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10 Standard Costing and Analysis of Direct Costs FOCUS COMPANY >>> THIS CHAPTER’S FOCUS COMPANY is DCdesserts.com, which supplies fancy desserts to a variety of restaurants, caterers, and upscale food stores in Washington, D.C. The company’s order-taking system is entirely Web-based. Each day, DCdesserts.com posts its dessert menu on its website, and orders are accepted via the Internet. In this chapter, we explore DCdesserts.com’s use of standard costing. A standard-costing system sets predetermined (or standard) costs for each of a product’s inputs, such as direct material and direct labor. Then the actual costs to produce the product are compared with the standard costs that should have been incurred. DCdesserts.com’s management uses the standard-costing system to help control the company’s production costs. <<< IN CONTRAST In contrast to the food-processing setting of DCdesserts.com, we will turn our attention to the financial-services industry. Here we will explore Forest Home National Bank’s (FHNB) implementation of a standard costing system to better manage its business. FHNB uses direct-labor standards to understand and manage its performance of the various service tasks that are required in a modern bank, and variance analysis helps the company to pinpoint opportunities for improvement. After completing this chapter, you should be able to: 10-1 Describe the elements of a cost control system. 10-2 Describe two ways to set cost standards and distinguish between perfection and practical standards. 10-3 Compute and interpret the direct-material price and quantity variances and the direct-labor rate and efficiency variances. 10-4 Explain several methods for determining the significance of cost variances. 10-5 Describe some behavioral effects of standard costing. 10-6 Explain how standard costs are used in product costing. 10-7 Summarize some advantages of standard costing. 10-8 Explain several common criticisms of standard costing. 10-9 Prepare journal entries to record and close out cost variances (appendix). The Financial Planning and Analysis (FP&A) process, introduced in Chapter 9, includes steps prior to operations (planning) and after operations (analysis). A budget provides a plan for managers to follow in making decisions and directing an organization’s activities. At the end of a budget period, after operations are completed, the budget serves another useful purpose. At that time, managers use the budget as a benchmark against which to compare the results of actual operations. Did the company make as much profit as anticipated in the budget? Were costs greater or less than expected? In this chapter, we will study standard costing and variance analysis, tools used by accountants and managers for analyzing and controlling an organization’s operations and costs. Managing Costs Learning Objective 10-1 Describe the elements of a cost control system. 410 Any control system has three basic parts: a predetermined or standard performance level, a measure of actual performance, and a comparison between standard and actual performance. A thermostat is a control system with which we are all familiar. First, a thermostat has a predetermined or standard temperature, which can be set at any desired level. If you want the temperature in a room to be 68 degrees, you set the thermostat at the standard of 68 degrees. Second, the thermostat contains a thermometer that measures the actual temperature in the room. Third, the thermostat compares the preset or standard temperature with the actual room temperature. If the actual temperature deviates from the preset or standard temperature, the thermostat activates a heating or cooling device. The three features of a control system are depicted in Exhibit 10–1. A financial planning and analysis system includes a cost-control system that works like a thermostat. First, a predetermined or standard cost is set. In essence, a standard cost is the company’s best estimate of the average cost to produce a single unit of product Chapter 10 60 70 80 90 50 100 90 80 70 60 50 40 30 20 10 411 Standard Costing and Analysis of Direct Costs 1. Predetermined or standard performance (The thermostat is set to a standard temperature.) 2. Measure of actual performance (The thermometer measures the actual room temperature.) Exhibit 10–1 Control System: A Thermostat. 3. Comparison of actual and standard performance (The thermostat compares the preset or standard temperature with the actual temperature.) or service. This cost estimate serves as the starting point for creating the relevant budgets. When the firm plans to produce multiple units, managers use the standard unit cost to determine the total standard or budgeted cost of production. For example, suppose the standard direct-material cost for one unit of product is $5 and the firm expects to manufacture 100,000 units. The total standard or budgeted direct-material cost for 100,000 units is $500,000 ($5 3 100,000). Second, the cost-control system measures the actual cost incurred in the production process. For our example, suppose the firm does produce 100,000 units, as planned, and the actual cost of materials used is measured by the cost-control system at $550,000. Third, the manager compares the actual cost with the budgeted or standard cost. Any difference between the two is called a cost variance. Cost variances then are used in controlling costs. The $50,000 cost variance in this example ($550,000 2 $500,000) tells the company that their planning figures were incorrect and that they were unable to produce the quantity of product anticipated at the cost for materials anticipated. This information may well lead the company to look for an explanation for the incorrect prediction. Notice that because the variance in the example above was measured specifically for direct materials, we can imagine specific reasons for the cost variance. For example, maybe the price paid for that