MODULE 5: STANDARD COSTING AND VARIANCE ANALYSIS

STANDARDS Standards set in organizations could either

motivate or de-motivate employees, give
Standards are expected levels of performance. relevance or insignificance in the meaning of
Standards are established to institute order, their work, or produce excellent or mediocre
discipline, expectations, and normalcy. performance. If the standards set are too high
Standards are expressed and used in many and improbable to achieve, it will create
forms. Societal standards are reflective of ethics, dysfunctional employee behavior. Standards
values, culture, traditions, beliefs, laws and that are set too low would attract mediocre
decrees. Organizational standards are expressed performance and would fail to maximize the
in policies, procedures, rules, regulations, potentials of employees.
manuals and systems. Standards could be
STANDARD LEVELS
financial or non-financial, quantitative or non-
quantitative. In the field of financial accounting, Standard levels may be theoretical, practical or
for example, the standards used are the tax.
International Financial Reporting Standards, while
Theoretical standards (or ideal, maximum
tax laws and regulations are the standards on
efficiency, or perfection standards) are set at the
taxation services.
highest possible capacity where there are no
Standards are oftentimes quantitative for allowances for waste, spoilage, inefficiencies,
objectivity in measurement. There are standards machine breakdowns and other downtimes, and
established and followed in accounting, treasury, other interruptions in the production line.
engineering, design, legal, administration, Standards bring the organization at
marketing, human resources, distribution,
the level of business operations where machines,
customer relations, information technology and
systems, and personnel are working in the best
other areas of responsibility centers.
possible situation without allowances for normal
Standards are used in almost all facets of operating interruptions. It is based on the work of
management – planning, organizing, directing, most skilled workers, most efficient machines, and
and controlling. In planning, standards serve as best production design and processes. These
basis for forecasting. In organizing and directing, standards may bring in positive attitude and
standards are used as indicators to monitor behavior if employees are motivated to strive for
production yield rate, conformity or quality and excellence. If the standards are
nonconformity with administrative policies, and perceived to be too high to attain, employees
personnel efficiencies. In controlling, standards react negatively – this defeats the motivational
are used in costs variances analyses for on-line purpose of standards. Theoretical standards are
monitoring and adjustments and for – end-of-the- adopted by companies which employ total
line evaluation and remedial actions. quality management principles. Theoretical
standards are normally replaced by practical
standards in financial planning and controlling to
make estimated financial data more reliable.

STANDARDS SETTING Practical standards attain the most reasonable

production level, with allowances for machine
Standards-setting is strategic in nature. Standards breakdowns, downtimes, inefficiencies, waste
could be set by top management, outsourced and spoilage, and other normal production
from an independent entity, developed by the disturbances. Practical standards still require
industrial engineering department, or established utmost efficiency and optimum use of resources
with the participation and involvement of lower- under normal circumstances. Practical standards
level managers and personnel. The process of are reasonable and attainable.
developing standards is a matter of managerial
prerogative. Lax standards (or slack standards) provide the
maximum allowances for inefficiencies and
When standards are developed with the ineffectiveness and are not geared towards
participation of operating personnel and officers, producing less than the reasonable output from
there appears no reasons for not meeting them. the process. It is a sure formula to slowdown
Besides, standards set by hands-on personnel are activities and make the business much less
more reflective on the realities in the production competitive and self-sustaining.
line and other facets of business operations.

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BUDGET, STANDARDS, AND NORMAL VOLUME

Budget, standards and normal volume levels
differ in terms of usage (or quantity) but not in
their rate per unit.

