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STANDARD COSTING

Standards are benchmarks for measuring performance. These also are widely used in managerial accounting,
where they relate to the quantity and acquisition price (or cost) of the inputs used in making a product or
providing services. Managers have to decide regarding the prices of materials or salaries to pay and the
quantities or labor hours to use, including overhead costs. Price standards specify how much should be paid
for each unit of the input. If either the quantity or acquisition price of an input departs significantly from the
standard, managers investigate the discrepancy to find the cause of the problem and eliminate it (Garrison et
al., 2018).

Companies set standards at one (1) of two (2) levels: ideal or normal.
1. Ideal standards represent optimum levels of performance under perfect operating conditions.
2. Normal or practical standards represent efficient levels of performance that are attainable under
expected operating conditions.

Some managers believe ideal standards will stimulate workers to constant improvement. However, most
managers believe that ideal standards lower the morale of the entire workforce because they are so difficult, if
not impossible, to meet.

Standard Costing System

Any control system has three (3) basic parts: (1) a predetermined or standard performance level, (2) a measure
of actual performance, and (3) a comparison between standard and actual performance. For example, a
thermostat is a control system with which people are all familiar. First, a thermostat has a predetermined
temperature that can be set at any desired level. If someone wants the temperature in a room to be 68 degrees,
they will set the thermostat at the standard of 68 degrees. Then, the thermostat contains a thermometer that
measures the actual temperature in the room. Lastly, the thermostat compares the preset or standard
temperature with the actual room temperature. If the actual temperature deviates by more than a small amount
from the preset or standard temperature, the thermostat will trigger a response, activating a heating or cooling
device (Hilton & Platt, 2017).

Figure 1. Cost control system

Source: Managerial Accounting: Creating Value in a Dynamic Business Environment, 2017. p. 421

In management accounting, standard costing system is a cost control system that works like a thermostat.

First, a predetermined or standard cost is set. In essence, a standard cost is the company’s best estimate of
the average cost to produce a single unit of product or service. This cost estimate serves as the starting point
for creating the relevant budgets. When the firm plans to produce multiple units, managers use the standard
unit cost to determine the total standard or budgeted cost of production. Standard cost is the predetermined unit
cost that is used as a measure of performance. Suppose the standard cost of the milk (a direct material) used
to make one gallon of ice cream is P40, and the company expects to manufacture 20,000 gallons. The total
standard or budgeted direct-material cost of ice cream for 20,000 gallons is P800,000 (P40 × 20,000).

Second, the cost control system measures the actual cost incurred in the production process. Suppose the
company produced 20,000 gallons of ice cream, as planned, and the actual cost of milk used in production is
measured by the cost control system at P820,000.

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Third, the manager compares the actual cost of milk with the budgeted or standard cost. Any difference between
the two is called cost variance. Cost variances are then used in controlling costs. The P20,000 cost variance
in this example (P820,000 – P800,000) tells the company that their planning figures were incorrect and that they
were not able to produce the quantity of product anticipated at the cost of materials anticipated. This information
may lead the company to look for an explanation for the incorrect prediction. After computing the variance, the
management may take corrective action when needed or revise standards if necessary. Notice that because
the variance in the example was specifically measured for a direct material, there can be specific reasons for
the cost variance. Maybe the market price for the milk had risen unexpectedly after the budget was finalized.
By setting standard costs and measuring cost variances for specific types of costs, meaningful explanations for
the variances can be found. For that reason, standards are set and variances are measured for direct materials,
direct labor, and overhead (Hilton & Platt, 2017).

Standards vs. Budgets

In theory, standards and budgets are essentially the same. Both are predetermined costs, and both contribute
to management planning and control. They only differ in the way the terms are expressed. A standard is the
unit amount. A budget is the total amount. For example, the standard cost of direct labor for a unit of product is
P10. If 10,000 units of the product are to be produced, the P100,000 of direct labor is the budgeted direct labor
cost. (Budgets will be further discussed in the Business Planning and Short-Term Budgetary Systems topic.)

Advantages of Standard Costing System

Standard costs offer several advantages to an organization. These advantages are available only when
standard costs are carefully established and prudently used.

