CHAPTER SEVEN : STANDARD COSTING

CHAPTER SEVEN : STANDARD COSTING

What is  Standard Costing :

Standard costing is a technique which establishes predetermined estimates of the costs of products and services and then compares these predetermined costs with actual costs as they are incurred.

The predetermined costs are known as standard costs and the difference between the standard cost and actual is known as a variance.

The process by which the total difference between actual cost and standard cost is broken down into its different elements is known as variance analysis.

Definition of Standard Cost :

A standard cost is a standard expressed in money. It is a target cost which should be attained.

Uses of Standard Costing

Standard costing has two principal uses:

-          To act as a control device via variance analysis.

-          To value stocks and cost production.

Types of Standards

There are three types of standard; basic, ideal and attainable.

i)                    Basic standards: These are long term  standards which would remain unchanged over the years. Their sole role is to show trends over time for such items as material prices, labour rates and efficiency  and the effect of changing methods. They cannot be used to highlight current efficiency or inefficiency and would not normally form part of the reporting  except  as a background, statistical exercise. 

ii)                  Ideal Standards : These are based on the best possible operating  conditions, i.e no breakdowns, no material wastage , no stoppage or idle time , in short, perfect  efficiency.

iii)                Attainable standard : This is by far the most frequently encountered standard. It is a standard based on efficient ( but not perfect ) operating conditions. The standard would  include allowances for normal material losses, realize allowance  for fatigue, machine breakdowns etc

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Setting Standards

Setting standards is detailed, lengthy process usually based on engineering and technical studies of times, materials and methods. Standards are set for each of the elements which make up the standard cost: materials, labour and overheads.

The following lines explain some of the detailed procedures involved in setting  standards.

Setting Standards – material price

v  Estimated by purchasing department

v  Problems:

Ø  Allowing for bulk purchase discounts

Ø  Allowing for inflation

- Current price (procedures constantly increasing adverse variances)

- Estimated mid-year price (procedures favourable variances in the first half of the year, adverse variance in the second half)

   Setting Standards – Labour rate

v  Set by reference to the payroll, taking account of any agreed pay rises.

v  (Average) rate for each grade / type of employee

v  Problem of wage rate inflation

Setting Standards – Material usage and Labour efficiency

v  Technical specifications prepared for each product by production experts.

Setting Standards – Overheads

v  Standard absorption rate = predetermined OAR

v  Standard absorption rate depends on planned production volume, which depends on two factors

Ø  Production capacity (in standard hours of output)

Ø  Efficiency of working

Setting Standards – Sales

Standard selling price will depend on a number of factors.

v  Anticipated market demand

v  Manufacturing cost

v  Competition

v  Inflation

Variance Analysis

A variance is the difference between an actual result and an expected result.

When actual results are better than expected results, we have a favourable variance (F) but if actual results are worsen than expected results, we have an adverse variance (A).

The following  information will be used throughout our discussion below:

Standard cost of Product A	GMD
Materials ( 5Kg x GMD10 per kg)	50
Labour (4 hrs x GMD5 per hr)	20
Variance overheads ( 4 hrs x GMD2 per hr)	8
Fixed overheads ( 4 hrs x GMD6 per hr)	24
	102

Budgeted results	Results for July 2010
Production: 1,200	Production: 1,000 units
Sales : 1,000 units	Sales: 900 units
Selling price: GMD150 per unit	Materials: 4,850 kgs, GMD46,075
	Labour: 4,200 hrs, GMD21,210
	Variable overheads: GMD9,450
	Fixed overheads: GMD25,000
	Selling price: GMD140 per unit

Direct Material Variances

This is the difference between what the output actually cost and what it should have cost, in terms of material.

	GMD
1,000 units should have cost (x GMD50)	50,000
But did cost	46,075
Direct material total variance	3,925 (F)

It can be divided into two sub-variance as follows:

v  The direct material price variance : This is the difference between what the actual quantity of material used did cost and what it should have cost.

	GMD
4,850 kgs should have cost (x GMD10)	48,500
But did cost	46,075
Direct material price variance	2,425 (F)

Reasons for Material Price Variance:

ü  (F) – unforeseen discounts received, greater care taken in purchasing, change in material standard.

ü  (A) – price increase, careless purchasing, change in material standard.

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v  The direct material usage variance : This is the difference between how much material should have been used for the number of units actually produced and how much material was used, valued at standard cost.

