Management Accounting and Finance II

© School of Accountancy, University of the Witwatersrand

Standard Costing (Week 1 & 2)

TEXTBOOK CHAPTER

Chapter 18

Standard Costing and Variance Analysis 1

• Pages 532 - 575

LEARNING OBJECTIVES

After studying this chapter, you should be able to:

• explain how a standard costing system operates

• explain how standard costs are set
• explain the meaning of standard hours produced
• identify and describe the purposes of a standard costing system
• calculate labour, material, overhead and sales margin variances and reconcile actual profit with
budgeted profit
• identify the causes of labour, material, overhead and sales margin variances
• distinguish between standard variable costing and standard absorption costing.
 Management Accounting and Finance II
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What is standard costing?

A standard is something that is understood by the entire organisation to be acceptable as the norm. e.g.
the standard time that you should spend pre-reading a chapter is 2 hours.

A standard cost is therefore a ________________________________for any resource that an

organisation uses to manufacture a product or deliver a service.

An example of a standard cost card:

As you can see, both the usage and the price must be stated for every resource used.

• They are pre-determined target costs that will be achieved under efficient operating conditions.
• Standard costs are given on a per unit basis, while budgeted costs are given on a total cost basis.
• Standard costs should be continuously reviewed to reflect current target costs.

Purpose of Standard Costing

Things don’t always go according to plan. Actual activity levels may not be the same as budgeted activity
levels. Actual cost may not always be the same as budgeted costs. Standard costs help us isolate the effect
of certain occurrences on profit (e.g. the effect of labourers taking longer than budgeted to make one unit
of product). It helps management to control the functions of an organisation, because if the standard
differs from actual results ________________can be taken.

• Standard costs therefore predict future cost that can be used for _________________.
• They provide a ________ for individuals to achieve and thus ensure efficient operations.
• It assists in setting budgets and to evaluate management performance;
• It acts as a control device through highlighting those activities that are not efficient; and
• Helps trace costs to products to calculate gross profit and value inventory.
 Management Accounting and Finance II
© School of Accountancy, University of the Witwatersrand

How do we set standard costs? (Figure 18.1 pg 536)

✓ Past historical records or (better method) engineering studies – detailed studies of each operation
to determine the best combination of resources, production methods and product quality.
✓ Standards should take into account unavoidable delays (e.g. machine maintenance).
✓ Standards should be achievable under efficient operating conditions (if impossible, employee
morale will be affected).

What is variance analysis?

The evaluation of performance by means of variances, whose timely reporting should maximise the opportunity for
managerial action. – CIMA, 2005
 Management Accounting and Finance II
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What variances usually arise under a standard costing system?

• Material variances
• Labour variances Production variances
• Variable overhead variances
• Fixed overhead variances
• Sales variances

What levels of activity are important when calculating variances?

• Budgeted Production Quantity: Only use to calculate budgeted profit

• Actual Production Quantity: Use to calculate your production variances

• Budgeted Sales Quantity: Use to calculate your budgeted profit and the BV in your sales variance
• Actual Sales Quantity: Use to calculate your sales variances

Remember:

Rate variances Usage variances

Given [AQ of DM purchased/AQ of labour hours Given actual units produced, how many kg’s or
used]; how much should I have spent and how hours should I have used and how many did I
much did I spend? use?
 Management Accounting and Finance II
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What are the short comings associated with using a standard costing system?

• Standards may not be accurate and may result in dysfunctional slack behaviour.
• Employees may work towards meeting standards rather than seeking an improvement.
• Companies may lose track of actual costs associated with their activities.
• If the data is not accurate and reliable, the value of the standard costing system is limited.

