- .11 STANDARD COSTING Overview of Product Costing Introduction Standards in the Organisation Types of Standards - Material Standards - La bo ur Standards - Overh ead St andards Illustration: The Pine Chair Company When Purchases Do Not Equal Consumption Summary of Variances Summary Overview of Product Costing The issue of how to accumulate costs in order to manage and control resources and aid in the pricing decision has been the focus of much debate over the last decade. The issue, in many ways, is highlighted in the difference between the management accounting techniques taught at universities and other institutions, and what is actually practise d in indus try. Part of the difference has resulted from short product ion runs result ing in increasi ng setup costs as opposed to production cost s, and the general move to nich e production marketing. The result of more flexible product ion has been a declin e in the relev ance of the traditional costing system s. One response to this has been the ‘discovery’ of activity based costing in industry and the realisation that costs are driven by ce rtain activities. These costs should be ‘attached’ or traced to those activities. Two general commen ts should be made. Firstly, the standard costing systems and allocation systems that have been severely criticised in recent times have become mis-matched to business needs due to a lackof change on the part of m any accountan ts and system designers. However, in modified form with more flexible adaptations, they are still potentially powerful and useful tools. Secondly, many accountants hav e been trapped into using ex isting software and costing packag es. Unfortunately, people typically revis e systems only when there is a substantial misfit; it is this misfit and consequent period of criticism that has been observed over the last decade.
This document is posted to help you gain knowledge. Please leave a comment to let me know what you think about it! Share it to your friends and learn new things together.
Overview of Product CostingThe issue of how to accumulate costs in order to manage and control resources and
aid in the pricing decision has been the focus of much debate over the last decade.
The issue, in many ways, is highlighted in the difference between the management
accounting techniques taught at universities and other institutions, and what is
actually practised in industry. Part of the difference has resulted from short
production runs resulting in increasing setup costs as opposed to production costs,
and the general move to niche production marketing. The result of more flexible production has been a decline in the relevance of the traditional costing systems.
One response to this has been the ‘discovery’ of activity based costing in industry
and the realisation that costs are driven by certain activities. These costs should be
‘attached’ or traced to those activities. Two general comments should be made.
Firstly, the standard costing systems and allocation systems that have been severely
criticised in recent times have become mis-matched to business needs due to a lack
of change on the part of many accountants and system designers. However, in
modified form with more flexible adaptations, they are still potentially powerful and
useful tools. Secondly, many accountants have been trapped into using existing
software and costing packages. Unfortunately, people typically revise systems only
when there is a substantial misfit; it is this misfit and consequent period of criticism
Chapters 11 and 12 should be seen as providing examples of product costing insimplified situations, yet the principles are sound and generalisable as long as they
are applied with care and thought to fit the actual production environment.
IntroductionEarlier we discussed the concepts and implications of planning and control. The
necessity for feedback was emphasised so that adjustments can be made to the
business that will better meet business goals. Standard costing is one of the tools
used in determining the performance of a product and how efficiently it is being
produced. The development of standards is also a major part of the planning and
budgeting process before production begins. There are several ways of
approaching the standard costing area as well as various levels at which it may be
examined. This text takes a middle approach in that we pursue the different
variances to a level suitable for most small to medium businesses but not in
sufficient detail for the needs of large corporations. However, the principles are the
same and it is straightforward to extend the level of analysis given here to cater for
any depth of problem.
Several key terms must be understood when dealing with standard costs. The first
is standard cost itself. A standard cost is a measure of cost performance that is
efficient and attainable. A standard cost is a predetermined figure based on what
individuals in the area consider to be an efficient level of production, given no
untoward breakdowns or holdups and presuming things are running smoothly. It is
not a theoretic maximum output unlikely to ever be achieved. One of the principlesof setting budgets and responsibility accounting is that the target is attainable and
that under favourable circumstances the workers will actually achieve the target.
When targets are set too high, the desired level is never attained and the
consequence can be one of worker insecurity and alienation.
The difference between the actual performance and the standard performance or
standard cost is the variance. The variance will either be favourable or
unfavourable depending upon whether the actual position was more efficient than
the standard position.
Standard costs can be used in virtually any business organisation from
manufacturing through to professional service organisations such as doctors,
accountants, lawyers. Generally, standard costing is used where there is a fairly
standard product, produced in a relatively repetitive situation. (Later in this chapter
we use an example of a small joinery firm that is producing wooden chairs).
