24-1. CHAPTER 24 C ONTROL THROUGH S TANDARD C OSTS

24-2 CHAPTER 24 C ONTROL THROUGH S TANDARD C OSTS Caution! This chapter is second only to Chapter 15 (bonds) for the amount of grief it causes most students in this course.

24-3 l Up to this point in the course, we have been using actual costs. l This chapter considers standard costs (i.e., what costs should be under stated conditions). u The achievement of standard represents a reasonable and acceptable level of performance. u Standards for materials, labor, and overhead are determined through engineering studies and time and motion studies. Nature of Standard Costs

24-4 Nature of Standard Costs Standard Costs are Based on carefully predetermined amounts. Used for budgeting labor, material and overhead requirements. Used for variance analysis. Benchmarks for measuring performance.

24-5 Type of Product Cost Amount Direct Material Direct Labor Manufacturing Overhead Actual costs Standard costs - what costs should be under stated conditions. Nature of Standard Costs

24-6 Type of Product Cost Amount Direct Material Direct Labor Manufacturing Overhead Standard cost variances - amounts by which actual costs differs from standard costs. Standard Cost Variances

24-7 Type of Product Cost Amount Direct Material Direct Labor Manufacturing Overhead The materials variance is unfavorable because the actual cost exceeds the standard cost. The overhead variance is favorable because the actual cost is less than the standard cost. Standard Cost Variances

24-8 Type of Product Cost Amount Direct Material Direct Labor Manufacturing Overhead Managers focus on standard cost variances, a practice known as management by exception. Standard Cost Variances

24-9 Standard Cost Variances Why are variances important to me? Ê They point to causes of problems and directions for improvement. Ë They trigger investigations in departments having responsibility for incurring the costs.

24-10 Setting Standard Costs Should we use practical standards or ideal standards? Engineer

24-11 Setting Standard Costs Practical standards should be set at levels that are currently attainable with reasonable and efficient effort. Production manager

24-12 Setting Standard Costs I agree. Ideal standards, that are based on perfection, are unattainable and therefore discouraging to most employees. Human Resources Manager

24-13 Setting Standard Costs This is your decision. I’m here to advise you and account for the resulting transactions. Managerial Accountant

24-14 Advantages of Standard Costs Advantages Cost savings in record-keeping Improved cost control and performance evaluation Better Information for planning and decision making Possible reductions in production costs More reasonable and easier inventory measurements

24-15 Disadvantages of Standard Costs Disadvantages Emphasis on negative exceptions may lower morale. Emphasis on negative exceptions may lead to under-reporting. It may be difficult to determine which variances are significant.

24-16 Are standards the same as budgets? A standard is the expected cost for one unit. A budget is the expected cost for all units. Use of Standard Costs in Developing Budgets

24-17Specifics O.K., let’s get down and dirty with some specifics!

24-18 The total standard cost for one unit of finished product is the sum of:  Standard cost for direct materials  Standard cost for direct labor  Standard cost for manufacturing overhead necessary to produce one unit of the product. Types of Standard Costs

24-19 Setting Standards Direct Materials Usage Standards Price Standards Use product design specifications Use competitive bids for the quality and quantity desired

24-20 Standard Costs Direct Materials cost price quantity Standard cost for direct materials is standard price for one unit of raw material (pound, yard, etc.) multiplied by the standard quantity of raw material to produce one unit of product

24-21 price l Standard price is the amount that should be paid for each unit of raw material. quantity l Standard quantity is the amount of raw material that should be used to produce one unit of finished product. cost The standard material cost for one unit of product is: quantity price standard quantity standard price for of material one unit of material required for one unit of product × Standard Costs Direct Materials

24-22 Standard Costs Direct Materials Example price l Standard price is the amount that should be paid for each unit of raw material. e.g.., each sheet of plywood should cost $6 quantity l Standard quantity is the amount of material that should be used to produce one unit of finished product. e.g., each table should take 5 sheets The High Point Furniture Company makes top quality tables from sheets of plywood. 863

