How a CFO Can Help with Standard Cost Accounting
As a business owner or manager, you have to accurately predict costs in order to set prices that enable your company to operate efficiently and turn a profit.
In industries such as manufacturing, standard cost accounting allows you to see if your cost predictions are correct and to adjust as needed in a timely manner.
What Is Standard Cost Variance Analysis?
Standard cost variance analysis is a process that reveals gaps between what you expect to pay in key budget areas (such as materials and labor) and what you are actually paying. You use a formula to determine your expected cost—the standard—then at month-end you compare that number to actual figures. Ideally, the numbers should be close, but it is not unusual to see positive or negative variances.
Types of Standard Cost Variances
There are several types of standard cost variances, including:
- Fixed overhead spending variance
- Labor rate variance
- Purchase price variance
- Variable overhead spending variance
However, many smaller businesses consolidate down to two variances: purchase price and manufacturing cost (which typically includes labor and overhead).
Why Standard Cost Variance Matters
Clearly understanding your costs can sharpen your budgeting and forecasting and improve operational efficiencies. However, smaller manufacturers may not track enough of the details. Often, they simply flush their costs each month, lumping them into one of two general ledger accounts—payroll and materials costs. They likely estimate a cost for the inventory used, without having an exact figure. That makes effective analysis challenging.
More sophisticated manufacturers use standard cost accounting, which allows for detailed tracking and, therefore, valuable analysis. Ultimately, standard cost variance becomes a KPI you see right on your financial statement.
How It Works
Let’s say your company manufactures a widget. Your production cost includes labor and the cost of the materials that go into the widget plus overhead.
Purchase price variances
When you buy materials used to make the widget, you book the standard cost you expect to pay. If there is a difference between the standard and what you actually paid, that amount goes to the variance account. If you paid more than your expected cost, that is a negative variance. If you paid less, that is a positive variance.
Over time, variances may fluctuate. Hopefully, they even out, but that is not usually the case. If the variance is mostly positive, you may adjust your standard figure for this material accordingly. You might also consider reducing your prices since it costs less to make the widget than you thought.
If you are seeing negative purchase price variance, especially if the variance is large, you need to understand why so you can take corrective action. Did prices go up due to inflation? Do you need a savvier purchasing person? Should you buy in larger quantities to get a volume discount? You may need to consider raising your prices if its something you can’t easily mitigate.
Manufacturing cost variances
Manufacturing cost variance is far more complex, so it may make sense to break out labor from overhead. You follow the same process—producing each widget involves this much labor and this much overhead, so you calculate standards for each type of cost.
At the end of the month, you can analyze the variances. If it is negative in terms of labor cost, ask yourself:
- Is the standard wrong? (Perhaps it is taking longer to make each item than the standard accounts for. If so, a price increase would be most appropriate.)
- Are you running up unexpectedly high overtime expenses? This might happen if you bring in temporary workers to handle a big project or because business is booming and you simply need more help to maintain productivity. However, if high overtime expenses are ongoing, careful analysis is required to uncover the cause(s).
- Is your cost of labor off? For instance, are temps costing too much, or are skilled workers being used to perform unskilled tasks?
On the overhead side, you follow the same process, considering the multiple factors that contribute to cost, such as:
- Your factory/facility
- Shipping materials
Again, at month-end, you book the standard overhead cost and then calculate any positive or negative variance. Some overhead costs, such as rent or salaries of foremen and supervisors, tend to be fixed, while others, such as supplies costs, vary. Still, this process will make it easier to control overhead costs and understand the reasons behind variances.
Almost always, overhead variances are due to volume because you have fixed costs but a variable manufacturing volume. If you make fewer widgets than expected, fixed overhead costs are still the same. If you make more than anticipated, you likely will see a positive variance.
Some common causes of variable overhead variances include wasting supplies, shrinkage/theft of tools, and inaccurately created standards. Usually, in smaller organizations, this last one is the easiest cause to see and fix.
It is important to follow the same process to develop standards and analyze variances for each type of cost.
The Role of a CFO
Because analyzing costs is crucial to profitability, this is an area where a CFO can be especially useful, helping you understand how standard cost accounting works and how to “read” variances when they occur. This does not change the budgeting process, but variances do inform your budget. Budgets should be developed using standard cost, and budgeted items help develop accurate standards, especially for overhead.
Take the following steps to get started:
- Use current purchasing and payroll information to determine standard material and labor costs.
- When you budget, you can work backward to calculate your actual overhead costs. You can also perform the calculations using historical standard costs. These numbers should be close. You should adjust either your standard or your budget based on that analysis. This can become part of your regular budgeting process each year.
- Review standard costs midyear or at least annually so you can make timely adjustments if needed. Meanwhile, monthly analysis will also provide early warning that a standard cost is off so you can investigate the cause.
If you are seeing cost variances in your manufacturing operations and do not have a CFO on your team, consult an experienced financial advisor or fractional CFO, who can perform the same role. They can come in for a limited engagement to help you identify and correct current cost problems and also set up a process to accurately calculate standard costs to support effective future accounting and profitability analyses.
Gregory R. Smith
Greg Smith is a director and practice lead of the Accounting and Management Outsourcing (AMO) group at Redpath and Company. He provides oversight and direction to each of the accounting, payroll consulting and Fractional CFO/Controller areas within AMO as well as directly providing Fractional CFO services. Greg began his career in the entrepreneurial services group at EY in audit and has been a Controller and CFO in public and private companies for over 20 years. Over that time, he has gained experience in a wide range of industries including manufacturing, services, software/internet/high tech, med tech, and real estate. Greg joined Redpath and Company in 2021.
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