Unit 3: Standard Costing

I. Orientation

Standard costing is a system of cost control in which predetermined costs are established for products, services, or operations and compared with actual costs. Differences are called variances. Management analyses these variances to identify causes, assign responsibility, and take corrective action.

A. Governing Principle

The system applies the principle of management by exception: management concentrates on significant deviations from planned performance rather than examining every transaction equally.

• Standard cost: A scientifically predetermined cost of producing one unit or performing one operation under specified conditions.
• Actual cost: The cost actually incurred for the quantity produced during a period.
• Variance: The difference between standard cost and actual cost.
• Favourable variance: A result that increases profit relative to the standard, such as actual material cost below standard material cost.
• Adverse variance: A result that reduces profit relative to the standard, such as actual labour hours exceeding standard hours.
• Cost elements: Standards are normally fixed separately for direct material, direct labour, variable overhead, and fixed overhead.
• Control cycle:
  • Establish standards.
  • Record actual performance.
  • Compare actual results with standards.
  • Analyse significant variances.
  • Investigate causes and take corrective action.
• Variance convention: These notes calculate cost variances as standard cost minus actual cost; a positive result is favourable and a negative result is adverse.

II. Standard Costing — Meaning, Role, and Use

A. Meaning, significance and applications of standard costing

Standard costing combines predetermined unit costs with variance analysis to support planning, control, and performance evaluation.

• Meaning: A standard cost represents what a cost should be, not merely what it was historically. For example, if 4 kg of material should be used at ₹6 per kg, the standard material cost is ₹24 per unit.
• Standard cost versus estimated cost:
  1. Standard cost: Based on technical studies and specified efficiency conditions; it acts as a control benchmark.
  2. Estimated cost: A forecast of likely cost based largely on expected circumstances; it may not establish a performance target.
• Significance:
  • Cost control: Variances reveal departures from approved quantities, prices, hours, rates, or production volumes.
  • Planning: Standards provide the cost foundation for budgets, quotations, production plans, and profit forecasts.
  • Performance measurement: Variances can indicate the performance of purchasing, production, personnel, and overhead departments.
  • Inventory valuation: Materials, work-in-progress, and finished goods may be recorded at standard cost, with variances reported separately.
  • Decision support: Standard contribution data assist pricing, product-mix, and make-or-buy analysis, provided relevant costs are identified.
• Applications: The system is especially useful in repetitive manufacturing, assembly operations, food processing, textiles, chemicals, and standardized service activities.
• Conditions for effective use: Products and processes should be sufficiently uniform, responsibilities should be clearly assigned, and actual quantities and costs must be recorded promptly.
• Limitations: Standards can become obsolete after changes in technology, prices, product design, or working methods. Excessively tight standards may reduce motivation, while loose standards weaken control.

III. Fixing Cost Standards — Determining Expected Inputs and Prices

A. Fixation of standards

Fixation of standards means determining the quantity, price, time, rate, and overhead benchmarks applicable to a product or operation.

• Preliminary requirements: Products must be specified, operations standardized, cost centres defined, and responsibility allocated before standards are set.
• Types of standards:
  1. Ideal standard: Assumes perfect conditions, no wastage, no breakdowns, and maximum efficiency; mainly aspirational.
  2. Practical standard: Allows normal losses, rest periods, and unavoidable interruptions; generally best for control.
  3. Basic standard: Fixed for a long period and used to measure long-term trends.
  4. Current standard: Reflects expected conditions during the current budget period.
• Material quantity standard: Engineering specifications, bills of materials, normal spoilage, and expected yield determine the standard input per unit.
• Material price standard: Purchase price, freight, duties, discounts, and expected market conditions are considered.

Standard material cost per unit = SQ × SP

Here, SQ is standard material quantity per unit and SP is standard price per unit.

• Labour standards: Time-and-motion studies determine standard hours, while wage agreements, skill grades, payroll charges, and expected bonuses determine standard rates.
• Overhead standards: Overheads are classified as fixed or variable and absorbed using an appropriate base, such as labour hours, machine hours, or units produced.
• Participation: Accountants coordinate the process, but engineers, production managers, purchasing officers, and human-resource specialists supply operational evidence.
• Revision: Standards should be revised when permanent changes occur in product design, input prices, technology, labour methods, or capacity.

IV. Standard Costing Infrastructure — Installing the Control System

A. Establishment of standard costing system

Establishing the system requires technical standards, accounting procedures, responsibility reporting, and regular review to operate as one coordinated control mechanism.

• Define objectives: Management must specify whether the system will support cost control, inventory valuation, budgeting, pricing, or all these purposes.
• Conduct feasibility analysis: The expected control benefits should justify installation, data collection, training, and maintenance costs.
• Establish cost centres: The organization is divided into locations or functions where costs are accumulated and controlled, such as machining, assembly, and maintenance.
• Classify accounts: A suitable coding system distinguishes materials, labour, variable overhead, fixed overhead, departments, and variance accounts.
• Develop standard cost cards: Each card records the standard input and cost allowed for one unit.

