P1 Management Accounting

Module: 09

Variance Analysis –Standard Costing

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1. Standard costing

Introduction

Let’s look at a scenario to introduce the key concepts behind standard costing and variance analysis:

Imagine you are asked to set-up a hot dog stand at the school fair this weekend. You know you’re going to need a grill, gas, hot dogs, bread rolls, sauces and transport. You estimate all your costs and calculate that it’s going to cost you £500 altogether to make 500 hot dogs. That works out as £1 each.

This is known as your standard cost.

Finally, the weekend comes around and you’re ready to make some money. You decide you’re going to sell your hot dogs for £3 each for a total income of £1,500. That’s £1,000 profit for a weekend’s work!

However, a few things don’t go according to plan. Near the end of the day your grill’s gas tank runs out. This is known as downtime. You were left with a handful of hotdogs you couldn’t cook and sell.

During the day you also burn about 30 hotdogs because you were too busy playing a game on your phone. You couldn’t sell these and had to feed them to the pigeons instead. This is known as waste.

You also had to send your little brother to buy more ketchup and napkins, as they ran out faster than you expected.

At the end of the day you try to work out how much you earned. You had to buy more napkins, more ketchup and more hot dogs due to waste and excess usage. There were also a few hotdogs you didn’t have time to cook and can’t sell any more due to your grill’s downtime.

As a result, your costs actually increased to £600, which was £100 higher than you had planned. You also only sold 440 hot dogs instead of your planned 500. These are known as variances, which are basically differences compared to your plan.

You go home and write up a summary of your actual profit. You consider why and how your costs and sales ended up being different to what you originally planned, and why you ended up experiencing adverse cost and sales variances instead of favourable variances. With this information in hand, you’re now well prepared to increase your profits at the next school fair!

This scenario represents the basic idea of standard costing and variance analysis. It revolves around calculating pre-set standards for your unit costs

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and unit sales and then comparing this to actual costs and sales. What follows is a variance analysis to determine why the standards were or were not achieved. This is a valuable process that enhances a business’s ability to maximise efficiency.

Why use standards?

We use standard costing for various different reasons. However, the main goal of standard costing is to maximise the efficiency of our production process while also minimising waste of any resource whether it be labour, materials or overheads. Standard costing helps us to achieve this through the following avenues:

Setting accurate budgets – If we set accurate and realistic standards, this information can also be used to set effective budgets. Notice how calculating the cost per hot dog helped us budget for the day.

Highlights areas of concern – Standard costs act as a benchmark. Through variance analysis, we can highlight the areas that require attention (not getting distracted by the mobile phone game, and possible overuse or under-budgeting for napkins). We can also highlight the areas that are performing well. Management can then focus their time and attention accordingly.

Performance evaluation – Standard costing provides benchmarks and goals for staff to aspire to achieve (selling 500 hot dogs or making £1000 in this case). The system can then be used as a means of assessment for bonuses etc.

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Planning – Having set standards of materials and labour allows us to plan ahead effectively. We know how many workers to hire, how many hours to allow and how much material to order before production has even started. This allows for effective resource allocation and budgetary planning.

Inventory valuation – Standard costing provides a simple alternative for inventory valuation, in which stock can be valued at standard cost.

Calculating standard cost

Standard costing is a unique budgetary control in that it calculates a budgeted cost for each individual unit as opposed to a budget for a whole period or project.

To calculate the standard cost of a unit, both the amount and the cost of the resources used are detailed. For example, standard costing for materials might be detailed as 5kg per unit at £25 per kg. The importance of such detail will become clear during our variance analysis section further on.

Management might decide to set their standard cost based on previous performance, competitor’s performance, or simply in accordance with their own goals. Whichever they choose, the difficulty of the level of standard would fall into one of three categories:

Ideal standard

An ideal standard is technically only achievable if the production process is perfectly efficient. That means no waste, no downtime and normal loss. As this is practically impossible, setting an ideal standard will always result in

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an adverse variance and might leave staff unable to reach goals and bonus achieving levels. It can however be helpful to highlight wastage and lost capacity.

