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gar26703_ch10_417-473.indd Page 417 12/25/06 3:32:05 PM epg1 /Volumes/201/MHIY010/mhgar12/gar12ch10 CONFIRMING PAGES Chapter 10 Standard Costs and the Balanced Scorecard BU SIN E S S F O CU S Managing Materials and Labor Schneider Electric’s Oxford, Ohio, plant manufactures busways that transport electricity from its point of entry into a building to remote locations throughout the building. The plant’s managers pay close attention to direct material costs because they are more than half of the plant’s total manufacturing costs. To help control scrap rates for direct material inputs such as copper, steel, and aluminum, the accounting department prepares direct materials quantity variances. These variances compare the standard quantity of direct materials that should have been used to make a product (according to computations by the plant’s engineers) to the amount of direct materials that were actually used. Keeping a close eye on these differences helps to identify and deal with the causes of excessive scrap, such as an inadequately trained machine operator, poor quality raw material inputs, or a malfunctioning machine. Because direct labor is also a significant component of the plant’s total manufacturing costs, the management team daily monitors the direct labor efficiency variance. This variance compares the standard amount of labor time allowed to make a product to the actual amount of labor time used. When idle workers cause an unfavorable labor efficiency variance, managers temporarily move workers from departments with slack to departments with a backlog of work to be done. ■ Source: Author’s conversation with Doug Taylor, plant controller, Schneider Electric’s Oxford, Ohio, plant. Learning Objectives After studying Chapter 10, you should be able to: LO1 Explain how direct materials standards and direct labor standards are set. LO2 Compute the direct materials price and quantity variances and explain their significance. LO3 Compute the direct labor rate and efficiency variances and explain their significance. LO4 Compute the variable manufacturing overhead spending and efficiency variances. LO5 Understand how a balanced scorecard fits together and how it supports a company’s strategy. LO6 Compute delivery cycle time, throughput time, and manufacturing cycle efficiency (MCE). LO7 (Appendix 10A) Prepare journal entries to record standard costs and variances. gar26703_ch10_417-473.indd Page 418 12/25/06 3:32:22 PM epg1 418 /Volumes/201/MHIY010/mhgar12/gar12ch10 CONFIRMING PAGES Chapter 10 I n this chapter we begin our study of management control and performance measures. Quite often, these terms carry with them negative connotations. Indeed, performance measurements can be used counterproductively to create fear, to cast blame, and to punish. However, if used properly, as explained in the following quotation, performance measurement serves a vital function in both daily life and in organizations: Imagine you want to improve your basketball shooting skill. You know that practice will help, so you [go] to the basketball court. There you start shooting toward the hoop, but as soon as the ball gets close to the rim your vision goes blurry for a second, so that you cannot observe where the ball ended up in relation to the target (left, right, in front, too far back, inside the hoop?). It would be pretty difficult to improve under those conditions. . . . (And by the way, how long would [shooting baskets] sustain your interest if you couldn’t observe the outcome of your efforts?) Or imagine someone engaging in a weight loss program. A normal step in such programs is to purchase a scale to be able to track one’s progress: Is this program working? Am I losing weight? A positive answer would be encouraging and would motivate me to keep up the effort, while a negative answer might lead me to reflect on the process: Am I working on the right diet and exercise program? Am I doing everything I am supposed to?, etc. Suppose you don’t want to set up a sophisticated measurement system and decide to forgo the scale. You would still have some idea of how well you are doing from simple methods such as clothes feeling looser, a belt that fastens at a different hole, or simply via observation in a mirror! Now, imagine trying to sustain a weight loss program without any feedback on how well you are doing. In these . . . examples, availability of quantitative measures of performance can yield two types of benefits: First, performance feedback can help improve the “production process” through a better understanding of what works and what doesn’t; e.g., shooting this way works better than shooting that way. Secondly, feedback on performance can sustain motivation and effort, because it is encouraging and/or because it suggests that more effort is required for the goal to be met.1 In the same way, performance measurement can be helpful in an organization. It can provide feedback concerning what