Cambridge AS & A Level9706

Standard costing (A Level)

Accounting 9706 Chapter Notes

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Standard costing (A Level)
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In this chapter

  1. 1Introduction to Standard Costing
  2. 2Material and Labour Variances
  3. 3Sales and Fixed Overhead Variances
  4. 4Flexible Budgeting for Control
  5. 5Reconciling Budgeted and Actual Profit
  6. 6Evaluating Standard Costing

1. Introduction to Standard Costing

Standard costing is a management accounting technique used to control costs and measure performance. It involves setting predetermined, 'standard' costs for each element of production (materials, labour, overheads). These standards act as a benchmark. After a period, actual results are compared to these standards, and any differences, known as 'variances', are calculated and investigated. The goal is not just to find differences, but to understand why they occurred and take corrective action.

Key term

Standard Cost: A predetermined or budgeted cost of a single unit of output, used as a benchmark for measuring performance.

Examiner insight

Examiners expect you to understand that standard costing is a tool for control, not just a calculation exercise. Emphasise its role in highlighting areas for management attention.

Fun fact

Standard costing principles are used outside of manufacturing. For example, hospitals use standard costs to manage the expense of surgical procedures, and fast-food chains use them to control the cost of a burger.

Worked example 13 marks

Creative Crates Ltd has the following standard cost card for one wooden crate: Direct Materials: 2 metres of wood at $5 per metre Direct Labour: 0.5 hours at $16 per hour Fixed Overheads are absorbed at $4 per unit. Calculate the total standard cost of one crate.

  1. 1

    Step 1: Calculate the standard material cost per unit.

  2. 2

    2 metres × $5/metre = $10

  3. 3

    Step 2: Calculate the standard labour cost per unit.

  4. 4

    0.5 hours × $16/hour = $8

  5. 5

    Step 3: Identify the standard fixed overhead cost per unit.

  6. 6

    Fixed Overhead = $4

  7. 7

    Step 4: Sum the costs to find the total standard cost.

  8. 8

    Total Standard Cost = $10 (Materials) + $8 (Labour) + $4 (Overheads) = $22

Recap

  • Standard costing sets expected costs for production.
  • It provides a benchmark to compare actual performance against.
  • A 'variance' is the difference between a standard cost and an actual cost.
  • The primary purpose is cost control and performance evaluation.
  • Standards are set for price and quantity of materials, labour, and overheads.

Quick check

  1. What is the main purpose of comparing actual costs with standard costs?1 mark
  2. List the three main cost elements for which standards are typically set.3 marks

2. Material and Labour Variances

Variances pinpoint where actual costs have deviated from the standard. For materials and labour, we split the total variance into two parts: a 'price' or 'rate' variance (paying more or less than expected) and a 'usage' or 'efficiency' variance (using more or less than expected). A variance is 'Favourable' (F) if it increases profit (e.g., paying less for materials) and 'Adverse' (A) if it decreases profit (e.g., workers taking longer than standard).

Material Price Variance = (Standard Price - Actual Price) × Actual Quantity Purchased

Material Usage Variance = (Standard Quantity for Actual Production - Actual Quantity Used) × Standard Price

Labour Rate Variance = (Standard Rate - Actual Rate) × Actual Hours Worked

Labour Efficiency Variance = (Standard Hours for Actual Production - Actual Hours Worked) × Standard Rate

Key term

Variance: The difference between a standard (budgeted) amount and the actual amount incurred or achieved.

Examiner insight

Always state whether a variance is Favourable (F) or Adverse (A). A number without this label will not earn full marks. Show your workings clearly, especially the formulas you are using.

Fun fact

A favourable price variance might cause an adverse usage variance. For example, buying cheaper, lower-quality material (favourable price) could lead to more waste during production (adverse usage).

Worked example 18 marks

Using the standard cost for one crate from Creative Crates Ltd (2m wood @ $5/m; 0.5 hrs labour @ $16/hr), consider the following actual results for the production of 1,000 crates: Materials: Purchased and used 2,100 metres of wood for $10,080. Labour: Workers were paid $8,580 for 520 hours. Calculate all material and labour variances.

  1. 1

    Step 1: Calculate Material Price Variance.

  2. 2

    Standard Price = $5/m. Actual Price = $10,080 / 2,100m = $4.80/m.

  3. 3

    Variance = ($5.00 - $4.80) × 2,100m = $420 Favourable (F)

  4. 4

    Step 2: Calculate Material Usage Variance.

  5. 5

    Standard Quantity for 1,000 crates = 1,000 × 2m = 2,000m. Actual Quantity Used = 2,100m.

  6. 6

    Variance = (2,000m - 2,100m) × $5 (Std Price) = -$500, which is $500 Adverse (A)

  7. 7

    Step 3: Calculate Labour Rate Variance.

