Standard Costing and Variance Analysis

Chapter 22
Standard Costing
and
Variance Analysis
Multimedia Slides by: Gail A. Mestas, MAcc, New Mexico State University
Learning Objectives
1. Define standard costs and describe
how managers use standard costs in
the management cycle.
2. Explain how standard costs are
developed and compute a standard
unit cost.
3. Prepare a flexible budget and describe
how variance analysis is used to
control costs.
Copyright Houghton Mifflin Company.
222
Learning Objectives (contd)

4. Compute and analyze direct materials
variances.
5. Compute and analyze direct labor
variances.
6. Compute and analyze manufacturing
overhead variances.
7. Explain how variances are used to
evaluate managers performance.
223
Standard Costing
Objective 1
Define standard costs and describe how
managers use standard costs in the
management cycle
224
Standard Costing
is a method of cost control
that includes a measure of actual
performance and a measure of the
difference, or variance, between
standard and actual performance
225
Standard Costs
Realistic estimates of costs
Based on analysis of both past and
projected operating costs and conditions
Provide a predetermined performance

level for the standard costing method
Usually stated in terms of cost per unit
226
Standard Costs (contd)

Based on
Past costs
Engineering estimates
Forecasted demand
Worker input
Time and motion studies
Type and quality of direct materials
227
Standard Costing
How the standard costing method
differs from the normal and actual
costing methods
228
Standard Costs and the Management Cycle
Planning
Managers use standard costs to
Develop budgets
Direct materials
Direct labor
Variable manufacturing overhead
Establish goals for product costing
229

(contd)
Executing
Managers use standard costs to
Apply dollar, time, and quality standards to
work
Collect actual cost data
2210

(contd)
Reviewing
Managers compare standard and actual
costs
Compute variances
Provide measures of performance that can be used
to control costs and evaluate managers
Analyze significant variances to determine cause
Unfavorable variances may reveal operating
problems that require correcting
Favorable variances may indicate favorable
practices that should be implemented elsewhere
2211

(contd)
Reporting
Managers use standard costs to report on
Operations
Managers performance
2212
Standard
Costing,
Variance
Analysis,
and the
Management
Cycle
2213
The Relevance of Standard Costing in

Today's Business Environment
Manufacturing companies
Increased automation
Significant decrease in direct labor cost
Corresponding decline in importance of labor-related
standard costs and variances
Many companies now apply standard costing only to

direct materials and manufacturing overhead
Service organizations
Use standard costing for direct labor and service
overhead costs
2214
Discussion
Q. What is the main difference between
the standard costing and normal
costing methods?
A. The standard costing method uses
estimated costs for direct materials and
direct labor, whereas the normal costing
method uses actual costs for these items
The methods are similar in that both use
estimated costs for manufacturing
overhead
2215
Computing Standard Costs

Objective 2
Explain how standard costs are developed
and compute a standard unit cost
2216
Computing Standard Costs

Fully integrated standard costing system
Uses standard costing for all elements of product
cost
Direct materials
Direct labor
Manufacturing overhead
Inventory accounts and Cost of Goods Sold

account
Maintained and reported in terms of standard costs
Standard unit costs used to compute account balances
Actual costs recorded separately
Actual and standard costs can then be compared
2217
Computing Standard Costs (contd)

Six elements of a standard unit cost for
a manufactured product
1. Price standard for direct materials
2. Quantity standard for direct materials
3. Standard for direct labor rate
4. Standard for direct labor time
5. Standard for variable overhead rate
6. Standard for fixed overhead rate
2218
Standard Direct Materials Cost

is found by multiplying the price
standard for direct materials by the
quantity standard for direct materials
2219
Standard Direct Materials Cost (contd)

Direct materials price standard
Careful estimate of the cost of a specific
direct material in the next accounting
period
Developed by purchasing agent or
purchasing department
Takes into account
All possible price increases
Changes in available quantities
New sources of supply
2220
Standard Direct Materials Cost (contd)

Direct materials quantity standard
Estimate of the amount of direct materials that will
be used in the accounting period
Includes scrap and waste
Influenced by
Product engineering specifications

Quality of direct materials
Age and productivity of machinery
Quality and experience of work force
Established and monitored by

