KHALID AZIZ

Direct Costs in Standard Costing

Setting cost standards; direct materials cost variances: price and efficiency
variance; direct labor cost variances: price and efficiency variance; journal
entries for direct materials and direct labor cost variances.

Typical cost standards

In accordance with US GAAP, for external reporting purposes companies have to

use the actual costing method. However, for internal reporting purposes, many
businesses use the standard costing approach. Standard costing allows the
company’s management to set operating targets and evaluate actual
performance. By setting standard costs and performing standard cost variance
analysis, companies can determine concrete ways to improve future operations
and can prepare more realistic operating budgets

To monitor performance and plan operations, management sets standards for

resources used in production. Typical resources used in production are: direct
materials, direct labor, variable factory overhead, and fixed factory overhead
costs. Standard costs for the aforementioned resources are determined as
follows:

Illustration 1: Typical standard cost calculation

Direct Standard Price (SP) per Unit of Input

Materials X
Standard Quantity (SQ) per Unit of Output
Direct Standard Price (SP) per Labor Hour (Input)
Labor X
Standard Labor Hours/Rate (SR) per Unit of Output
Variable Standard Variable Overhead Allocation Rate (SR)
Factory X
Overhead Standard Quantity of Allocation Base per Unit of Output
Fixed Standard Fixed Overhead Allocation Rate (SR)
Factory X
Overhead Standard Quantity of Allocation Base per Unit of Output

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As we can see in the table above, when calculating each standard cost, we
multiple the “input” standard rate or price by the “output” standard quantity.
To illustrate a simple example, let’s assume ALumloyParts Ltd. produces
aluminum alloy parts. To manufacture AL200 series tubes, the company uses 1
pound of aluminum to produce 2 tubes. The company expects that in May 20X0
the price of aluminum will be $1.20 per pound. In April 20X0 the company’s
management determines the following standard cost of aluminum (direct
materials) used in AL200 pipes:

Standard price per unit of input = $1.2 per pound of aluminum

Standard quantity of input per unit of output = 0.5 pound of aluminum per tube
Standard cost of aluminum per unit of output = $1.2/lb x 0.5 lb = $0.6 per
pound of AL200 tube.

2. Setting cost standards

To establish cost standards, companies make certain assumptions about their

production as well as input prices and quantities, identify standard levels, and
collect information about operating costs.
Companies make assumptions concerning the factors listed below:
Production volume (e.g. 100,000 units per month).
Production efficiency (e.g. 95 % efficiency, 5% defected items and waste).
Input standards: prices and quantities (e.g. $1 per gallon of milk and 1 gallon of
milk per ice cream bucket).
In addition to making assumptions, management has to identify standard levels:
Ideal standards can be achieved only with the highest efficiency and
performance (usually under perfect conditions).
Attainable standards are attainable under current conditions that have an
element of inefficiency. Usually it is better to use currently attainable standards
than ideal standards because attainable standards may discourage employees
less and motivate them to perform better.
Companies usually determine attainable standards for the following costs:

Direct Materials:
Materials price standard is the price a company expects to pay per unit of
direct materials (e.g. $ 4 per 1 yard of atlas fabric, $1 per gallon of milk). It is a
standard for the direct materials input. Materials price standard is based on
expected costs of direct materials. It is usually set by a purchasing agent.

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However, purchasing agent might be tempted to overestimate the materials price

