APPLICATION OF STANDARD COSTING

IN BUSINESS

INTRODUCTION
Standard costing is an accounting technique that some manufacturers use to
identify the differences or variances between

1) the actual costs of the goods that were produced, and

2) the costs that should have occurred for those goods. The costs that should
have occurred for the actual good output are known as standard costs.

Standard costing is likely integrated with a manufacturer's budgets (profit

plan, master budget) for an accounting year and involve the product costs:
direct materials, direct labor, and manufacturing overhead. With standard
costing, the accounts for inventories and the cost of goods sold contain the
standard costs of the inputs that should have been used to make the actual
good output.

If the company had incurred more than the standard costs for the direct
materials, direct labor, and manufacturing overhead, the company will not
meet its projected net income. In other words, the variances will direct
management's attention to the production inefficiencies or higher input costs.
In turn, management can take action to correct the problems or seek higher
selling prices.

Since the external financial statements must reflect the historical cost
principle, the standard costs in the inventories and the cost of goods sold will
need to be adjusted for the variances. Since most of the goods manufactured
will have been sold, most of the variances will be reported on the income
statement as part of the cost of goods sold.

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 Objectives of Standard Costing
The objectives of Standard Costing for which it is implemented are:

(a) It helps to implement budgetary control system in operation;

(b) It helps to ascertain performance evaluation.

(c) It supplies the ways to utilise properly material, labour and also overhead
which will be economic in character.

(d) It also helps to motivate the employees of a firm to improve their

performance by setting up a ‘standard’.

(e) It also helps the management to supply necessary data relating to cost
element to submit quotations or to fix up the selling price of a firm.

(f) It also helps the management to make proper valuations of inventory (viz.,
Work-in- progress, and finished products).

(g) It acts as a control device to the management.

(h) It also helps the management to take various corrective decisions viz.,
fixation of price, make-or-buy decisions etc. which will be more beneficial to
the firm.

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 Types of standards
Following are different type of standards:
 Basic standards
 Normal standards
 Current standards
 Attainable (expected) standards

1) Basic standards
These are standards established considering those factors that are basic in
nature and remain unchanged over a long period of time and are altered only
when the business operations change significantly affecting the very basic
foundations of the entity and nature of busienss. These standards help
compare business operations over a longer period of time. Basic standards are
used not only to evaluate actual results but also current expected results
(current standards). We can say that basic standards work as a standard for
other standards. As basic standards are not updated according to latest
circumstances thus they are not used often as they cannot help in short term
period variance analysis.

2) Normal Standards:
These are such standards which are expected if normal circumstances prevail.
Term normal represents the normal conditions of the business in the absence
of any unexpected fluctuations (either favourable or unfavourable). Even
through normal standards are more of a theoretical in nature as reality cannot
be sufficiently predicted with all its fluctuations in advance. Also,
circumstances may change in such a way that factors which were expected to
be controllable are not so controllable by the mangers. Thus it has limited
application in today’s business environment. However, normal standards acts
as a good yardstick that represents challenging yet attainable results and can
be used by management in such environment which is simple in nature and is
not prone to great fluctuations.

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3) Current standards

These standards are representative of current business conditions. These are

mostly short term in nature and are widely used as they are the most relevant
standards to be used for control purposes. These standards represent the state
that business currently achieving or must achieve.

4) Attainable standards / Expected standards

These standards are based on current conditions and circumstances and
represents what can be attained with the present setup in place and if the
current conditions prevail. Current standards may be set lower or easier then
expected standards but good managers always try to achieve what is
attainable so that no resource is left unused. It means that attainable
standards are representative of the potential that business is capable to
achieve. For example a machinery is expected to run for 4,000 hours where it
can run for 5,000. Thus current standard is 4,000 hours where attainable is
5,000 hours. These standards are useful as they help management to
analyzetheir performance and to use the unused potential at the right time

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 Advantages of Standard Costing
The following advantages may be derived from Standard Costing:

(i) Standard Costing serves as a guide to the management in several

management functions while formulating prices and production policies etc.

