Chapter 10: Standard Costs and Overhead Analysis

Standard Costs – Management by Exception

  • Standard – Benchmark for measuring performance, relating to the quantity and cost and are set for each major input.
  • Quantity Standards – Specify how much of an input should be used to make a unit of product or provide a unit of service.
  • Cost (price) Standards – Specify how much should be paid for each unit of the input.
  • Management by Exception – A system of management in which standards are set for various operating activities that are then periodically compared to actual units.
  • Differences are called “exceptions” and are brought to the attention of management.
  • Variance Analysis Cycle – Basic approach to identifying and solving problems.

Objective 1 – Explain how direct materials standards and direct labour standards are set.

Setting Standard Costs

Who Uses Standard Costs?

  • Manufacturing, service, food, and NFP organizations (basically any business) all use standards to measure performance.
  • Standard Cost Record – A detailed listing of the standard amounts of materials, labour, and overhead that should go into a unit of product or service x standard rate/price set for each cost element.
  • Manufacturing companies use these to assign costs and keep records.

Ideal vs Practical Standards

  • Ideal Standards – Standards that allow for no machine breakdowns or other work interruptions and require peak efficiency at all time.
  • Some argue these standards provide motivational value, but they may be discouraging because they are near impossible.
  • Practical Standards – Standards that allow for normal machine downtime and other work interruptions and can be attained through reasonable, although, highly efficient, efforts by the average employee.
  • Variances signal a need for management attention because they represent deviations that fall outside normal operating conditions.
  • Can be used to forecast cash flows and plan inventory.

Setting Direct Materials Standards

  • Standard Price Per Unit – Price that should be paid for a single unit of materials, including shipping, receiving, and other such costs.
  • Standard Quantity Per Unit – The amount of materials that should be required to complete a single unit of product, including allowances for normal waste, spoilage, and other inefficiencies.
  • Typically recognizing allowances for waste, spoilage, and rejects is criticized for contradicting zero defects goal with improvement programs.
  • Calculate Standard Cost of Materials
  • Standard Quantity in Units x Standard Price per Unit

Setting Direct Labour Standards

  • Standard Rate Per Hour – The labour rate that should be incurred per hour of labour time, including Employment Insurance, employee benefits, and other labour costs.
  • Standard Hours Per Unit – The amount of labour time that should be required to complete a single unit of product, including allowances for breaks, machine downtown, cleanup, rejects, and other normal inefficiencies.
  • Calculate Standard Cost of Labour
  • Standard Labour-hours per unit of Product x Standard Rate per direct labour hour.

Setting Variable Manufacturing Overhead Standards

  • Standard Cost Per Unit - Represents the variable portion of the predetermined overhead rate.
  • Standard Quantity or Hours x Standard Price or Rate for the Cost Element

Are Standards the Same as Budgets?

  • Standards represent unit amounts whereas budgets represent total amounts.
  • A standard is the budgeted cost for one unit of product.

A General Model for Variance Analysis

  • Variances – The differences between standard prices and quantities vs. actual prices and quantities.
  • Important to separate discrepancies to deviations from price standards or quantity standards.
  • The General Model for Variance Analysis isolates price variances from quantity variances and shows how each is computed.
  • Price and quantity variances can be computed for all three variable cost elements (DL,DM,VMOH)
  • Variances have different names depending on which type of cost element and which type of variance. (e.g. Materials Price Variance, Labour Rate Variance)
  • They are computed identically.
  • Standard Quantity Allowed – The amount of materials that should have been used to complete the period’s output.
  • Actual Number of Units Produced x Standard Quantity per unit.
  • Standard Hours Allowed – The time that should have been taken to complete the period’s output
  • Actual number of units produced x standard hours per unit.
  • The flexible budget variance may be broken down into price and quantity components.

Objective 2 – Compute the direct materials price and quantity variances and explain their significance.

