4.2 Standard Costing

Meaning of a System of Standard Costing

• Definition:
  Standard costing is a system where predetermined (standard) costs are established for materials, labour, and overheads. These standards act as benchmarks against which actual costs are compared.
• Standard cost:
  The expected cost of producing one unit of product or service under efficient operating conditions.
• Purpose:
  To measure efficiency and performance by comparing actual results with expected standards.
• Types of Standards:
  • Ideal standards: Assume perfect efficiency, no wastage, no idle time. Rarely achievable, but serve as long-term goals.
  • Attainable (practical) standards: Allow for normal wastage and inefficiencies. More realistic and commonly used in business decision-making.
  • Current standards: Reflect current operating conditions. Adjusted frequently to changing environments.
  • Basic standards: Long-term, unchanging benchmarks used to measure trends over time.

Advantages of a Standard Costing System

• Performance measurement: Variances highlight areas of efficiency and inefficiency.
• Cost control: Identifies where actual costs deviate from expected, enabling corrective actions.
• Budgeting aid: Standard costs simplify preparation of budgets and facilitate variance analysis.
• Decision-making: Provides management with reliable cost information for pricing, outsourcing, and resource allocation.
• Simplifies inventory valuation: Inventory can be valued at standard cost, avoiding frequent recalculations.
• Motivation: Clear cost benchmarks can motivate employees to work efficiently.
• Variance analysis: Enables management by exception – focus only on significant variances instead of all data.

Disadvantages of a Standard Costing System

• Time and cost of setting standards: Requires significant effort to update regularly.
• Rigidity: Outdated standards may be unrealistic if not revised frequently.
• Employee resistance: Workers may feel pressured or demotivated if standards are seen as unattainable.
• Focus on cost minimisation: May encourage short-term savings over long-term efficiency and quality.
• Not suitable for all industries: Service sectors and highly customised production processes may find it less relevant.
• Non-financial aspects ignored: Standard costing often focuses on financial numbers, neglecting customer satisfaction, innovation, or employee morale.

Use of Standard Costing to Improve Performance

• Variance analysis highlights inefficiencies in production, material use, or labour hours.
• Budget refinement: Past variances inform better forecasting and standard-setting for the future.
• Pricing decisions: By knowing expected costs, management can set selling prices more strategically.
• Efficiency tracking: Trends in variance analysis indicate whether efficiency is improving or declining.
• Strategic planning: Helps managers identify unprofitable products or inefficient departments.

Variances: Definitions and Calculations

Variance = Difference between actual cost and standard cost.

• Favourable variance (F): When actual results are better than expected (e.g., lower costs or higher revenues).
• Adverse variance (A): When actual results are worse than expected (e.g., higher costs or lower revenues).

1. Direct Material Variances

• Direct Material Price Variance (MPV):
  Formula: (Standard Price − Actual Price) × Actual Quantity
  • Indicates whether materials were bought at a higher/lower price than standard.
• Direct Material Usage (Quantity) Variance (MUV):
  Formula: (Standard Quantity − Actual Quantity) × Standard Price
  • Indicates efficiency in using materials compared to standard.

2. Direct Labour Variances

• Direct Labour Rate Variance (LRV):
  Formula: (Standard Rate − Actual Rate) × Actual Hours
  • Shows whether labour was paid higher/lower than standard wage rate.
• Direct Labour Efficiency Variance (LEV):
  Formula: (Standard Hours − Actual Hours) × Standard Rate
  • Measures efficiency in time taken compared to standard allowance.

3. Fixed Overhead Variances

• Expenditure (Budget) Variance:
  Formula: Budgeted Overhead − Actual Overhead
  • Shows difference in planned vs actual spending on fixed overheads.
• Volume Variance:
  Formula: (Actual Output − Budgeted Output) × Standard Overhead Absorption Rate
  • Measures impact of difference in activity level.
• Capacity Variance:
  Formula: (Actual Hours − Budgeted Hours) × Standard Rate
  • Relates to whether resources were under-utilised or over-utilised.
• Efficiency Variance:
  Formula: (Standard Hours − Actual Hours) × Standard Rate
  • Shows productivity of workforce relative to expectations.

