April 28, 2014 - · PDF file · 2015-01-16Analysis & Standard Costs April 28, ... Standard Cost versus Actual Cost ! Variance Analysis ! ... above the Standard Cost of $1.67 would

McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Flexible Budgets, Variance Analysis & Standard Costs

April 28, 2014


Today’s Agenda

n  Variance Analysis

n  What is a Flexible Budget n  Flexible versus Static Budget

n  Shortcomings of Static Budgets

n  Advantages of Flexible Budgets

n  Building a Flexible Budget

n  Standard Costs


Variance Analysis Cycle

Conduct next period’s

operations

Identify questions

Receive explanations

Take corrective

actions

Analyze variances

Prepare standard cost performance

report

Begin


Characteristics of Flexible Budgets

n  Planning budgets are prepared for a single, planned level of activity.

n  Evaluation is difficult when actual activity varies from planned activity.

n  Flexible Budgets are prepared to provide an accurate budget for differing levels of output.

n  When comparing actual performance to budgeted performance at the actual level of output, we can better identify and isolate problem areas and areas which over performed


Flexible Budgets

May be prepared for any activity level within the relevant range.

Show costs that should have been incurred at the actual level of activity, enabling “apples to apples” cost comparisons.

Reveal variances related to cost control.

Improve performance evaluation.


Planning ActualBudget Results Variances

Number of lawns (Q) 500 550

Revenue 37,500$ 43,000$ 5,500$ FExpenses:

Wages and salaries 20,000$ 23,500$ 3,500$ UGasoline and supplies 4,500 5,100 600 UEquipment maintenance 1,500 1,300 200 FOffice and shop utilities 1,000 950 50 FOffice and shop rent 2,000 2,000 - Equipment Depreciation 2,500 2,500 - Insurance 1,000 1,200 200 U

Total expenses 32,500 36,550 4,050 UNet operating income 5,000$ 6,450$ 1,450$ F

Leong's Pool Cleaning ServiceFor the Month Ended March 31, 2014

Deficiencies of the Static Planning Budget

Leung’s Actual Results Compared with the Planning Budget


Creating a Flexible Budget

n  Establish the “relevant range” of activity n  Range in which fixed costs remain in place; i.e., no

requirement for stepped up investment (or step down)

n  Develop a cost function (mathematical equation) as to has each cost line item should behave based on differing activity levels

n  Calculate the budget for forecast activity


Preparing a Flexible Budget

Revenue/Cost FlexibleFormulas Budget

Number of pools (Q) 550

Revenue ($75Q) 41,250$ Expenses:

Wages and salaries ($5,000 + $30Q) 21,500$ Gasoline and supplies ($9Q) 4,950 Equipment maintenance ($3Q) 1,650 Office and shop utilities ($1,000) 1,000 Office and shop rent ($2,000) 2,000 Equipment depreciation ($2,500) 2,500 Insurance ($1,000) 1,000

Total expenses 34,600 Net operating income 6,650$

Leong Pool CleaningFor the Month Ended March 31, 2014

Leong’s Flexible Budget


Revenue and Spending Variances

Flexible budget revenue Actual revenue

The difference is a revenue variance.

Flexible budget cost Actual cost

The difference is a spending variance.


Revenue andRevenue/Cost Flexible Actual Spending

Formulas Budget Results Variances

Number of lawns (Q) 550 550

Revenue ($75Q) 41,250$ 43,000$ 1,750$ FExpenses:

Wages and salaries ($5,000 + $30Q) 21,500$ 23,500$ 2,000$ UGasoline and supplies ($9Q) 4,950 5,100 150 UEquipment maintenance ($3Q) 1,650 1,300 350 FOffice and shop utilities ($1,000) 1,000 950 50 FOffice and shop rent ($2,000) 2,000 2,000 - Equipment depreciation ($2,500) 2,500 2,500 - Insurance ($1,000) 1,000 1,200 200 U

Total expenses 34,600 36,550 1,950 UNet operating income 6,650$ 6,450$ 200$ U

Leong's Pool Cleaning ServiceFor the Month Ended March 31, 2014

Leong’s Flexible Budget Compared with the Actual Results

Revenue and Spending Variances

Spending variances


Standard Costs – Setting Cost Formulas for Flexible Budgets

n  What is Standard Cost and what is its purpose?

n  How are they set?

n  Direct Material Standard n  Direct Labour Standard n  Variable Overhead Standard

n  Standard Cost versus Actual Cost


n  Benefits and Problems with Standard Cost


Standard Costs

Standards are benchmarks or “norms” for measuring performance. In managerial accounting,

two types of standards are commonly used.

Quantity standards specify how much of an input should be used to

make a product or provide a service.

Price standards specify how much should be paid for each unit of the

input.

Examples: Firestone, Sears, McDonald’s, hospitals, construction, and manufacturing companies.


