Budgeting And Standard Costing


A standard cost is an estimated unit cost built up of standards for each cost element (standard resource price and standard resource usage).

Standard costing is principally used to value inventories and cost production and to act as a control device.

What is a standard cost?

A standard cost is an estimated unit cost.

The uses of standard costing

Standard costing has two principal uses.

  • To value inventories and cost production for cost accounting purposes. It is an alternative method of valuation to methods such as FIFO and LIFO which you will have covered in your earlier studies.
  • To act as a control device by establishing standards (expected costs) and comparing actual costs with the expected costs, thus highlighting areas of the organisation which may be out of control.


It can also be used in the following circumstances.

  • To assist in setting budgets and evaluating managerial performance.
  • To enable the principle of ‘management by exception’ to be practised. A standard cost, when established, is an average expected unit cost. Because it is only an average, actual results will vary to some extent above and below the average. Only significant differences between actual and standard should be reported.
  • To provide a prediction of future costs to be used in decision-making.
  • To motivate staff and management by the provision of challenging targets.
  • To provide guidance on possible ways of improving efficiency.


Although the various uses of standard costing should not be overlooked, we will be concentrating on the control aspect.

Standard costing as a control technique

Standard costing involves the establishment of predetermined estimates of the costs or units of products or services, the collection of actual costs and units and the comparison of the actual costs/units with the predetermined estimates. The predetermined costs/units are known as standard costs or units and the difference between standard and actual is known as a variance. The process by which the total difference between standard and actual results is analysed in known as variance analysis.

Where standard costing should be used

Standard costing is most suited to mass production and repetitive assembly work.


Although standard costing can be used in a variety of costing situations (batch and mass production, process manufacture, jobbing manufacture (where there is standardisation of parts) and service industries (if a realistic cost unit can be established)), the greatest benefit from its use can be gained if there is a degree of repetition in the production process so that average or expected usage of resources can be determined. It is therefore most suited to mass production and repetitive assembly work and less suited to organisations which produce to customer demand and requirements.

But even in cases such as production of “one offs”, the method of production, or even design, can often be measured “by unit”, standard costing can be useful.  A unit could be an hour, a sq. metre of steel or metre of cable



The responsibility for deriving standard costs should be shared between managers able to provide the necessary information about levels of expected efficiency, prices and overhead costs.

Setting standards for materials costs

Direct materials costs per unit of raw material will be estimated by the purchasing department from their knowledge of the following.

  • Purchase contracts already agreed
  • Pricing discussions with regular suppliers
  • The forecast movement of prices in the market
  • The availability of bulk purchase discounts
  • The quality of material required by the production departments


The standard cost ought to include an allowance for bulk purchase discounts, if these are available on all or some of the purchases, and it may have to be a weighted average price of the differing prices charged for the same product by alternative suppliers.

A decision must also be taken as to how to deal with price inflation. Suppose that a material costs RWF10,000 per kilogram at the moment, and during the course of the next 12 months, it is expected to go up in price by 20% to RWF12,000 per kilogram. What standard price should be selected?


  • If the current price of RWF10,000 per kilogram were used in the standard, the reported price variance would become adverse as soon as prices go up, which might be very early in the year. If prices go up gradually rather than in one big jump, it would be difficult to select an appropriate time for revising the standard.
  • If an estimated mid-year price of, say, RWF11,000 per kilogram were used, price variances should be favourable in the first half of the year and adverse in the second half, again assuming that prices go up gradually. Management could only really check that in any month, the price variance did not become excessively adverse (or favourable) and that the price variance switched from being favourable to adverse around month six or seven and not sooner.


Standard costing is therefore more difficult in times of inflation but it is still worthwhile.

  • Usage and efficiency variances will still be meaningful
  • Inflation is measurable: there is no reason why its effects cannot be removed
  • Standard costs can be revised, so long as this is not done too frequently

Setting standards for labour costs

Direct labour rates per hour will be set by reference to the payroll and to any agreements on pay rises with trade union representatives of the employees. A separate hourly rate or weekly wage will be set for each different labour grade/type of employee and an average hourly rate will be applied for each grade (even though individual rates of pay may vary according to age and experience).

Similar problems to those which arise when setting material standards in times of high inflation can be met when setting labour standards.

