Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Standard Costs: Direct Labor and Materials Chapter Twelve
Mar 26, 2015
Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin
Standard Costs: Direct Labor and
Materials
Chapter Twelve
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Connection to Other ChaptersChapter 12 shows how standard costs
and variances are used for decision control.
Chapter 4 discussed the decision control process.
Chapter 6 showed how budgets are used in decision control.
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Standard Cost
Definition: The expected cost that is reasonably required to achieve a given objective under specified conditions.
Used for Decision Management: Standards can be better predictors of future costs
than actual past costs. Can be used in product pricing, bidding, and
outsourcing decisions.
Used for Decision Control: Set performance expectations or benchmarks for the
costs of products, processes, or sub-components. Variances from standards get attention of managers.
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Setting and Revising StandardsSetting standards depends on specialized
knowledge. Price standards from economic forecasts Quantity standards from engineering studies
Choosing between tight and loose standards Tight standards motivate higher performance
(decision control). Loose standards allow more discretion (decision
management).
Standards are usually set once a year. Frequent revision would reduce incentives to
control costs.
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Target Costing
Target costing is a technique used for new product planning.
1.Market planners begin with selling price required to achieve a desired market share.
2.Selling price Desired profit = Total target cost
3.Assign portion of total target costs to marketing, engineering, and manufacturing departments.
4.Redesign product and techniques to achieve target.
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Purpose of Variances
Variances measure the difference between actual and standard costs.
Favorable (F) variance, if actual < standard Unfavorable (U) variance, if actual > standard
Decision control Variances alert managers to deviations from
plan. Performance rewards may be based on
minimizing variances.
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Variance Computation
Symbols: T= Total; A = Actual; S = Standard; P = Price; Q = Quantity
Total Variance = Actual Cost minus Standard cost TV = (AQ AP) - (SQ SP)
= (AQ AP) + [ - (SP AQ) + (SP AQ)] - (SQ SP)
= [(AQ AP) - (SP AQ)] + [(SP AQ) - (SQ SP)]
= [AQ (AP - SP)] + [(AQ - SQ) SP]
= PV + QV Total Variance = Price Variance + Quantity Variance
See Self-Study problem.
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Direct Labor VarianceSymbols: a = Actual; s = Standard; H = Hours; W = Wage
rate per hour
Total Flexible budget Totalactual based on standardcost actual input cost(Ha Wa) (Ha Ws) (Hs Ws) |_______________________| |______________________|
[Ha (Wa - Ws)] [(Ha - Hs) Ws]Wage variance Efficiency variance
|_________________________________________________| [(Ha Wa) (Hs Ws)]
Total labor variance
See Figure 12-1.
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Interpreting Direct Labor VarianceLarge variances in either direction indicate
performance is not as planned, due to either poor planning, poor management, or random fluctuation.
Unfavorable wage varianceWorkers were not available at lower rates
Unfavorable wage variance with favorable efficiency variance
Higher-paid workers performed work more efficiently
Favorable wage variance with unfavorable efficiency variance
Lower-paid workers performed work less efficiently
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Direct Materials Variance - current use In this case, no direct materials remain in ending inventories.
Total Flexible budget Totalactual based on standardcost actual use cost(Qa Pa) (Qa Ps) (Qs Ps) |__________________| |_____________________|
[Qa (Pa - Ps)] [(Qa - Qs) Ps] Price variance Quantity variance
|____________________________________________| [(Qa Pa) (Qs Ps)]
Total materials variance
See Figure 12-2.
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Direct Materials Variance - no current use In this case, all purchased materials remain in ending
inventories.
Recognize material purchase price variance at time of purchase rather than waiting until materials are used.
Qb = Actual quantity bought
Total Flexible budgetactual based oncost actual purchased(Qb Pa) (Qb Ps) |_______________________|
[Qb (Pa - Ps)] Price variance
See Figure 12-3.
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Direct Materials Variance - current and future useTotal actual Flexible budget basedcost on actual purchased(Qb Pa) (Qb Ps) |_____________________|
[Qb (Pa - Ps)] Price variance
Flexible budget based Total standard on actual use cost (Qa Ps) (Qs Ps)
|_______________________| [(Qa - Qs) Ps] Quantity variance
Price variance recognized at time materials purchased.Quantity variance recognized at time materials are
used.
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Timely Reporting of Materials Price Variance is Important! Managers can act quickly to mitigate or
capitalize on price changes.
For example, if a raw materials price rises, managers might want to use less of the more expensive material and more of the relatively less expensive material, if such a substitution is possible.
And/or management might want to raise the selling price for the final products.
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Risk Reduction and Standard Costs Risk reduction is a service individuals are
willing to buy from financial markets.
Standard costs remove price and efficiency fluctuation from performance measures of downstream users.
Downstream users bear less risk because they know the standard costs they will be charged in the future.
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Incentive Effects: Build Inventories Rewarding purchasing managers for favorable
direct materials price variances creates an incentive for them to buy large quantities when price discounts are offered for high-volume purchases.
Penalizing production managers for unfavorable labor efficiency variances encourages keeping labor busy producing more.
Mitigation of inventory building incentiveCharge purchasing department for cost of holding
inventory.Just-in-time (JIT) purchasing and production policies
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Incentive Effects: ExternalitiesPurchasing externalities on production Purchase cheaper substandard materials. Purchase price variance is favorable. Unusable material results in unfavorable
material quantity variance.
Production externalities on purchasing Short lead times on requisitions lead to higher
purchase prices. Requesting special orders for materials leads
to higher prices.
See self-study problem, part b.
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Incentive Effects: Discourage Cooperation Evaluating performance evaluation on
individual's variances Emphasizes individual instead of team efforts Reluctance to help others look good
Solution: Base reward system on both individual and
departmental (team) variances. Too much weight on teamwork can lead to
shirking (free-rider problem).
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Incentive Effects: Mutual MonitoringMutual monitoring Method where managers or employees at the same
level monitor each other’s performance Noninsulating allocations encourage mutual
monitoring (see Chapter 7)
Example when performance evaluation of both purchasing and production managers depends on both material price and quantity variances.
Purchasing manager wants to help production manager become more efficient in material usage.
Production manager wants to schedule requisitions to help purchasing manager buy materials at better prices.
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Incentive Effects: Satisficing
Satisficing behavior: Managers have incentives to achieve standard
but go no further.
Firm value would increase if managers attempted
continuous improvement beyond standard innovate to meet competitive threats
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Disposition of Standard Cost VariancesAlternatives for disposing (writing off) standard cost
variances are similar to the alternatives for disposing of over/underabsorbed overhead (Chapter 9).
1. Writing all variances off to cost of goods sold (expense)
2. Allocating between costs of goods sold (expense) and work-in process and finished good inventory
3. Recalculating the cost of each job
The above alternatives are listed in order of increasing complexity.
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Cost of Maintaining Standard Cost System
Standard cost systems require: Detailed standards for each labor and material input Updating for technological and price changes Time to investigate and explain variances
Standard cost systems are less likely to be used when: Direct labor cost is a small portion of total cost Rapid change in production processes or new
product introductions require frequent revisions of standards