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Syllabus Content
B - Standard Costing – 25%
Manufacturing standards for material, labour, variable overhead and fixed overhead.
Fixed overhead expenditure and volume variances. (Note: the subdivision of fixed overhead
volume variance into capacity and efficiency elements will not be examined.)
Price/rate and usage/efficiency variances for materials, labour and variable overhead. Further
subdivision of total usage/efficiency variances into mix and yield components. (Note: The
calculation of mix variances on both individual and average valuation bases is required.)
Planning and operational variances.
Sales price and sales revenue/margin volume variances (calculation of the latter on a unit basis
related to revenue, gross margin and contribution margin). Application of these variances to all
sectors, including professional services and retail analysis.
Standards and variances in service industries, (including the phenomenon of "McDonaldization"),
public services (e.g. Health), (including the use of "diagnostic related" or "reference" groups), and
the professions (e.g. labour mix variances in audit work). Criticisms of standard costing in general
and in advanced manufacturing environments in particular.
Interpretation of variances: interrelationship, significance.
Benchmarking.
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1.1 Introduction to standard costing
A standard cost is a planned or forecast unit cost for a product or service, which is assumed
to hold good given expected efficiency and cost levels within an organisation. It represents a
target cost and is useful for planning, controlling and motivating within an organisation.
Variance analysis is a budgetary control process, which compares standard or budgeted costs
and revenues with the actual results of an organisation, in order to obtain information
regarding any exceptions from budget, this information is also used to improve performance
through control action e.g. correcting problems.
Under a standard costing system an organisation can value stock at standard cost,
incorporating this within the ledger or cost accounts of the organisation, the budget or
forecasts being a memorandum kept outside the ledger accounts.
Types of standard
• Ideal Standard e.g. attained under the most favourable conditions with no allowance
for any waste, scrap, idle time or downtime
• Attainable or Expected Standard e.g. what should be achieved with a reasonable
level of effort given current efficiency and cost levels
• Loose Standard e.g. loosely set and easy to achieve
• Basic Standard e.g. first standard ever used by the organisation and used as a basis or
yardstick for comparing current standards or monitoring trends over time
• Historical Standards e.g. standards used historically in previous accounting periods
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How to create a standard cost
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1.2 Methods for planning and control
A fixed budget is a budget prepared on the basis of an single estimated production and sales
volume. It does not mean it is never revised or changed, just fixed at a certain level of
output sold and produced. This tends to be a form of budgeting for a service organisation
where a high proportion of total cost is fixed, and therefore does not vary significantly, with
the volume or activity of the service performed. Such a form of budgeting would be little use
for control purposes, when comparing to actual results, if significant variable cost exists. A
fixed budget provides details of costs, revenues or resource requirements for a single
level of activity.
Flexible budgets are prepared for many different sales and production quantities and can be
used to plan more effectively for an organisation e.g. useful at the planning stage for ‘what
if?’ analysis. Flexible budgeting recognises different cost behaviour patterns, that may rise or
fall with the volume of production or sales and is a better system for control purposes. A
flexible budgeting system based upon its budget set at the beginning of the period can be
flexed to correspond to the actual activity volume of results for a period. When a budget is
flexed it would give an appropriate level of revenue and costs as a yardstick to compare like
for like to actual results, at the same activity level, meaningful variances can then be reported
to the managers responsible for control purposes.
Flexible budgeting
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Example 1.1
Butliness is a business that offers packaged holiday deals in 3 locations in the UK and as part
of this service has a restaurant that serves many different meals and puddings through out the
day to guests staying over in chalets on the holiday park. One such serving counter has been
a major concern for the management, the ‘All week Sunday lunch’ counter, as it is expensive
to run.
The stand uses 2 staff on different shifts to cook and serve meals at the counter, the standard
cost and price of the ‘Hungry man roast of the day’ is as follows:
The counter works on a 6-day shift (all week except Sunday) and the budget aims to sell 500
meals within week 43 the following actual information was obtained.
Ingredients purchased
Chicken Vegetables
Purchased 180kg (£405) 250kg (£140)
Used 165kg 220kg
Produce the original budget, flexed budget based upon actual sales volume, and
compare this to actual results in order to calculate any variances?
