Budgetary control is extensive and concerned with the operations of a business as a whole, whereas standard costing is intensive and concerned with controlling the production expenses of a business.
Updated May 20, 2024
Standard Costing: Its Variance, Calculation, Questions, and Pros and Cons
Standard costing is a cost accounting practice that is performed to control the expense of production. It compares the actual price of production of output with the estimated cost of production of the same volume of output. Application of this practice to your business can set the prices of the output even before the production is started.
Usually, beginners find it difficult to calculate the standard cost and its variance. Therefore, we have come up with this article to discuss what standard costing is, its variance, elements, calculations, and questions, along with the pros and cons.
What is Standard Costing?
Standard costing refers to an accounting practice that is concerned with preparing an estimation of the cost of the production process and comparing it with the actual cost.
It is a branch of cost accounting that is most suitable for the production of standardized goods of a repetitive nature. Its main objective is to emphasize the difference between the planning and execution of the business.
After comparing the actual cost with the standardized cost, managers determine if the new practices need to be utilized.
Standard Costing: Variance Analyses
The difference between the actual cost incurred and the estimated cost of production is known as the variance.
Standard cost – Actual cost = Variance
The difference between these two can be classified as favorable or unfavorable (Adverse) conditions.
Favorable Condition
Standard cost > Actual cost
A higher standard cost means a higher profit than expected.
Unfavorable Condition
Standard cost < Actual cost
A higher actual cost means a lower profit than expected.
Importance of Standard Costing
Apart from budgeting the expenses of the business, the following are the benefits of standard costing in businesses.
- The core purpose of standard pricing is to set performance benchmarks for production costs. Businesses make sure that the actual cost doesn’t exceed the standard cost.
- Standard costing is used to create a budget and evaluate performance based on these budgets.
- In this practice, all the possibilities of expenses are evaluated for making decisions related to the future cost of production of the business.
Elements of Standard Costing
The following are the components of the standard cost of production.
Standard Cost = direct labor cost + direct material cost + fixed overhead + variable overhead
- Direct Labor Cost: The cost of direct labor refers to the salaries and wages paid to the workers who are directly involved in the production process.
- Direct Material Cost: It is the cost of raw materials used for the production of output.
- Fixed overhead: These are the fixed ongoing expenses that remain constant with the production capability of a business. It includes rent, property taxes, the depreciation of assets, etc.
- Variable overhead: These expenses vary with the production capability of a business. It includes fright outwards, advertisements, tax, etc.
Changes in any of these will directly affect the cost of production and profitability of the business.
Calculating Standard Costing (All Formulas)
Now let’s see the standard cost formula and how to calculate the standard cost and variances.
Standard Costing = Standard Rate x Standard Quantity
The standard rate is the estimated price of producing a single unit of output, whereas the standard quantity is the quantity of output predetermined to be produced.
Variance = Standard Cost – Actual Cost
= (Standard rate x Standard quantity) – (Actual rate x Actual quantity)
Furthermore, there are various types of standard cost variance, showcasing the different aspects of the production of output.
Direct Material Variance
Material cost variance is the difference between the estimated and actual cost of purchasing material.
Material Cost Variance
= Standard Material Cost – Actual Material Cost
= (Standard Quantity x Standard Rate) – (Actual Quantity x Actual Rate)
OR
= Material Price Variance + Material Usage Variance
= [Actual Quantity x (Standard Rate – Actual Rate)] + [Standard Rate x (Standard Quantity – Actual Quantity)]
- Material Usage Variance: Based on the standard rate, it is the difference between the standard quantity and the actual quantity.
- Material Mix Variance: This refers to the difference between the budgeted and actual mixes of direct material costs in the production process. MMV = standard rate x (standard quantity – actual quantity)
- Material Yield Variance: It corresponds to the difference between the actual amount of material used, and the standard amount expected to be used, multiplied by the standard rate of the materials. MYV = standard rate x (actual yield – standard yield)
- Material Price Variance: It is the difference between the standard cost and the actual cost incurred on direct material.
The direct material cost is measured to control and understand production expenses and cost behavior, respectively.
Direct Labor Variance
Labor variance is the difference between the actual and estimated cost of labor for producing a definite quantity of output.
Labor Cost Variance
= Standard Labor Cost – Actual Labor Cost
= (Standard Hours x Standard Rate) – (Actual Hour – Actual Rate)
OR
= Labor Efficiency Variance + Labor Rate Variance
= [(Standard Time – Actual Time) x Standard Rate] + [(Standard Rate – Actual Rate) x Actual Hour]
- Labor Efficiency Variance: Using standard rates, it reflects the difference between the standard time and the actual time of direct labor.
