Notes on Standard Costing and Variance Analysis

This discussion covers standard costs and variance analysis as a component of management
advisory services, including theoretical backgrounds, factors giving rise to variances, and an in-
depth look into material, labor, and overhead variances.

I. Overview of Variance Analysis

 What is Variance Analysis?

o It is simply the difference between actual results and a
budget or standard amount. The root word "vary" means
"difference".
o For this discussion, the concentration is on the deviation
between actual production results against standard
production.
o Revenue variances (difference between actual vs. budgets) are
not discussed.

 Concepts Supporting Variance Analysis

o Management by Exception: This concept supports variance
analysis by stating that only significant variances must be
analyzed. Analyzing all variances entails costs.
 Top-level management decides what constitutes a
"significant" variance.
 Significance can be defined as a percentage of total
cost (e.g., exceeding 5% of total manufacturing cost) or a
certain amount (depending on the company's scale).
 Standards should be realistic and helpful in attaining
company goals.
o Purpose of Variance Analysis:
 It is intended to measure effectiveness and efficiency.
 It is part of the performance evaluation function of
management and the control function.
 Effectiveness: Measured by the attainment of goals.
 Efficiency: Measured by the proper utilization of company
resources.
 It provides feedback for planning and control by
gathering past data and analyzing deviations from
objectives.

 Costing Methods and Variances

o Absorption Costing: Variances are recognized and recorded
in the books through journal entries. Variances are typically
closed to Cost of Goods Sold.
 o Variable Costing: There are no journal entries for variable
costing, and therefore, variances are not recognized under
variable costing, although they may still be analyzed based on
behavior.

II. Causes of Variances

 Causes of Variances and Budget Types

o The core cause is the difference between actual and
standard amounts.
o Static Budget: Prepared before the start of operations.
o Flexible Budget: Prepared after the end of operations and
intended for performance evaluation. It facilitates better analysis
and interpretation of variances. It is adjusted to actual levels of
operation
o The difference between a flexible budget and a static
budget is the volume variance.

 Favorable vs. Unfavorable Variances

o The objective is always to increase net income and improve
profitability.
o A variance is favorable if it increases net income.
o A variance is unfavorable if it decreases net income.
o For Cost Variances:
 Actual Cost > Standard Cost: Unfavorable (decreases
net income).
 Actual Cost < Standard Cost: Favorable (increases net
income).
o For Revenue Variances:
  Actual Revenue > Standard Revenue: Favorable
(increases net income).
 Actual Revenue < Standard Revenue: Unfavorable
(decreases net income).
o Closing Entries and Net Income Effect:
 Unfavorable variances are typically debited to Cost of
Goods Sold (when closed/closing entries: increasing CGS,
decreasing gross profit and net income).
 Favorable variances are typically credited to Cost of
Goods Sold (when closed/closing entries: decreasing CGS,
increasing gross profit and net income).

 Analysis of Variances and Corrective Actions

o Not all variances are analyzed. The only variance that is not
analyze is the overhead volume/production variance as it is
beyond the control of anybody and it is purely composed of fixed
cost.
o Production variances are analyzed to determine corrective
actions and to improve operational efficiency.
o Variance analysis is a constructive process intended to
improve future operations, not to punish employees or find
fault.
o It leads to motivation and significantly impacts employee
output.
o Avoid excessive emphasis on a single performance
measure. For example, favorable materials price variance from
substandard materials can lead to unfavorable quantity variance,
rework, additional labor hours, and unfavorable overhead
variances. An overall effect on net income must be considered.
o Corrective actions involve identifying the responsible parties and
addressing the root cause (e.g., purchasing manager ensuring
materials meet standards).
III. Price Factor and Quantity Factor

 Types of Standards
o Theoretical Standards (Ideal Standards):
 Assume 100% production efficiency and are very difficult
to attain.
 Useful for modern production management strategies like
Six Sigma or process engineering. Degree of acceptable
error is 0 as possible.
o Practical Standards (Attainable Standards):
 More realistic and are the ones typically used for
performance evaluation.
 Use for high volatile like cash

 Analysis of Variances and Corrective Actions

Variance analysis typically breaks down into price/rate and quantity/efficiency factors.

