Standard Costing and Variance Analysis

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CERTIFICATE LEVEL

Subject Fundamentals of Management Accounting (BA2)


K.Sivagar
Lecturer B.Sc (Hons), ACMA, CGMA

Module Tute 05 – Standard Costing and Variance Analysis

Code BA2/KS/05
Standard Costing and Variance Analysis
Standard
Standard is a pre-determined estimate for a future period. Standards are developed per unit. Any
estimate for the total activity is known as a budget.

The standard cost may be stored on a standard cost card like the one shown below but nowadays it is
more likely to be stored on a computer, perhaps in a database. Alternatively, it may be stored as part of
a spreadsheet so that it can be used in the calculation of variances.

Example: Standard Cost Card – Product XP


$ per unit

Direct material cost 4kgs x $5/kg 20

Direct labour cost 3hrs x $4/kg 12

Variable production overhead 2hrs x $7/kg 14

Fixed production overhead 10

Selling & distribution and Administration 4


overhead
Total cost 60

Standard costing
A control technique which compares standard cost and revenues with actual results to obtain variances
which are then often used to stimulate improved performance.

The CIMA Terminology defines standard costing as a “a control technique that reports variances by
comparing actual costs to pre-set standards facilitating action through management by exception”.

Looking at the above definition, standard costing has 4 main steps to be followed.
1. Developing standards
2. Comparing actual against standards
3. Variance analysis (identifying possible causes for the deviations)
4. Decision making based on the information derived to improve future performance

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Developing standards
• Before developing a standard, it is important to identify the factors or types of information which
will affect these standards.
• Decision makers will use this information and develop the standards accordingly.

1. Past information
• Previous standards and past actual information are the best sources of information to develop
standards into the future.
• Depending on the deviations in the past, future standards will be decided.

2. Quotation received from suppliers


• This will give them the idea of the prices, quality and the service given by the suppliers.
• That information is used to develop future standards.

3. National legislation/labour laws/trade union agreements


• Labour rates and any other work agreements should be decided before setting standards for
labour in the organization.

4. Set specifications
• Level of quality of the work undertaken will be another deciding factor of the standards.
• If the organization is producing a quality output they should set standards to purchase quality
materials so that the price they are planning to pay is set at a higher level.

5. Environmental factors
• These are the external factors like political, economic, social legal and technological (PEST
factors) which are common to any organization.
• Additionally, customers, suppliers and competitor information should also be considered before
setting standards into the future.

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Types of standards
1. Ideal standard
Standard is set expecting perfect performance where no allowance is kept for normal problems
(inefficiencies such as normal losses, wastage, machine break down etc) is known ideal standard. It
is difficult to achieve this standard and often results in adverse variances.

2. Attainable standard
A standard set keeping allowances for normal problems is known as attainable standard. Such a
standard should be achievable but challenging.

3. Current standard
A standard set based on current performance is known as current standard. Their disadvantage is
that they do not encourage any attempt to improve on current level of efficiency.

4. Basic standard
A basic standard is one which is kept unchanged over period.

Comparing standards with actuals (variances)


Standards which are developed at the beginning of a period (standard costs and sales) are compared
with actual information at the end of the period (actual costs and sales) to identify varainces.

Standard Actual

Variance

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Types of variances
There are three main variance types.
1. Variable cost variances
• Direct material
• Direct labour
• Variable overhead

2. Fixed cost variances


3. Sales variances

Variance Calculation – Guidelines


There are basic guidelines for any variance calculations carried out.
• Comparisons are made at the actual activity level.
• Even though standards are per unit calculations and their comparisons are also per unit. In order to
highlight the real impact of the variance it is converted into a total figure.
• Any quantity differences should be identified in value terms.
• Any variances which are positive for the organization is called as “favourable” and anything
unfavourable are known as “adverse” variance.

Variable cost variances


Direct Material Variances
(a) Direct material total variance
• This will be the difference between the standard material cost for actual production and the
actual cost.
• Formula;
Standard material cost per X Actual no. of units - Actual material cost
unit produced incurred

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(b) Direct material price variance
• Simply this shows the difference between the price we should have paid and the actual price we
paid for the materials consumed during the period.
• Formula;
(Standard material cost per - Actual material cost per kg) X Actual material
Kg purchased/used

Purchased or used depends on the stock valuation method. If the stocks are valued at standard,
variance is identified at purchased place (purchased figure should be taken). But, if the stocks
are valued based on actual, variance is only identified with usage (used figure should be taken).

