Standard Costing, Variance Analysis and Kaizen Costing 16 Standard Costing, Variance Analysis and Kaizen Costing

Learning Objective 1

Using Standard-Costing Systems for Control based on carefully predetermined amounts. Standard costs are used for planning labor and material requirements. the expected level of performance. benchmarks for measuring performance.

Using Standard-Costing Systems for Control a budget for the production of one unit of product or service ACTUAL COST incurred and recorded in the production of the product or service COST VARIANCE the difference between the actual cost and the standard cost

Using Standard-Costing Systems for Control This variance is unfavorable because the actual cost exceeds the standard cost. Standard A standard cost variance is the amount by which an actual cost differs from the standard cost. Product cost

Management by Exception Managers focus on quantities and costs that deviate significantly from standards (a practice known as management by exception). Standard Amount Direct materials Direct labor Type of Product Cost

Management by Exception Take the time to investigate only significant cost variances. What is significant? Depends on the size of the organization Depends on the production process Depends on the type of the organization

Variance Analysis Cycle Take corrective actions Identify questions Receive explanations Conduct next period’s operations Analyze variances Prepare standard cost performance report Begin

Setting Standards Analysis of historical data Task analysis Combined What DID the product cost? Used in a mature production process What SHOULD the product cost? Task analysis Analyze the process of manufacturing the product Combined approach Analyze the process for the step that has changed, but use historical data for the steps that have not changed

Participation in Setting Standards Accountants, engineers, personnel administrators, and production managers combine efforts to set standards based on experience and expectations.

Learning Objective 2

Perfection versus Practical Standards: A Behavioral Issue PRACTICAL OR ATTAINABLE STANDARDS Can only be attained under near perfect conditions Tight as practical, but still expected to be attained Peak efficiency Lowest possible input prices Best-quality material No disruption in production Occasional machine breakdowns Normal amounts of raw material waste

Perfection versus Practical Standards: A Behavioral Issue Practical standards should be set at levels that are currently attainable with reasonable and efficient effort. Should we use practical standards or perfection standards?

Perfection versus Practical Standards: A Behavioral Issue I agree. Perfection standards are unattainable and therefore discouraging to most employees.

Setting Standards – Direct Materials Price Standards Quantity Standards Use competitive bids for the quality and quantity desired. Use product design specifications.

Setting Standards – Direct Materials The standard materials cost for one unit of product is: Standard quantity Standard price for of material one unit of material required for one unit of product ×

Setting Standards – Direct Labor Rate standards Efficiency standards Use wage surveys and labor contracts. Use time and motion studies for each labor operation.

Setting Standards – Direct Labor The standard labor cost for one unit of product is: Standard number Standard wage rate of labor hours for one hour for one unit of product ×

Standard Cost in Service Industries Jobs with repetitive tasks lend themselves to efficiency measures. Computing non-manufacturing efficiency variances requires some assumed relationship between input and output activity. Examples Examples

Standard Cost in Service Industries

Costs and Benefits of Standard-Costing Systems IMPROVED DECISION MAKING, BUT: Implementing and maintaining cost standards can be time-consuming, labor-intensive, and expensive.

Cost Variance Analysis Standard cost variances Price variance Quantity variance The difference between the actual price and the standard price The difference between the actual quantity and the standard quantity

A General Model for Variance Analysis Actual quantity Actual quantity Standard quantity × × × Actual price Standard price Standard price Price / Rate variance Quantity / Efficiency variance

A General Model for Variance Analysis Actual quantity Actual quantity Standard quantity × × × Actual price Standard price Standard price Price / Rate variance Quantity / Efficiency variance Standard price is the amount that should have been paid for the resources acquired.

A General Model for Variance Analysis Actual quantity Actual quantity Standard quantity × × × Actual price Standard price Standard price Price / Rate variance Quantity / Efficiency variance Standard quantity is the quantity allowed for the actual good output.

A General Model for Variance Analysis Actual quantity Actual quantity Standard quantity × × × Actual price Standard price Standard price Price / Rate variance Quantity / Efficiency variance Materials price variance Materials quantity variance Labor rate variance Labor efficiency variance Variable overhead Variable overhead spending variance efficiency variance AQ(AP - SP) SP(AQ - SQ) AQ = Actual Quantity SP = Standard Price AP = Actual Price SQ = Standard Quantity

Standard Costs Let’s use the concepts of the general model to calculate standard cost variances, starting with direct materials.

Learning Objective 3

12 square meters per tent at $8.00 per square meter (sq m) Materials Variances Koala Camp Gear Company in Melbourne Australia has the following direct material standard to manufacture one Tree Line tent: 12 square meters per tent at $8.00 per square meter (sq m) Last month Koala purchased 40,000 square meters at $8.15 per square meter and used 36,400 square meters to make 3,000 tents.

