MANAGEMENT ACCOUNTING

MANAGEMENT ACCOUNTING Cheryl S. McWatters, Jerold L. Zimmerman, Dale C. Morse

Management Accounting Standard costs andvariance analysis (Control) Chapter 12

Objectives • Provide reasons for using standard costs • Describe planning and control issues in setting standards • Calculate direct labour and direct material variances • Identify potential causes of different favourable and averse variances • Recognize incentive effects of standard costs • Measure expected, standard and actual usage of an allocation base to apply overhead and determine overhead variances • Identify factors that influence the decision to investigate variances • Summarize the costs and benefits of using standard variances

Standard Costs Future costs are used for planning because historical costs are not representative of future operations if conditions have changed

Standard Costs Standard Costs Expected future costs ofproducts and services The expected levelof performance Benchmarks formeasuring performance Used for planning labour, materialand overhead requirements

Reasons for Standard Costing ProductPricing ContractBidding PlanningDecisions Assessing alternative production decisions OutsourcingDecisions

Reasons for Standard Costing Bonus allocation Basis for contracts ControlDecisions Basis for managerial performance evaluation

Reasons for Standard Costing Managers focus on quantities and coststhat exceed standards, a practice known asmanagement by exception Standard Amount DirectMaterial Directlabour ManufacturingOverhead Type of Product Cost

This variance is unfavorable because the actual cost exceeds the standard cost Reasons for Standard Costing Standard A standard cost varianceis the amount by whichan actual cost differs fromthe standard cost Product Cost

Setting and Revising Standards • Accountants, industrial engineers, personnel administrators, and production managers often combine efforts to set standards based on experience and expectations • Attainable standards should be set at levels that are currently attainable with normal and reasonable effort Standards may be set using a . . . • Bottom-up approach involving the participation of all levels of management and staff • Top-down approach called target costing

Setting and Revising Standards DesiredMarket Share DesiredProfit TargetCosts Desired Returnon Capital Cost ReductionGoals

Direct Labour and Direct Materials Variances • Variances used primarily to identify problems • Variances calculated to help managers determine the cause and responsibility for the problem • By partitioning variances into component variances cause and responsibility become easier to identify • Variance due to actual price per unit differing from plan • Variance due to actual quantity per unit differing from plan

Direct Labour Variances Direct Labour variance is the difference between the actual direct labour costs and the standard direct labour costs Labour rate variance Labour efficiency variance

Direct Labour variance = Actual cost of labour - Standard cost of labour ( ) ( ) = Actual labour rate x Actual hours - Standard Labour rate x Standard hours Labour rate variance = Actual labour rate - Standard Labour rate x Actual hours ( ) Labour efficiency Variance = Actual hours - Standard hours x Standard Labour rate ( ) Direct Labour variance = Labour rate variance + Labour efficiency Variance Direct Labour Variances

Standard Cost Variances Standard Cost Variances Price Variance Quantity Variance The difference betweenthe actual price and thestandard price The difference betweenthe actual quantity andthe standard quantity

Direct labour Variances A Favorable variance occurs when the actual costs are less than the standard costs An adverse variances occurs if the actual costs are greater than the standard costs

Direct Labour Variances Rate per hour, R Rate Variance Ra Rs Efficiency Variance Hs Ha Hours of work, H Ra is the actual rate Ha is the actual hours Rs is the standard rate Hs is the standard hours

Direct Labour VariancesNumerical Example A public accounting firm estimates that an audit will require the following work: The following were the actual hours and costs

Direct Labour VariancesNumerical Example The direct labour variance Labour rate variance Labour efficiency variance

Direct Labour Variances Actual Hours Actual rate Actual Hours x Standard rate Standard Hours Standard rate x x £4,886 £4,835 £4,800 Direct labour rate variance £51 Adverse Direct labour efficiency variance £35 Adverse Direct labour variance £86 Adverse

Poorlytrainedworkers Poorqualitymaterials Poorsupervisionof workers Poorlymaintainedequipment Direct labour Variances UnfavorableEfficiencyVariance

Direct materials variances are similar to those computed for direct labour Direct Materials Variances Total direct materials variance is decomposed into a material price variance and a material quality variance

Direct material variance = Actual cost of material - Standard cost of material ( ) ( ) = Actual price x Actual quantity - Standard price x Standard quantity Price variance = Actual price - Standard price x Actual quantity ( ) Quantity Variance = Actual quantity - Standard quantity x Standard price ( ) Direct material variance = Price variance + Quality Variance Direct Materials Variances

Direct Materials Variances Price per unit on material, P Price Variance Pa Ps Quality Variance Qs Qa Units of material, Q Pa is the actual price Qa is the actual quantity Ps is the standard price Qs is the standard quantity

