Cost Classification (Quick Recap)
Standard Costing &
Variance Analysis
Ruwan Samarakoon (B.sc Finance, MBA,ACA,ACMA)
Standard Cost
Introduction
Loaf of Bread
• Standard Costing- Standard costing is a control
technique that reports variances by comparing
actual costs to preset standards facilitating action
through management by exception
-CIMA
Pre-set
Standards
Direct Material cost
Wheat flour-0.450kg@ Rs 50
Direct Labor cost 0.1 hrs @ Rs 150
Prime Cost
Variable Production Overhead
0.1 hrs@ Rs 100
Fixed Production Overhead (5500/1100)
Production Cost
22.50
15.00
37.50
10.00
5.00
52.50
Actual
Cost
(Standard
cost)
Variance
Action ?
(Managem
ent by
exception
How much a firm should spend (Target cost) to
manufacture a good or service
Actual Cost
For the month of January
Actual production = 1,000 units
Rs.
Direct materials: 430 kgs purchased and used- 23,650
Direct labor: 110 hours
- 17,600
Variable production overhead
- 9,000
Fixed Production overhead
- 5,200
Total cost
55,450
Budgeted Fixed Production overhead is 5500 and budgeted
production quantity is 1100 units.
Standard cost
• Standard cost is carefully predetermined unit cost
which is prepared for each cost unit.
• These are target costs that should be incurred under
efficient operating conditions
• These are not the same as budgeted costs. A budget
relates to an entire activity or operation; but a
standard cost is for a unit
• It contains details of the standard amount and price of
each resource that will be utlised in manufacturing the
product or providing service.
• Standard cost card- this contains the standard cost per
unit. But now a days details are stored in computers
Question
Types of cost standards
The following data is given for the standard details of
one unit of T.shirt. Prepare a standard cost card.
Direct materials: 2 square meters @Rs. 50/sq m
Direct wages :
• The main purpose of standard costs it to provide a
benchmark against which actual performance can be
monitored
• How demanding the benchmark or standard should be?
Should they represent ideal performance or should
they represent easily attainable performance?
• Different types are,
1. Ideal standards
2. Attainable standards
3. Current standard
4. Basic cost standards
• Production department-3 hours @ Rs. 100/hour
• Packing department- 0.5 hours @ Rs.80/hour
Budgeted costs and labor hours per annum
Rs
hours
Variable production overhead
Production department
375,000
500,000
Packing department
150,000
300,000
Fixed production overhead
300,000
Fixed production overhead is absorbed based on labor hours
Ideal standard
• Ideal standard represent perfect performance.
• Ideal standard costs are the minimum costs that
are possible under the most efficient operating
conditions
• No allowance for inefficiencies such as losses,
waste, machine downtime
• Ideal standard costs are difficult to achieve so that
always it results adverse variance
• So it can be demotivating for individuals who feel
that an adverse variance suggests that they have
performed badly
Attainable standard
• Standards are set at efficient operation levels but
include allowances for factors such as losses, waste
and machine downtime.
• These standards are difficult, but not impossible to
achieve
• They do not have a negative impact on motivation
unlike ideal standards.
Current standard
Basic cost standards
• Standards are based on current performance levels
(current wastage, current inefficiencies).
• The disadvantage is that they do not encourage any
attempt to improve on current levels of efficiency.
• Basic cost standards represent constant standards
that are left unchanged over long periods.
• The main advantage of basic standards is that a
base is provided for a comparison with actual costs
through a period of years with the same standard,
and efficiency trends can be established over time.
