Chapter 15

Standard Costing: Setting

Standards and Analyzing
Variances

The cost of manufacturing a product may be determined before production begins. Cost
accumulation procedures (either job order costing or process costing) may apply
predetermined costs to units as they are produced, rather than wait for actual data to be
accumulated.

This chapter will present a discussion on how costs are accumulated and controlled
effectively through the use of standard costing. In particular, how a standard costing
system operates.

ACTUAL, NORMAL AND STANDARD COSTING

In actual cost system, product costs are recorded when they are incurred. This system is
acceptable in recording direct materials and direct labor because they can be easily traced
to specific jobs (job order costing) or department (process costing). Since manufacturing
overhead, usually cannot be easily traced to a specific job or department because it is not
a direct cost of production, a modification of an actual cost system, called normal costing
is used. Under this system, direct materials and direct labor costs are accumulated as they
are incurred, while manufacturing overhead is applied to production on the basis of actual
inputs multiplied by a predetermined overhead application rate.

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Under standard costing, all costs attached to products are based on standards or
predetermined amounts. The costs of every product to be produced during the period can
be computed at the start of the period. This method enables the use of a simplified
recording system. No record need be kept of the actual costs of items used. Once
standards have been set, the costs of operating standard costing can be low as compared
to actual or normal costing. The comparison of actual, normal and standard costing are
shown below:

Debits to Work in Process Inventory

Elements of Cost Actual Costing Normal Costing Standard

Costing

Direct materials Actual Actual Standard

Direct Labor Actual Actual Standard
Overhead Actual Applied* Standard**
*Actual base x Predetermined overhead rate
**Standard base x Predetermined overhead rate

USES OF STANDARD COSTS

Standard cost is the predetermined cost of manufacturing a single unit of product during a
specified period in the immediate future. It is the planned cost of a product under normal
conditions. Standard costing is concerned with cost per unit and serves basically the same
purpose of a budget. Standard costs do not replace actual costs in a cost accumulation
system. Instead, standard costs and actual costs are both accumulated.

Standard cost can be used in numerous ways. The following are some of the typical uses:

Controlling costs.
Costing inventories.
Planning budgets.
Pricing products.

Controlling Costs. The objective of controlling costs is to aid management in the

production of a unit of product or service, at the lowest possible standards enable
management to make periodic comparisons of actual costs with standard costs for the
purpose of evaluating performance and correct inefficiencies.

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Costing Inventories. The use of standard costs eliminates complex computations for
inventories and cost of goods sold in preparing financial statements.

Planning Budgets. Standard costs and budgets are basically the same. Both are
predetermined costs. There is a difference, however, in the way these terms are
expressed. A standard is unit amount, whereas a budget is a total amount. Standard costs
are very useful when preparing a budget.

Pricing Products. Setting prices is greatly enhanced by the availability of reliable

standards and the continuous review of standard costs.

SETTING STANDARDS

In setting standards, management must choose a level of operating efficiently with which
to work. Standards may be set at one of two levels: Ideal Standards (sometimes called
attainable standards).

Ideal Standards

Ideal standards represent goals that could be attained only by achieving perfection. They
make no provision for lost or idle time, breakdowns, and other factors that reduce
efficiency. Since they can seldom be met, ideal standards have a psychological
disadvantage. Management often develops the attitude Why try when we arent sure to
meet these goals anyway? As a result, ideal standards are seldom used.

Normal Standards

Normal standards represent goals that can be met under reasonably efficient operating
conditions because they provide for idle time, breakdowns, and common operating
problems. They differ from ideal standards in that they can be met or even surpassed by
the employment of efficient operations. Normal standards assume that the three elements
of costs can be acquired at a good overall price, not necessarily the lowest price at all
times, but well below the expected highest price. This chapter assumes that standard costs
are set at normal level.

