Standard Costing System

How do managers control the prices that are paid for inputs and the quantities that are
used? They could examine every transaction in detail, but this obviously would be an inefficient
use of management time. For many companies, the answer to this control problem lies at least
partially in standard costing system.

A standard cost refers to the cost that management believes should be incurred to produce a
good or service under anticipated conditions. Standard costing is a technique which establishes
predetermined estimates of the costs of products and services and then compares these
predetermined costs with actual costs as they are incurred. The predetermined costs are known
as standard costs and the difference between the standard cost and the actual cost is known as a
variance. The process by which the total difference between actual cost and standard cost is
broken down into different elements known as variance analysis.

Setting Standard Costs

Setting price and quantity standards requires the combined expertise of all persons who have
responsibility over input prices and over effective use of inputs. In a manufacturing firm, this
might include accountants, purchasing managers, engineers, production supervisors, line
mangers, and production workers. Past records of purchase prices and input usage can help in
setting standards. However, the standards should be designed to encourage efficient future
operations, not a repetition of past inefficient operations.

Types of standards
a) Basic standards: These are long term standards which would remain unchanged over the
years, or it is a standard established for use over a long period from which a current
standard can be developed.
b) Ideal standards: Are standards which can be attained under the most favorable conditions
with no allowance for normal losses, waste and machine breakdown. It is also known as
potential standard. Clearly ideal standards would be unattainable in practice and
accordingly are rarely used.
c) Attainable standards: This is by far the most frequently encountered standard. It is a
standard based on efficient (but not perfect) operating conditions. Attainable standards
provide tough, but realistic target and can be used for product costing for control, for
stock valuation and as a basis for budgeting.

A general approach to variance analysis

Companies that have standard costing systems can analyze the difference between a standard and
actual cost, referred to as a standard cost variance, to determine if operations are being
performed efficiently. The analysis is referred to as variance analysis – it generally involves
decomposing the difference between standard and actual cost into two components. For direct
materials, the two components are the material price and the material quantity variances. For
direct labor, the two components are the labor rate variance and the labor efficiency variance.
And for manufacturing overhead, the two components are the overhead volume variance and the
controllable overhead variance. Variance analysis helps companies control operations by
highlighting potential problems in operations.
Direct Material Variances
Standard price per unit of direct materials is the price that should be paid for a single unit of
materials, including allowances for quality, quantity purchased, shipping, receiving, and other
such costs, net of any discounts allowed.

a) Material Price Variance:

This is equal to the difference between the actual price per unit of material (AP) and the standard
price per unit of material (SP) times the actual quantity of material purchased (AQP)
Material price variance = (SP – AP) AQP

b) Material quantity variance: This is equal to the difference between the actual quantity of
material used (AQU) and the standard quantity of materials allowed for the number of
units produced (SQ) times the standard price of material (SP).
Material quantity variance = (SQ - AQU) SP

Note:
• Actual prices or quantities greater than standard are labeled unfavorable.
• Actual prices or quantities less than standard are labeled favorable.

Direct labor variances

Direct labor price and quantity standards are usually expressed in terms of a labor rate and labor
hours. The standard rate per hour for direct labor includes not only wages earned but also fringe
benefit and other labor costs.

a) Labor rate variance: It is equal to the difference between the actual wage rate (AR) and
the standard wage rate (SR) times the actual number of labor hours worked (AH). This
variance is very similar to the material price variance.
Labor rate variance = (SR - AR) AH

b) Labor efficiency variance: It is equal to the difference between the actual number of
hours worked (AH) and standard labor hours allowed for the number of units produced
(SH) times the standard labor wage rate (SR). This variance is similar to the material
quantity variance.
Labor efficiency variance = (SH – AH) SR

Overhead variances
Procedures for the establishing and using standard factory overhead rates are similar to the
methods of dealing with the estimated direct and indirect factory overhead and its application to
jobs and products.

Jobs or processes are charged with cost on the basis of standard hours allowed multiplied by the
standard factory over head rate. The standard overhead rate or predetermined overhead rate is
discussed in detail on the job order costing system. The standard hours allowed figure is
determined by multiplying the labor hours required to produce one unit (the standard labor hours
per unit) times the actual number of units produced during the period. The units produced are the
equivalent units of production for the departmental factory overhead cost being analyzed. At the
end of the month, the total variance for manufacturing overhead is the difference between the
overhead applied to inventory at standard and actual overhead costs. The difference between
these figures is called the overall or net factory overhead variance.

The overall or net factory overhead variance needs further analysis to reveal detailed causes for
the variance and to guide management toward remedial action. This analysis may be made by
using (1) the two variance method, (2) the three variance method, or (3) the four variance
method.

