JAIIB AFM Module-D Unit 5 : Standard Costing

JAIIB Paper 3 AFM Module D Unit 5 : Standard Costing (New Syllabus)

IIBF has released the New Syllabus Exam Pattern for JAIIB Exam 2023. Following the format of the current exam, JAIIB 2023 will have now four papers. The JAIIB Paper 3 (Accounting and Financial Management for Bankers) includes an important topic called “Standard Costing”. Every candidate who are appearing for the JAIIB Certification Examination 2023 must understand each unit included in the syllabus. In this article, we are going to cover all the necessary details of JAIIB Paper 3 (AFM) Module D (TAXATION AND FUNDAMENTALS OF COSTING ) Unit 5 : Standard Costing Aspirants must go through this article to better understand the topic, Standard Costing, and practice using our Online Mock Test Series to strengthen their knowledge of Standard Costing. Unit 5 : Standard Costing

Definition And Meaning Of Standard Costing

• Standard cost of a product or service refers to the costs expected to be incurred to produce a goods or provide a service under anticipated conditions, keeping in view the prevailing market conditions.

• For example: If we have to construct a residential house of 1000 sq ft carpet area with class I RCC construction, we need not calculate the cost of each construction material, labour etc. The estimate for such Construction is available with the architect/engineer, based on the detailed analysis taking into account the present market rates of all the items.

• This estimate of the cost of constructing our house, before the construction has actually started, is called the standard cost of the house.

The actual cost will be known after the house is actually constructed.

Variance = Actual cost – Estimated/ Standard cost

• The standard cost is valid only over a period of time.
• Depending of inflationary conditions, market forces of demand and supply and various other factors, a periodic updating of the standard cost may be necessary.

Significance/ Advantage Of Standard Costing

Simple and time saving technique:

• Simpler in comparison to other costing techniques
• For example, difficult exercises like time and motion study to decide labour costs are not required be conducted as standard costs are already available. This results in saving time, money and manpower, while using this technique.

Eliminate the sources of inefficiencies:

• As the technique of standard costing involves comparison of actual costs with the estimated costs by calculating the variance, it enables the management to locate and eliminate the sources of inefficiencies and wastages.

Delegation is simple:

• The delegation of authority and fixation of responsibility for each department or individual is relatively simpler in applying this technique.

Greater efficiency:

• As the standards are already known, the operating staff tends to be more competitive to achieve the standards and show greater efficiency.

More realistic:

• Prices based on standard costs are more realistic. If the selling prices are fixed on the basis of actual costs, the market may not accept these. as it is not concerned with the inefficiencies of any particular producer.  The market prefers the product which is available at the competitive price.

Applications Of Standard Costing

Some of the main applications of standard costing are as under: 

• In Planning:  The production, sales and profit budgets are prepared based on the standard costs.
• It is used for measurement of variances between standards and actuals.
• It is used to identify the areas of inefficiencies so that corrective action can be initiated.
• Controlling: It is effective in controlling the actual costs as the management gets timely information about variances at each cost centre.
• It is also used to measure the performance of each cost centre/department.
•  It can be used to motivate the workforce to contain the expenses within the set standards. It is also useful in devising an incentive system for the employees to increase productivity.
• It is useful in inventory valuation.

Various Types Of Standards

Suppose, a transport company wants to find out how many kilometres a truck driver can drive in a day. It wants to set an appropriate standard for the purpose of preparing its budgets and to compare the performance of the truck drivers employed by it. The company may fix standards on the basis of performance of a few drivers who have maximum efficiency, have very little idle time, and can work

Basic Standards 

• These are the standard which are established for use over a long period of time.
• ADVANTAGE: It provides a base over a long period for comparison of actual costs with the same standard.
• DISADVATAGE: Not very useful if frequent changes take place in production methods, price levels, labour conditions and other relevant factors.
• As they may not represent the current costs correctly, their use in practice is limited.

Ideal Standards 

• These standards take into account the perfect performance. These standards represent the costs which are achievable under the ideal operating conditions. Hence, these are more idealistic and less realistic.

• As these standards may have an adverse impact on motivation and moral of the workers, their us is also limited in practice.