Using Standard Costs – Direct Materials Variances

  • Calculate the three values in the model to get the price variance and quantity variance.
  • Actual Quantity of Input at the Actual Price, Actual Quantity of Input at the Standard Price, and Standard Quantity Allowed for Actual Output at the Standard Price.
  • For Price variance
  • Favourable if the actual purchase price is less than the standard price, and unfavourable if the actual price exceeds standard price.
  • For Quantity Variance - Use the Standard Price in calculation of Standard Quantity Allowed for Actual Output at Standard Price
  • Favourable if the actual quantity used is less than the standard quantity and unfavourable if the actual quantity used exceeds standard.
  • Materials price variance is calculated when materials are purchased.
  • Delaying computation of price variance results in less timely variance reports.
  • Materials can be carried in the inventory accounts at their standard cost.

Materials Price Variance

  • Measure of the difference between the actual unit price paid for an item and the standard price multiplied by the quantity purchased.
  • Materials Price Variance = (AQ x AP) – (AQ x SP)
  • Or AQ(AP-SP)
  • Favourability - Negative variance is favourable and Positive variance is unfavourable.

Isolation Of Variances

  • Variances should be isolated and brought to attention of management so that problems can be identified and corrected on a timely basis.
  • Significant variances may be red flags that require explanation.

Responsibility for the Variance

  • Purchasing manager has control over price paid for goods, and many factors affect the price (including units ordered and delivery).
  • Others may be responsible, such as the production manager.
  • Use variance analysis to support line managers and assist them in meeting goals.

Materials Quantity Variance

  • A measure of the difference between the actual quantity of materials used in production and the standard quantity allowed, multiplied by the standard price per unit of materials.
  • Materials Quantity Variance = (AQ x SP) – (SQ x SP)
  • Or SP(AQ – SQ)
  • Best isolated at the time that materials are placed into production.
  • Calls attention to the excessive usage of materials while production is still in process.
  • Production department is typically responsible for overseeing materials usage.
  • Sometimes the purchasing department is responsible for low-quality materials.

Objective 3 – Compute the direct labour rate and efficiency variances and explain their significance.

Using the Standard Costs – Direct Labour Variances

  • Calculate the three values in the model to get price variance and quantity variance.
  • Actual Hours of Input at the Actual Rate, Actual Hours of Input at the Standard Rate, Standard Hours Allowed for Actual Output at the Standard Rate

Labour Rate Variance

  • A measure of the difference between actual hourly labour rate and the standard rate, multiplied by the number of hours worked during the period.
  • Labour Rate Variance = (AH x AR) – (AH x SR)
  • Or AH(AR – SR)
  • Rates are typically predictable, but variances arise the way labour is used.
  • Different workers with different skill levels must be assigned the appropriate job to result in a balance of favourability and efficiency.

Labour Efficiency Variance

  • A measure of the difference between actual hours taken to complete a task and the standard hours allowed, multiplied by the standard hourly labour rate.
  • Labour Efficiency Variance = (AH x SR) – (SH x SR)
  • Or SR(AH – SH)
  • Possible cause of unfavourable efficiency may be poorly trained/motivated workers, poor quality materials, requiring more labour time for processing, etc.
  • Manager in charge of production is generally responsible for efficiency variance, but purchasing management is involved if lower-quality materials affects the labour processing time.
  • Insufficient demand for company’s products may result in unfavourable labour efficiency variance – small volume of customer’s orders causes the manager to either produce goods beyond demand or accept the inefficiency.

Objective 4 – Compute the variable manufacturing overhead spending and efficiency variances and explain their significance.

Using Standard Costs – Variable Manufacturing Overhead Variances

  • Calculate the three values in the model to get price variance and quantity variance. (These are the same as the ones for DL)
  • Actual Hours of Input at the Actual Rate, Actual Hours of Input at the Standard Rate, Standard Hours Allowed for Actual Output at the Standard Rate

Variable Manufacturing Overhead Variances

  • The difference between actual variable overhead cost incurred during a period and the standard cost that should have been incurred based on the actual activity of the period.
  • Variable MOH Variance = (AH x AR) – (AH x SR)
  • Or AH(AR – SR)
  • Variable Overhead Efficiency Variance = (AH x SR) – (SH x SR)
  • Or SR(AH – SH)

