Chapter 3 - Standard Costing
1. Introduction to standard costing & Variance Analysis
A standard cost is a planned or forecast unit cost for a product or service, which is assumed to apply to the
expected efficiency and cost levels within an organisation. It represents a target cost and is useful for planning,
controlling and motivating within an organisation. We therefore develop costings based on out expected level of
Variance analysis is a budgetary control process, which compares standard or budgeted costs and revenues with
the actual results of an organisation. This reveals information regarding any exceptions from budget. This information
is also used to improve performance through control action e.g. correcting problems.
How do managers control the prices that are paid for inputs and the quantities that are used? They could
examine every transaction in detail, but this obviously would be an inefficient use of management time. For many
companies, the answer is in an effective standard costing system.
A standard cost is the predetermined cost of manufacturing a single unit or a number of product units during a
specific period in the immediate future. It is the planned cost of a product under current and/or anticipated operating
conditions. It should enable management by exception by drawing attention to areas of concern and risk.
2. Standard costing can be used for
• Budget preparation e.g. planning
• Control through exception reporting e.g. performance measurement
• Stock valuation
• Cost bookkeeping.
• Motivating staff
Under a standard costing system an organisation can value inventories at standard cost.
3. Types of standards
It is essential to create realistic standards.
• Ideal Standard e.g. attained under the most favourable conditions with no allowance for any waste, scrap,
idle time or downtime
• Attainable or Expected Standard e.g. what should be achieved with a reasonable level of effort given
current efficiency and cost levels
• Loose Standard e.g. loosely set and easy to achieve
• Basic Standard e.g. first standard ever used by the organisation and used as a basis or yardstick for
comparing current standards or monitoring trends over time
• Historical Standards e.g. standards used historically in previous accounting periods
4. Product Vs Period Costs
We need to appreciate that we have two different types of costs. One that is attributable to the production and one
that is controlled by time. We may produce garden chairs and most costs will be influenced by the levels of activity.
However, there are also costs that are based on time such as rent and insurance.
5. How to create a standard cost and where can we get the correct information so as to have realistic costs:
Setting price and quantity standards require the combined expertise of all persons who have responsibility over input
prices and over effective use of inputs. In a manufacturing firm, this might include accountants, purchasing managers,
engineers, production supervisors, line mangers, and production workers. Past records of purchase prices and input
usage can help in setting standards. However, the standards should be designed to encourage efficient future
operations, not a repetition of past inefficient operations
There are three key cost activities:
5.1 Standard material price
Supplier quotations and estimates
5.2 Standard material usage
Quality of material e.g. natural wastage
Specification of standard product manufactured
Operational wastage expected
5.3 Standard labour rate
Market rate for grade/type of labour
Internal rates from HR department
Bonus schemes or piece work rates in current use
5.4 Standard labour efficiency
Idle time expected during operations
Skill/expertise of staff
Motivation of staff
Remuneration systems in place
5.5 Standard overhead rate
Overhead absorption rates obtained by dividing forecast overhead with an expected level of activity
Understand fixed and variable relationship with output, labour hours, machine hours or % of cost
6. What are the costs
Every product has costs attached to it. Some are easily to identify. Materials consumed in the process and direct
labour represent the two most usual items.
In Chapter 2 we looked at Variable, Semi Variable and Fixed Costs. These costs differ with levels of production
or time. To develop an accurate summary of products costs, we need to apply our understanding of how cost
react to volumes and develop a schedule of the actual costs per unit of production.
A company producing a metal box for use to contain luxury biscuits:
Metal for the tin box = 100 grams of steel at £2 per kilo
Paint for decoration of box = 5 ml at £20 per ltr.
It takes 1 minute of labour at £20 per hour.
Depreciation of the production machine is 1p per tin
Power consumed is 1.5p per tin
Other Overheads consumed based on 500,000 tins a year is 2.5p per tin
So how do we develop a cost per item?
7. Marginal (Variable or direct)Costing
• Is just the direct costs that will vary with production. Labour & Materials
• It excludes overheads.
