Chapter 11

STANDARD COSTING AND ANALYSIS OF VARIANCE

Introduction

Cost accountants can provide feedback to managers by comparing dimensions of actual service to
predetermined measures. Without a predetermined performance measure, there is no way to know what
level of performance is expected. And, without making a comparison between the actual result and the
predetermined measure, there is no way to know whether expectations were met and no way for managers
to exercise control.

Organizations develop and use standards for almost all tasks. Because of the variety of
organizational activities and information objectives, no single performance measurement system is
appropriate for all situations. Some systems use standards for prices, but not for quantities; other systems
(especially in service businesses) use labor, but not material, standards. This chapter discusses a
traditional standard cost system that provides price and quantity standards for each cost component: direct
material (DM), direct labor (DL), and factory overhead (OH). Discussion is provided on how standards are
developed, how variances are calculated, and what information can be gained from detailed variance
analysis. Journal entries used in a standard cost system are also presented.

Learning Objectives:

 State the nature and rationale of standard costs.

 Discuss the benefits and limitations of standard costs.
 Describe how standards are set for direct material, direct labor and overhead.
 Identify the possible causes of variances and responsibility for them.
 Compute and analyze the variances between actual costs and standard costs.

Lesson 1 – Standard Costs

Standards

 Standards are expected level of performance.

 Standards are established to institute order, discipline, expectations, and normalcy.
 Standards are oftentimes quantitative for objectivity of measurement.
 Standards are used in almost all functions of management – planning, organizing, directing, and
controlling.

Standards Setting

 Standard setting is strategic in nature. Standard could be set by top management, outsourced from
independent entity, developed by industrial engineering department, or established with the
participation and involvement of lower level managers and personnel.
 Standards set in organizations could either motivate or demotivate employees, give relevance or
irrelevance to their work, or produce excellent performance or mediocre performance.
  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:
 Quantity standards specify how much of an input should be used to make a product or
provide a service. For example: Auto service centers like Firestone and Sears set labor time
standards for the completion of work tasks. Fast-food outlets such as McDonald’s have
exacting standards for the quantity of meat going into a sandwich.
 Price standards specify how much should be paid for each unit of the input. For example:
Hospitals have standard costs for food, laundry, and other items. Home construction
companies have standard labor costs that they apply to sub-contractors such as framers,
roofers, and electricians. 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.
 Capacity levels in standard setting include:
1. Theoretical capacity – Standards are set at the highest possible capacity where there are no
allowance for waste, spoilage, inefficiencies, machine breakdowns and other downtimes, and
other interruptions in the production line.
2. Practical capacity - Standards attain the most reasonable production level, with allowances for
machine breakdowns, downtimes, inefficiencies, waste and spoilage, and other normal
production disturbances.
3. Budgeted Capacity – This is the estimated level of performance that the company plans to
achieve in the next 12 months.
4. Standard capacity – This is the estimated capacity that should have been used in actual
capacity. It is determined by multiplying actual production in units by the standard rate per unit
produced.
5. Normal capacity – This is the average production level over a long period of time. It is the middle
point where variations in production levels over a longer span of time would finally settle down.

Sample Problem on Capacity Levels

Myrcella Company acquired a machine with a 200,000 units level of capacity five years ago. Using this
machine, the standard labor time is 2 hours per unit. Engineering estimates based on attainable
performance is 170,000 units. Management has planned to produce only 160,000 units in the coming year
using the same machine. Total production in the last five years is 828,000 with annual production recorded
as follows:

first year 180,000 units

second year 140,000 units
third year 170,000 units
fourth year 182,000 units
fifth year 156,000 units

The capacity levels are as follows:

Hours
(units x 2
Units hours)
Maximum Capacity 200,000 400,000
 Practical Capacity 170,000 340,000
Budgeted Capacity 160,000 320,000
Normal Capacity (828,000/5 years 165,600 331,200
Standard capacity first year (180,000 x 2 hours 360,000

Setting Direct Material Standards

 The standard price per unit for direct materials should reflect the final, delivered cost of the
materials, net of any discounts taken.
 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.
 A bill of materials is a list that shows the quantity of each type of material in a unit of finished
product.

