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UNIT FOUR
STANDARD COSTING AND VARIANCES
4.1. INTRODUCTION
One of the most important functions of management is control. The major aspect of managerial control is cost control. Control normally refers to the function which ensures the actual performance conforms to a given plan. Hence, the control function of management can be effective only when it is preceded by planning. Standard costing is a technique which helps management to plan and control business operations. The word ‘standard’ means a bench-mark or yardstick. The standard cost is a predetermined or expected cost which determines what each product or service should cost under given conditions. In other words, it is the expected cost of producing one unit. It is, in effect, a budget for one unit. Standard costing may be defined basically as a technique of cost accounting which compares the standard cost of each product or service with the actual cost to determine the efficiency of operation so that remedial action may be taken immediately. The institute of costs and management accounts of England defines standard costing as “the preparation and use of standard costs, the comparison with the actual costs, and the analysis of variances to their cause and the points of incidence.” Variance is the difference between a budget or standard amount and the actual amount during a given period. 4.2. STANDARD COST SYSTEMS 4.2.1. MEANING OF STANDARD COSTING Standard costs are predetermined costs that are usually expressed on per unit basis. In other word, standard cost is a predetermined calculation of how much costs should be incurred under specified working condition. It is built up from an assessment of the value of direct material, direct labor and overhead items. 4.2.2. WHY STANDARD COST SYSTEMS ARE USE “A standard cost system has three basic functions: collecting the actual costs of a manufacturing operation, determining the achievement of that manufacturing operation, and evaluating
performance through the reporting of variances from standard.” These basic functions result in six distinct benefits of standard cost systems. Clerical Efficiency A company using standard costs usually discovers that less clerical time and effort are required than in an actual cost system. In an actual cost system, the accountant must continuously recalculate changing actual unit costs. In a standard cost system, unit costs are held constant for some period. Costs can be assigned to inventory and cost of goods sold accounts at predetermined amounts per unit regardless of actual conditions. Motivation Standards are a way to communicate management’s expectations to workers. When standards are achievable and when workers are informed of rewards for standards attainment, those workers are likely to be motivated to strive for accomplishment. The standards used must require a reasonable amount of effort on the workers’ part. Planning Planning generally requires estimates about the future. Managers can use current standards to estimate future quantities and costs. These estimates should help in the determination of purchasing needs for material, staffing needs for labor, and capacity needs related to overhead that, in turn, will aid in planning for company cash flows. In addition, budget preparation is simplified because a standard is, in fact, a budget for one unit of product or service. Standards are also used to provide the cost basis needed to analyze relationships among costs, sales volume, and profit levels of the organization. [ Controlling The control process begins with the establishment of standards that provide a basis against which actual costs can be measured and variances calculated. Variance analysis is the process of categorizing the nature (favorable or unfavorable) of the differences between actual and standard costs and seeking explanations for those differences. A well-designed variance analysis system captures variances as early as possible, subject to cost-benefit assessments. The system should help managers determine who or what is responsible for each variance and who is best able to explain it. An early measurement and reporting system allows managers to monitor operations,
Budgetary control system Standard costing system
- Budgetary control is related to all types of items of revenue and expenditure, whether they belong to the product or not, i.e. to all types of business activities. Hence, it is more extensive.
- Budget is based on past experience and in most cases a projection of financial accounts.
- Budgets are comparatively less rigid and ‘should be’ estimates. They fix limits.
- Budgetary control can be operated without a standard costing system. It can be adopted in part.
- The study of variances is not a subject of special study as in the case of standard costing 1. Standard costing is related to production and production costs. Hence, it is more rigorous and intensive. 2. Standard is established on the basis of technical estimates. It is the projection of accounts. 3. Standard are very rigid and ‘ought to be’ estimates. They fix targets. 4. Standard costing system cannot operate well without a budgetary control system. Also, it is not possible to operate the system in parts 5. Variance analysis is a subject of special study of standard costing. 4.2.4. ADVANTAGES AND LIMITATIONS OF STANDARD COSTING Advantages of standard costing
- The weakness of the traditional costing system can be estimated by compiling standard costs more carefully.
- Standard costs can be used as a yardstick against which actual costs can be compared. It is an effective tool for planning production costs. Hence, cost control is greatly facilitated.
- Variance analysis helps management to have regular as well as better checks over costs incurred. It makes the application of the principle of management by exception more easy. That is, the management can concentrate its attention on variances only, leaving the other aspects of cost control to be taken care of at the lower level.