• It focuses on the “MARGINAL” issues leaving out those that will not be directly affected.
• Used for internal planning and decision making
• Does not include fixed factory overhead as a product cost
• The same as used for external financial reporting
• Includes direct materials, direct labor, variable factory overhead, and fixed factory overhead as part of total
• Variable costing is simple to understand
• It provides more useful information for decision-making
• It removes from profit the effect of inventory changes
• The separation of costs into fixed and variable is difficult and sometimes gives misleading results
• It underestimates the importance of fixed costs
• A system which ignores fixed costs is less effective since a major portion of fixed cost is not taken care of
under marginal costing
• In practice, sales price, fixed cost and variable cost per unit may vary. Thus, the assumptions underlying the
theory of variable/marginal costing sometimes becomes unrealistic. For long term profit planning, absorption
costing is the only answer
• is used for managerial decision-making and control
• Variable/Marginal Costing focuses on Variable and Incremental Costs
• With Variable/Marginal Costing you will be able to calculate:
– Floor Price
– Out of Pocket Price
– Break Even Price
– Target Profit Price
– Most profitable sales mix
– Profitable Sales Strategies
8. Absorption (Full) Costing
• Costing method which involves or “absorbs” all the costs necessary to produce the product into its saleable
• It is both the marginal and the fixed costs
• Allocates indirect costs to a range of products produced by the firm.
• is widely used for cost control purpose especially in the long term.
• In essence we under or over absorb the overheads.
• Is effective in internal reporting for frequent profit statements and measurement of managerial performance
• Avoids fixed overheads being capitalized in unsalable stocks
• The effects of alternative sales or production policies can be easier assessed thus the decisions yield the
maximum return to business
• By concentration on maintaining a uniform and consistent marginal cost practical cost control is greatly
• Application of fixed overhead depends on estimates. There may be under or over absorption of the same
9. Marginal Vs Absorption Costing
Overview of Absorption and
Product Direct Labor
Costs Variable Manufacturing Overhead
Fixed Manufacturing Overhead
Period Variable Selling and Administrative Expenses
Costs Fixed Selling and Administrative Expenses
10. Fixed Vs Variable Budgets
A fixed budget is a budget prepared on the basis of a single estimated production and sales volume. It does not
mean it is never revised or changed, just fixed at a certain level of output sold and produced. This tends to be a
form of budgeting for a service organisation where a high proportion of total cost is fixed, and therefore does not vary
significantly, with the volume or activity of the service performed. Such a form of budgeting would be little use for
control purposes, when comparing to actual results, if significant variable cost exists. A fixed budget provides
details of costs, revenues or resource requirements for a single level of activity.
Flexible budgets are prepared for many different sales and production quantities and can be used to plan more
effectively for an organisation e.g. useful at the planning stage for „what if?‟ analysis. Flexible budgeting recognises
different cost behaviour patterns that may rise or fall with the volume of production or sales and is a more effective
system for control purposes.
A flexible budgeting system based upon a budget set at the beginning of the period can be flexed to correspond to
the actual activity volume of results for a period. When a budget is flexed it would give an appropriate level of revenue
and costs as a yardstick to compare like for like to actual results, at the same activity level, meaningful variances can
then be reported to the managers responsible for control purposes.
In summary, a flexible budget:
Is highly useful at the planning stage (what if analysis)
Can be „flexed‟ retrospectively and compared to actual results for control purposes
11. Critics of standard costing
Sometimes it is hard to define an „attainable standard‟ as well as uncontrollable events within operations e.g.
discounts lost due to the reduction in the quantity ordered or seasonal price fluctuations within the period of appraisal
With more automation within operations, they become less valuable as information feedback not feed forward control
e.g. out of date information revisions to standards may be too frequent to guide performance over time standard
costing is an internal not external control measure e.g. improvement also needs to consider competition and
customers performance measurement would be inadequate as a process if the standard is wrong the reason or
cause of the variance are sometimes overlooked or not investigated.
