Incentives of Standard Cost
Systems
•
•
•
•
•
Build Inventories
Externalities
Discourage Cooperation
Mutual Monitoring
Satisficing
Incentive Effects: Build Inventories
• Rewarding purchasing managers for favorable
DM price variances creates an incentive for them
to buy large quantities when price discounts are
offered for high-volume purchases.
• Penalizing production managers for unfavorable
labor efficiency variances encourages keeping
labor busy producing more.
• Mitigation of inventory building incentive
– Charge purchasing department for cost of holding
inventory
– Just-in-time (JIT) purchasing and production policies
Adapted from material accompanying AFDMC 2/e
 The McGraw-Hill Companies, Inc. 1997
Incentive Effects: Externalities
• Purchasing externalities on production
– Purchase cheaper substandard materials
– Purchase price variance is favorable
– Unusable material results in unfavorable
material quantity variance
• Production externalities on purchasing
– Short lead times on requisitions leads to higher
purchase prices
– Requesting special orders for materials leads to
higher prices
Adapted from material accompanying AFDMC 2/e
 The McGraw-Hill Companies, Inc. 1997
1
Incentive Effects: Discourage Cooperation
• Evaluating performance evaluation on
individual's variances
– Emphasizes individual instead of team efforts
– Reluctance to help others look good
• Solution:
– Base reward system on both individual and
departmental (team) variances.
– Too much weight on teamwork can lead to
shirking (free-rider problem).
Adapted from material accompanying AFDMC 2/e
 The McGraw-Hill Companies, Inc. 1997
Incentive Effects: Mutual Monitoring
• Mutual monitoring -- managers or employees
at the same level monitor each other’s
performance -- noninsulating allocations
encourage mutual monitoring (see Ch 7, p. 327)
• Example: Hold both the purchasing and
production managers responsible for 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
Adapted from material accompanying AFDMC 2/e
 The McGraw-Hill Companies, Inc. 1997
Incentive Effects: Satisficing
Satisficing behavior: Managers have incentives to
achieve standard but go no further.
Firm value would increase if managers attempted
• continuous improvement beyond standard
• innovate to meet competitive threats
Adapted from material accompanying AFDMC 2/e
 The McGraw-Hill Companies, Inc. 1997
2
Cost of Maintaining Standard Cost System
Standard cost systems require
• Detailed standards for each labor and material
input
• Updating for technological and price changes
• Time to investigate and explain variances
Standard cost systems are less likely to be used when
• Direct labor cost is a small portion of total cost
• Rapid change in production processes or new
product introductions would require frequent
revisions of standards
Adapted from material accompanying AFDMC 2/e
 The McGraw-Hill Companies, Inc. 1997
Overhead Volume Measures
• BV: Budgeted volume (denominator volume)
– Estimated at the beginning of the year and used
for calculating the overhead rate
• SV: Standard volume (standard volume allowed)
– (Output units completed) × (Standard input
hours per output unit)
– Volume used to apply overhead to work-inprocess inventory
• AV: Actual volume
– Actual hours or other input resource used
during period
Adapted from material accompanying AFDMC 2/e
 The McGraw-Hill Companies, Inc. 1997
Overhead
• The overhead rate is the total budgeted overhead
dollars for the year divided by the budgeted
volume for the year and consists of the estimated:
– fixed overhead $ per input hour (FOH ÷ BV), and
– variable overhead $ per input hour (VOH)
• In a standard costing system overhead is absorbed
using the standard volume
Overhead absorbed = Overhead rate × Standard volume
= OHR × SV
3
Overhead is absorbed (also known as applied) by the product when work
is done in the factory. The accounting system transfers costs from the
overhead account to the work-in-process account (Fig. 9-1 at p. 418).
For most firms, overhead is absorbed using the standard volume.
Overhead absorbed = Overhead rate × Standard volume = OHR × SV
Standard Volume = Units of output × Standard input per output
Example at p. 598: SV = 67,400 machine hours for 96,000 blocks
Overhead absorbed = $34 × 67,400 machine hours
Slide 13-07
AFDMC 2/e
 The McGraw-Hill Companies, Inc. 1997
4