Accounting Discussion #6 (part A)
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spptchap011.pptPowerPoint Authors: Susan Coomer Galbreath, Ph.D., CPA Charles W. Caldwell, D.B.A., CMA Jon A. Booker, Ph.D., CPA, CIA Cynthia J. Rooney, Ph.D., CPA
Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.
Standard Costs and Variances
Chapter 11
Chapter 11: Standard Costs and Operating Performance Measures
This chapter extends our study of management control by explaining how standard costs are used by managers to control costs. It demonstrates how to compute direct materials, direct labor, and variable overhead variances. The chapter also defines some nonfinancial performance measures that are frequently used by companies.
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Standard Costs
Standards are benchmarks or “norms” for
measuring performance. In managerial accounting,
two types of standards are commonly used.
Quantity standards
specify how much of an
input should be used to
make a product or
provide a service.
Price standards
specify how much
should be paid for
each unit of the
input.
Examples: Firestone, Sears, McDonald’s, hospitals,
construction, and manufacturing companies.
A standard is a benchmark or “norm” for measuring performance. In managerial accounting, two types of standards are commonly used by manufacturing, service, food, and not-for-profit organizations:
- Quantity standards specify how much of an input should be used to make a product or provide a service. For example:
- Auto service centers like Firestone and Sears set labor time standards for the completion of work tasks.
- Fast-food outlets such as McDonald’s have exacting standards for the quantity of meat going into a sandwich.
- Price standards specify how much should be paid for each unit of the input. For example:
- Hospitals have standard costs for food, laundry, and other items.
- Home construction companies have standard labor costs that they apply to sub-contractors such as framers, roofers, and electricians.
- Manufacturing companies often have highly developed standard costing systems that establish quantity and price standards for each separate product’s material, labor, and overhead inputs. These standards are listed on a standard cost card.
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Standard Costs
Direct
Material
Type of Product Cost
Amount
Direct
Labor
Manufacturing
Overhead
Standard
Deviations from standards deemed significant
are brought to the attention of management, a
practice known as management by exception.
Management by exception is a system of management in which standards are set for various operating activities, with actual results compared to these standards. Any deviations that are deemed significant are brought to the attention of management as “exceptions.”
This chapter applies the management by exception principle to quantity and price standards with an emphasis on manufacturing applications.
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Variance Analysis Cycle
The variance analysis cycle is a continuous process used to identify and solve problems:
- The cycle begins with the preparation of standard cost performance reports in the accounting department.
- These reports highlight variances that are differences between actual results and what should have occurred according to standards.
- The variances raise questions such as:
- Why did this variance occur?
- Why is this variance larger than it was last period?
- The significant variances are investigated to discover their root causes.
- Corrective actions are taken.
- Next period’s operations are carried out and the process is repeated.
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Setting Standard Costs
Engineer
Managerial Accountant
Should we use
ideal standards that
require employees to
work at 100 percent
peak efficiency?
I recommend using practical standards that are currently attainable with reasonable and efficient effort.
Standards tend to fall into one of two categories:
- Ideal standards can only be attained under the best of circumstances. They allow for no work interruptions and they require employees to work at 100% peak efficiency all of the time.
- Practical standards are tight, but attainable. They allow for normal machine downtime and employee rest periods and can be attained through reasonable, highly efficient efforts of the average worker. Practical standards can also be used for forecasting cash flows and in planning inventory.
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Setting Direct Materials Standards
Standard Price
per Unit
Summarized in
a Bill of Materials.
Final, delivered
cost of materials,
net of discounts.
Standard Quantity
per Unit
The standard price per unit for direct materials should reflect the final, delivered cost of the materials, net of any discounts taken.
The standard quantity per unit for direct materials should reflect the amount of material required for each unit of finished product, as well as an allowance for unavoidable waste, spoilage, and other normal inefficiencies.
A bill of materials is a list that shows the quantity of each type of material in a unit of finished product.
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Setting Direct Labor Standards
Use time and
motion studies for
each labor operation.
Standard Hours
per Unit
Often a single
rate is used that reflects
the mix of wages earned.
Standard Rate
per Hour
The standard rate per hour for direct labor includes not only wages earned but also fringe benefits and other labor costs. Many companies prepare a single rate for all employees within a department that reflects the “mix” of wage rates earned.
The standard hours per unit reflects the labor hours required to complete one unit of product. Standards can be determined by using available references that estimate the time needed to perform a given task, or by relying on time and motion studies.
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Setting Variable Manufacturing Overhead Standards
The rate is the
variable portion of the
predetermined overhead
rate.