standard in order to look good by purchasing direct materials at a lower price.
Materials usage standard is the quantity of direct materials needed to
produce one finished item (e.g. 1 gallon of milk per ice cream bucket, 3 yards of
atlas fabric per dress). It is a standard for the direct materials input. Materials
usage standard is set using engineering estimates and historical data.
Direct materials standard is expected direct materials cost per unit of output
(e.g. $12 of direct materials cost per dress).
Direct Labor:
Labor rate standard is expected cost (“price”) per one hour of direct labor
(e.g. $10 per hour). Labor rate standard is often equal to the average wage rate
paid to workers with various skills levels.
Labor efficiency (usage) standard is the number (quantity) of direct labor
hours needed to produce one finished item (e.g. 2 direct labor hours per dress, 1
machine hour per aluminum pipe). Labor efficiency standard is a difficult
standard to set because it depends on individual workers as well as on a type of
work performed. Also, when setting this standard under managements’
supervision, workers may work slower in order to decrease the labor efficiency
standard. Thus, it is better to use engineering estimates and adjust the standard
periodically.
Direct labor standard is expected direct labor cost per unit of output (e.g. $20
of direct labor costs per dress).
Variable Factory Overhead:
Variable overhead rate standard is estimated variable overhead cost per
direct labor hour (e.g. $5 per direct labor hour). It is determined by dividing
expected total variable overhead costs by total budgeted application base.
Variable overhead application base standard is expected total direct labor
hours for a period (e.g. 200,000 direct labor hours per year).
Budgeted variable overhead cost (BVOC) is estimated total variable
overhead cost for a period (e.g. $1,000,000 per year).
Fixed Factory Overhead:
Fixed overhead rate standard is estimated fixed overhead cost per unit of
output (e.g. $2 per dress). It is determined by dividing expected total fixed
overhead costs by total budgeted production (e.g. $300,000 / 100,000 dresses =
$3 per dress).
Fixed overhead application base standard is standard volume of allocation
base (e.g. 100,000 dresses per year)
Budgeted fixed overhead cost (BFOC) is estimated total fixed overhead cost
for a period (e.g. $300,000 per year).
Standards for manufacturing costs are summarized in the table below:

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Illustration 2: Standard cost components

Product Price (Rate) Usage (Efficiency) Cost Standard
Costs Standard Standard (3) = (1) x (2)
(1) (2)
Direct Materials Price Materials Usage Direct Materials
Materials Standard Standard Standard
Direct Labor Rate Labor Efficiency Direct Labor
Labor Standard (Usage) Standard Standard
Variable Factory Variable Overhead Variable Overhead Budgeted Variable
Overhead Rate Standard Application Base Standard Overhead Cost (BVOC)
Fixed Factory Fixed Overhead Fixed Overhead Budgeted Fixed
Overhead Rate Standard Application Base Standard Overhead Cost (BFOC)

To illustrate an example, see the table below:

Product Price (Rate) Usage (Efficiency) Cost Standard
Costs Standard Standard
Direct $4 per 1 yard 3 yards per dress $12 per dress
Materials
Direct $10 per direct 2 direct labor $20 per dress
Labor labor hour hours per dress
Variable $ 5 per direct 200,000 direct labor $ 1,000,000 per year
Factory labor hour hours per year
Overhead
Fixed Factory $3 per dress 100,000 dresses $ 300,000 per year
Overhead per year

Companies periodically review standards due to the following reasons:

Cost reduction goals
Quality improvements goals
Unattainable standards
Large variances from standards
As mentioned above, one of the incentives for a company to review its standards
is caused by the standard cost variances, which can be identified through
variance analysis. Let’s look at the major steps and goals of variance analysis.

3. Cost variance analysis

Variance analysis is a process of identifying variances and then analyzing the

reasons (causes) of their occurrences. Standard cost variance is a difference

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between a standard and actual cost. Thus, standard variance analysis is a

process of identifying variances between standard and actual costs and then
analyzing the reasons for their occurrence. In general, variance analysis is
performed for bookkeeping and monitoring purposes.
Firstly, companies calculate the dollar amount of variances by comparing actual
and standard costs. Then, they select important variances for further
investigation; selected variances usually play an important role in the
management’s decision making process (e.g. worker’s productivity or labor
efficiency rate). Finally, companies identify the reasons for variances, make
conclusions, and take action. This process is illustrated below:
Illustration 3: Standard cost variance analysis

Management, with the help from accountants, determines the reasons for
variance occurrence and decides whether to take any further action. To make
such a decision, management may utilize the following guideline:
Inappropriate standard: revise the standard to improve the accuracy of future
budgeting.
Operations out of control: change (correct) operations.
Better than expected operations: make sure quality is maintained.

Better than expect operations + high quality: change operations to take

advantage of operating efficiency and review standards.
Accounting error: correct the error as well as the accounting system.
Random variance: do nothing.
As mentioned earlier, companies select important variances and break them
down into components in order to make the variance analysis easier to
interpret. First, let’s look at the direct cost variances. Then, in a separate tutorial
we can study variable and fixed overhead variances.

