Budgeting with Standard Costing Series (AAT Professional Diploma)
Standard costing is used by lots of manufacturing organisations to calculate the expected costs of products. It’s distinct from general budget setting because it focuses on cost units. In other words, it focuses on the cost of what the business produces, as opposed to the costs of the business’s sections or departments. Standard costing is used in all stages of the budgetary process; planning, decision making, monitoring and control.
In previous articles we’ve considered how it can be used to help plan production when resources are limited. And in an upcoming article we’ll look at how material price and usage variances are used to monitor actual costs against budgeted costs.
In this article for the AAT Professional Diploma students, we’re going to review the monitoring and control phase, and look at how labour variances can be analysed to see how the actual cost differs from the expected cost that was budgeted, using standard costing.
How a budget accountant uses standard costing
Let’s resume the role of the budget accountant for a company that manufactures specialist windscreen wipers. Standard costing is used alongside budgeting because the components for its products are identical and the manufacturing process is repetitive.
The company makes a range of products including one coded DM0211. The standard cost card for this product show that each unit requires 40 minutes of labour, which is paid at a standard hourly rate of £20. The operating statement shows tht the cost of direct labour was £82,500 in quarter 2. The direct labour hours worked were 4,000, and 6,500 units were made and sold.
You are preparing the monthly performance indicators, based on standard costing data, which includes some labour cost variance analysis, plus the actual labour time per unit and actual labour rate.
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Carrying out variance analysis
The variance analysis starts with the overall labour cost variance. This is the difference between the actual cost and the budgeted cost, usually after it has been flexed. We already know the actual cost was £82,500 but need to calculate the flexed budgeted cost before we can calculate the variance.
What we’re calculating is how much we expected the labour cost to be, given the standard time allowed for the number of units made. Therefore, the calculation is:
- 40 mins x 6,500 units ÷ 60 mins x £20 per hour = £86,666.66
This can be rounded to whole £’s and the labour cost variance calculation is then simply:
- £82,500 – £86,667 = -£4,167
Despite the calculation resulting in a negative figure, the variance is analysed as being favourable. This is because the actual cost paid for labour was less than expected, based on the standard cost for the actual level of production:
Standard costing allows us to analyse this overall variance, and understand how much of it is the result of paying a different rate to the standard and how much is due to more or less units being produced than expected. This is done by calculating the rate and efficiency variances.
Calculating the direct labour rate variance
The direct labour rate variance looks at different labour costs, standard and actual, and calculates figures that are comparable as both relate to the actual number of labour hours worked. It is calculated as:
Standard cost of actual hours used
Actual cost of actual hours used
In this case:
- £20 x 4,000 hours – £82,500 = -£2,500
The calculation tells us that the standard cost of the labour hours used should have been £80,000. However, the actual cost was £82,500 so the variance is analysed as adverse, as the cost is higher than expected due to the rate paid.
We can verify this by calculating the actual rate paid:
- £82,500 ÷ 4,000 hours = £20.625
And sanity check our figures by reconciling the variance, because the £0.625 extra paid per hour in comparison to the standard rate of £20, accounts for the difference:
- £0.625 x 4,000 hours = £2,500
These figures can now be added into the table:
Calculating the direct labour efficiency variance
The direct labour efficiency variance looks at different numbers of hours, again standard and actual, and converts them both into standard values, using the standard labour rate, so they can be compared like for like. It’s calculated as:
Standard number of labour hours for actual production at standard rate
(ie. flexed budget/standard cost)
Actual number of labour hours at standard rate
In this case:
- £86,667 – 4,000 hours x £20 = £6,667
We’ve already flexed the budget and know that the standard number of hours for production are 4,333 (40 mins x 6,500 units ÷ 60 mins) and the expected the labour cost is £86,667*. However, actual hours used were only 4,000 and therefore the cost of labour at standard rates for the actual hours worked is £80,000, which results in a difference of £6,667.
The variance is analysed as favourable as it cost less to make the 6,500 units than allowed as standard because production took 333 hours less than expected. In other words, the workers worked at a quicker rate and were more efficient than expected and that resulted in a cost saving.
Confirming a cost saving
We can verify this by calculating the actual minutes per unit:
- 4,000 hours x 60 minutes ÷ 6,500 units = 36.92 minutes
The standard cost card allows 40 minutes per unit but in reality each unit was made roughly 3 minutes more quickly than expected.
These figures can now be added into the table:
Finally, the cost variance percentage can be calculated as a percentage of the flexed budget figure:
- 4,167 ÷ £86,667 x 100 = 4.80805
The labour cost variance is explained by the combination of the rate and efficiency variances. The overall favourable variance of £4,167 is due to the fact that the actual labour rate paid was higher than standard, but that the actual number of units produced were made in less time than expected which resulted in an efficiency saving. The figures are reconciled as:
- £6,667 – £2,500 = £4,167
Read part 2 of this series now, where we’ll look at a material variance analysis.
* Note there is a £7 round discrepancy if the standard number of hours for production is rounded to 4,333 part way through the calculation. Therefore the cost is based on the unrounded figure.
Gill Myers is a self-employed accounts consultant. She has taught AAT qualifications since 2005 and written numerous articles and e-learning resources.