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Standard Costing, Variance Analysis and Kaizen Costing

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### 16

Standard Costing,Variance Analysis and Kaizen Costing

Using Standard-Costing Systems for Control

based on carefullypredetermined amounts.

used for planning labor

and material requirements.

the expected levelof performance.

benchmarks formeasuring performance.

a budget for the production of one unit of product or

service

ACTUAL COST

incurred and recorded in the production of the product or service

Using Standard-Costing Systems for ControlCOST VARIANCE

the difference

between the

actual cost and

the standard cost

This variance is unfavorable because the actual cost exceeds the standard cost.

Using Standard-Costing Systems for ControlStandard

A standard cost varianceis the amount by whichan actual cost differs fromthe standard cost.

Product cost

Management by Exception

Managers focus on quantities and coststhat deviate significantly from standards

(a practice known as management by exception).

Standard

Amount

Directmaterials

Directlabor

Type of Product Cost

Take the time to investigate only significant cost variances.Management by Exception

What is significant?

Depends on the size of the

organization

Depends on the production

process

Depends on the type of the organization

Variance Analysis Cycle

Takecorrective actions

Identifyquestions

Receive explanations

Conduct next period’s operations

Analyze variances

Prepare standard cost performance report

Begin

Setting Standards

What DID

the product

cost?

Analysis of

historical

data

Used in a mature

production process

What

SHOULD the product cost?

Task

analysis

Analyze the process

of manufacturing

the product

Combined

approach

Analyze the process for the step that

has changed, but use historical data

for the steps that have not changed

Participation in Setting Standards

Accountants, engineers, personnel administrators, and production managers combine efforts to set standards based on experience and expectations.

Perfection versus Practical Standards: A Behavioral Issue

PERFECTION

STANDARDS

PRACTICAL OR

ATTAINABLE

STANDARDS

Can only be attained under near perfect conditions

Tight as practical,

but still expected to be attained

- Peak efficiency
- Lowest possible input prices
- Best-quality material
- No disruption in
- production

- Occasional machine
- breakdowns
- Normal amounts
- of raw material
- waste

Practical standardsshould be set at levelsthat are currentlyattainable with

reasonable and

efficient effort.

Should we usepractical standardsor perfection standards?

Perfection versus Practical Standards: A Behavioral IssuePerfection versus Practical Standards: A Behavioral Issue

I agree.Perfection standardsareunattainable and therefore discouraging to most employees.

Setting Standards – Direct Materials

PriceStandards

QuantityStandards

Use competitivebids for the qualityand quantity desired.

Use product design specifications.

Setting Standards – Direct Materials

The standard materials cost for one unit of product is:

Standard quantity Standard price for of material one unit of material required for one unit of product

×

Setting Standards – Direct Labor

Ratestandards

Efficiencystandards

Use wage surveys andlabor contracts.

Use time and motion studies foreach labor operation.

Setting Standards – Direct Labor

The standard labor cost for one unit of product is:

Standard number Standard wage rate of labor hours for one hour for one unit of product

×

Examples

Standard Cost in Service Industries- Jobs with repetitive tasks lend themselves to efficiency measures.
- Computing non-manufacturing efficiency variances requires some assumed relationship between input and output activity.

Costs and Benefits ofStandard-Costing Systems

Benefits

Costs

IMPROVED

DECISION

MAKING, BUT:

Implementing and maintaining cost standards can

be time-consuming, labor-intensive, and expensive.

Price variance

Quantity variance

The difference betweenthe actual price and thestandard price

The difference betweenthe actual quantity andthe standard quantity

Cost Variance AnalysisA General Model for Variance Analysis

Actual quantity Actual quantity Standard quantity × × × Actual price Standard price Standard price

Price / Ratevariance

Quantity / Efficiency variance

A General Model forVariance Analysis

Actual quantity Actual quantity Standard quantity × × × Actual price Standard price Standard price

Price / Ratevariance

Quantity / Efficiency variance

Standard price is the amount that should have been paid for the resources acquired.

A General Model forVariance Analysis

Actual quantity Actual quantityStandard quantity × × × Actual price Standard price Standard price

Price / Ratevariance

Quantity / Efficiency variance

Standard quantity is the quantityallowed for the actual good output.

A General Model forVariance Analysis

Actualquantity ActualquantityStandardquantity× × × Actualprice Standardprice Standardprice

Price / Ratevariance

Quantity / Efficiency variance

Materials price variance Materials quantity varianceLabor rate variance Labor efficiency varianceVariable overhead Variable overhead spending variance efficiency variance

AQ(AP - SP) SP(AQ - SQ)

AQ = Actual Quantity SP= Standard PriceAP = Actual Price SQ = Standard Quantity

Standard Costs

Let’s use the concepts of the general model to calculate standard cost variances, starting withdirect materials.

Materials Variances

Koala Camp Gear Company in MelbourneAustralia has the following direct materialstandard to manufacture one Tree Line tent:

12 square meters per tent at$8.00 per square meter (sq m)

Last month Koala purchased 40,000 squaremeters at $8.15 per square meter and used36,400 square meters to make 3,000 tents.