RAW MATERIALS VARIANCES

Total Raw Materials Variance = Standard Cost – Actual Cost
= (SQ x SP) – (AQ x AP)
Standard Quantity = the quantity of raw materials that should have been used at our actual level of production.
(assuming the standard quantity per unit was used for each unit actually produced)

The Total raw materials variance = RM Price Variance + RM Usage Variance

Raw Materials Price Variance Raw Materials Usage Variance

(Standard Price – Actual Price) x Actual Quantity (Standard Quantity – Actual Quantity) x Std Price
(SP – AP) x AQ (SQ – AQ) x SP

LABOUR VARIANCES

Total Labour Variance = Standard Cost – Actual Cost

= (SH x SR) – (AH x AR)

Standard Hours = the time that it should have taken to produce our actual level of production.
(assuming the standard time per unit was spent on each unit actually produced)

Total Labour Variance = Labour Rate Variance + Labour Efficiency Variance

Labour Rate Variance Labour Efficiency Variance

(Standard Rate – Actual Rate) x Actual Hours (Standard Hours – Actual Hours) x Standard Rate
(SR – AR) x AH (SH – AH) x SR
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VARIABLE OVERHEAD VARIANCES

Total Variable Overhead Variance = Standard Cost – Actual Cost

= (SH x SR) – (AH x AR)

Standard Hours = the time that it should have taken to produce the units at our actual level of production.
(assuming the standard time per unit was spent on each unit actually produced)

Total Variable Overhead Variance = Overhead Expenditure Variance + Overhead Efficiency Variance

Variable Overhead Expenditure Variance Variable Overhead Efficiency Variance

(Standard Rate – Actual Rate) x Actual Hours (Standard Hours – Actual Hours) x Std Rate
(SR – AR) x AH (SH – AH) x SR

FIXED OVERHEAD VARIANCES

Total Fixed Overhead Variance

Fixed Overhead Volume Variance Fixed Overhead Expenditure Variance

(Only in Absorption Costing) (In Absorption Costing and Variable Costing)

(AP – BP) x SR (BFO – AFO)

FIXED OVERHEAD VARIANCES (UNDER A VARIABLE COSTING SYSTEM)

Fixed Overhead Expenditure Variance

Total Fixed Overhead Variance
(Budgeted Fixed overheads – Actual Fixed Overheads)
(BFO – AFO)

• The full fixed overheads are seen as a period cost and expensed.
• Therefore the only variance that arises is where the budgeted fixed overheads are different to the actual fixed
overheads.

Meaningful information is only obtained when fixed overheads are broken down into their individual components
and actual costs are compared with budget.
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FIXED OVERHEAD VARIANCES (UNDER ABSORPTION COSTING)

Total Fixed Overhead Variance = Fixed Overhead Expenditure Variance + Fixed Overhead Volume Variance

Fixed Overhead Volume Variance Fixed Overhead Expenditure Variance

(Actual Production – Budgeted Production) x Standard

SALES VARIANCES (In Absorption Costing and Variable Costing)
Rate (AP – BP) x SR (BFO – AFO)

SALES VARIANCES

Total Sales Variance = Budgeted Contribution – Actual Contribution

= (AV x AM) - (BV x SM)

Both Standard Margin and Actual Margin are determined using the standard cost of the product; never the actual
cost.

Total Sales Variance = Sales Margin Price Variance + Sales Margin Volume Variance

Sales Margin Price Variance Sales Margin Volume Variance

(Standard Margin – Actual Margin) x Actual Volume (Budgeted Volume – Actual Volume) x Std Margin
(AM – SM) x AV (AV – SV) x SM

NB: The sales variance will differ depending on whether the company is using variable or absorption costing:
- Variable Costing – The standard and actual margins are determined by deducting the standard variable costs
from the selling price i.e. contribution margin (SP – VC)
- Absorption Costing – The standard and actual margins are determined by deducting the full standard cost
from the selling price (product cost includes an allocation of fixed costs) i.e. Profit margin
 Management Accounting and Finance II
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Class Example (page 542)

Alpha Ltd, a manufacturing company, uses a variable costing system for internal profit measurement purposes. The company
produces a single product, which is known as Sigma. Sigma requires a single operation and the standard cost for this operation
is presented in the following standard cost card:

Standard cost card for product Sigma: R

Direct materials:
2kg of A at R100 per kg R 200.00
1kg of B at R150 per kg R 150.00
Direct labour (three hours at R90 per hour) R 270.00
Variable overhead (three hours at R20) R 60.00
Total standard variable cost R 680.00
Standard contribution margin R 200.00
Standard selling price R 880.00

Alpha Ltd plans to produce 10 000 units of Sigma in the month of April. Annual budgeted fixed overheads are R14 400 000
and are assumed to be incurred evenly throughout the year. The budgeted costs based on the information contained in the
standard cost card are as follows:

Budget based on the above standard costs and an output of 10 000 units:
R R
Sales (10 000 units at R880) R8 800 000.00
Direct materials:
A: 20 000kg at R100 per kg R2 000 000.00
B: 10 000kg at R150 per kg R1 500 000.00
Direct labour (30 000 hours at R90 per hour) R2 700 000.00
Variable overheads (30 000 hours at R20 per hour) R600 000.00
Total variable costs (R6 800 000.00)
Budgeted contribution R2 000 000.00
Fixed overheads (R14 000 000/12) (R1 200 000.00)
Budgeted profit R800 000.00

The actual results for April are:

R R
Sales (9 000 units at R900) R8 100 000.00
Direct materials:
A: 19 000kg at R110 per kg R2 090 000.00
B: 10 100kg at R140 per kg R1 414 000.00
Direct labour (28 500 hours at R96 per hour) R2 736 000.00
Variable overheads (30 000 hours at R20 per hour) R520 000.00
Total variable costs (R6 760 000.00)
Budgeted contribution R1 340 000.00
Fixed overheads (R1 160 000.00)
Budgeted profit R180 000.00

Manufacturing overheads are charged to production on the basis of direct labour hours. Actual production and
sales for the period were 9,000 units.
 Management Accounting and Finance II
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Solution:

Material price variance: = (SP - AP) x AQ

Material usage variance: = (SQ - AQ) x SP

Total material variance: = SC for actual output - AC

Labour rate variance: = (SR-AR) * AH

 Management Accounting and Finance II
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Labour efficiency variance: = (SH-AH) * SR

Total labour variance: = formula is same as total materials variance

Variable overhead rate variance: = (SR - AR) x AH

Variable overhead efficiency variance: = (SH - AH) x SR

Total variable overhead variance: = formula is the same as total labour and total materials
 Management Accounting and Finance II
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Fixed overhead expenditure variance = BFO - AFO

Fixed overhead volume variance = (SH-BH)*SR

Total fixed overhead variance: = (SC for actual output - AC)

Sales price variance = (AP-SP) * AV

Sales volume variance = (AV-BV) * SM – VARIABLE COSTING

Total Sales variance = (AS-BS)

 Management Accounting and Finance II
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Variance interrelationships

Variances in one area of the organisation may be interrelated with variances elsewhere. A favourable
material price variance due to purchasing a cheaper material may result in an adverse material usage
variance as there will be more material wasted. This will also cause an adverse labour efficiency variance
due to an increase in labour time spent on working with the cheaper quality of materials.

Sales price and volume as an increase in sales price may result in a decrease in the units sold. A favourable
sales price variance may result in an adverse sales volume variance. Or a reduction in the selling price may
cause a higher sales demand from customers.

Unskilled labour may provide a favourable labour rate variance resulting in an adverse labour efficiency
variance. Or, using more experienced labour to do the work will cause the labour rate variance to be
adverse, but will increase productivity.

A favourable labour efficiency variance also accounts for a favourable overhead efficiency variances when
overheads are absorbed on a labour hour basis.

Adverse material variances due to more expensive materials may result in higher output levels and a
favourable yield variance.
 Management Accounting and Finance II: Standard Costing Week 1
Additional tutorial question (Adapted)

QUESTION 1

SoccerCraze Pty Ltd (SC) is a relatively new small South African company that sells soccer shoes and soccer
balls to local football clubs. SC has a manufacturing facility in Rosettenville and a 31 January year-end. The
company manufactures its own soccer shoes, but the manufacturing of the soccer balls is outsourced to a large
soccer ball manufacturer IBhola.

Soccer shoes
SC uses an absorption costing system for their internal management accounts. The company budgeted to
produce 100 000 pairs of soccer shoes for the year ending 31 January 2018 to meet expected demand of
100 000 pairs in terms of contractual arrangements with the football clubs they supply stock to. However, as
there was opening stock of 30 000 pairs of shoes, SC reduced their actual production for the year to 80 000 pairs
of shoes. The budgeted fixed manufacturing overhead was equal to the actual overhead for the period.