As the task, or product, becomes more individual or unique, such as might be
associated with the product from professional or service organisations, the variation
in the form of the product means that standard costing must be much more carefully
and critically calculated. At some stage management must make a determination as
to whether it is cost effective to introduce a standard costing system or whether it is
better merely to review the performance of members of the organisation from time
to time, and compare members doing like tasks. With the increasing pressure on
organisations to be more accountable - especially in many professional areas -
people are now questioning both the efficiency of professional organisations as well
as whether they should in fact be doing the jobs that they are doing. This has led toa movement of standard costing into the areas of professional service organisations,
private hospitals, although in these instances the form of standard costing is less
structured and less regular than is found in a manufacturing situation. Part of the
move to a much broader acceptance of standard costing has also come from low
cost data processing facilities enabling the user to manipulate and adjust the raw
data to a number of alternate ends.
Standards may be derived in a number of ways. For example, historical standards
are derived from accumulated cost data that take no account of changing factors of
prices or efficiency. Thus, they are of little relevance in standard setting. Theoretic
or ideal standards are almost never attainable and should not be used since they
abstract from the real world of breakdown and human factors. Currently attainable
standards should be used and are described here.
The standard should be seen as achievable when the relevant factors are pursued in
an efficient manner. It should not be seen as an ultimate standard as this would
virtually never be achieved. Equally, it must not be seen as something that is
normally easily reached. In the everyday work situation, breakdowns will occur,
workers will not be as efficient as they could be for one reason or another, the
quality of the raw material may be variable, or any number of other reasons will
mean that an efficient standard is not reached. Thus, the standard must be set above
some ‘average’ level but it should be at a realistically attainable target. The
standard may be summarised as something that can be attained but is not always
attainable.
Standards in the OrganisationThe standard is in place to provide feedback to the organisation’s planning and
control system. It is therefore an integral part of the firm’s overall management
system and, as such, associated issues such as motivation and the psychology of the
workers cannot be ignored. It is important that when standards are set the workers
likely to be affected are involved in the standard setting process. For example, in an
organisation producing wooden stools it would be important to involve the fitters
and woodworkers in determining normal production levels, types of problems faced
in timber selection and quality, as well as problems with resins, stains, etc. By
involving the workers, management can better put together a realistic standard that
also has the understanding and support of the workers. A ready course for
obtaining worker dissatisfaction and disloyalty is for management to unilaterally
impose standards which bear little relation to the reality of the workplace.
When standards are put in place the inevitable favourable or unfavourable variances
will result in the supervisor attempting to sort out what went ‘wrong’ and discussing
this with the workers. It is therefore critical that the workers have confidence in
both the system and the information given to them. Thus, standards are seen as a
way to achieve efficient and harmonious operations in a business. It cannot be
- yet they must involve high achievement if they are to be met.
Standards are based on a number of specific pieces of information and as these
elements change, it is essential that the standard itself is updated. All too often
firms do not update the standards frequently enough, the standards become out of
date and people then lose confidence in the system. Price changes can easily and
quickly be adjusted for, as can labour rate changes. Questions of productivity and
labour efficiency as well as material usage will change over time depending on
many factors such as the performance of workers and their learning curves, format
of the factory floor and the use of different sorts of machines. Thus, it is critical
that the standard be monitored and changes incorporated.
The implementation of a standard costing system will result in favourable and
unfavourable variances. It is important that both favourable and unfavourablevariances that are material (important) are investigated by management. Often a
favourable variance in one area may be associated with an unfavourable variance in
another. For example, a discount purchase of timber might lead to a significant
favourable price variance. However, the timber may be of a poorer quality than
usual or not in the normal lengths leading to both an unfavourable material usage
variance as well as an unfavourable labour efficiency variance. Thus, when
working in the area of standard costing and variances it is critical that management
be aware of the interactions between the different variances and view the production
process from an overall perspective, as an integrated whole.
Although there will always be a variance from the standard, the minor or immaterial
variances should be treated as such and virtually ignored. Only when a major variance takes place, or a trend is perceived, should corrective action be initiated. It
costs money to run a standard cost system and therefore the costs of savings through
using the system must be balanced against the cost of running the system itself. In
large organisations threshold levels for intervention would be set based on past
experience and having evaluated the cost of taking action versus not taking action.
These levels or thresholds for intervention can themselves be seen as standards
which should change over time.
Types of StandardsWe will deal with three principal areas of standards, these being material, labour,
and overhead.
