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Chapter Twelve
Standard Costs:
Direct Labor and
Materials
McGraw-Hill/Irwin
Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.
Connection to Other Chapters
Chapter 12 shows how standard costs and
variances are used for decision control.
Chapter 4 discussed the decision control
process.
Chapter 6 showed how budgets are used in
decision control.
12-2
Standard Cost
Definition: The expected cost that is reasonably
required to achieve a given objective under specified
conditions.
Used for Decision Management:


Standards can be better predictors of future costs than actual
past costs.
Can be used in product pricing, bidding, and outsourcing
decisions.
Used for Decision Control:


Set performance expectations or benchmarks for the costs of
products, processes, or sub-components.
Variances from standards get attention of managers.
12-3
Setting and Revising Standards
Setting standards depends on specialized knowledge.


Price standards from economic forecasts
Quantity standards from engineering studies
Choosing between tight and loose standards


Tight standards motivate higher performance (decision
control).
Loose standards allow more discretion (decision
management).
Standards are usually set once a year.

Frequent revision would reduce incentives to control
costs.
12-4
Target Costing
Target costing is a technique used for new product
planning.
1. Market planners begin with selling price required to
achieve a desired market share.
2. Selling price Desired profit = Total target cost
3. Assign portion of total target costs to marketing,
engineering, and manufacturing departments.
4. Redesign product and techniques to achieve target.
12-5
Purpose of Variances
Variances measure the difference between
actual and standard costs.


Favorable (F) variance, if actual < standard
Unfavorable (U) variance, if actual > standard
Decision control


Variances alert managers to deviations from plan.
Performance rewards may be based on minimizing
variances.
12-6
Variance Computation
Symbols:
T= Total; A = Actual; S = Standard; P = Price; Q = Quantity
Total Variance =
TV
=
=
=
=
=
Total Variance =
Actual Cost minus Standard cost
(AQ  AP) - (SQ  SP)
(AQ  AP) + [ - (SP AQ) + (SP  AQ)] - (SQ  SP)
[(AQ  AP) - (SP  AQ)] + [(SP  AQ) - (SQ  SP)]
[AQ  (AP - SP)]
+ [(AQ - SQ)  SP]
PV
+
QV
Price Variance + Quantity Variance
See Self-Study problem.
12-7
Direct Labor Variance
Symbols: a = Actual; s = Standard; H = Hours; W = Wage rate per
hour
Total
Flexible budget
Total
actual
based on
standard
cost
actual input
cost
(Ha  Wa)
(Ha  Ws)
(Hs  Ws)
|_______________________|
|______________________|
[Ha  (Wa - Ws)]
[(Ha - Hs)  Ws]
Wage variance
Efficiency variance
|_________________________________________________|
[(Ha  Wa)  (Hs  Ws)]
Total labor variance
See Figure 12-1.
12-8
Interpreting Direct Labor Variance
Large variances in either direction indicate
performance is not as planned, due to either poor
planning, poor management, or random fluctuation.
Unfavorable wage variance
Workers were not available at lower rates
Unfavorable wage variance with favorable efficiency
variance
Higher-paid workers performed work more efficiently
Favorable wage variance with unfavorable efficiency
variance
Lower-paid workers performed work less efficiently
12-9
Direct Materials Variance - current use
In this case, no direct materials remain in ending
inventories.
Total
Flexible budget
Total
actual
based on
standard
cost
actual use
cost
(Qa  Pa)
(Qa  Ps)
(Qs  Ps)
|__________________|
|_____________________|
[Qa  (Pa - Ps)]
[(Qa - Qs)  Ps]
Price variance
Quantity variance
|____________________________________________|
[(Qa  Pa)  (Qs  Ps)]
Total materials variance
See Figure 12-2.
12-10
Direct Materials Variance - no current use
In this case, all purchased materials remain in ending
inventories.
Recognize material purchase price variance at time of
purchase rather than waiting until materials are used.
Qb = Actual quantity bought
Total
Flexible budget
actual
based on
cost
actual purchased
(Qb  Pa)
(Qb  Ps)
|_______________________|
[Qb  (Pa - Ps)]
Price variance
See Figure 12-3.
12-11
Direct Materials Variance current and future use
Total actual
Flexible budget based
cost
on actual purchased
(Qb  Pa)
(Qb  Ps)
|_____________________|
[Qb  (Pa - Ps)]
Price variance
Flexible budget based
Total standard
on actual use
cost
(Qa  Ps)
(Qs  Ps)
|_______________________|
[(Qa - Qs)  Ps]
Quantity variance
Price variance recognized at time materials purchased.
Quantity variance recognized at time materials are used.
12-12
Timely Reporting of Materials Price
Variance is Important!



