Lecture 8

Paolo Perego

Management Accounting IBA 2005-2006

• Chapter 10: Standard costing and operational performance measures:

– Cost variance analysis

– Behavioral impact of standard costing

– Criticisms of standard costing

– Operational performance measures

– Balanced Scorecard

• Chapter 11: Flexible budgeting and Overhead cost variances

Program

Managing costsC

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Standardperformance

level

Actualperformance

level

Comparison between standard and actual

performancelevel

Costvariance

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Standard costs

Benchmarks formeasuring performance.

The expected levelof performance:- difficult, yet attainable targets!

Based on carefullypredetermined amounts:- Historical data- Task analysis

Used for planning laborand material requirements.

Standard Costs are

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Management by Exception

DirectMaterial

Managers focus on quantities and coststhat exceed standards, a practice known as

management by exception.

Type of Product Cost

Am

ou

nt

Standard

DirectLabor

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Cost Variance Analysis

Standard Cost Variances

Quantity VariancePrice Variance

The difference betweenthe actual price and the

standard price

The difference betweenthe actual quantity andthe standard quantity

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A General Model of Cost Variance Analysis

Actual Quantity Actual Quantity Standard Quantity × × × Actual Price Standard Price Standard Price

Price Variance Quantity Variance

Standard price is the amount that should have been paid for the resources acquired

Standard quantity is the quantity allowed for the actual good output

AQ(AP - SP) SP(AQ - SQ)

AQ = Actual Quantity SP = Standard Price AP = Actual Price SQ = Standard Quantity

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7Material variances: Example

Hanson Inc. has the following direct material standard to manufacture one product called 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.

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Material variances: Example

Actual Quantity Actual Quantity Standard Quantity × × × Actual Price Standard Price Standard Price

1,700 lbs. 1,700 lbs. 1,500 lbs. × × × $3.90 per lb. $4.00 per lb. $4.00 per lb.

$6,630 $ 6,800 $6,000

Price variance$170 favorable

Quantity variance$800 unfavorable

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Material variances: Example

Suppose 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.

How are the variances computed if the amount purchased differs from the amount used?

Price variance is computed on the entire quantity purchased

Quantity variance is computed only on the quantity used.

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Material variances: Example

Actual Quantity Actual Quantity Purchased Purchased × × Actual Price Standard Price

2,800 lbs. 2,800 lbs. × × $3.90 per lb. $4.00 per lb.

$10,920 $11,200

Price variance$280 favorable

Price variance increases because quantity purchased

increases.

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Material variances: Example

Quantity variance is unchanged because actual

and standard quantities are unchanged

Actual Quantity Used Standard Quantity × × Standard Price Standard Price

1,700 lbs. 1,500 lbs. × × $4.00 per lb. $4.00 per lb.

$6,800 $6,000

Quantity variance$800 unfavorable

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Labor variances: Example

Hanson Inc. has the following direct labor standard to manufacture one Zippy:

1.5 standard hours per Zippy at $10.00 per direct labor hour

Last week 1,550 direct labor hours were worked at a total labor cost of $15,810 to make 1,000 Zippies.

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Labor variances: Example

Actual Hours Actual Hours Standard Hours × × × Actual Rate Standard Rate Standard Rate

Rate (or wage) variance$310 unfavorable

Efficiency variance$500 unfavorable

1,550 hours 1,550 hours 1,500 hours × × ×$10.20 per hour $10.00 per hour $10.00 per hour

$15,810 $15,500 $15,000

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Interpreting interaction among variances (1)

• Large variances in either direction indicate performance is not as planned, due to either poor planning, poor management, or random fluctuation.

• Unfavorable labor rate (wage) variance:– could indicate overtime had to be paid – workers were not available at lower rates

• Unfavorable labor efficiency variance:– poor quality materials– poorly maintained equipment– poor supervision of workers

• Unfavorable rate (wage) variance with favorable efficiency variance:

– higher-paid workers performed work more efficiently

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Behavioral impact of standard costing (1)

Evaluating performance evaluation on individual's variances:

• Emphasizes individual instead of team efforts• Reluctance to support others

Example: effect of incentive system that insulates purchasing department from production department

Purchasing externalities on production:• Purchase cheaper substandard materials• Purchase price variance is favorable• Unusable material results in unfavorable material

quantity varianceProduction externalities on purchasing:• Short lead times on requisitions leads to higher

purchase prices• Requesting special orders for materials leads to higher

prices

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Behavioral impact of standard costing (2)

Solution to insulation effects:• Base reward system on both individual and departmental

(team) variances. However: too much weight on teamwork can lead to shirking (free-rider problem)!

