Department of Business Studies

AC222 Cost Accounting 2

Standard Costing
Normal costing and Standard costing

 Normal costing system in which direct materials and direct labor are
recorded at actual costs, and overhead is applied to products using a
predetermined overhead rate.
 At the end of the period, only over or underapplied overhead cost needs to be
adjusted to the actual overhead cost.
 Standard costing system, in which all products costs are recorded at
standard cost while the products are being made.
 A unit recorded last week and one recorded in the inventory today both will
have been recorded at the same standard cost, regardless of actual cost of
the unit.
 This way, there is never any question about the recorded cost of a unit in
inventory, its always at the standard cost.
Normal costing and Standard costing

 At the end of an accounting period, the balances in all inventory and cost of
goods sold accounts will be at standard amounts.
 Because the inventory and cost of goods sold amounts must be reported on
financial statements at actual cost rather than standard cost, companies
make adjustments to the recorded balances through a series of journals
entries using the variances to change from standard cost to actual cost.
Variances

 A variance is the difference between actual results and expected

performance.
 The expected performance is also called budgeted performance, which is a
point of reference for making comparisons.
The Use of Variances

1. Variances bring together the planning and control functions of management and
facilitate management by exception.
 Management by exception is a practice whereby managers focus more closely on
areas that are not operating as expected and less closely on areas that are.
 For example, if a direct material actual costs of Lae Biscuit to product snax is
higher than originally budgeted, then the variances will prompt the managers to
find out why and correct the problem so future operations result in less direct
material costs.
 Sometimes a large positive variance may occur, such as a significant decrease in
the manufacturing costs of a product.
 Managers will try to understand the reasons for the decrease (better operator
training or changes in manufacturing methods, for example) so these practices can
be continued and implemented by other divisions within the organization.
The Use of Variances

2. Variances are also used for evaluating performance and to motivate managers.
❖ Production-line managers at Lae Biscuits may have quarterly efficiency
incentives linked to achieving a budgeted amount of operating costs.
3. Sometimes variances suggest that the company should consider a change in
strategy.
❑ For example, large negative variances caused by excessive defect rates for a
new product may suggest a flawed product design.
❑ Managers may then want to investigate the product design and potentially
change the mix of products being offered.
4. Variances also help managers make more informed predictions about the
future and thereby improve the quality of the five-step decision-making process..
Multiple Causes of Variances

To interpret variances correctly and make appropriate decisions based on them,

managers need to recognize that variances can have multiple causes.
1. Poor design of products or processes
2. Poor work on the production line because of underskilled workers or faulty
machines.
3. Inappropriate assignment of labor or machines to specific jobs.
4. Congestion due to scheduling a large number of rush orders placed.
Standard Costing

This topic will focus on standard costing process.

 What is standard costing? A standard costing is a carefully determined price,
cost, or quantity that is used as a benchmark for judging performance.
 Benchmarking is the continuous process of comparing your firm’s performance
levels against the best levels of performance in competing companies or in
companies having similar processes.
 Standards are usually developed by the firm itself.
 Standards are usually expressed on a per-unit basis.
Standard Costing

Consider how a company determines its direct manufacturing labor standards.

 The company conducts engineering studies to obtain a detailed breakdown of
the steps required to make a jacket.
 Each step is assigned a standard time based on work performed by a skilled
worker using equipment operating in an efficient manner. Similarly, the
company determines the standard quantity of square yards of cloth based on
what is required by a skilled operator to make a jacket.
Standard Costing –Advantages &
Disadvantages

Advantages: Standard times

(1) aim to exclude past inefficiencies and (2) take into account changes
expected to occur in the budget period.
An example of the latter would be a decision by the company’s managers to lease
new, faster, and more accurate sewing machines. Webb would incorporate the
resulting higher level of efficiency into the new standards it sets.
Disadvantages:
Because they are not based on realized benchmarks, the standards might not be
achievable, and workers could get discouraged trying to meet them
Standard Costing

The term standard refers to many different things:

▪ A standard input is a carefully determined quantity of input, such as square
yards of cloth or direct manufacturing labor-hours, required for one unit of
output, such as a jacket.
▪ A standard price is a carefully determined price a company expects to pay for
a unit of input.
▪ A standard cost is a carefully determined cost of a unit of output, such as the
standard direct manufacturing labor cost of a jacket.
Standard Costing
Standard Costing

 Standard direct material cost per jacket: 2 square yards of cloth input
allowed per output unit (jacket) manufactured, at $30 standard price per
square yard.

