STANDARD COST

CANDELARIA, JHUNE PAOLO

GINETE, ANGELA GRABRIELLE
PEREZ, SHAYNE
REYES, KATE
 Standard Costs—Setting the Stage
A standard is a benchmark or “norm” for measuring
performance.
Standards are found everywhere.
Quantity and price standards are set for each major input such as
raw materials and
labor time.
 Quantity standards specify how much of an input should be
used to make a
product or provide a service.
 Pricestandards specify how much should be paid for each
unit of the input.
 Actual quantities and actual costs of inputs are
compared to these standards. If either the quantity or
the cost of inputs departs significantly from the
standards, managers investigate the discrepancy to find
the cause of the problem and eliminate it.

This process is called management by exception.

 This basic
approach to
identifying and
solving
problems is the
essence of the
variance
analysis cycle,
which is
illustrated in
Exhibit 10–1.
 Who Uses Standard Costs?
Manufacturing, service, food, and not-for-profit organizations all
make use of standardsto some extent. Auto service centers like
Firestone and Sears, fast-food outlets such as McDonald’s,
hospitals are examples. In short, you are likely to run into
standard costs in virtually any line of business.

Manufacturing companies often have highly developed standard

costing systems in which standards for direct materials, direct
labor, and overhead are created for each product.
 A standard cost card shows the standard quantities and costs of
the inputs required to produce a unit of a specific product.
 Setting Standard Costs
Standards should be designed to encourage efficient future
operations, not just a repetition of past operations that may or may
not have been efficient. Standards tend to fall into one of two
categories—either ideal or practical.
 Ideal standards can be attained only under the best circumstances.
They allow for no machine breakdowns or other work interruptions,
and they call for a level of effort that can be attained only by the
most skilled and efficient employees working at peak effort 100% of
the time.
 Practical standards are standards that are “tight but attainable.”
They allow for normal machine downtime and employee rest
periods, and they can be attained through reasonable, though highly
efficient, efforts by the average worker.
 Setting Direct Materials Standards
Terry Sherman’s first task was to prepare price and quantity standards for the
company’s only significant raw material, pewter ingots. The standard price per
unit for direct materials should reflect the final, delivered cost of the materials.
After consulting with purchasing manager Janet Warner, Terry set the standard
price of pewter at $4.00 per pound.
The standard quantity per unit for direct materials should reflect the amount of
material required for each unit of finished product as well as an allowance for
unavoidable waste.1 After consulting with the production manager, Tom Kuchel,
Terry set the quantity standard for pewter at 3.0 pounds per pair of bookends.
Once Terry established the price and quantity standards he computed the standard
cost of material per unit of the finished product as follows:

3.0 pounds per unit × $4.00 per pound = $12.00 per unit
This $12.00 cost will appear on the product’s standard cost card.
Setting Direct Labor Standards

Direct labor price and quantity standards are usually expressed

in terms of a labor rate and labor-hours. The standard rate per
hour for direct labor should include hourly wages, employment
taxes, and fringe benefits. Using wage records and in
consultation with the production manager, Terry Sherman
determined the standard rate per direct labor-hour to be
$22.00.After consulting with the production manager, Terry set
the standard for direct labor time at 0.50 direct labor-hours
per pair of bookends. Once Terry established the rate and time
standards, he computed the standard direct labor cost per unit
of product as follows:
 0.50 direct labor-hours per unit × $22.00 per
direct labor-hour = $11.00 per unit

This $11.00 per unit standard direct labor cost

appears along with direct materials on the standard
cost card for a pair of pewter bookends.
 Setting Variable Manufacturing
Overhead Standards
As with direct labor, the price and quantity standards for variable
manufacturing overhead are usually expressed in terms of rate and
hours. The rate represents the variable portion of the predetermined
overhead rate discussed in the job-order costing chapter; the hours
relate to the activity base that is used to apply overhead to units of
product (usually machine-hours or direct labor-hours). At Colonial
Pewter, the variable portion of the predetermined overhead rate is
$6.00 per direct labor-hour. Therefore, Terry computed the standard
variable manufacturing overhead cost per unit as follows:

0.50 direct labor-hours per unit × $6.00 per direct labor-hour =

$3.00 per unit
 A General Model for Standard Cost
Variance Analysis
The basic idea in standard cost variance analysis is to decompose
spending variances from the flexible budget into two elements—one due
to the amount of the input that is used and the other due to the price
paid for the input. Using too much of the input results in an unfavorable
quantity variance. Paying too much for the input results in an
unfavorable price variance. A quantity variance is the difference
between how much of an input was actually used and how much should
have been used and is stated in dollar terms using the standard price of
the input. A price variance is the difference between the actual price
of an input and its standard price, multiplied by the actual amount of
the input purchased.
Why are standards separated into two
categories—quantity and price?
Using Standard Costs—Direct Materials
Variances
Terry Sherman’s next step was to compute the
company’s variances for June.

the standard cost of direct materials was computed as

follows:

3.0 pounds per unit × $4.00 per pound = $12.00 per

unit
 Colonial Pewter’s records for June showed that 6,500 pounds
of pewter were purchased at a cost of $3.80 per pound, for a
total cost of $24,700. All of the material purchased was used
during June to manufacture 2,000 pairs of pewter bookends.
2 Using these data and the standard costs from Exhibit 10–2,
Terry computed the quantity and price variances shown in
Exhibit 10–5
The third total cost figure, $24,700, is the actual amount paid
 The variances in Exhibit  10–5 are based on three
for the actual amount of pewter purchased. The difference
different total costs—$24,000, $26,000, and $24,700. The
between the $24,700 actually spent and the amount that
first, $24,000, refers to how much should have been
should have been spent, $24,000, is the spending variance for
spent on pewter to produce the actual output of 2,000
the month of $700. This variance is unfavorable (denoted by U)
units. The standards call for 3 pounds of pewter per unit.
because the amount that was actually spent exceeded the
Because 2,000 units were produced, 6,000 pounds of
amount that should have been spent.
pewter should have been used. This is referred to as the
The second total cost figure, $26,000, is the key that allows us
standard quantity allowed for the actual output. If this
to decompose the spending variance into two distinct elements
6,000 pounds of pewter had been purchased at the
—one due to quantity and one due to price. It represents how
standard price of $4.00 per pound, the company would
much the company should have spent if it had purchased the
have spent $24,000. This is the amount that appears in
actual amount of input, 6,500 pounds, at the standard price of
the company’s flexible budget for the month.
$4.00 a pound rather than the actual price of $3.80 a pound.
 The Materials Quantity Variance
Using the $26,000 total cost figure in column (2), we can make two
comparisons—one with the total cost of $24,000 in column (1) and
one with the total cost of $24,700 in column (3). The difference
between the $24,000 in column (1) and the $26,000 in column (2) is
the quantity variance of $2,000, which is labeled as unfavorable
(denoted by U).

The Materials Price Variance

The difference between the $26,000 in column (2) and the $24,700
in column (3) is the price variance of $1,300, which is labeled as
favorable (denoted by F)
 Materials Quantity Variance
The materials quantity variance measures the difference between the
quantity of materials used in production and the quantity that should
have been used according to the standard. Although the variance is
concerned with the physical usage of materials, it is generally stated
in dollar terms to help gauge its importance

SQ = 2,000 units × 3.0 pounds per unit = 6,000 pounds.

Materials quantity variance = (6,500 pounds − 6,000 pounds) × $4.00 per pound
= $2,000 U
An excerpt from Colonial Pewter’s variance report is
shown below along with the production manager’s
explanation for the materials quantity variance.
 Materials Price Variance
A materials price variance measures the difference between
what is paid for a given quantity of materials and what
should have been paid according to the standard