We should compute the price variance using the actual quantity purchased.

Materials VariancesActual quantity Actual quantity purchased purchased × × Actual price Standard price

40,000 sq m 40,000 sq m × × $8.15 per sq m $8.00 per sq m

$326,000 $320,000

Price variance$6,000 Unfavorable

Materials Variances

SQ = 3,000 tents × 12 sq m per tent SQ = 36,000 sq m

Actual quantityused Standard quantity × × Standard price Standard price

We should compute the quantity variance using the actual quantity used.

36,400 sq m 36,000 sq m × × $8.00 per sq m $8.00 per sq m

$291,200 $288,000

Quantity variance$3,200 Unfavorable

Materials Variances

We may also calculate materialsvariances using formulas:

MPV = AQp(AP – SP) MPV = 40,000 sq m × ($8.15 – $8.00) MPV = $6,000 Unfavorable

MQV = SP(AQu – SQ) MQV = $8.00(36,400 sq m – 36,000 sq m) MQV = $3,200 Unfavorable

I need the variances as soonas possible so that I canbetter identify problems and control costs.

You accountants just don’tunderstand the problems weproduction managers have.

Okay. I’ll computethe price variance whenmaterials are purchased, and the usage variance assoon as material is used.

Reporting Materials VariancesYour poorly trained workers and poorly maintained equipment caused the problems.

Also, your poor scheduling requires rush orders of materials at higher prices, causing unfavorable price variances.

Responsibility for Materials VariancesI am not responsiblefor this unfavorablematerials usagevariance.

You bought poor qualitymaterials, so my peoplehad to use more of it.

Standard Costs

Now let’s calculate standard cost variances for direct labor.

Labor Variances

Koala has the following direct laborstandard to manufacture one Tree Line tent:

2 standard hours per tent at$18.00 per direct labor hour

Last month 5,900 direct labor hours were worked at $19.00 per hour to make 3,000 tents.

Labor Variances

SH = 3,000 tents × 2 hours per tent SH = 6,000 hours

Actual hours Actual hours Standard hours × × × Actual rate Standard rate Standard rate

5,900 hours 5,900 hours 6,000 hours × × ×$19.00 per hour $18.00 per hour $18.00 per hour

$112,100 $106,200 $108,000

Rate variance$5,900 Unfavorable

Efficiency variance$1,800 Favorable

Labor Variances

We may also calculate laborvariances using formulas:

LRV = AH(AR - SR) LRV = 5,900 hrs($19.00 - $18.00) LRV = $5,900 Unfavorable

LEV = SR(AH - SH) LEV = $18.00(5,900 hrs - 6,000 hrs) LEV = $1,800 Favorable

Labor Rate Variance – A Closer Look

Using highly paid skilled workers toperform unskilled tasks results in anunfavorable price variance.

High skill,high rate

Low skill,low rate

Production managers who make work assignmentsare generally responsible for price variances.

Poorqualitymaterials

Poorsupervisionof workers

Poorlymaintainedequipment

Labor Efficiency Variance –A Closer LookUnfavorableEfficiencyVariance

You used too much time because of poorly trained workers and poor supervision.

Responsibility for Labor VariancesI am not responsible for the unfavorable laborefficiency variance!

You bought poor qualitymaterials, so my people tookmore time to process them.

Responsibility for Labor Variances

Maybe I can attribute the laborand materials variances to personnel for hiring the wrong peopleand training them poorly.

= 80% X Input quantity

Good output quantity ÷ 80%

= Input quantity allowed

5,000 liters of good

output ÷ 80%

= 6,250 liters of

input allowed

Allowance for Defects or SpoilageIn some manufacturing processes, a certain amount of defective production or spoilage is normal.

Example: 1,000 liters of chemicals are normally required in a chemical process in order to obtain 800 liters of good output. If total good output in February is 5,000 liters, what is the standard allowed quantity of input?

Relative amount

Significance of Cost Variances: When to Follow UpHow does a manager know when to follow up

on a cost variance and when to ignore it?

Size of variance

?

What clues help me to determine the variances that I should investigate?

Significance of Cost Variances- Size of variance
- Dollar amount
- Percentage of standard
- Recurring variances
- Trends
- Controllability
- Favorable variances
- Costs and benefits of investigation

Larger variances, in dollar amount or as a percentage of the standard, are investigated first.

Significance of Cost Variances: When to Follow UpHow do I know which variances to investigate?

We could use a rule of thumb such as:investigate all variances that are over $10,000or over 10 percent of the standard cost.

Significance of Cost Variances: When to Follow Up

What about recurring variances?

None of the variances are greater than $10,000 or

10% for any one month, but they should be investigated because of they have continued for several months.

Significance of Cost Variances: When to Follow Up

What about trends?

None of the variances are greater than $10,000 or

10% for any one month, but they should beinvestigated because of the unfavorable trend.

Significance of Cost Variances: When to Follow Up

Controllability

A manager is more likely to investigate a variance that is controllable by someone in the organization than one that is not.

Favorable variances

It is as important to investigate significant favorable variances as well as significant unfavorable variances.