Standard direct manufacturing labor cost per jacket: 0.8 manufacturing labor-
hour of input allowed per output unit manufactured, at $20 standard price per
hour.
Standard Costing

How are the words budget and standard related? Budget is the broader term.
❖ To clarify, budgeted input prices, input quantities, and costs need not be
based on standards.
❖ These inputs could be based on past data or competitive benchmarks.
❖ However, when standards are used to obtain budgeted input quantities and
prices, the terms standard and budget are used interchangeably.
❖ The standard cost of each input required for one unit of output is determined
by the standard quantity of the input required for one unit of output and the
standard price per input unit.
Standard Costing

 Notice how the standard-cost computations shown previously for direct

materials and direct manufacturing labor result in the budgeted direct
material cost per jacket of $60 and the budgeted direct manufacturing labor
cost of $16 referred to earlier in the example.

 In standard costing system, a company uses standards that are attainable by

operating efficiently but that allow for normal disruptions.
 A normal disruption could include, for example, a short delay in the receipt of
materials needed to produce goods or a production delay because a piece of
equipment needed a minor repair.
Standard Costing System

 Recall what we covered earlier about standard costing.

 Lets look at an example in applying standard costing. Paradise Food Ltd
produces yeast that is used by Lae Biscuit Ltd in production of its Snax biscuit.
Lae Biscuit pays K0.29 per yeast. Lae Biscuit purchases yeasts in batch of 1,
000 and Paradise Food’s standard cost card for one batch of 1000 yeasts is
K220.
 Machine hours is the activity base used to apply overhead.
 The company expects to use its five machines a total of 10, 000 hours each
year ( 2000 hours per machine). Because all five machines do exactly the
same thing, five batches of yeasts are always in process.
 Each batch of yeasts takes one machine hour to make, so the company
expects to make 10, 000 batches of yeasts each year.
Standard Costing System

 Variable overhead costs are expected to be K270, 000, resulting in a variable

overhead rate of K27 per machine hour (K270, 000/10, 000 MH).
 Fixed overhead costs are expected to be K500, 000, resulting in a fixed
overhead rate of K50 per machine hour (K500,000/10, 000 MH).

Direct Materials 27.5 kg of yeast @ K3.60/kg K99

Direct Labor 4 direct labor hours @ K11/DLH K44
Variable overhead 1 machine hour @ K27/machine hour K27
Fixed overhead 1 machine hour @ K50/machine hour K50
Total standard cost per 1000 yeasts K220

Exhibit 1: Standard cost card for one batch of yeasts

Standard Costing Process

The following production events occurred at Paradise Food Company during the
year.
 9, 858 batches of yeasts were produced and sold.
 280, 000 kg of soda were purchased at K3.65 per kg.
 273, 395 kgs of soda were used during the year.
 40, 000 direct labor hours were worked at a cost of K10.50 per hour.
 Machines ran for 9990 hours.
 Variable overhead costs totaled K263, 000.
 Fixed overhead costs totaled K510, 000.
The next slide will show how to record these events using standard costing
process.
Standard Costing Process: Recording
Direct Material
 When materials are purchased, the transaction is recorded in the Direct
Materials Inventory Account at the standard price, and Account Payable is
charged for the full amount owed to the supplier.
✓ Paradise Food Ltd, the Raw Materials Inventory is debited for K1, 008, 000
(280, 000 kg of Soda x K3.60 standard price per kg.
✓ Accounts Payable is credited for K1, 022, 000 (280,000 kg of soda x K3.65
actual price per kg).
✓ The difference between those two amounts is charged to the direct materials
price variance to balance the journal entry. The variance is calculated using
the equation;
✓ Direct Materials price variance = AQ x (AP – SP) = 280, 000 x (3.65 - 3.60)
= K14, 000 U
Standard Costing Process: Recording
Direct Material
Account Name Dr Cr

