STANDARD COSTING

Chapter 12
 Learning Objectives
 Define standards and discuss how they are developed
 Explain the difference between actual, normal, and standard costing
 Understand the uses of standard costing
 Explain the establishment of direct merials standards, direct labor
standards and factory overhead standards
 Compute the direct materials price variance and the direct materials
usage variance
 Compute the direct labor rate variance and the labor efficiency
variance
 Compute factory overhead variance using the one, two, three and
four way variances
• 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
(job order costing) or departments (process costing).
• 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.
 Normal Costing
• Under 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, etc.)
multiplied by a predetermined factory overhead
application rate.
 Standard Costing and Standard Costs
• Under standard costing, all costs attached to products
are based on standard or predetermined accounts.
• Standard costs represent the “planned” costs of a
production and are generally established well before
production begins.
• The establishment of standards thus provide
management with goals to attain (i.e - planning) and
bases for comparison with actual results (i.e - control).
• Standard costing is concerned with cost per unit and
serves basically the same purpose as budget.
• Budgets, however, quantify management expectations in
terms of total costs rather than in terms of per unit costs.
• Standard costs do not replace actual costs in a costing
accumulation system. Instead, standard costs and actual
costs are both accumulated.
• Standard costs are also known as planned costs,
scheduled costs, and specification costs.
• Estimated costs are different from standard costs
because estimated costs have historically been used as
projections of what per unit costs will be for a period,
while standard costs are what a unit cost of production
should be.
• The purpose of standard costing is to control costs and
promote efficiency. This system is not a third cost
accounting method, but it is used with either job order or
process costing to manufacture a product and the
subsequent comparison of the actual costs with the
established standard.
Fig. 12-1 Comparison of Actual, Normal, And Standard Costing

Actual Costing Normal Costing Standard Costing

Cost of product
Direct materials Actual Actual Standard
Direct labor Actual Actual Standard
Factory
Actual Applied Standard
Overhead
• Standard costs are usually determined for a period of one
year and are revised annually. However, if cost analyses
during the year indicate that a standard is incorrect, or if a
significant change has occured in costs or other related
factors management should not hesitate to adjust the
standard accordingly.
 USES OF STANDARD COSTS
1. Cost control
2. Pricing decisions
3. Performance appraisal
4. Cost awareness
5. Management by objectives (MBO)
 1. Cost Control
• Cost control refers to identifying a cost with its related
benefits and making sure that the cost is justified given
the benefits derived. Standard costs provide a very useful
tool for cost control.
• Actual costs can be compared with standard costs as
frequently as necessary. With time performance,
reporting, management can take action quickly to control
problems as they arise. Unnecessary high costs could go
undetected without standard costs.
 2. Pricing Decisions
• Prices are established by business firms to cover the cost
of a product and at the same time provide for profit.
• While actual costs reflect accurately the costs involved in
producing goods or services, they do not always provide
consistent and timely information for pricing. Standard
costs provide a measure of consistency by eliminating
fluctuations in actual costs, such as seasonal costs for
some raw materials or random fluctuations such as
unexpected cost changes in world markets.
 3. Performance Appraisal
• When standards are established for performance
appraisal, they provide measurements that can be
applied uniformly to all personnel being evaluated.
• Standards provide one of the few objective means of
performance evaluation. For the standards to work well,
they must be understood by the people being evaluated.
The employee should also know how the standards are
used in employee evaluation and reward system.
 4. Cost Awareness
• The primary concern of many managers are usually
increasing production, improving product quality, and
reducing absenteeism. Although these are important
goals, each has specific cost consequences which
managers may not be aware of.
• Standard cost performance reports inform managers of
the cost implications of these actions and as a result
make them take steps to effectively control costs.
 5. Management By Objectives (MBO)
• Management by objective means that specific objectives
are established for each business activity and the
manager responsible for that activity works to avhieve the
objectives.
• A standard cost system facilitates MBO because it
provuides a quick reference for identifying and reporting
differences between standard and actual peformance.
 ESTABLISHMENT OF STANDARDS
• DIRECT MATERIALS STANDARD
1. Direct materials price standards
2. Direct materials usage (efficiency) standards
• DIRECT LABOR STANDARDS
1. Direct labor price standards
2. Direct labor efficiency standards
• FACTORY OVERHEAD STANDARDS
 DIRECT MATERIALS STANDARDS
1. Direct materials price standards
Price standards are the unit price at which direct
materials should be purchased.
The sales forecast is of utmost importance because it will
first determine the total units of finished goods that will have
to be produced and then determine the total quantity of
direct materials that will have to be purchased during the
next period.
The cost accounting department and/or the purchase
department are normally responsible for setting the direct
material price standards since they have ready access to
price data and should have knowledge of market conditions
and other relevant factors.
The purchasing department is responible for canvassing
suppliers to determine which supplier will give the best
price at the desired quality level and within the costraint of
delivery and other requirements.
2. Direct materials usage (efficiency) standards
Efficiency (quantity or usage) standards are predetermined
specifications of the quantity of direct materials that should
go into the production of one finished unit.

