Chapter 7 Overview:
Standard Costs and
Variances
7.1 What Are Standards?
Controlling Via Standards
• Standards are the predetermined expectations
of the inputs necessary to achieve a unit of
output
– Standard costs provide an assessment of what
those inputs should cost
• Standards are important in planning and
control
– Ex) In a restaurant, managers set standards for
how many tables must be “turned,” and the bus
staff is allowed only so much “breakage”
Establishing Standards
• Should consider waste, spoilage, evaporation,
human mistakes, rest time, etc.
• Should originate with personnel who best
understand
the processes
• May be based on averages
– Ex) Total estimated costs divided by total
estimated output
or activity
Establishing Standards
• Achievable standards are realistically within reach
– Take into account normal spoilage and inefficiency
– Provide clear metrics for evaluation
– Reduce frustration and discouragement associated with
less-attainable goals
• Ideal standards may never be reached
– Represent what will result in a state of perfection without
spoiled goods, worker fatigue, or errors
– Designed to encourage employees to constantly strive to
hit
lofty goals
• But employees may see as meaningless
Establishing Standards
• If employees are encouraged to work fast,
quality
can suffer
– Standards for quality should also be established
• Seasoned employees may be so skilled that
they can easily meet their output goals
– These employees may need higher standards
7.2 General Variance Model
• Standard costs are compared to actual costs, and
deviations are termed variances
– Favorable variances result when actual costs are less
than standard costs (and vice versa)
• Can be conducted for material, labor, and
overhead
• When total actual costs differ from total standard
costs, management should perform more analysis
to determine the root causes of the variances
Variances Relating to Direct
Material
• The total variance compares actual direct
material cost to standard direct material cost
– Materials Price Variance: The difference between the
standard price for materials purchased and the
amount actually paid for those materials
• [(standard price - actual price) X actual quantity]
– Materials Quantity Variance: Compares the standard
quantity of materials that should have been used to
the actual quantity of materials used, measured at the
standard price per unit
• [(standard quantity - actual quantity) X standard price]
Variances Relating to Direct
Material
Variances Relating to Direct
Material
• There are several ways to perform the intrinsic
variance calculations
– Compute the values for the red, blue, and green
balls and note the differences
– Perform the algebraic calculations for the
variances
• Note that unfavorable variances (negative)
offset favorable (positive) variances
Variances Relating to Direct
Material
• Blue Rail produces handrails, banisters, and
similar welded products
– The company has adopted a standard of 1.25
pieces (50’) of raw pipe per section of rail
– During August, Blue Rail produced 3,400 rail
sections
– Pipe was anticipated to cost $80 per 40’ piece
– Actual material cost was $369,000
Standard Material Cost
Output - Number of rail sections
3,400
Standard quantity of input per rail section- 40’ long pieces of pipe
Standard quantity of input (pipes) to achieve output (rail sections)
X    1.25
4,250
Standard price per unit of input (pipe)
X    $80
Standard cost of direct materials
$340,000
Actual Material Cost
Actual quantity of input (pipes) to achieve output (rail sections)
4,100
Actual price per unit of input (pipe)
X    $90
Actual cost of direct materials
$369,000
Variances Relating to Direct
Material
• The total direct material variance was unfavorable $29,000
($340,000 vs. $369,000)
• This unfavorable outcome was driven by higher prices for raw
material, not waste
MATERIALS PRICE VARIANCE
(SP - AP) X AQ = ($80 - $90) X 4,100
= <$41,000>
MATERIALS QUANTITY VARIANCE
(SQ - AQ) X SP = (4,250 - 4,100) X $80
=$12,000
This illustration presumes that all raw materials purchased are put into production.
If this is not the case, the price variances would be based on the amount purchased
while the quantity variances would be based on output.
