UNIT 4: Standard Costing and Variance Analysis

Introduction

When you play a sport, you are evaluated with respect to how well you perform
compared to a standard or to a competitor. In bowling, for example, your score is
compared to a perfect score of 300 or to the scores of your competitors. In this class,
you are compared to performance standards. These standards are often described in
terms of numeric grades, which provide a measure of how well you achieved the class
objectives. On your job, you are also evaluated according to performance standards.

Just as your class performance is evaluated, managers are evaluated according to goals
and plans. Performance is often measured as the difference between actual results and
planned results.

Standard costs are useful tools for management because they are based on realistic
estimates of operating costs. Managers use them to develop budgets, to control costs,
and to prepare reports. Because of their usefulness in comparing planned and actual
costs, standard costs have usually been most closely associated with the performance
evaluation of cost centers. In this chapter, we describe how standard costs are
computed and how managers use the variances between standard and actual costs to
evaluate performance and control costs.

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 Unit Learning Objectives

By the end of this unit, you should be able to:

• Explain the major characteristics and conditions of a standard cost system.

• Compute standard costs for materials, labor and overhead.
• Explain the fundamental features of variance analysis.
• Calculate direct material variances, direct labor variances and factory
overhead variances.
• Evaluate the results of variance computations.
• Construct an income statement showing variances.

Timing

This unit is good for more than a week—7 days at maximum. You can devote three
hours per day on the subject. Don’t worry, the content is abridged, which means it
only includes the most salient points you need to know relative to our module
learning outcomes (MLO).
For easier monitoring of your progress, you may use the study planner attached to
this module. Be sure to make use of your planner to have a more organized and
orderly studying. Plus, the planner is a PROCRASTINATION-beater!

Getting Started!

4.1 STANDARD COSTING

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.

A standard is a "benchmark" or "norm" for measuring performance. Standards are

found everywhere, your doctor, for example, evaluates your weight using standards
that have been set for individuals of your age, height and gender. The food we eat in
restaurants must be prepared under specified standards of cleanliness. The
buildings we live in must conform to standards set in building codes. Standards are
also widely used in managerial accounting where they relate to the quantity and
cost of inputs used in manufacturing goods and producing services. Engineers and
accountants assist managers to set quantity and cost standards for each major input
such as raw materials and direct labor time.

Quantity standards specify how much of an input should be used to make a product
or provide a service. Cost or price standards specify how much should be paid for
each unit of input. Actual quantities and actual costs are then compared with these
standards. In case of significant deviations managers investigate the discrepancies.
The purpose is to find the problem and eliminate it so that it does not recur. This
process is called management by exception.

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 In our daily lives we often operate in a management by exception mode. Consider what
happens when you sit down in the driver’s seat of your car. You put the key in the
ignition, you turn the key, and your car starts. Your expectation (standard) that the
car will start is met; you do not have to open the car hood and check the battery, the
connecting cables, the fuel lines, and so on. If you turn the key and the car does not
start, then you have a discrepancy (variance). Your expectations are not met, and you
need to investigate why. Note that even if the car starts after a second try, it still would
be wise to investigate. The fact that the expectation was not met should be viewed as
an opportunity to uncover the cause of the problem rather than as simply an
annoyance. If the underlying cause is not discovered and corrected, the problem may
recur and become much worse.

The Variance Analysis Cycle. Adapted from Managerial Accounting (Thirteenth Edition) by R.H. Garrisont,
E.W. Noreen and P.C. Brewer, 2010, p. 453. Copyright 2010 by The McGraw-Hill Companies, Inc.

This basic approach to identifying and solving problems is exploited in the variance
analysis cycle. The cycle begins with the preparation of standard cost performance
reports in the accounting department. These reports highlight the variances, which
are the differences between actual results and what should have occurred according
to the standards. The variances raise questions. Why did this variance occur? Why
is this variance larger than it was last period? The significant variances are
investigated to discover their root causes. Corrective actions are taken. And then
next period's operations are carried out.

4.2 SETTING STANDARDS

The standard-setting process normally requires the joint efforts of accountants,
engineers, and other management personnel. The accountant converts the results of
judgments and process studies into dollars and cents. Engineers with the aid of
operation managers identify the materials, labor, and machine requirements needed
to produce the product. For example, engineers estimate direct materials by
studying the product specifications and estimating normal spoilage. Time and
motion studies may be used to determine the direct labor required for each
manufacturing operation. Engineering studies may also be used to determine
standards for factory overhead, such as the amount of power needed to operate
machinery.

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 Setting standards often begins with analyzing past operations. However, caution
must be used when relying on past cost data. For example, inefficiencies may be
contained within past costs. In addition, changes in technology, machinery, or
production methods may make past costs irrelevant for future operations.

Advantages of Standard Costs. Adapted from Managerial Accounting Tools for Business Decision Making (Sixth Edition) by J.J.
Weygandt, P.D. Kimmel and D.E. Kieso, 2012, p. 497. Copyright 2012 by John Wiley & Sons, Inc.

The setting of standard costs to produce a unit of product is a difficult task.

It requires input from all persons who have responsibility for costs and quantities.
To determine the standard cost of direct materials, management consults
purchasing agents, product managers, quality control engineers, and production
supervisors. In setting the standard cost for direct labor, managers obtain pay rate
data from the payroll department. Industrial engineers generally determine the
labor time requirements. The managerial accountant provides important input for
the standard-setting process by accumulating historical cost data and by knowing
how costs respond to changes in activity levels.

To be effective in controlling costs, standard costs need to be current at all times.

Thus, standards are under continuous review. They should change whenever
managers determine that the existing standard is not a good measure of
performance. Circumstances that warrant revision of a standard include changed
wage rates resulting from a new union contract, a change in product specifications,
or the implementation of a new manufacturing method.

4.2.1 SETTING PRICE AND QUANTITY STANDARDS

This activities 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.

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 STANDARD COSTS…
✓ The monetary value of chosen standards.
✓ Usually relate to the quantity and costs of INPUTS in
manufacturing goods or providing services.

▪ PRICE STANDARDS – specifies how much should be paid for each

unit of input.

▪ QUANTITY STANDARDS – specifies how much of an input

(such as DM, DL, OH) should be used to make a product or
provide a service.

Standard costs are estimates of the actual costs in a company’s production

process, because actual costs cannot be known in advance. This helps a business
to plan a budget. Later, when the actual costs are determined, the company can see
if it has a favorable budget variance (meaning, actual costs did not exceed standard
costs) or unfavorable budget variance (the standard costs were exceeded).
Standard costs for all cost elements (direct materials, direct labor and
manufacturing overhead) are written on a document known as standard cost card.
A standard cost card is prepared for every individual product. The proper form of
standard cost card is as follows:

NOTE: SQ, SH, SP and SR may vary.

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 Note:

1. Analysis of historical data and engineering studies

- Identification of things to be considered in coming up with the standards

2. Task analysis
- shows the most probable personnel that will be in charge of their respective
standards

3. Computation of the standard

- determining what should be included and excluded in the computation of the
standards—that is, standard price/rate & standard quantity/hours

4.2.2 TYPES OF STANDARDS

Standards imply an acceptable level of production efficiency. One of the major
objectives in setting standards is to motivate employees to achieve efficient
operations.

❖ IDEAL STANDARDS (or Theoretical Standards)

Those that can be attained only under the best circumstances. They allow for no
machine breakdowns or other work interruptions and they call for a level of effort
that can be attained only by the most skilled and efficient employees working at
peak effort 100% of the time.

