This
lecture expand our study of
management and cost control by explaining how
standard
costs are used by accountants to control costs. It demonstrates how to compute
direct materials, direct labor, and variable overhead variances.
I.
Standard costs – setting the stage
A. Basic definitions/concepts
i.
A standard
is a benchmark for measuring performance. In managerial accounting, two types of standards are commonly
used by manufacturing, service, food, and not-for-profit organizations:
1.
Quantity standards specify how much of an
input should be used to make a product or provide a service. For example:
a. Auto
service centers like Firestone and Sears set labor time standards for the
completion of work tasks.
b. Fast-food
outlets such as McDonald’s have
exacting standards for the quantity of meat going into a sandwich.
2. Price standards specify how much should be
paid for each unit of the input. For example:
a. Hospitals have standard costs for food, laundry, and
other items.
b.
Home
construction companies have standard labor costs that they apply to
sub-contractors such as framers, roofers, and electricians.
c. 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.
II.
Setting standard costs
A.
Setting direct materials
standards
i.
The standard
price per unit for direct materials should reflect the final, delivered
cost of the materials.
ii.
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.
B.
Setting direct labor
standards
i.
The
standard rate per hour for direct
labor includes not only wages earned but also fringe benefits and other labor
costs.
1. Many companies prepare a single rate for all employees within a department that reflects the
“mix” of wage rates earned.
ii.
The
standard hours per unit reflects the
labor hours required to complete one unit of product.
1. 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.
C.
Setting variable manufacturing
overhead standards
i.
The
price standard for variable
manufacturing overhead comes from the variable
portion of the predetermined overhead rate.
ii.
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.
D.
The standard cost card
i.
The
standard cost card is a detailed listing of the standard amounts of direct materials, direct labor, and
variable overhead inputs that should go into a unit of product, multiplied
by the standard price or rate that has been set for each input.
III.
Using standards in flexible budgets
A. Activity and spending
variances
i. 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.
B. Price and quantity variances
ii. Spending
variances become more useful by breaking them down into price and quantity
variances. This is our focus in this chapter.
IV.
A general model for standard cost variance analysis
A. Price and quantity
variances
i.
A price variance is the difference between the actual price
of an input and its standard price, multiplied by the actual amount of the
input purchased.
ii.
A quantity variance is the difference between
how much of an input was actually used and how much should have been used and
is stated in dollar terms using the standard price of the input.
B.
Price and quantity standards
i.
Price and quantity standards are determined separately because price
and quantity variances usually have different causes. In addition:
1.
Different
managers are usually responsible for buying and for using inputs. For example:
a.
The
purchasing manager is responsible for raw material purchase prices and the
production manager is responsible for the quantity of raw material used.
2. The buying and using activities occur at
different points in time. For example:
a. Raw
material purchases may be held in inventory for a period of time before being
used in production.
C. The general model—an overview
i.
Price
and quantity variances can be computed for all three variable cost elements – direct materials, direct labor, and
variable manufacturing overhead – even though the variances have different
names as shown.
ii.
Although
price and quantity 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.
1.
The actual
quantity represents the actual
amount of direct materials, direct labor, and variable manufacturing overhead
used.
Helpful Hint:
Emphasize that the quantities in this model pertain to inputs not outputs. So,
in the case of direct materials, the quantities will be stated in terms such as
pounds, ounces, etc., not the number of units of finished goods produced.
2.
The
standard quantity represents the standard quantity allowed for the
actual output of the period.
Helpful Hint:
Mention that the “SQ” portion of the model is the most common stumbling block
for students when it comes to variance analysis. Emphasize that “SQ” refers to
the standard quantity of inputs allowed for the actual level of output achieved. For example, if 5,000 drapes were
produced and each requires 2 yards of fabric, the standard quantity allowed
would be 10,000 yards. Any other amount of fabric used would result in a
variance.
3.
The actual
price represents the actual amount paid for the input used.
4.
The
standard price represents the amount
that should have been paid for the input used.
V.
Using standard costs—direct materials variances
Learning Objective 1:
Compute the direct materials price and quantity variances and explain their
significance.
A.
Glacier Peak Outfitters – an example
i.
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.
1. The price variance is labeled favorable
because the actual price was less than the standard price by $0.10 per kilogram.
ii.
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.
1. The
quantity variance is labeled unfavorable
because the actual quantity exceeds the standard quantity allowed by 10 kilograms.