Production managers
Management accountants
Others
Engineers, purchasing agents, machine operators
2221
Standard Direct Labor Cost

for a product, task, or job
is calculated by multiplying
the standard wage for direct labor by
the standard hours of direct labor
2222
Standard Direct Labor Cost (contd)

Direct labor rate standard
Hourly direct labor rate expected to prevail
during the next accounting period
For each function or job classification
Average standard rate is developed for

each task
Standard rate is used even if worker is paid
more or less than the standard rate
Easy to establish
Rates are set by labor unions or defined by the
company
2223
Standard Direct Labor Cost (contd)

Direct labor time standard
Expected time required for each department,
machine, or process to complete the production of
one unit or one batch of output
Developed using
Current time and motion studies of workers and
machines
Records of past performance
Should be revised when

Machinery is replaced
Quality of work force changes
2224
Standard Manufacturing Overhead Cost

is the sum of the estimates of variable
and fixed overhead costs in the next
accounting period
Two parts
Variable costs and fixed costs
Compute separately because their cost
behavior differs
2225

(contd)
Standard variable overhead rate

Computed by dividing the total budgeted
variable overhead costs by an expression
of capacity, such as number of standard
direct labor hours or standard machine
hours
2226

(contd)
Standard fixed overhead rate

Computed by dividing the total budgeted
fixed overhead costs by an expression of
capacity, usually normal capacity in terms of
standard hours or units
Denominator expressed in same terms as the
variable overhead rate
Normal capacity is the level of

operating capacity needed to
meet expected sales demand
Its use ensures that all fixed OH* costs

have been applied to units produced by
the time normal capacity is reached
*Overhead
2227
Total Standard Unit Cost

Remember When,
Inc., recently
updated the
standards for its
line of watches
Compute the total

standard cost of
one watch
2228
Discussion
Q. Why are the variable and fixed
components for the standard
manufacturing overhead cost
computed separately?
A. Variable costs and fixed costs are
computed separately because their cost
behavior differs
2229
Variance Analysis
Objective 3
Prepare a flexible budget and describe how
variance analysis is used to control costs
2230
Variance Analysis
is the process of computing the
differences between standard costs and
actual costs and identifying the causes
of those differences
Managers use
Flexible budgets to improve variance analysis
Variance analysis to control costs
2231
The Role of Flexible Budgets in Variance

Analysis
Accuracy of variance analysis depends

greatly on the type of budget managers
use when comparing variances
Static budget
Flexible budget
2232

Analysis (contd)
Static budget
Also called fixed budget
Forecasts revenues and expenses for just
one level of sales and just one level of
output
Does not allow for changes in output level
If actual output differs from budgeted output, a
variance between actual and budgeted amounts will
occur
Cannot judge performance accurately
2233
Performance Report Using Data from a Static

Budget
2234

Analysis (contd)
Flexible budget
Also called variable budget
Summary of expected costs for a range of
activity levels
Provides forecasted data that can be adjusted
for changes in output level
Used primarily as a cost control tool in

evaluating performance
2235

Analysis (contd)
Flexible budget formula

An equation that determines the expected,
or budgeted, cost for any level of output
Includes
Per unit amount for variable costs
Total amount for fixed costs
Total Budgeted Costs (Variable Cost per Unit No. of Units Produced) Budgeted Fixed Costs
2236
Flexible Budget for Evaluation of Overall

Performance
2237

Analysis (contd)
The flexible budget formula for Remember
When, Inc. is
Total Budgeted Costs ($3.71 No. of Units Produced) $9,450
The company produced 19,100 units during

20x5
Total Budgeted Costs ($3.71 19,100) $9,450
$70,861 $9,450
$80,311
2238
Performance Report Using Data from a

Flexible Budget
2239
Using Variance Analysis to Control Costs

Step 1
Compute variance
Is the variance
significant?
No
No corrective
action needed
Yes
Step 2
Analyze variance to
determine its cause
Step 3
Select performance
measures to correct
the problem
Step 4
Take corrective action
2240
Using Variance Analysis to Control Costs

