Chapter

Standard costing and variance analysis

Syllabus Content B - Standard Costing 25% Manufacturing standards for material, labour, variable overhead and fixed overhead. Fixed overhead expenditure and volume variances. (Note: the subdivision of fixed overhead volume variance into capacity and efficiency elements will not be examined.) Price/rate and usage/efficiency variances for materials, labour and variable overhead. Further subdivision of total usage/efficiency variances into mix and yield components. (Note: The calculation of mix variances on both individual and average valuation bases is required.) Planning and operational variances. Sales price and sales revenue/margin volume variances (calculation of the latter on a unit basis related to revenue, gross margin and contribution margin). Application of these variances to all sectors, including professional services and retail analysis. Standards and variances in service industries, (including the phenomenon of "McDonaldization"), public services (e.g. Health), (including the use of "diagnostic related" or "reference" groups), and the professions (e.g. labour mix variances in audit work). Criticisms of standard costing in general and in advanced manufacturing environments in particular. Interpretation of variances: interrelationship, significance. Benchmarking.

1 -

1.1 Introduction to standard costing A standard cost is a planned or forecast unit cost for a product or service, which is assumed to hold good given expected efficiency and cost levels within an organisation. It represents a target cost and is useful for planning, controlling and motivating within an organisation. Variance analysis is a budgetary control process, which compares standard or budgeted costs and revenues with the actual results of an organisation, in order to obtain information regarding any exceptions from budget, this information is also used to improve performance through control action e.g. correcting problems. Standard costing can be used for Budget preparation e.g. planning Control through exception reporting e.g. performance measurement Stock valuation Cost bookkeeping. Motivating staff

Under a standard costing system an organisation can value stock at standard cost, incorporating this within the ledger or cost accounts of the organisation, the budget or forecasts being a memorandum kept outside the ledger accounts. Types of standard Ideal Standard e.g. attained under the most favourable conditions with no allowance for any waste, scrap, idle time or downtime Attainable or Expected Standard e.g. what should be achieved with a reasonable level of effort given current efficiency and cost levels Loose Standard e.g. loosely set and easy to achieve Basic Standard e.g. first standard ever used by the organisation and used as a basis or yardstick for comparing current standards or monitoring trends over time Historical Standards e.g. standards used historically in previous accounting periods

Critism of standard costing Sometimes hard to define an attainable standard Uncontrollability of performance within operations e.g. discounts lost due to the reduction in the quantity ordered or seasonal price fluctuations within the period of appraisal With more automation within operations, they become less valuable as information Feedback not feed forward control e.g. out of date information Revisions to standards may be too frequent to guide performance over time Standard costing is an internal not external control measure e.g. improvement also needs to consider competition and customers Performance measurement would be inadequate as a process if the standard is wrong The reason or cause of the variance are sometimes overlooked or not investigated

2 -

How to create a standard cost

Standard material price

Supplier quotations and estimates Previous invoices/trends Internet/websites of suppliers Discounts for bulk purchases Price seasonality Cost to manufacture internally Differences between the quality of different material

Standard material usage

Time/motion studies Quality of material e.g. natural wastage Specification of standard product manufactured Operational wastage expected

Standard labour rate

Market rate for grade/type of labour Internal rates from HR department Bonus schemes/piece work rates in current use

Standard labour efficiency

Idle time expected during operations Time/motion studies Skill/expertise of staff Learning curve Motivation of staff Remuneration systems in place

Standard overhead rate

Overhead absorption rates obtained by dividing forecast overhead with an expected level of activity Review overhead Understand fixed and variable relationship with output, labour hours, machine hours or % of cost

3 -

1.2 Methods for planning and control A fixed budget is a budget prepared on the basis of an single estimated production and sales volume. It does not mean it is never revised or changed, just fixed at a certain level of output sold and produced. This tends to be a form of budgeting for a service organisation where a high proportion of total cost is fixed, and therefore does not vary significantly, with the volume or activity of the service performed. Such a form of budgeting would be little use for control purposes, when comparing to actual results, if significant variable cost exists. A fixed budget provides details of costs, revenues or resource requirements for a single level of activity. Flexible budgets are prepared for many different sales and production quantities and can be used to plan more effectively for an organisation e.g. useful at the planning stage for what if? analysis. Flexible budgeting recognises different cost behaviour patterns, that may rise or fall with the volume of production or sales and is a better system for control purposes. A flexible budgeting system based upon its budget set at the beginning of the period can be flexed to correspond to the actual activity volume of results for a period. When a budget is flexed it would give an appropriate level of revenue and costs as a yardstick to compare like for like to actual results, at the same activity level, meaningful variances can then be reported to the managers responsible for control purposes. Flexible budgeting 1. Useful at the planning stage (what if analysis) 2. Can be flexed retrospectively and compared to actual results for control purposes

4 -

Example 1.1 Butliness is a business that offers packaged holiday deals in 3 locations in the UK and as part of this service has a restaurant that serves many different meals and puddings through out the day to guests staying over in chalets on the holiday park. One such serving counter has been a major concern for the management, the All week Sunday lunch counter, as it is expensive to run. The stand uses 2 staff on different shifts to cook and serve meals at the counter, the standard cost and price of the Hungry man roast of the day is as follows: Standard cost information for 1 meal Chicken 0.3kg @ 2.50 per kg Vegetables 0.5kg @ 0.50 per kg Labour 15 mins @ 9.00/hr Variable overhead 15 mins @ 2.00/hr Fixed overhead 15 mins @ 20.00/hr Standard profit Selling price (included in packaged price) Per meal 0.75 0.25 2.25 0.50 5.00 8.75 3.20 11.95

The counter works on a 6-day shift (all week except Sunday) and the budget aims to sell 500 meals within week 43 the following actual information was obtained. Meals actually sold were 476 the revenue earned 5,688.

