standard costing & variance analysis...

Standard Costing & Variance Analysis

Ruwan Samarakoon (B.sc Finance, MBA,ACA,ACMA)

Cost Classification (Quick Recap)

Introduction

• Standard Costing- Standard costing is a control technique that reports variances by comparing actual costs to preset standards facilitating action through management by exception

-CIMA

Pre-set

Standards (Standard

cost)

Actual

Cost

Variance

Action ?

(Managem

ent by

exception

Standard Cost

Loaf of Bread

Direct Material cost

Wheat flour-0.450kg@ Rs 50 22.50

Direct Labor cost 0.1 hrs @ Rs 150 15.00

Prime Cost 37.50

Variable Production Overhead

0.1 hrs@ Rs 100 10.00

Fixed Production Overhead (5500/1100) 5.00

Production Cost 52.50

How much a firm should spend (Target cost) to

manufacture a good or service

Actual Cost

For the month of January

Actual production = 1,000 units

Rs.

Direct materials: 430 kgs purchased and used- 23,650

Direct labor: 110 hours - 17,600

Variable production overhead - 9,000

Fixed Production overhead - 5,200

Total cost 55,450

Budgeted Fixed Production overhead is 5500 and budgeted

production quantity is 1100 units.

Standard cost

• Standard cost is carefully predetermined unit cost which is prepared for each cost unit.

• These are target costs that should be incurred under efficient operating conditions

• These are not the same as budgeted costs. A budget relates to an entire activity or operation; but a standard cost is for a unit

• It contains details of the standard amount and price of each resource that will be utlised in manufacturing the product or providing service.

• Standard cost card- this contains the standard cost per unit. But now a days details are stored in computers

Question

The following data is given for the standard details of one unit of T.shirt. Prepare a standard cost card.

Direct materials: 2 square meters @Rs. 50/sq m

Direct wages :

• Production department-3 hours @ Rs. 100/hour

• Packing department- 0.5 hours @ Rs.80/hour

Budgeted costs and labor hours per annum

Rs hours

Variable production overhead

Production department 375,000 500,000

Packing department 150,000 300,000

Fixed production overhead 300,000

Fixed production overhead is absorbed based on labor hours

Types of cost standards

• The main purpose of standard costs it to provide a benchmark against which actual performance can be monitored

• How demanding the benchmark or standard should be? Should they represent ideal performance or should they represent easily attainable performance?

• Different types are,

1. Ideal standards

2. Attainable standards

3. Current standard

4. Basic cost standards

Ideal standard

• Ideal standard represent perfect performance.

• Ideal standard costs are the minimum costs that are possible under the most efficient operating conditions

• No allowance for inefficiencies such as losses, waste, machine downtime

• Ideal standard costs are difficult to achieve so that always it results adverse variance

• So it can be demotivating for individuals who feel that an adverse variance suggests that they have performed badly

Attainable standard

• Standards are set at efficient operation levels but include allowances for factors such as losses, waste and machine downtime.

• These standards are difficult, but not impossible to achieve

• They do not have a negative impact on motivation unlike ideal standards.

Current standard

• Standards are based on current performance levels (current wastage, current inefficiencies).

• The disadvantage is that they do not encourage any attempt to improve on current levels of efficiency.

Basic cost standards

• Basic cost standards represent constant standards that are left unchanged over long periods.

• The main advantage of basic standards is that a base is provided for a comparison with actual costs through a period of years with the same standard, and efficiency trends can be established over time.

• When changes occur in methods of production, price levels or other relevant factors, basic standards are not very useful, since they do not represent current target costs

Development of Standard Cost

Loaf of Bread




Prime Cost 37.50


0.1 hrs@ Rs 100 10.00



Direct

Material

Qty Price

Direct

Labor

Hours Rate

Manu’

OH

1.Budget the total

2.Divide as fixed & variable

3.Abosorption base

Standard Direct Materials Cost

• Direct materials price standard

• Careful estimate of the cost of a specific direct material in the next accounting period

• Developed by purchasing agent or purchasing department

• Takes into account

• All possible price increases

• Changes in available quantities

• New sources of supply

Direct Material

Standard Direct Materials Cost• Direct materials quantity standard

• Estimate of the amount of direct materials that will be used in the accounting period

