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Module 7: Standard costs for materials, labour, and variable overhead

Required reading

Chapter 10, pages 423-442, 449-456 (omit pages 451-452, Capacity Analysis for Management) Appendix 10A, pages 460-462

Overview
The focus of this module is standard cost analysis, a technique used by management to monitor and control the input costs and quantities of materials, labour, and variable overhead. After defining these terms, the textbook presents the concepts and computations related to standard costs for each of the inputs, along with a general model and examples of variance analysis. Computer illustration 7-1 shows you how to use a spreadsheet program to do an analysis of direct material mix- and-yield variances. (Note that the analysis of fixed overhead on pages 442-449 is covered in Module 8.)

Assignment reminder
Assignment 2 is due this week (see Course Schedule). Be sure to allocate time to complete and submit the assignment by the deadline. Assignment 3 (see Module 9) is due at the end of week 9. It is a good idea to take a look at it now in order to familiarize yourself with the requirements as you work through the next modules.

Topic outline and learning objectives

7.1 7.2 7.3 Standard costs Management by exception Setting standard costs A general model for variance analysis Explain the term management by exception and how it relates to standard costs. (Level 2) Explain how direct materials standards, direct labour, and variable overhead standards are set. (Level 1) Calculate the following variances and explain their significance: (Level 1) direct materials price and quantity variances direct labour-rate and efficiency variances mix-and-yield variances 7.4 Variable overhead variances Prepare a variable overhead performance report using the flexible budget to show both spending and efficiency variances. (Level 1) Explain how managers determine whether a variance constitutes an exception that requires their attention. (Level 2) List the advantages and disadvantages of using standard costs. (Level 1) Construct a worksheet to calculate the components of mix-and-yield variances. (Level 2)

7.5

Variance analysis and management by exception Advantages and disadvantages of standard costs Computer illustration 7.7-1: Mix-and-yield variances

7.6

7.7

Module summary Print this module

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7.1 Standard costs Management by exception

Learning objective

Explain the term management by exception and how it relates to standard costs. (Level 2)
LEVEL 2

This topic specifies two types of standards in the illustrations. The first is the usage standard such as units of time for labour or units of quantity for materials. The second is the associated cost standard such as the labour rate per hour or material price per kilogram. During a given period, the total standard cost of production is given by the formula: Standard total production cost = Production x Standard usage x Standard cost. For example, in a given situation where 3,000 units of goods have been produced, using 2 kg of raw materials per unit of output, when the price of raw materials is $4 per kg, the standard total cost of raw materials is as follows: Standard total cost of raw materials = 3,000 units x 2 kg per unit x $4 per kg = $24,000. Standard costs identify where actual costs or quantities differ from standard. Managers set levels of tolerance, so that when the difference between the actual cost and the standard is greater than the acceptable variance, the manager looks for the cause of the discrepancy. This is called management by exception. A wide range of businesses and various types of organizations use standard costs. The organization must have some capacity to forecast requirements, and there must be enough stability in the operation to justify the prediction being made. Without stability, standard costs can easily become irrelevant for management and accounting purposes.

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7.2 Setting standard costs

Learning objective

Explain how direct materials standards, direct labour, and variable overhead standards are set. (Level 1)
LEVEL 1

Setting standards is difficult. First, it is necessary to define the nature of the standard desired ideal or practical. Ideal standards allow for no machine breakdowns or work interruptions. These standards are sometimes used for management planning purposes such as evaluating present operations or assessing the potential of the competition. Practical standards are used for normal situations and are generally the standards referred to in this module. Practical standards provide reasonable costs for inventory valuation. They can be used for control and some planning decisions. The textbook reading deals with material, labour, and variable overhead standards, in that order.

Direct material standards

These standards are specified on a bill of materials. The standards consist of the standard price for direct materials and the standard quantity of direct materials used, also called usage. This information is usually presented to the accountant by design or production staff. For practical standards, the amounts contain an allowance for normal waste and rejects.

Direct labour standards

Standard hours are the most difficult standard to set. Sometimes industrial engineers can determine the standard hours by time and motion studies or work study investigations. Motivation and labour relations issues arise here. For office workers, the standard time is often determined by work sampling techniques. The labour rate can include fringe benefits costs, if these are treated as direct labour rather than overhead. Review Chapter 2 for an elaboration on this point. In practice, because wage rates are often set by the labour contract, the actual rate per hour could be used.

Variable overhead standards

The concept of a predetermined overhead rate was introduced in Module 2 and is briefly explained on pages 82-84 of the textbook. The predetermined overhead rate for variable overhead represents the standard. Notice that to become a standard cost per unit, the variable overhead rate is multiplied by the activity base per production unit. In some textbook examples, this multiplication is already done, in which case it is called the standard variable overhead per unit of inventory (technically, per production unit).

