Performance Evaluation Through Standard Costs

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Chapter 8
Managerial Accounting Weygandt, Kieso, Kimmel

• Performance Evaluation Through Standard Costs

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The Need for Standards

• In managerial accounting, standard costs are
  predetermined unit costs, which are used as
  measures of performance.
• The focus in this text is on manufacturing
  standards however, standards are applicable to
  many types of businesses.

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Distinguishing Between Standards and Budgets

• Conceptually, standards and budgets are
  essentially the same. Both are pre-determined
  costs and both contribute significantly to
  management planning and control.
• A standard is a unit amount, whereas a budget is
  a total amount.
• A standard is concerned with each individual cost
  component that makes up the entire budget.

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Why Standard Costs?

• Carefully established and prudently used standard
  costs offer the following advantages to an
  organization
• They facilitate management planning.
• They promote greater economy by making employees
  more cost conscious.
• They are useful in setting selling prices.
• They contribute to management control by
  providing a basis for the evaluation of cost
  control.
• They are useful in highlighting variances in
  management by exception.
• They simplify the costing of inventories and
  reduce clerical costs.

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Setting Standard Costs

• Setting standards requires input from all persons
  who have responsibility for costs and quantities.
  
• To be effective in controlling costs, standard
  costs need to be current at all times. Thus,
  standards should be under continuous review.

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Ideal versus Normal Standards

• Standards may be set at one of two levels
• Ideal standards represent optimum levels of
  performance under perfect operating conditions.
• Normal standards represent efficient levels of
  performance that are attainable under expected
  operating conditions.
• Most companies that use standards set them at a
  normal level. Properly set normal standards
  should be rigorous but attainable.

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Setting Standard CostsA Case Study

• To establish the standard cost of a product, it
  is necessary to establish standards for each
  manufacturing cost element - direct materials,
  direct labor, and manufacturing overhead.
• The standard for each element is derived from a
  consideration of the standard price to be paid
  and the standard quantity to be used.

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Direct Materials Price Standard

• The direct materials price standard is the cost
  per unit of direct materials that should be
  incurred.
• This standard is based on the purchasing
  departments best estimate of the cost of raw
  materials.

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Direct Materials Quantity Standard

• The direct materials quantity standard is the
  quantity of direct materials that should be used
  per unit of finished goods.
• This standard is expressed as a physical measure,
  such as pounds, barrels, or board feet.
• This standard should include allowances for
  unavoidable waste and normal spoilage.

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A Case StudyDirect Materials

• The direct materials price standard per pound of
  material for Xonics weed killer is

• The direct materials quantity standard per unit
  of weed killer is

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A Case Study Standard Materials Cost per Unit

• The standard direct materials cost per unit is
  the standard direct materials price times the
  standard direct materials quantity.
• For Xonic, Inc., the standard direct materials
  cost per gallon of Weed-O is 12.00 (3.00 x 4.0
  pounds).

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Direct Labor Price Standard

• The direct labor price standard is the rate per
  hour that should be incurred for direct labor.
• This standard is based on current wage rates
  adjusted for anticipated changes, such as cost of
  living adjustments.
• This standard generally includes employer payroll
  taxes and fringe benefits, such as paid holidays
  and vacations.

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Direct Labor Quantity Standard

• The direct labor quantity standard is the time
  that should be required to make one unit of the
  product.
• This standard is especially critical in
  labor-intensive companies.
• In setting this standard, allowances should be
  made for non-productive time.

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A Case StudyDirect Labor

• The direct labor price standard per direct labor
  hour for Xonic, Inc., is

• For Xonic, Inc., the direct labor quantity
  standard is

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A Case Study Standard Labor Cost per Unit

• The standard direct labor cost per unit is the
  standard direct labor rate times the standard
  direct labor hours.
• For Xonic, Inc., the standard direct labor cost
  per gallon of Weed-O is 20.00 (10.00 x 2.0
  hours).

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Manufacturing Overhead Standard

• For manufacturing overhead, a standard
  predetermined overhead rate is used in setting
  the standard.
• This overhead rate is determined by dividing
  budgeted overhead costs by an expected standard
  activity index.

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A Case StudyManufacturing Overhead

• Xonic, Inc., uses standard direct labor hours as
  the activity index. The company expects to
  produce 13,200 gallons of Weed-O. Since it takes
  two direct labor hours for each gallon, total
  standard direct labor hours are 26,400 (13,200 x
  2). At this level of activity, overhead costs
  are expected to be 132,000, of which 79,200 are
  variable and 52,800 are fixed.

