STANDARD COSTING

SESSION 6

August 19
 LEARNING OBJECTIVES

Standard costing
a) Explain the use of standard costs.
b) Outline the methods used to derive standard costs
and discuss the different types of cost possible.
c) Explain and illustrate the importance of flexing
budgets in performance management.
d) Explain and apply the principle of controllability in
the performance management system.
 STANDARD COSTING SYSTEM

o a system of accounting based on predetermined costs

and revenue per unit which are used as a benchmark
to assess actual performance and therefore provide
useful feedback information to management.
 Standard Cost Systems

A standard cost variance

is the amount by which
an actual cost differs from
the standard cost.

Standard cost
Amount

Direct
Material
Direct Manufacturing
Labor Overhead

Type of Product Cost

 Standard Cost Systems

This variance is unfavorable because This variance is

the actual cost exceeds the standard favorable because
cost. the actual cost
is less than the
standard cost.

Standard cost
Amount

Direct
Material
Direct Manufacturing
Labor Overhead

Type of Product Cost

Use of Standard Costs in Developing Budgets

A standard is the expected

cost for one unit.
Are standards the same as A budget is the expected cost
budgets? for all units.
 Standard Cost Systems
Predetermined .(targets of performance)
Inventory Valuation.

Used for planning labor, material

Standard
and overhead requirements.
Costs

Used in setting accurate budgets.

Performance evaluation and

Undertaking corrective action.
 TPYES OF STANDARD

o Ideal Standard
o Attainable Standard
o Current Standard
o Basic Standard
PARTICIPATION IN SETTING
STANDARDS
How do you think each of the bases
of standard would
impact an employee's motivation?
 Direct Material Standards

Price Quantity
Standards Standards

Standard Quantity
Standard Price For One Of Material Required
Unit Of Material. For One Unit Of A
× Product.
 WASTAGE

Suppose that the fresh raspberry juice content of a

litre of Purple Pop is 100ml and that there is a 10%
loss of raspberry juice during process due to
evaporation. The standard material usage of
raspberry juice per litre of Purple Pop will be ?
 ASSIGNMENT

Each unit of X uses 6 kg of material.

Budgeted sales in month 1 are 18,000 units. During
the production process 10% of production is usually
scrapped as being faulty. Opening inventories of
finished units are15,000 and closing inventories are
11,400
Required
What is the amount of raw material required for
Month 1?
 Direct Labor Standards

Rate Time
Standards Standards

Standard Wage Rate Standard Labour Hours

For One Hour. For One Unit Of A Product.

×
 STANDARD LABOUR COST

o A unit of product X requires 24 active labour hours

for completion. It is anticipated that there will be
20% idle time which is to be incorporated into the
standard times for all products. If the wage rate is
$10 per hour, what is the standard labour cost of one
unit of product X?
A $192
B $240
C $288
D $300
 Manufacturing Overhead Standards

Rate Activity
Standards Standards

Standard overhead rate .

Standard number of
ror one unit of activity .
activity units for one unit
of a product .
×
 EXAMPLE
 The stand has the following manufacturing overhead at three
different levels of activity.

Labour Hours 4,000 6,000 8,000

Meals Served 1,000 1,500 2,000

Variable Overhead 8,000 12,000 16,000

Fixed Overhead 120,000 120,000 120,000
Total Overhead 128,000 132,000 136,000

The stand applies overhead on the basis of labour hours and

they have estimated the activity of 6,000 hours.
 IMPLICATIONS OF STANDARD COSTING
IN THE MODERN ENVIRONMENT

TRADITIONAL
MODERN ENVIRONMENT
ENVIRONMENT

o Labour driven
o Stable environment /
Products
o Standard product
o Focus on cost
o Raw material and
finished goods
inventory is important
 STANDARD COSTING

o Manufacturing highly automated (can ask machine to

speed up)
o Rapidly changing environment (shorter product
lifecycles + regular revisions)
o Customised product
o Focus on quality and continuous improvement, no
adherence to present standards
o JIT & TQM philosophy
o Complex processes to manufacture (Gathering of
information)
o More detailed information needed for effective
management control
 Advantages of Standard Costs

Forces regular analysis

To update standards

Highlight areas of
Helps to maximize
concern
Efficiency

Advantages
Helps in Enhances
performance responsibility
evaluation and accounting
cost control
11-21
 Disadvantages Of Standard Costs

Emphasizing standards Favorable

may exclude other variances may
important objectives. be misinterpreted.
Potential
ProblemsToo much internal focus.
Standard cost
reports may
not be timely. (maybe Emphasis on
Out of date. Information negative may
needed in real time impact morale.