• Includes scrap and waste

• Influenced by • Product engineering specifications• Quality of direct materials• Age and productivity of machinery• Quality and experience of work force

• Established and monitored by • Production managers• Management accountants• Others

• Engineers, purchasing agents, machine operators

Direct Material

Standard Direct Labor Cost

• Direct labor rate standard

• Hourly direct labor rate expected to prevail during the next accounting period

• For each function or job classification

• Average standard rate is developed for each task

• Standard rate is used even if worker is paid more or less than the standard rate

• Easy to establish

• Rates are set by labor unions or defined by the company

Direct Labor

Standard Direct Labor Cost (cont’d)

• Direct labor time standard

• Expected time required for each department, machine, or process to complete the production of one unit or one batch of output

• Developed using

• Current time and motion studies of workers and machines

• Records of past performance

• Should be revised when

• Machinery is replaced

• Quality of work force changes

Direct Labor

Standard Manufacturing Overhead Cost

• Budget the total manufacturing OH for the period (Ex. Factory rent, electricity, Salaries of supervisors & production manager, factory insurance,etc)

• Divide the manufacturing OH into two

�Variable manufacturing OH

�Fixed manufacturing OH

( Techniques; High-low method, Regression,etc)

• Select an absorption base for each to compute unit cost such as labor hours, machine hours, units produced,etc. Take the normal capacity for these.

Manu’OH

Standard Manufacturing Overhead Cost

• Standard variable overhead rate

• Computed by dividing the total budgeted variable overhead costs by an expression of capacity, such as number of standard direct labor hours or standard machine hours

Manu’OHStandard Manufacturing Overhead Cost (cont’d)

• Standard fixed overhead rate

• Computed by dividing the total budgeted fixed overhead costs by an expression of capacity, usually normal capacity in terms of standard hours or units

• Denominator expressed in same terms as the variable overhead rate

Normal capacity is the level of

operating capacity needed to

meet expected sales demand

Its use ensures that all fixed OH costs have

been applied to units produced by the time

normal capacity is reached

Manu’OH

Standard costing in the modern business environment

Is standard cost appropriate for modern business environment ?

• Standard costing was developed when the business environment was more stable and operating conditions were less prone to change. But now we have dynamic environment. If conditions are not stable it is difficult to set a standard cost which can be used to control over period of time

Cont’d

• In past, if the standard costs are achieved that is a satisfactory performance. But today it needs to have constant improvement in order to remain competitive.

• The emphasis on labor variances is no longer appropriate with the increasing use of automated production methods.

Variance Analysis

• Variance is the difference between standard cost or the target cost and the actual cost incurred.

• Since the standard cost include both usage of resources and price per resource the variance can also broken down to variance from price changes and variance from the changes in usage

Direct Material Cost V

Direct Labor Cost V

Variable MOH Cost V

Fixed MOH Cost V

DM Price V

DM Qty V

DL Rate V

DL efficiency V

VMOH efficiency V

VMOH expenditure V

FMOH expenditure V

FMOH Volume V

Total

Manufacturing

Cost V

(Standard

Manufacturing

Cost- Actual

manufacturing

Cost)

Example

Standard cost of Loaf of Bread




Prime Cost 37.50


0.1 hrs@ Rs 100 10.00



Firm has estimated a total production overhead cost of Rs.16,500 for

the next month (January). Out of this fixed production OH is

identified as Rs. 5500 and the balance is variable component.

Budgeted production quantity is 1100 units and budgeted labor

hours are 110. FPOH are absorbed based on number of units while

VPOH are absorbed on labor hours

Actual Cost

For the month of January

Actual production = 1,000 units

Rs.

Direct materials: 430 kgs purchased and used- 23,650

Direct labor: 110 hours - 17,600

Variable production overhead - 9,000

Fixed Production overhead - 5,200

Total cost 55,450

Example Cont’d

Total Cost Variance

Total Standard Manufacturing Cost xxxx

Total Actual Manufacturing Cost xxxx

Total Cost Variance xxxx

Favorable (F) Or Adverse (A)

Computing Direct Materials Variances

• Total direct materials cost variance

• Difference between the standard cost and actual cost of direct materials

Standard Material cost xxxx

Actual Material cost xxxx

Total direct materials cost variance xxxx

Direct Material Cost V

Computing Direct Materials Variances (cont’d)

