Chapter 14 -Standard Costing: Setting Standards and Analyzing Variances

Actual, Normal, and Standard Costing

According to Pedro P. Guerrero, in actual cost system, product costs are recorded when they are
incurred.¹

On normal costing, direct materials and direct labor costs are accumulated as they are incurred, while
manufacturing overhead is applied to production on the basis of actual inputs multiplied by a
predetermined overhead application rate.¹

Under standard costing, all costs attached to products are based on standards or predetermined
amounts.¹

Uses of Standard Costs:

a. Controlling Costs – Standards enable management to make periodic comparisons of actual costs
with standard costs for the purpose of evaluating performance and correct inefficiencies.¹

b. Costing Inventories – The use of standard costs eliminates complex computations for inventories
and cost of goods sold in preparing financial statements.¹

c. Planning Budgets – Standard costs are very useful when preparing a budget.¹

d. Pricing Products – Setting prices is enhanced by the availability of reliable standards and the
continuous review of standard costs.¹

Setting Standards

a. Ideal Standards – represent goals that could be attained only by achieving perfection. They make
no provision for idle time, breakdowns, and other factors that reduce efficiency.¹

b. Normal Standards – represent goals that can be met under reasonably efficient operating
conditions because they provide for idle time, breakdowns, and common operating problems.¹

Implementing A Standard Cost System

To develop and use a standard cost system, the following procedures are usually used:

a. Establish standards for each cost element (materials, labor, and overhead).¹

b. Record actual costs incurred during the period.¹

c. Determine the standard costs for the number of units produced during the period.¹

¹Pedro P. Guerrero, Cost Accounting, Principles and Procedural Applications, 2018 Edition
 d. Compute variances by comparing the actual costs of the units produced and the standard costs
of those units.¹

e. Break down the variance for each element into its component parts in order to determine the
cause of the variance.¹

f. Record production costs and variances.¹

Establishing Standards

To illustrate how standard costs are set up, assume that Zorro Inc., wished to use standard costs to
measure performance in filling an order for 1,000 gallons of Product X.

1. Direct Materials Standards – price and quantity standards are set for each type of material
used.¹

a. Materials Price Standards – a material price standard is the price that should be paid for
a unit of raw material purchased. It should include an amount for related costs such as
receiving, storing and handling.¹

For example, the material price standard per kilo of material for Product X is:

Purchase price, net of discount P 27

Freight costs 2

Receiving and handling costs 1

Standard material price per kilo P30

b. Materials Quantity Standards – a material quantity standard is the amount of material

that should be consumed in manufacturing a unit of product. Materials spoilage or
waste that is a necessary part of the manufacturing process must be considered in
setting the quantity standards.¹

For example, the material quantity standard per unit of Product X is as follows:

Total quantity required 3 kilos

Allowance for spoilage 1 kilo

Standard material quantity per unit 4 kilos

Determining Standard Material Costs Per Unit

The total standard cost of a raw material per unit of production is computed by multiplying ( 1 ) the total
standard quantity of raw materials required to manufacture the number of units of production by (2)
the standard price per unit of raw materials.¹

For Zorro, Inc. the standard materials cost per gallon of Product X is P120 (P30 x 4 kilos).
 2. Direct Labor Standards – both rate (price) and time (efficiency) standards are established for
direct labor cost.¹

a. Labor Rate Standards – Labor rate or price standards is the predetermined rate per
hour based on current wage rate, which generally includes payroll taxes and fringe
benefits, such as paid holidays. Items like sick and vacation leave pays are usually not
included in the standard rate because they are normally accounted for as part of
manufacturing overhead.¹

For Zorro, Inc. the labor rate standard is as follows:

Hourly wage rate P 30.00

Payroll taxes 4.00

Fringe benefits 6.00

Standard labor rate per hour P 40.00

b. Labor Efficiency Standards – Labor efficiency or time standards are predetermined time
required to finish one unit of product. Allowances should be made for rest periods,
machine setup, and machine downtime.¹

For Zorro, Inc., the direct labor efficiency standard is as follows:

Production time 1.5 hours

Rest periods .2

Machine setup .3

Standard labor-efficiency per unit 2.0 hours

Determining Standard Direct Labor Cost Per Unit

The standard labor cost per unit of production is computed by multiplying ( 1 ) standard direct labor rate
by the ( 2 ) standard direct labor hours.¹

For Zorro, the standard direct labor cost per unit is P80. ( P40 x 2 hrs.)

