Standard costing values its manufactured products with a predetermined materials cost, a predetermined direct labor cost, and a predetermined manufacturing overhead cost. These standard costs will be used for valuing the manufacturer’s cost of goods sold and inventories. If the actual costs vary only slightly from the standard costs, the resulting variances will be assigned to the cost of goods sold. If the variances are significant, they should be prorated to the cost of goods sold and to the inventories.

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A product’s manufacturing cost, consisting of direct materials, direct labor and manufacturing overhead, is used to report the cost of goods sold and also the cost of units in inventory. Therefore, if you look at the detail of a product’s inventory cost, you may see the manufacturing overhead being assigned or applied to the unit through a burden rate.

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The overhead rate is normally a predetermined rate—meaning that it was calculated prior to the start of the accounting year by using 1) the expected amount of overhead costs, and 2) the expected volume of production. Because of these two estimates, it is unlikely that the amount of overhead allocated, applied, assigned, or absorbed will be equal to the actual overhead costs incurred.

If the actual products manufactured are assigned or absorb more overhead through the overhead rate than the actual amount of overhead costs incurred, the products have overabsorbed the overhead costs.

At the end of the accounting year, the amount of the overapplied, overassigned, or overabsorbed overhead is often credited to the cost of goods sold. The reasons are 1) the overabsorbed amount is not significant, and 2) most of the products absorbing too much overhead costs have been sold. If the overabsorbed amount is significant, then the amount overabsorbed must be prorated or allocated as a reduction to the cost of the inventories and to the cost of goods sold based on where the overabsorbed overhead costs are residing at the end of the accounting year.

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On the other hand, the materials usage variance, the labor efficiency variance, and the variable manufacturing efficiency variance are indicators of operating efficiency. However, it is possible that some of these variances could result from standards that were not realistic. For example, if it realistically takes 2.4 hours to produce a unit of output, but the standard is set for 2.5 hours, there should be a favorable variance of 0.1 hour. This 0.1 hour variance results from the unrealistic standard, rather than operational efficiency.

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While a simple cost system using just one cost driver (machine hours) may result in accurate financial statements, it often fails to provide the true cost of individual products that vary in complexity. For example, one product might require very few machine hours but will require many hours of special handling. The costs assigned on the basis of machine hours alone will be too low in relationship to the true cost of manufacturing this product. Another product might require many machine hours but no other activities. This product’s cost will be overstated because the rate assigned via the machine hours will include an amount for other activities that generally occur for the other products manufactured.

A cost system developed for inventory valuation is limited to the cost of direct materials, direct labor, and manufacturing overhead. The total cost of providing products to a customer will also include nonmanufacturing expenses. One customer might require a company to incur additional selling, delivering, storing, and administrative expenses. Another customer might not require any of those activities and their related expenses.

Activity based costing attempts to calculate the true cost of a product and customer by assigning costs and expenses based on their root causes. Because there are many root causes, the company will assign costs based on many cost drivers. This results in more accuracy for the cost and expense of a specific product for a specific customer than simply spreading the manufacturing costs on the basis of one cost driver such as machine hours.

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For example, if a direct material has a standard cost of $400 but the company paid $422, the financial statement must report $422 (the standard cost of $400 plus the price variance of $22).

How the variances are reported on the financial statements is discussed in the last part of the topic Standard Costing.

Variance analysis helps management to understand the present costs and then to control future costs.

Variance analysis is also used to explain the difference between the actual sales dollars and the budgeted sales dollars. Examples include sales price variance, sales quantity (or volume) variance, and sales mix variance. A difference in the relative proportion of sales can account for some of the difference in a company’s profits.

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Absorption costing is often contrasted with variable costing or direct costing. Under variable or direct costing, the fixed manufacturing overhead costs are not allocated or assigned to (not absorbed by) the products manufactured. Variable costing is often useful for management’s decision-making. However, absorption costing is required for external financial reporting and for income tax reporting.

