Harvard Business School
Rev. May 12, 1993
Standard Costs and Variances
A standard cost is a measure of how much one unit of product or services should cost to produce or deliver. With such a reference point established, the actual cost to produce or deliver a unit can be evaluated. Variances of actual cost from standard cost can be evaluated, and reasons for variances may suggest corrective action or highlight the need to consider changing the standard cost. Standard cost accounting systems are usually less costly to use because they require less record keeping. Once a standard cost is established, it provides a basis for decisions, a basis for analyzing and controlling costs, and a basis for measuring inventory accounts and cost of goods sold. Standard costs may be established using careful analysis of the product or service and the materials and process used to create it. Standard costs established in this way could be thought of as ideal costs, and actual costs may differ from such costs because of actual price differences, errors or mistakes, or changed conditions from the ideal. However, other ways of determining standard costs are also common. For example, actual cost this year can be compared to the “standard” established by spending and performance in a prior period, such as when we compare cost this year to cost last year. Because standard costs are only reference points, measurements to anchor analyses and the questions they raise, there is nothing inherently good about favorable variances or bad about unfavorable variances from standard costs.
Although the remainder of this note emphasizes manufacturing cost variances, many of the same concepts can be applied to the delivery of services. The focus on manufacturing allows a more orderly discussion of material and overhead variances, which are often harder to conceptualize in service organizations.
Prime Cost Variances
The term prime costs refers to the material and labor costs that can be directly related to a unit of product. The standard for any element of prime cost involves two components: a price component and a quantity component. The standard cost is the standard quantity to be used multiplied by the standard price per unit of measure. For example, if an electric motor contains four bushings and each bushing should cost $.25, then the standard cost for bushings is $1.00 (standard quantity of 4 × the price per unit of $.25). Variances are usually computed for each of the two components for both material and labor costs. The formulas for calculating the variances are as follows: This technical note is based upon “Some Comments on Computing Prime Cost Variances” (HBS No. 176-061) and “Some Comments on Computing Manufacturing Overhead Cost Variances” (HBS No. 176-062), prepared by Professor John K. Shank as the basis for class discussion.
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Standard Costs and Variances
Price variance (PV) = (SP - AP) × AQ
Quantity variance (QV) = (SQ - AQ) × SP
Total variance (TV) = PV + QV
Total variance (TV) = (SP x SQ) - (AP x AQ)
where SP = standard price
AP = actual price
SQ = standard quantity
AQ = actual quantity
Since the total variance is the difference between the standard cost allowance (SP × SQ) and the actual cost incurred (AP × AQ), you should be able to verify for yourself that the price and quantity variance in the above formulas do sum to the total variance. An example of the calculation of prime cost variances...
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