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The Flexible Budget and Standard Costing: Direct Materials and Direct Labor

Chapter Thirteen. The Flexible Budget and Standard Costing: Direct Materials and Direct Labor. Learning Objectives. Explain the essence of control systems in general and operational control systems in particular

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The Flexible Budget and Standard Costing: Direct Materials and Direct Labor

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  1. Chapter Thirteen The Flexible Budget and Standard Costing: Direct Materials and Direct Labor

  2. Learning Objectives • Explain the essence of control systems in general and operational control systems in particular • Distinguish between effectiveness and efficiency aspects of operational performance • Develop standard costs for product costing, performance evaluation, and control • Develop and apply flexible budgets for evaluating short-term financial performance

  3. Learning Objectives (continued) • Recognize behavioral considerations in implementing a standard cost system • (Appendix): Record manufacturing cost flows and associated variances in a standard cost system

  4. Management Accounting & Control Systems • Control = set of procedures, tools, and systems organizations use to monitor activities and guide managerial actions • Management accounting & control system = core performance-measurement system of the organization, including both planning and feedback components: • Management Control Systems • Operational Control Systems

  5. Evaluation Operating Performance Components of an Operational Control System: • Effectiveness: • Has the organization accomplished its specified goals? • Efficiency: • Did the organization use resources efficiently? (Comparison of inputs to outputs—productivity) • Financial Performance Measures: • Standard Cost (and Revenue) Variance Analysis • Nonfinancial Performance Indicators: • These measures can be leading indicators (predictors) of future financial performance

  6. Standard Costs Standard Costs vs. a Standard Cost System? • Standard Costs = costs that should be incurred under efficient operating conditions • Standard Cost System = standard costs recorded in the formal accounting records • Regardless of whether a standard cost system is used, standard costs can be useful at the end of the period for financial control purposes (i.e., conducting variance analysis)

  7. Standard Costs • Types of Standards: • Ideal (Perfection) Standards • Currently Attainable Standards • Standard-Setting Procedures: • Authoritative Standards • Participative Standards • Standard Cost Sheet: • Contains both price and quantity components of each cost • See text Exhibits 13.2 and 13.3

  8. Budget Preparation • Master Budget: • Prepared before the start of the period • Contains the following items: • Budgeted sales volume • Budgeted sales price per unit • Budgeted variable cost per unit • Budgeted total fixed costs • Flexible (Control) Budget: • Prepared at the end of the period (after actual activity is known) • Actual sales volume is used, but with budgeted selling price per unit, budgeted variable cost per unit, and budgeted total fixed costs • Key to performing variance analysis at the end of the period

  9. Master Budget Example

  10. Actual Operating Profit Generated During the period the company actual produced and sold 8,000 units (not 10,000 as was originally planned). The actual operating income is $12,400, as follows:

  11. Total Operating Income (Master Budget) Variance for the Period ($12,600 U)

  12. Flexible Budget Example At the end of the period, we prepare a flexible (control) budget based on the 8,000 unit level, as follows:

  13. Explaining the Total Operating Income Variance • The total operating income variance should be traceable to a combination of the following four factors: • Actual sales volume was different than planned • Actual variable cost per unit was different than planned • Actual total fixed costs were different than planned • Actual selling price per unit was different than planned • The flexible budget allows us to breakdown the total operating income variance into components related to the above four factors

  14. Decomposing the Total Operating Income Variance ($5,300 U) (1) (2) (3)

  15. Breakdown of Total Operating Income Variance ($5,300 U) The difference between actual results and the flexible budget results = $4,700 F: • This difference is called the total flexible (controllable) budget variance • This variance captures the net effect of: • Actual selling prices per unit being different than planned • Actual variable cost per unit was different than planned • Actual total fixed costs were different than planned

  16. Breakdown of Total Operating Income Variance (continued) The difference between the flexible budget results and the master budget results = $10,000 U: • This difference is called the sales volume variance • Everything else other than volume is being held constant in calculating this variance; hence, the difference in operating income between the two budget columns is due entirely to sales volume being different than planned • The sales volume variance can also be calculated as: budgeted cm per unit x (actual – budgeted) units • In the example: $5/unit x 2,000 units = $10,000 U

