Chapter 22 Cost Control Using Standard Costing and Variance Analysis Belverd E. Needles, Jr. Marian Powers Sherry K. Mills Henry R. Anderson - - - - - - - - - - - Multimedia Slides by: Dr. Paul J. Robertson New Mexico State University Steve Leask

Standard Costs in Today’s Business Environment OBJECTIVE 1 Define standard costs and describe how managers use standard costs in the management cycle.

Standard Costs Standard costs are predetermined costs that are developed from analyses of both: Past operating costs, quantities, and times. Future costs and operating conditions.

Standard Cost Flow In a standard costing system, standard costs for direct materials, direct labor, and manufacturing overhead flow through the inventory accounts and eventually into the Cost of Goods Sold account.

The Management Cycle Managers use standard costs throughout the management cycle. In the planning stage of the management cycle, standard costs aid in the development of budgets. During the executing stage, standard costs, quantities, and time are applied to work performed.

The Management Cycle During the reviewing stage, actual costs are compared with standard costs to compute variances, and managers analyze the causes of those variances to improve operations. During the reporting stage, a variance report provides information on operations and managerial performance.

The Management Cycle In today’s globally competitive environment, new standards or measurements are necessary to help managers: Reduce processing time. Improve quality. Improve customer satisfaction. Improve on-time deliveries.

Discussion Q. What is the difference between a standard costing system in service versus manufacturing organizations? A. The primary difference between a standard costing system in service versus manufacturing organizations is that there are no direct materials variances in service organizations.

The Nature and Purpose of Standard Costing OBJECTIVE 2 State the purposes for using standard costs.

Standard Costs Standard costs are used with existing job order or process costing systems. Standard costs are usually expressed as the cost per unit of a finished product or process.

Standard Costs Standard costs are based on: Engineering estimates. Forecasted demand. Worker input. Time and motion studies. Type and quality of direct materials.

Standard Costing Standard costing is expensive to use because the management accounting system must keep separate records of actual costs to compare with what should have been spent.

Using Standard Costs Standard costs are used in several ways: Preparing operating budgets. Identifying production costs and processes that must be managed to reduce waste and inefficiency. Evaluating the performance of managers and workers. Setting prices. Simplifying inventory and product costing procedures.

The Development of Standard Costs OBJECTIVE 3 Identify the six elements of, and compute, a standard cost.

Standard Cost per Unit There are six standards used to determine the standard cost per unit: 1. Direct materials price standard. 2. Direct materials quantity standard. 3. Direct labor time standard. 4. Direct labor rate standard. 5. Standard variable manufacturing overhead rate. 6. Standard fixed manufacturing overhead rate.

Direct Materials Price Standard The direct materials price standard is found by carefully considering: Expected price increases. Changes in available quantities. Possible new sources of supply.

Direct Materials Quantity Standard The direct materials quantity standard is affected by: Product engineering specifications. Quality of direct materials. Age and productivity of machines. Quality and experience of the work force.

Direct Labor Time Standard The direct labor time standard is based on: Current time and motion studies of workers and machines. Past performance.

Direct Labor Rate Standard The direct labor rate standards are affected by: Labor union contracts. Company personnel policies.

Standard Direct Materials and Standard Direct Labor Costs Standard direct materials cost = Direct materials price standard x Direct materials quantity standard Standard direct labor cost = Direct labor time standard x Direct labor rate standard

Standard Manufacturing Overhead Costs (Standard variable overhead rate + Standard fixed overhead rate) x Application basis

Standard Rates Standard variable manufacturing overhead rate = Total budgeted variable manufacturing overhead costs ÷ Expected number of standard machine hours Standard fixed manufacturing overhead rate = Total budgeted fixed manufacturing overhead costs ÷ Normal capacity in terms of standard machine hours

Standard Unit Cost A product’s standard unit cost is determined by adding: Standard direct materials cost. Standard direct labor cost. Standard manufacturing overhead rate.

Using Variance Analysis to Control Operations OBJECTIVE 4 Describe how to control costs through variance analysis.

Standard Costing Systems A standard costing system has traditionally been associated with: Cost control activities. Evaluation of operating performance.

Using Variance Analysis to Control Costs Compute Variance Is the Variance Material Significant? No Corrective Action Needed No Determine Cause(s) of Variance Yes Identify and Analyze Performance Measures to Determine Corrective Action Take Corrective Action

Direct Materials Variances OBJECTIVE 5 Compute and analyze direct materials variances.

Direct Materials Cost Variance Direct materials cost variance is the sum of: 1. Direct materials price variance. (Standard Price - Actual Price) x Actual Quantity. 2. Direct materials quantity variance. (Standard Quantity - Actual Quantity) x Standard Price.

Direct Materials Price Variance Possible causes of a direct materials price variance are: 1. Changes in vendor prices. 2. Inaccurate or outdated direct materials price standards. 3. Differences between the quality of direct materials purchased and the quality desired.

Direct Materials Price Variance 4. Differences between quantity discounts received and those anticipated. 5. The purchase of substitute direct materials that differ from product specifications.

Direct Materials Quantity Variance Possible causes of a direct materials quantity variance are: 1. Inaccurate or outdated direct materials quantity standards. 2. Poor workmanship or excellent workmanship.