material was higher than the manager expected at the time she produced the budget. By setting standard costs and measuring cost variances for specific types of costs, we can find meaningful explanations for the variances. For that reason, standards are set and variances are measured for many different direct materials, many classes of direct labor, and sometimes many different categories of overhead. We will discuss these in more detail later in this chapter and the next. Management by Exception Although many different cost variances are measured, they are not all investigated. Managers are busy people. They do not have time to look into the causes of every variance between actual and standard costs. However, they do take the time to investigate the causes of significant cost variances. This process of following up on only significant cost variances is called management by exception. When operations are going along as planned, actual costs and profit will typically be close to the budgeted amounts. However, if there are significant departures from planned operations, such effects will show up as significant cost variances. Managers investigate these variances to determine their causes, if possible, and take corrective action when indicated. What constitutes a significant variance? No precise answer can be given to this question, since it depends on the size and type of the organization and its production process. We will consider this issue later in the chapter when we discuss common methods for determining the significance of cost variances. First, however, we will turn our attention to the process of setting standards. “I have been struck by how important measurement is to improving the human condition. You can achieve incredible progress if you set a clear goal and find a measure that will drive progress toward that goal.” (10a) Bill and Melinda Gates Foundation 412 Chapter 10 Standard Costing and Analysis of Direct Costs Setting Standards Methods for Setting Standards Learning Objective 10-2 Describe two ways to set cost standards and distinguish between perfection and practical standards. Cost standards generally are established by a company’s managerial accountants, who use two methods for setting them: analysis of historical data and task analysis. Analysis of Historical Data One indicator of future costs is historical cost data. In a mature production process, where the firm has a lot of production experience, historical costs can provide a good basis for predicting future costs. The methods for analyzing cost behavior that we studied in Chapter 6 are used in making cost predictions. The company often will need to adjust these predictions to reflect movements in price levels or technological changes in the production process. For example, the amount of rubber required to manufacture a particular type of tire will likely be the same this year as last year, unless there has been a significant change in the process used to manufacture tires. However, the price of rubber is likely to be different this year than last, and this fact must be reflected in the new standard cost of a tire. Despite the relevance of historical cost data in setting cost standards, managers must guard against relying on them blindly. Understanding how standards were derived can provide important insights into their reliability. For example, even a seemingly minor change in the way a product is manufactured may make historical data almost totally irrelevant. Moreover, new products also require new cost standards. For new products, such as genetically engineered medicines, there are no historical cost data upon which to base standards. In such cases, the manager should turn to another approach. Task Analysis Another way to set cost standards is to analyze the process of manufacturing a product to determine what it should cost. The emphasis shifts from what the product did cost in the past to what it should cost in the future. In using task analysis, the manager or accountant typically works with engineers who are intimately familiar with the production process. Together they conduct studies to determine exactly how much direct material should be required and how machinery should be used in the production process. Time and motion studies are conducted to determine how long each step performed by direct laborers should take. A Combined Approach Managerial accountants often apply both historical cost analysis and task analysis in setting cost standards. It may be, for example, that the technology has changed for only one step in the production process. In such a case, the managerial accountant would work with engineers to set cost standards for the technologically changed part of the production process. However, the accountant would likely rely on the less time-consuming method of analyzing historical cost data to update the cost standards for the remainder of the production process. Participation in Setting Standards Standards should not be determined by the managerial accountant alone. Besides needing to assess the standard’s reliability, as discussed above, managers generally will be more committed to meeting standards if they participate in setting them. For example, production supervisors should have a role in setting production cost standards, and sales managers should be involved in setting targets for sales prices and volume. In addition, knowledgeable staff personnel should participate in the standard-setting process. For example, task analysis should be carried out by a team consisting of production engineers, production supervisors, and managerial accountants. Chapter 10 413 Standard Costing and Analysis of Direct Costs Perfection versus Practical Standards: A Behavioral Issue How difficult should it be to attain standard costs? Should standards be set so that actual costs rarely exceed standard costs? Or should it be so hard to attain standards that actual costs frequently exceed them? The answers to these questions depend