Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 16 Standard Costing, Variance Analysis and Kaizen Costing

16-2 Learning Objective 1

16-3 benchmarks for measuring performance. the expected level of performance. used for planning labor and material requirements. Standard costs are based on carefully predetermined amounts. Using Standard-Costing Systems for Control

16-4 STANDARD COST a budget for the production of one unit of product or service STANDARD COST a budget for the production of one unit of product or service ACTUAL COST incurred and recorded in the production of the product or service ACTUAL COST incurred and recorded in the production of the product or service COST VARIANCE the difference between the actual cost and the standard cost COST VARIANCE the difference between the actual cost and the standard cost Using Standard-Costing Systems for Control

16-5 Product cost Standard A standard cost variance is the amount by which an actual cost differs from the standard cost. This variance is unfavorable because the actual cost exceeds the standard cost. Using Standard-Costing Systems for Control

16-6 Direct materials Managers focus on quantities and costs that deviate significantly from standards (a practice known as management by exception). Type of Product Cost Amount Direct labor Standard Management by Exception

16-7 Take the time to investigate only significant cost variances. What is significant? Depends on the size of the organization Depends on the size of the organization Depends on the type of the organization Depends on the production process Depends on the production process Management by Exception

16-8 Prepare standard cost performance report Conduct next period’s operations Analyze variances Identify questions Receive explanations Take corrective actions Begin Variance Analysis Cycle

16-9 Analysis of historical data Analysis of historical data Task analysis Task analysis Used in a mature production process Used in a mature production process Analyze the process of manufacturing the product Analyze the process of manufacturing the product What DID the product cost? What DID the product cost? What SHOULD the product cost? What SHOULD the product cost? Combined approach Combined approach Analyze the process for the step that has changed, but use historical data for the steps that have not changed Analyze the process for the step that has changed, but use historical data for the steps that have not changed Setting Standards

16-10 Accountants, engineers, personnel administrators, and production managers combine efforts to set standards based on experience and expectations. Participation in Setting Standards

16-11 Learning Objective 2

16-12 Perfection versus Practical Standards: A Behavioral Issue PERFECTION STANDARDS PERFECTION STANDARDS PRACTICAL OR ATTAINABLE STANDARDS PRACTICAL OR ATTAINABLE STANDARDS Can only be attained under near perfect conditions Tight as practical, but still expected to be attained Tight as practical, but still expected to be attained Occasional machine breakdowns Normal amounts of raw material waste Occasional machine breakdowns Normal amounts of raw material waste Peak efficiency Lowest possible input prices Best-quality material No disruption in production Peak efficiency Lowest possible input prices Best-quality material No disruption in production

16-13 Should we use practical standards or perfection standards? Practical standards should be set at levels that are currently attainable with reasonable and efficient effort. Perfection versus Practical Standards: A Behavioral Issue

16-14 I agree. Perfection standards are unattainable and therefore discouraging to most employees. Perfection versus Practical Standards: A Behavioral Issue

16-15 Quantity Standards Price Standards Use product design specifications. Use competitive bids for the quality and quantity desired. Setting Standards – Direct Materials

16-16 The standard materials cost for one unit of product is: Standard quantity Standard price for of material one unit of material required for one unit of product × Setting Standards – Direct Materials

16-17 Efficiency standards Rate standards Use time and motion studies for each labor operation. Use wage surveys and labor contracts. Setting Standards – Direct Labor

16-18 The standard labor cost for one unit of product is: Standard number Standard wage rate of labor hours for one hour for one unit of product × Setting Standards – Direct Labor

16-19 Jobs with repetitive tasks lend themselves to efficiency measures. Computing non- manufacturing efficiency variances requires some assumed relationship between input and output activity. Examples Standard Cost in Service Industries

16-20 Standard Cost in Service Industries

16-21 Implementing and maintaining cost standards can be time-consuming, labor-intensive, and expensive. Implementing and maintaining cost standards can be time-consuming, labor-intensive, and expensive. Costs and Benefits of Standard-Costing Systems IMPROVED DECISION MAKING, BUT: IMPROVED DECISION MAKING, BUT: Costs Benefits

16-22 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 Cost Variance Analysis

16-23 A General Model for Variance Analysis Actual quantity Actual quantity Standard quantity × × × Actual price Standard price Standard price Price / Rate variance Quantity / Efficiency variance

16-24 A General Model for Variance Analysis Actual quantity Actual quantity Standard quantity × × × Actual price Standard price Standard price Standard price is the amount that should have been paid for the resources acquired. Price / Rate variance Quantity / Efficiency variance

16-25 Quantity / Efficiency variance Price / Rate variance A General Model for Variance Analysis Actual quantity Actual quantity Standard quantity × × × Actual price Standard price Standard price Standard quantity is the quantity allowed for the actual good output.