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4. Direct cost variances

As you may recall direct costs (i.e. direct materials and direct labor) have two
major components:

Price (rate) standard (relates to price variance)

Efficiency (usage) standard (relates to efficiency variance)
As the result, direct costs have two major types of variance: price variance and
efficiency variance. Important to note, variances for factory overhead are
different, and that is why we will talk about them later. So, what do price and
efficiency variances mean?
Price variance is the difference between actual and standard price paid for
resources used in production. Actually, we deal with price variances on a daily
basis. For instance, if you usually pay $2.00 per loaf of bread and then buy the
same bread for $2.20 at a different store, the 20 cents difference ($2.00 – 2.20)
is a price variance. In this example, it is also an unfavorable variance ($2.00 –
2.20 = - $0.20) because you had to pay a higher than standard (normal) price
for the product. On the other hand, if you purchase two loafs of bread for
$2.50, you essentially paid $1.25 per loaf of bread. In this case, you have a
favorable price variance of 75 cents (per loaf of bread: $2.00 – $1.25).
The later scenario is applicable for many businesses as companies often try to
take advantage of bargain purchases. Bargain purchases might have affect on
the quality of the material, usage requirements (e.g. need to use more material
of a lower quality), storage space, and cash flows. Unfortunately, price variance
does not tell how bargain purchases affect production efficiency. In such a case,
we use efficiency variances.
Efficiency variance tells how economically and efficiently direct materials and
direct labor are used in production. We deal with efficiency variances on a daily
basis as well. For instance, if it usually takes you 30 minutes to get to work by
car, and then one day you get to work in 20 minutes, you have a favorable
efficiency variance of 10 minutes (i.e. which can be transferred into a dollar
value; for example, $100).
Now, let’s look at price and efficiency variances in greater detail.

4.1. Price variances

There are two types of price variances: direct materials price variance and direct
labor price variance. The calculation of both variances applies the same type of
logic: the difference between an actual and standard price is multiplied by an
actual quantity of input. In the case of direct materials, actual quantity of input
represents the actual quantity of purchased materials, and in the case of direct
labor, actual quantity equals the actual hours used.

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Direct materials price variance (MPV) is the difference between the actual
quantity purchased at the actual price and the actual quantity purchased at the
standard price. Its formula is provided below:
Direct Materials Price Variance
=
(Actual Price – Standard Price)
x
Quantity Purchased
MPV = (AP – SP) x AQ
Where MPV = Materials price variance; AP = Actual price; SP = Standard price;
and AQ = Actual quantity.
Direct materials price variance is usually calculated at the time direct materials
are purchased. Important to note, companies using standard costing record
direct materials in the raw materials inventory account at a standard price rather
than at an actual one. This reduces bookkeeping complexity because there is no
need to keep track of all different actual prices paid for direct materials. At the
point of purchase, management has to calculate the direct materials price
variance and record it in the books.
To illustrate an example, let’s assume XLCoutureDresses Inc. manufactures
evening dresses. The company usually pays $100 per yard of embroidered silk
fabric. In March 20X0 the company purchased 200 yards of embroidered silk
fabric for $95 a yard, and in April 20X0 it bought 60 yards of the same fabric for
$110 a yard.
In March 20X0 the materials price variance was calculated as follows: MPV =
($95 - $100) x 200 yards = ($1,000). This is a favorable variance because the
company paid $5 dollars less per each yard of the purchased fabric. Also, we
can see that the $1,000 value has a negative sign, which in this case also
indicates a favorable variance. We can abbreviate whether a variance is
favorable or unfavorable by writing the letter “F” or “U” next to the
dollar amount of a variance, accordingly. For instance, in this case we have
the materials price variance of $1,000 F.
Let’s continue our example. In April 20X0 the company had the following direct
materials price variance: MPV = ($110 – 100) x 60 yards = $600 or $600 U.
This is an unfavorable variance because the company paid $10 more than normal
per each yard of the fabric. In addition, in this case, the positive sign of the
dollar amount indicates an unfavorable variance. Importantly, not always
positive and negative signs indicate favorable and unfavorable
variances, accordingly; it depends on the application of formulas (e.g. (actual
price – standard price) or (standard price – actual price) will have the same
value result, but difference signs). Thus, carefully interpret each variance!

