Standard Costs and Operating Performance Measures

Standard Costs and Operating Performance Measures
Chapter 11: 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. Chapter 11

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
Accountants, engineers, purchasing agents, and production managers combine efforts to set standards that encourage efficient future operations. Setting price and quantity standards requires the combined expertise of everyone who has responsibility for purchasing and using inputs. In a manufacturing setting, this might include accountants, engineers, purchasing managers, production supervisors, line managers, and production workers. Standards should be designed to encourage efficient future operations, not just a repetition of past inefficient operations.

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

Learning Objective 1 Explain how direct materials standards and direct labor standards are set. Learning objective number 1 is to explain how direct materials standards and direct labor standards are set.

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 Standards Six Sigma advocates have sought to eliminate all defects and waste, rather than continually build them into standards. As a result allowances for waste and spoilage that are built into standards should be reduced over time. Six Sigma advocates argue that waste and spoilage should not be tolerated. If allowances for waste and spoilage are built into the standard quantity, the level of those allowances should be reduced over time.

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.

Standard Cost Card – Variable Production Cost
A standard cost card for one unit of product might look like this: The standard cost card is a detailed listing of the standard amounts of direct materials, direct labor, and variable overhead inputs that should go into a unit of product, multiplied by the standard price or rate that has been set for each input.

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.

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

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.

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.

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.

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.

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.

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

Learning Objective 2 Compute the direct materials price and quantity variances and explain their significance. Learning objective number 2 is to compute the direct materials price and quantity variances and explain their significance.

Material Variances – An Example
Glacier Peak Outfitters has the following direct material standard for the fiberfill in its mountain parka. 0.1 kg. of fiberfill per parka at $5.00 per kg. Last month 210 kgs. of fiberfill were purchased and used to make 2,000 parkas. The material cost a total of $1,029. Here’s an example that will give us an opportunity to compute material price and quantity variances.

Material Variances Summary
Actual Quantity Actual Quantity Standard Quantity × × × Actual Price Standard Price Standard Price 210 kgs kgs kgs × × × $4.90 per kg $5.00 per kg $5.00 per kg. = $1, = $1, = $1,000 The materials price variance, defined as the difference between what is paid for a quantity of materials and what should have been paid according to the standard, is $21 favorable. The price variance is labeled favorable because the actual price was less than the standard price by $0.10 per kilogram. The materials quantity variance, defined as the difference between the quantity of materials used in production and the quantity that should have been used according to the standard, is $50 unfavorable. The quantity variance is labeled unfavorable because the actual quantity exceeds the standard quantity allowed by 10 kilograms Price variance $21 favorable Quantity variance $50 unfavorable

Actual Quantity Actual Quantity Standard Quantity × × × Actual Price Standard Price Standard Price 210 kgs kgs kgs × × × $4.90 per kg $5.00 per kg $5.00 per kg. = $1, = $1, = $1,000 $1,029  210 kgs = $4.90 per kg The actual price of $4.90 per kilogram is computed by dividing the actual cost of the material by the actual number of kilograms purchased. Price variance $21 favorable Quantity variance $50 unfavorable

Actual Quantity Actual Quantity Standard Quantity × × × Actual Price Standard Price Standard Price 210 kgs kgs kgs × × × $4.90 per kg $5.00 per kg $5.00 per kg. = $1, = $1, = $1,000 0.1 kg per parka  2,000 parkas = 200 kgs The standard quantity of 200 kilograms is computed by multiplying the standard quantity per parka times the number of parkas made. Price variance $21 favorable Quantity variance $50 unfavorable

Material Variances: Using the Factored Equations
Materials price variance MPV = AQ (AP - SP) = 210 kgs ($4.90/kg - $5.00/kg) = 210 kgs (-$0.10/kg) = $21 F Materials quantity variance MQV = SP (AQ - SQ) = $5.00/kg (210 kgs-(0.1 kg/parka  2,000 parkas)) = $5.00/kg (210 kgs kgs) = $5.00/kg (10 kgs) = $50 U The equations that we have been using thus far can be factored as shown and used to compute price and quantity variances.

Isolation of Material Variances
I need the price variance sooner so that I can better identify purchasing problems. You accountants just don’t understand the problems that purchasing managers have. I’ll start computing the price variance when material is purchased rather than when it’s used. Most companies compute the materials price variance when materials are purchased. They calculate the materials quantity variance after materials are used in production.

Material Variances The price variance is computed on the entire quantity purchased. The quantity variance is computed only on the quantity used. Hanson purchased and used 1,700 pounds. How are the variances computed if the amount purchased differs from the amount used? The materials price variance is computed using the entire amount of material purchased during the period. The materials quantity variance is computed using only the portion of materials that was used in production during the period.