1. Facilitate management planning.

Planning requires estimates of the future. Managers can use current standards to estimate future costs
and quantities. This is achieved through flexible budget, a budget that changes based on the level of
activity. It is a useful tool in comparing actual costs incurred to the cost allowable for the actual output
(or activity level) achieved.
2. Promote greater economy and efficiency by making employees more cost-conscious.
Standards serve as the information for management’s expectations to workers. Standards should be
achievable and workers should be informed of rewards for the attainment of those standards. In this
way, they are more likely to be motivated to strive and do their best to accomplish their tasks.
3. Help set selling prices.
As standard costs are set, management can determine how much to charge for a product so that it can
produce the desired net income. As the business actually incurs these costs, management determines
if the selling prices set are still reasonable and, when necessary, considers some price adjustments
after taking competition into account.
4. Contribute to management control by providing a basis for evaluation of cost control.
The controlling function starts with the establishment of standards that provide a basis for comparing
actual costs to determine variances, if any. A well-designed variance analysis system captures
variances as early as possible. The system helps managers who or what is responsible for each
variance and who is best able to explain it. An early measurement and reporting system allow managers
to monitor operations to take remedial action on issues, evaluate performance, and motivate workers
to achieve the standards set.
5. Help highlight variances in management by exception.
Management by exception is the practice of giving attention only to those situations in which large
variances occur so that management may have more time for more important problems of the business,
not just routine supervision of subordinates.
When the top management receives variance reports highlighting the operating performance of the
subordinate managers, the top management would be able to know when costs were not controlled and
by which managers. It allows the top management to provide feedback to subordinates, investigate
areas of concern, and make performance evaluations about who needs additional supervision, who
should be replaced, or who should be promoted.

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6. Simplify the costing of inventories and reduce clerical costs.

A company using standard costs usually utilizes lesser clerical time and effort in determining costs
necessary for decision making than in an actual costing system. This is because when using standard
costing, costs are assumed to be constant for some period. In actual costing system, costs are
continuously computed as activity level changes. Costs can be assigned to inventory at a predetermined
rate regardless of actual conditions.

Variance Analysis
To establish the standard cost of producing a product, establishing standards for each manufacturing cost
element—direct materials, direct labor, and manufacturing overhead—is necessary. The standard for each
element is determined from the standard price to be paid and the standard quantity to be used.

Total variance is the difference between the total actual cost incurred and the total standard cost applied to the
actual output produced or achieved during the period.
Actual Cost (Actual price
of actual input used)
Total Variance
(Favorable or
Standard Cost (Standard Unfavorable)
price of actual output
produced)

The total variance does not provide useful information for determining why cost differences occurred. To help
managers in achieving their objectives, total variances are subdivided and further analyzed into price and usage
components. Price variances and quantity variances usually have different causes. In addition, different
managers are usually responsible for buying and using inputs. For example, in the case of a raw material, the
purchasing manager is responsible for its price and the production manager is responsible for the amount of
the raw material actually used to make products. Therefore, clearly distinguishing between deviations from price
standards (the responsibility of the purchasing manager) and deviations from quantity standards (the
responsibility of the production manager) is important.

General Model for Standard Costing

Where: AP = Actual Price

AQ = Actual Quantity
SP = Standard Price
SQ = Standard Quantity

Standard price or rate is the amount that should be paid for one (1) unit of input factor.
Standard quantity is the amount of input factor that should be used to make a unit of product.
* Both standards relate to the input factors: direct materials, direct labor, and manufacturing overhead
The model can be used to compute a price variance and a quantity variance for each of the three (3) variable
cost elements—direct materials, direct labor, and variable manufacturing overhead—even though the variances
have different names. The following must be considered in determining the standard costs (Garrison et al.,
2018):

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1. Direct Materials
• The standard price per unit is the cost per unit of direct materials that should be incurred. This
standard should be based on the purchasing department’s best estimate of the cost of raw
materials.
• The standard quantity per unit defines the number of direct materials that should be used for each
unit of the finished product, including an allowance for normal inefficiencies, such as waste and
spoilage.
2. Direct Labor
Direct labor quantity and price standards are usually expressed in terms of labor hours or labor rate.
• The standard hours per unit defines the amount of direct labor hours that should be used to produce
a unit of product.
• The standard rate per hour defines the company’s expected direct labor wage rate per hour,
including employment taxes and fringe benefits.
3. Variable manufacturing overhead
As with direct labor, the quantity and price standards for variable manufacturing overhead are usually
expressed in terms of hours and a rate.
• The standard hours per unit for variable overhead measures the amount of the allocation base from
a company’s predetermined overhead rate that is required to produce one (1) unit of finished goods.
• The standard rate per unit that a company expects to pay for variable overhead equals the variable
portion of the predetermined overhead rate.

