2 Standard CostsStandards are benchmarks or “norms” for measuring performance. In managerial accounting,two types of standards are commonly used.Quantity standards specify how much of an input should be used to make a product or provide a service.Price standards specify how much should be paid for each unit of the input.A standard is a benchmark or “norm” for measuring performance. In managerial accounting, two types of standards are commonly used by manufacturing, service, food, and not-for-profit organizations:Quantity standards specify how much of an input should be used to make a product or provide a service. For example:Auto service centers like Firestone and Sears set labor time standards for the completion of work tasks.Fast-food outlets such as McDonald’s have exacting standards for the quantity of meat going into a sandwich.Price standards specify how much should be paid for each unit of the input. For example:Hospitals have standard costs for food, laundry, and other items.Home construction companies have standard labor costs that they apply to sub-contractors such as framers, roofers, and electricians.Manufacturing companies often have highly developed standard costing systems that establish quantity and price standards for each separate product’s material, labor, and overhead inputs. These standards are listed on a standard cost card.Examples: Firestone, Sears, McDonald’s, hospitals,construction, and manufacturing companies.
3 Manufacturing Overhead Standard CostsDeviations from standards deemed significant are brought to the attention of management, a practice known as management by exception.StandardAmountDirect MaterialManagement by exception is a system of management in which standards are set for various operating activities, with actual results compared to these standards. Any deviations that are deemed significant are brought to the attention of management as “exceptions.”This chapter applies the management by exception principle to quantity and price standards with an emphasis on manufacturing applications.Direct LaborManufacturing OverheadType of Product Cost
4 Variance Analysis Cycle The variance analysis cycle is a continuous process used to identify and solve problems:The cycle begins with the preparation of standard cost performance reports in the accounting department.These reports highlight variances that are differences between actual results and what should have occurred according to standards.The variances raise questions such as:Why did this variance occur?Why is this variance larger than it was last period?The significant variances are investigated to discover their root causes.Corrective actions are taken.Next period’s operations are carried out and the process is repeated.
5 Setting Standard Costs Should we use ideal standards that require employees to work at 100 percent peak efficiency?I recommend using practical standards that are currently attainable with reasonable and efficient effort.Standards tend to fall into one of two categories:Ideal standards can only be attained under the best of circumstances. They allow for no work interruptions and they require employees to work at 100% peak efficiency all of the time.Practical standards are tight, but attainable. They allow for normal machine downtime and employee rest periods and can be attained through reasonable, highly efficient efforts of the average worker. Practical standards can also be used for forecasting cash flows and in planning inventory.EngineerManagerial Accountant
6 Setting Direct Materials Standards Standard Price per UnitStandard Quantity per UnitSummarized in a Bill of Materials.Final, delivered cost of materials, net of discounts.The standard price per unit for direct materials should reflect the final, delivered cost of the materials, net of any discounts taken.The standard quantity per unit for direct materials should reflect the amount of material required for each unit of finished product, as well as an allowance for unavoidable waste, spoilage, and other normal inefficiencies.A bill of materials is a list that shows the quantity of each type of material in a unit of finished product.
7 Setting Direct Labor Standards Often a single rate is used that reflects the mix of wages earned.Standard Rate per HourUse time and motion studies for each labor operation.Standard Hours per UnitThe standard rate per hour for direct labor includes not only wages earned but also fringe benefits and other labor costs. Many companies prepare a single rate for all employees within a department that reflects the “mix” of wage rates earned.The standard hours per unit reflects the labor hours required to complete one unit of product. Standards can be determined by using available references that estimate the time needed to perform a given task, or by relying on time and motion studies.
8 Setting Variable Manufacturing Overhead Standards The rate is the variable portion of the predetermined overhead rate.Price StandardThe quantity is the activity in the allocation base for predetermined overhead.Quantity StandardThe price standard for variable manufacturing overhead comes from the variable portion of the predetermined overhead rate.The quantity standard for variable manufacturing overhead is expressed in either direct labor hours or machine hours depending on which is used as the allocation base in the predetermined overhead rate.