24-23 price l Standard price is the amount that should be paid for each unit of raw material. e.g.., each sheet of plywood should cost $6 quantity l Standard quantity is the amount of material that should be used to produce one unit of finished product. e.g., each table should take 5 sheets costprice quantity v Standard cost is standard price times standard quantity for one unit of product e.g., $6 X 5 sheets = $30 Standard Costs Direct Materials Example

24-24 Efficiency Standards Rate Standards Use time and motion studies for each labor operation Use wage surveys and labor contracts Setting Standards Direct Labor

24-25 cost wagerate number of labor Standard cost for direct labor is standard wage rate for one hour of labor multiplied by the standard number of labor hours needed to produce one unit of product. Standard Costs Direct Labor

24-26 wage rate l Standard wage rate is the amount that should be paid for each hour of labor. number of hours l Standard number of hours is the number of hours that should be worked to produce one unit of finished product. cost The standard labor cost for one unit of product is: number wage rateof labor hours standard number standard wage rate of labor hours for one hour for one unit of product × Standard Costs Direct Labor

24-27 The High Point Furniture Company’s dining room tables are made by highly skilled, hourly paid carpenters. wage rate l Standard wage rate is the amount that should be paid for each hour of labor. e.g.., each hour should cost $10 number of hours l Standard number of hours is the number of hours that should be worked to produce one unit of finished product. e.g., each table should take 2 hours Standard Costs Direct Labor Example

24-28 wage rate l Standard wage rate is the amount that should be paid for each hour of labor. e.g.., each hour should cost $10 number of hours l Standard number of hours is the number of hours that should be worked to produce one unit of finished product. e.g., each table should take 2 hours costwage ratenumber of hours v Standard labor cost is standard wage rate times standard number of hours for one unit of finished product e.g., $10 X 2 hours = $20 Standard Costs Direct Labor Example

24-29 Standard Rate Select a standard level of output and define a basis for activity Setting Standards Manufacturing Overhead

Standard Costs Manufacturing Overhead input input If, however, the overhead rate is based on units of input such as direct labor hours, the denominator is based on the input labor hours. The above calculation is really what? Total budgeted overhead cost at the standard level of output Standard level of output rate Standard overhead rate per unit = rate A standard manufacturing overhead rate is applied for each unit of activity.

24-31 l Budgeted overhead cost l Budgeted overhead cost is the total amount of overhead cost that should be incurred for the year to produce at the standard level of output. l Standardlevel of output l Standard level of output is what the activity level for the cost driver should be for the year. budgeted overhead cost Standardlevel of output Total budgeted overhead cost at the standard level of output Standard level of output rate Standard overhead rate per unit = Standard Costs Manufacturing Overhead

24-32 l Budgeted overhead cost l Budgeted overhead cost is the amount of overhead cost that should be incurred to produce at the standard level of output. e.g., total overhead cost = $100,000 l Standardlevel of output l Standard level of output is what the activity level for the cost driver should be. e.g., total labor hours should be 20,000 Standard Costs Manufacturing Overhead Example The High Point Furniture Company applies overhead to tables based on machine hours.

24-33 l Budgeted overhead cost l Budgeted overhead cost is the amount of overhead cost that should be incurred to produce at the standard level of output. e.g., total overhead cost = $100,000 l Standardlevel of output l Standard level of output is what the activity level for the cost driver should be. e.g., total labor hours should be 20,000 budgeted overhead cost Standardlevel of output Total budgeted overhead cost at the standard level of output Standard level of output rate Standard overhead rate per unit = Standard Costs Manufacturing Overhead Example

24-34 l Budgeted overhead cost l Budgeted overhead cost is the amount of overhead cost that should be incurred to produce at the standard level of output. e.g., total overhead cost = $100,000 l Standardlevel of output l Standard level of output is what the activity level for the cost driver should be. e.g., total labor hours should be 20,000 rate Standard overhead rate per unit (i.e, hour) = $100,000 20,000 =$5 Standard Costs Manufacturing Overhead Example

