Section 1.) Standard Costing - Overview
Last week we talked about the concept of budgeting. A company needs to generate a budget to be able to control and predict costs. This is also used to determine accountability for the various managers that are in charge of certain items. When setting standards, the first thing that needs to be considered is how they are going to be set in the first place. There are a variety of philosophies and methodologies for determining standards as discussed below.
Ideal Standard – This standard is set based on a perfect scenario of everything going according to plan. In other words, all machines work as expected at 100% capacity. Nothing ever breaks down. All staff are at full productivity 100% of the time; no one ever calling in sick or just slowing down a bit due to a bad day. All materials are always immediately available. Although this is certainly a challenging standard to set, it is very seldom going to be accomplished and as a result it could demotivate and demoralize staff.
Past Experience Standard – This standard is developed by using past actual results and adjusting them slightly upwards or downwards based on the desires and goals of management. This is actually a common standard, but it is not generally the best. Using prior results as a starting point means that any inefficiencies that existed in the prior year will still be in the current year’s standard. In other words, if the employees didn’t work very efficiently last year, why would we want to even use that as a starting point?
Attainable Standard – This method sets a challenging, yet attainable goal for the upcoming period. This considers that 100% perfection may not exist and that a reasonable amount of downtime should be expected for both human employees and machines. A challenging goal that is set will give something for employees to shoot for, while still motivating them to do their best.
Once the standards are set, the next step is to determine how the actual results are going to be compared to the budgeted results and who sees the results. The concept of responsibility reporting involves the creation of various layers within the company where lower-level managers report on their various activities to higher levels. In this way the information flows up to top management. Each manager is generally responsible for a set number of variances, and the goal is to reduce the unfavorable variances. Even though favorable variances are good, they should still be explained and taken into consideration when creating next year’s budget.
Although detail is important, it can quickly become overwhelming for the top-level management to see all of the details of every level beneath them. Certainly, they should have access to this information if they want it, but as a general rule, the performance reports that go to their level should start off with higher level summaries. This reflects a concept known as management by exception. This is the idea that management should focus only on the issues that are the exception, which in many cases means they are not going according to plan. Although this seems negative, the idea is that if something is going wrong, that is where management needs to focus their attention. Of course, it is good to know that other things went well, but they should not take up a significant amount of management’s time poring over details of why the other things went well.
Section 2.) Flexible Budgeting
When a budget is set, it is based on an expected activity level. For example, if a company had the capacity to produce 100,000 units, but was currently only producing 40,000 units, materials, labor, and overhead would be at a set amount less than what they would otherwise be at capacity. However, any fixed cost wouldn’t change regardless of whether the company was operating at capacity or significantly below it.
The budget that was set when activity level was expected to be 40,000 wouldn’t be relevant anymore if the actual activity level came in at 80,000 units. For example, assume that materials were expected to be $10 per unit. At 40,000 units, that would require $400,000 in materials. Let’s assume that the actual activity level came in at 80,000 units, and the actual total material cost came in at $750,000. If someone was just looking at the materials budgeted amount of $400,000 and compared it to the actual cost of $750,000, they may think that the manager in charge of that performed quite poorly. However, when they took a deeper dive, they would realize that with more units it makes sense that the cost budget should be set higher. In fact, in this case, the “flexible” budget would be $800,000. When they realize that, the actual cost of $750,000 looks fairly impressive.
This flexible budget concept reflects that a budget based on expected activity levels can be flexed to accommodate other higher or lower activity levels. This is due to the fact that the variable costs vary based on the activity levels. As long as you know the standard variable cost per unit and the number of actual units, you can determine the new “flexible” budgeted amounts. With fixed cost, assuming we are still operating within capacity, there should be no change from the original “static” budget.
Consider the below situation where a static budget has been set based on those 40,000 units. The actual units were at 80,000 units, in which case many of the costs would be expected to be higher. If variances are calculated, all of them would look unfavorable.
However, if a flexible budget is calculated to adjust the budgeted amount to what would be expected at this higher level, the true picture comes out. Many of the variances in this case are actually favorable. However, there are still a couple of variances that show up as unfavorable.