Materials Quantity Variance Materials Price Variance
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 Material Variances
Your poor scheduling sometimes requires me to rush order material at a higher price, causing unfavorable price variances. I am not responsible for this unfavorable material quantity variance. You purchased cheap material, so my people had to use more of it. The materials variances are not always entirely controllable by one person or department. For example, the production manager may schedule production in such a way that it requires express delivery of raw materials resulting in an unfavorable materials price variance. The purchasing manager may purchase lower quality raw materials resulting in an unfavorable materials quantity variance for the production manager.

1.5 pounds per Zippy at $4.00 per pound
Quick Check  Hanson Inc. has the following direct material standard to manufacture one Zippy: 1.5 pounds per Zippy at $4.00 per pound Last week, 1,700 pounds of material were purchased and used to make 1,000 Zippies. The material cost a total of $6,630. In this example, the company produces a Zippy. The direct materials standard calls for 1.5 pounds per Zippy at $4.00 per pound. Last week, Hanson purchased and used 1,700 pounds of material to produce 1,000 Zippies. The 1,700 pounds of material cost a total of $6,630. Now, we will see several questions based on the information on this screen. You may wish to take some notes to use as you answer the questions. Try to answer each question before advancing to the solution.

Quick Check  Hanson’s material price variance (MPV) for the week was:
Zippy Quick Check  Hanson’s material price variance (MPV) for the week was: a. $170 unfavorable. b. $170 favorable. c. $800 unfavorable. d. $800 favorable. What is Hanson’s material price variance for the week?

Quick Check  Hanson’s material price variance (MPV) for the week was:
Zippy Quick Check  Hanson’s material price variance (MPV) for the week was: a. $170 unfavorable. b. $170 favorable. c. $800 unfavorable. d. $800 favorable. MPV = AQ(AP - SP) MPV = 1,700 lbs. × ($ ) MPV = $170 Favorable We find the material price variance by multiplying the actual quantity of material purchased times the difference between the actual price per pound and the standard price per pound. We find the actual price per pound by dividing the $6,630 total actual price paid for the material by the 1,700 pounds purchased. The $170 favorable material price variance results because Hanson paid 10 cents per pound less than standard for 1,700 pounds of material.

Zippy Quick Check  Hanson’s material quantity variance (MQV) for the week was: a. $170 unfavorable. b. $170 favorable. c. $800 unfavorable. d. $800 favorable. What is Hanson’s material quantity variance for the week?

Zippy Quick Check  Hanson’s material quantity variance (MQV) for the week was: a. $170 unfavorable. b. $170 favorable. c. $800 unfavorable. d. $800 favorable. MQV = SP(AQ - SQ) MQV = $4.00(1,700 lbs - 1,500 lbs) MQV = $800 unfavorable The standard quantity is the amount of material that Hanson should have used to make 1,000 Zippies. We find the standard quantity by multiplying the 1.5 pounds per unit standard for one Zippy times the 1,000 Zippies. Now that we know the standard quantity, let’s calculate the material quantity variance. We find the material quantity variance by multiplying the standard price for one pound of material times the difference between the actual quantity of material and the standard quantity of material. The $800 unfavorable material quantity variance results because Hanson used 200 pounds more than standard to make the 1,000 Zippies, and each pound of material has a standard price of $4.00.

Zippy Quick Check  Actual Quantity Actual Quantity Standard Quantity × × × Actual Price Standard Price Standard Price 1,700 lbs ,700 lbs ,500 lbs × × × $3.90 per lb $4.00 per lb $4.00 per lb. = $6, = $ 6, = $6,000 Here we see a summary of the material price and quantity variance computations in a convenient three-column format. You may find this three-column format more helpful than the equations that we used to answer the previous two questions. Price variance $170 favorable Quantity variance $800 unfavorable

Quick Check  Continued
Zippy Quick Check  Continued Hanson Inc. has the following material standard to manufacture one Zippy: 1.5 pounds per Zippy at $4.00 per pound Last week, 2,800 pounds of material were purchased at a total cost of $10,920, and 1,700 pounds were used to make 1,000 Zippies. Let’s extend the Hanson example by increasing the quantity of material purchased to 2,800 pounds at a total cost of $10,920. All other information is the same as before.

Zippy Quick Check  Continued Actual Quantity Actual Quantity Purchased Purchased × × Actual Price Standard Price 2,800 lbs ,800 lbs × × $3.90 per lb $4.00 per lb. = $10, = $11,200 Hanson actually paid $10,920 for the 2,800 pounds of material. Multiplying the standard price of $4.00 per pound times the 2,800 pounds of material purchased, we find that Hanson should have paid $11,200. The price variance is now $280 favorable. The price variance increases in this example because the quantity purchased increased. The $280 favorable material price variance results because Hanson paid $0.10 per pound less than standard for 2,800 pounds of material. Price variance $280 favorable Price variance increases because quantity purchased increases.