(c) Direct material usage variance


• This identifies the difference between the quantities the firm should have used and actually
used.
• Formula;
(Standard material X Actual no. of units - Actual materials) X Standard
usage per unit produced used material cost
per Kg

Direct Labour Variances


(a) Direct labour total variance
• This is the difference between the standard labour cost for the actual production and the actual
cost of labour.
• Formula;
Standard labour cost per X Actual no. of units produced - Actual labour cost
unit incurred

(b) Direct labour rate variance


• This calculates the difference between the standard and actual rate per labour and the
difference between the former in converted under total actual hours worked to indicate
significance.

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• Formula;
(Standard labour rate per - Actual labour rate per hour) X Actual labour hours
hour worked

(c) Direct labour efficiency variance


• This is the difference between the standard labour hours for actual production and the actual
labour hours worked during the period converted into value terms by multiplying it by the
standard labour rate per hour.
• Formula;
(Standard labour X Actual no. of units - Actual hours X Standard
hours per unit produced actively worked) labour rate per
hour

Total hours = Productive/Active hours + Idle hours


*Any identification of efficiency should be based on productive or active hours. But any variance
calculated for payments should be based on total hours (total hours worked)

(d) Idle time variance


Idle time occurs when labour is available for production but is not engaged in active production due
to for example, shortage of material or work. During idle time, direct wages are being paid but no
output is being produced.

• Formula;
Idle hours X Standard labour rate per hour

Variable Overhead Variances


Variable overhead variances are based on two fundamental assumptions.
1. Variable overheads are related using labour hours
2. Overheads would incur only with active hours

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(a) Variable overhead total variance
• Simply this is the difference between the variable overhead what should have been and the
actual variable overhead cost.
• Formula;
Standard variable overhead X Actual no. of units produced - Actual variable
cost per unit overhead cost incurred

(b) Variable overhead expenditure variance


• This identifies the difference between overheads planned be incurred per hour and the actual
overhead paid per hour converted into total active hours worked.
• Formula;
(Standard variable - Actual variable overhead X Actual active hours
overhead expenditure per expenditure per hour) worked
hour

(c) Variable overhead efficiency variance


• This shows the difference created in variable overheads due to the difference in labour the firm
should have used, and the actual active hours used.
• Formula;
(Standard hours per X Actual no. of units - Actual active X Standard variable
unit produced hours) overhead per hour

Fixed Overhead Variances


Formulas applicable for fixed overhead variances are as follows.

(a) Fixed overhead total variance


Standard fixed overhead X Actual output - Actual fixed overhead cost incurred
cost per unit

This is similar to the way in which we calculate under or over absorption.

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(b) Fixed overhead expenditure variance
Budgeted fixed overhead cost – Actual fixed overhead cost

(c) Fixed overhead volume variance


(Budgeted units – Actual units) X Fixed overhead absorption rate per unit

Sales Variances
Traditionally, total sales variance is not calculated.

(a) Sales price variance


• Formula;
(Standard selling price per - Actual selling price per unit) X Actual no. of units sold
unit

(b) Sales volume contribution variance


• Formula;
(Budgeted sales units - Actual sales units) X Standard contribution per unit

(c) Sales volume profit variance


• Formula;
(Budgeted sales units - Actual sales units) X Standard profit per unit

This depends on the overhead cost accounting system used. If absorption costing is used standard profit
taken (sales volume profit variance should be calculated). If marginal costing is used standard contribution
is taken (sales volume contribution variance should be calculated).

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Working backwards
• This is a situation where a concept in the former formula’s needs to be computed when the
relevant variance is provided.
• When the mathematical and logical situations coincide, a favourable variance will be considered
as positive and an adverse as negative.
• When the mathematical and logical situations does not coincide, a favourable variance will be
considered as negative and an adverse variance will be considered as positive.

Operating Statements
A document that gives the original plan, and the deviations (through variances) is normally known as an
operating statement.
• This is also known as statement of reconciliations

There are 2 types of reconciliations.


1. Profit reconciliation
2. Contribution reconciliation

Profit reconciliation
This is a reconciliation between the budgeted profit and actual profit.

Budgeted profit XXX

+ Favourable Variances X

(-) Adverse Variances (X)

Actual Profit XXX

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Contribution reconciliation
This is the reconciliation between the budgeted contribution and the actual contribution.