The production supervisor has provided the following information related to the production of the shoes:

Selling price per pair of shoes R480

Variable production cost per pair of shoes R320

Fixed manufacturing cost per pair of shoes ¹ R100

Fixed component: R1 000 000

Marketing and selling expenses ²
Variable component: R 30 per unit sold

¹ Pre-determined overhead rate of R100 calculated based on budgeted production of 100 000 pairs of shoes.
A R100 pre-determined overhead rate was also used for the 2017 year.
² SC aims to expand their client base and invests heavily in their marketing as a result.

SC’s management accountant is currently on maternity leave and the employee responsible for the management
accounts in the interim has prepared the annual income statement that follows. The employee is unable to justify
to management why the division is making a loss this year.

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 Management Accounting and Finance II: Standard Costing Week 1
Additional tutorial question (Adapted)

Comments made by the employee:

“Maybe I made mistakes in preparing the income statement? This is not my area of expertise and I have tried to
remember how to prepare these income statements from my days at varsity. Perhaps the problem is that we are
using an absorption costing system, I remember something about a variable costing statement being better for
decision-making purposes. Can someone please review the statement and tell me where I went wrong?”

DIVISIONAL INCOME STATEMENT (SOCCER SHOES)

For the year ending 31 January 2018
Revenue 80000*480 38 400 000.00
Cost of sales -36 800 000.00
Production costs 80000*420 33 600 000.00
Fixed marketing and selling expenses -1 000 000.00
Closing stock 10000*420 4 200 000.00

Contribution 1 600 000.00

Other expenses
Variable marketing and selling expenses 80 000*30 -2 400 000.00
Profit -800 000.00

Soccer balls (outsourced to IBhola)

IBhola manufactures top quality soccer balls which are sold to various local and international retailers and
distributors (including SC) and uses a standard, absorption costing system. Inventory is valued at standard and
the company has a 31 January year-end.

Manufacturing of the soccer balls

The outside of the balls are made from sheets of foam which have been coated with a chemical which prevents
it from scuffing. Three (3) sheets are layered and glued together with latex glue in an automated process which
presses the sheets together to form a glued foam stack. The balls’ design is then put onto the glued foam stack
using a screen printer. Thereafter a machine punches out shaped panels that will make each soccer ball (a ball
is made from 32 panels consisting of various hexagons and pentagons). Each glued foam piece delivers 64
panels.

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 Management Accounting and Finance II: Standard Costing Week 1
Additional tutorial question (Adapted)

Labourers (refered to as “bundlers”) then bundles them into heaps to be sent off for stitching: It takes 10 minutes
to place the panels from one glued foam stack into two ball’s heaps. The panels are sewn together by hand,
using a standard of 15 meters of thread per ball and 3.5 hours of labour (sewer) time per ball. The ball is turned
inside out with a few panels still unstitched, an inner-tube is then put in and the ball is then completely sewn up.

Once the ball is inflated, it is placed in a round machine and heated to ensure that it is perfectly round. The final
step consists of various quality checks to ensure that the ball meets FIFA regulations in terms of weight and
circumference. On standard, the IBhola factory only produces 750 balls a day, 20 days a month, 12 months a
year. Production is spread evenly throughout the year.

3 sheets Forms a Design put Machine Labourer Panels sewn Inflated,

are layered glued foam onto stack punches bundles into 2 and tube heated and
& glued stack 64 panels heaps inserted quality

Additional standard information for the year ending 31 January 2018 is found on the next page.

Standard information for the year ending 31 January 2018:

Input Cost Note

Annual fixed indirect manufacturing
overhead R 14 400 000.00 Allocated based on annual production
Foam (per sheet) R 40.00
Thread (per meter) R 16.00
Total annual variable labour cost (Bundlers) R 450 000.00
Glue and ink (per glued foam stack) R 60.00
Hourly labour rate (sewer) R 40.00
Pack of 8 tubes, bought from TUBE
Inner-tube (one per ball) R 360.00 (Note 1)

Note 1 (TUBE)
The inner-tubes are manufactured by a company called TUBE. The company uses a process costing system
and converts plastic pellets (which are added at the start of the process) into the individual tubes. A normal loss
of 2% of input is expected, with losses occurring at the end of the period.
A small steel pipe is added to the tube and then packaged in packs of 8 tubes at the end of the process.

