Standard Costing PDF

What is standard costing? A standard cost is used by manufacturers when preparing realistic budgets. Standards can also be set for revenue. Standard costing compares actual costs against standard costs. The differences between actual and standard costs and revenue are known as variances. This compar...

What is standard costing? A standard cost is used by manufacturers when preparing realistic budgets. Standards can also be set for revenue. Standard costing compares actual costs against standard costs. The differences between actual and standard costs and revenue are known as variances. This comparison will help managers to assess and control costs and take action where needed. For example, a difference between the actual and budgeted cost of materials might show that the purchase price of the materials has increased since the budget was prepared. Possible causes of a significant variance would be investigated. Corrective action might be that the purchasing manager reviews current suppliers or actively seeks additional discounts. 38.2 Setting standards Standards must be realistic if they are to be useful. Standards will need to be regularly reviewed and kept up to date if they are to be realistic. For example, if new machinery is purchased, direct labour time for production will need to be updated. There are various types of standard that businesses might use. The main types of standard and their practical uses are: Ideal standards are standards that can only be met under ideal conditions. In practice, conditions under which businesses work are rarely ideal, therefore these standards are unrealistic and are unlikely to be attained. As a result, they can demotivate managers and cause them to perform less efficiently. Ideal standards should not be used. Current standards are based on present levels of performance. This may be inappropriate for the future. They do not offer management or workers any incentive to perform more efficiently. Current standards should only be used when present conditions are too uncertain to enable more appropriate standards to be set. Attainable standards recognise that there is some wastage of materials and not all the hours worked are productive. Time spent unproductively by workers is called idle time and may occur when machinery breaks down or the machinery has to be ‘set up’ for a production run. The standards should take account of these factors and give the workers an incentive to use their time and materials efficiently. The standards set should be attainable ones. Calculation of fixed overhead variances The aim of setting standard costs for fixed overheads is to absorb the amount of fixed overheads into the overall cost of output. Actual costs and levels of production will vary from the standards or budgets set. Thus, there will be an under- (shortfall) or over-(surplus) absorption of overheads. The fixed overhead variances are calculated as follows: a Fixed overhead expenditure variance, which is the difference between the actual fixed overheads incurred and the budgeted fixed overheads. b Fixed overhead volume variance is the difference between the standard hours for actual output and the budgeted hours. This difference in hours is then multiplied by the budgeted fixed overhead absorption rate (OAR). Assuming the fixed overheads are absorbed based on direct labour hours, the formula is: (standard hours for the actual output – budgeted hours) × budgeted OAR If the fixed overheads are absorbed based on direct materials then the formula will need to be adapted. Note: the budgeted fixed OAR will be needed to calculate this variance. The OAR will also be needed for the fixed overhead capacity variance and the fixed overhead efficiency variance. c Fixed overhead capacity variance is a sub-division of the volume variance, where actual direct labour hours for actual output differ from the budgeted direct labour hours. Again, this difference in hours is multiplied by the budgeted fixed OAR. Assuming the fixed overheads are absorbed based on direct labour hours, then the formula is: (actual direct labour hours – budgeted direct labour hours) × OAR Fixed overhead efficiency variance, again, is a sub-division of the volume variance, where the actual direct labour hours for the actual output differ from the standard direct labour hours for the actual output. This difference is multiplied by the budgeted fixed OAR. Assuming the fixed overheads are absorbed based on direct labour hours, then the formula is: (standard hours for the actual output – actual direct labour hours) × OAR Causes of variances and their interrelationships Variances highlight where actual figures differ from standards. Variances do not explain the causes of the differences but do show management where further investigation is required. Once management understands the cause(s) of a variance, they can consider whether there is corrective action that can be taken. It is important management understands that each variance does not operate in isolation. If action is taken to correct one variance, there can be an effect on another variance. For example, if a business buys cheaper direct materials than the standard, this will result in a favourable direct materials variance. However, if these cheaper materials are of a poorer quality, this might lead to materials being wasted or employees having more work to produce the good to be sold. As a result, the favourable direct materials variance may lead to adverse materials usage and adverse labour efficiency variances. Sales variances Sales volume variance A sales volume variance means that the actual amount sold was more or less than budgeted. A favourable sales volume variance means that the actual amount sold was more than expected. Causes of favourable variances increase in customer demand, for example through improved promotion of the product creating popularity selling price has been reduced to increase volume seasonal sales have increased volume competition from other businesses has reduced or disappeared  more special discounts have been given to selected customers to increase orders. An adverse sales volume variance means that the actual amount sold was less than expected. Causes of adverse variances decrease in customer demand, for example due to the goods becoming unfashionable or obsolete selling price has been increased to pass increased costs onto customers seasonal sales have decreased volume competition from other businesses has increased fewer special discounts have been given to selected customers customers have heard that new, improved products will be available soon and are waiting for those. Other variances that affect sales volume There is a close relationship between selling price and sales volume. Management decides the selling price and knows that this will affect the volume sold. An increase in selling price leads to lower sales volume. Therefore, a favourable sales price variance can lead to an adverse sales volume variance and vice versa. Sales price variance A sales price variance means that the actual selling price was more or less than budgeted. A favourable sales price variance means