- Labor Rate Variance: Based on the actual working hours, it is the difference between the actual rate and the standard rate of direct labor.
Measuring the direct labor variance determines how efficient the company’s labor is and how effectively the company has priced its labor.
Fixed Overhead Variance
It refers to the difference between the estimated and actual indirect fixed costs associated with the production of output.
Fixed Overhead Cost Variance
= Recovered Overhead – Actual Overhead
= (Standard Rate of Recovery x Actual Output) – Actual Overhead [Unit based]
= (Standard Rate Per Hour x Standard Hours) – Actual Overhead
OR
= Fixed Overhead Spending Variance + Fixed Overhead Volume Variance
= (Budgeted Fixed Overhead – Actual Fixed Overhead) + [(Standard hour – Budged hour) x Standard Rate]
- Fixed Overhead Spending Variance: It is the sum of the difference between budgeted fixed overhead expenses and actual fixed overhead expenses incurred by a business.
- Fixed Overhead Volume Variance: The difference between the actual fixed overhead applied to produced goods based on production volume and the amount that was budgeted to be applied to produced goods.
Calculating the fixed overhead variance shows how well a company manages and controls its resources and costs, respectively.
Variable Overhead Variance
The difference between the standard variable overhead for actual production and the actual variable overheads incurred.
Variable Overhead Cost Variance
= Standard Variable Overhead – Actual Variable Overhead
= (Standard Variable Overhead Rate x Actual Output) – (Actual Rate x Actual Output)
= (Standard Variable Overhead Rate x Actual Output) – Actual Variable Overhead Incurred (Unit Formula)
= (Standard Hours for Actual Output x Standard Variable Overhead Rate) – Actual Variable Overhead Incurred (Hours Formula)
OR
= Variable Overhead Spending Variance + Variable Overhead Efficiency Variance
= [(Standard rate – Actual rate) x Actual hour] + [(Standard hour – Actual hour) x Standard rate]
- Variable Overhead Spending Variance: The difference between standard variable overhead and actual variable overhead during the manufacturing period.
- Variable Overhead Efficiency Variance: The variation between estimated time and actual time for manufacturing output.
Examples of Standard Costing
Here, we have provided a few solved standard cost examples for a better understanding.
Material Variance
Example 1. XYZ Ltd. provided the following records. The requirements for making 10 kg. of output are the following.
| Material | Quantity (in kg.) | Rate per kg. (in $) |
| A | 8 | 6.00 |
| B | 4 | 4.00 |
During September 2024, 1000 outputs were produced, with the actual consumption of material as follows.
| Material | Quantity (in kg.) | Rate per kg. (in $) |
| A | 750 | 7.00 |
| B | 450 | 5.00 |
Calculate all the material variances.
Solution.
| Standard | Actual | |||||
| Quantity | Rate | Cost | Quantity | Rate | Cost | |
| A | 800* | 6 | 4800 | 750 | 7 | 5250 |
| B | 400* | 4 | 1600 | 450 | 5 | 2250 |
Material Cost Variance = (Standard Quantity x Standard Rate) – (Actual Quantity x Actual Rate)
A = 4800 – 5250 = 450 (Adverse)
B = 1600 – 2250 = 650 (Adverse)
Material Cost Variance from both materials = 450 (Adverse) + 650 (Adverse)
= 1100 (Adverse)
Material Price Variance = Actual Quantity x (Standard Rate – Actual Rate)
A = 750 x (6 – 7) = 750 (Adverse)
B = 450 x (4 – 5) = 450 (Adverse)
Material Price Variance from both materials = 750 (Adverse) + 450 (Adverse)
= 1200 (Adverse)
Material Usage Variance = Standard Rate x (Standard Quantity – Actual Quantity)
A = 6 x (800 – 750) = 300 (Favorable)
B = 4 x (400 – 450) = 200 (Adverse)
Material Usage Variance from both materials = 300 (Favorable) + 200 (Adverse)
= 100 (Favorable)
To verify,
Material Cost Variance = Material Price Variance + Material Usage Variance
Material Cost Variance = 1200 (Adverse) + 100 (Favorable) = 1100 (Adverse)
Working Note
Calculation of the standard quantity.
| Raw Material A | Raw Material B | Output (in kg.) |
| 8 | 4 | 10 |
| 800 | 400 | 1,000 |
Labor Variance
Example 2. Calculate the labor variance from the following information.