Budgeted (or expected actual capacity is the

estimated level of performance that the
company plans to achieve in the next 12 months. *The standard hours is based on the actual
Budgeted quantity is based on budgeted level of capacity, and in this case is 180,000 units.
production. It equals the budgeted unit of
production multiplied by the standard quantity Standard Costs
(e.g., pounds or hours) per unit of product. Standard costs (standard quantity times standard
price) are used to motivate optimal productivity
Standard capacity is the estimated capacity and efficiency. These are monetary measures
that should have been used in actual capacity. It with which actual costs are compared to.
is determined by multiplying the actual Standard costs may be based on engineering,
production in units by the standard quantity rate accounting, and statistical quality control studies.
per unit produced. Standard costs are used in all phases of
managerial functions. It is also applied in all types
Normal capacity (or normal volume) may be set
of industries where performance levels could be
based on the average sales demand of the
established based on historical performance,
product, engineering or estimates and technical
time and motion study, and other means of
specifications, legal variables, cultural
establishing standards.
orientations, or other factors.

Normal capacity is the average production level The standard quantities and prices are to be
of the business over the period covered by the established by the standard-setting fee created
budget. It is the middle point of variations in the for such purpose. This sub-committee, under the
budgeted production levels serving as the basis supervision of the Budget Committee, is
in budgetary planning where the concept of composed of the chosen
stability is of prime importance. Normal capacity
operating managers from various functional line
is also the basis in determining the fixed
of operations such as production, purchasing,
overhead rate, where:
human resources, payroll, legal, industrial
Standard fixed overhead rate = Budgeted fixed engineering, accounting among others.
overhead/Normal capacity
Sample Problem – Capacity Levels Budgeting would be a disaster if estimates are
Melanie Corporation acquired a machine with a not based on a well-established standard cost
200,000 units level of capacity five years ago. systems. Standard cost are bases of intelligent
Using this machine, the standard labor time is 2 forecasting and projections. The determination of
hours per unit. Engineering estimates based on standard unit costs ordinarily needs the
attainable performance is 170,000 units. participation of middle and lower-level
Management has planned to produce only managers.
160,000 units in the coming year using the same
machine. Total production in the last 5 years is
828,000 with annual production recorded as
follows:

First year, 180,000 units

Second year, 140,000 units
Third year, 170,000 units
Fourth year, 182,000 units
Fifth year. 156,000 units

The capacity levels are as follows:

The standard materials per unit (3 Ibs,, 6 pcs., 4
units) may be initially determined by the
production manager and the standard number

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of hours to make a unit of output may be based

on the study of the industrial engineering
department. The unit materials costs shall be
primarily determined by the purchasing Each department should have its own standard
manager. The quality and specifications of the costs sheet. The plant operations should also
materials shall however be that of the production have its plant’s standard cost sheet which is a
manager. The standard labor rate may be summary of all departmental standard costs
estimated on the advise of the human resource sheets. An example of a plant standard cost
manager, legal officer, and the production sheet is shown below:
manager.

The standard variable overhead rate is

determined based on past experiences with
adjustments on current and anticipated
developments that impact variable overhead.
The fixed overhead rate is based on normal
capacity. Standard rate or price should be
based on a net basis. Standard hours are
quantity should be set at gross basis after
including allowances for spoilage, breakdowns,
and similar events.
Standard cost shall regularly be evaluated to
The standard quantities and prices shall be maintain relevance, validity and reliability.
consensually developed and recommended for
approval by the USES OF STANDARDS COSTS
standard setting committee. Some of the most regular uses of standard costs
are as follows:
Sample Problem: Setting Standard Materials Costs 1. Profit planning and cost-volume-profit analysis.
Southern Corporation produces product Durito Standard costs are used in predicting scenarios
after 45 minutes of direct labor time. The under varying conditions of volume, prices, and
company pays its production personnel for eight cost leading to the basic analysis and sensitivity
(8) hours a day and gives a 30-minute daily paid analysis of contribution margin, margin of safety
breaktime. It normally starts its process with 5,000 and operating leverage.
units and completes at 4,500 good units. It pays 2. Responsibility accounting
its personnel at an hourly rate of P70 plus social Standard costs are used to make the assignment
welfare benefits of approximately 10% on the of controllable and non-controllable costs more
basic rate. What is the standard direct labor meaningful and acceptable to managers of
hours, rate and cost per unit? various responsibility centers.
3. Budgeting
Solutions/Discussions: Standard costs are used as reliable bases in
The productivity rate is 90% , (4,500/5,000). Since it anticipating budgeted costs and expenses.
is not mentioned on when does the loss occur, it 4. Performance evaluation
is assumed to have happened at the start of the Standard costs are used as meaningful
process. The standards are determined as benchmarks in evaluating actual performances
follows: of center managers,

otherwise known as “cost variances analysis”.