Note, though, that tight, unrealistic standards may have a negative impact on
performance. This is because employees may become frustrated with an inability to
meet the standards and may give up trying to do their best.

On the other hand, standards that are too loose might not motivate employees to
perform at their best. This is because the standard level of performance can be
reached too easily. As a result, operating performance may be lower than what could
be achieved.

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 ❖ PRACTICAL STANDARDS (or Currently Attainable Standards or Normal
Standards)

Those standards that are tight but attainable. They allow for normal machine
downtime and employee rest period. They can be attained through reasonable,
though highly efficient, efforts by the average worker.

Variances from such standards represent deviations that fall outside of normal
operating conditions and signal a need for management attention. Furthermore,
practical standards can serve multiple purposes. In addition to signaling abnormal
conditions, they can also be used in forecasting cash flows and in planning inventory.

By contrast, ideal standards cannot be used in forecasting and planning; they do not
allow for normal inefficiencies, and therefore they result in unrealistic planning and
forecasting figures.

4.2.3 REVIEWING AND REVISING STANDARDS

Standard costs should be periodically reviewed to ensure that they reflect current
operating conditions. Standards should not be revised, however, just because they
differ from actual costs. For example, the direct labor standard would not be revised
just because employees are unable to meet properly set standards. On the other
hand, standards should be revised when prices, product designs, labor rates, or
manufacturing methods change.

4.2.4 PURPOSE OF STANDARD COSTING

Standard cost systems aid in planning operations and gaining insights into the
probable impact of managerial decisions on cost levels and profits. Standard costs
are used for:

1. Establishing budgets.
2. Controlling costs, directing and motivating employees and measuring
efficiencies.
3. Promoting possible cost reduction.
4. Simplifying costing procedures and expediting cost reports.
5. Assigning costs to materials, work in process, and finished goods inventories.
6. Forming the basis for establishing bids and contracts and for setting sales
prices

4.3 DISTINGUISHING BETWEEN STANDARDS AND BUDGETS

Both standards and budgets are predetermined costs, and both contribute to
management planning and control. There is a difference, however, in the way the
terms are expressed. A standard is a unit amount. A budget is a total amount.
Thus, it is customary to state that the standard cost of direct labor for a unit of
product is, say, $10. If the company produces 5,000 units of the product, the
$50,000 of direct labor is the budgeted labor cost. A standard is the budgeted cost
per unit of product. A standard is therefore concerned with each individual cost
component that makes up the entire budget.

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 The budget is one method of securing reliable and prompt information regarding
the operation and control of an enterprise. When manufacturing budgets are based
on standards for materials, labor, and factory overhead a strong team for possible
control and reduction of costs is created.
Standards are almost indispensable in establishing a budget. Because both standard
and budgets aim at the same objective-managerial control-it is felt that the two are
the same and cannot function independently. This opinion is supported by the fact
that both use predetermined costs for the coming period. Both budgets and
standard costs make it possible to prepare reports which compare actual costs and
predetermined costs for management.
Building budgets without the use of standard cost figures can never lead to a
real budgetary control system. The principle difference between budgets and
standard costs lies in their scope. The budget, as a statement of expected costs, acts
as a guidepost which keeps the business on a charted course. Standards, on other
hand, do not tell what costs are expected to be, but rather what they will be if certain
performances are achieved. A budget emphasizes the volume of business and the
cost level which should be maintained if the firm is to operate as desired. Standard
stress the level to which costs should be reduced. If costs reach this level, profit will
be increased.

Note:

BUDGETS
✓ Includes both income and expenses
✓ Comprehensive in nature and covers several business activities (such as production,
purchase, selling and distribution, R&D)
✓ A “total” concept
✓ A quantitative expression of planned activities.

STANDARDS
✓ Usually set for expenses only
✓ Developed only for the production and related manufacturing cost.
✓ A “unit” concept (it may be helpful to think of a standard as a budget for the
production of a single unit of output)
✓ The quantitative expression of the benchmark or norms for performing activities.

4.4 COMPUTING STANDARD COSTS

A fully integrated standard costing system uses standard costs for all the elements
of product cost: direct materials, direct labor, and overhead. Inventory accounts for
materials, work in process, and finished goods, as well as the Cost of Goods Sold
account, are maintained and reported in terms of standard costs, and standard unit
costs are used to compute account balances. Actual costs are recorded separately so
that managers can compare what should have been spent (the standard costs) with
the actual costs incurred in the cost center.

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 A standard unit cost for a manufactured product has the following six (6) elements:

✓ Price standard for direct materials

✓ Quantity standard for direct materials
✓ Standard for direct labor rate
✓ Standard for direct labor time
✓ Standard for variable overhead rate
✓ Standard for fixed overhead rate

4.4.1 HOW STANDARDS ARE USED IN BUDGETING

The master budget assists a company in planning, directing, and controlling
performance. The control function, or budgetary performance evaluation, compares
the actual performance against the budget.

To illustrate, Orange Marmalade Inc., a manufacturer of blue jeans, uses standard

costs in its budgets. The standards for direct materials, direct labor, and factory
overhead are separated into the following two components:

1. Standard price
2. Standard quantity

The standard cost per unit for direct materials, direct labor, and factory overhead is
computed as follows:

Standard Cost per Unit = Standard Price x Standard Quantity

Orange Marmalade’s standard costs per unit for its XL jeans are shown below:

As shown above, the standard cost per pair of XL jeans is $19.50, which consists of
$7.50 for direct materials, $7.20 for direct labor, and $4.80 for factory overhead.
The standard price and standard quantity are separated for each product cost. For
example, Exhibit 1 indicates that for each pair of XL jeans, the standard price for
direct materials is $5.00 per square yard and the standard quantity is 1.5 square
yards. The standard price and quantity are separated because the department
responsible for their control is normally different. For example, the direct materials
price per square yard is controlled by the Purchasing Department, and the direct
materials quantity per pair is controlled by the Production Department.

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The report that summarizes actual costs, standard costs, and the differences for the
units produced is called a budget performance report. To illustrate, assume that
Orange Marmalade produced the following pairs of jeans during June:

The exhibit below illustrates the budget performance report for June for Orange
Marmalade Inc. The report summarizes the actual costs, standard costs, and the
differences for each product cost. The differences between actual and standard costs
are called cost variances. A favorable cost variance occurs when the actual cost is
less than the standard cost. An unfavorable cost variance occurs when the actual
cost exceeds the standard cost.

Orange Marmalade Inc.

Budget Performance Report
For the Month Ended June30, 2020

The budget performance report shown in above is based on the actual units
produced in June of 5,000 XL jeans. Even though 6,000 XL jeans might have been
planned for production, the budget performance report is based on actual
production.

Note:
FAVORABLE COST VARIANCE
Actual Cost < Standard Cost @ actual volumes

UNFAVORABLE COST VARIANCE

Actual Cost > Standard Cost @ actual volumes

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 The total manufacturing cost variance is the difference between total standard
costs and total actual cost for the units produced. As shown in the illustration above,
the total manufacturing cost unfavorable variance and the variance for each product
cost are as follows:

For control purposes, each product cost variance is separated into two additional
variances as shown in the exhibit below:

Manufacturing Costs Variances. Adapted from Managerial Accounting (10th Edition) by C.S. Warren, J.M. Reeve
and J.E. Duchac, 2009, p. 279. Copyright 2009 by South-Western, a part of Cengage Learning

4.5 VARIANCE ANALYISS

In managerial accounting, variance analysis refers to the investigation of
deviations in financial performance from the standards defined in organizational
budgets. Also, this involves the quantitative investigation of the difference between
actual and planned behavior.