Materials price variance = 6,500 pounds ($3.80 per pound − $4.00 per pound)
= $1,300 F
An excerpt from Colonial Pewter’s variance report is
shown below along with the purchasing manager’s
explanation for the materials price variance.
 Isolation of Variances
Variances should be isolated and brought to the attention of
management as quickly as possible so that problems can be
promptly identified and corrected. The most significant
variances should be viewed as “red flags”; an exception has
occurred that requires explanation by the responsible
manager and perhaps follow-up effort. The performance
report itself may contain explanations for the variances, as
illustrated above. In the case of Colonial Pewter Company,
the purchasing manager said that the favorable price
variance resulted from bargaining for an especially good
price.
 Responsibility for the Variance
Who is responsible for the materials price variance? Generally
speaking, the purchasing manager has control over the price paid for
goods and is therefore responsible for the materials price variance.
Many factors influence the prices paid for goods including how many
units are ordered, how the order is delivered, whether the order is a
rush order, and the quality of materials purchased. If any of these
factors deviates from what was assumed when the standards were
set, a price variance can result. For example, purchasing second-
grade materials rather than top grade materials may result in a
favorable price variance because the lower-grade materials may be
less costly. However, we should keep in mind that the lower-grade
materials may create production problems.
 However, someone other than the purchasing
manager could be responsible for a materials price
variance.
A word of caution is in order. Variance analysis
should not be used to assign blame. The emphasis
should be on supporting the line managers and
assisting them in meeting the goals that they have
participated in setting for the company. In short,
the emphasis should be positive rather than
negative. Excessive dwelling on what has already
happened, particularly in terms of trying to find
someone to blame, can destroy morale and kill any
cooperative spirit.
 Using Standard Costs-Direct Labor
Variances
Labor Efficiency Variance
 The labor efficiency variance attempts to measure the productivity of direct
labor. No
variance is more closely watched by management because it is widely
believed that
increasing direct labor productivity is vital to reducing costs. The formula for
the labor
efficiency variance is expressed as follows:
Labor efficiency variance = (AH × SR) − (SH × SR)

Where:
AH=Actual hours
SR=Standard rate
SH=Standard hours allowed for actual output
The formula can be factored as follows:

Labor efficiency variance = (AH − SH)SR

Using the data from Exhibit 10–6 in the formula, we have the following:
SH = 2,000 units × 0.5 hours per unit = 1,000 hours.
Labor efficiency variance = (1,050 hours − 1,000 hours) $22.00 per hour = $1,100 U
 Possible causes of an unfavorable labor efficiency variance
include poorly trained or motivated workers; poor quality
materials, requiring more labor time; faulty equipment,
causing breakdowns and work interruptions; poor supervision
of workers; and inaccurate standards.
 Another important cause of an unfavorable labor efficiency
variance may be insufficient demand for the company’s
products. If customer orders are insufficient to keep the
workers busy, the work center manager has two options—
either accept an unfavorable labor efficiency variance or
build inventory.
 Labor Rate Variance
As explained earlier, the price variance for direct labor is commonly called the labor rate
variance. This variance measures any deviation from standard in the average hourly rate
paid to direct labor workers. The formula for the labor rate variance is expressed as
follows:
 Labor rate variance = (AH × AR) − (AH × SR)
Where:
AH=Actual hours
AR=Actual rate
SR=Standard rate
The formula can be factored as follows:
Labor rate variance = AH(AR − SR)

Using the data from Exhibit 10–6 in the formula, the labor rate variance can be computed
as follows:
Labor rate variance = 1,050 hours ($21.60 per hour − $22.00 per hour) = $420 F
 In most companies, the wage rates paid to workers are quite
predictable. Nevertheless, rate variances can arise because of the
way labor is used. Skilled workers with high hourly rates of pay
may be given duties that require little skill and call for lower
hourly rates of pay. This will result in an unfavorable labor rate
variance because the actual hourly rate of pay will exceed the
standard rate specified for the particular task. In contrast, a
favorable rate variance would result when workers who are paid
at a rate
lower than specified in the standard are assigned to the task.
However, the lower-paid workers may not be as efficient. Finally,
overtime work at premium rates will result in an unfavorable rate
variance if the overtime premium is charged to the direct labor
account.
 Using Standard Costs—Variable
Manufacturing Overhead Variances
 The variable portion of manufacturing overhead can be analyzed
using the same basic formulas that we used to analyze direct
materials and direct labor.
 Recall from Exhibit 10–2 that the standard variable manufacturing
overhead is $3.00 per unit of product, computed as follows:
0.5 hours per unit × $6.00 per hour = $3.00 per unit
 Colonial Pewter’s cost records showed that the total actual
variable manufacturing overhead cost for June was $7,140. Recall
from the earlier discussion of the direct labor variances that 1,050
hours of direct labor time were recorded during the month and
that the company produced 2,000 pairs of bookends.
Terry’s analysis of this overhead data appears in Exhibit 10–7 .
Notice the similarities between Exhibits 10–6 and 10–7 .
 