Price
Standard
The quantity is
the activity in the allocation base for predetermined overhead.
Quantity
Standard
The price standard for variable manufacturing overhead comes from the variable portion of the predetermined overhead rate.
The quantity standard for variable manufacturing overhead is expressed in either direct labor hours or machine hours depending on which is used as the allocation base in the predetermined overhead rate.
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Using Standards in Flexible Budgets
Standard costs per unit for direct materials, direct labor, and variable manufacturing overhead can be used to compute activity and spending variances.
Spending variances become more useful by breaking them down into quantity and price variances.
Standard costs per unit for direct materials, direct labor, and variable manufacturing overhead can be used to compute activity and spending variances as described in the previous chapter.
Spending variances become more useful by breaking them down into quantity and price variances. This is our focus in this chapter.
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Variance Analysis
Materials price variance
Labor rate variance
VOH rate variance
Materials quantity variance
Labor efficiency variance
VOH efficiency variance
A General Model for Variance Analysis
Quantity Variance
Price Variance
Quantity and price variances can be computed for all three variable cost elements – direct materials, direct labor, and variable manufacturing overhead – even though the variances have different names as shown.
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A General Model for Variance Analysis
Quantity Variance
(2) – (1)
Price Variance
(3) – (2)
(1)
Standard Quantity
Allowed for Actual Output,
at Standard Price
(SQ × SP)
(2)
Actual Quantity
of Input,
at Standard Price
(AQ × SP)
(3)
Actual Quantity
of Input,
at Actual Price
(AQ × AP)
Spending Variance
(3) – (1)
Although quantity and price variances are known by different names, they are computed exactly the same way (as shown on this slide) for direct materials, direct labor, and variable manufacturing overhead.
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A General Model for Variance Analysis
Actual quantity is the amount of direct materials, direct labor, and variable manufacturing overhead actually used.
Quantity Variance
(2) – (1)
Price Variance
(3) – (2)
(1)
Standard Quantity
Allowed for Actual Output,
at Standard Price
(SQ × SP)
(2)
Actual Quantity
of Input,
at Standard Price
(AQ × SP)
(3)
Actual Quantity
of Input,
at Actual Price
(AQ × AP)
Spending Variance
(3) – (1)
The actual quantity represents the actual amount of direct materials, direct labor, and variable manufacturing overhead used.
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A General Model for Variance Analysis
Standard quantity is the standard quantity allowed for the actual output of the period.
Quantity Variance
(2) – (1)
Price Variance
(3) – (2)
(1)
Standard Quantity
Allowed for Actual Output,
at Standard Price
(SQ × SP)
(2)
Actual Quantity
of Input,
at Standard Price
(AQ × SP)
(3)
Actual Quantity
of Input,
at Actual Price
(AQ × AP)
Spending Variance
(3) – (1)
The standard quantity represents the standard quantity allowed for the actual output of the period.
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A General Model for Variance Analysis
Actual price is the amount actually
paid for the input used.
Quantity Variance
(2) – (1)
Price Variance
(3) – (2)
(1)
Standard Quantity
Allowed for Actual Output,
at Standard Price
(SQ × SP)
(2)
Actual Quantity
of Input,
at Standard Price
(AQ × SP)
(3)
Actual Quantity
of Input,
at Actual Price
(AQ × AP)
Spending Variance
(3) – (1)
The actual price represents the actual amount paid for the input used.
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A General Model for Variance Analysis
Quantity Variance
(2) – (1)
Price Variance
(3) – (2)
(1)
Standard Quantity
Allowed for Actual Output,
at Standard Price
(SQ × SP)
(2)
Actual Quantity
of Input,
at Standard Price
(AQ × SP)
(3)
Actual Quantity
of Input,
at Actual Price
(AQ × AP)
Spending Variance
(3) – (1)
Standard price is the amount that should
have been paid for the input used.
The standard price represents the amount that should have been paid for the input used.
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Learning Objective 11-1
Compute the direct materials quantity and price variances and explain their significance.
Learning objective 11-1 is to compute the direct materials quantity and price variances and explain their significance.
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Glacier Peak Outfitters has the following direct materials standard for the fiberfill in its mountain parka.
0.1 kg. of fiberfill per parka at $5.00 per kg.
Last month 210 kgs. of fiberfill were purchased and used to make 2,000 parkas. The materials cost a total of $1,029.
Materials Variances – An Example
Here’s an example that will give us an opportunity to compute materials quantity and price variances.
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200 kgs. 210 kgs. 210 kgs.
