Standard Costs and Overhead Analysis

Chapter Ten

Standard Costs
Standards are benchmarks or norms for measuring performance. Two types of standards are commonly used.
Quantity standards specify how much of an input should be used to make a product or provide a service. Cost (price) standards specify how much should be paid for each unit of the input.

Standard Costs
Deviations from standards deemed significant are brought to the attention of management, a practice known as management by exception.

Amount

Standard Direct Material

Direct Labour

Manufacturing Overhead

Type of Product Cost

Variance Analysis Cycle

Take corrective actions

Exhibit 10-1

Identify questions

Receive explanations

Analyze variances Prepare standard cost performance report

Conduct next periods operations

Begin

Setting Standard Costs

Accountants, engineers, purchasing agents, and production managers combine efforts to set standards that encourage efficient future production.

Setting Standard Costs

Should we use ideal standards that require employees to work at 100 percent peak efficiency? I recommend using practical standards that are currently attainable with reasonable and efficient effort.

Engineer

Managerial Accountant

Setting Direct Material Standards

Price Standards Quantity Standards

Final, delivered cost of materials, net of discounts.

Summarized in a Bill of Materials.

Setting Direct Labour Standards

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Rate Standards

Time Standards

Often a single rate is used that reflects the mix of wages earned.

Use time and motion studies for each labour operation.

Setting Variable Overhead Standards

Rate Standards Activity Standards

The rate is the variable portion of the predetermined overhead rate.

The activity is the base used to calculate the predetermined overhead.

Standard Cost Card Variable Production Cost A standard cost card for one unit of product might look like this:
A
Standard Quantity or Hours
3.0 lbs. 2.5 hours 2.5 hours

B
Standard Price or Rate

AxB
Standard Cost per Unit
12.00 35.00 7.50 54.50

Inputs
Direct materials Direct labor Variable mfg. overhead Total standard unit cost

$ 4.00 per lb. $ 14.00 per hour 3.00 per hour $

Standards vs. Budgets

Are standards the same as budgets? A budget is set for total costs.

A standard is a per unit cost. Standards are often used when preparing budgets.

Price and Quantity Standards

Price and and quantity standards are determined separately for two reasons:
The purchasing manager is responsible for raw material purchase prices and the production manager is responsible for the quantity of raw material used.

The buying and using activities occur at different times. Raw material purchases may be held in inventory for a period of time before being used in production.

A General Model for Variance Analysis

Variance Analysis

Price Variance

Quantity Variance

Difference between actual price and standard price

Difference between actual quantity and standard quantity

A General Model for Variance Analysis

Variance Analysis

Price Variance

Quantity Variance

Materials price variance Labour rate variance VOH spending variance

Materials quantity variance Labour efficiency variance VOH efficiency variance

A General Model for Variance Analysis

Actual Quantity Actual Price

Actual Quantity Standard Price

Standard Quantity Standard Price

Price Variance

Quantity Variance

A General Model for Variance Analysis

Actual Quantity Actual Price

Actual Quantity Standard Price

Standard Quantity Standard Price

Price Variance

Quantity Variance

Actual quantity is the amount of direct materials, direct labour, and variable manufacturing overhead actually used.

A General Model for Variance Analysis

Actual Quantity Actual Price

Actual Quantity Standard Price

Standard Quantity Standard Price

Price Variance

Quantity Variance

Standard quantity is the standard quantity allowed for the actual output of the period.

A General Model for Variance Analysis

Actual Quantity Actual Price

Actual Quantity Standard Price

Standard Quantity Standard Price

Price Variance

Quantity Variance

Actual price is the amount actually paid for the input used.

A General Model for Variance Analysis

Actual Quantity Actual Price

Actual Quantity Standard Price

Standard Quantity Standard Price

Price Variance

Quantity Variance

Standard price is the amount that should have been paid for the input used.

A General Model for Variance Analysis

Actual Quantity Actual Price

Actual Quantity Standard Price

Standard Quantity Standard Price

Price Variance
(AQ AP) (AQ SP) AQ = Actual Quantity AP = Actual Price

Quantity Variance
(AQ SP) (SQ SP) SP = Standard Price SQ = Standard Quantity

Material Variances Example

Glacier Peak Outfitters has the following direct material standard for the fiberfill in its mountain parka.
0.1 kg. of fiberfill per parka at $5.00 per kg.

Last month 210 kgs of fiberfill were purchased and used to make 2,000 parkas. The material cost a total of $1,029.

Material Variances Summary

Actual Quantity Actual Price 210 kgs. $4.90 per kg. = $1,029 Actual Quantity Standard Price 210 kgs. $5.00 per kg. = $1,050 Standard Quantity Standard Price 200 kgs. $5.00 per kg. = $1,000

Price variance $21 favourable

Quantity variance $50 unfavourable

Material Variances: Using the Factored Equations

Materials price variance
MPV = AQ (AP - SP) = 210 kgs ($4.90/kg - $5.00/kg) = 210 kgs (-$0.10/kg) = $21 F

Materials quantity variance

MQV = SP (AQ - SQ) = $5.00/kg (210 kgs-(0.1 kg/parka 2,000 parkas)) = $5.00/kg (210 kgs - 200 kgs) = $5.00/kg (10 kgs) = $50 U

Responsibility for Material Variances

Materials Quantity Variance Materials Price Variance

Production Manager

Purchasing Manager

The standard price is used to compute the quantity variance so that the production manager is not held responsible for the purchasing managers performance.

Responsibility for Material Variances

Your poor scheduling sometimes requires me to rush order material at a higher price, causing unfavourable price variances.

I am not responsible for this unfavourable material quantity variance. You purchased cheap material, so my people had to use more of it.

Quick Check

Zippy

Hanson Inc. has the following direct material standard to manufacture one Zippy:
1.5 pounds per Zippy at $4.00 per pound

Last week, 1,700 pounds of material were purchased and used to make 1,000 Zippies. The material cost a total of $6,630.

Quick Check

Zippy

Hansons material price variance (MPV) for the week was: a. $170 unfavourable. b. $170 favourable. c. $800 unfavourable. d. $800 favourable.

Quick Check

Zippy

Hansons material quantity variance (MQV) for the week was: a. $170 unfavourable. b. $170 favourable. c. $800 unfavourable. d. $800 favourable.

Isolation of Material Variances

I need the price variance sooner so that I can better identify purchasing problems. You accountants just dont understand the problems that purchasing managers have. Ill start computing the price variance when material is purchased rather than when its used.

Material Variances

Hanson purchased and used 1,700 pounds. How are the variances computed if the amount purchased differs from the amount used?

The price variance is computed on the entire quantity purchased. The quantity variance is computed only on the quantity used.

Quick Check Continued

Zippy

Hanson Inc. has the following material standard to manufacture one Zippy:
1.5 pounds per Zippy at $4.00 per pound

Last week, 2,800 pounds of material were purchased at a total cost of $10,920, and 1,700 pounds were used to make 1,000 Zippies.

Labour Variances Example

Glacier Peak Outfitters has the following direct labour standard for its mountain parka.
1.2 standard hours per parka at $10.00 per hour

Last month, employees actually worked 2,500 hours at a total labour cost of $26,250 to make 2,000 parkas.

Labour Variances Summary

Actual Hours Actual Rate 2,500 hours $10.50 per hour = $26,250 Actual Hours Standard Rate 2,500 hours $10.00 per hour. = $25,000 Standard Hours Standard Rate 2,400 hours $10.00 per hour = $24,000

Rate variance $1,250 unfavourable

Efficiency variance $1,000 unfavourable

Labour Variances: Using the Factored Equations

Labour rate variance
LRV = AH (AR - SR) = 2,500 hours ($10.50 per hour $10.00 per hour) = 2,500 hours ($0.50 per hour) = $1,250 unfavourable

Labour efficiency variance

LEV = SR (AH - SH) = $10.00 per hour (2,500 hours 2,400 hours) = $10.00 per hour (100 hours) = $1,000 unfavourable

Responsibility for Labour Variances

Production managers are usually held accountable for labour variances because they can influence the: Mix of skill levels assigned to work tasks. Level of employee motivation. Quality of production supervision. Quality of training provided to employees.

Production Manager

Responsibility for Labour Variances

I think it took more time to process the materials because the Maintenance Department has poorly maintained your equipment.

I am not responsible for the unfavourable labour efficiency variance! You purchased cheap material, so it took more time to process it.

