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M07_ATRI3622_06_SE_C07.QXD 242 CHAPTER 7 5/29/09 10:38 AM Page 242 ACCOUNTING FOR CONTROL are complex and can vary according to the particular situation. For example, it has been found that the impact of different management styles on such factors as jobrelated stress and the manipulation of budget figures seems to vary. The impact is likely to depend on such factors as the level of independence enjoyed by the subordinates and the level of uncertainty associated with the tasks to be undertaken. It seems that where there is a high level of interdependence between business divisions, subordinate managers are more likely to feel that they have less control over their performance, because the performance of staff in other divisions could be an important influence on the final outcome. In such a situation, rigid application of the budget could be viewed as being unfair and may lead to undesirable behaviour. However, where managers have a high degree of independence, the application of budgets as a measure of performance is likely to be more acceptable. In this case, the managers are likely to feel that the final outcome is much less dependent on the performance of others. Later studies have also shown that where a subordinate is undertaking a task that has a high degree of uncertainty concerning the outcome (for example, developing a new product), budget targets are unlikely to be an adequate measure of performance. In such a situation, other factors and measures should be taken into account in order to derive a more complete assessment of performance. However, where a task has a low degree of uncertainty concerning the outcome (for example, producing a standard product using standard equipment and an experienced workforce), budget measures may be regarded as more reliable indicators of performance. Thus, it appears that a budget-constrained style is more likely to work where subordinates enjoy a fair amount of independence and where the tasks set have a low level of uncertainty concerning their outcomes. Failing to meet the budget ‘ The existence of budgets gives senior managers a ready means to assess the performance of their subordinates (that is, junior managers). If a junior manager fails to meet a budget, this must be dealt with carefully by the relevant senior manager. Adverse variances may imply that the manager needs help. If this is the case, a harsh, critical approach would have a demotivating effect and would be counterproductive. Real World 7.5 gives some indication of the effects of the behavioural aspects of budgetary control in practice. REAL WORLD 7.5 Behavioural issues explored The survey by Drury and others referred to earlier indicates that there is a large degree of participation in setting budgets by those who will be expected to perform to the budget (the budget holders). It also indicates that senior managers have greater influence in setting the targets than their junior manager budget holders. Where there is a conflict between the cost estimates submitted by the budget holders and their senior managers, in 40 per cent of respondent businesses the senior manager’s view would prevail without negotiation, but in nearly 60 per cent of cases there would be M07_ATRI3622_06_SE_C07.QXD 5/29/09 10:38 AM Page 243 BEHAVIOURAL ISSUES a reduction that would be negotiated between the budget holder and the senior manager. The general philosophy of the businesses that responded to the survey, regarding budget holders influencing the setting of their own budgets, is: l l 23 per cent of respondents believe that budget holders should not have too much influence since they will seek to obtain easy budgets (build in slack) if they do; 69 per cent of respondents take an opposite view. The general view on how senior managers should judge their subordinates is: l l 46 per cent of respondent businesses think that senior managers should judge junior managers mainly on their ability to achieve the budget; 40 per cent think otherwise. Though this research is not very recent (1993), in the absence of more recent evidence it provides some feel for budget setting in practice. Source: Drury, C., Braund, S., Osborne, P. and Tayles, M., A Survey of Management Accounting Practices in UK Manufacturing Companies, Chartered Association of Certified Accountants, 1993. Self-assessment question 7.1 Toscanini Ltd makes a standard product, which is budgeted to sell at £4.00 a unit, in a competitive market. It is made by taking a budgeted 0.4 kg of material, budgeted to cost £2.40/kg, which is worked on by hand by an employee, paid a budgeted £8.00/hour, for a budgeted 6 minutes. Monthly fixed overheads are budgeted at £4,800. The output for May was budgeted at 4,000 units. The actual results for May were as follows: Sales revenue (3,500 units) Materials (1,425 kg) Labour (345 hours) Fixed overheads Actual operating profit £ 13,820 (3,420) (2,690) (4,900) 2,810 No inventories of any description existed at the beginning and end of the month. Required: (a) Deduce the budgeted profit for May and reconcile it, through variances, with the actual profit in as much detail as the information provided will allow. (b) State which manager should be held accountable, in the first instance, for each variance