3. Manufacturing Overhead Standards – In establishing manufacturing overhead standards, a

predetermined overhead rate is used. The overhead rate is computed by dividing the ( 1 )
budgeted overhead costs by the ( 2 ) expected standard activity base (i.e., standard direct
labor hours or standard machine hours).¹

For example, Zorro, Inc. uses standard direct labor hours as the activity base. The company
expects to produce 14,250 gallons of Product X during the year at normal capacity. Since it
will take two direct labor hours for each gallon, the total standard direct labor hours to
produce 14,250 gallons of Product X is 28,500 hours (14,250 x 2). At this level of activity,
overhead costs are estimated to be P285,000, of which P171,000 are variable and P114,000
are fixed.
 Based on the example, the standard predetermined overhead rates for variable and fixed
overhead are computed as follows:

Variable overhead costs (P171,000 / 28,500) = P6.00 per labor hour

Fixed overhead costs (P114,000 / 28,500 ) = P4.00 per labor hour

Total P10.00 per labor hour

Determining Standard Overhead Rate per Unit

The standard overhead rate per unit is equal to standard labor hours times the predetermined overhead
rate.¹

For Zorro, the standard overhead rate per gallon of Product X is P20 ( 2 hours x P10).

Total Standard Cost Per Unit

The total standard cost per unit is the total of the standard costs of direct materials, direct labor and
manufacturing overhead.¹

For Zorro Inc., the standard cost per gallon of Product X is P 200 computed as follows:

Cost Elements Standard Quantity Standard Price Standard Cost

Direct materials 4 kilos P 30 P 120

Direct labor 2 hours P 40 80

Overhead 2 hours P 10 20

Total P 220

Variances From Standards

Variances are the differences between the total actual cost incurred and the total standard costs.¹

For example, assume that in producing 1,000 gallons of Product X, Zorro Inc., incurred the following
costs:

Direct materials P 123,410

Direct labor 82,950

Variable overhead 11,500

Fixed overhead 9,500

Total actual cost incurred P 227,360

The total variance is computed as follows:

Actual cost incurred P 227,360

Standard costs 220,000

Total variance P 7,360

Computing and Analyzing Variances

To compute and analyze variances the underlying factors should be determined. For each
manufacturing cost element, a total peso variance is computed and analyzed. The computations are
shown below:

Total Variance = Total Materials Variance + Total Labor Variance + Total Overhead Variance

Total Materials Variance = Materials Price Variance + Materials Quantity Variance

Total Labor Variance = Labor Rate Variance + Labor Efficiency Variance

Total Overhead Variance = Overhead Controllable Variance + Overhead Volume Variance

Direct Materials Variance

Assume that to produce the order of 1,000 gallons of Product X, Zorro Inc. purchased 4,100 kilos of
direct materials A1 at a cost of P30.10 per kilo. The total materials is computed using the following
formula:

Standard Quantity x Standard Price – (Actual Quantity x Actual Price) = Total Materials Variance

For Material DM A1, the total material variance is determined as follows:

4,000 standard quantity x P30 standard price P 120,000

4,100 actual units x P30.10 actual price 123,410

Total materials variance P 3,410 (U)

Material Price Variance - A material price variance results when the actual price per unit differs from
the standard price per unit.¹

The variance is computed as follows:

(Actual Quantity x Standard Price) – (Actual Quantity x Actual Price) = Material Price Variance

4,100 actual units purchased x P30 standard price per unit P123,000

4,100 actual units purchased x P30.10 actual price per unit 123,410

Material price variance P 410 (U)

Materials Quantity Variance – The amount of materials quantity variance or materials usage variance is
computed by comparing the cost of the standard quantity of materials at the standard price per unit
with the cost of the actual quantity of materials at the standard price per unit.¹

The variance is computed as follows:

(Standard Quantity x Standard Price) – (Actual Quantity x Standard Price) = Materials Quantity Variance

4,000 standard quantity x P30 standard price per unit P 120,000

4,100 actual quantity x P30 standard price per unit 123,000

Materials quantity variance P 3,000 ( U)

The total materials variance of P3,410 (U) consists of the following:

Materials price variance P 410 (U)

Materials quantity variance 3,000 (U)

Total materials variance P 3,410 (U)

Direct Labor Variances

Assume that in completing Product X, Zorro Inc. incurred 2,100 direct labor hours at an average hourly
rate of P39.50. The standard hours allowed for the units produced are 2,000 hours (1,000 gallons x 2
hours) and the standard rate is P40 per hour.

