Performance Evaluation Using Variances

from Standard Costs

______________________________
Standard Cost System
✓makes use of estimated costs (or budgeted costs) to manufacture a
single unit of product or perform a single service

✓a tool wherein the company uses estimated costs in planning budgets,

managing and controlling costs, and evaluating cost management
performance
Why adopt a standard cost system?

1. Improves planning and control. A standard cost system compares

actual amounts with standard amounts to determine variances from
the standard.

2. Facilitates product costing. Standard costing uses standard costs for

DM, DL and OH. Standard cost systems provide readily available unit
cost information that can be used for pricing decisions.
Components of Standard Cost System:

1. Standard costs, which provide a standard or a predetermined

performance level
2. A measure of actual performance
3. A measure of the variance between standard and actual performance
Standards
✓relate to the cost and quantity of inputs used in manufacturing goods
or providing services.
✓it is the benchmark or “norm” for measuring performance

Standard costs
✓realistic estimates of cost based on analyses of both past and projected
operating costs and conditions
✓the expected or budgeted cost of materials, labor, and MOH required
to produce one unit of product
Setting Standards
1. Establishment of cost centre (before setting the standards)
Cost centre – location, person or item of equipment (or group of these) for
which cost may be ascertained and used for the purpose of cost control. Cost
centre is necessary because fixing of responsibility and defining the lines of
authority becomes easier.
2. Classification and Coding of Accounts.
3. Determine the period and what type of standards to apply.
4. Organization of Standard Costing – Standard Committee (managers
and experts)
5. Setting of Standards.
Types of Standards:
1. Ideal standard – is one which applies in dream conditions where
nothing ever goes wrong – no machinery problems or worker
problems which is very unrealistic.

2. Practical standards (currently attainable standards) – tight but

attainable that have allowances made for machinery problems and
rest periods for workers and can be attained through reasonable but
highly efficient efforts by average worker.
How to develop standards:
1. Direct material price standards – based on careful estimate of all
possible price increases, changes in availability of materials in the
market and the economic conditions

2. Direct materials quantity standard – based on product engineering

specifications, the quality, the age and productivity of machines, and
the quality and experience of the work force

3. Direct labor rate standard – defined by labor union contracts and

company personnel policies
How to develop standards:
4. Direct labor time standard – based on current time and motion
studies of workers and machines and records of their past performance
5. Standard variable overhead rate and standard fixed overhead rate –
are found by dividing total budgeted variable and fixed overhead
costs by an appropriate application base* (also known as
predetermined factory overhead application rates)

*application base – the variable that is used for allocating/assigning

costs in different cost pools to different cost objects
Setting Standard Costs
Price standards – specify how much should be paid for the quantity of the
input to be used

Quantity standards – specify how much of the input should be used per
unit of output

Standard cost = Standard price x Standard quantity

A product’s standard unit cost is the sum of the following:

▪ Standard direct materials cost

▪ Standard direct labor cost
▪ Standard overhead cost
Standard Cost Sheet
Sample exercise:

Tip Top Corp. produces a product that requires six standard pounds per
unit. The standard price is $4.50 per pound. It requires 2.5 standard hours
per unit at a standard hourly rate of $12.00 per hour. Variable overhead
rate is $2.20 per direct labor hour. Fixed overhead rate is $0.90 per direct
labor hour. Compute the standard unit cost of the product.
Standard Cost Sheet
Description Standard Price Standard Quantity/Usage Standard cost
Direct Materials $4.50 6 lbs. $27.00
Direct Labor $12.00 2.5 hours $30.00
Variable Overhead $2.20 2.5 hours $5.50
Fixed Overhead $0.90 2.5 hours $2.25
Product’s standard unit $64.75
cost
Standard Cost Sheet
Sample exercise:

Tip Top Corp. produces a product that requires six standard pounds per
unit. The standard price is $4.50 per pound. It requires 2.5 standard hours
per unit at a standard hourly rate of $12.00 per hour. Variable overhead
rate is $2.20 per direct labor hour. Fixed overhead budgeted cost for the
month is $6,750. Normal monthly capacity is 3,000 units. Compute the
standard unit cost of the product.
Standard Cost Sheet
Fixed Overhead Standard rate:

Budgeted Fixed OH cost $ 6,750.00

Application base (in direct labor hours) 7,500
Fixed OH standard rate (per DL hour) $ 0.90