on the purpose for which standards will be used and how standards affect behavior. Perfection Standards A perfection (or ideal) standard is one that can be attained only under nearly perfect operating conditions. Such standards assume peak efficiency, the lowest possible input prices, the best-quality materials obtainable, and no disruptions in production due to such causes as machine breakdowns or power failures. Some managers believe that perfection standards help achieve the lowest production cost by motivating employees to achieve the lowest cost possible. They claim that since the standard is theoretically attainable, employees will have an incentive to come as close as possible to achieving it. Other managers and many behavioral scientists disagree. They feel that perfection standards discourage employees, since they are so unlikely to be attained. Moreover, setting unrealistically difficult standards may encourage employees to sacrifice product quality to achieve lower costs. By skimping on raw-material quality or the attention given to manual production tasks, employees may be able to lower the production cost. However, this lower cost may come at the expense of a higher rate of defective units. Thus, the firm ultimately may incur higher costs than necessary as defective products are returned by customers or scrapped upon inspection. Practical Standards Standards that are as tight as practical, but still are expected to be attained, are called practical (or attainable) standards. Such standards assume a production process that is as efficient as practical under normal operating conditions. Practical standards allow for such occurrences as occasional machine breakdowns and normal amounts of raw-material waste. Attaining a practical standard keeps employees on their toes, without demanding miracles. Most behavioral theorists believe that practical standards encourage more positive and productive employee attitudes than do perfection standards. “At Best Foods, standard costs are set at attainable levels.” (10b) Best Foods (a subsidiary of Unilever) Use of Standards by Service Organizations Many service industry firms, nonprofit organizations, and governmental units make use of standards. For example, FedEx allows its crews 18 minutes to unload the 9 to 12 containers of packages from a Boeing 727. A delay of over a minute must be explained at a daily 5 a.m. meeting. Burger King sets a standard for the amount of meat in a hamburger. Airlines such as American or United set standards for fuel and maintenance costs. Insurance companies such as Allstate or State Farm set standards for the amount of time to process an insurance application. Even a county motor vehicle office may have a standard for the number of days required to process and return an application for vehicle registration. These and similar organizations use standards in budgeting and cost control in much the same way that manufacturers use standards. Insurance companies use standards to manage how long it takes to underwrite a new policy or settle a claim. 414 Chapter 10 Standard Costing and Analysis of Direct Costs Cost Variance Analysis Learning Objective 10-3 Compute and interpret the direct-material price and quantity variances and the direct-labor rate and efficiency variances. To illustrate the use of standards in managing costs, we will focus on a producer of fancy desserts located in the Washington, D.C., area. You might be surprised to learn that the fancy desserts available in a lot of restaurants are not actually made there. A pastry chef is a luxury that not all restaurants can afford. That is where DCdesserts.com comes in. DCdesserts.com supplies fresh and frozen desserts to a variety of restaurants, caterers, and upscale food stores. The company’s order-taking system is entirely Web-based. DCdesserts.com posts its menu of fresh fancy dessert products for each day on its website four days in advance of the delivery date. Orders are accepted via the Internet three days in advance of delivery. For example, the menu of desserts to be available for delivery on Friday afternoon is posted to DCdesserts.com’s website on Monday, and orders are accepted up to midnight on Tuesday. The company places orders for ingredients on Wednesday and accepts delivery on Thursday. DCdesserts.com’s ordering is also done largely via the Internet. Production then takes place throughout the day on Friday, and the desserts are delivered Friday afternoon. DCdesserts.com uses three independent delivery services to deliver its dessert products: Capital Couriers, Potomac Door-to-Door, and Washington Delivery Service. DCdesserts.com also produces frozen dessert products for upscale grocery stores. Unlike the fresh desserts, which vary daily, the frozen desserts are stock items that are varied less frequently. Like the fresh desserts, however, the frozen dessert menu is posted to DCdesserts.com’s website, and orders are accepted entirely via the Internet. The company produces its fresh fancy desserts and frozen desserts in two different production facilities, both located on the outskirts of central Washington, D.C. The production process for the fresh fancy desserts involves a combination of semiautomated equipment and manual labor. Even in this era of widespread automation, making fancy desserts still involves considerable direct labor. In the words of DCdesserts.com’s founder and owner, “making a Black Forest cake or a Linzer torte to be served in the U.S. Senate dining room is not the same as making your basic pumpkin pie. There’s a lot of touch labor by skilled people in doing these fancy desserts.” The basic steps in the production process are much as you might expect. These steps include selecting ingredients, mixing, baking, cooling, and finishing. The finishing work, of course, involves the most skilled direct labor. In making a six-layer chocolate raspberry cake, for example, each individual cake layer must be sliced into two pieces, and then fillings and icings are spread on each layer. The cake’s top is finished artistically, and any additional toppings are carefully applied. DCdesserts.com’s director of cost management has set standards for direct material and direct labor as follows for a category of dessert products generically referred to as multilayer fancy cakes. Direct-Material Standards The standard quantity and price of ingredients for one multilayer fancy cake, such as a Black Forest cake, are shown in the following table: Standard quantity: Ingredients in finished product ................................................................................................ Allowance for normal waste .................................................................................................... 