(contd)
Computing the amount of a variance is

important
But, this does not prevent the variance
from reoccurring
Must determine its cause
Select performance measures that will help
track the problem
Must then find the best solution
2241
Discussion
Q. What is the flexible budget formula?
A. It is an equation used to determine
expected, or budgeted cost for any level
of output
Total Budgeted Costs (Variable Cost per Unit
No. of Units Produced)
Budgeted Fixed Costs
2242
Computing and Analyzing Direct Materials

Variances
Objective 4
Compute and analyze direct materials
variances
2243
Computing and Analyzing Direct Materials

Variances
To control operations, managers

compute and analyze variances for
Whole cost categories
Such as total direct materials costs
Elements of those categories

Such as the price and quantity of each direct
material
The more detailed the analysis of a variance is, the
more effective managers will be in controlling costs
2244
Computing Direct Materials Variances

Total direct materials cost variance
Difference between the standard cost and
actual cost of direct materials
2245

Cambria Company makes leather bags. Each bag should use 4 feet of
leather (standard quantity), and the standard price of leather is $6.00
per foot. During August, the company purchased 760 feet of leather
costing $5.90 per foot and used the leather to produce 180 bags
Standard cost
Standard price standard quantity
$6.00 per foot (180 bags 4 feet per bag)
$6.00 per foot 720 $4,320
Less actual cost
This is an
unfavorable
(U) situation
Actual price actual quantity

$5.90 per foot 760 4,484
Total direct materials cost variance
$ 164 (U)
Actual cost > standard cost
2246

(contd)
Total direct materials cost variance must

be broken into two parts to find the
cause of the variance
Direct materials price variance
Direct materials quantity variance
2247

(contd)
Direct materials price variance
Difference between the standard price and the
actual price per unit multiplied by the actual
quantity purchased
Also called the direct materials spending or rate
variance
Direct Materials Price Variance (Standard Price Actual Price)
Actual Quantity
($6.00 $5.90) 760 feet
$76 (F)
Because the company paid less for direct materials
than it expected, the variance is favorable (F)
Copyright Houghton Mifflin Company. All rights reserved.
2248

(contd)
Direct materials quantity variance
Difference between the standard quantity and the
actual quantity used multiplied by the standard
price
Also called the direct materials efficiency or usage
variance
Direct Materials Quantity Variance Standard Price (Standard Quantity
Allowed Actual Quantity)
$6.00 per foot (720 feet 760 feet)
$240 (U)
Because the company used more for direct materials
than it expected, the variance is unfavorable (U)
2249

(contd)
Test calculations of variances

If correct, the net of the direct materials
price variance and direct materials quantity
variance will equal the total direct materials
cost variance
2250
Diagram of Direct Materials Variance Analysis
2251
Analyzing and Correcting Direct Materials

Variances
Company had been experiencing direct
materials price variances and quantity
variances for some time
For three months, managers tracked
Purchasing activities
Discovered that the purchasing agent had purchased,
without authorization, a lower grade of leather at a
reduced price
After analysis, engineers determined the lower grade of
leather was not appropriate
Scrap and rework

Discovered that inferior leather was causing the
unfavorable quantity variance
2252
Discussion
Q. What is the direct materials price
variance?
A. It is the difference between the standard
price and the actual price per unit
multiplied by the actual quantity
purchased. It is also called the direct
materials spending or rate variance
Direct Materials Price Variance (Standard Price Actual Price)
Actual Quantity
2253
Computing and Analyzing Direct Labor

Variances
Objective 5
Compute and analyze direct labor
variances
2254
Computing Direct Labor Variances

Total direct labor cost variance
Difference between the standard direct
labor cost for good units produced and
actual direct labor costs
Good units are the total units produced less
units that are scrapped or need to be reworked
2255
Computing Direct Labor Variances (contd)

At Cambria Company, each leather bag requires 2.4 standard direct
labor hours, and the standard direct labor rate is $8.50 per hour.
During August, 450 direct labor hours were used to make 180 bags at
an average pay rate of $9.20 per hour
Standard cost
Standard rate standard hours allowed
$8.50 per foot (180 bags 2.4 hours per bag)
$8.50 per hour 432 hours $3,672
Less actual cost
Actual rate actual hours