Application base = 3,000 units x 2.5 standard hours to produce one unit
= 7,500 direct labor hours
Standard Cost Sheet
Description Standard Price Standard Quantity/Usage Standard cost
Direct Materials $4.50 6 lbs. $27.00
Direct Labor $12.00 2.5 hours $30.00
Variable Overhead $2.20 2.5 hours $5.50
Fixed Overhead $0.90 2.5 hours $2.25
Product’s standard unit $64.75
cost
 Process flow of Standard Cost System

Perform and
collect Revise
Setting the Actual vs Variance
information on standards, if
standards standards Analysis
actual necessary
performance

The responsibility of management is to

investigate significant variances. This process
of focusing only on the most significant
variances is called Management by Exception.
 Management by Exception
✓Enables management to concentrate its efforts on those variances that
could have a big effect on the company, ignoring variances that are not
significant

When is variance significant?

o when there is a sudden change in costs which questions the operations.

Take note however that if budgets were not set accordingly and it caused a large
amount of variances, investigating these variances will be a waste of time.
Manufacturing Cost Variances

Direct Direct Materials Price Variance

Materials
Direct Materials Quantity Variance
Cost Variance

Direct Labor Rate Variance

Direct Labor
Cost Variance Direct Labor Time Variance

Factory Variable FOH Controllable Variance

Overhead
Cost Variance Fixed FOH Volume Variance
Direct Materials Price Variance
Direct Materials Price Variance = (Actual Price – Standard Price) x Actual Quantity

OR
MPV = (AP-SP) x AQ

Direct Materials Quantity Variance

Direct Materials Quantity Variance = (Actual Quantity – Standard Quantity) x Standard Price

OR
MQV = (AQ-SQ) x SP
Sample Exercise

Tip Top Corp. produces a product that requires six standard pounds per unit. The standard price is
4.50 per pound. If 3,000 units required 18,500 pounds, which were purchased at 4.35 per pound,
what is the direct materials (a)price variance (b) quantity variance (c) cost variance?

Given : Standard Price : 4.50 per pound

Standard Quantity: 18,000 ( 3000*6)

Actual Price : 4.35 per pound

Actual Quantity : 18,500 pounds

Solution:
Direct Materials Price Variance = (Actual Price – Standard Price) x Actual Quantity

MPV = (4.35-4.50) * 18,500 = (P2,775)

Direct Materials Quantity Variance = (Actual Quantity – Standard Quantity) x Standard Price

MQV = (18,500-18,000) * 4.50 = P2,250

Direct Materials Variance Analysis
• Unfavorable Variance quantity variance might be caused by the
following:
• Equipment that has not been properly maintained
• Low –quality (inferior ) direct material

• Not all variances are controllable

• Example, an unfavorable materials price variance might be due to market-
wide price increase.
Direct Labor Rate Variance
Direct Labor Rate Variance = (Actual Rate per hour – Standard Rate per hour) x Actual Hours

Direct Labor Time Variance

Direct Labor Time Variance = (Actual Direct Labor Hours – Standard Direct Labor Hours) x Standard Rate per hour
Sample Exercise

Tip Top Corp. produces a product that requires 2.5 standard hours per unit at a standard
hourly rate of 12 per hour. If 3000 units required 7,420 hours at an hourly rate of 12.30,
what is the a)direct labor rate variance b)direct labor time variance and c)total direct
labor cost variance?

Given : Standard rate per hour : 12 per hour

Standard Direct Labor Hours: 7,500 hours ( 3000*2.5)
Actual Price rate per hour: 12.30 per hour
Actual Direct Labor Hours :7,420 hours
Solution:
Direct Labor Rate Variance = (Actual Rate per hour – Standard Rate per hour) x Actual Hours

LRV = (12.30 – 12.00) * 7,420 hours = P2,226

Direct Labor Time Variance = (Actual Direct Labor Hours – Standard Direct Labor Hours) x Standard
Rate per hour

LEV = (7,420 – 7,500) * 12 = (P960)

Direct Labor Variance Analysis

✓Normally production supervisors are responsible for controlling direct

labor cost
➢Unfavorable Rate variance may caused by improper scheduling and use of
employees

➢Unfavorable Time variance may be caused by shortage of skilled employees.

 Variable Factory Overhead Controllable Variance

It is the difference between the actual variable overhead costs and the budgeted variable
overhead for actual production.

