McGraw-Hill/Irwin
16
Standard Costing,
Variance Analysis and Kaizen Costing
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

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Learning Objective 1

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Using Standard-Costing Systems for
Control based on carefully predetermined amounts.
Standard costs are used for planning labor and material requirements.
the expected level of performance.
benchmarks for measuring performance.

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Using Standard-Costing Systems for
Control
STANDARD COST a budget for the production of one unit of product or service
ACTUAL COST incurred and recorded in the production of the product or service
COST VARIANCE the difference between the actual cost and the standard cost

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Using Standard-Costing Systems for
Control
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 by Exception
Managers focus on quantities and costs that deviate significantly from standards
(a practice known as management by exception) .
Standard
Direct materials
Direct labor
Type of Product Cost

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Management by Exception
Take the time to investigate only significant cost variances.
What is significant?
Depends on the size of the organization
Depends on the type of the organization
Depends on the production process

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Variance Analysis Cycle
Identify questions
Receive explanations
Take corrective actions
Analyze variances
Begin
Prepare standard cost performance report
Conduct next period’s operations

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Setting Standards
Analysis of historical data
What DID the product cost?
Task analysis
Combined approach
Used in a mature production process
What
SHOULD the product cost?
Analyze the process of manufacturing the product
Analyze the process for the step that has changed, but use historical data for the steps that have not changed

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Participation in Setting Standards
Accountants, engineers, personnel administrators, and production managers combine efforts to set standards based on experience and expectations.

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Learning Objective 2

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Perfection versus Practical
Standards: A Behavioral Issue
PERFECTION
STANDARDS
Can only be attained under near perfect conditions
• Peak efficiency
• Lowest possible input prices
• Best-quality material
• No disruption in production
PRACTICAL OR
ATTAINABLE
STANDARDS
Tight as practical, but still expected to be attained
• Occasional machine breakdowns
• Normal amounts of raw material waste

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Perfection versus Practical
Standards: A Behavioral Issue
Should we use practical standards or perfection standards?
Practical standards should be set at levels that are currently attainable with reasonable and efficient effort.

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Perfection versus Practical
Standards: A Behavioral Issue
I agree.
Perfection standards are unattainable and therefore discouraging to most employees.

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Setting Standards – Direct Materials
Price
Standards
Quantity
Standards
Use competitive bids for the quality and quantity desired.
Use product design specifications.

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Setting Standards – Direct Materials
The standard materials cost for one unit of product is:
Standard price for
Standard quantity of material unit of product

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Setting Standards – Direct Labor
Rate standards
Efficiency standards
Use wage surveys and labor contracts.
Use time and motion studies for each labor operation.

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Setting Standards – Direct Labor
The standard labor cost for one unit of product is:
Standard number for one hour for one unit of product

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Standard Cost in Service Industries
 Jobs with repetitive tasks lend themselves to efficiency measures.
 Computing nonmanufacturing efficiency variances requires some assumed relationship between input and output activity.
Examples Examples

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Standard Cost in Service Industries
Department
Mailing
Personnel
Food service
Input
Labor hours
Labor hours
Labor hours
Output
Number of pieces mailed
Number of personnel changes processed
Number of meals served
Consulting
Nursing
Billable hours
Labor hours
Customer revenues
Number of patients and/or procedures
Check processing Computer hours Number of checks processed

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Costs and Benefits of
Standard-Costing Systems
Costs Benefits
IMPROVED
DECISION
MAKING, BUT:
Implementing and maintaining cost standards can be time-consuming, labor-intensive, and expensive.

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Cost Variance Analysis
Standard cost variances
Price variance
The difference between the actual price and the standard price
Quantity variance
The difference between the actual quantity and the standard quantity

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A General Model for
Variance Analysis
Actual quantity Actual quantity
× ×
Standard quantity
×
Actual price Standard price Standard price
Price / Rate variance
Quantity / Efficiency variance

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A General Model for
Variance Analysis
Actual quantity Actual quantity
×
Actual price
×
Standard quantity
×
Standard price Standard price
Price / Rate variance
Quantity / Efficiency variance
Standard price is the amount that should have been paid for the resources acquired.