• Total direct materials cost variance must be broken into two parts to find the cause of the variance

• Direct materials price variance

• Direct materials quantity variance


• Direct materials price variance• Difference between the standard price and the actual

price per unit multiplied by the actual quantity purchased

• Also called the direct materials spending or rate variance

DM Price V


• Direct materials quantity variance• Difference between the standard quantity and the

actual quantity used multiplied by the standard price

• Also called the direct materials efficiency or usage variance

DM Qty V


• Test calculations of variances

• If correct, the net of the direct materials price variance and direct materials quantity variance will equal the total direct materials cost variance

Reasons for Material variances

Variance Favorable Adverse

Materials

price

Standard price set too high Standard price set too low

Unexpected discounts available Unexpected general price

increase

Lower quality materials used Higher quality materials

used

Careful purchasing Careless purchasing

Gaining bulk discounts by buying

larger quantities

Loosing bulk discounts by

buying smaller quantities

Materials

usage

Standard usage set too high Standard usage set too low

Higher quality materials used lower quality materials

used

A higher grade of worker used A lower grade of worker

used

Stricter quality control Theft

Computing Direct Labor Variances

• Total direct labor cost variance

• Difference between the standard direct labor cost for actual units produced and actual direct labor costs.

Standard Direct Labor cost xxxx

Actual Direct Labor cost xxxx

Total direct Labor cost variance xxxx

Direct Labor Cost V

Computing Direct Labor Variances (cont’d)

• Total direct labor cost variance must be broken onto two parts to find the cause of the variance

• Direct labor rate variance

• Direct labor efficiency variance


• Direct labor rate variance

• Difference between the standard direct labor rate and the actual direct labor rate multiplied by the actual direct labor hours worked

• Also called the direct labor spending variance

DL Rate V


• Direct labor efficiency variance• Difference between the standard direct labor hours

allowed for good units produced and the actual direct labor hours worked multiplied by the standard direct labor rate

• Also called the direct labor quantity or usage variance

DL efficiency V



• If correct, the net of the direct labor rate variance and direct labor efficiency variance will equal the total direct labor cost variance

Reasons for DL variancesVariance Favorable Adverse

Labor rate Standard rate set too high Standard rate set too

low

A lower grade of worker

used

A higher grade of

worker used

Increasing labor rates

due to union actions

Labor

efficiency

Standard hours set too

high

Standard hours set too

low

A higher grade of worker A lower grade of

worker

Higher grade of material

was quicker to process

lower grade of

material was slower to

process

Improved motivation Poor motivation

Computing and Analyzing Manufacturing Overhead Variances

• Controlling variable and fixed overhead costs is more difficult for managers than controlling direct materials and direct labor costs

• Responsibility for manufacturing overhead costs is hard to assign

• Fixed overhead costs

• Unavoidable past costs

• Not under the control of any department manager

• Variable overhead costs

• Some control possible if they can be related to departments or activities

Variable Overhead Variance

• Total variable overhead variance

• Difference between actual variable overhead costs and the standard variable overhead costs that are applied to good units produced using the standard variable rate

Standard Variable Manuf’ OH cost xxxx

Actual Variable Manuf’ OH cost xxxx

Total Manuf’VOH cost variance xxxx

Variable MOH Cost V

Variable Overhead Variances (cont’d)

• Total variable overhead cost variance must be broken into two parts to find the cause of the variance

• Variable overhead Expenditure variance

• Variable overhead efficiency variance


• Variable overhead expenditure variance

• Difference between the standard variable overhead costs at actual hours and actual variable overhead

V.O.A.R= Variable OH Absorption Rate

VMOH expenditure V


• Variable overhead efficiency variance

• Difference between the standard direct labor hours allowed for good units produced and the actual hours worked multiplied by the standard variable overhead rate

VMOH efficiency V



• If correct, the net of the variable overhead expenditure variance and variable overhead efficiency variance will equal the total variable overhead cost variance

Fixed Overhead Variance

• Total Fixed overhead variance

• Difference between actual fixed overhead costs and the standard fixed overhead costs that are applied to good units produced using the standard rate

Standard Fixed Manuf’ OH cost xxxx

Actual Fixed Manuf’ OH cost xxxx

Total Manuf’ FOH cost variance xxxx

Fixed MOH Cost V

Fixed Overhead Variances (cont’d)