(ii) More effective cost control is possible under standard costing if the same is
reviewed and analysed at regular intervals for improvements and immediate
action can be taken if deviations from standards are found out which,
ultimately, leads to cost reduction.

(iii) Analysis of variance and its measurement helps to detect inefficiencies and
mistakes which enable the management to investigate the reasons.

(iv) Since standard costs are predetermined costs they are very useful for
planning and budgeting. It also helps to estimate the effect of changes in Cost-
Price-Volume relationship which also helps the management for decision-
making in future.

(v) As standard is fixed for each product, its components, materials, process
operation etc. it improves the overall production efficiency which also
ultimately reduces cost and thereby increases profit.

(vi) Once the Standard Costing System is implemented it will lead to saving cost
since most of the costing work can be eliminated.

(vii) Delegation of authority and responsibility becomes effective by setting up

standards for each cost centre as the supervisors or executives of each cost
centre will know the standard which they have to maintain.

(viii) This system also helps to prepare Profit and Loss Account promptly for
short period in order to know the trend of the business which helps the
management to take decisions promptly.

(ix) Standard costing also is used for inventory valuation purposes. Stock can
be valued at standard cost which can reduce the fluctuation of profit for
different methods of valuation for the same.

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(x) Efficiency of labour is promoted.

(xi) This system creates cost-consciousness among all employees, executives

and top management which increase efficiency and productivity as well.

Disadvantages of Standard Costing:

The alleged disadvantages of Standard Costing are:
(i) Since Standard Costing involves high degree of technical skill, it is, therefore,
costly. As such, small organisations cannot, introduce the system due to their
limited financial resources. But, once introduced, the benefits achieved will be
far in excess to its initial high costs.

(ii) The executives are liable for those variances that are found from actions
which are actually controllable by them. Thus, in order to fix up the
responsibilities, it becomes necessary to segregate variances into non-
controllable and controllable portions although that is not an easy task.

(iii) Standards are always changing since conditions of the business are equally
changing. So, standards are to be revised in order to make them comparable
with actual results. But revision of standards creates many problems,
particularly in inventory adjustment.

(iv) Standards are either too liberal or rigid since the same are based on
average past results, attainable good performance or theoretical maximum
efficiency. So, if the standards are very high, it will adversely affect the morale
and motivation of the employees.

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 Material Variance
 MATERIAL COST VARIANCE

The difference between the standard cost of direct materials specified for
production and the actual cost of direct materials used in production is known
as Direct Material Cost Variance. Material Cost Variance gives an idea of how
much more or less cost has been incurred when compared with the standard
cost. Thus, Variance Analysis is an important tool to keep a tab on the
deviations from the standard set by a company.

MATERIAL COST VARIANCE FORMULA

Material Cost Variance Formula = Standard Cost – Actual Cost

Material Cost Variance can be due to less purchase price being paid than the
standard or because of change in the quantity of material used. Thus, Material
Cost Variance is made up of two components namely; Material Price Variance
and Material Usage Variance.

MATERIAL PRICE VARIANCE

Material Price Variance is the difference between the standard price and the
actual price for the actual quantity of materials used for production. The cause
for material price variance can be many including changes in prices, poor
purchasing procedures, deficiencies in price negotiation, etc.

MATERIAL PRICE VARIANCE FORMULA

MPV = (Standard Price – Actual Price) x Actual Quantity

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Let us understand this formula with the help of an example.

Standard Actual
Price 10 per kg 8 per kg
Qty 200 kgs 150 kgs

Here, the Material Price Variance can be calculated as follows:

MPV = (10 – 8) x 15
= 300 (F)
Here (F) stands for favorable. The variance is favorable because the
actual price is less than the standard price. In cases where the actual price is
more than the standard price, the result is (A) which means adverse.