Currently Attainable Standards 

• If frequent changes take place in production methods, price levels, labour conditions and other relevant factors of production, it is advisable to make necessary adjustments in the cost standard also to make it more realistic.
• A current attainable standard is a such an adjusted standard representing certain condition and for certain circumstances prevailing in a certain period.
• These standards are fixed on the basis of scientific studies but adjusted for changes in the subjective factors in current period.
• More realistic to achieve as they take into account normal idle time, wastages, break-down of machines etc.
• These standards are neither too easy to achieve nor impossible to achieve.
• Widely used in industry.

Components Of A Standard Costing System

The standard costing system involves the following components:

• Decision on the standard costs of materials, labour and overheads, for the production line
• Decision on the pricing of the products and preparing the budget of sales and profit
• Segregating, ascertaining and recording the actual costs and profits
• Finding out the variances of various cost components
• Analysing the variances and ascertaining the causes of variances
• Initiating corrective actions in areas showing variance

Standard Costs of Materials, Labour and Overheads 

Starts with ascertaining the standard costs of the elements of cost i.e. materials, labour and overheads.

As the efficacy depends largely upon the correct estimate of the standard costs, we have to exercise extreme care in deciding these.

Some of the important points in setting the cost standards, are as under: 

• Benchmark to be used in ascertaining the standards
• Peculiar operational aspects of the organisation
• Whether the standard to be applied by the organisation is basic, ideal or currently attainable standard
• Proper identification of the cost centres so that the variances may be properly segregated

Standard Cost of Materials 

• This relates to the quantities and prices of materials required to be used in producing a product.
• Therefore, we have to set both

• Materials Usage Standard and
• Materials Price Standard

• Materials Usage Standard: Ascertaining the standard quantities of materials to be used per unit of production.

• Also the specifications like size, grade etc.
• Based on an estimated unavoidable wastage, due allowance is made for normal wastage through evaporation, spillage, breaking of parts, generation of scrap in cutting, machining etc.

• Materials Price Standard: Set for the prices of materials used per unit of production.

• Due consideration is given to the efficiency of functions like purchasing and store-keeping.
• While setting the price standard, we have to keep in mind factors

• Discount on purchases,
• Economy of bulk purchasing,
• Past trend of prices and
• Anticipated changes in market price of materials required to be used.

Standard Cost of Labour 

• Two factors: labour time and wage rates.
• Set both the Standard Labour Time and the Labour Rate Standard.

• Standard Labour Time : The labour time required per unit of production. In ascertaining this time, we have to consider the performance of a particular grade of labour required for the particular operation involved in the production process.

• Setting the standard time of labour: Standards published by the International Labour Organisation (ILO) or the industry bodies or the time and motion studies conducted by the organisation.
• Past performance with adjustments for change of conditions can also form a basis for setting this standard.

• Labour Rate Standard: To the wage rates estimated to be paid to different grades of labour used for performing particular types of operations in the production process.

• The factors to be considered while setting the standard wage rates, include past and future trends of the labour market, agreement with the labour unions, statutory minimum wages etc.

Standard Overhead Costs 

• Overhead costs may be variable costs which depend on the volume of production or, the fixed costs which do not depend on the volume of production but have to be incurred over a period of time irrespective of the production volume.
• We should be able to correlate the work to be done by the service departments to the level of activity of production departments.
• The standard overhead rates for each of the service departments should be ascertained and then applied to various producing departments.
• Make use of past data, suitably adjusted for prevailing conditions and the anticipated future trends, for the purpose of ascertaining the costs of the service departments.
• The standard overhead rates for the producing departments may be expressed as a % of the direct labour costs or, machine hour rate etc.

Setting Standards for Other Costs 

• Other costs: Administrative costs and selling and distribution costs.
• For setting standards for these costs, we may use past performance data, time and motion studies standards published by industries bodies etc.
• Some of these costs may have a direct relationship with the volume of production. For example, the selling and distribution costs, may largely depend on the sales volume.

Preparing Sales and Profit Budget 

NEXT STEP IN PROCESS:

We have to decide on the sales price, based on cost of production, prices of products of the competitors, consumer preference etc.

