhead by the overhead rate for each kind of overhead. Standard Cost

The standard cost of one unit of output is what it should cost at optimum operational efficiency. If operational efficiency (as it usually happens) is sub-optimal, an adverse cost variance is the result. It is the convention to represent adverse variances prefixed with a negative sign. A favourable variance would result from super-operational efficiency or abnormal efficiency. This would be pre-fixed with a positive sign or no sign would be prefixed.
Illustrative Data The table below sets out data that serves to illustrate the concepts introduced in the rest of this article: Standard (Production 5000) Actual (Production 6000) MaterialQuantity Unit CostCost Quantity Unit CostCost X (kg) 1000 20 200001500 21 31500 Y (kg) 600 30 18000710 31 22010 Z (L) 200 40 8000 240 40 9600 Total 46000 63110 Budgeted Cost

The table above shows that the budgeted cost of the output was 46000 whereas the actual cost came to 63110. The adverse cost variance was -17110 but it can be seen straightaway that the comparison between budgeted and actual costs is not valid or fair. It is vitiated as the budgeted and actual volumes of production are different. Such a comparison gives no useful information to management. Actually, the comparison becomes valid only when the comparisons are made on the basis of a production volume of 6000 (the actual volume). Set out below is a valid comparison: Standard (Production for comparison 6000) Material X (kg) Y (kg) Z (L) Total Variance Analysis The total adverse material cost variance based on the same volume of output here is -7910. This can be divided into the following variances: (1) Quantity Variance An adverse quantity variance of -5700 resulted from the actual operations. This was the net result of an adverse quantity variance of -6000 in the quantity of X and a favourable quantity variance of +300 in the quantity of Y and a zero quantity variance in the quantity of Z. Therefore, the area where management should exercise control is the quantity of X as operational inefficiency in the use of material X is indicated by the analysis. Unit Quantity Cost 1200 20 720 30 240 40 (Actual Production 6000) Cost Quantity 240001500 21600710 9600 240 55200 Unit Cost 21 31 40 Cost 31500 22010 9600 63110

MaterialStandardActualVarianceStd. CostValue X (kg) 1200 1500 -300 20 -6000 Y (kg) 720 710 10 30 300 Z (L) 240 240 0 40 0 Total -5700 (1) Price Variance The other part of the material cost variance is an adverse price variance of -2210. This is made up as under: MaterialStandardActualVarianceAct. QtyValue X (kg) 20 21 -1 1500 -1500 Y (kg) 30 31 -1 710 -710 Z (L) 40 40 0 240 0

MaterialStandardActualVarianceAct. QtyValue Total -2210 Therefore, the total material cost variance of -7910 at the volume of production used for comparison purposes (6000) is made up as under: (1) Quantity Variance -5700 (2) Price Variance -2210 Total -7910 In addition, there is an adverse material cost variance purely due to an actual volume of production of 6000 instead of the budgeted 5000. This amounts to (1000 X 92 = the difference in volume times the actual unit cost) = -9200 Thus: (1) Quantity Variance -5700 (2) Price Variance -2210 (3) Pure Volume Variance -9200 Total -17110

Labour & Overhead Variances The computation of variances for Labour and Overhead Costs is similar to that for the Material Cost Variance. Any differences are purely terminological: the price variance is called the Rate Variance for Labour and Overheads. A peculiarity of the Overhead Variance is the treatment of Overheads is the treatment of Fixed Overheads like Factory Rent and Salaries. These are actually fixed costs. Therefore, the establishment of rates based on output is an exercise undertaken purely for convenience and wholly unrelated to control as fixed costs have to be controlled as totals rather than as unit costs. Conclusion Budgetary Control is vital to the management of a business. It means a comparison between the actual and planned performance. Central to Budgetary Control is Standard Costing and Variance Analysis.