MANAGEMENT ACCOUNTING

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Cheryl S. McWatters, Jerold L. Zimmerman, Dale C. Morse

12-2

Management Accounting Standard costs and variance analysis (Control)

Chapter 12

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Management Accounting McWatters, Zimmerman, Morse

Objectives

• Provide reasons for using standard costs • Describe planning and control issues in setting standards • Calculate direct labour and direct material variances • Identify potential causes of different favourable and averse variances • Recognize incentive effects of standard costs • Measure expected, standard and actual usage of an allocation base to apply overhead and determine overhead variances • Identify factors that influence the decision to investigate variances • Summarize the costs and benefits of using standard variances 12-3

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Management Accounting McWatters, Zimmerman, Morse

Standard Costs

Future costs are used for planning because historical costs are not representative of future operations if conditions have changed

12-4

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12-5

Standard Costs

Standard Costs

Expected future costs of products and services The expected level of performance Management Accounting McWatters, Zimmerman, Morse Benchmarks for measuring performance Used for planning labour, material and overhead requirements

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Reasons for Standard Costing

12-6

Planning Decisions

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Management Accounting McWatters, Zimmerman, Morse

Reasons for Standard Costing

12-7

Control Decisions Basis for managerial performance evaluation

Management Accounting McWatters, Zimmerman, Morse

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12-8

Reasons for Standard Costing

Managers focus on quantities and costs that exceed standards, a practice known as management by exception Standard Direct Material Direct labour Manufacturing Overhead Type of Product Cost

Management Accounting McWatters, Zimmerman, Morse

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12-9

Reasons for Standard Costing

This variance is unfavorable because the actual cost exceeds the standard cost Standard A standard cost variance is the amount by which an actual cost differs from the standard cost

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Management Accounting McWatters, Zimmerman, Morse

12-10

Setting and Revising Standards

• Accountants, industrial engineers, personnel administrators, and production managers often combine efforts to set standards based on experience and expectations • Attainable standards should be set at levels that are currently attainable with normal and reasonable effort Standards may be set using a . . .

• Bottom-up approach involving the participation of all levels of management and staff • Top-down approach called target costing Management Accounting McWatters, Zimmerman, Morse

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Setting and Revising Standards

12-11

Target Costs

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Management Accounting McWatters, Zimmerman, Morse

Direct Labour and Direct Materials Variances

• Variances used primarily to identify problems • Variances calculated to help managers determine the cause and responsibility for the problem • By partitioning variances into component variances cause and responsibility become easier to identify – Variance due to actual price per unit differing from plan – Variance due to actual quantity per unit differing from plan 12-12

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Management Accounting McWatters, Zimmerman, Morse

Direct Labour Variances

Direct Labour variance is the difference between the actual direct labour costs and the standard direct labour costs

12-13

Labour rate variance

Management Accounting McWatters, Zimmerman, Morse

Labour efficiency variance

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12-14

Direct Labour Variances

Direct Labour variance

= Actual cost of labour = ( Actual labour rate x Standard cost of labour Actual hours ) ( Standard Labour rate x

Labour rate variance Labour efficiency Variance Direct Labour variance

= = ( Actual labour rate = ( Actual hours Labour rate variance + Standard Labour rate Standard hours ) Labour efficiency Variance ) x x Actual hours Standard Labour rate Standard hours )

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Management Accounting McWatters, Zimmerman, Morse

12-15

Standard Cost Variances

Standard Cost Variances

Price Variance The difference between the actual price and the standard price Management Accounting McWatters, Zimmerman, Morse Quantity Variance The difference between the actual quantity and the standard quantity

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Direct labour Variances

A Favorable variance occurs when the actual costs are less than the standard costs An adverse variances occurs if the actual costs are greater than the standard costs

12-16

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Management Accounting McWatters, Zimmerman, Morse

12-17

Direct Labour Variances

Rate per hour, R Rate Variance R a R s Efficiency Variance R a is the actual rate R s is the standard rate Management Accounting McWatters, Zimmerman, Morse H s H a H a is the actual hours Hours of work, H H s is the standard hours

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Direct Labour Variances Numerical Example

A public accounting firm estimates that an audit will require the following work:

Type of auditor

Manager Senior Staff Totals

Expected hours

10 20 40 70

Cost per hour (£)

50 40 30

Standard costs (£)

