Standard Costing, Variance Analysis, and Kaizen Costing

Standards Predetermined amount for what should happen Quantity standard Quantity of the resource that should be consumed Cost standard Cost per unit that should be paid for the resource Provides a context for evaluating actual amounts

Advantages Provides a context for evaluating actual amounts Standard costs do not fluctuate Simplified accounting Less expensive than actual costing

Management by Exception Take the time to investigate only significant cost variances Depends on the Size of the organization Depends on the Type of the Organization Depends on the Production Process

Setting Standards Analysis of historical data Used in a mature production Process Task analysis Analyze the process of manufacturing the product A Combined approach Analyze the process for the step that has changed, but use historical data for the steps that have not changed

Perfection versus practical standards: A behavioral issue Perfection standards Can only be attained under near perfect conditions Peak efficiency Lowest possible input prices Best-quality material No disruption in production Practical or attainable standards Tight as practical, but still are expected to be attained Occasional machine breakdowns Normal amounts of raw material waste

Cost and benefits of standard-costing systems Provide information that can help managers control costs Time consuming Costly Labor- intensive Expensive process Must be updated periodically to reflect changes in the cost structure of production process The benefit of information, in terms of improved production cost control and decision making, must be weighed against the cost of generation the information

Standard direct material quantity: Total amount of material normally required to a finished product, including allowances for normal waste or inefficiency any purchase discount. Standard direct-material price: Is the total delivered cost after subtracting any purchase discounts. Standard direct-labor quantity: Is the number of labor hours normally needed to manufacture one unit of product. Standard direct-labor: Is the total hourly cost of compensation, including fringe benefits.

Analysis of Cost Variances Cost management analyst uses the following deviations to control the excess costs: 1- Direct-Material Variances 2- Direct-Labor Variances 1- Direct-Material Variance Imagine the company manufactures tents. Standard amount of material in square meters=36,000 Direct material purchases in square meters =40,000 Direct material used in square meters = 36,400 Standard cost per square meter= $ 8.00 Actual Cost per square meter= $ The Budgeted or Standard costs for direct materials are as follows: Total standard direct-material cost=36,000* $8= $288,000 -The Actual costs for the direct-materials are as follows: -Direct material purchases=40,000*$8.15=$326,000 -Direct material used=36,400*$8.15=$296, Direct-Material Price Variance = (Quantity purchased)*(Actual price-Standard price) Direct-Material Price Variance = 40,000($8.15-$8)=$6,000 Unfavorable  The variance is unfavorable, because the actual purchase price exceeded the standard price.

2-1-Direct-Material Quantity Variance = (Standard Price)*(Actual Quantity Used-Standard Quantity Allowed) =$8(36, )=$3,200 Unfavorable  The variance is unfavorable, because the actual quantity of direct material exceeded the standard quantity allowed. NOTICE: Standard quantity of material must be based on the actual production output to provide helpful information for management. 2- Direct-Labor Variance 1-2- Direct-Labor rate Variance=Actual Hours Used(Actual Rate per Hour-Standard Rate per Hour) = 5,900($19-$18)= $5,900 Unfavorable  This variance is unfavorable because the actual rate exceeded the standard rate Direct-Labor Efficiency Variance= Standard Rate per Hour (Actual Hour used-Standard Hours Allowed)=$18(5,900-6,000)=$1.80  This variance is favorable because the actual number of direct labor hours were less than the number of standard hours allowed.

NOTICE: The number of standard hours of direct labor allowed is based on the actual production output. Multiple Types of Direct Material and Direct Labor Manufacturing processes usually involve types of direct material. In such cases, direct materials price and quantity variances are computed for each type of material. Then these variances are added to obtain a total price variance and a total quantity variance: Direct Material X…………………….$1,500 F Direct Material Y…………………….$2,400 U Direct Material Z…………………….$900 U Total Variance………………………..$1,800 U Allowance for Defects or Spoilage In some manufacturing processes, a certain amount of defective production or spoilage is normal. Forexample when 1000 units of inputs are required to obtain 800 outputs and the total output in a certain period is going to be 5000 units, the standard allowed quantity of input will be calculated as below: Good output quantity=80% * Input quantity Input allowed= 5000/ 80%= 6250 units of input allowed Significance of Cost Variances: Managers are busy people. They don’t have time to investigate the causes of every cost variance. A manager applies judgement and experience in making guesses, following his guesses and relying on intution to determine when to investigate a variance.Nevertheless, these are guidelines and rules of thumb that managers often apply.

Size of variance How does a manager know when to follow up on a cost variance and when to ignore it? Absolute size Relative size Managers are more likely to follow up on large variances than on small size Standard direct- material cost: 200,000 $ Material quantity variance: 40,000 $(20%) Standard direct –labor cost:3,000,000 Labor efficiency variance: 60,000$(2%)

The Rule of Thumb: Investigate variances that are either more than 10,000 $ or more than 10% of standard cost Recurring variances None of the variances are greater than $10,000 or 10%, but this variance should be investigated because it has occurred at a reasonably high amount for four months

Trends None of the variances are greater than $10,000 or 10%, but this variance should be investigated because it has an unfavorable trend. Controllability A manager is more likely to investigate a variance that is controllable by someone in the organization than one that is not Favorable Variances It is as important to investigate significant favorable variances as well as significant unfavorable variances Cost and Benefits of Investigation The decision whether to investigate a variance is a cost - benefit decision