Setting standards for material usage and labour efficiency

To estimate the materials required to make each product (material usage) and also the labour hours required (labour efficiency), technical specifications must be prepared for each product by production experts (either in the production department or the work study department).

Setting standards for overheads

When standard costs are fully absorbed costs (standard costs can be used in both marginal and absorption costing systems), the absorption rate of fixed production overheads will be predetermined and based on budgeted fixed production overhead and planned production volume.

Production volume will depend on two factors.

  • Production capacity (or ‘volume capacity‘) measured perhaps in standard hours of output (a standard hour being the amount of work achievable at standard efficiency levels in an hour), which in turn reflects direct production labour hours.
  • Efficiency of working, by labour or machines, allowing for rest time and contingency allowances.


Suppose that a department has a work force of ten men, each of whom works a 36 hour week to make standard units, and each unit has a standard time of two hours to make. The expected efficiency of the work-force is 125%.

  • Budgeted capacity, in direct labour hours, would be 10 × 36 = 360 production hours per week.
  • Budgeted efficiency is 125% so that the work-force should take only 1 hour of actual production time to produce 1.25 standard hours of output.
  • This means in our example that budgeted output is 360 production hours × 125% = 450 standard hours of output per week. At 2 standard hours per unit, this represents production activity or volume of 225 units of output per week.

Setting standards for sales price and margin

The standard selling price will depend on a number of factors including the following.

  • Anticipated market demand                    Manufacturing costs
  • Competing products                                  Inflation estimates


The standard sales margin is the difference between the standard cost and the standard selling price.

The following problems can occur when setting standards.

  • Deciding how to incorporate inflation into planned unit costs
  • Agreeing on a performance standard (attainable or ideal)
  • Deciding on the quality of materials to be used (a better quality of material will cost more, but perhaps reduce material wastage)
  • Estimating materials prices where seasonal price variations or bulk purchase discounts may be significant
  • Finding sufficient time to construct standards as standard setting can be time consuming
  • Incurring the cost of setting up and maintaining a system for establishing standards


Types of standard

There are four types of standard: 

  • ideal,
  • attainable, current and
  • basic.

These can have an impact on employee motivation.

How demanding should a standard be?

Should the standard represent perfect performance, easily attainable performance or achievable target?


An ideal standard is a standard which can be attained under perfect operating conditions: no wastage, no inefficiencies, no idle time, no breakdowns

An attainable standard is a standard which can be attained if production is carried out efficiently, machines are properly operated and/or materials are properly used. Some allowance is made for wastage and inefficiencies

A current standard is standard based on current working conditions (current wastage, current inefficiencies)

A basic standard is a long-term standard which remains unchanged over the years and is used to show trends


The different types of standard have a number of advantages and disadvantages.

  • Ideal standards can be seen as long-term targets but are not very useful for day-today control purposes.
  • Ideal standards cannot be achieved. If such standards are used for budgeting, an allowance will have to be included to make the budget realistic and attainable.
  • Attainable standards can be used for product costing, cost control, stock (raw materials,WIP & finished goods) valuation, estimating and as a basis for budgeting.
  • Current standards or attainable standards provide the best basis for budgeting, because they represent an achievable level of productivity.
  • Current standards do not attempt to improve on current levels of efficiency.
  • Current standards are useful during periods when inflation is high. They can be set on a month by month basis.
  • Basic standards are used to show changes in efficiency or performance over a long period of time. They are perhaps the least useful and least common type of standard in use.


The impact on employee behaviour of the type of standard set

The type of standard set can have an impact on the behaviour of the employees trying to achieve those standards.

Type of standard Impact
Ideal Some say that they provide employees with an incentive to be more efficient even though it is highly unlikely that the standard will be achieved. Others argue that they are likely to have an unfavourable effect on employee motivation because the differences between standards and actual results will always be adverse. The employees may feel that the goals are unattainable and so they will not work so hard.
Attainable Might be an incentive to work harder as they provide a realistic but challenging target of efficiency.
Current Will not motivate employees to do anything more than they are currently doing.
Basic May have an unfavourable impact on the motivation of employees. Over time they will discover that they are easily able to achieve the standards. They may become bored and lose interest in what they are doing if they have nothing to aim for.




Budgets and standards are very similar and interrelated, but there are important differences between them.

You will recall from previous chapters that a budget is a quantified monetary plan for a future period, which managers will try to achieve. Its major function lies in communicating plans and coordinating activities within an organisation.