that the actual selling price was higher than the standard. Causes of favourable variances prices have been increased, for example due to increased costs or inflation fewer discounts have been allowed to customers improved products have allowed prices to be increased. An adverse sales price variance means that the actual selling price was lower than the standard. Causes of adverse variances prices have been reduced, for example to increase sales volume some customers have been given price concessions to increase the volume of orders competition has necessitated a price reduction selling prices have been reduced in seasonal sales. Other variances that affect sales price An increase in either direct materials price or direct labour rate may lead to a management decision to increase the selling price. Therefore, an adverse direct material price variance or an adverse direct labour rate variance can lead to a favourable sales price variance. Direct materials variances Materials usage variance A materials usage variance means that the actual amount of material used in production was more or less than expected. A favourable material usage variance means that the actual amount of material used in production was less than in the flexible budget. Causes of favourable variances actual materials used were higher quality than the standard, resulting in materials that are easier to work with actual labour was more highly skilled than the standard skill; which may lead to less wastage of the materials. An adverse material usage variance means that the amount of material used in production was more than in the flexible budget. Causes of adverse variances actual materials used were lower quality than the standard resulting in materials that are harder to work with actual labour was lower skilled than the standard skill, which may lead to more wastage of the materials. Other variances that affect materials usage Purchasing higher quality materials can lead to an adverse direct materials price variance but a favourable direct materials usage variance and vice versa. Using more highly skilled labour than the standard can lead to an adverse direct labour rate variance but a favourable direct materials usage variance and vice versa. Materials price variance A materials price variance means that the actual price of the material bought was more or less than expected. A favourable material price variance means that the actual purchase price of material was less than in the flexible budget. Causes of favourable variances actual materials price falls because the supplier(s) offers new trade or bulk discounts actual materials price falls because materials bought are of a lower quality. An adverse material price variance means that the actual price of materials purchased was more than in the flexible budget. Causes of adverse variances actual materials price rises because the supplier(s) passes on their own increase in costs sometimes due to inflation actual materials price rises because materials bought are of a higher quality. Direct labour variances Labour efficiency variance A labour efficiency variance means that the actual labour hours were more or less than expected. A favourable labour efficiency variance means that the actual labour time used was less than the standard time allowed. Causes of favourable variances better skilled workers were employed who work more efficiently than the standard highly motivated staff good quality materials and/or machinery for staff to work with. An adverse labour efficiency variance means that the actual labour time used was more than the standard time allowed. Causes of adverse variances less skilled workers were employed who work less efficiently than the standard low motivation of staff poor quality materials and/or machinery breakdowns. Labour rate variance A labour rate variance means that the actual wage rate was more or less than the standard wage rate. A favourable labour rate variance means that the actual wage rate was less than the standard wage rate. Causes of favourable variances actual labour employed was of a lower grade than standard. An adverse labour rate variance means that the actual wage rate was more than the standard wage rate. Causes of adverse variances actual labour employed was of a higher grade than standard a wage increase has been given to staff (the standard should be revised). Fixed overhead variances A favourable fixed overhead expenditure variance will arise from the actual fixed overhead spend being lower than the budgeted overhead spend, for example because of cost savings made after the budget was set. An adverse fixed overhead expenditure variance will arise when more has been paid for fixed overheads than was budgeted, for example because of an unexpected cost or a supplier increasing costs more than budgeted. As an example, rent may be increased by a higher figure than was expected when the budget was set. A favourable fixed overhead volume variance will arise if hours actually worked by direct labour are greater than the direct labour hours budgeted in the master budget. A new order could have been received that requires extra labour to be employed and therefore extra hours are worked. An adverse fixed overhead volume variance will arise when the opposite occurs. Fewer direct labour hours were worked than were budgeted for in the master budget. A favourable fixed overhead efficiency variance arises when the output produced by the direct workers took less time in actual hours than the standard hours set. This may be because higher skilled labour was used. The use of 637 less skilled labour will lead to the opposite. An adverse fixed overhead efficiency variance arises when the output produced by the direct workers took more time in actual hours than the standard hours set. This may be because lower skilled labour was used. Note: if fixed overheads are absorbed using machine hours instead of direct labour hours, the comments regarding the fixed overhead volume and efficiency variances will apply to machine hours worked, rather than direct labour. in isolation but discuss them across departments to agree the best decision for the business as a whole. Not all variances need corrective action. Managers focus their attention on the most significant variances. Significant variances are the largest variances, particularly where they are adverse. This is because large variances have the biggest impact on business performance and adverse variances lead to lower than expected profit. The investigation of all variances in a business can be very time consuming, therefore managers should prioritise variances by taking the following steps: Step 1 Decide which variances are significant Step 2 Determine the causes of each significant variance Step 3 If the cause of the variance can be controlled, then take corrective action Note: not all variances can be controlled by a business manager. For example, a supplier may increase the price of materials because of inflation. This may make it difficult to find an alternative, cheaper supplier. In this case, it is the standard that will need to be updated for future budgets and variance analysis.