works and what does not work, and it can help motivate people to sustain their efforts. IN BUSINESS FOCUSING ON THE NUMBERS Joe Knight is the CEO of Setpoint, a company that designs and builds factory-automation equipment. Knight uses a large whiteboard, with about 20 rows and 10 columns, to focus worker attention on key factors involved in managing projects. A visitor to the plant, Steve Petersen, asked Knight to explain the board, but Knight instead motioned one of his workers to come over. The young man, with a baseball cap turned backward on his head, proceeded to walk the visitor through the board, explaining the calculation of gross margin and other key indicators on the board. “ ‘I was just amazed,’ Petersen recalls. ‘He knew that board inside and out. He knew every number on it. He knew exactly where the company was and where they had to focus their attention. There was no hesitation . . . . I was so impressed . . . that the people on the shop floor had it down like that. It was their scoreboard. It was the way they could tell if they were winning or losing. I talked to several of them, and I just couldn’t get over the positive attitude they had and their understanding of the numbers.’ ” Source: Bo Burlinghan, “What’s Your Culture Worth?,” Inc. magazine, September 2001, pp. 124–133. 1 Soumitra Dutta and Jean-François Manzoni, Process Reengineering, Organizational Change and Performance Improvement (New York: McGraw-Hill), Chapter IV. gar26703_ch10_417-473.indd Page 419 12/25/06 3:32:23 PM epg1 /Volumes/201/MHIY010/mhgar12/gar12ch10 CONFIRMING PAGES Standard Costs and the Balanced Scorecard Our study of performance measurement begins with the lowest levels in the organization. We work our way up the organizational ladder in subsequent chapters. In this chapter we see how various measures are used to control operations and to evaluate performance. Even though we are starting with the lowest levels in the organization, keep in mind that performance measures should be derived from the organization’s overall strategy. For example, a company like Sony that bases its strategy on rapid introduction of innovative consumer products should use different performance measures than a company like Federal Express where on-time delivery, customer convenience, and low cost are key competitive advantages. Sony may want to keep close track of the percentage of revenues from products introduced within the last year; whereas Federal Express may want to closely monitor the percentage of packages delivered on time. Later in this chapter when we discuss the balanced scorecard, we will have more to say concerning the role of strategy in the selection of performance measures. But first we will see how standard costs are used by managers to help control costs. Companies in highly competitive industries like Federal Express, Southwest Airlines, Dell, and Toyota must be able to provide high-quality goods and services at low cost. If they do not, their customers will buy from more efficient competitors. Stated in the starkest terms, managers must obtain inputs such as raw materials and electricity at the lowest possible prices and must use them as effectively as possible—while maintaining or increasing the quality of what they sell. If inputs are purchased at prices that are too high or more input is used than is really necessary, higher costs will result. How do managers control the prices that are paid for inputs and the quantities that are used? They could examine every transaction in detail, but this obviously would be an inefficient use of management time. For many companies, the answer to this control problem lies at least partially in standard costs. Standard Costs—Management by Exception A standard is a benchmark or “norm” for measuring performance. Standards are found everywhere. Your doctor evaluates your weight using standards for individuals of your age, height, and gender. The food we eat in restaurants is prepared under specified standards of cleanliness. The buildings we live in conform to standards set in building codes. Standards are also widely used in managerial accounting where they relate to the quantity and cost (or acquisition price) of inputs used in manufacturing goods or providing services. Quantity and cost standards are set for each major input such as raw materials and labor time. Quantity standards specify how much of an input should be used to make a product or provide a service. Cost (price) standards specify how much should be paid for each unit of the input. Actual quantities and actual costs of inputs are compared to these standards. If either the quantity or the cost of inputs departs significantly from the standards, managers investigate the discrepancy to find the cause of the problem and eliminate it. This process is called management by exception. In our daily lives, we operate in a management by exception mode most of the time. Consider what happens when you sit down in the driver’s seat of your car. You put the key in the ignition, you turn the key, and your car starts. Your expectation (standard) that the car will start is met; you do not have to open the car hood and check the battery, the connecting cables, the fuel lines, and so on. If you turn the key and the car does not start, then you have a discrepancy (variance). Your expectations are not met, and you need to investigate why. Note that even if the car starts after a second try, it still would be wise to investigate. The fact that the expectation was not met should be viewed as an opportunity to uncover the cause of the problem rather than as simply an annoyance. If the underlying cause is not discovered and corrected, the problem may recur and become much worse. 