Interpreting the Spending Variance

  • Useful when cost driver is the actual variable activity allocation base.
  • Spending Variance for overhead occurs when:
  • Actual purchase price of the variable overhead items differs from the standards.
  • Actual quantity of variable overhead items used differs from the standards.
  • Example Calculation Process
  • POHR (variable) = Estimated total variable overhead cost / estimated total direct labour hours
  • VMOH is made up of indirect labour, indirect materials, and utilities.
  • The Variable POHR is made up of both price per unit paid for each item and the quantity of those items used for each direct labour hour worked on the product.
  • Price and quantity components of spending variance are not separated because the price element is very small, it is mostly affected by the efficiency of quantity.

Interpreting the Efficiency Variance

  • Efficiency Variance is useful if the cost driver is the actual hours worked – it is an estimate of effect on variable overhead costs of efficiencies or inefficiencies in the use of the base.
  • Variance results from ineffective use of the allocation base, not the overhead resources.

Control of the Efficiency Variance

Whoever is responsible for the base is responsible for the control of the variance.

Summary of Variance Formulas for Variable Costs

  • Direct Materials
  • Price variance: AQ(AP – SP)
  • Quantity Variance: SP(AQ – SQ)
  • Direct labour
  • Rate Variance: AH(AE – SR)
  • Quantity Variance: SR(AH – SH)
  • Variable Overhead
  • Spending Variance: AH(AR – SR)
  • Efficiency Variance: SR(AH – SH)

Standards Costs and Variances in the Service Industry

  • Uses different terminology and a different way the COGS account is constructed.
  • COGM = sum of DM, DL, and MOH.
  • COGS is calculated as the net purchase price paid for the products sold during the period – for services these are labour, indirect overhead, and small amounts of direct materials.
  • Variance Analysis is still applicable, but items are different – labour variance is the most useful since salaries/wages make up most of the costs.

Objective 5 – Explain the significance of the dominator activity figure in determining the standard cost of a unit of product.

Overhead rates and Fixed Overhead Analysis

Flexible Budgets and Overhead Rates

  • In product costing, allocating the fixed overhead cost creates the problem of getting a higher cost per unit for small number of units produced.
  • Likewise, costs appear low when many units are produced.
  • Flexible Budget Schedule can be used to compensate for this problem.

Denominator Activity

  • POHR = estimated total MOH cost / estimated total units in the base
  • Denominator Activity – Activity figure used to compute the predetermined overhead rate.
  • Once the estimated activity level is chosen, it remains unchanged throughout the year to maintain stability.

Computing the Overhead Rate

  • Estimated total manufacturing cost is determined from the flexible budget.
  • New Variation on the POHR:
  • New POHR = Overhead from the flexible budget at the denominator level of activity / Denominator level of activity.
  • Overhead rate can be broken down into variable and fixed elements:
  • Variable Element = Total Variable Overhead Cost / Denominator Activity
  • Fixed Element = Total Fixed Overhead Cost / Denominator Activity

Objective 6 – Compute and interpret the fixed and overhead budget and volume variances.

Overhead Application and Fixed Overhead Variances

Overhead Application in a Standard Costing System

  • The Standard Costing System – overhead is applied to work in process on the basis of the standard hours allowed for the actual output of the period.
  • For this calculation there are 3 new values to get Budget Variance and Volume Variance.
  • Actual Fixed Overhead Cost, Flexible Budget Fixed Overhead cost, and Fixed Overhead Cost Applied to Work in Process.

Budget Variance

  • A measure of the difference between actual fixed overhead costs incurred during the period and the budgeted fixed overhead costs as contained in the flexible budget.
  • Budget Variance = Actual Fixed Overhead Cost – Flexible Budget Fixed Overhead Cost
  • Represents the difference between how much should have been spent and how much was actually spent.