4. Sales Variances

• Sales Price Variance:
  Formula: (Actual Price − Standard Price) × Actual Quantity Sold
  • Reflects effect of selling products at higher/lower price.
• Sales Volume Variance:
  Formula: (Actual Sales Volume − Budgeted Sales Volume) × Standard Contribution or Profit per Unit
  • Measures difference in sales quantity compared to plan.

Causes of Variances

• Direct Material Price Variance:
  • Favourable: Bulk discounts, negotiation success, cheaper suppliers.
  • Adverse: Inflation, poor purchasing decisions, market shortages.
• Direct Material Usage Variance:
  • Favourable: Higher quality materials reducing waste.
  • Adverse: Wastage, theft, production errors.
• Direct Labour Rate Variance:
  • Favourable: Hiring lower-wage employees, reduced overtime.
  • Adverse: Overtime pay, higher-skilled workers, union demands.
• Direct Labour Efficiency Variance:
  • Favourable: Better training, improved machinery, motivated workforce.
  • Adverse: Poor supervision, machine breakdowns, unskilled workers.
• Overhead Variances:
  • Expenditure: Unexpected maintenance costs, energy price changes.
  • Volume: Demand lower/higher than expected.
  • Capacity: Idle time vs over-utilisation of machinery.
  • Efficiency: Workers completing tasks faster/slower.
• Sales Price Variance:
  • Favourable: Strong demand, successful branding, price increases accepted.
  • Adverse: Price wars, discounts, weak demand.
• Sales Volume Variance:
  • Favourable: Good marketing, strong customer demand.
  • Adverse: Recession, poor sales strategy, competition.

Relationships Between Variances

• Variances are often interlinked, not independent.
• Example:
  • Adverse material usage variance may cause an adverse labour efficiency variance (low-quality material requires more time to process).
  • A favourable labour efficiency variance may reduce overhead absorption cost per unit.
• Managers must analyse variances in combination, not isolation.

Business Decisions Using Variances

• Corrective action: Identify whether problems are due to controllable or uncontrollable factors.
• Supplier choice: Material price variance informs decisions on supplier negotiations.
• Labour training: Efficiency variances may highlight training needs.
• Capacity utilisation: Fixed overhead capacity variance shows whether machinery is under/over-used.
• Pricing strategy: Sales variances guide decisions on future price-setting.
• Profitability focus: Variance analysis shows which products or departments perform better/worse than expected.

Non-Financial Factors

• Quality of products: Cutting costs may lead to poor quality.
• Customer satisfaction: Lower selling prices may attract customers but harm brand image.
• Employee morale: Unrealistic standards may demotivate employees.
• Sustainability: Decisions should consider environmental impacts beyond cost variances.
• Reputation: Ethical practices affect long-term success beyond short-term variances.

4.2 Standard Costing (A Level)

Meaning of Standard Costing

• Standard costing is a system where predetermined (standard) costs are established for materials, labour, and overheads.
• These standards are compared with the actual costs incurred, and differences are called variances.
• Used to monitor performance, identify inefficiencies, and improve decision-making.
• Standards are often set based on historical data, engineering studies, or industry benchmarks.

Advantages of Standard Costing

• Provides a benchmark against which actual performance can be measured.
• Helps in cost control by highlighting variances.
• Encourages efficiency and responsibility among managers.
• Simplifies preparation of budgets and facilitates variance analysis.
• Aids in decision-making by providing quick cost estimates.
• Useful for performance evaluation of departments and individuals.

Disadvantages of Standard Costing

• Can become outdated if costs change frequently (e.g., material price fluctuations).
• Setting accurate standards is difficult and time-consuming.
• Employees may feel demotivated if standards are unrealistic.
• Too much focus on variances may ignore quality, customer satisfaction, or innovation.
• More suitable for mass production industries than service-based or highly customised industries.

Use of Standard Costing to Improve Performance

• Identifies inefficiencies in material usage, labour hours, or overheads.
• Provides a framework for variance analysis → managers investigate causes and take corrective action.
• Highlights areas where processes can be improved.
• Helps in budgeting and forecasting, making them more realistic.

