A Beginners Guide to Standard Costs

Greater detail about the calculation of the variable and fixed overhead is provided in Compute and Evaluate Overhead Variances. The currently attainable standard is the most popular standard, and standards of this kind are acceptable to employees because they provide a definite goal and challenge to them. These standards make proper allowances for normal recurring interferences such as machine breakdown, delays, rest periods, unavoidable waste, and so on. They are projections that are rarely revised or updated to reflect changes in products, prices, and methods. In setting standards, the key question is to decide on the type of standard to be used in fixing the cost. The main types of standards are ideal, basic, and currently attainable standards.

A manufacturer must disclose in its financial statements the cost of its work-in-process as well as the cost of finished goods and materials on hand. A budget for a company (that manufactures a product) cannot be prepared without standard costing. When a dollar amount is assigned to labor, materials and manufacturing overhead, the budget can be completed. Companies use standard costs for budgeting because the actual costs cannot yet be determined. This is because in the manufacturing process, it is impossible to predict the demand of a product or all the variables that will affect the costs of manufacturing it. Standard costing involves the creation of estimated (i.e., standard) costs for some or all activities within a company.

Using the standard and actual data given for Lastlock and the direct materials variance template, compute the direct materials variances. Standard costs are established for all direct materials used in the manufacturing process. Direct materials include all materials that can be easily and economically traced to the production of a product. For example, the direct materials necessary to produce a wood desk might include wood and hardware. Indirect materials are not easily and economically traced to a particular product.

The company can then compare the standard costs against its actual results to measure its efficiency. Sometimes when comparing standard costs against actual results, there is a difference. To illustrate standard costs variance analysis for direct labor, refer to the monthly bookkeeping data for NoTuggins in Exhibit 8-1 above. Each unit requires 0.25 direct labor hours at an average rate of $18 per hour for a total direct labor cost of $4.50 per unit. During the period, 45,000 direct labor hours were worked and $832,500 was paid for direct labor wages. It may have purchased the wrong grade of material or hired employees with more or less experience than required.

A variance is the difference between the actual cost incurred and the standard cost against which it is measured. A variance can also be used to measure the difference between actual and expected sales. Thus, variance analysis can be used to review the performance of both revenue and expenses. Standard costs have their flaws, but they’re still a useful tool for companies to create an accurate business budget without having to do a ton of complicated math. Coming up with an accurate standard cost does require you to know your product and your team’s capabilities, but even if you start with guesses, you’ll get closer and closer to your actual costs over time. This is the number of hours of labor required to produce your product times the average hourly rate you pay your workers.

Calculate your manufacturing overhead

General Motors also can add up all of the standard times for all vehicles it makes to determine if too much or too little labor was used in production. The setting up of standard costs requires the consideration of quantities, price or rates, and qualities or grades for each element of cost that enters a product (i.e., materials, labor, and overheads). The difference between actual costs and standard costs is known as variance. Variance is identified and carefully analyzed, and it is reported to managers to inform suitable corrective actions. A standard cost is one that a company expects at the outset of a year under a normal level of operational efficiency.

The completed top section of the template contains all the numbers needed to compute the direct labor efficiency (quantity) and direct labor rate (price) variances. The direct labor efficiency and rate variances are used to determine if the overall direct labor variance is an efficiency issue, rate issue, or both. The total amounts for direct materials actually purchased and used are reported on the following line.

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Refer to the total direct materials variance in the top section of the template. Total standard quantity is calculated as standard quantity per unit times actual production or 4.2 feet of flat nylon cord per unit times 150,000 units produced equals 630,000 feet of flat nylon cord. Total direct material costs per the standard amounts allowed are the total standard quantity of 630,000 ft. times the standard price per foot of $0.50 equals $315,000. Per the standard cost formulas, Brad projected he should have paid $315,000 for the direct materials necessary to produce 150,000 units. Refer to the total direct labor variance in the top section of the template. Total standard quantity is calculated as standard quantity per unit times actual production or 0.25 direct labor hours per unit times 150,000 units produced equals 37,500 direct labor hours.

1. Remember, actual profits might differ from projected profits if standard costs deviate significantly from actual costs.
2. He estimates that each unit should require 4.2 feet of flat nylon cord that costs $0.50 per foot for total direct material costs per unit of $2.10.
3. For example, an investigation could reveal that the company had to pay a higher rate to attract employees, so the standard hourly direct labor rate needs to be adjusted.
4. If it costs less to produce a product than the standard cost predicted, that’s a favorable variance.
5. These standards are compared to the actual number of direct labor hours worked and the actual rate paid for each type of direct labor.

For example, a policy decision to increase inventory can harm a manufacturing manager’s performance evaluation. Increasing inventory requires increased production, which means that processes must operate at higher rates. When something goes wrong, the process takes longer and uses more than the standard labor time. The manager appears responsible for the excess, even though they have no control over the production requirement or the problem.

Direct labor efficiency variance

Per the standards, the variable manufacturing overhead rate is $3 and each unit requires 0.25 direct labor hours. The total standard variable manufacturing overhead cost per unit is $0.75. During the period, 45,000 direct labor hours were actually worked and actual variable manufacturing overhead of $121,500 was incurred.

Standard costs are predetermined harry walton costs that provide a basis for more effectively controlling costs. Standard costs also assist the management team when making decisions about long-term pricing. The Ascent is a Motley Fool service that rates and reviews essential products for your everyday money matters.

Taking the time to continuously update actual costs means a lot of number adjustments for a company’s accountant. As a result, the required financial reports for a company’s management can be generated easier and faster. For example, by analyzing the difference between actual costs and standard costs, management can identify the factors leading these differences.

During the period, Brad projected he should pay $112,500 for variable manufacturing overhead to produce 150,000 units. Once the top section is complete, the amounts from the top section can be plugged into the formulas to compute the variable manufacturing overhead efficiency (quantity) and rate (price) variances. All standard cost variances are computed using the actual production quantity. The goal is to determine how much should have been incurred to produce the actual quantity of units produced and compare that to how much was actually incurred to produce the actual quantity of units produced.