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Chapter 7

Standard Costing and Variance Analysis

Cost AccountingFoundations and Evolutions

Kinney and RaibornSeventh Edition

COPYRIGHT © 2009 South-Western, a part of Cengage Learning. South-Western is a trademark used herein

under license.

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Learning Objectives (1 of 2)

• Describe how standards are set for material, labor, and overhead

• List the documents that are associated with standard cost systems and describe the information that those documents provide

• Calculate and record material, labor, and overhead variances

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Learning Objectives (2 of 2)

• Explain why standard cost systems are used

• Identify changes in the use of standards

• Contrast the traditional labor and overhead elements to a single conversion element

• (Appendix) Explain how multiple material and labor categories affect variances

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Standard Cost Systems

• Manufacturing

• Service

• Not-for-Profit

• Record standard and actual costs in the accounting records

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Standards• Standard costs are budgeted costs to

– manufacture a single unit of product, or– perform a single service

• To develop standards identify– material and labor types, quantities, and prices– overhead types and behavior

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Manufacturing Objective

Minimize unit cost while achieving certain quality specifications

Input Resource

s

OutputQuality

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Material Standards• Materials used

– Types– Quantity– Quality– Price

• From – Product specifications, observation, inquiry– Bill of materials

• Balance cost, quality, and projected sales price

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Material Standards

StandardMaterial = Unit Purchase Price x quantityCost

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Labor Standards• Labor used

– Types

• Production, setup, cleanup, and rework

– Quantity

– Cost • Include wages, payroll taxes, and fringe benefits

• From– Industrial engineering studies including methods-time

measurement (MTM), time and motion studies, historical data

– Operations flow document

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Labor Standards

Standard

Labor = Hours x Wage Rate

Cost

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Overhead Standards

• Variable and fixed manufacturing overhead

• Estimated level of activity

• Estimated costs

• Predetermined factory overhead application rates

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Standard Cost Card

For one unit of output (a bike)

Standard Direct Material Components

Standard Direct Labor Components

Manufacturing Overhead

Variable Overhead

Fixed Overhead

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Variance

Variance is the difference between an actual cost and

a standard cost

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Total VarianceTotal actual cost incurred minus

total standard cost applied to output produced

Standard cost of actual

production output

Actual price of actual

production input

Total Variance*

*Favorable or unfavorable

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SP x SQAP x AQ

Total Variance

Total Variance

AP = actual cost/price per unit of materials or hours of labor

AQ = actual quantity of materials or hours of labor

SP = standard cost/price per unit of materials or hours of labor

SQ = standard quantity of materials or hours of labor

Inputs Outputs

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Price Variance

AP x AQ SP x SQ

Total Variance

SP x AQ

Price/Rate Variance

(AP - SP) x AQ*

*Favorable or unfavorable

What was paid

What shouldhave been

paid

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Usage Variance

AP x AQ SP x SQ

Total Variance

SP x AQ

Usage Variance

(AQ - SQ) x SP*

*Favorable or unfavorable

What shouldhave been

used for the level of output

What wasused

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Material Price Variance (MPV)

AP x AQ SP x SQ

Total Variance

SP x AQ

MPV

(AP - SP) x AQ*

*Favorable or unfavorable

What was paid

What shouldhave been

paid

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Material Price Variance

• Calculate Material Price Variance at

– point of purchase, or

– when materials used

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Material Quantity Variance (MQV)

AP x AQ SP x SQ

Total Variance

SP x AQ

MQV

(AQ - SQ) x SP*

*Favorable or unfavorable

What shouldhave beenused for

level of output

What wasused

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Labor Rate Variance (LRV)

AP x AQ SP x SQ

Total Variance

SP x AQ

LRV

(AP - SP) x AQ*

*Favorable or unfavorable

What was paid

What shouldhave been

paid

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Labor Efficiency Variance (LEV)

AP x AQ SP x SQ

Total Variance

SP x AQ

LEV

(AQ - SQ) x SP*

*Favorable or unfavorable

What shouldhave beenused for

level of output

What wasused

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Overhead Variances

Variable Overhead

Actual variable overhead is total of various ledger accounts

SP = Predetermined variable overhead rate

Fixed Overhead

Actual fixed overhead is total of various ledger

accounts

SP = Predetermined fixed overhead rate

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Variable Overhead Variances

What should have beenused for level of output

For actual hoursused

VOH Spending Variance

VOH Efficiency Variance

Total VOH Variance

SP x SQSP x AQ

Actual VOH

Budgeted VOH

Applied VOH

Actual

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VOH Spending Variance

• Caused by price differences

– managers have little control over prices

• Caused by shrinkage or waste

– managers should be held accountable

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Fixed Overhead Variances

SP x SQ

Actual FOH

Budgeted FOH

Applied FOH

FOH Spending Variance

FOH Volume

Variance

Total FOH Variance

What should have beenused for level of output

ConstantAmount

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FOH Spending Variance

• Calculate variance for each component

• Caused by price differences

• May reflect mismanagement of resources

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FOH Volume Variance

• Measures capacity utilization

• Caused by producing at a level that differs from the capacity level used to compute the predetermined overhead rate

