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 concentrates on cost units, in other words 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. We have also discussed how labour variances can be analysed to see how the actual cost differs from the expected cost that was budgeted using standard costing.
In this article, we’re going to focus on a raw material cost statement and see how material’s price and usage variances are used to monitor actual costs against budgeted costs.
Using standard costing as a budget accountant
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 ET2709. This is a new product and as yet a standard cost card hasn’t been created. However, it was included in the budget and has been in production for the last quarter, consequently, some activity data is available:
You need to prepare a raw material cost statement from the information you have as part of the monthly monitoring cycle. The statement shows material variances which can then be used to analyse why the actual costs have deviated from the budget.
Whilst there are only four boxes to complete, a good understanding of both standard costing and variance analysis is needed in order for the figures in them to be correct.
What does standard costing do?
Let’s start with clarifying what standard costing does. Fundamentally, it establishes, in detail, the standard cost of each component of a product and then calculates its total standard cost. In this case, we are only dealing with one component and that’s raw material. We can establish, from the information in the budget row of the activity data, that:
- the standard cost per unit is £4.36 (£37,060 ÷ 8,500 units)
- the standard cost of the raw material per kilo is £5.45 (£37,060 ÷ 6,800kg).
- 1 unit requires 0.8kg of the raw material (6,800kg ÷ 8,500 units)
This information would normally be shown on the standard cost card. However, understanding these calculations is important if we are to accurately calculate and understand the figures that feature on the cost statement.
That isn’t the only underpinning knowledge we need. In order to calculate the standard material cost of production, we also need to be familiar with flexing budgets so we can apply the standard cost to the actual production levels. The calculation to do that is:
- Standard cost per unit x actual quantity of units produced
- £4.36 x 8,300 = £36,188
Next we need to draw on our knowledge and understanding of variances and variance analysis. A variance is the difference between the actual cost and the budgeted cost*, usually after it has been flexed. The variance is then analysed to see if it’s favourable or adverse, in other words, whether the actual cost is more than or less than expected.
Working out the material cost variance
The material cost variance is therefore the difference between the actual cost of £36,412 and the flexed budgeted cost of £36,188, which is £224. The variance is analysed as adverse because the actual cost of the raw materials was more than expected, based on the standard cost for the actual level of production:
Standard costing allows us to analyse this overall variance to understand what proportion of it is the result of paying a different price to the standard, and how much is due to using more or less materials than expected. This is done by calculating the price and usage variances.
Calculating the direct material price variance
The direct material price variance looks at different material prices, standard and actual, and calculates figures that are comparable, as both relate to the actual quantity of material used. It is calculated as:
Standard cost of actual materials used
Actual cost of actual materials used
In this case:
- £5.45 x 6,806kg – £36,412 = £680.70
The calculation tells us that the standard cost of materials should have been £37,092.70. However, the actual cost was £36,412 so the variance is analysed as favourable as the cost is less than expected due to the actual price paid.
Calculating the actual rate paid
We can verify this by calculating the actual rate paid:
- £36,412 ÷ 6,806kg = £5.35
And sanity check our figures by reconciling the variance because the £0.10 less paid per kilo in comparison to the standard price of £5.45, accounts for the difference, bar a rounding discrepancy:
- £0.10 x 6,806kg = £680.60
This figure can be added to the statement:
Calculating the direct material usage variance
The direct material usage variance looks at different amounts of material used, again standard and actual, and converts them both into standard values, using the standard price, so they can be compared like for like. It is calculated as:
Standard quantity of material for actual production at standard price
(ie. flexed budget standard cost)
Actual quantity of material at standard price
In this case:
- £36,188 – 6,806kg x £5.45 = £904.70
We have already flexed the budget and know that the standard quantity of materials for production is 6,640kg (0.8kg x 8,300 units) and the expected materials cost is £36,188 (6,640kg x £5.45). However, the actual quantity of material used was 6,806kg and therefore the cost of raw material at standard price for the actual quantity used is £37,092.70, which results in a difference of £904.70. The variance is analysed as adverse as it cost more to make the 8,300 units than allowed as standard, because actual production used 6 kilos more than expected.
Calculating the actual material usage
We can verify this by calculating the actual material usage per unit:
- 6,806kg ÷ 8,300 units = 0.82kg
The standard cost requires 0.8kg per unit and the calculation shows that in reality each unit was made using 0.82kg instead.
The completed statement is:
The material cost variance is explained by the combination of the price and usage variances. The overall adverse variance of £224 is due to the fact that the actual price paid for material was less than standard but that the amount of material used to produce the actual number of units was slightly more than expected. The figures are reconciled as:
- £681 – £905 = -£224
* Income variances are also calculated and analysed. A favourable variance would be when the actual income is more than expected and an adverse variance when there is a shortfall.
Read more study tips for Professional Diploma in Accounting:
- Budget part 1 – compiling the material elements
- Limiting factors – using standard costing to plan for production constraints
- Understanding fixed overhead variances
Gill Myers is a self-employed accounts consultant. She has taught AAT qualifications since 2005 and written numerous articles and e-learning resources.