• Fixed cost per month would be 52,800/124,400.

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A Case Study Standard Overhead Cost per Unit

• The standard manufacturing overhead rate per unit
  is the predetermined overhead rate times the
  activity index quantity standard.
• For Xonic, Inc., which uses direct labor hours as
  its activity index, the standard manufacturing
  overhead rate per gallon of Weed-O is 10.00
  (5.00 x 2.0 hours).

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Total Standard Cost per Unit

• The total standard cost per unit is the sum of
  the standard costs of direct materials, direct
  labor, and manufacturing overhead.
• For Xonic, Inc., the total standard cost per
  gallon of Weed-O is 42, as shown on the
  following standard cost card

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Variances from Standards

• A variance is the difference between total actual
  costs and total standard costs.
• When actual costs exceed standard costs, the
  variance is unfavorable..
• If actual costs are less than standard costs, the
  variance is favorable.
• There may be trade-offs between variances

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Variances Illustrated

• To illustrate variances, assume that in producing
  1,000 gallons of Weed-O in the month of June,
  Xonic, Inc., incurred the following costs

• The total standard cost of Weed-O is 42,000
  (1,000 gallons x 42). Thus, the total variance
  is 2,500, as shown

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Analyzing Variances

• For each manufacturing cost element, a total
  dollar variance is computed. Then this variance
  is analyzed into a price variance and a quantity
  variance.

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Relationships of Variances
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Direct Materials Variances Total

• The total materials variance

• In completing the order for 1,000 gallons of
  Weed-O, Xonic used 4,200 pounds of direct
  materials purchased at a total cost of 3.10 per
  unit.
• For Xonic, Inc., the total materials variance is
  1,020 (13,020 - 12,000) unfavorable

(4,200 x 3.10) (4,000 x 3.00) 1,020 U
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Direct Materials Variances Price

• The materials price variance

• For Xonic, Inc., the materials price variance is
  420 (13,020 - 12,600) unfavorable as shown
  below

(4,200 x 3.10) (4,200 x 3.00) 420 U
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Direct Materials Variances Quantity

• The materials quantity variance

• For Xonic, Inc., the materials quantity variance
  is 600 (12,600 - 12,000) unfavorable as shown
  below

(4,200 x 3.00) (4,000 x 3.00) 600 U
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Direct Materials Variances Summary

• The total materials variance of 1,020 (U),
  therefore, consists of the following

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Matrix for Direct Materials Variance
A matrix is sometimes used to determine and
analyze a variance.
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Causes of Materials Variances

• The causes of variances may relate to both
  internal and external factors.
• The investigation of a materials price variance
  usually begins in the purchasing department.
• The starting point for determining the cause(s)
  of a materials quantity variance is in the
  production department.

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Matrix for Direct Labor Variance
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Causes of Labor Variances

• Labor price variances usually result from two
  factors
• paying workers higher than expected wages, and
• misallocation of workers.
• Labor quantity variances relate to the efficiency
  of the workers.

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Manufacturing Overhead Variances

• The computation of the manufacturing overhead
  variances is conceptually the same as the
  materials and labor variances.
• However, the task is more challenging because
  both variable and fixed overhead costs must be
  considered.

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Actual and Applied Overhead Costs

• Weed-Os manufacturing overhead costs incurred
  were 10,900

• With standard costs, manufacturing overhead is
  applied to work in process on the basis of the
  standard hours allowed, which are the hours that
  should have been worked for the units produced.
• For the Weed-O order, the standard hours allowed
  are 2,000 and the predetermined overhead rate is
  5 per direct labor hour. Thus, overhead applied
  is 10,000 (2,000 x 5).

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Overhead Variances Total

• The formula for the total overhead variance is

• The total overhead variance is 900 unfavorable

10,900 10,000 900 U

• The total overhead variance is generally analyzed
  through a price variance and a quantity variance.
  The name usually given to the price variance is
  the overhead controllable variance, whereas the
  quantity variance is referred to as the overhead
  volume variance.

