FINAL a Comparitive Study of Standard Costing 2003

PROJECT REPORT ON

A COMPARATIVE STUDY OF

STANDARD COSTING SYSTEM

AND VARIANCE ANALYSIS OF TWO

COMPANIES

SUBMITTED BY

ALISHA MAHAWLA 10008

AMI SAVLA 10010

ANKIT NALOTIA 10016

ESLYN FERNANDES 10043

GARGI CHAKRAWARTHY 10046

JITEN GOGRI 10054

A Report submitted to the MET Institute in partial fulfillment of the

requirement for the award of PG eMBA – Trimester II

UNDER THE GUIDANCE OF

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Prof. L. N. Chopde

MET INSTITUTE

CERTIFICATE

This is to certify that project titled A COMPARATIVE STUDY OF STANDARD COSTING SYSTEM

AND VARIANCE ANALYSIS OF TWO COMPANIES is based on the original study conducted by:

Alisha Mahawla, Ami Savla, Ankit Nalotia, Eslyn Fernandes, Gargi Chakrawarthy, Jiten Gogri

under my guidance and this has not formed a basis for the award of any other degree of MET

Institute.

Date: 25th February, 2011.

Place: Mumbai

PROF. L. N. CHOPDE

(Project Guide)

MET Institute of Management

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PREFACE

We had to prepare project report in our Accounting subject. We pondered over many topics

and came to conclusion that we would prepare the Project Report on Standard Costing and

Variance Analysis. We decided to prepare project report on Standard Costing, as they are the

guidelines set, which have to be followed while accounting and reporting transactions by a

company. We thought this would give us strong understanding and knowledge of these costing.

We went through, Standard Costing System and understood various concepts and mandatory

procedures required in calculation and reporting of Standard Costing System by companies. We

also clarified our doubts from qualified Chartered Accountants and their knowledge has helped

us to have a better insight on the standard.

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ACKNOWLEDGEMENTS

We wish to express our gratitude to some of the individuals who have contributed to the

successful completion of our project, directly or indirectly. In particular, we express our

gratitude to the following people without whom this project could not have been completed.

First and foremost we are grateful to our guide Prof. L. N. Chopde, under whose guidance we

have been able to successfully complete our project. We would like to acknowledge the

wholehearted cooperation and guidance provided by him.

We would also like to thank all our friends who gave their support and guidance and also

provided with deep insights on the subject. We are indebted to them for their support,

cooperation, and encouragement.

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EXECUTIVE SUMMARY

Basically, standard costing is a management tool for control. In the process, we have taken standards as parameters for measuring the performance. Cost analysis and cost control is essential for any activity. Cost includes material labor and overheads. Sometimes, we need to revise the standards due to change in uses, raw material, technology, method of production etc. For a proper organization, it is required to implement this under a committee for the activity. It is a continued activity for the optimum utilization of resources.

A standard cost system is designed to aid management in judging performance of a responsibility center in an organization.

The standard costing system is designed to facilitate:

(1) planning and controlling costs;

(2) judgment of performance;

(3) budget preparation;

(4) inventory valuation; and

(5) employee motivation.

The analysis of variances that are the differences between standard and actual costs is the key in a standard cost system. This reveals the causes of deviations between actual and standard costs. This feedback aids in planning future goals, controlling costs, and measuring performance.

It is a process by which production activities are recorded at standard costs and variances from actual costs are isolated. Standard costs are carefully predetermined target costs that should be attained under efficient operating conditions.

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STANDARD COSTING SYSTEM

Sr. No. Content Page No.1 Introduction 7

2 Material Standards 9

3 Labour Standards 10

4 Overhead StandardsVariance Analysis

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5 Case Study of:Harden CompanyStrayer Company

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6 Case Analysis of Parkside Products 18

7 Need for using standard costing 25

8 Summary of Actual costing, Normal costing and Standard costing 26

9 Summary of Standard Costs Formulas 27

10 Advantages of Standard Costing 28

11 Limitations of Standard Costing 29

12 Bibliography 30

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Introduction:

Standard Costing:Standard costs are realistic estimates of costs based on analysis of both past and projected operating costs andconditions. Standard costing is a budgetary control technique Standard costing has three components1. A standard. (A predetermined performance level)2. Actual performance3. A variance (comparing actual to standard)

Standard costs are pre-determined based on past and projected performance.In manufacturing it can be used in Job Order, Process costing or activity-based costing systems.In service it can be used to measure and evaluate operating performance. A bank or insurancecompany, for example, can use standard costing. Service organization will not have a materialinventory, however, standard levels of labor and overhead can be calculated.Once standards are determined, management use them as a tool for cost planning and control.

