07 - Standard Costing

Question 1

What are the learning outcomes of the chapter on Standard Costing?

Answer 1

• Explain the difference between ascertaining costs after the event and establishing standard costs in advance.
• Explain why planned standard costs, prices and volumes are useful in setting a benchmark.
• Calculate standard costs for the material, labour and variable overhead elements of the cost of a product or service.
• Calculate variances for materials, labour, variable overhead, sales prices and sales volumes.
• Prepare a statement that reconciles budgeted contribution with actual contribution.
• Prepare variance statements.

Question 2

What is Standard Costing?

Answer 2

Definition

Standard Costing is a control technique that reports variances by comparing:

• actual cost
• to pre-set standards facilitating action through management by exception.

Question 3

How does one use Standard Costs?

Answer 3

The pre-set standards require managers to plan in advance the amount and price of each resource that will be used in providing a service or manufacturing a product.

These resources include:

• Manpower
• Money
• Time
• Equipment
• Raw materials.

These pre-set standards, for selling prices and sales volumes as well as for costs, provide:

• a basis for planning,
• a target for achievement
• and a benchmark against which the actual costs and revenues can be compared.

The actual costs and revenues recorded after the event are then compared with the pre-set standards and the differences are recorded as variances.

Question 4

What is a favourable variance and an adverse variance?

Answer 4

Favourable variance

If a resource price is below standard, or if sales volume or selling prices is above standard, the result will be a favourable variance.

Adverse variance

If a resource price is above standard, or if sales volume or selling prices is below standard, the result will be a favourable variance.

Question 5

Why would you use standard costing and variance analysis?

Answer 5

Careful analysis of the variances and their presentation to management can help to direct managers’ attention to areas of the business that are performing below or above expectation.

If certain variances are large or significant, then managers can concentrate their attention on these activities where any corrective action is likely to be most worthwhile.

If other variances are small or not significant then managers can ignore these activities, knowing that they appear to be conforming to expectations.

This is the principle of management by exception that is mentioned in CIMA’s definition of standard costing.

Question 6

What is a Standard Cost?

Answer 6

A standard cost is a carefully predetermined unit cost which is prepared for each cost unit.

It contains details of the standard amount and price of each resource that will be utilised in providing the service or manufacturing the product.

Exceptions

It can be difficult to apply standard costing in some types of service organisation, where cost units may not be standardised and they are more difficult to measure.

Question 7

What is required to produce a Standard Cost Card?

Answer 7

In order to be able to apply standard costing, it must be possible to identify a measurable cost unit.

This can be a unit of product or service but it must be capable of standardising, for example, standardised tasks must be involved in its creation.

The cost units themselves do not necessarily have to be identical.

Example

For example, standard costing can be applied in situations such as costing plumbing jobs for customers where every cost unit is unique. However, the plumbing jobs must include standardised tasks for which a standard time and cost can be determined for monitoring purposes.

Storing

The standard cost may be stored on a standard cost card but nowadays it is more likely to be stored on a computer, perhaps in a database. Alternatively, it may be stored as part of a spreadsheet so that it can be used in the calculation of variances.

Details for the Standard Cost Card

For every variable cost

• the standard amount of resource to be used is stated,
• as well as the standard price of the resource.

This standard data provides the information for a detailed variance analysis, as long as the actual data is collected in the same level of detail.

Standard costs and standard prices provide the basic unit information which is needed for valuing budgets and for determining total expenditures and revenues.

Question 8

What is a Standard?

Answer 8

Definition

A standard is a benchmark measurement of resource usage or revenue or profit generation, set in defined conditions.

Question 9

Describe different bases that can be used for setting standards?

Answer 9

• Prior period
• Comparable organisations
• Organisational objectives

Prior period

A prior period level of performance by the same organisation: The use of this basis indicates that management feels that performance levels in a prior period have been acceptable. They will then use this performance level as a target and control level for the forthcoming period.

Comparable organisation

The level of performance achieved by comparable organisations: When using this basis management is being more outward-looking, perhaps attempting to monitor their organisation’s performance against ‘the best of the rest’.

Organisational objectives

The level of performance required to meet organisational objectives: This basis sets a performance level which will be sufficient to achieve the objectives which the organisation has set for itself.

Question 10

What type of standards are there?

Answer 10

• Ideal standard
• Attainable standard
• Current standard

Question 11

Describe the ideal standard.

Answer 11

Standards may be set at ideal levels which make no allowance for inefficiencies such as losses, waste and machine downtime.

This type of ideal standard is achievable only under the most favourable conditions and can be used if managers wish to highlight and monitor the full cost of factors such as waste etc.

However this type of standard will almost always result in adverse variances since a certain amount of waste etc. is usually unavoidable.