Price variance $6,000 Unfavorable Materials Variances Actual quantity Actual quantity purchased purchased × × Actual price Standard price We should compute the price variance using the actual quantity purchased. 40,000 sq m 40,000 sq m × × $8.15 per sq m $8.00 per sq m $326,000 $320,000 Price variance $6,000 Unfavorable

Quantity variance $3,200 Unfavorable Materials Variances SQ = 3,000 tents × 12 sq m per tent SQ = 36,000 sq m Actual quantity used Standard quantity × × Standard price Standard price We should compute the quantity variance using the actual quantity used. 36,400 sq m 36,000 sq m × × $8.00 per sq m $8.00 per sq m $291,200 $288,000 Quantity variance $3,200 Unfavorable

We may also calculate materials variances using formulas: MPV = AQp(AP – SP) MPV = 40,000 sq m × ($8.15 – $8.00) MPV = $6,000 Unfavorable MQV = SP(AQu – SQ) MQV = $8.00(36,400 sq m – 36,000 sq m) MQV = $3,200 Unfavorable

Reporting Materials Variances I need the variances as soon as possible so that I can better identify problems and control costs. You accountants just don’t understand the problems we production managers have. Okay. I’ll compute the price variance when materials are purchased, and the usage variance as soon as material is used.

Responsibility for Materials Variances Your poorly trained workers and poorly maintained equipment caused the problems. Also, your poor scheduling requires rush orders of materials at higher prices, causing unfavorable price variances. I am not responsible for this unfavorable materials usage variance. You bought poor quality materials, so my people had to use more of it.

Now let’s calculate standard cost variances for direct labor. Standard Costs Now let’s calculate standard cost variances for direct labor.

2 standard hours per tent at $18.00 per direct labor hour Labor Variances Koala has the following direct labor standard to manufacture one Tree Line tent: 2 standard hours per tent at $18.00 per direct labor hour Last month 5,900 direct labor hours were worked at $19.00 per hour to make 3,000 tents.

Labor Variances SH = 3,000 tents × 2 hours per tent SH = 6,000 hours Actual hours Actual hours Standard hours × × × Actual rate Standard rate Standard rate 5,900 hours 5,900 hours 6,000 hours × × × $19.00 per hour $18.00 per hour $18.00 per hour $112,100 $106,200 $108,000 Rate variance $5,900 Unfavorable Efficiency variance $1,800 Favorable

We may also calculate labor variances using formulas: LRV = AH(AR - SR) LRV = 5,900 hrs($19.00 - $18.00) LRV = $5,900 Unfavorable LEV = SR(AH - SH) LEV = $18.00(5,900 hrs - 6,000 hrs) LEV = $1,800 Favorable

Labor Rate Variance – A Closer Look Using highly paid skilled workers to perform unskilled tasks results in an unfavorable price variance. High skill, high rate Low skill, low rate Production managers who make work assignments are generally responsible for price variances.

Labor Efficiency Variance – A Closer Look Poorly trained workers Poor quality materials Poorly maintained equipment Poor supervision of workers Unfavorable Efficiency Variance

Responsibility for Labor Variances I am not responsible for the unfavorable labor efficiency variance! You bought poor quality materials, so my people took more time to process them. You used too much time because of poorly trained workers and poor supervision.

Responsibility for Labor Variances Maybe I can attribute the labor and materials variances to personnel for hiring the wrong people and training them poorly.

Allowance for Defects or Spoilage In some manufacturing processes, a certain amount of defective production or spoilage is normal. Example: 1,000 liters of chemicals are normally required in a chemical process in order to obtain 800 liters of good output. If total good output in February is 5,000 liters, what is the standard allowed quantity of input? Good output quantity = 80% X Input quantity Good output quantity ÷ 80% = Input quantity allowed 5,000 liters of good output ÷ 80% = 6,250 liters of input allowed

Learning Objective 4

Significance of Cost Variances: When to Follow Up How does a manager know when to follow up on a cost variance and when to ignore it? Size of variance Absolute amount Relative amount ?

Significance of Cost Variances What clues help me to determine the variances that I should investigate? Size of variance Dollar amount Percentage of standard Recurring variances Trends Controllability Favorable variances Costs and benefits of investigation

Significance of Cost Variances: When to Follow Up Larger variances, in dollar amount or as a percentage of the standard, are investigated first. How do I know which variances to investigate? We could use a rule of thumb such as: investigate all variances that are over $10,000 or over 10 percent of the standard cost.

Significance of Cost Variances: When to Follow Up What about recurring variances? None of the variances are greater than $10,000 or 10% for any one month, but they should be investigated because of they have continued for several months.

Significance of Cost Variances: When to Follow Up What about trends? None of the variances are greater than $10,000 or 10% for any one month, but they should be investigated because of the unfavorable trend.

Significance of Cost Variances: When to Follow Up Controllability A manager is more likely to investigate a variance that is controllable by someone in the organization than one that is not. Favorable variances It is as important to investigate significant favorable variances as well as significant unfavorable variances. Cost and benefits of investigation The decision whether to investigate a variance is a cost - benefit decision

Provide a warning signal when variations are beyond a specified level. Statistical Analysis Control charts Display variations in a process and help to analyze the variations over time. Distinguish between random variations and variations that should be investigated. Provide a warning signal when variations are beyond a specified level.

