Edexcel A-Level Accounting: Standard costing (YAC11)

This guide teaches topic 2.5, Standard costing, from the Pearson Edexcel International Advanced Subsidiary/Advanced Level in Accounting (XAC11/YAC11) specification, Issue 2, September 2018. Every outcome from 2.5.1 to 2.5.6 is taught here. Standard costing is examined in Unit 2, Corporate and Management Accounting: Unit 2 (A2) only. The companies and numbers are made up for teaching; money is in dollars throughout.

See the Edexcel A-Level Accounting course page and tick topics off on the printable YAC11 checklist. After this guide, condense with the standard costing revision notes and test yourself on the standard costing practice questions. A free diagnostic will show which topics need most work.

What the specification asks for

Ref	Skill
2.5.1	Explain the purpose of standard costing
2.5.2	Describe the stages in establishing a standard costing system, including collecting data from accounting records
2.5.3	Calculate material variances (price, usage, total), labour variances (rate, efficiency, total), the total fixed overhead variance and the total variable overhead variance
2.5.4	Suggest possible reasons for variances
2.5.5	Explain possible interrelationships between variances
2.5.6	Apply the principle of management by exception to variance analysis

Overhead absorption rates come from the introduction to costing guide; flexing to actual output comes from the budgeting guide.

What a standard cost is

A standard cost is a predetermined cost for one unit of output. It is built from a quantity and a price for each element:

Standard cost of an element = standard quantity per unit x standard price
                              (kg x price per kg; hours x rate per hour)

The difference between a standard cost and an actual cost is a variance. A variance is favourable (F) when actual cost is below standard, so profit is higher than planned. It is adverse (A) when actual cost is above standard, so profit is lower. Label every variance F or A.

The purpose of standard costing (2.5.1)

• Planning. Unit standards make budgets quick to build for any output level.
• Control. Comparing actual cost with the standard cost of actual output shows where money was lost or saved, and who is responsible.
• Performance measurement. The purchasing manager is judged on material prices, the production manager on usage and efficiency.
• Pricing and inventory valuation. A reliable unit cost supports quotations, and inventory can be valued at standard.
• Motivation. A realistic target gives staff something to aim for.
• Management by exception. Managers look only at significant variances (see 2.5.6).

Establishing a standard costing system (2.5.2)

1. Decide the type of standard. An ideal standard assumes perfect conditions (no waste, idle time or breakdowns); it is rarely met and can demotivate. An attainable standard allows normal waste and idle time, so it is demanding but achievable. A basic standard stays unchanged for years to show trends, but soon goes out of date.
2. Set the standard quantities. Engineers and production managers specify the kilograms and labour hours each unit should need, from work studies and past records.
3. Set the standard prices. Purchasing estimates material prices, allowing for discounts and expected changes. Payroll sets standard wage rates from agreed pay scales.
4. Set overhead absorption rates. Budgeted overheads are divided by budgeted activity (usually standard labour hours or units) to give standard fixed and variable overhead rates.
5. Record the standard cost card for each product: quantity, price and cost of every element.
6. Collect actual data from the accounting records. Actual material prices come from purchase invoices; actual quantities from stores requisitions and inventory records; actual hours from clock cards, time sheets and job cards; actual wage cost from the payroll; actual overheads from the ledger expense accounts. Actual output comes from production reports.
7. Calculate and report variances promptly, usually monthly, to the manager responsible.
8. Investigate significant variances and take action. Review the standards regularly so they stay realistic.

Calculating variances (2.5.3)

Every variance compares an actual figure with the standard allowed for the actual output, not the original budget. This is the same idea as a flexible budget.

MATERIALS
Price variance  = (standard price - actual price) x actual quantity
Usage variance  = (standard quantity for actual output - actual quantity) x standard price
Total variance  = standard material cost of actual output - actual material cost
                = price variance + usage variance

LABOUR
Rate variance        = (standard rate - actual rate) x actual hours
Efficiency variance  = (standard hours for actual output - actual hours) x standard rate
Total variance       = standard labour cost of actual output - actual labour cost
                     = rate variance + efficiency variance

OVERHEADS
Total variable overhead variance = standard variable overhead for actual output
                                   - actual variable overhead
Total fixed overhead variance    = fixed overhead absorbed by actual output
                                   (actual output x standard fixed overhead per unit)
                                   - actual fixed overhead

Set out this way, a positive answer is favourable and a negative one adverse.

Worked example 1: Thurlby Ceramics Ltd

Thurlby Ceramics Ltd makes glazed washbasins. Its standard cost card for one basin is:

Element	Standard	Cost
Direct materials	12 kg of clay at 1.50 per kg	18.00
Direct labour	1.5 hours at 16.00 per hour	24.00
Variable overhead	1.5 hours at 4.00 per hour	6.00
Fixed overhead	1.5 hours at 10.00 per hour	15.00
Standard cost per basin		63.00

The fixed overhead rate came from budgeted fixed overheads of 60,000 and budgeted output of 4,000 basins (6,000 standard hours).

In March the company made 3,800 basins. Actual results:

• 47,400 kg of clay bought and used, costing 67,308
• 5,520 labour hours worked, costing 89,976
• variable overhead 23,460; fixed overhead 58,200

Step 1: standards for actual output. Standard quantity = 3,800 x 12 = 45,600 kg. Standard hours = 3,800 x 1.5 = 5,700 hours.

Step 2: actual prices. Actual price per kg = 67,308 / 47,400 = 1.42. Actual rate per hour = 89,976 / 5,520 = 16.30.

Step 3: material variances.

Price:  (1.50 - 1.42) x 47,400        = 3,792 F
Usage:  (45,600 - 47,400) x 1.50      = 2,700 A
Total:  (45,600 x 1.50) - 67,308
        = 68,400 - 67,308             = 1,092 F
Check:  3,792 F - 2,700 A             = 1,092 F

Step 4: labour variances.