Setting Direct Labor Standards

 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.
 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 Variable Manufacturing Overhead Standards

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

 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.
 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.

Sample Problems on Setting Standards for Materials and Labor

1. Southern Corporation produces product Durito weighing 3.2 lbs., net of 20% processing loss. It buys
materials from a supplier at an invoice price of P40 per pound with a normal trade discount of 2/10,
n/30. Freight for the delivery of materials costs P5 per lb. What is the standard materials quantity,
price and cost per unit?
Solution:
Standard materials input = Standard materials output / (100 – loss rate)
= 3.2 lbs. / 80% = 4 lbs.
Standard price per lb.:
Purchase price P40 x 98% P39.20
Freight-in 5.00
Standard price per lb. P44.20
Standard materials cost = Standard materials input x Standard net price
= 4 lbs. x P44.20 = P176.80
2. Northern Company produces product Durito after 45 minutes of direct labor time. The company
pays its production personnel for eight (8) hours a day and gives a paid break time of 30 minutes a
day. It normally starts its process with 5,000 units and completes at 4,500 good units. It pays its
personnel at an hourly rate of P70 plus social welfare benefits of approximately 10% on the basic
rate. What is the standard direct labor hours, rate and cost per unit?
Solution:
The production rate is 90% (4,500/5,000). The standards are determined a follows:
Standard direct labor hours = Standard output time / (100 – Loss rate)
= 45 minutes / 90%
= 53.33333 minutes or 0.888889 hour
Standard direct labor rate per hour:
Basic wage rate per hour P70.00
Fringe benefits (10%) 6.00
Standard rate per hour P76.00
Standard direct labor costs = standard direct labor time x Standard labor rate
= 0.888889 hrs x P76.00
= P67.5556

Production Costs Variance Analysis

  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.
 A variance should be investigated, analyzed, studied, and avoided in the future.
 A variance may be unfavorable or favorable. If actual cost is more than the standard costs, the
variance is unfavorable. If actual cost is less than standard costs, the variance is favorable.
 A variance may be normal or exceptional.

A General Model for 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 quantity 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.
 In equation form, price and quantity variances are calculated as shown below:
Responsibility for Variances:

 Material Cost Variances:

The purchasing manager and production manager are usually held responsible for the materials
price variance and materials quantity variance, respectively. The standard price is used to compute
the quantity variance so that the production manager is not held responsible for the performance of
the purchasing manager.
 Labor Variances:
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.

Advantages of Standard Costs

Research has shown that a substantial portion of companies in the United Kingdom, Canada, Japan, and
the United States use standard cost systems. This is because standard cost systems offer many
advantages including:

 Standard costs are a key element of the management by exception approach which helps
managers focus their attention on the most important issues.

 Standards that are viewed as reasonable by employees can serve as benchmarks that promote
economy and efficiency.

 Standard costs can greatly simplify bookkeeping.

 Standard costs fit naturally into a responsibility accounting system

Potential Problems with Standard Costs

The use of standard costs can also present a number of problems. For example:

 Standard cost variance reports are usually prepared on a monthly basis and are often released
days or weeks after the end of the month; hence, the information can be outdated.

 If variances are misused as a club to negatively reinforce employees, morale may suffer and
employees may make dysfunctional decisions.

 Labor variances make two important assumptions. First, they assume that the production process
is labor-paced; if labor works faster, output will go up. Second, the computations assume that labor
 is a variable cost. These assumptions are often invalid in today’s automated manufacturing
environment where employees are essentially a fixed cost.

 In some cases, a “favorable” variance can be as bad or worse than an unfavorable variance.

