CHAPTER V

STANDARD COSTING AND VARIANCE

ANALYSIS

Prepared By: Fitsum Kidane (Phd)

Department of Accounting and Finance
Sun Daero College

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 Standard Costs
 refers to expected costs under anticipated
conditions.
 Used for planning labor, material and
overhead requirements.
 Standard cost systems allow for comparison
of standard versus actual costs.
 Differences are referred to as standard cost
variances.
 Variances should be investigated if
significant.
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 Development of Standard Costs

Standard costs are developed in a variety of

ways. They are
1. specified by formulas or recipes.
2. developed from price lists provided by
suppliers.
3. determined time and motion studies
conducted by industrial engineers.
4. developed from analyses of past data.

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 Procedures of standard costing system

• Set the predetermined standards for sales

margin and production costs
• Collect the information about the actual
performance
• Compare the actual performance with the
standards to arrive at the variance
• Analyze the variances and ascertaining the
causes of variance
• Take corrective action to avoid adverse variance
• Adjust the budget in order to make the standards
more realistic
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 Types of standards
Ideal Standards:
 refers to the target which can be
attained under most ideal
conditions.
 Can be attained under the most
favourable conditions, with no
allowance for normal losses waste
and machine down time.
 It is more idealistic and less
realistic.
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 Types of standards
Normal Standards:
• These are the standards that may be
achieved under normal operating
conditions.
• The normal activity has been defined
as number of standard hours which
will produce normal efficiency
• The average standard which it is
intended to cover a long period of
time.
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 Types of standards
Basic or Bogey standards:
• These standards are use only when
they are likely to remain constant
or unaltered over long period.
• a base year is chosen for
comparison purposes in the same
way as statistician use price indices.

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 Types of standards
Basic or Bogey standards:
 When basic standards are in use,
variances are not calculated as the
difference between standard and
actual cost.
• the actual cost is expressed as a
percentage of basic cost.
• Are more idealistic
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 Types of standards
Current Standard:
 These standards reflect the
management’s anticipation of what
actual cost will be for the current
period.
 Is a standard for a certain period,
for certain condition and for
certain circumstances.
 Are more realistic
 Most companies use current and not
basic standards.
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 Investigation of Standard Cost Variances

1. Standard cost variances are not a

definitive sign of good or bad
performance.
2. Variances are merely indicators of
potential problems which must be
investigated.
3. There are many plausible explanations
for them.

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 Management By Exception
1. Investigation of standard cost variances
is a costly activity
2. Management must decide which
variances to investigate.
3. Most managers practice management
by exception.
4. What is “exceptional?” Usually an
absolute dollar amount or a percentage
dollar amount.
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 “Favorable” Variances May Be
Unfavorable
1. A “favorable” variance does not mean
that it should not be investigated.
2. Raw materials are good examples of this
phenomenon.
3. Consider inferior, low-priced materials.
4. A favorable price variance may result, but
there may also be substantially more
scrap and rework, and thus a higher
quantity variance.
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 Responsibility Accounting and
Variances
1. Managers should be held responsible
only for costs they can control.
2. This is also true in the area of variance
analysis.
3. A purchasing agent may be held
responsible for direct material price
variances, but certainly not direct
material quantity (usage) variances.

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 1. Material 2. Labour 3. Overhead 4. Other
Variance Variance Variance Variances

Material Cost Labour Cost Overhead Cost Calendar

variance Variance Variance Variance

Types of
Variances Material Price Labour Rate Variable OH Sales price
Variance Variance spending Var. variance

Labour
Material Usage Variable o/h Sales volume
Efficiency
Variance efficiency var. variance
Variance

Material Mix
Variance

Material Yield
Variance

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 Direct material price variance
• Is also called direct material spending/rate
variance
• may arise due to number of reasons like
fluctuations in market prices, error in buying
due to wrong purchasing policy etc,
• This can be calculated by using the following
formula,
DM Price Variance = (SP – AP) x AQ
• Where,
SP = Standard price per unit of material
AQ = Actual quantity
AP = Actual price per unit of material

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 Continued
• A positive value of direct material price
variance is favorable which means that direct
material was purchased for lesser amount
than the standard price.
• A negative value of direct material price
variance is unfavorable because more than
estimated price per unit is paid.