Zippy Quick Check  Continued Actual Quantity Used Standard Quantity × × Standard Price Standard Price 1,700 lbs ,500 lbs × × $4.00 per lb $4.00 per lb. = $6, = $6,000 The material quantity variance is the same as before because Hanson again used the same amount of material as before to make the same number of Zippies. Quantity variance is unchanged because actual and standard quantities are unchanged. Quantity variance $800 unfavorable

Learning Objective 3 Compute the direct labor rate and efficiency variances and explain their significance. Learning objective number 3 is to compute the direct labor rate and efficiency variances and explain their significance.

Labor Variances – An Example
Glacier Peak Outfitters has the following direct labor standard for its mountain parka. 1.2 standard hours per parka at $10.00 per hour Last month, employees actually worked 2,500 hours at a total labor cost of $26,250 to make 2,000 parkas. Now let’s turn our attention back to Glacier Peak Outfitters to illustrate the computation of labor rate and efficiency variances.

Labor Variances Summary
Actual Hours Actual Hours Standard Hours × × × Actual Rate Standard Rate Standard Rate 2,500 hours ,500 hours ,400 hours × × × $10.50 per hour $10.00 per hour $10.00 per hour = $26, = $25, = $24,000 The labor rate variance, defined as the difference between the actual average hourly wage paid and the standard hourly wage, is $1,250 unfavorable. The rate variance is labeled unfavorable because the actual average wage rate was more than the standard wage rate by $0.50 per hour. The labor efficiency variance, defined as the difference between the actual quantity of labor hours and the quantity allowed according to the standard, is $1,000 unfavorable. The efficiency variance is labeled unfavorable because the actual quantity of hours exceeds the standard quantity allowed by 100 hours. Rate variance $1,250 unfavorable Efficiency variance $1,000 unfavorable

Actual Hours Actual Hours Standard Hours × × × Actual Rate Standard Rate Standard Rate 2,500 hours ,500 hours ,400 hours × × × $10.50 per hour $10.00 per hour $10.00 per hour = $26, = $25, = $24,000 $26,250  2,500 hours = $10.50 per hour The actual price (or rate) of $10.50 per hour is computed by dividing the actual total cost for labor by the actual number of hours worked. Rate variance $1,250 unfavorable Efficiency variance $1,000 unfavorable

Actual Hours Actual Hours Standard Hours × × × Actual Rate Standard Rate Standard Rate 2,500 hours ,500 hours ,400 hours × × × $10.50 per hour $10.00 per hour $10.00 per hour = $26, = $25, = $24,000 1.2 hours per parka  2,000 parkas = 2,400 hours The standard quantity of 2,400 hours is computed by multiplying the standard hours for one parka times the number of parkas made. Rate variance $1,250 unfavorable Efficiency variance $1,000 unfavorable

Labor Variances: Using the Factored Equations
Labor rate variance LRV = AH (AR - SR) = 2,500 hours ($10.50 per hour – $10.00 per hour) = 2,500 hours ($0.50 per hour) = $1,250 unfavorable Labor efficiency variance LEV = SR (AH - SH) = $10.00 per hour (2,500 hours – 2,400 hours) = $10.00 per hour (100 hours) = $1,000 unfavorable Factored equations can also be used to compute the rate and efficiency variances.

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.

Responsibility for Labor Variances
I think it took more time to process the materials because the Maintenance Department has poorly maintained your equipment. I am not responsible for the unfavorable labor efficiency variance! You purchased cheap material, so it took more time to process it. However, labor variances are not entirely controllable by one person or department. For example: The Maintenance Department may do a poor job of maintaining production equipment. This may increase the processing time required per unit, thereby causing an unfavorable labor efficiency variance. The purchasing manager may purchase lower quality raw materials resulting in an unfavorable labor efficiency variance for the production manager.

1.5 standard hours per Zippy at $12.00 per direct labor hour
Quick Check  Hanson Inc. has the following direct labor standard to manufacture one Zippy: 1.5 standard hours per Zippy at $12.00 per direct labor hour Last week, 1,550 direct labor hours were worked at a total labor cost of $18,910 to make 1,000 Zippies. Let’s return to the Hanson Company and compute labor variances. The direct labor standard to produce each Zippy is 1.5 hours at $12.00 per hour. Last week, it took 1,550 direct labor hours to produce 1,000 Zippies, and the total labor cost was $18,910. Next, we will see several questions based on the information on this screen. Again, you may wish to take some notes to use as you answer the questions. Also, just as you did with the material variance questions, try to answer each question before advancing to the solution.

Quick Check  Hanson’s labor rate variance (LRV) for the week was:
Zippy Quick Check  Hanson’s labor rate variance (LRV) for the week was: a. $310 unfavorable. b. $310 favorable. c. $300 unfavorable. d. $300 favorable. What is Hanson’s labor rate variance for the week?

