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Prepared by:
Joy Solares-Torno
Valeriano A. Lugti


Course Objectives
To be able to understand
 Standard Costing Process
 Uses in the management of business
 Tools and practices for effective cost management

A standard is a benchmark or “norm” for measuring performance. In managerial accounting,

two types of standards are commonly used by manufacturing, service, food and not-for-profit
1. Quantity standards specify how much of an input should be used to make a product or
provide a service. For example:
a. Auto service centers like Firestone and Sears set labor time standards for the
completion of work tasks.
b. Fast-food outlets such as McDonald’s have exacting standards for the quantity of
meat going into a sandwich.
2. Price standards specify how much should be paid for each unit of the input. For
a. Hospitals have standard costs for food, laundry, and other items.
b. Home construction companies have standard labor costs that they apply to sub-
contractors such as framers, roofers, and electricians.
c. Manufacturing companies often have highly developed standard costing systems
that establish quantity and price standards for each separate product’s material,
labor and overhead inputs. These standards are listed on a standard cost card.

To establish the standard cost of producing a product, it is necessary to establish standards for
each manufacturing cost element—
 direct materials,
 direct labor, and
 manufacturing overhead

The standard for each element is derived from the standard price to be paid and the standard
quantity to be used.

Management by exception is a system of management in which standards are set for various
operating activities, with actual results compared to these standards. Any deviations that are
deemed significant are brought to the attention of management as “exceptions.”
This chapter applies the management by exception principle to quantity and price standards with
an emphasis on manufacturing applications.

Variance Analysis Cycle

The variance analysis cycle is a continuous process used to identify and solve problems:

1. The cycle begins with the preparation of standard cost performance reports in the
accounting department.
2. These reports highlight variances that are differences between actual results and what
should have occurred according to standards.
3. The Variances raise questions such as:
a. Why did this variance occur?
b. Why is this variance larger than it was last period?
4. The significant variances are investigated to discover their root causes.
5. Corrective actions are taken.
6. Next period’s operations are carried out and the process is repeated.

Setting Standard Costs

 Requires input from all persons who have responsibilities for costs and quantities
 Standard costs need to be current and should be under continuous review

Standards tend to fall into one of two categories:

1. Ideal standards can only be attained under the best of circumstances. They allow for no
work interruptions and they require employees to work at 100% peak efficiency all of the
2. Practical standards are tight, but attainable. They allow for normal machine downtime
and employee rest periods and can be attained through reasonable, highly efficient efforts
of the average worker. Practical standards can also be used for forecasting cash flows
and in planning inventory.

Setting Direct Material Standards

Direct materials price standard - The standard price per unit for direct materials should reflect the
final, delivered cost of the materials, net of any discounts taken.

Direct materials quantity standard - 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.
A bill of materials is a list that shows the quantity of each type of material in a unit of
finished product.

Setting Direct Labor Standards

Direct labor rate standard - The standard rate per hour for direct labor includes not only wages
earned but also fringe benefits and other labor costs. Many companies prepare a single rate for
all employees within a department that reflects the “mix” of wage rates earned.

Direct labor time standard - The standard hours per unit reflects the labor hours required to
complete one unit of product. Standards can be determined by using available references that
estimate the time needed to perform a given task, or by relying on time and motion studies.

Setting Variable Manufacturing Overhead Standards

Variable manufacturing overhead rate standard - The price standard for variable manufacturing
overhead comes from the variable portion of the predetermined overhead rate.

Variable manufacturing overhead quantity standard - The quantity standard for variable
manufacturing overhead is expressed in either direct labor hours or machine hours depending on
which is used as the allocation base in the predetermined overhead rate.

Price and quantity standards are determined separately for two reasons:

1. Different managers are usually responsible for buying and for using inputs. For example:
The purchasing manager is responsible for raw material purchase prices and the
production manager is responsible for the quantity of raw material used.
2. The buying and using activities occur at different points in time. For example: Raw
material purchases may be held in inventory for a period of time before being used in


Differences between standard prices and actual prices and standard quantities and actual
quantities are called variances. The act of computing and interpreting variances is called
variance analysis.

Price and quantity variances can be computed for all three variable cost elements – direct
materials, direct labor, and variable manufacturing overhead – even though the variances have
different names as shown.
 Materials price/quantity variance
 Labor rate/efficiency variance
 VOH rate/efficiency variance

A General Model for Variance Analysis

Although price and quantity variances are known by different names, they are computed exactly
the same way (as shown on the slide) for direct materials, direct labor, and variable
manufacturing overhead.