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 Continued
• A favorable direct material price variance is
not always good
– purchasing department may purchase low quality
raw material
– be analyzed together with direct material quantity
variance.
• Such a favorable material price variance will
be offset by an unfavorable direct material
quantity variance due to wastage of low
quality direct material. price variance.xlsx
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 Direct material usage variance
• Is also called Direct material
quantity/efficiency variance
• is the difference between the actual
quantities of raw materials used in
production and the standard quantities
that should have been used to produce
the product,
• is calculated to determine the efficiency of
production department in converting raw material
to finished goods.
• This can be calculated by using the
following formula,
• DM Usage Variance = (SQ – AQ) x SP
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 Continued
• A negative value of direct material quantity
variance is unfavorable and it implies that more
quantity of direct material has been used in the
production process than actually needed.
• may arise due to number of reasons like
Pilferage of materials , Wastage , Sub-
standard or defective materials.
• A positive value of direct material quantity
variance is favorable implying that raw material
was efficiently converted to finished goods.M
Quantity variance.xlsx
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 Direct Material Mix Variance
• is calculated when a product uses mixture of
different raw materials,
• Is difference between the standard and actual
composition of a mixture.
• It can be represented by the following formula:
DM mix variance = (SM – AQ) x SP
• Where,
SM is the standard mix quantity of direct material
AQ is the actual quantity of material used
SP is the standard price per unit of direct material
used
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 Continued
• Standard mix quantity is calculated by multiplying
standard mix percentage of a given material by
total actual quantity of the material used.
• For example, if three materials A, B and C are
mixed in ratio 5:3:2 and the total actual quantity
of material used is 2.5 kg then,
• Standard mix quantity of material A = 2.5 × 5 / (5
+ 3 + 2) = 2.5 × 50% = 1.25 kg
• A positive value of DM mix variance is favorable
whereas as a negative value is unfavorable.
DMmixvariance.xlsx
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 Direct material yield variance
• can be calculated only for a product made
from two or more direct materials
• is the product of the standard price per unit
of direct material and the difference between
standard quantity of direct material allowed
for actual production and the standard mix
quantity of direct material.

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 Continued
• The formula is:
DM Yield Variance = ( SQ − SM ) × SP
• Where,
• SQ is the standard quantity of direct material
SM is the standard mix quantity of material used
SP is the standard price per unit of direct material used
• Standard mix quantity is calculated by
multiplying standard mix percentage of a given
material by total actual quantity of the material
used. DMyieldvariance.xlsx
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 Direct Labor Rate Variance
• also called direct labor price/spending variance
or wage rate variance
• determines the performance of human
resource department in negotiating lower
wage rates with employees and labor unions.
• Production managers who make work
assignments are generally responsible for rate
variances.

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 Continued
 The DL rate (price) variance is expressed as
(SR – AR)AH
where:
(SR) = standard wage rate (price).
(AR) = actual wage rate (price).
(AH) = actual number(quantity) of labor
hours.
If actual rate > standard rate, then the variance
is unfavorable.
If actual rate < standard rate, then the variance
is favorable.
 A positive value of direct labor rate variance may not
always be good.
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 Continued
• When low skilled workers are recruited at lower
wage rate, the direct labor rate variance will be
favorable however, such workers will be
inefficient and will generate a poor direct labor
efficiency variance.
• Using highly paid skilled workers to
perform unskilled tasks results in an
unfavorable rate variance.
• Direct labor rate variance must be analyzed in
combination with direct labor efficiency variance.
DLratevariance.xlsx
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 Direct Labor Efficiency Variance
• also called direct labor quantity/usage variance
• The labor efficiency variance is expressed
as (SH – AH)SR where:
(SH) = standard number of hours worked.
(AH) = actual number of hours worked.
(SR) = standard labor wage rate.
• The standard direct labor hours allowed (SH) in
the above formula is the product of standard
direct labor hours per unit and number of
finished units actually produced.
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 Continued
•The purpose of calculating the direct labor
efficiency variance is to measure the
performance of production department in
utilizing the abilities of the workers.
•If actual hours > standard hours, then
the variance is unfavorable.
•If actual hours < standard hours, then
the variance is favorable.