 Excessive emphasis on meeting the standards may overshadow other important objectives such as
maintaining and improving quality, on-time delivery, and customer satisfaction.

 Just meeting standards may not be sufficient; continual improvement using techniques such as Six
Sigma may be necessary to survive in a competitive environment

Sample Problems on Variance Analysis

Materials and labor costs variances

The standard unit cost of Tomen Company is given below:

Direct materials : 4 lbs. @ P4.00 P16.00
Direct labor : 3 hrs. @ P8.00 24.00
Variable Overhead : 3 hrs. @ P2.00 P6.00
Fixed Overhead : 3 hrs. @ P3.00 P9.00 P15.00
Total standard unit cost P55.00
The company has a normal capacity of 135,000 units and a budgeted capacity of 132,000 units. Actual
data taken from the production records in the month of September 2018 are:
Actual production 130,000 units
Materials purchases (580,000 lbs. @ P3.90) P2,262,000
Materials used 525,000 lbs.
Payroll incurred (380,000 lbs. @ P8.15) P3,097,000
Factory overhead: Variable P 800,000
Fixed P1,250,000
Required: Materials and labor cost variances using 2-way analyses.
Solution/Discussion:

Direct Materials Costs Variances

Material variances are classified as price variance and quantity variance as tabulated below:
Quantity Unit Price Amount
Actual 525,000 lbs P3.90 P2,047,500
Less: Standard 520,000 4.00 2,080,000
Variance - UF (F) 5,000 UF P (0.10) F P (32,500) F

The total peso value of these materials variances are computed as follows:
Materials Price Variance = (Actual price – Standard price) x Actual Quantity
Materials Quantity Variance = (Actual Quantity – Standard Quantity) x Standard Price
MPV = (AP – SP) x AQ = (P3.90 – P4.00) x 525,000 lbs. = (P52,500) F
MQV = (AQ – SQ) x SP = (525,000 – 520,000) x P4.00 = 20,000 UF
Net direct materials costs variance P (32,500) F

Direct Labor Costs Variances

Except for terminologies, the manner in which the direct labor costs variances are analyzed is similar to that
of the direct materials. Direct labor is also basically affected by two factors – hours and rate per hour. The
variances are presented below:

Hours Rate /Hr Amount

Actual 380,000 P8.15 P3,097,000
Less: Standard 390,000 8.00 3,120,000
Variance - UF (F) (10,000) F P 0.15 UF P(23,000) F

Labor Rate Variance = (Actual Rate – Standard Rate) x Actual Rate

Labor Efficiency Variance = (Actual Hours – Standard Hours) x Standard Rate

LRV = (AR – SR) x AH = (P8.15 – P8.00) x 380,000 lbs = P57,000 UF

LEV = (AH – SH) x SR = (380,000 – 390,000) x P8.00 = (80,000) F
Net Direct Labor Costs Variance P(23,000) F

Factory Overhead Variance Analysis

Sample Problem
In analyzing the factory overhead variances, the following relevant data are taken from the original
information:
Normal Capacity 135,000 units or 405,000 hours
Standard hours 390,000 hours
Actual hours 380,000 hours
Standard overhead rates:
Fixed overhead rate P3.00 per hour
Variable overhead rate 2.00 per hour
Total overhead rate P5.00 per hour
Actual Overhead costs
Variable P800,000 and Fixed, P1,250,000

Required: Analyze the factory overhead variances using the:

1. 2-way analysis (ConVo)
2. 3-way analysis (SEV)
3. 4-way analysis
4. 5-way analysis
Solution/Discussions:
 First, let us analyze the total factory overhead variance, then analyze it into ist components. The
total factory overhead variance is calculated below:

OVERHEAD
Fixed Variable Total
Actual factory overhead 1,250,000 800,000 2,050,000
Less: Standard factory overhead 1,170,000 780,000 1,950,000
 Variances-UF (F) 80,000 20,000 100,000