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7.3 A general model for variance analysis

Learning objective

Compute the following variances and explain their significance: (Level 1) direct materials price and quantity variances direct labour rate and efficiency variances Mix-and-yield variances
LEVEL 1

Variance calculations are an important part of this module. It is important to note the timing of the material variance calculation and the order of calculation of price and quantity variances. The complex part of the calculation is the standard quantity allowed for the actual output produced. The difference between the actual output and the planned (or predicted) output is made by using actual production, specified in units, multiplied by the standard quantity per production unit. Process costing systems can also use standard costing to cost products. Using this method, equivalent unit costs are based on a predetermined standard cost. Actual production is measured using the FIFO method. (Refer to Module 3 and Chapter 4, for a review of the FIFO calculation.) The following example is based on Exercise 10-11 on page 469.
Example 7.3-1: Sonne Company variance analysis

Sonne Company variance analysis

Standard quantity or hours Direct materials Direct labour 7.2 grams 0.4 hours Standard price or rate $2.50 per gram $10.00 per hour Standard cost $18.00 $ 4.00

The following activity was recorded during the most recent month:

1. 20,000 grams of material were purchased at a cost of $2.40 per gram. 2. All of the material purchased was used to produce 2,500 bottles of the perfume Whim. 3. 900 hours of direct labour time were recorded at a total labour cost of $10,800.
Required

a. Compute the direct materials price and quantity variances for the month. b. Compute the direct labour rate and efficiency variances for the month. To calculate the direct materials price and quantity variances for the month, you can use either the general variance model or the equations. Study the model first, then look at the equations. Part a Direct material variances

i) General variance model graphically

*2,500 units 7.2 g = 18,000 g

ii) Unfactored equations

Using the equations, you need to solve for [(AQ x AP) (AQ x SP)], the materials price variance, and for [(AQ x SP) (SQ x SP)], the materials quantity variance, as follows:

iii) Factored equation

As demonstrated in the textbook, these formulas can be further reduced as follows:

Regardless of which approach you use, the answer is the same. The total material variance is $3,000 unfavourable. This is made up of a $2,000 favourable price variance and a $5,000 unfavourable quantity variance. It is difficult to determine the cause of a total variance without determining the individual components of the variance. Taking appropriate management action depends on knowledge of the details. To continue with this exercise, look at the labour variances. The components of a labour variance are the labour rate (or price) variance and the efficiency variance. Begin with the more graphic general variance model and then calculate the variances using the equations. Part b Direct labour variances

i) General variance model graphically

* $10,800 / 900 hrs = $12 per hr ** 2,500 units 0.4 hrs = 1,000 hrs

ii) Unfactored equations

Using the equations, you need to solve for [(AH x AR) (AH x SR)], the labour rate variance, and for [(AH x SR) (SH x SR)], the labour efficiency variance, as follows:

iii) Factored equation

As demonstrated in the textbook, these formulas can be further reduced as follows:

Each of these approaches to the variance analysis gives the same result, but you may find one approach easier to work with than the others. In the factored equation approach, there are only two computations, whereas there are four computations in the unfactored equation approach and three in the general variance model. To see the difference, review the calculation of the materials variances in each approach. In the unfactored equation approach, (AQ x SP) is calculated twice once for the price variance and once for the quantity variance. In the general variance model, however, this computation is done just once. The general variance model is set up so that this computation is available to use for both the price and the quantity variance. In calculating the price variance, (AQ x SP) is the subtrahend that is, it is subtracted from the actual quantity at the actual price. In calculating the quantity variance, (AQ x SP) is the minuend that is, the standard quantity at the standard price is subtracted from it. The two variances are readily calculated by computing (AQ x SP) just once. Work with each of these approaches and find one that you prefer.

Activity 7.3-1 Basic direct materials and direct labour variance analysis This activity reinforces your understanding of the calculation of material and labour variances.

Mix-and-yield variances
Appendix 10A provides further analysis of the materials usage variance by introducing the mix-and-yield variances. These variances are calculated where the final product requires more than one type of direct material input. The input quantities of each ingredient and the final output can effect variances. To illustrate mix-and-yield variances, suppose that two materials, A and B, are required to make a product. Assume their standard unit prices are SPA and SPB, and that the materials can be mixed in different proportions when producing the product. The following is a variation of the formulas presented in the textbook:

where: AQA and AQB are the actual quantities of A and B used in production. SQ A and SQ B are the standard quantities of A and B for the units produced, using their standard proportions. (AQA SQ A ) and (AQB SQ B ) are the typical material quantity differences (before multiplying by their respective standard prices) discussed in the text. M A and M B are the actual total quantity of material used, in the proportions specified by the standard mix; that is, what should have been used of A and B had the standard mix been followed for the total quantity of material actually used. Review the example on pages 460-462, which suggests that material A was overused in the mix of materials A and B compared to the standard ($45 U). Material B was underused in the mix ($75 F). The shift in material mix seems to have caused an increased use of materials A and B, which, in turn, is reflected in the two unfavourable yield variances. Because of fluctuations in actual prices for materials, the actual unit prices for materials may be used in practice, rather than predetermined standard prices.

