Standard Costing A control tool

1.How unit input standards are developed 2.Why standard cost systems are adopted 2.Purpose of a standard cost sheet 3.Compute direct materials and direct labor variances, and explain how they are used for control. 4.Compute overhead variances three different ways ObjectivesObjectives

Management Planning: Determination of objectives & Attainment of the objectives Done through identification of alternatives Choosing from alternatives Plan is useless, if not achieved Control: Control function looks after operation of plan, Feedback from the system and Corrective measures for deviations

DEFINITIONS Standard: Predetermined measurable quantity set in defined conditions. Standard cost: “a pre-determined cost which is calculated from management’s standards of efficient operation and the necessary expenditure” a standard expressed in money assuming a particular level of efficiency in utilisation resources. Quantity aspect comes from engineering specifications & rate aspect comes from budgets

STANDARD COST V. ESTIMATED COST Scientifically determined Indicates management’s efficiency view Controls cost performance (what should be) Only past data is adjusted for anticipated changes in future No such indication Does not control (what will be)

Need for standard cost ‘What a product should have costed’ is more important than ‘what it did cost’ (a measure of cost performance) The need for standard costing emanates from the limitations of historical costing. Price based on historical cost may vary from day to day Actual cost can be known after a long time in some cases, but cost has to be determined before production in some cases. Efficiency cannot be gauged from historical cost Timely corrective action cannot be taken under historical costing to reduce losses.

Use of standard cost Price fixation Cost control through variance analysis Facilitates management by exception

SELECTION OF RIGHT TYPE OF STANDARDS Basic or Bogey standard: a base year is chosen similar to price index Ideal standard: in all favourable conditions with maximum efficiency, what is achievable. [not attainable, variance does not reveal what could have been avoided] Normal standards / Expected standard / Attainable standard: what can be achieved under normal operating conditions. If performance is abnormal, it can result in large variances. Current standards: forecast of current period costs taking the current output level into consideration. Variance reveals the efficiency or inefficiency in usage of factors of production. Kaizen standards reflect a planned improvement and are a type of currently attainable standard.

STANDARD COSTING & BUDGETRAY CONTROL A unit idea Seeks to procure efficient utilisation of factors of production Relates to one function i.e., Production A total idea Lays down the limit of expenses that should not be crossed under normal condition to attain projected profitability Relates to all functions i.e., production, purchase, selling, R & D, etc.

ADVANTAGES OF STANDARD COSTING Leads to optimum utilisation of resources Reveals cost performance By reporting distinct variances, facilitates management by exception Helps in planning, control and price fixation Creates cost consciousness Sets defined targets to be achieved. Helps in standardisation of product Helps cost determination immediately after production Encourages cost reduction.

LIMITATIONS OF STANDARD COSTING Standard fixation is a highly complex and technical task. Absolutely perfect standards are not found. Variances cannot be linked with responsibility. Multiple factors act at the same time. Current conditions are always volatile. So standard revision is must – a costly thing to do always. Can not be applied where standardisation of job is not possible (Job work) Isolating controllable and uncontrollable reasons is very difficult Achievable standard fixation, if high, creates psychological problems Depends on management support Is not that relevant for industries where technological changes are rapid Selection of the right type of standard is also a problem. Effectiveness of standard costing decreases in face of frequent changes in the following: Changes in price Change in level of output Change in product-mix

ESTABLISHMENT OF STANDARD COST PROBLEMS FACED IN SETTING PHYSICAL STANDARDS: Difficult for new products Change in technology Product diversification Materials may not be available as per specification What level of wastage to be fixed (past average or unavoidable) Choosing the right standard (best attainable, attainable good performance, past average)

Cont….. Direct Material: Standard quantities Normal loss based on past experience Standard price of all material taking into consideration present stock, future price fluctuation and forward contracts, if any, existing contracts, etc

Cont…. Direct Labour: Different grades of labour required Processing time gathered from work study Rates struck with union

Cont…. Variable overhead: Assumption is that move in sympathy with production Fixed Overhead: Total cost of the period Budgeted production Number of hours expected to be worked in the period Then a standard cost sheet is prepared & actual is compared with the standard

Variance Analysis Variance = difference between standard and actual Analysis: process of finding out the reason for difference for improving performance finds contribution of each causal factor to the total variance and indicates possible areas for cost control through management intervention. [addresses two issues: how much difference and why the difference]

Causes of variance efficiency in usage (quantity) price (due to change in unit price of material or labour or indirect expenses) change in volume

Different types of variances under different elements of cost For different components of cost: Efficiency variance Price varianceVolume variance MaterialUsage, Mixture, Yield Price Revision LabourEfficiency, Idle time Pay rate Varibale overhead EfficiencyExpenditureRevision Fixed OverheadEfficiencyExpenditureCapacity Calendar SalesQuantity, Mixture Price

Some terms Favourable variance/Unfavourable variance Controllable /Uncontrollable variance Revision variance: If the standard has to undergo a material change due to unforeseen causes, variance due to this reason has to be separated under revision variance so that it saves time in revising the standard in future. Once revised for effective operation of standard costing, it would not recur.