ACTUAL Cost STANDARD VARIANCE

Cost
Based on Actual Cost <
Recorded No. of Units Standard Cost
Transactions Produced x = Favorable
in Accounting Standard Variance
System Quantity
Cost Actual Cost >
Standard Cost
=
Unfavorable
Variance

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A price variance is the difference between the actual price of an input and its
standard price, multiplied by the actual amount of the input purchased. A quantity
variance is the difference between how much of an input was actually used and how
much should have been used and is stated in dollar terms using the standard price
of the input.

A General Model for Variance Analysis—Variable Manufacturing Costs

Three things should be noted from the general model for variance analysis
presented above.

First, a price variance and a quantity variance can be computed for each of the three
variable cost elements—direct materials, direct labor, and variable manufacturing
overhead—even though the variances have different names. For example, a price
variance is called a materials price variance in the case of direct materials but a labor
rate variance in the case of direct labor and a variable overhead rate variance in the
case of variable manufacturing overhead.

Second, the price variance—regardless of what it is called—is computed in exactly

the same way regardless of whether one is dealing with direct materials, direct
labor, or variable manufacturing overhead. The same is true of the quantity
variance.

Third, the input is the actual quantity of direct materials, direct labor, and variable
manufacturing overhead purchased or used; the output is the good production of
the period, expressed in terms of the standard quantity (or the standard hours)
allowed for the actual output.

The standard quantity allowed or standard hours allowed means the amount of
an input that should have been used to produce the actual output of the period. This
could be more or less than the actual amount of the input, depending on the
efficiency or inefficiency of operations. The standard quantity allowed is computed
by multiplying the actual output in units by the standard input allowed per
unit of output.

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 Note:

A General Model for Variance Analysis

Why are standards separated into two categories—price and quantity?
Different managers are usually responsible for buying and for using inputs.
For example, in the case of a raw material, a purchasing manager is
responsible for its price. However, the production manager is responsible
for the amount of the raw material actually used to make products. As we
shall see, setting up separate standards for price and quantity allows us to
better separate the responsibilities of these two managers. It also allows
us to prepare more timely reports. The purchasing manager’s tasks are
completed when the material is delivered for use in the factory.

A performance report for the purchasing manager can be prepared at that

point. However, the production manager’s responsibilities have just begun
at that point. A performance report for the production manager must be
delayed until production is completed and it is known how much raw
material was used in the final product. Therefore, it is important to clearly
distinguish between deviations from price standards (the responsibility of
the purchasing manager) and deviations from quantity standards (the
responsibility of the production manager).

4.6 DIRECT MATERIALS VARIANCES

The total direct materials variance is separated into a price and quantity variance.
This is because standard and actual direct materials costs are computed as follows:

Thus, the actual and standard direct materials costs may differ because of either a
price difference (variance) or a quantity difference (variance).

4.6.1 STANDARD DIRECT MATERIAL PRICE

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.

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 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.

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.

Example: Calculation of standard price per unit of direct materials or raw

materials:

Purchase price, top-grade pewter ingots, in 40- P 3.60

pounds ingots +0.44
Freight, by truck, from suppliers warehouse +0.05
Receiving and handling -0.09
Less purchase discount P4.00
Standard price per pound ====

Notice that the standard price reflects a particular grade of materials (top grade),
purchased in particular lot size (40 pound ingots), and delivered by a particular type
of carrier (truck). Allowances have also been made for handling and discounts. If
everything proceeds according to these expectations, the net cost of a pound of pewter
(direct material in the example above) should therefore be P4.00.

4.6.2 STANDARD DIRECT MATERIAL QUANTITY

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.

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.

Example: Calculation of standard quantity per unit of direct materials or raw

materials:

Materials requirement (in pounds) per unit as

specified in the bill of materials* 2.7
Allowance for wastage and spoilage 0.2
Allowance for rejects 0.1
Standard of materials requirements (in pounds) 3.0
====

Once the direct materials price and quantity standards have been set, the
standard cost of a material per unit of finished product can be computed as follows:

3 pounds per unit × P 4.00 per pond = P 12 per unit

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

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 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.

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.

4.6.3 DIRECT MATERIALS PRICE VARIANCE

Materials Price Variance (or MPV) 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. When this variance is computed at the time of purchase of
materials it is called Direct Materials Purchase Price Variance (MPPV). When this
variance is computed at the time of usage this is typically called Direct Materials
Price Usage Variance (MPUV).

Following formula is used to calculate materials price variance:

Materials Price Variance = (Actual quantity purchased × Actual price) −

(Actual quantity purchased × Standard price)

Simplified Formula
Version 1.0 MPV or MPPV = (AQ purchased x AP) – (AQ x SP)
Version 2.0 MPV or MPPV = (AP – SP) x AQp

Version 1.0 MPUV = (AQ used x AP) – (AQ x SP)

Version 2.0 MPUV = (AP – SP) x AQu

Where, MPPV is Materials Purchase Price Variance and

MPUV is Materials Price Usage Variance.

Example:
Colonial Pewter Company provides the following information:

Standard price of material is P4.00 per pound and 6,500 pounds of materials have
been purchased at a cost of P3.80 per pound. This cost figure includes freight and
handling and is net of quantity discount. All the materials purchased has been used
and an output of 2000 units is produced during the period.

Required:
Calculate materials price variance.

Solution:
MPV = (6,500 pounds × P3.80) − (6,500 pounds × P4.00)
= P24,700 − P26,000
= P1,300 Favorable

A favorable material price variance of P1,300 exists because the actual price of
materials purchased is less than the standard price of materials purchased. A
material price variance is called unfavorable materials price variance if the actual
price of materials purchased is more than the standard price of materials purchased.
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 Most companies compute materials price variance when the materials are
purchased than they are used in production. There are two reasons for this practice.

First, delaying the computation of the price variance until the materials used would
result in less timely variance report. Second, by computing the price variance when
the materials are purchased, the materials are carried in the inventory accounts at
their standard costs. This greatly simplifies book keeping. When the materials price
variance is computed at the time of purchase of materials it is typically called
materials purchase price variance.

4.6.4 FACTORS LEADING TO PRICE VARIANCES

Price variances are caused by a lot of factors which includes, but not limited to, the
following:

a) Inefficient buying or failure to make timely purchases

b) Increase in market price
c) Emergency purchases
d) Bulk purchases
e) Change in transport cost
f) Non-availability of standard quality
g) Loss of cash discount
h) Change in the method of material collection

4.6.5 DIRECT MATERIALS QUANTITY VARIANCE

Materials Quantity Variance (MQV) is also known as Materials Efficiency Variance

(MEV) and Materials Usage Variance (MUV). It 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.

Following formula is used to calculate materials quantity variance or direct materials

usage variance:

Materials quantity variance = (Actual quantity used × Standard price) −

(Standard quantity allowed × Standard Price)

Simplified Formula
Version 1.0 MQV or MUV = (AQ used x SP) – (SQ x SP)
Version 2.0 MQV or MUV = (AQu – SQ) x SP

Example:
Colonial Pewter Company provides the following data:

3.0 pounds of materials are required to produce a unit of product according to

standards set by the management. The standard price of direct materials is P4.00
per pound. During the period 2000 unit were completed with an actual consumption
of 6,500 pounds of direct materials.

