What is Process Costing?

							ACCG304 Lecture 10:

Standard Costing
Lecture Objective
Standard costs represent costs that should be incurred under existing, efficient production operations. They are planned costs or target costs. Standard costing is a tool for planning and control where the objective is to manage the difference between actual results obtained and planned outcomes referred to as variances.

Lecture Outline
10.1 10.2 10.3 10.4 10.5 10.6 10.7 10.8 10.9 Introduction Need for Standards Definition of a Standard Cost Uses of standard Costs Advantages of a standard cost system Development of Standards Cost Control using Variance Analysis Understanding Variance Analysis Variance Analysis - Materials, Labour and Factory Overhead

10.10 Direct Materials - Variance Analysis 10.11 Direct Labour - Variance Analysis

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10.1

Introduction

One of the many advantages of a standard cost accounting system is that it serves as the basis for the control function in an organisation. Standards are frequently developed for material, labour and overhead costs that comprise product output as well as non-manufacturing costs. Significant variances are reported to management for investigation. The given level of activity decided on, which the budget is based upon, is often the firm’s normal (or expected) capacity. The process of variance analysis requires the comparison of a firm's actual results against those planned. The variances are the difference between actual cost incurred for material, labour and factory overhead and the standard cost allowed for by the budget. The variances will either be favourable or unfavourable. This method of analysis helps to promote efficiency and reduce costs by assigning responsibility for those variances to specific functional areas of the firm. In most cases management utilises standard costs as the norm; costs that should be incurred for the production of a unit. Firms develop standards for each input: Direct materials, direct labour and factory overhead for manufacturing companies Direct labour and factory overhead for service companies.

10.2

Need for Standards

Product costing systems that utilise and record actual costs do not facilitate cost control. Actual cost systems cannot answer questions such as: Did the job or product cost too much? How efficient were we in the consumption of resources required for production? Measurement requires a basis for comparison which is provided by standards. A standard may be expressed by length, weight, quantity, time and then equated in monetary terms. • • • Management in assigning responsibility for the actual results of operations needs to be able to evaluate performance. This can only be achieved by way of comparison. Standards provide the basis of comparison as they represent what should have occurred under efficient operating conditions and provide management with the tools to be able to judge good or poor performance.

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10.3

Definition of a Standard Cost

A standard cost is an estimated unit cost of manufacture of a company's product prepared in advance of production, which reflects management's expectations of: (a) Efficient usage of the physical manufacture the product; material and labour resources required to

(b) (c)

The expected costs of input resources comprising, materials and labour; Expected overhead costs and the associated capacity measure used to allocate this cost to the product being manufactured.

10.4

Uses of standard Costs

Cost information may be used for many different purposes in an organisation. The management functions of planning and controlling are facilitated by the use of Standard costs. In particular standard costs aid in the performance of the following activities: (a) Budgeting and Planning The distinction between BUDGETS and STANDARD costs is that STANDARDS are a UNIT COST CONCEPT whereas BUDGETS represent aggregate amounts. For example, the standard cost of 1 unit of product is $12.00 whereas the budgeted costs for expected production of 10,000 units is $120,000. (b) (c) Product Pricing Inventory Valuation AAS2 para. 13 allows the use of standard costs for determining inventory valuations for financial reporting purposes. Cost Control for performance evaluation

(d)

STANDARD COSTS provide a set of benchmarks established in advance of production, for the quantity of resources that ought to be consumed by each product or other per unit output measure and the price of these resources.

10.5
(a)

Advantages of a standard cost system
Managers become cost conscious as cost variances are computed and provide a springboard for the analysis of their performance. Standards provide a measuring device which focuses attention on the deviations of actual performance standards. These variances are used to evaluate operations and for planning

A standard cost system offers many advantages including:

(b)

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(c)

Standards provide the foundations for the development of product costs which are used to guide management towards cost and efficiency improvements. Standard cost systems provide a linkage between the functional areas of management, accounting and engineering in the development of production standards and implementation of cost control. If the standard setting process is effectively communicated, employees will have a better understanding of what is expected of them, thereby providing a motivational tool.