Price variance reflects the difference between what was paid for inputs and what should have been paid for
inputs.
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣 = (𝐴𝐴𝐴𝐴 − 𝑆𝑆𝑆𝑆)𝑥𝑥 𝐴𝐴𝐴𝐴

Usage variance shows the difference between how much of the input was actually used and how much should
have been used for the actual level of output.
𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈 𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣 = (𝐴𝐴𝐴𝐴 − 𝑆𝑆𝑆𝑆)𝑥𝑥 𝑆𝑆𝑆𝑆

Another diagram could be presented as follows:

Figure 2. General model for standard cost variance analysis

Source: Managerial Accounting, 2017. p. 455

Price variance is called materials price variance (MPV) in the case of direct materials, labor rate variance (LRV)
in the case of direct labor, and variable overhead rate variance (VRV) in the case of variable manufacturing
overhead.

Quantity variance is called materials quantity variance (MQV) in the case of direct materials, labor efficiency
variance (LEV) in the case of direct labor, and variable overhead efficiency variance (VEV) in the case of variable
manufacturing overhead.

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All the columns in the figure are based on the actual amount of output produced during the period. Even the
standard or budgeted cost in Column 3 depicts the standard cost allowed for the actual amount of output
produced during the period.

The standard quantity (SQ) allowed (when computing direct materials variances) or standard hours allowed
(when computing direct labor and variable manufacturing overhead variances) refers to the amount of an input
that should have been used to manufacture the actual output of finished goods produced during the period. It is
computed by multiplying the actual output by the standard quantity (or hours) per unit. The standard quantity
(or hours) allowed is then multiplied by the standard price (or rate) per unit of the input to obtain the total cost
according to the flexible budget. For example, if a company actually produced 50 units of product during the
period and its standard quantity per unit of product for direct materials is five (5) pounds, then its standard
quantity allowed would be 250 pounds, i.e., 50 units × 5 pounds per unit. If the company’s standard cost per
pound of direct materials is P2, then the standard or budgeted direct materials cost would be P500 (250 pounds
× P2 per pound).

Also, the spending, price, and quantity variances, as seen in the diagram, are computed the same way
regardless of whether it is dealing with direct materials, direct labor, or variable manufacturing overhead. In all
of these variance calculations, a positive number should be labeled as an unfavorable (U) variance and a
negative number should be labeled as a favorable (F) variance.

An unfavorable price variance indicates that the actual price (AP) per unit of the input was greater than the
standard price (SP) per unit. A favorable price variance indicates that the actual price (AP) of the input was less
than the standard price (SP) per unit. An unfavorable quantity variance indicates that the actual quantity (AQ)
of the input used was greater than the standard quantity allowed (SQ). Conversely, a favorable quantity variance
indicates that the actual quantity (AQ) of the input used was less than the standard quantity allowed (SQ).

In addition, fixed overhead (FOH) variances can also be computed using the general model. However, instead
of using adjusted cost or actual quantity of input at standard price, the budgeted cost at budgeted level of activity
is used. The total variance for fixed factory overhead is further analyzed into the following:
a. FOH Spending Variance – It is the difference between the actual FOH and the budgeted FOH based on
budgeted input activity.
b. FOH Volume Variance – It is the difference between the budgeted FOH based on budgeted input activity
and the applied or standard FOH based on actual output achieved. It is caused solely by producing at a
level that differs from that used to compute the predetermined fixed overhead rate.

