c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Performance Evaluation Using Variances from Standard Costs Chapter 7

Learning Objectives 1. Describe the types of standards and how they are established. 2. Describe and illustrate how standards are used in budgeting. 3. Compute and interpret direct materials and direct labor variances. 4. Compute and interpret factory overhead controllable and volume variances. 5. Journalize the entries for recording standards in the accounts and prepare an income statement that includes variances from standard. 6. Describe and provide examples of nonfinancial performance measures.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Learning Objective Describe the types of standards and how they are established. 1

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Standards o Standards are performance goals. Manufacturing companies normally use standard cost for each of the three following product costs:  Direct materials  Direct labor  Factory overhead

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Standards o Accounting systems that use standards for product costs are called standard cost systems. o Standard cost systems enable management to determine the following:  How much a product should cost (standard cost)  How much it does cost (actual cost)

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Standard o When actual costs are compared with standard costs, only the exceptions or variances are reported for cost control. This reporting by the principle of exceptions allows management to focus on correcting the cost variances.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Setting Standards o The standard-setting process normally requires the joint efforts of accountants, engineers, and other management personnel.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Types of Standards o Unrealistic standards that can be achieved only under perfect operating conditions (such as no idle time, no machine breakdowns, and no materials spoilage) are called ideal standards or theoretical standards.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Types of Standards o Currently attainable standards, sometimes called normal standards, can be attained with reasonable effort. Such standards, which are used by most companies, allow for normal production difficulties and mistakes.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Reviewing and Revising Standards o Standard costs should be periodically reviewed to ensure that they reflect current operating conditions. Standards should not be revised, however, just because they differ from actual costs.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Criticisms of Standard Costs o Standards limit operating improvements by discouraging improvement beyond the standard. o Standards are too difficult to maintain in a dynamic manufacturing environment, resulting in “stale standards.” o Standards can cause workers to lose sight of the larger objectives of the organization by focusing only on efficiency improvements.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Criticisms of Standard Costs o Standards can cause workers to unduly focus on their own operations to the possible harm of other operations that rely on them.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Learning Objective Describe and illustrate how standards are used in budgeting. 2

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Budgetary Performance Evaluation o The standard cost per unit for direct materials, direct labor, and factory overhead is computed as follows: Standard Cost Per Unit Standard Price Standard Quantity = x

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Budgetary Performance Evaluation o Western Rider’s standard costs per unit for XL jeans are shown in Exhibit 1.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Budget Performance Report o The report that summarizes actual costs, standard costs, and the differences for the units produced is called a budget performance report.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Budget Performance Report o The differences between actual and standard costs are called costs variances. o A favorable cost variance occurs when the actual cost is less than the standard cost (at actual volumes). o An unfavorable cost variance occurs when the actual cost exceeds the standard cost.

B UDGET P ERFORMANCE R EPORT

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Manufacturing Cost Variances o The total manufacturing cost variance is the difference between total standard costs and total actual costs for the units produced. o For control purposes, each product cost variance is separated into two additional variances as shown in Exhibit 3 (next slide).

M ANUFACTURING C OST V ARIANCES

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Manufacturing Cost Variances o The total direct materials variance is separated into a price and quantity variance. o Thus, the actual and standard direct materials costs may differ because of either a price difference (variance) or a quantity difference (variance) or both.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Manufacturing Cost Variances o Likewise, the total direct labor variance is separated into a rate and a time variance. o Therefore, the actual and standard direct labor costs may differ because of either a rate difference (variance) or a time difference (variance) or both.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Learning Objective Compute and interpret direct materials and direct labor variances. 3

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Direct Materials Variances o During June, Western Rider reported an unfavorable total direct materials cost variance of $2,650 for the production of 5,000 XL style jeans, as shown in Exhibit 2 and reproduced below.

Actual Direct Materials Cost = Actual Price x Actual Quantity Actual Direct Materials Cost = ($5.50 per sq. yard) x (7,300 sq. yards.) Actual Direct Materials Cost = $40,150 Standard Direct Materials Cost = Standard Price x Standard Quantity Standard Direct Materials Cost = ($5.00 per sq. yard) x (7,500 sq. yards.) Standard Direct Materials Cost = $37,500 Actual costs ($40,150) – Standard costs ($37,500) = $2,650 Total Unfavorable Materials Variance Direct Materials Variances

Direct Materials Price Variance = (Actual Price – Standard Price) x Actual Quantity Direct Materials Price Variance = ($ $5.00) x 7,300 sq. yds. Direct Materials Price Variance = $3,650 Western Rider paid $0.50 more per square yard of material than the standard. Unfavorable direct materials price variance Direct Materials Price Variance

Direct Materials Quantity Variance = (Actual Quantity – Standard Quantity) x Standard Price Direct Materials Quantity Variance = (7,300 sq. yds. – 7,500 sq. yds.) x $5.00 Direct Materials Quantity Variance = – $1,000 Western Rider used 200 square yards less than the standard. Favorable direct materials quantity variance Direct Materials Quantity Variance

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Direct Materials Variance Relationships o The relationship among the total direct materials cost variance, the direct materials price variance, and the direct materials quantity variance is shown in an animated reproduction of Exhibit 4 in the next slide.