× × ×
$5.00 per kg. $5.00 per kg. $4.90 per kg.
= $1,000 = $1,050 = $1,029
Materials Variances Summary
Standard Quantity Actual Quantity Actual Quantity
× × ×
Standard Price Standard Price Actual Price
Quantity variance
$50 unfavorable
Price variance
$21 favorable
The materials quantity variance, defined as the difference between the quantity of materials used in production and the quantity that should have been used according to the standard, is $50 unfavorable. The quantity variance is labeled unfavorable because the actual quantity exceeds the standard quantity allowed by 10 kilograms.
The materials price variance, defined as the difference between what is paid for a quantity of materials and what should have been paid according to the standard, is $21 favorable. The price variance is labeled favorable because the actual price was less than the standard price by $0.10 per kilogram.
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Materials Variances Summary
200 kgs. 210 kgs. 210 kgs.
× × ×
$5.00 per kg. $5.00 per kg. $4.90 per kg.
= $1,000 = $1,050 = $1,029
Standard Quantity Actual Quantity Actual Quantity
× × ×
Standard Price Standard Price Actual Price
0.1 kg per parka 2,000 parkas = 200 kgs
Quantity variance
$50 unfavorable
Price variance
$21 favorable
The standard quantity of 200 kilograms is computed by multiplying the standard quantity per parka times the number of parkas made.
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Materials Variances Summary
200 kgs. 210 kgs. 210 kgs.
× × ×
$5.00 per kg. $5.00 per kg. $4.90 per kg.
= $1,000 = $1,050 = $1,029
Standard Quantity Actual Quantity Actual Quantity
× × ×
Standard Price Standard Price Actual Price
$1,029 210 kgs = $4.90 per kg
Quantity variance
$50 unfavorable
Price variance
$21 favorable
The actual price of $4.90 per kilogram is computed by dividing the actual cost of the material by the actual number of kilograms purchased.
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Materials Variances:
Using the Factored Equations
Materials quantity variance
MQV = (AQ × SP) – (SQ × SP)
= SP(AQ – SQ)
= $5.00/kg (210 kgs – (0.1 kg/parka 2,000 parkas))
= $5.00/kg (210 kgs – 200 kgs)
= $5.00/kg (10 kgs) = $50 U
Materials price variance
MPV = (AQ × AP) – (AQ × SP)
= AQ(AP – SP)
= 210 kgs ($4.90/kg – $5.00/kg)
= 210 kgs (– $0.10/kg) = $21 F
The equations that we have been using thus far can be factored as shown and used to compute price and quantity variances.
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Materials Price Variance
Materials Quantity Variance
The standard price is used to compute the quantity variance
so that the production manager is not held responsible for
the purchasing manager’s performance.
Responsibility for Materials Variances
Production Manager
Purchasing Manager
The purchasing manager and production manager are usually held responsible for the materials price variance and materials quantity variance, respectively. The standard price is used to compute the quantity variance so that the production manager is not held responsible for the performance of the purchasing manager.
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Responsibility for Materials Variances
Production Manager
Purchasing Manager
I am not responsible for
this unfavorable materials
quantity variance.
You purchased cheap
material, so my people
had to use more of it.
Your poor scheduling sometimes requires me to rush order materials at a higher price, causing unfavorable price variances.
The materials variances are not always entirely controllable by one person or department. For example, the production manager may schedule production in such a way that it requires express delivery of raw materials resulting in an unfavorable materials price variance. The purchasing manager may purchase lower quality raw materials resulting in an unfavorable materials quantity variance for the production manager.
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Learning Objective 11-2
Compute the direct labor efficiency and rate variances and explain
their significance.
Learning objective 11-2 is to compute the direct labor efficiency and rate variances and explain their significance.
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Glacier Peak Outfitters has the following direct labor standard for its mountain parka.
1.2 standard hours per parka at $10.00 per hour
Last month, employees actually worked 2,500 hours at a total labor cost of $26,250 to make 2,000 parkas.
Labor Variances – An Example
Now let’s turn our attention back to Glacier Peak Outfitters to illustrate the computation of labor rate and efficiency variances.
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Standard Hours Actual Hours Actual Hours
× × ×
Standard Rate Standard Rate Actual Rate
Labor Variances Summary
2,400 hours 2,500 hours 2,500 hours
× × ×
$10.00 per hour $10.00 per hour $10.50 per hour
= $24,000 = $25,000 = $26,250
Efficiency variance
$1,000 unfavorable
Rate variance
$1,250 unfavorable
The labor efficiency variance, defined as the difference between the actual quantity of labor hours and the quantity allowed according to the standard, is $1,000 unfavorable. The efficiency variance is labeled unfavorable because the actual quantity of hours exceeds the standard quantity allowed by 100 hours.
