Managerial Accounting by James Jiambalvo Chapter 9: Standard Costs and Variance Analysis Slides Prepared by: Scott Peterson Northern State University

Chapter 9: Standard Costs and Variance Analysis Chapter Themes:  It’s all about standards and benchmarks.  It is important to measure actual values against goals and standards.  Responsibility should be commensurate with controllability. Learning Objectives: 1. Explain how standard costs are developed. 2. Calculate and interpret variances for direct material. 3. Calculate and interpret variances for direct labor. 4. Calculate and interpret variances for manufacturing overhead. 5. Discuss how the management by exception approach is applied to investigation of standard cost variances.

Standard Costs The term standard cost refers to the cost that management believes should be incurred to produce a good or service under anticipated conditions. The primary benefit of a standard cost system is that it allows for comparison of standard versus actual costs. Differences are referred to as standard cost variances and should be investigated if significant. Learning Objectives: 1. Explain how standard costs are developed. 2. Calculate and interpret variances for direct material. 3. Calculate and interpret variances for direct labor. 4. Calculate and interpret variances for manufacturing overhead. 5. Discuss how the management by exception approach is applied to investigation of standard cost variances.

Standard Costs and Budgets At the outset, it is important to understand the subtle differences in definitions of standard cost and budgeted cost. Standard cost: the standard cost of a single unit. Budgeted cost: the cost, at standard, of the total number of budgeted units. Related Learning Objectives: 1. Explain how standard costs are developed. 2. Calculate and interpret variances for direct material. 3. Calculate and interpret variances for direct labor. 4. Calculate and interpret variances for manufacturing overhead. 5. Discuss how the management by exception approach is applied to investigation of standard cost variances.

Development of Standard Costs Standard costs are developed in a variety of ways. They are 1. specified in engineering plans. Related Learning Objectives: 1. Explain how standard costs are developed. 2. Calculate and interpret variances for direct material. 3. Calculate and interpret variances for direct labor. 4. Calculate and interpret variances for manufacturing overhead. 5. Discuss how the management by exception approach is applied to investigation of standard cost variances.

Development of Standard Costs Standard costs are developed in a variety of ways. They are 1. specified by formulas or recipes. 2. developed from price lists provided by suppliers. Related Learning Objectives: 1. Explain how standard costs are developed. 2. Calculate and interpret variances for direct material. 3. Calculate and interpret variances for direct labor. 4. Calculate and interpret variances for manufacturing overhead. 5. Discuss how the management by exception approach is applied to investigation of standard cost variances.

Development of Standard Costs Related Learning Objectives: 1. Explain how standard costs are developed. 2. Calculate and interpret variances for direct material. 3. Calculate and interpret variances for direct labor. 4. Calculate and interpret variances for manufacturing overhead. 5. Discuss how the management by exception approach is applied to investigation of standard cost variances. Standard costs are developed in a variety of ways. They are 1. specified by formulas or recipes. 2. developed from price lists provided by suppliers. 3. determined time and motion studies conducted by industrial engineers.

Development of Standard Costs Related Learning Objectives: 1. Explain how standard costs are developed. 2. Calculate and interpret variances for direct material. 3. Calculate and interpret variances for direct labor. 4. Calculate and interpret variances for manufacturing overhead. 5. Discuss how the management by exception approach is applied to investigation of standard cost variances. Standard costs are developed in a variety of ways. They are 1. specified by formulas or recipes. 2. developed from price lists provided by suppliers. 3. determined time and motion studies conducted by industrial engineers. 4. developed from analyses of past data.

Ideal Versus Attainable Standards In developing standard costs, there are two schools of thought. Ideal standards: developed under the assumption that no obstacles to the production process will be encountered. They are sometimes referred to as perfection standards. Attainable Standards: developed under the assumption that there will be occasional problems in the production process such as equipment failure, labor turnover, and materials defects. Related Learning Objectives: 1. Explain how standard costs are developed. 2. Calculate and interpret variances for direct material. 3. Calculate and interpret variances for direct labor. 4. Calculate and interpret variances for manufacturing overhead. 5. Discuss how the management by exception approach is applied to investigation of standard cost variances.

A General Approach to Variance Analysis An analysis of the difference between a standard cost and and actual cost is called variance analysis. The process decomposes the difference in two components. For direct material: materials price and materials quantity variance. For direct labor: labor rate (price) and labor efficiency (quantity) variance. For overhead: overhead volume variance and controllable overhead variance. Related Learning Objectives: 1. Explain how standard costs are developed. 2. Calculate and interpret variances for direct material. 3. Calculate and interpret variances for direct labor. 4. Calculate and interpret variances for manufacturing overhead. 5. Discuss how the management by exception approach is applied to investigation of standard cost variances.