Budgeted contribution XXX

+ Favourable Variances X

(-) Adverse Variances (X)

Actual contribution XXX

Points to remember:
• Budgeted contribution = Std contribution per unit X Budgeted sales units
• Actual contribution = All the items are valued at the actual
• Sales volume contribution variance used is sales volume contribution variance
• Fixed overhead variances are excluded since we do not consider fixed overheads to calculate the
contribution

Interpretation of Variances (Reasons for variances)


After calculating variances, we need to look at those in detail and try to interpret them to give us more
understanding about what could have caused them. Understanding the causes (reasons) of the variances
will help organisations take appropriate corrective action.

Since organisations are different from each other possible reasons behind their variances are also likely
to be different. Some of generally possible reasons are as follows.

1. Incorrect standards
• Adverse variance – Ideal standard (hard)
• Favourable variance – Attainable standard (easy)

2. Efficient/inefficient operations/controls
• Adverse variance – inefficient operations
• Favourable variance – efficient operations

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3. Errors in recording standards

4. Macro and Micro factors


• Macro factors (Political/ Economical/ Social and Legal/ Technical)
• Micro factors (Customers/ Suppliers/ Competitors)

5. Interrelationship of variances (variance caused due to another variance)

Variance Favourable Adverse


Material Price -Standard price set too high -Standard price set too low
-Unexpected discounts available -Unexpected general price increase
-Lower quality material used -Higher quality material used
-Careful purchasing -Careless purchasing
-Gaining bulk discounts by buying -Losing bulk discounts by buying
larger quantities smaller quantities

Material usage -Standard usage set too high -Standard usage set too low
-Higher-quality material used -Lower-quality material used
-A higher grade of worker used the -A lower grade of worker used the
material more efficiently material less efficiently
-Stricter quality control -Theft

Labour rate -Standard rate set too high -Standard rate set too low
-Lower grade of worker used -Higher grade of worker used

Labour efficiency -Standard hours set too high -Standard hours set too low
-Higher grade of worker -Lower grade of worker
-Higher grade of material was -Lower grade of material was
quicker to process slower to process
-More efficient working through -Less efficient working due to poor
improved motivation motivation

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Idle time - -Shortage of work
-Machine breakdown
-Shortage of material

Variable -Standard hourly rate set too high - Standard hourly rate set too low
overhead
expenditure Since overheads consist of a number of items, (indirect material, indirect
labour, maintenance costs, power etc) any meaningful interpretation of
the expenditure variance must focus on individual cost items.

Variable See labour efficiency variance


overhead
efficiency

Sales price -Higher quality product -Increased competition forced a


variance commanded higher selling price reduction in selling price below
than standard standard

Sales volume Increased marketing activity led to Quality control problems resulted
contribution higher than budgeted sales volume in lower than budgeted sales
volume

Standard hour
Sometimes it can be difficult to measure the output of an organization which manufactures a variety of
dissimilar items (table, chair, cupboard etc).
A standard hour is a useful way of measuring output when a number of dissimilar items are manufactured.

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Example:-

Units Produced

January 2019 February 2019

Table 7 4

Chair 5 2

Cupboard 3 5

15 11

Standard labour hours per unit

Table 3 hours

Chair 1 hour

Cupboard 5 hours

January 2019 February 2019

Std hours per Units Std hours Std hours per Units Std hours
unit unit

Table 3 7 21 3 4 12

Chair 1 5 5 1 2 2

Cupboard 5 3 15 5 5 25

41 39

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Practice Question-01
The following is the budget prepared by X ltd for each the year ended 31/12/2017

$ Per unit
Sales 10000 units 100.00
Costs
Direct material - A 3kg @ 5/ kg 15.00
B 2kg @ 3/ kg 6.00
Direct labour – Skill 2 Hrs @ 10/ Hr 20.00
Unskill 1 Hr @ 5/ Hr 5.00
Variable prod overhead (3Hrs @ 5/ Hr) 15.00
Fixed production overhead 20.00 (81.00)
19.00
Actual information for the same period is as follows.

Sales 9,500units @ 105 unit 997,500.00


Direct material A 25,650kg 141,075.00
B 19,950kg 61,845.00
Direct labour Skilled 18,150 hrs 199,650.00
Unskilled 11,400 hrs 62,700.00
Variable production overhead 176,700.00
Fixed production overhead 191,425.00
(833,395.00)
Net profit 164,105.00

Calculate possible variances and reconcile the budged and actual profit assuming actual skilled
labour includes idle time of 100 hours.

