10: Chapter Standard Costing: A Managerial Control Tool
Cornerstones of Managerial Accounting, 4e
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Learning Objectives
1. Explain how unit standards are set and why standard cost systems are adopted. 2. Explain the purpose of a standard cost sheet. 3. Describe the basic concepts underlying variance analysis, and explain when variances should be investigated. 4. Compute the materials variances, and explain how they are used for control. 5. Compute the labor variances, and explain how they are used for control. 6. (Appendix 10A) Prepare journal entries for materials and labor variances.
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Unit Standards
Budgets set standards that are used to control and evaluate managerial performance. To determine the unit standard cost for a particular input, two decisions must be made:
The quantity decision: The amount of input that should be used per unit of output The pricing decision: The amount that should be paid for the quantity of the input to be used
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Quantity and Price Standards
The quantity decision produces quantity standards. The pricing decision produces price standards. The unit standard cost can be computed by multiplying these two standards:
Standard cost per unit = Quantity standard x Price standard
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How Standards Are Developed
Three potential sources of quantitative standards are as follows:
Historical experience: Historical experience can provide an initial guideline for setting standards, but should be used with caution because they can perpetuate existing inefficiencies. Engineering studies: Engineering studies can identify efficient approaches rigorous guidelines, but engineered standards often are too rigorous. Input from operating personnel: Since operating personnel are accountable for meeting standards, they should have significant input in setting standards.
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Types of Standards
Standards are generally classified as either ideal or currently attainable.
Ideal standards demand maximum efficiency and can be achieved only if everything operates perfectly. No machine breakdowns, slack, or lack of skill (even momentarily) are allowed. Currently attainable standards can be achieved under efficient operating conditions. Allowance is made for normal breakdowns, interruptions, less than perfect skill, and so on. These standards are demanding but achievable.
Of the two types, currently attainable standards offer the most behavioral benefits.
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Why Standard Cost Systems Are Adopted
Comparing actual costs with budgeted costs identifies variances, the difference between the actual and planned costs for the actual level of activity. Overall variances can be further broken down into a price variance or a usage or efficiency variance if unit price or quantity standards have been developed. This additional information is very helpful for managers.
Two reasons for adopting a standard cost system are frequently mentioned: To improve planning and control
To facilitate product costing
Costs are assigned to products using quantity and price standards for all three manufacturing costs: direct materials, direct labor, and overhead.
Standard costing and variance analysis for controlling cost and evaluating performance can have strong ethical implications. 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
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Cost Assignment Approaches
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Advantages of Standard Product Costing
Standard product costing has several advantages over normal costing and actual costing.
Greater capacity for control Provides readily available unit cost information that can be used for pricing decisions at any time throughout the period because actual costs do not need to be known No unit cost calculations for each equivalent unit category in process costing No need to distinguish between FIFO and weighted average methods of accounting for beginning inventory costs
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Standard Product Costs
In manufacturing firms, standard costs are developed for direct materials, direct labor, and overhead. Using these costs, the standard cost per unit is computed. The standard cost sheet provides the production data needed to calculate the standard unit cost.
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The Standard Cost Sheet
The standard cost sheet also shows the quantity of each input that should be used to produce one unit of output. A manager should be able to compute the standard quantity of materials allowed (SQ) and the standard hours allowed (SH) for the actual output, where and
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Cornerstone 101 2 Computing Standard Quantities Allowed (SQ & SH) Information:
Assume that 100,000 packages of corn chips are produced during the first week of March. Recall from the standard cost sheet for corn chips that the unit quantity standard is 18 ounces of yellow corn per package and the unit quantity standard for machine operators is 0.01 hour per package produced. Required: How much yellow corn and how many operator hours should be used for the actual output of 100,000 packages?
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Variance Analysis: General Description
AP = Actual price per unit AQ = Actual quantity of input used
Actual input cost can be calculated as: Actual cost = AP x AQ
where
It is also possible to calculate the costs that should have been incurred for the actual level of activity.
Planned cost = SP x SQ
where
SP = Standard price per unit SQ = Standard quantity of input allowed for the actual output
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Total Budget Variance
The total budget variance is the difference between the actual cost of the input and its planned cost:
Because responsibility for deviations from planned prices tends to be located in the purchasing or personnel department and responsibility for deviations from planned usage of inputs tends to be located in the production department, it is important to separate the total variance into 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a price license distributed with a certain product or service or otherwise on a password-protected website for classroom use. and usage (quantity) variances.
