LECTURE NOTE

ACCTBA3- Fundamentals of Accounting 3

Chapter 12: Standard Costing

A standard is a benchmark or “norm” for measuring performance. In

managerial accounting, two types of standards are commonly used by
manufacturing, service, food and not-for-profit organizations:

1. Quantity standards specify how much of an input should be used to

make a product or provide a service. For example:
a. Auto service centers like Firestone and Sears set labor
time standards for the completion of work tasks.
b. Fast-food outlets such as McDonald’s have exacting
standards for the quantity of meat going into a sandwich.

2. Price standards specify how much should be paid for each unit of the
input. For example:
a. Hospitals have standard costs for food, laundry, and
other items.
b. Home construction companies have standard labor costs
that they apply to sub-contractors such as framers,
roofers, and electricians.
c. Manufacturing companies often have highly developed
standard costing systems that establish quantity and
price standards for each separate product’s material,
labor and overhead inputs. These standards are listed on
a standard cost card.
For example:
A particular table

Based on Cost Card, standard cost to produce one unit of there table would
require the following manufacturing costs:
 Direct Materials
Wood, Nails, Paints $ 80.00
 Direct Labor
Design, Carpentry, Finishing 100.00
 Manufacturing Overhead
Variable MOH (PDOH per unit) 40.00

 Management by exception is a system of management in which standards

are set for various operating activities, with actual results compared to
these standards. Any deviations that are deemed significant are brought to
the attention of management as “exceptions
The variance analysis cycle is a continuous process used to identify and
solve problems:
1. The cycle begins with the preparation of standard cost performance
reports in the accounting department.
2. These reports highlight variances that are differences between actual
results and what should have occurred according to standards.
3. The Variances raise questions such as:
a. Why did this variance occur?
b. Why is this variance larger than it was last period?
4. The significant variances are investigated to discover their root causes.
5. Corrective actions are taken.
Next period’s operations are carried out and the process is repeated.
 Setting price and quantity standards requires the combined expertise of
everyone who has responsibility for purchasing and using inputs. In a
manufacturing setting, this might include accountants, engineers,
purchasing managers, production supervisors, line managers, and
production workers.

 Standards should be designed to encourage efficient future operations,

not just a repetition of past inefficient operations.

Standards tend to fall into one of two categories:

1. Ideal standards can only be attained under the best of circumstances.

They allow for no work interruptions and they require employees to
work at 100% peak efficiency all of the time.

2. Practical standards are tight, but attainable. They allow for normal
machine downtime and employee rest periods and can be attained
through reasonable, highly efficient efforts of the average worker.
Practical standards can also be used for forecasting cash flows and in
planning inventory
SETTING UP STANDARD FOR DIRECT MATERIALS
1. The standard price per unit for direct materials should reflect the final,
delivered cost of the materials, net of any discounts taken.
2. The standard quantity per unit for direct materials should reflect the
amount of material required for each unit of finished product, as well as an
allowance for unavoidable waste, spoilage, and other normal inefficiencies.
3. A bill of materials is a list that shows the quantity of each type of material
in a unit of finished product.

SETTING UP STANDARDS FOR DIRECT LABOR

1. The standard rate per hour for direct labor includes not only wages
earned but also fringe benefits and other labor costs. Many companies
prepare a single rate for all employees within a department that reflects
the “mix” of wage rates earned.

2. The standard hours per unit reflects the labor hours required to
complete one unit of product. Standards can be determined by using
available references that estimate the time needed to perform a given
task, or by relying on time and motion studies.

SETTING UP STANDARDS FOR VARIABLE MANUFACTURING OVERHEAD

1. The price standard for variable manufacturing overhead comes from the
variable portion of the predetermined overhead rate.

2. The quantity standard for variable manufacturing overhead is expressed

in either direct labor hours or machine hours depending on which is
used as the allocation base in the predetermined overhead rate.
Price and quantity standards are determined separately for two reasons:
1. Different managers are usually responsible for buying and for using
inputs. For example: The purchasing manager is responsible for raw
material purchase prices and the production manager is responsible for
the quantity of raw material used.
2. The buying and using activities occur at different points in time. For
example: Raw material purchases may be held in inventory for a period
of time before being used in production.

 Differences between standard prices and actual prices and standard

quantities and actual quantities are called VARIANCES.

 The act of computing and interpreting variances is called VARIANCE

ANALYSIS
  Price and quantity variances can be computed for all three variable
cost elements – direct materials, direct labor, and variable
manufacturing overhead – even though the variances have different
names as shown.
 Although price and quantity variances are known by different
names, they are computed exactly the same way (as shown on this
slide) for direct materials, direct labor, and variable manufacturing
overhead.

