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Chapter 10 Outline
Standard Costing and Performance Measures for Today’s
- Cost Control
cost systems are used to help managers control the cost of operations. The
system has three components: standard costs (i.e., predetermined
costs), actual costs, and the difference between the two (termed a variance).
Calculated on a per-unit basis: A standard cost for each product cost
category (materials, labor, and overhead) is calculated on a per-unit basis.
This calculation considers the planned quantity of each input factor allowed
(pounds, hours, etc.) and the planned price for each input factor (price per
pound, rate per hour, etc.). The total planned cost is a mini, per-unit
Report showing variances: After the actual costs are known, a report
is generated showing actual costs, planned costs, and variances between the
two. A manager can examine the variance column quickly to ascertain which
exceptions require attention. Following up on significant variances is called
"management by exception." Managers focus their efforts where
they are most needed in the limited time available.
- Helps managers control costs
- Setting Standards
: Managers set standards by
analyzing historical data when the firm has experience in producing certain
product. This historical data must be termpered by giving consideration to
expected changes in technology, the production process, inflation and other
similar factors. Managers also use task analysis to focus on how much
a product should cost (e.g., time and motion studies as mentioned earlier in
Cross-functional standard setting useful: Knowledgeable people such as
engineers, purchasing agents, production supervisors, and accountants should
be brought into the standard-setting process. Cross-functional teams are very
Two types of standards: There are two types of standards that may be
used: perfection standards and practical standards.
- Standards sets based on historical data
- Perfection standards assume ideal world: Perfection standards assume
that production takes place in the ideal world: employees always work at
peak performance, materials are never defective, and machines never break
down. Although some managers feel that ideal standards give employees a goal
to shoot for, many behavioral scientists feel that setting unattainable
goals has a demotivating effect, as employees simply give up trying to reach
- Practical standards encourage productivity: In contract, practical
standards are set high enough to encourage efficient and effective
operations but not so high as to seem impossible. Behavioral scientists feel
that practical standards have a more positive effect on the productivity of
employees. Also, variances are more meaningful as they represent deviations
from a realistic goal.
- Service firms use standards: For example, McDonald’s restaurants
are noted for using standards, not only for quantities of material (amount
of beef per burger) but also for the time allowed to serve customers at the
drive-in window or counter.
- Variance Analysis
: Variance analysis involves
calculating the actual amount of input used in manufacturing and comparing
it to the amount of input that should have been used. More specifically, the
real cost of production is compared to a budget for that level of production
(the standard cost allowed for actual output). The variance is then
analyzed into its component parts and used to direct attention to deviations
from the plan.
Standards established: Standards are established for the amount of
material required to produce a finished product (the standard material
quantity), the anticipated delivered cost of materials (the standard
material price), the number of hours normally needed to manufacture one
unit of product (the standard direct-labor quantity), and the estimated
hourly cost of compensation (the standard labor rate).
Formulas for variance calculations for direct material and labor:
- Calculating and comparing input
DM Price = (AQ Purchased x AP) — (AQ Purchased x SP)
DM Qty. = (AQ Used x SP) — (SQ Used* X SP)
DL Rate = (AQ x AP) — (AQ x SP)
DL Efficiency = (AX x SP) — (SQ* x SP)
* Standard quantity for the actual production level
- Notice that the price and rate variance use a similar approach, and
the quantity and efficiency variances use a similar approach, with
efficiency being another way to say "quantity of hours) allowed.
- Variance Investigation
- Time restrictions make selective review necessary: A manager does
not have time to examine each variance; therefore, he or she must consider
selected factors in deciding when an investigation should take place. The
factors include one or more of the following:
- Size of variance: in absolute and/or relative terms, such as "I
will investigate every variance more than $6,0000 or 10% of standard
- Frequency of occurrence: an otherwise small variance may require
investigation if it consistently occurs, as it may indicate an ongoing
problem in production or an outdated standard.
- Trends: a small but ever-increasing variance could be a sign of a
- Controllability: it is useless to investigate items over which no
control can be exerted.
- Favorable variances: a manager should investigate both favorable and
unfavorable variances. A favorable variance with advertising expense, for
instance, could lead to the conclusion that an insufficient amount is being
spent on promotion, which could lead to a loss of customers.
- Costs and benefits: the decision to investigate involves a
cost-benefit analysis, as a number of investigative costs are incurred.