  17. Breakdown of Total Operating Income Variance: Summary • Total Operating Income Variance = Actual Operating Income – Master Budgeted Operating Income = $19,700 - $25,000 = $5,300 U • Flexible (Controllable) Budget Variance = Actual Operating Income – Flexible Budget Operating Income = $19,700 - $15,000 = $4,700 F

  18. Breakdown of Total Operating Income Variance (continued) • Sales Volume Variance = Flexible Budget Operating Income – Master Budget Operating Income = $15,000 - $25,000 = $10,000 U • Total Operating Income Variance = Flexible Budget Variance + Sales Volume Variance = $4,700F + $10,000U = $5,300 U

  19. Breakdown of Total Flexible (Controllable) Budget Variance ($4,700 F) Sales Price Variance = Actual Sales $ - Flexible Budget Sales $ = $88,000 - $80,000 = $8,000 F Or, = AQ x (AP – SP) = 8,000 units x ($11 - $10)/unit = $8,000 F

  20. Breakdown of Total Flexible (Controllable) Budget Variance ($4,700 F) (continued) • Total Fixed Cost Variance = Actual Fixed Costs – Flexible Budget Fixed Cost = $25,700 - $25,000 = $700 U • Note that this budget (spending) variance on fixed costs can be further broken down: • First, by functional categories (e.g., Marketing) • Second, by individual costs within categories (e.g., Sales Manager Salaries)

  21. Breakdown of Total Flexible (Controllable) Budget Variance ($4,700F) (continued) • Total Variable Cost Variance = Actual Variable Costs – Flexible Budget Variable Costs = $42,600 - $40,000 = $2,600 U or, = AQ x (AP – SP) = 8,000 units x ($5.325 - $5.00)/unit = $2,600 U • This total variance can be further broken down: • First, by functional categories (e.g., Manufacturing) • Second, by individual costs within categories (e.g., Direct Materials Cost)

  22. General Model: Decomposing Variable Cost Flexible Budget Variances into Price and Quantity Components (1)(2)

  23. Decomposing Variable Cost Variances into Price and Quantity Components: Variable Notation

  24. Formulas for Decomposing Variable Cost Flexible Budget Variances into Price and Quantity Components • Variable Cost Variance = Actual Variable Costs – Flexible Budget Variable Costs = (AQ x AP) x (SQ x SP) • Breakdown of total variance: • Price (Rate) Variance = AQ x (AP – SP) • Quantity (Efficiency) Variance = SP x (AQ – SQ)

  25. Formulas for Decomposing Variable Cost Flexible Budget Variances into Price and Quantity Components (continued) • Notes: • For DM: AQ in the Price Variance formula represents “actual quantity purchased” • SQ = “standard quantity of resource input (e.g., DL) for the output of the period” • In a standard cost system, these variances are recorded in the formal accounting records (i.e., each in a descriptive account, such as “Direct Labor Rate Variance”)

  26. Example: Direct Materials (DM) Variance Decomposition Hanson Inc. has the following direct material standard to manufacture one unit of “Jerf”: 1.5 pounds per Jerf at $4.00 per pound Last month 1,700 pounds of material were purchased and used to make 1,000 Jerfs. The material cost a total of $6,630.

  27. Direct Materials (DM) Variance:Question 1 What is the actual price per pound (AP) paid for the material? a. $4.00 per pound. b. $4.10 per pound. c. $3.90 per pound. d. $6.63 per pound.

  28. Answer: Question 1 What is the actual price per pound(AP) paid for the material? a. $4.00 per pound. b. $4.10 per pound. c. $3.90 per pound. d. $6.63 per pound. AP = $6,630 ÷ 1,700 lbs.AP = $3.90 per lb.

  29. Direct Materials (DM) Variance:Question 2 Hanson’s materials price variance (MPV) forthe month was: a. $170 unfavorable. b. $170 favorable. c. $800 unfavorable. d. $800 favorable.

  30. Answer: Question 2 Hanson’s materials price variance (MPV) forthe month was: a. $170 unfavorable. b. $170 favorable. c. $800 unfavorable. d. $800 favorable. MPV = AQ x (AP - SP) MPV = 1,700 lbs. × ($3.90 - 4.00) MPV = $170 Favorable

  31. Direct Materials (DM) Variance:Question 3 The standard quantity (SQ) of material thatshould have been used to produce 1,000 Jerfs is: a. 1,700 pounds. b. 1,500 pounds. c. 2,550 pounds. d. 2,000 pounds.

  32. Answer: Question 3 The standard quantity of material (SQ) thatshould have been used to produce 1,000 Jerfs is: a. 1,700 pounds. b. 1,500 pounds. c. 2,550 pounds. d. 2,000 pounds. SQ = 1,000 units × 1.5 lbs per unit SQ = 1,500 lbs

  33. Direct Materials (DM) Variance:Question 4 Hanson’s material usage variance (MUV) for the month was: a. $170 unfavorable. b. $170 favorable. c. $800 unfavorable. d. $800 favorable.

  34. Answer: Question 4 Hanson’s material usage variance(MUV) for the month was: a. $170 unfavorable. b. $170 favorable. c. $800 unfavorable. d. $800 favorable. MUV = SP x (AQ - SQ) MUV = $4.00 x (1,700 - 1,500) lbs. MUV = $800 unfavorable

  35. Direct Materials (DM) Variances: Summary Total Flexible Budget Variance = $6,630 - $6,000 = $630U

  36. Causes of DM Variances • Price Variances: • Purchase of materials of different grade • Quantity discounts • Freight/delivery expediting cost (“rush orders”) • Quantity Variances: • Purchase of non-standard quality materials • Poorly trained or poorly supervised workers • Poorly maintained machinery (not calibrated properly)

  37. Causes of DL Variances • Price (Rate) Variances: • Labor substitution • Out-of-date standards (e.g., new labor contract) • Quantity (Efficiency) Variances: • Poorly trained workers • Poor quality raw materials used in production • Poorly maintained equipment • Poor supervision of workers • Out-of-date standards

  38. Behavioral/Implementation Issues • A standard cost system provides guidelines for operations and criteria or benchmarks for evaluating performance. • Companies should use variances strictly as inputs to gain a better understanding of and to improve operations • Variances should not be used to place blame (i.e., avoid “scapegoating”) • Research shows the importance of linking incentives to performance

  39. Appendix: Recording Standard Costs Recording DM Purchases: Materials Inventory (AQ X SP) $6,800 Materials Purchase Price Variance $ 170 Accounts Payable (AQ x AP) $6,630 Recording DM Usage: Work-in-process Inventory (SQ X SP) $6,000 Materials Usage Variance $ 800 Materials Inventory (AQ x SP) $6,800

  40. Chapter Summary • We defined the terms control systems, management accounting & control systems, and operational controlsystems • We distinguished between effectiveness and efficiency aspects of operational performance • We discussed the development of standard costs for product costing, performance evaluation, and control • We distinguished between flexible budgets and master budgets; the former are key for evaluating short-term financial performance (i.e., for financial control purposes)

  41. Chapter Summary (continued) • The difference between actual operating income and master budgeted operating income = total operating income variance • Also called “total master (static) budget variance” • Through the introduction of a flexible budget based on output, the total operating income variance is broken down into: • A total flexible budget variance, and • A sales volume variance = budgeted cm/unit x (actual – budgeted) sales in units

  42. Chapter Summary (continued) • The total flexible (controllable) budget variance is then broken down into component variances, e.g., • Total variable manufacturing cost variance • Total variable selling & administrative cost variance • Total fixed manufacturing cost variance • Total fixed selling & administrative cost variance • Further breakdown of the total variable manufacturing cost variance: • Total DM variance • Total DL variance • Total variable overhead variance (Chapter 14)

  43. Chapter Summary (continued) • Breakdown (decomposition) of total DM variance: • DM Purchase Price Variance: = AQ x (AP – SP) • DM Quantity Variance: = SP x (AQ – SQ) • Breakdown (decomposition) of total DL variance: • DL Price (Rate) Variance: = AQ x (AP – SP) • DL Quantity (Efficiency) Variance: = SP x (AQ – SQ)

  44. Chapter Summary (continued) • We discussed various behavioral considerations in implementing a standard cost system • (Appendix): We discussed how to record manufacturing cost flows and associated variances in a standard cost system • Standard cost variance analysis for overhead costs is covered in Chapter 14 • The end-of-period disposition of standard cost variance accounts is covered in Chapter 14

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