July 17, 2015

Arachchi C.W.K.kuruppu FGS/MBus/2015/05Submitted By:

of kelaniya University G.M. Mudith sujeewa,Submitted To: Sir

pplication of standard costing A

MBACC 51044 Management Accounting

ASSIGNMENT NO.1

costs are aid in the Standard

Abstract:

1

STANDARD COSTING AND VARIANCE ANALYSIS

INTRODUCTION 0 3

DEFINITON 04

HOW TO CREATE STANDARD COST 05

VARIANCE ANALYSIS 07

VARIANCE CALCULATION 08

CAUSES OF VARIANCE 12

INVESTINGATING VARIANCE 14

PLANNING AND OPERATION VARIANCE 16

ADAVANTAGE & DISADVANTAGE 20

Introduction to Standard Costing

A standard cost is planned or forecast unit cost for a product or service, which is assumed to hold good given expected efficiency and cost levels within an organization. It represents a target cost and is useful for planning, controlling and motivating within an organization.

Variance analysis is a budgetary control process, which compares standard or budgeted costs and revenues with the actual results of an organization, in order to obtain

2

information regarding any exceptions from budget, this information is also used to improve performance through control action e.g. correction 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 organization can value stock at standard cost, incorporating this within the ledger or cost accounts of the organization, the budget or forecasts being a memorandum kept outside the ledger accounts.

Types of Standard

• Ideal Standard e.g. attained under the most favorable 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 organization 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.

Standard Costing

Costing is the identification of the value of resources used for specified goods or services. One purpose of costing is to determine what resources were required to provide the goods or services. A second purpose is to provide a guide to resource usage through the use of budgets that clearly identify managers' responsibility. It is the second purpose that is considered in the following discussion.

3

Methods of Costing Identified Budgets

Budget figures may be based on actual, budgeted, or standard costs. These categories are not mutually exclusive. For example, while a standard cost is a budgeted cost, a budgeted cost is not always a standard cost. An actual cost may or may not be the budgeted cost.

Allowed for forth coming activity. To establish budgeted costs, actual costs of the previous year, information from supervisors about where resources might be more efficiently used, and subjective judgments about the need to conserve resources are often considered. Standard costs are objectively determined costs that reflect Budgets based on actual costs reflect expenditures anticipated for the level of resource use. Budgeted costs are generally described as the best estimate about what should be the effective and efficient use of resources.

Standard Costs

Standard costs are costs established through identifying an objective relationship between specified inputs and expected outputs.

How to Create a Standard Cost

4

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 Labor Rate • Market rate for grade/type of labor

• Internal rates form HR department

• Bonus schemes/piece work rates in current use

Standard Labor Efficiency • Idle time expected during operations

• Time/motion studies

• Skill/expertise of staff

• Learning curve

• Motivation of Staff

• Remuneration system 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, labor hours, machine hours or % of cost

5

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 charged, just Fixed at a certain level of output sold and produced. This tends to be a form of budgeting for a service organization where a high proportion of total cost if 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 detail 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 organization e.g. useful at the planning stage for ‘what it?’ analysis. Flexible budgeting recognizes different cost behavior 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 prepared. 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

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-dividend further, calculated, interpreted and used to correct problems within the organization 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

6

• 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.

Variance calculation

Cost Variances

7

Material Variances:

1. Material Cost Variance = Standard Cost - Actual Cost

2. Material Price Variance = Standard Cost of Actual Qty. - Actual Cost

= Actual Qty. (Standard Price - Actual Price)

3. Material Usage Variance = Standard Cost - Standard Cost of Actual Qty.

= Standard Price (Standard Qty. - Actual Qty.)

4. Material Mix Variance = Actual Qty. (Std. Price of Std. Mix - Std. Price of Actual Mix

= (Actual Qty. x Std. Price of Std. Mix) - Standard Cost of Actual Qty.

5. Material Sub-Usage Variance = Std. Price of Std. Mix (Total Std. Qty. - Total Actual Qty.)

=

Standard Cost - (Actual Qty. x Std. Price of Std. Mix)

6. Material Yield Variance = Std. Price of Yield (Actual Yield - Standard Yield) (When there is Std. Loss or i.e. Std. Cost per unit of O/P

I/P : O/P ratio differs) = Standard Cost - (Std. Price of Yield x Standard Yield)

7. Standard Price of Standard Mix = Total Std. Cost/ Total Std. Qty.

8. Standard Price of Actual Mix = Std. Cost of Actual Qty. / Total Actual Qty.

8

Labour Variances:

1. Labour Cost Variance = Standard Cost - Actual Cost

2. Labour Rate Variance = Standard Cost of Actual Time - Actual Cost = Actual Hrs. (Standard Rate - Actual Rate)

3. Labour Efficiency Variance = Standard Cost - Standard Cost of Actual Time = Standard Rate (Standard Hrs. - Actual Hrs.)

