Standard costing 1 Standard costing system l l

Standard costing 1

Standard costing system l l 2 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

Procedures of standard costing system l l l 3 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

Functions of standard costing system l Valuation – l Planning – l Use the current standards to estimate future sales volume and future costs Controlling – 4 Assigning the standard cost to the actual output Evaluating performance by determining how efficiently the current operations are being carried out

l Motivation – l 5 Notify the staff of the management’s expectations Setting of selling price

Variance 6

Variance analysis l l l 7 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)

Profit variance Selling and administrative Cost variance Total production Cost variance Total sales margin variance Sales margin Price variance Materials cost variance 8 Labour Cost variance Variable Overhead variance Sales margin volume variance Fixed Overhead variance

Materials cost variance Material Price variance Material Usage variance Labour cost variance Labour rate variance 9 Labour Efficiency variance

Variable Overhead variance VO Expenditure variance VO Efficiency variance Fixed Overhead variance Fixed Expenditure variance 10 Fixed Volume variance

Cost variance 11

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 12 • 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

Three types of cost variance l l l 13 Material cost variance Labour cost variance Variable overheads variance

Material and labour variance 14

Material cost variance l Material price variance = (standard price – actual price)*actual quantity l Material usage variance = (Standard quantity – actual quantity)* standard price = (Standard quantity for actual production – actual quantity production) * standard price 15

Labour cost variance l Labour rate variance = (standard price – actual price)*actual quantity l Labour efficiency variance = (standard quantity – actual quantity)*standard price = Standard quantity for actual production – actual quantity used) * standard price 16

Example 17

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 2005. A budget statement is produced as follow: Budgeted income statement for the month ended 31 May 2005 $ $ 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 18

The actual sales and production is 800 units. The actual income statement is shown as follows: Income statement for the month ended 31 May 2005 $ Sales ($60*800) Less: Variable cost of goods sold Direct materials ($3. 2*2400) Direct labour ($6*3200) Actual Variable overheads Contribution Fixed overhead Net profit 19 $ 48000 12000 15000 5500 32380 15620 2600 13020

Material cost variance Material price variance = (standard price – actual price)*actual quantity = ($3 - $3. 2)*2400 = $480 (A) l Material usage variance = (Standard quantity – actual quantity)* standard price = (Standard quantity for actual production – actual quantity production) * standard price 4000 units = (4*800 – 2400)*$3 1000 units = $2400 (F) 20 l

Material cost variance l l l 21 Material price variance Material usage variance Total Material cost variance $480 (A) $2400 (F) $1920 (F)

Labour cost variance l Labour rate variance = (standard price – actual price)*actual quantity = ($5 - $6)*3200 = $3200 (A) l 3000 units 1000 units 22 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)

Labour cost variance l l l 23 Labour rate variance $3200 (A) Labour efficiency variance $4000 (A) Total labour cost variance $7200 (A)

Overheads variance 24

Overheads variance l l 25 Variable overheads variance Fixed overheads variance

Variable overheads variance l 26 Variable overheads variance is the difference between the standard variable overheads absorbed into the actual output and the actual overheads incurred

Actual VO Budgeted VO (SP * Actual hours worked VO expenditure variance/ VO spending variance VO efficiency variance Total VO variance (under-/over- absorbed) 27 Absorbed VO (SP* standard hours for actual output

Calculation on overhead absorbed l Step 1 Budgeted overheads POAR = Budgeted activity level in standard hours l Step 2 Overhead absorbed = POAR * Standard hours for actual number of units produced 28

Variable overheads variance l Variable overheads variance = variable overheads absorbed – actual variable overheads incurred l Variable overheads expenditure variance = standard variable overheads for actual hours worked – Actual variable overheads incurred l 29 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

Example 30

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 2005. A budget statement is produced as follow: Budgeted income statement for the month ended 31 May 2005 $ $ 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 31

The actual sales and production is 800 units. The actual income statement is shown as follows: Income statement for the month ended 31 May 2005 $ Sales ($60*800) Less: Variable cost of goods sold Direct materials ($3. 2*2400) Direct labour ($6*3200) Actual Variable overheads Contribution Fixed overhead Net profit 32 $ 48000 12000 15000 5500 32380 15620 2600 13020

Budgeted overheads POAR = Budgeted activity level in standard hours = $6000 3000 = $2 Overhead absorbed = POAR * Standard hours for actual number of units produced = $2 *3 hr per unit * 800 units Standard hr per unit = 3000 hr /1000 units 33

Variable overheads variance l l 34 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)

l 35 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 l l l 36 Variable overheads expenditure variance $900 F Variable overheads efficiency variance $1600 A Total Variable overhead variance $400 A

Sales variance 37

Actual contribution Budgeted contribution (Standard margin * Actual Volume) Sales margin price variance Budgeted contribution (Standard margin* Standard volume) Sales margin volume variance Total sales margin variance 38

Sales variance (Marginal costing) l Total sales margin variance = actual contribution – budgeted contribution = [(Actual selling price – Standard cost of sales )*Actual sales volume] – Budgeted contribution l Sales margin price variance = (Actual contribution per unit – Standard contribution per unit) * Actual sales volume l 39 Sales margin volume variance = (Actual volume – Budget volume)* Standard contribution per unit

Sales variance (Absorption costing) l Sales margin price variance = (Actual profit margin per unit – Standard profit margin per unit) * Actual sales volume l Sales margin volume variance = (Actual volume – Budget volume)* Standard profit margin per unit 40