• Also called the noncontrollable variance

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Alternative Overhead Variance Approaches

• One variance

• Two variance

• Three variance

• Four variance

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One Variance Approach

SP x SQ

Actual OH

Standard Cost of

OH

Total OH VarianceApplied

Overhead

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Two Variance Approach

SP x SQ

Actual OH

Budgeted OH based on Standard Quantity

Standard Cost of

OH

Budget Variance

Volume Variance

Total OH Variance Applied Overhead

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Three Variance Approach

SP x SQ

Actual OH

based on actual output

Standard OH

Volume Variance

Total OH Variance

Budgeted OHbased on

Actual Inputs

OH Spending Variance

OH Efficiency Variance

Applied Overhead

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Standard Cost Journal Entries

• Variances recorded in accounting system

• Favorable variances– Credits– Represent savings in production costs

• Unfavorable variances– Debits– Represent excess production costs

• Inventories are recorded at standard cost during the period

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Purchase of Materials(Point of Purchase Method)

Materials Accts Pay

MaterialsPrice

Variance

Debit - Unfavorable

Credit - Favorable

AP x AQ purchased

SP x AQ purchased

U F

AtStandard

Cost

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Use of Materials

WIP Materials

MaterialsQuantityVariance

SP x AQ used

SP x SQ allowed

Debit - Unfavorable

Credit - Favorable

U F

AtStandard

Cost

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Record Labor

Wages Pay

Labor Efficiency Variance

AP x AQ

WIP

SP x SQ allowed

Labor Rate Variance

Debit - Unfavorable

Credit - Favorable

AtStandard

CostU F U F

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SP x SQ Allowed

Apply Overhead Throughout the Year

SP x SQ

Allowed

WIP FOHVOHSP x SQ

Allowed

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Year-End Treatment for VOH

Enter a debit

or credit to

bring balance

to zero

VOH Efficiency Variance

VOH Spending Variance

Debit - Unfavorable

Credit - Favorable

VOH

Actual Applied---------------

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Year-End Treatment for FOH

FOH Spending Variance

Volume Variance FOH

Actual Applied-------------

Enter a debit

or credit to

bring balance

to zero

Debit - Unfavorable

Credit - Favorable

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Year-End Treatment of Variances

Material Price Variance

• Raw Materials

• WIP

• Finished Goods

• Cost of Goods Sold

All other variances

• WIP

• Finished Goods

• Cost of Goods Sold

Immaterial - Adjust Cost of Goods SoldMaterial - Prorate variances to

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Why Use Standard Cost Systems

• Clerical efficiency

• Motivation

• Planning

• Controlling - variance analysis

• Decision making

• Performance evaluation

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Setting Standards

• Appropriateness

• Attainability

– Expected standards

– Practical standards

– Ideal standards

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Trends in Standards

• Ideal Standards and Theoretical Capacity

• Adjusting standards

• Price variance on purchase versus usage

• Decline in direct labor content

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Conversion Costs

• Combine direct labor and manufacturing overhead

• Variances– Spending variance for overhead– Efficiency variances for machinery and

production costs– Volume variances for production

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Material Mix and Yield VariancesAM xAQ xAP

AM xAQ xSP

SM xAQ xSP

SM xSQ xSP

MaterialPrice

Variance

MaterialMix

Variance

MaterialYield

Variance

What should have beenused for level of output

AM - Actual MixSM - Standard Mix

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Labor Mix and Yield VariancesAM xAH xAR

AM xAH xSR

SM xAH xSR

SM xSH xSR

LaborRate

Variance

LaborMix

Variance

LaborYield

Variance

What should have beenused for level of output

M - MixH - HoursR - Rate

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Questions

• How are standards set for material, labor, and overhead?

• How is variance analysis used for control and performance evaluation?

• Why are labor and overhead elements sometimes combined into a single conversion element?

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Potential Ethical Issues

• Setting high standards to create favorable variances

• Ignoring effects of one production area on another

• Setting overhead rates too low based on high production levels to distort inventory cost and operating income

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Potential Ethical Issues

• Producing inventory only to create a favorable volume variance

• Not updating standards so that favorable variances are created

• Using low quality materials or labor to create favorable variances and low quality products