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 Required:
Calculate direct materials quantity variance or direct materials usage variance.

Solution:
MQV =(6,500 pounds × P4.00) − (6,000* pounds × P4.00)
= P26,000 − P24,000
= 2,000 Unfavorable

*Standard quantity allowed (3.00 per unit × 2,000 units)

Above calculation shows an unfavorable direct materials quantity variance.

When materials are used more than what is allowed by standard an unfavorable
quantity variance occurs. If materials used is less than the quantity allowed a
favorable direct materials quantity variance occurs.

4.6.6 FACTORS LEADING TO USAGE VARIANCES

Usage variances are caused by a lot of factors which includes, but not limited to, the
following:

a) Poor quality of material

b) Carelessness in the use of material
c) Inefficient production method
d) Defective machinery
e) Unskilled employees
f) Wrong specification
g) Change in mix
h) Experimental production
i) Pilferage

4.7 DIRECT LABOR VARIANCES

The total direct labor variance is separated into a rate and a time variance.
This is because standard and actual direct labor costs are computed as follows:

Therefore, the actual and standard direct labor costs may differ because of either a
rate difference (variance) or a time difference (variance).

Direct labor price and quantity standards are usually expressed in terms of a
labor rate and labor hours.

✓ Direct labor rate | price standards

✓ Direct labor efficiency | usage | quantity standards

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4.7.1 STANDARD DIRECT LABOR RATE

The standard rate per hour for direct labor includes not only wages earned but also
fringe benefit and other labor costs.

Example of Standard rate per direct labor hour:

Basic wages rate per hour P10
Employment taxes at 10% of the basic rate P 1
Fringe benefits at 30% of the basic rate P 3
Standard rate per direct labor hour -----
P14
====

4.7.2 STANDARD DIRECT LABOR EFFICIENCY | USAGE | QUANTITY

The standard direct labor time required to complete a unit of product (called the
standard hours per unit) is perhaps the most difficult standard to determine. One
approach is to divide each operation performed on the product into elemental body
movements (such as reaching, pushing, and turning over). Standard times for such
movements are available in reference works.

These standard times can be applied to the movements and then added together to
determine the total standard time allowed per operation. Another approach is for
an industrial engineer to do a time and motion study, actually clocking the time
required for certain tasks. The standard time should include allowances for breaks,
personal needs of employees, cleanup, and machine downtime.

Example of standard labor hours per unit:

Basic labor time per unit, in hours 1.9
Allowance for breaks and personal need 0.1
allowance for cleanup and machine 0.3
downtime 0.2
Allowance for rejection -------
Standard labor hours per unit of 2.5 hrs.
product ====

Standard labor hours per unit and standard direct labor rate per hours computed
above shall be used in calculating labor rate variance and labor efficiency variance.
Once the rate and time standards have been set, the standard labor cost per unit of
product can be computed as follows:

2.5 hours per unit × P14 per hour = P35 per unit

4.7.3 DIRECT LABOR RATE | PRICE VARIANCE

Labor Price Variance (LPV) is also termed as Labor Rate Variance (LRV). This
variance measures any deviation from standard in the average hourly rate paid to
direct labor workers. In other words, direct labor rate variance is the difference
between the amount of actual hours worked at actual rate and actual hours worked
at standard rate.
Page 91 of 186
 Following formula is used to calculate direct labor rate variance or direct labor price
variance:

Labor rate variance = (Actual hours worked × Actual rate) − (Actual hours
worked × Standard rate)

Simplified Formula
Version 1.0 LRV = (AH x AR) – (AH x SR)
Version 2.0 LRV = (AR – SR) x AH

Example:
Suppose that 2,000 units have been produced during the period and 5,400 direct
labor hours have been worked at a rate of P13.75 per direct labor hour. Standard
rate per direct labor hour is P14.00.

Required:
Calculate labor rate variance.

Solution:
LRV = (5,400 × P13.75) − (5,400 × P14.00)
LRV = 74,250 − 75,600
LRV = P1,350 Favorable

Calculation shows a favorable labor rate variance because actual rate paid to
workers is less than standard rate. When the actual rate is more than the standard
rate an unfavorable labor rate variance results.

4.7.4 FACTORS LEADING TO RATE VARIANCES

Rate variance can be attributed to different factors which may include one or more
of the following:

a) Revision in wages
b) Overtime for urgent completion of job
c) Change in gang composition or wrong grade of labor
d) Executive overtime, special increment/high labor awards
e) Special rates for experimental production

4.7.5 DIRECT LABOR EFFICIENCY VARIANCE

The quantity variance for direct labor is generally called Labor Efficiency
Variance (LEV) or Labor Usage Variance (LUV). This variance measures the
productivity of labor time. No variance is more closely watched by management,
since it is widely believed that increasing the productivity of direct labor time is vital
to reducing costs.

The formula for the labor efficiency variance is expressed as follows:

Labor efficiency variance = (Actual hours worked × Standard rate) − (Standard

hours allowed × Standard rate)

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 Simplified Formula
Version 1.0 LEV = (AH x SR) – (SH x SR)
Version 2.0 LEV = (AH – SH) x SR

Example:
A company produces 2000 units of finished products using 5,400 hours. Standard
time allowed for a unit of finished product is 2.5 hours. Standard rate that is paid to
workers is P14.00 per direct labor hour.

Required:
Calculate direct labor efficiency variance or direct labor quantity variance.

Solution:
LEV = (5,400 × P14.00) − (5,000* × P14.00)
LEV = P75,600 − P70,000
LEV= P5,600 Unfavorable

5,000* = 2,000 actual production × 2.50 standard hour allowed per unit

Processing of 2000 units required more time than what was allowed by standards.
The result is an unfavorable labor efficiency variance. A favorable labor
efficiency variance occurs when actual processing time is less than the time
allowed by standards.

4.7.6 FACTORS LEADING TO EFFICIENCY VARIANCES

Efficiency variance can be attributed to different factors which may include one or
more of the following:

a) Inefficient/Untrained workers
b) Machinery breakdown
c) Poor quality of material
d) Inefficient supervision
e) Hours lost in waiting, delay in routing material, tools, instructions and
improper production scheduling
f) Poor working conditions
g) Change in design, quality standard of product

4.8 FACTORY (MANUFACTURING) OVERHEAD VARIANCES

The total factory overhead variance is separated into a controllable and volume
variance. Because factory overhead has fixed and variable cost elements, it is more
complex to analyze than direct materials and direct labor, which are variable costs.
The controllable variance is similar to a price or rate variance, and the volume
variance is similar to the quantity or time variance.
Factory overhead costs are analyzed differently from direct labor and direct
materials costs. This is because factory overhead costs have fixed and variable cost
elements. For example, indirect materials and factory supplies normally behave as
a variable cost as units produced changes. In contrast, straight-line plant
depreciation on factory machinery is a fixed cost.

Page 93 of 186
 Factory overhead costs are budgeted and controlled by separating factory overhead
into fixed and variable costs. Doing so allows the preparation of flexible budgets and
analysis of factory overhead controllable and volume variances.

4.8.1 STANDARD OVERHEAD COST

For manufacturing overhead, companies use a standard predetermined

overhead rate in setting the standard. This overhead rate is determined by dividing
budgeted overhead costs by an expected standard activity index. For example, the
index may be standard direct labor hours or standard machine hours.