Variance measurements Statistical Analysis Warning signals for investigation • • Favorable limit • • • • Desired value • • Unfavorable limit • 1 2 3 4 5 6 7 8 9 Variance measurements

Learning Objective 5

Behavioral Effects of Standard Costing Standard costs, budgets and variances are used to evaluate the performance of individuals and departments They can profoundly influence behavior when they are used to determine salary increases, bonuses and promotions

Which Managers Influence Cost Variances? Direct-materials price variance Purchasing manager Get the best prices available for purchased goods and services through skillful purchasing practices Direct-materials quantity variance Production supervisor Skillful supervision and motivation of production employees, coupled with the careful use and handling of materials, contribute to minimal waste Direct-labor rate variance Production supervisor Generally results from using a different mix of employees than that anticipated when the standard were set Direct-labor efficiency variance Production supervisor Motivating employees toward production goals and effective work schedules improves efficiency

Interaction among Variances Exh. 16-5 Interaction among Variances Interaction among variances often occurs, making it difficult to determine the responsibility for a particular variance. Variances in one part of the value chain can be due to root causes in another part of the chain. Value chain Research and develop- ment Design Supply Produc- tion Marketing Distri- bution Customer service Human resources Physical perspective

Learning Objective 6

Using Standard Costs for Product Costing Exh. 16-6 Using Standard Costs for Product Costing Work-in-process inventory Finished-goods inventory Direct-materials cost Product cost transferred Direct-labor cost when product is finished Manufacturing overhead Product cost transferred when product is sold Cost of goods sold Income summary Expense closed into Income summary at end of accounting period

Standard Cost Journal Entries Inventories are recorded at standard cost. Variances are recorded as follows: Favorable variances are credits, representing savings in production costs. Unfavorable variances are debits, representing excess production costs. Standard cost variances are usually closed to cost of goods sold. Favorable variances decrease cost of goods sold. Unfavorable variances increase cost of goods sold.

Impact of Information Technology on Standard Costing Labor time and rate are recorded at standard, using bar codes and employee IDs. CAD designers can access the data base for instant design cost estimates. Standard cost data base Materials purchases and uses are recorded at standard, using bar codes.

Learning Objective 7

Standard Costing: Its Traditional Advantages Sensible cost comparisons Advantages Management by exception Performance evaluation Employee motivation Less expensive than actual- or normal- costing systems More stable product costs

Learning Objective 8

Criticisms of Standard Costing in Today’s Manufacturing Environment Variances are often too aggregated. They are not tied to specific product lines, production batches, or to the flexible management system. Standard costing may not be applicable in flexible manufacturing operations with short life-cycle products. There is too much focus on cost minimization rather than increasing product quality or customer service. There is too much focus on the cost and efficiency of direct labor. Automation reduces labor costs and the significance of labor variances. Automated manufacturing processes tend to be more consistent in meeting production specifications. Variance reports are often provided too late to be useful to managers.

Adaptation of Standard-Costing Systems Applications of standard costing have adapted to changes in the manufacturing environment and the resulting criticisms leveled at standard costing. Reduced importance of labor standards. More emphasis on material and overhead costs. Automation means more overhead, less labor. Less use of labor as a cost driver.

Adaptation of Standard-Costing Systems Applications of standard costing have adapted to changes in the manufacturing environment and the resulting criticisms leveled at standard costing. Automation Reduces labor efficiency variance Reduces material quantity variance Reduces variation in quality and increases quality

Adaptation of Standard-Costing Systems Applications of standard costing have adapted to changes in the manufacturing environment and the resulting criticisms leveled at standard costing. More frequent benchmarking Shorter product life cycles Elimination of non-value-added costs More frequent revisions of standard costs Non-financial measures such a delivery times are more important Real-time information systems provide more timely variance reports

Learning Objective 9

Comparing Standard Costing and Kaizen Costing Standard costing – the use of carefully predetermined product costs for budgeting and performance evaluation. Standard costs are typically used in established production processes. Kaizen costing – the emphasis is on continuous reduction of production costs. Rather than standards or targets, the goal is current costs that are less than previous costs.

Kaizen Costing Cost per product unit 12/31/x0 12/31/x1 Time Cost base Exh. 16-7 Kaizen Costing Cost per product unit 12/31/x0 12/31/x1 Time Cost base for next year Actual cost reduction achieved Current year cost base Kaizen goal: cost reduction rate performance of the current year Kaizen goal: cost reduction amount

Learning Objective 10

Production Mix and Yield Variances Nearly all production processes require multiple materials and labor inputs. A summary quantity variance for materials and labor would hide the individual effects of these inputs. The quantity variances can be analyzed into two further variances: Mix (the difference between actual and standard input proportions) Yield (the difference between actual and standard input used) The analysis assumes, of course, that the inputs can be substituted for each other.

End of Chapter 16