9 A General Model for Variance Analysis Quantity VarianceDifference between actual quantity and standard quantityPrice VarianceDifference between actual price and standard priceDifferences between standard prices and actual prices and standard quantities and actual quantities are called variances. The act of computing and interpreting variances is called variance analysis.A quantity variance is the difference between how much of an input was actually used and how much should have been used and is stated in dollar terms using the standard price of the input.A price variance is the difference between the actual price of an input and its standard price, multiplied by the actual amount of the input purchased.
10 Quantity and Price Standards Quantity and price standards are determined separately for two reasons:The purchasing manager is responsible for raw material purchase prices and the production manager is responsible for the quantity of raw material used.Quantity and Price standards are determined separately for two reasons:Different managers are usually responsible for buying and for using inputs. For example: The purchasing manager is responsible for raw material purchase prices and the production manager is responsible for the quantity of raw material used.The buying and using activities occur at different points in time. For example: Raw material purchases may be held in inventory for a period of time before being used in production.The buying and using activities occur at different times. Raw material purchases may be held in inventory for a period of time before being used in production.
11 A General Model for Variance Analysis Quantity VariancePrice VarianceQuantity and price variances can be computed for all three variable cost elements – direct materials, direct labor, and variable manufacturing overhead – even though the variances have different names as shown.Materials quantity varianceLabor efficiency varianceVOH efficiency varianceMaterials price variance Labor rate variance VOH rate variance
12 A General Model for Variance Analysis Actual quantity is the amount of direct materials, direct labor, and variable manufacturing overhead actually used.(1)Standard Quantity Allowed for Actual Output, at Standard Price (SQ × SP)(2) Actual Quantity of Input, at Standard Price (AQ × SP)(3) Actual Quantity of Input, at Actual Price (AQ × AP)The actual quantity represents the actual amount of direct materials, direct labor, and variable manufacturing overhead used.Quantity Variance (2) – (1)Price Variance (3) – (2)Spending Variance (3) – (1)
13 A General Model for Variance Analysis Standard quantity is the standard quantity allowed for the actual output of the period.(1)Standard Quantity Allowed for Actual Output, at Standard Price (SQ × SP)(2) Actual Quantity of Input, at Standard Price (AQ × SP)(3) Actual Quantity of Input, at Actual Price (AQ × AP)The standard quantity represents the standard quantity allowed for the actual output of the period.Quantity Variance (2) – (1)Price Variance (3) – (2)Spending Variance (3) – (1)
14 A General Model for Variance Analysis Actual price is the amount actually paid for the input used.(1)Standard Quantity Allowed for Actual Output, at Standard Price (SQ × SP)(2) Actual Quantity of Input, at Standard Price (AQ × SP)(3) Actual Quantity of Input, at Actual Price (AQ × AP)The actual price represents the actual amount paid for the input used.Quantity Variance (2) – (1)Price Variance (3) – (2)Spending Variance (3) – (1)
15 A General Model for Variance Analysis Standard price is the amount that should have been paid for the input used.(1)Standard Quantity Allowed for Actual Output, at Standard Price (SQ × SP)(2) Actual Quantity of Input, at Standard Price (AQ × SP)(3) Actual Quantity of Input, at Actual Price (AQ × AP)The standard price represents the amount that should have been paid for the input used.Quantity Variance (2) – (1)Price Variance (3) – (2)Spending Variance (3) – (1)
16 Materials Quantity Variance Materials Price Variance Responsibility for Materials VariancesMaterials Quantity VarianceMaterials Price VariancePurchasing ManagerProduction ManagerThe purchasing manager and production manager are usually held responsible for the materials price variance and materials quantity variance, respectively. The standard price is used to compute the quantity variance so that the production manager is not held responsible for the performance of the purchasing manager.The standard price is used to compute the quantity variance so that the production manager is not held responsible for the purchasing manager’s performance.
17 Responsibility for Labor Variances Production managers are usually held accountable for labor variances because they can influence the:Mix of skill levels assigned to work tasks.Level of employee motivation.Quality of training provided to employees.Quality of production supervision.Production ManagerLabor variances are partially controllable by employees within the Production Department. For example, production managers/supervisors can influence:The deployment of highly skilled workers and less skilled workers on tasks consistent with their skill levels.The level of employee motivation within the department.The quality of production supervision.The quality of the training provided to the employees.