12. Variance analysis
By comparing a flexed budget, which has been prepared using standard cost information to actual results, total
variances can be calculated. These reconcilable differences between the two statements can then be sub-divided
further, calculated, interpreted and used to correct problems within the organisation to stay on target through control
action by management or employees
Variances can occur for the following reasons
• Inaccurate data when creating standards, producing the budget or compiling actual results
• A standard used which is either not realistic or perhaps out of date
• Efficiency of how operations were undertaken by management or employees during the period of
• Random or chance
Fixed overhead variances further explained
Traditional absorption costing takes the total budgeted fixed overhead for a period and divides by a budgeted (or
normal) activity level e.g. units, in order to find the overhead absorption rate. This is a simple method of charging
fixed overhead and allows fixed overhead to be allocated to products, jobs or work-in-progress
Overhead absorption rate (OAR) = Budgeted production overhead
13. Absorption of Overheads
At the end of the period, the overhead „absorbed‟ or charged to production is compared to the actual production
overhead incurred for the period. Any shortfall in overhead charged would be an ‘under absorption’ of production
overhead (DR profit and loss account CR Production overhead control account). Any „over charge’ to the profit and
loss account during a period would be an ‘over absorption’ of production overhead (CR profit and loss
account DR Production overhead control account).The sum of the fixed overhead expenditure and volume variance
would be equal to the under or over absorption, when sub-divided, explaining the two different causes as to how this
occurred during a period e.g. under or over spent and/or under or over produced when compared to the original
budget. The difference between absorption costing and marginal costing organisations is that the marginal costing
organisation makes no attempt to absorb or charge production overhead into a cost unit or the profit and loss account.
It treats production overhead as a period cost only and does not absorb overhead, but rather charges it entirely to the
profit and loss account for each period. With marginal costing organisations only the fixed overhead expenditure
never the fixed overhead volume variance would be applicable within a question. Actual production overhead Actual
production (units) x O.A.R = Charge to W.I.P during the period
14. Budgetary planning
Involves the production of budgets or forecasts using realistic standards for cost and efficiency levels. Budgetary
control identifies areas of responsibility for management and is the process of regularly comparing actual results
against budget or standards. Because the original budget would have forecast a different number of units produced
or sold, when compared to actual units produced or sold, a „flexed budget‟ would be prepared in order to compare
costs and revenues on a like with like basis.
15. Normal/budget level of activity
16. Working through a practical example – The Better Garden Furniture Company
Sales Variances Analysis
We need to compare what we actually sold against what we had expected to sell. So if The Better Garden
Furniture Company had expected to sell 500 units at a price of $20 each but in fact only sold 480 units at a price of
Sales price variance
Actual Sales Activity (actual quantity sold x actual price) = 7,100 units @ $19 = 134,900
Expected to sell (actual quantity sold x standard price) = 7,100 units @ $20 = 142,000
Sales price variance = 8,000 (U)
Note we need to just compare the price difference and therefore have to use actual units sold.
Sales volume profit variance units
Actual units sold (actual quantity sold x Actual Price) = 7,100 units @ $19 = 134,900
Should sell (budget quantity sold x Actual Price) = 7,200 units @ $19 = 136,800
Sales Volume Variance = 1,900 (U)
NOTE: we mark a favourable variance with a (F) and an unfavourable with a (U)
Materials Variance Analysis:
Direct materials price variance is the difference between the actual purchase price and standard purchase price of
materials. Direct materials price variance is calculated either at the time of purchase of direct materials or at the time
when the direct materials are used. Standard price per unit of direct materials used 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. Direct materials quantity variance or usage variance measures the difference
between the quantity of materials used in production and the quantity that should have been used according to the
standard that has been set. Although the variance is concerned with the physical usage of materials, it is generally
stated in dollar terms to help gauge its importance
Materials Price Variance
Materials Usage (Quantity) Variance
The Better Garden Furniture Company uses 12 meters of aluminium pipe at $0.80 per meter as standard for the
production of its Type A lawn chair. During one month's operations, 100,000 meters of the pipe were purchased at
$0.78 a meter, and 7,200 chairs were produced using 87,300 meters of pipe. The materials price variance is
recognized when materials are purchased.
