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Standard Cost Systems

A Common Scenario

Mike manages a production facility for Amalgamated Widgets, Inc. Under him are the following departments: purchasing, production, warehousing and shipping, maintenance and security. Mike gets a bonus each year, depending on how well he manages the production facility. He also has the authority to give bonuses to employees working under him when they meet or exceed performance goals.

Mike, and his management team, use a standard cost system. They have determined the quantities possible, and the cost components of their products,  under normal conditions. Costs are divided into the following categories: Direct Materials, Direct Labor and Factory Overhead. The factory incurs no Selling or G&A (General and Administrative) expenses. All their costs relate to producing products.

A product's standard cost, is what it should cost to make the product. At the start of each month a production budget is prepared, using standard costs and estimated production quantities. At the end of each month a variance report is prepared to compare the production budget with the actual quantities and costs of production.

The variance report tells Mike and his managers how well they did at achieving their budget goals. A favorable variance shows that actual costs are less than budgeted (standard) costs. An unfavorable variance is just the opposite - actual costs are greater than budgeted costs.

By using a budget the management team can estimate their future costs and cash needs, plan production, schedule employees, coordinate materials purchases, reduce waste, increase production efficiency and meet shipping deadlines. Variances help the managers identify specific areas where they came in either over or under budget. They will try to repeat their successes and eliminate their failures. Each month they hope to become a little more efficient.

The budgets will be used to evaluate Mike and his managers. Their annual bonuses will depend on how well they meet their budget goals. Managers who consistently produce unfavorable variances will probably be replaced. We ask a few questions and answer them by using relevant variances. How well did management (managers) do:

  • buying and using materials to make products?
  • scheduling employee time and motivating employees to be efficient?
  • controlling factory overhead costs?

Variances

  1. Total Materials Variance
    1. Materials Price Variance
    2. Materials Quantity Variance
  2. Total Labor Variance
    1. Labor Rate Variance
    2. Labor Efficiency Variance
  3. Variable Overhead Variance
  4. Fixed Overhead Variance

Variances and Standard Costs are entered into the accounting records using journal entries. The use of standard costing systems greatly simplifies some accounting procedures. Standard costs are entered weekly or monthly. Variances are calculated and entered. Monthly production and income reports are prepared. Managers use current information to prepare budgets for the coming months.

Actual Costs
<- difference = variance ->
Standard Costs
$1200
<- $50 favorable variance ->
$1250

Actual costs are less than standard = favorable variance.

By breaking the total variance down into its component parts managers can pinpoint the cause of the variance. Sometimes a favorable variance in one area causes an unfavorable variance in another area. Managers should be alert to these possibilities.

For instance, there might be a favorable materials price variance, because lower cost materials were purchased. If the materials were of an inferior grade, there could be an increase in waste, giving rise to an unfavorable materials quantity variance. Additionally, more labor could be required to handle and deal with the inferior materials, giving rise to an unfavorable labor efficiency variance.

Don't be mislead by a small total variance. This example shows large favorable and unfavorable variances offsetting each other. This is not a sign of efficient or effective management.

quantity variance
$1000
favorable
price variance
(950)
unfavorable
total variance
$50
favorable

Changes in Costs

Variances can arise for a large number of reasons:

  • errors in estimating
  • mis-management of resources
  • unforeseen price changes
  • equipment breakdown
  • labor problems
  • poor planning
  • shortage of raw materials

Budgeting and Variance accounting presume that managers should fix problems, not bury or hide them. It also presumes that these problems are short term problems, and can be effectively controlled in the future.

Sometimes there is a change in actual costs that necessitates a change in standard costs. For instance, a new labor contract could increase total labor costs by a predictable amount. Standard labor costs should be re-calculated to reflect the new actual labor costs. Once a new standard cost is calculated, future variances will be correctly reflected in the monthly variance report. If standard costs are not updated periodically, the monthly reports can show unrealistic favorable or unfavorable variances.

The purpose of variances and budgeting is to give management an effective tool for controlling costs. But the system must be continually reviewed and kept up to date. This is also important, because standard costs and variances are entered into the books as journal entries, so they must be based on reliable underlying assumptions. These assumptions must pass the critical eye of the company's certified auditors, so they must be current and accurate.

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