Continuous
Relies on existence of repetitive
improvement may
Operations/standard products.
May encourage short termism and be more important
than meeting standards.
Attempts to incorporate budgetary slack.
11-22
Variance Analysis: An Illustration

Let’s use the

concepts of the
general model to
calculate standard
cost variances,
starting with
direct material.
 Standard Cost Variances

First, they point to causes of

problems and directions
I see that there for improvement.
is an unfavorable
variance. Second, they trigger
investigations in departments
But why are having responsibility
variances for incurring the costs.
important to me?
 EXAMPLE

Standard cost of Product A $

Materials (5kgs x $10 per kg) 50
Labour (4hrs x $5 per hr) 20
Variable o/hds (4 hrs x $2 per hr) 8
Fixed o/hds (4 hrs x $6 per hr) 24
102

Budgeted ACTUAL
Results Results
Production: 1,200 units Production: 1,000 units
Sales : 1,000 units Sales : 900 units
Selling price : $150 per unit Materials: 4,850 kgs, $46,075
Labour: 4,200 hrs, $21,210
Variable o/hds: $9,450
Fixed o/hds: $25,000
Selling price: $140 per unit
 DIRECT MATERIAL

o Direct Material total variance = material price variance +

material usage variance
o The direct material total variance is the difference between what the
output actually cost and what it should have cost, in terms of
material.

o The direct material price variance

This is the difference between what the actual quantity of material
purchases did cost and what it should have cost.

o The direct material usage variance

o This is the difference between how much material should have been
used for the number of units actually produced and how much
material was used, valued at standard cost per kg
 Isolation of Material Variances
I’ll start computing
I need the price variance the price variance
sooner so that I can better
when material is
identify purchasing problems.
purchased rather than
You accountants just don’t when it’s used.
understand the problems that
purchasing managers have.
 Material Variances

The price variance is

Hanson purchased and
computed on the entire
used 1,700 pounds.
quantity purchased.
How are the variances
computed if the amount The quantity variance is
purchased differs from computed only on the
the amount used? quantity used.
 WASTAGE

o Wastage (evaporation , testing , spoilage ) –

Company may allow for wastage in the budget.
o Variance calculated by comparing actual results with
adjusted standard for expected wastage.
EXAMPLE
o Material M is used to make product A, 10 kg of
material M costing $10 per kg Wastage of 5% is
expected . During a period , 1,000 units of A were
produced using 11,200 kg while the company
purchased 11,700kg of Material M which cost
$98,600.
 Responsibility for
Material Variances

You used too much material because of

poorly trained workers and poorly
maintained equipment.
I am not responsible for Also, your poor scheduling sometimes
this unfavorable material requires me to rush order material at a
quantity variance. higher price, causing unfavorable price
You purchased cheap variances.
material, so my people
had to use more of it.

Production Manager Purchasing Manager

 MATERIAL PRICE VARIANCE
FAVORABLE
o An overall decrease in the market
price level
o Purchase of materials of lower
quality than the standard (this
will be reflected in adverse
material usage variance)
o Better price negotiation by the
procurement staff
o Implementation of better
procurement practices (e.g.
invitation of price quotations
from multiple suppliers)
Purchase discounts on larger
orders
ADVERSE
o An overall hike in the market
price of materials
o Purchase of materials of
higher quality than the
standard (this will be reflected
in favorable material usage
variance)
o Increase in bargaining power
of suppliers
o Loss of purchase discounts
due to smaller order sizes
o Inefficient buying by the
procurement staff
 MATERIAL USAGE VARIANCE
FAVORABLE
(EFFICIENT USAGE OF
MATERIALS)
o Purchase of materials of
higher quality than the
standard (this will be reflected
in adverse material price
variance)
o Greater use of skilled labour
o Training and development of
workforce to improve
productivity
o Use and improvement of
automated manufacturing
tools and processes -
ADVERSE (HIGHER
CONSUMPTION OF
MATERIALS THAN
STANDARD)
o Purchase of materials of
lower quality than the
standard (this will be
reflected in a favorable
material price variance)
o Use of unskilled labour
o Increase in material
wastage due to
depreciation of plant and
equipment
Labor Rate and Efficiency Variances

