- Businesses are ‘in control’ when operations proceed to plan and achieve objectives
- Necessary requirements for control
- –A predetermined performance level
- –A measure of actual performance
- –A comparison between standard performance and actual performance
- Standard costing: a budget for the production of one unit of product, either goods or services.
- It is the cost that serves as the benchmark in the budgetary control system.
- When the firm produces many units, the management accountant uses the standard unit cost to calculate the total standard or budgeted cost of production
- The process of setting those standards and related accounting activities are called Standard Costing
- (micro level budgeting!)
- Standard costing is a part of the budgetary control system
- –A predetermined or standard cost is developed
- –The actual cost incurred in the product process is measured
- –The actual cost is compared to the standard cost to determine a standard cost variance
Standard cost variances
- Standard cost variances: Any difference between the actual cost with the budgeted or standard cost.
- Used to evaluate actual performance and control costs
- Standard costs can be developed for direct material, direct labour and manufacturing overheads
- Significant cost variances must be investigated
- This may result in changes to actual operations to bring them back in line with standards (e.g. retraining production workers or purchasing raw materials of the correct quality). Alternatively, management may need to reconsider whether the standards are appropriate benchmarks.
Investigating significant variances and taking corrective actions
- Management by exception: Only significant cost variances are reported and investigated.
- Managers do not have time to look into the causes of every standard cost variance, so they need to determine which variances are significant enough to warrant investigation.
- Favourable and unfavourable variances warrant similar investigation
- –May reveal efficiencies and new improved practices
- –May mean that the standard is too loose
Which variances are significant?
- Size of variance (relative and absolute): The absolute size of a variance is one consideration. Managers are more likely to follow up large variances than small ones. The relative size of the variance compared with the standard is probably even more important.
- Managers may apply a rule of thumb that allows for both the absolute and the relative size of a variance; for example; ‘Investigate variances that are either greater than $10 000 or greater than 10 per cent of standard cost’.
- Recurring variances: whether the variance occurs repeatedly or only infrequently. eg. 6% variance each month
- Trends: eg. variance is increasing each month. An alert manager may follow up this trend to find out the causes before costs get out of hand.
- Controllability: the manager’s view of the controllability of the cost item. A manager is more likely to investigate the variance for a cost that is controllable by someone in the organisation than a cost that is uncontrollable.
- For example, there may be little point in investigating a material price variance if the business has no control over the price. This could happen, for example, if the firm has a long-term contract with a supplier at a price determined by the international market.
- Management judgement
- It is just as important to investigate significant favourable variances as it is to investigate significant unfavourable variances.
- For example, a favourable direct labour efficiency variance may indicate that employees have developed a more efficient way of doing a production task. By investigating the variance, management can learn about the improved method. It may be possible to use a similar approach elsewhere in the organisation.
- A continuing favourable variance may also indicate that the standard for material or labour is too loose or inaccurate, and needs to be made more challenging.
A statistical approach to variance investigations
- People are not machines, and they are not perfectly consistent in their work habits.
- Random fluctuations in direct labour efficiency variances can be caused by such
- factors as employee illnesses, or simply fatigue.
- Ideally, managers should sort the randomly caused variances from those with substantive and controllable underlying causes.
- Statistical control chart: plots standard cost variances across time and compares them with a statistically determined critical value that triggers an investigation.
- Critical value: is usually determined by assuming that standard cost variances have a normal probability distribution with a mean of zero. The critical value is set at some multiple of the distribution’s standard deviation. Variances greater than the critical value are investigated.
What is the behavioural impact of standard costing?
- Standard costing systems can be used to control costs and operations and to provide a basis for investigating both positive and negative cost performance.
- How well a standard costing system does this may depend on how the cost standards are developed and how they are used.
- Practical vs perfection standards
- Another factor that contributes to the effectiveness of standard costing systems in controlling costs is ensuring that the right managers develop the cost standards. Not just accountants- include managers in operations and HR.
- Participation: people will usually have greater confidence in the accuracy of standards, and be more committed to meeting those standards, if they have played a role in setting the standards.
- Thus, managers who are an integral part of an operation or process and who will be using the standards to control processes should participate in setting the standards.
- Similar to budgeting...
- Can be used to evaluate performance
- Hence, can be used to determine salary increases, bonuses and promotions
- As a result?
- –Motivate positive behaviours
- –Encourage the manipulation of data and reports and dysfunctional activities and decisions
- -participation may also create an incentive to set standards at a level that can be too easily achieved. That is, the standards may include padding.
- -could encourage manager to buy cheaper, low quality. Could result in dissatisfied customers.
Static and flexible budgets
- Static: relates to one specific planned level of activity
- Flexible: A detailed budget prepared for a range of levels of activity
- Allows us to select the most appropriate benchmark for cost control
- Provides a valid basis for comparing actual and expected costs to budget, for the actual level of activity
But first, how to Set standards
- A variety of methods used
- –Analysis of historical data: in a mature production process, where there is a lot of production experience, historical costs can provide a good basis for predicting future costs.
- The management accountant will often need to adjust predictions to reflect expected movements in price levels or technological changes in the production process.
- Management accountants must guard against relying on them excessively. Even a seemingly minor change in the way a product is manufactured may make historical data irrelevant; and standards based on historical data will embody any inefficiencies of the past. Moreover, for new products there will be no historical cost data upon which to base standards.
- –Engineering methods: to analyse the process of manufacturing a product or providing a service. The emphasis shifts from what the product did cost in the past to what it should cost in the future. (common for completely new products)
- When using this approach, the management accountant typically works with engineers who are familiar with the production process.
- Together they conduct studies to determine exactly how much direct material should be required and how machinery and direct labour should be used in the production process
- Time and motion studies: may be conducted to determine how long it should take workers to perform each step.
- Combined approach: In practice, both historical cost analysis and engineering methods are used to set cost standards.
- For example, if the technology has changed for one step of the production process, the management accountant would work with engineers to set cost standards for the changed part of the production process.
- However, the accountant would probably rely on the less expensive method of analysing historical cost data to update the cost standards for the remainder of the production process.
- Ideal/ Perfection Standards: (or theoretical standards)
- Reflect minimum attainable costs under nearly perfect operating conditions
- Assumes peak efficiency, the lowest possible material and labour prices, the use of the best quality materials and no production disruptions due to machine breakdowns or power failure.
- Motivational impact?
- –Motivation to achieve lowest cost possible- theorists claim that, since the standard is theoretically attainable, employees will be motivated to work as hard as possible to achieve it.
- –May discourage employees from working hard as standards unlikely to be achieved
- –Setting unrealistic and difficult standards may encourage employees to sacrifice product quality to achieve low costs. However, this lower cost may be achieved at the expense of a higher rate of defective units. Thus the firm ultimately incurs higher costs, as defective products may be scrapped or returned by dissatisfied customers.
- Practical/Attainable Standard:
- Standards that are challenging but are expected to be attained are called
- These standards assume a production process that is as efficient as is practical, under normal operating conditions.
- Practical standards are the minimum attainable costs under normal operating conditions
- Practical standards factor in occurrences such as occasional machine breakdowns and normal amounts of raw material wastage.
- Attaining a practical standard keeps employees on their toes, without demanding miracles.
- Motivational impact?
- - greater motivation to achieve standards (as more realistic)
- –May encourage more positive attitudes towards targets
- –May encourage inefficiency and waste
- –Can build continuous improvement into standards to make them more demanding
- In some companies, standard costs are determined by adding an amount (say, 5 percent) to costs to allow for idle time, wastage of material or normal spoilage.
- However, this practice is considered by many managers to provide the wrong signal to employees; ‘It’s OK to have a certain level of inefficiency and waste’.
- It also means that cost variances will hide the amount of wastage or spoilage that is built into the standard costs.
- Many manufacturing companies aim for continuous improvement, including improvements in work practices, standard costs and budget targets.
- This implies that standards should be challenging and, once attained, can then be made more demanding.
- The use of static practical standards may not meet these needs, as they are not continually adjusted to provide that extra stretch.
Benchmarking cost standards
- Benchmarking of costs involves identifying companies that have the best cost performance, assessing their levels of cost, and identifying the cost performance gap that needs to be closed.
- This allows the company to identify areas where it needs to improve its cost performance to achieve greater competitiveness.Cost standards may be formulated to achieve external performance standards over the medium to long term
Developing standards in service organisations
- In service firms, standard costs may be used for budgeting and cost control in much the same way that manufacturers use standards. eg. airplane
- However, in many service organisations, standard quantities and costs are not developed because the services provided to customers are non-repetitive. Services may be customised to suit the specific needs of a customer.
- There are several ways that costs can be managed so that inefficiencies can be detected and controlled.
- Rather than developing standard costs and variances for material and labour, service firms can develop standard quantities for key activities or processes used to deliver services, and measure variances from those standards.
- For example, in a call centre, standards may be set for the time taken to answer a phone and the time taken to solve a customer complaint.
- Note that these are not cost standards but focus on managing the time taken for key critical activities, which may lead to cost reductions.
Direct material standards
- Direct material: significant cost that can be traced directly to the product.
- Standard material quantity: the total amount of direct material normally required to produce one unit of a product.
- In subsequent years these quantities are adjusted as workers become more efficient in using materials, or as production processes change.
- Standard material price: the total delivered cost of the material, after subtracting any discounts.
- The standard price includes the cost of transportation to the plant.
- The prices of all materials are estimated by the purchasing manager as part of the budgeting process.
- The prices are based on the company ordering a certain quality of material in specific order quantities from a specified supplier.
- Thus any discounts for ordering material in economic quantities have been incorporated in the estimated price.
Direct labour standards
- Standard direct labour hours: is the number of labour hours normally needed to manufacture one unit of a product.
- The standard time that it takes to produce each R.M. Williams product is determined by the company engineer, who uses time and motion techniques
- Time and motion techniques: observes the production workers as they produce each product, and records the average times for each process.
- Standard labour rate: is the total hourly cost of wages, including on-costs.
- These on-costs are the extra salary-related costs that all Australian companies have to pay, and are usually treated as part of the cost of labour. They include a provision for annual and long service leave, workers’ compensation insurance, payroll taxes and employer’s superannuation contributions.
- The standard wage rates are determined by the accountant by considering the current wage rate and estimates of future wage rises for the coming year.
Standard costs given actual output
- Notice that the total standard cost for the direct material and direct labour inputs is based on the company’s actual output.
- The company should incur costs of $77 500 for direct material and $84 000 for direct labour, given that it produced 2 000 pairs of moleskins.
- The total standard costs for direct material and direct labour serve as the
- benchmarks against which to compare actual costs.
- This comparison then provides the basis for controlling direct material and direct labour costs.
Allowances for wastage, inefficiency or normal spoilage
- Some accountants argue that, when developing standards for direct material and direct labour, allowances should be made for material wastage and labour inefficiency.
- For example, instead of the standard quantity of 3.1 metres of fabric, an allowance of 5 per cent may be added to account for material wastage due to error or production problems. Such errors or production problems may result in normal spoilage, which is discarded. Therefore, the standard for cotton fabric would be 3.25 metres (3.1 metres × 1.05).
- However, these practices are becoming less common as many managers consider that wastage, allowances for inefficiency or normal spoilage should not be included in the standard cost.
- This is because it can send a message to operators and managers that a certain amount of wastage is an expected part of the production process.
- When allowances for wastage are not included within the standards for materials and labour, then any inefficiencies that occur are highlighted as unfavourable cost variances.
- Standard cost of a unit of output is a carefully determined cost based on standard quantity and standard price of DM, DL, MOH
- Standard cost is important for planning and control