The engineering department, because it designs the

production process is in the best position to set realistically
attainable material standards.
 DIRECT LABOR STANDARDS
1. Direct labor price standards
Price (rate) standards are predetermined rates for a period.

The standard rate of pay that an individual will receive is

usually based on the type of job being performed and the
experience that the person has had on the job.
Items like vacation pay and sick pay are usually not
included in the standard rate of pay because they are
normally accounted for as part of factory overhead.
2. Direct labor efficiency standards
Efficiency standards are predetermined performance
standards for the amount of direct labor hours that should
go into the production of one finished unit.

Time and motion studies are helpful in developing direct

labor efficiency standards.
Studies have shown that the average time (hours) required
to complete one unit will decrease at a constant percentage
rate from the first job or unit, until complete processing had
taken place.

The effect of the learning process on workers may be

visually shown in what is technically called the learning
curve.
Time and motion engineers are usually given the
responsibility for setting direct labor efficiency standards.

The engineers should have a thorough kn rowledge of the

production process to complement their knowledge of the
techniques of time and motion studies.
 FACTORY OVERHEAD STANDARDS
When preparing factory overhead cost for the next period,
assumption must also be made about changes in costs as
a reslult of inflation, technology advances, and policy
decisionsregarding production standards or objectives.

Budgets are commonly used in controlling factory overhead

costs.
Actual factory overhead costs are later compared with those
budgeted as a means of evaluating managerial performance.
Budgets may either be static or flexible.

Static budgets show anticipated costs at one level of activity only

Flexible budgets show anticipated costs at different activity levels.
This preparation of flexible budgets eliminate the problems
associated with static budgets in terms of fluctuations in productive
activity.
 Variance Analysis
• is a technique that can be used by management to
measure performance, correct inefficiencies, and deal
with the "accountability function".
• Cost center managers report to the production supervisor
who delegated authority to them.
• Before accountability can be required of managers,
responsibility for costs must be clearly defined.
• Responsibility for costs should be assigned only to the
department or cost center having the authority to incur the
cost.
• When authority is delegated by upper level management
to middle or lower level managers, they will be held
accountable for their performance.
Upper level management
(delegates)
Authority
(assigns)
Responsibility
(requires)
Accountability
 Direct Materials Variances
(Direct Materials Variances may divided into Price Variance and Efficiency (usage) Variance)

• Direct material price variance

• Direct material efficiency (usage) variance

 Direct material 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 is 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 out into production may be used.
 Direct material efficiency (usage) variance
• the difference between actual variance 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 of
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 Rate/price variance and efficiency variance)

• Direct labor rate (price) variance

• Direct labor efficiency variance

 Direct labor rate (price) variance
• the difference between the actual hourly wage rate and
the standard hourly rate 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.
• 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.
 Direct labor efficiency variance
• the differences 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 (fifo) 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 solely
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.
 Factory Overhead Variance
• Factory overhead control under the 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 the
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 (materials and labor) were analyzed.
Methods used to determined Factory Overhead
Variance
One - factor analysis