Helpful Hint:
Remind students that a favorable price variance might not always be a good
thing. If it arose from receiving inferior or obsolete goods at a reduced
price, the total costs of making the company’s products might be higher.
iii.
Supporting/additional
computations
1.
The
standard quantity of 200 kilograms
was computed as shown.
2.
The actual price of $4.90 per kilogram was computed as shown.
3.
The equations that we have been using thus
far can be factored as shown and
used to compute price and quantity variances.
B.
Direct materials
variances—points of clarification:
i.
The purchasing
manager and production manager
are usually held responsible for the materials price variance, and materials
quantity variance, respectively.
1. 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.
ii.
The materials variances are not always
entirely controllable by one person
or department. For example:
1.
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.
2. The
purchasing manager may purchase lower
quality raw materials resulting in an unfavorable materials quantity
variance for the production manager.
Quick Check –
direct materials variance calculations
VI.
Using standard costs—direct labor variances
Learning
Objective 2: Compute the direct labor rate and efficiency variances and explain
their significance.
A.
Glacier Peak Outfitters – continued (assume the
information as shown)
i.
The labor rate variance,
defined as the
difference between the actual average hourly wage paid and the standard hourly
wage, is $1,250 unfavorable.
1. The rate variance is labeled unfavorable because the actual average
wage rate was more than the standard wage rate by $0.50 per hour.
ii.
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.
1. The
efficiency variance is labeled unfavorable
because the actual quantity of hours exceeds the standard quantity allowed by 100 hours.
iii.
Supporting/additional
computations
1.
The
standard quantity of 2,400 hours was
computed as shown.
2.
The
actual price (or rate) of $10.50 per
hour was computed as shown.
3.
Factored
equations
can also be used to compute the efficiency and rate variances.
B.
Direct labor variances—points of clarification:
i.
Labor variances are partially controllable by employees within the Production
Department. For example, production managers/supervisors can influence:
1. The
deployment of highly skilled workers and less skilled workers on tasks
consistent with their skill levels.
2.
The level of employee motivation within the
department.
3. The
quality of production supervision.
4. The
quality of the training provided to the employees.
ii.
However, labor variances are not entirely controllable by one person or
department. For example:
1.
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.
2. The
purchasing manager may purchase lower
quality raw materials resulting in an unfavorable labor efficiency variance
for the production manager.
Quick Check – direct labor variance calculations
VII.
Using standard costs—variable manufacturing overhead variances
Learning Objective 3: Compute the
variable manufacturing overhead rate and efficiency variances and explain their
significance.
A.
Glacier Peak Outfitters – continued
i.
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.
1. 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.
ii.
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.
1. 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.
iii.
Supporting/additional
computations
1.
The standard quantity of
2,400 hours was computed as shown.
2.
The actual price of $4.20 per
hour was computed as shown.
3.
Factored equations can be used to compute the efficiency and rate
variances.
Quick Check –
variable overhead variance calculations
VIII.
Materials variances—an important subtlety
A.
When the quantity of materials
purchased differs from the quantity used in production, the price variance is based on the quantity
purchased and the quantity variance is based on the quantity used in production.
B. Glacier Peak Outfitters—revisited
i. The materials
price variance is computed using the actual quantity purchased (210 kgs.); therefore, the materials
price variance is $21 favorable.
ii. The materials quantity variance is computed
using the actual quantity used in production (200 kgs.); therefore,
the materials quantity variance is $0.
IX. Standard
costs—managerial implications
A. Advantages of standard
costs:
i.
Standard costs are a key element of the management
by exception
approach.
ii.
Standards
can provide benchmarks that promote
economy and efficiency.
iii.
Standards can greatly simplify bookkeeping.
iv.
Standards can support responsibility accounting systems.
B. Potential problems with
standard costs:
i.
Standard cost variance reports are usually
prepared on a monthly basis; hence, they may contain information that is outdated.
ii.
If
variances are misused as a club to
negatively reinforce employees, morale
may suffer and employees may make dysfunctional
decisions.
iii.
Labor variances make two important assumptions. First, they assume that production is
labor-paced; if labor works faster, output will go up. Second, they 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.
iv.
In some cases, a “favorable” variance can be as bad as or worse than an “unfavorable” variance.
v.
Excessive emphasis on meeting the standards may overshadow other important objectives
such as maintaining and improving quality, on-time delivery, and customer
satisfaction.
vi.
Just meeting standards may not be sufficient;
continuous process improvement may
be necessary to survive in a competitive environment.
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