Let’s turn
our
attention
to labor
variances.
 DIRECT LABOUR

o Direct Labour total variance = labour rate variance + labour efficiency

variance + idle time variance
o The direct labour total variance is the difference between what the output should
have cost and what it did cost, in terms of labour.

o Direct labour rate variance

o This is the difference between what the actual number of hours worked should have
cost and what it did cost.
When calculating labour rate variance all the hours are considered including idle
hours

o The direct labour efficiency variance

o The is the difference between how many hours should have been worked for the
number of units actually produced and how many hours were worked, valued at the
standard rate per hour
When idle time occurs the efficiency variance is based on hours
actually worked (not hours paid for) and
an idle time variance (hours of idle time x standard rate per hour) is
calculated.
 IDLE TIME

o Idle time variance always adverse

o How about in cases where its expected? We need to adjust the
our hourly rate for expected idle time. Lets say our standard
rate is $5 and the expected idle time is 5%
o Idle time needs to be controlled by investigating why the idle
time occurred/excess than expected
o Idle Time = (Hours Paid – Hours Worked) X Standard Rate
per hour
EXAMPLE
o Product A needs grade A labour 2 hours of grade A labour at
$5 per hour .During a period, 1,500 units of product A were
produced, direct labour cost of Grade A was $17,500 for 3,080
hours of which 100 hours were idle time.
 Responsibility for Labor Variances

I am not responsible for

the unfavorable labor You used too much time
efficiency variance! because of poorly trained
You purchased cheap workers and poor supervision.
material, so it took more
time to process it.
Responsibility for Labor Variances

Maybe I can attribute the labor

and material variances to personnel
for hiring the wrong people
and training them poorly.
 DIRECT LABOUR RATE
FAVORABLE (COST
EFFICIENT
EMPLOYMENT OF
LABOUR BY THE
ORGANISATION
o Hiring of more un-skilled or
semi-skilled labour (this may
adversely impact labour
efficiency variance)
o Decrease in the overall wage
rates in the market due to an
increase in the supply of
labour
o Inappropriately high setting
of the standard cost of direct
labour which may, in the
hindsight, be attributed to
inaccurate planning
ADVERSE (HIGH
LABOUR COSTS
INCURRED DURING THE
PERIOD COMPARED
WITH THE STANDARD )
o Increase in the national
minimum wage rate
o Hiring of more skilled
labour than anticipated in
the standard (this should
be reflected in a favourable
labour efficiency variance)
o Inefficient hiring by the HR
department Effective
negotiations by labour
unions -
 Labor Rate Variance

Using highly paid skilled workers to

perform unskilled tasks results in an
unfavorable rate variance.

High skill, Low skill,

high rate low rate

Production managers who make work assignments

are generally responsible for rate variances.
 DIRECT LABOUR EFFICIENCY
FAVORABLE (BETTER
PRODUCTIVITY OF
DIRECT LABOUR
DURING A PERIOD)
o Hiring of more higher skilled
labour (this may adversely
impact labour rate variance)
o Training of work force in
improved production
techniques and
methodologies
o Use of better quality raw
materials which are easier to
handle
o Higher learning curve than
anticipated in the standard
ADVERSE (LOWER
PRODUCTIVITY OF
DIRECT LABOUR
DURING THE PERIOD
COMPARED TO
STANDARD)
o Hiring of lower skilled labour than
the standard (this should be
reflected in a favourable labour
rate variance)
o Lower learning curve achieved
during the period than anticipated
in the standard
o Decrease in staff morale and
motivation
o Idle time incurred during a period
caused by disruption or stoppage
of activities (idle time variance
may be calculated separately from
the labour efficiency variance to
reflect the underlying increase or
Manufacturing Overhead Variances

Let’s turn our

attention to
manufacturing
overhead
 VARIABLE PRODUCTION OVERHEAD

o Variable production overhead total variance = variable overhead

expenditure variance + variable overhead efficiency variance
The variable production overhead total variance is the difference between
what the output should have cost and what it did cost, in terms of variable
production overhead.
When calculating both the variable production expenditure and efficiency
variance, idle hours are not considered

o The variable production overhead expenditure variance

This is the difference between what the variable production overhead did
cost and what it should have cost per labour hours / machine hours
worked.

o The variable production overhead efficiency variance

This is the same as the direct labour efficiency variance in hours, valued at
the variable production overhead rate per hour.
 VARAIBLE OVERHEAD RATE VARIANCE
FAVORABLE ( INCURRED
LOWER EXPENSE THAN
STANDARD)
o Economies of scale (e.g. increase in
order size of indirect material leading
to bulk discounts on purchase)
o A decrease in the general price level of
indirect supplies
o More efficient cost control (e.g.
optimizing electricity consumption
through the installation of energy
efficient equipment)
o Planning error (e.g. failing to take into
account the learning curve effect which
could have reasonably be expected to
result in a more efficient use of indirect
materials in the upcoming period)
ADVERSE (INCURRED
HIGHER COSTS THAN
STANDARD )
o A rise in the national minimum wage rate
leading to a higher cost of indirect labour
o A decrease in the level of activity not
fully offset by a decrease in overheads
(e.g. electricity consumption of machines
during set up is usually same even if a
smaller batch of output is required to be
produced)
o In efficient cost control (e.g. not
optimizing the batch production
quantities leading to higher set up costs)
o Planning error (e.g. failing to take into
account the increase in unit rates of
electricity applicable for the level of
activity budgeted during a period)
 VARIABLE OVERHEAD EFFICIENCY
FAVORABLE (fewer ADVERSE (more
VARIANCE
manufacturing hours were manufacturing hours were
expended during the
period than the standard
hours required for the
level of actual output)
o Use of a raw material which is easier to
work with (this should be evident in a
favourable material usage variance and
possibly an adverse material price
variance)
o Employment of a higher skilled labour or
improvement of skills of existing
workforce through training and
development leading to improved
productivity (this should be indicated by a
favourable labour efficiency variance and
potentially an adverse labour rate
variance)
o Installation of a more efficient
manufacturing equipment
o Planning error (e.g. ignoring or under
estimating the impact of learning curve
effect on productivity
expended during the
period than the standard
hours required for the
level of actual production)
o Use of a cheaper raw material which is
harder to work with (this should be
corroborated with an adverse material
usage variance and a favourable a
material price variance)
o Inefficient production caused by the
employment of lower skilled labour
(this shall be evident in an adverse
direct labour efficiency variance and
probably a favourable labour rate
variance)
o Decline in the productivity of
manufacturing equipment due to for
example technical problems or wear
and tear
o Planning error (e.g. over calculating the
impact of learning curve effect on the
manufacturing efficiency)
 FIXED OVERHEAD VARIANCES

Fixed overheads

Total variance Over/under-

absorption

Expenditure Volume variance

variance
Efficiency Capacity
variance variance

Slide 50
 FIXED OVERHEAD VARIANCES

o The fixed production overhead variances are

calculated as follows:
o Fixed production overhead variance
o This is the difference between fixed production
overhead incurred and fixed production overhead
absorbed (= the under/over-absorbed fixed
production overhead)
 FIXED OVERHEAD VARIANCES

o Fixed production overhead expenditure variance

This is the difference between the budgeted fixed production overhead
expenditure and actual fixed production overhead expenditure
o Fixed production overhead volume variance
This is the difference between actual and budgeted production volume
multiplied by the standard absorption rate per unit.
o Fixed production overhead volume efficiency variance
This is the difference between the number of hours that actual production
should have taken, and the number of hours actually worked (usually the
labour efficiency variance), multiplied by the standard absorption rate per
hour
o Fixed production overhead volume capacity variance
This is the difference between budgeted hours of work and the actual hours
worked, multiplied by the standard absorption rate per hour
 FIXED OVERHEAD EXPENDITURE
VARIANCE
FAVORABLE (actual fixed
costs incurred during the
period have been lower
than budgeted cost)
o Planned business expansion, which
was anticipated to cause a stepped
increase in fixed overheads, not
being undertaken during the period.
o Cost rationalization measures carried
out during the period aimed at
reducing fixed overheads by
elimination of inefficiencies (e.g.
through process re-engineering and
optimization of the usage of shared
resources and facilities).
o Planning inaccuracies (e.g. actual
salary raise being lower than
anticipated in budget
o Change is service provider
ADVERSE (higher fixed
costs were incurred
during the period than
planned in the budget)
o Expansion of business
undertaken during the period,
which was not taken into
consideration in the budget
setting process, causing a
stepped increase in fixed
overheads.
o Inefficient fixed overheads
management (e.g. due to empire
building pursuits of senior
management).
o Planning errors (e.g. increase in
insurance premium being higher
than budget due to changes in
the risk profile of business
 SALES PRICE VARIANCE
FAVORABLE (HIGHER
ADVERSE (SALES MADE
SELLING PRICE
AT A LOWER SELLING
REALIZES DURING THE
PRICE THAN THE
PERIOD OTHER THAN
STANDARD)
STANDARD

o Decrease in the o Increase in competition

number of competitors in the market
in the market
o Decrease in demand
o Improved product
for the products
differentiation and
market segmentation o Reduction in price
o Better promotion and enforced by regulatory
aggressive sales authorities
campaign
 SALES VOLUME VARIANCE
FAVORABLE (HIGH
STANDARD PROFIT OR
CONTRIBUTION THAN
BUDGETED PROFIT /
CONTRIBUTION)
o Favourable sales quantity
variance (i.e. higher total
number of units sold
than budgeted)
o Favourable sales mix
variance> (i.e. higher
proportion of the more
profitable products sold
than planned in the
budget)
ADVERSE (LOW
STANDARD PROFIT /
CONTRIBUTION THAN
BUDGETED PROFIT /
CONTRIBUTION)
o Adverse sales quantity
variance (i.e. lower total
number of units sold
than budgeted)
o Adverse sales mix
variance (i.e. higher
proportion of the less
profitable products sold
than anticipated in the
budget)
 OPERATING STATEMENTS

o OPERATING STATEMENTS
o **Note: when preparing the operating statement,
do not use the total variances
o VARIANCES UNDER MARGINAL COSTING
Fixed overheads: expenditure variance ONLY
Sales volume: variance in units valued at
standard contribution (not standard profit)
Operating statement: begins with budgeted
contribution (not budgeted profit)
 CONTROL REPORTS

o compares actual performance against a flexed budget

(and/or original fixed budget)
o Be issued regularly and on a timely basis.
o highlights significant variances (A or F) - (absolute /
percentage amount / trend )
o presents key reasons for variances;
o draws management's attention to the possible
implications of variances;
o identifies possible action(s) to eliminate variances and
their
o recommends appropriate control actions. (revise)
o Consider controllability and exception reporting

August 19
 Investigating Variances
o IF BENEFIT > COST
o MATERIALITY
o TREND
o INTERDEPENDENCE
o TYPE OF STANDARD
USED(OUT OF DATE
UNREASONABLE)/
Variance
o LIKEHOOD OF
IDENTIFYING CAUSE investigation
o ADVERSE OR
FAVOURABLE

Feedforward system
• act in advance

• Controllable – take
action
Feedback system
• act after
• Non controllable – revise
plan
 INTERDEPENDENCE OF VARIANCES

o Material Price and Material Usage

o Material Price and Labour Efficiency
o Labour Rate and Labour Efficiency
o Sales Price and Sales Volume
 CAUSES OF VARIANCES

o Inappropriate Standard (While preparing standards

or budgets)
o Random Events
o Inaccurate recording of actual costs and revenues
o Uncontrollable Expenditure
o Interdependence of variances
o Operating Inefficiency.
 VARIANCE AND PERFORMANCE
EVALUATION

o Identify cause of variance

o Identify who is responsible
o Consider whether standard was fair
o Non financial factors
o Improving future performance
Variance Analysis and Management by Exception

