Standard costs and variance analysis

The standard costs are developed based on direct and indirect costs budgeted. The standard cost is a measure of how much should cost to produce or deliver a product or service. The standard cost of a product is made of the costs of the components required to produce that product. For example, the standard cost of a leather jacket includes:

- Cost of materials (leather, zipper, buttons, etc.)
- Direct labor cost (the time required to cut the design, sew it, etcetera, at the rate of production of employees who work in the process), and
- Indirect manufacturing costs related to the product (depreciation of the skin cutter machine, electricity, rent of the factory, etc.).

Once the standard cost is established, this provides the basis for decision-making, to analyze and control costs, and to measure the inventory and the cost of goods sold (see valuation of inventories). The standard costs serve as a benchmark against which actual costs are compared. The differences between current costs and standard costs are called variances. The actual costs may differ from the standard costs due to differences in price, differences in quantity, errors, or other conditions. To determine the reasons for the variances a corrective action may be suggested or demonstrate that the products are currently costing more or less than the anticipated.

Direct cost

The direct costs, such as materials and labor, are the costs that can be specifically assigned to a unit of products. The standard cost for the direct costs of a product involves two components: the price component and quantity component. The standard cost for one unit of production is calculated by multiplying the standard quantity to be used by the price per standard unit.
Example: Assume that our leather jacket contains an average of 2 meters of skin at a cost of $16.00 per meter, a zipper at a cost of $5.00 per meter and two buttons at a cost of $0.50 each. Based on a time study recently made by the administration, a jacket requires an average of 5 hours of time spent by an employee to be produced. The production workers are paid on average $10 per hour of work, including benefits. The standard cost for the direct costs (the one for indirect costs will be seen later in this section) shall be as follows:

	Quantity X Price = Standard Cost
Materials:
Skin	2 meters X $ 16.00	$32.00
Zipper	1 Zipper X $ 5.00	$5.00
Buttons	2 X buttons $ 0.50	$1.00
Materials Total Cost		$38.00
Direct Labor Cost	5 hours X $10.00	$50.00
TOTAL DIRECT COST		$88.00

Throughout the year, our leather jacket company will buy leather, zippers and buttons, and also recruit and pay to production employees. But what hill happened 1) if the company found skin at a lower price with a new supplier, which it is offering a discount, 2) a new machine has been acquired by the company to minimize the amount of material required by each jacket reducing the material scrap; 3) due to a very special order, the company had to ask their workers to work overtime, which must be paid on time and a half the normal rate, i.e. 150%; 4 ) the new machine to improved productivity, and now are used only 4.8 hours to produce a jacket. These differences will lead to variations between actual cost and standard costs budgeted as follows:

	Quantity X Price = Standard Cost
Materials:
Skin	1.5 meters X $12.00	$18.00
Zipper	1 Zipper X $5.00	$5.00
Buttons	2 botones X $0.50 2 X buttons $ 0.50	$1.00
Materials Total Cost		$24.00
Direct Labor Cost	4.6 hours X $ 15.00	$69.00
TOTAL DIRECT COST		$93.00

Now it's easy to see how jackets cost $5.00 more than what was budgeted. To understand a variance or variation, it must be analyzed and broken into its component parts. The analysis of variance in material would be:

Materials	Quantity X Price = Standard Cost
Skin:
Budget	2 meters X $16.00	$32.00
Actual	1.5 meters X $12.00	$18.00
Material Variance		$14.00 Favorable

Price variance	($16.00 - $12.00) X 1.5 meters	$6.00 Favorable
Variance in quantity	(2.0 - 1.5) X $16.00	$8.00 Favorable
Material Variance		$14.00 Favorable

The analysis of variance in direct labor would be the following:

Direct Labor	Quantity X Price = Standard Cost
DL:
Budget	5 hours X $10.00	$50.00
Actual	4.6 meters X $15.00	$69.00
DL Variance		$ 19.00 Unfavorable

Price variance	($ 10.00 - $ 15.00) X 4.6 meters	$23.00 Unfavorable
Variance in quantity	(5.0 - 4.6) X $10.00	$4.00 Favorable
DL Variance		$19.00 Unfavorable

The variance is added as follows:

Standard Cost	$88.00
Actual Cost	$93.00
Total Variance	$5.00 Unfavorable

Material variance	$14.00 Favorable
DL Variance	$19.00 Unfavorable
Total Variance	$ 5.00 Unfavorable

The formulas to analyze variances can be expressed as follows:

Price Variance	(SP - AP) X AQ
Variance in quantity	(SQ - AQ) X SP
Total Variance	(SP X SQ) - (AP X AQ)

Where:
SP = Standard Price
AP = Current Price
SQ = Standard Quantity
AQ = Actual Quantity

Overhead or indirect costs

The direct costs vary in relation to the volume of units produced. Overhead or indirect costs or general expenses, however, are elements that vary directly with the volume (variable costs) and other elements that do not (fixed costs).

