Direct Costs in Standard Costing

Setting cost standards; direct materials variances: price and efficiency variance; direct labor variances: price and efficiency variance; journal entries.

1. Typical cost standards

In accordance with US GAAP, for external reporting purposes companies have to use the actual costing method. However, for internal reporting purposes, many businesses use the standard costing approach. Standard costing allows a company's management to set operating targets and evaluate actual performance. By setting standard costs and performing standard cost variance analysis, companies can determine concrete ways to improve future operations and can prepare more realistic operating budgets.

To monitor performance and plan operations, management sets standards for resources used in production. Typical resources used in production are: direct materials, direct labor, variable factory overhead, and fixed factory overhead costs. Standard costs for the aforementioned resources are determined as follows:

Illustration 1: Typical standard cost calculation

Direct

Materials

Standard Price (SP) per Unit of Input

X

Standard Quantity (SQ) per Unit of Output

Direct

Labor

Standard Price (SP) per Labor Hour of Input

X

Standard Labor Hours (SR) per Unit of Output

Variable

Factory

Overhead

Standard Variable Overhead Allocation Rate (SR)

X

Standard Quantity of Allocation Base per Unit of Output

Fixed

Factory

Overhead

Standard Fixed Overhead Allocation Rate (SR)

X

Standard Quantity of Allocation Base per Unit of Output

As you can see in the table above, when calculating each standard cost, you multiple the input standard rate or price by the output standard quantity.

To illustrate a simple example, let's assume ALumloyParts Ltd. produces aluminum alloy parts. To manufacture AL200 series tubes, the company uses one pound of aluminum to produce two tubes. The company expects that in May 20X0 the price of aluminum will be $1.20 per pound. In April 20X0 the company's management determines the following standard cost of aluminum (direct materials) used in AL200 pipes:

  1. Standard price per unit of input = $1.2 per pound of aluminum
  2. Standard quantity of input per unit of output = 0.5 pound of aluminum per tube
  3. Standard cost of aluminum per unit of output = $1.2 per lb x 0.5 lb = $0.6 per pound of AL200 tube
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