Material Price Variance Unit Cost Amount
Actual quantity purchased 100,000 $0.78 actual $78,000
actual quantity purchased 100,000 $80,000
----------- ----------- -----------
Materials purchase price variance 100,000 $(0.02) $(2,000) (F)
======= ======= =======
Materials Usage (Quantity) Variance
87,300 0.80 standard $69,840
Actual quantity used
Standard quantity allowed 86,400 0.80 standard $69120
------------- ------------- -------------
Materials sage (quantity) variance 900 0.80 $720 (U)
======= ======= =======
NOTE: we mark a favourable variance with a (F) and an unfavourable with a (U)
Labour Variance Analysis:
Direct labour price and quantity standards are usually expressed in terms of a labour rate and labour hours. The
standard rate per hour for direct labour includes not only wages earned but also fringe benefit and other labour costs.
Direct Labour price variance is also termed as direct labour rate variance. This variance measures any deviation from
standard in the average hourly rate paid to direct labour workers The quantity variance for direct labour is generally
called direct labour efficiency variance or direct labour usage variance
The processing of one Garden Type A chair, requires a standard of 0.8 direct labour hours per unit at a standard
wage rate of $6.75 per hour. The 7,200 units actually produced using 5,860 direct labour hours at a cost of $6.90 per
hour. (Note that we would have expected to have 5,760 hours of labour to produce 7,200 units. 7200 x 0.8 hrs)
Labour rate variance Time Rate Amount
Actual hours worked x Actual Rate 5860 $6.90 actual $40,434
Actual hours worked x Expected Rate 5860 $6.75 standard $39,555
-------- -------- --------
Labour rate variance 5860 $0.15 $879 (U)
===== ===== =====
Labour efficiency variance
5860 $6.75 standard $39,555
Actual hours worked
Standard hours allowed 5,760 $6.75 standard $38,880
---------- ------------ -----------
Labour efficiency variance (100) 6.75 standard $675 (U)
====== ====== ======
NOTE: we mark a favourable variance with a (F) and an unfavourable with a (U)
Factory Overhead Variance Analysis:
Clearly this is more difficult to calculate than direct costs such as materials and labour. What overheads? and do we
include all or just some? The objective is to try to ensure that the costing system is informative and enables
management to be able to take intelligent decisions based on accurate costing.
Cleary there are costs such as the rent of the factory that would be reasonable to attribute as a cost to the production
process. However, what about the wages of the receptionist or the costs of running the CEO‟s vehicle? We need to
identify which overheads are to be included and how they will react to volume activity. We then need to create either
a rate per hour worked or per unit produced.
Jobs or processes are charged with cost on the basis of standard hours allowed multiplied by the standard factory
over head rate The standard hours allowed figure is determined by multiplying the labour hours required to produce
one unit (the standard labour hours per unit) times the actual number of units produced during the period. The units
produced are the equivalent units of production for the departmental factory overhead cost being analyzed. At the
end of the month, overhead actually incurred is compared with the expenses charged into process using the standard
factory overhead rate. The difference between these figures is called the overall or net factory overhead variance.
Absorbtion Costing e.g. if a firm produces three products - a, b, and c - and has indirect costs of £1 million, assume
proportion of direct costs of 20% for a, 55% for b and 25% for c
– Indirect costs allocated as 20% of 1 million to a, 55% of £1 million to b and 25% of £1 million to c
1. The following information relates to Product W‟s Standard Cost Card
Material 20kg at £10/kg 200
Labour 4 hours at £8/hour 32
Variable overhead 4 hours at £4/hour 16
Fixed overhead 4 hours at £3/hour
Standard selling price per unit 300
The Fixed Overhead Absorption Rate is based on a normal (expected) output of 2,000 units (8,000 standard hours)
and a budgeted total fixed overhead cost of £24,000. For the period under consideration, the actual results were as
Actual output 2100 units
Material 44,100kg used 418,950
Labour 7,350 hours worked 62,475
Variable overheads 7,350 hours 25,725
Fixed overheads 7,350 hours 28,665
Sales revenue £619,500
2. When presented with such information you are requested to calculate the following variances:
material price and usage;
labour rate and efficiency;
variable overhead expenditure and efficiency
fixed overhead expenditure and volume;
Prepare a statement reconciling standard and actual profits; and provide two possible reasons for each of the
material and labour variances.
