Chapter 10
Standard costs for control: direct
material and direct labour
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Outline
•
•
•
•
Controlling costs
Setting standards
Calculating standard cost variances
Investigating significant variances and taking
corrective action
• Behavioural impact of standard costing
• Cost control through assigning responsibility
• Standard costs for product costing
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Controlling costs
• Businesses are in control when operations
proceed to plan and objectives are achieved
• Control systems provide regular information to
assist in control, which is an essential part of
effective resource management
• Necessary requirements for control
– A predetermined or standard performance level
– A measure of actual performance
– A comparison between standard performance and actual
performance
(cont.)
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Controlling costs (cont.)
•
•
Standard costing is a part of the budgetary
control system
All control systems have three basic parts:
– A predetermined or standard cost is developed
 A standard cost is a budgeted cost of one unit of product
 Includes cost of material, labour and overhead
– The actual cost incurred in the product process is
measured
– The actual cost is compared to the standard cost to
determine a cost variance
(cont.)
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Controlling costs (cont.)
• Standard cost variances are used to evaluate
actual performance and control costs
• Standard costs can be developed for direct
material, direct labour and overheads
• When cost variances are significant, the cause of
the variance must be investigated
– May result in operations being changed to bring cost
back in line with standards
– Management may reconsider whether the standard costs
are appropriate benchmarks
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Setting standards
• A variety of methods may be used to set cost
standards
• Analysis of historical data
– Can provide a good basis for predicting future costs
– May need to be adjusted to reflect expected movements
in price levels or technological changes in the product
process
– Must be used with care as changes can make those
costs irrelevant and can include inefficiencies of the past
(cont.)
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Setting standards (cont.)
• Engineering methods
– The focus is on what the product should cost in the
future
– There is a need to determine how much material should
be required and how much direct labour should be used
in the production process
– Time and motion studies may be conducted to determine
how long it should take for workers to perform each step
in a production process
– In practice, both historical cost analysis and engineering
methods may be used together
• Participation in standard setting may lead to
greater commitment to meeting those standards
(cont.)
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Setting standards (cont.)
• Perfection standards reflect minimum attainable
costs under nearly perfect operating conditions
– Assumes peak efficiency, the lowest material and labour
prices, the use of the best quality materials and no
production disruptions
• Perfection standards
– May motivate people to achieve the lowest cost possible,
as the standard is theoretically attainable
– May discourage employees from working hard as the
standards are unlikely to be achieved
– May encourage employees to sacrifice quality to achieve
low costs
(cont.)
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Setting standards (cont.)
• Practical standards are the minimum attainable
costs under normal operating conditions, with
allowances made for downtime and wastage
– May encourage more positive and productive attitudes
among employees compared to perfection standards
– Including allowances for idle time, material wastage or
normal spoilage, may encourage inefficiency and waste
– Some companies build continuous improvements into
standards to make them more demanding
(cont.)
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Setting standards (cont.)
• Benchmarking of costs may involve
– Identifying companies that have the best cost
performance
– Assessing their level of costs
– Identifying the cost performance gap that needs to be
closed
• Cost standards may be formulated to achieve
external performance standards over the medium
to long term
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Direct material standards
• Standard material quantity
– The total amount of direct material required to produce
one unit of product
• Standard material price
– The total delivered cost of direct material required to
produce one unit of product
– Based on ordering a certain quality of material in specific
order quantities from a specified supplier
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Direct labour standards
• Standard direct labour
– The number of labour hours normally needed to
manufacture one unit of products
• Standard labour rate
– The total hourly cost of wages, including on-costs
 On-costs are extra salary-related costs that all companies
have to pay and are usually treated as part of the cost of
labour
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Standard costs given actual
output
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Direct material variances
• Direct material price variance
– A measure of the effect on cost of purchasing at a price
that is different from standard
= PQ(AP – SP)
Where
PQ = quantity purchased
AP = actual price
SP = standard price
(cont.)
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Direct material variances (cont.)
• Sometimes the direct material price variance is
calculated using the quantity of materials used in
production (AQ) rather than the quantity of
material purchased (PQ)
= AQ(AP – SP)
Where
AQ = actual quantity of material used in
production
AP = actual price
SP = standard price
(cont.)
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Direct material variances (cont.)
• Direct material quantity variance
– A measure of the effect on cost of using a different
quantity of material in production compared with the
standard quantity that should have been used for the
actual production output
= SP(AQ – SQ)
Where
SP = standard price
AQ = actual quantity used
SQ = standard quantity used, given
actual output
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Direct labour variances
• Direct labour rate variance
– A measure of the effect on cost of paying a different
labour rate, compared with standard
= AH(AR – SR)
Where
AH = actual hours used
AR = actual rate per hour
SR = standard rate per hour
(cont.)
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Direct labour variances (cont.)
• Direct labour efficiency variance
– A measure of the effect on cost of using a different
number of direct labour hours, compared with the
standard hours that should have been used for the actual
production output
= SR(AH – SH)
Where
AH = actual hours used
SH = standard hours allowed, given
actual output
SR = standard rate per hour
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Investigating significant variances
and taking corrective actions
• Management by exception
– Only significant cost variances are reported and
investigated
• Which variances are significant?
–
–
–
–
Size of variance
Recurring variances
Trends
Controllability
(cont.)
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Investigating significant variances
and taking corrective actions
(cont.)
• Favourable variances warrant similar investigation
to unfavourable variances
– May reveal efficiencies and new practices that can be
used again
• Investigating variances may include
– Talking with managers and employees familiar with the
operations to find causes
– Written reports to explain significant variances and
possible corrective actions
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A statistical approach to
variance investigation
• Variances may be caused by random fluctuations
which may not require correction
• Statistical control charts plot standard cost
variances across time and compare them with a
critical value
– Highlight the variances which should be investigated
– Critical value is a multiple of the standard deviation of the
normal distribution of that cost variance
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Costs and benefits of
investigation
• Costs include
– Time spent investigating the problem
– Disruption to the production process due to the
investigation
– Cost of implementing corrective actions
• Benefits include
– Reduced costs if the cause of the variance is eliminated
– Causes of favourable variances may improve work
practices
• Management judgment and experience is used to
weigh up these considerations
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Behavioural impact of standard
costing
• Standard costing can be used to evaluate the
performance of managers, employees and
departments
• Comparing individuals’ performance with
standards or budgets can be used to determine
salary increases, bonuses and promotions
• These practices can profoundly influence
behaviour
– Motivate positive behaviours
– Encourage the manipulation of data and reports and
dysfunctional activities and decisions
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Cost control through assigning
responsibility
• Cost control is accomplished through the efforts of
individual managers and employees
• Managers held responsible for certain cost standards
– Need to be able to control these outcomes and be involved
in setting the standards
• Interactions between variances make it difficult to
assign responsibility for particular variances
– Not all favourable variances are desirable
– Unfavourable variances do not always indicate a problem
– Source of the variance may lie in a different area of the firm
than where the variance is being reported
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Standard costs for product
costing
• Standard costing system
– All inventories are recorded at standard cost
• Variances are closed off at the end of the
accounting period
– To cost of goods sold expense
– Prorate variances between WIP, FG and COGS, if
significant
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Summary
• Standard costing systems can be used for cost
control, through the calculation of cost variances
• Cost variances can be calculated for direct
material (price and quantity) and direct labour
(rate and efficiency)
• Decision rules will guide which cost variances are
significant and thus need to be investigated
• Variance reporting can form part of a responsibility
accounting system
• Standard costs can be used for product costing
purposes for external reporting
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