MA W5

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Standard Costs and Operating Performance Measures

Chapter 11

McGraw-Hill/Irwin Copyright 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

Standard Costs

Standards are benchmarks or norms formeasuring performance. In managerial accounting,

two types of standards are commonly used.

Quantity standardsspecify how much of aninput should be used to

make a product orprovide a service.

Price standardsspecify how muchshould be paid for

each unit of theinput.

Examples: Firestone, Sears, McDonalds, hospitals, construction and manufacturing companies.

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Standard Costs

DirectMaterial

Deviations from standards deemed significantare brought to the attention of management, apractice known as management by exception.

Type of Product Cost

A

m

o

u

n

t

DirectLabor

ManufacturingOverhead

Standard

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Variance Analysis Cycle

Prepare standard Prepare standard cost performance cost performance

reportreport

Analyze variances

Begin

Identifyquestions

Receive explanations

Takecorrective

actions

Conduct next periods

operations

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Setting Standard Costs

Should we useideal standards that require employees towork at 100 percent

peak efficiency?

Engineer Managerial Accountant

I recommend using practical standards that are currently attainable with reasonable

and efficient effort.

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Setting Direct Material Standards

PriceStandards

Summarized in a Bill of Materials.

Final, deliveredcost of materials,net of discounts.

QuantityStandards

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Setting Direct Labor Standards

RateStandards

Often a singlerate is used that reflectsthe mix of wages earned.

TimeStandards

Use time and motion studies for

each labor operation.

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Setting Variable Manufacturing Overhead Standards

RateStandards

The rate is the variable portion of the

predetermined overheadrate.

QuantityStandards

The quantity is the activity in the

allocation base for predetermined overhead.

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Price and Quantity Standards

Price and quantity standards are determined separately for two reasons:

n The purchasing manager is responsible for rawmaterial purchase prices and the production manageris responsible for the quantity of raw material used.

n The purchasing manager is responsible for rawmaterial purchase prices and the production manageris responsible for the quantity of raw material used.

o The buying and using activities occur at different times.Raw material purchases may be held in inventory for aperiod of time before being used in production.

o The buying and using activities occur at different times.Raw material purchases may be held in inventory for aperiod of time before being used in production.

11-9

A General Model for Variance Analysis

Variance Analysis

Price Variance

Difference betweenDifference betweenactual price and actual price and standard pricestandard price

Quantity Variance

Difference betweenDifference betweenactual quantity andactual quantity andstandard quantitystandard quantity

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Variance Analysis

Materials price varianceLabor rate varianceVOH rate variance

Materials quantity varianceLabor efficiency varianceVOH efficiency variance


Price Variance Quantity Variance

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Actual Quantity Actual Quantity Standard Quantity

Actual Price Standard Price Standard Price


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Actual quantity is the amount of direct materials, direct labor, and variable

manufacturing overhead actually used.

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Standard quantity is the standard quantity allowed for the actual output of the period.

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Actual price is the amount actuallypaid for the input used.

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Standard price is the amount that should have been paid for the input used.




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(AQ AP) (AQ SP) (AQ SP) (SQ SP)AQ = Actual Quantity SP = Standard PriceAP = Actual Price SQ = Standard Quantity




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Materials Price VarianceMaterials Quantity Variance

Production Manager Purchasing Manager

The standard price is used to compute the quantity varianceso that the production manager is not held responsible for

the purchasing managers performance.

The standard price is used to compute the quantity varianceso that the production manager is not held responsible for

the purchasing managers performance.

Responsibility for Material Variances

11-18

Responsibility for Labor Variances

Production Manager

Production managers areusually held accountable

for labor variancesbecause they can

influence the:

Mix of skill levelsassigned to work tasks.

Level of employee motivation.

Quality of production supervision.

Quality of training provided to employees.

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Advantages of Standard Costs

Management byexception

Advantages

Promotes economyand efficiency

Simplifiedbookkeeping

Enhances responsibility

accounting

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PotentialProblems

Emphasis onnegative may

impact morale.

Emphasizing standardsmay exclude other

important objectives.

Favorablevariances may

be misinterpreted.