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In April 20X0 the company made the following journal entry:

Dr Raw Materials (60 yards x $100 per yard) 6,000

Dr Direct Materials Price Variance 600
Cr Accounts Payable (60 yards x $110 per yard) 6,600
As stated earlier, direct materials are recorded in the raw materials inventory
account at a standard price (e.g. in this case, standard price is $100 per year),
while accounts payable are recorded at actual price. The difference is recorded
as direct materials price variance: Dr Unfavorable Materials Price Variance and Cr
Favorable Materials Price Variance.
Direct labor price variance (LPV) compares the actual price and standard
price of direct labor, multiplied by the number of actual hours used in
production. Its formula is provided below:
Direct Labor Price Variance
=
(Actual Price – Standard Price)
x
Actual Hours Used
LPV = (AP – SP) x AQ
Where LPV = Labor price variance; AP = Actual price; SP = Standard price; and
AQ = Actual quantity.
Standard and actual prices are sometimes called standard and actual rates. They
are expressed in dollars per labor hour.
To illustrate an example, let’s assume XLCoutureDresses Inc. manufactures
evening dresses. The company’s standard labor rate is $10 per hour. In April
20X0 the company paid $11 per hour for 100 hours of work. In this case, the
direct labor price variance is calculated as follows: LPV = ($11 - $10) x 100 hours
= $100 or $100 U. The direct labor price variance is unfavorable because the
company paid $1 more than the standard rate required.
In April 20X0 the company made the following journal entry:
Dr Work-in-process Inventory (100 hours x $10 per hour) 1,000
Dr Direct Labor Price Variance 100
Cr Wages Payable (100 hours x $11 per hour) 1,100

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4.2. Efficiency (usage) variances

There are two types of efficiency variances related to the direct costs: direct
materials efficiency variance and direct labor efficiency variance. They are
calculated using the same logic: the difference between standard quantity of
input and actual quantity of input is multiplied by standard price. It makes sense
to calculate the difference between actual and standard input quantity because
this difference shows how efficiently companies use their resources in
production.
Direct materials efficiency (usage) variance (MEV) compares a standard
and actual quantity of direct materials used in production (i.e. materials put in
production represent input quantity). In other words, it is the difference between
the actual quantity of materials used and the standard quantity that should have
been used at the actual production level, multiplied by the standard price. Its
formula follows:
Direct Materials Efficiency Variance
=
(Actual Quantity For Actual Output
–
Standard Quantity For Actual Output)
x
Standard Price
MEV = (AQ – SQ) x SP
Where MEV = Materials efficiency variance; AQ = Actual quantity of input for
actual output; SQ = Standard quantity of input for actual output; and SP =
Standard price.
To illustrate an example, assume XLCoutureDresses Inc. manufactures evening
dresses. The company usually uses 10 yards of embroidered silk fabric per
evening dress. The standard price of 1 yard of this fabric is $100. In April 20X0
the company manufactured 100 dresses using 900 yards of embroidered silk
fabric. In this case, the standard quantity (of input) for actual output is 1,000
yards of embroidered silk fabric (i.e. 100 dresses (actual output) times 10 yards
per dress = 1,000 yards). Now we can calculate the direct materials efficiency
variance: MEV = (900 yards – 1,000 yards) x $100 per yard = ($1,000) F. The
materials efficiency variance is favorable because the company used 100 yards of
materials less than the standard required.
In April 20X0 the company made the following journal entry:
Dr Work-in-process Inventory (1,000 yards x $100) 10,000
Cr Direct Materials Efficiency Variance 1,000
Cr Raw Materials (900 yards x $100 per yard) 9,000
As we can see once again, companies enter data into the inventory
accounts at standard prices and standard quantities, in some cases.
Previously, XLCoutureDresses recorded the purchased raw materials in the raw
inventory accounts at the standard price (e.g. in April 20X0, 60 yards x $100 per

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yard). When the company used the materials in the production, it credited the
raw materials inventory for the actual amount of raw materials used times the
standard price (i.e. 900 yards x $100 per yard). Also, the company recorded the
used materials in the work-in-process inventory account at both the standard
quantity and standard price (i.e. 1,000 yards x $100 per yard).

