Unit 3: Standard Costing - Subjective Questions

Standard costing is a technique of cost accounting in which predetermined costs are established for materials, labour, and overheads under specified operating conditions. Actual costs are compared with these standards, and the differences are analyzed as variances.

Meaning:

• A standard cost is an estimated cost set in advance for a product, service, or activity.
• It represents the cost that should be incurred under efficient operating conditions.
• Variance analysis helps management identify the reasons for deviations.

Difference from historical costing:

• Historical costing records costs after they are incurred, whereas standard costing determines costs before production.
• Historical costing mainly reports what happened, whereas standard costing also explains why actual performance differs from expected performance.
• Standard costing supports planning, control, and corrective action more effectively than historical costing.

Standard costing is significant because it provides a systematic basis for planning and controlling costs.

Significance:

• Provides a basis for measuring efficiency.
• Helps in preparing budgets and estimating future costs.
• Facilitates management by exception by highlighting significant variances.
• Assists in pricing, profit planning, and cost reduction.
• Fixes responsibility for unfavorable performance.
• Improves coordination among production, purchasing, personnel, and finance departments.

Applications:

• Manufacturing cost control.
• Budgetary control and performance evaluation.
• Inventory valuation and cost estimation.
• Product pricing and quotation preparation.
• Labour efficiency measurement.
• Analysis of material usage, wage rates, and overhead spending.
• Identification of areas requiring corrective action.

An effective standard costing system requires realistic standards, reliable records, and cooperation from all departments.

Essential conditions:

• Clearly defined production methods and operating procedures.
• Accurate technical specifications for materials and labour.
• Proper classification of costs into material, labour, and overheads.
• Reliable accounting and cost-recording systems.
• Regular review and revision of standards.
• Participation of production, engineering, purchasing, and accounting personnel.
• Prompt reporting and investigation of significant variances.

Limitations:

• Standards may become outdated because of changes in prices, technology, or methods.
• Setting accurate standards can be costly and time-consuming.
• Employees may resist standards if they consider them unfair.
• Variances may be caused by external factors beyond management control.
• Excessive focus on cost variances may reduce quality or customer service.
• The system is less suitable where production is highly customized or conditions change frequently.

Fixation of standards means determining the predetermined quantity, price, rate, time, and expenditure required to produce a unit of output under specified conditions.

Principles for fixing standards:

• Standards should be based on technical studies, engineering specifications, and work measurement.
• Normal losses, unavoidable idle time, and ordinary inefficiencies should be considered.
• Standards should be challenging but attainable under efficient working conditions.
• Current market prices and expected price trends should be considered for material standards.
• Labour standards should reflect wage agreements, skill levels, and expected productivity.
• Overhead standards should be based on realistic capacity and appropriate cost behavior.
• Responsibility for each standard should be assigned to a competent department.
• Standards should be reviewed periodically and revised when significant conditions change.

The establishment of a standard costing system generally involves the following steps:

1. Define objectives: Determine whether the system is intended for cost control, budgeting, pricing, performance evaluation, or all of these purposes.
2. Study production methods: Analyze the product design, manufacturing process, machine capacity, and workflow.
3. Classify cost centers: Divide the organization into suitable production and service cost centers.
4. Fix standards: Establish material quantities and prices, labour hours and rates, and overhead rates.
5. Prepare standard cost cards: Record the standard cost of each product or unit of activity.
6. Record actual costs: Collect actual data using appropriate accounting documents.
7. Calculate variances: Compare actual costs with standard costs.
8. Investigate variances: Identify causes and assign responsibility.
9. Take corrective action: Remove controllable causes and improve operations.
10. Review standards: Revise standards when operating conditions change materially.

A standard cost card is a document that shows the predetermined cost of producing one unit of a product or performing one unit of activity.

Typical contents:

• Product name, code, and unit of output.
• Standard quantity and price of each material.
• Standard material cost.
• Standard labour hours and wage rates for each operation.
• Standard labour cost.
• Variable and fixed overhead rates.
• Total standard prime cost and total standard production cost.
• Date of preparation and revision number.

For example, the standard material cost may be expressed as:

Importance:

• Provides a basis for calculating total standard cost.
• Helps in determining product prices and quotations.
• Facilitates variance analysis.
• Supports budgeting and inventory valuation.
• Provides a common reference for production and accounting departments.