500 800 1,200 2,500 12-18

The following were the actual hours and costs

Type of auditor

Manager Senior Staff Totals Management Accounting McWatters, Zimmerman, Morse

Expected hours

9 22 44 75

Cost per hour (£)

52 38 30

Standard costs (£)

468 836 1,320 2,624

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12-19

Type of auditor

Manager Senior Staff Totals

Direct Labour Variances Numerical Example

The direct labour variance

Actual costs (£)

468 836 1,320 2,624

Standard costs (£)

500 800 1,200 2,500

Direct labour variance (£)

(32) 36 120 124 Adverse

Labour rate variance

Manager (£52 - £50 x 9) Senior (£38 - £40 x 22) Staff (£30 - £30 x 44) Total labour rate variance £18 £(44) 0 (26) F Management Accounting McWatters, Zimmerman, Morse

Labour efficiency variance

Manager (9 – 10 x £50) Senior (22 – 20 x £40) Staff (44-40 x £30) Total labour efficiency variance (£50) £80 £120 £150 A

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12-20

Direct Labour Variances

Actual Hours

x

Actual rate Actual Hours

x

Standard rate Standard Hours

x

Standard rate

£4,886 £4,835 £4,800 Direct labour rate variance £51 Adverse Management Accounting McWatters, Zimmerman, Morse Direct labour variance £86 Adverse Direct labour efficiency variance £35 Adverse

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Poorly trained workers

Direct labour Variances

Poor quality materials

Unfavorable Efficiency Variance

Poor supervision of workers Poorly maintained equipment 12-21

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Management Accounting McWatters, Zimmerman, Morse

Direct Materials Variances

Direct materials variances are similar to those computed for direct labour

12-22

Total direct materials variance is decomposed into a material price variance and a material quality variance

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Management Accounting McWatters, Zimmerman, Morse

12-23

Direct Materials Variances

Direct material variance

= = ( Actual cost of material Actual price

Price variance

= ( Actual price x Standard cost of material Actual quantity ) ( Standard price x Standard quantity ) Standard price ) x Actual quantity

Quantity Variance

= ( Actual quantity

Direct material variance

= Price variance + Standard quantity ) x Standard price Quality Variance Management Accounting McWatters, Zimmerman, Morse

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Direct Materials Variances

Price per unit on material, P Price Variance P a P s Quality Variance 12-24 P a is the actual price P s is the standard price Management Accounting McWatters, Zimmerman, Morse Q s Q a Units of material, Q Q a is the actual quantity Q s is the standard quantity

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Direct Materials Variances Numerical Example

A tyre manufacturer has a standard quantity of 3 kg of fibreglass cord per automobile tyre. The standard price is €1.00 per kg During the month the purchasing manager bought 98,000kg of cord for €102,000. The plant used 95,000kg of cord to manufacture 30,000 tyres

Actual purchase price Material variance Material quality variance €102,000/98,000 = €1.04082/kg (€1.04082 - €1.00/kg) x 98,000 = €4,000 adverse (95,000kg – 90,000kg) x €1.00/kg = €5,000 adverse 12-25

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Management Accounting McWatters, Zimmerman, Morse

12-26

Direct Materials Variances

Actual quantity

x

Actual price Actual quantity

x

Standard price Standard quantity

x

Standard price

£9,588 £9,610 £9,600 Direct material price variance (£22) Favourable Management Accounting McWatters, Zimmerman, Morse Direct material variance (£12) Favourable Direct material quality variance £10 Adverse

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Incentive Effects of Direct labour and Materials Variances

12-27 When used as performance measures, standard cost variances create subtle incentive effects: • The incentive to build inventories • Externalities • Discouraging cooperative effort • Mutual monitoring incentives • Satisficing behaviour

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Management Accounting McWatters, Zimmerman, Morse

12-28

Incentive to Build Inventories

The evaluation of purchasing managers based on direct materials price variances creates incentives for these managers to build inventories This incentive can be reduced by charging the purchasing department for the cost of holding inventories An alternative mechanism for controlling inventory-building is to adopt techniques such as just-in-time manufacturing

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Management Accounting McWatters, Zimmerman, Morse

12-29

Externalities

Purchasing managers can impose externalities on production by purchasing sub-standard materials To offset this incentive the materials can be inspected on receipt against a set of engineering specifications An alternative mechanism would be to set a performance measure for the purchasing manager to minimize the amount of rework generated Production managers can impose externalities on purchasing by requesting materials are purchased on short lead times or in small lot sizes