On the other hand, a standard is a carefully predetermined quantity target which can be achieved under certain conditions.

Budgets and standards are similar in the following ways.

  • They both involve looking to the future and forecasting what is likely to happen given a certain set of circumstances.
  • They are both used for control purposes. A budget aids control by setting financial targets or limits for a forthcoming period. Actual achievements or expenditures are then compared with the budgets and action is taken to correct any variances where necessary. A standard also achieves control by comparison of actual results against a predetermined target.


As well as being similar, budgets and standards are interrelated. For example, a standard unit production cost can act as the basis for a production cost budget. The unit cost is multiplied by the budgeted activity level to arrive at the budgeted expenditure on production costs.

There are, however, important differences between budgets and standards.

Budgets Standards
Gives planned total aggregate costs for a function or cost centre Shows the unit resource usage for a single task, for example the standard labour hours for a single unit of production
Can be prepared for all functions, even where output cannot be measured Limited to situations where repetitive actions are performed and output can be measured in more than monetary terms
Expressed in money terms Need not be expressed in money terms. For example a standard rate of output does not need a financial value put on it



In the exam you may be asked to deal with a situation in which not all resources are actually used to make saleable products.



The amount of raw material used to meet the budgeted production level might be less than the amount of raw material contained in the finished products for a number of reasons.

  • Evaporation
  • Spillage
  • Natural wastage (such as the skin of fruit used to make fruit juice)


This wastage can be built into an attainable materials standard and adjustments can be made to materials budgets.

If the wastage occurs before production commences, the materials purchases budget must be adjusted. If the wastage occurs during production, the materials usage budget must be adjusted.

Idle time

A workforce that is expected to work at a particular level of efficiency may not always be able to achieve this. Idle time may be caused by machine breakdowns or not having enough work to give to employees, perhaps because of bottlenecks in production or a shortage of orders for customers.

Idle time can again be built into an attainable labour hours standard and adjustments can be made to the labour budget.


Comparison of a fixed budget with the actual results for a different level of activity is of little use for control purposes. Flexible budgets should be used to show what cost and revenues should have been for the actual level of activity.

A flexible budget is a budget which, by recognising different cost behaviour patterns, is designed to change as volume of activity changes.

If you previously studied F2, you will be familiar with this material.

Preparing a flexible budget

Step 1


The first step in the preparation of a flexible budget is the determination of cost behaviour patterns, which means deciding whether costs are fixed, variable or semi-variable.
Step 2 The second step in the preparation of a flexible budget is to calculate the budget cost allowance for each cost item.

Budget cost allowance = budgeted fixed cost* + (number of units × variable cost per unit)**

* nil for variable cost

** nil for fixed cost

Semi-variable costs therefore need splitting into their fixed and variable components so that the budget cost allowance can be calculated. One method for splitting semi-variable costs is the high-low method, which we covered in Study Unit 14.



Flexible budgets and performance management

Budgetary control involves drawing up budgets for the areas of responsibility for individual managers (for example production managers, purchasing managers and so on) and of regularly comparing actual results against expected results. The differences between actual results and expected results are called variances and these are used to provide a guideline for control action by individual managers.

Note that individual managers are held responsible for investigating differences between budgeted and actual results, and are then expected to take corrective action or amend the plan in the light of actual events.

The wrong approach to budgetary control is to compare actual results against a fixed budget. Suppose that a company manufactures a single product, Z. Budgeted results and actual results for June 20X2 are shown below.

  • Here the variances are meaningless for control purposes. Costs were higher than budget because the output volume was also higher; variable costs would be expected to increase above the costs budgeted in the fixed budget. There is no information to show whether control action is needed for any aspect of costs or revenue.
  • For control purposes, it is necessary to know the following.
    • Were actual costs higher than they should have been to produce and sell 3,000 Zs?
    • Was actual revenue satisfactory from the sale of 3,000 Zs?


The correct approach to budgetary control is as follows.

  • Identify fixed and variable costs
  • Produce a flexible budget using marginal costing techniques


Let’s suppose that we have the following estimates of cost behaviour for the company.

  • Direct materials, direct labour and maintenance costs are variable.
  • Rent and rates and depreciation are fixed costs.
  • Other costs consist of fixed costs of RWF1,600,000 plus a variable cost of RWF1,000 per unit made and sold.