Ingredients purchased Purchased Used Chef wages for week 43 Hours paid Hours worked Chicken 180kg (405) 165kg Vegetables 250kg (140) 220kg

120 hours (wages paid 1,200) 114 hours

6 hours were idle due to ovens failing on Tuesday afternoon Variable overhead Fixed overhead 150 2,750

Produce the original budget, flexed budget based upon actual sales volume, and compare this to actual results in order to calculate any variances?

5 -

Answer to Example 1.1 Budgets prepared for an organisation using absorption costing principles Original Production and sales Sales Chicken Veg Labour Variable overhead Fixed overhead Profit 500 5,975 375 125 1,125 250 2,500 4,375 1,600 Flexed 476 5,688 357 119 1,071 238 2,380 4,165 1,523 Actual 476 5,688 368 125 1,200 150 2,750 4,593 1,095 11(A) 6 (A) 129(A) 88(F) 370(A) 428(A) 428(A) Variances

Budgets prepared for an organisation using marginal costing principles Original Production and sales Sales Chicken Veg Labour Variable overhead Contribution Fixed overhead Profit Notes The 368 actual charge for Chicken is the actual cost less standard cost of closing stock e.g. (405 less (15kg x 2.50)) The 125 actual charge for Vegetables is the actual cost less standard cost of closing stock e.g. (140 less (30kg x 0.50)) The absorption costing company charges fixed overhead to the profit and loss account on the basis of 5.00 for every meal produced e.g. 476 meals x 5.00 per meal = 2,380, for this reason, when a budget is flexed, we prorate the budgeted fixed overhead, but never for marginal costing organisations, they do not charge or absorb fixed overhead in this manner. 6 500 5,975 375 125 1,125 250 1,875 4,100 2,500 1,600 Flexed 476 5,688 357 119 1,071 238 1,785 3,903 2,500 1,403 Actual 476 5,688 368 125 1,200 150 1,843 3,845 2,750 1,095 11(A) 6 (A) 129(A) 88(F) 58(A) 58(A) 250(A) 308(A) Variances

1.3 Variance analysis By comparing a flexed budget, which has been prepared using standard cost information to actual results, total variances can be calculated. These reconcilable differences between the two statements can then be sub-divided further, calculated, interpreted and used to correct problems within the organisation to stay on target through control action by management or employees. Variances can occur for the following reasons Inaccurate data when creating standards, producing the budget or compiling actual results A standard used which is either not realistic or perhaps out of date Efficiency of how operations were undertaken by management or employees during the period of assessment Random or chance

Budgetary planning involves the production of budgets or forecasts using realistic standards for cost and efficiency levels. Budgetary control identifies areas of responsibility for management and is the process of regularly comparing actual results against budget or standards. Because the original budget would have forecast a different number of units produced or sold, when compared to actual units produced or sold, a flexed budget would be prepared in order to compare costs and revenues on a like with like basis.

7 -

Variance calculations

Sales price variance

Did sell (actual quantity sold x actual price) X Should sell (actual quantity sold x standard price) (X) Sales price variance X

Did sell (actual quantity sold) Should sell (budget quantity sold)

Sales volume profit variance

units X (X) X x standard profit per unit* X

* Standard profit would be used if the organisation uses absorption costing methods, when using marginal costing methods, the standard contribution volume variance, rather than standard volume profit variance would be used. The proforma above would be the same however the difference in units above would be multiplied by the standard contribution per unit rather than standard profit per unit. Sales volume There is also the calculation of the sales volume revenue variance profit variance units Did sell (actual quantity sold) X Should sell (budget quantity sold) (X) X x standard price Sales volume revenue variance X This would be a calculation considered in isolation from an operating statement e.g. if an organisation wants to reconcile the difference between the original sales budget revenue and actual sales revenue achieved rather than profit or contribution.

Material price variance

Did spend (actual quantity purchased x actual price) X Should spend (actual quantity purchased x standard price) (X) Material price variance X This variance calculation always uses the quantity of material actually purchased never used, if there is a difference between the two within a question.

8 -

Material usage variance

Kg/litres Actual production did use X Actual production should use (actual production x standard usage) (X) X x standard price Material usage variance X This variance calculation always uses the quantity of material actually used never purchased, if there is a difference between the two within a question.

Labour rate variance

Did spend (actual hours paid x actual rate) Should spend (actual hours paid x standard rate) Labour rate variance

X (X) X

This variance calculation always uses the actual hours paid for never hours worked if there is a difference between the two within a question.

Labour efficiency variance

Hours Actual production did take X Actual production should take (actual production x standard hours) (X) X x standard rate Labour efficiency variance X This variance calculation always uses the actual hours worked never hours paid if there is a difference between the two within a question.

Labour idle time variance

Actual hours paid for Actual hours worked Idle time Labour idle time variance

Hours X (X) X x standard rate X

Only applicable if there is idle time e.g. a difference between labour hours paid and worked.

