Here is a simple standard costing example. Let’s take a company that makes widgets. Based on historical data, a cost analyst determines that producing one widget typically requires 1 pound of raw material costing $2 dollars and 1 hour of labor costing $20 dollars. These are the standard amounts and costs for material and labor.

The company expects to produce 1,000 widgets in the upcoming quarter. Based on this sales forecast, and using the standards determined by the cost analyst, the company can plan a budget for the production costs required for the upcoming quarter. The budget includes 1,000 pounds of raw material costing $2,000 dollars and 1,000 hours of labor costing a total of $20,000 dollars. So the total production costs for the upcoming quarter are expected to be $22,000 dollars.

At the end of the quarter, the company analyzes the production process to see how well they stuck to the budget. As it turns out, the company produced 1,000 widgets at a total cost of $35,000 dollars. Clearly, the production process turned out to be more expensive than they had planned. The cost analyst can then compare the standard budgeted costs to the actual costs to see what the differences were and then the managers can analyze the production process to find out why the differences occurred.

Conclusion

Let’s say, as it turns out, the company actually used 1,000 pounds of raw material costing $2,000 dollars and 1,000 hours of labor costing $33,000 dollars. Clearly the variance occurred in the pay rate. For some reason, the labor ended up costing $13,000 dollars more than they had planned. Maybe this is because the original estimates were off. Or maybe some of the workers were working on overtime. Or maybe somebody made a mistake. By comparing the standard cost and the actual costs the company can analyze the situation. Then they can dig deeper to find out what went wrong.