Attainable standard

An attainable standard provides a reasonable allowance for downtime, waste and normal loss, but still set in line with an efficient operation. Therefore any variance at this standard indicates excessive losses that should be avoidable. This is a preferable to an ideal standard as it is an achievable goal and hence a good motivator for staff and management.

Basic/Historic standard

This is often left unchanged and can be helpful for trend analysis and comparison purposes. Essentially it is an assessment of how much time and cost the activity spent in the past.

How to set standards

When setting a standard, both absorption costing and marginal costing principles can be used, depending on the costing system of the business.

The standard costs are compared to actual costs to measure the performance of the operation. Such comparisons will tell us whether we are operating efficiently and where and how we can improve. Therefore it is imperative that the standards we set are accurate and attainable. Here are some of the sources of information we can use when setting standards to ensure our standard costing system is effective:

Material price

� Quotations from suppliers. � Previous invoices and payments, e.g. details of discounts, special

deals. � Trend information where prices may fluctuate, e.g. coal, gold, oil. � Type of material, e.g. higher quality will cost more. � Information for related charges, e.g. freight, packaging.

Material quantity

� The standard to be used – i.e. ideal standard, attainable standard or

basic standard. � Quality of material – might require higher quantities if material is low

quality and vice versa. � Historical data, i.e. how much we used in the past. � How much allowance to make for normal levels of waste, losses. � Machinery/techniques to be used.

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Labour rate

� Information from payroll or HR on current wage rates. � Allowances for bonuses/overtime. � Allowances for specialist workers. � Forecasts of wage increases/current negotiations.

Labour hours

� The standard to be used – i.e. ideal standard, attainable standard

etc. � Allowances for downtime, idle time. � Work study exercises, i.e. studies of how much time should be

required to complete each task. � Specifications of each task to be performed and details of any special

tasks involved.

Production overhead costs

� Overhead absorption rates. � Trend information and historical data. � Quotations from suppliers.

Revising standard cost

Comparing results to standard costs which are out-dated is obviously a meaningless exercise. Therefore, standard costs need to be continually updated if they are to be useful. Standard costs should be revised so they are representative of current material prices, labour rates and methods of production.

2. Variance analysis Any difference between the standard cost and the actual cost incurred is known as a variance. We use variance analysis to determine the size of the difference and why the difference occurred. You should recall that our standard costs include both price and quantity, e.g. £3 per kg at 25kg per unit. Therefore, when we break down our variances we will be able to see how much of our variance was caused by a price variance and how much was caused by a quantity variance.

If we achieve an actual cost lower than our standard cost, the variance will be considered favourable. If the actual cost is higher, the variance is considered adverse.

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Example

Imagine we are the management accountant at a company that manufactures office furniture – tables, chairs, desks etc. Let’s assume we operate using a standard costing system and are carrying out variance analysis on one of our products.

The standard variable costs are as follows:

Unit costs

Direct material 17kg £5 per kg £85 Direct labour 30 hours £3 per hour £90 Variable overhead 30 hours £2 per hour £60

£235

We produced 400 units during the period. Our actual costs were as follows:

Direct material 6,600kg £34,320 Direct labour 11,520 hours £32,256 Variable overhead 11,520 hours £24,422

Budgeted fixed production overhead

£7,000 Actual fixed production overhead £9,000

Budgeted output (units)

350 Actual output (units) 400

Direct material cost variance

400 units at standard cost (£85/unit) £34,000

400 units at actual cost £34,320

Variance £320 adverse

To calculate this variance, we determine the standard material cost for the actual units produced (400 in this case) and compare it to the actual material cost of the actual units produced. In the above example, actual cost exceeds standard cost. This means the variance is adverse.

This variance can relate to either price being more or less than expected or the quantity being more or less than expected. In this case, perhaps the adverse variance was caused by material price being higher and/or the quantity of material used to be more than expected. The next step then is to break the variance down into the price portion and the quantity portion.

