Managerial Accounting by James Jiambalvo Chapter 11: Standard Costs and Variance Analysis Slides Prepared by: Scott Peterson Northern State University

Objectives Explain how standard costs are developed. Calculate and interpret variances for direct material. Calculate and interpret variances for direct labor. Calculate and interpret variances for manufacturing overhead. Calculate the financial impact of operating at more or less than planned capacity.

Objectives (Continued) Discuss how the management by exception approach is applied to investigation of standard cost variances. Explain why a “favorable” variance may be unfavorable, how process improvements may lead to “unfavorable” variances, and why evaluation in terms of variances may lead to overproduction.

Standard Costs Standard cost refers to expected costs under anticipated conditions. Standard cost systems allow for comparison of standard versus actual costs. Differences are referred to as standard cost variances. Variances should be investigated if significant.

Standard Costs and Budgets Standard cost is the standard cost of a single unit. Budgeted cost is the cost, at standard, of the total number of budgeted units.

Development of Standard Costs Standard costs are developed in a variety of ways: Specified by formulas or recipes. Developed from price lists provided by suppliers. Determined by time and motion studies conducted by industrial engineers. Developed from analyses of past data.

Ideal Versus Attainable Standards Two schools of thought: Ideal standards (perfection standards): developed under the assumption that no obstacles to the production process will be encountered. Attainable Standards: developed under the assumption that there will be occasional problems in the production process.

A General Approach To Variance Analysis Direct material: materials price and materials quantity variance. Direct labor: labor rate (price) and labor efficiency (quantity) variance. Overhead: overhead volume variance and controllable overhead variance.

Material Variances Differences between standard and actual material costs: Material price variance. Material quantity variance.

Material Price Variance Material price variance:(AP – SP) x AQp (AP) = actual price per unit of material. (SP) = standard price per unit of direct material. (AQp) = actual quantity of material purchased. Actual price > standard price: unfavorable. Actual price < standard price: favorable.

Material Quantity Variance Material quantity variance: (AQu – SQ)SP (AQu) = actual quantity of material used. (SQ) = standard quantity of material allowed. (SP) = standard price of material. Actual quantity > standard quantity: unfavorable. Actual quantity < standard quantity: favorable.

You Get What You Measure

Direct Labor Variances Differences between standard and actual direct labor costs: Labor rate (price) variance. Material efficiency (quantity) variance.

Labor Rate Variance Labor rate (price) variance: (AR – SR)AH (AR) = actual wage rate (price). (SR) = standard wage rate (price). (AH) = actual number(quantity) labor hours. Actual rate > standard rate: unfavorable. Actual rate < standard rate: favorable.

Labor Efficiency Variance Labor efficiency (quantity) variance: (AH – SH)SR (AH) = actual number of hours worked. (SH) = standard number of hours worked. (SR) = standard labor wage rate. Actual hours > standard hours: unfavorable. Actual hours < standard hours: favorable.

Overhead Variances Differences between overhead applied to inventory at actual overhead costs: Controllable overhead variance. Overhead volume variance.

Controllable Overhead Variance Actual overhead ($$) - flexible budget level of overhead ($$) for actual volume of production. Referred to as controllable because managers are expected to control costs. Actual > budget: unfavorable. Actual < budget, then the variance is favorable.

Overhead Volume Variance Overhead volume variance: flexible budget level of overhead for actual level of production - overhead applied to production using standard overhead rate. This variance is solely the result of a different number of units being produced than planned in the static budget. Usefulness is limited.

Calculating The Financial Impact Of Operating At More or Less Than Planned Capacity Operating at less than planned capacity results in an unfavorable variance equal to the number of units (less than planned) x the marginal cost per unit. Operating at more than planned capacity results in a favorable variance equal to the number of units (more than planned) x the marginal cost per unit.

Comprehensive Example: Darrington Ice Cream Standard Costs Per Unit: Item Qty. x Price = Total Direct Materials: .8 gal. 2.50 = $2.00 Direct Labor: .125 hrs. 12.00= $1.50 Mfg. Overhead: $ .75 Total Cost Per Unit (Standard) $4.00

Comprehensive Example: Darrington Ice Cream

Material Variances Material price variance:(AP – SP) x AQp : ($2.72 - $2.50) x 810,000 = $178,200 unfavorable. Material quantity variance: (AQu – SQ)SP: (809,000 – 800,000) x $2.50 = $22,500 unfavorable.

Labor Variances Labor rate (price) variance: (AR – SR)AH: ($12.10 - $12.00) x 130,000 = $13,000 unfavorable. Labor efficiency (quantity) variance: (AH – SH)SR: (130,000 – 125,000) x $12 = $60,000 unfavorable.

Overhead Variances Controllable overhead variance: Actual overhead ($$) - flexible budget level of overhead ($$) for actual volume of production: $680,000 - $700,000 = $20,000 unfavorable. Overhead volume variance: flexible budget level of overhead for actual level of production - overhead applied to production using standard overhead rate: $700,000 - $750,000 = $50,000 favorable.