ILLUSTRATION:
Assume that a company manufactures smoked crabs in its smoking department with the following ingredients
on a per lot basis:
Material standard
3,000 pounds of carbs at P5.00 per pound P15,000
Labor standard
40 hours at P15 per hour 600

Variable overhead standard

5 hours at P150 per machine hour 750
P150 = Budgeted monthly variable overhead
of P15,000 at a budgeted activity of 100
machine hours

Fixed overhead standard

8 hours at P140 per hour of move or wait time
(P140 = Budgeted monthly fixed overhead of
P28,000 at a budgeted activity of 200 hours) 1,120
Total cost for one (1) lot of smoked crabs P17,470

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Actual data for the month in the smoking department are as follows:
Number of lots produced (47,500 pounds) 20 lots
Pounds of crabs purchased 60,450
Pounds of crabs used 60,450
Price per pound of crabs purchased P6.00
Direct labor hours incurred 1,000
Total direct labor cost incurred P14,500
Total variable overhead cost P19,000
Machine hours incurred 87
Total fixed overhead cost P30,000
Hours of move/wait time incurred 140

SOLUTION:
Variance analysis can be done using the general model:

1. Direct material variances

Actual Quantity of Input at Actual Quantity of Input at Standard Quantity Allowed for
Actual Price Standard Price Actual Output at Standard Price
(AQ x AP) (AQ x SP) (SQ x SP)
SQ= 20 lots x 3,000 lbs = 60,000
60,450 lbs x P6.00 60,450 lbs x P5.00
60,000 lbs. x P5.00
= P362,700 = P302,250 =P300,000

MPUV P60,450 unfavorable MQV P2,250 unfavorable

Spending Variance (SV) P62,700 unfavorable

MPUV = Material price usage variance

Normally, materials price variance is assumed to be the price usage variance to be consistent with that of the
quantity variance. It is more meaningful as it concerns production rather than the purchasing function. However,
this model can be used to compute direct materials variances only when the actual quantity of materials
purchased equals the actual quantity of materials used in production.

There are cases where these two (2) are different. Because the material price variance relates to the purchasing
function, the materials price variance is computed using the quantity of materials purchased rather than the
quantity of materials used. The variance is called material purchase price variance (MPPV) because it is based
on the quantity of materials purchased. It is best to recognize the price variance for direct materials when the
materials are purchased.

2. Direct labor variances

Actual Hours of Input at Actual Hours of Input at Standard Hours Allowed for
Actual Rate Standard Rate Actual Output at Standard Rate
(AH x AR) (AH x SR) (SH x SR)
SQ= 20 lots x 40 hrs/lot = 800 hrs
1,000 hrs x P14.50 1,000 hrs x P15.00 800 hrs. x P15.00
= P14,500 = P15,000 =P12,000

LRV P500 favorable LEV P3,000 unfavorable

SV P2,500 unfavorable

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3. Variable overhead variances

Actual Hours of Input at Actual Hours of Input at Standard Hours Allowed for
Actual Rate Standard Rate Actual Output at Standard Rate
(AH x AR) (AH x SR) (SH x SR)
SQ= 20 lots x 5 hrs = 100 hrs
87 hrs x P150.00
P19,000 100 hrs x P150.00
= P13,050
=P15,000

VOH rate variance (VRV) VOH efficiency variance (VEV)

P5,950 unfavorable P1,950 favorable

Total variance P4,000 unfavorable

4. Fixed overhead variance

Actual Hours of Input at Standard Hours Allowed for

Budgeted Fixed Overhead
Actual Rate Actual Output at Standard Rate
(Budgeted Capacity x SR)
(AH x AR) (SH x SR)
SQ = 20 lots x 8 hrs = 160 hrs
200 hrs x P140.00
P30,000 160 hrs x P140.00
= P28,000
=P22,400

FOH spending variance (FSV) FOH volume variance (FVV)

P2,000 unfavorable P5,600 unfavorable

Total variance P7,600 unfavorable

References:
Garrison, R. H., Noreen, E. W., & Brewer, P. C. (2018). Managerial accounting. McGraw-Hill Education.
Hilton, R. W., & Platt, D. E. (2017). Managerial accounting: Creating value in a dynamic business environment.
McGraw-Hill Education.
Weygandt, J. J., Kimmel, P. D., Kieso, D. E., & Aly, I. M. (2018). Managerial accounting: Tools for business
decision-making. John Wiley & Sons, Inc.

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