Cost Accounting

Foundations and Evolutions

Kinney and Raiborn
Seventh Edition
Chapter 7
Standard Costing and Variance Analysis

COPYRIGHT © 2009 South-Western, a part of Cengage Learning. South-Western is a trademark used herein

under license.
1
 Learning Objectives (1 of 2)
• Describe how standards are set for material,
labor, and overhead
• List the documents that are associated with
standard cost systems and describe the
information that those documents provide
• Calculate and record material, labor, and
overhead variances

2
 Learning Objectives (2 of 2)
• Explain why standard cost systems are used
• Identify changes in the use of standards
• Contrast the traditional labor and overhead
elements to a single conversion element
• (Appendix) Explain how multiple material
and labor categories affect variances

3
 Standard Cost Systems
• Manufacturing
• Service
• Not-for-Profit

• Record standard and actual costs

in the accounting records

4
 Standards
• Standard costs are budgeted costs to
– manufacture a single unit of product, or
– perform a single service
• To develop standards identify
– material and labor types, quantities, and prices
– overhead types and behavior

5
 Manufacturing Objective
Minimize unit cost while achieving
certain quality specifications

Input Output
Resources Quality

6
 Material Standards
• Materials used
– Types
– Quantity
– Quality
– Price
• From
– Product specifications, observation, inquiry
– Bill of materials
• Balance cost, quality, and projected sales price
7
8
 Material Standards
Standard
Material = Unit Purchase Price x quantity
Cost

9
 Labor Standards
• Labor used
– Types
• Production, setup, cleanup, and rework
– Quantity
– Cost
• Include wages, payroll taxes, and fringe benefits
• From
– Industrial engineering studies including methods-time
measurement (MTM), time and motion studies,
historical data
– Operations flow document 10
11
 Labor Standards
Standard
Labor = Hours x Wage Rate
Cost

12
 Overhead Standards
• Variable and fixed manufacturing overhead
• Estimated level of activity
• Estimated costs
• Predetermined factory overhead application
rates

13
 Standard Cost Card
For one unit of output (a bike)
Standard Direct Material Components
Standard Direct Labor Components
Manufacturing Overhead
Variable Overhead
Fixed Overhead

14
15
 Variance
Variance is the
difference between
an actual cost and
a standard cost

16
 Total Variance
Total actual cost incurred minus
total standard cost applied to output produced
Actual price of Standard cost of
actual actual
production input production
output

Total Variance*
*Favorable or unfavorable 17
 Total Variance
AP x AQ SP x SQ

Total Variance
Inputs Outputs

AP = actual cost/price per unit of materials or hours of

labor
AQ = actual quantity of materials or hours of labor
SP = standard cost/price per unit of materials or
hours of labor
SQ = standard quantity of materials or hours of labor
18
 Price Variance
AP x AQ SP x AQ SP x SQ
Price/Rate
Variance
Total Variance
What
was What should
(AP - SP) x AQ* have been
paid
paid
*Favorable or unfavorable
19
 Usage Variance
AP x AQ SP x AQ SP x SQ
Usage
Variance
Total Variance
What
was What should
used (AQ - SQ) x SP* have been
used for the
*Favorable or unfavorable
level of output
20
 Material Price Variance (MPV)
AP x AQ SP x AQ SP x SQ

MPV
Total Variance
What
was What should
(AP - SP) x AQ* have been
paid
paid
*Favorable or unfavorable
21
 Material Price Variance
• Calculate Material Price Variance at
– point of purchase, or
– when materials used

22
Material Quantity Variance (MQV)
AP x AQ SP x AQ SP x SQ

MQV
Total Variance
What
was What should
used (AQ - SQ) x SP* have been
used for
*Favorable or unfavorable
level of output
23
24
 Labor Rate Variance (LRV)
AP x AQ SP x AQ SP x SQ

LRV
Total Variance
What
was What should
(AP - SP) x AQ* have been
paid
paid
*Favorable or unfavorable
25
 Labor Efficiency Variance (LEV)
AP x AQ SP x AQ SP x SQ

LEV
Total Variance
What
was What should
used (AQ - SQ) x SP* have been
used for
*Favorable or unfavorable
level of output
26
 Overhead Variances
Variable Overhead Fixed Overhead
Actual variable overhead Actual fixed overhead is
is total of various total of various ledger
ledger accounts accounts

SP = Predetermined SP = Predetermined
variable overhead rate fixed overhead rate

27
 Variable Overhead Variances
Actual Budgeted Applied
VOH VOH VOH
Actual SP x AQ SP x SQ
VOH VOH
Spending Efficiency
For Variance Variance
actual Total VOH Variance
hours
What should have been
used
used for level of output28
 VOH Spending Variance
• Caused by price differences
– managers have little control over
prices
• Caused by shrinkage or waste
– managers should be held accountable