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IMPLEMENTING A STANDARD COST SYSTEM

To develop and use a standard cost system, the following procedures are usually used:

Establish standards for each cost element (materials, labor, and overhead).
Record actual costs incurred during the period.
Determine the standard costs for the number of units produced during the period.
Compute variances by comparing the actual costs of the units produced and the
standard costs of those units.
Breakdown the variance for each element into its component parts in order to
determine the cause of the variance.
Record production costs and variances.

Establish Standards
To establish the standard cost of producing a product, it is necessary to have standards for
each manufacturing cost element: direct materials, direct labor, and manufacturing
overhead.

To illustrate how standard costs are set up, assume that Zorro, Inc., wished to use
standard costs to measure performance in filling an order for 1000 gallons of Product X.

Direct Materials Standards

Price and quantity standards are set for each type of materials used.

Materials Price Standards. A material price standard is the price that should be paid for
a unit of raw material purchased. This standard should be based on purchasing
departments best estimate of the cost of raw materials after an analysis of current
purchase prices. The price standard should include an amount for related costs such as
receiving, storing and handling.

For example, the material price standard per kilo of material for Product X is:

Purchase price, net discount P27

Freight costs 2
Receiving and handling costs 1
Standard material price per kilo P30

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Materials Quantity Standards. A material quantity standard is the amount of material

that should be consumed in manufacturing a unit of product. This standard is expressed in
terms of physical measure, such as kilos or barrels. Materials spoilage or waste that is
necessary part of the manufacturing process must be considered in setting the quantity
standards.

For example, the material quantity standard per unit of Product X is as follows:

Total quantity required 3 kilos

Allowance for spoilage 1 kilo
Standard material quantity per unit 4 kilos

Determining Standard Material Costs per Unit

The total standard cost of a raw material per unit of production is computed by
multiplying (1) the total standard quantity of raw materials required to manufacture the
number of units of production by (2) the standard price per unit of raw materials.

For Zorro, Inc., the standard materials cost per gallon of Product X is P120 (P30 x 4
kilos).

Direct Labor Standards

Both rate (price) and time (efficiency) standards are established for direct labor cost.

Labor Rate Standards. Labot rate or price standards is the predetermined rate per hour
based on current wage rate, which generally includes payroll taxes and fringe benefits,
such as paid holidays. Items like sick and vacation leave pays are usually not included in
the standard rate because they are normally accounted for as part of manufacturing
overhead.

For Zorro, Inc., the labor rate standard is as follows:

Hourly wage rate P30.00

Payroll taxes 4.00
Fringe benefits 6.00
Standard labor rate per hour P40.00

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Labor Efficiency Standards. Labor efficiency or time standards are predetermined time
required to finish one unit of product. Allowances should be made for the rest periods,
machine setup, and machine downtime.

For Zorro, Inc., the direct labor efficiency standard is as follows:

Production time 1.5 hours

Rest periods .2
Machine setup .3
Standard labor efficiency per unit 2.0 hours
Determining Standard Direct Labor Cost per Unit
The standard labor cost per unit of production is computed by multiplying (1) standard
direct labor rate by the (2) standard direct labor hours.

Manufacturing Overhead Standards

In establishing manufacturing overhead standards, a predetermined overhead rate is
used. As discussed in Volume 1, the overhead rate is computed by dividing the (1)
budgeted overhead costs by the (2) expected standard activity base (i.e., standard direct
labor hours or standard machine hours).

For example, Zorro, Inc., uses standard direct labor hours as the activity base. The
company expects to produce 14,250 gallons of Product X during the year at normal
capacity. Since it will take two direct labor hours for each gallon, the total standard direct
labor hours to produce 14,250 gallons of Product X is 28,500 (14,250 x 2). At this level
of activity, overhead costs are estimated to be 285,000, of which P171,000 are variable
and P114,000 are fixed.