Actual Quantity Actual Quantity Standard Quantity

Actual Price Standard Price Standard Price

Price Variance

Actual Quantity Actual Quantity

Actual Price Standard Price

Quantity Variance

Actual Quantity Standard Quantity

Standard Price Standard Price

The actual quantity represents the amount of direct materials, direct labor, and variable
manufacturing overhead actually used.

The standard quantity represents the standard quantity allowed for the actual output of the

The standard quantity represents the standard quantity allowed for the actual output of the

The actual price represents the actual amount paid for the input used.

The standard price represents the amount that should have been paid for the input used.

In equation form, price and quantity variances are calculated as shown.

Price Variance Quantity Variance

(AQ × AP) – (AQ × SP) (AQ × SP) – (SQ × SP)

AQ=Actual Quantity SP=Standard Price
AP=Actual Price SQ=Standard Quantity

Total Variance

(AQ × AP) – (SQ × SP)

AQ=Actual Quantity SP=Standard Price
AP=Actual Price SQ=Standard Quantity

Analyzing and Reporting Variances

When actual costs exceed standard costs, the variance is unfavorable.

When actual costs are less than standard costs, the variance is favorable.

To interpret properly the significance of a variance, you must analyze it to determine the
underlying factors. Analyzing variances begins by determining the cost elements that comprise
the variance.


 The standard material for one ingot is 2 pounds of copper at $2.00 per pound.
 During the period the company made 1,000 ingots.
 The company actually used 1,950 pounds of copper costing $1.75 per pound.
 What are the direct material variances?

AQ X AP = X1
1950 x $1.75 = $3,412.50
$487.50 Favorable Price
AQ x SP = X2
1950 x $2.00 = $3,900.00

AQ X AP = X1
1950 x $1.75 = $3,412.50

AQ x SP = X2 $487.50 Favorable Price

1950 x $2.00 = $3,900.00

$100 Favorable Quantity

SQ x SP = X3
2000 x $2 = $4,000.00

Responsibility for Material Variances

The purchasing manager and production manager are usually held responsible for the materials
price variance and materials quantity variance, respectively. The standard price is used to
compute the quantity variance so that the production manager is not held responsible for the
performance of the purchasing manager.

Responsibility for Labor Variances

Labor variances are partially controllable by employees within the Production Department. For
example, production managers/supervisors can influence:

 The deployment of highly skilled workers and less skilled workers on tasks consistent
with their skill levels.
 The level of employee motivation within the department.
 The quality of production supervision.
 The quality of the training provided to the employees.

Advantages of Standard Costs

Research has shown that a substantial portion of companies in the United Kingdom, Canada,
Japan, and the United States use standard cost systems. This is because standard cost systems
offer many advantages including:
 Standard costs are a key element of the management by exception approach which helps
managers focus their attention on the most important issues.
 Standards that are viewed as reasonable by employees can serve as benchmarks that
promote economy and efficiency.
 Standard costs can greatly simplify bookkeeping.
 Standard costs fit naturally into a responsibility accounting system.

Potential Problems with Standard Costs

The use of standard costs can also present a number of problems. For example:
 Standard cost variance reports are usually prepared on a monthly basis and are often
released days or weeks after the end of the month; hence, the information can be
 If variances are misused as a club to negatively reinforce employees, morale may suffer
and employees may make dysfunctional decisions.
 Labor variances make two important assumptions. First, they assume that the production
process is labor-paced; if labor works faster, output will go up. Second, the computations
assume that labor is a variable cost. These assumptions are often invalid in today’s
automated manufacturing environment where employees are essentially a fixed cost.
 In some cases, a “favorable” variance can be as bad or worse than an unfavorable
 Excessive emphasis on meeting the standards may overshadow other important
objectives such as maintaining and improving quality, on-time delivery, and customer
 Just meeting standards may not be sufficient; continual improvement using techniques
such as Six Sigma may be necessary to survive in a competitive environment.

Delivery Performance Measures

Delivery cycle time is the elapsed time from when a customer order is received to when the
completed order is shipped.

Throughput (manufacturing cycle) time is the amount of time required to turn raw materials into
completed products. This includes process time, inspection time, move time, and queue time.
Process time is the only value-added activity of the four times mentioned.