419 /Volumes/201/MHIY010/mhgar12/gar12ch10 CONFIRMING PAGES gar26703_ch10_417-473.indd Page 420 12/25/06 3:32:24 PM epg1 420 Chapter 10 Variance Analysis Cycle E X H I B I T 10–1 The Variance Analysis Cycle Identify questions Receive explanations Take corrective actions Conduct next periodís operations Analyze variances Prepare standard cost performance report Begin This basic approach to identifying and solving problems is the essence of the variance analysis cycle, which is illustrated in Exhibit 10–1. The cycle begins with the preparation of standard cost performance reports in the accounting department. These reports highlight the variances, which are the differences between actual results and what should have occurred according to the standards. The variances raise questions. Why did this variance occur? Why is this variance larger than it was last period? The significant variances are investigated to discover their root causes. Corrective actions are taken. And then next period’s operations are carried out. The cycle begins again with the preparation of a new standard cost performance report for the latest period. The emphasis should be on highlighting problems, finding their root causes, and then taking corrective action. The goal is to improve operations— not to assign blame. Who Uses Standard Costs? Manufacturing, service, food, and not-for-profit organizations all make use of standards to some extent. Auto service centers like Firestone and Sears, for example, often set specific labor time standards for the completion of certain tasks, such as installing a carburetor or doing a valve job, and then measure actual performance against these standards. Fast-food outlets such as McDonald’s have exacting standards for the quantity of meat going into a sandwich, as well as standards for the cost of the meat. Hospitals have standard costs for food, laundry, and other items, as well as standard time allowances for certain routine activities, such as laboratory tests. In short, you are likely to run into standard costs in virtually any line of business. IN BUSINESS STANDARD COSTING AT PARKER BRASS The Brass Products Division at Parker Hannifin Corporation, known as Parker Brass, is a world-class manufacturer of tube and brass fittings, valves, hose and hose fittings. Management at the company uses variances from its standard costing system to target problem areas for improvement. If a production variance exceeds 5% of sales, the responsible manager is required to explain the variance and to propose a plan of action to correct the detected problems. In the past, variances were reported at the end of the month—often several weeks after a particular job had been completed. Now, a variance report is generated the day after a job is completed and summary variance reports are prepared weekly. These more frequent reports help managers take more timely corrective action. Source: David Johnsen and Parvez Sopariwala, “Standard Costing Is Alive and Well at Parker Brass,” Management Accounting Quarterly, Winter 2000, pp. 12–20. gar26703_ch10_417-473.indd Page 421 12/25/06 3:32:25 PM epg1 /Volumes/201/MHIY010/mhgar12/gar12ch10 CONFIRMING PAGES Standard Costs and the Balanced Scorecard 421 Manufacturing companies often have highly developed standard costing systems in which standards for direct materials, direct labor, and overhead are created for each product. A standard cost card shows the standard quantities and costs of the inputs required to produce a unit of a specific product. In the following section, we provide a detailed example of setting standard costs and preparing a standard cost card. Setting Standard Costs Setting price and quantity standards ideally combines the expertise of everyone who has responsibility for purchasing and using inputs. In a manufacturing setting, this might include accountants, purchasing managers, engineers, production supervisors, line managers, and production workers. Past records of purchase prices and input usage can be helpful in setting standards. However, the standards should be designed to encourage efficient future operations, not just a repetition of past operations that may or may not have been efficient. Ideal versus Practical Standards Should standards be attainable all of the