Material
Standards
There are two principal areas to be considered. Firstly, the price of the material on
a per unit basis and, secondly, the amount of the material used. The variance
between what the flexible budget expected you to pay for material and what you
actually paid is the price variance. The variance between what you expected to use
per unit of output and what you actually used is the usage variance. These two
variances together make up the materials variance. They are illustrated in Exhibit
11.1. A negative figure indicates an unfavourable (U) variance and a positive figure
These again fall into two elements. The labour rate variance is the difference
between the expected labour rate and the labour rate that is actually paid when
calculated on a total payment basis. The labour efficiency variance is the difference
between the hours expected to complete each unit of output and the actual hours
involved in each unit of output, multiplied by the standard rate. These two
variances combined make the labour variance, as illustrated in Exhibit 11.2. As withmaterials variances, a negative figure indicates an unfavourable (U) variance and a
positive figure indicates a favourable (F) variance.
Overhead costs are generally divided into variable overheads and fixed overheads.
Variable overheads comprise items such as power, heat, lighting and any other
items which generally vary with respect to the level of output. Note that the term
‘generally vary’ is used since the reason such items are classed as variable
overheads (as opposed to being itemised as direct materials) is that it is not cost
effective to itemise them nor to determine the direct relationship between these
variable items and the product output. Thus, variable overheads represent an
approximation to what is actually going on - they are a cost effective approximation
to the reality of the workplace.
The variable overheads are related to the units produced via a common
denominator. This denominator should vary as closely as possible with fluctuations
in the overhead costs themselves, in order that as representative a measure as possible of the efficiency of production with respect to variable overheads may be
obtained. Direct labour hours are commonly used as a basis for the allocation of
variable overhead costs since typically, variable overheads such as lighting and
power will vary according to the number of direct hours employed. Although this is
obviously a generalisation, it is sustained by the argument that it fairly approximates
the real world and it is not cost effective to use a more direct relationship. In some
circumstances, machine hours might be a better basis for allocating variable
overheads, but this is not commonly the case.
Variable overheads are examined under two categories in a similar manner to direct
materials and direct labour, these being a spending variance based on the difference
between the actual costs incurred and the standard costs of variable overheads based on the actual hours (labour or machine whichever is the case), and, an
efficiency variance, the difference between the standard variable costs based on the
actual hours and the standard variable costs based on the standard hours.
Fixed overheads include items such as rent and rates as well as supervisorysalaries. These can also be analysed under a two part format as above, but the fixed
overhead analysis is on a slightly different basis. This is best shown
diagrammatically, as in Exhibit 11.4.
The left-hand item (A) is the actual fixed overhead cost incurred. In other words,
the actual amount the firm paid to the suppliers of overhead services. The centre
amount (B) is the budgeted expenditure on fixed overhead costs which will of
course be the same under a fixed and variable budgeting system. The fixed
overheads should not change as long as there are only modest changes in output.
Note that when output becomes severely different from that which was budgeted,
there is likely to be a difference between the flexible budget for fixed overhead and
the fixed budget. (Remember that the determination of fixed and variable items is
virtually never ‘black and white’ and is always to some extent a mixed item.) Thus,
for these fixed costs it is held that, in the main, they closely approximate thecharacteristics of a fixed item. However, we are not saying that for every
conceivable level of output they are fixed (refer to the relevant range). The third
element of the calculation of the fixed overhead variance (C), is the actual fixed
overhead allocated. This is based on the actual units of output multiplied by the
standard rate. Since lower and middle management will often have no control over
fixed overheads, the volume variance should not normally be used for control
purposes.
These various elements of standard costing are demonstrated in the following
The spending variance is the difference between the incurred or actual expenditureand the budgeted overhead figure. The volume variance is the difference between
the budgeted figure and what is actually applied to jobs, in this case making the
over application $111, this being due to the extra 20 stools being produced. The
$5.55 is derived from the budgeted fixed overheads of $1,000 divided by the
expected output of 180 stools or $5.55 per stool. The application rate is then
multiplied by 200 stools, this being the actual output. This highlights how the
volume variance of $111, which is a direct recovery from the client arising from
extra volume of sales beyond that budgeted, is achieved.
Thus, the favourable volume variance and favourable spending variance combined
give the total fixed overhead variance of $161 favourable.
In making further bids for supplying stools, management must consider the
following points:
1. Whether the standard for materials should be changed, as both price and usage
were unfavourable.
