Limitations of Standard Costing & Variance Analysis
While standard costing and variance analysis are important tools in an organization's budgetary control system, it is important for a management accountant to appreciate their limitations and disadvantages.
- Non-Standardized Production
- Service Organizations
- Assigning Responsibilities
- Reporting Delay
- Behavioral issues
Non Standardized Production
Standard Costing is traditionally suited to businesses involved in the manufacture of standardized products in mass production environments.
Problems arise when standard costing is applied to organizations involved in the production of small batches of customized products because of the lack of historical benchmark standards for the new custom products. While new standards could be developed for every new batch of custom products, the amount of time that would be required to oversee the entire process for products with such short life cycle may not make it practically feasible.
Standard costing and variance analysis is more difficult to apply to service sector organizations because major portion of their cost is comprised of overhead expenses rather than production expenses (e.g. direct labor cost, direct materials cost, etc). While traditional variance analysis of overheads does not provide very useful information for overheads control purposes, application of newer approaches to standard costing (e.g. use of activity based costing) can provide a constructive basis for variance analysis of overheads in service sector organizations although this may require significant time and investment in the implementation of a management information system that is capable of delivering such information.
Responsibility accounting is a major function of standard costing and variance analysis. Variances could arise for a number of reasons ranging from unrealistic standards (e.g. failing to take into account an expected increase in wage rates) to operational causes (e.g. increase in direct material usage due to hiring of lower skilled labor). Planning inefficiencies that may have caused large variances due to the setting of faulty standards could be dealt with by computing planning and operational variances retrospectively. It can however be more difficult to ascertain the precise causes and assigning responsibilities of an operational variance to a specific individual, department or function within an organization. It may however be argued that although the causes and responsibilities for variances can get blurred at times, variance analysis does provide a basis for investigation that could actually promote a better understanding of the operational environment among an organization's management.
Variance analysis is usually conducted as part of the annual budgeting exercise. The usefulness of variance analysis as a control mechanism declines as the duration of reporting period increases because the delay in the provision of such information reduces its relevancy for the decision making needs of management. Use of continuous budgeting system can significantly reduce the lead times associated with variance analysis although it might be costly in terms of management time and the resources required to implement an information system with the required functionality.
Standard costing and variance analysis may encourage short-termism due to their inherent tendency towards short-term, quantified objectives and results.
A negative perception of an organization's standard costing and variance analysis process can also encourage other sub-optimal behavior among employees such as attempts to incorporate budget slacks.
The behavioral issues associated with standard costing and variance analysis could be managed by involving employees during budget setting so that they do not view the process as unfair. It is also important for an organization's performance measurement system to be based on a wide range of quantitative and qualitative measures so as to encourage management to adopt a long term view that is aligned with an organization's strategic direction.