Is Standard Costing Right for Us?
A Critical Thinking Model Applied to Cost Accounting (300-level)
Amy Fredin, St. Cloud State University
Attention 2010 AAA Annual Meeting Attendees:
Are you tired of formulaic textbook writing assignments? Do you want to simulate the
messy information used in real decision making? You can use this model to do just
that – and help students master the topic of standard costing*. Details of this project
include:
Purpose: To determine whether students understand how and when a standard costing system can
be beneficial for a company, and when a less sophisticated system may be more appropriate.
Student groups must act as a consulting team and prepare a written recommendation to the
company’s management team specifying which costing system they would recommend and why.
Unique Aspect: Students must weed through additional information provided (some of which adds
important context; some of which is biased and/or irrelevant) in order to cite appropriate evidence in
support of their recommendation.
Data: I have assigned this project in multiple Cost Accounting sections spanning two semesters; the
data indicates that the majority of students reached a high level of understanding in relation to
project objectives. Further, student feedback has been very positive for this project – both in terms
of learning and enjoyment.
___________________________________________________________________________________
Project information included here:
Project Overview……………………………………………………………………..
Page 1
Project Requirements (as provided to students)………………………
Pages 2-4
Outline of Source Documents duplicated here...……………………..
Page 5
Source Documents (as provided to students)…….…………………….
Pages 6-10
Main Issues of the case……………………………………………………………. Page 11
___________________________________________________________________________________
Note: All project information, including the solution to the journal entry portion of the project as well
as data from past semesters is available in electronic form from the author.
Comments are also welcome in regards to any component of this project!
*This same project model could be used to simulate real world decision making within any topic of
accounting or other discipline, for that matter.
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Critical Thinking Project
For Cost Accounting
Spring Semester 2010
Project Title: What costing system should we use?
Scenario:
 ChillOut Corporation produces custom frozen food orders (by the case) for group homes where
patients/clients have special dietary requirements.
 ChillOut needs to determine which type of costing system it is going to use for the upcoming fiscal
year, which starts next week. The company is currently shut down for the Christmas/New Year
holiday.
 Your consulting firm has been hired by ChillOut to assess the alternative costing options and to make a
written recommendation to ChillOut’s management team and board of directors.
Project Requirements (to be completed in groups of 2 to 4 people) (30 points)
 Prepare journal entries to account for the specific transactions noted during the month of December;
prepare them independently for each of the following costing systems: (round to the nearest cent
when necessary)
o Actual costing
o Normal costing
o Standard costing
 Determine ending balances in the following accounts for each costing system listed above:
o Direct materials
o Work in process
o Finished goods
o Cost of goods sold
 Prepare a written report of your assessment of the company’s costing alternatives as well as your
recommendation as to which costing system the company should use in the next and/or future
calendar year(s). Your boss, one of the partners at your consulting firm, will be the initial recipient of
the report. He or she will look it over and provide you with feedback regarding the criteria established
(see rubric ). Once your boss is satisfied with the quality of your work, the report will be presented to
ChillOut Corp’s management team and board of directors. (Naturally, you would like to impress your
boss with the quality of your work the first time through.)
o Just to be clear: For purposes of grading, you will only have one shot at this project
Your boss is limiting your research in this project to the following sources (in addition to your textbook)
1) Memo from ChillOut CEO. Available on D2L.
2) Excerpts from a variety of companies’ management teams. Available on D2L.
3) Article: Problems of obtaining information for standards and budgets. Available on D2L.
4) Direct Cost Variance Trend Chart from past 2 years. Available on D2L.
5) Article: Is standard costing obsolete? Available on D2L.
6) Link to the IMA Statement of Ethical Professional Practice: www.imanet.org/about_ethics.asp
Your boss will be evaluating the written report/recommendation portion of the project according to the
following criteria (see rubric, attached, for further details):
1) Recognizing the relevance/flaws of various documents
2) Recognizing the value of each costing method, and potentially even considering other alternatives not
provided
3) Recommendation is based on appropriate evidence, rather than opinion
4) Ideas are presented as part of an organized and logically cohesive argument
5) Proper business writing is utilized (organization, expression, & mechanics)
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Specific Information for the company, ChillOut Corporation, follows. During the month of December, ChillOut
produced 1,250 cases of food and incurred the following actual costs:
Variable Overhead
(all utility costs, paid in cash)
Fixed Overhead
(mgmt salaries, $10,000, paid in cash;
Depreciation on PP&E, $10,000)
Labor costs (6000 direct-labor hours, paid in cash)
Material costs (22,500 pounds purchased on credit)
$ 10,000
20,000
103,500
43,875
Standard cost and annual budget information were as follows:
Standard costs per case
Direct labor (5 hours at $18/hr)
Direct material (20 pounds at $2/lb)
Variable Overhead (5 hours at $1.50/hr)
Fixed Overhead (5 hours at $3/hr)
Total
$
90.00
40.00
7.50
15.00
$ 152.50
Annual budget information
Variable Overhead
Fixed Overhead
Planned activity level
$120,000
$240,000
80,000 direct-labor hours
All units produced in the month of December were completed.
There were no beginning inventories of DM, WIP, or FG as of December 1.
125 units remained unsold as of December 31, however.
Units (or cases) are sold for $225 each.
Specific journal entries to account for:
 Purchase of DM
 Transfer of 20,000 pounds of DM into production
 Payment for DL
 Incur OH costs
 Transfer/allocate OH costs into production
 Transfer completed units to FG
 Sale of units on credit
 Account for any OH variances (the company does this on a monthly basis)
 Close out any variances (and/or any under- or over-applied OH) using the most accurate approach you
can, given the information provided (the company does this on a monthly basis)
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Rubric for Costing System Project
Skill/Criteria
Recognize the
relevance/flaws of
various documents
Not there yet
Does not identify
relevant documents or
flaws/biases in any of the
documents;
Does not correctly
interpret documents
Recognize the value of
each costing method
(possibly consider other
alternatives not provided)
Does not understand or
adequately acknowledge
the advantages and
drawbacks of any of the
methods
Recommendation is
based on evidence, rather
than opinion
No position is stated as to
which costing method
should be used
Ideas are presented as
part of an organized &
logically cohesive
argument
Ideas or arguments
presented (if there are
any) are not logically
presented and are
fragmented throughout
the paper
Audience is not
considered, discussion
rambles and is not
focused; any comments
related to the documents
provided are not cited
Proper business writing
techniques are utilized
(consider audience)
Level of Performance
Developing
Identifies some relevant
documents but does not
interpret them all
correctly;
Identifies some of the
flaws/biases in the
documents
Understands and
adequately acknowledges
some of the advantages
and drawbacks of one or
more methods
A position is stated as to
which costing method to
use, but is not adequately
supported with valid
evidence
Some ideas and
arguments are given, but
not all are logically
presented and not all are
cohesive
Audience is somewhat
considered and
discussion is somewhat
concise; some comments
related to the documents
provided appropriately
cite the source
Mastery
Identifies and correctly
interprets the relevant
documents;
Identifies the
flaws/biases in the
documents
Understands and
adequately acknowledges
all of the key advantages
and drawbacks to each
costing method;
Considers other methods
that may also be
appropriate under these
circumstances
A position is stated as to
which costing method to
use, and is adequately
supported with valid
evidence
Ideas and arguments are
presented logically, and
thought processes are
focused and cohesive
Audience is considered
and discussion is concise
(including necessary
details but leaving out
‘the fluff’); comments
related to the documents
appropriately cite the
source*
*For purposes of this project, since your source documents are limited to the ones given, you do not need to create a
bibliography page. To cite the sources where you are getting your information, please use parenthetical notation (i.e. the
author’s last name(s) and the year the article was published) either at the end of the specific sentence where you used
the document’s information, or at the end of a paragraph, if the entire paragraph is discussing content from a given
source. If an author’s name is not provided, simply provide the type of source document in parentheses (such as ‘Memo
from CEO’, or ‘IMA Ethical Standards’, for example).
Citing the sources that you use is considered an important part of this project. Your boss needs to know what information
you used from the given set of documents as he or she reviews your work. By citing the sources used, your boss will be
able to tell whether you picked up on the key aspects of the project, or not. (FYI: The citations that you make note of in
your initial report to your boss will be removed before the final report is presented to ChillOut Corp.)
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Source Documents attached to this packet include:




Memo from CEO
Excerpts from a variety of companies’ management teams
Article: Problems of obtaining information for standards and budgets
Direct Cost Variance Trend Chart from past 2 years
Remaining source document (Article: Is Standard Costing Obsolete?) is available from the author.
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Memo
To: Consulting Team
From: ChillOut CEO, Dave Buckley
Re: Consulting engagement related to selecting a costing method
Please let this memo serve as an engagement letter, outlining exactly what it is that we would like to get from
you.
As part of your consulting effort, we hope that you will assess how a normal, actual, and standard costing
system may affect our company’s financial status. After assessing these systems, we also hope that you will be
able to make a recommendation as to which costing system would be most beneficial to our company.