Rate:        (16.00 - 16.30) x 5,520   = 1,656 A
Efficiency:  (5,700 - 5,520) x 16.00   = 2,880 F
Total:       (5,700 x 16.00) - 89,976
             = 91,200 - 89,976         = 1,224 F

Step 5: overhead variances.

Total variable overhead:  (3,800 x 6.00) - 23,460
                          = 22,800 - 23,460       = 660 A
Total fixed overhead:     (3,800 x 15.00) - 58,200
                          = 57,000 - 58,200       = 1,200 A

Step 6: summary. The standard cost of 3,800 basins is 3,800 x 63 = 239,400. Actual cost is 67,308 + 89,976 + 23,460 + 58,200 = 238,944.

Variance	F	A
Material price	3,792
Material usage		2,700
Labour rate		1,656
Labour efficiency	2,880
Total variable overhead		660
Total fixed overhead		1,200
Totals	6,672	6,216
Net variance	456 F

Check: standard cost 239,400 - actual cost 238,944 = 456 F, the same as the net of the six variances. Always do this check: if the two disagree, a variance is wrong or mislabelled.

Understanding the fixed overhead variance

In standard costing, fixed overhead is absorbed at the standard rate on the standard hours for actual output (here 5,700 x 10 = 57,000), not on actual hours as in the introduction to costing topic. The total fixed overhead variance is therefore the under- or over-absorption. At Thurlby it has two causes, which help when you explain it:

• spending: actual fixed overhead 58,200 was 1,800 below the budget of 60,000 (favourable)
• volume: output of 3,800 was 200 basins short of the 4,000 budgeted, so 200 x 15 = 3,000 of budgeted fixed overhead was not absorbed (adverse)

1,800 F - 3,000 A = 1,200 A. The specification only asks for the total variance, but this split is a strong basis for explaining it.

Possible reasons for variances (2.5.4)

Variance	Possible favourable reasons	Possible adverse reasons
Material price	Bulk discounts; cheaper supplier; lower-grade material	Price rises; lost discounts; urgent purchases; higher-grade material
Material usage	Better material; skilled workers; new machinery	Poor material; inexperienced staff; theft; badly maintained machines
Labour rate	Less skilled (lower-paid) staff; fewer overtime hours	Pay rise; overtime premiums; more skilled staff; bonuses
Labour efficiency	Skilled or motivated staff; better material or machines	New or unskilled staff; breakdowns; poor material; idle time
Total variable overhead	Lower power or consumables prices; fewer hours worked	Price rises for power and consumables; more hours worked than standard
Total fixed overhead	Spending below budget; output above budget (over-absorption)	Spending above budget (rent, insurance rises); output below budget (under-absorption)

A favourable variance is not automatically good, and any variance may reflect a poor standard rather than poor performance.

Interrelationships between variances (2.5.5)

One decision often causes variances in more than one place, so a manager should not be judged on a single variance in isolation.

• Cheap material. Lower-grade material gives a favourable price variance but can cause an adverse usage variance (more waste) and an adverse labour efficiency variance (slower work).
• Skilled labour. Experienced, higher-paid staff give an adverse rate variance but often a favourable efficiency variance and a favourable material usage variance.
• Hours and overheads. If variable overhead is absorbed on labour hours, an adverse labour efficiency variance usually brings an adverse variable overhead variance, because more hours use more power and consumables.

At Thurlby, the 3,792 F price variance and the 2,700 A usage variance suggest a cheaper, lower-grade clay that caused more waste. The 1,656 A rate variance and 2,880 F efficiency variance suggest more skilled workers on a higher rate. The variable overhead cost 4.25 per actual hour against a standard of 4.00, so its 660 A variance is a spending problem despite the time saved.

Management by exception (2.5.6)

Management by exception means managers concentrate only on variances that are significant, and leave the rest. Most small variances are random, so this saves time. A business sets a rule, for example a percentage of standard cost or a fixed amount, above which a variance is investigated. Significant favourable variances are investigated too: they may reveal a standard that is too loose, or a saving that should become the new standard.

Worked example 2: Skelwith Mats Ltd

Skelwith Mats Ltd investigates any variance that is more than 5% of the related standard cost or more than 1,500. Its April report:

Variance	Amount	Standard cost of actual output	% of standard	Investigate?
Material price	640 F	32,000	2.0%	No
Material usage	2,240 A	32,000	7.0%	Yes
Labour rate	380 A	18,000	2.1%	No
Labour efficiency	1,170 A	18,000	6.5%	Yes
Total variable overhead	210 A	6,000	3.5%	No
Total fixed overhead	1,600 A	20,000	8.0%	Yes

Three variances are investigated. Usage and efficiency are both adverse, so a shared cause (a faulty machine or poor material) is worth checking first.

Benefits: managers’ time goes where it matters, and small random variances do not trigger pointless enquiries. Limitations: a small variance that grows each month can be missed; the threshold is a judgement; and offsetting variances can make a total look acceptable when its parts are not.

Common errors

• Using budgeted output instead of actual output to find standard quantity and standard hours.
• Multiplying the price variance by standard quantity, or the usage variance by actual price.
• Absorbing fixed overhead on actual hours rather than standard hours for actual output.
• Leaving off F or A, or labelling a cost saving as adverse.
• Not checking that sub-variances add to the total variance.
• Giving reasons that do not match the direction of the variance.

Official syllabus

Pearson Edexcel International Advanced Subsidiary/Advanced Level in Accounting (XAC11/YAC11) specification, Issue 2, September 2018 (first teaching September 2015), Pearson Education Limited. Unit 2: Corporate and Management Accounting, topic 2.5 Standard costing.