The labor rate variance, defined as the difference between the actual average hourly wage paid and the standard hourly wage, is $1,250 unfavorable. The rate variance is labeled unfavorable because the actual average wage rate was more than the standard wage rate by $0.50 per hour.
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2,400 hours 2,500 hours 2,500 hours
× × ×
$10.00 per hour $10.00 per hour $10.50 per hour
= $24,000 = $25,000 = $26,250
Labor Variances Summary
Standard Hours Actual Hours Actual Hours
× × ×
Standard Rate Standard Rate Actual Rate
1.2 hours per parka 2,000 parkas = 2,400 hours
Efficiency variance
$1,000 unfavorable
Rate variance
$1,250 unfavorable
The standard quantity of 2,400 hours is computed by multiplying the standard hours for one parka times the number of parkas made.
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2,400 hours 2,500 hours 2,500 hours
× × ×
$10.00 per hour $10.00 per hour $10.50 per hour
= $24,000 = $25,000 = $26,250
Labor Variances Summary
Standard Hours Actual Hours Actual Hours
× × ×
Standard Rate Standard Rate Actual Rate
$26,250 2,500 hours = $10.50 per hour
Efficiency variance
$1,000 unfavorable
Rate variance
$1,250 unfavorable
The actual price (or rate) of $10.50 per hour is computed by dividing the actual total cost for labor by the actual number of hours worked.
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Labor Variances: Using the Factored Equations
Labor efficiency variance
LEV = (AH × SR) – (SH × SR)
= SR (AH – SH)
= $10.00 per hour (2,500 hours – 2,400 hours)
= $10.00 per hour (100 hours)
= $1,000 unfavorable
Labor rate variance
LRV = (AH × AR) – (AH × SR)
= AH (AR – SR)
= 2,500 hours ($10.50 per hour – $10.00 per hour)
= 2,500 hours ($0.50 per hour)
= $1,250 unfavorable
Factored equations can also be used to compute the rate and efficiency variances.
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Responsibility for Labor Variances
Production managers are
usually held accountable
for labor variances
because they can
influence the:
Production Manager
Mix of skill levels
assigned to work tasks.
Level of employee motivation.
Quality of production supervision.
Quality of training provided to employees.
Labor variances are partially controllable by employees within the Production Department. For example, production managers/supervisors can influence:
- The deployment of highly skilled workers and less skilled workers on tasks consistent with their skill levels.
- The level of employee motivation within the department.
- The quality of production supervision.
- The quality of the training provided to the employees.
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Responsibility for Labor Variances
I am not responsible for
the unfavorable labor
efficiency variance!
You purchased cheap
material, so it took more
time to process it.
I think it took more time to process the materials because the Maintenance Department has poorly maintained your equipment.
However, labor variances are not entirely controllable by one person or department. For example:
- The Maintenance Department may do a poor job of maintaining production equipment. This may increase the processing time required per unit, thereby causing an unfavorable labor efficiency variance.
- The purchasing manager may purchase lower quality raw materials resulting in an unfavorable labor efficiency variance for the production manager.
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Learning Objective 11-3
Compute the variable manufacturing overhead efficiency and rate variances and explain their significance.
Learning objective 11-3 is to compute the variable manufacturing overhead efficiency and rate variances and explain their significance.
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Glacier Peak Outfitters has the following direct variable manufacturing overhead labor standard for its mountain parka.
1.2 standard hours per parka at $4.00 per hour
Last month, employees actually worked 2,500 hours to make 2,000 parkas. Actual variable manufacturing overhead for the month was $10,500.
Variable Manufacturing Overhead Variances – An Example
Now that we have studied material and labor variances, let’s take a look a variable manufacturing overhead variances. We will return to Glacier Peak Outfitters to illustrate the computation of variable manufacturing overhead efficiency and rate variances.
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2,400 hours 2,500 hours 2,500 hours
× × ×
$4.00 per hour $4.00 per hour $4.20 per hour
= $9,600 = $10,000 = $10,500
Variable Manufacturing Overhead Variances Summary
Standard Hours Actual Hours Actual Hours
× × ×
Standard Rate Standard Rate Actual Rate
Efficiency variance
$400 unfavorable
Rate variance
$500 unfavorable
The variable overhead efficiency variance, defined as the difference between the actual activity of a period and the standard activity allowed, multiplied by the variable part of the predetermined overhead rate, is $400 unfavorable. The efficiency variance is labeled unfavorable because the actual quantity of the activity (hours) exceeds the standard quantity of the activity allowed by 100 hours.