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Answer to Example 1.1
Notes
• The £368 actual charge for Chicken is the actual cost less standard cost of closing
stock e.g. (£405 less (15kg x £2.50))
• The £125 actual charge for Vegetables is the actual cost less standard cost of closing
stock e.g. (£140 less (30kg x £0.50))
• The absorption costing company charges fixed overhead to the profit and loss account
on the basis of £5.00 for every meal produced e.g. 476 meals x £5.00 per meal =
£2,380, for this reason, when a budget is flexed, we prorate the budgeted fixed
overhead, but never for marginal costing organisations, they do not charge or absorb
fixed overhead in this manner.
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1.3 Variance analysis
By comparing a flexed budget, which has been prepared using standard cost information to
actual results, total variances can be calculated. These reconcilable differences between the
two statements can then be sub-divided further, calculated, interpreted and used to correct
problems within the organisation to stay on target through control action by management or
employees.
• Inaccurate data when creating standards, producing the budget or compiling actual
results
• A standard used which is either not realistic or perhaps out of date
• Efficiency of how operations were undertaken by management or employees during
the period of assessment
• Random or chance
Budgetary planning involves the production of budgets or forecasts using realistic standards
for cost and efficiency levels. Budgetary control identifies areas of responsibility for
management and is the process of regularly comparing actual results against budget or
standards. Because the original budget would have forecast a different number of units
produced or sold, when compared to actual units produced or sold, a ‘flexed budget’ would
be prepared in order to compare costs and revenues on a like with like basis.
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Variance calculations
units
Did sell (actual quantity sold) X
Should sell (budget quantity sold) (X)
X
x standard profit per unit*
Sales volume profit variance X
Sales volume
profit There is also the calculation of the sales volume revenue variance
variance
units
Did sell (actual quantity sold) X
Should sell (budget quantity sold) (X)
X
x standard price
Sales volume revenue variance X
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Kg/litres
Actual production did use X
Actual production should use (actual production x standard usage) (X)
X
Material
x standard price
usage
Material usage variance X
variance
This variance calculation always uses the quantity of material actually
used never purchased, if there is a difference between the two within a
question.
Hours
Actual production did take X
Actual production should take (actual production x standard hours) (X)
Labour X
efficiency x standard rate
variance Labour efficiency variance X
This variance calculation always uses the actual hours worked never
hours paid if there is a difference between the two within a question.
Hours
Actual hours paid for X
Actual hours worked (X)
Labour idle Idle time X
time x standard rate
variance Labour idle time variance X
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Did spend (actual hours worked x actual OH rate) X
Should spend (actual hours worked x standard OH rate) (X)
Variable Variable overhead expenditure variance X
overhead
expenditure Variable overhead expenditure within a question will be assumed to be
variance driven by labour hours worked never paid if there is a difference
between the two e.g. if production stops and staff are idle then no
variable overhead should be incurred.
Hours
Actual production did take X
Actual production should take (actual production x standard hours) (X)
Variable X
overhead x standard overhead rate
efficiency Variable overhead efficiency variance X
variance
This variance calculation always uses the actual hours worked never
hours paid if there is a difference between the two within a question;
notice the proforma is similar to the labour efficiency variance.
units
Did produce (actual quantity produced) X
Should produce (budget quantity produced) (X)
X
Fixed
x overhead absorption rate (O.A.R)
overhead
Fixed overhead volume variance X
volume
variance
This variance calculation is only applicable if the organisation uses
absorption costing, never when marginal costing, and is to do with the
way the organisation charges the profit and loss account within the
production fixed overhead control account.
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1.4 Fixed overhead variances further explained
Traditional absorption costing takes the total budgeted fixed overhead for a period and
divides by a budgeted (or normal) activity level e.g. units, in order to find the overhead
absorption rate. This is a simple method of charging fixed overhead and allows fixed
overhead to be allocated to products, jobs or work-in-progress
At the end of the period, the overhead ‘absorbed’ or charged to production is compared to the
actual production overhead incurred for the period. Any shortfall in overhead charged
would be an ‘under absorption’ of production overhead (DR profit and loss account CR
Production overhead control account). Any ‘over charge’ to the profit and loss account
during a period would be an ‘over absorption’ of production overhead (CR profit and loss
account DR Production overhead control account).