16-26 A General Model for Variance Analysis Actual quantity Actual quantity Standard quantity × × × Actual price Standard price Standard price Materials price variance Materials quantity variance Labor rate variance Labor efficiency variance Variable overhead Variable overhead spending variance efficiency variance AQ(AP - SP) SP(AQ - SQ) AQ = Actual Quantity SP = Standard Price AP = Actual Price SQ = Standard Quantity Price / Rate variance Quantity / Efficiency variance

16-27 Let’s use the concepts of the general model to calculate standard cost variances, starting with direct materials. Standard Costs

16-28 Learning Objective 3

16-29 Koala Camp Gear Company in Melbourne Australia has the following direct material standard to manufacture one Tree Line tent: 12 square meters per tent at $8.00 per square meter (sq m) Last month Koala purchased 40,000 square meters at $8.15 per square meter and used 36,400 square meters to make 3,000 tents. Materials Variances

16-30 We should compute the price variance using the actual quantity purchased. Price variance $6,000 Unfavorable 40,000 sq m 40,000 sq m × × $8.15 per sq m $8.00 per sq m $326,000 $320,000 Actual quantity Actual quantity purchased purchased × × Actual price Standard price Materials Variances

16-31 We should compute the quantity variance using the actual quantity used. Quantity variance $3,200 Unfavorable 36,400 sq m 36,000 sq m × × $8.00 per sq m $8.00 per sq m $291,200 $288,000 Actual quantity used Standard quantity × × Standard price Standard price SQ = 3,000 tents × 12 sq m per tent SQ = 36,000 sq m Materials Variances

16-32 MPV = AQp(AP – SP) MPV = 40,000 sq m × ($8.15 – $8.00) MPV = $6,000 Unfavorable MQV = SP(AQu – SQ) MQV = $8.00(36,400 sq m – 36,000 sq m) MQV = $3,200 Unfavorable We may also calculate materials variances using formulas: Materials Variances

16-33 Okay. I’ll compute the price variance when materials are purchased, and the usage variance as soon as material is used. I need the variances as soon as possible so that I can better identify problems and control costs. You accountants just don’t understand the problems we production managers have. Reporting Materials Variances

16-34 Responsibility for Materials Variances I am not responsible for this unfavorable materials usage variance. You bought poor quality materials, so my people had to use more of it. Your poorly trained workers and poorly maintained equipment caused the problems. Also, your poor scheduling requires rush orders of materials at higher prices, causing unfavorable price variances.

16-35 Now let’s calculate standard cost variances for direct labor. Standard Costs

16-36 Koala has the following direct labor standard to manufacture one Tree Line tent: 2 standard hours per tent at $18.00 per direct labor hour Last month 5,900 direct labor hours were worked at $19.00 per hour to make 3,000 tents. Labor Variances

16-37 Actual hours Actual hours Standard hours × × × Actual rate Standard rate Standard rate Rate variance $5,900 Unfavorable Efficiency variance $1,800 Favorable 5,900 hours 5,900 hours 6,000 hours × × × $19.00 per hour $18.00 per hour $18.00 per hour $112,100 $106,200 $108,000 SH = 3,000 tents × 2 hours per tent SH = 6,000 hours Labor Variances

16-38 LRV = AH(AR - SR) LRV = 5,900 hrs($ $18.00) LRV = $5,900 Unfavorable LEV = SR(AH - SH) LEV = $18.00(5,900 hrs - 6,000 hrs) LEV = $1,800 Favorable We may also calculate labor variances using formulas: Labor Variances

16-39 Labor Rate Variance – A Closer Look Production managers who make work assignments are generally responsible for price variances. High skill, high rate Low skill, low rate Using highly paid skilled workers to perform unskilled tasks results in an unfavorable price variance.