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A General Model for
Variance Analysis
Actual quantity Actual quantity
× ×
Standard quantity
×
Actual price Standard price Standard price
Price / Rate variance
Quantity / Efficiency variance
Standard quantity is the quantity allowed for the actual good output.

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A General Model for
Variance Analysis
A ctual q uantity
×
A ctual p rice
A ctual q uantity
×
S tandard
× q uantity
S tandard p rice S tandard p rice
Price / Rate variance
Quantity / Efficiency variance
Materials price variance Materials quantity variance
AQ(AP - SP) SP(AQ - SQ)
Labor rate variance Labor efficiency variance
AQ = Actual Quantity SP = Standard Price
AP = Actual Price SQ = Standard Quantity

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Standard Costs
Let’s use the concepts of the general model to calculate standard cost variances, starting with direct materials.

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Learning Objective 3

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Materials Variances
Koala Camp Gear Company in Melbourne
Australia has the following direct material standard to manufacture one Tree Line tent:
12 square meters per tent at
$8.00 per square meter (sq m)
Last month Koala purchased 40,000 square meters at $8.15 per square meter and used
36,400 square meters to make 3,000 tents.

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Materials Variances
Actual quantity Actual quantity purchased purchased
× ×
Actual price Standard price
We should compute
40,000 sq m 40,000 sq m the price variance
× × using the actual
$8.15 per sq m $8.00 per sq m quantity purchased.
$326,000 $320,000
Price variance
$6,000 Unfavorable

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Materials Variances
SQ = 3,000 tents × 12 sq m per tent
SQ = 36,000 sq m
We should compute the quantity variance using the actual quantity used.
Actual quantity used
×
Standard quantity
×
Standard price Standard price
36,400 sq m 36,000 sq m
× ×
$8.00 per sq m $8.00 per sq m
$291,200 $288,000
Quantity variance
$3,200 Unfavorable

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Materials Variances
We may also calculate materials variances using formulas:
MPV = AQp(AP – SP)
MPV = 40,000 sq m × ($8.15 – $8.00)
MPV = $6,000 Unfavorable
MQV = SP(AQu – SQ)
MQV = $8.00(36,400 sq m – 36,000 sq m)
MQV = $3,200 Unfavorable

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Reporting Materials Variances
I need the variances as soon as possible so that I can better identify problems and control costs.
You accountants just don’t understand the problems we production managers have.
Okay. I’ll compute the price variance when materials are purchased, and the usage variance as soon as material is used.

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Responsibility for Materials Variances
I am not responsible for this unfavorable materials usage variance.
You bought poor quality materials, so my people had to use more of it.
Your poorly trained workers and poorly maintained equipment caused the problems.
Also, your poor scheduling requires rush orders of materials at higher prices, causing unfavorable price variances.

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Standard Costs
Now let’s calculate standard cost variances for direct labor .

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Labor Variances
Koala has the following direct labor standard to manufacture one Tree Line tent:
2 standard hours per tent at
$18.00 per direct labor hour
Last month 5,900 direct labor hours were worked at $19.00 per hour to make 3,000 tents.

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Labor Variances
SH = 3,000 tents × 2 hours per tent
SH = 6,000 hours
Actual hours Actual hours
× ×
Standard hours
×
Actual rate Standard rate Standard rate
5,900 hours 5,900 hours 6,000 hours
× × ×
$19.00 per hour $18.00 per hour $18.00 per hour
$112,100 $106,200 $108,000
Rate variance
$5,900 Unfavorable
Efficiency variance
$1,800 Favorable

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Labor Variances
We may also calculate labor variances using formulas:
LRV = AH(AR - SR)
LRV = 5,900 hrs($19.00 - $18.00)
LRV = $5,900 Unfavorable
LEV = SR(AH - SH)
LEV = $18.00(5,900 hrs - 6,000 hrs)
LEV = $1,800 Favorable

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Labor Rate Variance –
A Closer Look
Using highly paid skilled workers to perform unskilled tasks results in an unfavorable price variance.
High skill, high rate
Low skill, low rate
Production managers who make work assignments are generally responsible for price variances.