Base on the above example, the standard predetermined overhead rates for variable and
fixed overhead are computed as follows:
Variable overhead costs (P171,000 28,500) = P 6.00 per labor hour
Fixed overhead costs (P114,000 28,500) = P 4.00 per labor hour
Total P10.00 per labor hour

Determining Standard Overhead Rate per Unit

The standard overhead rate per unit is equal to standard labor hours times the
predetermined overhead rate. For Zorro, the standard overhead rate per gallon of Product
X is P20 (2 hours x P10).

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TOTAL STANDARD COST PER UNIT

The total standard cost per unit is the total of the standard costs of direct materials, direct
labor and manufacturing overhead.

For Zorro, Inc., the total standard cost per gallon of Product X is P220 computed as
follows:

Cost Elements Standard Quality Standard Price Standard Cost

Direct Materials 4 kilos P30 P120
Direct Labor 2 hours P40 80
Overhead 2 hours P10 20
Total P220

VARIANCES FROM STANDARDS

Variances are the difference between the total actual cost incurred and the total standard
costs.

For example, assume that in producing 1,000 gallons of Product X, Zorro, Inc., incurred
the following costs:

Direct Materials P123,410

` Direct Labor 82,950
Variable Overhead 11,500
Fixed Overhead 9,500
Total Actual Cost Incurred P227,360

The total standard costs of Product X of 220,000, determined by multiplying the units
produced by the standard cost per unit (1000 gallons x P220) is compared to the total
actual cost incurred of P227,360 to determine the total variance of P7,360 as shown
below:

Actual costs incurred P227,360

Standard costs 220,000
Total Variance P 7,360

Note that the total variance is expressed in total pesos not on a per unit basis.

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When actual costs exceed standard costs, the variance is unfavorable (U). Thus, the
P7,360 variance is unfavorable. As unfavorable variance has a negative connotation. It
means that too much was paid for one or more of the manufacturing cost of elements or
that the elements were used inefficiently.

On the other hand, if the actual costs are less than standard costs, the variance is
favorable (F). A favorable variance has a positive inference suggesting efficiencies in
incurring manufacturing costs and in using them.

COMPUTING AND ANALYZING VARIANCES

To compute and analyze variances the underlying factors should be determined. For each
manufacturing cost elements, a total peso variance is computed and analyzed into price
variance and quantity variance. The computations are shown below:

Total Materials Materials

Material Price Quantity
= = +
Variance Variance Variance

Labor
Total Total Labor Labor Rate
= = + Efficiency
Variance Variance Variance
Variance

Total Overhead Overhead

= Overhead = Controllable + Volume
Variance Variance Variance

To illustrate the application of the above computations, the example of Zorro, Inc., will
be continued.

DIRECT MATERIALS VARIANCE

Assume that to produce the order of 1,000 gallons of Product X, Zorro, Inc., purchased
4,100 kilos of direct materials A1 at a cost of P30.10 per kilo. The total materials
variance is computed using the following formula:

Standard Quantity Actual Quantity Total Materials

x Standard Price - x Actual Price = Variance
(SQ) x (SP) (AQ) x (AP) (TMV)

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For material DM- A1, the total material variance is unfavorable, determined as follows:

4,000 standard quantity x P30 standard price P120,000*

4,100 actual units x P30.10 actual price 123,410
Total material variance P3,410 (U)

Units completed (1,000 gallons) x standard quantity per gal. (4 kilos)

Two factors that account for the total material variance as follows:
There may be a difference between the standard cost per unit and the actual cost
per unit of materials used (a material price variance).
There may be a difference between the standard quantity called for and the actual
quantity of materials used (a material quantity of usage variance).

Materials Price Variance. A material price variance results when the actual price per
unit differs from the standard price per unit. It is computed by taking the difference
between the cost of actual quantity used at the standard unit price and the cost of the
actual quantity of materials used as the actual unit price. If the actual price per unit
exceeds the standard price per unit, there is an unfavorable (U) variance. The variance is
computed as follows:

Actual Quantity Actual Quantity Material Price

x Standard Price - x Actual Price = Variance
(AQ) x (SP) (AQ) x (AP) (MPV)

For Material DM- A1, the price variance is unfavorable (U).