Manufacturing cycle efficiency (MCE) is computed by dividing value-added time by

manufacturing cycle (throughput) time. An MCE less than one indicates that non-value-added
time is present in the production process.

Next, we will look at a series of questions dealing with delivery performance measures.


Balanced Scorecard Basics

It was originated by Drs. Robert Kaplan (Harvard Business School) and David Norton as a
performance measurement framework that added strategic non-financial performance measures
to traditional financial metrics to give managers and executives a more 'balanced' view of
organizational performance. While the phrase balanced scorecard was coined in the early 1990s,
the roots of the this type of approach are deep, and include the pioneering work of General
Electric on performance measurement reporting in the 1950’s and the work of French process
engineers (who created the Tableau de Bord – literally, a "dashboard" of performance measures)
in the early part of the 20th century.

The balanced scorecard incorporates financial and nonfinancial measures in an integrated

system that links performance measurement and a company’s strategic goals. Importantly, the
measures included in a company’s balanced scorecard are unique to its specific strategy.

The balanced scorecard enables top management to translate its strategy into four groups of
performance measures – financial, customer, internal business processes, and learning and
growth – that employees can understand and influence.

Example of Balanced Scorecard


The balanced scorecard suggests that we view the organization from four perspectives, and to
develop metrics, collect data and analyze it relative to each of these perspectives:

The Financial Perspective - covers the financial objectives of an organisation and allows
managers to track financial success and shareholder value.

 Uses traditional tools and reports

 Include additional financial-related data, such as risk assessment and cost-benefit data, in
this category

 Emphasizes growth and improvement

 Links financial performance to strategy

The Customer Perspective - covers the customer objectives such as customer satisfaction,
market share goals as well as product and service attributes.

 Management increasing realization of the importance of customer focus and customer

satisfaction in any business
 If customers are not satisfied, they will eventually find other suppliers that will meet their

 Poor performance from this perspective is thus a leading indicator of future decline, even
though the current financial picture may look good

The Internal Business Perspective - covers internal operational goals and outlines the key
processes necessary to deliver the customer objectives.

This perspective refers to internal business processes. Metrics based on this perspective allow the
managers to know how well their business is running, and whether its products and services
conform to customer requirements (the mission). These metrics have to be carefully designed by
those who know these processes most intimately; with our unique missions these are not
something that can be developed by outside consultants.

 Focus on process improvement

 Chose processes aligned with strategy

 Identify customer need

 Identify the market

 Create the product/service offering

 Build the products/services

 Deliver the products/services

 After-sale customer service

 Customer need satisfied

The Learning & Growth Perspective - covers the intangible drivers of future success such as
human capital, organisational capital and information capital including skills, training,
organisational culture, leadership, systems and databases.

This perspective includes employee training and corporate cultural attitudes related to both
individual and corporate self-improvement. In a knowledge-worker organization, people -- the
only repository of knowledge -- are the main resource. In the current climate of rapid
technological change, it is becoming necessary for knowledge workers to be in a continuous
learning mode. Metrics can be put into place to guide managers in focusing training funds where
they can help the most. In any case, learning and growth constitute the essential foundation for
success of any knowledge-worker organization.

Kaplan and Norton emphasize that 'learning' is more than 'training'; it also includes things like
mentors and tutors within the organization, as well as that ease of communication among
workers that allows them to readily get help on a problem when it is needed. It also includes
technological tools; what the Baldrige criteria call "high performance work systems."

 Core measurements
 Employee productivity

 Employee satisfaction

 Employee retention

 Enablers

 Staff competencies

 Technology infrastructure

 Climate for action/change

From Measurement Dashboards to Strategy Maps

When it was first introduced the Balanced Scorecard perspectives were presented in a four-box
model (see Figure above). Early adopters created Balanced Scorecards that were primarily used
as improved performance measurement systems and many organisations produced management
dashboards to provide a more comprehensive at a glance view of key performance indicators in
these four perspectives.