(d)

(e)

10.6

Development of Standards

Developing standards can be a large and detailed task, depending on the size of the company and the complexity and diversity of the engineering design of the product. The design of the production process to be used in manufacture must also be considered. The development of standards requires a thorough understanding of: (a) The engineering design of the product, which sets out material content and production techniques required for its manufacture including labour and facilities; The determination of direct product costs as well as the basis of allocation of indirect costs.

(b)

The determination of a standard product cost is dependent upon physical standards. It is a joint responsibility of a number of departments namely, production, engineering, purchasing, human resources and accounting, with the accounting department collecting and attaching monetary amounts to the physical standards provided by the operational departments. The determination of the standard cost per unit of a product should detail: (a) (b) (c) Expected material quantity requirements and prices Expected labour times and rates of pay applicable Expected overhead costs and the basis for their application to units.

10.7

Cost Control using Variance Analysis

The function of standards in cost control lies in revealing variances between standard costs which are allowed and actual costs which have been incurred. If actual costs exceed the standard, the variance is unfavourable. Conversely if the actual costs are less than the standard, the variance is favourable. The isolation of variances is the technical objective of the standard costing system. This places the focus on the variances and is indicative of MANAGEMENT BY EXCEPTION, which means that management's attention is concentrated on the variances from standard. In this way, managers do not waste time on those aspects of operations which are running according to plans.

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10.8

Understanding Variance Analysis

The difference between standard cost and actual cost is called a variance. The expression of this relationship is shown in the following formulas:

Variance = Actual Cost - Standard Cost

The comparison of actual costs to standard costs will provide control information referred to as COST VARIANCES which are either: (a) (b) FAVOURABLE if actual costs are less than standard costs, or UNFAVOURABLE if actual costs are greater than standard costs.

10.9 Variance Analysis - Materials, Labour and Factory Overhead
The manufactured cost of a product comprises: (a) (b) (c) Direct material Direct Labour Factory Overhead

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OVERVIEW OF STANDARD COSTING VARIANCE ANALYSIS.

STANDARD COST ACCOUNTING

STANDARD SET BASED ON: 1. IDEAL PERFORMANCE 2. PAST PERFORMANCE 3. ATTAINABLE PERFORMANCE

STANDARDS SET FOR: 1. DIRECT MATERIALS 2. DIRECT LABOUR 3. FACTORY OVERHEAD ACTUAL PERFORMANCE

VARIANCE ANALYSIS

DIRECT MATERIAL VARIANCES

DIRECT LABOUR VARIANCES

FACTORY OVERHEAD VARIANCES

MATERIAL PRICE VARIANCE

MATERIAL QUANTITY VARIANCE

LABOUR RATE VARIANCE

LABOUR EFFICIENCY VARIANCE

OVERHEAD SPENDING VARIANCE

OVERHEAD
EFFICIENCY

VARIANCE

OVERHEAD VOLUME VARIANCE

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10.10

Direct Materials

Direct materials are a variable cost and their utilisation in the production process should be relatively easy to measure once the bill of materials, prepared by the product engineers has been finalised. When preparing direct material standard, two standards need to be set: (a) PRICE STANDARD Which indicates the cost of materials input under efficient purchasing operations. QUANTITY STANDARD Used to specify the type and quantity of materials required per finished unit of production.

(b)

Material price variances:
The material price variance is calculated using the following formula:

Materials Price Variance = (Actual Purchase price - Standard Price) x Purchase Quantity

Although there are various methods that may be adopted as to the method and timing of the analysis of the Materials Price variance, we shall concentrate on that method which ISOLATES THE MATERIAL PRICE VARIANCE AT TIME OF PURCHASE. This variance, be it favourable or unfavourable, will need to be explained by the PURCHASING DEPARTMENT MANAGERS who are responsible for the acquisition of materials

Material usage (or quantity) variances
The material usage standard set by the production engineering department reflects material specifications for routine production operations. The quantity standard is an indicator of the efficient usage of materials in production activities. The material quantity or usage variance is calculated using the following formula:

Materials Usage Variance = (Actual Quantity Issued - Standard Quantity) x Standard Price

The STANDARD QUANTITY is calculated by multiplying:

Actual Good Production x Standard Materials Allowance

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Isolating the Raw Material Purchase Price Variance
For cost control purposes method 1 is preferred as this will result in the Raw Materials Account being maintained at Standard Cost thereby providing better control over the purchasing activities of the firm. The operation of both of these methods along with the relevant journal entries will be covered. Template for the Analysis of Direct Material Variances Input Actual Qty * Actual Price Input Actual Qty * Standard Price Output Actual Good Prodn * Standard Cost

Purchases

Usage

RM Price Var

RM Usage Var

The variance analysis is divided into two parts, with the first part relating to the PURCHASE of raw materials with the PRICE variance being isolated at the time of purchase and is calculated on all materials purchased. The raw material inventory is then recorded and maintained at standard cost.

Journal Entries for Materials
In the preparation of the accounting journal entries for a standard costing system, remember:

UNFAVOURABLE Variances are DEBITED FAVOURABLE Variances are CREDITED
Journal Entry for the PURCHASE of Materials with the Price Variance being recognised at the time of purchase: Debit Direct Materials Inventory ( Raw Material Control ) Debit Raw materials UNFAVOURABLE PRICE variance Credit Raw materials FAVOURABLE PRICE variance Credit Accounts Payable Journal Entry for the ISSUE of Materials: Debit Work in Process Debit Raw Materials UNFAVOURABLE USAGE variance Credit Raw Materials FAVOURABLE USAGE variance Credit Direct materials Inventory ( Raw Material Control )

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10.11

Direct Labour

Direct labour standards are developed along the same lines as that for direct materials in that there are two distinct standard which are calculated, namely: (a) RATE STANDARD Set by the Human Resources department which is the result of collective bargaining agreements, government regulations and other factors. EFFICIENCY Standard Which is set by the production engineering department as a result of "time and motion studies" and specifies the standard time it should take to complete a production task.

(b)

Setting standards:
Because of the human element, the setting of labour standards is slightly more complex than materials standards. The level of skill, qualifications and seniority of workers will influence the standard labour cost. The PRICE or RATE standard is relatively straight forward as, wage rates for employees are set by union awards. The EFFICIENCY standard is where most complications arise as the speed of work performed by employees varies according to skill etc. Nevertheless, an average time per unit of production is determined using engineering studies which forms the basis of the standard cost.

Labour Rate Variances
The Labour Rate variance is calculated using the following formula:

Labour Rate Variance = (Actual Hourly Rate - Standard Hourly Rate) x Actual Hours Worked

Labour Efficiency Variances
The Labour Efficiency variance is calculated using the following formula:

Labour Efficiency Variance = (Actual Hours - Standard Hours) x Standard Labour Cost

Actual Hours

=

Actual Direct Labour hours worked as per the time sheet records Actual Production x Standard Hours per unit of product.

Standard Hours

=

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Template for the Analysis of Direct Labour Variances
Input Actual Hours * Actual Rate Input Actual Hours * Standard Rate Output Actual Good Prodn * Standard Cost

Labour Rate Var

Labour Efficiency Var
Total Labour Variance

Journal Entries for Labour
Journal Entries for Direct labour and the resulting variances are as follows: Debit Work in Process Debit UNFAVOURABLE LABOUR RATE variance Debit UNFAVOURABLE LABOUR EFFICIENCY Variance Credit Credit Credit FAVOURABLE LABOUR RATE Variance FAVOURABLE LABOUR EFFICIENCY Variance Accrued payroll (Wages Payable)

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Standard Costing Direct Material & Direct Labour Variance Analysis
Lecture 10 - Demonstration Problem
Seaforth Manufacturing Company uses a flexible budget for factory overhead and a standard cost system for product costing purposes. The company isolates material price variances on purchase. The following standards have been established for the company's single product. Direct material AA (2 Kgs @ $2.50 /Kg.) Direct material BB (3 Kgs @ $1.50 /Kg.) Direct labour (2.5 hrs. @ $12.00 /hr.)

Actual Results for August: • • • • • • Production: 2,340 units, Purchases of material AA were 5,000 Kgs. at a total cost of $13,250. Purchases of material BB were 7,400 Kgs. at a total cost of $10,804. Usage records showed 4,860 Kgs of material AA and 7,300 Kgs of material BB were issued to production. The direct labour rate was $12.65 per hr. for a total 5,480 direct labour hours. There were no opening or closing work-in-process inventories.

Required: (i) Calculate all relevant standard cost variances for: • Direct material, • Direct labour.

(ii)

Prepare suitably documented journal entries covering the months transactions.

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Standard Cost Templates for Lecture Demonstration Problem:
INPUT Actual Quantity * Actual Price INPUT Actual Quantity * Standard Input Price OUTPUT Actual Good Production * Standard Price

Material AA:

Material Price Variance

Material USAGE Variance

Material BB:

Material Price Variance

Material USAGE Variance

Labour Variances:
INPUT Actual Hours * Actual Rate INPUT Actual Hours * Standard Rate OUTPUT Actual Good Production * Standard Price

Labour Rate Variance

Labour EFFICIENCY Variance

Total Labour - Flexible Budget Variance

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Lecture 10 - Handout Home Assignment Questions:
Question 10-1:
A particular product has the following standard cost data with respect to material and direct labour.

Material A Material B Direct Labour

(1 Kg. @ $2;00/Kg.) (1.2 Kg @ $0.85/Kg.) (1.5 hrs. @ $7:00/hr.)

$ 2.00 $ 1.02 $10.50

At the beginning of the current period there were no initial inventories, and the following events took place. (a) Purchases of the following raw materials were made: 20,000 Kg. of A at $1:20/Kg. and 2,500 Kg. of B at $0.80/Kg. 15,000 Kg. of A and 17,500 Kg. of B were issued to the Production Dept. Direct labour costs were $181,890 for 23,500 hours worked. Production was completed on 14,800 units. At the end of the production period 500 Kg. of material A was returned to raw materials stores.

(b) (c) (d) (e)

Required : (1) (2) Calculate relevant Materials and Labour Variances. Show journal entries for the above under a standard cost system.

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Standard Cost Template:
INPUT Actual Quantity * Actual Price INPUT Actual Quantity * Standard Input Price OUTPUT Actual Good Production * Standard Price

Material A:

Material Price Variance

Material USAGE Variance

Material B:

Material Price Variance

Material USAGE Variance

Labour Variances:
INPUT Actual Hours * Actual Rate INPUT Actual Hours * Standard Rate OUTPUT Actual Good Production * Standard Price

Labour Rate Variance

Labour EFFICIENCY Variance

Total Labour - Flexible Budget Variance

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Question 10-2:
The Smith Company uses a standard cost system and manufactures two products: Current standards are as follows: Standard Usage Product X Product Y 12 units 12 units 6 Units 8 units 14 hours 20 hours

Material A Material B Direct Labour

Standard Costs $1.20 /unit $2.60 /unit $8.00 /hour

Operating data for the month of August shows the following: Purchases Material A Material B

8,500 units total actual cost $9,725 1,800 units total actual cost $5,635 Material A 8,800 units 175 units Material B 4,500 units

Material Requisitions Issued from Store Returned to Store Direct Labour Actual hours worked Actual Cost Transferred to Finished Goods Product X Product Y Required : (a) (b)

12,000 $100,500

400 units 300 units

Calculate all relevant variances for direct materials and direct labour. Show journal entries to record the above transactions including variances.

Standard Cost Template:
INPUT Actual Quantity * Actual Price INPUT Actual Quantity * Standard Input Price OUTPUT Actual Good Production * Standard Price

Material A:

Material Price Variance

Material USAGE Variance

Material B:

Material Price Variance

Material USAGE Variance

Labour Variances:
INPUT Actual Hours * Actual Rate INPUT Actual Hours * Standard Rate OUTPUT Actual Good Production * Standard Price

Labour Rate Variance

Labour EFFICIENCY Variance

Total Labour - Flexible Budget Variance