24-35 l Budgeted overhead cost l Budgeted overhead cost is the amount of overhead cost that should be incurred to produce at the standard level of output. e.g., total overhead cost = $100,000 l Standardlevel of output l Standard level of output is what the activity level for the cost driver should be. e.g., total labor hours should be 20,000 cost rate v Standard overhead cost is standard overhead rate times number of activity units for each unit of finished product e.g., $5 X 2 labor hours = $10 Standard Costs Manufacturing Overhead Example

24-36 Standard Costs For One Table Direct materials - $6 X 5 sheets $30 Direct labor - $10 X 2 hours 20 Manufacturing overhead - $5 X 2 labor hours 10 Total standard cost $60 Standard Costs Summary of Examples

24-37 Computing Variances l Standard cost variance for the actual volume level attained Amount by which actual cost differs from standard cost for the actual volume level attained l Favorable variance Actual cost is less than standard cost l Unfavorable variance Actual cost is greater than standard cost

24-38 Know how to calculate all six cost variances and what causes each. * For the actual volume level attained * * * * * Computing Variances 872

24-39 Let’s use what we have learned to calculate the six standard cost variances for a different company, starting with direct materials. Computing Variances

24-40 Hanson Inc. has the following material standard to manufacture one Zippy: 1.5 pounds per Zippy at $4.00 per pound Records last week show 1,700 pounds of material were purchased in May at a total cost of $6,630. The material was used to make 1,000 Zippies in May. Computing Variances Materials Price Variance AP = $6,630 ÷ 1,700 lbs AP = $3.90 per lb MPV = (AP - SP) x AQ MPV = ($ ) x 1,700 lbs. MPV = -$170 Favorable Materials Price Variance Zippy

24-41 Hanson Inc. has the following material standard to manufacture one Zippy: 1.5 pounds per Zippy at $4.00 per pound Records last week show 1,700 pounds of material were purchased in May at a total cost of $6,630. The material was used to make 1,000 Zippies in May. AP = $6,630 ÷ 1,700 lbs AP = $3.90 per lb MPV = (AP - SP) x AQ MPV = ($ ) x 1,700 lbs. MPV = -$170 Favorable Note that the authors’ use of +/- is counter- intuitive Computing Variances Materials Price Variance Zippy

24-42 * actual standard Materials inventory must always be debited for the actual quantity X standard price 1,700 lbs. X $4.00 = $6,800 * Price variance is recorded at time of purchase. Recording Variances Materials Price Variance

24-43 Hanson Inc. has the following material standard to manufacture one Zippy: 1.5 pounds per Zippy at $4.00 per pound Records last week show 1,700 pounds of material were purchased in May at a total cost of $6,630. The material was used to make 1,000 Zippies in May. Materials Usage Variance SQ = 1,000 units × 1.5 lbs per unit SQ = 1,500 lbs MUV = (AQ - SQ) x SP MUV = (1,700lbs - 1,500lbs) x $4.00 MUV = +$800 unfavorable Computing Variances Materials Usage Variance Zippy

24-44 actual standard Materials inventory must always be relieved for the actual quantity X standard price 1,700 lbs. X $4.00 = $6,800 * * Recording Variances Materials Usage Variance

24-45 standard standard Work in Process Inventory must always be debited for the standard quantity X standard price (1,000 units X 1.5 lbs.) X $4.00 = $6,000 * * Usage variance is recorded at time of use. Can materials price and usage variances be added to get a total materials variance? Recording Variances Materials Usage Variance

24-46 Now let’s calculate standard cost variances for direct labor. Computing Variances

