BUS 2003 - Chapter 10 - Professor: D. Mortimer PDF

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Professor: D. Mortimer...

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STANDARD COSTS AND OVERHEAD ANALYSIS What we’re trying to effectively do is reconcile our budget or master budget to our actual results If there is anything that is variable cost driven, you want to use a flexible budget to isolate the cause of the variance

STANDARD COSTS When we talk about standard costs, what we’re referring to is the number of inputs to yield an output STANDARDS are benchmarks or “norms” for measuring performance - Found everywhere - Relate to the quantity and cost of inputs used in manufacturing goods or providing services There are two types of standards that are commonly used: - (1) QUANTITY STANDARDS specify how much of an input should be used to make a product or provide a service  Ex: how much flour we will need for our cupcakes - (2) COST (PRICE) STANDARDS specify how much should be paid for each unit of the input  Ex: the cost of the flour, not the cost of the cupcake

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The red bar: deviations from standards deemed significant are brought to the attention of management, a practice known as MANAGEMENT BY EXCEPTION  Ie., a system of management in which standards are set for various operating activities that are then periodically compared to actual results Either under or over would be something that you would want to look at as a management team The standard gives us that benchmark rate

 Now we have actuals and can say whether we are out or within control

VARIANCE ANALYSIS CYCLE Exhibit 10-1: the variance analysis cycle

Sometimes we are not going to take corrective actions, and that would be in a situation where it is not controllable by the company - Ex: gasoline The cycle begins with the preparation of standard cost performance reports in the accounting department - These reports highlight the variances, which are then differences between actual results and what should have occurred according to the standards - The variances can raise numerous questions  Why did the variance occur?  Why is this variance larger than it was last period? - The significance variances are investigated to discover their root causes - Corrective actions are taken, and then the next period’s operations are carried out Important to note that individuals within the organization are usually called upon to help investigate and explain variances based on their specific responsibilities Once the variance has been investigated and explained and corrective action has been taken, the cycle begins again with the preparation of a new standard cost performance report for the most recent period - The emphasis should be on highlighting problems, finding their root causes, and taking corrective action - The goal is to improve operations – not to assign blame

SETTING STANDARD COSTS Setting price and quantity standards ideally combines the expertise of everyone who is responsible for purchasing and using the inputs; this includes accountants, engineers, purchasing agents, and production managers

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Past records of purchase prices and of input usage can be helpful in setting standards The standards should be designed to encourage efficient future operations, not a repetition of past operations that may or may not have been efficient

WHO USES STANDARD COSTS? -

Manufacturing Service Food Not-for-profit Auto services Fast-food outlets Hospitals

The STANDARD COST RECORD is a detailed listing of the standard amounts of materials, labour, and overhead that should go into a unit of product or service, multiplied by the standard price or rate that has been set for each cost element - These records are electronically created and maintained as part of the company’s accounting info system

IDEAL VS. PRACTICAL STANDARDS Standards tend to fall into one of two categories: - (1) Ideal - (2) Practical IDEAL STANDARDS can only be attained under the best circumstances - Ie., requires employees to work at 100% peak efficiency all the time - Some managers feel that such standards have motivational value  They argue that even though employees know they will rarely meet their standard, it is a constant reminder of the need for ever-increasing efficiency and effort  Few firms use ideal standards because most managers feel they are discouraging for even the more diligent workers - Variances from the standards have little meaning  Large variances are normal, so it is difficult to manage by exception - Not realistic - Not what we want to use because they can be demotivating because you’re comparing actual results to the standard and using that as a performance gauge for how management is done PRACTICAL STANDARDS are right but attainable - Ie., standards that allow for normal machine downtime and other work interruptions and can be attained through reasonable, although highly efficient, efforts by the average employee - Variances signal a need for management attention because they represent deviations that fall outside normal operating conditions - They can also be used to forecast cash flows and plan inventory - Cannot be used in normal budgets or plans; they do not allow for normal inefficiencies, so they result in unrealistic planning and forecasting figures