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 Continued
• Unfavorable direct labor efficiency variance is
simply the result of recruiting low skilled
workers, Poorly trained workers, Poor quality
materials, Poor supervision of workers,
Poorly maintained equipment.
• It is necessary to analyze direct labor
efficiency variance along with direct labor rate
variance. . DLefficiencyvariance.xlsx

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 Variable Overhead Spending variance
• also called variable overhead rate variance
• The formula to calculate the variable overhead
spending variance is:
• VOH Spending Variance = ( SR − AR ) × AU
• Where,
SR is the standard variable overhead rate
AR is the actual variable overhead rate
AU are the actual units of allocation base

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 Continued
• The standard variable overhead rate is the
same as variable overhead application rate.
• The allocation base is usually the number of
labor hours used.
• The above formula can also be stated
alternatively as follows:
VOH Spending Variance = ( SR × AU ) − Actual
Variable Overhead Cost

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 Continued
• A positive value of variable overhead spending
variance is favorable and a negative value is
unfavorable.
• In case of a negative variable overhead
spending variance, production department is
usually responsible\VOHspendingvariance.xlsx

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Variable Overhead Efficiency Variance
• The difference between actual variable
overhead based on the true time taken to
manufacture a product, and standard variable
overhead based on the time budgeted for it.
• measure the efficiency of production
department in converting inputs to outputs.
• the formula to calculate variable overhead
efficiency Variance will be:
VOH Efficiency Variance = ( SH − AH ) × SR
• Where,
SH are standard direct labor hours allowed
AH are the actual direct labor hours
SR is the standard variable overhead rate
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 Continued
• The standard direct labor hours allowed (SH)
in the above formula is calculated by
multiplying standard direct labor hours per
unit and actual units produced.
• A positive value is favorable implying that
production process was carried out efficiently
with minimal loss of resources.
• When actual hours exceed standard hours
allowed, the variance is negative and
unfavorable implying that production process
was inefficient. VOHefficiencyvariance.xlsx
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 Sales Price Variance
• is the difference between the actual total
price of goods sold and the standard total
price of actual sales.
• Standard total price equals actual units sold
multiplied by budgeted price per unit.

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 Continued
• the formula to calculate Sales price Variance will be:
Sales Price Variance
= Actual Sales Revenue
– Actual Sales at Budgeted Price
OR
Sales Price Variance
= Actual Sales Units × Actual Price
– Actual Sales Units × Budgeted Price
OR
Sales Price Variance
= (Actual Price – Standard Price) × Actual Sales Units

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 Continued
• A positive sales price variance is considered
favorable
• A negative value is unfavorable.
• Positive sales price variance may simply be
caused by inflation or it may be due to better
sales price realization by sales department.
• A higher value is not always beneficial for the
business as a whole.
• Sales price variance may be artificially inflated by
charging higher and higher price per unit but
doing so will likely reduce the total number of
units sold and may result in lower total sales.
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 Continued
• The responsibility for a lower price variance
typically lies on sales department but the
lower than anticipated sales price may be
caused by, for example,
– poor quality product,
– poor planning,
– unrealistic budgeting etc.
• In such cases, the responsibility lies on the
respective departments\salespricevariance.xlsx

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 Sales Volume Variance
• is the change in revenue or profit caused by the
difference between actual and budgeted sales
units.
• For revenue reconciliation:
Sales Volume Variance
= (Actual Sales Units – Budgeted Sales Units)
× Standard Unit Price
• For profit reconciliation (absorption costing):
Sales Volume Variance
= (Actual Sales Units – Budgeted Sales Units)
× Standard Unit Profit
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 Continued
• For profit reconciliation (marginal costing):
Sales Volume Variance
= (Actual Sales Units – Budgeted Sales Units)
× Standard Unit Contribution
• Sales volume variance as calculated above is
favorable if the value obtained is positive.
• A negative value is unfavorable indicating that
actual units sold were less than budgeted.

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 Continued
• Possible causes for unfavorable sales volume
variance include
– stiff competition from outsiders or another
product by the company itself,
– poor quality product,
– higher sales price variance,
– unrealistic budgeted sales units etc.
salesvolumevariance.xlsx

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