Excessive inventory on hand, especially in the work in process inventory account, may lead to

The planned or expected costs. Often used in manufacturing for accounting for inventories and production. When actual costs differ from the standard costs, variances are reported.

"Standard costing is an important subtopic of cost accounting. Standard costs are usually associated with a manufacturing company's costs of direct material, direct labor, and manufacturing overhead.

Rather than assigning the actual costs of direct material, direct labor, and manufacturing overhead to a product, many manufacturers assign the expected or standard cost. This means that a manufacturer's inventories and cost of goods sold will begin with amounts reflecting the standard costs, not the actual costs, of a product. Manufacturers, of course, still have to pay the actual costs. As a result there are almost always differences between the actual costs and the standard costs, and those differences are known as A term used with standard costs to report a difference between actual costs and standard costs. To learn more, see Explanation of Standard Costing.

variances.

Standard costing and the related variances is a valuable management tool. If a variance arises, management becomes aware that manufacturing costs have differed from the standard (planned, expected) costs.

• If actual costs are greater than standard costs the variance is unfavorable. An unfavorable variance tells management that if everything else stays constant the company's actual profit will be less than planned.

• If actual costs are less than standard costs the variance is favorable. A favorable variance tells management that if everything else stays constant the actual profit will likely exceed the planned profit.

The sooner that the accounting system reports a variance, the sooner that management can direct its attention to the difference from the planned amounts.

If we assume that a company uses the The inventory system where purchases are debited to the inventory account and the inventory account is credited at the time of each sale for the cost of the goods sold. Hence, the balance in the inventory account is constantly or perpetually changing. Under this system there is a general ledger account Cost of Goods Sold. To learn more, see Explanation of Inventory and Cost of Goods Sold.

Perpetual inventory system and that it carries all of its inventory accounts at standard cost (including Direct Materials Inventory or Stores), then the standard cost of a finished product is the sum of the standard costs of the inputs:

1. Direct material

2. Direct labor

3. Manufacturing overhead

   1. Variable manufacturing overhead
   2. Fixed manufacturing overhead

Usually there will be two variances computed for each input:

Since the calculation of variances can be difficult, we developed several business forms (for PRO members) to help you get started and to understand what the variances tell us. Learn more about AccountingCoach PRO.

New! We just released our 29-page Managerial & Cost Accounting Insights. This PDF document is designed to deepen your understanding of topics such as product costing, overhead cost allocations, estimating cost behavior, costs for decision making, and more. It is only available when you join AccountingCoach PRO.

Sample Standards Table

Let's assume that your Uncle Pete runs a retail outlet that sells denim aprons in two sizes. Pete suggests that you get into the manufacturing side of the business, so on January 1, 2015 you start up an apron production company called DenimWorks. Using the best information at hand, the two of you compile the following estimates to use as standards for 2015:

Standards Table for DenimWorks

The aprons are easy to produce, and no apron is ever left unfinished at the end of any given day. This means that your company never has That part of a manufacturer's inventory that is in the production process and has not yet been completed and transferred to the finished goods inventory. This account contains the cost of the direct material, direct labor, and factory overhead placed into the products on the factory floor. A manufacturer must disclose in its financial statements the cost of its work-in-process as well as the cost of finished goods and materials on hand.

work-in-process inventory.

When we make your journal entries for completed aprons (shown below), we'll use an account called The products in a manufacturer's inventory that are completed and are awaiting to be sold. You might view this account as containing the cost of the products in the finished goods warehouse. A manufacturer must disclose in its financial statements the amount of finished goods, work-in-process, and raw materials.

Inventory-FG which means Finished Goods Inventory. (Some companies will use WIP Inventory or Work-in-Process Inventory). We'll also use the account That component of a product that has not yet been placed into the product or into work-in-process inventory. This account often contains the standard cost of the direct materials on hand. A manufacturer must disclose in its financial statements the actual cost of materials on hand as well as its actual cost of work-in-process and finished goods." >Direct Materials Inventory. (Other account titles often used for direct materials are Raw Materials Inventory or A part of a manufacturer's inventory that includes direct and indirect materials. Also see inventory: materials. " >Stores.)

Direct Materials Purchased: Standard Cost and Price Variance

Direct materials refers to just that—raw materials that are directly traceable into a product. In your apron business the direct material is the denim. (In a food manufacturer's business the direct materials are the ingredients such as flour and sugar; in an automobile assembly plant, the direct materials are the cars' component parts).

DenimWorks purchases its denim from a local supplier with terms of net 30 days, FOB destination. This means that title to the denim passes from the supplier to DenimWorks when DenimWorks receives the material. When the denim arrives, DenimWorks will record the denim received in its Direct Materials Inventory at the standard cost of $3 per yard (see standards table above) and will record the liability at the actual cost for the amount received. Any difference between the standard cost of the material and the actual cost of the material received is recorded as a purchase price variance.

Examples of Standard Cost of Materials and Price Variance

Let's assume that on January 2, 2015 DenimWorks ordered 1,000 yards of denim at $2.90 per yard. On January 8, 2015 DenimWorks receives 1,000 yards of denim and an invoice for the actual cost of $2,900. On January 8, 2015 DenimWorks becomes the owner of the material and has a liability to its supplier. On January 8 DenimWorks' Direct Materials Inventory is increased by the standard cost of $3,000 (1,000 yards of denim at the standard cost of $3 per yard), Accounts Payable is credited for $2,900 (the actual amount owed to the supplier), and the difference of $100 is credited to Direct Materials Price Variance. In general journal format the entry looks like this:

The $100 credit to the price variance account communicates immediately (when the denim arrives) that the company is experiencing actual costs that are more favorable than the planned, standard cost.

In February, DenimWorks orders 3,000 yards of denim at $3.05 per yard. On March 1, 2015 DenimWorks receives the 3,000 yards of denim and an invoice for $9,150 due in 30 days. On March 1, the Direct Materials Inventory account is increased by the standard cost of $9,000 (3,000 yards at the standard cost of $3 per yard), Accounts Payable is credited for $9,150 (the actual cost of the denim), and the difference of $150 is debited to Direct Materials Price Variance as an unfavorable price variance:

After the March 1 transaction is posted, the Direct Materials Price Variance account shows a debit balance of $50 (the $100 credit on January 2 combined with the $150 debit on March 1). A debit balance in a variance account is always unfavorable—it shows that the total of actual costs is higher than the total of the expected standard costs. In other words, your company's profit will be $50 less than planned unless you take some action.

On June 1 your company receives 3,000 yards of denim at an actual cost of $2.92 per yard for a total of $8,760 due in 30 days. The entry is:

Direct Materials Inventory is debited for the standard cost of $9,000 (3,000 yards at $3 per yard), Accounts Payable is credited for the actual amount owed, and the difference of $240 is credited to Direct Materials Price Variance. A credit to the variance account indicates that the actual cost is less than the standard cost.

After this transaction is recorded, the Direct Materials Price Variance account shows an overall credit balance of $190. A credit balance in a variance account is always favorable. In other words, your company's profit will be $190 greater than planned due to the favorable cost of direct materials.

Note that the entire price variance pertaining to all of the direct materials received was recorded immediately. In other words, the price variance associated with the direct materials received was not delayed until the materials were used.