29
 Fixed Overhead Variances
Actual Budgeted Applied
FOH FOH FOH
SP x SQ
FOH FOH
Spending Volume
Constant Variance Variance
Amount Total FOH Variance
What should have been
used for level of output30
 FOH Spending Variance
• Calculate variance for each component
• Caused by price differences
• May reflect mismanagement of
resources

31
 FOH Volume Variance
• Measures capacity utilization
• Caused by producing at a level that
differs from the capacity level used to
compute the predetermined overhead rate
• Also called the noncontrollable variance

32
 Alternative Overhead Variance
Approaches
• One variance
• Two variance
• Three variance
• Four variance

33
One Variance Approach
Actual Standard
OH Cost of
OH
SP x SQ

Total OH Variance
Applied
Overhead

34
Two Variance Approach
Actual Budgeted OH Standard
OH based on Cost of
Standard OH
Quantity SP x SQ
Budget Volume
Variance Variance
Total OH Variance Applied
Overhead
35
 Three Variance Approach
Budgeted OH
Actual Standard
based on based on
OH Actual Inputs actual output OH
SP x SQ
OH OH
Spending Efficiency Volume
Variance Variance Variance
Total OH Variance
Applied
Overhead
36
 Standard Cost Journal Entries
• Variances recorded in accounting system
• Favorable variances
– Credits
– Represent savings in production costs
• Unfavorable variances
– Debits
– Represent excess production costs
• Inventories are recorded at standard cost
during the period 37
 Purchase of Materials
(Point of Purchase Method)
At
Standard
Materials
Cost
Price
Materials Variance Accts Pay
SP x AQ U F AP x AQ
purchased purchased
Debit - Unfavorable
Credit - Favorable
38
 Use of Materials
At
Standard Materials
Cost Quantity
WIP Variance Materials
SP x SQ U F SP x AQ
allowed used

Debit - Unfavorable
Credit - Favorable
39
 Record Labor
At Labor
Labor Rate Efficiency
Standard Variance Variance
Cost
U F U F
WIP Wages Pay
SP x SQ AP x AQ
allowed

Debit - Unfavorable
Credit - Favorable
40
 Apply Overhead
Throughout the Year

WIP VOH FOH

SP x SQ SP x SQ SP x SQ
Allowed Allowed Allowed

41
 Year-End Treatment for VOH
VOH VOH
Efficiency Spending
Variance Variance VOH
Actual Applied
---------------

Enter a debit
Debit - Unfavorable
or credit to
Credit - Favorable
bring balance
to zero 42
 Year-End Treatment for FOH
FOH
Spending Volume
Variance Variance FOH
Actual Applied
-------------

Enter a debit
Debit - Unfavorable
or credit to
Credit - Favorable
bring balance
to zero 43
 Year-End Treatment of Variances
Immaterial - Adjust Cost of Goods Sold
Material - Prorate variances to
Material Price Variance All other variances
• Raw Materials • WIP
• WIP • Finished Goods
• Finished Goods • Cost of Goods Sold
• Cost of Goods Sold
44
Why Use Standard Cost Systems
• Clerical efficiency
• Motivation
• Planning
• Controlling - variance analysis
• Decision making
• Performance evaluation
45
 Setting Standards
• Appropriateness
• Attainability
– Expected standards
– Practical standards
– Ideal standards

46
 Trends in Standards
• Ideal Standards and Theoretical Capacity
• Adjusting standards
• Price variance on purchase versus usage
• Decline in direct labor content

47
 Conversion Costs
• Combine direct labor and manufacturing
overhead
• Variances
– Spending variance for overhead
– Efficiency variances for machinery and
production costs
– Volume variances for production

48
 Material Mix and Yield Variances
AM x AM x SM x SM x
AQ x AQ x AQ x SQ x
AP SP SP SP

Material Material Material

Price Mix Yield
Variance Variance Variance

AM - Actual Mix What should have been

SM - Standard Mix used for level of output
49
 Labor Mix and Yield Variances
AM x AM x SM x SM x
AH x AH x AH x SH x
AR SR SR SR

Labor Labor Labor

Rate Mix Yield
Variance Variance Variance

M - Mix
H - Hours What should have been
R - Rate used for level of output
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 Questions
• How are standards set for material, labor,
and overhead?
• How is variance analysis used for control
and performance evaluation?
• Why are labor and overhead elements
sometimes combined into a single
conversion element?

51
 Potential Ethical Issues
• Setting high standards to create favorable
variances
• Ignoring effects of one production area on
another
• Setting overhead rates too low based on
high production levels to distort inventory
cost and operating income

52
 Potential Ethical Issues
• Producing inventory only to create a
favorable volume variance
• Not updating standards so that favorable
variances are created
• Using low quality materials or labor to
create favorable variances and low quality
products

53