  8. 8

    Standard Rate = $16/hr. Actual Rate = $8,580 / 520 hrs = $16.50/hr.

  9. 9

    Variance = ($16.00 - $16.50) × 520 hrs = -$260, which is $260 Adverse (A)

  10. 10

    Step 4: Calculate Labour Efficiency Variance.

  11. 11

    Standard Hours for 1,000 crates = 1,000 × 0.5 hrs = 500 hrs. Actual Hours = 520 hrs.

  12. 12

    Variance = (500 hrs - 520 hrs) × $16 (Std Rate) = -$320, which is $320 Adverse (A)

Recap

  • Material variances are split into price and usage.
  • Labour variances are split into rate and efficiency.
  • Price/Rate variances compare standard and actual prices for the actual quantity purchased/worked.
  • Usage/Efficiency variances compare standard and actual quantities for the actual output, valued at the standard price/rate.
  • A positive result is Favourable (F); a negative result is Adverse (A).

Quick check

  1. If you pay less for materials than the standard price, is the material price variance favourable or adverse?1 mark
  2. Which price/rate do you use to calculate a usage/efficiency variance?1 mark

3. Sales and Fixed Overhead Variances

Variances aren't just for costs; they apply to revenue as well. Sales variances measure how actual sales revenue differs from the budget. The Sales Price variance shows the effect of selling at a different price than planned. The Sales Volume variance shows the effect on profit of selling more or fewer units than planned. Fixed overhead variances measure differences in budgeted and actual fixed costs. The Expenditure variance is simply the difference between budgeted and actual spend. The Volume variance arises if you produce more or less than budgeted, causing a difference in the amount of overhead absorbed.

Sales Price Variance = (Actual Price - Standard Price) × Actual Volume

Sales Volume Profit Variance = (Actual Volume - Budgeted Volume) × Standard Profit per unit

Fixed Overhead Expenditure Variance = Budgeted Fixed Overheads - Actual Fixed Overheads

Fixed Overhead Volume Variance = (Actual Production Units - Budgeted Production Units) × Standard Fixed Overhead Absorption Rate per unit

Key term

Flexible Budget: A budget adjusted to the actual level of activity, allowing for a more meaningful comparison between budgeted and actual results.

Examiner insight

Examiners reward students who can explain the interrelationship between variances. For instance, a favourable fixed overhead volume variance (due to high production) might be linked to an adverse labour efficiency variance if workers rushed.

Common pitfall

A common mistake with the sales volume variance is to use the standard selling price instead of the standard profit per unit. The variance measures the impact on profit, not just revenue.

Worked example 16 marks

Creative Crates Ltd budgeted to sell 900 crates. The standard selling price is $30 per crate and the standard cost is $22, giving a standard profit of $8 per unit. Budgeted fixed overheads were $3,600 (900 units x $4/unit). Actual results: 1,000 crates were sold for $30,500. Actual fixed overheads were $4,100. Calculate the sales and fixed overhead variances.

  1. 1

    Step 1: Calculate Sales Price Variance.

  2. 2

    Standard Price = $30. Actual Price = $30,500 / 1,000 = $30.50.

  3. 3

    Variance = ($30.50 - $30.00) × 1,000 units = $500 Favourable (F)

  4. 4

    Step 2: Calculate Sales Volume Profit Variance.

  5. 5

    Standard Profit = $8 per unit.

  6. 6

    Variance = (1,000 units - 900 units) × $8 = $800 Favourable (F)

  7. 7

    Step 3: Calculate Fixed Overhead Expenditure Variance.

  8. 8

    Budgeted Fixed Overheads = $3,600. Actual Fixed Overheads = $4,100.

  9. 9

    Variance = $3,600 - $4,100 = -$500, which is $500 Adverse (A)

  10. 10

    Step 4: Calculate Fixed Overhead Volume Variance.

  11. 11

    Standard OH Rate = $4 per unit.

  12. 12

    Variance = (1,000 units produced - 900 units budgeted) × $4 = $400 Favourable (F)

Recap

  • Sales variances are split into price and volume.
  • The sales volume variance is calculated using standard profit per unit, not revenue.
  • Fixed overhead variances are split into expenditure and volume.
  • The expenditure variance is a simple comparison of budgeted vs actual spend.
  • The volume variance reflects the value of over- or under-production compared to the budget.

Quick check

  1. If you sell more units than budgeted, is the sales volume profit variance favourable or adverse?1 mark
  2. What is the difference between the fixed overhead expenditure and volume variances?2 marks

4. Flexible Budgeting for Control

Comparing a 'fixed' budget (based on one planned activity level) with actual results for a different activity level is like comparing apples and oranges. If we planned to make 1,000 units but actually made 1,200, of course our material costs will be higher! A flexible budget solves this. It adjusts the original budget to the actual level of activity. We take our standard costs per unit and multiply them by the actual number of units produced. This creates a new, relevant benchmark that allows for a fair comparison and meaningful variance analysis.

