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8 Cost Control Through Standard Costs

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Learning Objectives

After studying Chapter 8, you will be able to:

• Explain the significance of profit analysis for an organization.

• Describe the major characteristics and conditions of a standard cost system.

• Understand the information contained in a standard cost sheet.

• Compute materials price and usage variances, and identify potential causes of such variances.

• Compute labor rate and efficiency variances, and identify potential causes of such variances.

• Explain the major considerations that are the basis of standard costs for overhead and compute budget variances and capacity variances for overhead.

• Explain why the capacity variance is related only to fixed overhead costs.

• Understand issues relating to variance investigation and disposal of variances.

• Explain how standard costs can be used in various different settings.

• Describe ethical considerations relating to standards and variances.

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Chapter Outline

8.1 Profit Analysis

8.2 The Use of Standards Definition of Standard Costs Advantages of Standards The Quality of Standards Revising the Standards

8.3 Standard Cost Sheet

8.4 Standards for Materials Materials Price Variance Materials Usage Variance Interrelationships of Price and Usage Variances

8.5 Standards for Labor Setting Rate Standards Setting Time Standards Accounting for the Rate and Efficiency Variances Causes of Labor Variances Responsibility for Labor Variances Interrelationships of Variances The Influence of Automation

8.6 Standards for Overhead Development of Overhead Rates Flexible Overhead Budgets Framework for Two-Way Overhead Variance Analysis

8.7 Capacity and Control

8.8 Variances Summary of Standard Cost Variances Disposition of Variances

8.9 Standard Costs in Different Settings Standard Costs in Service Organizations Standard Costs in a Process Cost System Standard Costs in JIT/CIM Environments Target Costing and Kaizen Cost Targets

8.10 Ethical Considerations

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Section 8.1 Profit Analysis

Where Do I Start With Standard Costs?

Jean-Claude Recca, President of Rue de Lorraine, a chain of fast-food restaurants in central France, just returned from a reunion of his INSEAD graduating class. During the day of activities in the Riviera, he talked with several of his classmates who have become extremely successful in various businesses. One of those classmates suggested to Jean-Claude that adoption of a standard cost system eliminated most of her firm’s unacceptable scrap and spoilage, caused an examination of nonvalue-added activities, and substantially reduced several inefficient operations.

Jean-Claude did not know whether his restaurant chain would really benefit from a standard cost system. He wondered: If he makes the change, which costs should be put on standards? How does he set up standards? When do variances mean something? Isn’t a standard cost system expensive to use? Isn’t it a pain in the derriere? Wouldn’t a tight budget do the same thing?

These questions were more than Jean-Claude could consider. He decided to bounce the idea of standard costs off his controller.

In measuring success in any undertaking, a comparison is usually made between actual per- formance and expected performance. Any difference is a variance. A manager is then left with the responsibility to explain the what, why, and how of the variance. In doing so, the manager must understand the influence of key variables on the actual results, focus on areas that deserve more detailed investigation, and determine changes that must be made in future planning and control. This chapter introduces the concept of profit analysis and then concen- trates on variances associated with a standard cost system for direct materials, direct labor, and factory overhead.

8.1 Profit Analysis Profit is an overall measure of how well an organization is doing. A profit variance then is the difference between the actual net income and the planned net income for the same period. The causes of such a variance are related to the various elements that make up net income: revenues, cost of goods sold, and operating expenses. The following table shows a disaggrega- tion of the profit variance into more detailed elements.

Actual Budget Variance

Revenues $385,000 $365,000 $20,000 Favorable

Cost of goods sold 282,500 227,250 55,250 Unfavorable

Gross margin $102,500 $137,750 $35,250 Unfavorable

Operating expenses 81,250 90,000 8,750 Favorable

Net income $21,250 $47,750 $26,500 Unfavorable

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Section 8.2 The Use of Standards

To have a variance, a baseline with which to compare actual results is necessary. Common baselines are results of a prior month or year, a budget, a flexible budget, or a standard. The analysis of a profit variance necessarily looks at each significant area in the income statement, and each area has a baseline that management feels is appropriate for the circumstances. The analysis then looks at causes of variation from the baseline.

The cost of goods sold, comprised of the cost of materials, labor, and factory overhead, is generally the most significant cost in the income statement. Consequently, companies expend great effort to manage and control these costs. Managers can easily cite examples of how small savings on a unit basis—or on a single operation or task performed—add many dollars to profit. Analysis of cost variances helps managers to find cost savings.

Cost variances are often based on comparisons between actual and standard costs. Besides cost control, cost variances are also used to evaluate the performance of managers who are responsible for particular costs. For example, a plant manager might examine materials, labor, and overhead cost variances in the grinding department to evaluate the performance of the grinding department manager.

8.2 The Use of Standards Standard costs are appropriate where an organization has standard products, services, or repetitive operations, and where management controls the factors comprising a standard cost.

Definition of Standard Costs A standard cost for a product is the amount that management believes one unit of product should cost and consists of a price standard (a generic term indicating price for materials, rate for labor, and rate for factory overhead) and a quantity standard (a generic term indi- cating quantity for materials, time for labor, and activity or volume for factory overhead). Setting standards for price and quantity involves management judgments, industrial engi- neering studies, work measurement studies, vendor analyses, union bargaining, as well as a number of other techniques.

Standards are generally stated on a per-unit basis: per unit of quantity, per unit of time, per unit of activity, or per unit of product. Once set, these standards remain unchanged as long as no changes occur in operating methods, in factors that influence quantities, or in unit prices of materials, labor, and factory overhead.

Advantages of Standards A standard cost system presents many advantages to an organization. Although the primary purpose has always been cost control, properly set standards have many other advantages. This section covers five major advantages of standard costs.

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Section 8.2 The Use of Standards

Cost Control. Cost control is comparing actual performance with the standard performance, analyzing variances to identify controllable causes, and taking action to correct or adjust future planning and control. As discussed later in this chapter, costs can change for at least four reasons: (1) changes in levels of prices or rates, (2) changes in efficiency, (3) changes in activity or volume, and (4) changes in the product mix. Variance analysis must identify these changes as well as the managers responsible for these differences so that adjustments can be made to the standards or that good performance can be rewarded.

Standard cost accounting follows the principle of management by exception. Actual results that correspond closely to the standards require little attention. The exceptions, however, are scrutinized. Management by exception can be desirable because it highlights only those weak areas that require management’s attention. However, a behavioral effect can occur when management by exception is applied to people. If a worker is ignored when operating accord- ing to the standard and is noticed only when something is wrong, the worker may become resentful and perform less satisfactorily. While it may be argued that the worker is being paid to operate at standard, the human factor cannot be ignored. Without recognition, the worker becomes discontented; this discontentment may spread throughout the organization with a loss of both morale and productivity.

Cost Management. Cost management is related to cost control, but here the emphasis is on establishing the level of costs that becomes the benchmark for measuring performance. It can be as simple as decreasing the costs of operations through improved methods and pro- cedures, using better selection of resources (human, materials, and facilities), or eliminat- ing unnecessary (nonvalue-added) activities. As standards are set and periodically reviewed, operations can be analyzed to identify waste and inefficiency and to eliminate their sources. These reviews can also highlight better than expected performance; appreciation will moti- vate employees to continue looking for better ways to operate. A standard cost system cre- ates an environment in which people become cost conscious, always looking for continuous improvements in the process.

Decision Making. If standards are set at currently attainable levels (a concept discussed later in “The Quality of Standards” section), the standard costs are useful in making many types of decisions. For example, some common decisions involve regular, special order, or transfer pricing; cash planning; whether to sell or process further; and whether to make or buy. When an analysis is used as the basis for setting the standard costs, managers need not perform a new analysis for each decision.

Recordkeeping Costs. A standard cost system saves recordkeeping costs, not during the initial startup, but in the long-run operation of the system. When using actual costs, each item of materials issued from a storeroom has its cost, which came from a specific purchase order. The cost transferred to work in process inventory is calculated using an inventory flow method: specific identification, FIFO, LIFO, moving average, or weighted average. For com- panies with thousands of different materials categories in stock, identifying costs to move to work in process inventory can be an enormous task. When standard costs are in place, each item in the same materials classification has the same standard cost. Therefore, costs trans- ferred to work in process inventory are the standard cost per unit times the number of units issued. This same process applies to work in process inventory transfers to finished goods. All inventories have their standard costs, and balances are always stated at standard.

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Section 8.2 The Use of Standards

Inventory Valuation. A standard cost system records the same costs for physically identical units of materials and products; an actual cost system can record different costs for physi- cally identical units. Differences between the two costs tend to be waste, inefficiency, and nonvalue-added activities. Such items, if incurred at all, are period costs and excluded from inventory amounts. They should not be capitalized and deferred in inventory values. There- fore, standards provide a more rational cost in valuing inventories.

Occasionally, differences between actual and standard costs show positive efficiencies. Per- formance has been better than expected. If this situation will continue, the standards are revised. Otherwise, the current standards still provide a rational basis for costing products.

The Quality of Standards The term standard has no meaning unless we know upon what the standard is based. A stan- dard may be very strict at one extreme or very loose at the other extreme. We broadly classify standards as strict or tight standards, attainable standards, and loose or lax standards.

No easy solution exists as to how standards should be set. The objective, of course, is to obtain the best possible results at the lowest possible cost. Often human behavior becomes the dom- inant concern in setting standards. A very rigorous standard may motivate some employees to produce exceptional results. On the other hand, a standard that is too strict and cannot be reached may discourage employees and produce only modest results. In setting a level of standards, management must consider the employees, their abilities, their aspirations, and their degree of control over the results of operations.

Strict standards are set at a maximum level of efficiency, representing conditions that can seldom, if ever, be attained. They ignore normal materials spoilage and idle labor time due to such factors as machine breakdowns. These standards appear to represent perfection, something few employees will achieve. Although a standard should challenge people, a stan- dard that is virtually unattainable will not motivate most employees to do their best and may actually be counterproductive. An employee is more likely to put forth increased effort when feeling successful. In other words, a person’s aspirations increase with success and decrease with failure.

In addition, variances from strict standards have little significance for control purposes. There will never be a favorable variance, only zero or unfavorable variances. In fact, most variances will be large and unfavorable. The question is: “What does such a variance measure?”

Loose standards tend to be based on past performance and represent an average of prior costs. They include all inefficiency and waste in past operations. Such standards are not likely to motivate employees to higher performance. The very nature of loose standards means less than efficient performance. As a result, variances from loose standards are almost always favorable and provide little useful information for cost control. Again, the question is: “What does such a variance measure?”

Attainable standards can be achieved with reasonable effort. Perhaps the standards should be somewhat lower than what can be achieved by earnest effort. With success, the employees

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Section 8.2 The Use of Standards

gain confidence and tend to be more productive. For a more experienced group of workers, an exacting standard may serve as a challenge that motivates an employee to higher levels of performance. With less experienced workers, standards may have to be set at a lower level at first. As learning takes place, the standards may be raised. Increases in standards should be made with caution and should be accepted by the employees as being fair.

Managers should expect to see favorable and unfavorable variances with an attainable stan- dard. Some employees will meet and exceed the standard with reasonable effort, while others will not meet the standard because of poor performance.

Revising the Standards Standard costs should be reviewed periodically to see if revisions are necessary to maintain a selected level of quality. Although many factors may combine that determine the best time to review standard costs, they should be reviewed at least once a year. Otherwise, they may not be current. This does not mean waiting until the end of the year. Companies with thousands of items on standards will have a department dedicated to reviewing standards throughout the year.

A key for reviewing standards is to identify changes taking place that outdate existing stan- dards. Changes that typically call for a revision to one or more standard costs include:

1. Increases or decreases in the price levels of specific materials and supplies 2. Changes in personnel payment plans or wage schedules 3. Modifications of materials type or specifications 4. Acquisitions of new equipment or dispositions of old equipment 5. Modifications of operations or procedures 6. Additions or deletions of product lines 7. Expansions or contractions of facilities 8. Changes in management policies that affect the amount of costs and the way costs

are accumulated and identified with activities, operations, and products 9. Increased experience of employees

Management policies can have a significant impact on standard costs. Examples of the most common policy areas are the definition of capacity, the classification of fringe benefits, depre- ciation methods, and capitalization and expense policies. Capacity definitions influence the level of waste and inefficiency that management will tolerate and the amount of fixed costs applied to individual units of an operation, task, or product. A redefinition of capacity can be due to changes in the number of shifts, in hours of operation with given shift schedules, or in demand for the product or service. Fringe benefits can appear in several ways, any of which can influence a product cost significantly. Management can classify any element of fringe ben- efit cost as a direct cost of the product, an indirect cost through a labor-related cost pool, an indirect cost through a factory overhead cost pool, or a period cost through a general and administrative cost pool. Management determines which depreciation methods are in use. One common policy is to change from a declining balance method for existing equipment to a straight-line method at about the mid-life point of the asset life. Occasionally, management will change the method applied to new equipment purchased. The criteria for capitalization

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Section 8.3 Standard Cost Sheet

and expense decisions determine which costs are capitalized as assets and charged to opera- tions through depreciation and amortization and which costs are charged immediately upon incurrence. Any change in the criteria alters the treatment of those costs affected.

Throughout the chapter, we assume that standards are recorded into the formal accounting system. As such, product costing is determined through a standard cost system. Many com- panies do not follow this practice. Instead, they use standards to determine cost variances for control purposes. Revision of standards is much more critical if the standards are the basis for product costing.

Contemporary Practice 8.1: Setting Standards at a Consumer Packaged Goods Company

“In operations, the standard input costs are based on a set of assumptions that are updated each year during the company’s annual budgeting cycle. To make the input costs as accurate as possible, several divisions within the operations group are involved in developing standards. Updating standard costs begins with analyzing the prior year’s actual costs for each input: direct materials, direct labor, and overhead. Not surprisingly, analyzing input costs becomes highly complex given the large and diverse nature of the company. The analysis includes reviewing dozens of direct material inputs, several levels of labor tied to thousands of employees with various benefit cost combinations, and many manufacturing locations, which involve multiple facility types and configurations. All of these inputs are examined closely for cost efficiency and are applied consistently across the company. When the analysis of last year’s input costs is complete, these amounts are adjusted based on known changes related to the current year.”

Source: Dosch, J. & Wilson, J. (2010, August). Process costing and management accounting in today’s business environment. Strategic Finance, 37–43.

8.3 Standard Cost Sheet Once standards have been set for each cost component (direct materials, direct labor, and manufacturing overhead), the costs are summarized in a standard cost sheet. First, this sheet itemizes each type of direct material used, each direct labor operation employed, and all overhead tasks, operations, processes, and support functions applied to a unit of final prod- uct. Then, the cost per unit of output for each of these items is determined and displayed. Finally, these unit costs are tallied to obtain a total cost per unit for the final product. Standard cost sheets can be extremely lengthy or very simple depending on the product and manufac- turing process.

Suppose that Zaner Restaurants, Inc., owner of over 200 Steakout Restaurant franchises, uses a standard cost system in accounting for its daily dinner special, the “Goliath Feast.” The stan- dards currently are as follows:

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Section 8.4 Standards for Materials

This standard cost sheet gives the total unit cost of each meal produced. For each completed meal, three pounds of direct materials at a total cost of $12 is taken from materials inventory and charged to work in process. Also, $8.50 is charged for direct labor, and a total of $7.50 in overhead costs is applied. Nothing is noted here about the actual costs incurred because all production is carried only at standard cost. Thus, when completed meals are transferred from work in process to finished goods and later to cost of goods sold, the cost is $28 per meal. The standard cost sheet becomes the basis for all accounting entries related to the cost of the meal.

To explain standards for materials, direct labor, and overhead, we need to know the volume of output and the materials quantities allowed for that volume in order to calculate certain variances. The standard cost sheet lists the allowed amounts. The volume of output will be expressed as units of product or equivalent units, depending on the circumstances in production.

8.4 Standards for Materials Standards are established for the cost of obtaining materials and for the quantities to be used in production. Managers then compare actual costs against these standards to ascertain vari- ances. Basically, two types of variances exist: price and usage. Different variances may be developed for specialized purposes, but they can always be classified as variations in the price of materials or in the quantities used, or as a combination of price and usage. If the actual cost is greater than the standard cost, the variance is an unfavorable variance; if actual cost is less than the standard cost, the variance is a favorable variance. It should be noted that favorable versus unfavorable does not necessarily imply good versus bad for the overall inter- ests of the company. This will be illustrated in a later section that discusses the interrelation- ships of price and usage variances.

Materials Price Variance A materials price variance measures the difference between the prices at which materials are acquired and the prices established in the standards. What is in the standard, how a vari- ance is calculated, and what are potential causes of variances are now explained.

Component Total Cost of Component Unit Cost

Materials 3 lbs. at $4.00 per pound $12.00

Direct labor .5 hour at $17.00 per hour 8.50

Variable overhead .5 hour at $6.00 per hour 3.00

Fixed overhead .5 hour at $9.00 per hour 4.50

Total cost per meal $28.00

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Section 8.4 Standards for Materials

Setting the Price Standard. A standard price is set for each item of materials the company expects to use. The cost elements that make up the standard are a matter of management pol- icy. Although the purchase price is the dominant element, other costs may also be included, such as the cost of insurance for materials in transit, the cost of transporting materials, vari- ous cash and trade discounts, and costs of receiving and inspecting materials at the receiving dock. Once management decides on the elements, the next step is assessing prices. The esti- mation techniques are not discussed here, but common approaches to determining amounts include:

1. Statistical forecasting 2. Knowledge and experience in the particular type of business 3. Weighted average of prices in most recent purchases 4. Prices agreed upon in long-term contracts or purchase commitments

Accounting for a Price Variance. A materials price variance is isolated at the time of pur- chase. To be able to act upon an excessive variance as soon as possible, management should determine the materials price variance when the materials are purchased rather than waiting until the time the materials are used in production.

The actual quantity of materials purchased is entered in the materials inventory at standard prices. The liability to the supplier is recorded at actual quantities and actual prices. Any dif- ference between the two amounts is recorded as a price variance.

To illustrate, assume that Zaner Restaurants bought 40,000 pounds of materials for $159,200, which is $3.98 per pound. To make the example easier to follow, we will use the following symbols:

AQP = Actual quantity purchased

AP = Actual price

SP = Standard price

MPV = Materials price variance

The cost flow of actual and standard costs would appear in T-account form as follows:

Materials Inventory

AP � AQP �

$3.98 � 40,000 �

$159,200

SP � AQP �

$4.00 � 40,000 �

$160,000

Materials Price Variance

(AP � SP) � AQP �

($3.98 � 4.00 � 40,000 �

$800 Favorable

Accounts Payable

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Section 8.4 Standards for Materials

To calculate the variance without thinking in terms of accounts, the information from the T-accounts can be summarized into convenient formulas.

AP × AQP = $3.98 × 40,000 = $159,200

SP × AQP = $4.00 × 40,000 = $160,000

MPV = (AP – SP) × AQP = –$0.02 × 40,000 = $800 Favorable

Note that the actual quantity is used in all three calculations above. Only the prices differ. A materials price variance can be either favorable or unfavorable when actual costs are compared with standard costs. In this illustration, the materials price variance is favorable because the materials were purchased at a cost below the standard.

Causes of the Price Variance. A variance occurs for any number of reasons. If the variance is significant, we must identify causes. If performance is deemed good, the responsible people should be praised, and, where appropriate, rewarded. If the investigation finds out-of-control situations, corrections can be made so variations are eliminated in the future. In some cases, outdated standards are being used and need to be adjusted.

Although many causes for variances pertain to any given situation, a list of the common sources is as follows:

1. Fluctuations in market prices 2. Materials substitutions 3. Market shortages or excesses 4. Purchases from vendors other than those offering the terms used in the standard 5. Purchases of higher or lower quality materials 6. Purchases in nonstandard or uneconomical quantities 7. Changes in the mode of transportation 8. Changes in the production schedule that result in rush orders or additional materials 9. Unexpected price increases or decreases

10. Fortunate buys 11. Failure to take cash discounts

Responsibility for the Price Variance. The purchasing department is usually charged with the responsibility for price variances. If the purchasing function is carried out properly, the standard price should be attainable. When lower prices are paid, a favorable materials price variance is recorded, indicating that the department’s purchases were below the standard cost. Higher prices are reflected in an unfavorable materials price variance. In some circum- stances price variances really should be charged to a production department instead of to the purchasing department. As examples, a rush order may be caused by last-minute production changes, or production people may request a specific brand name for materials rather than allowing the purchasing department to buy by specifications.

Periodic reports show how actual prices compare with standard prices for the various types of materials purchased. Reports on price variances may be made as frequently as daily, but will generally be weekly or monthly. They reveal which materials, if any, are responsible for a large part of any total price variation and can help the purchasing department in its search for more economical vendors.

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Section 8.4 Standards for Materials

Materials Usage Variance Materials are put into production, but the actual quantity used may be more or less than spec- ified by the standards. The variation in the quantity of materials is called a materials usage variance. Other names for this type of variance are materials quantity variance, materials use variance, and materials efficiency variance.

Setting the Quantity Factor. The quantity factor in a materials standard is based on engi- neering specifications, blueprints and designs, bills of materials, and routings. Combined, these items specify the quality, size, thickness, weight, and any other factors necessary for a good unit of final product. Also included in the quantity factor are any desired allowances for normal acceptable waste, scrap, shrinkage, and spoilage that may occur during the manufac- turing process.

Accounting for a Usage Variance. As materials are used, the work in process account is increased by the standard quantity used multiplied by the standard price. The materials inventory account is decreased by the actual quantity used multiplied by the standard price. Returning to Zaner Restaurants, assume that 31,000 pounds of materials are withdrawn from Materials Inventory for making 10,000 meals. Because the standard cost sheet indicates only three pounds should be used for each meal, the standard quantity of materials that should have been used is 30,000 pounds (3 pounds × 10,000 meals).

For our example, we will use the following symbols:

SP = Standard price

AQU = Actual quantity used

SQ = Standard quantity allowed

MUV = Materials usage variance

The cost flow of actual and standard costs would appear in T-account form as follows:

Work in Process Inventory

SP � AQU �

$4.00 � 31,000 �

$124,000

SP � SQ �

$4.00 � 30,000 �

$120,000

Materials Usage Variance

SP � (AQU � SQ) �

$4.00 � 1,000 �

$4,000 Unfavorable

Materials Inventory

$160,000

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Section 8.4 Standards for Materials

To calculate the variance without thinking in terms of accounts, the above information can be summarized into convenient formulas.

SP × AQU = $4.00 × 31,000 = $124,000

SP × SQ = $4.00 × 30,000 = $120,000

MUV = SP × (AQU - SQ) = $4.00 × 1,000 = $4,000 Unfavorable

In the first two equations, the standard unit price is used, but the quantities differ. In one case, the actual quantities issued from the storeroom are used. In the other, the standard materials quantity allowed for each meal is used. Because only quantities can differ in the equations, any variation is a usage variance. The variance for Zaner Restaurants is unfavorable because the amount of materials used is greater than the amount called for by the standard.

The following table illustrates the materials costs and variances:

A B C D E F G

AQP × AP A – C = AQP × SP C – E = AQU × SP E – G = SQ × SP

Direct Materials

Price Variance

Increase or Decrease in

Materials Inventory

Direct Materials

Usage Variance

40,000 $159,200 40,000 $160,000 31,000 $124,000 30,000

× $3.98 – $160,000 × $4.00 – $124,000 × $4.00 – $120,000 × $4.00

= $159,200 = $800F = $160,000 = $36,000 = $124,000 = $4,000U = $120,000

Causes of the Usage Variance. What causes a materials usage variance? To answer this ques- tion, we look at the elements that make up the quantity standard and the specific situation. Examples of common causes include:

1. Changes in product specifications 2. Materials substitutions 3. Breakage during the handling of materials in movement and processing 4. Improper use of materials by workers 5. Machine settings operating at nonstandard levels 6. Waste 7. Pilferage

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Section 8.4 Standards for Materials

Responsibility for the Usage Variance. Ordinarily, materials usage variances are chargeable to production departments. They often arise as a result of wasteful practices in working with materials, or they arise because of products that must be scrapped through faulty production.

Reports on the quantities of materials used are given to the responsible production depart- ment supervisor. A production supervisor, for example, may receive daily or weekly summa- ries showing how the quantities used in the department compare with the standards. At the operating level, managers can directly control the use of materials. Often, reports on varia- tions from standard are for physical quantities only. Managers may not need immediate feed- back from a cost report. Daily or weekly cost reports simply tell managers the financial mag- nitude of variations and serve as a reminder that corrections should be made before losses become too great.

Summary reports of actual and standard materials consumption given in dollars, with vari- ances and variance percentages, also go to the plant superintendent at least monthly. If the variances in any department are too large, the superintendent can take steps to reduce them. During the month, of course, the operating managers will watch materials usage; if they have been doing their jobs properly, the accumulated variances for the month should be relatively small.

Contemporary Practice 8.2: Using the Materials Usage Variance to Detect Fraud

“Large purchase orders, coupled with a significant unfavorable material usage (quantity) variance (MUV), could indicate inventory theft via collusion between the purchasing and receiving or delivery departments; materials delivery may be made to an unauthorized location for the benefit of the purchasing agent or another employee.”

Source: Raiborn, C., Butler, J.B & Zelazny, L. (2013, May/June). Standard cost variances: Potential red flags of fraud? Cost Management, 16–27.

Interrelationships of Price and Usage Variances We have treated the materials price and usage variances as though they are independent and unrelated. In many cases, the event that causes one variance also causes the other. For example, assume the purchasing department buys lower-grade materials at a substantially reduced price. This generates a favorable price variance for purchasing. When those mate- rials reach production, they result in a higher than normal waste. This gives the operating supervisors unfavorable usage variances. Keeping the two variances in isolation makes the purchasing agent look good, while the operating supervisors turn in poor performances. In reality, both variances are the responsibility of the purchasing department. If the variances net out favorable, the purchasing decision has benefited the company. On the other hand, a net unfavorable variance is a loss to the company.

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Section 8.5 Standards for Labor

The operating people can also influence the price variance. If improperly adjusted machines, for instance, generate a higher than usual waste, more materials may be needed from the storeroom. When a production supervisor requisitions the materials and the storeroom manager realizes sufficient quantities are not available, a request is made to the purchasing department to order more. To keep the production schedule current, a rush order is issued. The higher prices paid for a rush order will result in an unfavorable price variance.

The warning of these situations is simple: Investigation of variances must not be done in isolation.

8.5 Standards for Labor We can set standards for direct labor and measure variances from the standards in much the same way as we did for materials. The price factor is called rate; the quantity factor is time. When referring to variations in time, we use the term efficiency. The labor rate variance measures the portion of the total labor cost variance caused by the difference between the actual wage rate paid and the standard wage rate. The labor efficiency variance measures the portion of the total labor cost variance caused by the difference between the actual hours worked and the standard hours required for production.

When discussing standards for labor, we assume direct labor only. Indirect labor consists of the costs for people working in the production departments but not directly on products, and for the time of direct laborers classified as training time, break time, overtime premium, and idle time. These costs are often distributed from payroll to overhead and become part of over- head standards. Therefore, indirect labor is discussed later as part of overhead.

Setting Rate Standards Standard cost systems rely on individual labor rates by skill-level classification for better con- trol and accuracy. However, in some cases, standard rates can be set for entire cost centers or departments. Regardless of how it is structured, the underlying wage or salary rate used as the standard rate will be either established through contract negotiations or by the prevailing rates in the location where the work is performed. The details for selecting wage-level classi- fications cover training, education, experience, special physical abilities, and set of task skills.

When setting the standard rates, management must decide whether to use a basic labor rate or a “loaded” labor rate as the standard. A “loaded” labor rate includes labor-related costs such as overtime premiums, shift premiums, bonuses and incentives, payroll taxes, and fringe benefits. Those factors not included in the labor rate standard will be included in overhead. Therefore, management will look at the advantages of treating these cost factors as direct costs or as indirect costs. For example, if the company is performing contracted work for the federal government, the company would typically recover more of its costs through the “loaded” standard labor rate.

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Section 8.5 Standards for Labor

Setting Time Standards Time standards are more difficult to establish than materials quantity standards. People’s productivity is the basis for setting time standards, and people tend to differ in behavior from one time to the next. Setting time standards involves answering two questions: (1) What operations are performed? and (2) How much time should be spent on each operation for the product or service? The answer to the first question is determined by reviewing operations and procedures, process charts, and routing lists. The answer to the second question will be determined from one or more of the following methods:

1. Operation and body movement analysis. (This involves dividing each operation into the elementary body movements such as reaching, pushing, turning over, etc. Pub- lished tables of standard times are available for each movement. These standard times are applied to the individual movements and added together for the total standard time per operation.)

2. Time and motion studies conducted by industrial engineers. 3. Averages of past performance, adjusted for anticipated changes. 4. Test runs through the production process for which standards are to be set.

Accounting for the Rate and Efficiency Variances Unlike materials, labor cannot be purchased and stored until needed. We purchase and use labor at the same time. Therefore, accounting for both variances is combined.

Zaner Restaurants shows a payroll for its direct workers of $90,584 and 5,200 hours. That gives an actual rate of $17.42 per hour. The standard cost sheet shows that each completed meal requires one-half hour of direct labor time. Since 10,000 meals were produced, 5,000 hours should have been worked (.5 hour × 10,000 meals).

For our example, we will use the following symbols:

AR = Actual rate

SR = Standard rate

AH = Actual hours

SH = Standard hours allowed

LRV = Labor rate variance

LEV = Labor efficiency variance

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Section 8.5 Standards for Labor

The cost flow of actual and standard costs would appear in T-account form as follows:

The labor rate variance is commonly calculated first. It results whenever the actual rate paid to a worker differs from the standard rate. Calculating a labor rate variance requires holding the actual hours constant while comparing the difference in rates, as follows:

AR × AH = $17.42 × 5,200 = $90,584

SR × AH = $17.00 × 5,200 = $88,400

LRV = (AR - SR) × AH = $0.42 × 5,200 = $2,184 Unfavorable

The variance is unfavorable because the actual rate exceeds the standard rate.

The labor efficiency variance (also called quantity, time, or usage variance) results when employees’ total actual hours worked differ from the standard. We calculate the variance by holding the rate constant while comparing the difference in hours. The following summarizes this procedure:

SR × AH = $17.00 × 5,200 = $88,400

SR × SH = $17.00 × 5,000 = $85,000

LEV = SR × (AH - SH) = $17.00 × 200 = $3,400 Unfavorable

The variance is unfavorable because the actual hours worked are more than the standard hours allowed for the 10,000 meals produced.

Work in Process Inventory

AR � AH �

$17.42 � 5,200 �

$90,584

SR � SH �

$17.00 � 5,000 �

$85,000

(AR � SR) � SP �

($17.42 � $17.00)

5,200�

Wages Payable

Labor Ef iciency VarianceLabor Rate Variance

$17.00 � (5,200 � 5,000) �

$3,400 Unfavorable

SR � (AH � SH) �

$2,184 Unfavorable

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Section 8.5 Standards for Labor

Because the hours are purchased and used at the same time, an alternate approach to calcu- lating the variances can be used:

Actual Cost Inputs at Standard Standard Cost

AR × AH SR × AH SR × SH

$17.42 × 5,200 hours = $90,584 $17.00 × 5,200 hours = $88,400 $17.00 × 5,000 hours = $85,000

Rate variance Efficiency variance

$2,184 Unfavorable $3,400 Unfavorable

Causes of Labor Variances Labor rates are usually set by contract, negotiations, management, or federal laws or regula- tions. So, why would a labor rate variance occur? Two basic reasons exist. First, labor rates often represent an average for a task, operation, or work center. If a departmental manager shifts workers’ assignments because of sudden changes in personnel requirements or a short- age of personnel, the average rate can easily change depending on how the shift relates to higher-paid or lower-paid workers. A second reason is that standard labor rates may include cost elements beyond the basic labor rate. Any changes in overtime worked, shift differen- tials, payroll taxes, or fringe benefits will show up in a labor variance if these elements are part of the standard rate.

Labor efficiency relates to how many units are completed per actual hour for each task, oper- ation, or process. Many reasons exist for why productivity varies from the level assumed in the standard time. Some of the common causes of a labor efficiency variance include:

1. Use of lower-skilled or higher-skilled workers 2. Effects of a learning curve 3. Use of lower-quality or higher-quality materials 4. Changes in production methods 5. Changes in production scheduling 6. Installation of new equipment 7. Poorly maintained equipment or machine malfunction 8. Delays in routing work, materials, tools, or instructions 9. Insufficient training, incorrect instructions, or worker dissatisfaction

Responsibility for Labor Variances Labor rate and efficiency variances are charged to the department managers who have con- trol over the use of workers. Labor rate variances are often the responsibility of personnel managers who manage hiring, union contracts, and perhaps labor scheduling. Although a labor rate variance is important to understand and control, managers tend to concentrate more on the labor efficiency variance because it has a greater impact on capacity utilization

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Section 8.5 Standards for Labor

and the department’s ability to meet production schedules. Labor efficiency is compared by department and by job with established standards. Daily or weekly reports to department managers and the plant superintendent help to locate and solve difficulties on a particular job or in a department. Differences between standard costs and actual costs incurred by a job or department may show that a job cannot be handled at the standard labor cost or that a department is not managed properly.

Interrelationships of Variances As discussed with materials, variances should not be analyzed in isolation from one another. The event that causes one variance can easily be the cause for one or more other variances. Future cost planning and control can be improved when interrelationships among labor vari- ances and between materials and labor variances are identified and understood.

Labor Rate and Efficiency Variances. People perform the productive effort; thus, the rate of pay and the time required are related. Because so many relationships can exist between the two factors, only a few examples are cited to aid in identifying what to look for in a specific operation.

Assume a number of employees are in various military reserve units that have been called to active duty. As a short-term solution, a manager has two options: (1) Employ temporary workers or (2) shift other workers internally and add overtime. Using temporary workers may be cheaper or more expensive depending on the situation. They are not as experienced with the equipment, procedures, and processes. They may take more time than the standard allows. Therefore, hiring temporary workers can result in both rate and efficiency variances. The second option is to shift existing workers and use overtime. The move will put differently skilled workers on new jobs. The move can create either a favorable or an unfavorable rate variance depending on the mix of workers. Their experience levels may be higher or lower than the specific job requires and can result in an efficiency variance. Adding overtime could affect a rate variance, depending on how the company treats the overtime premium. Effi- ciency should not be an issue of overtime unless the workers become less productive through fatigue.

In another case, suppose an employee is having difficulties working on a particular machine. The worker is taking more time than standard to complete good units. The manager, trying to keep production on schedule and not lose capacity to inefficiency, shifts a more skilled, higher-paid worker to the job. The higher-paid worker will yield an unfavorable rate variance but can reduce the unfavorable efficiency variance or create a favorable one.

Materials and Labor Variances. Materials and labor variances can also be related to the same source. Assume, for instance, that a purchasing agent made a fortunate buy on a lower- quality grade of materials. The “good buy” yields a favorable materials price variance for pur- chasing. However, when the materials are used in production, they crumble and create more waste than anticipated. More materials are needed, and an unfavorable materials usage vari- ance arises. A department manager, desiring to minimize the lost time, moves higher-skilled people to the operation where the higher waste occurs. This action leads to a labor rate vari- ance and may influence the magnitude or the direction of a labor efficiency variance.

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Section 8.6 Standards for Overhead

In another case, a worker starts the shift fatigued and stressed. Lack of concentration results in higher waste, which takes more materials and time. This results in unfavorable materi- als usage and labor efficiency variances. Because more materials are needed, the manager requisitions additional materials from the storeroom. The storekeeper finds fewer materials available than are now required. Purchasing is asked to place a rush order so that production can proceed with minimum delay. The rush order increases the purchasing costs, causing an unfavorable materials price variance.

The Influence of Automation Companies are constantly seeking to automate various aspects or even all aspects of their production. The purpose of this is to increase productivity and quality while keeping unit costs low. With automatic equipment, the need for high-skill levels of direct labor is substan- tially reduced. Direct labor in such an environment becomes such an insignificant element of cost that variances have little meaning.

In some industries, automation may not go beyond a certain point, in which case direct labor will remain a smaller but significant cost element. However, with a great deal of automation, direct labor time becomes more dependent on the speed of a machine operation than on the speed of individual workers. Hence, labor efficiency is more related to machine efficiency than to employee efficiency. Therefore, a labor efficiency variance will carry little meaningful information.

8.6 Standards for Overhead The factory overhead costs consist of all manufacturing costs that are not classified as direct materials and direct labor. Examples of factory overhead costs include indirect materials and supplies, indirect labor, maintenance and repairs, lubrication, power, factory property taxes and insurance, and depreciation. Service organizations will have similar overhead costs related to providing services.

In a standard cost system, we use a standard overhead rate to apply these costs to prod- ucts and services. We accumulate the actual overhead costs and compare them to the applied amounts to determine whether the standards were met. Variances from the standard help to direct management’s attention to situations where costs should be controlled more closely, where managers should be praised and rewarded for good performance, or where the stan- dards should be revised.

Development of Overhead Rates Standard costs for overhead have price and quantity factors, just like direct materials and direct labor. Price is reflected in one or more overhead rates; quantity is the measure of activ- ity. Price and quantity in this case are closely linked. In developing standard overhead rates, five major considerations must be evaluated.

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Section 8.6 Standards for Overhead

First, which cost elements are included in overhead? We need to identify the individual costs that compose overhead. When certain variances occur, these items will be examined for spe- cific changes.

The second consideration is the measure of activity for relating overhead costs to products. A measure of activity for this purpose represents the factor that best expresses how costs change as volume increases or decreases. As noted in earlier chapters, we refer to the mea- sure of activity as an allocation base or cost driver. Although many factors can influence costs, we select a dominant cost driver. The common ones are direct labor hours or costs, machine hours, and units of products. In Chapter 4, we examined activity-based costing and identified other cost drivers that cause costs to be incurred. Our use of the measure of activity is the same as a primary-stage cost driver in those discussions. For standard costs, the appropriate measure must be selected if variances are to provide any meaningful information.

Third, and closely related to the measure of activity, is the concept of capacity and the antici- pated volume level for the current period. We discussed several capacity concepts in Chap- ter 2. The capacity or volume concept selected and the determination of the current period level significantly influence overhead rates because of the presence of fixed costs.

A fourth consideration is cost behavior. The behavior of each cost within overhead is impor- tant because management plans and controls variable costs differently than it plans and con- trols fixed costs. Consequently, distinguishing variable from fixed overhead costs aids in ana- lyzing variances for cause and responsibility. Standard cost systems often use dual overhead rates for variable overhead costs and for fixed overhead costs. In separating the variable and fixed cost rates, different cost drivers may be used for each cost behavior.

The fifth consideration is the level at which overhead rates should be set: by task, by machine or labor operation, by activity center, by department, by facility, or overall. For a single prod- uct operation, overall rates for variable and fixed costs are sufficient. The greater the product and operation diversity, the more likely it is that rates are set for smaller groupings of costs. For our illustration with Zaner Restaurants, we assume an overall rate merely to illustrate the concepts. The same considerations will apply should a company compute rates by task, activ- ity center, and so forth.

Flexible Overhead Budgets As we have noted in previous chapters, a flexible overhead budget is based on a formula that expresses the budgeted overhead at any point within the relevant range. The formula recognizes that some costs are variable and some are fixed. The following schedule shows the flexible overhead budget formula for Zaner Restaurants. We assume here that the measure of activity is direct labor hours.

The flexible budget cost function is: $49,500 + ($6.00 × number of hours). Since we know that the hours are related to meals prepared in terms of two per hour, we can restate the formula as: $49,500 + ($3.00 × meals prepared). Typically, we would have multiple products using dif- ferent amounts of direct labor, which would require the use of the basic formula.

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Section 8.6 Standards for Overhead

As a sidelight, the overhead rates are also available from these numbers, if we assume a vol- ume of 5,200 direct labor hours or 10,000 meals prepared. For variable costs, the rate is $6.00 per hour or $3.00 per unit (.5 hour × $6.00). The fixed costs are $9.52 per hour ($49,500 ÷ 5,200 hours) or $4.76 per unit (.5 hour × $9.52).

The significance of the flexible overhead budget becomes apparent in the next section where we identify variances for overhead costs.

Framework for Two-Way Overhead Variance Analysis Because different factors give rise to underapplied or overapplied overhead, we need a frame- work to identify the areas of potential causes of variations. In our framework, we compare actual overhead costs with a flexible budget and with the applied overhead to arrive at two possible variances: budget variance and capacity variance.

To begin, we need to know the actual overhead costs and the applied overhead costs. We have already seen for Zaner Restaurants that the company produced 10,000 meals during the month. Actual overhead costs for the month are $31,500 variable and $50,000 fixed. The overhead accounts would then show the following information:

Cost Item Fixed Cost Variable Cost per Direct Labor Hour

Indirect materials — $ 1.90

Hourly indirect labor — 1.27

Supervision $ 21,000 —

Repair and maintenance 3,600 1.11

Utilities and occupancy 10,580 1.00

Depreciation 13,800 —

Miscellaneous costs 520 0.72

Totals $ 49,500 $ 6.00

Actual costs:

Variable $31,500

Fixed 50,000 $ 81,500

Applied costs:

Variable ($3.00 × 10,000 meals) $30,000

Fixed ($4.50 × 10,000 meals) 45,000 75,000

Underapplied $6,500

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Section 8.6 Standards for Overhead

This information would appear in a T-account as follows:

Manufacturing Overhead

Actual overhead = $81,500 Applied overhead = $75,000

Underapplied overhead = $6,500

Remember, the cost per unit for variable and fixed overhead is calculated in advance and appears on the standard cost sheet for individual products. Therefore, the rates used in the example are applied directly to actual units or equivalent units of product.

The next step is to compare the actual costs and applied costs with the flexible budget for 10,000 meals produced. Figure 8.1 summarizes this information. Note that the two-way over- head variance analysis actually produces three variances: variable and fixed overhead budget variances, plus the fixed overhead capacity variance.

Figure 8.1: Overhead variances for Zaner Restaurants

Overhead

Actual

Overhead

Costs

Flexible

Budget for

10,000 Meals

Standard Costs of

Meals Produced

(Applied Costs)

Variable.... Fixed........ Total.........

$ 31,500 50,000 $ 81,500

$ 30,000 49,500 $ 79,500

$ 30,000 45,000 $ 75,000

Variable............. Fixed................. Total..................

$ 1,500 500

$ 2,000

$ 6,500 Unfavorable and Underapplied

$ 0 4,500 $ 4,500

Budget Variance Capacity Variance

*$6 � .5 hour � 10.000 meals

Unfavorable Unfavorable Unfavorable

Budget Variance. A budget variance is the difference between actual overhead costs and the flexible budget for actual units produced. It is also called a controllable variance. This variance is deemed controllable by the appropriate operating departments. In the forego- ing example, the variance is unfavorable; more dollars were spent than were budgeted for 10,000 meals. A more detailed examination of the variance is necessary to identify areas

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Section 8.6 Standards for Overhead

where managers need to take action. One approach for providing greater detail is to show the budget variance by individual cost item with the use of the flexible overhead cost function, as shown in the following table:

Cost Item Actual

Overhead

Flexible Budget for

10,000 Units Budget

Variance

Indirect materials $ 10,250 $ 9,500 $ 750 U

Hourly indirect labor 6,250 6,350 100 F

Supervision 21,400 21,000 400 U

Repair and maintenance 9,050 9,150 100 F

Utilities and occupancy 15,930 15,580 350 U

Depreciation 13,800 13,800 0

Miscellaneous costs 4,820 4,120 700 U

Totals $ 81,500 $ 79,500 $ 2,000 U

A number of causes may exist for either a favorable or an unfavorable budget variance. The common causes will fall into one of four categories:

1. Price changes in individual cost components of overhead costs 2. Quantity changes in individual items within overhead cost components, probably in

the variable overhead area 3. Estimation errors in segregating variable and fixed costs 4. Any overhead costs that are incurred or saved because of inefficient or efficient use of

the underlying activity measure (machine hours or labor hours, for example)

The estimation errors come in two varieties: (1) the inaccuracies in predicting what will occur in the future and (2) the reliability of approximations made in separating overhead costs into variable and fixed categories. The inefficient or efficient use of activity relates to the fact that in an activity (labor worked, for example) overhead costs are incurred to support that activity. If the activity is inefficient, overhead costs support inefficiency. On the other hand, if less activity occurs, lower total overhead costs are incurred to support it. Therefore, efficient resource use also saves overhead costs.

Capacity Variance. The capacity variance (also called a volume variance) is the difference between the flexible budget for the actual units produced and the amounts applied to work in process inventory. In Figure 8.1, because the variable overhead costs are the same in each column, the capacity variance is the difference between the budgeted fixed overhead and the applied fixed overhead. Therefore, the capacity variance is the amount of budgeted fixed overhead not applied (unfavorable) or the amount applied in excess of the budgeted fixed costs (favorable). A capacity variance, then, occurs when actual production differs from the capacity level used to calculate the standard fixed overhead rate.

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Section 8.6 Standards for Overhead

Continuing with the example, we know that fixed overhead for the month was budgeted at $49,500, and we presume that 5,500 direct labor hours or 11,000 meals constitute a normal level of operation. We first compute the hourly overhead rate:

We then convert the hourly rate to a rate per meal with the following computation:

0.5 hour per unit × $9.00 = $4.50 per meal

We see that the standard overhead rate for costing meals is computed at the normal volume, so in this case it is $4.50 per meal. During the month, Zaner Restaurants produced 10,000 meals. Fixed overhead is costed to the meals by multiplying the standard rate of $4.50 per meal by the 10,000 meals.

$4.50 × 10,000 meals = $45,000 applied

Fixed overhead budget $49,500

Fixed overhead applied 45,000

Capacity variance (unfavorable) $ 4,500

Figure 8.2 illustrates a graphical approach to the capacity variance concept. The diagonal line on the graph represents the amount of fixed overhead applied for various meal volumes. It rises at the rate of $4.50 per meal and reaches the $49,500 budgeted fixed overhead level at the normal volume of 11,000 meals. However, the company only produced 10,000 meals. With the rate of $4.50 per meal, only $45,000 of the budgeted fixed overhead was applied. The difference between the budgeted fixed overhead and the fixed overhead applied is the capac- ity variance, as designated on the vertical scale.

{ Fixed overhead applied

Capacity variance

Fixed overhead budgeted

$49,500

$45,000

O v e rh

e a d

F ix

e d

C o

s ts

11,000 units � $4.50 rate = $49,500 budgeted

10,000 units � $4.50 rate = $45,000 applied

10,000 11,000

Actual

output

Normal

volume

Units of Product

Figure 8.2: Analysis of capacity variance

$49,500 (Budgeted fixed overhead)

5,500 (Hours of direct labor) = $9.00 per hour

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Section 8.7 Capacity and Control

Earlier we presented the budget variance for individual categories of overhead costs. We could extend the idea to the capacity variance, but we do not gain additional information from fur- ther detail. The capacity variance is an overall issue and has little to do with individual costs.

8.7 Capacity and Control In general, we consider the capacity variance as an item that production departments do not control. The plant produces what marketing identifies as the sales requirements. Therefore, the production departments cannot be held responsible if the sales demand exceeds or falls below production at a normal level of plant operation. Other factors, however, may contribute to producing below capacity. Some of these factors are controllable (or somewhat control- lable) by production departments. Excessive machine downtime (due to poor maintenance, for example) or inefficient production scheduling could be problems traceable to production managers. Lack of rapidity in completing tasks due to unskilled workers is a factor that is expected to some degree, but an excess of this condition may also be traceable to one or more production managers.

For Zaner Restaurants, normal volume was defined at 5,500 direct labor hours or 11,000 meals. Normal volume, as defined in Chapter 2, represents the average level of actual opera- tion over several years. Practical capacity, on the other hand, is the level at which all facilities are used to full extent. Some allowance is made under this definition for expected delays because of changes in machine setups, necessary maintenance time, and other interruptions. Hence, practical capacity is less than theoretical maximum capacity, which could be obtained only under ideal conditions.

A comparison of the actual output with the output for practical capacity broadly measures the failure of the facility to operate at the level for which it was designed. Assume, for example, that Zaner Restaurants can reasonably be expected to produce 15,000 meals a month. Yet only 10,000 meals were produced. The idle capacity is defined as the difference between the practical capacity and the actual production for a given month. The idle capacity for Zaner Restaurants is determined as follows:

Practical capacity 15,000 meals

Actual production 10,000

Total idle capacity 5,000 meals

The idle capacity can be analyzed further to determine why facility capacity was not used as intended. Assume that the sales budget shows that 12,000 meals were expected to be sold during the month but that orders for only 11,500 meals were received. The differences between practical capacity, sales budget, orders received, and actual production are illus- trated as follows:

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Section 8.8 Variances

1. Practical capacity minus sales budget. The difference between the practical capacity and the sales budget for the month requires further investigation. Per- haps the company was overly optimistic and provided too much capacity. Or the Marketing Department may not be obtaining potential available customers. Addi- tional analysis may reveal the nature of the problem and provide a foundation for improvements.

2. Sales budget minus orders received. The difference between the sales budget for the month and the orders received is a measurement of the inability of the Market- ing Department to meet the budget quota. Perhaps the quota was too high, or the Marketing Department was not sufficiently aggressive.

3. Orders received minus actual production. The difference between the orders received and actual production reflects a mixture of idle time and inefficiency. Sup- pose that Zaner Restaurants used 5,200 hours to produce 10,000 meals and 5,000 hours were allowed. The 200 hours of inefficiency, in this case, consumed time that could have been used for production of an additional 400 meals (200 hours ÷ .5 hour per unit). The difference between the orders received and the expected production for the time used (11,500 – 10,400 = 1,100 meals) is a measurement of idle time.

8.8 Variances When cost variances occur, managers need to know what caused them. Knowing the amount of variance does not disclose the cause(s); rather, investigation is required. However, manag- ers must decide whether the benefits of investigation and corrective action exceed the related costs. Obviously, a $10 unfavorable materials usage variance from a standard cost of $50,000 would not be worth investigating. But where should the line be drawn?

Ideally, if the costs and benefits of investigating and correcting can be estimated, these costs and benefits should be compared in deciding whether to investigate. In practice, however, this is extremely difficult. Instead, many companies use simple decision rules based on pre- scribed dollar limits, such as “investigate any variance over $500.” The main problem with this method is that $500 may be significant when the standard cost is $2,000 but may be insignificant when the standard cost is $20,000. Therefore, many companies use a percent- age rule, such as “investigate any variance of five percent or more.” Some companies use more sophisticated statistical approaches that set limits based on standard deviations from the standard cost. However, most companies do not seem to have formal decision rules; rather, managers are instructed to use “judgment.”

Practical capacity

Sales budget

Orders received

Actual production

15,000

12,000

11,500

10,000

3,000(1)

500 (2)

1,500 (3)

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Section 8.9 Standard Costs in Different Settings

Summary of Standard Cost Variances We have completed a number of variance computations for the cost elements of production. Figure 8.3 contains a summary of all variances and the methods of calculating them. It also emphasizes that the costs charged to units produced are the standard costs. Therefore, work in process inventory and all subsequent accounts containing product costs will be stated at standard. Notice that costs on the far left side are all actual costs, while costs on the far right side are standard costs. If dollar amounts become smaller as we move from left to right, we experience unfavorable variances. If amounts become larger, we experience favorable variances.

Disposition of Variances In our discussion of materials and labor variances, we set up separate variance accounts. Overhead variances, although identified separately in worksheet analysis, are combined in the underapplied or overapplied amounts. At the end of each period, variance accounts must be closed. Where do these variances go? As a practical matter, all standard cost vari- ances eventually go to cost of goods sold. The most common practice is to close the variance accounts directly to cost of goods sold, thus treating them as period costs. Occasionally, if the variances are significant in amount, they will be prorated to cost of goods sold and to the appropriate materials, work in process, and finished goods inventories. We assume here that variances are closed to the cost of goods sold account.

8.9 Standard Costs in Different Settings Standard costs are applicable to service organizations, as we have shown with Zaner Restau- rants. As with manufacturing companies, the more routine the service organization’s activi- ties, the easier it is to set standards. Generally, though, a service organization’s activities are less routine than those of a manufacturing company. The following list contains examples of service organization activities for which standard costing would be appropriate:

1. Filling prescriptions in a pharmacy 2. Picking orders in a warehouse 3. Preparing food in a restaurant 4. Answering telephones in advertising agencies, airline offices, customer service

departments, and computer technical hotlines 5. Processing orders in a mail-order house 6. Calling on customers (by phone or door-to-door)

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Section 8.9 Standard Costs in Different Settings

Figure 8.3: Summary of standard cost variances

ACTUAL COSTS INCURRED (Resource Inputs)

STANDARD COSTS OF UNITS PRODUCED (Costs Charged to Production)

MATERIALS

Actual Prices � Actual Quantities Purchased

AP � AQP

Standard Prices � Actual Quantities Purchased

SP � AQP

Standard Prices � Actual Quantities Used

SP � AQU

Standard Prices � Standard Quantities for Work Done

SP � SQ

Materials Price Variance (AP – SP) � AQP

Materials Usage Variance SP � (AQU – SQ)

DIRECT LABOR DIRECT LABOR

Actual Rates Paid � Actual Hours Worked

AR � AH

Standard Labor Rates � Actual Hours Worked

SR � AH

Standard Labor Rates � Standard Hours for Work Done

SR � SH

Labor Rate Variance (AR – SR) � AH

Labor Efficiency Variance SR � (AH – SH)

VARIABLE OVERHEAD VARIABLE OVERHEAD

Actual Expenditures for Variable Overhead

Flexible Budget for Variable Overhead Adjusted to Units

Produced (Work Done)

Variable Overhead Applied to Units Produced (Work Done)

Variable Overhead Budget Variance (Actual Expenses –

Adjusted Budget)

FIXED OVERHEAD FIXED OVERHEAD

Actual Expenditures for Fixed Overhead

Budget for Fixed Overhead Fixed Overhead Applied to

Units Produced (Work Done)

Fixed Overhead Budget Variance (Actual Expenses – Budget)

Fixed Overhead Capacity Variance (Budgeted Fixed – Applied Fixed)

No Variance

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Section 8.9 Standard Costs in Different Settings

Standard Costs in Service Organizations Standard costing in a service setting will tend to emphasize labor and overhead, since mate- rials are usually not a significant item. Notable exceptions, however, would be restaurants and auto repair shops, where food ingredients and car parts, respectively, are sizable cost elements. Calculating standard costs and variances for service organizations is similar to manufacturing companies. The main difference is that in determining standard quantities, the output of a service organization is often not as clear as for a manufacturing company. The following list contains examples of output measures that might be chosen in various service settings:

1. Number of claims processed in an insurance company 2. Number of loan applications processed at a bank 3. Number of deliveries made by a delivery service 4. Number of patients treated in a particular department of a hospital 5. Number of passengers transported by an airline

Standard Costs in a Process Cost System Standard costs are appropriate for job cost systems or process cost systems. Where we have a process cost system, the equivalent units are calculated using the FIFO method discussed in Chapter 3. Remember that equivalent units can be different for materials, labor, and overhead.

One convenience realized in a standard cost system is the availability of unit costs without the computations we did in Chapter 3. Since standard costs are predetermined, we simply multiply the equivalent units by the appropriate standard costs to determine costs of goods completed and costs of the ending inventory. Except for the use of equivalent units, variance analysis in a process cost system does not differ from the analysis used in a job cost system.

Standard Costs in JIT/CIM Environments In JIT and computer-integrated manufacturing (CIM) environments, standard cost systems face greater challenges. These environments are often characterized by rapid technological changes in production processes and products produced, which make it very difficult to set standards that will be relevant for a reasonable time period. Furthermore, the prevalence of short production runs and the need for real-time information require variance reporting on a much more timely basis than the typical monthly or even weekly basis.

Companies with JIT/CIM environments are increasingly turning to a philosophy of continu- ous improvement. With this approach, the focus is more on trends of variances rather than their magnitudes.

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Section 8.10 Ethical Considerations

Generally, fewer types of cost variances are computed in JIT/CIM environments. Since JIT/ CIM companies tend to be highly automated, direct labor variances are of little or no rel- evance. Also, materials price variances have little relevance because JIT companies usually have long-term contracts with a small number of suppliers.

In many companies with JIT/CIM processes, cost variances are being supplemented or, in some cases, replaced by nonfinancial measures of performance. We discuss these types of measures in Chapter 12.

Target Costing and Kaizen Cost Targets Recognizing that most costs of production are determined when products are developed and designed, many companies are turning to a technique developed by Japanese companies known as target costing. After a target selling price and a target profit are established, an allowable cost consistent with these targets is obtained for the product. The company then designs the product and sets cost standards based on the allowable (target) cost. To promote continuous improvement, these cost targets, known as kaizen cost targets, are reduced in each successive period. Target costing and kaizen cost targets are discussed more fully in Chapter 12.

8.10 Ethical Considerations Because cost variances are used to evaluate performance of cost center managers, there may be temptation to compromise ethics. This might happen in the standard-setting process or in reporting actual costs. A manager who has input in setting standards might deliberately provide inaccurate information in an attempt to produce loose standards. Likewise, a man- ager who plays a role in gathering or reporting actual costs might intentionally distort actual data. Top management should be aware that performance evaluation based on cost variances can produce these behaviors. Cost center managers must guard against compromising their integrity for a possible short-term gain.

A more subtle form of unethical behavior results when managers avoid doing their best for fear of causing the standards to be tightened. A manager might believe that cost decreases in the current period are unlikely to be replicated due to some unique conditions. In that case, the manager should prepare a convincing argument to upper management not to revise standards significantly. Upper management can alleviate these types of problems by not auto- matically adjusting the cost standard by the full amount of cost reduction. For instance, if the production manager knows that any cost reduction will cause next period’s cost standards to decrease by only 50% of the cost reduction, the manager would tend to put more effort into cutting costs than if the standards were to be adjusted by the full cost reduction.

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Chapter Summary When actual performance varies from expectations, explanations for the differences are sought. Once causes of variations are identified, changes can be made through the planning process or control mechanisms. One aid to the analysis is the use of a standard cost system for costs that ultimately flow into cost of goods sold. Standard cost systems operate effec- tively in situations where standardized products or standardized operations exist. Although the primary advantage of such a system is cost control, several other advantages can also be achieved: cost management, improved decision making, savings in recordkeeping costs, and more rational inventory valuation.

A standard cost consists of a price factor and a quantity factor. The quality of a standard is expressed as strict, attainable, or loose. The preferred standard for all purposes is one that is current and attainable. A standard cost sheet is a basic element of the standard cost system. Here the standard quantities and prices are stated for direct materials, direct labor, and all overhead. The standard cost sheet gives the total unit cost that is attached to a completed unit of a given product.

Materials standards are set after considering the purchase price and other dollar amounts to be included and after determining the quantities needed for the intended operations. A mate- rials price variance occurs anytime the actual price differs from the standard price. The vari- ance is calculated as the actual quantity purchased times the difference between the actual price and the standard price. A materials usage variance is caused by using more or less mate- rials than set by the standard. This variance is calculated as the standard price times the dif- ference between the actual quantity used and the standard quantity allowed. Price variances are generally the responsibility of the purchasing department while usage variances are gen- erally the responsibility of production department managers.

In establishing labor standards, management looks at what operations are performed, how much time should be spent in each operation, what labor skills are needed to perform the operations, and what rate should be paid. The standard labor rate is the base rate of pay plus any other costs associated with labor that management chooses to include. A labor rate vari- ance occurs any time the actual rate differs from the standard rate. The variance is the actual hours worked times the difference between the actual rate and the standard rate. A labor efficiency variance is caused by using more or less time than the standard specifies. This vari- ance is calculated as standard rate times the difference between actual hours worked and the standard hours allowed. Both variances generally are the responsibility of production depart- ment managers.

Standards for overhead are set after considering five important factors: the cost elements to include in the standards, the measure of activity that best relates the costs to the work done, the capacity concept for the selected measure of activity, the cost behavior of each element of overhead cost, and the rate structure, whether by task, operation, process, department, or overall. During any period, the actual overhead cost can differ from the overhead applied to products. To understand the significance of the underapplied or overapplied amounts, we cal- culate a budget variance and a capacity variance. A budget variance is the difference between

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attainable standards Standards that can be achieved with reasonable effort.

budget variance The difference between actual overhead costs and the flexible bud- get for actual units produced.

capacity variance The difference between the budgeted fixed overhead and the fixed overhead costed to products by the use of the predetermined fixed overhead rate.

controllable variance The difference between actual overhead costs and the flex- ible budget for actual units produced.

cost control Comparing actual perfor- mance with the standard performance, analyzing variances to identify controllable causes, and taking action to correct or adjust future planning and control.

favorable variance Actual cost is less than the standard cost.

flexible overhead budget A budget based on a formula that expresses the budgeted overhead costs at any point within the rel- evant range.

idle capacity The difference between the practical capacity and the actual production for a given period.

kaizen cost targets Cost targets that are set at the last period’s actual level with the intent to reduce these costs.

labor efficiency variance The differ- ence between the actual and standard time required for production multiplied by the standard labor rate.

labor rate variance The difference between the actual and standard labor rates multiplied by the actual hours worked.

loose standards Standards that can be achieved with very little effort.

management by exception A philosophy of emphasizing the exception, highlighting only areas that deviate from the plan and that require management’s attention.

materials price variance The difference between the actual and standard materials prices multiplied by the actual quantity of materials.

materials usage variance The difference between the actual and standard quantity of materials multiplied by the standard materi- als price.

measure of activity The factor that best expresses how costs change as volume changes.

price standard A generic term that means a standard price for materials, rate for labor, and rate for factory overhead.

quantity standard A generic term that means a standard quantity for materials, time for labor, and activity or volume for fac- tory overhead.

actual overhead costs incurred and the flexible budget for the actual number of units pro- duced. It represents those overhead cost elements over which department managers have control. The capacity variance is the difference between the flexible budget for the actual units produced and the amounts applied to products. This variance consists only of fixed overhead costs and represents the amount by which actual production differs from planned capacity.

Key Terms

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Problem for Review Glusman Office Furniture is a well-known supplier of quality office furniture. It is currently setting up a standard cost system for its products. One product is the Home Office Workstation for those who operate a business in their homes. The production process for this workstation involves four departments: Cutting, Assembly, Staining, and Finishing. Materials, labor, and overhead costs are accumulated by department.

Raw materials include lumber, stain, drawer handles and fixtures, screws, dowels, and glue. Each workstation requires 64 feet of lumber at $1.60 per foot. Drawer handles and other drawer fixtures are $16.80 per workstation. Stain required is 0.8 gallons at $16.70 per gallon. Screws, dowels, and glue are included in the overhead costs of the Assembly Department. Lumber enters the process in the Cutting Department; drawer handles and other drawer fix- tures, in the Assembly Department; and stain, in the Staining Department.

Direct labor occurs in Cutting, Assembly, and Finishing. Cutting requires 30 minutes per work- station with labor cost at $19.50 per hour. Assembly requires two hours per workstation with a labor cost of $21.60 per hour. Finishing requires 20 minutes with a labor cost of $17.70 per hour. Staining is an automated department and has no direct labor.

Factory overhead is applied to workstations by department on the basis of direct labor hours in the three departments with direct labor. Cutting is $10 per hour, Assembly is $9.50 per hour, and Finishing is $9 per hour. The Staining Department overhead is applied on the basis of machine time, and the rate is $18 per machine hour. Each workstation requires one-fourth of an hour of machine time.

Question:

Prepare a standard cost sheet that shows all of the elements of cost for a completed worksta- tion. For convenience, identify the cost elements by department.

standard cost The combination of a price standard and a quantity standard.

standard cost sheet A summary of the cost for each category of direct materials used; the cost of each direct labor operation employed; and the cost of all overhead tasks, operations, processes, and support functions applied to a unit of final product.

strict standards Standards set at a maxi- mum level of efficiency, representing condi- tions that are very difficult to attain.

target costing A cost target set by subtract- ing the desired profit from the target selling price.

unfavorable variance Actual cost is greater than the standard cost.

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Solution:

Standard cost sheet for completed workstation:

Direct materials:

Lumber (64 feet at $1.60) $102.40

Drawer handles and fixtures 16.80

Stain (0.8 gallons at $16.70) 13.36 $132.56

Direct labor:

Cutting (0.5 hour at $19.50) $9.75

Assembly (2 hours at $21.60) 43.20

Finishing (1/3 hour at $17.70) 5.90 58.85

Factory overhead:

Cutting (0.5 hour at $10.00) $5.00

Assembly (2 hours at $9.50) 19.00

Staining (1/4 hours at $18.00) 4.50

Finishing (1/3 hour at $9.00) 3.00 31.50

Total standard cost per workstation $222.91

Questions for Review and Discussion

1. Under what conditions will a standard cost system work best? 2. Define a standard cost. Explain what constitutes the components of a standard cost. 3. Point out advantages and disadvantages of following the principle of management

by exception. 4. Which level of standard (tight, attainable, or loose) will give the lowest standard cost

per unit? Explain. 5. A standard cost sheet is a key component of a standard cost system. Describe a stan-

dard cost sheet and explain why it is significant. 6. In purchasing materials, what amounts are recorded in Accounts Payable and what

amounts in Materials Inventory? What happens to the difference? 7. Describe five potential causes of a materials price variance. 8. List and explain five potential causes of materials usage variances. 9. Explain how the purchase of materials at less than the standard price may have an

adverse effect on other production variances. 10. List five causes of a labor rate variance. 11. List five causes of a labor efficiency variance. 12. Give an example of how labor variances and materials variances are related. 13. Explain briefly how underapplied or overapplied overhead can be analyzed into a

budget variance and a capacity variance. 14. Define a capacity variance and explain why it consists solely of fixed overhead costs. 15. What is the primary difference between using standard costs in a job cost system

and a process cost system?

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Exercises

8-1. Standard Cost Sheet. Arnovitz Enterprises manufactures special electronic equip- ment and parts. It has adopted a standard cost system with separate standards for each part. A special electronic “black box” has standards set with the following components. Materials include both iron and copper. Each “black box” requires six sheets of iron which cost $7 per sheet and four spools of copper at $3.50 per spool. Four hours of direct labor are needed for producing each box, and the standard rate per hour is $16. Overhead costs are charged to products on the basis of direct labor time. The variable overhead rate is $3 per hour, and the fixed overhead rate is $2 per hour.

Question:

Prepare a standard cost sheet that shows the standard cost per unit for each “black box.”

8-2. Labor Variances. Marvin & Singer TV Repair Shop fixed 550 television sets during the year, using 1,447 direct labor hours. Standards state that television sets, on aver- age, should take 2.5 hours to repair. The standard direct labor rate is $19 per hour, while the actual rate averaged $18.60 per hour.

Question:

Compute the labor rate variance and the labor efficiency variance.

8-3. Materials Variances – Missing Information. In May, Sobel Equipment Company purchased 50,000 parts at a total cost of $600,000. During the month, 46,000 parts having a standard unit cost of $11 were used in production. The materials usage variance for the month was unfavorable by $33,000. According to the standards, five parts should be used for each unit of product.

Questions:

1. Calculate the materials price variance. 2. How many units of product were made? 3. How many units of parts should have been used in production?

8-4. Labor Standards. Four employees each work 38 hours a week in an assembly operation at Goozh Company. Standard production for the week was established at 2,280 assemblies, or at a rate of production of 15 assemblies per labor hour. A time study person, Keith Baker, has observed that it is possible to make 20 assemblies an hour, and this rate has been set as the new standard.

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Production data for one week under the new standard are as follows:

Employee Hours

Worked Units

Assembled

1 38 660

2 38 590

3 38 630

4 38 620

The standard labor rate per hour is $12. During this week, an unfavorable materials usage variance due solely to above normal scrap and waste was $2,500. Also, 500 units that had been fully assembled were rejected by Jean Emmer, an inspector.

Questions:

1. What was the standard labor cost per assembly under the old standard of 15 assem- blies per hour?

2. What was the anticipated labor cost per assembly under the new standard of 20 assemblies per hour?

3. What was the actual labor cost per assembly during the week (after deducting the rejected units)?

4. Comment on the new labor standard and possible reasons for the losses.

8-5. Labor Efficiency Variance and Ethics. Gold Burgers is a large fast-food restaurant located in Washington and managed by Randee Menashe. Standards indicate that each hamburger cook should make 100 burgers per hour and that the labor rate is $10 per hour. This month, 263,000 burgers were cooked in 2,150 hours.

Questions:

1. What was the labor efficiency variance this month? 2. Why might the restaurant manager be tempted to report to top management a

smaller variance than actually occurred?

8-6. Labor Variances – Incomplete Data. Lipis & Glinsky, a consulting firm, reports the following data related to its labor cost:

Question:

Determine the actual hours worked.

Labor efficiency variance $7,000 favorable

Total labor cost variance $13,000 unfavorable

Actual wage rate paid $120 per hour

Standard wage rate $110 per hour

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8-7. Materials Price Variance and Finding Unknowns. The Kurland Youth Baseball League has 3,000 baseballs in inventory, which were purchased by the director, Jack Williams, for a total of $6,600. Each baseball game should require a standard usage of five baseballs. During July, 330 baseball games were played. The total standard cost allowed for the baseballs amounted to $3,762. There was an unfavorable mate- rials usage variance of $800.

Questions:

1. Compute the standard price for one baseball. 2. How many baseballs were used in July? (Round to nearest whole number.) 3. Compute the price variance for the baseballs used in July.

8-8. Materials Variances and T-accounts. Rita Pollack & Company has the following data for the month of November:

Materials purchased, 2,600 kilograms $8,580

Materials used in production 1,320 kilograms

Units of product manufactured 17,000

Materials usage variance $384 Unfavorable

Standard price per kilogram $3.20

Questions:

1. Find the standard quantity of materials allowed for the units of product manufactured.

2. Determine the materials price variance. 3. Record the materials costs and variances in T-accounts with Work in Process Inven-

tory as the final account.

8-9. Standard Rate for Direct Labor. Frankel Brothers, Inc. manufactures tennis rackets. During one week in January, the company had a total standard cost for direct labor of $3,600. There was a favorable direct labor efficiency variance of $240. The actual amount of direct labor hours worked was 560 hours.

Question:

Compute the standard rate for direct labor.

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8-10. Overhead Variance Analysis. A flexible budget for Mark Fisher’s Tire Service is given in summary form as follows:

Machine hours 60,000 70,000 80,000 90,000

Variable overhead $240,000 $280,000 $320,000 $360,000

Fixed overhead 480,000 480,000 480,000 480,000

Total overhead $720,000 $760,000 $800,000 $840,000

The standard rate of production is six jobs per machine hour, and normal volume has been defined at 80,000 machine hours. The company performed 420,000 jobs in 70,000 machine hours. Actual variable overhead was $287,000, and the fixed over- head was $475,000.

Questions:

1. Compute the amount of underapplied or overapplied overhead. 2. Compute the budget variance. 3. Explain the major causes of a budget variance. 4. Compute the capacity variance. 5. Cite three possible reasons for the existence of this capacity variance.

8-11. Overhead Variances. Shapiro’s Delivery Service hires drivers to deliver packages in St. Louis. An average standard time to make a delivery has been established as one hour. The office is centrally located, and it takes about as much time to deliver to one location as it does to another. Fixed costs have been budgeted at $240,000 for the year. Under normal conditions, the company expects to make 60,000 deliveries a year. The variable cost has been budgeted at $12 per hour. Last year, the company made 63,000 deliveries in 59,000 hours and incurred total costs of $988,000, includ- ing fixed costs.

Questions:

1. Compute the standard cost of making a delivery. 2. How much overhead costs were charged to deliveries in total during the year? 3. Determine the budget variance. 4. Determine the capacity variance.

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Problems

8-12. Standard Cost Sheet – Materials and Labor. An industrial solvent with the brand name Velocidad is produced by Proveedor Chemical Company in Caracas, Venezuela, and sold in 25-liter drums. Data with respect to materials and labor are as follows:

1. A batch of 1,500 liters of Velocidad is made from an input of 1,500 liters each of Des- tino and Promesa. In the boiling operation, 50% of the volume of both Destino and Promesa is lost through evaporation.

2. At the end of the boiling operation, 2 kilograms of Bono are added to each 1,500-liter batch. (This has no measurable effect on volume.)

3. A worker can process one 25-liter drum in 20 minutes. 4. At the final inspection, two 25-liter drums are rejected out of every 10 drums

received from the production line. 5. Standard materials prices and the labor rate (in bolivars) are as follows:

Destino B 200 per liter

Promesa B 150 per liter

Bono B 600 per kilogram

Labor rate B 1,200 per hour

Question:

Prepare a standard cost sheet that shows the standard materials and labor costs for each 25-liter drum of completed product.

8-13. Interrelationship of Materials and Labor Variances. Vicki Kayser, purchasing agent for the western region of Knockout Nail Salons, was pleased to report that she bought 50,000 units (i.e., nails) for $15,000, which was lower than the $22,500 cost at its standard price. The nails also were a lower grade than called for by the stan- dard. Allowing for a normal amount of breakage, an average of 5.2 nails should be used for each hand.

When these nails were used on customers, breakage was higher than normal. To keep the abnormal breakage to a minimum, the operating manager, Lori Brickman, shifted more skilled workers into the salons where breakage occurred. The standard labor rate was $18 per hour. One half hour is the standard time for putting nails on one hand.

Last month, the salons used 42,000 units and 3,300 hours in doing 6,000 hands. The labor cost was $65,750.

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Questions:

1. Compute materials price and materials usage variances. 2. Compute labor rate and labor efficiency variances. 3. Combine the four variances to obtain the net effect. Did the purchasing agent save

the company money in buying the nonstandard nails? 4. Which variance amounts would be assigned to the purchasing agent and which

would be assigned to the operating manager? Comment on the interrelationships among the variances here.

8-14. Reconstructing Actual Inputs. Schoen Corporation manufactures a number of dif- ferent products. Its most profitable product comes from a division in Alabama that has the following standard cost sheet:

Materials (2 ounces at $8.50 per ounce) $17

Labor (.5 hour at $12 per hour) 6

Overhead ($18 per labor hour) 9

Total product cost $32

At the end of a recent month, the following variance information was available for the product:

Manufacturing cost variances:

Materials price $7,500 F

Materials usage 8,500 U

Labor rate 5,900 U

Labor efficiency 12,000 F

Materials purchases for the month were 300,000 ounces. The division produced 120,000 units, with no work in process inventories at the beginning or end of the month.

Questions:

1. Calculate the actual materials price per ounce. 2. Calculate the number of ounces of materials actually used in production. 3. Calculate the actual number of labor hours worked.

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8-15. Materials Variances. The current year budget for Ed Lynn’s Courier Service esti- mated 153,000 miles to be driven by its couriers based on a forecast of 17,000 deliv- eries. The standard price of gasoline was set at $2.20 per gallon, and the company expected to drive an average of 22 miles per gallon for its deliveries. During the year, 18,480 deliveries were actually made, 165,600 miles were driven, the average price per gallon of gasoline purchased was $2.16, and an average of 24 miles per gallon was achieved for the company’s deliveries.

Question:

Compute the materials price variance and the materials usage variance for the current year.

8-16. Overhead in an Automated Operation. Joe Tate observes, “The nature of costs has changed since Eruv Company installed more automated equipment. At one time, direct labor was an important factor. With automation, direct labor is essentially a fixed cost with workers monitoring the operation on television screens. Variable overhead cost is lower and is related to hours of machine operation. On the other hand, fixed cost is much higher than it was in a labor-oriented operation. However, the production line can only move so fast. If it is stepped up, too many pieces are broken.”

Jan Spector, the production manager, says, “We may not obtain much more savings from increases in productivity. Additional savings will have to come by holding down fixed costs and receiving a large volume of orders.”

Data from last year is as follows:

Variable cost per machine hour $4

Number of standard units of product per machine hour 100

Fixed overhead budget $6,000,000

Normal number of product units produced in a year 60,000,000

Actual hours of operation 500,000

Actual product units produced 58,000,000

Actual overhead cost:

Variable overhead $1,935,000

Fixed overhead $6,030,000

Questions:

1. What was the standard variable overhead cost per product unit and the standard fixed overhead cost per product unit?

2. How much overhead was applied to production for the year? 3. Determine the following variances:

a. Overhead budget variance. b. Overhead capacity variance.

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8-17. Overhead Budget and Capacity Variances. Levene Finance, Inc. specializes in home equity loans. It bases its overhead on the flexible budget cost function of:

$33,000 + ($2.40 × labor hours)

Normal volume is based on 12,000 labor hours. Standards call for two labor hours per loan processed.

For the current period, the operating results were as follows:

Actual labor hours worked 11,400

Loans processed 5,800

Actual variable overhead costs $28,460

Actual fixed overhead costs $31,950

Questions:

1. Calculate the rates for variable and fixed overhead that would be used to apply over- head to loans.

2. Calculate the underapplied or overapplied overhead for the period. 3. Determine the following variances:

a. Overhead budget variance. b. Overhead capacity variance.

4. How much of the budget variance is due to variable costs and how much to fixed costs?

8-18. Comprehensive Variance Analysis. Weissmann Company uses a standard cost system and isolates the following six variances for the appropriate departments:

Materials price variance Labor efficiency variance

Materials usage variance Overhead budget variance

Labor rate variance Overhead capacity variance

The company uses direct labor as the measure of activity for each of the producing departments.

Question:

For each of the following independent events, indicate which variances would be affected. Briefly explain why they would be affected, and indicate whether the effect is favorable or unfavorable. If more than one variance is influenced in a given situation, limit your discussion to the two or three most important variances for that situation.

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a. Demand exceeded expectation, and the number of units produced during the year was much greater than the number planned.

b. Because of an improperly adjusted machine, more materials were wasted than anticipated. When the department supervisor requisitioned more materials from the storeroom, no materials were there. A rush order for more materials was placed, and the materials arrived by special delivery before the end of the day.

c. A purchasing agent bought substandard materials at a large savings. Because of the lower quality of the materials, more scrap was produced, and an additional employee was hired to assist in the cutting operation.

d. Several customer rush orders were accepted and placed into production. The orders were completed within the standard time allotted; however, overtime was required to meet the customers’ delivery schedules.

e. A new union contract at the beginning of the year required an increase in labor rates. Adjustments to the standard wage rates were made as required at the beginning of the year. During the year, the rate of inflation in the economy was lower than what was predicted for the contract wage rates.

f. Due to food poisoning in the plant cafeteria, several highly skilled employees from one department were sick for two days. The department supervisor hired temporary, unskilled production-line workers to substitute for the skilled work- ers. The wages for the temporary help were less than standard, and the output was also less than standard.

g. Because there were more than the usual machine breakdowns, repair and main- tenance personnel used more supplies than called for in the overhead budgets.

h. A brownout caused by the overload of extra power usage in the city resulted in the inability to run machines at full power for four hours during a second shift.

i. A forklift driver inadvertently ran into a large machine, dumping his load and stopping the machine. Several direct labor workers and the machine operator helped clean up the mess and got the machine going again.

j. A new quality control inspector was less strict than policy standards required. Units that should have been reworked were passed over, released to the finished goods warehouse, and sold to customers.

8-19. Analysis of Overhead Items. Elaine Alexander, administrator of a dialysis clinic in Peyton, New Mexico, has estimated overhead costs for the year at an expected oper- ating level of 6,000 dialyzer machine hours. Past experience indicates a rate of cost variability per hour as follows:

Lubrication $.75

Supplies .30

Power .25

Repairs .50

Maintenance .80

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Costs that are fixed are budgeted as follows:

Supervision $ 4,500

Indirect labor 11,500

Heat and light 3,200

Taxes and insurance 1,600

Depreciation 1,800

During the year, the clinic incurred 5,500 dialyzer machine hours and treated the number of patients that should have been treated in 5,000 dialyzer machine hours. The clinic incurred the following overhead costs:

Lubrication $ 3,900

Supplies 1,700

Power 1,500

Repairs 2,800

Maintenance 4,300

Supervision 4,000

Indirect labor 12,000

Heat and light 3,200

Taxes and insurance 1,400

Depreciation 1,600

Total $36,400

Questions:

1. Prepare a budget of overhead costs for 5,000 dialyzer machine hours. 2. Compare the actual overhead costs with the budget for 5,000 dialyzer machine

hours. Show budget variances for each item. 3. Explain what factors could cause the budget variance to arise.

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Case: Sydney’s Bicycles, Inc.

Sydney’s Bicycles, Inc. is a large manufacturer located in Omaha. Its usual production of bicycles is 10,000 units per year. The company has been a leader in the 21-speed bike industry for several years. However, with increasing competition and a higher public emphasis on quality, the company has been searching for ways to maintain quality and cut costs. Andy Lewis, production planner, suggested that starting at the beginning of 2019 the company invest in higher-quality materials and hire more experienced workers at a slightly higher pay rate.

The company has used a standard cost system for the past five years. The current standard costs for one bicycle, based on production of 10,000 units, are as follows:

Jonathan Levin, president, is skeptical about decreasing costs by increasing materials and labor costs. However, after much debate, he agrees to try the changes for one year beginning with January 2019. Because the exact costs of changes were not known at the beginning of 2019, the existing standard costs were retained. Therefore, the changes will be in the variances from standard costs.

During 2019, the company produced only 9,500 bicycles because the marketplace showed a decreasing demand. The following data show the actual results for 2019:

1. Materials costing $617,500 were purchased and used. No usage variance existed, so any differences were due solely to price changes.

2. Direct labor was $249,375 for 23,750 direct labor hours. 3. Actual variable overhead totaled $163,000. 4. Actual fixed overhead totaled $80,000.

Mr. Levin was pleased with the results. Even though production was down by 500 bicycles, the difference in costs was significant. He would like to know why.

Questions:

1. Compute all appropriate variances for the following categories: a. Materials b. Labor c. Overhead

2. Explain how any of the variances interrelate (have the same basic cause). 3. Explain which of the variances are controllable. 4. Assuming that the actual cost results for 2019 represent the new standard

performance, calculate the new standard cost per bicycle, showing separately the materials, labor, and overhead components. (Normal production is still based on 10,000 bicycles.)

Materials $ 60

Direct labor (4 hours at $10) 40

Variable overhead (based on labor) 20

Fixed overhead (based on labor) 8

Standard cost per bicycle $128

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