9-1 Standard Costs Standards are benchmarks or “norms” for measuring performance. In managerial accounting, two types of standards are commonly used. Quantity standards specify how much of an input should be used to make a product or provide a service. Price standards specify how much should be paid for each unit of the input. A standard is a benchmark or “norm” for measuring performance. In managerial accounting, two types of standards are commonly used by manufacturing, service, food, and not-for-profit organizations: Quantity standards specify how much of an input should be used to make a product or provide a service. For example: Auto service centers like Firestone and Sears set labor time standards for the completion of work tasks. Fast-food outlets such as McDonald’s have exacting standards for the quantity of meat going into a sandwich. Price standards specify how much should be paid for each unit of the input. For example: Hospitals have standard costs for food, laundry, and other items. Home construction companies have standard labor costs that they apply to sub-contractors such as framers, roofers, and electricians. Manufacturing companies often have highly developed standard costing systems that establish quantity and price standards for each separate product’s material, labor, and overhead inputs. These standards are listed on a standard cost card. Examples: Firestone, Sears, McDonald’s, hospitals, construction, and manufacturing companies.

Manufacturing Overhead 9-2 Standard Costs Deviations from standards deemed significant are brought to the attention of management, a practice known as management by exception. Standard Amount Direct Material Management by exception is a system of management in which standards are set for various operating activities, with actual results compared to these standards. Any deviations that are deemed significant are brought to the attention of management as “exceptions.” This chapter applies the management by exception principle to quantity and price standards with an emphasis on manufacturing applications. Direct Labor Manufacturing Overhead Type of Product Cost

Variance Analysis Cycle 9-3 Variance Analysis Cycle Identify questions Receive explanations Take corrective actions Conduct next period’s operations Analyze variances The variance analysis cycle is a continuous process used to identify and solve problems: The cycle begins with the preparation of standard cost performance reports in the accounting department. These reports highlight variances that are differences between actual results and what should have occurred according to standards. The Variances raise questions such as: Why did this variance occur? Why is this variance larger than it was last period? The significant variances are investigated to discover their root causes. Corrective actions are taken. Next period’s operations are carried out and the process is repeated. Prepare standard cost performance report Begin

Setting Standard Costs 9-4 Setting Standard Costs Should we use ideal standards that require employees to work at 100 percent peak efficiency? I recommend using practical standards that are currently attainable with reasonable and efficient effort. Standards tend to fall into one of two categories: Ideal standards can only be attained under the best of circumstances. They allow for no work interruptions and they require employees to work at 100% peak efficiency all of the time. Practical standards are tight, but attainable. They allow for normal machine downtime and employee rest periods and can be attained through reasonable, highly efficient efforts of the average worker. Practical standards can also be used for forecasting cash flows and in planning inventory. Engineer Managerial Accountant

A standard cost card for one unit of product might look like this: 9-5 Standard Cost Card A standard cost card for one unit of product might look like this: The standard cost card is a detailed listing of the standard amounts of direct materials, direct labor, and variable overhead inputs that should go into a unit of product, multiplied by the standard price or rate that has been set for each input.

Price and Quantity Variances 9-6 Price and Quantity Variances Variance Analysis Price Variance Quantity Variance Price and quantity variances can be computed for all three variable cost elements – direct materials, direct labor, and variable manufacturing overhead – even though the variances have different names as shown. Materials price variance Labor rate variance VOH rate variance Materials quantity variance Labor efficiency variance VOH efficiency variance

Price and Quantity Variances 9-7 Price and Quantity Variances Price Variance Quantity Variance Actual Quantity Actual Quantity Standard Quantity × × × Actual Price Standard Price Standard Price In equation form, price and quantity variances are calculated as shown. (AQ × AP) – (AQ × SP) (AQ × SP) – (SQ × SP) AQ = Actual Quantity SP = Standard Price AP = Actual Price SQ = Standard Quantity

Direct Materials Variances – Points of Clarification 9-8 Direct Materials Variances – Points of Clarification I need the price variance sooner so that I can better identify purchasing problems. You accountants just don’t understand the problems that purchasing managers have. I’ll start computing the price variance when material is purchased rather than when it’s used. Most companies compute the materials price variance when materials are purchased. They calculate the materials quantity variance after materials are used in production.

Materials Quantity Variance Materials Price Variance 9-9 Direct Materials Variances – Points of Clarification Materials Quantity Variance Materials Price Variance Purchasing Manager Production Manager The purchasing manager and production manager are usually held responsible for the materials price variance and materials quantity variance, respectively. The standard price is used to compute the quantity variance so that the production manager is not held responsible for the performance of the purchasing manager. The standard price is used to compute the quantity variance so that the production manager is not held responsible for the purchasing manager’s performance.

