LECTURE 5 – STANDARD COSTING; DIRECT MATERIAL AND LABOUR VARIANCES
Preliminary Analysis of Variances
Static and Flexible Budgets Reviewed
1 July 30 June
Flexible budget? Budgetedcostsfor50,000 units.
“Flexing” the budget from the static budget is the starting point for all variance calculation,
and variance calculation is an integral part of standard costing.
Firms commonly prepare a variance report analysing the difference between:
o budgeted costs at budgeted activity level (static budget) – far right column, and
o actual costs (far left column)
The report shows two levels of variances. First, the static budget variance, which is the
difference between budgeted costs at budgeted activity level, and actual costs. This variance is
then split to show:
o the difference between budgeted costs at budgeted activity and budgeted costs at actual
activity, called the volume variance ($95,000 F), and
o The difference between budgeted costs at actual activity level, and actual costs incurred
(called cost variances or flexible budget variances ($15,950 U).
Discussions of the Variances
Static Budget Variance
Thedifferencebetweenthestatic budget andtheactualcostisfavourable ($79,050 F),
o That isvery misleading.
o Ifyouanalysethatvariancefurther, itisevidentthatthefavourablevarianceis
attributableto the factthatthefirm produced10,000 fewer unitsthanitexpectedto
o In fact,forthatlevelof productionallcostsexceptDM werehigherthanexpected
o Why? notcomparingthesameactivitylevel
The differences between the static budget and flexible budget column are due solely to the fact
that actual production level (50,000) differed from budgeted production (60,000). Where the
actual activity level is:
o higher than budgeted, the variance is unfavourable
o lower than budgeted, the variance is favourable
this data has limited usefulness
Cost Variances The differences between the actual and flexible budget column are the cost variances, because
we are comparing “what costs should have been (budget) to produce 50,000 units” and “what
costs were (actual) to produce 50,000 units”.
These variances will be the focus of this unit. If the actual cost is:
o higher than budget, the variance is unfavourable
o lower than budget, the variance is favourable
These are the most useful variances, as they provide the starting point for analysing managers’
performance in controlling costs.
o However, even these provide only limited information
Limitations of Cost Variances
Variances provide data for:
o Entries in the accounts
o Use by managers for performance evaluation (firms set up as cost centres may reward
managers of the cost centres for controlling costs, as measured by variances), and
o Use by managers for investigating and if necessary correcting an out-of-control situation.
If managers want to use variances to “fix problems” they need to be able to see
what is causing the variance.
The variance report above shows a variance between what the firm expected to pay for
manufacturing costs (flexible budget column) and what it did pay (actual column).
o ITB paid $200 less than expected for DM, and $5,250 more than expected for DL.
However, we do not know whether the variance is due to:
a difference in price from budget (paying something other than 25c sq.m or $18
DL hour), or
a difference in quantity used from budget (using something other than 10 sq.m
or 20 mns/unit), or
a difference in both price and quantity.
Managers looking to fix problems would need this additional information. Therefore, the DM
and DL variances above will be split into:
o the part of the variance due to price, and
o the part due to quantity (efficiency)
o Oncethevarianceissplitinto thesetwo componentsmanagerswillknowwhichareas
Standard Costing Overview
Standard costing is an acceptable method of valuing inventories under AASB102 provided:
Results approximate actual cost (para.21);
They take into account normal levels of materials and supplies, labour, efficiency and capacity
Any variation between actual and standard is treated appropriately (para.13).
Introduction to Standing Costing
Standard costing can be implemented by firms whether they are using job or process
costing, and in both absorption and variable costing systems.
All costing systems will record product (inventoriable) costs DM, DL and OH in the factory
accounts (WIP, FG, COGS).