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Objective Test Questions
1. A standard cost is:
A. The planned unit cost of a product, component or service in a period
B. The budgeted cost ascribed to the level of activity achieved in a budget centre in a control
period
C. The budgeted production cost ascribed to the level of activity in a budget period
D. The budgeted non-production cost for a product, component or service in a period

Data for question 2 - 7


Budgeted production of product V is 650 units each period. The standard cost card for product V contains
the following information.
£ Per unit
Ingredients 12 litres @ £4 per litre 48
Direct labour 3 hours @ £9 per hour 27
Variable production overhead 3 hours @ £2 per hour 6
During the latest period 670 units of product V were produced. The actual results recorded were as
follows:
Ingredients purchased and used 8,015 litres £33,663
Direct labour 2,090 hours £17,765
Variable production overhead £5,434

2. The ingredients price variance is:


A. £1,503 favourable
B. £1,503 adverse
C. £1,603 favourable
D. £1,603 adverse

3. The ingredients usage variance is:


A. £100 favourable
B. £100 adverse
C. £105 favourable
D. £860 adverse

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4. The labour rate variance is:
A. £325 favourable
B. £325 adverse
C. £1,045 favourable
D. £1,045 adverse

5. The labour efficiency variance is:


A. £680 adverse
B. £720 adverse
C. £720 favourable
D. £1,260 adverse

6. The variable overhead expenditure variance is:


A. £1,254 favourable
B. £1,254 adverse
C. £1,534 favourable
D. £1,534 adverse

7. The variable overhead efficiency variance is:


A. £151 adverse
B. £160 adverse
C. £160 favourable
D. £280 adverse

8. ABC Ltd uses standard costing. It purchases a small component for which the following data are
available:

Actual purchase quantity 6,800 units


Standard allowance for actual production 5,440 units
Standard price 85p per unit
Purchase price variance (adverse) (£544)

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What was the actual purchase price per unit?
A. 75p
B. 77p
C. 93p
D. 95p

9. During a period 17,500 labour hours were worked at a standard cost of £6.50 per hour. The labour
efficiency variance was £7,800 favourable. The number of standard labour hours expected for the
output achieved was:
A. 1,200
B. 16,300
C. 17,500
D. 18,700

10. XYZ Ltd uses standard costing. It makes an assembly for which the following standard data are
available:

Standard labour hours per assembly 24


Standard labour cost per hour £8

During a period 850 assemblies were made, there was a nil rate variance and an adverse efficiency
variance of £4,400.
How many actual labour hours were worked?
A. 19,850
B. 20,400
C. 20,950
D. 35,200

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Data for questions 11 and 12
The standard cost of providing a meal in a fast food restaurant is as follows.
£
Ingredient cost 1.80
Direct labour cost 0.30
Variable overhead cost 0.20

The standard price of the meal is £4.50 and the budgeted sales volume is 4,650 meals each period.
During period 9 a total of 4,720 meals were sold for £20,768. The actual total variable cost per meal was
£2.30.

11. The sales price variance for period 9 was:


A. £465 favourable
B. £465 adverse
C. £472 favourable
D. £472 adverse

12. The sales volume contribution variance for period 9 was:


A. £147 favourable
B. £147 adverse
C. £154 favourable
D. £154 adverse

13. The standard cost card for product F shows that each unit requires 3 kg of material at a standard
price of £9 per kilogram. Last period, 200 units of F were produced and £5,518 was paid for 620 kg
of material that was bought and used. Calculate the following variances and tick the correct box to
indicate whether each variance is adverse or favourable.
Adverse Favourable

(a) The direct material price variance is £


(b) The direct material usage variance is £

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14. The standard cost card for product K shows that each unit requires four hours of direct labour at a
standard rate of £8 per hour. Last period, 420 units were produced and the direct labour cost
amounted to £15,300.

The direct labour efficiency variance was £160 adverse.


The actual rate paid per direct labour hour is £

15. The budgeted sales of product Y are 230 units per period at a standard sales price of £43 per unit.
Last
period the sales volume contribution variance was £1,100 favourable and all units were actually sold
for £46 per unit. The sales price variance was £840 favourable.

The standard variable cost per unit of product Y is £

Data for questions 16 –18


The standard direct labour cost of one unit of product Q is £3.00 (0.25 hours _ £12.00).
The eight employees who make product Q work a 7-hour day. In a recent 3-day period, results were as
follows:
Actual units produced 650 units
Actual labour cost £2,275

During this period, there was a power failure. This meant that all work had to stop for 2 hours.