Continuousimprovement maybe more important

than meeting standards.

Standard costreports may

not be timely.

Invalid assumptionsabout the relationship

between laborcost and output.

Potential Problems with Standard Costs

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Process time is the only value-added time.

Delivery Performance Measures

Wait TimeProcess Time + Inspection Time

+ Move Time + Queue Time

Delivery Cycle Time

Order Received

ProductionStarted

Goods Shipped

Throughput Time

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ManufacturingCycle

Efficiency

Value-added timeManufacturing cycle time

=

Wait TimeProcess Time + Inspection Time

+ Move Time + Queue Time

Delivery Cycle Time

Order Received

ProductionStarted

Goods Shipped

Throughput Time

Delivery Performance Measures

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End of Chapter 11

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11-

Segment Reporting, Decentralization, and the Balanced Scorecard

Chapter 12

McGraw-Hill/Irwin Copyright 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

Cost Center

A segment whose manager has control over costs, but not over revenues or investment funds.

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Profit Center

A segment whose manager has control over both costs and

revenues, but no control over investment funds.

RevenuesSalesInterestOther

CostsMfg. costsCommissionsSalariesOther

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Investment Center

A segment whose manager has control over costs, revenues,

and investments in operating assets.

Corporate Headquarters

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Decentralization and Segment Reporting

A segmentsegment is any part or activity of an

organization about which a manager

seeks cost, revenue, or profit data.

Quick MartQuick Mart

An Individual Store

A Sales Territory

A Service Center

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Keys to Segmented Income Statements

There are two keys to building segmented income statements:

A contribution format should be used because it separates fixed from variable costs and it enables the calculation of a

contribution margin.

Traceable fixed costs should be separated from common fixed costs to enable the

calculation of a segment margin.

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Identifying Traceable Fixed Costs

Traceable costs arise because of the existence of a particular segment and would disappear over time if the segment itself disappeared.

No computer division means . . .

No computerdivision manager.

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Identifying Common Fixed Costs

Common costs arise because of the overall operation of the company and would not disappear if any particular segment were

eliminated.

No computer division but . . .

We still have acompany president.

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Traceable Costs Can Become Common Costs

It is important to realize that the traceable fixed costs of one segment may be a

common fixed cost of another segment.

For example, the landing fee paid to land an airplane at an

airport is traceable to the particular flight, but it is not

traceable to first-class, business-class, and

economy-class passengers.

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Segment MarginThe segment margin, which is computed by

subtracting the traceable fixed costs of a segment from its contribution margin, is the best gauge of

the long-run profitability of a segment.

TimeTime

P

r

o

f

i

t

s

P

r

o

f

i

t

s

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Traceable and Common Costs

FixedCosts

Traceable Common

DonDont allocatet allocatecommon costs to common costs to

segments.segments.

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Activity-Based Costing

9-inch 12-inch 18-inch TotalWarehouse sq. ft. 1,000 4,000 5,000 10,000 Lease price per sq. ft. 4$ 4$ 4$ 4$ Total lease cost 4,000$ 16,000$ 20,000$ 40,000$

Pipe Products

Activity-based costing can help identify how costs shared by more than one segment are traceable to

individual segments. Assume that three products, 9-inch, 12-inch, and 18-inch pipe, share 10,000

square feet of warehousing space, which is leased at a price of $4 per square foot.

If the 9-inch, 12-inch, and 18-inch pipes occupy 1,000, 4,000, and 5,000 square feet, respectively, then ABC can be used to trace the warehousing costs to the

three products as shown.

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Return on Investment (ROI) Formula

ROI = ROI = Net operating incomeNet operating income

Average operating assets Average operating assets

Cash, accounts receivable, inventory,plant and equipment, and other

productive assets.

Cash, accounts receivable, inventory,plant and equipment, and other

productive assets.

Income before interestand taxes (EBIT)

Income before interestand taxes (EBIT)

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Understanding ROI

ROI = ROI = Net operating incomeNet operating income

Average operating assets Average operating assets

Margin = Margin = Net operating incomeNet operating income

Sales Sales

Turnover = Turnover = SalesSalesAverage operating assets Average operating assets

ROI = ROI = Margin Margin TurnoverTurnover12-38

Increasing ROI

There are three ways to increase ROI . . .

nIncreaseSales

oReduceExpenses pReduce

Assets

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Criticisms of ROI

In the absence of the balancedscorecard, management may

not know how to increase ROI.

Managers often inherit manycommitted costs over which

they have no control.

Managers evaluated on ROImay reject profitable

investment opportunities.

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Calculating Residual Income

Residual income =

Net operating income

-Average

operating assets

Minimum

required rate of return

( )This computation differs from ROI.

ROI measures net operating income earned relative to the investment in average operating assets.

Residual income measures net operating income earned less the minimum required return on average

operating assets.

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Motivation and Residual IncomeResidual income encourages managers to

make profitable investments that wouldbe rejected by managers using ROI.

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The Balanced Scorecard

Management translates its strategy into performance measures that employees

understand and influence.

Management translates its strategy into performance measures that employees

understand and influence.

Performancemeasures

Customers

Learningand growth

Internalbusiness

processes

Financial

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The Balanced Scorecard: Non-financial Measures

The balanced scorecard relies on non-financial measures in addition to financial measures for two reasons:

n Financial measures are lag indicators that summarizethe results of past actions. Non-financial measures areleading indicators of future financial performance.

n Financial measures are lag indicators that summarizethe results of past actions. Non-financial measures areleading indicators of future financial performance.

o Top managers are ordinarily responsible for financialperformance measures not lower level managers. Non-financial measures are more likely to beunderstood and controlled by lower level managers.

o Top managers are ordinarily responsible for financialperformance measures not lower level managers. Non-financial measures are more likely to beunderstood and controlled by lower level managers.

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The balanced scorecard lays out concrete actions to attain desired outcomes.

A balanced scorecard should have measuresthat are linked together on a cause-and-effect basis.

If we improveone performance

measure . . .

Another desiredperformance measure

will improve.

The Balanced Scorecard

Then

12-45

Key Concepts/DefinitionsA transfer price is the price

charged when one segment of a company provides goods or

services to another segment of the company.

The fundamental objective in setting transfer prices is to

motivate managers to act in the best interests of the overall

company.

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Three Primary Approaches

There are three primary approaches to setting

transfer prices:

1. Negotiated transfer prices;

2. Transfers at the cost to the selling division; and

3. Transfers at market price.

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Negotiated Transfer Prices

A negotiated transfer price results from discussions between the selling and buying divisions.

Advantages of negotiated transfer prices:

1. They preserve the autonomy of the divisions, which is consistent with the spirit of decentralization.

2. The managers negotiating the transfer price are likely to have much better information about the potential costs and benefits of the transfer than others in the company.

Upper limit is determined by the buying division.

Lower limit is determined by the selling division.

Range of Acceptable Transfer Prices

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Transfers at the Cost to the Selling Division

Many companies set transfer prices at either the variable cost or full (absorption) cost

incurred by the selling division.Drawbacks of this approach include:

1. Using full cost as a transfer price can lead to suboptimization.

2. The selling division will never show a profit on any internal transfer.

3. Cost-based transfer prices do not provide incentives to control costs.

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Transfers at Market Price

A market price (i.e., the price charged for an item on the open market) is often regarded as

the best approach to the transfer pricing problem.

1. A market price approach works best when the product or service is sold in its present form to outside customers and the selling division has no idle capacity.

2. A market price approach does not work well when the selling division has idle capacity.

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Reasons for Charging Service Department Costs

To encourage operating departments to wisely use service

department resources.

To encourage operating departments to wisely use service

department resources.

To provide operating departments with

more complete cost data for making

decisions.

To provide operating departments with

more complete cost data for making

decisions.

To help measure the profitability of

operating departments.

To help measure the profitability of

operating departments.

To create an incentive for service

departments to operate efficiently.

To create an incentive for service

departments to operate efficiently.

Service department costs are charged to operating departments for a variety of reasons including:

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Charging Costs by Behavior

Whenever possible,variable and fixed

service department costsshould be charged

separately.

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End of Chapter 12

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