Quick Check  Hanson’s labor rate variance (LRV) for the week was:
Zippy Quick Check  Hanson’s labor rate variance (LRV) for the week was: a. $310 unfavorable. b. $310 favorable. c. $300 unfavorable. d. $300 favorable. LRV = AH(AR - SR) LRV = 1,550 hrs($ $12.00) LRV = $310 unfavorable We find the actual labor rate by dividing the $18,910 total labor cost by 1,550 direct labor hours actually worked. Now that we know the actual labor rate, let’s calculate the labor rate variance. We find the labor rate variance by multiplying the actual labor hours worked times the difference between the actual rate per labor hour and the standard rate per labor hour. The $310 unfavorable labor rate variance results because Hanson paid $0.20 per labor hour more than standard for 1,550 labor hours actually worked.

Zippy Quick Check  Hanson’s labor efficiency variance (LEV) for the week was: a. $590 unfavorable. b. $590 favorable. c. $600 unfavorable. d. $600 favorable. What is Hanson’s labor efficiency variance for the week?

Zippy Quick Check  Hanson’s labor efficiency variance (LEV) for the week was: a. $590 unfavorable. b. $590 favorable. c. $600 unfavorable. d. $600 favorable. LEV = SR(AH - SH) LEV = $12.00(1,550 hrs - 1,500 hrs) LEV = $600 unfavorable The total standard hours for labor is the amount of time Hanson’s employees should have worked to make 1,000 Zippies. We find the total standard hours by multiplying the 1.5 standard hours for one Zippy times the 1,000 Zippies made. Now that we know the total standard hours, let’s calculate the labor efficiency variance. We find the labor efficiency variance by multiplying the standard rate for one hour of labor times the difference between the actual hours of labor and the standard hours of labor. The $600 unfavorable labor efficiency variance results because Hanson’s employees worked 50 hours more than standard to make 1,000 Zippies, and each hour of labor has a standard rate of $12.00.

Zippy Quick Check  Actual Hours Actual Hours Standard Hours × × × Actual Rate Standard Rate Standard Rate 1,550 hours ,550 hours ,500 hours × × × $12.20 per hour $12.00 per hour $12.00 per hour = $18, = $18, = $18,000 Here we see a summary of the labor rate and efficiency variance computations in a convenient three-column format. You may find this three-column format more helpful than the equations that we used to answer the previous two questions. Rate variance $310 unfavorable Efficiency variance $600 unfavorable

Learning Objective 4 Compute the variable manufacturing overhead rate and efficiency variances. Learning objective number 4 is to compute the variable manufacturing overhead rate and efficiency variances.

Variable Manufacturing Overhead Variances – An Example
Glacier Peak Outfitters has the following direct variable manufacturing overhead labor standard for its mountain parka. 1.2 standard hours per parka at $4.00 per hour Last month, employees actually worked 2,500 hours to make 2,000 parkas. Actual variable manufacturing overhead for the month was $10,500. Now that we have studied material and labor variances, let’s take a look a variable manufacturing overhead variances. We will return to Glacier Peak Outfitters to illustrate the computation of variable manufacturing overhead rate and efficiency variances.

Variable Manufacturing Overhead Variances Summary
Actual Hours Actual Hours Standard Hours × × × Actual Rate Standard Rate Standard Rate 2,500 hours ,500 hours ,400 hours × × × $4.20 per hour $4.00 per hour $4.00 per hour = $10, = $10, = $9,600 The variable overhead rate variance, defined as the difference between the actual variable overhead costs incurred during the period and the standard cost that should have been incurred based on the actual activity of the period, is $500 unfavorable. The rate variance is labeled unfavorable because the actual variable overhead rate was more than the standard variable overhead rate by $0.20 per hour. The variable overhead efficiency variance, defined as the difference between the actual activity of a period and the standard activity allowed, multiplied by the variable part of the predetermined overhead rate, is $400 unfavorable. The efficiency variance is labeled unfavorable because the actual quantity of the activity (hours) exceeds the standard quantity of the activity allowed by 100 hours. Rate variance $500 unfavorable Efficiency variance $400 unfavorable

Actual Hours Actual Hours Standard Hours × × × Actual Rate Standard Rate Standard Rate 2,500 hours ,500 hours ,400 hours × × × $4.20 per hour $4.00 per hour $4.00 per hour = $10, = $10, = $9,600 $10,500  2,500 hours = $4.20 per hour The actual price of $4.20 per hour is computed by dividing the actual total cost for variable manufacturing overhead by the actual number of hours worked. Rate variance $500 unfavorable Efficiency variance $400 unfavorable

Actual Hours Actual Hours Standard Hours × × × Actual Rate Standard Rate Standard Rate 2,500 hours ,500 hours ,400 hours × × × $4.20 per hour $4.00 per hour $4.00 per hour = $10, = $10, = $9,600 1.2 hours per parka  2,000 parkas = 2,400 hours The standard quantity of 2,400 hours is computed by multiplying the standard hours for one parka times the number of parkas made. Rate variance $500 unfavorable Efficiency variance $400 unfavorable

Variable Manufacturing Overhead Variances: Using Factored Equations
Variable manufacturing overhead rate variance VMRV = AH (AR - SR) = 2,500 hours ($4.20 per hour – $4.00 per hour) = 2,500 hours ($0.20 per hour) = $500 unfavorable Variable manufacturing overhead efficiency variance VMEV = SR (AH - SH) = $4.00 per hour (2,500 hours – 2,400 hours) = $4.00 per hour (100 hours) = $400 unfavorable Factored equations can be used to compute the rate and efficiency variances.

1.5 standard hours per Zippy at $3.00 per direct labor hour
Quick Check  Hanson Inc. has the following variable manufacturing overhead standard to manufacture one Zippy: 1.5 standard hours per Zippy at $3.00 per direct labor hour Last week, 1,550 hours were worked to make 1,000 Zippies, and $5,115 was spent for variable manufacturing overhead. Now let’s return to the Hanson company and compute the variable manufacturing overhead variances. The variable manufacturing overhead standard to produce each Zippy is 1.5 hours at $3.00 per hour. Last week, it took 1,550 hours to produce 1,000 Zippies, and the total variable manufacturing overhead cost was $5,115. Next, we will see several questions based on the information on this screen. Again, you may wish to take some notes to use as you answer the questions. Also, just as you did with the material and labor variance questions, try to answer each question before advancing to the solution.

Zippy Quick Check  Hanson’s rate variance (VMRV) for variable manufacturing overhead for the week was: a. $465 unfavorable. b. $400 favorable. c. $335 unfavorable. d. $300 favorable. What is Hanson’s rate variance for variable manufacturing overhead for the week?

Zippy Quick Check  Hanson’s rate variance (VMRV) for variable manufacturing overhead for the week was: a. $465 unfavorable. b. $400 favorable. c. $335 unfavorable. d. $300 favorable. VMRV = AH(AR - SR) VMRV = 1,550 hrs($ $3.00) VMRV = $465 unfavorable We find the actual variable manufacturing overhead rate by dividing the $5,115 total variable manufacturing overhead cost by $1,550 direct labor hours actually worked. Now that we know the actual variable manufacturing overhead rate, let’s calculate the variable manufacturing overhead rate variance. We find the variable manufacturing overhead rate variance by multiplying the actual hours worked times the difference between the actual variable manufacturing overhead rate per hour and the standard variable manufacturing overhead rate per hour. The $465 unfavorable variable manufacturing overhead rate variance results because Hanson’s actual variable manufacturing overhead rate per labor hour is $0.30 per hour more than the standard variable manufacturing overhead rate per hour for the 1,550 hours actually worked.

Zippy Quick Check  Hanson’s efficiency variance (VMEV) for variable manufacturing overhead for the week was: a. $435 unfavorable. b. $435 favorable. c. $150 unfavorable. d. $150 favorable. What is Hanson’s efficiency variance for variable manufacturing overhead for the week?

Zippy Quick Check  Hanson’s efficiency variance (VMEV) for variable manufacturing overhead for the week was: a. $435 unfavorable. b. $435 favorable. c. $150 unfavorable. d. $150 favorable. 1,000 units × 1.5 hrs per unit The total standard hours is the amount of time Hanson’s employees should have worked to make 1,000 Zippies. We find the total standard hours by multiplying the 1.5 standard hours for one Zippy times the 1,000 Zippies made. Now that we know the total standard hours, let’s calculate the variable manufacturing overhead efficiency variance. We find the variable manufacturing overhead efficiency variance by multiplying the standard rate for variable manufacturing overhead times the difference between the actual hours of labor and standard hours of labor. The $150 unfavorable variable manufacturing overhead efficiency variance results because Hanson’s employees worked 50 hours more than standard to make 1,000 Zippies at a standard variable manufacturing overhead rate of $3.00 per hour. VMEV = SR(AH - SH) VMEV = $3.00(1,550 hrs - 1,500 hrs) VMEV = $150 unfavorable

Zippy Quick Check  Actual Hours Actual Hours Standard Hours × × × Actual Rate Standard Rate Standard Rate 1,550 hours ,550 hours ,500 hours × × × $3.30 per hour $3.00 per hour $3.00 per hour = $5, = $4, = $4,500 Just as we did with labor and material variances, we can summarize the variable manufacturing overhead variance computations in a convenient three-column format. You may find this three-column format more helpful than the equations that we used to answer the previous two questions. Rate variance $465 unfavorable Efficiency variance $150 unfavorable

Variance Analysis and Management by Exception
Larger variances, in dollar amount or as a percentage of the standard, are investigated first. All variances are not worth investigating. Methods for highlighting a subset of variances as exceptions include: Looking at the size of the variance. Looking at the size of the variance relative to the amount of spending. How do I know which variances to investigate?