Developing Standard Costing:The computation of standard costs is more detailed than that of predetermined overhead cost. Whereas predetermined overhead rates are usually based on past cost, standard costs are based on engineering estimates, forecasted demand, worker input, time and motion studies, and type of quality of direct materials.

If you were to design a cost accounting system with no accounting education other than financial accounting courses, you would probably design an accounting system that collects, summarizes, and reports actual costs. This approach would be consistent with the implicit assumption throughout every financial accounting course that when financial statements report historical cost data, such as would normally be the case for cost-of-goods-sold and ending inventory, that the information reported represents actual costs. Therefore, it comes as a surprise to most students that the initial journal entries to record the production and movement of inventory in the costing systems of most manufacturing firms are not based on actual costs at all, but rather are based on budgeted per-unit costs.

In most manufacturing firms, the initial journal entries to debit work-in-process, finished goods and cost-of-goods-sold are based on the actual quantity of output produced, multiplied by budgeted data about the inputs necessary to produce those outputs, and the budgeted costs of those inputs. Then, at the end of the month (or possibly quarterly), an “adjusting” or “closing” entry is made to record in the inventory accounts the difference between actual costs incurred,

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and the budgeted information that has formed the basis for the journal entries during the month. The nature of this adjusting entry depends on the materiality of the amounts involved. If the differences between actual costs and budgeted costs are small, this adjusting entry might be made in an expedient manner, involving only cost-of-goods-sold, but if the differences are large, the adjusting entry might also involve work-in-process and finished goods inventory accounts.

The accounting system described above is called a standard costing system, and it is widely-used by companies in the manufacturing sector of the economy. This chapter describes standard costing systems, and explains why companies use them. But first we discuss a related concept, standard costs, which constitutes an important component of standard costing systems. Computing Standard Costs:A standard costing system uses all elements of product cost, that is, Direct Materials, Direct Labor, andManufacturing Overhead.Calculating Direct Materials Costs Standards:Steps:

1. Calculate the Direct Material Price Standard. Direct Material Price Standard is an estimatedof the cost of materials needed in the next accounting period. Typically the purchasing thedepartment is responsible for developing this number.

2. Calculate the Direct Material Quantity Standard. Direct Material QuantityStandard is an estimate of all the materials needed to manufacture the budged number units.The production manager or accountants are responsible for developing this standard.

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Material Standard

Setting Standards for Direct Materials

There are several basic principles which ought to be appreciated in setting standards for direct materials. Generally, when you want to purchase some material what are the factors you consider. If material is used for a product, it is known as direct material. On the other hand, if the material cost cannot be assigned to the manufacturing of the product, it will be called indirect material. Therefore it involves two things:

Quality of material Price of the material

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Labour Standard

Setting Direct Labor Cost

If you want to engage a labor force for manufacturing a product or a service for which you need to pay some amount, this is called wages. If the labor is engaged directly to produce the product, this is known as direct labor. The second largest amount of cost is of labor. The benefit derived from the workers can be assigned to a particular product or a process. If the wages paid to workers cannot be directly assigned to a particular product, these will be known as indirect wages. The time required for producing a product would be ascertained and labor should be properly graded. Different grades of workers will be paid different rates of wages. The times spent by different grades of workers for manufacturing a product should also be studied for deciding upon direct labor cost. The setting of standard for direct labor will be done basically on the following:

Standard labor time for producing Labor rate per hour

Standard labor time indicates the time taken by different categories of labor force which are as under:

Skilled labor Semi-skilled labor

Unskilled labor

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For setting a standard time for labor force, we normally take in to account previous experience, past performance records, test run result, work-study etc. The labor rate standard refers to the expected wage rates to be paid for different categories of workers. Past wage rates and demand and supply principle may not be a safe guide for determining standard labor rates. The anticipation of expected changes in labor rates will be an essential factor. In case there is an agreement with workers for payment of wages in the coming period, these rates should be

used. If a premium or bonus scheme is in operation, then anticipated extra payments should also be included. Where a piece rate system is used, standard cost will be fixed per piece. The object of fixed standard labor time and labor rate is to device maximum efficiency in the use of labor.