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Direct material price variance

6,600kg should have cost (at £5/kg) £33,000

6,600kg actually cost £34,320

Variance £1,320 Adverse

To calculate this variance, we determine the standard cost of the actual materials used (6,600kg) and compare it to the actual cost of the actual materials used.

In this example, the adverse variance indicates that we spent £1,320 more than standard, suggesting that we paid a higher price for materials than we budgeted for.

Direct material usage variance

400 units should have used (17kg/unit) 6,800kg

400 units actually used 6,600kg Variance 200kg favourable

200kg x standard cost (£5/kg) £1,000 favourable

To calculate this variance, we determine the standard quantity of materials required for the actual units produced (400 units) and compare it to the actual quantity of materials that were used. To express this variance in monetary terms, we then multiply it by the standard price of the materials.

In this example, the favourable variance indicates that we used less material than originally estimated, perhaps due to using better quality materials or more efficient processes, and this resulted in a total saving of £1,000 at the standard cost.

Reconcile

It’s important that after separating our variances into their price and quantity elements, we add them together to ensure they add up to our original total variance:

Direct material price variance £1,320 adverse Direct material quantity variance £1,000 favourable Direct material cost variance £320 adverse

Because our individual price and quantity variances add up to the correct total variance, we can be confident our calculations are correct.

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Issues with stock valuation

There may be times when then the quantity of material purchased, and the quantity of material used is different. In this case, we need to know which amount to use as our “actual quantity” in our direct material price variance calculation.

The rule is if we value our stock at standard cost, we base our variance on material purchased. If we value our stock at actual cost, we base our variance on material used.

Direct labour cost variance

400 units at standard cost (£90/unit) £36,000

400 units at actual cost £32,256

Variance £3,744 favourable

To calculate this variance, we determine the standard labour cost of our actual output (400 units) and compare it to the actual labour cost of our actual output.

In the above example actual cost is less than standard cost, leading to a favourable variance which indicates that we spent £3,744 less than expected on labour costs. This variance can relate to both price (here the price of staff could be less than expected) and quantity of labour (it may suggest we used less labour than expected). The next step is to break the variance down into the price portion and the quantity portion to get more information to help our decision making.

Direct labour rate variance

11,520 hours should have cost (£3/hour) £34,560

11,520 hours actually cost £32,256

Variance £2,304 favourable

To calculate this variance, we determine the standard cost of the actual hours of labour and compare it to the actual cost of the actual hours of labour.

In this example, the favourable variance indicates that we spent £2,304 less than standard due to us paying a lower hourly rate than expected. This may be because labour rates fell or less skilled staff were used, or perhaps the original estimate was poor.

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Direct labour efficiency variance

400 units should have used (30 hours/unit) 12,000 hours

400 units actually used 11,520 hours

Variance 480 hours favourable

480 hours at standard cost (£3/hour) £1,440 favourable

To calculate this variance, we determine the standard number of hours required and compare to the actual number of hours that were required. To express the variance in monetary terms, we multiply the difference in hours by the standard hourly rate of labour.

In this example, the favourable variance indicates that we spent £1,440 less than standard due to us requiring fewer labour hours than expected, perhaps due to more efficient procedures, better skilled labour, or again because of a poor original estimate.

For a quick guide on how to calculate variances for the direct labour cost, direct labour rate and the direct labour efficiency, see the following graph:

Reconcile

As before, we need to reconcile the individual variances:

Direct labour price variance £2,304 favourable Direct labour quantity variance £1,440 favourable Direct labour cost variance £3,744 favourable

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Variable overhead cost variance

400 units at standard cost (£60/unit) £24,000 400 units at actual cost £24,422 Variance £422 adverse

To calculate this variance, we determine the standard overhead cost for the units produced and compare it to the actual overheads allocated.

In the above example, actual cost exceeds standard cost leading to an adverse variance. This suggests we spent £422 more than standard on variable overheads.

The next step is to break this variance down into its expenditure and efficiency components.

