Standard Costing: Setting

Standards and Analyzing

Variances: Materials and
Labor
Using Standard-Costing Systems for
Control
Based on carefully
predetermined amounts.

Used for planning labor

Standard and material requirements.
Costs are
The expected level
of performance.

Benchmarks for
measuring performance.
Using Standard-Costing Systems for
Control
STANDARD COST
ACTUAL COST
a budget for the
used in the
production of one
production of the
unit of product or
product or service
service

COST VARIANCE
the difference
between the
actual cost and
the standard cost
 Using Standard-Costing Systems for
Control
This variance is unfavorable
because the actual cost
exceeds the standard cost.

Standard
Product Cost

A standard cost variance

is the amount by which
an actual cost differs from
the standard cost.
 Management by Exception

Managers focus on quantities and costs

that exceed standards, a practice known as
management by exception.

Standard
Amount

Direct
Material
Direct
Labor

Type of Product Cost

 Management by Exception

Take the time to investigate only significant cost variances.

What is significant?

Depends on
Depends on
the
the Size of the
Production
Organization
Depends on Process
the Type of
the
Organization
Variance Analysis Cycle

Take
Identify Receive
corrective
questions explanations
actions

Conduct next
Analyze
periods
variances
operations

Begin Prepare standard

cost performance
report
 Setting Standards

Analysis of What DID

Used in a mature
Historical the product
production Process
Data cost?

What
Analyze the process
Task SHOULD the
of manufacturing
Analysis product
the product
cost?

A Analyze the process for the step that

Combined has changed, but use historical data
Approach for the steps that have not changed
Participation in Setting Standards

Accountants, engineers, personnel

administrators, and production managers
combine efforts to set standards based on
experience and expectations.
 Perfection Versus Practical
Standards: A Behavioral Issue
PERFECTION OR PRACTICAL OR
IDEAL ATTAINABLE
STANDARDS STANDARDS
Can only be attained Tight, but are still
under near perfect expected to be
conditions attained

Peak efficiency
Occasional machine
Lowest possible
breakdowns
input prices
Normal amounts
best-quality material
of raw material
no disruption in
waste
production
Perfection Versus Practical
Standards: A Behavioral Issue
Practical standards
should be set at levels
that are currently
attainable with
Should we use reasonable and
practical standards efficient effort.
or perfection
standards?
Perfection Versus Practical
Standards: A Behavioral Issue
I agree. Perfection
standards are
unattainable and
therefore discouraging
to most employees.
 Selection of a Standard

Activity analysis
Historical data
Benchmarking
Market
expectation
Strategic
decisions
Nonfinancial Measures

Friendly service
On-time delivery
Quality
Cleanliness
Value
Setting Standards Direct Materials

Price Quantity
Standards Standards

Use competitive Use product

bids for the quality design specifications;
and quantity desired; summarized in a
final, delivered cost Bill of Materials.
of materials,
net of discounts.
Setting Standards Direct Materials

The standard material cost for one unit of product is:

standard quantity
standard price for of material
one unit of material required for one
unit of product
Setting Standards Direct Labor

Rate Efficiency
Standards Standards

Use wage
surveys and
labor contracts
Often a single
Use time and
rate is used that reflects motion studies for
the mix of wages earned.
each labor operation.
Setting Standards Direct Labor

The standard labor cost for one unit of product is:

standard number
standard wage rate of labor hours
for one hour for one unit
of product
 Setting Standards - Variable
Overhead
Rate Activity
Standards Standards

The rate is the The activity is the

variable portion of the base used to calculate
predetermined overhead the predetermined
rate. overhead.
Standards vs. Budgets

Are standards the A standard is a per

same as budgets? unit cost.
A budget is set for Standards are often
used when
total costs. preparing budgets.
 Cost Variance Analysis

Standard Cost Variances

Price Variance Quantity Variance

The difference between The difference between

the actual price and the the actual quantity and
standard price the standard quantity
 A General Model for
Variance Analysis

Actual Quantity Actual Quantity Standard Quantity

Actual Price Standard Price Standard Price

Price or Rate Quantity or Efficiency

Variance Variance
 A General Model for
Variance Analysis
Actual Quantity Actual Quantity Standard Quantity

Actual Price Standard Price Standard Price

Price or Rate Quantity or Efficiency

Variance Variance
Standard price is the amount that should
have been paid for the resources acquired.
 A General Model for
Variance Analysis
Actual Quantity Actual Quantity Standard Quantity

Actual Price Standard Price Standard Price

Price or Rate Quantity or Efficiency

Variance Variance
Standard quantity is the quantity
allowed for the actual good output.
 A General Model for
Variance Analysis
Actual Quantity Actual Quantity Standard Quantity