Section 3.) Variable Cost Variances
Budgets relate to the firm’s overall performance for all quantities of units. Standard costs are like a budgeted amount for one individual unit. Standards are broken down into two components: Quantity of input and Price per unit of input. By creating a standard expected amount for each item, we can then compare this to the actual quantity we have used or the actual price we paid for each unit. For example, if we were producing a chemical that is made up of two other chemicals, we expect to have to use a certain number of ounces of one material and we expect that each of those ounces costs us $x. If we find that we had to use more than the standard number of ounces, or if we had to pay more than the expected price per ounce, then we can make decisions based on this variance from the standard.
Total Budget Variance- This is the total variance for any particular cost component between actual and budgeted amounts. This is caused by two things:
The difference between actual and budgeted (standard) quantities of a particular input. This is sometimes referred to as the quantity, usage, or efficiency variance.
The difference between actual and budgeted (standard) unit costs. This is sometimes referred to as the price, rate, or spending variance.
To find a Quantity variance you take the following equation:
(Standard quantity allowed – Actual quantity used) multiplied by the Standard price per unit. Notice that you are focusing on the difference in the quantity, not the difference in the cost (if any.)
A simplified way of looking at this is:
SP * (AQ-SQ)
SP = This Standard Price is a per unit, rather than total price for everything. This is often given in the problem, but if it is not, then the problem would give you the total standard price and you would have to divide it by the total standard number of units.
AQ = This actual quantity is a total amount, and not an amount per unit. If it is not given in the problem, then you would have to take the actual pounds, hours, etc. per unit and multiply it by the actual number of units produced.
SQ = This standard quantity is a total amount, and not an amount per unit. This one is often NOT given in the problem. Assuming it is not, then you would have to take the standard pounds, hours, etc. per unit and multiply it by the actual number of units produced. It is easy to get this one confused, because you may think that a standard quantity should be entirely standard (per unit and number of units.) However, the standard quantity per unit must be multiplied by the actual number of units for the comparison to be relevant.
To find a Price variance you take the following equation:
(Standard price per unit – Actual price per unit) multiplied by the Actual quantity used.
A simplified way of looking at this is:
AQ * (AP-SP)
SP = This Standard Price is a per unit, rather than total price for everything. This is often given in the problem, but if it is not, then the problem would give you the total standard price and you would have to divide it by the total standard number of units.
AP = This Actual Price is a per unit, rather than total price for everything. This is often given in the problem, but if it is not, then the problem would give you the total actual price and you would have to divide it by the total actual number of units.
AQ = This actual quantity is a total amount, and not an amount per unit. If it is not given in the problem, then you would have to take the actual pounds, hours, etc. per unit and multiply it by the actual number of units produced.
Favorable versus Unfavorable Variances – Variances are always considered to be positive numbers (absolute values.) The determination of whether a variance is favorable or unfavorable depends on what type of activity you are looking at and whether it increased over budgeted amounts or decreased below it. For example, higher expenses than budget would be an unfavorable variance, whereas higher revenues would be favorable.
Materials Price Variance (MVP)
- If the MPV ends up being favorable, this could mean that either the purchasing manager did a good job at negotiating a lower-than-expected price, or it could mean that they purchased lower quality materials. The latter could harm production and potentially lead to a higher quantity being needed due to breakage.
Materials Quantity Variance (MQV)
- If the MQV ends up being favorable, this could mean that either the production manager did a good job at managing efficient usage of their materials, or it could mean that higher quality materials were purchased which makes it easier for the production staff to use them.
Labor Price Variance (LPV)
- If the LPV ends up being favorable, this could sometimes mean that lower skilled staff are being hired than expected. The problem is that could harm production if the employees aren’t fully trained. It may also lead to more hours being needed if they aren’t as efficient.
Labor Quantity Variance (LQV)
- If the LQV ends up being favorable, this could mean that higher skilled staff were hired that likely are paid more and are more efficient. Of course, the lower quantity of hours may be partially offset by the higher price per hour.
This below video goes through an example of variable analysis, as well as a version of the assignment for this week.
Variance Analysis Overview
Variance Analysis Exercise
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