Presentation on Standard Costing

Manpreet KaurMBA 4th sem.

Standard

• The word ‘standard’ means a ‘benchmark or yardstick’. The standard cost is a predetermined cost which determines in advance what each product or service should cost under given circumstances.

• Real life examples are the following:ISO – International Standards for Business, Government and

Society.CMMI – Process improvement approach from Carnegie

Mellon University, USA.NBA – An AICTE program for institution evaluation.

Standard cost

• In the words of Backer and Jacobsen, “Standard cost is the amount the firm thinks a product or the operation of the process for a period of time should cost, based up on certain assumed conditions of efficiency, economic conditions and other factors.

Standard Costing

•The technique of using standard costs for the purposes of cost control is known as standard costing.

•Standard Costing is the preparation of standard costs and applying them to measure the variations from actual costs and analyzing the causes of variances with a view to maintain maximum efficiency in production. It is a technique which uses standards for costs and revenues for the purposes of control through variance analysis.

Objectives of Standard Costing• To provide a formal basis for assessing performance and

efficiency.• To control costs by establishing standards and analysis of

variances.• To enable the principle of “Management by Exception” to be

practiced at the detailed operational level.• To assist in setting budgets.• To motivate staff and management.• To provide basis for estimating costs.• To provide guidance on possible ways of improving

performance.

Difference between Standard Costs and Estimated Costs

• The object of estimated cost is to have a reasonable assessment of what a cost ‘will be’ whereas standard cost aims at what a cost ‘should be’.

• Estimated costs are calculated on the basis of past performance adjusted in the light of anticipated changes in the future. Standard costs, on the other hand, are determined on a scientific basis keeping in view certain factors and conditions of efficiency.

• Estimated costs are used by the concerns which adopt historical costing system of ascertaining cost whereas standard costs are used by the concerns which follow standard costing system.

• Standard costs are used as a regular system of accounts from which variances are found out whereas use of estimated costs is as statistical data only.

Advantages of standard costing• Efficiency measurement-- The comparison of actual costs with standard costs

enables the management to evaluate performance of various cost centers. In the absence of standard costing system, actual costs of different period may be compared to measure efficiency. It is not proper to compare costs of different period because circumstance of both the periods may be different. Still, a decision about base period can be made with which actual performance can be compared.

• Finding of variance-- The performance variances are determined by comparing actual costs with standard costs. Management is able to spot out the place of inefficiencies. It can fix responsibility for deviation in performance. It is possible to take corrective measures at the earliest. A regular check on various expenditures is also ensured by standard cost system.

• Management by exception-- The targets of different individuals are fixed if the performance is according to predetermined standards. In this case, there is nothing to worry. The attention of the management is drawn only when actual performance is less than the budgeted performance. Management by exception means that everybody is given a target to be achieved and management need not supervise each and everything. The responsibilities are fixed and every body tries to achieve his/her targets.

Cont….• Cost control-- Every costing system aims at cost control and cost reduction.

The standards are being constantly analyzed and an effort is made to improve efficiency. Whenever a variance occurs, the reasons are studied and immediate corrective measures are undertaken. The action taken in spotting weak points enables cost control system.

• Right decisions-- It enables and provides useful information to the management in taking important decisions. For example, the problem created by inflating, rising prices. It can also be used to provide incentive plans for employees etc.

• Eliminating inefficiencies-- The setting of standards for different elements of cost requires a detailed study of different aspects. The standards are set differently for manufacturing, administrative and selling expenses. Improved methods are used for setting these standards. The determination of manufacturing expenses will require time and motion study for labor and effective material control devices for materials. Similar studies will be needed for finding other expenses. All these studies will make it possible to eliminate inefficiencies at different steps.

Limitations of Standard Costing• It cannot be used in those organizations where non-standard

products are produced. If the production is undertaken according to the customer specifications, then each job will involve different amount of expenditures.

• The process of setting standard is a difficult task, as it requires technical skills. The time and motion study is required to be undertaken for this purpose. These studies require a lot of time and money.

• There are no inset circumstances to be considered for fixing standards. The conditions under which standards are fixed do not remain static. With the change in circumstances, if the standards are not revised the same become impracticable.

• The fixing of responsibility is not an easy task. The variances are to be classified into controllable and uncontrollable variances. Standard costing is applicable only for controllable variances.