SETTING DIRECT MATERIAL STANDARDS

The STANDARD PRICE PER UNIT is the final, delivered cost of materials, net of discounts including shipping, receiving and other such costs - Ex: how much is per litre of gas? Example: Heirloom Pewter Standard price of a kg of pewter in ingot form: Purchase price per kg, top-grade pewter Freight cost, by truck, from the supplier’s warehouse Receiving and handling cost Less purchase discount Standard price per kg

$3.60 $0.44 $0.05 ($0.09) $4.00

The standard price reflects a particular grade of material (top-grade) delivered by a particular type of carrier (truck) If everything proceeds according to these expectations, the net standard price of a kilogram of pewter should therefore be $4.00 The STANDARD QUANTITY PER UNIT is the amount of material required for each unit, as well as an allowance for unavoidable waste, spoilage, and other normal inefficiencies - Ex: how many kilometres should you get per litre of gas? - More of an efficiency metric Example: Heirloom Pewter Standard quality of pewter required for a pair of bookends: Materials requirements as specified in the bill of materials bookends, in kilograms Allowance for waste and spoilage, in kilograms Allowance for rejects, in kilograms Standard quantity per pair of bookends, in kilograms

for a pair of 2.7 0.20 0.10 3.0

Terminology:  BILL OF MATERIALS details the type and quantity of each item of material that should be used in a product  Should be adjusted for waste and other factors when determining the standard quantity per unit of product  WASTE AND SPOILAGE = materials that are wasted as a normal part of the production process or that spoil before they are used  REJECTS = direct materials contained in units that are defective and must be scrapped Standard cost = standard quality per pair * standard price per pair Standard cost = 3.0 kg per unit * $4 per kg Standard cost = $12 per unit  This $12 cost figure for a pair of bookends will appear as one item on the standard cost record of the product

SETTING DIRECT LABOUR STANDARDS Direct labour prices and quantity standards are usually expressed in terms of a labour rate and labour-hours

The STANDARD RATE PER HOUR is the labour rate that should be incurred per hour of labour time - Including employment insurance, employee benefits, and other labour costs - We are assuming that these people are paid hourly - We are assuming that what drives the number of hours is the number of units that are produced Example: Heirloom Pewter Standard labour rate per hour: Basic average wage rate per hour Employment taxes at 10% of the basic rate Employee benefits at 30% of the basic rate Standard rate per direct labour-hour

$15.00 $1.50 $4.50 $21.00

This standard rate reflects the expected “mix” of workers, even though the actual wage rates may vary somewhat from individual to individual due to differing skill or seniority The direct labour rate for Heirloom Pewter should average $21 per hour The STANDARD HOURS PER UNIT is the time and motion studies for each labour operation to determine the amount of labour time to complete one unit - Should include allowance for normal inefficiencies Example: Heirloom Pewter Standard hours per unit: Basic labour time per unit, in hours Allowance for breaks and personal needs Allowance for cleanup and machine downtime Allowances for rejects Standard labour-hours per unit of product

1.9 0.1 0.3 0.2 2.5

Standard labour cost per unit = standard labour hours * standard rate per DLH Standard labour cost per unit = 2.5 hours * $21 Standard labour cost per unit = $52.50 per unit  This $52.50 cost figure appears along with direct materials as one item on the standard cost record of the product

SETTING VARIABLE OVERHEAD STANDARDS As with labour, the price and quantity standards for variable manufacturing overhead are expressed in terms of rate and hours - The rate represents the variable portion of the predetermined overhead rate (first discussed in chapter 5) - Developing the rate requires estimating both the unit cost of the variable overhead items used in production and the quantity required for the planned level of production The PRICE STANDARDS is the rate of the variable portion of the predetermined overhead rate - This is the POHR that is related to the variable part of the total mfg. overhead

The QUANTITY STANDARDS is the quantity the activity in the allocation base used to calculate the predetermined overhead - Based on whatever the allocation basis - If we are using labour hours as a quantity, then this standard will be the same as the labour hours standard that we had for the direct labour cost - The quantity we’re using to allocate this indirect cost is based on usually some unit level drivers of labour hours (ex: machine hours) Example: Heirloom Pewter The variable portion of the predetermined overhead rate is $3 per DLH. Therefore, the standard variable manufacturing overhead cost per unit is computed as follows: Variable MOH = standard labour hours * predetermined OH rate Variable MOH = 2.5 hours * $3 per hour Variable MOH = $7.50 per unit  This $7.50 cost figure appears along with direct materials and direct labour as one item on the standard cost record for variable production costs