4.75 pounds .25 pound Total standard quantity required per multilayer fancy cake ........................................................ 5.00 pounds Standard price: Purchase price per pound of ingredients (net of purchase discounts) ........................................ Transportation cost per pound ................................................................................................ $1.30 .10 Total standard price per pound of ingredients .......................................................................... $1.40 Chapter 10 Standard Costing and Analysis of Direct Costs The standard quantity of ingredients needed to produce one cake is 5 pounds, even though only 4.75 pounds actually remain in the finished product. One-quarter pound of ingredients is wasted as a normal result of the production process. Therefore, the entire amount of ingredients needed to produce a fancy cake is included in the standard quantity of material. The standard price of ingredients reflects all of the costs incurred to acquire the material and transport it to the plant. Notice that the cost of transportation is added to the purchase price. Any purchase discounts would be subtracted out from the purchase price to obtain a net price. To summarize, the standard direct-material quantity is the total amount of direct material normally required to produce one unit of finished product, including allowances for normal waste or inefficiency. The standard direct-material price is the total delivered cost, after subtracting any purchase discounts, of one direct-material unit. Notice that the standard price is expressed in the same units that are used to describe the standard quantity. At DCdesserts.com, standard direct-material quantity is expressed in pounds per unit, so standard direct-material price is expressed per pound. If a similar company were based in Paris, the quantity would be measured in kilograms per unit and the price would be expressed per kilogram (and in euros per kilogram, not dollars). Direct-Labor Standards The standard quantity and rate for direct labor for the production of one multilayer fancy cake are as follows: Standard quantity: Direct labor required per multilayer fancy cake .................................................................................... Standard rate: Hourly wage rate ............................................................................................................................... Fringe benefits (25% of wages) .......................................................................................................... $16 4 Total standard rate per hour ................................................................................................................ $20 .5 hour The standard direct-labor quantity is the number of direct-labor hours normally needed to manufacture one unit of product. The standard direct-labor rate is the total hourly cost of compensation, including fringe benefits. Standard Costs Given Actual Output During September, DCdesserts.com produced 2,000 multilayer fancy cakes. The total standard or budgeted costs for direct material and direct labor are computed as follows: Direct material: Standard direct-material cost per cake (5 pounds 3 $1.40 per pound) ............................................... Actual output ................................................................................................................................... $ 7 3 2,000 Total standard direct-material cost .................................................................................................... $14,000 Direct labor: Direct-labor cost per cake (.5 hour 3 $20.00 per hour) ..................................................................... Actual output ................................................................................................................................... $ 10 3 2,000 Total standard direct-labor cost ......................................................................................................... $20,000 Notice that the total standard cost for the direct-material and direct-labor inputs is based on DCdesserts.com’s actual output. The company should incur costs of $34,000 for direct material and direct labor, given that it produced 2,000 multilayer fancy cakes. The total standard costs for direct material and direct labor serve as the manager’s benchmarks against which to compare actual costs. This comparison then serves as the basis for controlling direct-material and direct-labor costs. 