Standard Cost

n  Standard Costs are benchmark costs that management believes are appropriate for measuring performance

n  Quantity Standards n  How many units of an input should be used to produce a unit of

output n  E.g., it should take 20 minutes of Direct Labour to produce one

cell phone

n  Price Standards n  What is the appropriate price of a unit n  E.g., an hour of labour should cost $5

n  In this case, the Direct Labour Standard is .33 * 5, or $1.67 per unit


Standard Cost

n  Standard Cost information is used for several purposes:

n  Budgeting n  Build up of expected appropriate costs are input into budgets

n  Monitoring costs n  Budgets are tracked on a regular basis

n  Controlling costs n  With budgeted inputs in place, managers are incentivized to work

to and exceed targets

n  Isolating problems n  When compared to actual costs, it is helpful in identifying problem

areas and isolating the source


Variance

n  Deviations from Standard Cost are called “Variances”

n  Variances can be “Favourable” or “Unfavourable”

n  In the case of the cell phone manufacturer, any Direct Labour cost per unit which is n  above the Standard Cost of $1.67 would be described as an

Unfavourable Variance n  Below the Standard Cost of $1.67 would be described as a Favourable

Variance

n  Managers can focus in particular on Unfavourable Variances n  There could be a problem in the production process n  There could be a problem with the application of the methodology


Who Sets Standard Costs

n  Setting appropriate Standard Costs requires the input of several people n  Purchasing Managers

n  Pricing of Direct Materials n  Production Managers

n  Quantity of Direct Materials n  Required Labour

n  Engineers n  Optimizing processes and determining impact on Standard Cost

n  Accountants n  Verification n  Calculation and monitoring n  Exception reporting

n  As managers will be held to account for Variances, therefore Standard Costs should be “reasonable” and achievable (remember “Participating Budgeting Process”)

n  Additional incentive can be provided for reducing costs, designing out high value parts and processes, etc.


Product Costing, revisited

n  Product Costs n  Direct Labour n  Direct Materials n  Manufacturing Overhead

n  Variable n  Fixed

n  Flexible budgets require all variable costs to be separated from fixed costs

n  Recall “Absorption Costing” - included fixed and variable Manufacturing Overhead

n  Recall “Variable Costing” – included only Variable Overhead


Standard Costs – Direct Materials & Labour n  Direct Materials

n  Quantity Standard n  Quantity or each component required n  Lead times – impacts inventory financing costs (as

apposed to standard cost) n  Price Standard

n  Price of the components at the volume required n  Net of discounts, shipping etc. – “landed cost”

n  Direct Labour n  Time Standard

n  Time required from Direct Labour to “Convert” the Direct Materials into a Finished Product

n  Rate Standard


Setting Direct Materials Standards

Standard Price per Unit

Summarized in a Bill of Materials.

Final, delivered cost of materials, net of discounts.

Standard Quantity per Unit

•  What costs are included in “final, delivered” materials, net of discounts?

•  What is a “Bill of Materials”?


Setting Direct Labor Standards

Use time and motion studies for

each labor operation.

Standard Hours per Unit

Often a single rate is used that reflects the mix of wages earned.

Standard Rate per Hour


Standard Costs – Variable Manufacturing Overhead n  Variable Manufacturing Overhead

n  Price Standards n  Quantity Standards

n  The 3rd and final cost to address for Flexible Budgeting is Variable Manufacturing Overhead n  Think back to the POHR (Predetermined Overhead Rate) in

Product Costing n  We selected a basis for allocating Manufacturing Overhead

n  Eg, Overhead/Labour hour; or Overhead/Machine hours; etc. n The “Activity Base”

n  We will do something similar here, but applied only to Variable Overhead n  It is only the Variable portion of overhead that will “Flex”

with volume/output


Setting Variable Manufacturing Overhead Standards

The rate is the variable portion of the

predetermined overhead rate.

Price Standard

The quantity is the activity in the

allocation base for predetermined overhead.

Quantity Standard


The Measure of Activity– A Critical Choice

Three important factors in selecting an

activity base for an overhead flexible budget

Activity base and variable overhead

should be causally related.

Activity base should not be expressed

in dollars or other currency.

Activity base should be simple and

easily understood.


Standard Cost Card – Variable Production Cost

Standard Cost Card A A x B

Standard Standard StandardQuantity Price Cost

Inputs or Hours or Rate per Unit

Direct materials (pieces) 5 10.00$ per piece 50.00$ Direct labor (hours) 3 14.00 per hour 42.00 Variable mfg. Overhead (hours) 4 3.00 per hour 12.00 Total standard unit cost 104.00$

B

n  A Standard Cost Card is produced for each SKU


A General Model for Variance Analysis

Variance Analysis

Price Variance

Difference between actual price and standard price

Quantity Variance

Difference between actual quantity and standard quantity


Price Variance Quantity Variance

Actual Quantity Actual Quantity Standard Quantity × × × Actual Price Standard Price Standard Price

A General Model for Variance Analysis

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

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


General Variance Analysis Applied

n  Assumptions: n  Standard Rate = $104 n  Standard Quantity = 1,000 n  Actual Quantity = 900 n  Actual Cost = $100,080 n  What is the Price and quantity Variance?