Variances Relating to Direct
Material
Impact on the Ledger
• Variance accounts are debited for unfavorable
outcomes and credited for favorable ones
• Raw Materials Inventory carries only the
standard price of materials
• Work in Process is debited for the standard
cost of the standard quantity that should be
used for the productive output achieved
Impact on the Ledger
08-31-XX Raw Materials Inventory
328,000
Materials Price Variance
41,000
Accounts Payable
369,000
To record purchase of raw materials at
standard price and unfavorable variance
08-31-XX Work in Process Inventory
Raw Materials Inventory
Materials Quantity Variance
To transfer raw materials to production at
standard usage and record favorable variance
340,000
328,000
12,000
Impact on the Ledger
Variances Related to Direct
Labor
• The total variance is found by comparing
actual direct labor cost to standard direct
labor cost
– Labor Rate Variance: The difference between the standard
rate and actual rate for the actual labor hours worked
• [(standard rate - actual rate) X actual hours]
– Labor Efficiency Variance: Compares the standard hours of
direct labor that should have been used to the actual
hours worked, measured at the standard rate per hour
• [(standard hours - actual hours) X standard rate]
Variances Related to Direct
Labor
Variances Related to Direct
Labor
• Recall Blue Rail Manufacturing
– During August, Blue Rail produced 3,400 rail
sections
– The company has adopted a standard of 3 labor
hours for each section of rail
– Skilled labor is anticipated to cost $18 per hour
– Actual labor cost was $175,000
Variances Related to Direct
Labor
Standard Labor Cost
Output - Number of rail sections
Standard hours per rail section
Standard hours to achieve output
3,400
X    3.00
10,200
Standard rate per hour of labor
X    $18
Standard cost of direct labor
$183,600
Actual Labor Cost
Actual hours of labor
12,500
Actual rate per hour
X    $14
Actual cost of direct labor
$175,000
Variances Related to Direct
Labor
• The total direct labor variance was favorable
$8,600 ($183,600 vs. $175,000)
• Blue Rail experienced a very favorable labor
rate variance but this was offset by a
significant unfavorable labor efficiency
LABOR RATE VARIANCE
(SR - AR) X AH = ($18 - $14) X 12,500
= $50,000
LABOR EFFICIENCY VARIANCE
(SH - AH) X SR = (10,200 - 12,500) X $18
=<$41,400>
Variances Related to Direct
Labor
Impact on the Ledger
08-31-XX Work in Process Inventory
Labor Efficiency Variance
Labor Rate Variance
Wages Payable
To increase work in process for the standard
direct labor costs and record the related
efficiency and rate variances
183,600
41,400
50,000
175,000
Impact on the Ledger
Variances Related to Factory
Overhead
• Recall that overhead has both variable and
fixed components
– As a result, variance analysis for overhead is split
between variances related to variable overhead
and variances related to fixed overhead
Variances Related to Factory
Overhead
• When more is spent on actual variable factory
overhead than is applied based on standard
rates, the result is underapplied overhead
– Produces unfavorable variances
• When less is spent than applied, the balance
represents overapplied overhead
– Produces favorable variances
• Differences are transferred to variance
accounts
Variances Related to Factory
Overhead
Variances Related to Factory
Overhead
Variances Related to Factory
Overhead
• The total variance can be divided:
– Variable Overhead Spending Variance: A variance
that reflects the difference between actual
variable overhead and standard variable overhead
associated with the actual units of the application
base
– Variable Overhead Efficiency Variance: A variance
that reflects the level of efficiency associated with
the application of variable overhead to production
Variances Related to Factory
Overhead
• Recall Blue Rail Manufacturing
– It was estimated that variable factory overhead
should be applied at $10 per direct labor hour
– During August, $105,000 was actually spent on
variable factory overhead items
Variances Related to Factory
Overhead
Standard Production Cost
Output - Number of rail sections
Standard hours per rail section
Standard hours to achieve output
3,400
X    3.00
10,200
Standard variable overhead rate per hour of labor
X    $10
Standard cost of variable overhead
$102,000
Variances Related to Factory
Overhead
• The total variable overhead variance is
unfavorable $3,000 ($102,000 - $105,000)
• A closer look reveals that overhead spending
was quite favorable, while overhead efficiency
was not
Variances Related to Factory
Overhead
Variances Related to Factory
Overhead
08-31-XX Work in Process Inventory
Variable Overhead Efficiency Variance
Variable Overhead Spending Variance
Factory Overhead
To increase work in process for the standard
variable overhead and record the related
efficiency and spending variances
102,000
23,000
20,000
105,000
Variances Related to Factory
Overhead
• The variable overhead efficiency variance may
reflect efficiencies or inefficiencies
experienced with the base used to apply
overhead
– Ex) The total number of hours was “run up”
because of inexperienced labor
Variances Related to Factory
Overhead
• Actual fixed factory overhead may show little
variation from budget
– Many fixed costs are tied to contracts or determined
in advance
• Can be divided:
– Fixed Overhead Volume Variance: Compares the
budgeted fixed overhead to the fixed overhead that is
applied to production based on standard fixed
overhead per unit of output
– Fixed Overhead Spending Variance: Compares actual
fixed overhead to the budgeted fixed overhead
Variances Related to Factory
Overhead
• Recall Blue Rail Manufacturing
–
–
–
–
It budgeted total fixed overhead at $72,000
Only $70,000 was spent
Blue Rail had planned to produce 4,000 rail systems
Planned fixed overhead was $18 per rail
• $72,000 ÷ 4,000 = $18
– The fixed overhead allocation rate is $6 per direct
labor hour
• 3 labor hours are needed per rail
• $18 ÷ 3
Variances Related to Factory
Overhead
Variances Related to Factory
Overhead
• The standard cost allocation of fixed overhead
is allocated to work in process
• The volume variance is unfavorable
– Production did not rise to the anticipated level
– Much of the fixed cost was “under-utilized”
• The spending variance was favorable
– Less was spent than budgeted
Variances Related to Factory
Overhead
Impact on the Ledger
08-31-XX Work in Process Inventory
Fixed Overhead Volume Variance
Fixed Overhead Spending Variance
Factory Overhead
To increase work in process for the standard
fixed overhead and record variances
61,200
10,800
2,000
70,000