24-47 Hanson Inc. has the following labor standard to manufacture one Zippy: 1.5 standard hours per Zippy at $6.00 per hour Payroll records show 1,450 hours were worked at a total labor cost of $8,990 to make 1,000 Zippies. Computing Variances Labor Rate Variance Labor Rate Variance AR = $8,990 ÷ 1450 hours AR = $6.20 per hour LRV = (AR - SR) X AH LRV = ($ $6.00) X 1,450 hrs LRV = +$290 unfavorable Zippy

24-48 Hanson Inc. has the following labor standard to manufacture one Zippy: 1.5 standard hours per Zippy at $6.00 per hour Payroll records show 1,450 hours were worked at a total labor cost of $8,990 to make 1,000 Zippies. Labor Efficiency Variance SH = 1,000 units × 1.5 hours per unit SH = 1,500 hours LEV = (AH - SH) X SR LEV = (1,450 hrs - 1,500 hrs) X $6.00 LEV = -$300 favorable Computing Variances Labor Efficiency Variance Zippy

24-49 Recording Variances Labor Rate & Efficiency Variances Note that unlike materials variances, both labor variances are recorded at the same time. (i.e., when the payroll summary account is cleared out.)

* standard standard Work in Process Inventory must always be debited for the standard quantity X standard price (1,000 units X 1.5 lbs.) X $6.00 = $9,000 * * Source? Recording Variances Labor Rate & Efficiency Variances

24-51 Now let’s calculate standard cost variances for manufacturing overhead. Computing Variances

24-52 rate l Overhead is applied to goods produced using a standard overhead rate. l Overhead rate is set prior to the start of the period. standard level of output Standard level of output Total budgeted overhead cost at the standard level of output Standard level of output rate Standard overhead rate per unit = Standard Overhead Rate

24-53 Standard Overhead Rate per unit variable Contains a variable per unit component which stays constant at all levels of activity. fixed Contains a fixed per unit component which declines as activity level increases. standard level of output Is a function of the projected volume level chosen to determine the rate. (i.e., standard level of output) Standard Overhead Rate

24-54 Budget Variance actualbudgeted for the actual volume attained Is calculated as the difference between total actual overhead cost and budgeted amount of overhead for the actual volume attained Volume Variance budgeted for the actual volume level attained applied standard level of output Is calculated as the difference between the budgeted amount of overhead for the actual volume level attained and the applied overhead at the standard level of output Overhead Variances

24-55 Overhead Variances Actual VolumeStandard Level Level Attainedof Output Budgeted Applied Overhead at Overhead at Actual Actual Volume Standard Level Overhead Level Attained of Output Budget Variance Volume Variance AOH - BOH BOH - Applied OH AOH = Actual Overhead BOH = Budgeted Overhead

24-56 Overhead Variances Budget Variance Volume Variance Actual VolumeStandard Level Level Attainedof Output Budgeted Applied Overhead at Overhead at Actual Actual Volume Standard Level Overhead Level Attained of Output Total Overhead Variance

24-57 Total Overhead Variance Overhead Variances Budget Variance Volume Variance Shows how economically overhead services were purchased and how efficiently overhead services were used. Contains both fixed and variable costs. Actual VolumeStandard Level Level Attainedof Output Budgeted Applied Overhead at Overhead at Actual Actual Volume Standard Level Overhead Level Attained of Output

24-58 Total Overhead Variance Overhead Variances Budget Variance Volume Variance Caused by producing at a level other than that used for computing the standard overhead rate. Contains only fixed costs. Actual VolumeStandard Level Level Attainedof Output Budgeted Applied Overhead at Overhead at Actual Actual Volume Standard Level Overhead Level Attained of Output

24-59 Flexible budgets, showing budgeted amount of overhead for various levels of activity, are used to analyze overhead costs. Overhead Variances Hanson’s flexible budget for overhead

