Standard costing

January 05, 2019

Standard Costing Overview

Standard costing is the practice of substituting an expected cost for an actual cost in the
accounting records. Subsequently, variances are recorded to show the difference between the
expected and actual costs. This approach represents a simplified alternative to cost laye ring
systems, such as the FIFO and LIFO methods, where large amounts of historical cost
information must be maintained for inventory items held in stock.

Standard costing involves the creation of estimated (i.e., standard) costs for some or all
activities within a company. The core reason for using standard costs is that there are a number
of applications where it is too time-consuming to collect actual costs, so standard costs are used
as a close approximation to actual costs.

Since standard costs are usually slightly different from actual costs, the cost accountant
periodically calculates variances that break out differences caused by such factors as labor rate
changes and the cost of materials. The cost accountant may periodically change the standard
costs to bring them into closer alignment with actual costs.

Advantages of Standard Costing

Though most companies do not use standard costing in its original application of calculating the
cost of ending inventory, it is still useful for a number of other applications. In most cases, users
are probably not even aware that they are using standard costing, only that they are using an
approximation of actual costs. Here are some potential uses:

 Budgeting. A budget is always composed of standard costs, since it would be impossible to include
in it the exact actual cost of an item on the day the budget is finalized. Also, since a key
application of the budget is to compare it to actual results in subsequent periods, the standards
used within it continue to appear in financial reports through the budget period.

 Inventory costing. It is extremely easy to print a report showing the period-end inventory balances
(if you are using a perpetual inventory system), multiply it by the standard cost of each item, and
 instantly generate an ending inventory valuation. The result does not exactly match the actual cost
of inventory, but it is close. However, it may be necessary to update standard costs frequently, if
actual costs are continually changing. It is easiest to update costs for the highest -dollar
components of inventory on a frequent basis, and leave lower-value items for occasional cost
reviews.

 Overhead application. If it takes too long to aggregate actual costs into cost pools for allocation to
inventory, then you may use a standard overhead application rate instead, and adjust this rate every
few months to keep it close to actual costs.

 Price formulation. If a company deals with custom products, then it uses standard costs to compile
the projected cost of a customer’s requirements, after which it adds a margin. This may be quite a
complex system, where the sales department uses a database of component costs that change
depending upon the unit quantity that the customer wants to order. This system may also account
for changes in the company’s production costs at different volume levels, since this may call for
the use of longer production runs that are less expensive.

Nearly all companies have budgets and many use standard cost calculations to derive product
prices, so it is apparent that standard costing will find some uses for the foreseeable future. In
particular, standard costing provides a benchmark against which management can compare
actual performance.

Problems with Standard Costing

Despite the advantages just noted for some applications of standard costing, there are
substantially more situations where it is not a viable costing system. Here are some problem
areas:

 Cost-plus contracts. If you have a contract with a customer under which the customer pays you for
your costs incurred, plus a profit (known as a cost-plus contract), then you must use actual costs,
as per the terms of the contract. Standard costing is not allowed.

 Drives inappropriate activities. A number of the variances reported under a standard costing
system will drive management to take incorrect actions to create favorable variances. For example,
they may buy raw materials in larger quantities in order to improve the purchase price variance,
even though this increases the investment in inventory. Similarly, management may schedule
 longer production runs in order to improve the labor efficiency variance, even though it is better to
produce in smaller quantities and accept less labor efficiency in exchange.

 Fast-paced environment. A standard costing system assumes that costs do not change much in the
near term, so that you can rely on standards for a number of months or even a year, before
updating the costs. However, in an environment where product lives are short or continuous
improvement is driving down costs, a standard cost may become out-of-date within a month or
two.

 Slow feedback. A complex system of variance calculations is an integral part of a standard costing
system, which the accounting staff completes at the end of each reporting period. If the production
department is focused on immediate feedback of problems for instant correction, the reporting of
these variances is much too late to be useful.

 Unit-level information. The variance calculations that typically accompany a standard costing
report are accumulated in aggregate for a company’s entire production department, and so are
unable to provide information about discrepancies at a lower level, such as the individual work
cell, batch, or unit.

The preceding list shows that there are many situations where standard costing is not useful, and
may even result in incorrect management actions. Nonetheless, as long as you are aware of
these issues, it is usually possible to profitably adapt standard costing into some aspects of a
company’s operations.

Standard Cost Variances

A variance is the difference between the actual cost incurred and the standard cost against
which it is measured. A variance can also be used to measure the difference between actual and
expected sales. Thus, variance analysis can be used to review the performance of both revenue
and expenses.