The standard overhead cost is the sum of the estimates of variable and fixed
overhead costs in the next accounting period. It is based on standard overhead rates
that are computed in much the same way as the predetermined overhead rate that
was already discussed before. Unlike that rate, however, the standard overhead rate
has two parts, one for variable costs and one for fixed costs. The reason for
computing the standard variable and fixed overhead rates separately is that their
cost behavior differs.

The standard variable overhead rate is computed by dividing the total budgeted
variable overhead costs by an expression of capacity, such as the number of
Standard machine hours or standard direct labor hours. (Other bases may be used
if machine hours or direct labor hours are not good predictors, or drivers, of variable
overhead costs.) For example, using standard machine hours as the base, the
formula is as follows:

The standard fixed overhead rate is computed by dividing the total budgeted fixed
overhead costs by an expression of capacity, usually normal capacity in terms of
standard hours or units. The denominator is expressed in the same terms as the
variable overhead rate. For example, using normal capacity in terms of standard
machine hours as the denominator, the formula is as follows:

Many companies employ activity-based costing (ABC) to allocate overhead costs.

Because ABC uses multiple activity indices to allocate overhead costs, it results in a
better correlation between activities and costs incurred than do other methods. As
a result, the use of ABC can significantly improve the usefulness of standard costing
for management decision-making.

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 Self-Check:
04
This self-check will not be graded and will not be submitted. You may try to answer the
questions asked and check the answers afterwards in Appendix A at the end of the
module.

Using the following information, compute the standard unit cost of a 5-pound bag of
sugar: (See answers on Appendix A)

Direct materials quantity standard 5 pounds per unit

Direct materials price standard $0.05 per pound
Direct labor time standard 0.01 hour per unit
Direct labor rate standard $10.00 per hour

Variable overhead rate standard $0.15 per machine hour

Fixed overhead rate standard $0.10 per machine hour
Machine hour standard 0.5 hour per unit

You may use this as a guide…

The standard cost per unit for direct materials, direct labor, and factory
overhead is computed as follows:

Standard Cost per Unit = Standard Price x Standard Quantity

4.8.2 COMPUTING THE STANDARD FACTORY OVERHEAD RATE

The standard factory overhead rate is a predetermined rate that is usually based
on the direct labor hours. Other bases may also be used, e.g., direct labor dollars or
machine hours. The data from the following flexible budget for department is used
to illustrate the calculation of standard overhead rate and overhead variances.

Department 3
Monthly Flexible Budget

Capacity 80% 90% 100%

Standard 800 1,000 1,200

production

Direct labor 3,200 4,000** 4,800

hours

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Variable
factory
overhead:

Indirect labor P1,600 P2,000 P2,400 P0.50 /

dlh.

Indirect 960 1,200 1,440 P0.30

materials

Supplies 640 800 960 P0.20

Repairs 480 600 720 P0.15

Power and 160 200 240 P0.05

light
--------- ---------- --------- ----------
- -
Total P3,840 P4,800^ P5,760 P1.20
variable per dlh.
factory
overhead

Fixed factory
overhead:

Supervisor P1,200 P1,200 P1,200

Depreciation 700 700 700

on machinery

Insurance 250 250 250

Property tax 250 250 250

Power and 400 400 400

light

Maintenance 400 400 400

--------- ---------- ---------
- -
Total fixed P3,200 P3,200^^ P3,200 P3,200
factory per
overhead month
--------- ---------- --------- ======
- -
Total factory P7,040 P8,000* P8,960 P3,200
overhead per
month
+ P1.20
per dlh.
======

In the Monthly Flexible Budget given below, “dlh” means “direct labor hours”.
Or you may also write “DLHr.” instead. ☺

Page 96 of 186
 Assuming that 90% column represents normal capacity, the standard
overhead rate is computed as follows:
Total factory overhead / Direct labor hours = P8,000* / 4,000**
= P2 per standard direct labor hour

At 90% capacity level, the rate consists of:

Total variable factory overhead / Direct labor hours = P4,800^ / 4,000**
= P1.20 variable factory overhead rate per hour

Total fixed factory overhead / Direct labor hours = P3,200^^ / 4,000**

= P0.80 fixed factory overhead rate per hour

Notice that
Total factory overhead rate at normal capacity the results of
both
(P1.20 + P0.80) = P2.00 per hour computations
are equal.

4.8.3 OVERALL or NET FACTORY OVERHEAD VARIANCE

Overall or net factory overhead variance is the difference between actually

incurred factory overhead and expenses charged into process using the standard
factory overhead rate.

Overall or net overhead variance is calculated by the following formula:

Total FOH Variance = (Actual overhead – Overhead charged to production)

Simplified Formula

Version 1.0 FOH Variance = Actual FOH – Standard FOH*

Version 2.0 FOH Variance = Actual FOH – Applied FOH*

* Std. FOH or App. FOH = Std. Hrs. allowed** x Overall Std. FOH Rate per hour
**Standard Hours = Actual Production x No. of hours needed to make 1 output

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Example:
At the end of a month the data for a department are as follows: (Continuation of the
above illustration)

Actual overhead P7,384

Units produced 850 units
Actual hours used 3,475 hours
Standard hours allowed per unit of product 4.00 hours

Required:
Calculate net/overall/total factory overhead variance.

Solution:
Actual departmental overhead P7,384
Overhead charged to production (3,400 6,800
standard hours allowed** × P2 standard
overhead rate)
----------
Overall or net overhead variance P584
Unfavorable
======

This unfavorable overall overhead variance needs further analysis to reveal detailed
causes for the variance and to guide management toward remedial action. This
analysis is made by using:

Set A Set B

The two variance method: The two variance method:

1. Controllable 1. Controllable
variance variance
2. Volume variance 2. Volume variance

The three variance method: The three variance method:

1. Spending variance
2. Idle capacity OR 1. Spending variance
2. Efficiency variance
variance 3. Volume variance
3. Efficiency variance
The four variance method:
The four variance method: 1. Variable spending
1. Spending variance variance
2. Variable efficiency 2. Fixed spending
variance variance
3. Fixed efficiency 3. Efficiency variance
variance 4. Volume variance
4. Idle capacity
variance

For illustrative purposes, we wi’ll use Set A.

Page 98 of 186
 Note:

4.8.4 CONTROLLABLE VARIANCE

Factory overhead controllable variance is the difference between actual
expenses incurred and the budget allowance based on standard hours allowed for
work performed.

It is also called as BUDGET VARIANCE since it presents how much should have been
spent by the company with its actual output of production.

Factory overhead controllable variance is the responsibility of the department

managers to the extent that they can exercise control over the costs to which the
variances relate.

Following formula/equation is used for the calculation of controllable variance:

CONTROLLABLE VARIANCE = AFOH – BASH*

Where,
AFOH = Actual Factory Overhead
*BASH = Budgeted Allowance based on Standard Hours allowed
= Budgeted Fixed Expenses + Variable Expenses**

**Variable Expenses = (Standard Hours Allowed for Actual

Production x Variable Overhead Rate)
To illustrate:
Actual factory overhead is P7,384. Actual production is 850 units of finished
complete a unit of finished product. The total budgeted fixed factory overhead is
P3,200.

Required:
Calculate factory overhead controllable variance.