Quick Check

Zippy

Hanson Inc. has the following direct labour standard to manufacture one Zippy:
1.5 standard hours per Zippy at $12.00 per direct labour hour

Last week, 1,550 direct labour hours were worked at a total labour cost of $18,910 to make 1,000 Zippies.

Quick Check

Zippy

Hansons labour rate variance (LRV) for the week was: a. $310 unfavourable. b. $310 favourable. c. $300 unfavourable. d. $300 favourable.

Quick Check

Zippy

Hansons labour efficiency variance (LEV) for the week was: a. $590 unfavourable. b. $590 favourable. c. $600 unfavourable. d. $600 favourable.

Variable Manufacturing Overhead Variances Example

Glacier Peak Outfitters has the following direct variable manufacturing overhead labour standard for its mountain parka.
1.2 standard hours per parka at $4.00 per hour

Last month, employees actually worked 2,500 hours to make 2,000 parkas. Actual variable manufacturing overhead for the month was $10,500.

Variable Manufacturing Overhead Variances Summary

Actual Hours Actual Rate 2,500 hours $4.20 per hour = $10,500 Actual Hours Standard Rate 2,500 hours $4.00 per hour = $10,000 Standard Hours Standard Rate 2,400 hours $4.00 per hour = $9,600

Spending variance $500 unfavourable

Efficiency variance $400 unfavourable

Variable Manufacturing Overhead Variances: Using Factored Equations

Variable manufacturing overhead spending variance
VMSV = AH (AR - SR) = 2,500 hours ($4.20 per hour $4.00 per hour) = 2,500 hours ($0.20 per hour) = $500 unfavourable

Variable manufacturing overhead efficiency variance

VMEV = SR (AH - SH) = $4.00 per hour (2,500 hours 2,400 hours) = $4.00 per hour (100 hours) = $400 unfavourable

Quick Check

Zippy

Hanson Inc. has the following variable manufacturing overhead standard to manufacture one Zippy:
1.5 standard hours per Zippy at $3.00 per direct labour hour

Last week, 1,550 hours were worked to make 1,000 Zippies, and $5,115 was spent for variable manufacturing overhead.

Quick Check

Zippy

Hansons spending variance (VOSV) for variable manufacturing overhead for the week was: a. $465 unfavourable. b. $400 favourable. c. $335 unfavourable. d. $300 favourable.

Quick Check

Zippy

Hansons efficiency variance (VOEV) for variable manufacturing overhead for the week was: a. $435 unfavourable. b. $435 favourable. c. $150 unfavourable. d. $150 favourable.

Overhead Rates and Overhead Analysis

Recall that overhead costs are assigned to products and services using a predetermined overhead rate (POHR):
Assigned Overhead = POHR Standard Activity Overhead from the flexible budget for the denominator level of activity Denominator level of activity

POHR

Overhead Rates and Overhead Analysis

The predetermined overhead rate can be broken down into fixed and variable components.
The variable component is useful for preparing and analyzing variable overhead variances. The fixed component is useful for preparing and analyzing fixed overhead variances.

Normal versus Standard Cost Systems

In a normal cost system, overhead is applied to work in process based on the actual number of hours worked in the period. In a standard cost system, overhead is applied to work in process based on the standard hours allowed for the actual output of the period.

Fixed Overhead Variances

Actual Fixed Overhead Incurred Fixed Overhead Budget DH FR Fixed Overhead Applied SH FR

Budget Variance

Volume Variance

FR = Standard Fixed Overhead Rate SH = Standard Hours Allowed DH = Denominator Hours

Overhead Rates and Overhead Analysis Example

ColaCo prepared this
Machine Hours 3,000 4,000 Total Variable Overhead $ 6,000 8,000

budget for overhead:

Variable Overhead Rate ? ? Total Fixed Overhead $ 9,000 9,000 Fixed Overhead Rate ? ?

Lets calculate overhead rates. ColaCo applies overhead based on machine-hour activity.

Overhead Rates and Overhead Analysis Example

ColaCo prepared this
Machine Hours 3,000 4,000 Total Variable Overhead $ 6,000 8,000

budget for overhead:

Variable Overhead Rate $ 2.00 2.00 Total Fixed Overhead $ 9,000 9,000 Fixed Overhead Rate ? ?