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Labor Efficiency Variance –
A Closer Look
Poorly trained workers
Poor quality materials
Unfavorable
Efficiency
Variance
Poor supervision of workers
Poorly maintained equipment

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Responsibility for Labor Variances
I am not responsible for the unfavorable labor efficiency variance!
You bought poor quality materials, so my people took more time to process them.
You used too much time because of poorly trained workers and poor supervision.

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Responsibility for Labor Variances
Maybe I can attribute the labor and materials variances to personnel for hiring the wrong people and training them poorly.

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Allowance for Defects or Spoilage
In some manufacturing processes, a certain amount of defective production or spoilage is normal.
Example: 1,000 liters of chemicals are normally required in a chemical process in order to obtain 800 liters of good output.
If total good output in February is 5,000 liters, what is the standard allowed quantity of input?
Good output quantity = 80% X Input quantity
Good output quantity ÷ 80% = Input quantity allowed
5,000 liters of good output ÷ 80%
= 6,250 liters of input allowed

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Learning Objective 4

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Significance of Cost Variances:
When to Follow Up
How does a manager know when to follow up on a cost variance and when to ignore it?
Absolute amount
Size of variance
?
Relative amount

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Significance of Cost Variances
What clues help me to determine the variances that I should investigate?





 Size of variance

Dollar amount

Percentage of standard
Recurring variances
Trends
Controllability
Favorable variances
Costs and benefits of investigation

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Significance of Cost Variances:
When to Follow Up
How do I know which variances to investigate?
Larger variances, in dollar amount or as a percentage of the standard, are investigated first.
We could use a rule of thumb such as: investigate all variances that are over $10,000 or over 10 percent of the standard cost.

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Significance of Cost Variances:
When to Follow Up
What about recurring variances?
Month Variance
September $6,000 F
October 6,400 F
November 3,200 F
December 6,200 F
Percentage of standard cost
6.0%
6.4%
3.2%
6.2%
None of the variances are greater than $10,000 or
10% for any one month, but they should be investigated because of they have continued for several months.

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Significance of Cost Variances:
When to Follow Up
What about trends?
Month Variance
September $ 250 U
October 840 U
November
December
4,000 U
9,300 U
Percentage of standard cost
0.25%
0.84%
4.0%
9.3%
None of the variances are greater than $10,000 or
10% for any one month, but they should be investigated because of the unfavorable trend.

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Significance of Cost Variances:
When to Follow Up
Controllability
A manager is more likely to investigate a variance that is controllable by someone in the organization than one that is not.
Favorable variances
It is as important to investigate significant favorable variances as well as significant unfavorable variances.
Cost and benefits of investigation
The decision whether to investigate a variance is a cost benefit decision

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Statistical Analysis
Control charts
Display variations in a process and help to analyze the variations over time.
Distinguish between random variations and variations that should be investigated.
Provide a warning signal when variations are beyond a specified level.

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Statistical Analysis
Warning signals for investigation
Favorable limit
Unfavorable limit
1 2 3 4 5 6 7 8 9
Variance measurements

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Learning Objective 5

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Behavioral Effects of Standard
Costing
Standard costs, budgets and variances are used to evaluate the performance of individuals and departments
They can profoundly influence behavior when they are used to determine salary increases, bonuses and promotions

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Which Managers Influence Cost
Variances?
Direct-materials price variance Purchasing manager
Get the best prices available for purchased goods and services through skillful purchasing practices
Direct-materials quantity variance Production supervisor
Skillful supervision and motivation of production employees, coupled with the careful use and handling of materials, contribute to minimal waste
Direct-labor rate variance Production supervisor
Generally results from using a different mix of employees than that anticipated when the standard were set
Direct-labor efficiency variance Production supervisor
Motivating employees toward production goals and effective work schedules improves efficiency