Direct Labor Variances – Points of Clarification 9-10 Direct Labor Variances – Points of Clarification Production managers are usually held accountable for labor variances because they can influence the: Mix of skill levels assigned to work tasks. Level of employee motivation. Quality of production supervision. Quality of training provided to employees. Production Manager Labor variances are partially controllable by employees within the Production Department. For example, production managers/supervisors can influence: The deployment of highly skilled workers and less skilled workers on tasks consistent with their skill levels. The level of employee motivation within the department. The quality of production supervision. The quality of the training provided to the employees.

Direct Labor Variances – Points of Clarification 9-11 Direct Labor Variances – Points of Clarification I think it took more time to process the materials because the Maintenance Department has poorly maintained your equipment. I am not responsible for the unfavorable labor efficiency variance! You purchased cheap material, so it took more time to process it. However, labor variances are not entirely controllable by one person or department. For example: The Maintenance Department may do a poor job of maintaining production equipment. This may increase the processing time required per unit, thereby causing an unfavorable labor efficiency variance. The purchasing manager may purchase lower quality raw materials resulting in an unfavorable labor efficiency variance for the production manager.

Variance Analysis and Management by Exception 9-12 Variance Analysis and Management by Exception Larger variances, in dollar amount or as a percentage of the standard, are investigated first. All variances are not worth investigating. Methods for highlighting a subset of variances as exceptions include: Looking at the size of the variance. Looking at the size of the variance relative to the amount of spending. How do I know which variances to investigate?

Advantages of Standard Costs 9-13 Advantages of Standard Costs Management by exception Promotes economy and efficiency Advantages Research has shown that a substantial portion of companies in the United Kingdom, Canada, Japan, and the United States use standard cost systems. This is because standard cost systems offer many advantages including: Standard costs are a key element of the management by exception approach which helps managers focus their attention on the most important issues. Standards that are viewed as reasonable by employees can serve as benchmarks that promote economy and efficiency. Standard costs can greatly simplify bookkeeping. Standard costs fit naturally into a responsibility accounting system. Enhances responsibility accounting Simplified bookkeeping

Potential Problems with Standard Costs 9-14 Potential Problems with Standard Costs Emphasizing standards may exclude other important objectives. Favorable variances may be misinterpreted. Potential Problems Standard cost reports may not be timely. Emphasis on negative may impact morale. The use of standard costs can also present a number of problems. For example: Standard cost variance reports are usually prepared on a monthly basis and are often released days or weeks after the end of the month; hence, the information can be outdated. If variances are misused as a club to negatively reinforce employees, morale may suffer and employees may make dysfunctional decisions. Labor variances make two important assumptions. First, they assume that the production process is labor-paced; if labor works faster, output will go up. Second, the computations assume that labor is a variable cost. These assumptions are often invalid in today’s automated manufacturing environment where employees are essentially a fixed cost. In some cases, a “favorable” variance can be as bad or worse than an “unfavorable” variance. Excessive emphasis on meeting the standards may overshadow other important objectives such as maintaining and improving quality, on-time delivery, and customer satisfaction. Just meeting standards may not be sufficient; continual improvement using techniques such as Six Sigma may be necessary to survive in a competitive environment. Invalid assumptions about the relationship between labor cost and output. Continuous improvement may be more important than meeting standards.

Recording Material Variances 9-15 Recording Material Variances The first entry is to record the purchase of direct materials. A favorable materials price variance is recorded with a credit. The second entry is to record the use of material. The use of material involves a transfer of material from the asset account raw materials inventory to the asset account work-in-process inventory. An unfavorable materials quantity variance is recorded with a debit.

Recording Direct Labor Variances 9-16 Recording Direct Labor Variances Here we see the entry for the incurrence of direct labor. Both labor variances are unfavorable and are recorded with debits.

Cost Flows in a Standard Cost System 9-17 Cost Flows in a Standard Cost System Inventories are recorded at standard cost. Variances are recorded as follows: Favorable variances are credits, representing savings in production costs. Unfavorable variances are debits, representing excess production costs. Standard cost variances are usually closed out to cost of goods sold. Unfavorable variances increase cost of goods sold. Favorable variances decrease cost of goods sold. The entries into the various accounts are made at standard cost – not actual cost. The differences between actual and standard costs are entered into special accounts that accumulate the various standard cost variances. The standard cost variance accounts are usually closed out to Cost of Goods Sold at the end of the period. Unfavorable variances increase Cost of Goods Sold, and favorable variances decrease Cost of Goods Sold.