As at 1 January 2018 TUBE had no opening stock. Throughout the month 16 000 units were started and 15 900
units were completed by the end of the month.

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 Management Accounting and Finance II: Standard Costing Week 1
Additional tutorial question (Adapted)

Question 1
Required
Marks
(Round your answers to two decimals, where applicable)
a) Carefully inspect and critically analyse the employee’s absorption costing income
statement.

• Include the correct calculations in your discussion where applicable. 12

• You are NOT required to prepare the correct income statement and you may ignore
the effects of taxation.
b) Assuming the correct absorption costing profit is R4 000 000, calculate what the
variable costing profit would have been for 2018.

• You need to perform a reconciliation between absorption and variable profits. 3

• You are NOT required to prepare the variable costing income statement and will be
penalised if you do so.
c) Calculate the standard absorption cost per soccer ball.
9

d) Calculate the labour efficiency variance for the bundlers during January 2018
assuming the following:

• The actual time taken to place the panels into heaps was 1.5 times more 4

than planned as labourers were exhausted from working through December.

• 6 500 balls were made during the month.
f) Briefly discuss how information systems can assist IBhola in their cost
3
management.
g) With reference to the inner-tubes manufactured by TUBE, calculate the total
equivalent units relating to the Plastic for the month of January 2018.

• You are required to perform a unit recon and a table of equivalent units showing the 5
components that make up total equivalent units (for Plastic).
• You are NOT required to include costs in your table nor calculate a CPU.

Page 4 of 4
© School of Accountancy, University of the Witwatersrand
 Management Accounting and Finance II: ACCN 2006 and ACCN 2011
September Test 2015

Question 2 20 Marks
Answer in the BLUE book

You are the management accountant of Stars (Pty) Ltd, a medium sized company in Johannesburg
which manufactures and retails plastic lenses used in telescopes. The company was founded by a
well- known entrepreneur, Mr. Doug Vader. After 15 years as CEO, Doug gave his only son, Luke, full
responsibility of the operations of the company on 1 October 2015. Luke was appointed CEO but
Doug is still eager to keep an eye on the business as he is still the main shareholder. He has
requested that monthly performance updates, including the management accounts, be presented to
him.

Luke made several changes to the operation in his first month at the helm. Doug was very pleased
with the changes. He says, “My son is proving himself to be very capable of running the business. He
has managed to sell the blades at a higher price than we budgeted and even found a cheaper
supplier of materials – per metre, he paid just half the price in the budget. He has even managed to
secure cheaper labour!”

Several skilled workers left the company after several years of service and were replaced by unskilled
labourers. Training was not provided to the new workers as Luke believes that “the best way to learn
is by trial and error”.

The following standard cost information for the period of October 2015 is available.
Cost/
Unit
Labour 0.5 hours at R22 per hour R 11
Variable Manufacturing overheads 1 hour at R8 per hour R8
Material 4 metres at R6 per m R 24
Total Cost Per Unit R 43
Standard Contribution R 12

The budget for the same period reflected the following:

Sales 2010 units R 110 550
Material 8000 metres R 48 000
Labour 1000 hours R 22 000
Variable Manufacturing Overhead 2000 hours R 16 000
Fixed Overheads R 150 000
Production 2000 units

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 Management Accounting and Finance II: ACCN 2006 and ACCN 2011
September Test 2015

You have also determined that the actual production was 1 580 units and 2 000 units were actually
sold. The sales price variance for the period was R4 740, favourable. In addition, the following actual
information is available:
Materials purchased and used 16500 metres R 49 500
Labour 1200 hours R 25 200
Variable Manufacturing Overhead 1200 hours R 15 800
Fixed Overheads R 145 980

Required:

a. Calculate the actual selling price per lens and the sales volume variance for the period. (5)
b. Comment on the impact of the changes implemented by Luke, using the materials price,
materials usage and total materials variances to support your comments. (6)
c. Discuss the performance of Stars with reference to the wage rate, labour efficiency and total
labour variances for October 2015. (5)
d. Calculate all the variable overhead variances for the period. (4)

Round your final answers to two decimal places.

