© Pearson Education Limited 2008 MANAGEMENT ACCOUNTING Cheryl S. McWatters, Jerold L. Zimmerman, Dale C. Morse Cheryl S. McWatters, Jerold L. Zimmerman, Dale C. Morse

© Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse Management Accounting Standard costs and variance analysis (Control) Chapter 12

© Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse Objectives Provide reasons for using standard costs Describe planning and control issues in setting standards Calculate direct labour and direct material variances Identify potential causes of different favourable and averse variances Recognize incentive effects of standard costs Measure expected, standard and actual usage of an allocation base to apply overhead and determine overhead variances Identify factors that influence the decision to investigate variances Summarize the costs and benefits of using standard variances

© Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse Standard Costs Future costs are used for planning because historical costs are not representative of future operations if conditions have changed

© Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse Benchmarks for measuring performance The expected level of performance Expected future costs of products and services Used for planning labour, material and overhead requirements Standard Costs

© Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse Reasons for Standard Costing Planning Decisions Outsourcing Decisions Product Pricing Contract Bidding Assessing alternative production decisions

© Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse Reasons for Standard Costing Control Decisions Basis for managerial performance evaluation Bonus allocation Basis for contracts

© Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse Direct Material Managers focus on quantities and costs that exceed standards, a practice known as management by exception Type of Product Cost Amount Direct labour Manufacturing Overhead Standard Reasons for Standard Costing

© Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse This variance is unfavorable because the actual cost exceeds the standard cost Reasons for Standard Costing Product Cost Standard A standard cost variance is the amount by which an actual cost differs from the standard cost

© Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse Accountants, industrial engineers, personnel administrators, and production managers often combine efforts to set standards based on experience and expectations Attainable standards should be set at levels that are currently attainable with normal and reasonable effort Standards may be set using a... Bottom-up approach involving the participation of all levels of management and staff Top-down approach called target costing Setting and Revising Standards

© Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse Setting and Revising Standards Target Costs Desired Return on Capital Desired Market Share Cost Reduction Goals Desired Profit

© Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse Direct Labour and Direct Materials Variances Variances used primarily to identify problems Variances calculated to help managers determine the cause and responsibility for the problem By partitioning variances into component variances cause and responsibility become easier to identify –Variance due to actual price per unit differing from plan –Variance due to actual quantity per unit differing from plan

© Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse Direct Labour Variances Direct Labour variance is the difference between the actual direct labour costs and the standard direct labour costs Labour efficiency variance Labour rate variance

© Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse Direct Labour Variances Labour efficiency Variance + Labour rate variance = Direct Labour variance Standard cost of labour - Actual cost of labour = Direct Labour variance Standard hours xStandard Labour rate -Actual hoursxActual labour rate = (() ) Standard Labour rate x Standard hours - Actual hours = Labour efficiency Variance () Actual hours x Standard Labour rate - Actual labour rate = Labour rate variance ()

© Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse Quantity VariancePrice Variance The difference between the actual price and the standard price The difference between the actual quantity and the standard quantity Standard Cost Variances

© Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse Direct labour Variances A Favorable variance occurs when the actual costs are less than the standard costs An adverse variances occurs if the actual costs are greater than the standard costs

© Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse Direct Labour Variances Efficiency Variance Rate Variance Hours of work, H Rate per hour, R RaRa RsRs R a is the actual rate R s is the standard rate H a is the actual hours H s is the standard hours HaHa HsHs

© Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse Direct Labour Variances Numerical Example Type of auditorExpected hoursCost per hour (£)Standard costs (£) Manager Senior Staff40301,200 Totals702,500 A public accounting firm estimates that an audit will require the following work: Type of auditorExpected hoursCost per hour (£)Standard costs (£) Manager Senior Staff44301,320 Totals752,624 The following were the actual hours and costs

© Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse Direct Labour Variances Numerical Example Type of auditorActual costs (£)Standard costs (£)Direct labour variance (£) Manager468500(32) Senior Staff1,3201, Totals2,6242, Adverse Manager (£52 - £50 x 9)£18 Senior (£38 - £40 x 22)£(44) Staff (£30 - £30 x 44)0 Total labour rate variance (26) F The direct labour variance Labour rate variance Labour efficiency variance Manager (9 – 10 x £50)(£50) Senior (22 – 20 x £40)£80 Staff (44-40 x £30)£120 Total labour efficiency variance£150 A

© Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse Direct Labour Variances Actual Hours Actual rate Actual Hours Standard rate Standard Hours Standard rate x x x £4,886£4,835£4,800 Direct labour rate variance £51 Adverse Direct labour efficiency variance £35 Adverse Direct labour variance £86 Adverse

© Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse Unfavorable Efficiency Variance Poorly maintained equipment Poorly trained workers Poor quality materials Poor supervision of workers Direct labour Variances

© Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse Direct materials variances are similar to those computed for direct labour Direct Materials Variances Total direct materials variance is decomposed into a material price variance and a material quality variance

© Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse Direct Materials Variances Quality Variance + Price variance = Direct material variance Standard cost of material - Actual cost of material = Direct material variance Standard quantity xStandard price -Actual quantity xActual price = (() ) Standard price x Standard quantity - Actual quantity = Quantity Variance () Actual quantity x Standard price - Actual price = Price variance ()

© Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse Direct Materials Variances Quality Variance Price Variance Units of material, Q Price per unit on material, P PaPa PsPs P a is the actual price P s is the standard price Q a is the actual quantity Q s is the standard quantity QaQa QsQs

© Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse Direct Materials Variances Numerical Example A tyre manufacturer has a standard quantity of 3 kg of fibreglass cord per automobile tyre. The standard price is €1.00 per kg During the month the purchasing manager bought 98,000kg of cord for €102,000. The plant used 95,000kg of cord to manufacture 30,000 tyres Actual purchase price€102,000/98,000 = € /kg Material variance(€ €1.00/kg) x 98,000 = €4,000 adverse Material quality variance(95,000kg – 90,000kg) x €1.00/kg = €5,000 adverse

© Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse Direct Materials Variances Actual quantity Actual price Actual quantity Standard price Standard quantity Standard price x x x £9,588£9,610£9,600 Direct material price variance (£22) Favourable Direct material quality variance £10 Adverse Direct material variance (£12) Favourable

© Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse Incentive Effects of Direct labour and Materials Variances When used as performance measures, standard cost variances create subtle incentive effects: The incentive to build inventories Externalities Discouraging cooperative effort Mutual monitoring incentives Satisficing behaviour

© Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse Incentive to Build Inventories The evaluation of purchasing managers based on direct materials price variances creates incentives for these managers to build inventories This incentive can be reduced by charging the purchasing department for the cost of holding inventories An alternative mechanism for controlling inventory-building is to adopt techniques such as just-in-time manufacturing

© Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse Production managers can impose externalities on purchasing by requesting materials are purchased on short lead times or in small lot sizes Engineering can increase the price of purchases by making frequent design changes Externalities To offset this incentive the materials can be inspected on receipt against a set of engineering specifications An alternative mechanism would be to set a performance measure for the purchasing manager to minimize the amount of rework generated Purchasing managers can impose externalities on production by purchasing sub-standard materials

© Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse An alternative is to measure variances for a team or department within the organization Unco-operative Effort Evaluating individuals within an organization based on different variances can discourage co-operative effort To encourage co-operative effort many organizations calculate variances and measure performance at multiple levels

© Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse Mutual Monitoring Incentives Mutual monitoring occurs between managers who are not in a direct reporting relationship with each other In designing performance evaluation and reward systems, organizations can create mutual monitoring incentives that encourage managers to acquire and utilize their specialized knowledge to improve the performance of other managers

© Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse Satisficing Behaviour Satisficing behaviour occurs when manager have inventive to achieve a standard of performance but go no further Satisficing behaviour can affect quality if employees are motivated to meet quotas Management rewards should be based on achieving or exceeding the standard of performance

© Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse Quantity and price variances are defined in terms of the allocation base for overhead costs. The quantity of overhead is the level of usage of the allocation base The price of overhead is the overhead application rate Standard Overhead Costs and Variances

© Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse Expected, Standard, and Actual Usage of the Allocation Base Expected usage is estimated at the beginning of the year and used to compute the predetermined allocation rate Standard usage is the amount that should have been used for the actual output Actual usage is the amount of the allocation based actually used

© Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse Expected, Standard, and Actual Usage of the Allocation Base Numerical Example Pizzazz Pizza makes 2 types of pizza. The company allocates overhead based on the number of direct labour hours The direct labour hours for a pepperoni pizza is 5 minutes and the direct labour hours for a cheese pizza is 4 minutes. Pizzazz Pizza expected to make 12,00 pepperoni and 6,000 cheese pizzas. During the year the firm made 9,00 pepperoni and 7,500 cheese pizza. The labourers worked for 1,300 hours

© Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse Expected, Standard, and Actual Usage of the Allocation Base Numerical Example Expected number of direct labour hours Pepperoni (12,000 x 0.08)1,000 Cheese (6,000 x 0.07)400 Total1,400 Standard number of direct labour hours Pepperoni (9,000 x 0.08)750 Cheese (7,500 x 0.07)500 Total1,250 Actual number of direct labour hours1,300

© Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse Budgeted, Applied, and Actual Overhead Actual Overhead Budgeted Overhead Applied Overhead Actual costs of using overhead resources Overhead costs expected at the beginning of the period Overhead costs applied to cost objects through the standard usage of the allocation base The difference between actual overhead costs and applied overhead is the total overhead variance

© Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse Incentive Effects of Overhead Standards and Variances Desired Result Maintain the quality of overhead services while, at the same time, reducing overhead costs to obtain favorable variances Desired Result Maintain the quality of overhead services while, at the same time, reducing overhead costs to obtain favorable variances Problem Output is increased, resulting in actual overhead < applied overhead (favorable variance) and excess inventories Problem Output is increased, resulting in actual overhead < applied overhead (favorable variance) and excess inventories Solution Separate responsibilities so that overhead resource manager does not control output levels

© Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse Variance Investigation Variance Investigation Decision Cost of Correction Size of Variance Ease of Correction Cost of not Correcting

© Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse Costs and Benefits of Using Standard Costing Systems Advantages Management by exception Improved cost control and performance evaluation Better Information for planning and decision making Possible reductions in production costs

© Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse Disadvantages Emphasis on negative exceptions may impact morale Focus on big variances may obscure early stages of trends Emphasis on negative exceptions may lead to inappropriate behaviour It may be difficult to determine which variances are significant Costs and Benefits of Using Standard Costing Systems

© Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse Management Accounting Standard costs and variance analysis (Control) End of Chapter 12