3. On May 1, Bovar Company began the manufacture of a new mechanical device known a "Dandy." The company
installed a standard cost system in accounting for manufacturing costs. The standard costs for a unit of Dandy are:
Materials: 6 lbs. at $1 per lb. $ 6.00
Direct labour: 1 hour at $4 per hour $ 4.00
Factory overhead: 75% of direct labour cost $ 3.00
The following data were obtained from Bovar's record for May:
Actual production of Dandy 4,000 units
Units sold of Dandy 2,500
Purchases (26,000 pounds) 27,300
Materials price variance (applicable to May purchase)
Materials quantity variance
Direct labour rate variance
Direct labour efficiency variance 800 favourable
Factory overhead total variance
1. Standard quantity of materials allowed (in pounds).
2. Actual quantity of materials used (in pounds).
3. Standards hours allowed.
4. Actual hours allowed.
5. Actual direct labour rate.
4. Your manager has presented you with the following information, which he does not understand, and has asked for
your help: He is particularly concerned about the large material variances and thinks you should be investigating
these figures. You have been left to take action.
Material variances: Price £22,050 (favourable)
Usage £21,000 (adverse)
Rate £3,675 (adverse)
Efficiency £8,400 (favourable)
Butlins is a business that offers packaged holiday deals in 3 locations in the UK and as part of this service has a
restaurant that serves many different meals and puddings through out the day to guests staying over in chalets on the
holiday park. One such serving counter has been a major concern for the management, the „All week Sunday lunch‟
counter, as it is expensive to run. The stand uses 2 staff on different shifts to cook and serve meals at the counter,
the standard cost and price of the „Hungry man roast of the day‟ is as follows:
Standard cost information for 1 meal - £ Per meal
Chicken 0.3kg @ £2.50 per kg 0.75
Vegetables 0.5kg @ £0.50 per kg 0.25
Labour 15 mins @ £9.00/hr 2.25
Variable overhead 15 mins @ £2.00/hr 0.50
Fixed overhead 15 mins @ £20.00/hr 5.00
Selling price (included in packaged price) 11.95
Standard profit 3.20
The counter works on a 6-day shift (all week except Sunday) and the budget aims to sell 500 meals within week 43
The following actual information was obtained. Meals actually sold were 476 the revenue earned £5,688.
Purchased 180kg (£405) 250kg (£140)
Used 165kg 220kg
Clearly unconsumed will be held as inventories.
Chef wages for week 43
Hours paid 120 hours (wages paid £1,200)
Hours worked 114 hours .6 hours were idle due to ovens failing on Tuesday afternoon
Overheads per week
Variable overhead £150. Fixed overhead £2,750
Produce the original budget, flexed budget based upon actual sales volume, and compare this to actual
results in order to calculate any variances?
Materials Variance Analysis:
The standard price for material 3-291 is $3.65 per liter. During November, 2,000 liters were purchased at $3.60 per
liter. The quantity of material 3-291 issued during the month was 1775 liters and the quantity allowed for November
production was 1,825 liters. Calculate materials price variance, assuming that:
Required: Materials price variance, assuming that:
1. It is recorded at the time of purchase (Materials purchase price variance).
2. It is recorded at the time of issue (Materials price usage variance).
what factors should be taken into consideration when deciding whether to investigate the material price and
describe and evaluate possible actions you could take to investigate the material price and usage variance
describe the factors that should be taken into consideration before deciding whether to investigate a
variance (for example, cost of investigation v anticipated benefits);
evaluate the impact of price changes on reported variances;
explain potential causes of variances;
describe and evaluate possible actions that could be taken in response to a reported variance
– for example, an adverse material price variance (which means that the price paid for the material was higher than the standard
price) may be tackled by inviting quotes from alternative suppliers in a bid to obtain a more favourable price