Standard Costs: Direct Labor and Materials Chapter Twelve Standard Costs: Direct Labor and Materials

Outline of Chapter 12 Standard Costs: Direct Labor and Materials Direct Labor and Materials Variances Incentive Effects of Direct Labor and Materials Variances Disposition of Standard Cost Variances The Costs of Standard Costs

Connection to Other Chapters Chapter 12 shows how standard costs and variances are used for decision control. Chapter 4 discussed the decision control process. Chapter 6 showed how budgets are used in decision control.

Standard Cost Definition: The expected cost that is reasonably required to achieve a given objective under specified conditions. Used for Decision Management: Standards can be better predictors of future costs than actual past costs. Can be used in product pricing, bidding, and outsourcing decisions. Used for Decision Control: Set performance expectations or benchmarks for the costs of products, processes, or sub-components. Variances from standards get attention of managers.

Setting and Revising Standards Setting standards depends on specialized knowledge. Price standards from economic forecasts Quantity standards from engineering studies Choosing between tight and loose standards Tight standards motivate higher performance (decision control). Loose standards allow more discretion (decision management). Standards are usually set once a year. Frequent revision would reduce incentives to control costs.

Target Costing Target costing is a technique used for new product planning. 1. Market planners begin with selling price required to achieve a desired market share. 2. Selling price Desired profit = Total target cost 3. Assign portion of total target costs to marketing, engineering, and manufacturing departments. 4. Redesign product and techniques to achieve target.

Purpose of Variances Variances measure the difference between actual and standard costs. Favorable (F) variance, if actual < standard Unfavorable variance, if actual > standard Decision control Variances alert managers to deviations from plan. Performance rewards may be based on minimizing variances.

Variance Computation Symbols: T= Total; A = Actual; S = Standard; P = Price; Q = Quantity Total Variance = Actual Cost minus Standard cost TV = (AQ  AP) - (SQ  SP) = (AQ  AP) + [ - (SP AQ) + (SP  AQ)] - (SQ  SP) = [(AQ  AP) - (SP  AQ)] + [(SP  AQ) - (SQ  SP)] = [AQ  (AP - SP)] + [(AQ - SQ)  SP] = PV + QV Total Variance = Price Variance + Quantity Variance See Self-Study problem.

Direct Labor Variance Symbols: a = Actual; s = Standard; H = Hours; W = Wage rate per hour Total Flexible budget Total actual based on standard cost actual input cost (Ha  Wa) (Ha  Ws) (Hs  Ws) |_______________________| |______________________| [Ha  (Wa - Ws)] [(Ha - Hs)  Ws] Wage variance Efficiency variance |_________________________________________________| [(Ha  Wa)  (Hs  Ws)] Total labor variance See Figure 12-1.

Interpreting Direct Labor Variance Large variances in either direction indicate performance is not as planned, due to either poor planning, poor management, or random fluctuation. Unfavorable wage variance Workers were not available at lower rates Unfavorable wage variance with favorable efficiency variance higher-paid workers performed work more efficiently Favorable wage variance with unfavorable efficiency variance lower-paid workers performed work less efficiently

Direct Materials Variance - current use In this case, no direct materials remain in ending inventories. Total Flexible budget Total actual based on standard cost actual use cost (Qa  Pa) (Qa  Ps) (Qs  Ps) |_______________________| |____________________| [Qa  (Pa - Ps)] [(Qa - Qs)  Ps] Price variance Quantity variance |______________________________________________| [(Qa  Pa)  (Qs  Ps)] Total materials variance See Figure 12-2.

Direct Materials Variance - no current use In this case, all purchased materials remain in ending inventories. Recognize material purchase price variance at time of purchase rather than waiting until materials are used. Qb = Actual quantity bought Total Flexible budget actual based on cost actual purchased (Qb  Pa) (Qb  Ps) |_______________________| [Qb  (Pa - Ps)] Price variance See Figure 12-3.

Direct Materials Variance - current and future use Total actual Flexible budget based cost on actual purchased (Qb  Pa) (Qb  Ps) |___________________________| [Qb  (Pa - Ps)] Price variance Flexible budget based Total standard on actual use cost (Qa  Ps) (Qs  Ps) |__________________________| [(Qa - Qs)  Ps] Quantity variance Price variance recognized at time materials purchased. Quantity variance recognized at time materials are used.

Timely Reporting of Materials Price Variance is Important! Managers can act quickly to mitigate or capitalize on price changes. For example, if a raw materials price rises, managers might want to use less of the more expensive material and more of the relatively less expensive material, if such a substitution is possible. And/or management might want to raise the selling price for the final products.

Risk Reduction and Standard Costs Risk reduction is a service individuals are willing to buy from financial markets. Standard costs remove price and efficiency fluctuation from performance measures of downstream users. Downstream users bear less risk because they know the standard costs they will be charged in the future.

Incentive Effects: Build Inventories Rewarding purchasing managers for favorable direct materials price variances creates an incentive for them to buy large quantities when price discounts are offered for high-volume purchases. Penalizing production managers for unfavorable labor efficiency variances encourages keeping labor busy producing more. Mitigation of inventory building incentive Charge purchasing department for cost of holding inventory. Just-in-time (JIT) purchasing and production policies

Incentive Effects: Externalities Purchasing externalities on production Purchase cheaper substandard materials. Purchase price variance is favorable. Unusable material results in unfavorable material quantity variance. Production externalities on purchasing Short lead times on requisitions lead to higher purchase prices. Requesting special orders for materials leads to higher prices. See self-study problem, part b.

Incentive Effects: Discourage Cooperation Evaluating performance evaluation on individual's variances Emphasizes individual instead of team efforts Reluctance to help others look good Solution: Base reward system on both individual and departmental (team) variances. Too much weight on teamwork can lead to shirking (free-rider problem).

Incentive Effects: Mutual Monitoring Method where managers or employees at the same level monitor each other’s performance Noninsulating allocations encourage mutual monitoring (see Chapter 7) Example when performance evaluation of both purchasing and production manager depends on both material price and quantity variances. Purchasing manager wants to help production manager become more efficient in material usage. Production manager wants to schedule requisitions to help purchasing manager buy materials at better prices.

Incentive Effects: Satisficing Satisficing behavior: Managers have incentives to achieve standard but go no further. Firm value would increase if managers attempted continuous improvement beyond standard innovate to meet competitive threats

Disposition of Standard Cost Variances Alternatives for disposing (writing off) standard cost variances are similar to the alternatives for disposing of over/underabsorbed overhead (Chapter 9). 1. Writing all variances off to cost of goods sold (expense) 2. Allocating between costs of goods sold (expense) and work-in process and finished good inventory 3. Recalculating the cost of each job The above alternatives are listed in order of increasing complexity.

Cost of Maintaining Standard Cost System Standard cost systems require Detailed standards for each labor and material input Updating for technological and price changes Time to investigate and explain variances Standard cost systems are less likely to be used when Direct labor cost is a small portion of total cost Rapid change in production processes or new product introductions would require frequent revisions of standards