Raw Materials Inventory K1, 008, 000

Direct Materials Price Variance K14, 000

Account Payable K1, 022, 000

To record the purchase of direct materials

If the actual price had been less than the standard price, Direct Materials
Price Variance would have been credited, rather than debited.
Standard Costing Process: Recording
Direct Material
 When direct materials are transferred to the production floor, Work in Process
Inventory is debited for the standard cost of the materials.
 For production for of 9, 858 batches of yeast, 271, 095 kgs of soda (27.5
standard kg per batch x 9, 858 batches = 271, 095kgs) would be transferred at
a standard cost of K975, 942 (271, 095 kgs x K3.60 standard price per kg)
 The credit to Raw Materials Inventory is recorded using the actual amount of
material transferred at the standard price.
 Since 273, 395 kgs of soda were actually used, the credit to Raw Materials
Inventory is K984, 222 (273, 395 kgs x K3.60 per kg).
 Standard Costing: Recording Work in Process

The direct materials quantity variance is the difference between these two
entries and is calculated using the equation.

Direct Materials quantity variance = SP x (AQ – SQ) = K3.60 x (273, 395 – 271, 095) =
K8, 280 U
Standard Costing: Recording Work in
Process
Journal entry to record Paradise Foods materials quantity
variance at the time soda is used in production.
Account Name Dr Cr
Work in Process Inventory K975, 942
Direct Materials Quantity Variance K8, 280
Raw Material Inventory K984, 222
To record the use of direct materials

If the actual usage had been less than the standard quantity
allowed, Direct Materials Quantity Variances would be have
been credited rather than debited
Standard Costing: Recording Direct
Labor
 As products are being made, Work in Process Inventory is debited for the
standard cost of labor.
 The standard cost of labor consist of two components: standard direct
quantity of direct labor hours allowed for actual production and standard
direct labor rate per hour.
 For Paradise Food, the standard quantity of direct labor allowed is 39, 432
hours ( 9, 858 batches x 4 hours per batch) , and the standard direct labor
rate is K11 per hour.
 Therefore, the amount debited to Work in Process Inventory is K433, 752 ( 39,
432 direct labor hours x K11 per hour).
 The credit to Wages Payable is the actual amount of the payroll, K420, 000
(40, 000 direct labor hours x K10.50 per hour).
Standard Costing: Recording Direct
Labor
 The direct labor rate and efficiency variances are recorded at the same time
as the payroll.
 The direct labor variance is calculated using the equation;
Direct labor rate variance = AQ x (AP – SP) = 40, 000 x (K10.50 – K11)
= K20, 000 F
 The direct labor efficiency variance can be also be calculated using the
equation

Direct labor efficiency variance = SP x (AQ – SQ) = K11 x (40, 000 – 39, 432) =
K6, 248 U
Standard Costing: Recording Direct
Labor
Journal entries that Paradise Food made each pay period.

Account Name Dr Cr
Work in Process Inventory K433, 752
Direct Labor Efficiency Variance K8, 280
Direct labor Rate Variance K20, 000
Wages Payable K420, 000
To record direct labor costs incurred
Standard Costing: Recording Variable
Overhead
To record events related to variable overhead requires three separate journal
entries.
First, as products are made during the period, variable overhead is applied to
Work in Process Inventory using predetermined variable overhead rate and
standard quantity of the application based allowed.
Paradise Food’s applied variable overhead for the period is K266, 166 (9, 858
batches x 1 machine hour per batch x K27 per machine hour), recorded .
Standard Costing: Recording Variable
Overhead
Journal Entry

Account Name Dr Cr
Work in Process Inventory K266, 166
Manufacturing Overhead K266, 166
To apply variable overhead costs to production
Standard Costing: Recording Variable
Overhead
 The second journal entry to record variable overhead in a standard costing
system is for the actual overhead incurred.
 When invoices are received for the variable overhead components.