calculated. (c) Assuming that the budget was well set and achievable, suggest at least one feasible reason for each of the variances that you identified in (a), given what you know about the business’s performance for May. (d) If it were discovered that the actual total world market demand for the business’s product was 10 per cent lower than estimated when the May budget was set, explain how and why the variances that you identified in (a) could be revised to provide information that would be potentially more useful. The answer to this question appears in Appendix B at the back of the book. 243 M07_ATRI3622_06_SE_C07.QXD 244 CHAPTER 7 5/29/09 10:38 AM Page 244 ACCOUNTING FOR CONTROL Standard quantities and costs ‘ We have already seen that a budget is a business plan for the short term – typically one year – that is expressed mainly in financial terms. A budget is often constructed from standards. Standard quantities and costs (or revenues) are those planned for an individual unit of input or output and provide the building blocks for budgets. We can say about Baxter Ltd’s operations (see Example 7.1 on page 221) that: l The standard selling price is £100 for one unit of output. l The standard marginal cost for one manufactured unit is £60. l The standard raw materials cost is £40 for one unit of output. l The standard raw materials usage is 40 metres for one unit of output. l The standard raw materials price is £1 a metre (that is, for one unit of input). l The standard labour cost is £20 for one unit of output. l The standard labour time is 2.5 hours for one unit of output. l The standard labour rate is £8 an hour (that is, for one unit of input). Standards, like the budgets to which they are linked, represent targets against which actual performance is measured. To maintain their usefulness for planning and control purposes, they should be subject to frequent review and, where necessary, revision. Standards provide the basis for variance analysis, which, as we have seen, helps managers to identify where deviations from planned, or standard, performance have occurred and the extent of those deviations. Standard costs may be helpful to derive the planned cost for units of output (products or services) that are much larger than those produced by Baxter Ltd. For example, a firm of accountants may find standard costing useful. It may set standard costs for each grade of staff (audit manager, audit senior, trainee and so on). When planning a particular audit of a client business, it can assess how many hours each grade of staff should spend on the audit and, using the standard cost per hour for each grade of staff, it can derive a standard cost or ‘budget’ for the job as a whole. These standards can subsequently be compared with the actual hours and hourly rates. Setting standards When setting standards various points have to be considered. We shall now explore some of the more important of these. Who sets the standards? Standards often result from the collective effort of various individuals including management accountants, industrial engineers, human resource managers, production managers and employees. The manager responsible for meeting a particular standard will usually be involved and may be relied on to provide specialised knowledge. The manager may, therefore, have some influence over the final decision, which brings with it the risk that ‘slack’ may be built into the standard in order to make it easier to achieve. The same problem was mentioned earlier in relation to budgets. M07_ATRI3622_06_SE_C07.QXD 5/29/09 10:38 AM Page 245 SETTING STANDARDS How is information gathered? Setting standards involves gathering information concerning how much material should be used, how much machine time should be required, how much direct labour time should be spent and so on. Two possible ways of collecting information for standard setting are available. Activity 7.18 Can you think what these might be? The first is to examine the particular processes and tasks involved in producing the product or service and to develop suitable estimates. Standards concerning material usage, machine time and direct labour hours may be established by carrying out dummy production runs, time-and-motion studies and so on. This will require close collaboration between the management accountant, industrial engineers and those involved in the production process. The second approach is to collect information relating to past costs, times and usage for the same, or similar, products and to use this information as a basis for predicting the future. This information may have to be adjusted to reflect changes in price, changes in the production process and so on. Where the product or service is entirely new or involves entirely new processes, the first approach will probably have to be used, even though it is usually more costly. What kind of standards should be used? ‘ There are basically two types of standards that may be used: ideal standards and practical standards. Ideal standards, as the name suggests, assume perfect operating conditions where there is no inefficiency due to lost production time, defects and so on. The objective of setting ideal standards, which are attainable in theory at least, is to encourage employees to strive towards excellence. Practical standards, also as the name suggests, do not assume ideal operating conditions. Although they demand a high level of efficiency, account is taken of possible lost production time, defects and so on. They are designed to be challenging yet achievable. There are two major difficulties with using ideal standards. 