The sum of the fixed overhead expenditure and volume variance would be equal to the under
or over absorption, when sub-divided, explaining the two different causes as to how this
occurred during a period e.g. under or over spent and/or under or over produced when
compared to the original budget.
The difference between absorption costing and marginal costing organisations, is that the
marginal costing organisation makes no attempt to absorb or charge production overhead into
a cost unit or the profit and loss account. It treats production overhead as a period cost only
and does not absorb overhead, but rather charges it entirely to the profit and loss account for
each period. With marginal costing organisations only the fixed overhead expenditure never
the fixed overhead volume variance would be applicable within a question.
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Stock valuation under absorption and marginal costing systems
It is also important to remember that marginal costing organisations would also value stock
at variable production cost only never full production cost, when contrasted to an
absorption costing company.
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Example 1.2
Butliness is a business that offers packaged holiday deals in 3 locations in the UK and
as part of this service has a restaurant that serves many different meals and puddings
through out the day to guests staying over in chalets on the holiday park. One such
serving counter has been a major concern for the management, the ‘All week Sunday
lunch’ counter, as it is expensive to run.
The stand uses 2 staff on different shifts to cook and serve meals at the counter, the
standard cost and price of the ‘Hungry man roast of the day’ is as follows:
The counter works on a 6-day shift (all week except Sunday) and the budget aims to
sell 500 meals every week. During week 43 the following actual information was
obtained.
Ingredients purchased
Chicken Vegetables
Purchased 180kg (£405) 250kg (£140)
Used 165kg 220kg
Prepare an operating statement for week 43 for both an absorption and marginal
costing organisation, which reconciles any differences between actual results and
budget?
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Example 1.3 – working backwards
Butliness had a problem with the accountant during period 46; he left in a fume and took all
the actual accounts information with him as revenge. You have been called in from a
temping agency to sort out the mess. The following information has been provided to you.
Budget 1,600
Sales volume variance 77(A)
Flexed budget 1,523
Sales price variance 0
1,523
Cost variances F A
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Additional information known
Note: an alternative form of question would have been to provide you with actual
information and the variances, asking you to calculate budgeted or standard cost information
instead. The principle would be exactly the same as within this example.
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1.5 Mix and yield (or productivity) variances
A material usage variance can be subdivided into a mix and yield variance where there
exists two or more ingredients that can be substituted for one another. The sum of the
material mix and yield variances will total the sum of the material usage variance. The same
concept can also be applied to labour mix and yield variances, when one grade or skill of
labour can be substituted for another, when making a particular product or completing a job.
The labour efficiency variance in this case reanalysed further into the mix and yield
variances, exactly in the same way as the material usage variance.
• If you use a quantity of material which is more than standard mix there would be an
adverse variance
• If you use a quantity of material which is less than standard mix there would be a
favourable variance
• If you use a quantity of material which is more than standard mix and the material is
more expensive than the average cost, there would be an adverse variance
• If you use a quantity of material which is more than standard mix and the material is
less expensive than the average cost, there would be a favourable variance
• If you use a quantity of material which is less than standard mix and the material is
more expensive than the average cost, there would be a favourable variance
• If you use a quantity of material which is less than standard mix and the material is
less expensive than the average cost, there would be an adverse variance
Both totals of the individual and average valuation bases give the same answer; it is the
analysis which makes up the total, where you would find the differences between the two
methods.
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Interpreting yield (or productivity) variances
Yield
The sum of the material mix/labour mix and material/labour yield variances will be equal to
the material usage/labour efficiency variance respectively. It is also worth noting that there
can be an interdependent relationship between a mix and yield variance e.g. a higher skill mix
of labour in substitute of a lower skill mix, would cause an adverse mix variance, but may
also cause at the same time a favourable yield variance, due to greater experience and
therefore efficiency by that type of labour. Lastly a word of caution favourable variances,
especially when dealing with mix and yield do not necessarily mean you have improved the
organisation e.g. more water and less flavouring would improve both mix and yield when
making soft drinks, but do little to improve the quality of the drink being made.
