Standard Costing and Variance Analysis

1
Chapter 25

• Standard Costing and Variance Analysis

2
Standard Costing

• Objective 1
• Define standard costs and describe how managers
  use standard costs in the management cycle

3
Standard Costing

• is a method of cost control that includes a
  measure of actual performance and a measure of
  the difference, or variance, between standard and
  actual performance

4
Standard Costs

• Realistic estimates of costs
• Based on analysis of both past and projected
  operating costs and conditions
• Provide a predetermined performance level for the
  standard costing method
• Usually stated in terms of cost per unit

5
Standard Costs (contd)

• Based on
• Past costs
• Engineering estimates
• Forecasted demand
• Worker input
• Time and motion studies
• Type and quality of direct materials

6
Standard Costing

• How the standard costing method differs from the
  normal and actual costing methods (see page 841)

7
Standard Costs and the Management Cycle

• Planning
• Managers use standard costs to
• Develop budgets
• Direct materials
• Direct labor
• Variable manufacturing overhead
• Establish goals for product costing

8
Standard Costs and the Management Cycle (contd)

• Executing
• Managers use standard costs to
• Apply dollar, time, and quality standards to work
• Collect actual cost data

9
Standard Costs and the Management Cycle (contd)

• Reviewing
• Managers compare standard and actual costs
• Compute variances
• Provide measures of performance that can be used
  to control costs and evaluate managers
• Analyze significant variances to determine cause
• Unfavorable variances may reveal operating
  problems that require correcting
• Favorable variances may indicate favorable
  practices that should be implemented elsewhere

10
Standard Costs and the Management Cycle (contd)

• Reporting
• Managers use standard costs to report on
• Operations
• Managers performance

11
Standard Costing, Variance Analysis, and the
Management Cycle
12
The Relevance of Standard Costing in Today's
Business Environment

• Manufacturing companies
• Increased automation
• Significant decrease in direct labor cost
• Corresponding decline in importance of
  labor-related standard costs and variances
• Many companies now apply standard costing only to
  direct materials and manufacturing overhead
• Service organizations
• Use standard costing for direct labor and service
  overhead costs

13
Discussion

• What is the main difference between the standard
  costing and normal costing methods?

14
Discussion

• What is the main difference between the standard
  costing and normal costing methods?
• The standard costing method uses estimated costs
  for direct materials and direct labor, whereas
  the normal costing method uses actual costs for
  these items
• The methods are similar in that both use
  estimated costs for manufacturing overhead

15
Computing Standard Costs

• Objective 2
• Explain how standard costs are developed and
  compute a standard unit cost

16
Computing Standard Costs

• Fully integrated standard costing system
• Uses standard costing for all elements of product
  cost
• Direct materials
• Direct labor
• Manufacturing overhead
• Inventory accounts and Cost of Goods Sold account
• Maintained and reported in terms of standard
  costs
• Standard unit costs used to compute account
  balances
• Actual costs recorded separately
• Actual and standard costs can then be compared

17
Computing Standard Costs (contd)

• Six elements of a standard unit cost for a
  manufactured product
• Price standard for direct materials
• Quantity standard for direct materials
• Standard for direct labor rate
• Standard for direct labor time
• Standard for variable overhead rate
• Standard for fixed overhead rate

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Standard Direct Materials Cost

• is found by multiplying the price standard for
  direct materials by the quantity standard for
  direct materials

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Standard Direct Materials Cost (contd)

• Direct materials price standard
• Careful estimate of the cost of a specific direct
  material in the next accounting period
• Developed by purchasing agent or purchasing
  department
• Takes into account
• All possible price increases
• Changes in available quantities
• New sources of supply

20
Standard Direct Materials Cost (contd)

• Direct materials quantity standard
• Estimate of the amount of direct materials that
  will be used in the accounting period
• Includes scrap and waste
• Influenced by
• Product engineering specifications
• Quality of direct materials
• Age and productivity of machinery
• Quality and experience of work force
• Established and monitored by
• Production managers
• Management accountants
• Others
• Engineers, purchasing agents, machine operators

21
Standard Direct Labor Cost

• for a product, task, or job is calculated by
  multiplying the standard wage for direct labor by
  the standard hours of direct labor

22
Standard Direct Labor Cost (contd)

• Direct labor rate standard
• Hourly direct labor rate expected to prevail
  during the next accounting period
• For each function or job classification
• Average standard rate is developed for each task
• Standard rate is used even if worker is paid more
  or less than the standard rate
• Easy to establish
• Rates are set by labor unions or defined by the
  company

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Standard Direct Labor Cost (contd)

• Direct labor time standard
• Expected time required for each department,
  machine, or process to complete the production of
  one unit or one batch of output
• Developed using
• Current time and motion studies of workers and
  machines
• Records of past performance
• Should be revised when
• Machinery is replaced
• Quality of work force changes

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Standard Manufacturing Overhead Cost

• is the sum of the estimates of variable and
  fixed overhead costs in the next accounting
  period
• Two parts
• Variable costs and fixed costs
• Compute separately because their cost behavior
  differs

25
Standard Manufacturing Overhead Cost (contd)

• Standard variable overhead rate
• Computed by dividing the total budgeted variable
  overhead costs by an expression of capacity, such
  as number of standard direct labor hours or
  standard machine hours

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Standard Manufacturing Overhead Cost (contd)

• Standard fixed overhead rate
• Computed by dividing the total budgeted fixed
  overhead costs by an expression of capacity,
  usually normal capacity in terms of standard
  hours or units
• Denominator expressed in same terms as the
  variable overhead rate

Normal capacity is the level of operating
capacity needed to meet expected sales demand
Its use ensures that all fixed OH costs have
been applied to units produced by the time normal
capacity is reached
Overhead
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Total Standard Unit Cost
Remember When, Inc., recently updated the
standards for its line of watches
Compute the total standard cost of one watch
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Discussion

• Why are the variable and fixed components for the
  standard manufacturing overhead cost computed
  separately?
• Variable costs and fixed costs are computed
  separately because their cost behavior differs

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Variance Analysis

• Objective 3
• Prepare a flexible budget and describe how
  variance analysis is used to control costs

30
Variance Analysis

• is the process of computing the differences
  between standard costs and actual costs and
  identifying the causes of those differences
• Managers use
• Flexible budgets to improve variance analysis
• Variance analysis to control costs

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The Role of Flexible Budgets in Variance Analysis

• Accuracy of variance analysis depends greatly on
  the type of budget managers use when comparing
  variances
• Static budget
• Flexible budget

32
The Role of Flexible Budgets in Variance Analysis
(contd)

• Static budget
• Also called fixed budget
• Forecasts revenues and expenses for just one
  level of sales and just one level of output
• Does not allow for changes in output level
• If actual output differs from budgeted output, a
  variance between actual and budgeted amounts will
  occur
• Cannot judge performance accurately

33
Performance Report Using Data from a Static Budget
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The Role of Flexible Budgets in Variance Analysis
(contd)

• Flexible budget
• Also called variable budget
• Summary of expected costs for a range of activity
  levels
• Provides forecasted data that can be adjusted for
  changes in output level
• Used primarily as a cost control tool in
  evaluating performance

35
The Role of Flexible Budgets in Variance Analysis
(contd)

• Flexible budget formula
• An equation that determines the expected, or
  budgeted, cost for any level of output
• Includes
• Per unit amount for variable costs
• Total amount for fixed costs

36
Flexible Budget for Evaluation of Overall
Performance
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The Role of Flexible Budgets in Variance Analysis
(contd)

• The flexible budget formula for Remember When,
  Inc. is
• The company produced 19,100 units during 20x5
  (actual number)

38
Performance Report Using Data from a Flexible
Budget
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Using Variance Analysis to Control Costs
Compute variance
Step 1
No corrective action needed
Analyze variance to determine its cause
Step 2
Select performance measures to correct the
problem
Step 3
Take corrective action
Step 4
40
Using Variance Analysis to Control Costs (contd)

• Computing the amount of a variance is important
• But, this does not prevent the variance from
  reoccurring
• Must determine its cause
• Select performance measures that will help track
  the problem
• Must then find the best solution

41
Discussion

• What is the flexible budget formula?
• It is an equation used to determine expected, or
  budgeted cost for any level of output

42
Computing and Analyzing Direct Materials Variances

• Objective 4
• Compute and analyze direct materials variances

43
Computing and Analyzing Direct Materials Variances

• To control operations, managers compute and
  analyze variances for
• Whole cost categories
• Such as total direct materials costs
• Elements of those categories
• Such as the price and quantity of each direct
  material

The more detailed the analysis of a variance is,
the more effective managers will be in
controlling costs
44
Computing Direct Materials Variances

• Total direct materials cost variance
• Difference between the standard cost and actual
  cost of direct materials

45
Computing Direct Materials Variances
Cambria Company makes leather bags. Each bag
should use 4 feet of leather (standard quantity),
and the standard price of leather is 6.00 per
foot. During August, the company purchased 760
feet of leather costing 5.90 per foot and used
the leather to produce 180 bags
This is an unfavorable (U) situation
Actual cost gt standard cost
46
Computing Direct Materials Variances (contd)

• Total direct materials cost variance must be
  broken into two parts to find the cause of the
  variance
• Direct materials price variance
• Direct materials quantity variance

47
Computing Direct Materials Variances (contd)

• Direct materials price variance
• Difference between the standard price and the
  actual price per unit multiplied by the actual
  quantity purchased
• Also called the direct materials spending or rate
  variance

Because the company paid less for direct
materials than it expected, the variance is
favorable (F)
48
Computing Direct Materials Variances (contd)

• Direct materials quantity variance
• Difference between the standard quantity and the
  actual quantity used multiplied by the standard
  price
• Also called the direct materials efficiency or
  usage variance

Because the company used more for direct
materials than it expected, the variance is
unfavorable (U)
49
Computing Direct Materials Variances (contd)

• Test calculations of variances
• If correct, the net of the direct materials price
  variance and direct materials quantity variance
  will equal the total direct materials cost
  variance (see slide 45)

50
Diagram of Direct Materials Variance Analysis
51
Analyzing and Correcting Direct Materials
Variances

• The Company had been experiencing direct
  materials price variances and quantity variances
  for some time
• For three months, managers tracked
• Purchasing activities
• Discovered that the purchasing agent had
  purchased, without authorization, a lower grade
  of leather at a reduced price
• After analysis, engineers determined the lower
  grade of leather was not appropriate
• Scrap and rework
• Discovered that inferior leather was causing the
  unfavorable quantity variance

52
Discussion

• What is the direct materials price variance?
• It is the difference between the standard price
  and the actual price per unit multiplied by the
  actual quantity purchased. It is also called the
  direct materials spending or rate variance

53
Computing and Analyzing Direct Labor Variances

• Objective 5
• Compute and analyze direct labor variances

54
Computing Direct Labor Variances

• Total direct labor cost variance
• Difference between the standard direct labor cost
  for good units produced and actual direct labor
  costs
• Good units are the total units produced less
  units that are scrapped or need to be reworked

55
Computing Direct Labor Variances (contd)
At Cambria Company, each leather bag requires 2.4
standard direct labor hours, and the standard
direct labor rate is 8.50 per hour. During
August, 450 direct labor hours were used to make
180 bags at an average pay rate of 9.20 per hour
Actual cost gt standard cost
56
Computing Direct Labor Variances (contd)

• Total direct labor cost variance must be broken
  onto two parts to find the cause of the variance
• Direct labor rate variance
• Direct labor efficiency variance

57
Computing Direct Labor Variances (contd)

• Direct labor rate variance
• Difference between the standard direct labor rate
  and the actual direct labor rate multiplied by
  the actual direct labor hours worked
• Also called the direct labor spending variance

Because the company paid more per hour for direct
labor than it expected, the variance is
unfavorable
58
Computing Direct Labor Variances (contd)

• Direct labor efficiency variance
• Difference between the standard direct labor
  hours allowed for good units produced and the
  actual direct labor hours worked multiplied by
  the standard direct labor rate
• Also called the direct labor quantity or usage
  variance

Because the company used more direct labor hours
than it expected, the variance is unfavorable (U)
59
Computing Direct Labor Variances (contd)

• Test calculations of variances
• If correct, the net of the direct labor rate
  variance and direct labor efficiency variance
  will equal the total direct labor cost variance
  (see slide 55)

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Diagram of Direct Labor Variance Analysis
61
Analyzing and Correcting Direct Labor Variances

• Managers analyzed
• Employee time cards
• An assembly worker who had fallen ill was
  replaced with a machinery operator from another
  department
• Assembly worker is paid 8.50 per hour and the
  machine operator is paid 9.20 per hour
• Machine operator not as skilled as the assembly
  worker
• Temporary situation so no corrective action taken
• Materials handling
• Parts delivered late on five occasions
• Will track delivery time and number of delays for
  next three months

62
Discussion

• What is the direct labor efficiency variance?
• The direct labor efficiency variance is the
  difference between the standard direct labor
  hours allowed for good units produced and the
  actual direct labor hours worked multiplied by
  the standard direct labor rate. It is also
  called the direct labor quantity or usage variance

63
Computing and Analyzing Manufacturing Overhead
Variances

• Objective 6
• Compute and analyze manufacturing overhead
  variances

64
Computing and Analyzing Manufacturing Overhead
Variances

• Controlling variable and fixed overhead costs is
  more difficult for managers than controlling
  direct materials and direct labor costs
• Responsibility for manufacturing overhead costs
  is hard to assign
• Fixed overhead costs
• Unavoidable past costs
• Not under the control of any department manager
• Variable overhead costs
• Some control possible if they can be related to
  departments or activities

65
Using a Flexible Budget to Analyze Manufacturing
Overhead Variances

• Cambria Companys managers use a flexible budget
  to evaluate performance
• For manufacturing overhead costs only
• Evaluate activity level using direct labor hours
• Variable costs vary with the number of direct
  labor hours worked
• Total fixed overhead costs remain constant

66
Flexible Budget for Evaluation of Manufacturing
Overhead Costs
67
Using a Flexible Budget to Analyze Manufacturing
Overhead Variances

• Flexible budget formula
• Flexible budget formula when applied to Cambrias
  data

To find the total monthly budgeted overhead
costs, insert direct labor hours into the
flexible budget
68
Computing Manufacturing Overhead Variances

• Total manufacturing overhead variance
• Difference between actual overhead costs and
  standard overhead costs
• Standard overhead costs are applied to production
  using a standard overhead rate
• Standard overhead rate has two parts
• Variable
• Fixed

69
Computing Manufacturing Overhead Variances
(contd)
For Cambria Company, the standard variable
overhead rate is 5.75 per direct labor hour
(from the flexible budget). Total budgeted
overhead is 1,300 by normal capacity, which is
400 direct labor hours.
70
Computing Manufacturing Overhead Variances
(contd)
For Cambria Company, the standard variable
overhead rate is 5.75 per direct labor hour
(from the flexible budget). Total budgeted
overhead is 1,300 by normal capacity, which is
400 direct labor hours.
Actual cost gt standard cost
This amount can be divided into variable overhead
variances and fixed overhead variances
71
Variable Overhead Variance

• Total variable overhead variance
• Difference between actual variable overhead costs
  and the standard variable overhead costs that are
  applied to good units produced using the standard
  variable rate

72
Variable Overhead Variances (contd)
At Cambria Company, each leather bag requires 2.4
standard labor hours and the variable overhead
rate is 5.75 per direct labor hour. During
August, the company incurred 2,500 of variable
overhead costs
Actual cost gt standard cost
73
Diagram of Variable Overhead Variance Analysis
74
Variable Overhead Variances (contd)

• Total variable overhead cost variance must be
  broken into two parts to find the cause of the
  variance
• Variable overhead spending variance
• Variable overhead efficiency variance

75
Variable Overhead Variances (contd)

• Variable overhead spending variance
• Difference between the budgeted variable overhead
  costs at actual hours and actual variable
  overhead

76
Variable Overhead Variances (contd)

• Variable overhead efficiency variance
• Difference between the standard direct labor
  hours allowed for good units produced and the
  actual hours worked multiplied by the standard
  variable overhead rate

77
Variable Overhead Variances (contd)

• Compute standard hours allowed
• Compute variable overhead efficiency variance

78
Variable Overhead Variances (contd)

• Test calculations of variances
• If correct, the net of the variable overhead
  spending variance and variable overhead
  efficiency variance will equal the total variable
  overhead cost variance

79
Fixed Overhead Variances

• Total fixed overhead variance
• Difference between actual fixed overhead costs
  and the standard fixed overhead costs that are
  applied to good units produced using the standard
  fixed overhead rate

80
Diagram of Fixed Overhead Variance Analysis
81
Fixed Overhead Variances (contd)
At Cambria Company, each leather bag requires 2.4
standard direct labor hours and the standard
fixed overhead rate is 3.25 per direct labor
hour. During August, the company incurred 1,600
of actual fixed overhead costs
82
Fixed Overhead Variances (contd)

• Total fixed overhead cost variance must be broken
  into two parts to find the cause of the variance
• Fixed overhead budget variance
• Fixed overhead volume variance

83
Fixed Overhead Variances (contd)

• Fixed overhead budget variance
• Difference between the budgeted and actual fixed
  overhead costs
• Also called budgeted fixed overhead variance

84
Fixed Overhead Variances (contd)

• Fixed overhead volume variance
• Difference between budgeted fixed overhead costs
  and manufacturing overhead costs applied to
  production using the standard fixed overhead rate

85
Fixed Overhead Variances (contd)

• A volume variance will occur if more or less than
  normal capacity is used
• Fixed overhead volume variance measures the use
  of existing facilities and capacity
• Favorable overhead volume variance
• Capacity exceeds the expected amount
• Unfavorable overhead volume variance
• Company operates at a level below normal capacity
• May be in best interest of company during periods
  of slow sales
• Means company is not building up excess inventory

86
Summary of Manufacturing Overhead Variances
87
Analyzing and Correcting Manufacturing Overhead
Variances
88
Discussion

• What four variances are used to analyze the total
  manufacturing overhead variance?
• Variable overhead spending variance
• Variable overhead efficiency variance
• Fixed overhead budget variance
• Fixed overhead volume variance

89
Using Cost Variances to Evaluate Managers
Performance

• Objective 7
• Explain how variances are used to evaluate
  managers performance

90
Using Cost Variances to Evaluate Managers
Performance

• The effectiveness and fairness of a manager's
  performance evaluation depends on
• Human factors
• Company policies
• Should be based on input from managers and
  employees
• Should specify procedures that managers are to use

91
Using Cost Variances to Evaluate Managers
Performance (contd)

• Procedures that should be specified for managers
• Preparing operational plans
• Assigning responsibility for carrying out the
  operational plans
• Communicating operational plans to key personnel
• Evaluating performance in each area of
  responsibility
• Identifying causes of significant variances from
  the operational plan
• Taking corrective action to eliminate problems

92
Using Cost Variances to Evaluate Managers
Performance (contd)

• Variance analysis
• Provides detailed data about differences between
  standard and actual costs
• Effective at pinpointing efficient and
  inefficient operating areas
• Basic comparison of budgeted and actual data not
  as effective

93
Using Cost Variances to Evaluate Managers
Performance (contd)

• Effective managerial performance reports based on
  standard costs and related variances should
• Identify
• Causes of the differences
• Personnel involved
• Corrective actions taken
• Be tailored to the managers specific areas of
  responsibility
• Explain clearly and accurately in what way the
  managers department did or did not meet
  operating expectations

Managers should only be held accountable for cost
areas under their control
94
Using Cost Variances to Evaluate Managers
Performance (contd)

• Managerial performance reports should
• Summarize all cost data
• Include variances for direct materials, direct
  labor, and manufacturing overhead
• Identify
• Causes of variances
• Corrective actions taken

95
Using Cost Variances to Evaluate Managers
Performance (contd)

• The occurrence of a variance does not indicate
  poor performance
• If a variance consistently occurs, its cause is
  not identified, and no corrective action is
  taken, it may indicate poor performance on the
  part of the manager

96
Discussion

• What items should be included in an effective
  managerial performance report?
• Summarization of all cost data
• Variances for direct materials, direct labor,
  and manufacturing overhead
• Identification of the causes of the variances,
  personnel involved, and any corrective actions
  taken