MODULE 4 – Standard Costing and Variance analysis

Topic # Topic Title Hours

Topic 1 - Definition and uses of Standard costing
Topic 2- Direct Materials variance and Direct labor variance
Topic 3 - Factory overhead variance

Upon completion of this module, the learner should be able to:

1. Define standards and discuss how they are developed
2. Explain the difference between budgeted cost and standard cost
3. Understand the uses of standard costing
4. Compute the direct materials price variance and direct materials usage variance
5. Compute the direct labor rate variance and the labor efficiency variance
6. Compute the factory overhead variance using the one, two, three and four way
variances

Introduction ( Engage )
In an actual cost system, product costs are only recorded when they are incurred. This
technique is usually acceptable for the recording of direct materials, and direct labor
because they can be easily traced to specific jobs or departments. Factory overhead,
the indirect cost components of a product, usually cannot be easily traced to a specific
job or department. Since overhead is not a direct cost of production, a modification of an
actual cost system, called normal costing, is commonly used. Under the normal costing,
direct materials and direct labor costs are accumulated as they are incurred with one
exception, factory overhead is applied to production, on the basis of actual input (hours,
units, costs, and etc. multiplied by a predetermined factory overhead rate). Under
standard costing, all costs attached to products are based on standard or
predetermined accounts. Standard costs represent the “planned” costs of production
and are generally established well before production begins. The establishment of
standards thus provide management with goals to attain and bases for comparison with
actual results.

Definition and uses of Standard Costing(Explore)

Standard – a benchmark set by management in aid of performance measurement. In

manufacturing companies, standards are classified into two categories:

 Quantity standard – indicates the quantity of raw materials or labor time required
to produce a unit of product. This is normally expressed per unit of output ( e.g.,
3 pieces per unit).
  Cost standard – indicates what the cost of the quantity standard should be. This
normally expressed per unit of input ( e.g, P2.00 per piece).

Standard Costs – systematically pre-determined costs established by management to

be used as basis for comparison with actual cost.

Budgeted cost -  is a forecasted future expense that the company is expected to incur

in the future. In other words, it's an estimated expense that management anticipates will
be incurred in a future period based on projected revenues and sales.

STANDARDS vs. BUDGETS

BUDGETS STANDARDS
Purpose Budgets are statements of Standards pertain to what costs
expected costs should be given a certain level of
performance
Emphasis Budgets emphasize cost levels Standards emphasize the levels
that should not exceeded. to which costs should be reduced.
Coverage Budgets are set for all Standards are set only for the
departments – sales, production or manufacturing
administration & manufacturing. division of the firm.
Analysis When actual data differ from the Material amounts of variance are
budget, it may be an indication of reviewed and investigated so that
either good or bad performance. necessary corrective actions are
implemented.

Uses Of Standard Costs

1. Cost control
2. Pricing decisions
3. Costing of inventories
4. Motivation and performance appraisal
5. Cost awareness and cost reduction
6. Preparation of budgets
7. Preparation of cost report
8. Management by exception

Standard Costing procedures

1. Establish standards
2. Measure actual performance
3. Compare actual performance with standards
4. Take corrective action when needed
5. Revise standards when needed
Standard Variance Analysis
- one of the major purpose of using a standard cost system is to aid management
in controlling the costs of production. Standards enable management to make
periodic comparisons of actual results with standard result. Differences that arise
between actual results and planned results are called variances. Variance
analysis is a technique that can be used by management to measure
performance.

Variance = Actual cost (AC) – Standard Cost (SC)

Whereas,
AC > SC: Unfavourable (debit balance)
AC < SC: favourable (credit balance)

Direct Materials variance and Direct labor variance

Direct materials Variance

- Direct materials variances may be divided into (1) price variance and (2)
efficiency variance.

Actual materials cost Actual quantity (AQ) x Actual price (AP)

Minus Standard materials cost Standard quantity (SQ) X Standard price (SP)
Materials cost variance

Analysis:
Quantity variance: Q x SP = Difference in quantities X Standard price
Price variance: AQ X P = Actual quantity X Difference in prices

1. Materials price variance – the difference between actual price per unit of direct
materials purchased and standard price per unit of direct materials purchased
results in the direct materials price variance per unit, and if multiplied by the
actual quantity purchased, the result is the total direct material price variance.
This the preferred method of computing the direct material price variance
because the variances are recorded when purchases are made. If the problem
does not give the quantity purchased, then the quantity put into production may
be used. Most companies assign the responsibility for prior variances to the
purchasing department.
 2. Materials efficiency (usage) variance – the difference between actual quantity
of direct materials and standard quantity allowed multiplied by the standard price
per unit equals the direct material efficiency variance. Standard quantity allowed
is equal to the standard quantity of direct materials per unit multiplied by
equivalent production (FIFO method) or units completed during the period. As a
result of using the standard price per unit and not the actual price per unit, the
effect of price changes has been eliminated. The direct material efficiency
variance computed can be solely attributed to differences in the quantity of input
unaffected by purchasing department price efficiencies or inefficiencies. The
production department or cost center that controls the input of direct materials
into the production process is assigned the responsibility for this variance.

Direct Labor Variances

- Direct labor variances may be divided into (1) rate/price variance and (2)
efficiency variance.

