Standard Costing (Explanation Part 1)

Introduction to Standard Costing

Standard costing is an important subtopic of cost accounting. Historically, standard costs have been associated with a manufacturing company’s costs of direct materials, direct labor, and manufacturing overhead.

Rather than assigning the actual costs of direct materials, direct labor, and manufacturing overhead to a product, some manufacturers assign the expected or standard costs. This means that a manufacturer’s inventories and cost of goods sold will begin with amounts that reflect the standard costs, not the actual costs, of a product. Since a manufacturer must pay its suppliers and employees the actual costs, there are almost always differences between the actual costs and the standard costs, and the differences are noted as variances.

NOTE:
Standard costs can also be thought of as:

• Planned costs
• Expected costs
• Budgeted costs
• “Should be” costs
• Benchmark costs

Standard costing (and the related variances) is a valuable management tool. If a variance arises, it tells management that the actual manufacturing costs are different from the standard costs. Management can then direct its attention to the cause of the differences from the planned amounts.

If we assume that a company uses the perpetual inventory system and that it carries all of its inventory accounts at standard cost (including Direct Materials Inventory or Stores), then the standard cost of a finished product is the sum of the standard costs of these inputs:

1. Direct materials
2. Direct labor
3. Manufacturing overhead
   1. Variable manufacturing overhead
   2. Fixed manufacturing overhead

Usually there will be two variances computed for each input:

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Sample Standards Table

Let’s assume that your Uncle Pete runs a retail outlet that sells denim aprons in two sizes. Pete suggests that you get into the manufacturing side of the business, so on January 1, 2023, you start up an apron production company called DenimWorks. Using the best information at hand, the two of you compile the following information to establish the standard costs for 2023:

Standards Table for DenimWorks

The aprons are easy to produce, and no apron is ever left unfinished at the end of any given day. This means that DenimWorks will never have work-in-process inventory at the end of an accounting period.

When we make the journal entries for completed aprons, we’ll use an account called Inventory-FG which means Finished Goods Inventory. We’ll also be using the account Direct Materials Inventory or Raw Materials Inventory or Stores. Most manufacturers will also have an account
entitled Work-in-Process Inventory, which is commonly referred to as WIP Inventory.

Direct Materials Purchased: Standard Cost and Price Variance

Direct materials are the raw materials that are directly traceable to a product. In your apron business the main direct material is the denim. (In a food manufacturer’s business the direct materials are the ingredients such as flour and sugar; in an automobile assembly plant, the direct materials are the cars’ component parts).

DenimWorks purchases its denim from a local supplier with terms of net 30 days, FOB destination. This means that title to the denim passes from the supplier to DenimWorks when DenimWorks receives the material. When the denim arrives, DenimWorks will record the denim received in its Direct Materials Inventory at the standard cost of $3 per yard (see the standards table above) and will record a liability for the actual cost of the material received. Any difference between the standard cost of the material and the actual cost of the material received is recorded as a purchase price variance.

Examples of Standard Cost of Materials and Price Variance

Let’s assume that on January 2, 2023, DenimWorks ordered 1,000 yards of denim at $2.90 per yard. On January 8, DenimWorks receives the 1,000 yards of denim and the supplier’s invoice for the actual cost of $2,900. On January 8, DenimWorks becomes the owner of the material and has a liability to its supplier. On January 8, DenimWorks’ Direct Materials Inventory is increased by the standard cost of $3,000 (1,000 yards of denim at the standard cost of $3 per yard), Accounts Payable is credited for $2,900 (the actual amount owed to the supplier), and the difference of $100 is credited to Direct Materials Price Variance. Putting this information in a general journal entry looks like this:

The $100 credit to the Direct Materials Price Variance account indicates that the company is experiencing actual costs that are more favorable than the planned, standard costs.

In February, DenimWorks orders 3,000 yards of denim at $3.05 per yard. On March 1, DenimWorks receives the 3,000 yards of denim and the supplier’s invoice for $9,150 due in 30 days. On March 1, the Direct Materials Inventory account is increased by the standard cost of $9,000 (3,000 yards at the standard cost of $3 per yard), Accounts Payable is credited for $9,150 (the actual cost of the denim), and the difference of $150 is debited to Direct Materials Price Variance as an unfavorable price variance:

After the March 1 transaction is posted, the Direct Materials Price Variance account shows a debit balance of $50 (the $100 credit on January 8 combined with the $150 debit on March 1). A debit balance in any variance account means it is unfavorable. It means that the actual costs are higher than the standard costs and the company’s profit will be $50 less than planned unless some action is taken.

On June 1 your company receives an additional 3,000 yards of denim at an actual cost of $2.92 per yard for a total of $8,760 due in 30 days. The entry is:

Direct Materials Inventory is debited for the standard cost of $9,000 (3,000 yards at $3 per yard), Accounts Payable is credited for the actual amount owed, and the difference of $240 is credited to Direct Materials Price Variance. The $240 variance is favorable since the company paid $0.08 per yard less than the standard cost per yard x the 3,000 yards of denim.

NOTE:
A debit to a variance account indicates unfavorable.
A credit to a variance account indicates favorable.

After this transaction is recorded, the Direct Materials Price Variance account shows a credit balance of $190. A credit balance in a variance account is always favorable. In other words, your company’s profit will be $190 greater than planned due to the lower than expected cost of direct materials.

Note that the entire price variance pertaining to all of the direct materials received was recorded immediately (as opposed to waiting until the materials were used).

We will discuss later how to handle the balances in the variance accounts under the heading What To Do With Variance Amounts.