The amount of DM, DL and OH recorded will depend on whether the firm is using actual,
normal or standard costing, as follows:
DM DL OH
ACTUAL actual actual actual activity x actual OH rate (actual OH incurred)
NORMAL actual actual actual activity x budgeted (standard) OH rate STANDARD standard standard standard activity x budgeted (standard) OH rate
Note that with standard costing, all manufacturing costs will be entered into the accounts at
their standard cost. None of them is recorded at actual cost.
Standard/Budgeted Cost per unit (SQ x SP)
The standard (budgeted) cost of a cardboard box is what one box would cost to produce if
ITB used the expected quantity of the factors of production (direct materials, direct labour
hours, machine hours – called the standard quantity (SQ)), and the prices of the inputs
(standard price (SP)) were as budgeted. The standard cost for one box would be $10.10
($2.50 DM + $6 DL + $1.60 OH).
o Standard (budgeted) DM cost per box is SQ x SP = 10 sq. metres x $.25 sq. metre = $2.50
o Standard (budgeted) DL cost per box is SQ x SP = 20 minutes x $18 hour = $6 per box.
o Next week - standard (budgeted) OH per box = $1.60 per box.
A firm can calculate its standard cost (we have just done that in the paragraphs above)
without using standard costing. STANDARD COSTING involves:
(i) determining the standard cost for DM, DL (as above) and OH, and
(ii) entering those amounts on the job cost sheets and through MATERIALS, WIP, FG and
COGS. The final cost that arrives in COGS will be the standard cost of units sold, not
the actual or normal cost.
Standard and Budget, are they the same?
Sometimes yes, sometimes no.
Product cost per unit. When talking about the cost/quantity per unit as above, or when
describing standards/budgets in general terms, the words are interchangeable.
Total product cost. It is when calculating variances and discussing total production costs
that the terms may not be interchangeable. This is because of the “quantity” component of
the calculations below. When we use the term “quantity” we are meaning either the:
o Quantity of metres, kg, yards etc of material (DM)
o Quantity of DL hours (DL)
o Quantity of machine hours, DL hours, units or whatever is the cost driver for OH (OH)
When referring to total costs:
Budgeted quantity (BQ) means the quantity (of material, labour etc) we “should have used”
for the units we “should have produced”.
Standard quantity (SQ) means the quantity we “should have used” for the units actually
Actual quantity (AQ) means the quantity we actually used for the units actually produced.
These quantities will then be multiplied by the price (either actual (AP) or budgeted/standard (SP)
depending on what we are trying to measure), e.g.:
Price per kg, yards etc for DM
Price per DL hour for DL
Price per machine hour, DL hour, units etc for OH
Each of the following can be calculated for each cost component (DM, DL, OH):
Budgeted cost (BQ x SP) What the firm expected it would cost to produce the units it expected to produce in the period.
Standard cost (SQ x SP) What the firm expected it would cost to produce the units it actually
produced in the period.
Actual cost (AQ x AP) What it actually cost the firm to produce the units it actually produced
in the period.
Accounting for Cost Variances
A variance is calculated and entered in the accounts in any costing system where costs
recorded on the job cards (and through the ledger accounts) are not the actual costs.
For normal costing, because actual DM and actual DL are recorded in the accounts,
variances are not calculated for DM and DL. However, because OH applied uses a budgeted
OH rate, under/over applied OH will be calculated.
o Review: The overhead variance under normal costing (called under or over-applied
overhead) is the difference between:
actual cost of OH incurred, and
OH applied (actual activity (DL hours/machine hours etc) x budgeted OH
rate (per DL hour/machine hour etc)
For standard costing systems, all of the manufacturing cost items are recorded in the ledger
at standard cost rather than actual cost, which means that variances will be calculated for all
three manufacturing costs.
We will see that in standard costing the basic journal entries remain the same as for normal
costing, but in addition:
o the calculation of variances is required before the firm records journal entries, and that
o the journal entries will now include entries to the variance accounts
Required Knowledge for all Standard Costing Variances
For each manufacturing cost (DM, DL and OH) firms would typically