Analysis and Interpretation of Financial Statements · Analyze the variances and ascertaining the causes of variance . ... Material Price Variance . The material price variance is

Standard Costing

CA Final Course Paper 5 Advanced Management Accounting Chapter 5 Part 1

Arijit Chakraborty, FCA

Learning Objectives

1. Understand the concept and purpose of Standard Costing & Variance analysis

2. Learn the classification of standard costing techniques

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Sections of our discussion

Standard costing & variance – Overview, assumptions, objectives

Calculation of cost variances – material labour, overheads with illustrations

Sales variances and profit reconciliation statements under marginal and absorption costing

MBE, Responsibility accounting, reasons for variance, interpretation of variances, case study on enterprise performance management using variance

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Standard Costing

OBJECTIVE 1:

Define standard costs,

explain how standard costs are developed, and

compute a standard unit cost.

Standard Costing

Standard costs: realistic estimates of cost based on analyses of both past and projected operating costs and conditions.

The three components of standard costing:

• Standard costs, which provide a standard, or predetermined, performance level

• A measure of actual performance • A measure of the variance between standard and actual

performance

Standard Costing

How standard costing differs from actual costing and normal costing. • Standard costing uses estimated costs exclusively to

compute all three elements of product costs: direct materials, direct labor, and overhead.

How managers use standard costs for planning and control in the management process: • Planning—For budget development; product costing, pricing,

and distribution • Performing—For measurement of expenditures and control

of costs as they occur

Standard Costing

How managers use standard costs for planning and control in the management process: (cont.) • Evaluating—For variance analysis • Communicating—For variance reports • The primary difference between standard

costing in a service organization and standard costing in a manufacturing organization is that a service organization has no direct materials costs.

Standard Costing

In a standard costing system, costs are entered into the Materials, Work in Process, and Finished Goods Inventory accounts and the Cost of Goods Sold account at standard cost; actual costs are recorded separately.

Standard Costing

The following elements are used in determining a standard cost per unit:

Direct materials price standard

Direct materials quantity standard

Direct labor rate standard

Direct labor time standard

Standard variable overhead rate

Standard fixed overhead rate

Standard Costing

How standards are developed: The direct materials price standard is based on a careful estimate of all

possible price increases, changes in available quantities, and new sources of supply in the next accounting period.

The direct materials quantity standard is based on product engineering specifications, the quality of direct materials, the age and productivity of

machines, and the quality and experience of the work force.

The direct labor rate standard is defined by labor union contracts and company personnel policies.

Standard Costing

How standards are developed: (cont.)

The direct labor time standard is based on current time and motion studies of workers and machines

and records of their past performance.

The standard variable overhead rate and standard fixed overhead rate are found by dividing total

budgeted variable and fixed overhead costs by an appropriate application base.

Standard Costing

Standard direct materials cost is the product of the direct materials price standard and the direct materials quantity standard.

Standard direct labor cost is the product of the direct labor rate standard and the direct labor time standard.

Standard overhead cost is the sum of the standard variable overhead rate and standard fixed overhead rate.

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Standard costing system

The management evaluates the performance of a company by comparing it with some predetermined measures

Therefore, it can be used as a process of measuring and correcting actual performance to ensure that the plans are properly set and implemented

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Procedures of standard costing system

Set the predetermined standards for sales margin and production costs

Collect the information about the actual performance

Compare the actual performance with the standards to arrive at the variance

Analyze the variances and ascertaining the causes of variance

Take corrective action to avoid adverse variance

Adjust the budget in order to make the standards more realistic

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Functions of standard costing system

• Valuation • Assigning the standard cost to the actual output

• Planning • Use the current standards to estimate future sales volume and

future costs • Controlling

• Evaluating performance by determining how efficiently the current operations are being carried out

• Motivation • Notify the staff of the management’s expectations

• Setting of selling price

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Variance Analysis, computation and implication

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Variance analysis - overview

A variance is the difference between the standards and the actual performance

When the actual results are better than the expected results, there will be a favourable variance (F)

If the actual results are worse than the expected results, there will be an adverse variance (A)

Material cost variance

Labour cost variance

Variable overheads variance

Cost variance

• Cost variance = Price variance + Quantity variance

• Cost variance is the difference between the standard cost and the Actual cost

• Price variance = (standard price – actual price)*Actual quantity • A price variance reflects the extent of the profit change resulting

from the change in activity level

• Quantity variance = (standard quantity – actual quantity)* standard cost

• A quantity variance reflects the extent of the profit change resulting from the change in activity level

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A General Approach to Variance Analysis An analysis of the difference between a standard cost and actual cost is called variance analysis. The process decomposes the difference in two components. For direct material: materials price and materials quantity variance. For direct labor: labor rate (price) and labor efficiency (quantity) variance. For overhead: overhead volume variance and controllable overhead variance.

Related Learning Objectives: 1. Explain how standard costs are

developed. 2. Calculate and interpret variances

for direct material. 3. Calculate and interpret variances

for direct labour. 4. Calculate and interpret variances

for manufacturing overhead. 5. Discuss how the management by

exception approach is applied to investigation of standard cost variances.

Material Price Variance The material price variance is expressed as (AP – SP)AQp where: (AP) = actual price per unit of material. (SP) = standard price per unit of direct material. (AQp) = actual quantity of material purchased. If actual price > standard price, then the variance is unfavorable. If actual price < standard price, then the variance is favorable.



for direct material. 3. Calculate and interpret variances for

direct labor. 4. Calculate and interpret variances for

manufacturing overhead. 5. Discuss how the management by


Material Quantity Variance The material quantity variance is expressed as (AQu – SQ)SP where: (AQu) = actual quantity of material used. (SQ) = standard quantity of material allowed. (SP) = standard price of material. If actual quantity > standard quantity, then the variance is unfavorable. If actual quantity < standard quantity, then the variance is favorable.



for direct material. 3. Calculate and interpret variances for

direct labor. 4. Calculate and interpret variances for



Labor Rate Variance The labor rate (price) variance is expressed as (AR – SR)AH where: (AR) = actual wage rate (price). (SR) = standard wage rate (price). (AH) = actual number(quantity) of labor hours. If actual rate > standard rate, then the variance is unfavorable. If actual rate < standard rate, then the variance is favorable.


developed. 2. Calculate and interpret variances for

direct material. 3. Calculate and interpret variances

for direct labor. 4. Calculate and interpret variances for



Labor Efficiency Variance The labor efficiency (quantity) variance is expressed as (AH – SH)SR where: (AH) = actual number of hours worked. (SH) = standard number of hours worked. (SR) = standard labor wage rate. If actual hours > standard hours, then the variance is unfavorable. If actual hours < standard hours, then the variance is favorable.



direct material. 3. Calculate and interpret variances

for direct labor. 4. Calculate and interpret variances for



Controllable Overhead Variance The controllable overhead variance is expressed as (actual overhead - flexible budget level of overhead) for actual level of production. It is referred to as controllable because managers are expected to control costs so they are not substantially different from budget. If actual > budget, then the variance is unfavorable. If actual < budget, then the variance is favorable.



direct material. 3. Calculate and interpret variances for

direct labor. 4. Calculate and interpret variances



Overhead Volume Variance The overhead volume variance is expressed as (flexible budget level of overhead for actual level of production - overhead applied to production using standard overhead rate). This variance is solely the product of more or less units being produced than planned in the static budget. Its usefulness is limited.



direct material. 3. Calculate and interpret variances for

direct labor. 4. Calculate and interpret variances



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Profit variance

Selling and administrative Cost variance

Total production Cost variance

Total sales margin variance

Sales margin Price variance

Sales margin volume variance

Materials cost

variance

Labour Cost

variance

Variable Overhead variance

Fixed Overhead variance

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Materials cost variance

Material Price variance Material Usage variance


Labour rate variance Labour Efficiency variance

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Variable Overhead variance

VO Expenditure variance

VO Efficiency variance

Fixed Overhead variance

Fixed Expenditure variance

Fixed Volume variance

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Material and labour variance

Recap of key formulae for variance computation

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Material price variance

• = (standard price – actual price)*actual quantity

Material usage variance

• = (Standard quantity – actual quantity)* standard price • = (Standard quantity for actual production – actual

quantity production) * standard price

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Labour rate variance

• = (standard price – actual price)*actual quantity

Labour efficiency variance

• = (standard quantity – actual quantity)*standard price • = Standard quantity for actual production – actual

quantity used) * standard price

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Example Numerical illustration of variance calculation

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ABC Ltd. makes and sells a single product. The company uses a Standard marginal costing system. It plans to produce and sell 1000 units in May 2013. A budget statement is produced as follow: Budgeted income statement for the month ended 31 May 2013 $ $ Sales ($50*1000) 50000 Less: Variable cost of goods sold Direct materials ($3*4000) 12000 Direct labour ($5*3000) 15000 Variable overheads ($2*3000) 6000 33000 Budget contribution 17000 Fixed overhead 3000 Budget profit 14000

Example

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The actual sales and production is 800 units. The actual income statement is shown as follows: Income statement for the month ended 31 May 2013 $ $ Sales ($60*800) 48000 Less: Variable cost of goods sold Direct materials ($3.2*2400) 7680 Direct labour ($6*3200) 19200 Actual Variable overheads 5500 32380 Contribution 15620 Fixed overhead 2600 Net profit 13020

Example Cont…


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Material price variance = (standard price – actual price)*actual quantity = ($3 - $3.2)*2400 = $480 (A) Material usage variance = (Standard quantity – actual quantity)* standard price = (Standard quantity for actual production – actual quantity

production) * standard price = (4*800 – 2400)*$3 = $2400 (F)

4000 units

1000 units

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• Material price variance $480 (A)

• Material usage variance $2400 (F)

• Total Material cost variance $1920 (F)


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Labour rate variance = (standard price – actual price)*actual quantity = ($5 - $6)*3200 = $3200 (A)

Labour efficiency variance = (standard quantity – actual quantity)*standard price = Standard quantity for actual production – actual quantity used) *

standard price = (3* 800 – 3200)*$5 = $4000 (A)

3000 units

1000 units

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• Labour rate variance $3200 (A)

• Labour efficiency variance $4000 (A)

• Total labour cost variance $7200 (A)

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Overheads variance Concepts, computation and illustration

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Overheads variance


Fixed overheads variance

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Variable overheads variance is the difference between the standard variable

overheads absorbed into the actual output and the actual overheads incurred

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Actual VO

Budgeted VO (SP * Actual

hours worked)

Absorbed VO (SP* standard

hours for actual Output)

VO expenditure variance/ VO spending variance

VO efficiency variance

Total VO variance (under-/over- absorbed)

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Variable overheads variance • = variable overheads absorbed – actual variable overheads

incurred

Variable overheads expenditure variance • = standard variable overheads for actual hours worked –

Actual variable overheads incurred

Variable overheads efficiency variance • = Standard variable overheads for standard hours of output –

Actual variable overhead absorbed • = (standard hours for actual output – Actual hours worked)*

standard price

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Example OH Variance calculation

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Example

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Example Cont…

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POAR = Budgeted overheads

Budgeted activity level in standard hours

Overhead absorbed = POAR * Standard hours for actual number of units produced

= $2 *3 hr per unit * 800 units

= $6000 / 3000

= $2

Standard hr per unit = 3000 hr /1000 units


Variable overheads variance • = variable overheads absorbed – actual variable

overheads incurred • = $4800 - $5500 • = $700 (A)

Variable overheads expenditure variance • = standard variable overheads for actual hours worked –

Actual variable overheads incurred

= ($2* 3200 hr) - $5500 • = $900 (F)

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• Variable overheads efficiency variance

= Standard variable overheads for standard hours of

output – Actual variable overhead absorbed

= (standard hours for actual output – Actual hours worked)*

standard price

= (3 hr *800 units – 4 hr *800 units)*$2

= $1600 (A)

Actual hour per unit = 3200 hr/800 units

Variable overheads variance Cont…

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Variable overheads variance • Variable overheads expenditure variance $900 F • Variable overheads efficiency variance $1600 A • Total Variable overhead variance $700 A

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Fixed overhead variance Concepts, computation and illustration

Recap of key points covered so far

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Actual FO Budgeted FO

Absorbed FO (SP* standard

hours for actual output

FO expenditure variance/ FO spending variance FO volume variance

Total FO variance (under-/over- absorbed)

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Fixed overhead variance

Fixed overheads variance • = Fixed overheads absorbed – Actual fixed

overheads incurred

Fixed overheads expenditure variance • Budgeted fixed overheads – Budgeted

overheads absorbed

Fixed overheads volume variance • = Absorbed fixed overheads – Budgeted

overheads absorbed

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Example Variance calculation

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Example

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Example Cont…

Fixed overhead variance

Fixed overheads variance • = Fixed overheads absorbed – Actual fixed overheads incurred • = ($1*3*800) - $2600 • = $200 A

Fixed overheads expenditure variance • = Budgeted fixed overheads – Budgeted overheads absorbed • = $3000 - $2600 • = $400 F

Fixed overheads volume variance • = Absorbed fixed overheads – Budgeted overheads absorbed • = ($1*3*800) - $3000 • = $600 A

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FO Variance in marginal and absorption costing

In marginal costing: • Fixed overheads are charged as period costs instead of

charging to product in marginal costing. • It is assumed that the fixed overheads remain unchanged

with the change in the level of activity. Single fixed overhead expenditure variance will be used

In absorption costing • Fixed overheads are charged to the products and included in

the valuation of closing stock. • Total fixed overheads variance is divided into fixed

overheads price variance and fixed overheads volume variance

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Sales variance Concepts, computation and illustration

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Actual contribution

Budgeted contribution (Standard margin * Actual

Volume)

Budgeted contribution

(Standard margin* Standard volume)

Sales margin price variance Sales margin volume variance

Total sales margin variance

Sales variance (Marginal costing)

• Total sales margin variance = actual contribution – budgeted contribution

= [(Actual selling price – Standard cost of sales )*Actual sales volume] – Budgeted contribution

• Sales margin price variance

= (Actual contribution per unit – Standard contribution per unit) * Actual sales volume

• Sales margin volume variance = (Actual volume – Budget volume)* Standard contribution per unit

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Sales variance (Absorption costing)

• Sales margin price variance

= (Actual profit margin per unit – Standard profit margin

per unit) * Actual sales volume

• Sales margin volume variance = (Actual volume – Budget volume)* Standard profit margin per unit

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Example Sales variance calculation

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Example

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Example Cont…

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Sales variance (Marginal costing) • Total sales margin variance

= actual contribution – budgeted contribution = [(Actual selling price – Standard cost of sales )*Actual sales

volume] – Budgeted contribution = [($60 - $33)*800] - $17000 = $21600 - $17000 = $4600 (F) $33000/1000 units

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Sales variance

• Sales margin price variance = (Actual contribution per unit – Standard contribution

per unit) * Actual sales volume = [($60 - $33) – ($50 - $33)]*800 = $8000 F • Sales margin volume variance

= (Actual volume – Budget volume)* Standard contribution per unit = (800 -1000)*$17 = $2800 (A)

$33000/1000 units

$17000/1000 units

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Sales variance (Marginal costing)

• Sales margin price variance $8000 F

• Sales margin volume variance $3400 A

• Total sales variance $4600 F

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• Sales margin price variance = (Actual profit margin per unit – Standard profit margin per unit) *

Actual sales volume = [($60-$36) – ($50-$36)]*800 = $8000 F • Sales margin volume variance

= (Actual volume – Budget volume)* Standard profit margin per unit = (800-1000)*$14 = $2800 A

(33000+3000)/1000 units

$14000/1000 units

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• Sales margin price variance $8000 F

• Sales margin volume variance $2800 A

• Total sales variance $5200 F

Thank You

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Documents

Analysis and Interpretation of Financial Statements · Analyze the variances and ascertaining the causes of variance . ... Material Price Variance . The material price variance is