Types of standards• There are three types of standards: -

Current standards : - A current standard is a standard which is established for use over a short period of time and is related to current condition. It reflects the performance that should be attained during the current period. The period for current standard is normally one year. It is presumed that conditions of production will remain unchanged. In case there is any change in price or manufacturing condition, the standards are also revised. Current standard may be ideal standard and expected standard.

Cont…..Ideal standard: - This is the standard which represents a high

level of efficiency. Ideal standard is fixed on the assumption that favorable conditions will prevail and management will be at its best. The price paid for materials will be lowest and wastes etc. will be minimum possible. The labor time for making the production will be minimum and rates of wages will also be low. The overheads expenses are also set with maximum efficiency in mind. All the conditions, both internal and external, should be favorable and only then ideal standard will be achieved.

Expected standard: - this is the standard which is anticipated during a future specified budget period. In setting up this standard, a reasonable allowance is also made for unavoidable (normal) wastages. This standard is therefore, considered to be more realistic than the ideal standard because is based on realities rather than on the most ideal conditions.

Cont…Basic standard: - A basic standard may be defined as a standard which is established for use for an indefinite period which may a long period. Basic standard is established for a long period and is not adjusted to the preset conations. The same standard remains in force for a long period. These standards are revised only on the changes in specification of material and technology productions. It is indeed just like a number against which subsequent process changes can be measured. Basic standard enables the measurement of changes in costs. For example, if the basic cost for material is Rs. 20 per unit and the current price is Rs. 25 per unit, it will show an increase of 25% in the cost of materials. The changes in manufacturing costs can be measured by taking basic standard, as a base standard cannot serve as a tool for cost control purpose because the standard is not revised for a long time. The deviation between standard cost and actual cost cannot be used as a yardstick for measuring efficiency.

Cont….Normal Standard: - As per terminology, normal standard has been defined as a standard which, it is anticipated, can be attained over a future period of time, preferably long enough to cover one trade cycle. This standard is based on the conditions which will cover a future period of five years, concerning one trade cycle. If a normal cycle of ups and downs in sales and production is 10 years, then standard will be set on average sales and production which will cover all the years. The standard attempts to cover variance in the production from one time to another time. An average is taken from the periods of recession and depression. The normal standard concept is theoretical and cannot be used for cost control purpose. Normal standard can be properly applied for absorption of overhead cost over a long period of time.

Why standard costing?•Facilitation of management planning.•Make employees more cost conscious.•Helpful in setting prices.•Provides basis for evaluating management

performance.•Allows management by exception.•Simplifies clerical costs and inventory costing.

Setting Standards• Normally, setting up standards is based on the past

experience. The total standard cost includes direct materials, direct labor and overheads. Normally, all these are fixed to some extent. The standards should be set up in a systematic way so that they are used as a tool for cost control.

• Various Elements which Influence the Setting of Standards:Setting Standard for Direct MaterialSetting Standard for Direct Labor CostSetting Standard of Overhead

Setting standard for Direct material

• When you want to purchase some material what are the factors you consider. If material is used for a product, it is known as direct material. On the other hand, if the material cost cannot be assigned to the manufacturing of the product, it will be called indirect material. Therefore, it involves two things:

• Quality of material• Price of the material

The procedure for purchase of materials, minimum and maximum levels for various materials, discount policy and means of transport are the other factors which have bearing on the materials cost price.It includes:Cost of materials Ordering cost Carrying cost

Setting standard for Direct Labor• If you want to engage a labor force for manufacturing a product or a

service for which you need to pay some amount, this is called wages. If the labor is engaged directly to produce the product, this is known as direct labor. The second largest amount of cost is of labor. The benefit derived from the workers can be assigned to a particular product or a process. If the wages paid to workers cannot be directly assigned to a particular product, these will be known as indirect wages. The time required for producing a product would be ascertained and labor should be properly graded. Different grades of workers will be paid different rates of wages. The times spent by different grades of workers for manufacturing a product should also be studied for deciding upon direct labor cost. The setting of standard for direct labor will be done basically on the following:

• Standard labor time for producing• Labor rate per hour

Setting Standard of Overhead• The next important element comes under overheads.

The very purpose of setting standard for overheads is to minimize the total cost. Standard overhead rates are computed by dividing overhead expenses by direct labor hours or units produced. The standard overhead cost is obtained by multiplying standard overhead rate by the labor hours spent or number of units produced. The determination of overhead rate involves three things:

• Determination of overheads• Determination of labor hours or units manufactured• Calculating overheads rate by dividing A by BThe overheads are classified into fixed overheads, variable

overheads and semi-variable overheads.