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Example 1.4
Butliness also does a ‘deep pan cheesy and tomato pizza’ on one of it’s counters, the
standard or budget cost and usage of the topping ingredients for one pizza are as
follows
£
0.5kg Tomatoes @ £1.40 a kg 0.70
0.6kg Cheese @ £7.50 a kg 4.50
5.20
1.1kg ingredients will produce or yield a 1kg pizza (due to evaporation in the cooking
process). On a Wednesday afternoon 60 pizzas were cooked (to the weight specified
of 1.0 kg) and the following ingredients were used during the process;
Tomatoes 28 kg £45.00
Cheese 40kg £270.00
Calculate the material usage, mix and yield variances for Butliness for this day?
Note: two methods exist for calculation of the mix variance, the individual valuation
and average valuation bases. Make sure you are familiar with both types of
calculation.
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1.6 Investigating variances
From the answer of example 1.4 above this would have been calculated as
Favourable
0
JAN FEB MAR APR
Adverse
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Factors to consider before investigation
1. The size of it (materiality)
2. The general trend of it e.g. use of control charts for this
3. The type of standard that was used
4. Interdependence with other variances
5. The likelihood of identifying the cause of it
6. The likelihood that if a cause is found then it is controllable
7. The cost and benefits of correcting the cause
8. The cost of the investigation
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Example 1.5
Mr Chumney-Warner, the accountant that left Butliness, due to personal grievances against
the organisation and has set up an audit practice, providing work to local business within the
area. Even though being a service organisation, Mr Chumney-Warner recognises that
variances can also be applied to such organisations. He has created a standard cost of an
average audit, which normally takes a partner, semi-senior and junior together, 20 hours.
£
Partner 3 hours @ £100 per hour 300
Semi-senior 5 hours @ £70 per hour 350
Junior 12 hours @ £30 per hour 360
1,010
During the period of February, time sheets recorded the following information. In total, 90
hours was logged as audit work, completing 5 audits during this period. The new junior that
had been recruited was under allot of pressure, and did not cope well. This had meant the
semi-senior had to be involved more in compliance work to improve the quality of audit files.
Mr Chumney-Warner was pleased however that his time as a partner was used less because
of the final quality of the audit files, due to more involvement from the semi-senior.
Partner 12 hours
Semi-senior 40 hours
Junior 38 hours
90 hours
You have again been recruited from an agency as a temp, your first job apart from idle
chit chat about working conditions at Butliness, is to produce labour mix and yield
calculations for Mr Chumney-Warner, within an operating statement, for the period of
February above. Your mix calculations to use both the average and individual bases of
valuation.
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1.7 Planning and operational variances
Planning variances are caused by the budget or standard at the planning stage being wrong.
The budget and standard used would therefore need revising if your operational variances are
to be more realistic.
Operational variances are your normal variance calculations as learned earlier within this
chapter, that is, assuming all planning errors within the budget have been adjusted for or
removed and your standard used is realistic.
1. Calculate the planning variance and adjust the original budget within the operating
statement for this, before any operational variances are calculated
2. Adjust the standard cost used in the budget from ex ante to ex post (revised) standard
3. Now that the original budget and standard cost has been adjusted, the operational
variances that would be effected by the adjustment, will give a more realistic
standard.
1. The planning variance which is beyond the control of staff e.g. planning errors
2. The operational variances which may be within the control of staff
Planning and operational variances are not alternatives to the conventional approach; they
just produce a more detailed analysis. Further analysis of variances into groups e.g. planning
which are to do with poor planning or inadequate standards used compared with actual true
favourable or adverse operational variances, allow managers to be appraised truly on
deviations they can control not those variances which are beyond their control.
However critism includes still the question of determining a ‘realistic standard’ in the first
place and putting too much emphasis on ‘bad planning’ rather than ‘bad management’ and
the analysis can be more time consuming and costly than the conventional approach.
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Example 1.6
Using the information from Example 1.2, how should Butliness deal with the variance
calculations if you were told the following; due to salmonella scare across the country
the price of chicken had fallen to £2 a kg this should have been reflected in the budget
when it was completed, but was overlooked.
