Cost accounting Session 7

Learning objectives Define standard costing and standard cost Determine standard costs for materials, labour and overhead Calculate basic Material, Labour and Overhead variances Know what is meant by Variance Analysis and its purpose Determine causes of Variances

Define standard costing and standard cost Learning objective 1 Define standard costing and standard cost

Standard Costing is a technique which establishes predetermined estimates of the costs of products and services (standard cost) And compares the standard cost with actual cost as they are incurred. The difference between standard cost and actual cost is a variance.

Standard Cost Is the planned unit cost of the products, components or services in a period. A standard cost is not an average of previous costs.

Uses of standard costs Performance measurement Control Stock valuation Determine selling prices Setting budgets Provide a challenging target Decision making (predict future costs)

Bases for setting standards On an ex ante estimate of expected performance On an ex post estimate of attainable performance On a prior period level of performance by the same organisation On the level of performance achieved by comparable organisations On the level of performance required to meet organisational objectives

Types of Standards Basic standard a standard established for use over a long period from which a current standard can be developed Ideal standard based on the best possible operating conditions. unattainable in practice, hence rarely used. Attainable standard based on efficient level of operating conditions. includes allowances for normal material losses, idle time, machine breakdown, etc. standards are difficult, but achievable; hence frequently used.

Standards and Budgets Standards are a unit concept apply to particular products, individual operations or processes or services. Budgets are concerned with totals lay down cost limits for functions and departments and for the firm as a whole.

Motivation and standards Standards are expected to motivate people to achieve the targets set by the standards. Three factors affect motivation - participation - attainment level - feedback Note: there are behavioural aspect to standards. To some extent, there is subjectivity in setting standards.

Advantages of Standard Costing Variances directs management’s attention to items not going according to plan. The process of setting, revising and monitoring standards encourages reappraisal of systems, hence leading to cost reduction. Standard costs represent what parts and products should cost; hence provide better guide to pricing than historical costs. Provide a simpler basis of inventory valuation A properly developed standard costing system with everyone’s participation creates a positive, cost effective attitude in the whole organisation.

Disadvantages of Standard Costing May be expensive and time consuming to install and to keep up to date. Where methods, rates and prices change rapidly, standards become out of date. Elaborate variances may not be understood by managers and hence become ineffective for control purposes. Concentrates only on narrow range of financial factors; however, there are other factors affecting performance. May be less useful in JIT manufacturing; latter assumes continuous improvement.

Determine standard costs for materials, labour and overhead Learning objective 2 Determine standard costs for materials, labour and overhead

Setting Standards A standard cost implies that a target or standard exists for every single element that contributes to the product. There are two approaches to set standard costs. past historical records can be used to estimate labour and material usage. Problem: may include past inefficiencies. Engineering studies: a detailed study is undertaken of each operation based on careful specification of materials, labour and equipment. Line managers and top management have ultimate responsibility for setting the standards.

Standard costs for Materials A material cost standard is based on: Estimates of the quantity of materials required for a unit of product and Unit standard cost to purchase the materials used. Management will consult: engineering department for materials specification (design, types, usage, normal loss/wastage) and purchasing department regarding suppliers’ prices.

Standard costs for Labour The agreed methods of manufacture are the basis of setting the standard labour times. The techniques of work measurement are involved, often combined with work study projections. The labour standards must specify the exact grades of labour and times involved. Labour time is expressed in standard hours (or minutes). i.e. the amount of work achievable at standard efficiency levels, in an hour or minute.

Standard costs for Overheads Predetermined overhead absorption rates become the standards for overheads for each cost centre using the standard labour hours as the activity base ( or other such as units, weight, etc). Standard Variable OAR = Budgeted variable overheads for cost centre Budgeted standard labour hours for cost centre Standard Fixed OAR = Budgeted fixed overheads for cost centre

Standard sales price and margin Standard selling price Top management decision, based on number of factors like Anticipated market demand Competing products Manufacturing costs Inflation estimates, etc. Standard sales margin = standard selling price – standard cost

Standard Cost Card Once standards are set, the standard cost of a product is found. The make-up of the standard cost is recorded on a standard cost card. The standard cost details can also be held on Various cards and on a summary card. Computer file. Note that standards are rarely changed, but can be adjusted periodically to reflect up-to-date targets.