Overhead Budgets. One way to budget the overhead is ignoring the indirect effects of volume. This approach is called fixed costs budget. Under this approach, the administration determines the amount of overhead that should be taken based on a desired or normal level of production. The total expenditure becomes the overhead budget against which performance is measured, regardless of the level of production currently achieved. An example of this would be as follows:

Overhead Permitted (in thousands)
Rent	$500
Machinery Depreciation	500
Supervision Salaries	1,000
Indirect Material	800
Electricity	800
TOTAL	$3,600

The performance at the end of the year may be measured against the total $3'600,000. However, not taking into account the true nature of costs, may lead to a manager to take inaccurate conclusions about the performance. For example, lets assume that this budget is based on a "normal" level of production of leather jackets (160,000 units). Also assume that the costs of electricity, accounting in part for cutting machines and sewing, vary with the level of production. So, if 200,000 jackets are produced during the year, the cost of electricity will exceed $800,000, say that these were a total of $1'000,000. Comparing this with a fixed budget, the manager can say that the supervisor of the warehouse did his job poorly in terms of managing the costs of electricity, when in fact, excessive spending is due solely to 40,000 extra jackets that occurred.

The other approach for budgeting overhead is called flexible budget. A flexible budget specifies a cost permissible at each possible level of production. Once the period is completed and the volume of production known, the standard budget is determined by reference to flexible budget for the current level of production. This is a parallel method to the way used to determine the budget for direct materials and manpower. Example of a simplified flexible budget:

Amounts in Thousands

Utilization Capacity	40%	60%	70%	80% (Normal)	100%
Direct Labor Cost (rate per piece)	$4,000	$6,000	$7,000	$8,000	$10,000

Overhead Allowed						Cost Behavior
Rent	$500	$500	$500	$500	$500	No change or Fixed
Depreciation	500	500	500	500	500	No change or fixed
Supervision	500	1,000	1,000	1,000	1,500	Phased Cost
Indirect Material	400	600	700	800	1,000	Variable at 10% of Direct Labor
Electricity	600	700	750	800	900	Semivariable: $400 + 5% of DL

TOTAL	$2,250	$3,300	$3,450	$3,600	$4,400

A flexible budget allows us to analyze in a more intelligent way the variable overhead.

Overhead absorption. Now that our flexible budget is established, we need to establish how we are going to allocate indirect costs to our products. The total cost of a product should include all indirect costs that were generated to bring the product to its complete form. So apart from the direct labor and materials, the standard cost of a product includes indirect costs as well. But, manpower and materials are easy to measure and allocate their products. It is much more difficult to determine how much rent, indirect material, or depreciation was consumed by a particular product.
The accountants solve this problem by using an overhead allowance method. This is called overhead absorption. First indirect costs are collected in sets of costs. A group can include all the rent, other all the costs associated with the inspection, other the costs of supervision, etc. Now the sets of costs are allocated to products using a driver of cost. For simplicity, in the rest of this note we will assume that all indirect costs are added in a single set of cost for assignment.
In companies that produce a single product, the overall costs can be allocated based on units, using the units produced in the period as a driver of cost. The total budgeted indirect cost ($ 3.6 million using the example above) will be divided between the volume of production planned (assuming 200,000 jackets). Then for each jacket produced, $18.00 ($ 3.6 million between 200,000) shall apply as indirect costs. The standard cost per jacket under this method would be then:

Standard Cost
Materials	$38.00
Manpower (Direct labor)	$50.00
Overhead (Indirect cost)	$18.00

Total Standard Cost	$106.00

In multi-product firms, it is necessary to use a different method or cost driver than the number of units produced, so a more fair distribution of indirect cost between products can be made. For example, if our company makes leather gloves in addition to jackets and gloves can be manufactured in a quarter of the time it takes to produce a jacket, it would be unfair to charge each pair of gloves the same indirect cost that is charged to each jacket. Some other method of utilization of capacity must be used, as the labor hours, the amount paid by workforce in currency (either dollars, pesos, quarters, etc.) or machine hours. The choice for a business in particular should be based on which variable is the one that best measures the level of utilization of capacity for that business. For example, the overall costs of machinery depreciation can be allocated based on the number of machine hours per product as a cost driver. The entire cost of supervision can be distributed using the direct labor hours as a cost driver.
Since our production process of jackets is just more intense in direct labor, we will use the monetary cost of labor as a method of allocation (in this example we will use as currency the U.S. dollars). Using the direct labor dollars, the standard cost of overhead for a jacket would be $0.45 for each dollar of direct labor ($3.6 million of budgeted indirect cost divided by the total $8.0 million of budgeted manpower). Then, for a jacket $22.50 would be applied by indirect cost ($50.00 dollars per jacket multiplied by the $0.45 rate of indirect cost per DL dollar). The total standard cost for a leather jacket would be as follows:

Standard Cost
Materials	$38.00
Manpower (Direct labor)	$50.00
Overhead (Indirect Cost)	$22.50

Total Standard Cost	$110.50

This would be the amount to be accumulated as inventory by each jacket produced. However, differences between the planned and actual volume will make a volume variance to emerge. The volume variance can be explain as follows:

	Plan	Actual
Direct Labor / jacket	$50.00	$50.00
Overhead rate	x $0.45	x $0.45
Overhead cost / Jacket	$22.50	$22.50

Jackets produced	160,000	140,000
Total Overhead Absorption	$3,600,000	$3,150,000

If the plan was to produce 160,000 jackets and currently there were only 140,000, and if we assume that the $3.6 million in indirect costs are fixed and that at the end of the year we only have $3.15 million of absorption by finished product; if the actual costs were $3.6 million, that compared with the absorption have led to a volume variance of $450,000.