Rate = Total Variable Overhead Machine Hours This rate is constant at all levels of activity.

Overhead Rates and Overhead Analysis Example

ColaCo prepared this
Machine Hours 3,000 4,000 Total Variable Overhead $ 6,000 8,000

budget for overhead:

Variable Overhead Rate $ 2.00 2.00 Total Fixed Overhead $ 9,000 9,000 Fixed Overhead Rate $ 3.00 2.25

Rate = Total Fixed Overhead Machine Hours This rate decreases when activity increases.

Overhead Rates and Overhead Analysis Example

ColaCo prepared this
Machine Hours 3,000 4,000 Total Variable Overhead $ 6,000 8,000

budget for overhead:

Variable Overhead Rate $ 2.00 2.00 Total Fixed Overhead $ 9,000 9,000 Fixed Overhead Rate $ 3.00 2.25

The total POHR is the sum of the fixed and variable rates for a given activity level.

Fixed Overhead Variances Example

ColaCos actual production required 3,200 standard machine hours. Actual fixed overhead was $8,450. The predetermined overhead rate is based on 3,000 machine hours.

Overhead Variances

Now lets turn our attention to calculating fixed overhead variances.

Fixed Overhead Variances Example

Actual Fixed Overhead Incurred Fixed Overhead Budget Fixed Overhead Applied

$8,450

$9,000

Budget variance $550 favorable

Fixed Overhead Variances A Closer Look

Budget Variance
Results from spending more or less than expected for fixed overhead items.

Now, lets use the standard hours allowed to compute the fixed overhead volume variance.

Fixed Overhead Variances Example

Actual Fixed Overhead Incurred Fixed Overhead Budget Fixed Overhead Applied SH FR 3,200 hours $3.00 per hour $9,600

$8,450

$9,000

Budget variance $550 favorable

Volume variance $600 favorable

Volume Variance A Closer Look

Volume Variance
Results when standard hours allowed for actual output differs from the denominator activity.
Unfavorable when standard hours < denominator hours Favorable when standard hours > denominator hours

Volume Variance A Closer Look

Volume Variance Does not measure overor under spending

Results when standard hours for actual output differs Itallowed results from treating fixed from the denominator activity.

overhead as if it were a variable cost.

Unfavorable when standard hours < denominator hours

Favorable when standard hours > denominator hours

Quick Check
Yoder Enterprises actual production for the period required 2,100 standard direct labor hours. Actual fixed overhead for the period was $14,800. The budgeted fixed overhead was $14,450. The predetermined fixed overhead rate was $7 per direct labor hour. What was the budget variance? a. $350 U b. $350 F c. $100 F d. $100 U

Quick Check
Yoder Enterprises actual production for the period required 2,100 standard direct labor hours. Actual fixed overhead for the period was $14,800. The budgeted fixed overhead was $14,450. The predetermined fixed overhead rate was $7 per direct labor hour. What was the volume variance? a. $250 U b. $250 F c. $100 F d. $100 U

Overhead Variances and Under- or Overapplied Overhead Cost

In a standard cost system:
Unfavorable variances are equivalent to underapplied overhead. Favorable variances are equivalent to overapplied overhead.

The sum of the overhead variances equals the under- or overapplied overhead cost for a period.

Theoretical vs. Practical Capacity

Theoretical capacity is the volume of capacity if all available production time is used and no waste occurs.
(i.e.. operations conducted 24 hours per day, 7 days per week, 365 days per year, with no downtime)

Practical capacity represents what could be produced with operations at theoretical capacity less unavoidable downtime.

Variance Analysis and Management by Exception

How do I know which variances to investigate?

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

A Statistical Control Chart

Exhibit 10-9

Warning signals for investigation Favourable Limit Desired Value

Unfavourable Limit

8 9

Variance Measurements

Advantages of Standard Costs

Management by exception Promotes economy and efficiency

Advantages Simplified bookkeeping Enhances responsibility accounting

Potential Problems with Standard Costs

Emphasizing standards may exclude other important objectives. Favourable variances may be misinterpreted.

Potential Problems

Standard cost reports may not be timely.

Emphasis on negative may impact morale. Continuous improvement may be more important than meeting standards.

Invalid assumptions about the relationship between labour cost and output.