Every company wants to achieve a high level of profit. Costs of production is a factor that can easily destroy the plan. It can be tricky to control those costs as they depend on prices and quantities of materials used, cost and hours of labor involved, and overhead costs.
The solution to manage that control has been available since at least the 1920s. At that time standard costing was introduced. A standard costing system helps you to take over control of manufacturing costs. Implementation of standard costing by leveraging modern Information Technology makes this control much easier, more efficient, and more affordable.
One of the objectives of standard costing is to continuously monitor manufacturing costs to make sure that they are not going up and not destroying the company’s financial plans. But how you can monitor that? The idea is simple:
Manufacturing costs can be defined as direct cost and overhead cost. Direct costs are the costs that can be traced to a unit of finished (produced) goods. For example, it can be apples to produce apple juice, or oranges to produce orange juice, or wages of workers involved in production of a particular product. Overhead costs are the costs that cannot be traced directly to a unit of finished goods. For example, the salary of a supervisor who manages the production of apple and orange juice at the same time.
To simplify the discussion, let’s focus on direct materials cost only. Let’s focus on apples.
Consider the company plan’s cost to manufacture apple juice and presume the following values:
- To yield 1 liter of juice 2 kg of apples is needed.
- The price of 1 kg of apples is $1.50.
- So the cost of apples is $3 to produce 1 liter of juice (2 kg * $1.50).
That is called a standard cost for apples. And the company wants to keep this standard.
Now, let’s imagine that 5,000 liters of juice was yielded in a batch. To discover if you have kept the standard for apples or not, you need information about the quantity of apples used and the cost of those apples.
OK, so here is the actual data:
12,500 kg apples consumed and the total cost was $18,000.
Now let’s calculate allowed cost:
Allowed cost = Qty finished goods produced * Standard qty per unit produced * Standard cost
5 000 L * 2 kg/L * $1.50 = $15,000.
Comparing $18,000 actual cost with $15,000 allowed costs, it is easy to conclude that something went wrong. Production incurred $3,000 ($18,000 – $15,000) more than it should have be. The company experienced unfavorable direct material total variance.
How to analyze further
At this point you know that something went wrong. The objective now is to find out how to fix the situation and make sure that the next batch will not incur more cost than planned. To resolve the issue, it’s important to find out who or what is in charge of the increased cost and to develop correction actions.
As we know, the actual cost is quantity consumed times price per unit. Let’s focus on quantity now and answer the question: does the production consume of allowed quantity of apples or exceeded the standard? If the production consumed more quantity than planned, it means that something went wrong with production.
To estimate the influence of the quantity of apples consumed in production, let’s calculate direct material quantity variance. That is easy to do by using allowed quantity per unit of the finished good (2 kg of apples per 1 liter of juice), actual quantity of apples consumed (12,500 kg), and the standard cost ($1.50 per 1 kg of apples).
Here is how to calculate:
Direct material quantity variance = (Actual qty – Allowed qty) * Standard cost
Allowed qty = Qty finished goods produced * Standard qty per unit produced
(12,500 kg – 5,000 L * 2 kg) * $1.50 = $3,750
The calculation shows that because more apples were consumed than planned, the company lost $3,750 per batch. Knowing that a total variance is $3,000, it seems that the company benefited $750 ($3,000-$3,750) because of something. Knowing that cost is consumption times price and that consumption caused a $3,750 loss, then $750 is the benefit from the price. That is called direct material price variance.
Direct material price variance can be calculated this way:
Direct material price variance = (Actual price – Standard price) * Actual qty consumed
Actual price = Total cost / Actual qty consumed
($18,000 / 12,500 kg – $1.50) * 12,500 kg = $(750)
Now you know that the company lost $3,750 because production consumed more apples than was planned, and that the company benefited $750 because the price of the apples was lower than planned. That totaled in $3,000 unfavorable variance.
That is very valuable information that calls you to act. The objective of those actions is to eliminate the loss the company experienced. Most of the causes of that loss are fixable and the faster the company discovers what is wrong, the faster it can fix it and save money.
How to correct the situation
First of all, it is necessary to discover WHY more apples were consumed than initially planned. A production supervisor must be able to answer that question. The causes can differ. It can be poor machine setup, or labor making mistakes because they were not trained enough, or the quality of apples was poor.
Let’s assume that the exceed consumption of the apples happened because of the quality of the apples. It occurred because the apples are relatively poor and it is actually a great achievement that the production consumed only 2.5 kg per liter (12,500 kg / 5,000 L), not 5. In this case, the purchasing department is coming into play. It means that they bought subpar apples with a lower price, and that totaled a loss of $3,000 per 5,000 liters of juice.
As a possible correction, the purchasing department must be strongly instructed to find apples with a higher quality and priced no more than $1.50. Another option is to negotiate the price with the current supplier in order to lower it. Lower price must overcome increased consumption of the apples. As a result the cost of the next batch should be as planned.
Talking about a lower price, the price of the apples must be low enough to keep planned cost of production. Considering that the total standard cost of apples per liter is $3 (2 kg * $1.50) and actual consumption of apples is 2.5 kg, the actual cost of 1 kg of apples must be no more than $1.20 ($3 / 2.5 kg). The purchasing department must negotiate the price for the applies it buys and make it no more than $1.20 per kg. An alternative is to find another supplier to meet the required quality and price of the apples.
But what can be done if the market is strong and it is not possible to buy apples to meet standard costs?
In this case the standard cost must be adjusted in order to meet actual situation. And increased cost must be accepted as well as planned financial results adjusted.
Standard costing is not only about direct materials. It is also about direct labor cost, and manufacturing overhead. It also has some other implications. But the principles of those variations are the same. And if you understand and can see value with the example of apples, you can easily understand all other variations of standard costing.
To go deeper in the topic, a very good guide can be found on Accounting Coach.
Looking at the example of apples, it can appear that standard costing is very difficult to support when many different materials are used. That is correct. To calculate variances on paper or even in Excel collecting all the needed information takes a lot of effort. However, it is much easier and more robust to do that by using modern ERP systems. Don’t be afraid of standard costing. Implement it in the company you work for by leveraging cutting-edge information technologies. It helps to save money.