Study Notes

Standard Costing
Standard Costing

Introduction

 Standard cost is a criterion cost which may be used as a yardstick to measure the
efficiency with which actual cost has been incurred.
 Standard Costs are the predetermined costs or the target costs that should be incurred
under efficient operating conditions.

Steps in Standard Costing

Setting of standard costs

Ascertaining actual costs

Comparing actual with standrad to compute deviations

- "VARIANCES"

Analysing variances

Reporting variances to management for appropriate

action

Types of Standards

Below listed are the types of Types of

stadards
Standards

Basic standards are listed

for an indefinite period of time
whereas Current standards Basic Current
remain in operation for a
limited period and are related
Standards Standards
to current conditions

Ideal Standard is a theoretical

standard not practicable to
attain. Expected or Practical
Standard is anticipated to be
attained during a future period. Expected or
Ideal Normal
Normal Standards are known Practical
as Past Performance Standards Standards
Standards because they are Standards
based on average past
performance in the past

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Standard Costing

Setting Standards and making Standard cost sheet

Standards will be set for each component of the cost that includes the following:

1. Material – two standards are set for material costs:

a. Material price standard – forecast of average prices of the materials during the
future period
b. Material usage (or quantity) standard – usually developed from material
specifications prepared by the department of engineering of product design.

2. Labour – two standards are set for labour costs:

a. Labour rate Standard – is determined having regard to the current rates of pay
and any anticipated variations.
b. Labour time (or efficiency) Standard – Standard time for labour be scientifically
determined by time and motion studies, carried out in conjunction with a study to
determine the most efficient method of working.

3. Overheads – setting standards for overheads involves the following two distinct
calculations:
a. Determination of the standard overhead costs,

Standard Overhead rate (per hour) =

Or
Standard Overhead rate (per unit) =

b. Determination of the estimates of production, i.e standard level of activity

reduced to a common base, such as direct labour hours, units of production or
machine hours.

Once the standard cost is set, the standard cost card (or standard cost sheet) is prepared as
follows:

Direct Materials
Add: Direct Labour
Add: Factory Overheads
= Total Standard cost

Box 1: Standard cost and Budgeted cost

 Standard cost is a pre-cursor to the budget.
 Standard costing is computed on per unit basis. These are then used to
prepare the budget.
 As such, budget is set for total costs.

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Standard Costing

Variance Analysis

 Variance is the difference between the Actual and the Standard Costs.
 Variance Analysis refers to the investigation as to the reasons for deviations in the
financial performance from the standards set by a company in its budget

Variance may occur on account of Types

• Material • Price Variance (difference between

• Labour actual price and standard price)
• Variable Overheads • Quantity Variance (difference between
• Fixed Overheads actual quantity and standard quantity)
• Revenue/Sales

General Model of Variance Analysis

 Actual Quantity (AQ) = Direct

materials, Direct labour,
variable overheads actually
used
 Standard Quantity (SQ) =
standard quantity allowed for
the actual output for that period
 Actual Price (AP) = amount
actually paid for the input used
 Standard Price (SP) = Amount
that should have been paid for
the input used

Analysis conclusion:
 if the actual costs > Standard Costs, the variances will be Adverse/unfavorable
 if the actual costs < Standard Costs, the variances will be Favorable

Sales Variances – Calculation and Explanation

 Sales price variance = Actual quantity sold × Actual price per unit – Actual quantity sold ×
Standard price per unit

= AQ × (AP – SP)

If the difference calculated is positive, then the actual price (AP) is higher than the standard
price (SP), so the business has achieved a higher sales price than expected, and the variance
is favourable (F). If the difference is negative, then the variance is adverse (A)

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Standard Costing

 Sales Quantity variance = Actual quantity sold × Standard price per unit – Budgeted
quantity sold × Standard price per unit

= SP * (AQ – BQ)

If the difference calculated is positive, then the actual quantity (AQ) is higher than the expected
quantity (SQ), so the business has been able to sell more units, and the variance is favourable
(F). If the difference is negative, then the variance is adverse (A).

Comments

The adverse sales price variance can be a result of a drop in sales price per unit. Although this
could have been due to general competitive or economic conditions and therefore out of the
control of the business, perhaps it was a deliberate attempt to boost sales volume.

Material / Labor Variances – Calculation and Explanation

 Materials price variance = Actual quantity used x Actual price – Actual quantity used ×
Standard price
= AQ × (AP – SP)

 Labor price variance = Actual Hours used x Actual wage rate – Actual Hours used ×
Standard Wage Rate
= AH × (AR – SR)

If these price variances are positive, they must be adverse (A), because the actual price
paid must be higher than the standard price.

 Materials efficiency variance = Actual quantity used × Standard price – Standard quantity
that would have been used for actual output × Standard price
= (AQ– SQ) × SP

 Labor efficiency variance = Actual hours used × Standard wage rate – Standard hours
that would have been used for actual output × Standard wage rate
= (AH– SH) × SR

If the efficiency variances are positive, they must similarly be adverse (A), because the
actual quantity of resource used must be higher than the standard quantity would have
been. Conversely, if the variances are negative, they must be favourable (F).

* Note that the quantities used for these calculations are the quantities of the resource, not the
quantities of output. Similarly, the prices used for these calculations are the prices per unit of the
resource, not the prices per unit of output.