Total Marks = 20

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© School of Accountancy, University of the Witwatersrand, 2015
 Solution:
MARKS
A Actual selling price
BSP = VC+Contribution 55 1
(ASP-BSP)*AQ = 4 740 F
(ASP - 55)*2000 = 4 740 F 2
ASP = 57.37 0.5

Sales volume variance

(AV - BV)*SM
(2000-2010)*12 = -120 A 1.5 5

B Actual Price per metre 3

Material price
(SP-AP)*AQ
(6-3)*16500 = 49 500 F 1.5

Material usage
(SQ-AQ)*SP
(1580*4-16500)*6 -61 080 A 1.5

Total Materials Variance

SC-AC
(1580*24 - 49500) -11 580 A 1

The cheaper material that Luke found has resulted in a favourable price variance. 0.5
However, the material may be of inferior quality as the usage variance is adverse. 1
The total materials variance is advserse, indicating a negative effect on profit
when taking into account both price and usage 0.5 6

C Labour efficiency
(SH-AH)*SR
-9 020 A 1.5

Labour rate
(SR-AR)*AH
1 200 F 1.5
Total Labour Variance
SC-AC -7 820 A

The cheaper labour has resulted in a favourable wage rate variance 0.5
However, the labour efficiency variance is adverse. 0.5
This could be the result of unskilled staff taking longer to learn the production processes. 0.5
The total labour variance is adverse, indicating that the cost of the inefficient workforce
outweighs the benefit of the lower wage rate. 0.5 5

D Manufacturing overhead
Variable overhead expenditure
(AH*SR)-AC
-6 200 A 1.5

Variable overhead efficiency

(SH-AH)*SR 3 040 F 1.5

Total variable overhead variance

SC - AC
-3 160 A 1 4
TOTAL 20
Solution
Marks
Report 1
To: Managing Director, FX
From: Management Accountant
Date: 21 September 2015
Subject: Interpretation of August 2015 Variance Report

Overview 1
The company produced and sold 120 units. This was 20 units more than budgeted for and should have resulted in additional
profits of R180 000, and therefore total profits of R380 000. However, over-spending on labour and fixed overheads resulted in
an actual profit of R344 500.

Volume variance
Given that output and sales were higher than forecast by 20 units it is to be expected that the profits would be different from
those stated in the budget. The company uses a marginal costing system and consequently each unit sold is deemed to earn a
contribution of R9 000 towards fixed costs and profit. Fixed costs are not accounted for on a unit basis; they are charged to the
profit statement as a total figure. 0.5

Given that sales were 20 units higher than budget, it would be expected that profit would be R180 000 higher (20 x R9 000).
This level of sales and output (120 units) then provides the level of performance that other variances should be measured against.
0.5

Labour rate variance

The labour force worked 2 450 hours and we have paid them R24 500 less than we expected to do. We have paid them R10 per
hour below the standard rate. 1

Labour efficiency variance

The adverse efficiency variance indicates that the labour force took longer to produce 120 units that they should have done.
They should have taken 2 400 hours and this would be valued at R480 000. The adverse variance of R20 000 shows that they have
taken an additional 50 hours. 2

Variable overhead expenditure variance

This variance indicates whether the spending on variable overheads is in line with standard levels. Labour hours are being used for
the absorption rate: this means that it is thought that the variable overheads change proportionally with the labour hours worked.
The rate of expenditure was thought to be R200 per labour hour. Given that there is no variance it would appear that the use of
labour hours to predict the expenditure on these overheads is a good assumption.
1
OR: The amount spent on variable overheads was in line with budgets

Variable overhead efficiency variance

This is linked to the labour efficiency because labour hours are used as the base for the absorption rate. We used 50 hours too
many for the production achieved and now we will cost them at R200 per hour. This gives the variance of R10 000 adverse.
1

Fixed overhead variance

The variance is the fixed overhead expenditure variance and shows by how much the expenditure on fixed overheads differed
from that budgeted. The company uses marginal costing and therefore the fixed overheads are not attributed to individual units
of production. 1

Consequently there is no need for a fixed overhead absorption rate. The fixed production overheads are not broken down or
absorbed into products or units under such a system. The variance is R30 000 adverse and therefore we must have spent R730
000 on fixed overheads during August 2015. 1

If you require any further details please do not hesitate to contact me.

10