Standard for 100 units: Labor hours = 500, Rate = $24 per hour
Actual production: 1,000 units
Wages paid = $1,30,000 for 5,200 hours.
Solution.
| Standard | Actual | ||||
| Hour | Rate | Wages | Hour | Rate | Wages |
| 5,000* | 24 | 1,20,000* | 5,200 | 25* | 1,30,000 |
Labor Cost Variance = (Standard Hours x Standard Rate) – (Actual Hour – Actual Rate)
= (5,000 x 24) – (5,200 x 25) = 1,20,000 – 1,30,000
= 10,000 (Adverse)
Labor Rate Variance = (Standard Rate – Actual Rate) x Actual Hour
= (24 – 25) x 5,200
= 5,200 (Adverse)
Labor Efficiency Variance = (Standard Hours – Actual Hours) x Standard Rate
= (5,000 – 5,200) x 24
= 4,800 (Adverse)
To verify,
Labor Cost Variance = Labor Rate Variance + Labor Efficiency Variance
Labor Cost Variance = 5,200 (Adverse) + 4,800 (Adverse)
= 10,000 (Adverse)
Working Note
1. Calculation of standard hours = 1,000/100 x 500 = 5,000.
| Hours | Finished Units |
| 500 | 100 |
| 5,000 | 1,000 |
2. Calculation of the actual rate = 1,30,000/5,200 = 25.
3. Calculation of standard wages = Hour x Rate = 5,000 x 24
= 1,20,000
Overhead Variance
Example 3. The standard unit of production of XYZ Ltd. was fixed at 1,20,000 units and overhead expenditure is estimated as follows.
| Fixed = $12,000 | Variable = $6,000 |
The actual production during June of the year was 8,000 units. Each month has 20 working days. During the month, there was one holiday. The actual overhead amounted to:
| Fixed = $1,190 | Variable = $480 |
Calculate fixed and variable overhead variances.
Solution.
Fixed Overhead Cost Variance = (Standard Rate of Recovery x Actual Output) – Actual Overhead
= (0.1* x 8,000) – 1,190 = 800 – 1,190
= 390 (Adverse)
Variable Overhead Cost Variance = (Standard Variable Overhead Rate x Actual Output) – Actual Variable Overhead
= (0.05* x 8,000) – 480
= 400 – 480
= 80 (Adverse)
Working Note
1. Calculating the standard rate of recovery = 12,000/1,20,000 = 0.1
2. Calculating standard variable overhead rate = 6,000/1,20,000 = 0.05
Advantages and Limitations of Standard Costing
While implying the standard costing system, corporations need to be aware of its limitations, as this system might only suit some businesses. Furthermore, companies have to ensure that the strengths of standard costing are in their favor, or it may affect their functioning.
The following table showcases the advantages and limitations of standard costing.
| Advantages | Limitations |
| Performance Evaluation: Standard costing allows managers to evaluate business performance by comparing the estimated cost with the actual cost of production. | Complex Process: Even though the business environment is dynamic, standard costing is based on the assumption that the volume of production and prices of materials are constant. It depicts that even a small increase in prices can make this system ineffective. |
| Improved Efficiency: Standard costing enhances a business’s productivity by eliminating excess material, employed labor, and indirect production expenses. | Time-Consuming: Setting estimates of production expenses like labor, material, and overheads is a lengthy process and can even lead to appointing an expert. |
| Cost Control: Controlling the production cost is the primary objective of standard costing. Businesses imply this practice and lower the cost by eliminating the variances. | Expensive for Small Businesses: Standard costing is costly as it includes summarizing, analyzing, and interpreting past data to estimate the future cost of production. Hence, large-scale manufacturing corporations usually prefer it. |
| Manages Profit Margin: Effective management of the standard costing system aims at improving the profitability of the business. | Inflexibility: One of the biggest limitations of standard costing is rigidity. Once the business has set the estimates, making adjustments is very difficult. Even a tiny mismatch in the variances can affect the business’s profitability. |
| Assist in Decision-Making: After summarizing and analyzing the variances, business managers make operational decisions for the better functioning of the business. |
Wrapping Up
Standard costing is a method of determining the cost of goods and services produced to manage the budget of a business. Companies calculate an estimate of the cost of output produced and compare it with the actual cost of production to maximize profitability.
Businesses that engage in repetitive production processes usually opt for standard costing as their preferred cost accounting method, as it makes inventory valuation easier.
Also Read: What is Corporate Accounting? Benefits, Importance, Pros & Cons
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