May 25, 2009 Standard Costs Chapter 8: Standard Costs. This chapter begins our study of management control and performance measures. It explains how standard costs are used by managers to control costs.

Today’s Agenda What is Standard Cost and what is its purpose? How are they set? Direct Material Standard Direct Labour Standard Variable Overhead Standard Standard Cost versus Actual Cost Variance Analysis Benefits and Problems with Standard Cost

Standard Cost Standard Costs are benchmark costs that management believes are appropriate for measuring performance Quantity Standards How many units of an input should be used to produce a unit of output E.g., it should take 20 minutes of Direct Labour to produce one cell phone Price Standards What is the appropriate price of a unit I E.g., an hour of labour should cost $5 In this case, the Direct Labour Standard is .33 * 5, or $1.67 per unit

Standard Cost Standard Cost information is used for several purposes: Budgeting Build up of expected appropriate costs are input into budgets Monitoring costs Budgets are tracked on a regular basis Controlling costs With budgeted inputs in place, managers are incentivized to work to and exceed targets Isolating problems When compared to actual costs, it is helpful in identifying problem areas and isolating the source

Variance Deviations from Standard Cost are called “Variances” Variances can be “Favourable” or “Unfavourable” In the case of the cell phone manufacturer, any Direct Labour cost per unit which is above the Standard Cost of $1.67 would be described as an Unfavourable Variance Below the Standard Cost of $1.67 would be described as a Favourable Variance Managers can focus in particular on Unfavourable Variances There could be a problem in the production process There could be a problem with the application of the methodology

Variance Analysis Cycle Identify questions Receive explanations Take corrective actions Conduct next period’s operations Analyze variances The variance analysis cycle is a continuous five-step process: The cycle begins with the preparation of standard cost performance reports in the accounting department. These reports highlight variances that are differences between actual results and what should have occurred according to standards. Variances raise questions such as: a. Why did this variance occur? b. Why is this variance larger than it was last period? Significant variances are investigated to discover their root causes. Corrective actions are taken and the next period’s operations are carried out. Prepare standard cost performance report Begin

Who Sets Standard Costs Setting appropriate Standard Costs requires the input of several people Purchasing Managers Pricing of Direct Materials Production Managers Quantity of Direct Materials Required Labour Engineers Optimizing processes and determining impact on Standard Cost Accountants Verification Calculation and monitoring Exception reporting As managers will be held to account for Variances, therefore Standard Costs should be “reasonable” and achievable Additional incentive can be provided for reducing costs, designing out high value parts and processes, etc.

Standard Costs Objects Direct Materials Quantity Standard Quantity or each component required Lead times – impacts inventory financing costs (as apposed to standard cost) Price Standard Price of the components at the volume required Net of discounts, shipping etc. – “landed cost” Direct Labour Time Standard Time required from Direct Labour to “Convert” the Direct Materials into a Finished Product Rate Standard Variable Manufacturing Overhead Price Standards Quantity Standards

Standard Cost Card – Variable Production Cost A Standard Cost Card is produced for each SKU The standard cost card is a detailed listing of the standard amounts of direct materials, direct labor, and variable overhead inputs that should go into a unit of product, multiplied by the standard price or rate that has been set for each input.

A General Model for Variance Analysis Price Variance Difference between actual price and standard price Quantity Variance Difference between actual quantity and standard quantity Differences between standard prices and actual prices and standard quantities and actual quantities are called variances. The act of computing and interpreting variances is called variance analysis.

A General Model for Variance Analysis Price Variance Quantity Variance Actual Quantity Actual Quantity Standard Quantity × × × Actual Price Standard Price Standard Price Although price and quantity variances are known by different names, they are computed exactly the same way (as shown on this slide) for direct materials, direct labor, and variable manufacturing overhead. (AQ × AP) – (AQ × SP) (AQ × SP) – (SQ × SP) AQ = Actual Quantity SP = Standard Price AP = Actual Price SQ = Standard Quantity

General Variance Analysis Applied Assumptions: Standard Rate = $104 Standard Quantity = 1,000 Actual Quantity = 900 Actual Cost = $110,000 What is the Price and quantity Variance?

General Variance Analysis Applied Actual Rate = 900 units / $110,000 = $122 Price Variance = 93,600 – 110,000 = -$16,400 (unfavourable) Quantity Variance = 104,000 – 93,600 = $10,400 (favourable)

Detailed Variance Analysis Applied Variance Analysis is applied in the same way for detailed accounts as it is in general Direct Materials, Direct Labour, Variable Overhead Direct Materials Variance Assume: Standard Quantity = 5,000 pieces (5 pieces x 1,000 products) Standard Rate = $10 per piece Actual Quantity Used 4,500 pieces Actual Cost = $60,000

Detailed Variance Analysis Applied Actual Rate = $13 per piece ($60,000/4,500 pieces) Price Variance = -$15,000 unfavourable Quantity Variance = $5,000 favourable

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