 A. Price Factor (Input Price Variance / Rate Variance)

o Compares the actual price/rate paid with the standard
price/rate.
o Samples are Materials Price Variance, Labor Rate Variance,
Overhead Spending Variance (also known as budget
variance).
o This variance uses the actual quantity purchased or used.
o It is only a price variance that uses actual rate or cost

 B. Quantity Factor (Physical Factor / Usage Variance / Efficiency Variance)

*there’s no such thing as overhead hours as it is applied together with labor. Basis
of OH hours would be the labor hrs

o Compares the actual quantity/hours used with the standard

quantity/hours allowed for actual output.
o Samples are Materials Quantity Variance (deviation from
consumption of raw materials), Labor Efficiency Variance
(deviation from consumption of labor hours), Overhead
Efficiency Variance (automatic the variable component),
Volume Variance (automatic the fix component)
o Quantity variance can be further subdivided into mix
variance (deviation from the combination of parts/materials)
and yield variance (deviation from expected output from input
components). Mix and yield variances if a company uses a
combination of raw material or labor
 C. Volume Variance (Capacity Variance)
o Primarily associated with fixed overhead.
o Represents the deviation from production capacity against
the standard allowed for what was actually attained.
o It is considered a non-controllable variance because
production capacity is highly dependent on sales units, which are
affected by external factors like competitors.
o The difference between a flexible budget and a static budget
is the volume variance.
IV. Materials Variances

Origin of the General Model

 Journal Entry for Purchase of Raw Materials (Standard Costing)

o Debit: Raw Materials (at standard price * actual quantity) —
flexible budget
o Credit/Debit: Materials Price Variance (Debit for unfavorable,
Credit for favorable) ((AP-SP) x AQ) — per unit approach
o Credit: Accounts Payable (at actual price * actual quantity)—
actual
o Point of Recognition: Materials price variance is recognized at
the point of purchase of raw materials. If the problem is silent,
it's based on actual quantity purchased.

 Journal Entry for Issue of Raw Materials to Work-in-Process (Standard Costing)

*If the company uses standard costing, once nisud na sya sa work in process, puro
standard na na sya hantud sa pag baligya nimo. Nahimong actual ang COGS kung
mag closing entries na.

*kung nay movement, actual quantity jd na sya.

o Debit: Work in Process (at standard quantity * standard price) —

standard
o Debit/Credit: Materials Quantity Variance ((Debit for unfavorable,
Credit for favorable) ((AQ-SQ) xSP) — per unit approach
 o Credit: Raw Materials (at standard price* actual quantity)—
flexible budget

 Formulas:
o Materials Price Variance (Total Approach): (Actual Price *
Actual Quantity) - (Standard Price * Actual Quantity)
o Materials Price Variance (Per Unit Approach): (Actual Price -
Standard Price) * Actual Quantity
o Materials Quantity Variance (Total Approach): (Standard
Price * Actual Quantity) - (Standard Price * Standard Quantity)
o Materials Quantity Variance (Per Unit Approach): (Actual
Quantity - Standard Quantity) * Standard Price

 Responsibility:
o Materials Price Variance: Purchasing Manager.
o Materials Quantity Variance: Production Manager.

 Sample Problem 1: Materials Price Variance

o Given:

The following data pertain to the first week of operations during

the month of february.

 Actual purchases: 1,500 units at P3.80/unit

 Actual usage 1350 units
 Standard usage: 1020 units at 4.00 per unit

Direct labor:
Actual hours: 310 hours at P12.10 per hour
Standard hours: 340 hours at P12.00 per hour
 Responsible for material variances:

- If price, purchasing manager

- If quantity, production manager

V . Labor Variance

 Journal Entries (Standard Costing)

*trigger point of labor efficiency and labor variance is automatic upon application
of labor to WIP

o Debit: Work in Process (Standard Hours * Standard Rate)

o Debit/Credit: Labor Rate Variance (Debit for unfavorable, Credit
for favorable) (AR-SR) xAH
o Debit/Credit: Labor Efficiency Variance (Debit for unfavorable,
Credit for favorable) (AH-SH) xSR
o Credit: Wages Payable (Actual Hours * Actual Rate)

 Formulas:
o Labor Rate Variance: (Actual Rate - Standard Rate) * Actual
Hours
o Labor Efficiency Variance: (Actual Hours - Standard Hours) *
Standard Rate

Sample 1

The following data pertain to the first week of operations during

the month of february.