The two variance method: When an overall or net factory overhead variance is further analyzed
by using two variance approach, the following two variances are calculated:
1. Controllable variance
2. Volume variance

a) Controllable overhead variance: This is the difference between the actual amount of
overhead and the amount of overhead that would be included in a flexible budget for the
actual level of production. The variance is referred to as “controllable” because
managers are expected to be able to control costs so that they are not substantially
different from the amount that would be included in the flexible budget.

Controllable overhead variance = Actual overhead – Flexible budget level of overhead for
actual level of production

b) Overhead volume variance is equal to the difference between the amount of overhead
included in the flexible budget and the amount of overhead applied to production using
the standard overhead rate.

Overhead volume variance = Flexible budget level of overhead – overhead applied to production
For actual level of production using standard overhead rate

An overhead volume variance simply signals that the quantity of production was greater or less
than anticipated when that standard overhead rate was developed. If greater, the amount of
overhead applied to inventory exceeds the flexible because the amount of fixed cost per unit is
being applied to more units than anticipated.

The three variance method: When an overall or net factory overhead variance is further
analyzed by using three variance approach, the following three variances are calculated:
1. Spending variance
2. Idle capacity variance
3. Efficiency variance

Factory overhead spending variance:

(Actual factory overhead) – (Budgeted allowance based on actual hours worked)

Factory overhead idle capacity variance formula:

(Budgeted allowance based on actual hours worked) – (Actual hours worked × Standard
overhead rate)
Factory overhead efficiency variance formula:
(Actual hours worked × Standard overhead rate) – (Standard hours allowed for expected output ×
Standard overhead rate)

The four variance method: When an overall or net factory overhead variance is further
analyzed by using four variance approach, the following four variances are calculated:
1. Spending variance
2. Variable efficiency variance
3. Fixed efficiency variance
4. Idle capacity variance

Variable overhead efficiency variance formula:

(Actual hours worked × Standard variable overhead rate) – (Standard hours allowed × Standard
variable overhead rate)

Fixed overhead efficiency variance formula:

(Actual hours worked × Fixed overhead rate) – (Standard hours allowed × Fixed overhead rate)

Factory overhead yield variance formula:

(Standard hours allowed for expected output × Standard overhead rate) – (Standard hours
allowed for actual output × Standard overhead rate)

Favorable variances may be unfavorable

Variance analysis and performance reports are important elements of management by exception.
Simply put, management by exception means that the manager's attention should be directed
toward those parts of the organization where plans are not working out for one reason or another.

The fact that a variance is “favorable” does not mean that it should not be investigated. Indeed, a
favorable variance may be indicative of poor management decisions. For example, suppose the
price of raw materials increases. In order to avoid unfavorable material price variance, a manager
could generate a favorable material price variance if the price of inferior goods is less than the
standard price of materials. However, the inferior materials may result in undetected product
defects and cause the company to loose its reputation as a high quality producer. If the defects
are detected, items would be scrapped or “reworked”. This would lead to unfavorable material
quantity variance, because additional materials would be used to replace or rework defective
items.

Responsibility Accounting and Variances

The idea of responsibility accounting is that managers should he held responsible only for costs
they can control. The implication for variances is that managers and workers should only be
held responsible for variances they can control.

Advantages / Benefits of Standard Costing System:

Standard costing System has the following main advantages or benefits:
1. The use of standard costs is a key element in a management by exception approach. If
costs remain within the standards, Managers can focus on other issues. When costs fall
 significantly outside the standards, managers are alerted that there may be problems requiring
attention. This approach helps managers focus on important issues.

2. Standards that are viewed as reasonable by employees can promote economy and
efficiency. They provide benchmarks that individuals can use to judge their own performance.

3. Standard costs can greatly simplify bookkeeping. Instead of recording actual costs for
each job, the standard costs for materials, labor, and overhead can be charged to jobs.

4. Standard costs fit naturally in an integrated system of responsibility accounting. The

standards establish what costs should be, who should be responsible for them, and what actual
costs are under control.

Disadvantages / Problems / Limitations of Standard Costing System:

The use of standard costs can present a number of potential problems or disadvantages. Most of
these problems result from improper use of standard costs and the management by exception
principle or from using standard costs in situations in which they are not appropriate.

1. Standard cost variance reports are usually prepared on a monthly basis and often are
released days or even weeks after the end of the month. As a consequence, the information in
the reports may be so stale that it is almost useless. Timely, frequent reports that are
approximately correct are better than infrequent reports that are very precise but out of date by
the time they are released. Some companies are now reporting variances and other key
operating data daily or even more frequently.

2. If managers are insensitive and use variance reports as a club, morale may suffer.
Employees should receive positive reinforcement for work well done. Management by
exception, by its nature, tends to focus on the negative. If variances are used as a club,
subordinates may be tempted to cover up unfavorable variances or take actions that are not in
the best interest of the company to make sure the variances are favorable. For example, workers
may put on a crash effort to increase output at the end of the month to avoid an unfavorable
labor efficiency variance. In the rush to produce output quality may suffer.

