CHAPTER 1



CHAPTER 22

Standard Costing and Variance Analysis

reviewing the chapter

Objective 1: Define standard costs, and describe how managers use these costs.

1. Standard costs are realistic estimates of costs based on analyses of both past and projected costs and operating conditions. They provide a standard, or predetermined, performance level for use in standard costing, a method of cost control that also includes a measure of actual performance and a measure of the difference, or variance, between standard and actual performance. This method of measuring and controlling costs differs from the actual and normal costing methods in that it uses estimated costs only to compute all three elements of product cost—direct materials, direct labor, and overhead. Standard costing is especially effective for managing cost centers.

2. In the planning step of the management process, managers use standard costs to develop budgets for direct materials, direct labor, and variable overhead. These estimated costs not only serve as targets for product costing; they are also useful in making decisions about product distribution and pricing. In performing daily operations, managers use standard costs to measure expenditures and to control costs as they occur. At the end of an accounting period, managers evaluate operating performance by comparing actual costs with standard costs and computing variances. The variances provide measures of performance that can be used to control costs. Managers also use standard costs to report on operations and managerial performance. Variance reports tailored to a manager’s responsibilities communicate useful information about how well operations are proceeding and how well the manager is controlling them.

Objective 2: Explain how standard costs are developed, and compute a standard unit cost.

3. A fully integrated standard costing system uses standard costs for all the elements of product cost. 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.

4. A standard unit cost for a manufactured product has six elements: (a) a direct materials price standard, (b) a direct materials quantity standard, (c) a direct labor rate standard, (d) a direct labor time standard, (e) a standard variable overhead rate, and (f) a standard fixed overhead rate. (A standard unit cost for a service includes only the elements that relate to labor and overhead.)

5. To compute a standard cost per unit of output, the following amounts must be identified:

a. Standard Direct Materials Cost = Direct Materials Price Standard × Direct Materials Quantity Standard

(1) The direct materials price standard is the estimated cost of a specific direct material to be used in the next accounting period.

(2) The direct materials quantity standard is the estimated amount of direct materials to be used in the period.

b. Standard Direct Labor Cost = Direct Labor Rate Standard × Direct Labor Time Standard

(1) The direct labor rate standard is the hourly direct labor cost expected to prevail during the next accounting period for each function or job classification.

(2) The direct labor time standard is the expected time required for each department, machine, or process to complete the production of one unit or one batch of output.

c. Standard Overhead Cost = Standard Variable Overhead Rate + Standard Fixed Overhead Rate

(1) The standard variable overhead rate is the total budgeted variable overhead costs divided by an appropriate application base, such as standard machine hours or standard direct labor hours.

(2) The standard fixed overhead rate is the total budgeted fixed overhead costs divided by an expression of capacity, usually normal capacity in terms of standard hours or units.

6. A product’s standard unit cost is determined by adding the standard direct materials cost, the standard direct labor cost, and the standard overhead cost.

Objective 3: Prepare a flexible budget, and describe how managers use variance analysis to control costs.

7. Variance analysis is the process of computing the differences between standard (or budgeted) costs and actual costs and identifying the causes of those differences.

8. The accuracy of variance analysis depends to a large extent on the type of budget managers use when comparing variances. A flexible budget (also called a variable budget) is a summary of expected costs for a range of activity levels. Unlike a static budget, which forecasts revenues and expenses for just one level of sales and just one level of output, a flexible budget provides forecasted data that can be adjusted for changes in the level of output. It presents budgeted fixed and variable costs and their totals, as well as the budgeted variable cost per unit. The variable cost per unit and total fixed costs are components of the flexible budget formula, an equation that can be used to determine the expected, or budgeted, cost for any level of output. The formula is as follows: (Variable Cost per Unit × Number of Units Produced) + Budgeted Fixed Costs = Total Budgeted Costs. The total budgeted costs can be compared with actual costs to measure the performance of individuals and departments.

9. A flexible budget improves the accuracy of variance analysis, which is a four-step approach to controlling costs. First, managers compute the amount of the variance. If the amount is insignificant, no corrective action is needed. If the amount is significant, managers analyze the variance to identify its cause. In identifying the cause, they are usually able to pinpoint the activities that need to be monitored. They then select performance measures that will enable them to track those activities, analyze the results, and determine the action needed to correct the problem. Their final step is to take the appropriate corrective action.

Objective 4: Compute and analyze direct materials variances.

10. The total direct materials cost variance is the difference between the standard cost and the actual cost of direct materials. When standard costs exceed actual costs, the variance is favorable (F). When the reverse is true, the variance is unfavorable (U). The total direct materials cost variance is broken down into the direct materials price variance and direct materials quantity variance.

a. Direct Materials Price Variance = (Standard Price – Actual Price) × Actual Quantity

b. Direct Materials Quantity Variance = Standard Price × (Standard Quantity Allowed – Actual Quantity)

Objective 5: Compute and analyze direct labor variances.

11. The total direct labor cost variance is the sum of the direct labor rate variance and the direct labor efficiency variance.

a. Direct Labor Rate Variance = (Standard Rate – Actual Rate) × Actual Hours

b. Direct Labor Efficiency Variance = Standard Rate × (Standard Hours Allowed – Actual Hours)

Objective 6: Compute and analyze overhead variances.

12. Total overhead variance is the difference between actual overhead costs and standard overhead costs. The latter costs are applied to production by using a standard overhead rate. A standard overhead rate has two parts: a variable rate and a fixed rate. The standard fixed rate is calculated by dividing total budgeted fixed overhead by normal capacity. The total overhead variance can be broken down into variable overhead variances and fixed overhead variances.

a. The total variable overhead variance is the difference between the variable overhead spending variance and the variable overhead efficiency variance. The variable overhead spending variance is computed by multiplying the actual hours worked by the difference between actual variable overhead costs and the standard variable overhead rate. The variable overhead efficiency variance is the difference between the standard direct labor hours allowed for good units produced and the actual hours worked multiplied by the standard variable overhead rate per hour.

b. The total fixed overhead variance is the difference between actual fixed overhead costs and the standard fixed overhead costs that are applied to good units produced using the standard fixed overhead rate. For effective performance evaluation, managers break down the total fixed overhead cost variance into two additional variances: the fixed overhead budget variance and the fixed overhead volume variance. The fixed overhead budget variance is the difference between budgeted and actual fixed overhead costs. The fixed overhead volume variance is the difference between budgeted fixed overhead costs and the overhead costs that are applied to production using the standard fixed overhead rate. Because the fixed overhead volume variance gauges the use of existing facilities and capacity, a volume variance will occur if more or less than normal capacity is used.

c. The total overhead variance is also the amount of over- or underapplied overhead, which must be computed and reconciled at the end of each accounting period. By breaking down the total overhead variance into variable and fixed variances, managers can more accurately control costs and reconcile their causes. An analysis of these two overhead variances will help explain why the amount of overhead applied to units produced differs from the actual overhead costs incurred.

Objective 7: Explain how variances are used to evaluate managers’ performance.

13. To ensure that performance evaluation is effective and fair, a company’s evaluation policies should be based on input from managers and employees and should be specific about the procedures managers are to follow. The evaluation process becomes more accurate when managerial performance reports include variances from standard costs. A managerial performance report based on standard costs and related variances should identify the causes of each significant variance, as well as the personnel involved, and the corrective actions taken. It should be tailored to the cost center manager’s specific areas of responsibility. Managers should be held accountable only for the cost areas under their control.

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