Standard unit cost =
Direct material + Direct labour
+ Variable overhead + Fixed overhead

• Record actual data: Actual prices, quantities, hours, wage rates, overhead expenditure, and output must be captured accurately for the same period as the standards.
• Set variance thresholds: Management may investigate variances exceeding a monetary amount, percentage, or recurring trend.
• Assign responsibility: Reports should reach managers able to influence the cause; for example, purchase price variance normally concerns purchasing, while usage variance usually concerns production.
• Integrate with budgets: Standards express expected unit costs, whereas budgets express total costs and revenues for an expected activity level.
• Review continuously: Reports should be timely, standards periodically reviewed, and corrective actions monitored.

V. Variance Analysis — Interpreting Departures from Standards

A. Analysis of variance

Variance analysis separates the total difference between standard and actual cost into components that reveal operational causes.

• Basic relationship:

Total cost variance = Standard cost of actual output − Actual cost

• Standard quantity allowed: Variances must use the input permitted for the actual output, not the budgeted output. If each unit requires 3 kg and 500 units are produced, standard quantity allowed is 1,500 kg.
• Price and efficiency dimensions: Input cost differences are commonly divided into:
  1. A price or rate effect caused by paying a different amount per input unit.
  2. A usage or efficiency effect caused by consuming a different input quantity.
• Interpretation: An adverse variance is a signal for investigation, not automatic proof of poor performance. Higher-grade material may cause an adverse price variance but a favourable usage variance.
• Responsibility: Variances should be linked to controllable causes, but shared effects must be recognized; purchasing cheaper material may increase waste or labour time.
• Investigation criteria: Size, frequency, trend, controllability, and investigation cost determine whether management should act.
• Reconciliation: The combined material, labour, and overhead variances reconcile standard profit with actual profit, subject to sales variances and accounting adjustments.

VI. Direct Materials — Price and Consumption Control

A. Material variance

Material variance measures the difference between the standard material cost permitted for actual output and the actual material cost incurred.

• Symbols: SQ = standard quantity for actual output; AQ = actual quantity; SP = standard price; AP = actual price.
• Material cost variance (MCV):

MCV = (SQ × SP) − (AQ × AP)

• Material price variance (MPV):

MPV = AQ × (SP − AP)

It may arise from market movements, order size, supplier selection, freight, discounts, or material quality.

• Material usage variance (MUV):

MUV = SP × (SQ − AQ)
MCV = MPV + MUV

Usage differences may result from waste, spoilage, poor supervision, defective materials, machine condition, or inaccurate standards.

• Mix variance: Where several materials are combined, this variance measures the cost effect of changing the standard proportions, usually by comparing revised standard quantities with actual quantities at standard prices.
• Yield variance: Measures the cost effect of actual output differing from the standard output expected from the total actual input.
• Worked example: For 100 units, SQ = 500 kg at SP = ₹4; actual usage is 520 kg at AP = ₹4.50.

MCV = (500 × ₹4) − (520 × ₹4.50) = ₹340 adverse
MPV = 520 × (₹4 − ₹4.50) = ₹260 adverse
MUV = ₹4 × (500 − 520) = ₹80 adverse

VII. Direct Labour — Wage Rate and Time Efficiency

A. Labour variance

Labour variance compares standard labour cost for actual production with wages actually paid.

• Symbols: SH = standard hours for actual output; AH = actual hours paid; SR = standard wage rate; AR = actual wage rate.
• Labour cost variance (LCV):

LCV = (SH × SR) − (AH × AR)

• Labour rate variance (LRV):

LRV = AH × (SR − AR)

Causes include wage revisions, overtime premiums, skill substitution, labour shortages, or incorrect worker allocation.

• Labour efficiency variance (LEV):

LEV = SR × (SH − AH)
LCV = LRV + LEV

Efficiency is affected by worker skill, supervision, material quality, machine breakdowns, production scheduling, and the realism of the standard.

• Idle-time variance:

Idle-time variance = Idle hours × SR

It is adverse because wages are paid without production, perhaps due to power failure, material shortage, or machine breakdown. When separately reported, productive hours are used for detailed efficiency analysis.

• Interpretive link: Using skilled employees may produce an adverse rate variance but a favourable efficiency variance; the total labour cost effect provides the broader assessment.

VIII. Production Overheads — Expenditure, Efficiency, and Capacity

A. Overhead variance

Overhead variance measures the difference between overhead absorbed for actual output at standard rates and overhead actually incurred.

• Variable overhead cost variance:

Variable OH cost variance =
(SH × SVR) − Actual variable overhead

Here, SVR is the standard variable overhead rate per hour.

• Variable overhead expenditure variance:

= (AH × SVR) − Actual variable overhead

It reflects differences in indirect material prices, utility rates, or other variable spending.

• Variable overhead efficiency variance:

= SVR × (SH − AH)

It follows labour or machine-hour efficiency when variable overhead is absorbed by hours.

• Fixed overhead cost variance:

Fixed OH cost variance =
Absorbed fixed overhead − Actual fixed overhead

• Expenditure variance:

Budgeted fixed overhead − Actual fixed overhead

It arises from spending changes such as salary, rent, insurance, or depreciation differences.

• Volume variance:

Absorbed fixed overhead − Budgeted fixed overhead

It measures whether actual production was above or below the volume used to set the fixed overhead rate.

• Volume analysis: The volume variance may be divided into capacity variance, reflecting actual hours versus budgeted hours, and efficiency variance, reflecting standard hours for output versus actual hours.
• Control implication: Expenditure variance concerns fixed-cost spending, while volume variance concerns utilization of available capacity; low production does not necessarily mean the fixed-cost manager overspent.