Standard Cost Systems
A D V E R T I S E M E N T
A common scenario
Mike manages a production facility for Amalgamated Widgets, Inc.
Under him are the following departments: purchasing, production, warehousing and
shipping, maintenance and security. Mike gets a bonus each year, depending on
how well he manages the production facility. He also has the authority to give
bonuses to employees working under him when they meet or exceed performance
Mike, and his management team, use a standard cost system.
They have determined the quantities possible, and the cost components of their
products, under normal conditions. Costs are divided into the following
categories: Direct Materials, Direct Labor and Factory Overhead. The factory
incurs no Selling or G&A (General and Administrative) expenses. All their costs
relate to producing products.
A product's standard cost, is what it should cost to
make the product. At the start of each month a production budget is
prepared, using standard costs and estimated production quantities. At the end
of each month a variance report is prepared to compare the production
budget with the actual quantities and costs of production.
The variance report tells Mike and his managers how well they
did at achieving their budget goals. A favorable variance shows that
actual costs are less than budgeted (standard) costs. An unfavorable variance
is just the opposite - actual costs are greater than budgeted costs.
By using a budget the management team can estimate their
future costs and cash needs, plan production, schedule employees, coordinate
materials purchases, reduce waste, increase production efficiency and meet
shipping deadlines. Variances help the managers identify specific areas where
they came in either over or under budget. They will try to repeat their
successes and eliminate their failures. Each month they hope to become a little
The budgets will be used to evaluate Mike and his managers.
Their annual bonuses will depend on how well they meet their budget goals.
Managers who consistently produce unfavorable variances will probably be
replaced. We ask a few questions and answer them by using relevant variances.
How well did management (managers) do:
- buying and using materials to make products?
- scheduling employee time and motivating employees to be
- controlling factory overhead costs?
- Total Materials Variance
- Materials Price Variance
- Materials Quantity Variance
- Total Labor Variance
- Labor Rate Variance
- Labor Efficiency Variance
- Variable Overhead Variance
- Fixed Overhead Variance
Variances and Standard Costs are entered into the accounting
records using journal entries. The use of standard costing systems greatly
simplifies some accounting procedures. Standard costs are entered weekly or
monthly. Variances are calculated and entered. Monthly production and income
reports are prepared. Managers use current information to prepare budgets for
the coming months.
|^--------- difference = variance ---------^
|^------- $50 favorable variance -------^
actual costs are less than standard = favorable variance
By breaking the total variance down into its component parts
managers can pinpoint the cause of the variance. Sometimes a favorable variance
in one area causes an unfavorable variance in another area. Managers should be
alert to these possibilities.
For instance, there might be a favorable materials price
variance, because lower cost materials were purchased. If the materials were of
an inferior grade, there could be an increase in waste, giving rise to an
unfavorable materials quantity variance. Additionally, more labor could be
required to handle and deal with the inferior materials, giving rise to an
unfavorable labor efficiency variance.
Don't be mislead by a small total variance. This example
shows large favorable and unfavorable variances offsetting each other. This is
not a sign of efficient or effective management.
Changes in Costs
Variances can arise for a large number of reasons:
Budgeting and Variance accounting presume that managers should
fix problems, not bury or hide them. It also presumes that these problems are
short term problems, and can be effectively controlled in the future.
- errors in estimating
- mis-management of resources
- unforeseen price changes
- equipment breakdown
- labor problems
- poor planning
- shortage of raw materials
Sometimes there is a change in actual costs that necessitates
a change in standard costs. For instance, a new labor contract could increase
total labor costs by a predictable amount. Standard labor costs should be
re-calculated to reflect the new actual labor costs. Once a new standard cost is
calculated, future variances will be correctly reflected in the monthly variance
report. If standard costs are not updated periodically, the monthly reports can
show unrealistic favorable or unfavorable variances.
The purpose of variances and budgeting is to give management
an effective tool for controlling costs. But the system must be continually
reviewed and kept up to date. This is also important, because standard costs and
variances are entered into the books as journal entries, so they must be based
on reliable underlying assumptions. These assumptions must pass the critical eye
of the company's certified auditors, so they must be current and accurate.