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7.4 Variable overhead variances

Learning objective

Prepare a variable overhead performance report using the flexible budget to show both spending and efficiency variances. (Level 1)
LEVEL 1

During analysis, variable overhead variances are usually divided into two categories: spending variances and efficiency variances. The following schedule summarizes the two variable overhead variances:

These totals can be broken down to show the two variances for each component of variable overhead. For example, Exhibit 10-13 breaks variable overhead costs into indirect labour, lubricants, and power. (Fixed overhead variances are discussed in Module 8.) The overhead spending variance identifies the amount of variable overhead that was actually spent in comparison to what should have been spent. The actual base used, such as direct labour-hours, is the basis for the comparison. The overhead efficiency variance is the cost, in terms of budgeted variable overhead, of inefficiently using the base (such as direct labour-hours or machine-hours). Each unit of base used changes the variable overhead. An efficiency variance is not possible if a standard base is not calculated (for example, if production units are the activity base). Flexible budgets can also be used by companies that employ activity-based costing.

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7.5 Variance analysis and management by exception

Learning objective

Explain how managers determine whether a variance constitutes an exception that requires attention. (Level 2)
LEVEL 2

What is an exception? In other words, when should a variance be investigated? These questions are difficult to answer. They are the equivalent of asking in financial accounting: what is a material amount? There is always a tradeoff between the cost of investigating the variance and the cost of running the system "out of control." (In statistics, the tradeoff question is studied in the topic of Type I and Type II errors in hypothesis testing.) The statistical control chart (Exhibit 10-15) illustrates the concept of variance. While some variance is tolerable, a statistical control chart helps to identify those variances that are unusual. Ideally, managers take from 30 to 50 observations to determine any significant deviation from the standard. Because responsibility for the variance may be difficult to assess accurately, managers should also consider the behavioural aspect of variance analysis. To avoid behavioural problems, responsibility must be very carefully assessed. If a person feels wrongly blamed for a variance, avoidance and revenge are common reactions that can have negative implications for the company.

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7.6 Advantages and disadvantages of standard costs

Learning objective

List the advantages and disadvantages of using standard costs. (Level 1)

LEVEL 1

The advantages and disadvantages of standard costs are important for systems design work. They help to determine whether a standard cost system is appropriate. Pages 455-456 in the textbook discuss the advantages and potential problems that can be encountered with the use of a standard costing system. The use of a standard cost system presents advantages in that it allows managers to react only to the significant changes in cost behavior increases potential for promoting efficiency and effectiveness of process and work increases potential for improving the bookkeeping related to cost recording, and makes responsibility accounting transparent, and therefore easier to implement and control. The use of a standard cost system also presents some disadvantages; it can give rise to erroneous reports when the system is improperly designed or data used to generate reports is not updated properly create potential for undesired manipulations of variances result in procedure errors when assumptions are not properly defined provide useless data when used in environments in which the use of standard costing is not the best alternative require additional performance measures to help overcoming the tendency of over relying on meeting standards as a measure of performance, and lead some managers to focus on just meeting standards instead of continuous improvement. Many of the problems around using standard costs focus on their design. Care must be taken in the creation of standard costs to ensure that variance analysis provides meaningful information. The variance analysis needs to identify controllable issues. The analysis should also identify the base problem. Out-of-ordinary variances should trigger further analysis, especially when the variances have been attained at the expense of quality. Note the caution about dwelling on the negative aspects of performance.

Chapter summary
This topic marks the end of the textbook coverage of standard costs. To ensure you understand this material and the corresponding terminology, read the summary on page 457, work through the review problem on pages 457-460. (Note that fixed overhead analysis is covered in Module 8.)

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7.7 Computer illustration 7.7-1: Mix-and-yield variances

Learning objective

Construct a worksheet to calculate the various components of mix-and-yield variances. (Level 2)

LEVEL 2

Chapter 10 of the textbook describes how managers control costs through the use of standard costs and variance analysis. They generally use three types of standard costs direct material, direct labour, and variable overhead. This computer illustration demonstrates the derivation of standard direct material costs and the analysis of direct material variances using the extended model Exhibit 10-17 in Appendix 10A.