• Mutual monitoring: method where managers or employees at the same level monitor each other’s performance

• Example of mutual monitoring: performance evaluation of both purchasing and production manager depends on both material price and quantity variances:

– Purchasing manager wants to help production manager become more efficient in material usage

– Production manager wants to schedule requisitions to help purchasing manager buy materials at better prices

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A Statistical Approach

Display variations in a process and help to

analyze the variationsover time.

Distinguish between random variationsand variations that

should be investigated.

Provide a warning signal when variationsare beyond a specified level.

ControlCharts

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Statistical Control Chart

1 2 3 4 5 6 7 8 9

Variance Measurements

Favorable Limit

Unfavorable Limit

Desired Value •

••

• •

••

•

•

Warning signals for investigation

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Evaluation of Standard Costing

Advantages: • Sensible Cost Comparisons• Management by Exception• Performance Evaluation• Employee Motivation

Criticisms:• Standard costing may be inappropriate in some modern

manufacturing environments• Undue concern for variances and cost minimization may

lead to lower quality• Automation reduces labor costs and the significance of

labor variances• Standard costing may not be applicable in flexible

manufacturing operations with short life-cycle products

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Operational Control Measures

• Raw Material and Scrap Control (e.g. lead time)

• Inventory Control (e.g. no. of inventory items)

• Machine Performance (e.g. setup time)

• Product Quality (e.g. customer satisfaction)

• Productivity (e.g. cost of rework)

• Innovation and Learning (e.g. costs savings from process improvements)

• Production and Delivery

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Production and Delivery Performance Measures

Wait Time

Manufacturing Cycle Time

Process Time + Inspection Time+ Move Time + Waiting Time

Order Received

Production Started Goods Shipped

Delivery Cycle Time

ManufacturingCycle

Efficiency

Process Time

Manufacturing Cycle Time=

See review problems in Appendix!

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Non-financial “Leading” Indicators

Example: Major U.S. Telecommunications Firm (n = 2,156 customers)

1.221.24

0 20 40 60 80 1001.04

1.06

1.08

1.1

1.12

1.14

1.16

1.18

1.2

Customer Satisfaction in Year 1

Year

2 R

even

ue /

Year

1 R

even

ue

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Non-financial “Leading” Indicators

MV = -16,775 + 1.73 BVA - 1.77 BVL + 243.2 (ACSI)

Example: Valuation Aspects of Customer Satisfaction

Market Valueof Equity

Book Valueof Assets

Book Valueof Liabilities

American CustomerSatisfaction Index

• Customer satisfaction (i.e. intangible) is not fully reflected in balance sheet financial accounting measures

• A one-unit change in the ACSI is related to a $243.2 million change in the market value of equity

Business Model

A Compelling Place to Work

Employee Retention

A Compelling Place to Shop

Customer Recommendations

Return on Assets

Operating Margin

Revenue Growth

A Compelling Place to Invest

Customer Retention

Employee Behavior

Attitude About the

Job

Attitude About the Company

Service

Helpfulness

Customer Impression

5 unit increase in employee attitude

1.3 unit increase in customer impression

DRIVES0.5% increase in revenue growth

DRIVES

Merchandise

Value

NOTE: The rectangles represent survey information; the ovals, hard data.

Adapted from Harvard Business Review, January–February 1998.

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Balanced Scorecard

Measurement is the language that gives clarity to vague concepts.

Measurement is used to communicate, not to control.

Strategy can be described as a series of cause and effect relationships

"If we succeed, how will we look to our shareholders?”

Strategy

Financial Perspective

"To achieve my vision, how must I look to my

customers?”

Customer Perspective

"To satisfy my customers, at which processes must

I excel?”

Internal Perspective

"To achieve my vision, how must my organization

learn and improve?”