Management Accounting McWatters, Zimmerman, Morse

Engineering can increase the price of purchases by making frequent design changes

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Unco-operative Effort

Evaluating individuals within an organization based on different variances can discourage co-operative effort

12-30

To encourage co-operative effort many organizations calculate variances and measure performance at multiple levels An alternative is to measure variances for a team or department within the organization

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Management Accounting McWatters, Zimmerman, Morse

12-31

Mutual Monitoring Incentives

Mutual monitoring occurs between managers who are not in a direct reporting relationship with each other In designing performance evaluation and reward systems, organizations can create mutual monitoring incentives that encourage managers to acquire and utilize their specialized knowledge to improve the performance of other managers

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Management Accounting McWatters, Zimmerman, Morse

12-32

Satisficing Behaviour

Satisficing behaviour occurs when manager have inventive to achieve a standard of performance but go no further Satisficing behaviour can affect quality if employees are motivated to meet quotas Management rewards should be based on achieving or exceeding the standard of performance

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Management Accounting McWatters, Zimmerman, Morse

Standard Overhead Costs and Variances

Quantity and price variances are defined in terms of the allocation base for overhead costs.

• • The quantity of overhead is the level of usage of the allocation base The price of overhead is the overhead application rate 12-33

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Management Accounting McWatters, Zimmerman, Morse

Expected, Standard, and Actual Usage of the Allocation Base

• Expected usage is estimated at the beginning of the year and used to compute the predetermined allocation rate • Standard usage is the amount that should have been used for the actual output • Actual usage is the amount of the allocation based actually used 12-34

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Management Accounting McWatters, Zimmerman, Morse

Expected, Standard, and Actual Usage of the Allocation Base Numerical Example

Pizzazz Pizza makes 2 types of pizza. The company allocates overhead based on the number of direct labour hours

12-35

The direct labour hours for a pepperoni pizza is 5 minutes and the direct labour hours for a cheese pizza is 4 minutes. Pizzazz Pizza expected to make 12,00 pepperoni and 6,000 cheese pizzas. During the year the firm made 9,00 pepperoni and 7,500 cheese pizza. The labourers worked for 1,300 hours

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Management Accounting McWatters, Zimmerman, Morse

12-36

Expected, Standard, and Actual Usage of the Allocation Base Numerical Example

Expected number of direct labour hours Pepperoni (12,000 x 0.08) Cheese (6,000 x 0.07) Total Standard number of direct labour hours Pepperoni (9,000 x 0.08) Cheese (7,500 x 0.07) Total Actual number of direct labour hours Management Accounting McWatters, Zimmerman, Morse 1,000 400 1,400 750 500 1,250 1,300

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12-37

Actual Overhead

Budgeted, Applied, and Actual Overhead

Budgeted Overhead Applied Overhead Actual costs of using overhead resources Overhead costs expected at the beginning of the period Overhead costs applied to cost objects through the standard usage of the allocation base The difference between actual overhead costs and applied overhead is the total overhead variance

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Management Accounting McWatters, Zimmerman, Morse

Incentive Effects of Overhead Standards and Variances

Desired Result Problem Maintain the quality of overhead services while, at the same time, reducing overhead costs to obtain favorable variances Output is increased, resulting in actual overhead < applied overhead (favorable variance) and excess inventories

12-38

Solution Separate responsibilities so that overhead resource manager does not control output levels

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Management Accounting McWatters, Zimmerman, Morse

Variance Investigation

12-39

Variance Investigation Decision

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Management Accounting McWatters, Zimmerman, Morse

Costs and Benefits of Using Standard Costing Systems

Possible reductions in production costs Management by exception

12-40

Advantages Improved cost control and performance evaluation

Management Accounting McWatters, Zimmerman, Morse

Better Information for planning and decision making

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Costs and Benefits of Using Standard Costing Systems

Emphasis on negative exceptions may impact morale Emphasis on negative exceptions may lead to inappropriate behaviour

12-41

Disadvantages It may be difficult to determine which variances are significant

Management Accounting McWatters, Zimmerman, Morse

Focus on big variances may obscure early stages of trends

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12-42

Management Accounting Standard costs and variance analysis (Control)

End of Chapter 12

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Management Accounting McWatters, Zimmerman, Morse