$9.20 per hour 450 hours 4,140
Total direct labor cost variance
$ 468 (U)
2256
Total direct labor cost variance must be

broken onto two parts to find the cause
of the variance
Direct labor rate variance
Direct labor efficiency variance
2257

Direct labor rate variance
Difference between the standard direct labor rate
and the actual direct labor rate multiplied by the
actual direct labor hours worked
Also called the direct labor spending variance
Direct Labor Rate Variance (Standard Rate Actual Rate)
Actual Hours
($8.50 $9.20) 450 hours
$315 (U)
Because the company paid more per hour for direct
labor than it expected, the variance is unfavorable
2258

Direct labor efficiency variance
Difference between the standard direct labor hours
allowed for good units produced and the actual
direct labor hours worked multiplied by the standard
direct labor rate
Also called the direct labor quantity or usage
variance
Direct Labor Efficiency Variance Standard Rate (Standard Hours Allowed
Actual Hours)
$8.50 per hour (432 hours 450 hours)
$153 (U)
Because the company used more direct labor hours
than it expected, the variance is unfavorable (U)
2259

If correct, the net of the direct labor rate
variance and direct labor efficiency
variance will equal the total direct labor
cost variance
2260
Diagram of
Direct Labor
Variance
Analysis
2261
Analyzing and Correcting Direct Labor

Variances
Managers analyzed
Employee time cards
An assembly worker who had fallen ill was replaced with
a machinery operator from another department
Assembly worker is paid $8.50 per hour and the machine
operator is paid $9.20 per hour
Machine operator not as skilled as the assembly worker
Temporary situation so no corrective action taken
Materials handling
Parts delivered late on five occasions
Will track delivery time and number of delays for next three
months
2262
Discussion
Q. What is the direct labor efficiency
variance?
A. The direct labor efficiency variance is the
difference between the standard direct
labor hours allowed for good units
produced and the actual direct labor
hours worked multiplied by the standard
direct labor rate. It is also called the
direct labor quantity or usage variance
Direct Labor Efficiency Variance Standard Rate (Standard Hours
Allowed Actual Hours)

2263
Computing and Analyzing Manufacturing

Overhead Variances
Objective 6
Compute and analyze manufacturing
overhead variances
2264
Computing and Analyzing Manufacturing

Overhead Variances
Controlling variable and fixed overhead costs
is more difficult for managers than controlling
direct materials and direct labor costs
Responsibility for manufacturing overhead costs is
hard to assign
Fixed overhead costs
Unavoidable past costs
Not under the control of any department manager
Variable overhead costs

Some control possible if they can be related to
departments or activities
2265
Using a Flexible Budget to Analyze

Manufacturing Overhead Variances
Cambria Companys managers use a

flexible budget to evaluate performance
For manufacturing overhead costs only
Evaluate activity level using direct labor
hours
Variable costs vary with the number of direct
labor hours worked
Total fixed overhead costs remain constant
2266
Flexible
Budget for
Evaluation of
Manufacturing
Overhead
Costs
2267
Using a Flexible Budget to Analyze

Manufacturing Overhead Variances
Flexible budget formula
Total Budgeted OH Costs (Variable Costs per Direct Labor Hour
Number of Direct Labor Hours)
Budgeted Fixed OH Costs
Flexible budget formula when applied to

Cambrias data
Total Budgeted OH Costs ($5.75 No. of Direct Labor Hours)
$1,300
To find the total monthly budgeted overhead costs,
insert direct labor hours into the flexible budget
2268
Computing Manufacturing Overhead

Variances
Total manufacturing overhead variance

Difference between actual overhead costs
and standard overhead costs
Standard overhead costs are applied to
production using a standard overhead rate
Standard overhead rate has two parts
Variable
Fixed
2269

Variances (contd)
For Cambria Company, the standard variable overhead rate is $5.75
per direct labor hour (from the flexible budget). Total budgeted
overhead is $1,300 by normal capacity, which is 400 direct labor
hours.
Fixed overhead rate

Budgeted fixed overhead normal capacity
$1,300 400 direct labor hours $3.25
Total standard overhead rate
Standard variable overhead rate standard fixed overhead rate
$5.75 $3.25 $9.00
2270