A Statistical Control Chart
Warning signals for investigation • • Favorable Limit • • • • Desired Value • • Unfavorable Limit • Plotting variance analysis data on a statistical control chart is helpful in variance investigation decisions. Variances are investigated if: They are unusual relative to the normal level of random fluctuation. An unusual pattern emerges in the data. 1 2 3 4 5 6 7 8 9 Variance Measurements

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.

Learning Objective 5 Compute delivery cycle time, throughput time, and manufacturing cycle efficiency (MCE). Learning objective number 5 is to compute delivery cycle time, throughput time, and manufacturing cycle efficiency.

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.

Process Time + Inspection Time + Move Time + Queue 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 =

Quick Check  A TQM team at Narton Corp has recorded the following average times for production: Wait days Move days Inspection 0.4 days Queue days Process days What is the throughput time? a days. b days. c days. d days. Here’s your first question on delivery performance measures: What is the throughput time?

Quick Check  A TQM team at Narton Corp has recorded the following average times for production: Wait days Move days Inspection 0.4 days Queue days Process days What is the throughput time? a days. b days. c days. d days. Throughput time is the sum of process time, inspection time, move time, and queue time. The total for these four times is 10.4 days. Throughput time = Process + Inspection + Move + Queue = 0.2 days days days days = 10.4 days

Quick Check  A TQM team at Narton Corp has recorded the following average times for production: Wait days Move days Inspection 0.4 days Queue days Process days What is the Manufacturing Cycle Efficiency (MCE)? a. 50.0%. b %. c. 52.0%. d %. Here’s your second question on delivery performance measures: What is the manufacturing cycle efficiency?

Quick Check  A TQM team at Narton Corp has recorded the following average times for production: Wait days Move days Inspection 0.4 days Queue days Process days What is the Manufacturing Cycle Efficiency (MCE)? a. 50.0%. b %. c. 52.0%. d %. Manufacturing cycle efficiency is found by dividing value-added time by throughput time. Process time is the only value-added time. Process time of 0.2 days divided by throughput time of 10.4 days results in a manufacturing cycle efficiency of 1.9 percent. MCE = Value-added time ÷ Throughput time = Process time ÷ Throughput time = 0.2 days ÷ 10.4 days = 1.9%

Quick Check  A TQM team at Narton Corp has recorded the following average times for production: Wait days Move days Inspection 0.4 days Queue days Process days What is the delivery cycle time (DCT)? a days. b days. c days. d days. Here’s your third question on delivery performance measures: What is the delivery cycle time?

Quick Check  A TQM team at Narton Corp has recorded the following average times for production: Wait days Move days Inspection 0.4 days Queue days Process days What is the delivery cycle time (DCT)? a days. b days. c days. d days. Delivery cycle time is the sum of wait time plus throughput time. The total for these two times is 13.4 days. DCT = Wait time + Throughput time = 3.0 days days = 13.4 days

Predetermined Overhead Rates and Overhead Analysis in a Standard Costing System
Appendix 11A: Predetermined Overhead Rates and Overhead Analysis in a Standard Costing System Appendix 11A

Compute and interpret the fixed overhead budget and volume variances.
Learning Objective 6 (Appendix 11A) Compute and interpret the fixed overhead budget and volume variances. Learning objective number 6 is to compute and interpret the fixed overhead budget and volume variances.

Fixed Overhead Budget Variance
Actual Fixed Overhead Budgeted Fixed Overhead Fixed Overhead Applied Budget variance Here we see the general model for computing fixed overhead variances. The budget variance is the actual fixed manufacturing overhead cost minus the budgeted fixed manufacturing overhead. Actual fixed overhead Budgeted fixed overhead Budget variance = –

Fixed Overhead Volume Variance
Actual Fixed Overhead Budgeted Fixed Overhead Fixed Overhead Applied Volume variance The volume variance is budgeted fixed overhead minus the fixed overhead applied to work in process. Fixed overhead applied to work in process Budgeted fixed overhead Volume variance = –

Fixed Overhead Volume Variance
Actual Fixed Overhead Budgeted Fixed Overhead Fixed Overhead Applied DH × FR SH × FR Volume variance The volume variance can also be computed by multiplying the fixed portion of the predetermined overhead rate times the difference between denominator hours and standard hours. The equation on the prior slide and this equation result in identical answers. Both variance computations will be demonstrated in the forthcoming example. Volume variance = FPOHR × (DH – SH) FPOHR = Fixed portion of the predetermined overhead rate DH = Denominator hours SH = Standard hours allowed for actual output

Computing Fixed Overhead Variances
ColaCo’s production and machine-hour data is shown on your screen.