Standard costing and the related variances is a valuable management tool. If a variance arises, management becomes aware that

manufacturing costs have differed from the standard (planned, expected) costs.

If actual costs are greater than standard costs the variance is unfavorable. An unfavorable variance tells management that if everything else stays constant the company's actual profit will be less than planned.

If actual costs are less than standard costs the variance is favorable. A favorable variance tells management that if everything else stays constant the actual profit will likely exceed the planned profit.

By exerting control over costs in prosperous times, the ability to weather more demanding times is improved. Comparing actual amounts with budgeted amounts is one approach to control.

A standard cost is the expected or budgeted cost of materials, labor, and manufacturing overhead required to produce one unit of product.

The unit standard cost is calculated as follows:

Price standard × Quantity standard

A price standard is the price that should be paid per unit of input (such as pound of material).

A quantity standard is the quantity of input allowed per unit of output (for example, pounds of material allowed per one unit of product).

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A standard cost sheet calculates the total standard cost for one unit of product. It lists the standard costs for one unit of product for the following:

Materials (Price standard × Quantity standard)

Labor (Price standard × Quantity standard)

Variable manufacturing overhead (Price standard × Quantity standard)

Fixed manufacturing overhead (Price standard × Quantity standard

Overhead Standards

Normally, setting up standards is based on the past experience. The total standard cost includes direct materials, direct labor and overheads. Normally, all these are fixed to some extent. The standards should be set up in a systematic way so that they are used as a tool for cost control.

The purpose should be to increase efficiency in procuring and store keeping of materials. The type of standard used-- ideal standard or expected standard-- also affects the choice of standard price.

The next important element comes under overheads. The very purpose of setting standard for overheads is to minimize the total cost. Standard overhead rates are computed by dividing overhead expenses by direct labor hours or units produced. The standard overhead cost is obtained by multiplying standard overhead rate by the labor hours spent or number of units produced. The determination of overhead rate involves three things:

Determination of overheads Determination of labor hours or units manufactured

Calculating overheads rate by dividing A by B

The overheads are classified into fixed overheads, variable overheads and semi-variable overheads. The fixed overheads remain the same irrespective of level of production, while variable overheads change in the proportion of production. The expenses increase or decrease with the increase or decrease in output. Semi-variable overheads are neither fixed nor variable. These overheads increase with the increase in production but the rate of increase will be less than the rate of increase in production. The division of overheads into fixed, variable and semi-variable categories will help in determining overheads.

Overhead Rates

The rates considered for absorption of overheads in preparing the budgets are what are called budgeted rates. These are nothing but the standard (pre-determined) rates of absorption of overheads (since budgets are always based on the standards).

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The two types of absorption rates that we consider in variance analysis are

» Budgeted Rate Per unit

=Budgeted (Overhead) Cost

Budgeted OutputThis rate is generally identifiable from the budgeted data that is presented.

Rate per unit would be interpreted as

"Variable overhead Rate" per unit for analysing Variable Overhead Variances "Fixed overhead Rate" per unit for analysing Fixed Overhead Variances

"Total overhead Rate" per unit for analysing Total Overhead Variances

» Budgeted Rate per hour (unit time)

=Budgeted Overhead CostBudgeted Hours (Time)

This rate is identifiable from the budgeted data that is presented.

Rate per hour (unit time) would be interpreted as

"Variable overhead Rate" per hour (unit time) for analysing Variable Overhead Variances

"Fixed overhead Rate" per hour (unit time) for analysing Fixed Overhead Variances

"Total overhead Rate" per hour (unit time) for analysing Total Overhead Variances

• Budgeted (Overhead) Cost

The amount of overhead cost that is budgeted to be incurred during a period or process i.e. for the Normal/Budgeted activity.

It is obtained as the product of the Budgeted Activity and the Budgeted Rate (i..e the Pre determined rate of absorption of overhead).

Budgeted Cost =

= Budgeted Output × Budgeted Rate per unit.

This is relevant when the overheads are being absorbed on per unit basis.13

= Budgeted Time × Budgeted Rate per hour (unit time).

This is relevant when the overheads are being absorbed on per hour basis.

» Budgeted Overhead Cost would be interpreted as

Budgeted Variable Overhead Cost for analysing "Variable Overhead Variances"

The rate in such a case would be "Variable Overhead Rate" per unit/hour.

Budgeted Fixed Overhead Cost for analysing "Fixed Overhead Variances"

The rate in such a case would be "Fixed overhead Rate" per unit/hour.

Budgeted Total Overhead Cost for analysing "Total Overhead Variances"

The rate in such a case would be "Total overhead Rate" per unit/hour.

Actual Activity

This is the activity that is actually achieved during the production period or process. It may be measured in terms of output, input, labour time worked, machine hours worked, etc.

The two most common measures of activity that we deal with in analysing overhead variances are

» Actual Output

The output that has actually been achieved over the production period or process.

» Actual Time

The time for which the production process is actually carried on over the production period or process.

• Actual (Overhead) Cost » Incurred (Overhead) Expenditure

This is the actual overhead expenditure/cost incurred. This can be ascertained only after the incurrence of the cost i.e. at the end of the period or process in consideration.

The total overhead incurred is segregated into

Variable Overhead Expenditure/Cost

Fixed Overhead Expenditure/Cost

Semi-Variable Overhead Expenditure/Cost

• Where there are Semi-Variable Costs

If semi-variable overheads form a part of the total overhead cost/expenditure, it is segregated into two One a fixed part and the other a variable part.

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Since there are no tools to analyse semi-variable overheads separately, we add up the fixed part of the expense to Fixed Overhead Cost and the variable part of the expense to the Variable Overhead Cost respectively, for the purpose of variance analysis.

Therefore,

Fixed Overhead Cost/Expenditure Incurred = Fixed Overhead Cost/Expenditure + Fixed part in semi-variable overhead Cost/Expenditure

Total Variable Overhead Cost/Expenditure Incurred = Variable Overhead Cost/Expenditure + Variable part in semi-variable overhead Cost/Expenditure

The actual overhead cost/expenditure incurred would be interpreted as

Variable Overhead cost/expenditure incurred for analysing "Variable Overhead Variances"

Fixed Overhead cost/expenditure incurred for analysing "Fixed Overhead Variances"

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Standard Costing and Variance Analysis Case Study:

Case A:

Effect of Assumed Standard Levels:

Harden Company has experienced increased production costs. The primary area of concern identified by management is direct labor. The company is considering adopting a standard cost system to help control labor and other costs. Useful historical data are not available because detailed production records have not been maintained.

To establish labor standards, Harden Company has retained an engineering consulting firm. After a complete study of the work process, the consultants recommended a labor standard of one unit of production every 30 minutes, or 16 units per day for each worker. The consultants further advised that Harden's wage rates were below the prevailing rate of $ per hour.

Harden's production vice-president thought that this labor standard was too tight, and from experience with the labor force, believed that a labor standard of 40 minutes per unit or 12 units per day for each worker would be more reasonable.

The president of Harden Company believed the standard should be set at a high level to motivate the workers and to provide adequate information for control and reasonable cost comparison. After much discussion, management decided  to use a dual standard. The labor standard of one unit every 30 minutes, recommended by the consulting firm, would be employed in the plant as a motivation device, while a cost standard of 40 minutes per unit would be used in reporting. Management also concluded that the workers would not be informed of the cost standard used for reporting purposes. The production vice-president conducted several sessions prior to implementation in the plant, informing the workers of the new standard cost system and answering questions. The new standards were not related to incentive pay but were introduced when wages were increased to $7 per hour.The standard cost system was implemented on January 1, 19--. At the end of six months of operation, these statistics on labor performance were presented to executive management:

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*U = Unfavorable; F = Favorable

Case B

Factory Overhead Variance Analysis:

Strayer Company uses a standard cost system and budgets the following sales and costs for 2009

Unit sales $20,000Sales $2,00,000Total production cost at standard $130,000Gross profit $70,000Beginning inventories NoneEnding inventories None

The 2009 budgeted sales level was the normal capacity level used in calculating the factory overhead predetermined standard cost rate per direct labor hour.

At the end of 2009, Strayer Company reported production and sales of 19,200 units. Total factory overhead incurred was exactly equal to budgeted factory overhead for the year and there was under-applied total factory overhead of $2,000 at December 31. Factory overhead is applied to the work in process inventory on the basis of standard direct labor hours allowed for units produced. Although there was a favorable labor efficiency variance, there was neither a labor rate variance nor materials variances for the year.

Standard Costing Systems and Flexible Budgeting:

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January February March April May JuneProduction (units) 5100 5000 4700 4500 4300 4400Direct Labour Hrs 3000 2900 2900 3000 3000 3100 Variance of Quantity Based on labour std

$3150 U $2800 U $3850 U $5250 U $5950 U $6300 U

Variance of Based on cost std

$2800 F $3033 F $1633 U 0 $933 U $1167 U

In fact, a standard costing system tracks inventory during the period at the flexible budget amount. Recall that the flexible budget is the budgeted per-unit cost multiplied by the actual number of units. Hence, a standard costing system answers the question: what would the income statement and balance sheet look like, if costs and per-unit input requirements were exactly as planned, given the actual output achieved (units made and units sold).

For direct costs, such as materials and labor, this adjusting entry represents the sum of the price (or labor wage rate) variance and the efficiency (or quantity) variance. For overhead costs, this adjusting entry represents misapplied overhead. For variable overhead, misapplied overhead consists of the sum of the spending variance and the efficiency variance. Hence, standard costing systems track inventory at flexible budget amounts during the period, and post adjusting entries at the end of the period that provide variance information that managers use for performance evaluation and control.

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Case Analysis of Parkside Products.

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Material Cost &Variance Model

As shown below, Parkside Products uses813 boards to make 400 picnic tables in January 2001,However, rather than purchasing 813 boards the company purchases 850 boards at the price of $1.40. The material price variance is calculated as:

Labour Variances

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FLEXIBLE BUDGET FOR PICNIC

Overhead Variance23

Variable Overheads

Fixed Overheads

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Need of Standard Costing

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There are several reasons for using a standard costing system:

Cost Control: The most frequent reason cited by companies for using standard costing systems is cost control. One might initially think that standard costing provides less information than actual costing, because a standard costing system tracks inventory using budgeted amounts that were known before the first day of the period, and fails to incorporate valuable information about how actual costs have differed from budget during the period. However, this reasoning is not correct, because actual costs are tracked by the accounting system in journal entries to accrue liabilities for the purchase of materials and the payment of labor, entries to record accumulated depreciation, and entries to record other costs related to production. Hence, a standard costing system records both budgeted amounts (via debits to work-in-process, finished goods, and cost-of-goods-sold) and actual costs incurred. The difference between these budgeted amounts and actual amounts provides important information about cost control. This information could be available to a company that uses an actual costing system or a normal costing system, but the analysis would not be an integral part of the general ledger system. Rather, it might be done, for example, on a spreadsheet program on a personal computer. The advantage of a standard costing system is that the general ledger system itself tracks the information necessary to provide detailed performance reports showing cost variances.

Smooth out short-term fluctuations in direct costs: Similar to the reasons given in the previous chapter for using normal costing to average the overhead rate over time, there are reasons to average direct costs. For example, if an apparel manufacturer purchases denim fabric from different textile mills at slightly different prices, should these differences be tracked through finished goods inventory and into cost-of-goods-sold? In other words, should the accounting system track the fact that jeans production on Tuesday cost a few cents more per unit than production on Wednesday, because the fabric used on Tuesday came from a different mill, and the negotiated fabric price with that mill was slightly higher? Many companies prefer to average out these small differences in direct costs.

When actual overhead rates are used, production volume of each product affects the reported costs of all other products: This reason, which was discussed in the previous chapter on normal costing, represents an advantage of standard costing over actual costing, but does not represent an advantage of standard costing over normal costing.

Costing systems that use budgeted data are economical: Accounting systems should satisfy a cost-benefit test: more sophisticated accounting systems are more costly to design, implement and operate. If the alternative to a standard costing system is an actual costing system that tracks actual costs in a more timely (and more expensive) manner, then management should assess whether the improvement in the quality of the decisions that will be made using that information is worth the additional cost. In many cases, standard costing systems provide highly reliable information, and the additional cost of operating an actual costing system is not warranted.Summary of Actual Costing, Normal Costing and Standard Costing:

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The following table summarizes and compares three commonly-used costing systems.

Actual Costing System Normal Costing System Standard Costing System

Direct Costs:

(Actual prices or rates x actual quantity of inputs per output) x actual outputs

(Actual prices or rates x actual quantity of inputs per output) x actual outputs

(Budgeted prices or rates x standard inputs allowed for each output) x actual outputs

Overhead Costs:

Actual overhead rates x actual quantity of the allocation base incurred.

Budgeted overhead rates x actual quantity of the allocation base incurred.

Budgeted overhead rates x (standard inputs allowed for actual outputs achieved)

The following points are worth noting:

1. All three costing systems record the cost of inventory based on actual output units produced. The static budget level of production does not appear anywhere in this table.

2. Actual costing and normal costing are identical with respect to how direct costs are treated.

3. With respect to overhead costs, actual costing and normal costing use different overhead rates, but both costing systems multiply the overhead rate by the same amount: the actual quantity of the allocation base incurred.

4. Normal costing and standard costing use the same overhead rate.

5. Standard costing records the cost of inventory using a flexible budget concept: the inputs “that should have been used” for the output achieved.

There are costing systems other than these three. For example, some service sector companies apply direct costs using budgeted prices multiplied by actual quantities of inputs. For example, many accounting firms track professional labor costs using budgeted professional staff hourly rates multiplied by actual staff time incurred on each job.

Summarised Formulas for Standard Costing27

Advantages of Standard costing

Standard costing is a management control technique for every activity. It is not only useful for cost control purposes but is also helpful in production planning and policy formulation. It allows management by exception. In the light of various objectives of this system, some of the advantages of this tool are given below:

1. Efficiency measurement-- The comparison of actual costs with standard costs enables the management to evaluate performance of various cost centers. In the absence of standard costing system, actual costs of different period may be compared to measure efficiency. It is not proper to compare costs of different period because circumstance of both the

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periods may be different. Still, a decision about base period can be made with which actual performance can be compared.

2. Finding of variance-- The performance variances are determined by comparing actual costs with standard costs. Management is able to spot out the place of inefficiencies. It can fix responsibility for deviation in performance. It is possible to take corrective measures at the earliest. A regular check on various expenditures is also ensured by standard cost system.

3. Management by exception-- The targets of different individuals are fixed if the performance is according to predetermined standards. In this case, there is nothing to worry. The attention of the management is drawn only when actual performance is less than the budgeted performance. Management by exception means that everybody is given a target to be achieved and management need not supervise each and everything. The responsibilities are fixed and everybody tries to achieve his/her targets.

4. Cost control-- Every costing system aims at cost control and cost reduction. The standards are being constantly analyzed and an effort is made to improve efficiency. Whenever a variance occurs, the reasons are studied and immediate corrective measures are undertaken. The action taken in spotting weak points enables cost control system.

5. Right decisions-- It enables and provides useful information to the management in taking important decisions. For example, the problem created by inflating, rising prices. It can also be used to provide incentive plans for employees etc.

6. Eliminating inefficiencies-- The setting of standards for different elements of cost requires a detailed study of different aspects. The standards are set differently for manufacturing, administrative and selling expenses. Improved methods are used for setting these standards. The determination of manufacturing expenses will require time and motion study for labor and effective material control devices for materials. Similar studies will be needed for finding other expenses. All these studies will make it possible to eliminate inefficiencies at different steps.

Limitations of Standard Costing 1. It cannot be used in those organizations where non-standard products are produced. If

the production is undertaken according to the customer specifications, then each job will involve different amount of expenditures.

2. The process of setting standard is a difficult task, as it requires technical skills. The time and motion study is required to be undertaken for this purpose. These studies require a lot of time and money.

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3. There are no inset circumstances to be considered for fixing standards. The conditions under which standards are fixed do not remain static. With the change in circumstances, if the standards are not revised the same become impracticable.

4. The fixing of responsibility is not an easy task. The variances are to be classified into controllable and uncontrollable variances. Standard costing is applicable only for controllable variances.

For instance, if the industry changed the technology then the system will not be suitable. In that case, we will have to change or revise the standards. A frequent revision of standards will become costly.

BIBILOGRAPHY

www.google.com www.wikipedia.com www.icai.org www.investopedia.com

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