a) Briefly explain the following terms

Standard cost

A standard cost is a predetermined calculation of what a cost should be under specified working conditions. Standards can be set for materials, labour and overheads. Setting a standard involves the establishment of two components for each cost type, the volume required and the unit cost attached to that volume.

Materials usage variance

The materials usage variance is the difference between what was actually used and what should have been used for the actual production volume, based on standard cost per item of materials. It is calculated using the formula (standard cost per unit – actual cost per unit) x actual quantity used.

Labour rate variance

Labour efficiency variance

The labour efficiency variance is the difference caused by using more or less labour hours than the standard labour hours allowed for the actual production volume, based on the standard rate. It is calculated using the following formula (Standard hours allowed – actual hours) x standard rate per hour.

b) Outline the process for developing standards of efficiency and usage for both direct labour and direct materials

Setting standards for labour efficiency: This is effectively the average time a direct labour employee takes to perform tasks related to a unit of production. This is quite difficult to establish as a number of tasks may have to be separately identified in the preparation of a unit of production. Also, other more subjective variables need to be considered such as skill, experience, motivation, working conditions and training. Generally, each operation is studied and an allowed time agreed, usually after a time and motion study is carried out.

Setting standards for material usage: This is based on product specifications derived from an intensive study of the make-up of each product. It must take into account losses that may be caused by wastage, pilferage and deterioration of materials while in stock. Ultimately the business needs to set a standard that will indicate that if they plan to produce 50 units of production, then 1,000 kgs of material X will be needed. Thus they need to take into account the quality of the materials purchased, the quality of equipment used to develop the materials (which is related to the level of waste), the storage conditions and security.