Variance analysis is the process of calculating and interpreting the difference between standard cost and actual cost or between standard performance and actual performance.

For cost elements, the basic relationship is:

A favorable variance occurs when actual cost is lower than standard cost. An unfavorable variance occurs when actual cost is higher than standard cost.

Importance:

• Shows whether costs are under control.
• Identifies areas of inefficiency.
• Helps management focus on significant deviations.
• Facilitates responsibility accounting.
• Supports corrective action and future planning.
• Helps distinguish controllable causes from uncontrollable causes.
• Provides information for revising unrealistic standards.

Variance analysis is useful only when variances are interpreted along with operational conditions, quality, volume, and external factors.

Material variances measure the effect of differences in material price and material usage.

Let:

• = standard quantity for actual output
• = actual quantity used
• = standard price per unit
• = actual price per unit

1. Material Cost Variance:

2. Material Price Variance:

3. Material Usage Variance:

The relationship is:

Where applicable, material usage variance may be further divided into:

• Material Mix Variance: Measures the effect of using materials in a different proportion from the standard mix.
• Material Yield Variance: Measures the effect of obtaining a different output from the input materials than the standard yield.

A favorable variance increases profit, while an unfavorable variance decreases profit.

Given:

• kg
• per kg
• kg
• per kg

Material Cost Variance:

Material Price Variance:

Material Usage Variance:

Verification:

Therefore, the material cost variance is unfavorable, consisting of a favorable price variance and an unfavorable usage variance.

Material Price Variance measures the effect of paying a price different from the standard price.

Possible causes of material price variance:

• Changes in market prices.
• Bulk purchase discounts or loss of discounts.
• Emergency purchases.
• Change in suppliers or quality of materials.
• Incorrect purchasing estimates.
• Changes in freight, taxes, or duties.

Material Usage Variance measures the effect of using a quantity different from the standard quantity allowed for actual output.

Possible causes of material usage variance:

• Poor-quality materials.
• Wastage, scrap, or excessive spoilage.
• Inefficient methods or defective machinery.
• Inadequate supervision or inexperienced workers.
• Changes in product design or production specifications.
• Incorrect standard quantity.

Price variance is generally associated with the purchasing function, while usage variance is often associated with production, engineering, and quality control.

Labour variances measure the effect of differences in wage rates and labour time.

Let:

• = standard hours for actual output
• = actual hours worked
• = standard wage rate per hour
• = actual wage rate per hour

1. Labour Cost Variance:

2. Labour Rate Variance:

3. Labour Efficiency Variance:

The relationship is:

Further analysis may include:

• Labour Mix Variance: Arises when the composition of different grades of labour differs from the standard composition.
• Labour Idle Time Variance: Arises when workers are paid for time during which no production takes place.

A lower actual wage rate produces a favorable rate variance, while fewer actual hours than standard hours produce a favorable efficiency variance.

Given:

• hours
• per hour
• hours
• per hour

Labour Cost Variance:

Labour Rate Variance:

Labour Efficiency Variance:

Verification:

The lower wage rate created a favorable rate variance, but the additional hours worked caused an unfavorable efficiency variance.

Idle Time Variance arises when workers are paid for time during which production is interrupted or no productive work is performed.

It is normally unfavorable because wages are paid without corresponding output. Causes may include power failure, machine breakdown, shortage of materials, production delays, strikes, or poor scheduling.

Labour Mix Variance arises when the actual proportion of different grades of labour differs from the standard proportion.

A commonly used formula is:

The revised standard quantity is the quantity of each labour grade that would have been used if the total actual hours had been employed in the standard mix.

Labour mix variance may result from shortages of skilled workers, changes in labour availability, substitution of one grade for another, or changes in production requirements.

Overhead variance is the difference between standard overhead cost allowed for actual output and actual overhead cost incurred.

Overhead variances are generally classified as follows:

• Overhead Expenditure Variance: Measures the difference between budgeted overhead and actual overhead for the actual level of activity.
• Overhead Volume Variance: Measures the effect of producing at a level different from the budgeted capacity.
• Overhead Efficiency Variance: Arises when actual hours differ from standard hours for actual output.
• Overhead Capacity Variance: Arises when actual hours worked differ from the budgeted hours.
• Overhead Calendar Variance: Arises when the actual number of working days differs from the number allowed in the budget.