Material Price Variance The material price variance is expressed as (AP – SP)AQ p where: (AP) = actual price per unit of material. (SP) = standard price per unit of direct material. (AQ p ) = actual quantity of material purchased. If actual price > standard price, then the variance is unfavorable. If actual price < standard price, then the variance is favorable. Related Learning Objectives: 1. Explain how standard costs are developed. 2. Calculate and interpret variances for direct material. 3. Calculate and interpret variances for direct labor. 4. Calculate and interpret variances for manufacturing overhead. 5. Discuss how the management by exception approach is applied to investigation of standard cost variances.

Material Quantity Variance The material quantity variance is expressed as (AQ u – SQ)SP where: (AQ u ) = actual quantity of material used. (SQ) = standard quantity of material allowed. (SP) = standard price of material. If actual quantity > standard quantity, then the variance is unfavorable. If actual quantity < standard quantity, then the variance is favorable. Related Learning Objectives: 1. Explain how standard costs are developed. 2. Calculate and interpret variances for direct material. 3. Calculate and interpret variances for direct labor. 4. Calculate and interpret variances for manufacturing overhead. 5. Discuss how the management by exception approach is applied to investigation of standard cost variances.

Labor Rate Variance The labor rate (price) variance is expressed as (AR – SR)AH where: (AR) = actual wage rate (price). (SR) = standard wage rate (price). (AH) = actual number(quantity) of labor hours. If actual rate > standard rate, then the variance is unfavorable. If actual rate < standard rate, then the variance is favorable. Related Learning Objectives: 1. Explain how standard costs are developed. 2. Calculate and interpret variances for direct material. 3. Calculate and interpret variances for direct labor. 4. Calculate and interpret variances for manufacturing overhead. 5. Discuss how the management by exception approach is applied to investigation of standard cost variances.

Labor Efficiency Variance The labor efficiency (quantity) variance is expressed as (AH – SH)SR where: (AH) = actual number of hours worked. (SH) = standard number of hours worked. (SR) = standard labor wage rate. If actual hours > standard hours, then the variance is unfavorable. If actual hours < standard hours, then the variance is favorable. Related Learning Objectives: 1. Explain how standard costs are developed. 2. Calculate and interpret variances for direct material. 3. Calculate and interpret variances for direct labor. 4. Calculate and interpret variances for manufacturing overhead. 5. Discuss how the management by exception approach is applied to investigation of standard cost variances.

Controllable Overhead Variance The controllable overhead variance is expressed as (actual overhead - flexible budget level of overhead) for actual level of production. It is referred to as controllable because managers are expected to control costs so they are not substantially different from budget. If actual > budget, then the variance is unfavorable. If actual < budget, then the variance is favorable. Related Learning Objectives: 1. Explain how standard costs are developed. 2. Calculate and interpret variances for direct material. 3. Calculate and interpret variances for direct labor. 4. Calculate and interpret variances for manufacturing overhead. 5. Discuss how the management by exception approach is applied to investigation of standard cost variances.

Overhead Volume Variance The overhead volume variance is expressed as (flexible budget level of overhead for actual level of production - overhead applied to production using standard overhead rate). This variance is solely the product of more or less units being produced than planned in the static budget. Its usefulness is limited. Related Learning Objectives: 1. Explain how standard costs are developed. 2. Calculate and interpret variances for direct material. 3. Calculate and interpret variances for direct labor. 4. Calculate and interpret variances for manufacturing overhead. 5. Discuss how the management by exception approach is applied to investigation of standard cost variances.

Investigation of Standard Cost Variances It is important to note that standard cost variances are not a definitive sign of good or bad performance. These variances are merely indicators of potential problems which must be investigated. And there are many plausible explanations for them. Related Learning Objectives: 1. Explain how standard costs are developed. 2. Calculate and interpret variances for direct material. 3. Calculate and interpret variances for direct labor. 4. Calculate and interpret variances for manufacturing overhead. 5. Discuss how the management by exception approach is applied to investigation of standard cost variances.