Variance Analysis

• If actual costs are greater than standard costs the variance is unfavourable.

• If actual costs are less than standard costs the variance is favourable.

The difference between the actual costs and the standard costs are known as variances.

Standard costing and the related variances is a valuable management tool. If a variance arises, management becomes aware that manufacturing costs have differed from the standard (planned, expected) costs.

Variance analysis involves two phases :Computation of individual variances.Determination of the cause of each variance.

Materials Cost Variance

Usage Variance Price Variance

Mix Variance Yield Variance

Material cost variance is the difference between actual cost of direct materials used & standard cost of direct materials specified for the output achieved.FormulaMCV=(AQ*AP)-(SQ*SP)φAQ=actual quantityφAP=actual priceφSQ=standard quantity for actual outputφSP=standard price

Material cost variance

•Material cost variance = (Standard quantity of input for actual production × SP) – (Actual quantity of input × AP)

•Material cost variance = Material price variance + Material usage variance

Material price variance

• This is that portion of the material cost variance which is due to the difference between the standard price specified and the actual price paid.

• If the actual price is higher than the standard price, it would result in adverse price variance and if the actual price is lower than standard price, the result is favorable price variance.

•Material price variance = Actual quantity (Standard price – Actual price)

Material Usage Variance

• This is that portion of material cost variance which is due to the difference between the standard quantity of actual production and the actual quantity used.

• Formula:

•Material Usage Variance = Standard price (Standard quantity – Actual quantity)

Material Mixture Variance

• This is that portion of usage variance which is due to the difference between the standard and actual composition of mixture.

• Formula:• Material Mixture Variance = Standard price [Actual quantity in

standard mix (i.e. RSQ) – Actual quantity]

• Revised Standard quantity = Total actual quantity consumed ×

Material Yield Variance• When there is a loss in process industries, the material yield

variance can be calculated.• This variance arises due to the difference between the

standard yield specified and actual yield obtained.• This is also a portion of the material usage variance.

•Formula:•Material yield variance = [(Standard loss in terms of

actual input) – (Actual loss on actual input)] × (Average standard price)

•Material yield variance = Material usage variance – Material mix variance

Labour cost variance is the difference between the actual direct wages paid & standard direct wages specified for output achieved.Formula :LCV=(AH*AR)-(SH*SR)φAH=actual hoursφAR=actual rateφSH=standard hoursφSR=standard rate

Labour Cost Variance

Efficiency Variance Idle Time Variance

Rate Variance

Mix Variance Yield Variance

Labor Rate Variance •This is that portion of the labor cost variance which is

caused by the use of actual wage rate other than predetermined.

• Labor rate variance = Actual labor time (Standard wage rate – Actual wage rate)

Labor Idle Time Variance

• It is that portion of labor cost variance which is due to the abnormal idle time of workers.

• While calculating labor efficiency variance, abnormal idle time is deducted from the actual time spent to determine the real efficiency of the workers.

• Idle time variance = Abnormal idle time × Standard wage rate

Labor Efficiency Variance

• It is the difference between the standard time and the actual time spent multiplied by standard wage rate.

• Labor efficiency variance = Standard wage rate (Standard labor time – Actual labor time)

Labor Yield Variance

• It is computed on the basis of the increase or decrease in the actual yield or output when compared to the standard.

• Labor Yield Variance = [Standard yield in units expected from the actual hours worked – actual yield] × Standard labor cost per unit

Labor Mix Variance

• This variance arises due to the change in the composition or mix of a group of workers as compared to the standard composition or mix.

• It can be calculated in the following two situation:(a) When the totals of standard labour mix and actual labour

mix are same, but the two mix ratios are different.(b) When the totals of standard labour mix and actual labour

mix are different, and the two mix ratios are also different.

•Situation A• Labour mix variance = (Standard time mix – Actual

time mix) × Standard rate per hour

•Situation B• Labour mix variance = (Revised standard time –

Actual time) × Standard rate per hour•Here, RST= Total actual time ×

Overhead Cost Variance

Fixed Overhead Variance Variable Overhead VarianceThere are various other branches of these two variances as listed below :•Fixed overhead expenditure variance.•Fixed overhead volume variance.Variable overhead expenditure variance.Variable overhead efficiency variance.