Flexible Budget Cost = Standard Cost per unit × Actual number of units produced

Key term

Management by Exception: A management strategy where supervisors focus their attention on the most significant variances from standard or budget, ignoring areas that are performing as expected.

Examiner insight

Questions on flexible budgeting test your understanding of cost behaviour. Be clear that only variable costs scale with production, while fixed costs are held constant from the original budget.

Worked example 15 marks

A company has a fixed budget based on producing 10,000 units. The standard variable cost is $7 per unit, and budgeted fixed costs are $20,000. In the period, the company actually produced 12,000 units and incurred total costs of $106,000. Prepare a flexible budget for the actual activity level and calculate the total cost variance.

  1. 1

    Step 1: Create the flexible budget for 12,000 units.

  2. 2

    Flexible Budget Variable Costs = 12,000 units × $7/unit = $84,000

  3. 3

    Flexible Budget Fixed Costs = $20,000 (Fixed costs do not change with activity level within the relevant range)

  4. 4

    Total Flexible Budget Cost = $84,000 + $20,000 = $104,000

  5. 5

    Step 2: Compare the flexible budget with actual costs to find the total variance.

  6. 6

    Total Variance = Flexible Budget Cost - Actual Cost

  7. 7

    Total Variance = $104,000 - $106,000 = -$2,000, which is $2,000 Adverse (A)

  8. 8

    Step 3 (Interpretation): The original fixed budget total cost was $70,000 + $20,000 = $90,000. Comparing this to the actual cost of $106,000 gives a misleading adverse variance of $16,000. The flexible budget provides the true variance of $2,000 (A).

Recap

  • A fixed budget is prepared for only one level of activity.
  • A flexible budget adjusts the budget to the actual level of output.
  • Only variable costs are 'flexed'; fixed costs remain the same within the relevant range.
  • Flexible budgets are essential for meaningful variance analysis and performance control.
  • Comparing a fixed budget to actual results at a different activity level is not a valid comparison.

Quick check

  1. Which type of costs change in a flexible budget when the activity level changes?1 mark
  2. Why is it unhelpful to compare a fixed budget for 5,000 units with the actual costs of producing 6,000 units?2 marks

5. Reconciling Budgeted and Actual Profit

The ultimate goal of variance analysis is to explain the difference between the profit you planned to make (budgeted profit) and the profit you actually made. A profit reconciliation statement is a formal report that does exactly this. It starts with the original budgeted profit, and then systematically adds all favourable variances and subtracts all adverse variances. The final figure should exactly equal the actual profit achieved. This statement provides a powerful summary of performance for management.

Actual Profit = Budgeted Profit + All Favourable Variances - All Adverse Variances

Key term

Profit Reconciliation Statement: A statement that starts with budgeted profit and systematically adjusts it by all calculated variances to arrive at the actual profit.

Examiner insight

The reconciliation statement is a summary question that tests your ability to calculate and apply all other variances correctly. Marks are awarded for the correct layout and for correctly adding favourable and subtracting adverse variances.

Worked example 16 marks

A company budgeted to make a profit of $50,000. The following variances were calculated for the period:

  • Material Price: $2,000 (F)
  • Material Usage: $3,000 (A)
  • Labour Rate: $1,000 (A)
  • Labour Efficiency: $1,500 (F)
  • Sales Price: $4,000 (F)
  • Sales Volume Profit: $5,000 (F)
  • Fixed Overhead Expenditure: $500 (A)

Prepare a statement to reconcile budgeted profit to actual profit and calculate the actual profit.

  1. 1

    Step 1: Start with the Budgeted Profit.

  2. 2

    Budgeted Profit: $50,000

  3. 3

    Step 2: List and sum all favourable variances.

  4. 4

    Sales Price Variance: $4,000 F

  5. 5

    Sales Volume Profit Variance: $5,000 F

  6. 6

    Material Price Variance: $2,000 F

  7. 7

    Labour Efficiency Variance: $1,500 F

  8. 8

    Total Favourable Variances: $12,500

  9. 9

    Step 3: List and sum all adverse variances.

  10. 10

    Material Usage Variance: $3,000 A

  11. 11

    Labour Rate Variance: $1,000 A

  12. 12

    Fixed Overhead Expenditure Variance: $500 A

  13. 13

    Total Adverse Variances: $4,500

  14. 14

    Step 4: Prepare the reconciliation statement.

  15. 15

    Budgeted Profit: $50,000

  16. 16

    Add: Favourable Variances: $12,500

  17. 17

    Less: Adverse Variances: ($4,500)

  18. 18

    Actual Profit: $50,000 + $12,500 - $4,500 = $58,000

Recap

  • A profit reconciliation statement explains the difference between budgeted and actual profit.
  • It starts with budgeted profit.
  • Favourable variances are added to budgeted profit.
  • Adverse variances are subtracted from budgeted profit.
  • The end result of the statement is the actual profit for the period.