STANDARD COST CARD – VARIABLE PRODUCTION COST The STANDARD COST PER UNIT is computed by multiplying the standard quantity of hours by the standard price or rate for each cost element - = standard quantity/hours * standard price/rate Example: Heirloom Pewter Exhibit 10-2: standard cost record – variable production cost

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The $72 is the total finished product expected to cost The $3 per hour is your predetermined overhead rate (POHR) The $12 of direct materials is made up of the quantity of the materials and the cost per input per pound of materials  We have two variables going into that variable cost of $12 per unit  We are trying to isolate the cause of those flexible budget variances

STANDARDS VS. BUDGETS Standards and budgets are very similar - A budget is set for total costs, whereas a standard is a per unit cost  Budget is a total amount - A standard can be viewed as the budgeted cost for one unit of production

 Standard is a unit amount Example: Heirloom Pewter Standard cost for materials is $12 per pair of bookends and if 1000 pairs of bookends are to be manufactured during a budgeting period, then the budgeted cost of materials will be $12,000 A standard can be viewed as the budgeted cost for one unit of product

PRICE AND QUANTITY STANDARDS Price and quantity standards are determined separately for two reasons: - (1) 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 times  Raw material purchases may be held in inventory for a period of time before being used in production

A GENERAL MODEL FOR VARIANCE ANALYSIS An important reason for separating standards into two categories – price and quantity – is that different managers are usually responsible for buying and for using inputs, and these two activities occur at different times VARIANCES are the differences between standard prices and quantities and actual prices and quantities - The act of computing and interpreting variances is VARIANCE ANALYSIS There are two types of variances: - (1) PRICE VARIANCE is the difference between actual price and standard price  Ex: materials price variance, labour rate variance, and VOH spending variance - (2) QUANTITY VARIANCE is the difference between actual quantity and standard quantity  Ex: materials quantity variance, labour efficiency variance, and VOH efficiency variance The GENERAL MODEL for computing standard cost variances for variable costs isolates price variances from quantity variances and shows how each of these variances is computed Exhibit 10-3: a general model for variance analysis – variable production costs

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Flexible budget = standard quantity*standard price  Based on actual output Middle column = input flexible budget = we’re changing the price ACTUAL QUANTITY is the number of direct materials, direct labour, and variable manufacturing overhead actually used STANDARD QUANTITY is the standard quantity allowed for the actual output of the period  Flexible budget, not a static budget  This is the key thing ACTUAL PRICE is the amount actually paid for the input used

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STANDARD PRICE is the amount that should have been paid for the input used ( AQ × AP )−( AQ × SP )  AQ = actual quantity  AP = actual price  SP = standard price ( AQ × SP )− ( SQ × SP)  AQ = actual quantity  SP = standard price  SQ = standard quality

Things to note about exhibit 10-3: - (1) A price variance and a quantity variance can be computed for all three variable cost elements – direct materials, direct labour, and variable MOH – even though the variances are not called by the same name in all cases - (2) Although the price variance may be called different names it is computed in exactly the same way regardless of whether one is dealing with direct materials, direct labour, or variable MOH  The same is true with the quantity variance - (3) The inputs represent the actual quantity of direct materials, direct labour, and variable MOH used; the output represents the good production of the period, expressed in terms of the standard quantity (or the standard hours) allowed for the actual output - (4) The amount in column 3 (SQ*SP) represents the flexible budget for the period  Flexible budget is based on the standard quantity allowed for the actual output achieved multiplied by the standard price per unit The STANDARD QUANTITY ALLOWED is the number of materials that should have been used to complete the period’s output - = actual number of units produced * standard quantity per unit The STANDARD HOURS ALLOWED is the time that should have been taken to complete the period’s output - = actual number of units * standard hours per unit The standard quantity allowed, or standard hours allowed means the number of direct materials, direct labour, or variable MOH that should have been used to produce the actual output of the period - This could be more or less than the materials, labour, or overhead that were actually used, depending on the efficiency or inefficiency of operations