9 -

Variable overhead expenditure variance

Did spend (actual hours worked x actual OH rate) Should spend (actual hours worked x standard OH rate) Variable overhead expenditure variance

X (X) X

Variable overhead expenditure within a question will be assumed to be driven by labour hours worked never paid if there is a difference between the two e.g. if production stops and staff are idle then no variable overhead should be incurred.

Variable overhead efficiency variance

Hours Actual production did take X Actual production should take (actual production x standard hours) (X) X x standard overhead rate Variable overhead efficiency variance X This variance calculation always uses the actual hours worked never hours paid if there is a difference between the two within a question; notice the proforma is similar to the labour efficiency variance.

Fixed overhead expenditure variance

Actual fixed overhead expenditure Budgeted fixed overhead expenditure Fixed overhead expenditure variance

X (X) X

Fixed overhead volume variance

units Did produce (actual quantity produced) X Should produce (budget quantity produced) (X) X x overhead absorption rate (O.A.R) Fixed overhead volume variance X This variance calculation is only applicable if the organisation uses absorption costing, never when marginal costing, and is to do with the way the organisation charges the profit and loss account within the production fixed overhead control account.

10 -

1.4 Fixed overhead variances further explained Traditional absorption costing takes the total budgeted fixed overhead for a period and divides by a budgeted (or normal) activity level e.g. units, in order to find the overhead absorption rate. This is a simple method of charging fixed overhead and allows fixed overhead to be allocated to products, jobs or work-in-progress

Overhead absorption rate (OAR) =

Budgeted production overhead Normal/budget level of activity

Production fixed overhead control account

Actual production overhead

Actual production (units) x O.A.R = Charge to W.I.P during the period

At the end of the period, the overhead absorbed or charged to production is compared to the actual production overhead incurred for the period. Any shortfall in overhead charged would be an under absorption of production overhead (DR profit and loss account CR Production overhead control account). Any over charge to the profit and loss account during a period would be an over absorption of production overhead (CR profit and loss account DR Production overhead control account). The sum of the fixed overhead expenditure and volume variance would be equal to the under or over absorption, when sub-divided, explaining the two different causes as to how this occurred during a period e.g. under or over spent and/or under or over produced when compared to the original budget. The difference between absorption costing and marginal costing organisations, is that the marginal costing organisation makes no attempt to absorb or charge production overhead into a cost unit or the profit and loss account. It treats production overhead as a period cost only and does not absorb overhead, but rather charges it entirely to the profit and loss account for each period. With marginal costing organisations only the fixed overhead expenditure never the fixed overhead volume variance would be applicable within a question.

11 -

Stock valuation under absorption and marginal costing systems It is also important to remember that marginal costing organisations would also value stock at variable production cost only never full production cost, when contrasted to an absorption costing company. Standard cost per unit: Direct costs of production Direct labour Direct material Direct variable production overhead Total direct variable cost or total prime cost Indirect production overhead absorbed Full production cost

X X X X Marginal costing stock valuation X X Absorption costing stock valuation

12 -

Example 1.2 Butliness is a business that offers packaged holiday deals in 3 locations in the UK and as part of this service has a restaurant that serves many different meals and puddings through out the day to guests staying over in chalets on the holiday park. One such serving counter has been a major concern for the management, the All week Sunday lunch counter, as it is expensive to run. The stand uses 2 staff on different shifts to cook and serve meals at the counter, the standard cost and price of the Hungry man roast of the day is as follows: Standard cost information for 1 meal Chicken 0.3kg @ 2.50 per kg Vegetables 0.5kg @ 0.50 per kg Labour 15 mins @ 9.00/hr Variable overhead 15 mins @ 2.00/hr Fixed overhead 15 mins @ 20.00/hr Standard profit Selling price (included in packaged price) Per meal 0.75 0.25 2.25 0.50 5.00 8.75 3.20 11.95

The counter works on a 6-day shift (all week except Sunday) and the budget aims to sell 500 meals every week. During week 43 the following actual information was obtained. Meals actually sold were 476 the revenue earned 5,688.

Ingredients purchased Purchased Used Chef wages for week 43 Hours paid Hours worked Chicken 180kg (405) 165kg Vegetables 250kg (140) 220kg

120 hours (Wages paid 1,200) 114 hours

6 hours were idle due to ovens failing on Tuesday afternoon Variable overhead Fixed overhead 150 2,750

Prepare an operating statement for week 43 for both an absorption and marginal costing organisation, which reconciles any differences between actual results and budget?

13 -

Example 1.3 working backwards Butliness had a problem with the accountant during period 46; he left in a fume and took all the actual accounts information with him as revenge. You have been called in from a temping agency to sort out the mess. The following information has been provided to you. Operating statement for week 43 Budget Sales volume variance Flexed budget Sales price variance 1,600 77(A) 1,523 0 1,523 F 45 55 15 9 45 120 54 10 78 250 120 614 A

Cost variances Chicken price variance Chicken usage variance Vegetable price variance Vegetable usage variance Labour efficiency variance Labour rate variance Idle time variance Variable overhead efficiency variance Variable overhead expenditure variance Fixed overhead expenditure variance Fixed overhead volume variance

187 Actual profit Standard cost information for 1 meal Chicken 0.3kg @ 2.50 per kg Vegetables 0.5kg @ 0.50 per kg Labour 15 mins @ 9.00/hr Variable overhead 15 mins @ 2.00/hr Fixed overhead 15 mins @ 20.00/hr Standard profit Selling price (included in packaged price)