2-way analysis (Con Vo)

The 2-way variance analysis classifies the variances in relation to amount of money spent (controllable
variance) or level of production (volume variance). The 2-way overhead variance analysis is presented
below:

Controllable Variance
Actual Factory Overhead 2,050,000
Less: Budgeted Allowance on Standard Hours
Fixed (405,000 hours x P3.00) 1,215,000
Variable (390,000 hours x P2.00) 780,000 1,995,000 P55,000 UF
Volume Variance
Budgeted Allowance on Standard Hours 1,995,000
Less: Standard Factory Overhead
(390,000 hrs. x P5) 1,950,000 45,000 UF
Total Overhead Variance P100,000 UF

 The budgeted fixed overhead is based on normal capacity.

 In computed the budget allowance in standard hours, the fixed overhead is the budgeted fixed
overhead while, the variable overhead is standard hour times standard variable overhead rate.
 Controllable variance represents the change in the amount of money spent based on absolute
peso amount and on the number of hours used. It is composed of the spending variance and the
variable efficiency variance which are both controllable in the level of the supervisors.
 Volume variance measures the deviation in hours between the standard capacity from normal
capacity. Volume variance is strictly fixed overhead variance.

3-way analysis
The controllable variance could still be divided into two, the spending (or budget) variance and the variable
efficiency variance. As such, we will have three overhead variances computed as follows:

Controllable Variance
Actual Factory Overhead 2,050,000
Less: Budgeted Allowance on Actual Hours
1,215,00
Fixed (405,000 hours x P3.00) 0
Variable (380,000 hours x P2.00) 760,000 1,975,000 P75,000 UF
Variable Efficiency Variance
Budgeted Allowance on Actual Hours 1,975,000
Less: Budgeted Allowance on Standard Hours 1,995,000 (20,000) F
Volume Variance
Budgeted Allowance on Standard Hours 1,995,000
Less: Standard Factory OH 1,950,000 45,000 UF
P100,000
Total Overhead Variance UF

 In determining budgeted overhead amounts, the budgeted fixed overhead does not change
regardless of level of activity or level of hours used.
 Spending variance is the rate variance. It indicates the difference in the amount of money spent per
unit produced or per hour used.
 The variable efficiency variance refers to the amount of money spent on the difference in hours
used relative to variable overhead.
4-way analysis
The spending variance in the 3-way analysis above could still be divided as to fixed spending and variable
spending variance. This makes our overhead analysis into a 4-way analysis, as follows:

Fixed Spending Variance

Actual Factory Overhead 1,250,000
Less: Budgetd Fixed Overhead 1,215,000 P35,000 UF
Variable Spending Variance
Actual Variable Overhead 800,000
Less: Actual Hours x Variable OH rate
(380,000 hrs x P2.00) 760,000 40,000 UF
Variable Efficiency Variance
Budgeted Allowance on Actual Hours 1,975,000
Less: Budgeted Allowance on Standard Hours 1,995,000 (20,000) F
Volume Variance
Budgeted Allowance on Standard Hours 1,995,000
Less: Standard Factory OH 1,950,000 45,000 UF
Total Overhead Variance P100,000 UF

Materials price, mix and yield variances

Almost all products need different materials to complete. In this case, materials mixing and yield variances
are to be isolated, analyzed, studied, and given proper managerial action. The materials mix and yield
variances represent the quantity variance. The computation of the materials price, mix, and yield variances
are illustrated using the following information:
Sample Problem
The standard materials costs in producing 400 units of product “Covid” are as follows:
Materials Qty. in lbs. Price per lb. Total Costs
A 400 P10.00 P4,000
B 500 5.00 2,500
C 100 8.00 800
1,000 P7,300
Actual production data in October 2019 are as follows:
 Production, 16,000 units
 Materials used:
Materials Qty. in lbs. Price per lb. Total Costs
A 18,000 P10.20 P183,600
B 19,000 4.90 93,100
C 5,000 8.05 40,250
42,000 P316,950
Determine the materials price, mix and yield variances.
Solutions/Discussions:
 First, let us determine the Standard Output Cost (SOC) and the Standard Input Cost (SIC). SOC is
the average standard materials cost per output (completed units), while SIC is the average standard
materials cost per unit (materials input).