A tyre manufacturer has a standard quantity of 3 kg of fibreglass cord per automobile tyre. The standard price is €1.00 per kg Direct Materials VariancesNumerical Example During the month the purchasing manager bought 98,000kg of cord for €102,000. The plant used 95,000kg of cord to manufacture 30,000 tyres

Direct Materials Variances Actual quantity Actual price Actual quantity x Standard price Standard quantity Standard price x x £9,588 £9,610 £9,600 Direct material price variance (£22) Favourable Direct material quality variance £10 Adverse Direct material variance (£12) Favourable

Incentive Effects of Direct labour and Materials Variances When used as performance measures, standard cost variances create subtle incentive effects: • The incentive to build inventories • Externalities • Discouraging cooperative effort • Mutual monitoring incentives • Satisficing behaviour

Incentive to Build Inventories The evaluation of purchasing managers based on direct materials price variances creates incentives for these managers to build inventories This incentive can be reduced by charging the purchasing department for the cost of holding inventories An alternative mechanism for controlling inventory-building is to adopt techniques such as just-in-time manufacturing

Externalities Purchasing managers can impose externalities on production by purchasing sub-standard materials To offset this incentive the materials can be inspected on receipt against a set of engineering specifications An alternative mechanism would be to set a performance measure for the purchasing manager to minimize the amount of rework generated Production managers can impose externalities on purchasing by requesting materials are purchased on short lead times or in small lot sizes Engineering can increase the price of purchases by making frequent design changes

Unco-operative Effort Evaluating individuals within an organization based on different variances can discourage co-operative effort To encourage co-operative effort many organizations calculate variances and measure performance at multiple levels An alternative is to measure variances for a team or department within the organization

Mutual Monitoring Incentives Mutual monitoring occurs between managers who are not in a direct reporting relationship with each other In designing performance evaluation and reward systems, organizations can create mutual monitoring incentives that encourage managers to acquire and utilize their specialized knowledge to improve the performance of other managers

Satisficing Behaviour Satisficing behaviour occurs when manager have inventive to achieve a standard of performance but go no further Satisficing behaviour can affect quality if employees are motivated to meet quotas Management rewards should be based on achieving or exceeding the standard of performance

Standard Overhead Costs and Variances Quantity and price variances are defined in terms of the allocation base for overhead costs. • The quantity of overhead is the level of usage of the allocation base • The price of overhead is the overhead application rate

Expected, Standard, and Actual Usage of the Allocation Base • Expected usage is estimated at the beginning of the year and used to compute the predetermined allocation rate • Standard usage is the amount that should have been used for the actual output • Actual usage is the amount of the allocation based actually used

Expected, Standard, and Actual Usage of the Allocation BaseNumerical Example Pizzazz Pizza makes 2 types of pizza. The company allocates overhead based on the number of direct labour hours The direct labour hours for a pepperoni pizza is 5 minutes and the direct labour hours for a cheese pizza is 4 minutes. Pizzazz Pizza expected to make 12,00 pepperoni and 6,000 cheese pizzas. During the year the firm made 9,00 pepperoni and 7,500 cheese pizza. The labourers worked for 1,300 hours

Expected, Standard, and Actual Usage of the Allocation BaseNumerical Example

Budgeted, Applied,and Actual Overhead ActualOverhead Budgeted Overhead AppliedOverhead Actual costs of using overhead resources Overhead costs expected at the beginning of the period Overhead costs applied to cost objects through the standard usage of theallocation base The difference between actual overhead costs and applied overhead is the total overhead variance

Incentive Effects of Overhead Standards and Variances Desired Result Maintain the quality of overhead services while, at the same time, reducing overhead costs to obtain favorable variances Problem Output is increased, resulting in actual overhead < applied overhead (favorable variance) and excess inventories SolutionSeparate responsibilities so that overhead resource manager does not control output levels

Cost of not Correcting Size ofVariance Ease ofCorrection Cost of Correction Variance Investigation VarianceInvestigationDecision

Possible reductionsin production costs Management byexception Improved cost control and performanceevaluation Better Informationfor planning anddecision making Costs and Benefits of Using Standard Costing Systems Advantages

Emphasis on negativeexceptions may impactmorale Emphasis on negativeexceptions may leadto inappropriate behaviour It may be difficult to determine whichvariances are significant Focus on big variancesmay obscure earlystages of trends Costs and Benefits of Using Standard Costing Systems Disadvantages

Management Accounting Standard costs andvariance analysis (Control) End of Chapter 12

MANAGEMENT ACCOUNTING