- It is a valuable guide to management in the formulation of production and price policies in advance with certainty. It also assists management in the areas of profit – planning, product –pricing, and inventory pricing, etc.
- Standard costing makes the reporting of operating data more meaningful and also fast. This makes the interpretation of management reports easy.
- As the emphasis of the standard costing system is more on cost variations, it makes the entire organization cost conscious. It makes the employees recognize the importance of efficient operations so that costs can be reduced by joint efforts.
- Labor, materials and machines can be effectively used, and economies can be affected in addition to increase productivity. Standards may also be used as the basis for introducing incentive schemes. Limitations of standard costing
- Setting of standards is a very difficult task. It requires a lot of scientific studies such as time –study, motion study, etc., and therefore it is very costly. Small firms may find it very difficult to operate such a system.
- Standards are very rigid estimates and once set, are not changed for a considerable time. This makes the standards highly unrealistic in certain industries which face fluctuations in prices of products due to frequent changes.
- The utility of variance analysis depends much more on the standard set. While a loosely set standard may be ridicule the standards which are set very high may create frustration in the minds of the workers. At the same time setting of correct standards is also, it is difficult to apply this system when production takes more than one accounting period. 4.2.5. DEVELOPMENT OF A STANDARD COST SYSTEM Although standard cost systems were initiated by manufacturing companies, these systems can also be used by service and not-for-profit organizations. In a standard cost system, both standard and actual costs are recorded in the accounting records. This dual recording provides an essential element of cost control: having norms against which actual operations can be compared. Standard cost systems make use of standard costs, which are the budgeted costs to manufacture a single unit of product or perform a single service. Developing a standard cost involves judgment and practicality in identifying the material and labor types, quantities, and prices as well as understanding the kinds and behaviors of organizational overhead.
simply as guides for production activity. When converting quantities on the bill of materials into costs, allowances are often made for normal waste of components. After the standard quantities are developed, prices for each component must be determined. Prices should reflect desired quality, quantity discounts allowed, and freight and receiving costs. Although not always able to control prices, purchasing agents can influence prices. These individuals are aware of alternative suppliers and attempt to choose suppliers providing the most appropriate material in the most reasonable time at the most reasonable cost. The purchasing agent also is most likely to have expertise about the company’s purchasing habits. Incorporating this information in price standards should allow a more thorough analysis by the purchasing agent at a later time as to the causes of any significant differences between actual and standard prices. When all quantity and price information is available, component quantities are multiplied by unit prices to obtain the total cost of each component. (Remember, the price paid for the material becomes the cost of the material.) These totals are summed to determine the total standard material cost of one unit of product. Labor Standards Development of labor standards requires the same basic procedures as those used for material. Each production operation performed by either workers (such as bending, reaching, lifting, moving material, and packing) or machinery (such as drilling, cooking, and attaching parts) should be identified. In specifying operations and movements, activities such as cleanup, setup, and rework are considered. All unnecessary movements by workers and of material should be disregarded when time standards are set. To develop usable standards, quantitative information for each production operation must be obtained. Time and motion studies may be performed by the company; alternatively, times developed from industrial engineering studies for various movements can be used. A third way to set a time standard is to use the average time needed to manufacture a product during the past year. Such information can be calculated from employees’ past time sheets. A problem with this method is that historical data may include inefficiencies. To compensate, management and supervisory personnel normally make subjective adjustments to the available data. After all labor tasks are analyzed, an operations flow document can be prepared that lists all operations necessary to make one unit of product (or perform a specific service). When products are manufactured individually, the operations flow document shows the time necessary to
produce one unit. In a flow process that produces goods in batches; individual times cannot be specified accurately. Labor rate standards should reflect the employee wages and the related employer costs for fringe benefits, FICA (Social Security), and unemployment taxes. In the simplest situation, all departmental personnel would be paid the same wage rate as, for example, when wages are job specific or tied to a labor contract. If employees performing the same or similar tasks are paid different wage rates, a weighted average rate (total wage cost per hour divided by the number of workers) must be computed and used as the standard. Differing rates could be caused by employment length or skill level. Overhead Standards To provide the most appropriate costing information, overhead should be assigned to separate cost pools based on the cost drivers, and allocations to products should be made using different activity drivers. After the bill of materials, operations flow document, and predetermined overhead rates per activity measure have been developed, a standard cost card is prepared. This document summarizes the standard quantities and costs needed to complete one product or service unit. Data from the standard cost card are then used to assign costs to inventory accounts. Both actual and standard costs are recorded in a standard cost system, although it is the standard (rather than actual) costs of production that are debited to Work in Process Inventory. Any difference between an actual and a standard cost is called a variance. 4.2.6. CONSIDERATIONS IN ESTABLISHING STANDARDS When standards are established, appropriateness and attainability should be considered. Appropriateness, in relation to a standard, refers to the basis on which the standards are developed and how long they will be expected to last. Attainability refers to management’s belief about the degree of difficulty or rigor that should be incurred in achieving the standard. Appropriateness Although standards are developed from past and current information, they should reflect relevant technical and environmental factors expected during the time in which the standards are to be
