Standard Costs Budget for a single unit Each unit has standards for:Quantity & Price/ Rate

Distinguishing between Standards and Budgets Both standards and budgets are predetermined costs, and both contribute to management planning and control. There is a difference: A standard is a unit amount. A budget is a total amount

Types of standards 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. Current standards: are based on the current level of performance, which may be inappropriate for the future, no incentive for workers

Standard costing system The management evaluates the performance of a company by comparing it with some predetermined measures Therefore, it can be used as a process of measuring and correcting actual performance to ensure that the plans are properly set and implemented

Benefits of Standard Costs Valuation of stock Assigning the standard cost to the actual output Planning Use the current standards to estimate future sales volume and future costs Controlling Evaluating performance by determining how efficiently the current operations are being carried out Motivation Notify the staff of the management’s expectations Setting of selling price

Benefits of Standard Costs Helps managers: In budget preparation Target levels of performance Identify performance standards Set sales prices Decrease accounting costs U.S. surveys show that more than 80% of responding companies use standard costing. Over half of responding companies in the United Kingdom, Ireland, Sweden, and Japan use standard costing. Why? Standard costing helps managers: • Prepare the budget • Set target levels of performance • Identify performance standards • Set sales prices of products and services • Decrease accounting costs Copyright (c) 2009 Prentice Hall. All rights reserved.

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.

Variance analysis A variance is the difference between the standards and the actual performance When the actual results are better than the expected results, there will be a favourable variance (F) If the actual results are worse than the expected results, there will be an adverse variance (A)

Materials cost variance Material Price variance Material Usage variance Labour cost variance Labour Efficiency variance Labour rate variance

Cost variance Cost variance = Price variance + Quantity variance Cost variance is the difference between the standard cost and the Actual cost Price variance = (standard price – actual price)*Actual quantity A price variance reflects the extent of the profit change resulting from the change in activity level Quantity variance = (standard quantity – actual quantity)* standard cost A quantity variance reflects the extent of the profit change

Three types of cost variance Material cost variance Labour cost variance Variable overheads variance

Material cost variance Material price variance = (standard price – actual price)*actual quantity MPV=(SP-AP)AM SP= standard price per unit of direct material. AP = actual price per unit of material AM = actual quantity of material purchased Material usage variance = (Standard materials – actual materials)* standard price = (Standard quantity of materials for actual production – actual quantity of materials production) * standard price MUV=(SM-AM)SP SM= Standard quantity of materials Total Material cost varince=MPV+MUV

Causes of Material Variances Materials price variance – factors that affect the price paid for raw materials include the availability of quantity and cash discounts, the quality of the materials requested, and the delivery method used. To the extent that these factors are considered in setting the price standard, the purchasing department is responsible Materials usage variance – if the variance is due to inexperienced workers, faulty machinery, or carelessness, the production department is responsible.

Labour cost variance Labour rate variance = (standard rate – actual rate)*actual hours LRV=(SR-AR)AH Labour efficiency variance = (standard Hours – actual Hours)*standard Rate = Standard hours for actual production – actual hours used) * standard rate LEV=(SH-AH)SP Total Lobour cost variance=LRV +LEV AH = actual number of hours worked. SH = standard number of hours worked. SR = standard labor wage rate.

Causes of Labor Variances Labor rate variance – usually results from two factors: (1) paying workers higher wages than expected, and (2) misallocation of workers. The manager who authorized the wage increase is responsible for the higher wages. The production department generally is responsible variances resulting from misallocation of the workforce. Labor efficiency variances - relates to the efficiency of workers. The cause of a quantity variance generally can be traced to the production department.