time, part of the time, or almost none of the time? Opinions vary, but standards tend to fall into one of two categories—either ideal or practical. Ideal standards can be attained only under the best circumstances. They allow for no machine breakdowns or other work interruptions, and they call for a level of effort that can be attained only by the most skilled and efficient employees working at peak effort 100% of the time. Some managers feel that such standards spur continual improvement. These managers argue that even though employees know they will rarely meet the standard, it is a constant reminder of the need for ever-increasing efficiency and effort. Few organizations use ideal standards. Most managers feel that ideal standards tend to discourage even the most diligent workers. Moreover, variances from ideal standards are difficult to interpret. Large variances from the ideal are normal and it is therefore difficult to “manage by exception.” Practical standards are standards that are “tight but attainable.” They allow for normal machine downtime and employee rest periods, and they can be attained through reasonable, though highly efficient, efforts by the average worker. Variances from practical standards typically signal a need for management attention because they represent deviations that fall outside of normal operating conditions. Furthermore, practical standards can serve multiple purposes. In addition to signaling abnormal conditions, they can also be used in forecasting cash flows and in planning inventory. By contrast, ideal standards cannot be used for these purposes because they do not allow for normal inefficiencies and result in unrealistic forecasts. Throughout the remainder of this chapter, we will assume that practical rather than ideal standards are in use. The Colonial Pewter Company was organized a year ago. The company’s only product is a reproduction of an 18th century pewter bookend. The bookend is made largely by hand, using traditional metalworking tools. Consequently, the manufacturing process is labor intensive and requires a high level of skill. Colonial Pewter has recently expanded its workforce to take advantage of unexpected demand for the bookends as gifts. The company started with a small cadre of experienced pewter workers but has had to hire less experienced workers as a result of the expansion. The president of the company, J. D. Wriston, has called a meeting to discuss production problems. Attending the meeting are Tom Kuchel, the production manager; Janet Warner, the purchasing manager; and Terry Sherman, the corporate controller. MANAGERIAL ACCOUNTING IN ACTION The Issue colonial pewter C O M P A N Y gar26703_ch10_417-473.indd Page 422 12/25/06 3:32:26 PM epg1 422 /Volumes/201/MHIY010/mhgar12/gar12ch10 CONFIRMING PAGES Chapter 10 J. D.: I’ve got a feeling that we aren’t getting the production we should out of our new people. Tom: Give us a chance. Some of the new people have been with the company for less than a month. Janet: Let me add that production seems to be wasting an awful lot of material— particularly pewter. That stuff is very expensive. Tom: What about the shipment of defective pewter that you bought a couple of months ago—the one with the iron contamination? That caused us major problems. Janet: That’s ancient history. How was I to know it was off-grade? Besides, it was a great deal. J. D.: Calm down everybody. Let’s get the facts before we start sinking our fangs into each other. Tom: I agree. The more facts the better. J. D.: Okay, Terry, it’s your turn. Facts are the controller’s department. Terry: I’m afraid I can’t provide the answers off the top of my head, but it won’t take me too long to set up a system that can routinely answer questions relating to worker productivity, material waste, and input prices. J. D.: How long is “not too long”? Terry: I will need all of your cooperation, but how about a week from today? J. D.: That’s okay with me. What about everyone else? Tom: Sure. Janet: Fine with me. J. D.: Let’s mark it on our calendars. Setting Direct Materials Standards LEARNING OBJECTIVE 1 Explain how direct materials standards and direct labor standards are set. Terry Sherman’s first task was to prepare price and quantity standards for the company’s only significant raw material, pewter ingots. The standard price per unit for direct materials should reflect the final, delivered cost of the materials, net of any discounts taken. After consulting with purchasing manager Janet Warner, Terry prepared the following documentation for the standard price of a pound of pewter in ingot form: Purchase price, top-grade pewter ingots, in 40-pound ingots . . . . . . . Freight, by truck, from the supplier’s warehouse . . . . . . . . . . . . . . . . . Less purchase discount . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3.85 0.24 (0.09) Standard price per pound . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4.00 Notice that the standard price reflects a particular grade of material (top grade), purchased in particular lot sizes (40-pound ingots), and delivered by a particular type of carrier (truck). Allowances have also been made for discounts. If everything proceeds according to these expectations, the net cost of a pound of pewter should be $4.00. The standard quantity per unit for direct materials should reflect the amount of material required for each unit of finished product, as well as an allowance for unavoidable waste, spoilage, and other normal inefficiencies. After consulting with the production manager, Tom Kuchel, Terry Sherman prepared the following documentation for the standard quantity of pewter in a pair of bookends: Material requirements as specified in the bill of materials for a pair of bookends, in pounds . . . . . . . . . . . . . . . . . . . . . . . . Allowance for waste and spoilage, in pounds . . . . . . . . . . . . . . . . Allowance for rejects, in pounds . . . . . . . . . . . . . . . . . . . . . . . . . . 2.7 0.2 0.1 Standard quantity per pair of bookends, in pounds . . . . . . . . . . . . 3.0 /Volumes/201/MHIY010/mhgar12/gar12ch10 CONFIRMING PAGES gar26703_ch10_417-473.indd Page 423 12/25/06 3:32:26 PM epg1 Standard Costs and the Balanced Scorecard As discussed in Chapter 3, the bill of materials details the quantity of each type of material that should be used in a product. As shown above, the material requirements listed on the bill of materials should be adjusted for waste and other factors when determining the standard quantity per unit of product. “Waste and spoilage” refers to materials that are wasted as a normal part of the production process or that spoil before they are used. “Rejects” refers to the direct material contained in defective units that must be scrapped. Although allowances for waste, spoilage, and rejects are often built into standards, this practice is often criticized because it contradicts the zero defects goal that underlies improvement programs such as Six Sigma. If allowances for waste, spoilage, and rejects are built into the standard cost, those allowances should be periodically reviewed and reduced over time to reflect improved processes, better training, and better equipment. Once the price and quantity standards have been set, the standard cost of material per unit of the finished product can be computed as follows: 3.0 pounds per unit  $4.00 per pound  $12.00 per unit This $12.00 cost will appear on the product’s standard cost card. Setting Direct Labor Standards Direct labor price and quantity standards are usually expressed in terms of a labor rate and labor-hours. The standard rate per hour for direct labor includes wages, employment taxes, and fringe benefits. Using wage records and in consultation with the production manager, Terry Sherman determined the standard rate per direct labor-hour at the Colonial Pewter Company as follows: Basic wage rate per hour . . . . . . . . . . . . . . . . . . . . . Employment taxes at 10% of the basic rate . . . . . . . Fringe benefits at 30% of the basic rate . . . . . . . . . . $10.00 1.00 3.00 Standard rate per direct labor-hour . . . . . . . . . . . . . $14.00 Many companies prepare a single standard rate per hour for all employees in a department. This standard rate reflects the expected “mix” of workers, even though the actual wage rates may vary somewhat from individual to individual due to differing skills or seniority. According to the standard computed above, the direct labor rate for Colonial Pewter should average $14 per hour. The standard direct labor time required to complete a unit of product (called the standard hours per unit) is perhaps the single most difficult standard to determine. One approach is to break down each task into elemental body movements (such as reaching, pushing, and turning over). Published tables of standard times for such movements can be used to estimate the total time required to complete the task. Another approach is for an industrial engineer to do a time and motion study, actually clocking the time required for each task. As stated earlier, the standard time should include allowances for breaks, personal needs of employees, cleanup, and machine downtime. After consulting with the production manager, Terry Sherman prepared the following documentation for the standard direct labor hours per unit: Basic labor time per unit, in hours . . . . . . . . . . . . . . . . Allowance for breaks and personal needs . . . . . . . . . . Allowance for cleanup and machine downtime . . . . . . . Allowance for rejects . . . . . . . . . . . . . . . . . . . . . . . . . . 1.9 0.1 0.3 0.2 Standard direct labor-hours per unit of product . . . . . . 