Sales = sales volume * sales price per unit of the product

• The budget provides the estimates for the entire period for which the budget has been prepared.
• The estimates of sales, costs and profit provide a suitable base to the management to periodically review the actual performance and compare it with the budgeted one.

Variance Analysis

• Variance in standard costing refers to the deviation of actual cost from the standard cost and provides the basis for cost control by initiating the appropriate corrective actions.
• The variances indicate the extent to which the standards set have been achieved.
• Variance analysis is the process of ascertaining the amount of variance and identifying the cause of variance between actual cost and standard cost.

The cost variances can be divided into the following three broad categories, depending upon which cost element is involved:

Material Cost Variance 

• The cost of material is a finished product depends on two factors,
• 1^st : The quantity of the material consumed
• 2^nd: The price of the material consumed.

So, the variance of the actual cost of material consumed from the standard cost can also be arrived at by these two factors, as under:

Material price variance: 

• The cost of the material in the standard cost of the product is estimated by taking the prevailing prices of the material at the time of preparing the estimated.
• These estimates are for a future period and the prices may change during this period.

Illustration

In a furniture manufacturing factory, while estimating the cost of wood and steel which go into producing one table, the cost of material as ₹ 2,000

• After one week, when the review exercise was conducted, it was found that the actual cost of material in each table was ₹ 2,100 against the standard cost of ₹ 2,000.
• It was found out that the quantities of wood and steel, actually consumed were the same as estimated in the standard costing.
• Further analysis revealed that while the price of wood was the same as the standard cost, the price of stainless steel has increased

• Possible causes of Material price variance: Sometimes, the material price variance may not be the result of increase in the market rates alone.

• inefficiency of the purchase department, which has not been able to locate and utilise the most cost effective sources of supply of material or, has failed to take advantage of discount on bulk purchases.
• It is also possible that the inventory control department has not been efficient enough to notify the requirement of material in time resulting in emergency purchases.
• A favourable variance may also require proper scrutiny as it may be a result of purchase of material of inferior quality.

Material usage variance: 

• The cost of the material in the standard cost of the product is estimated by taking into account the quantities of material expected to be consumed in production of each unit.
• These estimates may not materialise during the actual manufacturing process.

Illustration 

• We will take the same example of the furniture manufacturing factory, taken above.
• When the review exercise was conducted after one week, it was found that the actual cost of material in each table was ₹ 2,100 against the standard cost of ₹ 2,000.

• The analysis revealed that while the prices of both wood and steel were the same as contained in the standard cost.
• The consumption of steel was as per the estimates in the standard costing. This caused a variance of ₹ 100 in the total cost of material consumed for each table.
• (It is important to note that the variance should be calculated for each material separately. As in above example, an increase in quantity of wood consumed could be nullified in money terms by a decrease in the quantity of steel consumed. The increased consumption of wood would not have been noticed if separate analysis of both materials had not been conducted).

Possible causes of Material usage variance: 

• Inferior quality of material purchased
• Theft, pilferage
• Increased wastage due to careless handling during manufacturing
• Not following the standard production procedures
• Changes in quality of the finished goods compared to that envisaged in standard costing

Labour Cost Variance 

• Total cost of labour depends on the rate of wages for the labour and the  quantity of labour used in manufacturing each unit.

So, the variance of the actual cost of labour from the standard cost, in producing one unit, can also be arrived at by these two factors, as under:

Labour rate variance: 

• The variance under this head is caused due to actual wages paid per hour being different from the standard wages per hour estimated in the standard costing.

Illustration 

• While preparing the estimates of standard costs, it was estimated that the labour hours required for manufacturing one table
• After one week, when the review exercise was conducted, it was found that the actual cost of labour for each table was ₹ 960 against the standard cost of ₹ 900.
• It was found out that while the actual labour hours for manufacturing each table were 6 hours, same as the estimates in standard costing,

The total variance in labour cost, due to this reason will be equal to the variance for one unit multiplied by the total number of units manufactured during the period

Possible causes of Labour rate variance: 

• Labour rate variance is, in all likelihood, not a controllable item as it is governed by the factors beyond the control of the management of the individual companies. Sometimes, arise due to new wage agreement with the workers’ union while, in the standard costing, the rates applicable earlier may have been taken.
• Another possible reason of the variance could be the wrong estimate of mix of skilled and unskilled labour hours involved in manufacturing, as the rates for both are different.