Organization Learning

Balanced Scorecard terminology:

Southwest Airlines Example

Objectives

•Fast ground turnaround

Objectives:

What the strategy is trying to achieve

Targets

•30 Minutes•90%

Targets:The level of performance or rate of

improvement needed

•Cycle time optimization

Initiatives:

Key action programs

required to achieve targets

InitiativesMeasures

•On Ground Time

•On-Time Departure

Measures:How success

or failure (performance) against

objectives is monitored

Strategic Theme: Operating Efficiency

Profits and RONAFinancial

Learning

Ground crew alignment

Lowest prices

Fewer planes

Customer

Internal

Fast ground turnaround

Strategy Map

On-time Service

Attract & Retain More Customers

Grow Revenues

A Complete Scorecard is a Program for Action

• % Ground crew trained

• % Ground crew stockholders

Objectives Measures

• # Customers• FAA On Time

Arrival Rating• Market Survey

• On Ground Time• On-Time

Departure

Strategic Theme:Operating Efficiency

Initiatives

• Cycle time optimization

• Ground crew training

• ESOP

•Customer loyalty

program• Quality management

Targets

• 30% CAGR

• 20% CAGR

• 5% CAGR

• 12% growth• Ranked #1• Ranked #1

• 30 Minutes• 90%

• yr. 1 70%yr. 3 90%yr. 5 100%

• Profitability

• Grow Revenues

• Fewer planes

• More Customers • Flight is on -time• Lowest prices

• Fast ground turnaround

• Ground crew alignment

Strategic Theme: Operations Excellence

Profits and RONAFinancial

Learning

Ground crew alignment

Fewer planes

Customer

Internal

Fast ground turnaround

Attract & Retain More Customers

Grow Revenues

Lowest prices

On-time Service

Strategy Map

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Make Strategy a Continuous Process

Strategic Learning Loop

Initiatives & Programs

test the hypotheses

Output(Results)

reportingManagement Control Loopfunding

Input(Resources)

update the strategy

PERFORMANCE

85% of management teams spend less than one hour per month on strategy

issues

92% of organizations do not report on lead

indicators

60% of organizations don’t

link strategy & budgets

78% of organizations lock budgets to an

annual cycle

20% of organizations take more than 16 weeks

to prepare a budget

STRATEGY

BALANCED SCORECARD

BUDGET

Balanced Scorecard and Strategy

Corporate StrategyCorporate Strategy Balanced Scorecard CategoriesBalanced Scorecard Categories

• Achieving good financial results

• Delivering for the customer

• Managing costs strategically

• Managing risk

• Having the right people in the right jobs

• Financial (revenues, expenses, margins)

• Strategy (number of customers, market share)

• Customer (overall and branch customer satisfaction)

• Control (audit reports)• People (teamwork, training,

employee satisfaction)• Standards (ethics, community

involvement)

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Balanced Scorecard and Incentive Systems

FinancialPar

Score

StrategyPar

Score

CustomerPar

Score

ControlPar

Score

PeoplePar

Score

Manager Bonus

Overall Par Score

3 Measures 11 Measures 2 Measures 3 AuditJudgements

StandardsPar

Score

5 QualitativeAssessments

5 QualitativeAssessments

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Static and Flexible BudgetsC

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• A static budget is a budget prepared for only one level of activity.

• It is based on the level of output planned at the start of the budget period.

• The master budget is an example of a static budget.

• A flexible budget is developed using budgeted revenues or cost amounts based on the level of output actually achieved in the budget period.

• A key difference between a flexible budget and a static budget is the use of the actual output level in the flexible budget

Static Budget: ExampleC

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Static ActualBudget Results Variances

Machine hours 10,000 8,000 2,000 U

Variable costs Indirect labor 40,000$ 34,000$ $6,000 F Indirect materials 30,000 25,500 4,500 F Power 5,000 3,800 1,200 F

Fixed costs Depreciation 12,000 12,000 0 Insurance 2,000 2,000 0

Total overhead costs 89,000$ 77,300$ $11,700 F

Since cost variances are favorable, havewe done a good job controlling costs?

Flexible BudgetsC

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The relevant question is . . .

“How much of the favorable cost variance is due to lower activity, and how much is due to good cost control?”

To answer the question, we must flex the budget to theactual level of activity.

Central Concept

If you can tell me what your activity wasfor the period, I will tell you what your costs and

revenue should have been

Advantages of Flexible BudgetsC

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• To flex a budget for different activity levels, we must know how costs behave with changes in activity levels

• Total variable costs change in direct proportion to changes in activity.

• Total fixed costs remain unchanged within the relevant range.

Improve performance evaluation

May be prepared for any activity level in the relevant range.

Show revenues and expensesthat should have occurred at theactual level of activity.

Reveal variances due to good costcontrol or lack of cost control.