Quick check

  1. In a profit reconciliation statement, do you add or subtract an adverse variance?1 mark
  2. What is the starting figure in a statement reconciling budgeted and actual profit?1 mark

6. Evaluating Standard Costing

While powerful, standard costing is not a perfect system. It's crucial to understand its strengths and weaknesses to use it effectively. Its main advantages lie in providing targets, simplifying budgeting, enabling control through variance analysis, and highlighting areas needing attention ('management by exception'). However, the disadvantages can be significant. Setting and updating standards is time-consuming. Variances only highlight problems but don't explain their causes. In modern, rapidly changing environments, standards can become outdated quickly, making variances meaningless. A balanced view is that when used properly, the benefits of control and performance improvement outweigh the drawbacks.

Key term

Ideal Standard: A standard set based on perfect operating conditions, with no allowance for wastage, breakdowns, or inefficiencies; often demotivating for staff.

Examiner insight

For evaluation questions, go beyond just listing points. Explain the points with reference to the specific scenario provided and show how different aspects of the business (like purchasing and production) are interlinked.

Fun fact

The rise of modern manufacturing techniques like Total Quality Management (TQM) and Just-In-Time (JIT) has challenged traditional standard costing, as they focus on continuous improvement rather than just meeting a fixed standard.

Worked example 14 marks

A manager of a production department is being criticised for a significant adverse labour efficiency variance. The manager argues that the variance is unfair because the company's purchasing department recently switched to a cheaper, lower-quality raw material to achieve a favourable material price variance. This new material is harder to work with and causes more defects, requiring extra labour time. Evaluate the manager's claim and explain how this illustrates a potential problem with standard costing.

  1. 1

    Step 1: Analyse the situation. The purchasing department achieved a favourable price variance, which looks like good performance.

  2. 2

    Step 2: Analyse the consequence. This action caused the production department to use more labour time, resulting in an adverse efficiency variance, which looks like poor performance.

  3. 3

    Step 3: Evaluate the claim. The manager's claim is likely valid. This shows how variances can be interrelated. The actions of one department can directly impact the performance metrics of another.

  4. 4

    Step 4: Link to problems with standard costing. This illustrates a key weakness: standard costing can encourage dysfunctional behaviour. Departments may focus on improving their own variances (e.g., purchasing getting a low price) at the expense of overall company performance (total cost may increase due to extra labour and waste). It also shows that variances need investigation; they don't tell the whole story on their own.

Recap

  • Advantages include improved cost control, better budgeting, and performance measurement.
  • Standard costing enables management by exception.
  • Disadvantages include the time and cost to set standards and the risk of them becoming outdated.
  • Variances can be misleading and require further investigation to find the root cause.
  • A focus on individual variances can lead to decisions that harm the business overall.

Quick check

  1. State one advantage of using standard costing.1 mark
  2. State one disadvantage of using standard costing.1 mark

End-of-chapter exercise

Test yourself on the whole chapter. Work through these before moving on.

  1. Explain the difference between a fixed budget and a flexible budget, and state why a flexible budget is considered more useful for control purposes.4 marks
  2. A company has a standard material cost of 3kg at $4 per kg for each unit. In May, it produced 2,000 units. It purchased and used 6,500kg of material for $25,350. Calculate the material price and material usage variances.5 marks
  3. Describe two possible causes of an adverse labour efficiency variance and one possible cause of a favourable labour rate variance.6 marks
  4. A business budgeted to sell 10,000 units at $15 each, with a standard profit of $4 per unit. Actual sales were 11,000 units for $159,500. Calculate the sales price and sales volume profit variances.5 marks
  5. Discuss two advantages and two disadvantages of a business implementing a standard costing system.8 marks
  6. The standard labour time for a product is 2 hours at $20 per hour. During March, 500 units were made. The labour cost was $21,450 for 1,100 hours. Calculate the labour rate and labour efficiency variances.5 marks
  7. A company's budgeted fixed overheads were $80,000 based on a production of 16,000 units. Actual production was 17,000 units and actual fixed overheads were $83,000. Calculate the fixed overhead expenditure and fixed overhead volume variances.5 marks
  8. Explain the concept of 'management by exception' and how it relates to standard costing and variance analysis.3 marks
  9. A company's original budget showed a profit of $120,000. After a period of trading, the total of all favourable variances was $22,000 and the total of all adverse variances was $17,500. Prepare a statement reconciling the budgeted profit to the actual profit.4 marks
  10. A manager is rewarded with a bonus for achieving a favourable material price variance. Explain why this policy might lead to 'dysfunctional behaviour' that could harm the company's overall profitability. Use an example in your answer.6 marks

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