This can be demotivating for individuals who feel that an adverse variance suggests that they have performed badly.

Question 12

Describe the attainable standard.

Answer 12

Standards may also be set at attainable levels which assume efficient levels of operation, but which include allowances for factors such as losses, waste and machine downtime.

This type of standard does no have the negative motivational impact that can arise with an ideal standard because it makes some allowance for unvoidable inefficiencies.

Adverse variances will reveal whether inefficiencies have exceeded this unavoidable amount.

Question 13

Describe the current standard.

Answer 13

Standards based on current performance levels (current wastage, current inefficiencies) are known as current standards.

Their disadvantage is that they do not encourage any attempt to improve on current levels of efficiency.

Question 14

What is the purpose of standard costs?

Answer 14

The main purpose of standard costs is to provide a yardstick or benchmark against which actual performance can be monitored.

If the comparison between actual and standard cost is to be meaningful, then the standard must be valid and relevant.

It follows that the standard cost should be kept as up-to-date as possible.

This may necessitate frequent updating of standards to ensure that they fairly represent:

• the latest methods and operations,
• and the latest prices which must be paid for the resources being used.

The standards may not be updated for every small change; however, any significant changes should be adjusted as soon as possible.

Question 15

What are the sources of information for standard costs?

Answer 15

Predetermined hourly rates are derived for production overhead. These overhead absorption rates represent the standard hourly rates for overhead in each cost centre. They can be applied to the standard labour hours or machine hours for each cost unit.

The overheads will be analysed into their fixed and variable components so that a separate rate is available for fixed production overhead and for variable production overhead. This is necessary to achieve adequate control over the variable and fixed elements.

Question 16

What are the criticisms of using standards in the modern business environment?

Answer 16

• Standard costing was developed when the business environment was more stable and operating conditions were less prone to change. In the present dynamic environment such stable conditions cannot be assumed. If conditions are not stable then it is difficult to set a standard cost which can be used to control costs over a period of time.
• Performance to standard used to be judged as satisfactory, but in today’s climate constant improvement must be aimed for in order to remain competitive.
• The emphasis on labour variances is no longer appropriate with the increasing use of automated production methods.

Question 17

When should standard costing be used?

Answer 17

An organisation’s decision to use standard costing depends on its effectiveness in helping managers to make the correct decisions.

It can be used in areas of most organisations, whether they are involved with manufacturing, or with services such as hospitals or insurance.

Example

For example, a predetermined standard could be set for the labour time to process an insurance claim. This would help in planning and controlling the cost of processing insurance claims.

Non-standardised products/services

Standard costing may still be useful even where the final product or service is not standardised.

It may be possible to identify a number of standard components and activities for which standards may be set and used effectively for planning and control purposes.

In addition, the use of demanding performance levels in standard costs may help to encourage continuous improvement.

Question 18

What is a variance?

Answer 18

A variance is the difference between the expected standard cost and the actual cost incurred.

Question 19

How is variance analysis used?

Answer 19

A unit standard cost contains detail concerning both:

• the usage of resources
• and the price to be paid for the resources.

Variance analysis involves breaking down the total variance to explain:

• how much of it is caused by the usage of resources being different from the standard
• and how much of it is caused by the price of resources being different from the standard.

These variances can be combined to reconcile the total cost difference revealed by the comparison of the actual and standard cost.

Question 20

Describe the break down of Total Variance into its constituent parts.

Answer 20

Total Variance

TV = SQSP - AQAP

Quantity variance = SQSP - AQSP

Price variance = AQSP - AQAP

Total variance = QV + PV

Question 21

What happens when the amount of material purchase is not equal to the amount used?

Answer 21

One slight complication sometimes arises with the calculation of the direct material price variance.

In the example used, the problem did not arise because the amount of material purchased was equal to the amount used.

However, when the two amounts are not equal then the direct material price variance could be based either on the material purchased or on the material used.

Obviously, if the purchase quantity is different from the usage quantity, then the two methods will give different results.

Based on material purchased - standard cost

If inventory is valued at standard cost, direct material price variance should be based on the material purchased.

This will ensure that all of the variance is eliminated as soon as purchases are made and the inventory will be held at standard cost.

Based on material used - actual cost

If inventory is valued at actual cost, then direct material price variance should be based on the
material used.

This means that the variance is calculated and eliminated on each bit of inventory as it is used up.

The remainder of the inventory will then be held at actual price, with its price variance still ‘attached’, until it is used and the price variance is calculated.

Question 22

What type of sales variances can be calculated?

Answer 22

Like variable cost variances, sales variances can also be calculated.

We will calculate two variances for sales:

• the sales price variance
• and the sales volume contribution variance.

