Chapter 11
Standard Costing and Variance
Analysis
Standard costing
Standard costing is a system where preset standards
are used in the estimation of costs. This can provide
more detailed variance analysis information for
managers.
It involves the setting of detailed predetermined
standard product costs, so that a business can
accurately estimate, based on the standards set, what
the cost of a product or service should be.
Comparing this standard to the actual cost of a
product enhances cost control.
Standard cost
‘Benchmark measurement of resource usage
or revenue or profit generation, set in defined
conditions’.
Standard cost as defined by CIMA Official Terminology
A standard cost is a predetermined calculation of
what a cost should be under specified working
conditions.
Setting a standard involves the establishment of two
components for each cost type, the volume required
and the unit cost attached to that volume.
Variance analysis
‘Evaluation of performance by a means of
variances, whose timely reporting should
maximise the opportunity for managerial
action’
Variance analysis as defined by CIMA Official Terminology
Budgetary control worksheet
Budgetary control reconciliation
Direct materials variance
The materials variance of €3,000 adverse could
be further analysed into its two component parts:
Materials price variance: This variance reflects the
difference between the actual purchase price of
materials (food) and the standard purchase price set.
Materials usage variance: This variance reflects the
difference between the actual quantity of materials
used and the quantity allowed, for the various
products produced.
Direct labour variance
The direct labour variance of €3,000 favourable
could be further analysed into its two component
parts:
Labour rate variance: This is caused by differences
between the actual labour rate and the standard rate
set in the budget.
Labour efficiency variance: This is due to the
differences between the actual time spent in
producing the products and the standard time allowed
or set in the budget.
Overhead variances
The variable overhead variance of €2,000 adverse could
be further analysed into its two component parts:
Rate: Caused by the difference between the actual variable
overhead rate and the budgeted rate.
Efficiency: Caused by the difference between the actual variable
overhead usage and the standard usage allowed in the budget.
The fixed overhead variance of €3,000 adverse Standards are not normally set for fixed overhead because they are
a product of time and not of efficiency or production.
Summary of variances
Key variances in standard
costing
Direct material variances
Key variances in standard
costing
Direct labour variances
Key variances in standard
costing
Variable overhead variances
Example 11.1: Standard costing
a) Calculate the standard variable cost of a single souvenir
unit
b) Prepare a worksheet showing the fixed budget, flexible
budget, actual results and variance for the period
c) Further analyse the materials, labour and overhead
variances into the following sub-variances
c) Further analyse the materials, labour and overhead
variances into the following sub-variances
c) Further analyse the materials, labour and overhead
variances into the following sub-variances
c) Further analyse the materials, labour and overhead
variances into the following sub-variances
c) Further analyse the materials, labour and overhead
variances into the following sub-variances
c) Further analyse the materials, labour and overhead
variances into the following sub-variances
c) Further analyse the materials, labour and overhead
variances into the following sub-variances
d) Prepare a statement reconciling the budgeted net profit
with actual net profit
Interpretation of Variances
Materials Price
€1543 F
Possible reasons
Availing of quantity discounts
General reduction in price of
raw materials
Materials usage
€40 A
Possible reasons
Purchase of poor quality
materials
Quality/age of equipment used
leading to greater waste
Poor labour efficiency leading
to greater waste
Accuracy of standard
Theft
Interpretation of Variances
Labour rate
Labour efficiency
€630 A
€500 A
Possible reasons
Unexpected wage deal that
applied retrospectively.
Out of date standard.
Increase in overtime.
Increase in labour taxes.
Possible reasons
Skill and training of staff.
Motivational factors such as
working conditions, pay, career
prospects.
Quality of materials.
Quality and age of equipment.
Accuracy of standard.
Interpretation of Variances
Variable O/H rate
€293F
Variable O/H Efficiency
€100 A
Possible reasons
Possible reasons
Standard not reviewed
regularly
Fall in the rate
This variance is related to the
labour efficiency variance and
is influenced by the same
factors that influence the
labour efficiency variance.
Summary of reasons for variances
Materials
Price
Changes in market price between the agreeing of standards and
actual performance.
Poor performance by the purchasing department staff in not
achieving better value purchasing.
Unrealistic standards not regularly reviewed.
Materials
Usage
Poor quality materials purchased, leading to high levels of waste.
Faulty equipment leading to higher levels of waste.
Poor levels of labour efficiency.
Unrealistic standards not reviewed.
Labour Rate
Standard not reflecting changing rates of pay.
Unanticipated increases in overtime levels.
Unanticipated increases in labour taxes (employers PRSI).
Labour
Efficiency
Poor staff motivation.
High staff turnover and hence an increase in staff training.
Poor quality materials.
Faulty equipment.
Delays in material supplies resulting in wasted labour time.
Interrelationship of variances
The purchase of cheap and inferior materials will lead to a
favourable materials price variance but can cause an adverse
materials usage variance, due to increased waste associated
with the inferior materials. It can also lead to an adverse labour
efficiency variance as employees may require added time as a
result of the inferior materials.
Cheaper labour costs will lead to a favourable labour rate
variance but can cause an adverse labour efficiency variance
due to the requirement for training and the effects of the learning
curve. This can also cause an adverse materials usage
variance.
Adverse labour efficiency variances can also create adverse
variable overhead efficiency variances
Not reinvesting in equipment can create favourable capital
spending variances, however this can lead to adverse variances
in materials usage, labour efficiency and variable overhead.
The standard setting process
Crucial to a system of standard costing is the setting of
standard costs that can be used as a benchmark against
which actual performance can be measured. Before a
system of standard costing can be implemented, a range
of information must be collected from various
departments to be analysed. Examples would include:
Purchasing costs of direct materials from the purchasing
department.
Wage rates and productivity agreements from the personnel
department.
Details of overhead costs from the accounting / production
department.
The standard setting process
Direct materials standard costs
Standard price – based on prices agreed and negotiated with supplier
(average price the firm expects to pay during the life of the standard)
Standard usage - based on product specifications allowing for
unavoidable losses.
Direct labour standard costs
Standard rate – the wage rate as agreed in any trade union agreement.
Standard efficiency – the average time a direct labour employee takes
to perform tasks related to a unit of production.
Variable production overhead standard costs
Variable overhead rate standard – based on historic information about
variable overhead costs.
Variable overhead efficiency standard – is generally either direct labour
hours or direct machine hours.
The standard setting process
Standards should be attainable and should not
assume perfect or ideal conditions.
Built into any standard should be certain allowances
for what is termed 'normal loss'.
Standards, although realistic and with allowances
built in, should also have a motivating affect on
employees.
Employees must be involved in the standard setting
process where it affects them, especially in terms of
the efficiency standards.
In setting standards, management must accept and
anticipate some degree of variability between actual
performance and the standard set.
Standards should to be revised to ensure they are
still realistic.
Advantages of standard costing
More accurate pricing of products based on detailed cost
analysis.
Carefully planned standards are an aid to more accurate
budgeting.
The business will have a more simplified stock control system,
as all materials purchased are valued at standard cost rather
than LIFO or FIFO value systems.
More detailed variance analysis leading to a deeper level of
investigation and better management decision-making.
A target of efficiency is set for employees and cost
consciousness is stimulated.
The setting of standards involves determining the best
materials and practices, which may lead to economies.
An overall improvement in the financial control of the business.