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Managerial Accounting Unit 8: Standard Costs and Variance Analysis

Standard costs set benchmarks for what inputs should cost, and variances measure how actual results differ. This unit teaches the flexible budget and every core variance formula.

Covers: Setting ideal and practical standards, Flexible budgets and activity vs. spending variances, Materials price and quantity variances, Labor rate and efficiency variances, Variable overhead spending and efficiency variances, Fixed overhead budget and volume variances, Management by exception and variance causes

Study guide

A standard cost is a carefully set benchmark for one unit of input or output, such as 3 pounds of material at $5 per pound. Ideal standards assume perfect efficiency and are rarely met, which can discourage workers; practical standards allow for normal waste, breaks and downtime and are tight but attainable. Standards are combined on a standard cost card showing the standard quantity and price for each input. Differences between actual and standard costs are variances. A variance is favorable (F) when actual cost is below standard and unfavorable (U) when above. Managers use management by exception, investigating only significant variances.

Before computing cost variances, compare actual results with a flexible budget, which restates the budget at the actual level of activity using cost formulas. The static budget is for the planned level only. The difference between the flexible and static budgets is the activity (volume) variance, caused only by the change in volume. The difference between actual results and the flexible budget is the spending or flexible budget variance, caused by prices and efficiency. Comparing actual costs directly with a static budget is misleading when activity changes, because higher volume naturally raises variable costs.

Direct materials and direct labor variances use one general model. A price variance = actual quantity × (actual price - standard price), and a quantity variance = standard price × (actual quantity - standard quantity allowed for actual output). For materials these are the materials price and quantity variances; for labor, the labor rate variance = AH × (AR - SR) and the labor efficiency variance = SR × (AH - SH). If materials purchased differ from materials used, the price variance uses the quantity purchased and the quantity variance uses the quantity used. Purchasing managers usually answer for price variances, while production supervisors answer for quantity and efficiency variances.

Variable overhead follows the same model. The spending variance = actual VOH - (AH × standard rate), and the efficiency variance = standard rate × (AH - SH). The VOH efficiency variance really measures efficient use of the allocation base, such as labor-hours, not of overhead itself. Fixed overhead is different because it does not change with activity. The budget variance = actual fixed OH - budgeted fixed OH, and the volume variance = budgeted fixed OH - applied fixed OH, where applied = fixed rate × standard hours allowed. The volume variance reflects using more or less capacity than the denominator level, not spending. Variances interact, so cheaper materials may cause extra waste.

Key ideas

• Standards are benchmarks; practical standards are preferred over ideal standards.
• Flexible budgets restate costs at actual activity, separating volume effects from spending.
• Price (rate, spending) variances use actual quantity; quantity (efficiency) variances use standard price.
• Standard quantity allowed is always based on actual output.
• Unfavorable cost variances mean actual cost exceeded the standard cost allowed.
• Fixed overhead has a budget variance (spending) and a volume variance (capacity use).
• Variances can be related, so investigate causes before assigning blame.

Formulas and rules

Common mistakes

• Computing standard quantity or hours from budgeted output instead of actual output.
• Using actual price in the quantity variance or standard quantity in the price variance.
• Using quantity used instead of quantity purchased when the price variance is taken at purchase.
• Comparing actual costs with the static budget when activity differs from plan.
• Calling a favorable volume variance a sign of fixed cost savings.

Before the test, make sure you can

• Explain the difference between ideal and practical standards.
• Prepare a flexible budget and split total variance into activity and spending variances.
• Calculate materials price and quantity variances, including when purchases differ from usage.
• Calculate labor rate and efficiency variances.
• Calculate variable overhead spending and efficiency variances.
• Calculate fixed overhead budget and volume variances and interpret each.
• Identify likely causes of variances and who is responsible for them.
• Work variance formulas backward to find missing quantities.

Words to know

Standard cost

A benchmark cost for one unit of an input or output under expected conditions.

Ideal standard

A standard assuming perfect efficiency with no waste, breakdowns or idle time.

Practical standard

A standard that is tight but attainable, allowing for normal waste and downtime.

Standard cost card

A record listing the standard quantity and price of each input for one unit.

Standard quantity allowed

Standard quantity per unit times the actual number of units produced.

Static budget

A budget prepared for one planned level of activity.

Flexible budget

A budget adjusted to the actual level of activity using cost formulas.

Activity variance

The difference between the flexible budget and the static budget, caused by volume.

Spending variance

The difference between actual results and the flexible budget.

Materials price variance

AQ × (AP - SP): the effect of paying a different price for materials.

Materials quantity variance

SP × (AQ - SQ): the effect of using more or less material than allowed.

Labor rate variance

AH × (AR - SR): the effect of paying a different wage rate.

Labor efficiency variance

SR × (AH - SH): the effect of using more or fewer labor-hours than allowed.

Variable overhead efficiency variance

SR × (AH - SH) for overhead; measures efficient use of the allocation base.

Fixed overhead volume variance

Budgeted fixed overhead minus applied fixed overhead; reflects capacity use.

Denominator activity

The activity level used to compute the predetermined fixed overhead rate.

Management by exception

Focusing attention on significant variances rather than all deviations.

Sample practice questions

30 more questions like these, from level 1 to 5, are in the practice set.