Presented by Ruvendra Nandan Slides adapted from Langfield-Smith et al.

2006

Lecture 3 Reading: Chapter 10

Standard costs for control: direct material and direct labour

Learning Outcomes:
Understand the role of standard costing in controlling costs and managing resources Describe the methods of standard setting Understand the behavioural implications or effects of standard costing Develop, calculate and interpret material and labour variances Explain a significant variance, causes and corrective measures needed Explain how standard costs are used in product costing

Controlling costs
Businesses are in control when operations proceed to plan and objectives are achieved Control systems provide regular information to assist in control, which is an essential part of effective resource management Necessary requirements for control A predetermined or standard performance level A measure of actual performance; and A comparison between standard performance and actual performance

Controlling costs
Standard costing is a part of the budgetary control system 1. A predetermined or standard cost is developed A standard cost is a budgeted cost of one unit of product Includes cost of material, labour and overhead 2. The actual cost incurred in the product process is measured 3. The actual cost is compared to the standard cost to form a cost variance

Controlling costs
Standard cost variances are used to evaluate actual performance and control costs Standard costs can be developed for direct material, direct labour and overheads When cost variances are significant, the cause of the variance must be investigated May result in operations being changed to bring cost back in line with standards Management may reconsider whether the standard costs are appropriate benchmarks

Setting standards
A variety of methods may be used to set cost standards Analysis of historical data Can provide a good basis for predicting future costs May need to be adjusted to reflect expected movements in price levels or technological changes in the product process Must be used with care as changes can make those costs irrelevant, and can include inefficiencies of the past

Setting standards
Engineering methods Rather than what it cost in the past, the focus is on what it should cost in the future Need to determine how much material should be required and how much direct labour should be used in the production process Time and motion studies may be conducted to ascertain how long it should take for workers to perform each step In practice, both historical cost analysis and engineering methods may be used in combination

Setting standards
Participation in setting standards
Standards should not be set by accountants alone People will usually be more committed to meeting standards and have greater confidence in their accuracy if they are allowed to participate in setting them Any manager who plays an integral part in an operation or process should participate in setting standards for that area

Setting standards
Perfection standards reflect minimum attainable costs under nearly perfect operation conditions Assumes peak efficiency, the lowest material and labour prices, the use of the best quality materials and no production disruptions due to power failures or machine breakdowns Perfection standards May motivate people to achieve the lowest cost possible, as the standard is theoretically attainable May discourage employees from working hard as the standards are unlikely to be achieved May encourage employees to sacrifice quality to achieve low costs

Setting standards
Practical standards are the minimum attainable costs under normal operating conditions, with allowances made for downtime and wastage Includes occasional machine breakdowns and normal amounts of raw material wastage May encourage more positive and productive attitudes among employees compared to perfection standards Some companies include allowances for idle time, material wastage or normal spoilage, which may encourage inefficiency and waste Others build continuous improvements into standards to make them more demanding

Setting standards
Benchmarking of costs may involve
Identifying companies that have the best cost performance Assessing their level of costs, and Identifying the cost performance gap that needs to be closed

Cost standards may be formulated to achieve external performance standards over the medium to long term

Direct material standards

Standard material quantity
The total amount of direct material required to produce one unit of product

Standard material price

The total delivered cost of the material, less quantity discounts Based on ordering a certain quality of material in specific order quantities from a specified supplier

Direct labour standards

Standard direct labour
The number of labour hours normally needed to manufacture one unit of products

Standard labour rate

The total hourly cost of wages, including oncosts On-costs are extra salary-related costs that all Australian companies have to pay; usually treated as part of the cost of labour

Direct material variances

Direct material price variances The measure of the effect on cost of purchasing at a price that is different from standard = PQ(AP SP) Where PQ = quantity purchased AP = actual price SP = standard price

Direct material variances

Sometimes the direct material price variance is calculated using the quantity of materials used in production (AQ) rather than the quantity of material purchased (PQ) = AQ(AP SP) Where AQ = actual quantity of material used in production AP = actual price SP = standard price

Direct material variances

Direct material quantity variance A measure of the effect on cost of using a different quantity of material in production compared with the standard quantity that should have been used for the actual production output
= SP(AQ SQ) Where SP = standard price AQ = actual quantity used SQ = standard quantity used, given actual output

Direct labour variances

Direct labour rate variance
A measure of the effect on cost of paying a different labour rate, compared with standard = AH(AR SR) Where AH = actual hours used AR = actual rate per hour SR = standard rate per hour

Direct labour variances

Direct labour efficiency variance

A measure of the effect on cost of using a different number of direct labour hours, compared with the standard hours that should have been used for the actual production output
= SR(AH SH) Where AH = actual hours used SH = standard hours allowed given actual output SR = standard rate per hour

Investigating significant variances and taking corrective actions

Management by exception
Only significant cost variances are reported and investigated

Significant variances
Size of variance Recurring variances Trends Controllability

Investigating significant variances and taking corrective actions

Favourable variances warrant similar investigation to unfavourable variances
May reveal efficiencies and new practices that can be used again, and used elsewhere in the organisation

Investigating variances may include

Talking with managers and employees familiar with the operations to find causes Written reports to explain significant variances and possible corrective actions

A statistical approach to variance investigation

Variances may be caused by random fluctuations which may not require correction Statistical control charts plot standard cost variances across time and compare them with a critical value
Highlight the variances which should be investigated Critical value is a multiple of a distribution's standard deviation

Costs and benefits of investigation

Costs include Time spent investigating the problem Disruption to the production process as the investigation is conducted Corrective actions Benefits include Reduced costs if cause of variance is eliminated Causes of favourable variances may improve work practices Management judgment and experience is used to weigh up these considerations

Behavioural impact of standard costing

Standard costing can be used to evaluate the performance of managers, employees and departments Comparing individuals performance with standards or budgets can be used to determine salary increases, bonuses and promotions These practices can profoundly influence behaviour Motivate positive behaviours Encourage the manipulation of data and reports and dysfunctional activities and decisions

Cost control through assigning responsibility

Cost control is accomplished through the efforts of individual managers and employees Managers held responsible for certain cost standards Need to be able to control these outcomes and be involved in setting the standards Interactions between variances make it difficult to assign responsibility for particular variances Not all favourable variances are desirable Unfavourable variances do not always indicate a problem Source of the variance may lie in a different area of the firm than where the variance is being reported

Standard costs for product costing

Standard costing system
All inventories are recorded at standard cost

Variances are closed off at the end of the accounting period

To cost of goods sold expense or Prorate variances between WIP, FG and COGS, if significant

Summary and Conclusion

Standard costing important management control tool. Note the difference between a budget and a standard. Participation in standard setting. Two variances for direct materials and two variances for direct labour. Management by exception to decide which variances to be investigated. Variance reporting and responsibility accounting Standard costs for product costing