Managers can act quickly to mitigate or capitalize on
price changes.
For example, if a raw materials price rises,
managers might want to use less of the more
expensive material and more of the relatively less
expensive material, if such a substitution is possible.
And/or management might want to raise the selling
price for the final products.
12-13
Risk Reduction and Standard Costs



Risk reduction is a service individuals are willing to
buy from financial markets.
Standard costs remove price and efficiency
fluctuation from performance measures of
downstream users.
Downstream users bear less risk because they know
the standard costs they will be charged in the
future.
12-14
Incentive Effects: Build Inventories
Rewarding purchasing managers for favorable direct
materials price variances creates an incentive for
them to buy large quantities when price discounts
are offered for high-volume purchases.
Penalizing production managers for unfavorable
labor efficiency variances encourages keeping labor
busy producing more.
Mitigation of inventory building incentive
Charge purchasing department for cost of holding
inventory.
Just-in-time (JIT) purchasing and production policies
12-15
Incentive Effects: Externalities
Purchasing externalities on production



Purchase cheaper substandard materials.
Purchase price variance is favorable.
Unusable material results in unfavorable material
quantity variance.
Production externalities on purchasing


Short lead times on requisitions lead to higher
purchase prices.
Requesting special orders for materials leads to
higher prices.
See self-study problem, part b.
12-16
Incentive Effects: Discourage Cooperation
Evaluating performance evaluation on
individual's variances


Emphasizes individual instead of team efforts
Reluctance to help others look good
Solution:


Base reward system on both individual and
departmental (team) variances.
Too much weight on teamwork can lead to shirking
(free-rider problem).
12-17
Incentive Effects: Mutual Monitoring
Mutual monitoring


Method where managers or employees at the same level
monitor each other’s performance
Noninsulating allocations encourage mutual monitoring
(see Chapter 7)
Example when performance evaluation of both
purchasing and production managers depends on
both material price and quantity variances.


Purchasing manager wants to help production manager
become more efficient in material usage.
Production manager wants to schedule requisitions to
help purchasing manager buy materials at better prices.
12-18
Incentive Effects: Satisficing
Satisficing behavior:

Managers have incentives to achieve standard but go
no further.
Firm value would increase if managers attempted


continuous improvement beyond standard
innovate to meet competitive threats
12-19
Disposition of Standard Cost Variances
Alternatives for disposing (writing off) standard cost
variances are similar to the alternatives for disposing
of over/underabsorbed overhead (Chapter 9).
1. Writing all variances off to cost of goods sold
(expense)
2. Allocating between costs of goods sold (expense)
and work-in process and finished good inventory
3. Recalculating the cost of each job
The above alternatives are listed in order of
increasing complexity.
12-20
Cost of Maintaining Standard Cost
System
Standard cost systems require:
 Detailed standards for each labor and material input
 Updating for technological and price changes
 Time to investigate and explain variances
Standard cost systems are less likely to be used when:
 Direct labor cost is a small portion of total cost
 Rapid change in production processes or new product
introductions require frequent revisions of standards
12-21