Standard costing uses the expected, budgeted costs to account for the goods manufactured, the goods in inventory, and the goods sold. In other words, the amounts in the respective general ledger accounts are the costs that should have occurred when manufacturing products.

The actual costs are then compared to the standard costs and any differences are reported as variances. Since the standard costs are often tied to the company's annual profit plan, a variance indicates that the actual profit will be different from the planned amount (unless some change takes place).

To illustrate standard costs, let's assume that a company's profit plan includes a standard of 15 pounds of materials at $4 per pound for each unit produced. The standard for the direct labor is 30 minutes at $12 per hour for each unit manufactured. Manufacturing overhead is budgeted to be $36 per direct labor hour. Based on this information, the standard cost for one unit of output is $84 consisting of $60 (15 lbs. x $4 per pound) for direct materials + $6 (0.5 hr. x $12 per hour) for direct labor + $18 (0.5 hr. x $36 per direct labor hour) for manufacturing overhead.

If the company manufactures 100 units and uses 1,550 pounds of materials, there will be an unfavorable direct materials usage variance of $200. This is determined by multiplying the output of 100 units x 15 lbs. (the standard lbs. allowed for each unit) = 1,500 lbs. The 1,500 standard lbs. versus the actual 1,550 lbs. meant that too much of the materials were used to make the actual output. The additional 50 lbs. X $4 standard cost per lb. results in an unfavorable direct materials usage variance of $200.

There will be a direct materials price variance when the actual cost of the materials is an amount other than $4 per pound. If the company pays more than $4 per pound, the materials price or purchase price variance will be unfavorable. If the company pays less than $4 per pound, the price variance will be favorable. The direct materials price variance will be recorded at the time when the materials are received from the supplier.

There are similar calculations for the direct labor. However, the usage or quantity variance for direct labor is often referred to as the direct labor efficiency variance. If the actual labor hours are more than the standard hours allowed for the good output, an unfavorable efficiency variance is reported. The price variance for direct labor is referred to as the direct labor rate variance. If the actual pay rate is greater than the standard hourly pay rate, the variance is unfavorable.

Manufacturing overhead variances include a volume variance and a budget variance associated with the fixed manufacturing overhead. An efficiency variance and a spending (or flexible budget) variance are computed for the variable manufacturing overhead. When actual overhead costs are greater than the standard overhead allowed for the actual, good output, the variance is unfavorable.

Since the general ledger accounts associated with raw materials, direct labor, and manufacturing overhead have the standard costs, significant variances must be allocated to the appropriate inventory accounts and to the cost of goods sold. (Since companies typically turn their inventories many times during the year, most of the variances will end up in the cost of goods sold.)