Page 99 of 186
 Solution:
Actual factory overhead P7,384
Budgeted allowance based on standard
hours allowed*
Fixed expenses budgeted P3,200
Variable expenses (3,400 standard
hours allowed x P1.20 variable overhead 4,080 7,280
rate)
Controllable variance P104 UF

Factory overhead controllable variance consists of variable expenses only and

can also be calculated as follows:

Actual variable expenses (P7,384 actual factory overhead P4,184

– P3,200 of fixed expenses budgeted)
Variable expenses for standard hours allowed P4,080

Controllable variance P104 UF

Controllable variance may have been caused by one, but not limited to, the following
factors:
a) Change in price/rate of the different items comprising total overhead.
b) Change in the consumption rate of the different items.
c) Error in estimating the actual amount of overhead to be incurred.
d) Inefficient (unfavorable) or efficient (favorable) use of the chosen activity
driver.

Note:

Possible reasons / causes for the unfavorable controllable variance are:

✓ Indirect materials were purchased from a different supplier with higher
costs.
✓ More Indirect materials were used due to waste.
✓ Indirect labor rates were higher due to a change in personnel or higher
negotiated raises than budgeted.
✓ Fixed overhead costs were more than budgeted.

4.8.5 VOLUME VARIANCE

Factory overhead volume variance represents the difference between the budget
allowance and the standard expenses charged to work in process (standard hours
allowed x standard overhead rate)
The volume variance indicates the cost of capacity available but not utilized or not
utilized efficiently and is considered the responsibility of the executive and
departmental management.

Page 100 of 186

It is also called CAPACITY or NON-CONTROLLABLE VARIANCE. This variance may
be caused by under or over production. This is deemed to be an uncontrollable
factor on the part of the production department since they only produced what the
sales department has ordered. However, there are other factors that may contribute
to the capacity variance like machine downtime due to poor maintenance,
production scheduling, unskilled or over skilled workers, etc.
Factory overhead volume variance is calculated by using the following
formula/equation:

VOLUME VARIANCE = BASH* - SFOH**

Where,
*BASH = Budgeted Allowance based on Standard Hours allowed
= Budgeted Fixed Expenses + Variable Expenses**

**Variable Expenses = (Standard Hours Allowed for Actual Production x

Variable Overhead Rate)

**SFOH = Standard hours allowed × Standard overhead rate

To illustrate:
Actual factory overhead is P7,384. Actual production is 850 units of finished
product. Actual hours used are 3,475 hours. 4 standard hours are allowed to
complete a unit of finished product. The total budgeted fixed factory overhead is
P3,200.

Required:
Calculate factory overhead volume variance.

Solution:
Budgeted allowance based on standard hours allowed*
Fixed expenses budgeted P3,200
Variable expenses (3400 standard hours allowed x
P4,080 P7,280
P1.20 variable overhead rate)

Overhead charged to production (3400 standard hours

allowed x P2 standard overhead rate)
P6,800
Volume Variance P480 UF

Factory overhead volume variance consists of fixed expenses only and can be
computed as follows:

Normal capacity hours 4000 hrs.

Standard hours allowed for actual production 3400 hrs.

Capacity hours not utilized or not utilized efficiently 600 hrs.

Volume Variance (600 hours × 0.80***) P480 UF

***Fixed expenses rate at normal capacity

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 The reasons of unfavorable overhead volume variance include the capacity
available but not utilized or not utilized efficiently.
Fixed volume variance can be caused by the following factors:
a) Slackening of sales, lack of orders
b) Lock out/Strikes
c) Power failure
d) Seasonal cuts in production
e) Machine breakdowns

4.8.6 SPENDING VARIANCE

Factory Overhead spending variance is the difference between actual expenses

incurred and the budgeted allowance based on actual hours worked.

The spending variance is the responsibility of the department manager, who is

expected to keep actual expenses within the budget.

SPENDING VARIANCE = AFOH – BAAH*

Where,
AFOH = Actual Factory Overhead
*BAAH = Budgeted Allowance based on Actual Hours worked
= Budgeted Fixed Expenses + Variable Expenses**

**Variable Expenses = (Actual Hours Worked x Variable Overhead Rate)

To illustrate:
Actual factory overhead is P7,384. Actual production is 850 units of finished
product. Actual hours used are 3,475 hours. 4 standard hours are allowed to
complete a unit of finished product. The total budgeted fixed factory overhead is
P3,200.

Required:
Calculate factory overhead spending variance.

Solution:
Actual factory overhead P7,384
Budgeted allowance based on actual hours worked*
Fixed expenses budgeted P3,200
Variable expenses (3,475 actual hours worked ×
P1.20 variable overhead rate) P4,170
P7,370
Overhead Spending Variance P14 UF

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 Overhead spending variance consists of variable expenses only and can be
computed as follows:

Actual variable expenses (P7,384 actual variable expenses –

P3,200 fixed expenses budgeted) P4,184
Allowed variable expenses for actual hours 4,170
Spending Variance P14 UF

By basing the budget allowance on actual hours instead of on standard hours

allowed as shown in the controllable variance, the department manager receives a
more favorable budget allowance, which reduces the variance from P104 to P14.
This reduction is caused by the influence of efficiency (or, in this case inefficiency),
which is identified separately as the variable expense portion of the efficiency
variance.

The spending variance may have been caused by:

a) Change in price/rate of the different items comprising total overhead.

b) Change in consumption rate of the different items.
c) Error in estimating the actual amount of overhead to be incurred.

4.8.7 IDLE CAPACITY VARIANCE

Factory overhead idle capacity variance is the difference between the budget
allowance based on actual hours worked and actual hours worked multiplied by
standard rate.
The idle capacity variance indicates the amount of overhead that is either under - or
over absorbed because actual hours are either less or more than the hours on which
the overhead rate was based. This variance is the responsibility of executive
management.
Following formula/equation is used for the calculation of factory overhead idle
capacity variance:

IDLE CAPACITY VARIANCE = BAAH* - AHSR

Where,
AHSR = Actual Hours worked x Standard Overhead Rate
*BAAH = Budgeted Allowance based on Actual Hours worked
= Budgeted Fixed Expenses + Variable Expenses**

**Variable Expenses = (Actual Hours Worked x Variable Overhead Rate)

Example:
Actual factory overhead is P7,384. Actual production is 850 units of finished
product. Actual hours used are 3,475 hours. 4 standard hours are allowed to
complete a unit of finished product. The total budgeted fixed factory overhead is
P3,200.

Required:
Calculate factory overhead idle capacity variance.
Page 103 of 186
 Solution:
Budgeted allowance based on actual hours worked*
Fixed expenses budgeted P3,200
Variable expenses (3,475 actual hours worked ×
P4,170 P7,370
P1.20 variable overhead rate)

Actual hours worked × Standard overhead rate

P6,950
(3,475 actual hours × 2 std. hours)

Idle Capacity Variance P420 UF

Idle capacity variance consists of fixed expenses only and can also be
computed as follows:

Normal capacity 4,000 hours

Actual hours worked 3,475 hours

Difference 525 hours

Idle Capacity Variance

P420 UF
(525 hours × P0.80 fixed rate***)

***Fixed expenses rate at normal capacity

4.8.8 EFFICIENCY VARIANCE

Factory overhead efficiency variance is the difference between actual hours

worked multiplied by standard overhead rate and standard hours allowed times the
standard overhead rate.

Overhead efficiency variance is the responsibility of department management. The

reasons / causes of unfavorable efficiency variance include inefficiencies,
inexperienced labor, changes in operations, new tools, and different types of
materials.

