Standard Costs and Operating Performance Measures Chapter 10 Standard Costs and Operating Performance Measures Chapter 10: Standard Costs and Operating Performance Measures This chapter extends our study of management control by explaining how standard costs are used by managers to control costs. It demonstrates how to compute direct materials, direct labor, and variable overhead variances. The chapter also defines some nonfinancial performance measures that are frequently used by companies. PowerPoint Authors: Susan Coomer Galbreath, Ph.D., CPA Charles W. Caldwell, D.B.A., CMA Jon A. Booker, Ph.D., CPA, CIA McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.

Standard Costs Standards are benchmarks or “norms” for measuring performance. In managerial accounting, two types of standards are commonly used. Quantity standards specify how much of an input should be used to make a product or provide a service. Price standards specify how much should be paid for each unit of the input. A standard is a benchmark or “norm” for measuring performance. In managerial accounting, two types of standards are commonly used by manufacturing, service, food and not-for-profit organizations: Quantity standards specify how much of an input should be used to make a product or provide a service. For example: Auto service centers like Firestone and Sears set labor time standards for the completion of work tasks. Fast-food outlets such as McDonald’s have exacting standards for the quantity of meat going into a sandwich. Price standards specify how much should be paid for each unit of the input. For example: Hospitals have standard costs for food, laundry, and other items. Home construction companies have standard labor costs that they apply to sub-contractors such as framers, roofers, and electricians. Manufacturing companies often have highly developed standard costing systems that establish quantity and price standards for each separate product’s material, labor and overhead inputs. These standards are listed on a standard cost card. Examples: Firestone, Sears, McDonald’s, hospitals, construction and manufacturing companies.

Manufacturing Overhead Standard Costs Deviations from standards deemed significant are brought to the attention of management, a practice known as management by exception. Standard Amount Direct Material Management by exception is a system of management in which standards are set for various operating activities, with actual results compared to these standards. Any deviations that are deemed significant are brought to the attention of management as “exceptions.” This chapter applies the management by exception principle to quantity and price standards with an emphasis on manufacturing applications. Direct Labor Manufacturing Overhead Type of Product Cost

Variance Analysis Cycle Identify questions Receive explanations Take corrective actions Conduct next period’s operations Analyze variances The variance analysis cycle is a continuous process used to identify and solve problems: 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. The Variances raise questions such as: Why did this variance occur? Why is this variance larger than it was last period? The significant variances are investigated to discover their root causes. Corrective actions are taken. Next period’s operations are carried out and the process is repeated. Prepare standard cost performance report Begin

Setting Standard Costs Should we use ideal standards that require employees to work at 100 percent peak efficiency? I recommend using practical standards that are currently attainable with reasonable and efficient effort. Standards tend to fall into one of two categories: Ideal standards can only be attained under the best of circumstances. They allow for no work interruptions and they require employees to work at 100% peak efficiency all of the time. Practical standards are tight, but attainable. They allow for normal machine downtime and employee rest periods and can be attained through reasonable, highly efficient efforts of the average worker. Practical standards can also be used for forecasting cash flows and in planning inventory. Engineer Managerial Accountant

Setting Direct Material Standards Price Standards Quantity Standards Summarized in a Bill of Materials. Final, delivered cost of materials, net of discounts. The standard price per unit for direct materials should reflect the final, delivered cost of the materials, net of any discounts taken. The standard quantity per unit for direct materials should reflect the amount of material required for each unit of finished product, as well as an allowance for unavoidable waste, spoilage, and other normal inefficiencies. A bill of materials is a list that shows the quantity of each type of material in a unit of finished product.

Setting Direct Labor Standards Rate Standards Often a single rate is used that reflects the mix of wages earned. Time Standards Use time and motion studies for each labor operation. The standard rate per hour for direct labor includes not only wages earned but also fringe benefits and other labor costs. Many companies prepare a single rate for all employees within a department that reflects the “mix” of wage rates earned.   The standard hours per unit reflects the labor hours required to complete one unit of product. Standards can be determined by using available references that estimate the time needed to perform a given task, or by relying on time and motion studies.

Setting Variable Manufacturing Overhead Standards Rate Standards The rate is the variable portion of the predetermined overhead rate. Quantity Standards The quantity is the activity in the allocation base for predetermined overhead. The price standard for variable manufacturing overhead comes from the variable portion of the predetermined overhead rate. The quantity standard for variable manufacturing overhead is expressed in either direct labor hours or machine hours depending on which is used as the allocation base in the predetermined overhead rate.

Price and Quantity Standards Price and quantity standards are determined separately for two reasons: The purchasing manager is responsible for raw material purchase prices and the production manager is responsible for the quantity of raw material used. Price and quantity standards are determined separately for two reasons: Different managers are usually responsible for buying and for using inputs. For example: The purchasing manager is responsible for raw material purchase prices and the production manager is responsible for the quantity of raw material used. The buying and using activities occur at different points in time. For example: Raw material purchases may be held in inventory for a period of time before being used in production. The buying and using activities occur at different times. Raw material purchases may be held in inventory for a period of time before being used in production.

