[ Music ] >> Welcome to module three, standard costing and variance analysis. In this first lesson, we'll achieve the following objectives. You will ultimately understand the definition of standard costs, the purpose of a standard costing system, and the fundamentals of variance analysis. Let's start at the beginning and talk about what a standard actually is. Well, the unsatisfying book definition of a standard is that it's a carefully predetermined price, cost, or quantity amount. It is generally expressed on a per-unit basis, and it is generally predetermined through the budgeted process. An important note to make here is that a standard is part of the budget. In the previous module, we talked about budgets at a more aggregate level. We talked about plan total sales, total costs, or total net income. A standard is also a budgeted piece of information or an expectation that managers have, but it's a very fundamental, small piece of the overall budget. We usually think about standards on a per-unit basis. In the coming lessons, you'll see the difference between the overarching or aggregate budget and the standard. No standards and standard costing systems provide control. Of course, the help to facilitate decisions that go on inside of the organization, but here we're talking about influencing decisions. At a very general level, you can think about control systems being diagnostic. That is, that these controls are being implemented at the end of an accounting period so that managers can see what went on and make the appropriate corrections or leverage the strengths that were exhibited. In a general level, you can think about a firm setting targets or goals. And then, at the end of an accounting period, monitoring the actual performance against those targets to see if goals were achieved. In the previous module, we talked about this setting target process as budgeting. And in this module, we're extending to the monitoring performance via an exploration of variance analysis. So let's first talk about some fundamental of variance analysis. First off, consider variance analysis as providing a comparison of actual outcomes and expected outcomes. Why do this? Well, first off, for the purposes of measuring performance that occurred during an accounting period. It also allows us to evaluate the judgements and decisions made by managers and employees throughout the accounting period. And also, looking forward, it allows us to leverage the strengths that we observe, as well as correct weaknesses or find opportunities for improvement in future accounting periods. A second fundamental about variance analysis is that allows for a detailed investigation of the various sources of differences from expectations. This isn't about looking at the total net income for a month and seeing that we surpassed our goal at that aggregate level. We're looking at very detailed analyses and looking all the different sources or reasons for why there would be a difference between actual performance and expected performance. And finally, variance analysis facilitates a management by exception approach. When a variance is small or in-line with expectations, then the management need not address that area of the company or the organization. However, when I variance is significantly large, management can spend their time and energy in the right places to investigate why actual performance was different than expected. In the future lessons, we'll talk about this threshold and the points at which management decides to investigate variances versus when they do not. Two important points need to be made at this time about variance analysis. At the top level, we need to distinguish between static budgets and flexible budgets. A static budget talks about how much we should have spent given the planned level of production or some other activity that we're engaged in. A flexible budget talks about how much we should have spent given our actual level of production. This is very useful because one of the first things that strays from expectations is what goes on outside in the marketplace. Sales might be higher or lower than we had planned, and so therefore, we had to adjust our production level. If this is the case, we don't throw the entire budget out of the window, we still use the standards at the heart of the budget to consider how much we should have spent or incurred in costs given what we actually produced. This distinction will be made more clear as we get into the calculations in future lessons. A second piece has to do with categorizing variances. Now in future lessons, we'll talk about variable costs versus fixed costs variances, as well as revenue variances. We'll talk about spending, efficiency, activity variances, and other types as well. But across all variances of all types, we can categorize them as either unfavorable or favorable. Unfavorable refers to a situation when the source of the variance or a particular variance creates actual net income that is lower than what was budgeted. And in the opposite case, a favorable variance signals that actual net income is higher than budgeted. Now this does not mean that the entire company's net income is higher or lower than budget. It's just particular to this variance that we're looking at. So multiple variances can be unfavorable or favorable, and they would offset each other in the aggregate level. Because we're looking at a single variance, we need to make an important note. That is, do not necessarily interpret unfavorable variances as bad or favorable variances as good. What we need to understand is why these variances are the way they are and the reasons for them, and that allows us to deem a situation positive or negative, good or bad, desirable, or undesirable. So keep this in mind as we go through our calculations and classify our variances as favorable or unfavorable.