Now that the cost behaviour patterns are known, a budget cost allowance can be calculated for each item of expenditure. This allowance is shown in a flexible budget as the expected expenditure on each item for the relevant level of activity. The budget cost allowances are calculated as follows –  RWF values in thousands.

Factors to consider when preparing flexible budgets

The mechanics of flexible budgeting are, in theory, fairly straightforward but in practice there are a number of points to consider before figures are simply flexed.

Splitting mixed costs is not always straightforward.

Fixed costs may behave in a step-line fashion as activity levels increase/decrease.

Account must be taken of the assumptions upon which the original fixed budget was based. Such assumptions might include the constraint posed by limiting factors, the rate of inflation, judgements about future uncertainty, the demand for the organisation’s products and so on.

‘Flexing … can incorporate changes for any factor which differs from that which applied when the budget was prepared, for example different states of the economy. In this way, flexing is saying “If I knew then what I know now, what budget would I set?” It is a useful concept but can lead to some concern, if taken to extremes, because managers can be confused and frustrated if faced throughout the year with a possibly moving target.’


The need for flexible budgets

We have seen that flexible budgets may be prepared in order to plan for variations in the level of activity above or below the level set in the fixed budget. It has been suggested, however, that since many cost items in modern industry are fixed costs, the value of flexible budgets in planning is dwindling.

  • In manufacturing industries, especially in Europe or North America,, plant costs (depreciation, rent and so on) are a very large proportion of total costs, and these tend to be fixed costs.
  • Wage costs also tend to be fixed, because employees are generally guaranteed a basic wage for a working week of an agreed number of hours.
  • With the growth of service industries, labour (wages or fixed salaries) and overheads will account for most of the costs of a business, and direct materials will be a relatively small proportion of total costs.

Flexible budgets are nevertheless necessary, and even if they are not used at the planning stage, they must be used for budgetary control variance analysis.



The principle of controllability is that managers of responsibility centres should only be held accountable for costs over which they have some influence.


Budget centres

Budgetary control is based around a system of budget centres. Each budget centre will have its own budget and a manager will be responsible for managing the budget centre and ensuring that the budget is met.

The selection of budget centres in an organisation is therefore a key first step in setting up a control system. What should the budget centres be? What income, expenditure and/or capital employment plans should each budget centre prepare? And how will measures of performance for each budget centre be made?            

A well-organised system of control should have the following features.


Feature Explanation
A hierarchy of budget centres If the organisation is quite large a hierarchy is needed. Subsidiary companies, departments and work sections might be budget centres. Budgets of each section would then be consolidated into a departmental budget, departmental budgets in turn would be consolidated into the subsidiary’s budget, and the budgets of each subsidiary would be combined into a master budget for the group as a whole.
Clearly identified responsibilities for achieving budget targets Individual managers should be made responsible for achieving the budget targets of a particular budget centre.
Responsibilities for revenues, costs and capital employed Budget centres should be organised so that all the revenues earned by an organisation, all the costs it incurs, and all the capital it employs are made the responsibility of someone within the organisation, at an appropriate level of authority in the management hierarchy.


Budgetary control and budget centres are therefore part of the overall system of responsibility accounting within an organisation.

Responsibility accounting is a system of accounting that segregates revenue and costs into areas of personal responsibility in order to monitor and assess the performance of each part of an organisation.

Controllable costs

Controllable costs are items of expenditure which can be directly influenced by a given manager within a given time span.

Care must be taken to distinguish between controllable costs and uncontrollable costs in variance reporting. The controllability principle is that managers of responsibility centres should only be held accountable for costs over which they have some influence. From a motivation point of view this is important because it can be very demoralising for managers who feel that their performance is being judged on the basis of something over which they have no influence. It is also important from a control point of view in that control reports should ensure that information on costs is reported to the manager who is able to take action to control them.

Responsibility accounting attempts to associate costs, revenues, assets and liabilities with the managers most capable of controlling them. As a system of accounting, it therefore distinguishes between controllable and uncontrollable costs.

Most variable costs within a department are thought to be controllable in the short term because managers can influence the efficiency with which resources are used, even if they cannot do anything to raise or lower price levels.