General Variance AnalysisActual Quantity Actual Quantity Standard Quantity

900 900 1,000

Actual Price Standard Price Standard Price? 104 104

? ? ?

Price Variance: ? Quantity Variance: ?


General Variance Analysis Applied

n  Actual Rate = 900 units / $100,080 = $111.20 n  Price Variance = 93,600 – 100,080 = -$6,480 (unfavourable) n  Quantity Variance = 104,000 – 93,600 = $10,400 (favourable)

n  NOTE: Less quantity isn’t exactly “favourable” for the business, but it removes the difference due to volume and highlights the inefficiencies relative to budget


Detailed Variance Analysis

n  General Variance Analysis exposed unfavourable performance relative to budget

n  Applying the same analysis to the three components can isolate particular problems, which can then be addressed

n  The same formulas were applied for General Variance are applied to: n  Direct Materials n  Direct Labour n  Variable Manufacturing Overhead


Actual Costs

n  On completion of the accounting period, we can obtain actual costs

n  Actual costs are compared to Standard Costs to analyze and identify problem areas


Detailed Variance Analysis Applied – Direct Materials

n  Variance Analysis is applied in the same way for detailed accounts as it is in general n  Direct Materials, Direct Labour, Variable Overhead

n  If need be, we can “drill down” line by line into the Bill of Materials

n  Both Price and Quantity Variance are Unfavourable

n  Too many scrapped pieces?

n  Poor purchasing? Or supply shortage?


I am not responsible for this unfavorable materials

quantity variance. You purchased cheap material, so my people had to use more of it.

Your poor scheduling sometimes requires me to rush order materials at a

higher price, causing unfavorable price variances.

Responsibility for Materials Variances

Production Manager Purchasing Manager


Detailed Variance Analysis Applied – Direct Labour

n  Production manager upgraded to more costly, skilled labour which could work faster n  Labour quantity came down to 2 hours per unit from 3 hours per unit n  Quantity variance is hugely favourable

n  While price variance was unfavourable, the cost increase was justified by the decrease in quantity


Responsibility for Labour Variances

Production managers are usually held accountable

for labor variances because they can

influence the:

Mix of skill levels assigned to work tasks.

Level of employee motivation.

Quality of production supervision.

Quality of training provided to employees.

n  How would you rate this production manager’s performance?


I am not responsible for the unfavorable labor

efficiency variance! You purchased cheap

material, so it took more time to process it.

I think it took more time to process the

materials because the Maintenance

Department has poorly maintained your

equipment.

Possible Conflicts - Labour Variances


Detailed Variance Analysis Applied – Variable Manufacturing Overhead

n  Quantity variance is “favourable” only due to the reduced output n  Price variance is unfavourable, the cause of which needs to be investigated


Summary of Variances

n  The sum of the variances for each product cost equals the total variance n  Recall that in many accounting systems, it is Standard Costs which are charged to

Inventory and COGS accounts as products are produced

n  In these companies, Variance from Standard Costs will require adjustments to accounts

n  Fixed Costs – the same principles apply n  Inevitably, even within the relevant range, there will be variances in fixed costs n  In an Absorption Costing system, fixed costs may have been over or under

applied and need to be cleared


Cost Flows in a Standard Cost System

Inventories are recorded at standard cost. Variances are recorded as follows:

w  Favorable variances are credits, representing savings in production costs.

w  Unfavorable variances are debits, representing excess production costs.

Standard cost variances are usually closed out to cost of goods sold. w  Unfavorable variances increase cost of goods sold. w  Favorable variances decrease cost of goods sold.


Variance Analysis and Management by Exception

How do I know which variances to

investigate?

Larger variances, in dollar amount or as a percentage of the

standard, are investigated first.


Advantages of Standard Costs

Management by exception

Advantages

Promotes economy and efficiency

Simplified bookkeeping

Enhances responsibility

accounting


Potential Problems

Emphasis on negative may

impact morale.

Emphasizing standards may exclude other

important objectives.

Favorable variances may

be misinterpreted.

Continuous improvement may be more important

than meeting standards.

Standard cost reports may

not be timely.

Invalid assumptions about the relationship

between labor cost and output.

Potential Problems with Standard Costs


Review


n  What is a Flexible Budget n  Flexible versus Static Budget

n  Shortcomings of Static Budgets

n  Advantages of Flexible Budgets

n  Building a Flexible Budget

n  Standard Costs

Documents

April 28, 2014 - · PDF file · 2015-01-16Analysis & Standard Costs April 28, ... Standard Cost versus Actual Cost ! Variance Analysis ! ... above the Standard Cost of $1.67 would