STANDARD HOUR In multi-product firms where different products have different volumes, quality, etc. all products are expressed in terms of a common measure called standard hour. It is thus a unit of output, not unit of time. It refers to the amount of work that has to be performed in one hour’s time.

Cost Assignment Approaches Actual costing systemActualActualActual Normal costing systemActualActualBudgeted Standard costing systemStandardStandardStandard Manufacturing Costs Direct Direct Direct Direct Materials Labor Overhead Materials Labor Overhead

Standard Cost Sheet Deluxe Strawberry Frozen Yogurt Standard Standard Standard Standard Standard Standard Description Price Usage Cost Subtotal Description Price Usage Cost Subtotal Direct materials: Yogurt$0.020x25 oz.=$0.50 Strawberries0.010x10 oz.= 0.10 Milk0.015x8 oz.=0.12 Whipped cream0.025x4 oz.=0.10 Gelatin0.010x1 oz. =0.01 Container0.030x1= 0.03 Total direct materials$0.86 Continued

Standard Standard Standard Standard Standard Standard Description Price Usage Cost Subtotal Description Price Usage Cost Subtotal Direct labor: Machine operators$8.00x0.01 hr.=$0.08 Total direct labor$0.08 Overhead: Variable overhead6.00x 0.01 hr.=$0.06 Fixed overhead20.00x0.01 hr.= 0.20 Total overhead 0.26 Total standard unit cost$1.20

Standard Usage Allowed Standard Quantity (SQ) of Materials Allowed for 20,000 quarts: SQ = Unit quantity standard x Actual output = 25 x 20,000 = 500,000 ounces Standard Hours (SH) of Labor Allowed for 20,000 quarts: SH = Unit quantity standard x Actual output = 0.01 x 20,000 = 200 direct labor hours

Price and Usage Variances Actual production: 30,000 quarts Actual yogurt usage: 780,000 ounces Actual price per ounce of yogurt: $0.025 Actual direct labor hours: 325 hours Actual wage rate: $8.20 per hour

Price and Usage Variances AP x AQ (Actual Quantity at Actual Price) (1) SP x AQ (Actual Quantity at Standard Price) (2) SP x SQ (Standard Quantity at Standard Price) (3) Price Variance (1) –(2) Usage Variance (2) – (3) Total Variance (1) – (3)

MPV = (AP – SP)AQ Material Price Variance = ($0.025 – $0.020)780,000 = $0.005 x 780,000 = $3,900 U

MUV = (AQ – SQ)SP = (780,000 – 750,000)$0.02 = 30,000 x $0.02 = $600 U Direct Materials Usage Variance

Rate and Efficiency Variances AH x AR (Actual Hours at Actual Rate) (1) AH x SR (Actual Hours at Standard Rate) (2) SH x SR (Standard Hours at Standard Rate) (3) Rate Variance (1) –(2) Efficiency Variance (2) – (3) Total Variance (1) – (3)

Labor Rate Variances Labor Rate Variances LRV = (AR – SR)AH = ($8.20 – $8.00)325 = $0.20 x 325 = $65 U

Labor Efficiency Variances Labor Efficiency Variances LEV = (AH – SH)SR = (325 – 300)$8.00 = 25 x $8.00 = $200 U

Disposition of Direct Materials and Direct Labor Variances If material in amount Prime Costs Percentage of Total Work in Process$ 00% Finished Goods3,48020 Cost of Goods Sold 13, Total$17,400100%

Disposition of Direct Materials and Direct Labor Variances The receiving report and the invoice are used to record the receipt of the merchandise and to control the payment. Cost of Goods Sold Direct Materials Price Variance Direct Materials Usage Variance Direct Labor Rate Variance65 00 Direct Labor Efficiency Variance If material in amount Finished Goods953 00

Variable Overhead Variances Variable overhead rate (standard)$6.00/DLH Actual variable overhead costs$7,540 Actual hours worked 1,300 Quarts of deluxe frozen strawberry yogurt produced120,000 Hours allowed for production1,200 Applied variable overhead$7,200

Variable Overhead Variances Actual Variable Overhead (1) Variable Overhead Rate x Actual Hours (2) Variable Overhead Rate x Standard Hours (3) Spending Variance (1) –(2) Efficiency Variance (2) – (3) Total Variance (1) – (3)

VOSV = (AVOR x AH) – (SVOR x AH) Variable Overhead Spending Variances = (AVOR – SVOR)AH = ($5.80 – $6.00)1,300 = $260 F

VOEV = (AH – SH)SVOR Variable Overhead Efficiency Variances = (1,300 – 1,200)$6.00 = $600 U

Helado Company, Inc. Flexible Budget Performance Report For the Month Ended May 31, 2004 Cost Formula Actual Costs Budget Spending Variance Natural gas$3.80$4,400$4,940$540 F Electricity2.002,8402, U Water U Total cost$6.00$7,540$7,800$240 F

