Accounting: The Language of Business - Vol. 1 (Part 140)

The concept of fair value accounting is correct and useful, but the application during periods of crisis is problematic.
Stephen A. Schwarzman

 Performance Evaluation Using Variance from Standard Costs (Part G)

by

Charles Lamson 

Recording and Reporting Variances from Standards

Standard costs can be used solely as a management tool from the accounts in the general ledger. However, many companies include both standard costs (predetermined costs, estimated future costs, expected costs, budgeted unit costs, forecast costs, or "should be" costs) and variances, in addition to actual costs, in their accounts. In doing so, one approach is to record the standard costs and variances at the same time the actual manufacturing costs are recorded in the accounts. To illustrate, assume that Western Rider Inc. purchased, on account, the 7,300 square yards of blue denim used at $5.50 per square yard. the standard price for direct materials is $5.00 per square yard. The journal entry to record the purchase and the unfavorable direct materials price variance is as follows:

The materials account is debited for the actual quantity purchased at the standard price, $36,500 (7,300 square yards x $5). Accounts payable is credited for the $40,150 actual cost. The unfavorable direct materials price variance [An unfavorable variance is the opposite of a favorable variance where actual costs are less than standard costs. Rising costs for direct materials or inefficient operations within the production facility could be the cause of an unfavorable variance in manufacturing (investopedia.com).] is $3,650 [($5.50 actual price per square yard - $5.00 standard price per square yard) x 7,300 square yards purchased]. It is recorded by debiting direct materials price variance. If the variance had been favorable, direct materials price variance would have been credited for the amount of the variance.

The direct materials quantity variance is recorded in a similar manner. For example, Western Rider Inc. used 7,300 square yards of blue denim to produce 5,000 pairs of XL jeans, compared to a standard of 7,500 square yards. The entry to record the materials used is as follows:

The work in process amount is debited for the standard price of the standard amount of direct materials required, $37,500 (7,500 square yards x $5.00). Materials is credited for the actual amount of materials used in the standard price, $36,500 (7,500 square yards x $5.00). The favorable direct materials quantity variance of $1,000 [(7,500 standard square yards - 7,300 actual square yards) x $5.00 standard price per square yard] is credited to direct material quantity variance. If the variance had been unfavorable, direct materials quantity variance would have been debited for the amount of the variance.

The entries for direct labor are recorded in a manner similar to direct materials. Thus, the work in process account is debited for the standard cost of direct labor and direct materials, as well as factory overhead. Likewise, the work in process account is credited for the standard cost of the product completed and transferred to the finished goods account.

In a given period, it is possible to have both favorable and unfavorable variances at the end of the period, the balances of the variance accounts will indicate the net favorable or unfavorable variance for the period.

Variances from standard costs are usually not reported to stockholders and others outside the business. If standards are recorded in the accounts, however, the variances may be reported to income statements prepared for management to use. Exhibit 8 is an example of such an income statement prepared for Western Rider Inc. internal use. In this exhibit we assume a sales price of $28 per pair of jeans, selling expenses of $14,500, and administrative expenses of $11,225.

EXHIBIT 8 Variances from Standards in Income Statement

At the end of the fiscal year, the variances from standard are usually transferred to the cost of goods sold account. However, if the variances are significant or if many of the products manufactured are still in inventory, the variances should be allocated to the work in process, finished goods, and cost of goods sold accounts. Such an allocation converts these account balances from standard cost to actual cost. 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 930-931*

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