Question

Of the several uses of standard costing, one of the most controversial is using these standards for performance evaluation of an individual, team, or unit. Consider the labor efficiency variance and assume it is one of the measures for a company’s performance evaluation of a business unit. When might or might not variance from such a standard be an appropriate measure? How would this metric’s effectiveness as a performance measure be affected by a decrease in demand or changes in production volume? Would its effectiveness be different for a service unit than a manufacturing unit? In the event that it is not effective as a performance measure, does it have a strong purpose? How does this compare with other variances from standard?

Answer 1

Standard Costing is a technique of budgetry control for business entities whereby a cost sheet prepared on expected values is compared with actual figures in order to evaluate performance efficiency.

Though this technique of cost management has many applications, it does suffer some drawbacks.

1. It is inappropriate for Cost Plus contracts, in which customer reimburses the manufacturer/service provider for all the expenses incurred in production and a profit margin over it. The budgeted figures can’t be used to prepare the bill. Only actual costs are to be used.

2. The variances have to be calculated in this system of cost accounting, which may prove to be a very complex data intensive procedure, the data for which may be available only after a certain period of time. Hence, this method may not be available as an immediate decision-making support.

3. Most importantly, this method fails at pin-pointing the inefficiencies of an individual, batch or unit. The reason behind it is that the variances are calculated for the data typically collected for the entire production department.

The variances that are calculated by this method are Rate Variance and Volume Variance.

Rate Variance is the difference between expected and actual material, labor or overhead rate.

Volume variance arises due to difference between expected and actual units of material, labor and overheads used.

A change in demand/production volume will result in volume variance. On a detailed investigation by management into irt will reveal the efficiency or discrepancy, as the case may be, of the production department by disclosing why more or less of the material units or labor hours or man power were consumed to reach a desired level of output.

The method of Standard Costing is equally relevant for a service industry as it is to a manufacturing one. Just like in manufacturing industry, the components of a cost sheet would include material, labour and overheads, a service provider’s cost sheet would majorly comprise of labour and overheads. It may have a very small amount of material. But the labour efficiency variance or rate variance or volume variance can be computed for service industry just as it is done for manufacturing one, thereby proving effective for performance evaluation.