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If the actual price per unit of direct materials is more than the standard cost per unit, the difference will be entered as a debit into the account Direct Materials Price Variance. If the actual price per unit of direct materials is less than the standard cost per unit, the difference will be entered as a credit into the price variance account.

The account Direct Materials Usage Variance will have a debit entered when the actual quantity of direct material used is greater than the standard quantity for the good output. If the actual quantity of direct material is less than the standard quantity of direct material for the good output, a credit is entered into the usuage variance account.

If the standards are realistic, a manufacturer would be pleased with a zero balance in its variance accounts. A credit balance in a variance account signifies that things were better than standard. A debit in a variance account indicates that things were worse than the standard.

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Let’s assume that a lower costing material is purchased in order to achieve a favorable materials price variance. If the materials have some negative attributes, it is possible that an unfavorable materials usage variance could result. If the materials’ attributes cause additional labor hours, then an unfavorable direct labor efficiency variance will result. If the materials required more experienced labor, it is possible that a labor rate variance will also occur.

The above example can also extend to the overhead variances. If more electricity and supplies had to be used because of the materials’ attributes, there will be an unfavorable variable overhead efficiency variance. If the volume of output is curtailed by the materials’ attributes, there could possibly be a fixed overhead volume variance.

Companies should have specifications for its materials in order to prevent the above situation from occurring.

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Assume that a manufacturer determines that its cost of electricity and supplies for the factory are approximately $10 per machine hour (MH). It also knows that the factory supervision, depreciation, and other fixed costs are approximately $40,000 per month. Typically, the production equipment operates between 4,000 and 7,000 hours per month. Based on this information, the flexible budget for each month would be $40,000 + $10 per MH.

Now let’s illustrate the flexible budget by using some data. If the production equipment is required to operate for 5,000 hours during January, the flexible budget for January will be $90,000 ($40,000 fixed + $10 x 5,000 MH). If the equipment is required to operate in February for 6,300 hours, then the flexible budget for February will be $103,000 ($40,000 fixed + $10 x 6,300 MH). If March requires only 4,100 machine hours, the flexible budget for March will be $81,000 ($40,000 fixed + $10 x 4,100 MH).

If the plant manager is required to use more machine hours, it is logical to increase the plant manager’s budget for the additional cost of electricity and supplies. The manager’s budget should also decrease when the need to operate the equipment is reduced. In short, the flexible budget provides a better opportunity for planning and controlling than does a static budget.

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The volume variance is also referred to as the production volume variance, the capacity variance, or the idle capacity variance.

In November 2004, the Financial Accounting Standards Board issued its Statement No. 151, which discusses the reporting of the fixed production overhead when less than normal capacity is utilized. The FASB’s Statements of Financial Accounting Standards are available at no cost at www.FASB.org/st.

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Fixed overhead costs are the indirect manufacturing costs that are not expected to change when the volume of activity changes. Some examples of fixed manufacturing overhead include the depreciation, property tax and insurance of the factory buildings and equipment, and the salaries of the manufacturing supervisors and managers.

Since the fixed manufacturing overhead costs should remain the same within reasonable ranges of activity, the amount of the fixed overhead budget variance should be relatively small.

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For example, if a company produces artisan furniture, the cost of the wood and the cost of the craftsperson are direct costs—they are clearly traceable to the production department and to each item produced—no allocation was needed. On the other hand, the rent of the building that houses the production area, warehouse, and office is not a direct cost of either the production department or the items produced. The rent is an indirect cost—an indirect cost of operating the production department and an indirect cost of crafting the product.

To calculate the total cost of the production department or to calculate each product’s total cost, it is necessary to allocate some of the rent (and other indirect costs) to the department and to the product.

I associate indirect with allocation and arbitrary.