There are two basic types of variances from a standard that can arise, which are the ra te
variance and the volume variance. Here is more information about both types of variances:

 Rate variance. A rate variance (which is also known as a price variance) is the difference between
the actual price paid for something and the expected price, multiplied by the actual quantity
 purchased. The “rate” variance designation is most commonly applied to the labor rate variance,
which involves the actual cost of direct labor in comparison to the standard cost of direct labor.
The rate variance uses a different designation when applied to the purchase of materials, and may
be called the purchase price variance or the material price variance.

 Volume variance. A volume variance is the difference between the actual quantity sold or
consumed and the budgeted amount, multiplied by the standard price or cost per unit. If the
variance relates to the sale of goods, it is called the sales volume variance. If it relates to the use of
direct materials, it is called the material yield variance. If the variance relates to the use of direct
labor, it is called the labor efficiency variance. Finally, if the variance relates to the application of
overhead, it is called the overhead efficiency variance.

Thus, variances are based on either changes in cost from the expected amount, or changes in the
quantity from the expected amount. The most common variances that a cost accountant elects to
report on are subdivided within the rate and volume variance categories for direct materials,
direct labor, and overhead. It is also possible to report these variances for revenue.

It is not always considered practical or even necessary to calculate and report on variances,
unless the resulting information can be used by management to improve the operations or lower
the costs of a business. When a variance is considered to have a practical application, the cost
accountant should research the reason for the variance in detail and present the results to the
responsible manager, perhaps also with a suggested course of action.

Standard Cost Creation

At the most basic level, you can create a standard cost simply by calculating the average of the
most recent actual cost for the past few months. In many smaller companies, this is the extent of
the analysis used. However, there are some additional factors to consider, which can
significantly alter the standard cost that is used. They are:

 Equipment age. If a machine is nearing the end of its productive life, it may produce a higher
proportion of scrap than was previously the case.
 Equipment setup speeds. If it takes a long time to setup equipment for a production run, the cost of
the setup, as spread over the units in the production run, is expensive. If a setup reduction plan is
contemplated, this can yield significantly lower overhead costs.

 Labor efficiency changes. If there are production process changes, such as the installation of new,
automated equipment, then this impacts the amount of labor required to manufacture a product.

 Labor rate changes. If you know that employees are about to receive pay raises, either through a
scheduled raise or as mandated by a labor union contract, then incorporate it into the new standard.
This may mean setting an effective date for the new standard that matches the date when the cos t
increase is supposed to go into effect.

 Learning curve. As the production staff creates an increasing volume of a product, it becomes
more efficient at doing so. Thus, the standard labor cost should decrease (though at a declining
rate) as production volumes increase.
 Purchasing terms. The purchasing department may be able to significantly alter the price of a
purchased component by switching suppliers, altering contract terms, or by buying in different
quantities.

Any one of the additional factors noted here can have a major impact on a standard cost, which
is why it may be necessary in a larger production environment to spend a significant amount of
time formulating a standard cost.

Overhead Controllable Variance:

Definition and Explanation:

The controllable variance is the difference between actual expenses incurred and the
budget allowance based on standard hours allowed for work performed. This variance may
be favorable or unfavorable.

If the actual factory overhead is more than the budget allowance based on standard hours
allowed for work performed, the variance is called unfavorable controllable variance.

If the actual factory overhead is less than the budget allowance based on standard hours
allowed for work performed, the variance is called favorable controllable variance.

Overhead controllable variance is calculated when overall or net overhead variance is

further analyzed using two variance method. Other variance that is calculated in two
variance method is volume variance.

Formula:

Following formula is used for the calculation of this variance:

Controllable variance = Actual Factory Overhead - Budgeted Allowance Based on Standard Hours Allowed
Example:

From the following data calculate factory overhead controllable variance:

Actual overhead $7,384

Actual hours used 3,475

Units produced during the period 850

Standard hours for one unit 4

Standard factory overhead rate:

Variable
$1.20

Fixed $2.00
$0.80

Normal Capacity in labor hours 4000 hours

Solution:
Actual factory overhead $7,384

Budgeted allowance based on standard hours allowed:

Fixed expenses budgeted $3,200

Variable expenses (3,400* standard hours allowed × $1.20 variable overhead

4,080 $7,280
rate)

Controllable variance $104 unfav

*Standard hours allowed = Units produced during the period × Standard time allowed for on unit

3,400 = 850 units × 4 hours

This variance consists of variable expense only and can also be computed as follows:
 Actual variable expense:

Actual overhead $7,384

Fixed expenses budgeted (4000 × 0.80) $3,200 $4,184

Variable expenses for standard hours allowed (3,400*× $1.20) 4,080

Controllable variance $104 unfav

Who is Responsible For Controllable Variance?