16-40 Labor Efficiency Variance – A Closer Look Unfavorable Efficiency Variance Poorly trained workers Poor quality materials Poorly maintained equipment Poor supervision of workers

16-41 You used too much time because of poorly trained workers and poor supervision. I am not responsible for the unfavorable labor efficiency variance! You bought poor quality materials, so my people took more time to process them. Responsibility for Labor Variances

16-42 Maybe I can attribute the labor and materials variances to personnel for hiring the wrong people and training them poorly. Responsibility for Labor Variances

16-43 In some manufacturing processes, a certain amount of defective production or spoilage is normal. Example: 1,000 liters of chemicals are normally required in a chemical process in order to obtain 800 liters of good output. If total good output in February is 5,000 liters, what is the standard allowed quantity of input? Good output quantity = 80% X Input quantity Good output quantity ÷ 80% = Input quantity allowed 5,000 liters of good output ÷ 80% 5,000 liters of good output ÷ 80% = 6,250 liters of input allowed = 6,250 liters of input allowed Allowance for Defects or Spoilage

16-44 Learning Objective 4

16-45?? How does a manager know when to follow up on a cost variance and when to ignore it? How does a manager know when to follow up on a cost variance and when to ignore it? Size of variance Absolute amount Relative amount Significance of Cost Variances: When to Follow Up

16-46 Size of variance Dollar amount Percentage of standard Recurring variances Trends Controllability Favorable variances Costs and benefits of investigation What clues help me to determine the variances that I should investigate? Significance of Cost Variances

16-47 Significance of Cost Variances: When to Follow Up How do I know which variances to investigate? Larger variances, in dollar amount or as a percentage of the standard, are investigated first. We could use a rule of thumb such as: investigate all variances that are over $10,000 or over 10 percent of the standard cost.

16-48 None of the variances are greater than $10,000 or 10% for any one month, but they should be investigated because of they have continued for several months. None of the variances are greater than $10,000 or 10% for any one month, but they should be investigated because of they have continued for several months. Significance of Cost Variances: When to Follow Up What about recurring variances?

16-49 Significance of Cost Variances: When to Follow Up What about trends? None of the variances are greater than $10,000 or 10% for any one month, but they should be investigated because of the unfavorable trend. None of the variances are greater than $10,000 or 10% for any one month, but they should be investigated because of the unfavorable trend.

16-50 Controllability A manager is more likely to investigate a variance that is controllable by someone in the organization than one that is not. 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. 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 Cost and benefits of investigation The decision whether to investigate a variance is a cost - benefit decision Significance of Cost Variances: When to Follow Up

16-51 Display variations in a process and help to analyze the variations over time. Distinguish between random variations and variations that should be investigated. Provide a warning signal when variations are beyond a specified level. Control charts Statistical Analysis

Variance measurements Favorable limit Unfavorable limit Desired value Warning signals for investigation Statistical Analysis

16-53 Learning Objective 5

16-54 Behavioral Effects of Standard Costing Standard costs, budgets and variances are used to evaluate the performance of individuals and departments 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 They can profoundly influence behavior when they are used to determine salary increases, bonuses and promotions

16-55 Direct-materials price variance Direct-materials quantity variance Direct-labor rate variance Direct-labor efficiency variance Purchasing manager 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 Influence Cost Variances?

16-56 Research and develop- ment Design Supply Produc- tion Marketing Distri- bution Customer service Human resources Human resources Physical resources Physical resources Variances in one part of the value chain can be due to root causes in another part of the chain. Interaction among variances often occurs, making it difficult to determine the responsibility for a particular variance. Interaction among variances often occurs, making it difficult to determine the responsibility for a particular variance. Interaction among Variances Value chain perspective Exh. 16-5

16-57 Learning Objective 6

16-58 Work-in-process inventory Direct-materials cost Direct-labor cost Manufacturing overhead Finished-goods inventory Cost of goods soldIncome summary Product cost transferred when product is finished Product cost transferred when product is sold Expense closed into Income summary at end of accounting period Exh Using Standard Costs for Product Costing

16-59 Standard Cost Journal Entries Inventories are recorded at standard cost. Variances are recorded as follows: Favorable variances are credits, representing savings in production costs. Unfavorable variances are debits, representing excess production costs. Standard cost variances are usually closed to cost of goods sold. Favorable variances decrease cost of goods sold. Unfavorable variances increase cost of goods sold. Inventories are recorded at standard cost. Variances are recorded as follows: Favorable variances are credits, representing savings in production costs. Unfavorable variances are debits, representing excess production costs. Standard cost variances are usually closed to cost of goods sold. Favorable variances decrease cost of goods sold. Unfavorable variances increase cost of goods sold.

16-60 Impact of Information Technology on Standard Costing Materials purchases and uses are recorded at standard, using bar codes. Labor time and rate are recorded at standard, using bar codes and employee IDs. CAD designers can access the data base for instant design cost estimates. Standard cost data base

16-61 Learning Objective 7

16-62 Standard Costing: Its Traditional Advantages Management by exception Performance evaluation Employee motivation Sensible cost comparisons Advantages More stable product costs Less expensive than actual- or normal- costing systems

16-63 Learning Objective 8

16-64 Criticisms of Standard Costing in Today’s Manufacturing Environment There is too much focus on the cost and efficiency of direct labor. Automation reduces labor costs and the significance of labor variances. Automated manufacturing processes tend to be more consistent in meeting production specifications. Variance reports are often provided too late to be useful to managers. There is too much focus on the cost and efficiency of direct labor. Automation reduces labor costs and the significance of labor variances. Automated manufacturing processes tend to be more consistent in meeting production specifications. Variance reports are often provided too late to be useful to managers. Variances are often too aggregated. They are not tied to specific product lines, production batches, or to the flexible management system. Standard costing may not be applicable in flexible manufacturing operations with short life-cycle products. There is too much focus on cost minimization rather than increasing product quality or customer service. Variances are often too aggregated. They are not tied to specific product lines, production batches, or to the flexible management system. Standard costing may not be applicable in flexible manufacturing operations with short life-cycle products. There is too much focus on cost minimization rather than increasing product quality or customer service.

16-65 Adaptation of Standard-Costing Systems Applications of standard costing have adapted to changes in the manufacturing environment and the resulting criticisms leveled at standard costing. Automation means more overhead, less labor. Reduced importance of labor standards. More emphasis on material and overhead costs. Less use of labor as a cost driver.

16-66 Adaptation of Standard-Costing Systems Applications of standard costing have adapted to changes in the manufacturing environment and the resulting criticisms leveled at standard costing. Reduces labor efficiency variance Reduces material quantity variance Automation Reduces variation in quality and increases quality

16-67 Adaptation of Standard-Costing Systems Applications of standard costing have adapted to changes in the manufacturing environment and the resulting criticisms leveled at standard costing. Shorter product life cycles Elimination of non-value- added costs More frequent revisions of standard costs More frequent benchmarking Real-time information systems provide more timely variance reports Non-financial measures such a delivery times are more important

16-68 Learning Objective 9

16-69 Comparing Standard Costing and Kaizen Costing Standard costing – the use of carefully predetermined product costs for budgeting and performance evaluation. Standard costs are typically used in established production processes. Kaizen costing – the emphasis is on continuous reduction of production costs. Rather than standards or targets, the goal is current costs that are less than previous costs. Standard costing – the use of carefully predetermined product costs for budgeting and performance evaluation. Standard costs are typically used in established production processes. Kaizen costing – the emphasis is on continuous reduction of production costs. Rather than standards or targets, the goal is current costs that are less than previous costs.

16-70 Cost per product unit 12/31/x012/31/x1 Time Cost base for next year Actual cost reduction achieved Current year cost base Kaizen goal: cost reduction rate Actual cost performance of the current year Exh Kaizen Costing Kaizen goal: cost reduction amount

16-71 Learning Objective 10

16-72 Production Mix and Yield Variances Nearly all production processes require multiple materials and labor inputs. A summary quantity variance for materials and labor would hide the individual effects of these inputs. The quantity variances can be analyzed into two further variances: Mix (the difference between actual and standard input proportions) Yield (the difference between actual and standard input used) The analysis assumes, of course, that the inputs can be substituted for each other.

16-73 End of Chapter 16