Example 41

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 2005. A budget statement is produced as follow: Budgeted income statement for the month ended 31 May 2005 $ $ 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 42

The actual sales and production is 800 units. The actual income statement is shown as follows: Income statement for the month ended 31 May 2005 $ Sales ($60*800) Less: Variable cost of goods sold Direct materials ($3. 2*2400) Direct labour ($6*3200) Actual Variable overheads Contribution Fixed overhead Net profit 43 $ 48000 12000 15000 5500 32380 15620 2600 13020

Sales variance (Marginal costing) l 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 44

Sales variance l Sales margin price variance = (Actual contribution per unit – Standard contribution per unit) * Actual sales volume = [($60 - $33) – ($50 - $33)]*800 $33000/1000 units = $8000 F l 45 Sales margin volume variance = (Actual volume – Budget volume)* Standard contribution per unit = (800 -1000)*$17 $17000/1000 units = $2800 (A)

Sales variance (Marginal costing) l l l 46 Sales margin price variance Sales margin volume variance Total sales variance $8000 F $3400 A $4600 F

Sales variance (Absorption costing) l Sales margin price variance = (Actual profit margin per unit – Standard profit margin per unit) * Actual sales volume = [($60 -$36) – ($50 -$36)]*800 (33000+3000)/1000 units = $8000 F l Sales margin volume variance = (Actual volume – Budget volume)* Standard profit margin per unit = (800 -1000)*$14 = $3400 A $14000/1000 units 47

Sales variance (Absorption costing) l l l 48 Sales margin price variance Sales margin volume variance Total sales variance $8000 F $2800 A $5200 F

Fixed overhead variance 49

Actual FO Budgeted FO FO expenditure variance/ FO spending variance FO volume variance Total FO variance (under-/over- absorbed) 50 Absorbed VO (SP* standard hours for actual output

Fixed overhead variance l l l 51 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

Example 52

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 2005. A budget statement is produced as follow: Budgeted income statement for the month ended 31 May 2005 $ $ 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 53

The actual sales and production is 800 units. The actual income statement is shown as follows: Income statement for the month ended 31 May 2005 $ Sales ($60*800) Less: Variable cost of goods sold Direct materials ($3. 2*2400) Direct labour ($6*3200) Actual Variable overheads Contribution Fixed overhead Net profit 54 $ 48000 12000 15000 5500 32380 15620 2600 13020

Fixed overhead variance l l l 55 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

FO Variance in marginal and absorption costing l In marginal costing: – – 56 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

l In absorption costing – – 57 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

Profit reconciliation statement 58

Profit reconciliation statement l l l 59 Profit reconciliation statement is used to sum up all variances It can help the top management to explain the major reasons for the difference between budgeted and actual profits The sales margin variance and fixed overheads variance are different between absorption and marginal costing system

Marginal costing 60

61 Profit Reconciliation Statement $ $ Budgeted profit Sales variances Sales margin price 8000 F Sales margin volume 3400 A 4600 F Materials cost variance Materials price 480 A Material usage 2400 F 1920 F Labour cost variance Labour rate 3200 A Labour efficiency 4000 A 7200 A Variable overhead variance VO Expenditure 900 F VO Efficiency 1600 A 700 A Fixed overhead expenditure variance 400 F Actual profit $ 14000 980 A 13020

Absorption costing 62

63 Profit Reconciliation Statement Budgeted profit Sales variances Sales margin price 8000 F Sales margin volume 2800 A 5200 F Materials cost variance Materials price 480 A Material usage 2400 F 1920 F Labour cost variance Labour rate 3200 A Labour efficiency 4000 A 7200 A Variable overhead variance VO Expenditure 900 F VO Efficiency 1600 A 700 A Fixed overhead variance FO expenditure 400 F FO Volume 600 A 200 A Actual profit 14000 980 A 13020

Reasons for variances l Material price variance – – – 64 Price changes in market conditions Change in the efficiency of purchasing dept. to obtain good terms from suppliers Purchase of different grades or wrong types of materials

Reasons for variances l Materials usage variance – – 65 More effective use of materials/ wastage arising from the efficient production process Purchase of different grade or wrong types of materials Wastage by the staff Change in production methods

Reasons for variances l Labour rate variance – – – 66 Non-controllable market changes in the basic wage rate Use of higher/lower grade of workers Unexpected overtime allowance paid

Reasons for variances l Labour efficiency variance – – – – – 67 Purchase of different grade or wrong types of materials Breakdown of machinery High/low labour turnover Changes in production method Introduction of new machinery Assignment wrong type of worker to work Adequacy of supervision Changes in working condition Change in motivation methods

Reasons for variances l Variable overheads expenditure variance – – 68 It may be caused by the non-controllable change in the price level of indirect wages or utility rates since the predetermined rate is set It is meaningless to interpret this kind of variance on its own. One should look various components of the fixed overheads

Reasons for variances l Variable overheads efficiency variance – 69 Both the variable overheads and direct labour cost vary with the direct labour hours worked

Reasons for variances l Fixed overheads expenditure – – 70 It is meaningless to interpret this kind of variance on its own. It may be caused by the change in the price levels of rent, rates and other fixed expenses

Reasons for variances l Fixed overhead volume variance – 71 When the level of activity is higher than the budgeted level, there is a favourable variance

Reasons for variances l Sales margin price variance – – 72 Change in the pricing strategies of the company Response to the change of pricing policies of its competitors Higher profit margin with growing demand for the product Lower profit margin for simulating sales

Reasons for variances l Sales margin volume variance – – 73 Change in prices and demand Change in the market share of its competitiors