• - the difference between the actual factory overhead and standard

factory overhead applied to production equals the one - factory
analysis variance.
• - standard factory overhead is applied to production by multiplying
tbe standard hours by the standard factory overhead application
rate.
• - the one - factor analysis technique is limited in its usefulness.
 Two - factor analysis
1. Controllable (budget) variance
• the difference between actual factory overhead and
budgeted overhead on the basis of standard direct labor
hours allowed equals the controllable (budget) variance.
• a variance will occur if a company actually spends more
or less on factory overhead than expected and/or uses
more or less than the number of direct labor hours
allowed.
2. Production volume (idle capacity) variance

• the difference between budgeted overhead on the basis of

standard direct labor hours allowed and standard factory
overhead applied to production.
• it may be computed also by getting the difference between the
denominator activity level (usually normal capacity) used to
determine the fixed factory overhead application rate and
standard direct labor hours allowed then multiply the difference by
the standard fixed factory overhead application rate.
• a production volume variance only relates to fixed factory
overhead
 Three - factory analysis
1. Spending variance

2. Efficiency Variance

3. Production (volume) variance

 1. Spending variance

• the difference actual factory overhead and budgeted factory

overhead on the basis of actual direct labor hours worked equals
the price (spending) variance.
• the price variance is also known as the spending variance
• a factory overhead spending variance is usually not controllable
by management it is results from external forces (examples
MERALCO increasing its rates); however, it is controllable in the
variance is the result of internal factors (examples, changes in
operating conditions)
 2. Efficiency Variance
• the difference between actual labor hours worked and
standard direct labor hours allowed multiplied by the
standard variable factory overhead application rate
equals the efficiency variance.
• a variance will occur of workers are more or less efficient
than planned.
 3. Production (volume) variance
• same as the volume variance computed under the two -
factor analysis.
• this variance is also known as the denominator variance
is the result of production of an activity level different from
that used as denominator to calculate the fixed factory
overhead application rate.
• Volume variance is also called the idle capacity variance.
 Four Factor Analysis

1. Variable overhead spending variance

2. Variable overhead efficiency variance
3. Fixed overhead spending variance
4. Volume variance
 1. Variable overhead spending variance
• the difference between variable overhead and budgeted variable
overhead on actual hours is the variable overhead spending
variance.
• the variable overhead spending variance is caused by both price
and volume differences
• variable overhead spending variances associated with Price
difference can occur
• variable overhead spending variance associated with volume
differences can be caused by waste or shrinkage of production
inputs such as indirect materials.
 2. Variable overhead efficiency variance

• the difference between budgeted variable overhead for

actual hours and applied variable overhead is the variable
efficiency variance.
• this variance quantifies the effect of using more or less of
the activity which is used as the base for the applied
variable overhead.
 3. Fixed overhead spending variance

• the difference between actual fixed factory overhead and

the budgeted fixed overhead is the fixed overhead
spending variance. This amount normally represents the
differences between budgeted and actual costs for the
numerous fixed factory overhead components
 4. Volume variance
• - this is just the same as the volume variance computed
under the two-factor and three-factor analysis.
 TYPES OF VARIANCES
(A variance cost exists when standard costs differ from actual
costs.)
A. MATERIALS
1. Material Price Variance
2. Material Quantity Variance

B. LABOR
1. Labor Rate Variance
2. Labor Efficiency Variance
C. FACTORY OVERHEAD
1. Two-Variance method
a. Controllable Variance
b. Volume Variance
2. Three-Variance method
a. Spending Variance
b. Idle Capacity Variance
c. Efficiency Variance
3. Four-variance method
a. Spending Variance
b. Efficiency Variance
c. Fixed Efficiency Variance
d. Idle Capacity Variance
 COMPUTING VARIANCES
I. MATERIAL VARIANCES
A price variance and a usage variance are isolated for
materials because a purchasing agent may be responsible
for the price variance and a production manager for the
usage variance.
A. MATERIAL 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 when multiplied by the actual quantity
purchased, the outcome is the total direct material price
variance.
 (1) (2) (3)
(AQ x AP) (AQ x SP) (SQ x SP)

Price variance Efficiency variance

(1) minus (2) (2) minus (3)