 Actual purchases: 1,500 units at P3.80/unit

  Actual usage 1350 units
 Standard usage: 1020 units at 4.00 per unit

Direct labor:
Actual hours: 310 hours at P12.10 per hour
Standard hours: 340 hours at P12.00 per hour

 Responsibility:
o Labor Rate Variance: Human Resource Manager (sets
compensation).
o Labor Efficiency Variance: Production Manager (controls
consumption of labor hours).
o from actual material consumption.
VI. Overhead Variance
Journal Entries for overhead variances:
Dr. Factory OH
Cr. Cash/Acnts Payable/Appropriate acnt

Dr. WIP
Cr. Applied FoH aka Standard Overhead

Closing entry (if allowed to recognize by mngmnt)

Dr. Applied FOH
Cr. Cogs (dirhi ibutang ang variance if giparecognize syas mngmnt. If not,
COGS ditso)
Cr. FOH

 Recognition of Overhead Variances:

OH variances are only recognized in the books depending on the company’s policy.
If gusto ni mngmnt nga I recognize ang policy, I recognize na sya sa closing entries.
But, for purposes of proper documentation and performance evaluation, they must be
recorded in the books.

 Key Components and Variances:

o Variable Overhead: Often divided into Spending and Efficiency
variances.
 o Fixed Overhead: Often divided into Spending (Budget) and
Volume (Capacity) variances.
o Controllable Variances:
 Variable Spending Variance: Controllable (disbursement
requires approval).
 Fixed Spending Variance: Controllable (disbursement
requires approval).
 Variable Efficiency Variance: Controllable (production
manager controls hours).
 The sum of these is the Controllable Variance in a two-
way analysis.
o Non-Controllable Variance:
 Volume Variance: Non-controllable (beyond the control of
management due to sales units and competitors).

Sample 2:

 The normal capacity of Department C is 6,000 direct labor hours per

month. At normal capacity, the standard factory overhead rate is P22
per direct labor hour, based on P96,000 of budgeted fixed expenses
per month and a variable expense rate of P6 per direct labor hour.
During February, the department operated at 5,600 direct labor hours,
with actual factory overhead of P33,750 Variable and P96,250 fixed.
The number of standard direct labor hours allowed for the production
actually attained is 5,700.
o Given:
 Normal Capacity (Budgeted Hours): 6,000 Direct Labor
Hours (DLH)
 Standard Overhead Rate: P22/DLH (total or combination of
variable and fixed)
 Budgeted Fixed Expenses: P96,000
 Variable Expense Rate: P6/DLH
 Fixed rate: 16 ((22-16) or 96k/6k=16)
 Actual Operated Hours: 5,600 DLH
 Actual Variable OH: P33,750
 Actual Fixed OH: P96,250
 Standard Hours Allowed for Production: 5,700 DLH
  Responsibility for Overhead Variances:
o Spending (Variable and Fixed): Controllable by the production
department manager or human resource manager.
o Efficiency (Variable): Production department manager (as it's
tied to labor hours).
o Volume: Considered non-controllable.