MATERIAL USAGE VARIANCE

Material Usage Variance is the difference between the
standard quantity specified for actual production and the actual quantity used
at the standard purchase price. There can be many reasons for material usage
variance including the use of sub-standard or defective products, pilferage,
wastage, the differences in material quality, etc.

MATERIAL USAGE VARIANCE FORMULA

MUV = (Standard Quantity – Actual Quantity) x Standard Price
With the help of the above example, let us now calculate Material Usage
Variance.
MUV = (200 – 150) x 10
= 500 (F)
The result is Favourable, since the standard quantity is more than the actual
quantity. In cases where the actual quantity is more than the standard
quantity, the result is in (A) which means Adverse.

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Conclusion
Material Cost Variance is composed of Material Price Variance and Material
Usage Variance. This means Material Cost Variance = Material Price Variance +
Material Usage Variance. We can confirm and cross check this equation with
the help of our example.

Material Cost Variance Formula:

= Standard Cost – Actual Cost

In other words, (Standard Quantity x Standard Price) – (Actual Quantity x

Actual Price)
= (200 x 10) – (150 x 8)= 800 (F)

Favourable, since the actual cost is less than the standard cost. If the actual
cost is more than the standard cost, the result is Adverse (A).

MCV= MPV + MUV

= 300 (F) +500 (F)
= 800 (F)

Material Mix Variance:

The materials usage or quantity variance can be separated into mix variance
and yield variance.

For certain products and processing operations, material mix is an important

operating variable, specific grades of materials and quantity are determined
before production begins. A mix variance will result when materials are not
actually placed into production in the same ratio as the standard formula. For
instance, if a product is produced by adding 100 kg of raw material A and 200
kg of raw material B, the standard material mix ratio is 1: 2.
Actual raw materials used must be in this 1: 2 ratio, otherwise a materials mix
variance will be found. Material mix variance is usually found in industries,
such as textiles, rubber and chemicals, etc. A mix variance may arise because
of attempts to achieve cost savings, effective resources utilisation and when
the needed raw materials quantities may not be available at the required time.

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Materials mix variance is that portion of the materials quantity variance which
is due to the difference between the actual composition of a mixture and the
standard mixture

It can be computed by using the following formula:

Material mix variance = (Standard cost of actual quantity of the actual mixture
– Standard cost of actual quantity of the standard mixture)
Or
Materials mix variance = (Actual mix – Revised standard mix of actual input) x
Standard price

Revised standard mix or proportion is calculated as follows:

Standard mix of a particular material/Total standard quantity x Actual input

Materials Yield Variance:

Materials yield variance explains the remaining portion of the total materials
quantity variance. It is that portion of materials usage variance which is due to
the difference between the actual yield obtained and standard yield specified
(in terms of actual inputs). In other words, yield variance occurs when the
output of the final product does not correspond with the output that could
have been obtained by using the actual inputs. In some industries like sugar,
chemicals, steel, etc. actual yield may differ from expected yield based on
actual input resulting into yield variance.
The total of materials mix variance and materials yield variance equals
materials quantity or usage variance. When there is no materials mix variance,
the materials yield variance equals the total materials quantity variance.
Accordingly, mix and yield variances explain distinct parts of the total materials
usage variance and are additive.

The formula for computing yield variance is as follows:

Yield Variance = (Actual yield – Standard Yield specified) x Standard cost per
unit Yield, in such a case, is known as sub-usage variance (or revised usage
variance) which can be computed by using the following formula:
Sub-usage or revised usage variance = (Revised Standard Proportion of Actual
Input – Standard quantity) x Standard Cost per unit of input

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 Labour Variances
Direct labour variances arise when actual labour costs are different from
standard labour costs. In analysis of labour costs, the emphasis is on labour
rates and labour hours.