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 Price and quantity variances can be computed for all three variable cost elements – direct materials, direct labor, and variable manufacturing overhead – even though the variances have different names as shown. Materials price variance Labor rate variance VOH rate variance Materials quantity variance Labor efficiency variance VOH efficiency variance

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.

A General Model for Variance Analysis Price Variance Quantity Variance Actual Quantity Actual Quantity Standard Quantity × × × Actual Price Standard Price Standard Price Actual quantity is the amount of direct materials, direct labor, and variable manufacturing overhead actually used. The actual quantity represents the amount of direct materials, direct labor, and variable manufacturing overhead actually used.

A General Model for Variance Analysis Price Variance Quantity Variance Actual Quantity Actual Quantity Standard Quantity × × × Actual Price Standard Price Standard Price Standard quantity is the standard quantity allowed for the actual output of the period. The standard quantity represents the standard quantity allowed for the actual output of the period.

A General Model for Variance Analysis Price Variance Quantity Variance Actual Quantity Actual Quantity Standard Quantity × × × Actual Price Standard Price Standard Price The actual price represents the actual amount paid for the input used. Actual price is the amount actually paid for the input used.

A General Model for Variance Analysis Price Variance Quantity Variance Actual Quantity Actual Quantity Standard Quantity × × × Actual Price Standard Price Standard Price The standard price represents the amount that should have been paid for the input used. Standard price is the amount that should have been paid for the input used.

A General Model for Variance Analysis Price Variance Quantity Variance Actual Quantity Actual Quantity Standard Quantity × × × Actual Price Standard Price Standard Price In equation form, price and quantity variances are calculated as shown. (AQ × AP) – (AQ × SP) (AQ × SP) – (SQ × SP) AQ = Actual Quantity SP = Standard Price AP = Actual Price SQ = Standard Quantity

Responsibility for Material Variances Materials Quantity Variance Materials Price Variance Purchasing Manager Production Manager The purchasing manager and production manager are usually held responsible for the materials price variance and materials quantity variance, respectively. The standard price is used to compute the quantity variance so that the production manager is not held responsible for the performance of the purchasing manager. The standard price is used to compute the quantity variance so that the production manager is not held responsible for the purchasing manager’s performance.

Responsibility for Labor Variances Production managers are usually held accountable for labor variances because they can influence the: Mix of skill levels assigned to work tasks. Level of employee motivation. Quality of training provided to employees. Quality of production supervision. Production Manager Labor variances are partially controllable by employees within the Production Department. For example, production managers/supervisors can influence: The deployment of highly skilled workers and less skilled workers on tasks consistent with their skill levels. The level of employee motivation within the department. The quality of production supervision. The quality of the training provided to the employees.

Advantages of Standard Costs Management by exception Promotes economy and efficiency Advantages Research has shown that a substantial portion of companies in the United Kingdom, Canada, Japan, and the United States use standard cost systems. This is because standard cost systems offer many advantages including: Standard costs are a key element of the management by exception approach which helps managers focus their attention on the most important issues. Standards that are viewed as reasonable by employees can serve as benchmarks that promote economy and efficiency. Standard costs can greatly simplify bookkeeping. Standard costs fit naturally into a responsibility accounting system. Enhances responsibility accounting Simplified bookkeeping

Potential Problems with Standard Costs Emphasizing standards may exclude other important objectives. Favorable variances may be misinterpreted. Potential Problems Standard cost reports may not be timely. Emphasis on negative may impact morale. The use of standard costs can also present a number of problems. For example: Standard cost variance reports are usually prepared on a monthly basis and are often released days or weeks after the end of the month; hence, the information can be outdated. If variances are misused as a club to negatively reinforce employees, morale may suffer and employees may make dysfunctional decisions. Labor variances make two important assumptions. First, they assume that the production process is labor-paced; if labor works faster, output will go up. Second, the computations assume that labor is a variable cost. These assumptions are often invalid in today’s automated manufacturing environment where employees are essentially a fixed cost. In some cases, a “favorable” variance can be as bad or worse than an unfavorable variance. Excessive emphasis on meeting the standards may overshadow other important objectives such as maintaining and improving quality, on-time delivery, and customer satisfaction. Just meeting standards may not be sufficient; continual improvement using techniques such as Six Sigma may be necessary to survive in a competitive environment. Invalid assumptions about the relationship between labor cost and output. Continuous improvement may be more important than meeting standards.

Delivery Performance Measures Order Received Production Started Goods Shipped Process Time + Inspection Time + Move Time + Queue Time Wait Time Throughput Time Delivery cycle time is the elapsed time from when a customer order is received to when the completed order is shipped. Throughput (manufacturing cycle) time is the amount of time required to turn raw materials into completed products. This includes process time, inspection time, move time, and queue time. Process time is the only value-added activity of the four times mentioned. Delivery Cycle Time Process time is the only value-added time.

Delivery Performance Measures Order Received Production Started Goods Shipped Process Time + Inspection Time + Move Time + Queue Time Wait Time Throughput Time Manufacturing cycle efficiency (MCE) is computed by dividing value-added time by manufacturing cycle (throughput) time. An MCE less than one indicates that non-value-added time is present in the production process. Next, we will look at a series of questions dealing with delivery performance measures. Delivery Cycle Time Manufacturing Cycle Efficiency Value-added time Manufacturing cycle time =

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