Static vs. Flexible Budgets Static Budget Flexible Budget Prepared for several different volume levels within a relevant range Separates fixed and variable costs Prepared for only one level of sales volume Variance = difference between actual and budget The master budget is a static budget, which means that it is prepared for only one level of sales volume. The static budget does not change after it is developed. A variance is the difference between an actual amount and the budgeted amount. The variances are classified as either: • Favorable (F) if an actual amount increases operating income, OR • Unfavorable (U) if an actual amount decreases operating income. A flexible budget summarizes costs and revenues for several different volume levels within a relevant range. Flexible budgets separate variable costs from fixed costs; it is the variable costs that put the “flex” in the flexible budget. To create a flexible budget, you need to know: • Budgeted selling price per unit • Variable cost per unit • Total fixed costs • Different volume levels within the relevant range Favorable – actual amount increases income Unfavorable – actual amount decreases income Copyright (c) 2009 Prentice Hall. All rights reserved.

Sales variance

Budgeted contribution (Standard margin* Standard volume) Actual contribution Budgeted contribution (Standard margin * Actual Volume) Sales margin price variance Sales margin volume variance Total sales margin variance

Sales variance Total sales variance = Total budgeted sales actual-Total actual sales TSV=SPV + SVV 1. Sales price variance =(standard selling price-actual selling price)*Actual quantity of sales 2. SPV=(SSP-ASP)AQS 2. Sales volume variance =(Standard quantity of sales – Actual quantity of sales)*Standard selling price SVV= (SQS –AQS)*SSP

Fixed overhead variance

Absorbed VO (SP* standard hours for actual output Actual FO Budgeted FO FO expenditure variance/ FO spending variance FO volume variance Total FO variance (under-/over- absorbed)

Fixed overhead variance Fixed overheads variance = Fixed overheads absorbed – Actual fixed overheads incurred Fixed overheads expenditure variance Budgeted fixed overheads – Budgeted overheads absorbed Fixed overheads volume variance = Absorbed fixed overheads – Budgeted overheads absorbed

Profit reconciliation statement

Profit reconciliation statement Profit reconciliation statement is used to sum up all variances It can help the top management to explain the major reasons for the difference between budgeted and actual profits The sales margin variance and fixed overheads variance are different between absorption and marginal costing system

Marginal costing

Profit Reconciliation Statement $ $ $ Budgeted profit 14000 Sales variances Sales margin price 8000 F Sales margin volume 3400 A 4600 F Materials cost variance Materials price 480 A Material usage 2400 F 1920 F Labour cost variance Labour rate 3200 A Labour efficiency 4000 A 7200 A Variable overhead variance VO Expenditure 900 F VO Efficiency 1600 A 700 A Fixed overhead expenditure variance 400F 980 A Actual profit 13020

Reasons for variances Material price variance Price changes in market conditions Change in the efficiency of purchasing dept. to obtain good terms from suppliers Purchase of different grades or wrong types of materials

Reasons for variances Materials usage variance More effective use of materials/ wastage arising from the efficient production process Purchase of different grade or wrong types of materials Wastage by the staff Change in production methods

Reasons for variances Labour rate variance Non-controllable market changes in the basic wage rate Use of higher/lower grade of workers Unexpected overtime allowance paid

Reasons for variances Labour efficiency variance Purchase of different grade or wrong types of materials Breakdown of machinery High/low labour turnover Changes in production method Introduction of new machinery Assignment wrong type of worker to work Adequacy of supervision Changes in working condition Change in motivation methods

Reasons for variances Variable overheads expenditure variance It may be caused by the non-controllable change in the price level of indirect wages or utility rates since the predetermined rate is set It is meaningless to interpret this kind of variance on its own. One should look various components of the fixed overheads

Reasons for variances Variable overheads efficiency variance Both the variable overheads and direct labour cost vary with the direct labour hours worked

Reasons for variances Fixed overheads expenditure It is meaningless to interpret this kind of variance on its own. It may be caused by the change in the price levels of rent, rates and other fixed expenses

Reasons for variances Fixed overhead volume variance When the level of activity is higher than the budgeted level, there is a favourable variance

Reasons for variances Sales margin price variance Change in the pricing strategies of the company Response to the change of pricing policies of its competitors Higher profit margin with growing demand for the product Lower profit margin for simulating sales

Reasons for variances Sales margin volume variance Change in prices and demand Change in the market share of its competitiors