Variable overhead expenditure variance

11,520 hours should have cost (£2/hour) £23,040 11,520 hours actually cost £24,422 Variance £1,382 adverse

To calculate this variance, we determine the standard overhead cost of the actual hours worked and compare it to the actual overhead cost allocated.

In this example, the adverse variance indicates that we spent £1,382 more than standard on variable overheads – perhaps energy costs rose more than expected for example.

Variable overhead efficiency variance

We know that our variable overheads are allocated based on labour hours. Therefore, a variance here will arise due to the number of labour hours used being different to the standard allowance. We have already calculated this amount in our previous direct labour efficiency variance calculation:

400 units should have used (30 hours/unit) 12,000 hours 400 units actually used 11,520 hours Variance 480 hours favourable

With this information already available, all we need to do is multiply the variance in hours by the standard overhead rate.

480 hours at standard cost (£2/hour) £960 favourable

The favourable variance indicates that our variable overheads were £960 less than standard due to a lower number of labour hours being required.

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For a quick guide on how to calculate variances for the variable overhead cost, variable overhead expenditure and the variable overhead efficiency, refer to the following diagram:

Reconcile

Variable overhead expenditure variance £1,382 Adverse Variable overhead efficiency variance £960 favourable Variable overhead cost variance £422 Adverse

Fixed production overhead variance

To calculate the variance, we need to calculate the amount of over/under absorption. You should be familiar with the following calculation from the absorption costing examples earlier on.

First, we need to determine our overhead absorption rate:

Budgeted fixed production overhead £7,000 Budgeted output (units) 350 Overhead absorption rate (per unit) £20

Next, we need to calculate the total amount of fixed overheads absorbed. This is simply our overhead absorption rate multiplied by our number of units produced:

Overhead absorption rate £20 Actual output (units) 400 Fixed production overhead absorbed £8,000

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We can now work out the amount of under/over absorption:

Actual fixed production overhead incurred £9,000 Fixed production overhead absorbed £8,000 Total amount of under absorption £1,000

Because our fixed overheads are under absorbed the variance is considered adverse. This is because our actual expenditure on fixed overheads exceeds the amount we absorbed, i.e. we overspent!

We know that over/under absorption can occur due to two things: either our actual expenditure was different to our budget or our actual output was different to our budget. We can determine how much of our fixed production overhead variance relates to each through the following:

Fixed production overhead expenditure variance

This is simply the difference between budgeted and actual expenditure:

Budgeted fixed production overhead £7,000

Actual fixed production overhead £9,000

Variance £2,000 adverse

This adverse variance indicates that our fixed overhead costs were £2,000 higher than standard. This portion of our over/under absorption occurs due to actual expenditure being different to our budget.

Fixed production overhead efficiency variance

This is the amount of variance that will arise due to a difference in volume of units produced:

Actual output (units) 400 Budgeted output (units) 350 Variance 50

x overhead absorption rate (£20 per unit) 1,000 favourable

The variance of £1,000 is considered favourable because actual units produced exceed budgeted units, i.e. we beat our target!

Now look at the following diagram for a quick reminder of how to calculate the variance for fixed production overheads, fixed production overhead expenditure and fixed production overhead efficiency:

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Reconcile

As with our other variances, we need to add the two together to ensure they match our total variance:

Expenditure variance 2,000 adverse Efficiency variance 1,000 favourable Fixed production overhead variance 1,000 adverse

Sales variances

It is important to set standards not only for our costs but also for our revenues. To determine if we’ve met these standards we use sales variances.

Following on from our previous example, we receive the following additional information:

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Budget £ Sales and production volume (units) 350

Selling price (per unit) 500 Variable cost (per unit) 235 Fixed cost (per unit) 20 Budget profit per unit 245

Actual Sales and production volume (units)

400

Selling price (per unit) 480

The cost information above is simply a summary of the cost information from our previous example rewritten here for your convenience.