4,000 actual units purchased x P30 standard price per unit P123,000
4,100 actual units purchased x P30.10 actual price per unit 123,410
Material price variance P 410 (U)
Note that the actual quantity purchased is used in the formula instead of the actual
quantity used, since it is the act of purchasing and not using that will result to a price
variance.

The materials price variance can also be computed by multiplying the actual quantity
purchased by the difference between the actual and standard price per unit, 4,100 units
(P30.10 P30.00) = 410 (U).

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Materials Quantity Variance. The amount of materials quantity variance or materials

usage variance is computed by comparing the cost of the standard quantity of materials at
the standard price per unit with the cost of the actual quantity materials at the standard
price per unit. These computations will show how much additional cost there would have
been using too many units of the materials if the cost per unit of materials had been the
standard cost per unit. If the quantity actually used is less than the standard, the
computation indicates how much would have been saved if the actual price per unit of
materials had been the standard price. If the actual quantity used exceeds the standard
quantity, there is an unfavorable materials quantity, or usage variance. On the other
hand, if the actual quantity is less than the standard quantity, there is favorable materials
quantity or usage variance. The variance is computed as follows:

Standard Quantity Actual Quantity Materials

x Standard Price - x Standard Price = Quantity Variance
(SQ) x (SP) (AQ) x (SP) (MQV)

For Materials DM-A1, the quantity variance is unfavorable (U).

4,000 standard quantity x P30 standard price per unit P120,000

4,100 actual quantity x P30 standard price per unit 123,000
Materials quantity variance P 3,000 (U)
The materials quantity variance can also be computed by multiplying the difference
between the actual and standard quantity used by the standard price. (4,100-4,000) x P30
= P3,000 (U).

The total materials variance of P3,410 (U), therefore, consists of the following summary:

Materials price variance P 410 (U)

Materials quantity variance 3,000 (U)
Total materials variance P3,410 (U)

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Causes of Material Variance

The causes of the variance as computed are due to both internal and external factors.
Material price variance is the responsibility of the purchasing department. The price paid
for raw materials purchased is affected by many factors. These include the availability of
quantity and cash discounts, and the quality of the materials requested. However, a
variance may be beyond the control of the purchasing department. In a period of
inflation, prices may rise faster than expected, giving rise to an unfavorable variances.

The production department that controls the input of direct materials into the production
process is assigned the responsibility of materials quantity variance. Whenever more
direct materials are used than allowed, the variance is unfavorable, because of the
increased direct material cost of the finished product. Variances are usually due to
inexperienced workers, and faulty machinery, or carelessness.

DIRECT LABOR VARIANCES

The procedures for determining direct labor variances are similar to that for the direct
material variances. Continuing our example, assume that in completing Product X, Zorro,
Inc., incurred 2,100 direct labor hours at an average hourly rate of P39.50. The standard
hours allowed for the units produced are 2,000 hours (1,000 gallons x 2 hours) and the
standard rate is P40 per hour. The total labor variance is computed as follows:

Standard Hours Actual Hours Total Labor

x Standard Rate - x Actual Rate = Variance
(SH) x (SR) (AH) x (AR) (TLV)

For Product X the total labor variance is P2,950 unfavorable.

2,000 standard hours x P40 standard rate per hour P80,000

2,100 actual hours x P39.50 actual rate per hour 82,950

Total labor variance P 2,950 (U)

The total direct labor variance is caused by rate (price) variance and efficiency (time)
variance.