Computing Fixed Overhead Variances
ColaCo’s overhead production costs are presented here.

Predetermined Overhead Rates
Estimated total manufacturing overhead cost Estimated total amount of the allocation base = Predetermined overhead rate $360,000 90,000 Machine-hours = Part I. The predetermined overhead rate is equal to the estimated total manufacturing overhead cost divided by the estimated total amount of the allocation base. Part II. ColaCo’s predetermined overhead rate is $4.00 per machine hour. Predetermined overhead rate = $4.00 per machine-hour

Predetermined Overhead Rates
Variable component of the predetermined overhead rate $90,000 90,000 Machine-hours = = $1.00 per machine-hour Fixed component of the predetermined overhead rate $270,000 90,000 Machine-hours = = $3.00 per machine-hour Part I. The predetermined overhead rate can be broken down into a variable component and a fixed component. The variable component is $1.00 per machine-hour. Part II. The fixed component, which will be used to compute the volume variance is $3.00 per hour.

Applying Manufacturing Overhead
Overhead applied Predetermined overhead rate Standard hours allowed for the actual output = × Overhead applied $4.00 per machine-hour 84,000 machine-hours = × Overhead applied $336,000 = Part I. The total overhead applied to work in process is computed by multiplying the predetermined overhead rate times the standard hours allowed for the actual output. Part II. The total overhead applied to work in process is $336,000. In the job-order costing chapter, we used the actual level of activity to apply overhead costs to work in process. The different approach arises because we are using a standard cost system in this chapter and the job-order costing chapter uses a normal costing system.

Computing the Budget Variance
Actual fixed overhead Budgeted fixed overhead Budget variance = – Budget variance = $280,000 – $270,000 The budget variance of $10,000 is the difference between the actual fixed overhead ($280,000) and the budgeted fixed overhead ($270,000). The variance is labeled as Unfavorable because the company actually incurred more cost than the budget projected. Budget variance = $10,000 Unfavorable

Computing the Volume Variance
Fixed overhead applied to work in process Budgeted fixed overhead = – Volume variance = $270,000 – $3.00 per machine-hour ( × $84,000 machine-hours ) Part I. The volume variance is budgeted fixed overhead minus the fixed overhead applied to work in process. The fixed overhead applied to work in process is equal to the fixed component of the predetermined overhead rate times the standard hours allowed for the actual output. Part II. The fixed overhead applied to work in process ($252,000) is computed by multiplying the fixed component of the predetermined overhead rate ($3.00) by the standard machine-hours allowed for the actual output (84,000 hours). The volume variance is $18,000 unfavorable. Volume variance = $18,000 Unfavorable

Computing the Volume Variance
= FPOHR × (DH – SH) FPOHR = Fixed portion of the predetermined overhead rate DH = Denominator hours SH = Standard hours allowed for actual output Volume variance = $3.00 per machine-hour ( × 90,000 mach-hours – 84,000 ) Part I. The volume variance can also be computed by multiplying the fixed portion of the predetermined overhead rate times the difference between denominator hours and standard hours. Part II. The volume variance is $18,000 unfavorable. Because the standard hours allowed is less than the denominator volume hours, it presumably signals inefficient usage of facilities. Therefore, the variance is labeled as unfavorable. Volume variance = 18,000 Unfavorable

A Pictorial View of the Variances
Actual Fixed Overhead Budgeted Fixed Overhead Fixed Overhead Applied to Work in Process 280,000 270,000 252,000 Budget variance, $10,000 unfavorable Volume variance, $18,000 unfavorable This slide offers a pictorial view of the computation of the fixed overhead budget and volume variances. Total variance, $28,000 unfavorable

Fixed Overhead Variances – A Graphic Approach
Let’s look at a graph showing fixed overhead variances. We will use ColaCo’s numbers from the previous example. Often it’s helpful to look at the fixed overhead relationships in graphical form. We will use the ColaCo data from the previous example for our graphical approach.

Graphic Analysis of Fixed Overhead Variances
Budget $270,000 Fixed overhead applied at $3.00 per standard hour The vertical axis is used to graph fixed overhead cost. The first cost that ColaCo would plot on this axis is $270,000 of budgeted fixed overhead. The horizontal axis is used to graph the volume of activity. The first activity level that ColaCo would plot is its denominator activity level of 90,000 machine hours. The linear manner in which fixed overhead is applied to products is depicted by drawing a straight line from the origin to the intersection of the budgeted fixed overhead ($270,000) and the denominator activity (90,000 hours). The slope of this line indicates that fixed overhead is applied at a rate of $3.00 per machine hour. Denominator hours 90 Machine-hours (000)