Following formula is used for the calculation of factory overhead efficiency variance:

EFFICIENCY VARIANCE = AHSR x SHSR

Where,
AHSR = Actual Hours worked x Standard Overhead Rate
SHSR = Standard Hours Allowed for actual production x Standard Overhead Rate

To illustrate:
Actual factory overhead is P7,384. Actual production is 850 units of finished
product. Actual hours used are 3,475 hours. 4 standard hours are allowed to
complete a unit of finished product.

Page 104 of 186

 Required:
Calculate factory overhead efficiency variance.

Solution:
Actual hours worked × Standard overhead rate
(3,475 actual hours × P2 standard hours) P6,950
Standard hours allowed × Standard overhead rate
( 3,400 standards hours^^ × P4 standard overhead rate) P6,800
Overhead efficiency variance P150 UF
^^P850 × 4 = P3,400

This variance can also be computed as follows:

Actual hours worked 3,475

Standard hours allowed 3,400
75
Difference
Overhead Efficiency Variance
P150 UF
(75 hours × 2 standard overhead rate)

This variance consists fixed and variable expenses and occurs when actual hours
used are more or less than the standard hours allowed. When labor hours are the
basis for applying factory overhead, this variance and its cause reflect the effect of
the labor efficiency variance on factory overhead. When machine hours are the
basis, the variance relates to efficiency of machine usage.

Efficiency variance can be caused by a lot of factors that include, but not limited to
the following:

a) Inefficient/Untrained workers
b) Machinery breakdown
c) Poor quality of material
d) Inefficient supervision
e) Hours lost in waiting, delay in routing material, tools, instructions and
improper production scheduling
f) Poor working conditions
g) Change in design, quality standard of the product

4.8.9 VARIABLE EFFICIENCY VARIANCE

When companies adopt four variance analysis approach they divide the overhead
efficiency variance (which is calculated when three variance approach is used) into
its variable and fixed components. Variable component is called variable overhead
efficiency variance and fixed component is called fixed overhead efficiency
variance.

Page 105 of 186

Following formula is used for the calculation of variable overhead efficiency
variance:

VARIABLE EFFICIENCY VARIANCE = BAAH – BASH

Where,
BAAH = Fixed expenses budgeted + (Actual Hrs. worked × Standard variable rate)
BASH = Fixed expenses budgeted + (Standard Hrs. allowed × Standard variable rate)

To illustrate:
Actual factory overhead is P7,384. Actual production is 850 units of finished
product. Actual hours used are 3,475 hours. 4 standard hours are allowed to
complete a unit of finished product.

Required:
Calculate variable overhead efficiency variance.

Solution:
Budgeted allowance based on actual hours
worked:
Fixed expenses budgeted P3,200
Variable expenses (3,475 actual hours × 1.20
P4,170 P7,370
standard rate)
Budgeted allowance based on standard hours
allowed:
Fixed expenses budgeted P3,200
Variable expenses (*3,400 standard hours ×
P4,080 P7,280
1.20 standard rate)

Variable overhead efficiency variance P90 UF.

*850 × 4 = P3,400

This variance recognizes the difference between the 3,475 actual hours worked and
the 3,400 standard (or allowed) hours for the work performed. Multiplying the
difference of 75 hours times P1.20 (variable expense rate) results in P90. The sum
of the spending variance and variable efficiency variance equals the controllable
variance, P104, of the two variance method.

When variable overhead efficiency variance and fixed overhead efficiency variance
are combined, they equal the efficiency variance of the three variance method. This
concept is further explained by the following equation:

Overhead efficiency variance = Variable overhead efficiency variance +

Fixed overhead efficiency variance

P150* = P90 + P60**

*See efficiency variance page (4.8.8)

**See fixed overhead efficiency variance page (4.8.10)

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4.8.10 FIXED EFFICIENCY VARIANCE
When companies adopt four variance approach they divide the overhead efficiency
variance (which is calculated when three variance approach is used) into its
variable and fixed components. Variable component is called variable overhead
efficiency variance and fixed component is called fixed overhead efficiency
variance.
Following formula is used for the calculation of fixed overhead efficiency variance:

FIXED EFFICIENCY VARIANCE = AHSFR x SHSFR

Where,
AHSFR = Actual Hours x Standard Fixed Overhead Rate
SHSFR = Standard Hours x Standard Fixed Overhead Rate

Example:
Actual factory overhead is P7,384. Actual production is 850 units of finished
product. Actual hours used are 3,475 hours. 4 standard hours are allowed to
complete a unit of finished product.

Required:
Calculate fixed overhead efficiency variance.

Solution:
Actual hours worked (3,475) × Fixed overhead rate (P0.80) P2,780
Standard hours allowed (3,400) × Fixed overhead rate (P0.80) P2,720
Fixed Overhead Efficiency Variance P60 UF

When variable overhead efficiency variance and fixed overhead efficiency variance
are combined, they equal the overhead efficiency variance of the three variance
method. This concept is further explained by the following equation:

4.9 VARIANCE ANALYSIS AND MANAGEMENT BY EXCEPTION

Variance analysis and performance reports are important elements of management

by exception, which is an approach that emphasizes focusing on those areas of
responsibility where goals and expectations are not being met.
The budgets and standards discussed in this unit reflect management’s plans. If all
goes according to plan, there will be little difference between actual results and the
results that would be expected according to the budgets and standards. If this
happens, managers can concentrate on other issues. However, if actual results do
not conform to the budget and to standards, the performance reporting system
sends a signal to managers that an “exception” has occurred. This signal is in the
form of a variance from the budget or standards.
Page 107 of 186
 However, are all variances worth investigating? The answer is NO. Differences
between actual results and what was expected will almost always occur. If every
variance were investigated, management would waste a great deal of time tracking
down nickel-and-dime differences. Variances may occur for a variety of reasons—
only some of which are significant and worthy of management’s attention. For
example, hotter-than normal weather in the summer may result in higher-than-
expected electrical bills for air conditioning. Or, workers may work slightly faster or
slower on a particular day. Because of unpredictable random factors, one can expect
that virtually every cost category will produce a variance of some kind.

Photo Credits: Google Images

How should managers decide which variances are worth investigating? One
clue is the size of the variance. A variance of $5 is probably not big enough to
warrant attention, whereas a variance of $5,000 might well be worth tracking down.
Another clue is the size of the variance relative to the amount of spending. A
variance that is only 0.1% of spending on an item is likely to be well within the
bounds one would normally expect due to random factors. On the other hand, a
variance of 10% of spending is much more likely to be a signal that something is
wrong.

4.10 EVALUATION OF CONTROLS BASED ON STANDARD COSTS

❖ ADVANTAGES OF STANDARD COSTS

Standard cost systems have a number of advantages.

1) Standard costs are a key element in a management by exception approach. If

costs conform to the standards, managers can focus on other issues. When
costs are significantly outside the standards, managers are alerted that
problems may exist that require attention. This approach helps managers
focus on important issues.

2) Standards that are viewed as reasonable by employees can promote

economy and efficiency. They provide benchmarks that individuals can use
to judge their own performance.

3) Standard costs can greatly simplify bookkeeping. Instead of recording actual

costs for each job, the standard costs for direct materials, direct labor, and
overhead can be charged to jobs.

4) Standard costs fit naturally in an integrated system of “responsibility

accounting.” The standards establish what costs should be, who should be
responsible for them, and whether actual costs are under control.
Page 108 of 186
❖ POTENTIAL PROBLEMS WITH THE USE OF STANDARD COSTS

The improper use of standard costs can present a number of potential problems.