Labour time or labour efficiency variance: 

• The variance under this head is caused due to actual time taken for manufacturing one unit being different from the standard hours estimated in the standard costing.

Illustration 

Taking the same example as above, where the labour hours consumed in manufacturing one unit is estimated at 6 hours @ ₹ 150 per hour. When the review exercise was conducted, it was found that the actual cost of labour for each table was ₹ 1,050 against the standard cost of ₹ 900.

The total variance in labour cost, due to this reason will be equal to the variance for one unit multiplied by the total number of units manufactured during the period.

Overheads Cost Variance 

The total overhead cost variance is the difference between the actual overhead cost incurred and the standard overhead cost allowed for the actual output achieved. Overhead cost variance consists of two parts: 

• Variable overhead variance
• Fixed overhead variance

Variable Overhead Variance 

This also consists of two broad categories, viz.:

• Variable Overhead expenditure variance
• Variable Overhead volume or efficiency variance.

Variable Overhead expenditure variance: 

This variance is due to actual variable overhead expenditure per hour being more than the budgeted (standard) variable overhead expenditure per hour, while the actual variable overhead hours, consumed in producing one table, are the same as the budgeted (standard) hours.

Illustration 

• In a factory, the cost of each variable overhead hour, for producing one table
• When the actual performance is reviewed,

Variable Overhead volume or efficiency variance: 

This variance is due to actual variable overhead hours, consumed in producing one table, being more than the budgeted (standard) variable overhead hours, while the expenditure per hour is as per the budget estimates.

• Calculated = Actual fixed overhead expenses – standard (budgeted) fixed overhead expenses.
• The overall variance figure may not be very useful to identify the area of actual cost increase as increase in one area may be nullified by decrease in expenditure in another area.
• Therefore, we have to further segregate this variance into variances of various sub-areas of fixed overhead costs.

Accounting Treatment Of Variances

• There is no uniform system of maintaining the cost records and making entries under a system of standard costing.

Normally, the cost variances at the end of the accounting period, may be dealt with in any of the following ways:

i)Transfer to costing profit and loss account

ii)Allocation of variances to finished stock, work-in-progress and cost of sales account

iii)Transfer to reserve account

• Under the first method, the stock of work-in-progress, finished goods and cost of sales are maintained at standard cost and variances are charged to costing profit and loss account
• while under the second method, the variances are distributed over the stocks of finished goods, work-in-progress and to cost of sales account in proportion to their respective closing values.
• Under the third method, positive variances are carried forward as deferred credits. These are adjusted against any negative variances in future accounting periods.

• The first method has the advantage of easier inventory valuation, as the valuation is done at standard costs.
• Also, as the variances are separately shown, the management attention and action becomes easier.

Reporting Of Variances To Management

• The basic purpose of standard costing is to identify the areas of inefficiencies, represented through variances, and take the corrective action by the management.
• The action cannot be taken by the management unless the variances are properly reported to them, timely and promptly.
• While devising the system of reporting the variances to the management, we have to keep in mind that the variances can be positive (favourable) or negative (adverse).
• If only the overall picture is presented to the management, the areas of concern may not be highlighted as a favourable variance may hide an adverse variance.
• The top management of the company are concerned with the overall efficiency of the execution of company’s plans by the middle and lower levels of management.
• Therefore, the report, submitted to them, should not convey only the net result, but should clearly mention the favourable and adverse variances, separately.

The main details should be highlighted. The following points may be considered to make the reports effective:

• The reporting should be prompt. Delays in reporting variances, specially the controllable variances, will result in delaying the corrective action by the management.
• The variances of each cost centre should be correctly separated. If part of a variance attributed to one cost centre is wrongly attributed to or merged with the variance of another cost centre, the report may be misleading.
• While analysing and reporting the uncontrollable variances, same care should be exercised as while reporting the controllable variances.
• The forms of reports for variances are to be selected keeping in view the preferences and needs of the management and the company.

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JAIIB Paper 3 (AFM) Module D Unit 5 – Standard Costing ( Ambitious_Baba )

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