Account Name Dr Cr
Manufacturing Overhead K263, 000
Accounts Payable or Cash K263, 000
To record actual variable overhead costs incurred
Standard Costing: Recording Variable
Overhead
 The final entry is made at the end of the period, to record the variable
overhead spending and efficiency variances and close over or underapplied
overhead.
 After recording the two previous journal entries, Manufacturing Overhead has
a credit balance of K3, 166 (K263, 000 actual – 266, 166 applied).
 A credit balance means that overhead was overapplied, so the account is
closed by debiting Manufacturing overhead for the K3, 166 difference.
 If Manufacturing Overhead is underapplied, this entry will be a credit.
Standard Costing: Recording Variable
Overhead
▪ The overapplied balance can be separated into the variable overhead
spending and variable overhead efficiency variances.
▪ The variable overhead spending variance is calculated using the equation.

Variable overhead spending variance = Actual cost – (AQ x SP) = K263, 000 - (9, 990
machine hours x K27) = K6, 730 F
▪ The variable overhead efficiency variance is calculated using the equation
Standard Costing: Recording Variable
Overhead

Variable overhead efficiency variance = SP x (AQ – SQ) = K27 x (9, 990 machine hours
– 9, 858 machine hours) = K3, 564 U
Unfavorable variances require a debit entry; favorable variances, a credit entry.
Standard Costing: Recording Variable
Overhead

Account Name Dr Cr
Manufacturing Overhead K3, 166
Variable overhead Efficiency Variance K3, 564
Variable Overhead Spending Variance K6, 730
To record the variable overhead efficiency and spending variance
Standard Costing: Recording Fixed Overhead
 As with variable overhead, three separate journal entries are required to record fixed overhead
in a standard costing system.
 As products are made, fixed overhead cost is applied to Work in Process Inventory using
predetermined fixed overhead rate and the standard quantity of the application base allowed.
 For Paradise Food’s applied fixed overhead for the period is K492, 900 (9, 858 batches x 1
machine hour per batch x K50 per machine hour), record the journal entry.

Account Name Dr Cr
Work in Process Inventory K492, 900
Manufacturing Overhead K492, 900
To apply fixed overhead costs to production
Standard Costing: Recording Fixed
Overhead
 The second journal entry to record fixed overhead in a standard costing
system is for the actual overhead incurred.
 When invoices are received for the various fixed overhead costs, the following
journal entry is made.

Account Name Dr Cr
Manufacturing Overhead K510, 000
Accounts Payable or Cash K510, 000
To record actual fixed overhead costs incurred
Standard Costing: Recording Fixed
Overhead
 After recording the previous two journal entries, manufacturing Overhead has a
debit balance of K17, 100 ( K510, 000 actual – K492, 900 applied).
 A debit balance means that overhead was underapplied, so the account is closed
by crediting Manufacturing Overhead for K17, 100 difference. (if Manufacturing
Overhead is overapplied, this entry will be a debit).
 The underapplied balance can be separate into fixed overhead spending and fixed
overhead volume variances.
 Fixed overhead spending variances is quite easy to calculate, it is simply the
difference between budgeted and actual fixed overhead: K510, 000 actual fixed
overhead costs – K500, 000 budgeted fixed overhead = K10, 000 U.
 The fixed overhead volume variance is the difference between the budgeted fixed
overhead and applied fixed overhead: K500, 000 budgeted fixed overhead – K492,
900 applied fixed overhead = K7, 100 U.
Standard Costing: Recording Fixed Overhead

 When actual activity differs from the expected level of activity, a fixed
overhead volume variance occurs.
 If production is greater than expected, the volume variance is favorable,
because the fixed overhead is spread over more units than expected,
reducing the per unit cost.
 If production is less than expected, the volume variance is unfavorable
because fixed overhead must be spread over fewer units than expected,
raising the per unit cost.
 If Paradise Food’s managers had known that only 9, 858 batches would be
made to requiring a standard of 9, 858 machines hours, they would have set
the predetermined fixed overhead rate at K0.72 per machine hour, or (K500,
000 / 9, 858 machine hours), instead of K50, and there would have been no
volume variance.
Standard Costing: Recording Fixed Overhead

 Journal entries records Paradise Food’s fixed overhead variances and disposes
underapplied fixed overhead for the period.

Account Name Dr Cr
Fixed Overhead Spending Variance K10, 000
Fixed Overhead Volume Variance K7, 100
Manufacturing Overhead K17, 000
To record the fixed overhead spending and volume variances

 The K17, 100 adjustment to Manufacturing Overhead closes out the fixed
overhead from this account.
Standard Costing: Recording Fixed Overhead

 Think about it!

The fixed overhead volume variance can easily be explained as being caused by
the production volume level – that is, by making more or fewer units than
budgeted.
Why is the same not true of the direct materials quantity variance, the direct
labor efficiency variance, and the variable overhead efficiency variance?
Transferring Completed Units to Finished
Goods Inventory

 Once units are complete, their cost must be transferred from Work in Process
Inventory to Finished Goods Inventory.
 Since all inventory accounts in a standard costing system are recorded at the
standard cost, this transfer is recorded at standard cost of the completed
units.
 Paradise Food Ltd completed 9, 858 batches of yeasts that must be
transferred from Work in Process Inventory to Finished Goods Inventory.
 The standard cost for one batch of yeast is K220, so K2, 168, 760 (9, 858
batches x K220 standard cost per batch) must be transferred to Finished
Goods Inventory through the journal entry.
Transferring Completed Units to
Finished Goods Inventory
Journal entries that Paradise Food made for the transfer

Account Name Dr Cr
Finished Goods Inventory K2, 168 760
Work in Process Inventory K2, 168, 760
To transfer completed units to finished goods inventory
Recording of Cost of Goods Sold

 When units are sold, their cost must be transferred from Finished Goods
Inventory to Cost of Goods Sold.
 Since all inventory in a standard costing system are recorded at the standard
cost, this transfer is recorded at standard cost of the units sold.
 Paradise sold 9, 858 batches of yeast that must be transferred from finished
goods to cost of goods sold.
 The standard cost for one batch of yeast is K22o, so K2, 168, 760 (9, 858
batches x K220 standard cost per batch) must be transferred to Cost of Goods
Sold through the following journal entry.
Recording of Cost of Goods Sold

Journal entries that Paradise Food made for the transfer

Account Name Dr Cr
Cost of Goods Sold K2, 168 760
Finished Goods Inventory K2, 168, 760
To transfer completed units to finished goods inventory
Standard Costing: Disposing of Variance

 The variances are recorded in actual general ledger accounts, though the
accounts are temporary ones.
 This means they need to be closed to a permanent general ledger account at
the end of the accounting period.
 The easiest approach is to close the variance accounts to the Cost of Goods
Sold account.
 However, if the variances are considered material (significant in dollar
amount), they should be closed to the appropriate inventory accounts.
 This final adjustments brings the inventory and Cost of Goods Sold accounts
back to actual cost.
Standard Costing: Disposing of
Variance
Lets look at one variance as an example.
▪ The Direct Labor Rate Variance account has a K20, 000 credit balance from
the journal entry that recorded the variance.
▪ This process is followed for each of the variances, and the amount needed to
balance the debits and credits is made to Cost of Goods Sold.
Standard Costing: Disposing of Variance

Paradise Food’s variances would be closed to the cost of goods sold account:

Cost of goods sold K22, 462

Direct Labor Rate Variance K20, 000
Variable Overhead Spending Variance K6, 730
Direct Material Price Variance 14, 000
Direct Material Quantity Variance 8, 280
Direct labor Efficiency Variance 6, 248
Variable overhead efficiency Variance 3, 564
Fixed Overhead Spending Variance 10, 000
Fixed Overhead Volume Variance 7, 100
To close variances to Cost of goods sold
Advantages of Standard Costing

 All these journal entries, you might wonder why a company would want to
implement a standard costing system.
 A standard costing system gives visibility to the variances that arise in the
production process.
 Because the variances must be recorded and closed to Cost of Goods Sold, the
impact of missing standards becomes unavoidably clear to managers.
 Alternatively if the variances are small, then managers don’t need to spend
their time evaluating processes that are in control.
 Essentially, a standard costing systems provides managers with information to
keep production processes operating as planned.