427(A) 1,096

Per meal 0.75 0.25 2.25 0.50 5.00 8.75 3.20 11.95

14 -

Additional information known Budgeted fixed overhead was 2,500 Actual hours paid were 6 more than worked due to an electrical fault with the ovens Closing stock for chicken and vegetables rose during this period by 15kg and 30kg respectively. Sales were the same as production during the week

You are required to 1. 2. 3. 4. 5. 6. Calculate the actual production and sale of meals Calculate actual hours worked for the chefs Calculate the actual quantity of chicken purchased Calculate the actual price paid for chicken Calculate the actual variable overhead expenditure Calculate the actual fixed overhead expenditure

Note: an alternative form of question would have been to provide you with actual information and the variances, asking you to calculate budgeted or standard cost information instead. The principle would be exactly the same as within this example.

15 -

1.5 Mix and yield (or productivity) variances A material usage variance can be subdivided into a mix and yield variance where there exists two or more ingredients that can be substituted for one another. The sum of the material mix and yield variances will total the sum of the material usage variance. The same concept can also be applied to labour mix and yield variances, when one grade or skill of labour can be substituted for another, when making a particular product or completing a job. The labour efficiency variance in this case reanalysed further into the mix and yield variances, exactly in the same way as the material usage variance. Interpreting mix variances individual valuation basis Actual output did use should use (at std mix) X kg/Hrs X kg/Hrs X kg/Hrs standard price variance

Material/Labour A Material/Labour B

X kg/Hrs X kg/Hrs X kg/Hrs

x x = x x =

x (F) x (A) x (A)

If you use a quantity of material which is more than standard mix there would be an adverse variance If you use a quantity of material which is less than standard mix there would be a favourable variance

Interpreting mix variances average valuation basis Actual output did use should use standard price variance (at std mix) less average price X kg/Hrs X kg/Hrs X kg/Hrs x x = x x = x (F) x (A) x (A)

Material/Labour A Material/Labour B

X kg/Hrs X kg/Hrs X kg/Hrs

If you use a quantity of material which is more than standard mix and the material more expensive than the average cost, there would be an adverse variance If you use a quantity of material which is more than standard mix and the material less expensive than the average cost, there would be a favourable variance If you use a quantity of material which is less than standard mix and the material more expensive than the average cost, there would be a favourable variance If you use a quantity of material which is less than standard mix and the material less expensive than the average cost, there would be an adverse variance

is is is is

Both totals of the individual and average valuation bases give the same answer; it is the analysis which makes up the total, where you would find the differences between the two methods.

16 -

Interpreting yield (or productivity) variances Yield Actual material used or labour time did produce Actual material used or labour time should produce Over/(under) produced x standard cost of one unit of output X X X x x X (A)/(F)

The sum of the material mix/labour mix and material/labour yield variances will be equal to the material usage/labour efficiency variance respectively. It is also worth noting that there can be an interdependent relationship between a mix and yield variance e.g. a higher skill mix of labour in substitute of a lower skill mix, would cause an adverse mix variance, but may also cause at the same time a favourable yield variance, due to greater experience and therefore efficiency by that type of labour. Lastly a word of caution favourable variances, especially when dealing with mix and yield do not necessarily mean you have improved the organisation e.g. more water and less flavouring would improve both mix and yield when making soft drinks, but do little to improve the quality of the drink being made.

17 -

Example 1.4 Butliness also does a deep pan cheesy and tomato pizza on one of its counters, the standard or budget cost and usage of the topping ingredients for one pizza are as follows 0.70 4.50 5.20

0.5kg Tomatoes @ 1.40 a kg 0.6kg Cheese @ 7.50 a kg

1.1kg ingredients will produce or yield a 1kg pizza (due to evaporation in the cooking process). On a Wednesday afternoon 60 pizzas were cooked (to the weight specified of 1.0 kg) and the following ingredients were used during the process; Tomatoes 28 kg Cheese 40kg 45.00 270.00

Calculate the material usage, mix and yield variances for Butliness for this day?

Note: two methods exist for calculation of the mix variance, the individual valuation and average valuation bases. Make sure you are familiar with both types of calculation.

18 -

1.6 Investigating variances Statistical methods for interpretation Variances can be expressed relatively rather than absolutely, the variance is normally expressed as a percentage against the standard cost. In a past exam (old syllabus the examiner asked students to express material mix and yield variances, the deviations in weight rather than values, as a percentage of the standardised weight for the product being produced. From the answer of example 1.4 above this would have been calculated as Tomato ingredient mix Cheese ingredient mix Yield 3kg/31kg = 9.7% (F) 3kg/37kg = 8.1% (A) 1.8kg/61.8kg = 2.9% (A)

These percentages could be plotted on a graph from one period to the next, which would provide managers with the following advantages. 9 Graphical presentation or percentages analysed over time allows easier interpretation and clearer understanding by managers 9 Presenting variances over time allows trends to be identified easier 9 By working out percentages expressed against standard, it removes changes in monetary size of the variance caused by changing activity levels, improving trend analysis Example of a variance chart

Favourable

0 JAN FEB MAR APR

Adverse

19 -

Factors to consider before investigation 1. 2. 3. 4. 5. 6. 7. 8. The size of it (materiality) The general trend of it e.g. use of control charts for this The type of standard that was used Interdependence with other variances The likelihood of identifying the cause of it The likelihood that if a cause is found then it is controllable The cost and benefits of correcting the cause The cost of the investigation