Budgeted variable factory overhead is the standard variable overhead for the actual units
produced
Variable Factory Overhead Controllable Variance

• Variable Factory Overhead Controllable Variance indicates the ability to keep the
factory overhead costs within the budget limit.

• Variable FOH are normally controllable at the department level, responsibility for
controlling this variance usually rests with the department supervisors
Sample Exercise
Tip Top Corp. produced 3,000 units of product that required 2.5 standard hours per unit.
The standard variable overhead cost per unit is 2.20 per hour. The actual variable
factory overhead was 16,850. Determine the variable factory overhead controllable
variance.

Variable Factory Overhead Controllable Variance = Actual Variable FOH – Budgeted Variable FOH
= 16,850 – [(3,000 units x 2.5 hours) x 2.20]
= 16,850 – 16,500
= 350 (Unfavorable)
 Fixed Factory Overhead Volume Variance
Fixed Factory overhead volume variance = (Standard hours for 100% Normal Capacity – Standard Hours for Actual
Units Produced) x Fixed Factory Overhead rate

Tip Top Corp. produced 3,000 units of product that required 2.5 standard hours per unit. The standard
fixed overhead cost per unit is 0.90 per hour at 8,000 hours , which is 100% of normal capacity.
Determine the Fixed factory overhead volume variance

Fixed Factory Overhead Volume Variance = [(8000 –(3000 units x 2.5 hours)] x 0.90 = 450
Fixed Factory Overhead Volume Variance

• The volume variance measures the use of fixed overhead resources.

✓Unfavorable Fixed FOH volume variance; the company used its fixed overhead
resources less than would be expected under normal operating conditions.

✓Favorable Fixed FOH volume variance; the company used its fixed overhead
resources more than would be expected under normal operating conditions
Causes Unfavorable Volume Variance

✓Failure to maintain an even flow of work

✓Machine Breakdowns

✓Works stoppages caused by lack of materials or skilled workers

✓Lack of enough sales orders to keep factory operating at normal

capacity
Sales volume variance
✓ difference between the profit as shown in the original budget and the profit as shown in
the flexed budget (absorption costing)
✓ difference between the contribution margin as shown in the original budget and the
profit as shown in the flexed budget (margin costing)

Sales volume variance = (Actual units sold – budgeted units sold) x Standard price per unit
Sales volume variance = (Actual units sold – budgeted units sold) x Standard profit per unit
Sales volume variance = (Actual units sold – budgeted units sold) x Standard Contribution
per unit

o Take note that the budgeted number of units sold is derived by the sales and marketing
managers.
Reasons for unfavorable sales volume variance
• Poor performance by sales personnel
• Deterioration in the market conditions between the setting of the
budget and actual event
• Lack of inventories or services to sell as a result of some production
problem
Sample exercise:
Tip top Corp. estimates that the company can sell 5,000 units for $125 per unit during the
upcoming month. During the month, Tip top Corp. failed to have any advertising campaign.
This results in sales of just 4,600 units. Variable manufacturing cost is $62.50 per unit.
Variable administrative expenses is $12,500. Compute the sales-volume variance.

Contribution margin per unit:

Budgeted Selling Price $ 125.00
Standard Variable cost per unit $ 65.00
Contribution Margin per unit $ 60.00

Sales volume variance = (Actual units sold – budgeted units sold) x Standard Contribution per unit
= (4,600 – 5,000) x $60
= 24,000 Unfavorable Sales volume variance
Selling price variance
✓ difference between actual sales revenue and the sales revenue as
shown in the flexed budget

Selling price variance = (Actual price – budgeted price) x Actual unit sales

o Take note that the budgeted price for each unit of product or sales is developed by the sales and
marketing managers and is based on their estimation of future demand for these products and
services, which in turn is affected by general economic conditions and the actions of competitors.
Reasons for unfavorable sales price variance
• Poor performance by sales personnel
• Deterioration in the market conditions between the setting of the
budget and actual event
Sample exercise:
Tip top Corp. estimates that the company can sell 5,000 units for $125 per unit
during the upcoming month. During the month, Top tip Corp., a new supplier of the
same product floods the market with a lower price. Tip top Corp. was forced to
lower its SP by $10 in order to compete and sold 4,800 units. Compute the selling
price variance.

Selling price variance = (Actual price – budgeted price) x Actual unit sales
= ($115 – $125) x 4,800 units
= 48,000 Unfavorable Selling Price variance