Standard direct labor hours = Standard output
5. Pricing
time/ (100-loss rate)
Standard costs are used in setting regular as well
= 45 minutes/90%/(7.5/8) as incremental sales prices used in determining
= 53.3333 minutes or 0.888889 hours the right and winning amount of bid prices most
*53.3333/60 = 0.888889 especially in a stiff competitive bidding.
6. Interim reporting
Standard costs are very useful in interim reporting
where to compare with actual costs in
evaluating situations and alternatives and in
making managerial decisions.

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Production costs are composed of direct

Bases of Cost Variances materials, direct labor and factory overhead.
Costs variance analysis may be based on master Each of these elements of costs have their
budget or flexible budget, respective variances. Direct materials have price
and quantity variances. Direct labor has rate and
The broadest type of variance is the static (or efficiency variances. Factory overhead has
master) budget variance. It is the difference controllable and volume variances.
between the actual amount and the budgeted
amount. It is composed of the flexible budget Sample Problem – Direct Materials and Direct
variance and the sales volume variance. Labor Costs Variances
Flexible budget variance is the difference
between actual costs and standard costs in a
given actual level of activity. It is analyzed in
relation to sales prices, costs, and input
quantities.
Sales volume (or sales activity) variance is the
difference between flexible budget and static
budget amounts, assuming sales prices and costs
are constant. Its components are the sales mix
and the sales quantity variances.

FLEXIBLE COSTS VARIANCES

The difference between actual and standard Solutions/Discussions:
costs is called a “variance”. It is sometimes called
1. Direct Materials Costs Variances Analyses
as “planning gap”. A variance should be
Direct materials cost is basically affected by two
investigated, analyzed, studied and the same
factors: quantity and price. The difference
should be avoided in the future. A variance may
between actual materials and standard
be unfavorable or favorable. If actual cost is
materials is materials variance. There is a
more than the standard costs, the variance is
difference between actual and standard in
unfavorable. Otherwise, it is favorable.
terms of price and quantity. As such, material
variances are classified as price variance and
quantity variance, as shown below:

In case 1, the cost variance is unfavorable (e.g.,

positive) because there is an excess cost of
P50,000. The business is supposed to spend only
Standard quantity is estimated quantity based on
P600,000 but spent P650,000 instead, so there is
actual production. The phrase “actual quantity
an increase in costs, an overspending and an
used” also refers to equivalent production, if the
unfavorable variance.
business is using process costing in accumulating
production costs. The standard materials per unit
In case 2, the costs variance is favorable (e.g.,
and the standard price remain constant. The
negative) because there is a saving. The business
total peso value of these materials variances are
is allowed to spend P800,000 but spent only
computed as follows:
P790,000, so there is a reduction in costs.

Direct Materials Costs Variances 2-way analysis

Unfavorable cost variance is called debit
variance because it is added (i.e., debited) to
cost of good sold at standard to get the actual
cost of goods sold. Favorable cost variance is
called credit variance because it is deducted
(i.e., credited) from cost of goods sold at
standard to get the actual cost of goods sold.
Variances whether favorable and unfavorable
need to be studied, analyzed and given solutions
Production Costs Variance
to avoid repeating the same in the next

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production cycle. Direct labor is also basically affected by two

factors – hours and rate per hour. In variance
Determining price and quantity (or usage) analysis, we consider the labor cost as variable,
variances allows management to evaluate the the labor hour (s) per unit as constant, and the
efficiency of the purchasing department and the labor rate per hour as constant. There are
production departments. Material price variance differences in actual and standards in terms of
is primarily the responsibility and accountability of hours, rate per hour and the total costs, The
the purchasing department. A favorable difference in rate per hour is the labor rate
materials price variance indicates savings variance. The difference in hours is the labor
generated from lower cost of materials efficiency variance (i.e. efficiency is measured in
purchased. A favorable variance contributes to terms of hours spent in an activity.
the increase in the overall estimated profit of the
business.