20 -

Example 1.5 Mr Chumney-Warner, the accountant that left Butliness, due to personal grievances against the organisation and has set up an audit practice, providing work to local business within the area. Even though being a service organisation, Mr Chumney-Warner recognises that variances can also be applied to such organisations. He has created a standard cost of an average audit, which normally takes a partner, semi-senior and junior together, 20 hours. Details of one standard audit 300 350 360 1,010

Partner Semi-senior Junior

3 hours @ 100 per hour 5 hours @ 70 per hour 12 hours @ 30 per hour

During the period of February, time sheets recorded the following information. In total, 90 hours was logged as audit work, completing 5 audits during this period. The new junior that had been recruited was under allot of pressure, and did not cope well. This had meant the semi-senior had to be involved more in compliance work to improve the quality of audit files. Mr Chumney-Warner was pleased however that his time as a partner was used less because of the final quality of the audit files, due to more involvement from the semi-senior. Actual time recorded on audit work Partner Semi-senior Junior 12 hours 40 hours 38 hours 90 hours

You have again been recruited from an agency as a temp, your first job apart from idle chit chat about working conditions at Butliness, is to produce labour mix and yield calculations for Mr Chumney-Warner, within an operating statement, for the period of February above. Your mix calculations to use both the average and individual bases of valuation.

21 -

1.7 Planning and operational variances Planning variances are caused by the budget or standard at the planning stage being wrong. The budget and standard used would therefore need revising if your operational variances are to be more realistic. Operational variances are your normal variance calculations as learned earlier within this chapter, that is, assuming all planning errors within the budget have been adjusted for or removed and your standard used is realistic. Process of calculating planning variances 1. Calculate the planning variance and adjust the original budget within the operating statement for this, before any operational variances are calculated 2. Adjust the standard cost used in the budget from ex ante to ex post (revised) standard 3. Now that the original budget and standard cost has been adjusted, the operational variances that would be effected by the adjustment, will give a more realistic standard. The effect is to sub-divide a variance into 2 parts 1. The planning variance which is beyond the control of staff e.g. planning errors 2. The operational variances which may be within the control of staff This allows better management information for control purposes Planning and operational variances are not alternatives to the conventional approach; they just produce a more detailed analysis. Further analysis of variances into groups e.g. planning which are to do with poor planning or inadequate standards used compared with actual true favourable or adverse operational variances, allow managers to be appraised truly on deviations they can control not those variances which are beyond their control. Advantages of planning variances 9 9 9 9 Highlight between variances which are controllable and uncontrollable Help motivate managers and staff Help use more realistic standards Give a fairer reflection of operational variances

However critism includes still the question of determining a realistic standard in the first place and putting too much emphasis on bad planning rather than bad management and the analysis can be more time consuming and costly than the conventional approach.

22 -

Example 1.6 Using the information from Example 1.2, how should Butliness deal with the variance calculations if you were told the following; due to salmonella scare across the country the price of chicken had fallen to 2 a kg this should have been reflected in the budget when it was completed, but was overlooked. Adjust standard cost

Revised Standard cost information for 1 meal Per meal Chicken 0.3kg @ 2.00 per kg Vegetables 0.5kg @ 0.50 per kg Labour 15 mins @ 9.00/hr Variable overhead 15 mins @ 2.00/hr Fixed overhead 15 mins @ 20.00/hr Standard profit Selling price (included in packaged price) 0.60 0.25 2.25 0.50 5.00 8.60 3.35 11.95

Chicken price planning variance 500 meals should have cost (x 0.3kg x 2.00) according to new standard 500 meals should have cost (x 0.3kg x 2.50) according to old standard 300 375 75(F)

Revise operational variances now because standard has changed 180kg did cost 180kg should cost (x revised standard 2 per kg) 405 360 45(A) 165kg 143kg 22kg x 2 per kg 44 (A)

476 meals did use 476 meals should use (0.3kg per meal) Revised standard price

Notice the biggest effect of this analysis is that the operational price variance changes from 45 favourable to 45 adverse. This highlights that the purchasing of the chicken is not as keener price as it should have been e.g. better control information. The planning variance will be offset against the original budget, just before the offset of the sales volume variance within the operating statement.

23 -

1.8 Machine expenditure and efficiency variances Such variances use the same method as labour rate, efficiency and idle time variances so do not be afraid when it comes to rate, efficiency and idle time variances for machines.

Example 1.7 In the bar at Butliness they produce a banana extravaganza by using a machine blender (it has proved to be very popular). Standard processing time for every 50 half-pint glasses is 0.6 hours at 40 variable overhead per hour. During one hot summer week there was 42 hours of processing time at a total cost that week of 1,880, 1,900 pints were produced. Calculate the machine expenditure and efficiency variances for the machine?

What if you were told that the machine has been replaced with a machine, which is 20% faster than the previous model, but this had not been reflected in the budget?

24 -

1.9 Causes of variances Possible causes of the individual variances are: Material price variance Different sources of supply. Unexpected general price increase. Alteration in quantity discounts. Alteration in exchange rates (imported goods) Substitution of a different grade of material Standard set at mid-year price so one would expect a favourable price variance for part of the year and an adverse variance for the rest of the year.