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Labor Rate Variance. The labor rate variance (also called the labor price variance)
occurs only when the actual labor rate per hour differs from the standard labor rate per
hour. The variance is unfavorable if the actual rate exceeds the standard rate and is
unfavorable if the actual rate is lower than the standard rate. Labor rate are usually set by
the personnel department. The labor rate variance is computed as follows:

Actual Hours Actual Hours Labor Rate

x Standard Rate - x Actual Rate = Variance
(AH) x (SR) (AH) x (AR) (LRV)

Using the above formula, the labor rate variance is favorable.

2,100 actual hours x P40 standard rate per hour P84,000

2,100 actual hours x P39.50 actual rate per hour 82,950
Labor rate variance P 1,050 F
The variance may also be computed by multiplying the difference between the actual rate
and the standard rate by the actual hours worked. The computation using the alternative
formula is (P40-P39.50) x 2,100 hours = P1,050 F.

Labor Efficiency Variance. The labor efficiency variance, also called labor time
variance, labor usage variance or labor quantity variance, compares the cost of actual
hours worked (based on the standard rate per hour) with the cost of standard hours
allowed for the number of units produced (based on the standard rate per hour). This
variance measures the effectiveness of labor. If the actual hours exceed the standard
hours, there is an unfavorable labor efficiency variance. The variance is computed as
follows:
Standard Hours Actual Hours Labor Efficiency
x Standard Rate - x Standard Rate = Variance
(SH) x (SR) (AH) x (SR) (LEV)

For Product X, the labor efficiency variance is unfavorable as shown below:

2,000 standard hours x P40 standard rate per hour P80,000

2,100 actual hours x P40 standard rate per hour 84,000

Labor Efficiency variance (100 hours x P40) P 4,000 (U)

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The labor rate and efficiency variances are summarized below:

Labor rate variance P1,050 F

Labor efficiency variance 4,000 (U)

Total direct labor variance P2,950 (U)

Causes of Labor Variances

Labor rate variances usually result in paying factory workers higher salaries than
expected. The responsibility for these variance rests with the manager who authorized the
salary increase. The use of an inexperienced worker instead of experienced one will result
in a favorable variance because the lower pay rate of the unskilled worker. An
unfavorable rate variance would result if the skilled worker were substituted for the
inexperienced worker.

Labor efficiency variance relate to the efficiency of workers. The causes of an

unfavorable efficiency variance may be due to poor training of workers, faulty
machinery, or carelessness. These causes are the responsibility of the production
department.

MANUFACTURING OVERHEAD VARIANCES

The computations of the manufacturing overhead variance are basically the same as the
computations of the material and labor variances. While the basic concept is similar, the
specific procedures used to analyze manufacturing overhead variances are quite different
because both variable and fixed overhead costs must be considered.

Total Overhead Variance. The total overhead variance is the difference between the
actual overhead costs incurred and standard costs applied to production (total standard
hours allowed for the units produced multiplied by the standard overhead rate per hour,
or the standard cost per unit of product multiplied by the number of units produced). To
continue our example. Assume that Zorro, Inc., incurred manufacturing costs of P21,000
broken down as follows:

Variable overhead costs P11,500

Fixed overhead costs 9,500

Total actual overhead costs P21,000

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With standard costs, manufacturing overhead costs are applied to work in process on the
basis of the standard hours allowed to production. Standard hours allowed are the hours
that should have been worked for the units produced. For Product X, the standard hours
allowed is 2,000 hours and the predetermined overhead rate is P10 per direct labor hour.
Therefore, applied overhead is P20,000 (2000 hours x P10). Note that actual hours of
direct labor (2,100) are not used in applying manufacturing overhead.

The total overhead variance is computed as follows:

Actual overhead P21,000

Applied overhead (2000 hours x P10) 20,000

Total overhead variance P 1,000 (U)

For the company to know why the actual overhead costs incurred during the period
differed from applied (standard) overhead costs for the work analysis of overhead
variances should be made. The analysis may be done using a two-variance analysis
method, a three-variance analysis method, or a four-variance analysis method, depending
on the degree of sophistication desired. In this, only the two-variance analysis method is
used and illustrated. The other methods are usually discussed in Management
Accounting.