VII. Practice Problems (Conceptual)

[Link] the actual price paid on credit for a raw material exceeds its
standard price, the journal entry would include:

A) Debit to Raw Materials; Credit to Materials Price Variance

B) Debit to Accounts Payable; Credit to Materials Price Variance

C) Debit to Raw Materials; Debit to Materials Price Variance/

D) Debit to Accounts payable; Debit to materials price variance

[Link] the actual amount of a raw material used in production is less than
the standard amount allowed for the actual output, the journal entry would
include:

A) Credit to Raw Materials; Credit to Materials Quantity Variance/

B) ) Credit to Work-In-Process; Credit to Materials Quantity Variance

C) Credit to Raw Materials; Debit to Materials Quantity Variance

D) Credit to Work-In-Process; Debit to Materials Quantity variance

3. When the actual amount of a raw material used in production is less than
the standard amount allowed for the actual output, the journal entry would
include:

A) Credit to Raw Materials; Credit to Materials Quantity Variance

B) ) Credit to Work-In-Process; Credit to Materials Quantity Variance

C) Credit to Raw Materials; Debit to Materials Quantity Variance/

D) Credit to Work-In-Process; Debit to Materials Quantity variance

[Link] of the following would produce a materials price variance?

A) An excess quantity of materials used.

B) An excess number of direct labor-hours worked in completing a job.

C) Shipping materials to the plant by air freight rather than by truck./

D) Breakage of materials in production.

5) A labor efficiency debit balance indicates that:

A) The wage rate paid to production workers was less the standard.

B) The wage rate paid to production workers was above the standard.

C) Less labor time was spent on production than was called for by the
standard.

D) More labor time was spent on production than was called for by the
standard./

6) When the actual wage rate paid to direct labor workers exceeds the
standard wage rate, the journal entry would include:
A) Credit to Wages Payable; Credit to Labor Rate Variance

B) Credit to Work-In-Process; Credit to Labor Rate Variance

C) Credit to Wages Payable; Debit to Labor Rate Variance/

D) Credit to Work-In-Process; Debit to Labor Rate Variance

7) When the actual wage rate paid to direct labor workers is less than the
standard wage rate, the journal entry would include:

A) Debit to Wages Payable; Credit to Labor Rate Variance

B) Debit to Work-In-Process; Credit to Labor Rate Variance/

C) Debit to Wages Payable; Debit to Labor Rate Variance

D) Debit to Work-In-Process; Debit to Labor Rate Variance

8) When the actual direct labor-hours exceed the standard direct labor-hours
allowed for the actual output of the period, the journal entry would include:

A) Credit to Wages Payable; Credit to Labor Efficiency Variance

B) Credit to Work-In-Process; Credit to Labor Efficiency Variance

C) Credit to Wages Payable; Debit to Labor Efficiency Variance/

D) Credit to Work-In-Process; Debit to Labor Efficiency Variance

9) If overhead is applied on the basis of units of output, the variable

overhead efficiency will

a. zero/

b. favorable, if output exceeds the budgeted level

c. unfavorable, if output is less that the budgeted level

d. a function of the direct labor efficiency variance

10) The production volume variance occurs when using

A) The absorption costing approach because of production exceeding the

sales.

B) The absorption costing approach because production differs from that use
in setting the fixed overhead rate used in applying fixed overhead to
production./
C) The variable costing approach because of sales exceeding the production
for the period.

D) The variable costing approach because of production exceeding the sales

for the period.

11) Variable overhead is applied on the basis of standard direct labor hours.
If, for a given period, the direct labor efficiency variance is unfavorable, the
variable overhead efficiency variance will be

a. favorable

b. unfavorable/

c. zero

d. the same amount as the labor efficiency variance

Materials Price Variance: An unfavorable variance results in a debit to

Materials Price Variance. Caused by factors affecting the price of
materials, like using air freight instead of truck for shipping.

 Materials Quantity Variance:

o Favorable (actual < standard): Credit to Materials Quantity
Variance.
o Unfavorable (actual > standard): Debit to Materials Quantity
Variance.
 Labor Efficiency Variance: A debit balance (unfavorable)
indicates actual hours are greater than standard hours.
 Labor Rate Variance: A credit balance (favorable) indicates actual
wage rate is less than standard wage rate.
 Production Volume Variance: Occurs when using absorption
costing.
 Variable Overhead Efficiency Variance and Labor Efficiency
Variance: Both use the same labor hours. If labor efficiency variance is
unfavorable, variable overhead efficiency variance will also be
unfavorable.