415 416 Chapter 10 Standard Costing and Analysis of Direct Costs Actual versus Budgeted Output: A Key Point The use of actual output in variance calculations is a common point of confusion for students. When DCdesserts.com prepared its budget, it estimated its costs of production based on its standard costs per unit and a forecast of the demand for its products. Suppose that DCdesserts.com’s demand forecast resulted in a budgeted production output of 2,200 multilayer fancy cakes in September. Based on that level of output, the September budget would have included the following costs: Direct material: Standard direct-material cost per cake (5 pounds 3 $1.40 per pound) .................................................... Forecast output .................................................................................................................................... $ 7 3 2,200 Total budgeted direct-material cost ........................................................................................................ $15,400 Direct labor: Direct-labor cost per cake (.5 hour 3 $20.00 per hour) .......................................................................... Forecast output .................................................................................................................................... $ 10 3 2,200 Total budgeted direct-labor cost ............................................................................................................. $22,000 But we know, from the prior section, that DCdesserts.com only produced 2,000 multilayer fancy cakes in September. Is it surprising that the budgeted output would differ from the actual output? Not really. After all, the current year’s budget was finalized almost a year earlier, late in the prior year! But while the costs in the budget were useful for planning, they are outdated for analyzing performance. DCdesserts.com should now compare actual costs to the standard cost for the actual output. For example, if DCdesserts.com compares its actual direct-material cost, reported by the accounting system to be $14,555 in September, against its budgeted direct-material cost, they will observe that the cost was $845 less than expected ($15,400 2 $14,555). Should DCdesserts.com conclude from this comparison that costs were effectively controlled? Of course not! It should not have cost as much to make 2,000 cakes as it would have cost to make 2,200 cakes. So, during cost variance analysis, we will update our expectation about the cost of production inputs to what it should have cost to make the actual output. We conclude that, because DCdesserts.com would have expected production of 2,000 cakes to cost $14,000 for direct material (not the $15,400 originally budgeted), direct-material costs were actually $555 more than expected in September ($14,555 2 $14,000). Analysis of Cost Variances During September, DCdesserts.com incurred the following actual costs for direct material and direct labor in the production of multilayer fancy cakes. Direct material used: actual cost 10,250 pounds at $1.42 per pound ............................................................... Direct labor: actual cost 980 hours at $21 per hour ......................................................................................... $14,555 $20,580 Compare these actual expenditures with the total standard costs for the production of 2,000 multilayer fancy cakes. DCdesserts.com spent more than the expected amount for both direct material and direct labor. When spending is higher than expected, the excess spending is called an unfavorable variance, abbreviated U. And when spending is lower than expected, the amount by which spending is less than planned is called a favorable variance (F). For DCdesserts.com, the overall direct-material variance is unfavorable ($14,555 2 $14,000 5 $555 U) and so is the overall direct-labor variance ($20,580 2 $20,000 5 $580 U). But why were these excess costs incurred? A manager would need to do additional analysis in order to answer this question. Cost variance analysis is the process of systematically comparing expected costs (standards) against actual costs, analyzing the Chapter 10 Projected Material Cost Actual Material Cost Standard Material Cost Actual Quantity Actual Price Actual Quantity Standard Price Standard Quantity Standard Price 10,250 pounds used $1.42 per pound 10,250 pounds used $1.40 per pound 10,000* pounds allowed $1.40 per pound $14,555 $14,350 $14,000 $205 Unfavorable $350 Unfavorable Direct-material price variance Direct-material quantity variance $555 Unfavorable Direct-material variance *Actual output Standard quantity per unit 2,000 units 5 pounds per unit 417 Standard Costing and Analysis of Direct Costs 10,000 pounds allowed. differences, and explaining significant deviations. We begin our systematic comparison by analyzing the variance in spending on direct material. Direct-Material Variances What caused DCdesserts.com to spend more than the anticipated amount on direct material? First, the company purchased ingredients at a higher price ($1.42 per pound) than the standard price ($1.40 per pound). Second, the company used more ingredients than the standard amount. The amount actually used was 10,250 pounds instead of the standard amount of 10,000 pounds, which is based on actual output of 2,000 multilayer fancy cakes. The financial planning and analysis system can identify both of these deviations from standards by computing a direct-material price variance and a direct-material quantity variance. The computation of these variances is depicted in Exhibit 10–2. Direct-Material Price Variance As illustrated in Exhibit 10–2, we compute the portion of the spending difference that is caused by a difference in the price of direct material by establishing a benchmark cost for the actual amount of material used, which we label the projected material cost. The deviation between the actual and projected material costs is caused by a difference in the price of material, and it is called the direct-material price variance. This can be seen in the formula for the direct-material price variance as follows: Direct-material price variance 5 (AQ 3 AP) 2 (AQ 3 SP) 5 AQ(AP 2 SP) where AQ 5 Actual quantity used AP 5 Actual price SP 5 Standard price DCdesserts.com’s direct-material price variance for September’s production of multilayer fancy cakes is computed as follows: Direct-material price variance 5 AQ(AP 2 SP) 5 10,250($1.42 2 $1.40) 5 $205 Unfavorable This variance is unfavorable, because the actual purchase price exceeded the standard price. Exhibit 10–2 Direct-Material Price and Quantity Variances