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Price and Usage Variances
For labor, the price variance is usually called a rate variance. Price (rate) variance is the difference between the actual and standard unit price of an input multiplied by the number of inputs used:
Price variance = (AP - SP) x AQ
The usage (quantity) variance is called an efficiency variance. Usage (efficiency) variance is the difference between the actual and standard quantity of inputs multiplied by the standard unit price of the input:
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Usage variance = (AQ - SQ) x SP
3 Variance Analysis: General Description
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Unfavorable and Favorable Variances
Unfavorable (U) variances occur whenever actual prices or actual usage of inputs are greater than standard prices or standard usage. When the opposite occurs, favorable (F) variances are obtained. Favorable and unfavorable variances are not equivalent to good and bad variances. The terms merely indicate the relationship of the actual prices (or quantities) to the standard prices (or quantities).
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The Decision to Investigate
As a general principle, an investigation should be undertaken only if the expected benefits are greater than the expected costs. Managers determine whether variances are significant based on an acceptable range that has top and bottom measures called control limits.
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Cornerstone 102 Using Control Limits to Trigger A Variance Investigation
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Cornerstone 102 Using Control Limits to Trigger A Variance Investigation (continued)
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Variance Analysis: Materials
The total variance for materials measures the difference between the actual costs of materials and their budgeted costs for the actual level of activity: Total Variance = Actual cost - Planned cost = (AP x AQ) - (SP x SQ)
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Information: Refer to the unit standards given previously (and shown) below. The actual results for the first week in March are:
Cornerstone 103 Calculating the Total Variance for Materials
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Direct Materials Variances
To help control the cost of materials, price and usage variances are calculated. The materials price variance is computed by using the actual quantity of materials purchased, and the materials usage variance is computed by using the actual quantity of materials used, calculated as:
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Information: Refer to the unit standards given previously (and shown) below. The actual results for the first week in March are:
Cornerstone 104 Calculating Materials Variances: Formula and Columnar Approaches
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Cornerstone 104 Calculating Materials Variances: Formula and Columnar Approaches
(continued)
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Materials Price Variance
The materials price variance (MPV) measures the difference between what should have been paid for raw materials and what was actually paid and is calculated as:
MPV = (AP - SP) x AQ
Where
AP = Actual price per unit SP = Standard price per unit AQ = Actual quantity of material
purchased
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Materials Usage Variance
The materials usage variance (MUV) measures the difference between the direct materials actually used and the direct materials that should have been used for the actual output. The formula is:
MUV = (AQ - SQ) x SP
Where AQ = Actual quantity of materials used SQ = Standard quantity of materials for allowed the actual output SP = Standard price per unit
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Using Materials Variance Information
Calculating materials variances is only the first step. Using the variance information to exercise control is fundamental to a standard cost system. Responsibility must be assigned, variance significance must be assessed, and the variances must be accounted for and disposed of at the end of the year.
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Responsibility for Materials Price Variance
The responsibility for controlling the materials price variance usually belongs to the purchasing agent. Admittedly, the price of materials is largely beyond the agent's control and can have undesirable outcomes from an evaluation perspective. Pressure to produce favorable variances may result in the purchase of materials of lower quality than desired or excessive inventory purchases in order to get quantity discounts.
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The Analysis of Materials Price Variance
The first step in variance analysis is to decide whether the variance is significant. If so, what is its cause? Once the reason is known, corrective action can be taken if necessary--and if possible. For example, if high quality materials were purchased due to a supply shortage of usual materials, no action is needed. A firm has no control over the supply shortage; it will simply have to wait until market conditions improve. If the variance is judged insignificant, no further steps are needed.
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Responsibility for Materials Usage Variance
The responsibility for controlling the materials usage usually belongs to the production manager. Minimizing scrap, waste, and rework are all ways in which the manager can ensure that the standard is met. However, at times, the cause of the variance is attributable to others outside the production area. Pressure to produce favorable variances may allow defective units to be transferred to finished goods and ultimately cause customer relations problems.
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The Analysis of Materials Usage Variance
If variance is significant, investigation is needed to find out the causes for the deviation. It is important to note that standards are not static. As improvements in production take place and conditions change, standards may need to be revised to reflect the new operating environment. The importance of evaluating current business conditions and updating standards to reflect any changes in these conditions cannot be overlooked.
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Accounting and Disposition of Materials Variances
Recognizing the price variance for materials at the point of purchase also means that the raw materials inventory is carried at standard cost. In general, materials variances are not inventoried. Typically, materials variances are added to cost of goods sold if unfavorable and are subtracted from cost of goods sold if favorable.