Some reasons for a favorable materials price

variance are: unforeseen reduction in prices of
materials ordered due to market forces,
unnecessary compromises in the quality of
materials ordered, or perhaps, standards set for
materials price per unit is impartially overstated.

An unfavorable materials quantity (or efficiency)

variance indicates overspending in terms of units
used. This variance is primarily the responsibility
and accountability of the production manager .
Possible explanations on this variance include
frequent machine and production downtimes,
personnel inefficiencies, weak production
scheduling, or understatement in the standard
quantity of materials per unit. Remedial actions
should be immediately taken to rectify variances
in accordance with plans.
Total standard hours equals actual production
Direct Materials Costs Variances, 3 –way Analysis multiplied by standards hours per unit (i.e.,
390,000 hours = 130,000 units x 3hrs.)

Direct Labor Cost Variances, 2 –way Analyses

The 3-way variance analysis determines the The unfavorable labor rate variance is the
materials price variance on standard quantity. responsibility and accountability of the human
This differs from the 2-way variance analysis resource manager and perhaps, the production
which determines price variance based on supervisor. In a labor-intensive production
actual quantity. The materials quantity variance environment where direct labor costs immensely
is the same as that of the 2-way analysis. The third consist of the total manufacturing costs, labor
variance is “joint materials variance” which is the rate variance analysis is of great importance. A
product of the difference in price and the reduction in wage rate will have reverberating
difference in quantity. effects on the cost competitiveness of an
enterprise. Sometimes, an unfavorable labor rate
Direct Labor Costs Variance Analyses variance is a result of a negotiated labor
Except for terminologies, the manner in which the contract. In this case, the variance is no longer
direct labor cost variances are analyzed is similar within the control of supervisors and middle
to that of the direct materials.

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operating managers. costs variances. This is true because variable

overhead, like direct materials and direct labor, is
The standard labor rate should be consequently also a variable cost.
adjusted. An unfavorable labor rate variance
The two (2) variable overhead costs variances,
may also indicate assigning a multi-skilled, highly
efficiency and spending variances are
paid worker in a job that could be performed by
computed as follows:
a lowly paid worker. The supervisor should always
examine unfavorable labor rate variance to be
certain that workers are allocated most
efficiently.

The favorable labor efficiency variance is the

accountability of the production manager. An
increase in efficiency means increase in
productivity that brings savings in the financial
reports of the business. Efficiency may indicate
more units , less idle tie, and highly motivated
work force which may be converted into higher 2. Fixed overhead costs variances
return of investment and operating The two (2) fixed overhead cost variances are as
competitiveness. follows:
1. Spending variance
Direct Labor Variances, 3 –way Analysis 2. Production volume variance

The computation for the fixed overhead

variances are shown below:

The differences between the 2-way and the 3-

way direct labor variance analyses are found in
the computation of labor rate variance and the
accounting for the joint labor variance. The labor
rate variance in the 3-way analysis is computed
based on standard hours in contrast to the 2-way
analysis which is based on actual hours worked.
The joint labor variance represents the mix
variance of the rate and efficiency variances.

Factory Overhead Variance Analysis

Sample Problem

Required:

1. Variable overhead costs variances.

2. Fixed overhead costs variances.

Solutions/Discussions:
1. Variable overhead costs variances
The analysis for the variable overhead variance
follows that of the direct materials and labor

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