Question 23

What is idle time?

Answer 23

Idle time is when labour is available for production but is not engaged in active production.

This can be due to, for example, shortage of work or material.

Question 24

What are the implications of idle time?

Answer 24

• Direct labour wages are being paid but no output is being produced.
• Variable production overhead variances can also be affected.

Question 25

How can issues arising from idle time be overcome?

Answer 25

Cost of direct labour wages can be highlighted separately in an idle time variance so that it is not hidden in an adverse labour efficiency variance. In this way, management attention can be directed towards the cost of idle time. It is usually assumed that variable production overhead expenditure is incurred in **active hours only**, for example, only when the machines are actually running, incurring power costs, etc. Therefore, variable production overhead expenditure is not being incurred during idle hours. The variable production overhead efficiency variance is affected in the same way as the labour efficiency variance. **_Idle time variance is a sub component of Direct labour efficiency variance._** Direct labour efficiency variance (total hours) = Idle time variance + Direct labour efficiency variance (actual hours)

Question 26

How would management decide which variances should be investigated?

Answer 26

Factors: * The size of the variance * The likelihood of the variance being controllable * The likely cost of an investigation * The interrelationship of variances * The type of standard that was set

Question 27

How should the **_size of the variance_** impact management's decision to investigate a variance?

Answer 27

Costs tend to fluctuate around a norm and therefore normal variances may be expected on most costs. The problem is to decide how large a variance must be before it is considered abnormal and worthy of investigation. A rule of thumb may be established that any variance which exceeds, say, 5% of its standard cost may be worthy of investigation. Alternatively, control limits may be set statistically and if a cost fluctuates outside these limits it should be investigated.

Question 28

How should the **_likelihood of the variance being controllable impace_** management's decision to investigate a variance?

Answer 28

Managers may know from experience that certain variances may not be controllable even if a lengthy investigation is undertaken to determine their causes. For example, it might be argued that a material price variance is less easily controlled than a material usage variance because it is heavily influenced by external factors.

Question 29

How should the **_likely cost of an investigation_** impact management's decision to investigate a variance?

Answer 29

The cost of an investigation would have to be weighed against the cost which would be incurred if the variance was allowed to continue in future periods.

Question 30

How should the **_inter-relationship of variances_** impact management's decision to investigate a variance?

Answer 30

Adverse variances in one area of the organisation may be interrelated with favourable variances elsewhere. For example, if cheaper material is purchased this may produce a favourable material price variance. However, if the cheaper material is of lower quality and difficult to process, this could result in adverse variances for material usage and labour efficiency.

Question 31

How should the **_type of standard that was set_** impact management's decision to investigate a variance?

Answer 31

An ideal standard will almost always result in some adverse variances because of unavoidable waste, etc. Managers must decide on the normal level of adverse variance which they would expect to see. Another example is where a standard price is set at an average rate for the year. Assuming that inflation exists, favourable price variances might be expected at the beginning of the year, to be offset by adverse price variances towards the end of the year as actual prices begin to rise.

Question 32

Possible inter-relationships?

Answer 32

**_Cost variances_** Employing a higher grade of labour than standard might produce an adverse labour rate variance. However, if these employees are more skilled than standard they may work more quickly and efficiently, resulting in a favourable labour efficiency variance and a favourable overhead efficiency variance. **_Sales price and sales volume contribution variance_** Charging a higher selling price than standard will produce a favourable sales price variance. However, the higher price might deter customers and thus sales volumes might fall below budget, resulting in an adverse sales volume contribution variance. **_Cost and sales variances_** Purchasing a higher quality material than standard might produce an adverse material price variance. However, the quality of the finished product might be higher than standard and it might be possible to command higher selling prices, thus producing a favourable sales price variance. Furthermore, the higher quality product might attract more customers to buy which could result in a favourable sales volume contribution variance.

Question 33

What is the defintion of a standard hour?

Answer 33

A standard hour (or minute) is the amount of work achievable at standard efficiency levels in an hour (or minute).

Question 34

Why would you calculate a standard hour?

Answer 34

If, for example, an organisation manufactures metal saucepans, utensils and candlesticks, it is likely that each item takes a different amount of time to produce and utilises a different amount of resource. It would not make sense to add together these dissimilar items to determine the total number of units produced. A standard hour is a useful way of measuring output when a number of dissimilar items are manufactured by an organisation.

Question 35

What is the difference between a standard hour and an actual hour?

Answer 35

The actual labour hours worked during each of these periods was probably different from the standard labour hours taken. The standard hours figure is simply an expression of how long the output should have taken to produce and provides a common basis for measuring output. The difference between the actual labour hours worked and the standard labour hours produced will be evaluated as the labour efficiency variance.