TOTAL VARIANCE
 A. MATERIAL PRICE VARIANCE
The materials price variance is caused by paying a higher or lower
price than the standard price for materials.
Formula
1. Material price variance=Actual quantity x (actual price less
standard price)
2. Actual quantity x Actual price xxxx
Actual quantity x Standard price xxxx
Materials price variance xxxx
3. Actual price xxxx
Less: Standard price xxxx
Difference in price xxxx
x Actual quantity xxxx
 B. MATERIALS USAGE VARIANCE
The materials usage variance is caused by using more or less than
the standard amount of materials to produce a product.
Formula
1. Materials usage variance=Standard price x (Actual
quantity less standard quantity)

2. Actual quantity x Standard price xxxx

Standard quantity x standard price xxxx
Materials usage variance xxxx
3. Actual quantity xxxx
Less: Standard quantity xxxx
Difference in quantity xxxx
x Standard price xxxx
Materials usage variance xxxx
AQ = Actual Quantity
AP = Actual Price
SQ = Standard Quantity
SP = Standard Price
 The possible causes of material price variance are as follows:

1. Fluctuations in market prices of materials

2. Purchasing from distant suppliers resulting in additional
transportation costs
3. Failure to avail of cash discounts
4. Purchasing materials of inferior quality
 The possible causes of material quantity variance

1. Loss of materials due to poor handling

2. Use of defective or substandard materials
3. Lack of proper tools or machines
4. Spoilage or waste due to use of inferior quality materials
II. LABOR VARIANCES
Labor rate and labor efficiency variances relate to the
same period because, unlike materials, labor services
cannot be purchased in one period, stored, and then used
in the next period.
 (1) (2) (3)
(AH x AR) (AH x SR) (SH x SR)

Labor Rate Labor Efficiency

(1) minus (2) (2) minus (3)

TOTAL VARIANCE
 A. LABOR RATE VARIANCE
The labor rate variance is caused by paying a higher or lower rate of
pay than standard to produce a product or complete a process.
Formula
1. Labor rate variance=Actual hours (actual rate less rate)

2. Actual hours x Actual rate xxxx

Actual hours x Standard rate xxxx
Labor rate variance xxxx
3. Actual rate xxxx
Less: Standard rate xxxx
Difference in rate xxxx
x Actual hours xxxx
Labor rate variance xxxx
 B. LABOR EFFICIENCY VARIANCE
The labor efficiency variance is caused by using more or less than
the standard amount of labor hours to produce a product or
complete a process.
Formula
1. Labor efficiency variance = Standard rate x (Actual hours
less Standard hours)

2. Actual hours x Standard rate xxxx

Standard hours x Standard rate xxxx
Labor efficiency variance xxxx
3. Actual hours xxxx
Less: Standard hours xxxx
Difference in hours xxxx
x Standard rate xxxx
Labor efficiency variance xxxx

AH = Actual Hours
AR = Actual Rate
SH = Standard Hours
SR = Standard Rate
 The possible causes of labor variance
1. Hiring of inexperienced workers
2. Change in labor rate
3. Hiring of workers with pay higher than that assumed
when then standard for a job was set.
 The possible causes of labor efficiency
variance
1. Lack of training for workers
2. Poor scheduling of work
3. Lack of supervision
4. Faulty equipment
 III. OVERHEAD VARIANCES
A. ONE-FACTOR METHOD
(1) (2)
Actual Factory Applied FO
Overhead SH x FO rate

TOTAL OVERHEAD VARIANCE

Formula
Actual factory overhead xxxx
Less: Standard hours x Standard FO rate xxxx
Total factory overhead variance xxxx
 Combined Manufacturing Overhead (Variable and Fixed)
Variance Analysis
A. If the company is using a flexible budget, the total
overhead variance may be analuzed using (a) Two-
Variance method (b) Three-Variance method and (c) Four-
Variance method
 A. TWO-VARIANCE METHOD

(1) (2)
Budget allowed on (3)
Actual Factory
Standard Hours SH x FO rate
Overhead

Controllable variance Volume variance

(1) minus (2) (2) minus (3)

TOTAL OVERHEAD VARIANCE

Formulas
1. Controllable (Budget) Variance
Actual factor overhead xxxx
Less: Budget allowance based on std. hrs Fixed
overhead xxxx
Variable (std. Hours x Variable rate) xxxx xxxx
Controllable Variance xxxx
2. Volume (Capacity or Production)