4. Labour Gang Variance = Actual Hrs. (Std. Rate of Std. Gang - Std. Rate of Actual Gang) = (Actual Hrs. x Std. Rate of Std. Gang) - Standard Cost of Actual Time

5. Labour Sub-Efficiency Variance = Std. Rate of Std. Gang (Total Std. Hrs. - Total Actual Hrs.) = Standard Cost - (Actual Hrs. x Std. Rate of Std. Gang)

6. Idle Time Variance = Std. Rate x Idle Time = Standard Rate (Actual Hrs. Worked - Actual Hrs. Paid)

7. Standard Rate of Standard Gang = Total Std. Cost/ Total Std. Gang Hrs.

8. Standard Rate of Actual Gang

Variable Overhead Variances:

= Std. Cost of Actual Hrs. / Total Actual Gang Hrs.

1. Variable Overhead Variance = Standard Variable Overheads - Actual Variable O/hs

2. Variable Overhead Budget/ Expenditure Variance = Budgeted Variable Overheads - Actual Variable O/hs for actual hrs.

= Actual Hrs. (Std. Rate - Actual Rate)

3. Variable Overhead Efficiency Variance

= Std. Variable O/h Rate Std. Hrs. for Actual - Actual Output Hrs.

= Budgeted Variable O/hs - Budgeted O/hs for for

Budgeted Hrs. Actual Hrs.

9

Fixed Overhead Variances:

1. Total Fixed Overhead Variance = Fixed Overheads Absorbed - Actual Fixed Overheads

2. Fixed Overhead Expenditure Variance = Budgeted Overheads - Actual Overheads

3. Fixed Overhead Volume Variance = Std. Fixed O/h Absorption Actual Hrs. - Budgeted)

Rate/ Hr./unit worked Hrs. (units) (units)

= Fixed O/hs Absorbed - Budgeted Fixed O/hs

4. Capacity Variance = Std. Fixed O/h Absorption Actual Hrs. - Budgeted Hrs.

Rate/ Hr. Capacity Capacity

5. Efficiency Variance = Std. Absorption Rate (Std. Hrs. Required - Actual Hrs.)

6. Calander Variance = Std. Absorption Rate (Budgeted Hrs. in Actual Period –Budgeted Hrs.)

1

0

Price Variance Volume Variance

Sales Margin Sales Margin

Quantity Variance Mix Variance 1. Sales Price Variance = Actual Sales - Standard Sales (for Actual Qty.) = Actual Qty. (Actual Price - Budgeted Price)

2. Sales Volume Variance = Standard Sales - Budgeted Sales

= Budgeted Price (Actual Qty. - Budgeted Qty.)

3. Total Sales Variance = Actual Sales - Budgeted Sales

4. Sales Margin Variance = Actual Margin - Budgeted Margin

5. Sales Margin Price Variance = Actual Qty. (Actual Margin - Budgeted Margin) Per Unit Per Unit

6. Sales Margin Volume Variance = Budgeted Margin (Actual Units - Budgeted Units) (Profit) Per Unit

7. Sales Margin Quantity Variance = Budgeted Margin (Total Actual - Total Budgeted) per unit of Qty. Qty.

Budgeted Mix

8. Sales Margin Mix Variance = Total Actual Qty. Budgeted Margin - Budgeted Margin

C.W.K.Kuruppu Arachchi

Sales Margin Sales Margin

Variance Variance Variance

Sales Margin Sales Mix olumeSales V Sales Price

Sales Variances

11

Sold per unit of per unit of Actual Mix Budgeted Mix

Causes of variances

Material price variance • Different sources of supply

• Unexpected general price increase

• Alteration in quantity discounts

• Alternation 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 first of the year.

Material Usage Variance • Higher/lower incidence of scrap

• Alternation 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 labor

Labor Efficiency Variance

• Improvement in methods or working conditions

• Variations in unavoidable idle time

• Introduction of incentive scheme

C.W.K.Kuruppu Arachchi 12

• Substitution of a different grade of Possible causes of the individual variances are:

C.W.K.Kuruppu Arachchi 13

C.W.K.Kuruppu Arachchi 14

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.

These percentages could be plotted on a graph from one period to the next, which would provide managers with the following advantages.

Graphical presentation or percentages analyses over time allows easier interpretation and clearer understanding by managers

C.W.K.Kuruppu Arachchi 15

labor

Variable Overhead Variance • Unexpected price changes for overhead items

• Labor efficiency variances (see above)

Fixed Overhead Expenditure Variance • 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 fourweekly periods without allowances for seasonal factors. Over a whole year the seasonal effects would cancel out.)