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Relationship between MPV and MUV
You Decide
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Relationship between MPV and MUV
(continued)
You Decide
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Variance Analysis: Direct Labor
The total labor variance measures the difference between the actual costs of labor and their budgeted costs for the actual level of activity:
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Cornerstone 105 Calculating the Total Variance for Labor
Information: Refer to the unit standards given previously (and shown) below. The actual results for the first week in March are:
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Direct Labor Variances
Labor hours cannot be purchased and stored for future use as can be done with materials (i.e., there can be no difference between the amount of labor purchased and the amount of labor used).
Therefore, unlike the total materials variance, the labor rate and labor efficiency variances always will add up to the total labor variance. The rate (price) and efficiency (usage) variances for labor can be calculated by using either the columnar approach or the associated formulas. Total labor variance = Labor rate variance + Labor efficiency variance
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Labor Rate Variance
The labor rate variance (LRV) computes the difference between what was paid to direct laborers and what should have been paid: LRV = (AR - SR) x AH
where
AR = Actual hourly wage rate SR = Standard hourly wage rate AH = Actual direct labor hours used
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Labor Efficiency Variance
The labor efficiency variance (LEV) measures the difference between the labor hours that were actually used and the labor hours that should have been used: LEV = (AH - SH) x SR
where
AH = Actual direct labor hours used SH = Standard direct labor hours that should have been
used
SR = Standard hourly wage rate
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Cornerstone 106 5 Calculating Labor Variances: Formula and Columnar Approaches Information:
Refer to the unit standards given previously (and shown) below. The actual results for the first week in March are:
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Cornerstone 106 Calculating Labor Variances: Formula and Columnar Approaches (continued)
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Using Labor Variance Information
Calculating labor variances initiates the feedback process. Using the labor variance information to exercise control is fundamental. Responsibility must be assigned, variance significance must be assessed, and the variances must be accounted for and disposed of at the end of the year.
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Responsibility for the Labor Rate Variance
Labor rates are largely determined by such external forces as labor markets and union contracts. Departures of actual rates from standard rates are rare and variances are usually due to unexpected overtime or the use of higher paid employees for less skilled tasks. The use of labor is controllable by the production manager, so responsibility for the labor rate variance generally is assigned to the individuals who decide how labor will be used.
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Responsibility for the Labor Efficiency Variance
Generally speaking, production managers are responsible for the productive use of direct labor. However, as is true of all variances, once the cause is discovered, responsibility may be assigned elsewhere. Production managers may be tempted to engage in dysfunctional behavior if too much emphasis is placed on the labor efficiency variance. For example, to avoid losing hours or using additional hours because of possible rework, a production manager could deliberately transfer defective units to finished goods.
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Analysis of the Labor Efficiency Variance
If variance is significant, investigation is needed to find out the causes for such variance. Based on the findings, corrective actions may be taken, if necessary.
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Additional Cost Management Practices
In addition to standard costing, some companies choose to employ other cost management practices, such as kaizen costing and target costing. Kaizen costing focuses on the continuous reduction of the manufacturing costs of existing products and processes. Target costing focuses on the reduction of the design costs of existing and future products and processes. A target cost is the difference between the sales price needed to capture a predetermined market share and the desired per-unit profit: Target cost per unit = Expected sales price per unit Desired profit per unit 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
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Appendix 10A: Accounting for Variances
The accounts containing the variances between applied standard costs and actual costs are closed, which allows the amount of actual costs to ultimately impact the final cost of goods sold number that appears in the financial statements. In recording variances, unfavorable variances always are debits, and favorable variances always are credits.
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Entries for Direct Materials Variances: 6 Materials Price Variance
The entry to record the purchase of materials follows (assuming an unfavorable MPV and that AQ is materials purchased):
Materials Materials Price Variance Accounts Payable
SP x AQ (AP - SP) x AQ AP x AQ
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Entries for Direct Materials Variances: 6 Materials Usage Variance
The general form for the entry to record the issuance and usage of materials, assuming a favorable MUV, is as follows:
Work in Process Materials Usage Variance Materials
SP x SQ (AQ - SQ) x SP SP x AQ
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Entries for Direct Labor Variances
Unlike the materials variances, the entry to record both types of labor variances is made simultaneously. If we assume an unfavorable labor rate variance and an unfavorable labor efficiency variance, the following entry will be made:
Work in Process Labor Efficiency Variance Labor Rate Variance Accrued Payroll
SR x SH (AH - SH) x SR (AR - SR) x AH AR x AH
Keep in mind that only standard hours and standard rates are used to assign costs to Work in Process. Actual prices or quantities are not used.
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Disposition of Materials and Labor Variances
At the end of the year, the variances for materials and labor usually are closed to Cost of Goods Sold. If the variances are material, they must be prorated among various accounts. Typically, materials variances are prorated on the basis of the materials balances in each of these accounts and the labor variances on the basis of the labor balances in the accounts.
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