- Statistical control chart: Some companies use a statistical approach
to variance investigation by preparing a statistical control chart.
Such charts help to pinpoint random and non-random variances, with a
statistically determined critical value being compared to a variance to
determine whether or not an investigation is warranted.
- Behavioral Impact of Standard Costing
: Variances may be used to evaluate
personnel, often with regard to salary increases, bonuses, and promotions.
Negative and positive incentives created: Such incentives can have
positive and negative effects, as a bonus plan may prompt a manager to pursue
actions that are not in the best interests of the organization.
- Variances evaluate personnel
- Controllability of Variances
: It is rare that one person
controls any event; however, it is often possible to identify the manager
who is most able to influence a particular variance. These managers are
often the following:
- Importance of identifying who controls
- Direct-material price variances: Purchasing manager
- Direct-material quantity variance: Production supervisor and/or
- Direct-labor rate variance: Production supervisor
- Direct-labor efficiency variance: Production supervisor
- Variance often affect more than one input: Variances often interact,
making investigation and controllability difficult. For example, a labor
efficiency variance may be caused by problems not only with labor but by
problems with machinery and material as well. In addition, managers
sometimes trade-off variances, purposely incurring an unfavorable variance
that is more than offset by favorable variances.
- Standard Costs and Variances
- Cost flows: In a standard-cost system, costs flow thought the same
accounts in the general ledger as shown earlier in the text; however, they
flow through at standard cost. In other words, Work-in-Process Inventory,
Finished-Goods Inventory, and Cost of Goods Sold are carried at standard
- Differences recorded in variance accounts: The differences between
standard costs and the actual costs incurred are recorded in variance
accounts. Unfavorable variances are recorded as debits; favorable variances
are recorded as credits.
- Closed at end of accounting period: Variances are normally closed at
the end of the accounting period to Cost of Goods Sold.
- Advantages of Standard Costs
: A standard system has several advantages listed below:
- Sensible method: It provides a sensible method to compare budgeted
costs to actual costs at the actual level of output.
- Management by exception: Managers can practice management by
- Benchmark for performance: It provides a benchmark for performance
evaluation and employee rewards.
- Stable product cost: Standard costs provide a stable product cost.
Actual costs may fluctuate erratically, whereas standard costs are changed
- Less expensive: Standard systems are usually less expensive to
operate than actual or normalized systems.
- Critisms of Standard Costing in Today’s Manufacturing Environment
: Criticisms of standard costing in the new manufacturing
- Too aggregated and untimely: Variances are too aggregated and arrive
too late to be useful. Variances should focus on activities, specific
product lines, production batches, and/or FMS cells.
- Focuses on less important production factors: Variances focus too
much on the cost and efficiency of labor, which is becoming relatively
unimportant factor of production.
- Less stability of manufacturing environment: Standard costs rely on
a stable production environment, and flexible manufacturing systems have
reduced the stability, with frequent switching among a variety of products
on the same manufacturing line.
- Too focused on costs rather than quality: Standards focus too much
on cost minimization and not enough on product quality, customer service,
and other contemporary issues.
- Firms changing: Firms are making changes in their use of standard
costing by focusing more on material and overhead costs, using a variety of
cost drivers (other than labor hours), having more frequent revisions of
standards to reflect an ongoing cut in non-value-added costs, and so forth.
See pages 412-413 of the text for a more complete discussion.
- Operational Control Measures and the Balanced Scorecard
: Companies are now
focusing on an increased number of performance measures. These are tied to
areas such as raw material and scrap, product quality, productivity,
customer satisfaction, and innovation and learning. Specific measures often
- Increased focus on different performance measures
- Customer acceptance measures (e.g., customer complaints,
warranty claims, and product returns).
- Delivery cycle time (i.e., the average time between the
receipt of a customer order and the delivery of goods).
- Manufacturing cycle time (i.e., the total production time per
- Manufacturing cycle efficiency (i.e., processing time divided
by the sum of processing time, inspection time, waiting time, and move time.
- Balanced approach to performance evaluation: The balanced
scorecard is a balanced approach to the area of performance evaluation.
Employees are evaluated on a series of financial and nonfinancial measures
in a variety of areas, namely, financial, internal operations, customer
satisfaction, and innovation and learning. The goal is to broaden-out
employees so they look at the diverse attributes that are needed to produce
a successful, competitive business.
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