3. Labor quantity standards and efficiency variances make two important assumptions. First,
they assume that the production process is labor-paced; if labor works faster, output will go up.
However, output in many companies is no longer determined by how fast labor works; rather, it
is determined by the processing speed of machines. Second, the computations assume that labor
is a variable cost. However, direct labor may be essentially fixed, then an undue emphasis on
labor efficiency variances creates pressure to build excess work in process and finished goods
inventories.

4. In some cases, a "favorable" variance can be as bad as or worse than an "unfavorable"

variance. For example, McDonald's has a standard for the amount of hamburger meat that
should be in a Big Mac. A "favorable" variance would mean that less meat was used than
standard specifies. The result is a substandard Big Mac and possibly a dissatisfied customer.
5. There may be a tendency with standard cost reporting systems to emphasize meeting the
standards to the exclusion of other important objectives such as maintaining and improving
quality, on-time delivery, and customer satisfaction. This tendency can be reduced by using
supplemental performance measures that focus on these other objectives.

6. Just meeting standards may not be sufficient; continual improvement may be necessary to
survive in the current competitive environment. For this reason, some companies focus on the
trends in the standard cost variances - aiming for continual improvement rather than just
meeting the standards. In other companies, engineered standards are being replaced either by a
rolling average of actual costs, which is expected to decline, or by very challenging target costs.

In summary, managers should exercise considerable care in their use of a standard cost system. It
is particularly important that managers go out of their way to focus on the positive, rather than
just on the negative, and to be aware of possible unintended consequences.

Nevertheless standard costs are still found in the vast majority of manufacturing companies and
in many service companies, although their use is changing. For evaluating performance, standard
cost variances may be supplanted in the future by a particularly interesting development known
as the balanced scorecard.

Exercise I
The Finrwa Lawn Furniture Company uses 12 meters of aluminum pipe at 0.80 Rwf per meter as
standard for the production of its Type A lawn chair. During one month's operations,
100,000 meters of the pipe were purchased at 0.78 Rwf a meter, and 7,200 chairs were
produced using 87,300 meters of pipe. The materials price variance is recognized when
materials are purchased.

Required: Compute the materials price and quantity variances

Exercise II
The standard price for material ZXX is 3.65 Rwf per liter. During November, 2,000 liters were
purchased at 3.60 Rwf per liter. The quantity of material ZXX issued during the month was 1775
liters and the quantity allowed for November production was 1,825 liters.

Required: Calculate Materials price variance, assuming that:

a) It is recorded at the time of purchase (Materials purchase price variance).
b) It is recorded at the time of issue (Materials price usage variance).

Exercise III
The processing of a product requires a standard of 0.8 direct labor hours per unit for Operation
T20 at a standard wage rate of 6.75 Rwf per hour. The 2,000 units actually required 1,580 direct
labor hours at a cost of 6.90 Rwf per hour.

Required: Calculate:
1. Labor rate variance or Labor price variance.
2. Labor efficiency or usage or quantity variance.
Exercise IV
The Sonatubes Company uses a standard cost system. The factory overhead standard rate per
direct labor hour is:
Fixed: Frw 4,500 / 5,000 hours = Frw 0.90
Variable: Frw 7,500 / 5,000 hours = Frw 1.50
Frw 2.40

For October, actual factory overhead was Frw 11,000 actual labor hours worked were 4,400 and
the standard hours allowed for actual production were 4,500.

Required: Compute the Factory overhead variances using two, three and four variance methods

Exercise V
On May 1, Brovard Company began the manufacture of a new mechanical device known a
"Dandy." The company installed a standard cost system in accounting for manufacturing costs.
The standard costs for a unit of Dandy are:

Materials: 6 kgs. at Frw.1 per Kg. Frw. 6.00

Direct labor: 1 hour at Frw. 4 per hour Frw. 4.00
Factory overhead: 75% of direct labor cost Frw. 3.00
Total Frw.13.00

The following data were obtained from Brovard's record for May:
Actual production of Dandy 4,000 units
Units sold of Dandy 2,500
Sales Frw. 50,000
Purchases (26,000 kgs) 27,300
Materials price variance (applicable to May purchase) Frw. 1,300 unfavorable
Materials quantity variance 1,000 unfavorable
Direct labor rate variance 760 unfavorable.
Direct labor efficiency variance 800 favorable
Factory overhead total variance 500 unfavorable

Required:
1. Standard quantity of materials allowed (in kgs).
2. Actual quantity of materials used (in kgs).
3. Standards hours allowed.
4. Actual hours allowed.
5. Actual direct labor rate.
6. Actual total factory overhead.