Material provided
A partially completed worksheet M7P1 A completed solution worksheet M7P1S

Description
The product Omega is made from three secret ingredients called Alpha, Beta, and Gamma. The materials are mixed in the following standard proportions to produce 100 litres of Omega:
Material Alpha Beta Gamma Quantity 80 litres 40 litres 30 litres Cost per litre $ 2.00 4.00 10.00

It takes 50 hours of direct labour at $15 per hour to produce 100 litres of Omega. Average monthly production and sales has been 200,000 litres of Omega. (Actual direct labour: 91,000 hours costing $1,380,000.) Last month, the company produced 175,000 litres of Omega using the following resources:
Material Alpha Beta Gamma Quantity 159,000 72,000 44,000 275,000 Cost $323,565 290,102 435,000 1,048,667

Required

a. Compute the 1. 2. 3. 4.

following variances: Material price variance Material usage variance Material mix variance Material yield variance

b. The supervisor of the Omega product line argues that workers were operating at standard, if not better, despite a large unfavourable labour efficiency variance of $52,500. Is the supervisor correct? Why or why not? Answer Requirement 1 by completing the worksheet M7P1. Answer Requirement 2 manually.

Procedure
Requirement 1 1. Open the file MA1M7P1. 2. Click the sheet tab M7P1 and study the layout of the worksheet. Rows 5 to 14 contain the data provided in the problem statement. Rows 16 to 49 contain a template that you will complete by entering the necessary formulas. 3. Following the extended model given in Exhibit 10-5, enter the required formulas to calculate the price variance in cells B19 to B21, D19 to D21, and E19 to E21. For example, cell B19 should contain the actual total material cost of product Alpha. This is found in cell E9. So enter +E9 in this cell. The formulas in row 22 have been pre-entered for you. Study the formula in cell E22, which uses the IF function to cross check the price variance calculations. 4. Enter in cell B25 the formula for the total standard amount of litres of input. In other words, given the standard quantity of materials required to produce one litre of Omega, calculate the total number of litres of inputs that should have been used to produce 175,000 litres of Omega. 5. Enter the necessary formulas in cells B29 to B31, D29 to D31, and E29 to E31 to calculate the total usage variance. The usage variance compares the standard cost of the actual quantity of inputs with the standard cost of the standard quantity of inputs. As an example of the latter, the formula in cell D29 should calculate the proportion of Alpha to total inputs required to produce one litre of Omega (the standard mix) multiplied by the total standard litres of inputs required to produce 175,000 litres of Omega (calculated in cell B25). This is the standard usage at standard mix. Multiply the result by the standard cost per litre for Alpha. This formula can then be copied to cells D30 and D31, assuming you used the appropriate absolute cell references. 6. Enter in cells B38 to B40 the cell references for the actual quantities and in cells C38 to C40 the formulas to calculate the actual quantity at the standard mix. In other words, you are comparing the proportion of each input used in producing 175,000 litres of Omega with the proportion of each input that should have been used (given the standard). 7. Calculate the yield variance by entering appropriate formulas in row 48. In cell C48, calculate the quantity of output that should have been produced given the quantity of inputs used (using the standard as a base). 8. Save your completed worksheet. 9. Print a copy of the completed worksheet and compare it with the solution worksheet M7P1S. 10. If you do not obtain the same results as in the worksheet M7P1S, print a copy of the formulas from your worksheet. Compare the formulas you entered with those in the solution worksheet. Correct any discrepancies.
Conclusion

Note that all variances in brackets reference unfavourable variances. Similarly, all variances that are positive are favourable variances. The usage variance is $39,000 Favourable. This usage variance is made up of a favourable mix variance and an unfavourable yield variance.

The detail of the usage variance gives management better insight into the situation. These variances should be carefully examined to determine why they occurred. This deviation from the standard mix appears to have negatively affected the yield variance. Requirement 2 Labour efficiency variance:

Part of actual labour hours were used to transform the materials that became part of the output yield loss. That amount is equal to: 1/2 hour 8,333 litres $15 = $62,500 U Therefore, the production foreman is correct in arguing that his workers are operating better than standard. Source: Ray H. Garrison, Eric W. Noreen, G.R. Chesley, and Raymond F. Carroll, Solutions Manual to accompany Managerial Accounting , Sixth Canadian Edition. Copyright 2004, by McGraw-Hill Ryerson Limited. Problem 10-21 Reproduced with permission.

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Module 7 summary
Module 7 addresses the concepts of management control and performance evaluation. Topic 7.1 deals with the need for standards in various activities and introduces the concept of management by exception. This concept consists of investigating and possibly taking action when the actual results vary significantly from these standards. Topic 7.2 discusses the standard setting for the three components of a product cost direct materials, direct labour, and variable overhead and Topic 7.3 proceeds with variance analysis of direct materials and direct labour. Topic 7.4 discusses the variable overhead spending and efficiency variances. Not all variances require management's attention. Topic 7.5 deals with those variances that are material and therefore require action, while Topic 7.6 evaluates the usage of standard cost. Finally, Topic 7.7 accounts for direct material mix-and-yield variances and relates the analysis to performance evaluation.