Variances (contd)
For Cambria Company, the standard variable overhead rate is $5.75
per direct labor hour (from the flexible budget). Total budgeted
overhead is $1,300 by normal capacity, which is 400 direct labor
hours.
Standard OH costs applied to good units produced

Total standard OH rate ( No. good units produced
standard hours allowed)
$9.00 per direct labor hour (180 bags 2.4 hours per bag) $3,888
4,100
Less actual overhead costs
Total manufacturing overhead variance
$ 212 (U)
This amount can be divided into variable overhead

variances and fixed overhead variances
2271
Variable Overhead Variance

Total variable overhead variance
Difference between actual variable
overhead costs and the standard variable
overhead costs that are applied to good
units produced using the standard variable
rate
2272
Variable Overhead Variances (contd)

At Cambria Company, each leather bag requires 2.4 standard labor
hours and the variable overhead rate is $5.75 per direct labor hour.
During August, the company incurred $2,500 of variable overhead
costs
Overhead applied to good units produced

Standard variable rate standard direct labor hours allowed
$5.75 per hour (180 bags 2.4 hours per bag)
Less actual cost
$5.75 per hour 432 hours $2,484

2,500
Total variable overhead cost variance
$ 16 (U)
2273
Diagram of
Variable
Overhead
Variance
Analysis
2274

must be broken into two parts to find the
Variable overhead spending variance
Variable overhead efficiency variance
2275

Variable overhead spending variance
Difference between the budgeted variable
overhead costs at actual hours and actual
variable overhead
Variable OH Spending Variance Budgeted Variable Costs at Actual Hours
Actual Variable Overhead
(Standard Variable Rate Actual
Hours Worked) Actual Variable OH
($5.75 450 hours) $2,500
$87.50 (F)
2276

Difference between the standard direct
labor hours allowed for good units
produced and the actual hours worked
multiplied by the standard variable
overhead rate
Variable OH Efficiency Variance Standard Variable Rate (Standard
Hours Allowed Actual Hours)
2277

Compute standard hours allowed
Standard Hours Allowed Good Units Produced Standard Hours per Bag
180 bags 2.4 hours per bag
432 hours
Compute variable overhead efficiency variance

Variable OH Efficiency Variance Standard Variable Rate (Standard
Hours Allowed Actual Hours)
$5.75 (432 hours 450 hours)

$103.50 (U)
2278

If correct, the net of the variable overhead
spending variance and variable overhead
efficiency variance will equal the total
variable overhead cost variance
2279
Fixed Overhead Variances

Total fixed overhead variance
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
2280
Diagram of
Fixed
Overhead
Variance
Analysis
2281
Fixed Overhead Variances (contd)

At Cambria Company, each leather bag requires 2.4 standard direct
labor hours and the standard fixed overhead rate is $3.25 per direct
labor hour. During August, the company incurred $1,600 of actual
fixed overhead costs
Overhead applied to good units produced

Standard fixed rate standard direct labor hours allowed
$3.25 per hour (180 bags 2.4 hours per bag)
$3.25 per hour 432 hours $1,404
Less actual cost
1,600
Total fixed overhead cost variance
$ 196 (U)
2282

Total fixed overhead cost variance must
be broken into two parts to find the
Fixed overhead budget variance
Fixed overhead volume variance
2283

Difference between the budgeted and
actual fixed overhead costs
Also called budgeted fixed overhead
variance
Fixed OH Budget Variance Budgeted Fixed Overhead
Actual Fixed Overhead
$1,300 $1,600
$300 (U)
2284

Difference between budgeted fixed
overhead costs and manufacturing
overhead costs applied to production using
the standard fixed overhead rate
Standard fixed OH applied for 432 direct labor hours
$3.25 per direct labor hour (180 bags 2.4 hours per bag)
Less total budgeted fixed overhead
$1,404
1,300
$ 104 (F)
2285

A volume variance will occur if more or less
than normal capacity is used
Fixed overhead volume variance measures the
use of existing facilities and capacity
Favorable overhead volume variance
Capacity exceeds the expected amount
Unfavorable overhead volume variance

Company operates at a level below normal capacity
May be in best interest of company during periods of slow
sales
Means company is not building up excess inventory
2286
Summary of Manufacturing Overhead

