Standard Costing (Copy)

4.2.1: Standard Costing – Cheat Sheet

What is Standard Costing?

• Standard costing is a method used by businesses to estimate costs for products or services. These predetermined costs (standard costs) are then compared with the actual costs to assess performance.
• It involves setting expectations for costs (materials, labour, overheads) and then comparing actual costs to these standards to identify variances.

Purpose of Standard Costing

• Cost Control: Helps manage and control costs by identifying where actual costs differ from standards.
• Performance Evaluation: Variance analysis helps measure the performance of departments, individuals, and the company.
• Budgeting: Provides a basis for future budgeting by comparing planned costs with actual costs.

Advantages of Standard Costing

1. Performance Measurement: Enables businesses to measure the effectiveness of their operations.
2. Cost Control: Helps in monitoring and controlling costs by identifying unfavorable variances.
3. Efficiency: Standardization leads to more consistent cost estimates and improves efficiency.
4. Improved Decision Making: Provides accurate data to make better management decisions.
5. Simplifies Planning: Facilitates planning by establishing clear cost targets.

Disadvantages of Standard Costing

1. Inflexibility: If standards are outdated or unrealistic, it can lead to misleading analysis.
2. Time-Consuming: Setting and maintaining standards can be time-consuming and expensive.
3. Lack of Focus on Non-Financial Factors: Does not account for non-financial variables, such as employee morale or market conditions.
4. Not Always Applicable: Not suitable for all businesses, especially those with highly fluctuating costs or those involved in project-based work.

Calculating Variances

1. Direct Material Price Variance
   • Formula:
     Direct Material Price Variance = (Actual Price – Standard Price) × Actual Quantity
   • Explanation: This variance measures the difference between the actual price paid for materials and the standard price expected.
2. Direct Material Usage Variance
   • Formula:
     Direct Material Usage Variance = (Actual Quantity – Standard Quantity) × Standard Price
   • Explanation: This variance measures whether more or less material was used than expected.
3. Direct Labour Rate Variance
   • Formula:
     Direct Labour Rate Variance = (Actual Rate – Standard Rate) × Actual Hours
   • Explanation: This variance reflects the difference between the actual wage rate paid and the standard wage rate expected.
4. Direct Labour Efficiency Variance
   • Formula:
     Direct Labour Efficiency Variance = (Actual Hours – Standard Hours) × Standard Rate
   • Explanation: This variance shows whether more or fewer hours were worked than expected for the given level of production.
5. Fixed Overhead Expenditure Variance
   • Formula:
     Fixed Overhead Expenditure Variance = Actual Fixed Overheads – Budgeted Fixed Overheads
   • Explanation: This variance shows whether actual fixed costs were higher or lower than the budgeted fixed costs.
6. Fixed Overhead Volume Variance
   • Formula:
     Fixed Overhead Volume Variance = (Actual Production – Expected Production) × Fixed Overhead Rate
   • Explanation: This variance measures the effect of producing more or fewer units than planned, impacting the allocation of fixed costs.
7. Fixed Overhead Capacity Variance
   • Formula:
     Fixed Overhead Capacity Variance = (Actual Hours Worked – Standard Hours) × Fixed Overhead Rate
   • Explanation: This variance measures the difference between the actual hours worked compared to the standard hours allocated for production.
8. Fixed Overhead Efficiency Variance
   • Formula:
     Fixed Overhead Efficiency Variance = (Standard Hours Worked – Actual Hours Worked) × Fixed Overhead Rate
   • Explanation: This variance measures the impact of inefficient production in terms of fixed overhead costs.
9. Sales Price Variance
   • Formula:
     Sales Price Variance = (Actual Selling Price – Standard Selling Price) × Actual Units Sold
   • Explanation: This variance measures whether the actual selling price differs from the expected selling price.
10. Sales Volume Variance
    • Formula:
      Sales Volume Variance = (Actual Units Sold – Budgeted Units) × Standard Selling Price
    • Explanation: This variance measures the difference between the actual number of units sold and the expected sales volume.

Causes of Favourable or Adverse Variances

1. Favourable Variances:
   Occur when actual costs are lower than the standard costs, or actual revenues exceed the expected revenues.
   • For example:
     • Lower material costs than expected
     • Higher sales prices than expected
     • Higher sales volume than expected
2. Adverse Variances:
   Occur when actual costs exceed the standard costs, or actual revenues fall short of expectations.
   • For example:
     • Higher material costs than expected
     • Lower sales prices than expected
     • Lower sales volume than expected

Interrelationship Between Variances

• Material and Labour Variances:
  • Direct Material Usage Variance and Direct Labour Efficiency Variance often interact. For instance, using more materials than expected can lead to inefficiency in labour, affecting the labour efficiency variance.
• Sales and Profit Variances:
  • Sales Price Variance and Sales Volume Variance impact profitability. Higher sales prices or larger sales volumes can increase profits, while lower sales prices or smaller volumes can have the opposite effect.
• Overhead Variances:
  • Fixed overhead variances (such as expenditure, volume, capacity, and efficiency) often interact with labour and material variances, as inefficiencies in production can lead to higher overhead costs.

Making Business Decisions with Standard Costing Data

• Evaluating Performance:
  • Standard costing allows managers to evaluate the performance of departments and individuals, identifying areas where costs need to be controlled or where there are profit opportunities.
• Cost Control:
  • By identifying unfavourable variances, businesses can focus on controlling costs and improving efficiency in production, sales, or other areas.
• Pricing Decisions:
  • Standard costing data can be used to assess the cost of products and determine the right selling price, ensuring that the company is profitable and competitive.
• Budgeting and Forecasting:
  • Standard costing helps in setting realistic budgets and forecasting future costs based on historical data and variances, leading to more accurate and reliable financial planning.

Significance of Non-Financial Factors

• Employee Performance:
  Variances, particularly in labour efficiency, may reflect the motivation and training needs of employees. Addressing these non-financial factors can improve performance.
• Market Conditions:
  Sales volume and price variances can be influenced by external market conditions, such as changes in consumer demand, competition, or economic downturns.
• Quality of Materials:
  Material usage variances might be due to the quality of materials used. Higher usage might indicate poor quality materials, requiring attention from procurement.
• Customer Satisfaction:
  Variances in sales price and volume could reflect customer perceptions of product quality and service levels.