As background information, I thought it may be important for you to know that we purchased a high-end
software package two years ago (we just finished our second year of using this software). This software
package has made it possible for us to implement a standard costing system that automatically sends alerts to
the responsible department when unfavorable variances occur at a level that we feel is significant; if a variance
is favorable, no notice is sent, as we assume all is well. When we made the decision to purchase this software,
we planned on getting use from it for at least 4 years (in order to make the investment somewhat costeffective). It would be easy enough for us to scale this standard costing system back (into something more
consistent with what we used previously). However, I am just not sure how I would feel about backing away
from this investment before the four years is up.
Additional background information related to employee incentives may also be helpful for you as you
complete your analysis. Our employees help to set the quantity/usage and cost standards for their respective
areas. They are awarded bonuses if their respective department has favorable variances for two consecutive
quarters. As you can see from the variance trend chart, this incentive program has been very successful.
Despite the favorable cost variances that have occurred in the past, you should know that our sales have
dropped from prior years. We feel that this is much more a reflection of touch economic times for everyone
than it is a reflection of our customers’ satisfaction with our products. Still, because we again are forecasting a
drop in sales going into next year, we must continue to focus on keeping our costs down. Our cost
accountant/analyst, who has been working full-time for us since the implementation of our new software
system, has even offered to cut back her hours for purposes of company cost savings (and for personal
reasons, as well). We cannot operate our current system without a full-time employee in this position, though.
As a final note, I thought that you may want to know that our company is looking to establish a long-term
relationship with a consulting firm (to help us assess other areas of our company’s performance, namely our
sales, operations and personnel activities). If we, the management team, find your work to be of high quality,
it is likely that we will look no further for another firm to engage in these additional projects.
Thank you for your efforts in assessing these costing systems. I look forward to reviewing your
recommendations with the entire management team.
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Excerpts from three companies’ management teams
Best Foods, a subsidiary of Unilever (2008 McGraw Hill ‘Managerial Accounting’ textbook):
“At Best Foods, standard costs are set at attainable levels… We designate variances as controllable or
uncontrollable. Plant managers are held accountable for the controllable variances.”
Parker Hannifin Corporation’s Brass Products Division (2008 McGraw Hill ‘Managerial Accounting’ textbook):
Parker Hannifin’s Brass Products Division, a world-class manufacturer of brass fittings, valves, and tubing, is a
standard-costing success story. “Parker Brass uses its standard-costing system and variance analyses as
important business tools to target problem areas so it can develop solutions for continuous improvement.
Variances are reported for each product line, and if any production variance exceeds 5 percent of product-line
sales, the product-line manager is required to provide an explanation. Also required is a plan to correct the
problems underlying any unfavorable variances. Variance reports, which are generated within one day of the
completion of a job order, are distributed to managers and production schedulers. A variance database is
kept, which can be assessed by product-line managers, to provide variance data by part number, by job-order
number, or by dollar amount.”
From the perspective of Parker Brass’s management, the division has modified its standard costing
system to provide disaggregated and timely cost information to enable timely corrective action in a rapidly
changing business environment.
“Many people have condemned standard costing, saying it is irrelevant to the current just-in-time, fast-paced
business environment. Yet surveys consistently show that most industrial companies in the U.S. and abroad
still use it. Apparently, these companies have successfully adapted their standard-costing system to their
particular business environments.”
Cost Management Systems in Germany (2008 McGraw Hill ‘Managerial Accounting’ textbook):
Throughout the world, flexible budgeting is found in cost management systems as a means of controlling
overhead costs. In Germany, for example, grenzplankostenrechnung (or “flexible standard costing”) exhibits
many of the features illustrated in this chapter. Under the German approach, “each cost center distinguishes
between variable costs (e.g., energy) and fixed costs (e.g., a manager’s salary).” The number of machine hours
is a common activity measure. “For purposes of cost planning and control, companies budget each cost
center’s expenses and then distribute the expenses each month of the budget year. The budgeted costs are
standards for efficient resource consumption…” The cost and performance information “allows for effective
discussions about productivity improvement” among department managers, management accountants, and
plant managers.
Among the companies using the flexible standard costing system is Stihl, a well-known German
manufacturer of chain saws and other landscaping equipment.
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Problems of Obtaining Information for Standards and Budgets
(From Chapter 14, ‘Advanced Management Accounting’ textbook, 3rd edition)
Standards and budgets occupy a prominent place in the literature of cost accounting, management control,
and organization theory. Standard-setting and budgeting activities are so pervasive in management teaching
and practice that we tend to accept them without considering the fundamental forces that make these
activities desirable. In an ideal world of certainty, costless information, and observability, and unbounded
computational capacity, a central decision maker can make globally optimal decisions and can direct
subordinates (local managers) to implement centrally determined plans. In this setting, there would seem to
be little role for budgets.