2. Whether there are likely to be any wage rate changes that will affect the costs if
the contract were won.
3. What caused the ‘blow-out’ in variable overhead spending as this could put
future jobs in jeopardy.
4. To what extent the firm will gain efficiencies, firstly by moving down itslearning curve, and secondly on bulk purchase of materials (depending on the
size of future contracts).
5. Any other factors that are relevant.
When Purchases Do Not Equal ConsumptionUp until now we have assumed that the raw materials purchased are used in the
production for a particular order. However, this is seldom the case and generally
there is an inventory question to be addressed. The principal element here is to
what function should the price variance be allocated, for instance, on excess
inventory? It is normal practice for the purchasing decision to be consideredseparate from the production or usage decision. Thus, if a firm buys 50% more
inventory than it needs for a particular job then any price variance on the purchase
of that inventory should in total be recorded as a price variance at that time and
whether favourable or unfavourable should be recorded in the accounts of the firm.
In other words, the decision to purchase those goods, whether a good or bad
decision, should be recorded as such, separate from the use to which some of those
inventory items may be put.
Concomitant with this, the materials usage variance is calculated solely on the
materials used and the materials that should have been used (the standard). This
implies that the previous two elements of the materials standard that were brought
together for a total variance on materials cannot now legitimately be summed,
because the two elements are measuring different levels of materials. One is
inventory purchased and the other inventory used. These should be handled as
shown below.
Example of
Excess
Purchase of
Materials
Inventory
If in the Pine Chair Company illustration, the company had purchased a larger
amount of inventory than was necessary for the initial job (perhaps in anticipation
of follow-up orders) then this would be handled as follows:
Purchase of inventory 2,000 metres @ $2.10 per metre
Standards remain the same:
Direct Materials 4.8 metres @ $2 per metre
Materials Variance
Actual Materials Purchased Actual Materials Purchased
at Actual Cost at Standard Cost
2,000 @ 2.10 2,000 @ 2.0
= 4,200 4,000
Price Variance $200 U
Actual Materials Used Standard Materials to achieve
behaviour of the staff then it is likely to have quite significant negative impacts onthe feeling of staff towards management and the business, and hence on output and
productivity.
Finally, it should be said that standard costing is a relatively straightforward tool
when viewed from a theoretic or conceptual point of view. However, in practice,
the successful continuing usage of standard costing in a business requires sensitivity
and empathy on the part of those instigating and running the system.
Glossary of
Key Terms
Flexible Budget
A budget that changes with respect to volume changes and typically includes both
fixed and variable costs.
Standard Cost
A measure of performance that is efficient and attainable.
Variance
The difference between attained performance and standard performance.
Commonly evaluated in the areas of Material, Labour, Variable Overhead and
Fixed Overhead.
SelectedReadings
Chatham, C., ‘Updating Standard Cost Systems’, Journal of Accountancy,December 1990.
Foster, G. and Horngren, C.T, ‘JIT: Cost Accounting and Cost Management
Issues’, Management Accounting , June 1987.
Hayde, D., ‘Activity Based Costing - Putting Relevance Back into Cost
Accounting’, Accountants Journal , March 1991.
Howell, R.A., and Soucy, S.R., ‘Cost Accounting in the New Manufacturing
Environment’, Management Accounting , August 1987.
Kaplan, R.S., ‘Yesterday’s Accounting Undermines Production’, Harvard Business
Review, July-August 1984.
Linnegar, G., ‘An Investigation into the Management of Change in Cost Accounting
Information System Requirements during the Transition from Traditional
Manufacture to JIT Concepts’, Ann Arbor, Michigan University Mictrofilms
International, 1988.
Woods, M.D., ‘How We Changed our Accounting’, Management Accounting ,
a. Explain each of the variances. b. Suggest possible causes of the variances.
11.22
What is a variable overhead efficiency variance and how does it arise?
11.23
The manufacturing department of Arco Industries produced 15,000 units of produce in June, using18,000 hours of direct labour. Variable overhead is applied on the basis of direct labour hours, with
one direct labour hour allowed per unit of output. The standard allowance for variable overhead items
and the actual costs incurred in June are as follows:
Budget formula per Actual Costs
standard direct June
labour hour
Indirect labour 2.50 46,000
Maintenance .50 8,750
Electricity 1.10 20,050
Indirect materials 1.00 17,500
Lubricants .60 9,460
$5.70 $101,760
Required:
Prepare a detailed performance report showing variable overhead variances.