Budget allowance based on std. hrs. xxxx

Less: Std. hrs. x Std. OH rate xxxx
Volume variance xxxx
Denominator direct labor hours
(used in computing Fixed OH rate) xxxx
Less: Standard direct lanor hours allowed xxxx
Difference in number of hours xxxx
X Standard fixed factory overhead application rate xxxx
Production volume (volume variance) xxxx
 B. THREE-VARIANCE METHOD

(2) (3)
(1) (4)
Budget allowed Budget allowed
Actual Factory SH x FO rate
on actual hours on standard hours

Variable Efficiency
Spending variance Volume variance
Variance
(1) minus (2) (3) minus (4)
(2) minus (3)

TOTAL OVERHEAD VARIANCE

Formulas
1. Spending variance
Actual factory overhead xxxx
Less: Budget allowance based on actual hrs.
Fixed overhead xxxx
Variable (actual hrs. x variable rate) xxxx xxxx
Spending variance xxxx
2. Variable efficiency variance
Budget allowance based on actual hours xxxx
Less: Budget allowance based on std. hours xxxx
Variable efficiency variance xxxx

3. Volume variance
Budget allowance bsed on std. hours xxxx
Less: Std. hrs. x factory overhead rate xxxx
Volume variance xxxx
 C. FOUR-VARIANCE METHOD
A. VARIABLE OVERHEAD VARIANCE
(1) (2) (3)
Actual Variance AH x Variable rate SH x Variable rate

Variable Spending Variable Overhead Efficiency

(1) minus (2) (2) minus (3)

TOTAL VARIABLE OVERHEAD VARIANCE

Formulas
1. Actual variable factory overhead xxxx
Less: Actual hours x variable overhead rate xxxx
Variable spending variance xxxx

2. Actual hours x variable overhead rate xxxx

Less: Standard hours x variable overhead rate xxxx
Variable efficiency variance xxxx
 The possible causes of variable overhead
efficiency variance
Efficiency is using the bases on which variable overhead
is applied. If the base used in applying variable overhead is
direct labor hours, then the cause of the labor efficiency
variance will also be the cause of the variable overhead
efficiency variance.
B. FIXED OVERHEAD VARIANCE
(2)
(1) Budgeted Fixed at (3)
Actual Fixed Normal Capacity SH x Fixed Rate

Fixed spending variance Volume variance

(1) minus (2) (2) minus (3)

TOTAL FIXED OVERHEAD VARIANCE

Formulas:
1. Actual fixed overhead xxxx
Less: Budgeted fixed overhead at xxxx
normal capacity
Fixed spending variance xxxx

2. Budgeted fixed overhead at normal capacity xxxx

Less: Standard hours x fixed overhead rate xxxx
Volume variance xxxx
 Possible causes of volume variance
1. Poor production scheduling
2. Unusual machine breakdown
3. Shortage of skilled workers
4. Decrease in demand from customers
5. Unused plant capacity
• For all efficiency variances, an alternative computation
may be made as follows:

Actual hours xxxx

Less: Standard hours allowed xxxx
Difference in number of hours xxxx
 The difference in hours will be multiplied by the labor rate
if the requirement is direct labor efficiency.
 If the requirement is variable overhead efficiency, then
the differnce in number of hours will be multiplied by the
variable overhead rate.
 If the requirement is fixed overhead efficiency, then the
difference in number of hours will be multiplied by the
fixed overhead rate.
 ILLUSTRATIVE PROBLEM
Last month, the following events took place at Shangrila
Company:
a. Produced 50,000 plastic microcomputer cases
b. Standard variable costs per unit (per case)
Direct materials; 2 pounds at ₱1.00 ₱2.00
Direct labor; 10 hours at ₱15 1.50
Variable manufacturing overhead; 0.50
10 hrs at ₱5
c. Fixed manufacturing overhead cost
Monthly budget - for 40,000 cases or 4,000
standard hours ₱80,000
d. Actual production costs
Direct materials purchased 200,000 lbs. at ₱1.20 240,000
Direct materials used -110,000 lbs. at ₱1.20 132,000
Direct labor - 6,000 hours at ₱14 84,000
Total factory overhead 111,000
Fixed factory overhead 75,000
Requirements:
1. Compute the materials, labor and overhead variances
2. Journal entries to record the given information