Volume Variance

  • Measures utilization of plant facilities, arising whenever the standard hours allowed for the actual output of a period are different from the denominator activity level that was planned when the period began.
  • Volume Variance = Fixed Portion of the POHR x (Denominator Hours – Standard Hours Allowed)
  • POHR is determined annually – so to assign a monthly volume variance, assign the annual denominator activity evenly to each month (Divide by 12).
  • Favourable – Company operated at an activity level above that planned for the period.
  • Unfavourable – Company operated at an activity level below that planned.
  • Doesn’t measure overspending nor underspending, and does not have an efficiency variance because fixed overhead budget does not change if you use standard or actual hours.

Graphic Analysis of Fixed Overhead Variances

  • Graphically
  • Fixed overhead cost is applied to WIP as the POHR for each standard hour of activity.
  • Applied Cost line crosses the budget cost line at exactly the denominator level used for the month,
  • If denominator hours and standard hours allowed are the same, there is no volume variance.

Image result for graphic analysis fixed overhead variance

Cautions in Fixed Overhead Analysis

  • When applying the fixed overhead costs to WIP, we treat fixed costs as “variable.”
  • We give fixed MOH a rate.
  • Manager may be easily misled to believe the fixed costs are actually variable, but this is artificial – increases/decreases in activity have no effect on total fixed costs.

Overhead Variances and Under/Over Applied Overhead Cost

  • Four Overhead variances calculated:
  • Variable Overhead Spending Variance, Variable Overhead Efficiency Variance, Fixed Overhead Budget Variance, and Fixed Overhead Volume Variance.
  • Sum of the overhead variances equals the under or overapplied overhead cost for a period.
  • Underapplied Overhead = Unfavourable Variance
  • Overapplied overhead = Favourable Variance

Objective 7 - Prepare a Performance Report for Manufacturing Overhead, decide which variances to investigate, and perform and analysis of capacity utilization.

Overhead Reporting, Variance Investigations, and Capacity Analysis

  • Overhead Performance Reports builds on the analysis of fixed and variable overhead with details on individual items in each category,
  • Managers use it to determine the amount that each overhead item contributes to the spending (budget) and efficiency variances.
  • Having both spending and efficiency variances is possible only if a standard costing system is in place.

Variance Investigation Decisions

  • If actual results do not conform to the budget and to standards, the performance reporting system reports an “exception.”
  • Variances are worth investigating based on
  • Dollar Amount
  • Size of the Variance relative to the amount of Spending
  • Statistical Control Chart – Used to monitor random fluctuates that are to be expected over time. (Usually use the Standard Deviation)
  • Common rule is to “Investigate all variances that are more than X standard deviations from zero.”
  • Monitor the pattern of the variances. (e.g. steadily increasing variances)

Capacity Analysis

  • Theoretical capacity – Volume of activity resulting from operations conducted with zero downtime (every day).
  • Practical Capacity – Productive capacity possible after subtracting unavoidable downtime from theoretical capacity.
  • Examine the overhead cost (variable + fixed) at each level of capacity:
  • Theoretical, Practical, Denominator, and Actual
  • Find the Operating Income at each level of capacity (Contribution Margin – total Overhead)

International Uses of Standard Costs

  • Standard costs are still used in many countries, commonly included in certain processes
  • Cost Control and Performance Evaluation
  • Product Costing
  • Budgeting and forecasting.

Evaluating of Controls Based on Standard Costs

Advantages of Standard Costs

  • Management By Exception – costs are addressed by managers when they fall outside standards.
  • Promotes Economy and Efficiency – reasonable benchmarks.
  • Simplified Bookkeeping – standard costs may be charged to jobs.
  • Enhances Responsibility Accounting – Establishes what costs should be, who is responsible, and whether they are under control.

Potential Problems with Standard Costs

  • Emphasizing Standards may exclude other important objectives.
  • Favourable variances may be misinterpreted – can be just as bad (e.g. Harvey’s puts less meat in their burgers.)
  • Standard Cost Reports may not be timely – outdated often.
  • Emphasis on negative may impact morale.
  • Invalid assumptions between labour cost and output – production process is labour paced, and labour is a variable cost.
  • Continuous improvement may be more important than meeting standards.

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