Learning objective 3 Calculate basic Material, Labour and Overhead variances plus Sales variances

Materials Variances DM Total Variance = (standard material cost of output produced – actual cost of material purchased) Where the quantities of materials purchased and used are different, Total variance = Price variance + Usage Variance

Materials Variances DM Price Variance = ((actual quantity of material purchased x standard price) – actual cost of material purchased) DM Usage Variance Measures efficiency in usage of materials = (actual production x standard material per unit – actual material usage) x standard cost per kg, ltr, etc.

Labour variances DL Total Variance = ((standard hours produced x standard direct labour rate per hour) – (actual hours paid x actual direct labour rate per hour))

Labour variances DL Rate Variance = ((actual hours paid x standard DL rate/hr) – (actual hours paid x actual DL rate/hour)) DL Efficiency Variance = (actual production in standard hours – actual hours worked) x standard direct labour rate per hour

Overhead Variances Total overhead absorbed = OAR x SHP, where SHP is the no. of Standard Hours of Production and OAR is overhead absorption rate. Fixed overheads absorbed = FOAR x SHP Variable overheads absorbed = VOAR x SHP Total overheads absorbed = (FOAR + VOAR) x SHP.

Variable Overhead Variances Variable overhead total variance = actual variable overheads incurred – variable overheads absorbed. Variable overhead expenditure variance = actual variable overheads incurred – allowed variable overheads based on the actual hours worked. Variable overhead efficiency variance = allowed variable overheads – absorbed variable overhead

Fixed Overhead Variances Fixed overhead total variance = fixed overhead attributed & charged to period – standard cost of fixed overhead absorbed in the production achieved, whether completed or not. Fixed overhead expenditure variance = actual fixed expenditure attributed & charged to period – budget cost allowance for production for a specified control period Fixed overhead volume variance = budget cost allowance for a specified control period – standard cost absorbed in the production achieved

Sales Variances Total sales margin variance Actual sales margin – budgeted sales margin, where COS is valued at standard cost of production Sales margin price variance (Actual margin/unit – standard margin/unit) x units sold Sales margin quantity variance (actual units sold – budgeted no. of units) x standard margin per unit

Know what is meant by Variance Analysis and its purpose Learning objective 4 Know what is meant by Variance Analysis and its purpose

Variance Analysis The evaluation of performance by means of variances, whose timely reporting should maximise the opportunity for managerial action. Variances arise from differences between Standard and actual quantities, and/or Standard and actual prices. Variances maybe Adverse, or Favourable.

Purpose of Variance Analysis Points to off-standard performance so management can Improve operations Increase efficiency Utilise resources more effectively, and Reduce costs. *The types of variances which are identified must be those which fulfil the needs of the organisation. i.e. a variance should only be calculated if it is useful.

Determine causes of Variances Learning objective 5 Determine causes of Variances

Causes of Variances Material Variances Price Variances paying higher or lower prices than planned. losing or gaining quantity discounts buying lower or higher quality than planned buying substitute material Usage Variances Greater or lower yield from material than planned Gains or losses due to substitute or higher/lower quality than planned Greater or lower rate of scrap than anticipated

Causes of Variances Labour Variances Rate Variances Higher rates being paid than planned due to wage award. Higher or lower grade of worker being used than planned. Payment of unplanned overtime or bonus. Efficiency Variances Use of incorrect grade of labour. Poor workshop organisation or supervision. Incorrect materials and/or machine conditions. Unexpectedly favourable conditions.

Standard Costing and Variance Analysis End of session 7