18 Advantages of Standard Costs Management by exceptionPromotes economy and efficiencyAdvantagesResearch has shown that a substantial portion of companies in the United Kingdom, Canada, Japan, and the United States use standard cost systems. This is because standard cost systems offer many advantages including:Standard costs are a key element of the management by exception approach which helps managers focus their attention on the most important issues.Standards that are viewed as reasonable by employees can serve as benchmarks that promote economy and efficiency.Standard costs can greatly simplify bookkeeping.Standard costs fit naturally into a responsibility accounting system.Enhances responsibility accountingSimplified bookkeeping
19 Potential Problems with Standard Costs Emphasizing standards may exclude other important objectives.Favorable variances may be misinterpreted.Potential ProblemsStandard cost reports may not be timely.Emphasis on negative may impact morale.The use of standard costs can also present a number of problems. For example:Standard cost variance reports are usually prepared on a monthly basis and are often released days or weeks after the end of the month; hence, the information can be outdated.If variances are misused as a club to negatively reinforce employees, morale may suffer and employees may make dysfunctional decisions.Labor variances make two important assumptions. First, they assume that the production process is labor-paced; if labor works faster, output will go up. Second, the computations assume that labor is a variable cost. These assumptions are often invalid in today’s automated manufacturing environment where employees are essentially a fixed cost.In some cases, a “favorable” variance can be as bad or worse than an unfavorable variance.Excessive emphasis on meeting the standards may overshadow other important objectives such as maintaining and improving quality, on-time delivery, and customer satisfaction.Just meeting standards may not be sufficient; continual improvement using techniques such as Six Sigma may be necessary to survive in a competitive environment.Invalid assumptions about the relationship between labor cost and output.Continuous improvement may be more important than meeting standards.
20 Fixed Overhead Volume Variance Fixed Overhead AppliedBudgeted Fixed OverheadActual Fixed OverheadSH × FRDH × FRVolume varianceThe volume variance can also be computed by multiplying the fixed portion of the predetermined overhead rate times the difference between denominator hours and standard hours. The equation on the prior slide and this equation result in identical answers. Both variance computations will be demonstrated in the forthcoming example. Volume variance=FPOHR × (DH – SH)FPOHR = Fixed portion of the predetermined overhead rate DH = Denominator hours SH = Standard hours allowed for actual output
21 Fixed Overhead Budget Variance Fixed Overhead AppliedBudgeted Fixed OverheadActual Fixed OverheadBudget varianceThe equation for computing the budget variance is shown on this slide. It is simply the difference between the actual fixed manufacturing overhead and the budgeted fixed manufacturing overhead for the period.Actual fixed overheadBudgeted fixed overheadBudget variance=–
22 In a standard cost system: Reconciling Overhead Variances and Underapplied or Overapplied OverheadIn a standard cost system:Unfavorable variances are equivalent to underapplied overhead.Favorable variances are equivalent to overapplied overhead.In a standard cost system, the sum of the overhead variances equals the under-or overapplied overhead cost for the period. Unfavorable variances are equivalent to underapplied overhead. Favorable variances are equivalent to overapplied overhead.The sum of the overhead variances equals the under- or overapplied overhead cost for the period.
23 Cost Flows in a Standard Cost System Inventories are recorded at standard cost.Variances are recorded as follows:Favorable variances are credits, representing savings in production costs.Unfavorable variances are debits, representing excess production costs.Standard cost variances are usually closed out to cost of goods sold.Unfavorable variances increase cost of goods sold.Favorable variances decrease cost of goods sold.The entries into the various accounts are made at standard cost – not actual cost. The differences between actual and standard costs are entered into special accounts that accumulate the various standard cost variances. The standard cost variance accounts are usually closed out to Cost of Goods Sold at the end of the period. Unfavorable variances increase Cost of Goods Sold, and favorable variances decrease Cost of Goods Sold.