USING STANDARD COSTS DIRECT MATERIALS VARIANCES HEIRLOOM PEWTER’S EXAMPLE Standard cost = standard quality per pair * standard price per pair Standard cost = 3.0 kg per unit * $4 per kg Standard cost = $12 per unit Heirloom Pewter’s purchasing records for June showed that 6500 kg of pewter were purchased at a cost of $3.80 per kg - This cost figure included freight and handling and was net of the quantity discount

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All materials purchased were used during June to manufacture 2000 pairs of pewter bookends

Exhibit 10-4: variance analysis – direct materials

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The three arrows point to three different total cost figures  (1) $24,700 = actual total cost purchased  (2) $26,000 = actual quantity would have cost if purchased at the standard price of $4 rather than $3.80  $1300 = price variance  Exists because the actual purchase price was $0.20 less than the standard purchase price  Favourable variance = actual < standard  Unfavourable variance = actual > standard  (3) $24,000 = flexible budget  Would have been the cost had it been purchased at the standard price and only the amount allowed by the standard quantity had been used  This is the standard quantity allowed for the actual output  $2000 = quantity variance  Standard price is used  Favourable variance = actual < standard  Unfavourable variance = actual > standard

Exhibit 10-5: variance analysis – direct materials, when the amount purchased differs from the amount used

There are two reasons why companies computer the materials price variance when materials are purchased rather than when they are used in production: - (1) Delaying the computation of the price variance until the materials are used would result in less-timely variance reports if there is a time gap between the purchase of materials and their use in production - (2) By computing the price variance at the time of purchase, materials can be carried in the inventory account at their standard cost

MATERIAL VARIANCES MATERIALS PRICE VARIANCE is a measure of the difference between the actual unit price paid for an item the standard price, multiplied by the quantity purchased - = (actual quantity*actual price) – (standard quantity*standard price) The formula can be factored into a simpler form: = AQ(AP-SP)

HEIRLOOM PEWTER EXAMPLE

GLACIER PEAK OUTFITTERS EXAMPLE Glacier Peak Outfitters has the following direct material standard for the fibrefill in its mountain parka - 0.1 kg of fibrefill per parka(p) at $5.00 per kg  The $5 is not for the parka, its per kilogram of the input Last month, 210 kgs of fibrefill were purchased and used to make 2000 parkas - The material cost a total of $1029  Sometimes we will get it in total, and sometimes we will get it per unit Solution: - AQ*AP = 210 kgs*$4.90 per kg = $1029  $4.90 = material cost/kgs used = $1029/210 kgs  This is how much we actually paid - AQ*SP = 210 kgs*$5.00 per kg = $1050  This is how much we should have paid - SQ*SP = 200 kgs*$5.00 per kg = $1000  200 kgs = direct material per fibrefill*actual output = 0.1 kg per parka*2000 parkas  This is the flexible budget since we are using actual output and standard input

USING THE EQUATIONS Materials price variance: MPV = AQ(AP-SP) MPV = 210 kgs ($4.90/kg - $5.00/kg) MPV = 210 kgs (-$0.10/kg) MPV = $21 favourable Materials quantity variance: MQV = SP(AQ-SQ) MQV = $5.00/kg (210 kgs – (0.1 kg/p*2000p)) MQV = $5.00/kg (210 kgs – 200 kgs) MQV = $5.00/kg (10 kgs) MQV = $50 unfavourable

ISOLATION OF MATERIAL VARIANCES Variances should be isolated and brought to the attention of management as quickly as possible so that problems can be identified and corrected on a timely basis The most significant variances should be viewed as red flags

RESPONSIBILITY FOR MATERIAL VARIANCES Production manager is responsible for the material 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

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If the purchasing manager purchases cheap material, more of it may need to be used in production causing unfavourable material quantity variances

Purchasing manager is responsible for the material price variance: - Poor sc...