Selling price variance

Standard selling price 500

Actual selling price 480 Difference 20 adverse x sales volume (units) 400

Selling price variance 8,000 adverse

To calculate this variance, we take the difference between actual and standard selling price and multiply it by actual sales volume.

In this example the variance is adverse, indicating that our revenue was £8,000 less than standard due to us selling our product at a lower price than expected. Perhaps that was due to market prices falling, negotiation of discounts by customers, or original estimates being poor.

Sales volume profit variance

Budgeted sales volume 350 Actual sales volume 400 Difference 50 favourable x budget profit per unit 245 Sales volume variance 12,250 favourable

To calculate this variance, we take the difference between our budgeted and actual sales volume and multiply it by our budgeted profit per unit.

The variance is favourable, showing that our profit is £12,250 higher due to our sales volume being higher than expected, perhaps due to the lower

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price being charged (see the price variance), a good marketing campaign or an unexpected increase in demand.

Note that we use the standard profit per unit rather than actual profit in this variance calculation.

Look at this diagram for a summary of how to calculate sales variances:

Budget to actual profit reconciliation

Once we have calculated all our variances, we can check their accuracy by preparing reconciliation between budget and actual profit. The statement below reconciles budgeted gross profit to actual gross profit, incorporating each of the variances we have just calculated.

A manager in charge of this department would look over this statement in detail and attempt to understand why the variances happened using their knowledge of the business. Their aim will be to try to avoid adverse variances (e.g. trying to manage material costs better) and keep the favourable variances (e.g. retain the lower pricing policy if it was that that caused sales volumes to rise so much).

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Budget to actual profit reconciliation Original budgeted gross profit (350 units x £245 gross profit per unit)

£ £

85,750

Sales volume profit variance 12,250

Selling price variance

Cost variances

(8,000) 90,000

Direct material price (1,320)

Direct material usage 1,000

Direct labour rate 2,304

Direct labour efficiency 1,440

Variable overhead expenditure (1,382)

Variable overhead efficiency 960

Fixed overhead expenditure (2,000)

Fixed overhead volume 1,000

Actual gross profit 92,002

Check Actual sales

192,000

Less: Actual direct materials

34,320

Actual direct labour 32,256 Actual variable overhead 24,422 Actual fixed overhead 9,000 Actual gross profit 92,002

Remember, ultimately, it’s not the numbers that are important to the business, it’s the interpretation of them, how the department manager can use this to improve for the future!

3. Standard marginal costing So how does all this new information about about standard costings and variances tie in with the costing systems we have spoken about previously? Well, under a marginal costing system, the following variances are calculated slightly differently.

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Fixed overhead volume variance

This variance does not exist under a marginal costing system. This is because fixed overheads are not absorbed under marginal costing and therefore are not affected by volume.

Sales volume contribution variance

The sales volume contribution variance is very similar to the sales volume profit variance. The only difference is that in this calculation we use contribution per unit rather than profit per unit. This is because the profit variance incorporates absorbed fixed costs which do not exist in a marginal costing system.

To calculate this variance for the above example, we first need to work out budgeted contribution per unit. Remember, contribution does not include a deduction for fixed costs:

Selling price per unit £500 Variable cost per unit £235 Contribution per unit £265

The next step, as with the sales volume profit variance, is to multiply this contribution amount by the variance in sales volume:

Budgeted sales volume 350 Actual sales volume 400 Difference 50 favourable x budget contribution per unit £265 Sales volume variance £13,250 favourable

Note that we use budgeted rather than actual contribution in this variance calculation.

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Budget to actual reconciliation

With our updated variances, we are now in a position to produce a budget to actual profit reconciliation:

Budget to actual profit reconciliation under marginal

Original budgeted contribution

costing £

£

(350 units x £265 contribution per unit) Sales volume contribution variance

13,250

92,750

Selling price variance

Cost variances

(8,000) 98,000

Direct material price (1,320)

Direct material usage 1,000

Direct labour rate 2,304

Direct labour efficiency 1,440

Variable overhead expenditure (1,382)

Variable overhead efficiency Actual contribution

960 101,002

Budgeted fixed costs (7,000)

Fixed overhead expenditure variance Actual gross profit

2,000) 92,002

We know the reconciliation is correct as the final figure we arrive at is our original gross profit figure of £92,002 - the same as in the previous example. Remember that our overall profit does not change between marginal costing and absorption costing (as long as there is no change in inventories in the year).