Actual labor Cost Actual hours (AH) x Actual Rate (AR)

Minus Standard Labor cost Standard hours (SH) x Standard Rate (SR)
Labor cost variance

Analysis:
Efficiency variance: H x SR = Difference in hours x Standard rate
Rate variance: AH x R = Actual hours x Difference in rates

1. Direct labor rate (price) variance – the difference between the actual hourly wage
rate and the standard hourly wage results in the direct labor price variance per
hour, when multiplied by the actual direct labor hours worked, the outcome is the
total direct labor price variance. The actual number of direct labor hours worked
as opposed to the standard direct labor hours allowed is used because we are
analyzing the cost difference between the payroll that should have been incurred
and the actual payroll was incurred. Both payrolls are based on the actual
number of direct labor hours worked. The supervisor of the department or cost
center where the work is performed is held accountable for a direct labor price
variance.

2. Direct labor efficiency variance – the difference between the actual direct labor
hours worked and the standard direct labor hours allowed, multiplied by the
standard hourly wage rate, equals the direct labor efficiency variance. Standard
direct labor hours allowed is equal to the standard number of direct labor hours
 per unit multiplied by equivalent production or units completed during the period.
As a result of using the standard wage rate per direct labor hour, the effect of
price changes has been eliminated. The direct labor efficiency variance can be
soely attributed to worker’s efficiencies or inefficiencies. The supervisor of the
department or cost center in which the work is performed are accountable for
direct labor efficiency variances in that it is their responsibility to oversee
production and exercise right control over the number of direct labor hours
worked.

FACTORY OVERHEAD VARIANCE

Factory overhead control under standard costing is similar to the control of direct
materials and direct labor. To evaluate performance predetermined standard costs are
compared with actual costs incurred. The analysis of factory overhead requires more
detail than variance analysis for direct materials and direct labor. A volume variance
must be considered in addition to the price (rate for labor) and efficiency variances that
were computed when the direct cost were analysed. Different methods have been
developed over the years to compute factory overhead variances. Factory overhead
variances may be determined using the two-way analysis, three-way analysis, and four-
way analysis. Whatever method we use the amount of total factory overhead variance
will be the same. The total factory overhead variance is determined by getting the
difference between actual factory overhead and standard factory overhead applied to
production.

One - way variance analysis: Computation Legend:

FOH variance AFOH - SFOH AFOH: Actual FOH

Two – way variance analysis:

Controllable variance AFOH – BASH BASH: Budget Adjusted for Standard Hours
Volume variance BASH – SFOH BASH: Budgeted FFOH + (SH x Variable FOH rate)
FFOH: Fixed factory overhead

Three – way variance analysis:

Spending variance AFOH – BAAH BAAH: Budget Adjusted for Actual Hours
Efficiency variance BAAH - BASH BAAH: Budgeted FFOH + (AH x Variable FOH rate)
Volume variance AFOH – SFOH

Four – way variance analysis:

Variable Spending variance AFOH(V) – BAAH(V) AFOH (V): Actual Variable FOH
Fixed spending variance AFOH(F) – AFOH(F) AFOH (F): Actual FFOH
Efficiency variance (variable) BAAH - BASH BAAH (v): Actual hours x Variable FOH rate
Volume variance (fixed) AFOH – SFOH BAAH (F): Budgeted FFOH
Important notes on Materials and Labor variance analysis (Explain)
1. Material price variance is also known as: material spending variance, material
money variance, and material rate variance.
2. Material quantity variance is also known as: material usage variance and material
efficiency variance.
3. Material usage variance is a quantity variance while material price usage
variance is a price variance.
4. Labor rate variance is also known as: labor price variance, labor spending
variance, and labor money variance.
5. Labor efficiency variance is also known as : labor hours variance, labor usage
variance, and labor time variance.
6. Labor efficiency variance excludes idle time spent in production. If any, idle time
is separately explained through the Idle time variance, which is regarded as
unfavourable. IDLE TIME variance = Idle time x standard labor rate.

Important notes on Factory Overhead Variance analysis

1. Standard Factory Overhead (SFOH) = Standard Hours x Standard FOH rate.
Under standard costing, SFOH is like likewise referred to as the Applied Factory
Overhead.
2. If AFOH is more than SFOH (applied), then factory overhead is said to be under-
applied; hence , under application indicates unfavourable variance, while over
application indicates favourable variance.
3. The term capacity variance is also used to mean the volume variance.
4. Budget variance = Actual cost – Budgeted cost = Actual FOH – Budgeted FOH
 If BFOH is adjusted based on standard hours (BASH) , then budget
variance = controllable variance
 If BFOH is adjusted based on actual hours (BAAH), then budget variance
= spending variance
5. Volume variance is actually the fixed volume variance; there is no such thing as a
variable volume or variable capacity variance.
6. Under the 3-way approach, the FOH efficiency variance is actually the variable
efficiency variance. Other then ‘BAAH - BASH’, variable variance may also be
computed based on:
Change in hours x variable FOH rate = (AH – SH)VR
7. FOH variances may be classified into:
  Variable FOH variance = Variable spending variance + (variable)
efficiency variance
 Fixed FOH variance = Fixed spending variance + (fixed) volume variance
8. The manufacturing efficiency variance incorporates the effect of both FOH
efficiency variance and Labor efficiency variance. In some cases, the material
quantity variance may also be included.
9. DM Variance + DL variance + FOH variance = Production or manufacturing cost
variance.