• When changes occur in methods of production,
price levels or other relevant factors, basic
standards are not very useful, since they do not
represent current target costs
Direct Material
Development of Standard Cost
Standard Direct Materials Cost
Loaf of Bread
Direct Material cost
Wheat flour-0.450kg@ Rs 50
Direct Labor cost 0.1 hrs @ Rs 150
Prime Cost
Variable Production Overhead
0.1 hrs@ Rs 100
Fixed Production Overhead (5500/1100)
Production Cost
Direct
Material
Qty
Direct
Labor
Price
Hours
22.50
15.00
37.50
10.00
5.00
52.50
Manu’
OH
Rate
1.Budget the total
2.Divide as fixed & variable
3.Abosorption base
• Direct materials price standard
• Careful estimate of the cost of a specific direct
material in the next accounting period
• Developed by purchasing agent or purchasing
department
• Takes into account
• All possible price increases
• Changes in available quantities
• New sources of supply
Direct Material
Standard Direct Materials Cost
• Direct materials quantity standard
• Estimate of the amount of direct materials that
will be used in the accounting period
• Includes scrap and waste
• Influenced by
•
•
•
•
Product engineering specifications
Quality of direct materials
Age and productivity of machinery
Quality and experience of work force
• Established and monitored by
• Production managers
• Management accountants
• Others
• Engineers, purchasing agents, machine
operators
Direct Labor
Standard Direct Labor Cost
• Direct labor rate standard
• Hourly direct labor rate expected to prevail
during the next accounting period
• For each function or job classification
• Average standard rate is developed for each
task
• Standard rate is used even if worker is paid more or
less than the standard rate
• Easy to establish
• Rates are set by labor unions or defined by the
company
Standard Direct Labor Cost
(cont’d)
Direct Labor
Manu’OH
Standard Manufacturing Overhead Cost
• Direct labor time standard
• Expected time required for each department,
machine, or process to complete the
production of one unit or one batch of output
• Developed using
• Current time and motion studies of workers and
machines
• Records of past performance
• Should be revised when
• Machinery is replaced
• Quality of work force changes
Manu’OH
Standard Manufacturing Overhead Cost
• Budget the total manufacturing OH for the period
(Ex. Factory rent, electricity, Salaries of supervisors
& production manager, factory insurance,etc)
• Divide the manufacturing OH into two
Variable manufacturing OH
Fixed manufacturing OH
( Techniques; High-low method, Regression,etc)
• Select an absorption base for each to compute unit
cost such as labor hours, machine hours, units
produced,etc. Take the normal capacity for these.
Standard Manufacturing Overhead Cost
(cont’d)
Manu’OH
• Standard fixed overhead rate
• Standard variable overhead rate
• Computed by dividing the total budgeted variable
overhead costs by an expression of capacity, such as
number of standard direct labor hours or standard
machine hours
• Computed by dividing the total budgeted fixed
overhead costs by an expression of capacity, usually
normal capacity in terms of standard hours or units
• Denominator expressed in same terms as the variable
overhead rate
Normal capacity is the level of
operating capacity needed to
meet expected sales demand
Its use ensures that all fixed OH costs have
been applied to units produced by the time
normal capacity is reached
Standard costing in the
modern business environment
Is standard cost appropriate for modern
business environment ?
• Standard costing was developed when the
business environment was more stable and
operating conditions were less prone to
change. But now we have dynamic
environment. If conditions are not stable it is
difficult to set a standard cost which can be
used to control over period of time
Cont’d
• In past, if the standard costs are achieved that is a
satisfactory performance. But today it needs to
have constant improvement in order to remain
competitive.
• The emphasis on labor variances is no longer
appropriate with the increasing use of automated
production methods.
DM Price V
Variance Analysis
• Variance is the difference between standard cost or
the target cost and the actual cost incurred.
• Since the standard cost include both usage of
resources and price per resource the variance can
also broken down to variance from price changes
and variance from the changes in usage
Direct Material Cost V
DM Qty V
Total
Manufacturing
Cost V
(Standard
Manufacturing
Cost- Actual
manufacturing
Cost)
DL Rate V
Direct Labor Cost V
DL efficiency V
VMOH expenditure V
Variable MOH Cost V
VMOH efficiency V
Fixed MOH Cost V
FMOH expenditure V
FMOH Volume V
Example
Example Cont’d
Actual Cost
Standard cost of Loaf of Bread
Direct Material cost
Wheat flour-0.450kg@ Rs 50
Direct Labor cost 0.1 hrs @ Rs 150
Prime Cost
Variable Production Overhead
0.1 hrs@ Rs 100
Fixed Production Overhead (5500/1100)
Production Cost
22.50
15.00
37.50
10.00
5.00
52.50
Firm has estimated a total production overhead cost of Rs.16,500 for
the next month (January). Out of this fixed production OH is
identified as Rs. 5500 and the balance is variable component.
Budgeted production quantity is 1100 units and budgeted labor
hours are 110. FPOH are absorbed based on number of units while
VPOH are absorbed on labor hours
For the month of January
Actual production = 1,000 units
Rs.
