Report on Standard Costs

Term-paper on: Standard CostsPrepared for: Tanzila AhmedCourse: ACT-201, Sec - 08

1. Abstract

Standard costs are aid in the planning, operations and gaining insights in to the probable impact of managerial decision on cost levels and profit. Standard cost is used for Establishing Budgets, Controlling cost and motivating and measuring efficiencies. Standard cost are also used for promoting possible cost reduction and assigning cost to material, work in process and finished goods inventories. Nowadays many companies are adopting the standard cost for their planning and budgeting.

2. Introduction

A standard is a benchmark or “norm” for measuring performance. Standards are set for both the cost and the quantity of inputs needed to manufacture goods or to provide services. Quantity standards indicate how much of an input, such as labor time or raw materials, should be used to make a product or provide a service. Cost standards indicate what the cost of the input should be. Standards are normally set so that they can be attained by reasonable, though highly efficient, efforts. Such “practical” standards are believed to positively motivate employees.

When standards are compared to actual performance, the difference is referred to as a variance. Variances are computed and reported to management on a regular basis for both the price and the quantity elements of direct materials, direct labor, and overhead. Price variances are computed by taking the difference between actual and standard prices and multiplying the result by the amount of input purchased. Quantity variances are computed by taking the difference between the actual amount of the input used and the amount of input that is allowed for the actual output, and then multiplying the result by the standard price of the input. Not all variances require management time or attention. Only unusual or particularly significant variances should be investigated—otherwise a great deal of time would be spent investigating unimportant matters.

Additionally, it should be emphasized that the point of the investigation should not be to find someone to blame. The point of the investigation is to pinpoint the problem so that it can be fixed and operations improved. Traditional standard cost variance reports are often supplemented with other performance measures. Overemphasis on standard cost variances may lead to problems in other critical areas such as product quality, inventory levels, and on-time delivery.

3. Standard Costs—Management by Exception

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A standard is a benchmark or “norm” for measuring performance. Standards are found everywhere. Your doctor evaluates your weight using standards for individuals of your age, height, and gender. The food we eat in restaurants is prepared under specified standards of cleanliness. The buildings we live in conform to standards set in building codes. Standards are also widely used in managerial accounting where they relate to the quantity and cost (or acquisition price) of inputs used in manufacturing goods or providing services. Quantity and cost standards are set for each major input such as raw materials and labor time. Quantity standards specify how much of an input should be used to make a product or provide a service. Cost (price) standards specify how much should be paid for each unit of the input. Actual quantities and actual costs of inputs are compared to these standards. If either the quantity or the cost of inputs departs significantly from the standards, managers investigate the discrepancy to find the cause of the problem and eliminate it. This process is called management by exception.

4. Who Uses Standard Costs?

Manufacturing, service, food, and not-for-profit organizations all make use of standards to some extent. Auto service centers like Firestone and Sears, for

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example, often set specific labor time standards for the completion of certain tasks, such as installing a carburetor or doing a valve job, and then measure actual performance against these standards. Fast-food outlets such as McDonald’s have exacting standards for the quantity of meat going into a sandwich, as well as standards for the cost of the meat. Hospitals have standard costs for food, laundry, and other items, as well as standard time allowances for certain routine activities, such as laboratory tests. In short, you are likely to run into standard costs in virtually any line of business.

5. Ideal versus Practical Standards

Ideal standards allow for no machine breakdowns or work interruptions, and can be attained only by working at peak effort 100% of the time. Such standards:

Often discourage workers.

Shouldn’t be used for decision making.

There is no rest time for workers.

Continuous working with a view to enhancing the efficiency level of employees.

It does not allow for any kind of operation interruption, machine breakdown or sabotage.

Even though it is called ideal standard but normally there happens to be usual work interruption of any organization. Hence it is impossible to attain ideal standard in practice. So, it the deviation from the standard is generally high in this situation that is impossible to “manage by exception”.

Practical standards allow for “normal” down time, employee rest periods, and the like. Such standards:

Are felt to motivate employees because the standards are “tight but attainable.”

Are useful for decision-making purposes because variances from standard will contain only “abnormal” elements.

Rest time for employees.

Since the discrepancy is kept at normal level, it is not implausible for manager to “manage by exception”.

6. Direct Material Standards

- Speeds, Inc. makes a popular jogging suit. The company wants to develop standards for material, labor, and variable manufacturing overhead.

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- The standard price per unit for direct materials should be the final, delivered cost of materials. The standard price should reflect:

• Specified quality of materials.

• Discounts for quantity purchases.

• Discounts for early payment, if any.

• Transportation (freight) costs.

EXAMPLE: A material known as verilon is used in the jogging suits. The standard price for a yard of verilon is determined as follows:

Purchase price, grade A verilon............................ $5.70Less purchase discount in 20,000 yard lots.......... (0.20)Shipping by truck.................................................. 0.50 Standard price per yard........................................ $6.00

- The standard quantity per unit for direct materials is the amount of material that should go into each finished unit of product. The standard quantity should reflect:

• Engineered (bill of materials) requirements.

• Expected spoilage of raw materials.

• Unavoidable waste of materials in the production process.

• Materials in expected scrapped units (rejects).

EXAMPLE: The standard quantity of verilon in one jogging suit is computed as follows:

Bill of materials requirement................... 2.8 yardsAllowance for waste................................. 0.6 yardsAllowance for rejects................................ 0.1 yardsStandard quantity per jogging suit.......... 3.5 yards

Once the price and quantity standards have been set, the standard cost of materials (verilon) for one unit of finished product can be computed:

3.5yards per jogging suit × $6 per yard = $21 per jogging suit

7. Direct Labor Standards

- The standard rate per hour for direct labor should include all the costs of direct labor workers, including:

• Hourly wage rates.

• Fringe benefits.

• Employment taxes.

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- Many companies prepare a single standard rate for all employees in a department, based on the expected mix of high and low wage rate employees. This procedure:

• Simplifies the use of standard costs

• Allows monitoring the actual mix of employees in the department

EXAMPLE: The standard rate per hour for the expected labor mix is determined by using average wage rates, fringe benefits, and employment taxes as follows:

Average wage rate per hour....................... $13Average fringe benefits.............................. 4Average employment taxes........................ 1 Standard rate per direct labor-hour............ $18

- The standard hours per unit for direct labor specifies the amount of direct labor time required to complete one unit of product. This standard time should include:

• Engineered labor time per unit.

• Allowance for breaks, personal needs, and cleanup.

• Allowance for setup and other machine downtime.

• Allowance for rejects.

EXAMPLE: The standard hours required to produce a jogging suit have been determined as follows:

Basic labor time per unit........................... 1.4 hoursAllowance for breaks and cleanup............. 0.1 hoursAllowance for setup and downtime........... 0.3 hoursAllowance for rejects................................. 0.2 hoursStandard hours per jogging suit................ 2.0 hours

Once the time and rate standards have been set, the standard cost of labor for one unit of product can be computed:

2.0 hours per jogging suit × $18 per hour = $36 per jogging suit.

8. Variable Overhead Standards

- There may be standards for variable overhead, as well as for direct materials and direct labor. The standards are typically expressed in terms of a “rate” and “hours,” much like direct labor.

• The “rate” is the variable portion of the predetermined overhead rate.

• The “hours” represent whatever base is used to apply overhead cost to products. Ordinarily, this would be direct labor-hours or machine-hours.

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EXAMPLE: Speeds, Inc. applies overhead cost to products on the basis of direct labor-hours. The variable portion of the predetermined overhead rate is $4 per direct labor-hour. Using this rate, the standard cost of variable overhead for one unit of product is:

2.0 hours per jogging suit × $4 per hour = $8 per jogging suit.

9. Standard Cost Card

- After standards have been set for materials, labor, and overhead, a standard cost card is prepared. The standard cost card indicates what the cost should be for a completed unit of product.

EXAMPLE: Referring back to the standard costs computed for materials, labor, and overhead, the standard cost for one jogging suit would be:

Standard Cost Card for Jogging Suits

(1 )StandardQuantityor Hours

(2)Standard

Priceor Rate

(1) × (2)

StandardCost

Direct materials........................... 3.5 yards $6 per yard $21Direct labor................................. 2.0 hours $18 per hour 36Variable manufacturing overhead 2.0 hours $4 per hour 8Total standard cost per suit......... $65

10.Difference between Standards and budgets

Standards and budgets are very similar. The major distinction between the two terms is that a standard is a unit amount, whereas a budget is a total amount. While standard cost is per unit cost. Both are performance measurement tools.

10.1 Types of Standard

1. Quantity Standard – Quantity standard describes how much input should be allowed or used to produce a unit of product.

2. Cost or price standard – Cost or price standard incorporates how much should be input cost produce a unit of a product.

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- If either of the above standards significantly deviate from the actual result, management should investigate the area of discrepancy to find out the problem and eliminate it. This is called “management by exception”.

- If the actual result (Quantity or cost) is less than the standard performance (Quantity or cost), the deviation is “favorable” which is denoted by “F” and if the actual result is greater than standard performance that leaves the “unfavorable” result which is denoted by “U”

11.The General Variance Model

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A variance is the difference between what was planned or expected and what

was actually accomplished. A standard cost system has at least two types of

variances. A price variance focuses on the difference between standard and

actual prices. A quantity variance is concerned with the difference between the

standard quantity of input allowed for the actual output and the actual amount of

the input used. The standard quantity allowed (standard hours allowed in the

case of labor and overhead) is the amount of materials (or labor) that should

have been used to complete the output of the period.

11.1 DIRECT MATERIAL VARIANCES

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- To illustrate variance analysis, refer to the standard cost card for Speeds, Inc.’s jogging suit. The following data are for last month’s production:

Number of suits completed..................... 5,000 unitsCost of material purchased

(20,000 yards × $5.40 per yard)......... $108,000Yards of material used............................ 20,000 yards

- Using these data and the data from the standard cost card, the material price and quantity variances are:

Actual Quantity

of Input, at

Actual Price

Actual Quantity

of Input, at

Standard Price

Standard Quantity

Allowed for Output, at

Standard Price

(AQ × AP) (AQ × SP) (SQ × SP)

20,000 yards ×

$5.40 per yard

20,000 yards ×

$6.00 per yard

17,500 yards* ×

$6.00 per yard

= $108,000 = $120,000 = $105,000

Price Variance,

$12,000 F

Quantity Variance,

$15,000 U

Total Variance,

$3,000 U

* 5,000 suits × 3.5 yards per suit = 17,500 yards F = Favorable U = Unfavorable

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DIRECT MATERIAL VARIANCES (continued)

- The direct material variances can also be computed as follows:

MATERIAL PRICE VARIANCE:

• Method one:

MPV = (AQ × AP) – (AQ × SP)

= ($108,000) – (20,000 yards × $6.00 per yard)

= $12,000 F

• Method two:

MPV = AQ (AP – SP)

= 20,000 yards ($5.40 per yard – $6.00 per yard)

= $12,000 F

- The material price variance should be recorded at the time materials are purchased. This permits:

• Early recognition of the variance.

• Recording materials at standard cost.

MATERIAL QUANTITY VARIANCE:

• Method one:

MQV = (AQ × SP) – (SQ × SP)

= (20,000 yards × $6.00 per yard) – (17,500 yards* × $6.00 per yard)

= $15,000 U

*5,000 suits × 3.5 yards per suit = 17,500 standard yards

• Method two:

MQV = SP (AQ – SQ)

= $6.00 per yard (20,000 yards – 17,500 yards)

= $15,000 U

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11.2 DIRECT LABOR VARIANCES

- The following data are for last month’s production:

Number of suits completed (as before).......................... 5,000 unitsCost of direct labor

(10,500 hours @ $20 per hour).................................. $210,000

- Using these data and the data from the standard cost card, the labor rate and efficiency variances are:

Actual Hours

of Input, at the

Actual Rate

Actual Hours

of Input, at the

Standard Rate

Standard Hours


the Standard Rate

(AH × AR) (AH × SR) (SH × SR)

10,500 hours ×

$20 per hour

10,500 hours ×

$18 per hour

10,000 hours* ×

$18 per hour

= $210,000 = $189,000 = $180,000

Rate Variance,

$21,000 U

Efficiency Variance,

$9,000 U

Total Variance,

$30,000 U

* 5,000 suits × 2.0 hours per suit = 10,000 hours.F = FavorableU = Unfavorable

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DIRECT LABOR VARIANCES (continued)

- The direct labor variances can also be computed as follows:

LABOR RATE VARIANCE:

• Method one:

LRV = (AH × AR) – (AH × SR)

= ($210,000) – (10,500 hours × $18 per hour)

= $21,000 U

• Method two:

LRV = AH (AR – SR)

= 10,500 hours ($20 per hour – $18 per hour)

= $21,000 U

LABOR EFFICIENCY VARIANCE:

• Method one:

LEV = (AH × SR) – (SH × SR)

= (10,500 hours × $18 per hour)

– (10,000 hours* × $18 per hour)

= $9,000 U

*5,000 suits × 2.0 hours per suit = 10,000 hours

• Method two:

LEV = SR (AH – SH)

= $18 per hour (10,500 hours – 10,000 hours)

= $9,000 U

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11.3 VARIABLE MANUFACTURING OVERHEAD VARIANCES

- The following data are for last month’s production:

Number of suits completed (as before)............... 5,000 unitsActual direct labor-hours (as before)................... 10,500 hoursVariable overhead costs incurred........................ $40,950

- Using these data and the data from the standard cost card, the variable overhead variances are:

Actual Hours

of Input, at the

Actual Rate

Actual Hours

of Input, at the

Standard Rate

Standard Hours


the Standard Rate

(AH × AR) (AH × SR) (SH × SR)

10,500 hours ×

$4 per hour

10,000 hours* ×

$4 per hour$40,950 = $42,000 = $40,000

Spending Variance,

$1,050 F

Efficiency Variance,

$2,000 UTotal Variance,

$950 U

* 5,000 suits × 2.0 hours per suit = 10,000 hours.F = FavorableU = Unfavorable

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VARIABLE OVERHEAD VARIANCES (continued)

- The variable manufacturing overhead variances can also be computed as follows:

OVERHEAD SPENDING VARIANCE:

• Method one:

VOSV = (AH × AR) – (AH × SR)

= ($40,950) – (10,500 hours × $4.00 per hour)

= $1,050 F

• Method two:

VOSV = AH (AR – SR)

= 10,500 hours ($3.90 per hour* – $4.00 per hour)

= $1,050 F

* $40,950 ÷ 10,500 hours = $3.90 per hour

OVERHEAD EFFICIENCY VARIANCE:

• Method one:

VOEV = (AH × SR) – (SH × SR)

= (10,500 hours × $4.00 per hour)

– (10,000 hours** × $4.00 per hour)

= $2,000 U

** 5,000 suits × 2.0 hours per suit = 10,000 hours

• Method two:

VOEV = SR (AH – SH)

= $4.00 per hour (10,500 hours – 10,000 hours)

= $2,000 U

EXERCISE 10-9 Material and Labor Variances

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Topper Toys has developed a new toy called the Brainbuster. The company has a standard cost system to help control costs and has established the following standards for the Brainbuster toy:

Material requirements, kilograms of white chocolate per dozen truffles . . . . . . 0.80 kilogramsAllowance for waste, kilograms of white chocolate per dozen truffles. . . . . . . . 0.02 kilogramsAllowance for rejects, kilograms of white chocolate per dozen truffles . . . . . . . 0.03 kilogramsPurchase price, fi nest grade white chocolate . . . . . . . . . . . . . . . . . . . . . . . . £9.00 per kilogramPurchase discount . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5% of purchase priceShipping cost from the supplier in Belgium . . . . . . . . . . . . . . . . . . . . . . . . . . £0.20 per kilogramReceiving and handling cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . £0.05 per kilogramDirect materials: 8 diodes per toy at $0.30 per diodeDirect labor: 1.2 hours per toy at $7 per hour

During August, the company produced 5,000 Brainbuster toys. Production data on the toy forAugust follow:

Direct materials: 70,000 diodes were purchased at a cost of $0.28 per diode. 20,000 of these diodes were still in inventory at the end of the month.

Direct labor: 6,400 direct labor-hours were worked at a cost of $48,000.Page - 458 Chapter 10

Required:

1. Compute the following variances for August:a. Direct materials price and quantity variances.b. Direct labor rate and efficiency variances.2. Prepare a brief explanation of the possible causes of each variance.

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Solution to Exercise 10-9

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12.Advantages of Standard Costs

Standard cost systems have a number of advantages.

1. Standard costs are a key element in a management by exception approach. If costs conform to the standards, managers can focus on other issues. When costs are significantly outside the standards, managers are alerted that problems may exist that require attention. This approach helps managers focus on important issues.

2. Standards that are viewed as reasonable by employees can promote economy and efficiency. They provide benchmarks that individuals can use to judge their own performance.

3. Standard costs can greatly simplify bookkeeping. Instead of recording actual costs for each job, the standard costs for direct materials, direct labor, and overhead can be charged to jobs.

4. Standard costs fi t naturally in an integrated system of “responsibility accounting.” The standards establish what costs should be, who should be responsible for them, and whether actual costs are under control.

12.1 Potential Problems with the Use of Standard Costs

The improper use of standard costs can present a number of potential problems.

1. Standard cost variance reports are usually prepared on a monthly basis and often are released days or even weeks after the end of the month. As a consequence, the information in the reports may be so outdated that it is almost useless. Timely, frequent reports that are approximately correct are better than infrequent reports that are very precise but out of date by the time they are released. Some companies are now reporting variances and other key operating data daily or even more frequently.

2. If managers are insensitive and use variance reports as a club, morale will suffer. Employees should receive positive reinforcement for work well done. Management by exception, by its nature, tends to focus on the negative. If variances are used as a club, subordinates may be tempted to cover up unfavorable variances or take actions that are not in the best interests of the company to make sure the variances are favorable.

3. Labor quantity standards and efficiency variances make two important assumptions. First, they assume that the production process is labor-

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paced; if labor works faster, output will go up. However, output in many companies is not determined by how fast labor works; rather, it is determined by the processing speed of machines. Second, the computations assume that labor is a variable cost. However, direct labor may be essentially fixed. If labor is fixed, then an undue emphasis on labor efficiency variances creates pressure to build excess inventories.

4. In some cases, a “favorable” variance can be as bad as or worse than an “unfavorable” variance. For example, McDonald’s has a standard for the amount of hamburger meat that should be in a Big Mac. A “favorable” variance would mean that less meat was used than the standard specifics. The result is a substandard Big Mac and possibly a dissatisfied customer.

5. Too much emphasis on meeting the standards may overshadow other important objectives such as maintaining and improving quality, on-time delivery, and customer satisfaction. This tendency can be reduced by using supplemental performance measures that focus on these other objectives.

6. Just meeting standards may not be sufficient; continual improvement may be necessary to survive in a competitive environment. For this reason, some companies focus on the trends in the standard cost variances—aiming for continual improvement rather than just meeting the standards. In other companies, engineered standards are replaced either by a rolling average of actual costs, which is expected to decline, or by very challenging target costs. In sum, managers should exercise considerable care when using a standard cost system. It is particularly important that managers go out of their way to focus on the positive, rather than just on the negative, and to be aware of possible unintended consequences.

Nevertheless, standard costs are found in the vast majority of manufacturing companies and in many service companies, although their use is changing. For evaluating performance, standard cost variances are often complemented by a performance measurement system called the balanced scorecard.

13.Conclusion

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In modern cost accounting, the concept of recording historical costs was taken

further, by allocating the company's fixed costs over a given period of time to

the items produced during that period, and recording the result as the total cost

of production. This allowed the full cost of products that were not sold in the

period they were produced to be recorded in inventory using a variety of

complex accounting methods, which was consistent with the principles

of GAAP (Generally Accepted Accounting Principles). It also essentially enabled

managers to ignore the fixed costs, and look at the results of each period in

relation to the "standard cost" for any given product.

An important part of standard cost accounting is a variance analysis, which

breaks down the variation between actual cost and standard costs into various

components (volume variation, material cost variation, labor cost variation, etc.)

so managers can understand why costs were different from what was

planned and take appropriate action to correct the situation.

REFERENCES:

Managerial Accounting by Garrison, Noreen & Brewer. 12th Edition

Principles of Accounting by Weygandt, Kieso & Kimmel. 9th Edition

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Managerial Accounting by James Jiambalvo, 2nd Edition

http://en.wikipedia.org/wiki/Cost_accounting#Standard_cost_accounting

www.managerialaccounting.org/

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http://www.managerialaccounting.org/

http://en.wikipedia.org/wiki/Cost_accounting#Standard_cost_accounting

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Report on Standard Costs