Labour variances constitute the following:

Labour Cost Variance:

Labour cost variance denotes the difference between the actual direct wages
paid and the standard direct wages specified for the output achieved.
This variance is calculated by using the following formula:
Labour cost variance = (AH x AR) – (SH x SR)

Where:
AH = Actual hours
AR = Actual rate
SH = Standard hours
SR = Standard rate

1. Labour Efficiency Variance:

The calculation of labour efficiency or usage variance follows the same pattern
as the computation of materials usage variance. Labour efficiency variance
occurs when labour operations are more efficient or less efficient than
standard performance. If actual direct labour hours required to complete a job
differ from the number of standard hours specified, a labour efficiency
variance results; it is the difference between actual hours expended and
standard labour hours specified multiplied by the standard labour rate per
hour.

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Labour efficiency variance is computed by applying the following formula:

Labour efficiency variance = (Actual hours – Standard hours for the actual
output) x Std. rate per hour.

Assume the following data:

Standard labour hour per unit = 5 hr
Standard labour rate per hour = Rs 30
Units completed = 1,000
Labour cost recorded = 5,050 hrs @ Rs 35

Labour efficiency variance = (5,050-5,000) x Rs 30 = Rs 1,500 (unfavourable) It

may be noted that the standard labour hour rate and not the actual rate is
used in computing labour efficiency variance. If quantity variances are
calculated, changes in prices/rates are excluded, and when price variances are
calculated, standard quantities are ignored.

(i) Labour Mix Variance:

Labour mix variance is computed in the same manner as materials mix

variance. Manufacturing or completing a job requires different types or grades
of workers and production will be complete if labour is mixed according to
standard proportion. Standard labour mix may not be adhered to under some
circumstances and substitution will have to be made. There may be changes in
the wage rates of some workers; there may be a need to use more skilled or
expensive types of labour, e.g., employment of men instead of women;
sometimes workers and operators may be absent.

These lead to the emergence of a labour mix variance which is calculated by

using the following formula:

Labour mix variance = (Actual labour mix – Revised standard labour mix in
terms of actual total hours) x Standard rate per hour

To take an example, suppose the following were the standard labour cost data
per unit in a factory:

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In a period, many class B workers were absent and it was necessary to
substitute class B workers. Since the class A workers were less experienced
with the job, more labour hours were used.

The recorded costs of a unit were:

Labour mix variance will be calculated as follows:

Labour mix variance = (Actual proportion – Revised standard proportion of

actual total hours) x standard rate per hour

Labour Yield Variance:

The final product cost contains not only material cost but also labour cost.
Therefore, gain or loss (higher or lower output than the standard output)
should take into account labour yield variance also. A lower output simply
means that final output does not correspond with the production units that
should have been produced from the hours expended on the inputs.
It can be computed by ap-plying the following formula:
Labour yield variance = (Actual output – Standard output based on actual
hours) x Av. Std. Labour Rate per unit of output.
Or Labour yield variance = (Actual loss – Standard loss on actual hours) x
Average standard labour rate per unit of output
Labour yield variance is also known as labour efficiency sub-variance which is
computed in terms of inputs, i.e., standard labour hours and revised labour
hours mix (in terms of actual hours).
Labour efficiency sub-variance is computed by using the following formula:

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Labour efficiency sub-variance = (Revised standard mix – standard mix) x
Standard rate

(ii). Labour Rate Variance:

Labour rate variance is computed in the same manner as materials price
variance. When actual direct labour hour rates differ from standard rates, the
result is a labour rate variance. It is that portion of the direct wages variance
which is due to the difference between actual rate paid and standard rate of
pay specified.

The formula for its calculation is:

Labour rate variance = (Actual rate – Standard rate) x Actual hours
Using data from the example given above, the labour rate variance is Rs
25,250, i.e.,
Labour rate variance = (35 – 30) x 5050 hours = 5 x 5050 = Rs 25,250
(unfavourable)

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 Overhead Variances
The analysis of factory overhead variances is more complex than variance
analysis for direct materials and direct labour. There is no standardisation of
the terms or methods used for calculating overhead variances. For this reason,
it is necessary to be familiar with the different approaches which can be
applied in overhead variances.