Direct materials: 430 kgs purchased and used- 23,650
Direct labor: 110 hours
- 17,600
Variable production overhead
- 9,000
Fixed Production overhead
- 5,200
Total cost
55,450
Computing Direct
Materials Variances
Total Cost Variance
Total Standard Manufacturing Cost
Total Actual Manufacturing Cost
Total Cost Variance
xxxx
xxxx
xxxx
Favorable (F) Or Adverse (A)
Direct Material Cost V
• Total direct materials cost variance
• Difference between the standard cost and actual cost of
direct materials
Standard Material cost
Actual Material cost
Total direct materials cost variance
xxxx
xxxx
xxxx
DM Price V
Computing Direct Materials Variances (cont’d)
• Total direct materials cost variance must be broken
into two parts to find the cause of the variance
• Direct materials price variance
• Direct materials quantity variance
Computing Direct Materials Variances (cont’d)
• Direct materials price variance
• Difference between the standard price and the actual
price per unit multiplied by the actual quantity
purchased
• Also called the direct materials spending or rate
variance
DM Qty V
Computing Direct Materials Variances (cont’d)
• Direct materials quantity variance
• Difference between the standard quantity and the
actual quantity used multiplied by the standard price
• Also called the direct materials efficiency or usage
variance
Computing Direct Materials Variances (cont’d)
• Test calculations of variances
• If correct, the net of the direct materials price variance
and direct materials quantity variance will equal the
total direct materials cost variance
Reasons for Material variances
Variance
Materials
price
Favorable
Standard price set too high
Unexpected discounts available
Lower quality materials used
Materials
usage
Careful purchasing
Gaining bulk discounts by buying
larger quantities
Standard usage set too high
Higher quality materials used
A higher grade of worker used
Stricter quality control
Adverse
Standard price set too low
Unexpected general price
increase
Higher quality materials
used
Careless purchasing
Loosing bulk discounts by
buying smaller quantities
Standard usage set too low
lower quality materials
used
A lower grade of worker
used
Theft
Direct Labor Cost V
Computing Direct Labor Variances
• Total direct labor cost variance
• Difference between the standard direct labor
cost for actual units produced and actual direct
labor costs.
Standard Direct Labor cost
Actual Direct Labor cost
Total direct Labor cost variance
xxxx
xxxx
xxxx
DL Rate V
Computing Direct Labor Variances (cont’d)
Computing Direct Labor Variances (cont’d)
• Direct labor rate variance
• Total direct labor cost variance must be
broken onto two parts to find the cause of
the variance
• Direct labor rate variance
• Direct labor efficiency variance
• Difference between the standard direct labor rate and
the actual direct labor rate multiplied by the actual
direct labor hours worked
• Also called the direct labor spending variance
DL efficiency V
Computing Direct Labor Variances (cont’d)
Computing Direct Labor Variances (cont’d)
• Direct labor efficiency variance
• Difference between the standard direct labor hours
allowed for good units produced and the actual direct
labor hours worked multiplied by the standard direct
labor rate
• Also called the direct labor quantity or usage variance
Reasons for DL variances
Variance
Labor rate
Labor
efficiency
Favorable
Adverse
Standard rate set too high Standard rate set too
low
A lower grade of worker
A higher grade of
used
worker used
Increasing labor rates
due to union actions
Standard hours set too
Standard hours set too
high
low
A higher grade of worker A lower grade of
worker
Higher grade of material
lower grade of
was quicker to process
material was slower to
process
Improved motivation
Poor motivation
• Test calculations of variances
• If correct, the net of the direct labor rate variance and
direct labor efficiency variance will equal the total direct
labor cost variance
Computing and Analyzing Manufacturing
Overhead Variances
• Controlling variable and fixed overhead costs
is more difficult for managers than
controlling direct materials and direct labor
costs
• Responsibility for manufacturing overhead costs
is hard to assign
• Fixed overhead costs
• Unavoidable past costs
• Not under the control of any department manager
• Variable overhead costs
• Some control possible if they can be related to
departments or activities
Variable MOH Cost V
Variable Overhead Variance
• Total variable overhead variance
• Difference between actual variable overhead costs and
the standard variable overhead costs that are applied to
good units produced using the standard variable rate
Standard Variable Manuf’ OH cost
Actual Variable Manuf’ OH cost
Total Manuf’VOH cost variance
xxxx
xxxx
xxxx
Variable Overhead Variances
(cont’d)
• Total variable overhead cost variance must be
broken into two parts to find the cause of the
variance
• Variable overhead Expenditure variance
• Variable overhead efficiency variance
VMOH expenditure V
Variable Overhead Variances
(cont’d)
• Variable overhead expenditure variance
• Difference between the standard variable overhead
costs at actual hours and actual variable overhead
V.O.A.R= Variable OH Absorption Rate
VMOH efficiency V
Variable Overhead Variances
(cont’d)
• Variable overhead efficiency variance
• Difference between the standard direct labor hours
allowed for good units produced and the actual hours