The ACTUAL QUANITY represents the amount of direct materials, direct labor,
and variable manufacturing overhead actually used

The STANDARD QUANTITY represents the standard quantity allowed for the
actual output of the period.

The ACTUAL PRICE represents the actual amount paid for the input used
The STANDARD PRICE represents the amount that should have been paid for
the input used.
MATERIAL PRICE VARIANCE
 Purchases of Raw Materials is a responsibility of the purchasing
department.

 Their task is to acquire exact kind of raw materials as required by

the product standard cost.

 Purchase of standard quality materials at a cheaper or higher price

may result to a variance

 Acquisition of a cheaper price raw materials would result to a

favorable variance. Most of the time, cheaper raw materials are
poor quality raw materials. This may result to wastage or spoilage.
Production may suffer.

 Acquisition of a higher price raw materials may result to unfavorable

variance and must analyzed and addressed immediately.
Unfavorable materials price variance can sometimes be caused
external forces (economics, calamities, political…)
Example:

Snowy Clothing Line has the following Direct Material standard for the
fiberfill in its winter jackets.

0.1 kg. of fiberfill per jacket at $5.00 per kg.

Last month 210 kgs. of fiberfill were purchased and used to make 2,000
parkas. The material cost a total of $1,029.
MATERIALS QUANTITY VARIANCE
 Usage of Raw Materials shall be more or the responsibility of the
production department.

 Their task is to efficiently utilize the raw materials based on the

product standard cost.

 If Production have ulitized less direct materials than what is

required in the standards , then it is a favorable variance. But then
again, quality of work must not suffer.

 If Production have utilized more direct materials that what is

required in the standards, then it is an Unfavorable variance. This
variance must be analyzed and explained accordingly.
 Standard Quantity – is the standard quantity of raw materials
allowed for the total number of output.

 Actual Quantity (AQ) - is the actual number of raw materials used in

the production.

 Standard Price (SP) – is the budgeted amount for the purchase of raw
materials as shown on the Product Cost Standards.
 Most companies compute the materials price variance when materials are
purchased. They calculate the materials quantity variance after
materials are used in production.
QUICK CHECK 1:

LABOR RATE VARIANCE

 Here , we would compare the Actual Labor Rate paid to the workers
with Standard Labor Rate.

 Actual Labor Rate can be computed using total actual amount paid
on labor divided by the actual number of labors hours worked in the
production.

 Standard Labor Rate is the rate of labor as stated in the actual cost
sheet.
  When Actual Labor Rate is greater than the Standard Labor Rate, it will
result to Unfavorable Rate Variance. The reason behind the
unfavorable results must be analyzed and attend to immediately.
 When Actual Labor Rate is lesser than the Standard Labor Rate, it will
result to a favorable Rate variance. Reason for favorable to must de
determined for future standards setting

Example:

Snowy Clothing Line has the following direct labor standard for its winter
jackets.

1.2 standard hours per winter jacket at $10.00 per hour

Last month, employees actually worked 2,500 hours at a total labor cost of
$26,250 to make 2,000 winter jackets.
LABOR EFFICIENCY VARIANCE
 Labor Efficiency Variance is the difference between the Actual
number of labor hours spent on production and the Standard labor
hours that should have been spent in production.

 Again, it is the tasked of the Production Manager to properly manage

the labor hours of the workers.

 If they were able to operate within the the standard hours or lesser-
then we can say that the production operation is efficient. This will
result to a zero or favorable variance
Labor variances are partially controllable by employees within the
Production Department. For example, production managers/supervisors
can influence:
 The deployment of highly skilled workers and less skilled workers on
tasks consistent with their skill levels.
 The level of employee motivation within the department.
 The quality of production supervision.
 The quality of the training provided to the employees.

However, labor variances are not entirely controllable by one person or

department. For example:
 The Maintenance Department may do a poor job of maintaining
production equipment. This may increase the processing time required
per unit, thereby causing an unfavorable labor efficiency variance.
 The purchasing manager may purchase lower quality raw materials
resulting in an unfavorable labor efficiency variance for the production
manager.

QUICK CHECK:
VARIABLE MANUFACTURING OVERHEAD (V-MOH) VARIANCE

 Variable Manufacturing Overhead Variances are computed and

analyzed very similarly with variance analysis of Labor Variance,
using cost drivers like direct labor hours, machines hours…)

 We have to account for V-MOH Rate Variance and –V-MOH Effficiency

Variance

EXAMPLE:

Snowy Clothing Line has the following direct variable manufacturing

overhead labor standard for its winter jackets.

1.2 standard hours per winter jacket at $4.00 per hour

Last month, employees actually worked 2,500 hours to make 2,000 winter
jackets. Actual variable manufacturing overhead for the month was
$10,500.
QUICK CHECK: