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Module 5: MANAGEMENT ACCOUNTING CONCEPTS AND TECHNIQUES FOR

PLANNING AND CONTROL

Standard Costing and Variance Analysis

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Dr. Siegfried M. Erorita, cpa

Standard costing and variance analysis

-Journal entries
-Direct material variance (quantity, price usage, purchase price,mix and yield)
-Direct labor variance (efficiency, rate, mix and yield)
-Factory overhead variance – two-way method (controllable and
volume); three-way method (spending, variable efficiency and
volume); four-way method (variable spending, fixed spending,
variable efficiency and volume)

Standard Costs—Management by Exception. A standard is a benchmark or “norm” for measuring

performance. In managerial accounting, standards relate to the prices and quantities of inputs used in making goods
or providing services.

1. Quantity standards. A quantity standard specifies how much of an input, such as labor time or raw materials,
should be used to make a unit of product or to provide a unit of service. To measure performance, the actual
quantity of an input that is used is compared to the standard quantity allowed for the actual output of the period.

2. Price standards. A price standard specifies how much each unit of input should cost. Actual costs of inputs are
compared to these standards.

Setting Standard Costs. Standards should be set so that they encourage efficient operations.

1. Ideal versus practical standard

• Ideal standards allow for no machine breakdowns or work interruptions, and require that workers operate
at peak efficiency 100% of the time.
• Practical standards are “tight, but attainable.” They allow for normal machine downtime and employee
rest periods and can be attained through reasonable, but highly efficient, efforts by the average worker.

2. Setting direct materials standards.

• The standard price per unit for a direct material should reflect the final, delivered cost of the material,
net of any discounts taken.
• The standard quantity of a direct material per unit of output in a traditional standard cost system
reflects the amount of material going into each unit of finished product, as well as an allowance for
unavoidable waste, spoilage, and other normal inefficiencies

3. Setting direct labor standards.

• The standard rate per hour for direct labor should include not only wages, but also fringe benefits and
other labor-related costs. Ordinarily, the standard rate is an average that assumes a specific mix of higher
and lower paid workers.

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 • The standard direct labor-hours per unit of output is the direct labor time allowed to complete a unit of
product. In traditional standard cost systems this standard time includes allowances for coffee breaks,
personal needs of employees, clean-up, and machine downtime.

4. Setting variable manufacturing overhead standards. Standards for variable manufacturing overhead are
usually expressed in terms of direct labor-hours or machine-hours. The rate represents the variable portion of
the predetermined overhead rate . The standard hours for variable overhead represent the standard hours for
whatever base is used to apply overhead cost to products or services. If direct labor-hours is the basis for
applying overhead to products, then the quantity standard for variable manufacturing overhead will be the
quantity standard for direct labor.

5. Standard cost card. A standard cost card is a summary of the standard costs of inputs required to complete one
unit of product.

6. Standards and budgets. One distinction between a standard and a budget is that a standard is a unit amount,
whereas a budget is a total amount. In effect, a standard can be viewed as the budgeted cost for one unit.

Variance Analysis. A variance is the difference between standard prices and actual prices or between standard
quantities and actual quantities

1. Price variance. A price variance is the difference between the how much should have been paid to acquire an
input and how much was actually paid.

2. Quantity variance. A quantity variance is the difference between how much of an input should have been used
to produce the actual output of the period and how much was actually used, multiplied by the standard price of
the input.

3. Alternative methods. As an alternative to the general model, variances can be computed using formulas. The
formulas for the price variance are:

Price (rate) variance = (AQ  AP) – (AQ  SP)

or
Price (rate) variance = AQ (AP – SP)

The formulas for the quantity variance are:

Quantity (efficiency) variance = (AQ  SP) – (SQ  SP)

or
Quantity (efficiency) variance = SP (AQ – SQ)
Where:
AQ = Actual quantity of inputs purchased (or used)
AP = Actual price per unit of inputs purchased
SP = Standard price per unit of input
SQ = Standard input allowed for the actual output. This equals the standard input per unit of output
multiplied by the actual output of the period.

Computation and Interpretation of Standard Cost Variances. Since direct material, direct labor, and
variable overhead are all variable manufacturing costs, the process of computing price and quantity variances for
each of these cost categories is the same. The general model, or the formulas, can be used in each case to compute

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the variances. The only complication is deciding in each case whether the actual quantity of inputs refers to the actual
quantity purchased or the actual quantity used.

1. Direct material variances.

a. The materials price variance is the difference between what is paid for a given quantity of materials and
what should have been paid according to the standard.

b. The materials quantity variance is the difference between the quantity of materials used in production and
the quantity that should have been used according to the standard—all multiplied by the standard price per
unit of input.

2. Direct labor variances.

a. The labor rate variance measures any deviation from standard in the average hourly rate paid to direct labor
workers. A labor rate variance can arise for a number of reasons. The mix of workers, and hence of lower
and higher wage rates, can be different from what was planned due to absences, changes in the composition
of the work force, and a variety of other circumstances. Overtime can give rise to a labor rate variance.

b. The quantity variance for direct labor is called the labor efficiency variance. When the direct labor
workforce is adjusted to changes in workloads, the main causes of the labor efficiency variance include
poorly trained workers, poorly motivated workers, poor quality materials which require more labor time and
processing, faulty equipment which causes breakdowns and work interruptions, and poor supervision

3. Variable overhead variances.

a. The variable overhead spending variance is computed as follows when the variable overhead rate is
expressed in terms of direct labor-hours:

Variable overhead spending variance =

Actual overhead cost – Actual direct labor-hours  Variable overhead rate

The variable overhead spending variance compares actual spending on variable overhead to the amount of
spending that would be expected, given the actual direct labor-hours for the period.

b. The variable overhead efficiency variance is computed as follows when the variable overhead rate is
expressed in terms of direct labor-hours:

Variable overhead efficiency variance =

(Actual direct labor-hours – Standard direct labor-hours allowed)  Variable overhead rate

Variance Analysis and Management by Exception. Management by exception means that management’s
attention should be directed towards areas where plans are not being met. Standard cost variances signal performance
different from what was expected.

General Ledger Entries to Record Formal entry of variances in the accounting records gives variances greater
emphasis and simplifies the bookkeeping process. It is important to note that unfavorable variances are debit entries
and favorable variances are credit entries.

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Potential Problems with Using Standard Costs.
1. Standard cost variance reports are usually prepared on a monthly basis and are released long after the end of the
month. As a consequence, the information in the reports may be so stale that it is almost useless

2. Management by exception, by its nature, tends to focus on the negative. Moreover, if variances are used as a
club, subordinates may be tempted to cover up unfavorable variances or take actions that are not in the best
interests of the company to make sure the variances are favorable.

3. Labor quantity standards and labor efficiency variances make two important assumptions. First, they assume
that the production process is labor-paced; if labor works faster, output will go up. Second, these computations
assume that labor is a variable cost.

4. In some cases, a “favorable” variance can be worse than an “unfavorable” variance

5. There may be a tendency with standard cost reporting systems to emphasize meeting the standards to the
exclusion of other important

6. Continual improvement—not just meeting standards—may be necessary to survive in the current competitive
environment.

Balanced Scorecard. A balanced scorecard consists of an integrated set of performance measures that are derived
from and support the company’s strategy throughout the organization.

Common characteristics of balanced scorecards.

a. It should be possible, by examining a company’s balanced scorecard, to infer its strategy and the
assumptions underlying that strategy.

b. The balanced scorecard should emphasize continuous improvement rather than just meeting present
standards or targets.

c. Some of the performance measures on the balanced scorecard should be non-financial. Financial measures
tend to be lagging rather than leading indicators. In addition, for most employees, non-financial measures
may be easier to understand and to influence than financial measures.

d. The entire company has a comprehensive scorecard, but the scorecards for individuals should contain only
those performance measures they can actually influence. As you go lower in the organization, you are likely
to observe fewer performance measures on individuals’ scorecards and that more of them will be non-
financial.

e. Most, but certainly not all, balanced scorecards will contain performance measures that fall into at least four
main categories: financial, customer, internal business process, and learning and growth. The ultimate
objectives of the organization are usually financial, but financial results depend on customers’ perceptions
of the company’s products and services. In order to improve customers’ perceptions of products and
services, it is usually necessary to improve internal business processes so that the products and services are
actually better. And in order to improve the business processes, it is necessary that employees learn.

2. The balanced scorecard as a motivation and feedback mechanism. The performance measures on the
balanced scorecard provide motivation and feedback. If an employee does something to improve a performance

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 measure and the measure actually improves, the employee is encouraged. If the performance measure does not
improve, the employee can adjust what he or she was doing and try again.

3. The balanced scorecard provides a reality check for the company’s strategy. If improvement in one area
does not lead to expected improvement elsewhere, something may be wrong with the theory underlying the
strategy.
4. Other internal business process performance measures.

a. Delivery Cycle Time. This is the total elapsed time between when an order is placed by a customer and
when it is shipped to the customer. Part of this time is wait time that occurs before the order is placed into
production. The remainder of this time is the throughput time, which is defined below.

b. Throughput (Manufacturing Cycle) Time. This is the total elapsed time between when an order is started
into production and when it is shipped to the customer. It consists of process time, inspection time, move
time, and queue time. The only element that adds value is processing time. Inspection time, move time,
queue time, and their associated activities do not add value and should be minimized.

c. Manufacturing Cycle Efficiency (MCE). MCE is the ratio of value-added time (i.e., process time) to total
throughput time. It represents the percentage of time an order is in production in which useful work is being
done. The rest of the time represents non-value-added time (i.e., inspection time, move time, and queue
time).
Static Budgets. The term static budget refers to the budget that is set at the beginning of a budgeting period and
that is geared to only one level of activity—the budgeted level of activity.

1. What Is Wrong with a Static Budget? The static budget is appropriate for the budgeted level of activity but is
not realistic for other levels of activity

2. Static Budgets and Performance Reports. Unfortunately, managers are commonly held responsible for
deviations of actual from budgeted costs. This approach confuses two different aspects of control—control over
the level of activity and control over the effective use of resources.

3. Why Do Actual Costs Deviate from Budgeted Costs?: i) the actual level of activity differs from the budgeted
level of activity and ii) the manager’s use of resources was more or less effective than assumed in the budget.
That is, a variance between actual and budgeted costs can be due to a change in activity level or to effective or
ineffective cost control.

4. Static Budget Comparisons Commingle Effects. If the actual level of activity differs greatly from the
budgeted level, most of the variance for variable costs will almost certainly be due to the change in activity
level. The variance would then be an extremely noisy indicator of how well a manager controlled costs. And at
any rate, the variance between actual and budgeted costs commingles effects due to changes in activity levels
and due to how well costs were controlled given the level of activity. If a manager is responsible for the level of
activity, control over that aspect of the manager’s responsibility should be separated from control over costs.
And if a manager is not responsible for the level of activity, it is even clearer that the two effects must be
disentangled to have a meaningful report. The key to resolving this problem is the use of flexible budgets.

Flexible Budgets. A flexible budget is geared to all levels of activity within the relevant range and is used to plan
and control spending.

Overhead Performance Report. compares actual costs to the flexible budget for the actual level of activity.

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Complications when Activity Is Measured In Hours. When a company makes a number of different products,
a unit of one product may require different overhead resources than a unit of another product. In that situation,
adding together units of output from different products is like adding apples and oranges. Some other measure of
activity should be used.

1. The measure of activity. Three factors should be considered in selecting an activity base for a flexible budget.

a. The activity base and overhead costs should be causally related.

b. The activity measure should not be stated in pesos.
c. The activity base should be simple and easily understood.

2. Actual versus standard hours allowed and variable overhead variances.

a. Actual Hours. When actual hours are used as the basis for the flexible budget allowance, only a spending
variance can be computed for variable overhead. The variable overhead spending variance is the difference
between the actual variable overhead cost and the budget allowance that is determined by multiplying the
actual hours by the variable overhead rate per hour. A spending variance occurs because prices differ from
those assumed in the flexible budget, because of effective or ineffective control of overhead resources, or
because of inaccuracies in the flexible budgets themselves. The variable overhead spending variance
basically combines price and quantity variances in one variance.

b. Standard Hours Allowed. The standard hours allowed could also be used as a measure of activity in a
performance report. However, in this case it is best to compute two variances rather than just one. The first
variance is the variable overhead spending variance based on the actual hours. The second variance is the
variable overhead efficiency variance based on the difference between the actual hours and the standard
hours allowed for the actual output of the period.

Predetermined Overhead Rates Predetermined overhead rates were discussed in earlier chapters, so this is
largely a review. The formula for the predetermined overhead rate used in this chapter is:

Separate predetermined rates can be computed for variable and fixed overhead by including only variable or fixed
overhead costs in the numerator. When overhead is fixed, the predetermined overhead rate will depend on the
denominator level of activity. The higher the level of activity is, the lower the rate will be.

Applying Overhead in a Standard Cost System. Overhead can be applied to units based on actual hours or on
standard hours allowed for the actual output. In a standard cost system overhead is applied on the basis of the
standard hours allowed for the actual output.

Fixed Overhead Variances in a Standard Cost System. Two variances are computed for fixed overhead—a
budget variance and a volume variance. These variances are quite different from the variances computed for variable
overhead.

1. Budget Variance. The budget variance is the difference between the actual fixed overhead costs incurred
during the period and the budgeted fixed overhead costs contained in the flexible budget. This variance is very
useful in that it indicates how well spending on fixed items was controlled.

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2. Volume Variance. The volume variance is the difference between the total budgeted fixed overhead and the
fixed overhead applied to production. Alternatively, it can be expressed as follows:

The volume variance occurs because the denominator level of activity differs from the standard hours allowed
for production. Thus, an unfavorable variance means that the company operated at an activity level below the
denominator level of activity. Conversely, a favorable variance means that the company operated at an activity
level greater than the denominator level of activity

Under- and Overapplied Overhead. The sum of the four manufacturing overhead variances—variable overhead
spending, variable overhead efficiency, fixed overhead budget, and fixed overhead volume—equals the under- or
overapplied overhead for the period.

1. The sum of the variances equals under- or overapplied overhead. The four overhead variances measure the
difference between actual overhead costs incurred and the standard overhead cost for the actual output. The
under- or overapplied overhead measures the difference between actual overhead costs incurred and the
overhead applied to inventory.

2. Underapplied overhead is equivalent to an unfavorable variance. If overhead is underapplied, more

overhead cost was incurred than was applied to inventory. The amount applied to inventory is the standard cost
allowed for the actual output. Therefore, if overhead is underapplied, more overhead cost was incurred than was
allowed for the actual output—hence, the overall variance is unfavorable. Similar reasoning leads to the
conclusion that overapplied overhead is equivalent to a favorable variance.