• Total fixed overhead cost variance must be broken into two parts to find the cause of the variance

• Fixed overhead expenditure variance

• Fixed overhead volume variance

Fixed Overhead Variances (cont’d)• Fixed overhead expenditure variance

• Difference between the budgeted and actual fixed overhead costs

• Also called budgeted fixed overhead variance

FMOH expenditure V


• Fixed overhead volume variance

• Difference between budgeted fixed overhead costs and manufacturing overhead costs applied to production using the standard fixed overhead rate

FMOH Volume V


• A volume variance will occur if more or less than normal capacity is used

• Fixed overhead volume variance measures the use of existing facilities and capacity

• Favorable overhead volume variance

• Capacity exceeds the expected amount

• Unfavorable overhead volume variance

• Company operates at a level below normal capacity

• May be in best interest of company during periods of slow sales

• Means company is not building up excess inventory



• If correct, the net of the Fixed overhead expenditure variance and Fixed overhead volume variance will equal the total fixed overhead cost variance

Reasons for OH variances

Variance Favorable Adverse

Variable overhead

expenditure

Standard hourly rate

set too high

Standard hourly rate set too low

Variations in rate or consumption of indirect materials,

indirect labor and indirect other costs

Variable overhead

efficiency variance

See labor hours efficiency variance

Fixed overhead

expenditure variance

Setting the budgeted

fixed oH too low

Setting the budgeted fixed oH too

high

Fixed overhead

volume variance

Using above the

normal capacity

Using below the normal capacity

Summary of Total Cost variance

• DM price V 2,150 A

• DM Qty V 1,000 F 1,150 A

• DL Rate V 1,100 A

• DL Efficiency V 1,500 A 2,600 A

• VOH expenditure V 2,000 F

• VOH efficiency V 1,000 A 1,000 F

• Fixed OH expenditure V 300 F

• Fixed OH volume V 500 A 200 A

Total Cost Variance 2,950 A

Advantages of Standard Costing

1. Accurate standards are helpful in setting the budgets.

2. Standard cost acts as a measurement to compare with the actual cost

3. Standard setting process is helpful in identifying new production techniques, alternative materials, etc

4. Costs can be controlled by setting efficiency levels for employees.

5. The management approach of “Management by exception” can be used.

6. It is convenient to prepare Cost accounts using standard costs.

7. Production planning can be done using the set standard time.

Disadvantages of Standard Costing

• Standard setting and updating process is a time and resource consuming work.

• When the prices and labor rates are changed frequently it is difficult control costs

• Empirical researches found that most of the managers are reluctant to apply standard cost controlling process due to the poor understanding of variances. There fore a proper controlling environment cannot be established within the organization.

Standard Costing vs. budgeting

• Both are used for the controlling purposes.

• However there is a significant difference between the two.

• Standard costing is used to control the cost of a unit (unit of product/service/ individual process).

• However the budgeting considers the controlling of overall costs.

• Cost controlling is done for an entire division, function or company as a whole. Responsibility of controlling is assigned to individuals or departments.

Standard Costing vs. budgeting cont’d

• Under the standard cost controlling, budgets are prepared based on the information available in the standard cost cards. Also budget information (ex: OH) is need to prepare a standard costs card. Thus it might be difficult to have standard cost controlling without having the budgets.

• However the budgetary control can be done even without having the standard costs. For example Incremental budgets can be prepared without the standards.

Practicing Question

• A company manufactures a single product for which the standard cost is as follows

Rs. Per unit

Direct materials: 81 kgs@ Rs. 7 per Kg 567

Direct labor: 97 hours@ Rs.8 per hour 776

Variable overhead: 97 hours @ Rs. 3 per

hour

291

Fixed overhead : 97 hours @ Rs 1 per hour 97

1634

Practicing Question cont’d

During January, 530 units were produced and the costs incurred were as follows.

• Direct material: 42845 kgs purchased and used; cost Rs 308,484

• Direct labor: 51380 hours worked; cost 400,764

• Variable overhead: Cost 156,709

• Fixed overhead: Cost 52,000

• Budgeted Fixed production OH cost is Rs 54029 and budgeted production quantity is 557 units.

Calculate all cost variances

standard costing & variance analysis...

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