500 meals should have cost (x 0.3kg x £2.00) according to new standard 300
500 meals should have cost (x 0.3kg x £2.50) according to old standard 375
75(F)
Notice the biggest effect of this analysis is that the operational price variance changes
from £45 favourable to £45 adverse. This highlights that the purchasing of the
chicken is not as keener price as it should have been e.g. better control information.
The planning variance will be offset against the original budget, just before the offset
of the sales volume variance within the operating statement.
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1.8 Machine expenditure and efficiency variances
Such variances use the same method as labour rate, efficiency and idle time variances – so do
not be afraid when it comes to rate, efficiency and idle time variances for machines.
Example 1.7
Standard processing time for every 50 half-pint glasses is 0.6 hours at £40 variable
overhead per hour.
During one hot summer week there was 42 hours of processing time at a total cost that
week of £1,880, 1,900 pints were produced.
Calculate the machine expenditure and efficiency variances for the machine?
What if you were told that the machine has been replaced with a machine, which is
20% faster than the previous model, but this had not been reflected in the budget?
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1.9 Causes of variances
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¾ Variable overhead variance • Unexpected price changes for overhead
items.
• Labour efficiency variances (see above).
¾ Fixed overhead expenditure variance • Changes in prices relating to fixed
overhead items e.g. rent increase.
• Seasonal effects e.g. heat/light in winter.
(This arises where the annual budget is
divided into four equal quarters of
thirteen equal four-weekly periods
without allowances for seasonal factors.
Over a whole year the seasonal effects
would cancel out.)
¾ Fixed overhead volume • Change in production volume due to
change in demand or alterations to
stockholding policy.
• Changes in productivity of labour or
machinery.
• Production lost through strikes etc.
¾ Operating profit variance due to selling • Unplanned price increase.
prices
• Unplanned price reduction e.g. to try and
attract additional business.
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1.10 Benchmarking
“Continuous, systematic process for evaluating the products, services and work processes
of an organisation that are recognised as representing best practice, for the purpose of
organisational improvement.”
Benchmarking
1. Internal. Compare an internal function to the best found elsewhere internally within
the same organisation.
2. ‘Best practice’ or functional. Compare an internal function to that of the best, not
necessarily an organisation in the same industry.
3. Competitive. Product/service features compared to that of firms/competition in the
same industry.
4. Strategic. Compare yourself in terms of organisational structure and culture, mission
statement and strategic choices made to the most successful market leader.
Companies to be the very best must establish where customers perceive differences, set the
very best standards to exceed, establish what the competition is doing and encourage, manage
knowledge and ideas of staff to exceed standards set.
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Benefits of benchmarking
Drawbacks of benchmarking
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1.11 McDonaldization
Modern manufacturing questions the thought of whether standard costing still plays a
valuable part when considering information for control purposes.
• Dynamic environments
• Customisation/differentiation not homogenous products
• Shorter product life-cycles
• Automation
• Higher concern for quality rather than efficiency
George Ritver within his book ‘The McDonaldization of Society’ listed the advantages of
producing standard or homogenous products, the pinnacle comparison being McDonalds,
with its fast food strategy of uniformity of operations and delivery on a global basis. A
concept you will find within thousands of companies in the world, especially the larger
corporations e.g. Audi or V/W Group incorporating hundreds of components, including the
engine, within a large range of cars manufactured. Although surely you would understand
such an idea better through the use of a ‘Big Mac’ right? Standardisation of machinery,
uniforms and packaging e.g. sachets, drinking cups and paper bags. Automation of
dispensers, cooking processes and staff… have a nice day! Food already pre-prepared before
cooking e.g. cheese sliced, salads prepared, sauces all pre-packed and easy to open and serve.
This is uniformity or standardisation.