SOC = Total Standard Materials Cost / Standard Production

SIC = Total Standard Materials Cost / Standard Materials Input

SOC = P7,300 / 400 units = P18.25 per unit

SIC = P7,300 / 1,000 lbs. = P7.30 per pound

Actual Direct materials costs P316,950

 Less: Actual output @ Standard Output Cost
(16,000 units x P18.25) 292,000
Total materials costs variance P24,950 UF
 The materials price, mix and yield variances are as follows:

Materials Price Variance:

Actual direct materials costs P316,950
Less: Actual Materials input @ Standard Price
A (18,000 lbs x P10.00) P180,000
B (19,000 lbs x P5.00) 95,000
C (5,000 lbs x P8.00) 40,000 315,000 P1,950 UF

Materials Mix Variance

Actual Materials Input @ Standard Price 315,000
Less: Actual Materials Input @ Standard Input cost
(42,000 lbs x P7.30 per lb) 306,600 8,400 UF

Yield Variance
Actual Materials Input @ Standard Input Cost 306,600
Less: Actual Output @ Standard Output Cost
(16,000 units x P18.25) 292,000 14,600 UF

P24,950
Total Materials Cost Variance UF

 Materials price variance is the difference in price multiplied by the actual quantity purchased (or
quantity used if quantity purchased is not available).
 The materials mix variance is the difference between the actual quantity used in a material and the
standard quantity that should have been used for that material based on the standard materials mix
and out of the total materials used.
 The materials yield variance represents the difference in actual output and the expected output
given a particular number of materials used in production. The standard materials yield is equal to
the ratio of output over the input.

Disposition of Variances
A variance may be normal or exceptional. Normal variances are those within the range of expectations
while exceptional variances are those outside the range of normal expectations. These variances are
disposed of as follows:
 Normal variance – adjusted to cost of goods sold, ie, immediately treated as period costs.
 Exceptional Variance – Traditionally, exceptional material variances are allocated among the
materials inventory, work-in-process inventory, finished goods inventory, and cost of goods sold
accounts. Exceptional variances of direct labor and overhead are allocated among work in process
inventory, finished goods inventory and cost of goods sold accounts. Modern business philosophies
treat exceptional variances as an expense.

Exercises
I – True/False
1. Specifications for materials are compiled on a bill of materials.
2. Specifications for materials are compiled on a purchase requisition.
3. An operations flow document shows all processes necessary to manufacture one unit of a product.
4. A standard cost card is prepared after manufacturing standards have been developed for direct
materials, direct labor, and factory overhead.
 5. The total variance can provide useful information about the source of cost differences.
6. The total variance does not provide useful information about the source of cost differences.
7. The formula for price/rate variance is (AP - SP) x AQ
8. The formula for price/rate variance is (AP - SP) x SQ
9. Specifications for materials are compiled on a bill of materials.
10. Specifications for materials are compiled on a purchase requisition.
11. An operations flow document shows all processes necessary to manufacture one unit of a product.
12. A standard cost card is prepared after manufacturing standards have been developed for direct
materials, direct labor, and factory overhead.
13. The total variance can provide useful information about the source of cost differences.
14. The price variance reflects the difference between the quantity of inputs used and the standard
quantity allowed for the output of a period.
15. The usage variance reflects the difference between the quantity of inputs used and the standard
quantity allowed for the output of a period.
16. The difference between the actual wages paid to employees and the standard wages for all hours
worked is the labor rate variance.
17. The difference between the actual wages paid to employees and the standard wages for all hours
worked is the labor efficiency variance.
18. The difference between the standard hours worked for a specific level of production and the actual
hours worked is the labor efficiency variance.
19. The difference between the standard hours worked for a specific level of production and the actual
hours worked is the labor rate variance
20. The difference between actual variable overhead and budgeted variable overhead based upon
actual hours is referred to as the variable overhead spending variance.
21. The difference between budgeted and applied fixed factory overhead is referred to as a fixed
overhead volume variance.
22. A fixed overhead volume variance is a controllable variance.
23. An overhead efficiency variance is related entirely to variable overhead
24. Managers have no ability to control the budget variance,
25. Unfavorable variances are represented by debit balances in the overhead account.