The controllable variance is the responsibility of the department managers to the extent
that they can exercise control over the costs to which the variances relate.

The three-way analysis shows the difference between the total actual factory overhead and
total standard factory overhead costs split into three components: spending
variance, efficiency variance, and volume variance.
Components of the Three-Way Analysis
The three-way analysis consists of:
1.) spending variance,
2.) efficiency variance, and
3.) volume variance.
The spending variance consists of the variable spending variance and fixed spending
variance (a.k.a. fixed budget variance).
Spending variance = Variable spending variance + Fixed budget variance

Efficiency variance = Variable efficiency variance

Volume variance = Fixed volume variance

Alternatively, the spending variance may be computed as the difference between actual
factory overhead and budget allowed based on actual hours (BAAH). If the actual FOH is
greater than the BAAH, the variance is unfavorable; otherwise, favorable.
The efficiency variance is the difference between the BAAH and the budget allowed based
on standard hours (BASH). If the BAAH is greater than the BASH, the variance is
unfavorable.
And finally, the volume variance is the difference between the BASH and the standard
factory overhead. Also, if the BAAH is greater than the standard FOH, the variance is
unfavorable.
Example
Company XYZ produces a product that has the following factory overhead standard costs
per unit. The budgeted production is at the normal capacity of 1,000 units, requiring a
budgeted time of 3,000 hours. The total fixed factory overhead at this capacity is $30,000.
Variable FOH 3 hours at $30 per hour

Fixed FOH 3 hours at $10 per hour

During the month, the company produced 1,100 units and incurred the following actual
factory overhead costs:
Variable FOH 3,250 hours at $29 per hour $ 94,250

Fixed FOH $ 36,500

Total $130,750

The three-way analysis variances can be computed as follows:

SPENDING VARIANCE

Actual FOH (variable + fixed) $130,750

Budget allowed on actual hours (BAAH) 127,500

*for variable (3,250 hours x $30)

*for fixed ($30,000 as budgeted)

Budget variance $ 3,250 UF

EFFICIENCY VARIANCE

Budget allowed on actual hours (BAAH) $127,500

Budget allowed on standard hours (BASH) 129,000

*for variable (1,100 x 3hours x $30)

*for fixed ($30,000 as budgeted)

Efficiency variance $ 1,500 F

VOLUME VARIANCE

Budget allowed on standard hours (BASH) $129,000

Standard FOH (1,100 x 3 hours x $40) 132,000

Volume variance $ 3,000 F

TOTAL FACTORY OVERHEAD VARIANCE $ 1,250 F

Four-Way Analysis
A more expanded breakdown known as "four-way analysis" simply separates the spending
variance into the variable and fixed components. The four-way analysis consists of: 1.)
variable spending variance, 2.) fixed spending variance, 3.) efficiency variance, and 4.)
volume variance.

Components of the Two-Way Analysis

The two-way analysis consists of:
1.) budget variance (also known as controllable variance), and
2.) volume variance.
These variances are computed as follows.
Budget variance = Variable spending variance + Variable efficiency variance + Fixed budget variance

Volume variance = Fixed volume variance

Alternatively, the budget variance may be computed as the difference between actual
factory overhead and budget allowed based on standard hours. If the actual FOH is greater
than the budget allowed, the variance is unfavorable; otherwise, favorable.
The volume variance is the difference between the budget allowed on standard hours and
the standard factory overhead. If the budget allowed is greater than the standard FOH, the
variance is unfavorable.
Example
Company XYZ produces a product that has the following factory overhead standard costs
per unit. The budgeted production is at the normal capacity of 1,000 units, requiring a
budgeted time of 3,000 hours. The total fixed factory overhead at this capacity is $30,000.
Variable FOH 3 hours at $30 per hour

Fixed FOH 3 hours at $10 per hour

During the month, the company produced 1,100 units and incurred the following actual
factory overhead costs:
Variable FOH 3,250 hours at $29 per hour $ 94,250

Fixed FOH $ 36,500

Total $130,750

The two-way analysis variances can be computed as follows:

BUDGET VARIANCE

Actual FOH $130,750

Budget allowed on standard hours 129,000

*for variable (1,100 x 3 hours x $30)

*for fixed ($30,000 as budgeted)

Budget variance $ 1,750 UF

VOLUME VARIANCE

Budget allowed on standard hours $129,000

Standard FOH (1,100 x 3 hours x $40) 132,000

Volume variance $ 3,000 F

TOTAL FACTORY OVERHEAD VARIANCE $ 1,250 F

The favorable variance of $1,250 in total factory overhead costs is brought about by a
$1,750 unfavorable budget variance and a $3,000 favorable volume variance.