In the real world, however, local managers are given considerable decision-making authority. Profitsharing incentive contracts may be instituted to motivate the managers to make decisions that are in the firm’s
best interest, as described above (and in Ch13). But, as we have seen, simple profit-sharing contracts
introduce uncertainty into the managers’ compensation functions, and managers may take actions (such as
lowering output levels) to compensate for this uncertainty. Such risk-avoiding behavior is not generally
desirable for the firm as a whole or for its shareholders. We must attempt to design the most efficient
contracts to balance the conflicts between managers and owners.
Using Information for Rewards and Control – The Moral Hazard Problem
Conflicts can arise in even simple situations. Consider a salesperson who is asked by the sales manager to
provide an estimate of expected sales in the upcoming period. The sales manager will use the estimate to plan
production and marketing efforts and as the basis for the compensation plan. More specifically, the
salesperson is paid a base salary and a commission on sales in excess of a target amount. The sales manager
will use the estimate of sales potential to set the target level of sales that the salesperson must attain before
commissions are paid. In this situation, almost all salespersons tend to understate the assessed sales
potential. The problem is not limited to sales. A production manager may understate the potential output
from an assembly line so that, if something goes wrong, she will still have a good chance of attaining the
production quota.
The misrepresentation of private information occurs because of two critical conditions: (1) the
subordinate has information, by virtue of specialization, that the superior requires for planning purposes; and
(2) the information is used both for planning and for control purposes. These problems are another example
of the moral hazard problem; in this case, the manager (or subordinate) is motivated by the structure of the
control or evaluation system to misrepresent private information. The condition for this moral hazard
situation arises whenever the manager’s information or actions are not directly observable by the manager’s
superiors.
Moral hazard is not necessarily the consequence of a poorly designed control system. In fact, because
of the specialization sought by decentralization, and the need for specialist information in control, moral
hazard is almost guaranteed in a decentralized firm that attempts to assess individual contributions to the
firm.
Moral Hazard and Information Impactedness
The existence of moral hazard creates the information impactedness situation, described earlier, whenever
available, valuable information does not flow as required in the firm. As another example of information
impactedness, consider a situation in which a manager knows that she has made a bad decision but refuses to
correct the situation because doing so would make the bad decision obvious to all. On the other hand, leaving
the existing decision unchanged may cause damage to the firm but not harm the manager’s reputation (or
compensation), because no one else will recognize that a bad decision has been made.
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Information impactedness arises when local managers possess valuable, perhaps unique, information
about their local environment but do not convey it truthfully. We are not suggesting that managers are evil or
indifferent to the overall performance of the firm. We are suggesting that when managers are evaluated and
promoted on the basis of comparisons of their performance with a standard, we should not expect managers
to act contrary to their own self-interest when asked to provide information on the appropriate level of the
standard. Their self-interest may cause them to strategically manipulate their information and intentions.
Because of inherent uncertainty and the costliness of observation, owners will rarely be able to detect whether
an unexpected outcome was due to the prior misrepresentation of information or an unusually good or bad
outcome.
Information impactedness problems can be mitigated by basing rewards on companywide rather than
individual performance. In this way, managers have more motivation to share information and cooperate.
But, when managerial rewards are based on overall rather than individual performance, managers will not
capture the gains from their individual efforts, information acquisition, and decision making. As a
consequence, they will reduce their efforts along those dimensions – the practice of free-riding (described in
Ch13). Many firms base rewards on individual performance. Apparently, the motivational benefits provided
by measuring and rewarding individual behavior outweigh the potential costs of information impactedness and
risk-avoidance behavior.
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ChillOut Corporation
Direct Cost Variances for past 2 yr period
Dollar Amount of Variance
(All are positive thus far)
(All positive amounts represent Favorable Variances)
1800
1600
1400
1200
1000
800
600
400
200
0
DM Price & Effic. Var
(combined)
DL Price & Effic. Var (combined)
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‘Main Issues’ that groups should address in their written reports
(I do not expect every group to hit all of these issues, but I do expect each group to cover most of them)









Is the company’s incentive plan really working well?
Are there other ways to set standards (other than how this company is setting them), if a standard
system is best for this company?
Is the previous investment in the software package a relevant cost for this decision?
Would switching to a simpler costing system be very expensive?
What benefit(s) are the users of the current system really getting? Is continued use this way worth
keeping a full-time analyst on staff?
Are there other benefits the company could get out of its current system to justify the accountant’s
salary? (i.e. are there other types of variances they could evaluate?)
Is the economy the only reasonable explanation for this company’s decreased sales? (what about
decreased quality, given its consistently favorable variances over the past two years; what about SP
being a bit too high, given the higher standard cost per unit as compared to the actual or normal cost
per unit)
Is it relevant that other companies have found a standard costing system to be useful?
Are there other ways to allocate indirect costs? Would they be appropriate for this company?
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