1 They do not provide a useful basis for exercising control. Unless the standards set are realistic, any variances computed are extremely difficult to interpret. 2 They may not achieve their intended purpose of motivating managers: indeed, the opposite may occur. We saw earlier that the evidence suggests that where managers regard a target as beyond their grasp, it is likely to have a demotivating effect. Given these problems, it is not surprising that practical standards seem to enjoy more widespread support than ideal standards. Real World 7.6 provides some evidence on the use of ideal standards in practice. 245 M07_ATRI3622_06_SE_C07.QXD 246 CHAPTER 7 5/29/09 10:38 AM Page 246 ACCOUNTING FOR CONTROL REAL WORLD 7.6 Setting the standard The study of UK manufacturers by Drury and others showed that only 5 per cent of respondents to the survey set standards at a level that could be achieved if everything went perfectly all of the time. Although the study is a little dated now (1993), it represents the most recent survey and is worth noting. Source: Drury, C., Braund, S., Osborne, P. and Tayles, M., A Survey of Management Accounting Practices in UK Manufacturing Companies, Chartered Association of Certified Accountants, 1993. The learning-curve effect ‘ Where an activity undertaken by direct workers has been unchanged for some time, and the workers are experienced at performing it, the standard labour time will normally stay unchanged. However, where a new activity is introduced, or new workers are involved with performing an existing activity, a learning-curve effect will normally occur. This is shown in Figure 7.10. Figure 7.10 The learning-curve effect Each time a particular task is performed, people become quicker at it. This learning-curve effect becomes less and less significant until, after the task has been performed a number of times, no further learning occurs. The first unit of output takes a long time to produce. As experience is gained, the worker takes less time to produce each unit of output. The rate of reduction in the time taken will, however, decrease as experience is gained. Thus, for example, the reduction in time taken between the first and second unit produced will be much bigger than the reduction between, say, the ninth and the tenth. Eventually, the rate of reduction in time taken will reduce to zero so that each unit will take as long as the preceding one. M07_ATRI3622_06_SE_C07.QXD 5/29/09 10:38 AM Page 247 SOME PROBLEMS . . . At this point, the point where the curve in Figure 7.10 becomes horizontal (the bottom right of the graph), the learning-curve effect will have been eliminated and a steady, long-term standard time for the activity will have been established. The learning-curve effect seems to have little to do with whether workers are skilled or unskilled; if they are unfamiliar with the task, the learning-curve effect will arise. Practical experience shows that learning curves show remarkable regularity and, therefore, predictability from one activity to another. The learning curve effect applies equally well to activities involved with providing a service (such as dealing with an insurance claim, in an insurance business) as to manufacturing-type activities (for example, upholstering an armchair by hand, in a furniture-making business). Clearly, the learning-curve effect must be taken into account when setting standards, and when interpreting any adverse labour efficiency variances, where a new process and/or new staff are involved. Other uses for standard costing We have seen that standards can play a valuable role in performance evaluation and control. However, standards that relate to costs, usages, selling prices and so on can also be used for other purposes. In particular, they can be used to determine the cost of inventories and work in progress for income-measurement purposes, and the cost of items for use in pricing decisions. Real World 7.7 provides some information on the use of standards in practice. REAL WORLD 7.7 Standards in practice The survey by Drury and others showed that respondent businesses found standards to be useful for the following purposes: Cost control and performance evaluation Valuing inventories and work in progress Deducing costs for decision-making purposes To help in constructing budgets Percentage of respondents 72 80 62 69 Source: Drury, C., Braund, S., Osborne, P. and Tayles, M., A Survey of Management Accounting Practices in UK Manufacturing Companies, Chartered Association of Certified Accountants, 1993. Some problems . . . Although standards and variances may be useful for decision-making purposes, they have limited application. Many business and commercial activities do not have direct relationships between inputs and outputs as is the case with, say, the number of direct labour hours worked and the number of products manufactured. Many expenses of 247 M07_ATRI3622_06_SE_C07.QXD 248 CHAPTER 7 5/29/09 10:38 AM Page 248 ACCOUNTING FOR CONTROL modern business are in areas