worked multiplied by the standard variable overhead
rate
Fixed MOH Cost V
Variable Overhead Variances
(cont’d)
Fixed Overhead Variance
• Test calculations of variances
• Total Fixed overhead variance
• If correct, the net of the variable overhead expenditure
variance and variable overhead efficiency variance will
equal the total variable overhead cost variance
• Difference between actual fixed overhead costs and the
standard fixed overhead costs that are applied to good
units produced using the standard rate
Standard Fixed Manuf’ OH cost
Actual Fixed Manuf’ OH cost
Total Manuf’ FOH cost variance
xxxx
xxxx
xxxx
FMOH expenditure V
Fixed Overhead Variances (cont’d)
Fixed Overhead Variances (cont’d)
• Fixed overhead expenditure variance
• Total fixed overhead cost variance must be broken
into two parts to find the cause of the variance
• Fixed overhead expenditure variance
• Fixed overhead volume variance
• Difference between the budgeted and actual fixed
overhead costs
• Also called budgeted fixed overhead variance
FMOH Volume V
Fixed Overhead Variances (cont’d)
Fixed Overhead Variances (cont’d)
• Fixed overhead volume variance
• A volume variance will occur if more or less than
normal capacity is used
• Difference between budgeted fixed overhead costs and
manufacturing overhead costs applied to production
using the standard fixed overhead rate
• Fixed overhead volume variance measures the use of
existing facilities and capacity
• Favorable overhead volume variance
• Capacity exceeds the expected amount
• Unfavorable overhead volume variance
• Company operates at a level below normal capacity
• May be in best interest of company during periods of slow sales
• Means company is not building up excess inventory
Fixed Overhead Variances (cont’d)
• Test calculations of variances
• If correct, the net of the Fixed overhead expenditure
variance and Fixed overhead volume variance will equal
the total fixed overhead cost variance
Reasons for OH variances
Variance
Favorable
Adverse
Variable overhead
expenditure
Standard hourly rate
Standard hourly rate set too low
set too high
Variations in rate or consumption of indirect materials,
indirect labor and indirect other costs
Variable overhead
efficiency variance
See labor hours efficiency variance
Fixed overhead
Setting the budgeted
expenditure variance fixed oH too low
Setting the budgeted fixed oH too
high
Fixed overhead
volume variance
Using below the normal capacity
Using above the
normal capacity
Summary of Total Cost variance
Advantages of Standard Costing
• DM price V
2,150 A
• DM Qty V
1,000 F
• DL Rate V
1,100 A
• DL Efficiency V
1,500 A
• VOH expenditure V
2,000 F
• VOH efficiency V
1,000 A
• Fixed OH expenditure V 300 F
• Fixed OH volume V
500 A
Total Cost Variance
1. Accurate standards are helpful in setting the budgets.
2. Standard cost acts as a measurement to compare with the
actual cost
3. Standard setting process is helpful in identifying new
production techniques, alternative materials, etc
4. Costs can be controlled by setting efficiency levels for
employees.
5. The management approach of “Management by
exception” can be used.
6. It is convenient to prepare Cost accounts using standard
costs.
7. Production planning can be done using the set standard
time.
1,150 A
2,600 A
1,000 F
200 A
2,950 A
Disadvantages of Standard
Costing
• Standard setting and updating process is a time and
resource consuming work.
• When the prices and labor rates are changed
frequently it is difficult control costs
• Empirical researches found that most of the
managers are reluctant to apply standard cost
controlling process due to the poor understanding of
variances. There fore a proper controlling
environment cannot be established within the
organization.
Standard Costing vs. budgeting
• Both are used for the controlling purposes.
• However there is a significant difference between the
two.
• Standard costing is used to control the cost of a unit
(unit of product/service/ individual process).
• However the budgeting considers the controlling of
overall costs.
• Cost controlling is done for an entire division, function
or company as a whole. Responsibility of controlling is
assigned to individuals or departments.
Standard Costing vs. budgeting
cont’d
• Under the standard cost controlling, budgets are
prepared based on the information available in the
standard cost cards. Also budget information (ex:
OH) is need to prepare a standard costs card. Thus
it might be difficult to have standard cost
controlling without having the budgets.
• However the budgetary control can be done even
without having the standard costs. For example
Incremental budgets can be prepared without the
standards.
Practicing Question cont’d
During January, 530 units were produced and the
costs incurred were as follows.
• Direct material: 42845 kgs purchased and used;
cost Rs 308,484
• Direct labor: 51380 hours worked; cost 400,764
• Variable overhead: Cost 156,709
• Fixed overhead: Cost 52,000
• Budgeted Fixed production OH cost is Rs 54029 and
budgeted production quantity is 557 units.
Calculate all cost variances
Practicing Question
• A company manufactures a single product for
which the standard cost is as follows
Rs. Per unit
Direct materials: 81 kgs@ Rs. 7 per Kg
Direct labor: 97 hours@ Rs.8 per hour
Variable overhead: 97 hours @ Rs. 3 per
hour
Fixed overhead : 97 hours @ Rs 1 per hour
567
776
291
97
1634