Standard Costs:Direct Labor andMaterials
Chapter Twelve
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Outline of Chapter 12Standard Costs: Direct Labor and Materials
•Standard Costs
•Direct Labor and Materials Variances
•Incentive Effects of Direct Labor and MaterialsVariances
•Disposition of Standard Cost Variances
•The Costs of Standard Costs
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Connection to Other Chapters
Chapter 12 shows how standard costs and variances are usedfor 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 givenobjective under specified conditions.
Used for Decision Management:
•Standards can be better predictors of future costs than actual pastcosts.
•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 Standards
Setting 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 toachieve 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 andstandard costs.
•Favorable (F) variance, if actual < standard
•Unfavorable 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 + QuantityVariance
See Self-Study problem.
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Direct Labor Variance
Symbols: a = Actual; s = Standard; H = Hours; W = Wage rate per hour
Total Flexible budget Total
actual based on standard
cost 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 Variance
Large variances in either direction indicate performance is not asplanned, due to either poor planning, poor management, or randomfluctuation.
Unfavorable wage variance
•Workers 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.
TotalFlexible budget Total
actual based on standard
cost 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 thanwaiting until materials are used.
Qb = Actual quantity bought
TotalFlexible budget
actual based on
costactual purchased
(Qb Pa) (Qb Ps)
|_______________________|
[Qb (Pa - Ps)]
Price variance
See Figure 12-3.
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Direct Materials Variance -current and future use
Total actual Flexible budget based
cost 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 Varianceis Important!
•Managers can act quickly to mitigate or capitalize on pricechanges.
•For example, if a raw materials price rises, managersmight want to use less of the more expensive material andmore of the relatively less expensive material, if such asubstitution is possible.
•And/or management might want to raise the selling pricefor the final products.
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Risk Reduction and Standard Costs
•Risk reduction is a service individuals are willing to buyfrom financial markets.
•Standard costs remove price and efficiency fluctuationfrom performance measures of downstream users.
•Downstream users bear less risk because they know thestandard costs they will be charged in the future.
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Incentive Effects: Build Inventories
Rewarding purchasing managers for favorable direct materials pricevariances creates an incentive for them to buy large quantities whenprice discounts are offered for high-volume purchases.
Penalizing production managers for unfavorable labor efficiencyvariances encourages keeping labor busy producing more.
Mitigation of inventory building incentive
•Charge purchasing department for cost of holding inventory.
•Just-in-time (JIT) purchasing and production policies
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Incentive Effects: Externalities
Purchasing externalities on production
•Purchase cheaper substandard materials.
•Purchase price variance is favorable.
•Unusable material results in unfavorable material quantityvariance.
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-riderproblem).
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Incentive Effects: Mutual Monitoring
Mutual monitoring
•Method where managers or employees at the same level monitoreach other’s performance
•Noninsulating allocations encourage mutual monitoring (seeChapter 7)
Example when performance evaluation of both purchasing andproduction manager depends on both material price andquantity variances.
•Purchasing manager wants to help production manager becomemore efficient in material usage.
•Production manager wants to schedule requisitions to helppurchasing manager buy materials at better prices.
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Incentive Effects: Satisficing
Satisficing behavior: Managers have incentives to achievestandard 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 Variances
Alternatives for disposing (writing off) standard costvariances are similar to the alternatives for disposing ofover/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 increasingcomplexity.
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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 productintroductions would require frequent revisions of standards