such as human resource development and advertising, where the expense is discretionary and there is no direct link to the level of output. There are also potential problems when applying standard costing techniques. These include the following: 1 Standards can quickly become out of date as a result of both changes in the production process and price changes. Standards should, therefore, be frequently monitored and updated where necessary. Although this can be costly, it is essential if standards are to be effective for control purposes. When standards become outdated, performance can be adversely affected. For example, a human resources manager who recognises that it is impossible to meet targets on rates of pay for labour, because of general labour cost rises, may have less incentive to minimise costs. 2 Factors over which a particular manager has no control may affect a variance for which that manager is held accountable. When assessing the manager’s performance, these uncontrollable factors should be taken into account but there is always a risk that they will not. 3 In practice, creating clear lines of demarcation between the areas of responsibility of various managers may be difficult. In this case, one of the prerequisites of effective standard costing is lost. 4 Once a standard has been met, there is no incentive for employees to improve the quality or quantity of output further. There are usually no additional rewards for doing so; only additional work. Indeed, employees may have a disincentive for exceeding a standard as it may then be viewed by managers as too loose and therefore in need of tightening. However, simply achieving a standard, and no more, may not be enough in highly competitive and fast-changing markets. To compete effectively, a business may need to strive for continuous improvement, and standard costing techniques may impede this process. 5 Standard costing may create incentives for managers and employees to act in undesirable ways. It may, for example, encourage the build up of excess inventories, leading to significant storage and financing costs. This problem can arise where there are opportunities for discounts on bulk purchases of materials, which the purchasing manager then exploits to achieve a favourable direct materials price variance. One way to avoid this problem might be to impose limits on the level of inventories held. Activity 7.19 Can you think of another example of how a manager may achieve a favourable direct materials price variance but in doing so would create problems for a business? A manager may buy cheaper, but lower quality, materials. Although this may lead to a favourable price variance, it may also lead to additional inspection and reworking costs, and perhaps lost sales. To avoid this problem, the manager may be required to buy material of a particular quality or from particular sources. A final example of the perverse incentives created by standard costing relates to labour efficiency variances. Where these variances are calculated for individual employees, and form the basis for their rewards, there is little incentive for them to M07_ATRI3622_06_SE_C07.QXD 5/29/09 10:38 AM Page 249 THE NEW BUSINESS ENVIRONMENT work co-operatively. However, co-operative working may be in the best interests of the business. To avoid this problem, some businesses calculate labour efficiency variances for groups of employees rather than individual employees. This, however, creates the risk that some individuals will become ‘free riders’ and will rely on the more conscientious employees to carry the load. Activity 7.20 How might the business try to eliminate the ‘free-rider’ problem just mentioned? One way would be to carry out an evaluation, perhaps by the group members themselves, of individual contributions to group output, as well as evaluating group output as a whole. The new business environment The traditional standard costing approach was developed during an era when business operations were characterised by few product lines, long production runs and heavy reliance on direct labour. More recently, the increasingly competitive environment and the onward march of technology have changed the business landscape. Now, many business operations are characterised by a wide range of different products, shorter product life cycles (leading to shorter production runs) and automated production processes. The effect of these changes has resulted in l More frequent development of standards to deal with frequent changes to the pro- duct range. l A change in the focus for control. Where manufacturing systems are automated, for example, direct labour becomes less important than direct materials. l A decline in the importance of monitoring from cost and usage variances. Where manufacturing systems are automated, deviations from standards relating to costs and usage become less frequent and less significant. Thus, where a business has highly automated production systems, traditional standard costing, with its emphasis on costs and usage, is likely to take on less importance. Other elements of the production process such as quality, production levels, product cycle times, delivery times and the need for continuous improvement become the focus of attention. This does not mean, however, that a standards-based approach