Generally, the computation of the following overhead variances are suggested:

(1) Total Overhead Cost Variance:

This overall overhead variance is the difference between the actual overhead
cost incurred and the standard cost of overhead for the output achieved.

This can be computed by applying the following formula:

(Actual overhead incurred) – (Standard hours for the actual output x Standard
overhead rate per hour)

Or

(Actual overhead incurred) – (Actual output x Standard overhead rate per unit)

(2) Variable Overhead Variance:

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It is the difference between actual variable overhead cost and standard
variable overhead allowed for the actual output achieved.

The formula for computing this variance is as follows:

(Actual Variable Overhead Cost) – (Actual Output x Variable Overhead rate per
unit)
Or
(Actual Variable Overhead Cost) – (Std. hours for actual output x Std. Variable
overhead rate per hour)

(3) Fixed Overhead Variance:

This variance indicates the difference between the actual fixed overhead cost
and standard fixed overhead cost allowed for the actual output.
This variance is found by using the following formula:

Fixed Overhead Variance = (Actual Fixed Overhead Cost – Fixed Overhead

absorbed)
Or (Actual Fixed Overhead Cost) – (Actual Output x Fixed Overhead rate per
unit)

Or (Actual fixed overhead cost) – (Std. hours for actual output x Std. fixed
overhead rate per hour)

(4) Variable Overhead Expenditure (Spending or Budget) Variance:

This variance indicates the difference between actual variable overhead and
budgeted variable overhead based on actual hours worked.

This variance is found by using the following:

(Actual variable overhead – Budgeted variable overhead)

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(5) Variable Overhead Efficiency Variance:

This variance is like labour efficiency variance and arises when actual hours
worked differ from standard hours required for good units produced. The
actual quantity produced and standard quantity fixed might be different
because of higher or lower efficiency of workers employed in the
manufacturing of goods.

This variance is found by us-ing the following formula:

(Actual hours – Standard hours for actual output) x Standard variable
overhead rate per hour

(6) Fixed Overhead Expenditure (Spending or Budget) Variance:

This variance indicates the difference between actual fixed overhead and
budgeted fixed overhead.

The formula for comput-ing this variance is as follows:

(Actual fixed overhead – Budgeted fixed overhead)

If actual fixed overhead costs are greater than budgeted fixed costs, an
unfavourable variance results because actual costs exceed the budget. Actual
overhead costs seldom equal budgeted costs because property tax rates may
change, insurance premiums may increase or equipment changes may affect
depreciation rates. As an illustration, assume that a company completed
36,000 units (equal to 18,000 standard production hours) in 18,500 hours at
the recorded fixed cost of Rs 7,51,000. The standard fixed cost rate per hour is
Rs 40. Therefore,

Expenditure variance = (Actual fixed overhead costs – Budgeted fixed overhead

costs)

The expenditure or budget variance provides management with information

which helps in controlling costs. The budget variance is usually prepared on a
departmental basis and the factors that cause the budget variances are,
therefore, controllable by departmental managers.

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(7) Fixed Overhead Volume Variance:

Volume variance relates to only fixed overhead. This variance arises due to the
difference between the standard fixed overhead cost allowed (absorbed) for
the actual output and the budgeted fixed overhead based on standard hours
allowed for actual output achieved during the period. The variance shows the
over-or-under-absorption of fixed overheads dur-ing a particular period. If the
actual output is more than the standard output, there is over-absorption and
variance is favourable. If actual output is less than the standard output, the
volume variance is unfavourable.

The formula for computing this variance is as follows:

(Budgeted fixed overhead applied to actual output – Budgeted fixed overhead

based on standard hours allowed for actual output)

Or

(Actual production – Budgeted production) x Std. fixed overhead rate per unit

(8) Fixed Overhead Calendar Variance:

It is that portion of volume variance which is due to the difference between

the number of actual working days in the period to which the budget is
applicable and budgeted number of days in the budget period.

