Chapter 7

Standard costing and variance analysis

Outcome

By the end of this session you should be able to:

 explain why planned standard costs, prices and volumes are useful

 calculate variances for materials, labour, variable overheads, sales prices and
sales volumes

 prepare a statement that reconciles budgeted profit with actual profit calculated
using marginal costing

 explain why variances could have arisen and the inter-relationships between
variances

and answer questions relating to these areas.

The underpinning detail for this chapter in your Integrated Workbook can
be found in Chapter 7 of your Study Text

185
Chapter 7

Overview

Standard Types of
cost standards

STANDARD COSTING
Criticisms AND VARIANCE Interpretation
ANALYSIS

Variable
Sales Variances costs

Reconciliation

186
 Standard costing and variance analysis

Standard costing

1.1 What is standard costing?

A standard cost is a carefully pre-determined unit cost which is

prepared for each cost unit.

The standard becomes a target against which performance can be

measured.

The actual costs incurred are measured after the event and compared
to the pre-determined standards.

The difference between the standard and the actual is known as a

variance. Analysing variances can help managers focus on the areas
of the business requiring the most attention. This is known as
management by exception.

187
 Chapter 7

1.2 Standard cost card

Once standard costs for a product or service have been set, they are presented in a
standard cost card. A standard cost card for a product, showing the variable
elements of production cost per unit, might look like this:

Standard cost card: XX1

$
Direct materials: 10 kg @ $5 50
Direct labour: 12 hours @ $11 132
––––
Prime cost 182
Variable production overhead: 12 hours @ $9 108
––––
Variable production cost 290
––––
For each of the variable costs, the standard amount and the standard price are
given.

Direct material: standard quantity (10 kg) × standard price ($5 per kg)

Direct labour standard hours (12 hours) × standard rate ($11 per hour)

Variable production standard hours (12 hours) × standard rate ($9 per hour)
overheads

Note: The standard hours for labour and overheads are usually the same as we
normally assume that variable overheads are absorbed on the basis of labour hours.

These standard data provide the information for a detailed variance analysis, as long
as the actual data are collected at the same level of detail.

188
 Standard costing and variance analysis

1.3 Types of standard

There are four main types of standards:

 Ideal standard

– no allowance for inefficiencies such as losses or machine downtime

– almost always result in adverse variances

– can be demotivating for managers.

 Attainable standard

– assume efficient levels of operation, but which include allowances for

factors such as losses, waste and machine downtime

– adverse variances will reveal whether inefficiencies have exceeded this

unavoidable amount

– more acceptable to managers.

 Current standard

– based on current performance levels

– do not encourage any attempt to improve on current levels of efficiency.

 Basic standard

– set for the long term and remain unchanged over a period of years

– often retained as a minimum standard and can be used for long term
comparisons of performance.

189
 Chapter 7

1.4 Standard costing in the modern business environment

There has recently been some criticism of the appropriateness of standard costing in
the modern business environment:

 Standard costing was developed when business environments were more

stable. In the present dynamic environment, such stable conditions cannot be
assumed. If conditions are not stable, then it is difficult to set a standard cost
which can be used to control costs over a period of time.

 Attainment of standard used to be judged as satisfactory, but in today’s climate,

continuous improvement must be aimed for in order to remain competitive.

 The emphasis on labour variances is no longer appropriate with the increasing

use of automated production methods.

190
 Standard costing and variance analysis

Variances

2.1 Variance example

We will use the following example in all of the variance calculations.