Larger variances, in
How do I know which dollar amount or as
variances to a percentage of the
investigate? standard, are
investigated first.
 VARIANCE INVESTIGATION MODELS

o % of standard cost approach. (Variance larger than a

fixed % should be investigated)
o Probability based model – If the expected value of
the resulting benefits exceeds the cost.
o Control Chart
 CAUTION

o WORKING BACKWARDS
o Most exam questions will give you a standard cost
card and actual results then you will be required to
calculate the variances. However the examiner can
give you the variances already calculated and ask you
to calculate the actual results.
 QUESTION 1

A business has budgeted to produce and sell 10,000 units

of its single product. The standard cost per unit is as follows:
Direct materials $15
Direct labour $12
Variable overhead $10
Fixed production overhead $8
During the period the following variances occurred:
fixed overhead expenditure variance $ 4,000 adverse
fixed overhead volume variance $12,000 favourable
Calculate the following.
(a) Actual fixed overheads in the period.
(b) Actual production volume in the period.
 QUESTION 2

In a period 6,500 units were made and there was an

adverse labour efficiency variance of $26,000. Workers w
ere paid $8 per hour, total wages were $182,000 and
there was a nil rate variance.
Calculate how many standard labour hours there were
per unit.
 QUESTION 3

A company uses standard marginal costing. Last month, the

budgeted sales were 6,000 units. The standard sales price is
$15 per unit and the contribution to sales ratio is 80%. Actual
sales in the month were 6,450 units and total sales revenue
was $92,880.
What were the adverse sales price and favourable sales
volume contribution variances?
Sales price Sales volume contribution
$ $
A 1,800 5,400
B 3,870 5,400
C 1,800 6,750
D 3,870 6,750
 QUESTION 4

A company uses standard marginal costing. Last

month, actual fixed overhead expenditure was 3%
below budget and the fixed overhead expenditure
variance was $4,800. What was the actual fixed
overhead expenditure last month?
A $155,200
B $159,856
C $160,000
D $164,800
 QUESTION 5

Who should a materials price variance be reported

to?
A Factory department manager
B Senior buying manager
C Human resources department manager
 QUESTION 6

A company uses standard absorption costing. It manufactures a

single product and the standard fixed production cost is $36 per
unit, consisting of 3 hours per unit at a fixed overhead rate of $12
per hour. The following data relates to the previous costing period.
Budget Actual
Sales and production (units) 35,000 36,000
The fixed overhead capacity variance for the month was $7,200
favourable.
How many hours were worked in the month?
A 104,400
B 105,600
C 107,400
D 108,600
 QUESTION 7

In a period, 11,280 kilograms of material were used at

a total standard cost of $46,248. The material usage
variance was $492 adverse.
Required:
Calculate the standard allowed weight of material for
the period.
 QUESTION 8

ABC Ltd uses standard costing. It purchases a small

component for which the following data are available:
Actual purchase quantity 6,800 units
Standard allowance for actual production 5,440 units
Standard price $0.85/unit
Material price variance (Adverse) ($544)
Required:
Calculate the actual price per unit of material.
 QUESTION 9

o Actual hours worked 11 520 hours

Total direct labour cost $32 256
Direct labour rate variance $2, 304 Fav
Direct labour efficiency variance $1,440 Ad
Calculate the following
o Standard hourly labour rate
o Standard total hours required
 QUESTION 10

o A company is considering its options with regard to a

machine which cost £60,000 four years ago. If sold the
machine would generate scrap proceeds of £75,000. If
kept, this machine would generate net income of
£90,000. The current replacement cost for this machine
is £105,000.
o What is the deprival value of the machine?
A £105,000
B £90,000
C £75,000
D £60,000
End of SESSION 6