Variances
2287
Analyzing and Correcting Manufacturing

Overhead Variances
2288
Discussion
Q. What four variances are used to
analyze the total manufacturing
overhead variance?
A. Variable overhead spending variance
2289
Using Cost Variances to Evaluate Managers

Performance
Objective 7
Explain how variances are used to
evaluate managers performance
2290

Performance
The effectiveness and fairness of a

manager's performance evaluation
depends on
Human factors
Company policies
Should be based on input from managers and
employees
Should specify procedures that managers are
to use
2291

Performance (contd)
Procedures that should be specified for
managers
Preparing operational plans
Assigning responsibility for carrying out the
operational plans
Communicating operational plans to key personnel
Evaluating performance in each area of
responsibility
Identifying causes of significant variances from the
operational plan
Taking corrective action to eliminate problems
2292

Performance (contd)
Variance analysis
Provides detailed data about differences
between standard and actual costs
Effective at pinpointing efficient and inefficient
operating areas
Basic comparison of budgeted and actual data not
as effective
2293

Performance (contd)
Effective managerial performance reports
based on standard costs and related
variances should
Identify
Causes of the differences
Personnel involved
Corrective actions taken
Be tailored to the managers specific areas of

responsibility
Explain clearly and accurately in what way the
managers department did or did not meet operating
expectations
Managers should only be held accountable for cost areas under their control
2294

Performance (contd)
Managerial performance reports should

Summarize all cost data
Include variances for direct materials,
direct labor, and manufacturing overhead
Identify
Causes of variances
Corrective actions taken
2295

Performance (contd)
The occurrence of a variance does not

indicate poor performance
If a variance consistently occurs, its
cause is not identified, and no
corrective action is taken, it may
indicate poor performance on the part
of the manager
2296
Discussion
Q. What items should be included in an
effective managerial performance
report?
A. Summarization of all cost data
Variances for direct materials, direct
labor, and manufacturing overhead
Identification of the causes of the
variances, personnel involved, and any
corrective actions taken
2297
Time for Review

1. Define standard costs and describe
how managers use standard costs in
the management cycle
2. Explain how standard costs are
developed and compute a standard
unit cost
3. Prepare a flexible budget and describe
how variance analysis is used to
control costs
2298
And Finally
4. Compute and analyze direct materials
variances
5. Compute and analyze direct labor
variances
6. Compute and analyze manufacturing
overhead variances
7. Explain how variances are used to
evaluate managers performance
2299

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Chapter 22

Learning Objectives (contd)

Copyright Houghton Mifflin Company.

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Provide a predetermined performance

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Standard Costs (contd)

Copyright Houghton Mifflin Company.

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Standard Costs and the Management Cycle

Establish goals for product costing

Copyright Houghton Mifflin Company.

Standard Costs and the Management Cycle

Copyright Houghton Mifflin Company.

Standard Costs and the Management Cycle

Standard Costs and the Management Cycle

Copyright Houghton Mifflin Company.

The Relevance of Standard Costing in

Many companies now apply standard costing only to

Copyright Houghton Mifflin Company.

Computing Standard Costs

Copyright Houghton Mifflin Company.

Computing Standard Costs

Inventory accounts and Cost of Goods Sold

Copyright Houghton Mifflin Company.

Computing Standard Costs (contd)

Standard Direct Materials Cost

Copyright Houghton Mifflin Company.

Standard Direct Materials Cost (contd)

Copyright Houghton Mifflin Company.

Standard Direct Materials Cost (contd)

Product engineering specifications

Established and monitored by

Copyright Houghton Mifflin Company.

Standard Direct Labor Cost

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Standard Direct Labor Cost (contd)

Average standard rate is developed for

Standard Direct Labor Cost (contd)

Should be revised when

Standard Manufacturing Overhead Cost

Standard Manufacturing Overhead Cost

Standard variable overhead rate

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Standard Manufacturing Overhead Cost

Standard fixed overhead rate

Normal capacity is the level of

Its use ensures that all fixed OH* costs

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Total Standard Unit Cost

Compute the total

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The Role of Flexible Budgets in Variance

Accuracy of variance analysis depends

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The Role of Flexible Budgets in Variance

Performance Report Using Data from a Static