Example 1
XYZ manufactures a single product. The standard cost card for one unit of the
product is given:
$
Direct material: 10 kg × $7 per kg 70
Direct labour: 40 hours × $10 per hour 400
Variable overhead: 40 hours × $3 per hour 120
——–
590
——–
For January, the company had budgeted to produce and sell 2,000 units, but
2,100 units were actually produced and sold and the actual costs incurred
were as follows:
Direct material: 22,500 kg purchased and used at a cost of $146,250
Direct labour: 83,000 hours worked at a cost of $845,000
Variable overhead: $248,200

191
 Chapter 7

2.2 Material variances

Direct material
price variance
Direct material total
variance
Direct material
usage variance

Direct material price variance

The direct material price variance reveals how much of the direct material total
variance was caused by paying a different price for the materials purchased.
$
22,500 kg purchased should have cost (× $7) 157,500
But did cost 146,250
———–
Direct material price variance $11,250 favourable
———–
Direct material usage variance

The direct material usage variance reveals how much of the direct material total
variance was caused by using a different quantity of material, compared with the
standard allowance for the production achieved.
kg
2,100 units produced should have used (× 10 kg) 21,000
But did use 22,500
——–—
Variance in kg 1,500 adverse
—–——
× standard price per kg ($7):
Direct material usage variance $10,500 adverse
——–—
Direct material total variance = $11,250 favourable + $10,500 adverse = $750
favourable

192
 Standard costing and variance analysis

Example 2
BGT budgeted to produce 3,000 units with the following standard cost for
materials:
$
Direct material: 5 litres × $0.60 per litre 3
During the year it produced 4,000 units and spent $11,440 on 20,800 litres of
material.

Calculate the material price and usage variances.

193
 Chapter 7

2.3 Labour variances

Direct labour rate

variance
Direct labour total
variance
Direct labour
efficiency variance

Direct labour rate variance

The direct labour rate variance reveals how much of the direct labour total variance
was caused by paying a different rate per hour for the labour hours worked.
$
83,000 hours should have cost (× $10) 830,000
But did cost 845,000
———–
Direct labour rate variance $15,000 adverse
———–
Direct labour efficiency variance

The direct labour efficiency variance reveals how much of the direct labour total
variance was caused by using a different number of hours of labour, compared with
the standard allowance for the production achieved.
hours
2,100 units produced should have used (× 40 hours) 84,000
But did use 83,000
——–—
Variance in hours 1,000 favourable
——–—
× standard rate per hour ($10):
Direct labour efficiency variance $10,000 favourable
——–—
Direct labour total variance = $15,000 adverse + $10,000 favourable = $5,000
adverse

194
 Standard costing and variance analysis

Example 3
BGT budgeted to produce 3,000 units with the following standard cost for
materials:
$
Direct labour 0.75 hours × $40 per hour 30
During the year it produced 4,000 units and spent $168,000 on 4,000 hours of
labour.

Calculate the labour rate and efficiency variances.

195
 Chapter 7

2.4 Variable overhead variances

Variable overhead
expenditure variance
Variable overhead
total variance
Variable overhead
efficiency variance

Variable overhead expenditure variance

The variable overhead expenditure variance reveals how much of the variable
overhead total variance was caused by paying a different hourly rate of overhead for
the hours worked.
$
83,000 hours should have cost (× $3) 249,000
But did cost 248,200
———–
Variable overhead expenditure variance $800 favourable
———–
Variable overhead efficiency variance

The variable overhead efficiency variance reveals how much of the variable
overhead total variance was caused by using a different number of hours of labour,
compared with the standard allowance for the production achieved. Its calculation is
very similar to the calculation of the labour efficiency variance.
Variance in hours (from labour efficiency) 1,000 favourable
———
× standard rate per hour ($3):
Variable overhead efficiency variance $3,000 favourable
———
Variable overhead total variance = $800 favourable + $3,000 favourable = $3,800
favourable.

196
 Standard costing and variance analysis

Example 4
BGT budgeted to produce 3,000 units with the following standard cost for
materials:
$
Variable overhead 0.75 hours × $8 per hour 6
During the year it produced 4,000 units and spent $31,200 on 4,000 hours of
variable overhead.
Calculate the variable overhead expenditure and efficiency variances.

Illustrations and further practice

Now attempt TYU 4

197
 Chapter 7

2.5 Sales variances

Sales
price variance
Sales
total variance
Sales volume
contribution variance

From our XYZ example, we can add some additional data:

Standard selling price was $650 per unit.