4.3.2. Classification of variances Budget Variances indicate the total deviation of actual costs from expected costs. However, they do not give the complete story about deviations between budgeted and actual results; i.e. it is not yet clear what contributed to the variances unless further investigations are made. Hence, a total flexible budget variance (FBV) is the difference between total actual costs incurred and total standard cost applied to the output produced during the period. This variance can be diagrammed as follows: Actual Cost of Actual Production Input Less Standard Cost of Actual Production Output Total Variance ( FBV) Since total variances do not provide useful information for determining why cost differences occurred; to help managers in their control objectives, total variances are subdivided into price and usage components. Hence, the total variance diagram can be expanded to provide a general model indicating the two sub-variances as follows: Actual Cost of Standard Cost of Standard Cost of Actual Production Actual Production Standard Quantity Inputs Inputs of Inputs (AP x AQ) (SP x AQ) (SP x SQ) Price/Rate Variance Quantity/Efficiency variance Total Variance ( FBV) A price/rate variance reflects the difference between what was paid for inputs and what should have been paid for inputs. A usage /Quantity//Efficiency variance shows the cost difference between the quantity of actual input and the quantity of standard input allowed for the actual output of the period. The quantity difference is multiplied by a standard price to provide a monetary measure that can be recorded in the accounting records. Usage variances focus on the efficiency of results or the relationship of input to output
As shown above, the diagram moves from actual cost of actual input on the left to standard cost of standard input quantity on the right. The middle measure of input is a hybrid of actual quantity and standard price. The change from input to output reflects the fact that a specific quantity of production input will not necessarily produce the standard quantity of output. The far right column uses a measure of output known as the standard quantity allowed. This quantity measure translates the actual production output into the standard input quantity that should have been needed to achieve that output. The monetary amount shown in the right-hand column is computed as the standard quantity allowed times the standard price of the input. The price variance portion of the total variance is measured as the difference between the actual and standard prices multiplied by the actual input quantity: i.e. Price Element= (AP -SP)(AQ Whereas, the usage variance portion of the total variance is measured as measuring the difference between actual and standard quantities multiplied by the standard price: i.e. Usage Element= (AQ - SQ)(SP) 4.3.2.1. DIRECT MATERIAL AND LABOR VARIANCES A. DIRECT MATERIAL COST VARIANCES: To completely and meaningfully analyze the flexible budget variance for material, it should be analyzed in terms of the materials price standard and the materials quantity standard. This level of analysis resulted in: (i) material price variance that identifies the effect of differences in prices paid for materials. (ii) Material quantity (usage) variance that identifies the effect of difference in the quantities of materials used. i) Material Price Variance(MPV) A material price variance is the difference between the actual price of material/unit and the standard price of material per unit multiplied by the actual quantity of material purchased. In other words, the material price variance (MPV) indicates whether the amount paid for material was below or above the standard price. Material price variance can be calculated as: MPV = (SP – AP) AQ where: SP is the standard price of material per unit
b) Compute the material price variance on the bases of purchase c) Calculate the material quantity variance. d) Total FBV Solution: a) Total cost of purchases for August would be: Actual unit purchase price (a) -------------------------------- Br 0.16 per page Actual quantity purchased during August (b) ---------------- 230,000 pages Total cost (a x b) ------------------------------------ Br.36, b) MPV = (SP – AP) AQ = (Br 0.15 per page - Br 0.16 per page) 230,000 pages= Br. 2,300 (U) c) MQV = (SQ-AQ) x SP = ( 195,800 pages - 200,000 pages) Br 0.15 per page= Br. 630(U) d) Total FBV═ Br 2,300U + Br. 630U═ Br.2,930 U Activity4. Iron Eagle makes wrought iron table and chair sets. During April 2001, the purchasing agent bought 12,800 pounds of scrap iron at Br. 0.89 per pound. Each set requires a standard quantity of 35 pounds at a standard cost of Br 0.85 per pound. During April, the company used 10, pounds and produced 300 sets. For April, compute the direct material price variance and the direct material quantity variance. B. LABOR COST VARIANCES: Just like we have done for material inputs, we will do the same meaningful analysis for labor inputs. Hence, the variance investigation to flexible budget variance for labor resulted in: (i) labor rate variance that identifies the effect of differences in the rates paid to workers, and (ii) labor efficiently or usage variance that identifies the effect of differences in the quantities of labor used. i) Labor Rate Variance(LRV) The labor rate variance (LRV) shows the difference between the actual wages paid to labor for the period and the standard wages for all hours worked. Thus, Labor rate variance is the difference between the actual rate of labor per hour and the standard rate of labor per hour, multiplied by the actual hours of labor worked.
LRV= (SR-AR) x AH Where: SR is standard rate of labor per hour AR is actual rate of labor per hour, AH is a total actual hour of labor worked ii) Labor Efficiency Variance (LEV) A labor efficiency variance is the difference between the actual labor hours worked and the standard labor hours that should have been worked to produce the actual output, multiplied by the standard rate of labor per hour. Thus, multiplying the standard labor rate by the difference between the actual minutes worked and the standard minutes for the production achieved results in the labor efficiency variance (LEV) LEV = (SH – AH) x SR Where: SH is standard hours of labor for the actual unit produced AH is actual labor hours used for the unit produced SR is standard rate of labor per hour Example 4.2 Sagittarius Corp. has established the following standards for the prime costs of one of its chief product, dart boards. Standard Qty standard Price (Rate) Total Standard cost Direct material 8.5 pounds Br.1.80/pound Br.15. Direct labor 0.25 hour 8.00/hour 2. Br.17. During May, Sagittarius purchased 160,000 pounds of direct material at a total cost of Br.304,
- The total wages for May were Br.42, 000, 90% of which were for DL. Sagittarius manufactured 19,000 dart boards during May; using 142,500 pounds of direct material & 5, direct labor hours. Required : Compute the following variances for May. a) Direct material price variances b) Direct material usage variance
When a company’s product uses more than one material, the goal is to combine those materials in such a way as to produce the desired product quality in the most cost-beneficial manner. Sometimes, materials can be substituted for one another without affecting product quality. In other instances, only one specific material or type of material can be used. For example, a furniture manufacturer might use either oak or maple to build a couch frame and still have the same basic quality. A perfume manufacturer, however, may be able to use only a specific fragrance oil to achieve a desired scent. Labor, like materials, can be combined in many different ways to make the same product. Some combinations will be less expensive than others; some will be more efficient than others. Again, all potential combinations may not be viable. Management desires to achieve the most efficient use of labor inputs. As with materials, some amount of interchangeability among labor categories is assumed. Skilled labor is more likely to be substituted for unskilled because interchanging unskilled labor for skilled labor is often not feasible. However, it may not be cost effective to use highly skilled, highly paid workers to do tasks that require little or no training. A rate variance for direct labor is calculated in addition to the mix and yield variances. Each possible combination of materials or labor is called a mix****. Management’s standards development team sets standards for materials and labor mix based on experience, judgment, and experimentation. Mix standards are used to calculate mix and yield variances for materials and labor. An underlying assumption in product mix situations is that the potential for substitution exists among the material and labor components. If this assumption is invalid, changing the mix cannot improve the yield and may even prove wasteful. In addition to mix and yield variances, price and rate variances are still computed for materials and labor. i) Material Mix and Yield Variances A material price variance shows the Birr effect of paying prices that differ from the raw material standard. The material mix variance (MMV) measures the effect of substituting a nonstandard mix of materials during the production process. The material yield variance (MYV) is the difference between the actual total quantity of input and the standard total quantity allowed based on output; this difference reflects standard mix and standard prices. The sum of the material mix and yield variances equals a material quantity variance; the difference between these two
variances is that the sum of the mix and yield variances is attributable to multiple ingredients rather than to a single one. A company can have a mix variance without experiencing a yield variance. Computations for the price, mix, and yield variances are given below in a format similar to that used in the above section. Actual Mix X Actual Mix X Standard Mix X Standard Mix X Actual Quantity Actual Quantity Actual Quantity Standard Quantity X Actual X Standard X Standard X Standard Price Price Price Price Material Price Material Mix Material Yield Variance Variance Variance The formula to compute material mix and yield variance would be: To compute material mix variance: Material Mix Variance(MMV)= (RSQ – AQ)SP Where, RSQ = revised standard quantity( i.e. actual quantity at standard mix) = SQ for each material x Total AQ (OR) Total SQ = Total AQ X standard mix ratio AQ= Actual Quantity at actual mix SP = standard price To compute material yield variance: MYV = (SQ – RSQ)SP Where, SQ= Standard Quantity at standard mix RSQ = Revised Standard Quantity SP = standard price Example4.3 The Scent Makers Company produces perfume. To make this perfume, Scent makers uses three different types of fluids: Dycone, Cycone, & Bycone are used in standard proportions of 4/10, 3/10, & 3/10 and their standard costs are Br. 6.00, Br. 3.50 & Br. 2.50 per unit, respectively. The chief engineer reported that for the past few months the standard yield has
SP x SQ SP x RSQ SP x AQ AP x AQ Dycone: 6 x 37,500 6 x 40,000 6 x 45,000 5.5 x 45, Cycone: 3.5x28, 125 3.5x30, 000 3.5x35, 000 4.2 x 35, Bycone: 2.5x28,125 2.5x30,000 2.5x20,000 2.75x20, 393,750 420,000 442,500 449, 26,250U 22,500U Yield Mix 7,000U 48,750U Price Usage 55,750U FBV for direct material Note: a) MYV = 1-2= SP x (SQ x RSQ) = Br. 26,250U b) MMV =2-3= SP x (RSQ-AQ) = Br. 22,500U c) MQV=1-3 = (SP x SQ) – (AP x AQ) =MYV+ MMV= Br. 48,750U d) MPV=3-4= (SP-AP)AQ= Br. 7,000 U e) FBV for DM= 1-4= (SP x SQ) –(AP x AQ)= MQV+ MPV= Br. 55,750 U ii. Labor Mix, and Yield Variances The labor rate variance is a measure of the cost of paying workers at other than standard rates. The labor mix variance is the financial effect associated with changing the proportionate amount of higher or lower paid workers in production. The labor yield variance reflects the monetary impact of using more or fewer total hours than the standard allowed. The sum of the labor mix and yield variances equals the labor efficiency variance. The diagram for computing labor rate, mix, and yield variances is as follows: (Actual Mix) X (Actual Mix) X (Standard Mix) X (Standard Mix) X (Actual Hours) (Actual Hours) (Actual Hours) (Standard Hours) X (Actual Rate) X (Standard Rate) X (Standard Rate) X (Standard Rate) Labor Rate Variance Labor Mix Variance Labor Yield Variance
The formula to compute labor mix and yield variance would be: To compute labor mix variance: Labor Mix Variance (LMV)= (RSH – AH)SR Where: RSH= revised standard hour (i.e. actual hours at standard mix) = SH for each labor x Total AH ( OR ) Total SH = Total AH X standard mix ratio AH=Actual hours at actual mix SR= standard rate per hours To compute Labor Yield Variance Labor Yield Variance(LYV) = (SH-RSH)SR Where: SH= standard hours at standard mix RSH= revised standard hour SR= standard rate per hours Example4.4 Buffon Legal Services has three labor classes: secretaries, paralegals, and attorneys. The standard wage rates are shown in the standard cost system as follows: secretaries, Br 25 per hour; paralegals, Br 40 per hour; and attorneys, Br 85 per hour. The firm has established a standard of 0.5 hours of secretarial time and 2 hours of paralegal time for each hour of attorney time in probate cases. The actual direct labor hours worked on probate cases and the standard hours allowed for the work accomplished for one month in 2001 were as follows: Standard Hours Actual Labor Hrs for Output Achieved Secretarial 500 500 Paralegal 1,800 2, Attorney 1,100 1, Total: 3, 400hrs 3,500hrs Required : Calculate the amount of the direct labor efficiency variance for the month and decompose the total into the following components:
1. Direct labor mix variance 2. Direct labor yield variance Solution:
