CHAPTER 4

Standard Costing
1 Setting standards
The nature of standards
A standard cost will comprise two elements. Technical standards for the quantities of material to be used and the working time required. Cost standards for the material prices and hourly rates that should be paid.

Standards from past records

Past data can be used to predict future costs. The main disadvantage with this method is that past data may contain inefficiencies which would then be built into the standards.

Engineering standards
This involves engineers developing standards for materials, direct labour and variable overheads by studying the product and the production process.

Types of standard
Ideal standards. In some cases standards are established on the assumption that machines and employees will work with optimal efficiency at all times. Attainable (expected) standards. In other cases the standards set will be those which are reasonably attainable.

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Current standards. These are standards established for use over a short period of time, related to current conditions. Basic standards A basic standard is one which, having been fixed, is not generally revised with changing conditions, but remains in force for a long period of time.

Revision of basic variances

A formula approach
The following operating statement will be used to revise direct materials, direct labour, machine cost and production overhead variances.

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Operating statement with flexed budget Period ____________ Std per unit Number of units Sales Direct materials: 1 kg @ 15 Direct labour: 1 hr @ 10 Machine cost: 1 hr @ 2.5 Fixed production overhead: 1 hr @ 5 Factory profit Other fixed costs Marketing cost Admin cost Operating profit 1 70.0 ____ 15.0 10.0 2.5 Budget fixed 1,000 70,000 ______ 15,000 10,000 2,500 Flexed budget 1,100 77,000 ______ 16,500 11,000 2,750 Actual 1,100 82,500 ______ 17,000 11,250 3,050 Budget variances

5.0 ____ 37.5 ____

5,000 ______ 37,500 ______ 12,500 13,000 ______ 12,000 ======

5,000 ______ 41,750 ______ 12,500 13,000 ______ 16,250 ======

5,300 ______ 45,900 ______ 12,950 13,550 ______ 19,400 ======

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Direct materials actual usage = 1,200 kg Direct labour actual hours worked = 1,250 hours Machine hours actually worked = 1,250 hours

All direct cost variances can be calculated using a simple formula approach. Formula approach for basic variances Formula Price type (SP AP) AQ Key: SP AP = = standard price actual price AQ SQ = = Quantity type (SQ AQ) SP actual quantity standard quantity

Applying the above formula to direct materials, labour and machine cost gives results shown below. Direct materials variances Total 500 A Price (SP AP) AQ Usage (SQ AQ) SP (1,100 1,200) 15

17,000 15 1,200 1,200

= 1,000 F

= 1,500 A

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Machine cost variances Total 300 A Expenditure (SR AR) AH Efficiency (SH AH) SR (1,100 1,250) 2.5

3,050 2.5 1,250 1,250

= 75 F Key: SR AR = = standard rate actual rate SH AH = =

= 375 A standard hours actual hours

Direct labour variances Total 250 A Rate (SR AR) AH Efficiency (SH AH) SR (1,100 1,250) 10

11,250 10 1,250 1,250

= 1,250 F

= 1,500 A

Given that absorption costing principles are being used in the operating statement, the following production overhead variances can be calculated.

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Analysing production overhead variances Total Volume Efficiency Capacity Expenditure

A tabular approach will be used to calculate the above variances. Calculating overhead variances Std AB 5,500 AFO 5,300

Total 200 F Std AB 5,500 BFO 5,000 AFO 5,300

Volume 500 F Std AB 5,500 Std AHW 6,250

Expenditure 300 A BFO 5,000

Efficiency 750 A

Capacity 1,250 F

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Key Std AB AFO BFO Std AHW = = = = = Standard absorbed in actual output 5 x 1,100 = 5,500 Actual fixed overhead = 5,300 Budgeted fixed overhead (flexed if necessary) = 5,000 Standard absorbed in actual hours worked 1 hour @ 5 x 1,250 hours = 6,250

Investigation of variances

Generalised reasons for variances

It has been suggested that the causes of variances can be classified under four headings. Planning errors (see Chapter 5) Measurement errors (errors caused by inaccurate completion of timesheets or job cards, inaccurate measurement of quantities issued from stores, etc the rectification of such errors will probably not give rise to any cost savings though this is a generalisation) Random factors (elimination of these may well not save costs) Operational factors (elimination of these may save costs so we will concentrate on them now)

Thus it is the specific operational causes of variances to which we will devote our attention and which we will consider rectifying.

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ACCA PAPER F5- FOCUS NOTES Trend and materiality of variances

By expressing each variance as a percentage of some base, such as the standard cost, then both trend and materiality will become more evident. Both of these characteristics should be important to management when deciding whether to investigate a variance and the production process which gave rise to it. A discernible trend could suggest either that the standard is wrong or out of date, or that there is a fault in the production process which should be rectified. The materiality of the variance will help to decide whether the benefits of investigation outweigh the costs.