Flexible BudgetsC

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Variable Total Flexible BudgetsCost Fixed 8,000 10,000 12,000

Per Hour Cost Hours Hours Hours

Machine hours 8,000 10,000 12,000

Variable costs Indirect labor 4.00 32,000$ 40,000$ 48,000$ Indirect material 3.00 24,000 30,000 36,000 Power 0.50 4,000 5,000 6,000 Total variable cost 7.50$ 60,000$ 75,000$ 90,000$

Fixed costs Depreciation 12,000$ 12,000$ 12,000$ 12,000$ Insurance 2,000 2,000 2,000 2,000 Total fixed cost 14,000$ 14,000$ 14,000$ Total overhead costs 74,000$ 89,000$ 104,000$

Flexible Budget Report at 8,000 actual machine hours

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Variable TotalCost Fixed Flexible Actual

Per Hour Costs Budget Results Variances

Machine hours 8,000 8,000 0

Variable costs Indirect labor 4.00$ 32,000$ 34,000$ $ 2,000 U Indirect material 3.00 24,000 25,500 1,500 U Power 0.50 4,000 3,800 200 FTotal variable costs 7.50$ 60,000$ 63,300$ $ 3,300 UFixed Expenses Depreciation 12,000$ 12,000$ 12,000$ 0 Insurance 2,000 2,000 2,000 0Total fixed costs 14,000$ 14,000$ 0Total overhead costs 74,000$ 77,300$ $ 3,300 U

Variable Overhead VariancesC

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Spending Variance Efficiency Variance

AH × SVR

AH × AR

AH = Actual Hours of Activity AR = Actual Variable Overhead RateSVR = Standard Variable Overhead RateSH = Standard Hours Allowed

SH × SVR

Actual Flexible Budget Flexible Budget Variable for Variable for Variable Overhead Overhead at Overhead at Incurred Actual Hours Standard Hours

Spending variance = AH(AR - SVR)

Efficiency variance = SVR(AH - SH)

Variable Overhead Variances: ExampleC

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ColaCo’s actual production for the period required 3,200 standard machine hours. Actual variable overhead incurred for the period was $6,740.

Actual machine hours worked were 3,300.

Compute the variable overhead spending and efficiency variances.

Variable Overhead Variances: ExampleC

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Budgeted variable Total overhead cost per activity activity unit units

× + Budgeted fixedoverhead cost

Total budgetedoverhead cost

=

Total budgetedoverhead cost

=$2.00 permachine

hour×

Totalmachine hours

+ $9,000

Flexible budget

Variable Overhead Variances: ExampleC

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3,300 hours 3,200 hours × × $2.00 per hour $2.00 per hour

Spending variance$140 unfavorable

Efficiency variance$200 unfavorable

$6,740 $6,600 $6,400

Actual Flexible Budget Flexible Budget Variable for Variable for Variable Overhead Overhead at Overhead at Incurred Actual Hours Standard Hours

The $140 unfavorable spending variance and the $200 unfavorable efficiency variance result in a $340 unfavorable flexible budget variance.

Fixed Overhead VariancesC

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Budget Variance

VolumeVariance

PFOHR = Predetermined Fixed Overhead Rate SH = Standard Hours Allowed

SH × PFOHR

Actual Fixed Fixed Fixed Overhead Overhead Overhead Incurred Budget Applied

Fixed Overhead VariancesC

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PFOHR =

Applied Fixed Overhead = PFOHR × Standard Hours

Budgeted Fixed Overhead

Planned Activity in Hours

Recall that fixed overhead costs are applied to products and services using a predetermined fixed overhead rate (PFOHR):

Fixed Overhead Variances: ExampleC

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ColaCo used the following predeterminedfixed overhead rate:

PFOHR =Budgeted Fixed Overhead

Planned Activity in Hours

PFOHR =$9,000

3,000 machine hours

PFOHR = $3.00 per machine hour

ColaCo’s actual production required 3,200 standard machine hours. Actual fixed overhead was $8,450.

Compute the fixed overhead budget and volume variances.

Fixed Overhead Variances: ExampleC

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3,200 hours × $3.00 per hour

Actual Fixed Fixed Fixed Overhead Overhead Overhead Incurred Budget Applied

$8,450 $9,000 $9,600

Budget variance$550 favorable

Volume variance$600 (neither favorable nor

unfavorable)

Additional variance analysesC

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See separate set of slides about:• Marketing sales-mix variances• Yield and mix variances• Disaggregation of overhead variances