Material usage variance

Higher/lower incidence of scrap. Alteration to product design. Substitution of a different grade of material.

Wages rate variance

Unexpected national wage award. Overtime/bonus payments different from plan. Substitution of a different grade of labour.

Labour efficiency variance

Improvement in methods or working conditions. Variations in unavoidable idle time. Introduction of incentive scheme. Substitution of a different grade of labour.

25 -

 Variable overhead variance

Unexpected price changes for overhead items. Labour efficiency variances (see above). Changes in prices relating to fixed overhead items e.g. rent increase. Seasonal effects e.g. heat/light in winter. (This arises where the annual budget is divided into four equal quarters of thirteen equal four-weekly periods without allowances for seasonal factors. Over a whole year the seasonal effects would cancel out.) Change in production volume due to change in demand or alterations to stockholding policy. Changes in productivity of labour or machinery. Production lost through strikes etc. Unplanned price increase. Unplanned price reduction e.g. to try and attract additional business.

Fixed overhead expenditure variance

Fixed overhead volume

Operating profit variance due to selling prices

26 -

1.10 Benchmarking Continuous, systematic process for evaluating the products, services and work processes of an organisation that are recognised as representing best practice, for the purpose of organisational improvement. World-class organisations strive to obtain competitive advantage. This can be achieved by using benchmarking. This is the process of comparing your performance with that of another organisation considered to be the best in its class. Benchmarking 1. Internal. Compare an internal function to the best found elsewhere internally within the same organisation. 2. Best practice or functional. Compare an internal function to that of the best, not necessarily an organisation in the same industry. 3. Competitive. Product/service features compared to that of firms/competition in the same industry. 4. Strategic. Compare yourself in terms of organisational structure and culture, mission statement and strategic choices made to the most successful market leader. Performance dimensions to gain competitive advantage Quality e.g. aesthetics (imperative to organisations like Dior or Cartier), features, courtesy and friendliness of staff involved within the purchase stages within the organisation, accuracy of administration Speed/flexibility e.g. AA/RAC 24/7, parcel force overnight, Concorde gave fast transatlantic flights Cost e.g. if the organisation pursues cost leadership Differentiation e.g. brand recognition for certain product features such as image, reliability or functional

Companies to be the very best must establish where customers perceive differences, set the very best standards to exceed, establish what the competition is doing and encourage, manage knowledge and ideas of staff to exceed standards set. The process would involve 1. Select what you want to benchmark/set objectives 2. Consider benefits against the cost of doing it 3. Assign responsibilities to a team 4. Identify potential partners/known leaders 5. Breakdown of processes to complete 6. Test and measure (observation, experimentation or investigation/interview) 7. Gather information 8. Gap analysis 9. Implement changes/programmes/communicate 10. Monitor and control 11. Repeat regularly 27 -

Benefits of benchmarking 9 9 9 9 9 9 9 9 9 Better understanding of competition and customers needs Discourages complacency/improves business awareness of managers You learn from other organisations mistakes Dont need to re-invent the wheel Source of new ideas/faster awareness of innovation Fewer complaints and warranty claims Leaner more efficient organisation in terms of waste and reworks Customer satisfaction and brand loyalty in the long-term Efficiency and effectiveness of functions or processes improved within the organisation 9 Sales and profitability improved Drawbacks of benchmarking Deciding and documenting what needs to be benchmarked is time consuming Getting the information to actually do it maybe a problem Confidential information could be leaked Damn lies and statistics Deciding who is the best in their class Keeping employees motivated, as standards once exceeded, will normally be raised

28 -

1.11 McDonaldization Modern manufacturing questions the thought of whether standard costing still plays a valuable part when considering information for control purposes. Dynamic environments Customisation/differentiation not homogenous products Shorter product life-cycles Automation Higher concern for quality rather than efficiency

George Ritver within his book The McDonaldization of Society listed the advantages of producing standard or homogenous products, the pinnacle comparison being McDonalds, with its fast food strategy of uniformity of operations and delivery on a global basis. A concept you will find within thousands of companies in the world, especially the larger corporations e.g. Audi or V/W Group incorporating hundreds of components, including the engine, within a large range of cars manufactured. Although surely you would understand such an idea better through the use of a Big Mac right? Standardisation of machinery, uniforms and packaging e.g. sachets, drinking cups and paper bags. Automation of dispensers, cooking processes and staff have a nice day! Food already pre-prepared before cooking e.g. cheese sliced, salads prepared, sauces all pre-packed and easy to open and serve. This is uniformity or standardisation. Some facts about McDonalds Started as a hot dog stand in 1939 by 2 brothers (Richard and Maurice McDonald) 30,000 outlets in 119 countries One of the first to end waiter service Cut their menus down to a few standard and homogenous dishes for simplicity Plates replaced with cardboard containers to save on washing up

Advantages of McDonaldization standardisation reduces cost and improves efficiency 9 Control e.g. easier to create a pre-defined standard as there is such uniformity within the specification of the products produced, also easier to manage, organise, train and control workers 9 Efficiency e.g. combined with specialisation it is the most efficient way of working within large organisations 9 Predictability e.g. customer always knows what they are buying, giving reassurance and brand recognition 9 Calculability e.g. quantitative not qualitative information so easier to interpret 9 Proficiency of staff can be assessed more effectively Such a philosophy and its advantages are similar to the classical school of management, but can have its disadvantages Excessive specialisation of tasks e.g. work dull and boring Removes initiative of workers e.g. reduces innovation and creativity Boredom, frustration and de-motivation of workers