The use of decision trees

Decision trees can be used to aid management in deciding whether to investigate variances.

Example
Bruff Ltd manufactures a cure for sore throats which is sold in 300ml bottles. In view of the problems being experienced in the mixing and bottling plant, a careful check is carried out on the quantity of materials used. Decisions then need to be made on whether or not to investigate the variance to determine whether it was caused by a fault that might be correctable. The following estimates have been made. Cost of carrying out an investigation = 2,000 If a fault is detected, the cost of trying to correct the fault = 500

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Cost incurred if a fault is not corrected = 6,000 Probability that a variance is caused by a fault = 0.6 Probability that the fault can be corrected = 0.8

Calculate whether the variance should be investigated.

Solution
To decide whether to investigate the variance, a decision tree is drawn as follows.
No fault 0.4 Investigate (2,000)

B
0.6 Fault (500) 0.8

Corrected

D
0.2 Uncorrected (6,000)

A
No fault 0.4 Dont Investigate

C
0.6 Fault (6,000)

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To evaluate the decision tree we start from the right hand side and work backwards, calculating the expected values of costs and benefits at each fork in the tree. As an example, the expected value of costs at fork C is given by 0.6 x 6,000 = 3,600. We call this EVC. Similarly, we can calculate the following values. EVD EVB EVinv EVC = = = = 0.2 x 6,000 0.6 x (500 + 1,200) 1,020 + 2,000 0.6 x 6,000 = = = = 1,200 1,020 3,020 3,600

Therefore investigate, because the expected costs of investigating are 3,020, whereas the expected costs of not investigating are higher at 3,600.

The learning curve effect

There are certain types of industry where the unit of production changes at regular intervals rather than a standard unit of production being manufactured for a very long period of time. In such industries it is known that the time taken to produce a unit in the early stages of a new product is significantly longer than the time per unit once the item has been manufactured for some time. For any operation which is repeated, the overall average time for the operation will decrease by a fixed percentage as the number of repetitions is doubled.

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A typical reduction percentage is 20 per cent, so that an operation would have the following time characteristics. Time for first unit Overall average time per unit for 2 units Overall average time per unit for 4 units Overall average time per unit for 8 units Overall average time per unit for 16 units = = 100 hours 100 x 0.8 = 80 hours (ie 100 hours 20% x 100 hours) 80 x 0.8 = 64 hours 64 x 0.8 = 51.2 hours 51.2 x 0.8 = 40.96 hours

= = =

This situation is said to follow an 80 per cent learning curve. (Note that the 20 per cent reduction in time is not quoted as the learning factor.)

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ACCA PAPER F5- FOCUS NOTES Graphical presentation

The learning curve Overall average time 100 90 80 70 60 50 40 30 20 10 0

2 Number of 4 units

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Example
The distinction between overall average time per unit and time to produce the latest unit (or batch of units) is demonstrated in the following example of a firm experiencing a learning factor of 80 per cent (or 0.8). A trial batch of 100 units of a new product is produced in an average time of 20 minutes per unit. Production times based on continually doubling the batch size would be as follows.

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Batch quantity (units) 100 100 200 400 Cumulative quantity (units) 100 200 400 800 Overall average time per unit (minutes) 20.00 20 x 0.8 = 16.00 16 x 0.8 = 12.80 12.8 x 0.8 = 10.24 Total time (minutes) 2,000 3,200 5,120 8,192 Batch time (minutes) 2,000 1,200 1,920 3,072

If the planned production of this item for the coming month was, say, 300 (over and above the initial 100 thus making cumulative production 400), the total time and average time per unit for this 300 would be: Total time for 300 units = 5,120 2,000 = 3,120 minutes Average time for these units = 3,120 300 = 10.4 minutes

General formula
In practice, it will frequently be necessary to estimate the effect of learning for a level of production which is not a doubling point. This can be done using a general formula, as follows. If a x = = time taken to produce the first unit (or first batch) the cumulative production in units (or in batches of the same size as the first batch)

and

b =

Log of the learning rate Log of 2

then y, the average time per unit (or per batch) to date is given by: y = ax b

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As an example, consider the 800 unit cumulative quantity and our initial batch size of 100 (note that x is expressed as batches).

800 100
b then y

= = = =

Log 0.8 0.0969 = = 0.3219 Log 2 0.3010

2,000 x 8 -0.3219 2,000 x 0.512 1,024 minutes = = 8 x 1,024 8,192 minutes

Cumulative time to date

The formula gives the average time per batch of 100 to date, and we must therefore multiply by eight to get the total time to date. Also note that most calculators allow you to find two types of log: log buttons (to base 10) and ln buttons (natural logarithms). It doesnt matter which you use, as long as you are consistent.

Effect on budgeting
It would make a considerable difference to production planning, delivery dates and costing for this product and therefore, if it is known that a learning effect is likely to occur, it should be taken into account when preparing budgets.

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