Management by Exception Because investigation of standard cost variances is itself 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. Related Learning Objectives: 1. Explain how standard costs are developed. 2. Calculate and interpret variances for direct material. 3. Calculate and interpret variances for direct labor. 4. Calculate and interpret variances for manufacturing overhead. 5. Discuss how the management by exception approach is applied to investigation of standard cost variances.

“Favorable” Variances May Be Unfavorable The fact that a variance is “favorable” does not mean that it should not be investigated. Raw materials are good examples of this phenomenon, especially considering the competitive pricing environment for most commodities. Suppose inferior, low-priced materials are ordered. One the one hand, a favorable price variance will arise. On the other hand, most likely there will be substantially more scrap and rework, and thus a higher quantity variance. Related Learning Objectives: 1. Explain how standard costs are developed. 2. Calculate and interpret variances for direct material. 3. Calculate and interpret variances for direct labor. 4. Calculate and interpret variances for manufacturing overhead. 5. Discuss how the management by exception approach is applied to investigation of standard cost variances.

Responsibility Accounting and Variances As noted previously, managers should be held responsible only for costs they can control. This is true in the area of variance analysis. For example, a purchasing agent may be held responsible for direct material price variances, but certainly not direct material quantity (usage) variances. Related Learning Objectives: 1. Explain how standard costs are developed. 2. Calculate and interpret variances for direct material. 3. Calculate and interpret variances for direct labor. 4. Calculate and interpret variances for manufacturing overhead. 5. Discuss how the management by exception approach is applied to investigation of standard cost variances.

Appendix A: Recording Standard Costs in Accounts In a standard costing system, the costs added to the Raw Materials Inventory, Work in Process Inventory, Finished Goods Inventory, and Cost of Goods Sold accounts are all recorded at standard rather than actual cost. Variances are also calculated and recorded for management’s use in performance evaluation. Related Learning Objectives: 1. Record standard costs in the account of a manufacturing firm.

Recording Material Costs Related Learning Objectives: Record standard costs in the account of a manufacturing firm. Purchase of raw materials inventory: Accountdr.cr. Raw Material Inventory (std.) x Material Price Variance x Accounts Payable (actual) x (This is an unfavorable price variance) Usage of raw materials inventory: Accountdr.cr. Work in Process Inventory x Material Quantity Variance x Raw Material Inventory x (This is an unfavorable quantity variance)

Recording Labor Cost Related Learning Objectives: Record standard costs in the account of a manufacturing firm. Accountdr.cr. Work in Process Inventory (std.) x Labor Rate Variance x Labor Efficiency Variance x Salaries Payable (actual) x (Note: both the labor rate variance and efficiency variance are unfavorable)

Recording Manufacturing Overhead Related Learning Objectives: Record standard costs in the account of a manufacturing firm. Recording manufacturing overhead in a standard costing system is a three-step process: 1. Actual overhead is recorded in the manufacturing overhead account. 2. Overhead is applied to Work in Process Inventory at the standard cost. 3. The difference between actual overhead and overhead applied at standard is closed and overhead variances are identified. More

Recording Manufacturing Overhead (Step 1) Related Learning Objectives: Record standard costs in the account of a manufacturing firm. To record actual overhead cost: Accountdr.cr. Manufacturing Overhead x *Various Accounts x *Various accounts include indirect wages payable, utilities payable and accumulated depreciation.

Recording Manufacturing Overhead (Step 2) Related Learning Objectives: Record standard costs in the account of a manufacturing firm. To apply overhead cost to work in process inventory at cost: Accountdr.cr. Work in Process Inventory x Manufacturing Overhead x

Recording Manufacturing Overhead (Step 3) Related Learning Objectives: Record standard costs in the account of a manufacturing firm. To close out manufacturing overhead cost to work in process inventory at cost: Accountdr.cr. Manufacturing Overhead x Overhead Volume Variance x Controllable Overhead Variance x

Recording Finished Goods Related Learning Objectives: Record standard costs in the account of a manufacturing firm. To record completed units sent to finished goods: Accountdr.cr. Finished Goods Inventory x Work in Process Inventory x

Recording Cost of Goods Sold Related Learning Objectives: Record standard costs in the account of a manufacturing firm. To apply overhead cost to work in process inventory at cost: Accountdr.cr. Cost of Goods Sold x Finished Goods Inventory x

Closing Variance Accounts Related Learning Objectives: Record standard costs in the account of a manufacturing firm. At the end of the accounting period, the temporary variance accounts must be closed. As a practical matter this is usually accomplished by debiting or crediting the variances to cost of goods sold. Accountdr.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

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