A cost which is not controllable by a junior manager might be controllable by a senior manager. For example, there may be high direct labour costs in a department caused by excessive overtime working. The junior manager may feel obliged to continue with the overtime to meet production schedules, but his senior may be able to reduce costs by hiring extra full-time staff, thereby reducing the requirements for overtime.

A cost which is not controllable by a manager in one department may be controllable by a manager in another department. For example, an increase in material costs may be caused by buying at prices higher than expected (controllable by the purchasing department) or by excessive wastage (controllable by the production department) or by a faulty machine producing rejects (controllable by the maintenance department).

Some costs are non-controllable, such as increases in expenditure items due to inflation. Other costs are controllable, but in the long term rather than the short term. For example, production costs might be reduced by the introduction of new machinery and technology, but in the short term, management must attempt to do the best they can with the resources and machinery at their disposal.


The controllability of fixed costs

It is often assumed that all fixed costs are non-controllable in the short run. This is not so.

  • Committed fixed costs are those costs arising from the possession of plant, equipment, buildings and an administration department to support the long-term needs of the business. These costs (depreciation, rent, administration salaries) are largely non-controllable in the short term because they have been committed by longer-term decisions affecting longer-term needs. When a company decides to cut production drastically, the long-term committed fixed costs will be reduced, but only after redundancy terms have been settled and assets sold.
  • Discretionary fixed costs, such as advertising and research and development costs, are incurred as a result of a top management decision, but could be raised or lowered at fairly short notice (irrespective of the actual volume of production and sales).


Controllability and apportioned costs

Managers should only be held accountable for costs over which they have some influence. This may seem quite straightforward in theory, but it is not always so easy in practice to distinguish controllable from uncontrollable costs. Apportioned overhead costs provide a good example.

Suppose that a manager of a production department in a manufacturing company is made responsible for the costs of his department. These costs include directly attributable overhead items such as the costs of indirect labour employed and indirect materials consumed in the department. The department’s overhead costs also include an apportionment of costs from other cost centres, such as rent and rates for the building it shares with other departments and a share of the costs of the maintenance department.

Should the production manager be held accountable for any of these apportioned costs?

  • Managers should not be held accountable for costs over which they have no control. In this example, apportioned rent and rates costs would not be controllable by the production department manager.
  • Managers should be held accountable for costs over which they have some influence. In this example, it is the responsibility of the maintenance department manager to keep maintenance costs within budget. But their costs will be partly variable and partly fixed, and the variable cost element will depend on the volume of demand for their services. If the production department’s staff treat their equipment badly we might expect higher repair costs, and the production department manager should therefore be made accountable for the repair costs that his department makes the maintenance department incur on its behalf.
  • Charging the production department with some of the costs of the maintenance department prevents the production department from viewing the maintenance services as ‘free services’. Over-use would be discouraged and the production manager is more likely to question the activities of the maintenance department possibly resulting in a reduction in maintenance costs or the provision of more efficient maintenance services.


Controllability and dual responsibility

Quite often a particular cost might be the responsibility of two or more managers. For example, raw materials costs might be the responsibility of the purchasing manager (prices) and the production manager (usage). A reporting system must allocate responsibility appropriately. The purchasing manager must be responsible for any increase in raw materials prices whereas the production manager should be responsible for any increase in raw materials usage.

This where Standard Cost analysis can be useful.  It can show price and usage variances separately.


You can see that there are no clear cut rules as to which costs are controllable and which are not. Each situation and cost must be reviewed separately and a decision taken according to the control value of the information and its behavioural impact.



  • A standard cost is an estimated unit cost built up of standards for each cost element (standard resource price and standard resource usage)
  • Standard costing is principally used to value inventories and cost production and to act as a control device.
  • Standard costing is most suited to mass production and repetitive assembly work.
  • The responsibility for deriving standard costs should be shared between managers able to provide the necessary information about levels of expected efficiency, prices and overhead costs.
  • There are four types of standard: ideal, attainable, current and basic. These can have an impact on employee motivation.
  • Budgets and standards are very similar and interrelated, but there are important differences between them.
  • Comparison of a fixed budget with the actual results for a different level of activity is of little use for control purposes. Flexible budgets should be used to show what cost and revenues should have been for the actual level of activity.
  • The principle of controllability is that managers of responsibility centres should only be held accountable for costs over which they have some influence.
  • Controllable costs are items of expenditure which can be directly influenced by a given manager within a given time span.


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