However, this four box model has now been superseded by a Strategy Map (see Figure below for
the generic template), which is at the heart of modern Balanced Scorecards. A Strategy Map

places the four perspectives in relation to each other to show that the objectives support each

Cause-and-Effect Logic

A Strategy Map highlights that delivering the right performance in the one perspective (e.g.
financial success) can only be achieved by delivering the objectives in the other perspectives
(e.g. delivering what customers want). You basically create a map of interlinked objectives. For

 The objectives in the Learning and Growth Perspective (e.g. developing the right
competencies) underpin the objectives in the Internal Process Perspective (e.g. delivering
high quality business processes).
 The objectives in the Internal Process Perspective (e.g. delivering high quality business
processes) underpin the objectives in the Customer Perspectives (e.g. gaining market
share and repeat business).

 Delivering the customer objectives should then lead to the achievement of the financial
objectives in the Financial Perspective.

Strategy maps therefore outline what an organisations wants to accomplish (financial and
customer objectives) and how it plans to accomplish it (internal process and learning and growth
objectives). This cause-and-effect logic is one of the most important elements of best-practice
Balanced Scorecards. It allows companies to create a truly integrated set of strategic objectives
on a single page.

The danger with the initial four-box model was that companies can easily create a number of
objectives and measures for each perspective without ever linking them. This can lead to silo
activities as well as a strategy that is not cohesive or integrated.

A balanced scorecard, whether for an individual or the company as a whole, should have
measures that are linked together on a cause-and-effect basis. Each link can be read as a
hypothesis in the form “If we improve this performance measure, then this other performance
measure should also improve.” In essence, the balanced scorecard lays out a theory of how a
company can take concrete actions to attain desired outcomes. If the theory proves false or the
company alters its strategy, the measures within the scorecard are subject to change.

What are the Key Benefits of using Balanced Scorecards?

Research has shown that organisations that use a Balanced Scorecard approach tend to
outperform organisations without a formal approach to strategic performance management. The
key benefits of using a BSC include (see Figure below):

1. Better Strategic Planning – The Balanced Scorecard provides a powerful framework for
building and communicating strategy. The business model is visualised in a Strategy Map
which forces managers to think about cause-and-effect relationships. The process of
creating a Strategy Map ensures that consensus is reached over a set of interrelated
strategic objectives. It means that performance outcomes as well as key enablers or
drivers of future performance (such as the intangibles) are identified to create a complete
picture of the strategy.
2. Improved Strategy Communication & Execution – The fact that the strategy with all
its interrelated objectives is mapped on one piece of paper allows companies to easily
communicate strategy internally and externally. We have known for a long time that a
picture is worth a thousand words. This ‘plan on a page’ facilities the understanding of
the strategy and helps to engage staff and external stakeholders in the delivery and review
of strategy. In the end it is impossible to execute a strategy that is not understood by
3. Better Management Information – The Balanced Scorecard approach forces
organisations to design key performance indicators for their various strategic objectives.
This ensures that companies are measuring what actually matters. Research shows that
companies with a BSC approach tend to report higher quality management information

and gain increasing benefits from the way this information is used to guide management
and decision making.
4. Improved Performance Reporting – companies using a Balanced Scorecard approach
tend to produce better performance reports than organisations without such a structured
approach to performance management. Increasing needs and requirements for
transparency can be met if companies create meaningful management reports and
dashboards to communicate performance both internally and externally.
5. Better Strategic Alignment – organisations with a Balanced Scorecard are able to better
align their organisation with the strategic objectives. In order to execute a plan well,
organisations need to ensure that all business and support units are working towards the
same goals. Cascading the Balanced Scorecard into those units will help to achieve that
and link strategy to operations.
6. Better Organisational Alignment – well implemented Balanced Scorecards also help to
align organisational processes such as budgeting, risk management and analytics with the
strategic priorities. This will help to create a truly strategy focused organisation.

These are compelling benefits; however, they won’t be realised if the Balanced Scorecard is
implemented half-heartedly or if too many short cuts are taken during the implementation.


The idea of the Balanced Scorecard is simple but extremely powerful if implemented well. As
long as you use the key ideas of the BSC to (a) create a unique strategy and visualise it in a
cause-and-effect map, (b) align the organisation and its processes to the objectives identified in
the strategic map, (c) design meaningful key performance indicators and (d) use them to
facilitate learning and improved decision making you will end up with a powerful tool that
should lead to better performance.

Capital Budgeting and Financial Statement Analysis – Comprehensive Exam Topics

Reference Materials:

Managerial Accounting 13th Edition by Garrison, Noreen, Brewer

Managerial accounting 5th Edition by Kieso, Weygandt, Kimmel