If actual working days is more than the budgeted working days, the variance is
favourable as work has been done on days more than budgeted or allowed and
vice-versa.

The formula is as follows:

(No. of actual working days – No. of budgeted working days) x Std. fixed
overhead rate per day. Calendar variance can be computed based on hours or
output.

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Then the formulae are:

Hours Basis:

Calendar Variance = (Revised Budget Capacity hours – Budget Hours) x Std.

Fixed Overhead rate per hour

If revised budgeted capacity hours are more than the budgeted hours, the
variance will be favourable. In the reverse situation, the variance will be
unfavourable.

Output Basis:

Calendar Variance = (Revised budgeted quantity in terms of actual number of

days worked – Budgeted quantity) x Standard fixed overhead rate per unitil.

If revised budgeted quantity is more than the budgeted quantity; the variance
is favourable; if revised budgeted quantity is less, the variance will be
unfavourable.

(9) Fixed Overhead Efficiency Variance:

It is that portion of volume variance which arises when actual hours of

production used for actual output differ from the standard hours specified for
that output. If actual hours worked are less than the standard hours, the
variance is favourable and when actual hours are more than the standard
hours, the variance is unfavourable.

The formula is:

Fixed Overhead Efficiency Variance = (Actual hours – Standard hours for actual
production) x Fixed overhead rate per hour

Fixed Overhead Efficiency Variance = (Actual production – Standard production

as per actual time available) x Fixed overhead rate per unit

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(10) Fixed Overhead Capacity Variance:

It is that part of fixed overhead volume variance which is due to the difference
between the actual capacity (in hours) worked during a given period and the
budgeted capacity (expressed in hours). The formula is

Capacity Variance = (Actual Capacity Hours – Budgeted Capacity) x Standard

fixed overhead rate per hour

This variance represents idle time also. If actual capacity hours are more than
the budgeted capacity hours, the variance is favourable and if actual capacity
hours are less than the budgeted capacity hours the variance will be
unfavourable.

In case actual number of days and budgeted number of days are also given,
then budgeted capacity hours will be calculated in terms of actual number of
days and it will be known as revised budgeted capacity hours, i.e., budgeted
hours in actual days worked.

In this situation, the formula for calculating capacity variance will be as follows:

Capacity Variance = (Actual Capacity hours – Revised Budgeted Capacity hours)

x Standard fixed overhead rate per hr.

In the above formula, the variance will be favourable if actual capacity hours
are more than the revised budgeted hours. However, if actual capacity hours
are lesser than the revised budgeted hours, the variance will be adverse as
lesser hours means that lesser actual hours have been worked taking the
actual days utilised into account.

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 Use of Standard costing in business
Standard Costing has long been used in manufacturing and some distribution
environments as a control for measuring variations from expected results.
Everyone has expected results of some kind...purchase price of materials,
amount of labor required for assembly, amount it will cost for outside
processing, etc. So shouldn't everyone use Standard Cost?

Make to order businesses rarely produce something in the same manner, since
each job differs based on the customer's quote. In this case, it is important to
understand the actual cost of a job once completed (or during the process) as
compared to how the job was quoted. Usually not a lot can be done about the
actual cost incurred, but a lot should be learned about improving the quoting
process from the comparison of actual cost versus quoted cost.

Enterprise software that controls the accounting, inventory, procurement,

fulfillment and manufacturing process (referred to ERP systems), provide a
choice of cost methods to use. Mid-market systems such as Macola ES and
Microsoft Dynamics GP (Great Plains) not only give you a choice of which
inventory valuation method to use, but if you choose standard costing, you
also get visibility into weighted average and last cost as well. Unfortunately,
unless you are using a much more expensive software solution, you can't pick
and choose costing methods at the item level. Once chosen, it applies to all
inventory for the whole company.

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