16. If the company reports idle time separately, the labour efficiency variance for the period is:
A. £126 favourable
B. £142 favourable
C. £66 adverse
D. £126 adverse

17. The labour rate variance for the period is:


A. £259 favourable
B. £259 adverse

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C. £325 favourable
D. £325 adverse

18. The idle time variance for the period is:


A. £24 adverse
B. £24 favourable
C. £192 adverse
D. £192 favourable

19. The direct material usage variance for last period was £3,400 adverse. Which of the following
reasons could have contributed to this variance? (Tick all that apply.)

(a) Output was higher than budgeted.


(b) The purchasing department bought poor quality material.
(c) The original standard usage was set too high.
(d) Market prices for the material were higher than expected.
(e) An old, inefficient machine was causing excess wastage.

20. If employees are more skilled than had been allowed for in the original standard cost, which four of
the following variances are most likely to result?

(a) Favourable material usage;


(b) Adverse material usage;
(c) Favourable labour efficiency;
(d) Adverse labour efficiency;
(e) Favourable labour rate;
(f) Adverse labour rate;
(g) Favorable variable overhead efficiency;
(h) Adverse variable overhead efficiency;

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21. The budgeted contribution for last month was £43,900 but the following variances arose:
£
Sales price variance 3,100 adverse
Sales volume contribution variance 1,100 adverse
Direct material price variance 1,986 favourable
Direct material usage variance 2,200 adverse
Direct labour rate variance 1,090 adverse
Direct labour efficiency variance 512 adverse
Variable overhead expenditure variance 1,216 favourable
Variable overhead efficiency variance 465 adverse

The actual contribution for last month was £

22. What is an attainable standard?


A. A standard that is based on currently attainable working conditions
B. A standard that is established for use over a long period
C. A standard that can be attained under perfect operating conditions, and which does not include
an allowance for wastage, spoilage, machine breakdowns and other inefficiencies
D. A standard that can be attained if production is carried out efficiently, machines are operated
properly and/or materials are used properly. Some allowance is made for waste and
inefficiencies

23. What is a standard hour?


A. An operating hour in which there are no exceptional events, eg machine breakdowns
B. An hour during which only standard units are made
C. The amount of work achievable in an hour, when working at standard efficiency levels
D. An hour during which only standard hourly rates are paid to labour

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24. What is basic standard?
A. A standard that includes no allowances for losses, waste and inefficiencies. It represents the
level of performance that is attainable under perfect operating conditions
B. A standard that includes some allowances for losses, waste and inefficiencies. It represents the
level of performance that is attainable under efficient operating conditions
C. A standard that is based on currently attainable operating conditions
D. A standard that is kept unchanged, to show the trends in costs

25. Which of the following statements is correct?


A. The operating standards set for production should be the most ideal possible
B. The operating standards set for production should be the minimal level
C. The operating standards set for production should be the attainable level
D. The operating standards set for production should be the maximum level

26. Standard costing provides which of the following?


I. Targets and measures of performance
II. Information for budgeting
III. Simplification of inventory control systems
IV. Actual future costs

A. I, II and III only


B. II, III and IV only
C. I, III and IV only
D. I, II and IV only

27. Which TWO of the following statements are INCORRECT?


A. Both budgets and standards relate to the future
B. Both budgets and standards must be quantified
C. Both budgets and standards are expressed in aggregate terms
D. Both budgets and standards are used in planning
E. Both budgets and standards are expressed in unit terms

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28. If the purchasing manager makes a decision to buy cheaper, inferior raw materials which THREE of
the following variances are most likely to result?
A. Favourable material usage
B. Adverse material usage
C. Favourable labour efficiency
D. Adverse labour efficiency
E. Favourable material price
F. Adverse material price

29. Which TWO of the following is a possible cause of an adverse labour efficiency variance?
A. The original standard hours were set too high
B. The employees were more skilled than had been planned for
C. Production volume was lower than budget
D. An ideal standard was used for labour time
E. A lower quality of material was used in production

30. Which TWO of the following statements regarding standard costing are correct?
A. Standard costing is a useful technique in dynamic environments
B. Standard costing is less useful in today’s environment because simply achieving standard is no
longer seen as acceptable
C. Standard costing has been criticized as it generally places emphasis on labour variances which is
no longer appropriate with the increasing use of automated production techniques
D. Standard costing is only really useful in manufacturing environments
E. Standard costing encourages companies to strive for continuous improvements

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