The variable overhead rate variance, defined as the difference between the actual variable overhead costs incurred during the period and the standard cost that should have been incurred based on the actual activity of the period, is $500 unfavorable. The rate variance is labeled unfavorable because the actual variable overhead rate was more than the standard variable overhead rate by $0.20 per hour.
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2,400 hours 2,500 hours 2,500 hours
× × ×
$4.00 per hour $4.00 per hour $4.20 per hour
= $9,600 = $10,000 = $10,500
Variable Manufacturing Overhead Variances Summary
Standard Hours Actual Hours Actual Hours
× × ×
Standard Rate Standard Rate Actual Rate
1.2 hours per parka 2,000 parkas = 2,400 hours
Efficiency variance
$400 unfavorable
Rate variance
$500 unfavorable
The standard quantity of 2,400 hours is computed by multiplying the standard hours for one parka times the number of parkas made.
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2,400 hours 2,500 hours 2,500 hours
× × ×
$4.00 per hour $4.00 per hour $4.20 per hour
= $9,600 = $10,000 = $10,500
Variable Manufacturing Overhead Variances Summary
Standard Hours Actual Hours Actual Hours
× × ×
Standard Rate Standard Rate Actual Rate
$10,500 2,500 hours = $4.20 per hour
Efficiency variance
$400 unfavorable
Rate variance
$500 unfavorable
The actual price of $4.20 per hour is computed by dividing the actual total cost for variable manufacturing overhead by the actual number of hours worked.
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Variable Manufacturing Overhead Variances: Using Factored Equations
Variable manufacturing overhead efficiency variance
VMEV = (AH × SR) – (SH – SR)
= SR (AH – SH)
= $4.00 per hour (2,500 hours – 2,400 hours)
= $4.00 per hour (100 hours)
= $400 unfavorable
Variable manufacturing overhead rate variance
VMRV = (AH × AR) – (AH – SR)
= AH (AR – SR)
= 2,500 hours ($4.20 per hour – $4.00 per hour)
= 2,500 hours ($0.20 per hour)
= $500 unfavorable
Factored equations can be used to compute the rate and efficiency variances.
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Variance Analysis and Management by Exception
How do I know
which variances to investigate?
Larger variances, in dollar amount or as a percentage of the standard, are investigated first.
All variances are not worth investigating. Methods for highlighting a subset of variances as exceptions include:
- Looking at the size of the variance.
- Looking at the size of the variance relative to the amount of spending.
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Advantages of Standard Costs
Management by
exception
Promotes economy
and efficiency
Simplified
bookkeeping
Enhances
responsibility
accounting
Advantages
Research has shown that a substantial portion of companies in the United Kingdom, Canada, Japan, and the United States use standard cost systems. This is because standard cost systems offer many advantages including:
- Standard costs are a key element of the management by exception approach which helps managers focus their attention on the most important issues.
- Standards that are viewed as reasonable by employees can serve as benchmarks that promote economy and efficiency.
- Standard costs can greatly simplify bookkeeping.
- Standard costs fit naturally into a responsibility accounting system.
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Emphasis on
negative may
impact morale.
Emphasizing standards
may exclude other
important objectives.
Favorable
variances may
be misinterpreted.
Continuous
improvement may
be more important
than meeting standards.
Standard cost
reports may
not be timely.
Invalid assumptions
about the relationship
between labor
cost and output.
Potential Problems with Standard Costs
Potential
Problems
The use of standard costs can also present a number of problems. For example:
- Standard cost variance reports are usually prepared on a monthly basis and are often released days or weeks after the end of the month; hence, the information can be outdated.
- If variances are misused as a club to negatively reinforce employees, morale may suffer and employees may make dysfunctional decisions.
- Labor variances make two important assumptions. First, they assume that the production process is labor-paced; if labor works faster, output will go up. Second, the computations assume that labor is a variable cost. These assumptions are often invalid in today’s automated manufacturing environment where employees are essentially a fixed cost.
- In some cases, a “favorable” variance can be as bad or worse than an unfavorable variance.
- Excessive emphasis on meeting the standards may overshadow other important objectives such as maintaining and improving quality, on-time delivery, and customer satisfaction.
- Just meeting standards may not be sufficient; continual improvement using techniques such as Six Sigma may be necessary to survive in a competitive environment.
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End of Chapter 11
End of chapter 11.
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