$3,650 U Direct materials price variance Actual quantity x Standard price 7,300 x $5.00 = $36,500 Actual quantity x Actual price 7,300 x $5.50 = $40,150 Standard quantity x Standard price 7,500 x $5.00 = $37,500 – $1,000 F Direct materials quantity variance Actual cost: Standard cost: $40,150 – $37,500 = $2,650 U Total direct materials cost variance Direct Materials Variance Relationships

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Direct Labor Variances o During June, Western Rider reported an unfavorable total direct labor cost variance of $2,500 for the production of 5,000 XL style jeans, as shown in Exhibit 2 and reproduced below.

Direct Labor Variances Actual Direct Labor Cost = Actual Rate per Hour x Actual Time Actual Direct Labor Cost = $10.00 per hr. x 3,850 hrs. $38,500 Actual Direct Labor Cost = $38,500 Standard Direct Labor Cost = Standard Rate per Hour x Standard Time Standard Direct Labor Cost = $9.00 per hr. x 4,000 hrs. $36,000 Standard Direct Labor Cost = $36,000 $2,500 Actual costs ($38,500) – Standard costs ($36,000) = $2,500 Total unfavorable direct labor cost variance

Direct Labor Rate Variance Direct Labor Rate Variance = (Actual Rate per Hour – Standard Rate per Hour) x Actual Hours Direct Labor Rate Variance = ($10.00 – $9.00) x 3,850 hours $3,850 Direct Labor Rate Variance = $3,850 The unfavorable variance could have been caused by improper scheduling and use of employees. Unfavorable direct labor rate variance

Direct Labor Time Variance = (Actual Direct Labor Hours - Standard Direct Labor Hours) x Standard Rate per Hour Direct Labor Time Variance =(3,850 hours – 4,000 direct labor hours) x $9.00 – $1,350 Direct Labor Time Variance = – $1,350 If there had been an unfavorable time variance, it might have been caused by a shortage of skilled workers. Favorable direct labor time variance Direct Labor Time Variance

$34,650 Actual hours x Standard rate 3,850 x $9 = $34,650 $38,500 Actual hours x Actual rate 3,850 x $10 = $38,500 $3,850 U Direct labor rate variance $36,000 Standard hours x Standard rate 4,000 x $9 = $36,000 –$1,350 F –$1,350 F Direct labor time variance Actual cost: Standard cost: $38,500 – $36,000 = $2,500 U Total direct labor cost variance D IRECT L ABOR V ARIANCE R ELATIONSHIPS

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Learning Objective Compute and interpret factory overhead controllable and volume variances. 4

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Factory Overhead Variances o Factory overhead costs are more difficult to analyze than direct labor and materials costs. This is because factory overhead costs have fixed and variable cost elements.

F ACTORY O VERHEAD F LEXIBLE B UDGET

Factory Overhead Rate Budgeted Factory Overhead at Normal Capacity Normal Productive Capacity = $30,000 5,000 direct labor hours Factory Overhead Rate = $6.00 per direct labor hour Factory Overhead Rate $6.00 per direct labor hour = Factory Overhead Flexible Budget

Variable Factory Overhead Rate = Budgeted Variable Overhead at Normal Capacity Normal Productive Capacity $3.60 per direct labor hour Variable Factory Overhead Rate = $3.60 per direct labor hour $18,000 5,000 direct labor hours Variable Factory Overhead Rate = Factory Overhead Flexible Budget

Fixed Factory Overhead Rate = Budgeted Fixed Overhead at Normal Capacity Normal Productive Capacity $2.40 per direct labor hour Fixed Factory Overhead Rate = $2.40 per direct labor hour $12,000 5,000 direct labor hours Fixed Factory Overhead Rate = Factory Overhead Flexible Budget

Variable Factory Overhead Controllable Variance Actual Variable Factory Overhead = Budgeted Variable Factory Overhead – Variable Factory Overhead Controllable Variance Standard Hours for Actual Units Produced Variable Factory Overhead Rate x

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Variable Factory Overhead Controllable Variance o The budgeted variable factory overhead is the standard variable overhead for the actual units produced.

Budgeted Variable Factory Overhead $14,400 = Variable Factory Overhead Controllable Variance $10,400 – $14,400 Actual Variable Factory Overhead = – Variable Factory Overhead Controllable Variance = – $4,000 Favorable Variance 4,000 direct labor hours x $3.60 Variable Factory Overhead Controllable Variance

Fixed Factory Overhead Volume Variance Standard Hours for 100% of Normal Capacity = Standard Hours for Actual Units Produced Fixed Factory Overhead Volume Variance – Fixed Factory Overhead Rate x = Fixed Factory Overhead Volume Variance 5,000 direct labor hours 4,000 direct labor hours x $2.40– = Fixed Factory Overhead Volume Variance $2,400 Unfavorable Variance

F IXED F ACTORY O VERHEAD V OLUME V ARIANCE

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Fixed Factory Overhead Volume Variance o An unfavorable volume variance may be due to factors such as the following:  Failure to maintain an even flow of work  Machine breakdowns  Work stoppages caused by lack of materials or skilled labor  Lack of enough sales orders to keep the factory operating at normal capacity

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Reporting Factory Overhead Variances o A factory overhead cost variance report is useful to management in controlling factory overhead costs. o Exhibit 8 (next slide) illustrates this report for Western Rider Inc. for June.