Actual sales revenue was $1,350,000

Sales price variance

The sales price variance reveals the difference in total revenue caused by charging a
different selling price from standard.
$
But did sell for 1,350,000
2,100 units should sell for (× $650) 1,365,000
——––—–
Sales price variance $15,000 adverse
——––—–

198
 Standard costing and variance analysis

Sales volume contribution variance

The sales volume contribution variance reveals the contribution difference which is
caused by selling a different quantity from that budgeted.
Actual sales volume 2,100
Budgeted sales volume 2,000
———
Variance in units 100 favourable
———
× standard rate contribution (650 – 590) 60
Sales volume contribution variance $6,000 favourable
———
Total sales variance = $15,000 adverse + $6,000 favourable = $9,000 adverse.

In all of the cost variance calculations we saw that the budgeted volume
was irrelevant. However, the budgeted sales volume is used in the
sales volume variance.

199
Chapter 7

Example 5
BGT budgeted to produce and sell 3,000 units at a selling price of $60 and
make a contribution of $21 per unit.

During the year it sold 4,000 units at a selling price of $55, with a contribution
of $18 per unit.

Calculate the sales price and volume variances.

Illustrations and further practice

Now attempt TYU 5, go over illustration 3 and attempt TYU 6

200
 Standard costing and variance analysis

Analysing variances

3.1 Reconciling actual contribution with budgeted contribution

A reconciliation statement, known as an operating statement, begins

with the original budgeted contribution. It then adds the favourable
variances and subtracts the adverse variances to arrive at the actual
contribution for the month.

Continuing with our XYZ example, we can produce the following operating statement.
$ $ $
Budgeted contribution (2,000 × $60) 120,000
Sales volume contribution variance 6,000 F
————
Standard contribution from actual sales
volume 126,000
Sales price variance 15,000 A
————
111,000
Cost variances: Fav Adv
Direct material price 11,250
Direct material usage 10,500
Direct labour rate 15,000
Direct labour efficiency 10,000
Variable overhead expenditure 800
Variable overhead efficiency 3,000
———— ————
Total cost variances 25,050 25,500 450 A
————
Actual contribution 110,550
–––––––

201
 Chapter 7

Check the actual contribution is correct:

$
Sales revenue 1,350,000
Direct material 146,250
Direct labour 845,000
Variable overheads 248,200
––––––––
Actual contribution 110,550
––––––––
In some questions you could be asked to reconcile budgeted profit to actual profit.

Budgeted profit + budgeted fixed overhead = budgeted contribution.

Actual contribution – actual fixed overhead = actual profit

202
 Standard costing and variance analysis

Example 6
An organisation had budgeted for contribution in October of $340,000 but
experienced an adverse labour rate variance of $20,000. The only other
variance was in fixed overheads, which showed a favourable expenditure
variance of $2,000 when compared to the budgeted fixed overhead cost of
$148,000.

What was the actual profit for October?

A $174,000

B $176,000

C $318,000

D $322,000

203
 Chapter 7

3.2 Interpreting variances

It is important to be able to interpret variances and to try to understand what could

have caused them.

Consider our variances for XYZ:

Variance Amount Reason

Direct material price $11,250 F  Standard price set too high

 Lower quality material used

 Unexpected discounts available

Direct material usage $10,500 A  Standard usage set too low

 Lower quality material used

 Less skilled workers

 Theft

204
 Standard costing and variance analysis

Variance Amount Reason

Direct labour rate $15,000 A  Standard rate set too low
 Higher pay rises
Direct labour efficiency $10,000 F  Standard hours set too high
 More skilled workers
 Higher grade of material
 More efficient working
Sales price $6,000 F  Higher quality product
 Higher selling price
Sales volume contribution $15,000 A  Quality control problems
 Competitors launching a better
product

3.3 The inter-relationships between variances

We can see from the XYZ example that one variance can be related to another.
Adverse variances in one area of the organisation may be inter-related with
favourable variances elsewhere, or vice versa. For example, if cheaper material is
purchased this may produce a favourable material price variance. However, if the
cheaper material is of lower quality and difficult to process, this could result in
adverse variances for material usage and labour efficiency.
There could also be an impact on the sales variances if the cheaper material affects
the overall quality of the final product. Sales volume could reduce resulting in an
adverse sales volume contribution variance, or the sales price may have to be
reduced which would result in an adverse sales price variance.