Actual Price Standard Price Standard Price

Price or Rate Quantity or Efficiency

Variance Variance
AQ(AP
Materials price- SP)
variance SP(AQ
Materials - SQ)
quantity variance
Labor rate variance Labor efficiency variance
AQ =Variable
Actual overhead
Quantity SP = Standard
Variable Price
overhead
AP = spending
Actual Price
variance SQ = Standard
efficiency Quantity
variance
Standard Costs

Lets use the

concepts of the
general model to
calculate standard
cost variances,
starting with
direct material.
Material Variances

Koala Camp Gear Company in Melbourne

Australia has the following direct material
standard to manufacture one Tree Line tent:
12 square meters per tent at
$8.00 per square meter
Last month Koala purchased 40,000 square
meters at $8.15 per square meter and used
36,400 square meters to make 3,000 tents.
 Material Variances

Actual Quantity Actual Quantity

Purchased Purchased

Actual Price Standard Price
We should compute
40,000 sqm. 40,000 sqm. the price variance
using the actual
$8.15 per sqm. $8.00 per sqm. quantity purchased.
$326,000 $320,000

Price variance
$6,000 Unfavorable
 Material Variances
SQ = 3,000 tents 12 sqm. per tent
SQ = 36,000 sqm.
Actual Quantity
Used Standard Quantity

We should compute Standard Price Standard Price
the quantity variance 36,400 sqm. 36,000 sqm.
using the actual
quantity used. $8.00 per sqm. $8.00 per sqm.
$291,200 $288,000

Quantity variance
$3,200 Unfavorable
Material Variances
We may also calculate material
variances using formulas:

MPV = AQp(AP SP)

MPV = 40,000 sqm. ($8.15 $8.00)
MPV = $6,000 Unfavorable

MQV = SP(AQu SQ)

MQV = $8.00(36,400 sqm. 36,000 sqm.)
MQV = $3,200 Unfavorable
 Reporting Material Variances

I need the variances as soon

as possible so that I can
Okay. Ill compute
better identify problems
the price variance when
and control costs.
material is purchased and
You accountants just dont the usage variance as
understand the problems we soon as material is used.
production managers have.
Responsibility for
Material Variances
Your poorly trained workers and
I am not responsible poorly maintained equipment
for this unfavorable caused the problems.
material usage
variance. Also, your poor scheduling
requires rush orders of material
You bought poor quality at higher prices, causing
material, so my people unfavorable price variances.
had to use more of it.
 Price and Quantity Standards
Price and and quantity standards are
determined separately for two reasons:

The purchasing manager is responsible for raw

material purchase prices and the production manager
is responsible for the quantity of raw material used.

The buying and using activities occur at different times.

Raw material purchases may be held in inventory for a
period of time before being used in production.
Allowance for Defects or Spoilage

In some manufacturing processes, a certain amount

of defective production or spoilage is normal.

Example: 1,000 liters of chemicals are normally required in a

chemical process in order to obtain 800 liters of good output.
If total good output in February is 5,000 liters, what is the
standard allowed quantity of input?

Good output quantity = 80% X Input quantity

Good output quantity 80% = Input quantity allowed

5,000 liters of good = 6,250 liters of

output 80% input allowed
Standard Costs

Now lets calculate

standard cost
variances for
direct labor.
Labor Variances

Koala has the following direct labor

standard to manufacture one Tree Line tent:
2 standard hours per tent at
$18.00 per direct labor hour
Last month 5,900 direct labor hours were
worked at $19.00 per hour to make 3,000 tents.
 Labor Variances
SH = 3,000 tents 2 hours per tent
SH = 6,000 hours

Actual Hours Actual Hours Standard Hours

Actual Rate Standard Rate Standard Rate
5,900 hours 5,900 hours 6,000 hours

$19.00 per hour $18.00 per hour $18.00 per hour
$112,100 $106,200 $108,000

Rate variance Efficiency variance

$5,900 Unfavorable $1,800 Favorable
Labor Variances

We may also calculate labor

variances using formulas:

LRV = AH(AR - SR)

LRV = 5,900 hrs($19.00 - $18.00)
LRV = $5,900 Unfavorable

LEV = SR(AH - SH)

LEV = $18.00(5,900 hrs - 6,000 hrs)
LEV = $1,800 Favorable
 Labor Rate Variance
A Closer Look
Using highly paid skilled workers to
perform unskilled tasks results in an
unfavorable price variance.

High skill, Low skill,

high rate low rate

Production managers who make work assignments

are generally responsible for price variances.
 Labor Efficiency Variance
A Closer Look
Poorly Poor
trained quality
workers materials

Unfavorable
Efficiency
Variance
Poor Poorly
supervision maintained
of workers equipment
 Responsibility for Labor Variances

I am not responsible for

the unfavorable labor You used too much
efficiency variance! time because of poorly
You bought poor quality trained workers and
material, so my people used poor supervision.
more time to process it.
Responsibility for Labor Variances

Maybe I can attribute the labor

and material variances to personnel
for hiring the wrong people
and training them poorly.
Mix and Yield Variances

Mix or Blend Variance results from the

mixing or combining or the basic
materials in a ratio different from
standard material specifications.
May also apply to a mix in the use of labor
with different pay rates
Mix and Yield Variances

Yield Variance is the result of obtaining

a yield different from what would be
expected from actual input.

Yield is the amount of product

manufactured from a given amount of
materials.
 Material Mix and Yield Variances
Actual Mix Actual Mix Standard Mix Standard Mix
x x x x
Actual Quantity Actual Quantity Actual Quantity Standard Quantity
x x x x
Actual Price Standard Price Standard Price Standard Price

Material Material Material

Price Mix Yield
Variance Variance Variance

What should have been

used for level of output
 Labor Mix and Yield Variances
Actual Mix Actual Mix Standard Mix Standard Mix
x x x x
Actual Hours Actual Hours Actual Hours Standard Hours
x x x x
Actual Rate Standard Rate Standard Rate Standard Rate

Labor Labor Labor

Rate Mix Yield
Variance Variance Variance

What should have been

used for level of output
Significance of Cost Variances:
When to follow Up
How does a manager know when to follow up
on a cost variance and when to ignore it?

What clues help me

to determine the
variances that I should
investigate?
Significance of Cost Variances
Size of variance
Amount
Percentage of standard
Recurring variances
Trends
Controllability
Favorable variances How do I know which
variances to
Costs and benefits of investigate?
investigation
Significance of Cost Variances:
When to follow Up

Larger variances, in
dollar amount or as a
percentage of the
standard, are
investigated first.

We could use a rule of thumb such as:

investigate all variances that are over $10,000
or over 10 percent of the standard cost.
Significance of Cost Variances:
When to follow Up
What about recurring variances?

Percentage of
MONTH VARIANCE Standard Cost
September $6,000 F 6.0%
October 6,400 F 6.4%
November 3,200 F 3.2%
December 6,200 F 6.2%

None of the variances are greater than $10,000 or

10% for any one month, but they should be investigated
because of they have continued for several months.
Significance of Cost Variances:
When to follow Up
What about trends?
Percentage of
MONTH VARIANCE Standard Cost
September $ 250 U 0.25%
October 840 U 0.84%
November 4,000 U 4.0%
December 9,300 U 9.3%

None of the variances are greater than $10,000 or

10% for any one month, but they should be
investigated because of the unfavorable trend.
 Significance of Cost Variances:
When to follow Up
Controllability Favorable Variances
A manager is more likely It is as important to investigate
to investigate a variance significant favorable variances as
that is controllable by well as significant unfavorable
someone in the variances.
organization than one
that is not.

Cost and Benefits of

Investigation
The decision whether to
investigate a variance is a cost -
benefit decision
Costs and Benefits of
Standard-Costing Systems

Costs Benefits

COST
BENEFITS

Implementing and maintaining cost standards can

be time-consuming, labor-intensive, and expensive.
 Behavioral Effects Of Standard
Costing
Standard costs, budgets, and variances are used to
evaluate the performance of individuals and departments

They can profoundly influence behavior when they are used to

determine salary increases, bonuses, and promotions
Behavioral Impact of Standard
Costing
If I buy cheaper materials, my direct-
materials expenses will be lower than
what is budgeted. Then Ill get my bonus.
But we may lose customers because of
lower quality.
 Which Managers Influence Cost
Variances?
Direct-material price variance The purchasing manager
Get the best prices available for purchased goods and
services through skillful purchasing practices

Direct-material quantity variance The production supervisor

Skillful supervision and motivation of production employees, coupled with
the careful use and handling of materials, contribute to minimal waste

Direct-labor rate variance The production supervisor

Generally results from using a different mix of employees
than that anticipated when the standard were set

Direct-labor efficiency variance The production supervisor

Motivating employees toward production goals and
effective work schedules improves efficiency
Advantages of Standard Costing
Sensible Cost Management by
Comparisons Exception

Performance Employee
Evaluation Motivation
Advantages

Stable Product
Costs
Lets set the
standard a
little higher.