For variable overhead, the basic formula is:

where is the standard variable overhead rate and is the actual variable overhead rate.

Variable overhead variances compare the standard variable overhead applicable to actual output with the actual variable overhead incurred.

Let:

• = standard hours for actual output
• = actual hours worked
• = standard variable overhead rate per hour
• = actual variable overhead rate per hour

Variable Overhead Cost Variance:

Variable Overhead Expenditure Variance:

This variance shows whether the actual overhead rate differs from the standard rate.

Variable Overhead Efficiency Variance:

This variance shows the effect of using more or fewer hours than the standard hours allowed for actual output.

The relationship is:

A lower actual overhead rate or fewer actual hours than standard generally produces a favorable variance.

Fixed Overhead Expenditure Variance measures the difference between the budgeted fixed overhead and the actual fixed overhead incurred.

It may be caused by changes in rent, salaries, depreciation, insurance, maintenance, or other fixed expenses.

Fixed Overhead Volume Variance measures the effect of the difference between the standard overhead absorbed by actual output and the budgeted fixed overhead.

It indicates whether actual production volume was higher or lower than the budgeted level.

Key distinction:

• Expenditure variance relates to the amount spent on fixed overhead.
• Volume variance relates to the level of output or activity achieved.
• Expenditure variance is often influenced by the overhead control function, whereas volume variance is influenced by production capacity and utilization.

Fixed overhead volume variance may be divided into capacity, efficiency, and calendar variances.

Let:

• = standard hours for actual output
• = actual hours worked
• = budgeted hours
• = standard fixed overhead rate per hour
• = budgeted working days
• = actual working days

Fixed Overhead Capacity Variance:

It arises when actual hours worked differ from budgeted hours.

Fixed Overhead Efficiency Variance:

It arises when actual hours differ from standard hours for actual output.

Fixed Overhead Calendar Variance:

This arises when actual working days differ from budgeted working days. It may be calculated as:

The relationship is:

These variances help management identify whether volume differences arose from working time, labour efficiency, or the number of available working days.

A controllable variance is a variance that can be influenced or corrected by a manager or department within a reasonable period. An uncontrollable variance arises from factors outside the manager's direct control.

Controllable variance examples:

• Excessive material wastage caused by poor supervision.
• Labour inefficiency due to inadequate training.
• Overhead overspending caused by unauthorized expenditure.
• Higher usage caused by inefficient production methods.

Uncontrollable variance examples:

• Material price increases caused by general market conditions.
• Idle time caused by an unexpected power failure.
• Labour cost changes caused by a new government regulation.
• Production volume changes caused by a sudden decline in customer demand.

The distinction is important for fair performance evaluation. Managers should be held responsible primarily for controllable variances, while uncontrollable variances should be separately reported and considered when revising standards or evaluating performance.

Management by exception is a control principle under which management concentrates on significant deviations from standards rather than reviewing every transaction.

Application in standard costing:

• Standards are established for cost and operational performance.
• Actual results are compared with the standards.
• Variances are classified as favorable or unfavorable.
• Tolerance limits are set for each important variance.
• Only variances exceeding the limits are investigated in detail.
• Responsibility is assigned to the appropriate department.
• Corrective action is taken where the cause is controllable.

Advantages:

• Saves managerial time.
• Directs attention to important problems.
• Encourages responsibility accounting.
• Supports faster corrective action.
• Helps management identify trends and recurring inefficiencies.

However, a small variance should not always be ignored if it is recurring, strategically important, or indicative of a larger future problem.

Advantages:

• Provides clear cost and performance targets.
• Helps detect inefficiencies promptly.
• Facilitates budgeting and profit planning.
• Supports pricing and quotation decisions.
• Simplifies inventory valuation and product costing.
• Encourages coordination among departments.
• Makes performance evaluation more systematic.
• Enables management by exception.

Disadvantages:

• Establishing standards may require considerable time and expense.
• Standards may be unrealistic or become outdated.
• The system may encourage employees to focus only on measurable costs.
• Unfavorable variances may create conflict if responsibility is assigned unfairly.
• It may be difficult to apply where products are customized or production conditions are unstable.
• Cost variance information may not adequately reflect quality, innovation, or customer satisfaction.

The system is most effective when standards are realistic, regularly reviewed, and interpreted together with non-financial performance measures.