When preparing the financial statements, a debit balance in the Materials Usage Variance account (which means an unfavorable variance) will have to be added to the standard cost of the products. If the standard costs associated with the variance are in the goods that have been sold, the debit balance in the variance account will be added to the Cost of Goods Sold, an income statement expense. (This is reasonable, because the standard cost is too low compared to the actual cost of the materials.) If the output associated with the variances is entirely in finished goods inventory, then the debit balance in the variance account will be added to the finished goods inventory amount reported on the balance sheet. Again, this is necessary because the standard cost of the finished goods inventory is too low. If the products are in work in process, finished goods inventory, and cost of goods sold, you would assign the variance to all three categories based on the proportions associated with the variance amounts. Accountants refer to this as prorating the variances. If the variance amount is insignificant, accountants will simply assign these small variances to the cost of goods sold. This is reasonable if most of the goods that were produced have been sold. Generally, inventories are small in relation to the quantities produced.

Credit balances in the variance accounts represent favorable variances and will reduce the standard costs that are reported as debit balances in inventory on the balance sheet or as cost of goods sold expense on the income statement. The favorable variances will be prorated as discussed above or simply credited to cost of goods sold when the variances are not significant or material in amount.

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Three examples of fixed manufacturing overhead costs include 1) depreciation of the manufacturing equipment, 2) the property tax on the factory building, and 3) the salaries of the factory supervisors. Each of these costs comes in large dollar amounts (they do not occur at a rate of say $1.00 per unit) and none is directly traceable to the products manufactured. The dollar amount of each of these costs will probably not change if the company produces 10% more units or 10% fewer units.

Because the fixed manufacturing overhead costs are indirect product costs (not directly traceable to the products) the accountant allocates (or assigns or applies) these costs to the products on some basis—perhaps on the basis of machine hours or through activity-based costing. While the accountant assigns or allocates these costs, the products are said to be absorbing these fixed manufacturing costs. (Absorption costing, which is required for external financial statements, means that each product’s cost includes direct materials, direct labor, variable manufacturing overhead, and fixed manufacturing overhead.)

Fixed manufacturing overhead cost is usually applied to the products (and is absorbed by the products) through the use of a predetermined annual overhead rate that is based on some planned volume of production. If the actual product volume is less than the planned volume (and the costs are as planned) the fixed manufacturing overhead will be “under-absorbed.” When the actual volume exceeds the planned volume and the costs are as planned, the fixed manufacturing overhead will be “over-absorbed.”

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The direct labor efficiency variance compares the standard hours that it should have taken to make the actual output Vs. the actual hours it took and multiplies the difference in hours by the standard cost per direct labor hour.

Here’s an example with amounts. Let’s assume the standard for direct labor is 3 hours per unit of output and the standard cost for an hour of direct labor is $10. Let’s say the output for the period is 6,000 units and the actual direct labor hours were 18,400 hours and the labor earned $10.30 per hour. The standard direct labor cost for the actual output should have been 18,000 hours (6,000 units of output times 3 standard hours) at $10 per hour for a total of $180,000. The actual direct labor cost was $189,520 (18,400 hours at $10.30 per hour). This means a TOTAL (efficiency and rate) variance of $9,520. Some of that variance is due to the rate being $0.30 too much and some of that variance is due to the direct labor using too many hours—not being efficient.

The direct labor efficiency variance focuses on the direct labor hours: 6,000 units of output should have taken 3 hours each for a total of 18,000 direct labor hours. The actual direct labor hours were 18,400 hours. This means there was an unfavorable direct labor efficiency variance of 400 hours times the standard rate of $10 for a total of $4,000.

The direct labor rate variance is the $0.30 unfavorable variance in the hourly rate ($10.30 actual rate Vs. $10.00 standard rate) times the 18,400 actual hours for an unfavorable direct labor rate variance of $5,520.

The combination of the unfavorable direct labor efficiency variance of $4,000 + the unfavorable direct labor rate variance of $5,520 is the total unfavorable direct labor variance of $9,520.

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