The Two-Variance Analysis Method

In the two-variance analysis method, the total overhead variance is separated into the
budget variance and vo;lume variance.

Overhead Budget Variance. The overhead budget variance also called overhead
controllable variance shows whether overhead costs were effectively corralled. This is
computed by comparing (1) the actual overhead costs incurred and (2) the budgeted costs
based on the standard hours allowed for the number of units produced.

The budgeted overhead costs for the standard hours allowed for the number of units
produced consists of two parts:

Variable costs. The total variable cost allowed for the number of units produced is
computed by multiplying (1) the standard direct labor hours allowed for the
number of units produced by (2) the standard variable ovrerhead rate per hour.
Fixed costs. The budgeted fixed costs for the period are usually known or can
easily be determined.
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The illustration below shows a flexible overhead budget for Zorro, Inc., for 2008:

Zorro, Inc.
Flexible Manufacturing Overhead Budget
For 2010
Activity Base:
Standard Direct Labor Hours 1,500 hrs. 2,000hrs. 2,500 hrs.
Costs:
Variable overhead costs
Indirect materials P 3,600 P 4,000 P 4,500
Indirect Labor 4,700 6,000 5,500
Repairs 1,900 2,000 2,200
Total variable overhead costs P10,200 P12,000 P12,200
Fixed overhead costs:
Supervision P 5,500 P 5,500 P 5,500
Depreciation 4,000 4,000 4,000
Total fixed overhead costs P 9,500P 9,500 P 9,500

Total overhead costs P19,700 P21,500 P21,700

As shown in the flexible budget above, the total budgeted costs for 2,000 standard hours
is P21,500 (12,000 variable and P9,500 fixed). The variable costs per direct labor hour is
P6.00 (P12,000 2,000 hours).
The overhead budget variance for Zorro, Inc., is thus a favorable variance of P500 as
computed below:
Actual overhead costs P21,000
Budgeted overhead costs for standard hours:
Fixed overhead costs P 9,500
Variable overhead costs:
Standard direct labor hours 2,000
Variable costs per hour x P6 12,000 21,500
Overhead budget variance P 500 F
Most overhead budget (controllable) variances are associated with variable costs which
are controllable costs. Fixed costs are usually known at the time the budget is prepared.
For Zorro, Inc., the variances may be proven by comparing the actual variable overhead
cost of P11,500 against the budgeted variable overhead costs of P12,000.

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Overhead Volume Variance.The volume variance relates to fixed costs because fixed
costs remain the same in total for many level of output. This variance determines whether
plant facilities were efficiently used.

The overhead volume variance is computed as follows:

Budgeted overhead costs P21,500

Standard (applied) overhead costs (2,000 hrs. x P10) 20,000
Overhead volume variance P1,500 (U)

In the above formula, the budgeted overhead costs of P21,500 is the same as the amount
used in computing the overhead budget variance. Standard (applied) overhead of P20,000
is the amount used in computing the total overhead variance.

Causes of Manufacturing Overhead Variances

Since the overhead budget (controllable) variance is due to variable manufacturing

overhead costs, the responsibility rests with the production department. The cause of this
favorable variance may be due to (1) lower than expected use of indirect materials,
indirect labor, and supplies or (2) decreases in indirect manufacturing costs. The
overhead volume variance is also the responsibility of production department and the
unfavorable variance may be due to inefficient use of direct labor.

Summary of the Budget and Volume Variances

A review of the variance analysis shows the following:

Standard (applied) costs P20,000

P1,500 (U)
Volume Variance
Budgeted costs 21,500 P1000
Total Variance
P 500 (F)
Budgeted Variance
Actual costs 21,000

Note that the sum of the volume variance and the budget variance should equal the total
overhead variance between the actual overhead costs and standard overhead cost of
production.

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