Question

A company using standard costing allocates fixed cost to each unit produced based on an output determined before the accounting period begins. Why is this a valuable technique and why, on the other hand, does it give rise to a production volume variance?

Answer 1

Standard costing is a branch of cost accounting or managerial accounting which is mostly used in a manufacturing concern that involves direct material, direct labor, and overheads.

Standard rates are used while assigning the cost of direct labor, direct material, and overhead costs, it means that the finished goods and cost of goods sold will contain standard rates rather than actual.

It does not mean that the company will not pay for actual, in fact, they will compare the standard or estimated rates with the actual expense, and the difference will be shown as a variance.

The result of variation may either be favorable or unfavorable. The differences come due to the distraction of actual figures from budgeted figures.

When the actual cost incurred is greater than the estimated cost, then the result will show as unfavorable.

The unfavorable results notify the management that if everything was constant, then the company earn less profit than it has planned.

When the actual cost incurred is less the budgeted or estimated cost, the result is favorable. Which means that the company has performed according to dor better than the expectations of the management.

Importance of Standard Costing:

1) Increase in Efficiency:

The standard costing is mostly used in companies which involve in manufacturing processes, and have a high value of direct labor, direct material, and overheads costs.

Using predetermined or standard rates for production and raw material, can help management in forecasting their costs for the future period and compare the standard costs with actual costs after completion of the job.

With a standard costing system, the employees are also well aware of the set standards, so they always try to meet the standards. This helps the employees to meet the set standards.

In the course of all these processes, the efficiency of the company’s will increase automatically.

For example, if the labor hour needed to complete one unit is already set by the company, the labor will try to complete their job according to standards. Hence the efficiency of labor will increase automatically.

Same will be the case with direct material also. To decrease the wastage and extra usage, management sets a predetermined quantity of raw material required to complete one unit of production.

And make sure that the standards should follow by every employee working in the production department. In this way, wastage of raw material will decrease which ultimately results in high profits.

2) Important While Making Budgets:

Standard cost is all about budgets and estimations. The standards are used to forecast any type of future cost.

These standards are usually the industry best practices, so while making budgets and estimates there is a little chance of deviating actual data from budgets.

3) Improved Cost Control:

Standard costing plays a very vital role in controlling the cost of material, labor, and overheads. As the standards are mostly taken from the industry best practices.

Improvement in labor efficiency and wastage control will always help the management to control their product cost.

4) Provide Information For Decision Making:

Decision making is involved in all type of organizations ranges from small to large.

In small organizations where all the control lies with one person, did not require much information to take decisions.

But in large organizations where a lot of financial data originated on a daily basis, managers require some calculations to come up with a decision.

Standard costing gives comparative information to the managers and directors about the internal costs of different departments.

Management can easily take their decisions keeping in mind the short term and long term future planning.

Production Volume Variance

Production volume variance is a statistic used by businesses to measure the cost of production of goods against the expectations reflected in the budget. It compares the actual overhead costs per unit that were achieved to the expected or budgeted cost per item.

• Production volume variance = (actual units produced - budgeted production units) x budgeted overhead rate per unit

Standard costing gives rise to production volume variance which can be both favourable or unfavourable.

Since the budgeted overhead rate per unit remains constant in the computation, the variance arises solely as a difference of budgeted and actual production. However a favouarble difference represents that actual units produced were more than the budgeted units, but it is important or analyse whether such difference is on account of increased sales, or due to unnecessary production leading to blockage of working capital & inventory pile up.