II – Problems
1. Fitzhugh Company has the following information available for the current year:

Standard:
Material 3.5 feet per unit @ $2.60 per foot
Labor 5 direct labor hours @ $8.50 per unit

Actual:
Material 95,625 feet used (100,000 feet purchased @ $2.50 per foot)
Labor 122,400 direct labor hours incurred per unit @ $8.35 per hour
25,500 units were produced
Required:
a. Refer to Fitzhugh Company. Compute the material purchase price and quantity variances.
b. Refer to Fitzhugh Company. Compute the labor rate and efficiency variances.

2. Taylor Company applies overhead based on direct labor hours and has the following available for
November:
Standard:
Direct labor hours per unit 5
Variable overhead per DLH $.75
Fixed overhead per DLH
(based on 8,900 DLHs) $1.90
Actual:
Units produced 1,800
Direct labor hours 8,900
Variable overhead $6,400
Fixed overhead $17,500
Required:
a. Compute all the appropriate variances using the two-variance approach.
 b. Compute all the appropriate variances using the four-variance approach.
c. Compute all the appropriate variances using the three-variance approach.

3. The Michigan Company has made the following information available for its production facility for
the month of June. Fixed overhead was estimated at 19,000 machine hours for the production
cycle. Actual machine hours for the period were 18,900, which generated 3,900 units.

Material purchased (80,000 pieces) $314,000

Material quantity variance $6,400 U
Machine hours used (18,900 hours)
VOH spending variance $50 U
Actual fixed overhead $60,000

Actual labor cost $40,120

Actual labor hours 5,900

Michigan’s standard costs are as follows:

Direct material 20 pieces @ $4 per piece
Direct labor 1.5 hours @ $6 per hour
Variable overhead
(applied on a machine hour basis) 4.8 hours @ $2.50 per hour
Fixed overhead
(applied on a machine hour basis) 4.8 hours @ $3 per hour
Require
a. material purchase price variance
b. standard quantity allowed for material
c. total standard cost of material allowed
d. actual quantity of material used
e. labor rate variance
f. standard hours allowed for labor
g. total standard cost of labor allowed
h. labor efficiency variance
i. actual variable overhead incurred
j. standard machine hours allowed
k. variable overhead efficiency variance
l. budgeted fixed overhead
m. applied fixed overhead
n. fixed overhead spending variance
o. volume variance
p. total overhead variance

4. The following information is available for Whitestone Company for the current year:
Standard:
Material X: 3.0 pounds per unit @ $4.20 per pound
Material Y: 4.5 pounds per unit @ $3.30 per pound
Class S labor: 3 hours per unit @ $10.50 per hour
Class US labor: 7 hours per unit @ $8.00 per hour

Actual:
Material X: 3.6 pounds per unit @ $4.00 per pound (purchased and used)
Material Y: 4.4 pounds per unit @ $3.25 per pound (purchased and used)
Class S labor: 3.8 hours per unit @ $10.60 per hour
Class US labor: 5.7 hours per unit @ $7.80 per hour
Whitestone Company produced a total of 45,750 units.

Required:
a. Compute the material price, mix, and yield variances (round to the nearest dollar).
b. Compute the labor rate, mix, and yield variances (round to the nearest dollar).