Standards costing

An estimated or predetermined cost of performing an operation or producing a good or service, under normal conditions. Standard costs are used as target costs (or basis for comparison with the actual costs), and are developed from historical data analysis or from time and motion studies. They almost always vary from actual costs, because every situation has its share of unpredictable factors. Also called normal cost.

Variance Analysis:
Material variance:Material Price variance:Standard price per unit of direct materials is the price that should be paid for a single unit of materials, including allowances for quality, quantity purchased, shipping, receiving, and other such costs, net of any discounts allowed. Price standards for direct materials permit checking the performance of the purchasing department and the influence of various internal and external factors and measuring the effect of price increase or decrease on the company's profits. Determining the price or cost to be used as the standard cost often difficult, because the prices used are controlled more by external factors than by company's management. Prices selected should reflect current market prices and are generally used throughout the forthcoming fiscal period. If the actual price paid is more or less than the standard price, a price variance occurs. This is usually called direct materials price variance. Price increases or decreases occurring during the fiscal period are recorded in the materials account(s). Price standards are revised at inventory dates or whenever there is a major change in the market price of any of the principle materials or parts Standard price per unit for direct materials should reflect the final delivered cost of materials, net of any discounts taken. Allowances for freights and handling should also be taken into account.

Materials Quantity variance:Standard quantity per unit of direct materials is the amount of direct materials or raw materials that should be required to complete a single unit of product, including allowances for normal waste, spoilage, rejects, and similar inefficiencies. Quantity of usage standards are generally developed from materials specifications prepared by the department of engineering (mechanical, electrical, or chemical) or product design. In a small

or medium sized company, the superintendent or even the foremen will state basic specifications regarding type, quantity, and quality of raw materials need and operations to be performed. Quantity standards should be set after the most economical size, shape, and quality of the product and the results expected from the use of various kinds and grades of materials have been analyzed The standard quantity should be increased to include allowances for acceptable levels of waste, spoilage, shrinkage, seepage, evaporation, and leakage. The determination of spoilage or waste should be based on figures that prevail after the experimental and developmental stages of the product have been passed. 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. An important reason for separating standards into two categories - price and quantity - is that different managers are usually responsible for buying and for using inputs and these two activities occur at different points in time. In the case of raw materials the purchasing manager is responsible for the price, and this responsibility is exercised at the time of purchase. In contrast, the production manager is responsible for the amount of raw materials used, and this responsibility is exercised when the materials are used in production, which may be many weeks or months after the purchase date. It is important, therefore, that we cleanly separate discrepancies due to deviations from price standards from those due to deviations from quantity standards. Differences between standard prices and actual prices and standard quantities and actual quantities are called variances. The act of calculating and interpreting variances is called variance analysis.

Labor variance Direct labor cost variance is the difference between the standard cost for actual production and the actual cost in production. Labor Rate Variance was adverse. As stated earlier, there was inflationary pressure in the country and labor demanded more wages or perks. However, its impact was off-set by efficiency variance. Many factors contributed to efficiency such as recruitment of good workers, quality of material and machines, good and conducive environment and friendly attitude of the owner who had served in the foreign countries. There are two kinds of labor variances. Labor Rate Variance is the difference between the standard cost and the actual cost paid for the actual number of hours. Labor efficiency variance is the difference between the standard labor hour that should have been worked for the actual

number of units produced and the actual number of hours worked when the labor hours are valued at the standard rate. (Actual rate - Standard rate) x Actual hours worked = Labor rate variance An unfavorable variance means that the cost of labor was more expensive than anticipated, while a favorable variance indicates that the cost of labor was less expensive than planned. There are a number of possible causes of a labor rate variance. For example:

Incorrect standards: The labor standard may not reflect recent changes in the rates paid to employees. For example, the standard may not reflect the changes imposed by a new union contract. Pay premiums: The actual amounts paid may include extra payments for shift differentials or overtime. For example, a rush order may require the payment of overtime in order to meet an aggressive delivery date. Staffing variances: A labor standard may assume that a certain job classification will perform a designated task, when in fact a different position with a different pay rate may be performing the work. For example, the only person available to do the work may be very skilled, and therefore highly compensated, even though the underlying standard assumes that a lower-level person (at a lower pay rate) should be doing the work. Thus, this issue is caused by a scheduling problem. Component tradeoffs: The engineering staff may have decided to alter the components of a product that requires manual processing, thereby altering the amount of labor needed in the production process. For example, a business may use a subassembly that is provided by a supplier, rather than using in-house labor to assemble several components. The standard labor rate is developed by the human resources and industrial engineering employees, and is based on such factors as the expected mix of pay levels among the production staff, the amount of overtime likely to be incurred, the amount of new hiring at different pay rates, the number of promotions into higher pay levels, and the outcome of contract negotiations with any unions representing the production staff. Labor Rate Variance Example The human resources manager of Hodgson Industrial Design estimates that the average labor rate for the coming year for Hodgson's production staff will be $25/hour. This estimate is based on a standard mix of personnel at different pay rates, as well as a reasonable proportion of overtime hours worked.

During the first month of the New Year, Hodgson has difficulty hiring a sufficient number of new employees, and so must have its higher-paid existing staff work overtime to complete a number of jobs. The result is an actual labor rate of $30/hour. Hodgson's production staff worked 10,000 hours during the month. Its labor rate variance for the month is: ($30/hr Actual rate - $25/hour Standard rate) x 10,000 hours = $50,000 Labor rate variance

Overhead Variance
Overhead variances arise due to differences between the actual overheads and the absorbed overheads. Thus, if we have to calculate an overhead variance, we have to know the amount of the actual overheads and that of the absorbed overheads. The actual overheads can be known only at the end of the accounting period when the expense accounts are finalized. The absorbed overheads are the overheads charged to each unit of production on the basis of pre-determined overhead rate. This pre-determined rate is also known as standard overhead recovery rate, standard overhead absorption rate or standard burden rate. To calculate the standard overhead recovery rate, we have to first make an estimate of the likely overhead expenses or each department for the next year. The estimate of the overheads is to be divided into fixed and variable elements. An estimate of the level of normal capacity utilization is then made either in terms of production or machine hours or direct labor hours. The estimated overheads are divided by the estimated capacity level to calculate the predetermined overhead absorption rate as shown below: Standard Fixed Overhead Rate = Budgeted Fixed Overheads/Normal Volume Standard Variable Overhead Rate = budgeted Variable Overhead/Normal Volume Overhead Variances can be classified in the following two major categories: 1. Variable overhead variances 2. Fixed overhead variances Variable Overhead Variances

This variance arises due to the difference between the standard overhead variance overhead for the actual output and the actual variable overhead. If the standard variable overhead exceeds the actual variable overhead, the variance is favorable and vice-versa. Mathematically it may be expressed as follows Variable Overhead Variance = Standard * (Actual Variable Overhead Variable Overhead) Variable overheads are usually measured in relation to output if the details of the input quantities on which these variable overheads have been incurred are not readily available. In such circumstances, only the variable overhead variance is calculated. Fixed Overhead Variances Fixed overhead variances maybe broadly classified into a) Expenditure variance: It represents the difference between the fixed overheads as per budget and the actual fixed overheads incurred b) Volume Variance: this variance represents the unabsorbed portion of the fixed costs because of the underutilization of capacity. In case a firm exceeds capacity, this variance is favorable in nature.

Factory overhead variances: Remember that manufacturing costs consist of direct material, direct labor, and factory overhead. You have just seen how variances are computed for direct material and direct labor. Similar variance analysis should be performed to evaluate spending and utilization for factory overhead. But, overhead variances are a bit more challenging to calculate and evaluate. As a result the techniques for factory overhead evaluation vary considerably from company to company (and textbook to textbook). If you progress to advanced managerial accounting courses, you will likely learn about a variety of alternative techniques. For now, let's focus on one comprehensive approach.

Variable versus fixed overhead: To begin, recall that overhead has both variable and fixed components (unlike direct labor and direct material that are exclusively variable in nature). The variable components may consist of items like indirect material, indirect labor, and factory supplies. Fixed factory overhead might include rent, depreciation, insurance, maintenance, and so forth. Because variable and fixed costs behave in a completely different fashion, it stands to reason that proper evaluation of variances between expected and actual overhead costs must take into account the intrinsic cost behavior. As a result, variance analysis for overhead is split between variances related to variable overhead and variances related to fix overhead.

Variances relating to variable factory overhead: The cost behavior for variable factory overhead is not unlike direct material and direct labor, and the variance analysis is quite similar. The goal will be to account for the total.