2.5 423 /Volumes/201/MHIY010/mhgar12/gar12ch10 CONFIRMING PAGES gar26703_ch10_417-473.indd Page 424 12/25/06 3:32:27 PM epg1 Chapter 10 424 E X H I B I T 10–2 Standard Cost Card— Variable Manufacturing Costs Inputs Direct materials . . . . . . . . . . . . . . . . . . . . . Direct labor . . . . . . . . . . . . . . . . . . . . . . . . Variable manufacturing overhead . . . . . . . (1) Standard Quantity or Hours (2) Standard Price or Rate Standard Cost (1)  (2) 3.0 pounds 2.5 hours 2.5 hours $4.00 per pound $14.00 per hour $3.00 per hour $12.00 35.00 7.50 Total standard cost per unit . . . . . . . . . . . . $54.50 Once the rate and time standards have been set, the standard direct labor cost per unit of product can be computed as follows: 2.5 direct labor-hours per unit  $14 per direct labor-hour  $35 per unit This $35 per unit standard direct labor cost appears along with direct materials on the standard cost card for a pair of pewter bookends. Setting Variable Manufacturing Overhead Standards As with direct labor, the price and quantity standards for variable manufacturing overhead are usually expressed in terms of rate and hours. The rate represents the variable portion of the predetermined overhead rate discussed in Chapter 3; the hours relate to the activity base that is used to apply overhead to units of product (usually machine-hours or direct laborhours, as we learned in Chapter 3). At Colonial Pewter, the variable portion of the predetermined overhead rate is $3 per direct labor-hour. Therefore, the standard variable manufacturing overhead cost per unit is computed as follows: 2.5 direct labor-hours per unit  $3 per direct labor-hour  $7.50 per unit This $7.50 per unit cost for variable manufacturing overhead appears along with direct materials and direct labor on the standard cost card in Exhibit 10–2. Observe that the standard cost per unit for variable manufacturing overhead is computed the same way as for direct materials or direct labor—the standard quantity allowed per unit of the output is multiplied by the standard price. In this case, the standard quantity is expressed as 2.5 direct laborhours per unit and the standard price (or rate) is expressed as $3 per direct labor-hour. Are Standards the Same as Budgets? Standards and budgets are very similar. The major distinction between the two terms is that a standard is a unit amount, whereas a budget is a total amount. The standard cost for direct materials at Colonial Pewter is $12 per pair of bookends. If 1,000 pairs of bookends are to be made, then the budgeted cost of direct materials would be $12,000. In effect, a standard can be viewed as the budgeted cost for one unit of product. A General Model for Variance Analysis Why are standards separated into two categories—price and quantity? Different managers are usually responsible for buying and for using inputs. For example, in the case of a raw material, a purchasing manager is responsible for its price. However, the production manager is responsible for the amount of the raw material actually used to make products. As we shall see, setting up separate standards for price and quantity allows us to better separate the responsibilities of these two managers. It also allows us to prepare more timely reports. The purchasing manager’s tasks are completed when the material is delivered for use in the factory. A performance report for the purchasing manager can be prepared at that point. However, the production manager’s responsibilities have just begun at that point. A performance /Volumes/201/MHIY010/mhgar12/gar12ch10 CONFIRMING PAGES gar26703_ch10_417-473.indd Page 425 12/25/06 3:32:27 PM epg1 Standard Costs and the Balanced Scorecard (1) Actual Quantity of Input, at Actual Price (AQ  AP) (2) Actual Quantity of Input, at Standard Price (AQ  SP) Price Variance (1)  (2) (3) Standard Quantity Allowed for Actual Output, at Standard Price (SQ  SP) Quantity Variance (2)  (3) Materials price variance Labor rate variance Variable overhead spending variance Materials quantity variance Labor efficiency variance Variable overhead efficiency variance Total variance report for the production manager must be delayed until production is completed and it is known how much raw material was used in the final product. Therefore, it is important to clearly distinguish between deviations from price standards (the responsibility of the purchasing manager) and deviations from quantity standards (the responsibility of the production manager). Differences between standard prices and actual prices and between standard quantities and actual quantities are called variances. The act of computing and interpreting variances is called variance analysis. Price and Quantity Variances Exhibit 10–3 presents a general model for computing standard cost variances for variable costs. This model isolates price variances from quantity variances and shows how each of these variances is computed.2 We will be using this model throughout the chapter to compute variances for direct materials, direct labor, and variable manufacturing overhead. Three things should be noted from Exhibit 10–3. First, a price variance and a quantity variance can be computed for each of the three variable cost elements—direct materials, direct labor, and variable manufacturing overhead—even though the