Fixed Overhead Volume • Change in production volume due to change in demand or alternatives to stockholding policy

• Changes in productivity of labor or machinery

• Production lost through strikes etc.

Operating Profit Variance Due To Selling Prices

• Unplanned price increase

• Unplanned price reduction e.g. to try and attract additional business.

Presenting variances over time allows trends to be identified easier

By working out percentages expressed against standard, it removes changes in monetary size of the variance caused by changing activity levels, improving trend analysis

Factors To Consider Before Investigation

1. The size of it (materiality)

2. The general trend of it e.g. use of control charts for this

3. The type of standard that was used

4. Interdependence with other variances

5. The likelihood of identifying the cause of it

6. The likelihood that if a cause is found then it is controllable

7. The cost and benefits of correcting the cause

8. The cost of the investigation

C.W.K.Kuruppu Arachchi 16

Example of a variance chart

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

variance that would be effected by the adjustment, will give a more realistic standard.

The effects 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

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

C.W.K.Kuruppu Arachchi 17

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.

C.W.K.Kuruppu Arachchi 18

C.W.K.Kuruppu Arachchi 19

C.W.K.Kuruppu Arachchi 20

Advantages / Benefits of Standard Costing System:

Standard costing System has the following main advantages or benefits:

1. The use of standard costs is a key element in a management by exception approach. If costs remain within the standards, Managers can focus on other issues. When costs fall significantly outside the standards, managers are alerted that there may be problems requiring attention. This approach helps managers focus on important issues.

2. Standards that are viewed as reasonable by employees can promote economy and efficiency. They provide benchmarks that individuals can use to judge their own performance.

3. Standard costs can greatly simplify bookkeeping. Instead of recording actual costs for each job, the standard costs for materials, labor, and overhead can be charged to jobs.

4. Standard costs fit naturally in an integrated system of responsibility accounting. The standards establish what costs should be, who should be responsible for them, and what actual costs are under control.

Disadvantages / Problems / Limitations of Standard Costing System:

The use of standard costs can present a number of potential problems or disadvantages. Most of these problems result from improper use of standard costs and the management by exception principle or from using standard costs in situations in which they are not appropriate.

1. Standard cost variance reports are usually prepared on a monthly basis and often are released days or even weeks after the end of the month. As a consequence, the information in the reports may be so stale that it is almost useless. Timely, frequent reports that are approximately correct are better than infrequent reports that are very precise but out of date by the time they are released. Some companies are now reporting variances and other key operating data daily or even more frequently.

2. If managers are insensitive and use variance reports as a club, morale may suffer. Employees should receive positive reinforcement for work well done. Management by exception, by its nature, tends to focus on the negative. If variances are used as

C.W.K.Kuruppu Arachchi 21

a club, subordinates may be tempted to cover up unfavorable variances or take actions that are not in the best interest of the company to make sure the variances are favorable. For example, workers may put on a crash effort to increase output at the end of the month to avoid an unfavorable labor efficiency variance. In the rush to produce output quality may suffer.

3. Labor quantity standards and efficiency variances make two important assumptions. First, they assume that the production process is labor-paced; if labor works faster, output will go up. However, output in many companies is no longer determined by how fast labor works; rather, it is determined by the processing speed of machines. Second, the computations assume that labor is a variable cost. However, direct labor may be essentially fixed, then an undue emphasis on labor efficiency variances creates pressure to build excess work in process and finished goods inventories.

4. In some cases, a "favorable" variance can be as bad or worse than an "unfavorable" variance. For example, McDonald's has a standard for the amount of hamburger meat that should be in a Big Mac. A "favorable" variance would mean that less meat was used than standard specifies. The result is a substandard Big Mac and possibly a dissatisfied customer.

5. There may be a tendency with standard cost reporting systems to emphasize meeting the standards to the exclusion of other important objectives such as maintaining and improving quality, on-time delivery, and customer satisfaction. This tendency can be reduced by using supplemental performance measures that focus on these other objectives.

6. Just meeting standards may not be sufficient; continual improvement may be necessary to survive in the current competitive environment. For this reason, some companies focus on the trends in the standard cost variances - aiming for continual improvement rather than just meeting the standards. In other companies, engineered standards are being replaced either by a rolling average of actual costs, which is expected to decline, or by very challenging target costs.

In sum, managers should exercise considerable care in their use of a standard cost system. It is particularly important that managers go out of their way to focus on the positive, rather than just on the negative, and to be aware of possible unintended consequences.

C.W.K.Kuruppu Arachchi 22

Nevertheless standard costs are still found in the vast majority of manufacturing companies and in many service companies, although their use is changing. For evaluating performance, standard cost variances may be supplanted in the future by a particularly interesting development known as the balanced scorecard.

C.W.K.Kuruppu Arachchi 23