1,000 units should have used (x 5 kgs)	5,000 kgs
But did used	4,850 kgs
Variance in kgs	150 kgs (F)
x standard cost per kg	x GMD10
	GMD1,500 (F)

Reasons for Material Usage variance:

ü  (F) – material used higher quality than standard, more effective used made of material.

ü  (A) – defective material, excessive waste, theft, stricter quality control.

Direct Labour Variances

This is the difference between what the output should have cost and what it did cost, in terms of labour.

	GMD
1,000 units should have cost (x GMD20)	20,000
But did cost	21,210
Direct labour total variance	1,210 (A)

The direct labour variance is sub-divided into two as follows:

v  The direct labour rate variance : This is the difference between what the actual number of hours paid for did cost and what they should have cost.

	GMD
4,200 hrs should have cost (x GMD5)	21,000
But did cost	21,210
Direct labour rate variance	210(A)

Reasons for Labour Rate Variance:

ü  (F) – use of workers at rate of pay lower than standard.

ü  (A) – wage rate increase.

v  The direct labour efficiency variance : This is the difference between how many hours should have been worked for the number of units actually produced and how many hours were worked, valued at the standard rate per hour.

1,000 units should have taken (x 4 hrs)	4,000 hrs
But did take	4,200 hrs
Variance in hrs	200 hrs (A)
x standard rate per hour	x GMD5
Direct material price variance	GMD1,000 (A)

Reasons for Labour Efficiency Variance:

ü  (F) – output produced more quickly than expected because of work motivation, better quality of equipment or materials..

ü  (A) – lost time in excess of standard allowed, output lower than standard set because of deliberate restriction, lack of training, sub-standard material used..

Sales Variances

This is sub-divided into two as follows:

v  The selling price variance: This is the difference between what the sales revenue should have been for the actual quantity sold, and what it was.

	GMD
Revenue from 900 units should have been (x GMD150)	135,000
But was	126,000
Selling price variance	9,000(A)

v  The volume variance : This is the difference between what the actual units sold and the budgeted quantity, valued at the standard profit per unit. It measures the increase or decrease in standard profit as a result of the sales volume being higher or lower than budgeted.

Budgeted sales volume	1,000 units
Actual sales volume	900 units
Variance in units	100 units (A)
x standard margin per unit  ( x GMD150 - GMD102)	x GMD48
Direct material price variance	GMD4,800 (A)

PRACTICE QUESTIONS

1.         The standard cost of making one unit is as follows:

            Direct material                         4 kilos at GMD7 per kilo

            Direct wages                           5 hours at GMD12 per hour

            The actual cost of a batch of 100 units was:

            Direct material                         GMD2,920 (435 kilos)

            Direct wages                           GMD6,250 (480 hours)

            REQUIRED

            a)    Calculate the following:

                   i        the material price variance [2]

                   ii       the material usage variance [2]

                   iii      the total material cost variance [1]

                   iv      the labour rate variance    [2]

                   v       the labour efficiency variance  [2]

                   vi      the total labour cost variance  [1]

                   vii     the total cost variance  [2]

            b)    Outline possible causes of the variances. [4]

           

2. The standard cost of making one unit is as follows:

            Direct material                7 kilos at GMD8.20 per kilo

            Direct wages                  6 hours at GMD9 per hour

            The actual cost of a batch of 100 units was:

            Direct material                GMD6,102 (795 kilos)

            Direct wages                  GMD5,740 (580 hours)

            REQUIRED

            a)    Calculate the following:

                   i        the material price variance   [2]

                   ii       the material usage variance   [2]

                   iii      the total material cost variance [1]

                   iv      the labour rate variance [2]

                   v       the labour efficiency variance  [2]

                   vi      the total labour cost variance  [1]

                   vii     the total cost variance  [2]

            b)    Outline possible causes of the variances. [4]

            c)    Distinguish between a budget and a standard.  [4]

3.         The standard cost of making one unit is as follows:

            Direct material     3 kilos at GMD4 per kilo

            Direct wages     2 hours at GMD8 per hour

            The actual cost of a batch of 500 units was:

            Direct material     GMD6,570 (1,680 kilos)

            Direct wages          GMD8,250 (975 hours)

            REQUIRED

            a)    Calculate the following:

                   i        the material price variance

                   ii       the material usage variance

                   iii      the labour rate variance

                   iv      the labour efficiency variance  [3 each]

            b)    Outline possible causes of the variances.  [4]

            c)    Explain the major purposes of standard (4)