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Interaction among Variances
Interaction among variances often occurs, making it difficult to determine the responsibility for a particular variance.
Variances in one part of the value chain can be due to root causes in another part of the chain.
Value chain
Physical resources perspective
Human resources
Research and development
Design Supply
Production
Marketing
Distribution
Customer service
Exh.
16-5

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Learning Objective 6

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Using Standard Costs for
Product Costing
Work-in-process inventory
Direct-materials cost
Direct-labor cost
Manufacturing overhead
Finished-goods inventory
Product cost transferred when product is finished
Product cost transferred when product is sold
Cost of goods sold Income summary
Expense closed into
Income summary at end of accounting period
Exh.
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Standard Cost Journal Entries



Inventories are recorded at standard cost.
Variances are recorded as follows:


Favorable variances are credits, representing savings in production costs.
Unfavorable variances are debits, representing excess production costs.
Standard cost variances are usually closed to cost of goods sold.


Favorable variances decrease cost of goods sold.
Unfavorable variances increase cost of goods sold.

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Impact of Information Technology on Standard Costing
CAD designers can access the data base for instant design cost estimates.
Labor time and rate are recorded at standard, using bar codes and employee IDs.
Standard cost data base
Materials purchases and uses are recorded at standard, using bar codes.

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Learning Objective 7

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Standard Costing: Its Traditional
Advantages
Sensible cost comparisons
Management by exception
Performance evaluation Advantages
More stable product costs
Employee motivation
Less expensive than actual- or normalcosting systems

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Learning Objective 8

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Criticisms of Standard Costing in
Today’s Manufacturing Environment



Variances are often too aggregated. They are not tied to specific product lines, production batches, or to the flexible management system.
Standard costing may not be applicable in flexible manufacturing operations with short life-cycle products.
There is too much focus on cost minimization rather than increasing product quality or customer service.




There is too much focus on the cost and efficiency of direct labor.
Automation reduces labor costs and the significance of labor variances.
Automated manufacturing processes tend to be more consistent in meeting production specifications.
Variance reports are often provided too late to be useful to managers.

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Adaptation of Standard-Costing
Systems
Applications of standard costing have adapted to changes in the manufacturing environment and the resulting criticisms leveled at standard costing.
Reduced importance of labor standards.
Automation means more overhead, less labor.
Less use of labor as a cost driver.
More emphasis on material and overhead costs.

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Adaptation of Standard-Costing
Systems
Applications of standard costing have adapted to changes in the manufacturing environment and the resulting criticisms leveled at standard costing.
Automation
Reduces labor efficiency variance
Reduces variation in quality and increases quality
Reduces material quantity variance

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Adaptation of Standard-Costing
Systems
Applications of standard costing have adapted to changes in the manufacturing environment and the resulting criticisms leveled at standard costing.
Shorter product life cycles
More frequent benchmarking
Elimination of non-valueadded costs
Non-financial measures such a delivery times are more important
More frequent revisions of standard costs
Real-time information systems provide more timely variance reports

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Learning Objective 9

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Comparing Standard Costing and
Kaizen Costing
 Standard costing – the use of carefully predetermined product costs for budgeting and performance evaluation.

Standard costs are typically used in established production processes.
 Kaizen costing – the emphasis is on continuous reduction of production costs.

Rather than standards or targets, the goal is current costs that are less than previous costs.

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Kaizen Costing
Current year cost base
Kaizen goal: cost reduction rate
Kaizen goal: cost reduction amount
Actual cost reduction achieved
12/31/x0
Actual cost performance of the current year
12/31/x1
Cost base for next year
Time
Exh.
16-7

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Learning Objective 10

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Production Mix and Yield Variances




Nearly all production processes require multiple materials and labor inputs.
A summary quantity variance for materials and labor would hide the individual effects of these inputs.
The quantity variances can be analyzed into two further variances:


Mix (the difference between actual and standard input proportions)
Yield (the difference between actual and standard input used)
The analysis assumes, of course, that the inputs can be substituted for each other.

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End of Chapter 16