Actual $280,000 { Budget Variance 10,000 U Budget $270,000 Fixed overhead applied at $3.00 per standard hour Next, plot the actual amount of fixed overhead costs on the vertical axis. The broken horizontal line above the budgeted fixed overhead represents the $280,000 of actual fixed manufacturing overhead. The vertical distance between the budgeted fixed overhead line and the actual fixed overhead line represents the fixed overhead budget variance of $10,000. Since the actual fixed overhead is greater than the budgeted fixed overhead, the fixed overhead budget variance is unfavorable. Denominator hours 90 Machine-hours (000)

Actual $280,000 { Budget Variance 10,000 U Budget $270,000 { Volume Variance 18,000 U Applied $252,000 Fixed overhead applied at $3.00 per standard hour Finally, identify the standard hours allowed for the actual level of output (84,000 hours) on the horizontal axis. Draw a vertical line from this activity level until it intersects the sloped line that depicts the fixed overhead applied to products. From this point, draw a horizontal line representing the applied fixed overhead ($252,000). The vertical distance between the budgeted fixed overhead line and the applied fixed overhead line represents the fixed overhead volume variance of $18,000. Since the budgeted fixed overhead is greater than the applied fixed overhead, the volume variance is unfavorable. Standard hours Denominator hours 84 90 Machine-hours (000)

In a standard cost system:
Reconciling Overhead Variances and Underapplied or Overapplied Overhead In a standard cost system: Unfavorable variances are equivalent to underapplied overhead. Favorable variances are equivalent to overapplied overhead. In a standard cost system, the sum of the overhead variances equals the under-or overapplied overhead cost for the period. Unfavorable variances are equivalent to underapplied overhead. Favorable variances are equivalent to overapplied overhead. The sum of the overhead variances equals the under- or overapplied overhead cost for the period.

Reconciling Overhead Variances and Underapplied or Overapplied Overhead
This slide shows how ColaCo’s underapplied or overapplied is computed. The manufacturing overhead is $44,000 underapplied.

Computing the Variable Overhead Variances
Variable manufacturing overhead rate variance VMRV = (AH × AR) – (AH × SR) = $100,000 – (88,000 hours × $1.00 per hour) = $12,000 unfavorable ColaCo’s variable overhead rate variance ($12,000 U) is computed as shown on this slide.

Computing the Variable Overhead Variances
Variable manufacturing overhead efficiency variance VMEV = (AH × SR) – (SH × SR) = $88,000 – (84,000 hours × $1.00 per hour) = $4,000 unfavorable ColaCo’s variable overhead efficiency variance ($4,000 U) is computed as shown on this slide.

Computing the Sum of All Variances
The sum of the variable and fixed overhead variances is $44,000 U. Notice, the sum of the variances equals the amount of ColaCo’s underapplied overhead.

Journal Entries to Record Variances
Appendix 11B: General Ledger Entries to Record Variances Appendix 11B

Prepare journal entries to record standard costs and variances.
Learning Objective 7 (Appendix 11B) Prepare journal entries to record standard costs and variances. Learning objective number 7 is to prepare journal entries to record standard costs and variances.

Appendix 11B Journal Entries to Record Variances
We will use information from the Glacier Peak Outfitters example presented earlier in the chapter to illustrate journal entries for standard cost variances. Recall the following: Material AQ × AP = $1,029 AQ × SP = $1,050 SQ × SP = $1,000 MPV = $21 F MQV = $50 U Labor AH × AR = $26,250 AH × SR = $25,000 SH × SR = $24,000 LRV = $1,250 U LEV = $1,000 U Standard costs and variance analysis can be used without formal journal entries. However, recording inventories and cost of goods sold using standard costs simplifies bookkeeping since it eliminates the need to keep track of the actual costs of each unit. We will use the information from the Glacier Peak Outfitters example presented earlier in the chapter to illustrate journal entries for labor and material variances. A summary of the standard cost variance computations for Glacier Peak Outfitters’ labor and material variances is shown on your screen. Now, let’s prepare the entries to record the labor and material variances.

Appendix 11B Recording Material Variances
The first entry is to record the purchase of direct materials. A favorable materials price variance is recorded with a credit. The second entry is to record the use of material. The use of material involves a transfer of material from the asset account raw materials inventory to the asset account work-in-process inventory. An unfavorable materials quantity variance is recorded with a debit.

Appendix 11B Recording Labor Variances
Here we see the entry for the incurrence of direct labor. Both labor variances are unfavorable and are recorded with debits.

Cost Flows in a Standard Cost System
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 out to cost of goods sold. Unfavorable variances increase cost of goods sold. Favorable variances decrease cost of goods sold. The entries into the various accounts are made at standard cost – not actual cost. The differences between actual and standard costs are entered into special accounts that accumulate the various standard cost variances. The standard cost variance accounts are usually closed out to Cost of Goods Sold at the end of the period. Unfavorable variances increase Cost of Goods Sold, and favorable variances decrease Cost of Goods Sold.

End of Chapter 11 End of chapter 11.

Standard Costs and Operating Performance Measures

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