Some facts about McDonalds
• Started as a hot dog stand in 1939 by 2 brothers (Richard and Maurice McDonald)
• 30,000 outlets in 119 countries
• One of the first to end waiter service
• Cut their menus down to a few standard and homogenous dishes for simplicity
• Plates replaced with cardboard containers to save on washing up
Advantages of McDonaldization ‘standardisation reduces cost and improves efficiency’
9 Control e.g. easier to create a pre-defined standard as there is such uniformity within
the specification of the products produced, also easier to manage, organise, train and
control workers
9 Efficiency e.g. combined with specialisation it is the most efficient way of working
within large organisations
9 Predictability e.g. customer always knows what they are buying, giving reassurance
and brand recognition
9 Calculability e.g. quantitative not qualitative information so easier to interpret
9 Proficiency of staff can be assessed more effectively
Such a philosophy and its advantages are similar to the classical school of management, but
can have its disadvantages
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1.12 Diagnostic related or reference groups (DRG) ‘can applied to a Big Mac’
Standard costing is and can be applied to service organisations such as the health service,
accountancy practice or even retail. The diagnostic reference group or healthcare resource
group is a system of classifying hundreds of different medical conditions within the health
sector, as a basis of recognising that similar medical illnesses require essentially similar
treatment or care. There are around 800 DRGs existing within the health service.
Such standards can also be used by government to benchmark the performance and create
league tables of those hospitals that complete treatments within standard times and costs and
those that do not. The DRG approach also used to remunerate hospitals for each standard
treatment they perform.
Such a system is not without its critics, arguing that surely it is the qualitative factors in
patient treatment more than the quantitative measures that are more important when it comes
to patient care, and not every operation or treatment can be cured in a single best way. If
payments are made to hospitals based on a standard amount or price, this could mean
overzealous treatment of a patient causing overspending; this in itself could affect the level of
patient care given.
Characteristics of services
It is for the above reasons, as well as the human influence in the quality and effectiveness of
the service performed, when compared to manufacturing a product, that makes standard
costing more difficult to apply within the service sector.
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Solutions to lecture examples
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Example 1.2 - absorption costing organisation
Cost variances F A
* Proof
Sales 5,688
Chicken 405
Closing stock (15kg x £2.50) (38)
Vegetables 140
Closing stock (30kg x 50p) (15)
Labour 1,200
V/OH 150
F/OH 2,750 (4,592)
1,096
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Example 1.2 - marginal costing organisation
Cost variances F A
* Proof
Sales 5,688
Chicken 405
Closing stock (15kg x £2.50) (38)
Vegetables 140
Closing stock (30kg x 50p) (15)
Labour 1,200
V/OH 150
(1,842)
Contribution 3,846
F/OH (2,750)
1,096
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Example 1.3
Hours paid for would have been 114 worked plus 6 hours idle time = 120 hours
165kg used as above + 15kg rise in closing stock levels = 180kg purchased.
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Example 1.4
Usage variance
(W1)
68kg ingredients x 0.5kg/1.1kg = 31kg of tomatoes you would have used had you kept to the
mix
68kg ingredients x 0.6kg/1.1kg = 37kg of cheese you would have used had you kept to the
mix
(did use less should use) x (average standard cost less standard cost) = variance
Thus if an actual mixed quantity is greater than the standard quantity mixed for this
material, but this material costs less than average, then a favourable variance will
result, as also would using less of a relatively more expensive ingredient, when
compared to the average cost.
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Example 1.4 – continued.
Yield
68kg of cheese and tomato should yield (68kg/1.1kg per pizza) 61.8
68kg of cheese and tomato did yield 60.0
Under produced 1.8
x standard cost of one pizza average cost per kg £4.73 x 1.1kg/1.0kg x £5.20*
£9.37 (A)
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Example 1.5
W1 Average rate
(3/20 x £100) + (5/20 x £70) + (12/20 x £30) = £50.50
Operating statement
5 audits did cost (assuming standard rates were correct e.g. no rate variance)
(12 hours x £100) + (40 hours x £70) + (38 hours x £30) = £5,140
Worse off by £90, the semi-senior improving productivity, due to higher quality of work, however this cost
the organisation £90 (adverse) labour efficiency variance due to the higher cost of using the semi-senior, shown
within the mix variance.
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Example 1.7
Efficiency
Expenditure
Operating statement
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Example 1.7 - continued
What if you were told that the machine has been replaced with a machine, which is 20%
faster than the previous model, but this had not been reflected in the budget?
Planning variance
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