Also notice how we exclude fixed cost variances from the contribution section. You should already recall that this is because fixed costs are not included in contribution in a marginal costing system but are rather deducted in full at the end of each period.

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4. Variance analysis in the modern manufacturing environment So, variance analysis seems very useful, but variance analysis was created a little while ago and since then the manufacturing environment has changed. For example, it used to be the case that products were fairly simple to produce, with long product life-cycles, such as furniture. Additionally, products like this would typically require labour intensive production techniques, which ins this instance would be carving the furniture from wood, sanding it down, oiling it and varnishing it etc.

However, in the modern manufacturing environment products are now considered non-standard, which means that they are essentially customised products. Additionally, these products tend to have short life-cycles and are produced by machines. A good example of this would be the Apple Watch, because there are a variety of models, all only differing slightly from each other, so that the customer can feel like the product is customised to their needs. Moreover, this product would have been using machine intensive production techniques and will have a short product life-cycle, as Apple typically release a new generation of each of their products every couple of years or so.

So, how does variance analysis and standard costing work in the modern manufacturing environment?

The answer is not so well and for the reasons why, please refer to the table below:

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Reasons why variance analysis may not be appropriate for the modern

manufacturing environment e.g. there are three types of Apple Watch (Apple Watch, Apple

Non-standard (customised) products

Customised products take different manufacturing times and material quantities.

Watch Sport and Apple Watch edition), all of which have numerous variations, wit each one most likely taking a

slightly different amount of time and materials to produce. e.g. because of the fast changing nature of technology Apple Standards need to be regularly release new

Short product life-cycles updated frequently in order to remain

versions of their products, which have

relevant. been updated with the latest, so that their products can remain relevant. e.g. the majority of the

Machine intensive production techniques

A manager can ask their workforce to speed up but they can't ask a machine to speed up!

production process for most of Apple’s products is done by machine and this will simply take as long as is

necessary. Information is needed to e.g. all the different do a variance analysis processes involved in and a very complex the creation of much of

Complex processes process may have hundreds of different

Apple’s products would make it difficult to

steps which would be collate the necessary very difficult to do a information needed for variance analysis on. a variance analysis.

Variances in a just-in-time (JIT) and total quality management (TQM) systems

Just-In-Time (or JIT), is a business and production strategy that seeks to eliminate excess stock of products or raw materials, producing reactively to customer demands and not before. The aim is to have the right material, at the right time, at the right place and in the exact amount.

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Total Quality Management on the other hand is the principle of a culture of quality throughout the whole organisation. Making it part of everyday activities until it becomes installed as part of what everyone does.

Regardless, how does variance analysis work under both the JIT and TQM systems?

Well, there are some traditional variances which go against the overall aims of JIT and TQM. This means that a favourable variance in a traditional system, is actually a bad thing in a TQM system.

Confused?

If so, then simply look below to further elucidate yourself.

A traditional variance is the material price variance, because traditional systems are focussed on getting materials at the lowest price possible. However, in TQM and JIT higher quality materials are typically more desirable in order to improve overall quality and customer satisfaction. Therefore, the material price variance is not very appropriate in this instance.

Additionally, labour, variable overhead and fixed overhead efficiency variances are less applicable. For example, in TQM a longer production time (more labour hours) may be acceptable if it produces a product with no defect and reaches customer expectations.

Finally, the material usage variance will have different meaning in JIT, TQM and traditional environments. In JIT more wastage can be expected, as the production process is made to order and very fast. However, in TQM the buyers will attempt to use suppliers who provide the highest quality materials, but because a fault free product is the goal, there may be more materials used to make it.