Variance Calculations

Candidates should be able to calculate the following variances:

Direct Material Variances

1. Direct Material Price Variance
   (Actual Price − Standard Price) × Actual Quantity

   Example:
   If standard price = $5 per kg, actual price = $6 per kg, and 1000 kg used:
   Direct Material Price Variance = (6 − 5) × 1000 = $1000 (Adverse).

2. Direct Material Usage Variance
   (Actual Quantity − Standard Quantity) × Standard Price

   Example:
   Standard quantity = 950 kg, actual quantity = 1000 kg, standard price = $5:
   Direct Material Usage Variance = (1000 − 950) × 5 = $250 (Adverse).

Direct Labour Variances

1. Direct Labour Rate Variance
   (Actual Rate − Standard Rate) × Actual Hours

   Example:
   Standard rate = $12 per hour, actual rate = $14 per hour, actual hours = 500:
   Direct Labour Rate Variance = (14 − 12) × 500 = $1000 (Adverse).

2. Direct Labour Efficiency Variance
   (Actual Hours − Standard Hours) × Standard Rate

   Example:
   Actual hours = 520, standard hours = 500, standard rate = $12:
   Direct Labour Efficiency Variance = (520 − 500) × 12 = $240 (Adverse).

Fixed Overhead Variances

1. Fixed Overhead Expenditure Variance
   Actual Fixed Overhead − Budgeted Fixed Overhead

   Example:
   Actual fixed overhead = $12,000, budgeted fixed overhead = $11,500:
   Variance = 12,000 − 11,500 = $500 (Adverse).

2. Fixed Overhead Volume Variance
   (Actual Output − Budgeted Output) × Standard Overhead Absorption Rate

   Example:
   Actual output = 5200 units, budgeted = 5000 units, rate = $2 per unit:
   Variance = (5200 − 5000) × 2 = $400 (Favourable).

3. Fixed Overhead Capacity Variance
   (Actual Hours − Budgeted Hours) × Standard Overhead Absorption Rate per Hour
4. Fixed Overhead Efficiency Variance
   (Standard Hours for Actual Output − Actual Hours) × Standard Rate

Sales Variances

1. Sales Price Variance
   (Actual Selling Price − Standard Selling Price) × Actual Quantity Sold

   Example:
   Actual price = $55, standard = $50, sales = 1000 units:
   Variance = (55 − 50) × 1000 = $5000 (Favourable).

2. Sales Volume Variance
   (Actual Quantity Sold − Budgeted Quantity) × Standard Contribution per Unit

   Example:
   Actual sales = 1200 units, budgeted = 1000 units, contribution = $10 per unit:
   Variance = (1200 − 1000) × 10 = $2000 (Favourable).

Causes of Favourable or Adverse Variances

• Material Price Variance:
  Favourable if bulk discounts obtained; Adverse if supplier prices rise.
• Material Usage Variance:
  Favourable if efficient use of materials; Adverse if wastage occurs.
• Labour Rate Variance:
  Favourable if cheaper labour used; Adverse if higher wages paid.
• Labour Efficiency Variance:
  Favourable if workers are more productive; Adverse if delays occur.
• Overhead Variances:
  Adverse if costs rise unexpectedly (e.g., electricity price hikes).
• Sales Variances:
  Favourable if higher demand allows higher prices; Adverse if market competition forces discounts.

Interrelationship Between Variances

• One variance may cause another:
  • Poor material quality (Adverse Material Usage Variance) may increase production time (Adverse Labour Efficiency Variance).
  • Higher selling prices (Favourable Sales Price Variance) may reduce demand (Adverse Sales Volume Variance).
• Managers must evaluate all variances together instead of in isolation.

Non-Financial Factors in Standard Costing

• Employee morale: standards too tight may discourage workers.
• Quality: focus on cost control may reduce product quality.
• Customer satisfaction: must ensure efficiency does not harm service.
• Innovation: overemphasis on cost variances may discourage creativity.
• Environmental and social impact: cost savings should not come at the expense of sustainability.

Business Decision-Making with Variance Analysis

• Managers investigate variances and decide whether action is needed.
• Adverse variances may indicate cost overruns or inefficiency requiring corrective measures.
• Favourable variances may reflect good performance, but must ensure quality is not compromised.
• Variances guide strategic decisions such as pricing, supplier selection, labour policies, and overhead control.