Cost and benefits of investigation

The decision whether to investigate a variance is a cost - benefit decision

Display variations in a process and help to analyze the variationsover time.

Distinguish between random variationsand variations thatshould be investigated.

Provide a warning signal when variationsare beyond a specified level.

Statistical AnalysisControlcharts

Statistical Analysis

Warning signals for investigation

•

•

Favorable limit

•

•

•

•

•

Desired value

•

Unfavorable limit

•

1

2

3

4

5

6

7

8

9

Variance measurements

Behavioral Effects of Standard Costing

Standard costs, budgets and variances are used to

evaluate the performance of individuals and departments

They can profoundly influence behavior when they are used to

determine salary increases, bonuses and promotions

Which Managers Influence Cost Variances?

Direct-materials price variance

Purchasing manager

Get the best prices available for purchased goods andservices through skillful purchasing practices

Direct-materials quantity variance

Production supervisor

Skillful supervision and motivation of production employees, coupled with

the careful use and handling of materials, contribute to minimal waste

Direct-labor rate variance

Production supervisor

Generally results from using a different mix of employeesthan that anticipated when the standard were set

Direct-labor efficiency variance

Production supervisor

Motivating employees toward production goals andeffective work schedules improves efficiency

16-5

Physical

resources

Human

resources

Research

and

develop-

ment

Design

Supply

Produc-

tion

Marketing

Distri-

bution

Customer

service

Interaction among VariancesInteraction among variances often occurs, making it difficult to

determine the responsibility for a particular variance.

Variances in one part of the value chain can bedue to root causes in another part of the chain.

Value chain

perspective

16-6

Using Standard Costs for Product CostingWork-in-process inventory

Finished-goods inventory

Direct-materials cost

Product cost transferred

Direct-labor cost

when product is finished

Manufacturing

overhead

Product cost transferred when product is sold

Cost of goods sold

Income summary

Expense closed into

Income summary at end

of accounting period

- Inventories are recorded at standard cost.
- Variances are recorded as follows:
- Favorable variances are credits, representing savings in production costs.
- Unfavorable variances are debits, representing excess production costs.
- Standard cost variances are usually closed to cost of goods sold.
- Favorable variances decrease cost of goods sold.
- Unfavorable variances increase cost of goods sold.

Impact of Information Technology on Standard Costing

Labor time and rate

are recorded at standard,using bar codesand employee IDs.

CAD designers can accessthe data base for instantdesign cost estimates.

Standard costdata base

Materials purchases

and uses are recordedat standard,using bar codes.

Standard Costing: Its Traditional Advantages

Sensible costcomparisons

Managementby exception

Performanceevaluation

Employeemotivation

Less expensive thanactual- or normal-costing systems

More stableproduct costs

There is too much focus on the cost and efficiency of direct labor.

Automation reduces labor costs and the significance of labor variances.

Automated manufacturing processes tend to be more consistent in meeting production specifications.

Variance reports are often provided too late to be useful to managers.

Variances are often too aggregated. They are not tied to specific product lines, production batches, or to the flexible management system.

Standard costing may not be applicable in flexible manufacturing operationswith short life-cycle products.

There is too much focus on cost minimization rather than increasing product quality or customer service.

Criticisms of Standard Costing in Today’s Manufacturing EnvironmentReduced importance of labor standards.

More emphasis on material and overhead costs.

Less use of laboras a cost driver.

Adaptation of Standard-Costing SystemsApplications of standard costing have adapted tochanges in the manufacturing environment and theresulting criticisms leveled at standard costing.

Automation means more overhead, less labor.

Adaptation of Standard-Costing Systems

Applications of standard costing have adapted tochanges in the manufacturing environment and theresulting criticisms leveled at standard costing.

Automation

Reduces labor efficiency variance

Reduces material quantity variance

Reduces variation in qualityand increases quality

Adaptation of Standard-Costing Systems

Applications of standard costing have adapted tochanges in the manufacturing environment and theresulting criticisms leveled at standard costing.

More frequent benchmarking

Shorter product life cycles

Elimination of non-value-added costs

More frequent revisions of standard costs

Non-financial measures such a delivery times are more important

Real-time information systems provide more timely variance reports

Comparing Standard Costing and Kaizen Costing

- Standard costing – the use of carefully predetermined product costs for budgeting and performance evaluation.
- Standard costs are typically used in established production processes.
- Kaizen costing – the emphasis is on continuous reduction of production costs.
- Rather than standards or targets, the goal is current costs that are less than previous costs.

16-7

Kaizen goal:

cost reduction

rate

Current year

cost base

Actual cost

reduction

achieved

Cost per product unit

Actual cost

performance

of the

current year

Cost base

for next

year

Time

12/31/x0

12/31/x1

Kaizen CostingKaizen goal:

cost reduction

amount

Production Mix and Yield Variances

- Nearly all production processes require multiple materials and labor inputs.
- A summary quantity variance for materials and labor would hide the individual effects of these inputs.
- The quantity variances can be analyzed into two further variances:
- Mix (the difference between actual and standard input proportions)
- Yield (the difference between actual and standard input used)
- The analysis assumes, of course, that the inputs can be substituted for each other.

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