A STATISTICAL CONTROL CHART plots cost variances across time and compares them with a statistically determined critical value that triggers an investigation Statistical Analysis 1 standard deviation 1 standard deviation X X X X X X Time Jan.Feb.MarchAprilMayJune Favorable variances Unfavorable variances Critical value Investigate Behavioral Effects Of Standard Costing Standard costs, budgets, and variances are used to evaluate the performance of individuals and departments They can profoundly influence behavior when they are used to determine salary increases, bonuses, and promotions

Direct-material price variance Direct-material quantity variance Direct-labor rate variance Direct- labor efficiency variance The purchasing manager The production supervisor Get the best prices available for purchased goods and services through skillful purchasing practices Skillful supervision and motivation of production employees, coupled with the careful use and handling of materials, contribute to minimal waste Generally results from using a different mix of employees than that anticipated when the standard were set Motivating employees toward production goals and effective work schedules improves efficiency Which Managers Generally Influence Cost Variances?

Interaction among variances Interaction among variances often occur making it difficult to determine the responsibility for a particular variance. Variances in one part of the value chain can be due to root causes in another part of the chain Value chain perspective Research and development DesignSupplyProductionMarketingDistribution Customer service

Use of standard cost for product costing Standard costing has long been used in manufacturing and some distribution environment as a control for measuring variation for expected results.

Standard costing system  Direct material  Direct labor  Disposition of variances

Impact of information technology on standard costing  Use of bar codes  Computer-aided design

Standard costing: its traditional advantage  Enables managers to employ management by exception.  Standard costs provide a basis for sensible cost comparison.  Variances provide a means of performance evaluation and rewards for employees.  They provide motivation for employees to adhere standards.  Use of standard costs in product costing results in more stable product costs.  A standard-costing system is usually less expensive.

Criticisms of Standard Costing in Today’s Manufacturing Environment Variances can be too aggregated Work best in stable, mass production environment Focus on cost minimization, not qualitative issues Greater automation reduces variances Standards are often relevant for only a short time

Adaption of Standard-Costing Systems Reduced importance of labor standards and variances Emphasis on material and overhead costs Cost drivers Shifting cost structure High quality and no defects Non-value-added costs New measures and standards

Kaizen costing most consistent with the saying "slow and steady wins the race." Kaizen costing is the process of cost reduction during the manufacturing phase of a product

Flexible-Overhead Budgets, budget that adjusts or flexes for changes in the volume of activity Flexible budget is not based on only one level of activity

Measuring the activity – input or output – When different type of product Flexible-Overhead budget illustration -Columnar flexible budget -Formula flexible budget

Overhead application – Normal costing: Actual figures – Standard costing: Standard figures allowed What is difference and similarities? Choice of Activity Measure: Technology Money!

Impact of Information Technology Many business are adopting integrated business software package that handle abroad range of computing need such as customer and supplier databases, personnel and pay roll function, production scheduling and management

Overhead Cost Variance At the end of each accounting period, the cost –management analyst uses the flexible- overhead budget to determine the level of overhead cost that should have been incurred, given the actual level of activity.

Variable- Overhead Efficiency Variance It is difference between the actual and standard quantity of an activity base multiplied by the standard variable-overhead rate

Fixed-Overhead Budget Variance The variance that managers use to control fixed overhead is called the fixed-overhead budget variance. The fixed-overhead budget variance is the difference between actual fixed overhead and budgeted fixed overhead given actual output

Capacity Utilization : Positive volume variance : It measures the cost of underutilizing productive capacity. The fault of this view: It ignores the real cost of underutilization productive capacity and the real cost results not produced when capacity is underutilized.

What do four –way, three-way, two-way variance analyses tell the cost manager ? Variable overhead spending variance Variable overhead efficiency variance Fixed overhead budgeted variance Fixed overhead volume variance

Journal entries under standard costing Manufacturing overhead……………………… 62,980 Indirect-material inventory.………………. 19,350 Wages payable………………………………….. 32,610 Utilities payable ………….…………………… 2,170 Accumulated depreciation ………………. 1,300 Prepaid insurance &property taxes.... 1,050 Engineering salaries payable ………….… 6,500

Work-in-process Inventory ……………… …………… 49,500 manufacturing overhead………………………….. 49,500 Actual 62,980 49,500 Applied Manufacturing Overhead

Disposition of Variances Cost of good sold……………………………. 13,480 Manufacturing overhead……… ,480

How Does ABC Affect Performance Reporting? Conventional and activity based flexible budgets use different cost drivers for overhead costs. The differences are important for performance reporting. The conventional budget: Treats quality assurance, setup, materials-handling and engineering costs as fixed. The activity-based flexible budget : Provides a more accurate prediction (And benchmark) of overhead costs. A more accurate benchmark against which to compare actual costs. Shows that quality assurance, setup, materials-handling and engineering costs are all variable with respect to the appropriate cost driver.

Standard Costing in a Just-in-Time Environment As a result, some companies have simplified their accounting system by charging all manufacturing costs directly to Costs of Goods Sold. This method of accounting is known as Backflush costing. Just-in-Time manufacturing setting with demand-pull of products Manufacturing process Minimizing inventories

Sales variance analysis with cost variance Sales performance is equally important in affecting a company’s bottom-line. Sales variance analysis: A technique used to help management understand and manage the effects of the company’s sales performance on its profitability. Sales Price Sales Volume of Each Product Revenue Contribution Margin Profit

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