Standard Costing and Variance Analysis:

Learning Objectives:

Explain how direct materials standard and direct labor standards are set.

Compute the direct materials price and quantity variances and explain their significance.

Compute the direct labor rate and efficiency variance and explain their significance.

Compute the manufacturing overhead spending and efficiency variance.

In this section of the website we study management control and performance measures. Quite
often, these terms carry with them negative connotations - we may have a tendency to think of
performance measurement as something to be feared. And indeed, performance measurements can
be used in very negative ways - to cast blame and to punish. However, that is not the way they
should be used. Performance measurement serves a vital function in both personal life and in
organizations. Performance measurement can provide feedback concerning what works and what
does not work, and it can help motivate people to sustain their efforts.

In this section we see how various measures are used to control operations and to evaluate
performance. Even though we are starting with the lowest levels in the organization, keep in mind
that performance measures should be derived from the organization's overall strategy. For example,
a company like Sony that bases its strategy on rapid introduction of innovative consumer products
should use different performance measures than a company like Federal Express where on-time
delivery, customer convenience, and low cost are key competitive advantages. Sony may want to
keep close track of the percentage of revenues from products introduced within the last year;
whereas Federal Express may want to closely monitor the percentage of packages delivered on time.
Later in this section when we discuss the balance scorecard, we will have more to say concerning the
role of strategy in the selection of performance measures. But first we will see how standard costs
are used by managers to help control costs.

Company in highly competitive industries like Federal Express, Southwest airlines, Dell Computer,
Shell Oil, and Toyota must be able to provide high quality goods and services at low cost. If they do
not, they will perish. Stated in the starkest terms, managers must obtain inputs such as raw
materials and electricity at the lowest possible prices and must use them as effectively as possible -
while maintaining or increasing the quality of the output. If inputs are purchased at prices that are
too high or more inputs are used than is really necessary, higher costs will result.

How do managers control the prices that are paid for inputs and the quantities that are used? They
could examine every transaction in detail, but this obviously would be an inefficient use of
management time. For many companies, the answer to this control problem lies at least partially in
standard costing system.

Standard Costs and Management By Exception:

A standard cost is the predetermined cost of manufacturing a single unit or a number of product
units during a specific period in the immediate future. It is the planned cost of a product under
current and/or anticipated operating conditions. Click here to read full article.

Setting Standard Costs - Ideal Versus Practical Standards:

Setting price and quantity standards requires the combined expertise of all persons who have
responsibility over input prices and over effective use of inputs. In a manufacturing firm, this might
include accountants, purchasing managers, engineers, production supervisors, line mangers, and
production workers. Past records of purchase prices and input usage can help in setting standards.
However, the standards should be designed to encourage efficient future operations, not a
repetition of past inefficient operations. Click here to read full article.

Direct Materials Standards and Variance Analysis:

Direct Materials Price and Quantity Standards:

Standard price per unit of direct materials is the price that should be paid for a single unit of
materials, including allowances for quality, quantity purchased, shipping, receiving, and other such
costs, net of any discounts allowed. Click her to read full article.

Direct Materials Price Variance:

Direct materials price variance is the difference between the actual purchase price and standard
purchase price of materials. Direct materials price variance is calculated either at the time of
purchase of direct materials or at the time when the direct materials are used. Click here to read full
article

Direct Materials Quantity Variance:

Direct materials quantity variance or Direct materials usage variance measures the difference
between the quantity of materials used in production and the quantity that should have been used
according to the standard that has been set. Although the variance is concerned with the physical
usage of materials, it is generally stated in dollar terms to help gauge its importance. Click here to
read full article.

Direct Labor Standards and Variance Analysis:

Direct Labor Rate and Efficiency Standards:

Direct labor price and quantity standards are usually expressed in terms of a labor rate and labor
hours. The standard rate per hour for direct labor includes not only wages earned but also fringe
benefit and other labor costs. Click here to read full article

Direct Labor Rate | Price Variance:

Direct Labor price variance is also termed as direct labor rate variance. This variance measures any
deviation from standard in the average hourly rate paid to direct labor workers. Click here to read
full article.

Direct Labor Efficiency | Usage | Quantity Variance:

The quantity variance for direct labor is generally called direct labor efficiency variance or direct
labor usage variance. Click here to read full article.

Manufacturing Overhead Standards and Variance Analysis:

Manufacturing Overhead Standards:

Procedures for the establishing and using standard factory overhead rates are similar to the
methods of dealing with the estimated direct and indirect factory overhead and its application to
jobs and products. Click here to read full article.

Factory Overhead Variances:

Jobs or processes are charged with cost on the basis of standard hours allowed multiplied by the
standard factory over head rate. The standard overhead rate or predetermined overhead rate is
discussed in detail at our job order costing system page. The standard hours allowed figure is
determined by multiplying the labor hours required to produce one unit (the standard labor hours
per unit) times the actual number of units produced during the period. The units produced are the
equivalent units of production for the departmental factory overhead cost being analyzed. At the
end of the month, overhead actually incurred is compared with the expenses charged into process
using the standard factory overhead rate. The difference between these figures is called the overall
or net factory overhead variance.

overall or net factory overhead variance needs further analysis to reveal detailed causes for the
variance and to guide management toward remedial action. This analysis may be made by using (1)
the two variance method, (2) the three variance method, or (3) the four variance method.

The two variance method: When an overall or net factory overhead variance is further analyzed by
using two variance approach, the following two variances are calculated:

Controllable variance

Volume variance

The three variance method: When an overall or net factory overhead variance is further analyzed by
using three variance approach, the following three variances are calculated:

Spending variance

Idle capacity variance

Efficiency variance
The four variance method: When an overall or net factory overhead variance is further analyzed by
using four variance approach, the following four variances are calculated:

Spending variance

Variable efficiency variance

Fixed efficiency variance

Idle capacity variance

Mix and Yield Variance - Definition and Explanation:

Basically, the establishment of standard product cost requires the determination of price and
quantity standards. In many industries, particularly of the process type, materials mix and materials
yield play significant parts in the final product cost, in cost reduction, and in profit improvement.
Click here to read full article

Calculation of Mix and Yield Variances:

Materials Mix and Yield Variance

Labor Yield Variance

Factory Overhead Yield variance

Variance Analysis and Management By Exception:

Variance analysis and performance reports are important elements of management by exception.
Simply put, management by exception means that the manager's attention should be directed
toward those parts of the organization where plans are not working out for reason or another.

Managerial importance and usefulness of variance analysis:

Costs of production are effected by internal factors over which management has a large degree of
control. An important job of executive management is to help the members of various management
levels understand that all of them are part of the management team. Click here to read full article.

Advantages and Disadvantages of Standard Costing System:

The use of standard costs is a key element in a management by exception approach. If costs remain
within the standards, Managers can focus on other issues. Click here to read full article

Standard Costing Discussion Questions and Answers:

Find answers of various important questions about standard costing system. Click here.

Standard Costing and Variance Analysis Formulas:

A collection of variance formulas / equations which can help you calculate variances for direct
materials, direct labor, and factory overhead. Click here to read full article

Standard Costing and Variance Analysis Problems and Solution:

Find a collection of comprehensive problems about standard costing and variance analysis. We have
also provided the solution. Click here

Standard Costing and Variance Analysis Case Study:

Click here for the study of cases about standard costing and variance analysis