Direct labor efficiency (usage) variance (LEV) compares the actual and
standard amount of labor hours used in production. In other words, it is the
difference between the actual hours used and the standard hours that should
have been used at the actual production level, multiplied by the standard rate.
The formula follows:
Direct Labor Efficiency Variance
=
(Actual Hours For Actual Output
–
Standard Hours For Actual Output)
x
Standard Price
LEV = (AQ – SQ) x SP
Where LEV = Labor efficiency variance; AQ = Actual quantity of input (hours) for
actual output; SQ = Standard quantity of input (hours) for actual output; and SP
= Standard price (rate).
To illustrate an example, assume XLCoutureDresses Inc. manufactures evening
dresses. The company usually uses 8 hours of direct labor per evening dress.
The standard price (rate) of 1 labor hour is $10. In April 20X0 the company
manufactured 100 dresses using 820 labor hours. In this case, the standard
quantity (of input) for actual output is 800 direct labor hours (i.e. 100 dresses
(actual output) times 8 labor hours per dress = 800 labor hours). Now we can
calculate the direct labor efficiency variance: LEV = (820 hours – 800 hours) x
$10 per hour = $200 or $200 U. The labor efficiency variance is unfavorable
because the company used 20 labor hours more than the standard required.
In April 20X0 the company made the following journal entry:
Dr Work-in-process Inventory (800 hours x $10 per hour) 8,000
Dr Direct Labor Efficiency Variance 200
Cr Wages Payable (820 hours x $10 per hour) 8,200

4.3. Summary for direct cost variance calculations

The summary of the standard variance analysis of direct costs is presented in the
tables below.
For the direct material variances we show two tables. One is for the situation
when the total direct materials variance is based on the same quantity of
inventory purchased and used during the month. In such situations (which are

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rare in real life) the AQ x SP is the ending point for the efficiency variance and
starting point for the price variance.
The other table shows a situation (which is more common in real life) when the
quantity of inventory purchased does not equal the quantity of inventory used
during the month. In such situations the AQ x SP for the efficiency and price
variances will be based on different quantities and thus, efficiency and price
variances must be calculated separately (can’t use the same AQ x SP). The price
variance will be based on the quantity purchased and the efficiency variance will
be based on the quantity used.

Illustration 4: Direct materials variances (same quantity purchased and

used)

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Illustration 5: Direct materials variances (different quantities

purchased and used)

Illustration 6: Direct labor variances

4.4. Reasons for direct cost variances

There are many events or circumstances that can cause direct materials and
direct labor variances. For example, companies may make a trade-off between
price and efficiency. Companies may purchase direct materials at a lower price;
such materials could be of a lower quality or more difficult to work with. In such

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a case, the company might have to either use more materials (of a lower quality)
than the standard requires or use more direct labor hours to produce the
product. Purchasing materials of a quality higher than needed could also result in
an unfavorable variance. Expensive high quality materials not always result in the
higher sales of the product made of such materials, and the company would
incur higher product costs in such a case.
Moreover, there can be a trade-off between difference variance. Elimination of
one unfavorable variance could cause the occurrence of another unfavorable
variance. For example, if a company’s management increases the monitoring of
its employees working with expensive direct materials, this could improve the
materials efficiency variance (e.g. from an unfavorable to a favorable variance),
but at the same time it could have an adverse affect on the labor efficiency (i.e.
cause an unfavorable labor efficiency variance). Thus, in this example we see a
trade-off between an unfavorable materials efficiency variance and an
unfavorable labor efficiency variance.
Examples of reasons causing direct cost variances are provided in the table
below:

Illustration 7: Reasons for direct cost variances

Price Variance Efficiency Variance
Direct Unreasonable materials price Unreasonable materials quantity
Materials standard (unreasonable SP). standard (unreasonable SQ).
Change in purchase price (e.g. Change in the quantity of spoiled
new supplier, change in materials due to the changes in
quantity of materials quality / equipment / technology,
purchased, change in purchase equipment malfunction, worker
discount). damage, etc.
Accounting error (in the actual Accounting error (in quantity of
price of materials). materials used).
Normal fluctuation in the usage
of materials.
Change in production processes.
Theft of raw materials.
Direct Labor Unreasonable labor price Unreasonable labor hours
standard. standard.
Changes in average wages paid Change in the average labor
to employees (e.g. changes in hours due to the changes in
workers’ experience and skills, workers’ experience and skills, in
in the minimum wage rate, production processes or
labor union strikes). equipment, intentional workers’
slowdown, etc.
Accounting error (in the actual Accounting error (in the actual
price of direct labor). quantity of labor hours).
Overtime hours Normal fluctuation in labor hours.

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(unanticipated). Underreporting of labor hours.

As we can see from the table above, there are many reasons for direct cost
variances. It is important for management to analyze such reasons and take
action. For example, when cost standards are unreasonable, they could cause
unfavorable variances. In such a case, management should review and change
cost standards.
Variance analysis can be performed not only to calculate and interpret direct cost
variances, but it can also be used to monitor factory overhead costs.

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