Investigation of Standard Cost Variances Standard cost variances are not a definitive sign of good or bad performance. Variances are merely indicators of potential problems which must be investigated. There are many plausible explanations for them.

Management By Exception Investigation of standard cost variances is a costly activity Management must decide which variances to investigate. Most managers practice management by exception. What is “exceptional?” Usually an absolute dollar amount or a percentage dollar amount.

“Favorable” Variances May Be Unfavorable A “favorable” variance does not mean that it should not be investigated. Raw materials are good examples of this phenomenon. Consider inferior, low-priced materials. A favorable price variance may result, but there may also be substantially more scrap and rework, and thus a higher quantity variance.

Can Process Improvements Lead to “Unfavorable” Variances? Process improvements frequently lead to unfavorable variances. Process improvements often lead to increased productivity. Therefore fewer hours may be required to produce a unit of output. But actual hours will remain unchanged unless the firm terminates the workers to became “more productive.”

Beware-Evaluation in Terms of Variances Can Lead To Excess Production A department in front of another (bottleneck) department should not produce more than the bottleneck department can handle. If it cuts back, it will idle workers. If it doesn’t there will be excess work in process and a negative effect on shareholder value.

Responsibility Accounting and Variances Managers should be held responsible only for costs they can control. This is also true in the area of variance analysis. A purchasing agent may be held responsible for direct material price variances, but certainly not direct material quantity (usage) variances.

Appendix: Recording Standard Costs Material Labor Overhead Finished goods Cost of goods sold Closing variance accounts

Recording Material Costs Purchase of raw materials inventory: Account dr. cr. Raw Material Inventory (std.) x Material Price Variance x Accounts Payable (actual) x Usage of raw materials inventory: Work in Process Inventory x Material Quantity Variance x Raw Material Inventory x

Recording Labor Costs Recording Labor Cost: Account dr. cr. Work in Process Inventory (std.) x Labor Rate Variance x Labor Efficiency Variance x Wages/Sal. Payable (actual) x

Recording Manufacturing Overhead: Step 1 To record actual overhead cost: Account dr. cr. Manufacturing Overhead x *Various Accounts x

Recording Manufacturing Overhead: Step 2 To apply overhead cost to work in process inventory at cost: Account dr. cr. Work in Process Inventory x Manufacturing Overhead x

Recording Manufacturing Overhead: Step 3 To close out manufacturing overhead cost to work in process inventory at cost: Account dr. cr. Manufacturing Overhead x Overhead Volume Variance x Controllable Overhead

Recording Finished Goods To record completed units sent to finished goods: Account dr. cr. Finished Goods Inventory x Work in Process Inventory x

Recording Cost Of Goods Sold To apply overhead cost to work in process inventory at cost: Account dr. cr. Cost of Goods Sold x Finished Goods Inventory x

Closing Variance Accounts Temporary variance accounts must be closed at the end of the period. Account dr. cr. Cost of Goods Sold x Overhead Volume Variance x Controllable Overhead Variance x Material Price Variance x Material Quantity Variance x Labor Rate Variance x Labor Efficiency Variance x

Quick Review Question #1 What does an unfavorable overhead volume variance mean? Overhead costs are out of control. Overhead costs are under control. Production was greater than anticipated. Production was less than anticipated.

Quick Review Answer #1 What does an unfavorable overhead volume variance mean? Overhead costs are out of control. Overhead costs are under control. Production was greater than anticipated. Production was less than anticipated.

Quick Review Question #2 Standard material costs per unit are $3.50. Actual costs per unit are $3.80 Actual quantity is 3,000. Standard quantity is 2,800. Material price variance is: $900 favorable $900 unfavorable $700 favorable $700 unfavorable

Quick Review Answer #2 Standard material costs per unit are $3.50. Actual costs per unit are $3.80 Actual quantity is 3,000. Standard quantity is 2,800. Material price variance is: $900 favorable $900 unfavorable $700 favorable $700 unfavorable

Quick Review Question #3 Standard material costs per unit are $3.50. Actual costs per unit are $3.80 Actual quantity is 3,000. Standard quantity is 2,800. Material quantity variance is: $900 favorable $900 unfavorable $700 favorable $700 unfavorable

Quick Review Answer #3 Standard material costs per unit are $3.50. Actual costs per unit are $3.80 Actual quantity is 3,000. Standard quantity is 2,800. Material quantity variance is: $900 favorable $900 unfavorable $700 favorable $700 unfavorable

Quick Review Question #4 What does a favorable labor efficiency variance mean? Labor rates were higher than called for by standards. Inexperienced labor was used, causing the rate to be lower than standard. More labor was used than called for by standards. Less labor was used than called for by standards.

Quick Review Answer #4 What does a favorable labor efficiency variance mean? Labor rates were higher than called for by standards. Inexperienced labor was used, causing the rate to be lower than standard. More labor was used than called for by standards. Less labor was used than called for by standards.

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