Expenditure variable

Efficiency variable

Expenditure variable

Volume variable

Efficiency variable

Capacity variable

Calendar variable

Variable overhead variance

• Difference between the standard variable overheads and absorbed variable overheads is called variable overhead variance.

• If variable overhead absorbed to actual output is more or less than its standard variable overhead, this variance is created.

• Overhead variance is the difference between the amount calculated at standard rate of variable overhead and the amount calculated at actual rate of variable overhead on the on the actual output.

•Variable overhead variance = AO (SR – AR) = (AO × SR) – (AO × AR) = SVO – AVO

Here, AO = Actual output, SR = Standard rate, AR = Actual rate, SVO = Standard variable overhead, and AVO = Actual variable overhead

Net or overall variable overhead variance

•Variable overhead variance = [Standard hours × Standard variable overhead rate per

hour] – [Actual hours × Actual variable overhead rate per hour]

= [SH × SVOR] – [AH × AVOR]

•This net variable overhead variance can be decomposed into following two variances:

(a) Variable overhead spending variance(b) Variable overhead efficiency variance

•Variable overhead efficiency variance (VOEV) :The difference between the actual hours used to

complete a job and the standard hours allowed to do it indicates the efficiency or inefficiency.

It measures the extent of cost saved or excess cost incurred due to efficient or inefficient performance.

• VOEV = (Standard hours allowed for actual volume or output – Actual hours taken for actual volume) × Standard variable overhead rate per hour

= (Actual output hours × Standard per unit) – (Actual hours × Standard variable overhead recovery

rate)

• The variable overhead can be attributed to the causes which are responsible for the labour efficiency variance.

• Factors such as workers’ personal problems, incentive plans, work process, frequency and quantity of machine repairs, materials quantity, etc. will cause variable overhead efficiency variance.

Variable overhead expenditure variance

•Variable overhead expenditure variance = Budgeted variable overheads – Actual variable

overheads

Fixed overhead variance•Fixed overhead variance is mainly concerned with

over – absorption or under – absorption on fixed overheads.

•As the fixed overheads are not affected by the volume of output, its absorption is done on actual output the predetermined rate only.

•Fixed overhead variance is caused due to the difference between standard fixed overhead and actual fixed overhead on actual output.

•Fixed overhead variance = TSC – TAC [AO × SFO] – [ AO × AFO] TSO – TAO

•Here, TSC = Total standard cost for actual output, TAC = Total actual cost, AO = Actual output SFO = Standard fixed overhead AFO = Actual fixed overhead TSO = Total standard overhead TAO = Total actual overhead

Expenditure Variance

• The difference between the amount actually spent during a certain period as fixed overhead and the amount of fixed overhead budgeted for the period is expressed by this variance.

• This part of fixed overhead cost variance shows whether the actual amount of fixed overhead is less or more than the amount budgeted for it.

• Expenditure variance = Budgeted fixed overhead – Actual fixed overhead

Volume variance

• Volume variance is caused mainly due to the difference between budgeted output and actual output.

• To calculate this variance, the difference of budgeted output and actual output is multiplied by the budgeted standard absorption rate.

• Volume variance = SC (AQ – BQ)• Where, SC = Standard cost per unit of fixed overheads AQ = Actual output in actual hours worked BQ = Budgeted standard output in budgeted standard

hours

Efficiency variance

•This variance gives information about the efficiency of workers because it arises due to their being less or more efficient.

• It also arises due to the change in production process or quality of material and efficiency of the machinery, plant, and workers.

•Efficiency variance = SC (AQ – SQ)•Here, SQ means the quantity produced during actual

working hours at the standard rate.

Capacity variance

•Capacity is expressed in terms of average direct labor hours per day.

• If capacity is utilized to a level less or more than the planned standard, variance arises.

•Use of plant and instruments less or more than their capacity affects the efficiency due to which this variance arises.

•Capacity variance = SC (SQ – BQ)

Calendar variance

• If the number of actual working days during a certain period is different from the standard number of working days during the same period, then it is called calendar variance.

•Calendar variance = SC (RBQ – BQ)•Here, RBQ = Budgeted quantity of output for actual

working days.

•Note:• If the calendar variance is being calculated, capacity

variance should be ascertained using the formula given below:

•Capacity variance = SC (SQ – RBQ)