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Overhead Variances Controllable

• Budgeted overhead is determined from the flexible
  manufacturing overhead budget for the standard
  hours allowed.
• For Xonic, budgeted overhead at the 2,000
  standards hours is 10,400 (4,400 fixed 3
  variable cost per unit x 2,000).
• Overhead controllable variance is 500
  unfavorable

10,900 10,400 500 U
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Overhead Variances Volume

• The overhead volume variance indicates whether
  plant facilities were efficiently used during the
  period. The formula for computing the variance
  is as follows

• The overhead volume variance is 400 unfavorable

10,400 10,000 400 U
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Detailed Analysis of Overhead Volume Variance

• The flexible overhead budget shows that of the
  budgeted overhead of 10,400, 6,000 of that
  amount is variable and 4,400 is fixed. The
  predetermined overhead rate of 5 consists of 3
  variable and 2 fixed. Therefore

• A more detailed analysis shows that the overhead
  volume variance relates solely to fixed costs
  (fixed costs budgeted 4,400 - fixed costs
  applied 4,000). Thus the volume variance
  measures the amount that fixed overhead costs are
  under- or overapplied.

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Overhead Variances Summary

• The total overhead variance of 900 (U),
  therefore, consists of the following

• In computing overhead variances, it is important
  to remember the following
• Standard hours allowed are used in each of the
  variances.
• Budgeted costs for the controllable variance are
  derived from the flexible budget.
• The controllable variance generally pertains to
  variable costs.
• The volume variance pertains solely to fixed
  costs.

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Matrix for Manufacturing Overhead Variance
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Causes of Manufacturing Overhead Variances

• Since the controllable variance relates to
  variable manufacturing costs, the responsibility
  for this variance usually rests with the
  production department. The cause of an
  unfavorable variance may be
• higher than expected use of indirect materials,
  indirect labor, and factory supplies, or
• increases in indirect manufacturing costs, such
  as fuel costs or maintenance.

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Causes of Manufacturing Overhead Variances

• The overhead volume variance is the
  responsibility of the production department if
  the cause is inefficient use of direct labor or
  breakdowns. If the cause is a lack of sales
  orders, the responsibility rests elsewhere.

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Reporting Variances

• Variance reports facilitate the principle of
  management by exception. In using variance
  reports, top management normally looks for
  significant variances.
• Reasons for variances must be investigated so
  that corrective action may be taken.
• Variances may also be used for evaluation.

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Standard Cost Accounting System

• A standard cost accounting system is a system of
  accounting in which standard costs are used in
  making entries and variances are recognized in
  the accounts.
• A standard cost accounting system includes two
  important assumptions
• variances from standards are recognized at the
  earliest opportunity, and
• the Work in Process account is maintained
  exclusively on the basis of standard costs.

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Standard Cost Accounting System Journal Entries

• 1 Purchased raw materials on account for 13,200
  when the standard cost is 12,600.

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Standard Cost Accounting System Journal Entries

• 2 Incur direct labor costs of 20,580 when the
  standard labor cost is 21,000.

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Standard Cost Accounting System Journal Entries

• 3 Incur actual manufacturing overhead costs of
  10,900.

• The controllable overhead variance is not
  recorded at this time. It depends on standard
  hours applied to work in process, which is not
  known at the time overhead is incurred.

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Standard Cost Accounting System Journal Entries

• 4 Issue raw materials for production at a cost of
  12,600 when the standard cost is 12,000.

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Standard Cost Accounting System Journal Entries

• 5 Assign factory labor to production at a cost of
  21,000 when standard cost is 20,000.

• The credit to Factory Labor produces a zero
  balance in this account.

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Standard Cost Accounting System Journal Entries

• 6 Applying manufacturing overhead to production,
  10,000.

• Work in Process Inventory is debited for standard
  hours allowed multiplied by the standard overhead
  rate.

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Standard Cost Accounting System Journal Entries

• 7 Transfer completed work to finished goods,
  42,000.

• Both inventory accounts are at standard cost.

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Standard Cost Accounting System Journal Entries

• 8 The 1,000 gallons of Weed-O are sold for
  60,000.

• Cost of Goods Sold is debited at standard cost.

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Standard Cost Accounting System Journal Entries

• 9 Recognize unfavorable overhead variances
  controllable, 500 volume, 400.

• Prior to this entry, a debit balance of 900
  existed in Manufacturing Overhead. The above
  entry therefore produces a zero balance in the
  Manufacturing Overhead account. The information
  needed for this entry is often not available
  until the end of the accounting period.

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Ledger Accounts

• The ledger accounts used in a standard job cost
  accounting system are the same as for the job
  order cost accounting system illustrated in
  Chapter 2, with the exception of adding ledger
  accounts for the variances.
• All debit balances in variance accounts indicate
  unfavorable variances all credit balances
  indicate favorable variances.

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Variances in Income Statement for Management
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