is not useful for the new manufacturing environment. It can still provide valuable control information and there is no reason why standard costing systems cannot be redesigned to reflect a concern for some of the elements mentioned earlier. Nevertheless, other measures, including non-financial ones, may help to augment the information provided by the standard costing system. We shall consider this issue in more detail in Chapter 10. Real World 7.8 indicates that, despite the problems mentioned above, standard costing is used by businesses. However, the extent to which particular standard costing variances are calculated and considered appears to vary. 249 M07_ATRI3622_06_SE_C07.QXD 250 CHAPTER 7 5/29/09 10:38 AM Page 250 ACCOUNTING FOR CONTROL REAL WORLD 7.8 Standard practice A study was carried out involving interviews with senior financial managers of businesses. Standard costing was used by 30 of the businesses in the study, which represented most of the businesses that might be expected to do so. The popularity among these businesses of standards for each of the main cost items is set out in Figure 7.11. Figure 7.11 The popularity of standards in practice Standards for materials were used by all businesses in the survey, and standards for labour were used by nearly all businesses. Despite the universal use of materials standards, the study found that four businesses calculated the total direct materials variance only and that only two-thirds of businesses calculated both the direct materials price and usage variances. For labour standards, the variance analysis is even less complete. The study found that 15 businesses calculated the total direct labour variance only and only one-third of businesses calculated both the direct labour and efficiency variances. It seems, therefore, that standard costing was not extensively employed by the businesses. Source: Figure based on information in Dugdale, D., Jones, C. and Green, S., Contemporary Management Accounting Practices in UK Manufacturing, Elsevier, 2006. SUMMARY The main points of this chapter may be summarised as follows: Controlling through budgets l Budgets act as a system of both feedback and feedforward control. l To exercise control, budgets can be flexed to match actual volume of output. Variance analysis l Variances may be favourable or adverse according to whether they result in an increase to, or decrease from, the budgeted profit figure. M07_ATRI3622_06_SE_C07.QXD 5/29/09 10:38 AM Page 251 SUMMARY l Budgeted profit plus all favourable variances less all adverse variances equals actual profit. l Commonly calculated variances: – Sales volume variance = difference between the original and flexed budget profit figures. – Sales price variance = difference between actual sales revenue and actual volume at the standard sales price. – Total direct materials variance = difference between the actual direct materials cost and the direct materials cost according to the flexed budget. – Direct materials usage variance = difference between actual usage and budgeted usage, for the actual volume of output, multiplied by the standard materials cost. – Direct materials price variance = difference between the actual materials cost and the actual usage multiplied by the standard materials cost. – Total direct labour variance = The difference between the actual direct labour cost and the direct labour cost according to the flexed budget. – Direct labour efficiency variance = difference between actual labour time and budgeted time, for the actual volume of output, multiplied by the standard labour rate. – Direct labour rate variance = difference between the actual labour cost and the actual labour time multiplied by the standard labour rate. – Fixed overhead spending variance = difference between the actual and budgeted spending on fixed overheads. l Significant and/or persistent variances should normally be investigated to establish their cause. However, the costs and benefits of investigating variances must be considered. l Trading off favourable variances against linked adverse variances should not be automatically acceptable. l Not all activities can usefully be controlled through traditional variance analysis. Effective budgetary control l Good budgetary control requires establishing systems and routines to ensure such things as a clear distinction between individual managers’ areas of responsibility; prompt, frequent and relevant variance reporting; and senior management commitment. l There are behavioural aspects of control relating to management style, participation in budget setting and the failure to meet budget targets that should be taken into account by senior managers. Standard costing l Standards = budgeted physical quantities and financial values for one unit of inputs and outputs. l There are two types of standards: ideal standards and practical standards. l Information necessary for developing standards can be gathered by analysing the task or by using past data. l There tends to be a learning-curve effect: routine tasks are performed more quickly with experience. l Standards are useful in providing data for income measurement and pricing decisions. l Standards have their limitations, particularly in modern manufacturing environ- ments, however, they are still widely used. 251