24-60 Overhead Variances Example Hanson, Inc. has the following flexible budget for overhead: standard activity level Hanson applies overhead based on machine hour activity and expects to produce 1,500 Zippies. (i.e., a standard activity level of 3,000 machine hours) Machine Hours2,000 3,000 4,000 Zippies1,000 1,500 2,000 Variable Overhead4,000$6,000$8,000$ Fixed Overhead9,000 Total Overhead13,000$15,000$17,000$ Zippy

24-61 Machine Hours2,000 3,000 4,000 Zippies1,000 1,500 2,000 Variable Overhead4,000$6,000$8,000$ Fixed Overhead9,000 Total Overhead13,000$15,000$17,000$ Variable Overhead Rate $6,000 ÷ 3,000 machine hours = $2.00 per machine hour (constant at all activity levels) Fixed Overhead Rate $9,000 ÷ 3,000 machine hours = $3.00 per machine hour (different at each activity level) Overhead Variances Example Zippy

24-62 Hanson’s actual production for the period was 1,600 Zippies resulting in 3,200 standard machine hours. Actual total overhead cost for the period was $15,450. Overhead Variances Example Zippy Compute the overhead budget and volume variances.

24-63 $15,450 $9,000 fixed + $6,400 variable $2.00 per hr. × 3,200 hrs. $15,450 $9,000 fixed 3,200 hrs. + × $6,400 variable $5.00 per hr. $2.00 per hr. variable plus $3.00 per hr. fixed Overhead Variances Example Zippy Actual VolumeStandard Level Level Attainedof Output Budgeted Applied Overhead at Overhead at Actual Actual Volume Standard Level Overhead Level Attained of Output $15,450

24-64 Budget variance $50 unfavorable Volume variance $600 favorable $15,450 $9,000 fixed 3,200 hrs. + × $6,400 variable $5.00 per hr. $15,450 $15,400 $16,000 Overhead Variances Example Zippy Actual VolumeStandard Level Level Attainedof Output Budgeted Applied Overhead at Overhead at Actual Actual Volume Standard Level Overhead Level Attained of Output Let’s try a slightly different approach for getting the $15,400 of Budgeted Overhead.

24-65 Machine Hours2,000 3,000 4,000 Zippies1,000 1,500 2,000 Variable Overhead4,000$6,000$8,000$ Fixed Overhead9,000 Total Overhead13,000$15,000$17,000$ Overhead Variances Example Hanson’s flexible budget for overhead Standard activity level 100%133% 67%

24-66 Machine Hours2,000 3,000 3,200 Zippies1,000 1,500 1,600 Variable Overhead4,000$6,000$6,400$ Fixed Overhead9,000 Total Overhead13,000$15,000$15,400$ Overhead Variances Example Hanson’s flexible budget for overhead Standard activity level 100%107% 67% Actual volume level attained BOH

24-67 Overhead account is closed and both variances are recorded at end of period in the same entry. Recording Overhead Variances

24-68 Investigating Variances l The decision to investigate a variance is based on: u Dollar amount of variance. u Size of variance relative to cost incurred. u Controllability of cost associated with variance. All of these relate to the “Management by Exception” concept l Variances may be interdependent. l Performance reports contain variances along with budgeted and actual cost data.

24-69 Variance Analysis and Management by Exception Now that I know all about standard cost variances, how do I apply that management by exception concept? Well, sir, you should keep in mind what my daddy taught me: "If it ain't broke, don't fix it” and "Don't sweat the small stuff."

24-70 Can you tell me which variances to investigate? Variance Analysis and Management by Exception Type of Product Cost Amount Direct Material Direct Labor Manufacturing Overhead

24-71 Possible guidelines are: u Dollar amount or percentage of the standard u Controllability of the cost variance Variance Analysis and Management by Exception Can you tell me which variances to investigate?

24-72 Reporting Variances

l Variance may be closed entirely to Cost of Goods Sold (normal case for small variances) or l Variance may be closed by prorating to Work in Process, Finished Goods, and Cost of Goods Sold based on relative size of these accounts. Disposing of Variances

24-74 THE END