Chapter 8 – Standard Costing

LEARNING OBJECTIVES
After completing this module, you should be able to know
the following:

1. What is standard costing?

2. What are the types of standards?
3. What are the advantages of standard costing
4. What is difference between actual, normal and
standard cost system?
5. How standard costs are being set-up?
6. How to perform variance analysis?

Standard
This is a measure of acceptable performance established by the management
of a company which serves as a guide in decision making.
This also serves as a benchmark in measuring performance

Types of standards
1. Expected Standards
This reflects an anticipation of inevitable circumstances in production like
production losses as well as inefficiencies. Since manufacturing
inefficiencies has been predicted, variances tend to be favorable most of
the time.
2. Practical Standards
These standards permits allowance for unavoidable delays due to
machine idle time or interruption and workers' breaks. With this, variances
can be either be favorable or unfavorable, or both.
3. Ideal Standards
These are the types of standards which do not allow any form of
inefficiencies and adopt a concept of "zero defect'. Thus, ideal standards
are viewed as unattainable standards and tend to result to unfavorable
variances.

Standard Cost System

Standard costing is a costing system which evaluates both the standard costs and
actual costs incurred in a given period and any variances that occurred between
the standard and actual costs, whether a favorable or unfavorable outcome, are
analyzed.

In standard costing, companies identify the expected costs to be incurred in

manufacturing a product but still consider that actual costs may differ. Like in the
case of purchase of materials, companies may set a standard price but may
actually differ in the quoted price in the market. It is also a similar case with labor
 rates, salary rates tend to increase from time to time, while overhead costs also varies due
to different reasons.

Advantages of Standard Costing

The following are the advantages of using standard cost system:
1. Employees will become cost conscious
2. It promotes better efficiency
3. It helps in facilitating management cost planning and control
4. It is useful in setting-up the price of the product
5. It will highlight variances in Management by Exception, in other words, it will give
attention to variances especially those involving large amount of variances

Difference between Actual, Normal and Standard Cost System

Cost System Valuation

Actual Cost System Actual Direct Material

Actual Direct Labor
Actual Overhead

Normal Cost System Actual Direct Material

Actual Direct Labor
Applied Overhead

Standard Cost System Standard Direct Material

Standard Direct Labor
Standard Overhead

Standard Setting Process

1. Material Standards
Before setting standards for materials it is important to know what type of materials
needed in production, its level of quality, quantity needed and the price per unit of
each material.

The cost accounting department and/or the purchasing department are the departments
responsible for setting the material price standards whereas the engineering
department are the ones responsible in setting standards as to level of quality to be
purchased, required quantity of purchase and the type of materials needed in the
 production.

2. Labor Standards
When setting up for labor standards, all necessary activities in the production
department should be determined first in order to estimate the required time needed
in producing a batch or unit of output. As to compensation of workers, standard rate
of payment is based on the type of job being performed as well as the experience and
skills that the worker has.

3. Overhead Standards

Overhead standards are also the manufacturing company’s predetermined overhead

rate as discussed in the previous modules.

Variance Analysis
Variances serve as "red flags" and a thorough analysis should be done to be able to
determine the root cause of any variances, whether it is unfavorable or even a favorable
variance because variance analysis provides a comprehensive evaluation of production
performance.
Variance analysis are performed on materials, labor and overhead.
The difference between the total actual costs incurred and total standard costs that should
have been incurred results in a variance. Total amount of variance can be calculated as
follows:

However, the calculated amount of total variance do not provide a comprehensive evaluation
why a variance has occurred since the method of calculation used does not indicate whether
such variance was due to factors affecting prices, quantities of input placed into production,
and other factors affecting the actual production process.

With this, the variance calculation method shall be expanded as follows:

The price element indicates the difference between the actual costs of inputs and costs that
should have been paid for inputs. Thus, price or rate variance is calculated as the difference
between actual price and standard price per unit of input multiplied by the actual quantity of
inputs:
Price or Rate Variance = (Actual unit price - Standard unit price) x Actual Quantity of Input

The usage element indicates the results of production efficiency calculated as:

It should be noted that unfavorable variances have negative effect on income, whereas the
favorable variances have positive effect on income.

Material Variances

Overhead Variance
Computation of overhead variances is itemized into two components, variable and fixed.

In determining overhead variances, a predetermined overhead rate is calculated in order to

define the specific capacity level for which budgeted overhead costs will be based, to compute:
 It should be noted that underapplied overhead is an unfavorable outcome whereas
overapplication of overhead is favorable to the company.
• Variable Overhead Spending Variance
- This variance is caused by both the price and activity volume/level
differences. It can be due to purchasing indirect materials at a higher price
or using more indirect materials than what the standard allows.
• Variable Overhead Efficiency Variance
This resulting variance is due to the effect of using more or less inputs in
a given activity level. When actual input exceeds the allowable standard
inputs, production operations are viewed to be inefficient.

Fixed Overhead Variance

Fixed Overhead Spending Variance or Budget Variance

This variance is caused by mismanagement of production resources.

Fixed Overhead Volume Variance or Capacity Variance

This variance is caused by producing at an activity level that differs from the level
that should have been used.
Moreover, overhead variance analyses can also be breakdown into four-variance approaches
which provide management with comprehensive details.

One Variance Approach

Budget or Controllable Variance

Under this variance, management has the influence and ability to control this
combined spending and efficiency variance

Volume or Noncontrollable Variance

- This variance is the result of production at an activity level that differs from the
level that should have been used.
Four Variance Approach
This consists of:
- Variable Overhead Spending Variance
- Fixed Overhead Spending Variance
- Efficiency Variance
- Volume Variance