Terms and Definitions:

Standard
The expected cost of one quantity
The quantity you expect to use to make one product.
A “standard” is normally a “per each” amount

Quantity Standard – how much should be used to make one

Cost (Price) Standard – how much should be paid for each one

Ideal Standards –
attained only under ideal/perfect circumstances

Practical Standards –
“tight” but attainable (allow for normal downtime and efficiency)

Variance
Difference in actual dollars incurred and the standard/budgeted dollars to make the product

Variance calculations are done for all product costs.

Unfavorable
Incurred more than the standard/budget cost
It cost more than expected to make the products

Favorable
Incurred less than the standard/budgeted
It cost less than expected to make the products

Predetermined Overhead Rate
The estimated manufacturing overhead cost incurred every-time the selected MOH activity occurs to make the product

The rate is stated in terms of “dollars per” something

The “something” can be direct labor hours worked, machine hours used, material used, total direct labor cost, etc. – called an “activity base”

Apply Overhead:

Assign manufacturing overhead costs to a product or a job based on how many times the “activity” occurs, using the predetermined overhead rate.

A predetermined overhead rate is used in the variance calculation as the standard price for what variable or fixed overhead costs the company.

Example:

Management develops a standard cost sheet (estimated quantity and cost) each product for direct material, direct labor, and manufacturing overhead. The estimates are written on a “standard cost sheet/card” to arrive at a total standard cost to make each product.

The standard cost sheet to manufacture one pair of thick socks would look like this:

Each type of material and labor has a quantity and a cost per each. The overhead in this example is based on direct labor hours, and the $2.50 was determined by using the predetermined overhead rate.

Management uses these standards to do variance analysis. The standard is the estimate of what management expects it to cost to manufacture the product. Management compares what it actually cost to manufacture the product with the standard/estimated cost. Comparing estimated cost to actual cost is called variance analysis.

Setting Direct Material Standards:

The standard quantity for direct materials should reflect the amount of each type of material
required to make one finished product. The standard usually gives extra for waste, spoilage,
and normal inefficiencies.

A bill of materials is used to show all the types of material and how much is used of each type of material to make one finished product.

Setting Direct Labor Standards:

Direct labor rate standards are expressed in terms of a labor rate (per hour)
The rate paid per hour includes the hourly wage, and usually taxes, & benefits

Direct labor quantity standards are expressed in terms of labor hours;
The time in hours required to make one product (include breaks/downtime)

Setting Variable Overhead Standards:

A variable overhead standard is an estimate of how much variable overhead cost will be incurred to make one product.

The estimated cost is stated in terms of how many overhead dollars are expected to be spent every time you do something (the activity),
Activity Examples: labor hours, machine hours, yards of material used, etc.

1st – Determine the total amount for the year of the activity. The activity should be what is done that causes overhead dollars to be incurred and it is easily counted.

Total products to produce
x  Quantity of the activity each one takes
= Total Activity

Ex: produce 500,000 products x each one takes ½ hour = 250,000 total hours

2nd – Estimate total variable overhead costs for the period (Ex: $750,000)
The period is normally one year.

3rd – Divide by the total amount of activity that will be used during the year (1st) to get a predetermined variable overhead rate.

$750,000 total annual variable overhead
250,000 total hours for the year

= $3 per hour

The quantity standard for variable overhead is the quantity of the activity used in the denominator that it takes to make one product. In this example, for manufacturing overhead quantity, you would use the actual number of direct labor hours that were worked during the period.

Important to understand:

The “$3 per hour” means than management expects to spend/incur $3 for manufacturing overhead costs every time a direct labor hour is worked.

Format of Variable Cost Variances:

Actual Quantity  		     Actual Quantity  		       Actual Units Made 
								             X  Quantity required to make One
								                = Standard Quantity
 X Actual Price		        X  Standard Price		                X  Standard Price   

(AQ  X  AP)			       (AQ  X  SP)		                      (SQ  X  SP)

         $		 		               $                                                     $

          difference is the variance		               difference is the variance

                Materials Price  		             	            Materials Quantity 
	        Labor Rate					            Labor Efficiency
	        Overhead Spending			           Overhead Efficiency

	

For material you do two middle calculations because you may not use all you buy:
1) use the actual quantity purchased – this is compared to left AQ X AP
2) use the actual quantity used – this is compared to right SQ X SP

Use the above formula for direct material, direct labor, and variable manufacturing O/H

Unfavorable: The left is greater than the right
Unfavorable means the company incurred more than the standard/expected

Favorable: The right is greater than the left
Favorable means you have spent less than the standard/expected