1) Standard cost variance reports are usually prepared on a monthly basis and
often are released days or even weeks after the end of the month. As a
consequence, the information in the reports may be so outdated that it is
almost useless. Timely, frequent reports that are approximately correct are
better than infrequent reports that are very precise but out of date by the
time they are released. Some companies are now reporting variances and
other key operating data daily or even more frequently.

2) If managers are insensitive and use variance reports as a club, morale will
suffer. Employees should receive positive reinforcement for work well done.
Management by exception, by its nature, tends to focus on the negative. If
variances are used as a club, subordinates may be tempted to cover up
unfavorable variances or take actions that are not in the best interests of the
company to make sure the variances are favorable. For example, workers
may put on a crash effort to increase output at the end of the month to avoid
an unfavorable labor efficiency variance. In the rush to produce more output,
quality may suffer.

3) Labor quantity standards and efficiency variances make two important

assumptions. First, they assume that the production process is labor-paced;
if labor works faster, output will go up. However, output in many companies
is not determined by how fast labor works; rather, it is determined by the
processing speed of machines. Second, the computations assume that labor
is a variable cost. However, direct labor may be essentially fixed. If labor is
fixed, then an undue emphasis on labor efficiency variances creates pressure
to build excess inventories.

4) In some cases, a “favorable” variance can be as bad as or worse than an

“unfavorable” variance. For example, McDonald’s has a standard for the
amount of hamburger meat that should be in a Big Mac. A “favorable”
variance would mean that less meat was used than the standard specifies.
The result is a substandard Big Mac and possibly a dissatisfied customer.

5) Too much emphasis on meeting the standards may overshadow other

important objectives such as maintaining and improving quality, on-time
delivery, and customer satisfaction. This tendency can be reduced by using
supplemental performance measures that focus on these other objectives.

6) Just meeting standards may not be sufficient; continual improvement using

techniques such as Six Sigma may be necessary to survive in a competitive
environment. For this reason, some companies focus on the trends in the
standard cost variances—aiming for continual improvement rather than just
meeting the standards. In other companies, engineered standards are
replaced either by a rolling average of actual costs, which is expected to
decline, or by very challenging target costs.

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 In sum, managers should exercise considerable care when using a standard
cost system. It is particularly important that managers go out of their way to
focus on the positive, rather than just on the negative, and to be aware of
possible unintended consequences.

4.11 STATEMENT PRESENTATION OF VARIANCES

In income statements prepared for management under a standard cost

accounting system, cost of goods sold is stated at standard cost and the
variances are disclosed separately. Unfavorable variances increase cost of goods
sold, while favorable variances decrease cost of goods sold. The illustration below
shows the presentation of variances in an income statement.

This income statement is based on the production and sale of 1,000 units of Oz
Hoodies at $70 per unit. It also assumes selling and administrative costs of $3,000.
Observe that each variance* is shown, as well as the total net variance. In this
example, variations from standard costs reduced net income by $3,000.

*Variances are assumed to be:

Materials price variance $ 420 U
Materials quantity variance 600 U
Labor price variance 420 F
Labor quantity variance 1,500 U
Overhead variance 900 U

Oz Hoodies
Income Statement
For the Month Ended June 30, 2020

Standard costs may be used in financial statements prepared for stockholders and
other external users. The costing of inventories at standard costs is in accordance
with generally accepted accounting principles when there are no significant
differences between actual costs and standard costs.

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 Oz Hoodies, for example, report their inventories at standard costs. However, if
there are significant differences between actual and standard costs, the financial
statements must report inventories and cost of goods sold at actual costs.

It is also possible to show the variances in an income statement prepared in the

variable costing (CVP) format. To do so, it is necessary to analyze the overhead
variances into variable and fixed components. This type of analysis is explained in
cost accounting textbooks.

Unit Summary

• 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.
• Quantity standards specify how much of an input should be used to make a product
or provide a service.
• Cost or price standards specify how much should be paid for each unit of input.
• The standard-setting process normally requires the joint efforts of accountants,
engineers, and other management personnel. Setting standards often begins with
analyzing past operations.
• Steps on setting the standards: (1) Analysis of historical data and engineering
studies; (2) Task analysis; and (3) Computation of the standard.
• Types of standards: Ideal and Practical standards
• Ideal/Theoretical Standards can only be attained under the best circumstances. They
allow for no machine breakdowns or other work interruptions and they call for a
level of effort that can be attained only by the most skilled and efficient employees
working at peak effort 100% of the time.
• Practical/Currently Attainable/Normal Standards are tight but attainable. They allow
for normal machine downtime and employee rest period. They can be attained
through reasonable, though highly efficient, efforts by the average worker.
• Both standards and budgets are predetermined costs, and both contribute to
management planning and control.
• A standard is a unit amount. A budget is a total amount.
• Standard Cost per Unit = Standard Price x Standard Quantity
• Favorable Cost Variance: Actual Cost < Standard Cost
• Unfavorable Cost Variance: Actual Cost > Standard Cost
• Not all variances are investigated. Only material variances, whether favorable or not,
are investigated.
• Materials purchase price variance Formula
Materials purchase price variance = (Actual quantity purchased × Actual price) –
(Actual quantity purchased × Standard price)
• Materials price usage variance formula
Materials price usage variance = (Actual quantity used × Actual price) – (Actual
quantity used × Standard price)
• Materials quantity / usage variance formula
Materials price usage variance = (Actual quantity used × Standard price) – (Standard
quantity allowed × Standard price)

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• Direct labor rate / price variance formula
(Actual hours worked × Actual rate) – (Actual hours worked × Standard rate)
• Direct labor efficiency / usage / quantity formula
(Actual hours worked × Standard rate) – (Standard hours allowed × Standard rate)
• Direct labor yield variance formula
(Standard hours allowed for expected output × Standard labor rate) – (Standard
hours allowed for actual output × Standard labor rate)
• Factory overhead controllable variance formula
(Actual factory overhead) – (Budgeted allowance based on standard hours allowed*)
• Factory overhead volume variance
(Budgeted allowance based on standard hours allowed*) – (Factory overhead applied
or charged to production**)
• Factory overhead spending variance
(Actual factory overhead) – (Budgeted allowance based on actual hours worked***)
• Factory overhead idle capacity variance formula
(Budgeted allowance based on actual hours worked***) – (Actual hours worked ×
Standard overhead rate)
• Factory overhead efficiency variance formula
(Actual hours worked × Standard overhead rate) – (Standard hours allowed for
expected output × Standard overhead rate)
• Variable overhead efficiency variance formula
(Actual hours worked × Standard variable overhead rate) – (Standard hours allowed
× Standard variable overhead rate)
• Variable overhead efficiency variance formula
(Actual hours worked × Fixed overhead rate) – (Standard hours allowed × Fixed
overhead rate)
• Factory overhead yield variance formula
(Standard hours allowed for expected output × Standard overhead rate) – (Standard
hours allowed for actual output × Standard overhead rate)
*Fixed overhead budgeted + standard hours allowed × Standard variable
overhead rate
**Standard hours allowed for actual production × Standard overhead rate
***Fixed overhead budgeted + Actual hours worked × Standard variable
overhead rate
• Unfavorable variances increase cost of goods sold, while favorable variances decrease
cost of goods sold.
• The costing of inventories at standard costs is in accordance with generally accepted
accounting principles when there are no significant differences between actual costs
and standard costs.
• if there are significant differences between actual and standard costs, the financial
statements must report inventories and cost of goods sold at actual costs.

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