 These similarities arise from the fact that direct labor-hours
are being used as the base for allocating overhead cost to
units of product; thus, the same hourly figures appear in
Exhibit 10–7 for variable manufacturing overhead as in Exhibit
10–6 for direct labor.
 
 The main difference between the two exhibits is in the
standard hourly rate being used, which in this company is
much lower for variable manufacturing overhead than for
direct labor.
 Manufacturing Overhead Variances—A
Closer Look
The formula for the variable overhead efficiency
variance is expressed as follows:

Variable overhead efficiency variance = (AH × SR) − (SH ×

SR)
Where
AH = Actual Hours
SR = Standard Rate
SH = Standard Hours Allowed for Actual Output
This formula can be factored as follows:
Variable overhead efficiency variance = (AH − SH)SR
Again using the data from Exhibit 10–7 , the variance can be
computed as follows:

SH = 2,000 units × 0.5 hours per unit = 1,000 hours

Variable overhead efficiency variance = (1,050 hours − 1,000
hours) $6.00 per hour
= $300 U
The formula for the variable overhead rate variance is expressed as follows:
 Variable overhead rate variance = (AH × AR) − (AH × SR)
Where
AH = Actual Hours
AR = Actual Rate
SR = Standard Rate

This formula can be factored as follows:

Variable overhead rate variance = AH(AR − SR)
 Using the data from Exhibit 10–7 in the formula, the variable overhead rate variance can
be computed as follows:
 AR = $7,140 ÷ 1,050 hours = $6.80 per hour
 
Variable overhead rate variance = 1,050 hours ($6.80 per hour − $6.00 per hour)
= $840 U
The interpretation of the variable overhead variances is not as
clear as the direct materials and direct labor variances.
In particular,
 the variable overhead efficiency variance is exactly the
same as the direct labor efficiency variance except for one
detail—the rate that is used to translate the variance into
dollars. In both cases, the variance is the difference
between the actual hours worked and the standard hours
allowed for the actual output.
 In the case of the direct labor efficiency variance, this difference is
multiplied by the direct labor rate. In the case of the variable
overhead efficiency variance, this difference is multiplied by the
variable overhead rate.
So when direct labor is used as the base for overhead, whenever
the direct labor efficiency variance is favorable, the variable overhead
efficiency variance will be favorable. And whenever the direct labor
efficiency variance is unfavorable, the variable overhead efficiency
variance will be unfavorable. Indeed, the variable overhead efficiency
variance really doesn’t tell us anything about how efficiently overhead
resources were used. It depends solely on how efficiently direct labor
was used
 An Important Subtlety in the Materials
Variances
Most companies compute the materials price variance when materials are
purchased rather than when they are used in production.
 
There are two reasons for this practice.
First, delaying the computation of the price variance until the
materials are used would result in less timely variance reports.
Second, computing the price variance when the materials are
purchased allows materials to be carried in the inventory accounts at
their standard cost.
This greatly simplifies bookkeeping
 Theequations presented earlier that define the direct materials
quantity and price variances are correct and are reproduced below:
Carefully note: the materials quantity variance is based on the
actual quantity used, whereas
 the materials price variance is based on the actual quantity
purchased . 
It does matter when the quantity purchased differs from the
quantity used.

To illustrate, assume that during June Colonial Pewter purchased

7,000 pounds of materials at $3.80 per pound instead of 6,500
pounds as assumed earlier in the chapter. In this case, the
quantity and price variances for direct materials would be
computed as shown: