Chapter 7: Using Cost Data for Control

Standards for Management

A control system is made of three sub-components. The first component is the “standard level” that experts determine before the operations begin. The second part is “actual level” that depends on measurement after the end of the operations; and, the last level is “comparison of standard and actual levels”.

Standard cost is the cost determined by careful analyses that states how much something cost to the company under normal conditions.

Management by Exceptions

Managers use these deviations to evaluate the performance and to take corrective actions, when necessary. However, in order to use their time more effectively, managers separate the deviations as significant and insignificant deviations and follow up only the material ones. This is called “management by exception”

The amount of variation also depends on the standards as the benchmark point. For providing the variances tell the true story, standards must also be determined correctly. If the targets are mistaken, even if the operations are effective, they will seem to need corrections. Therefore, the effectiveness of the controlling process depends partially on the effectiveness of standard setting.

Setting the Standards

Generally, managers use two methods for setting the cost standards: historical data analysis and task analysis.

• Analysis of historical data; can be a good way to determine the standards for the upcoming period, if the company has enough experience at producing the product. However, managers also need to update the standards considering the changes in prices and production technologies.
• Task Analysis; is another method to use in standard setting. In this method, historical data has no use. Managers work together with the engineers to determine the standards.
• Combined approach; is also applied frequently by managers, especially in cases that the company has enough experience in producing the product, but because of new technologies and techniques, the historical data needs technical modifications that require engineering support.

Types of Standards

There are several types of standards that can be classified from different perspectives, such as:

1. the level of difficulty,
2. updating frequency,
3. subject of standards,
4. level of participation to the standard-setting process.

Standard Costing

Benefits and Criticisms on Standard Costing

Benefits of Standard Costing

Use of standard costing makes it easier to compare the actual results with budgeted results, by providing the opportunity to determine a new target that is adjusted for the actual output level, instead of a fixed level of production. Considering the size of variations from target results, managers may spend their time on significant problems rather than wasting for insignificant ones. These variances also provide benchmark points for the managers to evaluate the performance. As a result of the evaluations, employees may be punished or rewarded; both motivate them to meet the standards

Critiques for Standard Costing

The first critique is about the timeliness of variance data. The opponents of standard costing suggest that the variances are calculated after the company incurred the costs and revenues; therefore, it becomes too late to guide the managers. In addition, traditional standard costing systems are blamed for focusing too much on the efficiency of direct labor, which loses its relative value in modern production systems. Shortening product-lifecycles also shortens the duration of standards’ validity. Thus, new standard development is required each time a new product is launched, again for a short period of time.

Use of Standard Costing

Standard costing is appropriate for both planning and pricing decisions. Because the use of predetermined costs and rates allows management to plan the capacity and determine an appropriate price for the product.

The important point in standard costing is the determination of appropriate standards to be used in the accounting system. Once these standards are set, they are brought together in standard cost sheets.

Determining the Standards

Establishing the Standard Cost for Direct Materials: The standard cost for direct materials has three facets as quality, quantity, and price. The first step is to specify the desired quality of direct materials.

Establishing the Standard Cost for Direct Labor: In order to determine the standards for direct labor cost, industrial engineers, production personnel, labor union representatives and managerial accountants work together. They consider the transactions and qualifications required for the work and the condition of equipment to use; and set a standard time of labor work. During this process, opinions of experienced employees and past accounting records on labor costs are used, as well as the industrial engineering techniques such as time-motion studies and job sampling. Depending on the skill level and experience of workers, personnel department determines the standard wage rates that include the fringe benefits and relevant payroll taxes, as well.

Establishing the Standard Cost for Manufacturing Overhead: In companies that apply standard costing, the use of flexible budgets is more useful for controlling the overhead costs. Because it represents the costs that change according to changes in the volume of activity, separately than the costs that do not change. In other words, allocation rates are determined separately for the variable and fixed portion of manufacturing overhead costs. The sum of these rates gives the total allocation rate for overhead cost.

Recording the Cost Flows and Variances in a Standard Costing System

Normal costing considers the actual costs of direct materials and direct labor, too; but it calculates the overhead cost by using the predetermined standard rates. Standard costing, on the other hand, applies the standards for all components of manufacturing in the calculation of product cost. The accounts used to represent the cost flows are the same for all systems; the difference is the bases considered for costing the components.

Another difference is the use of variances in standard costing system. Standard costing uses variance accounts specific to each component of manufacturing.

Direct Material Costs

Direct materials have two different aspects in terms of recording. The first record incurs at the time of purchases and the other record is prepared upon consumption. If the company applies standard costing and recognizes the price variances at the point of purchases, the price actually paid for the materials and budgeted purchase cost differs and this difference is recorded as direct materials price variance. Another perspective on direct materials is about the efficiency in consuming it.

Direct Labor Costs

Similar to direct materials, direct labor costs are also considered from price and quantity perspectives. The difference is that for labor cost, purchasing and consumption incur at the same time. In other words, an increase in work-in-process inventory, accrual of wage liability and relevant variances may be reported by using the same entry.

Manufacturing Overhead Costs

Manufacturing overhead costs are divided into variable and fixed components.

Variable Overhead Costs: Assignment of variable overhead cost differs from direct materials and direct labor costs because the resources that incur variable overhead are not directly included in the product or production process.

Fixed Overhead Costs: The last component of product costs to account for is the fixed portion of manufacturing overhead cost. These costs are generally accepted as the investments that companies incur in order to create the needed capacity.

Finished Goods

After the production is completed, the cost for completed units, which has been accumulated in “Work-In-Process” account, is transferred to Finished Goods account.

Cost of Goods Sold

When the goods are sold, cost of goods sold account is debited to represent the cost that the company has incurred for the goods that are sold and it is calculated by multiplying the number of units sold and unit cost.

Disposal of Variances

When the year ends, variances are used in order to convert the standard amounts to actual results. There are two methods of conversion. One method is to directly writingoff to Cost of Goods Sold account, which accepts the assumption that all units are sold. The second method is proration, which assigns the amount of accumulated variances on Cost of Goods Sold, Work-In-Process Inventory and Finished Goods Inventory accounts depending on their relative values at the end of the year.

Short-Term Financial Control Through Budgets and Variances

The financial dimension of control is provided by comparing the budgeted numbers with actual results. The budgeted numbers represent the standard amounts that signal the targets to reach and provides benchmark points for the company to evaluate the performance.

Static Budgets and Financial Control

At the first level of financial control, static (master) budget is on the focus of managers. Comparing the targets in the master budget with actual results gives the management opinion about the size and direction of variances, and this is useful for providing a basic understanding of operative effectiveness.

Flexible Budgets and Financial Control

In order to evaluate the short-term financial performance, companies at first revise the static budgets for the actual sales volume and this newly created budget is called “flexible budget”.

The static budget variance is divided into two components by preparing the flexible budget and calculating the variations from both the static budget and actual results. One component represents the deviation resulting from the difference in sales volume and the other component represents the financial performance.

Analyzing the Direct Materials Cost

Direct materials cost in the flexible budget states the standard amount of direct materials that should be used for producing the actual volume of outputs. By comparing this cost with the actual cost, direct materials flexible budget variance is calculated.

Direct Materials Price Variance: The difference between the actual and budgeted purchase prices of direct materials causes this variance. Companies may calculate the price variance at one of two points in time; (i) the time of purchases, and (ii) the time of usage. The calculation at the time of purchases is more preferable because having information sooner than later provides management the opportunity to take proper actions.

Direct Materials Efficiency Variance: The second component of direct materials flexible-budget variance is the direct materials efficiency variance, which reflects the company’s efficiency in using the materials. Efficiency variance is the difference between the actual quantity of materials used and the standard quantity that should have been used for producing the actual output, multiplied by the standard price per unit of direct material.

Direct Labor Price (Rate) Variance: Direct labor price variance arises when the wage rate that a company pays is different from the standard rates predetermined before the beginning of the periodThe formula is ; Direct labor price variance = (Actual rate - Budgeted rate) x Actual labor hours worked.

Direct Labor Efficiency Variance: The amount shown in the flexible budget considers the standard number of direct labor hours needed for producing the actual number of outputs and the standard hourly rate for direct labor. The calculation is; Direct labor efficiency variance = (Actual labor hours - Budgeted labor hours) x Budgeted rate

Analyzing the Variable Overhead Cost

Overhead is different from direct costs in that the resources cannot be traced to cost objects in an economically feasible way. Because the indirect manufacturing costs do not have a homogenous structure. For example, indirect materials, indirect labor, power, utilities, etc. are examples of overhead costs; and, in order to determine product cost, these overhead components should be allocated by using a common basis. The need for allocation brings together the necessity of considering the use of allocation bases in terms of both rate and quantity.

Variable Overhead Spending Variance: Variable overhead spending variance measures the effect of differences between actual and standard rates.

Variable Overhead Efficiency Variance: Variable overhead efficiency variance measures the change in variable overhead costs with respect to the use of allocation base chosen.

Analyzing the Fixed Overhead Cost

Analysis of fixed overhead is different than analyzing the other costs because the fixed overhead cost does not change with the production volume.

Fixed Overhead Spending Variance: The difference between the actual and budgeted fixed overhead costs is called the Fixed Overhead Spending Variance. In other words, the difference between what the company plans to incur and what the company incurs during the period is the spending variance.

Production Volume Variance: Different from other costs, controlling for the fixed overhead cost requires the examination of capacity utilization, as the fixed costs are accepted as investments in capacity. Companies make capacity investments according to budgeted production. Capacity investment refers to the expenditures for making the resources ready for producing the expected number of units. The variance that helps the control of fixed costs in terms of capacity utilization is called the production volume variance.