29 -

1.12 Diagnostic related or reference groups (DRG) can applied to a Big Mac Standard costing is and can be applied to service organisations such as the health service, accountancy practice or even retail. The diagnostic reference group or healthcare resource group is a system of classifying hundreds of different medical conditions within the health sector, as a basis of recognising that similar medical illnesses require essentially similar treatment or care. There are around 800 DRGs existing within the health service. This enables health service management to Standardise resources e.g. beds/wards/consultancy/medication Standardise patient treatment e.g. specifications of how treatment applied Standardise codes for insurance companies or standardise payments to the NHS or other private health providers for payment or charges made

Such standards can also be used by government to benchmark the performance and create league tables of those hospitals that complete treatments within standard times and costs and those that do not. The DRG approach also used to remunerate hospitals for each standard treatment they perform. Such a system is not without its critics, arguing that surely it is the qualitative factors in patient treatment more than the quantitative measures that are more important when it comes to patient care, and not every operation or treatment can be cured in a single best way. If payments are made to hospitals based on a standard amount or price, this could mean overzealous treatment of a patient causing overspending; this in itself could affect the level of patient care given. Characteristics of services Intangibility e.g. no material substance or physical existence of it when compared to a tangible good Legal ownership e.g. no physical evidence often exists, so you can never return it if it was faulty Instant perishability e.g. unlike goods, services cannot be stored Heterogeneity e.g. each time the service is performed even to the same customer it can be different each time, goods generally are homogenous Inseparability e.g. cannot be separated from the person who provides it

It is for the above reasons, as well as the human influence in the quality and effectiveness of the service performed, when compared to manufacturing a product, that makes standard costing more difficult to apply within the service sector.

30 -

Solutions to lecture examples

31 -

Example 1.2 - absorption costing organisation Operating statement for week 43 Budget (500 x 3.20) Sales volume variance (476-500 x 3.20) Flexed budget for 476 meals Sales price variance (476 x (11.95-11.95) 1,600 77(A) 1,523 0 1,523 F 45 55 15 9 45 120 54 A

Cost variances Chicken price variance (180kg x 2.25-2.50) Chicken usage variance (143-165 x 2.50) Vegetable price variance (250kg x 0.50-0.56) Vegetable usage variance (238kg-220kg x 0.50) Labour efficiency variance (119-114 x 9) Labour rate variance (120 x 10-9) Idle time variance (6 x 9) Variable overhead efficiency variance (119-114 x 2) Variable overhead expenditure variance (114 x 2-1.32) Fixed overhead expenditure variance (2500-2750) Fixed overhead volume variance (476-500 x 5)

10 78

250 120 614 =

187 Actual profit* * Proof Sales 5,688 Chicken 405 Closing stock (15kg x 2.50) (38) Vegetables 140 Closing stock (30kg x 50p) (15) Labour 1,200 V/OH 150 F/OH 2,750 (4,592) 1,096

427(A) 1,096

32 -

Example 1.2 - marginal costing organisation Operating statement for week 43 Budget (500 x 8.20) Sales volume variance (476-500 x 8.20) Flexed budget for 476 meals Sales price variance (476 x (11.95-11.95) 4,100 197(A) 3,903 0 3,903 F 45 55 15 9 45 120 54 A

Cost variances Chicken price variance (180kg x 2.25-2.50) Chicken usage variance (143-165 x 2.50) Vegetable price variance (250kg x 0.50-0.56) Vegetable usage variance (238kg-220kg x 0.50) Labour efficiency variance (119-114 x 9) Labour rate variance (120 x 10-9) Idle time variance (6 x 9) Variable overhead efficiency variance (119-114 x 2) Variable overhead expenditure variance (114 x 2-1.32) Actual contribution Budgeted fixed overhead Fixed overhead expenditure variance (2500-2750) Actual profit* * Proof Sales 5,688 Chicken 405 Closing stock (15kg x 2.50) (38) Vegetables 140 Closing stock (30kg x 50p) (15) Labour 1,200 V/OH 150 (1,842) Contribution 3,846 F/OH (2,750) 1,096

10 78 187

244 =

57(A) 3,846 2,500 250(A) 1,096

33 -

Example 1.3 Calculate the actual production and sale of meals Did sell Should sell Standard profit per meal 476 (balance figure) 500 (2500 Budget F/OH divided by 5 F/OH) 24 x 3.20 77(A)

Calculate actual hours worked for the chefs 476 meals did take 476 meals should take (476 x 0.25 hrs) Standard rate per hour 114 (balance figure) 119 5 x 9.00 per hour 45(F)

Hours paid for would have been 114 worked plus 6 hours idle time = 120 hours Calculate the actual quantity of chicken purchased 476 meals did use 476 meals should have used (x0.3kg) Standard price per kg 165 kg (balance figure) 143 kg 22 kg x 2.50 55 (A)

Calculate the actual price paid for chicken 165kg used as above + 15kg rise in closing stock levels = 180kg purchased. 180kg did cost 180kg should cost (x 2.50 kg) 405 (balance figure) 450 45(F)

Calculate the actual variable overhead expenditure 114 hrs worked did cost 114 hrs should have cost (x 2 per hour) 150 (balance figure) 228 78(F)