Direct Materials Quantity Variance 3. Faulty equipment. 4. Inferior or superior quality of direct materials. 5. Poor materials handling.

Direct Materials Variance Analysis Purchased (Actual quantity times actual price) Direct Materials Inventory (Actual quantity times standard price) Work in Process Inventory (Standard quantity times standard price) Direct Materials Price Variance Difference equals Direct Materials Quantity Variance Difference equals Total Direct Materials Cost Variance

Direct Labor Variances OBJECTIVE 6 Compute and analyze direct labor variances.

Direct Labor Cost Variance Direct labor cost variance is the sum of: 1. Direct labor rate variance. 2. Direct labor efficiency variance.

Direct Labor Rate Variance A direct labor rate variance can occur because: 1. A worker is hired at a pay rate that is higher or lower than expected. 2. An employee performed the duties of a higher- or lower-paid position.

Direct Labor Rate Variance 3. Overall wage rates changed due to: New labor agreements. Labor strikes that cause the temporary hiring of unskilled help. Large layouts that result in unusual usage of remaining workers.

Favorable Direct Labor Efficiency Variance A favorable direct labor efficiency variance can be caused by: 1. Improved training of employees. 2. New machinery. 3. Higher quality of materials.

Unfavorable Direct Labor Efficiency Variance An unfavorable direct labor efficiency variance can be caused by: 1. Machine breakdowns. 2. Inferior direct materials. 3. Poor supervision. 4. Slow materials handling. 5. Poor employee performance.

Direct Labor Variance Analysis Wages Paid to Employees (Actual direct labor hours times actual direct labor rate) Labor Budget Based on Actual Direct Labor Hours (Actual direct labor hours times standard direct labor rate) Work in Process Inventory (Standard direct labor hours allowed times standard direct labor rate) Direct Labor Rate Variance Difference equals Direct Labor Efficiency Variance Difference equals Total Direct Labor Cost Variance

Manufacturing Overhead Variances OBJECTIVE 7 Define and prepare a flexible budget.

Flexible Budget The budgets discussed earlier were static or fixed budgets, which forecast revenues and expenses for one level of sales and production. A flexible budget is a summary of anticipated costs for a range of activity levels, geared to changes in product output.

Flexible Budget Formula The flexible budget formula: 1. Includes a budgeted variable cost per unit, which is the same for all levels of output within the range chosen. 2. Includes a budgeted total fixed cost, which stays constant for the range.

Flexible Budget Formula 3. Has the format: Total budget costs = (Variable cost per unit x Number of units produced) + Budgeted fixed costs

Analyzing Manufacturing Overhead Variances OBJECTIVE 8 Compute and analyze manufacturing overhead variances.

Manufacturing Overhead Variance The total manufacturing overhead variance is equal to the difference between: The actual manufacturing overhead costs incurred and The standard manufacturing overhead costs applied to production.

Total Manufacturing Overhead Variance The total manufacturing overhead variance is then divided into two parts: Controllable manufacturing overhead variance. Manufacturing overhead volume variance.

Controllable Manufacturing Overhead Variance Is the difference between the actual manufacturing overhead costs incurred and the manufacturing overhead costs budgeted for the level of production achieved. Can occur because too much or too little is spent on manufacturing overhead items such as indirect materials, indirect labor, supervision, or machine maintenance.

Manufacturing Overhead Variance Analysis Actual Manufacturing Overhead Costs Incurred Flexible Budget at Level of Achieved Performance Total Manufacturing Overhead Costs Applied to Products Difference equals Controllable Manufacturing Overhead Rate Manufacturing Overhead Volume Variance Difference equals Total Manufacturing Overhead Variance

Manufacturing Overhead Volume Variance Is the difference between the manufacturing overhead budgeted for the level of production achieved and the total manufacturing overhead costs applied to production using the standard variable and fixed manufacturing overhead rates. Will occur if more or less capacity than normal is used.

Manufacturing Overhead Variance Analysis Controllable Manufacturing Overhead Variance Activity-Based Standard Costing System Setup Activity Controllable Setup Overhead Variance Work Cell Activity Controllable Work Cell Overhead Variance Repairs & Maintenance Activity Controllable Repairs & Maintenance Overhead Variance

Manufacturing Overhead Variance Analysis Volume Variance Setup Activity Setup Overhead Volume Variance Work Cell Activity Work Cell Overhead Volume Variance Repairs & Maintenance Activity Repairs & Maintenance Overhead Volume Variance

Activity-Based Costing Activity-based costing changes the analysis of overhead. Each activity has a different cost driver, so the basis of the variance analysis changes from one activity to another.

Using Variances in Performance Evaluation OBJECTIVE 9 Explain how variances are used to evaluate managers’ performance.

Management Evaluation The effective evaluation of managers’ performance depends on both human factors and company policies. To ensure effectiveness and fairness when establishing a performance evaluation process, management should develop appropriate policies and seek input from managers and employees.

Performance Reports The keys to preparing a performance report are to: Identify the personnel responsible for each variance. Determine the causes for each significant variance. Develop a reporting format suited to the task.

Performance Reports The management accountant should tailor performance to each manager’s responsibilities so that each report contains those cost items controllable by that manager.