variances have different names. For example, a price variance is called a materials price variance in the case of direct materials but a labor rate variance in the case of direct labor and an overhead spending variance in the case of variable manufacturing overhead. Second, the price variance—regardless of what it is called—is computed in exactly the same way regardless of whether one is dealing with direct materials, direct labor, or variable manufacturing overhead. The same is true of the quantity variance. Third, the input is the actual quantity of direct materials, direct labor, and variable manufacturing overhead purchased or used; the output is the good production of the period, expressed in terms of the standard quantity (or the standard hours) allowed for the actual output (see column 3 in Exhibit 10–3). The standard quantity allowed or standard hours allowed means the amount of an input that should have been used to produce the actual output of the period. This could be more or less than the actual amount of the input, depending on the efficiency or inefficiency of operations. The standard quantity allowed is computed by multiplying the actual output in units by the standard input allowed per unit of output. With this general model as the foundation, we will now calculate Colonial Pewter’s price and quantity variances. 2 Variance analysis of fixed costs will be discussed in the next chapter. 425 E X H I B I T 10–3 A General Model for Variance Analysis—Variable Manufacturing Costs /Volumes/201/MHIY010/mhgar12/gar12ch10 CONFIRMING PAGES gar26703_ch10_417-473.indd Page 426 12/25/06 3:32:27 PM epg1 Chapter 10 426 Using Standard Costs—Direct Materials Variances LEARNING OBJECTIVE 2 Compute the direct materials price and quantity variances and explain their significance. After determining Colonial Pewter Company’s standard costs for direct materials, direct labor, and variable manufacturing overhead, Terry Sherman’s next step was to compute the company’s variances for June, the most recent month. As discussed in the preceding section, variances are computed by comparing standard costs to actual costs. Terry referred to the standard cost card in Exhibit 10–2 that shows the standard cost of direct materials was computed as follows: 3.0 pounds per unit  $4.00 per pound  $12 per unit Topic Tackler PLUS 10–1 Colonial Pewter’s records for June showed that 6,500 pounds of pewter were purchased at a cost of $3.80 per pound. This cost included freight and was net of a quantity purchase discount. All of the material purchased was used during June to manufacture 2,000 pairs of pewter bookends. Using these data and the standard costs from Exhibit 10–2, Terry computed the price and quantity variances shown in Exhibit 10–4. The three arrows in Exhibit 10–4 point to three different total cost figures. The first, $24,700, refers to the actual total cost of the pewter that was purchased during June. The second, $26,000, refers to what the pewter would have cost if it had been purchased at the standard price of $4.00 a pound rather than the actual price of $3.80 a pound. The difference between these two figures, $1,300 ($26,000  $24,700), is the price variance. It exists because the actual purchase price was $0.20 per pound less than the standard purchase price. Since 6,500 pounds were purchased, the total amount of the variance is $1,300 ($0.20 per pound  6,500 pounds). This variance is labeled favorable (denoted by F), since the actual purchase price was less than the standard purchase price. A price variance is labeled unfavorable (denoted by U) if the actual purchase price exceeds the standard purchase price. The third arrow in Exhibit 10–4 points to $24,000—the cost if the pewter had been purchased at the standard price and only the standard quantity allowed per unit had been used. The standards call for 3 pounds of pewter per unit. Since 2,000 units were produced, 6,000 pounds of pewter should have been used. This is referred to as the standard quantity allowed for the actual output. If this 6,000 pounds of pewter had been purchased at the standard price of $4.00 per pound, the company would have spent $24,000. The difference between this figure, $24,000, and the figure at the end of the middle arrow in Exhibit 10–4, $26,000, is the quantity variance of $2,000. To understand this quantity variance, note that the actual amount of pewter used in production was 6,500 pounds. However, the standard amount of pewter allowed for the actual E X H I B I T 10–4 Variance Analysis—Direct Materials (1) Actual Quantity of Input, at Actual Price (AQ  AP) 6,500 pounds  $3.80 per pound  $24,700 (2) Actual Quantity of Input, at Standard Price (AQ  SP) (3) Standard Quantity Allowed for Actual Output, at Standard Price (SQ  SP) 6,500 pounds  $4.00 per pound 6,000 pounds*  $4.00 per pound  $26,000  $24,000 Price variance, $1,300 F Quantity variance, $2,000 U Total variance, $700 U *2,000 units  3.0 pounds per unit  6,000 pounds. F  Favorable; U  Unfavorable.