Calculate the actual fixed overhead expenditure Actual fixed overhead Budget fixed overhead 2,750 (balance figure) 2,500 250(A)

34 -

Example 1.4 Usage variance 60kg pizza Tomato Cheese did use 28kg 40kg should use 30kg x 36kg x standard price 1.40 = 7.50 = variance 2.80 (F) 30.00 (A) 27.20 (A)

Mix can be calculated by one of two ways First method (individual valuation bases) 60kg pizza Tomato Cheese did use 28kg 40kg 68kg should use (W1) 31kg x 37kg x 68kg standard price 1.40 = 7.50 = variance 4.20 (F) 22.50 (A) 18.30 (A)

(W1) 68kg ingredients x 0.5kg/1.1kg = 31kg of tomatoes you would have used had you kept to the mix 68kg ingredients x 0.6kg/1.1kg = 37kg of cheese you would have used had you kept to the mix Second method (average valuation bases) Weighted average cost of one Kg of ingredients (0.5kg/1.1kg x 1.40) + (0.6kg/1.1kg x 7.50) = 4.73 Within the mix (did use less should use) x (average standard cost less standard cost) = variance Thus if an actual mixed quantity is greater than the standard quantity mixed for this material, but this material costs less than average, then a favourable variance will result, as also would using less of a relatively more expensive ingredient, when compared to the average cost. Tomatoes Cheese 28kg-31kg= 3kg x 4.73-1.40 40kg-37kg= 3kg x 4.73-7.50 = = 10.00 (A) 8.31 (A) 18.31 (A)

For tomatoes 3kg used less than you should of but this costs less than the average cost, adverse. For cheese 3 kg used more than you should of which costs more than the average cost, adverse. Butliness have substituted a relatively less expensive ingredient for a more expensive one, hence both variances adverse. 35 -

Example 1.4 continued. Yield 68kg of cheese and tomato should yield (68kg/1.1kg per pizza) 68kg of cheese and tomato did yield Under produced x standard cost of one pizza average cost per kg 4.73 x 1.1kg/1.0kg 61.8 60.0 1.8 x 5.20* 9.37 (A)

*1.1KG INGREDIANT = 1.0KG OUTPUT THEREFORE THE COST OF ONE PIZZA SHOULD BE 1.1/1.0 X 4.73 AVERAGE COST PER KG.

36 -

Example 1.5 Labour Mix calculation - individual valuation basis

Partner Semi-senior Junior

Actual hours 12 40 38 90

Standard mix 3 / 20 5 / 20 12 / 20 20 / 20

Standard hours 13.5 22.5 54.0 90.0

Standard rate 1.5 100 150.00 (F) -17.5 70 -1225.00 (A) 16 30 480.00 (F) -595.00 (A) 0.0

Labour Mix calculation - average valuation basis

Actual hours 12 40 38 90 Standard hours 13.5 22.5 54.0 90.0 Standard rate - Average rate 100 50.50 -49.50 70 50.50 -19.50 30 50.50 20.50

Partner Semi-senior Junior

1.5 -17.5 16 0.0

74.25 (F) -341.25 (A) -328.00 (A) -595.00 (A)

W1 Average rate (3/20 x 100) + (5/20 x 70) + (12/20 x 30) = 50.50

Labour yield or productivity variance

90 hours did yield 90 audits should yield (90 hours/20 hours an audit) 5.0 audits 4.5 audits 0.5 audits x standard cost of an audit (1,010) 505(F)

Operating statement
5 audits should cost (based on standard mix of labour) Labour mix variance Labour yield variance 5 audits did cost (assuming standard rates were correct e.g. no rate variance) (12 hours x 100) + (40 hours x 70) + (38 hours x 30) = 5 x 1,010 = 5,050 595 (A) 505 (F)

5,140

Worse off by 90, the semi-senior improving productivity, due to higher quality of work, however this cost the organisation 90 (adverse) labour efficiency variance due to the higher cost of using the semi-senior, shown within the mix variance.

37 -

Example 1.7 Machine expenditure and efficiency variances Standard cost of 25 pints 40 x 0.6 hrs = 24 per 25 pints. Efficiency 1900 pints did take 1900 pints should take (1900/25 x 0.6 hrs) Standard cost per machine hour 42.0 hrs 45.6 hrs 3.6 hrs x 40 144(F)

Expenditure 42 hrs did cost 42 hrs should cost (42 x 40) 1,880 1,680 200 (A)

Operating statement Flexed budget based on actual output achieved Budget 1900/25 x 24 = 1,824 Efficiency 144(F) Expenditure 200(A) Actual 1,880

38 -

Example 1.7 - continued What if you were told that the machine has been replaced with a machine, which is 20% faster than the previous model, but this had not been reflected in the budget? Revise standard 0.6hrs x 0.8(20% faster time!!) x 40 Planning variance 1900 pints should have taken according to old standard 1900 pints should have taken according to new standard 46hrs 36hrs 10 hrs x 40 400(F)

Operational expenditure variance no change Operational efficiency variance (revised) 1900/25 x 0.6 hrs x 0.8 should take Did take 36 hrs 42 hrs 6 hrs x 40 240 (A)

Operating statement Flexed budget based on actual output achieved Budget 1900/25 x 24 = 1824 Planning 400(F) Efficiency 240(A) Expenditure 200(A) Actual 1880 About 14 rounding difference above.

39 -