R EPORTING F ACTORY O VERHEAD V ARIANCES

Factory Overhead Account Applied Factory Overhead Standard Hours for Actual Units Produced = Total Factory Overhead Rate x Applied Factory Overhead = $24,000 4,000 direct labor hrs. x $6.00 = $24,000 Applied Factory Overhead = 5,000 jeans x 0.80 direct labor hr. per pair of jeans x $6.00

Actual Factory Overhead = Applied Factory Overhead – Total Factory Overhead Cost Variance Standard Hours for Actual Units Produced Total Factory Overhead Rate x (continued) Factory Overhead Account

5,000 jeans x 0.80 direct labor hr. per pair of jeans $6.00 x (continued) Actual Factory Overhead = – Total Factory Overhead Cost Variance $24,000 Factory Overhead Account

Actual Factory Overhead = – Total Factory Overhead Cost Variance $24,000 $22,400 – $24,000 = Total Factory Overhead Cost Variance – $1,600 Favorable Variance = Total Factory Overhead Cost Variance Factory Overhead Account

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Factory Overhead Account o Underapplied and overapplied factory overhead account balances represent the following total factory overhead cost variances:  Underapplied Factory Overhead = Unfavorable Total Factory Overhead Cost Variance  Overapplied Factory Overhead = Favorable Total Factory Overhead Cost Variance

Factory Overhead $10,400 + $12,000 Applied factory overhead24,000 4,000 hours x $6.00 per hour Actual factory overhead22,400 Factory Overhead Account

Overapplied factory overhead Factory Overhead Applied factory overhead24,000 Actual factory overhead22,400 Balance, June 301,600 Factory Overhead Account

$2,400 U – $1,600 F – $4,000 F Controllable Variance Applied Factory Overhead $24,000 Volume Variance Budgeted Factory Overhead for Amount Produced Variable factory OH$14,400 Fixed factory OH 12,000 Total$26,400 Actual factory overhead $22,400 Applied factory overhead $24,000 Total Factory Overhead Cost Variance Actual Factory Overhead $22,400 Factory Overhead Account

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Learning Objective Journalize the entries for recording standards in the accounts and prepare an income statement that includes variances from standard. 5

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Recording and Reporting Variances o Standard costs may be used as a management tool to control costs separately from the accounts in the general ledger. However, many companies include both standard costs and variances, in addition to actual costs, in their accounts.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Recording and Reporting Variances o Western Rider Inc. purchased, on account, the 7,300 square yards of blue denim at $5.50 per square yard. The standard price is $5.00 per square yard. The entry to record the purchase and the unfavorable direct materials price variance is as follows:

$5.50 x 7,300 = $40,150 $5.00 x 7,300 = $36,500 $3,650 unfavorable direct materials price variance Recording and Reporting Variances

1. Western Rider Inc. used 7,300 square yards of blue denim to produce 5,000 pairs of XL jeans. The standard quantity of denim for the 5,000 jeans produced is 7,500 square yards. The entry to record the materials used is as follows:

$5.00 x 7,500 = $37,500 $5.00 x 7,300 = $36,500 – $1,000 favorable direct materials quantity variance Recording and Reporting Variances

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Recording and Reporting Variances o Two journal entries are usually required for the purchase and use of direct materials because they are rarely the same amount. o Direct labor can be recorded in a single entry because “what you buy is what you use.” o The diagram on the next slide is from Exhibit 5 where direct labor variances were illustrated.

36,000 Work in Progress36,000 Direct Labor Rate Variance3,850 Direct Labor Time Variance1,350 38,500 Wages Payable38,500 R ECORDING AND R EPORTING V ARIANCES

Work in Progress36,000 3,850 Direct Labor Rate Variance3,850 1,350 Direct Labor Time Variance1,350 Wages Payable38,500 R ECORDING AND R EPORTING V ARIANCES

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Learning Objective Describe and provide examples of nonfinancial performance measures. 6

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Nonfinancial Performance Measures o A nonfinancial performance measure expresses performance in a measure other than dollars.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Nonfinancial Performance Measures o Inventory turnover o Percent on-time delivery o Elapsed time between a customer order and product delivery o Customer preference rankings compared to competitors o Response time to a service call o Time to develop new products o Employee satisfaction o Number of customer complaints

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Nonfinancial Performance Measures o Nonfinancial measures can be linked to either the inputs or outputs of an activity or process. o A process is a sequence of activities linked together for performing a particular task.

Outputs Line wait Percent order accuracy Friendly service score Activity Counter service Inputs Number of employees Employee experience Employee training Fryer reliability Number of new menu items Fountain drinks available Counter Service Activity of a Fast-Food Restaurant Nonfinancial Performance Measures

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Performance Evaluation Using Variances from Standard Costs The End