Illustrations and further practice

Now attempt TYU 9

205
Chapter 7

You should now be able to answer

 Questions 1–10 from Chapter 7 of the Study Text

 Questions 85–98 from the Exam Practice Kit:

 Knowledge check: Standard costing and variance analysis

For further reading, visit Chapter 7 of the Study Text.

206
 Standard costing and variance analysis

Answers

Example 1
XYZ manufactures a single product. The standard cost card for one unit of the
product is given:
$
Direct material: 10 kg × $7 per kg 70
Direct labour: 40 hours × $10 per hour 400
Variable overhead: 40 hours × $3 per hour 120
——–
590
——–
For January, the company had budgeted to produce and sell 2,000 units, but
2,100 units were actually produced and sold and the actual costs incurred
were as follows:
Direct material: 22,500 kg purchased and used at a cost of $146,250
Direct labour: 83,000 hours worked at a cost of $845,000
Variable overhead: $248,200

207
Chapter 7

Example 2
Solution
$
20,800 litres purchased should have cost (× $0.6) 12,480
But did cost 11,440
———–
Direct material price variance $1,040 favourable
———–
litres
4,000 units produced should have used (× 5 ltrs) 20,000
But did use 20,800
——–—
Variance in litres 800 adverse
—–——
× standard price per litre ($0.60):
Direct material usage variance $480 adverse
——–—
Calculating variances is a way of demonstrating your technical knowledge on
systems and processes. Variances allow you to evaluate an organisation’s
systems and process and can lead to you making recommendations for
improvement. This in turn will lead to positive behaviours in adding value to
the organisation as you help the organisation in rectifying problems identified
by the variance. Even when variances are favourable and not necessarily
indicative of a problem, you can create positive behaviours for examining
whether the cause of the variance can be replicated and the organisation can
seek continuous improvement in this way. These knowledge, skills and
behaviours apply to all of the variance examples that follow.

208
 Standard costing and variance analysis

Example 3
Solution
$
4,000 hours of labour should have cost (× $40) 160,000
But did cost 168,000
———–
Direct labour rate variance $8,000 adverse
———–
hours
4,000 units produced should have used (× 0.75 hrs) 3,000
But did use 4,000
——–—
Variance in hours 1,000 adverse
—–——
× standard price per hour ($40):
Direct labour efficiency variance $40,000 adverse
——–—

209
Chapter 7

Example 4
Solution
$
4,000 hours of overhead should have cost (× $8) 32,000
But did cost 31,200
———–
Variable overhead expenditure variance $800 favourable
———–
hours
4,000 units produced should have used (× 0.75 hrs) 3,000
But did use 4,000
——–—
Variance in hours 1,000 adverse
—–——
× standard price per hour ($8):
Variable overhead efficiency variance $8,000 adverse

210
 Standard costing and variance analysis

Example 5
Solution
$
4,000 units actually sold for (× $55) 220,000
4,000 units should sell for (× $60) 240,000
——––—–
Sales price variance $20,000 adverse
——––—–
Actual sales volume 4,000
Budgeted sales volume 3,000
———
Variance in units 1,000 favourable
———
× standard rate contribution $21
Sales volume contribution variance $21,000 favourable
——–—

211
Chapter 7

Example 6
Solution

A
$
Budgeted contribution 340,000
Labour rate variance 20,000 adverse
——––—–
Actual contribution 320,000
Actual fixed overheads
($148,000 – $2,000 favourable variance) (146,000)
——––—–
Actual profit $174,000
——––—–

212