The total labor variance is computed as follows:

(Standard Hours x Standard Rate) – (Actual Hours x Actual Rate) = Total Labor Variance

2,000 standard hours x P40 standard rate per hour P 80,000

2,100 actual hours x P39.50 actual rate per hour 82,950

Total labor variance P 2,950 (U)

Labor Rate Variance – The labor rate variance (also called the labor price variance) occurs when the
actual labor rate per hour differs from the standard labor rate per hour.¹

The labor rate variance is computed as follows:

(Actual Hours x Standard Rate) – (Actual Hours x Actual Rate) = Labor Rate Variance

2,100 actual hours x P40 standard rate per hour P 84,000

2,100 actual hours x P39.50 actual rate per hour 82,950

Labor Rate Variance P 1,050 F

Labor Efficiency Variance – The labor efficiency variance, also called labor time variance, labor usage
variance or labor quantity variance, compares the cost of actual hours worked (based on the standard
rate per hour) with the cost of standard hours allowed for the number of units produced (based on the
standard rate per hour).¹

The labor efficiency variance is computed as follows:

(Standard Hours x Standard Rate) – (Actual Hours x Standard Rate) = Labor Efficiency Variance

2,000 standard hours x P40 standard rate per hour P 80,000

2,100 actual hours x P40 standard rate per hour 84,000

Labor Efficiency Variance P 4,000 (U)

The direct labor variance is composed of the following:

Labor rate variance P 1,050 F

Labor efficiency variance 4,000 (U)

Total direct labor variance P 2,950 (U)

Manufacturing Overhead Variances

Total Overhead Variance – The total overhead variance is the difference between the actual overhead
costs incurred and the standard costs applied to production.¹

Assume that Zorro Inc. incurred manufacturing costs as follows:

Variable overhead costs P 11,500

Fixed overhead costs 9,500

Total actual overhead costs P 21,000

For Product X, the standard hours allowed is 2,000 hours and the predetermined overhead rate is P10
per direct labor hour. Therefore, applied overhead is P20,000 (2,000 hours x P10).

The total overhead variance is computed as follows:

Actual overhead P 21,000

Applied overhead (2,000 hours x P10) 20,000

Total overhead variance P 1,000 (U)

Two Variance Analysis Method

In the two-variance analysis method, the total overhead variance is separated into the budget variance
and volume variance.¹

Overhead Budget Variance – The overhead budget variance also called overhead controllable variance
shows whether overhead costs were effectively corralled.

This is computed by comparing (1) the actual overhead costs incurred and (2) the budgeted costs based
on the standard hours allowed for the number of units produced.

The budgeted overhead costs for the standard hours allowed for the number of units produced consists
of two parts:

a. Variable costs – the total variable cost allowed for the number of units produced is computed by
multiplying (1) the standard direct labor hours allowed for the number of units produced by (2)
the standard variable overhead rate per hour.

b. Fixed costs – budgeted fixed costs for the period are usually known.

The illustration below shows a flexible overhead budget for Zorro Inc. for 200X:

Zorro Inc.

Flexible Manufacturing Overhead Budget

For 200X

Activity Base:

Standard Direct Labor Hours 1,500 hrs. 2,000 hrs. 2,500 hrs.

Costs:

Variable overhead costs

Indirect materials P 3,600 P 4,000 P 4,500

Indirect labor 4,700 6,000 5,500

Repairs 1,900 2,000 2,200

Total variable overhead costs P10,200 P12,000 P12,200

Fixed overhead costs:

Supervision P 5,500 P 5,500 P 5,500

Depreciation 4,000 4,000 4,000

Total fixed overhead costs P 9,500 P 9,500 P 9,500

Total overhead costs P 19,700 P 21,500 P 21,700

The variable costs per direct labor hour is P6.00 (P12,000/ 2,000 hours)

The overhead budget variance for Zorro Inc. is computed below:

Actual overhead costs P 21,000

Budgeted overhead costs for standard hours:

Fixed overhead costs P 9,500

Variable overhead costs:

Standard direct labor hours 2,000

Variable costs per hour x6 12,000 21,500

Overhead Budget Variance P 500 (F)

Overhead Volume Variance – the volume variance determines whether plant facilities were efficiently
used.

The overhead volume variance is computed as follows:

Budgeted overhead costs P 21,500

Standard (applied) overhead costs (2,000 hours x P10) 20,000

Overhead volume variance P 1,500 (U)

SOURCE AND REFERENCE:

Pedro P. Guerrero, Cost Accounting – Principles and Procedural Applications, 2018 Edition