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Standard Costing

Comments

 The adverse materials price variance might be a result of increased prices per kg. It is
possible that this is due to a change of supplier, or to a shortage of supply forcing prices
up.
 The favorable materials efficiency variance might suggests that the increased materials
price may be due to a decision to purchase higher quality materials, consequently
resulting in less wastage.
 The labor price variance might be favourable which may be the result of hiring lower-
skilled staff, who are cheaper but who take longer to perform the same tasks.
Alternatively, the poor efficiency variance may be the result of mistakes made when
working faster to produce the higher level of output.
 The variable overhead efficiency variance might be linked to that for labour as both costs
are based on labour hours.

Fixed Overhead Variances – Calculation and Explanation

 Fixed Overhead Spending variance = Actual fixed overhead expense – Original

budgeted fixed overhead expense
= AC – SC

 Fixed overhead volume variance = Budgeted fixed overhead expense – Applied

fixed overhead expense
= SC – Actual output × SP/unit

*Note Fixed costs should not vary with output. Therefore, any difference between the
original budget for fixed costs, and the actual amount of fixed costs, is not due to
changes in output volume.

Fixed Overhead variances are favourable if they are negative, and adverse otherwise.

Standard Costing – related accounting concepts

 Inventories are recorded at standard costs

 Variances are recorded as follows:
o Favourable variances represent savings in production costs (i.e. profit) and
therefore are ‘credits’
o Unfavourable variances represent excess cost in production (loss) and therefore
are ‘debits’
 Standard cost variances are usually closed to cost of goods sold:
o Favourable variances decrease cost of goods sold
o Unfavourable variances increase cost of goods sold

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Standard Costing

Standard Costing – advantages and disadvantages

Advantages
•Management by exception
•promotes economy and efficiency
•siplified book-keeping
•enhances responsibility accounting
•acts as a control mechanism
•facilitates assigning responsibility and
engages control mechanism
departments
Disadvantages
•emphasizing standards may exclude
other important objectives
•continuous improvement maybe more
important than meeting standards
•standard costs reports may not be timely
and involves past analysis which may
not be relevant in changing scenarios
on
•favourable variances may be
misinterprested and could be a result of
losely set standards
•emphasis on negative may reduce
morale
•invalid assumptions related to
relationship between labor cost and
output can distort results

Analysis of the Variances

1. Sales Price Variance

Adverse Sales Price Variance:

1. Deficiency in the product or service because of which the demand is low

requiring the organization to reduce prices
2. Quality might not be able to satisfy customers and competitors might be offering
a better product.
3. Obsolete product might also be the cause of this
4. If this is linked with increasing the market share, then can be clubbed with
positive sales quantity variance to give a net favourable position

Favourable Sales Price Variance:

1. Good negotiation skills

2. Better Quality product/ service which can satisfy our customers and competitors
might be offering a deficient product.
3. Innovative product might also be the cause of this
4. If this is linked with decreasing the market share, then can be clubbed with adverse
sales quantity variance to see the net effect on sales

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Standard Costing

2. Sales Volume Variance

Adverse Sales Volume Variance:

1. Deficiency in the product or service because of which the demand is low

2. Quality might not be able to satisfy customers and competitors might be offering a
better product.
3. Obsolete product might also be the cause of this
4. Might hint at inefficiency in production due to which there might be losses because
of unavailability of the product
5. Lack of resources

Favourable Sales Volume Variance:

1. Better Quality which can satisfy customers and competitors might be offering a
deficient product.
2. Innovative product might also be the cause of this
3. Proper utilization of resources
4. Capturing the market in an efficient way and the organization might be taking an
advantage of customer feedback properly

3. Fixed Overhead Spending Variance

Adverse Fixed Overhead Spending Variance

1. Understated and unrealistic Fixed overhead budget

2. Bad negotiation skills due to which couldn’t negotiate a better price
3. Increased projected demand might had led to increase in prices

Favourable Fixed Overhead Spending Variance

1. overstated Fixed overhead budget

2. Good negotiation skills due to which the organization could negotiate a better
price
3. Decreased projected demand might had led to increase in prices

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Standard Costing

4. Fixed Overhead Volume Variance

Adverse Fixed Overhead Volume Variance

1. Low output sold can be a result of:

a. Deficiency in the product or service because of which the demand is low
b. Quality might not be able to satisfy customers and competitors might be
offering a better product.
c. Obsolete product might also be the cause of this
d. Might hint at inefficiency in production due to which there might be losses
because of unavailability of the product

Favourable Fixed Overhead Volume Variance

1. Increased output sold can be a result of:

a. Better Quality which can satisfy customers and competitors might be
offering a deficient product.
b. Innovative product might also be the cause of this
c. Proper utilization of resources
d. Capturing the market in an efficient way and the organization might be
taking an advantage of customer feedback properly
2.

5. Variable Overheads Variances/ Labor / Material Price Variances

Adverse Price Variance

1. Bad negotiation skills in capturing the product/ services

2. Incorrect timing of purchase of inputs
3. Inefficiency in getting the adequate quotes from different suppliers
4. Inadequate research
5. Unrealistic target set in the budget

Favourable Price Variance

1. Good negotiation skills in capturing the product/ services

2. Correct timing of purchase of inputs
3. Increased efficiency in getting the adequate quotes from different suppliers

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Standard Costing

6. Variable Overheads Variances/ Labor / Material Volume Variances

Adverse Volume Variances

1. Increased wastages, idle time and inefficient utilization

2. Lack of motivation
3. Lack of coordination
4. Unsatisfied employees

Favourable Volume Variances

1. Efficient utilization of resources

2. Good motivational level
3. Good coordination and satisfied employees

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