Helado Company, Inc. Performance Report For the Month Ended May 31, 2004 Cost Formula Actual Costs Budget for Actual Hours Spending Variance Natural gas$3.80$4,400$4,940$540 F Electricity2.002,8402, U Water U Total $6.00$7,540$7,800$260 F Budget for Standard Hours Efficiency Variance $4,560$380 U 2, U U $7,200$600 U

Fixed Overhead Variances Budgeted fixed overhead$20,000 Expected activity1,000 direct labor hours Standard fixed overhead rate $20 Hours allowed to produce 100,000 quarts of frozen yogurt (0.01 x 100,000) Budgeted or Planned Items (May) Actual Results Actual production120,000 quarts Actual fixed overhead cost$20,500 Standard hours allowed for actual production (0.01 x 120,000)1,200

Total Fixed Overhead Variances Applied fixed overhead Standard fixed overhead rate x Standard hours = = $20 x 1,200 =$24,000 Total fixed overhead variance $20,500 – $24,000 = = $3,500 Overapplied

Fixed Overhead Variances Actual Fixed Overhead (1) Budgeted Fixed Overhead (2) Fixed Overhead Rate x Standard Hours (3) Spending Variance (1) – (2) Volume Variance (2) – (3) Total Variance (1) – (3)

Fixed Overhead Spending Variance FOSV = AFOH – BFOH = $20,500 – $20,000 = $500 U

Helado Company, Inc. Performance Report For the Month Ended May 31, 2004 Actual Cost Budgeted Cost Variance Depreciation$ 5,000$ 5,000 $---- Salaries13,40013, U Taxes1,1001,05050 U Insurance 1, U Total $20,500$20,000$500 U Fixed Overhead Items

Fixed Overhead Volume Variance FOVV = Budgeted fixed overhead – Applied fixed overhead = $20(1,000 – 1,200) = $4,000 F = [Standard fixed overhead rate x SH(D)] – (Standard fixed overhead x SH)

MIX AND YIELD VARIANCES: MATERIAL AND LABOR Standard Mix Information: Direct Materials Direct Material Mix Mix Proportion SP Standard Cost Peanuts128 lbs.0.80$0.50$64 Almonds 32 lbs Total160 lbs.$96 Yield120 lbs. Yield ratio: 0.75 (120/160) Standard cost of yield (SP): $0.80 per pound ($96/120 pounds of yield)

Malcom Nut Company produces a batch of 1,600 pounds and produces the following actual results: Direct Material Actual Mix Percentages Peanuts1,120lbs.70% Almonds Total1,600lbs.100% Yield1,300lbs.81.3%

SM = Standard mix proportion x Total actual input quantity SM(peanuts) = 0.80 x 1,600 pounds = 1,280 pounds SM(almonds) = 0.20 x 1,600 pounds = 320 pounds Standard Mix

Mix Variance = 3(AQ – SM)SP Direct Material AQ SM AQ – SM SP (AQ – SM)SP Peanuts1,1201, $0.50$-80 Almonds Mix variance$-80U Standard Mix

Standard yield = Yield ratio x Total actual inputs Direct Materials Yield Variance Yield variance = (Standard yield – Actual yield)SP y Yield variance = (1,200 – 1,300)$0.80 = $80 F

Standard Mix Information Labor Type Mix Mix Proportion SP Standard Cost Shelling3hrs.0.60$ 8.00$24 Mixing2hrs Total5hrs.$54 Yield120lbs. Yield ratio: 24 = (120/5), or 2,400% Standard cost of yield (SP ): $0.45 per pound ($54/120 pounds of yield) y

Malcom processes 1,600 pounds of nuts and produces the following actual results: Shelling20 hrs.40% Mixing30 hrs. 60% Total50 hrs.100% Yield1,300 lbs.2,600% *Uses 50 hours as the base. Standard Mix Information Labor TypeActual MixMix Percentages*

Labor Type AH SM AH – SM SP (AH – SM)/SP Shelling $ 8.00$-80 Mixing Direct Labor mix variance$-70U Direct Labor Mix Variance

Using the standard mix information and the actual results, the yield variance is computed as follows: Yield variance = (Standard yield – Actual yield)SP = [(24 x 50) – 1,300]$0.45 = (1,200 – 1,300)$0.45 = $45 F The yield variance is favorable because the actual yield is greater than the standard yield. Direct Labor Yield Variance y

Breaking Sales Volume variance 1.Market size variance =[(Actual Industry Sales in Units – Budgeted Industry Sales in Units) x Budgeted Market Share Percentage] x Budgeted Average Unit 2.Market share variance=[(Actual Market Share Percentage – Budgeted Market Share Percentage) x Actual Industry Sales in Units] x Budgeted Average Unit Contribution Margin [Size variance is uncontrollable, share variance is controllable]